Emerging Economies Crises:
Lessons from the 1990^
Sebastjan Strašek
Timotej Jagric
Nataša Špes
The paper examines the financial crises of the 1990s. They represent a
new kind of crises, as they do not seem to conform to the so-called
first generation and second generation literature on currency crises.
The outburst of the Asian crises brought a new challenge for economic
policy. The attention has been placed on the self-fulfilling character of
the speculative attacks and microeconomic weaknesses. The first part
of the paper reviews the recent theoretical literature on financial crises,
the second part addresses some lessons for emerging economies. The
authors consider the policies to manage financial crises and reduce the
risks associated with them.
Key Words: financial crises, emerging markets, contagion
jEL Classification: G15, gi8
Introduction
Over the past decades, the total capital flows to emerging economies
have increased tremendously and most of the increase was in equities
and portfolio investments. However, as international capital movements
have been the main catalyst for the accelerating global economic integra-
tion, market failures associated with them have also become more visible.
Since 1982 emerging markets have been rocked by three major financial
crises: the American debt crisis of the 1980s, the Mexican crisis of 1994-
1995 and the Asian crisis 1997. The Asian crisis spread to Russia and Latin
America and impacted the economies of many industrialized nations as
well.
Financial crises in emerging economies are very different today than
they were in the past. Between 1940 and the 1970s, financial crises in-
Dr Sebastjan Strašek is a Professor at the Faculty of Economics
and Business, University of Maribor, Slovenia.
Dr Timotej Jagric is an Assistant Professor at the Faculty of Economics
and Business, University of Maribor, Slovenia.
Nataša Špes is an Assistant at the Faculty of Economics and Business,
University of Maribor, Slovenia.
Managing Global Transitions 5 (3): 289-304
volved large fiscal deficits, repressed domestic financial systems, and bal-
ance of payments situations that were associated with a sharp worsening
of terms of trade. In the late 1990s, however, a 'new variety' of crisis has
evolved in Asia. Many of the emerging economies that have experienced
financial trauma have been considered very successful until the crises ex-
plode.
This paper aims to analyze the determinants of currency and finan-
cial crises in the aftermath of the Asian 1997 experience. In the literature
the commonly identified factors that increase vulnerability to the cur-
rency and financial crises have been imprudent fiscal policies, fragilities
of the financial sector, inadequacy of prudential supervision and regula-
tion, appreciated real exchange rate, a heavy lending to private sector and
low levels of foreign reserves in proportion to government's liabilities as
measured by broad money. There is a general consensus that all crises
of the 1990s involved two kinds of market failures, namely, first, inter-
national financial institutions over-lent to emerging market economies
and, second, governments' financial institutions or corporations over-
borrowed.
The paper is organized as follows. The next section summarizes finan-
cial crises and recent theoretical developments. Section three addresses
some lessons from the recent crises for emerging economies. The final
sections discuss the findings and conclude.
Financial Crises and Recent Theoretical Developments
Serious financial crises are not a new phenomenon; the Asian crisis fol-
lows on the tracks of Mexico 1994, the European Monetary System 1992-
1993, and previous crises in Latin America. These currency crises have
been the subject of extensive economic literature, both theoretical and
empirical. The theoretical literature on balance-of-payment crises has
flourished following Krugman's (1979) seminal paper. Krugman argued
that crises occur when a continuous deterioration in the economic fun-
damentals becomes inconsistent with an attempt to fix the exchange rate.
Krugman's canonical model therefore explains crises as the result of fun-
damental inconsistency between domestic polices - typically the persis-
tence of money-financed budget deficit - and the attempt to maintain a
fixed exchange rate. The inconsistency can be temporarily papered over
if the central bank has sufficiently large reserves, but when these reserves
become inadequate speculators force the issue with a wane of selling.
