The recent currency turmoil in Southeast Asia, beginning with the July 2, 1997 devaluation of the Thai baht, has significance that extends beyond the region's boundaries to the world at large, particularly to other emerging market economies. For 30 years, Southeast Asia has been a model of market-based economic success, with sustained high growth matched in its level and longevity only by its East Asian neighbors, South Korea, Taiwan, and Hong Kong.

    The region's experience initially validated World Bank and International Monetary Fund (IMF) recommendations to developing countries to follow liberal trade and investment policies in private enterprise-driven economies. Governments were told to focus on macroeconomic stability, high savings rates, and the delivery of public goods like education and infrastructure. Emerging market economies in other regions now emulate these policies with similarly positive results.

    Southeast Asia's sudden economic downturn prompts questions the wisdom of this policy; in particular the recommendations for capital market liberalization. No one has been more forceful in expressing these doubts than Prime Minister Dr. Mahathir Mohammed of Malaysia, probably the world's longest-serving elected head of government, a spokesperson of developing-country interests against "domination" by Western industrial nations, and co-author of the book, The Asia That Can Say No.

    Dr. Mahathir has reserved his most trenchant comments for global currency traders, particularly George Soros, an American currency hedge-fund operator and philanthropist. Even before their invited speeches at the World Bank-IMF annual meetings in Hong Kong in September 1997, Dr. Mahathir derided Mr. Soros and other currency speculators as wealthy people who use their money to force developing countries "to submit to the dictatorship of international manipulators." Mahathir expressed his own country's interest in a more international economy but one with protection "from self-serving rogues and international brigandage."

    These are remarkable claims from the leader of the world's most open economy; Malaysia's 1996 ratio of total trade to Gross Domestic Product was over 160 percent and the ratio of foreign direct investment to GDP peaked at 24 percent in the early 1990s. Dr. Mahathir is also an ardent pursuer of foreign capital, especially from American high-tech companies, many of which — such as Intel and Microsoft — recently accepted his invitation to establish regional operations in a proposed "Multimedia Supercorridor" or "wired city" to be built near Kuala Lumpur.

    Dr. Mahathir's remarks, and his subsequent policy to restrain foreign-capital mobility in Malaysia, have little support in the world of international finance. But his theory of a Western conspiracy to undermine Southeast Asia's economic growth, intended to "punish" these countries for their growing arrogance and opposition to U.S. foreign policy in areas such as human rights and the environment, has growing support among educated professionals and others in the region. Antagonism toward foreign capital-market players — not only currency traders but also (mostly American) bank and bond-rating agencies (and the IMF itself) — is reflected not only in Malaysia's controlled press, but also in Thailand's raucously free one.

    Asian countries have agreed to establish their own fund to stabilize currencies under speculative attack, but according to principles of the multilateral IMF. The failure of the U.S. government to contribute to the $17 billion IMF bail out fund for Thailand (in contrast to the lavish American response to the Mexican crisis) has been taken as evidence of Washington's lack of support (if not actual subversive intent). In response, the U.S. has agreed to contribute $3 billion to the IMF's rescue package for Indonesia, but the region remains rife with the belief that a conspiracy of the U.S. government and private financial sector is at least partly to blame for its current economic difficulties.


    The Political Moment

    The Southeast Asian financial crisis followed important political changes in the region. July 1, 1997 was meant to be a day of celebration for the Association of Southeast Asian Nations (ASEAN): the date marked both the association's 30th anniversary, and the admission of Burma (Myanmar), Cambodia, and Laos to join Vietnam as additions to the once staunchly anti-communist regional grouping. But the admission of Cambodia was deferred following its disintegration into civil war barely two weeks earlier, and the admission of Burma was strongly opposed by the U.S. and the European Union, which have imposed economic sanctions on that country to protest the continued repressive rule of the SLORC (State Law and Order Restoration Committee) military government.

    George Soros, whose Open Society Foundation funds anti-SLORC Burma activist groups in the U.S. and other countries, was one of the most vocal opponents of the country's admission into ASEAN. Perhaps unsurprisingly, conspiracy theorists claimed that Soros' actions in the currency market led to the collapse of the Thai baht on July 2 and the subsequent fall of other ASEAN countries' currencies. This was likened to a similar speculative attack Soros led on the British pound sterling in September 1992.

