Could the Financial Crisis in East Asia HaveBeen Predicted?

Dominick Salvatore, Fordham University

1. INTRODUCTION

During the past two years there have been a large number ofstudies trying to identify the various macroeconomic and financialindicators that might predict a financial crisis, like the one thatstarted in East Asia in summer 1997.1 No indicator, however, canpredict that a financial crisis will, in fact, occur or its timing. Allthat these warning indicators can do is to signal that a crisis ispossible. But for that, we do not need a large number of esotericindicators as some researchers have tried to identify—as this paperwill show, a few fundamental ones will do.

In my presentation I will first identify some fundamental warn-ing indicators of a possible financial crisis, and then show theirvalues for Mexico in 1994, just before its latest financial and eco-nomic crisis (which started at the end of 1994 and extended throughall of 1995, before a recovery set in during 1996) and comparethem to the same set of indicators for 1996 for the five East Asianemerging markets (Thailand, Indonesia, Malaysia, Korea, and thePhilippines) that were most adversely affected by the financialcrisis that officially started with the devaluation of the Thai bahton July 2nd 1997. The warning indicators presented will show thatconditions in the five East Asian emerging markets in 1996 werevery similar to the conditions that got Mexico into difficulties in

Address correspondence to Dominick Salvatore, Department of Economics, FordhamUniversity, New York, NY 10458.

1 See, for example, Morris Goldstein and Carmen Reinhart, Forecasting Financial Crises:Early Warning Signals for Emerging Markets (Washington, DC: Institute for InternationalEconomics, 1999); Graciela Kaminski, Saul Lizondo, and Carmen Reinhart, “LeadingIndicators of Currency Crises,” IMF Staff Papers, March 1998, pp. 1–45, and DominickSalvatore, “Capital Flows, Current Account Deficits, and Financial Crises in EmergingMarket Economies,” International Trade Journal, Spring 1998, pp. 5–22.

Journal of Policy Modeling 21(3):341–347 (1999) 1999 Society for Policy Modeling 0161-8938/99/$–see front matterPublished by Elsevier Science Inc. PII S0161-8938(99)00007-1

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1994 and, thus, a crisis in the East Asian emerging economiescould have been anticipated.

To be sure, neither Mexico in 1994 nor the five East Asiancountries that got into trouble in 1997 fared badly on all of thewarning indicators presented, but they did on most of them, thussignaling that a financial crisis was possible. Furthermore, theconditions that plunged Mexico into a crisis in 1994 were notidentical to what got the East Asian countries into trouble in 1997(i.e., not all crises are identical). These same warning indicatorswere also used to fully anticipate the Brazilian crisis at the Sympo-sium—which, in fact, erupted a week after!

2. WARNING INDICATORS OF A POSSIBLEFINANCIAL CRISIS

There are eight fundamental warning indicators of a possiblefinancial crisis. These are:

1. The rate of savings of the nation. A rate of savings that istoo low to provide for the capital requirements of the newyearly entrants into the nation’s labor force and for increasesin the average capital labor ratio for the entire economyrequired to promote economic development will encouragea nation to borrow abroad to make up for the shortfall ininvestments that can be financed by domestic savings. Overtime, however, the foreign capital can be withdrawn, espe-cially if it is not in the form of foreign direct investments,and this could lead to a financial and economic crisis in thenation.

This is exactly what happened to Mexico in 1994. The rateof savings of Mexico was only 18 percent of GDP, while arate of savings of about 24–25 percent is generally acknowl-edged to be needed to provide sufficient investments to createadequate jobs for the more than one million workers enteringthe labor force each year and to still leave some investmentfor growth of output per worker. Thus, Mexico had to relyon capital inflows of about 6–7 percent of its GDP per year.When capital started to pour out of Mexico as a result ofpolitical instability in 1994, Mexico was forced to devalue itscurrency, and the nation plunged into a serious financialcrisis. Inadequate domestic savings, however, was not a prob-lem for the five East Asian emerging market economies in1996, with the possible exception of the Philippines. In fact,

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domestic savings as a percentage of GDP was 37 for Malaysia,33 for Korea and Thailand, 29 for Indonesia, and 20 for thePhilippines.

2. The second fundamental warning indicators that could leadto a crisis in an emerging market is a large and unsustainablebudget deficit. Although there is no specific level of thebudget deficit that spells inevitable trouble, a budget deficitof 3 percent of GDP or larger can usually be taken as aserious warning signal of possible future problem for thenation.

