History of CRISES-Lessons to be learnt
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Ravi Chandran.K
Oct 13, 2008, 8:26:27 AM10/13/08
to Kences1
Not learning from history
=========================
As the world struggles in the throes of a credit crisis, it seems
appropriate to recount some (un)forgettable meltdowns of the twentieth
century, the economics behind them and the panic that they created.
Each of these major crises had features that have parallels in the
current one. Yet, history repeats itself. Could investors have drawn a
lesson or two from each of these and been more prudent? Read on.
The Japanese property bubble
============================
The fall in property prices and defaults by sub-prime borrowers
flagged off the now famous credit crisis. Will this crisis tip the
world into recession? Let us hark back to the Japanese property bubble
in the early 1980s.
At that time, Japan had huge trade surpluses (excess of exports over
imports) with the US. Alarmed at its unfavourable Balance of Trade
position, the US, through the Plaza Accord of 1985, allowed the yen to
appreciate against the dollar. In two years’ time, the yen was up by
almost 50 per cent.
The country’s export-dependent economy stumbled. Capital investments
slowed. To avoid a recession, Japan eased restrictions on borrowings
and progressively lowered interest rates. But low inflation (due to
cheap imports and the fall in international oil prices), coupled with
cheap money, enabled cash-flows into the property and stock markets as
well.
Over the next few years, as demand for land increased, property prices
soared. In the latter part of 1989, the Nikkei too raced towards its
all-time high of 38,957 points but inflation had started to rear its
head.
As the New Year dawned, the stock market nose-dived. The Bank of Japan
sharply increased lending rates and placed restrictions on lending to
the real estate sector. Property prices plummeted. Loans given with
land as collateral went bad.
Soon, slowing investment and consumption led to deflation. Following
the crash, the 1990s came to be known as ‘the lost decade’ in Japan.
With the Asian financial crisis further rubbing salt into the wounds,
Japan’s central bank adopted an extremely easy money policy that kept
interest rates at virtually zero. Even today, at half a per cent,
Japan has one of the lowest lending rates in the world. Little wonder
that its central bank couldn’t cut rates earlier this week, alongside
several other countries, in response to the US credit crisis!
Great Depression
================
The current credit crisis is increasingly being compared to the Great
Depression in the US in the 1930s. The 1920s witnessed a huge increase
in manufacturing output in the US. But the wages didn’t keep pace.
Instead, the bulk of the profits was pocketed by corporates, creating
a wide gap between the rich and the blue-collared.
At the same time, capacity expansions by companies (signalling higher
profits), rising dividends and speculation drew surplus into the stock
market. The upward spiral helped the Dow Jones Industrial Average hit
a peak of 381 in September 1929.
When volatility rose, speculation gave way to fear and the party wound
up quickly. The rich stopped spending. The poor, who were earlier
financing their purchases mostly on credit, cut back. As demand
declined, so did production. As a result, unemployment rose. Borrowers
defaulted.
Ironically, it was the onset of World War II that boosted spending and
bailed out the economy .
Asian crisis
============
If the Great Depression was born out of the unequal fruits of
industrial prosperity, the Asian currency crisis of 1997-98 exposed
the harm that volatile capital flows and highly leveraged positions
can cause to entire economies. The years preceding the crisis saw
South-east Asian economies such as Thailand, Malaysia and Indonesia
open up their economies to foreign direct investments and capital
flows.
Full capital mobility was allowed, with these Asian economies aligning
their exchange rates closely with the dollar.
A sharp appreciation in the dollar in 1995 caused South-east Asian
currencies to appreciate against other currencies as well. This
resulted in significant losses on the export front — which was a key
blow to these externally dependent economies.
A widening current account deficit (financed with overseas borrowings)
coupled with basic differences in the economies of the US and these
countries aroused speculation as to the ‘real’ exchange rate — the
fixed exchange rate regime collapsed. As a result, the currencies of
countries such as Thailand, Malaysia, Indonesia, Korea and Philippines
were sharply devalued.
Interest rates were steeply raised to protect the local currencies.
