How Will The Currency Crisis Affect The Economies of Southeast Asia?

How will the currency crisis affect the economies of southeast Asia?
Analysis by John D. Hancock, Senior Economist
Written September 12, 1997

Central banks in Thailand, the Philippines, Malaysia and Indonesia have succumbed to currency speculators in recent months and have abandoned their policies of pegging their currencies to a basket of currencies dominated by the U.S. dollar. The currency pegging policies became vulnerable because of ballooning trade deficits. The deterioration of trade accounts in turn were caused by several factors (not all applicable to all countries). The dramatic rise of the dollar against the yen over the past two years has hurt the competitiveness of producers in the region. Global over-investment in semiconductor, petro-chemical, steel and automobile manufacturing have hit major export industries. Rising real wages have diminished the cost advantage that attracted waves of foreign direct investment over the previous decade. Finally, banks in the region have been hurt by bad loans brought about by increasingly speculative risk taking in economies that, it seemed for a while at least, could do no wrong.

The currencies of these countries are not likely to fall significantly more. The depreciation to date has been sufficient in most cases to offset the appreciation that had occurred due to the rise of the dollar over the past two years. In some cases, the recent depreciation has been twice the magnitude of the previous appreciation. The currencies of the region will also be supported by higher interest rates, which will compensate international investors for additional currency risk and trade balances are already improving.

Domestic demand in the short run will suffer and therefore, U.S. exports to the region will as well. The depreciation hurts in a number of ways. Because lending in developing countries is risky, international investors often hedge risks by making loans denominated in dollars and by making short maturity loans. The devaluation of the local currency makes debt servicing of dollar denominated loans more expensive for domestic companies. In addition, because most debt is of short maturity, developing economies are particularly sensitive to interest rate increases. The devaluation will create even more problems for banking systems already troubled by non-performing loans and low capital-adequacy ratios. Japan has by far the highest exposure to the region of the developed countries. Japan’s economy will be hurt not only by week demand for Japanese exports, but also by a loss of competitiveness from the currency devaluations.

In the long run, Asian economies may well be better off from the latest currency fiasco. Economies in the region are largely export based and will therefore benefit substantially from the devaluation. The crisis might also lead to financial free-market reforms that would attract more foreign direct investment and would ultimately lead to greater productivity. In the early 1980’s falling commodities prices led to balance of payments crises in Thailand, Malaysia, and Indonesia. These crises led to trade reforms and the Plaza Accord, which effectively devalued local currencies against the yen. These reforms resulted in the massive inflows of capital that have driven the boom economies of the region for the last decade.