they defaulted on their debts to the domestic banking sector. at the same time, foreign lenders, who had felt protected by the foreign currency denomination of the loans, now realised that a fall in the exchange rate increased their credit risk, and so they pulled credit lines or failed to roll over short - term debt. this exchange rate shock impinged on financial systems which already had fracture lines and structural tensions. there were a number of specific weaknesses - - connected lending, government - directed loans, poor credit evaluation, lack of transparency, and inadequate prudential supervision. the situation was sustainable if growth and capital flows were maintained, but was not sustainable in the harsh world in which we live, where confidence is fragile, capital flows are flighty, and the stabilising forces of the “ fundamentals ” are slow to assert themselves. why did it happen? the first point that should be made is that the praise which had been heaped on these countries for several decades is entirely understandable. these countries have been high savers, budgets have been balanced or in surplus, inflation has been reasonably well contained, and exports had been the dynamic driving - force of growth ( with the globalisation that this implies ). they ran high current account deficits because, however much they were saving, they were investing even more. who could, ex ante, have criticised the broad - brush developments in the financial sector? open capital markets were a merit - badge of economic maturity and a requirement for entry into the industrial - nations ’ economics club - - the oecd. not only were these markets generally opened up and linked in with international capital markets, they embraced this eagerly, including the latest sophisticated products of the financial sector. equity markets burgeoned and the arcane products of wall street were readily available. international agencies urged further and faster deregulation, commercial financial interests ( domestic and foreign ) were eager to stake out a role for themselves in the fast - growing sector, and sophistication in financial products was seen as being as important as having the latest in industrial technology. while it is easy enough now to see the fracture lines and lack of resilience of these financial sectors, it was less easy to predict the outcomes beforehand. the transition from a regulated financial system to a deregulated financial system is intrinsically difficult. under the best of circumstances, it was inevitably going to be accompanied by false starts and mis - cues. the pace of growth of credit is difficult to

evaluate in a world where you would expect it to be growing quickly because financial repression ( mckinnon ’ s phrase ) is ending. the transition leaves the financial system quite fragile during the process. there is a fair bit of evidence that problems have arisen for almost every country during the transition, with the problem usually taking the form of excessive lending as each institution in the deregulated financial sector competes vigorously for its share in the new world. in the process, poor loans are made and asset prices are bid up. these two things come together in mutual reinforcement when the problems come to a head. lenders who had used collateral as their main loan - evaluation technique find their security to be illiquid and inadequate. at the same time, it is almost inevitable that the process of financial deregulation will run ahead of the capacity of the prudential supervisors to devise a suitable regulatory framework. to start with, the climate of deregulation is often inimical to the regulators. this was certainly our experience in australia during the 1980s : as we tried to put in place the basis of some “ rules of the game ” for the new deregulated financial sector, many people who should have known better were calling this “ re - regulation by the back - door ”, and criticising us for being out of sympathy with the brave new world of deregulation. this experience seems to have been repeated elsewhere. managers at all levels have been dealing with products and systems with which they are unfamiliar ( but to admit this would disqualify them from participating in this exciting new world ), and commercial imperatives encouraged them “ to boldly go where no man has gone before ”. as we look at the problems of foreign currency borrowings in some of our asian neighbours, one might recall the similar experience with swiss franc loans in australia during the 1980s, with the ( fortunate ) difference that these were, in a macro sense, quite small for australia. there is another difficult issue here for the authorities. even when problems were identified, there was the classic dilemma well known to prudential supervisors - - do you “ blow the whistle ” on the problem and precipitate a crisis ( for which you will surely be blamed ), or do you quietly work behind the scenes to try to avert the perceived problem, in the hope that you will succeed or the problem will go away of its own accord, but knowing that if it doesn ’ t, it will be