FRBSF Economic Letter
1998-01 | January 16, 1998
On July 2, 1997, the Thai baht fell 17% against the U.S. dollar, ending a 13-year period in which the baht closely shadowed the U.S. currency. The devaluation was not entirely a surprise. In fact, it followed months of repeated speculative attacks, during which the Bank of Thailand spent billions of dollars defending its currency. What was a surprise, however, was how contagious the devaluation turned out to be. Following the baht devaluation, currency traders immediately turned their attention to the Philippine peso. For a few days the Philippine central bank put up a brave fight, raising interest rates above 30%, but by mid-July it announced that it too was allowing its currency to float against the dollar. The peso immediately fell by over 10%. With the baht and the peso now floating, currency traders moved on to the Indonesian rupiah and the Malaysian ringgit. These countries adopted a somewhat more accommodative policy, allowing their currencies to succumb more gradually to speculative selling. However, the end result was similar. By early December, the baht, the rupiah, and the ringgit had each depreciated by about 60% and the peso by about 35%.
This Letter provides an interpretation of this recent “currency crisis.” We interpret these devaluations as the result of external factors, not the result of domestic policy mismanagement. In particular, we argue that depreciations of the yen and Chinese yuan during the past two years led to a loss of export competitiveness in the region, which necessitated a devaluation. We also argue that these devaluations are best viewed as the choice of central banks (even if the choice itself is an unhappy one). In fact, we claim that occasional episodes of simultaneous currency collapse within a region of competing exporters are to be expected, and that these crises are actually part of an equilibrium process which is designed to mitigate the pressures for “competitive devaluations.”
We develop our argument in two steps. First, we provide a brief historical overview of export competition and exchange rate policy in Southeast Asia. These developments set the stage for last summer’s crisis. Next, we discuss how an insight from game theory can be used to understand region-wide currency crises. Our game-theoretic analysis focuses on how central banks cope with the temptations to engage in mutually destructive competitive devaluations.
Thailand, Malaysia, Indonesia, and the Philippines have much in common. In particular, they all depend on exports to the U.S., and partly because of this, each has attempted to maintain a stable (real) exchange rate against the U.S. dollar; before the collapse in July, each country kept its exchange rate within a narrow band around the dollar. (Technically speaking, these countries were pegged to a broader basket of currencies, but the dollar received by far the largest weight.)
Like the first-generation tigers (Korea, Taiwan, Singapore, and Hong Kong), these second-generation tigers have used exports as their engines of growth and development. Most of these exports consist of labor-intensive manufactured goods, which are sensitive to relative labor costs. Along with Japan, the U.S. is the most important market for these exports; the U.S. recently has been absorbing about 20% of the exports of Thailand, Malaysia, and Indonesia, and more than 40% of the exports of the Philippines. Combined with their pegs to the U.S. dollar, this trade pattern implies that an appreciation of the dollar would tend to erode these countries’ export competitiveness.
Figure 1 is an alternative perspective on export competition in Southeast Asia. It shows the share of U.S. imports from Asia (excluding Japan) by source country, i.e., it shows how big a slice of the U.S. market each of these countries is getting. What stands out in this figure is the upward sloping line corresponding to Chinese exports. While the shares of Thailand, Malaysia, Indonesia, and the Philippines have been stuck in the 5-10% range, China’s share of the U.S. market rose from under 15% in 1989 to about 30% in 1996. This growth does not reflect a shift in demand toward products in which China has a special comparative advantage. In fact, the types of products exported are quite similar. For example, both China and the smaller Southeast Asian economies rely heavily on exports of “electrical machinery” and “equipment parts”. Instead, China’s growing share of the U.S. market reflects a combination of increasing cost competitiveness and a shifting to the mainland of Hong Kong and Taiwanese production.
For the most part, the rising tide of Chinese competition has been gradual, reflecting China’s evolution toward a market economy. Unfortunately, this kind of steady increase in competition cannot easily explain the timing of Southeast Asia’s currency collapse. To explain why the collapse occurred when it did, we need to find evidence of a sudden change in the relative competitiveness of China.
As it turns out, we do not have to look very far. On January 1, 1994, the Chinese government unified its exchange rate system by abolishing the official rate. Overnight the market value of China’s currency fell by 50%. Of course, some of this decline simply reflected a convergence between the official rate and the actual market rate. Although it is inherently difficult to say what share of transactions already were taking place at the market rate, some estimates put the share as high as 80%, in which case the effective devaluation was only about 10%. However, since the market rate itself depreciated about 40% during the previous two years, the fact that some transactions were already occurring at the market rate may not be that important. It only reduces the suddeness of the devaluation.
Another reason to be cautious about the effective magnitude of the Chinese devaluation is that during this period China’s inflation rate exceeded the U.S. inflation rate, so that some of the devaluation simply reflected a higher overall rate of price increase in China. Again, it is hard to say how important this consideration is, since China’s consumer price data are notoriously difficult to interpret. On the face of it, China’s 26% rate of inflation during 1994 would seem to offset much of the nominal devaluation. However, most experts agree that China’s official inflation rate greatly overstates the actual inflation rate, particularly in the tradeable goods sector. Moreover, the same kind of inflation-induced real appreciation was taking place in most ASEAN nations, albeit to a lesser degree.
