Anatomy of a Currency Crisis
Hong Kong's stock index fell 10 percent in a single day in late October, and stock markets around the world reverberated in response. In Boston, members of the financial community watched anxiously as stock prices slumped in Athens and São Paulo as well as Seoul and New York. For weeks thereafter, the financial press spewed tales of Asian flu bugs, typhoons, dominoes, and, in a geographically mixed metaphor, herds of gazelles fleeing lions, real and imagined. Some of the commentary was hyperbole; some depicted the episode as a "blessing" for the United States, with increased competition from Southeast Asia "solving" any problem with incipient inflation. According to most early estimates, however, Round One of the Asian crisis (the devaluations sweeping Thailand, the Philippines, Indonesia, and Malaysia in early July) was likely to slow U.S. GDP growth very modestly -- by just one-quarter to one-third of 1 percentage point in 1998. But clearly, events have outrun this assessment. Currencies and asset prices in developing countries remain under pressure; governments continue to take restrictive measures. Our "Goldilocks" world has suddenly become more complicated.
WHY DIDN'T WE SEE IT COMING?
How did we get to this predicament, not three years after the Mexican peso crisis? First, the global policy setting matters. Over the 1990s, the industrial countries have succeeded in bringing inflation below 2 or 3 percent and their fiscal deficits down sharply. In general, tight fiscal policies have been partially offset by relatively accommodative monetary policies. As a result of this policy mix, interest rates have declined to unusually low levels -- especially in Europe and Japan.
Investors seeking higher returns quickly spotted the Southeast Asian countries, which were gradually opening their capital markets to foreigners. As the table shows, these tiger economies were growing fast. By LDC standards, their inflation was moderate and their fiscal positions prudent. Moreover, currency risk must have seemed small since these countries had long pegged or nearly pegged their currencies to the U.S. dollar. Small, open economies sometimes choose to peg their exchange rates, at least for a time, to encourage trade and investment, to anchor domestic prices, and to signal their commitment to sound monetary policies. With these many attractions, Southeast Asia's miracle countries have experienced huge capital inflows in recent years.
Investors focused on the Asian tigers' rapid growth and moderate inflation until 1997, when they noted deteriorating current accounts and accumulating foreign debt.
| Real GDP |
| Consumer Prices|
| Current Account |
(% of GDP)
| Foreign Bank |
| 1994-1997* |
| 1994-1997* |
|1994||1995||1996||1997*||End '95||End '96|
Ý= Claims of BIS reporting banks.
* = Projection
Source: I.M.F., WORLD ECONOMIC OUTLOOK, October 1997, and INTERNATIONAL FINANCIAL STATISTICS; DRI, Bank for International Settlements, THE MATURITY, SECTORAL AND NATIONALITY DISTRIBUTION OF INTERNATIONAL BANK LENDING, SECOND HALF 1996,
July 1997, and INTERNATIONAL BANKING AND FINANCIAL MARKET DEVELOPMENTS, AUGUST 1997.
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But, with exchange rates fixed, capital inflows to purchase Thai securities or to expand an Indonesian manufacturing plant required that their central banks buy dollars and supply the needed baht or rupiahs, ballooning the money supply. Central bank efforts to offset these flows, by selling government securities, say, raised domestic interest rates and encouraged further inflows. With inflation even modestly above U.S. levels and exchange rates fixed, these countries' products became relatively costly on world markets. Several developments magnified their problem. The 1994 devaluation of the yuan made China more competitive; the yen's slide against the U.S. dollar made matters worse. Finally, Taiwan's entry into the chip market brought a glut in a major regional industry. So when world trade slowed in 1995-96, one of the first signs of trouble for the Asean-4 (Indonesia, Malaysia, the Philippines, and Thailand) was a deterioration in their current account deficits.
Another yellow flag was the rapid expansion of domestic credit, abetted by lax banking supervision and rapid deregulation. In Indonesia, state-owned banking gave way to a system where anyone with $1million or so could open a bank. Because capital controls continued to deter outflows of domestic capital, much of this new credit flowed into misguided real estate investments and industries already burdened with unneeded capacity. In Hong Kong, real estate prices quadrupled in five years, and Malaysia became home to the world's tallest and longest buildings. Throughout the area, newcomers to the auto industry -- national favorites, presidents' relatives, electronics companies, and others -- insisted on pushing their way onto the crowded field. So by late 1996, bank and nonbank borrowers in these countries had taken on large amounts of foreign debt, much of it short-term, denominated in unhedged dollars, and invested in iffy projects.
In retrospect, it seems surprising that the crisis did not occur sooner. The International Monetary Fund and others had been warning of potential trouble in Thailand since early 1996.
