The collapse of the Mexican peso in 1994–5 was called the first financial crisis of the 21st century. But well before the millennium, we have another. A new CEPR Report draws some lessons from the Asian breakdown.

Asia’s financial crisis has prompted sharp falls in equity prices and exchange rates in the region. Thailand, Indonesia and South Korea are all facing outright recessions this year, notwithstanding substantial packages of international financial support. In their trading partners, economic growth will slow and current account deficits widen as the crisis countries export their way to recovery. Resurgent protectionism remains a threat.

A new CEPR Report explores the causes and consequences of the crisis, and a number of proposed cures. Bringing together the views of leading researchers on international capital markets, the Report examines whether in future it might be possible to identify ‘early warning signals’ and avert potential crises.

The Asian crisis is difficult to explain with conventional economic models, the Report notes. Government policies have not been particularly profligate and unemployment has not been high enough to encourage expectations of looser policy. Instead, the story is one of unsustainable bubbles in asset prices, fuelled by capital inflows to economies with weak and poorly regulated financial systems. As in the US Savings and Loans debacle, lenders were encouraged to pump money into financial intermediaries in these countries by implicit guarantees that they would be repaid if things went wrong.

This and other features of ‘crony capitalism’ cannot explain the timing of the crisis, but they do explain its breadth and severity. And the authorities in the crisis countries made matters worse by engaging in last-gasp defences of their fixed exchange rate regimes, which made the eventual rescue packages even more costly. The crisis spread as the initial problems in Thailand exposed similar weaknesses elsewhere.

As conditions for its financial support, the IMF has imposed its traditional macroeconomic prescriptions: tightmonetary policy, fiscal consolidation and the closure of troubled financial institutions. These have been controversial: critics argue that contractionary policies are inappropriate in economies with budget surpluses, low inflation and high savings. Meanwhile, closing banks undermines confidence and exacerbates any underlying credit crunch. This, the critics argue, explains why the announcement of IMF programmes failed to restore market confidence and shore up the affected countries’ exchange rates.

The fiscal policy imposed by the IMF may indeed have been too tight, but it is not clear that the monetary policy was. More likely, confidence was undermined when the authorities backed away from policy being tightened too quickly, which the markets may have read as a signal that longer term structural reforms were unlikely to be pursued consistently either. With bank closures, it may be that they were not closed early enough and that not enough was done to re-establish confidence in the solvency of the remaining institutions.

As with the Mexican rescue package, the promises of financial assistance in Asia have raised the issue of ‘moral hazard’. Foreign lenders to Asian corporations and banks have taken much less of a hit than foreign equity holders, which may encourage them to engage in excessive risky lending in the future. The G10 argued after Mexico that ‘neither debtor countries nor their creditors should expect to be insulated from adverse financial consequences by the provision of large-scale official financing in the event of a crisis’. More needs to be done to ensure that this is the case in future.

To avoid moral hazard, IMF programmes should make it clear that any blanket guarantees offered to lenders by the affected governments should not be expected to be honoured. But it is unrealistic to expect governments to accept the failure of core institutions. The international community should also be prepared to encourage the private sector to reschedule a country’s short-term debt earlier than it did in Asia.

Given that private sector debt was in effect taken onto the public sector balance sheet, there remains a strong argument to push ahead with the ‘orderly workout’ agenda put forward after Mexico. Governments in the industrial countries should set an example by agreeing to insert majority voting and sharing provisions in their bond contracts. The international community should also consider the possibility of allowing the IMF to sanction debt standstills.

IMF surveillance of national economic policies was tightened up in the wake of Mexico’s crisis, and the IMF did supposedly see the Asian crisis coming. The authorities were warned to take action in private and in public, though the impact of the public warnings was tempered by the traditional courtesies that the IMF feels it must adopt when commenting on the policies of its member governments.

In future, the IMF should perhaps sacrifice some courtesy in favour of greater clarity. This may reduce the amount of sensitive information that national authorities provide to the IMF, but it is probably a price worth paying. In some ways, market participants and credit rating agencies have better and more up-to-date information than the Fund. If the national authorities find themselves ‘gambling for resurrection’, the IMF and the markets alike may be in the dark.

Where are banking and currency crises likely to strike next? Various models have been used to devise early warning indicators and it appears that the best predictors of crises are real exchange rate overvaluation, falls in exports, and recessions. These models seem able to predict 80% of crises, but with one false alarm for every two or three correct signals. This is an advance on the current state of knowledge, but may not be reliable enough to justify public warnings. Crises all share common features, but each is different in its own way. So any model based on the features of past crises can only be reliable up to a point - crises will always be with us.