The First Generation And Second Generation Financial Crisis Theory

Published Date: 02 Nov 2017

Currency crisis is one kind of financial crisis, according to Eichengreen et al(1997), currency crisis is that one country have to give up its original exchange rate system under pressure, its currency devalue considerably, or accept assistance from other institutions. Many economists have a intensive study about currency crisis, the most important contribution are Krugman and Obstfeld. Krugman (1979) has present a crisis model which known as ‘First-generation financial crisis theory’. The main point of this model is that under open economy, if government wants to maintain the fixed exchange rate, while there would be a long time current account deficit because of the imbalance in economy that will lead their currency devaluated. However, even government can use the foreign reserve to maintain the balance of current account in the short time, but if the deficits continue increasing, the result should be run out of foreign reserve and the fixed exchange rate breakdown eventually. In Krugman’s paper, he presents a conception called ‘rational expectations’, speculators are actively attempting to forecast the future in a ‘sophisticated manner’. They expect that government would have to give up its fixed exchange rate sooner or later, so they would change their domestic currency to foreign currency before the government’s foreign reserve run out in order to avoid the loss from devaluation. However, this kind of action would lead the foreign reserve exhausting earlier and financial crisis as well, so this phenomenon can be seem as speculative attach. Krugman also figured out that if government can get help from international institutions, then it can have more reserve to against speculative attach and maintain its exchange rate system temporarily. But if government can not solve the deficit of its current account, speculative attach would happen again sooner or later. In First-generation financial crisis model, currency crisis is an inevitable consequence with a open economy with current account imbalance, however, in fact, the breakout of financial crisis is random, under a same economy, it is difficult to expect that whether currency crisis would happen or not. Actually, in 1997 financial crisis, most of the affected countries gave up maintaining their fixed exchange rate system before ran out of foreign reserve, but the first-generation model can not explain this phenomenon.

In order to explain when the government would give up the fixed exchange rate system and would not give up under which situation, Obstfeld has present another model in 1996, which known as Second-generation financial crisis theory. In his paper, Obstfeld points out that the government may face cost like higher interest rate, deflation in economy when maintaining fixed exchange rate. From Obstfeld’s paper, he assume that the cost government would face is

Where y is the total output of Hong Kong, and y* is the government’s output target, is the change in the exchange rate (the price of foreign currency),is the fixed cost,and are positive multipliers. The output is determined by the expectations-augmented Phillips curve

Where is the average output level, is domestic expectation of change of exchange rate, is other variables may affect output level like higher interest rate, higher unemployment or massive capital outflow etc.,is positive constant. Because the HKD is pegged with the USD at the level of USD1=7.8HKD, so it means that there is no change of exchange rate of HKD in the short-term, so for Hong Kong, its determination of output should be

(3)

Combination of (1) and (3), we get the simple loss function for Hong Kong government

(4)

We assume that in the short run, the average level of output and government’s output target are unchanged, so formula (4) change to:

(5)

Obviously, the cost of maintaining fixed exchange rate system will increase if the expectation of devaluation of HKD increases. However, if the government decides to give up keeping the system, then they would face the loss of government credibility. We assume this loss would be a positive constant, and if, then the government will willing to maintain the fixed exchange rate system, otherwise, they will give up. If there is no expectation of devaluation of HKDand other shock in markets, then cost may keep low, government will keep the exchange rate fixed. If, it means that the expectation goes up, then. Thus, expectation of devaluation is point aspect of keeping exchange rate fixed.

Before I keep going, it is worth to introduce the Hong Kong’s monetary system and exchange rate regime. On 17 October, 1983, the Hong Kong government announced a new monetary regime called ‘linked exchange rate’ or ‘Currency Board’ [1] system which played an important role in the Asian financial crisis in Hong Kong area. The most important measure in this regime was that US dollar used as the anchor currency, the re-imposition of the foreign exchange limit by requiring note-issuing banks to pay US dollar to the Exchange Fund to obtain the Certificates of Indebtedness as cover for banknotes issued, at a fixed rate of US＄1to HK＄7.8(Jao, 2011). There are three kinds of depository institutions also known as ‘Authorized Institutions’ in Hong Kong financial sector under the three-tier system which initiated from 1981. The first tier is licensed banks, which are the most strictly regulated by the government, it can accept all typed of deposits. The second tier is called ‘Deposit-taking companies’, its deposit is restricted to their time deposits. The third tier is ‘Restricted license banks’. There is no formal central bank in Hong Kong; the functions were shared by a number of public and private agencies before the establishment of the Hong Kong Monetary Authority (HKMA) in 1993.

