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Lessons from past: The Asian Financial Crisis - Views on News from Equitymaster
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  • Mar 25, 2009

    Lessons from past: The Asian Financial Crisis

    In the previous article, we discussed about the dot com bubble. Dot com companies believed that the internet business would somehow instantly take off and the entire business landscape will change in a very short span of time. The hype didn't live up to its promises. Unfortunately, the growth of the tech sector proved to be illusionary and the dot com bubble burst in the year 2001. In this article, we will discuss about the 'Asian Financial Crisis', which engulfed most of the South East Asian countries in the 1990s.

    The Asian Financial Crisis
    The economies of Thailand, Malaysia, Singapore, Indonesia, Hong Kong, and South Korea, were posting some of the most impressive economic growth rates in the world during 1980 to 1990. Their Gross Domestic Product was compounding by 6% to 9% per annum during this period. A combination of inexpensive and relatively well educated labor, export orientation, falling barriers to international trade and heavy inward investment by foreign companies led to this impressive growth.

    The wealth created by these countries fueled an investment boom in commercial and residential property, industrial assets, and infra-structure. However, this unprecedented investment boom was mostly financed with borrowed money. Furthermore, the investments were made on the basis of unrealistic projections about future demand. Very soon this resulted into significant excess capacity, which in turn led to a significant decline in prices. The companies that had made the investments started groaning under huge debt burden that they were now finding difficult to service.

    By the mid 1990s, imports in these countries started growing dramatically, mainly aided by the investments in infrastructure, industrial capacity, and commercial real estate. This growth in imports moved the current account of their balance of payments into the red. To make matter worse, most of the borrowing to fund these investments had been in US dollars, as opposed to local currencies.

    The growing deficits made it difficult for the governments of these countries to maintain the peg of their currencies against the US dollar. If that peg could not be held, the local currency value of dollar dominated debt would increase, raising a large scale default on debt service payments.

    The Asian meltdown began in early 1997 in Thailand with a Thai property developer announcing its failure to make a scheduled US$ 3.1 m interest payment on an US$ 80 bn eurobond loan. This incidence raised the red flag and the Thai market started falling. Very soon the crisis percolated into the currency market. Thailand's growing current account deficit and dollar denominated debt burden increased demand for dollars in Thailand and simultaneously decreased demand for Baht. Taking advantage of the situation currency traders began a concerted attack on the Thai currency. At that point of time, the Thai baht had been pegged to the US dollar at an exchange rate of around US$ 1=Bt 25. With this concentrated attack on Thai baht, the peg became difficult to defend. In order to defend the peg, the Thai government used its foreign exchange reserves to purchase Thai baht. The cost to defend the peg was US$ 5 bn, but Thai central bank had locked up most of Thailand's foreign exchange reserves in forward contracts. Thus, Thailand only had US$ 1.14 bn available foreign exchange reserves left to defend the dollar peg. Ultimately, the Thai government had to bow down to the inevitable and the government allowed the baht to float freely against the dollar. The baht immediately started a slide. Following the devaluation of the Thai baht, a wave hit other Asian currencies and in a short spans of few weeks the Malaysian ringgit, Indonesian rupiah and the Singapore dollar all nosedived one after the other and the entire region was gripped by the crisis. These countries lost a decade of economic progress due to this crisis.

    The region had been promoted by many as the future economic engine of the world economy. Investors have invested billions of dollars in the region on the assumption that the rapid growth of the last decade would continue. But it came grinding to a halt.

    It once again proved that during periods of abundant capital, there is an often-irresistible temptation to anchor to false beliefs. This strategy may bear fruit for a while, but is costly over the long haul.



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