Asian Financial crises
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Chapter 3 What Caused the Recent Asian Currency Crises?

Author(s):
International Monetary Fund
Published Date:
January 2001
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Abstract

This paper argues that the recent Asian currency crisis was caused by prospective future deficits associated with implicit bank bailouts.

Recent events in Asia have led economists and policymakers to reevaluate the causes and consequences of currency crises. The view favored by many Asian policymakers is that the crises happened because the market expected them to happen. The basic argument is that the economies of the affected countries (Thailand, Indonesia, South Korea, the Philippines, and Malaysia) were fundamentally sound. But at some point in time, speculators came to believe that currency collapses would occur. Based on this belief, investors refused to roll over loans denominated in these currencies. This led to a massive drain on the foreign exchange reserves of the affected countries. Unable to borrow additional reserves at any interest rate or one that was prohibitive because of the effect on their economies, governments capitulated and abandoned fixed exchange rates. In this way, speculators’ beliefs became self-fulfilling. Not surprisingly, proponents of this view have argued that the International Monetary Fund should provide the resources required to fend off speculative currency attacks. Indeed some, like Krugman (1998), have gone so far as to suggest that currency controls may be desirable.

The view that the Asian currency crises was a multiple equilibrium phenomenon induced by self fulfilling beliefs can be formalized using dynamic general equilibrium theory. Ruling out such an interpretation of the data is a difficult and subtle task. Rather than trying to do so, we pursue a different objective. Specifically, we present an alternative explanation that attributes the crises to fundamentals: large prospective fiscal deficits stemming from implicit government guarantees to failing banking systems.

There is already a large amount of literature that seeks to explain currency crises on the basis of fundamentals. Perhaps the simplest fundamentalist view is that currency collapses reflect monetary and fiscal policies that predate the crises.1 The idea is that large deficits lead to high growth rates of money and inflation which are incompatible with a fixed exchange rate regime. While this theory has been very useful in explaining a variety of historical episodes, it is not particularly helpful in understanding the recent Asian crises. This is because all of the affected countries had fiscal surpluses or small reported deficits as well as low reported growth rates of inflation (see for example Corsetti, Pesenti and Roubini (1998)).

An alternative fundamentalist view which seems more promising is that large prospective fiscal deficits were the key factor behind the recent Asian currency crises. The basic idea is that markets expected these prospective deficits would be financed, at least in part, by future seignorage revenues. So, future, rather than past, monetary policy was the main culprit behind the crises.

The mere fact that governments had to fund future bank bailouts does not imply that a currency crisis was inevitable. After all, markets could have believed that the bailouts would be paid for by cuts in other types of government expenditures or tax hikes. If this were the case, then the banking crises associated with the bailout promises need not have been associated with currency crises. To establish a connection between the two, one must argue that the banking crises caused a change in either past or future monetary policy.

Is the view that the Asian governments would fund bank bailouts by raising taxes and reducing government expenditures credible? In our view it is not. Precisely because banking crises have real causes and consequences, bank failures would be associated with declines in current and future output as well as tax revenues. Massively raising distortionary taxes and cutting government expenditures under those circumstances would be very costly, both politically and socially. To us it seems more credible that governments would attempt to fund the bank bailouts by raising seignorage revenues and obtaining aid from the International Monetary Fund.

In Burnside, Eichenbaum, and Rebelo (1998) we formalize the notion that expected changes in future monetary policy can cause a collapse in a fixed exchange rate regime. We do this by studying the dynamics of a speculative attack in a variant of Calvo’s (1987) perfect foresight, general equilibrium, small open economy model. The basic argument is as follows. Consider a small open economy that is initially in the steady state of a fixed exchange rate regime. Imagine that at some point in time, people receive information that the present value of current and future government deficits will be larger than they initially thought. Then it follows directly from the government’s intertemporal budget constraint that the collapse of the fixed exchange rate regime is inevitable. This is because, by assumption, the government has no alternative to funding higher future fiscal deficits than by raising seignorage revenues. But this is incompatible with maintaining fixed exchange rates.

The literature refers to the time of the collapse of the fixed exchange rate regime as the time of a speculative attack. The key result in our paper is that the speculative attack occurs after the new information about the rise in the present value of the government deficit arrives, but before the new monetary policy is implemented.

