**2.2 The 1997/98 Asian financial crisis2**

Prior to the crisis, most of the Far Eastern countries that were involved in the crisis did very well. Business-friendly policies and cautious fiscal and monetary policies had translated into high rates of savings and investment, supporting GDP growth rates exceeding 5% and often approaching 10%.

However, as the crisis unfolded, it became clear that the strong growth record of these economies had masked important vulnerabilities. Years of rapid domestic credit growth and inadequate supervisory oversight had resulted in a significant build-up of leverage and doubtful loans. Industrial policies of governments led corporations and banks to believe that, in case of financial difficulties, they will be bailed out in spite of the fact that there was no official commitment to such bailouts (see Ref. [4]).

Overheating domestic economies and real estate markets added to the risks and led to increased reliance on foreign savings. This was reflected in mounting current account deficits and a build-up in external debt. Heavy foreign borrowing, often at short maturities, also exposed corporations and banks to exchange rate and funding risks. Prior to the crisis, those risks had been masked by longstanding currency pegs. When the crisis erupted, most of those pegs proved unsustainable and firms saw sharp increases in the local currency value of their external debts, leading many into distress and even insolvency.

The crisis burst into the open on July 2 1997 when, following months of speculative pressures that had depleted its foreign exchange reserves, Thailand devalued its currency relative to the U.S. dollar. In subsequent months, Thailand's currency, equity, and property markets weakened further as its difficulties evolved into a twin balanceof-payments and banking crisis. Malaysia, the Philippines, and Indonesia also allowed their currencies to weaken in the face of market pressures, with Indonesia gradually falling into a financial and political crisis. Severe balance-of-payments pressures in South Korea brought the country to the brink of default. Hong Kong faced several large but unsuccessful speculative on its peg to the dollar, the first of which triggered short-term stock market sell-offs across the globe. Across East Asia, capital inflows

<sup>2</sup> This subsection draws on Ref. [3].

slowed or reversed direction, and growth slowed sharply. Banks came under significant pressure, investment rates plunged, and some Asian countries entered deep recessions, producing important spillovers to trading partners across the globe.

In response to the spreading crisis, the IMF, the World Bank, the Asian Development Bank, and governments in the Asia-Pacific region, Europe, and the U.S. provided large loans to help the crisis countries rebuild official reserves and buy time to restore confidence and stabilize their economies, while also minimizing lasting disruptions to countries' relations with their external creditors. To address the structural weaknesses exposed by the crisis, aid was conditional on substantial domestic policy reforms. These included measures to deleverage, clean up and strengthen weak financial systems and improvement of competitiveness. Countries hiked interest rates to help stabilize currencies and tightened fiscal policy to speed external adjustment and cover the cost of bank clean-ups. But, as markets began to stabilize, the macro policy mix evolved to include some loosening of fiscal and monetary policies to support growth.
