Asian Financial Crisis Revisited

Steven A.Y. Lin

Introduction

Asia's financial crisis began in Thailand nearly two years ago when a sharp devaluation of the Thai currency triggered a chain reaction affecting Indonesia, Malaysia and Korea. Recent signs indicated that things are looking up for South Korea as well as Thailand. Here's another kind of Asian miracle. Much has been done to shore up weak spots in the economy and revamp poor policy. But even the toughest of S. Korea reforms have fallen short of what experts recommended. For the following, we shall revisit the Asian financial crisis of 1997-'98 and search for possible insight.

Due to its unprecedented complexities, it is argued that a full understanding of the Asian crises requires a new theoretical paradigm in the literature on currency and financial crises. The traditional conceptual scheme does not seem to fit well the specific characteristics of the 1997-'98 crisis in a number of dimensions. Let's see why the traditional currency crisis models do not explain fully the Asian crisis of 1997-'98.

At the core of the first generation models of speculative attacks by Krugman (1979), and Flood and Garber (1984), the fiscal deficits is the key factor for currency crisis. An excessively large fiscal deficit is the cause for currency crisis in a country with a fixed exchange rate. In other words, deteriorating economic fundamentals and inconsistent economic policies are the cause of the crisis. By contrast, second generation models of currency crisis posited that a currency crisis could be driven by a worsening of domestic economic fundamentals or shifts in expectations of the economy under fixed exchange rate regime (Obstfeld, 1994; Cole and Kehoe, 1996; Sachs, Tornell and Velasco, 1996). Countries are vulnerable to speculative attacks when economic fundamentals, such as foreign exchange reserves, fiscal deficits, and the government's commitment to defend the currency, are fairly weak. A spontaneous speculative attack on a national currency can cause a crisis, even if the country's monetary and fiscal policies are consistent. Corsetti, Pesenti and Roubini, 1998) computed a "crisis index" (see Table 1). This is a measure of speculative pressure on a country currency. This index is a weighted average of the percentage rate of exchange rate depreciation relative to the US dollar (with the assigned weight of 0.75), and the percentage rate of change in foreign reserve between the end of December 1996 and the end of December 1997. A large negative value for this index corresponds to a high devaluation rate and/or a large fall in foreign reserves. The speculative pressure on the currency is higher. All data are from IMF, the International Financial Statistics.

 

Table 1 The Country Currency Crisis Index

Argentina 4.9 Brazil -0.5 Chile -1.4

China 7.6 Columbia -9.1 Czech -19.5

Hong Kong 5.7 India 5.7 Indonesia -38.3

Korea -38.6 Malaysia -38.8 Mexico 10.9

Pakistan 11.4 Peru 0.7 hilippines -29.8

Singapore -15.7 Sri Lanka -1.0 Taiwan -11.4

Thailand -47.8 Turkey 4.3 Venezuela 4.9

___________

Source: Corsetti, Pesenti and Roubini (hereafter, CPR), June 1998.

 

The competing interpretations of Asian financial crisis are an extension of the currency crisis models just alluded to. The "fundamentalist view" attributes the cause of Asian financial crisis to poor economic fundamentals and policy inconsistencies. It is closely related to the first generation currency crisis models. According to this view, Asian crisis was caused by basic economic weaknesses. It said that the rosy macroeconomic indicators of many Asian economies painted a misleading picture before the crisis. In contrast, the "panic interpretation" of the financial crisis is akin to the "second generation" currency model. These models contend that a fixed exchange rate regime that is not perfectly credible is basically unstable and is subject to speculative attack and swings in market sentiment.

 An additional or supplementary interpretation attributed the crisis to "severe structure weakness in these economies financial systems." In pursue of the goal for high economic growth, almost all of the Asian economies adopted the industrial policy. They emphasized export expansion, centralized coordination of production activities, as well as a close operational relationship and ownership between banks and firms. These government long subsidized private enterprises or directed credits to favored companies and/or industries. The government appeared willing to intervene in favor of troubled firms or banks. The implicit or explicit guaranteed of banks or non-bank financial institutions created moral hazard problem. Lax supervision and weak regulation of the financial system further distorted banks' incentive for project selection and monitoring. Quite often it led to outright corrupt lending practices. The rapid processes of capital account liberalization and financial market deregulation in these economies during the 1990s aggravated the distortion in financial market.

