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Analysis and Commentary
From the 1960s to the early 1990s, many southeastern Asian nations — including Thailand, South Korea, Indonesia, Malaysia, and the Philippines — experienced a long period of prosperity dubbed the “Asian Miracle.” This strong growth continued through the 1980s and early 1990s. In the 10 years preceding the crisis of 1997, Asian economies experienced robust growth (according to World Bank Statistics[1]). For instance, Thailand’s GDP growth rate averaged 9.5%, South Korea’s averaged 8.7%, Indonesia’s averaged 6.5%, and Malaysia’s averaged 9.1%. Exports were even more robust. In this same period, Thailand’s export growth averaged 15% annually, South Korea’s averaged 12.2%, Indonesia’s averaged 9.0%, and Malaysia’s averaged 14.9%. With such perennially strong growth rates, these countries came to be known as “Asian Tigers.”
Many of these countries achieved their growth by using some variant of the “infrastructure growth model” (sometimes known as the “mercantilist model”). In this approach, the countries invested heavily in manufacturing, exports, technology, and infrastructure while coupling these investments with abundant cheap labor. To protect their fledgling industries, many of them also pegged their currencies to the value of the US dollar.
Thailand, for example, first pegged its currency to the US dollar in 1956. Under a free-floating exchange rate regime, if enough foreigners either invest in or purchase goods and services of a particular country, the price of that country’s currency gets bid up. The escalating price of the currency then slows down the growth of that country’s foreign investment and exports thereby creating balance. However, when one country’s currency is pegged to another country’s currency, the balancing mechanism of floating exchange rates is suspended — until the point when economic forces overwhelm the central bank managing the pegged exchange rate. Hence, countries using fixed exchange rates create imbalances by overbuilding their export industries, by taking in too much capital, by taking on too much debt, and so on. So, in the case of the Asian Tigers, fixing their currencies to the US dollar provided exchange rate stability, albeit temporarily, and ensured that their export products maintained competitive prices within their end markets — particularly, the United States.
During the late 1980s and early 1990s, many of the Asian Tiger economies began to experience the economic imbalances brought on by their fixed exchange rate regimes. So, in some cases they abandoned the currency peg in favor of a managed exchange rate. By the time the crisis erupted in Asia in 1997, there were essentially two kinds of countries in the area, namely, those with currencies pegged to the US dollar and those with currencies partially pegged to the US dollar (through managed exchange rates). Nevertheless, the managed exchange rates used by South Korea and Indonesia, for instance, still prevented these economies from maintaining balance. So, the managed exchange rate regimes created similar problems to the fixed exchange rate regimes: nonmarket exchange rates create macroeconomic imbalances. The difference is only one of magnitude.
Pegging a currency also more closely aligns the monetary, trade, and even geopolitical policies of the pegging country with the “peggee” — in this case, the United States. So, in 1985, when the United States entered into the Plaza Accord (with France, the United Kingdom, West Germany, and Japan) to weaken the value of the US dollar on international exchange markets in the hopes of correcting burgeoning trade imbalances in the US, the currencies of the Asian Tiger markets were also affected by the US move (due to their respective currency pegs). As a backdrop, note that the US dollar had been appreciating sharply in the early 1980s. As the dollar rose, US manufacturers found themselves less competitive in world export markets, and consequently, the US current account deficit grew to roughly 3.5% of GDP.[2] On the flip side, Japan and Germany experienced large and growing current account surpluses.
In the 18 months after the Plaza Accord, the US dollar declined by about 50% and took all the pegged currencies with it, including, among others, the Thai baht, the South Korean won, the Indonesian rupiah, and the Malaysian ringgit. The lower dollar stimulated not only US exports but also the export-driven economies of the pegged Asian Tigers. Obviously, the exchange rate between the two currencies in a peg (e.g US$ and Thai Baht) can remain fixed indefinitely. However, the exchange rates between the local currency (Thai baht) and other countries (e.g. Japanese yen) may change substantially, with a large impact on trade levels and current account balances in a given country.
Many Asian Tiger markets were too immature to raise adequate capital to finance their growth internally and thus relied heavily on foreign capital. The pegged currencies likely amplified the interest of foreign investors and lenders, who were enticed by the promise of limited currency risk. Similarly, the pegs influenced many local Asian issuers to borrow money in US dollars (and some other currencies) because interest rates in more liquid currencies were lower and funding markets could provide more capital. Naturally, dollar-denominated loans needed to be repaid in US dollars, so these local [Asian] borrowers, rather than the investors, assumed the currency risk.
