wps2008 - December 3, 1998 Volatility and Contagion in a

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December 3, 1998 Volatility and Contagion in a Financially-Integrated World: Lessons from East Asia ’s Recent Experience By Pedro Alba * , Amar Bhattacharya * , Stijn Claessens * , Swati Ghosh * , and Leonardo Hernandez ** World Bank * and Central Bank of Chile ** Recent events in East Asia have highlighted the risks of financial structures in a financially integrated world. This paper documents that the buildup of vulnerabilities in East Asia was mainly the result of weaknesses in domestic financial intermediation, poor corporate governance, and deficient government policies, including poor macro-economic policy responses to large capital inflows. Weak due diligence by external creditors, in part fueled by ample global liquidity, also played a role in building up vulnerabilities, but global factors were more important in triggering the crises than in causing them. In spite of these policies and weaknesses, we argue, however, that for most East Asian countries a large financial crisis was not “inevitable,” but was mainly triggered by spillovers from nearby countries. Differences between countries, both in degree of vulnerability and depth of crisis, support this conclusion. The paper concludes with some lessons for other countries. ------------------------------------------------------------------------------------------------------------------ Paper presented at the PAFTAD 24 conference, “Asia Pacific Financial Liberalization and Reform”, May 20-22, 1998, Chiangmai, Thailand, hosted by School of Development Economics, NIDA, in collaboration with PAFTAD International Steering Committee. This paper has really been a group effort. We would like to thank Jos Jansen and Peter Montiel for very useful contributions, Sergio Schmukler for his insights, Michael Dooley, the discussant, Akira Kohsaka, and seminars participants for comments, and the PAFTAD steering committee for guidance. This paper draws on and extends the analysis in the joint-World Bank-ADB study: Managing Global Financial Integration In Asia: Emerging Lessons and Prospective Challenges , March 10-12, 1998, for comments. The opinions expressed do not necessarily reflect those of the World Bank or of the Central Bank of Chile.
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2 I. Introduction Private capital flows to developing countries increased six-fold over the years 1990-1996. These large inflows are not simply an independent and isolated macroeconomic shock for these countries to manage. They are rather the manifestation of a structural change in the world economic environment, in the form of a transition by many countries from near financial autarky to fairly close integration with world capital markets. The capital inflow phenomenon, and the associated need to address the potential macroeconomic overheating, were the direct products of the transition between these polar financial integration regimes. In the new, more integrated environment, however, capital could potentially flow out as well as in. Key challenges facing newly financially integrated countries concern not just how to manage large inflows, but also how to reduce vulnerability to the potentially disruptive effects of sudden and massive capital outflows.
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This note was uploaded on 08/08/2008 for the course ECON 365 taught by Professor Muniagurria during the Spring '07 term at Wisconsin.

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wps2008 - December 3, 1998 Volatility and Contagion in a

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