What we know,what we still need to know: the Asian currency crisis revisited

From the literature on currency crises, it is widely understood that weak economic fundamentals increase tremendously the probability of currency crises, especially in emerging markets. However, what was not known is that an accumulation of small problems interacting with each other can be equally damaging. Using a new technique, a combination of Classification and Regression Tree (CART) and Logit regression, this paper re‐examines the causes of the Asian currency crisis in 1997–98. The results indicate that although weak fundamentals were at the root of the crisis, only self‐fulfilling panic and herd behaviour can explain the severity of the crisis. Contrary to previous empirical research, our results indicate that the Asian crisis was caused by the accumulation of small fragilities rather than large deficiencies in the macroeconomic fundamentals. An important policy implication of such findings is the need for governments not to underestimate small problems, which, when they interact, can create chaos. Another novelty of this paper is the interpretation of the crisis in terms of the concepts of trigger and vulnerability, using an empirical model that captures the magnitude of the self‐fulfilling panic and its contribution to capital reversal and eventually to the collapse of the currencies.     

What Caused the Korean Currency Crisis in 1997?*: Weak Fundamentals or Self‐fulfilling Expectations*

The present paper investigates which factor is primarily responsible for the sharp depreciation of the Korean won against the US dollar in 1997, using a bivariate vector autoregressive model of real and nominal exchange rates. In the present study, we directly identify the relative importance of fundamental and non‐fundamental factors from the raw data series on exchange rates. This approach is different from most previous studies on the Korean currency crisis, which use proxy variables to represent the two factors. The empirical results show that the collapse of the Korean currency in 1997 appears to be mostly a result of the weakened macroeconomic fundamentals of the economy with, to a limited extent, some non‐fundamental factors.     

China's vulnerability to currency crisis: A KLR signals approach

In this paper we use the Kaminsky–Lizondo–Reinhart (KLR) [Kaminsky, G., Lizondo, S., Reinhart, C., 1998. Leading Indicators of Currency Crises. International Monetary Fund Staff Papers 45, 1–48.] approach to conduct an ex-post study of the probabilities of China suffering a currency crisis during the period of January 1991 to December 2004. Two high-probability periods are identified: July 1992–July 1993 and August 1998–May 1999. The first period correctly predicts China's 1994 devaluation. The second period predicts currency devaluation in the aftermath of the Asian crisis, which did not occur. The results of the model indicate that the fundamentals were weak enough for China to experience contagion of the Asian crisis, and raise the question of the possible role of China's institutional arrangements in preventing the crisis. The paper further analyzes the economic fundamentals of China that drive the high probability of crises, and provides some suggestions for further reform.     

Why are currency crises contagious? A comparison of the Latin American Crisis of 1994–1995 and the Asian Crisis of 1997–1998

Why Are Currency Crises Contagious? A Comparison of the Latin American Crisis of 1994–1995 and the Asian Crisis of 1997–1998.—This paper analyzes three channels through which currency crises are transmitted between countries: contagion based on unsustainable economic fundamentals; contagion resulting from herding behaviour in financial markets; contagion induced by close trade integration. The presented model that links currency crises with these three types of contagion is employed to analyze the transmission of the Mexican crisis in 1994–1995 and the Thai crisis in 1997 to other emerging economies. The empirical results show that, first, the most important contagion channels were based on close financial and trade integration rather than on the weakness of macroeconomic fundamentals. Second, the vulnerability to capital flow reversals and weak financial sectors made countries particularly prone to a currency crisis, while external imbalances and currency misalignments were much less important. JEL no. F30, E60, E65, E44     

Speculative attacks and currency crises: The Mexican experience

By using data from the Mexican economy, this paper estimates a speculative attack model of currency crises in order to identify the role of macroeconomic fundamentals and early warning signals of a potential currency crisis. A deterioration in fundamentals appears to generate high one-step-ahead probabilities for the observed regime changes during the sample period 1982–1994. Particularly, foreign reserve losses, expansionary output, monetary and fiscal policies, an increase in inflation differentials and the share of short-term foreign currency-indexed debt, and an appreciation of the real exchange rate appear to have contributed to the speculative pressures and the associated regime changes.     

High‐Frequency Contagion of Currency Crises in Asia*

Using daily data from the Asian currency crisis, the present paper examines high‐frequency contagion effects among six Asian countries. The ‘origin’ (of exchange rate depreciation, or decline in stock prices) and the ‘affected’ (currencies, or stock prices) in the daily spillover relationship were defined and identified. Indonesia is found to be the main origin country, affecting exchange rates of other countries. Contrary to conventional wisdom, evidence of high‐frequency crisis spillover from the Thai exchange rate to other currencies was weak at best. There exists a high‐frequency contagion in stock markets among East Asian countries. Contagion coefficients are positively correlated with trade indices, indicating that investors lower their financial assessment of a country that has trade linkage to a crisis origin country within days, if not hours, of a shock.     

