I congratulate the authors of chapter 1 on their taxonomy of the Asian crises. They make a very complete coverage of the nature and sources of vulnerabilities in the East Asian countries that have experienced the most recent financial crisis. In most discussions of international financial crises – the present as well as the historical – a central debate concerns whether the crises are due to domestic or external factors. Conclusions often lean in the direction of a crisis being generated as a consequence of a combination of domestic as well external factors, but opinions differ on their relative importance. In their chapter 1, the authors deny that they are undertaking any discussion of international aspects of the crisis. Instead, the chapter is an attempt to identify the nature and the sources of vulnerabilities in the East Asian economies.

Having narrowed the focus to an analysis of domestic factors leaves the task of identifying which domestic factors were behind the crisis. Historical experience and economic theory tell us that short-term macroeconomic policies, as much as structural microeconomic attributes, institutional setting and inevitably their interaction deserve attention. The chapter starts with the assertion that ‘the build-up of financial vulnerabilities in East Asia was associated with reinforcing dynamics between capital flows, macro policies and weak financial and corporate sector institutions.’ Put this way, I find very little to disagree with the authors' analysis, and find that they present a highly informative and valuable overview.

Introduction

The ‘Asian flu’ of 1997–8, the Mexican meltdown and ‘Tequila hangover’ of 1994–5, and the European Monetary System (EMS) crisis of 1992–3 are three samples of speculative attacks on fixed exchange rate regimes. These currency crises generally involved countries in the same region. Once a country had suffered a speculative attack – Thailand in 1997, Mexico in 1994, Finland in 1992 – other countries in the same region were disproportionately likely to be attacked themselves.

Why? One explanation is that currency crises tend to spread through a region because countries are linked by trade, and trade tends to be regional. Once Thailand floated the baht, its main trade competitors (for example, Malaysia and Indonesia) were suddenly at a competitive disadvantage, and so were themselves likely to be attacked. The spread of currency crises thus reflects international trade patterns: countries that trade and compete with the targets of speculative attacks are themselves likely to be attacked.

Prima facie, then, trade linkages seem like an obvious place to look for a regional explanation of currency crises. But most economists think about currency crises using variants of two standard models of speculative attacks. The ‘first-generation’ models of, for example, Krugman (1979) direct attention to inconsistencies between an exchange rate commitment and domestic economic fundamentals such as an underlying excess creation of domestic credit, typically prompted by a fiscal imbalance. The ‘second-generation’ models of, for example, Obstfeld (1986) view currency crises as shifts between different monetary policy equilibria in response to self-fulfilling speculative attacks.

A financial crisis is a disturbance to financial markets that disrupts the market's capacity to allocate capital – financial intermediation and hence investment come to a halt. The term ‘financial crisis’ is used too loosely, often to denote either a banking crisis, or a debt crisis, or a foreign exchange market crisis. It is perhaps preferable to invoke it only for the ‘big one’: a generalised, international financial crisis. This is a nexus of foreign exchange market disturbances, debt defaults (sovereign or private) and banking system failures: a triple crisis, in which the interactions are the key to causality, depth and persistence (Eichengreen and Portes, 1987).

The widespread securitisation of debt in recent years has not changed the picture – after all, one of the major historical examples is the 1930s crisis of defaults on sovereign bonds. Nor has it diminished the importance of banking sector fragility in provoking and exacerbating financial crises.

In chapter 4, a financial crisis is interpreted as a financial sector crisis. The stress is on banks and non-performing loans and the ultimate need for government bail-outs. This drives the story – and it provokes the exchange rate and debt crises. The framework includes explicit discussion of the impact of bail-outs on income distribution and the fiscal position. This is new and important. But my brief comments focus on the limitations of the analysis.

The evidence that crises are frequent and painful

Must financial crises be this frequent and this painful? Before discussing some of the considerations that go into answering this question, I first want to document my claim that they are frequent and painful. Clearly anyone watching the world from mid-1997 to late 1998 would be left with little doubt that financial crises can be very severe. But the East Asian crisis is only the latest in a series of spectacular economic catastrophes in developing countries. In the last 20 years there have been at least 10 countries that have suffered from the simultaneous onset of a currency crisis and a banking crisis. The result has been full-blown economic crises causing, in many cases, GDP contractions of 5–12 per cent in the first year of the crisis, and negative or only slightly positive growth for several years after. Many other countries have witnessed contractions of similar magnitude following currency or banking crises.

Financial crises are not strictly exogenous and in many cases the slow down itself, or the same factors that led to it, also helped cause the financial crisis. But there is no doubt that the over-shooting of exchange rates, the withdrawal of foreign capital, the non-rollover of short-term debts, the internal credit crunches, the process of disintermediation and many of the other characteristics of external and internal crises played a large role in these collapses.

