Currency composition of debt, risk premia and the 1997 Korean crisis

This paper analyses the behaviour of the interest rate differential in the 1997 Korean crisis. Its decline prior to the crisis suggests that investors did not anticipate the crisis. Using a simple portfolio balance model, we show the currency risk premium to be positively related to the relative supply of won-denominated corporate financial debt. The empirical estimates support this relationship and attribute the decline of the interest differential prior to the Korean crisis to the significant fall in the relative volume of won-dominated corporate debt during that period. When we control for the latter effect in the risk premium, the adjusted differential reveals that prior to the Korean crisis, devaluation expectations were much higher than that implied by the observed interest differential.