Case Study: 1997 Asian Financial Crisis: Part II

Overview
This case study examines the 1997 Asian Financial Crisis from the perspective of an analyst/trader that utilizes fundamental, technical, quantitative, and intermarket analyses. Part II investigates the phenomenon of deflation and how it impacts economies and financial markets worldwide. Part I focuses on the events leading up to the crisis and its effect on emerging market economies and financial markets. What condition pressures bonds and stocks to decouple? Can a butterfly flapping its wings in Bangkok lead to trillion dollar losses in Internet stocks?

Commodities Go Ugly Early
Chart 1 Chart 2
The 1985 Plaza Accord to weaken the greenback boosts commodities and emerging market stocks, particularly in Asia, through the 1990s. In August 1995, the U.S. dollar starts to strengthen once again, placing downward pressure on commodities and Asian commodity producers, such as Indonesia, Malaysia, Philippines, and, to a lesser extent, Thailand. As many Asian central banks peg their currencies to the dollar, strengthening local currencies also builds up pressure on exports. And, as Part I discusses, Asian governments and local companies increasingly rely on USD loan and bond financing – as long as the peg holds, all seems well (Charts 1, 2).

Asian Contagion
Chart 3
With downward pressure building on the baht, Thailand’s central bank intervenes in the currency market to support its currency. But, as foreign reserves (U.S. dollars) rapidly diminish, the central bank throws in the towel and lets the baht float in early July 1997. The baht devalues from THB25 to THB54 per USD over the next seven months. Soon, contagion spreads throughout the region as foreign investors exit Asian financial markets and currencies. A sample of stock market losses recorded from peak to trough follows: Bangkok SET -86%, Seoul KOSPI -81%, Kuala Lumpur Composite -80%, Philippine Composite -68%, Singapore Strait Times -67%, Jakarta JCI -64%, HK Hang Seng -58%, and Taiwan TWSE -45% (Chart 3).

Deflation in Asia
Chart 4 Chart 5
While equity markets crumble throughout Asia, deflation as defined by economists (a decrease in the general price level of goods and services) takes hold in only a handful of countries. Regardless, the deflationary effects are felt throughout the region and all countries enter recession or an economic slowdown. As deflation favors hording of currency and liquid assets, while punishing borrowers and holders of illiquid assets, under-investment tends to occur that impacts the economy. For society, the gap between wealthy and poor can widen dramatically. In severe cases, a deflationary spiral leads to a decrease in prices, which in turn causes lower production that places downward pressure on wages and demand, resulting in further lower prices, and so on. For Asia, without a doubt, three countries that maintain their currency pegs to the U.S. dollar suffer the worst effects of deflation: Hong Kong, China, Singapore. Hong Kong does not emerge from deflation until Q4 2004 (Chart 4, 5).

Deflation Arrives in the U.S….
Chart 6 Chart 7
The U.S. bond market feels the effect of Asia’s meltdown next. As the Asian Financial Crisis unfolds, capital returning from Asia bids up bonds, collapsing yields (Chart 6). Although U.S. stocks dip in August and October 1997, equities quickly regain its legs to rocket to new highs. Nothing out of the ordinary, bonds and stocks continue to track one another, typical relationship under benign disinflationary conditions. Then, in July 1998, the correlation between bonds and stocks changes from positive to negative (ellipse in Chart 7). Now, rather than stocks trading in sync with bond prices, stocks are following bond yields – stocks and bonds decouple. This is a tell-tale sign of deflation. Furthermore, exacerbating the situation, supply-side deflation creeps into the U.S. via low-cost goods from China and the rest of Asia. Advancement in technology and, to a lesser extent, an aging U.S. population also places downward pressure on prices. While the 4-5 year business cycle continues, under deflationary conditions, the tendency is for bond yields to peak (or trough) first, followed by stocks, and then commodities.

…But Deflation Goes Unnoticed
Unfortunately, this early indication of deflation washing up on the shores of the U.S. goes unnoticed. In March 2000, when the Dot-com Bubble finally bursts in spectacular fashion, pundits and mass media low-play the threat of deflation (circle in Chart 7). By October 2002, the NASDAQ Composite falls 78% from its peak, wiping out over $5 trillion in share holdings. Nevertheless, as late as December 20, 2002, in a speech to the Economic Club of New York, Fed Chairman Greenspan states that the U.S. is “nowhere near” falling into deflation, which, by this time, only strengthens belief that deflation is a serious threat.

Epilogue
Deflationary effects emanating from Asia spreads to Russia in 1998, Argentina in 2000, and contributes to the bursting of the Dot-com Bubble and collapse of European stock markets in 2000. Deflation last reared its ugly head in the U.S. during the Great Depression of the 1930s. Once entrenched deflation becomes difficult to eradicate.The 2007-2009 U.S. Bear Market and this century’s European economic meltdown stems from deflation. While this case study focuses on the 1997 Asian Financial Crisis, the 1991 Japanese Asset Bubble burst, arguably, initiated the deflationary effects that eventually encircled the globe in the 21st century.

Lessons
In today’s interconnected world, inflation, disinflation, and deflation can be transmitted across the globe in short order. Intermarket, technical, and quantitative analyses serve as tools to identifying when economic conditions change before traditional economic and fundamental analyses foresee a shift. Commodities impact developing markets via the producer and consumer links; the latter will play an increasing role as middle classes continues to expand. A weakening U.S. dollar tends to boost commodity prices, while strengthening curtails prices. Developing countries that peg their currencies, whether to the U.S. dollar, euro, or, even, gold, run the risk of building up pressure on exports (or imports) and on financial stability, should governments and local companies rely too heavily on external financing. Bonds and stocks decoupling over an extended period of time signals deflation. Once established, deflation is difficult to eradicate and leads to under-investment that impacts the growth of an economy. For society, the gap between wealthy and poor can widen dramatically, which can lead to the social unrest witnessed in parts of Europe and some urban areas of the U.S. since 2007. In severe cases, a deflationary spiral as occurred during the Great Depression can devastate a country. Even the most senior economists do not always spot deflation before it is too late.

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