Working Paper

Prospective deficits and the Asian currency crisis

Abstract: This paper argues that the recent Southeast Asian currency crisis was caused by large prospective deficits associated with implicit bailout guarantees to failing banking systems. We articulate this view using a simple dynamic general equilibrium model whose key feature is that a speculative attack is inevitable once the present value of future government deficits rises. This is true regardless of the government's foreign reserve position or the initial level of its debt. While the government cannot prevent a speculative attack, it can affect its timing. The longer the delay, the higher inflation will be under flexible exchange rates. We present empirical evidence in support of the three key assumptions in our model: (i) foreign reserves did not play a special role in the timing the attack, (ii) large reserves in the banking sector were associated with large increases in governments' prospective deficits, and (iii) the public knew that banks were in trouble before the currency crises.

Keywords: Financial crises - Asia; Foreign exchange rates; Monetary policy; Money;

Bibliographic Information

Provider: Federal Reserve Bank of Chicago

Part of Series: Working Paper Series

Publication Date: 1998

Number: WP-98-5