Financial Crisis essay example
Instead the financial crisis has been transformed into a full-blown recession or depression. Moreover the threat of depreciation has spread from a few countries to many in the region, and is spreading to other areas such as Russia, South Africa, and possibly Eastern Europe and South America. The objective f this term paper is to analyze the o factors behind the east asian crisis o Background Financial liberalization o Policy implication. Back ground of Crisis.
The great debate on causes is whether the blame should be allocated to domestic policies and practices or to the intrinsic and volatile nature of the global financial system. In the first phase of the crisis, as it spread from Thailand to Malaysia, Indonesia, the Philippines, then to South Korea, the international establishment (represented by the IMF) and the G 7 countries placed the blame squarely on domestic ills in the East Asian countries. They cited the ill judgment of the banks and financial institutions, the over-speculation in real estate and the share market, the collusion between governments and businesses, the bad policy of having fixed exchange rates (to the dollar) and the rather high current account deficits. They studiously avoided blaming the financial markets, or currency speculation, and the behavior of huge institutional investors.
Although the cited weaknesses certainly existed, the view that these in themselves caused the crisis was difficult to sustain. For it implied that the 'economic fundamentals' in East Asia were fatally flawed, yet only a few months or even weeks before the crisis erupted, the countries had been praised as models of sound fundamentals to be followed by others. And in 1993 the World Bank had coined the term the East Asian Miracle to describe the now vilified economies. In an attempt to blame the crisis solely on the affected countries, intellectual 'flip-flops' were made. Features that had been toasted as strengths were overnight concerted into evils.
For example, the countries had been praised (indeed, over-praised) for having strong linkages between the public and private sectors. Today, that is totally condemned as the fatal flaw of crony capitalism. As an alternative to mainly blaming the countries, there rapidly developed another view of how the crisis emerged and spread. This view put the blame on the developments of the global financial system, with the combination of the following features: o Financial deregulation and liberalization across the world (as the legal basis); o The increasing interconnection of markets and speed of transactions through computer technology (as the technological basis); and o The development of large institutional financial players (such as the speculative hedge funds, the investment banks, and the huge mutual and pension funds). This combination has led to the rapid shifting of large blocks of short-term capital flowing across borders in search of quick and high returns, to the tune of US$2 trillion a day. Only one to two percent is accounted for by foreign exchange transactions relating to trade and foreign direct investment.
The remainder is for speculation or short-term investments that can move very quickly when the speculators' or investors' perceptions change. When a developing country carries out financial liberalization before its institutions or knowledge base is prepared to deal with the consequences, the it opens itself to the possibility of tremendous shocks and instability associated with inflows and outflows of funds. What happened in East Asia is not peculiar, but has already happened to many Latin American countries in the 1980's, to Mexico in 1994, to Sweden and Norway in the early 1990's. They faced sudden currency depreciation's due to speculative attacks or large outflows of funds. A total of US$184 billion entered developing Asian countries as net private capital flows is 1994-96, according to the Bank of International Settlements. In 1996, US$94 billion entered and in the first half of 1997 $70 billion poured in.
But with the onset of the crisis, the inflow suddenly shifted into reverse gear: $102 billion went out in the second half of 1997. The massive outflow has continued since. These figures help to show: (i) how huge the flows (in and out) can be; (ii) how volatile and sudden the shifts can be, when inflow turns to outflow; ( ) how the huge capital flows can be subjected to the tremendous effect of 'herd instinct,' in which a market opinion or operational leader starts to pull out, and triggers or catalyses a panic withdrawal by large institutional investors and players. In the case of East Asia, although there were grounds to believe that some of the currencies were over-valued, there was an over- reaction of the market, and consequently an 'over-shooting' downwards of these currencies beyond what was justifiable by fundamentals. It was a case of self-fulfilling prophecy. It is believed that financial speculators, led by some hedge funds, were responsible for the original 'trigger action' in Thailand.
The Thai government used up over US$20 billion of foreign reserves to ward off speculative attacks. Speculators are believed to have borrowed and sold Thai baht, receiving US dollars in exchange. When the baht fell, they needed much less dollars to repay the baht loans, thus making large profits. The active role of hedge funds in the initial phase of the crisis seems to be confirmed by a report in Business Week in August 1997 that revealed that hedge funds made big profits from speculative attacks on Southeast Asian currencies in July 1997. In some countries, the first outflow by foreigners was followed by an outflow of capital by local people who feared further depreciation, or who were concerned about the safety of financial institutions. This further depreciated the currencies.
The sequence of events leading to and worsening the crisis included the following. Financial liberalization Firstly, the countries concerned carried out a process of financial liberalization, where foreign exchange was made convertible with local currency not only for trade and direct-investment purposes but also for autonomous capital inflows and outflows (i.e. for 'capital account' transactions); and where inflows and outflows of funds were largely deregulated and permitted. This facilitated the large inflows of funds in the form of international bank loans to local banks and companies, purchase of bonds, and portfolio investment in the local stock markets. For example, the Bangkok International Banking Facilities (B IBF) was set up on March 1993, to receive foreign funds for recycling to local banks and companies, and it received US$31 billion up to the end of 1996. South Korea recently liberalis ed its hitherto strict rules that prohibited or restricted foreign lending, in order to meet the requirements for entering the OECD. Its banks and firms received large inflows of foreign loans, and the country accumulated US$150 billion of foreign debts, most of it private-sector and short-term.
In Indonesia, where the financial liberalization process has also taken place in the past decade, local banks and companies also borrowed heavily from abroad. Currency depreciation The full extent of the three countries' external debt was only revealed after the crisis had broken out. It was later found that The debt levels had climbed rapidly to dizzying heights: about US$150 billion for South Korea and Indonesia, and about US$100 billion for Thailand. Most of the debt (especially for Korea and Thailand) was contracted by the private sector. In particular, the build-up of short-term debts was becoming alarming. What transformed this debt build-up into a major crisis for Thailand, Indonesia and South Korea was the sharp and sudden depreciation of their currencies, coupled with the reduction of their foreign reserves in anti-speculation attempts.
When the currencies depreciated, the burden of debt servicing rose correspondingly in terms of the local-currency amount required for loan repayment. That much of the loans were short-term was an additional problem. Foreign reserves also fell in attempts to ward off speculative attacks. The short-term foreign funds started pulling out sharply, causing reserves to fall further. When reserves fell to dangerously low levels, or to levels that could not enable the meeting of foreign debt obligations, Thailand, Indonesia and South Korea had to seek IMF help.