What lessons can be learnt? “A financial crisis is “a situation where the supply of money is outpaced for the demand of money” (buisnessdictionary. com). It is necessary to first distinguish the three principal types of crisis which can be experienced individually or as a result of each other. The first type of crisis could be a banking crisis wherein people lose confidence in their banking system and systematically withdraw all of their savings.
The second is an exchange rate crisis where inhabitants become worried about the strength of their currency and exchange it – in the context of this essay, into dollars. Thirdly is an external debt crisis which commences from an increase in foreign debt and no more loans are provided to a country as there is some perceived doubt that they will not be able to guarantee investment. The East Asian crisis is particularly astounding as it attacked some of the fastest growing economies.
After such rapid growth in capital often described as the “Asian Miracle” how did a crisis in East Asia occur when the region had so much promise? The miracle that had occurred created a region rife with over investment and the success of the economies was taken for granted. Primarily, signs of the crisis started to emerge in Thailand with the collapse of their currency – the “baht” and it then became pegged to the US dollar. The crisis is now at an end but mainly due to the errors of the International Monetary Fund (IMF), it could take years for these countries to get back to their previous economic conditions. … IMF policies not only exacerbated the downturn but were partially responsible for the onset…” (Stiglitz 2002, pp 89) East Asia didn’t actually need any additional capital that they were pressured into receiving. South Korea for example was a region that had experienced admirable growth but realised the necessity for some deregulation or liberalisation. The US treasury believed the system of liberalisation implemented by South Korea was too slow and the treasury made the decision to speed up liberalisation for maximum profit making opportunities. The main cause of this crisis was extreme capital market and financial iberalisation pushed on East Asian regions by the IMF. South East Asian countries did not fully comprehend the policies in place so this also had a role in worsening the crisis. The IMF made the serious mistake of not researching the countries in which they were trying to help so policies implemented were generic and not specific. Eventually however, the World Bank was persuaded to do some research on the region of East Asia which was named “The East Asian Miracle” wherein East Asia saved and invested wisely and did not follow any advice of the Washington Consensus. However, the IMFand Treasury made their most profound mistakes in their initial response to the crisis” (Stiglitz, 2002, pp 104). The IMF badly diagnosed the problems in East Asia and understood the issues as being far more severe than they actually were. It can be debated that a further root of the East Asian Crisis was a weakness in the financial system and irresponsible lending. This risky lending is also known as “moral hazard” meaning loans were provided by banks knowing that little of their own money was being put at risk.
Therefore, financial institutions had no incentive to reduce this risky lending as they did not have to face the consequences. The value of the floating currency fell and was no longer pegged to the US dollar. To a large extent, financial institutions became weak through foreign exchange risks. Economies such as Korea started to reluctantly permit their companies to borrow money from abroad. Suddenly these institutions that had been so willing to lend money originally were demanding repayment but unfortunately these developing countries did not have the reserves available to pay such liabilities.
Speculative attackers also impacted the contagion and took advantage of the situation by trying to devalue the currency in order to make monetary gains. Government tried to fend off these attacks by buying up local currency until no reserves remained. Meaning the local currency eventually becomes devalued. Speculators make a profit by converting their money at the right point so that there were more “baht” to every dollar. The IMF responded as always and provided countries affected with large bail-outs in order to level out the exchange rate. The money was in reality used to pay back some of the loans aken out from the Western world. “It was thus, in part, a bailout to the international banks as much as it was a bailout to the country; the lenders did not have to face the full consequences of having made bad loans” (Stiglitz, 2002, pp95). The IMF added to the crisis by imposing a higher interest rate and strict monetary and fiscal polices in an aim to attract investors. In reality, many companies were highly leveraged and were at risk of failure with fluctuating interest rates. Inevitably, this higher interest rate resulted in many bankruptcies and put the region into deeper recession.