This set off a vicious spiral of rising cost of financing for
companies and a squeeze on debt servicing capabilities. Earlier, the
fixed exchange rates and the free flow of foreign funds had prompted
domestic banks and corporates to borrow heavily from abroad.
Once disaster struck, the high leverage choked borrowers. Banks which
resorted to borrowing from abroad for lending domestically too felt
the heat. The excessive inflows had also found their way into asset
classes such as the stock market and real estate.
When foreign investors began to pull money out, both stock market and
real estate prices slumped. In the latter half of 1997, the IMF, along
with the World Bank and the Asian Development Bank, provided aid to
these countries as they were in danger of defaulting on their debt
repayments.
These countries also agreed to undertake structural reforms by
tightening their fiscal and monetary policies.
Latin American debt crisis
==========================
A similar story had already been enacted in Latin America in the
1980s. In the context of massive inflows of foreign capital and
subsequent flight, the Asian crisis was, in fact, Latin America Part
II.
The substantial increase in oil prices in 1973-74 by the OPEC nations
resulted in massive inflows of surplus money into the oil-exporting
countries. With the availability of funds far exceeding domestic
requirements, these countries parked surplus funds in international
commercial banks.
This happened at a time when countries such as Chile, Uruguay and
Argentina had just liberalised trade and needed money to implement
economic reforms.
Besides, oil-importing countries in this area also needed money to
finance their deficits. So Latin America resorted to borrowing these
surplus ‘petro-dollars’ from commercial banks whose loans were short-
term and carried variable rates.
As the 1970s drew to a close, oil prices spiked again, fuelling
inflation and, hence, higher interest rates. Money was needed to
finance both the trade imbalance and the higher interest. For this,
these countries resorted to fresh borrowings, and were thus pulled
into a debt trap.
A year or two later, oil prices fell, but not interest rates. In
Mexico, an oil-exporting country there was a flight of capital abroad.
The peso depreciated by about 80 per cent; Mexico was unable to
service its debt and was on the verge of defaulting on loan
repayments.
Other Latin American countries followed suit. Further lending to these
countries was refused and they could not get out of the debt trap.
These nations were later forced to renegotiate their debt and the IMF
stepped in to co-ordinate.
Ravichandran K
Research Analyst
=========================
As the world struggles in the throes of a credit crisis, it seems
appropriate to recount some (un)forgettable meltdowns of the twentieth
century, the economics behind them and the panic that they created.
Each of these major crises had features that have parallels in the
current one. Yet, history repeats itself. Could investors have drawn a
lesson or two from each of these and been more prudent? Read on.
The Japanese property bubble
============================
The fall in property prices and defaults by sub-prime borrowers
flagged off the now famous credit crisis. Will this crisis tip the
world into recession? Let us hark back to the Japanese property bubble
in the early 1980s.
At that time, Japan had huge trade surpluses (excess of exports over
imports) with the US. Alarmed at its unfavourable Balance of Trade
position, the US, through the Plaza Accord of 1985, allowed the yen to
appreciate against the dollar. In two years’ time, the yen was up by
almost 50 per cent.
The country’s export-dependent economy stumbled. Capital investments
slowed. To avoid a recession, Japan eased restrictions on borrowings
and progressively lowered interest rates. But low inflation (due to
cheap imports and the fall in international oil prices), coupled with
cheap money, enabled cash-flows into the property and stock markets as
well.
Over the next few years, as demand for land increased, property prices
soared. In the latter part of 1989, the Nikkei too raced towards its
all-time high of 38,957 points but inflation had started to rear its
head.
As the New Year dawned, the stock market nose-dived. The Bank of Japan
sharply increased lending rates and placed restrictions on lending to
the real estate sector. Property prices plummeted. Loans given with
land as collateral went bad.
Soon, slowing investment and consumption led to deflation. Following
the crash, the 1990s came to be known as ‘the lost decade’ in Japan.
With the Asian financial crisis further rubbing salt into the wounds,
Japan’s central bank adopted an extremely easy money policy that kept
interest rates at virtually zero. Even today, at half a per cent,
Japan has one of the lowest lending rates in the world. Little wonder
that its central bank couldn’t cut rates earlier this week, alongside
several other countries, in response to the US credit crisis!
