This article reviews and interprets the recent currency crises in Korea and Thailand. The authors argue that a prime cause of the crises were large, unfunded government guarantees to failing financial sectors.
Introduction and summary
In late 1997, Southeast Asia was rocked by banking and currency crises. While dramatic in scope and intensity, this episode was only the latest in a series of twin crises. Other prominent examples include Argentina (1980), Chile (1981), Uruguay (1981), Finland (1991), Sweden (1991), and Mexico (1994). In this article, we review and interpret the recent Korean and Thai experiences, focusing on the pivotal role of unfunded contingent government liabilities. We concentrate on the Korean and Thai cases both because their crises were severe and because neither country appeared to be a likely candidate for a currency crisis, at least not from the perspective of standard economic models.
In addition to being of independent interest, the lessons learned from the Korean and Thai episodes should be useful in predicting and averting future twin crises. In a nutshell, these lessons are as follows. First, twin crises are likely to erupt in countries whose governments have large prospective deficits stemming from guarantees to failing financial sectors. Such guarantees typically insure creditorsboth domestic and foreign against realizing large losses when financial institutions that they have lent money to become insolvent or go broke. Second, past deficits are, at best, a noisy indicator of how large a governments prospective deficits are. Accurately measuring the latter requires a careful analysis of the nature of a government's guarantees and the probability that those guarantees will be called upon. It may never be possible to predict precisely when a twin crisis will occur. But more accurate measures of prospective deficits are likely to be helpful in predicting where twin crises will occur. Finally, to avoid currency crises, governments must have credible plans to finance contingent liabilities with credible, explicit fiscal reforms. Such reforms include concrete measures to cut government expenditures or raise taxes. Read the entire article.