2012

ASIAN FINANCIAL CRISIS

ITS DEVALUATION AND BANKING CRISIS ACROSS ASIA

SUCHITRA KUMARI NEHA KUMARI

CENTRAL UNVERSITY OF JHARKHAND

INTRODUCTION
The term financial crisis is applied broadly to a variety of situations in which some financial institutions or assets suddenly lose a large part of their value. When a financial system is hit or threatened by widespread bank failure, it is referred as Financial Crisis. The Asian financial crisis was a period of financial crisis that gripped much of Asia beginning in July 1997, and raised fears of a worldwide economic meltdown due to financial contagion. Until 1997, Asia attracted almost half of the total capital inflow into developing countries. The economies of Southeast Asia in particular maintained high interest rates attractive to foreign investors looking for a high rate of return. As a result the region's economies received a large inflow of money and experienced a dramatic run-up in asset prices. At the same time, the regional economies of Thailand, Malaysia, Indonesia, Singapore, and South Korea experienced high growth rates, 812% GDP, in the late 1980s and early 1990s. This achievement was widely acclaimed by financial institutions including the IMF and World Bank, and was known as part of the "Asian economic miracle". Much of the crisis is attributed to the substantial depreciation of Asian currencies, which caused severe financial problems for firms and government throughout Asia, as well as some other regions. This crisis demonstrated how exchange rate movements can affect country conditions and therefore affect the firms that operate in those countries. Our specific objectives are to describe the condition of the Asian Crisis, explain the reason behind the crisis and its consequences on the Asian countries and on the rest of the world. We will also deal with our learning from this report.

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EVENTS HAPPENED IN ASIAN FINANCIAL CRISIS:

Early 1997: The Thai Baht was hit by massive speculative attack. Early 1997: There were seven high-profile bankruptcies of Korean conglomerates. July 1997: The Philippines abandoned dollar-peg and imposed certain foreign exchange controls. Malaysia also abandoned its pegged exchange rate. August 20, 1997: The IMF put together a $17.2 billion Thai rescue. Mid-October, 1997: Devaluations to the dollar average 20% to 30% in Thailand, Indonesia, Malaysia and the Philippines. November 5, 1997: Indonesia finalized a deal with the IMF for funding that could total up to $42.3 billion. December 4, 1997: The IMF organized a $58.2 billion rescue for Korea. June, 1998: The second phase of the crisis began with another speculative attack on the Hong Kong dollar. June, 1998: The Hong Kong dollar peg was defended by the authorities with market intervention. July 17, 1998: The United States begun to intervene in the foreign exchange markets, attempting to support the Japanese yen. August, 1998: The Hong Kong dollar was attacked again and $8.8 billion were spent defending it. September 1, 1998: Malaysia imposed more capital controls. Mid-September, 1998: As real economic activity contracts, Korea lowers short term interest rates. Indonesia, South Korea and Thailand were the countries most affected by the crisis. Hong Kong, Malaysia, Laos and the Philippines were also hurt by the slump. The People's Republic of China, Taiwan, Singapore, Brunei and Vietnam were less affected, although all suffered from a loss of demand and confidence throughout the region. Crisis in Thailand: The crisis started in Thailand with the financial collapse of the Thai baht after the Thai government was forced to float the baht (due to lack of foreign currency to support its fixed exchange rate), cutting its peg to the U.S. dollar. At the time, Thailand had acquired a
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burden of foreign debt that made the country effectively bankrupt even before the collapse of its currency. As the crisis spread, most of Southeast Asia and Japan saw slumping currencies, devalued stock markets and other asset prices, and a precipitous rise in private debt.

Fig.: Graph showing Exchange Rates-domestic currency value of U.S dollar. The high level of spending and low level of saving put forward a pressure on the prices of real estate and on products and on the local interest rates. Normally, countries desire a large inflow of funds because it can help support the countrys growth. In Thailands case, the inflow of funds provided Thai banks with more funds than the banks could use for making loans. Consequently, in an attempt to use all the funds, the banks made many very risky loans. While the large inflow of funds put downward pressure on interest rates, the supply was offset by a strong demand for funds as developers and corporations sought to capitalize on the growth economy by expanding. Thailands government was also borrowing heavily to improve the countrys infrastructure. Thus, the massive borrowing was occurring at relatively high interest rates, making the debt expensive to the borrowers. The Thai stock market dropped 75%. Finance One, the largest Thai finance company until then, collapsed. Crisis in Indonesia: In July 1997, when Thailand floated the baht, Indonesia's monetary authorities widened the rupiah currency trading band from 8% to 12%. The rupiah suddenly came under severe attack in August. On 14 August 1997, the managed floating exchange regime was replaced by a free-floating exchange rate arrangement. The rupiah dropped further. The IMF
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came forward with a rescue package of $23 billion, but the rupiah was sinking further. Companies that had borrowed in dollars had to face the higher costs imposed upon them by the rupiah's decline, and many reacted by buying dollars through selling rupiah. Before the crisis, the exchange rate between the rupiah and the dollar was roughly 2,600 rupiah to 1 USD. The rate plunged to over 11,000 rupiah to 1 USD on 9 January 1998, with spot rates over 14,000 during January 2326, 1998. Indonesia lost 13.5% of its GDP that year.

