This case study examines the 1997 Asian Financial Crisis from the perspective of an analyst/trader that utilizes fundamental, technical, quantitative, and intermarket analyses. For efficient flow, this case study is broken into two parts: Part I focuses on the events leading up to the crisis and its effect on emerging market economies and financial markets; Part II investigates the phenomenon of deflation and how it impacts economies and financial markets worldwide. While many pundits highlight that the collapse of the Thai baht initiated Asia’s meltdown, what were the warning signals? Can a butterfly flapping its wings in Bangkok lead to trillion dollar losses in Internet stocks?
The Build Up
Asian equity markets (ex Japan) record strong performances during the early-mid 1990s. Bouyed by falling U.S. interest rates and plummeting Japanese asset prices, following the 1991 Japanese Asset Bubble burst, foreign investors pile into Asian ex Japan investments. Hong Kong’s Hang Sang Index skyrockets over 450% from the beginning of 1991 to its high in early August 1997 (Charts 1, 2, 3).
Following the 1985 Plaza Accord, the weakening U.S. dollar contributes to the flow of capital into emerging markets, particularly Asia. During the 1990s, an investment boom ensues with cranes filling the skylines from Seoul to Kuala Lumpur, sucking in natural resources and energy commodities that boost commodity prices worldwide (Charts 4, 5).
Several indications emerge pointing to trouble ahead for Asian financial markets. Commodities provide, perhaps, the first signal. Historically, commodities show a positive correlation with emerging market stocks via the production link (oil, natural gas, timber, metals, agriculture, etc.) and, more recently, through rising consumption of commodities to fuel the growing middle class. Commodities and equity prices track one another higher throughout the early 1990s. Then, starting in early 1996, commodities begin to form a topping pattern, peaking in February 1997. Within 6 months, Asian equity markets enter freefall (ellipse in Chart 6).
However, Thai stocks actually crack first. Commencing in early 1994, a large triangle top forms in Thai stocks. As prices approach the apex, prices break down through lower support in July 1996, a full twelve months ahead of the Thai baht’s meltdown (Chart 7).
Completing the circle, currency markets provide another cue. During the 1990s, many Asian countries stabilize their currencies by actively pegging their currencies to the greenback. This helps financial flows and exports. The stable exchange rate also encourage governments and local companies to finance themselves via USD loans and bonds. In Thailand, by 1995, external debt as a percent of GDP eventually rises to 60%, when investors finally realize that any devaluation in the baht would make repayment of U.S. dollar borrowings prohibitive (first arrow in Chart 8). In early July 1997, the Thai baht gives way by breaking a multi-year support line, depreciating about 115%, from THB25 to nearly THB54 per USD, over the next 7 months (Chart 9). All hell breaks loose shortly thereafter as investors flee all Asian financial markets and currencies (Chart 1).
With urging from the IMF, central banks across Asia increase interest rates, tighten monetary policy, and cut fiscal spending, which fails to stabilize currencies. Interestingly, some ten years later, the Federal Reserve does the exact opposite to alleviate the 2007-2008 Financial Crises in the U.S. By May 1998, Indonesian President Suharto steps down after 30 years following widespread riots. Deflationary effects spread from Asia to Russia in 1998, Argentina in 2000, and, finally, contributes to the bursting of the Dot-com Bubble in 2000.
In pegging foreign exchange rates, stresses build within emerging market economies and financial systems. When foreign borrowing as a percent of GDP and debt service as a percent of exports rise to critical levels, it only takes a minor wobble (or, even, flapping of a butterfly’s wings) to set in motion a chain of events that can quickly spread across interconnected global economies and financial markets. Relationships between commodities, equities, bonds, and currencies exist that can provide early warning of brewing troubles in economies and financial markets. Intermarket, technical, and quantitative analyses serve as tools to uncovering problems even before fundamentals give a clear indication that all is not well. Part II examines the impact of deflation emanating from Asia on the rest of the world.