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Unit 26 : East Asian Crisis and Lessons for Developing Countries

exchange rate systems or moved to greater flexibility quickly after an initial period of pegging Notes
aimed at reducing inflation expectations. When they have not done this, they have tended to
experience real appreciations and current account deficits that leave them vulnerable to
speculative attack. Even in Argentina, where the public’s fear of returning to the
hyperinflationary past instilled a widely shared determination to prevent inflation, a fixed
exchange rate proved untenable over the long term.
2. The central importance of banking : A large part of what made the Asian crisis so devastating
was that it was not purely a currency crisis, but rather a currency crisis inextricably mixed with
a banking and financial crisis. In the most immediate sense, governments were faced with the
conflict between restricting the money supply to support the currency and the need to print
large quantities of money to deal with bank runs. More broadly, the collapse of many banks
disrupted the economy by cutting off channels of credit, making it difficult for even profitable
companies to continue business. This should not have come as a surprise in Asia. Similar effects
of banking fragility played roles in the crises of Argentina, Chile, and Uruguay in the 1980s and
of Mexico in 1994-1995, and even in those of industrial countries like Sweden during the 1992
attacks on the EMS. Unfortunately, Asia’s spectacular economic performance prior to its crisis
blinded people to its financial vulnerabilities. In the future, wise governments will devote a
great deal of attention to shoring up their banking systems to minimize moral hazard, in the
hope of becoming less vulnerable to financial catastrophes.
3. The proper sequence of reform measures : Economic reformers in developing countries have
learned the hard way that the order in which liberalization measures are taken really does
matter. That truth also follows from basic economic theory : The principle of the second best tells
us that when an economy suffers from multiple distortions, the removal of only a few may
make matters worse, not better. Developing countries generally suffer from many, many
distortions, so the point is especially important for them. Consider the sequencing of financial
account liberalization and financial sector reform, for example. It is clearly a mistake to open up
the financial account before sound safeguards and supervision are in place for domestic financial
institutions. Otherwise, the ability to borrow abroad will simply encourage reckless lending by
domestic banks. When the economy slows down, foreign capital will flee, leaving domestic
banks insolvent. Thus, developing countries should delay opening the financial account until
the domestic financial system is strong enough to withstand the sometimes violent ebb and
flow of world capital. Economists also argue that trade liberalization should precede financial
account liberalization. Financial account liberalization may cause real exchange rate volatility
and impede the movement of factors of production from nontraded into traded goods industries.
4. The importance of contagion : A final lesson of developing country experience is the
vulnerability of even seemingly healthy economies to crises of confidence generated by events
elsewhere in the world—a domino effect that has come to be known as contagion. Contagion
was at work when the crisis in Thailand, a small economy in Southeast Asia, provoked another
crisis in South Korea, a much larger economy some 7,000 miles away. An even more spectacular
example emerged in August 1998, when a plunge in the Russian ruble sparked massive
speculation against Brazil’s real. The problem of contagion, and the concern that even the most
careful economic management may not offer full immunity, has become central to the discussion
of possible reforms of the international financial system, to which we now turn.

Mexico’s experience since 1995 shows that larger developing countries can manage
quite well with a floating exchange rate, and it is hard to believe that, if Mexico had
been fixing, it would have survived the Asian crisis repercussions of 1998 without a
currency crisis of its own.

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