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Shen, Andrew 2009: From Asian to Global Financial Crisis: An Asian Regulator's View of Unfettered Finance in the 1990s and 2000s, Cambridge University Press
Hello, welcome to Daily Book in DeDao app. I'm Xu Ling. I'll interpret the book From Asian to Global Financial Crisis for you.
This is a classic in financial history, first published in 2009. The version I have now is the fourth edition issued in June 2020. The book provides a detailed review of the entire process of the 1997-1998 Asian Financial Crisis. During that crisis, Asian currencies such as the Thai Baht, Malaysian Ringgit, and Indonesian Rupiah sharply depreciated against the US dollar. The market value of the stock markets in these economies plummeted to only 1/10 of what it was before the crisis, with many financial institutions and enterprises going bankrupt. Even developed economies like South Korea, Singapore, and China's Hong Kong were severely hit. It can be said that some Asian economies have not fully recovered from that crisis till today.
Why is the book titled 《十年轮回》(A Decade Reincarnation) in Chinese? In the past half-century, there has almost been a global financial crisis every ten years. You can see that from the 1987 US stock market crash and Latin American debt crisis to the 1997 Asian Financial Crisis, and then to the 2007 US subprime crisis, the pattern is clear. Although nothing major happened in 2017, three years later, at the beginning of 2020, the COVID-19 pandemic, a once-in-a-century black swan event, severely impacted the global stock market. Generally speaking, the pattern of a financial crisis every ten years still holds.
The author of this book, Shen Liantao, is a legendary figure in Asia's financial circle. Shen Liantao is of Chinese Malaysian descent. His father, Shen Ziren, was a wealthy businessman in Chongqing during the Republic of China period and later immigrated to Malaysia. Shen Liantao once served as the Chief Economist of the Central Bank of Malaysia. From 1993 to 1998, which was around the time of the Asian Financial Crisis, Shen Liantao was the Deputy Chief of the Hong Kong Monetary Authority. The Monetary Authority is equivalent to Hong Kong's central bank, and Shen Liantao was in charge of Hong Kong's foreign exchange reserves.
During the Asian Financial Crisis, international speculators heavily shorted the Thai Baht, depleting the foreign exchange reserves that the Thai government had painstakingly accumulated over decades. Afterward, the international speculators turned their attention to the Hong Kong Dollar. The Hong Kong Monetary Authority withstood the pressure and engaged in several thrilling battles with the international speculators, ultimately successfully defending the stability of the Hong Kong Dollar. From 1998 to 2005, Shen Liantao was re-elected as the Chairman of the Hong Kong Securities and Futures Commission for three consecutive terms.
That is to say, Shen Liantao is an "insider" in the high-level circles of Asia's finance and a witness to the 1997 Asian Financial Crisis. In the ten years following the crisis, he continuously reflected on the root causes of the crisis and the painful lessons it left for Asian countries. In 2007, Shen Liantao wrote this book based on his decade of contemplation when the US subprime crisis suddenly erupted. He saw that the international hedge funds, which had made a fortune by attacking Asian countries' currencies, suffered heavy losses in the subprime crisis, both an irony of history and a reflection of the cyclical nature of events.
At present, the international financial situation faced by China is unprecedentedly complex. At this time, it is necessary for us to revisit the historical lessons of the 1997 Asian Financial Crisis to prepare for the crisis.
Below, let's follow Shen Liantao's analysis. First, from a macro perspective, what were the background and conditions for the outbreak of the Asian Financial Crisis? Then, from a micro perspective, how was the Asian Financial Crisis triggered, and how did the economies hit by the crisis respond?
Regarding the root causes of the 1997 Asian Financial Crisis, there were two opposite views at the time. The Western camp, represented by the United States, Europe, and the International Monetary Fund (IMF), believed that the victim countries had only themselves to blame. These countries had serious problems with their economic fundamentals, and their governments had made obvious mistakes in managing financial risks. However, many Asian leaders believed that the main culprit was international speculators represented by Soros, who maliciously attacked Asian currencies and caused the outbreak of the crisis. Mahathir Mohamad, then Prime Minister of Malaysia, publicly condemned Soros. Asian countries also pointed out that when they sought help from the IMF, the organization prescribed the wrong medicine, even worsening the crisis.