The timing of the attack in Krugman's model is therefore determined by
a critical level in the amount of reserves. Once the reserves have been
lost in the attack, the central bank has no choice but to abandon the
peg. Crises thus result in a transition to floating. More recently, however,
some papers have argued that the authorities may decide to abandon the
parity for other reasons: they may be concerned about the adverse conse-
quences of policy needed to maintain the parity (such as higher interest
rate) or other key economic variables (such as the level of employment).
The Krugman model and its extensions represent what has become
known as first-generation models of balance-of-payment crises. Since
crisis arises as a result of an inconsistency between an excessive public
sector deficit that becomes monetized and the exchange rate system, a
crisis is both unavoidable and predictable in an economy with a constant
deterioration of its fundamentals.
Recent models have shown that a crisis may develop without a signifi-
cant change in the fundamentals. Models built along this line are known
as second-generation models of balance-of-payment crises. There are at
least two types of these models, where crises are not affected by the po-
sition of the fundamentals, but instead, they may simply occur as a con-
sequence of pure speculation against the currency. Calvo and Mendoza
(1997) developed the model of herding behaviour; the model stresses that
information costs may lead foreign investors to take decisions based on
limited information and therefore to be more sensitive to rumours.
A second type of models stresses the possibility of contagion effects.
There are again two types; the first type (Gerlach and Smets 1995) focuses
on trade and on the loss of competitiveness associated with devaluation
by a main trading partner, which in turn leaves the domestic currency
more vulnerable to attack. The model presents a situation in which the
devaluation by one country leads its trading partners to devalue in or-
der to avoid a loss of competitiveness. The same effect could be derived
in a model with multiple equilibria, in which the devaluation by a trade
partner serves to coordinate a worsening of expectations about the do-
mestic economy and generate a self-fulfilling attack. If contagion effects
are present, a crisis in a neighbouring country may be an indicator of
a future domestic crisis. Masson (1998) developed a second type, which
is related to multiple equilibria, suggesting that a crisis in one country
may raise the odds of a crisis elsewhere by signalling that a devaluation
is more likely as a result of the initial crisis. The signal may then lead to
a self-fulfilling speculative attack.
One may conclude that many of the second-generation models im-
plicitly or explicitly accept the possibility of self-fulfilling crisis. Esquivel
and Larrain (1998) define this type of crises as crises that occur when
the sheer pessimism of a significant group of investors provokes a capital
outflow that leads to the eventual collapse of the exchange rate system,
thus validating the negative expectations. These recent theoretical devel-
opments accord a smaller role to fundamentals in generating balance-of-
payment crises, but they also have highlighted the importance that other
variables may have in helping to predict those crises.
The difficulties in accounting for some key aspects of more recent
crises have led some economists (Krugman 1998) to emphasize the need
for a 'third generation' crises model, centring around banking system
problems associated with moral hazard.
Lessons from the International Financial Crises of the 1990's
Two major approaches dominated in the post-1997 theoretical literature.
The first one, represented by McKinnon and Pill (1998) as well as Krug-
man (1998; 1999) modelled the 'over-borrowing syndrome', and empha-
sized the role of moral-hazard-driven lending by unregulated banks and
financial institutions (Corsetti, Pesenti, and Roubini 1998). According to
this view, a rational agent can expect the government rescue operation
of any large bank or corporation with good political connections in case
it had solvency problem.
Radelet and Sachs (1998) blamed a combination of a set of factors such
as panic in the international investment community, policy mistakes in
crisis management, and poorly designed international rescue programs,
for triggering a fully fledged financial panic resulting in currency crises,
bank runs, massive bankruptcies, and political disorder. Chang and Ve-
lasco (1998) have proposed similar approach, i. e. explaining the Asian
currency crisis as a product of a bank run. The first theory of herding
(Chari and Kehoe 1997) underlines that a bandwagon effect is driven by
an assumption that some investors have private information.
Building on this discussion, Krugman (1999) elaborated a third-
generation model concentrating on microeconomic weaknesses (such as
moral hazard and resulting over-borrowing), which may trigger, in the
world of high capital mobility, speculative attacks against the existing ex-
change rate regimes. This model attempts to consider both fundamental
factors and multiply equilibria in the market behaviour.
