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Chapter 3 Recommendations Based on the Lessons Learned from the AsianCurrency Crises

Chapter 3 Recommendations Basedon the Lessons Learned from the Asian Currency Crises

There are many things that must be done toenable the Asian economies to overcome the effects of the currencycrises and to return to the path of self-sustaining economic growth.Moreover, there is no guarantee that this "21st century-type"currency crisis will not occur again. Perfect forecast and preventionof similar crises is extremely difficult to achieve, given theglobalization of markets and the advance toward further liberalization.As such, it is extremely important to take every available preparatorymeasure to reduce the probability of a recurrence and to minimizethe impact of a crisis should one occur.

In chapters one and two, an analysis of thecauses and characteristics of the Asian currency crises was undertakenand various issues and challenges presented by the crises wereexamined. In the process, we were able to outline numerous lessonswhich various aspects of the crises had to offer. Based on thisanalysis and the resultant lessons, we shall attempt in this presentchapter to formulate a series of recommendations for overcomingthe effects of the Asian currency crises and preventing a recurrenceof a crisis in the future. These recommendations address the questionof what should be done by the countries affected by the currentcrises, by countries which may become embroiled in future crises,by international financial organizations, by the leading industrializedcountries, and by Japan.

1. Recommendations to Emerging MarketEconomies

As active absorbers of foreign capital, muchresponsibility rests on the shoulders of the emerging market economieswhich were caught up in the Asian currency crises, or are at therisk of experiencing a similar crisis in the future. As the analysisand lessons of chapters one and two indicate, these countriesmust develop appropriate policies and systems for minimizing therisks attendant on capital movements while continuing to enjoythe benefits conferred by foreign capital.

(1) Coping with Short-Term CapitalMovements

The flows of capital, particularly short-termcapital, are subject to dramatic changes in incoming and outgoingvolumes based on exchange rate fluctuations, changing expectationsof economic growth rates, trends in interest rates, and politicaldevelopments. These are factors which were directly connectedto the Asian currency crises. Therefore, various policies mustbe implemented with regard to these factors to reduce the possibilityof a crisis and to minimize the impact of a crisis should oneoccur.

[1] Sound Macroeconomic Management
The volume of short-term capital inflows and outflows is particularlysusceptible to the changing expectations of investors. Sound macroeconomicmanagement (low inflation, balanced budget, etc.) constitutesthe first and foremost element in raising and maintaining investorexpectations at stable levels.

[2] Economic Policy Transparency and Disclosure
To prevent the spread of undue suspicions and fears in the market,economic policies must be transparent. Similarly, more timelyinformation must be disclosed regarding economic management andkey economic indicators.

[3] Prudential Regulation of Capital Inflows
In addition to the above, it is important to institute prudentialregulations to ensure the soundness of capital flows. Such regulationshave two separate aspects. One aspect pertains to macroeconomicsoundness of the entire economy, while the other pertains to thesoundness of individual financial institutions (or the entirefinancial sector) and corporations which are borrowing from abroad.The government must implement appropriate risk management measureswhen the GDP ratio of the balance of short-term capital inflows(or the ratio to foreign reserves) reaches high levels, or whenindividual financial institutions or the entire financial sectoraccumulate large volumes of foreign liabilities. As a prerequisiteto such measures, a system must be developed for monitoring capitalflows and the overseas operations of the private sector.

One of possible risk management measuresto be used when abrupt short-term capital inflows are triggeredsimply by interest rate differentials would be to raise the reserveratios of banks accepting these short-term funds. Such measurescould be justified for maintaining the financial health of banks.

Following the example of Chile, the inflowsof short-term capital can be suppressed by requiring that a portionof the inflowing capital be left on deposit with the central bankfor a prescribed period of time. The method developed by Argentinato prepare for foreign exchange shortages is also promising.

[4] Proper Sequencing of Capital Liberalization
Prior to lifting the restrictions on the short-term capital inflows,various measures must be taken to bolster the domestic financialand capital markets to render financial institutions less vulnerableto external shocks. In this connection, deregulation measuresmust be properly sequenced.

[5] Lifting of Restrictions on Foreign DirectInvestments
To avoid undue dependence on short-term capital, appropriate measuresshould be taken to lift restrictions on the introduction of long-termforeign capital. In particular, restrictions on foreign directinvestments should be abolished within feasible limits as soonas possible.

[6] Promoting the Development of DomesticCapital Markets
In parallel to the above measures, effective steps must be takento promote the development of the domestic stock market and thelong-term government and corporate bond market to facilitate themobilization of long-term capital from both domestic and foreignsources. (Necessary steps include the establishment of transparentmarket rules, upgrading the functions of the stock exchanges,modernizing the settlements system, establishing custodial systemsfor securities, making serious efforts to nurture ratings institutions,and nurturing institutional investors.)

