Vorläufige Fassung / Preliminary version

Between 1991-92 and the beginning of 1997, most Asian countries have experienced a real appreciation of their currencies, vis-à-vis the US dollar or vis-à-vis a trade weighted basket of the currencies of trading partners, as shown below in Table 1.

Real appreciation is not systematically linked to currency crisis

In most cases, real parities have fluctuated quite wildly from 1992-93 onwards. Countries can be classified into several groups:

• Moderate deterioration (10-15%) of competitiveness: Malaysia, Thailand, Indonesia and Singapore belong to this group. In Malaysia and Thailand, the nominal exchange rate against the dollar has remained stable since 1992; in Indonesia it has depreciated and in Singapore it has appreciated. In all cases, there has been a real appreciation. In the first three countries, excess inflation in relation to the United States has been such that trends in the nominal parity have been incompatible with the currency's stability. In all countries, the situation in terms of the trade-weighted parity has been worsened by the dollar's rise since 1995.

• Sharp deterioration (15-25%) of competitiveness: Philippines, Hong Kong. In Hong Kong, the nominal parity has been pegged to the dollar. In the Philippines, it has fluctuated within a narrow range. But in both countries, average inflation has substantially exceeded inflation in the United States by some 5 to 6 percentage points p. a.

• Near-stability of competitiveness, or slight improvement: South Korea, Taiwan. In South Korea, the won has been depreciating against the dollar since the US currency began to rise in 1995 and has therefore not undergone the real appreciation experienced by the other countries. In Taiwan, the nominal exchange rate has also been flexible and, in addition, inflation has been as low as in the United States over the period.

China is a case apart because of the unification of exchange rates in 1993. This led to a very sharp devaluation and boosted competitiveness substantially. Since that point in time, the exchange rate has experienced a real appreciation.

Among the 10 countries, only China and Hong Kong have not experienced a visible depreciation against the dollar since the summer of 1997. The 7 other countries have seen their currencies depreciate massively against the dollar since the end of the first half of 1997. Note that the depreciation has been automatic in Singapore since the Singapore dollar is pegged to a basket of currencies weighted in terms of exports. It therefore includes neighbouring countries whose currencies have been attacked.

If the analysis is restricted to the 6 countries whose currencies have come under attack (Malaysia, Thailand, Philippines, Indonesia, South Korea and Taiwan), it is noteworthy that the last two had not been subject to real appreciation. Another point of interest is that the real appreciation in Hong Kong and Singapore has not resulted in the currency dropping below the level desired by the authorities. If real appreciation is a frequent occurrence, there is no systematic link between an excessively strong currency and the breakout of exchange rate crises.

Except in the case of South-Korea, external deficits are consistent with the trends in competitiveness

When analyzing the evolution of the external deficits, one can again devide the countries into three groups :

• Countries which have current-account surpluses or are close to current-account equilibrium: Taiwan and China enjoy substantial trade surpluses in 1996 (USD 18 bn for Taiwan and USD 12 bn for China); Indonesia has a large trade surplus (3% of GDP) and a bearable current-account deficit.

• Hong Kong and Singapore are in an odd situation as they have a large trade deficit but no problems with their current-account balance, notably because of interest payments received on external assets, including their foreign reserves. Singapore even has a significant current-account surplus.

• Countries with excessively high current-account deficits: Malaysia (6% of GDP in 1996), Thailand (8% of GDP), Philippines (4,5% of GDP) and, to a lesser extent, South Korea (with a current-account deficit of nearly 5% of GDP in 1996 but correcting rapidly as soon as in 1997).

Is there a link between a country's competitive position and its current-account balance? Countries having suffered from a sharp drop in competitiveness (Philippines and Hong Kong) have substantial trade deficits (in 1996, 14% of GDP in the Philippines, 10% of GDP in Hong Kong) even though their current-account balances are far smaller. Countries with a moderate deterioration in competitiveness (Malaysia, Thailand, Indonesia and Singapore) all have trade deficits, although Singapore's is masked by capital income. Countries with steady or sound competitiveness (Taiwan and China) enjoy trade surpluses. Only South Korea displays an "abnormal” configuration: trade deficits but favourable competitiveness, as has been seen above. We will later link this situation to trends in domestic demand.

