CONCLUDING OBSERVATIONS

The economic linkages among countries have become far more complex and less predictable with greater policy liberalization and financial integration. In the past, there used to exist, by and large, a symmetrical, follow-on relationship between the developed and developing countries. The economic performance in the latter mirrored closely the cyclical stages in the former. This appears to have changed radically from the early 1990s, when the recession in the developed countries left many developing economies largely untouched, and especially those in Asia. Growth in intraregional trade and investment provided a crucial impetus for such resilience in regional economic performance.

On the other hand, economic performance among developed countries seems to have become more sensitive to the unfolding difficulties in their major trade and financial partners and markets within the developing region. Among other indications of this enlarged degree of vulnerability were the contagious changes in world trade and the decline in world economic growth in the immediate aftermath of the Asian crisis. But the impact has been uneven.

The financial turmoil in Asia caused a large repatriation and relocation of financial resources from the developing and other countries to dollar-denominated assets as a safe financial haven. This movement partially fuelled the growth momentum of the American economy. The transmission mechanisms operated through the enhanced buoyancy in the stock and bond markets, substantial capital gains, strong consumer confidence and increased household spending. The inflow of financial resources was also instrumental in raising the exchange rate of the dollar and muting inflationary impulses despite a tight labour market, providing a boost to consumer spending.

It is unlikely that the flow would be reversed significantly if the rate of growth in output and employment in the American economy were to falter for whatever reason. This asymmetrical relationship possibly rests on the very nature of financial markets as they exist now. The integration of capital markets has tended to inflate the value of, and the premium on, less risky assets such as United States treasury bills and other government-guaranteed papers. At the same time, such integration has facilitated a shift of resources in real time and with relative ease into, and out of, individual markets within the global economy. The process is well illustrated by the Asian crisis starting from July 1997, and then financial problems in the Russian Federation and elsewhere in 1998 and 1999. In practice, all this means that funds move rapidly out of developing countries with the slightest signs of trouble, but the reverse process takes considerable time even after objective conditions improve. How to deal with this asymmetry poses a major policy challenge for the international community.¹⁸

A fallout of the integration of financial markets has been a concurrent and noticeable increase in variations in both foreign exchange rates and the volumes of capital market transactions. The magnitude of such instability rose during the 1990s generally, but more so following the crisis. Market-based, daily fluctuations in exchange rates hitherto were confined largely to developed economies. They have now virtually become the norm in the more open developing economies as well, following the abandonment, by an increasing number of these countries, of fixed or quasi-fixed exchange rates in the aftermath of the Asian crisis. This phenomenon poses new policy issues and a dilemma for several reasons. First, many developing economies had become accustomed to exchange rate stability stretching back several years. Such stability remains a critically important anchor for investment, trade, financing and other business decisions. Second, market sentiment has tended to overshoot, exaggerating the degree of economic uncertainty at any particular point in time. Third, market perceptions do not often reflect closely, or are not primarily a consequence of, changes in the so-called macroeconomic fundamentals: inflation, the budgetary position, the balance on external current accounts, rates of interest and the level of foreign exchange reserves. The understanding of how market sentiment is formed in the private sector, and how it can be influenced by public policy responses, particularly in developing economies and emerging markets, remains rather nebulous.

Increased volatility in stock market prices, largely a result of reactions of private sector market participants, presents a broadly similar dilemma for governments. A prolonged upward movement in share prices raises several inevitable questions about its sustainability. A "market correction" is inevitable if an observed upswing does not represent a secular change in investors' portfolio preferences, or if it does not embody a lasting rise in rates of return. The magnitude of such an adjustment in market sentiment, however, could be more pronounced than necessary as a result of collective panic and widespread liquidation orders; a soft landing may not always prove feasible under the circumstances. The highly deleterious effects of such a financial bubble on financial and macroeconomic stability, and on production and employment in the real economy, need no further reiteration in the light of the Asian crisis.

A connected issue pertains to government policy towards inflated prices of financial and real-estate assets within the private sector. Two questions, among others, are urgent: at what stage should such private sector bubbles be contained, and what measures are needed to ensure a soft landing to minimize their ripple effects. There are no painless answers, no easy short cuts. Financial sector management requires a better grasp of the quantum increases in its technical intricacies, fostered by closer interlinkages among financial markets in different parts of the world, but other equally important prerequisites include more detailed and up-to-date information for monitoring and decision-making purposes, a talent for forming fine judgements on the choice of policy instruments, and institutional capacity to implement policy decisions.

The Asian crisis brought in its wake terrible hardship for millions through aggravated poverty, loss of employment and earnings, and reduced access to social services, including health and educational services. This has underscored the need for enhancing social security protection for all and, in particular, providing protection for the vulnerable through the provision of safety nets. However, enhanced social security protection will probably require additional public expenditure at a time when government budgets are already under severe pressure to provide the resources required to solve financial sector problems. The fiscal implications of increasingly vocal demand for improved social security protection, while integrating into the world economy with all its attendant vulnerabilities, will emerge as an increasingly significant challenge for developing countries.

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