Debtor countries import capital goods from creditor countries, with international finance provided by creditor countries. Debtor countries can grow by increasing their production capacity, and creditor countries can receive higher investment returns from debtor countries. This system has worked well in the Asian region over the past several decades.

However, this system sometimes faces difficulties because of excessive capital flows, overly optimistic expectations of the economy, and asset price bubbles. As we have seen, reversals of these movements can throw countries into crisis.

Let’s look back on the Asian experience when the perfect storm hit the region’s economies in 1997. Many Asian emerging economies had enjoyed high growth, thanks to the deepening manufacturing-sector supply chains in the late 1990s. Investment opportunities were abundant and were financed by international capital flows. Behind the booming economies, however, imbalances had built up. The banking sector provided excess loans with maturity and currency mismatches. Asset prices surged beyond their fundamentals. Fixed exchange rate regimes promoted international capital flows based on the assumption that fixed exchange rates would be maintained forever. Then the crisis broke. Exchange rates plunged, capital flows reversed, asset prices collapsed and banks failed. Financial assistance by international organizations and individual countries alleviated the pain to some extent but did not eradicate all of it since the situations became out of control so quickly.

This history shows that, while strengthening the international financial architecture is important, the first line of defence is to increase domestic resilience as are shown in the recent situations in Argentina and Turkey.

What can Asian economies do to make their financial systems more resilient?

First, the domestic financial system should have a sufficient capital base and liquidity cushion to weather negative shocks to the economy and the financial system. In this regard, the commitment by each jurisdiction to full, timely and consistent implementation of the bank regulation and standards framework, called Basel III, is necessary. The Financial Stability Board, standard-setting bodies and national authorities carefully monitor the implementation process and evaluate the effect of the reform. The possible costs and unintended consequences of imposing higher prudential requirements are carefully monitored. The evaluation of the reforms of infrastructure financing and over-the-counter derivatives is making good progress at FSB under the Argentine G20 Presidency in 2018. The impact of financial reforms on small- and medium-sized enterprises has already been agreed as the next evaluation topic and will be discussed under the Japanese G20 Presidency in 2019.

Second, macroprudential surveillance and monitoring should be strengthened. Based on bad experiences in the late 1990s and early 2000s, the Bank of Japan (BOJ) began publishing the Financial System Report (FSR) semi-annually, which examines the Japanese financial system from a macroprudential perspective. The BOJ has also developed analytical tools, such as the Financial Activity Index and a macro stress-testing framework. Since financial activities are evolving over time and the boundary of the financial system is blurred by technological progress, attention needs to be paid to developing financial activities in a broad context. It is true that the banking sector has become much safer than before. But there is an increasing share of market-based financial activities all over the world. Are there sufficient data and capacity to monitor these activities? Are there policy tools if excessive activities in the shadow banking sector are detected? Continued efforts will be needed to pursue a safer financial system.

Third, a sound macro policy framework needs to be in place. In the past there were common features among crisis countries: high inflation, large current account deficits, large fiscal deficits and asset price bubbles. Currency speculators have attacked these countries. To avoid these speculative attacks, national authorities need to maintain healthy macroeconomic management with strong institutional settings such as central bank independence and secured long-term fiscal sustainability. While monetary and fiscal policy measures are classical tools, there also may be a need to calibrate macroprudential policy measures with more care. It is true that some countries have implemented macroprudential policy measures successfully to mitigate financial excesses. However, we have limited experience of implementing such policy measures so far. The effectiveness of such macroprudential policy measures as countercyclical capital buffers is largely untested. Is it possible to raise the capital buffer held by banks sufficiently to prepare for large strains? Can the capital buffer level during a financial downturn be reduced without creating distrust in the financial system? Would banks be ready to maintain levels of lending in times of stress as buffers are drawn down? The effectiveness of such macroprudential policy will be examined in coming years.

Fourth, fostering domestic financial markets with their sovereign currencies is desirable. We have seen and experienced currency and external crises when the domestic currency cannot be used to borrow abroad. Based on the experiences of the Asian financial crisis, Asian emerging economies have made efforts to foster their domestic currency bond markets. The Asian Bond Fund Initiative — started in 2003 by the 11 central banks that comprise the Executives’ Meeting of East Asia and Pacific Central Banks — has contributed to supporting these efforts. Still, many countries have experienced turmoil when their domestic currency cannot be used for foreign borrowings.

Finally, flexible exchange rates, where feasible, contribute to smooth adjustments of macro imbalances. Stable and rigid exchange rate arrangements are preferred by investors during calm periods and ‘fear of floating’—a reluctance to let the currency’s value fluctuate—remains a popular idea. But countries with rigid exchange rate arrangements will suffer enormously when these arrangements collapse. The combination of sound macroeconomic management and flexible exchange rate regimes contribute to improving economic welfare in the long run.

Domestic macro policy frameworks have improved, but still there has been a recurrence of currency and financial crises. Preparing for the next crisis during the current calm period is difficult work. There is a tendency to develop ‘this time is different’ syndrome and to stop thinking about ‘unthinkable’ incidents. Together with a strong international financial architecture as a last line of defence — including the IMF’s lending capacity, swap agreements and regional financial arrangements — strengthening the domestic financial system and macro policy framework is imperative.

Koji Nakamura is Associate Director-General (G20 Affairs) at the Bank of Japan. The opinions expressed here are those of the author and not necessarily those of the Bank of Japan.

This article appeared in the most recent edition of East Asia Forum Quarterly, ‘Asian crisis, ready or not’.