The Asian Financial Crisis: An East Asian Perspective

The Asian Financial Crisis:An East Asian Perspective

Jesus P. Estanislao, George N. Manzano and Gloria O. Pasadilla*

Two views dominate the academic discussion of the root cause of the Asiancrisis: the ‘panic–illiquidity’ view and the ‘moral hazard–structural’ view. Thispaper traces the factors that contributed to the build-up of financialvulnerabilities across the affected economies and compares these two accountsof the crisis. The paper argues that the two views are complementary in thatpolicy prescriptions derived from one that disregard the prescriptions from theother would be incomplete. It summarises the medium and long-termpost-crisis policy directions at the national, regional and international levels.

While a large number of explanations have beenoffered for the Asian crisis, two competingexplanations dominate the debate.1 Onesuggests that the Asian financial crisis was aconsequence of panic-induced illiquidity ofcapital markets, the other that the crisis was aconsequence of latent structural defects, manyinduced by incentives to take excessive risks.Both concur that there were significant eco-nomic weaknessess in Asia prior to the crisisand that both panic and moral hazard werepresent, but they differ as to the core factors thatsparked the upheaval.2

The divide between the two views extends tomajor policy implications for the post-crisisglobal financial environment. The panic camphas for its major policy focus the reform of theinternational financial system whose inherentinstability was spotlighted in the Asian crisis.Proposals for an international lender of last

resort or an international bankruptcy court areuppermost in its prescriptions. The moralhazard camp, on the other hand, focuses onremoving the incentives that gave rise to thevulnerabilities. It proposes arms-length relationsbetween banks and firms, increased trans-parency, stronger corporate governance, etc.

The two explanations differ from earliermodels in their emphasis on financial sectorfragilities. Three versions of the speculativeattack model can be identified. The first (Krugman1979; Flood and Garber 1984) emphasised themonetisation of fiscal deficits through depletionof international reserves. Once reserves reach acritical threshold below which the governmentis unable to defend the exchange rate, acurrency attack becomes increasingly likely.This explanation does not seem to apply inAsia because these economies did not sufferfrom massive fiscal deficits. Indeed, Asian

* Professor and Assistant Professors, respectively, University of Asia and the Pacific, Manila, Philippines. The authorsacknowledge the very generous comments and suggestions of Ramon Moreno, Associate Director of the Center for PacificBasin Studies, Federal Reserve Bank of San Francisco. All remaining errors are our own.

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1 Another feature to which the financial crisis has been attributed is ‘cronyism’ (Hughes 1999), the use of public authorityand power to limit access to markets and resources to a selected few. Cronyism favours mutual benefits at the expense oftransparency and fair business practice. It created serious macroeconomic problems at the heart of the ‘Asian miracle’.

2 Some authors have made distinctions among types of causes. Furman and Stiglitz (1998), for example, classify causationas either stochastic or nonstochastic. Hill (1999) distinguishes ‘core’ causes from ‘exacerbating’ causes.

governments had beenaccumulating surplusesprior to the crisis.3

The second model ofspeculative attack arguesthat such attacks are likelyto succeed once the social and economic cost ofmaintaining the peg exceeds its benefits(Obstfeld 1994). This explains quite accuratelythe case of the European Monetary Union crisisin the early 1990s where the exchange ratemechanism was constraining appropriatesolutions for rising unemployment and sluggishgrowth across Europe brought about byGermany’s tight monetary policy. This couldnot be said of Asia, since, notwithstanding theexport slowdown, GDP growth across theregion was still respectable and unemploymentwas not increasing alarmingly.

Which perspective explains the Asian crisisbest? The next section discusses the two views.It argues that the complexity of the Asian crisisis such that no single model can fully explainthe phenomenon. Both views, therefore, meritclose scrutiny.

