Fiscal positions in Asia were far weaker than they initially appeared to be because of the enormous contingent liabilities that governments faced as a result of the collapse of the banking systems. This limited the room for countercyclical fiscal policy, although each government moved eventually to put in place modest fiscal stimulus. This diagnosis of financial vulnerabilities led to a very substantial improvement in the quality of national balance sheets in the region. More on this later. Exchange rate regimes and the perils of the middle A second, and closely related lesson, relates to the exchange rate regime. In the crisis countries, the exchange rate regime of choice had been a fixed but adjustable peg. This was softer than a currency board – the possibility of adjustment was built into the arrangement, but it was presented as a commitment to a fixed nominal exchange rate for an indefinite period of time. Although these regimes of limited exchange rate flexibility had been regarded as a means of achieving economic stability, in fact they turned out to be a source of instability. Nominal exchange rates against the dollar had been held fixed for some time, while real effective exchange rates had appreciated significantly. Because of weaknesses in the financial system, the investment booms of the previous decade had not translated into increased productivity. As investors grew concerned about potential weakness, pressure on the exchange rate further intensified until it became unsustainable. Exchange rate intervention proved ineffective.
Part of this is aversion to appreciation, and part of it aversion to variability in the exchange rate. In this sense, the high level of reserves today could be read less as an indication of fundamental strength than as an indication of the need for more progress toward completing the transition to a modern monetary policy regime. Even though reported inflation in most emerging economies has been moderate, the observed preference for nominal exchange rate stability suggests a monetary policy regime with less independence to sustain price stability over time. Emerging market economies have retained controls on cross-border capital flows, some quite comprehensive, some more selective. These come with a range of different justifications, from insulation against volatility and speculation, to protection of the domestic financial system, to limiting variability in the exchange rate or maintaining a specific objective for the level of the exchange rate. By design, these controls limit the degree of integration with the global economy and they necessarily distort incentives in ways that affect all economic and financial activity. Their appeal as a source of durable stability has diminished over time, and we now have a greater understanding of the effects they can have in lowering long-run growth potential. For policymakers in many emerging economies,  BIS Review 91/2006  3  the question is not whether to remove controls, but when and how to do it without significantly raising short-run vulnerability to financial instability.