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Fixed Exchange Rate And An Open Capital Account Economics Essay


The financial crisis which was happened in Southeast Asia in 1997 is one of the defining events of our time and it was unforeseen, and unexpected. In 1996, ASEAN’s prospects looked so shining. For the first time in its recorded history, all six major economies (Indonesia, Malaysia, Philippines, Singapore, Thailand, and Vietnam) were growing strongly, at 5% more. The dream of consolidating all 10 Southeast Asian countries within a strong, successful, harmonious and internationally oriented regional grouping was within reach. Stocks markets were booming, business was stable, and broad-based improvements in living standards were everywhere can be found.

By early 1998, a dramatic reversal in fortunes had occurred. Private capital has fled from Southeast Asian countries, whereas there was a net private capital inflow to the 5 worst affected East Asian Economies (Indonesia, Korea, Malaysia, Phi8lippines, and Thailand) of US$93 billion in 1996 but become net outflow of US$12 billion next year. A loss of confidence was clear: in the international financial architecture, in international and regional organizations, in governments’ capacity to protect their citizens from internationals shocks, immediate business prospects, and even continued community and ethic harmony.

Many researchers tried to find out what has happened, why it has happened, what is socio-economic effect and what are some of the boarder policy and analytical implications of the crisis? Based on previous researchers’ finding, this Assignment try to focus financial reform and regulation, poverty, exchange rate policy options, attempts to model the crisis and aftermath of the crisis, regional economic co-operation, and political issues related to the crisis.

Literature review

What happened (Arndt, H.W. & Hill, H.(1999) Southeast Asia’s economic crisis, page 3)

Many people know that “It all begin in Thailand”. Why it was the first domino to fall? One of the principal policy mistakes in Thailand was the commitment to a rigidly fixed exchange rate. This was fixed not to a basket of currencies but rather to one currency (U.S. dollar) with huge short-term external dept and the progressive opening of the international account, which was in addition appreciating significantly during the pre-crisis period.

The second factor was premature financial liberalization. Based on the theory, a country can not run an independent monetary policy in the context of a fixed exchange rate and an open capital account. In the early 1990sthe bank of Thailand had begun to relax the restrictions to closing its capital account. Especially in 1993, the establishment of the Bangkok International Banking Facility came with more removal of many regulatory restrictions and barriers to entry in the finance industry. Soon, major firms were in trouble.

Major stage of the crisis (Arndt, H.W. & Hill, H.(1999) Southeast Asia’s economic crisis, page 5)

First stage, Baht floats, and falls sharply; other currencies float too, and begin to decline; no real sense of crisis evident during July and August in 1997.

Stage 2, further currency declines, but still relatively modest and no sense of impending calamity is present; indeed, a cautious optimism prevails, the situation had alert those governments, and the devaluations would enhance international competitiveness during September and October in 1997.

Stage 3, during November 1997 to February 1998, it is now clear that the crisis is very serious, Korea joins the affected economics; Indonesia parts company from the others as adverse economic and political factors push the economy suddenly into beginnings of a deep depression; the Rupiah goes into free fall in January, at one points its rate being just one- sixth of that pre-crisis.

Stage 4, a limited and cautious optimism returns to the region; currencies begin to appreciate slightly in response to market sentiments that earlier trends had resulted in ‘over-shooting’; even in Indonesia a new cabinet signals some renewed hope had been happened in March and April in 1998.

Step 5, during May until August in 1998, further and deepening pessimism is evident; mounting student protests and political turbulence in Indonesia force president to resign; nasty-Chinese protests also occur, leading to mass evacuations among the expatriate and Chinese communities; Japan problem deepen; for the first time during the crisis there is significant concern over the state of the global economy.

The final stage was happened after September in 1998, there is a little return of cautious optimism; currency realignments work in favor of Southeast Asia; debt workouts are commencing on a wider scale, and the governments appear to be responding pragmatically to the challenges; Malaysia introduces controversial capital controls on 1 September.

