While I was preparing my discussion of chapter 2, I had a strange dream. Some of you may think that this shows a shameful lack of concentration on my part. Be that as it may, the dream was striking. I dreamed that I was about to mark a large number of essays written by history undergraduates. The evident absurdity of this idea was not felt in the dream. The essays were concerned with the causes of the First World War. My first task was to map out a marking scheme, and my dream self felt entirely confident of my ability to do that.

One thing was clear. I would give low marks to any answer which advocated any single cause. Especially low marks would go to an essay which claimed that the war was caused by the assassination of the Arch-Duke in Sarajevo. The idea that the assassination of any individual, however prominent, could inescapably entail the outbreak of a Europewide war is completely ridiculous. Of course, a good answer could describe how the assassination triggered general conflict by being the occasion of a war between Austro-Hungary and Russia, which dragged in many other countries via the system of interlocking alliances which had maintained peace in Europe for over 40 years. The best answer would have to address that long peace, because one cannot reasonably claim that Europe's alliances made war inevitable in 1914, without explaining why very similar alliances had maintained peace for a length of time without precedent in modern Europe.

Chapter 7 takes further the ideas of Morris and Shin (1998) in that it allows for more natural Brownian-motion representation of fundamentals. In addition the chapter assumes that the information of market participants about the true value of the fundamental is distributed according to a normal distribution about the true value, as opposed to a uniform distribution in the earlier paper. This allows the authors to tell a dynamic story about when a currency attack might occur, and also to examine what happens when the nature of the differential private information is varied. The results remain startling: a tiny departure from common knowledge entirely eliminates the multiplicity of equilibria. This work represents a major challenge to the traditional multiple-equilibrium models of currency attacks, most notably associated with Obstfeld (1986, for example). Of course the insights here are also applicable to other market situations with similar multiple-equilibrium properties, such as bank-run models.

The arguments of the chapter, however, are technical and it is difficult to get a clear idea of why a small departure from common knowledge about the fundamental can lead to such a radical change in the set of equilibria. So I will start by attempting an overview of the argument, before discussing the extent to which I think these insights are important.

Introduction

The swiftness and devastating effect of recent financial crises pose considerable challenges for economists seeking an explanation of their onset. It is easy to give a narrative of the sequence of events leading up to the crisis with the benefit of hindsight. However this falls short of an explanation, since it begs the question of why the crisis occurred at that particular moment in time. More importantly, it does not explain the absence of a crisis in apparently similar countries, or in the same country at different moments in history. The challenge is all the more acute in the light of evidence that the onset of the Asian financial crisis of 1997 was largely unanticipated by market participants, as well as by the international agencies. Radelet and Sachs (1998) note that credit-risk spreads for borrowers in the region increased only after the crisis was in full swing, and the credit-rating agencies were largely reacting to events rather than acting in advance. Nor was there much indication from international agencies or the country analysts of normally canny investment banks that a crisis of such magnitude was brewing.

Given the difficulties in coming up with a rigorous theory, it is tempting to fall back on unexplained shifts of sentiment on the part of fickle investors, or the unexplained onset of panic among creditors as an explanation.

Introduction

The East Asian financial crisis plunged the most rapidly growing and successful economies in the world into financial chaos and deep depression. At the time of writing, 18 months from its onset, neither the events them selves nor the appropriate policy responses are properly understood; but the outlines of a picture are becoming clear.

We see the Asian crisis – as many others do – as the outcome of a flawed process of financial liberalisation. But the trouble with that diagnosis is that it has often been served up accompanied by a rather loose list of mistakes, and buttressed by no very clear argument. Accordingly, the question which we set ourselves is a precise one: why was the crisis so bad? In other words, why did ‘crisis’ turn into ‘collapse’? Our answer to this question is that it was because of the inter-relationship between currency crises and financial crisis. Our argument proceeds in four stages, which are set out schematically in figure 2.1.

1. (1) We argue that vulnerability was created both by liberalisation in the presence of a bank-based financial regime (which contained implicit promises of bail-out if its balance sheet deteriorated), and by liberalisation in the presence of a monetary policy regime based on pegged exchange rates (which led to boom and bust). These vulnerabilities were interconnected, and led to a risk of currency and financial collapse (levels 1 and 2 in figure 2.1).

