Now and Yen

Lately, I've seen a new theory about the impact of the weakening yen: Some folks posit that since a weak yen was one of the precursors to 1998's Asian financial crisis, we could soon see a repeat.

It's a scary thought—the Asian Contagion, as it's known, was a dark time for emerging Asia. It was so bad in South Korea that countless citizens donated gold jewelry—wedding rings and family heirlooms—to the government to rescue the near-bankrupt state. Thankfully, a few key differences between then and now make a repeat highly unlikely.

Here's the Reader's Digest version of what happened in 1998. For years, the Asian tigers enjoyed rip-roaring growth. Several nations' currencies were pegged to the US dollar, which helped insulate trade from regional exchange rate instability—if everyone was pegged to the dollar, their currencies largely didn’t rise and fall against each other, and no one had a significant mercantilistic advantage (i.e., relying on cheap currency to boost exports in the region). The fixed exchange regime also helped keep borrowing cheap and foreign investment strong—a dollar peg had an implied stability, and to many investors, these nations seemed somehow safer than those with volatile floating currencies. Many emerging Asian countries took advantage of this, running up high tabs to support infrastructure buildouts and rapid development, while private foreign investors funded myriad real estate projects.

For a few years, it worked like a dream, and the world witnessed the “Asian miracle” for much of the 1990s. But then the cracks began to show. Because most nations were pegged to the dollar, they were über sensitive to the yen/dollar exchange rate. And when the yen weakened in 1996 and 1997, not only did dollar-pegged currencies get stronger, hurting exports, but in Thailand, the baht fell victim to speculative attacks—similar to the British pound during Europe’s ERM crisis in 1992. At first officials tried to defend the dollar peg, spending billions of Thailand’s forex reserves, but they ultimately had to drop the peg—effectively devaluing the baht, which fell about 20% to all-time lows once market forces took over. Foreign investors fled en masse, and the cash-strapped government had to get a $30 billion bailout from the IMF. The crisis soon spread, and panic filled the region as nations defended and discarded currency pegs. The economic fallout was vast. Global stocks corrected sharply, GDP fell across the region, foreign capital flooded out, domestic assets weakened while foreign currency liabilities ballooned, and companies and financial firms failed left and right. Indonesia and South Korea, the hardest-hit, nearly went bankrupt and together received nearly $100 billion in IMF loans in 1997 and 1998.

Since then, a few things have happened to mitigate the risk of a repeat. First, these nations recovered and emerged with arguably stronger financial systems, thanks to structural reform—South Korea’s privatization of formerly state-owned banks is but one example. As a result, their economies are more diverse and less dependent on foreign capital flows—they've created wealth domestically, and that wealth underpins much of today’s private investment. They’ve also amassed much higher forex reserves, giving them more breathing room if their currencies come under fire—not that they’ll need it. Save for China, Hong Kong and Malaysia, none have fixed exchange systems. Some seemingly maintain an unofficial fixed float, but that doesn’t require anywhere near as much intervention as a fixed peg. Overall and on average, if nations are worried about currency fluctuations, they can adjust monetary policy accordingly—they don't have to use their forex reserves to defend a peg (though they occasionally choose to intervene during times of economic stress, as South Korea did after the won fell nearly 20% in 2008). That drastically reduces the likelihood of a currency crisis, whether or not the yen falls further from here.

That holds true even if some nations choose to pursue competitive devaluations—better known as a “currency war.” The theory goes that a weak yen makes Japanese exports cheaper and, as a consequence, its neighbors’ exports get more expensive as their currencies strengthen, so these nations will try to weaken their own currencies to regain their edge. Korea intervened to weaken the won in November 2012, and officials have suggested they may act again. And other nations might follow suit. But the occasional competitive devaluation isn’t a currency crisis—there’s nothing forcing nations to intervene, as the dollar pegs did in 1997. Despite the widely held belief, a weaker currency isn’t a necessity or even a net benefit—especially not in today’s globalized economy, where few goods are produced start-to-finish in one country. If a nation has a stronger currency, manufacturers can import inputs (raw materials, intermediate components, energy) more cheaply, helping keep costs low and offsetting much of the stronger currency’s impact on the final product’s price. Consumers benefit from cheaper imports, too. Many nations likely understand this and opt not to devalue. Those that do devalue are making a political choice—picking winners and losers—not an economic one.

In short, while a weak yen may have coincided with the Asian Contagion, it’s far from an automatic regional negative—the yen was quite a bit weaker than today's levels in 2003 and 2004 without causing Asian or global doom. The global financial system isn’t riskless—never is—but fears of a weak yen are vastly overstated.