How did Shen Liantao view these two completely different opinions? He believed that both the Western and Asian views were partially correct but not comprehensive. We need to abandon a single perspective and analyze the root causes of the crisis from multiple dimensions. Standing at a height of 300 feet, you can see how international speculators, central banks of various countries, and ordinary investors operated during the crisis; standing at a height of 3,000 feet, you can see the macroeconomic problems of the countries affected by the impact; and standing at a height of 30,000 feet, you can see that the Asian Financial Crisis was the result of a larger change in the international situation.
Let's now ascend to a height of 30,000 feet to see what exactly happened. First, let's review which economies were affected by the Asian Financial Crisis. Among them, the five most severely affected were Thailand, Malaysia, Indonesia, the Philippines, and South Korea; in addition, Singapore, Hong Kong, China, and Taiwan, China also suffered relatively severe impacts.
Have you noticed that these eight affected economies happened to be the fastest-growing emerging economies in Asia after the Second World War, known as the “Four Asian Tigers” and the “Four Little Dragons of Asia”? Why are these eight economies said to be the fastest growing? This is related to the post-war Asian economic locomotive - Japan. In the 1960s, after the completion of industrialization in Japan, the rising cost of labor made Japan need to transfer low-end manufacturing to other parts of Asia.
According to the order of transfer, Japanese economists designed a "flying geese model." Like geese flying in a "V" formation, Japan was the "lead goose" of Asia's economy, followed closely by the Four Asian Tigers, then the Four Asian Dragons, and finally mainland China and Vietnam. Japan transferred the low end of its industrial chain and began to make large-scale investments in the Four Asian Tigers and Dragons.
In the 1980s, another major event that accelerated this process was the Plaza Accord in 1985. We know that to alleviate its trade deficit, the United States forced the Japanese yen to appreciate significantly against the US dollar. Within less than two and a half years after the Plaza Accord was signed, the yen-to-dollar exchange rate changed from 240:1 to 120:1, with the yen appreciating by 100%.
Such a sharp appreciation would deal a fatal blow to Japan's export-oriented enterprises. What could they do? Consequently, Japanese manufacturing enterprises accelerated the pace of transferring their industrial chains to the Four Asian Tigers and Dragons, as exports from overseas production bases would not be affected by the appreciation of the yen. In particular, massive investments from Japanese automakers in Thailand earned it the reputation of "Asia's Detroit." Moreover, after the yen appreciated, foreign land and labor became relatively cheaper, and the cost of outward direct investment for Japanese manufacturing enterprises decreased, leading to a further increase in outward direct investment. Within five years after the Plaza Accord was signed, Japan's direct investment in Asia increased nearly sixfold, with the majority going to the Four Asian Tigers and Dragons.
Conversely, from the perspective of the Four Asian Tigers and Dragons, the five years following the Plaza Accord were the golden period of development. On one hand, the significant appreciation of the yen impacted Japan's domestic exports, and these East Asian economies seized the opportunity to fill the gap, resulting in substantial export growth. On the other hand, Japan's massive investments drove rapid GDP growth in the region. The capital inflow, primarily in the form of long-term direct investment, did not cause economic overheating.
However, a turning point occurred in 1991 when Japan's asset bubble burst, plunging the country into severe deflation. To stimulate the economy, the Japanese government implemented an ultra-loose monetary policy, cutting interest rates to an ultra-low 0.5%. This triggered a critical consequence: the rise of yen carry trades in Asia.
Take Thailand, the first country to experience a crisis, as an example. In 1991, Thailand's domestic interest rates were as high as around 10%, creating a significant interest rate differential with Japan's 0.5%. At that time, one only needed to borrow yen from Japan, exchange it for Thai baht, and deposit it into Thai banks to enjoy substantial profits. Consequently, well-connected Thai investors and international speculators competed to engage in the yen carry trade. Not only the yen but also the US dollar had a considerable interest rate differential with the Thai baht, so the US dollar carry trade was also very active in Thailand.