2. […]

Introduction

The world has in recent months been captivated by the sight of the ‘miracle’ economies of a few months ago tumbling first into a financial crisis and then into a full-scale macroeconomic collapse. Not surprisingly, several potential explanations for why this happened are already in the air: some argue that it was pure happenstance (a ‘panic’); others blame the peculiarities of the financial sector in these economies (‘crony capitalism’).

This chapter takes a somewhat contrarian position with respect to this debate. Specifically it argues that what happened in East and Southeast Asia is not necessarily an aberration requiring a special explanation. In the years before the crisis hit, these economies had been going through a process of rapid change. The financial sector was being liberalised, making it easier for domestic firms to borrow. Partly as a result of this liberalisation, capital was flowing into these economies in large quantities, causing a real currency appreciation, rapid growth in lending and a boom in investment. When the crisis came it is these forces that got reversed – capital flowed out, the currency fell, lending stopped and investment collapsed.

This pattern of a boom accompanied by capital inflows and a real appreciation followed by a dramatic collapse with capital outflows and rapid depreciation is by no means unknown in other middle-income countries. Very much the same thing happened in Mexico in 1994 and in the Southern Cone in the early 1980s.

Perhaps more importantly, this pattern of growth and collapse may be a natural feature of economies at an intermediate level of financial development, especially those with a liberalised financial sector.

Introduction: globalisation challenged

Rome was not built in a day: nor can global capital markets be created overnight. The smooth functioning of a market economy needs more than freedom to buy and sell: institutions matter too, and creating them can take time. Accounting, banking and legal practices developed in Renaissance Italy, for example, played a central role in expanding mercantile trade from Venice and its sister states to the world at large (Jardine, 1996). The institutional framework is even more important when the items traded are promises to pay – as the history of financial crises testifies. Nineteenth century London capital markets were plagued by recurrent liquidity crises until the Bank of England learned to act as a lender-of-last-resort (LOLR): and it was the catastrophic bank runs of the early 1930s that led the fledgling Fed to implement a policy of deposit insurance.

Now, at the end of the twentieth century, the need for institutions to underpin emerging markets has been dramatically demonstrated yet again. First in the traumatic experience of economies in transition from communism, where the lack of adequate legal and accounting systems and the pervasive presence of corruption and crime (to say nothing of political failure) has so threatened enterprise and stunted development in Russia, for example, that some no longer consider it an emerging market. Second in the financial crises that have racked the newly liberalised capital markets in East Asia and drained the funds of the institutions set up after the Second World War to manage the international financial system. Why is it that rapid liberalisation of financial markets seems to court crisis? What can be done about it? This is what we study here.

Introduction

Private capital flows to developing countries increased sixfold over the years 1990 to 1996. These large inflows were not simply an independent and isolated macroeconomic shock but rather the manifestation of structural changes in the world economic environment and in developing countries themselves. The structural changes resulted in the transition by many countries from near financial autarky to fairly close integration with world capital markets. The capital inflow phenomenon, and the associated need to intermediate efficiently large amounts of foreign capital and address potential macroeconomic overheating, were the direct products of the transition between these polar financial integration regimes.

Countries in East Asia were at the forefront of the worldwide movement toward increased financial integration (see World Bank, 1997) and are good examples of both the benefits, and the risks, of integration. East Asian countries fared quite well during the initial stages of this integration process, especially in comparison with many developing countries outside the region. Indeed, in many ways lessons to be applied elsewhere regarding the appropriate adjustment to large capital inflows have been drawn from the experiences of East Asia (for example, Corbo and Hernandez, 1996). Countries in the region also weathered the storm associated with the Mexican currency crisis of December 1994 in relatively good form, suggesting that the policies they adopted to manage inflows also proved effective in rendering them relatively less vulnerable to a financial shock that created serious disruptions elsewhere. Nonetheless, the summer of 1997 and events since have made clear that this view could no longer be sustained.

The final section of the book is an updated report on a Round Table discussion which was held at the conclusion of the conference on ‘World Capital Markets and Financial Crises’, University ofWarwick (24–25 July 1998). The discussion produced a comprehensive review of thinking about the crisis, which is why we report it in full here. Richard Portes talked about early-warning indicators and LOLR facilities. Phillip Turner spoke about risk in financial markets and the role of the public sector in the context of such risk. Finally, Charles Goodhart talked about the impact of external events on the exchange rate and also on the treatment of foreign currency debt, both of which have implications for the IMF programmes.

