The Asian Financial Crisis of 1997 - 1998 and the Behavior of Asian Stock Markets

by Urbi Garay

Urbi Garay urbi.garay@iesa.edu.ve is an Assistant Professor of Finance at the Instituto de Estudios Superiores de Administracin (IESA) in Caracas, Venezuela. [1]

ABSTRACT

This paper analyzes the currency and stock market collapses experienced by Hong Kong, Indonesia, Malaysia, the Philippines, Singapore, South Korea, Taiwan, and Thailand in 1997 and early 1998. Documented is the close relationship between the behavior of the stock markets of these countries during this period, and the evolution of their currencies. Price/Earnings and Price/Book ratios are used to show that Asian stock markets were not overvalued before the crisis started; thus suggesting that the crisis was not the result of a bursting bubble. This paper also describes the different theories of stock market co-movements across countries, which again become important with the post-crash reduction in the advantages to investors of international diversification.

1. Introduction
The aim of this paper is twofold. First of all, it reveals that the stock market collapses experienced by a number of South East Asian economies in 1997 and early 1998 where highly correlated with the evolution of the currencies of the countries involved. Secondly, using Price/Earnings and Price/Book ratios it is shown that Asian stock markets were not overvalued before the crisis started; thus suggesting that the crisis was not the result of a bursting bubble that some authors such as Krugman have argued. This paper also presents the different theories of stock market co-movements across countries. The presence of contagion or inter-dependence among economies of a certain region become important with the diminishment of the advantages to investors of international diversification, via increases in cross-correlations among stock market returns. The issue of international contagion and interdependence has been in the forefront of academic discussions as a result of Mexicos 1994 and Asias 1997-'98 financial crises. In the second section of this paper the behavior of S.E.-Asian currencies during the crisis is analyzed. The rest of the paper is organized as follows: the third section analyzes the evolution of S.E.-Asian stock markets during the crisis; the fourth section inquires whether Asian stock markets were overvalued before the financial crisis erupted; the fifth section presents the different channels of transmission through which the stock market of one country might be influenced by the evolution of other stock markets; and, finally, the sixth section summarizes and presents the author's conclusions.

2. The Evolution of Asian Currencies During the Financial Crisis

The Asian financial crisis started with the devaluation of Thailands Bath, which took place on July 2, 1997, a 15 to 20 percent devaluation that occurred two months after this currency started to suffer from a massive speculative attack and a little more than a month after the bankruptcy of Thailands largest finance company, Finance One. This first devaluation of the Thai Baht was soon followed by that of the Philippine Peso, the Malaysian Ringgit, the Indonesian Rupiah and, to a lesser extent, the Singaporean Dollar. This series of devaluations marked the beginning of the Asian financial crisis. [2] This first sub-period of the currency crisis took place between July and October of 1997. Figures 1A and 1B (below) present the monthly evolution of the currencies of the eight South-East Asian countries studied here for the period July 1997 (rebased to 100 in all the graphs) to May 1, 1998. [3] Included are the Hong Kong (H.K. Dollar), Indonesia (Rupiah), Malaysia (Ringgit), the Philippines (Peso), Singapore (SG Dollar), South Korea (Won), Taiwan (New Dollar) and Thailand (Baht).

A second sub-period of the currency crisis can be identified starting in early November, 1997 after the collapse of Hong Kongs stock market (with a 40 percent loss in October). This sent shock waves that were felt not only in Asia, but also in the stock markets of Latin America (most notably Brazil, Argentina and Mexico). In addition to these stock markets, were those of the developed countries (e.g. the U.S. experienced its largest point loss ever in October 27, 1997, which amounted to a 7 percent loss). These financial and asset price crises also set the stage for this second sub-period of large currency depreciations. This time, not only the currencies of Thailand, the Philippines, Malaysia, Indonesia and Singapore were affected, but those of South Korea and Taiwan also suffered. In fact, the sharp depreciation of Koreas Won beginning in early November added a new and more troublesome dimension to the crisis given the significance of Korea as the eighth largest economy in the world; the magnitude of the depreciation of its currency which took place in less than two months; and the Korean Central Banks success in maintaining the peg ever since the Thais first devaluation (i.e. the nominal anchor of the largest of the Asian Tigers was suddenly lost). In addition, was the other important component of this second sub-period: the complete collapse of the Indonesian Rupiah that started at about the same time. Finally, starting in January of 1998, the currencies of all of these countries regained part of what they had lost since the crises started. It is also important to note that at a great cost Hong Kong was able to maintain its peg after the crisis first erupted. This required that interest rates be raised to fend-off these currencies from repeated speculative attacks.

