Ask Dr. Econ

April 1998

What is behind the currency crisis in East Asia and how will it affect U.S. economic activity?

Beginning in July, 1997, first Thailand, then the Philippines, Indonesia, Malaysia, Hong Kong, Taiwan, and Korea--one after another--suffered "attacks" on their currencies; that is, large portions of these currencies were put up for sale in the markets. These countries tried to fight off the selling pressures by raising their interest rates, but ultimately, all but Hong Kong were forced to let their currencies depreciate.

At least two factors led to these attacks. One factor was the link these countries tried to maintain between their currencies and the U.S. dollar. The dollar had been appreciating against many currencies, in part because of our strong economic performance relative to other countries. As the dollar rose, the linked East Asian currencies moved up with it. In particular, the dollar and the linked currencies appreciated substantially against the Japanese yen and the Chinese yuan, which meant that the products of these East Asian countries grew more expensive relative to Japan's and China's products. That hurt the East Asian countries' competitiveness and put pressure on their currencies to depreciate.

The second factor is the banking systems in these East Asian countries. Many of their banks financed part of their operations with short-term debt denominated in dollars and other foreign currencies. With their currencies depreciating, these banks face much higher debt burdens, which means severe financial hardship for them. Moreover, these banks are saddled with a lot of bad loans. The result is that these economies face some tough times ahead, with slowdowns in output and employment.

How will the downturn in East Asian economies affect the U.S. economy? Much of the impact is likely to be through trade with East Asia. The combination of a higher dollar relative to those countries' currencies plus the weakness in their economies will mean a drop in U.S. exports to that region, as well as some pickup in our imports from there. But our exposure is less than some people might think--estimates suggest that our exports with East Asia amount to only about 3 percent of our GDP, and imports about 5 percent. On this basis, most estimates suggest the Asia turmoil is likely to reduce real GDP growth this year by between 1/2 and 1 percentage point.

But this reduction in growth is not likely to derail the U.S. expansion. The U.S. economy is currently in very good shape, with strong growth, low unemployment, and low inflation. Though no one welcomes the troubles in East Asia, at least they have come at a time when the U.S. economy appears to be resilient enough to absorb the negative effects.

References

Huh, Chan, and Kenneth Kasa. 1998. "Export Competition and Contagious Currency Crises." FRBSF Economic Letter 98-01 (January 16).

Parry, Robert T. 1998. "Prospects for the U.S. and California Economies." FRBSF Economic Letter 98-06 (February 27).

For Further Reading

Daly, Mary. 1998. "East Asia's Effect on the Twelfth District." FRBSF Economic Letter 98-10 (March 27).