The Asian Financial Crisis - Case Study Example

The Asian Financial Crisis Name Course Tutor Institution Date The Asian (1997) and the 2008 financial crises Introduction Financial crises are not caused by market shortcomings but rather, by market self- correction. Errors caused by speculation are eliminated in this self correction process to attain market equilibrium where asset prices are not inflated. Generally, financial crises come after a period of remarkable economic growth and follow a defined course. Overspending on investment leads to asset price inflation. As demand for supply declines, the prices start depreciating towards the market equilibrium. Confidence in the markets starts declining and investors start withdrawing capital inflows while liquidating portfolio assets (Mishel, Bivens, Gould, & Shierholz 2012). The stop in currency inflows create deficits in trade balances hence a crisis sets in as demand for foreign currency sets in. The 1997 Asian financial crisis and the 2008 financial crisis followed the same path. Analysts argue that with the experience of the 1997 crisis, the 2008 crisis would have been averted or better managed. This essay will look at lessons learnt from the 1997 Asian financial crisis in the response to the 2008 financial crisis. Causes of the Asian Economic Crisis The Asian economic crisis was caused by both speculations of market trends and poor structures and policies in the region. Overreactions due to panic and hedging led to the plunging of asset prices and foreign exchange rates. Political regimes in East Asia were pushing firms to ensure and sustain high economic growth rates by encouraging increased investment. Governments offered credits with subsidized interest rates and even promised to bail out those firms that incurred losses while implementing government policies. Such provisions encouraged massive investments by firms with little regard for risk and cost assessment. In most cases, returns from the new investments were low and loan repayment was a problem. This created deficits in these countries’ balance of payments. Increased defaults in loan repayments and reduced exports due to competition from cheaper alternatives available in other countries played a major role in reducing investor confidence. This was made worse by the appreciation of the US dollar against Asian currencies after 1995. Foreign investors started withdrawing from the Asian markets, by withholding inflows of capital while liquidating fixed and portfolio assets. These were converted into foreign currencies like the Euro and the US dollar which were considered less vulnerable to depreciation. Financial institutions started facing a sharp increase in the demand for foreign currencies. With the exhaustion of their foreign reserves, there was an imminent risk of the depreciation of local currencies. This, in addition to the reduced currency inflows created a crisis as governments could not sustain domestic spending. The Crisis in Korea The financial crisis in Korea started with the market liberalization of the early 90’s so as to conform to the OECD membership requirements. The government also encouraged the borrowing of short term loans from foreign sources. These steps made the Korean market attractive to both local and foreign investors. With time, the nation’s foreign debt increased as investors took short term loans to finance long term projects. By the time the crisis hit in 1997, the foreign debt had accumulated to over 63 billion US dollars against a foreign reserve of slightly over 9 billion US dollars(Blinder & Zandi 2010). In the period preceding the financial crisis, the value of the dollar relative to that of the Korean Won was low. This encouraged more dollar borrowing by investors and subsequent investment in Korea. When the value of the US dollar started rising in 1995, loan repayment became a problem. At that time, Korean exports were facing competition from Japanese products hence revenues from exports were reducing. Korean firms started experiencing financial struggle with some of them selling assets at a loss. The expectation that the government would give monetary bail outs never came to be. The continued use of foreign reserves to fund financial institutions, which were then facing a huge demand for foreign currency, depleted the reserves to a point that continuation of the same proved risky. The final step was to seek help from the International Monetary Fund (IMF). The Crisis in Thailand Thailand was the origin of the Asian crisis which later spread to other East Asia nations. The events that led to the crisis in Thailand were similar to those in Korea. Excessive domestic spending on unproductive investments using foreign sourced loans was identified as the culprit. The central bank in Thailand had instituted a fixed exchange rate policy. This, plus the high interest rates on loans made the Thai market attractive for foreign investors seeking to make quick profits. Local borrowers, on the other hand, took advantage of cheaper foreign loans which had a less interest rates compared to domestic loans. The increased cash inflow and availability of loans created an investment bubble. Most of the money was invested in real estate, where prices were inflated and the supply of housing surplus to the nation’s requirements (Jansen 2001). The use of short term loans to finance long term projects made loan resettlement a problem since incomes from the projects were very low. Finally, this investment bubble burst and the value of properties started depreciating at a dramatic rate. Investors were recording losses and could not repay the accumulated foreign debt. The trade deficit was made worse by the exit of investors through liquidation of portfolio assets into foreign currency. This led to the creation of a financial gap that put Thailand in a crisis. The 2008 Financial Crisis The financial crisis was as a result of self adjustment to solve internal shortcomings that affect market equilibrium. The crisis lasted for about five years and was as a result of the bursting of an investment bubble. Massive withdrawal of investors from markets as confidence waned increased stock market volatility and reduced liquidity for banking institutions. Just like other financial crises that have occurred in the past, the 2008 financial crisis was caused by trade deficits. Financial crises usually follow a particular trend of excessive spending on investment, price inflation and subsequent price falls as asset liquidation takes over. Differences in imports and exports define a country’s trade deficit. Where the rate of consumption exceeds the rate of income generation, a country has to find ways of making up for the extra consumption. This usually prompts government to seek foreign sources of money. This is what happened in 2008 as the availability of cheap