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Table of Contents
Introduction
I. Trade between Asian countries.
II. Interdependence in Asia, i.e.. lending and borrowing between countries.
Reasons for Asian market failure:
III. The Suharto government.
IV. Poor investments and debts to other countries.
V. Poor monetary policy. VI. Depreciation of the Indonesian rupiah.
Reasons for Asian market failure affecting U.S. market decline:
VII. Simple arithmetic: PV = (D * (1 + g)) / (k - g)
Solutions to Asia’s economic downturn:
VIII. The IMF
IX. Lending to Mexico in 1995 X. Currency Board
These Asian countries tend to rely on short-term debt rather than creating a long-term plan to aspire growth individually. They have been in debt to one another, and have shifted toward borrowing from countries all over the world. This debt load has increased by $82 billion U.S. dollars since 1995. Also, short-term debt is substantially higher, practically triple that of long-term debt owed by the Asian countries. This is illustrated in the graph below, taken from the Bank for International Settlements which coordinates the world’s central banks.
Banks all over the world were ready to lend money to Asia as soon as the countries began showing signs of an economic crisis. Some of the U.S. banks included: Chase Manhattan, Citicorp, J.P. Morgan, BankAmerica, and Bankers Trust. Obviously, the incentive for lending is the interest rate that these loans will return. These banks were ready to bail the Asian countries out in the name of profit. However, many banks are finding their loans are seriously overdue already. Due to interdependence in various economic aspects, including trade and mutual debt, stock markets in Indonesia, the Philippines, South Korea and Thailand are intertwined. They make up what I will refer to as the ‘Asian Market’.
Recently, Indonesia’s market crashed triggering a domino effect which spread to the other members of the Asian market first, and proceeded to travel all around the globe. There are many reasons for the Asian market failure. The first being poor economic planning on the part of the Indonesian government. Indonesia has a communist government. For the past thirty-two years, President Suharto has been in office. Indonesia has a central bank, but Suharto maintained control of it and recently he decided to fire the governor of the Bank, Sudradjad Djiwandono, because the two disagreed on policies. Suharto’s family and friends have made poor investments using government funds. They’ve taken on positions that they are not qualified for, and made important decisions which led to crucial mistakes. “U.S. officials say they are somewhat mystified by Suharto. They describe him as increasingly isolated and say he has disregarded the advice of his chief financial advisers, many of whom led Indonesia to its remarkably fast growth over the past decade. They speculate that he is loathe to dismantle his direct control over the economy” (Sanger). President Suharto is in an ironically ideal position, he has minimal knowledge of how to run his country economically, and he has essentially sole power, so naturally his monetary policies have been one of the causes of the market crash.
Last July, the Indonesian rupiah began to depreciate rapidly. It dropped from 2,500 rupiah to the dollar, to 17,000 rupiah to the dollar in January. “These countries encountered a currency crisis because their governments attempted to maintain an exchange rate pegged to the U.S. dollar, while conducting monetary policies that diverged from that of the U.S. Capital inflows covered up this disparity for a time” (Shultz, Simon & Wriston). This incredible increase in inflation, not only caused the standard of living in these Asian countries to decline, but also made it impossible for them to repay their debts. The World Bank remarked that Asia’s reliance on short-term debt “left the economies vulnerable to a sudden collapse of confidence” (O’Brien). This debt, which I mentioned earlier, must be repaid in a stable currency. “One particular problem fostered by all the global lenders is that most of the loans are short term -- due in a year or less -- and must be repaid in dollars, francs or marks” (O’Brien).
