CURRENCY

CONVERTIBILI
TY
– PROS & CONS
&
1997 ASIAN
CRISIS
 Index
Foreign Exchange Markets

Introduction

Convertibility Currency

Fully Convertible Currency

Partially Convertible Currency

Non Convertible Currency

Advantages of capital account convertibility

Limitations of capital account convertibility

Currrent Account convertibility –Pros and Cons

Why should you park your investments abroad if the rate of return is low?

governmen’t attitude to issue

Difference between Capital a/c convertibility & Current a/c convertibility

1997 Asian Financial Crisis

History of 1997 Asian Financial Crisis

IMF Role

IMF and high interest rates

Consequences
Foreign Exchange Markets

Introduction

 During 2003-04 the average monthly turnover in the Indian foreign exchange market touched
about 175 billion US dollars.
 Compare this with the monthly trading volume of about 120 billion US dollars for all cash,
derivatives and debt instruments put together in the country, and the sheer size of the foreign
exchange market becomes evident.
 Since then, the foreign exchange market activity has more than doubled with the average
monthly turnover reaching 359 billion USD in 2005-2006, over ten times the daily turnover of
the Bombay Stock Exchange.
 As in the rest of the world, in India too, foreign exchange constitutes the largest financial
market by far. Liberalization has radically changed India’s foreign exchange sector.
 Indeed the liberalization process itself was sparked by a severe Balance of Payments and
foreign exchange crisis.
 Since 1991, the rigid, four-decade old, fixed exchange rate system replete with severe import
and foreign exchange controls and a thriving black market is being replaced with a less
regulated, “market driven” arrangement.
 While the rupee is still far from being “fully floating” (many studies indicate that the effective
pegging is no less marked after the reforms than before), the nature of intervention and range
of independence tolerated have both undergone significant changes.
 With an overabundance of foreign exchange reserves, imports are no longer viewed with fear
and skepticism.
 The Reserve Bank of India and its allies now intervene occasionally in the foreign exchange
markets not always to support the rupee but often to avoid an appreciation in its value.
 Full convertibility of the rupee is clearly visible in the horizon.
 The effects of these development s are palpable in the explosive growth in the foreign
exchange market in India.

 An important corollary of India’s foreign exchange policy has been the quick and significant
accumulation of foreign currency reserves in the past few years.
 Starting from a situation in 1990-91 with foreign exchange reserves level barely enough to
cover two weeks of imports, and about $32 billion at the beginning of 2000, India’s foreign
exchange position rocketed to one of the largest in the world with over $155 billion in mid-
2006.
 Since 2000, this implies a compounded annual growth rate of about 28% with the years 2003
and 2004 having the most stunning rises at 48% and 45% respectively.
 During these two years the US dollar fell against the Euro by 19% and against the rupee by
9%.
 Without RBI intervention, the latter figure is likely to have been larger and the reserves
accumulation less spectacular.
 A sizable foreign exchange reserve acts as liquidity cover and protects against a run on the
country’s currency, and reduces the rate of interest on Indian debt in the world market by
lowering the country risk perception by international rating agencies.
 However, beyond a point, it begins to affect the money supply in the country, and interest
rates.
 There are significant “sterilization costs” to avoid this and the RBI loses money by earning
low returns on the safe assets used to park the reserves.
 Given this low rate of return, there has been discussion about the unique proposal to use part
of the reserves to fund infrastructure projects.
Convertibility currency

 The Prime Minister, Dr. Manmohan Singh in a speech at the Reserve Bank of India, Mumbai,
on March 18, 2006 referred to the need to revisit the subject of capital account convertibility.

 To quote:“Given the changes that have taken place over the last two decades, there is merit in
moving towards fuller capital account convertibility within a transparent framework…I will
therefore request the Finance Minister and the Reserve Bank to revisit the subject and come
out with a roadmap based on current realities”.

 Convertible currencies are defined as currencies that are readily bought, sold, and converted
without the need for permission from a central bank or government entity.

 Most major currencies are fully convertible; that is, they can be traded freely without
restriction and with no permission required.

 The easy convertibility of currency is a relatively recent development and is in part

attributable to the growth of the international trading markets and the FOREX markets in
particular.

 Historically, movement away from the gold exchange standard once in common usage has led
to more and more convertible currencies becoming available on the market.

 Because the value of currencies is established in comparison to each other, rather than
measured against a real commodity like gold or silver, the ready trade of currencies can offer
investors an opportunity for profit.

Fully convertible currency

 The U.S. dollar is an example of a fully convertible currency.

 There are no restrictions or limitations on the amount of dollars that can be traded on the
international market, and the U.S. Government does not artificially impose a fixed value or
minimum value on the dollar in international trade.

 For this reason, dollars are one of the major currencies traded in the FOREX market.

Partially convertible currency

 The Indian rupee is only partially convertible due to the Indian Central Bank’s control over
international investments flowing in and out of the country.

 While most domestic trade transactions are handled without any special requirements, there
are still significant restrictions on international investing and special approval is often
required in order to convert rupees into other currencies.

 Due to India’s strong financial position in the international community, there is discussion of
allowing the Indian rupee to float freely on the market, altering it from a partially convertible
currency to a fully convertible one.

Non convertible currency

  Almost all nations allow for some method of currency conversion; Cuba and North Korea are
the exceptions.

 They neither participate in the international FOREX market nor allow conversion of their
currencies by individuals or companies.

