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The Asian Financial Crisis: What Have We Learnt?

by Norman T.L. Chan, Deputy Chief Executive, Hong Kong Monetary Authority

(Speech at the Oxford University Asia-Pacific Affairs Society Speaker Event)

7 June 1999

Mr Rui Nie, Ladies and Gentlemen,

1. I am delighted to have been invited by the Oxford Asia-Pacific Affairs Society to attend tonight's event and to share with you a few thoughts on what went wrong in Asia over the last two years and on where we should go from here. When the Society invited me to the speaker event in March last year, I immediately accepted the kind invitation, not least because it is always pleasant to be back to Oxford, of which I retain many happy memories as a student more than two decades ago. However, it did not occur to me at the time that I would have to defer the speech until June this year because of the rapid deterioration in the situation in Asia, including Hong Kong, which made it impossible for me to make the trip to Oxford any earlier. Fortunately, I had not prepared a speech last year because, if I had, it would be totally unusable now. It is not just a question of updating the speech with the latest figures or statistics. Having experienced the dramatic and stressful moments in August last year, I now have a much clearer perspective on the nature of the Asian financial crisis. It is this new perspective that I would like to share with you tonight.

2. I would like to divide my presentation into two parts. First, I shall talk about what went wrong in Asia - and in other parts of the world - and, more importantly, what lessons we have learnt from our bitter experience. Secondly, I shall outline the various efforts being made to reform the international financial system to make it more resilient. I shall also offer a few reflections on whether these efforts are sufficient to ensure the long-term stability of the global financial system, and if not why not.

What lessons have we learnt?

3. What has the Asian Financial crisis taught us? The most obvious lesson is that we cannot take economic growth for granted. After years of rapid growth throughout most of the region, the assumption had been - outside Asia perhaps even more than within - that economic growth in the region would go on for ever, that there were no limits to what these little tigers and dragons could achieve. 'Asia Rising', the 'East Asian Miracle', the 'Pacific Century' were the sensational catch-phrases and book titles summing up the euphoria that predicted endless growth, and endless opportunities for investment in the region. When the crisis came, the sharp plunge into recession was a severe shock, prompting questions and a great deal of theorising about what had turned the miracle so suddenly into a catastrophe, about why - to go back to the dramatic book titles - 'Asia Rising' had become 'Asia Falling'. The Asian virtues, such as high savings rates, fiscal discipline, dedication to education and a hard working labour force, which were the subjects of constant praise from all quarters prior to the eruption of the crisis, had suddenly vanished. Instead, to use Professor Paul Krugman's words, the Asian downfall had become "a punishment for Asian sins, even if the punishment was disproportionate to the crimes."

4. There should be no misunderstanding about the extent and the intensity of this punishment, which has affected millions of people throughout Asia in a very severe way. The economies of the crisis-hit countries have shrunk dramatically. The wealth loss from asset price deflation has been staggering. Tens of thousands of companies have gone bankrupt. Millions of workers have lost their jobs. Mass poverty has reappeared on a scale not seen in more than a generation, and in some countries civil unrest has challenged the established order. The extent of the economic and social devastation is distressing.

5. What then, were the causes of the dramatic and abrupt reversal of fortune for the crisis-hit Asian economies? There are many explanations. Let me start with the more straightforward and less controversial ones. Obviously, many Asian economies had weak and vulnerable domestic financial systems. The banking systems were inadequately supervised and were prone to incurring excessive risks by borrowing short-term funds to finance long-term lending to projects the viability of which was doubtful. Moreover, the corporate sectors of many Asian economies were over-stretching themselves by engaging in risky or unproductive investments. To a varying degree, both the banks and corporates were taking excessive currency risks by borrowing in foreign currencies, which had a much lower interest costs than domestic currencies, to fund projects which could only generate income, if any at all, in domestic currencies. The implicit guarantee of exchange rate stability provided by the governments weakened the alertness to the risks arising from currency and maturity mismatches. As the amounts of international capital flows increased phenomenally in the last few years, disaster struck when the bubble burst.

