By Ha-Joon Chang, Gabriel Palma, D. Hugh Whittaker
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Additional info for Financial Liberalization and the Asian Crisis
Government saving Sg is total tax revenue net of public consumption Cg, transfers to households, and interest payments at home (Zg) and abroad (eZ*g). For simplicity, the ﬁnancial system is assumed to have zero saving, so that its interest income ﬂows from households, business, and government just cover its payments to households. Finally, ‘foreign saving’, Sf, in local currency terms is the exchange rate times the foreign currency values of imports (M) and interest payments less exports (E). The implication is that the rest of the world applies part of its overall saving to cover ‘our’ excess of spending over income.
Finally, private portfolio and direct investment ﬂows were considered to be preferable to syndicated bank lending because they were thought to segregate the problem of foreign exchange instability from asset market instability. Syndicated lending was denominated in the currency of the lending bank, and the exchange rate risk was thus borne by the borrower. However, direct equity investors purchase foreign ﬁnancial assets in foreign currency and thus bear the currency risk. It was suggested that in a crisis the foreign investor would suffer from a fall in asset prices as well as from a decline in the exchange rate, which would discourage sales of security investments, thereby reducing selling pressure in the foreign exchange market.
A currency attack follows. The economically untenable ﬁscal expansion is instantly erased. A second version of this tale is based on the assumption that the local monetary authorities raise ‘deposit’ interest rates to induce households to hold ﬁnancial system liabilities created in response to greater public borrowing. 1, h will increase so that interest rates on outstanding domestic debts have to go up as well. The spread ⌺i immediately widens. 1 reserves begin to grow. If the monetary authorities allow the reserve increase to feed into faster growth of the money supply, we are back to the previous story.