The Continuing Asian Financial Crisis: Global Adjustment and Trade

Working Paper
January 1999

Published jointly with the IFPRI. Contact information: Trade and Macroeconomics Division, International Food Policy Research Institute, 2033 K St. NW, Washington DC 20006-1002, USA; 202-862-5600; 202-467-4439 (fax); [email protected]. We would like to thank Mina Kim for research assistance.


In this paper we use a multi-region computable general equilibrium model to analyze the impact of the Asian crisis thus far, highlighting the implications of possible future developments in Japan and China. The main conclusion is that depreciation of the yen would tend to have an adverse impact on the rest of Asia, even if Japanese growth were to be restored. The reason is that the most affected Asian countries need to run trade surpluses over the medium-run due to weakness in domestic demand and a need to service foreign debt. A weak yen cuts into these surpluses by eroding the competitiveness of these countries both in the Japanese market and in relatively unaffected third country markets such as the United States and Western Europe. In contrast, modest devaluation of the reminbi, which restores China's external balance to its pre-crisis level, would have less impact than yen devaluation. A larger Chinese devaluation, however, would have a more negative impact on Asian trade. Moreover, any Chinese devaluation could spark renewed financial unrest. For this reason, we recommend that China focus on addressing its fundamental macro- and microeconomic problems. Under the current Chinese circumstances, exchange rate management is a second-order issue.


The financial crisis, which began in Thailand in July 1997, continues to reverberate throughout the global economy. And though it is conventional to begin analyzing the crisis with Thailand, in all likelihood future outcomes will hinge far more critically on developments in Japan and China than in the most affected Asian countries.

In the case of Japan-the world's second largest economy, the largest in Asia, and the world's largest creditor country-economic performance has gone from bad to worse. Growth has essentially been flat since 1992, and the economy is now shrinking at an annualized rate of more than three percent. As a consequence of this prolonged period of subpar growth, Japan has accumulated a substantial "output gap" indicating that actual growth is well below potential, though considerable disagreement remains as to the precise size of this shortfall.1 Even the most conservative estimate of Japan's long-run potential growth rate (1.6 percent (OECD 1998)) is above the consensus forecast of roughly zero growth for 1999 derived from professional surveys (Blue Chip Economic Indicators, 10 January 1999; FT Currency Forecaster, January 1999).

Faster growth in Japan would benefit the rest of the world, as well as Japan. First and foremost, it would facilitate economic recovery in the rest of Asia by providing a market for Asian goods, reducing Japanese export competition in third country markets, encouraging new lending by Japanese financial institutions, and promoting foreign direct investment and technological transfer by Japanese firms. Furthermore, renewed Japanese growth would dampen political pressures in the trade arena, as evidenced by the steel industry, that are likely to intensify as the US trade deficit, already at historically unprecedented levels, continues to widen.

To achieve recovery, Japan must rekindle domestic demand, address its financial problems, and undertake structural reforms. Japan now faces a deflationary spiral. As prices fall, households and firms postpone purchases of durable goods in anticipation of lower prices in the future. Deflation contributes to high real interest rates, which in turn impede investment. With consumption and investment falling (the two largest components of domestic demand), inventories rise, prices fall, and the economy contracts. Households then increase precautionary saving, further depressing demand. The economy goes into a self-reinforcing spiral of contracting aggregate demand and supply.

In such a situation, the standard remedies are expansionary monetary and fiscal policies, and most observers have called for further monetary and fiscal stimuli (Posen 1998; Krugman 1998a, b; 1999; OECD 1998; Financial Times, 30 December 1998). Government spending boosts aggregate demand, while an expansionary monetary policy reduces interest rate (stimulating investment), generates expectations of future price increases (discouraging postponement of expenditures on durables), and contributes to exchange rate depreciation (boosting foreign demand for domestic output). The preferred mix of policies in the current situation is subject to ongoing debate. The basic question for policy makers is how Japanese households regard government spending. Some argue that they will simply increase savings to offset future tax liabilities, so that the stimulus should come solely through monetary policy, although this approach would tend to generate a bigger exchange rate depreciation and larger trade surpluses (Meltzer 1998; Makin 1998).

Thus a weaker yen is a component of almost any Japanese adjustment scenario.2 Since Japan is the world's largest net creditor, international financial markets cannot discipline Japan for policy errors in the way the emerging markets of Asia were punished. The real risk is that Japanese households and institutions could lose confidence in the economy and the sanctity of the financial system, leading to capital flight as detailed in Posen (1998). In such a scenario, the yen would weaken precipitously as the Japanese economy contracted. An alternative scenario could be thought of as the Krugman-Makin-Meltzer prescription: the yen weakens in response to loosened monetary policy as part of a macroeconomic adjustment package that generates positive growth.

A collapsing yen and a Japanese economy in free-fall would put enormous pressure on the rest of Asia. The second largest economy in the region, China, has won kudos for resisting the temptation to devalue its currency in an environment of slowing aggregate demand and declining competitiveness. Nevertheless, a capital-flight scenario in Japan could push China into a policy of devaluation. Noland, Liu, Robinson, and Wang (1998) argue that, even in these circumstances, a Chinese devaluation would be, at best, a second-best policy and, at worst, counterproductive, even in narrow mercantilist terms. A Chinese devaluation could set off another iteration of competitive devaluations and financial instability throughout the region, and indeed, the world. Nonetheless, the possibility that China could pursue such a policy cannot be ruled out.