    Speculators, though not necessarily Soros himself, did indeed have a role to play in triggering the depreciation of Southeast Asia's currencies. But by market criteria these currencies were already ripe for a fall, and local corporations in the region did the bulk of the selling once it began.


    Economic Causes

    The immediate economic trigger was large deficits in the countries' current accounts. In Southeast Asia the deficits resulted from years of rapid growth in imports (mostly of capital goods and equipment to feed high rates of investment which in turn fed rapid output and income growth) that persistently exceeded exports of goods and services. Until recently this was not a problem, as inflows of foreign capital in both short-term portfolio (stocks and bonds) and long-term direct (plant and equipment) investment were adequate to cover the gap and maintain the more-or-less fixed parity of local currencies with the U.S. dollar.

    During the long years when the dollar was weak against the yen (the currency of Southeast Asia's largest foreign investor and trade partner), the region's export competitiveness and investment attractiveness, based on its cheap dollar-linked currencies and absence of currency risk, proved extremely attractive to foreign capital. Domestic capital-market liberalizations since the late 1980s also helped rank Malaysia, Indonesia, and Thailand among the eight largest developing-country recipients of foreign direct investment, and among the six largest recipients of net foreign-capital flows (including portfolio capital) in the 1990s. They also maintained their 30-year ranking among the world's 10 fastest-growing emerging economies.

    The appreciation of the U.S. dollar since 1995 worsened the current account deficit, by making exports expensive (especially against competing labor-intensive products from China, which had devalued its currency by 34 percent against the dollar in 1994) and imports relatively cheap. This made it more difficult to attract foreign capital, as investments became relatively expensive for investors from non-dollar countries, particularly Japan. Competition from other reforming emerging economies for both international capital and export markets also intensified. But Southeast Asian governments were unwilling to delink their currencies from the dollar.

    This absence of currency risk, and the large spread between high domestic interest rates and low U.S. dollar rates, encouraged foreigners to lend and local companies to borrow dollars for the short-term. Most of these dollar loans were not protected against exchange-rate fluctuations. The lack of such hedging was due to hedging's high cost in currencies without well-developed markets to do so, high domestic lending rates, and the presumed absence of currency risk. Cheap loans fueled domestic booms, especially in property, and contributed to widening current account deficits by stimulating import demand and increasing external debt-service payments. They also led to grand plans for big-ticket government infrastructural projects, which are externally debt- and import-intensive but earn revenues in local currency.

    At the same time, financial market liberalization not only made offshore loans easier to get, but also led to a proliferation of new banks and finance companies, especially in Indonesia and Thailand. Competition and inexperience in the funds market, together with common local business practices such as preferred lending to related companies, lending on the basis of personal and political connections, the use of stock values as collateral for loans, and generally weak financial disclosure and corporate governance, contributed to the accumulation of bad debt.

    Thailand was the worst affected, as rising wages and labor shortages hurt its labor-intensive export industries, which face intense competition from China. Low educational levels make it difficult for Thailand to raise productivity and upgrade into higher-value activities. In 1996 real GDP growth slowed to below 7 percent for the first time in many years. A looming property glut threatened the solvency of some politically well-connected finance companies, which were imprudently bailed out by the central bank. IMF warnings to the government beginning in early 1996 went unheeded.


    Political Aggravations

    In addition to weakening economic fundamentals, what tipped Thailand over the edge and made it increasingly vulnerable to speculative attacks were coincident, but related, political developments. Since the re-establishment of parliamentary democracy in 1992, the country has had a series of short-lived coalition governments, with the larger parties heavily dependent for election on vote-buying in rural areas, and intent on recouping those costs through influencing budgetary expenditures during their short stay in power. An estimated US $1.1 billion was spent in the November 1996 general elections; this led to inflation, import leakage, and lack of confidence in the new coalition government, which put further downward pressure on the exchange rate.

