Currency Crises in Emerging Asia and Elsewhere

Keith Rankin, 15 August 1998


Paul Krugman, in his second lecture on the Asian economic crisis (Robb Lectures, University of Auckland, 12 August 1998), sought to explain the crises in, in particular, Thailand, Indonesia and South Korea, using three different models of national currency crisis.


The first type of model examined is the "first generation" model by which national governments print money in order to fund a budget deficit. This is most likely to happen in countries in which the collection of taxes is difficult; eg countries such as Russia today. While such countries may have balance of payments problems, such problems are not seen as a part of the mechanism of crisis. Printing money leads, allegedly, to inflation (internal currency depreciation) which in turn leads to external currency depreciation. The process stops, supposedly, when the printing presses stop.


This "budget deficit" model of currency crisis can be applied not only to unstable countries, but to stable countries with left of centre "spending" governments. One of the classic cases in history is the run on the French Franc during Leon Blum's Popular Front government of 1936. The 'markets' (and the Alliance) in New Zealand were concerned in 1996 that Labour had a policy which seemed to require much more spending but offered no tax increases. Furthermore, Winston Peters claimed that there would have been a currency crisis in New Zealand had he formed a coalition with Labour and the Alliance. Part of the risk at that time was the fact that the New Zealand dollar was clearly overvalued.


The budget deficit model did not work as an explanation for the rapid depreciations of the currencies of emerging Asia in 1997 and 1998.


Hyperinflations this century in Europe and Latin America have been attributed to the printing press. In fact the empirical evidence is less clear. In many historical cases, it can be argued that the external depreciation preceded the printing press, and indeed made printing money the only way of avoiding a much greater tragedy. It is my view that many of the historical hyperinflations had much in common with the present crisis in emerging Asia, and much less to do with budget deficits and government printing of money.


The second type of model of currency crisis applies to developed countries which seek to prevent their currencies from depreciating, thereby creating a "one-way-bet" situation in which international "investors" such as George Soros can exploit. The depreciation becomes self-fulfilling, and it may be quite sudden. The run on the currency is most likely to happen during a regular sort of recession; especially a recession caused by high interest rates and an overvalued currency. The currency may be being supported at a high level in order to avoid imported inflation.


Krugman's main example was the big depreciation of the British pound in 1992 after international financial markets forced the pound sterling to depreciate. Such crises turn out to be blessings in disguise, because the underlying economy is strong. After the crisis, Britain had the ability to take advantage of an undervalued currency to increase its rate of economic growth. The crisis turned out to be the solution rather than the problem.


This model cannot explain the Asian crisis. There is no automatic recovery mechanism in emerging Asia. Rather, Krugman likened the situations of Indonesia, Thailand and South Korea to that which nations have not faced since the 1930s.


For these countries, Krugman's preferred third model is one of chronic bank failure, and of likening the International Monetary Fund to the big business banks of 100 years ago. The problem is that fixing the crooked banks is not enough in Asia (unlike Mexico in 1994), and the chronic flight of capital (arguably led by domestically sourced flight rather than the exodus of foreign money) has no end in sight. The problem began because, under crony capitalism ("public risk, private reward"), investments were too easy in these countries. The governments bore the risk. The problem keeps getting worse because of the high levels of foreign currency debt which looks very bad on local banks' balance sheets. And the IMF can do little because the problems are firmly located in these countries' private sectors. Bank credit has dried up, and the growth needed to get these countries out of the mess is unable to be funded.


Krugman sees this type of crisis as mutually exclusive from the second type. The third type is confined to countries with a banking system riddled with nepotism and a high private foreign debt exposure.


What about New Zealand's crises? In 1975 the government did print money following a huge fall in the terms of trade. But the appropriate devaluations were taken. There was no financial crisis as such, but GDP did fall sharply in 1977. Given low unemployment, the decline in GDP may have been driven by emigration as much as by any financial or trade contingency. In 1977, the British, Australian and American economies were in full recovery, and New Zealand had a Prime Minister who was intensely disliked by a large number of young people.


Britain's currency run in 1976 seems to have had elements of the first and the second models. It followed a severe sharemarket slump in 1974 and 1975. The IMF was called in, and financial confidence returned.


In 1984, there is an element of Britain in 1992. The exchange rate was being held up when many people believed that it should have been falling. Once the election was called in June 1984, the one-way bet mechanism set in. The chance of a substantial devaluation was high, and the chance of a revaluation was nil. The highish level of overseas debt did not seem to be playing any role. There was no sign of a run before the snap election was called.


The high growth rate of 1985 makes this New Zealand event seem similar to Britain in 1992. In fact, statistics not available at the time show that the exchange rate was not overvalued in June 1984, and they show that the economic growth of 1985 was lower than that of early 1984. Nevertheless, perceptions did create a crisis out of nothing; a crisis that precipitated an unnecessary devaluation, and which gave windfall profits to the mainly local people who exported their capital between 14 June and 14 July 1984.


In 1987-88 there was no currency crisis, when perhaps there should have been. This was partly prevented by interest rates being held at higher levels that almost every other country with a floating exchange rate. The result was a purely domestic crisis. New Zealand was also lucky in that a significant improvement in the terms of trade facilitated an improvement in the balance of payments problem which was very serious by 1987.


In 1991-93, an orderly depreciation of the New Zealand currency ensured that there would be no financial crisis. On the other hand, in 1996, as in 1992 in Britain, New Zealand was well poised for a flight of capital. Such a flight could have been more significant than that of Britain because of New Zealand's massive private foreign debt. Re the Asian crisis, it could have been New Zealand that was the 'first cab off the rank' and not Thailand. On the other hand, the international financial community has a considerable investment in New Zealand. New Zealand could not be allowed to experience an Asian-style crisis, because it has done all of the things and more that the IMF could have asked it to do. Furthermore, New Zealand is small enough for the international community to protect; to protect in the interest of the international community, not New Zealand's.


New Zealand has been scared this year by the Asian crisis. The Reserve Bank has done all the right things, for once. The conditions for any of these three types of financial crisis are absent. But there is a danger of an internally generated economic slump arising in part from our policymakers' misreading the Asian crisis in particular and globalisation in general. The sleeping dog is not the Reserve Bank Act, but the Fiscal Responsibility Act, the Employment Contracts Act, and the pressure for further tax cuts in order to raise New Zealand's "competitiveness". Krugman's third lecture addressed the issue of copycat domestic crises.

Krugman's syllabus

Little by little, a picture of what happened to Asia has begun to come together. It began with weaknesses in Asia's system - crony capitalism is more that a catchphrase. But the punishment has been vastly disproportionate to the crime, because the initial loss of confidence turned into a vicious circle deflation, recession, and banking collapse. And the rescue attempts of the IMF are starting to look increasingly futile - good loans are going bad faster that banks can be restructured. What should Asia have done instead? How can the best and the brightest have presided over such a disaster? And what happens now?