Difficulties of keeping a pegged exchange rate : the case of China during the Asian crisis

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University of Amsterdam

Faculty of Economics and Business

Difficulties of keeping a pegged exchange rate:

The case of China during the Asian crisis

Author: Gossaart van Kranendonk (5876869) Supervisor: dhr. C.G.F. van der Kwaak MSc Study program: BSc Economics and Business

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China is the largest country in Asia, and due to its magnitude, its economy is a substantial factor in the regional economy. Money flows in and out of China via trade and capital transactions, affecting the money demand. Since there are capital controls in China, the money supply is influenced by the

government of China. Therefore, the government influences the exchange rate. The authorities in China have a good reputation of securing the exchange rate.

In 1997, South Korea, Indonesia and Thailand were hit by a currency crisis; they saw their exchange rates tumble. Before 1997, growth rates in these countries were in excess of 5%. Next to the growth rates, these countries show strong similarities in their financial culture. Firms interact on a strong relational base, and governments have strong ties with the business. In section 5, the relationship-based system is explained. On top of that the countries are regionally linked via trade. If a country spends less, imports could decrease. Therefore, it could affect the export of the other country. A decreased income then decreases the income in the other country. Before the crisis, the currencies of South Korea, Indonesia and Thailand were pegged to the US dollar.

China shows the same similarities in its financial culture and has close ties to South Korea, Thailand and Indonesia. The currency of China, the yuan, is also pegged to the US dollar. The exchange rate has not been adjusted much since the last decade. During the turbulent period of the Asian financial crisis, the Chinese authorities managed to maintain a fixed exchange rate. This paper attempts to investigate the following: Why did the Chinese yuan not depreciate during the Asian crisis, although the currencies in Indonesia, South Korea and Thailand did?

Via the following sub-questions and the use of the IS-LM-BP model, this paper tries to form a substantiated answer for the above question.

1. What variables affect the exchange rate?

2. What is the economic state of Indonesia, Thailand, South-Korea and China?

3. What are the economic differences between Indonesia, Thailand, South-Korea and China? Section 2 discusses the variables affecting the exchange rate. Section 3 elaborates on three systems of exchange rates. A review of the crisis is given in section 4. Section 5 presents the analysis of macro

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economic variables. In section 6, the paper analyzes the situation of Indonesia, Thailand, South Korea and China on the basis of the IS-LM-BP model, followed by the conclusion in section 7.

2. What variables affect the exchange rate?

In this paper the exchange rate is denominated as the value of different Asian currencies in terms of US dollars

� = ��ℎ�� =�� _{�� }

If the exchange rate increases, one gets more units of an Asian currency for 1 unit of US Dollars. Since this paper has as an Asian point of view, one calls the increase of the exchange rate a depreciation.

2.1 The IS-LM-BP model

The IS-LM-BP model is an extension of the IS-LM model1_{. The extended model takes the effect of trade}

in goods and services into account (trade balance) as well as trade in assets (capital account). Figure 1, The IS-LM-BP curves

Total expenditures (Y) in an open economy are the sum of total consumption (C), total investments (I), governmental expenditure (G) and net exports (NX).

� = � + � + � + ��

NX is equal to the level of exports minus the imports. Exports represent the external demand for domestic goods and services. The external demand depends on foreign income levels, just like domestic demand depends on domestic income levels. The model assumes that foreign income is constant.

1_{The IS-LM model is a macroeconomic model that shows the relationship between interest rates and}

real output in the goods and services market and the money market. The intersection of the IS and LM curves is called the "General Equilibrium".

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Therefore, the foreign demand for domestic goods and services is depends on the exchange rate, assuming that prices are constant. Foreigners will consume more foreign goods and less domestic goods if the exchange rate appreciates from a domestic point of view. The demand for foreign goods depends on the relative price. The higher the domestic price in regard to the foreign price, the more goods consumers will purchase abroad. The exchange rate is an indicator of the relative price. A depreciation of the exchange rate causes domestic residents to pay more for foreign goods. Thus, exports are

determined by foreign income levels (constant) and the exchange rate (relative price). Domestic income levels (variable) and the exchange rate determine import (Pilbeam, 2009).

In the model, the IS-curve represents the combinations of interest (i) and output (Y) for which the level of total expenditures equals the level of production. Recall that the exchange rate also determines total expenditure, since NX is affected by the exchange rate. The IS-curve shifts due to changes of the

exchange rate. If the domestic currency depreciates, exports increases, imports fall, thus NX increases, which means total expenditure increases, the IS-curve shifts to the right. When the domestic currency appreciates, it works the other way around. Fiscal and monetary policy has different effects on the IS-curve when applied in a system of fixed or flexible exchange rates and depending upon whether capital is mobile (Pilbeam, 2009).

The LM-curve depicts the combination of i and Y for which the money market is in equilibrium. The money market and the coherent monetary policy of a central bank are discussed in section 3.5. When the money supply increases, the equilibrium interest rates decrease. The LM-curve shifts right when the money supply is increased.

The BP-curve shows the combinations of i and Y for which the current account and the capital account offset each other; then the Balance of Payments is in equilibrium. The current account in this model is determined by three variables: 1. The domestic level of income, which affects import. 2. The foreign level of income, which affect export. 3. The exchange rate, which affects both import and export. The rate of return on comparable assets between countries determines the capital account. Assuming that the exchange rate is fixed and that the foreign interest rate is a constant, an increase of domestic interest rates will attract capital to the country. A fall in domestic interest rates will push capital abroad. The slope of the BP-curve characterizes the degree of capital mobility. The curve is perfectly horizontal when capital is perfectly mobile. Financial assets are perfect substitutes across countries. When there is perfect capital mobility, a small deviation of the interest rate results in an infinite amount of capital

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flows. Due to the mobility of capital, interest rate differences can be arbitraged away when the domestic interest rate equals the foreign interest rate. When assets are not perfect substitutes across countries, one speaks of capital immobility. The curve is steeper by degree of immobility. A perfect vertical BP-curve reflects immobile capital. In the case of perfect capital immobility, a deviation of the interest rate does not result in infinite capital flows. Capital flows are controlled, so interest rate differentials cannot be arbitraged away, as the domestic interest rate does not equal the foreign interest rate. One speaks of immobile capital when the BP- curve is steeper than the LM-curve. A less steep BP-curve indicates more mobile capital. The principle behind it is that a small deviation of the interest rate, in an economy with immobile capital, has a smaller impact on the output via capital flows as compared to the impact it has on the output via the money market. The degree of capital mobility influences the outcome of various fiscal and monetary policies (Pilbeam, 2009).

Figure 2, Capital mobility

2.2 Foreign exchange reserves and the balance of payments

The balance of payments (BoP) shows all transactions that a country conducts with the rest of the world. On the debit side of the account, money outflow is accounted for. On the credit side, money inflow is accounted for. Transactions on the BoP are categorized into two categories: transactions on the current account, and transactions on the capital account.