Financial crises of the kind experienced in East Asia have highlighted
the fact that in a globalizing environment policy mistakes can have more
abrupt and profound consequences for the country involved than has
been the case in the past. The Asian crisis and the wave of currency crises
in Latin America had significant spillover effects outside the regions, and
especially transition economies have been negatively affected by develop-
ments in Asia and Russia. What can the Asian and Russian experiences
tell us about how a small emerging economy might avoid such crisis in
its own economy?
The issue that arises in connection with crisis is to determine what
policy implication the currency crisis holds. The problems experienced
by the emerging countries differ from each other, but there are certain
weaknesses that should be addressed for the small open emerging econ-
omy to reduce the chance of a recurrence. Let us single out some lessons
on key areas, many of which are interrelated:
lesson 1: Financial Market Liberalization is the Best Predictor
of Currency Crises
This fact has been realised in Latin America in the 1980s, in Europe in
the early 1990s and again in Asia in 1997. Kaminsky and Reinhart (1999)
found that banking crises were rare during the 1970s, with only 3 taking
place (in contrast to a total of 26 balance-of-payment crises). The absence
of banking crisis may reflect the highly regulated nature of financial mar-
kets during this period. While the number of balance-of-payment crises
per year does not increase much during the 1980s and 1990s (from 2.9 to
3.1), the number of banking crises per year more than quadruples in the
post-liberalization period. Empirical studies suggest that domestic finan-
cial market deregulation leads to boom-and-bust cycles. The wave of lib-
eralization that started in the mid-1980s had two major effects (Wyplosz
1998): making self-fulfilling attacks possible and installing weaknesses in
domestic financial markets.
Two problems are exacerbated when the domestic financial market be-
comes international. The asymmetry of information widens when the
lender and the borrower belong to two very different economies. The
result is that risk and volatility associated with financial operations are
higher in global markets than in domestic financial markets.
The second channel through which volatility in financial markets is
widened when they become international is through the increased use
of derivatives (options and futures). Although the main target of such
a market was to reduce risk (mainly exchange rate risk) in financial or
trade operations, the use of these kinds of products quickly became spec-
ulative, leading to higher volatility through a wider asymmetry of infor-
mation.
The third mechanism through which risk increases volatility in global
financial markets is through the role played by institutional investors
(hedge funds, pension funds, mutual fund, insurance companies ...).
Some big institutional investors display highly leveraged operations (Das
1998; Reisen 1999). Leveraged operations are highly risky, adding higher
volatility to the financial system.
The message is clear: financial market liberalization must be preceded
by a number of measures (effective prudential regulation and supervi-
sion of banks, implementation of market-based instruments such as re-
serve requirements on foreign currency deposits and short term borrow-
ing, etc.). Deregulation must follow, not precede the strengthening of
the banking and financial sectors. This factor has been admitted also by
the International Monetary Fund (imf 1998). The events in East Asia
have demonstrated that the partial financial reforms could led to increas-
ingly fragile financial systems characterized by growing short-term for-
eign debt, rapidly expanding bank credit, and inadequate regulation and
supervision of financial institutions. Such weaknesses leave the economy
vulnerable to rapid reversal of capital flows.
lesson 2: Increased Globalisation Raises the Contagion Effects
The last two decades have been characterized by significant and funda-
mental changes, which have challenged the capacities of economies to
adapt. Widespread lowering of national and regional barriers to trade
and foreign direct investment has led to closer links between economies.
Increased integration of markets across countries has acted as a major
stimulus to trade between developed and transition countries on the one
hand, but also as a potential channel of contagion on the other hand
(Strasek and Jagric 2002).
