The 19971998 Twin Crises Asia and Latin America24

Conquering The Coming Collapse

Bill White Conquering The Coming Collapse

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The Asian meltdown in 1997 has ignited a hot debate about the driving forces of crises. While some have argued that deteriorating market fundamentals are at the core of the currency and banking crises, others have stressed the role of herding behavior in international capital markets as the sole culprit of the collapse. The estimations in the paper can throw some light into this debate.

Before examining these probabilities, it is interesting to examine in more detail the built up of the crises in these four countries. Thailand constitutes the perfect picture of the typical financial crisis, with the onset of the crisis as the economy enters a marked slowdown in growth (to about 6 percent in 1996 and forecasted to fall even further), following a prolonged boom in economic activity (about 8 to 14 percent growth rates in the period 1988-1995) that is, in part, fueled by heavy capital inflows and rapid credit creation.25 As

While the data is updated to include December 1997, the data becomes more sparse in the last six months of 1997, thus a decline in the probabilities of crises in the last six months of the sample may reflect this lack of data on the leading indicators.

Short-term capital inflows to Thailand amounts to 7-10 percent of GDP in each of the years 1994-1996.

in Latin America in the 1980s and Mexico in 1994, this extremely high expansion in credit raises questions about the asset quality of the banks. Another source of vulnerability of the Thai banking system is the banks' investment in nonbank financial institutions with large-scale exposure to the domestic property market. The explosive growth in Thailand in the early 1990s comes to an end with the real appreciation of the domestic currency and the corresponding loss of exports markets (the annual growth rate of exports falls from a peak of 30 percent per year in 1994 to about 0 in 1996). Already in 1996, financial fragilities are also quite evident. In May 1996 there is a run against the Bangkok National Bank, which is later rescued by the central bank. The collapse of the real estate market and stock prices compounds the problems of the financial sector. Finally, the increase in interest rates in 1997 to prop up the baht puts the nail in the coffin of the already defunct banking sector.

The boom-bust cycle in lending is also evident in the Philippines, fueled not only by capital inflows but also by a reform to the banking sector, which entails a dramatic reduction in reserve requirements. Bank credit increases by 44 percent a year in 1995-1996, with this doubling of loans in 2 years raising questions about asset quality in the future. As in Thailand, the rapidly expanding credit is an important contributor to the rally in stock and real estate markets. By the end of 1996, according to the estimates of the central bank of the Philippines, commercial banks' property loans account for 10 percent of total loans. Total banks' exposure to the property sector may have been even higher since property is a common form of loan collateral.26 Naturally, the exposure of banks to the real estate sector contributes to the fragility of the banking industry in the aftermath of the decline of property prices. As in other countries in the region, foreign currency exposure increases in the Philippines in the 1990s through foreign borrowing to finance domestic lending and also through the rapid expansion of foreign currency deposits27 Consumer lending also increases and fuels a surge in consumption, leading to a deterioration of the current account, which is accentuated by the real exchange rate appreciation of the domestic currency. The loss of competitiveness and the accompanying steady weakening of exports anticipate a future decline in growth

In contrast, FDI languishes at about 1 percent of GDP. The growth rate of credit to the nonfinancial private sector over 1990-1995 is more than 23 percent -and the loan to deposit ratio increases from 103 percent at the end of 1990 to 141 percent in October 1996. See, International Capital Markets: Development, Prospects, and Key Policy Issues, 1997.

See International Capital Markets: Development, Prospects, and Key Policy Issues, 1997.

While banks are required to maintain balanced FCDU books by lending in foreign currency, still banks bear the foreign exchange exposure because many borrowers may experience servicing difficulties in the event of a devaluation.

and also contribute to a substantial deterioration of the quality of banks' assets, further reducing the odds of survival of many individual financial institutions. Overall, in Thailand and the Philippines, about 70 percent of the indicators are signaling the deterioration of the macroeconomic fundamentals in the two years prior to the collapse of the peg in July 1997. The probabilities of currency crises for Thailand and the Philippines increase from a low of 20 percent in 1995 to about 100 and 80 percent, respectively, in 1997. The estimated probabilities of banking crises also show increasing financial fragilities, with the probabilities of a banking crisis in Thailand increasing from about 5 percent in 1995 to almost 40 percent in 1996. Similar pattern is observed in the Philippines, but the growth in probabilities is more moderate.

