Causes Of Asian Crisis.docx

Credit bubbles and fixed currency exchange rates In the mid-1990s, Thailand, Indonesia and South Korea had large private current account deficits, and the maintenance of fixed exchange rates encouraged external borrowing , leading to excessive exposure to foreign exchange risk in both the financial and corporate sectors. At this same time, a series of external shocks began to change the economic environment. The devaluation of the Chinese renminbi, and the Japanese yen due to the Plaza Accord of 1985, the raising of U.S. interest rates which led to a strong U.S. dollar, and the sharp decline in semiconductor prices, all adversely affected their growth.As the U.S. economy recovered from a recession in the early 1990s, the U.S. Federal Reserve Bank under Alan Greenspan began to raise U.S. interest rates to keep inflation in check. This made the United States a more attractive investment destination in comparison to Southeast Asia, which had been attracting hot money flows through high short-term interest rates, and raised the value of the U.S. dollar. For the Southeast Asian nations which had currencies pegged to the U.S. dollar, the higher U.S. dollar caused their own exports to become more expensive and less competitive in the global markets. At the same time, Southeast Asia's export growth slowed dramatically in the spring of 1996, deteriorating their current account position. Some economists have advanced the growing exports of China as a factor contributing to ASEAN nations' export growth slowdown, though these economists maintain the main cause of their crises was excessive real estate speculation. China had begun to compete effectively with other Asian exporters particularly in the 1990s after the implementation of a number of export-oriented reforms. Other economists dispute China's impact, noting that both ASEAN and China experienced simultaneous rapid export growth in the early 1990s. Many economists believe that the Asian crisis was created not by market psychology or technology, but by policies that distorted incentives within the lender–borrower relationship. The resulting large quantities of credit that became available generated a highly leveraged economic climate, and pushed up asset prices to an unsustainable level. These asset prices eventually began to collapse, causing individuals and companies to default on debt obligations.

Panic among lenders and withdrawal of credit The resulting panic among lenders led to a large withdrawal of credit from the crisis countries, causing a credit crunch and further bankruptcies. In addition, as foreign investors attempted to withdraw their money, the exchange market was flooded with the currencies of the crisis countries, putting depreciative pressure on their exchange rates. To prevent currency values collapsing, these countries' governments raised domestic interest rates to exceedingly high levels (to help diminish flight of capital by making lending more attractive to investors) and intervened in the exchange market, buying up any excess domestic currency

at the fixed exchange rate with foreign reserves. Neither of these policy responses could be sustained for long. Very high interest rates, which can be extremely damaging to a healthy economy, wreaked further havoc on economies in an already fragile state, while the central banks were haemorrhaging foreign reserves, of which they had finite amounts. When it became clear that the tide of capital fleeing these countries was not to be stopped, the authorities ceased defending their fixed exchange rates and allowed their currencies to float. The resulting depreciated value of those currencies meant that foreign currencydenominated liabilities grew substantially in domestic currency terms, causing more bankruptcies and further deepening the crisis. The events in Thailand prompted investors to reassess and test the robustness of currency pegs and financial systems in the region. The result was a wave of currency depreciations and stock market declines, first affecting Southeast Asia, then spreading to the rest of the region. Despite the clear evidence of increased external vulnerability and symptoms of financial instability, particularly in Thailand, foreign investors continued to pour funds into the region, and sovereign credit ratings remained extremely favourable until early 1997, when pressures mounted and reserves fell rapidly as net capital inflows were not sufficient to meet the widening current account deficits. The crisis broke out in early July 1997, when the Bank of Thailand could no longer maintain the currency within the fluctuation band in view of massive withdrawal of funds.

Lack of incentives for risk management Two characteristics common in countries that have experienced financial crises were present in a number of East Asian economies. First, financial intermediaries were not always free to use business criteria in allocating credit. In some cases, wellconnected borrowers could not be refused credit; in others, poorly managed firms could obtain loans to meet some government policy objective. Hindsight reveals that the cumulative effect of this type of credit allocation can produce massive losses. Second, financial intermediaries or their owners were not expected to bear the full costs of failure, reducing the incentive to manage risk effectively. In particular, financial intermediaries were protected by implicit or explicit government guarantees against losses, because governments could not bear the costs of large shocks to the payments system (McKinnon and Pill 1997) or because the intermediaries were owned by “Ministers’ nephews” (Krugman 1998). Krugman points out that such guarantees can trigger asset price inflation, reduce economic welfare, and ultimately make the financial system vulnerable to collapse.