Asian financial crisis

The Asian financial crisis in the late 1990s with devaluation of local currencies caused unexpected havoc in global markets, with a domino effect, including a crisis in Russia, declines in stock markets around the world, and the fall and bailout of the U.S. hedge fund Long Term Capital Management (LTCM).


The Asian financial crisis in the late 1990s with devaluation of local currencies caused unexpected havoc in global markets, with a domino effect, including a crisis in Russia declines in Stock markets around the world ,and the fall and bailout of the U.S. hedge fund Long Term Capital Management (LTCM).

A financial crisis that hit Southeast Asia in 1997, subsequently affected other Asian countries causing considerable uncertainty in the global economy. It had triggered a series of events that some say contributed to further turmoil in Russia in 1998 and to the default of Long-Term Capital Management – a major U.S. hedge fund at the time. It is of interest to precious metals investors because of the impact it had on the price of commodities, most notably on oil, but also metals.

Astonishing Performance of Asian Economies

During the 1980s and in the first half of 1990s countries in Southeast Asia (among others: South Korea, Indonesia and Thailand) experienced a period of rapid economic growth. Their economies grew by around 10% year on year (just to compare: on average the U.S. GDP grew by less than 3% during this period). The region’s good perfromance convinced investors that profits were to be made, and relatively high interest rates encouraged foreign entities to transfer money to Southeast Asia in hope of high returns. Due to this, Southeast Asia enjoyed an amazing inflow of capital.

Fixed Exchange Rates

Monetary policies of local authorities who maintained fixed exchange rates tied with the U.S. dollar caused this inflow to increase. Such policies eliminated the exchange risk and domestic interest rates were relatively high which made it less costly for companies and individuals from the region to borrow money elsewhere in the world. They were able to incur relatively cheap foreign debts and they didn’t need to worry that a change in the exchange rate would make their debts rocket.

Let’s use an example to explain why a fixed exchange rate secures the level of your debt. Imagine that your domestic currency is the U.S. dollar and you have a debt in euros, say €100 and the exchange rate EUR/USD is 2. In that situation your debt is worth 2 * $100 = $200. However, if the exchange rate changed to 3, than your debt would be 3 * $100 = $300 – you would lose $100 on the volatility of the exchange rate only. If the exchange rate was fixed at 2, then you wouldn’t need to worry about such changes and the possible risk that your debt would increase.

This situation led to an even bigger influx of foreign money to Southeast Asia (to a serious increase in foreign debt) – companies preferred to borrow money abroad than to issue new shares to gather required capital. This resulted in a lack of shareholder supervision and in an ineffective use of resources. Partly because of that, the Southeast Asian economies failed to increase their productivity.

The Bubble

The inflow of foreign capital stimulated demand which fueled increases in prices of assets (particularly in real estate) to the point when a price bubble started growing without control. As the entities needed more money to buy assets, they borrowed it abroad and deepened the dependency of South Asia on foreign capital. Initially, the bubble was hidden, but in the mid-1990s, a conjunction of factors threatened to expose it.

This was mainly because at that time the U.S. economy entered a path of recovery after a period of recession. As it gained momentum, the U.S. Federal Reserve Bank decided to raise interest rates in order to combat the risk of inflation. This was a problem for Southeast Asia – the U.S. interest rates became relatively high and therefore the USA were able to attract more investors than before at the expense of Southeast Asia. Southeast Asia responded with a series of rises of their interest rates but another factor came into play.

The outflow of capital to the U.S. caused the U.S. dollar to appreciate. Keep in mind that Southeast Asian currencies were tied with the dollar, and therefore the appreciation of the dollar triggered the appreciation of local currencies. This harmed the exports which were already threatened by China. Decreasing exports deteriorated the economic situation even more and the bubble in real estate started to show. Investors found out that their assets were overvalued and tried to sell them off. As a result more entities wanted to sell the assets than wanted to buy them and prices declined. When the prices declined, more investors wanted to sell but there were even fewer investors willing to buy. Finally, the market reached the point when everybody (who had assets) wanted to sell but virtually nobody wanted to buy – the market collapsed.

