The Asian currency crisis that spread out in 1997 re-activated discussion about the mechanism behind currency crises and the factors that determine the magnitude of a crisis as well as their effect on aggregate output. The resumption of studies, which seek to explain the outbreak of a currency crisis in terms of economic “models”, alleged “failure” of already-existing theories in accounting for the Asian currency crisis.
As growing number of researchers have investigated the causes of currency crises, the number of empirical analyses that include the Asian crisis has increased as well. In addition, financial market turmoil as represented by the 1997 Asian currency crisis has prompted discussion focusing on the following questions. What is a desirable international financial architecture? How should the public sector tackle a currency crisis? Should we or should we not involve the private sector in handling a currency crisis? Discussion of these questions has also prompted study of currency crises. In order to answer the aforementioned questions, it is necessary to clarify the causes and mechanism of currency crises.
This paper attempted to re-organize theories on causes of Asian currency crisis. Many papers reviewing theoretical aspects of the topic have already been published. Therefore, rather than going into detailed explanation for each theory, this paper focuses on the background of each theory as well as the position of each in the development of theoretical investigations into currency crises. Financial markets comprise participants with conflicting interests, and it is often quite difficult to reach a consensus. Thus, in order to implement concrete measures, it is necessary to form opinions based on theoretical support.
The organization of this paper is as follows: Part 2 reviews economic theories regarding the mechanism behind the outbreak of currency crises. Part 3 looks at Theories on the 1997 Asian Currency Crisis. Then Part 4 describes the mechanics of currency crisis that lead to a plunge in aggregate output. And the last part is conclusion.
2. Economic Theories on Currency Crises
There are two economic theories that explain currency crises before the Asian currency crisis. They are first and second generation models. Many theoretical evaluations were presented after the Asian currency crisis. These theories have already been reviewed by others. Therefore in this section, we focus on aspects relating to the Asian currency crisis. And also position of each theory in the development of theories on the subject.
2.1 Currency Crisis Theories before the Asian Current Crisis
2.1.1 First and second generation models
First and second generation models are generally known as theories on currency crises before the Asian currency crisis. As far as it became clear that they could not fully explain the outbreak of the Asian currency crisis, efforts to build theories that explain its outbreak have been made.
Krugman (1979) and Flood and Garber (1984) indicated first generation models which explain the relation between fiscal deficit and currency crisis. This is elaborated useful in explaining the debt and currency crises in Latin American countries during the 1980s. Based on these models, a government sustaining from a large fiscal deficit will try to monetize the deficit by extending domestic credit. In such a manner making it difficult to maintain a fixed foreign exchange rate system. In order to encourage a fixed foreign exchange rate system, money supply (the sum of domestic credit and foreign reserves) needs to be maintained at a certain level. The extension of domestic credit results to a fall in foreign reserves by the same amount. When foreign reserves fall below a certain level, investors look forward to a depreciation of the currency and start to sell it, and the economy can no longer maintain the fixed foreign exchange rate system.
Obstfeld (1994, 1996) emphasized second generation models which are often described by multiple equilibria occasioned by self-fulfilling expectations. We focus on their implications regarding the relation between monetary policy and currency crises.
After the unification of former East and West Germany, Germany had recourse to a tight monetary policy. For the purpose of maintaining the exchange-rate mechanism (ERM) other countries also followed it. Consequently, the member countries of the ERM suffered from low growth rate and high unemployment rate. In 1992, the ERM crisis made the UK and Italy leave the ERM. Spain also devalued its currency. Other countries run out by losing a considerable amount of foreign reserves.
Second generation models can efficiently interpret the mechanism behind the ERM crisis. They are considered as pointing the opposite purposes of a fixed exchange rate system and an expansionary monetary policy. Assume a case where monetary policy is employed to maintain a fixed foreign exchange rate, but the trigger for the central bank in the economy to make recourse to temporary expansionary monetary policy to boost domestic demand (e.g. high unemployment rate) is mounting. Anticipations for an expansionary monetary policy lead to expectations for exchange rate depreciation. Furthermore, more depreciation pressure will be observed if it is thought that the authority will discover it hard to stand against such pressure by intervention. To maintain a fixed foreign exchange rate system, the central bank needs to raise interest rates. Nevertheless, this only counteracts the effects of expansionary monetary policy. As consequence of such inconsistent policy intentions, the cost of maintaining a fixed exchange rate system could exceed the benefits. In such case, the authority will eliminate the system.
