MINI-GASE Asian Currencies Sink in 1997 a ea aL or Daring the second half of 1997, and beginning in Thailand, currencies and stock markets plunged across Eas Asia, while hundreds of banks, builders, and manufacturers went bank rupt. The Thai baht, Indonesian rupiah, Malaysian tinggi, Philippine peso, and South Korean won depreciated by 40% to 80% apiece. All this happened despite the fact that Asia’ funda” rentals looked good: low inflation, bslanced budgets, well-run central banks, high domestic savings, srong export iidustis, a large and growing middleclass, a vibrant entrepreneurial class, and industrious, well mined, and often welleducated workfores paid relatively low wages. But investors were looking past these positives o signs of impending trouble. What they ‘07 Was that many Fast Asian economies were locked on a course that was unsustainable, char. acterized by large trade defics, huge shortterm foreign debts, overvalued currencies and Financia systems that were rotenat their core. Each ofthese ingredients played a role nthe e= ‘sand is spread from one country to another. Loss of Export Competitiveness. To begin, most East Asian counteies depend 6n ‘exports as thelr engines of growth and developmen, Along with Japan, the United States the ‘ost important market for these exports. Pardy because of this, many of them had tied their currencies tothe dolla. This te served them well until 1995, promoting low inflation and cur- rency stability It slso boosted expons atthe expense of Japan as the dollar fell against the yen, forcing Japanese companies to shift production to East Asa to cope with the sttong yen, CCarrency stability also led East Asian banks and companies to finance themselves with dollars, yen, and Deutsche marks—some $275 billion worth, much of it shor term—beeause dolla and other foreign currency loans catied lower interes ates than did their domestic currencies, ‘The party ended in 1995, when the dollar began recovering aguinst the yen and other currencies,By mid-1997, de dollar hd ven by over 50% against the yen and by 20% against the German mark Dollar appreciation alone would have made Est Asi exports less rice competive But their competiveness problem was grealy exacerbated by the fact that during this period, he Chinese yuan deprecated by about 25% agains the dolla? China exported simula products, so the yuan devaluation raised China export competivness al East Ass expense The loss of ‘export competitiveness slowed dowa Asan growth and caused ulation rates and pfs — ‘on huge investments in production capacity to plunge. I ako gave the Asan central banks mutual incenve to devalue their eumences. According to one theory reognting des led incentives, speculators atacked the East Asian currencies almost simblaneously and forced a toured of devstsations Moral Hazard and Crony Capitalism, Another theory sugges that moral hazard—the tendency to incur risks that one is protected against—ties atthe heart of Asia financial prob lems. Specially, most Asian banks and finance companies operated with implicc or explicit government guarantees. For example, the Sou Korean government deed the banking 9s- tem to lend massively to companies and industries that viewed as economically statics wih litle regard for thie profiabilty. When combined with poor regulation, these guarantees dis- torced investment decisions, encouraging financial fnsittions to fund risky projects in the ‘expectation thatthe banks would enjoy any profs, while ticking the government with any losses, (These same perverse incentives unde the savings and lan acon the United Sates during the 1960s) in Asia case the problem was compounded bythe con capitalism that i Penasive throughout the region, with lending decsons often dictated more by politcal and family ties than by economic reality Billions of dolla in easy-mone loans were made to fam\- ly and friends ofthe wel connected, Without marke dicplineosk-based bank lending, the resule was overinvestment——fnanced by vast quatts of debr—and inflated prices of acts in “shor supply, sucha land? ‘This financial bubble persists as long as the goverament guarantee is maintained. The Inevitable glut of real esate and excess production capacy leads to large amounts of nouper- forming loins and widespread loan defaults. When tality strikes, nd investors reali that he gpvernment doesn have the esourees to balou everyone, asset vals pet and the bub- ies burst, The decline in asset values tigers ure loan defauls,eausing alos ofthe con- fidence on which economic activity depends. lnvestrs also worry thatthe government will ty toinila is way out fis dificult. The result isa elreinforeng downvwar spiral and capital fight As foreign investors refuse to renew las and begin to sll off shares of overvalued Local