The Asian Currency Crisis

student to apply the course materials to a developing country. Students will develop the paper in the context of the materials covered in class during the semester. Students will review and analyze a country’s policies towards exchange rates, foreign trade, domestic monetary systems and foreign policy.

The Asian Currency Crisis
Asia is a region that is home to 60% of the world’s people, and where many economies were growing by nearly 10% a year in real terms. By late 1997, the economic outlook for many of the Asian Tigers had changed drastically. This paper takes a look at the events that have been taking place during Asia’s 1997 currency crisis. We begin with a look at several of the countries involved and follow up with the causes of the crisis.

Thailand

The first hint of the Asian currency crisis appeared in Thailand. In the summer of 1996, it was revealed that the Bangkok Bank of Commerce had made billions of dollars in questionable loans, including lending significant sums to a convicted swindler and biscuit-maker known locally as the “Biscuit King.”

Until the problems at the Bangkok bank exposed system-wide problems with Thailand’s banking and bank regulatory system, Thailand was a model developing country. Thailand was a country that had averaged over 8% real GDP growth since the late 1980s and joined the rapidly growing group of countries known as the Asian Tigers. The country consistently reported a balanced budget in government spending and technocrats who ran the financial markets and economy were considered to be highly professional. The country had relatively open trade and financial markets that attracted large amounts of foreign capital in the 1990s.

In the early 1990s, foreign money poured into Thailand’s economy through financial markets and direct investment. In addition, Thailand allowed offshore banking in 1993, and these banks offered high interest rates on deposit that attracted tremendous amounts of foreign savings. Loaded with foreign money, the banks loaned carelessly and loan defaults began to rise.

Combined with the cracks in the domestic banking sector, was a sharp decline in Thailand’s rate of export growth. At the beginning of 1996, the Thai government forecast as usual, strong export growth for that year of 18 percent. However, by mid-1996, Thai exports were growing at a much slower rate. Thailand’s major exports of footwear, garments and seafood, were facing increased competition from India, China, Vietnam and Burma. Thailand was losing out in world markets due to a combination of higher labor and production costs and the strong value of the Thai baht in foreign exchange markets.

The decrease in export growth was significant, since it also softened the demand for the Thai currency known as the baht in foreign exchange markets. As foreign savers exited in mass from the Thai financial markets and offshore banks, the value of the baht came under serious pressure. Currency speculators, judging that the baht was significantly overvalued, flooded foreign exchange markets with relatively thinly traded bahts. By increasing the supply of baht in the foreign exchange market, the baht was under pressure to devalue. Although pegged to the U.S. dollar, by July 1997, the Thai government’s supply of foreign currencies reserves available to buy baht and thus support it price, were nearly exhausted. Hit with a sustained speculative attack by currency traders, the Thai government abandoned the dollar peg and the baht devalued sharply as it became a floating currency.

South Korea

South Korea’s economy is dominated by large industrial conglomerates. The origins of South Korea’s troubles can be traced back to the 1960s. After the Korean war of 1950-53, the South was a wasteland. In the 1960s, the South Korean economy underwent a tremendous transformation as a result of rigorous schooling, hard work, high domestic savings rates, imported technology and export-led economic growth. The South Korean government worked closely with the banking sector, and banks lent out money at negative real rates of interest to further government goals for economic development. As a result, a primarily agricultural economy was transformed in a single generation into the world’s 11th-largest economy. Along the way, South Korean exports grew from $33 million in 1960 to $130 billion in 1997. South Korea is the world’s largest producer of ships and computer memory chips, and has the world’s fifth-largest car maker.

At first the government controlled credit allocation was a huge success as the Korean economy matured under strict federal government guidance. Eventually, the economy outgrew the ability of civil servants to manage it. The state-guided banks continued to lend based on political preferences and favoritism rather than on proper risk-assessment, sowing the seeds of 1997.

The chaebol of multinational conglomerates that dominate the economy, fueled by easy money, borrowed too much, and expanded recklessly, without regard for adequate returns. The top five conglomerates are involved in an average of 140 different business each. They quickly diversified into areas where they have little expertise. The top four conglomerates (Hyundai, Daewoo, LG and Samsung) account for over half of the country’s exports, but yet are making minimal profits.