Malaysia has a number of features in common with Thailand. It is also affected by the slowdown in the region, though to a much smaller degree. It also has current account deficits similar in magnitude to those in Thailand in the period 1990-1995, although in 1996 the outlook of the external sector improves somewhat with the current account/GDP ratio declining to -5.3 percent (In Thailand the current account/GDP ratio in 1996 is still -8.0 percent). And as Thailand, Malaysia accumulates debt rapidly in the 1990s. The real estate market also surges as in Thailand.28 Malaysia is also suffering from financial fragilities as a result of the high degree of leverage of the economy29 and the large exposures to the property and stock markets. For Malaysia, 70 percent of the indicators are showing signs of distress at the onset of the crisis, with the probabilities of currency and banking crises increasing about seven times in the 1996-1997 period to 70 percent and 30 percent, respectively.

Indonesia, however, looks somewhat different. While it is true that as the other countries in the area, it is exhibiting banking fragilities30 and short-term debt sharply exceeds available foreign exchange reserves,31 the current account deficit is not deteriorating as fast32 the slowdown in growth is not yet evident, and the real exchange rate does not appreciate as much as in the other countries in the region. In fact, only very few indicators are showing signs of anomalous behavior in the months prior to the crisis,33 with the probabilities of

28 In Malaysia as in Thailand, the stock market indices of the property sector tripled in the early 1990s.

In fact, Malaysia has one of the highest credit-to-GDP ratio in the world.

In fact, the beginning of banking crisis in Indonesia can be dated to November 1992 when a large bank (Bank Summa) collapses and triggers runs on three smaller banks.

Short-term foreign debt is about 1.7 times the stock of foreign exchange reserves of the country.

In fact, in 1996, the current account deficit only reaches 3.5 percent of GDP.

33 The indicators in this paper do not pay attention to the balance sheet of the corporate sector, which crises showing a stable pattern in 1996-1997.34

As the financial crisis in Asia intensifies in 1997, financial markets in Latin American countries also come under pressure. The pressure escalates in 1998 as the crisis engulfs Russia in the summer of 1998, with some of the currencies, such as the Mexican peso declining by about 25 percent against the dollar in the first 9 months of 1998. While countries can fall prey of speculative attacks even with immaculate market fundamentals as panic spreads out and contagion takes over, it is also true that, overall, those with more severe vulnerabilities are the ones that are in general the hardest hit when euphoria ends and gloom sets in. The out-of-sample probabilities of crisis estimated in Figures 4 and 5 can suggest a "market fundamentals" assessment of the odds of full blown-out financial crisis in Latin America.

Interestingly, some of the countries that in the past have experienced periodic currency and banking crises look less prone to crises in 1998. Argentina, Bolivia, Mexico, and Peru are in this group. Others, such as Brazil, Chile, and Colombia seem more frail, with many indicators flashing red lights. For example, for Brazil there is a marked appreciation of the real exchange rate, real interest rates increase sharply, with the lending/deposit interest rate ratio showing a marked upturn and signaling the onset of a recession and increased bankrupcies. Also, banking fragilities are present. While foreign debt has still not reached dangerous levels, there are some alarming signs of possible capital flight surfacing in 1996.

Problems in Chile are mostly focused in its external sector. For example, the terms of trade deteriorate substantially following the collapse of the price of copper -Chile's most important single export and contribute to a deterioration of the current account. The deterioration of the current account is further fueled by an overall real appreciation of the domestic currency. While the economy is still growing, high lending-deposit interest rate spreads are already alerting of a future slowdown and perhaps increasing future bankrupcies. During 1996, there is also evidence of offsetting gross capital flows with domestic resident both borrowing from overseas while increasing their assets in BIS banks. Finally, the concentration of debt at short maturities has also increased.

The signs of fragility in Colombia are substantially more widespread. Overall in 19951997, mostly all financial indicators warn about an exaggerated boom-bust financial cycle, seems to be at the root of the external payments crisis in Indonesia.

Although not reported in Table 4, the out-sample forecasting accuracy of the preferred composite indicator in crisis times for Malaysia, Philippines, and Thailand increases sharply compared with the insample performance of that indicator. In contrast, the out-of-sample performance in crisis times for Indonesia deteriorates substantially, also suggesting a different characterization of the crisis in Indonesia.

with the M2 multiplier, the ratio of domestic credit-to-GDP, "excess" Ml balances, and M2/reserves increasing substantially and the stock market declining even before the unfolding of the Asian crises. Deposits in banks also decline substantially (in real terms). Signs of vulnerability are also present in the external sector, with the domestic currency appreciating in real terms and the maturity of the foreign debt declining substantially. Again in Colombia, both the deposit and the lending domestic interest rates suggest present and future fragilities.

Overall, the probabilities of currency crises for these three countries increase to about 60 to 70 percent in 1997. In contrast, (at least with information up to mid-1997) the early warnings indicators do not capture signs of banking vulnerabilities.

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