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Williamson, John
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ADBI Research Paper Series 8
The evidence of the East Asian crisis is now in, and does indeed point to the conclusion that weaknesses in the financial systems and free capital mobility played a central role in propagating and deepening the crisis. All the crisis countries had essentially opened themselves to uncontrolled inflows of short-term funds, and allowed foreign borrowing of their domestic currency. It is well known that the abolition of capital controls has often been followed by a large inflow of capital. Moreover, this inflow has typically been disproportionately in the form of short-term capital. As the crisis developed, domestic financial institutions found themselves unable to borrow, or even to roll over maturing loans on any terms at all. A major factor behind the financial crisis was the unbalanced currency exposure resulting from a large level of dollar borrowing. As illustrated by the case of Thailand, this meant that depreciation of the baht produced illiquidity/insolvency of the banks either directly (if the currency exposure was taken by them) or indirectly (if the currency exposure was taken by their customers, whose loans then turned bad). The banks’ financial problems then forced them to cut back lending, which aggravated, and may have been the principal cause, of the recession that followed. In terms of recommendations, the author suggested that while current account convertibility is certainly desirable, countries that still have capital controls should not be expected to make a sudden rush for convertibility. Such controls may be aimed at controlling the sudden withdrawal of short-term loans, by banks and other financial institutions, which led to earlier crises. While the author expressed a belief that people and governments can learn from the experience accrued from the financial crisis, he was actually less optimistic as to whether market participants will learn things that will head-off future crises. He also expressed doubts as to whether personal incentive structures in markets are calibrated in a way that makes it individually advantageous to take actions that reduce the likelihood of crisis. This will change only when governments decide to do something to change the parameters within which the markets operate. The primary lesson that the author drew for crisis-affected countries is to be cautious about liberalizing the capital account. This does not mean that they should freeze all activity in that direction, but it does mean avoiding getting carried away by euphoria when growth trends return, as now appears the case. A second lesson was that even if bankruptcy laws, good supervision, reformed corporate governance are of marginal relevance to the avoidance of crises, they are important to prepare developing countries for the next stage of development. In East Asia, the main needs are for strengthened bank supervision, better bank management, and, once that is in place, bank recapitalization. The final step would be to reprivatize those banks that were saved by the injection of public funds and are now owned by the government. He also mentioned that despite images to the contrary, equity markets are already rather well developed in Asia in comparison to world norms. In terms of banking reform, Dr. Williamson suggested an orderly approach that starts with building up supervisory and managerial capacity, followed by raising interest rates to something close to market-clearing levels. Only then should interest rates be freed and all controls on the flow of credit be abolished. As already argued, capital account liberalization should be left to the end.
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