The contagion effects are the contribution of the second-generation
models. Masson (1998) argues that contagion reflects a situation where
a crisis in one country may trigger a crisis elsewhere for reasons unex-
plained by macroeconomic fundamentals. Contagion is therefore an ad-
ditional effect above and beyond those of domestic fundamentals. The
rising importance of contagion is striking: some studies (Schmukler and
Frankel 1996) suggest that investors differentiated among countries to a
greater extent after the 1994 Mexican crisis than after its 1982 predecessor.
Mason (1998) also points out that the notion of contagion is not really
well defined, since assigning explanatory power to 'contagion' could be
regarded as a measure of our ignorance. A possible way of avoiding con-
fusion is to distinguish between various reasons. The factors that help
to explain why currency crises tend to be clustered fall into several cate-
gories:
•	Monsoonal effects, defined as major economic shifts in industrial
countries that trigger crises in emerging markets. In this case, crises
may be due to common shocks, for instance polices undertaken by
industrial countries (a steep rise in world interest rates, a sharp
slowdown in world aggregate demand, a decline in commodity
prices, large changes in exchange rates between major currencies)
which have similar effects on emerging markets.
•	Spill-over effects, defined as a case where a crisis in one emerg-
ing market may affect the macroeconomic fundamentals in other
emerging markets. Spillovers result from independence among de-
veloping countries themselves. Typical examples: a devaluation in
one emerging country reduces the price competitiveness of the
emerging counties, or because lack of liquidity in one market
leads financial intermediaries to liquidate another emerging market
(Valdes 1996).
•	Pure contagion effects, defined as indirect spillover effects, i. e. the
simultaneous occurrence of crises which are not directly linked to
the common deterioration of macroeconomic fundamentals. This
kind of pure contagion may be explained in two manners (Blejer
1998): either there are psychological factors that result in similar be-
haviour (unrelated to fundamentals) or a crisis in one country has
a trigger-effect in a second country, by creating panic. The first type
of effects include the so called 'wake-up call' hypothesis (Goldstein
1998). It is said that Tailand acted as wake-up call for international
investors to reassess the creditworthiness of Asian borrowers and
when they did that reassessment, they found that a quite a few of
these economies had weaknesses similar to those in Tailand.
The evaluation of the East Asia crisis suggests that contagion effects
played a role, even greater than in previous crises. Trade and financial
ties and associated emerging market economies (eme) vulnerabilities
appear to help explain some of the spread of the crisis in Thailand to
other Asian emes in 1997/1998. In the more recent crisis in Argentina, a
lower incidence of emes with both strong links to Argentina and high
associated vulnerabilities to shocks may go some way towards explaining
why the crisis has had a less marked impact elsewhere (Hall and Taylor
2002). If shifts in investor behaviour explain the limited spillovers from
Argentina, contagious crises may be less likely in the future.
lesson 3: Increased Entwinedness Between Banking
andBalance-of-Payment Crises (bop Crises)
There was no apparent link between balance-of-payment crises and
banking crises during the 1970s, when financial markets were highly
regulated. Liberalization of financial markets in the 1980s brought very
close entwinedness between banking and currency crises. The crises in
Asia in 1997 highlighted this important link. Kaminsky and Reinhart
(1999) found some interesting lessons:
•	Most often, the beginning of banking sector problems predates the
bop crisis. A banking crisis increases the probability that a country
will fall prey to a currency crisis.
•	Empirical results also suggest that the twin crises may have common
origins in the deregulation of the financial system and that the credit
booms and asset bubbles appears to accompany these. Inadequate
regulation and lack of supervision at the time of the liberalization
may play a key role in explaining why deregulation and banking
crises are so closely entwined.
•	Empirical tests found also evidence of a vicious cycle, in which the
currency collapse further undermines an already ailing banking sec-
tor. There may be also an adverse relation: financial sector problems
undermine the currency. Devaluation, in turn, aggravates the exist-
ing banking sector problems and creates new ones. When currency
and banking crises occur jointly, they are far more severe than when
they occur in isolation. In both types of crises, a financial shock,
possibly financial liberalization or increased access to international
capital markets, appears to activate a boom-bust cycle by providing
easy access to financing.