6. Let me pause here for a moment. It takes two to tango. So why were international banks not aware of the problems earlier, and why did they continue to lend huge amounts to the Asian economies until the crisis hit? What happened to the very elaborate and sophisticated risk management systems of these international banks, and why did they not function to reduce the banks' exposure to unsound lending? One explanation, which was first presented by Professor Krugman, of the breakdown of the risk management of the international lenders and investors is "crony capitalism". Crony capitalism, the theory goes, creates enormous moral hazard arising from the perceived implicit guarantee for the banks and corporates that were closely influenced by, or connected with, the government.

7. The crony capitalism theory seems fine, except that it answers only part of the question. For example, crony capitalism is nothing new in Asia. Crony capitalism, however defined, existed for quite some time, but why did the Asian economies manage to achieve remarkable growth and prosperity in the past decade or so while the same system ended up in turmoil in the last two years. It is therefore necessary to look further for explanations of why the financial crisis happened the way it did. Professor Jeffrey Sachs has suggested another explanation, which sees the crisis more in terms of a mass panic, with sudden runs on the banking system, followed by massive capital flight in the absence of an effective international lender of last resort to come to the rescue. Professor Sachs' theory offers a useful explanation from the market dynamics perspective, which enables us to better understand the reasons for the depth and severity of the crisis. However, even if one combines the crony capitalism and market panic theory, we still do not seem to have all the answers. I say this because economies such as Hong Kong, which has sound fundamentals, consistent policies and a strong banking system, with no crony capitalism, were also hit very badly.

8. Fortunately or unfortunately, depending on how you look at it, the near-collapse of a US hedge fund known as Long Term Capital Management (LTCM) in September last year and the near meltdown of the global financial system that seemed to be about to follow from the threatened abrupt unwinding of its very large positions have helped to provide the missing pieces in our explanation of the Asian crisis. LTCM was said to be holding US$1.3 trillion of positions in the US and other mature markets with only US$5 billion capital. Somehow, the complex mathematical models deployed by the Nobel laureates of LTCM were not working. LTCM was losing so much money that the New York Fed had to broker a deal with a consortium of banks to rescue LTCM in view of the systemic risks that would be posed by an abrupt unwinding of LTCM's positions in the markets should it be allowed to go into default. The US Fed also followed through by cutting US interest rates three times by 75 basis points to restore calm and order to the financial markets.

9. Compared with September last year we now know a lot more about the LTCM case. A number of studies, including the recently published report by the US President's Working Group, have been conducted and, on the basis of these studies, a key point has emerged: excessive leverage by the so-called Highly Leverage Institutions (HLIs), including hedge funds, which normally operate in secrecy and are not subject to any regulatory regime, can pose considerable systemic risks to financial markets.

10. The LTCM episode has prompted several puzzling questions. The commercial banks and financial institutions, which had lent huge amounts to enable the LTCM and other hedge funds to build up excessive leverage, had very sophisticated internal risk management systems. Yet these risk management systems seem to have broken down. Although the true extent of leverage of LTCM was not known to its bankers and counterparties until it collapsed in September, the puzzling question is why did the bankers neglect to ask for the necessary information before they lent so heavily to LTCM. It does not seem appropriate to explain the breakdown of risk management among these reputable international financial firms by the theory of crony capitalism or by pointing to a poorly supervised and vulnerable banking system. Nor can one argue that there was any implicit guarantee by the US Government that a hedge fund such as LTCM would be bailed out if it should fail.

