European Lessons From the Asian Crisis

by Ivan Martchev | June 10, 2012 7:00 am

[1]Having just penned a missive on the escalation of the eurozone crisis[2] — something that I had expected for a while and has been coming in an eerily slow and orderly manner — I got an unwanted response from the editor that originally suggested the topic.

“Your angle would be the ‘practicality’ of dissolving the euro. … basically, starting at the (completely hypothetical) decision that nothing can be done and the euro would have to be dissolved.”

I must have subconsciously evaded answering the original question because the obvious answer to the practicality of dissolving the euro, despite the euro’s numerous flaws, is “there is none.”

After a decade of slow political integration, dissolving the euro would cause chaos that by definition is difficult to forecast ahead of time. All the benefits that came with the single currency would disappear. The removal of exchange rate risk was a big marketable point of the euro, which would mean exchange rate risk will be reintroduced.

The lower interest rates that came with the common currency for most of the 2000s will be replaced by sharply higher interest rates for some currencies, which are only bound to make matters worse in economies already in recession. (This already is ongoing as sovereign yields in Germany are falling while they are rising for most PIIGS countries. At one point even France saw a widening yield differential[3] with Germany, which now has calmed down as investors allocate a small chance on having exchange rate risk there).

The original currencies that were folded into the euro in effect still have a “hard” peg, as they were exchanged at a fixed rate for the common currency. The only recent example of multiple countries losing their exchange rate pegs to a hard currency was the Asian Crisis, where Thailand[4] set of a series of devaluations in 1997 that caused a lot more damage in the following year that anyone originally expected. Indonesia[5], South Korea[6] and Malaysia[7] experienced exchange rate moves that can only be qualified as truly extraordinary.

Not every country in the region lost its exchange rate peg to the dollar, but in the European case, capital flight will make matters sharply worse for weaker economies in the short run, similar to what happened in 1997.

In trying to qualify the possible outcomes of for the current euro situation, I came upon a great paper[8] by Steven Radelet and Jeffrey Sachs on the causes of the Asian Crisis. They stressed that different types of financial crises require different responses, so it was important to qualify the Asian Crisis to find the right approach to resolving it. They came up with five “crisis” categories:

1. Macroeconomic policy-induced crisis is “a balance of payments crisis (currency depreciation; loss of foreign exchange reserves; collapse of a pegged exchange rate) arises when domestic credit expansion by the central bank is inconsistent with the pegged exchange rate.”
2. Financial panic is a bank run of sorts where “short-term creditors suddenly withdraw their loans from a solvent borrower.”
3. Bubble collapse “occurs when speculators purchase a financial asset at a price above its fundamental value in the expectation of a subsequent capital gain. In each period, the bubble (measured as the deviation of the asset price from its fundamental price) may continue to grow, or may collapse with a positive probability. The collapse, when it occurs, is unexpected but not completely unforeseen, since market participants are aware of the bubble and the probability distribution regarding its collapse.”
4. Moral-hazard crisis “arises because banks are able to borrow funds on the basis of implicit or explicit public guarantees of bank liabilities. If banks are undercapitalized or under-regulated, they may use these funds in overly risky or even criminal ventures.”
5. Disorderly workout “occurs when an illiquid or insolvent borrower provokes a creditor grab race and a forced liquidation even though the borrower is worth more as an ongoing enterprise. A disorderly workout occurs especially when markets operate without the benefit of creditor coordination via bankruptcy law. The problem is sometimes known as a “debt overhang.”

The authors stressed that the theoretical differences among these five types of crises are significant and the response mechanisms are different. They admitted these various types of financial crisis can become intertwined, and therefore were difficult to diagnose.

As I read though the elaborate piece of research, it became clear that the eurozone crisis is quite a bit different than the Asian Crisis, which was brought on by a the reversal of a huge influx of foreign capital and the resulting domino effect in local over-leveraged financial systems.

The eurozone crisis has elements of all of the five crisis categories in different PIIGS countries, and a dissolution of the euro will do absolutely nothing to resolve the present issues ironically brought on by the euro itself.

The only solution is to fiscally integrate the eurozone and the EU, which Germany — its strongest member — currently vehemently opposes.

Unless Germany changes its mind, the Asian Crisis will look a picnic compared to what the eurozone is facing.

Ivan Martchev is a research consultant with institutional money manager Navellier & Associates. The opinions expressed are his own.

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