Phil - Greenspan, from Dec 2:
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The current crisis is likely to accelerate the dismantling in many Asian countries of the remnants of a system with large elements of government-directed investment, in which finance played a key role in carrying out the state's objectives. Such a system inevitably has led to the investment excesses and errors to which all similar endeavors seem prone. Government-directed production, financed with directed bank loans, cannot readily adjust to the continuously changing patterns of market demand for domestically consumed goods or exports. Gluts and shortages are inevitable. The accelerated opening up in recent years of product and financial markets worldwide offers enormous benefits to all nations over the long run. However, it has also exposed more quickly and harshly the underlying rigidities of economic systems in which governments--or governments working with large industrial groups--exercise substantial influence over resource allocation.......
Sustained, spectacular growth in Asian economies fostered expectations of high returns with moderate risk. Moreover the global stock market boom of the 1990s provided the impetus to seek these perceived high returns. As that boom progressed, investors in many industrial countries found themselves more heavily concentrated in the recently higher valued securities of companies in the developed world, whose rates of return, in many instances, had reached levels perceived as uncompetitive with the earnings potential in emerging economies, especially in Asia. The resultant diversification induced a sharp increase in capital flows into those economies. To a large extent, they came from investors in the United States and western Europe. A substantial amount came from Japan, as well, owing more to a search for higher yields than to rising stock prices and capital gains in that country. The rising yen through mid-1995 also encouraged a substantial increase in direct investment outflows from Japan.
In retrospect, it is clear that more investment monies flowed into these economies than could be profitably employed at reasonable risk. It may have been inevitable in those conditions of rapid growth, ample liquidity, and an absence of sufficient profitable alternatives,that much investment moved into the real estate sector, with an emphasis by both the public and private sectors on conspicuous construction projects that had little economic rationale. These real estate assets, in turn, ended up as collateral for a significant proportion of the assets of domestic financial systems. In many instances, those financial systems were already less than robust, beset with problems of poor lending standards, weak supervisory regimes, and inadequate capital.
At the same time, rising business leverage added to financial fragility. Businesses were borrowing to maintain high rates of return on equity and weak financial systems were poorly disciplining this process. In addition, explicit government guarantees of debt or, more often, the presumption of such guarantees by the investment community, encouraged insufficient vigilance by lenders and hence greater leverage. But high debt burdens allow little tolerance for rising interest rates or slowdowns in economic growth, as recent events have demonstrated.
Moreover, the rapidly growing foreign currency denominated debt, in part the result of pegged exchange rates to the dollar, put pressure on companies to earn foreign exchange. But earning it became increasingly difficult. The substantial rise in the value of the dollar since mid-1995, especially relative to the yen, made exports of the Southeast Asian economies less competitive. In addition, in some cases, the glut of semiconductors in 1996 and the accelerated drop in their prices suppressed export earnings growth, exerting further pressures on highly leveraged businesses.
In time, the pressures on what had become fixed exchange rate regimes mounted as investors, confronted with ever fewer profitable prospects, slowed the pace of new capital inflows. Fearing devaluation, many domestic Asian businesses sought increasingly to convert domestic currencies into foreign currencies, or, equivalently, slowed the conversion of export earnings into domestic currencies. To counter pressures on exchange rates, countries raised interest rates. For fixed-exchange-rate, highly leveraged economies, it was only a matter of time before slower growth and higher interest rates led to difficulties for borrowers, especially those with fixed obligations.
Particularly troublesome over the past several months has been the so-called contagion effect of weakness in one economy spreading to others as investors perceive, rightly or wrongly, similar vulnerabilities. This is an age old phenomenon. When investors are unsettled by uncertainties and fears, they withdraw commitments on a broad front; the finer distinctions between countries and currencies are lost. There is a flight to safe-haven investments, many of which are in developed nations.
....a small open economy can maintain an exchange rate fixed to a hard currency only under certain conditions....But when exchange rates are fixed, with or without currency boards, should monetary and fiscal policies diverge significantly from those of the larger economy, the currency lock of the smaller economy would be difficult to hold irrespective of the size of reserves..... the exploitation of above normal profit opportunities, that is, arbitrage, will force prices to change until expected returns have been equalized.
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