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The Asian Financial Crisis of 1997 - 1998 and the Behavior of

Asian Stock Marketsby Urbi Garay

Urbi Garayurbi.garay@iesa.edu.ve is an Assistant Professor of Finance at the Instituto deEstudios Superiores de Administracin (IESA) in Caracas, Venezuela.[1]

ABSTRACT

This paper analyzes the currency and stock market collapses experienced by HongKong, Indonesia, Malaysia, the Philippines, Singapore, South Korea, Taiwan, andThailand in 1997 and early 1998. Documented is the close relationship between the

behavior of the stock markets of these countries during this period, and the evolutionof their currencies. Price/Earnings and Price/Book ratios are used to show that Asianstock markets were not overvalued before the crisis started; thus suggesting thatthe crisis was not the result of a bursting bubble. This paper also describes thedifferent theories of stock market co-movements across countries, which againbecome important with the post-crash reduction in the advantages to investors ofinternational diversification.

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1. Introduction

The aim of this paper is twofold. First of all, it reveals that the stock market collapses experienced ba number of South East Asian economies in 1997 and early 1998 where highly correlated with theevolution of the currencies of the countries involved. Secondly, using Price/Earnings and Price/Bookratios it is shown that Asian stock markets were not overvalued before the crisis started; thussuggesting that the crisis was not the result of a bursting bubble that some authors such asKrugmanhave argued.

This paper also presents the different theories of stock market co-movements across countries. Thepresence of contagion or inter-dependence among economies of a certain region become importantwith the diminishment of the advantages to investors of international diversification, via increases incross-correlations among stock market returns. The issue of international contagion and inter-dependence has been in the forefront of academic discussions as a result of Mexicos 1994 and

Asias 1997-'98 financial crises.

In thesecond sectionof this paper the behavior of S.E.-Asian currencies during the crisis isanalyzed. The rest of the paper is organized as follows: thethird section analyzes the evolution ofS.E.-Asian stock markets during the crisis; thefourth sectioninquires whether Asian stock markets

were overvalued before the financial crisis erupted; the fifth sectionpresents the different channelsof transmission through which the stock market of one country might be influenced by the evolution oother stock markets; and, finally, thesixth sectionsummarizes and presents the author's conclusions

2. The Evolution of Asian Currencies During the Financial Crisis

The Asian financial crisis started with the devaluation of Thailands Bath, which took place on July 21997, a 15 to 20 percent devaluation that occurred two months after this currency started to sufferfrom a massive speculative attack and a little more than a month after the bankruptcy of Thailandslargest finance company, Finance One. This first devaluation of the Thai Baht was soon followed bythat of the Philippine Peso, the Malaysian Ringgit, the Indonesian Rupiah and, to a lesser extent, the

Singaporean Dollar. This series of devaluations marked the beginning of the Asian financial crisis. [2This first sub-period of the currency crisis took place between July and October of 1997. Figures 1Aand 1B (below) present the monthly evolution of the currencies of the eight South-East Asiancountries studied here for the period July 1997 (rebased to 100 in all the graphs) to May 1, 1998. [3]Included are the Hong Kong (H.K. Dollar), Indonesia (Rupiah), Malaysia (Ringgit), the Philippines(Peso), Singapore (SG Dollar), South Korea (Won), Taiwan (New Dollar) and Thailand (Baht).

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A second sub-period of the currency crisis can be identified starting in early November, 1997 after

the collapse of Hong Kongs stock market (with a 40 percent loss in October). This sent shock waves

that were felt not only in Asia, but also in the stock markets of Latin America (most notably Brazil,Argentina and Mexico). In addition to these stock markets, were those of the developed countries(e.g. the U.S. experienced its largest point loss ever in October 27, 1997, which amounted to a 7percent loss). These financial and asset price crises also set the stage for this second sub-period oflarge currency depreciations. This time, not only the currencies of Thailand, the Philippines, MalaysiaIndonesia and Singapore were affected, but those of South Korea and Taiwan also suffered. In fact,the sharp depreciation of Koreas Won beginning in early November added a new and moretroublesome dimension to the crisis given the significance of Korea as the eighth largest economy inthe world; the magnitude of the depreciation of its currency which took place in less than two monthsand the Korean Central Banks success in maintaining the peg ever since the Thais first devaluation(i.e. the nominal anchor of the largest of the Asian Tigers was suddenly lost). In addition, was the

other important component of this second sub-period: the complete collapse of the Indonesian Rupiathat started at about the same time.

