Ten Years Later-- A Look Back at the East Asian Currency Crisis

Transcription

1 Ten Years Later-- A Look Back at the East Asian Currency Crisis Lawrence J. Lau, Ph. D. President and Ralph and Claire Landau Professor of Economics The Chinese University of Hong Kong and Kwoh-Ting Li Professor in Economic Development, Emeritus, Stanford University 27 Asian Pension Fund Roundtable Pension Funds in Asia: Setting the Pace Singapore, November 2, 27 Phone: (852) ; Fax: (852) LAWRENCELAU@CUHK.EDU.HK; WebPages:

2 A Preview The East Asian Currency Crisis Revisited The Fundamental Causes of the East Asian Currency Crisis Predatory Speculation--It Works in Both Directions Is Another Crisis Possible? Concluding Remarks Lawrence J. Lau, The Chinese University of Hong Kong 2

3 A Brief History of the East Asian Currency Crisis The East Asian currency crisis began in Thailand in late June of 1997 and essentially stabilized in the last quarter of With the exception of two currencies, the Chinese Yuan and the Hong Kong Dollar, all other East Asian currencies lost significant value vis-à-vis the U.S. Dollar, albeit by varying degrees, and did not recover to pre-crisis levels. China contributed greatly to the stabilization of and subsequently recovery from the East Asian currency crisis by holding firm the exchange rate of the Renminbi. This was much appreciated by all the affected East Asian economies. Once the exchange rates stabilized at their new (lower) levels, the rates of interest began to decline to more reasonable levels that permitted normal real economic activities to resume. While the declines in real GDP were exceptionally sharp in the affected East Asian economies, the recoveries were also very rapid-- by mid-1999 the real GDPs of all of the affected economies began to show positive rates of growth. Lawrence J. Lau, The Chinese University of Hong Kong 3

4 The Recovery Followed the Stabilization of the External Environment The Hong Kong Government entered into the Hong Kong Stock Market to counter predatory speculation in August The hedge funds had a credit crunch due to losses, net redemption and curtailment of available credit lines in the aftermath of the collapse of the Russian ruble and the ensuing Long-Term Capital Management crisis. After 3Q/1998, there were no more speculative attacks on the Thai Baht or any other East Asian currency. The U.S. economy was exceptionally strong throughout the period of the East Asian currency crisis (until 4Q/2), providing a market for East Asian exports and compensating for the very slow recovery of the Japanese economy. Lawrence J. Lau, The Chinese University of Hong Kong 4

5 The Recovery from the Crisis For most of the East Asian economies, the bottom was reached (% rate of growth of real GDP) in 2Q/1999 with the recovery most tentative in Indonesia and Philippines with their then political problems. In terms of quantity, exports as well as imports began to grow very rapidly once the exchange rates stabilized. The current accounts turned positive and foreign exchange reserves were more than replenished. Inflation caused by the devaluation subsided very quickly. The stock markets rebounded from their troughs but not all of them recovered fully to their pre-crisis levels. While the simultaneous downturns in the East Asian economies exacerbated the problems of one another, the simultaneous upturns allowed the recovery to be extraordinarily and unexpectedly rapid, with the rising import demands of each economy feeding into rising export demands Lawrence of its trading J. Lau, The Chinese partners. University of Hong Kong 5

6 Indexes of East Asian Exchange Rates: Local Currency/US$ (1/2/1997=1) Exchange Rate Index (1/2/97=1) of Selected Countries/Regions Japanese Yen Brazilian Real Chinese Yuan Hong Kong Dollar Indian Rupee Indonesian Rupiah Malaysian Ringgit Philippine Peso Singapore Dollar Korean Won New Taiwan Dollar Thai Baht /2/97 4/2/97 7/2/97 1/2/97 1/2/98 4/2/98 7/2/98 1/2/98 1/2/99 4/2/99 7/2/99 1/2/99 1/2/ 4/2/ 7/2/ 1/2/ 1/2/1 4/2/1 7/2/1 1/2/1 1/2/2 4/2/2 7/2/2 1/2/2 1/2/3 4/2/3 7/2/3 1/2/3 1/2/4 4/2/4 7/2/4 1/2/4 1/2/5 4/2/5 7/2/5 1/2/5 1/2/6 4/2/6 7/2/6 1/2/6 1/2/7 4/2/7 Lawrence J. Lau, The Chinese University of Hong Kong 6 Day

7 Indexes of East Asian Exchange Rates: Without Indonesia (January 2, 1997=1) 25 Exchange Rate Index (1/2/97=1) of Selected Countries/Regions Japanese Yen Chinese Yuan Hong Kong Dollar Malaysian Ringgit Philippine Peso Singapore Dollar Korean Won New Taiwan Dollar Thai Baht 1/2/97 4/2/97 7/2/97 1/2/97 1/2/98 4/2/98 7/2/98 1/2/98 1/2/99 4/2/99 7/2/99 1/2/99 1/2/ 4/2/ 7/2/ 1/2/ 1/2/1 4/2/1 7/2/1 1/2/1 1/2/2 4/2/2 7/2/2 1/2/2 1/2/3 4/2/3 7/2/3 1/2/3 1/2/4 4/2/4 7/2/4 1/2/4 1/2/5 4/2/5 7/2/5 1/2/5 1/2/6 4/2/6 7/2/6 1/2/6 1/2/7 4/2/7 Lawrence J. Lau, The Chinese University of Hong Kong 7 Day

