IMPLICATIONS OF THE CURRENT REGIONAL ECONOMIC CRISIS ON FUTURE DEVELOPMENT POLICIES AND STRATEGIES OF DEVELOPING COUNTRIES

Abstract

The Asian economic crisis is to a great extent a currency crisis as it takes place in a world of increasingly integrated markets and high degree of capital mobility. Severe exchange rate misalignments and economic recessions have been witnessed in almost an the East Asian economies. In this thesis, we examine different policy responses by two countries affected by the contagion effects of the crisis. Malaysia and Hong Kong are chosen as case studies as they have been perceived to be two of the more interventionist countries in dealing with the economic crisis in 1998. Malaysia chose a radical policy stance by reversing from an open economy to one with capital and exchange controls. The Hong Kong government, despite its reliance on the free market principle, was forced to intervene in the stock market when speculative attacks threatened the credibility of the Hong Kong dollar peg. Using economic models like the Portfolio Balance Approach and the Mundell-Fleming model, an attempt is made in this thesis to analyse the policy responses of these two countries. A theoretical analysis of the nature of the Asian crisis is also presented. While trade liberalization yields definite positive benefits, capital account liberalization should be sequenced properly. Asset markets and the foreign exchange market in particular, are driven by herd behavior rather than rational expectations. As a result, uncontrolled short-term capital flows increase the vulnerability of countries to a currency crisis, which is worsened into a financial crisis if the financial system has not been adequately strengthened prior to liberalization. Contagion effects are severe as the Asian countries are interdependent and domestic financial markets are linked tightly to international financial markets. It may be argued that in such a context, controls on capital flows or government intervention will be necessary. An attempt is thus made in the last part of the thesis to suggest future development strategies for developing countries regarding the sequencing of capital account and financial liberalization, exchange rate management, and possible controls on cross-border capital flows. The experiences of other economies, such as Chile, that have successfully imposed selective controls on capital inflows and adopted a crawling band regime, are cited as examples. The objective is to suggest alternative policies the Asian countries can adopt in the future so as to prevent the occurrence of another crisis of a similar nature.