This, however, was neither a problem for Mexico in 1994(which had a budget deficit of only 0.7 percent of GDP) norof the East Asian emerging market economies that got intotrouble in 1997. In fact, only Korea among the five EastAsian countries under consideration had a budget deficit in1996, but this was only 0.1 percent GDP, the Philippines hada balanced budget, and the other three countries had in facta budget surplus (Thailand of 3%, Indonesia of 1.2%, andMalaysia of 0.9%). Thus, neither the 1994 Mexican crisis northe 1997 East Asian crisis were due to unsustainable fiscalimbalances.

3. The third fundamental warning indicator is the current ac-count deficit. A current account deficit equal to 4–5 percentof GDP is generally regarded as unsustainable and ofteneventually leads to turmoil in foreign exchange markets anddevaluation of the nation’s currency. In 1994, Mexico had acurrent account deficit of 7.3 percent of GDP—clearly in thedanger territory, and so did most of the East Asian emergingmarket economies in 1996. Their budget deficit as a percent-age of their GDP in 1996 was 7.9 for Thailand, 4.9 for Malay-sia, 4.8 for Korea, 4.7 for the Philippines and 3.3 for Indo-nesia.

4. The fourth warning indicator is the size of the nation’s totalforeign debt as a percentage of the nation’s GDP. Experienceindicates that any value above 30 percent or so can spellfuture trouble if the nation is unable to service and eventuallyrepay the debt. In 1994, the total foreign debt as a percentageof GDP was 34.3 for Mexico, and much higher for four of thefive East Asian countries (59.7 for Indonesia, 50.3 for Thailand,47.3 for the Philippines, and 42.1 for Malaysia). It was lowerfor Korea but still above 30 percent (32.1%). This warning

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indicator clearly signaled potential future problems for Mexicoand for all the East Asian countries being examined.

5. The fifth indicator is the percentage of the short-term debt toGDP. Experience also shows that any value for this indicatorabove 8–10 percent can easily lead a country to financialdifficulty because of the ease and speed with which this typeof foreign capital can be withdrawn from the nation. Thispercentage was 9.3 for Mexico in 1994 and 20.8 in Thailand,14.9 in Indonesia, 10.3 in Korea, and 9.1 in the Philippinesin 1996. Thus, indicator also signaled potential troubles downthe road for the East Asian countries after 1996, as it actuallycaused for Mexico at the end of 1994 and in 1955.

6. The sixth fundamental warning indicator of a potentialfinancial crisis is the current account minus foreign directinvestments as a percentage of GDP. A negative value forthis indicator measures the portion of the nation’s currentaccount deficit (as a percentage of the nation’s GDP) fi-nanced by short-term capital of “hot money” inflows. Thesecan just as easily and quickly flow out and plunge the nationinto a financial crisis. Past experience shows that any valueof this indicator in excess of 2 or 3 percent of GDP can leadto future trouble for the nation. According to this measure,Mexico in 1994 and three of the five East Asian countrieswere exposed to the possibility of a future financial crisis.The value for this indicators was 4.6 for Mexico in 1994 and6.8 for Thailand, 5.2 for Korea, 4.0 for Malaysia, 1.4 forIndonesia, and 0.6 for the Philippines in 1996.

7. The seventh indicator is the debt service of the nation on itsforeign debt as a percentage of its export earnings. The largerthe proportion of the nation’s export earnings required toservice its foreign debt, the more precarious is the positionof the nation, because there are many other developmentclaims on its foreign earnings. Once again, there are no clear-cut figures for the value of this indicator signaling possiblefinancial difficulties for the nation. The value of this indicatorthat got Mexico into trouble in 1994 and 1995 was 28.1 per-cent. Only Indonesia had a higher value for this indicator in1996 (36.8%). The other four East Asian countries had muchlower values, so that this indicator, by itself, could not havebeen taken as a sign of potential future financial problemsfor these nations. The value of this indicator for the otherfour East Asian countries in 1996 was 13.7 percent for the

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Philippines. 11.5 percent for Thailand, 8.2 percent for Malay-sia, and 7.0 percent for Korea.

8. The last warning indicator of potential financial crisis in anemerging market is the average number of months of importsthat the nation can finance with the international reservesat its disposal. For Mexico this was 0.7—a dangerously lowfigure and a clear warning signal of possible future financialproblems (which, in fact, materialized at the end of 1994 andin 1995). For the East Asian countries under considerationin 1996, only Korea had a value for this indicator (1.1) thatwas close to Mexico’s. The other four countries were some-what better off, with the value of this indicator of 2.3 for thePhilippines, 3.3 for Malaysia, 5.1 for Thailand, and 5.5 forIndonesia in 1996.