(2) Foreign Exchange Regimes

Under a fixed exchange rate regime (peggingto a specific foreign currency), it is not possible to liberalizecapital movements while maintaining autonomy in domestic monetarypolicies. In view of this fact, the choice of an appropriate foreignexchange regime is of critical importance to developing countries.

[1] Increasing the Flexibility of ForeignExchange Regimes
In order to maintain a degree of autonomy in domestic monetarypolicies while promoting capital liberalization, at a certainjuncture it becomes necessary to move from a fixed exchange rageregime to a more flexible system. It is then desirable to optfor a system in which current account disturbances are amelioratedby exchange rate adjustments. Hence, emerging market economieswhich generally operate under fixed exchange rate regimes shouldbe prepared to exit this system at some stage in the process oftheir economic development in favor of more flexible arrangements(arrangements which take into consideration the closeness of eacheconomy's trade ties with leading partners). Although some Asiancountries have switched to an independently floating foreign exchangeregime following the currency crises, it should be noted thatthe maintenance of a float may not be necessarily desirable forthe medium to long terms.

[2] Defining a Desirable Foreign ExchangeRegime for Asia
The developing countries of Asia require an appropriately flexibleforeign exchange regime through which undue overvaluations andundervaluations can be averted, while at the same time avoidingvolatility. For instance, exchange rates can be stabilized bylinkage to a "real effective exchange rate" which isweighted for such factors as the rate of inflation and trade shares.Specifically, currencies can be linked to a basket of foreigncurrencies whose composition is weighted according to the closenessof economic ties, such as trade volumes.

(3) Addressing the Financial Sectorand Other Structural Issues

A currency crisis and a financial crisisare two sides of the same coin. As such, there is a pressing needto promptly improve the financial health of the financial sector(banks, securities companies, non-banks and others) which wasseriously jeopardized by the currency crises. Additionally, thereis a need to upgrade the risk management capabilities of leadingdomestic industries which are accessing the international capitalmarkets. Similarly, other structural issues which have surfacedas a result of the currency crises must be properly addressed.

[1] Reforming the Financial Sector and EnforcingStricter Supervision
To avoid future currency crises, first of all it is necessaryto bolster the financial foundations of financial institutions,including banks and non-banks, and to comprehensively installrisk management systems. Financial institutions must upgrade theircapitalization and learn to manage properly foreign exchange risks,interest risks and risks attendant on the temporal mismatchingof funds. By the same token, a stronger supervisory system mustbe put into place to ensure that rules of prudent management offinancial institutions are maintained. Furthermore, deposit insurancesystems must be properly established or upgraded, and steps mustbe taken to establish better procedures for the disposal of failedfinancial institutions.

[2] Human Resources Development in the FinancialSector
The development of the human resources needed for the monetarysupervision authorities and the financial institutions is highlytime consuming. Hence, the liberalization of the financial marketsmust proceed with due care. However, the need for due care shouldnot be used as an excuse to delay liberalization.

[3] Reforming the Financial Sector
Financial institutions were not the only borrowers of foreignfunds. In countries such as Indonesia where considerable progresshas been made in capital liberalization, leading corporationsare also able to access directly the international financial andcapital markets to raise funds. In such countries, proper corporaterisk management, particularly the management of foreign-currencydenominated liabilities, takes on special importance. In casessuch as South Korea where chaebols are closely supportedby banks, corporate strategies inevitably affect the financialsoundness of banks. This situation renders it increasingly importantto upgrade the standards of corporate governance, particularlyin relation to the financial aspects of corporate behavior. Similarly,the situation requires the improvement and streamlining of theprocedures for the disposal of failed corporations (better bankruptcylaws).

[4] Infrastructure and Human Resources Development
One of the most important challenges facing the emerging marketeconomies as they endeavor to overcome the effects of the currencycrises is to once again achieve sustained economic growth by improvingtheir industrial structures and nurturing the development of coreindustries. The success of these efforts depends to an importantdegree on the development of social infrastructure (communications,transportation, etc.) and human resources. In turn, human resourcesdevelopment depends on reforming the educational systems of thesecountries so as to train the nation's manpower in the skills andcapabilities required by the core industries.

[5] Coping with Environmental Issues, IncomeDistribution, and Vulnerable Groups
Efforts to achieve short-term growth will have a negative long-termimpact on economic growth if they sacrifice the environment orexacerbate income differentials. Hence, it is crucial that dueattention be paid to environmental issues, income distribution,and vulnerable groups.


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