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Figure 3, Overview balance of payments

On the current account all transactions, relating to trade in goods and services, net interest and transfers in the form of foreign aid, are recorded. The account consists of three components:

1. The trade balance 2. Net foreign income 3. Unilateral transfers

In the trade balance, the difference between export levels and import levels is shown. There is a trade surplus when there is an excess of exports over imports. One speaks of a deficit in the BoP when there is an excess of imports over exports. Net foreign income is the income earned on assets held abroad, reduced with the income earned by foreigners who hold domestic assets. The income includes interest and dividends. Unilateral transfers are transfers that are made without consideration. International aid is one of them (Pilbeam, 2009).

The capital account records all financing transactions. It covers transactions such as international investments in the stock market or the raising of capital abroad. On the capital account, money flows

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can be best categorized by maturity period. Long-term loans are not easily withdrawn; this sort of capital flow is not reversed quickly. On the contrary, short-term loans can be withdrawn easily. The capital flow can be reversed quickly. These short-term capital flows can cause severe market disruptions as it did during the Asian crisis (Pilbeam, 2009).

The capital and current account are complementary. The net total of the two determines whether the foreign exchange reserves of the country decrease or increase. A net surplus in the balance of payments has an accumulating effect on the foreign exchange reserves.

��/�� ℎ� �� 

+ ��/�� ℎ� �� 

= �� ℎ�� ℎ��  China has both a surplus on the capital account and the current account. Therefore, their foreign exchange reserves increased substantially during the 90s.

Figure 4, China’s Foreign Exchange reserves in million US dollars

The capital account reflects the net change of asset ownership of a nation. The account shows all money flows that are caused by public and private investments. An outflow of money suggests that investments are done abroad. When investments done abroad are larger than investments made by foreign investors in the domestic country, one speaks of a deficit of the capital account. Debt is translated as a surplus of the capital account. Debt is an important factor in the Asian crisis (Pilbeam, 2009).

The balance of payments is always in equilibrium when there is a flexible exchange rate regime. If the current account is in deficit, the capital account is in surplus, and vice versa. For example, if a country

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spends more than it earns, the country needs to finance this overspending with external sources. In the balance of payments, there is a deficit on the current account, and a surplus on the capital account. In this example, there is an excess demand for foreign currency. Excess demand for a currency raises the value of the currency. At the same time, the value of the domestic currency decreases. This results in a depreciation of the exchange rate (Pilbeam, 2009).

2.3 Interest

Interest is the compensation a person receives for the lending of his or her money; it is paid by the person who borrows the money. For instance, in the case of a homeowner and a bank, the homeowner borrows money and pays interest on his mortgage. The bank receives interest for granting the credit to the homeowner. A lender always bears a risk, because of the borrower’s probability of default. Interest is often seen as a risk premium, the premium for the incurred risk of the lender. The system of lending and borrowing provides incentives for both parties. One party receives money that it can invest, the other party earns interest on the loan. The interest rate is an important variable in a borrowing-lending situation. When the interest rate is high, a borrower has less incentive to borrow money, the debt plus the amount of interest would be expensive to pay back. A high interest rate directly affects the

willingness to borrow and indirectly influences the possibilities to invest. With a low interest rate, there is more incentive to invest, as one could receive a higher return by investing in other projects than by putting money on a savings account (Pilbeam, 2009).

The interest rate that is set by commercial banks consists of two parts. The central bank defines the first part of the interest rate. Economic conditions such as economic growth and the level of inflation, the creditworthiness of banks and consumer confidence are external factors that the central bank takes into account when it sets the interest rate. The rate is controllable by the central bank. Via the money supply, a central bank can influence the money market. In a fixed exchange rate system, the central bank has to adjust the money supply to keep the peg. Thus, in a system of fixed exchange rates the first part of the interest rate is not determined by the central bank. The second part, the risk premium, is set by the lender.

The nominal interest rate is one of the causes for various money flows between regions. Differences between countries in nominal interest rates make money flow from one country to another. Investors want to obtain the highest yield. When the interest rate is higher abroad, one will invest abroad. If a foreign investor has to exchange his foreign currency for domestic currency, the demand for the domestic currency increases. It has an appreciating effect on the exchange rate (Pilbeam, 2009).

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For instance: Home country A has a nominal interest rate of 5%. Foreign country B has a nominal interest rate of 7%. In country B, the yield on capital is higher. Investors are more willing to lend money to entities in country B, because of the higher yield. Money flows from country A to country B. Before the currency of country A can be used in country B, it should be exchanged for currency B. In this example, currency B is demanded and currency A is supplied. The increased demand for currency B increases the value of currency B. Recall that the value of foreign currency is expressed in domestic currency and one has a domestic viewpoint. The exchange rate depreciates.

2.4 Inflation

Inflation is the rate that measures the price changes of goods and services. If there is inflation, the price level increases, and when the price level increases, purchasing power decreases. Purchasing power measures how much a consumer can buy with a certain amount of money. When there is inflation, the value of money decreases. With the same amount of money, a consumer can buy fewer goods. If there is deflation, the price level decreases, and there is an increase in purchasing power.

Inflation has an indirect effect on the exchange rate. A higher price will affect the competitiveness of a country. Due to the higher price, domestic goods and services will become more expensive for the foreign market. Imports on the other hand will become cheaper. That way, inflation may lead to a trade deficit, which is a situation where imports exceed exports. This would increase the demand for foreign currency. The value of the foreign currency increases, which has a weakening effect on the exchange rate.

If an investor invests in a country where inflation is high, he would want to be compensated for the fact that he can buy fewer goods with the foreign currency. For the investor, the exchange rate should improve, in order that a unit of domestic currency can buy more units of foreign currency, thus he can buy more goods. The investor would now invest in a high inflation country, since the right exchange rate neutralizes the differences in inflation. Thus, if the exchange rate is right there are no price differences between countries. In the economic theory, this mechanism is called the purchasing power parity. The parity states that foreign prices equal domestic prices when the exchange rate is right. Prices are sticky in the short run, it means that the price level do not changes quickly. Current economic consensus about the parity is that the parity does not hold in the short run. Although prices are considered sticky,

investors do want to be compensated if inflation increases, because they want to be able to buy the same amount of goods.

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In the economic theory there are three main schools of thought about which factors affect inflation, i.e. whether monetary and fiscal policies affect the rate of inflation. Stein (1981) gives an overview of these thoughts and whether monetary and fiscal policies affect the rate of inflation.

Keynesians claim that monetary and fiscal policies have weak effects on the rate of inflation. The policies do affect output and employment through their effects upon aggregate demand. In Keynesian theory, fiscal policy does affect inflation when it creates a significant Okun gap (Stein 1981). The Okun gap is the gap between potential output and actual output. When potential output is below actual output,

inflation increases.