Socio-economic impact (Arndt, H.W. & Hill, H.(1999) Southeast Asia’s economic crisis, page 5)

Tables 1 summarize the effects of the crisis across each country. From the graph show that economic growth is likely to range from -15% or worse in Indonesia to a positive figure in Vietnam, and inflation is a very serious problem in Indonesia,

Table 1

Southeast Asian Economic Indicators, 1996-1998 (%)

Ind Mal Phil Sing Thai VN

GDP growth

1996 8.0 8.6 5.5 6.9 5.5 9.4

1997 4.7 8.0 5.1 7.8 -0.4 9.0

1998 -15.0 -5.8 -0.2 -0.2 -8.0 7.0


1996 6.5 3.5 8.4 1.4 5.8 4.5

1997 11.6 2.6 5.1 2.0 5.6 4.0

1998 75.0 5.0 8.0 2.0 8.0 5.0

Sources: Asia Pacific Economics Group, Asia Pacific Profiles 1998 (Canberra 1998); Far Eastern Economic Review, 15 October 1998.

3.0 Theoretical Framework

A general theoretical understanding of how international capital markets work-and fail to work in the previous global capitalist system can help the readers to understanding the Asian financial crisis.

Asian financial crisis in 1997-1998 are characterized by an unexpected and significant shift from net capital inflow to net capital outflow from one year to next. Generally, the crisis typically reflected a 3-stage process that hit a developed country engaged in large-scale international borrowing. In first stage, the exchange rate becomes overvalued as a result of internal or external macroeconomic events. In the second stage, the exchange rate is defended, but at the cost of a substantial consume of foreign exchange reserves held by the central, the depletion of reserves, usually in combination with devaluation, triggers a panicked outflow by foreign creditors holding short-term claims, the trigger in most cases is the devaluation itself, resulting from collapse of reserves. The panicked outflow of short-term capital leads to macroeconomic collapse, characterized by a sharp economic downturn, soaring interest rates, depressed equited prices and a plummeting currency. (Wing Thye Woo, Jeffret D. Sachs, Klaus Schwab (2000). The Asian Financial Crisis. The MIT press, Cambridge. Massachusetts, London, England)

In others words, the start of the crisis is because of the role of fiscal imbalances. At the core of “exogenous-policy” models of speculative attacks, the key factor that explains the loss of reserves leading to a crisis is the acceleration in domestic credit expansion related to the monetization of fiscal deficits. In the case or Southeast Asia, the pre-crisis budget balances of the countries suffering from speculative attacks were either in surplus or limited deficit. In “endogenous-policy” models of currency crisis governments rationally choose on the basic of their assessment of costs and benefits in terms of social welfare, whether or not to maintain de fixed rate regime. A crisis can be driven by worsen of domestic economic fundamentals, or can be the result of self-validating shifts in expectations in the existence of multiple equilibriums, provided that the fundamentals are weak enough to push the economy in the region of parameters where self-validating shifts in market expectations can occur as rational events. The indicators of weak macroeconomic performance typically considered in the literature focus on output growth, employment, and inflation. In the Asian economies prior to the 1997 crisis, however, GDP growth rates were very high and unemployment and inflation rates quite low. (Corsetti, Giancarlo, Paolo Pesenti, Nouriel Roubini (1998) Paper tigers? A model of the Asian crisis, paper presented at the NBER-Bank of Portugal International Seminar on Macroeconomics, Lisbon 14-15. June.)