loans encouraged excessive investments. The rate of income generation from these investments was not enough to offset debts incurred through loans. Governments were, therefore, forced to borrow money in order to sustain domestic spending. This further increased deficits in current accounts. Falling investor confidence and the bursting of the investment bubble led to mass liquidation of fixed and portfolio assets into currencies perceived to be cushioned against depreciation (Provopoulos 2013). Additionally, investors stopped the flow of money into the affected countries. These events caused the financial crisis as governments tried to fill the void created in the markets. Comparison of the 1997 Asian Financial Crisis and the 2008 Financial Crisis The two crises (the 1997 Asian financial crisis and the 2008 financial crisis) share a number of similarities. Both happened as a result of massive capital inflows to finance investment bubbles, mainly in the housing sector. This was followed by the bursting of the bubbles, reduced investor confidence and increased stock market volatility (Helleiner 2011). These factors contributed to the withdrawal of capital inflows. While the Asian crisis started in Thailand, the 2008 crisis started in the US. In both cases, the impact of the crises was felt in far lying regions of the world. In both cases, the impacts of the crises were more pronounced in the Asian markets than in the US and Europe. For example, (Moon 2011) stated that the Korean won depreciated sharply with the exchange rate against the US dollar being 1700 won to one US dollar in 1997 and 1400 won to one US dollar. Previously, the exchange rates stood at less than 1000 won for one US dollar (Goodhart 2014). The Role of Market Self- Correction in the Crises The two crises underline the fact that markets undergo self correction to eliminate errors. Speculation through over-optimism and over-pessimism lead to price exaggeration, over and below the market equilibrium respectively (Leeson, Coyne, & J, 2012). The financial crises were as a result of a boom in real estate markets driven by remarkable economic growth. Economic growth and subsequent increment in job opportunities increased purchasing power and town populations. This created a sharp increase in the demand for housing, thus creating an investment bubble in the housing sector. Due to over-optimism, trader errors in the form of price inflation occurred. The reducing demand in the backdrop of high supply forced landlords to re-value their properties downwards, leading to sharp depreciations. This lead to even more trader errors as over-pessimism set in. Investors liquidated their properties en-masse. Errors from over-optimism are easier to correct through price adjustment than over-pessimism errors. To prevent their economies from crumbling as a result of over-pessimism trade errors, governments had to find foreign sources of currency so as to offset the deficit or gap left by the stop in currency inflows. This helped in restoring sanity in the balances of trade and re-establishing market equilibrium. Comparison of Responses in the 1997 Asian Financial Crisis and the 2008 Financial Crisis The crisis in Korea was made worse by the fact that the country had spent its foreign reserve currency to near depletion. Towards the end of 1997, an agreement between the IMF and the Korean government for financial aid was arrived at. This agreement came with conditions requiring Korea to restructure its financial sector and fiscal management. Considering that the situation in Korea was urgent and in demand of huge cash inflows, the initial 9.8 billion US dollars availed to Korea was not enough (Kihwan 2006). Within a short period, the nation’s foreign reserves were depleted. The US intervention in the matter helped Korea secure more funds urgently. In addition, the implementation of financial reforms restored investor confidence hence the Korean won appreciated once again. The crisis in Thailand was equally as a result of poor fiscal policy with most of the investments being financed with foreign debts. Worse still, funds were borrowed in US dollars and loaned by banks in the baht form. This was risky as a slight appreciation of the US dollar against the baht would lead to massive losses. When the investment bubble burst, such frailties in the financial system exposed the economy to a meltdown. Due to the poor nature of the response in Thailand, the Thai baht depreciated sharply to a point that it was devalued. At first, the central bank of Thailand attempted to solve the crisis locally. Even when the nation’s government sought foreign assistance, aid came in limited amounts due to the underestimation of the crisis. By the time adequate measures were taken, the economy had already faced serious damages. In the financial crisis of 2008, governments took bold and rapid measures to cushion their economies against the crisis through the popular economic stimulus programs. For example, the US proposed a trillion dollar economic stimulus project, while the Australian government launched a several billion dollars program.In Greece, and other peripheral nations in the euro zone, central banks were financed through what was referred to as the Target 2 program(Gibson, Palivos, & Tavlas 2013). This helped them maintain their lending abilities and meet their capacity to make payments for hard currency outflows. Compared to the 1997 response, the 2008 response was more fast and direct. Conclusion While increased investments are important for economic development, governments need to strike a balance between domestic consumption and income generation. Despite the lessons from the 1997 crisis, economists failed to predict impending doom in 2008. This was due to the misconception that economies were then more diversified and financial structures stronger and could not face a crisis similar to the Asian. In the modern economies, financial crises are almost inevitable (Truman 2009). However, what matters most is how the crises are managed. The fact that the 2008 response was more fast, direct and effective in that there were no excessive currency depreciations and devaluations shows that lessons from the 1997 Asian crisis were critical in managing the recent crisis. Reference List Blinder, A.S. & Zandi, M., 2010. How the Great Recession was Brought to an End. Princeton: Moody's Analytics. Czepiel, J. & Kerin, R.A., 2010. Competitor Analysis. Dissertation. 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Athens: Federal Reserve Bank of St. Louis Review, 94 (1), 1-20 Truman, E.M., 2009. Speeches and Papers: Peterson Institute for International Economics. [Online] Available at: HYPERLINK "http://www.iie.com/publications/papers/paper.cfm?ResearchID=1240" http://www.iie.com/publications/papers/paper.cfm?ResearchID=1240 [Accessed 22 October 2014]. Read More