New Classical Economics (NCE) do not find that a fiscal policy can raise or lower the unemployment rate. There is a relationship between the unemployment rate and the rate of inflation. Philips found a

consistent inverse relationship: when unemployment is high, wages increased slowly, when

unemployment was low, wages rose rapidly (Hoover, 2008). Fisher (1973) claims that he already had found this relation in 1926. Fisher is considered one of the earliest American Neo-classical economists. Wages are an important factor of inflation. The NCE claims that a monetary policy affects the price level quickly and systematically because, in the Quantity Theory Equation2_{, it has no systematic effects upon}

either the level of output or velocity.

Monetarists take the opposite angle of the Keynesian view. Their main idea is that inflation is primarily a monetary phenomenon. They also claim that a restrictive fiscal policy, without a reduction in the rate of monetary expansion, cannot reduce the rate of inflation (Stein, 1981). On this point they agree with the NCE, but they disagree on the point that there is a tradeoff between the speed at which inflation is reduced and the temporary rise in the unemployment rate. Monetarists cling to the view that fiscal policy is powerless, that is, that the multiplier3_{for government spending is approximately zero (Blinder}

and Solow, 1973). Besides inflation there is an expectation about inflation. In the monetary theory, money growth is the cause of inflation. Since the central bank determines money growth, the monetary policy of a bank is a considerable determinant of inflation expectations.

2_{The quantity theory of money states that there is a direct relationship between the quantity of}

money in an economy and the level of prices of goods and services sold. M x V=P x T, Amount of Money x Velocity of Circulation = Total Spending

3_{In Keynesian economic theory, a factor that quantifies the change in total income as compared to}

the injection of capital deposits or investments, which originally fueled the growth.

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Economic agents considering the economic environment, where the policy of the central bank is an important factor, form expectations on inflation. Additionally, the expectation of inflation is taken into account when the central bank formulates a monetary policy.

The policy of the central bank can be one of inflation targeting. In this framework, the central bank communicates that controlling inflation is a long-term goal of their monetary policy and sets targets for inflation. Often central banks, which commit to an inflation target, have an independent character and a transparent policy. The European Central Bank (ECB) is a good example of such a bank. The primary objective of the ECB’s monetary policy is to maintain price stability. The ECB aims at inflation rates of below, but close to, 2% over the medium term. The governing council of the ECB is responsible for setting the target. The governing council of the ECB consists of the members of the Executive Board of the ECB and the governors of the National Central Banks, of the euro area countries. For less independent central banks the government has more or is fully responsible for setting the inflation target.

Through transparency, investors know what to expect. When a central bank is reliable, and has a transparent system, the expected inflation is close to the target. Grilli, Masciandro and Tabellini (1991) found that more independent central banks are associated with lower levels of inflation.

2.5 Supply and demand for money

The money supply is all money available to the public. Central banks use the money supply to influence economic variables like output, unemployment and the real interest rate. If the central bank wants higher output, lower unemployment or lower interest rates, it needs to increase the money supply. A central bank increases the money supply via open market operations. These operations involve buying bonds to ensure that money flows into the economy. When a central bank sells treasury bills, money flows out of the economy. This decreases the money supply. In the long run the supply of money is highly correlated with inflation (McCandless and Weber, 1995).

Researchers view the relationship between money and interest rates in different ways. According to the liquidity effect view, since the interest rate is the opportunity cost of holding cash, money demand is a decreasing function of the nominal interest rate. An increase of the money supply should cause a decrease of the interest rates. If not, the money market equilibrium will not hold (Monnet and Weber, 2001). The mechanism of a decrease is explained below.

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When the money supply is greater than money demand, there is excess liquidity. At the current interest rate people are holding more money than they desire to hold. To reduce their liquidity, they will buy assets that pay interest. Since the money demand is less than the money supply, there will be more people wanting to buy assets than willing to sell them. As a result the interest rate, which can be seen as the price of financial assets, slowly decreases. The decrease of the interest rate reflects the market mechanism of creating a higher incentive for people to sell assets. The interest rate will decrease to the point where there are equal numbers of assets bought and sold.

The other view follows from the Fisher equation, which is a monetarist view. The Fisher equation states that the nominal interest rate equals the real interest rate plus the expected inflation. With this

equation, the money supply and the interest rate should move in the same direction. In the monetarist view the money supply affects the price level. An increase of the money supply will induce higher inflation. The higher inflation will lead to a higher expected inflation, thus the nominal interest increases as well.

These two views are in a conflict with each other. The study of Monnet and Weber (2001) finds proof for both views. They conclude that the money - interest relationship is negative when there is a surprise increase of the money supply and the public expects this to be temporary. When the public believes the shock is permanent, then the growth of the money supply will also trigger a rise in the nominal interest rate.

2.6 Capital controls and speculative attacks

Governments generally have two ways to control capital: by qualitative or quantitative restrictions. A qualitative form is posing a restriction on exchanging currency. Another way for a government is to impose tax rates on international financial transactions.

With quantitative restrictions the government can impose constraints on foreign ownership. Investors cannot own more than certain percentage of domestic operations, cannot invest more than certain amounts of investment projects, cannot own more than certain number of real assets, and cannot open bank accounts with domestic currency (Lam, 2002). In section 5, the controls for China are explained. Capital controls are an important factor for currency crises. Due to capital controls, and especially inconvertibility of the currency, it is not possible for speculators to perform a speculative attack. A speculative attack works as follows:

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Assume that a country has a pegged exchange rate, and that the peg is maintained by the central bank of that country, by intervention on the foreign exchange market. If the value of a currency decreases, a central bank has to buy back domestic currency, and pay with their foreign exchange reserves. Due to this buying back policy, the foreign exchange reserves of a country decline. At some point, speculators believe that a fixed exchange rate will not hold in the near future. At that moment a country still could have enough foreign reserves to counter the depreciatory effects. Speculators who believe that an exchange rate will fall can make profits by selling the country’s currency at the fixed rate. With doing this, the value of the currency tends to decrease, which has a depreciatory effect on the exchange rate. A central bank will counter the depreciation by buying back the domestic currency. Due to this policy the foreign exchange reserves will decrease further. If speculators persist with selling the currency, a central bank would not be able to defend the currency, because it would not have enough foreign exchange reserves (Krugman, 1979).

Above mechanism describes that speculators need units of a foreign currency for performing a speculative attack. Thus, a speculative attack is not possible when speculators cannot convert their money.

3 Fixed, floating or a managed floating exchange rate and the impossible

trinity

Exchange rate regimes take many forms. This paper divides the regimes into three main policies: a fixed, floating or managed floating exchange rate regime. Every regime has its own advantages and

disadvantages. For example, a fixed exchange rate takes away exchange rate risk, which is beneficial for international trade. In this section, the paper elaborates on the different regimes. The tools available to a central bank, to influence economic variables like the exchange rate, are treated at the end of this section.

