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

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  • Hong G. Min
  • McDonald, Judith A.

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.

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Bibliographic Info

Paper provided by The World Bank in its series Policy Research Working Paper Series with number 2056.

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Date of creation: 28 Feb 1999
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Handle: RePEc:wbk:wbrwps:2056

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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;

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  1. Goodhart, Charles A. E. & Payne, Richard G., 1996. "Microstructural dynamics in a foreign exchange electronic broking system," Journal of International Money and Finance, Elsevier, vol. 15(6), pages 829-852, December.
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  14. Razzaque Bhatti & Imad Moosa, 1995. "An alternative approach to testing uncovered interest parity," Applied Economics Letters, Taylor & Francis Journals, vol. 2(12), pages 478-481.
  15. Grinblatt, Mark & Titman, Sheridan & Wermers, Russ, 1995. "Momentum Investment Strategies, Portfolio Performance, and Herding: A Study of Mutual Fund Behavior," American Economic Review, American Economic Association, vol. 85(5), pages 1088-1105, December.
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