The Asian financial crisis, Part Two. The Philippine response

Let us recall again how the Asian financial crisis started 20 years ago in July 1997, and how it produced a domino effect on Asian countries.

Thailand’s banks and large corporations had been borrowing US dollars at cheaper rates and then turned around, converting them to baht for re-lending to domestic borrowers at higher rates. There was an abundant flow of credit that  encouraged overlending to many ventures of marginal profitability, much of this to property development.  This was the scenario, but what was ignored was the fact that Thailand had overborrowed and its foreign reserves had dwindled fast, exacerbated by a sudden drop in exports and the strengthening of the dollar against the baht (which was pegged to the dollar). In short, Thailand was in a most vulnerable position of being unable to meet its foreign-debt obligations.

The Philippines was not exactly surprised when the Asian financial crisis descended upon the Asian scene. Bangko Sentral ng Pilipinas (BSP) Governor Gabriel Singson would have known that in May 1997, Thailand had poured billions of US dollars from its foreign reserves to defend the Thai baht from the concentrated assaults of currency speculators, and Moody’s, the credit-rating agency, had in April 1997, in fact, downgraded Thailand’s ratings, noting the drastic reduction of the country’s foreign reserves.

Anticipating a possible contagion from the currency speculators, the BSP raised in mid-May 1997 the overnight borrowing rate by 175 bps to 13 percent as a defense measure. The peso-dollar exchange was 26.40 to 1, trading within a 1.5-percent band. On July 2, 1997, the day the baht was devalued, the BSP drastically increased its overnight borrowing rate to 24 percent. There were rife rumors that the Philippines would devalue the peso, and this fueled greater speculation. The BSP further increased its overnight borrowing rate to 30 percent the next week, then higher to 32 percent!

These moves notwithstanding, the peso was being sold for dollars in unusually big amounts. At the Philippine Dealing System Exchange, daily volume of transactions had shot up to over $1 billion, as against the BSP’s foreign-exchange reserves of $12 billion.  This level could easily be dissipated if the BSP used it—i.e., sell dollars—to defend the peso-dollar rate at the 26.40 to 1 level.

On July 11, 1997, a Friday, just nine days after Thailand devalued, the Philippines followed suit and allowed the peso to be traded beyond the limited 1.5 percent band.  The peso depreciated by 11.5 percent that day; the peso hit 29.45 to one US dollar, from the “normal” 24.5. In August 1997 the peso-dollar rate was recorded at 28.98, shooting up to 35.61 in October 1997.

The International Monetary Fund (IMF) was very much involved in rescue operations, and offered a $1-billion loan facility to the Philippines to help it replenish its reserves.  The facility was used, for it was needed.

In further support of the peso, the BSP increased liquidity reserve requirements from 2 percent to 3 percent on July 30, 1997, then quickly to 4 percent a couple of days later.  On August 20, 1997, the BSP closed its lending window to reduce liquidity in the market in further defense of the peso.  On August 28, 1997, liquidity reserve requirements were increased further to 8 percent.

The BSP was closely managing the situation.

It is a peculiar immediate response, when defending a level of foreign-exchange rate, to hike local interest rates. Higher interest rates translate to a higher return on funds, which, because of this, might induce these funds to stay on in the local currency.  The problem is, interest rates also translate to cost of funds for business borrowers, and any sudden increase in interest rates—as in this case of managing the defense of the exchange rate—creates havoc on the profitability, even the viability, of businesses and business projects whose borrowing costs have unexpectedly increased. That is why the BSP has always been sensitive and aware that interest rates have to be as quickly brought down to normal levels after—hopefully—stabilizing the foreign-exchange speculative environment.

Consequently, the benchmark overnight lending rate was brought down to 15 percent in mid-October 1997as the market calmed down a bit.  The consensus was that the BSP performed well and managed the currency volatility properly.

It is easy now to look back and recount how we survived the crisis, but those where harrowing days.  We must continue to review the lessons we need to learn from the experience.

I find the following explanation as providing about the most succinct capsulized broad perspective of the crisis, and I share this with my readers.

“The underlying causes of the Asian crisis have been clearly identified. First, substantial foreign funds became available at relatively low interest rates, as investors in search of new opportunities shifted massive amounts of capital into Asia.  As in all boom cycles, stock and real-estate prices in Asia shot up initially, so the region attracted even more funds.

However, domestic allocation of these borrowed foreign resources was inefficient because of weak banking systems, poor corporate governance and a lack of transparency in the financial sector.

These countries’ limited absorptive capacity also contributed to the inefficient allocation of foreign funds. Second, the countries’ exchange rate regimes—exchange rates were effectively fixed—gave borrowers a false sense of security, encouraging them to take on dollar-denominated debt.  Third, in the countries affected by the crisis, exports were weak in the mid-1990s for a number of reasons, including the appreciation of the US dollar against the yen, China’s devaluation of the yuan in 1994, and the loss of some markets following the establishment of the North American Free Trade Agreement.
“The massive capital inflows and weakening exports were reflected in widening current-account deficits.  To make matters worse, a substantial portion of the capital inflows was in the form of short-term borrowing, leaving the countries vulnerable to external shocks.” (Bijan B. Aghevli, “The Asian Crises. Causes and Remedies” in the IMF quarterly magazine, Finance and Development, June 1999 vol. 36. No.2)

Never should we ever be complacent.

source:  Business Mirror by Santiago F. Dumlao Jr.