What Happens When Central Banks Lose Control?

In the 1990s, because government spending and private speculation in Asia shifted into 5th gear, the “tiger economies” started to overheat.

Certain industries and sectors known as “hot spots” bloated as they receive lots of money derived from foreign debt. Because they were too exposed to the international money markets, these developing economies crashed when the situation went downhill.

Stock markets and currencies their lost around 70% of their value as a result. Had you entered the market at the right moment, you would have benefited greatly from the economic bubble.

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Rather than being distributed evenly across the economy, money created by central banks or borrowed by governments are injected towards specific locations, which can either be a sector, industry or company.

These are known as “hot spots,” and they can be sources of growth and investment opportunities.

What Creates Hot Spots?

Each government official has their own agenda. Some may focus on policies that grow the manufacturing sector. Others may have more sinister goals, such as abusing the system for personal gain. Regardless of their political pursuit, the fuel that grows these sectors is usually money.

Funds are concentrated towards certain locations. For example, if the government wants to carry out a health care plan, then the healthcare sector will receive more money. Or, if an official has friends who had helped him with his political career, then the industries or companies that those friends work in may receive more government funding.

Because of this, sectors that benefit more become ‘hot spots’.

Prior to the Asian financial crisis in 1997, many Asian economies received lots of ‘hot’ money. These ‘Asian Tigers’ were Thailand, Malaysia, Indonesia, Hong Kong and South Korea. As a result, their economies grew rapidly and consequently led to asset bubbles.

What’s worth noting is that whenever a government funds more towards specific sectors, independent investors will follow that trend and invest as well. They gather around these artificial hot spots.

For example, before 1997, the Thai government funded heavily towards real estate projects. Institutional investors and hedge funds made record profits by chasing after these hot sectors.

How Favoritism Speed Things Up

Velocity is a term used to describe the speed of money as it circulates in an economy. If money circulation gets clogged up at a certain point or sector, then an asset bubble begins to form.

Many Asian economies are export-based state-capitalist. In other words, money that go to ‘strategic sectors’ are directed by governments, not the free market. The manufacturing sector is hot because exporting these goods is considered strategic.

Industries in Asia that manufactured exported goods were high-velocity.

Strategic sectors change along with economic development. For example, in early stages of economic development, high amounts of funding generally flow into agriculture, and so this economic sector becomes high-velocity. When the economy becomes more developed, money is shifted towards the manufacturing and service sectors at a faster rate.

What affects velocity?

As time goes by, velocity fluctuates within the economy. Velocity of investment can change due to greed and fear, and if that velocity slows down quickly, crashes can happen.

Whenever there’s panic, many people tend to sell away assets. For example, in 1990, if you had invested in a Malaysian palm oil processing plant, and had you worried about a crash, then you would have sold this asset.

If people put faith in the currency, then they would stash the cash that they get when they sell their financial assets. Because of this, velocity slows down and money supply drops.

However, if people don’t believe in the currency, then they will quickly switch to goods, precious metals or foreign currencies. This accelerates money supply.

How Did Booming Asian Markets Begin to Bust?

Thai, Malaysian, Indonesian and South Korean economies suffered because “hot” money in the 1990s.

The ‘Washington Consensus’ is widely regarded as the model for economic development. This is a set of rules based on free market ideologies upheld by supranational organizations. It started with the coercion from the World Bank, IMF, WTO and the American treasury towards several Asian countries. They advocate for over-liberalizing current economic models, specifically support free market, free trade, floating exchange rates and macroeconomic stability.

Domestic industries were motivated to grow using loans from foreign investors instead of local credit options. A lot of local corporations go after foreign loans because they were cheaper than that from local banks.

Because these loans came as U.S. dollars, central banks offered to fix the exchange rate mechanism between the countries so that the risk of currency fluctuations during the repayment period is reduced and borrowers become less worried regarding overall cost and loan repayment terms.

As a result, the more attractive foreign credit benefited mostly to the most productive industries. Meanwhile, domestic banks had to rely more on higher risk borrowers when lending out their credit.

Rather than being offered to profitable businesses, this new hot money was often fed to less efficient institutions that were hungry for credit. Once the economic environment stumbled because of a series of internal and external financial shocks, investors looked for lower risk assets and shifted capital away from Southeast Asia.

Thailand, Indonesia and South Korea quickly adjusted their GDP growth during the 1997 Asian financial crisis.

After capital shifted away from Thailand, the amount of Thai Bhat increased rapidly, and so the currency quickly loss value. The Thai Central Bank tried to fix up their currency using their limited amount foreign reserves. But speculative investors took advantage and started to bet against the Thai Baht. Realizing that capital won’t stop escaping Thailand, the currency was allowed to free float, and its value dropped even further.

This essentially bloated foreign debt (denominated in dollars). Many Thai companies bankrupted because they couldn’t service the USD-based loans, endangering the Thai economy.

That was how the Asian financial crisis began. And because of inter-regional relationships, the Thai economic epidemic spread to all tiger economies.

After capital shifted away from Thailand, the amount of Thai Bhat increased rapidly, and so the currency quickly loss value. The Thai Central Bank tried to fix up their currency using their limited amount foreign reserves. But speculative investors took advantage and started to bet against the Thai Baht. Realizing that capital won’t stop escaping Thailand, the currency was allowed to free float, and its value dropped even further.

This essentially bloated foreign debt (denominated in dollars). Many Thai companies bankrupted because they couldn’t service the USD-based loans, endangering the Thai economy.

That was how the Asian financial crisis began. And because of inter-regional relationships, the Thai economic epidemic spread to all tiger economies.

The Asian Financial Crisis is the basis of several PHD theses, and a more detailed analysis of the consequences will be in future dailies. We will have an article dedicated towards real estate and the inherent risks that occur when investing in property.

Because you’re an individual investor, you cannot alter markets and the external forces that shift power around the globe. However, you can identify patterns of Asian economies, and regardless whether they boom or bust, there are always opportunities there for you to make profit.

We hope you look forward to our special publications that discuss the concept of “financial repression” and how governments around the globe apply this to balance out unsustainable debt levels.

Additionally, we have a unique case study about Japan, the land of the rising sun seems to be drowning in debt. As always, our goal is to support you when investing in Asia!
Source: Forbes

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