The Economic Monster Twister - Causes and Course of the Asian Crises

Index

1. Introduction

2. Currency Crisis Analyses
2.1. First and second-generation models
2.2. Self-fulfilling crises, herding, and contagion

3. The Asian success story
3.1. Capital accumulation
3.2. The role of the governments
3.2.1. Human capital formation
3.2.2. The Financial Sector
3.2.3. Trade policy and macroeconomic stability

4. The Crisis
4.1. The framework in the crisis’ forefield
4.2. The crisis unfolds
4.3. The governments’ reactions
4.4. Different hypotheses about the causes
4.5. The role of the financial markets

5. The case of Taiwan
5.1. Reasons for Taiwan being different
5.2. Taiwan’s political status and financial architecture

6. A basic model approach to the Crisis
6.1. A modified model for open-economy macroeconomics
6.2. Policy implications

7. Bibliography

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Index of tables

Table 1: Contributions to average annual percent in output per worker

Table 2: Incremental Capital-to-Output Ratios

Table 3: Asian countries’ external debt to banks

Table 4: Nonperforming Loans as percent of total loans

Table 5: Export and Import Growth rates of selected countries in percent

Table 6: Selected exchange rates and stock market indices

Index of figures

Figure 1: Export growth of selected countries in percent

Figure 2: Net Capital flows of Asian Crisis Countries

Figure 3: Exchange rates of selected Asian countries

Figure 4: Short-term debt as percentage of foreign-exchange reserves as of June 1997

Figure 5: Net debt-to-equity ratio as of 1998

Figure 6: Non-performing loans as a percentage of total loans as of 1998

Figure 7: Determination of equilibrium output and the exchange rate

Figure 8: Possible negative effects of a depreciation

1. Introduction

Stanford economist Paul Krugman once described the relationship between an economist and economic crises as similar to that between a “tornado chaser catching up with a monster twister”¹. The idea of this statement is that one learns best about how economies work in the real world when something goes wrong. The Asian crises of 1997 and 1998 can surely be seen as such monster twisters, with exchange rates plunging some 80%, equity prices falling some 90%, and countries facing a sudden negative real GDP growth of -13% with preceding years of an average 8% growth in the region.

As manifold as the crisis’ dimensions were the economists’ opinions on what and why things had happened. Some of them mainly focus on the currency crisis, others emphasize the aspect of “bad banking”, some say it was a punishment of the governments for their mismanagement. The truth probably lies somewhere in-between and maybe it was really just arbitrary which was the last straw that broke the camel’s back. However there are some elements of standard currency crisis analyses that contribute to explaining the events, thus this paper first describes some of these models in general.

Then the rise and fall of the so-called “tiger countries” is pictured in more detail in an attempt to cover the most important elements that caused the collapse as well as to illustrate the crisis events themselves. Since the phenomenon of contagion is generally regarded as an important aspect in currency crises, the case of Taiwan is given special attention, because although being geographically located in the middle of the turmoil, the country remained largely untouched by the economic plunge.

Finally this paper briefly introduces a simplistic economic model that tries to picture the crisis on a more abstract level. Given this model different ways for governments to react to similar crises will be examined.

2. Currency Crisis Analyses

2.1. First and second-generation models

The term “currency crisis” is defined by massive speculation against a currency, resulting from each investor’s very rational intent to get out of a currency before all the others do so. The question remains if this behavior is also collectively rational, i.e. if currency crises are always justified or if they sometimes merely are self-fulfilling prophecies.

In economic literature, there exist basically two different models that try to explain currency crises, distinguishing between crises caused by a deterioration in fundamentals and those that result from self- fulfilling speculative attacks². Regarding the first approach, there are two different hypotheses, the first of them being the so-called canonical crisis model, also known as “first-generation model”, which was developed in the mid-1970s. The original model dealt with commodity boards trying to stabilize commodity prices, but it also can be applied to central banks trying to stabilize fixed exchange rates.

Generally there are several reasons to tie one currency to another. In case of flexible exchange rates, there can be speculative action, leading to a higher volatility or to exchange rates that don’t represent the fundamental situation. This has negative effects on production levels, investment, and trade. Another problem of flexible exchange rates is the so-called “beggar my neighbour policy”, i.e. a country tries to improve its competitive situation by depreciating its currency which means lowering the prices of its exports, bearing the danger of a depreciation contest. In this case every country involved tries to do the same which in the end leads to a “depreciation race” and hence to welfare loss. Besides, fixed exchange rates can prevent a so-called inflation spiral. This would be caused by a speculative attack leading to the currency’s depreciation. This makes import prices go up and thus the consumer price index increase which consequently leads to wage increases above the productivity growth.

Simpler reasons for maintaining a fixed exchange rate are the idea that it serves as a guarantor of credibility or the aspect that very often exchange rates are seen as a symbol of national pride or commitment to international co-operation. With regard to the Asian crisis countries, many of them had linked their currencies to the US-Dollar (Malaysia, Thailand, the Philippines, Hong Kong, and Singapore), others maintained a “crawling peg” (Indonesia and Taiwan), i.e. each year a certain and predictable depreciation toward the US-Dollar was done.

Problems with fixed or pegged exchange rates occur when there is an inconsistency between what the central bank does in order to keep exchange rates fixed and what the government may do by issuing money to finance a budget deficit. In this situation the supply of money in the domestic currency increases which generally would mean a decrease in its price, i.e. the exchange rate. The central bank however prevents the exchange rate from falling by selling its stock of foreign exchange reserves. It is quite obvious that this activity can only be a temporary one as one day these reserves are going to be exhausted, forcing the country to abandon its fixed exchange rate. At that point, from an investor’s point of view it would be more attractive to hold foreign exchange because its price will go up since the price of the domestic currency will go down.

Usually investors or speculators try to be ahead of their time, so they won’t wait until the foreign exchange reserves are completely spent, instead they will start speculating against the foreign currency as soon as a certain critical level of reserves has been reached. This causes an even faster decrease in the reserves and consequently an earlier abandonment of the fixed exchange rate than it would have been necessary without the abrupt speculative attacks.

Although this model may seem quite logical, it probably doesn’t reflect very realistically the involved institutions’ activities. It is not very likely that both the government and the central bank will mechanically carry on with their fatal actions, i.e. printing money and selling the reserves until suddenly they realize that something went wrong. This criticism lead to the development of “second-generation models” that try to explain currency crises in a more sophisticated way.

In these models, the government faces three aspects:

1. A reason why it would like to abandon its fixed exchange rate

2. A reason why it wants to defend its fixed exchange rate

3. The cost of defending the exchange rate increases when investors suspect that the peg or th fixed exchange rate is about to be abandoned.

The existence of multiple government objectives implies a trade-off between a fixed exchange rate policy and other objectives. While several reasons have been mentioned above for maintaining a fixed exchange rate, there are similar strong reasons for abandoning it, even or especially if this leads to the currency’s depreciation. Let us suppose that a government faces a huge debt burden denominated in domestic currency. This debt would be diminished by inflation since in this case its real value would decrease. In order to maintain a fixed exchange rate, the money supply must not increase strongly, thus there is not much room for inflation, and therefore the government won’t be able to “inflate” its debt away. Another reason could be a country’s wish to stimulate its economy by a more expansionary monetary policy. Again the country would not be able do this as long as its currency is committed to another one.