 

What Caused the Currency and Financial Crisis?

 Economic Imbalances

Several Asian currencies appreciated in real term in the 1990s causing these countries to experience large current account imbalances under fixed exchange rate regimes. Because the exchange rates of several currencies in Asia were pegged to the U.S. dollar, these currencies appreciated along with the U.S. dollar against the yen since mid-1995. South Korea is the only exception. The appreciated currencies contributed to losses in the international competitiveness of these countries. This and weak demand for their products caused these countries to experience export slowdowns in 1996-97 and wider external imbalances. Thailand, the Philippines, Malaysia, Korea and Indonesia all had generated large current account deficit (see Table 2). Capital inflows increased as a consequence.

Table 2. Current Account, NIA Definition (% of GDP)

 
                     1990 1991 1992 1993 1994 1995 1996 1997

Korea            -1.24 -3.16 -1.70 -0.16 -1.45 -1.91 -4.82 -1.90

Indonesia       -4.40 -4.40 -2.46 -0.82 -1.54 -4.27 -3.30 -3.62

Malaysia        -2.27 -14.01 -3.39 -10.11 -6.60 -8.85 -3.73 -3.50

Philippines      -6.30 -2.46 -3.17 -6.69 -3.74 -5.06 -4.67 -6.07

Singapore        9.45 12.36 12.38 8.48 18.12 17.93 16.26 13.90

Thailand         -8.74 -8.01 -6.23 -5.68 -6.38 -8.35 -8.51 -2.35

Hong Kong      8.40 6.58 5.26 8.14 1.98 -2.97 -2.43 -3.75

China               3.02 3.07 1.09 -2.19 1.16 0.03 0.52 3.61

Taiwan            7.42 6.97 4.03 3.52 3,12 3.05 4.67 3.23

Note: The source of all data in these Tables is the International Financial Statistics of the International

Monetary Fund (unless otherwise noted). The data for Taiwan are from various sources (Economist Intelligence Unit Reports, IMF's December 1997 World Economic Outlook and Asian Development Bank). The data for Singapore for 1997 are from the Economist Intelligence Unit Country Report, 2nd quarter 1998.

CPR,1998.

The large capital inflows were also driven by the needs to finance excessive speculative demands in the non-traded sector (e.g. land and real estates) and lavish consumption. Due to a lack of well-developed securities markets in these countries, these capital inflows were mostly channeled through respective countries' banking systems. Table 3 indicates that the foreign liabilities of banks increased substantially in Thailand, the Philippines, Korea, Indonesia and Malaysia. These Banks borrowed from abroad mostly with short-term loans (see Table 5,6 and 7). Because of a moral hazard problem created by government's explicit or implicit promises to bail them out in bad times, banks of these countries borrowed too much from abroad and lent at home at a substantially low interest rate relative to the degree of riskiness of the projects being financed. This phenomenon can be related to a proposition by McKinnon and Pill (1996). It hypothesizes that under-regulated intermediaries are prone to under-estimate riskiness for investment and this under-estimation, in turn, can lead to excessive borrowing and investment by an economy as a whole. Banks from Thailand, the Philippines, Malaysia, Indonesia and South Korea carry large amounts of foreign liabilities relative to these countries' official reserves. Tables 5 indicates that short-term debt as percentage of foreign reserve and Table 6 indicates that debt service plus short-term debt as percentage of foreign reserve are both very high.