Richard Portes

Robert Rubin says that ‘The purpose of IMF packages is to help Korea, a by-product is that we help investors and creditors.’ Do we really agree with this? Or do we think that IMF packages do this? Or do they mainly create moral hazard? Start with Mexico. Of course it is impossible to demonstrate from the data that the Mexican bail-out, through creating moral hazard, contributed to what we have observed in Asia. But I believe passionately that it did. I would be delighted if anybody here could suggest ways in which we could observe in the data the effects of the moral hazard that such rescues create. But what we have observed in the Asian sequence is the creation of further moral hazard.

Take the Korean bail-out. What happened? During three weeks in December 1997 the IMF package of 10 bn dollars went directly into reducing the short-term exposure of the banks.

In their chapter 6, Agénor and Aizenmann develop a theoretical model of the effects of opening up the financial markets of a country. They explore the effects on the returns of domestic firms, banks and savers, and explore the amount of investment undertaken and the effects on welfare. The chapter begins with a model in which the domestic economy can provide a fixed supply of saving at a constant reservation price, which meets a fixed domestic demand for funds, well below domestic saving. This is the central case which occupies most of the exposition and provides most of the chapter's insights. The chapter goes on to consider two extensions. One allows for an upward-sloping supply curve of funds and heterogeneity of projects in terms of their expected returns, and the other allows additionally for congestion externalities. These two cases allow the opening up of financial markets to affect the amount of investment that takes place in the economy. Congestion externalities increase the likelihood that internationalisation will lead to excessive investment which reduces welfare.

The analysis assumes that there is asymmetric information between banks and the firms to which they lend, in that the firms alone discover costlessly the returns on their investments, which are random variables. While the banks can also discover the returns to investment projects, monitoring is costly, and is carried out only when firms default on loans. However, although asymmetric information and costly monitoring are assumed, there is no room for moral hazard or adverse selection in the model.

Introduction

Was the Asian crisis caused by fundamental weaknesses and policy mistakes, or was it due to a financial ‘panic’ (encompassing phenomena such as ‘fickle investors’, volatile hot money, multiple instantaneous equilibria, speculative capital flights and bank runs)? An analysis of the causes of the crisis is important because, depending on one's view, conclusions may differ as regards what could have been done differently to prevent the crisis and its global contagion, and what can be done in the future to reduce the risk of financial turmoil.

Yet, the two ‘views’ of the crisis are not completely inconsistent with each other. On the one hand, the possibility of multiple instantaneous equilibria – underlying interpretations based on self-fulfilling attacks – arises only when economic fundamentals are ‘weak enough’ – i.e. some deterioration of fundamentals is a necessary condition preceding a panic. On the other hand, the view that the crisis is initially triggered by fundamental factors does not necessarily rule out the possibility that, after the crisis, movements of asset prices (exchange rates and stock market indexes) and capital flow reversals may be excessive and not warranted by fundamentals.

Challenging the readings of the 1997–8 events that downplay the role of structural factors, in the first part of this chapter we attempt to document the extent to which the Asian crisis was related to fundamental imbalances. We argue that, beneath apparently strong economic performances (low budget deficits, low public debt/GDP ratios, single-digit inflation rates, high economic growth and high savings and investment rates) lay institutional weaknesses, policy inconsistencies and severe structural distortions.

In countries hit by the Asian financial crisis there stalked dark shadows whose like had not been seen since the Great Depression: one after another, banks and currencies collapsed and confident growth ceded to fierce contraction. The waiting world watched in shocked surprise, and wondered: Why did the crisis happen? Why did it spread like wildfire from country to country in the second half of 1997? Why were its effects so serious? What can be done to aid recovery?

These are important questions, both for the world's citizens and for economic analysis. This volume brings together studies by a number of distinguished scholars and policy-makers who try to answer them. The authors seek to clarify:

1. (1) the role of ‘vulnerability’ in what happened

2. (2) the interconnection between currency crisis and financial crisis, and how they combined to cause collapse

3. (3) what the mechanisms of contagion were

4. (4) what needs to be done, subsequent to this collapse.

The book is divided into four parts.

Part One begins with four wide-ranging chapters that, taken together, provide a systematic overview. In chapter 1 Alba, Bhattacharya, Claessens, Ghosh and Hernandez mobilise the research resources of the World Bank to provide a detailed empirical account of the crisis. In interpreting what happened, they make two major points. First, they show how events in East Asia have thrown up challenges for macroeconomic management in a financially integrated world. Second, they demonstrate the importance of avoiding risky financial structures.