 As a result, these currencies are known as blocked currencies; the North Korean won and the
Cuban national peso cannot be accurately valued against other currencies and are only used
for domestic purposes and debts.

 Such nonconvertible currencies present a major obstruction to international trade for

companies who reside in these countries.

 Convertibility is the quality of paper money substitutes which entitles the holder to redeem
them on demand into money proper.

Advantages of capital account convertibility

 Capital Account Convertibility refers to the freedom to convert local financial assets into
foreign financial assets and vice versa at market determined rates of exchange.
 It is associated with changes of ownership in foreign/domestic financial assets and liabilities
and embodies the creation and liquidation of claims on, or by, the rest of the world. CAC can
be, and is, coexistent with restrictions other than on external payments.
 It also does not preclude the imposition of monetary/fiscal measures relating to foreign
exchange transactions which are of a prudential nature”.
 So this means that CAC will result in free and unregulated inflow and outflow of Capital
funds.
 India has since long adopted the Current Account Convertibility wherein the exporters and
importers can have easy conversion to and forth in foreign currency where they trade.

 It enables relaxation of the Capital Account, which is under tremendous pressure from the
commercial sectors of India.
 Along with the financial capitalists, the reputed commercial firms in India jointly derive and
enjoy the benefits of the CAC policy, which speculate the stock markets through investments.
 In fact, the CAC policy in India is pursued primarily to gain the speculator's and the punter's
confidences in the stock markets.
 Greater Capital Mobility: If CAC is allowed, it is argued that foreign fund inflows to the
country become easier thus increasing the availability of large capital stock. Developing
nations, which are usually capital-scarce, are blessed under unhindered mobility of capital and
this capital can be used in long term investments thus raising the national income. Our NRI
Diaspora will benefit tremendously if and when CAC becomes a reality. The reason is on
account of current restrictions imposed on movement of their funds. As the remittances made
by NRI’s are subject to numerous restrictions which will be eased considerably once CAC is
incorporated.
 Access to global pool of savings: Once the door to investing in international securities gets
opened up, CAC will allow residents to hold internationally diversified portfolios thereby
reducing the vulnerability of income streams to shocks in the domestic market. It also opens
the gate for international savings to be invested in India. It is good for India if foreigners
 invest in Indian assets — this makes more capital available for India’s development. That is,
it reduces the cost of capital. When steel imports are made easier, steel becomes cheaper in
India. Similarly, when inflows of capital into India are made easier, capital becomes cheaper
in India.
 Effective Financial Intermediation: CAC helps institutions access to various financial
instruments and institutions.
 In terms of theory, one of the primary aims of increasing the degree of capital account
openness is to help countries to obtain the advantages of improved risk sharing and thereby
lowering the volatility in macroeconomic aggregates like output, consumption and
investment, which will, in turn, has welfare enhancing effects.
 There would be more and more capital available to the country, and the cost of capital would
decline. Just as there are gains from trade, there are advantages to the free movement of
capital, which is, in a way, the freedom to trade in financial assets.
 The spreads of banks and nonbank financial institutions would come down due to growing
competition, rendering the financial system more efficient.
 Tax levels would move closer to international levels thereby reducing evasion and capital
flight.
 The cost of government borrowing would fall in response to lower interest rates, thus
lowering the fiscal deficit.
 It would become quite difficult for a country to follow unwise macroeconomic policies,
because, under CAC, Markets would peremptorily punish imprudence.
 The adoption of convertibility will speed up the reform, especially in the financial sector. This
will help India turn into a major financial centre in Asia. Given its vast pool of skilled labor
force and rapidly developing information technology industry, India certainly has the
potential to become such a centre. It is also true that full convertibility is a necessary
condition for becoming a hub of financial activity.
 Most importantly convertibility induces competition against Indian finance. Currently,
finance is a monopoly in mobilizing the savings of Indian households for the investment plans
of Indian firms. This will have repercussions for GDP growth, since finance is the ‘brain’ of
the economy.