Finally, starting in January of 1998, the currencies of all of these countries regained part of what thehad lost since the crises started. It is also important to note that at a great cost Hong Kong was ableto maintain its peg after the crisis first erupted. This required that interest rates be raised to fend-offthese currencies from repeated speculative attacks.

3. The Evolution of Asian Stock Markets During the Asian Financial Crisis

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It is necessary to study the evolution of the stock markets and the inflow of money that went to theAsian economies in order to understand the financial crisis of 1997- 1998. Net equity investments inthe economies of South Korea, Indonesia, Malaysia, Thailand, and the Philippines amounted to US$12.2 billion in 1994, US$ 15.5 billion in 1995, US$19.1 billion in 1996, and US$ 4.5 billion in 1997according to the Institute of International Finance in 1998. The reversal for 1997 came as a result ofthe financial crisis that started in Thailand, which added pressure to the currency markets of thecountries considered in this article. Net equity investments and new private loans financed most of thincreasing current account deficits that the SE-Asian economies, as well as most of the developingworld, experienced during the 1990s. The ability of most of the developing world to import capitalthrough securities markets was enhanced by the exponential growth in the U.S. mutual fund industryand the low interest rates available in the U.S. and Japan during the past decade.

Now, through the following figures, let us turn our attention to the behavior of the Asian stock markeindices during the crisis.

Figures 2A and 2B (above) show the monthly evolution of national stock price indices (expressed inUS dollars) for these same eight countries and during the same period of time. The stock marketindices are those provided by Morgan Stanley International Capital (MSCI). Figures 3A and 3B(below) show the behavior of the same Asian stock market indices from January 1997 to May 1998but expressed in local currency. As can be seen, the direction of the stock markets is similar to that oFigures 2A and 2B in which the indices where expressed in US$ terms. However, the magnitude ofthe decline on the local stock market prices is not as pronounced when expressed in local currency.

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Figures 3A and 3B (above) show the behavior of the same Asian stock market indices from Januar

1997 to May 1998 but expressed in local currency. As can be seen, the direction of the stock marketsis similar to that of Figures 2A and 2B in which the indices where expressed in US$ terms. However,the magnitude of the decline on the local stock market prices is not as pronounced when expressed ilocal currency. This finding suggests the existence of a currency effectaffecting stock price returnsduring the crises, as is explained in the next paragraph.

The finding of a close relationship between exchange rate depreciations and stock returns during acrisis is consistent with Bailey, Chan and Chung (2001). These authors demonstrate, using intradaydata, that the severe downturn of the Mexican stock market in December 1994 and early 1995 can bassociated with the Peso devaluation that took place during this same period. In the case of the five

Asian countries whose currencies experienced the sharpest depreciations during the Asian crisis

(Indonesia, Malaysia, Philippines, South Korea, and Thailand) the average correlation betweenweekly stock market returns and currency changes (where currency is defined as the number of unitsof foreign currency per 1 U.S. dollar) between the first week of July 1997 and the first week of May1998 is0.63 and is significant at the 1percent level. My explanation for this strong association is thacurrency devaluations have traditionally been accompanied by declining stock markets in thedeveloping world because they have usually taken place in the middle of a financial crisis anduncertainty about the future course of economic policies and outcomes. For instance, the negativeimpact of devaluing currencies on S.E.-Asian banks and companies that had borrowed heavily oninternational markets most probably surpassed the potential export gains. But an orderly devaluatiosuch as that of Britain in 1992 did not have negative effects on the London stock market since ithelped the British economy recover from a three-year recession via an export-boom.

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4. Were the Stock Markets Overvalued Before the Crisis Started?