Twin crises have been characterised by the following stylised facts:
sharp reversal of capital flows, financial liberalisation, financial fragility,
market overreaction. The mechanism relies on two features that charac-
terised emerging markets which experienced twin crises:
•	First, governments held fixed exchange rate regimes or narrow ex-
change rate bands, which were vulnerable to speculative attacks.
•	Second, domestic banks had a mismatch between foreign liabilities
and domestic assets and were thus exposed to exchange rate risks.
Goldstein's (2005) study shows, that an increase in the probability of
one type of crisis generates an increase in probability of the other type.
Both crises occur as a result of the complementarities between the bank-
ing sector and the currency market. Twin crises are expected to be more
frequent in financially liberalised emerging markets and are expected
also to be more costly than regular banking and currency crises. Im-
portant implication: policy measures that do not affect the reserves of
government, such as an international lender of last resort or suspension
of convertibility may be preferable for attacking twin crises.
lesson 4: Crises are Becoming Unanticipated
Financial crises in Mexico in 1994-1995, Argentina in 1995 and the five
East Asian economies 1997 display elements of self-fulfilling crises. The
evidence so far is that self-fulfilling attacks have become more likely in
a world of increased capital openness and mobility. Until the mid-1980s,
most countries enforced capital controls, therefore the self-fulfilling at-
tacks have played a minor role.
Many observers have noted the increasing intrinsic instability in in-
ternational lending: Radelet and Sachs (1998) concluded that emerging
markets are especially prone to self-fulfilling crises, since many emerging
markets lack the lender of last resort capacity to handle sudden shifts in
depositor confidence. Premature financial liberalization in such markets
creates self-fulfilling attacks. Emerging markets are handicapped twice:
•	First, they aren't sufficiently equipped with a bulwark against panic,
since they usually don't pasess a well-defined and relatively trans-
parent system for managing bankruptcies, liquidations and other
forms of debt workouts.
•	Second, international financial markets feel the lack of bulwarks
against self-fulfilling panics, that are available in the domestic mar-
kets (deposit insurance, lender of last resort function, etc). With
globalization and premature financial liberalization the emerging
economies are increasingly exposed to the instabilities of the inter-
national financial markets.
The handicap of partial and incomplete liberalization has been man-
ifested in opening loopholes in other areas, which firms were quick to
exploit (Cole and Slade 1996). Asian events suggest an important lecture
for emerging economies: if an economy suffers from distortions deriving
from implicit and explicit public guarantees that everybody would be
bailed-out if things went wrong, the liberalization of the capital market
will surely exacerbate these distortions. Government bail-out guarantees
will lead to serious moral hazard problems in the behaviour at banks:
they will be tempted to overland in the more risky investment projects.
The bail out promise derives from political distortions that lead govern-
ments to want to increase short-term growth and investment above their
socially optimal values (Corsetti, Pesenti, and Roubini 1998).
The difficulties in predicting crises lead to the suggestion that special-
ists should be focused instead on the more modest goal of developing
early-warning indicators in order to prevent (and not predict) the recur-
rence of crises. In order to create a new set of early-warning indicators,
economists should focus on non-convencial deficiences, such as those
related to financial fragility associated with financial deregulation and
with capital inflows, to a declining efficiency of investment and to high
short-term external debt.
lesson 5: Keep Current Account Deficit Sustainable
A number of authors indicate that balance of payment crises are typically
related to persistent current account deficits. The East Asia crisis and
some studies (Frankel 1998) confirm that close attention should be paid
to any current-account deficit in excess of 4% of gdp, particularly if it
is financed in a way that could lead to rapid reversals. A current account
imbalance may be less sustainable if it is derived from a large trade deficit
than from a large negative net factor income from abroad component. In
the case of Mexico (1994), a large and growing current account deficit is
often singled out as a key determinant of the crisis. The Asian crises also
confirm a clear connection between real appreciation, current account
deficit and possible currency crashes.
