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Book Review
Lessons from the East Asian financial crash
THE EAST ASIAN CURRENCY CRISIS: Mihir Rakshit; Oxford University Press, YMCA Library Building, Jai Singh Road, New Delhi-110001. Rs. 545.
SINCE THE 1970s, currency crises, the most important feature of which is sharp depreciation of the exchange rate, have almost become a regular phenomenon in the Latin American countries. But the currency crisis in East Asia in the 1990s has drawn much greater attention because it was unexpected.
It was unexpected because economic fundamentals in the East Asian economies till the onset of the crisis were fairly strong. And this has forced us to reconsider the theoretical tools developed during the 1970s and 1980s. Although hundreds of articles have come out ever since the crisis started, the book under review stands apart for its comprehensive coverage and lucid but rigorous style.
Prof. Mihir Rakshit has been able to blend successfully the rigour of a theoretician with the vision of a policy-maker. Following the Latin American currency crisis in the 1970s, a number of theoretical models by Paul Krugman and others were developed.
These models, what Rakshit calls, the "First-Generation Models", attributed the Latin American currency crisis to the inconsistency between expansionary monetary and fiscal policies on the one hand and the pegged exchange rate system on the other. Under fixed exchange rate with perfect capital mobility and persistent government deficit financed by borrowing from the central bank, the central bank does not have much control over the money supply. This is what happened in Latin America, according to the models. One way to get around this problem is to make adjustment mainly through the foreign exchange reserves. Persistent government deficit creates inflationary pressure, which in turn depletes foreign exchange reserves, and the exchange rate, in turn, gets overvalued. If private economic agents with "perfect foresight" anticipate it, they buy up the entire foreign exchange reserves of the central bank. Such a speculative attack would force the central bank to abandon the pegged exchange rate, which would precipitate the crisis. From the ex-post analysis of the Latin American currency crisis it was evident that the weakening of the long-term fundamentals prompted the speculative attack. However, the situations were different in the U.K. and some other European countries, which faced currency turmoil during the 1980s and early 1990s. Theories developed to explain these crises — the so-called "Second-Generation Theories" — emphasise the role of expectations on the behaviour of the government and private agents. While in the first generation models the authorities give up the peg only when they run short of foreign exchange reserves, in the Second-Generation Models the government decision is based on evaluation of the net benefit to the economy of sticking to or abandoning the fixed exchange rate system.
The East Asian experience resembles the Latin American in one respect. Like the Latin American countries, pegged exchange rate had to be abandoned by the East Asian economies for shortage of foreign exchange reserves.
But unlike their Latin American counterparts, East Asian countries did not experience the problems of recession and unemployment during the currency crisis. The book gives a systematic account of the East Asian currency crisis, which originated in Thailand in May 1997 and became contagious, over the second half of 1997, to four other Asian economies viz., the Philippines, Malaysia, Indonesia and Korea.
The author has made a number of critical remarks on the arguments earlier put forward by two of the most prominent commentators on the East Asian crisis — Lawrence Summers and Paul Krugman.
To trace the roots of the Asian crisis, while Krugman focuses on the theory of moral hazard and the banking crisis, Summers identifies the unsustainability of large current account deficits along with the fixed exchange rate as the primary cause. Rakshit has put in painstaking effort in compiling a large volume of very important data. It is clear from the data that between 1992 and 1996 the current account deficit as the percentage of the GDP was negligible in Korea and Indonesia.
On the other hand, some other Asian countries, viz., Japan, China, Taiwan and Singapore, which experienced financial turbulence due to the contagion effect, maintained surplus in their current account.
The proximate source of Asian crisis, according to Rakshit, is large-scale investment in the export sector, which was financed by short-term external borrowing.
The investment decisions were based on the extrapolation of the past trends into the future. Sharp deceleration in the export growth rate due to external demand shock affected investors' confidence.
Inadequate foreign exchange reserves in relation to short-term external liabilities finally resulted in the crisis.
Although the origin of the currency crisis could be traced to the instability in the real sector, there were other factors too, which include lax regulatory environment of the banking sector.
Analysing the five phases of the currency crisis, its aftermath in the real sector and the recovery of the East Asian economies the book concludes with the lessons that could be drawn by other countries turning to financial liberalisation.
Firstly, full capital account convertibility should be preceded by a reform in the banking system so that an efficient regulatory system is ensured.
Secondly, sufficient foreign exchange reserves should be maintained so that at any point of time the volume of external liabilities does not exceed the foreign exchange reserve. And finally, temporary restrictions on capital outflows may prove effective during the time of the currency turmoil.
The most remarkable aspect of the book is that any student of international financial system — a beginner or a hardened scholar — would find it useful.
Discussions on the evolution of currency regimes since the Second World War, breakdown of the Bretton Woods arrangement etc., would help introduce these topics to a non-specialist.
Specialists, on the other hand, would find the advanced theoretical arguments explaining various currency crises experienced by the countries in Latin America, Europe and East Asia very stimulating.
Presentation of the theoretical arguments formally in the appendices would enable the general reader to grasp the narrative details of the chapters without difficulty.
INDRANI CHAKRABORTY
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