For Malaysia, its economy is better than other countries before the crisis, it had enjoyed rapid growth, stable inflation, falling unemployment rate and fiscal surplus, but because of 4 main causes, Malaysia also had badly harm by the crisis. (Colin Barlow, Francis Loh Kok Wah (2003) Malaysian economics and politics in the new Century. Edward Elgar Publishing Limited, Cheltenham, UK· Northampton, MA, USA) Page18

First is the economy had been made vulnerable by the unsustainable pace of economic growth and by certain structural weakness including massive over-building and over-valued exchange rate. The relationship between firms, government and banks in Malaysia can not be described as being “cosy” before the crisis. The government’s commitment to a high growth policy based on a high ratio of investments to gross domestic product led eventually to the promotion and support of certain giant projects, to the implicit assumption by lenders that the government would not let those projects fail, and to lending decisions by bankers based not on project cash flows but also on collaterals and implied government support. Such over-investment led aggregate demand to outstrip aggregate supply, with a consequently persistent external deficit, it also led to poorer cash flows and more problems.

Second problem is about the deficiencies in risk management. Although the currency mismatch is modest in Malaysia, the exchange control regime required approvals for foreign currency borrowings. Several prominent corporations were allowed to raise foreign currency loans; although the only had ringgit cash flows. With the sharp ringgit depreciation these corporations faced massive foreign exchange losses or insolvencies, because of their currency mismatched and inabilities to hedge exposures. On the other hands, 40% of the loans of commercial banks, the dominant component of the banking system, were callable on demand in 1995. Another 40% comprised term loans of 47 tears and above, but these were funded with short-term deposits with the weight average maturity of deposits being only 15.2 months. Given this high leverage together with over reliance on short-term floating-rate financing and the maturity mismatch, the credit squeeze and jump in interest rates accompanying the outbreak of financial crisis in middle of 1997 greatly damaged the balance sheets of the Malaysian banking and corporate sectors. In addition, risky banking is taken with bad macroeconomics would create and explosive mix for any corporate entity which has over-borrowed and assumed too much maturity or currency mismatches. The high risk nature of banking arises from its high gearing and massive asset liability mismatches, and in particular from its tendency to borrow short and lend long. So that, a bank run can convert a liquidity crisis into a panic, and then turn it into a solvency crisis. It started from banks influence money supply, and a run on banks can cause multiple con traction in credit. Secondly, banking is a high risk business, because its undercapitalization and over-gearing leads to risky lending. Thirdly, banks are engaged in providing payment services and are therefore susceptible to or cause systemic risk.

Third is about forming of corporate governance and equity markets. In Malaysia the equity market is very sizeable, in spite of concentrated shareholdings. The news at the outbreak of the regional crisis of corporate governance breakdowns, and the weak responses to this of regulators, led to a big stock market sell-down. The problem was compounded by new rules on scrip delivery which were imposed to check the sell-down, and these rules were scrapped soon thereafter, but initiatives to facilitate the development of suitable mechanisms for improved corporate governance were taken only later, and doubts still persist on issues related to enforcement.

The following problem is the policy slippage. The initial response of the Malaysian Government to the outbreak of the currency crisis was one of denial. Given the perceived soundness of economic fundamentals, former Prime Minister Dr Mahathir’s immediate reaction was to pounce on the villains: currency speculators. By implicating the American financier George Soros in the speculative attack, he complained about a Jewish conspiracy to jeopardize the Malaysia miracle. At the IMF and World Bank annual meetings in Hong Kong, Dr Mahathir stated that currency trading was “unnecessary, unproductive and immoral”, and that “it should be made illegal”. Then he continued attack on speculators in domestic and international forums, including the Annual Asia Pacific Economic Cooperation and Commonwealth heads of Government Meeting. Almost every attack by Mahathir against his perceived enemies precipitated a further sliding of the ringgit. Even more damaging to investor confidence than the Dr Mahathir’s attacks on speculators were several initiatives to directly intervene in share market operation with a view to punishing speculators. On 27 August, the KLSE banned the short selling of 100 blue chip stocks and rules were launched out to discourage the sale of stocks, sellers were required to deliver physical share certificates to their brokers before selling and the settlement period was reduced from 5 days to 2 days. On 3 September, the Malaysia government unveiled a plan to use funds from the Employees Provident Fund (EPF) to prop up share prices by buying stocks from Malaysian shareholders, but not foreigners —at a premium above prevailing prices. These moves backfired, triggering a massive sell off stocks in the KLSE and undermining sentiment on other regional bourses. As luck would have it, government sponsored share purchases were seen by market participants, both local and foreign, as an opportunity to get rid of Malaysian shares, rather than as a reason for holding onto them. Next, the ban on short selling was lifted in early September and the government announced the postponement of some grandiose infrastructure projects amounting to about US$10 billion. The Budget for 1998 unveiled on 17 October contained some measures to reduce the current account deficit through selective import duties and “buy Malaysia” campaign. However, the government failed to come up with a rational program of reforms to deal with the crisis. (Arndt, H.W. & Hill, H. (1999) Southeast Asia’s economic crisis, page 33)