3. The Evolution of Asian Stock Markets During the Asian Financial Crisis

It is necessary to study the evolution of the stock markets and the inflow of money that went to the Asian economies in order to understand the financial crisis of 1997- 1998. Net equity investments in the economies of South Korea, Indonesia, Malaysia, Thailand, and the Philippines amounted to US$ 12.2 billion in 1994, US$ 15.5 billion in 1995, US$19.1 billion in 1996, and US$ 4.5 billion in 1997 according to the Institute of International Finance in 1998. The reversal for 1997 came as a result of the financial crisis that started in Thailand, which added pressure to the currency markets of the countries considered in this article. Net equity investments and new private loans financed most of the increasing current account deficits that the SE-Asian economies, as well as most of the developing world, experienced during the 1990s. The ability of most of the developing world to import capital through securities markets was enhanced by the exponential growth in the U.S. mutual fund industry, and the low interest rates available in the U.S. and Japan during the past decade. Now, through the following figures, let us turn our attention to the behavior of the Asian stock market indices during the crisis.

Figures 2A and 2B (above) show the monthly evolution of national stock price indices (expressed in US dollars) for these same eight countries and during the same period of time. The stock market indices are those provided by Morgan Stanley International Capital (MSCI). Figures 3A and 3B (below) show the behavior of the same Asian stock market indices from January 1997 to May 1998 but expressed in local currency. As can be seen, the direction of the stock markets is similar to that of Figures 2A and 2B in which the indices where expressed in US$ terms. However, the magnitude of the decline on the local stock market prices is not as pronounced when expressed in local currency.

Figures 3A and 3B (above) show the behavior of the same Asian stock market indices from January 1997 to May 1998 but expressed in local currency. As can be seen, the direction of the stock markets is similar to that of Figures 2A and 2B in which the indices where expressed in US$ terms. However, the magnitude of the decline on the local stock market prices is not as pronounced when expressed in local currency. This finding suggests the existence of a currency effect affecting stock price returns during the crises, as is explained in the next paragraph. The finding of a close relationship between exchange rate depreciations and stock returns during a crisis is consistent with Bailey, Chan and Chung (2001). These authors demonstrate, using intraday data, that the severe downturn of the Mexican stock market in December 1994 and early 1995 can be associated with the Peso devaluation that took place during this same period. In the case of the five Asian countries whose currencies experienced the sharpest depreciations during the Asian crisis (Indonesia, Malaysia, Philippines, South Korea, and Thailand) the average correlation between weekly stock market returns and currency changes (where currency is defined as the number of units of foreign currency per 1 U.S. dollar) between the first week of July 1997 and the first week of May 1998 is 0.63 and is significant at the 1percent level. My explanation for this strong association is that currency devaluations have traditionally been accompanied by declining stock markets in the developing world because they have usually taken place in the middle of a financial crisis and uncertainty about the future course of economic policies and outcomes. For instance, the negative impact of devaluing currencies on S.E.-Asian banks and companies that had borrowed heavily on international markets most probably surpassed the potential export gains. But an orderly devaluation such as that of Britain in 1992 did not have negative effects on the London stock market since it helped the British economy recover from a three-year recession via an export-boom.