In this paper, we use a multi-region, computable general equilibrium (CGE) model developed to analyze the implications of the Asian financial crisis for both Asia and the rest of the world. Specifically, we simulate some possible future trajectories of the Japanese economy and a possible Chinese devaluation that could occur in response to developments in Japan. We find that depreciation of the yen would tend to have an adverse impact on the rest of Asia, even if Japanese growth were to be restored. The reason is that the most affected Asian countries need to run trade surpluses over the medium-run due to weak domestic demand and a need to service foreign debt. A weak yen cuts into these surpluses by eroding the competitiveness of the most affected countries in both the Japanese market and relatively unaffected third country markets such as the United States and Western Europe. Under the weak yen scenario Japan's global trade surplus would increase by more than $200 billion, with more than $60 billion coming at the expense of the rest of Asia. Indeed, the difference in Japan's global position between the weak yen scenario and a recovery with real appreciation scenario could be on the order of $400 billion.

In contrast, modest devaluation of the reminbi, which restores China's external balance to its pre-crisis level, would have less impact than yen devaluation. A larger Chinese devaluation, however, would have a more negative impact on Asian trade. Moreover, any Chinese devaluation could spark renewed financial unrest. For this reason, we recommend that China focus on addressing its fundamental macro- and microeconomic problems. Under the current Chinese circumstances, exchange rate management is a second-order issue.

Structure of the World Model

The model is a multisectoral, multi-region, CGE model that is part of a family of models that have been used widely to analyze the impact of global trade liberalization and structural adjustment programs.3 Our model focuses on real trade flows, trade balances, world prices, and real exchange rates. It incorporates considerable detail on sectoral output, consumption, and trade flows-both bilateral and global. However, we obtain this structural detail at the cost of not expliciting modeling financial markets, interest rates, or inflation, so this model cannot be used to analyze the impact of the crisis on asset and money markets.4 Similarly, the model is comparative statics in nature-given the pattern of world output and trade at one moment of time, it generates the pattern of output and trade resulting from world economic adjustment to the shocks specified in the alternative scenarios. The model is not designed to generate quarterly macroeconomic forecasts. In principle, it could be linked to a macro model that includes asset flows and could determine the set of real exchange rates resulting from a macro shock. Given a macro scenario, this model could then be used to determine the resulting real trade flows and regional sectoral structural adjustments in a comparative-statics framework.

The model includes 17 regional models,5 each with 14 sectors6 and five primary factors of production: agricultural land, natural resources, capital, unskilled labor, and skilled labor.7 The regions are linked by commodity trade. Within each region, the model solves for domestic commodity and factor prices, equating supply and demand in all goods and factor markets. The model also solves for world prices, equating supply and demand for sectoral exports and imports across the world economy. In addition, for each region, the model specifies an equilibrium relationship between the balance of trade (in goods and nonfactor services, or the current account balance) and the real exchange rate (which measures the average price of traded goods-exports and imports-relative to the average price of domestically produced goods sold on the domestic market). An exogenous change in a particular region's exchange rate will reverberate across the world economy, affecting the aggregate trade balances and/or real exchange rates of all 17 regions as they adjust their trade flows and structures of production to achieve a new equilibrium.

Each regional economy includes a number of economic actors. Producers are assumed to maximize profits, purchasing inputs and supplying output to both domestic and world markets (exports) in response to market prices in commodity and factor markets. Consumers receive income from firms and demand goods (and save) in response to prices and incomes. The government collects taxes, buys goods and services, and saves (government surplus or deficit). An aggregate savings-investment account serves the function of financial markets, collecting all savings (private, government, and foreign) and allocating it for the purchase of investment goods.

It is reasonable to wonder if an equilibrium model is sufficient for analyzing adjustment to a crisis such as the one at hand. In normal operation, the regional models all assume perfect competition and complete adjustment in all markets, and, hence, solve for a new full-employment equilibrium after any shock. However, the Asian financial crisis is causing disruptions in the affected economies that are having serious effects on aggregate employment of resources. Many firms throughout the region are going bankrupt, and the rate of labor unemployment is rising. We simulate these effects by introducing negative "supply-side" shocks, reducing total factor productivity (TFP) across all sectors in the affected regions. In other words, for convenience, instead of specifying increased unemployment or closed factories, we allow all resources to remain employed but reduce their efficiency, thereby generating the same fall in output. The magnitudes of these shocks are described in more detail below as we analyze the scenarios. The model determines relative prices within each region and on world markets. Traded and non-traded goods are assumed to be distinct (and imperfect substitutes) by sector, so changes in relative world market prices are only partially transmitted to domestic markets.

The model thus incorporates a realistic degree of insulation of domestic commodity markets from world markets. The links are still important and provide the major mechanism through which the crisis is transmitted across regions. Since the model cannot determine inflation, only relative prices change. The United States is specified as the "reference" economy, with both its aggregate price level and exchange rate fixed. That is, all relative world prices and trade balances are measured in terms of real US dollars. In addition, the aggregate consumer price index is fixed in each region, which defines a regional "no inflation" benchmark.8

The equilibrium exchange rate determined by the model for each region can be interpreted as the real effective exchange rate (REER) deflating by the ratio of the regional consumer price index and the US index.9 It is important to emphasize that the exchange rate variable in the model is not the nominal exchange rate that one reads in the newspaper. The REER differs from the nominal rate because it takes the price level of the two countries and the structure of trade among countries into account. So, for example, if the Korean REER depreciates by 25 percent, this could reflect a 25 percent nominal depreciation of the won against the US dollar and no change in relative price levels or inflation rates, or it might reflect a 35 percent nominal depreciation of the won against the US dollar combined with a ten percent increase in the Korean price level. In other words, movements in the REER reflect changes in both nominal exchange rates and relative price levels as well as the composition of trade, and any particular change in the REER is consistent with an infinite number of combinations of those variables. In this model, the REER is not a financial exchange rate, since the model has no assets or asset markets. The model specifies an equilibrium relationship between the real exchange rate and the trade balance, given world prices and regional export supply and import demand functions.

