Depreciation and Recessions in East Asia

One of the striking characteristics of the recent currency crises in East Asia is the sharp reductions in output that followed depreciations. This paper draws on an earlier literature on contractionary depreciations to motivate an empirical model of the relationship between exchange rate and output fluctuations in a panel of six East Asian economies. There is evidence of a negative relationship between economic activity and the real exchange rate in East Asia. Informal examination of output fluctuations around episodes of sharp depreciation over the 1975–1996 period conveys the impression that such episodes are associated with modest expansion and contraction cycles, with output above trend before a sharp depreciation episode and below trend after it. The cyclical pattern is accentuated when the sharp depreciation episode occurs during a banking crisis. The very steep output declines that followed the 1997 sharp depreciation episodes appear to reflect a high concentration of banking crises of unprecedented severity. However, explicitly accounting for sharp depreciation episodes or banking crises does not add to the explanatory power of the benchmark model over the period 1975–1996. The recent currency and financial crises in East Asia have sparked a new round of theoretical and empirical research on the causes of such crises, leading to significant advances in our understanding of these issues.1 However, there has been relatively little recent discussion of the aftermath of these crises. In particular, one of the striking characteristics of the recent currency crises in East Asia is the sharp reductions in output that followed depreciations. At first glance, this outcome seems counterintuitive, as depreciations are generally expected to boost output. Recent explanations for closely timed depreciations and output contractions focus on the interaction between external shocks and financial sector disruptions. In this view, low interest rates in industrial economies and sterilized intervention policies that kept interest rates high in emerging markets contributed to a surge in capital flows to the emerging markets in the first half of the 1990s (Calvo, Leiderman, and Reinhart 1996). These capital flows supported credit growth and a boom in economic activity in East Asia that was associated with growing financial sector vulnerability. Financial liberalization also may have played a role in financial vulnerability (Diaz Alejandro 1985, Kaminsky and Reinhart 1999). According to these explanations, the unprecedented contractions in output observed in East Asia following the currency depreciations of 1997 were the result of financial crises. These in turn were caused either by panics in illiquid financial systems (Chang and Velasco 1998, Radelet and Sachs 1998) or by moral hazard that made financial systems vulnerable to shocks because of excessively risky lending or unhedged foreign currency borrowing (McKinnon and Pill 1998, Krugman 1998, Corsetti, Pesenti, and Roubini, 1998). While the relationship between financial crises and currency crises in East Asia in 1997 is very evident and is broadly consistent with the experience in other emerging markets (Kaminsky and Reinhart 1999), the characteristics of past depreciations in East Asia—and their implications Depreciation and Recessions in East Asia