The Asian Financial Crisis What Have We Learned?

• Author: Timothy Lane
• Position: Chief of the Policy Review Division in the IMF's Policy Development and Review Department

Now that the Asian crisis is behind us, what lessons can we draw from the experience, and how can we use this knowledge to forestall future crises and minimize damage from those that occur?

The Asian financial crisis, which spread from Thailand to other countries in the region during the second half of 1997, plunged the countries affected into deep recessions that brought rising unemployment, poverty, and social dislocation. The outbreak, spread, and persistence of the crisis also challenged some basic assumptions: the countries most strongly affected were "tiger economies" that had few of the weaknesses usually associated with countries that turn to the IMF for help. They had fiscal surpluses, high private saving rates, and low inflation; and in most cases their exchange rates did not seem out of line.

The crisis now appears to be over: market conditions have stabilized and strong recoveries are under way, although the countries still face a long agenda of needed structural reforms. But the events of the past two years have raised many important questions. Why did crises occur in these countries? Why did the IMF-supported policy programs introduced in Indonesia, Korea, and Thailand initially fail to quickly stop the market panic and prevent a sharp recession?

Financial fragility

Many factors may have contributed to the onset and spread of the Asian crisis, but there is a growing consensus that the main ingredient was financial fragility. This involved four related aspects. First, many financial institutions and corporations in the countries affected had borrowed in foreign currencies without adequate hedging, making them vulnerable to currency depreciation. Second, much of the debt was short-term while assets were longer-term, creating the possibility of a liquidity attack, the effect of which would be similar to that of a bank run. Third, prices in these countries' equity and real estate markets had risen substantially before the crisis, increasing the likelihood of a sharp deflation in asset prices. Fourth, credit was often poorly allocated, contributing to increasingly visible problems at banks and other financial institutions before the crisis hit.

How did these countries' financial systems become so fragile? In part, this reflected ineffective financial supervision and regulation in the context of countries' financial sector liberalizations. Capital account liberalization was poorly sequenced, encouraging short-term borrowing, while limited exchange rate flexibility led borrowers to underestimate exchange risk. Monetary policies allowed domestic credit to expand at a breakneck pace. But if banks and corporations in these countries borrowed imprudently, foreign lenders also lent imprudently, possibly reflecting sloppy risk management, perceptions of implicit government guarantees, and the incomplete information available.

Given these vulnerabilities, once a crisis started, it became difficult to stop. As foreign and domestic investors rushed for the exits, a vicious circle was created: currencies depreciated, plunging more institutions into insolvency, further undermining creditors' prospects of repayment, and accelerating the exit of capital. Many unfavorable events aggravated these adverse dynamics after the IMF-supported programs were introduced: political events and initial hesitation in implementing agreed policies cast doubt on the authorities' commitment to reform programs; disturbing information (especially on weak international reserves) that had previously been withheld was revealed at the height of the crisis; and, in Indonesia, the much-needed closings of insolvent banks were accompanied by only limited and ill-publicized deposit guarantees; in addition, there were doubts about how much of the announced financing packages were actually available.

Crisis management

Given the nature of the financial crisis, the policy response, in the context of the IMF-supported programs, had three main elements: large official financing packages, together with some action to keep private money in place; an unprecedented body of structural reforms; and macroeconomic policies intended to counter the crisis itself. The policy content of the programs is addressed in greater depth elsewhere (see, for example, Lane and others...