Limitations of capital account convertibility

 An open capital account could lead to the export of domestic savings, which for capital scarce
developing countries would disrupt the financing of domestic investment.
 Secondly, CAC could expose the economy to larger macroeconomic instability emanating
from the volatility of short-term capital movements and the risk of massive capital outflows.
 Thirdly, premature liberalization (that is, if the speed and sequencing of reforms are not
appropriate) could initially stimulate capital inflows that would lead to appreciation of real
exchange rate and thereby destabilize an economy undergoing the fragile process of transition
and structural reform.
 Fourthly, because of higher capital inflows preceding CAC, the appreciating real exchange
rate would shift resources from tradable to non-tradable sectors (such as construction,
housing, hotels and tourism, etc.) and this would happen in the backdrop of rising external
liabilities.
 Finally, a convertible capital account could generate financial bubbles, especially through
irrational investment in real estate and equity market financed by unrestrained foreign
borrowing.
 Despite several benefits, CAC has proved to be insufficient in solving the Indian financial
crises, the complete solution of which lies in having a regulated inflow of capital into the
economy.
 The famous trilemma of international macroeconomics says that a country cannot
simultaneously attain the three objectives of open capital account, monetary independence,
and a fixed exchange rate. India, which has had a flexible exchange rate for much of its
history, can continue to have monetary independence even with CAC. The problem will arise
when there are significant upward pressures on the exchange rate as a result of capital inflows
(or foreign currency borrowing by domestics). In this case, the government might want to
resist this pressure for the sake of preventing undue pressures on the tradable sector. In other
words, it might de facto want to maintain a fixed or a semi fixed exchange rate, and the
trilemma will then bite.
 Sterilization means that the RBI sells debt paper to absorb the excess liquidity arising from its
purchase of dollars. Sterilization has its cost. The value of the debt paper the RBI sells to the
banks decreases as its market supply increases. This means that the interest rate payable on
sterilization increases.
 The Tarapore committee did not pay much attention on exchange rate overvaluation.
 Added to this are the quasi-fiscal costs of holding reserves which are invested in US or other
Treasury securities, carrying a lower rate of interest than the rate at which it causes
Government to raise money in the Indian market.
 Inflation in India arising from excess liquidity introduced by the RBI’s purchase of dollars to
weaken the currency. It seems obvious that fuller CAC may increase the problems, both of
inflation and loss of competitiveness of the Rupee at a global stage.
 The difference between Trade in Widgets and Dollars, persuasive empirical evidence on the
benefits of full convertibility is lacking.
 But for countries with weak financial sectors and macroeconomic vulnerabilities,
convertibility leads to greater instability in growth without dividend in terms of higher
average rate. on the fiscal front, India remains far from ideal conditions for convertibility. The
average growth rate of almost 8% during 2003-04 to 2005-06 has led to increased tax
revenues and some reduction in the deficit but not nearly enough.
 Moreover, we can scarcely be sure that the deficit will not return to the higher level if the
GDP growth rate and therefore tax revenue growth revert to the previous trend as happened
after 1996-97. With interest payments on the debt amounting to more than 6% of the GDP,
gross fiscal deficit of 8% and debt-to-GDP ratio of more than 90%, convertibility is bound to
leave India vulnerable to a crisis.
 One hazard is that the government itself would be tempted to turn to lower-interest short-term
external debt to finance its deficits and debt.
 Third, the financial sector is still insufficiently developed in India. Banks are predominantly
in the public sector and credit markets relatively shallow.
 Insurance has barely been opened to the private sector with the foreign investment in it
capped at 26%.
 The debt and equity markets are thin and dominated by public sector FIs and FIIs. Because
the Indian debt and equity markets are tiny in relation to the worldwide stakes of the FIIs, any
time the latter begin to exit the Indian market, the financial markets go into turmoil.
  India is still far from fully integrated on the trade front. For this reason ensuring a competitive
exchange rate is a high priority. A move to the capital account convertibility is bound to bring
more capital inflows initially and force an appreciation of the rupee. If the appreciation ends
up being large and persistent, it could put trade integration into jeopardy.
 Finally, the embrace of full capital account convertibility can place the ongoing reforms in
other areas at grave risk.

Currrent Account convertibility –Pros and Cons

 Current account convertibility opens up the domestic economy to foreign capital.

 Foreign capital augments investible resources of the home country and facilitates faster
growth.
 Cost of capital for domestic firms is lowered and access to global capital markets is enhanced.
 Just as there is gains from international trade in goods and services, there are gains from trade
in financial assets.
 It allows residents to hold globally diversified portfolios improving their risk return trade off.
 It lowers the funding cost for resident borrowers.
 Economists talk of capital output ratio. In order for the GDP to grow at 8-9 percent, 25
percent more investment is required.
 Twenty to 25 percent of the country’s gross icome should be invested in various
infrastructural assets. India’s investment rate has not been more than 20-25 percent of GDP at
best of times.
 The remaining five to six percent must come from foreign investments otherwise we will not
be able to achieve a high growth rate.
 Our savings rate should be 32-34 percent but in actuality it is only 26 percent.
 The gap has to be filled by foreign investment.
 Take the case of Japan, Scandinavia, Europe—there the opportunities for investment are
limited.
 They are looking for more attractive investments abroad which will give say, eight percent
return as against the three percent they get in their own country.
 So money is lying idle in those countries. Developing countries are short of funds, therefore,
the opening up of capital account does augment the investible resources of the home country.
 Our companies can access the capital and their cost of capital will come down. If we are to
rely only on domestic capital, the cost would be high.
 Some investments will simply not be undertaken. Export and import of goods and services is
good for the welfare of all countries engaged in it.
 For example, software services from India, we do it much better than developed countries.
 But we have to import a lot of goods either because other countries produce it better.
 Then why not apply the same logic to capital.
 The major fear is not only about foreigners investing here but what if domestic investors start
investing abroad. But why should they do it. As a wise investor, who will be tempted to invest
abroad and earn three percent when the same investment can yield eight percent in the
domestic market.
Why should you park your investments abroad if the rate of return is low?

 Rate of return on investment has come to two percent in Japan.