    Meanwhile the authority, independence, technocratic competence, and integrity of the Thai central bank, once a bastion of monetary stability, has been undermined by years of political interference and an exodus of talent to the booming private financial sector. Elected parliamentarians representing various business interests also increased their self-interested interventions into the work of the once-autonomous and powerful government ministries, which made it difficult to maintain the country's tradition of running balanced or surplus government budgets. Four finance ministers and three central bank governors within a 12-month period did not help. Needed improvements in education and industrial upgrading were neglected. Thailand's economic growth had outpaced the development of institutions necessary to add greater local value to its exports in order to compete in the world's increasingly open markets.

    The Thai central bank continued to support the baht by selling dollars from its foreign reserves, until it gave up and floated the currency on July 2. The subsequent IMF "rescue package" provides $17 billion mainly to restore the country's depleted reserves, in exchange for tax increases, spending cuts, the closure of 42 finance companies, and a restructuring of the financial sector. A new bankruptcy law is needed, as is abolition of the two-tier system separating baht transactions by foreigners and locals introduced in May to curb foreign speculation.

    After the baht was floated, speculative selling triggered similar falls of the Philippine peso, Malaysian ringgit, and Indonesian rupiah, whose economic fundamentals were similar to, but not as bad as, those in Thailand. The initial 10 to 25 percent fall in these currencies (in comparison with the 35 percent fall in the baht) was in line with similar depreciations by European currencies against the U.S. dollar over the past year.

    Why the Southeast Asian currencies continued to fall beyond this level — and are now considered by many economists to be very much undervalued — is a matter of some debate. Dr. Mahathir's prominent verbal attacks on currency traders and his stock-market interventions in Malaysia helped push regional markets down, as already nervous local and foreign investors took flight in anticipation of possible further capital market controls. Indonesian forest fires contributed to current account deficits and a decrease in confidence in government-management capabilities. More seriously, the initial devaluations exposed weaknesses in many local companies, whose dollar purchases to cover massive dollar loan exposures were much larger than anticipated, thus further depressing markets. Other local residents then panicked, selling off their local-currency holdings.


    Global Capital: Friend or Foe?

    Southeast Asia's experience highlights the increasingly important role of those working in financial markets — bond traders, fund managers, currency speculators, and international bankers — in the management of the global economy. Their influence is especially powerful in small, emerging market economies, who are in the midst of liberalizing trade policies and capital markets to accelerate their growth with inputs of foreign capital. Ironically, both Dr. Mahathir and George Soros agree that global capitalism has excesses that must be curbed.

    Southeast Asia's currency turmoil shows that both domestic and foreign market actors were quite adept in knowing when and where to pull out their capital. Even before the crisis, high domestic interest rates suggest that markets were putting a high risk premium on domestic loans in these countries. Thailand was "hit" first and hardest by speculators, followed by the Philippines, while Malaysia (until Dr. Mahathir's interventions), which has stronger economic fundamentals, was least affected. In contrast, Singapore and Hong Kong, which have the region's most open capital markets but well-managed monetary authorities and private financial sectors, were initially untouched by speculators until it was apparent that the deep plunge in their neighbors' currencies would have negative impacts on the two cities' competitiveness, particularly in service exports. Still, Hong Kong's currency remains firm and Singapore's has depreciated by only 10 percent.

    Many economists view positively the perspicacity of financial market actors who exert a necessary discipline on governments' fiscal and monetary behavior and corporations' business practices. This in turn restrains economically inefficient and politically inequitable practices like vote-buying and "crony capitalism" such as credit, government contract, and privatization privileges for the politically well-connected. In this view, market opening can substitute for and hasten along liberal political and economic reforms. These ultimately benefit the largest number of people in a country, not just a small political or business elite.

    Yet many governments view negatively the fact that financial markets undermine their national sovereignty by reducing the ability of fiscal and monetary policy to pursue their goals. They put countries at the mercy of shadowy, politically unaccountable, and ill-informed money merchants. Whether out of malice, ignorance, or excessively short-term horizons, they can drive currencies — and hence domestic and international prices — out of line with economic fundamentals. This leads to resource misallocation, higher interest rates (due to increased volatility and risk), and thus slower economic growth.

    After the Mexican peso crashed in December 1994, "the markets" were dismissed as "fifteen guys in tennis shoes in their twenties" who, by not understanding Mexico, undervalued its currency. Malaysia's Finance Minister Anwar Ibrahim has also suggested that "foreigners" do not understand its economic fundamentals and thus withdrew their capital unnecessarily from the local stock market. These statements suggest that developing country prices are controlled by ignorant Western MBAs, working from distant computer terminals in New York or London.