Despite these caveats concerning the magnitude of the effective devaluation by China, evidence suggests that it had a real impact on China’s export competitiveness. For example, China’s aggregate trade balance went from a deficit of $10.6 billion in 1993 to a surplus of $4.2 billion in 1994. At the same time, trade balances rapidly deteriorated in Thailand, Malaysia, and Indonesia. Only in the Philippines did the trade balance remain relatively stable.
Clearly, China’s devaluation represented a severe negative shock to the economies of Southeast Asia. The question now is to understand how this kind of shock alters the incentives of central banks to support their exchange rates. We argue that this loss of competitiveness gave central banks in the region an incentive to devalue, that currency speculators knew this, and that this reassessment of the costs and benefits of devaluation precipitated an attack on these countries’ currencies.
Rotemberg and Saloner (1986) offered a novel account of “price wars.” They studied the problem of a cartel attempting to maintain a collusive pricing strategy in the presence of aggregate demand shocks. The cartel faces two difficulties. First, anti-trust law makes explicit pricing agreements illegal and unenforceable. Thus, collusion can only be achieved implicitly through repeated interactions that permit identification and punishment of “cheaters.” Second, since binding agreements are unenforceable, the aspiring cartel must design its pricing policy in such a way that it remains in everyone’s self-interest to stick to the agreement. This is a difficult task because aggregate shocks alter the costs and benefits of cheating, and unless the cartel’s pricing policy recognizes these changing incentives, it may not be sustainable.
For example, Rotemberg and Saloner argue that positive demand shocks increase the temptation to cheat on a collusive pricing agreement, since a cheater who undercuts his co-conspirators would get to supply the market when demand and profits are high. Of course, eventually the cheater is detected, but only after demand and profits have declined to more normal levels. If a sufficiently strong demand shock occurs, a firm might be willing to sacrifice its share of future collusive profits for a one-time grab at super-normal profits. To prevent this from happening, which would trigger a breakdown of cooperation, the cartel must actually lower prices when demand is high. Lower prices reduce the incentive to cheat on the agreement. Although this might look like a “price war” to outsiders, it is important to realize that the price cuts take place in order to sustain the cartel. They do not reflect a breakdown of cooperation. Interestingly, Rotemberg and Saloner provide empirical evidence that most price wars have occurred during periods of strong demand.
What does all this have to do with the recent currency crisis in Southeast Asia? In a recent paper (Huh and Kasa 1997), we show that the logic of Rotemberg and Saloner can be used to understand the nearly simultaneous devaluation of competing exporters’ currencies. Like a cartel attempting to sustain collusion, central banks in Southeast Asia were attempting to fix their exchange rates to the dollar in order to avoid mutually destructive competitive devaluations. Also like a cartel, these central banks do not have the means to enforce binding agreements (see, e.g., Moreno 1997). The only difference is that the incentive to cheat on the implicitly cooperative arrangement occurs during “bad” times, i.e., when there is a negative shock to the demand for exports. That is, if left to itself, each central bank would like to respond to falling export demand by devaluing its currency. If this incentive is strong enough, the only way for central banks to prevent a total collapse of cooperation is if all countries devalue together. Of course, in the end a region-wide devaluation doesn’t increase anyone’s competitiveness. However, it does reduce each country’s incentive to further devalue unilaterally, which then supports the maintainence of a cooperative arrangement that in the long run leads to superior outcomes.
Like a “price war,” the simultaneous devaluation of several currencies may on the surface appear to be a breakdown of central bank cooperation. The novelty of our interpretation is to show that, on the contrary, the recent spate of devaluations in Southeast Asia can be thought of as being part of a single dynamic equilibrium. As further evidence for such an interpretation, we show (in Huh and Kasa 1997) that a similar (but less dramatic) episode occurred in the region in the mid-1980s. Although a Chinese devaluation doesn’t always have to be the trigger, as it turned out this earlier regional devaluation also followed a sharp depreciation of China’s currency.
While we believe our interpretation captures an important aspect of Asia’s recent currency crisis, there are clearly some missing elements from our story. First, China’s devaluation occurred in January 1994, while the “crisis” didn’t erupt until July 1997. One possible explanation of the delayed reaction is the steady depreciation of the yen that has occurred during the past couple of years. This also reduced Southeast Asia’s export competitiveness, although probably not as much as China’s devaluation, since the product mix of Japan’s exports is quite different from the emerging economies of Southeast Asia. A second limitation of our analysis is that it does not explain why the crisis became so widespread. Certainly, a competitive devaluation story seems rather far-fetched when applied to the recent currency attacks in such dissimilar economies as Russia and Brazil! Nor does our account explain the depth of the crisis, i.e., its spread to equity and property markets. Along with bank regulators, sorting through the wreckage of the recent financial turmoil in Southeast Asia will keep economists busy for years to come.
Huh, C., and K. Kasa. 1997. “A Dynamic Model of Export Competition, Policy Coordination, and Simultaneous Currency Collapse.” FRBSF Pacific Basin Working Paper 97-08.
Moreno, Ramon. 1997. “Dealing with Currency Speculation in the Asian Pacific Basin.” 97-10 (April 11).
Rotemberg, J., and G. Saloner. 1986. “A Supergame-Theoretic Model of Price Wars during Booms.” American Economic Review 76, pp. 390-407.
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