How can the Asian countries afford to buy dollars, francs, or marks, with a currency that is quickly becoming worthless? “As the rupiah went into a free fall, from about 2,500 to the dollar when the Asian economic crisis began last July, to a nadir of 17,000 to the dollar last month, the burden of that nation’s dollar-denominated debt effectively increased sixfold” (Forsyth). The combined impact of Suharto’s poor monetary policy, poor investments, increased inflation, and debt, caused the Asian markets to crash. A recession in one part of the world results in a decrease in demand for goods being produced in other parts of the world. Therefore, when the Asian market failed, it resulted in other markets around the globe to follow. There are many reasons for Asian market failure affecting the United States, and many other countries around the world. The dividend discount model, or Gordon model, expresses the present value of a stock in terms of the previous year’s dividend, the market’s discount rate, and the firm’s expected earnings growth rate:
PV = (D * (1 + g)) / (k - g)
If the expected growth rate is high, then the present value will be high, ceteris paribus. Let’s say that the dividend (D) is $4, the discount rate (k) is 12%, and the expected earnings growth rate (g) is 9%. According to the Gordon model, the present value of this stock is 145.333.
Now, let’s say that a country’s market is declining. This is going to affect our market by decreasing our stock’s expected growth rate. Due to the Asian market downturn, imagine that this stock’s expected growth rate has declined by .5%. In other words, it has weakened from 9% to 8 1/2%. One would think that such a small decline would not have much affect on the stock’s present value. However, by employing the equation, we discover that the new present value is equal to: 124. Present value has dropped by about 15%. This causes a dramatic outcome. Now, imagine the growth rate declined by more than .5%. The effects are devastating. When present values are high, the expectations for market growth is also high. From this logical assumption, a small decline in expected growth rates will have a devastating effect on stock prices. In an environment where present values are high, as they have been, stocks are extremely sensitive to new information. So, if a market is falling on the other side of the globe, we can speculate that it will affect our market negatively as well. In what seemed like a matter of hours, Americans watched our bull market plummet. Forecasts are predicting that the Asian crisis will cause our overall market growth to decline by anywhere from .5% to a full 1% this year. Employment and profit growth have, and will continue to, slow in many U.S. firms that rely on Asia for a significant percentage of their sales. The trade gap between Asia and the U.S. will grow since Asian countries will reduce their imports, and will flood the market with cheap exports. However, Americans have also seen some benefits of the Asian market failure. Falling prices on commodities in Asia have resulted in reduced prices here. We are also seeing lower interest rates since banks are encouraging borrowing.
When investors receive information of a market decline anywhere, they tend to behave irrationally. Forecasts of economic downturn often lead investors into a mass panic. This ‘herd instinct’ has proven to heighten the perception of risk, and thus create further economic decline. Studies have shown that, over time, markets generally bounce back. Panicking only lengthens the time it takes for the market to recover.
The International Monetary Fund has proposed a solution to the Asian market failure. The IMF is an organization made up of 182 countries, who pay a quota when they join. One purpose of the IMF is to lend money to a member if they suffer economically. The troubled country is given the loan if they agree to follow guidelines set by the IMF to help their economy recover. The larger the country, the more they pay for the quota, the stronger their voting voice, and the more they can borrow if they ever need to. Naturally, the United States is the largest member of the IMF. In the past, the IMF has been there to finance a country that is in need of financial assistance. The graph below depicts various countries which have received lending from the IMF since 1947. This is measured in levels of SDR’s, an acronym for special drawing right. SDR is measured in an artificial value which is the average of the five major world currencies.
The most recent loan, the 1995 Mexican bailout, was considered to be a successful mission. Mexico’s economy managed to recover, and they managed to repay their debt on time, while following the guidelines imposed on them by the IMF. However, the Mexican people suffered a decline in standard of living as a result of the intervention.
Ever since the IMF was founded during the Great Depression, there have been opposing views on the functions of the IMF. Some economists believe that bailing a country out targets aid to commercial banks and private investors, instead of helping the unemployed. The more liberal politicians and economists, believe that the IMF truly benefits those in need. In respect to the Asian bailout, the IMF is undergoing much criticism. This is particularly due to President Suharto’s seemingly confrontational attitude toward the U.S. and his unwillingness to agree to follow any guidelines imposed on him or his country. The IMF has already agreed to lend $43 billion to Indonesia, and $57 billion to South Korea. A plan to lend to Thailand has not been agreed to as of yet. This bailout, which will most likely reach $160 billion U.S. dollars, is by far the largest ever undertaken by the IMF.