8 Indexes of East Asian Exchange Rates: Local Currency/US$ (3/31/1995=1) 3 Indexes of Selected East Asian Exchange Rates (March 31, 1995 = 1) Chinese Yuan Japanese Yen 25 Korean Won Thai Baht Lawrence J. Lau, The Chinese University of Hong Kong 8 3/31/95 6/3/95 9/3/95 12/31/95 3/31/96 6/3/96 9/3/96 12/31/96 3/31/97 6/3/97 9/3/97 12/31/97 3/31/98 6/3/98 9/3/98 12/31/98 3/31/99 6/3/99 9/3/99 12/31/99 3/31/ 6/3/ 9/3/ 12/31/ 3/31/1 6/3/1 9/3/1 12/31/1 3/31/2 6/3/2 9/3/2 12/31/2 3/31/3 6/3/3 9/3/3 12/31/3 3/31/4 6/3/4 9/3/4 12/31/4 3/31/5 6/3/5 9/3/5 12/31/5 3/31/6 6/3/6 9/3/6 12/31/6 3/31/7 Day

9 Indexes of East Asian Stock Market Indexes:Local Currency (1/2/1997=1) Stock Market Index (1/2/97=1) of Selected Countries/Regions China Hong Kong Indonesia Korea Malaysia Philippines Singapore Taiwan Thailand Japan India /2/97 4/2/97 7/2/97 1/2/97 1/2/98 4/2/98 7/2/98 1/2/98 1/2/99 4/2/99 7/2/99 1/2/99 1/2/ 4/2/ 7/2/ 1/2/ 1/2/1 4/2/1 7/2/1 1/2/1 1/2/2 4/2/2 7/2/2 1/2/2 1/2/3 4/2/3 7/2/3 1/2/3 1/2/4 4/2/4 7/2/4 1/2/4 1/2/5 4/2/5 7/2/5 1/2/5 1/2/6 4/2/6 7/2/6 1/2/6 1/2/7 4/2/7 Lawrence J. Lau, The Chinese University of Hong Kong 9 Day

10 Indexes of East Asian Stock Market Indexes:Local Currency (1/2/1997=1) 4 Stock Market Index (1/2/97=1) of Selected Countries/Regions China Hong Kong Indonesia Korea Malaysia Philippines Singapore Taiwan Thailand Japan Lawrence J. Lau, The Chinese University of Hong Kong 1 Day 1/2/97 4/2/97 7/2/97 1/2/97 1/2/98 4/2/98 7/2/98 1/2/98 1/2/99 4/2/99 7/2/99 1/2/99 1/2/ 4/2/ 7/2/ 1/2/ 1/2/1 4/2/1 7/2/1 1/2/1 1/2/2 4/2/2 7/2/2 1/2/2 1/2/3 4/2/3 7/2/3 1/2/3 1/2/4 4/2/4 7/2/4 1/2/4 1/2/5 4/2/5 7/2/5 1/2/5 1/2/6 4/2/6 7/2/6 1/2/6 1/2/7 4/2/7

11 Short-Term Rates of Interest 7 Short-term Rates of Interest of Selected Countries/Regions (percent p.a.) China Hong Kong 6 Indonesia Korea Malaysia Philippines 5 Singapore Taiwan Thailand Japan India /2/97 4/2/97 7/2/97 1/2/97 1/2/98 4/2/98 7/2/98 1/2/98 1/2/99 4/2/99 7/2/99 1/2/99 1/2/ 4/2/ 7/2/ 1/2/ 1/2/1 4/2/1 7/2/1 1/2/1 1/2/2 4/2/2 7/2/2 1/2/2 1/2/3 4/2/3 7/2/3 1/2/3 1/2/4 4/2/4 7/2/4 1/2/4 1/2/5 4/2/5 7/2/5 1/2/5 1/2/6 4/2/6 7/2/6 1/2/6 1/2/7 4/2/7 Percent per annum Lawrence J. Lau, The Chinese University of Hong Kong 11 Day

12 Early Warning Signals (1) L. J. Lau and and J. S. Park, Is There a Next Mexico in East Asia?, Project LINK World Meeting, Pretoria, South Africa, Sept., 1995; Lau and Park, Is There a Next Mexico in East Asia?, Beijing, China, 1996 Thailand and Philippines were identified as the most likely candidates as the next Mexico, followed by S. Korea and Indonesia China, Hong Kong, Singapore and Taiwan were identified as the least likely candidates as the next Mexico Indicators of potential vulnerability, e.g. Stock of potential short-term foreign-currency liabilities (including portfolio investment and bank loans) relative to foreign exchange reserves Interest rate differential between domestic and foreign currency-denominated loans Real exchange rate appreciation (loss of competitiveness) Lawrence J. Lau, The Chinese University of Hong Kong 12

13 Early Warning Signals (2) Indicators of economic performance, e.g. Level and rate of change of the marginal efficiency of real capital (rate of return) Rates of return on the domestic stock market relative to the rates of return on the world stock markets Lawrence J. Lau, The Chinese University of Hong Kong 13

14 Follow-On Research L. J. Lau and I. K. M. Yan, Predicting Currency Crises with a Nested Logit Model, Pacific Economic Review, Vol. 1, No. 3, 25, pp Lawrence J. Lau, The Chinese University of Hong Kong 14

15 The Causes of the East Asian Currency Crisis Revisited Insufficient official foreign exchange reserves Inadequate savings rates (the original sin of Latin American economies) relative to investment demands The high debt to equity ratio The role of expectations Lawrence J. Lau, The Chinese University of Hong Kong 15

