Academic journal article The Economic and Labour Relations Review : ELRR

Real Estate Speculation as a Source of Banking and Currency Instability: Some Different Lessons from the Asian Crisis

Academic journal article The Economic and Labour Relations Review : ELRR

Real Estate Speculation as a Source of Banking and Currency Instability: Some Different Lessons from the Asian Crisis

Article excerpt

1. Introduction

Table 1 shows the extent of capital inflows into Asian economies prior to the crash. In 1996, the inflow of capital into the MF-3 (Thailand, Indonesia and Korea) averaged nearly 7 per cent of GDP. Associated with the inflow of capital was a trend to current account deficits (CAD's), and by 1996 Hong Kong SAR, Korea, Indonesia, Malaysia and Thailand were in this position. Table 2 shows the CADs in Asian countries along with, for comparison, the position in some other countries. A third related feature was that much of the inflow financed a vast over-expansion of commercial real estate development. Rapid reversal of the movement of capital and plunging real estate values were common across the region, as were severe difficulties in the banking and financial sector. This concurrence forms the basis of our analysis.

Many factors undoubtedly played a part in the Asian crisis. (1) Paul Krugman (1998a) takes the view that the currency instability was symptomatic of bad loans which result from the expectation that insolvent banks will be bailed out by the taxpayer. Later he gave a prominent role to "crony capitalism" under which "dubious investments were cheerfully funded by local banks, as long as the borrowers had the right government connections" (Krugman, 1998b). However, banking and currency crises are not new, and occurred long before there was any public support for the banking system. One such episode took place in Australia in the 1890s, when the ingredients were much the same as in the Asian crisis of the 1990s--heavy overseas borrowings, vast real estate speculation and a banking crash (54 out of 64 banks and 35 out of 36 finance houses were forced to close). (2)

Our argument is that, even without banking support arrangements and "crony capitalism", large international portfolio capital flows intermediated by banks will usually lead to rapidly appreciating asset prices which will result in banking/currency crises. This is because portfolio investment will push the currency up to relatively high and unsustainable levels, and the boom in asset prices which is fuelled by bank lending must result in bad loans on the part of those "left last on the field", because there are no buyers left on which to offload property at the higher price required to cover borrowing costs. This in turn will lead to a joint loss of confidence in both the currency and those financial institutions.

The paper falls into two parts. One considers various forms of foreign investment (FI) and their impact on the exchange rate. Our purpose is to identify those capital flows which impose either small or large adjustment costs on the host country, and those capital flows which lead to exchange rate changes which are either more or less rationally based. The second part of the paper focuses on the question of real estate speculation and the role of bank lending.

2. When does FI create adjustment problems?

What patterns of foreign investment (FI) push the real exchange rate up to levels which makes, the domestic economy vulnerable to adjustment costs and changes in investor sentiment? Second, what patterns of foreign investment (FI) are likely to trigger an abrupt reversal in that sentiment? These are the questions examined.

In the general case, capital inflow leads to a mixture of increased domestic spending and real exchange rate appreciation for the host country, which induces a corresponding increase in its CAD/trade deficit and resource transfer from abroad. In an economy producing traded and non traded goods, this real appreciation takes the form of a rise in the relative price of non traded goods, which leads to a fall in the production of traded goods and an increase in their consumption, this change in relative prices and the ensuing substitution effects being required to increase the CAD.

When this foreign capital flow ceases or reverses, these mechanisms are then thrown into reverse. …

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