With subsidized loans, the large conglomerates expanded annual productive capacity at a double-digit pace. Domestic and international consumer markets were flooded and the excess supply drove down prices. For example computer memory chips and hard drive storage sells essentially at production cost. Profits tumbled for Korean firms that had exorbitant debt obligations to banks. Of the top 30 chaebol, 25 have debt-to-equity ratios of more than three-to-one, and ten of more than five-to-one, against the one-to-one usual in an ordinary economy.

Many Korean firms were having trouble raising the cash needed to make their interest payments. Corporate debt increased to nearly double the annual GDP. Thirteen of the top 30 conglomerates were losing money, including four of the top ten. In January 1997, the giant Hanbo Group went bankrupt with a total debt of about $6 billion – making it the first big conglomerate to fail. In July of the same year, the country’s eighth largest conglomerate, Kia Motors, also collapsed. Kia was heavily indebted to Korea First Bank, one of South Korea’s premier banks that also failed as Kia defaulted on its loan payments.

The troubled conglomerates threaten the entire South Korean banking system as they postpone paying off their loans due to a lack of revenues. Eight big chaebol have sought protection from their creditors in 1997. It is estimated that as many as 18% of South Korean banks’ outstanding loans have little likelihood of being repaid unless by the federal government. The banking troubles in South Korea run deep. Many companies had a strong linkage with South Korea’s merchant banks that took in public deposits and then acted as private sources of funds for the conglomerates that owned them. Many Korean merchant banks had borrowed U.S. dollars from American banks at relatively low interest rates and used the funds to expand their parent corporations and to buy high-yield bonds in Thailand. These banks now must deal with a sharply devalued won, that in turn significantly increases the won required to make dollar denominated interest payments to U.S. lenders and a slowing stream of revenues from their cash-poor corporate parents.

South Korea’s is by far the biggest economy to have succumbed to East Asia’s current crisis. The government has asked the International Monetary Fund (IMF) for $20 billion, money that it hopes will keep things from collapsing until early 1998. Total estimates of how much it will cost to clean up the country’s disintegrating banking system range from $60 billion to $100 billion.

As part of the loan package, the IMF will require that South Korea undertake significant reforms in its corporate structure, and in financial and labor markets. South Korean workers will be hit especially hard. During the 1960s and 1970s, the government put restraints on the growth of wages by banning most trade-union activities. This was a way to keep production costs from significant increases. In return, workers were essentially given lifetime employment guarantees as employers were legally prohibited from firing workers except for criminal offenses. As a result, the official South Korean unemployment rate is under 3%. However, it is estimated that as many as 10% of employed workers are not needed.

The IMF will demand that a few more conglomerates and several badly run banks should be allowed to close in addition to the ones that have already gone under. Unemployment will certainly rise as as workers lose their lifetime right to jobs. To keep the majority of the banking sector from collapsing and the economy with it, it is likely that the government will have to undertake a massive taxpayer financed bailout of the banking sector (similar to the U.S. in the 1980s) to pay off depositors. The IMF will also require that South Korea reduce tariffs on imports, exposing the domestic conglomerates to even more foreign competition.

When South Korean firms borrow from banks, they typically use commercial real estate as the main collateral for the loans. As the chaebol sell their assets to cover their debts, property prices could collapse by the same magnitude as seen in Japan earlier in the decade when property prices dropped by 70%.

Indonesia

In June of 1997, the International Monetary Fund cited the Indonesian government for “prudent macroeconomic policies, high investment and savings rates, and reforms to liberalize markets.” Now Indonesia appears to be the hardest hit of all the Asian Tigers.

The explanation for Indonesia’s currency’s devaluation comes primarily from the actions of domestic and foreign savers and borrowers. Indonesians bet on the stability of their currency, the rupiah, in foreign exchange markets, while foreign money flowed into Indonesia’s financial markets seeking high rates of return.

Although Indonesia is one of the world’s largest countries with over 200 million people, the foreign exchange market for its currency is small. Before the currency crisis, trading in the rupiah was less than $5 billion a day, a tiny part of the more than $1 trillion that is traded daily in foreign exchange markets. Indonesia had successfully pegged rupiah to the dollar, allowing it to fluctuate day-to-day within a narrow band. To compensate for higher inflation rates than the U.S., and to keep exports competitive, the central bank moved down the band’s midpoint at a gradual and predictable 4% to 5% each year, resulting in a predictable devaluation of the rupiah in dollar terms. Indonesian businesses counted on the rupiah’s value. They seldom took out hedges to protect themselves against any adverse devaluation’s of the rupiah. Furthermore, in an accepted way to boost income, it was common for Indonesian firms and currency traders to buy rupiah when its value dropped to the lower portion of the band in anticipation of its return to a normal price.

