Hello, welcome to Investor’s Bookshelf. In this episode, we are interpreting Ten-Year Cycle.
This is a classic work in the field of financial history, first published in 2009, and the edition I have now is the fourth edition, released in June 2020. This book gives a detailed review of the entire process of the 1997–1998 Asian financial crisis. During that crisis, Asian currencies such as the Thai baht, the Malaysian ringgit, and the Indonesian rupiah depreciated sharply against the U.S. dollar. The stock market capitalization of these economies plummeted to only one-tenth of what it had been before the crisis, and a large number of financial institutions and companies went bankrupt. Even developed economies such as South Korea, Singapore, and Hong Kong were severely impacted. It can be said that some Asian economies have not fully recovered from that crisis to this day.
Why is the book titled “Ten-Year Cycle”? Over the past half-century, almost every ten years, a global financial crisis has erupted. Look: from the 1987 U.S. stock market crash and the Latin American debt crisis, to the 1997 Asian financial crisis, and then to the 2007 U.S. subprime mortgage crisis—the pattern is obvious. Although nothing major happened in 2017, three years later, in early 2020, the COVID-19 pandemic, a once-in-a-century black swan event, severely shocked global stock markets. Broadly speaking, the pattern of a financial crisis occurring about once every ten years still holds.
The author of this book, Andrew Sheng (Sheng Liantao), is a legendary figure in Asian finance. Sheng is a Malaysian of Chinese descent; his father, Sheng Zhiren, was a wealthy businessman in Chongqing during the Republic of China era and later immigrated to Malaysia. Andrew Sheng once served as the chief economist of the Central Bank of Malaysia. From 1993 to 1998—right around the time of the Asian financial crisis—he was Deputy Chief Executive of the Hong Kong Monetary Authority, which is essentially Hong Kong’s central bank, where he was responsible for managing Hong Kong’s foreign exchange reserves.
During the Asian financial crisis, international speculators massively shorted the Thai baht, draining the foreign exchange reserves that the Thai government had painstakingly accumulated over decades. After that, international speculators set their sights on the Hong Kong dollar. The Hong Kong Monetary Authority held firm under pressure and engaged in several thrilling battles with international speculators, ultimately succeeding in defending the stability of the Hong Kong dollar. In the following years, from 1998 to 2005, Andrew Sheng served three consecutive terms as Chairman of the Hong Kong Securities and Futures Commission.
In other words, Andrew Sheng was an “insider” at the top levels of Asian finance and a firsthand witness to the 1997 Asian financial crisis. In the ten years following the crisis, he continuously reflected on its root causes and the painful lessons it left for Asian countries. In 2007, while Sheng was writing this book to capture a decade of reflection, the U.S. subprime mortgage crisis suddenly erupted. He saw that the international hedge funds that had once profited enormously from attacking Asian currencies now brought ruin upon themselves in the subprime crisis—both a historical irony and a vivid example of the cyclical law of retribution.
Today, the international financial situation is more complex than ever. At such a time, it is necessary for us to revisit the historical lessons of the 1997 Asian financial crisis to prepare for potential crises.
Next, following Andrew Sheng’s analysis, we will first look from a macro perspective at the background and conditions for the outbreak of the Asian financial crisis. Then, from a micro perspective, we will examine how the crisis was triggered and how the affected economies responded.
Part One
Regarding the roots of the 1997 Asian financial crisis, there were two completely opposite viewpoints at the time. The Western camp, represented by the United States, Europe, and the International Monetary Fund (IMF), believed that the victim countries had only themselves to blame. These countries had serious problems with their economic fundamentals, and their governments made obvious mistakes in managing financial risks. However, many Asian leaders believed that the true culprits were international speculators represented by George Soros, who maliciously attacked Asian currencies and caused the crisis to break out. Then–Prime Minister of Malaysia Mahathir Mohamad publicly condemned Soros. Asian countries also pointed out that when they sought help from the IMF, the IMF prescribed the wrong remedies, which led to a further worsening of the crisis.
