Economic Analysis Series No.164
An Eastern Asian Macroeconometric LINK model

April, 2002
Kanemi Ban
(Professor, Osaka University;
Senior Visiting Fellow, Economic Research Institute, Cabinet Office)
Kiyomi Watanabe
(Research Fellow, Economic Research Institute, Cabinet Office)
Mantaro Matsuya
(Economic and Social Research Institute, Cabinet Office)
Masakatsu Nakamura
(Associate Professor, Fukushima University;
Economic and Social Research Institute, Cabinet Office)
Mototsugu Shintani
(Lecturer, Keio University;
Visiting Fellow, Economic and Social Research Institute, Cabinet Office)
Takeshi Ihara
(Shikoku Electric Power Co., Inc.;
Economic and Social Research Institute, Cabinet Office)
Masumi Kawade
(The University of Tokyo;
Economic and Social Research Institute, Cabinet Office)
Tomonari Takeda
(University of Tsukuba;
Economic and Social Research Institute, Cabinet Office)

The full text is written in Japanese.

(Abstract)

1. Background

The Japanese economy has suffered from the collapse of asset price bubbles in the early 1990s. Average GDP growth of the Japanese economy in the 1990s was 1.3 percent, compared to 4.3 percent in the 1980s. GDP growth climbed to 3.5 percent in 1996 temporarily, which was the highest level in the 1990s. However the economy turned downward in 1997, and recorded minus 1.1 percent growth in 1998. The rising consumption tax burden, the termination of special income tax reductions, the turmoil surrounding the Asian currency crises, and the collapse of several Japanese financial institutions were just a few of the factors that brought about the recession of the period from 1997 to 1998.

The developing economies, especially the East Asian economies, experienced drastic changes in the 1990s. The East Asian economies had recorded higher economic growth than other regions, led by high growth in investments and exports since the mid 1980s. The vigorous investment was financed by a high domestic savings ratio and a vigorous foreign capital inflow. Even though current accounts continued to record huge deficits, other macroeconomic indicators had shown good performance. These included high GDP growth rates, low inflation, and balanced government budgets. They had contributed to form the confidence for the future in the Asian economies. In addition to good economic performance, the exchange rate system pegged to the US dollar and the keeping of interest rates higher than other developed countries caused a large amount of foreign capital inflow into Asian countries. All of this led to what people began calling the "Asian Miracles."

Thailand, however, had been attacked by speculation to devalue its currency since mid 1996, because export growth had slowed. In spite of an effort to sustain the baht, Thailand moved to a floating currency system after the currency attack in May 1997. At the same time, large amounts of capital fled from Thailand, which combined with the collapse of the weak financial sector. GDP growth rate in Thailand became negative in 1997, and recorded minus 10 percent in 1998, both of which were due to sharp declines in private demand and exports caused by the credit crunch. At this point, the currency crises spread over Malaysia, Indonesia, and Korea. By then, most of the East Asian economies had fallen into severe recession.

The East Asian crises have several common threads. Movements of asset prices, such as the currency and stock market prices, have played extremely important roles in the fluctuations of the East Asian economies. It is well known that asset prices are influenced by expectations and risks. Expectations and risks are also known to be volatile and contagious. Because the East Asian economies are closely interrelated through both trade and capital movement, it is reasonable that a chain reaction exists whereby a concern about one economy based on cautious expectations on difficulties influence the other economies instantaneously.

2. Forward-Looking Model

The model is designed to evaluate the impacts of not only traditional policy changes, but also volatilities of expectations and risks, where forward-looking mechanisms take on important roles. The model includes 11 economies: Japan, the United States, Korea, Thailand, Malaysia, Indonesia, the Philippines, Singapore, China, Taiwan, and the European Union.