In case the investors expect the currency to depreciate in the future, the government in the short run will only be able to keep pressure from the exchange rate when it pays high short term interest rates. These high interest rates in turn have negative effects onto the entire economy’s output and employment, thus the balance between the cost and the benefits of defending the exchange rate increases indeed in the light of investors’ depreciation expectations.

The essence of the story evolving from these assumptions is quite similar to that of the canonical model: If the costs of defending the fixed exchange rate outweigh its benefits, the government will devaluate the currency. As soon as speculators realize that an eventual devaluation is about to come, they will want to get out of the currency in order to anticipate this devaluation at the earliest possible date. Thereby they again worsen the government’s trade-off which finally leads to an even earlier devaluation. If market sentiment coalesces around the belief that a currency might be devalued and the devaluation expectations are built into higher nominal interest rates, then the prospects for a lower debt burden or reduced unemployment are worsened, and for the government the cost of maintaining the peg are increased. At the time the speculative attacks happen, they might seem to be the driving force that causes the government to devaluate, but in fact they are just the result of certain inconsistencies of government policies that in any event cannot be maintained in the long run.

However the question remains if currency crises are in fact always justified by fundamentals as stated in these models or if there are cases when really the financial markets have to be blamed.

2.2. Self-fulfilling crises, herding, and contagion

Suppose that in a certain economy it is self-evident that a government has to abandon its fixed exchange rate in the long run. Then the process described above will materialize, the investors will withdraw their money from the country. On the other hand there may be a situation where a government follows a sound policy with regard to consistency between a pegged exchange rate regime and its monetary and fiscal policy. In this case there is no devaluation necessary, even in the long run. Between these two situations, we can also imagine the existence of an intermediate range which means that given a government’s conduct there is a chance that a crisis can happen, but need not. In these cases it depends on market sentiment what happens. The good thing referring to the government’s cost-benefit calculus in the second-generation models is that if market sentiment is dominated by the belief that the currency will not be devaluated, then the costs of maintaining the fixed exchange rate are reduced, and the peg can even more easily be maintained.

Problems occur when market sentiment turns pessimistic. In this case an investor will pull out his money. But he will do it for the only reason that he thinks that the others are also doing so, as the most egregious sin in the bankers’ craft is to be the last one out. Although the exchange rate regime is in no imminent danger, a sudden pessimism - due to any reason whatsoever - may become self-confirming, finally leading to unnecessary panicked reversals in capital flows. This collective action then becomes the reason for market failure in areas other than the currency markets, leading to the breakdown of solvent but illiquid borrowers. Illiquidity means not having the ready cash to repay current debt-servicing obligations, whereas insolvency means lacking the net worth to repay outstanding debts out of future earnings³. Assume that a certain borrower owes debt to a large number of creditors, each of this credits being due after one period. The money is used in a long-term project which pays off only after a certain number of periods. Thus it is necessary to borrow fresh funds from capital markets in order to remain current on debt-servicing obligations, i.e. new loans are needed to repay existing credits. In a financial crisis the borrower may face the market’s unwillingness to provide new funds. This may be for example because creditors are afraid of asymmetric information about debtors and thus possibly respond more to the actions of other creditors which are being taken as signals⁴than to private information. The creditors’ refusal to make new loans does not occur because they think that their money is invested badly, but because each individual creditor thinks that the others are withdrawing their money, and everybody wants to be ahead of them. As a consequence the borrower has to scrap the investment project which leaves him with the salvage value that is typically worth less than the sum of the outstanding credits. This results in the borrower’s illiquidity and finally liquidation. When the investors are getting paid the salvage value, the debtor defaults, and everyone feels vindicated that the decision to withdraw the money was justified although the borrower originally may have been completely solvent.

Believing that the withdrawal of somebody else’s money implies more information than the own private information is a problem of limited information efficiency or asymmetric information. One of the resulting phenomena is called “herding” and may become particularly virulent in markets dominated by institutional investors like pension fund managers. For different reasons, they always have a strong incentive to stick with the market. Fund managers are usually being paid in comparison to other fund managers. So they would rather be in line with the market than being the only one who takes the risk that the market is wrong, even when their information doesn’t justify what the market does in a given situation.

Another aspect which in the past often affected the course of currency crises is the issue of “contagion”. Nearly always it was not one single country that came under attack, instead there have been regional waves, be it in ERM crises, the Latin American crises or the Asian crises. The reasoning behind this could be that a worsening of the data in a certain country has effects on the economic situation of some neighbor countries, as usually one could assume that there is an intense trade going on between countries within the same region. Surprisingly this couldn’t be strongly verified by the actual data so far, as trade links in the European and the especially Asian crises in fact have been very weak. Thus there seems to be a certain irrational perception of similarity by the investors. Countries are being seen as a group, e.g. “the” Asian countries. Once a country has abandoned its fixed exchange rate, the other countries are considered as being inclined to do the same, simply because they belong to the same “group” of countries. But even in case that there is no such general irrational behavior, certainly the individual decision making process of investment managers is again an important point. Suppose a fund manager not reducing his exposure in South Korea as he realizes that there are only very weak trade links with some troubled neighbor economies. If finally the South Korean economy gets into trouble as well, he probably will be blamed for lack of due diligence, simply because “Asian countries have been risky” in the recent past.

3. The Asian success story

So what does all this give us for the analysis of the Asian crises? Given the fact that economic policy and the according data of the crisis countries were the envy of all emerging markets prior to the crisis, one has to admit that the first two “classical” models cannot be perfectly applied to the Asian crisis: In both models, there was some inconsistency in the country’s economic policy involved that created a tension resulting in some fundamentally justified attacks. This kind of a widening gap, e.g. between fixed exchange rates and a deficit budgetary policy wasn’t seen in the crisis countries, but rather the contrary is the case: For years, a lot of economists regarded the Asian countries who got hit by the crisis as the most successful models for emerging economies that had ever been seen. An estimated 350 million people had been lifted out of poverty and it appeared that the countries had broken out of the poverty trap and had entered the ranks of dynamic and self-sustaining economies. Thus, given the stable conditions in the entire region, there was no reason not to have further confidence into a continuing Asian success story which left basically everybody completely unprepared to the crisis events.

The boost began as early as in the mid 1960s with the economies of Korea, Taiwan, Hong Kong, and Singapore growing at very high rates, followed by Indonesia, Malaysia, and Thailand in the 1980s and 1990s. The growth rates were way above the ones economists had expected, accompanied by immense social improvements: Poverty, infant mortality, and adult illiteracy declined, and - most surprisingly - in spite of the rapid growth there was no significant increase in income inequality to be seen. Although there was no uniform recipe for success in all of those countries, it is necessary first to touch the main success factors in order to understand the onset of the following crisis.

3.1. Capital accumulation

One common way to find out which factors caused economic success is to split output growth into different parts: If we deduct from the output growth per worker the components that can been assigned to 11 capital accumulation and human capital accumulation, the residual is the so-called total factor productivity growth (TFP). This number then explains an increase in productivity caused by technological advances and greater organizational efficiency.

Table 1: Contributions to average annual percent in output per worker⁵

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Looking at table 1 we find it was the accumulation of capital that played a major role in explaining the Asian growth. Total output growth per worker for the period between 1960 and 1994 was significantly higher in Asia than in the United States and other industrial countries. However, there is no equivalently significant difference in the TFP growth in most of Asian countries. This means that obviously economic prosperity wasn’t achieved by enhancing economic efficiency, although the initial level of technological development in these countries was fairly low. Instead it came about by extraordinarily high investment rates of as much as around 40% of GDP in the 1990s in Korea, Malaysia, and Thailand.