Crises are also becoming increasingly frequent, at least relative to the post-Second World War period. We have had, in Caprio's memorable phrase, ‘a boom in bust[s]’ (Caprio, 1997, p. 80).

The Asian financial crisis hit the most rapidly growing and successful economies in the world, plunging them into deep crisis, with effects that will be felt for years to come; and it has, of course, generated an enormous policy debate. But little has been published in academic form. This book is intended to help fill the gap with a carefully selected set of papers covering the causes and consequences of the crisis, and possible cures.

Most of the contributions were commissioned for two key conferences on the Asian crisis held in England in May and July 1998. These meetings, at London and Warwick Universities, respectively, were collaboratively organised by the Centre for Economic Policy Research (CEPR), the World Bank Institute (WBI), the ESRC's Global Economic Institutions (GEI) Programme, the Centre for the study of Globalisation and Regionalisation of Warwick University (CSGR), and the Department of Economics at Warwick University (financed by ESRC project no. L120251024, ‘A Bankruptcy Code for Sovereign Borrowers’). Additional financial support was also provided by Credit Suisse First Boston (CSFB). The meetings brought together a lively group of authors, discussants, and others from Europe, the USA and elsewhere, including members of the IMF and the World Bank, as well as academics and market participants. These meetings grew, in part, out of two earlier gatherings held in Cambridge and London in July 1997, and in London in February 1998, organised by CEPR, and funded by the UK Foreign and Commonwealth Office, HM Treasury, the Bank of England and the GEI Programme of the ESRC.

Introduction

The view that international financial market integration brings significant long-term benefits is hardly a controversial one among mainstream economists. Financial openness, for instance, increases opportunities for portfolio risk diversification and consumption smoothing through borrowing and lending; and producers who are able to diversify risks on world capital markets may invest in more risky (and higher-yield) projects, thereby raising the country's rate of economic growth (Obstfeld, 1994, 1998). Increased access to the domestic financial system by foreign banks is often viewed as raising the efficiency of the intermediation process between savers and borrowers, thereby lowering the cost of investment. Higher foreign direct investment flows (FDI) often have a direct, positive effect on productivity and the efficiency of domestic resource utilisation (through transfers of technology and other intangible assets), thereby raising the rate of economic growth.

But it is increasingly recognised that a high degree of financial openness may entail significant short-term costs as well. The magnitude of the capital flows recorded by some developing countries in recent years, and the abrupt reversals that such flows have displayed at times, have raised serious concerns among policy makers. The Mexican peso crisis of December 1994 led to financial instability throughout Latin America, particularly in Argentina. The collapse of the pegged exchange rate regime in Thailand on 2 July 1997 led to currency turmoil throughout Asia, particularly in Indonesia, Korea, Malaysia and the Philippines.

Introduction

The magnitude and speed of the contagion effects that materialised in East Asia in the second half of 1997 has attracted much attention. This chapter asks to what extent the observed contagion may have had ‘real’ underpinnings, in the sense that the pattern of production, consumption and trade increased the vulnerability of East Asian countries to external shocks. In particular, we explore two major possibilities that are relevant in this connection: the ‘competition-cum-export similarity’ story or the ‘flying-geese-cum-Asia Inc.’ story which puts greater emphasis on regional integration and specialisation in complementary production structures.

The competition story posits that Asian economies have specialised in similar export bundles. In a longer-term perspective, the competition story hinges importantly on the emergence of China as a major exporter to world markets. An implication is that given a major devaluation by one country, others are forced to follow in order not to lose export market share. The complementarity story is based on the recent experience of Asianwide growth based on intra-regional trade and geographically cascading investments. In the past two decades, labour-intensive production gradually moved down from Japan, first to the Tigers – the ‘newly industrialised economies’ (NIEs) of Taiwan, Singapore, Hong Kong and Korea – then on to the Dragons (Thailand, Indonesia, Malaysia and the Philippines) and then to China and Vietnam. As a result East Asia became more integrated, its growth path generated by a constant process of industrial upgrading, in turn driven by a rapidly expanding stock of skills and real assets.

Chapter 5 by Aghion, Bacchetta and Banerjee (hereafter ABB) sheds new light on the largely debated issue of the effects of financial liberalisation on output volatility. ABB support the view that relation is positive, as some other contributions do. For example, McKinnon and Pill (1996) suggest that the removal of constraints on international capital movement is at least partially responsible for the Mexico 1994 and the Southern Cone crises. Chang and Velasco (1998a, 1998b) take a similar position concerning the Asian currency and financial turmoils.

