Did the ‘Herd Behaviour’ give the East Asian Economies a ride during the Financial Crisis?

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By Lakshmi Priya

Introduction: Herding the Behaviour

In the world of ambiguity, rationality is encompassed by informative and cognitive curtailments. This herds the subjects to imitate and copy the actions of others during a crisis as it is the quickest decision-making device to make a qualitative perception that others are aware of. Rather than enduring the consequence of decisions made by the individual logical sense, a group perception is highly considered. Herding or demonstration effect is a psychological prodigy where the behavior of a group of subjects is catalyzed by observing the actions of the others and their consequences. Researched and probed under behavioural economics, herd behaviour is a well-defined behavioural crisis attribute that could explain the reason behind why subjects mirror the ‘wisdom of the crowd’ during the spread of any financial crisis especially the herd effect unveiled during the East Asian crisis in the late 1990s.

Witnessing Demonstration Effect During East Asian Crisis

The crisis transmission that was exhibited due to the demonstration or herding effect could also be better christened as a self-fulfilling effect or the wake-up effect or the information effect. This is because as each economy in East Asia is interconnected and the decision made by one economy would directly or indirectly affect the rest, which prompts the others to adopt similar decisions without having a choice. It is also because the world is bound by rationality and even without a direct interaction between the subjects there is a consistent social influence because of the social learning from a cluster’s decision. Herd behaviour being an amalgamation of rational and instinctive economical, psychological and sociological decision, is an end process of this social learning. As it is instinctive, it is hard to predict if the decision to follow the other subjects is right or wrong and so it is a mostly a wake-up call or an educating sign for all other subjects in the system. This research essay explains how the demonstration effect shaped the East Asian financial crisis by considering both the emerging economies and the industrialised economies as the subjects in the foreign sector.

Essence of Rationality

Herding can either be rational or irrational. Rational herding is when the subjects voluntarily ignore their understanding and analysis and depend on valuable information or reputation or compensation. But irrational herding is when the action of a subject contributes to a collective action of a group of subjects. This could be because the subject who initiates the action is a dominating subject in the group and all other subjects would just assume that the decision made by the former would be favouring all of them, which is difficult to confirm.

The East Asian crisis could be better classified under rational herding that occurred due to the social learning from information. This social influence is because of the contest of uncertainty experienced by the East Asian economies which prompted the imitation of one subject by another in the cluster to improve the domestic understanding and to provide information regarding the crisis. With respect to the emerging countries, they ignored their own private information and observed the movement and policy steps initiated by the other economies for better social learning. The decision of ignoring their own private information and joining the herd depicts that there exists a negative externality on other economies.

Speculative Jitters

During the year 1997, the South East Asian economies experienced a financial crisis due to the shift of speculative pressure from one economy to another. This shift of speculative pressure was facilitated by the herd effect. The crisis emanated in Thailand because of the devaluation of Thai Baht which drastically unfurled currency and banking crisis in other emerging economies like Malaysia, Indonesia, Thailand, and the Philippines. The values of Thai Baht, Malaysian ringgit, Indonesian rupiah, and South Korean Won weakened by 50% to 70% in the last phase of 1997. But then it gradually diffused and created less dramatic disruptions in the industrialised economies like South Korea, Taiwan, and Japan. The debt crisis in Russia (Russia cold of 1998) and the currency crisis in Brazil (Brazilian fever) were two prominent Western economies infected by the contagion effects of the Asian flu.

Elucidation of macroeconomic aspects of the crisis

The overspread crony capitalism in Indonesia, weak governance in Thailand, formidable conglomerates in South Korea, catatonic state of economic policies in Japan and existence of bad bank loans contributed to the debut of the East Asian flu. The major macroeconomic attributes that ballooned the crisis were the weakening of financial sector, high debt-equity ratio, the large lump of accumulated short-term foreign liabilities and the lack of transparencies in the lending industries of all the economies. These macroeconomic attributes were found to a great extent in the emerging economies compared to the industrialised economies. That is the reason why this crisis contagion gravely affected the emerging countries and created an imbalance and instability among them while the industrialised countries were able to reconcile their stability.
A superior role is exhibited by demonstration effect when markets of all the economies swing from a period of euphoria to a period of skepticism. As the period of skepticism gathered in the market, a panicky mode was established. During the period of euphoria, the euphoric lenders involved in the industrialised economies to diversify their portfolios while the emerging economies attempted to increase their investments and growth rates. It is stimulating that the euphoric lenders and investors preferred to invest in the industrialised countries than the emerging countries. The sharp depreciation of Thai Baht in 1997 deflected the values of the currencies of its trading partners and there was a shift of speculative pressure from Thailand to the Philippines.

Chronology of crisis transmission

Chronologically the speculative pressure or the herd behaviour was witnessed from Thailand to Philippines, Malaysia, Indonesia, Singapore, Taiwan, South Korea and Japan (Figure 1). Singapore was the economy that acted as an intermediary in transferring the panic attack from the emerging economies (like Indonesia) to the industrialised economies (like Taiwan). With the origin of the demonstration effect in Thailand, the emerging economies like the Philippines, Malaysia, Indonesia, and Singapore were gravely affected by the crisis compared to the industrialised economies as mentioned previously. The decisions and the herd behaviour were mutually affected and transmitted between Singapore and Malaysia. Decisions made by Thailand indirectly affected by Indonesia and South Korea had its impact on the Philippines. This clarifies how Malaysia and Thailand occupied the most persuasive and influential role while Indonesia and the Philippines had a meager role in the transmission of the contagion. Indonesia and the Philippines had a little role as they were left with no choice but to adapt to the changes brought forth by Thailand and South Korea respectively. This was because of the interdependency of the economies with one another.

