Case Number Two: Asian Currencies Sink in 1997

During the second half of 1997, and beginning in Thailand, currencies and stock markets plunged across East Asia, while hundreds of banks, builders, and manufacturers went bankrupt. The Thai baht, Indonesian rupiah, Malaysian ringgit, Philippine peso, and South Korean won depreciated by 40% to 80% apiece. All this happened despite the fact that Asias fundamentals looked good: low inflation; balanced budgets; well-run central banks; high domestic savings; strong export industries; a large and growing middle class; a vibrant entrepreneurial class; and industrious, well-trained, and often well-educated workforces paid relatively low wages. But investors were looking past these positives to signs of impending trouble. What they saw was that many East Asian economies were locked on a course that was unsustainable, characterized by large trade deficits, huge short-term foreign debts, overvalued currencies, and financial systems that were rotten at their core. Each of these ingredients played a role in the crisis and its spread from one country to another.

Loss of Export Competitiveness

To begin, most East Asian countries depend on exports as their engines of growth and development. Along with Japan, the United States is the most important market for these exports. Partly because of this, many of these countries had tied their currencies to the dollar. This tie served them well until 1995, promoting low inflation and currency stability. It also boosted exports at the expense of Japan as the dollar fell against the yen, forcing Japanese companies to shift production to East Asia to cope with the strong yen. Currency stability also led East Asian banks and companies to finance themselves with dollars, yen, and Deutsche markssome $275 billion worth, much of it short termbecause dollar and other foreign currency loans carried lower interest rates than did their domestic currencies. The party ended in 1995, when the dollar began recovering against the yen and other currencies. By mid-1997, the dollar had risen by more than 50% against the yen and by 20% against the German mark. Dollar appreciation alone would have made East Asias exports less price competitive. But their competitiveness problem was greatly exacerbated by the fact that during this period, the Chinese yuan depreciated by about 25% against the dollar.3 China exported similar products, so the yuan devaluation raised Chinas export competitiveness at East Asias expense. The loss of export competitiveness slowed down Asian growth and caused utilization ratesand profitson huge investments in production capacity to plunge. It also gave the Asian central banks a mutual incentive to devalue their currencies. According to one theory, recognizing these altered incentives, speculators attacked the East Asian currencies almost simultaneously and forced a round of devaluations.

Moral Hazard and Crony Capitalism

Another theory suggests that moral hazardthe tendency to incur risks that one is protected againstlies at the heart of Asias financial problems. Specifically, most Asian banks and finance companies operated with implicit or explicit government guarantees. For example, the South Korean government directed the banking system to lend massively to companies and industries that it viewed as economically strategic, with little regard for their profitability. When combined with poor regulation, these guarantees distorted investment decisions, encouraging financial institutions to fund risky projects in the expectation that the banks would enjoy any profits, while sticking the government with any losses. (These same perverse incentives underlay the savings and loan fiasco in the United States during the 1980s.) In Asias case, the problem was compounded by the crony capitalism that is pervasive throughout the region, with lending decisions often dictated more by political and family ties than by economic reality. Billions of dollars in easy-money loans were made to family and friends of the well-connected. Without market discipline or risk-based bank lending, the result was overinvestmentfinanced by vast quantities of debtand inflated prices of assets in short supply, such as land.

This financial bubble persists as long as the government guarantee is maintained. The inevitable glut of real estate and excess production capacity leads to large amounts of nonperforming loans and widespread loan defaults. When reality strikes, and investors realize that the government doesnt have the resources to bail out everyone, asset values plummet and the bubble is burst. The decline in asset values triggers further loan defaults, causing a loss of the confidence on which economic activity depends. Investors also worry that the government will try to inflate its way out of its difficulty. The result is a self-reinforcing downward spiral and capital flight. As foreign investors refuse to renew loans and begin to sell off shares of overvalued local companies, capital flight accelerates and the local currency falls, increasing the cost of servicing foreign debts. Local firms and banks scramble to buy foreign exchange before the currency falls further, putting even more downward pressure on the exchange rate. This story explains why stock prices and currency values declined together and why Asian financial institutions were especially hard hit. Moreover, this process is likely to be contagious, as investors search for other countries with similar characteristics. When such a country is found, everyone rushes for the exit simultaneously and another bubble is burst, another currency is sunk.

The standard approach of staving off currency devaluation is to raise interest rates, thereby making it more attractive to hold the local currency and increasing capital inflows. However, this approach was problematic for Asian central banks. Raising interest rates boosted the cost of funds to banks and made it more difficult for borrowers to service their debts, thereby further crippling an already sick financial sector. Higher interest rates also lowered real estate values, which served as collateral for many of these loans, and pushed even more loans into default. Thus, Asian central banks found their hands were tied and investors recognized that.

The Bubble Bursts

These two storiesloss of export competitiveness and moral hazard in lending combined with crony capitalismexplain the severity of the Asian crisis. Appreciation of the dollar and depreciation of the yen and yuan slowed down Asian economic growth and hurt corporate profits. These factors turned ill-conceived and overleveraged investments in property developments and industrial complexes into financial disasters. The Asian financial crisis then was touched off when local investors began dumping their own currencies for dollars and foreign lenders refused to renew their loans. It was aggravated by politicians, such as those in Malaysia and South Korea, who preferred to blame foreigners for their problems rather than seek structural reforms of their economies. Both foreign and domestic investors, already unnerved by the currency crisis, lost yet more confidence in these nations and dumped more of their currencies and stocks, driving them to record lows.

This synthesized story is consistent with the experience of Taiwan, which is a net exporter of capital and whose savings are largely invested by private capitalists without government direction or guarantees. Taiwanese businesses also are financed far less by debt than by equity. In contrast to its Asian competitors, Taiwan suffered minimally during 1997, with the Taiwan dollar (NT$) down by a modest 15% (to counteract its loss of export competitiveness to China and Japan) and its stock market actually up by 17% in NT$ terms.

The way out, said Confucius, is through the door. The clear exit strategy for East Asian countries was to restructure their ailing financial systems by shutting down or selling off failing banks (e.g., to healthy foreign banks) and disposing of the collateral (real estate and industrial properties) underlying their bad loans. Although the restructuring has not gone as far as it needs to, the result so far is fewer but stronger and better-capitalized banks and restructured and consolidated industries and a continuation of East Asias strong historical growth record. However, progress has been slow in reforming bankruptcy laws, a critical element of reform. Simply put, governments must step aside and allow those who borrow too much or lend too foolishly to fail. Ending government guarantees and politically motivated lending would transform Asias financial sector and force cleaner and more transparent financial transactions. The result would be better investment decisionsdecisions driven by market forces rather than personal connections or government whimand healthier economies that attract capital for the right reasons.

Required Questions

5. Why did so many East Asian companies and banks borrow dollars, yen, and Deutsche marks instead of their local currencies to finance their operations? What risks were they exposing themselves to?