Panic and illiquidity

The panic story, simply told, is that thefrenzied haste to get out of the region resultedin costly asset liquidations, asset pricecollapses, domestic bank runs, and drying up ofcredit. According to adherents of this view,economic fundamentals in crisis countries,including government policies, may not havebeen satisfactory but the required correctionsdid not need to be of crisis proportions. Realexchange rates, for instance, were only slightlyover-valued; again, firm insolvency can hardlybe attributed to high leverage in the region,since there was only a small change in worldinterest rates. The crisis took place because of

an adverse shift in marketexpectations that can beprecipitated by almostanything—collapse of abig bank, political turmoilor lacklustre export per-

formance. Market expectations, therefore, are akey to the understanding of crises (Chang 1999).

On this interpretation, the essence of theAsian financial crisis is no different from aclassical bank run (Diamond and Dybvig 1983),except that it is on an international scale. In theDiamond–Dybvig model, expectations that abank may go under can lead to a run by depositors.The run forces the bank to liquidate itsinvestments at a loss, pushes it to insolvency,and thus validates expectations that the bank isindeed bankrupt. Classical runs like this can bemitigated by the presence of a lender of lastresort that can restore confidence in the system.

In the case of Asia, the crisis was due more tocreditor reaction. International lenders, fearinga crisis, suddenly refused to roll over loans,exercised their options for early repayment, andwithdrew their funds from the domesticfinancial system. The lack of an effective lenderof last resort in the international capital marketmade capital flight more severe and morecontagious.

The investments that were liquidated at aloss may have been sound and profitable in thelong run. Thus, a key implication is that thecrisis did not need to happen and that theeconomic and financial vulnerabilities presentprior to the crisis could have been resolved inan orderly and less costly manner. In otherwords, one can find multiple equilibria in theconditions of many Asian countries—some ofthem good, others bad. But with panic, the badequilibrium was realised even though a goodequilibrium was possible (Fischer 1999a).4

The complexity of the Asiancrisis is such that no singlemodel can fully explain the

phenomenon

ASIAN-PACIFIC ECONOMIC LITERATURE

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3 Corsetti, Pesenti and Roubini (1998), a paper considered as a third generation model, emphasises prospective fiscal deficitscaused by financial sector collapse as the source of the currency collapse.

4 Theoretically, the root of a panic is a ‘co-ordination’ problem: Market players base their decisions less on objectivefundamentals and more on what they expect others will do. In the bank run model, once creditors think that an economyis going to default, they move to call back their loans. Had they co-ordinated their actions and jointly rolled over the loans,the bad equilibrium (actual default) would have been prevented. But since each lender thinks the others will run off, heis forced to do the same. Judging by the model, it is ‘rational’ for creditors not to continue giving out loans because tobehave otherwise imperils their own investments in the country. Such a co-ordination problem mirrors the inherent

One version of the panic hypothesis arguesthat a crucial condition for a country to besusceptible to financial panics is internationalilliquidity (Chang and Velasco 1997, 1998). Acountry is illiquid if its potential short-termobligations in foreign currency exceed theamount of foreign currency to which it hasaccess at short notice. Chang and Velascoobserved that the crisis in Mexico in 1994–95, asin Southeast Asia in 1997, occurred when theinternational liquidity positions of thesecountries deteriorated, as indicated by highlevels of short-term debt in relation to liquidinternational reserves. Using a probit model,Radelet and Sachs (1998a, 1998b) have shownthat a low short-term liabilities-to-reserves ratiowas strongly associated with the onset of acrisis. They also tested the relative strength ofvarious risk indicators in predicting a financialcrisis (Radelet and Sachs 1998b). A high ratio ofshort-term debt to short-term assets, privatecredit to GDP ratio, and capital inflow to GDPproved statistically very significant, the currentaccount to GDP ratio weakly significant, andreal exchange rate overvaluation insignificantin explaining the probability of a financial crisis.

