What Caused the Asian Currency and Financial Crisis By G. Corsetti, P. Pesenti and N. Roubini

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What Caused the Asian Currency and Financial
Crisis ?By G. Corsetti, P. Pesenti and N. Roubini

• Introduction
• At the Root of The Asian Crisis
• Current Account Imbalances and Macroeconomics
  fundamentals
  
• 3.1. The evidence
• 3.2. Solvency, resource balance gaps, and
  sustainability
  
• 3.3. Output growth
• 3.4 Investment rates, efficiency and
  profitability
  
• 3.5 Private and Public Savings
• 3.6 Inflation
• 3.7 Openness

3.8 Real exchange rate appreciation
3.9 Political instability and policy
uncertainty 4 The Role of Financial System
4.1 The evidence on financial over lending
quantity 4.2 and quality 4.3. Bankin
g Problems, financial deregulations, and
institutional deficiencies 5. Imbalances in forei
gn debt accumulation and management 5.
1. The foreign debt burden and the role of
short-term external debt 5.2. Foreign exchan
ge reserves 5.3 Composition and size of the
capital inflows 6. Conclusion
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• 3.8 Real Exchange rate appreciation
• Virtually, all analyses of crisis emphasize that
  a significant real exchange rate appreciation is
  associated with a loss of competitiveness and a
  structural worsening of the trade balance
• What caused that in the Asian country ?
• Mixed of misalignment and external balance
  deterioration as the fact shows that the degree
  of real appreciation over 1990s was different
  widely across countries

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Trend of Change in Nominal Exchange Rate ( to
US),
Period Average

• Malaysias, Thailands and Philippines exchange
  rates were effectively fixed
  
• Korea was following somewhat a flexible exchange
  rate
  
• Indonesia and Taiwan were following exchange rate
  targeting

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• Except Korea, all currencies experienced real
  appreciation
  
• The choice of exchange rate regime against US
  was also a key factor (countries with more rigid
  policy experienced larger appreciation)
  
• Generally, the real appreciation was correlated
  with current account worsening
  

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Trends on Real Exchange Rate. End of year data

• Theories of the causes of movements in relative
  prices
  
• Balassa-Samuelson effect
• Increase in consumption and investment in Non
  Traded Goods after a successful inflation
  stabilization.

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• Question Did movements in relative price in
  Asia reflect a change in the equilibrium real
  exchange or its a misalignment ?
  
• The answer is open, but its better not to
  rely too much on a change in equilibrium
  exchange rate, because
  
• Evidence of Balassa-Samuelson effect is slim
• Theres no background story that a exchange
  rate-based stabilization was caused by high
  inflation, because most Asian countries peg their
  currency to facilitate external financing of
  domestic projects (to get lower risk premium)
• There are evidences of misalignment exacerbated
  by some shocks (e.g. slowdown in Japan economy
  and rapid growth of export from China)

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• 3.9 Political instability and policy uncertainty
• Low expectations about political and financial
  environment contribute to balance of payment and
  currency crisis
  
• Example of political instability
• - Thailand governmental collapse
• - Malaysia PMs ranting against speculators
  intl
  
• - Indonesia elections tension and uncertainty
• about Soehartos health
• - Korea contradictory signals of presidents
  campaign and threat of labor movement
  
• That IMF plans was not seriously implemented
  (regardless if its appropriate or not) shows
  government flippancy
  
• Corruption and cronysm

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• 4. The Role of the Financial System
• Its believed theres link between balance of
  payments crises and banking crises
  
• Jeffrey Sachs excessive lending is driven by
  moral hazard incentives
  
• 4.1 Evidence of over lending In quantity
• Upward trend of the ratio of private sector
  lending to GDP in all countries
  
• The largest Philippines, Thailand and Malaysia
• Data on lending by other banking and non banking
• Institution shows similar trend, except for
  Thailand where the lending boom was significantly
  larger for finance and securities companies than
  for banks

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Bank Lending to Private Sector ( of GDP)
Philippines, Thailand and Malaysia show sustained
lending boom. These countries were the first to
be hit by currency speculation in 1997
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• 4.2 Evidence of lending boom in Bad Quality
• The growth rate of the lending to GDP ratio gives
  an indication of the quantity of loans
  
• Many of the loans are low quality dubious
  profitability or speculating purchases, over
  investment in risky and poorly performing loans
  
• Banking system was highly exposed to real estate
  crisis

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• Non-Performing Loan (as proportion of total
  lending in 1996)
  
• Korea 8 Singapore 4
• Thailand 13 Indonesia 13
• Hong Kong 3 Malaysia 10
• China 14 Philippines 14
• Taiwan 4

This figures show a strong relationship between
the amount of bad loans and the extent of the
currency crisis
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Banking System Exposure to Risk ( of assets at
the end of 1997
This clarifies the links between high shares of
bad loans, excessive exposure to the property
sector, and overly optimistic estimates of
collateral
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4.3. Banking problems, financial deregulation and
institutional deficiencies

• In Asia, bond and equity markets relatively
  underdeveloped most financial intermediation
  occurred through the banking system
  
• Domestic banks borrowed from foreign banks, then
  lent them to domestic firm
  
• When domestic firms experienced financial
  difficulties, the banks were faced with
  non-performing domestic assets and short term
  foreign currency liabilities
• There was evidence that the Asian banking and
  financial system were fragile poorly supervised,
  poorly regulated, and in shaky condition

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• Thailand
• Financial liberalization in 1990 led to growth of
  non-bank intermediaries that could circumvent
  credit limit
  
• Tax incentives to offshore borrowing was provided
  and accelerated borrowing to real estate and
  property sector
  
• Korea
• Excessive lending to large-traded-sector
  conglomerates
  
• They controlled private banks, giving privileged
  access to credit and exacerbating moral hazard
  
• They went bankrupt before currency crisis hit in
  1997
  
• Indonesia
• Series of reform in 1988/1989 supported rapid
  growth of private banking sector. This resulted
  in excessive number of small undercapitalized
  banks that were vulnerable to fraudulent lending.

