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Asian Financial Crisis: Causes, Response, Lessons Learned

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Asian Financial Crisis: Causes, Response, Lessons Learned

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What Was the Asian Financial Crisis?

The Asian financial crisis, also called the “Asian Contagion,” was a sequence of currency devaluations and other events that began in July 1997 and spread across Asia. The crisis started in Thailand when the government ended the local currency’s de facto peg to the U.S. dollar after depleting much of the country’s foreign exchange reserves trying to defend it against months of speculative pressure.

Just weeks after Thailand stopped defending its currency, Malaysia, the Philippines, and Indonesia were also compelled to let their currencies fall as speculative market pressure built. By October, the crisis spread to South Korea, where a balance-of-payments crisis brought the government to the brink of default.

Other economies also came under pressure, but those with solid economic fundamentals and hefty foreign exchange reserves fared much better. Hong Kong fended off several major but unsuccessful speculative attacks on its currency, which is pegged to the U.S. dollar via a currency board system and backed by massive U.S. dollar reserves. 

Key Takeaways

  • The Asian financial crisis started in July 1997, when Thailand stopped defending the baht after months of downward market pressure, causing the currency to fall quickly.
  • The contagion spread quickly, with currencies across the region falling—some quite catastrophically.
  • The crisis was rooted in economic growth policies that encouraged investment but also created high levels of debt (and risk) to finance it.
  • The International Monetary Fund (IMF) bailed out many countries but imposed strict spending restrictions in exchange for the help.
  • Affected countries have since put in place mechanisms to avoid creating the same scenario in the future.

Impact of the Asian Financial Crisis

As the Thai baht fell, other Asian currencies fell—some precipitously. Across Asia, inflows of capital slowed or reversed.

The Thai baht had been trading at about 26 to the U.S. dollar before the crisis but lost half its value by the end of 1997, falling to 53 to the dollar by January 1998. The South Korean won fell from about 900 to the dollar to 1,695 by the end of 1997. The Indonesian rupiah, which had been trading at around 2,400 to the dollar in June 1997, plummeted to 14,900 by June 1998, less than one-sixth its precrisis level.

Some of the more heavily affected countries fell into severe recession. Indonesia’s gross domestic product (GDP) growth fell from 4.7% in 1997 to -13.1% in 1998. In the Philippines, it slid from 5.2% to -0.5% over the same period. Malaysia’s GDP growth similarly slid from 7.3% in 1997 to -7.4% in 1998, while South Korea’s contracted from 6.2% to -5.1%.

In Indonesia, the ensuing economic crisis led to the collapse of the three-decade-old dictatorship of President Suharto.

The crisis was alleviated by intervention from the International Monetary Fund (IMF) and The World Bank, among others, which poured some $118 billion into Thailand, Indonesia, and South Korea to bail out their economies.

As a result of the the crisis, affected countries restructured their economies, generally because the IMF required reform as a condition of help. The specific policy changes were different in each country but generally involved strengthening weak financial systems, lowering debt levels, raising interest rates to stabilize currencies, and cutting government spending.

The crisis also serves as a valuable case study for economists to understand how interwoven markets affect one another, especially as it relates to currency trading and national accounts management.

Causes of the Asian Financial Crisis

The crisis was rooted in several threads of industrial, financial, and monetary government policies and the investment trends that they created. Once the crisis began, markets reacted strongly, and one currency after another came under pressure. Some of the macroeconomic problems included current account deficits, high levels of foreign debt, climbing budget deficits, excessive bank lending, poor debt-service ratios, and imbalanced capital inflows and outflows.

Many of these problems were the result of policies to promote export-led economic growth in the years leading up to the crisis. Governments worked closely with manufacturers to support exports, including providing subsidies to favored businesses, more favorable financing, and a currency peg to the U.S. dollar to ensure an exchange rate favorable to exporters.

While this did support exports, it also created risk. Explicit and implicit government guarantees to bail out domestic industries and banks meant investors often did not assess the profitability of an investment but instead looked to its political support. Investment policies also created cozy relationships among local conglomerates, financial institutions, and the regulators who oversaw their industries. Large volumes of foreign money flowed in, often with little attention to potential risks. These factors all contributed to a massive moral hazard in Asian economies, encouraging major investment in marginal and potentially unsound projects.