Under these circumstances, an econometrician looking at the data would see an exchange rate crisis. But he would not see large fiscal deficits, higher growth rates of money, nor, necessarily, a loss of reserves. If the econometrician were naive, he might even conclude that the attack was a multiple equilibrium phenomenon caused by capricious speculators. But the attack was actually caused by fundamentals: high prospective deficits financed by future seignorage revenues.

According to our model, a rise in the present value of government deficits leads inevitably to the end of fixed exchange rates. Even so, the government can delay the date of collapse. But it can do so only at a price: the longer the delay, the higher inflation will be when the collapse does happen. The policy conclusion is straightforward. The government has two options. First it can fix the real problem by fundamental banking and fiscal reforms. Alternatively, it can admit that it does not have the political will to pursue the first option. But then there is no point in delaying the inevitable collapse of the fixed exchange rate regime. The government should float as quickly as possible to minimize the impact on future domestic inflation.

In the remainder of this paper we discuss some of the empirical evidence regarding the three key assumptions in our analysis: (i) foreign reserves did not necessarily play a role in the timing of the attack, (ii) large losses in the banking sector were associated with a large rise in prospective deficits, and (iii) the market knew the banks were in trouble well before the currency crises.

1. FOREIGN RESERVES

Foreign reserves do not play a special role in our discussion of the Asian currency crises. Our basic logic is that whatever their level was prior to the crisis, they were pledged to financing the old level of the deficit. Moreover we assume that governments could always borrow more reserves if they wished, subject to their intertemporal budget constraint. Burnside, Eichenbaum, and Rebelo (1998) discuss the ratio of foreign reserves to the monetary base and Ml in the crisis countries over the period July 1995 to May 1998. Two key facts emerge from our analysis. First, all of the crisis countries had more than enough reserves to buy back the monetary base at the time their currencies collapsed. In fact, in all cases, they could have bought back over ninety percent of Ml. Thailand’s reserves were actually twice as large as Ml at the time of the collapse. It is true that some of these reserves may have been effectively sold forward. But this strengthens our basic point: the key issue is what the net assets of the governments are, rather than the level of foreign reserves per se.

2. THE SIZE OF THE GOVERNMENT’S IMPLICIT LIABILITIES

Corsetti, Pesenti, and Roubini (1998) provide estimates of loan default rates in Asia prior to the crises. These are summarized in the first columns of Tables 1 and 2, reproduced from Burnside, Eichenbaum, and Rebelo (1998). The key point to note is the sharp difference between default rates in the crisis and non-crisis countries. Using these default rates and data on total credit to domestic enterprises and financial institutions, Burnside, Eichenbaum, and Rebelo (1998) generate a rough estimate of the government’s total implicit liabilities stemming from guarantees to the financial sector.

Table 1.Estimated Total Nonperforming Bank Loans
Nonperforming LoansNonperforming Credit


% of all loans


% of MB


% of GDP
% of central

gov’t, rev.
Indonesia17129.69.463.0
Korea16454.122.1103.7
Malaysia1688.823.398.3
Philippines1484.57.841.1
Thailand19289.630.2176.7
Hong Kong491.66.633.6
Singapore435.04.411.8
Taiwan426.86.050.0
Table 2.Estimated Liabilities from Nonbank Foreign Borrowing
Nonperforming loansNonperformingNonbankForeign Borrowing


% of all loans


% of MB


% of GDP
% of central

gov’t, rev.
Indonesia1734.62.516.8
Korea1618.00.94.1
Malaysia164.11.14.5
Philippines148.30.84.0
Thailand1912.61.37.7
Hong Kong48.20.63.0
Singapore42.60.30.9
Taiwan40.20.00.4

Columns 2, 3 and 4 of Table 1 report total nonperforming bank loans as a percentage of the monetary base, real output and central government revenue, respectively.2Table 2 reports the analogue percentages for the liabilities associated with nonbank foreign borrowing.3 Note that regardless of which measure we use, all of the crisis countries exhibited high levels of total implicit liabilities.

The previous two tables summarize information on default rates and implicit liabilities prior to the currency crises. Burnside, Eichenbaum, and Rebelo (1998) review estimates from J. P. Morgan (1998) regarding the post-crisis situation. Specifically we look at (i) nonperforming loans as a percentage of total loans and GDP in Indonesia, Korea, Malaysia, and Thailand, as of June 1998, and (ii) the amount of capital, as a percentage of GDP, needed to restore bank capital to the eight percent Bank of International Settlements Capital Adequacy Requirement level. These estimates are summarized in Table 3, reproduced from Burnside, Eichenbaum, and Rebelo (1998).

