A country's financial system is internationally illiquid if its potential short-term obligations in foreign currency exceed the amount of foreign currency it can have access to in short notice. This condition may be necessary and sufficient for financial crises and/or exchange rate collapses (Chang and Velasco 1998a, b). In this paper we argue that the 1997-98 crises in Asia were in fact a consequence of international illiquidity. This follows from an analysis of empirical indicators of illiquidity as well as other macroeconomic statistics. We trace the emergence of illiquidity to financial liberalization, the shortening of the foreign debt structure, and the currency denomination of assets versus liabilities. We explain how financial crises became exchange rate collapses due to a government policy of both fixing exchange rates and acting as lender of last resort. Finally, we outline the policy implications of our view for preventing crises and for dealing with them.
JEL classification: F3, E5, G2
Key words: crises, financial systems, exchange rate systems, liquidity
The authors thank Will Roberds for useful comments and suggestions and Mike Chriszt and Vincenzo Guzzo for able research assistance. Velasco also acknowledges generous support from the C.V. Starr Center for Applied Economics at New York University. The views expressed here are those of the authors and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System. Any remaining errors are the authors' responsibility.
Please address questions regarding content to Roberto Chang, Research Officer, Research Department, Federal Reserve Bank of Atlanta, 104 Marietta Street, NW, Atlanta, Georgia 30303-2713, 404/498-8057, email@example.com; or Andrés Velasco, Professor of Economics at New York University and NBER, Department of Economics, NYU, 269 Mercer Street, 7th floor, New York, New York 10003, 212/998-8958, firstname.lastname@example.org.
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