As the crisis spread, it became clear that the impressive economic growth rates in these countries were concealing serious vulnerabilities. In particular, domestic credit had expanded rapidly for years, often poorly supervised, creating significant leverage along with loans extended to dubious projects. Rapidly rising real estate values (often fueled by easy access to credit) contributed to the problem, along with rising current account deficits and a buildup in external debt. Heavy foreign borrowing, often at short maturities, also exposed corporations and banks to significant exchange rate and funding risks—risks that had been masked by long-standing currency pegs. When the pegs fell apart, companies that owed money in foreign currencies suddenly owed a lot more in local currency terms, forcing many into insolvency.

Many Asian economies had also slid into current account deficits. If a country has a current account surplus, that means it is essentially a net lender to the rest of the world. If the current account balance is negative, then the country is a net borrower from the rest of the world. Current account deficits had grown on the back of heavy government spending (much of it directed to supporting continued export growth).

Response to the Asian Financial Crisis

The IMF intervened to stem the crisis with loans to stabilize the affected economies. The IMF and others lent roughly $118 billion in short-term loans to Thailand, Indonesia, and South Korea. The bailouts came with conditions, though: Governments had to raise taxes, cut spending, and eliminate many subsidies. By 1999, many of the affected countries began to show signs of recovery.

Other financial institutions also intervened. For example, in December 1997, the U.S. Federal Reserve Bank brokered a deal under which U.S. banks owed money by South Korean companies on short-term loans voluntarily agreed to roll them over into medium-term loans.

Lessons from the Asian Financial Crisis

Many of the lessons of the Asian financial crisis remain relevant today. First, beware of asset bubbles, as they have a habit of bursting. Another is that governments need to control spending and pursue prudent economic development policies.

How do government spending and monetary policy affect a currency’s value?

When governments spend, implement policies that keep taxes low, subsidize the price of staple goods, or use other methods that effectively put more money in people’s pockets, consumers have more money to spend. As most economies rely at least partly on imports for many goods and services, this increased spending creates demand for foreign currency (usually U.S. dollars), as importers have to sell local currency and buy foreign currency to pay for imports.

Demand for foreign currency (and selling of local currency to buy it) increases exponentially when those policies also promote heavy investment in infrastructure, new businesses, and other economic projects. As more local currency is offered for sale on foreign exchange markets, its value goes down, unless there is a corresponding demand to buy it (say, by exporters selling foreign currency that they earn from exports).

Why do governments keep exchange rates high?

Governments, especially in developing economies, seek to manage exchange rates to balance their ability to pay debts denominated in foreign currencies. Because investors generally prefer instruments denominated in more stable currencies, governments in developing economies often raise funds by issuing bonds denominated in U.S. dollars, Japanese yen, or euros.

However, if the value of the domestic currency falls vs. the currency in which its debt is denominated, that effectively increases the debt, as more local currency is needed to pay it. So, when the Thai baht lost half of its value in 1997, that meant local borrowers needed twice as many baht to pay debts denominated in U.S. dollars. As many developing countries also rely on imports, a higher-valued local currency also makes those imports cheaper in local currency terms.

Why do governments keep exchange rates low?

Conversely, governments may seek to keep their exchange rates low to increase the competitiveness of exports.

In the 1980s, following years of complaints from U.S. companies about competition from cheap Japanese imports, the U.S. government convinced Japan to allow its currency to appreciate as part of the Plaza Accord. The currency’s value climbed from 250 yen to one U.S. dollar in early 1985 to less than 130 yen by 1990. The U.S. trade deficit with Japan fell from $55 billion in 1986 to $41 billion in 1990.

The Bottom Line

In 1997, decades of economic policy planning that featured close relationships among government policy planners, regulators, the industries they regulated, and financial institutions came to a head when markets began putting downward pressure on Asian currencies. The most vulnerable were those countries with high levels of debt and insufficient financing to pay it.

The IMF stepped in to bail out the most affected economies, but it imposed strict conditions in exchange for the help. Some measures included requiring governments to cut spending, raise taxes, eliminate subsidies, and restructure their financial systems.

The crisis also serves as a case study in asset bubbles and how quickly panic selling can trigger contagion that central bankers cannot control.

