Needless to say, Phase I is the most spectacular, full of fire and brimstone, the stuff of high drama. Phase II, the smell of cordite still wafting over a battlefield strewn with the vanquished is by contrast an anti-climax for most, the source of utter despair for those who had been involved in trying to defend the currency in the first place. The devalued currency overshoots, and usually dramatically so - in the case of Thailand, the baht went from 25 baht to the dollar to 56, while in Indonesia the rupiah’s fall was even more spectacular, collapsing from 2,300 to 17,000 The threat of imported inflation which such a collapse - in the case of Indonesia, a complete meltdown
- that usually entails, requires a combination of tight monetary and fiscal policy, both to dampen that price pressure and also to stabilise the currency. With the country’s monetary credibility having been cut to pieces in the wake of the devaluation, emergency measures are needed in order to stem the tide and stop complete panic. Such measures usually cripple the economy, and in the cases of Thailand and Indonesia that is indeed what happened. In 1998, the Thai economy contracted by some 9.4 while that of Indonesia contracted by a stunning 13.2%. At street level, such a degree of macroeconomic contraction means bankruptcy, tragedy and despair. In the Asian crisis, millions lost their jobs or were made homeless. Companies went bust by the thousand. The extent of the calamity had to be seen to be believed. Thailand and Indonesia were by no means exceptions, though they were extraordinary to the extent of the collapse. Similar phenomena have been seen elsewhere around the global emerging markets of the world, for a start in the rest of Asia, but also in the likes of the Czech Republic, Mexico, Brazil, Colombia, Ecuador, Russia, Romania, Bulgaria and the Ukraine.
This brings us to an interesting paradox, which we shall deal briefly with here, but return to later on in the book: the possibility that there is a fundamental difference between emerged market crises and their emerging market counterparts. After all, in the cases of the UK in 1992 and the ERM in 1992 and 1993 (one could even count the dramatic fall in the dollar from 1993-1995 as a mini crisis), currency devaluations did not result in an economic catastrophe in the same way that this occurred in Asia, or the rest of the emerging markets for that matter. Indeed, as far as the UK is concerned, the ejection of the sterling from the ERM was the best thing that ever happened to the UK economy (a repeat of the UK’s ejection from the Gold Standard and with similarly beneficial results). Equally, the widening of the ERM bands in mid-1993 was positive rather than negative for the EU economies, allowing them greater policy as well as exchange rate flexibility to cope with the economic dislocation. In the emerging markets, by contrast, currency devaluations were seismic events with similarly catastrophic consequences to those of an earthquake. Why the difference? It is a gross oversimplification to say, but that notwithstanding, that the emerging market crises were the result of excess capital inflows relative to the ability to absorb them, of financial bubbles which were spectacularly burst. In this regard, the Asian crisis bares a strong resemblance to that of Japan in 1990- 1991, at least in terms of what happened to the local asset markets and subsequently to the economy. The yen did not come under pressure in the same way as the Thai ba/it, for instance, because of the relative immense size of Japanese trade flows to capital flows. In the UK and the EU, by contrast, the devaluations were not so much the result of financial bubbles (though those played a part, to be sure) as lack of policy credibility. The UK, at the time, was mired in a vicious recession with a clearly overvalued currency and a widening current account deficit. For the UK to defend its currency with higher interest rates and intervention was simply not credible. In September of 1992, when the Bank of England raised UK interest rates to 12 and then to l5 the market barely reacted. Such a move, when the dole queues were getting ever longer and the housing market was in tatters as to the high mortgage costs resulting from those interest rates, was simply not credible. The market did not believe that the UK was prepared to take the pain in order to defend the sterling, and (thankfully) it was proved right. Equally, ERM-member countries were pursuing questionable economic policies were put to the test, and found wanting.
The economic fallout from the emerging market currency crises was thus partly the result of their stage of development and partly because they occurred at or close to the height of the economic cycle. Concerning the latter, the dollar remains vulnerable to this type of currency crisis, and even if this happens the policy response from the U.S. authorities is likely to be substantially different to those pursued by the likes of Thailand and others. Having finally achieved a considerable degree of inflation-fighting credibility, the U.S. authorities would only protest dollar weakness if its decline threatened imported inflation or if the degree of the move resulted in a lack of two-way risk in the market. Thailand, Indonesia and others did not respond in this fashion, partly because they were told how to respond by the IMF - the fact that they had to ask for IMF loan programmes being the result of having sought to defend their currencies through massive intervention and thus having thrown away most of their foreign exchange reserves - and partly because they did not have such policy credibility. The damage was already done and to a large degree it is questionable whether any policy framework would have stopped the slide. Several leading commentators have been critical of the IMF policy response to the Asian crisis, saying that the combination of extremely tight fiscal and monetary policy represented a worse cure than the disease itself. While I have some sympathy with this view, particularly given that the public policy adjustment is not necessarily the appropriate policy response to private sector imbalance (too many Asian companies borrowing too much in dollars and speculated too much in their own stock markets), this still does not answer the question as to what one does to stop the local currency from falling, an important consideration bearing in mind that the collapse of the rupiah resulted in the bankruptcy of almost every company in Indonesia. Whether you favour the argument of the IMF’s Herbert Neiss or Harvard’s Jeffrey Sachs, it is pretty irrelevant. By then, the damage was already done, the battle had already been lost. By then, it was a question only of damage limitation.
