The Hindu Business Line : Remembering the financial earthquake

When the devaluation in Thailand took place in July 1997, following the floatation of the baht, no one imagined it would transform into the epicentre of a financial earthquake, affecting not just the region but even countries as far-flung as Russia, Brazil and Argentina, say D. SAMBANDHAN and S. S. TABRAZ

Ten years after the crisis, the Asian countries have made a remarkable recovery, although the crucial variable — investment as percentage of GDP — has declined markedly.

“Some years, like some poets and politicians and some lovely women, are singled out for fame far beyond the common lot, and 1929 was clearly such a year,” observes J. K. Galbraith, in his introductory chapter of a book dealing with the anatomy of the great crash of 1929. What 1929 was to Europe and the US, 1997 was to the Asian miracle economies. The year 1997 has already become a synonym for the darker side of globalisation, dominated and frustrated by the menace of global finance.

July 2, 2007, marks the 10th anniversary of the Asian financial crisis. Ten years ago, on this fateful day, the bank of Thailand allowed its currency baht to float after its prolonged battle with speculators through intervention in spot and forward markets miserably failed. Even the usual interest rate defence and selective capital controls to check the currency slide could not succeed.

Soon, what was considered a simple currency/balance of payment crisis in a small country like Thailand degenerated into a full-fledged banking and financial crisis. The crisis was reminiscent of the classical pattern of all the financial crises witnessed in the past.

What went wrong

What went wrong with Asia? Despite Paul Krugman exploding the myth of Asian miracle in Foreign Affairs (1993), it must be conceded that the success story of Asian miracle economies, until late 1980s and early 1990s, was built around their critical ability to save more and invest more without relying much on foreign capital.

While experiencing the greatest economic expansion during the post-War period, they not only enjoyed a higher standard of living and income, but also made a visible dent on reducing poverty. This region experienced a remarkable macroeconomic stability and fiscal austerity.

Inflation was moderate and export growth was robust. It was only after they embraced financial market liberalisation in early 1990s that the seeds of the currency crisis were sown. Much of the capital inflows towards this region were in the form of bank debt.

Given high interest rate at home and low interest rate environment prevailing abroad, both firms and banks, including investors, found it advantageous to borrow in dollars and re-lend/invest in the local currency.

While most of the currencies of the region were pegged to US dollar, these borrowings in foreign currencies were largely kept unhedged with a naive assumption that the fixed dollar peg would rule forever and hence would not pose any problem at the time of repayment.

In the 1990s, fuelled by huge foreign capital, the current account deficit increased; as long as it was within manageable limits and exports did not experience much discomfort, the dollar peg was not threatened.

However, after Chinese currency devaluation (1994) and Mexican peso collapse (1994-95), the Asian region began losing its competitiveness.

With the dollar also emerging strong, maintaining the fixed exchange rate regime became unsustainable; the real exchange rate had appreciated to a great extent.

With export growth faltering and revised forecast of current account deficit touching the magic figure of 8 per cent of GDP, it was clear that the days of Thai baht were numbered and that at any time it would be devalued.

When the crisis began it was not just that the foreign investors alone wanted to make an exit, but more important the domestic investors were the first to resort to ‘capital flight’ which depleted reserves at a faster pace and thus precipitated the financial crisis.

It happened earlier in Mexico and it was to happen in Russia in late 1990s.

The aftermath of devaluation

When the devaluation did finally take place on July 2, 1997, following the floatation of the Thai baht, no one would have ever imagined that it would transform into an epicentre of a financial earthquake enveloping not just the region but even countries as far flung as Russia, Brazil and Argentina.

In almost all the crisis-affected countries, the short-term debt denominated in foreign currency exceeded the available foreign exchange reserves.

With lenders not willing to roll over credit, the US showing its indifference, IMF lending reluctantly with exorbitant conditions, the banks were in deep trouble.

Why did the capital leave? What was considered good earlier during the miracle period — be it financial and industrial policy or exchange rate policy — became bad in the second half of 1990s.

Excessive capacity creation by over investment fuelled by huge foreign capital, resulting in over heating of the economy and the stock market and real estate were on a roll.

All this was made possible because of crony capitalism and the moral hazard problem — the implicit guarantee that there would be some anticipatory bail-out by national governments and international agencies as and when the crisis occurs to dethrone the dollar peg.

Alas, it did not happen the way market expected, although IMF assistance did help selectively the western banks to recover their loans.

Before we conclude, a few comments are in order to highlight some striking dissimilarities between Asian crisis and the two crises that preceded it — the crisis in ERM (European Exchange Rate Mechanism, 1991-92) and the Mexican peso collapse in 1994-95.

The 1992 September Pound crisis eventually ended up in a one-shot large devaluation, but it was followed by a welcome decline in interest rates and order was restored in the foreign exchange market.

On the other hand, the Thai baht’s fall generated a contagion, sinking most of the Asian currencies to bottomless pit. Despite this huge depreciation, no beneficial influence could follow on interest rate front.

Though the 1994-95 Mexican peso collapse was a typical balance of payment crisis, it was resolved with the help of its NAFTA partner — the US and IMF.

While Mexico could make a remarkable economic recovery within a year, the Asian region had to undergo a severe punishment in the form of lost output and employment, which was more than proportionate to the alleged economic sins committed by them.

To sum up, the prime villain of the piece for the Asian currency turmoil was not only the corruption cum moral hazard as it was initially believed by Paul Krugman, but essentially the misplaced enthusiasm for financial market liberalisation by these countries without bothering to put controls and supervisory mechanism in place, something maintained by Joseph Stiglitz all along and articulated at the time of the crisis, and later acknowledged by Paul Krugman himself.

Indeed, even Jagdish Bhagwati, an ardent defender of free market economy and globalisation, wrote soon after the crisis that the emerging markets should not have opted for financial market liberalisation with undue haste.

Ten years after the crisis, the Asian countries have made a remarkable recovery, although the crucial variable — investment as percentage of GDP — has declined markedly.

Besides taking measures to clean up the financial sector mess, they have all accumulated huge foreign exchange reserves as a war chest in order to insulate themselves from any future crisis.

Asian countries providing a parachute for the dollar cannot go on for long, as it would put more pressure on the exchange rate and would also amount to subsidising Americans’ extravagant living.

They cannot avoid appreciating pressure perpetually. Like India, they must learn to live with an appreciating and appreciated exchange rate.

(The authors are on the faculty of Department of Politics and International Studies, Pondicherry University.)

More Stories on : Financial Markets | Economy | Forex | Insight

Article E-Mail :: Comment :: Syndication :: Printer Friendly Page