Revisiting the Causes of the East Asian Financial Crisis: Was it predictable?

Headnote

ABSTRACT

This study evaluates two predictive indicators of the East Asian Currency Crisis using the balance of payment and interest rate parity model. The paper examines whether a continuous current account deficit and overvaluation of real exchange rate are able to predict the crisis. Six different countries which include Thailand, Philippines, Indonesia, Malaysia, South Korea and Singapore were investigated. All, except for Singapore, confronted a speculative currency attack and either abandoned their managed float rate regime or forced the monetary authority to surrender to the market and let the rate pass over their target level. The results from the analysis indicate that the current account of the balance of payment for Malaysia, Thailand, Indonesia, Philippines and South Korea were continuously in deficit from 1991 to 1996. The findings also show that the real exchange rates for the said countries were overvalued against the United State dollars.

JEL Classification: H15.

Keywords: Balance of Payments, Interest Rate Parity, Currency Over-Valuation.

I. INTRODUCTION

The crisis that took place exactly ten yean ago in the mid of 1 997 in East Asia rekindled many works on financial crisis. The financial sector was observed to be the main reason for East Asian financial crisis. Since currency crisis and financial crisis are closely related in the sense of causality, we should take into account the relationship between them when analyzing the East Asian crisis. Instead of sticking with only one explanation for the link between financial and currency crises, Kaminsky and Reinhart (1999) classify the models of this link in three groups.

One chain of causation runs from balance of payments problems to financial crisis. An external shock, such as an increase in foreign interest rates, coupled with a commitment to managed float parity, will result in the loss of foreign exchange reserves, because investors and their agents will find it more profitable to invest in foreign countries.

The second group models point to the opposite causal direction; financial sector problems give rise to the currency collapse. Such models stress that when central banks finance the bailout of troubled financial institutions by printing money, a currency crash prompted by excessive money creation will occur. Saxena and Wong (1999), and Bumside, Eichenbaum and Rebelo (2001; BER henceforth) are in this second...