In nearly all cases, the expected link between competitiveness (real exchange rate) and trade balance is found: deficits in the event of real appreciation, surpluses in the event of favourable competitiveness.

Capital inflows account for the accumulation of foreign reserves

Let us begin with countries suffering from a persistent current-account deficit. In Malaysia, foreign reserves grew markedly until end-1993 before ebbing at virtually the same pace as the current-account deficit. In Thailand, despite very high deficits, reserves increased until mid-1996 before plummeting. In the Philippines, despite the deficits, reserves have been rising slowly. In Indonesia, despite the worsening current-account deficit from 1995 onwards, foreign reserves have ballooned. South Korea's current-account deficits in 1994-96 (a cumulative USD 37 bn) grew even as foreign reserves rose by USD 15 bn.

Let us now look at countries with surpluses: Singapore's foreign reserves have grown at the same pace as its current-account surpluses, Hong Kong's twice as fast. Taiwan has accumulated fewer reserves than cumulative current-account surpluses (USD 30 bn against USD 59 bn from 1990 to 1996). China's foreign reserves have risen dramatically since 1994, up by USD 105 bn, whereas its cumulative current-account surplus was only USD 26 bn. The most blatant anomalies therefore concern Thailand, the Philippines, Indonesia and South Korea - where current-account deficits have been recorded even as foreign reserves grew - and Hong Kong and China, where the rise in foreign reserves has outstripped the current-account surplus significantly. The situations of Malaysia, Singapore and even Taiwan are far more normal.

In a high number of cases (Thailand, Philippines, Indonesia and Hong Kong), the fact that capital inflows enabled foreign reserves to rise even at a time of current-account deficit is due to the pegging of the nominal exchange rate to the dollar: In China, the nominal exchange rate can be said to have been fixed since mid-1994, and this coincides with a surge in foreign reserves. In South Korea, the nominal exchange rate has not been fixed but foreign reserves have nevertheless grown very rapidly.

When the balances on capital flows are examined (Tables 2 and 3), it can be seen that this is due to direct investments in China, which have been substantial since 1993. In the case of South Korea, this is due in particular to financial inflows from the banking sector. When one looks at the other countries with an "abnormal” accumulation of foreign reserves (Thailand, Philippines and Indonesia), it can be seen that direct investment has been low and financial capital inflows very high (notably in Thailand).

Countries which have accumulated foreign reserves despite current-account deficits are countries that have received substantial financial capital inflows while direct investment has been weak.

What is the link between capital flows and the level of interest rates? Most of the countries (Philippines, Indonesia, Thailand, South Korea and China) have experienced, during the 1990's, short term interest rates well above the level of US rates : around 10% in the Philippines and in Thailand, 15% in Indonesia, 9% in Korea, 11% in China, but China's case is different since there is no convertibility.

Not surprisingly, Thailand, Philippines, Indonesia and South Korea have had large financial capital inflows, drawn by high returns. In all these countries, the nominal exchange rate has remained virtually pegged to the dollar (in South Korea only until early 1995). When the nominal rate is pegged and interest rates are high in relation to US rates, financial capital is attracted as the country's currency is deemed similar to the dollar but with a higher return. In Singapore and Malaysia, conversely, interest rates have been low and speculative capital inflows have not appeared. On the contrary, capital outflows have been recorded in Singapore.

Investment and growth: very rapid increase has been the rule

A distinction can be drawn between countries in which a substantial investment drive has promoted very rapid growth and the others. Malaysia, Thailand, Indonesia, Singapore, South Korea and China are in the former group, with average growth of 8-11% and investment often exceeding 10% per year.

In the Philippines (average growth of 2.9% p.a.), Hong Kong (5.1%) and Taiwan (6.3%), real growth has been more reasonable with investment rising by what could be called a mere 5-10% p.a.

