Seeds of disaster

SERIOUS MONEY:It is 10 years since the Asian financial crisis began to unfold with the collapse of the Thai baht on July 2nd, 1997.

Currency speculation spread rapidly and within weeks Indonesia, Malaysia, South Korea and the Philippines joined Thailand in its downward trajectory. The "crisis" countries informally pegged their currencies to the American dollar before the turmoil began and the greenback's upward trajectory, beginning in early 1995, led to the overvalued currencies that would lead to the region's economic collapse.

The fixed exchange-rate regimes proved extremely vulnerable to capital flight due to their unusually low ratios of reserves to short-term debt. Capital inflows, which had grown to $93 billion (€67 billion) or more than 8 per cent of GDP in 1996, became outflows of more than $12 billion within a year. The currency depreciations had devastating consequences on both domestic banks and their clients due to the prevalence of dollar-denominated liabilities while investments were denominated in local currencies.

The toll in both human and economic terms was substantial as the most affected countries experienced an almost 8 per cent drop in their economies, which was accompanied by a sharp increase in the number of people out of work.

The crisis did not go unnoticed in the Western world and in October as the problems reached Hong Kong, the Dow dropped by more than 500 points in a single trading session for the first time since "Black Monday" a decade earlier. The devastating crisis proved to be a temporary setback and by 2003, GDP in all of the affected countries had exceeded its pre-crisis level. Per capita incomes took a little longer to recover but had reached new highs in each of the crisis countries by the end of 2005.

Ten years on and Asia is among the star performers in the global economy. The worst-hit countries have recorded economic growth of 4 per cent per annum over the past decade despite the sharp economic contraction during the crisis period.

Each country runs a current account surplus as against the persistent and unsustainable deficits apparent in the mid-90s. Furthermore, the absolute amount of foreign exchange reserves today amounts to almost 20 per cent of GDP in the crisis countries and exceeds short-term debt by a substantial margin. This means that these countries are virtually immune to a repeat of the 1997 crisis.

The financial and corporate sectors in southeast Asia have regained a solid footing. Vigorous restructuring in the financial sector has reduced non-performing loans to more manageable levels while the once overleveraged corporate sector has substantially reduced its debt. Meanwhile, governments have adopted fiscal policies that take a longer-term perspective in order to safeguard debt sustainability.

Despite the impressive advances in recent years, Asian countries may well be sowing the seeds of their next crisis in the years ahead. Unfortunately, the floating exchange-rate regimes that were adopted in the midst of crisis have disappeared and the region has effectively returned to fixed exchange rates. Record surpluses have placed upward pressure on exchange rates and to maintain undervalued currencies, Asian countries have been accumulating foreign exchange reserves at a staggering pace.

The initial intervention was justified by the need to accumulate reserves and avoid the risk of renewed capital flight. However, continued accumulation is not warranted given that the current level of reserves exceeds short-term foreign currency debt in the "crisis" countries by a magnitude of four to five times.

The return to a fixed exchange-rate regime is leading to economic distortions. The undervalued currency promotes excessive reliance on export-led growth and punishes domestic private consumption by lowering the external purchasing power of the local currency. Not surprisingly, research confirms that income inequality has increased over the past decade while contrary to conventional wisdom the region is more dependent on growth in the industrialised world than ever before.

Rapid reserve accumulation keeps interest rates artificially low and causes excessive monetary and credit growth.

Easier monetary conditions lead to inflationary pressures. Real exchange rates are undervalued relative to their equilibrium level, and appreciation to that level can be achieved in one of two ways - a nominal appreciation or an increase in domestic inflation.

The adjustment looks set to arise through higher domestic prices since most countries prevent nominal appreciation. Excessive monetary growth also fuels asset bubbles, which increase the risk of a crash at some point.

Ten years after the east Asian crisis, the region is performing well and stock prices continue to record gains. Inflation is subdued despite five years of global growth. However, valuations are no longer appealing while exchange-rate policy is sowing the seeds of the region's next crisis.

charliefell@sequoia1.ie