We have to ask if these immense capital flows still could be invested efficiently or if the returns on capital have been going down. One way to measure the efficiency of overall investment is the incremental capital to output ratio (ICOR). It compares the investment of a certain period to the period’s change in output. A rise in ICOR means that more investment spending is needed to support a given increase in GDP. This can be seen as a decrease in efficiency since the output response to investment is declining. Although there may be other factors responsible for an increasing ICOR - e.g. a decrease in output - in literature it is generally regarded as a proper measurement of investment quality. In fact in almost all the crisis countries ICORs increased in the 1990s as can be seen from the data in table 2.

Table 2: Incremental Capital-to-Output Ratios

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One of the reasons for this decline is an increased investment in non-traded or protected sectors. In Indonesia, Malaysia, and Thailand this was real estate or petrochemicals. Furthermore an increasing amount of investments went into sectors like South Korea’s semiconductor, steel, or ship industry or Thailand’s construction industry, which were all operating with high or excess capacities. Consequently only very low or even negative yields could be obtained. However the capital inflows were large enough to cause 11% real growth rates in Thailand’s real estate and construction sector between 1992 and 1996 in spite of increasing office vacancy rates at the same time. Also in Korea the big conglomerates, the so- called “chaebols”, didn’t pay too much attention to profitability. Facing continuing investment inflows, they made sometimes quite bizarre attempts to diversify into ever more sectors, for instance Ssang Bang Wool branching out from knitting and underwear into building an Austrian-style ski resort. However, in 1996 the net profits of the 30 largest chaebols were close to zero, some of them even invested in firms and industries whose debt servicing costs were higher than their prospective earnings.

Evidently, risks have been underestimated by international investors. One of the reasons may have been their search for higher yields. Investment opportunities appeared less profitable in Japan and Europe at that time owing to sluggish economic growth that necessitated low interest rates. Thanks to pegged or fixed exchange rates in Asia, investors may have thought that they had found a way of reaching higher interest rates without exchange rate risk. World-wide private capital flows to developing countries grew some 500% between 1990 and 1997, with nearly two-thirds of this amount going to Asia. But also from the domestic perspective there was some kind of a gold rush atmosphere. Asian investors in the 90s realized that borrowing money abroad was by far cheaper than in their own countries, thus it was for example possible to borrow Japanese Yen at nearly zero interest, invest in a Bangkok skyscraper, and expect to earn 20% annual return.

3.2. The role of the governments

3.2.1. Human capital formation

This massive investment raises the question for what reason investor confidence became so extraordinarily strong with regard to the entire region. Apart from lower yields in alternative investments one has to concede with regard to the fundamental level that there were indeed major achievements by the different governments that justifiably contributed to a broad optimism concerning the future of these emerging countries.

One of the main merits of the Asian governments is surely their performance in the sector of human capital formation. In nearly all the countries, the educational systems grew immensely and also their quality, measured by education expenditure per pupil and pupil-teacher ratios, improved. In Korea, enrollment numbers in secondary school changed from some poor 35% to 100% between 1965 and 1995⁶. Also in other countries the enrollment rate was higher than in countries with comparable income levels. This growing educational activity had various positive external effects. Not only did it contribute to an increase in productive capacity and thus the economies’ growth potential. Since generally a certain skill level is necessary to make the use of further physical capital equipment reasonable, also greater investment was induced. This accumulation of capital in turn led to high growth rates that caused an increase in the populations’ incomes which again helped to raise overall saving, causing again further investment.

Domestic savings activity was furthermore stimulated by a stable macroeconomic environment, low inflation rates and the establishment of mandatory saving schemes in some countries. At the same time, corporate saving also increased, representing a substantial part of the overall savings. In Thailand this percentage increased from 45% to 60% and in Korea from 3% to 6% of GDP over the decades. Compared to less successful developing countries, these numbers are exceptionally high which again reflects a strong confidence into the macroeconomic performance of the region.

3.2.2. The Financial Sector

Due to highly underdeveloped private securities markets, the allocation of the capital had to take place mainly through the banking system. Not only the securities markets showed very little market liquidity, unlike in other industrial countries, they also played a relatively unimportant role in corporate governance which in the end certainly was one of the many reasons for the crisis. Regarding the usage of the money, borrowing rather than equity was the main source of fresh capital, thus enterprises were highly leveraged, with Korean companies having a debt to equity ratio of over 317% in 1996, which was twice the U.S. level. The governments’ own financing activities increased the importance of the banking sector relative to the capital market even more. Usually a bond market evolves in consequence of a government bond market. However the governments either didn’t need any substantial budgetary financing due to balanced budgets, or they borrowed directly from banks.

While in every country the government activity in the financial sector was different, the degree of intervention was generally extensive. In some of the countries, the public sector owned and managed financial institutions to encourage and intermediate savings, particularly where financial institutions were weak. Governments also influenced financial institutions by tax incentives and subsidies, e.g. by subsidizing loans to priority industries. In Korea, in particular, companies that performed well in export markets were granted ready access to credit and foreign exchange.

As the economies matured, production structures became more complex and the need for more financing and especially more sophisticated financial products increased. Thus in a response to these 16 new necessities, the governments started to liberalize their financial sectors from the mid-1980s onward. Unfortunately liberalization and regulation was done only on an ad hoc basis in the face of certain single problems arising, thus leaving many problems unsolved and many risks uncovered.

3.2.3. Trade policy and macroeconomic stability

One of the most remarkable features of the Asian economies was their export performance. Since initially most of the countries had relatively small populations with rather low per capita incomes, export demand was one of the key requirements to sustain the growth process. Therefore the governments took different steps to improve the companies’ international competitiveness, e.g. by importing technology for the production of technology-intensive products. Thanks to this strategy the countries could extend their export activities relatively fast from low-technology products like apparel, footwear, or electronics assembly, to high-technology products like consumer electronics. Given the overwhelming importance of the export industry, the governments often provided tax incentives for exports, subsidized export- marketing efforts and export-related infrastructure, promoted the creation of international trading companies, and provided incentives for foreign investment directed towards export.

Export also helped the countries to maintain a macroeconomic equilibrium: Governments were forced by their high trade activity to maintain stable foreign exchange rates which made them take care of fiscal and monetary stability in order to avoid the currencies’ real appreciation. The export growth also avoided large current account deficits that otherwise could have occurred due to the large external financing. And finally the income that was generated by the exports sustained the governments’ ability to maintain the fiscal balance that was demanded by the stable exchange rates. Some legislations even explicitly limited the size of public sector deficits so that the countries’ fiscal account deficits were less than one-half of the average for other developing countries.

4. The Crisis

Although obviously there were many good reasons for the Asian countries’ extraordinary economic success, there were however several flaws as already indicated. No single clear reason can be made responsible for what happened during the crisis, but instead the interaction of several different factors made the Asian countries highly vulnerable to external financial shocks. Generally there was no Asian capitalist model that failed. Instead the incompleteness of financial reforms exposed these economies more directly to the instability of international financial markets⁷that finally led to some of the events described in the general crisis characterization above.