How did Andrew Sheng view these two sharply different opinions? He believed that both the Western and Asian perspectives contained some truth, but neither was complete. We need to abandon a single perspective and analyze the roots of the crisis from multiple dimensions. From a 300-foot perspective, you can observe how international speculators, central banks, and ordinary investors operated during the crisis; from a 3,000-foot perspective, you can see the macroeconomic problems of the affected countries; and from a 30,000-foot perspective, you can recognize that the Asian financial crisis was actually the result of a larger shift in the international order.
Next, let’s rise to the 30,000-foot level and see what really happened. First, let’s review which economies were damaged in the Asian financial crisis. Among them, the five most severely affected were Thailand, Malaysia, Indonesia, the Philippines, and South Korea; in addition, Singapore, Hong Kong, and Taiwan were also seriously impacted.
Have you noticed? These eight damaged economies happened to be the fastest-growing emerging economies in Asia after World War II, known as the “Four Asian Tigers” and the “Four Little Dragons.” Why were these eight economies developing the fastest? This leads us to the locomotive of Asian economic growth after World War II—Japan. In the 1960s, after Japan completed industrialization, rising labor costs forced it to transfer low-end manufacturing to other parts of Asia.
Regarding the sequence of this transfer, Japanese economists designed the “Flying Geese Model.” Just as wild geese fly in a V-shaped formation, Japan was the “leading goose” of the Asian economy, followed closely by the Four Asian Tigers, then the Four Little Dragons, and finally mainland China and Vietnam. Following this sequence, Japan gradually transferred the low end of its industrial chain outward and began large-scale investment in the Four Tigers and the Four Little Dragons.
In the 1980s, another major event occurred that accelerated this process: the signing of the Plaza Accord in 1985. As we know, in order to reduce its trade deficit, the United States forced the Japanese yen to appreciate significantly against the U.S. dollar. In less than two and a half years after the Plaza Accord was signed, the yen rose from 240 to 120 against the dollar, appreciating by 100%.
Such a dramatic appreciation would deliver a fatal blow to Japanese export companies. What could they do? Japanese manufacturers sped up the transfer of their industrial chains to the Four Asian Tigers and the Four Little Dragons, because exports from overseas production bases would not be affected by the yen’s appreciation. In particular, Japan’s massive investment in Thailand’s automotive sector earned Thailand the nickname “Detroit of Asia.” Moreover, with the yen appreciating, overseas land and labor became relatively cheaper, which further lowered the cost of direct investment abroad for Japanese manufacturers, prompting them to increase foreign direct investment even more. Within five years after the Plaza Accord was signed, Japan’s direct investment in Asia grew nearly sixfold, with the vast majority flowing to the Four Asian Tigers and the Four Little Dragons.
Conversely, from the perspective of the Four Tigers and the Four Little Dragons, the five years after the signing of the Plaza Accord were their golden period of development. On one hand, because the sharp appreciation of the yen hit Japanese exports, the Four Tigers and Four Little Dragons seized the opportunity to fill the gap, and their exports surged. On the other hand, Japan made massive investments in these economies, and their GDPs grew rapidly. The inflowing capital was mainly long-term direct investment, so their economies did not experience overheating.
However, a turning point came in 1991. That year, Japan’s asset bubble burst, and the country fell into severe deflation. To stimulate the economy, the Japanese government implemented an ultra-loose monetary policy, lowering interest rates to the extremely low level of 0.5%. This had an important consequence: the rise of yen carry trades in Asia.
Take Thailand, the first to explode in the crisis, as an example. In 1991, Thailand’s domestic interest rate was as high as about 10%, creating a huge interest rate gap with Japan’s 0.5%. At this time, all one had to do was borrow yen from Japan, convert it into Thai baht, and deposit it in Thai banks to enjoy handsome profits. Thus, well-connected Thai investors and international speculators rushed to engage in yen carry trades. In fact, it was not just the yen; there was also a significant interest rate gap between the U.S. dollar and the Thai baht, so U.S. dollar carry trades were also active in Thailand.
