It’s an anniversary that many would like to forget, but shouldn’t. Almost exactly 10 years ago, on 14 May and 15 May 1997, there were savage speculative attacks on the Thai baht. The reason: Thailand was running up a huge current account deficit and funding it with foreign capital, including large portions of short-term debt.
Currency vigilantes figured out, quite correctly, that the baht was due for a plunge, though the Thai central bank was openly committed to maintaining a fixed exchange rate between the baht and the US dollar.
These attacks on the Thai baht were the opening salvos in a long war between currency speculators and Asian central banks. The Bank of Thailand held out till 2 July, when it eventually ran out of dollars and the baht was devalued. Within weeks, currencies across the region tumbled as speculators mounted pressure. There was little to stop the waves of panic that lashed the region. Once-dynamic economies spun out of control and into recession.
There are striking similarities between 1997 and 2007. Economic growth in most Asian countries today is very strong. Then, as now, foreign capital is flooding into emerging markets, pushing up currencies and inflating asset prices. Risk premiums have dropped to record lows. But what if this money reverses course and heads for the exits? Should Asia prepare for another financial crisis?
There is no reason to let down defences. But, more positively, there are notable differences in circumstances as well. Most Asian countries today have current account surpluses, though India is a notable exception. Regional central banks are sitting on more than a trillion dollars of reserves that they can use to fight speculative attacks on their currencies. And, perhaps most importantly, fixed exchange rates have been replaced by flexibility (admittedly of a weak sort). So, Asian central banks are unlikely to enter a fight unto death.
Memories of the Asian financial crisis are still seared on the collective memory of Asian countries. Is it an episode that we must forget, and move on? After all, didn’t Thailand, Singapore, South Korea, Taiwan and the rest bounce back within a couple of years? That’s true, but recent research shows that average growth rates in the region are still 2% below their immediate pre-crisis levels. We should forget 1997 at our own peril.
There are two main sets of lessons from the Asian crisis of 1997. The first set has to do with the real economy of production and productivity. Paul Krugman had famously argued in 1994 that the Asian economic miracle was no miracle at all. It was driven by use of more capital and labour, rather than by productivity. It was doomed to run into the roadblock of diminishing returns. So, one big lesson is that growth is more stable if it is based on efficiency and productivity, rather than on an investment mania. What matters is not how much you invest but how well you invest.
The other set of lessons are financial. It is now widely accepted that countries need strong banks and high-quality financial supervision to ensure that capital flows are absorbed in the economy.
There is also a growing consensus that central banks should not be obsessed with a fixed exchange rate. More controversially, there is reason to believe that governments should have the freedom to close the capital account in special circumstances, as Malaysia did immediately after the crisis.
But the most significant lesson is a broader one. Global capital flows can be highly unpredictable—rushing in and out with a damaging suddenness. Capital needs to be welcomed in, but while keeping an eagle eye on where it goes. This is something that the Reserve Bank of India, to its credit, has insisted on way before its global peers did.
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