 In India it is 4.6 percent.
 Unless e are fearing a massive crisis—either a political or economic collapse, the fear about
capital account convertibility is not justified.
 Our political system is working well, government is functioning well, no major political crises
is also foreseen?
 We also do not expect an economic crisis as in Thailand.
 Foreign capital in India constitutes a very small part of the total capital.
 Particularly short term capital that has a maturity of six month.
 That constitutes a much small portion.
 Even if all of that leaves tomorrow, Indian economy is not going to collapse.
 Our total foreign debt as a percentage of GDP is very small. Short term debt component in
that is still smaller.
 So this fear about taking foreign capital away from India if capital account convertibility
comes is totally unjustified.
 Today India and China offer the best investment opportunity globally in manufacturing,
services and infrastructure.
 Because of wrong policies in power, roads, ports, investments are not flowing in.
 Current account convertibility also means, competition among financial intermediaries,
improves efficiency, cuts transaction costs, deepen financial markets.
 Specialisation in financial services guided by core competence may be increased, increasing
allocative efficiency.
 Capital account convertibility imposes certain disciplines on federal,state governments and
policy makers.
 Domestic tax regimes and other fiscal parameters must coverge to international standards to
prevent capital flight from home.
 Competition is the best way to increase efficiency in public sector banks and other private
banks.
 Our banking sector requires a dose of competition. Banks, investment companies, mutual
funds and insurance sector will only benefit from competition.
 Capital accounts convertibility will also lead to specialization in products offered by banks.
 It also puts a cap on uncontrolled budget deficits, uncontrolled government expenditure
thereby putting certain discipline in the Finance Ministry.
 Large deficits show up on current account as debits and running up large current account
deficits will lose the confidence of foreign investors in meeting our liabilities.
 When there is current account deficit, it means imports are more than exports.
 In normal situations it should not exceed 1.5-2 % of GDP.
 Anything beyond that is not sustainable and quite dangerous also. In Thailand, the current
account deficit for three years was nine percent of GDP.
 If we have to keep current account under control then budget deficits should also be under
control. They must raise more resources by way of taxation not by way of borrowing.
 Borrowing creates problems for the future as interest burden will increase.
 Large deficits will also lead to depreciation of currency.
 Imposes discipline on domestic macro economic policy making.
  Monetary policy must work within the constraints of uncovered interest rate regime must be
in tandem with what is happening and cannot be arbitrary.
 Right now the country’s capacity to attract foreign capital is substantial.
 Once the capital account is convertible then the monetory policy, interest rate policy, fiscal
policy must converge to international standards a there cannot be any undue restriction on
flow of money.

What is the governmen’t attitude to the issue?

1) We must be able to follow our own monetory policy.

2) We must have exchange rate stability

3) Our currency, financial markets should be reasonably linked to foreign markets.

 But the fact is that a country cannot enjoy all three of them, only two.
 For eg. If you want freedom with monetary policy and foreign market linkages then exchange
rate will not be quite stable. If you want stable exchange rates and linkage with rest of the
world, the country cannot have an independent monetary policy.
 So current account deficits puts restrictions on the ability of government to run independent
policies. Financial markets will become volatile with interest rates, exchange rates fluctuating
every minute.
 Banks, companies, individuals will have to learn to live with it. Financial derivatives have
been evolved to manage these volatilities. Financial products to hedge the risks have to be in
place.
 When foreign capital flows freely in the country in times of a political or economic crisis it
can be taken back as freely by investors. In crisis times, every investor is not rational.
 They follow a herd mentality. The remedy for this is prudent economic management, prudent
political management, but keeping political capital out is not the answer.
 We have partial capital mobility? At present there are NRI, FCNR bank accounts and FII
investments coming in.
 Will capital account convertibility bring more of those? No according to Jagdish Bhagavati.
In China controls on capital and current account has not affected the flow of FDI.
 Why don’t we selectively open up sectors for foreign investors as China. Some say it is our
labor laws and lack of infrastructure that is keeping foreign investment away and not capital
controls.
 In the case of exchange rate, many countries have tied their currency to the US $ at fixed rate
of exchange. Argentina, Hongkong, and China have done that.
 We have a market determined rate. Exchange rate will be fixed between $ and Rs by a
Currency Board, a controversy that is yet to be settled.
 Many economists say if you want to have a stable current account what is required is a fixed
exchange rate. In capital account convertibility regime, the risk of contagion of inevitable.
 If some thing goes wrong in Pakistan then investors panic and get away from India even if
India is doing well. They might take the view that the entire South Asia is unsafe.
  This is what happened in the East Asian Crisis. South Korea and Malaysia were doing fine
unlike Thailand but investors panicked and withdrew from all similar countries.
 Nobody can guarantee that even if inflation rates are moderate, budget deficits are low,
current account deficit is low, then no crisis will occur.
 If neighbouring countries are not performing well, then investors might panic about a similar
situation occurring in India.
 Investors in developed countries do not distinguish between well-managed strong emerging
economies and ill-managed weak economies.
 For them all emerging economies are emerging economies. South Korea and Malaysia were
doing fine but when things went wrong in Thailand and Indonesia investors withdrew from all
the places. Before we move to a full current account convertibility we need to have other pre-
requisites. Government must bring down fiscal deficit, RBI should be given full control

How are capital a/c convertibility and current a/c convertibility different?

 Current account convertibility allows free inflows and outflows for all purposes other than for
capital purposes such as investments and loans.
 In other words, it allows residents to make and receive trade-related payments -- receive
dollars (or any other foreign currency) for export of goods and services and pay dollars for
import of goods and services, make sundry remittances, access foreign currency for travel,
studies abroad, medical treatment and gifts, etc.
 Current account is defined as including the value of trade in merchandise, services,
investment, income and unilateral transfers.
 Current account convertibility, being essential to the development of multilateral trade, three
approaches to current account convertibility has been adapted by developing countries.
 These are the pre-announcement, by-product, and front-loading approaches. Each approach is
distinguished by the importance it attaches to convertibility relative to other economic
objectives.