16 Fundamental Macroeconomic Causes of the East Asian Currency Crisis Savings-investment imbalance, with investment exceeding savings--also reflected as current account imbalance. (However, current account imbalance per se does not necessarily cause a currency crisis, for example, if the imbalance is offset by long-term capital flows such as foreign direct investment or long-term foreigncurrency loans). Dependence on short-term (less than a year in maturity) foreign capital (portfolio investment--both equity and debt instruments--and loans) by private investors Foreign equity is better than foreign debt Direct investment is better than portfolio investment Insolvency caused by the revaluation of foreign-currency denominated debts and the rise in the rate of interest Domino effects of insolvency and bankruptcy Problems magnified by high leverage (high debt to equity ratio) Inadequacy of foreign exchange reserves (working capital of a country) for supporting imports, debt service, and (potential) net short-term capital outflows Real exchange rate appreciation (loss of competitiveness) due to a domestic rate of inflation higher than the U.S. rate of inflation Lawrence J. Lau, The Chinese University of Hong Kong 16

17 Dependence on Potentially Short-Term Foreign Capital Dependence on foreign capital per se is not necessarily risky, but dependence on potentially short-term foreign capital, such as foreign portfolio investment and short-term bank loans, that can be withdrawn on short notice (and usually at the first sign of real or perceived trouble), can be risky. Both the foreign portfolio investors and lenders need to be paid, directly or indirectly, in terms of foreign exchange, thus potentially putting tremendous pressure on the exchange rate to devalue, especially if the domestic borrowers do not have matching sources of foreigncurrency revenue. Lawrence J. Lau, The Chinese University of Hong Kong 17

18 Inadequacy of Foreign Exchange Reserves Relative to Liquefiable Foreign-Currency Liabilities Traditional yardstick of a level of foreign exchange reserves equal to 3-6 months of imports no longer adequate for some countries because of the magnitudes of potential movements in the capital accounts (foreign direct and portfolio investment, short- and long-term bank loans and deposits) relative to the current accounts. The International Monetary Fund s pre-crisis standard of 13 weeks of imports was established in an era in which trade flows dominate capital flows (late 195s and early 196s). (For some time after the occurrence of the East Asian currency crisis, the operation manuals of the International Monetary Fund still continues to suggest that 13 weeks of imports would be adequate.) The cross-border flow of short-term capital, if any, at the time was primarily related to the financing of trade. The old standard is totally inadequate in today s world in which the magnitudes of the potential capital flows dwarf those of the trade flows. To take care of the liquidity requirements of foreign trade under a crisis scenario, in which exporters will delay the repatriation of their export proceeds and importers and domestic borrowers of foreign debt will accelerate their payments and repayments, one has to allow at least 6 months of imports, based on the expectation that during that time frame the situation will return to normal. Lawrence J. Lau, The Chinese University of Hong Kong 18

19 Inadequacy of Foreign Exchange Reserves A higher level of foreign exchange reserves is therefore necessary to support not only imports, but also debt service (including both principal and interest), and potential net short-term capital outflows resulting from the withdrawal of foreign portfolio investors and lenders. Moreover, if the level of foreign exchange reserves is allowed to fall to a level perceived to be inadequate, a crisis, based on self-fulfilling rational expectations, will likely ensue. Potential disruptions in the foreign exchange and capital markets can be caused by the quick inflows and outflows of large pools of hot money, which can in turn affect adversely trade flows, real fixed investment and real output in the absence of a high level of foreign exchange reserves as a buffer Lawrence J. Lau, The Chinese University of Hong Kong 19

20 Ratio of Liquefiable Foreign-Currency Liabilities to Foreign Exchange Reserves The potential liquefiable foreign exchange liabilities, that is, the foreign exchange that can be withdrawn from the country in the short term, with little or no prior notice, consist of the market value of the stock of foreign portfolio investment and short-term (with maturity less than one year) foreign loans. The market value of the stock of foreign portfolio investment is not in general readily available. It can be estimated by cumulating past foreign portfolio investments; however, the existing stock may be under- or over-estimated by this procedure because of the possibilities of gains and losses from these investments. If the economy has been growing steadily, so that the annual rates of return of the portfolio investment have been positive, then the market value of the stock of portfolio investment may well be higher than the estimate above. To these may be added the current account deficit, if any, of the current period. If foreign exchange reserves are low relative to these potential demands for withdrawals of foreign exchange, the currency may be vulnerable to a run. Lawrence J. Lau, The Chinese University of Hong Kong 2

21 Refinements It is possible to construct a more refined foreign exchange reserves adequacy indicator as follows: Potential withdrawals = 6 months of imports + the stock of liquefiable foreign currency denominated liabilities (foreign portfolio investment + short-term loans with maturity less than a year) + scheduled debt service on long-term loans + expected cash dividend payments and profit repatriation (based on a percentage of the cumulative stock of foreign direct investment). The potential withdrawals can be compared to the sum of total foreign exchange reserves and pre-arranged credit lines a low ratio indicates that a country is relatively safe from a speculative attack and a high ratio indicates vulnerability. If foreign exchange reserves, plus available lines from multilateral organizations and other counties, are perceived to be less than the estimated potential foreign currency needs, a run on the foreign exchange reserves may ensue. Lawrence J. Lau, The Chinese University of Hong Kong 21

22 Ratio of Short-Term Liquefiable Liabilities to Official Foreign Exchange Reserves 2 15 % CHINA INDIA KOREA MEXICO Ratio of Short-Term Foreign Currency Liabilities to Foreign Exchange Reserves HONG KONG INDONESIA MALAYSIA PHILIPPINES SINGAPORE THAILAND TAIWAN Lawrence J. Lau, The Chinese University of Hong Kong Year

