Frame of Reference
The ultimate goal of the asset markets as well as of the financial, monetary and banking systems, is to increase the efficiency of real activity and resource allocation and thus to boost the country’s economy. The disruptions in these systems generally have a nega-tive impact on the economy and are broadly referred to as financial or economic crises.
Such crises can originate in the government, financial institutions or in the financial markets. Goldstein and Razin (2012) conduct an extensive review, summarizing and an-alyzing literature on the topic of financial crises developed over the past thirty years. They classify the various types of financial crises and respectively categorize the litera-ture into three categories: banking crises and panics; credit frictions and market freezes; and currency crises.
In the following sections a closer look will be taken into currency and banking crises. Firstly the two branches of literature dedicated to the topic of currency crises are dis-cussed – namely the first- and second generations of models. After, causes and implica-tions of a banking crisis are presented. Finally introducing a relatively new branch of literature that was developed following the events of East Asian crisis – the third gener-ation of models concludes the chapter3.
Currency crises are generally characterized in the literature as a speculative attack on the foreign exchange value of a country’s currency. A government, with the goal of keeping the economy stable, maintains certain financial and monetary regulations, most commonly a fixed exchange-rate regime. In particular circumstances these regulations become unsustainable, putting the country’s central bank under pressure to abandon the exchange rate peg of the local currency. This usually results in dramatic change in the value of the currency over very short period of time. Such rapid changes often pose se-vere implications for the economy, resulting in decreased output, possible inflation, and a disruption in both domestic and foreign financial markets.
While the effects and the causes of any particular currency crisis may differ from one country to another, a high level of pressure on the exchange market caused by speculative attacks is something they all share. Speculative attacks occur because investors may anticipate certain fluctuations in a currency’s exchange rate – most commonly a fear of sharp decrease in the value of a currency. This anticipation causes large outflows of funds from the local currency, usually on top of the existing balance of payment deficit. Given such pressure on the exchange market, keeping the currency from devaluating becomes challenging and costly for the central banks. Keeping the currency at a stable level may, among other things, imply: draining the government’s foreign reserves, bor-rowing from abroad, increasing the interest rates or imposing capital controls in order to limit the outflows.
Over- or undervaluation of the local currency, which is often the outcome of inconsist-encies between the domestic exchange rate and economic policies are the fundamental causes of currency crises. Therefore countries with floating exchange rates are, in theo-ry, more resilient to currency crises, as ongoing adjustments of the market economy limit the possibility of extreme fluctuation in the value of a currency. On the other hand, countries that adopt a pegged or intermediate exchange rate regimes are less resistant to currency crises and are in most cases forced to abandon the peg upon experiencing such a crisis.
While most of the currency crises are associated with downward pressure on the local currency (i.e. investors fearing that the currency will depreciate), appreciation of the currency may also be anticipated, putting an upward pressure on the local currency. This case is most notable for China, where there is an ongoing debate on whether the currency is under- or overvalued as compared to what its value would be in the case of floating exchange rate regime. The debate is summarized in Yang, J., Yin, H., He, H. (2007) and will not be further addressed in this paper.
The currency (or balance of payment) crises taking place around the globe over the dec-ades following the collapse of the Bretton Woods system have encouraged a huge amount of academic research on the topic. The desire to explain the causes of currency crises, as well as the need to detect and prevent the crises from happening in the future, have generated three branches of theoretical models, each of which focuses on specific aspects that cause a currency crisis. These models will be discussed in the following sections.
Trilemma in International Finance
In their reviews of theories on currency crises, Glick and Hutchison (2011) and Gold-stein and Razin (2012) advise to consider the basic trilemma in international finance (al-so referred to as impossible trinity or unholy trinity) to better understand the origins of a currency crisis. This trilemma occurs in the context of international finance as most countries aim to accomplish the following three goals simultaneously:
In order to benefit from the skills and know-hows brought into the country by for-eign investors as well as to allow domestic investors to diversify their portfolios abroad, the policy makers would like to have the economy open to international trade and capital flows, increasing global financial interaction and capital mobility over time.
To be able to stabilize the financial sector of the economy as well as some of the fundamental economic variables such as inflation and output, an independent mone-tary policy and full control over domestic interest rates is the second goal for policy makers. When this is the case, the central bank can either increase or decrease the money supply and respectively reduce or raise the interest rates when the economy is either in a recession or overheated.
