Ethos Issue 3, Oct 2007

The Asian Financial Crisis in Hindsight
Donald Low

The Asian crisis is evidence that economic growth and financial stability are related but separate policy objectives, and that IFIs cannot afford to ignore financial and corporate health and vulnerabilities even if macroeconomic fundamentals appear healthy.

It is also a cautionary tale about financial liberalisation in emerging markets. While the case for liberalising long-term foreign direct investment⁹ remains sound, the crisis suggests that a more nuanced and sequenced approach to capital market liberalisation, particularly in ensuring that the requisite regulatory institutions are in place, would be more prudent. To a large extent, this lesson has been taken on board by the IFIs. The IMF, for instance, now emphasises the need to build stronger regulatory regimes and financial institutions alongside more open capital markets, reducing the risks of instability.

The crisis made clear the dangers of fixed or semi-fixed exchange rate regimes (or soft pegs). Fixed rates may reduce volatility and uncertainty; they can also be useful in providing a price anchor in high-inflation countries. But because fixed rate regimes do not allow for nominal rate adjustments, they tend to cause currencies to become misaligned (e.g. over-valued) with the economy’s fundamentals.

To the extent that the severity of the crisis was in large part due to panic, a key policy thrust of the IFIs must be to improve disclosure and transparency in emerging economies before crises occur. In the Asian economies, poor information environments created uncertainty and led to markets over-reacting and assuming the worst when new information—for example, concerning the strength of a particular bank—was revealed. Such over-reactions are less likely if banks, financial institutions and governments comply with international and stricter codes and standards on financial, statistical and fiscal reporting.

The Asian crisis also demonstrated the need for market-based mechanisms that could facilitate more orderly private debt workouts. The complication with the Asian crisis was that it involved a large number of private-sector debtors, rather than a sovereign debtor. This calls for a debt restructuring mechanism that would impose a generalised standstill on a country’s debt servicing obligations, in tandem with bringing together debtors and creditors for collective rollovers and debt renegotiation. This would have reduced the need for costly IMF bailouts and a reduction in the moral hazard created by these bailouts. Investors and creditors would also exercise greater due diligence and focus appropriately on risk in good times, since they would have to bear the consequences of their decisions. One market-based alternative that has been taken up by some emerging economies is to set collective action clauses in bond issues, requiring investors to authorise a third party to represent their collective interests in the event of default.

Finally, the crisis revealed the need for stronger social safety nets in most emerging economies. Strengthening governments’ capabilities to sustain essential social services to the most vulnerable segments of their populations should become a priority area for development lending and assistance. This in turn requires institutions such as the World Bank and regional development banks to develop the expertise in fiscally sustainable unemployment insurance/assistance programmes that do not undermine work incentives. In many emerging economies, families and local communities have tended to play a bigger role than the state in delivering such assistance. In this context, the IFIs should look to strengthen and build on these existing structures rather than require governments to supplant these traditional institutions of providing assistance.

This article is extracted from a case study prepared by the author, as Director of the Institute, for teaching within the Institute of Policy Development, Civil Service College. Donald Low is currently Associate Fellow at the Civil Service College.

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