1997 Asian Financial Crisis

 The Asian Financial Crisis was a period of financial crisis that gripped much

of Asia beginning in July 1997, and raised fears of a worldwide economic meltdown due
to financial contagion.

 The crisis started in Thailand with the financial collapse of the Thai baht caused by the
decision of the Thai government to float the baht, cutting its peg to the USD, after exhaustive
efforts to support it in the face of a severe financial over extension that was in part real
estate driven.

 At the time, Thailand had acquired a burden of foreign debt that made the country
effectively bankrupt even before the collapse of its currency.
  As the crisis spread, most of Southeast Asia and Japan saw slumping currencies, devalued
stock markets and other asset prices, and a precipitous rise in private debt.

 Though there has been general agreement on the existence of a crisis and its consequences,
what is less clear are the causes of the crisis, as well as its scope and resolution. 

 Indonesia, South Korea and Thailand were the countries most affected by the crisis. Hong

Kong, Malaysia, Laos and the Philippines were also hurt by the slump.

 The People's Republic of China, India, Taiwan, Singapore, Brunei and Vietnam were less

affected, although all suffered from a loss of demand and confidence throughout the region.

 Foreign debt-to-GDP ratios rose from 100% to 167% in the four large ASEAN economies in
1993–96, and then shot up beyond 180% during the worst of the crisis.

 In South Korea, the ratios rose from 13 to 21% and then as high as 40%, while the other
northern newly industrialized countries fared much better. Only in Thailand and South Korea
did debt service-to-exports ratios rise.

 Although most of the governments of Asia had seemingly sound fiscal policies,

the International Monetary Fund (IMF) stepped in to initiate a $40 billion program to stabilize
the currencies of South Korea, Thailand, and Indonesia, economies particularly hard hit by
the crisis. The efforts to stem a global economic crisis did little to stabilize the domestic
situation in Indonesia, however.

 After 30 years in power, President Suharto was forced to step down on 21 May 1998 in the

wake of widespread rioting that followed sharp price increases caused by a drastic
devaluation of the rupiah. The effects of the crisis lingered through 1998. In the Philippines
growth dropped to virtually zero in 1998.

 Only Singapore and Taiwan proved relatively insulated from the shock, but both suffered
serious hits in passing, the former more so due to its size and geographical location between
Malaysia and Indonesia. By 1999, however, analysts saw signs that the economies of
Asia were beginning to recover.

History

 Until 1997, Asia attracted almost half of the total capital inflow to developing countries. The
economies of Southeast Asia in particular maintained high interest rates attractive to foreign
investors looking for a high rate of return.

 As a result the region's economies received a large inflow of money and experienced a

dramatic run-up in asset prices. At the same time, the regional economies of  Thailand,
 Malaysia,  Indonesia,  Singapore, and South Korea experienced high growth rates, 8–12%
GDP, in the late 1980s and early 1990s. This achievement was widely acclaimed by financial
institutions including the IMF and World Bank, and was known as part of the "Asian
economic miracle".

 The causes of the debacle are many and disputed. Thailand's economy developed into a
bubble fuelled by "hot money". More and more was required as the size of the bubble grew.

 The same type of situation happened in Malaysia, and Indonesia, which had the added
complication of what was called "crony capitalism". 

 The short-term capital flow was expensive and often highly conditioned for quick profit.
Development money went in a largely uncontrolled manner to certain people only, not
particularly the best suited or most efficient, but those closest to the center of power.

 Many economists believe that the Asian crisis was created not by market psychology or
technology, but by policies that distorted incentives within the lender–borrower relationship.

 The resulting large quantities of credit that became available generated a

highly leveraged economic climate, and pushed up asset prices to an unsustainable level.

 These asset prices eventually began to collapse, causing individuals and companies
to default on debt obligations.

 The resulting panic among lenders led to a large withdrawal of credit from the crisis
countries, causing a credit crunch and further bankruptcies.

 In addition, as foreign investors attempted to withdraw their money, the exchange market was

flooded with the currencies of the crisis countries, putting depreciative pressure on their
exchange rates.

 To prevent currency values collapsing, these countries' governments raised domestic interest
rates to exceedingly high levels (to help diminish flight of capital by making lending more
attractive to investors) and to intervene in the exchange market, buying up any excess
domestic currency at the fixed exchange rate with foreign reserves.

 Neither of these policy responses could be sustained for long. Very high interest rates, which
can be extremely damaging to an economy that is healthy, wreaked further havoc on
economies in an already fragile state, while the central banks were hemorrhaging foreign
reserves, of which they had finite amounts.

 When it became clear that the tide of capital fleeing these countries was not to be stopped, the
authorities ceased defending their fixed exchange rates and allowed their currencies to float.
The resulting depreciated value of those currencies meant that foreign currency-
 denominated liabilities grew substantially in domestic currency terms, causing more
bankruptcies and further deepening the crisis.

 Other economists, including Joseph Stieglitz and Jeffrey Sachs, have downplayed the role of

the real economy in the crisis compared to the financial markets.

 The rapidity with which the crisis happened has prompted Sachs and others to compare it to a
classic bank run prompted by a sudden risk shock.

 Sachs pointed to strict monetary and contractory fiscal policies implemented by the
governments on the advice of the IMF in the wake of the crisis, while Frederic Mishkin points
to the role of asymmetric information in the financial markets that led to a "herd mentality"
among investors that magnified a small risk in the real economy.

