History shows intervening in currency crises is not the only solution
Markets have been coping with euro zone contagion for years. Cyprus kicks off another round, but investors should keep their heads
Early last week the value of the euro tumbled in response to the financial turmoil in tiny Cyprus, which triggered worldwide stock market plunges. Here was another example of financial contagion, a phenomenon that is hardly new but only began to be regularly used to describe the situation in financial markets during the Asian financial crisis.
That crisis began in the summer of 1997 when the Thai government decided to devalue its currency. The ripple effects of this move were quick to engulf other East Asian states, having a seemingly indiscriminate impact on weaker economies such as the Philippines and Indonesia before moving on to cause financial turmoil in the stronger economies of Hong Kong and Singapore.
It is now clear that much of the contagion was unreasonable and the rather panicky response of the affected governments showed that the pressure of contagion was rather more powerful than the remedies adopted to fix the problem.
In Asia, the Malaysian and Hong Kong governments took draconian measures to intervene in their financial markets to restore "stability". The usually interventionist government of Singapore resisted this temptation, as did South Korea (albeit, at the time, the country put its economic affairs in the hands of the International Monetary Fund - such were the terms for accepting a massive bailout from the fund).
As the crisis unravelled, what became clear was that high levels of interventionism achieved more or less the same result as that of governments who were prepared to allow the markets to sort themselves out. Basically recovery occurred at about the same rate and so there was little evidence to prove that intervention rescued markets.
There are other lessons to be drawn from what is happening in the euro zone and what happened during the Asian crisis. Asia's crisis started in a nation with a dodgy financial base, Thailand. And although the country recovered, the baht is still below pre-crisis exchange levels with the US dollar. Moreover it is important to note that the stronger Asian economies swept up in the crisis emerged with all their strengths intact.
Meanwhile in Europe, perhaps the most remarkable thing about the euro-zone crisis is how little it affected the strength of the euro even after the shocks of what happened in Ireland, Spain and Greece, not to mention what's likely to happen in Italy and elsewhere. The thing about contagion is that it is very hard to tell when a blip will be transformed into a rout. The euro suffered a number of blips in recent times but so far they have been contained.
This tells us that, while there is always the possibility of contagion, this may not play out in an entirely rational fashion. Liquidity concerns drive contagion. In other words, investors take fright and start selling. Hong Kong's 1998 market intervention - when the government sank an estimated HK$100 billion into buying local shares at the height of the Asian financial crisis - was to counterbalance heavy selling with heavy buying.
So, what does the sensible investor do in the face of contagion? The answer is that, once it sets in, the bigger players will almost certainly have already made their move and so there is no point trailing them and selling assets at knockdown prices. The effects of contagion will pass and assets that are fundamentally strong will reassert themselves and quickly appreciate in value. So, contagions are opportunities for buying and staying calm.