The Unwinding of the Asian Currency Crisis
by gjohnsit
Sat Sep 22, 2007 at 04:33:31 PM PDT
"And it's a hard, and it's a hard, it's a hard, it's a hard,
And it's a hard rain's a-gonna fall.
- Dylan
A decade ago 20% of the population of the Earth was undergoing afinancial crisis. In several large nations the entire middle class wassimply wiped out. Governments were overturned.
Why should this matter to you? If it wasn't for the Asian crisisthere would never have been a Real Estate Bubble in America, interestrates would be much higher, and the monetary policy of the past decadewould have been radically different.
Even more importantly, the fallout from the Asian Currency Crisisis coming to an end. This unwinding will cause a shift in global powerthe world hasn't seen since America eclipsed England after WWII.
- gjohnsit's diary :: ::
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What caused the crisis
For much of the 1990's east Asia was the target of massive amountsof speculative investment, much of it directed at real estate andstocks. The run-up in asset prices led to annual growth rates of 8-12%.This led to talk of the Asian Economic Miracle.
Interest rates were kept high in these nations in order toattract hundreds of billions of dollars worth of short-term,dollar-based debt, which was then lent out to domestic industry andearned its profits in local currency. This created a mismatch between the demonetization of the liabilities of the nation's banks and their assets.
The rapid increase in foreign currency exposure was encouraged byfixed exchange rate regimes, since these created the illusion ofprotection from exchange rate risk. It was encouraged by taxincentives that favored short-term foreign currency borrowing throughoffshore banking centers.
This problem was made worse by weak disclosure laws, leavinginvestors in the dark to the extent of problems once the crisis hit.
When America emerged from the early 1990's recession the FederalReserve began raising interest rates, which caused the dollar to beginrising in value. Because the Asian countries pegged their currencies tothe dollar, the rising dollar made their exports less competitive andtheir economies began to slow. As their economies slowed many of themost speculative investments began to default. At the same time Chinabegan to be a force in the field of cheap exports, thus taking robbingthe rest of east Asia of market share and foreign investment.
In the summer of 1997 foreign investors began to get spookedand started pulling money out of Asia. A net inflow of $92.8 billion in1996 turned into a net outflow of $12.1 billion in 1997. Much of thatdebt was short-term, this maturing debt could not be rolled over andhad to be paid right then. Because these countries had chronic currentaccount deficits, and their debts were in dollars, they were forced toburn through their gold and foreign currency reserves in an attempt todefend their currency pegs. Currency speculators sensed weakness andattacked.
The Crisis
On July 2, 1997, Thailand was forced to give up their peg to thedollar and float their currency. The event was like an earthen damspringing a leak. The Thai baht quickly lost half of its value. TheThai stock market dropped by 3/4. You can see a video on the south-eastAsian Ghost Towers (abandoned skyscrapers), left over from the 1990's boom.
When a currency gets devalued everything in that country thatcan't be boxed up and shipped to foreign customers gets devalued. Inother words, the nation and its citizens get poorer. When its a quickand drastic devaluation its economy also experiences a shock, as wellas getting poorer. The timing of these devaluations was particularlybad because 1998 was the bottom of an 18-year worldwide bear market incommodity prices. Thus making it almost impossible for these countriesto export their way out of the economic crisis by giving away theirnatural resources.
The very next day the Phillipine Peso was under attack and lost about 40% of its value by the end of the crisis.
Malaysia suffered a similar drop in both their currency and stock market by the end of the year.
A month later the Hong Kong stock market came under attack. Thecurrency peg was saved only by massive government intervention.
For the first time is many years, the word "contagion" was beingused. Each time a nation's currency dropped, so did the wealth of thenation. Savings were made worthless. Inflation soared and interestrates spiked as middle class jobs were wiped out. It was instantstagflation.
But the real damage was yet to be inflicted.
Indonesia is the fourth-most populace nation on Earth. In June 1997 the Indonesian economy was fundamentally sound and strong.
But for no other reason than because it was close to Thailand theIndonesia rupiah dropped from 2,000 to 1 dollar, to 18,0000 per 1dollar when the currency was floated on August 14. Before the end ofthe year 13% of the Indonesian economy vanished, and even today theper-capita of Indonesia has not returned to its 1997 levels. Theeconomy was so bad that famine began to appear in rural areas. Riotsbroke out in the streets that left 500 dead, and President Suharto, adictator since the 1960's, was forced to resign.
Because the currency crisis seemed to spread for no other reason than geography, it was nicknamed the "Asian Flu".
The largest economy to get humbled by this crisis was SouthKorea's. Their currency fell by 70%, their stock market fell by over20%, and their national debt rating dropped to junk status.
Singapore, Taiwan, and Japan also took hits to their economies, but not nearly as large as the other five countries.