4.1. The framework in the crisis’forefield

Some aspects in the preliminary stages of the crisis during the 1990s certainly indicated a worsening in the macroeconomic and microeconomic environment but these figures however didn’t suggest the devastating fall that followed:

Annual capital inflows into the crisis countries remained at a very high level with large parts of it flowing into real estate and property. In Indonesia, South Korea, Malaysia, the Philippines, and Thailand capital inflows averaged some 6% of GDP between 1990 and 1996, with some 13% for 1995 in Thailand, and some 15% in 1992 and 1993 for Malaysia. With the expectation that outstanding loans would continue to be rolled over, short-term borrowing was used increasingly for long-term investments, causing an increase of the maturity mismatch between assets and liabilities.

Governments maintained either fixed exchange rates or pegged exchange rates. This shifted exchange rate risk from the investors to the central banks. Thus investments became less risky which again encouraged foreign currency borrowing. Sometimes risks were neglected that investors would have accounted for in case of flexible exchange rates, facing the permanent existence of risk of devaluation.

Real exchange rates appreciated because the huge capital inflows made the prices go up. Real exchange rates are exchange rates adjusted by inflation, and an appreciation generally happens in the case of fixed exchange rates when the domestic inflation is above the foreign one, meaning that purchasing power of the domestic currency increases, thus worsening the attractiveness of the country’s exports. Export growth indeed began to slow and finally dropped sharply in 1996, partially due to a global excess-supply in the semiconductor industry. But also the appreciation of the US-Dollar against the Japanese Yen from mid-1995 onwards made competitiveness deteriorating and contributed to the export slowdown.

Figure 1: Export growth of selected countries in percent⁸

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Domestic bank lending expanded rapidly. In 1996 banking claims on the private sector accounted for some 140% of GDP in Thailand, Malaysia, and Korea, being a 50% increase since the beginning of the 1990s. Debt to foreign banks grew in some countries up to 300% during the 1990s (see table 3), with an increasing percentage of short term debt.

Even without the nonbank sector, i.e. bonds etc., the ratio of short-term debt to foreign exchange reserves eventually exceeded the critical value of one in some of the countries. This ratio is a possible indicator for the vulnerability of a financial system. Since the investors get aware of the fact that there is not enough foreign exchange in the system to repay all of them at once it creates an incentive to demand repayment quickly in case of a general wave of withdrawal of foreign capital.

Table 3: Asian countries’ external debt to banks⁹

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4.2. The crisis unfolds

With most currencies being linked to the Dollar, central banks had no means of pushing back the domestic lending by increasing interest rates. The economies sucked in more and more imports with the current-account deficits widening even more due to a rise in the Dollar that pulled the Asian currencies up and thus made their export companies less competitive. In late 1996, the first serious problems emerged in Thailand when property prices fell dramatically and one of the big property developers proved unable to meet its credit obligations. By then the markets suspected that finance companies with a large exposure in the property market were in trouble and started withdrawing their money.

Figure 2: Net Capital flows of Asian Crisis Countries¹⁰

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Rumours emerged about rapidly decreasing foreign exchange reserves that would lead to an eventual free float of the Thai Baht. The currency soon became a target for speculators. It came under attack several times with the government first still defending its exchange rate.

Korea also came under pressure in early 1997 although not having a fixed exchange rate regime. The reason were some of the big chaebols declaring bankruptcy, especially Handbo Steel, leaving $5.8 billions of debt. Serious financial weakness could also be seen in other companies like Kia Motors and Sammi Steel, nourishing fears about the condition and the future of other chaebols.

Meanwhile the Thai government had to give up its fight for the exchange rate. After loosing the vast majority of their foreign exchange reserves in a desperate battle led by George Soros, they had to cut loose the Baht in July of 1997. This was followed by a general withdrawal of capital from the whole region, causing an exchange rate plunge of 20% or more of the currencies of Indonesia, Malaysia, the Philippines, and Thailand. The financial sector problems in Thailand quickly spilled over into the real economy. As fear took over, there were runs on large and small otherwise solvent banks which forced many of them to close. Their otherwise viable customers followed, unable to obtain funds to meet ordinary operating needs. Some investors did not distinguish between the different countries, which largely matches the described contagion scenario, others took a closer look and became aware of the explosive mixture of fixed exchange rates, shady banking systems, massive unhedged short-term foreign debt and a general lack of transparency also existing in other countries. When the major rating agencies then downgraded several countries in the region, the stampede became the only strategy left for the investors, they dumped their assets and headed for the nearest exits.

The falling exchange rates made the huge foreign debt burden suddenly extremely expensive. Creditors refused to roll over existing loans, on the one hand due to a general distrust in all of the countries, on the other hand because at the same time the property bubble burst, leaving the banks with a pile of bad debts. Facing the paucity of fresh foreign funds, domestic debtors had to buy foreign currency to serve their obligations and to close unhedged foreign exchange exposures, which also contributed to the currencies’ fall¹¹.

In South Korea, due to the close relationship between the public and the private sector, many of the conglomerates had expected the government to bail them out in case that something went wrong. Thus having borrowed extensively and invested recklessly, their average debt-to-equity ratio had reached some 400% at the end of 1996, compared to around 70% in the U.S. At the moment when the currency fell and exports declined, they suddenly weren’t able anymore to serve their foreign debt, while fresh funds from abroad also dried up due to the foreign creditors’ anxiety. Yet the short-term debt was already three times as big as the country’s foreign exchange reserves in June of 1996, and in December it had finally risen to 14 times.

In the beginning of the turmoil, most people thought of Indonesia as the only country being in quite good shape, as some economists had agreed that the fundamental data looked good. Thanks to a wider range for currency floating, the country wasn’t prone to the problems the others were facing. But over time it became clear that inadequate banking supervision, very questionable borrower-creditor relationships, and heavy unhedged foreign borrowing also would cause problems for Indonesia. In the course of the currency devaluations, the immense amount of foreign debt made the ratio of foreign bank debt to GDP rise from 35% to 140% which left most Indonesian banks and firms practically bankrupt.

Figure 3: Exchange rates of selected Asian countries¹²

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In few words, the main original problem of the countries involved was too much cheap money, combined with a financial system that failed to allocate it efficiently. Instead, it inflated property and stock market values and enlarged external deficits, leading to eventual overheating pressures. Governments were not able to respond properly to this overheating, because they refused to let their exchange rates float which would have enabled them to follow an autonomous monetary policy. Capital markets trusted the governments’ intention to keep exchange rates pegged and thus took them for granted. Consequently, external borrowing increased, but it materialized primarily at short maturities. Within the countries, this capital was supervised only very inadequately. There was no sufficient risk control, only a lax enforcement of prudential rules and seedy relationship between the governments and the financial sector additionally contributed to a deterioration in the loan portfolios. However foreign investors were not able to identify these problems due to poor data availability and a serious lack of transparency. Once they became aware of their lack of knowledge of economic fundamentals, uncertainty and nervousness spread. Some of the foreign creditor eventually refused to roll over their short-term loans, confidence became weaker. Political uncertainties exacerbated the situation, and the withdrawal of capital continued, increasing the downward pressure on currencies and stock markets.

4.3. The governments’reactions

Particularly in the face of irrational investor behavior it is probably mere speculation to think about a potential mitigation of the crisis’ course that could have taken place in case of different government reactions to the events. However there is a broad agreement that what some of the governments did was everything but an appropriate reaction to the slump.

