 "A tale of two crises")
The recent rampage in emerging market currencies brought back memories of the 1997 Asian currency crisis. Comparisons are being made and many feel that we might be headed towards a similar crisis once again, but this time the contagion will be more wide spread.
This time it's different (though not completely) and unfortunately more scary. But first let's walk down memory lane and look at what the Asian crisis of 1997 was all about.
The crisis started in Thailand in July 1997. Thailand in those days had pegged its currency, baht to the US dollar. From late 80s to early 90s, economies like Thailand, Malaysia, Indonesia, Singapore and South Korea saw GDP growth rates of 8-12 per cent. This growth rate attracted foreign capital both in the form of equity and debt. However, as economist Paul Krugman pointed out, the growth was a result of investment in capital and not productivity.
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Like in every bubble, these economies needed more capital to keep their growth rates high thus building on huge amount of debt. Their growth rates and promise of fast buck attracted 'hot money' in the countries, especially in the real estate segment. Malaysia's Petronas Twin Towers still stands as a symbol of real estate boom of that era. Along with hot money in equity, companies and government resorted to foreign debt which as a per cent of GDP rose to 180 per cent during the peak of the crises.
Meanwhile the US, which recovered from its recession in early 1990s increased interest rates making it a preferred destination for investment. This strengthened the dollar. As currencies of most of the Asian economies were fixed to the dollar, their exports turned out to be costly resulting in lower growth. China and Japan, among the biggest trading partners of US, devalued their currency in order to protect growth. However other countries were slow to respond and soon their current account deficits and the currency value against the dollar became unmanageable. Ultimately they had to float (market determined rates and not artificially fixed rates) their currency resulting in a collapse in its value.
This time around the similarity is 'hot money'. Quantitative easing along with near zero interest rates strategy followed by central banks of US, Eurozone, UK and Japan has resulted in hot money floating across the globe. This time around too, the economies that are in trouble are those with some of the highest current account deficits. Fear of flight of capital is as real now as it was then.
In order to prevent foreign capital from leaving, Turkey's central bank increased rates from 4.5 per cent to 10 per cent. This drastic step failed to pacify the currency market with the lira touching a new low after the announcement. South Africa, India, Brazil and Indonesia are following a similar strategy to prevent flight of capital and control current account deficit.
On the other hand, US has started its tapering process, which means this would aggravate the flight of capital situation. Ambrose Evans-Pritchard in a recent article in Telegraph has quoted a World Bank report titled 'Capital Flows and Risks in Developing Countries' which says that "If market reactions to tapering are precipitous, developing countries could see flows decline by as much as 80 per cent for several months"
Two of the biggest economies in the world US and China have begun deleveraging. US tapering is expected to impact the financial markets first before it hits the broad economy. China's deleveraging has already impacted its growth and that of countries whose economies are largely dependent on commodities.
This time around in order to protect the currencies, countries are keen on preventing hot money from leaving the country and in doing so they are willing to sacrifice growth.
The same strategy of suppressing growth has now resulted in Europe staring at deflation. Deflation, a general decline in price is normally caused by decrease in government or personal spending. The biggest problem of deflation is that it increases the real value of debt and may aggravate recession. Ambrose in his article says that 80 per cent of the global economy is tightening or cutting stimulus. As matters stand, the next recession will push Western economic system over the edge into deflation.
While the Asian currency crises could be contained by infusion of only $40 billion by IMF, this time around the contagion has spread across the globe. This time around the problem is that developed countries want their money back which they pumped in over the last few years and developing countries do not want them to take it back.