CONTEMPORARY ECONOMICS 293
The East Asian
financial crisisThe 1997 East Asian
crisis seemed to come from
nowhere, overwhelming
countries with strong growth
records and government
surpluses. Before the crisis
most countries in the region
had pegged their exchange
rates to the US dollar. The
first signs of trouble were
businesses failing in Thailand
and South Korea. On July 2,
1997, after months of battle
to save its pegged rate,
Thailand devalued. The
Philippines was then forced
to float on July 11, Malaysia
on July 14, Indonesia on
August 14. In less than a year
the currencies of Indonesia,
Thailand, South Korea,
Malaysia, and the Philippines
fell by between 40 and 85
percent. Only Hong Kong held
out against the speculators.
The crisis has been blamed
on a severe banking crisis.
Borrowing was often short-
term, and when foreign
lenders withdrew their
capital, contagion ensued,
and currencies collapsed.Icelanders take to the streets of
Reykjavik to denounce the state's
handling of the currency crisis in 2008,
which saw the krona lose more than
one third of its official value.
currencies came under sudden,
massive speculative attack. In the
second generation models the
escape clause of devaluation was
supposed to relieve the economy
from social costs, but the sharp
collapse of their currencies was
followed by a severe—though short-
lived—downturn. Financial
fragility, caused by a banking boom
and bust, played an important role.
In light of this economists began
to focus on the interaction of
weaknesses in the economy
and speculators’ self-fulfilling
expectations. This third generation
model now took into account new
kinds of financial fragilities, such
as those that arise when firms and
banks borrow in foreign currency
and lend in local currency. Banks
would be unable to pay their
debts in the event of currency
devaluation. These kinds
of weaknesses could spark
speculative attacks and crises.
As well as developing theories,
economists have looked at the
evidence for possible warning signs
of currency crises. In a 1996 article
Jeffrey Frankel and Andrew Rose
reviewed currency crashes in 105
developing countries from 1971 to
- They found that devaluations
occur when foreign capital inflows
dry up, when the central bank’s
foreign currency reserves are low,
when domestic credit growth is
high, when major external
(especially US dollar) interest rates
rise, and when the real exchange
rate (prices of traded goods from
home relative to those abroad) is
high, which means that a country’s
goods become uncompetitive in
foreign markets. Economists argue
that by monitoring such warning
signs, crises may be predictable up
to one or two years in advance.Avoiding crises
Studies suggest that between
5 and 25 percent of recent history
has been spent in one crisis or
another. New crises will continue
to surprise us, but there are signals
—such as the real exchange rate,
exports and the current account,
and the amount of money in the
economy relative to the central
bank’s international reserves—
that may help to warn us
when currency hurricanes are
approaching. The experiences
of the last few decades have
exposed the financial roots
of crises. Economists now talk of
“twin crises”—vicious spirals
of currency and banking crises.
Rapid financial deregulation and
liberalization of international
capital markets are thought to
have led to crises in countries with
weak financial and regulatory
institutions. As well as paying
attention to the macroeconomic
signs of future crises, governments
also need to attend to these
institutional vulnerabilities. ■