Large deficits lead to high external debt, to the point where the coun-
try either becomes insolvent (the present value of conceivable trade bal-
ance surpluses does not suffice to cover external obligations) or hits bor-
rowing constraint (lenders understand that the country will have no in-
centives to repay any additional debt). In the case of the Thailand cri-
sis, macroeconomic policy should have reigned in aggregate demand,
avoided excessive credit expansion and curtailed the excessive external
reliance on foreign savings. This would have reduced the extent of real
effective overvaluation and the current account deficit, and slowed the
build up of short-term external debt relative to foreign exchange rescives.
The common factor observed in many crises is that economies had se-
rious macroeconomic imbalances, besides large and growing current ac-
count deficit also fiscal deficit, which led to excessive accumulation of
public debt or external debt that eventually become unsustainable. The
lesson is clear: avoid large current account deficits financed through
short-term, unhedged private capital inflows.
National measures, the aims of which are to improve the mechanism
for crisis prevention, management and resolution at the national level
should include these instruments:
•	secure adequate foreign exchange reserves,
•	maintain sound fiscal and monetary policy,
•	adopt a viable exchange rate regime,
•	establish orderly capital account liberalization,
•	aggressively regulate and supervise financial systems to ensure that
financial institutions manage risks prudently.
Although strong macroeconomic fundamentals are necessary, they are
not sufficient for averting all crises; a resilient financial sector is required
for coping with abrupt changes in asset prices and capital flows. Having a
resilient and robust financial sector is therefore the key to avoiding crises.
It deals as a preventive measure against contagion and allows flexibility to
cope with external shocks. Empirical studies (Stiglitz and Bhattacharya
1999), suggest polices that can achieve this financial structure: pruden-
tial regulation of asset liability mismatches, and portfolio and loan stan-
dards that adhere to internationally accepted norms; capital adequacy
regulations that, at a minimum, match those which are required un-
der the Basle standards; clear governance rules to prevent insider and
group lending not subject to loan evaluation and creditworthiness and
standards; transparency for investors and depositors through mandatory
public disclosure of audited financial statements; and, finally, deposit in-
surance limited to a minimal share of private liabilities to bound govern-
ment contingent liabilities in event of crisis, and share risk with investors
and depositors. These policies should be supplemented on a global level
with policies that tighten regulations over financial institutions that lend
to highly leveraged institutions.
Policy Implication
The generation approach towards financial crises clearly shows evolu-
tion of economic policy considerations: the differences between first and
second generation approach suggest that crises are no longer the result
of obviously irresponsible economic policy and that crises may occur
suddenly in situations where no crises seemed inevitable. With the third
generation, crises are no longer mainly about monetary policy, so crises
become damaging for the economy.
Considering recent changes in the profileration of third generation
models, we accept Krugman's suggestion (2001) that a fourth generation
crisis model may not be a currency crisis model at all; it may be a more
general financial crisis model in which other asset prices play the starring
role.
In order to improve the policy response to financial crises, three is-
sues must be considered: first, the complexities involved in designing an
appropriate policy framework; second, the considerable trade-offs that
policy makers face in formulating policy options; third, in the long run,
a country can remain exposed to significant post-crises vulnerabilities.
Economic policy response is especially complicated by the need to assess
a variety of trade-offs; fiscal consolidation vis a vis medium-term growth
prospects; administrative measures for quelling a banking crisis vis-a-vis
risks of eroding confidence in the banking system and triggering capital
flight.
The appropriate policy framework is attributed to the government
to undertake the appropriate restrictive measures at the right time: the
low interest rate policies in Malaysia after the runs on the Thai baht are
a fitting example of the unwillingness. The maintenance of restrictive
measures beyond an 'emergence scenario' can have destabilizing conse-
quences. Excessively tight fiscal discipline made the crisis-induced reces-
sion worse.