23 Ratio of Short-Term Liquefiable Liabilities to Official Foreign Exchange Reserves Ratio of Short-Term Foreign Currency Liabilities, Including Current Account Balance, to Foreign Exchange Reserves % 25 CHINA HONG KONG India INDONESIA 2 KOREA MALAYSIA 15 PHILIPPINES THAILAND SINGAPORE TAIWAN 1 MEXICO Year Lawrence J. Lau, The Chinese University of Hong Kong 23

24 Ratio of Short-Term Liquefiable Liabilities to Official Foreign Exchange Reserves Ratio of Short-Term Foreign Currency Liabilities, Including Current Account Balance, to Foreign Exchange Reserves % 8 CHINA HONG KONG 7 INDONESIA KOREA 6 MALAYSIA PHILIPPINES 5 SINGAPORE THAILAND 4 TAIWAN Year Lawrence J. Lau, The Chinese University of Hong Kong 24

25 Ratio of Short-Term Liquefiable Liabilities to Official Foreign Exchange Reserves 8 % Ratio of Short-Term Foreign Currency Liabilities to Foreign Exchange Reserves CHINA INDIA KOREA PHILIPPINES THAILAND HONG KONG INDONESIA MALAYSIA SINGAPORE TAIWAN Lawrence J. Lau, The Chinese University of Hong Kong Q1 1996Q1 1997Q1 1998Q1 1999Q1 2Q1 Quarter

26 Ratio of Short-Term Liquefiable Liabilities to Official Foreign Exchange Reserves Ratio of Short-Term Foreign Currency Liabilities, Including Current Account Balance, to Foreign Exchange Reserves 8 7 % CHINA INDIA HONG KONG INDONESIA 6 KOREA MALAYSIA 5 PHILIPPINES SINGAPORE 4 THAILAND TAIWAN Q1 1996Q1 1997Q1 1998Q1 1999Q1 2Q1 21Q1-1 Year Lawrence J. Lau, The Chinese University of Hong Kong 26

27 External Debts vs. Official Foreign Exchange Reserves--China China's External Debts vs. Official Foreign Exchange Reserves Long-term Debt Short-term Debt Total Reserves 6 US$ billions Lawrence J. Lau, The Chinese University of Hong Kong Year

28 External Debts vs. Official Foreign Exchange Reserves--Thailand 8 Thailand's External Debts vs. Official Foreign Exchange Reserves 7 6 Long-term Debt Short-term Debt Total Reserves 5 US$ billions Lawrence J. Lau, The Chinese University of Hong Kong Year

29 External Debts vs. Official Foreign Exchange Reserves Republic of Korea 25 Korea's External Debts vs. Official Foreign Exchange Reserves Long-term Debt 2 Short-term Debt Total Reserves 15 US$ billion Lawrence J. Lau, The Chinese University of Hong Kong 29 Year

30 External Debts vs. Official Foreign Exchange Reserves--Indonesia 14 Indonesia's External Debts vs. Official Foreign Exchange Reserves 12 Long-term Debt Short-term Debt Total Reserves 1 US$ billions Lawrence J. Lau, The Chinese University of Hong Kong Year

31 External Debts vs. Official Foreign Exchange Reserves Hong Kong 4 Hong Kong's External Debts vs. Official Foreign Exchange Reserves 3 Long-term Debt Short-term Debt Total Reserves 2 US$ billion Lawrence J. Lau, The Chinese University of Hong Kong 31 Year

32 External Debts vs. Official Foreign Exchange Reserves--Malaysia 8 Malaysia's External Debts vs. Offical Foreign Exchange Reserves 7 6 Long-term Debt Short-term Debt Total Reserves 5 US$ billions Lawrence J. Lau, The Chinese University of Hong Kong Year

33 External Debts vs. Official Foreign Exchange Reserves--Philippines 6 Philippines's External Debts vs. Official Foreign Exchange Reserves Long-term Debt 5 Short-term Debt Total Reserves 4 US$ billions Lawrence J. Lau, The Chinese University of Hong Kong Year

34 External Debts vs. Official Foreign Exchange Reserves--Singapore 25 Singapore's External Debts vs. Official Foreign Exchange Reserves US$ billions Long-term Debt Short-term Debt Total Reserves Lawrence J. Lau, The Chinese University of Hong Kong 34 Year

35 External Debts vs. Official Foreign Exchange Reserves--Brazil 25 Brazil's External Debts vs. Official Foreign Exchange Reserves Long-term Debt 2 Short-term Debt Total Reserves US$ billions Lawrence J. Lau, The Chinese University of Hong Kong Year

36 External Debts vs. Official Foreign Exchange Reserves--India 14 India's External Debts vs. Official Foreign Exchange Reserves 12 Long-term Debt Short-term Debt Total Reserves 1 US$ billions Lawrence J. Lau, The Chinese University of Hong Kong Year

37 Ratio of Year-End Foreign Exchange Reserves to Total International Trade 1 Figure 3: Ratio of Year-End Official Foreign Exchange Reserves to Total International Trade Selected East Asian Economies Lawrence J. Lau, The Chinese University of Hong Kong 37 China Indonesia Japan S. Korea Malaysia Philippines Singapore Thailand

38 The Current Account Balances 25 The Current Account Balance, Billion US$ Japan Hong Kong India Indonesia Korea Malaysia Philippines China Thailand Taiwan US$ billions -1-3 Lawrence J. Lau, The Chinese University of Hong Kong 38 Year