For each region, the model includes the three macro balances: savings-investment, balance of trade (in goods and non-factor services), and government expenditure-receipts (government deficit). The three balances are not independent-if two of the balances are determined, the third follows from the fact that the three must always sum to zero. The determination of these macro balances is the subject of traditional macroeconomic models. In terms of our real trade model, which does not include financial markets or variables typical of macro models, the determination of these macro aggregates is specified by simple rules. The macro adjustment mechanism constitutes the macro "closure" of the model.

In the absence of any convincing analysis that the macroeconomic adjustment has particular quantitative impacts on different components of national income, we specify a macro closure that assumes any adjustment in aggregate absorption is spread in a neutral manner across aggregate consumption, investment, and government expenditure. Aggregate investment and government expenditure are simply specified as fixed shares of total absorption in each region (or aggregate regional expenditure, which equals gross domestic product [GDP] plus imports minus exports). Aggregate private savings in each region is assumed to adjust endogenously to match aggregate investment, thus achieving savings-investment equilibrium even with endogenous changes in the government deficit and the balance of trade.

In the aggregate, as noted above, there is a functional relationship between the balance of trade (in goods and nonfactor services, or the current account balance) in each region and the real exchange rate. If the real exchange rate depreciates, the price of traded goods increases relative to the price of domestically produced goods sold on the domestic market. Exports increase, imports decrease, and the trade balance improves. Given our assumption that aggregate investment is determined as a share of aggregate absorption, changes in the trade balance, which directly affect foreign savings, are assumed to have only a partial effect on aggregate investment in the region. Instead, these changes lead to an equilibrium adjustment in the domestic savings rate, which partially offsets the change in foreign savings.

In the model, we specify a fixed real exchange rate for each region. In the base solution, calibrated to 1995 (the most recent year for which world data on regional SAMs and trade are available), the initial trade balance and exchange rate are assumed to be in equilibrium for each region-that is, the initial trade balance is assumed to be "sustainable" and consistent with the initial real exchange rate. In simulation experiments, we change the exchange rate for a particular region, which changes the equilibrium trade balance both in aggregate and bilateral terms. In the multi-region model, there is a ripple effect, since a depreciation in one region's real exchange rate implies a relative appreciation for its trading partners, which also leads to changes in their equilibrium trade balances. The world model is closed in that the sum of all regional trade balances must equal zero. Thus, we can use the model to see how real exchange rate shocks lead to trade balance adjustments in a globally consistent framework.

Modeling Scenarios

We model the Asian financial crisis as a combination of real exchange rate depreciations and supply-side contractions due to domestic financial disintermediation, which impedes the affected countries' ability to respond to the real exchange rate change. In this application, we program a set of real exchange rate changes and supply-side shocks approximating what occurred between July 1997 and December 1998.10 This forms scenario 1-the Asian financial crisis without any response on the part of Japan.

We then examine three Japan-specific scenarios. Scenario 2 can be thought of as the Krugman-Meltzer-Makin scenario in which the yen depreciates in response to aggressive monetary expansion as part of a proactive recovery package. Real activity increases by three percent and the real exchange rate depreciates by 30 percent (equivalent to a nominal yen-dollar rate of around 170).

Scenario 3 can be thought of as Posen's capital flight scenario-the yen weakens further and the slump deepens (Posen 1998). In this scenario, Japan experiences a real depreciation of 20 percent (roughly equivalent to a yen-dollar rate of 155) and a negative TFP shock of four percent. The fundamental difference between these first two scenarios is that, in the first, exchange rate depreciation is a means to recovery. In the second, it is a symptom of crisis.

A crisis in Japan would put tremendous pressure on the rest of Asia, and in scenario 4 we examine the implications of a Chinese devaluation. Specifically, we subject the reminbi to the real depreciation of five percent, which effectively re-attains its trade balance in the base-that is, the devaluation necessary to offset the Japanese move.11

Lastly, in scenario 5, we specify a Japanese recovery that combines real appreciation of 20 percent (equivalent to a yen-dollar rate of around 105) with positive growth of one percent. We present scenario 5 last because we believe that this optimistic scenario is unlikely to occur. One could imagine a set of circumstances under which it could happen-for example, if significant fiscal stimulus (without portfolio substitution away from yen-denominated instruments) and structural reforms (which raise the marginal product of capital) lead to renewed growth and higher interest rates, and, by extension, an appreciated currency.


Tables 1-11 report results for the five scenarios described above. Changes in global trade balances for the eight aggregated regions are given in table 1. In scenario 1, real exchange rate depreciation and negative productivity shocks generate an adjustment pattern in which the Asian newly industrialized countries (NICs) and the Asian less developed countries (LDCs) experience positive swings in their global trade balances. For the Asian LDCs, this swing is approximately equal to $108 billion, due mainly to import compression as both price and income factors depress imports. The NICs experience a $44 billion positive swing in their trade balances, the preponderance of this reflecting developments in Korea. The mirror image of these trade balance gains is a deterioration in the balances of Western Europe ($50 billion), the United States ($35 billion), Japan ($33 billion), and China ($11 billion).12

Some sectoral output changes underlying these trade balance changes are reported in tables 2-6. The US sectoral changes are shown in table 2. In scenario 1, these changes are spread fairly evenly across the economy, with no sector experiencing sectoral output changes of more than two percent in absolute value. This uniformity arises because some export sectors such as machinery are adversely affected by the collapse of investment and falling import demand in Asia, while others such as light manufacturing are hit by rising imports from Asia. Non-traded goods sectors expand as resources are shifted out of tradables in response to the real exchange rate appreciation. A similar story holds for Japan-output declines fairly uniformly across tradables, and non-tradables expand (table 3).