Obstfeld and Rogoff (1995): “We use the terms fixed or pegged exchange rate to refer to any system in which a monetary authority announces buying and selling rates for its currency in terms of a foreign currency and promises to trade in unlimited amounts at that rate.” It could be the case that a currency is pegged to a basket of currencies. Alternatively, it could be pegged to another unit of measure, such as gold. In the 20th_{century, many Asian countries pegged their currency to the US dollar. If the value of the}

US Dollar declined, the currency pegged to it also decreased. If a currency changed in value, and a country wanted to maintain a fixed exchange rate, it should buy or sell the own currency on the open

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market. This is one of the reasons why countries with a fixed exchange rate grow or lose foreign

exchange reserves. China, for instance, has a huge amount of foreign exchange reserves, due to the peg with the US Dollar.

When a central bank intervenes in the foreign exchange market, it alters the money supply. If a central bank wants to counter depreciation it has to buy domestic currency with foreign reserves. Hereby the bank removes currency form circulation, thus it decreases the money supply. The central bank could sterilize the decrease of the money supply. The central bank can do this with buying domestic financial assets with domestic currency. That way, the money supply will increase again. With sterilized

intervention a central bank can counter depreciation, without altering the money supply. This is desirable, because altering the money supply can have inflationary or deflationary effects.

There are three main reasons for a pegged exchange rate. First, it removes exchange rate uncertainty. Many economists believe that uncertainty reduces international trade and that it discourages

investments (Perée and Steinherr, 1989). Second, there is the belief that, when pegging to a currency of a country with low inflation, the currency will restrain domestic inflation pressure due to the discipline that is needed from a government. The idea is that the announcement of a policy pegging the exchange rate serves as a commitment from the government to resist excessive expansionary macroeconomic temptations (Obstfeld and Rogoff, 1995). The third reason applies to countries disinflating after periods of price instability. For these countries, a fixed rate has the attraction of anchoring price inflation for international traded goods, and providing a potentially transparent guide for private-sector inflation expectations (Bruno, 1991). The main disadvantage of a fixed exchange rate is that the government gives up its monetary tool to stabilize an economy. The classic policy trillema or impossible trinity theorem suggest that only two out of three goals can be achieved at a time (Sivalingam, 2009). Thus, a government cannot use the monetary tool without inflicting multiple consequences. As described in section 4, it is not possible for an economy to have free capital mobility, a fixed exchange rate, and an independent monetary policy. Moreover, in the case of the Asian countries, when a currency comes under pressure, it can be expensive to keep the exchange rate pegged. Due to the sudden outflow of money there was a downward pressure on the exchange rate. To counter the downward pressure, and to keep the exchange rate pegged, the central banks had to buy back their currency. When the pressure holds, it can be expensive to stick to the peg. A central bank needs a sufficient amount of reserves to cope with devaluating pressure on the exchange rate.

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Under a free-floating currency, a country has monetary independence. When the economy needs an impulse to decrease unemployment or increase economic growth, the central bank can increase the money supply. It reduces the interest rate, depreciates the currency, and raises asset prices. All consequences give an impulse to the economy. The next advantage is that, under a floating currency, the currency automatically responds to changes in the level of exports. A lower export demand for a country should lead to an automatic fall in the value of its currency. Depreciation automatically increases the demand for exports, due to the cheaper goods and services (Frankel, 2003).

Many countries choose a mix of the two regimes. This is called a managed floating regime. Central banks buy and sell currency to move the exchange rate within a determined band. In fact they are doing the same as with a fixed exchange rate, but within a broader bandwidth. The choice of policy depends on the preferences of the country. These preferences are partly formed by, and related to, the impossible trinity theorem. In the model, there are three different goals that a central bank can set.

1) Exchange rate stability 2) Independent monetary policy 3) Free international capital mobility

Figure 5, Impossible Trinity

The theorem states that only two out three goals can be achieved simultaneously. Thus, if a country wants an independent monetary policy to increase or decrease their interest rates, and have an open capital account (free capital mobility), it must let go of the wish to have exchange rate stability (fixed exchange rate).

Countries that want free capital mobility and a fixed exchange rate must let go of the independent monetary policy goal. They have to accept the inflationary shocks that can occur due to the international capital flows. Central banks that want an independent monetary policy and a fixed exchange rate must control the capital flows.

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Before the Asian crisis, the IMF and other institutions were propagating free international capital mobility in Indonesia, Thailand and South Korea. According to the theorem this left the countries with two goals they could follow. One of them was already set, namely the fixed exchange rate. Thus, these countries could not pursue an independent monetary policy.

4 Review of the crisis

Wade (1998) gives a clear overview of the crisis. It all started with the Plaza Accord of 1985, which was an agreement between the governments of France, West Germany, the United Kingdom, the United States, and Japan. The goal was to appreciate the Japanese yen in relation to the US dollar. The

following appreciation induced Japanese companies to seek cheaper manufacturing locations, especially in countries where the currency was pegged to the US dollar. Because the currencies of South-Korea, Thailand and Indonesia were pegged to the US dollar, the Japanese yen also appreciated with respect to the currency of these Asian countries. Due to this appreciation, one unit of yen is worth more abroad. Japanese firms could thus invest more in relative terms, and reduce costs when they produced in South Korea, Thailand and Indonesia. Japanese firms mostly invested in export-orientated manufacturing projects (Ichikawa, Cusumano and Polenske, 1991). To produce in another country, investments had to be made in building factories and acquiring land and labor. Furthermore, the Asian countries were close to Japan, were cheap and had skilled workers. Cheap Japanese credit and encouragement from the three Asian governments were reasons that Japanese investments increased in Southeast Asia. For example, in Thailand the Board of Investment (BOI) is responsible for attracting foreign direct investment (FDI). Together with other government agencies, they create an attractive investment environment. Under the Thai “Investment promotion act” the BOI is authorized to grant tax and non-tax incentives, guarantees and protection. In Indonesia, it is the Indonesian Investment Promotion Agency that is responsible for attracting FDI. For South Korea, the Korea Trade-Investment Promotion Agency (KOTRA) has the authority to give incentives for attracting FDI.

Besides Japanese FDI, the Japanese capital flow consisted of loans. Japanese banks lend funds to developing countries; 84% of the funds went to Southeast Asia (Wade, 1998).

In the period before the crisis, there was a worldwide situation of excess liquidity. Due to slow growth in Japan and in European countries, the associated central banks followed a monetary expansionary policy (Wade, 1998). By pushing money into the economy, the central bank tried to increase consumption. The consumers however did not react quickly enough to this policy. The consumers were still saving money

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instead of spending it. This resulted in excess liquidity in the economic systems. Excess liquidity implies that there is a large amount of funds that need to be invested. The excess money was in the hands of financial institutions that were searching for higher returns than in their own respective country (Wade, 1998).

The slow growth of GDP in Japan, the United Kingdom, France and Germany are shown in figures 6,7,8 and 9. The general consensus is that 2.5-3.5% per year growth in GDP is normal (Barnes, n.d.) A rate below this spread is considered as slow growth.