Illiquidity is consistent with rapid financialliberalisation and credit booms. By allowingfreer access to international private fundingsources, financial liberalisation increases thepotential foreign currency short-term liabilitiesof banks, exacerbating potential illiquidity.Local banks in Asia—particularly in Thailand,Korea, and to some extent Malaysia—borrowedheavily offshore at short-term to take advantageof the differential between low internationaland high local interest rates under peggedexchange rates. These funds were subsequentlylent at home in local currency, leaving the banksto assume all the exchange risk and thedenominational mismatch in their balancesheets. Illiquidity plus the exchange risks madethe economies more prone to crises.5

Illiquidity can be aggravated by attempts todefend the currency from earlier speculativeattacks. Sachs and Wing (1999a) claim that

further drawdowns from international reservesresulting from these attempts seriouslyundermine the lender-of-last-resort function ofa central bank, making the economy morevulnerable to panic. Thailand was a case inpoint. Earlier attempts to defend the baht fromspeculation made it a heavy player in theforward market, bringing down uncommittedreserves from $39 billion to less than $20 billion.Thus, when the fatal attack came in July 1997, ithad no option left but to let the peg go.

An immediate implication of the panichypothesis is that the high interest rates, rapidbank closures and tight fiscal policies imposedby the IMF on Thailand and other affectedcountries were not called for. Rather, thesolution lies in finding ways to dispel panic; forinstance, calming the market by providing aco-ordinating (lender of last resort) function forall foreign creditors. They argue that a moreaccommodating monetary policy should havebeen pursued in place of a tight one because lowinterest rates allow firms to continue operating,abate bankruptcies and thus help confidence toreturn. Precipitate bank closures onlyexacerbate runs on the financial system.

Structural defects and moral hazard

The moral hazard view attempts to explain whyAsian economies like Thailand, Korea, andIndonesia reached degrees of vulnerability thatwere disasters waiting to happen. On thisexplanation, the root of the crisis lies in wrongincentives in the economy, brought about byimplicit or explicit government guarantees, bypolitical connections or by interlocking owner-ship structures leading to over-borrowing,over-lending and over-investment. Putdifferently, the moral hazard view maintainsthat the highly vulnerable financial systemswere an offshoot of many years’ accumulationof bad policies. These were glossed over whilethe going was good; some, ironically, were infact residues of the very industry and winner-

ESTANISLAO et al. — ASIAN FINANCIAL CRISIS

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instability of the international financial system.5 Demirgüç-Kunt and Detragiache (1998) show that banking crises are more likely in liberalised systems, especially those

with weak institutional environments such as lack of respect for the rule of law and a high level of corruption.

picking policy that propel-led these economies totigerhood.

According to this view,the severity of the crisiscannot be adequately explained by thepremature liquidation of assets suggested bythe panic hypothesis. Many projects—such asunder-subscribed, over-luxurious real estate—were, it is argued, only financed because of anunduly optimistic outlook on the economy andthe possibility of government bail-outs, butwere fundamentally unsound, as reflected indeclining returns on investments below the costof capital, as in the case of twenty of the thirtylargest conglomerates in South Korea (WorldBank 1998).

Corsetti, Pesenti and Roubini (1998a) presenta systematic articulation of the moral hazard–structural view. Their model demonstrates that,given public guarantees of bail-outs, foreigncreditors are willing to lend to unprofitableprojects and cover cash shortfalls of these firms.This practice could lead to over-lending andover-risky projects as well as persistent andunsustainable current account deficits. Thoughthe liabilities may be manageable in the presenceof mild shocks, they become insurmountable inthe face of a sizeable macroeconomic shock. Inthis literature, what these shocks are dependson different models. McKinnon and Pill (1998),for instance, consider a devaluation to be macro-economic shock that can drive over-leveragedbanks to bankruptcy. On the other hand,Corsetti, Pesenti and Roubini (1998a) define ashock as anything that diminishes the govern-ment’s capacity to bail out guaranteed firms,thus precipitating a systemic retreat of foreigncreditors. This includes, for instance, high fiscaldeficits or poor exports. Krugman (1998a)explains that these shocks can trigger adownward spiral of asset prices that ends inbankruptcy. Meanwhile, the government’sguarantee of the outstanding external debts,causes it, over time, to incur short-term liabilitiesthat threaten to exceed its internationalreserves, fuelling expectations of future

monetisation of thedeficit. The expectation ofinflationary financingcauses the collapse of thecurrency, as in the first

currency model (Krugman 1979), andeventually a financial crisis.