The converse holds for the Asian NICs (table 4) and LDCs (table 5). For the NICs, output falls in non-tradables and primary product sectors within tradables. However, output increases across manufacturing, especially for other transportation equipment, which for these countries is largely shipbuilding. The more heavily affected Asian LDCs exhibit dramatic results as construction collapses along with investment. But driven by exports, output of light manufactures and textiles and apparel grow by ten percent and 13 percent, respectively.13

Sectoral output changes for China are reported in table 6. The effects of the first stage of the Asian financial crisis (scenario 1) are relatively modest: the decline in output is not more than two percent in any sector. The labor-intensive sectors of light manufacturing and textiles and apparel are hit the hardest. The relatively labor-intensive, though not internationally traded, sector of housing and construction expands to absorb the labor released from the most affected tradables sectors.

Some key bilateral balances are shown in table 7. In scenario 1, the US experiences deterioration in its bilateral balances with the Asian NICs and LDCs of $15 billion and $17 billion, respectively, while Japan's bilateral balances fall by $14 billion with the NICs and $26 billion with the LDCs.

Nearly all these results change considerably in scenario 2 when Japan experiences a 30 percent real depreciation and a three percent TFP gain. Japan's global trade balance improves by $168 billion, with this increase coming at the expense of Western Europe ($50 billion), the US ($45), and the Asian NICs and LDCs ($42 billion-much of this with Korea, which among the Asian countries competes most directly against Japan). In Japan, output increases by 31 percent in other transportation equipment (largely rail-related equipment and shipbuilding), 28 percent in motor vehicles, and 16 percent in machinery. Other traded-good sectors, which had experienced mild contractions in response to the Asian crisis, now expand.

The mirror image of the increased output in Japan is contractions elsewhere. This result is most evident in the US, where, in contrast to the previous scenario, output declines are no longer spread evenly among the traded-good sectors. Three sectors are hit particularly hard: machinery (eight percent), motor vehicles (eight percent), and electronics (six percent). US-Japan sectoral trade balances are shown in table 8. The motor vehicles sector experiences a $22 billion shift in favor of Japan, while the bilateral balance in machinery changes by $16 billion.

In scenario 3, Japan experiences capital flight-as in the previous scenario, the yen depreciates, but this time the depreciation is accompanied by falling output in Japan. The main result is to magnify the previous trade results, since, with demand shrinking in Japan and the exchange rate depreciating, the economy relies more on external demand. So, for example, Japan's external surplus increases by around $50 billion from the previous scenario, or by around $185 billion from the base. The impact on Japanese production is shown in table 3, where the negative TFP shock offsets the increase in foreign demand in all but the most internationally competitive sector.

In scenario 3, China's external surplus falls by $20 billion. The Asian devaluations are not all negative for China. More than half of China's exports in recent years are processed goods, many involving assembling of imported parts and materials for re-exporting. Korea, Taiwan, and ASEAN countries are important suppliers of inputs for China, and devaluation in these countries lowers input costs for Chinese exports. The net impact of devaluations in these countries on China's trade balance is thus relatively small.

In scenario 4, we devalue the reminbi by five percent in real terms, which roughly restores the status quo ante defined in terms of China's trade balance. As shown in table 6, the impact of devaluation is felt most strongly in sectors of China's greatest comparative advantage, textiles and apparel and light manufacturing, where output increases by three to four percent.14 Conversely, housing and construction contracts as resources are released into the tradables sector. Elsewhere in the world, the impact of the Chinese devaluation is felt most acutely by the Asian NICs and LDCs. They lose international competitiveness, especially in textiles and apparel and light manufactures.

In the final optimistic scenario 5, Japan experiences economic recovery which is accompanied by a strengthening of the real exchange rate. Renewed growth and exchange rate appreciation are mutually reinforcing, and Japan's external surplus declines by nearly $200 billion relative to the base. This decline more than offsets the impact of events in the rest of Asia on the external balances of the US, Western Europe, and China, and the external balances of the Asian NICs and LDCs increase by an additional $51 billion relative to the base (table 1). Unfortunately, this nirvana-like scenario in which Japan's recovery takes the pressure off the adjustment to the Asian crisis elsewhere in the world is the least likely to occur in reality.

Tables 9-11 summarize the impact of these developments on agriculture in some of the main producing and consuming areas. As shown in tables 9 and 10, the impact of the initial experiment tends to dominate subsequent scenarios involving Japan and China. The results indicate a combination of income effects and relative-price effects. Agriculture is a larger share of total output in countries such as Indonesia and Thailand, compared to Japan, China. Agriculture is also significant in the Asian NICs. In both the Asian LDCs and NICs, major devaluation leads to significant import substitution (table 11) and a decline in domestic production (table 9). Agriculture is also a major export sector in Australia/New Zealand.

