FRBSF Economic Letter
98-01; January 16, 1998
Export Competition and Contagious Currency Crises
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.
Export competition in Southeast Asia
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.
Sustaining cooperation among self-interested
central banks
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.
Conclusion
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.
Chan Huh, Economist
Kenneth Kasa, Economist
References
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." FRBSF Economic Letter 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.
Opinions expressed in this newsletter do not necessarily reflect
the views of the management of the Federal Reserve Bank of San Francisco,
or of the Board of Governors of the Federal Reserve System. Editorial
comments may be addressed to the editor or to the author. Mail comments
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Research Department
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