Initially put in place to create policy and economic stability, the Asian currency pegs did their job too well. They caused such stability, such lack of volatility that investors and corporates alike were lulled into a false sense of security - though that false sense of security in some cases lasted for a decade or more. The result, along with the macroeconomic policy mix which Asian governments adopted in the late 1980s and 1990s (fiscal rationalisation, strategic industrial intervention, encouraging high savings’ rates), was massive capital inflows, both of the portfolio and of the foreign direct investment kind. Yet, investors are a fickle lot. While they were generally keen to take advantage of the apparently high returns available in the Asian emerging asset markets, the lack of a track record on defeating inflation in many of these countries relative to emerged market levels necessitated high risk premiums in local bonds and money markets. Despite the fact that the region was running significant fiscal surpluses throughout the 1990s, interest rates remained substantially higher in most Asian countries than they did in the anchor country of those currency pegs, the U.S.. This was not a problem at the public or governmental level since most Asian governments did not seek to expand domestic borrowing. It was a problem however for the domestic private sector. Those same currency pegs which allowed for economic and policy stability and consistency allowed local private sector corporates and financial institutions to borrow offshore, usually in the dollar bond or loan
markets and then swap back to the local currency.
In a time of currency stability, this seemed not only prudent but profitable and for many it certainly was. Significant external debt burdens were thus built up, but unlike the case of Latin America in the 1980s, this was in the private not public sector and thus went largely unnoticed in the public accounts. Such was the degree of capital inflow that it was far too much for the fragile institutional structures of these markets to absorb efficiently. As emphasised in Asia Falling, the lack of deep and liquid bond markets in Asia caused a heavy price to be paid subsequently for the resulting inefficient allocation of these capital inflows. The money went into the local stock and property markets, into get-rich-quick schemes of all sorts, shapes and sizes and was ultimately recycled into the external debt markets, adding further to these countries’ private sector external debt burden. Yet as beneficial as capital inflows are - and as characteristic of an emerging economy as they also are - one of the few economic laws in reality necessitates that significant capital account surpluses lead to significant current account deficits. Most things in economics are opinion or interpretation, but this is a pretty sound law which holds true. The larger the inflows, usually the larger the current account deficit. By 1996, Thailand was running a current account deficit of some 8 of the GDP.
How does this happen? Clearly, significant capital account inflows are a major fundamental positive for a currency. The very nature of emerging markets is such that they are perceived to be growing at a faster rate than the emerged markets and thus absorb greater amounts of capital relative to their ability to absorb it. Faster growth rates also suck in imports, as do the infrastructure and building projects which were financed by those capital inflows. This creates the beginnings of a trade deficit.
On the currency side, the central bank usually attempts to sterilise such flows given the dampening effect they have on interest rates and the potential inflationary effect they have on domestic prices (too much money chasing too few goods), but eventually such is the scale of those capital inflows that the Central bank has at some point to stand aside, no longer draining that liquidity out of the money market through daily operations. In terms of the currency, this is a turning point. Rising demand and reduced supply is an irresistible
combination and the result is inevitable - a strengthening local _______ currency. This would not be a problem on its own except that the
currency usually strengthens to such an extent that it becomes _______ significantly un-competitive on a Trade-Weighted and REER (Real _____ Effective Exchange Rate) basis. In turn, this exacerbates the degree of
economic external imbalance, that is to say the trade deficit widens at
an accelerating rate as exports become increasingly un-competitive
due to the strength of the currency.
This is precisely what happened in the case of Thailand. Indeed, it is
a central part of the model which we are looking at. The way to avoid
this is to loosen capital controls gradually relative to the construction
of institutional infrastructure, that is the ability to absorb capital
inflows. Deep and liquid capital markets have to be created first and llrnB the appropriate regulatory bodies to oversee both the capital market
and the domestic banking industry. It is no coincidence whatsoever
that the least degree of economic structural damage as a result of the
Asian crisis occurred in Singapore and Hong Kong where the degree
of institutional infrastructure development was the greatest and the
extent of regulatory supervision the most vigilant. The subsequent 1II collapses in Thailand, Indonesia and Korea say a considerable amount
about the efficacy of institutional infrastructure development in
those countries.