Perhaps these warnings came too soon. As a self-styled Cassandra from investment banking noted, anyone heeding his clear-sighted advice in 1996 would have missed many profitable opportunities; his firm did not remove "buy" and "outperformer" labels from Thai banks until February 1997. Although bank lending did slow from 1995's torrid pace in Thailand, the other Aseans generally enjoyed relatively low international borrowing costs through early 1997 and did not face rating downgrades until quite recently.
But finally, in early 1997, the Thai bubble burst. Default by a Thai property company drew the world's attention to the thousands of empty housing units around Bangkok. Estimates of nonperforming loans began to rise, Moody's downgraded credit ratings, and Texas Instruments withdrew from a joint venture. Facing sporadic currency pressures from February on, the Thais tried to defend the baht by raising interest rates, imposing capital controls, and spending $10 billion in reserves.
But once speculators note a long-run conflict between a government's policy goals -- here, saving the currency peg, which required high interest rates, versus saving the banking system, which required low interest rates -- they enjoy a one-way bet; eventually the central bank will run out of reserves. With over $1 trillion in foreign exchange activity each day, even the largest stock of official reserves is puny. When the Thais finally let the baht float on July 2, its value promptly sank 15 percent.
Within days, the markets had turned on the other Asean countries, which analysts had certified as "fundamentally different" from Thailand just weeks before. Even the IMF staff appear to have been genuinely surprised by how widely the Thai crisis spread. By mid-July, all the Aseans had abandoned their exchange rate pegs. Devaluation by a neighbor or two greatly reduces the stigma of following suit. Furthermore, these countries compete in many markets and could not afford to be left behind. The IMF-led $17 billion rescue package for Thailand did little to calm the markets, and the Asean currencies continued their erratic descent through the summer and fall.
The crisis then swept on to north Asia and Latin America. Once Taiwan released its dollar on October 17, the markets set out to test the determination of the Hong Kong Monetary Authority (HKMA) to defend its currency board and dollar peg. On October 23, the HKMA created a liquidity squeeze that drove overnight interest rates briefly above 250 percent. The shock deflated prices in Hong Kong's real estate and other asset markets and the Hang Seng index fell 10 percent in a day. This sharp decline triggered stock market reactions worldwide. While U.S. and European markets soon recovered, emerging markets generally remain nervous. As of early December, Asian markets are widely down 15 to 60 percent from the start of the year. Key Latin markets fell 10 to 25 percent in late October, but later rebounded and are well up for the year.
More fundamentally, the perceived risk of investing in LDC markets has surged. So interest rates generally remain above early 1997 levels, and currencies are under pressure. At one extreme, in early December, the Thai baht, the Indonesian rupiah, and the Korean won were 40 to 50 percent below their year-end 1996 levels versus the dollar. The Taiwan and Singapore dollars were down just 12 to 15 percent from the start of the year.
For these very open economies, sharp currency depreciations represent supply shocks akin to a large oil price increase -- these depreciations are likely to spur inflation and slow output growth simultaneously. The price of essential imports rises abruptly, creating a surge in inflation. Like a tax increase, it also absorbs funds that might otherwise be spent on domestic products. In addition, many borrowers have unhedged dollar liabilities that are suddenly more expensive in local currency terms; the resulting bankruptcies weaken already fragile banking systems and further dampen domestic demand. Developing a balanced policy response is not easy.
As is typical, the IMF rescue programs for Thailand and Indonesia stress slowing inflation to preserve the long-run competitive benefits of a devaluation and to restore financial stability. They also call for the government to strengthen its fiscal position and to shore up the banking system -- by closing or merging failed banks and by requiring improved accounting practices and disclosure.
To IMF critics like Harvard's Jeffrey Sachs, this approach gives too much weight to restoring price stability versus supporting employment and output. Keeping interest rates high also prolongs asset-price deflation in real estate and in other markets, and the ensuing defaults compound banking system problems.
With the Japanese auto makers all closing their Thai factories for the rest of the year, and Indonesian construction workers being laid off by the thousands, many analysts now forecast that Indonesia and Thailand will face significant recessions next year. Neighboring economies will likely stagnate -- in part because of their own restrictive policies, and in part because these countries do 30 to 50 percent of their trade with each other. Most analysts agree, however, that the long-run fundamentals in these countries remain attractive. So the IMF hopes to see a quick, V-shaped recession and recovery in Thailand and Indonesia, like that in Mexico.
