International Finance: Case: Asian Currency Crisis 1997

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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 best suited or most efficient of the lot to handle the investments, but only because of the ties between them and those in power. This happened not only in Malaysia, but in our neighbouring countries Indonesia and Thailand as well.

Or secondly, it could even have originated in the mid-1990s when the US raised its interest rates to head off inflation in order to recover from a recession from the early 1990s. When this happened, investors saw the US as a more attractive investment in comparison to Southeast Asia, and at the end of the day, raised the value of the US Dollar. For the Southeast Asian countries with currencies pegged to the US Dollar, the increase caused their own exports to become more expensive thus less competitive in global markets. At the same time, our export’s growth slowed dramatically, deteriorating to its current account position then.

Standard economic indicators revealed large macroeconomic imbalances such as export growth slowing markedly, current account deficit was persistently large and was financed increasingly by short-term inflows, and the real exchange rate appreciated to a level that appeared unsustainable. It is all these problems that then uncovered other weaknesses in the economy: substantial unhedged foreign borrowing by the private sector; inflated property market; and an over-exposed financial system. These weaknesses reflected undisciplined foreign lending, unfavourable movements in the currency-to-Dollar rate, and weak domestic policies. The latter was said to be the cause of it all. Last but not least, the Asian currency crisis was due to policies that distorted the incentives within a lender-borrower connection. The inflow of money that became available generated a high leveraged economic climate which pushed up asset prices to an unsustainable level. When the prices began to collapse, individuals and companies defaulted on debt obligations. The ensuing panic led to a hefty withdrawal of credit from the crisis countries...
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