Editor’s Note

Though this article contains applications of economics, one does not need to be well-versed in principles of macroeconomics to appreciate the author’s scholarship. The author helpfully explains most of the necessary concepts as her analysis progresses.

Abstract

In 1997, the East Asian currency and financial crisis sparked one of the largest reversals of growth in recent times. The detrimental effects were felt around the world, though they were particularly severe for Thailand, Korea, Malaysia, and Indonesia. Because currency crises can be incredibly damaging to economies, setting back growth and development by many years, I draw from economic currency crisis theory to investigate how currency crises occur and provide recommendations for preventative government action. My analysis proceeds in the following order. The first section briefly reviews the currency crisis literature. To this end, I present three generations of currency crisis models chronologically. The second section introduces the Korean economic landscape over the past forty years and other background information necessary to understand the financial crisis of 1997-1998. In the third section, I evaluate the three generations of models using the empirical case of the Korean crisis from 1997-1998. My analysis concludes with policy recommendations and future prospects.

I. Review of Currency Crisis Literature

This section will present the most prominent models for financial and currency crisis grouped by generation. While each subsequent generation is increasingly sophisticated, every model supports that “speculative attacks occur when there is an expectation of future monetary and fiscal policy changes that triggers a ‘run’ on a central bank’s international reserves.”¹ Each model uses different variables and analyses to explain what drives the change in future expectation of policy and why the change in expectations uniquely resulted in a run.

Quick Economics: Implications of the Fixed Exchange Rate

Under a system of fixed exchange rates, as was the case in South Korea before the 1997 financial crisis, the central bank must maintain the level of the peg by buying and selling foreign currency with the home currency. For example, the central bank may decide that its domestic currency is overpriced and proceed to devaluate by selling foreign currency reserves. Then, there would be a permanent decrease in the exchange rate and an increase in the money supply.

First Generation Model

Paul Krugman developed the first generation model (FGM) in 1987. The FGM analyzes financial crises based on the status of macroeconomic fundamental variables. Krugman’s model proposes that exogenous fiscal deficits drain international reserves and are the underlying cause of the balance of payments crisis.² For example, fiscal deficits are financed through domestic credit, which induces investors to rebalance their portfolios by buying domestic assets with foreign reserves. Thus, as foreign exchange reserves are depleted there must follow an exchange rate devaluation. Otherwise, speculators will realize that the peg is unsustainable and launch an attack for profit (Detailed explanation included in Appendix 1).

Flood and Garber in 1984 add a variable of uncertainty over the rate of change of domestic credit to the Krugman FGM. Their model holds that unanticipated increases in domestic credit can cause speculators to attack the peg because they view that it is overvalued and that there are arbitrage profit opportunities.³ Additionally, they conclude that the greater uncertainty over the government policy, the faster the reserves will be depleted. The experience of currency crises in the 1970s and 1980s supports the first generation models.⁴

Second Generation Models

Instead of positing that a marcoeconomic problem is necessary for a currency attack, the Second Generation Models (SGM) hold that investors determine the timing and presence of an attack. However, the SGM’s are not necessarily mutually exclusive with the FGM. In fact, the SGM’s analyze the market decision-making behind the drain of international reserves initially modeled by the FGM.

Obstfeld SGM – Market Instability, Uncertainty

In 1996, Maurice Obstfeld unveiled a SGM of currency crisis that focused on self-fulfilling features. Obstfeld’s model depicts the government as powerless to retain its preferred exchange rate if the market expects another rate. In fact, small speculative attacks would trigger government responses that validate the devaluation and facilitate greater attacks. For example, when devaluation expectations cause interest rates to rise, the helpless government would be unable to buy foreign reserves because the cost is too high.⁵

Building off Obstfeld, in 1995 Mona and Shin studied the impact of uncertainty on creating a currency crisis. Their model holds that all economic agents have different information about the economy with different margins of error. Thus, one agent must consider the range of economic information held by other agents and make decisions based on their perceptions. Hence, the Ostfled SGM concludes that currency crises can be triggered by changes in market agents’ beliefs without any sign of weakness in the actual underlying fundamentals.⁶ Also, growing uncertainty over the state of fundamentals may increase speculators’ incentive to act on these expectations.