The higher inflation rate even forced capital out of the country! These IMF policies not only had negative effects in one country but brought down its neighbouring countries too. As one country reduced its imports from local countries contagion was enabled to spread also known as the “Beggar thy neighbour” policy. This is where the term “contagion” became more widely used to explain the rush of financial stability through East Asia. The contagion was exported to neighbours through increased Globalization which opens up barriers and in this case, created vulnerability.
These countries were asked to cut their trade deficit and increase trade surplus by increasing exports or reducing imports. Reducing imports was the only viable option so this went ahead and sparked a worldwide recession. The downturn was again being spread to neighbour countries and slow economic growth created a slump in commodity prices. As the crisis deepened the IMF proposed a need for “Restructuring” which was a priority but, as with all the other IMF policies, it merely succeeded in worsening the crisis. The East Asian crisis is now at an end and most Asian countries have become strong again.
However, crucial mistakes were made by the IMF and the East Asian regions consequently took longer to recover. The second crisis I shall be analysing is that of Argentina which was viewed as one of the great countries in the Latin American continent until the late 1980’s when macro economic factors caused the strong economy to collapse. The events which occurred during this time were triggers of the crisis that began in 1997. Excessive Government spending during this period meant too much money was being printed as levels of inflation reached 5000% so Government corruption played a large role in over-spending.
The Washington Consensus was then followed in an effort to restructure the economy. The Government then made the decision to peg the Argentine Peso to that of the US dollar hoping this would improve confidence and prevent hyperinflation. “At the time, the strategy worked, but in time Argentina suffered the disadvantages of such a fixed peg” (news. bbc. co. uk). Argentina had adopted a currency with an exchange rate which displayed little in common with their economy. Effectively, Argentina had given away any control they had had over their monetary policies.
The interest rate could not be altered and the exchange rate wouldn’t be perceived as competitive. Furthermore, overspending on behalf of the Government and a pegged exchange rate meant Argentina was neither attractive nor competitive to investors. The next big thing to have an effect on the Argentine economy was known as the “Tequila crisis” which occurred in Mexico with the collapse of their currency and resulted in making Argentina’s exports very expensive in comparison with its neighbours. The result of course was bankruptcies. The IMF gave funds to Argentina and growth did start to recover for a minimal period.
However, this fund could not alter the fact that Argentine export levels continued to drop due to lack of competitiveness. Following this blow, came the devaluation of Brazil’s currency which naturally had further damaging effect on Argentine exports. Argentina’s neighbours benefited from a floating exchange rate meaning that the value of their currency depended upon market conditions. Argentina’s exchange rate was unfortunately pegged to the US dollar. “Moreover, as the peso was pegged to the dollar, it was overvalued when compared to its neighbours in the region making Argentina’s exports uncompetitive in world markets” (jstor. rg). Consequently a large trade deficit arose hand in hand with increased unemployment. Further loans in dollars were taken out by Argentina at this point which just increased the high foreign debt burden they already held. Many companies had to be privatised which resulted in higher priced products and services therefore dampening product demand. Privatisation was not necessarily a bad strategy but in the short term did start a recession. Argentina had been left virtually powerless so altering fiscal policy was the only method that could be taken to better the situation.
The Government continued to spend excessive proportions during this time and the continual increase in foreign liabilities meant the level of debt was spiralling out or control. The IMF pushed forward a contractionary fiscal policy, the same that was encouraged in East Asia. Argentina implemented a “convertibility law” stating that everybody had the right to exchange pesos in return for dollars. “To give credibility to that promise, the government provided that each peso in circulation would have to be backed by a dollar…” (jstor. rg). When pesos were being turned into dollars the supply of money at the central bank plummeted and yet again interest rates soared. This strategy had come to the end of its course as frequent inputs of cash did not bring the economy up to its former glory. “…With the overvalued exchange rate holding down its exports, it became evident that Argentina was headed into a debt trap” (fpif. org). As the exchange rate in Argentina was fixed at so high a level, the countries imports and export levels didn’t balance.