To analyze the East Asian crises, we developed a world econometric model with forward-looking expectations. The basic structure of the model is based on a Mark III version of MULTIMOD developed by the IMF. In the model, economic agents are assumed to behave in a forward-looking manner based on a model consistent with rational expectations. The East Asian crises were associated with a fear of significant capital losses by US, EU, and Japanese financial institutes and by a major reversal of capital flows. A fear of these capital losses has potentially damaged the balance sheets of foreign financial institutes. As a result, asset prices have fallen and forced them to reconsider the risk and size of their loan portfolios. On the other hand, the condition of a borrower's balance sheet was also a source of output dynamics. As a result, lower borrower net worth increases the agency costs of financing real capital investment. That is, if business fluctuations undergo a downturn, shocks affect net worth, and reduce real investment.

Paul Krugman emphasized two factors: the role of business firms' balance sheets in determining their ability to invest, and capital flows in affecting the real exchange rate. Kiyotaki and Moore also proposed the model of credit cycles whereby temporary shocks generate persistent fluctuations in asset prices due to credit market imperfections. The model is used to evaluate asset price bubbles and their bursting in the East Asian economies.

If we want to take those factors into account, we need to involve a forward-looking mechanism in our macroeconometric models. If we don't, macroeconometric models tend to overestimate the expansionary effects of currency depreciations even though depreciation leads to capital losses in local currencies that have negative effects on consumption and investment. It implies that macroeconometric models fail to simulate crises in Asia. The East Asian economies have been severely depressed by their currency depreciations. Consumption depends on discounted future labor income, current labor income, and wealth, where wealth is the net assets of the countries. Investment depends on Tobin's average Q. Monetary policy has a direct effect on consumption and investment through expectation mechanism in the model. According to simulations, currency depreciation expands net exports and has an expansionary impact on the domestic economy in general, unless monetary and fiscal policies have negative impacts. If wealth is negative, that is, the country is a net borrower; currency depreciation may have a negative impact on wealth.

3. Simulation Results

The consensus is that the East Asian crises began with the currency crisis in Thailand. Thailand had pegged its currency to the US dollar until early 1997 to encourage foreign capital inflow for investment in export-oriented industries and the promotion of industrialization. During the period when the Thai economy was attractive, huge amounts of foreign capital inflow had supported the long-lived high economic growth and huge current account deficit. Unfortunately, immediately after Thailand lost its attractiveness, foreign capital flew away. As a result, the currency depreciated tremendously. Generally speaking, currency depreciation has an expansionary effect on the economy. However, financial institutes and business firms in Thailand suffered from a liquidity crisis brought on by the rapid withdrawal of foreign capital. The resulting liquidity shortage and sudden increase in risk premiums pushed down the economy.

Both Japan and Korea also suffered from an increase in risk premiums. In some sense, both countries were damaged by a fear of contagion of the currency crisis in Thailand, which was presented as a risk premium. Many Japanese and Korean banks were significant creditors of Thailand and other ASEAN countries. Korea had borrowed short-term debt from foreign financial institutes, and invested it in ASEAN countries through long-term capital investment. So it was natural that the currency crisis in Thailand created an anticipation of a run on Korean banks. As a result, Korea failed to refinance against the sudden withdrawal of foreign capital, and went into its own liquidity crisis of international reserves, which led to the currency depreciation.

According to the simulation results, the volatility of asset prices such as currency and stock market prices has a strong impact on the East Asian economies. The Japanese yen had appreciated during the period from late 1985 to early 1995, when lots of Japanese business firms moved their factories to the East Asian economies to keep their competitiveness in the world market. The East Asian economies also became attractive for the US and EU economies. These movements contributed to stimulate a rapid development in the region, but caused asset bubbles. Unfortunately, the yen depreciation, in addition to the RMB yuan, reduced the competitiveness of the East Asian economies. As a result, export growth showed a sharp decline in 1996. Many factors contributed to the East Asian crises, but the appreciation of the yen might have been a trigger.

The Japanese economy had suffered from the collapse of asset bubbles in the early 1990s, despite the zero-interest policy taken by the Bank of Japan and the economic stimulus packages put forth by the government. According to the simulations, fiscal and monetary policies are limited as means for the recovery of the Japanese economy. In some cases, policies for stimulating the Japanese economy result in deflationary effects on its East Asian neighbors.

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