The IMF Crisis
Outside of the nations directly effected by this currency crisis, the International Monetary Fundwas most effected. In fact, while this economic crisis is known in thewest as the East Asian Currency Crisis, in the east it was known as The IMF Crisis.
In an interview last December [1997] with BusinessWeek, [IMFmanaging director Michel] Camdessus recounted: "I visited Thailand fourtimes from July 1996 to July 1997, for the exclusive purpose of tellingthem: `You are going to make a mess. You must get rid of this verydangerous peg to the dollar.'" Mr. Camdessus said the IMF gave the sameadvice to "Indonesia, Korea, and the Philippines."
The IMF has an enormous amount of power in the financial sector because it is "gatekeeper" to the world's banking system.
A borrowing country that did not meet IMF conditions would often notbe eligible for loans from the much larger World Bank, regional bankssuch as the Inter-American Development Bank (IDB), high-income countrygovernments including those belonging to the Paris Club, and sometimeseven the private sector.
The influence of the member countries of the IMF are based on thesize of their economies, thus America has by far the most influence inthe IMF. In 60-some years of existence, no American veto at the IMF hasever been overridden. The IMF only loans money based in dollars.
The IMF's greatest failure was its attempt to transition theRussian economy following the collapse of the Soviet Union in 1991. TheRussian economy fell by 50% from 1992 to 1996, far worse than America'sexperience during the Great Depression. However, the mainstream mediafailed to report the IMF's failures in this regard, and instead focusedon the triumphalism of the capitalists.
This time around the media followed a similar trend, using the nonsensical term of "crony capitalism" for all of Asia's problems. Thus they blamed the victims, when the victims were doing exactly what the IMF wanted them to.
The IMF had originally encouraged these nations to peg theircurrency to the dollar, thus creating the dependence on foreigncapital. They then encouraged them to float their currencies, thiscreating the crisis. But the real problem was the IMF's "solutions" tothe crisis.
As a condition for a massive IMF bailout, these nations were forced to:
a) cut government spending on basic services even while their countries were sinking into economic depression
b) raise interest rates in the face of a collapsing economy
c) allow banks and financial institutions to fail during a currency crisis and bank runs
On top of that, the IMF failed to loan the money in a timely way.For instance, months after promising Indonesia $40 Billion in loans,they had still only sent $3 Billion.
The IMF was pushing for economic restructuring, but the Asiannations already had high savings rates, low inflation, and tradesurpluses. What was happening was a liquidity crisis, not a chronicstructural problem. Thus the IMF misdiagnosed the problem and gave thewrong "cure".
In other words, everything the IMF did was designed to make things worse.
The IMF's job was "lender of last resort" and they completelyfailed. Unlike the case with Russia, this wasn't going to be ignored.Nationalist sentiments were inflamed.
Jeffrey Sachs, then at the Harvard Institute of InternationalDevelopment, was even more blunt, calling the IMF "the Typhoid Mary ofemerging markets, spreading recessions in country after country."
It didn't help that Camdessus called the crisis a "blessing indisguise" at a time when Indonesian press was reporting people livingon "grass and tree bark".
It was the IMF's botched "rescue" that caused a present-day "crisis of legitimacy" at the IMF.
What has happened in the world is that no one wants to borrow money from the IMF anymore.
Speaking at the same event as de Tray, Ngaire Woods, an OxfordUniversity specialist on the IMF and World Bank, revealed that the IMFprojects that payments of charges and interest to the organizationwould more than halve from US$3.19 billion in 2005 to US$1.39 billionin 2006 and halve again to US$635 million in 2009, creating what shedescribed "a huge squeeze on the budget of the organization."
While it does not have the aura of controversy and failure thatsurrounds the IMF, the World Bank is also in crisis, say informedobservers. A budget crisis is also overtaking the Bank, according toWoods: Income from borrowers' fees and charges dropped from US$8.1billion in 2001 to US$4.4 billion in 2004, while income from the Bank'sinvestments went from US$1.5 in 2001 to US$304 million in 2004. China,Indonesia Mexico, Brazil and many of the more advanced developingcountries are going elsewhere for their loans.
America has been able to exert "dollar hegemony" on the rest ofthe world through these international organizations. Their downfallalso means less American influence on the rest of the world. The post-Bretton-Woods era that has defined the world since the end of WWII is coming to an end.
The Fallout
The currency crisis didn't end with East Asia. By August 1998 it struck Russia, causing yet another currency devaluation of more than 70%. This caused inflation to spike to 84% and Russia to default on their foreign debts.
A few months later Brazilwas forced to devalue their currency by 32%. This caused their leadingtrading partner, Argentina, to go into a recession which ultimatelycaused their 2001 debt default and currency devaluation.
But the biggest fallout from the crisis was not something that the financial world ever expected.
The Asian countries collectively decided to never allow themselvesto be vulnerable to foreign lenders and the IMF ever again. To do thisthey began a process of "self-insurance".
