Question 1 [8 marks] In 1997, the South East Asian currency crisis led to the devaluation of many Asian currencies. Most severely impacted was the Thai baht. Briefly outline the main causes and characteristics of Thailand’s currency crisis in 1997. (4 marks)The two characteristics which define a country experiencing a financial crisis are a drop in the currency value and a drop in the traded equity prices. There are however two main interpretations as to what caused the crisis in Asia. One of them is that there was a sudden shift in the market expectations and confidence.
This was as a result of panic from the domestic and international investors emphasized by the faulty policy response of the international monetary fund. The other interpretation is that fundamental imbalances of structural and policy distortions in those countries covering that region (Frankel & Kose 1996). Further to this, the moral hazard problem accelerated the financial vulnerability especially due to market liberalization in the 1990’s leading to an exposure of the market fragility with the macroeconomic and financial distress which was experienced in 1997.The crisis exhibited an interrelation between the corporate, financial and the international levels. The corporate level involved political pressures in maintenance of high economic growth rates which had led to public guarantees of private projects but the production plans had overlooked the risks and costs involved in those investment projects which resulted to the profitability of the projects to be low (Asian Development Bank 2003).
Under the financial problem, the banks had excessively borrowed from abroad to lend domestically. However, structural distortions of the banking sector such as laxity in supervision, weak regulation capital adequacy ratios which were low, lack of compatible deposit insurance schemes, corrupt lending practices and lack of a market criteria to credit allocation led to the buildup of weaknesses in the financial sector.
Internationally, the banks had neglected the standards of sound risk assessment to lend large amounts to the region. The most of the foreign debt was in short term unhedged and foreign currency denominated obligations and that large fraction of the short term liabilities to the foreign reserves was an indicator of financial fragility. What major lessons were learnt from Thailand’s currency crisis about the ways the exchange rate for a currency can be determined?
(2 marks) Since the crisis led to bankruptcy of organizations, some of the lessons learnt include: avoidance of vulnerability. This is to be curbed by watching the buildup of leveraged debt financing. Another lesson is that sequencing of financial liberalization is important. Therefore, unless the financial systems are strong and globally competitive, domestic banks are not to be allowed to enter into foreign currency exposures (Radelet & Sachs 2001). Also, the banks developed should rely less on the financial system.
This will lead to dissipation of risks if other financing alternatives are adapted such as bond and money markets. Finally, the old government directed industrialization models no longer work as the state connected conglomerates had the highest debt and foreign currency exposures and workable models should therefore be formulated (Radelet & Sachs 2001). .