Parvatha Vardhini C.
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 bubbleThe 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 DepressionThe 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 crisisIf 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 crisisA 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.