In order to briefly analysis how HKMA use the policies to peg its currency to USD within the currency board system went facing speculative attack, I try to employ a simple model according to the Mundell-Fleming model [2] (also known as IS-LM model). We assume that:

The IS curve for the asset market (1)

Where Y is output (GDP), is total consumption in HK, T is taxes, is total investment in HK’s markets, G is HK’s government expenditure, is the net export (Export-Import) of HK, Y* is the combined GDP of countries that are trade partners with Hong Kong.

The LM curve for the money market (2)

M is money supply of HKD, P is price level of HKD, and L (i, Y) is the money demand of HKD, determined by the nominal interest rate in HKD and HK’s income level, and . Additionally, according to Fisher hypothesis, the nominal interest rate in Hong Kong should be:

(3)

Where R is the real interest rate in HK and is the expectation of depreciation of HKD. From (1) and (3) we can have:

(4)

We assume taxes, government expenditure in Hong Kong is unchanged, and moreover, the exchange rate of HKD is fixed, so we can have a relationship between output, interest rate, e and expectation of depreciation of currency:

(5)

And we know that,,,.

Nevertheless, as I mentioned above, the cost of maintaining exchange rate level by government is that:

(6)

If the economy is in equilibrium, then function (2) (5) (6) are satisfied. Under currency board system, the supply of HKD is decides totally by the markets, there is no intervention of government, and the total value of HKD in markets is equal the total value of USD which inflow from aboard to local financial institutions, so it means that the flow of capital will influence the change of and then affect the equilibrium of economy, because of this, the government of Hong Kong has a lot of foreign reserve, like 91.4 billion US dollar before the breakout of Asian financial crisis, so normally, people do not expect the HK dollar will depreciated, it can be seem that , and (6) becomes to

(7)

Obviously, the cost of maintaining fixed exchange rate by government is now depend on the variety of shock in markets, like the effect in investment and output due to extreme increasing in interest rate. Generally, the cost for HKMA to keep exchange rate fixed is low, however, in fact, when facing speculative attack during Asian financial crisis, the interest rate in Hong Kong was increased seriously, which made the cost higher directly, I will discuss it later.

Another main point of Hong Kong’s currency board system, there is an ‘inherent stability mechanism’ which will maintain the exchange rate of HKD stable automatically. The logic of this mechanism is that when the market is not in equilibrium, the demand of US dollar in foreign exchange market is large than supply, the price of USD increased, then the exchange rate of HKD will be a little different from the official rate 1:7.8, like 1:7.85. In this situation, the local financial institutions will arbitrage, buy US dollar from note-issuing banks at the exchange rate at 1:7.8, and then sell them to foreign exchange market at the exchange rate at 1:7.85, profit 0.05 UKD. Nevertheless, the quality of HKD in markets will decline progressively, which will enhance the interest rate of HKD. The high interest rate in Hong Kong will accelerate the capital inflow to Hong Kong markets, so the demand of HKD will increase while exchange rate will go back to official level shortly. Evidently, under currency board system, the exchange rate is highly stable.

Impact on the banking sector

There were several aspects of the negative impacts on the banking sector. The most important one was the steady deterioration of the quality of asset from Q4, 1997 onward, which did not stabilize until Q4, 1999. The data from HKMA Annual Report (1998) manifested that for all authorized institutions, problem assets as percentages of total loans nearly quadrupled from 1.07% at the end of 1997 to 4.1% at the end of 1998; for locally incorporated banks, more than doubled from 1.81% to 5.1. Nevertheless, during the period of 1997 to 1998, the ‘pass’ category asset [3] of the banking system had decreased considerably, from 92.63% in 1997 to 85.81% in 1998 for all authorized institutions and 94.87% to 84.68% for all local banks, while other categories had increased correspondingly. The second aspect of the negative impact in banking sector was the sharp decrease in profitability of locally incorporated banks. From the annual report of HKMA again, in 1998, the average profit before tax of all locally incorporated banks fell by 39%, from 1.92% (% of average total assets) to 1.17% in 1998. The main reason for the poor performance of the asset in banking sector was the large increase in bad debt charge, the

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decrease in net interest margin and the decline in lending and income from fees and commissions (Jao, 2001). However, despite of this, there was not other obvious impact in the Hong Kong’s banking sector. Even though the data mentioned above seems that this sector has suffered seriously in the Asian financial crisis, but actually, all local banks and some international banks have strong roots in Hong Kong, they were still profitable even suffered reduced profitability, and there was no bank had closed down during the crisis. An important aspect of this strong root of Hong Kong’s banking system is the high average capital adequacy ratio. This ratio rose from 17.5% at the end of 1997 to 18.6% at the end of 1998, it further to 20.1% at the end of September, 1999 (Jao, 2001). Furthermore, Hong Kong’s average capital adequacy ratio is one of the highest in the world, excess the 8% minimum recommended ratio [4] .