Ozkan-Sutherland SGM – Unemployment

On the other hand, the Ozkan-Sutherland SGM explains that attacks occur when government maintains a fixed exchange rate and there is high and rising unemployment. Unemployment is often remedied by expansionary policies, but expansionary policies would put upward pressure on the exchange rate. In a period of high unemployment and expansionary government policy, speculators preempt the government exchange rate change by launching a speculative attack.

Illiqudity-Insolvency SGM – Herding and Self-fulfilling Expectations

Radelet and Sachs hold that while individual investors may act rationally, collective “market outcomes [could] produce sharp, costly, and fundamentally unnecessary reversals in capital flows.”⁷ In order to illustrate this model, it seems useful to distinguish between an insolvent borrower who does not have funds to repay debt out of future earnings and an illiquid borrower who lacks the ready cash to repay the debt in the short-term. While lending to the latter may prove profitable, small individual creditors typically cannot cover the short term debt of the illiquid borrower unless they team up with other willing individual creditors. Thus, if a small individual creditor perceives that there are no other willing creditors, she will rationally choose not to lend to an illiquid debtor The debtor would then be pushed to default, vindicating the creditors’ decisions not to lend.⁸ In the context of international markets, the same scenario occurs but on a larger scale with national central banks as chief economic agents.

Douglas Diamond and Philip Dybvig sketched a very similar model, but in the context of bank runs. Their model seeks to explain the mentality behind large groups of depositors suddenly withdrawing their funds, subsequently pushing the bank into bankruptcy.⁹ The mentality is very similar to a speculative currency attack; depositors demand their deposits when they fear other depositors are acting rather than when there is an intrinsic problem with the bank. More important for my case study is the insight that banks exist to take in short-term deposits and lend long-term loans.

Mishkin-Hamn SGM – Information Asymmetries

Asymmetric information is a phenomenon where some actors do not have the same information as other actors and often in the financial markets, this plays out in investors being guided by the observed actions of other investors rather than private information.¹⁰ Asymmetric information can make markets inefficient and non-functional. Mishkin and Hamn cite four factors that may increase asymmetric information and lead the banking system to collapse: deterioration of corporate balance sheets, interest rate increase, uncertainty increase, and changes in asset prices deteriorating non-corporate balance sheets.

Third Generation Models

Third generation models (TGM) are a less uniform category than the first and second-generation models. They were developed as a reaction to the unique aspects of the currency crisis in East Asia and tend to contain many variables.

Chang-Velasco TGM – Domestic Bank System and International Illiquidity

Tailored to the age of increasing financial liberalization, Chang and Velasco’s TGM assigns a key role to financial institutions, particularly the domestic bank system, and tests the impact of international illiquidity as exasperating factor for crisis.¹¹ The model concludes that market-orientated policies increase prospects for growth but also make the financial system more vulnerable to quick capital flow reversals and herd behavior. Additionally, Chang and Velasco state that bad government policies can make financial crisis more likely but largely because bad policy increases illiquidity and vulnerability.¹²

Corsetti-Pesenti-Roubini TGM – Bailout Guarantees and Weak Regulations

Another key model is that of Giancarlo Corsetti, Paolo Pesenti, and Nouriel Roubini. Their model posits that moral hazards promote overinvestment, excessive external borrowing, and current account deficits. This model focuses on bailout guarantees and weak private sector regulations.¹³ The key assumption is that investment decisions are decided based on an expectation that fiscal authorities will guarantee a rate of return on domestic financial investment.¹⁴ When the rate of return is guaranteed banks will lend wildly and disregard risk assessments. The economists state that eventually foreign creditors will refuse to refinance the country’s losses and the government will need to step in to guarantee the debt. The government must undertake appropriate fiscal reforms to raise money to cover the losses.¹⁵ The money is raised by fiscal deficits, which put pressure on the exchange rate as shown by the first generation model.

