Stock Prices as a Leading Indicator of the East Asian Financial Crisis


Simon Broome
Economics Department
National University of Ireland, Maynooth

and

Bruce Morley
Economics Group
University of Wales, Aberystwyth

September 2003

Abstract: Using a basic currency crisis model, we assess the effectiveness 
of stock prices as a leading indicator of the East Asian currency crisis in 
1997 and 1998. Stock prices are incorporated into a basic monetary model, 
through the wealth effect postulated by Friedman (1988). In addition to the 
domestic stock price, we also incorporate the stock prices of Hong Kong, 
China and Japan to determine their ability to predict the crisis. Using 
monthly data, the results indicate that the domestic stock price is a 
significant leading indicator, however the main stock prices indicator of 
the crisis is the Hong Kong stock price. In addition the US price level is 
also a highly significant predictor of the crisis. Causality tests suggest 
evidence of bi-causality between the stock markets and  foreign exchange 
markets.

Key Words: Currency Crisis, Stock Prices, Monetary Model.


I Introduction


The aim of this paper is to primarily determine whether the domestic stock 
market can be used as a leading indicator during a regional currency crisis, 
as in East Asia during 1997 and 1998. Further we investigate whether the 
major stock markets within East Asia had any effect on the currencies 
suffering the crisis and can also be used as an early warning system. A 
particular feature of the East Asian crisis was the almost simultaneous 
decline in asset prices and currencies, as international investors moved 
their capital out of the respective domestic markets. This resulted in a 
subsequent depreciation of the exchange rate as the domestic currency was 
sold. However the degree of severity of the crisis varied across East Asia, 
as did the extent of the decline in the domestic stock markets.

 To date most models for predicting currency crises have concentrated on 
leading indicators from either the banking sector or the current account 
(e.g., Kaminsky et al., 1998, Kwack, 2001). When stock prices have been 
included, it has been limited to only domestic stock prices. In this paper 
we suggest a simple monetary based model, in which stock prices can be 
incorporated as a leading indicator of currency crises. We also investigate 
whether foreign stock prices are a significant leading indicator, based on 
three theories concerning the origins of the South East Asian currency 
crisis.

 When investigating the relationship between stock prices and exchange 
rates, the main concern is usually over the direction of causality between 
these variables. There are theoretical reasons for causality to run in both 
directions, as suggested by Bahmani-Oskooee and Sohrabian (1992) and Granger 
et al (2000). The empirical evidence is equally ambiguous, although Granger 
et al (2000) finds evidence of causality running from stock markets to 
exchange rates during a currency crisis, but their study uses daily data 
rather than monthly data. In this study we too assume causality is from 
stock prices to exchange rates.

 Following the introduction, we assess the interrelationship between stock 
prices and exchange rates during a currency crisis. We then derive a simple 
model of currency crises, in which stock markets are incorporated through 
the demand for money function. The next section describes the data and 
assesses the results from the empirical models. Finally we give our 
conclusions and suggest some implications for future policies.




II Currency Crises and Stock Prices

 The main attempt to incorporate the domestic stock market into empirically 
based currency crisis models has been Kaminsky and Reinhart (1996) and 
Kaminsky et al (1998). These models incorporate a number of real, financial 
and political variables in purely empirical models, to identify which are 
significant and also the length of the signalling horizon. They use the 
"signals" approach, which in general involves a one step ahead probability 
of a devaluation, in the context of a multivariate probit or logit type 
model. The domestic stock markets are generally found to be a significant 
leading indicator of currency crises, over a number of different currency 
crises in the recent past. In the study by Kaminsky et al. (1998), stock 
prices are found to be the fourth best predictor of currency crises.