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What Are Alternative Investments? Definition and Examples

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What Are Alternative Investments? Definition and Examples

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What Is an Alternative Investment?

An alternative investment is a financial asset that does not fall into one of the conventional investment categories. Conventional categories include stocks, bonds, and cash. Alternative investments can include private equity or venture capital, hedge funds, managed futures, art and antiques, commodities, and derivatives contracts. Real estate is also often classified as an alternative investment.

Key Takeaways

  • An alternative investment is a financial asset that does not fit into the conventional equity/income/cash categories.
  • Private equity or venture capital, hedge funds, real property, commodities, and tangible assets are all examples of alternative investments.
  • Most alternative investments have fewer regulations from the U.S. Securities and Exchange Commission (SEC) and tend to be somewhat illiquid.
  • While traditionally aimed at institutional or accredited investors, alternative investments have become feasible to retail investors via alternative funds.

Understanding Alternative Investments

Most alternative investment assets are held by institutional investors or accredited, high-net-worth individuals because of their complex nature, lack of regulation, and degree of risk. Many alternative investments have high minimum investments and fee structures, especially when compared to mutual funds and exchange-traded funds (ETFs). These investments also have less opportunity to publish verifiable performance data and advertise to potential investors. Although alternative assets may have high initial minimums and upfront investment fees, transaction costs are typically lower than those of conventional assets due to lower levels of turnover.

Most alternative assets are fairly illiquid, especially compared to their conventional counterparts. For example, investors are likely to find it considerably more difficult to sell an 80-year old bottle of wine compared to 1,000 shares of Apple Inc. due to a limited number of buyers. Investors may have difficulty even valuing alternative investments, since the assets, and transactions involving them, are often rare. For example, a seller of a 1933 Saint-Gaudens Double Eagle $20 gold coin may have difficulty determining its value, as there are only 13 known to exist and only one can be legally owned.

Regulation of Alternative Investments

Even when they don’t involve unique items like coins or art, alternative investments are prone to investment scams and fraud due to the lack of regulations.

Alternative investments are often subject to a less clear legal structure than conventional investments. They do fall under the purview of the Dodd-Frank Wall Street Reform and Consumer Protection Act, and their practices are subject to examination by the U.S. Securities and Exchange Commission (SEC). However, they usually don’t have to register with the SEC. As such, they are not overseen or regulated by the SEC as are mutual funds and ETFs.

So, it is essential that investors conduct extensive due diligence when considering alternative investments. In some cases, only accredited investors may invest in alternative offerings. Accredited investors are those with a net worth exceeding $1 million—not counting their primary residence—or with an annual income of at least $200,000 (or $300,000 combined with a spousal income). Financial professionals who hold a FINRA Series 7, 65, or 82 license may also qualify as an accredited investor.

Some alternative investments are only available to accredited investors—e.g., those with a net worth above $1 million, or an annual income of at least $200,000.

Strategy for Alternative Investments

Alternative investments typically have a low correlation with those in standard asset classes. This low correlation means they often move counter to the stock and bond markets. This feature makes them a suitable tool for portfolio diversification. Investments in hard assets, such as gold, oil, and real property, also provide an effective hedge against inflation, which hurts the purchasing power of paper money.

Because of this, many large institutional funds such as pension funds and private endowments often allocate a small portion of their portfolios—typically less than 10%—to alternative investments such as hedge funds.

The non-accredited retail investor also has access to alternative investments. Alternative mutual funds and exchange-traded funds—also called alt funds or liquid alts—are now available. These alt funds provide ample opportunity to invest in alternative asset categories, previously difficult and costly for the average individual to access. Because they are publicly traded, alt funds are SEC-registered and regulated, specifically by the Investment Company Act of 1940.

Example of Alternative Investments

Just being regulated does not mean that alt funds are safe investments. The SEC notes, “Many alternative mutual funds have limited performance histories.”

Also, although its diversified portfolio naturally mitigates the threat of loss, an alt fund is still subject to the inherent risks of its underlying assets. Indeed, the track record of ETFs that specialize in alternative assets has been mixed.

For example, as of January 2022, the SPDR Dow Jones Global Real Estate ETF had an annualized five-year return of 6.17%. In contrast, the SPDR S&P Oil & Gas Exploration & Production ETF posted a return of –6.40% for the same period.