Modified Krugman Model – Corporate Balance Sheets and Capital Flow

Paul Krugman modifies his FGM to include the role of corporate “balance sheets in influencing investments and that of capital flow in affecting the real exchange rate.”¹⁶ Krugman sets up the model so that investors lose confidence as a country experiences a large real depreciation. The depreciation worsens the balances sheets of domestic corporations and validates the loss of confidence.¹⁷ These actions cause a reversal in the current account, deemed “the transfer problem.” Furthermore, weak corporate balance sheets are a root cause of non-performance loans at the domestic banks. Krugman finds that weak corporate balance sheets are often a problem with under regulated financial intermediaries and overpriced assets. Krugman’s variables fit neatly as modifiers of first and second-generation models. Although his model is not particularly polished theoretically (as Krugman himself admits), Krugman is able to make an intuitive argument while combining most of the factors that other economists cite.

II. South Korea Case Study

Korea has had an incredible record of growth and success in the second half of the twentieth century. There is still debate over the cause of Korea’s tremendous growth rates. Some economists credit export-orientated, pro-market government policies, while others emphasize industrial policy and technical change. Yet another group cites only domestic industrialization policy to explain growth.¹⁸ Regardless of the reason, by the 1990s. Korea was one of the World’s top emerging markets. The graph below titled “Industrial Production and Export Growth” illustrates how quickly Korea was able to industrialize and increase its exports. Even the financial crisis in 1997 only made a small dent in Korea’s fast paced growth.

Exchange Rate Regime Background

Korea has had a multitude of exchange rate regimes over the past 25 years. The single currency peg, a hard peg to the U.S. Dollar, was first established in 1964. The government did not allow banks to trade the currency.¹⁹ Starting in 1980, the Bank of Korea replaced the Won’s fix with the U.S. dollar with a multiple currency basket peg using currencies of Korea’s major trading partners, such as the Chinese Yuan. This is obvious from the graph below that depicts the steady peg as a straight horizontal line and the managed pegged expressing volatility. Then in 1989, the exchange rate was allowed to fluctuate in a band, creating a managed float but pegged loosely to the U.S. Dollar. Later in the 90s, the band became harder for the Bank of Korea to maintain. The fluctuation range widened from .4% to 2.25% during 1990-1995. Thailand’s abrupt switch to a floating exchange rate in July 1997 signaled instability throughout Southeast Asia. Consequently, the Korean Won came to depreciate rapidly. In response, the Bank of Korea decided to switch to a floating exchange rate on December 12, 1997.²⁰

Macroeconomic Variables before the crisis

Korea’s macroeconomic fundamentals were fairly standard years before the crisis. The Korean government was not fiscally irresponsible, and the money supply did not suffer from inflation like crisis-ridden Latin American countries or large balance of payment deficits.²¹

Table 1 shows the stability of key macroeconomic variables. CPI inflation rate is fairly steady, particularly the years leading up to the crisis when inflation never rises higher than 6.2%. Additionally, in 1996 and 1997 before the crisis the government budget was about balanced and the GDP to Current Account shows an improvement from -4.42% to -1.71%.

The graph above shows the government balance in Billions of Wons, we can see that from 1994-1996 the government operated in a surplus, not a deficit.

Sources of Short-term Debt: Private Sector, Banking System, and High Interest

Korea has a history of investing resources in huge family-operated conglomerates called Chaebols, which dominate particular industries. Before the crisis the government was pouring financial support into these few big companies. As the economy matured, however, government officials could no longer maintain the same control and oversight and began to adopt market-oriented policies and liberalize capital flows.²²

Nevertheless, government officials passed legislation that ensured domestic banks that the government would bail the Chaebols out in a crisis. Simultaneously, regulations upholding the supervision of the banking system were relaxed. In fact, in 1992, Korea established financial institutions charged with security writing, leasing, and short-term lending to the corporate sector. These institutions were called “merchant banks,” and they directly catered to the needs of the Chaebols.²³

The combination of added bank insurance and decreased oversight created a risk because banks began to offer large amounts of debt to the Chaebols without regard to risk assessments.²⁴ The problems with the Chaebols were not immediately evident, however. At first, the Chaebols were seen as too big to fail, a view reinforced by impressive growth rates. See the graph above that depicts the negative return that the 30 largest conglomerates had the year of the crisis. The graph below displays the incredible fall the Chaebols suffered once terms of trade and confidence turned against them.

