Hedge Funds: 1997 Asian Financial Crisis, Response and Regulatory Measures in South Korea

Arun Khatri

Abstract

Introduction:

The principal focus of this paper is on the role of hedge funds in the 1997 Asian financial crisis, and the reforms and regulations adopted by South Korea after the crisis. Apart from this it also discusses some aspects of the role played by world bodies like the IMF in bailing South Korea out of the crisis. The paper will begin with an analysis of events leading to the Asian financial crisis. From there, it will discuss the basic fundamentals of hedge funds, strategies employed by hedge funds and then their role in the crisis. It will then analyze some of the regulatory measures adopted by the South Korean Government in regulating the financial markets.

The analysis of hedge funds with respect to the Asian financial crisis is important because some scholars still believe that hedge funds were primarily responsible for the crisis, while other ascribe different reasons for the crisis. Even more than 10 years after the crisis, the real causes are still disputed. After crisis two major international studies were conducted to ascertain the role of hedge funds in crisis. The first was the IMF study “Hedge Funds and the Financial Markets dynamics” led by Barry Eichengreen and Donald Methieson and published in May 1998. According to this, hedge funds were small entities of a very large system and it is misguided to blame them. Another major international report was written by FSF Working group on Highly Leveraged Institutions and published in 2000. According to this, hedge funds and proprietary trading desks have the potential to destabilize financial markets. The idea that hedge funds played major role was also supported by political figures. Dr Mahathir, the then Malaysian Prime Minister, in one of the statements published in the Wall Street Journal on September 23, 1997 remarked.

“Whole region can be bankrupted by just a few people whose only objective is to enrich themselves and their rich clients....”

However, Dr Mahathir has not supported his argument with any substantial evidence. Thereafter several studies were conducted by world bodies like IMF but there is no consensus on the real causes till date. According to IMF, South East Asian economies were experiencing a huge inflow of money and from 1990 to 1995, financial intermediaries invested somewhere around $20 billion in these economies and in 1996 this amount had dramatically increased to $45 billion per annum. Then with the collapse of Thai Baht and Malaysian Ringitt, there was a sudden outflow of $58 billion which created a chain reaction and currencies of other nations also started falling. But the question is if this was not sufficient to trigger crisis why these South East Asian economies which were experiencing high growth before 1997 faced economic crisis only after depression in their currencies.

All the studies undertaken for assessing the role of hedge funds in Asian crisis used empirical and statistical evidences. However, this research paper is written from a different perspective as it assessed the reforms undertaken and regulations enacted by the countries hit by Asian crisis. If any country has enacted any law with respect to the regulation of hedge funds then it is clear evidence that hedge funds played role in Asian Financial crisis. Assessing reforms of all South Asian economies is too broad and research may not be able to provide clear picture of causes and especially the role of hedge funds. It may be more productive to choose a country and analyze all the causes and reforms relative to that country. South Korea had phenomenal growth in the three decades preceding the crisis and was a preferred destination for international investors, whether hedge funds played any role in crisis could be seen by analyzing the reforms adopted by South Korea.

About the Sources:

Entire research on the paper was done by me only and sources include material from westlaw, lexis-nexis, internet, books and electronic resource of Northwestern libraries. All the sources will be cited in the footnotes.

Asian Financial Crisis:

The Asian financial crisis was one of the worst financial crises in Asia and has raised concerns not only for the future of region’s economy but also of the world’s economy as a whole. Though Asian crisis was centered only in South Asia but its impact was so deep that its reverberations were felt in the whole world. Asian financial crisis became a moot point and in recent subprime crisis policy makers tried to take lessons from it. In one of the articles recently published, it was quoted “The catchphrases may be different, but there are many similarities between the 1997 Asian financial crisis and today's” .

Asian financial crisis was triggered in July 1997 with the collapse of Thai Baht, which was directly the result of a decision by the Thai Government to float the Baht . At that time, the baht was pegged to the dollar and current account deficit of Thailand increased demand for dollar. As a result of which Thai government had to use its foreign exchange reserves to buy Thai baht. The cost of defending baht was around $5 billion but Thai central bank had locked its foreign reserves in forward contracts so it had only $1.14 reserves to defend baht . As a result of which Thai government had to take the decision to float baht against dollar which resulted in the collapse of baht. With the devaluation of Baht, currencies of other neighboring countries also started falling and within weeks entire South Asian region came into the grip of crisis. The countries most affected in the crisis were Indonesia, Thailand, South Korea, Malaysia, Singapore, Hong Kong and Taiwan. According to CRS Report for Congress, 1997-1998, two rounds of currency depreciation were responsible for the crises. First round started with the sudden fall in the Thai baht, Malaysian ringgit, Philippines peso, Indonesian rupiah. When these currencies stabilized, a second round began with the fall in the Taiwan Dollar, South Korean won, Singapore dollar and Hong Kong dollar. These currencies lost substantial value relative to the United States dollar. In order to prevent currency depreciation, South Asian economies took sudden measures of selling foreign exchange reserves and raising interest rates which in turn further slowed economic growth. The impact of crisis was so deep that some economies like Thailand, Indonesia, Malaysia, South Korea and Philippines experienced negative growth rates between July, 1997 and July, 1998.

Growth in Real GDP (%) in crisis-affected countries

1996 1997 1998

Thailand 5.5 -0.4 -8.0

Indonesia 7.8 4.9 -13.7

Malaysia 8.6 7.7 -6.2

South Korea 7.1 5.5 -5.5

Philippines 5.8 5.2 -0.4

There has been continuous debate on the reasons for financial crisis and different scholars have different views on it . One view suggests inherent weakness in the domestic structural factors of the economies was responsible for the crisis . This includes weak banking system, lack of adequate laws and regulations, and also the absence of strong supervision and enforcement of prudential regulation. Another view suggests that short term capital flows were more responsible for it . South Asian economies were the preferred destination for global investors because of high interest rates and therefore attractive to investors considering higher rates of return. There was a large influx of money and soaring asset prices. The South Asian economies were inflated with this short term capital which was expensive and conditioned on quick profits .

There was never a consensus on the causes but it seems that there is no one reason and all the factors resulting in crisis overlap. The financial crisis has not only economic but also political ramifications. President Suharto of Indonesia was forced to resign and world bodies like the IMF had to step-in and design bailout packages for crisis ridden countries.