Fig.: Graph showing Exchange Rates-domestic currency value of U.S dollar. Crisis in South Korea: Exports growth fell significantly and the current account deficit widened dramatically during 1996, compounding a massive build-up of short-term debt. However, Koreas more flexible exchange rate arrangement and its relatively closed financial sector had made the immediate risk of a speculative attack less likely.

Fig.: Graph showing Exchange Rates-domestic currency value of U.S dollar.

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Yet problems were mounting in the corporate sector. Large Korean conglomerates were reporting deteriorating profitability, thereby creating fears about possible bankruptcies. Stock markets fell sharply as a result. A number of conglomerates went bankrupt in 1997, which worsened the fragile state of the banking system. Crisis in Malaysia: In July 1997, within days of the Thai baht devaluation, the Malaysian ringgit was "attacked" by speculators. The overnight rate jumped from under 8% to over 40%. This led to rating downgrades and a general sell off on the stock and currency markets. Shortterm capital inflows surged, bank lending increased sharply, and the availability of loans fuelled an asset (especially property) price boom. In 1998, the output of the real economy declined plunging the country into its first recession for many years.

Fig.: Graph showing Exchange Rates-domestic currency value of U.S dollar. Crisis in Philippines: The Philippine GDP contracted by 0.6% during the worst part of the crisis. As Thailand triggered the crisis on 2 July and on 3 July; the Philippine Central Bank intervened to defend the peso, raising the overnight rate from 15% to 32% at the onset of the Asian crisis in mid-July 1997. The peso dropped from 26 pesos per dollar to 54 pesos per dollar as in early August, 1997.

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Fig.: Graph showing Exchange Rates-domestic currency value of U.S dollar.

Causes of the crisis

There were two major hypotheses behind the cause. The first set claims that poor fundamentals and structural weaknesses were at the root of the crisis. Fundamental imbalances and inadequately regulated domestic financial markets created a situation that proved unsustainable. Secondly, the crisis was the result of a sudden shift in investor sentiment, unrelated to economic fundamentals. According to the fundamentals view, basic economic weaknesses and policy inconsistencies were at the origin of the financial crisis in 1997. First, on a microeconomic level, several financial sector weaknesses appear to have played a significant role in the onset of the Asian crisis. Liberalization of financial markets in the early 1990s led to a rapid expansion of financial services and a surge in capital flows which made the East Asian economies increasingly vulnerable to the potential instability of international financial markets. The tremendous increase in private capital inflows fuelled a domestic lending boom and contributed to the emergence of significant asset price bubbles, such as a real estate bubble in Thailand. Since many of these assets were used as collateral against bank loans, many banks found themselves in an especially vulnerable position (table 1).

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Table 1 A large share of the capital flows that were intermediated through banking system consisted of private short-term unhedged loans. These foreign currency-denominated loans were used to finance domestic long-term investments. This created serious maturity and currency mismatches, which made domestic banks increasingly vulnerable to changes in exchange rates and interest rates. Low interest rates and excess liquidity in the major industrialized economies favored investment into emerging markets. Moreover, Asias strong economic performance had made foreign investors increasingly confident in the regions prospects. Government guarantees (both implicit and explicit) of bank liabilities and de facto fixed exchange rates enhanced this perceived sense of security and encouraged moral hazard on the part of both borrowers and lenders. This contributed to the heavy dependence on foreign debt and its associated risks. Several signs of growing risk on a macroeconomic level intensified these microeconomic vulnerabilities. Several observers have focused on the growing current account deficits. These widening external deficits were the result of appreciating real exchange rates and slowing exports growth. Those Asian economies that had effectively pegged their exchange rates to the US dollar suffered a loss in competitiveness when the dollar appreciated against the Japanese yen and major European currencies. Exports growth was also adversely affected by the stagnation of the Japanese economy and a shift of comparative advantage towards China. Once economic growth slowed and concerns about the financial sector imbalances started to rise, capital flows reversed and increased the probability of successful speculative attack.