As described above, the Thai government completely ignored all analyst warnings, they desperately tried to maintain the exchange rate peg to the US Dollar, thereby losing more and more of their foreign reserves and increasingly engaging in forward purchases of the baht. At the same time they flooded ailing banking institutions with money without taking fundamental steps towards their closure, so that in the end investor confidence was completely gone. Not only had the government caused a fairly large amount of this confidence loss, it also had created an environment that was even more vulnerable to investor panic because of its vastly diminished foreign reserves.

But other countries didn’t do much better. Malaysia’s prime minister frightened the markets with the threat to ban foreign currency trading, then the government imposed mild capital controls and announced it would establish a fund to support stock prices, but this plan was abandoned some days later. South Korea at first seemed to react properly by allowing some of its big conglomerates to go bankrupt, but then they also lost a large amount of their reserves when they tried to defend their exchange rate.

Although Indonesia didn’t do this, the government eventually also became the victim of inconsistencies in its activities. In the beginning it announced that it would postpone over one hundred investment projects, but then it withdrew this intent for several large projects, and then later postponed them again. This back and forth, suggesting an apparent inconclusiveness, didn’t contribute to the restoration of investor confidence, and when state enterprises had to pull large deposits out of the banking system, interest rates increased sharply, causing further withdrawals of foreign capital.

Even when the IMF intervened, things didn’t get much better, and in the aftermath of the crisis, the IMF activities themselves have often been seen in a very critical light: In spite of an emergency fund of $100 billion for Thailand, Indonesia, and South Korea, the fund wasn’t able to prevent the currencies from falling. The initial programs targeted fiscal deficits, high interest rates, restrictive money growth, and the closure of insolvent financial institutions. But within very short periods of time, these programs were abolished again, accompanied by a further depreciation of the currencies and a fall in the stock prices. This didn’t stop until December of 1997, when the international community initiated a different approach to the problem based on debt restructuring, accelerated disbursements of international funding, and more comprehensive and rational restructuring of the financial sector¹³.

4.4. Different hypotheses about the causes

Although the crisis mechanisms themselves can be reproduced quite precisely, there is still no general agreement about the actual incitement of capital markets’ malfunction. Some economists, one of them being Paul Krugman¹⁴, brought forward the quite popular argument that foreign investors assumed their loans were being implicitly guaranteed by the governments. They claim that due to shady relationships especially between the big conglomerates and government officials investors expected that they would be bailed out and that mainly because of this belief foreign borrowing became that massive. Other economists, e.g. Harvard’s Jeffrey Sachs, were not able to find sufficient supportive data to sustain this theory and thus refuse to attach an overwhelming importance to it as a major cause for the crisis.

If the hypothesis of “crony capitalism” holds true, several things would have happened as a logical consequence: Investors wouldn’t have cared anymore too much about due diligence on the repayment potential of the debtors. Loan quality would have significantly deteriorated, and the main driver for investors to keep on lending would have been their expectation to receive bailouts if necessary instead of their belief in continued economic success of the region. In an attempt to verify this hypthesis no significant deterioration in the credit quality can be found, as table 4 shows.

However there exist certain in favor of the crony captialism-hypothesis: indicators like corruption indices etc. suggest that some things in the South-East Asian economies didn’t work as they should have according to conventional economic textbook wisdom, so probably there was indeed some kind of “crony capitalism” involved, but regarding the question how essential this point was, it doesn’t seem to be likely that it was a major cause for the economic nightmare that took place.

Table 4: Nonperforming Loans as percent of total loans

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Another possible source for the events are shifts in international market conditions. Before the crisis, the economic environment seemed quite friendly, growth in international trade was strong, risk premiums on loans to emerging markets were falling, world commodities markets seemed relatively stable. Then a sharp decline in the crisis countries’ export growth occurred in 1996 (see table 1), which could suggest an unexpected international shock to the Asian economies. However the significance of this shock remains to be discussed.

In table 5 we can indeed see some dramatic numbers regarding the economies’ export value growth. South Korea just obtained some 3.7% compared to 30.3% in the year before, and Thailand even suffered a negative growth of -1.3%, coming from some stunning 13.4% in 1995. The creation of the NAFTA could have been one of the reasons for this. With the United States still being the single most important export market for many of the Asian economies, the surge of Mexico as a potential competitor might have hit Asian export demand severely. This was even fostered by the aftermath of the 1994 peso devaluation, resulting in a Mexican total export increase from $52 in 1993 to $96 in 1996, consisting of some products that directly compete with Asian ones.

But even though the value growth points in the same direction in all of the countries, the split of these numbers into volume and unit value gives us quite an inconsistent pattern. Volume kept on growing steadily in Korea and Malaysia, accompanied by a sharp decline in unit value. This probably can be explained by a global excess supply of labor intensive manufactured products like consumer electronics and semiconductors. The resulting price decline then hit these two countries especially hard, as the exports of both of them were mainly fuelled by this industry.

Table 5: Export and Import Growth rates of selected countries in percent¹⁵

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In Thailand, both volume and unit value stagnated, and in other countries again different combinations can be seen, and each one has a different reason. The overall impact of this environment change on the actual crisis’ ignition however seems to remain rather modest, especially compared to the Latin American debt crises of 1980, when external shocks clearly played a major role.

4.5. The role of the financial markets

In the aggregate, none of the single factors described so far can be identified as the ultimate explanation of the crisis, although some things were definitely going wrong. Of course investor expectations are not formed in a vacuum, and there is certainly a relation between the crisis and the economic fundamentals. But after all, there still seems to be quite a good chance that a fair amount of the crisis events owes to the financial markets themselves. The increased globalization of capital markets means that crises involve capital account more than in the past. A change in expectations or investor sentiment can induce a sudden, sharp reversal in capital flows, precipitating a currency crisis, as mentioned above. With larger capital flows, a crisis can occur more rapidly than in the past. This was first seen in the Mexico crisis, which generally extended the focus of crisis analysis from the role of traditional economic fundamentals in currency crisis to that of financial sector weaknesses and the globalization of financial markets in increasing an economy’s vulnerability to sudden capital outflows¹⁶. And it seems to be confirmed by the Asian crisis once again. To test this hypothesis, Jeffrey Sachs et al. performed a probit analysis¹⁷to test the explanatory power of certain variables for the occurrence of financial crises. They analyzed 22 emerging markets for the period from 1994 to 1997, defining a financial crisis as a sharp shift from capital inflow to capital outflow from year t-1 to year t. The dependent variable was set at 1 for a given country in year t if that country experienced a crisis, in this case the country was excluded from the panel in all subsequent years. Although the model itself shall not be completely reproduced in this context, its results deserve some attention since they indeed confirm certain assumptions.

They observed some degree of relationship between the crisis outbreak and the build-up of claims of the financial sector against the private sector could be found. Furthermore they found only a very weak explanatory result for current account deficits and real exchange rate overvaluation, as well as for the level of perceived corruption. Nevertheless in some cases the level of corruption was fairly high, but it was also in non-crisis countries, thus it didn’t seem to have been the driving force of the crisis.

Interestingly, the ratio of short-term debt to foreign reserves was indeed strongly associated with the onset of a crisis, supporting the thesis that it makes the investors worry about the ability to pay off all short-term creditors in case of a crisis. However, there was no statistically significant explanatory power of the ratio of total debt to reserves. If a crisis were fundamentally justified, this ratio should make creditors concerned about their outstanding loans regarding the debtors’ solvency. This evidence strongly suggests that the analyzed crises have in fact rather been crises of illiquidity, not insolvency, just like the banking crises in the U.S. in 1936 are believed to be.

