Asia's financial crisis: lessons and policy responses

Abstract

This paper argues that fundamental weaknesses in Asian financial systems that had been masked by rapid growth were at the root of East Asia's 1997 currency and financial crisis. These weaknesses were caused by the lack of incentives for effective risk management created by implicit or explicit government guarantees against failure. The weakness of the financial sector was accentuated by large capital inflows, which were partly encouraged by pegged exchange rates. ; Policy responses need to be designed to restore growth in an environment of macroeconomic stability in the short run, and to prevent the recurrence of crises in the long run. In the short run, the priority is to bring about the resumption of external and internal domestic credit flows, by addressing issues such as trade financing, short-term external debt financing, the recapitalization of the financial sector through foreign investment and fiscal policy. In addition, it is suggested that fiscal policy be assigned to supporting growth and the financial sector, and monetary policy to curbing inflation and stabilizing exchange rate expectations. In the long run, policies should aim to reduce the vulnerability of the financial sector by encouraging adequate risk-management through financial reform, strengthened supervision, and regulation. It is noted that greater exchange rate flexibility and the maintenance of open capital accounts may also create incentives for managing risks effectively.

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