Figure 6, France GDP growth rate (quarterly %)

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Figure 7, UK GDP growth rate (quarterly %)

Figure 8, Germany GDP growth rate (quarterly %)

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Figure 9, Japan GDP growth rate (quarterly %)

Source: www.tradingeconomics.com

Within the economic environment of low growth and excess liquidity, investors from developed countries have been prepared to lend money to firms in East and Southeast Asia. As can be seen in figure 10, investing in the Southeast Asian region was popular since the yield was higher at that time. Figure 10, lending interest rates %

(Lending rate is the bank rate that usually meets the short- and medium-term financing needs of the private sector.)

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The flow of money came in the form of carry trade. This is a strategy in which an investor sells a certain currency with a relative low interest rate and uses the funds to purchase financial assets, accounted in a different currency, yielding a higher interest rate. A trader using this strategy attempts to capture the difference between the rates, which can often be substantial, depending on the amount of leverage used. In the period preceding the crisis, much capital was pushed into the Asian economies, because investors expected a higher return than in their own or in other countries.

All Asian countries, except for Korea and Japan, had a fixed exchange rate with the US Dollar. The fixed exchange rate was assumed to hold due to good macroeconomic indicators (Wade (1998), Stiglitz (1997)). Stiglitz (1997) describes that the Asian countries had a good export-driven growth rate of GDP, low inflation and low budget deficits (or surpluses) as can be seen in figure 11.

Figure 11, Overall Budget Deficits (-)/ Surpluses(+) (As a percentage of GNP)

Countries 1971-75 1976-80 1981-85 1986-90 1991-92

Indonesia -2.56 -2.93 -1.19 -1.81 0.003

Korea -1.55 -1.67 -1.95 0.28 -1.06

Thailand -1.43 -3.86 -4.49 0.39 3.79

Source: Government Finance Statistics, IMF and for Taiwan Statistical Data book (CEPD, 1994)

Investors had a similar perception about the economy. Therefore, investors did not expect sudden fluctuations in the variables affecting the exchange rate. The system of fixed exchange rates stimulated the economies of the Asian countries, because firms were exposed to lower currency risks when doing business (Pilbeam, 2009). When trading with a country that has a different currency, the investor is exposed to exchange rate risk. Profits are denominated in the foreign currency and have to be

exchanged back to domestic currency in the future; it is possible that this investment loses value. When the foreign currency depreciates during the period after the deal is made, the proceedings from the deal, accounted in the foreign currency, lose value when exchanged back to the domestic currency. With a reliable fixed exchange rate, an investor knows what the future exchange rate will be, and avoids exchange rate risk.

At the same time, the traditional financial system was being deregulated. After the period of

deregulation, there were almost no restrictions on the in- and outflow of capital. The high degree of 21

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capital mobility was an important factor in the Asian crisis. In a deregulated system with high capital mobility, an investor can easily invest or withdraw money. The higher yield and a high degree of capital mobility initiated an enormous capital flow into Southeast Asia. Wade (1998) describes that the deregulation happened with little attention to new kinds of regulations that would be required to cope with an enormous amount of capital. Besides, the Asian financial firms were not skilled enough to allocate the money correctly and efficiently. Therefore they made bad loans.

Due to the capital inflow, private firms and had easy access to cheap foreign credit. The credit was cheap, since the foreign lending rate was lower. Moreover, with this cheap credit firms were making high profits, since they could borrow foreign currency at a low foreign rate and lend domestic currency at a higher domestic rate (Corsetti et al., 1998). Thus, the firms put pressure on their governments to deregulate the financial markets further (Wade, 1998). The extra deregulation should have led to cheaper credit in order to make higher profits. The IMF and the US treasury strived for perfect capital mobility and supported the pressure on deregulation. Stiglitz (2004):“In the 1980s and 1990s, the IMF and the US Treasury tried to push capital-market liberalization around the world.”

After the restrictions were lifted on both the interest-rate ceiling and the type of lending allowed, lending increased drastically. As documented in Corsetti et al. (1998), Goldstein (1998), World Bank (1998), Kamin (1999), credit extensions in the Asian crisis countries grew at far higher rates than their respective GDP. The expansion of lending was just a part of the problem. On top of the lending expansion, economic agents took excessive risks, because funds were likely to be protected by the government. The government can provide a safety net to prevent big banks or firms from falling on account of having low liquidity on their balance sheet. Negative returns on investment are less likely when the government protects the firm. If a firm is in risk of default, the government could help by lending money. This way the firm can pay off their loans and elude default. Investors are then paid by governmental money. When investors take excessive risks, they allocate their funds poorly. The

investment could result in a negative return. In the Southeast Asian case, poorly allocated funds resulted in large losses on loans (Mishkin, 1999).

The losses led to deterioration of the banks’ balance sheets. A healthy balance sheet has a high level of cash on the balance, but more important a sound debt over equity ratio. When the ratio is high, a bank has a high level of debt. One has to pay interest on the debt burden. The higher the amount of debt, the higher the interest costs will be. By having enough liquid assets, like cash or government bonds, a bank has enough space on the balance sheet to extend credit and earn money from the loans. Due to

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excessive risk taking of the lenders, the balance sheets became more and more filled with bad loans. This was the key fundamental that drove the Asian countries into the financial crisis. Mishkin (1999) states that the deterioration of bank balance sheets can promote a currency crisis because a central bank cannot raise the interest rate to keep the national currency from depreciating. If the central bank increases the interest rate, it would attract capital to the country and stem the outflow of capital. Due to higher demand for the currency, the exchange rate should depreciate less. On the other hand, an

increase of the interest rate will hurt the bank balance sheet. The bank will borrow money at a higher rate, and have higher costs with their debt payment. This could lead to default. Thus, the banking system may collapse when a central bank raises interest rates to defend the currency.

During the period preceding the deregulation, Asian households saved money. Gross domestic savings were about one-third of the GDP, making East and Southeast Asia the biggest saving countries in the world at that time. US savings amounted to 15%. These countries were considered to have a “deep” banking system4_{with households and the governments as net savers. Since households and}

governments were non-borrowers, the borrowers had to be firms and other investors. According to Wade (1998), the system had high debt to equity ratios in the corporate sector. The higher the debt-equity ratio of a firm, the higher the risk of default when there is a depressive shock. If the central bank increases the interest rate, having debt becomes more expensive and increases the chance of illiquidity and default.

In the years before the crisis, the countries of Southeast Asia began to feel inflationary pressure. Due to an increase of foreign direct investment and the inflow of financial capital, central banks were forced to increase the domestic money supply5_.

4_{When banks have a high level of deposits to GDP (Wade, 1998).}

5_{Under the rules of fixed exchange rate system the central bank has to buy the foreign currency with}

domestic currency, which increases the money supply.