Note that rapid growth does not always entail the appearance of a trade deficit; this has not occurred in China and Indonesia. Conversely, moderate growth can coincide with trade deficits, as in the Philippines and Hong Kong. In the Philippines, however, growth and investment have accelerated since economic reforms were implemented in 1994.

Although China is in the high-growth group, its export capacity has prevented any deficit from appearing. In cases where deficits occur despite modest growth, real appreciation in the exchange rate is the main cause.

Real overvaluation as a way to finance unbalanced growth

Table 4 summarizes the results we have obtained. What does it show about the origin of the currency crisis and the role of real appreciation?

China, Singapore and Hong Kong are the only countries so far to have been spared a currency depreciation. China displays none of the worrisome characteristics of the other countries. Even though growth is rapid, there is no trade deficit and capital inflows are direct investments. In Singapore, there is both real overvaluation and a trade deficit, but no current-account deficit thanks to capital income. There is no sign of unstable external financing - quite the contrary in fact.

The situation is slightly more worrisome in Hong Kong as its currency is highly overvalued and its trade deficit is substantial but it has not run up a current-account deficit. The authorities' strategy seems to be to try to curb the deficit by discouraging capital imports in driving down prices of assets (stock market and real estate). The authorities also undeniably enjoy great credibility.

Some of the countries show most of the possible unfavourable characteristics: overvalued currency, external deficit, financing by short-term or speculative capital attracted by high returns and very rapid growth. This applies especially to Thailand, the Philippines and Indonesia.

* not in the current account balance.

** in relation to the cumulative current-account balance.

*** since 1995.

In these countries, the economy has been financed by short-term or speculative capital. The strategy to attract this type of capital has been quite straightforward: propose an attractive return with high interest rates and peg the currency nominally. Real overvaluation was therefore a prerequisite for them to attract indispensable external financing of growth. In the long term, the strategy proved to be disastrous since it hurt foreign trade and triggered a pullout of foreign investors.

In South Korea, there has been no real appreciation, at least in recent years, thanks to the exchange rate's relative flexibility. Nevertheless, after two years of very robust growth (1994 and 1995), a substantial trade deficit appeared along with huge financial capital inflows. Apparently, foreign lenders were sufficiently confident to obviate the need to let the currency appreciate in real terms, unlike what occurred in other Southeast Asian countries.

Lastly, Malaysia and Taiwan seem to have suffered more from contagion effects than pronounced macroeconomic imbalances. Malaysia's external deficit is entirely covered by direct investments and Taiwan has avoided currency overvaluation, deficits and an influx of capital.

There is therefore no systematic link between real appreciation and currency crisis. Some countries were affected by contagion, others can cope with real appreciation thanks to other sources of income. Conversely, the financing structure can be unbalanced, like in South Korea, without entailing overvaluation of the currency. However, stability in the nominal exchange rate against the dollar has enabled several Asian countries to attract the capital required to underpin robust growth when domestic savings were insufficient. Overvaluation permitted an unstable financing of excessively robust growth.

Diverging paths out of the crisis

The analysis implies that, in a medium-term perspective, the situations of the different Asian countries will probably diverge:

• In South-Korea, the exchange rate strategy has nothing to do with the crisis; it has been caused by the combination of the depreciation of the won, due mostly to a contagion mechanism, and by the fact that banks and corporations had been massively borrowing abroad without hedging for currency risk. The high degree of leverage of the economy proved disastrous when the won collapsed. A global and painful recapitalization will therefore be necessary.

• Malaysia, Taiwan and Singapore will mostly benefit from the crisis ; they have no serious domestic macroeconomic or financial imbalance, and their competitiveness is now well above normal, which should imply a robust growth in the future.

• Thailand, Indonesia and the Philippines are text book cases of a bad macroeconomic strategy: pegging the nominal exchange rate and using high interest rates to obtain the (short-term) capital inflows necessary to finance an investment rate above the level domestic savings could permit to obtain. In the future, those countries will have to self finance growth, which means a permanent reduction in trend growth rates.