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.
A popular perception was that economies with strong records of growth and financial management were forced into positions of vulnerability by externally imposed programs of capital-account liberalization and then were pushed into turmoil by an unstable, even predatory international financial system. Adherents of this view tended to view the policy response to the crisis as harsh or inept or both. Time has taken some of the edge off these criticisms, but they still affect the political debate in the region today. They reflect anxieties about the balance of risks and benefits of economic and financial integration that still play an important role in shaping economic policy, even with the substantial progress achieved since the crises. I want to outline some of the principal lessons of that period, both in terms of reducing vulnerability to financial crisis and in terms of strategies for crisis resolution. I offer these with the knowledge that it is hard for anyone who was not a finance minister or a central bank governor in the region at the time to understand what it was like. As one of those involved in shaping the international response, I can say that there was a lot we did not fully appreciate about the dynamics of the crises then, and that justifies humility today in thinking about the lessons for the future.