Arbitrage An Explanation for South-East Asian Crisis and Indian Immunity

Crisis and Indian Immunity Ashima Goyal Shridhar Dash In many south-east Asian countries, the short-term bank lending interest rate significantly exceeded the US rate through the 1990s. This interest differential exceeded the change in nominal exchange rates over the period. Country risk was low because growth was high. Governments committed to stimulate exports would not allow an appreciation of the exchange rate, and the large foreign inflows ruled out an immediate depreciation. Therefore private corporations and banks had a large incentive to borrow abroad in the short- term without hedging. But because medium-run expectations of depreciation had to be positive, to satisfy arbitrage, and equilibrate domestic to foreign returns, the economies were susceptible to shocks. This together with financial market weaknesses explains the rapid collapse after mild external shocks. In monetary theories of exchange rate determination, the currency depreciates under excessive money growth. We demonstrate conditions under which an expected depreciation of the exchange rate can occur under low monetary growth. Tight money policy and a high revenue deficit kept our interest rates far above foreign and triggered an industrial recession in 1996-97, and a depreciation of the exchange rate. But during the onset of the southeast Asian crisis monetary policy had been relaxed. This helped India escape the crisis. Other implications of our analysis for Indian economic trends are explored.