5. The case of Taiwan

5.1. Reasons for Taiwan being different

As we saw so far, investor behavior and the dispersion of the crisis was often rather characterized by phenomena like herding and contagion than by a rational reaction to fundamental data. Hence it remains very surprising at first sight that one single economy in the region remained nearly unhurt by the events. Table 6 reveals that the Taiwan Dollar suffered only a minor decrease in the period between December 1996 and 1998 whereas other currencies lost as much as nearly 80% of their value. The Taiwanese stock market index even increased during that period which actually does not come as a surprise as Taiwan probably had the best fundamentals in the whole of Asia: Large foreign-exchange reserves, a current-account surplus, little foreign borrowing and a healthy banking sector. The question is in what respect Taiwan was different from all other countries in the region, because obviously there were some similarities: like in South Korea, the Taiwanese government had also been intervening vigorously in the economy. However its industrial policies have been more flexible and better suited to changing business conditions, and Taiwan had also made more progress than South Korea in deregulating its economy.

Table 6: Selected exchange rates and stock market indices

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In part the good shape of the Taiwanese economy is certainly a result of more government efforts regarding the population’s education in the long run. In 1975, Taiwan had approximately the same income

per head as Thailand and Indonesia had in 1996. However the educational situation at that time in Taiwan was by far more advanced than it was in the other countries when they reached this income levels. Thailand, Indonesia, and Malaysia spent all less on education as a share of GDP in 1997 than Taiwan did at the same level of income, and this money often was badly spent. To name a famous example, the Thai government once bought computers for rural schools that had no electricity.

Another rather obvious reason for the different reaction of Taiwan’s economy to the crisis of the neighbor countries are the trade relationships. It was America and China who accounted for more than 50% of Taiwan’s exports, and both countries hadn’t been significantly affected by the crisis. Taiwan’s exposure to Southeast Asia was rather on the investor side, not as an exporter depending on the local markets. Taiwanese companies had set up factories in Malaysia, Thailand, Vietnam and Indonesia to take advantage of cheaper labor there. When those countries’ currencies devalued, it made the labor even cheaper. The main exports to these countries were raw materials and components to their factories, so that even the regional exports didn’t fall as much as the ones from other countries that sold mainly to consumers. These kind of trade relationships was also the reason for the U.S. not being pulled into the turmoil, but the remarkable thing about Taiwan in contrast to the U.S. is the direct geographical vicinity to the crisis countries which theoretically could have led to the contagion phenomenon.

5.2. Taiwan’s political status and financial architecture

Another reason which in the face of the financial dimension of the crisis seems to be even more relevant is the structure of the economy. This structure is likely to be owed to the political status of the province. Taiwan covers an area whose size is just about the same as the one of the Netherlands, with a population of 22 millions, being located about 100 miles off the China mainland. Due to China’s political interest in the island, Taiwan is a diplomatic pariah, always in fear of isolation, with some authors even claiming “paranoia” and the resulting permanent safety concerns to be the reason for Taiwan’s economic success¹⁸: Taiwan knows that it simply cannot afford to go bust. Since it is also banished from all important international organizations, including the IMF, there would be no hope for bail-out in case of economic trouble. Instead there is a chance that in this case the province would be invaded by the Chinese mainland. In legal terms, Taiwan is a non-political state, frozen in a cold-war mould by an accident of history, aware of a menace always being at the door, which the rest of Asia maybe had forgotten. This permanent endeavor for safety explains the only significant black marks in Taiwan’s macroeconomic environment which are its chronic budget deficits and its relatively high national debt (about 20% of GDP), both mainly due to a large defense budget.

But on the other hand, these efforts to maintain a stable system are also responsible for the world’s third-largest foreign reserves which amounted to $84 billion in 1998, exceeded only by China and Japan, and one of the world’s lowest foreign debts of about $250 million (see figure 4).

Figure 4: Short-term debt as percentage of foreign-exchange reserves as of June 1997

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This role of Asia’s top performer in the crisis years appears to be even more stunning given the province’s largely closed financial markets and unreliable economic statistics, constantly withstanding the urge of the United States and other countries to liberalize the capital markets as all the other countries had done avidly in the years and decades before the crisis. South Korea also still restricted some kinds of international capital flows, but others, particularly Thailand, had flung their doors wide open with the resulting vulnerability described above. Therefore, when the markets went down, Taiwan turned out to be much less violable by foreign investors’ panic. With international investors just accounting for some 3% of Taiwan’s stockmarket holdings, there was simply not much to do for foreign currency and stockmarket speculators even if they were unimpressed by Taiwan’s economy. These closed financial markets clearly don’t seem to be a good thing in the light of some general principles of economic policy, but in this case they were an effective shield against contagion from other countries.

However, before the crisis Taiwan was perhaps the least admired of the tigers. It was neither a financial center nor home of many huge and prestigious companies as in the case of South Korea. Nevertheless Taiwan in 1996 was the world leader in more industries than any of its peers. Most of them were admittedly quite unexciting ones, such as umbrellas, fasteners and handtools, with computers being the one big exception.

Even though not being very successful in making the province liberalize its financial markets, the United States however was able to impose some laisser-faire principles on Taiwan that caused the entrepreneurial potential of this society to be fully realized. The resulting numbers are quite astonishing: the average Taiwanese company had only 18 employees which is the highest density in the world, small to medium-sized enterprises make up 98.5% of Taiwan’s companies and 75-80% of all employment. These figures show a high preference for being self-employed, which perfectly reflects the Chinese self- image which regards it to be “better the head of a chicken than the tail of an ox”, as a Chinese saying goes. Such a high percentage of small companies that are mainly financed and run by families makes the whole economy extremely flexible. Small companies are by far better able to switch business if market conditions do so than large enterprises, which makes them better able to adapt to the ever-changing global economy. Apart from that, small and medium-sized companies are less likely than large conglomerates to form bonds of corruption with governments and banks on a scale that could jeopardize the entire economy. And, again compared to South Korea, Taiwan had allowed sick firms to fail, thus keeping the economy in a healthier state by not artificially respiring some inefficient giants. Correspondingly, Taiwan’s rate of TFP growth quickened from an annual average of 1.1% in 1960-1973 to 2.8% in 1984-94. This was much higher than TFP growth in rich industrial economies (an average of only 0.7% in the ten years to 1994)¹⁹.

Talking about these companies’ way to finance their operations, the government’s strict capital controls are certainly one of the key factors that determined the finance activities. In order to prevent leakage of precious hard currency, the government prevented Taiwanese companies from taking on cheap foreign-currency loans for speculative projects. This regulation and other kinds of capital control made bank loans basically unavailable for companies other than the biggest ones. So the entrepreneurs didn’t have a chance but to borrow money from their friends, families, communities, or loan sharks, constituting the so-called “kerb-market” with interest rates often three times the official one due to the credit shortage. Although interest rates were that high, they were at least somehow determined by the market which distinguishes Taiwan from South Korea. Since borrowing was extremely expensive, companies borrowed as little as they could and paid it back quickly which as an overall effect encouraged less capital-intensive production and again the large number of smaller, equity-financed firms.

Figure 5: Net debt-to-equity ratio as of 1998

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No wonder Taiwan has one of the lowest debt-to-equity ratios in Asia with 30% for listed Taiwan as a whole, compared with more than 400% for Indonesia (see figure 5). Taiwan’s non-performing loans accounted for just 1.5% of total assets, compared with Thailand’s 30%, or some 10% of total loans compared with some 60% in Indonesia (see table 6).

