Economic Analysis Series No.165
International Capital Movement and Currency Crisis: A Revaluation of the Asian Crisis

May, 2002
Shinji Takagi
(Senior Visiting Fellow, Economic and Social Research Institute, Cabinet Office;
Professor, Osaka University)
Kazuo Yokokawa
(Visiting Fellow, Economic and Social Research Institute, Cabinet Office;
Professor, Tohoku University)
Hiroshi Shibuya
(Visiting Fellow, Economic and Social Research Institute, Cabinet Office;
Professor, Otaru University of Commerce)
Ryuzo Miyao
(Visiting Fellow, Economic and Social Research Institute, Cabinet Office;
Associate Professor, Kobe University)
Yasuyuki Sawada
(Visiting Fellow, Economic and Social Research Institute, Cabinet Office;
Associate Professor, University of Tokyo)
Satoshi Urasawa
(Economic and Social Research Institute, Cabinet Office)
Yoshinori Kinoshita
(Economic and Social Research Institute, Cabinet Office;
The Hachijuni Bank, Ltd.)
Kensho Hashikawa
(Economic and Social Research Institute, Cabinet Office;
The Chuo Mitsui Trust and Banking Company, Limited)
Hidetoshi Tanaka
(Economic and Social Research Institute, Cabinet Office;
The Hachijuni Bank, Ltd.)
Hitoshi Maeda
(Economic and Social Research Institute, Cabinet Office;
Bank of The Ryukyus, Limited)

The full text is written in Japanese.


1. Background

In the latter half of 1997, a currency crisis, having spread over East Asia within a few months after the collapse of the Thai baht, sparked one of the most wide-ranging debates of the 20th century on the both economic theory and policy-making. From the 1980s to the 1990s, the East-Asian emerging market economies recorded high economic growth led by enormous amounts of capital inflows from developed countries under the premise of regulated macroeconomic policy, a stable dollar-pegged exchange system, and the liberalization of domestic and foreign financial transactions. However, such high growth backed by international capital inflows was not permanent. In Thailand, revelations of serious problems in the economy such as the collapse of asset inflation, the fragility of financial system, shadows in export increases, and others caused a wave of baht speculative attacks that eventually led to the currency crisis in July 1997, just after the central bank allowed a sharp drop in the value of the baht. Moreover, although a causal relationship is not clear, Thailand's currency crisis spread to other East Asian countries including Malaysia, Korea, and Indonesia, and triggered the outbreak of what came to be known as the Asian currency crisis.The Asian currency crisis became a matter of concern not only because of the negative impact it exerted on the world and regional economies, but rather because it occurred in the economies that seemed to be supported by good fundamentals and considered healthy from both policy management and economic performance points of view. Nevertheless, the post-crisis evaluation demonstrated that the economic policy of East Asian countries before the crisis was not completely adequate. The significance of the Asian currency crisis was that the new market economies had considerable difficulties in controlling international economic integration in the midst of separate currencies and separate economic policy-making sovereignties.

On the other hand, the Asian currency crisis stimulated the development of theoretical currency crisis models. Essentially, the prototypes of currency crisis models are the models constructed to explain the current balance of payments crisis in Latin America in the 1980s and the crisis of European Monetary System in the early 1990s. The literature showed a rapid progress with the Asian crisis. The central focus of this paper is whether a currency crisis is an inevitable crisis caused by fundamentals as explained in so-called the "first-generation model", or is it a self-realizing crisis unnecessarily caused by market expectations and herd behavior as explained in so-called the "second-generation model"?

This paper analyzes all aspects of Asian currency crisis (and currency crises in general), taking into account theoretical and policy-making points. From the standpoint of economic policy-making, we analyze three themes concerning capital inflows: sustainability of capital inflows (Chapter 2), endogenous nature of the capital inflows in monetary and exchange policy (Chapter 3), and the possibility of avoidance of exchange risk in capital inflows (Chapter 4). We develop an analytical model that analyzes currency crises from a realistic viewpoint as a movement between multiple equilibria that are immanent in economic development of emerging markets (Chapter 1) and a model that incorporates currency substitution into the "first-generation model", suggesting new factors of currency crises (Chapter 5). Chapters 1 and 4 focus on theoretical analysis, Chapters 2 and 3 attach weight to empirical analysis, and Chapter 5 includes both analytical and empirical analyses. The research consists of five chapters, summarized as follows.

