August 19 2004 16 36 WSPC 172 SER 00085 The Singapore Economic Review Vol 49 No 2 2004 135 161 c World Scientific Publishing Company INVITED EMINENT PAPER SERIES ASIAN CRISES THEORY EVIDENCE WARNING SIGNALS Jerome L Stein Emeritus Professor of Economics and Eastman Professor of Political Economy is Visiting Professor Research in the Division of Applied Mathematics at Brown University He has been an associate editor of the American Economic Review the Journal of Banking and Finance and the Journal of Finance He received the degrees of PhD from Yale University 1955 and Docteur Honoris Causa from the Universite de la Mediterrane e Aix Marseille II 1997 His interests are in developing economic theory to explain significant economic problems These subjects include microeconomics futures markets rate of return regulation environmental policy macroeconomics inflation and unemployment Monetarism economic growth financial markets and international finance His books reflect these interests They include Fundamental Determinants of Exchange Rates 1995 Money and Capacity Growth 1971 Monetarism Keynesian and New Classical Economics 1982 The Economics of Futures Markets 1986 and Economic Growth in a Free Market 1964 Since 1998 his interdisciplinary research with Wendell Fleming of the Division of Applied Mathematics applies stochastic optimal control dynamic programming to international finance and debt crises In this connection he has been invited to give lectures to the American Mathematical Society and the World Congress of Nonlinear Analysts Empirical implications of this research have been presented at seminars at the European Central Bank the Bank for International Settlements Banque de France and at various universities 135 August 19 2004 136 16 36 WSPC 172 SER 00085 The Singapore Economic Review ASIAN CRISES THEORY EVIDENCE WARNING SIGNALS JEROME L STEIN Brown University GUAY C LIM University of Melbourne 1 Aims of the Study In July 1997 the economies of East Asia became embroiled in one of the worst financial crises of the postwar period Yet prior to the crisis these economies were seen as models of economic growth experiencing sustained growth rates that exceeded those earlier thought unattainable Table 1 describes the situation for ASEAN4 and Korea before and after 1997 The high growth from 1986 1996 was suddenly followed by a collapse of the real economy with negative growth in 1998 In 1997 the exchange rates depreciated by double digits and for some countries the depreciation continued into 1998 What went wrong What caused the financial crisis With hindsight there is now a consensus as to what went wrong with the Asian countries Dean 2001 1 briefly describes the consensus as follows The Asian growth was generated by high investment and saving The difference was financed by capital inflows made possible when the economies were liberalized in the early 1990s Since these economies generally had fixed exchange rates the capital inflows led to increases in the money supply There were inflation of asset prices speculative bubbles but not inflation of prices of goods and services The investment was poorly intermediated and misallocated Table 1 The Asian Crisis 1997 1998 Country Indonesia Korea Malaysia Philippines Thailand GDP Annual Growth Rate Exchange Rate Depreciations 1986 1996 1998 1 1998 6 1997 1998 1 1998 6 7 4 8 6 7 8 3 7 9 1 12 0 5 0 5 0 12 5a 8 0 52 0 43 0 33 0 29 0 44 0 50 0 6 0 1 0 5 0 16 0 Source IMF October 1998 Tables 3 11 3 12 a 1997 4 1998 2 1 Dean 2001 contains the basic references on this subject and the reader is referred to his article for the extensive bibliography Flouzat 1999 and recent International Monetary Fund WEO reports describe the consensus view country by country August 19 2004 16 36 WSPC 172 SER 00085 Asian Crises Theory Evidence Warning Signals 137 The capital inflows produced a high ratio of external debt and debt service obligations relative to export earnings With the bursting of the speculative bubble in asset prices the former capital inflows turned to outflows The countries faced a dilemma If interest rates were raised to stem the outflow the debt service burden to domestic borrowers would be raised If the interest rates were not raised devaluation would have to occur and the debt service burden on the foreign currency denominated debt would rise The net result was a financial collapse and exchange rate depreciation But why did the market not anticipate the crises 2 Could it be that the market and credit rating agencies failed to anticipate the crisis because there were no useful warning signals More importantly could it be that the range of qualitative and quantitative indicators normally monitored for example per capita income growth rates inflation rates ratios of foreign debt to exports history of defaults level of economic development government budget deficits ratio of current account deficits to GDP were not helpful because these measures were assessed in an ad hoc manner We contend that it would be more useful to derive warning signals based on concepts derived from a coherent theoretical framework which can predict the crisis Hence our aim is to present a coherent theory which may be used to generate operational warning signals To this end we review the Asian financial crisis from two related perspectives whether the crisis was precipitated by a failure of the real exchange rate to be aligned with its fundamental determinants and or whether the crisis was precipitated by a divergence of the foreign debt from its optimal path The first perspective is based on a coherent theory of the equilibrium real exchange rate which shows how misalignments lead to currency crises The second perspective is based on a model of optimal foreign debt ratio which showed why divergences lead to debt crises The important point here is that these models suggest important variables which may serve as warning signals to predict crises The paper is organized as follows In Section 2 of the paper we discuss some traditional warning signals Section 3 provides an overview of the Natural Real Exchange Rate NATREX approach to the determination of the equilibrium real exchange rate and the measure of misalignment that may serve as a warning signal for currency crises This section also describes the stochastic optimal control dynamic programming SOC DP approach to derive the optimal foreign debt ratio and shows how the deviation of the actual debt from this benchmark
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