4. Were the Stock Markets Overvalued Before the Crisis Started?

The stock markets of Hong Kong, Indonesia, and South Korea fluctuated with no clear trend before the first sub-period of the currency crisis began in early July, 1997. The stock markets of Malaysia, Singapore, the Philippines, and Thailand drifted downward during this same sub-period, with the later two countries experiencing the sharpest declines. Finally, Taiwan's stock market drifted upwards during this same sub-period of time. Therefore, I not see any evidence of a clear pattern of stock markets collapsing in a contagious fashion before the first round of devaluations took place in July, 1997, as Krugman (1998) suggested was the case: [4] And then the bubble burst. The mechanism of crisis, I suggest, involved that same circular process in reverse: falling asset prices made the insolvency of intermediaries visible, forcing them to cease operations, leading to further asset deflation. This circularity, in turn, can explain both the remarkably severity of the crisis and the apparent vulnerability of the Asian economies to self-fulfilling crisis which in turn helps us understand the phenomenon of contagion between economies with few visible economic links. I have checked the evolution of the same national stock market indices since 1991 (the preceding five years to the crisis) and, on one hand, I found a significant increase in Hong Kongs stock market asset prices (a fourfold increase), while, on the other hand, the remaining seven stock markets stayed remarkably flat, with some minor fluctuations. Furthermore, the performance of the Asian stock markets lagged behind the Latin American, the British, and the United States stock markets during the same years prior to the crisis. Thus, it seems hard to contend that the collapse of the stock markets in South East Asia was the result of a bursting bubble, since the stock prices of the markets of SE-Asia had hardly any growth six years prior to the currency crises of 1997.

To analyze whether rapidly increasing stock prices represent a bubble; financial economists try to express these prices in terms of indicators such as; the earnings of companies which trade stocks in the market (the P/E or Price/Earnings ratio, and the P/B or Price/Book ratio.) Rising stock prices and earnings may well yield a flat P/E ratio (i.e. there is no bubble since higher stock prices are justified by fundamentals, at least as it pertains to the P/E ratio.) For instance, authors like Gilibert and Steinherr (1996) contend that the rise in stock prices that took place in Mexico in the early 1990s was the product of a speculative bubble and that it was not justified by fundamentals. However, analyzing P/E and P/B ratios of Asian stock markets just before the crisis erupted it is difficult to contend that these markets were overvalued since the ratios were below the world average (See Table 1 above.) Finally, Table 2 (above) shows that the U.S. stock market had been, on a risk-adjusted basis, the best market performer during the period 1990-96, followed by Latin America, U.K., Asia (excluding

Hong Kong), and Japan. The fact that S.E.-Asian markets plummeted after having lagged behind the performance of those of the rest of the world, and after having remained relatively flat during the 1990s (i.e. no bubble), is another indication of how severe and dramatic the financial crisis was. Krugmans assertion is nonetheless consistent with the behavior of national stock prices in South East Asia after the first round of devaluations. Such evolution had actually preceded the second and more intense wave of devaluations of November and December of 1997. This is because, as was shown in Figures 2A and 2B (above), between the first and second round of devaluations the stock markets of Hong Kong, Indonesia, Korea, Malaysia, the Philippines, Singapore, Taiwan, and Thailand experienced sharp declines. Not until the currencies of these countries stabilized in early 1998 were their stock markets able to reverse the downward trend in stock prices (except in Indonesia). In summary, it is difficult to contend that falling stock prices during the Asian crises were the result of a bubble that was bursting or that Asian stock markets were overvalued before the crisis first erupted.

5. Stock Market Co-Movements: The Channels of Transmission [5]

In this section the literature of the determinants of stock market co-movements is briefly examined. Why do stock market co-movements occur? What are the linkages among stock markets that can explain a crisis such as the Asian? Calvo and Reinhart (1996) provide a brief summary of the existent explanations in the context of currency crisis, [6] and in this paper an attempt is made to adapt some of these explanations to the case of stock market co-movements during periods of financial crises, a sub-area in this field that has received relatively little attention. [7] Nonetheless, the inflow of capital to the developing world that took place in the late 1980s and early 1990s was accompanied by an increasing share of portfolio investments as local stock markets became increasingly open towards foreign investors. Such is the case for the Latin America countries where this situation is presented more frequently than in the South Eastern Asia countries. Stock market co-movements can be explained as follows: The first reason is that stock market co-movements may take place when the financial markets of two countries are highly integrated so that shocks to the larger country are transmitted to the smaller ones via assets-trading. An example of this type of spillover is the integration of the capital markets of Argentina and Uruguay. As a result of Argentinas 2001-2002 severe crisis and subsequent external debt default and currency devaluation, Uruguay has recently been forced to devalue its currency. The second most important reason are the trade partners and bilateral or multilateral trade arrangements that enhance the possibilities of international shocks. For instance, when the currency of a country experiences a large real depreciation, imports from its trading partners fall, and the trade balance of the country whose currency is devalued deteriorates, thereby setting the stage for the currencies of its neighbors to suffer speculative attacks if the impact is large enough. For example, the Brazilian devaluation of 1999 placed great pressure on Argentinas currency, Brazils most important trading partner. The third reason (See Chua, 1993.) emphasizes the role of technological factors on economic growth. Technological spillovers between neighboring countries tend to occur because ideas and capital flow are faster and easier across neighboring countries rather than across distant countries. Thus, the economic growth of a country is affected by the economic growth of its neighbors. I have found a highly significant and positive regional spillover effect in a number of the South East Asian countries.

