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2.3.3 Financial contagion
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If nothing else, the sequence and breadth of events in 1997 underlined a consequence of an increasingly globalised and integrated financial system. Indeed, 1997 provided striking evidence of the power of financial contagion in today's environment. While there have been various factors identified as potentially specific causes of the crisis, the scope and the extent of the East Asian crisis cannot be adequately addressed without examining the role of financial contagion.
The financial turbulence may be traced through a chain of financial events that include, as a major link, the collapse of a speculative real estate bubble in Bangkok which surfaced in the guise of the default of the Somprasong Land Euro-convertible in January 1997. The countries of East Asia have experienced numerous financial crises in the modern era, but the notion of defaults on Thai property loans rocking the currencies of, among others, Korea, Estonia, and Brazil would have been regarded as fanciful less than five years ago.
The issue of contagion can be addressed at two levels. Firstly, contagion can be addressed at the cross-market level, ie, how volatility in one market is transmitted to another market within the same economy. For example, from the currency market to the securities market. Secondly, contagion can be addressed at a broader level, that is, cross-country contagion effects and the channel(s) through which it occurs.
At the cross-market level, the speculative pressure in the currency markets of some EMC jurisdictions were so severe that central banks there resorted to imposing restrictions on swap transactions. However, this inadvertently translated the demand for domestic currency to selling pressure in the equity market as currency speculators-in a bid to circumvent the central banks' restrictions-used the equity market to raise the funds needed to cover their respective short-currency positions. Another channel through which the volatility in the currency markets spilled over onto equity markets was via central banks' operations to defend the domestic currency by raising interest rates. The rapidly collapsing currencies and rocketing interest rates coupled to erode the portfolio values of equity investors.
In terms of cross-country contagion, a clear consensus which appears to be emerging is that bilateral trade links and investment shares alone cannot account for the scope and the scale of the contagion. In an effort to understand the reasons for cross-country contagion effects and the channels through which it occurred, various views have been advanced.
One view is that the troubles in Thailand which began in the second half of 1996 and culminated in the floating of the baht on July 2nd 1998 acted as a "wake-up call" to investors who had been excessively euphoric over the fundamentals of emerging market economies. Weaknesses that had been overlooked, ignored or justified on the basis of expected returns were from then on viewed with greater scrutiny. In essence, investors' risk aversion jumped by quite a few points higher and, as a consequence, any situation in Indonesia, South Korea, Malaysia and the Philippines which bore the slightest resemblance to that in Thailand came to be viewed in the worst possible light.
A second view is that the differences in liquidity over time and across markets also led to what the BIS has termed "proxy hedging". This occurs when equity funds, in response to a market crisis in a particular geographical region, liquidate positions in markets which are barely affected and geographically removed in order to raise liquidity in anticipation of margin calls of a significant wave of redemptions. This can aid in the transmission of the selling pressures across geographical markets which, on the face of things, would otherwise seem totally unrelated.
The third view concerning the mechanism of transmission has been defined as the "dynamics of devaluation". The initial devaluation of the Thai baht and some other currencies within the East Asian region resulted in real exchange rate depreciation of these economies. This however, resulted in an increase in the relative competitiveness of these economies vis-à-vis other emerging market economies. As a consequence, the currencies of other emerging markets became increasingly over-valued vis-à-vis the economies which have undergone a devaluation and hence, it is thought, came under pressure themselves to depreciate.
The fourth view of cross-country contagion is the so-called "demonstration effect" of profits and losses on speculative positions. The realisation of profits and losses from speculative positions in the past can lead to shifting in such positions that increases the probability of another depreciation. The first wave of exchange rate volatility awakened domestic corporations with unhedged foreign currency exposure to their speculative positions and the urgency of hedging. However, it has been argued that this rush to hedge only caused further depreciating pressures on the respective currencies. A widening of bid-ask spreads on the indicated prices of currency options in Asia suggested that the availability of such hedges diminished rapidly just when they were most in demand.
Last is the question of why some economies proved more resilient than others to the East Asian crisis. Many observers credit this to the presence of stronger financial sectors and better banking supervision in these economies. For example, their banking sectors, while competitive, tended to have little directed lending. Implicit guarantees were perceived to be minimal and supervision more effective. Credit booms, while not altogether absent, were not fuelled to the extent that they were in other more affected economies. Lastly, institutional strength and governance in these economies are generally accepted to be stronger and more established compared to the worst afflicted economies.
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Case Studies *
The Causes of the Asian Financial and Economic Crisis *
2. Causes *
2.3 Financial Market issues