The Asian experience suggests that the economic policies with their
effective rescue strategy must be bound to address the issues at the very
core of the crisis: strategies and measures have to differentiate between
structural problems and traditional macroeconomic imbalances. The
lessons we elaborate in our paper could significantly reduce the fre-
quency and damage from capital flow reversals and contagion.
It appears that policy makers have to focus on three distinct elements:
preventing crises, managing crises, and resolving the systemic conse-
quences of crises. In order to improve mechanisms for crises preven-
tion, management and resolution, Kawai et al. (2003) suggest measures
at the national, global and regional level. Financial globalization and
surge of capital flows to emerging economies has made these economies
more vulnerable to shocks coming from the capital market itself. Calvo
(2005) referred to these capital market shocks as 'globalization hazard'
and found that traditional fiscal and monetary stabilization policies do
not seem very effective and need to be complemented with structural
policies that help to lower domestic financial vulnerability, especially in
economies suffering from a high incidence of foreign-exchange denom-
inated domestic bank loans.
Conclusions
The evidence reviewed in this paper confirms that the growing vulner-
ability in emerging market economies can be attributed to the surge in
capital inflows and private investment. Financial crises of the 1990s have
undoubtedly involved several interlinked phenomena, most of which
seem to be very important for the future development of the emerging
economies. Several aspects of the lessons are worth highlighting:
•	The factors that underlie the emergence of imbalances of the finan-
cial sector could be seen as the combined consequence of domestic
financial liberalization, external capital account liberalization, mas-
sive capital inflows and lack of prudential supervision and regula-
tion of the financial system.
•	If an economy initiates, but does not complete, the process of fi-
nancial sector liberalization and reform, this fact would lead to
an increasingly fragile financial system. Such a system is poten-
tially very vulnerable to rapid reversal of capital inflows. Emerg-
ing economies need properly functioning and well-regulated finan-
cial sectors. Banks and other financial institutions need to be well-
structured and properly supervised.
•	Current account imbalances have become larger since 1980 and
have led to building up a serious source of instability to the global
macroeconomy. National economy could be seriously damaged, if
the current account deficit is financed with the accumulation of for-
eign debt in the form of short-term foreign-currency denominated
and unhedged liabilities. Asian events clearly suggest that current
account deficit should be financed largely by direct investment; in
this way, first, a deficit is more sustainable than a deficit financed by
short-term hot money (especially if it is coming from official credi-
tors), and second, financial flows are less volatile and less reversible.
•	Lessons from Asia, Russia and Argentina suggest that the power
of the early warning system is still weak. The problem with recent
crises lies in the fact that an early warning system should indicate
vulnerability to crises well in advance and that a number of the in-
dicators tend not to signal vulnerability until a crisis is about to
occur.
•	Emerging economies must be warned against the cases where ex-
ternal borrowing is heavily reliant on short-term, foreign currency-
denominated and unhedged foreign debt. The possible depreciation
(exchange rate crisis) would increase the real burden of the debt and
provoke a further financial crisis.
•	Emerging economies are by definition poorly institutionally devel-
oped. Therefore, what may start out as one type of crisis may de-
velop into others as well - foreign debt crisis, banking crisis, cur-
rency crises or even systemic financial crises.
•	A key feature of recent crises arises from financial linkages between
countries. Globalization in the 1990s has turned out not to be the
cure but a cause of financial crises. Changes in asset returns that are
due to shocks will contribute to changes in portfolio allocation to
all other emerging markets. Recent contagion episodes show that
the financial crises in small economies have devastating effects on
economies of very different sizes and structures, with very few di-
rect trade or financial links and in very severe and unexpected ways.
Recent events suggest that contagion is the likely reason for huge
and sudden withdrawal of capital.
•	The financial channel is, besides the trade channel, and similarity
channel another strong conduit spreading the contagion. With the
larger rise of mutual fund industry it is on a good way to becoming
the dominant channel.
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