 The crisis had thus attracted interest from behavioural economists interested in market

psychology

IMF Role

 Such was the scope and the severity of the collapses involved that outside intervention,
considered by many as a new kind of colonialism, became urgently needed.

 Since the countries melting down were among not only the richest in their region, but in the
world, and since hundreds of billions of dollars were at stake, any response to the crisis had to
be cooperative and international, in this case through the International Monetary Fund (IMF).

 The IMF created a series of bailouts ("rescue packages") for the most affected economies to
enable affected nations to avoid default, tying the packages to reforms that were intended to
make the restored Asian currency, banking, and financial systems as much like those of the
United States and Europe as possible.

 In other words, the IMF's support was conditional on a series of drastic economic reforms
influenced by neoliberal economic principles called a "structural adjustment package" (SAP).
The SAPs called on crisis-struck nations to cut back on government spending to reduce
deficits, allow insolvent banks and financial institutions to fail, and aggressively raise interest
rates.

 The reasoning was that these steps would restore confidence in the nations' fiscal solvency,
penalize insolvent companies, and protect currency values.

 Above all, it was stipulated that IMF-funded capital had to be administered rationally in the
future, with no favoured parties receiving funds by preference.
  In at least one of the affected countries the restrictions on foreign ownership were greatly
reduced. There were to be adequate government controls set up to supervise all financial
activities, ones that were to be independent, in theory, of private interest.

 Insolvent institutions had to be closed, and insolvency itself had to be clearly defined.

 In short, exactly the same kinds of financial institutions found in the United States and Europe
had to be created in Asia, as a condition for IMF support.

 In addition, financial systems had to become "transparent", that is, provide the kind of reliable
financial information used in the West to make sound financial decisions.

 However, the greatest criticism of the IMF's role in the crisis was targeted towards its
response. 

 As country after country fell into crisis, many local businesses and governments that had
taken out loans in US dollars, which suddenly became much more expensive relative to the
local currency which formed their earned income, found themselves unable to pay their
creditors.

 Although such reforms were, in most cases, long needed, the countries most involved ended
up undergoing an almost complete political and financial restructuring.

 They suffered permanent currency devaluations, massive numbers of bankruptcies, collapses

of whole sectors of once-booming economies, real estate busts, high unemployment,
and social unrest. For most of the countries involved, IMF intervention has been roundly
criticized.

 The role of the International Monetary Fund was so controversial during the crisis that many
locals called the financial crisis the "IMF crisis". 

IMF and high interest rates

 The conventional high-interest-rate economic wisdom is normally employed by monetary

authorities to attain the chain objectives of tightened money supply, discouraged currency
speculation, stabilized exchange rate, curbed currency depreciation, and ultimately contained
inflation.

 In the Asian meltdown, highest IMF officials rationalized their prescribed high interest rates
as follows:

 When their governments approached the IMF, the reserves of Thailand and South Korea were
perilously low, and the Indonesian Rupiah was excessively depreciated. Thus, the first order
of business was... to restore confidence in the currency. To achieve this, countries have to
make it more attractive to hold domestic currency, which in turn, requires increasing interest
 rates temporarily, even if higher interest costs complicate the situation of weak banks and
corporations.

 "Why not operate with lower interest rates and a greater devaluation? This is a relevant trade
off, but there can be no question that the degree of devaluation in the Asian countries is
excessive, both from the viewpoint of the individual countries, and from the viewpoint of the
international system. Looking first to the individual country, companies with substantial
foreign currency debts, as so many companies in these countries have, stood to suffer far
more from… currency (depreciation) than from a temporary rise in domestic interest rates….
Thus, on macroeconomics… monetary policy has to be kept tight to restore confidence in the
currency..."

Thailand

 From 1985 to 1996, Thailand's economy grew at an average of over 9% per year, the highest
economic growth rate of any country at the time. Inflation was kept reasonably low within a
range of 3.4–5.7%. The baht was pegged at 25 to the US dollar.

 On 14 May and 15 May 1997, the Thai baht was hit by massive speculative attacks. On 30
June 1997, Prime Minister said that he would not devalue the baht. This was the spark that
ignited the Asian financial crisis as the Thai government failed to defend the baht, which was
pegged to the U.S. dollar, against international speculators. Thailand's booming economy
came to a halt amid massive layoffs in finance, real estate, and construction that resulted in
huge numbers of workers returning to their villages in the countryside and 600,000 foreign
workers being sent back to their home countries. The baht devalued swiftly and lost more
than half of its value. The baht reached its lowest point of 56 units to the US dollar in January
1998. The Thai stock market dropped 75%. Finance One, the largest Thai finance company
until then, collapsed.

 The Thai government was eventually forced to float the Baht, on 2 July 1997. On 11 August
1997, the IMF unveiled a rescue package for Thailand with more than $17 billion, subject to
conditions such as passing laws relating to bankruptcy (reorganizing and restructuring)
procedures and establishing strong regulation frameworks for banks and other financial
institutions. The IMF approved on 20 August 1997, another bailout package of $3.9 billion.

 By 2001, Thailand's economy had recovered. The increasing tax revenues allowed the country
to balance its budget and repay its debts to the IMF in 2003, four years ahead of schedule.
The Thai baht continued to appreciate to 33 Baht to the Dollar in December 2009.
Indonesia

 In June 1997, Indonesia seemed far from crisis. Unlike Thailand, Indonesia had low inflation,
a trade surplus of more than $900 million, huge foreign exchange reserves of more than $20
billion, and a good banking sector. But a large number of Indonesian corporations had been
borrowing in U.S. dollars.