23

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Figure 12, Inflation, CPI (annual %)

The mid 90’s saw two significant devaluations of exchange rates. The first was in Japan; the yen was devaluated approximately 50% against the US Dollar. The second was the Chinese yuan; that was devaluated by 35% against the US dollar.

The combination of decreasing inflation and the devaluation made the yuan the most undervalued currency of any major country. The two devaluations and a relative low inflation had consequences for the economies in the region. In the Southeast Asian region, the US dollar appreciated, and there was relatively high inflation, higher than those of their trading partners, as can be seen in figure 12. Goods were more expensive than the goods in competing countries. The relatively high inflation weakened the competitive position of Indonesia, Thailand and South Korea. It made imported goods cheaper and exports expensive. Consequently, the current accounts of the Asian countries ran deficits (Wade, 1998). In the Southeast Asian countries savings were high; domestic inflation was higher than that of trading partners, and there was little foreign demand for domestic products. Profits were less likely by investing in export-based projects. Inflation was expected to increase; the real estate market was a good

alternative. The price of real estate was expected to increase; an investment would likely have a positive

-10 0 10 20 30 40 50 60 70 19 87 19 88 19 89 19 90 19 91 19 92 19 93 19 94 19 95 19 96 19 97 19 98 19 99 20 00 20 01 20 02 China Indonesia South Korea Thailand United States Japan 24

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return. Thus economic agents invested in real estate projects. As a consequence, the housing prices increased further, leading to a real estate bubble (Wade, 1998).

In 1995, the Thai real estate bubble burst, followed by a stock market crash in 1996. The bursting of the bubble left investors in high debt. Investors had borrowed money to invest in real estate. When prices decrease, the value of the underlying asset decreases. When the value of an asset falls beneath the value of the amount borrowed, and that asset is sold, the investors are left with debt. Foreign lenders now saw that Thai borrowers were less able to pay back their short-term loans.

In the second half of the 90’s, Thai exports were being increasingly threatened by competition from China and other less developed countries (Ministry of Finance Japan, 1998). Therefore, export growth slowed, as can be seen in figure 13.

Figure 13, Thailand export of goods and services (annual % GDP)

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Figure 14, Thailand GDP annual growth rate (%)

Since an important factor for the Thai economy is export, the decrease in exports accompanied a declining economic growth, as can be seen in figure 14.

The slowing growth provoked insecurity about the Thai Baht. When there is a steady foreign demand for export, there is a steady demand for the Thai currency. If the demand for the currency decreases, the exchange rate tends to depreciate. Due to the faltering growth, economic agents, both foreign and domestic, expected a devaluation of the Baht and tried to exchange their Thai Baht for US dollars. This led to an excess supply of Baht. To keep the peg to the US dollar, the Bank of Thailand (BoT) was forced to buy back Thai Baht with their foreign exchange reserves. Eventually the foreign exchange reserves dropped to such a level that speculators believed that the peg with the dollar would collapse soon. Thus, speculators responded with an attack on the Thai Baht. The speculative attack caused the foreign reserves of the Bank of Thailand to decrease further and quicker. The exchange rate proved not to hold. In July 1997 it was decided to float the exchange rate between the Thai Baht and the US dollar. The Baht sank immediately (Wade, 1998).

After the enormous depreciation of the Baht, the IMF stepped in with an aid package. The Thai government had to reform the structure of the financial system to receive the aid, which amounted to 17 billion US dollar. By stating that the financial system is not well structured, it was perceived that the IMF indicated that there were troubles in the financial system. The signal damaged the trust in the Thai economy and the financial system. Researchers say that the policy of the IMF led to more panic than

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there already was (Bullard, Bello and Mallhorta, 1998). Sachs (1998) compared the policy of the IMF to “screaming fire in the theater.” The policy of the IMF aggravated the runs on Thai Baht.

Before the crisis, economists and financial institutions based the rating of risk on macroeconomic factors. After the sharp devaluation of the Baht they paid more attention to microeconomic factors, as the volume of the debt and debt/equity ratios of the institutions needed funding. This risk of default was higher than the good macroeconomic factors suggested. With this new rating of risk, a different perspective was valid: the perspective that all Southeast Asian countries were high-risk areas for investors. As a consequence, investors pulled their money out of the region (Wade, 1998). This was possible because the financing consisted mostly out of short-term debt. The sudden pullout of money, which forced central banks to buy back domestic currency, and the high degree of capital mobility made the region vulnerable for speculative attacks. Speculation first hit Thailand, and ensured the Thai baht depreciated. After the currency crisis of Thailand, speculation hit other countries in the region. These countries had the same economic fundamentals and export structure as Thailand. Due to the similarities in debt structure, falling export growth, and the sudden pull out of money, speculators targeted

countries in the region. As a consequence of the speculative attacks, the Thai Baht, Indonesian Rupiah and Korean Won depreciated sharp, as can be seen in figure 15b, 15c and 15d.

Figure 15 a, Absolute exchange rate Chinese Yuan (CNY) / US Dollars (USD)

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Figure 15 b, Absolute exchange rate Thai Baht (THB) / US Dollars (USD)

Figure 15 c, Absolute exchange rate Indonesian Rupiah (IDR) / US Dollars (USD)

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Figure 15 d, Absolute exchange rate South Korean Won (KRW) / US Dollars (USD)

Figure 16, Annual GDP growth (%)

-15 -10 -5 0 5 10 15 20 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 China Indonesia Korea, Rep. Thailand 29

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Summarized there were some pre-conditions for the Asian currency crisis: - Fixed or partially fixed exchange rate regimes

- Liberalization of capital markets - High leverage

- High level of capital inflow - Cheap credit

Radelet and Sachs (1999) provide four causes for the Asian crisis: (i) weakness of the Asian economies on inadequate financial, industrial and exchange rate policies; (ii) overinvestment in dubious activities resulting from the moral hazard of implicit guarantees by the government, corruption and bailouts; (iii) financial panic, in what began as moderately-sized capital withdrawal cascaded into a panic; (iv) the exchange rate devaluation of the Thai Baht.

In the next sections, this paper elaborates on the factors that drive the exchange rate and focuses on the different economic situations of the Asian countries, including China.

5 Analysis

5.1 Macroeconomic variables

This section of the paper focuses on the macroeconomic variables per country. First we elaborate on the common culture and form of capitalism that is called crony capitalism, which differs from the modern contractual system, which we call the free-market system. Crony capitalism is a relationship-based system. Rajan and Zingales (1998) suggest that relationship-based systems work well when contracts are poorly enforced and capital scarce, which was the case in the Asian countries before the enormous capital inflow. In both systems, financier and borrower have close ties. When assessing the borrowing needs of the firm and when mapping the risk of default, the financier will consider the current debt-servicing capability and the long-term opportunities of a firm. The current debt-debt-servicing capability is the capability of repaying the debt in the short term. The investor also considers the long-term ability to service the debt; he looks at plans and growth forecasts. In a relationship-based system the interest rate charged will be repeatedly negotiated over time, without capturing the agreement in a contract. The charged interest rate may not be directly related to the intrinsic risk of the firm or project (Rajan and Zingales, 1998). In contrast with the free-market system, the loans are not contracted for a particular period.