Shen Liantao believes that the carry trade changed the structure of capital inflows in Asian countries, shifting from being mainly long-term direct investment to short-term investment, which was an important factor in triggering the Asian Financial Crisis. Perhaps not coincidentally, in 1990, Thailand agreed to the IMF's request to relax foreign exchange controls, leading to a flood of short-term capital, which inflated Thailand's stock and real estate markets. The rise in asset prices further attracted capital inflows. From 1990 to 1995, Thailand's net capital inflow increased by 126%; correspondingly, Thailand's foreign debt soared to over 100 billion US dollars, accounting for about 60% of its GDP.
At the same time, due to the influx of a large amount of cheap capital, Thailand's banking system began to relax lending conditions and expand credit, causing the economic bubble to grow larger and the risks accumulated in the financial system to increase. What's worse, Thai banks borrowed short-term foreign debt and converted it into Thai baht for long-term domestic loans, creating a high-risk situation known as "double mismatch," where both maturity and currency mismatches exist simultaneously. At this point, the fuse had been lit: if the direction of international capital flows reversed and there was a large-scale capital withdrawal from Thailand, the country's financial system would definitely face significant problems.
The reversal occurred in 1995. In April 1995, the yen-to-dollar exchange rate reached a peak of 80:1, after which the yen's value began to fall sharply. As mentioned earlier, the appreciation of the yen would encourage Japan to increase its outward investment; conversely, the depreciation of the yen would lead to a large-scale withdrawal of Japanese capital from overseas. From June 1995 to 1999, Japanese banks withdrew a total of 235.2 billion US dollars from the Four Asian Tigers and Dragons, accounting for 10% of these economies' GDP during the same period. No economy could withstand such a large-scale capital shock. Consequently, the bubbles in these economies began to burst, and their financial systems faced a large amount of non-performing assets, with the crisis imminent.
Looking back now, the broader context of the Asian Financial Crisis is clear. For the Four Asian Tigers and Dragons, Japan could be said to have been both a maker and a breaker. After World War II, Japan transferred its low-end industrial chain to these economies through the "flying geese model," driving their economic takeoff; after the Plaza Accord in 1985, the significant appreciation of the yen led Japan to increase its investment in these economies, further fueling their prosperity; however, after the asset bubble burst in 1991, Japan's ultra-low interest rates encouraged the yen carry trade, leading to a flood of hot money into the Four Asian Tigers and Dragons, creating asset bubbles and financial risks in these economies and laying the groundwork for the crisis; and by 1995, as the yen's value turned downward, a large amount of capital quickly withdrew. At this point, the powder keg for the Asian Financial Crisis was in place, waiting only for a spark to ignite it.
As I was writing this, I suddenly understood the author's words on the first page of the first chapter: "The only cause of depression is prosperity."
Next, we need to descend rapidly from a height of 30,000 feet to 300 feet, looking at the situation from the perspective of market participants to see how the Asian Financial Crisis was triggered and how the affected economies responded.
Before the Asian Financial Crisis, although the exchange rate systems of the Four Asian Tigers and Dragons had different names, they were all effectively fixed exchange rates, with their currencies maintaining long-term stability against the US dollar. For example, the Thai baht has maintained an exchange rate of 25:1 against the US dollar since 1984, which was very stable. Since the main export destinations of these economies were the United States, maintaining the stability of the US dollar exchange rate was crucial. However, on May 8, 1997, a rumor suddenly began circulating in the London financial market that the Thai baht's exchange rate against the US dollar would experience significant fluctuations. Within a week, the Thai baht was heavily sold in the London and New York foreign exchange markets, facing tremendous depreciation pressure.
Let me first explain how international speculators profit from short-selling a country's currency. Taking the Thai baht as an example, international speculators would borrow a large amount of Thai baht before its depreciation, then sell it in the foreign exchange market in exchange for US dollars. For instance, if they borrowed 1 million Thai baht and sold it to get 40,000 US dollars, and if the Thai baht could not withstand the pressure and depreciated, with the exchange rate changing from 25:1 to 50:1 against the US dollar, then the speculators would only need to use 20,000 US dollars to buy back 1 million Thai baht to repay the loan, with the remaining 20,000 US dollars, after deducting the interest on the borrowed Thai baht, being pure profit. Of course, if the Thai baht held its exchange rate and did not depreciate, the speculators would lose the interest on the borrowed Thai baht. In reality, by January 1998, the Thai baht's exchange rate against the US dollar had fallen to 56:1, depreciating by more than half, and international speculators made a fortune.
