Capital Infows and Real Exchange Rate Appreciation – practice
Asian countries pegged their currencies to the US dollar in order to provide a foundation for economic stability, while they got on with the job of growing their economies. In a sense these dollar pegs did their job too well. With Asian currencies pegged to the US dollar, it appeared that the idea of currency risk had been all but eliminated. Asia in the 1980s and early 1990s had been growing strongly in any case. Thus the Asian currency pegs together with strong domestic growth rates provided the platform for a veritable tidal wave of capital inflows to the region, both of the portfolio and foreign direct investment kind. The lack of currency volatility lulled investors into a false sense of security — though that false sense of security in some cases lasted for more than a decade.
Many Asian countries had relatively high inflation rates, higher than the US whose currency they were pegged to. Ordinarily, this should mean that a currency depreciates to offset its higher inflation rate, however in the case of Asia the sheer weight of massive capital inflows, combined with the currency pegs, meant that Asian currencies appreciated on a real (inflation- adjusted) basis, which was greatly exacerbated by the 35% devaluation of the Chinese yuan in 1994 and the depreciation of the Japanese yen from 1995. The result was widening Asian trade and current account deficits. Put simply, Asian countries were slowly but surely losing export competitiveness. High inflation and currency pegs meant high interest rates, despite the fact that most Asian countries ran healthy fiscal surpluses. This was not a problem for Asian governments since most were not seeking to expand domestic borrowing, but it was a problem for the private sector. Those currency pegs provided the illusion of exchange rate stability, encouraging corporations to borrow offshore at lower interest rates and swap back to domestic currency. As a result, significant external debt burdens were built up. Unlike in Latin America in the 1980s, this was private not public debt and went largely unnoticed in the more transparent public accounts. Thus, Asian corporate and bank balance sheets became increasingly exposed to external, US dollar-priced debt. While Asian currencies could not move, this was not an issue. Implicitly however, it meant if Asian currencies were ever allowed to depreciate, the capital base of those same corporate and banking sectors would be severely depleted if not eliminated. Asian currency devaluation would mean the cost of repaying that external debt would be multiplied by the extent of that devaluation.
By late 1996, real exchange rate appreciation had resulted in significant trade and current account balance deterioration. Thailand was running a current account deficit of some 8% of GDP. Assuming the balance of payments must indeed balance, the other side of a current account deficit must be a capital account surplus. This is indeed what happened in Asia. Massive capital inflows helped cause real currency appreciation, which in turn led to a rising current account deficit. To fund its widening current account deficit, Thailand had to attract an ever increasing amount of capital inflows. It did not get them. Instead, “fundamental” investors became increasingly wary and started if anything to reduce their exposure to Thailand in early 1997 due to a combination of increasing political and economic concerns and diminishing returns on their investments. As that capital fled — selling Thai baht in order to do so — so Thai domestic interest rates edged higher while the Thai baht itself came under increasing downward pressure.
Tags: Business, Exchange rate, finance
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