Table 3 Foreign Debt, World Bank Data (as a % of GDP)

                     1990 1991 1992 1993 1994 1995 1996

Korea            13.79 13.51 14.34 14.18 14.32 23.80 28.40

Indonesia       65.89 68.21 68.74 56.44 60.96 61-54 56.74

Malaysia       35.80 35.48 34.51 40.74 40.40 39-31 40.06

Philippines    69.02 71.45 62.29 66.09 62.42 53.21 49.75

Singapore     11.23 11.07 9.47 9.45 10.79 9.84 10.74

Thailand       32.80 38.38 37.51 34.10 33.31 33.78 50.05

Hong Kong   16.80 14.84 14.99 14.35 18.38 16.60 15.44

China           14.26 14.84 14.99 14.35 18.38 16.60 15.44

Taiwan         11.04 10.73 9.37 10.44 10.87 10.40 10.07

Note: The source for Tables 23-27 is the Global Development Finance (GDF) report of the World Bank and IMF-IFS. The data for Hong Kong, Singapore, Taiwan in tables 23-24 and 26-27 are from the Asian Development Bank. The data for Korea in 1995 and 1996 (in italics) are from OECD, External Debt Statistics. CPR,1998.

 

Table 4 Debt Service as a Ratio of Exports. World Bank Data

 
                    1990 1991 1992 1993 1994 1995 1996

Korea             10.80 7.20 7.80 9.40 6.90 7.30 8.80

Indonesia        33.40 34.30 32.60 33.60 30.70 30.90 36.80

Malaysia         12.60 7.40 9.10 8.40 9.00 7.00 8.20

Philippines       27.00 23.00 24.40 25.60 18.90 16.40 13.70

Thailand          16.90 13.00 13.80 13.70 13.50 11.60 11.50

Hong Kong        1.71 1.23 1.08 0.93 1.49 0.71

China               11.70 11.90 10.20 11.10 8.90 9.90 8.70

Taiwan               2.29 2.01 1.86 1.33 1.68 1.82

 

Source: CPR,1998

Table 5 . Short-Term Debt, World Bank Data (% of foreign reserves).

 
                     1990 1991 1992 1993 1994 1995 1996

Korea               72.13 81.75 69.62 60.31 54.06 171.45 203.23

Indonesia       149.28 154.62 172.81 159.70 160.36 189.42 176.59

Malaysia         19.54 19.05 21.12 25.51 24.34 30.60 40.98

Philippines     479.11 152.31 119.37 107.68 95.00 82.85 79.45

Singapore          2.65 2.67 2.35 2.04 1.75 1.78 2.60

Thailand          62.55 71.31 72.34 92.49 99.48 114.21 99.69

Hong Kong      23.52 21.78 18.38 17.09 16.49 14.16 22.35

China               31.49 24.68 66.76 68.33 33.04 29.62 23.74

Taiwan            21.56 20.21 21.00 23.64 21.76 21.64 21.31

Source: CPR, 1998.

 

Table 6 . Debt Service plus Short-Term Debt, World Bank Data (% of foreign reserves ).

 
                     1990 1991 1992 1993 1994 1995 1996

Korea            127.43 125.90 110.35 105.66 84.90 204.93 243.31

Indonesia       282.92 278.75 292.03 284.79 277.95 309.18 294.17

Malaysia         63.96 45.87 45.55 42.37 48.73 55.92 69.33

Philippines     867.64 256.99 217.08 212.60 171.98 166.60 137.06

Thailand         102-.35 99.34 101.34 120.28 126.54 138.13 122.62

Hong Kong       30.51 26.87 22.82 20.64 22.02 16.82

China                55.34 43.70 108.55 113.74 54.08 49.61 38.46

Taiwan             23.92 22.29 23.08 25.21 23.69 24.20

Source: CPR, 1998.

 

Table 7 Short-Term Liabilities towards BIS Banks (% of foreign reserves, end of 1996)

Korea 213%      Philippines 77%

Indonesia 181% Thailand 169%

Malaysia 47%    China 36%

Source: CPR,1998.


