10 lessons from the Asian financial crisis

QUESTION TIME | This month marks the 20th anniversary of the Asian Financial Crisis or AFC which started with the plummeting of the Thai baht in July 1997 after investors sold down the currency when they “suddenly” discovered that Thailand was using short-term inflows to fund long-term projects.

While that sudden discovery was viewed by some as an opportunistic attempt to make some quick money on trading, the revelation that the Thai central bank had lied and overstated their level of reserves opened the floodgates. The currency went into a free-fall and Thailand turned to the International Monetary Fund or IMF for help.

Almost like a disease, the contagion took place with South Korea and Indonesia targeted by the speculators, both of whom turned to the IMF for help which prescribed rather harsh measures such as raising interest rates and cutting expenditure, which would cause the proverbial blood to flow in the streets.

Malaysia came under attack as well although its foreign borrowings were well-contained but with confidence hammered down and near panic in the markets, there were signs that locals were moving their money out of ringgit on an unprecedented scale. Even strong Singapore and free-market Hong Kong were not spared.

Although Malaysia never required nor sought IMF help, the initial response, under then finance minister and deputy prime minister Anwar Ibrahim was to take IMF-like measures by cutting expenditures and raising interest rates. Meantime, a leadership tussle between Anwar and then prime minister Dr Mahathir Mohamad escalated, leading to further uncertainty.

Mahathir blamed speculators for the attack on the currencies and he was at least partially right about that. Large international funds basically used a two-pronged approach to force markets down.

They simultaneously sold short currency and stocks of the affected currencies, that is sold them first without having them, with the intention of buying back when they fell and making on the difference. If central banks had sufficient reserves, then they could buy the currencies being sold and holding prices up, forcing the funds to buy back at a loss and halting the speculation.

Hong Kong, whose currency was pegged to the US dollar, took that route. Their equivalent of the central bank mopped up currencies being sold while government funds bought up shares of key stocks when they came into the market.

Singapore chose to ride the wave, letting the currency and stocks slide but not too much and waiting for the attacks to subside. Taiwan, India and China, all of which did not have a freely floating currency, came out completely unscathed.

Malaysia eventually opted for capital controls, following which Mahathir arrested and jailed Anwar. Malaysia recovered rapidly as it pumped liquidity into the system, lowered interest rates and increased spending to counter the downturn, in a move which predated similar measures to be adopted when developed countries faced their own World Financial Crisis (WFC) a decade later.

A lot has since been written about the AFC but for me, there were a number of key lessons from the crisis. Here are 10 of them:

1. There is no such thing as a free market. A free market is one where no single investor or group of investors can by themselves affect prices on the markets. That only works for very large markets such as the US but for small markets like Malaysia, that’s not true at all. A relatively small number of investors can effectively cause a market collapse.

2. There is no perfect market. A perfect market is defined as one where everyone has equal access to information. Small markets are not anywhere near perfect with many investors having inside information not available to the general public and advance information of how people are going to trade. 

3. The IMF is often wrong. Despite its coterie of highly-paid economists and experts, the IMF is often wrong and terribly so when it came to the AFC. The way the WFC of a decade later was handled amply shows that a gentler approach to financial crisis is to maintain and even increase liquidity and spend some more to regain confidence, not the other way around.

4. Blood need not flow to correct financial excesses. This follows from point three above. A specific programme to contain financial contagion need not necessarily throw an entire country into panic and despair but instead can be ameliorated by a carefully thought out programme to keep the money tap open and to keep spending up.

5. Liquidity is especially important when confidence is low. Liquidity is especially important during troubled times. It’s during these times that money is needed to cover deficits and shortfalls and banks should be encouraged to step up spending, not to withhold it just at the time that it is needed most. What’s the point of pulling the umbrella away just as it starts to pour?

6. When people are not spending, the government should. When confidence is low and people are holding back on spending, that’s the time for the government to spend, thereby taking up the slack. Eventually the government can pull back as confidence in the economy returns.

7. Fund managers can and do manipulate markets. They make all sorts of noises about free markets and how important it is but if they see an opportunity to manipulate a market and make money from trading on it, they will. They have been doing it from the time they have existed.

8. Small countries can have their currencies systematically attacked. Small countries are especially vulnerable to attacks by speculators because their foreign exchange reserves are small and it only requires a few funds to push down the currencies by a lot. 

9. Governments can and should take action to stop manipulation. When funds take covert action in concert to depress a currency for quick trading gains, governments and central banks have every right to take action. And they have over the years. But this is not always easy to do, and brings us up to our final point.

10. Capital controls are a legitimate last resort. Smaller countries, if they encounter too much firepower from the funds, in other words excessive short-selling of their currencies, have a legitimate last resort in capital controls. Used properly as Malaysia mostly did in 1998, they can extinguish unwarranted speculation pretty quickly.

If these lessons are kept in mind, if smaller nations maintain a decent amount of foreign exchange reserves and they are willing to cooperate to beat back speculators, there is no reason why events like the AFC should recur. And if they should, governments must remember that there are less painful ways of dealing with it as the WFC has shown.

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P GUNASEGARAM was head of research at a local stockbroking firm when the AFC broke out and remembers well the panic, the arguments, the accusations, the recriminations and the irrationality of it all. E-mail: t.p.guna@gmail.com.- Mkini