Korean banks did not respond appropriately to the fall. The banks continued to issue large sums of debt because they felt secure by government bailout guarantees. The banks issued long-term loans to the Chaebols by borrowing short-term from foreign institutions.²⁵ In a period of a couple months, Korea had built up a high level of short-term external debt relative to reserves (see graphs below).

The shortcomings of the banking system could partly be attributed to the fact that Korean financial liberalization had proceeded without sufficient regulation. Though Korea had first privatized its banks in 1981, the government continued to mandate that the banks grant loans in support of the corporate sector and the government’s social policy goals.²⁶ In exchange for the directive on loans, the Korean government guaranteed private banks insurance against insolvency, encouraging them to borrow frequently from the government and the Korean central bank.

In fact, Korea’s financial sector was based on “relationship-banking,” a system where borrowers and lenders operate in close communication to ensure timely update interchange on economic conditions and business plans.²⁷ While relationship-banking can decrease moral hazards by increasing the flow of information, its manipulation can also decrease supervision and transparency. Thus, by the mid 1990s, “government-controlled” banks in Korea broke many banking standards without penalty.

The final source of Korea’s short-term debt is interest rates. Starting in the 1980s, Korea had maintained high interest rates, hoping to curb inflation and encourage savings (The level of domestic interest rate before and after the crisis can be seen in the graph below). As an unintended side effect, however, the high domestic rate encouraged foreign borrowing. As liberalization increased and foreign interest rates decreased, foreign borrowing increased more than six-fold.²⁸ Thus, short-term foreign borrowing dominated in dollars put Korean domestic banks at tremendous risk for exogenous shocks.

The graph “Korea’s External Debts” illustrates the make-up of the Korean government debt. The graph “Bank External Debt” depicts the number of bank loans for foreign and domestic sources. From 1994 through the crisis in mid-1997, Korean banks borrowed from short-term sources more than long-tem.

The chart below illustrates the movement of Korea’s current account. It shows the increase in current account deficits leading up to the crisis in 1997 and the subsequent surplus after the IMF and international sources back up Korea.

Exogenous Shocks and the Onset of the Crisis

Before the crisis, the Korean market was exposed to a large shift in international market conditions. South Korea suffered from negative shocks to export prices from the depreciation of their competitor currencies, mainly that of the Japanese Yen.²⁹ Also, Korea suffered from competition as China geared up its export production and devalued the Yuan by 50% in 1994.³⁰ The depreciation of the Yen and the devaluation of the Yuan had a large impact on South Korea because Japan is one of Korea’s top competitors in the export market. The Yen’s depreciation caused the price of major Japanese export goods to fall an average of almost 20%.³¹

The decline in prices hurt the already faltering Chaebols, causing five of Korea’s largest companies to declare bankruptcy before the end of 1997. The bankruptcy declaration of Hanbo steel, Sammi Steel, and Kia Motors helped trigger the financial crisis, as their unpaid debts put pressure on the banks that had borrowed short-term from foreign sources. South Korea’s banded fixed exchange rate peg that had helped stimulate capital inflow also left the economy vulnerable to speculative attack. Speculators realized that the Korean central bank could no longer defend the currency by raising interest rates because the banks were already in crisis. This created a self-fulfilling prophesy as foreign creditors continued to withdraw all their capital, effectively pulling all investment from the region.

At the end of 1997 the Korean government realized that it was in a tremendous financial crisis and that it could no longer maintain its pegged currency. Korea switched to a flexible exchange rate regime. At this same time, Korea needed the IMF to provide economic liquidity to prevent even more default and panic. The IMF put economic reform conditions on the loan. Starting Dec. 1997, the IMF required that Korea begin a tight, but expansionary fiscal policy.³² The government of Korea in a “Letter of Intent” to the IMF sent on February 7, 1998, proclaimed that the Korean government attempted to “sustain the restoration of confidence” by “resolving the external financing crisis” and “minimize disruptions to the real economy.”³³ In this same letter the Korean government laid out its coming monetary and fiscal policy. Its fiscal policy called for the cutting of extraneous government expenditures but the increasing of social spending and infusion of government spending to help the economy recover.

