Before the East Asian crisis, few people question the value of the free movement of money.  As an article of faith, economists believe that the free flow of capital across borders increases economic efficiency, with savings going to the most productive sectors.  Under greater competition, it is argued that financial systems will become more efficient, and good governance is rewarded while poor governance is punished by investors.  Many developing countries started opening their capital accounts ahead of measures to strengthen their institutional capability to cope with the new liberalised environment.  This proved a fatal move, as shown by the East Asian experience.

    With the large economic, social and political costs suffered by the East Asian economies, some economist are now arguing that international movement of capital brings more costs than benefits.  Professor Jagdish Bhagwati from Columbia University argues in the Foreign Affairs that "the claims of enormous benefits from free capital mobility are not persuasive".  He argued that the Asian crisis was partly due to rapid financial liberalisation in the crisis countries, without the adequate policy and institutional framework.  This was echoed by Dani Rodrik, a trade specialist from Harvard University, who said that there is no evidence that capital mobility would solve any of our problems, and some reason to think that it may make them worse.  Joseph Stiglitz, the World Bank's chief economist and an expert on financial markets, is cautious about the risks involved in setting the financial sector free.  He is worried that hasty opening of a country's banking market to foreigners could cause excessive competition and instability.

Causes of the Crisis

    Economists have different perceptions of the Asian crisis and are hardpressed to explain the causes.  Early into the crisis, the blame was placed squarely on the crisis-hit countries.  One view was put up by Professor Paul Krugman of MIT.  The countries were blamed for "crony capitalism", the lack of transparency, and "Asian values".  They were blamed for their inept domestic policies, inefficient resource allocation, and over-investment in property, which came about from over-borrowing, poor bank supervision, and extreme moral hazard.  The crisis was said to be a "wake-up call" to these countries so that they amend their ways.

    Another explanation is given by Professor Jeffrey Sachs of Harvard University that the Asian turmoil is the classic case of financial panic.  There was speculative attack on currencies, which led to the run on banks, capital flight, and the collapse of asset values.  Although the Asian economies are healthy according to conventional measures, the fragility in the banking systems gave way because of maturity mismatch of loans.  While Krugman's explanation focuses on values and institutions of countries and regions, Sach attributes the problem to a much wider issue beyond the domain of individual nations, that is, the imperfections in the global financial architecture.

    Much of the explanations of the crisis are given by economists and analysts from large developed economies, some of whom speak as high priests from the pulpit.  Malaysia was the first crisis-hit country to highlight the shortfalls in the management of the international financial system.  In his characteristic outspoken manner, Dr. Mahathir Mohamad, the Prime Minister of Malaysia, pointed out the dangers of volatile flows of speculative, short-term capital in disrupting trade and real economic activities.  His speech, which was delivered at the Joint Annual Meetings of the IMF and the World Bank in September 1997, resounded throughout the financial world.  He argued that large market players could manipulate the financial markets to their advantage, to the detriment of the economic welibeing of many economies.  Currency trading, undertaken by offshore bank operations and hedge funds managers, has become so much larger than real trade in goods and services.  He called for an international mechanism to regulate short-term capital flows.

Growing Agreement

    At first, these statements were received with criticisms and cries of outrage from Wall Street and the developed world.  As the Asian crisis deepened, these criticisms gave way to increasing agreement with Dr. Mahathir's stand, as more people saw the dangers of predatory speculative activities and volatile short-term capital flows.  Hong Kong came under several speculative attacks aimed at pushing its dollar off the peg, although its economy has the third largest foreign currency reserve in the world.  Transparency of the financial sector and corporate governance in Hong Kong were not in question.  The world came close to an economic disaster as a result of the Russian debt default that hit Brazil and caused the near collapse of Long-Term Capital Management (LTCM).  The LTCM crisis brought the thickly veiled and highly intricate schemes of over-leveraged operations of present day international finance into the open.

    The highly leveraged hedge funds move massive amount of funds rapidly across the world, without being subject to disclosure rules.  Like modern-day pirates of high seas, they distort and manipulate markets with complete impunity as they profit from the currency and economic volatility that they initiated.  Even small but well-run economies are powerless against the resources that they can marshal and the panic they transmit through the world media, causing a self-fulfilling stampede of investors rushing to the door.  Bloodlust, avarice and greed are the rules of the day, while the free market is taken for a free ride.  Meanwhile, smaller, vulnerable economies are being pushed to the brink of bankruptcy, as investors from rich nations pick cherries among the spoils.  As Ian Macfarlane, the Governor of the Reserve Bank of Australia, noted the hedge funds are "the privileged children of the financial scene, being entitled to the benefits of free markets without any of the responsibilities."

