In May 1997, a speculative run against the Thai baht became the first clear signal that a problem was developing in Asia. Over the next three years, Asia and other emerging markets, including Russia and Brazil, were rocked by a historic financial crisis.
These nations recovered strongly in the following eight years and generally made it through the 2007-09 global financial crisis in relatively good shape. However, the impact of the Asian economic crisis remains a major factor in the behavior of these emerging nations. The crisis dented confidence among the regions’ leaders and raised concerns about external interference in their economic progress.
In this report, we will recap the events of the Asian economic crisis, examining the structural reasons why these affected countries were so vulnerable to a financial crisis. We will also discuss how they have reacted to prevent future issues. From there, we will move to the performance of the IMF in the Asian economic crisis and why an end to the “gentlemen’s agreement” that has prevailed since the founding of the IMF, where a European is the managing director, could have significant implications for Eurozone rescue programs going forward. As always, we will examine the ramifications of this potential change on the financial and commodity markets.
The Asian Economic Crisis
The exact date the crisis began is disputed (like many historical events), but a key date is July 2, 1997. On that day, Thailand stopped defending the pegged rate of its currency, the baht. Prior to that devaluation, Thailand’s financial markets had been suffering for nearly five months. Fears of bad loans and concerns about loan servicing (most borrowers in Thailand had borrowed in U.S. dollars) had caused a speculative run on the baht. The central bank spent heavily to defend the exchange rate and raised interest rates to increase the cost of shorting the currency. However, their efforts failed. After the baht floated, the currency lost half its value in short order. By the end of July, the Thai government had petitioned the IMF for support.
The crisis was spreading to other countries. On July 11, 1997, the Philippine peso was devalued. A week later, the IMF offered the Philippines assistance. Indonesia’s rupiah was also under assault in mid-July; the central bank widened its trading band to relieve bearish pressure. By the end of July, the Singapore dollar was declining. On July 24, Malaysian PM Mahathir Mohamad went on a rant, blaming “rogue speculators” for the developing currency crisis in the region. Soon after, he specifically blamed George Soros for the selling pressure. Mohamad argued that the crisis was being engineered by the West to bring down the newly rising Asian powers.
By early August, Thailand had agreed to a lending program of $17 bn. As part of this program, an austerity package was required.
By mid-August, Indonesia abandoned its peg and allowed the rupiah to freely float. The currency fell 30% in the ensuing two months. On October 8, 1997, Indonesia petitioned the World Bank and the IMF for assistance. By Halloween, the IMF loan package to Indonesia was $40 bn; an unpopular austerity program was required as well.
By late October, the Hong Kong stock market began to weaken as speculators turned their attention to the HK$. However, the currency held because the Hong Kong monetary authority was a currency board, meaning it only issued currency equal to the U.S. dollars held in reserve. During the same period, the South Korean won began to weaken.
The South Korean situation moved the crisis to another level. Signs of trouble were emerging as early as January 1997, when the chaebol (large, mostly family-controlled conglomerates) Hanbo failed. By October, South Korea, the 11th largest economy in the world, was in trouble. Several heavily indebted chaebols were facing severe debt servicing problems, meaning the banks who lent them money were in trouble as well. The central bank was trying to defend the Korean won at 1,000 per USD, but abandoned that effort on November 17 after seeing $15 bn in reserves lost in the effort. Nearly 20% of the chaebols were facing bankruptcy.
On November 13, South Korean officials said they “did not need help from the IMF.” Eight days later, South Korea could no longer avoid the inevitable and requested a $20 bn standby loan. This loan was eventually increased to $57 bn and, later, a debt restructuring was implemented in early 1998.
The pressures extended to Japan, whose banks had been lending to entities in the region. During November 1997, Sanyo Securities, Hokkaido Takushoku and Yamaichi Securities all failed.