Andrew Sheng believed that carry trades changed the structure of capital inflows into Asian countries—from being dominated by long-term direct investment to being dominated by short-term investment. This was an important factor that triggered the Asian financial crisis. Perhaps it was no coincidence that in 1990 Thailand agreed to the IMF’s request to relax foreign exchange controls, which led to a frenzy of short-term capital inflows, driving up Thailand’s stock and real estate markets, and the surge in asset prices further attracted capital inflows. From 1990 to 1995, Thailand’s net capital inflows grew by 126%; correspondingly, Thailand’s external debt soared to more than US$100 billion, about 60% of Thailand’s GDP.
At the same time, because it had borrowed a large amount of cheap capital, Thailand’s banking system began loosening lending conditions and expanding credit. Thailand’s economic bubble grew larger and larger, and financial risks accumulated. Worse still, Thai banks were borrowing short-term foreign debt and converting it into long-term loans in Thai baht, creating a high-risk situation known as “double mismatch,” meaning a maturity mismatch and a currency mismatch existed simultaneously. At this point, the fuse was set: once international capital flows reversed and withdrew from Thailand on a large scale, Thailand’s financial system was bound to face major problems.
The reversal came in 1995. In April 1995, the yen-to-dollar exchange rate reached a peak of 80:1, and afterward, the yen began a sharp decline. As mentioned earlier, yen appreciation drove Japan to increase outward investment; conversely, yen depreciation led to large-scale capital repatriation from overseas. From June 1995 to 1999, Japanese banks withdrew a total of US$235.2 billion from the Four Tigers and the Four Little Dragons, equivalent to 10% of these economies’ combined GDP during the same period. Clearly, even the healthiest economy could not withstand such a massive shock from capital flows. As a result, bubbles in these economies began to burst, their financial systems developed large volumes of nonperforming assets, and a crisis was on the verge of breaking out.
Looking back now, the broader background of the Asian financial crisis is clear. For the Four Asian Tigers and the Four Little Dragons, Japan was truly “the source of both their rise and their fall.” After World War II, Japan, through the “Flying Geese Model,” transferred low-end industrial chains to these economies, spurring their economic takeoff. After the 1985 Plaza Accord, the sharp appreciation of the yen drove Japan to increase investment in these economies, fostering further prosperity. However, after the bursting of the asset bubble in 1991, Japan’s ultra-low interest rates encouraged yen carry trades, causing a flood of hot money into the Four Tigers and Four Little Dragons, inflating their asset bubbles and financial risks, and laying the groundwork for the crisis. By 1995, when the yen exchange rate turned downward, massive capital quickly exited. At that point, the powder keg that would ignite the Asian financial crisis was already in place—only a spark was needed to set it off.
As I wrote this, I suddenly understood the sentence the author placed on the frontispiece of Chapter One: “The only cause of depression is prosperity.”
Part Two
Next, we need to drop from the 30,000-foot level down to 300 feet and examine, from the perspective of market participants, how the Asian financial crisis was ignited and how the affected economies responded.
Before the Asian financial crisis, although the exchange rate systems of the Four Asian Tigers and the Four Little Dragons had different names, they were all essentially fixed exchange rates. Their currencies were long-term stable against the U.S. dollar. For example, from 1984 onward, the Thai baht maintained a very stable rate of 25:1 against the dollar. Because these economies’ primary export market was the United States, keeping a stable dollar exchange rate was crucial. However, on May 8, 1997, rumors suddenly spread in the London financial market that the baht’s exchange rate against the U.S. dollar would fluctuate sharply. Within a week, the baht was heavily sold off in the London and New York foreign exchange markets, facing enormous depreciation pressure.