Over-investment, Excessive External Debt and Moral Hazard

The current account deficits in Asian economies were driven by high rates of investment as well. During 1990s, investment rates in many Southeast Asian countries were above 30% of GDP. In countries such as Thailand, Malaysia and China the rates went up to above 40% (see Table 8). The profitability of many new investment projects was low (see Table 11). In Thailand, Indonesia and Malaysia, for example, the non-performing loans as percentage of GDP was above 15% in 1996. In Korea, 8 of the 30 largest conglomerates were in effect bankrupt by mid-1997. In 1996, 20 of the largest 30 conglomerates had a rate of return on invested capital below the cost of capital (see Table 10). The falling investment efficiency of the Asian economies was evidence in the increasing capital output ratio.

 

Table 8 Investment Rates (% of GDP)

 
                      1990 1991 1992 1993 1994 1995 1996 1997

 Korea            36.93 38.90 36.58 35.08 36.05 37.05 38.42 34.97
Indonesia        36.15 35.50 35.87 29.48 31.06 31.93 30.80 31.60
Malaysia         31.34 37.25 33.45 37.81 40.42 43.50 41.54 42.84
Philippines      24.16 20.22 21.34 23.98 24.06 22.22 24.02 24.84
Singapore       35.87 34.21 35.97 37.69 32.69 33.12 35.07 37.40
Thailand          41.08 42.84 39.97 39.94 40.27 41.61 41.73 34.99
Hong Kong      27.44 27.20 28.50 27.54 31.85 34.91 32.38 35.08
China              34.74 34.77 36.17 43.47 40.88 40.20 38.73 37.55
Taiwan            23.08 23.29 24.90 25.16 23.87 23.65 21.24 22.20

Source: CPR,1998.

Table 9 Incremental Capital Output Ratio (ICOR)

                 1987-92 1993-96

Korea             3.8 4.9       
Thailand          3.4 5.1
Indonesia        4.0 3.8
Hong Kong      3.7 6.1
Malaysia         3.7 4.8
China              3.1 2.9
Philippines      6.0 5.5
Taiwan            2.4 3.9
Singapore       3.6 4.0

Source: JP Morgan and authors calculations. CPR, 1998.

 

 Table 10 . Financial Conditions of Top 30 Korean Chaebol at the end of 1996 (in hundred million won and %)

Chaebol           Total Assets Debt Sales Net Profit Debt/Equity Ratio

Samsung         508.6 370.4 601.1 1.8 268.2

Hyundai           531.8 433.2 680.1 1.8 439.1

Daewoo           342.1 263.8 382.5 3.6 337.3

LG                   370.7 287.7 466.7 3.6 346.5

Hanjin             139.0 117.9 87.0 -1.9 556.9

Kia                  141.6 118.9 121.0 -1.3 523.6

Ssangyong      158.1 127.0 194.5 -1.0 409.0

Sunkyong        227.3 180.4 266.1 2.9 385.0

Hanhwa           109.7 97.2 96.9 -1.8 778.2

Daelim               57.9 45.9 48.3 0.1 380.1

Kumho             74.0 61.2 44.4 -0.2 477.9

Doosan            64.0 55.9 40.5 -1.1 692.3

Halia                66.3 63.2 52.9 0.2 2067.6

Sammi            25.2 25.9 14.9 -2.5 3245.0

Hyosung         41.2 32.5 54.8 0.4 373.2

Hanil               26.3 22.3 13.0 -1.2 563.2

Donga Construction 62.9 49.1 38.9 0.4 355.0

Kohap            36.5 31.2 25.2 0.3 589.5

Jinro               39.4 39.0 14.8 -1.6 8598.7

Dongguk Jaekank 37.0 25.4 30.7 0.9 210.4

Lotte               77.5 51.0 71.9 0.5 191.2

Kolon            38.0 28.9 41.3 0.2 316.5

Haitai            34.0 29.5 27.2 0.4 658.3

Sinho Jaeji     21.3 17.7 12.2 -0. 1 489.5

Anam Industrial 26.4 21.8 19.8 0.1 478.1

Dongguk Muyok 16.2 13.6 10.7 -0.2 587.9

New Core       28.0 25.9 18.3 0.2 1224.0

Songif            20.3 18.3 8.7 -0.9 920.5

Hansol           47.9 37.1 25.5 -0. 1 343.2

Hansin Kongyong 13.3 11.5 10.6 0.0 648.8

Source: Chosun llbo, November 29, 1997. CPR, 1998.