The stock markets of Hong Kong, Indonesia, and South Korea fluctuated with no clear trend beforethe first sub-period of the currency crisis began in early July, 1997. The stock markets of Malaysia,Singapore, the Philippines, and Thailand drifted downward during this same sub-period, with the latetwo countries experiencing the sharpest declines. Finally, Taiwan's stock market drifted upwardsduring this same sub-period of time. Therefore, I not see any evidence of a clear pattern of stockmarkets collapsing in a contagious fashion before the first round of devaluations took place in July,

1997, asKrugman(1998) suggested was the case:[4]

And then the bubble burst. The mechanism of crisis, I suggest, involved that same circular processin reverse: falling asset prices made the insolvency of intermediaries visible, forcing them to ceaseoperations, leading to further asset deflation. This circularity, in turn, can explain both the remarkablyseverity of the crisis and the apparent vulnerability of the Asian economies to self-fulfilling crisis which in turn helps us understand the phenomenon of contagion between economies with few visibleeconomic links.

I have checked the evolution of the same national stock market indices since 1991 (the precedingfive years to the crisis) and, on one hand, I found a significant increase in Hong Kongs stock market

asset prices (a fourfold increase), while, on the other hand, the remaining seven stock markets stayeremarkably flat, with some minor fluctuations. Furthermore, the performance of the Asian stockmarkets lagged behind the Latin American, the British, and the United States stock markets during thsame years prior to the crisis. Thus, it seems hard to contend that the collapse of the stock markets iSouth East Asia was the result of a bursting bubble, since the stock prices of the markets of SE-Asiahad hardly any growth six years prior to the currency crises of 1997.

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To analyze whether rapidly increasing stock prices represent a bubble; financial economists try to

express these prices in terms of indicators such as; the earnings of companies which trade stocks inthe market (the P/E or Price/Earnings ratio, and the P/B or Price/Book ratio.) Rising stock prices andearnings may well yield a flat P/E ratio (i.e. there is no bubble since higher stock prices are justified bfundamentals, at least as it pertains to the P/E ratio.) For instance, authors likeGilibert and Steinhe(1996) contend that the rise in stock prices that took place in Mexico in the early 1990s was theproduct of a speculative bubble and that it was not justified by fundamentals. However, analyzing P/Eand P/B ratios of Asian stock markets just before the crisis erupted it is difficult to contend that thesemarkets were overvalued since the ratios were below the world average (See Table 1 above.)

Finally, Table 2 (above) shows that the U.S. stock market had been, on a risk-adjusted basis, thebest market performer during the period 1990-96, followed by Latin America, U.K., Asia (excluding

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Hong Kong), and Japan. The fact that S.E.-Asian markets plummeted after having lagged behind theperformance of those of the rest of the world, and after having remained relatively flat during the1990s (i.e. no bubble), is another indication of how severe and dramatic the financial crisis was.

Krugmans assertion is nonetheless consistent with the behavior of national stock prices in SouthEast Asia after the first round of devaluations. Such evolution had actually preceded the second andmore intense wave of devaluations of November and December of 1997. This is because, as wasshown inFigures 2A and 2B(above), between the first and second round of devaluations the stockmarkets of Hong Kong, Indonesia, Korea, Malaysia, the Philippines, Singapore, Taiwan, and Thailanexperienced sharp declines. Not until the currencies of these countries stabilized in early 1998 weretheir stock markets able to reverse the downward trend in stock prices (except in Indonesia).

In summary, it is difficult to contend that falling stock prices during the Asian crises were the result oa bubble that was bursting or that Asian stock markets were overvalued before the crisis firsterupted.

5. Stock Market Co-Movements: The Channels of Transmission[5]

In this section the literature of the determinants of stock market co-movements is briefly examined.

Why do stock market co-movements occur? What are the linkages among stock markets that canexplain a crisis such as the Asian? Calvo and Reinhart (1996) provide a brief summary of the existenexplanations in the context of currency crisis,[6]and in this paper an attempt is made to adapt someof these explanations to the case ofstock marketco-movements during periods of financial crises, asub-area in this field that has received relatively little attention. [7]Nonetheless, the inflow of capital tthe developing world that took place in the late 1980s and early 1990s was accompanied by anincreasing share of portfolio investments as local stock markets became increasingly open towardsforeign investors. Such is the case for the Latin America countries where this situation is presentedmore frequently than in the South Eastern Asia countries.

Stock market co-movements can be explained as follows:

The first reason is that stock market co-movements may take place when the financial markets oftwo countries are highly integrated so that shocks to the larger country are transmitted to the smallerones via assets-trading. An example of this type of spillover is the integration of the capital markets

Argentina and Uruguay. As a result of Argentinas 2001-2002 severe crisis and subsequent externaldebt default and currency devaluation, Uruguay has recently been forced to devalue its currency.