39 The Current Account Balance as a Percent of GDP 25 The Current Account Surplus (Deficit) as a Percent of GDP 2 15 China India Japan Malaysia Thailand Hong Kong Indonesia Korea Philippines Taiwan Percent Lawrence J. Lau, The Chinese University of Hong Kong 39 Year

40 Fundamental Microeconomic Causes:Borrowing Too Much, Short-Term and in Wrong Currency Maturity mismatch--borrowing short and investing (lending) long Currency mismatch--revenue and cost (liability) in different currencies Vulnerability magnified by high debt to equity ratio Insolvency caused directly or indirectly (through domino effects of bankruptcy and high nominal rates of interest) by declines in the exchange rates Oversold currencies create unnecessary bankruptcies and discourage re-capitalization and re-structuring Moral hazard on the parts of both lenders and borrowers Past bailouts (Latin American loans, Mexican loans) of developed country lenders encourage moral hazard on the part of lenders Implicit guarantee of banks and enterprises too big to fail by governments encourage moral hazard on the part of borrowers Lawrence J. Lau, The Chinese University of Hong Kong 4

41 Fundamental Microeconomic Causes: Excessive Leverage and Herd Mentality Excessive Leverage Excessive leverage of enterprises magnifies the negative effects of a sharp devaluation on foreign-currency denominated debt as well as the resulting rise in both the domestic and the foreign rates of interest Excessive leverage encourages moral hazard (recklessness) on the part of the borrowers Excessive leverage magnifies the domino effect of insolvency and bankruptcy on the entire financial system Excessive leverage also enables the hedge funds to engage in predatory speculation on a large scale Herd mentality --too much money chasing too few good projects leading to mis-pricing by developed country investors and lenders (it is better to make the same mistake Lawrence J. Lau, The Chinese University of Hong Kong 41 as everyone else)--the making of an East Asian bubble

42 What is New with the 1997 Crisis? (1) New Channels for Contagion! The speculative attacks on the New Taiwan Dollar (1/17/97) and the Hong Kong Dollar (1/23/97) showed that even ECONOMIES WITH SOUND FUNDAMENTALS WERE NOT IMMUNE! Spread to South Korea, Latin America, and Russia Traditional Channels for Contagion (through trade) Competitive devaluation Nervous domestic traders and investors (Prof. Jeffrey Sachs s rational panic ) New Channels for Contagion (through short-term capital flows) Predatory speculation by hedge funds The confidence factor--withdrawals by indiscriminate investors of developing (emerging) countries equity and debt; reduction of outstanding credit by multinational banks Domino effect of cross-country lending and re-lending (e.g., by Korean banks and chaebols) Lawrence J. Lau, The Chinese University of Hong Kong 42

43 Predatory Speculation (1) Large pools of hot money (3,-4, hedge funds with aggregate capital of US$4 billion+ in the late 199s; there are probably over 1, such funds with aggregate capital of US$5 trillion) that can move (small) markets Formulae for almost risk-free profits, especially in economies that are expected to defend their exchange rates (transactions must be large enough to be a credible threat to the exchange rates) (Short) Sales of large quantities of local currency induce purchases by local central bank or monetary authority Such purchases by the central bank or monetary authority cause the local money supply to contract and liquidity to tighten, sending the short-term rate of interest up The local central bank or monetary authority may also raise the rate of interest directly to discourage the conversion of local currencydenominated assets into foreign currency-denominated assets Lawrence J. Lau, The Chinese University of Hong Kong 43

44 Predatory Speculation (2) For example: Simultaneous shorting of currency and going long on interest rate futures (Attack on the British Pound, 1992) Simultaneous shorting of currency and stock (or stock index futures), in either spot or forward markets or both (Attacks on Hong Kong) Shorting the stock market and then selling the domestic currency proceeds for U.S. dollars Simultaneous longing of currency and stock or stock market index Predatory speculation can occur and succeed independently of the economic fundamentals if the resources of the speculators are sufficiently large relative to the size of the market Short sales of forward contracts in the local currency will have the same effect through arbitrage (Buyers of forward contracts will sell short in the spot market) Predatory speculation (of the double-short type) has the effect of depressing the exchange rate and increasing its volatility and hence Lawrence J. Lau, The Chinese University of Hong Kong 44 the interest rate risk premium

45 An Example: Hong Kong Relationship between Exchange Rate, Stock Market Index and Interest Rate, Hong Kong Exchange Rate Index, 1/2/97=1 Stock Market Index, 1/2/97=1 Interest Rate (right scale) Lawrence J. Lau, The Chinese University of Hong Kong 45 1/2/97 7/15/97 1/23/98 8/5/98 2/15/99 8/26/99 3/8/ 9/18/ 3/29/1

46 Exchange Rate, Stock Market Index and Interest Rate: China 35 Exchange Rate, Stock Market Index and Interest Rates China Exchange Rate Index, 1/2/97=1 3 Stock Market Index, 1/2/97=1 Interest Rate (3 months) r. scale 25 Interest Rate (1 year) r. scale /2/97 3/2/97 5/2/97 7/2/97 9/2/97 11/2/97 1/2/98 3/2/98 5/2/98 7/2/98 9/2/98 11/2/98 1/2/99 3/2/99 5/2/99 7/2/99 9/2/99 11/2/99 1/2/ 3/2/ 5/2/ 7/2/ 9/2/ 11/2/ 1/2/1 3/2/1 5/2/1 7/2/1 9/2/1 11/2/1 1/2/2 3/2/2 5/2/2 7/2/2 9/2/2 11/2/2 1/2/3 3/2/3 5/2/3 7/2/3 9/2/3 11/2/3 1/2/4 3/2/4 5/2/4 7/2/4 9/2/4 11/2/4 1/2/5 3/2/5 5/2/5 7/2/5 9/2/5 11/2/5 1/2/6 3/2/6 5/2/6 7/2/6 9/2/6 11/2/6 1/2/7 3/2/7 5/2/7 Lawrence J. Lau, The Chinese University of Hong Kong 46 Day