Moral hazard has been identified at thecorporate, financial and international level. Atthe corporate level, moral hazard arises whengovernments extend guarantees to promote bothpublic and private investment by eliminatingcertain risk components. Because of suchguarantees, government owned and controlledfirms that are supported by subsidies take onrisks that private corporations would notnormally assume without insurance. In the samevein, private corporations that are recipients ofpreferential lending and regulatory treatmentby virtue of political relationships tend to takeon imprudent risks. Then there are investmentsthat are made to advance government policyobjectives rather than business objectives(Moreno, Pasadilla and Remolona 1998).

In the financial sector, moral hazard arisesbecause banks (unlike other firms), because oftheir special function in the economy, have animplicit bail-out guarantee from the govern-ment. Since banks reap the benefits of highreturns but do not necessarily absorb all thelosses in bad times, they are encouraged to takeon very high risk projects.6 These projects arevalued and traded according to their highestpossible returns (‘Pangloss value’), leading toasset price inflation. When things take a turn forthe worse and the cost of guarantees becomesapparent, no further bail-out can be expectedbecause government resources are not infinite.The result is a vicious circle of asset price deflationwhich magnifies losses and undermines banks.The collapse of banks, in turn, ratifies the dropin asset prices.

A distinct interpretation of moral hazardarising from financial sector guarantees issuggested by McKinnon and Pill (1998).Problems arise when, in ‘euphoria’ over goodeconomic conditions, low world interest rates

Moral hazard can best beseen as the underlying

cause . . .


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6 Krugman (1998a) refers to investments with ‘fat right tails’; that is, investments that could yield high returns if the investorwas lucky, but might also incur heavy losses.

and fixed exchange rates,local banks over-borrowabroad without hedgingthese foreign exposures.In the event of a de-valuation, banks suffer massive capital lossesbecause the value of their assets denominatedin local currency falls relative to the value oftheir liabilities which are denominated inforeign currencies.

At the international level, moral hazard arosewhen international creditors over-extendedcredit to Asian countries in the belief that theIMF would bail out any troubled economies, asit had done in Mexico a few years earlier.Creditors were fully secured as they stood toreap high returns while the bubble held and, inthe event of a bust, they could recoup theirmoney from the bail-out funds expected fromthe international community.

The moral hazard view is consistent with thefacts of financial liberalisation, as interest rateswere deregulated and entry and competition inthe financial sectors promoted before the crisis.It also tallies with the credit boom that precededthe crisis. By eliminating controls and regulations,financial liberalisation allowed borrowers totake excessive risk and engage in unprofitableactivities (ADB 1999; Chang 1999).

The policy implications of this view includegreater financial transparency and a show ofresolve to undertake structural reforms throughclosure of insolvent institutions, mergers, orrecapitalisation. In contrast to the panic view’srecommendation, the moral hazard campconsiders an accommodating monetary policyand lender of last resort function quiteincompatible because of the risk that increasedlending may merely be gambled away.

Contagion

The two views of the causes of the Asianfinancial crisis need not be mutually exclusive.Post-crisis policy changes incorporate impli-cations of both views. Moral hazard can best beseen as the underlying cause without which thepanic reaction would not have occurred.