    After waging a concerted battle against speculators, Joseph Yam from the Hong Kong Monetary Authority has joined the growing chorus in agreeing with Malaysia's Dr. Mahathir.  Mr. Yam argues that the Asian crisis reflected the flaws in the global financial system.  The management of the global financial system remained primitive and fragmented, while global finance has advanced with financial market liberalisation, information technology, and sophisticated investment tools.  Therefore, the international financial architecture is incapable of coping with the demands of global finance.

Policy Response

    The early diagnosis of the Asian crisis was policy weaknesses of individual countries.  Thailand, Indonesia, and South Korea, which sought assistance from the International Monetary Fund (IMF), adopted tight monetary and fiscal policies and undertook structural reforms of the financial sector.  Nonviable financial institutions were closed and legal and institutional frameworks, such as bankruptcy and foreclosure procedures, were established for the disposal of assets.

    Malaysia, on the other hand, moved away from conventional macroeconomic measures by adopting selective capital control measures in September 1998 in the face of worsening regional and global financial markets and speculative pressures on the Malaysian ringgit.  These measures curbed the internationalisation of the Malaysian ringgit and discouraged destabilising short-term capital inflows so as to protect the economy from potentially damaging external shocks and provide a stable environment for economic recovery.  With improving economic environment, Malaysia eased the capital control measures with the adoption of repatriation levy in February 1999.  This is the case of a small, open economy that was forced to adopt measures for self-protection, while the world engages in debate about reforming the financial architecture.  After being a vociferous critic of Malaysia's measures, the IMF later conceded that the currency exchange rate controls can be useful and palatable under certain circumstances.  Stanley Fischer, the first deputy managing director of IMF, praised Malaysia for its approach in using currency controls while pushing ahead with its banking reform measures.

    In August 1998, when speculators launched coordinated and well-planned attacks of the Hong Kong financial markets, the Hong Kong government bought substantial amount of its stock and futures exchanges in 'an unexpected move to defend its financial system against the concerted speculative attacks.  This market operation was condemned as a criminal breach of free market principles, but Hong Kong justifies its interventions as a necessity to keep the market free from disruptive speculation and prevent a possible systemic collapse.

New International Financial Architecture

    Until the reform of the international financial architecture, the small open economies are at risk of being destabilised by large players who are capable of moving massive volume of international capital.  But large rich economies are not entirely free from danger.  Following the LTCM crisis, it suddenly dawns on world leaders that even the largest countries and their financial systems are exposed to the risks of highly-leveraged financial operators, whose activities could potentially lead to global crises.  This gave the impetus for the developed countries to respond to calls for a new international financial architecture to avert future disasters.

    The international financial architecture should be reformed to regulate volatile capital flows, especially short-term flows, for the orderly functioning of international financial markets and preventing destructive volatility of international capital flows.  There should be improved transparency, information and disclosure by financial institutions, including the parties involved in hedging activities and cross-border movement of funds.  Higher prudential standards are needed for financial institutions, especially among commercial banks exposed to highly leveraged financial institutions.  In addition, the new financial architecture should have higher regulatory standards and better prudential oversight of capital flows, both domestically as well as internationally.  The near collapse of LTCM shows that the weakness in prudential oversights is not merely an Asian problem, but one affecting developed countries alike.  There must be some concerted effort to rein in cross-border manipulation, such as the operations of hedge funds and highly leveraged offshore institutions.

    The international community should mount a concerted effort to reform the global financial system so as to avert future outbreaks of financial crisis in various parts of the world.  Although international forums, such as the Group of 7 (G-7), have given some recognition and considered proposals on the issue of hedge funds and short-term capital flows, much more remains to be done.  With the return of stability to world financial markets, there is danger that the sense of urgency to push ahead with the new international financial architecture might whittle away.  Unless the international community is committed to reform the international financial system, there would be no permanent solution to the currency crisis.  Individual countries can only adopt local defensive measures, but for any solution to stick, it has to be international in nature because global capital flows traverse national boundaries.  Both the developed and developing countries should act together in setting up a new global financial architecture.