Over the past 20 years, Indonesia has moved away from a government-controlled financial system toward a more market-based one. The number of privately owned banks has soared and the Jakarta Stock Exchange has attracted large sums of foreign money beginning in 1967 when Indonesia has let money flow across its borders with few restrictions.

With Indonesian banks offering relatively high interest rates to attract depositors, the return on equity consistently strong, and the exchange rate of the rupiah comfortably predictable, the result was a steady flow of dollars into the country. The surplus of money was more than the banks and companies could invest carefully and as noted in Thailand and South Korea, there was an explosion of property development and productive capacity. This was fueled primarily by foreign savings and borrowing by domestic companies from foreign banks at favorable interest rates compared to domestic interest rates.

Indonesian borrowers could borrow rupiah at the 18% or 20% domestic interest rate and not worry about the exchange rate. Or they could borrow dollars at 9% or 10% a year from foreign banks and then convert the proceeds to rupiah. A year later, it would typically take 4% or 5% more rupiah to buy the dollars needed to repay the loan. The calculation appeared simple, borrow abroad and save 3% to 7% on interest costs.

Few Indonesian borrowers worried about the possibility that Bank Indonesia would let the rupiah fall sharply. Even fewer were willing to pay the cost of hedging, insurance that banks and investment houses sell to protect against currency collapse. By the end of September 1997, Indonesia’s total foreign debt was $133.3 billion, of which $65.6 billion was owed by private companies. In late July and early August, Goldman, Sachs & Co. surveyed 34 Indonesian chief financial officers. Two-thirds had more than 40% of their debt in foreign currencies; of those, half were completely unhedged, and most of the rest had well under half of their debt hedged. The consequences were costly. To repay a $100 million loan in early July of 1997, it took 243.1 billion rupiah; to repay it by the end of the same year took 500 billion rupiah.

The crash of the rupiah began on July 11, 1997 when Bank Indonesia widened the rupiah’s trading band to 12% from 8%, permitting the currency, then worth around 2,450 to the dollar to move as much as 300 rupiah against the dollar every day. In the past, speculators had made steady money buying the rupiah when it dipped to the lower part of its trading band. However, when the band was widened, some of the smart traders started selling the rupiah, betting that it would fall further. The rupiah buyers were in trouble and as their losses mounted as the rupiah continued to fall, they joined in the selling resulting in a plunge in the currency’s value.

In the beginning of August, Bank Indonesia tried to support the rupiah by raising three-month interest rates to 28% from 11%, and used a good part of its remaining $20 billion of dollar reserves buying rupiah. Finally, on Aug. 14, 1997, the bank announced it would allow the rupiah’s to float.

The plunge in the rupiah devastated companies like Indonesia’s big car company, PT Astra International that buys parts in dollars and yen, but sells cars in rupiah. Or for example, Bakrie & Brothers still has more than $100m in unhedged short-and long-term debt, and its revenues in dollar terms will collapse this year. The firm needs to raise at least $50m within the next three or four months just to meet its operating costs and keep open credit lines with suppliers, according to analysts. Issuing
bonds or more equity is out of the question: the government’s debt moratorium will probably have driven the international capital markets away from Indonesia for a long time.

Additionally, many Indonesian companies had a good portion of their debt in dollar denominated loans. They could barely make their interest payments as the rupiah lost its value falling below 12,000 rupiah per dollar. On January 27th 1998, the Indonesian government declared what amounts to a moratorium on payments of all Indonesian corporate debt since technically, the great majority of Indonesian companies are bankrupt.

A More General Look at the Asian Currency Crisis

Since we have taken a look at the circumstances in several Asian countries, let us now approach the currency crisis from a more general standpoint. Traditional economic theory suggests two possible causes for a significant currency devaluation of a pegged exchange rate:

The first reason results from an excess supply of domestic money. If a country with a pegged exchange rate prints money to finance government spending and to cover a budget deficit, investors will prefer to hold a less inflation-prone foreign currency, and the supply of that country’s currency will rise in foreign exchange markets. Speculators may assume that the country will no longer be able to defend its exchange rate and will attack the currency.