Nominal debt and inflation stabilization

The “fiscal theory of currency crises” ( Daniel 2001 ; Corsetti and Ma?kowiak 2005, 2006 ) claims that with long‐term nominal debt, a government can delay the timing of an inevitable currency crisis that results from a fiscal shock. The present paper shows that, in contrast, long‐term nominal debt might have destabilizing effects when a government introduces an inflation stabilization policy. It is shown that a stabilization policy that is successful in the absence of long‐term nominal debt can cause a crisis when long‐term nominal debt exists. The model implies that a government with a large stock of long‐term nominal debt must overcome a high fiscal hurdle for a successful stabilization policy. This difficulty is avoidable if long‐term debt is indexed to inflation.     

FORECASTING CURRENCY CRISES: WHICH METHODS SIGNALED THE SOUTH AFRICAN CRISIS OF JUNE 2006?

In this paper we test the ability of three of the most popular methods to forecast South African currency crises with a special emphasis on their out‐of‐sample performance. We choose the latest crisis of June 2006 to conduct an out‐of‐sample experiment. The results show that the signals approach was not able to forecast the out‐of‐sample crisis correctly; the probit approach was able to predict the crisis but only with models, that were based on raw data. The Markov‐regime‐switching approach predicts the out‐of‐sample crisis well. However, the results are not straightforward. In‐sample, the probit models performed remarkably well and were also able to detect, at least to some extent, out‐of‐sample currency crises before their occurrence. The recommendation is to not restrict the forecasting to only one approach.     

REER Imbalances and Macroeconomic Adjustments in the Proposed West African Monetary Union

With the spectre of the euro crisis hunting embryonic monetary unions, we use a dynamic model of a small open economy to analyse real effective exchange rate (REER) imbalances and examine whether the movements in the aggregate real exchange rates are consistent with the underlying macroeconomic fundamentals in the proposed West African Monetary Union (WAMU). Using both country‐oriented and WAMU panel‐based specifications, we show that the long‐run behaviour of the REERs can be explained by fluctuations in the terms of trade, productivity, investment, debt and openness. While there is still significant evidence of cross‐country differences in the relationship between underlying macroeconomic fundamentals and corresponding REERs, the embryonic WAMU has a stable error correction mechanism, with four of the five cointegration relations having signs that are consistent with the predictions from economic theory. Policy implications are discussed, and the conclusions of the analysis are a valuable contribution to the scholarly and policy debate over whether the creation of a sustainable monetary union should precede convergence in macroeconomic fundamentals that determine REER adjustments.     

Is a Common Currency Area Feasible for East Asia? A Multivariate Structural Vector Autoregression Approach

In this paper the feasibility of forming a common currency area in East Asia is investigated. A three‐variable structural vector autoregression model is used to identify three types of shocks: global, regional and domestic shocks. The empirical results show that in the post‐crisis period the importance of asymmetric domestic shocks has declined sharply, whereas that of symmetric global and regional shocks has increased. Furthermore, although a ‘prevalent shock’ cannot be uniquely defined, most East Asian economies respond to global and regional shocks in a symmetric way. Although the findings do not provide strong support for forming a common currency area in this region at the current stage, they suggest that most East Asian economies have become relatively symmetric in terms of economic shocks and adjustments, implying that a common currency area might become viable through deepening regional integration.     

What caused the Asian currency and financial crisis?

The paper explores the view that the Asian currency and financial crises in 1997 and 1998 reflected structural and policy distortions in the countries of the region, even if market overreaction and herding caused the plunge of exchange rates, asset prices and economic activity to be more severe than warranted by the initial weak economic conditions. The first part of the paper provides an overview of economic fundamentals in Asia on the eve of the crisis, with emphasis on current account imbalances, quantity and quality of financial ‘overlending’, banking problems, and composition, maturity and size of capital inflows. The second part of the paper presents a reconstruction of the Asian crisis from the antecedents in 1995–1996 to the recent developments in early 1999 in parallel with a survey of the debate on the strategies to recover from the crisis, the role of international intervention, and the costs and benefits of capital controls.     

China's Bilateral Currency Swap Lines

We study the determinants of China's bilateral local currency swap lines that were established following the recent global finance crisis. It is found that economic factors, political considerations and institutional characteristics, including trade intensity, economic size, strategic partnership, free trade agreements, corruption and stability, affect the decision to sign a swap line agreement. Once a swap line agreement decision is made, the size of the swap line is then mainly affected by trade intensity, economic size and the presence of a free trade agreement. The results are quite robust with respect to the choices of the Heckman two‐stage framework or the proportional hazard model. The gravity effect captured by distances between China and its counterparts, if present, is mainly observed during the early part of the sample period under consideration.     

Foreign devaluation as a coordinating device of heterogeneous investors: A game‐theoretic analysis of financial contagion

This paper investigates financial contagion by extending the Morris–Shin (1998) model of financial crises. It is assumed that before a devaluation in a foreign country, home investors have only private information on the state of the home country. It is demonstrated that the occurrence of a currency crisis in the foreign country may trigger a similar crisis in the home country by coordinating heterogeneous beliefs of home investors. The model is designed to describe the Asian currency crisis of 1997.     