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A relationship-based system differs from the free market system on the different degree of legal enforcement. The reputation of a party is very important in the relationship-based system. In order to ensure a healthy relationship, the parties honor the agreements made. This relationship helps them with future business. These agreements are often verbal, without written contracts. The idea behind this is that trust and loyalty cannot be written into a contract. On top of that, law enforcement in the Southeast Asian region is less developed. Thus, investors from the free-market system wanted to

minimize their risk. Financiers lent funds for short-term periods, making it easy to withdraw their capital. In combination with the financial liberalization, this was an important factor in the Asian crisis. Foreign investors had pushed capital into Thailand, Indonesia and South Korea. This was in the form of short-term lending and the buying of equity. When the expectations about the Thai economy worsened, they pulled back their funds. Due to the financial liberalization it was easy to pull back funds. Loans were not rolled over and equity was sold, which led to a major capital outflow.

In relationship-based systems like they have in China, Thailand, Indonesia and South Korea, firms have close ties to the government. Politicians favor firms based on the personal relation they have with members of the board of a firm.

In the remainder of this chapter, the paper shifts it focus to financial and macroeconomic facts of Indonesia, Thailand, South Korea and China during the 90’s.

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5.1.1 Capital mobility (BP curve)

Figure 17, Chinn Ito index (KAOPEN).

On the Y-axis: The degree of openness according to Chinn and Ito. The Chinn Ito Index measures the degree of openness of the capital account.

On the X-axis: Year

To measure the degree of capital mobility we have to analyze the capital account. An open capital account implicates mobile capital. Chinn and Ito (2007) created an index that measures the extent of openness in capital account transactions. The index is based on information from IMF’s Annual Report on Exchange Arrangements and Exchange Restrictions. As can be seen in figure 17, the index of China is always below Indonesia, Thailand and South Korea. It means that capital in China is always less mobile than in Indonesia, Thailand and South Korea.

By construction, the index has a mean of zero (Chinn and Ito, 2007). The Chinn Ito index shows that South Korea and Thailand have a value of zero. Thus, their financial openness is not more open, or less open than the peer group. There is consensus between researchers that South-Korea and Thailand have an open capital account. This paper uses Figure 17 to show that China has a lower degree of capital mobility than South Korea, Indonesia and Thailand.

-2,5 -2 -1,5 -1 -0,5 0 0,5 1 1,5 2 2,5 3 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000

China Indonesia Thailand Korea, Rep.

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Ma (1996) states that there are two kinds of capital controls in emerging capital markets. Both capital controls can be applied to China. The first one is that China sets limitations on foreign ownership of domestic equity. They do this by letting firms issue two types of shares. Chinese citizens and firms can buy Type 1. Foreigners only can buy Type 2 shares. Type 1 shares are traded in yuan, while type 2 shares are traded in foreign currency. In Indonesia, Thailand and South Korea there is no segregation in shares. The outflow, which consists of the selling of equity, means that domestic currency is converted to foreign currency. In China the currency does not have to be converted, since the shares are already bought with foreign currency, which implies no pressure on the exchange rate when foreign investors are dumping their shares. The second capital control limits domestic investment in foreign capital markets: Chinese citizens cannot exchange currency freely. If Chinese citizens borrow foreign funds, the funds have to be exchanged into domestic currency. Again, Chinese citizens cannot do this freely. Thus, the incentive to borrow abroad decreases due to the capital controls. Therefore, foreign funds are present in lesser extent in China than in the Asian countries, where convertibility is not a problem. The capital controls of the Chinese government make it hard for foreign investors to convert their currency into Chinese currency.

Due to capital controls crony capitalism can function (Rajan and Zingales, 1998). In a relationship-based sytem, relationships between politicians and firms cause funding of these firms. This way of funding is easier to sustain when no or less funding comes from outside the country. If it becomes easier to borrow international capital, a result could be excessive borrowing (Rajan and ZIngales, 1998). This is what happened in Thailand, Indonesia and South Korea.

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5.1.2 Balance of payments

Figure 18, Current account (% of GDP),

On the Y-axis: Current account as a percentage of GDP. When the percentage is negative, there is a deficit. On the X-axis: Year

Figure 19, Foreign reserves in US Dollars (% of GDP)

On the Y-axis: Foreign reserves in US dollar as a percentage of foreign reserves On the X-axis: Year

-10 -8 -6 -4 -2 0 2 4 6 1990 1991 1992 1993 1994 1995 1996 1997 Indonesia Korea Thailand China 0 5 10 15 20 25 30 1990 1991 1992 1993 1994 1995 1996 1997 1998 China Indonesia South korea Thailand 34

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As can be seen in figure 18, Korea, Indonesia and Thailand showed current account deficits. Due to the deficits, the central banks had to sell foreign reserves to keep the peg. People wanted to exchange domestic currency for foreign currency in order to be able to purchase foreign products. This has a depreciatory effect on the exchange rate. When, in a fixed exchange rate regime, a central bank has to counter this effect it should buy back domestic currency with foreign currency, reducing its amount of foreign exchange reserves. This works the other way around for a surplus on the current account. In the case of China the foreign reserves accumulated due to the surplus on the current account.

In all of the countries there was an inflow of foreign capital, accumulating the foreign reserves. Besides the reducing effect from a deficit on the current account described above, the capital inflow finally led to a high level of foreign reserves. Due to both a surplus on the current and the capital account, the growth of foreign reserves was the highest in China (figure 19).

Figure 19 shows a sharp increase of foreign reserves as a percentage of GDP. The sharp increase is a consequence from a sharp drop of GDP during the crisis.

Because all countries before the crisis had systems of fixed exchange rates, none of their BP curves shifted. As stated above, the central banks had to change their money supply to counter any surplus or deficit in the Balance of Payments.

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5.1.3 Debt

Figure 20, External short-term debt, world bank data (% of foreign reserves)

On the Y-axis: Short-term debt as a percentage of foreign reserves. On the X-axis: Year

Figure 21, Foreign debt, world bank data (% GDP)

On the Y-axis: Foreign debt as a percentage of GDP. On the X-axis: Year

Rodrik and Velasco (1999) discusses that countries, that have more short-term liabilities to foreign banks than foreign exchange reserves, are more likely to experience a large reversal in capital flows. The higher the short-term exposure, the more severe the crisis will be when capital flows reverse.