The first three theories or reasons presented above attempt to explain stock market co-movements as a consequence of economic linkages among countries. These theories are what Forbes and Rigobon (2000 and 2002) might call interdependence explanations. Nevertheless, the last three theories or reasons, which are of a contagious nature, deal with the effects of investors behavior on stock markets, the result of which may cause a stock market crisis or exacerbate an existing one. The fourth reason, is that spillovers or contagious crises may occur for institutional reasons according to the theories of Calvo and Reinhart (1996) theories: [8] In response to a large adverse shock (such as the Mexican devaluation) [9] an open-end emerging market mutual fund that is expecting an increasing amount of redemptions will sell off its equity holdings in several emerging markets in an effort to raise cash. However, given the illiquidity that characterizes most emerging markets, the sell-off by a few large investors will drive stock prices lower. Hence, the initial adverse shock to a single country gets transmitted to a wider set of countries. The fifth reason is that investors sentiments can generate self-fulfilling crises if foreign investors do not discriminate among different macroeconomic fundamentals across countries. There exists a vast literature on banking and financial crises in the developed world in which the issue of contagion effects arise frequently. According to Calvo and Reinhart, for example:[10] In the wake of a bank failure (particularly a large of prominent bank), anxious depositors possessing imperfect information about the soundness of other banks rush to withdraw their deposits from the banking system at large. The stampede by depositors generates a liquidity crisis that spreads to other healthy banks. Thus, herding behavior by depositors alters the "fundamentals" for a broader set of financial institutions and the crisis becomes self-fulfilling...A similar story can be told about investors in international currency and equity markets...With regards to emerging markets, however, relatively little is known about these issues. The sixth reason is that contagion may occur because of the way market participants interpret possible co-movements in macroeconomic policies and fundamentals in the economies subject to attack. [Eichengreen, Rose, and Wyplosz (1996)] Given the experience of currency crisis being accompanied by stock market collapses in the developing world (The figures shown above confirmed this in the context of the SE-Asian financial crises), a speculative currency attack against one currency and the concomitant effects may well trigger simultaneous declines in the stock markets of these same countries.

6. Conclusions
In this paper the currency and stock market collapses experienced by a number of South East Asian economies in 1997 and mid 1998 have been examined, and the close relationship between the behavior of their stock markets during this period and the evolution of the currencies of the countries involved was analyzed. Shown was that the severe downturn of the Asian stock markets during the financial crisis can be associated with the currency devaluations of the five countries whose currencies experienced the sharpest depreciations during the crises, especially in the case of Indonesia, Malaysia, Philippines, South Korea, and Thailand. This was reflected in an average correlation between weekly stock market returns and currency depreciations of 0.63 during the crisis period. When the evolution of South East Asian stock markets prior to the crisis was analyzed there was no evidence found of a clear pattern of stock markets collapsing in a contagious fashion before the first round of devaluations took place in July, 1997 as Krugman (1998) suggested was the case. Krugmans assertion is nonetheless consistent with the behavior of national stock prices in South East

