Causes of the Asian crisis
Several earlier currency crises, notably those in Latin America in the 1980s, occurred in the context of modest growth and large fiscal deficits, which then led to growing external debt and high inflation. By contrast, most Asian economies enjoyed strong macroeconomic fundamentals before the crisis. Gross domestic product and investment grew at high rates, and inflation, fiscal deficits, and government debt were low by international standards.
In Asia, Roubini suggested, the key weaknesses were in the private sector. He cited poor corporate structures (in which the focus too often was on increasing scale and market share rather than on economic returns), weak supervision and regulation of the financial system, connected and directed lending, and implicit and explicit guarantees of financial institution liabilities that created a degree of moral hazard. Weaknesses in the private sector contributed to a lending boom and an overinvestment in risky projects, such as real estate, with low profitability.
Domestic and international capital liberalization may have aggravated existing distortions. Domestic capital liberalization permitted increased borrowing for speculative purposes, which, in turn, led to asset price bubbles. International capital liberalization allowed domestic banks and firms to rapidly increase their borrowing in international markets at low interest rates.
Korea’s experience, Roubini said, illustrated his arguments. Excessive investment by the chaebols (the large conglomerates that dominate the Korean economy) had been facilitated by the chaebols’ control of financial institutions and the government’s policy of directing lending toward favored sectors. Profitability in Korea’s auto, steel, shipbuilding, and semiconductor industries dropped, and the corporate sector became more highly leveraged. The top 30 chaebols saw their average debt-to-equity ratio rise to more than 300 percent by the end of 1996, while return on capital fell below the cost of capital for two-thirds of the top chaebols in 1997.
Roubini also noted the problematic role that the exchange rate peg of the Asian currencies to the U.S. dollar (or to a basket of currencies where the U.S. dollar had a large weight) played in touching off the crisis. As negative terms-of-trade shocks hit Asia and as the U.S. dollar appreciated during the 1990s, Asian currencies became overvalued, and large external current account deficits emerged. Compounding matters, short-term unhedged foreign currency borrowing provided most of the financing for these deficits, as the fixed exchange rate regimes encouraged domestic corporations and banks to borrow externally without due regard for the possible currency risk.
Emergence of a “twin” crisis
When the bubble burst in 1997, a “twin” crisis emerged in Asia, meaning that the currency crisis was accompanied by a crisis in the banking and financial sector. Similar twin crises also occurred in Mexico, Russia, and Turkey. In all countries, Roubini observed, a vicious circle quickly emerged, as the depreciation of the currencies exacerbated weaknesses in the financial sector, which in turn fueled further capital outflows and pressure on the exchange rate.
Even before the emergence of a crisis, low profitability in the corporate sector had weakened the financial system, saddling it with a large and growing number of nonperforming loans. With the onset of the crisis, Roubini said, many financial institutions and corporations also found themselves with severe currency and maturity mismatches on their balance sheets. Liabilities were largely in foreign currencies and of short maturities, while assets were mostly in a domestic currency and of longer maturities.
When the Asian currencies started to depreciate rapidly, the domestic currency value of their external debt rose, resulting in severe distress in both the corporate and banking sectors. Currency and stock markets may also have overreacted, Roubini noted. Panic, herd behavior, and a general increase in risk aversion among investors fueled large capital outflows. This, in turn, exacerbated pressure on the currencies and caused liquidity problems for the banks. Moreover, as panic set in, the depreciations became exaggerated and the currencies overshot levels warranted by fundamentals, causing further stress on the financial sector and the corporations. The severe problems associated with the balance sheet mismatches also help to explain why the sharp depreciation of the currencies contributed to a severe recession in Asia.
Roubini also examined how the emergence of a currency crisis in one country can quickly result in similar crises in other countries. A number of factors can explain this contagion effect, he said, including neighboring countries devaluing their currencies to stay competitive, investors reassessing risks in countries with similar structural vulnerabilities, and international banks reducing their total exposure to a wide range of emerging market economies as they incur losses in one country.
Roubini downplayed irrationality as the chief instigator of contagion. It can be very costly for an investor to acquire complete country-specific information. Indeed, investors may rationally decide not to acquire such costly information, as a well-diversified portfolio tends to reduce the overall risk. Moreover, a certain degree of herd behavior among fund managers could be expected, as their remuneration may be based in part on the fund’s performance relative to benchmarks, which discourages unconventional investment strategies.
IMF’s role, lessons to learn
Did IMF-supported programs exacerbate the problems of the crisis countries or help restore confidence and growth? On balance, Roubini viewed IMF-supported programs as well designed. Some critics argued that tight monetary policy and high interest rates worsened the crisis and led to further falls of the currencies, but he countered that restoring confidence and preventing a currency free fall required a period of high interest rates. He said there was no evidence that easier monetary policy would lead to an appreciation of a currency in a panic situation. And considering the severe balance sheet problems in Asia, he added, sharper currency depreciations would have exacted a higher cost than temporarily high interest rates did.
There is a general consensus, Roubini said, that fiscal policy might have been a bit too tight in Asia relative to the fall in output. But even this consensus is subject to a few caveats, he noted. First, the fall in output was larger than expected, and fiscal policy was eased once the recession emerged; second, the fiscal costs of the banking crises were large, and fiscal policy was consequently more expansionary than perceived; and, third, additional fiscal stimulus would probably have had only a small effect on output while not restoring investor confidence.
The Asian crisis yielded two important lessons. An emerging market economy that unilaterally pegs its currency to, for example, the U.S. dollar can hope to anchor inflation expectations and avoid excessive exchange rate volatility. But the Asian crisis showed that such a regime is fragile. The peg does not necessarily provide monetary and fiscal discipline and can lead to an overvalued currency and a widening of current account imbalances. Moreover, a pegged rate may encourage excessive foreign currency borrowing, as the perceived exchange rate risk is deceptively small. It is preferable, he indicated, to let the currency float or adopt a hard fixed exchange rate regime akin to a monetary union.
The second lesson highlights the importance of avoiding balance sheet mismatches in the private sector. The Asian crisis experience vividly demonstrates that the vulnerabilities triggered by currency or maturity mismatches can exacerbate the negative effects of a shock to the economy even when overall macroeconomic fundamentals appear sound. Still, it should be remembered, Roubini suggested, that some countries may have to run current account deficits as they grow, so the question remains how such deficits could best be financed. Asia’s experience suggests that if the deficits are financed through external borrowing in foreign currencies, it is important that the banks and corporations hedge their exposures. Admittedly, comprehensive hedging might prove difficult and complicated at times, he said, especially for long-term borrowing in countries with less-developed financial markets. For these reasons, he concluded, foreign direct investment remains the best financing alternative.