Financial Crisis, Capital Outflows and Monetary Policy Responses: Simple Analytics with Reference to East Asia

Financial crises seem to have become the norm rather than the exception since 1992.2 Specifically, in 1992–1993, Europe was faced with the very real possibility of a complete collapse of the European Exchange Rate Mechanism (ERM). The Italian lira and British pound withdrew from the ERM, three other currencies (the Spanish peseta, Irish pound and Danish krona) were devalued, and there was a substantial widening of the bands within which the currencies could fluctuate. In 1994–1995, the Mexican currency crisis, which saw a steep devaluation of the peso, brought Mexico to the brink of default. There were also spillover effects on Argentina and Brazil. Between July 1997 and mid-1998, the world experienced the effects of the East Asian crisis, which started somewhat innocuously with a run on the Thai baht, but spread swiftly to a number of other regional currencies, most notably the Indonesian rupiah, Malaysian ringgit and Korean won. Other large emerging economies such as Russia and Brazil also experienced periods of significant market weakness and required the assistance of the IMF. The Russian ruble was devalued in August 1998—during a period of exceptional financial market turbulence (Bank for International Settlements 1999)—and the Brazilian real’s peg was eventually broken in January 1999. A number of other smaller emerging economies such as Turkey and Ecuador also experienced currency crises in the 1990s; Argentina and Venezuela were the most recent victims.