ECONOMICS IN PRACTICE CHAPTER 50 Financial Crises, Stabilization, and Deficits 635 Bubbles or Rational Investors? ‘A financial rsis gripped much of southeast Asia in 1997. From 1985, 10 1996, Thailand’s economy had grown at an average of over 9 per ‘cent per year, the highest economic growth rat of any country atthe time, This was widely acclaimed by such financial institutions asthe IMF and World Bank, and described as part ofthe “Asian economic ‘miracle In order to encourage confidence among foreign investors, the baht was effectively pegged at 25 baht to the dollar. Until 1997, the economies of southeast Asia kept interest rates high in order to attract foreign investment. The region's ‘economies enjoyed a large inflow of capital and a dramatic increase in stock and real-estate asset prices. Investors were often ‘ignorant of the fundamentals or risk profile ofthe Thai economy, and the short-term capital flow, which was often looking for a quick profit, was expensive. The Thai economy developed 3 “bubble” fucled by this hot money, which investors may have known and been nervous about In 1994, Paul Krugman, the 2008 Noble laureate in Economics, {questioned whether there really was an Asian economic miracle, rguing that economic growth had resulted largely from increasing ‘capital investment without an accompanying increase in productiv ity. He warned that this could not lead to long-term prosperity ‘Thailand's maintenance of the fixed exchange rate encouraged ‘Thais to borrow abroad and led to excessive exposure to foreign exchange risk in both the financial and corporate sectors ‘As the US. economy recovered from recession in the early 1990s, the Federal Reserve Bank began to raise interest rates to dampen inflation. This made the United States 1 more attractive investment destination and strengthened the dolla, Thailand's exports conse quently became more expensive and less competitive in global ma ets and export growth slowed dramatically in spring 1996, Some see the main cause of the criss as a bubble caused by irresponsible real estate speculation ‘As suspicions grew that Thailand's financial institutions might bbe in trouble, the Bank of Thailand supported them by issuing ‘money. which fueled speculation against the baht and depleted net reserves. To reduce the flight of capital, interest rates were raised to very high levels and the baht was supported atthe Fixed exchange rate by using foreign currency reserves. Neither policy could be sus tained for long. High interest rates damaged an already fragile con: ‘omy, and the central bank risked running out of foreign currency ‘On May L415, 1997, the Thai baht was hit by massive speculative attach, but on June 30, 1997, rime Minister Chavalt Yongchaiyudh, said he would not devalue it. This ignited the Asian financial criss, On July 2, 1997, the government gave up defending the fixed exchange rate against international speculators and allowed the cur rency to float. ‘Thailand’s booming economy ground to ahalt.Some economists ‘compared the rapidity with which the financial markets collapsed to classic bank run, and it has been suggested that asymmetric infor- ration in the financial markets made a “herd mentality” among, However, mi 1y economists believe the Asian crisis resulted not From market psychology but from policies which distorted incem tives to lenders and borrowers, Large amounts of available credit led to a highly leveraged economy and raised asset prices to an “unsustainable evel When these began to collapse, they caused indi- viduals and companies to default on debt repayments, which led to a credit crunch and further bankruptcies. ‘In August 1997, the IMF unveiled a rescue package for Thailand totaling $20.9 billion. The crisis-ridden nation was required to reduce government spending and deficits, allow insolvent banks and financial institutions to fil, and raise interest rates aggressively in order to restore confidence in the nation’s fiscal solvency. ‘The baht lost more than half its value, reaching its lowest point of 56 babt to the dallar in January 1998, while the Thai stock market fell 75 percent. Many Asian nations learned from their experiences, and allowed their currencies to weaken in order to build up foreign exchange eserves as a hedge against future attacks. This led to them investing, in U.S. treasury bonds, which then allowed stock asict and housing, bubbles to develop in the United States. By 2001, Thailand's economy had recovered and the Thai cur rency stands at29 baht tothe US. dollar in October 2010. Sources: Bluse, Paul 2003, The Chastening: Inside the Cris that Racked the Global Financial System and. Humbled the IME, New York PublicAfurs; Flood, R- and Garber, P, 1984, Collapsing Exchange Rate Regimes: Some Linear Examples Journal of International Esemomies W:1-13 Halder, A. Khan, 2008, Globul Markets and Financial Crises in Asia University of Denver, Hughen Hclen, 1999, rony Capitalism and he Eat Asian Currency Financial ‘Crises Kautman, ©.G, Keusgen, TH, and Hunter, Wc. 1999, The Asian Financial Crisis: Origins, Implications aed Solutions Netherlands: Speingct: Krugman, P.1979.°A Model of Balance ‘of Payments Crises: Journal of Money, Credit, and Ranking: 311-825 Keangman, Paul 1998, The Nh of Asis Miracle: A Cautionary Fable Retrieved from wwasewaciclu/~munia/473/SS1047Slecture8 pat [Accessed 13 November 2010]: Krugman, Py 1998s, Bubble, Boom, Crash ‘Theoretical Nos on Asus Criss mimeo: Krugman, P1998, What happened to Avia? mimeo: Licbhold, Davi, 1999, "Thailand's Scapegoat? Batling Exiradition over Charge of Embeczlement, Financier Says he's the Fall, Guy for the 1997 Fina Rand Pill H., 1996, Credible. Liberaiations and. International” Captal. Flows: The Overborroming in TARo and A.0. Krucger, eds, Financtal Deregulation and ix Bast Asi, Chicago: Chicago University ress Obstield, M..1994, The Logic of Currency Crises, Cahiers Economiques et Monetaires 43:189-213. Stammwally, Amoar, 1997, Thailand: Boom and Bust, B Thailand Development Research Instinite: Sight oreph 1996.5 The Es Asan Miracle The World Bank Resetech Observer: 1