Asian Financial Crisis of 1997
The Asian financial crisis was another major currency crisis that happened during the 1990’s.
The crisis assumed epic proportions.
This is because it started in only one country i.e. Thailand whose currency faced an attack from
speculators.
However, in a very short span of time the crisis had gripped the entire South East Asian region.
Countries like Vietnam, Malaysia and Indonesia all got involved in this crisis which almost
appeared without any prior warnings.
This phenomenon of the crisis spreading quickly to multiple countries is called the “Asian
contagion”.
In this article, we will discuss these events in detail.
Dollar Peg
The dollar peg was the common feature amongst all currency crises that occurred during the
1990’s. However, unlike South American countries, the ones in Asia did not have excessively
weak foundations.
This meant that they were not inflating their currencies excessively while maintaining pegs
thereby overvaluing it.
In fact, prior to the crisis, these South Asian economies were considered to be growing extremely
fast and were therefore high on the list of investment destinations which offered good returns!
However, the dollar peg caused severe damage to these economies in multiple ways. Firstly, it
caused the value of these currencies to appreciate with the dollar appreciation.
This caused the exports from these countries to become expensive as compared to exports from
other countries like China, Hong Kong and Taiwan. Economies like Thailand and Indonesia lost
a huge chunk of export business as a result of this dollar peg.
Also, a stable peg with the dollar led to excessive inflow of foreign capital in Thailand.
This money was parked in the equity markets which were witnessing an unprecedented rise
further giving credence to the theory that the economy of these Asian nations was undergoing a
transformation.
Without the peg, the rising inflows would have made the dollar more expensive and as a result
would have discouraged an even greater flow of investments to the equity markets.
Lastly, the Asian economies had to hold a large amount of Forex reserves in order to maintain
their currency pegs with the dollar.
As and when speculative attacks increased, the Central Banks had to use these reserves to defend
the value of their currency and maintain the pre-determined exchange rates.
Credit Expansion
During the 1990’s the economies in South East Asia were also facing one of the largest credit
expansions of the century. Banks were rapidly making loans to private corporations despite the
fact that these corporations were already extremely leveraged.
The South East Asian banks had a very cozy relationship with the governments. As such, all of
them assumed that in the event of a crisis, the government would have to intervene and
continued to give out risky loans.
The money derived from the loans found its way to the overheated equity and real estate
markets. Foreign investors had already driven the asset prices upwards.
This was further aggravated by the domestic investors who invested their bank loans in such
assets.
The higher asset prices created a self reinforcing loop in which the higher priced assets were
used as collateral to issue more loans which in turn ended up driving asset prices even higher! To
add to the woes, most of the Asian banks were largely funded with borrowed money.
The equity that the banks held was extremely less and therefore when the loans went bad, banks
started going bankrupt leading the crisis to spread across nations!
Currency Attacks
1990’s was the era of currency speculators. They figured out that Thailand’s central bank does
not have enough reserves to defend its peg against the dollar.
As a result, the Thai baht came under a speculative attack and within hours of extremely heavy
selling the Thai baht had to be opened up to the markets.
This is because the Thai central bank did not have enough reserves to protect the peg. In essence,
the speculators had taken on the Thai central bank in the open market and won!
The loss of the Thai central bank was a turning point as speculators turned their attention on to
other economies in the region. Speculative attacks were happening on several countries in the
region who had pegged to the dollar.
The Philippines was forced to float its currency. Similar cases happened with Malaysian ringgits
and the Indonesian rupiah. The domino even spread to developed economies like South Korea,
Hong Kong and Taiwan. However, they survived the crisis with a few minor bruises.
However, it needs to be noted that the Forex market was not the only market in crises in these
countries. Most of these currencies lost more than one third of their value. As a result, the foreign
hot money quickly pulled out of these countries. This led to a massive sell off as a result of
which the local stock markets and property markets also faced historic crashes.
