A retrospective on the Asian crisis of 1997: Was it foreseen?

Chicago Fed Letter, Jan 2001 by Halcomb, Darrin, Marshall, David

In early July 1997, the Thai baht was devalued following a speculative attack by currency traders. The fallout from this event went far beyond the usual consequences of speculative currency attacks. Devaluations followed in Malaysia, the Philippines, Indonesia, and South Korea. In all five countries, economic activity went into a tailspin. As shown in figure 1, the declines in industrial production following the currency crises were of magnitudes associated with economic depression. These declines are especially noteworthy in light of the extraordinary economic growth in these countries during the years preceding the crisis, demonstrated in the third and fourth columns of figure 1.

Given the huge collateral damage to these countries' economies, most economists agree that the 1997 crisis goes well beyond the usual case of an overvalued currency being forced by currency traders to realign its exchange rate. Massachusetts Institute of Technology economist Paul Krugman makes this point forcefully: "[T] he currency crises were only part of a broader financial crisis, which had very little to do with currencies or even monetary issues per se."1

In this article, we focus on one important piece of the puzzle: "Was the crisis foreseen?" This question is important because it may help us decide between two distinct classes of candidate explanations. Following Paul Krugman, we may call these two candidates the "fundamentalist" and "selffulfilling" approaches.2

The fundamentalist approach holds that the crisis resulted from a gradual accumulation of structural imbalances. Observers point to accounting practices that had inadequate transparency, bank loan decisions being made for political reasons rather than for sound economic rationales, and a legal infrastructure inadequate for a modern capitalist economy. For example, at the time of the 1997 crisis Thailand did not even have a wellfunctioning bankruptcy code.3 Even more strikingly, Indonesia's bankruptcy law, drafted by the Dutch in 1905, remained unchanged through 1997 and had never even been translated from Dutch into the native language!4 Most notably, the banking sector in many of these countries had severe problems, with a vast accumulation of unrecognized bad loans.

The self-fulfilling approach holds that the crisis ultimately reflected a reversal in investor beliefs about the future economic prospects of the crisis countries. According to this explanation, this reversal in beliefs led investors to pull capital out of East Asia, causing the very economic downturn that the investors feared. In this sense, the reversal represented a self-fulfilling prophecy.

Which of these two approaches best explains the events of 1997? A key piece of evidence is whether the crisis was foreseen by investors. Under the fundamentalist approach, the crisis resulted from years of fundamental problems. These problems were common knowledge to investors and were perceived well before the speculative attacks that marked the onset of the full-blown crisis. For example, Burnside, Eichenbaum, and Rebelo5 provide evidence that the poor quality of bank assets was well known months or even years before the devaluations that marked the beginning of the crisis. Investors would have known that as these problems became worse, the odds favoring a severe financial crisis (including a currency devaluation) were increasing. The model of Burnside, Eichenbaum, Rebelo (1998) implies that the Thai devaluation could have been foreseen over two years before the devaluation occurred. Financial markets would react to the increased probability of devaluation by bidding up nominal interest rates and forward exchange rates (in dollars per own-currency). We therefore would see these financial indicators move prior to the onset of the crisis.

Evidence that the crisis was not foreseen by financial markets would represent a challenge for the fundamentalist approach. However, it would be easier to reconcile with the self-fulfilling approach. Investor sentiment is crucial for generating a self-fulfilling crisis. A crisis can result if investors switch from optimism to pessimism about future economic prospects. In principle, there is no reason why such a shift in sentiment need be foreseen by financial markets.

Evidence from financial markets

To measure whether the large currency devaluations were foreseen, we look at foreign exchange forward rates and nominal interest rates (denominated in the Asian countries' currency). If investors forecasted an increase in the probability of a foreign exchange crisis, these rates would have responded before the actual beginning of

the crisis.

We use daily data from Malaysia, Indonesia, and Thailand. We choose these countries because we were able to obtain exchange rate and interest rate data from offshore trading for these three currencies. The offshore aspect of these contracts is important, since it means that these data are market based and have not been manipulated in any way by domestic authorities. Our data are from Bloomberg Financial Markets, based on contracts issued and traded by Prebon Yamane Asia, an offshore brokerage firm based in Hong Kong.