Asia after the first round of devaluations occurred. Also, the fact that South East Asian stock markets plummeted after having lagged behind the performance of those of the rest of the world, and after having remained relatively flat during the 1990s (i.e. no bubble), is another indication of how severe the financial crisis was. Stock market co-movements may occur for different reasons. First, they may take place when the financial markets of two countries are highly integrated so that shocks to the larger country are transmitted to the smaller ones via assets-trading. Second, trade partners and bilateral or multilateral trade agreements enhance the transmission of shocks internationally. Third, spillover effects may be the result of technological factors or economic growth. Fourth, contagious crisis may occur for institutional reasons. Fifth, investors sentiment can generate self-fulfilling contagious crisis if foreign investors do not discriminate among different macroeconomic fundamentals across countries. And sixth, contagion may occur because of the way market participants interpret possible co-movements in macroeconomic policies and fundamentals in the economies subject to attack. Even though I did not test any of the theories of contagion in this article, I am inclined to think that competitive devaluations were present during the crisis and that a domino effect was created when international mutual funds sold Asian stocks and bonds of both crisis and non-crisis countries in an effort to raise cash. These two channels of transmission correspond to the second and fourth theories of contagion outlined in the previous paragraph. Finally, I conclude that contagion or interdependence across stock market returns diminishes greatly the advantages of international diversification highlighting the instability of historical correlation coefficients among stock market indices when a crisis occurs.

References
Bailey, W., Chan, K., and P. Chung, Depositary Receipts, Country Funds, and the Peso Crash: The Intraday Evidence, The Journal of Finance, (Dec. 2002), v55, n6, pp. 2693-2717. Calvo, S., and C. Reinhart; Capital Flows to Latin America: Is There Evidence of Contagion Effects, in Calvo, Goldstein, and Hochreiter, Private Capital Flows to Emerging Markets after the Mexican Crisis (Vienna: IIE, 1996.) Chua, H.; Regional Spillovers and Economic Growth, Center Discussion Paper No. 700. New Haven, CT: Yale University Economic Growth Center. Eichengreen, B., Rose, A., and Ch. Wyplosz; Contagious Currency Crises, National Bureau of Economic Research Working Paper 5681, 1996. Forbes, K., and R. Rigobon; Contagion in Latin America: Definitions, Measurement, and Policy Implications, NBER Working Paper No. 7885, 2000. Forbes, K., and R. Rigobon; No Contagion, Only Interdependence: Measuring Stock Market Comovements, The Journal of Finance, (Oct. 2002), v57, n5, pp. 2223-2261. Gilbert, P., and A. Steinherr; Private Capital Flows to Emerging Markets after the Mexican Crisis, in Calvo, Goldstein, and Hochreiter, Private Capital Flows to Emerging Markets after the Mexican Crisis (Vienna: IIE, 1996.)

International Finance Corporation, Emerging Markets Factbook (Washington: The World Bank, 1998) Krugman, P.; What Happened to Asia?, Unpublished Manuscript, 1998 Patel, S., and A. Sarkar; Stock Market Crises in Developed and Emerging Markets, Federal Reserve Bank of New York Working Paper, 1998.

Footnotes
1. The author would like to thank Gerald Epstein and B>Quest referees for very helpful comments. The usual disclaimer applies. 2. Chinas 1994 40 percent devaluation and the Japanese Yens 25 percent depreciation between 1995 and 1996 weakened the competitive position of the rest of the countries of the region and set the stage for the round of competitive devaluations that took place in the middle of 1997. 3. The source of the data is Datastream. 4. Krugman (1998), p. 3 5. It is beyond the scope of this study to attempt to test any of the theories presented in this section. 6. The literature on the subject of currency crises is vast. A widely cited paper in this area is Eichengreen, Rose, and Wyplosz (1996). Using thirty years of panel data from twenty industrialized countries, these authors find evidence that speculative attacks tend to be temporarily correlated and that currency crises seem to pass from one country to another. The authors also conclude that an important variable explaining these currency co-movements was the existing linkages of international trade between the countries affected. 7. Patel and Sarkar (1998) study stock market crises in developed and emerging markets between 1970 and 1997 finding evidence of contagion across markets from the same region. 8. Calvo and Reinhart (1996), p. 156 9. The authors refer to the large devaluation of the Peso that took place in December 1994 and early 1995. 10. Calvo and Reinhart (1996), p. 157.

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