Here, I need to explain how international speculators profit by short-selling a country’s currency. Take the baht as an example. Before the baht depreciated, international speculators would first borrow large amounts of baht and then sell it on the foreign exchange market in exchange for U.S. dollars. For instance, they might borrow 1 million baht and sell it to obtain 40,000 U.S. dollars. If the baht failed to hold its value and depreciated from 25:1 to 50:1 against the dollar, the speculators would then need only 20,000 U.S. dollars to buy back 1 million baht to repay the loan. After subtracting the interest on the borrowed baht, the remainder would be pure profit. Of course, if the baht held steady and did not depreciate, the speculators would lose the interest on the borrowed baht. In reality, by January 1998, the baht’s exchange rate had fallen to 56:1, more than halving in value, allowing international speculators to earn huge profits.
As we know, financial speculation is a zero-sum game. So whose money did international speculators earn? The answer is: Thailand’s foreign exchange reserves. As mentioned earlier, Thailand operated under a de facto fixed exchange rate. To maintain the stability of the baht’s exchange rate, when the baht was in short supply in the foreign exchange market, the Thai government would sell baht and buy dollars; when the baht was in oversupply, the government would sell dollars to buy baht. The dollars used here came from Thailand’s foreign exchange reserves. In fact, the purpose of the speculators’ attack on the baht was precisely to drain Thailand’s foreign exchange reserves.
In May 1997, as international speculators massively sold baht and caused a severe oversupply, the Thai government was forced to urgently use its dollar reserves to buy back baht and defend the exchange rate. At the time, the Thai government was determined to protect the baht. First, Thailand possessed US$37.2 billion in foreign exchange reserves—the highest among the Four Little Dragons—so the government believed it had a chance to win. At the same time, the government temporarily reinstated capital controls, ordering Thai financial institutions not to lend baht to foreign speculators. Other Southeast Asian countries also coordinated with Thailand’s government and stopped lending baht to foreign speculators.
However, the Thai government underestimated both the greed and the strength of international speculators. What they did not expect was that the reaction of Thai domestic enterprises further worsened the situation. As mentioned earlier, during its economic boom, Thailand had borrowed heavily from abroad, and these foreign debts were denominated in U.S. dollars or Japanese yen. A sharp depreciation of the baht would mean a significant rise in the baht value of these debts. To hedge their risk, Thai companies that had borrowed large amounts of foreign debt desperately sold baht and bought dollars. Their intention was hedging rather than speculation, but their actions mirrored those of international speculators, further flooding the foreign exchange market with baht.
The Thai government fought back desperately, but soon exhausted its foreign reserves. In just two weeks, from May 1 to May 14, 1997, the net foreign exchange reserves of the Bank of Thailand fell by US$21.7 billion—60% of the pre-crisis total. By June 30, the usable net foreign reserves were only US$2.8 billion, virtually zero. The Thai government had fired all its bullets. On July 2, the Bank of Thailand was forced to announce that the baht would be unpegged from the U.S. dollar and move to a floating exchange rate system. On the day the news was released, the baht plunged 17%; within one year, it had depreciated by 56%.
On the same day it announced the depegging, Thailand requested emergency assistance from the International Monetary Fund. However, IMF assistance was not unconditional. To receive aid, the Thai government had to agree to a series of harsh conditions, including further opening its financial sector to foreign capital, fully privatizing state-owned enterprises, and implementing tight fiscal policies, among others. In hindsight, the IMF’s austerity prescriptions not only failed to reverse the situation but actually deepened Thailand’s economic recession.
More critically, to obtain this rescue, the Thai government lost a significant part of its economic sovereignty. Andrew Sheng observed that Westerners could not understand how painful and humiliating it was for Asians to once again cede the sovereignty they had so painstakingly gained. On December 3, 1997, South Korea, which was also severely hit by the financial crisis, accepted IMF assistance at the cost of surrendering much of its economic sovereignty. That day was called the second “National Humiliation Day” by the Korean people, the first being the day Japan occupied the Korean Peninsula.