Low debt-to-equity ratios of course also left most Taiwanese companies highly underleveraged, thus not being not able to expand as rapidly as e.g. the Korean conglomerates who always had easy access to cheap capital. Instead, they had to finance growth largely from cash flow, which made them concentrate on profits. The average Taiwanese electronics company showed an impressive return on equity of 34% in 1997.

Figure 6: Non-performing loans as a percentage of total loans as of 1998

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Nevertheless the country wasn’t always an economic paragon, instead there had been several severe irrationalities in the past. Particularly in the late 1980s and early 1990s the country had seen mad property inflation and stockmarket booms, just like Thailand, Hong Kong and the others. In 1989 for instance, Taiwan’s stockmarket had he world’s second largest turnover, behind New York but ahead of London and Tokyo. Approximately 25% of the adult population was playing the market full-time, and although many of them were housewives, this situation created a serious labor shortage and, of course, a bubble in the stock markets. In rural areas, there were even color-coded stock listings so that illiterate farmers could join in.

Then several corrective crashes followed, the most recent one in 1995 and 1996 due to a crisis of confidence when China conducted military exercises and missile tests in the Taiwan straits. So when the other countries were hit by the crisis, Taiwan’s stock and property markets were already more than 30% down from their peaks, simply leaving less of a bubble to burst.

Summarizing the role of Taiwan in the financial turmoil of the crisis, we find that the economy was indeed in a better fundamental state than others and it was also lucky that its business cycle happened to be out of phase with the rest of the region. Apart from that, it was also simply less vulnerable to financial crises. However we shouldn’t forget that the policy that led to this situation is not in accordance with pure economic textbook recommendations. Although the entrepreneurial business culture and the increasingly high-tech based industry are impressive and indeed seem to be a model that will also succeed in the future, one motivation for the government to limit private companies’ credit was the fear that a strong merchant class could arise which might challenge the ruling party’s hold on power. This former government also distrusted the Korean model in part because it worried that such big conglomerates could become a force unto themselves. They even might have been right, but yet this way of thinking does not reflect the ideas and architecture of a liberal economic system.

6. A basic model approach to the Crisis

6.1. A modified model for open-economy macroeconomics

Coming back to the less fortunate countries of the crisis, we still have to ask what implications the course of the crisis has for similar situations in the future and what policy recommendations can be given in order to properly face them. First there will be a basic model presented to illustrate what happened to South-East Asia on a more abstract level.

The classical model for explaining open-economy macroeconomics is the Mundell-Fleming model. We will use a very simple version of the model consisting of three basic equations. First we look at the aggregate demand. In an open economy, the goods produced can be bought by domestic residents as well as by foreign ones²⁰. Purchases of domestic goods by foreigners are exports. The expenditure of domestic residents on domestic products is a residual (absorption), equal to the total aggregate amount that domestic residents spend minus the domestic spending on foreign goods, i.e. imports. If D represents absorption and NX the net value of exports minus imports, we come to the following equation²¹:

Abbildung in dieser Leseprobe nicht enthalten

The determinants of domestic spending D are the real income and the interest rate, whereas the net exports depend on the real income and the real exchange rate.

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This equation describes a money market equilibrium with the demand for money being a decreasing function of the interest rate i and an increasing function of real income. And finally we assume to have risk-neutral investors with static expectations about the exchange rate which gives us a world interest-rate arbitrage equation under perfect capital mobility:

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Now we can determine the exchange rate by the following figure:

Figure 7: Determination of equilibrium output and the exchange rate

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The LL curve shows all combinations of income and interest rate that keep the money markets in an equilibrium. This equilibrium specifies a certain level of income that is not directly affected at all by the exchange rate, hence the curve is a vertical one. The YY line shows all combinations of exchange rate and income levels that keep the goods market in equilibrium. The ascending slope depicts a positive relationship between both variables. If the exchange rate depreciates (i.e. “e” rises), foreign goods become more expensive to domestic residents, and demand shifts from foreign to domestic goods, thereby increasing domestic production levels. On the other hand the domestic demand for foreign goods will increase when the exchange rate falls, i.e. in case of an appreciation of the domestic currency. Consequently, domestic output will have to decrease.

There is an overall equilibrium determining an equilibrium exchange rate where the goods market clears at the level of income that is consistent with equilibrium in the money market. Now the model is modified in order simulate a crisis²². The idea is that there is a wealth constraint. Companies are assumed to be highly leveraged, having a high percentage of their debt denominated in foreign currency, and facing certain constraints regarding that leverage, e.g. due to balance sheet constraints. This means that the amount domestic entrepreneurs can borrow from foreign creditors depends on their wealth and simultaneously on the overall level of foreign borrowing, as the volume of capital inflows affects the valuation of foreign currency-denominated debt. The supply of credit from abroad thus depends on what the lenders think will be the value of the borrower’s collateral and thus on the real exchange rate, because debt is denominated in foreign currency. If there is a decline in capital inflows, it will adversely affect the balance sheets of domestic entrepreneurs, reducing their ability to borrow and hence further reducing capital inflows.

Consequently, the aggregate demand must also depend on the real exchange rate:

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If the real exchange rate is very low this would mean a very favorable situation for the domestic companies. Foreign debt would be very cheap and hence it would account for a rather small amount in their balance sheets. Thus most of them wouldn’t be balance-sheet constrained, the direct effect of the real exchange rate on aggregate demand would be minor. In case of a very unfavorable real exchange rate, the foreign currency would be so expensive that domestic companies with foreign debt wouldn’t be able to invest at all. This is basically the situation that could be seen in Indonesia, where the entire

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corporate sector was bankrupt whereas small firms could still benefit from the weak currency. Again, the overall effect of the real exchange rate on aggregate demand would be negligible. However, there may also be an intermediate range between these two scenarios, where the contractual effects of a depreciation outweigh the direct effects on export competitiveness. In this range, the overall effect of a depreciation of the currency would be contractionary rather than expansionary, or - in the language of the model - the YY-curve would have a backward-bending segment. These three scenarios are shown in figure 8, revealing the existence of multiple stable equilibria, with point C indicating a normal exchange rate whereas A represents a hyperdepreciated exchange rate and a bankrupt sector. In this context B represents the “bad” equilibrium. This could be a very simplified model of what happened in Asia, where anything seemingly unimportant could cause a sudden panic and a sharp depreciation, thereby significantly affecting the companies’ balance sheets and finally making the economy plunge into the crisis equilibrium.

Figure 8: Possible negative effects of a depreciation

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On the basis of this model, we will now examine the possible reactions to collapsing economies that seemingly match this pattern.

6.2. Policy implications

One thing that could happen is that the troubled country receives financial aid from the IMF in order to intervene in the exchange market. The problem here is what Paul Krugman calls a “sterilized” intervention. Particularly because of an increasing capital mobility, the limited magnitude of this activity also limits its chances to be successful. However there is a chance that it will still work, simply because of the psychological effects of this measure that may be sufficient to restore confidence. Another possible reaction is persuading private creditors to maintain or roll over short-term debts as it has been attempted in Latin America in the past. This could be achieved either by moral persuasion or by the threat of unilateral moratorium. Generally this seems to be a good idea, but there is also certain reasonable doubt if it would work. Suppose that there is a large pool of mobile capital, then a standstill that freezes only bank loans and bondholders will alter just the composition of capital flight but not its volume when other investors still are able to flee the currency.

