What was the 1997 Asian economic crisis? How did the crisis affect LTCM?
Several Asian countries experienced a currency collapse in 1997. The crisis eventually found its way to the US, affecting several hedge funds, including LTCM.
Here’s how the 1997 Asian economic crisis led to the collapse of LTCM.
The 1997 Asian Financial Crisis Breakdown
In 1997, the currencies of several Asian countries—Indonesia, Malaysia, the Philippines, South Korea, and Thailand, the so-called “Asian tigers”—collapsed. In the years leading up to the crisis, investors had mistakenly believed that the economies of these nations were on sounder footing than they actually were. As a result, when these currencies collapsed, those investors found that their money was now tied up with these sharply devalued currencies. The crisis spread to the US as the American stock market suffered a 7% decline in a brutal selloff on October 27, 1997.
The 1997 Asian economic crisis threatened to undermine LTCM’s whole strategy. In a turbulent market, asset prices tend to fall together: There aren’t price discrepancies, says Roger Lowenstein, because everything collapses at the same time. There wouldn’t be arbitrage opportunities to exploit: There would instead be a liquidity crisis where everyone was trying to sell their much-discounted assets at the same time, LTCM included. This had the potential to wipe out the fund.
(Shortform note: Experts suggest that during a liquidity crisis, businesses can take some key steps to protect themselves. The steps include understanding their current cash position, cash flows, and the impact of the crisis on their operations. Companies should focus on managing cash flows, which may involve accelerating cash collections, delaying payments, and closely monitoring working capital. Businesses should develop various financial scenarios to understand the potential impacts of the crisis on their liquidity. This helps in making informed decisions and contingency planning. Finally, companies should explore all available sources of capital, including bank credit lines, government relief programs, and negotiations with lenders and investors.)
|Currency Pegs, Overvaluation, and the 1997 Asian Financial Crisis
To give a more complete understanding of the circumstances that led to LTCM’s collapse, it’s worth adding some historical context for the 1997 Asian financial crisis. The crisis was triggered by the fixed exchange rate regimes or “currency pegs.” By pegging their currency to a stronger foreign currency (like the US dollar), developing countries (like the Asian countries affected by the crisis) often hope to instill confidence in foreign investors and facilitate trade. By pegging their currency to a stronger one, these countries aim to provide stability and predictability for businesses and investors, making it more attractive for foreign capital to flow into their economies.
However, when currencies are pegged to stronger ones, they can become overvalued, meaning their exchange rate doesn’t accurately reflect economic fundamentals. This is what happened in 1997. Due to the overvalued currencies, many businesses in these Asian countries borrowed in US dollars, at low interest rates. However, when their local currencies devalued, the real cost of servicing this debt in foreign currency soared, causing financial distress and corporate bankruptcies. As the crisis deepened, several Asian countries were forced to abandon their currency pegs and allow their currencies to devalue. While this helped restore export competitiveness, it significantly impacted foreign investors who had assumed the exchange rate was stable and suffered losses when the local currencies devalued.