Currency Crises and the Term Structure of Interest Rates

The currency crisis literature has identified two possible types of crisis: fundamentals based crises and self-fulfilling crises. A fundamentals based crisis arises when some state variable, such as foreign exchange reserves, reaches a critical level and triggers the abandonment of the fixed rate. A self-fulfilling crisis is triggered by an autonomous change in the beliefs of speculators. This paper demonstrates how these two types of crises generate different behaviour in the term structure in the period before the crisis. JEL Classification Numbers: E43, F31     

Estimating Open Economy New Keynesian Phillips Curve for Korea

We estimate the open economy new Keynesian Philips curve (NKPC) to characterize the inflation dynamics of Korea. While recent studies show that the NKPC holds for the pre‐currency crisis period, the empirical evidence is inconclusive for the post‐crisis period. Has globalization increased the role of global factors relative to domestic factors? Can labor income share still serve as a good measure of real marginal cost following the structural break? To address these issues for the post‐crisis period, we use two types of open NKPC: the relative prices model and the incomplete pass‐through model. The estimation of both models indicates that the forward‐looking behavior is important, and its role is reinforced in an open economy specification. Both NKPC models also show that the external factors are more relevant inflation drivers than the domestic factors.     

Sovereign Spreads and Contagion Risks in Asia

In the aftermath of the recent global financial turmoil, sovereign spreads have exhibited a significant degree of volatility. This paper explores how much of these movements in the spreads of Asian economies reflected shifts in global risk aversion or country‐specific risks, directly from worsening fundamentals, or indirectly from spillovers originating in other sovereigns, or risks and uncertainty surrounding their exchange rates. This analysis finds that earlier in the crisis, the increase in market‐implied contagion led to an increase of sovereign bond yields relative to the swaps. Higher‐rated sovereign bonds in Asia benefited from the flight to quality that accompanied the increase in global risk aversion during this period. Once the systemic risks in the financial sectors worldwide were contained, the risk of sovereign spillovers eased, which, together with a fall in perceived currency‐related risks, led to a fall in sovereign bond yields relative to swaps yields across the board. Comparing the situation to that of Europe, the present paper concludes that the debt crisis in the euro area has not affected the perception of sovereign risks of Asian economies. In fact, a fall in exchange rate and spillover risks, combined with stronger fundamentals, have led to a continued normalization of Asian sovereign spreads since the height of the financial crisis.     

Exchange-rate policy in East Asia after the fall: how much have things changed?

This paper evaluates the changes in the exchange-rate policies of East Asian economies in the aftermath of the currency crisis and the process in which the exchange-market stability was re-established. The empirical analysis evaluates the changing roles of the yen and the US dollar in the currency baskets, the shifts in the volatility of the underlying macroeconomic fundamentals and their implications on exchange-rate management, the exchange-market perception of credibility and risk of the postcrisis exchange-rate regimes, and the process of reversion to fundamental values after the massive currency depreciation.The analysis shows that after the abandonment of the quasi-dollar peg, the yen had gained a greater weight in the currency baskets and the greater flexibility in which the exchange rates are being managed serve to accommodate the greater volatility in the macroeconomic fundamentals. The improvement in the macroeconomic conditions and the greater credibility that has been acquired by the regional monetary authorities had allowed the exchange market to stabilize and enabled the exchange rates to revert back to their fundamental values.     

The Asian currency crash: were badly driven fundamentals to blame?

This paper examines the extent to which a number of currencies central to the Asian currency crisis were misaligned at the end of 1996. A well-known fundamentals-based exchange rate model, the monetary approach to exchange rate behavior, is used to produce estimates of equilibrium exchange rates for a number of Asian currencies. The estimates, calculated using panel methods, are shown to be consistent with the underlying model. Most significantly, very little evidence of misalignment is found to exist in 1996. This suggests that the cause of the Asian crash cannot be attributed to traditional fundamentals.     

The Asian currency crash: were badly driven fundamentals to blame?☆

This paper examines the extent to which a number of currencies central to the Asian currency crisis were misaligned at the end of 1996. A well-known fundamentals-based exchange rate model, the monetary approach to exchange rate behavior, is used to produce estimates of equilibrium exchange rates for a number of Asian currencies. The estimates, calculated using panel methods, are shown to be consistent with the underlying model. Most significantly, very little evidence of misalignment is found to exist in 1996. This suggests that the cause of the Asian crash cannot be attributed to traditional fundamentals.     

The lira and the pound in the 1992 currency crisis: Fundamentals or speculation?

The prevalent explanation of the Exchange Rate Mechanism (ERM) currency crisis of September, 1992 is that myopic speculation prevailed over the “fundamentals.” Our paper explores the reasons why the Italian lira and the U.K. pound were attacked and, subsequently, forced out of the ERM. The crisis was sparked by a common awareness that political unification and the commitment to monetary union had petered out in the summer of 1992, leaving the field open to speculators to pick countries with the weakest fundamentals (Italy) or with policy makers who feared jeopardizing an economic recovery by keeping the currency in the ERM (the U.K.).