We know that financial speculation is a zero-sum game, so who did the international speculators make money from? The answer is the Thai government's foreign exchange reserves. As mentioned earlier, the Thai government adopted an effectively fixed exchange rate. To maintain the stability of the Thai baht's exchange rate, when there was a shortage of Thai baht in the foreign exchange market, the Thai government would sell Thai baht to buy back US dollars; and when there was an excess of Thai baht in the foreign exchange market, the Thai government would sell US dollars to buy back Thai baht. The US dollars used here were the Thai government's foreign exchange reserves. The purpose of international speculators' attack on the Thai baht was to drain Thailand's foreign exchange reserves.
In May 1997, when international speculators heavily sold the Thai baht, causing a severe excess supply of Thai baht, the Thai government had to urgently use its US dollar reserves to buy back Thai baht and defend the exchange rate. At that time, the Thai government was determined to defend the Thai baht. First, Thailand had 37.2 billion US dollars in foreign exchange reserves, the highest among the Four Asian Dragons, and the Thai government believed it had a chance of winning; at the same time, the Thai government temporarily reinstated capital controls, ordering Thai financial institutions not to lend Thai baht to foreign speculators. Other Southeast Asian countries also coordinated with the Thai government and stopped lending Thai baht to foreign speculators.
However, the Thai government underestimated the greed and strength of international speculators, and they did not anticipate that the reaction of Thai domestic enterprises would further worsen the situation. As mentioned earlier, Thailand had borrowed a large amount of foreign debt during its economic boom, denominated in US dollars or Japanese yen. If the Thai baht depreciated significantly, it would mean a substantial increase in foreign debt calculated in Thai baht. To hedge risks, Thai enterprises that had borrowed a large amount of foreign debt recklessly sold Thai baht and bought US dollars. Although their intention was not speculation but risk avoidance, their operations were the same as those of international speculators, further increasing the excess supply of Thai baht in the foreign exchange market.
The Thai government desperately carried out reverse operations but soon exhausted its foreign exchange reserves. From May 1 to 14, 1997, in just two weeks, the net foreign exchange reserves of the Bank of Thailand decreased by 21.7 billion US dollars, accounting for 60% of the total foreign exchange reserves before the crisis; by June 30, the available net foreign exchange reserves were a mere 2.8 billion US dollars, almost zero, and the Thai government had fired all its bullets. On July 2, the Bank of Thailand announced that the Thai baht's exchange rate would be decoupled from the US dollar and a floating exchange rate system would be adopted. On the day of the announcement, the Thai baht's exchange rate plummeted by 17%; within a year, the Thai baht depreciated by 56%.
On the day of the exchange rate decoupling announcement, Thailand also requested emergency assistance from the IMF. However, the IMF's assistance was not unconditional. To obtain the aid, the Thai government had to agree to a series of harsh conditions, including further opening up the financial sector to foreign capital, completely privatizing state-owned enterprises, implementing a tight fiscal policy, and so on. In hindsight, the austerity measures prescribed by the IMF did not reverse the situation but instead deepened Thailand's economic recession.
More importantly, to obtain the rescue, the Thai government lost a significant part of its domestic economic sovereignty. Shen Liantao said that Westerners would not understand how painful and humiliating it was for Asians to cede the sovereignty they had worked so hard to obtain. On December 3, 1997, South Korea, which was also severely hit by the financial crisis, accepted the IMF's rescue at the cost of losing a large amount of economic sovereignty. This day was called the second "National Humiliation Day" by the South Korean people, with the first being the day Japan occupied the Korean Peninsula.
After the Thai baht was breached, international speculators immediately turned their attention to the Philippine peso, Malaysian ringgit, and Indonesian rupiah, using the same tactics. These countries followed in Thailand's footsteps: consuming a large amount of foreign exchange reserves, then having to abandon the fixed exchange rate, and subsequently experiencing significant currency depreciation. Among them, the Indonesian rupiah depreciated by an astonishing 85% against the US dollar, and the severe economic crisis triggered large-scale social unrest. In a critical situation, Indonesia and the Philippines accepted the IMF's rescue, with the only exception being Malaysia.
