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It is widely believed that seriously excess debt problems form a major cause of the 1997 Asian financial crisis. This paper investigates empirically the role of the debt problems using Korea’s won/US$ rate as the guinea pig. The problems are represented by two institutional variables in nonlinear equilibrium-correction models. The variables are found to exert positive feedback effects on Korea’s won rate returns in three forms: disequilibrium in levels, short-run shocks, and explosive bubbles. However, the estimated effects are not so singly conspicuous as to serve as the predictor of a likely collapse in the won rate in late 1997. Excess debt is hence found to only constitute one of the many factors that brought about the 1997 won crisis.

The 1997 East Asian financial crisis has led to rapidly mounting studies in currency volatilities and crises.1 While theorists wrestle with feasible explanations for sudden currency crashes, empirical modelers delve extensively into data for possible crisis predictions. There are, however, still relatively few empirical works that try to verify or test certain theoretical explanations by using country-specific data information. This paper presents such an attempt. It examines how much, from time-series data, we can identify and estimate the contribution of Korea’s excess debt problems to the won crisis in the November of 1997. The choice of the subject stems from several considerations. Korea has long been recognized as a model of state-directed, export-led economy that has sustained rapid and continuous growth, and it is the strongest of the Asian economies which suffered currency crises during the 1997 financial turmoil. In fact, the macroeconomic management in Korea was considered generally sound by the international community and the country obtained its OECD membership shortly before the won collapsed. Indeed, there was little forewarning that the Korean currency would not be able to ride out the Asian financial crisis. The won has been under close control by the Korean government until recent years. This is best seen from the macroeconometric models built by the Bank of Korea, e.g. BOK, 1993, in which the exchange-rate variable is assumed exogenous. The government exchange-rate intervention management has nevertheless undergone several phases of liberalization. Prior to 1980, the Korean won had been pegged to the U.S. dollars. During the 1980s, the won was fixed according to a certain weighted average formula centered around the U.S. dollars (Haggard et al., 1994; Chapter 9). In 1993, the government launched a 5-year programme of financial liberalization, in which the exchange rate was to float gradually via widening margins of its fixed fluctuation zones, see e.g., OECD 1994 and OECD 1996. Unfortunately, the program was soon affected adversely by the slowdown of the economy since the late 1995 and brought eventually to a disastrous currency collapse in November 1997 (see Fig. 1), in the wake of financial turmoils in Malaysia, the Philippines, Thailand, and Indonesia.It has been widely recognized that a series of bankruptcies of chaebols, i.e., large Korean conglomerates, in early 1997 seriously damaged foreign investors’ confidence in the Korean economy and eventually exposed the won to severe speculative attacks in October 1997 (see footnote 1 for a chronology of the won crash). It is widely known that the bankruptcies were mainly caused by hefty debts due to cumulation of seriously underperforming investment projects that had been undertaken under weak banking supervision and strong state-directed development policies. The link between currency crises and cumulative debt-ridden investment projects thus serves as key evidence for a number of recent theories and diagnoses. For example, Stiglitz (1998) maintains that deregulated capital accounts combined with under-regulated domestic financial sector is a key weak point of the 1997 Asian financial crisis because it makes the national financial system very vulnerable to external shocks for an open economy, especially shocks from international capital markets (Radelet and Sachs, 1998). The underderegulation is further related to moral-hazard investment behaviour, e.g., see Krugman (1998), and linked with the soft-budget syndrome, which is believed to generate deteriorating economic fundamentals for transitional economies (Huang and Xu, 1999). These diagnoses suggest that the recent crisis was not entirely an unforeseeable burst of an explosive bubble fostered by widespread financial panic over external shocks, and that there are certain internal factors with disequilibrium potentials, which have contributed positively to the crisis. Several recent empirical studies have actually made use of the diagnoses. For instance, Kaminsky et al. (1998) use banking crisis, money-to-reserve ratio, domestic credit-to-GDP ratio, and other ratios as possible leading indicators of currency crises. Kumar et al. (1998) choose external debt-export ratio, budget deficit-GDP ratio, etc. as explanatory variables in modeling currency crises. Similar variables are also employed by Esquivel and Larraı́n (1998) and Glick and Rose (1998). However, most of these studies focus on the predictability of currency crises conditioned upon these explanatory variables by means of binary choice models, such as probit or logit models.2 What remain largely untackled empirically are questions such as whether such disequilibrium factors have been propagating into currency movements regularly, and how different institutional mechanisms in different emerging markets exert their roles in destabilizing the currency market. To seek answers to these questions, detailed country-specific econometric models of exchange-rate determination are required. The next section reports such an experiment on the Korean won. The modeled effects of excess debt are discussed in Section 3. The main implications of the experiment are summarized in the concluding section.

The present empirical study renders mainly the following: 1. Excess debt in Korea is found to continuously exert perturbing feedbacks to the won/US$ rates, and thus have contributed significantly to Korea’s currency collapse in late 1997. Excess debt is represented here by two institutional variables: wealth-debt ratio and liability-debt ratio, with the latter variable being the most important one. The effects of the two variables are further specified into three types: disequilibrium level effect, short-run shocks and self-fulfilling explosive bubbles. 2. In spite of the reasonably sound model results, the 1997 won crisis remains virtually unpredictable. This reinforces the common view that the exchange-rate policies per se in Korea have been prudent and well in line with the markets by and large. 3. Theoretically, the modeled effects of excess debt can be regarded as being caused by disequilibrium not only in the internal capital structure of the economy, but also in the external debt structure. The effects also fit, in principle, with the theorization of the soft-budget constraint syndrome by Huang and Xu (1999). However, the effects estimated in the models are less direct, less dominant and dynamically more complicated than what Huang and Xu suggest. In particular, the effects are found to be mainly explanatory rather than predictive. This finding inclines us to ascribe the main cause of the won crisis to “spillover” or “contagion,” as theorized by Masson (1998), and to rational, short-term speculative activities in the international currency market, as analyzed by Osler (1998). 4. Practically, the model results carry interesting policy implications. Primarily, great caution should be exercised in the design of any macro policies relating to financial market liberalization when the currency is in virtually free floatation, irrespective of the existing degrees of exchange-rate controls, because the closer the currency is allowed to take its market values, the more susceptible the exchange rate becomes to a multitude of random shocks and, hence, the less predictable its volatility. Under such circumstances, it is far from sufficient for policy makers to monitor the band of the nominal return movements narrowly by the movements of the economic fundamentals. What becomes crucially important is to maintain exchange-rate policies well in coordination with any other policy programmes on financial liberalization.17 Financial marketisation has reduced the scope, or increased the risk, of disequilibrium policy maneuvering domestically. Finally, policy makers should pay more attention not only to the possible dynamic complications of short-term shocks to the exchange rate relating to speculative activities in the world currency market, but also to the possible cumulative effect of the past or existing disequilibrium problems in the domestic economy, once they have decided to unleash the home currency into the world market. The present modeling exercise is limited to finding empirically the role of the debt problems in the won rate fluctuations. Many issues have been left aside. Further model extensions are definitely desirable, especially in relation to the questions of how the debt problems feed into international capital markets, how the Korean case compares with other open economies with comparably serious debt problems, whether certain safety boundaries of the debt ratios are estimable with respect to the exchange rate fluctuations under different policy scenarios, and how the degrees of institutional disequilibrium effects could be related to the susceptibility of the economy to regional spillover and contagion.