BOOK REVIEW by Ila Patnaik

Ref: BR/304/2001

Title: The East Asian Currency Crisis

Author: Mihir Rakshit

Oxford University Press, Delhi 2002

pp xii+288, Rs 545

The benefit of hindsight allows analysts to reconsider conventional wisdom and place events in their proper perspective. The same is true of the East Asian currency crisis. Apart from offering a commentary on the unfolding of events in the upheaval, Mihir Rakshit, in this book brings together the major theoretical and policy implications of the currency crisis.

The currency crisis in East Asia caught even the keenest watchers of these economies unawares. High GDP and export growth for nearly two decades and fiscal prudence had convinced most economists that there was no impending crisis. The Asian Development Bank, for instance, wrote in the first half of 1997 , “Most South East Asian economies are expected to strengthen their performance in 1997 and 1998”.

The main reason for the failure of economists to predict the crisis was that existing theories did not suggest that these economies were anything but healthy. Even later, when the currency turbulence had begun, the difficulty in reconciling the crisis with generally expected theories was responsible for the failure to understand the crisis.

Theories to explain currency crisis in the post-Bretton Woods system were advanced in the context of the first, Latin American currency crisis in the 1970s and early 1980s and later the speculative attacks on some currencies under the European Monetary System and the Mexican debacle of 1984-85.

The first generation of currency crisis models explained a currency crisis under fixed exchange rate regimes. They suggested that if the equilibrium exchange rate, driven by fundamentals, consistently deviates from the pegged rate, then the central bank will be unable to defend the currency peg, no matter how big their foreign exchange reserves. It was essentially expansionary domestic policies that led to the deviation and the consequent pressure on the currency.

The focus of the first generation models was on economic fundamentals that govern the long run exchange rate and they were unable to explain the speculative attacks on some European currencies such as the British pound in 1992-3. These crisis could not be attributed to long term fundamentals. Second generation models try to explain these varieties of currency crisis to the behaviour of the government and currency traders. While the government maintains the peg as long as there is no great speculative attack on the currency, it is not ready to defend the currency at all costs. Thus if it is too costly to defend the currency, the central bank does not do so and allows it to depreciate. If there were no speculative attack then, unlike in the first generation models, the currency peg could still have continued. But if an attack takes place then it is the attack that raises the cost of maintaining the currency. This makes it optimal for the government to abandon the peg.

Given that these theories were tailored to explain specific instances, the Asian crisis came as a complete surprise to almost everybody as it did not fit in with earlier experiences and theories. And, as the author suggests, economists and analysts well versed in the then prevailing theories, failed, not only to anticipate the problem, but also to foresee the widening and deepening of the crisis, even after the fall of the Thai Baht in mid-1977.

Krugman tried explain the East Asian currency crisis mainly on the grounds of a failure in financial intermediation resting on the moral hazard problem. The problem arises because of the explicit or implicit guarantee of bank deposits by governments. This leads banks to large scale extension of credit for financing risky investments as these offer the ‘Pangloss return’, that which obtains under the best of all possible circumstances. The resulting misallocation of resources is manifested in a diversion of funds from projects having higher expected returns to those yielding low or even negative returns on the average. The moral hazard leads to an increase in domestic investment and saving. The expected return on investment falls short of the cost of borrowing so that a financial crisis becomes inevitable. Capital account convertibility aggravates the crisis. Not only is there an ‘overinvestment’ but also a higher current account deficit, a lower level of domestic saving, and a heavier burden of domestic borrowing.

Rakshit suggests that, one, since most investment in East Asian economies was not routed through banks ( FDI and portfolio investment continued to be substantial ) and two, since these countries enjoyed a prolonged spell of high and sustained growth with little volatility, investment in these countries could not have been driven by Pangloss returns. He thus finds that neither the assumptions underlying Krugman’s hypothesis are in conformity with the conditions prevailing in the East Asian financial markets, not are the predictions of the model borne out by the East Asian experience. Further, he suggests that the model suffers from a serious theoretical flaw which undermines the relevance of its results. Investment in Krugman’s framework inevitably leads to widespread losses of firms and large scale banking crisis and a rational economic agent should be able to foresee this and thus not take the government’s guarantee seriously. Hence the behaviour of depositors in the Krugman model cannot be explained in terms of rational expectations.

The bulk of the book consists of 5 papers that were originally written over the period 1997-99 as a series of articles for Money and Finance. The introduction discusses the evolution of the international financial system theories explaining currency crisis. The papers trace the origins and explain the phases of the East Asian currency crisis. On the basis of the behaviour of exchange rates, share prices and interest rates he distinguishes between five phases of the Asian currency crisis. He finds that financial variables went through two major cycles in the course of the crisis. The behaviour of the real side was, however, characterised by a single cycle with the GDP declining everywhere from September 1997 and picking up only after at least a year. Rakshit identifies the factors that differenciate the Asian crisis from the Latin American and European ones and assesses the role of liquidity, informational problems, fragility of short term expectations and self-fulfilling expectations. He identifies the combination of factors such as the downturn in export demand, disproportionately large external liabilities in relation to foreign exchange assets, and the weakening of banks balance sheets that may force a country to renege on its foreign dues and suffer a currency crisis. He suggests comprehensive policy measures to make countries less vulnerable to currency crisis and its impact.

The book is made eminently readable by its narrative style. Unlike books that offer theoretical rigour by including equations and diagrams in the main text and at the cost of readability, this one confines the rigorous theoretical backup to appendices and footnotes for the more specialist reader. The general reader can absorb the intuitive argument without losing the main thread of the discussion with ease. This makes the book valuable not only to academics and policy makers but also to those who do not have an economics background but want to understand the working of the international financial system, foreign exchange markets and currency crisis.

Ila Patnaik