Academic journal article Economic Perspectives

Understanding the Korean and Thai Currency Crises

Academic journal article Economic Perspectives

Understanding the Korean and Thai Currency Crises

Article excerpt

Introduction and summary

In late 1997, Southeast Asia was rocked by banking and currency crises. While dramatic in scope and intensity, this episode was only the latest in a series of "twin crises." Other prominent examples include Argentina (1980), Chile (1981), Uruguay (1981), Finland (1991), Sweden (1991), and Mexico (1994). In this article, we review and interpret the recent Korean and Thai experiences, focusing on the pivotal role of unfunded contingent government liabilities. We concentrate on the Korean and Thai cases both because their crises were severe and because neither country appeared to be a likely candidate for a currency crisis, at least not from the perspective of standard economic models.

In addition to being of independent interest, the lessons learned from the Korean and Thai episodes should be useful in predicting and averting future twin crises. [1] In a nutshell, these lessons are as follows. First, twin crises are likely to erupt in countries whose governments have large prospective deficits stemming from guarantees to failing financial sectors. Such guarantees typically insure creditors--both domestic and foreign--against realizing large losses when financial institutions that they have lent money to become insolvent or go broke. Second, past deficits are, at best, a noisy indicator of how large a government's prospective deficits are. Accurately measuring the latter requires a careful analysis of the nature of a government's guarantees and the probability that those guarantees will be called upon. It may never be possible to predict precisely when a twin crisis will occur. But more accurate measures of prospective deficits are likely to be helpful in predicting where twin crises will occur. Finally, to avoid currency crises, governments must have credible plans to finance contingent liabilities with credible, explicit fiscal reforms. Such reforms include concrete measures to cut government expenditures or raise taxes.

In the body of the article, we provide the empirical background for our analysis. We begin by motivating empirically the importance of past banking crises as a source of government liabilities. We then briefly review the salient features of the recent crises in Korea and Thailand. These can be summarized as follows.

1. Both currency crises were difficult to predict on the basis of standard economic indicators, such as inflation rates, monetary growth rates, or past government deficits.

2. Neither banking crisis was difficult to anticipate, certainly not if one used publicly available information about the market value of financial firms in Korea and Thailand.

3. When the crises came, they came with a vengeance. The Korean won and Thai baht rapidly depreciated by over 50 percent and 80 percent, respectively, vis-a-vis the dollar before partially rebounding in value. In addition to the large social costs associated with severe recessions, the crises saddled the Korean and Thai governments with very large liabilities. These arose both from their implicit guarantees and the need to restructure their respective banking systems. As we discuss below, these costs are now estimated to exceed 25 percent of Korea's and Thailand's gross domestic product (GDP).

4. After the crises, the rates of inflation and money growth rose in both countries, though not by nearly as much as the rates of depreciation of the won and the baht. The rise in the price of tradable goods was much larger than the rise in the price of nontradable goods.

Later, we provide an explanation of the way in which prospective deficits could have caused the currency crises. The basic idea is that the Korean and Thai financial sectors were in trouble prior to the currency crises and investors knew this. Given the Korean and Thai governments' implicit guarantees to their banking sectors, market participants revised upwards their estimates of future government deficits. …

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