Self-fulfilling expect-ations and herd behaviourexplain sudden jumpsfrom one equilibrium toanother, making it difficult

to predict a crisis (Osband and Rijckeghem1999). Such sudden jumps among differentequilibria, however, can only exist in a certainzone of vulnerability (Obstfeld 1994; Flood andMarion 1998). Panic is not the only explanationof contagion. Financial linkages, through directinvestment, bank lending and capital marketactivities, can explain the almost simultaneouscollapse of the currencies. Events in one countryled market participants to revise their model ofdevelopment in East Asia which then negativelyaffected asset prices in a larger group ofcountries. Trade links provide anotherexplanation for the spread of crises that isindependent of panic arguments. But panic isthe most plausible explanation for the rapidspread of the crisis to other countries.

How do crises spread? Why did the collapseof the baht deeply affect some Asian countriesbut not others? Why were Singapore, Taiwanand Hong Kong largely spared the direconsequences that befell Indonesia and Korea?

Two points of view compete to explain thecontagion phenomenon: one focuses on regionaltrade links (Glick and Rose 1998), the other oncommon fundamentals (Tornell 1999). The firstargues that since countries in the same regiontend to have similar trade structures, a currencydevaluation in one country necessarily lessensthe competitiveness of the other countries, andthus forces a similar devaluation in others tomaintain competitiveness. Alternatively, sinceintra-regional trade among the affected Asianeconomies accounts for almost 40 per cent oftheir total exports, decline in import demand inone country leads to decline in exports inanother. This argument explains why recentcrises like the Tequila and the Asian crisis havetended to be regional in their adverse effects.

The other view is that currency crises spreadto countries which have common funda-mentals. In the Asian crisis, as in the Mexican,countries badly affected were those with similarmacroeconomic characteristics: credit booms,

...without which the panicreaction would not have

occurred


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real exchange-rate appreciation prior to thecrisis, and high ratios of short-term debt toreserves (Tornell 1999). This view is close to thepanic theory but fails to explain why the effectshave been quite different, for instance, forThailand and Indonesia, on one hand, and thePhilippines and Malaysia, on the other. All thesecountries had experienced credit booms as aresult of financial liberalisation, real exchange-rate appreciation and rising short-termliabilities, but Indonesia, obviously, paid thehighest price in the crisis.

Other reasons for contagion are discussed inIMF (1998). One reason, along the ‘fundamental’line of analysis, is that crises stem from acommon cause—an external event, such as risein world interest rates. These are referred to as‘monsoonal’ effects. But though these eventsmay trigger a crisis, the domestic weaknesses,such as over-borrowing for unproductive uses,have a lot more to do with the extent of thecontagion. Another avenue for contagion isthrough the inter-dependence of creditors’portfolios or capital or trade market linkages(see also Glick and Rose 1998). Further, a crisisin one country may lead creditors to re-assessthe fundamentals of other countries, or maylead creditors to reduce the riskiness of theirportfolios and ‘flee to quality’ (Tornell 1999).

The primary reason for the calamitous effectin Indonesia is beyond economics. It is political,even though crony capitalism (Hughes 1999)undoubtedly also played a big role. In Malaysiaand the Philippines, a relatively strong financialsystem appears to be the reason why these twocountries remained relatively unscathed. Theywere not able to escape the contagion, buteventually, as panic behaviour subsided,market participants recognised the countries’relative financial sector strength. This helpedminimise the severity of the speculative attack.Similarly, Hong Kong, Singapore and Taiwanwere less affected because of the strength oftheir financial systems. A strong regulatorystructure prevented severe maturity mis-

matches and high levels of debt as a percentageof GDP (Athukorala and Warr 1999).7

Policy implications

If short-term and longer-term factors havecombined to bring about the East Asianfinancial crisis of the late 1990s, and to make itso severe and widespread, then the solutionneeds to be multi-dimensional as well. Forshort-term illiquidity, there has to be a practicaland quick response designed to restoreliquidity. Credit lines have to be restored. Tradefinance has to be provided. Reserves have to beincreased. Some degree of stability has to besecured in the foreign exchange market.