After the baht’s defense collapsed, international speculators immediately turned their firepower toward the Philippine peso, the Malaysian ringgit, and the Indonesian rupiah, using exactly the same tactics. These countries repeated Thailand’s fate: burning through large amounts of foreign reserves, then being forced to abandon fixed exchange rates, followed by sharp currency devaluations. Among them, the Indonesian rupiah depreciated an astonishing 85% against the dollar, and the severe economic crisis triggered large-scale social unrest. In desperation, Indonesia and the Philippines accepted IMF assistance, with Malaysia being the only exception.
Prime Minister Mahathir Mohamad of Malaysia announced that he would reject IMF aid, asserting that Malaysia was capable of saving itself and unwilling to accept conditions that infringed on its sovereignty. Contrary to the IMF’s austerity prescription, Malaysia adopted expansionary fiscal and monetary policies to stimulate economic recovery. At the same time, Malaysia announced the implementation of “selective capital controls” to prevent international hot money from further attacking its financial market.
After this news broke, Western countries and the IMF unanimously condemned Malaysia, claiming that implementing foreign exchange controls was a step backward in history. But the book’s author, Andrew Sheng, believed this choice was understandable. He said, “If a bleeding patient cannot get a transfusion from the doctor, doesn’t he have the right to bandage himself to stop the bleeding?” Facts proved that Malaysia’s foreign exchange controls were effective: they successfully stabilized the situation and allowed Malaysia to be the first among the Four Little Dragons to resume growth.
Part Three
We have already seen that international speculators won a sweeping victory in their contest with Asian governments, advancing with unstoppable momentum. Among the eight economies of the Four Asian Tigers and the Four Little Dragons, seven experienced currency depreciation: the Indonesian rupiah fell by 85%, the Thai baht by 56%, the South Korean won by 55%, and the Malaysian ringgit by 48%. The only exception was the Hong Kong dollar. During the Asian financial crisis, the Hong Kong dollar maintained its fixed exchange rate of 7.8 to the U.S. dollar.
Did international speculators suddenly grow a conscience and spare Hong Kong? Impossible. Especially given that Hong Kong’s financial market was highly developed, with complex financial derivatives and no restrictions on short selling—conditions that made it even easier for speculators to operate. From August 1997 to August 1998, international speculators launched four massive assaults on the Hong Kong dollar. The Hong Kong Monetary Authority (HKMA) fought back head-on, turned the tide, and successfully defended the currency’s peg to the U.S. dollar. Looking back now, the entire process was nothing short of breathtaking.
Simply put, when speculators attacked the Hong Kong dollar, they used a “double play” strategy: not only did they short the Hong Kong dollar on the foreign exchange market, but they also heavily shorted Hong Kong stocks. If the Hong Kong dollar depreciated, speculators would profit directly from the currency short. Even if the Hong Kong dollar held its value, the HKMA, in order to defend the peg, would inevitably tighten liquidity, causing Hong Kong dollar interest rates to rise. Higher interest rates would in turn drive down Hong Kong stocks and stock index futures. In this way, speculators could profit from their short positions in the stock market. By simultaneously shorting both the currency and the stock market, speculators ensured they could profit regardless of the outcome.
Sure enough, in October 1997, speculators launched an assault by selling the Hong Kong dollar. The HKMA chose not to intervene directly in the foreign exchange market but instead tightened Hong Kong dollar liquidity. This led to a severe Hong Kong dollar “cash crunch” for institutions that had heavily sold the currency short. On October 23, Hong Kong’s overnight interbank lending rate skyrocketed from 9% to an astonishing 280%. The soaring interest rates effectively increased the cost of borrowing Hong Kong dollars to short the currency, discouraging speculative activity. However, the surge in interest rates had a serious side effect: the stock market plunged. Between October 20 and 28, the Hang Seng Index collapsed by 30%.
In this first round of attacks, the HKMA essentially fought speculators to a draw: it defended the Hong Kong dollar’s exchange rate but could not prevent a stock market crash. International speculators lost money shorting the Hong Kong dollar but more than made up for it with profits from shorting Hong Kong stocks. Their gains in the stock market far exceeded their losses in the currency market.
