External economy considerations – Part 10

I am now using Friday’s blog space to provide draft versions of the Modern Monetary Theory textbook that I am writing with my colleague and friend Randy Wray. We expect to publish the text sometime in 2013. Our (very incomplete) textbook homepage – Modern Monetary Theory and Practice – has draft chapters and contents etc in varying states of completion. Comments are always welcome. Note also that the text I post here is not intended to be a blog-style narrative but constitutes the drafting work I am doing – that is, the material posted will not represent the complete text. Further it will change as the drafting process evolves.

Chapter 21 Policy in an Open Economy: Exchange Rates, Balance of Payments, and Competitiveness

This material updates the work already done on Chapter 21 that appeared in the following blogs:

Today, I am just continuing filling in the gaps in the Chapter.
21.7 Currency crises


The South East Asian Debt Crisis 1997


The crisis proper began in Thailand in July 1997. The Thai baht was pegged to the US, a practice that was common among the Asian economies. Its real estate sector had pushed the nation’s foreign debt beyond sustainable limits and speculative capital outflows, motivated by the fear of losses if the currency fell in value put pressure on the exchange rate.

In the face of these pressures, the central bank was unable to maintain the peg as it ran short of the required foreign currency reserves. Once the government floated the baht on July 2, 1997, its value fell by more than 50 per cent as international investors dumped it on the foreign exchange rate and created a massive excess supply.

The collapse of the currency effectively rendered the nation bankrupt, given the large volumes of foreign-currency denominated debt held by the private sector. There was a significant fall in the local shares market and several major financial institutions were bankrupted.

The development exposed the dangers of maintaining currency pegs, which required central banks to have sufficient foreign currency reserves to maintain the agreed parities. This made all currencies in the region susceptible to speculative attacks.

While the structure of the Thai economy was very different economy to the Tigers in the East, speculators considered that all currencies were in danger. This belief became a self-fulfilling prophecy and by August 1997, speculative attacks on the currencies of Indonesia, Malaysia and the Philippines led to declines in their exchange rates.

The crisis spread in September to Hong Kong, Singapore, and Taiwan and, in November 1997, the capital outflow from South Korea forced it to devalue.

The banks that had extended short-term loans to these nations refused to roll-over the debt and an instant credit crunch was created.

It is clear that the stronger advanced nations such as the US, Japan and the EU could have intervened and facilitated enough liquidity to stop the panicked capital outflow. Not only should have their central banks provided credit lines to the central banks in the Asian nations but the advanced governments should have brokered roll-over arrangements with the private banks to stop the panic.

Instead, the main response from the advanced nations came through the IMF which intervened, first, in Thailand in July 1997.

The Asian financial crisis exposed the deficiencies in the International Monetary Fund (IMF). In the Advanced Material Box – The IMF Annual Report 1997 we see that the IMF considered the Asian economies both advanced (South Korea) and less developed (for example, Indonesia and Thailand) to be growing strongly on the back of extensive deregulation of the their financial systems.

While there was some recognition that capital inflow was very strong and perhaps volatile, the IMF failed to correctly assess the vulnerability that their policy prescriptions (liberalisation etc) had created. The world found out just two weeks after this report was published.

By the end of 1997, the IMF was harshly criticising the Asian governments that earlier in the year they had been praising.

It is now accepted that a series of policy blunders in the IMF respose deepened and spread the crisis.

In return for bailout funds, the IMF insisted that the nations under speculative attack in the currency markets introduce sharp increases in interest rates and substantial fiscal contraction. The IMF applied their “one-size-fits-all” approach that was their standard response when budget deficits were significant and inflation accelerating.

This approach is questionable at the best of times but certainly was inapplicable to the Asian economies which were running budget surpluses and had stable inflation rates.

In its most simple form, the crisis was the result of excessive financial liberalisation that promoted massive capital inflow (and commensurate liabiliites) between 1993 and 1996. The liabilities tended to be short-term but the funds were used for long-term investments (for example, real estate speculation).

When export growth slowed, the capital inflows started reversing very quickly. One economist described it as “akin to a bank run” (J. Sachs, The Wrong Medicine for Asia, November 3, 1997).

But the IMF demands ensured that the crisis moved out of the foreign exchange markets and became a full-blown economic recession.

As capital outflows accelerated with the worsening economic conditions, the IMF insisted that interest rates be pushed up further and fiscal contraction deepened.

As part of the Indonesian bail-out plan, the IMF forced the government to close 16 insolvent banks claiming that this would restore confidence in the remaining banks. The result was the opposite and the panicked withdrawals of funds undermined the solvency of many of the private banks.

The Indonesian central bank injected funds into these banks (equivalent to 5 per cent of GDP) to save them, which had the effect of exacerbating the collapsing rupiah and was contradictory with the IMFs insistence that interest rates had to rise sharply.

In summary, the Asian financial crisis was the result of a lack of regulation on capital flows combined with the currency pegs.

In the case of the latter, these were interpreted by financial markets as the government insuring them against foreign exchange risk and so there was a lack of private foreign exchange hedging of the borrowing.

One the currencies collapsed and floated, these unhedged positions quickly led to bankrupcty.

Advanced material: The IMF Annual Report 1997

The – IMF Annual Report 1997 – was published on April 30, 1997, just a few weeks before the collapse in the Thai baht triggered the region’s crisis.

The Report noted (page 26):

Directors remarked upon the speed with which net capital flows to emerging markets had recovered from the disturbances associated with the Mexican financial crisis in early 1995. There was general agreement that investors had become more aware of the risks associated with investing in emerging markets. Notably, there had been a greater reliance on a wider range of macroeconomic, financial, and banking soundness indicators in assessing both economic conditions and investment opportunities in developing markets.

Chapter 5 of the Report summarised the assessments the IMF made from its annual consultations with the member countries:

South Korea:

  • “Since 1994, the current account deficit had widened sharply … [but] … capital inflows, growing in response to continued relaxation of controls on foreign equity investment and on access to trade financing, had comfortably financed this deficit” (page 59).
  • Its expanding privatisation program was praised (page 59).
  • The IMF Directors “welcomed Korea’s continued impressive macroeconomic performance … noted the challenge of ensuring that the speed of structural reforms in the financial sector and the capital account … praised the authorities for their enviable fiscal record and suggested … maintaining a strong budgetary position … welcomed the recent acceleration of capital account liberalization … considered that rapid and complete liberalization offered many benefits at Korea’s stage of economic development.” (pages 59-60)


  • The IMF considered “further substantial reforms, including financial sector reforms and the development of a strong capital market, were essential for maintaining rapid, sustained growth” (page 80)
  • “Further deregulation and opening of the economy to world markets were the key to maintaining competitiveness” (page 81)


  • The IMF “Directors strongly praised Thailand’s remarkable economic performance and the authorities’ consistent record of sound macroeconomic policies.” (page 91)
  • “The stability of the baht had served the Thai econ- omy well in the past, but Directors recommended a greater degree of exchange rate flexibility to improve monetary autonomy …” (page 91)
  • “Directors noted, economic fundamentals remained generally very strong, characterized by high saving and investment, a public sector surplus, strong export growth in recent years, and manageable debt and debt-service returns.” (pages 91-92).

27.8 Capital controls




Saturday Quiz

The Saturday Quiz will be back again tomorrow. It will be of an appropriate order of difficulty (-:

That is enough for today!

(c) Copyright 2013 Bill Mitchell. All Rights Reserved.

This Post Has 2 Comments

  1. Bill – I notice you still haven’t answered my question from part 9:

    Was Malaysia’s currency genuinely overvalued? Or would its value have quickly bounced back had their government not repegged it?

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