As a result of the crisis, the decline in income leads to a decline in consumer demand, and agricultural production is depressed in most parts of the world. In the Asian NICs and LDCs, the income effect complements the import substitution effect. However, Australia/New Zealand is exceptional. There, the decision to accept a real depreciation boosts competitiveness, generating increased agricultural exports and, with exports being a large share of output, the net effect is to increase supply.15 For the US, exports decline and imports rise, and domestic output falls, regardless of the subsequent scenarios regarding Japan. For both the Asian NICs and LDCs, exchange rate depreciation does boost exports, but import substitution is more important and, combined with the decline in domestic demand, the net effect is to decrease domestic production. As in the case of the United States, subsequent scenarios involving Japan do not alter this fundamental result. Only in the cases of Western Europe, China, and the rest of the world is the direction of agricultural output change sensitive to developments in Japan.


This paper uses a multi-region CGE model to analyze the impact of the continuing Asian crisis, highlighting the implications of possible future developments in Japan and China. The main conclusion is that yen depreciation would tend to have an adverse impact on the rest of Asia, reducing its external balances by more than $60 billion, even if Japanese growth were to be restored. The crisis leads to major changes in the structure of production and trade. The significant fall in income in major Asian countries, which leads to a fall in aggregate demand, hurts agriculture across the world; and the aggregate impact is largely unaffected by alternative reactions in Japan and China. The impact on the manufacturing sectors, however, is much more sensitive to what happens in Japan and China.

Increases in external balances will inevitably be a component of recovery in the Asian countries, due to their need to service their outstanding foreign debt, as well as to offset the contraction in domestic demand. The industrial countries should expect their trade deficits with these countries to widen in the next few years as an unavoidable aspect of the global adjustment process induced by the Asian crisis and a necessary component of the Asian countries' recoveries. A weak yen shifts this adjustment primarily onto the US and Western Europe. In this respect, there is need for burden-sharing, and the industrialized economies should consider consultation and a coordinated macroeconomic response to this emerging situation.

With regard to the US, developments in Japan could have significant adverse effects on output and employment in the engineering-intensive sectors of motor vehicles and parts, electronics, and machinery. Noland (1996, 1997) has shown that the single biggest predictor of bilateral trade conflict is bilateral balances. Moreover, the likelihood of conflict is greater when the imbalances are concentrated, especially in sectors with relatively few producers and hence low coordination costs for political lobbying. The results indicate that adjustment in Japan could generate large increases in the bilateral imbalances in engineering-intensive sectors such as motor vehicles would appear to be a recipe for trade conflict.

What, then, should Japan do? The first-best solution would be to use macroeconomic tools to generate domestic demand-led growth. This would lead to both rising incomes in Japan and an appreciating real exchange rate. Moreover, this scenario would have the direct effect of boosting welfare in Japan, while taking adjustment pressure off other areas (most notably Western Europe and the US which would both experience improvements in their external balances of more than $50 billion). Unfortunately, for both economic and political reasons, this scenario appears to be the least likely outcome.

Finally, we examine the possibility that China devalues the reminbi in the event of a financial panic in Japan. Our model suggests that a relatively modest depreciation on the order of five percent in real terms would be sufficient to restore China's pre-crisis external balances. Of course, there is no guarantee that a Chinese devaluation would be modest, nor is there any guarantee that it would not set off another round of competitive devaluations in the region and possibly across the globe. Consequently, China should focus less on exchange rate policy and, instead, address the underlying macro- and microeconomic reform challenges, largely domestic in nature, that it faces.

Annex: Model Summary

In each regional model, production is characterized by a two-level nesting of constant elasticity of substitution (CES) functions. At the first level, firms are assumed to use two types of inputs, a composite primary factor and an aggregate intermediate input, with a CES cost function. At the second level, the split of intermediate demand is assumed to follow a Leontief specification, with no substitution among intermediate inputs. Technology in all sectors exhibits constant returns to scale. Output is sold on the domestic market or exported to other regions according to a constant elasticity of transformation (CET) function.16

Agents in each region view products from different regions as imperfect substitutes (the Armington assumption). The private household in each region maximizes a Stone-Geary utility function over the 14 composite goods, subject to their budget constraints, which leads to the Extended Liner Expenditure System (ELES) of household demand functions. Household savings are treated as demand for future consumption goods (Howe 1975). An economywide consumer price index is specified as the price of savings. It represents the opportunity cost of giving up current consumption in exchange for future consumption (Wang and Kinsey 1994). Government spending and investment decisions in each region are based on Cobb-Douglas utility functions, which generate constant expenditure shares for each composite commodity. In each region, intermediate inputs of firms, household consumption, government spending, and investment demand constitute total demand for the same Armington composite of domestically produced and imported goods from different sources. A two-level nested CES aggregation function is specified for each composite commodity in each region. Total demand is first divided between domestically produced and imported goods. Then the expenditure on imports is further divided according to the geographical origin under the assumption of cost minimization. Complete trade flow matrices for all trade partners are part of the model solution.

There is an international shipping industry in the model to transport products from one region to another. Each region is assumed to allocate a fraction of the output of its transportation and service sector to satisfy the demand for shipping which is generated by interregional trade. The global shipping industry is assumed to have a unitary elasticity of substitution among supplier sources. This means that the margins associated with this activity are commodity/route specific. In equilibrium, the total value of international transportation services at the world price equals the sum of the export proportions of the service sector's output from each region.

The government in each region is assumed to impose import tariffs, export subsidies, and indirect taxes, all in ad valorem terms. Tariff and tax (subsidy) rates vary by sector and by destination. Quantitative restrictions on trade are converted to tariff-equivalents.

In all, the model has around 17,000 equations and endogenous variables. A complete algebraic statement of the model is presented in Noland, Liu, Robinson, and Wang (1998), appendix A.