Thus, bailing out the smaller economies in the region became more important because the risks of a financial collapse in Japan were rising. Deputy Treasury Secretary Summers and Deputy Managing Director Fischer (from the U.S. Treasury and the IMF, respectively) both were sent to quell the trouble. They were instrumental in the private sector restructuring of South Korean loans which marked the beginning of the end of the crisis phase in Asia.
However, the contagion continued in Russia. By May 1998, the Russian financial system was near its breaking point. Russian equity and debt markets were in free fall. To stabilize the ruble, overnight rates were raised to 150%. By early June, foreign reserves had dwindled to $14 bn. Later in the month, Russia submitted an austerity budget with the goal of getting an IMF loan. After some arm twisting from President Clinton, the IMF announced a bailout package. On July 20, the IMF gave formal approval for the loan package, but only after President Yeltsin overruled the Duma and implemented new taxes. However, the program did not save the ruble; despite Yeltsin’s promise not to devalue on August 14, the currency was devalued three days later. Two days later, Russia defaulted on its sovereign debt.
By September, the crisis had spread to Mexico and Brazil. The former’s central bank started buying pesos to stabilize its currency and the Brazilian equity markets plunged. Capital flight became endemic; Brazil was seeing $2.0 bn flee daily despite 50% overnight interest rates. By late October, Brazil needed an IMF assistance package; Brazil received $41.5 bn by mid-November. Brazil abandoned its currency peg on January 15, 1999.
The financial turmoil also roiled U.S. markets and in late September, Long-Term Capital Management, a hedge fund operated by a plethora of Nobel laureates, was in serious trouble. The New York Federal Reserve engineered a bailout and the Greenspan Federal Reserve began cutting interest rates aggressively. By New Year’s, equity markets began to turn, buoyed by the Fed’s rate cuts.
The postmortems about the crisis isolate several factors that caused the crisis:
Pegged exchange rates: To stabilize inflation and enhance foreign investor confidence, most of these nations used pegged exchange rates; even those who didn’t still operated a “managed float” where they would occasionally intervene to guide the exchange rate. Pegged exchange rates encouraged domestic borrowers to seek loans in lower rate currencies. Essentially, companies in these nations borrowed in dollars which carried a lower interest rate than in local currency terms. As long as the exchange remains pegged, borrowing costs are stable. However, if the currency depreciates, borrowing costs increase. By pegging exchange rates, these nations increased the risk of their borrowing; unfortunately, the peg plus the lower rate reduced the perception of risk, leading to the second problem.
Excessive leverage: These countries tended to have undeveloped financial systems. Instead of raising capital by issuing equity or bonds, the most common practice was to borrow from banks. Many of the firms were controlled by politically connected families; banks believed that the government would effectively guarantee the loans to these firms. Thus, leverage became excessive.
Overreliance on foreign capital: Although these countries were using export promotion (see below), their robust growth rates and relatively open capital accounts encouraged foreign loans. On the positive side, these flows allowed for more rapid investment. Unfortunately, this money proved to be fluid and withdrew as problems developed.
Overreliance on export promotion: The strategy of export promotion is a very effective development program. To make it work, nations suppress consumption which creates domestic savings to stimulate investment. As part of this program, import barriers are usually used under the argument of “infant industries,” which is that newly formed industries need temporary protection from developed outsiders. The program has two weaknesses. The first is that there must be an importer for these goods. Fortunately, for most of the postwar period, the U.S. has played that role. Second, the investment must be properly allocated. Allocating investment is hard in any society because it requires forecasts of the future. In nations with undeveloped financial systems, investment allocation is often made by political connections. In the early stages of development, the lack of a financial system to allocate investment isn’t a problem because the low starting base usually means any investment provides ample returns. However, as development progresses the odds of malinvestment increase. In many of these nations, excessive investment led to overcapacity. Once growth slowed, firms became uncompetitive and struggled to service their loans.