 In July 1997, when Thailand floated the baht, Indonesia's monetary authorities widened the
rupiah trading band from 8% to 12%. The rupiah suddenly came under severe attack in
August. On 14 August 1997, the managed floating exchange regime was replaced by a free-
floating exchange rate arrangement. The rupiah dropped further. The IMF came forward with
a rescue package of $23 billion, but the rupiah was sinking further amid fears over corporate
debts, massive selling of rupiah, and strong demand for dollars.

 Although the rupiah crisis began in July and August 1997, it intensified in November when
the effects of that summer devaluation showed up on corporate balance sheets. Before the
crisis, the exchange rate between the rupiah and the dollar was roughly 2,600 rupiah to 1
USD. The rate plunged to over 11,000 rupiah to 1 USD in January 1998, with spot rates over
14,000 during January 23–26 and trading again over 14,000 for about six weeks during June-
July 1998. On 31 December 1998, the rate was almost exactly 8,000 to 1 USD. Indonesia lost
13.5% of its GDP that year.

South Korea

 Macroeconomic fundamentals in South Korea were good but the banking sector was
burdened with non-performing loans as its large corporations were funding aggressive
expansions. The South Korean conglomerates, more or less completely controlled by the
government, simply absorbed more and more capital investment. Eventually, excess debt led
to major failures and takeovers. For example, in July 1997, South Korea's third-largest car
maker, Kia Motors, asked for emergency loans.

 In the wake of the Asian market downturn, Moody's lowered the credit rating of South Korea
from A1 to A3, on 28 November 1997, and downgraded again to B2 on 11 December. That
contributed to a further decline in South Korean shares since stock markets were already
bearish in November. In 1998, Hyundai Motors took over Kia Motors. Samsung Motors' $5
 billion dollar venture was dissolved due to the crisis, and eventually Daewoo Motors was sold
to the American company General Motors (GM).

 The South Korean won, meanwhile, weakened to more than 1,700 per dollar from around
800. Despite an initial sharp economic slowdown and numerous corporate bankruptcies,
South Korea has managed to triple its per capita GDP in dollar terms since 1997.

 In South Korea, the crisis is also commonly referred to as the IMF crisis.

Philippines

 The Philippine central bank raised interest rates by 1.75 percentage points in May 1997 and
again by 2 points on 19 June. Thailand triggered the crisis on 2 July and on 3 July, the
Philippine Central Bank was forced to intervene heavily to defend the peso, raising the
overnight rate from 15% to 32% right upon the onset of the Asian crisis in mid-July 1997.
The peso fell significantly, from 26 pesos per dollar at the start of the crisis, to 38 pesos as of
mid-1999, and to 54 pesos as of first half August 2001.

 The Philippine economy recovered from a contraction of 0.6% in GDP during the worst part
of the crisis to GDP growth of some 3% by 2001.

Hong Kong

 Although the two events were unrelated, the collapse of the Thai baht on 2 July 1997, came
only 24 hours after the United Kingdom handed over sovereignty of Hong Kong to the
People's Republic of China.

 In October 1997, the Hong Kong dollar, which had been pegged at 7.8 to the U.S. dollar since
1983, came under speculative pressure because Hong Kong's inflation rate had been
significantly higher than the U.S.'s for years.

 Monetary authorities spent more than US$1 billion to defend the local currency. Since Hong
Kong had more than US$80 billion in foreign reserves, which is equivalent to 700% of
its M1 money supply and 45% of its M3 money supply, the Hong Kong Monetary
Authority (effectively the city's central bank) managed to maintain the peg.

 The Hong Kong Monetary Authority then promised to protect the currency. On 15 August
1998, it raised overnight interest rates from 8% to 23% , and at one point to 500%. The
HKMA had recognized that speculators were taking advantage of the city's unique currency-
 board system, in which overnight rates automatically increase in proportion to large net sales
of the local currency.

 The HKMA and Donald Tsang, then the Financial Secretary, declared war on speculators.
The Government ended up buying approximately HK$120 billion (US$15 billion) worth of
shares in various companies, and became the largest shareholder of some of those companies.

China

 The Chinese currency, the renminbi (RMB), had been pegged to the US dollar at a ratio of 8.3
RMB to the dollar, in 1994.

 Having largely kept itself above the fray throughout 1997–1998 there was heavy speculation
in the Western press that China would soon be forced to devalue its currency to protect
the competitiveness of its exports vis-a-vis those of the ASEAN nations, whose exports
became cheaper relative to China's.

 However, the RMB's non-convertibility protected its value from currency speculators, and the
decision was made to maintain the peg of the currency, thereby improving the country's
standing within Asia.

 The currency peg was partly scrapped in July 2005 rising 2.3% against the dollar, reflecting
pressure from the United States.

 While China was unaffected by the crisis compared to Southeast Asia and South Korea, GDP
growth slowed sharply in 1998 and 1999, calling attention to structural problems within its
economy.

 In particular, the Asian financial crisis convinced the Chinese government of the need to
resolve the issues of its enormous financial weaknesses, such as having too many non-
performing loans within its banking system, and relying heavily on trade with the United
States.

