Does a thin foreign exchange market lead to destabilizing capital-market speculation in the Asian Crisis countries?

Hong-Ghi Min and Judith A. McDonald

No 2056, Policy Research Working Paper Series from The World Bank

Abstract: The authors investigate how the thinness of foreign-exchange markets causes destabilization speculation, especially when exchange-rate flexibility is increased, as it has been in the countries involved in the Asian crisis. They analyze the impact of this market thinness on the dynamic capital mobility and capital market risk of four countries involved in the Asian crisis: Indonesia, the Republic of Korea, Malaysia, and Thailand. Using the vector-autoregression model, impulse response functions, and variance decomposition, they show that in response to one-standard-deviation shock to interest and exchange rates, the dynamic capital mobility of all four countries decreases in the short run. These shocks also cause the capital market risk of these countries to rise. Since the onset of the Asian crisis, the countries involved responded by raising their interest rates and devaluing their currencies. These measures were intended to stem capital flight from the borrowing countries and to encourage capital inflows. But in an environment of protracted financial sector reform and thin foreign exchange markets, these standard policies did not stabilize capital inflows into these countries. The authors'research supports the view that because standard policies were unable to change institutional investors'(self-fulfilling) expectations and herding behavior, the countries'policies have, in the short run, not been successful. This failure is in large part attributable to the very thin foreign exchange markets in these Asian countries.

Keywords: Fiscal&Monetary Policy; Banks&Banking Reform; Payment Systems&Infrastructure; Economic Theory&Research; Capital Markets and Capital Flows; Banks&Banking Reform; Economic Theory&Research; Macroeconomic Management; International Terrorism&Counterterrorism; Insurance&Risk Mitigation (search for similar items in EconPapers)
Date: 1999-02-28
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Citations: View citations in EconPapers (1)

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