These are the conventional elements of anypackage put together in response to a financialcrisis. The IMF put these elements together forseveral East Asian economies much as it hasalways done when called upon to rescue aneconomy in crisis.

The IMF package has been criticised, as italmost always is, not so much for what it triedto do to return liquidity but for being too severe,with too little money actually flowing in, andthen only after protracted negotiations(therefore, too late). It has also been regarded astoo blunt, unable to differentiate the characterof the East Asian crisis from other types offinancial crisis (such as the Latin Americanones) nor the segments upon which the burdenof adjustment should fall. Too many elementswere included and too much importance wasattached to long-term structural reforms.

The IMF has admitted that its initialprescriptions—such as the imposition of a tightfiscal surplus to GDP ratio—may have been toosevere. But where this has been the case, the IMFin time flexibly relaxed the requirement. Thatthe return of money into the crisis-affectedeconomies was too little and too late is a chargethat cannot be laid at the door of the IMF alone,since it was the responsibility of thoseeconomies, through the fulfilment of IMF


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7 Athukorala and Warr (1999) show that the crisis countries (Thailand, Malaysia, Philippines, Korea, and Indonesia) exhibitdistinctively higher ratios of short-term liabilities to reserves, private sector outstanding loans to GDP, and short-term tolong-term debt from non-crisis economies. The difference between crisis and non-crisis countries’ economies was notdefinitive as regards real exchange rate appreciation.

conditionalities, to seethat the flow was goingtheir way. The real problemwas one of credibility. Thishad to be regained. But itcould be regained only ifthe longer-term factors, the structuralweaknesses that had been developing in thecrisis-affected economies, were in fact ad-dressed. Many of these factors are embedded inthe economic, political and social structures ofthese economies, and changing them demandeda strong political will. That this is a matterbeyond the purview and power of the IMF hasled to appreciation of its limitations.

The conventional package of measures didwork out in East Asia in the late 1990s. After theinitial exchange rate and interest rateadjustments, some stability returned to thecrisis-affected economies. They had to gothrough the pains of a severe recession, whichhurt the local people, not the internationalcreditors who generally benefited from the IMFbail-out. Money started to flow back from inter-national financial markets, and after someadjustments, domestic recovery began.

Despite the onset of recovery, the challengeof properly managing macroeconomic risks stillhad to be faced. As Athukorala and Warr (1999)have pointed out, in East Asia this means moreprudent expansion of credit, greater flexibilityin exchange rate management, better dis-cernment (or tighter control) over the flow andvolume of short-term funds and a higher levelof free reserves relative to short-term foreignexchange liabilities.

But there are also serious microeconomicrisks that still have to be faced. The balancesheets of financial institutions have to becleaned up. Some of these institutions have tobe restructured. Supervision has to be tightenedin line with the core principles adopted by theBank for International Settlements. Riskmanagement systems have to be modernisedand corporate governance reformed in line withthe principles formulated by the OECD.

Nor can the reforms stop with financialinstitutions. They must also extend to theborrowers. At enterprise level, the same

program has to be under-taken, involving theclean-up of books and anoverall restructuring andmodernisation of riskmanagement and corpor-

ate governance.Bergsten (1999) has noted that, in the wake

of the East Asian financial crisis, there hasbeen an upsurge of efforts towards regionalconsultation and co-ordination. These effortshave ranged from a modest attempt at jointmonitoring of macroeconomic performance tothe ambitious suggestion of an Asian MonetaryFund (Rajan 1999). There has been a pre-sumption that the crisis-affected economies inEast Asia would henceforth be more open toshare information and look for practical stepsforward in regional financial co-operation. Thispresumption remains to be tested since thearrangements are in their initial phase. Otherproposals are under preliminary discussion(IIMF–TDRIF 1999).