The foreign debt exacerbated by taking out loans in dollars was even more so on the increase and it became necessary to devalue the peso in an aim to increase exports making Argentina attractive again. In the short term, currency devaluation provoked a surge of bankruptcies as the majority of loans had been taken out in dollars and became more difficult to repay when the value of the peso was weakened. “As the debt grew, the interest rate that Argentina had to pay foreign creditors also rose, further increasing the annual imbalance and accelerating growth of foreign debt”( jstor. rg). By increasing levels of foreign debt, Argentina was opening itself up and showing vulnerability to the evident risks of Globalization. Default of Argentina was impossible to avoid which turned out to be the biggest sovereign debt to be occurred by any region. Instead of the IMF providing the liquidity at a crucial time to help safely lower the value of the peso, they actually took upon themselves a strategy of adjusting the conditionality goal posts. Meaning Argentina couldn’t be provided with more funds until they agreed to every new set of policies imposed.
Without injections of liquidity, inflation mounted and the social conditions within Argentina worsened. “Argentine GDP plummeted 15% in the first quarter of 2002, open unemployment rose to nearly 25% and the number of Argentine households consuming below the poverty line soared above 50%” (fpif. org). When analysing the two crises, it can be viewed that there are many similarities but also many differences between the East Asian crisis and the Argentine crisis. Both the discussed regions received bail-outs from the IMF in order to try and sustain the exchange rate.
Both of these regions had to follow the conditions in order to receive these bail-outs which did no prove successful in either case. The build of debt is one of the strongest similarities between the two crises as both of these regions experienced growing amounts of debt, short-term in East Asia and long-term in Argentina and corporations were heavily indebted in both regions. The slumping exports were caused in both regions as they were perceived as too expensive, whereas imports increased particularly in East Asia.
The miracle that occurred years before had created a boom in the region and “.. sucked in ever increasing imports – from machinery and elevators to Mercedes Benz cars and French cognac”( Lassere, Schutte 1999, pp 20). An overvalued exchanged rate was a feature within both crises and had an underlying effect on exports and lack of investment into the regions. “The havoc that an overvalued exchange rate and excessive foreign debt caused in Argentina is certainly not unique. These two conditions, either singly or together, have been the cause of every currency crisis (e. south-east Asia) during the last two decades” (jstor. org). Due to the overvalued exchange rate, both of the regions experienced a lack of competitiveness. An additional significant alikeness between the two crises is the affect the dollar pegs had on creating vulnerability. Argentina’s peso was strongly linked to the US dollar, as were East Asian economies prior to 1997 and after this period had unofficial links to the US dollar. Those East Asian countries which were linked to the US dollar suffered lack of competitiveness as in Argentina.
Secondly, corruption featured highly in the Argentinean crisis and was a recurring feature within East Asia. The corruption in East Asia however was in a different form. The Argentine Government continued to overspend whereas the President of Indonesia for example was constantly accused of abusing his authority. Most crises including East Asia and Argentina result in contagion being spread to neighbouring countries. In both crises the level of exports decreased significantly and this naturally has had an onward affect upon surrounding economies.
Although both regions exported their financial instability to neighbours, the extent to which this was done was more so in East Asia as this crisis attacked others on a global scale. In the case of Argentina, contagion did exist but to a much lower extent. “In addition, the Argentine crisis, having been well anticipated, did not lead to Contagious fallout to other emerging economies in the region, let along the globe” (lkyspp. nus). The responsibility for the blame was put down to ill managed domestic policies and little thought went into whether financial crises could actually be contagious.
The contagion from Argentina was dispersed mainly in Brazil, Uruguay and Paraguay rather than spreading worldwide. The biggest difference between the two crises was the liberalisation which was pushed on East Asia by the IMF. Liberalisation was never forced upon Argentina by the IMF even though they were both developing countries and would both be at risk from liberalisation – particularly fast liberalisation as in East Asia. A second major contrast between the two crises was the Government which in East Asia has surpluses which was the opposite of Argentina’s status.
