Wednesday, August 8, 2012

How Malaysia handled the Asian Financial Crisis without IMF and its aftermath

The Asian Financial Crisis in 1997 came as a surprise and caught most people by surprise not only by the speed but also the severity of the crisis. At that time the Asian Economic Miracle was the buzzword then and the Asian Tiger economies are at their peak not only in the performance of their export oriented economies but also the stocks and properties market. To accommodate the shortage of funds needed to boost their economies, their governments embark on a ‘loose money’ monetary policies regime.

Loose Money Policy

Rules governing the inflow and outflow of foreign funds are relaxed and so does the terms of borrowing by banks and corporations. Instead of the traditional ‘borrow long lend short’, banks then did the opposite and they ‘borrow short lend long’. Such practice will put bank in a precarious position because if they borrow short say 3 years and lend long for 10 years then there will exist a ‘window of interest rate risk of 7 years’ , from fourth year to the 10th year. It will put the banks in a extremely risky position. This because during a financial crisis, a country’s  currency will most likely be victim to currency  speculators when they start attacking their currency .   

Currency depreciation

Normally there are two monetary tools available to the authorities to fend off the currency speculators. One is to raise the domestic interest rates and the other is to defend its exchange rate by using its reserves to artificially prop up its currencies. As usual once the reserves dries up then the currency will continue to fall.

While defending their currencies, the authorities will raise their interest rates which resulted in the increased in the ‘cost of funds’ for the banks and corporations. As a result, it will be very prohibitive for them to service their debts. If left unchecked, it will send many of them into bankruptcies.

I still recalled during the height of the Financial Crisis in 1998, the interest rate in Malaysia went up to as high as 18%. Coupled with the currency devaluation it provided a double whammy to many of the businesses in Malaysia. To do business in Malaysia then was very difficult due to the wide trading band between the Ringgit and US$. Many businesses found that whatever they have quoted their customers a week ago resulted in a loss due to the depreciation of the Ringgit. In other words the business activity came to a halt. The Malaysian Government needs to do something to stem any further devaluation of the Ringgit. In the next few sections we will delve into this topic.   

Due to the length and depth of this article, I will separate it into the following parts.

  1. Pre Crisis            – How it started
  2. During the Crisis - How the Malaysian Government responded
  3. The aftermath      - How did Malaysia’s economy performed as compared to those that embraced the IMF assistance during the Crisis. Is our solution to the crisis a desperate move for crony bailout or an economic crisis stabilization program? Instead of weeding out the deadwoods did the authorities use this opportunity to reinforce the ‘Bumiputra’ grip on the economy at the expense of other races.


Part One – Initiation of the Crisis.

Before we delve into the possible reasons for the Crisis , I think it is best to take a look at the chronicle of events leading up to the crisis. The following is the table describing the various events.

Column1The 1997 Asian Financial Crisis
  
DateChronicle of Events during the Asian Financial Crisis
2nd July 1997After exhausted of funds defending the Baht. Thailand decides to float it
18th JulyPhilippine and Indonesia devalues their currencies
18th JulyIMF extends $1.1 billion loan to Philippines
24th JulyAsian currencies under severe pressure especially the rupiah
20th AugustIMF extends $17 billion loan to Thailand
28th AugustAsian Stock Markets plunging to multi year lows
23rd OctoberHong Kong dollar and stocks under heavy selling pressure. Hang Seng lost 10%
28th OctoberCurrency Speculators moving to Korea. Korean won hits new low
5th NovemberIndonesia seeks IMF assistance with $40 billion approved
24th NovemberCollapse of Sanyo and Yamaici Securities and Hokkaido Takushoku Bank
3th DecemberKorea seeks IMF assistance. A total of $57 billion approved
5th DecemberMalaysia imposes tough market reforms in order to stem foreign funds outflow



As with all Financial Crisis, there are caused by multiple factors. The Asian Financial Crisis of 1997-98 is no exception. Listed below are some of the most debated reasons for the onset of the Asian Financial Crisis.

  1. Deteriorating economic conditions
  2. Moral Hazards by banks and corporations
  3. Too much inflow of foreign funds
  4. Stock market and Real Estate Bubble
  5. Lack of regulatory control on funds
  6. Massive disinvestment by the Japanese during the early 1990s due to their misadventure in the U.S coupled with their stock market crash. This resulted in the recalling of funds in the region by Japanese banks.


In the following, we shall provide an account on the few most possible factors for the initiation of the crisis.

  1. Liberalization of the Financial Sector

As from our discussion above due to the credit boom in the international front and the relaxation on foreign capital inflows by the authorities, it led to an increase in the foreign capital inflow. Normally the funds will find its way into either the real economy in terms of loans to businesses or the unproductive stock and property market. Unfortunately during that time the capital inflow are directed towards the stock and property market. The following table shows the percentages of the loans given to the property sector and also the NPL during 1997.

Bank Lending to Property Sector as % in 1997.  Source BISColumn1Column2
Country% of loan to propertyNPL - Non Performing Loan
Hong Kong40-55
1%
Singapore30-40
4%
Thailand30-40
36%
Malaysia30-40
15%
Indonesia25-30
15%
South Korea 15-26
30%
Philippines15-20
7%


Source : Bank of International Settlement

As can be seen from the above the four countries that are most affected by the crisis also coincide with having the highest NPLs in their respected banking industry.

