Economics Update (October-December 1998)

Lack of Liquidity Drives Asian Crisis

I nternational illiquidity is the key condition in the development of a financial crisis like Asia's, argue Roberto Chang, an Atlanta Fed research officer, and Andres Velasco, an economics professor at New York University. The economists explore theoretical and empirical aspects of this view in two recent Atlanta Fed working papers.

In "Financial Crises in Emerging Markets: A Canonical Model," Chang and Velasco develop a model of a small open economy in which domestic banks issue demand deposits and borrow abroad to finance investments. This arrangement may improve social welfare, but it can also induce a crisis if it is internationally illiquid — that is, if the financial system's potential short-term obligations exceed its asset liquidation value.

The maturity structure of foreign debt is a critical factor in determining whether a country is internationally illiquid, the authors note. Short-term financing aggravates international illiquidity, so short-maturity foreign debt is undesirable from the viewpoint of preventing financial crises.

Chang and Velasco's theory also implies that international illiquidity may emerge after a national policy of financial liberalization has been implemented. Hence financial liberalization, while socially beneficial in principle, may make the financial system more fragile.

In a companion paper, "The Asian Liquidity Crisis," the authors examine basic macroeconomic data from the so-called Asean Five countries (Korea, Indonesia, Malaysia, Thailand and the Philippines). The data show that macroeconomic performance in these countries was satisfactory before the crisis but also that the short-term obligations of their financial systems were rather large relative to their internationally liquid assets. What's more, these economies had experienced a period of financial reform and liberalization that may have aggravated their international illiquidity problem.

Chang and Velasco point to several policy implications of their research. For preventing crises, restricting short-term borrowing abroad and monitoring the financial system for maturity mismatches seem two appropriate responses. For dealing with a crisis in progress, providing international liquidity to the financial system should be the main priority, implying the need for an international lender of last resort.

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