2.1.2 Feasibility of the first and second generation models to the Asian currency crisis
After the Asian currency crisis, a consensus reached that first and second generation models could not fully explain the crisis (Table 1). We observed fiscal situation of each country and found that there were fiscal surpluses in most countries except for Taiwan. As for the economic growth rate, in most countries we mentioned slowdown of growth. But they had still maintaining high growth rate. Therefore, it did not appear that they need to adopt an expansionary monetary policy to stimulate domestic demand at the sacrifice of exchange rate policy. A serious problem in Thailand was increase in current account deficit. And the baht had frequently come under speculative attack even before 1997. Korea was also struck by the crisis. But it seemed to have had no problem in terms of such statistics. All these facts have led researchers to either build new theoretical models or to expand the existing theories to explain the causes of the outbreak of the Asian crisis.
Table 1. Economic Situation in Asian Countries before the Outbreak of the Asian Crisis (%)
GDP growth rate
CPI growth rate
Ratio of fiscal balance to nominal GDP
Ratio of current account balance to nominal GDP
Source: national statistics
3. Theories on the 1997 Asian Currency Crisis
3.1 Plunge in currency values theory
There are two main theories were developed that explain the causes of the Asian currency crisis. They are “fundamentals-driven crisis theory” and “financial panic-driven crisis theory”. These two views were seen as opposing theories. Nonetheless, we cannot view them as totally opposing theories. Because economic fundamentals and the formation of investors’ expectations are not independent of each other. Thereafter, such intuition received theoretical support from the development of game theory. It ultimately led to a theory emphasizing the relation between the formation of investors’ expectations and economic fundamentals.
3.1.1 Fundamentals-driven crisis theory
Krugman (1998), Corsetti, Pesenti, and Roubini (1999) notice that implicit guarantee by the government for liabilities of domestic banks leads to moral hazard in domestic banks’ lending policy. Non-performing loans will increase, and thereby, lead to a currency crisis. To be more specific, they contemplate the considerable amount of non-performing loans held by domestic banks as future government expenditure. As long as people expect the government to bail out troubled domestic banks because of their close relationship. In a certain way, it can be said that the bad loans of private banks are substantively equivalent to the fiscal expenditures of the government. Expectations of international investors that governments will monetize the resulting budget deficits result in expectations of currency devaluation. In such a way, this theory argues that the crisis in Asia occurred even though there had been no considerable fiscal deficit. As for the process of fiscal deficits triggering a currency crisis, the logic in the first generation model is employed in essence.
3.1.2 Financial panic-driven crisis theory
Even though Radelet and Sachs (1998) and Chang and Velasco (1998) have different approaches in focusing on economic variables or developing detailed models. They both pay attention to the possibility of the undesirable equilibrium (an equilibrium where a depreciation of the currency occurs) materializing within multiple equilibria (an equilibrium where “everyone expects currency depreciation and thus sell the currency, resulting in the actual depreciation of the currency” and an equilibrium where “everybody expects the maintenance of the value of the currency, and thus do not sell the currency, resulting in the actual maintenance of its value”) in the economy, depending on investors’ expectations. The idea is principally based on coordination-failure theory or bank-run theory. They affirm the occurrence of equilibrium such as the breaking out of a currency crisis i.e. “for some reason investors expect devaluation and start to sell the currency, making it impossible for the country to maintain a fixed exchange rate system, actually resulting in currency devaluation”. Believers of this theory claim that the large reversal of capital flows from Asia cannot be explained by changes in fundamentals (such as fiscal deficit, unemployment rate, money supply) of the crisis-hit countries. They also call attention various financial variables (yield spread between national issued US dollar- denominated bonds and US treasury notes, etc.), market projections (foreign exchange rate projections by investment banks, consensus forecasts, etc.), and the ratings of rating agencies did not provide any early warning at the time of the Asian currency crisis. By this means, they claim that the crisis is triggered by a unexpected change in the expectations of market participants.
3.1.3 Theory regarding the relation between the formation of investors’ expectations and economic fundamentals
The previously noted explanation on currency crises (application of coordination failure theory or bank-run theory) does not provide an answer to the problem as to which equilibrium of multiple equilibria would hold. According to investors’ expectations, both equilibria with a crisis and without a crisis can exist at a certain state of economic fundamentals. This is because these theories do not provide an answer to the cause of a change in investors’ expectations. Morris and Shin (1998) first theoretically analyze how the formation of investors’ expectations (and the decision making that accompanies it) is linked with the state of economic fundamentals. They then apply this to the financial crisis theory. The conclusion of the theory is: when expressing the state of economic fundamentals with a parameter, there exists a threshold value of economic fundamentals that triggers the selling of a currency.
