FREE ESSAY ON SOUTH EAST ASIAN CRISIS

SOUTH EAST ASIAN CRISIS

On the 2nd of July 1997, Asia was hit by one of the most devastating financial crises it
has ever seen. Of all the financial crisis that have taken place, this was one of the
most distressing in that it was totally unexpected. The purpose of this paper is to show
that particular developmental strategies employed by these economies eventually led to
their downfall. It will attempt to find out where the origins of the crisis lie, and what
events started the cycle that eventuated with this disaster. In order to trace the events
that led to the eventual collapse of the Asian economies, one must venture across the
ocean to the United States. The issue of liberalisation first gained attention in the US
during the Regan Administration. However, it was during the Clinton era that
liberalisation became a top priority. Whereas previous governments had pushed for the
liberalisation of Japan, one of Clinton's main foreign policy objectives was the
liberalisation of the Asian economies. This process was pushed forth in Asia with such
vehemence because the region held a lot of investment opportunities for American Banks,
Brokerages, and other financial sector businesses. Unfortunately, Asia's economies were
not structurally ready to deal with the influx of capital that was headed their way. They
had weak banking and legal systems that were unable, or unwilling, to regulate the flow
of foreign capital in the country. 
The Americans eventually persuaded Korea to relax its capital flow regulations by giving
it the option of joining the Organisation for Economic Co-operation and Development. Even
then, Korea was concerned that its financial institutions may not be able to deal with an
influx of foreign capital. One fatal mistake that Korea, as well as other Southeast Asian
countries made, was that they opened their capital markets in the wrong way. They did not
allow long term investments in Korean companies, but rather, only short-term investments
that could be removed easily. One example of the sort of quick investments that were
being made in Asia can be seen in the Japanese. In Japan the interest rates were very
low, so investors would borrow at 2 percent and then convert their currency into Thai
baht. Due to the interest rate differential, they were able to make a lot of money off
simple currency conversion. Other Asian economies were quick to follow suit, and soon
there was a movement of huge amounts of capital into the region. In just one year, more
then $93 billion was invested in five Asian countries. One must, however, concede that
Southeast Asia became very receptive to the changes being imposed on them by the United
States. Eventually, foreign investment came to be seen as a miracle cure for
underdevelopment. It was seen as a quick fix that could, in a short period of time, bring
countries to the same level of development as the West. 
The trouble started in 1995, when the United States inflated the dollar, and hence also
inflated the Thai baht and other Asian currencies that were pegged to the dollar. This
caused their exports to become expensive compared to Chinese exports. The Thai deficit
rose to such an extent that all their foreign currency reserves started to drain in order
to pay it. This is the first time that investors got to see the weakness in the Thai
financial market. 
It is not possible to place the entire blame for the crisis on the United States. As was
mentioned before, Asian countries were more than happy to accept the capital coming there
way. It is important to evaluate the different internal weaknesses in these economies
that led to the eventual crisis. Enough stress can not be placed on how the internal
weaknesses of the Asian region led to this crisis. The remainder of this essay with deal
with these weaknesses, and of the events that eventually led to the collapse of the East
Asian miracle. 
Liberalisation in Southeast Asia took place primarily in two steps. In Thailand, and in
much of Asia, this liberalisation consisted of the removal of foreign exchange controls,
interest rate restrictions, encouragement of nonbank (private) capital markets, and the
adoption of the capital adequacy standard for bank supervision. This liberalisation led
to intense competition in the Thai market. Banks competed on the size of their
portfolios, and this led to some of the frivolous, short term, investment that became
synonymous with the region. They also competed to generate off-balance sheet transactions
and quasi-banking operations, all of which added to the vulnerability of the region. In
Indonesia, as well, there was a removal of banking regulations. With the removal of these
regulations, the number of banks in the country more than doubled in a period of six
years. Many of these banks were owned by large industrial groups, which used them to
manage their own financial affairs. Banks also created Offsure accounts in order to
conduct illegal activity. This first liberalisation actually went a long way in reducing
the reliability of banks. Investments were made without paying proper heed to their
long-term returns and the credit worthiness of the parties. This combined with illegal
activities made the banking system extremely susceptible to any sort of external
pressure. One example of this type of short sighted activity can be seen in the expansion
of bank portfolios to include a large number of property companies. Property companies
would borrow from banks and then float shares for the property in the stock market. They
money made in this way would be enough to pay the banks and make a profit. 
The second phase of the liberalisation process consisted of openeing up the capital
accounts of the region. Guarantees were given to non-residents that they would be able to
withdraw their investments and, also, the end of restrictions regarding foreign asset
holding by residents. It is this phase that defined East Asian growth for almost a
decade. For the first time Thailand's companies had access to external finance. This
relationship between the corporations and the outside world also made this sector
vulnerable to external changes. 
