Throughout the 1990s, a series of financial crises rocked the world’s economy. T

Question

Throughout the 1990s, a series of financial crises rocked the world’s economy. The first of these was the 1994Mexico peso crisis. This was followed by the Asian crisis of1997. Since then there have been the Russian crisis of 1998,the 1999 Brazilian financial crisis, and the 2001 Argentine crisis. The following examines the first two of these.

The Mexican peso crisis

In late 1994 Mexico suffered one of the worst financial crises in its history. In less than one month the Mexican peso devalued from 3.45 to the US dollar to 5.57 to the dollar, and by the end of 1995 it was trading at 6.5 to the dollar. This was accompanied by heavy inflation, unemployment, and a severe stock market crash. Some critics claimed that all of this was a result of NAFTA, but this was not so. The crisis was caused by the Mexican government itself, which had liberalized trade and financial flows but had not allowed the peso to float. Moreover, previous governments had kept the peso overvalued. As a result, in less than one year Mexico’s foreign reserves were depleted by 75 per cent and the country’s current account deficit was equal to 8 per cent of GDP. Other factors also contributed to the low price of the peso. For instance, as a result of the Zapatista armed rebellion of 1996 in Chiapas, in southern Mexico, both foreign and Mexican investors took tens of millions of dollars out of the country. These developments had far-reaching consequences throughout the region. For example, many investors in other Latin American countries, fearing a similar crash, withdrew their funds from these economies and deposited them in the United States for safe keeping. One unexpected development of the Mexican peso crisis was the devaluation of the Canadian dollar, which was sideswiped by the Latin American currency crisis. Thanks to NAFTA, Canada and Mexico had become linked in the international currency markets. At the same time international investors began showing a preference for the US dollar against both the Mexican peso and the Canadian dollar. Perhaps the most surprising thing about the peso crisis was how quickly the country bounded back. With the help of a $50 billion loan from the United States and other countries, a tough economic reform that saw cutsin government spending, and increases in deregulation and privatization, the Mexican economy began to revive. Hardly a year had passed when investors who were running from the region were quickly lured back by short-term interest rates of up to 40 per cent. Additionally, the stock market crash had led to underpriced shares, and investors began buying these issues and driving the prices back up. Today the financial crisis of 1995 in Mexico is a thing of the past. The country’s economy is healthy and investors are back.

The Asian financial crisis

In the early 1990s, the Asian economies of South Korea, Indonesia, Taiwan, Malaysia, and Japan were being praised as economic miracles. In 1997, these countries faced one of the worst blows to their economies. The Asian crisis began in July 1997, when Thailand stopped pegging its currency to the US dollar. In two months the Thai bath had devaluated by nearly 40 per cent. The effect was two-fold. First, Asian exporters to Thailand faced decreased demand for their product. Second, there waste decrease of investor confidence in the region. Individual countries in the region faced their own sets of problems. In Malaysia, it was excessive lending to the property sector. Once foreign investment was cut short, over lending, overinvestment, and overproduction led to a downward spiral in the economy. In South Korea, the chaebols (large manufacturing conglomerates) that dominated the economy had invested recklessly without regard to profit. In Indonesia, President Suharto’s corruption and lack of accountability led investors to flee the country. In addition, the banking system that the government there had fostered was plagued with bad loans for many unreliable projects. These loans benefited and created wealth for well-positioned individuals—in particular, members of the Suharto family, but they did nothing for the rest of the country. Some financial observers believe that Western speculators were a major reason for the financial troubles in the region. The trend toward deregulation of the world capital markets and the free flow of capital, it was argued, contributed to the currency panic. Additionally, the relatively good health of these nations prior to 1997 made them attractive to foreign investors and lenders. Unfortunately, many of these loans were short term and were in foreign currency. So while the economy grew, the loans presented no problem. But when trouble looked likely the foreign lenders began calling in their loans. When this happened, the value of the local currencies plummeted and the loans payable in foreign currencies created a debt crisis.

It was initially believed that the Asian economic problem would be contained in that geographic region. However, by mid-1998 the crisis was having an effect on the global economy. The cross-border interconnections of global industries and the resulting interdependence pushed the problem to other regions. Among other things, the crisis led to decreases in the prices of many commodities including oil, metals, grain, pulp, and paper. Industrial nations came to the aid of these Asian governments. The IMF negotiated billions of dollars in bailouts. Initially, the IMF wanted these governments to decrease their budget deficit and to maintain stable interest rates. By July 1998, however, the IMF was allowing increases in deficits and lower interest rates. This helped ease some of the problems, although there was still a great deal of disagreement regarding what else needed to be done. For example, some observers argued that the government needed to continue to deregulate the country’s capital markets, while others blamed the economic disaster on this deregulation.

How is trade affected by currency devaluations as a result of a financial crisis?

Explanation / Answer

In the last decade world has witnessed many financial crises like European financial crisis, Mexican peso crisis & the Asian crisis in 1997-98. There are several reasons to these crises like current account deficit, declining foreign reserves, increasing foreign debt & fiscal deficit etc. International trade links also play an important role in expanding effects of these crisis in other countries. These financial crises also affected exchange rates of currencies leading to devaluation. Fluctuation in the valuation of currencies have far reaching effects on trade by altering imports & exports.

If we look at the Asian crisis which started with devaluation of Thai baht, there was a huge speculative trading which forced Thailand’s central bank to stop pegging it to US dollar & float it. This severely affected the trade resulting in contraction of economy. Because of currency crisis exchange rate becomes more uncertain. Importers & exporters chose to reduce their business for short time. So in short term devaluation can have negative effects on trade.

In long run market becomes stable but it can have different effects according to countries affected & economic factors like demand & supply, bailouts & monetary policies etc.

If demand for local products falls, consumers income fall which leads to fall in both imports & exports.

If prices of local products decreases consumers may increase their consumption of local products & decrease consumption for foreign products which leads to fall in both imports & export.

If price elasticity of demand for local products in international market is higher, it leads to increase in export for a shot period.

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