Two Lessons of the East Asian Financial Crisis

Toyoo Gyohten

The following text is an edited transcript of remarks made by Toyoo Gyohten to the 1999 annual meeting of the Trilateral Commission in Washington, D.C. Toyoo Gyohten is the President of the Institute for International Monetary Affairs in Tokyo and a Senior Advisor at the Bank of Tokyo-Mitsubishi.

The East Asian financial crisis has left us with many lessons to learn. Two lessons are particularly relevant to the improvement of the international financial architecture. First, we need to have an emergency financing mechanism to cope with the onset of a financial crisis. Second, we need to have greater stability of exchange rates between major trading currencies.

Regional Emergency Financing Mechanism in East Asia
The East Asian crisis was triggered by the sharp reversal of short-term capital flows. At first, affected countries tried to counter the movement by intervening in the market. However, their reserves were soon depleted and their resistance was given up. What followed was a sharp depreciation of the currency—the magnitude of which exceeded by far the necessary level of adjustment—and also the acute shortage of foreign exchange liquidity. As a result, the external debt service burden mounted sharply, and defaults became prevalent. Industries couldn’t finance imports of necessary materials, parts, and components; exporters couldn’t get the letter-of-credit facility. In other words, the vital parts of the countries’ economies suffered serious damage and the crisis left a lasting scar on the balance sheet of banks and business firms of those affected countries.

In order to prevent the recurrence of such traumatic developments, it is desirable to create a mechanism which provides quick and ample financing to the country suffering the first blow of a financial crisis. Financing should be used for the purpose of preventing the excessive depreciation of the currency and of keeping the trade-related industries going. In my view, certain mechanisms could be established as the IMF’s regional vehicle. In order to ensure the high degree of maneuverability which is the key for the success of this kind of operation, the vehicle should be accorded the minimum necessary autonomy, backed by regional contributions and regional voting rights. East Asia will be the fitting place to establish such a new facility. With the much increased recognition of the need for closer regional cooperation and $600 billion of official reserves held within the region, the conditions to support such an enterprise seem to be favorable. And I believe Japan is willing to play a leading role.

Greater Exchange Rate Stability Between Major Trading Currencies
The second lesson is the importance of exchange rate stability. It is now a common view that the so-called dollar-peg system was a major culprit of the East Asian financial crisis. Well, certainly it is true that affected countries ignored the fundamental disequilibrium that had emerged in their economies and failed to adjust their currencies’ exchange rates accordingly. In that sense, the rigidity of exchange rate policies was responsible for the crisis. However, more important was the fact that the dollar itself fluctuated violently vis-à-vis the yen, which is another important trading currency for the affected economies. The ten-year weakening of the dollar between 1985 and 1995 brought about a windfall trade surplus for the affected countries. Then the sharp reversal started in 1995 erased their excessive price advantage and weakened their current account position, which in turn undermined market confidence and prepared a feeding ground for a crisis. In other words, it was not the dollar-peg system, per se, which is to blame. It was the unheeded fundamental disequilibrium in the countries’ economies and the wild fluctuation of the dollar-yen exchange rate.

It is hardly possible to explain or justify such wild fluctuation by the relative situation of American and Japanese economies during the period. In my view, it was a product of the combination of the enormous amount of volatile capital and the herd mentality of market participants which can be triggered by capricious flow of information.

I am not advocating the return to a fixed exchange rate or even a rigid kind of stability. Exchange rates should change over time, reflecting such fundamentals as balance of payments, inflation, or interest rates. What I am arguing is that unwanted volatility, which tends to create a prolonged misalignment, destroys the reasonable predictability of exchange rates and thereby distorts trade and investment decisions. I think it is indisputable that the wild fluctuation of the dollar-yen exchange rate since 1985 has produced a serious distortion not only for the Japanese economy, but also for East Asian economies as well. If the dollar-yen exchange rate had remained reasonably stable, I suspect the severity of the East Asian crisis could have been mitigated considerably.

Now, having said that, how to achieve exchange rate stability is clearly a different subject. I have no time to go into the argument now; however, if there is a broad agreement about the desirability of exchange rate stability then we should explore to find a way. In my view, the first and the most important step to be taken is a joint public commitment by countries concerned to recognize the importance of cooperation and exchange rate stability. Then, we will be able to discuss practical means to agree upon the mutually acceptable range of stability and various instruments to be used to achieve the goals. On this issue, also, Japan is willing and anxious to cooperate with other major currency countries.