The issue of demand was also significantly different in the two cases and should have altered the IMF’s policies towards this as Argentina required less demand but East Asia on the other hand would have benefited from supplementary demand. While it is true that both crises were partly caused by that of mounting debt, this debt in Argentina was created through proliferate spending by the Government. East Asia accumulated their high level of debt in the private sector. Although contagion was rife in both crises, the third of three elements of contagion differed between East Asia and Argentina.
In East Asia, there was a deficiency in opportunities for trade and furthermore created a reduction in imports in neighbour after neighbour. “This channel of contagion was powerful because, by the mid -1990’s, East Asia provided markets for more than half of the exports of East Asian developing economies…” (McLeod, Garnaut, 1998, pp362). This element differed from the Argentine contagion as it made recuperation of East Asian regions more intricate. There are several lessons that can be learnt from both of these crises in order to prevent similar consequences in other economies.
The severity of the crisis in East Asia shows the necessity of creating strong macroeconomic policies which are region specific. The first lesson that can be taken is the importance of realistic macroeconomic policies for all concerned because of the globalization of financial markets. Institutional characteristics are crucial and a lack of control – particularly within the financial sector causes bankruptcies. The risky lending from financial institutions showed a lack of control over the institutions and the borrowers themselves. The banking industry naturally becomes weak and triggers crisis such as in East Asia.
This highlights the need to provide support to liberalisation in the financial industry. “In addition, the East Asian crisis exposed inadequacies in he application of existing best practices in banking and financial intermediation, both areas where better information and guidance were needed” (imf. org). The second lesson to be learnt from the East Asian crisis is that liberalisation in the globalising world can sometimes be effective when countries are strongly encouraged to open their economies. East Asia however proved that liberalisation can actually destroy smaller dependant economies.
This would indicate that it is necessary for a developing country to have strategies in place to limit risks that are associated with the effects of globalization. If liberalisation does occur in developing countries then it should be a slower process so the country can gain knowledge while the process is occurring in order to be adequately prepared for the challenges of this liberalisation. Thirdly, a further lesson to be learnt from East Asia is that on a macro economic level, foreign debt has to be strictly managed. Governments must take care to limit the amount of loans that can be taken out by companies in dollars.
It can be debated that it was the excessive foreign debt that actually made the crisis so severe. If may seem that countries with higher levels of exports are able to maintain a high level of foreign debt, this, however is not the case. Export growth can slump as happened in most East Asian countries. Finally a strong feature of the East Asian crisis was the contagion that spread through neighbouring countries as effects are passed through the supply chain. An awareness of “exporting contagion” is necessary, as is constant guidance within the financial sector.
This is the only evidence needed to show that no country can isolate itself from the events occurring in another. Additionally, neighbouring countries should be taken into consideration when devising policies that may suit one country but have negative effects on another. There are of course also lessons to be learnt from the ongoing crisis in Argentina. Firstly a fixed exchange rate should be avoided where possible as it leads to an overvalued exchange rate. Moreover, the currency is unable to remain competitive in comparison with neighbouring countries inflicting plummeting exports and defaults.
A floating exchange rate is necessary to combat such issues. Pegging a currency to the dollar is risky when the exchange rates are unstable. In addition to this, the Argentine crisis is a harsh lesson that Globalization exposes an economy to external shocks and adjustments in exchange rates need to be made to deal with this. Secondly and rather obviously as in the case of East Asia, foreign loans should be limited as excessive levels of borrowing is US dollar involves risk taking. If the dollar strengthens, as in East Asia, it is more difficult to pay back loans when they are rolled over.
This excessive borrowing leads to defaults as experienced in 2001. To conclude, increasing foreign loans were the main cause to the deepening of both crises as this affected their viability for investment. Finally, there is one vital lesson that should be learnt when helping developing countries to avoid crisis like so many before. Fixed exchange rates are rarely beneficial for a developing country. As in both cases, it becomes overvalued when pegged against a currency of higher status and a crisis is inevitable when a country is not worthy of investment in comparison with its neighbours.