SOUTHEAST ASIAN FINANCIAL CRISIS : THE ROLE OF DERIVATIVES

Abstract

The financial turmoil that started in early July 1997 has cast doubts on the 'East Asian Miracle' economic growth. The open nature of Southeast Asia's economies that, since the early 1990s, has helped them tremendously in achieving double-digit growth rates is, ironically, now chiefly suspect as the main cause of their apparent downfall. This paper does an in-depth analysis of the balance of payments flows of Thailand, Indonesia, the Philippines and Malaysia. Findings indicate that although current account deficits have been on the rise in recent years, foreign capital inflows have been a more than adequate source of financing. The nature of these capital inflows have, however, been heavily debt based, resulting in foreign debt levels deserving of concern. The role of derivatives for hedging these foreign debts is, in the present context, mainly in stemming the loss of foreign investor confidence and preventing the capital flight that has resulted from speculative attack on the currency. Foreign debt may not have been hedged due to high transaction costs, exchange controls, fixed exchange rate regimes and over-confidence factors. Based on the covered interest parity condition, a computation of the covered interest arbitrage margin is carried out. Results show that the margin i.e. deviations from parity is significant for all four countries, implying thinness of forward markets lacking depth and width as well as the prevalence of exchange controls leading to considerable market distortion. This further confirms that foreign debt in these countries had been unhedged, leading to a panic during the speculative attack that further exacerbated the situation. It is concluded that more extensive use of derivatives as hedging tools could have helped prevent the current financial crisis.