Identifying the role of macroeconomic fundamentals in the 1997 Asian currency crisis: An application of the currency crisis model to Thailand, Indonesia, the Philippines, and Korea

For some East Asian countries, the experiences in 1997 must have been a nightmare. Raging waves of currency crises swept East Asian countries away that year. The Asian crisis was unprecedented in its scale and contagion. Not only has the crisis, originating in Thailand, spread to many other economies in Asia, but also spillover effects have been felt throughout the global economy.;In this paper, I perform an empirical analysis to identify the role of macroeconomic fundamentals in the recent crisis as well as earlier devaluations, i.e., to evaluate whether the associated regime changes could be explained by a deterioration in these fundamentals in the sample countries: Thailand, the Philippines, Indonesia and Korea. In order to identify such a role, this paper computed the one-step-ahead probability of a regime change (or devaluation) as a function of economic fundamentals by using an extension of the basic currency crisis model. It is a stochastic version of the monetary approach to exchange rate determination. To test the implications of the theoretical model, I perform a logit analysis using quarterly data during the sample period 1970--1997.;The one-step-ahead probability is expected to peak before an actual devaluation (or regime change) materializes. The empirical results show that the probability peaked in most cases before or when the actual devaluations (or regime changes) happened in the sample countries. So it can be said that the model identifies the role of economic fundamentals in the sample countries relatively well. In other words, the deterioration in macroeconomic fundamentals generates reasonably good one-step-ahead probabilities for the devaluations that took place in these countries during the sample period.;As regards the 1997 currency crisis, the model also provides some good information. According to the empirical findings, there were some evident warning signals for devaluations in the sample countries. The empirical results show an increase in the one-step-ahead probabilities just before the crisis happened. That is, the Asian crisis was not unpredictable from the viewpoint of macroeconomic fundamentals. According to the empirical results, market participants seem to have perceived the existing fixed exchange regimes in the sample countries as inconsistent with the underlying economic fundamentals. The model, however, does not perform equally well in predicting the recent currency crisis for all the sample countries. While the warning signal was relatively strong in the cases of Thailand, the Philippines and Korea, it was weak in the case of Indonesia.;The one-step-ahead probabilities predicting the 1997 crisis are much lower than expected, in the range of about 7--15 percent. This means that the recent Asian currency crisis cannot be fully explained by only the macroeconomic fundamentals. Therefore, this result may provide support for the view that consistent macroeconomic policies such as external, monetary, and fiscal policy are necessary but not sufficient to ensure the maintenance of stable exchange rates. It might also suggest that other factors, such as contagion (or international spillover) and domestic political effects not captured by this model had an important role in the recent crisis.;Nevertheless, considering the model's reasonably good fit for the devaluations in the sample countries, the model could possibly be useful as an early warning device for currency crises (or devaluations), thus signaling impending trouble.