The Asian Currency Crisis: Lessons for Bangladesh
THE currency turmoil that erupted in mid-1997 in Southeast Asia shows little sign of abating amid forecasts that the region's currency meltdown will persist in 1998. Since July, 1997 the US dollar has appreciated from a formidable 52 per cent against the Philippine peso to a staggering 120 per cent against the Indonesian rupiah. With Japan in the grip of a recession, and Thailand, Indonesia and South Korea at the IMF's door, the rest of the world can have no doubt now that this currency crisis will affect them. The turmoil that began with Thailand's currency devaluation is already putting a damper on the world economy. Recent forecasts suggest that economic growth in the world's leading economies could be nearly 2 to 3 per cent lower in 1998 as a result of this financial turbulence.
For more than a decade, Southeast Asian economies grew rapidly. Not everyone benefitted equally, but the boom was quite widespread. There was a natural flow of foreign capital to regions with cheap labour, inexpensive land, and governments willing to build the infrastructure needed to produce goods. But gradually some weaknesses of these economies were exposed - the biggest being the misuse of capital. Corruption, greed and government interference diverted capital to areas that were unproductive and wasteful, such as, property development and securities speculation. Southeast Asian currencies pegged to the US dollar became overvalued as the macroeconomic fundamentals declined.
Thailand became the first victim of the currency crisis. It's economy was surging in the last decade, in part because Thais could borrow money at low interest rates abroad, in US dollars, than in the domestic market, in baht. Expecting strong economic growth, foreign lenders invested heavily in the country. With ever-greater amounts of foreign money at their disposal, Thai banks and finance companies lent generously. Given the stable exchange rate between Thai baht and US dollar, some customers borrowed heavily in dollars, while others squandered the loans on commercial and residential real estate.
In early 1997, several Thai property companies threatened default on foreign loans. This drew attention to the rapidly deteriorating Thai property market and possible problems for companies that needed to repay foreign loans. Persistent economic problems, such as, huge amount of foreign borrowing, highest current account deficit in the region (8 per cent of GDP), and a weak banking sector characterised by default loans, made the situation worse. Some foreign investors started to question Thais' ability to repay, and began taking out their money from Thailand. Many foreign investors and Thai companies rushed to convert their baht to US dollar anticipating that increased selling of baht in the foreign exchange market would lower its value. Adverse domestic economic news coupled with speculations that Japan would raise interest rates, precipitated a downward pressure on the Thai baht. The central bank, Bank of Thailand, responded by buying up baht with its dollar reserves, hoping to keep the value of baht stable. Interest rates were raised in order to discourage baht sales by making baht-denominated bonds and savings more attractive. The higher interest rates, on the other hand, made it more expensive to borrow money to pay for stocks and real estate, thereby lowering their prices.
In the meantime, the Bank of Thailand began running out of foreign exchange reserve to support the baht. Finally, on July 2, the Bank stopped defending the baht's fixed exchange value against the US dollar, and floated the currency. During the last six months, the exchange value of US dollar has more than doubled against the baht.
For the first time since the Mexican currency crisis in 1994, exchange rate pressure in Thailand spilled over to the currencies in the neighbouring countries, including the Indonesian rupiah, the Malaysian ringgit, and the Philippines' peso. These countries had a number of features in common with Thailand. Indonesia, Malaysia, and the Philippines had all been affected by an economic slowdown in Asia. All had current account deficits and accumulated huge debt. Moreover, their financial sectors had large exposure to the real estate sector due to a phenomenal appreciation of property prices.
The devaluation of baht alerted currency speculators across Asia and led to panic selling by companies who wanted to protect themselves because of their large US dollar-denominated debt. They bought US dollar as a hedge against future devaluation. This led to a frenzy of selling various Southeast Asian currencies and buying US dollar. Consequently, the rupiah, the ringgit, and the peso fell in value like dominoes in a row.
The panic spread to Hong Kong, where fast economic growth has been fueled by heavy borrowing. One cause for this panic was the uncertainty about Hong Kong's ability to sustain its currency peg to the US dollar following the realignments of other Southeast Asian currencies. In addition, the US dollar's nominal appreciation of about 50 per cent against the Japanese yen since mid-1995 pulled the Hong Kong dollar along with it. Moreover, Hong Kong's inflation rate had consistently been higher than the US rate indicating that Hong Kong's currency had appreciated in real terms relative to the US dollar. Amid the mayhem, Hong Kong's de facto central bank, the Hong Kong Monetary Authority, stood firm and talked tough. It spent an unknown portion of its almost 100 billion US dollar pool of foreign reserves to defend the fixed value of its currency against the US dollar.