  

Table 11. Profitability of Korean Chaebols. ROIC in 1992-1996.

 
Chaebol 1992-96 1996

Hanbo    3.0% 1.7%

Sammi   2.9% 3.2%

Jinro      2.7% 1.9%

Kia       18.9% 8.7%

Dainong  6.8% 5.5%

Source: LG Economic Research Institute . CPR, 1998.

 

Falling interest rates in industrial countries in mid-1990s stimulate the capital inflows to Asia despite the negative signals sent by the indicators of low profitability. But the roots of the sustained capital inflows to Asia have a lot to do with the structure of incentives under which the corporate and financial sectors operated in Asia. In these "managed market" economies, high economic growth was their main objective. They had a long tradition of public guarantees or providing subsidies to private projects or directed credit to favored companies and/or industries. With financial and industrial policy enmeshed within an interrelated network of personal and political favoritism, government appeared willing to intervene in favor of troubled firms or banks. The markets operated under the impression that government will serve as a cushion to any adverse shocks.

The implicit or explicit guarantee by the government for the banks or non-bank financial institutions' failure distorted the latter's incentive for project selection and monitoring. This moral hazard problem in investment by financial institutions leads to the strong tendency to borrow excessively from abroad and lend excessively at home country. Lax supervision and weak regulation of the financial system in addition to lack of incentive-compatible deposit insurance schemes and low capital adequacy ratios all contributed to the severe structural weakness in the undercapitalized financial systems.

In all of these countries that were severely affected, financial intermediaries seem to have been the crucial players. In Thailand, it was the "financial companies"-non-bank intermediaries that borrowed short-term money, often in dollars, then lent that money to speculative investors. In South Korea, it was conventional banks that borrowed extensively at short-term and lent to highly leveraged corporations for very speculative investments in retrospect (see Table 12, 13, and 14).

 

Table 12.. Lending Boom Measure (rate of growth between 1990 and 1996 of the ratio between the claims on the private sector of the deposit money banks and nominal GDP).

Korea 11%

Singapore 17%

Indonesia 10%

Thailand 58%

Malaysia 31%

Hong Kong 26%

Philippines 151%

China 7%

Source: CPRT,1998.

 

Table 13. Non-Performing Loans (as proportion of otal lending in 1996)

Korea 8%

Thailand 13%

Indonesia 13%

Hong Kong 3%

Malaysia 10%

China 14%

Philippines 14%

Taiwan 4%

Singapore 4%

Source: 1997 BIS Annual Report; Jardine Fleming. CPR, 1998.

 

Table 14. . Banking System Exposure to Risk. (% of assets at the end of 1997)

                       Property      Collateral      Non-Performing Loans          Capital
                       Exposure     Valuation         1997      1998f                   Ratio

Korea                   15-25% 80-100% 16% 22.50% 6-10%

Indonesia              25-30% 80-100% 11% 20.00% 8-1 0%

Malaysia               30-40% 80-100% 7.50% 15.00% 8-14%

Philippines           15-20% 70-80% 5.50% 7.00% 15-18%

Singapore            30-40% 70-80% 2.00% 3.50% 18-22%

Thailand               30-40% 80-100% 15% 25% 6-10%

Hong Kong          40-55% 50-70% 1.50% 3% 15-20%

Source: JP Morgan "Asian Financial Markets", January 1998. CPR, 1998.

Private individuals and foreign institutional investors bought stocks and real estates in all of the economies affected. The shifting of this "hot money" may have some explanatory role for the crisis as well. The "herding" by investors. The domestic financial intermediaries can not account for all of the over-investment and overvaluation of assets in Asia.

