The role global currency markets played in the Asian financial meltdown of late 1997 is now well documented. The crisis commenced in July 1997 when the Bank of Thailand was forced to abandon its hopeless defence of the Baht and, ran virtually uninterrupted through to the Brazillian Real collapse late in 1998.

In between most Asian currencies experienced a sharp and dramatic collapse as investors bailed out of regional market exposure, Indonesia the most spectacular, resulting in a collapse of the Soharto regime.

The root cause of the currency instability was a loss of faith in Asian investments by regional and global managers. The magnitude of the ensuing panic was exacerbated by a growing fear that collapsing confidence threatened not only returns on capital invested throughout the region but the capital itself. The panic turned into a self fulfilling prophecy and the most spectacular currency meltdown ever witnessed resulted.

The Asia currency meltdown also had significant knock on effects for countries outside of the immediate region however. Those implicated by virtue of their commodity export dependency, notably Australia and Canada, saw sharp depreciations of their currencies. Most spectacular however was Russia, exposed by virtue of its commodity base and fragile financial system and economy. The Rouble collapsed in August 1998 under the weight of huge capital outflows. The resulting rise in the translated outstanding debt of the Russian government, largely denominated in foreign currencies, effectively bankrupted the country, driving it to default in September.

Calls for Capital Controls Misplaced

The role of global currency markets in acting as a conduit for capital flight and financial contagion has raised concerns as to whether some form of reregulation of capital movement is necessary to avoid similar instances of financial collapse and stress in future. These concerns generally turn to the appropriateness of the free market currency system as a means of transmitting capital and to the motives of professional currency speculators.

The argument in favour of capital and currency market reregulation however is misplaced. One of the important conditions in the drift towards globalisation is the necessity for free mobility of trade and capital across borders. Reregulation that challenges this central tenet raises the risk of derailing the Globalisation process. A quick look through history shows that the most dramatic failure of Globalisation this century was the Great Depression of the 1930's ultimately leading to World War 2. The impact and duration of the Great Depression was magnified by reregulation of capital and traded goods markets combined with poor macro policy settings.

Currencies as a Policy Tool

Arguments in favour of reregulation and even the adoption of currency bands, also however fail to acknowledge the important role that relative currency movements perform, acting as a tool for policy makers to assist in the balancing and management of global instability. By way of example, the strength of the Australian economy over the past year owes much to the cushioning effect of the Australian dollar. In an environment of deteriorating commodity prices and recession within its key trading partners, the weakened Australian dollar has acted as a defacto easing of monetary policy cushioning the blow to the domestic economy. This cushion would not be available if the Australian dollar were not freely floating.

A further example has been the role of the US dollar since 1997. The strength of the dollar has been a key factor in helping to boost US consumer activity to fill the void created by recessed Asian economies. A strong dollar has helped depress US inflation allowing lower interest rates and stronger financial market valuations at a time when higher US interest rates would have likely pushed the global economy over the edge into recession. In that sense the US dollar has performed a valuable role, in acting as a circuit breaker for the global economy.

Free Floating Currencies vs Pegged Currencies Within Asia, currency depreciation in 1997 and 1998 reflected violent capital outflows and hence has been considered a destructive force for regional economies. In some cases (ie. Malaysia) his resulted in the introduction of capital controls on foreign investment. In early 1999 we are seeing however the beneficial impact of lower currencies and free capital mobility with enhanced export competitiveness boosting export performance in Korea and Thailand allowing some rebuilding of economic performance. Capital is beginning to slowly flow back into the region. In that sense currencies in the region have acted as a stabilising influence over the past year.

Rather than highlighting the evils of a freely floating currency regime, the Asian meltdown has demonstrated the dangers of artificially fixed exchange rates. In the past Asian currencies were managed to maintain relative stability against the US$. This produced an expectation amongst global investors that Asian currencies were defacto US dollars and as such they could earn high returns in Asia with minimal risk. Investment flows into the region were artificially boosted as a result.

In fact higher relative growth and hence inflation, along with a loss of trade competitiveness and deteriorating trade performance within Asia, produced intensifying pressure on Asian currencies to depreciate against the US dollar. The eventual break in investor confidence and currency pegs was so spectacular that chronic Asian currency overvaluation rapidly turned to significant undervaluation.

Whilst confidence has improved somewhat and with it currency values, the damage done within the region from a long period of over-investment and debt-hang will undermine Asia for some time yet.

Most Currencies now Floating - Chinese Yuan and Hong Kong Dollar Exceptions Whilst the events of the past 18 months has forced the adoption of floating currency regimes by most countries, there remains some notable exceptions. China maintains firm capital controls that limits the exposure of its currency to speculative capital flows. In fact most of the capital flowing into China represents longer term direct investment in the economy.

Nonetheless whilst it is much more difficult to speculate against the Chinese Yuan, pressure against the currency is still apparent through the black market, undermining its unofficial value. In addition the maintenance of an overvalued Yuan, is placing significant pressure on the domestic Chinese economy.

The loss of relative competitiveness over the past 18 months is hitting Chinese exports at a time when the internal economy is going through painful reform. There is every likelihood that, whilst a free floating of the Yuan may not be on the cards, a discrete depreciation of the Yuan the order of perhaps 10-20% is possible later in 1999. It will likely have unavoidable flow on effects to other Asian currencies, however given that most have regained some ground in recent few months, a Chinese depreciation can be absorbed.

The Hong Kong dollar is a more difficult issue. The weakness of the regional economy and chronic overvaluation of the currency is a double blow to the Hong Kong economy. Given the regional deflation in asset prices that has occurred, the high cost structure within HK and its unwillingness to abandon its hard currency peg to the US dollar, then the HK economy is likely to take longer to absorb the economic pain and ultimately recover. For this reason whilst parts of Asia may return to positive growth in 1999, HK is likely to still be firmly in recession.

The unwillingness to abandon the peg reflects HK's desire to protect its unique role as a conduit of capital flowing within the region and into Asian from the West. Nonetheless HK is running the risk of pricing itself out of competition within the region. Ultimately a repegging of the HK dollar against the US dollar to regain some lost competitiveness cannot be ruled out.

Currency Markets the Messenger not the Cause

The global debate now underway regarding the lessons to be learnt from the Asian crisis will undoubtedly touch on the issue of capital reregulation as a means of controlling currency market instability. We have seen politicians within both Asia and Japan proposing the institution of currency bands for example.

However it will be important in this debate not to lose site of the real causes of the Asian crisis and instead shoot the messenger. Currency market instability often occurs in an environment where policy instability or conflict ultimately leads to a loss of investor confidence and capital flight.

In that sense currency markets can provide a (sometimes spectacular) signal of a deeper rooted systemic problem. As such moves to artificially constrain or limit currency volatility may at the very least disguise evidence of systemic failure. In the worst case excessive capital controls may in fact promote a misallocation of capital and resources adding to the systemic problem.