 There has been a certain amount of debate in the literature as to the 
direction of causality between stock prices and exchange rates. Granger et 
al. (2000) show that causality runs from domestic stock prices to exchange 
rates. They offer some theoretical support for a bi-directional relationship 
between the stock market and foreign exchange market, but only over the 
short run. They argue that a change in exchange rates would change the 
market value of all firms that trade internationally. This would depend on 
whether the firms are net importers or exporters, such that if in aggregate 
most firms were net exporters, a devaluation would have a beneficial affect 
on those firms profitability and therefore stock market value. This causal 
relationship is termed the traditional approach, although it does not 
specify the sign of the effect.

 In contrast to this approach, both Bahmani-Oskooee and Sohrabian (1992) and 
Granger et al. (2000) stress the importance of the portfolio approach to 
analysing the relationship between stock prices and exchange rates. This 
suggests that a rise in stock prices, increases the domestic wealth of 
investors, facilitating a rise in the demand for money. Following the 
consequent rise in interest rates, capital is attracted into the domestic 
economy appreciating the domestic currency. This approach assumes there is a 
negative relationship between stock prices and exchange rates, with 
causality running from the stock market to the foreign exchange market. Wu 
(2001) provides evidence of the negative relationship between equities and 
exchange rates in South East Asia. This explanation is the most relevant to 
this relationship during a currency crisis. We have conducted a set of 
Granger causality tests between domestic stock prices and exchange rates, as 
with other studies, there is evidence of bicausality between the stock 
market and foreign exchange markets. When causality runs from stock prices 
to the exchange rate, there is a negative relationship, which suggests the 
portfolio approach is most important in South East Asia.

 Apart from the US stock market, we have investigated whether the crisis 
could have originated from any of the main neighbouring stock markets, in 
Japan, Hong Kong and China. Although the crisis began in Thailand in 1997, 
others have suggested the crisis began earlier than this, with both China/ 
Hong Kong and Japan being suggested as contenders. Fernald et al (1999) have 
suggested that the rise in China's economic strength during the 1990's added 
to the crisis. They focused on the 1994 devaluation and subsequent strong 
export performance as the cause of the troubles, as China captured export 
markets, which had previously been dominated by the Association of Southeast 
Asian Nations (ASEAN) countries. This facilitated current account problems, 
reduced company profitability and culminated in the general financial demise 
of the area. It has also been argued that a further source of the crisis 
could have been Hong Kong, which in 1997 was officially returned to China 
from the UK. Initially this had a positive effect on Hong Kong's share 
prices, but as the date for the handover approached, so concern about 
investment in Hong Kong increased.

 Some argue that another source of the crisis was Japan. Following rapid 
rises in the stock market during the 1980's, the early and mid 1990's saw a 
reversal of this trend, with some sharp falls. At the same time the Japanese 
economy experienced an era of stagnant growth and lack of demand. This 
facilitated a decline in demand for ASEAN imports and a fall in investment 
flows to these countries. The financial crisis in Japan culminated in the 
failure of Yamaichi corporation in 1997, the fourth largest financial 
institution. This in turn caused another large fall in the Japanese stock 
market.

 If either Japan or China/ Hong Kong were the instigators of this crisis, 
then a measure of their financial troubles could be a useful leading 
indicator for the currency crises in East Asia. To determine if this is the 
case, we have incorporated the stock market indices of China, Hong Kong and 
Japan into the basic monetary based model, along with the domestic stock 
market index.



III Model



 The following model is based on the Krugman (1979) model of currency 
crisis, with stock market effects incorporated through the money demand 
specification. As with Edin and Vredin (1993), this is only used as a basis 
for the empirical investigation and as with the leading indicator literature 
in general, other leading indicators are also incorporated into the 
empirical tests, without specific theoretic modeling. The stock market is 
included in the money demand function2 for three reasons, as suggested by 
Friedman (1988). It primarily acts as a wealth effect, as a rise in stock 
prices increases nominal wealth. Additionally a rise in stock prices 
reflects a rise in expected returns from risky assets. To offset this rise 
in risk, agents switch away from long-term bonds to safer monetary assets. 
Thirdly a rise in stock prices implies a rise in financial transactions and 
thus transactional demand for money. These imply a positive relationship 
between money and stock prices. There could also be a negative relationship 
through a substitution effect. As stock prices rise, agents substitute the 
more attractive equities for money. However as with Friedman (1988) we 
assume the positive effect dominates.

