of rising off-budget liabilities and an increase in the fiscal deficit due to a falloff in tax revenues. Here, fiscal consolidation is a clear priority.

**Table 5. Key Macroeconomic Variables in the East Asian Crisis Countries, 1996-2002**

||Total P<br>% o|ublic De<br>f GDP|bt|Net Forei<br>% of|gn Assets<br>GDP||Short-ter<br>% o|m Externa<br>f Reserve|l Debt<br>s|
|---|---|---|---|---|---|---|---|---|---|
||1995-1997|1998|2002|1995-1997|1998|2002|1995-1997|1998|2002|
|Korea|12.8|43.0|42.4|4.6|10.4|19.4|200.7|54.1|34.13<sup>1</sup>|
|Malaysia|46.7|57.2|62.8|20.0|30.2|35.4|47.8|33.1|24.46|
|Indonesia|34.5|94.0|91.3|9.5|11.8|15.2|188.1|88.6|75.26|
|Thailand|21.2|57.7|45.3|-3.5|1.5|31.1|131.2|102.9|31.33|

1/ Number for 2002 is not available, 2001 used instead _Notes_ : Net foreign assets are the sum of foreign assets held by monetary authorities and deposit money banks, less their foreign liabilities. Short-term external debt is debt that has an original maturity of one year or less. Reserves are total reserves minus gold _Source:_ Staff estimates, Global Development Finance, various issues.

In addition to the level of debt, the dynamics, as determined by the interactions among the primary fiscal balances, real interest rates and real growth rates, also matter. Apart from the East Asian countries, the other prominent crisis countries of the mid-1990s—which also experienced an increase in debt by the end of the decade—were all engaged in a stabilization program. This list includes Argentina, Brazil, Russia and Turkey.

In all four cases, the nominal exchange rate served as the anchor, and the real exchange rate became overvalued. In varying degree, these countries faced similar situations. By pegging their exchange rates in the presence of open capital accounts in order to bring inflation down from high levels, these countries were subject to the macroeconomic policy ‘trilemma’,<sup>31</sup> and opted to choose the first two of the following three goals: (i) use exchange rate as an instrument for price stability; (ii) keep capital account open for efficiency and flexibility; and (iii) pursue an activist monetary (interest rate) policy. But they were also subject at some point during the 1990s to the problem of unsustainable public debt dynamics and a sudden stop in capital flows– creating an impossible ‘quadrilemma’. Fiscal reforms were incomplete or not credible or else fiscal policy was procyclical, as in Argentina. In such circumstances, enterprises might prefer to borrow offshore in view of pegged exchange rates combined with domestic interest rates exceeding foreign interest rates. If they are in the non-traded sector, e.g., real estate, this creates a currency mismatch and a potential vulnerability. If the size of this mismatch grows sufficiently large, borrowers might come to expect that losses would be nationalized should the exchange rate peg be abandoned, thus creating a moral hazard problem.

The preceding configuration created an exposure to a ‘sudden stop’ in capital flows, forcing the countries to raise interest rates in order to keep domestic currency government debt attractive. This worsened debt dynamics, with balance sheet mismatches reducing policy options further, as devaluation would trigger bankruptcies in the financial and corporate sector. Once

> 31 The trilemma, first articulated by Obstfeld and Taylor (1998), asserts that an open economy can choose only two out of the three goals listed in the text.

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