Great Depression
================
The current credit crisis is increasingly being compared to the Great
Depression in the US in the 1930s. The 1920s witnessed a huge increase
in manufacturing output in the US. But the wages didn’t keep pace.
Instead, the bulk of the profits was pocketed by corporates, creating
a wide gap between the rich and the blue-collared.
At the same time, capacity expansions by companies (signalling higher
profits), rising dividends and speculation drew surplus into the stock
market. The upward spiral helped the Dow Jones Industrial Average hit
a peak of 381 in September 1929.
When volatility rose, speculation gave way to fear and the party wound
up quickly. The rich stopped spending. The poor, who were earlier
financing their purchases mostly on credit, cut back. As demand
declined, so did production. As a result, unemployment rose. Borrowers
defaulted.
Ironically, it was the onset of World War II that boosted spending and
bailed out the economy .
Asian crisis
============
If the Great Depression was born out of the unequal fruits of
industrial prosperity, the Asian currency crisis of 1997-98 exposed
the harm that volatile capital flows and highly leveraged positions
can cause to entire economies. The years preceding the crisis saw
South-east Asian economies such as Thailand, Malaysia and Indonesia
open up their economies to foreign direct investments and capital
flows.
Full capital mobility was allowed, with these Asian economies aligning
their exchange rates closely with the dollar.
A sharp appreciation in the dollar in 1995 caused South-east Asian
currencies to appreciate against other currencies as well. This
resulted in significant losses on the export front — which was a key
blow to these externally dependent economies.
A widening current account deficit (financed with overseas borrowings)
coupled with basic differences in the economies of the US and these
countries aroused speculation as to the ‘real’ exchange rate — the
fixed exchange rate regime collapsed. As a result, the currencies of
countries such as Thailand, Malaysia, Indonesia, Korea and Philippines
were sharply devalued.
Interest rates were steeply raised to protect the local currencies.
This set off a vicious spiral of rising cost of financing for
companies and a squeeze on debt servicing capabilities. Earlier, the
fixed exchange rates and the free flow of foreign funds had prompted
domestic banks and corporates to borrow heavily from abroad.
Once disaster struck, the high leverage choked borrowers. Banks which
resorted to borrowing from abroad for lending domestically too felt
the heat. The excessive inflows had also found their way into asset
classes such as the stock market and real estate.
When foreign investors began to pull money out, both stock market and
real estate prices slumped. In the latter half of 1997, the IMF, along
with the World Bank and the Asian Development Bank, provided aid to
these countries as they were in danger of defaulting on their debt
repayments.
These countries also agreed to undertake structural reforms by
tightening their fiscal and monetary policies.
Latin American debt crisis
==========================
A similar story had already been enacted in Latin America in the
1980s. In the context of massive inflows of foreign capital and
subsequent flight, the Asian crisis was, in fact, Latin America Part
II.
The substantial increase in oil prices in 1973-74 by the OPEC nations
resulted in massive inflows of surplus money into the oil-exporting
countries. With the availability of funds far exceeding domestic
requirements, these countries parked surplus funds in international
commercial banks.
This happened at a time when countries such as Chile, Uruguay and
Argentina had just liberalised trade and needed money to implement
economic reforms.
Besides, oil-importing countries in this area also needed money to
finance their deficits. So Latin America resorted to borrowing these
surplus ‘petro-dollars’ from commercial banks whose loans were short-
term and carried variable rates.
As the 1970s drew to a close, oil prices spiked again, fuelling
inflation and, hence, higher interest rates. Money was needed to
finance both the trade imbalance and the higher interest. For this,
these countries resorted to fresh borrowings, and were thus pulled
into a debt trap.
A year or two later, oil prices fell, but not interest rates. In
Mexico, an oil-exporting country there was a flight of capital abroad.
The peso depreciated by about 80 per cent; Mexico was unable to
service its debt and was on the verge of defaulting on loan
repayments.
Other Latin American countries followed suit. Further lending to these
countries was refused and they could not get out of the debt trap.
These nations were later forced to renegotiate their debt and the IMF
stepped in to co-ordinate.
Ravichandran K
Research Analyst
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