For the United States, the direct impact of slow growth in Asia should be relatively modest. As mentioned above, most analysts forecast that the Southeast Asian phase of the crisis would deduct one-quarter to one-third of 1 percentage point from GDP growth in 1998. The impact is expected to come largely through declining net exports. At the end of 1996, investments in developing Asia plus Hong Kong and Singapore accounted for less than 2 percent of U.S. commercial bank, pension fund, and mutual fund assets. By contrast, the Asean-4 accounted for 4 percent of our exports. With Hong Kong, Singapore, Taiwan, and Korea, the share was 15 percent.
Southeast Asia's problems will affect Japan more seriously. The Asean-4 account for 12 percent of Japan's exports; with Korea, Hong Kong, and Singapore, the troubled Asian economies account for a third of Japan's trade. Thus, stage one of the crisis is expected to cut Japan's already unsatisfactory growth by one-half to three-quarters of 1 percentage point in 1998. In addition, the Japanese hold a large share of total bank loans to Asean borrowers. Although loans to developing Asia, Hong Kong and Singapore represent just 2 percent of the Japanese banks' total assets, the banks do not disclose data that would permit us to assess the impact of the crisis on their bad loan problem.
But individual banks could be exposed. And, without full disclosure of a bank's potential losses, lenders tend to leap to the worst conclusion. Thus, fears about the possible impact of the crisis have led to sharp declines in Japanese equity prices, with bank stock prices leading the way. Because Japanese banks count unrealized capital gains in their equity holdings as part of their required capital base, declines in the Nikkei can force a contraction of credit. Indeed, once the Nikkei falls below 16,000, as it has on several occasions since October 31, several major Japanese banks must take steps to reduce their outstanding loans.
Since markets don't know about not kicking a fellow when he is down, international lenders are charging a premium on loans to the Japanese banks. At this writing, for the first time in post-war history, a major Japanese bank has failed, as have a second bank and two brokerage houses. Japan is, of course, this country's second largest foreign market, accounting for 10 percent of U.S. exports.
The above estimates do not include the impact of the deteriorating situation in Korea or spillover effects in Latin America, where Argentina, Brazil, and Mexico absorb 13 percent of U.S. exports. And spillover is occurring. To defend its currency, the real, Brazil has recently announced a budget expected to reduce GDP growth next year from an anticipated 4 percent to 1 percent or less. In Korea, the world's eleventh largest economy, a string of conglomerate bankruptcies has led to a banking crisis resembling Japan's. With Korean institutions facing a growing liquidity crisis, the government sought and got a $57 billion IMF loan package to help it pay off short-term dollar-denominated debt and strengthen the country's banking system. But new questions about the size of the task and Korea's commitment to reform led to new pressures on the won.
In time, the attributes that once made the tiger economies "miraculous" should reassert themselves. Strengthened by the reforms impelled by the current crisis, these countries should resume above-average growth. It could take several years, however, for them to achieve recent levels of domestic demand, price stability, and investor confidence.
Progress on trade liberalization may also turn out to be more difficult because of Southeast Asia's currency crisis. Granting the president authority to negotiate trade pacts on a "fast track" basis was politically impossible this year. (Under "fast track," Congress could approve or reject the proposed pact but could not amend it.) How much more popular will it be next year, after the U.S. trade deficit has swelled with the currency devaluations and slow growth in Asia?
Similarly, global talks to open markets in financial services to international competition are coming to a head. Will the current difficulties discourage some developing countries from opening their fi nancial markets to foreigners as fast or fully as they might have done? Or will the severity of banking system problems in some countries accelerate foreign entry into previously closed banking markets -- as occurred to good effect in Mexico and Argentina after the Tequila Crisis?
The Asian turmoil has also jostled the political economy of the region. It has let China step forward as one of the lenders backing the multilateral rescue efforts; and Japan and Korea's rivalrous leadership claims within the region have been temporarily weakened. The West's aloof attitude may also have fostered an embryonic sense of Asian solidarity, embodied in modest steps toward monetary cooperation. For example, Singapore and Japan joined Indonesia in intervention to strengthen the rupiah after the announcement of the IMF package. Similarly, proposals for an Asia-only rescue fund (to serve, at U.S. insistence, only as a regional resource for IMF-led programs) could represent a small step toward the type of monetary cooperation that over decades led to the European Monetary Union.
What are the lessons of this currency crisis? Two are well known but bear repeating. A second pair may be more controversial.
1 Developing countries should adopt flexible exchange rate regimes as soon as strains start to become evident. Markets can be extremely strict disciplinarians once participants notice something amiss. Since investors tend to move in herds and momentum traders abound, markets sometimes overshoot. Delay can thus result in excessive devaluations, unwarranted output losses, and setbacks in the fight against inflation that can take years to overcome.
