The Asian Crisis: Causes and Cures

• Author: IMF Staff

The financial crisis that struck many Asian countries in late 1997 did so with an unexpected severity. What went wrong? How can the effects of the crisis be mitigated? And what steps can be taken to prevent such crises from recurring in the future?

THE EAST ASIAN countries at the center of the recent crisis were for years admired as some of the most successful emerging market economies, owing to their rapid growth and the striking gains in their populations' living standards. With their generally prudent fiscal policies and high rates of private saving, they were widely seen as models for many other countries. No one could have foreseen that these countries could suddenly become embroiled in one of the worst financial crises of the postwar period.

What went wrong? Were these countries the victims of their own success? This certainly seems to have been part of the answer. Their very success led foreign investors to underestimate their underlying economic weaknesses. Partly because of the large-scale financial inflows that their economic success encouraged, there were also increased demands on policies and institutions, especially those safeguarding the financial sector; and policies and institutions failed to keep pace with these demands (see table). Only as the crisis deepened were the fundamental policy shortcomings and their ramifications fully revealed. Also, past successes may have led policymakers to deny the need for action when problems first appeared.

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Several factors-both domestic and external-probably contributed to the dramatic deterioration in sentiment by foreign and domestic investors:

* a buildup of overheating pressures, evident in large external deficits and inflated property and stock market values;

* the prolonged maintenance of pegged exchange rates, in some cases at unsustainable levels, which complicated the response of monetary policies to overheating pressures and which came to be seen as implicit guarantees of exchange value, encouraging external borrowing and leading to excessive exposure to foreign exchange risk in both the financial and corporate sectors;

* a lack of enforcement of prudential rules and inadequate supervision of financial systems, coupled with government-directed lending practices that led to a sharp deterioration in the quality of banks' loan portfolios;

* problems resulting from the limited availability of data and a lack of transparency, both of which hindered market participants from taking a realistic view of economic fundamentals; and

* problems of governance and political uncertainties, which worsened the crisis of confidence, fueled the reluctance of foreign creditors to roll over short-term loans, and led to downward pressures on currencies and stock markets.

External factors also played a role, and many foreign investors suffered substantial losses:

* international investors had underestimated the risks as they searched for higher yields at a time when investment opportunities appeared less profitable in Europe and Japan, owing to their sluggish economic growth and low interest rates;

* since several exchange rates in East Asia were pegged to the U.S. dollar, wide swings in the dollar/yen exchange rate contributed to the buildup in the crisis through shifts in international competitiveness that proved to be...