East Asia Crisis: The Origin

The Countries that have been facing relentless recession are Thailand, Malaysia, Indonesia and Korea.

In order to recover and estimate future growth, it's essential to understand the origin of the crisis.

Even as growth was improving the livelihoods of the poor, it had begun creating several sources of vulnerability in the mid-1990s. The region's very success - rapid growth, conservative economic management, and low indebtedness - made it attractive to private capital.

These inflows, while spurring growth, were intermediated through poorly regulated domestic financial systems and helped fuel domestic credit expansion. The pace and pattern of growth, interacting with often-undisciplined capital inflows, produced three weaknesses in the foundation of East Asia's growth:

• Large current account deficits financed with short-term flows, exposed East Asian economies to sudden reversals.
• Liberalization of domestic financial markets without adequate prudential regulation and supervision allowed banks and corporations to assume unhedged foreign borrowing positions that left them vulnerable to sudden currency fluctuations.
• Companies, in the absence of fully developed bond and equity markets, borrowed heavily from banks to finance their rapid expansion, and in the process became very highly leveraged. This left them vulnerable to interest rate surges.

When markets became worried about the sustainability of the fixed exchange rate in Thailand, capital inflows became outflows. Asset values plummeted - particularly equities and property - and suddenly turned what had been a virtuous circle into a vicious one.

Falling asset values reduced wealth and imposed balance sheet losses on financial agents, demand fell, and contracting markets produced greater outflows. Finance stampeded to safe havens, making the situation worse.

Looking Ahead

If the pace of reform accelerates and if the international community responds positively, the region will soon find itself on the road to recovery.