According to their paper (Morris and Shin), the existing theory (the application of the coordination failure theory or the bank-run theory) allows multiple equilibria (an equilibrium where “everyone expects currency depreciation and thus sell the currency, resulting in the actual depreciation of the currency” and an equilibrium where “everybody expects the maintenance of the value of the currency, and thus do not sell the currency resulting in the actual maintenance of its value”) to exist under a certain state of fundamentals. Because these theories suppose that all investors have perfect information and common knowledge with respect to fundamentals (i.e. everyone knows the state of fundamentals and everyone knows “everyone knows the state of fundamentals” and everyone knowsâ€¦ ad infinitum). On the other side, by assuming a more realistic hypothesis that each investor would have different information regarding economic fundamentals, we can solve the problem of indetermination of equilibrium. This hypothesis can also prove that a threshold exists between the state of economic fundamentals with or without the outbreak of a crisis.
The intuitive explanation of the logic behind the above claim would be as follows. Under a situation where each investor’s payoff is influenced by not only his/her own action but also economic fundamentals and the action of other investors, each investor needs to consider how other investors view the economic fundamentals. If one tries to predict other investors’ view of economic fundamentals based on the attained signal regarding economic fundamentals (the true value plus noise), one can estimate the proportion of investors holding a more pessimistic view. Based on such information, investors can calculate their payoff and decide their course of action.
The signal here is disseminated from the state of economic fundamentals. Therefore, economic fundamentals are linked with formation of investor expectations and the action that accompanies it.
As shown above, this theory goes beyond the question of “fundamentals crisis vs. self- fulfilling crisis” and considers the relation between economic fundamentals and the formation of expectations, which previously was not given enough theoretical foundation. According to this theory, under a certain state of fundamentals, a certain equilibrium is uniquely determined: either one situation of the two, that is equilibrium with or without the crisis, will emerge. If fundamentals deteriorate and approach the threshold situation, the probability of a crisis occurring in response to even a slight change in fundamentals will emerge. It also implies that even a small shock occurring in a situation which is close to the threshold can trigger drastic selling by investors.
4. The Mechanics of Currency Crisis that Lead to a Plunge in Aggregate Output
When a national currency depreciates, the price competitiveness of that nation’s products will increase, leading to an increase in exports. As a result, there will be an increase in the aggregate output of countries with a high share of exports to its aggregate output. Yet, in the case of the Asian crisis, a plunge in aggregate output was observed following a plunge in the currency values. The observed phenomenon was that: an abrupt increase of interest rate after the crisis led to a drop in capital investment; there was a rapid outflow of capital, which led to the liquidation of investment projects as well as the depletion of operating funds for companies that depended on foreign capital.
The twin crisis hypothesis, which holds that the crisis in the domestic banking sector augments the impact of the currency crisis, stresses the fact that in the past many currency crises accompanied a crisis in the domestic banking sector (Kaminsky and Reinhart, 1999). In the case of the Asian crisis, the level of non-performing loans of domestic banks was already high even before the outbreak of the currency crisis. Also, when the crisis broke out, domestic banks had trouble rolling over foreign debt. As a result, non-performing loans increased and some banks failed. As for the reason for such bank crises leading to a lowering of total output, Chinn and Kletzer(1999) and Diamond and Rajan(2000) point to diminished monitoring and loan collection abilities on the part of domestic banks.
According to the agency theory, employed in Bernanke and Gertler(1989) for instance, it is claimed that, in imperfect financial markets, the maximum amount a company can borrow is determined based on the level of its net worth. An intuitive explanation of this theory is as follows. When a manager of a firm can choose investment projects or his/her effort level, the larger the financial loss of the default for him/her personally, the more careful he/she is to avoid risky investment and the more effort he/she puts into the business. Therefore, lenders of capital who only have imperfect information regarding the course of actions of managers would raise the amount of lending to borrowers with higher levels of net worth.
Lastly, the debt-overhang theory is examined. Suppose a company is suffering from a large amount of debt, and repayment is stagnating. Even if the company has a highly profitable new investment project, lenders may not lend capital. This is because, when investors consider the probability of repayment, they also consider the fact that the profit generated by this project will first be used to pay back overdue debt. Such a situation is termed debt-overhang. This is not a phenomenon unique to a currency crisis but the skyrocketing of foreign debt in terms of domestic currency due to massive devaluation is likely to have been a cause of the stagnation of new investment.
In this paper we have surveyed the theories put forward to explain the outbreak of past currency crises, the aggravation of crises, and the mechanism that leads to a drop in total output of a crisis-hit country. As for the scope of the survey, we have mainly focused on the 1997 Asian currency crisis.
There are two opposing views theories that explain the formative background of the Asian currency crisis. The first one is “fundamentals-driven crisis theory”, and the second one is “financial panic-driven crisis theory”. Lately, a theory regarding the relation between the formation of investors’ expectations and economic fundamentals has also been advocated. The idea that “economic fundamentals and the formation of investor expectations are not independent of each other” is receiving theoretical support. As for the mechanism of currency crisis (depreciation of the currency) leading to a drop in total output, theories such as the twin-crisis hypothesis, the agency theory, and debt-overhang theory are referred