The 1997 Asian crisis made the world realize as to how quickly economies which were
considered to be growing suddenly became bankrupt! The power of the Forex markets and that
of currency speculators was once again established and currencies that were pegged to other
currencies once again realized the necessity of holding huge quantities of foreign exchange
reserves in order to fend off speculative attacks.
Currency Wars: “Beggar Thy Neighbor” Policy
What is a Currency War ?
A currency war is a situation wherein devaluation of currency by one country is retaliated
by a competitive devaluation from the other country. For instance if the United States were to
devalue the dollar against the Pound Sterling and if the British retaliated with their own
devaluation then the situation could be accurately described as a currency war. Devaluation is
believed to cause growth in the short run. However, this growth comes at the expense of one�s
trading partners. Hence currency wars are also known as “beggar thy neighbor” policy!
What Happens When a Currency is Devalued ?
The devaluation of a currency has multiple effects. Usually they are considered good for the
economy in the short run since they increase chances of growth. However, the growth happens at
the expense of other economies. Some benefits that arise due to devaluation are as follows:
A cheaper currency makes exports cheaper. Hence, when countries devalue their
currency, they end up pricing their products attractively in the international market and as
a result end up giving a major impetus to exports even if other factors such as
productivity remain constant.
A devalued currency also helps to stem imports since the goods produced by other
countries tend to become more expensive as compared to domestic goods. Thus, the
exports of other nations are negatively affected by currency devaluation.
Since higher exports means higher production and therefore implies higher employment,
currency devaluation seems like an effective mechanism to control unemployment in the
nation. However, this ends up being an export of unemployment! This is because goods
that will be exported from our country will replace goods being manufactured
domestically in that economy and hence cause unemployment there. Therefore, currency
devaluations do not create or extinguish unemployment, they just shift it from one
country to another
Lastly, currency devaluations can also positively impact the balance of payments as well
as the balance of trade of a nation thereby solving many problems by correcting persistent
macro-economic deficits.
Currency Wars: History
The modern world has faced at least two severe bouts of currency wars. They are as follows:
The first instance of a major currency war was witnessed after World War 1. Germany had
basically started inflating at an unprecedented rate. They were doing so in order to be able to pay
the damages due as a result of losing World War 1. However, other countries like France and
Britain also followed suit. Soon these countries were following devaluations by other countries
with higher devaluations of their own. This continued for a long while until Germany ended up
in a hyperinflation winning the race to the bottom! Other countries like France and Britain had
also inflated significantly. However, their economy did not implode like that of Germany.
The next currency wars were sparked on by the Nixon shock. This is when President Nixon took
the world off the gold standard. This was done with the intent to devalue the dollar and promote
employment and exports in the United States economy. This would automatically end up
promoting unemployment in countries that imported American goods.
The devaluation by the United States was swiftly followed by competitive devaluation by other
nations following the dollar standard. The “beggar thy neighbor” policy of currency devaluations
quickly became the norm. This round of currency wars ended with speculative attacks on many
currencies and raging currency crises in several parts of the world.
The Present Day Currency War
Some economists argue that we are facing a present day currency war as well. However, the war
is not so blatant and competitive devaluations, if any, are not immediate and there are often
diplomatic reasons provided for pursuing them.
At the present moment, over 20 central banks in the world have followed the lead of Bank of
Japan and the European Central Bank and have implemented expansionary monetary policies.
Countries in the Eurozone as well as Japan were reeling as their economies were not competitive
and incapable of exports given their currency valuations. As a result they inflated their currencies
and let the free market devalue it for them! This has led to increased exports from these nations
to the United States.
At first the United States was not concerned about these devaluations. This is because the
domestic demand was strong enough to absorb the excess goods supplied by these countries
without adversely affecting any economic parameters. However, of late, the United States
government and the Fed have started being vocal about their concerns.
The United States is now continuing its policy of quantitative easing unabated because it wants
to devalue its own currency and remain competitive in a market where German and Japanese
imports are becoming cheaper by the day! The modern currency war is not overt. Rather it is a
covert operation.