  As with the conventional monetary model, we assume purchasing power parity 
(PPP) and uncovered interest parity (UIP) 3hold;

           (1)

Where, e is the exchange rate, p are domestic prices and p* are foreign 
prices.

          (2)

 Where i are domestic interest rates and i*are foreign rates. Money demand 
takes the following form:

        (3)

 Where m is domestic money balances, y is domestic income and s is a 
domestic stock market index. We have assumed that the domestic money supply 
is purely accommodating.  By rearranging the above equations, we get:

        (4)

To test for the effects of stock prices on the exchange rate, we have chosen 
a standard empirical model, based on equation4 (4). This suggests the crisis 
is a function of:

      (5)

Where cc is the rate of change in the exchange rate for the month when the 
exchange rate is in a crisis condition,? m is the domestic money supply 
(M1), y is output, i* is the US interest rate, p* is the US price level, ds 
is the domestic stock market index, ?rer is the change in the real exchange 
rate, res are foreign currency reserves and xs are the relevant foreign 
stock market indexes (All variables are in logs and in change form). As with 
Edin and Vredin (1993) we have also included the real exchange rate, rather 
than the nominal exchange rate and added foreign exchange reserves. The 
relevant foreign stock market indexes are the US, Japan, Hong Kong and 
China. The US stock market is included because the East Asian currencies are 
pegged to the dollar, the Japanese markets have traditionally had a strong 
effect on the region as a whole. China has recently undergone important 
political changes which have affected their financial markets and Hong Kong 
has been transferred from UK to Chinese control.

 In addition to the main leading indicator tests, we have also included some 
Granger Causality tests, between the exchange rates and domestic stock 
prices. In addition we have included some causality tests between the 
exchange rates and foreign stock price variables. The basic tests is:

       (6)

 Where e is the exchange rate, s is the stock price variable and u and v are 
error terms. As with Blomstrom et al. (1996) we have included country dummy 
variables and use the t-statistic on the lagged explanatory variable to 
determine if there is evidence of causality.


 IV Data and Results



The countries included in the investigation are those that experienced the 
worst problems during the crisis. This includes Thailand, Malaysia, South 
Korea, Indonesia and the Philippines. The data is all monthly, running from 
January 1996 to December 1999, so including months where a crisis was 
evident as well as months in which the exchange rate was relatively stable. 
The exchange rate is expressed as the domestic currency in terms of the US 
dollar, the foreign explanatory variables are the respective US variables. 
This reflects the fact that the relevant currencies were initially all in 
effect pegged to the US dollar. The data on prices, foreign exchange 
reserves, money supply and interest rates are taken from International 
Financial Statistics and  Datastream..

 The stock market data consists of the total return expressed in index form 
as supplied by Datastream. This incorporates both the capital gain and 
dividend5 payment. In addition to the standard currency crisis variables and 
the domestic stock market indices, we have also added stock market variables 
from the surrounding countries. This includes Hong Kong, China and Japan, 
where the origins of the crisis are believed to have began, as well as the 
US stock market variable.

 The causality tests are reported in Table 1, where there is evidence of 
bi-causality between the exchange rate and domestic stock prices, as found 
in Kwack (2000). In addition there is evidence that the stock prices in 
China and particularly Japan cause the East Asian exchange rates.

A binomial probit6 is used to estimate the various models, where we define a 
crisis as a depreciation of the currency in any month greater than 2%. This 
roughly equates with the definition of a currency crisis given by Frankel 
and Rose (1996), which is a depreciation of the exchange rate greater than 
25% in any given  year7 so the dependent variable is the change in the 
exchange rate. Other values were also estimated, but made little difference 
to the results. The model has been estimated using both fixed and random 
effects, however in all tests there are no significant differences between 
the results, so only the fixed effects are reported.

