Three measures of East Asian currency evaluation

MENZIE D. CHINN [*] One of the prominent explanations for the East Asian financial crises of 1997 relies upon East Asian currency overvaluation. However, most empirical studies of these crises do not undertake serious examination of whether these currencies were overvalued. In this article, three major approaches to identifying the equilibrium exchange rate are implemented: long-run purchasing power parity (PPP), a productivity-based model, and a monetary model of the nominal exchange rate. The PPP calculations indicate that as of May 1997, the Hong Kong dollar, baht, ringgit, and peso were overvalued, and the won undervalued. In a framework that explicitly accounts for the role of productivity, substantial overvaluation of the peso is detected, but an undervaluation of the won is also uncovered. Misalignments of the ringgit and baht are small. Finally, the estimated equilibrium rates from a monetary model do not imply much deviation from short-run equilibrium at the end of June 1997. A conclusion of substantial overvaluation o n the eve of the East Asian currency turmoil is not very plausible, suggesting that some alternate mechanism for generating crises--other than one involving the conventional macroeconomic fundamentals--was at work. (JEL F31, F41, F47) I. INTRODUCTION Many observers have pointed to exchange rate overvaluation as a proximate cause of currency crises, and a number of econometric studies have concluded that overvaluation is a statistically important determinant of such events. For instance Dornbusch, Goldfajn, and Valdes (1995), Sachs, Tornell, and Velasco (1996), and Kaminsky and Reinhart (1999) all conclude that overvaluation is a key factor; relatedly, Goldfajn and Valdes (1999) conclude that the larger the overvaluation, the more likely is a discrete devaluation. In this article, several measures of "overvaluation" are implemented to assess the role of currency misalignment in the onset of the East Asian financial crises. There are at least three broad definitions of overvaluation in use. The first category can be loosely described as those models that use a price-based criterion, such as purchasing power parity (PPP) and its variants. More complicated definitions rely upon some criteria based on a formal model of exchange rates, such as a monetary, fiscal, or general equilibrium. Finally, there is a set of models that rely upon medium-term solvency and sustainability-based criteria. In this article, only the first two types of models are examined, primarily because most of the cross-country studies have used real exchange rate deviations as measures of misalignment. (The sustainability criteria are often assessed using current account to GDP ratios and export to debt ratios.) Finally, there is an emerging consensus that the events in East Asia did not represent a "currency crisis" in the traditional sense of misaligned macroeconomic fundamentals (budget deficits, excessive money growth), but rather a financial crisis involving asymmetric information and moral hazard, and implicit government guarantees in the form of insolvent banking system bailouts (Corsetti, Pesenti, and Roubini, 1998; Chinn, Dooley, and Shrestha,1999). The article proceeds in the following manner. In section II, the results using PPP-based measures are reported. In section III, the implications of a productivity-based model motivated by the Balassa-Samuelson approach are examined. Section IV examines the short-run implications of an augmented monetary model. According to the PPP criterion, the Hong Kong dollar, Malaysian ringgit, Philippine peso, and Thai baht were overvalued on the eve of the 1997 crisis. Neither the Korean won nor the Indonesian rupiah evidence overvaluation (unless, in the latter case, the reference period is restricted to the 1986-96 period, and even then the overvaluation is minor). Using the productivity-based model, substantial overvaluation of the Philippine peso is detected and a modest overvaluation of the baht, while both the won and the New Taiwan dollar were undervalued. …