1997 is remembered as the year when Asia suffered a financial crisis

triggered by the devaluation of the Thai currency. But ten years ago

this month, there was little to indicate the scale of the impending

collapse. Mark Headley, CEO and Portfolio Manager, Matthews

International Capital Management LLC, looks at some of the underlying

problems at that time, including capital misallocation and the mismatch

of foreign currency borrowings. He draws parallels with some of the more

recent lending practices in the U.S. housing market, considers the

benefits and challenges of closed currency systems, and also highlights

the positive effects that resulted in those Asian countries that rose to

the challenge of the crisis by embracing change and openness.

   

The Coming Storm — A Decade Ago

Mark W. Headley, Chief Executive Officer and Portfolio Manager

Matthews International Capital Management, LLC

Asia began 1997 in rather fine shape. While markets were generally not doing much, Hong Kong was feeling very good about its future marriage with China. Korea and Thailand were sputtering seriously in 1996, but not in a way that unnerved regional markets. I wrote that February in this publication that there was "an excellent chance that a low inflation and rising earnings environment will characterize the majority of the regional markets this year." I learned a great deal about making market predictions in the next eighteen months.Paul Krugman's article on the "Myth of the Asian Miracle" had provided the closest thing to an accurate prediction of a coming economic unraveling. While Asia was not quite the Soviet system Krugman suggested, it had gone through a long period of capital misallocation that was about to cause a great deal of pain. Currency systems would collapse, political systems would transform, and a severe recession would devastate corporate profits as much of Asia would be pulled into the maelstrom. A primary culprit was the failure of Asian companies to match their domestic currency earnings with domestic currency borrowings. A decade of stability in most Asian currencies relative to the dollar had brought on a major case of denial as to the structural risks of dramatic currency moves.While we tended to believe that the necessary devaluation of the Thai baht would be a healthy adjustment that could boost the economy, there was another side to the story. The vast amount of U.S. dollar borrowings by Asian corporations was widely hidden from view. Chief financial officers across Asia had sought to reduce their companies' borrowing costs by tapping into low interest loans from U.S. banks. A comparison to the current subprime lending practices is not inappropriate. U.S. banks provided relatively unsophisticated Asian borrowers with short-term debt that depended on the continuation of their recent earnings growth. When the artificial stability of local currencies was undone, a vicious cycle rapidly developed and a perfect storm swept across the region. Interest rates rose to defend currencies, pushing already panicked domestic markets into nosedives that further eroded currencies and eventually doomed domestic economies to severe recessions. Without making any predictions, U.S. banks have again made loans to an unsophisticated client base that borrowed on the assumption of long-term property appreciation and low interest rates.The beginning of 1997 saw no accurate description of the coming unraveling. While we criticized regulatory restrictions and poor corporate governance, others attacked wasteful spending and poor political stability. Krugman came closest to the mark but still missed the key issue of an unsustainable currency system that prompted destructive borrowing. The fact was that few really cared. Asia was seen as a fringe market. With Japan already underperforming for years, many international funds had comfortably turned to Europe with the bulk of their portfolios. The U.S. was deep into a powerful bull market driven by the new "miracle" of the NASDAQ.Valuations were not a very good guide to the coming disaster. Korea and Thailand looked very cheap after recent falls, and elsewhere only hot China plays looked exceptionally expensive. Predicting a collapse in corporate earnings due to a structural shift in currency systems is not something one can count on. In order to understand the devastation that was about to be inflicted on what this biased observer thought was a portfolio of reasonably high quality growth stocks in Asia ex-Japan, consider this: the Matthews Pacific Tiger Fund went from a peak NAV of $13.55 in August 1997 to a low of $4.03 in September 1998.The lessons of the Asian Financial Crisis are many, and we plan on visiting a number of them in greater detail over the coming year. Closed economies, like Korea's before the Crisis, tend to develop significant misallocations of capital. Can China escape such a fate today? Closed currency systems proved to have some advantages over the open and partially open currency systems in underdeveloped economies. While Indonesia and Thailand watched currency depreciation rip their economies apart, China and India sat behind currency controls relatively unscathed. Much of China's concern about a free floating currency today related to the fear of potential currency instability rather than mercantilist desire to drive exports. Democracies have the benefit of being able to let off steam and change leadership in times of distress, while Indonesia's dictatorship collapsed under the stresses of economic pain.Those countries that embraced change and allowed openness during the Crisis, epitomized by the brave actions of Korea's President Kim Dae Jung, have seen far better economic performance and stronger returns than those countries that retreated behind barriers, like Malaysia. Where foreign competition was allowed and partnerships with multi-nationals occurred, a positive effect was generally seen across whole segments of the economy, even as local firms were forced to compete with global players. In the process, much of Asia exited the Crisis on a stronger footing. Some countries saw profound change, others only marginal improvement. Investors have been well served by that period of transformation, but this is no reason for complacency.The real defense to a secular bear market lies in the answer to the question of whether or not you will panic. Most investors panic, this is a fact. When the world appears to be coming to an end, do you have the perspective and the financial reserves to be a buyer, or will you join the many sellers that streamed out of Asian assets at the bottom?April 5, 2007