Yes “It” Did Happen Again—A Minsky Crisis Happened in Asia

1. Yes “It” Did Happen Again—A Minsky Crisis Happened in Asia Written by J.A. Kregel

2. Introduction to Minsky’s ideas • The government should provide a floor below the aggregate demand • A central bank is needed to lend at the discount window to support asset prices and thus bank solvency • In Southeast Asia banks are lending in foreign currency therefore restricted by foreign currency reserves

3. Financial fragility & development • Banks should lend only to those with good credit, but the act of lending changes fair collateral • Lending may strengthen a firm and thus the bank that lent to them • Lending to countries will lower the value of a country’s assets, and in turn lower the bank’s credit standing

4. Minsky defines two types of financing 1. Speculative financing 2. Ponzi financing • The value of financing positions change with variations in the macro economy • a rise in the domestic interest rate “i” to the firm reduces present value of cash flows from current projects Increases cash flow commitments for financing charges • A depreciation in the Exchange rate has the same effect as an increase in “i”

5. The banks position if “i” increases or there is and ER depreciation 1. reduces the present value of domestic cash flows 2. Increases the interest cost of its foreign funding 3. Reduces the credit quality of its loans and reduces its own credit rating If these conditions occur a bank can find itself transforming into a Ponzi unit This creates a situation where banks are unwilling to lend to each other, so the domestic interbank market will contract Firms and banks attempt to reduce foreign currency exposure Therefore Financially fragile systems is now unstable

6. Endogenous Financial Fragility • Possibly comes form an underestimation of risk associated with certain investment plans • May happen when economic times are stable • Therefore there may be a reduction in the safety cushion required • Therefore am endogenous change in margins makes the passage from fragile to unstable system in the event of an exogenous shock

7. A Normal Crisis • Domestic Firms borrow foreign currency at “i” which is reset in a short rollover period • Short roll over-the maturity dates do not matter, here rates change in reset periods which are short • Therefore a rise in foreign interest rates is quickly transformed into an increased cash commitment for the borrower, which in turn instantly reduces safety margins i.e. diminishes the cushion • If there is a domestic currency depreciation relative to borrowed currency , cushioned further eroded • And if Government raises domestic “i” to increase foreign demand for their currency domestic demand may fall and domestic cash flows will be reduced and domestic financed will be decreased

8. The Asian Crisis • Most countries financed with the $ and the Yen predominantly the Yen • Therefore an appreciation of the Yen relative the $ represents an increase in Asian domestic currency cash flow commitment on borrowing form Japan • The changing point • Then a switch and the Yen depreciated against the $, this and low Japanese “i” ,meant investors were placing short-term funds in Asian benefited from interest rate differential and possible exchange rate gain as the Yen depreciated • Crisis because everyone in Japan was trying to do this

9. Flow increased b/c countries set-up special “offshore financial centers to increase the role of domestic Asian banks in their intermediation of international capital flows into the region • This made it easier to borrow funds at a lower “i” and invest them at higher Asian rates • These institutions did not retain a sharp division from domestic markets and mediums for foreign lending to domestic banks which created large expansions in domestic lending • Next these countries restrictions on trading creating greater speculative lending

10. Thus the shift from Yen strength and high Japanese “i” to weakness and low, shifted capital flows form long-term to short • Therefore exchange rates were supported by temporary capital flows, while domestic production was losing competitively to Japan and other non-$ markets • China enters Asian Market driving down prices of all goods within Asia • Therefore the strength of the ER did not really reflect the strength of the manufacturing market • Spring of 1997 the Bank of Thailand decides not to save the countries largest financial firm: happened at a time of uncertainty in international markets concerning the evolution of international interest rate differentials

11. May 1997 people think Japanese economy is turning around • Funds borrowed at low interest rates in Japan and Hong Kong and invested in Asia are withdrawn and returned to Japan, appreciating the Yen, and increasing pressure on Asian reserves and ERs • Asian funding falls; domestic banks respond by calling their loans, but this is a false alarm b/c Japan is not turning around, the Yen reversed down again

12. Reasons for financial crisis in Asia were endogenous and exogenous Endogenous • Fact the ERs remained stable against the $ for so long clearly reduced safety cushions for lenders and borrowers • The capital inflows that kept currencies stable thus implicitly increased fragility and decreased the ability to finance the commitments of these flows by reducing the competitiveness of manufacturing

13. exogenous • The volatility of the Yen/$ ER and the associated in relative interest rate spreads, and the flow of arbitrage funds into and out of the region put increased pressure on the already thin declining margins of safety • Also international regulatory factors played a role • Once there was a reversal of capital flows it brought attention to factors that were already there: prior bank failures, corporate bankruptcies, warnings form the Bank for International Settlements, rising real exchange rates, and current account deficits

14. Central Banks Responses • When currencies reversed CB’s tried to defend the exchange rates • They engaged in a series of rapid devaluations to delink from the $ • \In 3 weeks 6 countries gave up fixed ER’s that had been stable against the $ for extended periods • Tried to discourage speculation so they didn’t have to raise “i” to protect the currency • In the 3 weeks movement in the ER wiped out already insufficient margins of safety for domestic and corporate banks

15. Therefore rims and banks transformed from Speculative to Ponzi and the delinking of the $ encouraged speculators when countries did not respond to with tight monetary policy • AS currencies failed to stabilize “i” were raised barely raised which reinforced the ER depreciation on the balance sheets of firms and banks • Banks and firms then sought to limit damage from rising $ rising interest rates by repaying foreign currency loans as fast as possible • The result was a free fall in the ER and asset prices in many countries as financing units tried to sell anything possible to raise funds and reduce cash payment commitment and foreign exposure • A Minsky debt deflation crisis was underway

16. What is to be done—What has been done? • Cannot save Ponzi firms policy must try to save the firms that are still in the speculative stage • To stop firms and banks from shifting from speculative firms to Ponzi firms cash flows to firms by supporting domestic demand and reducing their lending costs • This leaves a productive capacity in place that can increase exports earning to repay foreign debt, and stops banking failure caused by nonpayment and other things such as default and credit downgrades

17. IMF Rescue • It was patterned after the Mexico crisis • IMF wanted to prevent erosion and devaluation from increased import prices and increased demand from the bailout of banks, to keep imports down, and domestic demand was constrained through a reduction in government expenditures and tight monetary policy • To stop devaluation interest rates were raised and financial institutions that could not meet international capital standards were closed

18. IMF wanted to restore international confidence, return short-term capital flows, increase experts and decrease imports that will eventually make capital inflows unnecessary • Because the collapse of the ER was due to financing imports of capital goods therefore the banks and firms need help the IMF only made their positions worst Disappearance of foreign capital meant that banks had to finance through domestic banks at higher “i” With falling global demand firms relied on domestic demand, but domestic demand fell due to IMF enforced tight monetary policy Firms had to repay lenders in Foreign currency but firms could not purchase imports to meet payrolls therefore they sold positions to make positions which equal a rapid fall in export prices, while import prices rose in step with devaluation of the currency

19. Tight monetary policy increases trading financing costs, credit lines were reduced and payment penalties increase • Therefore export capacity was reduced by the inability of firms to get finance to continue current operations • These Polices were exactly the opposite of what is required to stop a Minsky debt deflation crisis • IMF considered problem as a flow but it was a stock, firms and banks tried to liquidate their stocks of goods and assets to liquidate their stocks of FX debt • In Keynesian terms it was a problem of a shift in liquidity preference not a problem of a shift in spending propensities that had to be achieved

20. Is the Crisis Over? • If it is a Minsky debt deflation it is not over