Malaysian Prime Minister Mahathir announced the rejection of the IMF's assistance, stating that Malaysia was capable of self-rescue and was unwilling to accept the requirement that infringed upon sovereignty. Contrary to the austerity measures prescribed by the IMF, Malaysia adopted expansionary fiscal and monetary policies to stimulate economic recovery. At the same time, Malaysia announced the implementation of "selective capital controls" to prevent further impacts of international hot money on Malaysia's financial market.
After the news spread, Western countries and the IMF unanimously condemned Malaysia, believing that the implementation of foreign exchange controls was a step backward in history. However, the author of this book, Shen Liantao, believed that this choice was justified. He said, "If a bleeding patient cannot obtain blood from a doctor, does he not have the right to bandage himself to stop the bleeding?" It turned out that the foreign exchange controls implemented by Malaysia were effective, successfully stabilizing the situation and enabling Malaysia to be the first among the Four Asian Dragons to resume growth.
We have seen that international speculators achieved a resounding victory over the governments of Asian countries. Among the eight economies of the Four Asian Tigers and Dragons, seven experienced currency depreciation, with the Indonesian rupiah depreciating by 85%, the Thai baht by 56%, the South Korean won by 55%, and the Malaysian ringgit by 48%. The only exception was the Hong Kong dollar. During the Asian Financial Crisis, the Hong Kong dollar maintained its exchange rate of 7.8:1 against the US dollar unchanged.
Did the international speculators have a change of heart and spare Hong Kong? Impossible. Especially since Hong Kong's financial market was highly developed, with complex financial derivatives and no restrictions on short-selling, which facilitated the operations of international speculators even more. From August 1997 to August 1998, international speculators launched four large-scale attacks on the Hong Kong dollar, and the Hong Kong Monetary Authority (HKMA) met them head-on and turned the tide, successfully defending the Hong Kong dollar's exchange rate. Looking back now, the entire process was thrilling.
In simple terms, when attacking the Hong Kong dollar, international speculators used a "double kill strategy": not only did they heavily short the Hong Kong dollar in the foreign exchange market, but they also massively shorted Hong Kong stocks in the stock market. By shorting the Hong Kong dollar, if it depreciated, the speculators could directly profit; even if the Hong Kong dollar did not depreciate, the HKMA would inevitably tighten monetary policy to defend the exchange rate, leading to an increase in Hong Kong dollar interest rates, and the rise in interest rates would cause the decline of Hong Kong stocks and stock index futures, allowing the speculators to profit from shorting Hong Kong stocks in advance. In short, by shorting both the Hong Kong dollar and Hong Kong stocks simultaneously, international speculators could ensure profits regardless of the outcome.
Sure enough, in October 1997, speculators launched an attack by selling the Hong Kong dollar. The HKMA did not directly intervene in the foreign exchange market but chose to tighten the liquidity of the Hong Kong dollar, causing institutions that had previously sold a large amount of Hong Kong dollars to face a "Hong Kong dollar cash crunch." On October 23, the overnight interbank lending rate in Hong Kong skyrocketed from 9% to 280%, which was astonishing. The sharp increase in the Hong Kong dollar interest rate effectively curbed speculative behavior by increasing the cost of borrowing Hong Kong dollars for short-selling by speculators. However, the sharp rise in interest rates also had a serious side effect, which was the immediate plunge in the stock market. Within the week from October 20 to 28, the Hang Seng Index in Hong Kong plummeted by 30%.
In this round of attack, the HKMA and the speculators fought to a draw: the HKMA defended the Hong Kong dollar's exchange rate but failed to prevent the stock market crash; international speculators lost money in shorting the Hong Kong dollar but made it back from shorting Hong Kong stocks, with their profits in the stock market far exceeding their losses in the foreign exchange market.
After tasting the sweetness of success, in August 1998, international speculators made a comeback. This time, they first spread rumors in the financial market, such as the Hong Kong dollar would be decoupled from the US dollar, the Chinese yuan would depreciate significantly, and Hong Kong banks would face run pressures, shaking the confidence of ordinary investors in the Hong Kong dollar and inducing panic selling; then, within two days on August 5 and 6, international speculators sold more than 4 billion Hong Kong dollars in the foreign exchange market, putting the Hong Kong dollar and Hong Kong stocks under extreme pressure.