The discussion features capital controls, suchas those that were imposed by Malaysia. Thesewere temporary measures, taken in crisisconditions, when continued outflows threatenedexchange rate stability. They were a challengeto the view of the IMF, which was activelypromoting further liberalisation of the capitalaccount when the East Asian crisis had juststarted in 1997. Rogoff (1999) has argued that, ifenforced cleanly and transparently, capitalcontrols are not open to strong objections. Theinitial results of the Malaysian experimentappear to vindicate the view of those who allowfor strong measures, taken under clearlydefined conditions, in extreme circumstances(Krugman 1999a). However, Corsetti, Pesentiand Roubini (1998b) warn that even temporarycontrols are potential sources of distortion.Once imposed, they are difficult to lift becauseof the influence of strong political lobbies.Calvo, Leiderman and Rheinhart (1996) alsomake the point that capital controls tend in thelong run to be ineffective in regulating foreigncapital flows since market participants can findways to circumvent the rules. Johnston (1998)fears that the benefits of capital control tend to

The IMF has admitted that itsinitial prescriptions may have

been too severe


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be eroded quickly,depending on their scopeand the level of sophis-tication of financial instru-ments and financialmarkets. He warns, forexample, that financial derivatives could beused to circumvent capital controls. TheMalaysian experience bears closer scrutiny,since it appears to have achieved the desiredresults. Although Malaysia did not follow theconditions indicated by Krugman (1999a), itdisplayed enough flexibility to make changesand remove restrictions before distortions hadtime to develop.

More market-friendly capital controls, suchas the Chilean taxation of short-run portfolioinflows, have also attracted great interest. Soto(1997) has pointed to the shift in thecomposition of inflows from short to long term.But he found the impact on domestic interestrates short-lived, from 12 to 18 months. Rogoff(1999) favours capital controls with a clear effectof lengthening maturities and shifting awayfrom loans to equities. He argues that aneconomy whose foreign fund inflows areweighted more towards equity and directinvestments is in a stronger position to absorbmarket volatility and avoid a currency crisis.Corsetti, Pesenti and Roubini (1998b) insist that,in the case of Chile, the apparent success inavoiding the recent currency crisis can be tracedmore to prudent regulation and supervision ofits banking system than to its controls onshort-term capital flows.

The discussion has not been limited to capitalcontrols. There has also been discussion of theexchange rate mechanism. Several East Asianeconomies have been criticised for the virtualpeg they maintained for too long to the USdollar, which was strengthening against allmajor currencies in the run-up to the 1997financial crisis in the region. After the crisisbroke out, they had to allow their currency tofloat.

Wolf (1998) has discussed in detail the effectsof fixed and floating exchange rates on inflationand output. A peg, for as long as the com-mitment to a given exchange rate is credible,

makes a currency muchless volatile. It can alsoserve as an inflationanchor. It can facilitateinternational transac-tions and increase their

volume. But in a dynamic and open world, itcan make the economy more inflexible, andshocks can inflict greater damage to it. Adjust-ments, when they eventually have to bemade, need to be severe, as the crisis in theregion made only too painfully clear. Camdessus(1999a) has insisted that pegs can have finitelives, and they may be appropriate only underspecific conditions for certain stages ofdevelopment.

McKinnon and Pill (1998) make a strong casefor a much freer float. It helps avoid a deepdeflationary response to adverse shocks. Itcompels investors to shoulder the risks ofexchange rate fluctuation. It discourages over-borrowing. But the exchange rate volatility itentails can impose a substantial economic cost.It can dampen the flow of goods, and even moreso of funds.

For East Asia, the discussion of exchangerates has led to a search for anchors. Monetarytargets had become less reliable. Inflationtargets were being seriously considered.Garnaut (1999) has suggested that, given theexperience of the crisis, a weighted average ofmajor currencies should be used in a peg,instead of the US dollar alone. Kwan (1998) hasproposed the use of the Japanese yen, the USdollar and the European euro in a basket ofreserves, with the proportion between themdynamic and flexible. Williamson (1996) earliersuggested a managed float, based on such amultiple anchor, i.e. a basket of reserve currencies,and with a wider band between the currenciesin the region.