Hong Kong is recognized as one of an in international financial centre in the world. During the Asian financial crisis, the two other leading financial centre, Tokyo and Singapore, have also been affected, so the negative effect in Hong Kong can not be ignored. As shown at the table 1, the data from the HKMA Quarterly Bulletin (1998), we can easily find that after the Asian crisis, as one of the leading international financial centre in Asia, the foreign exchange and derivatives market of Hong Kong was the most affected one than markets in Japan and Singapore. The turnover of foreign exchange market was decreased by 13% while 12% in the derivatives market, totally, turnover dropped by 13% in two markets while only 2% in Japan and even had positive turnover in the Singapore’s market, like 22% increased between 1995 to 1998. What I mentioned above is attempt to say that the impact of the Asian financial crisis on the Hong Kong’s banking sector is reduced the profitability of banks, fortunately, there was no banking crisis. However, the Asian crisis still has had a negative but slim impact on the Hong Kong’s status as an international financial centre, like the shrink of the derivatives market, foreign assets and liabilities of domestic deposit banks and so on.

Impact on the Real Economy

In the previous, we have reviewed that the monetary system and exchange rate regime have remained stable and safe even there had has a rapid decrease of the profitability in banking system because of the massive attacks, however, they experienced no crisis. The asset market suffered a decrease as well while the equity market kept stabilized due to the government intervention (Detail will be discuses later).

The macro-economy is connected to each sector, so the overall effect on the real economy can be regarded as the weighted average of the impact on each separate sector (Jao, 2001). In 1998, the Hong Kong economy experienced its largest contraction, Real GDP decreased by 5.1%, unemployment increased and exports and imports declined. Nevertheless, due to the speculative attacks on the Hong Kong dollar, leading the massive increased in interest rates and sharp declines in asset prices.

As shown in the table 3, after the Asian financial crisis in 1997, the Hong Kong economy experienced a sharp decline in 1998. The real GDP contracting by 5.1%, while in the first six months after the outbreak of crisis, Hong Kong still has a positive growth of real gross domestic product, like 5.3%. There were five main reasons that resulted this recession of the economy.

The first one is inflation declined progressively. From the data shown at table 4, in 1996, the change of composite consumer price indexes in Hong Kong was 6.3%, however, when the time moved to 1997, the year that Asian crisis out broke, the change of CCPI declined to 5.8%, and even decreased to 2.8% at the post-crisis year. As we known, deflation raises the real interest rate, thus discouraging both consumption and investment, and then triggers downturn in economy. The second one is weaken domestic demand, private consumption, which accounts for 60% of GDP, decreased by 6.8% in 1998. The reasons contributed to the setback in local consumer spending were the fall in asset prices, made downward pressure on wages and high real interest rates (Table 2).

The third reason is that export moderated steadily in 1998, the volume of domestic export declining by 7.9% while re-exports decreased by 3.7%, and the export value dropped by 7.4% (Table 5). This contraction in exports reflected the pressure on Hong Kong’s competitiveness, as data from Bank for international settlements, the average real effective exchange rate of the Hong Kong dollar increased by 7.9% in 1998 which due to weaker foreign demand详细说. Imports in 1998 recorded a steeper decreased than exports, falling by 7.2% in real term and 11.5% in value terms. Compare with the contraction of exports, the reason of declines in imports was that curbed by sluggish re-export activities associated with the economic downturn (HKMA annual report, 1998), and the weakness of domestic demand for the foreign goods.

As mentioned above, the CCPI has a negative progress during the crisis and post-crisis period, which reflected the price of Hong Kong dollar declined. However, the price decline is not fully harmful. It still benefits consumers in general, especially lower-income families. But if the unemployment rates keep high as well, it will make the situation worse. The number of unemployment doubled from 87400 in 1996 before the Asian crisis, to about 154100 in 1998 while the rate the unemployment increased from 2.8% to 4.7%. This became one of the facts that exactly influenced the Hong Kong economy after 1997. Totally, the impact of the Asian financial crisis on the real economy of Hong Kong was obvious serious and can not be ignored. Real GDP sharp fall, rapid decline of exports and imports, continued increasing of unemployment, and the deflationary all reflect that there was a recession in Hong Kong’s economy after Asian financial crisis.

