Financial Liberalization and Credit-Asset Booms and Busts in East Asia

This paper presents econometric evidence that sheds new light on the role played by financial liberalization in the Korean and Thai financial crises. Drawing on previous empirical studies, it argues that while the banking systems of both Korea and Thailand supported their remarkable long-run growth performance, they were ill prepared to face the risks emanating from financial liberalization. New evidence is then presented which shows that financial liberalization set in motion a classic credit-asset boom and bust cycle in Thailand and created other weaknesses in the Korean financial system, which made both economies vulnerable to the sentiments of foreign investors and lenders. When capital flows were reversed, the ensuing liquidity crisis triggered a bust that was further magnified by currency depreciations and interest rate hikes. In the light of this analysis, the paper argues that besides strengthening prudential regulation and accounting standards, there is a need for upgrading management systems and expertise to deal with financial risks and an important need for a more widespread appreciation of the risks associated with financial liberalization. Furthermore, there remain gaps in the international financial architecture that need to be addressed, such as the absence of an effective international lender of last resort. Given that these weaknesses may require a long time to address, it is argued that in the interim period financial restraints can act as a relatively cheap, effective and transparent safety device in safeguarding financial stability.