Alan Greenspan, Chairman of the U.S. Federal Reserve Bank, lobbied for approval of IMF lending. IMF Director, Michael Camdessus, announced the guidelines for the Asian bailout in a speech, “the governments must strengthen the regulation and supervision of their financial systems. Banks must comply with international accounting, disclosure and other rules, and all insolvent banks must be closed” (“For IMF, Globalization Means Getting Criticism From All Over”). In “Who Needs the IMF,” George P. Shultz, secretary of state under President Reagan, along with colleagues, William Simon, and Walter Wriston remark on IMF intervention in Asia, “The IMF interferes with this fundamental market mechanism by encouraging investors to seek out risky markets on the assumption that if their investments turn sour, they still stand a good chance of getting their money back through IMF bailouts. This kind of interference will only encourage more bailouts” (Shultz, Simon and Wriston). Shultz, Simon, and Wriston believe that in cases of IMF intervention, “the governments and the lenders are rescued, but not the people” (Shultz, Simon and Wriston).
A currency board was proposed to President Suharto through a friend of his children as an alternate, or contributing solution to Asia’s economic situation. Under this proposal, the rupiah would be fixed to the dollar, to hold enough foreign reserves to back all the rupiah in circulation, thus restoring some of its value temporarily. The central bank would no longer have control over monetary policy or interest rates. This system has been successful in Hong Kong and Argentina. However, many economists feel that a currency board would not be effective in Indonesia. In order for it to be successful, Indonesia would need a strong banking system and an extensive supply of dollars, to resist the high interest rates. Unfortunately, this country has neither.
The IMF has threatened to discontinue assistance if Indonesia creates a currency board to act as their central bank. The general feeling is that this system will actually result in more damage being done to the country. Some economists and U.S. officials believe that Suharto’s true motive for creating a currency board is personal. His $30 billion family fortune has been all but lost in this financial crisis. Through improvement of the exchange rate, he would have a chance to convert his holdings to dollars. In conclusion, much of the world is becoming democratic, and implementing free economic markets. The United States is often criticized for acting as ‘big brother’, so to speak, of the world today. The uprising in Asia supports this opinion. Having the most power in the IMF, America can reform any country which is suffering into one who’s market is similar to that of our own. The Asian citizens, for the most part, do not want IMF intervention in their countries because they don’t want the U.S. to have any form of control over them. This is made blatantly aware to us when we turn on the television and watch a group of Indonesian citizens burning the American flag.
While communism exists in the world, globalization is extremely dangerous. Maybe, the best solution to Asia’s economic crisis is non-intervention. Perhaps, we should listen to the conservatives and let them learn from their mistakes. After all, when we bailed out Mexico, they weren’t disrespecting our country or threatening to discard our sanctions. The information age is leading us into an era of complete globalization. The world is becoming smaller in many ways. Electronic communication, free trade, and improved technology are increasing our world-wide output and contributing to optimal economic performance. While there are many benefits to globalization, a problem in one country can affect the entire world at any given moment. We must create a system to monitor the flow of money and prevent an abrupt market crash anywhere on the globe. We can continue to reap the benefits of globalization if we learn to work together towards unified goals, but we must prevent market failure rather than react to it.
Works Cited
Forsyth, Randall W.. “A Currency Board Could Help Indonesia, But Does Suharto Know There’s No Gain Sans Pain?”. The Wall Street Journal. 16 February 1998.
O’Brien, Timothy L.. “Banks Were Slow to See Warning Signs in Asia”. The New York Times. 28 January 1998.
Sanger, David E.. “Risking I.M.F. Aid, Suharto Dismisses Central Banker”. The New York Times. 18 February 1998.
Shultz, George P., Simon, William E., and Wriston, Walter B.. “Who Needs the IMF?”.The Wall Street Journal. 3 February 1998.
“Asia’s Coming Explosion”. The Economist. 21 February 1998 - 27 February 1998. Graph: Bank for International Settlements.
“For IMF, Globalization Means Getting Criticism From All Over”. Interactive Wall Street Journal. 6 February 1998.
http://www.imf.org Graph: “Principle Users of IMF Financing”.