The extreme financial volatility in east Asian markets in the second half of 1997 and early 1998 needs to be explained and put into context. This chapter does this in four sections. The first summarises recent developments, describing what happened to key financial variables. The second examines the fundamental factors that lay behind these events. The third is an assessment of what these fundamental factors and financial market dynamics imply for financial liberalisation and reform policies. The fourth tries to put these events in a broader, more long-term focus, by reviewing the empirical literature on the costs and benefits of financial reform.

What happened?

In the second half of 1997 and early 1998, there was a severe loss of confidence in east Asian financial markets. Table 2.1 presents a chronology of events in markets over this period. The crisis began with a deterioration of confidence in the Thai baht that spread through to other markets in the region (IMF 1997a). The baht, which had been a currency pegged largely to the US dollar, came under selling pressure in early May 1997, as forecasts for economic growth weakened, on the back of a sharp excess supply of semiconductors, a rising current account deficit (fuelled in part by the baht being tied to the US dollar which had been steadily appreciating against other major currencies since mid-1995) and an emerging expectation of a rise in Japanese interest rates.