Table 1. CHANGE IN GLOBAL TRADE BALANCES (billions of dollars)

  United States Western Europe Australia and New Zealand Japan China Asian NIC's Asian LDC's Other

Scenario 1
Asian adjustment through December 1998, except Japan
-34.6 -50.4 8.2 -33.1 -11.0 44.0 107.7 -30.8
Scenario 2
30 percent Japanese depreciation plus 3 percent productivity gain
-96.4 -120.4 3.7 184.9 -21.0 10.5 89.2 -50.6
Scenario 3
20 percent Japanese depreciation plus 4 percent productivity loss
-79.5 -100.0 4.1 135.2 -19.9 17.7 92.4 -50.1
Scenario 4
5 percent Chinese depreciation plus
Scenario 3
-82.9 -105.2 3.7 132.4 0.3 14.3 90.7 -53.3
Scenario 5
20 percent Japanese appreciation plus 1 percent productivity gain
17.0 4.3 13.1 -230.0 0.2 75.7 126.9 -7.2

Table 2. U.S. CHANGE IN OUTPUT FROM THE BASE (percentages)

  Scenario 1 Scenario 2 Scenario 3 Scenario 4 Scenario 5

Agriculture -1.0 -0.8 -0.9 -1.1 -1.1
Processed Food -0.1 0.2 0.1 0.1 -0.3
Forestry and Fishery -1.4 -2.1 -2.1 -2.3 -0.6
Mining -0.5 -1.0 -0.9 -1.0 -0.1
Energy 0.0 0.2 0.0 0.0 -0.1
Textile and Apparel -0.6 -0.6 -0.6 -0.9 -0.6
Light Manufactures -0.8 -1.3 -1.2 -1.5 -0.5
Intermediate Goods -0.5 -1.9 -1.5 -1.6 0.7
Motor Vehicles and Parts 0.2 -7.8 -4.9 -4.8 5.2
Other Transportation Equipment -0.9 -2.6 -2.0 -2.0 0.1
Electronics -1.7 -6.2 -4.8 -4.9 1.9
Machinery -1.6 -7.9 -5.9 -6.1 3.3
Housing and Construction 0.5 1.7 1.4 1.4 -0.4
Services 0.3 1.1 0.8 0.9 -0.4


  Scenario 1 Scenario 2 Scenario 3 Scenario 4 Scenario 5

Agriculture -0.1 2.7 -1.6 -1.6 -0.6
Processed Food 0.2 0.0 -2.8 -2.8 1.7
Forestry and Fishery -0.8 4.6 -1.3 -1.5 -2.7
Mining -0.5 3.8 -3.5 -3.5 -0.3
Energy -0.6 6.8 -1.3 -1.4 -3.0
Textile and Apparel -0.3 5.4 -0.4 -0.7 -1.8
Light Manufactures -0.3 6.2 -2.1 -2.3 -1.0
Intermediate Goods -0.6 7.1 -1.0 -1.1 -2.7
Motor Vehicles and Parts -1.6 28.2 12.4 12.4 -15.2
Other Transportation Equipment -1.6 31.3 13.9 13.7 -15.9
Electronics -0.3 9.3 0.7 0.7 -3.5
Machinery -2.1 15.7 5.3 5.0 -11.2
Housing and Construction 0.9 -3.5 -8.3 -8.2 6.7
Services 0.4 0.3 -6.1 -6.0 3.4


  Scenario 1 Scenario 2 Scenario 3 Scenario 4 Scenario 5

Agriculture -3.9 -2.7 -3.0 -3.0 -4.9
Processed Food -5.8 -4.0 -4.5 -4.4 -7.4
Forestry and Fishery -2.9 -2.6 -2.8 -2.9 -2.9
Mining -6.0 -4.5 -4.8 -4.7 -7.6
Energy -2.5 -2.2 -2.4 -2.5 -2.5
Textile and Apparel 5.4 3.5 4.0 3.0 6.8
Light Manufactures 4.0 2.6 2.7 2.0 5.3
Intermediate Goods 1.8 -1.1 -0.2 -0.6 4.1
Motor Vehicles and Parts 3.6 3.5 4.0 4.3 2.5
Other Transportation Equipment 11.4 10.4 11.1 10.9 10.8
Electronics 3.0 1.0 1.5 1.5 5.0
Machinery 3.9 0.1 1.2 0.8 6.9
Housing and Construction -12.7 -5.4 -7.3 -6.8 -19.0
Services -5.3 -3.2 -3.9 -3.7 -7.2


  Scenario 1 Scenario 2 Scenario 3 Scenario 4 Scenario 5

Agriculture -5.0 -4.6 -4.6 -4.7 -5.5
Processed Food -8.0 -7.0 -7.2 -7.2 -9.1
Forestry and Fishery -5.3 -5.4 -5.4 -5.6 -5.1
Mining -6.5 -6.0 -6.4 -6.4 -6.7
Energy -4.2 -4.4 -4.7 -4.8 -3.4
Textile and Apparel 12.5 11.6 11.9 11.4 13.3
Light Manufactures 9.8 8.7 8.8 8.5 10.5
Intermediate Goods -1.1 -1.8 -1.6 -1.7 -0.6
Motor Vehicles and Parts -11.7 -12.5 -11.6 11.3 -14.4
Other Transportation Equipment 6.7 8.0 7.9 8.0 4.8
Electronics 5.1 3.4 3.8 3.8 6.8
Machinery 3.9 6.2 5.3 5.2 2.0
Housing and Construction -38.7 -31.4 -33.2 32.7 -45.5
Services -16.4 -13.8 -14.6 14.4 -18.8