III. Model Application

First Generation Model

Krugman’s FGM has strong predictions on the behavior of financial variables before a crisis. The model predicts that large budget deficits, quick money growth, and rising wages and prices should predate a crisis. Also, international reserves should dwindle as domestic interest rates rise. However, the symptoms the FGM predicts are not present in the case study of South Korea. Reference the empirical data a few pages prior. Table 1 displaying the Macroeconomic data from Korea shows stable, moderate inflation of around 4-6 percent. There were no large deficits. As I will demonstrate in Appendix 1, this model is useful to illustrate the movement of reserves, but it tells us little about what actually caused the macroeconomic fundamentals to change.

Second Generation Models

Generally, the explanatory power of SGM’s in the case of Korea is piecemeal. Though there are convincing instances of herding behavior and collective outcomes driven by asymmetric information, economists such as Krugman argue that the second-generation models do not accurately depict the East Asian crisis.³⁴ For example, Krugman argues that while the Radelet-Sachs SGM rightly identifies bad loans as a key component in the crisis, many of the bad loans may be a consequence of the crisis, not a cause (Details of this model follow in Appendix 2).

Moreover, the case of Korea clearly does not fit the Ozkan-Sutherland model of speculative attacks based in unemployment expectations. Korea’s unemployment rates averaged around 2.1 to 2.5 % from 1994 to 1996.³⁵ Additionally, Korea’s consistent GDP growth and government assurances did not make it a target for unemployment compensation like Europe in 1992.

Nevertheless, SGM’s have sparked productive debate on the market psychology aspect of the crisis. For example, researchers have argued that the currency crisis of other Southeast Asian countries increased doubts and uncertainty in the minds of investors.³⁶ Investors, warier from Hong Kong and Thailand, refused to continue to offer loans to Korean borrowers. I leave it to the individual reader to evaluate the validity of this claim.

For me, the asymmetric information story is much more persuasive than the other SGM’s because it focuses on the role of financial intermediaries and looks to the deterioration of financial-sector balance sheets as evidence. In the case of Korea the link between financial liberalization and excessive risk-taking is strong. Korean domestic banks failed to use proper risk-assessment systems and the government provided weak supervision.³⁷

In Korea, capital flows increased tremendously because of high domestic interest rates, government default guarantees, and the pegged exchange rate. The large increase in capital flows caused excessive risk-taking, and in turn led to large loan losses, as the model predicts. The role of the new merchant banks in granting Chaebols additional loans also suggests asymmetry problems in the Korean financial system. Reference the table on expected return to the Chaebols to see the declining growth rates.

Also, as the stock market declined and investor uncertainty increased, it was harder to screen out good from bad borrowers, a key element that was present in the Korean crisis. Overall, the asymmetric information model in the case of Korea tells a convincing story. The model states that poor financial sector policies led to excessive risk-taking and overinvestment. The bad investment decisions by domestic banks were not sustainable when the market suffered from even a small macroeconomic shock.

Third Generation Models

Many economists have attempted to define a new “third generation” model to specifically explain the events of the East Asian crisis. These models take into account contagion – the phenomenon of the quick spread of financial crisis, the transfer problem – that a huge portion of the current that can reverse quickly to cause instability, and the balance sheet problem – fiscal irresponsibility on the balance sheets of individual firms.³⁸

The moral hazard focused model of Corsetti, Pesenti and Roubini, is persuasive in the case of South Korea. On the industry level, political pressure to continue strong economic growth led to government guarantees to banks and the Chaebols. As stated in the previous section, there was evidence that banks were issuing many loans to Chaebols without full risk assessments, incurring short-term foreign debts to finance them. Moreover, there was evidence of overly close relationships between government bureaucrats and corporate leaders, which tended to decrease transparency. Korean merchant banks and relationship-banking may have contributed to the moral hazard. On the international level, moral hazard was apparent when foreign banks lent excessively because the government or the IMF would guarantee their investment in case of default.

