Ebook An Early Warning System for Contagious Currency Crisis
Disputes on how to resolve the crisis seem to have originated from divided views on what caused the crisis in the first place. For the sake of simplicity, academic circles may be split into two camps. One camp, which focuses on Asian countries’ liquidity shortage, emphasizes the instability of the international financial market and the sudden shifts in market expectations and confidence as the major triggering factor in the outbreak of the crisis. The fact that a country can suddenly experience a crisis situation even with relatively sound fundamentals tells us that contagion and vulnerability deserve renewed attention to better understand the dynamics leading to crises in Asia.
In opposition to this financial panic view, the other camp stresses structural weaknesses and policy distortions of the country in question, and, in particular, moral hazard problems in both the corporate and financial sectors. This view emphasizes the necessity of restructuring and the sustainability of growth based upon sound macroeconomic and financial systems. In Korea’s case, even with seemingly sound macroeconomic fundamentals compared to other East Asian neighbors, the lax supervision of and regulations for financial institutions, and the resulting significant mismatch in the sources and uses of funds helped activate crisis dynamics (Choi 1999).
In retrospect, we believe that both an internal structural weakness and the instability of international financial markets led to the Asian crisis. Also, while the identification of either of the two as the primary cause of the crisis might help in some regards, an eclectic approach would be more beneficial in constructing an EWS and drawing policy lessons. Furthermore, two seemingly independent causes may be intertwined because structurally unsound economies are likely to be more vulnerable to the instability of financial markets. At least, the contagion related crisis dynamics are also related to the fundamental weakness even with the visible role of expectations that contributes to the realization of a crisis.
In fact, if the triggering mechanism for a currency crisis cannot be traced to structural problems or macroeconomic imbalances, it is almost impossible to design an early warning system (EWS) for a currency crisis since subtle changes in investor's risk appetite are hard to predict. Also, even with early signs of an impending crisis identified, it may be too late to expect an effective policy response, which far exceeds the leading time of any reliable EWS. This study examines the feasibility of designing an early warning system for a currency crisis in Korea by looking into the dynamics of vulnerability and contagion. It is built on the idea that the seed for crises can be detected and monitored with relative accuracy even with the nonlinear features of crises dynamics that were observed during the 1997-98 crises in Asia.
Regardless of the differences between competing theories of crises, contagion and vulnerability emerged as essential features of the recent Asian crises. Contagion refers to the situation where problems in other parts of the region increase the probability of crisis at home. Shocks from outside can be grouped to better explain contagion: trade link, common lender, and similarity with other countries in terms of the capital market structure, macro conditions, etc. Notably, some of the possible explanations for recent contagions include herding behavior or the common lender problem. There have been several incidences of contagious currency crises, notably those of Asian crises during 1997-98. The Tequila effect confirmed that a trade link is not necessary for contagion to affect a nation as financial markets become intricately linked. A particularly well-known example is the extensive research done on the contagion effect that affected many nations after the Mexican crisis in 1994. These studies are based on cross-country data and allow us to investigate the general pattern of crisis that goes beyond the experience of an individual country. However, cross-country studies cannot properly reveal the characteristics of each individual country, and inter-country comparison is at best limited. In this paper, we are interested in investigating the dynamics of crises that emanate mainly from Asian countries from the Korean perspective.
Quantifying the contagion effect is not an easy task, but at least we can start building the contagion vulnerability index ; e.g., Kaminsky and Reinhart (1999). Special attention is given to the role of the Japanese banking system in setting off shocks that would test the vulnerabilities of other Asian nations, specifically Korea. After the crisis, the role of the Japanese bank in supplying credit has been less noticeable in Korea. Still, given a sizable exposure to European banks, the common lender problem may exacerbate the situation in an abrupt manner. Also, the trade link remains one of the potential channels of contagion because the most likely fallout from the Japanese problem would be a depreciation of Japanese Yen. Given that Korea has high exports, like Japan, exchange market pressure is like to build up when the Japanese banking problem begins to be realized.
One of the fundamental changes from the previous version of EWS is that we take the role of vulnerability in transmitting shocks seriously. In addition to the role of key fundamentals-related variables, the dynamics are affected by the level of vulnerability of the main country as well as other countries within the region. It turns out that the contagion vulnerability index does a reasonably better job in predicting a crisis in this region. The issue is how to model the nonlinear feature of crisis dynamics using the vulnerability index. Above a certain level of vulnerability, the crisis index remains sensitive to any changes in leading indicators, including various contagion variables. As such, the nonlinearity feature can be the result of not fully utilizing the relevant information set. Also, another modeling issue is to allow different responses to various shocks. If the number of countries within the region increase or when the vulnerability increases above a certain threshold, then the contagion effect should be stronger.
The paper is organized as follows. In section II, a simple exposition is made to compare traditional and self-fulfilling currency crises, and some improvements over the previous version are explained. In section III, we construct a crisis index and introduce some of the factors explaining the movement in the crisis index. In section IV, the signals approach was applied to ferret out explanatory variables, which are then followed by a brief discussion on the newly constructed composite index of vulnerability with its connection to the probability of a crisis. In section V, some of the likely scenarios in which contagion is likely to be propagated are examined. The final section concludes the study.
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