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• Although official prudential requirements met
  Basle committee recommendations, compliance and
  enforcement were low
  
• In April 1996 out of 240 banks, 15 not meet 8
  CAR, 41didnt comply the lending limit
  
• 12 out of 77 foreign banks didnt meet net
  overnight position
  
• Government encouraged merger and provided
  supports rather than shutting down ailing banks
  (except one), giving incentives to banks to
  involve in even more riskier projects
• Asset quality of state banks were even worse
  because of the rule that would not permit a state
  bank to default on its obligation. Also because
  of greater susceptibility to government direction
  in their lending patterns

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Malaysia

• Theres evidence of excessive lending in highly
  risky projects which escalated in 1996 and early
  1997
  
• There were too many small bank to be
  internationally competitive
  
• In 1996 there was increase in bank lending with a
  sharp switch from manufacturing sector to equity
  purchases
  
• By the end of 1996, the exposure to property
  sector and equity sector reached 42.6 of total
  credits, and continued to rise rapidly in early
  1997
• In 1997 Bank Negara announced ceilings on lending
  to property sector and stock purchasing, but this
  action were too little, too late

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• 5.1 Foreign debt burden and the role of
• short-term external debt
• If a liquidity crisis occurs, foreign reserves
  must be large enough to cover a countrys debt
  service obligation (including the roll over of
  short-term debt).
• A country may suffer a short run liquidity
  problem when the available stock of reserves is
  lower than overall burden of external debt
  service
• This occurs when panicking external creditors
  wont roll over existing short term credit
  
• Crisis may take the form of a pure liquidity
  shortfall, the inability to roll over its
  short-term debt

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• Data of WB is considered by the authors to be
  relatively low and
  
• grow modestly, or high but actually falling.
• In most countries, foreign liabilities towards
  BIS reporting banks
  
• are liabilities of domestic banks, as opposed
  to liabilities of the
  
• corporate or non-bank sectors

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• These figures were well below 10, except
• Indonesia (above 30)
• Philippines (16-20)
• Thailand (11.6-13)

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• 5.2 Foreign Exchange Reserves
• Large foreign exchange reserves facilitates the
  financing of a current account deficit and
  enhances the credibility of a fixed exchange rate
  policy
• Measurement of adequacy of foreign exchange
  reserves
  
• Stock of reserves in months of imports
• Ratio of money assets (M1 or M2) to foreign
  reserves (a better measurement, since a rapid
  outflows of speculative money have become a more
  important source of foreign exchange pressure
  than trade imbalances)
• Total short term liabilities to foreign reserves

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While China had the highest ratio (at the end of
1996), the ability to convert domestic assets to
foreign currency is limited by widespread capital
controls (that didnt exist in most of the other
countries)
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• This figure is higher than previous, show the
  importance of quasi money
  
• Above unity in China, Korea, Indonesia and
• Malaysia

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Short Term Liabilities towards BIS Banks
( of foreign reserves, end of 1996)
By the end of 1996, while BIS banks no longer
willing to roll over short-term loans, foreign
reserves in Korea, Indonesia and Thailand were
insufficient to cover short term liabilities, let
alone to pay interest payment and long-term debt
principal payment
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• 5.3 Composition and Size of the Capital Inflow
• Current account sustainability is enhanced when
  the deficit is largely financed by FDI than by
  short-term flows that may be reversed by market
  conditions and sentiments
• Inflows from official creditors are more stable
  and less subject to reversal than private
  creditors
  
• Loan from foreign bank are less volatile than
  portfolio inflows (bonds and non-FDI equity
  investments)
  
• Borrowing in foreign currency is generally
  associated with greater capital inflows and lower
  interest rate than issuing debt denominated in
  domestic currency, but if local currency
  depreciate, it may end up in a currency crisis

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• Korea and Thailand were financed only by a
  relatively small
  
• fraction on FDI, while other countries relied
  much more on
  
• FDI
• Non-FDI net capital inflows were often large
  enough (relative
  
• to current account deficit and net FDI
  inflow), so the
  
• overall balance of payments was in surplus

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• 6.Conclusion
• 1. While the macroeconomic performance of some
  countries had worsened in the mid 1990s, the
  extent and depth of the crisis should not be
  attributed to a deterioration in fundamentals,
  but rather to panic on the part of domestic and
  international investors
• 2. However, fundamental imbalances are actually
  the one that triggered the crisis. This worsened
  by the fact that once the crisis started, market
  overreaction and herding caused the plunge of
  exchange rates, asset price and economic activity
  to be more severe than warranted by the initial
  economic conditions
• 3. Macroeconomic imbalances in the countries
  being observed are assessed within a broad
  overview of structural factors current account
  deficits and foreign indebtness, growth and
  inflation rates, real exchange rates, foreign
  reserves, indexes of excessive bank lending,
  credit growth and financial fragility and
  political instability.