The 1997 Asian Debt Crisis

Began in July, 1997.

Basically, Asian corporations borrowed lots of Dollars and converted the loans to local currency. This allowed them to pay a much lower interest rate on the loans. Since the exchange rate of many nations was fixed to the dollar, hedging didn't occur.

So why was the exchange rate fixed? To attract foreign investment. Theoretically foreign investment is good for a country - it starts new businesses, brings in cash, et cetera. However, if all the investors believe there's too much risk of losing their invesment (because the exchange rate could change and wipe out any gains they made), they don't invest. So a country says to the world 'Look! Our exchange rate is pegged to the dollar! What you put in is what you get out!'

However, when you peg an exchange rate, you basically paint a target on yourself. Sooner or later everyone knows something will shift in your country so that there is an imbalance and your peg will have to be maintained by force. This presents an opportuinity for speculators who, when they see such an imbalance (for example, every month you import twice as much as you export), can start to bet against your currency by (for example) taking loans in local currency and buying dollars with them. If the exchange rate shifts (so a dollar buys more of the local currency), they can pay back the loan with fewer dollars, and pocket the rest.

This speculation puts further downward pressure on a currency (in addition to any pressure it was already experiencing). The sensible thing to do would be to move the peg. But that might make all the investors run away. So the country defends its currency (by spending international reserves it has kept back for just such an occasion to buy local currency, and thus prop up the value). Well, if the pressure keeps up long enough, the country runs out of money and the value of the currency plummets.

So now we go back to the corporations who borrowed lots of money in dollars. Suddenly they owe two or three times as much (measured in local currency) as they did before. And they start going bankrupt.

So Asia has a financial crisis. Now the question is, why the heck did Brazil get hit? This is the idea of 'Contagion.' Let's take a speculator who has money highly leveraged throughout the world. He or she takes heavy losses in Asia, and has to pay back the loans. So a position which was profitable gets sold for cash. And if enough people do that, totally unrelated areas of the world suddenly start to see all their investors leaving, for no good reason.