Finally, the policy makers want to preserve the exchange rate at a stable level by the means of fixed or managed exchange rate regime. Volatilities in the exchange rate may lead to broader financial volatility and substantially damage the trade prospects for domestic businesses as well as cause uncertainty for the investors.
The impossible trinity implies that a country is only able to achieve two out of the three goals listed above. The constraints imposed by this trilemma have been put to test by a number of countries resulting in some of the world’s most severe currency crises.
When a country wishes to maintain capital mobility and the exchange rate is pegged to another country’s currency, the domestic interest rates become linked to those abroad based on the interest rate parity principle. This severely limits the central bank’s flexi-bility to pursue an independent monetary policy, as the money supply is now automati-cally adjusted to the domestic interest rates. If the central bank would, for example, try to raise the domestic interest rates above those abroad by the means of contractionary monetary policy, capital inflow would be encouraged in response, which would in turn reduce the initial rise in the domestic interest rate (Glick and Hutchison, 2011).
The above scenario was the case for individual members of the EMU, which were hit by speculative attacks during 1992-1993, as Germany was fighting the inflation by the means of raising domestic interest rates. As a result, other EMU members who had their currencies pegged to the Deutschmark also experienced an increase in their domestic in-terest rates. Large speculative flows of capital started taking place and some countries were forced to leave the EMU and depreciate their currencies as a consequence (Glick and Hutchison, 2011).
The conclusion is that for the central bank to maintain control over the domestic interest rate and/or monetary policies while having open capital flows, the exchange rate needs to float freely, as is the case in the United States. Alternatively, if the government pri-oritizes to keep the exchange rate under control while being able to have an independent monetary policy, capital control needs to be imposed, as is the case in China (Goldstein and Razin, 2012).
First Generation Models on Currency Crises
The collapse of the Bretton Woods, the global system of fixed exchange rates, in the 1970s has encouraged academics to design a branch of models to explain the events that took place. These works are now referred to as the first generation of models on curren-cy crises.
The first work regarding this topic dates back to Krugman (1979)4, who described a sit-uation in which a government attempts to maintain a fixed exchange rate regime but is also a subject to increasing current account and fiscal deficits. To finance the imbalance, the government will need to continuously spend their foreign reserves or borrow from abroad. This is something the government cannot do indefinitely and therefore an attack on a fixed exchange rate regime, according to the model, is inevitable.
Speculators will attempt to profit once they realize that the central bank may run out of the reserves and not be able to maintain the exchange rate. Investors, on the other hand, fearing the increased likelihood of domestic currency devaluation due to increasing deficit, will change their portfolio by rapidly selling domestic assets. Foreign reserves of the central bank will continue depleting until they reach a critical point where the peg is no longer sustainable, resulting in the collapse of the fixed exchange rates regime and sudden devaluation of the domestic currency.
The model was later extended and elaborated on by Flood and Garber (1984). Accord-ing to the model, a fixed exchange rate regime is inconsistent with the capital mobility and fiscal imbalances because central bank’s domestic assets will continue to grow, but the total assets must stay at a constant level, since the domestic interest rate is deter-mined by the foreign interest rate based on interest rate parity.
The need to finance the fiscal deficit requires domestic interest rates to decrease, which in turn requires the exchange rate to increase. The only solution for the central bank to avoid the latter is to intervene into the market and reduce their foreign assets, so that the decrease in foreign assets evens out the increase in domestic assets. As the foreign re-serves disposable to the central bank have a limit, this process cannot continue indefi-nitely. Referring to the trilemma described in the previous section, given free capital mobility, the central bank will eventually be forced to abandon the peg and allow for free exchange rate fluctuation.
Second Generation Models on Currency Crises
First generation models, with the assumption of essential inconsistency between various government policies, became challenged during the 1990s, following the EMU crisis of 1992-1993 and the Latin American crisis of 1994-1995. The EMU crisis, according to Rose and Svensson (1994) came as a surprise – given the absence of significant changes in the fundamental variables, the first generation models were unable to explain why in-vestors changed their expectations regarding the exchange rate peg so drastically and thus a new branch of models to explain the crises were needed.
