Paragraph on The domestic financial systems
Out of the three generation models, I strongly believe that third-generation models offer the most convincing explanation for the Asian crisis. Therefore a few policies could have been useful. First would be choosing with right exchange rate regime. The East Asia countries could have either pursued a monetary union and therefore relinquish their independent currencies, or have a floating exchange rate. The latter would mean that the economies would simply not offer speculators an easy target, by refusing to defend any particular exchange rate in the first place.
Therefore any speculative concerns about a country’s policies will already by reflected in the exchange rate. Thus anyone betting against the currency unit will face a real risk, rather than the one-way option in speculating against a fixed rate. The lesson learnt here is that countries should avoid half-way houses, which the East Asian countries became a victim of. Second is the central importance of banking.
As governments stood behind their banks, this bred moral hazard and led to excessive lending, especially in real estate, that temporarily concealed the poor quality of many of the investments; and that the inevitable end of this boom caused a downward spiral of declining prices and failing banks. The governments should have devoted a great deal of resources to shoring up their banking systems to minimize moral hazard, to reduce the likely chances of a financial catastrophe. Besides that, the East Asian governments should have paid more attention to the proper sequence of reform measures.
Many of these countries had liberalized their capital accounts before sound safeguards and supervision were in place for domestic financial institutions. With liberalized capital accounts, domestic banks began to borrow recklessly from abroad. Thus when the economies started to slow down, foreign capital fled, leaving domestic banks insolvent. The East Asian governments should have delayed the opening of capital accounts until the domestic financial systems were strong enough to withstand the sometimes violent streak of flow of world capital. So would appropriate policies have prevented the crisis.
As argued above, third-generation models provide the most credible rationalization of the Asian crisis thus far and that several policies could have reduced the likelihood of the crisis. Nonetheless, many of the countries in East Asia were not only facing an economic crisis during the period 1997-1998; countries like Malaysia and Indonesia, for example, were also facing political turmoil. In short, it would be wrong to say that the policies mentioned above could have prevented the crisis from happening but it would certainly have reduced its chances!