Japan seems to be devaluing its currency to boost its shattered domestic economy.
The European Union is following a loose monetary policy which leads to devaluation in
order to stave off the Euro crisis
The United States is devaluing its currency by creating more dollars to protect itself from
the effect of the 2008 subprime crisis
Thus, each of these nations has a pretext to inflate more and devalue its currency. However, none
of this changes the fact that the modern world is in a currency war and economic growth is not
happening as a result of a growing domestic economy. Rather it is a result of the beggar thy
neighbor policy being followed even by the developed nations.
Freely Falling Currencies
The freely floating currency system may have its advantages and disadvantages. However, it has
fundamentally changed the way we look at currencies. In doing so, it has created one major
obstacle. We now compare currencies with one another to check if they have gained or lost
value. This way of measurement is bizarre to say the least!
Currencies are meant to be exchanged for goods. Hence, their value must be measured against
the amount of goods that they can buy. Comparing them against one another will provide an
extremely misleading image especially when all currencies are falling in value. That is precisely
what is happening in the modern world. In this article, we will discuss how comparing currencies
against one another presents a completely different image as compared to what the reality is.
All Currencies Have Lost Value in the Past Century
Under the so called freely floating currency regimes, nearly all of the currencies have lost value.
The common man may not realize that their money is losing value right while staying in their
pockets. In fact, it is even losing value when it is in banks and is earning interest! The interest
earned is barely enough to provide a hedge against rising inflation. There is barely any real
interest earned. In fact, most people lose money on a real basis when they park their currencies in
banks.
The United States dollar has lost over 94% of its value in the past century. Similarly, other
major currencies like the Pound sterling have also been in a major decline. This consistent fall in
value is unprecedented given the fact that the value of the dollar remained almost unchanged for
the century prior to this! That was the period when the dollar was backed by gold and silver i.e.
with real value and fiat money was not the predominant monetary system of the world.
The case of the rapid decline in the value of the United States dollar is not unique. Rather all
currencies have lost a lot of value in the past few years. This can largely be attributed to the rise
of the fiat currency system worldwide and the fact that a floating rate exchange system creates a
false impression that some currencies are gaining value whereas other are losing value when in
reality everybody is facing a decline. It is the relative measurement which creates this distorted
vision. The countries that seem to be appreciating are the ones that are experiencing the least fall
in value. However, their value is declining and not rising!
Changed Standard of Measurement
The modern foreign exchange system compares the value of one currency against the value of
others. Thus, the value of the dollar is compared against the British pound or any such other
currency. Hence, the movements in the dollar are relative to the movement in the pound. In this
kind of measurement, both the currency units are variable and hence there is no stable basis to
compare against.
So the dollar could be losing value in the real world due to inflation and the case could be same
for the British pound as well. However, if the dollar is inflating less than the pound, it will
appear as though it is appreciating against the pound! Thus, freely floating currencies end up
becoming freely falling currencies. They gain or lose value when compared to one another
whereas when it comes to buying goods and services in the real world all of them are have
significantly lost purchasing power.
This can be contrasted with the gold standard. The value of gold was considered to be constant
and the value of currencies would rise and fall against the gold. Thus, when the currency
appreciated against the gold it also appreciated in the real world i.e. less of the currency was
required to buy increasing quantities of goods and services. This was the gold standard. As we
can see that the alternate system has led all the other currencies into a freefall!
Affects Underlying Economies
The freely falling currency system severely impacts the underlying economies as well. Inflation
has become a way of life in the fiat money world! Workers expect their wages to rise more than
their productivity. The loss of value that currencies face is considered to be the time value of
money! Also, since the freely floating currencies change in value every minute, an obscene
amount of resources are spent on predicting its future value. Speculators who add no value to the
real world also end up making fortunes!
Thus, from a conservative standpoint, the gold standard was probably the best way in
which the monetary system of the world could and should be organized. Currencies were a
store of value during the gold standard era whereas in the era of freely floating exchange rates,
they have simple become currencies that are freely falling in value!