2 LDCs must make their financial markets more transparent by providing more data and by using generally accepted accounting standards -- of course. But data are always subject to interpretation; thus, they are a necessary but not a sufficient condition for avoiding future crises.
3 Multilateral rescue/reform packages must be multilateral and clearly credible. The current turmoil has been less well contained than the peso crisis of 1994-95. The Asean governments' resistance/inability to reform contributed enormously to this outcome. But the West's hands-off attitude may also have played a role.
When the international community decides to provide a rescue package, it does so to curb contagion, as lender of last resort. True, moral hazard is an important issue; the international community should not encourage reckless future behavior by limiting today's losses too quickly or too generously. But at some point, the need to stop accumulating credit contraction takes precedence. In contrast to Mexico's $48 billion package, which far exceeded that country's dollar-denominated Tesobono liabilities, the $17 billion Thai rescue package was probably too small, given the central bank's $23 billion liability for dollars sold forward. In the end, a successful containment effort requires a financially and politically credible commitment from world policy makers -- borrowers and lenders alike.
4 In future, policy makers may want to look more carefully at global asset prices and the reasons for their behavior. Of late, policy makers worldwide have been well satisfied with the benign trends in consumer prices. If asset prices seemed high, that was a supervisory issue, not an issue for monetary policy. But with hindsight, the global asset price inflation seen in Asian real estate prices and in equity prices elsewhere may have been a significant symptom of excess world liquidity.
Brazil's President Cardoso described the currency crisis as "a ball that dropped on us from Asia." He went on, "We are good at soccer, and we plan to send the ball back so it falls on somebody else, or preferably in the middle of the Atlantic." We may all view the crisis as a ball that dropped on us, but the crisis did not grow in a vacuum. These problems reflect the many mistakes of individual developing nations and individual investors. They also reflect the tight fiscal and relatively loose monetary policies of the major industrialized countries. In times of crisis, policy makers usually feel compelled to step forward to halt an asset-price collapse. Perhaps they also have a stake in curbing excessive updrafts. The question is, how?
IMPACT OF THE CRISIS ON NEW ENGLAND
The fallout from the currency crisis will reach New England through reduced net exports to the devaluing countries and through its impact on the earnings of regional firms with investments in the affected areas. New Englanders will benefit from being able to purchase lower-cost consumer goods and producer inputs, but regional producers will also face increased competition from the devaluing countries. Given the distances involved, New England exporters are slightly less dependent on the eight Asian countries embroiled in the recent currency troubles than are exporters nationally; in 1996 the eight accounted for 14 percent of the region's total merchandise exports compared with 16 percent nationally. Nevertheless, New England exported over $4 billion in merchandise to the Asian eight in 1996 over $1 billion in electronics equipment, almost $1 billion in industrial equipment, and roughly $500 million in instruments. Transportation equipment, fabricated metals, chemicals, and paper were other important New England exports to Asia.
Some of these trade flows occur because many New England firms, particularly in the computer and electronics industries, have production facilities in these countries. These investments are extremely important to both parties. At the national level, U.S. multinationals in computers and other industrial equipment earned over 50 percent of their profits in their majority-owned foreign affiliates in 1995; for electronics companies, 30 percent of their profits came from their foreign affiliates. From the host country perspective, U.S. majority-owned affiliates accounted for 9 percent of Singapore's total GDP in 1995 and for 5 percent of output in Hong Kong and Malaysia. New England affiliates selling to Asian markets will, of course, be adversely affected by the recent disruptions to domestic demand in these nations. By contrast, affiliates producing for export to markets outside the Asia-Pacific region will benefit from the lower production costs brought on by the shift in exchange rates. As occurred in Mexico after the peso crisis, increased investments in these Asian affiliates will help spur recovery in the region.Some of these trade flows occur because many New England firms, particularly in the computer and electronics industries, have production facilities in these countries. These investments are extremely important to both parties. At the national level, U.S. multinationals in computers and other industrial equipment earned over 50 percent of their profits in their majority-owned foreign affiliates in 1995; for electronics companies, 30 percent of their profits came from their foreign affiliates. From the host country perspective, U.S. majority-owned affiliates accounted for 9 percent of Singapore's total GDP in 1995 and for 5 percent of output in Hong Kong and Malaysia. New England affiliates selling to Asian markets will, of course, be adversely affected by the recent disruptions to domestic demand in these nations. By contrast, affiliates producing for export to markets outside the Asia-Pacific region will benefit from the lower production costs brought on by the shift in exchange rates. As occurred in Mexico after the peso crisis, increased investments in these Asian affiliates will help spur recovery in the region.