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Impact of the crisis on Asian countries

Thailand, Malaysia, Indonesia and South Korea were the most affected countries. Hong Kong, Laos and the Philippines were also hit by the slump. China, India, Taiwan were relatively unaffected. Japan was not affected much but was undergone its own long-term economic difficulties.

Thailand:
Liberalization of capital movements and increasing capital inflow. Increase in short-term foreign borrowing of private sectors. Ratio of short-term foreign borrowing to international reserves increased from 72.2 %( 1992) and 114.2 %( 1995) to 145% before crisis. From 1985 until July 1997, the Baht was pegged at 25 to the dollar. In May, the Baht hit by two Speculative attack. On July 2, the fixed exchange rate regime broke down. The baht dropped very swiftly and lost half of its value. The Thai stock market dropped to 75% in 1997.

Indonesia:
It started in 1997 set off by contagion from Thailand. It reached its peak from 1998 to 2001. When Thai crisis erupts, pressure on the Rupiah significantly increased. By summer 1998, rupiah lost 85% of its value.

Malaysia:
Pre-crisis had a large current account deficit (-5%). The Malaysian ringgit was attacked by speculators within the days of Thai baht devaluation. Ringgit lost 50% of its value.

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South Korea:
Massive short-term international borrowing boom during 1990s. Debt/GDP ratio was lowered. Short-term debt/International reserves were much higher. In order to defend fixed exchange rates, Central bank depleted its low international reserves. Deep recession in 1998. Partial recovery in 1999.

Impact of the crisis on rest of the world

Impact on Latin American countries: Countries such as Chile, Mexico and Venezuela were adversely affected because the exports products to Asia and the weak Asian economies resulted in a lower demand for the Latin American exports. In addition, the Latin American countries lost some businesses to other countries that switched to Asian products because of the substantial depreciation of the Asian currencies, which made their products cheaper than those of Latin America. Impact on Europe: many European firms were adversely affected by the crisis. Like firms in Latin America, some firms in Europe experienced a reduced demand for their exports to Asia during the crisis. In addition, they lost some exporting business to Asian exporters as a result of the weakened Asian currencies that reduced Asian prices from an importers perspective. European banks were also affected because they had provided large loans to numerous Asian firms that defaulted. Impact on the United States: stock values of U.S firms such as Motorola, Hewlett-Packard, and Nike that conducted much business in Asia declined. Many U.S engineering and construction firms were also affected as Asian countries reduced their plans to improve infrastructure. Stock values of U.S exporters to those countries fell because of the decline in spending by the consumers in Asian countries and because of the weakening of the Asian currencies which made U.S products more expensive.

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Learning
Develop the right set of institutional incentives and tool to manage risk and operate effectively in a global market economy. Avoid large current a/c deficit financed through short-term or unhedged capital inflows. Avoid high leverages and excessive reliance on foreign borrowing. Floating exchange rates are more likely to encourage better risk management. Mitigate the effect of crisis on low-income group social policies. Developing countries should keep a healthy level of International reserves.

Conclusion
The Asian Financial Crisis was initially a financial one as speculation caused funds to drain out of Thai and Korean currencies and stock markets. The crisis eventually caused economic growth rates to collapse in several South East Asian countries. Due to this, many businesses collapsed, millions of people fell below the Poverty line in 1997-1998. There was a significant decrease in GDP and higher interest rates. Many lessons should be learned from this crisis to avoid future downfall in financial systems and foreign reserves. It cannot be denied that the international financial arena was in a constant state of flux. Emerging market countries have assumed a greater role, some under more auspicious circumstances than others. Increasing integration with global (financial) markets offers new opportunities, but also poses challenges. One of the challenges for policy-makers is to not only learn from past experiences, but to also be ahead of future developments. It really gave us the complete idea about the International Financial Management which will help us in further analyzing such Crisis and related state of affairs.

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References
Pilbeam Kieth, International Finance Macmillan Publishers, 2010. Jeff Mandura, International Financial Management 2010. Krugman, R.Paul and Obstfeld Maurice, International Economics Wiley Student Edition, 2010. www.google.com, www.authorstream.com, www.sciencedirect.com. THANK YOU.

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