11. So why did the risk management system of LTCM's creditor banks and counterparties break down? An important part of the answer, in my view, lies in the market power and dominance of the hedge fund industry. It was not the case that the bankers and traders in New York or London had forgotten the principles of prudent risk management. Nor was the breakdown the result of a lack of technology to assess and understand the risk of one particular hedge fund. It was due to competitive pressure from their peers, which impelled them to be somewhat "flexible" in order to gain a share in the very lucrative transactions that the major hedge funds customers could bring. Moreover, they badly wanted to serve the major hedge funds in order to gain important insights into their trading strategy. Flaws in the existing financial architecture, coupled with the common human weaknesses of greed and herd behaviour, somehow permitted a small number of unregulated entities to wield so much market power through excessive leverage and high market concentration that the stability of the financial system was placed at risk.

What is being done and is it enough?

12. This brings me to the second part of my presentation, which touches on what is being done to reform the international financial architecture, and whether what is being done is enough. The international community, under the leadership of G7, is taking steps to prevent excessive leverage by HLIs. This will be done primarily through indirect means by asking the banks and other financial institutions to be more prudent in granting credit lines to the HLIs. This is eminently logical and sensible, since without bank lending it will be very hard for the hedge funds to build up excessive leverage and concentration in the major financial markets. There are also calls for greater transparency and disclosure by the HLIs, but the technical and political problems involved are not easy to resolve since most hedge funds are structured in such a way that they do not fall within any regulatory regimes. A great deal more work will need to be done and a number of international forums, including various committees at Basle and the newly established Financial Stability Forum, are working very hard on this subject as part of the effort to make the international financial system more robust and stable.

13. We strongly support these international efforts to prevent a recurrence of the kind of crisis we saw with the LTCM episode. But are these efforts sufficient to address the destabilising impact of HLIs? I am afraid the answer is "no". I say this with conviction, given what Hong Kong went through last summer. To illustrate the point, it may be helpful to depict two scenarios. The first scenario is quite straightforward. This scenario is one in which a hedge fund, such as the LTCM, which has taken very large positions in the financial markets, is somehow overwhelmed by market forces. I have already explained the risks posed by this scenario and the various proposals that are being pursued internationally to address this particular problem. These proposals, if implemented in full, would reduce the excessive leverage of HLIs and would go a long way towards preventing the recurrence of an LTCM style of crisis. In parallel, crisis-affected countries are devoting a great deal of effort towards strengthening their financial markets, their banking systems, and their corporate sector to better enable them to withstand volatile capital flows.

14. The second scenario is less straightforward: it refers to a situation in which a market is overwhelmed by one or several hedge funds. This scenario would be most likely to happen to smaller and open market economies, since the hedge funds, even with more limited leverage resulting from more prudent lending by banks, could still overpower these markets. Unlike the first scenario, the intellectual validity of the second scenario is still being debated in various international forums. In this debate, a number of difficult issues are involved. First, there is the question of whether the hedge funds led the markets or whether they simply followed the markets by exploiting weaknesses or vulnerabilities. Secondly, is it really possible for a hedge fund to bring down a market? Or could it be that the authorities are looking for scapegoats for their past mistakes? What evidence is there to support the view that the hedge funds played a dominant role in precipitating and spreading the Asian financial crisis?

15. Since these live issues are still being debated, it is probably too early to say what will eventually emerge from the debate. But I would like to offer a few observations based on Hong Kong's experience with the hedge funds last year. It is difficult, if not impossible, to obtain direct or hard evidence on what the hedge funds did last year because they were and still are not subject to any reporting or disclosure or regulatory requirements. However, there is plenty of anecdotal evidence and market intelligence to enable us to reconstruct what happened.