After tasting success, speculators returned in August 1998. This time, they first spread rumors in the financial markets, claiming that the Hong Kong dollar would be depegged from the U.S. dollar, that the Chinese renminbi would sharply depreciate, and that Hong Kong banks faced a run—shaking ordinary investors’ confidence in the Hong Kong dollar and triggering panic selling. Then, on August 5 and 6, speculators dumped more than HK$40 billion in the foreign exchange market, subjecting the Hong Kong dollar and the Hong Kong stock market to extreme pressure.
This time, the HKMA adopted extraordinary measures. It no longer relied solely on raising interest rates but took a multi-pronged approach: first, it used its foreign exchange reserves to buy all HK$40 billion that speculators had sold; second, it drew on US$15 billion of reserves to enter the stock market, purchasing 33 constituent stocks of the Hang Seng Index to prop up prices; third, the Hong Kong government introduced laws and regulations to restrict short selling, raised margin requirements for stock index futures, and otherwise increased the costs for speculators.
In retrospect, this series of actions was a high-stakes gamble. Its success depended largely on whether ordinary Hong Kong investors trusted the government’s ability to stand up to international speculators. If the public had doubted the government’s strength, they might have panicked and dumped their Hong Kong stocks and Hong Kong dollars, or even converted their Hong Kong dollar deposits into U.S. dollars. In that case, no matter how large the foreign exchange reserves were, they would have been depleted, and both the Hong Kong dollar and Hong Kong stocks would have collapsed.
Fortunately, the government’s market-support measures worked. After bottoming out on August 13, the Hang Seng Index began to rebound and gradually stabilized; the Hong Kong dollar’s fixed exchange rate remained rock solid. At that point, international speculators, seeing no chance of victory, withdrew at a loss of more than HK$1 billion.
You may wonder why the Hong Kong government was able to successfully fend off international speculators while Thailand, Malaysia, and other countries could not. The main reasons are threefold. First, before the crisis, Hong Kong had ample foreign exchange reserves—nearly US$100 billion—ranking third in the world after Japan and mainland China. In other words, the Hong Kong government had plenty of ammunition. Second, Hong Kong’s financial system was very healthy and could withstand the shock of high interest rates. By contrast, Thailand’s financial system was riddled with bad debt, and the Bank of Thailand dared not sharply raise interest rates to punish speculators because higher rates would have bankrupted many heavily indebted financial institutions and businesses. Third, Hong Kong’s economic fundamentals were sound, with neither a fiscal deficit nor external debt. As long as the Hong Kong government could maintain public confidence, its chances of success were high. Of course, even more importantly, the public understood that behind the Hong Kong government stood a rising China as a powerful backer.
Summary
In the book, Andrew Sheng specifically notes that during the Asian financial crisis, the Chinese government decisively announced it would maintain the stability of the renminbi’s value, establishing China’s image as a responsible major power on the global stage. At that time, the currencies of the Four Asian Tigers, the Four Little Dragons, and even Japan were all depreciating. For the renminbi not to depreciate meant that China’s export conditions would worsen significantly, and making this decision came at a cost. However, conversely, the commitment not to devalue the renminbi forced China to carry out structural adjustments, tax reforms, and the restructuring of state-owned enterprises and the financial system. As a result, China maintained its export competitiveness not by devaluing its currency, but by increasing productivity and upgrading its industries.
Finally, the Asian financial crisis left us with an important question. In 1997, mainland China’s financial system was also fragile, with an underdeveloped capital market and a high level of nonperforming loans. Why was China not hit by the crisis? On this point, there is a basic consensus among Chinese scholars: the most critical firewall was China’s system of capital controls. For international speculators to short a country’s currency, they must first be able to borrow that currency on a large scale. Because the renminbi was not freely convertible and China’s capital markets were not fully open to foreign capital, international speculators had no channel to borrow renminbi in large quantities, and therefore could not short the renminbi.
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