47 Exchange Rate, Stock Market Index and Interest Rate: Hong Kong, Relationship between Exchange Rate, Stock Market Index and Interest Rate, Hong Kong Exchange Rate Index, 1/2/97=1 Stock Market Index, 1/2/97=1 Interest Rate (Right Scale) /1/1997 2/3/1997 2/5/1997 2/7/1997 2/9/1997 2/11/1997 2/1/1998 2/3/1998 2/5/1998 2/7/1998 2/9/1998 2/11/1998 2/1/1999 2/3/1999 2/5/1999 2/7/1999 2/9/1999 2/11/1999 2/1/2 2/3/2 2/5/2 2/7/2 2/9/2 2/11/2 2/1/21 2/3/21 2/5/21 2/7/21 2/9/21 2/11/21 2/1/22 2/3/22 2/5/22 2/7/22 2/9/22 2/11/22 2/1/23 2/3/23 2/5/23 2/7/23 2/9/23 2/11/23 2/1/24 2/3/24 2/5/24 2/7/24 2/9/24 2/11/24 2/1/25 2/3/25 2/5/25 2/7/25 2/9/25 2/11/25 2/1/26 2/3/26 2/5/26 2/7/26 2/9/26 2/11/26 2/1/27 2/3/27 2/5/27 2/7/27 2/9/27 Lawrence J. Lau, The Chinese University of Hong Kong 47 Day

48 Exchange Rate, Stock Market Index and Interest Rate: Hong Kong, Relationship between Exchange Rate, Stock Market Index and Interest Rate, Hong Kong, Exchange Rate Index, 1/2/6=1 Stock Market Index, 1/2/6=1 Interest Rate (Right Scale) /1/26 2/3/26 2/5/26 Lawrence J. Lau, The Chinese University of Hong Kong 48 2/7/26 2/9/26 2/11/26 Day 2/1/27 2/3/27 2/5/27 2/7/27 2/9/27

49 Exchange Rate, Stock Market Index and Interest Rate: Hong Kong, Relationship between Exchange Rate, Stock Market Index and Interest Rate, Hong Kong, Exchange Rate Index, 1/2/7=1 Stock Market Index, 1/2/7=1 Interest Rate (Right Scale) /1/27 1/3/27 Lawrence J. Lau, The Chinese University of Hong Kong 49 Day 1/5/27 1/7/27 1/9/27

50 Exchange Rate, Stock Market Index and Interest Rate: Republic of Korea 3 Relationship between Exchange Rate, Stock Market Index and Interest Rate, South Korea Exchange Rate Index, 1/2/97=1 25 Stock Market Index, 1/2/97=1 Interest Rate (Right Scale) /2/97 3/2/97 5/2/97 7/2/97 9/2/97 11/2/97 1/2/98 3/2/98 5/2/98 7/2/98 9/2/98 11/2/98 1/2/99 3/2/99 5/2/99 7/2/99 9/2/99 11/2/99 1/2/ 3/2/ 5/2/ 7/2/ 9/2/ 11/2/ 1/2/1 3/2/1 5/2/1 7/2/1 9/2/1 11/2/1 1/2/2 3/2/2 5/2/2 7/2/2 9/2/2 11/2/2 1/2/3 3/2/3 5/2/3 7/2/3 9/2/3 11/2/3 1/2/4 3/2/4 5/2/4 7/2/4 9/2/4 11/2/4 1/2/5 3/2/5 5/2/5 7/2/5 9/2/5 11/2/5 1/2/6 3/2/6 5/2/6 7/2/6 9/2/6 11/2/6 1/2/7 3/2/7 5/2/7 Lawrence J. Lau, The Chinese University of Hong Kong 5 Day

51 Exchange Rate, Stock Market Index and Interest Rate: Malaysia Relationship between Exchange Rate, Stock Market Index and Interest Rate, Malaysia Exchange Rate Index, 1/2/97=1 Stock Market Index, 1/2/97=1 Interest Rate (Right Scale) Lawrence J. Lau, The Chinese University of Hong Kong 51 2/1/1997 2/7/1997 2/1/1998 2/7/1998 2/1/1999 2/7/1999 2/1/2 2/7/2 2/1/21 2/7/21 2/1/22 2/7/22 2/1/23 2/7/23 2/1/24 2/7/24 2/1/25 2/7/25 2/1/26 2/7/26 2/1/27 Day

52 Exchange Rate, Stock Market Index and Interest Rate: Philippines 25 Relationship between Exchange Rate, Stock Market Index and Interest Rate, Philippines 2 15 Exchange Rate Index, 1/2/97=1 Stock Market Index, 1/2/97=1 Interest Rate (Right Scale) 1 5 1/2/97 3/2/97 5/2/97 7/2/97 9/2/97 11/2/97 1/2/98 3/2/98 5/2/98 7/2/98 9/2/98 11/2/98 1/2/99 3/2/99 5/2/99 7/2/99 9/2/99 11/2/99 1/2/ 3/2/ 5/2/ 7/2/ 9/2/ 11/2/ 1/2/1 3/2/1 5/2/1 7/2/1 9/2/1 11/2/1 1/2/2 3/2/2 5/2/2 7/2/2 9/2/2 11/2/2 1/2/3 3/2/3 5/2/3 7/2/3 9/2/3 11/2/3 1/2/4 3/2/4 5/2/4 7/2/4 9/2/4 11/2/4 1/2/5 3/2/5 5/2/5 7/2/5 9/2/5 11/2/5 1/2/6 3/2/6 5/2/6 7/2/6 9/2/6 11/2/6 1/2/7 3/2/7 5/2/7 Lawrence J. Lau, The Chinese University of Hong Kong 52 Day

