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Wednesday, 23 September 2009

1997-98 and 2008-09: a tale of two crises

AT THE simplest, the crisis of 1997-98 was regional, while the present crisis is global. Beyond the simple similarity, there are complex differences in origins and effects.

When the Thai baht was tested by speculative attacks in late 1996 and in the first half 1997, the Bank of Thailand, in tune with the then prevailing fixed exchange rate regime, had to defend the currency. It spent a large part of the nation's forex reserves to maintain the exchange rate, through direct sale of foreign currency and through forward currency swaps.

Outstanding swap contracts in mid-August 1997 amounted to US$23.4 billion dollars as against the reported US$30.4 billion in actual reserves. Relatively poor export performance, mounting external debt, weak financial sector and dwindling forex reserves led to a loss of confidence, setting off 'sudden' withdrawal of foreign funds.

Market pressure triumphed and on July 2, 1997, Thailand abandoned a 13-year-old exchange rate mechanism that pegged the baht at around 25 to 26 to the US dollar. When the baht was floated, it inevitably sank, leading in turn to financial and economic crises.

The so-called contagion affected at least six other economies in East and South-east Asia. Confidence crisis did hit Hong Kong, but it could ward off the currency crisis by doggedly sticking to the peg - at some cost which the policymakers preferred to incur instead of allowing the economy to slide into a recession.

Singapore and Taiwan allowed the currency slides, but had robust financial institutions and regulatory oversight that prevented a financial crisis. Indonesia was at the extreme, with financial and economic crises providing the much awaited opportune moment for political change.

The 1997-98 experience, though regional in character, had important implications. It demonstrates the close linkages between financial and economic crises, which is a reaffirmation of the importance of the health of the financial sector, which intermediates between the saving and investing classes.

It tells us clearly that the origin of a financial crisis need not be from within the financial sector, but could be at some spot elsewhere, leading to loss of confidence in an economy, its neighbours and a whole region.

The saving grace is that problems need to be tackled at the national level mostly, and speed of action ensures less damage for the economy.

The present crisis is different. The root cause was in the financial sector, a vital sector with strong links to the rest of the economy. Thanks to the globalisation of finance, the spread of the financial crisis was quick, and far reaching. It was dubbed the worst crisis since the Great Depression. Much has been done at national and global levels to boost public spending in the hope of reviving consumer spending. The signs of 'out of recession' are already placed on some doorsteps.

The role of regulation

Two points need to be remembered in the context of the present crisis. First, all the talk about regulation, international cooperation, transparency, accountability, etc is important and has its role. Yet, we must also underscore the simple idea that all financial products and activities must have perceptible and easily verifiable value addition.

The banker deserves her/his pay and stockholders their dividends because of the value addition involved in collecting and safeguarding our savings and making them available to investors with a good track record who produce goods and services, in turn leading to perceptible and clearly visible value addition.

Had the question 'what is the value addition' been raised at the first roll-out of the great innovation called financial derivatives, there would have been a lot less pain for the world as a whole. Innovations that 'spread risk' do just that - spread the risk widely, so innocent savers too pay the price. This is no value addition.

Second, all those who wish to say that 'crisis is over' should remember that the crisis has many dimensions and date lines, as brought out in the paper presented at the January meeting of the American Economic Association by Kenneth Rogoff of Harvard University and Carmen Reinhart of the University of Maryland. Their findings are based on a study of 14 severe financial crises, including the 1997-98 crises of Hong Kong, Indonesia, South Korea, Malaysia, the Philippines and Thailand.

The duration of peak to trough changes in key parameters are found to be five years for house prices, 3.4 for equity prices, 4.8 for unemployment and 1.9 for per capita gross domestic product (GDP).

We need to ask from now on: which crisis or which component of the crisis has ended?

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