Impact on the Asset Market

Figure 1 shown us the monthly movement of the Hong Kong Hang Seng stock index from 1964 to 1999, it is obvious that from January 1995 to August 1997, there was a rapid progress in the stock market, and the index raised from the bottom at 6978 on January 30, 1995 to reached its peak at 16673 on August 29, 1997, the index increased by almost 140%. However, from October 1997 onward, because of the contagion of crisis, both securities and property markets experienced a massive downtrend, the Hang Seng index reached the bottom at 6660 on August 29, 1998, which was even lower that on 6978 point on 1995. In order to avoid the collapse of investor confidence in the pegged currency system and in the securities markets, the Hong Kong government decided to intervene in these markets. The first step of interventions was bought a substantial amount of Hong Kong dollars, short-selling by the hedge funds, through the Hong Kong Foreign Exchange Reserve Fund. In order to keep the HSI at around 7800 point, the second strategy was took a long position for all the 33 HIS composite stocks, and bought large quantity of HSI futures contracts. Eventually, the Hong Kong government successfully defended the HSI at the 7800 level by 29 August 1998 while the cost of this intervention was large, approximate 15.4 billion US dollar. Nevertheless, figure 2 and 3 show us the price and rental index for Hong Kong property market respectively [5] . Obviously, the real prices of property increased significantly before and during the Asian crisis. However, after the government intervened in the asset markets, the price and rental of housing was decreased progressively.

Tables

Table1: Foreign Exchange and Derivatives Market (US Dollar billion)

Foreign Exchange [6] Derivatives [7] Total

Country Apr-95 Apr-98 %change Apr-95 Apr-98 %change Apr-95 Apr-98 %change

Hong Kong 90 79 -13% 4 4 -12% 95 82 -13%

Singapore 105 139 32% 18 11 -38% 124 150 22%

Japan 161 149 -8% 33 42 28% 194 191 -2%

Source: HKMA Quarterly Bulletin, Nov.1998

Table 2: HK dollar interest rates movement (annual average figures)

Time deposits HIBOR Savings deposits Best lending rate

1-month 3-month 12-month 1-month 3-month 12-month

1996 4.65 4.81 5.19 5.30 5.46 5.88 3.77 8.52

1997 5.99 6.20 6.40 6.85 7.12 7.47 4.08 8.83

1998 6.63 7.35 8.32 7.42 8.06 9.31 5.19 9.94

Source: data of 1996: HKMA Annual report, 1997; data of 1997&1998: HKMA Annual report, 1998

Table 3: Contributions to GDP growth by components (%)

1996 1997 1998

Private consumption expenditure 2.8 4.0 -4.1

Net domestic exports of goods -2.7 -5.2 6.9

Net exports of services 1.7 -0.9 -1.6

GDP 4.5 5.3 -5.1

Source: HKMA Annual report, 1998

Table 4: Composite Consumer Price Indexes (Annual rates of change %)

1996 1997 1998

Composite CPI 6.3 5.8 2.8

Source: Annual Report on the Consumer Price Index, 2012

Table 5: Total Exports, Re-exports, Domestic Exports and Imports (approximate annual growth rate %)

Total Exports Re-exports Domestic exports Imports

In In Change In In Change In In Change In In Change

value real in value real in value real in value real in

terms terms price terms terms price terms terms price terms terms price

1997 4 6 -2 5 7 -1 0.5 2 -2 5 7 -2

1998 -7 -4 -4 -7 -4 -4 -11 -8 -3 -12 -7 -5

1999 0.5 4 -3 2 5 -3 -9 -7 -2 -3 0.5 -2

Source: HK Economic Analysis Division, 1999 Economic Background

Table 6: Unemployment and Unemployment rate

1996 1997 1998

Number Rate Number Rate Number Rate

(thousands) (%) (thousands) (%) (thousands) (%)

Overall 87.4 2.8 71..2 2.2 154.1 4.7

Source: Hong Kong Annual Digest of Statistics, 2012

Figure 1: Hang Seng Stock Price Index, Monthly Movement 1964-1999

Source: Hong Kong Exchanges and Clearing Limited, Fact Book, 1999

Figure 2: Price Index for Hong Kong Property Market (1999=100)

Source: Hong Kong Rating and Valuation Department

Figure 3: Rental Index for Hong Kong Property Market (1999=100)

Source: Hong Kong Rating and Valuation Department