    In fact, traders in Hong Kong, Singapore and other capital cities of the region — most of them Asian nationals — are probably the prime movers of currency and stock markets in the region, including funneling information to multinational colleagues elsewhere in the world. Those with insight into local political risks and insider-corporate information may be even more pessimistic than distant foreigners, as perhaps suggested by the fact that the baht has traded at a significantly lower rate on the local, rather than the foreign, counter in Thailand. A related situation exists in Indonesia. The rupiah appears to be undervalued, judging by the country's economic fundamentals and "correct" policy moves since the crisis. This may reflect some inefficiency in international markets. But it is also possible that local players, who account for most of the holders of local currency and who have been dumping it to buy dollars, may have negative "inside information" about political and corporate risks not included in the conventional macro data.

    Global financial markets are imperfect because of such information gaps. In addition, open capital markets render small countries especially vulnerable to market developments elsewhere, over which they have no control; for example, a rise in American interest rates attracts short-term capital back to the U.S. For this reason, even the World Bank and IMF now recommend that developing countries retain some discretionary capital controls to protect their capital accounts from external shocks.

    Still, for Southeast Asia, the long-term benefits of participating in global financial markets have been positive. Foreign-capital inflows have enabled the region's economies to grow more rapidly than other emerging economies that have received less capital. The region's economic growth is far more rapid than it would have been if it relied only on local savings to fund investment. The recent market upheavals may be only a relatively small and temporary dent in this rapid-growth trajectory. If this crisis serves as a "wake-up call" to these countries to get their financial houses in order and increases their export and asset competitiveness, it could even trigger more efficient growth and attract more foreign capital in the near future. Mexico's strong recovery from the much more severe 1994 peso crisis, and Britain's equally impressive recovery from the 1992 sterling depreciation, suggest this is possible if the correct public and private sector policy responses are undertaken.


    The End of the "Asian Miracle"?

    The currency crisis in Southeast Asia, along with Japan's prolonged recession and South Korea's economic troubles, has prompted questions as to whether these events mark the vaunted Asian economic miracle's end. The short answer appears to be "no." First, only modest downturns in economic growth were projected immediately following the initial currency depreciations. All the affected economies are now expected to go into recession or muster growth rates of only up to 2.5% in 1998. Unfortunately, the subsequent "overshooting" of the currencies and the slowness of regional governments to implement the tough fiscal and monetary policies necessary to clear financial and property markets have since worsened the prognosis. But, except for Thailand, the other countries should still grow at least for the next 12 to 18 months.

    Second, the medium- to long-term fundamentals of these economies remain strong. They share high savings rates (at 40 percent, nearly twice as high as those in Latin America), favorable demographics (large young populations with shrinking dependency ratios, which will keep savings and thus investment and growth high), small governments (with expenditures relative to GDP typically only a third to half of those in more advanced countries) and balanced or surplus government budgets (the 1996-97 modest deficits in some countries were a temporary aberration).

    Third, Southeast Asia, South Korea, and Japan all have financial sectors that have lagged behind in development and in many cases are still captive to big-business interests. If the recent troubles lead to restructuring and continued liberalization of this sector — as well as strengthening the government institutions that underpin it — greater efficiency and fairness may be expected in the accumulation and circulation of capital, resulting in a return to fast growth but with higher productivity.

    But some reservations remain. First, financial reform requires political will, especially in countries where a small cartel of politically-powerful government or private banks and companies benefit from current restrictions on competition. Second, institutional reform and improved public- and private-sector financial management take expertise and time, and should precede further financial liberalization, which may therefore be delayed. Third, it is tempting for countries that are still doing relatively well to resist reform and to seek a less painful "third way" or "Asian way" out of their current problems, one probably involving the use of much larger public funds to bail out insolvent government agencies and companies deemed to be of strategic importance. But such a path is likely to be punished by the markets — a global force lacking nationalistic sensibility, political ideology, or cultural identity, in Asia as elsewhere.

    Linda Lim is a faculty member in the Business School. This piece was written with information current up to Novermber 1997 only.