Asian currency crisis contagion

A multi-period macroeconomic model is constructed to investigate the spread of financial crisis from Thailand to Korea in 1997. Unlike previous studies, this model is based on empirical data from 1993 to 1999. The baseline model replicated well the relevant events during the crisis, including the devaluation of Thai baht in the third quarter of 1997 and the devaluation of Korean won in the following quarter. Using the baseline model, two possible channels of transmission were tested. After blocking only the first channel, Thai crisis effects on investors\u27 expected risk of investing in Korea, the crisis would no longer spread to Korea. However, after blocking only the second channel, trade competition between Thailand and Korea, the crisis still spread to Korea. This suggests that the first channel is the more important transmission pathway. Different scenarios including measures that the local governments could have adopted were tried out. First, voluntary devaluation by Thailand in the second quarter of 1997 appears beneficial to both Thailand and Korea, as it allows Thailand to keep more foreign reserves and causes less disruption in the financial markets. The effectiveness of the second approach, capital control by Korea in the wake of Thai crisis, would depend on the investors\u27 sensitivity to the additional risks resulting from capital control. Only if the sensitivity is low, capital control might be an effective tool to avoid the currency crisis. The third scenario shows that the crisis in Korea could have been avoided due to a large accumulation of foreign reserves if the won had been devalued in 1994. The fourth scenario demonstrates that if the problems in the industrial and banking sectors in Korea had been revealed earlier, the crisis might have actually started in Korea and would have made the crisis in Thailand occur sooner than in the third quarter of 1997. The last scenario, voluntary devaluation by Thailand in the second quarter of 1997 with an endogenous shift of the variance of Thai asset returns, provides similar results as in the first scenario