Capture

 

Figure 1: Chronology of the crisis transmission

The first phase of the Asian financial crisis was majorly occupied by the spread of the contagion effect or spread of volatility while the later phase was engaged and dominated by the herding behaviour. Thus, it could be mentioned that the contagion is the effect of the crisis and the herding effect is the consequence of the contagion. The crisis contagion in the foreign sector of East Asian economies is better elucidated only by referring its consequence, i.e. herd behaviour. The closer the trade relationship between any two economies, the greater the demonstration effect experienced during the crisis period. The geographical closeness and the bilateral and multilateral relationship between the economies were closely twined. This crisis being a regional crisis within the South East Asian economies, it is notable how factors related to international trade plays a major role than the macroeconomic factors concerning the region. And so, the channels that espoused the passage of herd behaviour are interconnected trade relationships and the integrated South East Asian foreign financial sector.

Thailand and Malaysia, inhabiting the foremost role in the crisis, shaped the implosion of the bubbles in the stock prices and the real estate prices when the money inflow to them declined. As many of the companies on the list of stock markets owned large properties, it could be reasonable to state that the real estate bubble triggered the bubbles in the stock market. But the main factor that contributed to the bubble burst in real estate was the inhibition of poor investment decisions in the real estate market. In addition to this, few other economies were facing a huge capital outflow and weak financial sector which made them vulnerable to the attack of the crisis. Considering the theories under behavioural economics, this evoked a psychological impact on the market along with the erosion of domestic confidence within the economies. The depreciation of the Thai Baht was trailed by the direct depreciation of other domestic currencies. Here, the panicking lenders hedged by selling off their domestic currency due to the fear of the hopeless consequences of unhedged lenders. Due to this roll-over risk, there were high short-term financial liabilities and obligations which contributed to the development of insecurities among the hedged lenders that if some unhedged lenders do not roll-over their economy’s obligation then the other lenders would be left with non-performing loans.
Interestingly, the affected emerging economies were accounted with similar symptoms of vague financial and economic policies, persistent exchange rate, impulsive reversal of capital accounts, disconnected regulation and supervision system and overexpansion of domestic credit which led to unwanted private investment. In short, the traditional external sector or foreign sector vulnerabilities led to the appreciation of real exchange rates which directly prompted the slowdown of the gathering of export revenues. As the export revenues reduced, the current account deficits started piling up. As mentioned before, surprisingly during the crisis the industrialised countries were least affected by the contagion. This is mainly because these countries have established better governance and institutional strength than the emerging economies. This helps in interpreting that both the set of emerging and industrialised countries succumbed to the crisis but only the industrialised countries endured and retained its robustness. All the emerging economies were inflicted by the symptoms as mentioned above and were majorly shaken by the speculation pressure. It was hard for these economies to gather their stability like the strong ones.

Lucid demarcation of the herd behaviour

The herd behaviour in the Asian crisis context could be clarified and described using two methods- market and country effect. The cross-country contagion effect is when the volatility in the market is transmitted from market to another in the same economic system. In the Asian crisis, it is the turbulences or instabilities within the domestic currency system transmitted to the security market system of each economy. The first wave of exchange rate volatility stirred the domestic corporations with unhedged foreign currency exposure to the urgency of hedging. With reference to the cross-country contagion effect, it is the transfer of the instability from one country to another as mentioned before due to international interconnected trade deals. In both the cases, a wave of speculation was transferred from one market to another and from one country to another.

Conclusion: Steering by the herd behaviour

Psychologically the Asian crisis showcased a novel relationship between the subjects and the marvel of herding. It could be argued that the industrialised economies were first prone to investing in the information during the spread of the contagion while the emerging economies tend to imitate the portfolio decisions initiated by the industrialised economies. It is hard to comprehend if the attempt of the latter in imitating the former was a wise choice or not, as it is uncertain and unpredictable. And moreover, there is a large gap between the macroeconomic policies between these subjects which makes it harder for the emerging countries to cope with the hostile consequence of the herding effect if any.

Herd mentality gave the economies a ride during the financial crisis because these subjects were wired to follow one another. Interrelated to one another, the decision made by one economy affected another directly. In addition, due to the paucity of information and advance of threat, each economy is terrified to follow their own logic as there are uncertainties in the market. The broadcast of economic and political distress of economies and the news of stock and real estate bubble burst are the crucial instruments that ensured the passage of speculations. These rumors of disruption instill the subjects in choosing a herded decision. This herded decision leads to the spread of the financial crisis to all the economies that followed or adopted the same decision. In the end, it is interesting how economics, psychology, and sociology are conglomerated under behavioural economics to explain the course of the crisis, the behaviour of the subjects during the crisis, the effect of one subject on another and the recovery of all the subjects.

References
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Lakshmi Priya is a second year masters ‘ student of Diplomacy in Law and Business at Jindal School of International Affairs.

Featured Image Source: Daily Voice News

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