Fiscal policy is also a way a government could try to influence the markets. One option would be fiscal austerity. This would shift the YY curve to the left which would eventually eliminate the sound equilibrium, thereby guaranteeing the crisis to happen. The only chance is again the psychological effect of re-establishing confidence so that the market’s belief creates its own reality.

Fiscal expansion would accordingly shift the YY curve to the right, which in the end could eliminate the “bad” equilibrium. The only question is if a troubled government would still be in the position to undertake such expansion on the needed scale.

One of the primary IMF tools is a temporary sharp tightening of monetary policy in order to support the exchange rate, followed by a gradual loosening once confidence seems to have been restored. In the model context, this shifts the LL curve to the left which indeed rules out the crisis equilibrium. But in the real world it would also mean a large real contraction which could again cause a collapse of investment. Although this real contraction is hoped to be a short-lived one, it probably won’t be an easy job for the government officials to consequently and unrelentingly stick to this strategy.

Typically in a crisis the government is expected to announce and to implement structural reforms. But looking at the analysis of the Asian crisis, we found it to be a self-fulfilling one. Hence there is actually very little reason to assume that structural reforms should remove the general pessimism. Although this argument seems to be convincing, it also can be put vice versa. There is again the possibility that - rather as a psychological effect - market sentiment will turn positive again as a consequence of structural reforms. This doesn’t seem to be so unrealistic, particularly just because this sentiment had reacted irrationally before, so there is no reason why it shouldn’t react irrationally again towards the other side.

As a conclusion, obviously most of the mentioned options have their advantages as well as their disadvantages. Concerning the pros, it often seems doubtful if the methods are feasible ones in an overheated crisis environment.

What remains as another alternative are capital controls. One of the supporters of this proposal is again Paul Krugman²³, suggesting to deploy them as a temporary emergency measure during the crisis. He sees these kind of controls as a logical extension of the case for agreements to roll over short-term debt. This is clearly anything but conventional liberal textbook wisdom, and there is certainly the risk of disrupting ordinary commerce and causing irresponsible policies on the part of the imposing government. Still no one knows how large these distortions would really be, and maybe this proposal must also be seen in the light that unusual situations require unusual actions. Given the fatal chain reactions of the Asian crises, with some two-fifth of the whole region’s GDP literally being wiped off the stockmarket’s value, leading to thousands of bankruptcies and downsizing activities, making millions of East Asians lose their jobs, their incomes and their savings, this was truly a “monster twister” second to none in recent economic history. At the end of the day, large parts of the populations were plunged back into the poverty from which they had only escaped several years ago, and probably everyone would have been happy to stop this vicious circle somehow, no matter if the remedy was a classical economic medicine or some rather unorthodox elixir. Completely deregulated capital markets are generally most efficient medium of resource allocation. But as tempting as the idea of market mechanisms may be, its efficiency is always a matter of the assumptions, and these usually include complete information and rational behavior. In the absence of these suppositions, maybe some modifications to the consequences should be made.

7. Bibliography

Corbett, J., Vines, D. 1999

“Asian currency and financial crisis. Lessons from vulnerability, crisis, and collapse” in: The World Economy Nr. 22, S. 155-177.

Eastern Economic Journal “The Asian Financial Crisis”

The Economist, November 7th 1998 “In Praise of Paranoia”

The Economist, March 7th 1998 “Tigers adrift”

Friedman, M.,1953 “The case for flexible exchange rates” in: Friedman, M. Essays in positive economics, Chicago.

IMF 1997

World Economic Outlook, September 1997.

IMF 1999

“International Financial Contagion”

IMF 1998

“The Asian Crisis and the Region’s Long-Term Growth Performance” in: World Economic Outlook, September 1998

IMF 1999

The IMF's response to the Asian Crisis

http:www.imf.org/External/np/exr/facts/asia.HTML (received September 2001)

Krugman, P.

“Currency crises”

http://web.mit.edu/krugman/www/crises.html (received September 2001)

Krugman, P. 1994

“The Myth of Asia´s Miracle” in: Foreign Affairs, 73, 62-78.

Krugman, P. 1998

“Will Asia Bounce Back?”

http://web.mit.edu/krugman/www/suisse.html (received September 2001)

Krugman, P. 1998

“Asia: What went wrong” in: Fortune March 2, 1998

Krugman, P.

“Saving Asia. It’s time to get radical” in: Fortune, September 7, 1998

Krugman, P. 1998

“What happened to Asia?”

http://www.hartford-hwp.com/archives/50/010.html (received September 2001)

Krugman, P.

“Analytical afterthoughts on the Asian crisis”

http://web.mit.edu/krugman/www/MINICRIS.htm (received October 2001)

Krugman, P. 1999

“Balance Sheets, the transfer problem, and financial crises”

http://web.mit.edu/krugman/www/FLOOD.pdf (received October 2001)

McNeill, Bockman, 1998

“The Asian debt-and-development crisis 1997-?” in: World Development (Oxford), S. 1529-1609.

Radelet, S., Sachs, J., Cooper, J., Bosworth, R., Barry, P. 1998 The East Asian financial crisis Diagnosis, remedies, prospects in: Brookings Papers on Economic Activity

Radelet, S., Sachs, J. 1999

What have we learned, so far, from the Asian Financial Crisis?, HIID, Discussion Paper, Boston

Rivera-Batiz, F.L., Rivera-Batiz, L.A. 1994

International Finance and Open Economy Macroeconomics MacMillan Publishing Company

Sachs, J. 1999

Economic Survey: Missing Pieces in: Far Eastern Economic Review.

Sohmen, E. 1969 Flexible Exchange Rates, Chicago.

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[...]

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¹ Krugman, P. 1998 “Asia: What went wrong”, in: Fortune March 2, 1998

²Krugman, P., 1998, “Currency crises”

³Radelet, Sachs, Cooper, Bosworth et. al., 1998

⁴Banerjee, Mishkin, Stiglitz, Weiss, et. al.

⁵Source: Radelet, S., Sachs, J., et al., 1998

⁶IMF 1998, “The Asian Crisis and the Region’s Long-Term Growth Performance”

⁷Radelet, S., Sachs, J., et al., 1998

⁸Source: Asian development bank

⁹Source : IMF 1998, World Economic Outlook, September 1998

¹⁰Source : IMF 2001, World Economic Outlook, September 2001

¹¹The Economist, March 7th 1998, “Tigers adrift”

¹²Source : Oanda database

¹³Radelet, S., Sachs, J., et al., 1998

¹⁴Krugman, P. 1998, “What happened to Asia?”

¹⁵Radelet, S., Sachs, J., et al., 1998

¹⁶IMF 1999, “International Financial Contagion”

¹⁷Radelet, S., Sachs, J., et al., 1998

¹⁸The Economist November 7th 1998

¹⁹Economic Growth in East Asia: Accumulation versus Assimilation”, by Susan Collins and Barry Bosworth. Rookings Papers on Economic Activity, 2, 1996

²⁰Rivera-Batiz, F.L., Rivera-Batiz, L.A. 1994, International Finance and Open Economy Macroeconomics

²¹Krugman, P., 1999, “Analytical afterthoughts on the Asian crisis”

²²Paul Krugman, 1999, “Analytical Afterthoughts on the Asian Crisis”

²³Paul Krugman, 1999, “Analytical Afterthoughts on the Asian Crisis”