The following chart is the effect of the Financial Crisis on the respective GDP growth of those countries.


Asian GDP growth     
from 1996-97 (%),IMF    
Country
1996
May-97
May-98
              Change
Indonesia
9
7.4
-5.3
-12.4
Thailand
5.5
7
-3.1
-10.1
South Korea
7.1
6.3
-0.8
-7.1
Malaysia
8.6
7.9
2.5
-5.4
Philippines
5.7
6.4
2.5
-3.9
Singapore
6.9
6.1
3.5
-2.6
Hong Kong
4.9
5
3
-2
China
9.7
8.8
7
-1.8


Source : International Monetary Fund (IMF)


  1. Fiscal Imbalances

Fiscal imbalances refers to the difference between the negative balance of payment and the ability of a country to pay its debts.


Column1Column2Column3Column4Column5Column6
CountryCurrent A/C Balance Exports Annual (%)
      
 
1995
1996
 
1995
1996
Thailand
-7.9
-7.9
 
23.1
0.5
Indonesia
-3.3
-3.3
 
13.4
9.7
Malaysia
-10
-4.9
 
20.3
6.5
Philippines
-4.4
-4.7
 
28.7
18.7
Singapore
16.8
15.7
 
13.7
5.3
South Korea
-2
-4.9
 
30.3
3.7

Source : IMF

The above table shows the deterioration of the Exports and Current accounts. The table shows that while the current accounts deficits remains high, the exporting countries at the same time are experiencing a downturn in its export receipts. In South Korea and Thailand, their exports grew the least with only 3.7 and 0.5% respectively. This compared to 30.3 and 23.1% respectively a year earlier. Hence this represents a fiscal imbalance of reducing exports with persistently high current account deficits. In other words eventually export receipts will not be enough to pay for its current account deficits.

Due to the boom in the exports, there is a need of funds to finance its exports industry and other increase economic activity. At the time the liberalization of the Global Financial market provided a perfect avenue to source for external funds. However, eventually such borrowing will widen the current account deficits.

When a country’s current account deficits widened coupled with the drop in exports and an overvaluation of the currency due to the inflow of foreign funds, it will attract the attention of currency speculators. Currency speculators will eventually attack the domestic currency and the end result will be currency depreciation.  

The governments of the affected economies will try to defend its currency either by increasing the interest rates or using its foreign exchange reserves to prop up the currency. When they increase the interest rates it will eventually bring down the banking sector due to the increase cost of borrowing abroad. Eventually there will be a ‘reverse flow of funds’ from an inflow to outflow of foreign funds. With such outflow of funds it will result in a credit crunch and coupled with the high interest rate it will eventually bring down the real estate and banking sector.

The relationship between the balance of payment crisis and the banking crisis is much more evident nowadays due to the globalization of the financial industry. The following table shows the frequency of the crisis between banking and balance of payments.

Column1Column2Column3Column4Column5
 Frequency of Crisis   
Types of Crisis1970-79Avg/year1980-95Avg/year
     
Balance of payments
26
2.6
50
3.13
     
Banking
3
0.3
23
1.44
     



As can be seen from the above table, before 1980 the occurrence of crisis is more biased towards the Balance of Payments. Out of the total of 29 Crisis only 3 are banking crisis. However since the 1980s the total banking crisis rose to 23 out of 73. So we can deduce that somehow the modern day financial crisis may be caused by the relationship of both balance of payments and banking.

In other words a Banking crisis may predate a Balance of payment crisis and vice versa.

  1. Deterioration of Bank Balance Sheets

Since the factors affecting the Crisis are inter-related and when currency speculators sense there is a weak link between the various component of the economy like an over-valued currency, persistent high negative balance of payments and falling exports then there will be an opportunity to make big money by betting on a depreciation of the currency.

During the 1990s era most of the Central Banks in Asean pegged their currencies against the dollar. The short term benefits of such a move are creating a stable environment for the inflow of foreign investments and also no headaches on daily fluctuation of exchange rates. The disadvantage is that Central Banks will have to maintain the peg even at the expense of over-valuing their currencies.

Again when currency speculators found out that the central banks are maintaining an over-valued currency then they will be subjected to a speculative attack. Soon they will flood the market with massive sales of the currency and this will create a condition where supply outstrips demand and eventually the collapse of the currency. The central bank will first try to counter the move by selling the dollar and buying up the local currency. However with such massive sales of the local currencies by the speculators, central banks will soon used up their holdings of their foreign reserves. Once their foreign reserve is exhausted then currency devaluation will continue. Such a move will always fail because the foreign exchange market is not only unregulated but also it trades about $4 trillion a day. No central banks succeed in defending their currency this way.

Another avenue is to raise the domestic interest rates. By increasing the interest rates it not only helped to prevent further capital outflow but also encourage capital inflow. However such a move will have an effect on the bank’s balance sheet because of the higher cost of funds to obtain funds. If left unchecked it will eventually lead to the collapse of the weakened banking sector. If they don’t increase the interest rates then they will not be able to maintain the currency peg which will eventually collapse. In other words the Government and Central Banks are in between a rock and a hard place.

So how do Central Banks counter such a situation? In our next article we will explore how the Malaysian Government used its monetary policy tools to help it stem the onslaught.    

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