 The currency crisis in Asia
Probably because Thailand had relatively high portfolio flows, it is here where the crisis first began. By 1996 Thailand was in current account deficit on the balance of payments. Export growth was zero and the stock market was overvalued. When the crash came, Thai banks and finance companies had serious problems with loans which they had made, which now could not be enforced and became worthless assets. In May 1997 there was serious speculation on the value of the baht, and when it was floated its value immediately fell. Eventually agreement with the IMF was reached on a loan package. The conditions imposed on Thailand were strict monetary and fiscal policies, though Thailand had in any case always been fairly conservative in its budgetary policy. The Thai crisis was not the same as the
Latin American crises where fiscal imprudence had been an important contributory factor. Significantly, in Thailand strict controls were imposed on finance companies. Over fifty such companies were suspended before the IMF agreement was signed.
The role of financial intermediaries in the East Asian financial crises became very apparent when the Thai bubble burst. Essentially:
Financial intermediaries in emerging markets had been perceived by investors to be guaranteedin some way by their governments, but this was not the case.
In practice financial intermediaries were unregulated. They often engaged in very risky lending operations.
Excessive lending to risky ventures by financial institutions had brought about
inflationofassetprices.
High asset prices made financial intermediaries appear more profitablethan they were in reality.
The combination of high asset prices, deceptively ‘profitable’ intermediaries and perceived guarantees proved just too tempting for many investors. The circulatory
nature of the process explains the severity of the crisis when the bubble eventually burst. Then:
Falling asset prices made the insolvency of the financial intermediaries very apparent.
The intermediaries promptly ceased trading.
Asset prices collapsed.
A financial crisis developed.
We can see, therefore, how portfolio behaviour – the desire of an agent to diversify a portfolio overseas in order to gain high returns at minimum risk – could end in a currency crisis and an outflow of capital. These are the underlying processes and sequences of events which are common to all recent financial crises.
 It is also true that every crisis has its own special features. This was strikingly so in the Russian crisis of 1998, as this section demonstrates.
The 1998 Asian crisis had proved to be the final blow to the wavering Russian economy. The Asian crisis had resulted in a dramatic fall in Russia’s crude oil prices. They halved in the first six months of 1998. Confidence in the value of the rouble rapidly evaporated. By June of 1998 Russia’s domestic interest rates had soared. The Russian government was obliged to pay over 100 per cent interest on its rouble- denominated loans. Meanwhile, capital was fleeing the country.
An IMF rescue package was agreed in July 1998, but within weeks Russia had suspended IMF loan payments and devalued the rouble. This was a unilateral move which quickly sparked off a world crisis, deepening problems in Brazil which was already suffering a serious currency depreciation, and then spreading out to Argentina, Ecuador and Colombia (2001–2).
The Russian crisis is an interesting case study showing how vulnerable the former planned economies were to capital reversals. Stiglitz, the Nobel prizewinning econo- mist, was chief economist at the World Bank when the Russian crisis hit. In his book GlobalizationanditsDiscontentshe describes the Russian economy as a ‘rickety tower’ which collapsed when oil prices fell. Capital flows into Russia were domi- nated by large official flows (on average $3.5 billion during 1993–6) and a surge in private portfolio inflows in the form of purchases of Treasury bills in 1996. But the fundamentals of the economy were weak: an overvalued exchange rate, corruption (the World Bank had identified Russia as the most corrupt region in the world), legal uncertainties and economic mismanagement. In Stiglitz’s view, IMF policies had led Russia into deeper debt. Macro-economic failures compounded the problem, contributing to the enormity of the decline.
Examining the events leading up to the Russian crisis of 1998, it is by no means clear that the private capital flows which went into the economy during the 1990s could
ever be rationalised by economists in terms of portfolio theory and diversification. As Stiglitz argues (2002):
Russia was a nationally resource rich country. If it got its act together, it didn’t need money from the outside; and if it didn’t get its act together, it wasn’t clear that any money from the outside world would make much difference.
In the end, of course, the IMF rescue package failed. When payments were sus- pended and the rouble was devalued, significant amounts of IMF money allegedly fled the country and turned up in foreign banks. Russia’s erstwhile investors also repatriated as much capital as they could salvage from the wreckage.
Could any of this have been predicted? Although Russia received large capital inflows during the period 1990–7, a study of the Russian balance of payments indi- cates even to the non-specialist that there were large errors and omissions. Attempt- ing to reconcile current account balances, official flows and reserves leads to the conclusion that even in the early 1990s there were large unrecorded private capital outflows. Capital was already fleeing the economy in the early 1990s. The overvalued exchange rate was just one of the factors encouraging capital flight. More important, perhaps, was the underlying social and political culture. As funds came in, they were more than matched by the funds flowing out.
 Economists (and investors) have sought to answer the question as to why turbulence in one capital market tends to spread to others. The phenomenon is referred to as ‘contagion selling’ of assets, or simply ‘contagion’.
The contagion effect has been observed in all financial crises:
In Mexico during the 1994 crash it was referred to as the ‘tequila effect’. Investors reduced not only their exposure to collapsing Mexican assets, but also their expo- sure in other vulnerable markets such as Argentina and Brazil, as well as in coun- tries such as Chile which were widely believed to be relatively safe.
In the Asian crisis of 1997, capital outflow spread to Korea, a country which was initially believed to be far removed from any potential crisis. Korea held out until November 1997, at which point its currency came under heavy pressure. Foreign banks which had made loans to Korean banks started to withdraw their lending. By December 1997 Korea was obliged to agree an IMF assistance package. Inter- estingly this did not bring to an end the liquidity crisis. Eventually the monetary authorities in G-7 countries were obliged to put pressure on their commercial banks to maintain lending to the Korean banks. This marked the beginning of the end of the crisis in Korea.
In Russia in 1998 the collapse of the rouble had widespread implications for equity markets throughout the world. Even on the US stock market there was a ‘run for quality’, though the real-world exposure of the US economy to Russia’s collapsing currency was very minimal.
It is always possible that contagion occurs simply because countries have important ‘fundamentals’ in common. Local events in one country are symptomatic of wider problems. Problems emerge in one financial market and it is only a matter of time before they become apparent in other markets. A number of studies have concluded that the common ‘fundamentals’ in emerging markets are fiscal indiscipline and exchange rate mismanagement. The World Bank has suggested that closer policy co-ordination among the principal economies in a region might keep exchange rates in check and permit earlier action to contain a crisis. Co-ordination we now know must also extend to financial markets and particularly to regulation. Banking practices in emerging markets need to comply with the global rules for prudent banking behaviour established by the Basle Accord.
 When investors and fund managers react similarly to financial crises, at more or less the same time, the suspicion is that they are behaving like a ‘herd’. They rush into new markets without appropriate information and pull out as soon as crisis threatens. By acting like a herd, markets are destabilised and volatility increases.
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