Table 3.Post-crisis Estimates of Nonperforming Loans and Recapitalization Requirements
IndonesiaKoreaMalaysiaThailand
Nonperforming Loans (% of all loans)50302530
Nonperforming Loans (% of GDP)37.549.541.330
Recapitalization Need (% of GDP)30302230

Notice the dramatic increase in the magnitude of nonperforming loans relative to the pre-crisis estimates. From the perspective of our theory the post-crisis estimates are at least as relevant as the pre-crisis estimates, since these are tied to the current liabilities of the crisis governments.

3. WERE THE BANKING CRISES A SURPRISE?

We now briefly discuss whether private agents anticipated the state of the banking system prior to the currency crises. Corsetti, Pesenti, and Roubini (1998) discuss the fragile state of the financial sectors in the crisis countries prior to the recent speculative attacks. Burnside, Eichenbaum, and Rebelo (1998) construct monthly indices of the market value of the financial and nonfinancial sectors in Korea, Thailand, the Philippines, and Malaysia. These are summarized in Table 4. Note that in Korea, Thailand, and to a lesser extent the Philippines and Malaysia, the value of the financial sectors had been declining well before the currency crises.

Table 4.Changes in Banking Sector Stock Market Values
% Decline% Decline
PeakCrisisBanking Index
Banking IndexManufacturing Index
KoreaAug. 3, 1991Oct. 29, 19976764
ThailandJan. 4, 1994July 2, 19979280
PhilippinesFed. 17, 1997July 11, 19973414
MalaysiaFeb. 25, 1997July 11, 1997268

For Korea the decline in the banking index from its peak (August 3, 1991) to the date of the currency crisis (October 29, 1997) was sixty-seven percent. The analogue decline in the ratio of the banking index to the manufacturing index was sixty-four percent. In the case of Thailand the decline in the finance index from its peak (January 4, 1994) to the date of the crisis (July 2, 1997) was ninety-two percent. The analogue decline in the ratio of the finance index to the commerce index was eighty percent. In the Philippines, the peak in the finance index took place on February 17, 1997. This series declined by thirty-four percent between this date and the date at which their currency crisis began in earnest (July 11, 1997). The peak to trough decline in the ratio of the finance index to the commerce index was fourteen percent. Finally for Malaysia the peak in the finance index took place on February 25, 1997. This series declined twenty-six percent between this date and the date of the crisis (July 11, 1997). The peak to trough decline in the ratio of the finance index to the industrial index was eight percent.

Based on this evidence we conclude that private agents in these four countries understood the potentially fragile nature of their banking systems. As Burnside, Eichenbaum, and Rebelo (1998) point out, this evidence also suggests that markets anticipated that the government would bail out only depositors and creditors of the banks. Had they anticipated that the banks would be fully insured by the government, the equity value of banks would not have changed, other things being equal.

4. CONCLUDING REMARKS

Absent the political will to raise taxes or cut spending, governments must resort to seignorage revenues to pay for bank system bailouts. In a world of forward looking agents this makes a currency crisis inevitable. The model in Burnside, Eichenbaum and Rebelo (1998) implies that the collapse of fixed exchange rate happens after agents learn that future deficits will rise but before the government implements its new monetary policy. Under this scenario standard macroeconomic aggregates such as past inflation and fiscal deficits will not be useful in predicting currency crises. In this limited sense our model rationalizes claims that the Asian crises were hard to predict. More importantly our results suggest that empirical work aimed at forecasting currency crises should not look only at past fiscal and monetary policies of governments. It should pay at least as much attention to information that is useful for forecasting future fiscal deficits.

See for example Krugman (1979.)

Our estimates of nonperforming credit are the product of the percentage of non-performing loans and credit by deposit money banks to the nonbank private sector as of June 1997, as reported in the International Financial Statistics. We measured the monetary base as of the end of June 1997. GDP and government revenue were 1997 estimates from the IMF World Economic Outlook.

Our estimates of nonperforming foreign borrowing by the nonbank private sector are the product of the percentage of nonperforming loans and foreign credit to the nonbank sector as of June 1997, as reported by the Bank of International Settlements.

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