McKinnon and Pill blame the excessive optimism of the banking sector. According to their view, it favours a large capital inflow that finances an (unsustainable) increase in consumption and resolves into devaluation. Chang and Velasco remark that financial liberalisations often involve large capital inflows with short maturities. Hence, when short-term obligations in foreign currency exceed reserves and available credit, banks become vulnerable: a creditors' wave of panic may render possible a self-fulfilling bank run and therefore a financial crash with real consequences.

The channel highlighted by ABB is remarkably different: the driving force in their model is simply wealth accumulation and the possibility of output fluctuations is ascribed to the presence of capital market imperfections. Entrepreneurs, to produce, need to purchase a tradeable input (capital) and a non-tradeable one (skilled labour, real estates or land). Total investment is constrained by the presence of capital market imperfections and hence borrowers, when the country is open to international capital movements, enjoy a ‘rent’ as long as the marginal productivity of capital is higher than the world interest rate.

Introduction

Since the crisis in Mexico in late 1994 and early 1995, which was accompanied by speculative pressures in other countries of Latin America and elsewhere, there has been much discussion of contagion effects. Studies by Gerlach and Smets (1995); Sachs, Tornell, and Velasco (1996a); Valdés (1996); and Agénor and Aizenman (1997) present explanations of why a crisis in one country might trigger a crisis in another. Eichengreen, Rose and Wyplosz (1996), using data for 20 industrial countries from 1959–93, show that the occurrence of crises elsewhere increases the probability of a crisis occurring in a given country, after allowing for the standard set of macroeconomic fundamentals. They also attempt to identify what features of countries explain such contagion effects, finding that it is trade linkages, rather than similarity of macroeconomic fundamentals, that have the greatest explanatory power. We will follow them in defining ‘exchange rate crises’ broadly, to include not only devaluations but also successful defence of a peg that involves substantial increases in interest rates and losses of reserves.

The crisis in Thailand and other emerging market economies has once again raised the question of contagion effects. The Thai economy had for several years experienced a period of strong domestic demand associated with an appreciating real exchange rate and large current account deficits, as well as financial sector problems linked to over-exposure to a property market whose prices had fallen sharply. After long resisting pressures on the baht through measures that included capital controls and massive forward intervention, the Thai authorities were eventually forced to abandon the dollar exchange rate peg in July 1997.

I enjoyed reading chapter 8 because it presents a systematic and straightforward approach to modelling contagion in a currency crisis. The chapter stands in the tradition of the so-called ‘second-generation’ currency-crisis models, which originate in the work of Flood and Garber (1984) and Obstfeld (1986). In these models a self-propagating and potentially self-fulfilling speculative attack may occur even if economic fundamentals are consistent with the maintenance of a given exchange rate peg. The outbreak of the speculative attack typically involves multiple equilibria and the jump between a non-attack equilibrium and an attack equilibrium is driven by market sentiment rather than economic fundamentals. It has been stressed that such self-fulfilling speculative attacks may also have contagious effects on other currencies; for the precise modelling of these international spillovers through trade links or foreign debt accumulation, see Gerlach and Smets (1995), Buiter, Corsetti and Pesenti (1995, 1996), or Eichengreen, Rose and Wyplosz (1995).

Like the papers mentioned above, the present chapter views contagion models as a specific variant of the model of purely speculative currency crises. The key point about contagious currency crises is that the sudden swings in market expectations about future exchange rate movements are driven by the occurrence of a speculative attack in another emerging market economy. For contagion effects to work, both economies must have close economic links and/or similar economic structures. But the chapter rightly stresses that such interdependencies exist irrespective of speculative attacks, and it is important to distinguish between contagion and the other forms of interdependence.

The analogy between economics and medicine is sometimes a useful one. In medicine, progress is often made first through an improvement in understanding of a certain disease and then by improvements in treatment of the underlying causes of the disease and through preventive measures such as improvements in standards of hygiene. Similarly in economics, many ‘diseases’ which were apparently poorly understood by policy makers in the past – such as the hyperinflation which results from persistent recourse to the inflation tax through strong expansion of the money supply – have now been largely eradicated in industrialised countries; the IMF Mission Chief knows how to treat the hyperinflation of a programme country, and the Central Bank Governor knows how to avoid one. On the other hand, the medical profession has found it difficult to find a means of preventing orcuring some diseases, and economists, too, have found certain economic diseases – in particular speculative attacks on exchange rates – hard to find a panacea for. In the interesting chapter 9 by Glick and Rose, the authors seek to improve our understanding not of the underlying causes of the speculative-attack disease, but of the way in which the disease is transmitted from one victim to another, in other words the contagion of speculative attacks.