2. Outlines
Chapter 1 "Economic Takeoff and Capital Flight"

Steps away from the framework of monetary currency crisis models and analyzes the possibility of multiple equilibria from a realistic perspective as an essential problem of economic development. In other words, this chapter focuses on the strategic complementary relations in the optimal investment behavior of international investors due to increasing returns to capital and the fact that all investments complement each other in the early stages of economic development. It becomes obvious that there are two stable equilibria: high capital equilibrium and low capital equilibrium, developed as a result of these strategic complementary relations. The movement between these two equilibria is economic takeoff or capital escape. In this sense, the Asian economic crisis and the amazing economic development that came to be called the "Asian miracle" are two sides of the same coin. Emerging markets that have just reached economic takeoff are especially vulnerable to capital escape. Nonetheless, multiple equilibria cease to exist in developed countries where investment and accumulation of capital stock are no longer complementary due to economic development. Hence, government plays an important role in economic development until capital stock achieves a necessary level, but after that the rationality of intervention policy disappears.

Chapter 2 "Another Look at Origins of the Asian Crisis: Tests of External Borrowing Constraints"

Examines, on the basis of the latest time series method, whether Thailand, Indonesia, and Korea have been facing foreign borrowing constraints in capital inflows in the period from the latter half of the 1970s until the recent currency crisis. The basic standpoint here is that foreign borrowing constraints mean long-term solvency and whether the currency crisis that occurred under this constraint was caused by factors other than fundamentals. In other words, we try to identify crisis on the basis of presence or absence of foreign borrowing constraints.

Empirical analysis showed that, at the moment of currency crisis outbreak, Thailand was insolvent, while Indonesia and Korea satisfied this constraint. This suggests that Thailand's currency crisis can be explained within the framework of the "first-generation model" based on fundamentals, but that the crises in Indonesia and Korea were self-realizing as assumed in the "second-generation model". This is consistent with the idea that the Asian currency crisis, which originated in Thailand, had contagious spillover effects on Indonesia and Korea through the change in expectations of international investors.

Chapter 3 "Monetary and Exchange Policy and Capital Inflows"

Analyzes endogenous nature of capital inflows in economic policy in four East-Asian countries (Indonesia, Korea, Malaysia, and Thailand) before the currency crisis. In other words, in the period from the latter half of the 1980s until the currency crisis in 1997, while maintaining stable dollar-pegged exchange policies, these countries took sterilized foreign exchange intervention in an attempt to neutralize the impact of the increase in foreign exchange reserves entailed by capital inflows. The results of the empirical analysis are as follows. (1) Sterilized foreign exchange intervention was effective on the whole because there are no statistically significant relations between foreign exchange reserves and currency supply. (2) The risk premium of East Asian currencies was large, and the expected exchange rate against the dollar was not stable. Putting it another way, dollar-denominated assets and assets denominated in East Asian currencies were not perfect substitutes. Moreover, though sterilized intervention was effective, the increase in risk premiums widened gap in interest rates and, thus, increased the amounts of capital inflows. In this sense, capital inflows are endogenous in economic policy, but it is important to note that it was not the dollar-pegged exchange policy that triggered capital inflows: it was the sterilized foreign exchange intervention policy that did so.

Chapter 4 "Capital Account Liberalization and the Burden of Exchange Risks"

Gives the theoretical and numerical analyses of the distribution of exchange risks accompanying capital inflows. It has been suggested that the adverse impact of the currency crisis was magnified because borrowers in East Asian countries did not cover exchange risks and accumulated dollar-denominated short-term liabilities. The basic premise in this chapter is that a forward hedge is an exchange of liability denominated in foreign currency with liability denominated in domestic currency. Domestic agents can indeed avoid exchange risks if the authorities require them to forward-hedge against exchange risks. This transfer of risks may be desirable if foreign investors are more risk-tolerant or have access to better means of diversifying exchange risks, but the exchange risk itself does not disappear from the international capital market. The analysis in this chapter shows that an increase in domestic investment financed by large foreign currency debt arises when domestic investors under-estimate exchange risks and risks of domestic investment projects. Requiring forward hedge is justified when the authorities judge domestic agents under-estimate exchange risks, but not when domestic agents under-estimate risks of domestic investment projects. In addition, requiring forward hedge does not necessarily lead to a significant reduction of the total risks born by domestic agents including the risks of domestic investment projects.

Chapter 5 "Currency Substitution and Currency Crisis"

Develops an analytical framework of introduction of currency substitution into the "first-generation model", taking into account the recent increase in currency substitution (defined as increase in foreign currencies share of household's real money outstanding balance) and the depreciation of nominal exchange rates. From the analysis of this chapter it became obvious that (1) within the framework of an inter-temporal optimization model, depreciation of exchange rates stimulates currency substitution regardless of price-adjustment speed; (2) currency substitution can trigger a currency crisis even if expansionary policy is not implemented; and (3) these theoretical results are mainly consistent with the international comparative analysis based on specific data from the Penn World Tables of 1970, 1975, 1980 and 1985. In other words, there is a strong positive correlation between the depreciation bias of exchange rates and the extent of currency substitution. Moreover, there is a negative correlation between the extent of currency substitution and economic development. This analysis suggests that, as long as economic integration is accompanied by currency substitution, the possibility of currency crisis is growing with economic integration, just as it was in European countries in the 1990s.

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