The level of capital inflow in Asia reached monumental proportions due to another reason
as well. Before the liberalisation measures were implemented, these countries had
provided incentives in the form of subsidies to foreign investors. Once the
liberalisation was complete, these subsidies remained. This added an additional incentive
for foreign incentive. Besides this, the interest rate differential between the
developing and western countries was so great, local businesses had an incentive to move
towards foreign funding. In short, both the banking and corporate sector became extremely
dependent on foreign short-term debt liabilities. 
Some Asian countries could see where this type of short-term speculation was leading, but
they were not willing (or unable) to impose regulations on banks and investors. Malaysia
was one country that was able to reduce the degree of short-term speculation through a
combination of various measure. At one point net inflows of capital actually went into
the negative. Thai authorities, on the other hand, were unwilling to intervene to take
control of their current accounts deficit. They felt that it was inappropriate for a
government to intervene on behalf of a deficit that was caused purely by the private
sector. Similarly, in Indonesia also the current account deficit started becoming a
representation of private investments. Theories, like the one expressed by Cordon, imply
that market forces will take care of any current account deficit. However, in an unusual
situation like this, where enormous amounts of capital is available for short-term
profit, private agents do not always behave rationally. These countries themselves
provided investors with conditions that led to irrational behaviour. The adoption of a
fixed exchange rate and an absolute commitment to an unregulated capital account made for
good hunting. In these instances measures to keep the current account under control are
essential. 
Through this entire process, Thai governments were playing a delicate game trying to
balance the exchange rate and the interest rate. It was imperative for these economies
that the exchange rate should not appreciate. They engaged in sterilisation operations in
order to keep the exchange rate at certain level. However these activities caused
interest rates to increase, which again caused more foreign capital to come into the
countries. 
The East Asian economies, by the mid 90's were like a card house. Their foundation cards
were foreign investment and a fixed exchange rate. Foreign investment had provided all
the funding for banks in their ill-conceived ventures. It was this money that allowed
economies with very basic discrepancies to achieve such high growth rates. The fixed
exchange rate was necessary to keep foreign investment coming. In 1995 when the value of
the Thai baht, and other East Asian currencies that were pegged to the dollar, increased
in response to a corresponding increase in the dollar, it set off a chain of events that
ended with the destruction of the East Asian economies. The inflation of the baht led to
an increase in the current account deficit. Foreign currency reserves were exhausted in
an attempt to pay for the deficit. This economic instability caused panic selling by
investors. Thailand refused to devalue its currency, and in response interest rates went
up in Thailand and in the Philippians. Under increasing pressure that the flight of
capital created, the Thai government eventually let the baht float freely. In the open
market the baht hit a record low of 28.8 against the dollar. The Philippians also lets
their currency, the peso, float semi-freely with the result that it also ended at a
record low of 32.38 against the dollar. As the effects of this currency devaluation swept
throughout Southeast Asia, there was a multilateral currency meltdown. Dozens of
financial firms in the region were closed and their operations came under scrutiny. Banks
stopped extending short-term loans due to a dry up of capital and business, unable to pay
back, went bankrupt. Essentially what happened is that faced with the prospect of
economic instability in the region investors started selling their stakes in these
economies. As the money dried up, the entire system that had developed around this money
also crumbled. When an economy is built on such delicate cards, even a slight change in
any one factor (in this case the exchange rate) and lead to a catastrophe. What is
interesting is that even though all areas of Asia (in fact the entire world) were hit by
the crisis, certain countries weathered the crisis better. Singapore and the Philippines,
who had exercised come capital control and had placed prudential regulations on their
banks, were able to recover from the crisis much faster. In fact, that they were even hit
by the crisis is due more to the non-availability of financial information in the region
than anything else. The crisis caused general selling by investors in the entire region
who did not have time to differentiate between the various amount of economic distress in
the region. Essentially, it was due to some level of Contagion. 
As you can see, a variety of factors went into the destruction of the Southeast Asian
economies. The Americans failed to realise that under the conditions that existed in the
region, uncontrolled capital liberalisation would not work. The influx of capital
overwhelmed societies, which were not equipped with the knowledge to deal with it. The
entire system was dependent on a delicate balance between exchange rates and other
monetary factors. In the end the over liberalisation of these economies, without
sufficient controls led to one of the most dramatic crisis of all time. In response one
can not help but wonder if capital mobility is more a need of the west than of the east.
Underdeveloped countries need time to develop the institutional framework to handle this
new form of Globalisation. Until then, they can not be fully integrated into the world
capital market.