4.0 The general results of the financial crisis to the Malaysia (Arndt, H.W. & Hill, H. (1999) Southeast Asia’s economic crisis, page 30)

Previously, the exchange rate of the ringgit varied in the narrow range of 2.36 to 2.51 ringgit per US dollar. When the Thai bath came under heavy speculative attack in Middle of May, the ringgit also faced heavily selling pressure. The central bank, Bank Negara Malaysia responded with massive foreign exchange market intervention; it sold close to US$1.5 billion to prop up the ringgit . It held the ringgit firmly through continued market intervention for another week and then gave away to market forces on 14 July by floating. With the ability to defend the currency dramatically reduced, and without any indication as to the depth of the impending crisis, “unleashing the cavalry” was indeed the only sensible policy.

Between the first week of July 1997 and January 1998, the slide hit bottom (RM4.88= US$1), the ringgit depreciated against the dollar by almost 50%. After showing some signs of stability during February and March, the exchange rate continued to deteriorate with wide swings in the following months. This contrasted with the experience of Thailand and Korea where from March onwards their currencies showed signs of stabilizing at higher levels. The stock market collapse was even more drastic. Between July 1997 and mid-January 1998, the all ordinaries index of the Kuala Lumpur Stock Exchange (KLSE) fell by over 65%, whipping off almost US$225 billion of share values, the biggest stock market plunge among the 5 “crisis” countries. There was no improvement in stock prices until the newly-introduced capital controls brought about some recovery in October 1998.

As a result of the property market crash and massive capital outflows, non-performing loans in the banking system began to increase. According to BNM data, the proportion of non-performing assets increased from about 2% in July to 3.6% in December1997 and then to 11.8% in July 1998. Markets analysts believe, however, that problem is much more severe than the official figures suggest, as many companies have begun to roll over debt as part of their survival strategy. Independent estimates of non-performing loan ration ranged from 25% to 30%by mid-1998.

Domestic Market oriented industries, and the construction and services sectors were affected by the contraction in domestic demand resulting from the negative wealth effect of weaker stock prices and property market slump, and the net contractionary impact of the significant currency depreciation. The increase in non-performing loans of the financial sectors was reflected in a sharp downturn in borrowing and financing, contributing to the liquidity squeeze. Both traditional export industries and export oriented manufacturing have expanded significantly, reflecting the substantial gain in competitiveness through real exchange rate appreciation. But this was not adequate to compensate for the growth retarding effect of domestic deflation.

In October 1997 the government forecast a growth rate of 7% for 1998, but subsequently adjusted this downward to 4-5% in December and again to 2-3% in March this year. The national accounts for the first and second quarters of 1998 recorded 2.6% and 6.8% contraction in the economy compared to the corresponding quarters in the previous years. Based on these figures, the economy is likely to contract by 54% in 1998.

Malaysia Economic Indicators, 1995-1999






GDP per capita growth (annual %)






Inflation, consumer prices (annual %)






Foreign direct investment, net inflows (BoP, current US$)






Unemployment, total (% of total labor force)






5.0 Conclusion and Policy Implementation

This paper

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