Monetary disequilibrium seems to be a common thread that connects the Mexican and East Asian crises. Both crises have been characterized by governments attempting to minimize the adverse impacts of capital reversals on their domestic financial systems. This backstopping function of the monetary authority is modeled within an escape clause-based currency crisis framework which emphasizes the “nonmechanical” behavior of governments as they trade off various economic policy objectives.
Net capital flows to emerging economies peaked in the mid 1990s, reaching an all-time high of US$190 billion (bn) in 1996, more than ten times the average annual flow between 1984 and 1989 (Table 1). The increasing globalization of finance and capital flows has, however, not been an unmitigated blessing, as this period has witnessed several episodes of severe financial turbulence in global currency markets. Indeed, since 1992, currency crises seem to have been the norm rather than the exception.Specifically, in 1992–93, Europe was faced with the very real possibility of a collapse of the European Exchange Rate Mechanism (ERM). In 1994–95, there was the Mexican currency crisis, which saw a steep devaluation of the peso and brought Mexico to the brink of default. There were also some spillover effects to Argentina and Brazil. Between July 1997 and mid-1998, the world experienced the effects of the East Asian crisis. This crisis started somewhat innocuously with a run on the Thai baht, but spread swiftly to a number of other regional currencies, most notably the Indonesian rupiah, Malaysian ringgit, Philippine peso and Korean won. The currencies of other large emerging economies such as Russia and Brazil also experienced periods of significant market selling and required the assistance of the IMF. The Russian ruble was devalued in August 1998, while the Brazilian real peg was eventually broken in January 1999.
These events have generated much interest in currency crisis models and their corresponding policy implications.1 Dani Rodrik (Rodrik, 1998) has noted that:
[a] sad commentary on our understanding of what drives capital flows is that every crisis spawns a new generation of economic models. When a new crisis hits, the previous generation of models is judged to have been inadequate (p. 58).
Undoubtedly, each crisis has certain distinctive features and peculiarities. However, in light of Rodrik’s observation, it is important to determine what - if any - common elements exist between some or all of these crises, and to develop a general framework that captures these important commonalties. With this in mind, this paper focuses on the two most studied crises in developing economies in the 1990s, namely, those in Mexico and East Asia (Thailand in particular).
The next section stresses monetary disequilibrium as a common thread connecting the Mexican and East Asian crises, as governments attempted to minimize the adverse impact of capital flow reversals on their domestic financial systems. Section 3 formalizes the lender of last resort role of the monetary authorities in Mexico and East Asia in two closely related escape clause models. The final section concludes with a brief discussion of the main-policy implications arising from the models.
These were the stylized facts of the Mexican crisis sketched by Calvo (1996):
(1) during 1994, external and internal factors lead to a lower demand for money; (2) to offset these factors, the central bank pumps in more credit; (3) as a result, monetary aggregates do not fall, but international reserves are lost… ; (4) towards the end of 1994, a large gap between short-term government obligations and international reserves… is created; (5) an unscheduled devaluation takes place on 20 December (p. 214).
This description broadly fits the Thai crisis in 1997 in particular, and the other East Asian economies to lesser extents.
Two models have been presented in this paper in which the backstopping function of the monetary authority is modeled within an escape clause currency crisis framework that emphasizes the non-mechanistic behavior of government in trading off various policy objectives. The models stress that while speculative attacks are not inevitable, neither are they arbitrary. There must exist some weaknesses in the economic fundamentals of the country for an attack to occur, as the credibility of the fixed exchange rate regime is “less than perfect.”15
If the economy is either very “good” or very “bad,” it will, respectively, never or always be attacked. Within those two extremes - which imply unique equilibrium (i.e., an attack with close to 0 or 1 probabilities) - there is an intermediate range (gray area). Within this range, there may exist some weaknesses in the economy that are neither small enough to completely preclude a speculative attack on the currency, nor sufficiently great to make an attack unavoidable. Rather, there are a multiplicity of equilibria such that an economy remains on what seems to be a sustainable path (good equilibrium), until some trigger or event coalesces market expectations to an inferior path (bad equilibrium), which is then realized Obstfeld 1996a and Obstfeld 1996b.
Thus, in the models presented in this paper, a currency crisis may never (always) occur if the existing stock of the government’s contingent liabilities is “very low” (“very high”) and the domestic economy is “sufficiently immune” to an interest rate hike. However, when the fiscal costs of bank bailouts fall within a certain range (as formalized above), the currency is vulnerable to a crisis.