The rapid process of capital account liberalization and financial market deregulation in these economies during the 1990s aggravated the financial market distortion. The economic successes of the East Asian and Southeast Asian countries led foreign investors to further underestimate weakness in these economies and, to overestimate real estates and stock prices. The international dimension of the moral hazard problem depends upon the behavior of international banks. These banks presume that these governments' intervention or that of IMF effectively guaranteed the short- term cross-border liabilities.

Randall Wray (1998) and Martin Mayer (1998) contend that the Asian crises fits the case for Hyman Minsky's "financial instability hypothesis." Mayer observed that " ... Over periods of prosperity, confident expectation of a steady stream of profits produces a willingness to take risks that would have been considered unacceptable at another time. Conservative hedge financing gradually develops into speculative ventures until large segments of the economy are greatly extended on credit." Extents of the speculative ventures and loans in these countries can be found in the Tables 8, 9 and10. Mayer also argues that "---Banks looking for new credit instruments to maximize commissions, created derivatives, which mix interest-rate, credits, and foreign exchange risks into an amorphous total return that converted what otherwise would have been seen as a suspect investments into high-rated instruments . Derivatives are designed to pass on the responsibility of risk assessment to the lender and to make the risk more difficult to assess."

When these investment projects turned out not to be profitable, the firms and the banks ended up saddled with a huge amount of foreign debt denominated in foreign currencies that could not be repaid. Either due to fundamental factors or contagious devaluation among the countries compete in the same world market, the exchange rate crisis that followed exacerbated the debt problem by increasing the real burden of the foreign liabilities. Weak and non-credible governments that were not committed to structural reform added to the policy uncertainty and the financial panic that ensued. What all of this suggests is that the Asian financial crisis is really more of a story about a bubble in and subsequent collapse of asset values in general (Krugman, 1998). The currency crisis is not a cause of the real malady but rather a symptom.

 

Capital Account Liberalization and Financial Market Deregulation

 Market failures are often seen as the bases for government intervention. In the context of capital mobility, the divergence between capital movements and economic fundamental causes market imperfection. For example, when capital flows go to countries with unsustainable policies, or conversely international capital flow is either unavailable or too costly for countries with appropriate policy records and prospects. The Southeast Asian countries were receiving a greater volume of capital inflows than they had the capacity to absorb. The inflows posed problems for their monetary and exchange rate policies. It is under these situations that certain measures of controls on capital inflows are valid from the standpoint of individual countries. It could be rational to implement correct policies in these countries facing excessive amounts of capital flow, in or out. Chile is often cited as a country that has successfully implemented capital controls to limit short-run inflows. However, Chile's experience with control is different from East or Southeast Asia's. This is partly due to a) Chile had already addressed serious banking sector weakness because of an earlier banking crisis. In other words, it has better banking and financial institutions, and b) Chile had flexible exchange rate policy that was more attuned to dealing with significant capital inflows. In general, control should not be a standard weapon in a country's arsenal. From purely pragmatic reason, capital controls were ineffective in Indonesia and Thailand. But they may play a limited and constructive role, if it is properly monitored. Control is a double-edged sword, controls imposed by a country generally affects other countries adversely.

All countries benefit from access to global capital markets and from market-based competition for financing, including competition from foreign firms. At the same time there are important preconditions for an orderly liberalization of capital movements. The financial crises have been costly for countries directly affected, including those suffered because of the spillover and contagion effects. It is impossible to predict currency or financial crisis reliably, specially for crises brought on by pure contagion effects. It is possible, however, to identify the kinds of weaknesses that typically make economies vulnerable to currency and/or financial crises. There are significant costs associated with lenders and borrowers from financial crisis. It is highly unlikely that imprudent lending and investment decisions are the results of moral hazard caused solely by government's explicit or implicit promises to bail out the troubled financial intermediaries or due to the involvement of international financial bodies. This underscores the need to ensure that timely and accurate information is available to investors, lenders and borrowers. This is the "transparency" requirement. In addition, strict supervision and regulation of financial institutions are needed.

