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Exchange Rate Regimes and East Asia

SAN FRANCISCO - Three elements combined to produce financial crisis in East Asian economies: stagnation in Japan, the pegging of exchange rates to the U.S. dollar by national central banks, and the existence and policies of the IMF.

During the 1980's, the Bank of Japan fed the bubble in stock and land prices by permitting the quantity of money in Japan to grow rapidly --13% per year in 1990. The Bank of Japan then burst the bubble by stepping hard on the monetary brakes. The quantity of money declined a trifle in 1992 and from then to mid-1998 grew by only 2.6% per year.

The inevitable result was severe recession and stagnation. The stock market collapsed, moderate inflation turned into mild deflation, many bank loans became uncollectible and economic growth evaporated. In the six years preceding the stock market peak in 1990, Japan’s output grew by more than 30%; in the six years from 1992 to 1998, by less than 5%.

Japan is the largest economy in East Asia, the largest importer from and exporter to the smaller East Asian countries, their largest investor, and their largest supplier of credit. Its stagnation was offset until early 1997 by strong inflows of capital from around the world. That capital was attracted by the rapid rates of growth in East Asia, plus an underestimation of exchange rate risk, which brings us to the second and third element.