Currency Depreciation

Foreign investors who had sold their assets started to pull out of Southeast Asia. To do that they needed to get rid of their local currencies. Enormous amounts of currencies sold by foreign investors caused an effect similar to the one that caused real estate prices to fall. Everybody wanted to sell local currencies, nobody wanted to buy them. This led to a severe depreciation of local currencies. Southeast Asian governments tried to stop the outflow of capital by further raising interest rates and by currency interventions, but the situation was getting increasingly difficult as the real value of currencies was well below the fixed exchange rate (if €1 was worth $2 and the government would offer you $1 for €1, you probably wouldn’t enter such a deal).

At this moment international currency speculators started to suspect that the Asian governments would not be able to defend their currencies for much longer and that they would eventually devaluate or float them. Such a movement would possibly mean further depreciation and this was the reason why speculators opened enormous short positions in these currencies. Iin a short position you profit when a price of an asset declines. Afterwards, they started to sell as much of these currencies as they could, which led to deeper depreciation (and improved the chances of profit on a short position).

In an attempt to stimulate the demand for local currencies and stop the depreciation, Asian governments tried to buy huge amounts of local currencies in exchange for their foreign currency reserves but these reserves quickly dried up which left the authorities without an effective way to defend their currencies. On July 2nd, 1997 the Thai authorities floated their currency in an attempt to redress the country’s Balance of Payments deficits. Other Southeast Asian governments followed suit.

Results in Asia

The move by the Thai government led to a series of competitive devaluations across Southeast Asia and the situation was made worse by high levels of U.S. dollar loans held by the region’s private sector. Many of the region’s banks had borrowed funds on the international markets which were not hedged against the local currencies. These funds were used to finance rapid real estate development. As the economic situation worsened, default rates on those loans rose and resulted in a run on the banks increasing the pressure on governments.

The impact of the currency devaluations across the region quickly spread into regional and international stock markets and resulted in significant falls in import revenues (due to the devaluations and the reduction in available credit due to the problems in the banking sector) in the affected countries. The unstable economic situation evolved into a recession that hit the countries of the region in 1997 and 1998, with various severity. By 1998 most of the Southeast Asian countries needed help in the form of multi-billion dollar bailouts from the International Monetary Fund to avoid default. Hong Kong, Indonesia, Malaysia, the Philippines, Singapore, South Korea and Thailand entered recession. Hong Kong, Singapore and South Korea managed to overcome growth problems relatively quick while other countries had more problems with returning to growth – most notably, the Thai economy did not recover until 2001.

International Aftermath

The crisis was not confined to Southeast Asia itself. It affected markets in Russia and, despite the geographic remoteness, in the United States. It triggered significant declines in the price of oil – contracting economies did not need as much oil as they had previously, which weakened the demand and caused the prices to fall. The falling oil price contributed to the bankruptcy of Russia as oil exports were one of the crucial sources of financing the fiscal deficit.

The Russian default in 1998 caused investors to move their capital from Asia and Europe to the USA. Such a move was highly unexpected at the time and it contributed to the collapse of the U.S. hedge fund Long-Term Capital Management (LTCM) whose bets went bad because of the unexpected shift of capital. LTCM eventually lost approximately $4.6 billion which added to the decline in the U.S. stock market caused by the Asian financial crisis on its own.

The Asian financial crisis undermined the position of the IMF in the region as its strategy of high interest rates failed to heal the local economies. Asian governments adopted protectionist trade policies to stabilize their currencies and ensure that they operated with balance of payments surpluses.They invested these surpluses in U.S. Treasury Bills to build up extensive foreign currency reserves in order to be able to combat possible speculative attacks against their currencies. The crisis led to the reluctance of investors to transfer their capital to developing countries and increased the inflow of capital to the USA. This might have been one of the factors that created the environment in which interest rates in the U.S. were artificially low and the next bubble, the housing bubble, started to grow.

How About Gold and Silver?

Even though the crisis influenced the prices of commodities, most notably oil, it did not result in a gold/silver bull market. Investors who were fleeing developing countries did not resort to metals but to the U.S. Treasury Bills as the U.S. economy was perceived as a healthy one. The Russian default in 1998 did not change much as investors still preferred U.S. debt to other forms of “safe” investment. In such an environment gold not only did not appreciate but continued its path down. The situation was not to turn around until the beginning of the 2000’s.

These events are a proof that, even though financial turmoil usually does fuel the prices of metals, it is not a rule that the growing uncertainty on the markets always has to be reflected in sky-high prices of gold and silver. One should always see the big picture when investing in precious metals.