What this involved was using their large trade surpluses withAmerica to accumulate oversized foreign currency reserves. For thenations of Indonesia, South Korea, Thailand, Taiwan, and Malaysia, thatmeans holding around $500 Billion of dollar-assets in their centralbanks. Far more than they would need outside of a new currency crisis.China and Japan each hold around $1 Trillion in foreign currencyreserves each.
To do this those East Asian nations bought massive amounts ofAmerican bonds, mostly treasuries, but also Agency bonds such as FannieMae and Freddie Mac. By the end of 2006, Asian investors owned 32% of all U.S. Treasuries and 13% of all U.S. Agency bonds.
What this has done is allowed America to rely on the world'ssavings, rather than its own. It's artificially held down interestrates in America, which has encouraged borrowing (as opposed to saving)which has led directly to the Real Estate Bubble. In fact, the mortgagetitles of tens of thousands of Americans are currently being heldsomewhere on the other side of the Pacific.
All this cash makes them practically immune from a foreigncurrency speculator attack. But it also means that money that could beused to strengthen their local infrastructure and make the lives oftheir citizens better is not being utilized.
Also, because of the currencies now fixed at much lower rates,they've been able to undercut America's industrial base withartificially, low-priced goods. That makes their trade surpluses withAmerica even larger.
Ten Years Later
The strategy of holding their currencies artificially low andbuilding up massive foreign currency reserves made sense in the yearsfollowing the crisis, but it fails to make sense now.
The hollowing out of the American industrial base has made thetrade deficits in America chronic. Because of this America requires$1.6 Billion in loans every single day, 365 days a year, just tomaintain its standard of living. America's savings rate went negativemore than a year ago, and has only gotten worse. That's notsustainable.
While the U.S. Dollar has fallen more than 40% against europeancurrencies since 2002, it has barely even budged against most EastAsian currencies. For those Asian currencies to maintain theirartificially low pegs to the dollar, the central banks of Asia mustprint up massive amounts of their own currency to mop up all thedollars floating around their economy because of their trade surpluseswith America. By the simple laws of supply and demand, printing upmassive amounts of paper money eventually causes price inflation.
In a direct reflection of their domestic inflation problem, China recently instituted wage and price controls. Since Emperor Diocletian declared the Edict on Maximum Prices in 301 A.D., all the way to Nixon's wage and price controls in the early 1970's, these laws have always failed. China's experience will be no different.
The only solution for the domestic inflation in China and therest of Asia is to revalue their currency until it reflects real-worldvalues. Indiadid this in 2005 and 2006 and it cut their inflation rate in half. Thelogic being that the central banks of those countries would no longerhave to print currency to keep their currency low. Thus they would alsonot need as many dollars in their currency reserves. Thus the value ofthe currency in the pockets of their citizens would increase in value,making them richer. More wealthy citizens means more more domesticconsumption, thus no longer needing the obese consumers of America tobuy so many of their products.
But the biggest reason for Asia to stop loaning America money isbecause they already have too many dollar assets. There is simply nological justification for acquiring even more of our mortgage-backedsecurities, or low-yielding treasury bonds. What justification canSingapore have to hold more than 100% of the GDP in currency reserves?Or Taiwan with around 80% of GDP? It's completely out of proportion.
It really isn't a question of "if" Asia will allow theircurrencies to rise and stop loaning America so much money, but "when".
So when will it happen? It's already started. Two years ago China began taking baby-steps towards revaluing their currency.
Malaysia has tracked their currency reforms to the 800-poundguerrilla - China. To a lesser extent, all the other nations in the FarEast will reflect China's future currency adjustments.
As if to punish Asia for loaning us so much of their money, theinterest rate cuts from the Federal Reserve this week was described asa "blow to the head" of China.
What Ben Bernanke is saying with his sharp interest rate cuts, andwhat the nation is affirming its approval of with the orgiastic stockmarket response that followed, is that it continues to hold no othervalue higher than the pleasure to be attained through its own excessconsumption. In depreciating the value of the currency it uses to payChina for its goods, the US is telling China that it has no intentionof paying China the full value for what it buys from it; that would beunacceptable, it would mean that there would be less money to buy evenmore stuff.
Of course, China does not have to continue to put up with this.
On the other hand, that leaves America out on a limb, without ahealthy industrial base and without domestic savings. If Asia no longerrecycles their trade surpluses back to America then interest rates willrise dramatically in America.
Sure, if Asia starts investing all that cash into their owncountries then their economies will boom. But without the ability toproduce products that the rest of the world wants to buy, America willnot immediately benefit from this tidal shift in wealth. Instead, thedollar will fall and import prices will rise. That means thecombination of price inflation and higher interestrates - also known as Stagflation. It also means a dramatic lowering ofthe standard of living in America, even while the standard of living inAsia increases.
And this would create the most dramatic shiftin wealth and power the world has seen since America supplanted Englandas the world's economic and military superpower.
