International Finance: Case: Asian Currency Crisis 1997

Question 1
What were the origins of the Asian currency crisis?
In mid 1997, a financial crisis gripped most of the Asian countries and raised fears of a worldwide economic meltdown due to a financial contagion, a scenario that initially affects only a particular region of the economy that spreads to other countries whose economies were healthy, much like a transmitted disease. See, Asia attracted almost half the total capital inflow into developing countries because of the high interest rates maintained by the Southeast Asian economy, it attracted foreign investors looking for a high rate of return. Due to this, the economies received large amounts of money and experienced a dramatic run-up in asset prices. For the past couple of decades then, no other group of countries has produced not only such a rapid economic growth but also a dramatic decrease in poverty in the entire world. Korea, Malaysia and Thailand virtually eliminated hardcore poverty while Indonesia was close to reaching that target. Per capita income levels increased in Korea, Thailand and Malaysia - tenfold, fivefold and fourfold respectively, while that of Singapore and Hong Kong had exceeded that of some Western industrial countries. This was touted to be the “Asian economic miracle” by IMF and the World Bank. Noted economist Paul Krugman argued that while Asia’s economic growth is the result of increasing capital investment, total productivity had only marginally increased, if not at all even, stating that only growth in total factor productivity, not capital investment, could lead to long-term prosperity. And when the crisis hit, his views were seen as prophetic. Though there has been general consensus on the existence of this crisis, what is less clear is the cause of it.
Firstly, politics could have had a hand in it in what is called crony capitalism. With all the inflow from investors, development money went out in an uncontrolled manner to certain people who were possibly not

References: Krugman, P. (1998). What happened to asia?. Retrieved from http://web.mit.edu/krugman/www/DISINTER.html   Question 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? Many of East Asia companies borrow dollars, yen and Deutsche mark instead of their local currencies to finance their operation because these countries are the major importer from the East Asia countries. In addition, currency stability also led East Asia, bank and companies to finance themselves with dollars, yen, and deutsche mark. It is because dollars and other foreign currencies loan carried lower interest rate than did their domestic currencies. For example, in 1995 the dollars began recovering against the yen and other currencies. By mid 1997, the dollar had risen by more than 50 percent against the yen and by 20 percent against the German mark. The appreciation of the Dollar alone would have made East Asia’s export less price competitive. But their competitiveness problem was greatly exacerbated by the fact that during this period, the Chinese Yuan depreciated by 25 percent against the dollar. Thus, the lost of export competitiveness slowed down Asia growth and caused utilization expense. This kind of financing has involved with the risks which is in the maturity distribution of accounts. As for maturity distribution, many banks and businesses in the troubled Asian economies appear to have borrowed short-term for longer-term projects. Many economists blame these loans as the major cause that contributed for the Asian crisis. Some of this debt is to finance trade and is self-extinguishing as the trade transactions are completed. However, these short-term loans have fallen due before projects are operational or before they are generating enough profits that enabling repayments to be made. As long as an economy is growing and not facing particular financial difficulties, rolling over these loans such as obtaining new loans as existing ones mature may not be particularly difficult. It is because it leads the competition become intense among banks. In the Asian case, when a financial crisis hits, the loans suddenly become more difficult to procure, and lenders may decline to refinance debts. At the same time, private-sector financing virtually evaporates for a time. A structural change in the nature of the borrowing by these Asian countries is that the type of borrowing has shifted away from the government and banks borrowing from international financial institutions such as the World Bank or receiving development assistance funds through foreign aid programs to borrowing by private corporations. After capital markets were liberalized in the newly industrializing countries of Asia, most of the outside funds flowing into these economies were borrowed by the governments (public sector). Now major banks and the non-bank private sector account for most of the borrowing. In addition, the others risk that they were exposing is moral hazard problem. Most Asian bank 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, and encouraging financial institutions to fund risky project in the expectation that the banks would enjoyed any profit, while sticking the government with any losses. Besides that, in Asia’s case the problem was compounded by the crony capitalism. It is pervasive throughout the region with lending decision often dictated more by political and family ties than by economic reality. Hence, billions of dollars in easy-money loans were made to family and friends of the well connected and without market discipline or risk-based bank lending, the result was overinvestment and inflated prices of assets in short supply, such as land.