Paragraph on The East Asian crisis
In 1995, a number of economists had begun to wonder whether the countries in East Asia might be vulnerable to a Latin-type crisis. The main objective indicator was the emergence of large current account deficits. Upon closer examination, economists discovered that several countries had developed worrying financial weaknesses: heavy investment in highly speculative real estate ventures, financed by borrowing either from poorly informed foreign sources or by credit from under-regulated domestic financial institutions.
And then Thailand gave in to pressure and floated the baht in July 1997. Speculation against the other regional currencies became widespread and thus the Asian crisis was born. Given the warnings issued by the World Bank and the IMF to Thailand and Malaysia of the risks posed by their financial situations and urged corrective action, it remains unclear if appropriate policies could have prevented the crisis. Before this can be properly assessed, the root of the crisis must first be identified.
First-generation models, exemplified by Krugman in effect explain crises as the product of budget deficits: it is the ultimately uncontrollable need of the government for seignorage to cover its deficit that ensures the eventual collapse of a fixed exchange rate, and the efforts of investors to avoid suffering capital losses (or to achieve capital gains) when that collapse occurs provoke a speculative attack when foreign exchange reserves fall below a critical level.
If first-generation models are applicable to the East Asian experience, then the crisis was the result of a fundamental inconsistency between domestic policies-the persistence of money-financed budget deficits-and the attempt to maintain a fixed exchange rate. The inconsistency was temporarily papered over as the central banks of the region had sufficiently large reserves, but when these reserves became inadequate speculators forced the issue with a wave of selling.
Therefore the East Asian crisis could have been prevented if consistent policies were pursued. However the fundamental problems stressed by the first-generation models were not dreadfully weak in the Asian economies concerned. Therefore these generation models are not widely used for explaining the crisis. Moving to more sophisticated models, second-generation models, exemplified by Obstfeld, can be adopted.
These models explain crises as the result of a conflict between a fixed exchange rate and the desire to pursue a more expansionary monetary policy; when investors begin to suspect that the government will choose to let the parity go, the resulting pressure on interest rates can itself push the government over the edge, leading to a self-fulfilling crisis. Observable characteristics during many crises that justify self-fulfilling crises include herd behaviour, contagion and market manipulation.
Although the detailed workings of second-generation models may be different from those of the first-models, their general result can be much the same: a currency crisis is essentially the result of policies inconsistent with the long-run maintenance of a fixed exchange rate. Financial markets simply force the issue, and indeed must do so as long as investors are forward-looking. Therefore if second-generation models are relevant to the Asian crisis i. e. that the Asian governments were pursuing unsustainable long-run policies, then the crisis probably could have been prevented.
However several studies have shown that the second-generation models are not pertinent to the Asian crisis. There is a third explanation to the crisis and that is third-generation models. The third-generation of crisis explanations argues that financial sector asymmetries, microeconomic problems of the sector, moral hazard, an uneven policy of opening the country for capital flows and for financial sector deregulation, lack of supervision and regulation, and a lack of competition in the financial sector count as explaining factors for the Asian crisis.
More than this, the argument of a “crony capitalism” is brought in, a situation where the intense networks between government, the state bank sector and/or state-controlled banks, and the state industries and/or state controlled industries influence mutually the decision-making thereby transforming all policies (financial policies, industrial policies, budget policies) to the benefit of a small group of decision makers.
Using this rationale, the networks are the cause of the crisis. Therefore, under this model, currency and banking crises become more interrelated and have to do primarily with microeconomic distortions, political interdependencies, and a lack of institutional changes in the financial sector. At an unspecified and unpredictable date the knowledge of investors about the system of crony capitalism led to a speculative attack and to herding behaviour.
As credit booms and expansionary financing modalities are then associated with moral hazard and crony capitalism, at a certain point in time the investors feel that the situation will not be managed by the government, anticipating bank runs and currency depreciations. It became apparent that neither an effective lender of last resort nor an effective international lender of last resort existed to prevent liquidity problems and to restructure for insolvency.
For more than a decade, investors in East Asia had relied on the implicit and explicit guarantees that payments, deposits, repayment and transfers will work and will be honoured. The weakness in the system was that it was extremely difficult to monitor the economies’ financial shortcoming since an effective system of financial sector surveillance did not exist.