A Tale of Two Currency Crises: Korea and India

Abstract

India and Korea have experienced a currency crisis in 1991 and 1997, respectively. These two countries had made active economic reforms after the crises. Then, what were the causes of the two crises? It is said that before the crisis, India had some economic fundamentals problems such as trade deficit and government finance balance, etc. However, were these problems serious enough to cause the currency crisis? How about Korea? Just before the currency crisis occurred in 1997, Korean government insisted that there were not any fundamentals problems with its economy. The purpose of this paper is to empirically identify the roles of macroeconomic fundamentals in the currency crises as well as in earlier devaluations for a sample of two countries: Korea and India. In order to identify such a role, this paper computes 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. 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 two countries. So it can be said that the model identifies the role of economic fundamentals in the two countries relatively well. In other words, the deterioration in macroeconomic fundamentals generates reasonably good one-step-ahead probabilities during the sample period. As regards the two currency crises in Korea and India, the model also provides some good information. According to the empirical findings, there were some evident warning signals for devaluations in the countries. The empirical results show an increase in the one-step-ahead probabilities just before the crises happened. That is, the two crises were not unpredictable from the viewpoint of macroeconomic fundamentals. While the warning signal was strong in India, it was relatively weak in the case of Korea.