Capital inflows, largely through the banking system, helped finance a boom in investment and real estate. Distortions in the financial system led to a misallocation of resources so that high rates of private investment did not generate substantial improvements in productivity. Exchange rate regimes where the domestic currency was fixed to the dollar generated false expectations of stability, and the resulting increase in unhedged borrowing generated large exposures to changes in the exchange rate or interest rates. By 1997, the short-term external debt of the private sector had risen substantially, relative to GDP and to reserves, and this created conditions similar to a classic bank run, when the crises hit. The initial spark for the loss of confidence is still not fully clear, as is often the case in financial crises. And although the particular dynamics differed across the countries in the region, the basic pattern was common, with a rapid and sustained effort by domestic and foreign investors to reduce their exposure to further losses. The initial effects of this behavior made the exchange rate commitments untenable, and when those commitments were broken and currencies fell, the panic became self-reinforcing. Uncertainty and lack of information fed the run. Market participants were unable to judge whether deteriorating developments reflected temporary liquidity problems or deeper solvency issues. They  BIS Review 65/2007  1  reacted by assuming the worst. These shifts in market sentiment risked becoming self-validating, with liquidity problems transformed into solvency problems with broader risk of default.

After rising initially with the substantial costs associated with bank recapitalization programs, in recent years public debt ratios have generally been declining as a share of GDP. Monetary policy regimes have become more mature, with some progress toward greater de facto independence for central banks, with clearer mandates for price stability. Exchange rate regimes in the crisis countries have become somewhat more flexible, providing greater scope for monetary policy to sustain the domestic conditions for price stability. Financial systems are substantially stronger. Bank capital ratios now provide a significantly larger cushion against potential losses – though capital ratios in Asian banking sectors are still generally lower than those in other emerging economies. The quality of bank assets has improved. Nonperforming loans, estimated to have peaked at between one-quarter and three-quarters of total loans in the crisis countries, are now under 10 percent of total loans. Financial institutions that required government intervention have largely been restored to private ownership. Domestic capital markets  2  BIS Review 65/2007  are an increasingly important channel of intermediation in financial systems that had historically been dominated by banks. These are impressive achievements by any measure. And the changes that have taken place provide a strong foundation for future growth and they make it much less likely that these economies will be vulnerable to the type of crises of a decade ago. This progress is reflected in a broad range of financial market indicators of risk. Risk premia in domestic interest rates markets are low.