companies, capa ight accelerates and the local eurency fille, ncreasng the cost of servicing foreign debts. Local firms and banks scramble to buy foreign exchange before te currency fs farther, puting even more downward pressure on the exchange rte. This story explains hy stock prices and currency values declined together and why Asan financial igsttaons were ‘specially hand hit. Moreover, this process ely to be contagious, as investors search for cher countries with similar characteristics. When sich a county found, everyone rushes for the ext simulancousy and another bubble is burst, another crency is sunk 2or sdscussion ofthe role that the Chinese yuan deaaton played in the Ain criss see Kenneth Kas, “Export Competition an Contagious Carney Cres” Eno te, Feder Reserve Bak of San Frans, sry 16,198, ‘See. Hand Kemeth Kas, ‘A Dyramic Model of Expont Compton, Ploy Coonan, nd Simultaneous _Gamency Calpe” working paper, Federal Reserve Bak San Franco, 197 his explanation forthe Asan crise fons Krugman, “What Happened o Asa” MIT working paper 1994,The standard approach of staving off currency devaluation ito raise interest rate, there- by making t more attractive to hold the local eurency and increasing capta inflows Hloweree, {his approach was problematic for Asian central banks. Raising interes rates boosted the coe of funds to banks and made it more dificult for borrowers to service ther debts, thereby further rippling an already sick financial sector, Higher intrest rates also lowered real estate values, which served as collateral for many of these loans, and pushed even more loans tne deal ‘Thus, Asian central banks found their hands were ted and investors recognized that The Bubble Bursts. These wo stories—ioss of expon competitiveness and moral hazard in lending combined with crony captalism—combine to explain the severity of the Asian ests Appreciation of the dollar and deprecation of the yen and yuan slowed down Aslan eeonorn ‘rowth and hur corporate profits, These factor turned ill-conceived and overeveraged invest ‘ents in property developments and industrial complexes ino financial daastrs The kes financlal crisis then was touched off when local investors began dumping their own curteneies for dollars and foreign lenders refused to renew thit loans twas aggravated by politicians, such as in Malaysia and South Korea, who preferred to blanie foreigners for thet problems rather than seek structural reforms of their economies. Both foreign and domestic hivesto already spooked by the curency ers, lst yet more conidence in these nations and duped ‘more of their currencies and stock, driving them to record lows ‘This synthesized story is consistent with the experience of Taiwan, which is @ net ‘exporter of capital and whose savings ae largely invested by private capitalists without govern tment tection or guarantees Taiwanese busineses also are financed far less by deb than by quity. In contrast to its Aslan competitors, Talwan suflered minimally during 1997, with the ‘Talwar dollar (NTS) down by a modest 15% (to counteract is los of export compesiveness to (China and Japan) and is stock market atilly up by 17% in NTS terme, “The way ot,” said Confuelus, “is through the door.” The clear ext stntegy for Ease ‘Asian countries wast resituctare ther ling rand ysiems by shutting down ofelling off {ailing banks (fr example, to healthy foreign banks) and disposing ofthe collar veal eoste and industrial properis) underlying their bad loans, Although the restructuring has not gone 4 fara & needs to, the result so far is fewer but stronger and better-capitalized bans and restructured aind consolidated industries and a-conuintation of East Asia strong historical growth record: However, progress has been slow in reforming bankruptcy laws, a rial el iment of reform. Simply put, governments must step aside and allow those who bortow 109 ‘much or lend too foolishly to fail. Ending governmesc guarantees and peliically modvated lending wall transform Asia’ financial sector and forcécleaner and more transparent financial transactions. The result wll be beter investment decisions —decisione driven by market forces athe than personal connections or government whim-—and healthier economics that attract ‘apa forthe right reasons. : Questions 4, What were the origins ofthe Asian curency crisis? 2. What role did expeciations play in the Asan currency exis? 3. How did the appreciation of the USS. dollar and deprecation of the yuan affect the timing and magnitude of the Asian currency cris? 4: What is mora hazard and how did it help cause the Asan currency criss? 5. Why did so many East Asian companies and banks borrow dollat, yen, and Deutsche tmatls instead oftheir local currencies to finance their operations? What risks were they exposing themes) é