Another explanation is the use of monetary policy to maintain a pegged exchange rate. The government may be required to support the value of the currency with high domestic interest rates (offer foreign savers a currency premium) and by using its foreign reserves to buy the domestic currency. But high interest rates slow down domestic economic growth and make things uncomfortable for the nation’s ruling party. If currency traders doubt the government’s commitment to maintaining high interest rates and foreign currency reserves are nearly depleted, then they might attack the currency.
Neither explanation fits the Asian countries discussed above. There is an absence of significant budget deficits, and economic growth was unimpeded by domestic financial conditions. However, the East Asian countries have some characteristics in common.

Throughout the region banks and finance companies operated with government guarantees that resulted in their lending on overly risky projects. Poor regulation encouraging bankers to finance risky projects in the expectation that they would enjoy the profits, if any, while the government would cover any significant losses. Banks based lending decisions not on a project’s expected return but on its return in ideal circumstances. The result was too much investment and an inflated property bubble from overdevelopment of scarce land. Access to relatively inexpensive foreign capital injects additional funds into the system, resulting in even higher property prices.

Japan has encouraged banks to carry as good assets old mortgages on real estate now worth perhaps a quarter of face value. Korean multinationals have been permitted to conceal their subsidiaries’ losses by shifting loans from one set of books to another. In Thailand, banks were allowed to carry loans at full value until the borrowers hadn’t paid interest on them for more than a year. The Asian governments and central banks created a system of “zombie” banks – brain dead but still moving – similar to those found in the U.S. during the 1980s savings-and-loan crisis. Many Asian financial institutions continue to operate although they are insolvent when using accepted accounting practices. With governments and central banks vouching for the zombie banks, they were able to keep borrowing dollars from banks in other countries.

The dollar-denominated loans are devastating the Asian markets. Debtors have to sell the local currency to acquire dollars so they can pay their debts. As the local currency declines in value, debtors and local banks must find ever-increasing quantities of it to service their debts. The collapse of asset prices will lead to widespread loan defaults combined with corporate bankruptcy and insolvency for many domestic banks.

A long-term solution for the banking sector is not in sight. Thus far banks have been rolling over or renewing large amounts of debt when it comes due. Creditor banks have hinted they might be prepared to convert some of this debt into longer-term bonds, issued by the government. But this would effectively nationalize private debts.

The Outlook

The general consensus is that while the currency crisis will have serious short-term consequences for the economy’s involved, it will only be a bump in the road for the United States and the European economies. The days of rapid economic growth for Thailand, South Korea, Indonesia, Malaysia and the Philippines have come to at least a temporary end. Recession is the likely scenario for these countries in 1998 and perhaps 1999. China, Taiwan, Japan and other Asian countries see slower growth since their currencies have remained relatively stable and as a result their exports are now less competitive than those from the countries directly involved in the currency crisis.

The optimists point out that although 44% of Japan’s exports go to Asia, 30% of America’s and 9% of the European Union’s, measured by a more relevant yardstick, exports to Asia account for only 4.4% of Japan’s GDP, 3.4% of America’s and 2.7% of the EU’s. If Asian imports fall by an average of 15% next year, a greater amount than the fall in imports during Mexico’s currency crisis in 1995, America’s GDP growth would be reduced by half a percentage point and the European Union’s by four-tenths of a point. Some claim that the U.S. economy was close to reaching a point of higher inflation and thus the Asian currency crisis was perfectly timed to reduce American inflationary pressures and eliminate the need for the Federal Reserve to increase interest rates.

The pessimistic viewpoint emphasizes several factors.

The impact on the directly affected Asian countries may be underestimated and things could turn out much worse. Asian businesses are just beginning to feel the effects of the currency crisis. During the early part of 1998, firms will be unable to raise money and hold a fire sale on their products to make payments on their debt. When this is not enough, Asian banks will have to call in loans and foreclose on collateral associated with bad debts. Then lay-offs and bankruptcies will soar. Falling prices and a substantial and prolonged recession in South Korea could have a greater than anticipated impact on Japan, Taiwan and China.

By itself, Japan faces tremendous financial problems and a likely massive banking bailout that seriously inhibits economic growth for several years. Thirteen of the 19 biggest Japanese banks expect to report losses this year as a result of writing off bad loans. A deepening Japanese recession will significantly impact American and European firms that export to Japan.

Multinationals are more exposed to Asia than export figures suggest. There are estimates that Asia, excluding Japan, accounts for 7% of the revenues of listed European firms, about twice the region’s share of Europe’s overall exports.
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