In the summer of 1993 the World Bank Economic Development Institute asked me to prepare a paper for a conference evaluating the remarkable capital inflows that were then seen as both a problem and a blessing for developing countries in Latin America and Asia. The audience comprised senior officials from central banks and finance ministries in the emerging market countries. A revised version of that presentation is the foundation for this chapter. The argument presented is that capital inflows to emerging markets were motivated by a three-part government insurance policies.

The three ingredients were fixed exchange rates, lender-of-last-resort (LOLR) commitments and open capital markets. The paper warned that one of the three links in the insurance chain would have to be broken: if not broken voluntarily, the market would eventually force a regime change. With the benefit of hindsight it appears that these warnings were closer to the mark than the author, much less the audience, imagined. The key analytic point raised by the paper is that a sequence of capital inflows followed by sudden reversals is entirely consistent with rational investor behaviour. So-called ‘convergence play’ inflows to European countries before the crises in 1992, and deposit inflows into US Savings and Loans (S&Ls) before the crisis, are cited as examples of episodes in which investors moved into a country, or financial intermediary, with every intention of moving out under the umbrella of free government insurance. Moreover, the build-up of implicit government liabilities would eventually generate a successful speculative attack that would end the regime. These issues remain at the heart of arguments over reform of the international monetary system examined in this volume.

Chapter 10 is about the role of trade linkages in the Asian crisis. The authors argue that a proper understanding of these linkages is essential for an adequate understanding of the crisis. In doing so, they draw attention to the importance of differences between countries, and they note that much existing analysis of the crisis is unsatisfactory in that it has treated countries as if they were essentially similar. Their central idea is that the impact of events in one country on outcomes in an another will differ, depending on whether the countries in question have complementary or competitive trade structures.

The chapter deals with two distinct aspects of the Asian crisis. First it describes the way in which the onset of the crisis would be expected to be different for competitors and complementary countries. It then goes on to examine how contagion might have occurred between the different groups. Our comments are addressed mainly to the first issue. At the end of our comments we offer some rather brief remarks on the second.

In describing the onset of the crisis, and ascribing causes, the chapter first sets out a trade-competition story which describes the situation for countries producing in the same market segments, with high export concentration and similar export share structures. In such a story, an external shock, such as China's devaluation in 1994, affects all such countries similarly. A higher rate of Chinese growth would also increase competition in export markets and so would also have negative effects on them.

In chapter 3 and a companion paper (Dooley, 1997), Michael Dooley outlines an argument that various distortionary domestic policies are, to a significant degree, responsible for large financial capital inflows and subsequent financial and currency crises in the 1990s. This argument is an application of the broad truth that inflows of foreign financial capital can have undesirable welfare consequences in the presence of distortionary domestic policies, which is itself an application of the general theory of the second best. Dooley observes that many government policies toward financial intermediation provide implicit contingent insurance for asset holders. The distribution of the benefits of these implicit insurance subsidies can differ between foreign and domestic holders of claims on domestic debt service or dividends. Because of its basis in market and policy-induced distortions, this approach directly links welfare consequences to speculative capital inflows and currency crises.

Explicit and implicit insurance schemes are used by governments to avoid the real costs of domestic liquidity crises. Potential financial market intervention can distort the pattern of investment when such insurance is subsidised by the government, leading to excessive borrowing, investment or risk-taking. In the presence of international capital mobility, foreign purchasers of various domestic assets can partake of the benefits of these insurance schemes, including any implicit subsidies. This leads to the policy-created international capital market arbitrage opportunities Dooley mentions. It seems sensible to think that opportunities for private market participants to raid the public coffers are more acute for countries undergoing financial market development and liberalisation than for countries with fairly established institutions for regulating financial market activity.

As recently as 1960, a child born into poverty anywhere in the world had only a one-in-four chance of reaching his fifth birthday, while a person age 15 had a life expectancy of 67 years. Today, vaccines protect eight out of ten of the world's children, more than nine out of ten infants will enroll in school, and the average adult will live into his eighth decade. Around the world, the health gains made in the past two generations are arguably the greatest accomplishment of civilization. What makes these gains so remarkable is that they have been accomplished by people living on every continent on the globe—people representing a panoply of cultures, social structures, and values. Amid this diversity, there is a consistent belief that all societies, and the governments that represent them, are responsible for improving the well-being of the population.

In the health sector, this responsibility means understanding the many factors that go into improving people's health. Some of the most important factors—such as national economic development, education, particularly of women, and the creation of technologies that lead to more effective clinical care—lie outside of what is typically viewed as the health sector. Although these factors are not directly involved with the financing, organization, and delivery of health care, they are substantive sectoral inputs into any country's effort to create better health for its population, and, thus, need to be understood in any health policy context.