ARBITRAGE - AN EXPLANATION FOR SOUTH-EAST ASIAN CRISIS AND INDIAN IMMUNITY

In many south-ease Asian countries, the short-term bank lending intere st rate significantly exceeded the US rate through the 1990s. This int erest differential exceeded the change in nominal exchange rates over the period Country risk was low because growth was high. Governments c ommitted to stimulate exports would not allow an appreciation of the e xchange rate, and the large foreign inflows oiled out an immediate dep reciation. Therefore private corporations and banks had a large incent ive to borrow abroad in the short- term without hedging. But because m edium-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 weakn esses explains the rapid collapse after mild external shocks. In monet ary 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 moneta ry growth. Tight money policy and a high revenue deficit kept our inte rest rates far above foreign and triggered an industrial recession in 1996-97, mid a depreciation of the exchange rate. But during the: onse t 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.