Question

Question 2
Explain the causes and impact of a financial crisis as seen in the Asian Financial Crisis in 1997 and Global Financial Crisis in 2008. As both Singapore and Hong Kong have good banking regulations and are surplus economies in the balance of payments, how do they suffer from contagion effects of the Asian Financial Crisis and what can they do to minimise such effects?

Answer 1

Asian Financial Crisis :

The Asian financial crisis of 1997 refers to a macroeconomic shock experienced by several Asian economies – including Thailand, Philippines, Malaysia, South Korea and Indonesia. Typically countries experienced rapid devaluation and capital outflows as investor confidence turned from over-exuberance to contagious pessimism as the structural imbalances in the economy became more apparent.

Causes which precipitated the crisis :

• Higher US interest rates. In the late 1990s, the US started to increase interest rates to reduce US inflationary pressures. Higher interest rates in the US made the East less attractive as a place to move hot money flows. As hot money flows into the East slowed down, Asian currencies started to fall and governments struggled to keep exchange rates at their fixed level against the US Dollar.
• Contagion. On 2 July 1997, due to speculative attacks, Thailand was forced to float their currency the Thai Bhat. This caused a rapid devaluation, which triggered a loss of confidence throughout the Asian economies. Soon, other countries were forced to devalue as investors wanted to get out of Asian currencies. Investors realised the previous optimism was starting to look misplaced.
• Debt default. In the run-up to the crisis, both government and private firms built up high external debt ratios. However, the devaluations caused debt repayments to become more expensive and as a result firms and countries started to default on their debt repayments.
• At this stage, the IMF intervened to try and stabilise the crisis. However, their intervention has proved very controversial, with many arguing that their intervention made things worse. Higher interest rates in Indonesia and the Philippines did not stop the devaluation of the currency – suggesting investors were not convinced such high-interest rates were sustainable.

Impact of Asian Financial Crisis :

Severe Recession. Hit by the loss of confidence and rise in debt repayments, firms cut back on investment, leading to lower growth. The large devaluations also hit consumer spending as the price of imports and imported raw materials rose. This caused a recession in countries, such as South Korea, Indonesia, Malaysia and Thailand. Measured in dollar terms, Indonesia experienced a catastrophic 84% fall in GNP between June 1997 and July 1998.

Inflation – devaluation caused import prices to rise.

Global effects. The Asian crisis hit investor confidence in the US, though lower interest rates helped to stabilise US economy. China was largely insulated from the crisis because China had attracted physical capital investment and did not rely on foreign flows of capital. The crisis had a negative effect on Japan’s economy and they struggled with a decade of low growth.

Global Financial Crisis :

The Great Recession is the name commonly given to the 2008 – 2009 financial crisis that affected millions of Americans. In the last few months we have seen several major financial institutions be absorbed by other financial institutions, receive government bailouts, or outright crash.

Causes of Global Financial Crisis :

The first sign that the economy was in trouble occurred in 2006. That's when housing prices started to fall. At first, realtors applauded. They thought the overheated housing market would return to a more sustainable level.

Realtors didn't realize there were too many homeowners with questionable credit. Banks had allowed people to take out loans for 100 percent or more of the value of their new homes. Many blamed the Community Reinvestment Act. It pushed banks to make investments in subprime areas, but that wasn't the underlying cause.

The Gramm-Rudman Act was the real villain. It allowed banks to engage in trading profitable derivatives that they sold to investors. These mortgage-backed securities needed home loans as collateral. The derivatives created an insatiable demand for more and more mortgages.

Impact of Global Financial Crisis :

Debt-deflation is the process by which, in a period of falling prices, interest on debt takes an increasing share of declining income and so reduces the amount of money available for consumption.

The Gold Standard fixed exchange rates by the amount of gold in their currencies. As a result, it was not possible to vary exchange rates to solve a balance of payments (the difference between payments into and out of a country) deficit, and instead costs were driven down and competitiveness restored by deflationary policies.

The International Monetary Fund is an organisation created in 1944 which now concentrates on structural reform of developing economies and resolving crises caused by debt.

Monetary policy uses the supply of money and interest rates to influence economic activity. This is in contrast to fiscal policy which depends on changes in taxation or government spending.

Quantitative easing is the process by which a central bank purchases government bonds and other financial assets from private financial institutions. The institutions selling assets now have more money and the cost of borrowing is reduced. Individuals and businesses can borrow more, so boosting spending and increasing employment – though it is also possible that, when this process was employed, money went into buying equities, so boosting the gains of richer people.

Reflation refers to the use of policies that are employed to boost demand and increase the level of economic activity by increasing the money supply or reducing taxes, and so breaking the debt-deflation cycle.

Sovereign debt is the debt of national governments, with interest and repayment secured by taxation. If debt was too high, the country might default. This became a risk in 2010, above all in Greece.

In Asian Financial crisis some regions were not directly vulnerable to contagion effects. Countries such as singapore and hong kong escaped the spread of the crisis in region because they had stronger financial systems, including adequate bank regulation,

Financial reforms which strengthens bank regulatory and supervisory frame work may help to mitigate adverse contagion affects of the financial crisis