  Scenario 1 Scenario 2 Scenario 3 Scenario 4 Scenario 5

Agriculture 0.4 1.8 1.5 0.3 -0.8
Processed Food 0.2 1.5 1.2 0.0 -0.9
Forestry and Fishery 0.0 1.0 0.7 -0.3 -0.7
Mining 0.3 1.5 1.1 0.3 -0.6
Energy -0.3 0.0 -0.2 0.0 -0.3
Textile and Apparel -1.5 -4.0 -3.5 0.1 1.0
Light Manufactures -1.7 -3.6 -3.4 1.2 0.1
Intermediate Goods -0.7 -2.0 -1.6 -0.3 0.5
Motor Vehicles and Parts 0.5 -3.0 -1.7 0.2 2.3
Other Transportation Equipment -1.0 -2.3 -1.7 2.2 -1.0
Electronics -0.8 -2.5 -2.1 0.9 0.8
Machinery -0.2 -3.8 -2.6 -0.9 2.5
Housing and Construction 2.2 5.5 4.6 0.7 -0.7
Services 0.5 1.7 1.3 0.5 -0.4

Table 7. CHANGE IN KEY BILATERAL TRADE BALANCES (billions of dollars)


Scenario 1
Asian adjustment through December 1998, except Japan
-2.0 0.2 -14.7 -16.8 0.7 -13.7 -25.7 -4.7 -5.3
Scenario 2
30 percent Japanese depreciation plus 3 percent productivity gain
-62.7 -0.8 -15.8 -16.9 19.8 16.3 -8.3 -1.1 -4.7
Scenario 3
20 percent Japanese depreciation plus 4 percent productivity loss
-46.3 -0.5 -15.4 -16.9 15.9 10.0 -11.2 -2.2 -4.9
Scenario 4
5 percent Chinese depreciation plus Scenario 3
-46.4 -4.3 -15.3 -16.7 12.1 10.1 -10.9 1.1 -3.8

Scenario 5
20 percent Japanese appreciation plus 1 percent productivity gain

48.7 1.1 -13.9 -16.9 -18.0 -42.0 -43.8 -7.5 -5.8

Table 8. CHANGE IN U.S.-JAPAN TRADE BALANCE FROM THE BASE (billions of dollars)

  Scenario 1 Scenario 2 Scenario 3 Scenario 4 Scenario 5

Agriculture -0.1 -1.1 -0.9 -0.9 0.8
Processed Food -0.3 -1.4 -1.2 -1.2 0.9
Forestry and Fishery -0.2 -0.6 -0.6 -0.6 0.2
Mining -0.1 -0.6 -0.5 -0.5 0.4
Energy 0.0 -0.3 -0.3 -0.3 0.3
Textile and Apparel 0.0 -0.7 -0.5 -0.5 0.5
Light Manufactures -0.1 -3.4 -2.5 -2.4 2.5
Intermediate Goods -0.2 -4.8 -3.9 -3.9 4.5
Motor Vehicles and Parts -0.4 -21.7 -14.5 -14.5 14.1
Other Transportation Equipment 0.0 -3.2 -2.3 -2.3 2.7
Electronics 0.2 -7.5 -5.3 -5.3 6.8
Machinery 0.1 -15.7 -11.4 -11.4 14.0
Housing and Construction 0.0 0.0 0.0 0.0 0.0
Services -0.8 -3.8 -3.9 -4.0 2.5


  Scenario 1 Scenario 2 Scenario 3 Scenario 4 Scenario 5

United States -1.0 -0.8 -0.9 -1.0 -1.1
Western Europe -0.4 0.2 0.0 -0.1 -0.8
Australia and New Zealand 2.1 2.4 2.3 1.9 2.1
Japan -0.1 2.7 -1.6 -1.6 -0.6
China 0.4 1.8 1.5 0.3 -0.8
Asian NIC's -3.9 -2.7 -3.0 -3.0 -4.9
Asian LDC's -5.0 -4.6 -4.6 -4.7 -5.5
Other -0.1 0.3 0.2 0.2 -0.4


  Scenario 1 Scenario 2 Scenario 3 Scenario 4 Scenario 5

United States -4.4 -5.7 -5.4 -6.1 -2.9
Western Europe -2.7 -2.2 -2.3 -3.2 -2.9
Australia and New Zealand 4.5 4.6 4.6 3.6 4.8
Japan -8.6 53.7 24.0 22.3 -39.1
China -9.7 -15.1 -13.7 -2.9 -4.3
Asian NIC's 9.3 -2.7 -3.0 -3.0 17.6
Asian LDC's 36.6 29.3 31.1 30.3 43.6
Other -3.1 -3.3 -3.3 -3.8 -2.7


  Scenario 1 Scenario 2 Scenario 3 Scenario 4 Scenario 5

United States 2.9 2.8 2.7 2.7 3.3
Western Europe 1.8 1.8 1.7 2.0 1.9
Australia and New Zealand -4.7 -4.4 -4.7 -4.9 -4.4
Japan 2.1 -14.2 -10.5 -10.2 18.7
China 5.7 9.4 8.4 0.3 2.7
Asian NIC's -12.6 -7.9 -9.3 -8.7 -16.6
Asian LDC's -25.9 -22.0 -23.0 -22.8 -29.3
Other 2.2 2.7 2.6 2.9 1.7


Howe, Howard. 1975. "Development of the Extended Linear Expenditure System from Simple Saving Assumptions." European Economic Review, 6: 305-10.

Krugman, Paul R. 1998a. "It's Baaack: Japan's Slump and the Return of the Liquidity Trap." Brookings Papers on Economic Activity 1998: 2. Forthcoming.

Krugman, Paul R. 1998b. "Japan's Trap." (May 1998)

Krugman, Paul R. 1999. "Japan Heads for the Edge." Financial Times, 20 January.

