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ASSESSING THE VULNERABILITY OF THE PHILIPPINE ECONOMY TO A CURRENCY CRISIS: A COMPARISON OF THE ASIAN FINANCIAL
AND U.S. FINANCIAL CRISES
ERROL NAVARRO OCAMPO
SUBMITTED TO THE FACULTY OF THE DEPARTMENT OF ECONOMICS COLLEGE OF ECONOMICS AND MANAGEMENT
UNIVERSITY OF THE PHILIPPINES LOS BAÑOS IN PARTIAL FULFILLMENT OF THE REQUIREMENTS FOR GRADUATION
FOR THE DEGREE OF
BACHELOR OF SCIENCE IN ECONOMICS
APRIL 2009
iv ABSTRACT
OCAMPO, ERROL N. 2009. Assessing the Vulnerability of the Philippine Economy to a Currency Crisis: A Comparison of the Asian Financial and U.S. Financial Crises.
University of the Philippines Los Baños, College Laguna (Undergraduate Thesis).
Thesis Adviser: Prof. Niño Alejandro Q. Manalo
The object of this paper is to evaluate the vulnerability of the Philippine economy and determine the probability of occurrence of a currency crisis given the present financial crisis in the United States. The study uses the early warning system developed by Zhuang and Dowling that is based on the “signaling approach”, which monitors several indicators that tend to exhibit an unusual behavior in the periods preceding a crisis. When an indicator exceeds (or falls below) a threshold, then it is said to issue a
“signal” that a currency crisis may occur in the succeeding period.
Results show that the Philippine economy is very vulnerable to a currency crisis in light of the existing U.S. Financial Crisis based from the number of warning signals issued by the leading indicators. Furthermore, the probability that a currency crisis might occur in the Philippines has already reached above 50 percent as economic indicators continue to issue warning signals.
The study’s results reinforce the earlier study of Gesmundo (2005), who also used the Zhuang-Dowling early warning system model to predict and assess the vulnerability of the Philippine economy to the Asian Financial Crisis. Comparisons revealed similar factors that trigger currency crisis in the Philippines which includes the rapid depreciation and appreciation of the real exchange rate and the real effective exchange rate respectively, increasing trade and current account deficit, ballooning fiscal deficit, rapid enlargement of domestic credit, and economic slowdown.
By closely monitoring the fiscal and financial sector, the government can avert the occurrence of future currency crisis in the Philippines. On the other hand, monitoring the performance of the real exchange rate indicator can guide the government in predicting the likelihood of a currency crisis happening given an existing foreign financial crisis.
TABLE OF CONTENTS
Page
TITLE PAGE i
BIOGRAPHICAL SKETCH ii
ACKNOWLEDGEMENT iii
ABSTRACT iv
TABLE OF CONTENTS v
LIST OF TABLES vii
LIST OF FIGURES viii
INTRODUCTION 1
Background of the Study 3
U. S. Housing Industry Crisis 3
Rise of the U.S. Subprime Mortgage Crisis 4 Reaction of Domestic and Foreign Investors in the Philippines 5
The 1997 Asian Financial Crisis 8
Statement of the Problem 9
Significance of the Study 11
Objectives of the Study 12
Definition of Terms 12
REVIEW OF RELATED LITERATURE 14
Subprime Mortgaging 14
Growth of Subprime Mortgaging 16
Fair , Isaac, & Co. (FICO) Credit Score 18
The Credit Rating 18
The Low Credit Score 21
Asian Financial Crisis 22
CONCEPTUAL FRAMEWORK 26
vi
Assessing the Forecasting Ability of the Individual Indicators 34
Constructing the Composite Leading Index 36
RESULTS AND DISCUSSION 39
Statistical Dating of Crisis and Exchange Rate Pressure Index 39 Performance of Individual Indicators of the Early Warning System 40
Warning Signals During 2007-2008 45
Probabilities of Crises: Estimation of Forecasting Ability 52
Vulnerability of the Philippine Economy 55
U.S. Financial Crisis 55
Comparison with the Asian Financial Crisis 58 SUMMARY, CONCLUSION AND RECOMMENDATION 61
REFERENCES 64
LIST OF TABLES
Table # TABLE Page
1 List of Economic Indicators Used in the Early Warning 30 System Model
2 True and False Warning Signals 34
3 Historical Crises Episodes 39
4 Performance of Indicators 42
5 Warning Signals of Significant Leading Indicators during 45 The 24-Month Crisis Window
6 Probability Table for the Composite Index 52
7 Warning Signals During the 24-Month Crisis Window 59 (Gesmundo)
viii
LIST OF FIGURES
Figures TITLE Page
1 An Early Warning System for the U.S. Financial Crisis 28
2 Real Exchange Rate, deviation from trend 47
3 Real Effective Exchange Rate, deviation from trend 47
4 Trade Balance/GDP Ratio 48
5 Current Account Balance/GDI Ratio, 12-month % change 48
6 Foreign Reserves, 12-month % change 48
7 M2/Foreign Reserves ratio, deviation from trend 49
8 Foreign Liabilities/Foreign Assets 49
9 Central Bank Credit to the Public Sector/GDP Ratio, 49 12-month % change
10 M2 Multiplier, 12-month % change 50
11 Excess Real M1 Balances 50
12 Industrial Production, 12-month % change 50
13 Government Consumption/GDP Ratio 51
14 World Oil Price, 12-month % change 51
15 U.S. Real Interest Rate 51
16 Real Dollar/Yen Exchange Rate Ratio, deviation from trend 52
18 Probabilities of a Currency Crisis using the Sector-Specific 53 Composite Index
19 Probabilities of a Currency Crisis using the Overall Composite 54 Index
19 Probabilities of a Currency Crisis using vis-à-vis the Real 55 Exchange Rate