United States and Japan

 The "Asian flu" had also put pressure on the United States and Japan.

 Their markets did not collapse, but they were severely hit. On 27 October 1997, the Dow
Jones industrial plunged 554 points or 7.2%, amid ongoing worries about the Asian
economies.

 The New York Stock Exchange briefly suspended trading. The crisis led to a drop
in consumer and spending confidence (see 27 October 1997 mini-crash).
  Indirect effects included the dot-com bubble, and years later the housing bubble and
the Subprime mortgage crisis. Japan was affected because its economy is prominent in the
region.

 Asian countries usually run a trade deficit with Japan because the latter's economy was more
than twice the size of the rest of Asia together; about 40% of Japan's exports go to Asia.

 The Japanese yen fell to 147 as mass selling began, but Japan was the world's largest holder
of currency reserves at the time, so it was easily defended, and quickly bounced back.

 GDP real growth rate slowed dramatically in 1997, from 5% to 1.6% and even sank into
recession in 1998, due to intense competition from cheapened rivals. The Asian financial
crisis also led to more bankruptcies in Japan.

 In addition, with South Korea's devalued currency, and China's steady gains, many companies
complained outright that they could not compete.

Consequences

Asia

 The crisis had significant macro-level effects, including sharp reductions in values

of currencies, stock markets, and other asset prices of several Asian countries. 

 The nominal US dollar GDP of ASEAN fell by US$9.2 billion in 1997 and $218.2 billion
(31.7%) in 1998.

 In South Korea, the $170.9 billion fall in 1998 was equal to 33.1% of the 1997 GDP. Many
businesses collapsed, and as a consequence, millions of people fell below the poverty line in
1997–1998. Indonesia, South Korea and Thailand were the countries most affected by the
crisis.

 The above tabulation shows that despite the prompt raising of interest rates to 32% in the
Philippines upon the onset of crisis in mid-July 1997, and to 65% in Indonesia upon the
intensification of crisis in 1998, their local currencies depreciated just the same and did not
perform better than those of South Korea, Thailand, and Malaysia, which countries had their
high interest rates set at generally lower than 20% during the Asian crisis.

 This created grave doubts on the credibility of IMF and the validity of its high-interest-rate
prescription to economic crisis.

 There was a general rise in anti-Western sentiment, with George Soros and the IMF in

particular singled out as targets of criticisms.
  Heavy U.S. investment in Thailand ended, replaced by mostly European investment, though
Japanese investment was sustained. 

 More long-term consequences included reversal of the relative gains made in the boom years
just preceding the crisis. Nominal US dollar GDP per capital fell 42.3% in Indonesia in 1997,
21.2% in Thailand, 19% in Malaysia, 18.5% in South Korea and 12.5% in the Philippines. 

 The CIA World Fact book reported that the per capita income (measured by purchasing

power parity) in Thailand declined from $8,800 to $8,300 between 1997 and 2005; in
Indonesia it declined from $4,600 to $3,700. Over the same period, world per capita income
rose from $6,500 to $9,300. 

 The crisis has been intensively analyzed by economists for its breadth, speed, and dynamism;
it affected dozens of countries, had a direct impact on the livelihood of millions, happened
within the course of a mere few months, and at each stage of the crisis leading economists, in
particular the international institutions, seemed a step behind.

 Perhaps more interesting to economists was the speed with which it ended, leaving most of
the developed economies unharmed.

 These curiosities have prompted an explosion of literature about financial economics and a

litany of explanations why the crisis occurred.

 A number of critiques have been leveled against the conduct of the IMF in the crisis,
including one by former World Bank economist Joseph Stiglitz.

Outside Asia

 After the Asian crisis, international investors were reluctant to lend to developing countries,
leading to economic slowdowns in developing countries in many parts of the world.

 The powerful negative shock also sharply reduced the price of oil, which reached a low of
$8 per barrel towards the end of 1998, causing a financial pinch in OPEC nations and other
oil exporters.

 This reduction in oil revenue contributed to the 1998 Russian financial crisis, which in turn
caused Long-Term Capital Management in the United States to collapse after losing $4.6
billion in 4 months.

 A wider collapse in the financial markets was avoided when Alan Greenspan and the Federal
Reserve Bank of New York organized a $3.625 billion bail-out. Major emerging
economies Brazil and Argentina also fell into crisis in the late 1990s (see Argentine debt
crisis).
 The crisis in general was part of a global backlash against the Washington Consensus and
institutions such as the IMF and World Bank, which simultaneously became unpopular in
developed countries following the rise of the anti-globalization movement in 1999.

 Four major rounds of world trade talks since the crisis, in Seattle, Doha, Cancún, and Hong
Kong, have failed to produce a significant agreement as developing countries have become
more assertive, and nations are increasingly turning toward regional or bilateral free trade
agreements(FTAs) as an alternative to global institutions.

 Many nations learned from this, and quickly built up foreign exchange reserves as a hedge
against attacks, including Japan, China, South Korea. 

 Pan Asian currency swaps were introduced in the event of another crisis. However,
interestingly enough, such nations as Brazil, Russia, and India as well as most of East Asia
began copying the Japanese model of weakening their currencies, restructuring their
economies so as to create a current account surplus to build large foreign currency reserves.

 This has led to an ever increasing funding for US treasury bonds, allowing or aiding housing
(in 2001–2005) and stock asset bubbles (in 1996–2000) to develop in the United States.