53 Exchange Rate, Stock Market Index and Interest Rate: Singapore 2 Relationship between Exchange Rate, Stock Market Index and Interest Rate, Singapore 18 Exchange Rate Index, 1/2/97=1 Stock Market Index, 1/2/97=1 16 Interest Rate (Right Scale) /2/97 3/2/97 5/2/97 7/2/97 9/2/97 11/2/97 1/2/98 3/2/98 5/2/98 7/2/98 9/2/98 11/2/98 1/2/99 3/2/99 5/2/99 7/2/99 9/2/99 11/2/99 1/2/ 3/2/ 5/2/ 7/2/ 9/2/ 11/2/ 1/2/1 3/2/1 5/2/1 7/2/1 9/2/1 11/2/1 1/2/2 3/2/2 5/2/2 7/2/2 9/2/2 11/2/2 1/2/3 3/2/3 5/2/3 7/2/3 9/2/3 11/2/3 1/2/4 3/2/4 5/2/4 7/2/4 9/2/4 11/2/4 1/2/5 3/2/5 5/2/5 7/2/5 9/2/5 11/2/5 1/2/6 3/2/6 5/2/6 7/2/6 9/2/6 11/2/6 1/2/7 3/2/7 5/2/7 Lawrence J. Lau, The Chinese University of Hong Kong 53 Day

54 Exchange Rate, Stock Market Index and Interest Rate: Thailand 25 Relationship between Exchange Rate, Stock Market Index and Interest Rate, Thailand Exchange Rate Index, 1/2/97=1 2 Stock Market Index, 1/2/97=1 Interest Rate (Right Scale) /2/97 3/2/97 5/2/97 7/2/97 9/2/97 11/2/97 1/2/98 3/2/98 5/2/98 7/2/98 9/2/98 11/2/98 1/2/99 3/2/99 5/2/99 7/2/99 9/2/99 11/2/99 1/2/ 3/2/ 5/2/ 7/2/ 9/2/ 11/2/ 1/2/1 3/2/1 5/2/1 7/2/1 9/2/1 11/2/1 1/2/2 3/2/2 5/2/2 7/2/2 9/2/2 11/2/2 1/2/3 3/2/3 5/2/3 7/2/3 9/2/3 11/2/3 1/2/4 3/2/4 5/2/4 7/2/4 9/2/4 11/2/4 1/2/5 3/2/5 5/2/5 7/2/5 9/2/5 11/2/5 1/2/6 3/2/6 5/2/6 7/2/6 9/2/6 11/2/6 1/2/7 3/2/7 5/2/7 Lawrence J. Lau, The Chinese University of Hong Kong 54 Day

55 Market Capitalization of Selected Stock Exchanges 18, Market Capitalization of Four Stock Exchanges 16, 14, New York Stock Exchange London Stock Exchange Hong Kong Stock Exchange Shanghai Stock Exchange 12, 1, 8, 6, 4, 2, Jan-95 Apr-95 Jul-95 Oct-95 Jan-96 Apr-96 Jul-96 Oct-96 Jan-97 Apr-97 Jul-97 Oct-97 Jan-98 Apr-98 Jul-98 Oct-98 Jan-99 Apr-99 Jul-99 Oct-99 Jan- Apr- Jul- Oct- Jan-1 Apr-1 Jul-1 Oct-1 Jan-2 Apr-2 Jul-2 Oct-2 Jan-3 Apr-3 Jul-3 Oct-3 Jan-4 Apr-4 Jul-4 Oct-4 Jan-5 Apr-5 Jul-5 Oct-5 Jan-6 Apr-6 Jul-6 Oct-6 Jan-7 Apr-7 Jul-7 Lawrence J. Lau, The Chinese University of Hong Kong 55 Month USD billions

56 Daily Turnover of Selected Stock Exchanges Comparison of The Daily Turnovers of Four Stock Exchanges New York Stock Exchange Hong Kong Stock Exchange Shanghai Stock Exchange London Stock Exchange Lawrence J. Lau, The Chinese University of Hong Kong 56 2/1/199 2/4/199 2/7/199 2/1/199 2/1/1991 2/4/1991 2/7/1991 2/1/1991 2/1/1992 2/4/1992 2/7/1992 2/1/1992 2/1/1993 2/4/1993 2/7/1993 2/1/1993 2/1/1994 2/4/1994 2/7/1994 2/1/1994 2/1/1995 2/4/1995 2/7/1995 2/1/1995 2/1/1996 2/4/1996 2/7/1996 2/1/1996 2/1/1997 2/4/1997 2/7/1997 2/1/1997 2/1/1998 2/4/1998 2/7/1998 2/1/1998 2/1/1999 2/4/1999 2/7/1999 2/1/1999 2/1/2 2/4/2 2/7/2 2/1/2 2/1/21 2/4/21 2/7/21 2/1/21 2/1/22 2/4/22 2/7/22 2/1/22 2/1/23 2/4/23 2/7/23 2/1/23 2/1/24 2/4/24 2/7/24 2/1/24 2/1/25 2/4/25 2/7/25 2/1/25 2/1/26 2/4/26 2/7/26 2/1/26 2/1/27 2/4/27 2/7/27 Day USD billions