To defend the peg, the Hong Kong Monetary Authority reduced liquidity, thereby raising money market rates. Hong Kong's fixed exchange rate system, known as a currency board, gave its monetary authority a tool not enjoyed by any other central bank in the region - an automatic and theoretically unassailable mechanism for keeping exchange rate stability - no matter how high interest rates must go. Despite a wave of currency depreciation that has swept through the various countries in this region, only the Hong Kong dollar has clung on to its peg to the US dollar.
The next domino to fall was South Korea. In early 1997, several Korean conglomerates, having borrowed heavily, went bankrupt. Bad loans in Korean banks began to rise. This led to a flurry of selling of the Korean currency, won, in the foreign exchange market. By mid-November, the central bank of Korea stopped defending the currency, and the won collapsed.
The current fears swirling around the Asian financial market has raised a new question: Is Japan next? The collapse of the Yamaichi Securities, Japan's biggest ever corporate failure, has called attention to its ailing financial system. Japan's banks are crumbling under a mountain of bad debts. The government is hesitant to begin a cleanup of the financial sector because the tax payers would protest at footing the bill. However, much is at stake here. If Japan waffles, investors may start selling off Japanese stocks and bonds and lenders may cut down on loans to Japanese borrowers. This would trigger more failures in Japan's financial system and would prolong the country's economic stagnation.
Events in the last few months in various Southeast Asian countries could affect the rest of the world in various ways. Probably the most important are the financial market contagion and the effect on trade.
It is well recognised that financial market turbulence in one country can trigger reaction around the world. The international integration of financial markets leave few countries unexposed. Interestingly, except for a few jolts, the currencies and stock markets in the United States and Western Europe have held steady. This may be attributed to the fact that the western economies continue to grow steadily and are well-placed to withstand a shock to growth.
The most damaging and lasting effect has been to scare foreign investors away from the emerging markets in Asia. This comes at a time when many of these countries, including Bangladesh, is in dire need of foreign capital. Given the absence of substantial foreign financial assets in Bangladesh, it doesn't face the possibility of a capital flight. Speculative attacks on the Taka also appears remote due to the absence of any credible foreign exchange market. However, Bangladesh's ability to attract foreign private capital would be greatly hampered. The possibility of foreign investment from countries, such as, South Korea and Taiwan would substantially decline.
On the trade side, weak growth will depress the import of the Southeast Asian countries, while devaluations will make them more competitive. This would affect Bangladesh in at least two ways. First, the slowdown in the world economy could adversely affect the growth of Bangladesh's exports. Moreover, Bangladesh's exports would face stiff competition from exports from countries with devalued currencies. Foreign companies which might have toyed with the idea of setting up joint ventures in Bangladesh may find it more profitable to relocate in countries with devalued currencies.
What can Bangladesh learn from the recent experience with the currency crisis? An objective analysis of the events in the Southeast Asian countries would provide important lessons for the policy makers in Bangladesh.
First, Asian countries in the last decade used imported capital to help generate high investment rates. This imported capital had as its corollary large current account deficits. The crisis was worsened by badly run and poorly supervised banking systems, as well as by sharply overvalued exchange rates.
Second, a fundamental lesson from the currency crisis would be to avoid an early misdiagnosis of the crisis. For instance, Thailand's financial crisis was initially seen as a liquidity problem rather than an issue of solvency. Valuable time was lost before the government began to realise that a fundamental change in economic policy was required.
Third, the weak initial response to the crisis by many Asian government prolonged the debacle. In Thailand, for example, the government's political weakness clearly hampered efforts to change. In Malaysia, where political decision-making is more concentrated, there has been resistance to the notion that current difficulties have partial home-grown characteristics. Similar obstacles are present in Indonesia and the Philippines. The government's response should be swift and resolute. They should act fast to clean up financial systems hobbled by bad debts. The speed and scope of needed reform should not be underestimated. The government should promote transparency in its policy making. It should also have the political courage to accept short-term pains, such as shutting down unprofitable financial institutions, for long term economic progress.
Finally, the government should encourage investments that generate foreign exchange earnings as opposed to those that encourage consumer imports.
The author is a Professor of Economics at Marquette University, Wisconsin, USA.