The example of the Brazilian crisis, however, suggests that some refinements to the standard IMF policy response have been considered - not least at the IMF - in the wake of the Asian crisis. When the Brazilian real devalued in January 1999 and subsequently fell to a low of 2.2200 to the dollar from a band level of around 1.20, many forecast 2.50 or even 3.00. Yet, the real managed to regain substantial ground, rebounding to just above 1.60. Why? Clearly, the appointment of Arminio Fraga as the new head of the Brazilian central bank was an important step. Fraga had considerable experience of the financial markets. Indeed, he left Soros Fund Management in order to take up that post at the central bank. Once there, he and the Brazilian Finance Ministry conducted a superb PR campaign to assure the markets that the appropriate policy responses would indeed be conducted, that fiscal rationalisation would take place - here the government succeeded in passing a number of important bills through the parliament despite substantial opposition
- and that the focus was on internal price stability through appropriate monetary policy settings. The currency would eventually find its natural level and it was up to the markets themselves to set that level. While this effort has so far been relatively successful, needless to say governments cannot rely on PR exercises alone, certainly not if their fundamental economic policies remain mis-aligned. That said, there is a case to be made that emerging market authorities should focus on internal price stability, even at the expense of devaluation of their currency. In those days of crisis, however, it was already much too late for such considerations.
Why did the Asian crisis cause economic catastrophe for two years, while Brazil took only a couple of quarters to recover (a fragile recovery to be sure)? For one thing, Brazil’s problems are far from over. More importantly, however, by the time the Brazilian real was devalued, the degree of market inter-connectedness had been greatly reduced as investors became increasingly risk averse and went home to their own regions. Meanwhile, the ability of speculative, leveraged accounts to take on huge positions had also been greatly reduced as banks became more cautious in lending to this sector after the debacle over Long-Term Capital Management (LTCM). As a result of these two developments, the potential for transmission of “contagion” was short-circuited. Markets were volatile in the wake of the Brazilian devaluation, but such volatility paled in comparison to the typhoon which had devastated Asian markets in the second half of 1997 and their economies the following year.
fhose developments, beginning at the end of the first quarter of 1998, were the first signs that the huge external imbalances which the Asian economies had developed were being corrected, albeit at the expense of the domestic economies of those countries. Few in Asia would have found comfort in that at the time and understandably so, yet to return to the medical analogy this was surely the first blip on the patient’s heart monitor after a period - brief in historical terms but no doubt endless to the patient - of flat- lining. The key element of Phase II is that the collapse of the domestic economy causes a collapse in imports. This in turn forces the trade deficit first to decline and then to become a surplus. This is a fundamentally positive development, however severe the pain incurred in achieving it, yet during the initial part of this second phase, threats to the economy remain substantial. In the cases of Thailand and Philippines, the devaluation of their currencies caused an initial spike in domestic price pressures both because of imported inflation and shortages. The presence of inflation and more importantly of rising inflationary expectations was a clear threat with the potential to fuel a renewed devaluation of local currencies, in turn forcing a further wave region-wide of currency and asset market depreciation and competitive devaluation in sympathy. The fiscal and monetary screws had to be tightened even further, despite the near- term, added cost to an economy already wracked by severe dislocation.
In Indonesia, the rupiah lost an unbelievable 85 of its value against the dollar, causing justifiable fears of hyper-inflation. As a result, interest rates were raised to over 800o compared to a ‘paltry” 24 in Thailand after the baht was devalued. B the third quarter of 1998, the trade account of most Asian countries involved in the crisis and who had seen their currencies devalue was starting to see significant improvement. The exception to this obviously concerns ‘Greater China” and more specifically Hong Kong and China whose currencies remained pegged, in one form or another, thus distorting the timing and extent of the phases of the emerging market currency crisis model which we are looking at here. Even in the case of Taiwan, the model’s natural progression was distorted by the fact that the Central Bank of China managed (and still manages) the exchange rate in such a strict and un-free manner, not allowing it to fall or rise sharply and punishing those banks found to be aiding perceived speculative forces in the market.
Yet, for the most part, Asian trade and current account balances were improving significantly. Simultaneously, the domestic price pressure abated or at least stabilised. In turn, Asian currency markets had begun to stabilise. Once again, the price movements which theoretically should have occurred as part of Phase II of the model were briefly distorted in the wake of the May 1998 riots in Jakarta. However, from July onwards that year, the process worked remarkably well. Phase II of the model is where the local currencies appreciate, not because of any real or perceived fundamental improvement in the domestic economy, but because the defeat of inflation and the significant and positive shift in the trade and current account balances has allowed interest rates to stabilise and then to fall. In other words, market tensions which are stretched to a breaking point in Phase I finally relax and liquidity returns to the system. Phase II is where local currencies experience liquidity-based rallies - and this is precisely what happened in the cases of Asia (1998), Brazil (1999), Mexico (1995), the Czech Republic (1998) and others. The patient has not yet sat up and walked around the ward, but at least the pulse is stronger!
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