The suggestion of a band, necessarily wide,within which currencies in the region can floatrelative to each other brings to the fore anotheraspect of the discussion within the region. Thisis the issue of monetary independence orinter-dependence.

The phenomenon of contagion, clearlybrought out by the crisis, has forced several East

Several East Asian economieshave been criticised for the

virtual peg they maintained fortoo long


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Asian economies to reconsider their previouslystrong insistence on monetary policyindependence. Fear of competitive devaluation,their treatment as one inter-dependent regionby international fund managers, and theprospect of becoming a more free and opentrade area have led them to consider their scopefor closer monetary and financial co-operation.The launch of the euro brought to a conclusionthe long drawn-out process to forge a Europeanmonetary union. Japan increased its declaredcommitment to the eventual international-isation of the yen. The Asian Development BankInstitute (1998) discussed options for confidence-building measures that in time could leadtowards joint short-term action in a regionalfinancial crisis and longer-term co-ordination ofmonetary policy.

Such proposals within the region have to beextremely modest. In part this is becauseEast Asia has no long-standing regional mech-anisms for monetary policy co-ordination. Allthe current initiatives, such as the ASEANmonitoring and surveillance mechanism andthe Manila Framework Group within APEC, areof recent vintage. It has been considered morepragmatic, therefore, to take one step at a time.In this spirit, the more visionary calls from thepolitical leaders of Malaysia and the Philippinesfor a common ASEAN or East Asian currencyhave been received with cool politeness(Bergsten 1999).

Within the region there has been no con-sensus on a regime that suitably addresses the‘trilemma’ (Krugman 1999b): capital mobility,exchange rate flexibility and monetary policyindependence. There is a genuine desire forareas of closer co-operation. But as PECC(1999) noted, no consensus on tight co-ordination seems likely.

There is much greater openness on micro-economic risk management. The BasleCommittee on banking supervision had alreadymade considerable progress in developingstandards for banking supervision. Withvarying degrees of enthusiasm, several eco-nomies in East Asia have expressed willingnessto consider and adopt them. The standardspromoted by the International Organization of

Securities Commission (IOSCo) and by theInternational Accounting Standards Committee(IASC) are also being actively discussed (ADBInstitute 1998). The OECD (1999) has issued aCode of Corporate Governance, and a fewInstitutes of Directors committed to promotingthe observance of this code have already beenestablished in the region (World Bank 1999).

Eichengreen (1999) argues for modest andgradual changes, which if sustained over a longperiod can nonetheless bring about deepreforms. But much of the discussion about a newglobal financial architecture has been followedwith less interest and even lesser involvementin the region. The suggestion for an inter-national bankruptcy court (Sachs 1995) andvarious proposals for bailing in private creditorssuch as Eichengreen’s (1999) proposal for majoritydecisions in negotiations among creditors havebeen received politely. So has the exchangebetween Schwartz (1998) and Fischer (1999) onthe role of the IMF as a lender of last resort.

Conclusion

Any design to move East Asia forward on thebasis of lessons learned from the financial crisisof the late 1990s needs to be based on a radicalparadigm shift. This shift involves moving fromthe original idea that East Asia is different andcan do things differently to the idea that EastAsia needs to be more open to and consistentwith the West and the rest of the world.

Openness demands that East Asia treats theWest and the rest of the world in the same wayas it expects to be treated by others. This meansputting a greater premium on fairness, trans-parency and accountability. It also meansallowing greater leeway for market forces tobalance out competing interests. In particular,this calls for reining in the visible hands ofbureaucrats so that the invisible hand of themarket can carry out its work.

Consistency simply means that if East Asiabelieves in and benefits from an open,democratic, market-driven competitive system,it must be prepared to align its practices withbest practices elsewhere, and to conform to thestandards set by the international community.


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Documents

The Asian Financial Crisis: An East Asian Perspective