The second most important reason are the trade partners and bilateral or multilateral tradearrangements that enhance the possibilities of international shocks. For instance, when the currencyof a country experiences a large real depreciation, imports from its trading partners fall, and the tradebalance of the country whose currency is devalued deteriorates, thereby setting the stage for thecurrencies of its neighbors to suffer speculative attacks if the impact is large enough. For example,the Brazilian devaluation of 1999 placed great pressure on Argentinas currency, Brazils mostimportant trading partner.

The third reason (SeeChua, 1993.) emphasizes the role of technological factors on economicgrowth. Technological spillovers between neighboring countries tend to occur because ideas andcapital flow are faster and easier across neighboring countries rather than across distant countries.Thus, the economic growth of a country is affected by the economic growth of its neighbors. I havefound a highly significant and positive regional spillover effect in a number of the South East Asiancountries.

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The first three theories or reasons presented above attempt to explain stock market co-movementsas a consequence of economic linkages among countries. These theories are whatForbes andRigobon (2000 and 2002) might call interdependenceexplanations. Nevertheless, the last threetheories or reasons, which are of a contagious nature, deal with the effects of investors behavior onstock markets, the result of which may cause a stock market crisis or exacerbate an existing one.

The fourth reason, is that spillovers or contagious crises may occur for institutional reasonsaccording to the theories of Calvo and Reinhart(1996) theories: [8]

In response to a large adverse shock (such as the Mexican devaluation)[9]an open-end emergingmarket mutual fund that is expecting an increasing amount of redemptions will sell off its equityholdings in several emerging markets in an effort to raise cash. However, given the illiquidity thatcharacterizes most emerging markets, the sell-off by a few large investors will drive stock priceslower. Hence, the initial adverse shock to a single country gets transmitted to a wider set of countries

The fifth reason is that investors sentiments can generate self-fulfilling crises if foreign investors donot discriminate among different macroeconomic fundamentals across countries. There exists a vastliterature on banking and financial crises in the developed world in which the issue of contagioneffects arise frequently. According to Calvo and Reinhart, for example:[10]

In the wake of a bank failure (particularly a large of prominent bank), anxious depositors possessingimperfect information about the soundness of other banks rush to withdraw their deposits from thebanking system at large. The stampede by depositors generates a liquidity crisis that spreads to othehealthy banks. Thus, herding behavior by depositors alters the "fundamentals" for a broader set offinancial institutions and the crisis becomes self-fulfilling...A similar story can be told about investors international currency and equity markets...With regards to emerging markets, however, relatively littis known about these issues.

The sixth reason is that contagion may occur because of the way market participants interpretpossible co-movements in macroeconomic policies and fundamentals in the economies subject toattack. [Eichengreen, Rose, and Wyplosz (1996)]

Given the experience of currency crisis being accompanied by stock market collapses in thedeveloping world (The figures shown above confirmed this in the context of the SE-Asian financialcrises), a speculative currency attack against one currency and the concomitant effects may welltrigger simultaneous declines in the stock markets of these same countries.

6. Conclusions

In this paper the currency and stock market collapses experienced by a number of South East Asiaeconomies in 1997 and mid 1998 have been examined, and the close relationship between thebehavior of their stock markets during this period and the evolution of the currencies of the countriesinvolved was analyzed. Shown was that the severe downturn of the Asian stock markets during thefinancial crisis can be associated with the currency devaluations of the five countries whosecurrencies experienced the sharpest depreciations during the crises, especially in the case ofIndonesia, Malaysia, Philippines, South Korea, and Thailand. This was reflected in an averagecorrelation between weekly stock market returns and currency depreciations of0.63 during the crisperiod.

When the evolution of South East Asian stock markets prior to the crisis was analyzed there was noevidence found of a clear pattern of stock markets collapsing in a contagious fashion before the firstround of devaluations took place in July, 1997 asKrugman(1998) suggested was the case.Krugmans assertion is nonetheless consistent with the behavior of national stock prices in South Ea

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Asia after the first round of devaluations occurred. Also, the fact that South East Asian stock marketsplummeted after having lagged behind the performance of those of the rest of the world, and afterhaving remained relatively flat during the 1990s (i.e. no bubble), is another indication of how severethe financial crisis was.