Once Thailand ran into trouble, it became apparent that other countries had similar characteristics and the problem spread. What caught analysts and investors by surprise was the fact that the public sectors in these countries were actually in good shape. Most didn’t have deficit issues and spending levels were not out of line. There was a number of market distorting policies, including trade impediments, subsidies, etc. But, for the most part, the Asian economic crisis, until it spread to Russia, was a private sector debt problem (not too dissimilar to Spain and Ireland today).
The IMF Issue
In these international debt restructurings, the IMF is rarely the “good guy.” Its role is to ensure that its loans can be repaid. It tends to use a “cookbook” of policies that impose austerity, bring currency depreciation and deregulate economies, all with the goal of helping these nations repay creditors. Economists on the left tend to demonize the IMF for the austerity policies they recommend. In many cases, the IMF’s policies are the right ones. Nations that get into debt problems need to reduce spending and increase savings.
However, these policies may not have been the best for the Asian economic crisis. Since this was mostly a private sector issue and the household sectors were already saving, a better plan may have been to immediately restructure existing loans to improve the ability to service the debt. Austerity forced more saving on economies already doing so, which is where the geopolitical problem develops and is best encapsulated by the following photo.
This is a picture of Indonesian President Suharto signing IMF documents that will release funds. Note how IMF Managing Director Michel Camdessus is standing over Suharto as he applies his signature. This was seen in Asia as a symbol of the West “lording” over this important regional leader. In an area of the world that experienced colonization, the behavior of the West, using the IMF as the “tip of the spear,” was greatly resented.
There are two important outcomes from this perceived slight. First, nations in the region were determined to never suffer a similar fate again. This led them to continue export promotion but with artificially depressed exchange rates. The countries used this policy to amass a mountain of foreign reserves. China alone has $3.4 trillion. This policy has led to significant external imbalances between the region and the U.S., and was a contributing factor to the 2008 financial crisis. The persistent buying of U.S. Treasuries rendered Federal Reserve monetary tightening less effective and inadvertently encouraged excessive leverage.
The second factor is more subtle. Since the formation of the IMF after WWII, a European has held the position of managing director. There is an informal agreement between the U.S. and Europe that the World Bank will be controlled by an American and the IMF by a European.
Since the 1970s, the emerging world has become increasingly vocal about the need to change this arrangement. When Dominique Strauss-Kahn was forced to resign after being arrested for allegedly sexually assaulting a hotel maid, several emerging market nations pressed for a non-European for the post. In the end, Christine Lagarde was appointed but only because the BRIC nations could not coalesce around a single candidate. However, in 2016, when her term ends, this issue will likely return to the fore.
What makes this interesting is that a non-Western, emerging economy managing director may be more comfortable with harsher treatment of Eurozone borrowers. In other words, someone from this background may be more willing to press for austerity compared to a “fellow European.” Although there hasn’t been evidence of “easy” treatment from the IMF so far (in fact, with Cyprus, it was insistent on capping the loan at €10.0 bn), a non-European, especially with the IMF experiences from Latin America or Asia, might be even more austere.
This issue highlights the steady evolution of global influence since the end of WWII. As emerging economies become a bigger part of the global economy, they want a larger voice in the international institutions that govern the world. This situation is forcing the West and Japan to adjust. However, in this process, perspectives will be different and if a non-European, emerging economy candidate were to win the IMF Managing Director role, it would not be a shock to see Western debtor nations treated differently. Of course, any emerging economy candidate would be thoroughly versed in IMF procedures and may not behave differently. However, the general perception that the IMF is not treating European borrowers as strictly as emerging economy borrowers may lead to the IMF taking a harsher role in troika negotiations.
In terms of markets, this issue is still three years away. On the other hand, we doubt the Eurozone will be fixed by then. If that is the case, an emerging economy managing director could increase the risk of a Eurozone breakup as nations under a troika program decide its austerity measures are not worth the cost. This outcome would increase the risks of a global financial event.
April 15, 2013
This report was prepared by Bill O’Grady of Confluence Investment Management LLC and reflects the current opinion of the author. It is based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice. This information does not constitute a solicitation or an offer to buy or sell any security.
© Confluence Investment Management