16. It is clear to us that the hedge funds had launched their attack on Hong Kong after careful planning. First, the hedge funds borrowed Hong Kong dollars in large amounts months ahead of the attack to secure local currency funding at reasonably low costs to settle when the short-selling began. Secondly, they built up over a period of several months very sizeable short positions in the stock market and in the stock index futures market. Finally, they launched the attack in August by selling large amounts of Hong Kong dollars with a view to push interest rates sharply higher, thereby causing the stock and futures prices to collapse or even the Hong Kong dollar peg to break. The attack on Hong Kong was accompanied by numerous pessimistic reports on Hong Kong, on the Linked Exchange Rate System and on China. Rumours proliferated about bank runs in Hong Kong, on Hong Kong Government's decision to abandon the Link and on RMB devaluation. The strategy of the hedge funds was to generate undue pessimism and market panic so that they could close their short positions with huge profits. To frustrate this cross-market play by the hedge funds and to protect our market integrity and financial stability, the Government had no choice but to operate in the stock and futures markets. The outcome, which is well known, is that stability returned to our markets following the unwinding of the hedge funds' positions in the stock and futures markets. When they closed out their short positions in the currency market, Hong Kong dollar interest rates came down significantly, with three-month inter-bank rates falling by almost 12% to around 5% in December last year, which was comparable to that prevailing prior to July 1997.

17. So what does this mean? As far as we can make out, the very aggressive trading strategy of certain hedge funds and the way in which they conducted their trading activities can and did pose serious threats to systemic stability of smaller and open economies such as Hong Kong. More specifically, the very large concentration of the hedge funds' positions and market manipulation were highly destabilising and threatened to dislocate our markets. But the lack of transparency of the hedge funds, which normally operate through the equally opaque over-the-counter (OTC) markets, have made it very difficult to collect hard evidence. It is therefore not surprising that we are urging the international community to impose higher disclosure requirements and some discipline on the hedge funds and on the OTC markets.


18. It has often been said that history, especially financial crisis, tends to repeat itself. In the last ten years alone, we have had the ERM crisis in 1992, the Mexican peso crisis in 1994/95 and the latest Asian crisis in 1997/98. Notwithstanding the disturbingly frequent occurrence of seemingly similar financial crises, I am inclined to believe that history does not repeat itself because, upon close scrutiny, no two crises are the exactly the same. It may be more correct to say that mistakes will be punished by the market. If people do not learn from their mistakes, then the market will continue to repeat its punishment. The only difference between the major financial crises in this decade is that the punishment is getting more and more severe, if not violent.

19. To understand the cause of this rather disturbing phenomenon, one should take a good look at the changing nature of international capital flows and the phenomenal increase in the volume and complexity of the financial derivative trading through the OTC markets. It is now fully understood how volatile international capital flows can become. We have also learnt, in a painful way, how a sudden shift in these flows can devastate markets, economies and even social and political stability in Asia. But what we have not learnt fully is the changing nature of capital flows and the OTC markets.

20. The figures of the turnover of the foreign exchange and OTC markets are simply mind-boggling. The average turnover in the world's foreign exchange market increased from US$800 bn a day in 1992, to US$1.2 tln in 1995 and further to US$1.5 tln in 1998. The amount of outstanding financial derivative contracts also increased from US$48 tln in 1995 to US$72 tln in 1998. There is no doubt that the growth of foreign exchange and OTC markets, together with advances in information technology, have contributed to cross-border capital flows and risk management. It is, however, also legitimate to ask what lies behind these numbers. What does it mean for the underlying markets if the financial derivative trading continues to grow? Do we understand exactly what these US$70 tln derivative positions represent? Do we really understand the nature of the fund flows generated from the financial derivative trading in the OTC markets? Can the financial markets cope with the rapidly increasing fund flows? Will the global financial system become safer and more stable if greater transparency and discipline is placed on the hedge fund industry?

21. I am afraid I do not know the answers to all these questions. However, one thing I do know is that we do not know enough about the OTC markets and the hedge funds to justify complacency. To conclude, I can see two possible ways to learn more about the financial markets. One is to learn from past mistakes and do something now. The second is to wait until the next disaster strikes and try to do something there and then. Given what we have experienced in Asia over the past two years, it is my hope that the international community will see the wisdom of not waiting for the next crisis to learn how we can make the international financial system a more robust and safe one for all of us.

22. Thank you.

Last revision date: 15 September 2011
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