Aspects of the Korean crisis are also well explained by the Chang-Velasco model. Korea suffered from the quick capital reversal stemming from inadequate regulation of the liberalization process, just as the model would have predicted. Additionally, Korea wrestled with international illiquidity once investor confidence soured. The IMF stepped in to resolve the Korean crisis by providing over $55 billion in liquidity. Overall, the Chang-Velasco model highlights two of the key problems in the Korean crisis and convincingly explains their contribution.

Krugman’s third generation model provides the most comprehensive understanding of the crisis. The contagion factor was certainly present in Korea, as international investors associated Korea’s credit-worthiness to countries in crisis like Thailand and Russia. Krugman admits and incorporates the self-validating collapses in confidence as a factor in leading the crisis. Furthermore, Krugman’s emphasis on the large reversal in the current account – termed the “transfer problem” – is also important in the case of South Korea as the data shows a multi-billion dollar swing from inflows to outflows in a matter of months. Also, Krugman’s model emphasizes problems with corporate balance sheets, which as discussed in the asymmetric information model was a very pertinent issue in the withdrawal of capital.

Overall, each of the generations of models adds a unique aspect to consider in the Korean crisis. Clearly third generation models fit the events most accurately, but that is to be expected because they were created ex post facto. Also, third generation models evaluate the entirety of a financial crisis, not just the speculative attack on the currency. As Krugman writes, “the currency crisis was more a symptom than a cause of the underlying real malady.”³⁹ Thus, Krugman’s model incorporates elements of almost all previous models to expose the structural factors that manifested themselves in the Korean currency crisis.

IV. Policy Recommendations

First, financial liberalization can bring a lot of wealth, but it must be a careful, calculated process. Unfortunately, Korea’s large portion of short-term foreign debt lent to long-term domestic project was a recipe for disaster. Short-term flows are much more volatile than long-term flows, but the Korean government did not leave itself enough reserves to cover its short-term liabilities. The recommendations that stem from this lesson lead us to believe that liberalization needs to be slow and deliberate. Long-term capital should be liberalized before short-term capital.

Second, government should avoid making policies that have clear moral hazard implications. The Korean crisis has shown that even well intentioned policies can have disastrous consequences if they promote excessive risk taking incentives. Another clear lesson is the need for the emerging market governments to strengthen institutional oversight. The excessive lending to Chaebols draws attention to the need for prudent market supervision and explicit transparency measures.

Third, the Korean crisis also highlights the problem of banks lending domestically long-term and borrowing in foreign currency short-term debt. Perhaps in a world of rapid capital flows, emerging markets should set ratios of long-term to short-term international debt that banks can borrow.

Fourth, government should be aware that fixed exchange rates severely limit its ability to act quickly to avoid crises. One of the cited reasons that sparked the crisis was that the devaluation of the Yen decreased Korea’s terms of trade and thereby decreased the competitiveness of Korean exports, increasing the trade deficit and slowing economic growth. If Korea had a flexible exchange rate, then government could have used monetary policy to aid the economy. Additionally, under a floating exchange rate the market mechanism would have corrected the exchange rate in time. Fixed exchange rates leave the government to equilibrate the rate. Unfortunately, governments often lack the necessary information and are restrained by political forces from doing so.⁴⁰ Although this article focused on the economic realm of the currency crisis, it is important to remember the role of politics in determining economic policy choices.

V. Concluding Remarks

Luckily, the crisis ended relatively well for the Korean economy. Within a year, Korea had already embarked on an impressive speedy economic recovery. Korea’s quick recovery can be attributed to a number of factors, such as its economic openness with a large export sector that allowed investments to be dominated in various currencies, sound record for stable inflation levels, and also the rapid reaction by the South Korea government for meaningful political and financial reforms.⁴¹ For example, Korea enacted principles of corporate restructuring: enhanced transparency, resolution of cross-debt guarantees, improvement of the financial structure, and strengthening accountability.⁴²

Nevertheless, the country is not necessarily free from future crisis. The existing models of currency crisis provide valuable insights, but the field still has many unanswered questions. As the analysis in this paper has shown, there is no consensus on one cause of the Korean currency crisis. Thus, the interaction of different deficiencies, conditions, and poor policy choices may provide yet another unique context for crisis. Nevertheless, the world should learn from the example of the Asian crisis and third-generation models to actively reduce the probability of a similar financial collapse.

