Trouble can strike in the most unexpected places—a lesson that is worth remembering on the 10th anniversary of the most damaging financial crisis since the Wall Street collapse of 1929.
Ten years ago today, the world’s attention was focused on Hong Kong. The British had just handed over their last major colonial possession to the Chinese. The big debates in the run-up to the handover were on whether a capitalist enclave had any future in a communist country.
Compared to this seemingly momentous event, the devaluation of the Thai baht on 2 July 1997 seemed a minor matter. It was quite another thing that this devaluation was the first step in the road towards a financial crisis that rocked large parts of Asia, leaving in its wake shattered economies and broken lives.
Have we learnt the true lessons of the Asian crisis? A lot has been made of the fact that Asia has been careful to stash away billions of dollars in foreign exchange reserves as insurance against a repeat of 1997, when speculative attacks on regional currencies and capital flight brought countries such as Thailand, South Korea and Indonesia onto their knees. There has also been lots of debate about whether Asia is better placed to deal with a financial crisis today than it was in 1997.
We believe it is the wrong debate to enter into. The real issue is not whether Asia is a safer place today but whether the global economy has learnt to insulate itself against the next financial crisis. In other words, the question is a global rather than regional one.
And the answer is not a very comforting one.
We do not know enough about financial risk. In its new annual report published in the last week of June, the Bank of International Settlements (BIS), the central bankers’ club, says that “our understanding of economic processes may be even less today that it was in the past”. And adds: “We face a fundamentally uncertain world—one in which probabilities cannot be calculated—rather than simply a risky one.”
Economists have many good reasons to believe that this current party in the financial markets will come to a close as well. The only question is where and when. And that is why we believe that just looking at Asia will not suffice.
It was Asia that was the primary source of financial instability in 1997, with huge current account deficits, overvalued exchange rates and asset bubbles. And it was the US that was the stabilizing factor in the world economy then. Quick interest rate cuts by the US Federal Reserve and strong consumer demand in the world’s largest economy helped the world economy get back on the growth path after the Asian economies stabilized in 1998.
We see almost a mirror image of that situation today. It is very likely that the next spot of financial market instability will originate in the US. And Asia could be the stabilizing factor.
The US economy today has a large current account deficit. Low interest rates have fuelled a huge boom in all sorts of asset prices—from blue-chip equities to Impressionist paintings. And there are the new ingredients in this overheated soup. All sorts of deals have been built on leverage. And risk has been parcelled into new avatars, and sold to investors across the world. Despite all the impressive talk about risk management systems and prudential regulations, the fact is that few know what these new financial creatures are all about.
It is quite possible that the current fears of a meltdown in the credit markets, stuffed with all sorts of collaterized obligations, are overstated. Perhaps that great speculative game—the yen carry trade—will unwind without too much collateral damage.
But we cannot know for sure. The 10th anniversary of the Asian crisis is a good moment to remember this basic lesson.
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