0 50 100 150 200 250 1990 1991 1992 1993 1994 1995 1996 Indonesia Korea Thailand China 0 10 20 30 40 50 60 70 80 1990 1991 1992 1993 1994 1995 1996 Indonesia Korea Thailand China 36

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Figures 20 and 21 show that Indonesia, Thailand and Korea had higher levels of short-term external debt than China. The debt is borrowed from foreign lenders, like governments, commercial banks and other financial institutions. As can be seen in figure 20 and 21, both the percentage of debt in relation to foreign reserves and to GDP shows that the debt burden in the three Asian countries was bigger than in China. The higher the debt in relation to the borrowing country’s foreign exchange reserves, the higher the likelihood that the lender would not be repaid. The debt has to be repaid in the lender’s currency. When there is no more currency available, the borrower cannot pay back the lender in the demanded currency. Thus, if the debt to foreign reserves ratio increases, the lender would more likely withdraw his loan. The ratio in China is below 50%, while the ratios in Indonesia, Thailand and South Korea exceed 100%. The ratios are important to understand the urge of investors to quickly withdraw their funds from Indonesia, Thailand and South Korea.

The other difference is the amount of short-term debt. Since short-term debt is easily withdrawn, it can be risky to borrow high amounts of short-term capital. The non-Chinese countries did have an

considerable amount inflow of short-term foreign funds, thus carried a higher risk of a withdrawal. Since the loans had to be changed back to the foreign currency, a withdrawal has a depreciatory effect on the exchange rate. The foreign debt of China consisted mostly of medium and long-term loans (Lau, 2001). In the IS-LM-BP model, the withdrawal of capital is reflected in a shift from the BP-curve to the left. That is, if there is a flexible exchange rate. Recall that with a fixed exchange rate the BP-curve does not move, but that the LM-curve changes, due to the buying back or selling of foreign currency. When the capital inflow quickly changed to an outflow, the central banks had to sell foreign currency, decreasing the domestic money supply. A shift to the left of the LM-curve reflects a decrease of the money supply. At first, the central bank sterilized the intervention by purchasing domestic bonds. That way the money supply did not change. If the central bank did not sterilize the intervention, the money supply would decrease. A lower money supply would increase the domestic interest rate. The higher interest rate would push up borrowing costs, thereby hurting bank balance sheets. The higher interest rate could then lead to more defaults. The increase of the interest rate, due to the contraction of the money supply, could also counter or stem the outflow of capital.

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5.1.4 Inflation

Figure 22, Inflation rate

On the Y-axis: The inflation rate On the X-axis: Year

Figure 22 shows three things, a decreasing, steady, and increasing inflation. In the running up to the Asian crisis, China shows a sharp decline of inflation. Indonesia shows a sharp increase in the prevailing year of the crisis. Korea and Thailand show a steady inflation, this inflation is measured around 5%. With the exception for China, all countries had relatively low and stable inflation during the 90’s. China had a high inflation in the mid 90’s, but decreased in 1996 and 1997 to 3%. Stable inflation can be good indicators of the trust economic agents have in the economy. Beforehand the inflation rate did not indicate unstable economies.

6 IS LM BP ANALYSIS

In this paragraph, the paper discusses the effects the currency crisis has on the IS-LM-BP model. The model works out differently for China and the other countries. First, the curve movements for Indonesia, Thailand and South Korea are discussed. We take the three countries as a whole, because they have similar macroeconomic facts: capital mobility, fixed exchange rates, current account deficits, and high levels of short-term foreign debt. China, on the other hand, has capital controls, a fixed exchange rate, current account surplus and less short-term foreign debt. The countries share the fact that they have a

0 5 10 15 20 25 30 1991 1992 1993 1994 1995 1996 1997 Indonesia Korea Thailand China 38

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high amount of foreign exchange reserves. They differ when one looks at the foreign debt to foreign reserves ratio.

Figure 23 shows that the internal and external market is in equilibrium. It is the starting point for the analysis for both China and the other three Asian countries.

Figure 23, multiple equilibriums

The case of Indonesia, Thailand and South Korea

The crises started with an enormous outflow of capital. As a consequence, there was a deficit on the capital account. The deficit made the BP-curve shift to the left. To maintain the peg to the US Dollar, central banks had to sell their foreign reserves. When selling foreign reserves, the central banks buy back domestic currency. It means a contraction of the money supply. The LM-curve should shift left. It did not happen because central banks bought government securities in the open market at the same time. That way the central bank sterilized the contraction of the money supply. The reason for sterilization was to keep the interest rate at the same level. An increase would harm banks’ balance sheets (section 2). Thus, the money supply stayed the same, and the LM-curve did not shift. When the reserves declined, speculators believed that the exchange rate would not hold. They could make profits by selling the country’s currency at the fixed rate. With doing this, the value of the currency tends to decrease, which has a depreciatory effect on the exchange rate. A central bank will counter the

depreciation by buying back the domestic currency. The foreign exchange reserves decreased so far that the peg had to be abandoned. With releasing the peg, the BP-curve shifts sharp left.

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Figure 24, Capital outflow

After releasing the peg to the US dollar, the exchange rate depreciated. To reduce the depreciation of the exchange rate, central banks had to counter the capital flight. By increasing the interest rate, the capital outflow should diminish. With a higher interest rate, the incentive to invest in a country increases, which could lead to a capital inflow. One should tighten the money supply for a higher interest rate. When the exchange rate depreciation accelerated, monetary authorities decided to start monetary tightening to increase the interest rate (Roubini and Backus, 1998). As can be seen in figure 25, the contraction of the money supply is reflected in a shift leftward of the LM-curve.

Figure 25, Decline money supply

Most of the borrowing was done on international capital markets, thus in a foreign currency (Radelet and Sachs, 1998). Due to the devaluation, the foreign currency became more expensive. It increased the debt burden of banks, firms and the government. The higher interest increased the cost of the debt even more. Many firms and banks defaulted, especially in South Korea, since a lot of South Korean firms were highly leveraged. Due to bankruptcy, and damaged balance sheets, investment decreased. As a result, the IS-curve shifts to the left. Government debt payments increased, because of the higher interest rate, resulting in a higher budget deficit. The high deficit forced governments to cut spending or raise tax rates. The IS-curve shifts further to the left.

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To maintain a joint equilibrium, the LM-curve has to shift to the right. Thus, the government has to increase the money supply.

Figure 26, Decrease IS + LM

Eventually, the contractionary effects of the foreign capital outflow will slow down or stop, because the confidence is restored. In the period afterwards, the lower exchange rate will take effect. As a result, exports will increase and imports will decrease. The IS-curve shifts right. Simultaneously, the BP-curve shifts right, because of the increasing current account. For a joint equilibrium, the government has to increase the money supply.

Figure 27, stabilizing the economy

Figure 27 shows that in the new equilibrium output has decreased, and the interest rate is increased. This translates into higher unemployment and lower economic activity.

The case of China

China did not experience a sudden outflow of capital. Investors know that they cannot exchange currency freely, and cannot pull their funds out of the country. Radelet and Sachs (1998) see the capital controls as a factor why investors did not panic or panicked less.

Difficulties of keeping a pegged exchange rate : the case of China during the Asian crisis