Stock market co-movements may occur for different reasons. First, they may take place when thefinancial markets of two countries are highly integrated so that shocks to the larger country aretransmitted to the smaller ones via assets-trading. Second, trade partners and bilateral or multilateratrade agreements enhance the transmission of shocks internationally. Third, spillover effects may bethe result of technological factors or economic growth. Fourth, contagious crisis may occur forinstitutional reasons. Fifth, investors sentiment can generate self-fulfilling contagious crisis if foreigninvestors do not discriminate among different macroeconomic fundamentals across countries. Andsixth, contagion may occur because of the way market participants interpret possible co-movementsin macroeconomic policies and fundamentals in the economies subject to attack.

Even though I did not test any of the theories of contagion in this article, I am inclined to think thatcompetitive devaluations were present during the crisis and that a domino effect was created wheninternational mutual funds sold Asian stocks and bonds of both crisis and non-crisis countries in aneffort to raise cash. These two channels of transmission correspond to the second and fourth theorieof contagion outlined in the previous paragraph.

Finally, I conclude that contagion or interdependence across stock market returns diminishes greatlthe advantages of international diversification highlighting the instability of historical correlationcoefficients among stock market indices when a crisis occurs.

References

Bailey, W., Chan, K., and P. Chung, Depositary Receipts, Country Funds, and the Peso Crash: TheIntraday Evidence, The Journal of Finance, (Dec. 2002), v55, n6, pp. 2693-2717.

Calvo, S., and C. Reinhart; Capital Flows to Latin America: Is There Evidence of Contagion Effects,in Calvo, Goldstein, and Hochreiter, Private Capital Flows to Emerging Markets after the MexicanCrisis (Vienna: IIE, 1996.)

Chua, H.; Regional Spillovers and Economic Growth, Center Discussion PaperNo. 700. NewHaven, CT: Yale University Economic Growth Center.

Eichengreen, B., Rose, A., and Ch. Wyplosz; Contagious Currency Crises, National Bureau of

Economic Research Working Paper5681, 1996.

Forbes, K., and R. Rigobon; Contagion in Latin America: Definitions, Measurement, and PolicyImplications, NBER Working PaperNo. 7885, 2000.

Forbes, K., and R. Rigobon; No Contagion, Only Interdependence: Measuring Stock Market Co-movements, The Journal of Finance, (Oct. 2002), v57, n5, pp. 2223-2261.

Gilbert, P., and A. Steinherr; Private Capital Flows to Emerging Markets after the Mexican Crisis, inCalvo, Goldstein, and Hochreiter, Private Capital Flows to Emerging Markets after the Mexican Crisis(Vienna: IIE, 1996.)

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International Finance Corporation, Emerging Markets Factbook (Washington: The World Bank, 1998

Krugman, P.; What Happened to Asia?, Unpublished Manuscript, 1998

Patel, S., andA. Sarkar; Stock Market Crises in Developed and Emerging Markets, FederalReserve Bank of New York Working Paper, 1998.

Footnotes1. The author would like to thank Gerald Epstein and B>Quest referees for very helpful comments.The usual disclaimer applies.2. Chinas 1994 40 percent devaluation and the Japanese Yens 25 percent depreciation between1995 and 1996 weakened the competitive position of the rest of the countries of the region and setthe stage for the round of competitive devaluations that took place in the middle of 1997. 3. The source of the data is Datastream.4.Krugman(1998), p. 35. It is beyond the scope of this study to attempt to test any of the theories presented in this section. 6. The literature on the subject of currency crises is vast. A widely cited paper in this area isEichengreen, Rose, and Wyplosz (1996). Using thirty years of panel data from twenty industrializedcountries, these authors find evidence that speculative attacks tend to be temporarily correlated andthat currency crises seem to pass from one country to another. The authors also conclude that animportant variable explaining these currency co-movements was the existing linkages of internationatrade between the countries affected.7.Patel and Sarkar(1998) study stock market crises in developed and emerging markets between1970 and 1997 finding evidence of contagion across markets from the same region.8.Calvo and Reinhart (1996), p. 1569. The authors refer to the large devaluation of the Peso that took place in December 1994 and early1995.10.Calvo and Reinhart(1996), p. 157.

B>Quest(Business Quest)

A Web Journal of Applied Topics in Business and Economics

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