Currency Devaluations Financial Mismatch

The South East Asian Crisis of 1997

The South East Asian Crisis of 1997 was a series of currency devaluations and capital outflows that affected several Asian economies such as Thailand, Malaysia, Philippines, Indonesia, and South Korea. One of events leading to the crisis was a mismatch between local assets and foreign funded liabilities. The foreign debt-to-GDP ratio rose from 100 percent to 167 percent in the four big ASEAN economies between 1993 and 1996 (Huyghebaer and Wang, 2010). Liquidity was not matched in the sense that liabilities in these economies were higher than assets. This put the region in a precarious financial situation. Lastly, the Thailand government decided to stop pegging its currency to the US dollar resulting in devaluation of the Baht (Regnier, 2017). This spread to other countries causing the crisis. After the crisis, most governments reacted by adopting protectionist measures. This was not a wise reaction on their part because it caused the value of their currencies to drop further.

Phenomena such as Adverse Selection, Moral Hazard, and Principal-Agent played a significant role in fuelling the crisis (Emmers and Ravenhill, 2011). For example, there was adoption of risky policies such as high interest rates to attract foreign investments, which set the stage for the crisis. There was thereby adverse selection on the part of the governments. In terms of moral hazard, there was a strong political desire in the region to for rapid economic growth. As such, governments normally provided implicit guarantees to projects by the private sector (Choi, Kim and Lee, 2011). This helped to increase the risk of the crisis due to high debt level. Lastly, there was the Principal-Agent problem in the region in the sense that the governments created an environment that benefited foreign investors at the expense of the economy.

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The crisis was also significantly caused by inadequate regulations. For example, the governments in the region did not control the foreign debt causing it to increase to unmanageable levels. The governments also did not put in place regulations that control imports. This resulted in a higher current account deficit (Emmers and Ravenhill, 2011). Market liberalisation and financial innovation also played a significant role in the crisis in the sense that market liberalisation resulted in an influx of foreign companies and investors in the region without control (Mishkin, 2016; Mishkin, and Eakins, 2018). This contributed to the high foreign debt in the region. Financial innovation, on the other hand, encouraged heavy borrowing which also contributed in the increase in the debt-to-GDP ratio. In my opinion, there was inadequate identification, quantification, and management of risk during the crisis.

Majority of governments in the region raised interest rates to very high levels in order to attract investors and help diminish capital flight (Huyghebaert and Wang, 2010). However, such an action did not help since it was one of the causes of the crisis in the first place. In my opinion, Central Bankers and other official institutions contributed to the crisis in terms of its fiscal policies. For example, Central Bankers as well as other official institutions initiated policies such as high domestic interest rates which encouraged heavy lending and borrowing in the region (Bessis, 2015). This encouraged high capital inflow that contributed to the crisis. Banks in the region should have introduced policies that limit capital inflow in order to reduce the debt-to-GDP ratio.

Metallgesellshaft and its Hedging Program

By 1993, Metallgesellshaft had put on trades to sell over 150 million barrels of oil to its customers in the next 10 years. However, since Metallgesellshaft was not holding huge inventories of oil, the customer trades exposed it to huge risks in the market. Since Metallgesellshaft sold its products at fixed prices, if there was a rise in oil prices in the market in future, the company would make losses because it would be forced to buy at a higher price and sell at a lower price (Zeidan and Rodrigues, 2013). To avoid this risk, Metallgesellshaft entered into a futures trade by agreeing to purchase oil at a certain fixed price on a future date. The company created the hedge with the view that future prices would be lower than the spot prices.

However, there was a shift in the market where future prices were higher compared to spot prices (Stulz, 2013). This resulted in a loss as the gains from the short positions were less than the losses made from the futures positions. The actions taken by the company is an indication of its risk appetite and tolerance. As asserted by Mishkin and Eakins (2018), financial institutions have a huge risk appetite and tolerance owing to the amount of money it hedged. It stood to lose a lot if the market did not behave as expected yet it went ahead with the hedging process. The company also failed to use the Model Risk adequately in the sense that it did not take into consideration the opposite of what was expected taking place.

In my opinion, the control functions within the bank such as risk identification, quantification, and management were inadequate. During the hedging, there was only one assumption and that is, the futures price would be lower as compared to spot price. There was no consideration of the opposite happening (Bartram, 2015). There was inadequate analysis of the oil market over time to determine how oil prices have been fluctuating over time. Failure to identify adequately the risk involved also made it hard for the bank to quantify it. As a result, the amount hedged was so huge to a point that it was hard to manage the risk when the futures prices went in the opposite to that was expected (Zeidan and Rodrigues, 2013).

Phenomena such as Adverse Selection, Moral Hazard, and Principal-Agent also played a significant role in this risk management failure. With respect to Adverse Selection, Metallgesellshaft selected a hedging option that increased the risk of failure (Saha, 2011). With regard to Moral Hazard, the desire for increased profitability made Metallgesellshaft to fail to consider the opposite scenario occurring. This increased the risk and huge losses when the opposite of what was expected actually occurred. Lastly, the Principal-Agent phenomenon played a role whereby hedging was adopted with the hope resulting in higher profitability as opposed to protecting the firm from future losses (Stulz, 2013). This put the company at a higher risk.

Inadequate regulations also played a significant role in the risk management failure. There was need to regulate the size of the futures contract position. The size of the position made it impossible for the gains made to offset the hedge losses made. In my opinion, market liberalisation contributed to the failure in risk management because it exposed oil prices to market forces (Bartram, 2015; Mishkin and Eakins, 2018). It was thereby hard for Metallgesellshaft to predict accurately oil price trends. However, I believe that financial innovation did not play a role in this failure. In my view, the regulation that might have prevented the failure is restriction on the size of the position (Saha, 2011). There was need to restrict the size to ensure that the gains match the losses.