 The first model to be estimated is the basic model, in which the variables 
are lagged once, incorporating only domestic stock prices. The result is 
presented in Table 2 and suggests the domestic stock prices and US prices 
are significant leading indicators, although other domestic variables are 
insignificant8 Other lag lengths were also added, but were not significant 
as financial markets tend to adjust relatively quickly. The second model 
incorporates US stock prices, which are not significant, suggesting although 
the US real economy affected the crisis, the US stock prices are not a good 
leading indicator. In models 3 and 4, reserves and the Thailand stock price 
are included in the basic model. As with other studies reserves are not 
significant although the Thailand stock price is significant at the 10% 
level of significance This is not surprising as the crisis began with the 
collapse of the Thailand stock market..

 Only US prices and domestic stock prices are  significant leading 
indicators of the currency crisis. The domestic variables are not important 
predictors of the crisis, including the change in the real exchange rate, 
which as in Radelet and Sachs (1998) is insignificant. This result tends to 
support the contention of many observers who suggest there were very few 
domestic indicators of the impending crisis in these economies (e.g., Furman 
and Stiglitz (1998), Radelet and Sachs (1998)).

 The further inclusion of the Japanese, Chinese and Hong Kong stock prices 
individually into the model, also shows these are significant, except the 
Japanese stock market, which supports the theory that the origins of the 
currency crisis was not the relatively small domestic stock markets, but the 
more powerful stock markets of some of the neighbouring economies, 
particularly Hong Kong. All three stock markets are negatively signed, again 
suggesting that the falls in the respective markets precipitated the 
currency crisis. The probability of predicting an outcome correctly is 
reasonably high at about 70%9 in each case.

 The final set of tests involves all three neighbouring stock markets 
included in the model. Only the Hong Kong market is significant of the three 
main East Asian markets. This provides possible evidence that the source of 
the instability within the ASEAN countries was Hong Kong's financial 
markets. The instability in these markets was caused primarily by the change 
in ownership of Hong Kong in 1997, when China took over administrative 
control from the UK. However Hong Kong did not suffer from a currency crisis 
itself, this may be due to the larger size and greater development of its 
financial markets as suggested by Radelet and Sachs (1998) or due to the 
authorities using their reserves to purchase equities, thus preventing a 
collapse on the Hang Seng.

V Conclusion

This paper provides evidence of the domestic stock market being a 
significant leading indicator of the recent East Asian currency crisis, 
unlike other domestic variables. Although the most significant leading 
indicator of the crisis was US prices. The effectiveness of the domestic 
stock prices is less powerful as a leading indicator than the stock prices 
of the main economies in East Asia, particularly that of Hong Kong.

 The results in general support the evidence from other similar studies on 
the East Asian crisis, as there is little evidence that the domestic 
fundamentals could have been used to predict the crisis. However it could 
have been possible to predict the crisis with reasonable accuracy, based on 
the main neighbouring foreign stock markets, particularly the Hong Kong 
stock market. This implies that volatility in the Hong Kong economy and 
financial markets, possibly as a result of the change in ownership of Hong 
Kong in 1997, may have triggered the crisis. This supports the various 
contagion theories, although it does not explain why some financial markets 
survived the crisis better than others.

 Finally, although this model could act as an important early warning 
system, it has a number of limitations. These mainly relate to the 
individual nature of most crises, where different institutional and 
political factors affect the crises in different ways. However the 
intervention in the Hong Kong stock market by the authorities during the 
crisis, may have saved Hong Kong from a similar fate to its neighbours and 
provides the possibility of a mechanism for preventing such crises from 
occurring in the future. This could form part of an area for future 
research, as could the use of daily rather than monthly data as such data 
becomes more available.





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Table 1. Causality tests between Stock prices and Exchange rates.

