2  BIS Review 69/2007  Regional economic integration has increased rapidly in Asia in recent years, but these economies still seem a long way from the point where economic or political conditions would make a compelling case for some kind of regional monetary integration. (In Europe, of course, the political case for monetary integration largely preceded the economic argument.) For Asian economies, as for most emerging economies today, the principal challenge is to establish conditions that will enable them to prosper in a world where their exchange rates adjust more freely to changing fundamentals. Capital-account liberalization A third important conclusion from the crises relates to strategies for capital-account liberalization. Although this was not the conventional wisdom at the time, I think the evidence supports the view that the policy mistakes that contributed to the crises lay not in the decision to become more open to capital flows, but in the how those governments chose to become more open. The supervisory and regulatory regimes over the financial system did not provide a strong enough framework of incentives for risk management and controls over financial intermediaries. But the more consequential mistake was that the crisis economies each in different ways chose to liberalize capital controls selectively. Each had in place other incentives or distortions that led to an excessive reliance on short-term borrowing through the banking system. These weaknesses left the financial system and the economies as a whole with less capacity to manage the greater pressures and risks that came with openness to capital flows.

It was exacerbated by classic moral hazard – the result of past government  BIS Review 69/2007  1  interventions to limit corporate and bank failures. And it was made worse by poor disclosure, which masked the scale of the increase in external liabilities and the deterioration in the level of official reserves. The scale of the buildup of foreign currency debt was fundamental to the dynamics of the crises. Once confidence weakened, and fixed exchange rate commitments became unsustainable, the economies experienced a sharp reversal in capital flows as both residents and nonresidents sought to limit their exposure to domestic institutions and assets. This broad flight from domestic assets created conditions similar to a classic bank run. The exchange rate decline magnified concern about potential losses in the corporate sector and banking system, which led to a further shift in assets out of the country, which exacerbated the exchange rate decline. These balance sheet vulnerabilities led to a vicious cycle in which the exchange rate and financial weaknesses reinforced each other. As economies slipped toward the edge of the cliff, policymakers were left with alarmingly few options to try to contain the crisis and mitigate the damage inflicted on the real economy. Given that real interest rates were already negative, relaxing monetary policy further risked accentuating the exchange rate decline, which would, in turn, have exacerbated the problems of the banking system. But with demand already in free fall, policymakers were equally reluctant to tighten policy and risk further damage to growth.