Broadly, the company made a number of mistakes that resulted in the massive loses it experienced. For example, it did not articulate value at risk since this would have enabled it to commit less resources to hedging. There is also the possibility that the company was engaging in speculation rather than hedging. Hedging, in this case, was done with the hope of increasing profits in future rather than protecting the firm against unexpected market events.

The UK Consumer Credit Act of 2006

The Consumer Credit Act of 2006 is a law that was enacted by the UK parliament with the intention of increasing consumer protection when borrowing money. The motivation behind the enactment of the law was to ensure that borrowers are treated fairly by lenders (Campbell et al., 2011). For example, the Act provides that borrowers must be provided with adequate information by lenders in order to make an informed decision. One of the instruments through which the Act is supposed to interact with financial institutions is the contractual agreements between lenders and borrowers, that is, the Act controls the actions of the financial institutions through the agreements between lenders and borrowers. The Act focuses on the contractual agreements entered into by borrowers and lenders to determine whether borrowers have been treated fairly and according to the law (Ardic, Ibrahim, and Mylenko, 2011). The Act provides that the court can rewrite an agreement if determines that it is unfair to the borrower. Another instrument through which the Act is supposed to interact with financial institutions is the Financial Ombudsman Service. The Act allows consumers to use the Financial Ombudsman Service if they are not happy with the dispute resolution service provided by their lenders whether the lender provides their consent or not. The regulations were aimed to reduce or eliminate exploitation of borrowers by lenders. They were also meant to ensure that contracts entered between lenders and borrowers are fair and according to law.

The information that was necessary for the implementation or enforcement of the Act was unfair treatment of consumers by lenders. It was realized that creditors were introducing unfair clauses in agreements between them and their debtors, clauses that allowed them to make higher profits at the expense of the debtors (Burton, 2012; Campbell et al., 2011). In some cases, the clauses were introduced without the knowledge of debtors and this resulted in complaints. The Act has been successful in handling the problem because it has provided borrowers with the power of not only asking for more information concerning their agreements but also contest the agreement after it has come in play (Koffman and Macdonald, 2010; Mishkin, 2016). Consumers can also move to court to have the agreement rewritten if they feel that they have been treated unfairly. The law has thereby helped to lower exploitation of borrowers by lenders.

The organization that has the responsibility of enforcement is the Office of Fair Trading. The organisation has powers to investigate markets and lenders to ensure that they are fair to consumers (Ardic, Ibrahim, and Mylenko, 2011). The actions of the Office of Fair Trading are normally aimed at ensuring high level of consumer protection against exploitation.

The law has changed financial markets and institutions in a number of ways. One of them is it changed the way financial markets and institutions operated. The risk of losing the money lent out due to unfair conditions made financial institutions to revise their conditions (Burton, 2012; Mishkin, 2016). The financial markets have changed in terms of the number of lenders. The number of lenders reduced significantly as the Act tightened on conditions that one needed to satisfy before qualifying as a lender. Unscrupulous lenders had their licenses revoked. In terms of consumers, the Act encouraged more borrowing as borrowers were assured of protection should the conditions stipulated turn out to be unfair to them.

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References

  • Ardic, O. P., Ibrahim, J. A., and Mylenko, N. (2011). Consumer protection laws and regulations in deposit and loan services: A cross-country analysis with a new data set. The World Bank.
  • Bartram, S. M. (2005) ‘The Impact of Commodity Price Risk on Firm Value--An Empirical Analysis of Corporate Commodity Price Exposures’ Multinational Finance Journal, 9(3/4), pp. 161-187.
  • Burton, D. (2012) Credit and consumer society. Routledge.
  • Campbell, J. Y., Jackson, H. E., Madrian, B. C., and Tufano, P. (2011) ‘Consumer financial protection’, Journal of Economic Perspectives, 25(1), pp.91-114.
  • Choi, J. H., Kim, J. B., and Lee, J. J. (2011) ‘Value relevance of discretionary accruals in the Asian financial crisis of 1997–1998’, Journal of Accounting and Public Policy, 30(2), pp.166-187.
  • Emmers, R., and Ravenhill, J. (2011) ‘The Asian and global financial crises: consequences for East Asian regionalism’, Contemporary Politics, 17(2), pp.133-149.
  • Huyghebaert, N., and Wang, L. (2010) ‘The co-movement of stock markets in East Asia: Did the 1997–1998 Asian financial crisis really strengthen stock market integration?’, China Economic Review, 21(1), pp.98-112.
  • Koffman, L., and Macdonald, E. (2010) The law of contract. Oxford University Press.
  • Mishkin, F. (2016) The Economics of Money, Banking, and Financial Markets. 11th edn. Harlow: Pearson.
  • Mishkin, F. and Eakins, S. (2018) Financial Markets and Institutions. 9th end. Harlow: Pearson.
  • Regnier, P. (2017) Small and Medium Enterprises in Distress: Thailand, the East Asian Crisis and Beyond: Thailand, the East Asian Crisis and Beyond. Routledge.
  • Saha, D. (2011). The Collapse of Metallgesellschaft (MG): Hedging or Speculation. Available at SSRN:
  • Stulz, R. (2013) ‘How companies can use hedging to create shareholder value’, Journal of Applied Corporate Finance, 25(4), pp.21-29.
  • Zeidan, R., and Rodrigues, B. (2013) ‘The failure of risk management for nonfinancial companies in the context of the financial crisis: lessons from Aracruz Celulose and hedging with derivatives’ Applied Financial Economics, 23(3), pp.241-250.
  • Bessis, J. (2015) Risk management in banking. John Wiley & Sons.

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