An analysis of currency crisis in South Korea

This paper provides empirical evidence on the causes and timing of the 1997 currency crisis in South Korea. A persistent weakness in the economic fundamentals through out much of the pre-crisis period created necessary conditions for the crisis. However, the timing of the currency crisis was determined by a unique combination of an unprecedented increase in default risk faced by the banking system and a decrease in foreign exchange reserves (FXRES) that restricted the ability of the government to bail out. A VAR model identifies two important variables that were crucial in triggering the currency crisis. One is the ratio of dishonored bills (DS) that measures default risk and serves as a proxy for the market value of banks. The other is FXRES that measures the strength of the government's bailout policies. Estimates from a vector autoregressive (VAR) model confirm a strong impact of the lagged changes in the ratio of DS and FXRES on the current changes in the won's value. Immediately before the November crisis, the ratio of DS reached an all-time high while reserves dropped to 1-month imports. These developments significantly contributed to the negative expectations resulting in a massive capital outflow followed by a drastic devaluation of the currency.