Appendix 1

Paul Krugman’s First Generation Model

Krugman uses a “shadow exchange rate” to predict when the attack will occur. The shadow exchange rate is a hypothetical rate that the market would reach after the attack, or where the exchange rate would be if the government allowed it to float. If the shadow rate is above the fixed exchange rate, the attack will depreciate the home currency and appreciate the foreign currency.

Money supply equals the supply of domestic currency plus the rate of currency depreciation times the foreign currency reserves or M = BH + ε * BF. A speculative attack will occur when the market determines the reserves are completely depleted and the bank can no longer maintain the peg. This occurs when the money supply is equal to only the domestic currency, or modeled in equations as M = BH + 0 or when ε * BF = 0

Application of Paul Krugman’s FGM to Korean Currency Crisis

The FGM Diagram illustrates the impact of a change in money demand in a fixed exchange rate environment. Point A is the starting point; it is where the price of the Won (which is the equals E0P*, AKA it is the exchange rate times the price of the foreign currency) and money demand meet. To start at point A we are assuming that the Won is appropriately valued; in the context of Korea this is around 1995. From point A we move to point B. The movement to point B is caused by a money demand decrease. Money demand decreased in South Korea in 1997 because income fell when the negative terms of trade shock decreased export sales. The decrease in money demand is shown in the diagram by the money demand curve shifting left and the movement from point A to point B. Because the price of money is fixed at a rate of E0P* there must be a change in international reserves to offset the money demand change. This diagram signals that Korea must have an outflow of international reserves and experience a balance of payments deficit because the price of money (E0P*) is fixed so the quantity of money must change.

By the time crisis was almost upon Korea, FGM Diagram is a very accurate depiction of the movement in money demand and money supply. However, the first generation model does not predict or explain the events leading up to the crisis. As stated before, leading up to the crisis Korea’s macroeconomic fundamentals appeared strong. This model is useful to illustrate the movement of reserves but is not predictive or analytical to what caused the underlying variables to move.

Appendix 2

The Radelet and Sachs model raises the question about the role of herding behavior and intrinsic market instability in the Korean currency crisis. Radelet and Sachs argue that the crisis turned into panic because investors didn’t differentiate between countries, costs of servicing foreign debts rose as exchange rate depreciated and domestic debtors had to buy foreign reserves, continuing to place downward pressure on the exchange rate, and major rating agencies degraded the quality of the debt in the region causing more withdrawal. There is evidence that international investors pulled out of South Korea after the Thai devaluation partly based on a self-fulfilling fear that the Korean economy would similarly decline. Unfortunately it is almost impossible to know the exact reasons for the rapid capital flow reversal, and it is probably a combination of herding behavior and market instability with weak domestic financial institutions. Radelet and Sachs offer valuable insight into currency crisis phenomena but their particular contribution must be taken as part of a larger picture in the case of Korea.

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Footnotes

1. Kimbrough 46.
2. See Krugman 1979.
3. Echiengreen 8.
4. Flood and Marion 2.
5. Obstfeld 23.
6. Sbracia 205.
7. Radelet 7.
8. Ibid 8.
9. Diamond 402.
10. Mishkin 22.
11. Chang 490.
12. Ibid 514.
13. Corsetti 8. italics mine.
14. Ibid 12.
15. Ibid 14.
16. Krugman 1999: 460.
17. Ibid 464.
18. See Panagariya.
19. Stefan 70.
20. See Chinese University of Hong Kong.
21. Chang 3.
22. Mishkin 85.
23. Ibid 89.
24. Ibid 88.
25. Ibid 88.
26. See Adelman 1999.
27. See Adelman.
28. See Adelman.
29. Mishkin 93.
30. Radelet 32.
31. Mishkin 93.
32. Lee 11.
33. See Lee.
34. See Krugman 1999.
35. See International Financial Statistics.
36. Kihwan 9.
37. Hamn 26.
38. See Krugman 1999.
39. Krugman 1999 : 98.
40. Kihwan 20.
41. See Mishkin.
42. Haggard 103.

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