Exchange rate regimes and the cross‐country distribution of the 1997 financial crisis

ROBIN M. GRIER [*] We study variations in the severity of the 1997 financial crisis in a sample of 25 developing countries. We use both currency depreciation and stock market returns as crisis measures. Our key findings are that countries that started 1997 with an exchange rate peg experienced significantly greater currency depreciation and significantly lower stock returns than would be predicted from the levels of various macroeconomic indicators. (JEL F3, F4) I. INTRODUCTION The Asian financial crisis of 1997 is still a very hot topic. A recent search of EconLit turned up 243 articles in the system with "Asian Crisis" in the subject field. [1] Several recent articles attempt to explain variations in the severity of the crisis across developing countries using macroeconomic and financial variables and show that the distribution of the crisis is somewhat predictable. Our article extends this literature in two directions. First, we examine whether the initial exchange rate regime in place at the beginning of 1997 had any effect on the distribution of the financial crisis once the relevant macro and financial indicators are included in the model. Second, given that a real crisis followed on the heels of the financial one, we study the relationship between exchange rate regime, currency depreciation, and stock market performance in 1997. Our sample consists of 25 developing countries in 1997. [2] Though a cross-sectional approach limits the generality of our results, we believe we can ask and answer two interesting questions about the average performance of different exchange rate regimes in 1997. The first question is: Controlling for economic indicators, what was the average effect of having an initially pegged exchange rate on currency depreciation? There are theoretical arguments (presented in section II) that can justify either positive, negative, or zero effects. We find that, on average, countries with a pegged regime at the beginning of the year experienced more depreciation than what was predicted by their macro indicators. The second question we study is: What was the average effect of currency depreciation on stock market performance in 1997? Again, there are arguments (presented in section III) supporting either a positive, negative, or neutral relationship. We find that, on average, depreciation has a marginally significant negative impact on stock returns. However, in the 12 countries that began 1997 with a floating exchange rate, currency depreciation had a significantly positive effect on stock returns, whereas the effect of depreciation on stock returns was negative and significant for the 13 countries that started the year with a pegged currency. This relationship holds for stock returns measured either in U.S. dollars or in local currencies. The papers most similar to ours in the literature are Tornell and Velasco (1995), Edwards (1993), Corsetti et al. (1999) (hereafter CPR), and Tornell (1999). Tornell and Velasco and Edwards study whether or not the choice of exchange rate regime affects economic outcomes. [3] CPR and Tornell study the Asian financial crisis of 1997 in the broader context of developing country performance. They create a crisis index and estimate several regressions using macro and financial indicators to predict the extent of the crisis in a sample of developing countries. Our article applies the idea that the choice of exchange rate regime can affect macroeconomic and financial outcomes to the study of the determinants of the severity of the 1997 crisis in a model similar to those of CPR and Tornell. In what follows below, section II studies the relationship between macro and financial indicators, the initial exchange rate regime and currency depreciation in 1997. Section III considers the depreciation--exchange rate regime--stock market connection in 1997. Section IV presents our conclusions. II. MACRO INDICATORS, CURRENCY DEPRECIATION, AND EXCHANGE RATE REGIME IN 1997 The question of what exactly determines the value of the exchange rate is an important unsolved issue in open economy macroeconomics, and we are not going to settle it here. …