Download 3.3 Financial market issues

Causes, Effects And Regulatory Implications Of Financial and Economic Turbulence in Emerging Markets
3.3 Financial market issues
Currency market activity
One of the most significant features of the East Asian crisis has been the rapid and severe round of currency
devaluation experienced by the South East Asian countries. The speed and ferocity with which these
devaluation were transmitted from one currency to another have stirred heated and controversial debate as
to the exact role played by currency market activity in the East Asian crisis.
Most initial views generally fall into two categories. The first views the growth in currency market activity
as an inevitable development of the international financial system with increasing capital mobility.
According to this school of thought, any profit opportunities presented by inconsistent and unsustainable
economic policies or exchange rate regimes would be quickly taken advantage of and hence, traded away.
In that sense, it is argued that the forces of demand and supply in the currency market exerts “market
discipline” on policy makers.
While this view concedes that excessive volatility in the currency market may indeed cause exchange rates
to over-shoot their equilibrium values as implied by economic fundamentals, it is argued that the
impartiality of the forces of demand and supply are such that no prolonged state of over-shooting would
persist. Over time, excessive under- or over-valuation of a particular currency would be eliminated by the
fundamental forces of demand and supply.
The second view attributes fundamental responsibility for the crisis to the nature of currency market
activity. Firstly, it highlights the fact that the volume of currency trading far exceeds the volume of
international trade in goods and services suggesting that a majority of the volume of currency trading is
accounted for by the trading of currencies themselves as assets. Secondly, it notes that most of the
participants in the currency market often have capitalisation levels which dwarf the stock of foreign
exchange reserves of most, if not all, monetary authorities.
From the latter two points, this school of thought proceeds to argue that volatility in the currency market
presents natural profit opportunities to market participants. Given the deep pockets of market participants
and the over-the-counter (OTC) structure of currency trading, there exists potential, ability and incentives
for currency market participants to move markets in their favour. As such, notwithstanding the fact that
independent speculative activity may help markets equilibrate, this view argues that there are strong
incentives for rational traders to “herd” and in the process make significant gains by following the direction
of the market.
The strength of both views lies in the fact that both capture some aspects of reality from different
perspectives. The matter is still being debated even as this report goes into print. However, there are some
aspects with regard to the role of currency market activity in the crisis that are not in dispute.
Among these is the fact that volatility from the currency market spilled over to domestic equity markets and
subsequently unsettled the real economy in many of the crisis-stricken economies of East Asia. In this
sense, the East Asian crisis was, in part, caused by the sharp devaluation of regional currencies. The
prolonged weakness and instability of regional currencies is believed to have unnerved portfolio managers
with an exposure to the region. These managers would have shifted their portfolios into currencies of
“stronger” economies, in this case the US dollar, from some of the perceived “riskier” emerging markets
which had limited capabilities to support their currencies. This reallocation effectively created a sharp
downward spiral in the currencies which ultimately drew in fresh impetus in the form of domestic
corporations buying foreign currencies to hedge their respective foreign currency exposures.
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Causes, Effects And Regulatory Implications Of Financial and Economic Turbulence in Emerging Markets
Another aspect of currency markets that has raised concerns is the perception of a lack of transparency in
currency market activity. While there is dispute in the relative importance of currency market activity in the
unfolding of the crisis, there are strong views being expressed over the existing structure of currency
markets that arguably result in an opaque environment which stymied and frustrated policy makers in their
attempts to monitor market activity and take the appropriate policy response.
The final aspect of currency trading which is also well accepted is that the mechanics of currency
speculation coupled with the fixed or heavily managed exchange rate regimes adopted by many emerging
markets essentially render these economies vulnerable even if they have relatively sound macroeconomic
fundamentals. This is because the classic defences against such speculative attacks can have crippling
effects on the domestic economy.42 The East Asian crisis has shown that currency market participants who
have sufficient funds can defeat or critically weaken even the most determined monetary authorities.
42
See “Mechanics of Speculative Attacks” inInternational Capital Markets: Developments, Prospects, and
Key Policy Issues, International Monetary Fund, November 1997, pages 37-38.
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