History of recent financial crisis

Continued from last week

In the previous article, we stopped at the  stage where currency traders in Mexico, having lost confidence in the future of the peso (Mexican currency), rushed into the money market to get rid of the peso and acquire dollars.

The Mexican government tried to stabilise the strength of the peso by buying peso and selling dollars, but to no avail. The government did not have enough dollar reserves.

The peso dropped 40 percent in value. The IMF, the United States and the Bank of International Settlements pledged close to $50 billion to help Mexico stabilise the peso and to redeem (settle) $47 billion of public and private sector debt that was set to mature in 1995.

As is normal in such cases, the IMF demanded from Mexico tight monetary policies and further cuts in public spending. The Mexico government complied, and this pushed the country into recession.

Fortunately the recession was short-lived.

By 1997, Mexico was once more experiencing sound growth rates which enabled it to reduce its debt and pay the $20 billion borrowed from the United States ahead of schedule.

The South East Asian Crisis

The Asian financial crisis of 1997 engulfed particularly the economies of Indonesia, Thailand and South Korea. The IMF had to step in to bring about stability. Japan, Malaysia, Singapore and the Philippines also caught the financial flu, but they did not ask for IMF loans.

The seeds of these crises were seen during the previous decade when countries were astounding the world with their unprecedented growth rates. The engine of their economic growth was exporting. At first they exported basic materials such as rubber and textiles.

Later, they exported high technology products such as automobiles, semi-conductors and consumer electronics.

These exports brought wealth home and entrepreneurs branched into investing in commercial and residential properties, industrial assets and infrastructure. The value of commercial and industrial estates rose to dizzying heights, thereby enticing a building boom such as had never been witnessed in Asia in recent times.

The entrepreneurs or speculators easily obtained bank loans to finance the construction industry. Governments of these countries encouraged these investments. By the mid 1990, South East Asia was gripped by an investment mania of the unprecedented type much of it with loans made in dollars.

As the volume of investments ballooned, the quality thereof declined. New investments were being made on poor projections of future demand for the properties. The result was that supply outstripped demand. The crises began in this way.

By early 1997, excess capacity in South Korea and Thailand forced prices downwards. There was inadequate demand for the properties that had been constructed with bank loans.

The companies that obtained the loans could not pay back what they owed. The banks themselves were now in trouble. What had happened in South Korea and Thailand was being repeated elsewhere in the region.

The fact that debts were contracted in dollars meant that unless the countries had enough dollar reserves they could not repay foreign creditors. The foreign creditor realised this and started panicking.

Worst of all, the exports had tapered. Most of the Asian countries saw their import outpacing their exports and their current accounts changing from positive to negative.

The Asian financial meltdown started in Thailand where the country ran short of reserves to pay foreign creditors who were demanding reimbursements in dollars.

Shortage of reserves also meant that Thailand could not import goods needed both for consumption and development.

The IMF agreed to provide the Thai government with rescue loans but imposed strict conditions. The Thai government was required to raise taxes, privatise State enterprises, raise interest rates and to close insolvent financial institutions.

In December 1997, the Thai government shut 56 financial institutions, laying-off 16 000 employees. This made the recession worse.

As in case of Mexico, we see that in the troubled South East Asian economies, IMF conditionalities made conditions worse before economic revival started.