Hot Money and the East Asian Currency Crisis.

My summary of the East Asian currency crisis of 1997. Fears about low international reserves relative to external debt undermined investor confidence in these countries. The resulting withdrawal of short term credit from overseas lenders created liquidity crises. Expectations of deteriorating macro-economic performance led to selling pressure on currencies and then speculative raids on government reserves as countries tried to defend the currency pegs that had brought prosperity over the previous decade.

The dynamics and consequences of disruptive international flows of capital can be seen in the East Asian crisis of 1997, involving South Korea, Thailand, Malaysia and Indonesia. The crisis affected each country differently, but all had liberalised their capital accounts to foreign institutional investors and lenders.[1] Importantly, the affected countries also maintained fixed or narrow band foreign exchange rate regimes prior to 1997, pegging their currencies to the US dollar (Gottschalk & Griffith-Jones, 2006). Attracted by sound macroeconomic fundamentals,[2] the ‘East Asian 4’ received very high levels of capital inflows in the 1990s, rising as a proportion of GDP to an average of 9.2% in 1995 and 1996. Crucially, the composition of these external liabilities was skewed towards to the short end, with 66% of total flows into these countries between 1989 and 1996 made up of foreign portfolio investments (15%) and short term international bank loans (51%).[3] The withdrawal of short maturity bank credit constituted 92% of the capital outflows from the four countries during the crisis, as foreign lenders stopped rolling over loans. In total, bank credit of $27.6 billion and $30.6 billion left the countries in 1997 and 1998, amounting to 18.6% and 26.6% of GDP (Cailloux & Griffith-Jones, 2006). The ensuing liquidity and currency crisis devastated economies. South Korea, Thailand and Indonesia experienced massive devaluations of 46%, 56% and 84% (Gottschalk & Griffith-Jones, 2006). This massively increased the foreign debt-to-GDP ratios of these countries, bankrupted firms exposed to overseas debt and deteriorated the balance sheets of domestic banks, leading to a contraction of domestic demand that was only partially offset by rising exports (Takagi, 2007). GDP growth in some cases did not return to pre-1997 levels for several years.[4]
 

Liberalising the capital account when financial sectors were still immature made these economies dependent on foreign credit and investment, making them vulnerable to massive capital reversals. However, exchange rate policy and devaluation fears were also major factors in the liquidity crisis. A surge in the dollar in 1996-7 appreciated the dollar-pegged East Asian currencies against those of non-dollar countries, worsening current account deficits at a time when levels of international reserves relative to stocks of external debt were low, reducing the ability of governments to defend their currency pegs.[5] With debt collateral and paper assets denominated in vulnerable currencies the prospect of devaluation exposed international banks and investors to increased default and portfolio risk. The resulting capital outflows increased the supply of domestic currency,[6] which combined with speculative attacks by hedge funds, investment banks and other actors forced these countries off their pegs (Gottschalk & Griffith-Jones, 2006). The ‘East Asian 4’ have since allowed their currencies to trade freely in international markets, but they have also built up massive reserve holdings in part to safeguard against future financial and currency crises.[7]

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[1] The term ‘capital account liberalisation’, often used in the literature, refers to the ‘financial account’ as discussed earlier.

[2] The countries were performing well in terms of GDP growth, fiscal deficits and inflation (Gottschalk et al, 2006, p292).

[3] The ratio of short term external debt to total debt was especially high in South Korea (57.5%) and Thailand (41.4%) (Gottschalk & Griffith-Jones, 2006).  

[4] Thailand and Indonesia did so in 2006 and 2004(Trading Economics, 2012).

[5] In 1997 short term foreign capital amounted to $101 billion in South Korea and $75 billion in Thailand, 3 and 2.4 times the size of reserves respectively. A 1:1 ratio between international reserves and stocks of external short term debt is considered sufficient to safeguard against liquidity crises (Gottschalk & Griffith-Jones, 2006).

[6] For example as domestic borrowers sold assets to buy foreign currencies to repay principals on unrenewed foreign loans.

[7] In 2007 South Korea held $240 billion in reserves (20 percent of GDP), Thailand $59.1 billion (9.9 percent of GDP), Malaysia holds $82.3 billion (62.2 percent). Prior to the crisis, most countries' reserve holdings were less than 10 percent of their GDP (Baker, 2007).