This time, the HKMA took extraordinary measures, no longer relying solely on raising interest rates but adopting a multi-pronged approach: first, the HKMA used its foreign exchange reserves to buy all the more than 4 billion Hong Kong dollars sold by speculators; second, the HKMA used 1.5 billion US dollars of foreign exchange reserves to enter the stock market to support it, purchasing 33 constituent stocks of the Hang Seng Index; third, the Hong Kong government introduced regulations and laws to impose quantity restrictions on short-selling operations and increase futures index margin requirements, etc., to raise the cost for speculators.
In retrospect, this series of moves by the HKMA was a risky strategy. The success of this risky strategy largely depended on whether ordinary investors in Hong Kong had confidence in the government's ability. If ordinary investors believed that the Hong Kong government's strength was insufficient to compete with international speculators, they would panic and sell their Hong Kong stocks and Hong Kong dollars, and even exchange their Hong Kong dollar deposits for US dollars. At that point, no matter how much foreign exchange reserves the HKMA had, they would be exhausted, and both the Hong Kong dollar and Hong Kong stocks would be breached.
Fortunately, the Hong Kong government's market support was effective. The Hang Seng Index began to rebound after hitting bottom on August 13 and gradually stabilized; the fixed exchange rate of the Hong Kong dollar remained as solid as a rock. At this point, seeing no hope of a comeback, international speculators left the market at the cost of losing hundreds of millions of Hong Kong dollars.
You must be wondering why the Hong Kong government was able to successfully resist the attacks of international speculators, while countries like Thailand and Malaysia could not. The main reasons are threefold. First, before the crisis, Hong Kong had sufficient foreign exchange reserves, nearly 100 billion US dollars, ranking third in the world after Japan and mainland China, meaning the Hong Kong government had enough ammunition. Second, Hong Kong's financial system was healthy and could withstand the impact of high interest rates. In contrast, Thailand's financial system had serious non-performing loans, and the Bank of Thailand dared not significantly raise the interest rate of the Thai baht to punish speculators, as the increase in interest rates would lead to the bankruptcy of a large number of debt-ridden financial institutions and enterprises. Third, Hong Kong's economic fundamentals were sound, with neither a fiscal deficit nor foreign debt. As long as the Hong Kong government could stabilize public confidence, the chances of victory were still high. Of course, more importantly, the public understood that behind the Hong Kong government was the rising China as a strong backing.
Shen Liantao specifically mentioned in the book that during the Asian Financial Crisis, the Chinese government decisively announced the maintenance of the stability of the Chinese yuan's value, establishing the image of a responsible major country globally. At that time, the currencies of the Four Asian Tigers and Dragons, as well as Japan, were all depreciating. The non-devaluation of the Chinese yuan meant that China's export conditions would significantly deteriorate, and making this decision came at a cost. However, on the other hand, the commitment to not devalue the yuan forced China to carry out structural adjustments, tax reform, and the restructuring of state-owned enterprises and the financial system. As a result, China maintained its export competitiveness not through currency devaluation but through improving productivity and industrial upgrading.
Finally, the Asian Financial Crisis also leaves us with a question. In 1997, China's financial system was also fragile, with an underdeveloped capital market and a high level of non-performing loans. Why was China not affected by the crisis? The basic consensus in the domestic academic community is that the most critical firewall was China's capital controls. For international speculators to short a country's currency, they must first be able to borrow a large amount of that country's currency. The fact that the Chinese yuan was not freely convertible and China's capital market was not fully open to foreign capital meant that international speculators had no channel to borrow a large amount of yuan, and thus could not short the yuan.
The renowned Chinese financial scholar, Professor Yu Yongding, also agrees with the above view. He said that the Asian Financial Crisis made him deeply realize that "capital controls are the last line of defense for China's financial stability. If this line of defense is held, China will be fine; if it is not held, we may have problems. The complete abandonment of capital controls, that is, the full free convertibility of the Chinese yuan, should be the last step of all our market-oriented reforms, and it absolutely cannot be done before other reforms are completed. When we take this step, it means that our market-oriented reforms have been completed."