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February 1999 Raising interest rates and devaluing currencies-traditional measures to stem capital flight and stabilize capital inflows during a financial crisis-were unable to change institutional investors' (self-fulfilling) expectations and herding behavior in four countries studied (Indonesia, the Republic of Korea, Malaysia, and Thailand). This failure was largely attributable to the thin foreign exchange markets in these countries. Min and McDonald investigate how the thinness of foreign-exchange markets causes destabilization speculation, especially when exchange-rate flexibility is increased, as it has been in the countries involved in the Asian crisis. They analyze the impact of this market thinness on the dynamic capital mobility and capital market risk of four of the countries involved in the Asian crisis: Indonesia, the Republic of Korea, Malaysia, and Thailand. Using the vector-autoregression model, impulse response functions, and variance decomposition, they show that in response to one-standard-deviation shock to interest and exchange rates, the dynamic capital mobility of all four countries decreases in the short run. These shocks also cause the capital market risk of these countries to rise. Since the onset of the Asian crisis, the countries involved responded by raising their interest rates and devaluing their currencies. These measures were intended to stem capital flight from the borrowing countries and to encourage capital inflows. But in an environment of protracted financial sector reform and thin foreign exchange markets, these standard policies did not stabilize capital inflows into these countries. Min and McDonald's research supports the view that because standard policies were unable to change institutional investors' (self-fulfilling) expectations and herding behavior, the countries' policies have, in the short run, not been successful. This failure is in large part attributable to the very thin foreign exchange markets in these Asian countries. This paper-a product of Finance, Development Research Group-is part of a larger effort in the group to study capital market integration and international transmission of financial crises in emerging economies. The authors may be contacted at hmin@worldbank.org or djm0@Lehigh.edu.

Capital market.

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Capital market

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James D. Wolfensohn, President of the World Bank Group, remarked that despite remarkable successes, East Asian countries face formidable challenges in sustaining their development in the face of large-scale changes taking place throughout the region. Increasingly, countries of the region confront common development policy challenges. Their common agenda must be the agenda of the World Bank Group if the Bank is to remain relevant to them. Responding effectively to these needs will require that the Bank Group forge new partnerships and revitalize traditional ones.

Capital market.

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Capital market.