During the transition period to an open capital account regime, which will benefit an economy ultimately and has been promoted by International Monetary Fund, certain measures are desirable to moderate financial flows even with a liberalized domestic financial sector. The measures should include the use of market-based instruments such as reserve requirements on short-term borrowing and on foreign currency deposits. Long-term direct foreign investment should be encouraged. However, policy distortions to stimulate short-run capital flows should be eliminated. Banks and other institutions should be limited on their extent of foreign currency exposure deductibility for interest related to loans denominated or linked to foreign currency should be limited as well. Lawrence Summers' (1999) "integration trilemma" implies that controlling capital flows is the only way that a country can maintain its soverneity while regulate and support its financial markets. A gradual opening of capital and financial markets are suggested by a recent study by Rao and Singh (1998). The study indicates that larger capital market opening couple with weak financial system encouraged financial crises. Thailand, Malaysia, Indonesia and S. Korea are the examples. Relatively closed financial market (with lower openness indices) for Taiwan and India and closed market for China led these countries to escape the currency crisis relatively unscratched (see Table 15). The Asian financial crisis has shown that the appropriate market reforms are the prerequisite for liberalization of capital flows.

Table 15: Estimates of Financial Openness Index

for Certain Asian Developing Countries, 1980-1990

Country

Estimate

Country

Estimate

Country

Estimate

India

0.444

Malaysia

0.638

Sri Lanka

0.638

Indonesia

0.865

Philippines

0.577

Taiwan

0.353

Korea*

0.594

Singapore

1.000

Thailand

0.590

*South Korea--1980 0.2; 1984 0.85; 1987 0.3;

Source: Rao and Singh, Optimising the Pace of Capital Account Convertibility,

Economic and Political Weekly, May 23, 1998, P. 1247

 

 Need of a Sound Financial System

A few economists, most notably Krugman (1994), regarded the claims on Asian economic miracle as overstated. There was no one, even among them, actually anticipated the recent Southeast Asian currency crisis. Certainly no one has expected the drastic economic meltdown that we observed, and no one expected the wide spread vulnerability to crises contagion.

The crises affected Malaysia, Indonesia and Thailand that export similar commodities, and it also affected more economically developed South Korea. All of the available evidence suggests that the financial excesses of huge capital inflows. It also pointed to the importance of a robust financial system supposed by effective regulation and supervision of financial institutions.

A key task for future policymakers is to identify and address vulnerability before crisis arises. For some countries, the balance of costs and benefits indicates the advantages of adopting flexible exchange rate. Obstfeld and Taylor's (1999) "open economy trilemma" pointed out the incompatibility of capital market integration, exchange rate stability, and pursue of a country's own economic policy. Suppose a country wants a stable exchange rate and an internationally integrated capital market, it must either establish a currency board or joint a monetary union. This means it must give up the policy independence associated with a flexible exchange rate regime. The Asian crisis has shown that pegged, but adjustable, exchange rates are difficult to sustain in a world of increasing capital mobility. A speculative attack, sooner or later, are likely to force the country to raise interest rate and cut budget. Currency unions have served many countries well in supporting their stabilization efforts. The practical and political hurdles for establishing currency union in Asia are high, however the costs of excessive currency volatility and competing devaluation can not be ignored.

There are several important pre-conditions for an orderly liberalization of capital movements. The most important among these is a robust financial system supported by effective regulation and supervision of financial institutions The liberalization of domestic financial systems should precede the opening up to foreign investors. This liberalization will promote the development of domestic capital markets. Prudential limits on foreign currency exposure in the financial system are required as well. During the transition period to an open capital account regime with a liberalized domestic financial sector, certain measures are desirable to moderate financial flows. The measures should include the use of market-based instruments such as reserve requirements on short-term borrowing. Banks and other institutions should be limited on their extent of foreign currency exposure. These and other measures are needed to reduce the risk of capital inflows becoming a substitute for effective inter-mediation and the mobilization of domestic financial resources.

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