As capital flowed into the Asian Tiger markets, much of it found a home in the export sectors or in financial markets. Large markets, such as the United States, were importing substantial amounts of goods produced elsewhere, while foreign investors, such as large multinational companies, attracted by the cheap labor, were investing in the Asian Tiger economies. In 1993, the US Fed Funds Rate was at 3%, whereas comparable interest rates — in Thailand, for instance — were about 9%. Many investors saw the spread in interest rates as a way to increase returns. The inflow of capital led to a rapid expansion of money supply and credit in these markets, which contributed materially to their booming economies. For instance, in the 1993–96 period, Indonesia, Thailand, Malaysia, and the Philippines each experienced money supply growth in excess of 20% per year. Central banks in these countries had to issue substantial amounts of new currency to help prevent the local currencies from appreciating against the US dollar. Of course, the Asian central banks could have chosen to float their currencies at any time. Throughout the decade leading up to the crisis, the pressures on the Asian Tiger markets to float their currencies were accelerating, yet many invested as if the pegs and managed exchange rates would remain in place. The status quo is a powerful force in shaping the perception of market participants and, ultimately, market prices. In the case of Thailand, the peg to the dollar began in 1956 and remained in place (at various levels) until 2 July 1997, a full 41 years. Moreover, the power and authority of the state also adds to the appearance of certainty for many investors.
In late 1995, the United States adopted the so-called Reverse Plaza Accord, whereby the US Federal Reserve coordinated monetary policy with Japan and Germany to increase the value of the dollar and decrease the value of the yen (and mark). This escalation in the value of the dollar was a pivotal moment for what became known as the “Asian Contagion.” Over the 1995–97 time frame, the yen fell approximately 60% against the US dollar, making Japanese exports much cheaper on the international export market — and, naturally, much more competitive against exports from Asian Tiger countries that were still pegged to the (now rapidly appreciating) US dollar.
By early 1997, the Asian Tiger economies were confronted with a choice: (1) Do nothing, and watch their exports become much less competitive as the US dollar appreciated but be better be able to pay their US dollar–denominated debts or (2) break the peg to the US dollar, devalue their currencies, and resume their export growth. In the second choice, the Asian Tigers could recover much of their lost competitiveness, even though their US dollar–denominated obligations became much more costly. This choice wasn’t merely a theoretical exercise. The new currency levels were sharply hurting the Asian Tiger economies, whose exports and economic activity were faltering across the board. The currency markets astutely sensed the dilemma and, despite official pegs to the dollar, began selling the domestic Asian currencies.
The last line of defense for a government trying to maintain a currency peg (or collar) in the face of selling pressure is to sell its foreign currency reserves to purchase its home currency on the currency markets. However, this game lasts only as long as a country’s foreign currency reserves do. In May 1997, intense selling pressure erupted against the Thai baht; quoted exchange rates departed sharply from the government’s “official” exchange rate of 25 baht to the US dollar. The market sensed the growing imbalance between the “strength” of the pegged currencies and the growing weakness in the underlying economies. On the balance sheet, the Bank of Thailand’s foreign reserves had fallen from $37.2 billion in December 1996 to $30.9 billion by June of 1997 (Moreno 1998). Off the balance sheet, however, the Bank of Thailand was rapidly accumulating obligations to deliver baht in the forward markets; the total was as much as $23.4 billion by August 1997. So, in reality, the net foreign currency reserves in Thailand were much lower than the official reports (Moreno 1997).
As the selling pressure quickly overwhelmed the Thai government’s (failing) efforts to maintain the currency peg, another powerful lesson was demonstrated. In the very long run, market power exceeds government power. Nevertheless, in the short and medium term, the opposite is typically true. Governments can force industries to set prices that depart from supply and demand equilibrium for just about any product, service, or market. Policy can constrain supply or enhance it. Similarly, it can constrain demand or enhance it also. Whatever the case, government interventions create nonmarket prices and tap into nonmarket levels of supply and demand. Regardless of whether you view the government interventions as worthwhile, nonmarket prices often create imbalances in supply and demand that eventually must be rebalanced. The correction can manifest itself in supply and demand within the industry, in asset prices (or markets), in interest rates, or in currency values.
On 2 July 1997, Thailand officially broke the peg and allowed the price of the Thai baht to be determined by the market. Before the crisis broke out, the Thai baht traded at roughly 25 baht to the US dollar. After Thailand broke the peg, the currency traded (by October of 1997) as high as 53 baht to the dollar — meaning that it fell more than 50% in just three months. Once Thailand broke its peg, the markets swooned and other countries with financial profiles similar to Thailand’s, particularly those with pegs to the US dollar, became similar targets. The selling pressure moved first to the Philippine peso. Just two weeks after Thailand broke the peg, the Philippines broke its peg to the US dollar. Then, on 14 August 1997, Indonesia broke the rupiah’s peg and the currency immediately fell by 30%. By November 1997, South Korea had solicited and received a $57 billion bailout package from the IMF. The crisis rippled through all similar currencies, including those of non-Asian countries that had comparable financial profiles, such as Brazil and Russia. Hence, the phrase “financial contagion” was born. Ultimately, the IMF stepped in to provide financial support for these governments, to help arrest the capital flight, and to support continuity in local markets.
[1] The World Bank, GDP Growth by Country 1961 — 2015.
[2] Federal Reserve Bank of St. Louis Economic Research
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