September 2, 1997 [home]
By: William Gamble, President
During the summer the world financial community has been treated to the spectacle of crashing currencies. The most interesting aspect of the declines is that they have happened in some of the world's most successful emerging economies. Over the past few years these economies have exhibited some of the highest GDP growth rates in the world. The success of these economies was ascribed to everything from the economic savvy of their governments to the value of Asian cultural factors.
The problems started in may with the Czech Republic's failed attempt to stop the depreciation of the koruna. This was followed by the collapse of the Thai baht in the beginning of July. Like the 'Tequila Effect' following the devaluation of the Mexican peso in 1994, the southeast Asian currencies began to fall like dominos. By the end of August the Baht had fallen 20%, the Indonesian Rupiah had declined 12%, the Malaysian Ringgit was down 9%, the Philippine Peso was off 9% and even the stable Singapore Dollar had slipped 5%. Only the Hong Kong dollar was unaffected. All of the local stock markets were badly mauled by the devaluations.
There seems to be common agreement as to the reason for the collapse at least regarding the south east Asian currencies. Most of these countries pegged their currencies to a basket of currencies dominated by the dollar. This allowed these fast growing export markets to maintain price of their goods in their largest market, the United States. Rapid growth drove costs up and flooded local markets with foreign investment. Local companies and financial institutions were able to pile up dollar denominated debts at interest rates that did not adequately reflect the currency risk. This created real estate and stock market bubbles. The combination of a strong dollar and rising prices stalled the export growth. Without the cash flow from exports, firms were unable to service dollar denominated debt.
If we look only at the above analysis it might be simple to assume that currency fluctuations are a natural part of a business cycle for emerging economies. It could be said that all fast growing emerging economies will reach a point where their manufactured goods will become more expensive than a more primitive emerging economy and their newly rich populous will start purchasing vast quantities of upmarket foreign goods. The automatic result will be a poor balance of payments and an automatic multi country currency devaluation (interestingly enough along cultural lines).
My premise is that the weakness of a country's financial system is usually leading indicator in determining an overvalued currency. One of the main problems is often a lack of foreign competition. For example, in the Czech Republic the government has major stakes in at least four of the country's largest banks. The banks made loans to inefficient industries still in owned by the state. As a result of this indirect subsidy, 35% of all Czech bank loans were non-performing. Fortunately, to resolve the crisis, the government is finally following the lead of Hungary and selling off its holdings to foreign financial institutions.
Thailand had similar problems. Of the 91 finance companies, the government has already had to close 58. Of the remaining 33 finance companies and 15 banks, many are still in trouble. Again part of the problems is that foreign ownership is limited to 25%. As part of the IMF package, reserve and reporting requirements will be substantially strengthened.
Similar problems also beset South Korea. The scandal involving loans to Hanbo Steel made because of government pressure have resulted in pressure on the entire financial system. The won has not fared well either. Over the past year the won has depreciated over 10% against the dollar.
Although weakness in the banking sector is not the single cause of a currency devaluation, it tends to magnify the negative effects of a currency collapse. Governments are reluctant to raise interest rates to appropriate levels necessary to defend the currency when such action could force weak local financial institutions into collapse. Better reporting on bank financial conditions would always be helpful in determining the relative strength of a country's currency. In lieu of such data, I believe that it would be prudent to examine the local restrictions and especially government ownership. The more the local financial system is open to the rigors of the global marketplace, the safer it probably is.
By: William Gamble
Emerging Market Strategies Company
281 Olney Street, Providence, Rhode Island, United States 02906
Tel. 401-454-5899, Fax 401-454-3888, Internet: 73243.2104@COMPUSERVE.COM
This article can also be found on the University of Virginia Darden School of Business Administration Alumni Forum and in the EMS Newsletter. Some of these articles are referenced in Professor Roubini of New York University Stern School of Business Administration Asia Crises Home Page and in the Providence Journal - Commentary Section.