I
Now, just because a country has a large trade deficit does not
necessarily mean that its currency will inevitably collapse. The U.S. is
a fine example of this, possessing a significant trade and current
account deficit in the years of 1995-1998 and yet seeing its currency
appreciate against the Japanese yen from around 80 to a high of 147.
Capital flows in this modern world of ours significantly exceed trade
flows which means a country can run a trade and current account
deficit for quite some time - decades perhaps - without experiencing
significant disruption to its asset markets and eventually its
currency. There needs to be a catalyst, a trigger which changes
investor perceptions and thus reduces and eventually reverses those
capital inflows. What the history of currency market crises teaches us
is that the trigger can vary enormously. In Thailand, there were two
key triggers. Firstly, in the fourth quarter of 1996, Thailand recorded
a budget deficit, the first for a decade. Memories in the financial
markets are notoriously short, but in the aftermath of the Mexican crisis in 1994/199 5, investors were still keenly aware of the potential pitfalls and dangers of twin fiscal and current account deficits. The second trigger was political; Thailand threw out one notoriously corrupt regime only to get one which did not seem to be any better. The system itself appeared flawed, at least that was the perception to many. Investors became increasingly wary of putting new cash into the Thai asset markets. Because Thailand had by then a current account deficit of some 8% of the GDP, it needed increasingly large sums of capital inflow in order to offset that current account deficit. It didn’t get them. Instead, by the first quarter of 1997, capital was starting to head out the door.
The result was that Thai interest rates started to edge upward and the Thai ba/it started to weaken. Note that this was not due at that stage to speculative activity but instead to so-called “real money” investors taking an increasingly defensive turn towards Thai investment. Up until then, local Thai companies and banks had taken a relatively relaxed view towards the concept of currency hedging. Indeed, the perception was that there was little need to hedge as there was little prospect of currency risk given that the Thai ba/it was pegged to the dollar. Not content with such inaction, some took it a step further and effectively speculated on currency and interest rate risk by borrowing offshore in dollars, swapping back to ba/it and then lending that ba/it out, making a very healthy profit on the interest rate differential. Increasing risk aversion on the part of international investors towards Thailand however started to cause a re-think on the part of the Thai corporate base (though for many, that re-think was much too late). Perhaps there was a currency risk after all. By then, such was the size of external debt built up in the private sector, largely through the Bangkok International Banking Facility (BIBF) that hedging of that currency risk started to involve some serious dollar buying going through the foreign exchange market. Meanwhile, one or two speculators - somewhat belatedly - arrived on the scene. Indeed, objectively, if they can be accused of anything, it is of tardiness. The signs of fundamental imbalance in the likes of Thailand and Indonesia were there long before the first hedge fund showed its face and started to sell the ba/it or the rupiah.
By this time, the capital account had turned negative on a net basis, meaning that more capital was flowing out of the country than into it. This coupled with a current account deficit and a fiscal deficit increased the pressure on both the baht and the Thai interest rates. The Bank of Thailand responded by intervening in the currency market and hiking official rates. Still the selling pressure increased, if anything it accelerated. In May 1997, the BoT tried to ambush the market, stopping Thai banks from lending the ba/it to the offshore market, hiking interest rates dramatically and intervening very aggressively. The dollar collapsed against the Thai baht and the Thai overnight borrowing rate skyrocketed to 3000 before settling” at around 1SOO There was no question that many speculators were severely burned by that move, but more importantly it was extremely painful for Thai companies and banks. To focus on the speculators was - and is - to miss the point. The ba/it had been coming under pressure due to what we call “fundamental” rather than “speculative” flows, that is to say Thai manufacturing companies and banks were by far the main sellers, followed by foreign mutual funds. Hedge funds did not cause the Asian crisis. They showed up somewhat late and made some belated, opportunistic money - though some were burned in both Thailand and Indonesia - it is utter nonsense to lay the blame for the subsequent devaluations at their doorstep - though at the time it made perfect political sense to do so. If you face domestic instability, seek an external diversion. Hardly a new strategy as it has been around since the times of von Clausewitz and long before, Sun Tzu (“The Art of War”).
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