One of the problems with the framework of the first generation models was the difficul-ty to reason why the government would try to maintain the exchange rate peg and, sim-ultaneously, conduct a policy that will eventually cause a currency crisis. As a result, the second generation of models on currency crises were initiated by Obstfeld (1994, 1996) and later developed by Rangvid (2001). These models present a new way to ana-lyze the government’s behavior in the period leading up to a currency crisis and highlight the lack of strong correlation between fundamental economic variables and the be-havior of the agents. The models assume that at every single period of time, the gov-ernment will analyze the costs and benefits of maintaining the peg and may adjust the policies in response to the attack or may choose to abandon the exchange rate regime if the costs of keeping it exceed the benefits. Additionally, these models assume multiple equilibria5 for the rate of currency devaluation, where expectations of the private inves-tors are self-fulfilling. The government will be forced to conduct a policy that is ex-pected by the agents.
A dilemma for the government exists, as the policy designed to defend a given ex-change rate level comes with the cost of defense. Referring to the previously discussed trilemma, due to a fixed exchange rate regime, the government will not be able to use monetary policy. In this generation of models, doubts from the agents in regards to whether the government will maintain the peg or not lead to speculative currency at-tacks, which may succeed even when the government’s current policy does not remain inconsistent with the exchange rate commitment (as was the case in the first generation of models).
Banking Crises and Third Generation Models
In general, banks rely on short-term deposits by private investors to finance their long-term debt. While being a fundamental element for economic growth as well as improv-ing the welfare of the population, this scheme relies on the assumption that only a frac-tion of the investors will need to redeem their savings in the short-term. The scheme be-comes unsustainable once a large number of private investors (significantly more than the fraction initially forecasted by the bank) redeem their deposits within a short period of time. Such a situation is referred to as bank runs and forces the banks to release their long-term investments at a loss. Such unpredicted behavior on a large enough scale will ultimately cause the bank to collapse.
Diamond and Dybvig (1983) were first to investigate this phenomenon and to provide a framework for its analysis. According to the framework, bank runs happen in equilibri-um, as it is indeed considered rational behavior for investors to withdraw deposits from the banks once there is a common belief that the bank will collapse. The fundamental problem here, as discussed in Goldstein and Razin (2012), is the failure of coordination: the more investors that withdraw their deposits from a bank – the more of an incentive there is for other investors to withdraw their money and thus the more likely a bank is to fail. This behavior quickly creates a panic and rapidly spreads from one bank to another, as more and more depositors feel the need to withdraw their funds – not because they need them, but because they fear a possible collapse of their bank. As a result many banks fail at the same time and such systemic collapse negatively affects other parts of the economy.
The East Asian crisis of 1997 could not be explained by the first, or by the second gen-erations of models. The crisis has led the affected countries into abandoning the ex-change rate peg, but also substantially damaged financial and banking institutions. This has inspired a new generation of research on the interplay between a currency crises and distortions in the financial and banking systems (often referred to in the literature as the twin crises)
Krugman (1999) presented the first literature regarding this new generation of crises, where he talks about currency mismatch between the assets (denominated in domestic goods) and liabilities (denominated in foreign goods) of domestic firms. Depreciation of the real exchange rate therefore directly damages the firms’ balance sheet, resulting in reduced borrowing and ultimately reduced domestic investment. Decreased investment in the domestic market implies a decrease in demand for local goods in comparison to foreign, which in turn leads to real depreciation.
Table of Contents
3.1 High Growth and Sound Macroeconomic Fundamentals in East Asian Countries
3.2 Structural Weaknesses of the Asian Economies and the Crisis of 1997
3.3 The Events of 1997
4 Frame of Reference
4.1 Currency Crises
4.2 Trilemma in International Finance
4.3 First Generation Models on Currency Crises
4.4 Second Generation Models on Currency Crises
4.5 Banking Crises and Third Generation Models
5 Literature Review on Asian Currency Crises
5.2 Econometric Studies
5.3 Conclusions of the Models
6.2 Foreign Direct Investment (FDI)
6.3 GDP Growth
6.4 Short-term Debt (% of Reserves)
6.5 Financial and Capital Account Liberalization
6.6 Domestic Credit
6.7 Real Interest Rates
8 Further Research
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The East Asian Crisis of 1997: Causes and China’s Resilience