What Are the Key Characteristics of Alternative Investments?

Alternative investments tend to have high fees and minimum investments, compared to retail-oriented mutual funds and ETFs. They also tend to have lower transaction costs, and it can be harder to get verifiable financial data for these assets. Alternative investments also tend to be less liquid than conventional securities, meaning that it may be difficult even to value some of the more unique vehicles because they are so thinly traded.

How Can Alternative Investments Be Useful to Investors?

Some investors seek out alternative investments because they have a low correlation with the stock and bond markets, meaning that they maintain their values in a market downturn. Also, hard assets such as gold, oil, and real property are effective hedges against inflation. For these reasons, many large institutions such as pension funds and family offices seek to diversify some of their holdings in alternative investment vehicles.

What Are the Regulatory Standards for Alternative Investments?

Regulations for alternative investments are less clear than they are for more traditional securities. Although alternative investment vehicles are regulated by the SEC, their securities do not have to be registered. As a result, most of these investment vehicles are only available to institutions or wealthy accredited investors.

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Accrued Income: Money Earned But Not Yet Received

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Accrued Income: Money Earned But Not Yet Received

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What Is Accrued Income?

Accrued income is the money a company has earned in the ordinary course of business but has yet to be received, and for which the invoice is yet to be billed to the customer.

Mutual funds or other pooled assets that accumulate income over a period of time—but only pay shareholders once a year—are, by definition, accruing their income. Individual companies can also generate income without actually receiving it, which is the basis of the accrual accounting system.

Key Takeaways

  • Accrued income is revenue that’s been earned, but has yet to be received.
  • Both individuals and companies can receive accrued income.
  • Although it is not yet in hand, accrued income is recorded on the books when it is earned, in accordance with the accrual accounting method.

Understanding Accrued Income

Most companies use accrual accounting. It is an alternative to the cash accounting method and is necessary for companies that sell products or provide services to customers on credit. Under the U.S. generally accepted accounting principles (GAAP), accrual accounting is based on the revenue recognition principle. This principle seeks to match revenues to the period in which they were earned, rather than the period in which cash is received.

In other words, just because money has not yet been received, it does not mean that revenue has not been earned.

The matching principle also requires that revenue be recognized in the same period as the expenses that were incurred in earning that revenue. Also referred to as accrued revenue, accrued income is often used in the service industry or in cases in which customers are charged an hourly rate for work that has been completed but will be billed in a future accounting period. Accrued income is listed in the asset section of the balance sheet because it represents a future benefit to the company in the form of a future cash payout.

In 2014, the Financial Accounting Standards Board, which establishes regulations for U.S. businesses and non-profits, introduced “Accounting Standards Code Topic 606 Revenue from Contracts with Customers” to provide an industry-neutral revenue recognition model to increase financial statement comparability across companies and industries. Public companies were required to apply the new revenue recognition rules beginning in Q1 2018. The FASB also issued the following amendments to ASU No. 2014-09 to provide clarification on the guidance:

-ASU No. 2015-14, Revenue from Contracts with Customers (Topic 606) – Deferral of the Effective Date

-ASU No. 2016-08, Revenue from Contracts with Customers (Topic 606) – Principal versus Agent Considerations (Reporting Revenue Gross Versus Net)

-ASU No. 2016-10, Revenue from Contracts with Customers(Topic 606) – Identifying Performance Obligations and Licensing

-ASU No. 2016-12, Revenue from Contracts with Customers (Topic 606) – Narrow-Scope Improvements and Practical Expedients 

Examples of Accrued Income

Assume Company A picks up trash for local communities and bills its customers $300 at the end of every six-month cycle. Even though Company A does not receive payment for six months, the company still records a $50 debit to accrued income and a $50 credit to revenue each month. The bill has not been sent out, but the work has been performed, and therefore expenses have already been incurred and revenue earned.

When cash is received for the service at the end of six months, a $300 credit in the amount of the full payment is made to accrued income, and a $300 debit is made to cash. The balance in accrued income returns to zero for that customer.

Accrued income also applies to individuals and their paychecks. The income that a worker earns usually accrues over a period of time. For example, many salaried employees are paid by their company every two weeks; they do not get paid at the end of each workday. At the end of the pay cycle, the employee is paid and the accrued amount returns to zero. If they leave the company, they still have pay that has been earned but has not yet been disbursed.