57 The Price-Earning Ratios of Selected Stock Exchanges Price/Earnings Ratio of Four Stock Exchanges 7 Shanghai 6 Hong Kong Tokyo 5 New York Aug-7 Lawrence J. Lau, The Chinese University of Hong Kong 57 Jun-4 Jul-4 Aug-4 Sep-4 Oct-4 Nov-4 Dec-4 Jan-5 Feb-5 Mar-5 Apr-5 May-5 Jun-5 Jul-5 Aug-5 Sep-5 Oct-5 Nov-5 Dec-5 Jan-6 Feb-6 Mar-6 Apr-6 May-6 Jun-6 Jul-6 Aug-6 Sep-6 Oct-6 Nov-6 Dec-6 Jan-7 Feb-7 Mar-7 Apr-7 May-7 Jun-7 Jul-7 Month

58 Is Another Crisis Possible? The rapid inflow of foreign exchange from overseas (whether by domestic or foreign investors), to the extent that the inflows are used to make portfolio investment, increases the cumulative stock of liquefiable liabilities because portfolio investment can be withdrawn very quickly. This can cause the LL (liquefiable liabilities) to reserves ratio to rise. This is true especially if the central bank does not purchase the excess inflow of foreign exchange. Lawrence J. Lau, The Chinese University of Hong Kong 58

59 Is Another Crisis Possible? The critical question is whether the liquefiable liabilities to reserves ratio (LL ratio) is likely to rise to a level that is significantly higher than one? We distinguish between two cases: the case with no intervention (the central bank does not try to purchase the incremental inflow of foreign exchange) and the case with full intervention (the central bank purchases the entire incremental inflows of foreign exchange). In the no intervention case, the LL (liquefiable liabilities) ratio is going to rise, regardless of whether one starts with a ratio below one or above one. In the case of full intervention, the LL ratio rises if the ratio is below one, but falls if the LL ratio is above one. This shows that intervention is important if the incremental inflow is transitory (i.e. consists of hot money). Lawrence J. Lau, The Chinese University of Hong Kong 59

60 Is Another Crisis Possible? Moreover, because of the appreciation of the foreign portfolio investments resulting from the rise in the price level in the stock market as well as the appreciation of the currency, the liquefiable liabilities in terms of foreign exchange (U.S. Dollars) can be much higher than our estimates here, which are based on acquisition cost rather than current market value. Excess appreciation of the currency can also lead to a decline in exports and a rise in imports, increasing the short-term demand for foreign exchange to close the expanded current account balance gap, and hence the LL ratio. Ultimately, the foreign portfolio investors and speculators have to take profit and repatriate their principal and profits. When they do, both the stock market and the currency will be under tremendous selling pressure. Lawrence J. Lau, The Chinese University of Hong Kong 6

61 Is Another Crisis Possible? Reducing the leverage available to foreign speculators, either in the buying or selling of currency or in the buying or selling securities, is yet another way to discourage the inflow of short-term capital. Reducing the leverage (or equivalently, increasing the margin requirements, reduces the profit potential of predatory speculation). Lawrence J. Lau, The Chinese University of Hong Kong 61

62 The LL Ratio, w/o Interest Payments % 1,8 Ratio of Short-term Liquefiable Liabilities to Official Foreign Exchnage Reserves, w/o Interest Payment 1,7 1,6 1,5 1,4 1,3 1,2 1,1 1, China Taiwan Indonesia Malaysia Singapore Hong Kong India Korea Philippines Thailand 1 Lawrence J. Lau, The Chinese University of Hong Kong Year

63 The LL Ratio, with Interest Payments % 2, Ratio of Short-term Liquefiable Liabilities / Reserves, including Interest Payment 1,8 1,6 1,4 1,2 China Indonesia Philippins India Malaysia Thailand 1, Lawrence J. Lau, The Chinese University of Hong Kong Year

64 Concluding Remarks Another East Asian currency crisis cannot be entirely ruled out as capital has become much more mobile over the past ten years. Globally, risk is under-priced in the same way that loans to the East Asian firms were under-priced right before the East Asian currency crisis. The Yen carry trade may unwind at any time. However, there are now both bilateral and multilateral cooperative (mutual aid) agreements among central banks and governments in East Asia in place, so that the LL ratio may be able to rise higher than before without triggering a crisis. Moreover, even if there is a crisis, it may be more easily contained and may not do as much damage, unless of Lawrence J. Lau, The Chinese University of Hong Kong 64 course it is widespread and global in nature.

65 Concluding Remarks It is well worth remembering that financial engineering can only spread and share risks, but not reduce total risks. The current incentive system for asset management, with its emphasis on carry, encourages excessive risk-taking on the part of the asset managers. Lawrence J. Lau, The Chinese University of Hong Kong 65

66 Concluding Remarks The most significant risk facing the world economy is an abrupt global switch away from the U.S. Dollar to the Euro as the currency for international transactions, both trade and capital. The LL to foreign exchange reserves ratio for the U.S. is extremely high because the U.S. does not maintain foreign exchange reserves. It can print as much money as it needs so long as the U.S. Dollar remains the dominant reserve currency. An expectation that there will be a large devaluation of the US Dollar can be self-fulfilling. Such an expectation can be triggered by, for example, a war in Iran, which has the potential of stopping most of the oil flow from the Middle East, or by the redenomination of oil trade in Euro rather than in U.S. Dollar, or by a perceived prolonged economic recession in the U.S. Lawrence J. Lau, The Chinese University of Hong Kong 66