3. WARNING INDICATORS OF THE FINANCIALCRISIS IN EAST ASIA IN 1997

We have identified above eight possible fundamental warningindicators of a potential financial crisis in an emerging market. In1994, Mexico fared badly on seven of these indicators (the savingsrate, the current account deficit, the total foreign debt, the totalshort-term foreign debt, the proportion of the current accountdeficit financed by short-term capital or hot money inflows, thedebt service as a proportion of the nation’s export earnings, andthe number of months of imports that the nation could financewith its international reserves), and Mexico did plunge into aserious financial and economic crisis at the end of 1994. Only forthe budget indicator did Mexico not fare badly in 1994.

Most of the five East Asian emerging markets in 1996 (the yearbefore they fell into a deep financial crisis) faced values of at leastfour warning indicators as bad or worse then those of Mexico in1994. These were the current account deficit, the total foreigndebt, the short-term foreign debt, and the current account deficitfinanced by short-term capital inflows. Thus, the financial crisisthat started in these nations in summer 1997 was generally not asaving, a budget, or an international reserve crisis. An unsustaina-ble current account deficit and a large foreign debt (a great dealof which were short term) were enough to trigger the crisis—andonce the crisis started in Thailand in July 1997, it quickly andinexorably spread to the other four East Asian emerging marketeconomies.

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To be noted is that the eight fundamental warning indicatorsthat were utilized can generally be expected to provide usefulsignals of potential financial crises of different types in emerging-market economies. For example, if we look at Brazil in 1998, wefind that it resembled Mexico in 1994, even more than the five EastAsian countries did in 1996. Furthermore, Brazil (as contrasted toMexico in 1994 and the East Asian countries in 1996) also hada huge budget deficit (in excess of 7% GDP in 1998). Thus, inaddition to the other warning indicators, even our second indicatorsignaled the possibility of future potential problems for Brazil. Infact, on January 13, 1999—exactly 10 days after the Symposiumtook place and I made the comment that Brazil was heading fortrouble—a new Brazilian crisis erupted with the devaluation ofthe real by 8 percent and the subsequent (on Friday January 15)abolishment of the crawling peg system that Brazil had put inplace in 1994 as part of its plan to stabilize the exchange rate andwhich put an end to its hyperinflation. What happens next (i.e.,whether stability quickly returns and Brazil overcomes the reces-sion in a year or so, or plunges into a longer period of financialinstability and recession that may also drag other nations down,including the East Asian ones that only recently seem to have thereached the bottom of the crisis) depends on whether or not Brazilis able to quickly implement the rigorous austerity program thatcalls for the halving of its budget deficit during this year.

What is also crucial to note is that the efforts to identify amuch larger number of more refined and esoteric early warningindicators of potential future financial crises in emerging marketeconomies (as some authors have done or are trying doing) arelikely to prove futile. All that their efforts are likely to provideare a large number of additional but crisis-specific indicators oflittle general value or usefulness. Furthermore, the eight warningindicators presented and used above are broad enough to encom-pass many other and less general ones. For example, a great dealof effort is made to measure the degree by which an emergingmarket currency might be overvalued. But many emerging marketeconomies deliberately keep their exchange rate overvalued soas to attract foreign capital as the counterpart of the resultingcurrent account deficit. Thus, measuring the degree of possibleovervaluation of the nation’s currency does not provide the typeof market information that is being sought. It is only if the over-valuation is so large as to result in an unsustainable current accountdeficit that the nation may get into difficulty. But this is exactly

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what our third or current account deficit fundamental warningindicator tells us.

The overall conclusion that we can, therefore, reach is that noone can predict a crisis or its timing. All we can do is indicatesome general fundamental early warning indicators that might beuseful to signal that a nation is heading for a crisis (and in thehope that the nation can take adequate and immediate correc-tive measures that might allow it to avoid the crisis). These earlywarning indicators can also be useful in determining the measuresthat a nation that is heading for trouble could be asked to take asa condition for receiving financial assistance from the InternationalMonetary Fund, thus avoiding the moral hazard problem that isotherwise likely to arise. Finally, not all crises are alike. As wehave seen, some are primarily current account crises (as for Mexicoin 1994–95 and for the five emerging-market economies consideredin 1997–98), some are primarily budget crises (as in Brazil in 1999);still others are savings, foreign debt, or exchange rate crises. Butour fundamental warning indicators seem generally able to signalthem all. Trying to be more precise has not helped in the past,and is not likely to prove very useful in the future. All that wewould be likely to get are crisis-specific indicators—ex-post.