The East Asian Crisis - Macroeconomic Developments and Policy Lessons


WP/98/128-EAWP/98/128


The East Asian Crisis: Macroeconomic Developments and Policy Lessons
Kalpana Kochhar, Prakash Loungani, and Mark R. Stone


This paper reviews macroeconomic developments during the first year of the
crisis in east Asia and draws some preliminary policy lessons. The crisis is
rooted in the interaction of bank-intermediated capital inflows and weaknesses
in private- and public-sector governance. Investment, while high, shifted
recently to low-profit nontradable projects, in part, reflecting rigid exchange
rate policies and incipient structural weaknesses. The crisis was triggered by
external shocks, especially exchange rate shifts and terms of trade declines,
but was then spread throughout the region by the shared vulnerability to the
external shocks, trade and capital linkages, and investor herding behavior.


The paper contains a description of the key features of Fund programs and
their rapid evolution during the past year. Macroeconomic adjustment has
resulted in some surprising outcomes. The unexpectedly severe contractions of
GDP reflect a collapse in domestic demand, owing to the wealth shock associated
with plummeting asset prices and exchange rates. Inflation has been muted,
despite the sharp depreciations. External adjustment, driven by import
compression, has taken place remarkably fast. The restructuring of the
corporate and financial sectors, however, is only just beginning.


Some lessons for crisis resolution can be drawn at this early stage. Tight
monetary policy is needed early on, but interest rates can be reduced once the
exchange rate stabilizes. Fiscal policy should be flexible to strengthen the
social safety net and accommodate the costs of financial sector restructuring,
subject to financing constraints. Bank and corporate reforms are needed to
restore viability while at the same time improve incentives for profit
maximization.


The experience to date also offers lessons for crisis prevention. Prudent
macroeconomic policies and an outward orientation are essential. Proper bank
supervision and data transparency are imperative. Strong governance is needed
to ensure the free play of market forces. Capital account liberalization
requires a healthy domestic financial sector and external debt must be managed
prudently. Finally, crises are prevented by pragmatic policymaking that
recognizes and addresses problems early, even when the going is good.