Krugman, Paul R. 1998c. "Further Notes on Japan's Liquidity Trap."

McKibbin, Warwick. 1998. "The Crisis in Asia: An Empirical Assessment." Brookings Discussion Paper in International Economics No. 136. Washington: Brookings Institution.

Meltzer, Allan. 1998. "Time To Print Money." Financial Times, 17 July 1998.

Makin, John. 1998. "Mr. Greenspan's Dilemma." Washington: American Enterprise Institute for Public Policy Research (August).

Noland, Marcus. 1996. "Trade, Investment, and Economic Conflict Between the US and Asia." Journal of Asian Economics 7, :no. 3: 435-58.

Noland, Marcus. 1997. "Chasing Phantoms: The Political Economy of USTR." International Organization 51, no. 3: 365-88.

Noland, Marcus, Li-Gang Liu, Sherman Robinson, and Zhi Wang. 1998. The Global Economic Effects of the Asian Currency Devaluations. Washington: Institute for International Economics.

OECD. 1998. Economic Survey. November. Paris: OECD.

Posen, Adam. 1998. Restoring Japan's Economic Growth. Washington: Institute for International Economics.

Wang, Zhi, and Jean Kinsey. 1994. "Consumption and Saving Behavior under Strict and Partial Rationing." China Economic Review, 5: 83-100.

Wren-Lewis, Simon, and Rebecca L. Driver. 1998. Real Exchange Rates for the Year 2000. Washington: Institute for International Economics.


1. See Krugman (1998a) for an analysis of these issues.

2. An internationally coordinated interest rate cut could stabilize nominal (and real) exchange rates and might mitigate some of the pure yen depreciation effects modeled in this paper.

3. The model is fully specified in Noland, Liu, Robinson, and Wang (1998), appendix A. A brief description is contained in the annex of this paper.

4. McKibbin (1998) reports a model that explicitly models financial markets in an intertemporal context. However his model ignores much of the underlying structural change that our model captures.

5. The regions in the model are: the United States (USA), Canada (CAN), Mexico (MEX), Western Europe (WEU), Australia and New Zealand (OCN), Japan (JPN), South Korea (KOR), Taiwan (TWN), China and Hong Kong (CHN), Indonesia (IDN), Thailand (THA), the Philippines (PHL), Singapore (SGP), Malaysia (MYS), South Asia (SAS), Latin America and the Caribbean countries (LTA), and the rest of the world (ROW). For the purposes of this paper, we report results for eight groups: combining Korea, Taiwan, and Singapore into the Asian newly industrialized countries (NICs); Indonesia, Malaysia, the Philippines, and Thailand into the Asian less developed countries (LDCs); and adding LTA, CAN, SAS, and MEX to ROW.

6. The sectors are agricultural products, processed food and beverages, forestry and fisheries, mining, energy, textile and apparel, light manufactures, industrial intermediates, motor vehicles and parts, other transportation equipment, electronics, machinery, housing and construction, and services.

7. Skilled workers are defined as International Labor Office (ILO) International Standard Classification of Occupations (ISCO) occupation groups 0-2 (Professional; Technical and related workers; Administrative and managerial workers). The remainder-ISCO 3-5 (Clerical and related workers; Sales workers; Service workers), ISCO 6 (Agricultural workers), and ISCO 7-9 (Production and related workers; Transport equipment operators; Laborers)-are classified as unskilled.

8. Formally, the consumer price index is the "numeraire" price index for each region, and the US exchange rate is selected as the "numeraire" for world prices.

9. For another application of this notion, see Wren-Lewis and Driver (1998).

10. The real exchange rate and total factor productivity (TFP) shocks are Thailand (-25% devaluation, -5% TFP); Malaysia (-25, -5); Indonesia (-30, -10); the Philippines (-25, -5); South Korea (-15, -5); Taiwan (-5, 0); Singapore (-5, 0); and Oceania (-10; 0). Noland, Liu, Robinson, Wang (1998) discuss the difficulties in calibrating these shocks and summarize results derived from sensitivity analyses.

11. Of course it is quite possible that once the decision was made to devalue, China might implement a devaluation far in excess of that necessary to re-attain its pre-crisis trade balance.

12. It is noteworthy that Western Europe actually experiences a larger deterioration in its trade balance than the US. This is because Western Europe is larger than the US and its trade ties with Asia are larger than commonly assumed. However the model also embodies parameters that reflect secular responses to changes in variables. It is quite possible that in a crisis situation, firms facing an imperative to boost exports rapidly will look to large, wealthy, relatively open, English-speaking markets, namely the US and possibly the United Kingdom, first. In this sense the model's results may overstate the impact on Western Europe and understate the impact on the US.

13. For convenience, we model quantitative barriers to trade as their tariff-equivalents. This could affect our results by overstating adjustment in sectors, such as agriculture and textiles and apparel, where nontariff barriers are ubiquitous. If adjustment cannot occur in these sectors, adjustment will be forced onto sectors in which quantitative barriers to trade are not present.

14. To reiterate, nontariff barriers have been converted into tariff-equivalents and treated as tariffs in this model. It could be the case that the Multi-fibre Arrangement could constrain China's ability to expand exports. In this case, either more exports would be generated by other labor-intensive manufacturing sectors, or a larger devaluation would be necessary to reattain the pre-crisis trade balance.

15. In reality, Australia accepted a large devaluation, while New Zealand did not.

16. The CET function can be turned off for particular sectors. For these sectors, exports and domestic sales are assumed to be perfect substitutes, with the same price.