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Average Cost Method: Definition and Formula with Example

Written by admin. Posted in A, Financial Terms Dictionary

Average Cost Method: Definition and Formula with Example

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What Is Average Cost Method?

Average cost method assigns a cost to inventory items based on the total cost of goods purchased or produced in a period divided by the total number of items purchased or produced. Average cost method is also known as weighted-average method.

Key Takeaways

  • Average cost method is one of three inventory valuation methods, with the other two common methods being first in, first out (FIFO) and last in, first out (LIFO).
  • Average cost method uses the weighted average of all inventory purchased in a period to assign value to the cost of goods sold (COGS) as well as the cost of goods still available for sale.
  • Once a company selects an inventory valuation method, it needs to remain consistent in its use to be compliant with generally accepted accounting principles (GAAP).

Click Play to Learn What the Average Cost Method Is

Understanding the Average Cost Method

Businesses that sell products to customers have to deal with inventory, which is either bought from a separate manufacturer or produced by the company itself. Items previously in inventory that are sold off are recorded on a company’s income statement as cost of goods sold (COGS). COGS is an important figure for businesses, investors, and analysts as it is subtracted from sales revenue to determine gross margin on the income statement. To calculate the total cost of goods sold to consumers during a period, different companies use one of three inventory cost methods:

Average cost method uses a simple average of all similar items in inventory, regardless of purchase date, followed by a count of final inventory items at the end of an accounting period. Multiplying the average cost per item by the final inventory count gives the company a figure for the cost of goods available for sale at that point. The same average cost is also applied to the number of items sold in the previous accounting period to determine the COGS.

Example of Average Cost Method

For example, consider the following inventory ledger for Sam’s Electronics:

Purchase date Number of items Cost per unit Total cost
1/1 20 $1,000 $20,000
1/18 15 $1,020 $15,300
2/10 30 $1,050 $31,500
2/20 10 $1,200 $12,000
3/5 25 $1,380 $34,500
Total 100   $113,300

Assume the company sold 72 units in the first quarter. The weighted-average cost is the total inventory purchased in the quarter, $113,300, divided by the total inventory count from the quarter, 100, for an average of $1,133 per unit. The cost of goods sold (COGS) will be recorded as 72 units sold × $1,133 average cost = $81,576. The cost of goods available for sale, or inventory at the end of the period, will be the 28 remaining items still in inventory × $1,133 = $31,724.

Benefits of Average Cost Method

Average cost method requires minimal labor to apply and is, therefore, the least expensive of all the methods. In addition to the simplicity of applying average cost method, income cannot be as easily manipulated as other inventory-costing methods. Companies that sell products that are indistinguishable from each other or that find it difficult to find the cost associated with individual units will prefer to use average cost method. This also helps when there are large volumes of similar items moving through inventory, making it time-consuming to track each individual item.

Special Considerations

One of the core aspects of U.S. generally accepted accounting principles (GAAP) is consistency. The consistency principle requires a company to adopt an accounting method and follow it consistently from one accounting period to another.

For example, businesses that adopt average cost method need to continue to use this method for future accounting periods. This principle is in place for the ease of financial statement users so that figures on the financials can be compared year over year. A company that changes its inventory-costing method must highlight the change in its footnotes to the financial statements and apply the same method retroactively to prior period-comparative financial statements.

What is the average cost method formula?

The average cost method formula is calculated as:

Total Cost of Goods Purchased or Produced in Period ÷ Total Number of Items Purchased or Produced in Period = Average Cost for Period

The result can then be applied to both the cost of goods sold (COGS) and the cost of goods still held in inventory at the end of the period.

Why should I use average cost method?

Average cost method is a simple inventory valuation method, especially for businesses with large volumes of similar inventory items. Instead of tracking each individual item throughout the period, the weighted average can be applied across all similar items at the end of the period.

What inventory cost methods are acceptable under generally accepted accounting principles (GAAP)?

GAAP allows for last in, first out (LIFO), first in, first out (FIFO), or average cost method of inventory valuation. On the other hand, International Financial Reporting Standards (IFRS) do not allow LIFO because it does not typically represent the actual flow of inventory through a business.

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