The economic and financial crisis that erupted in southeast Asia in July 1997 has continued to deepen and broaden since the October 1997 World Economic Outlook was written. As investor sentiment toward the emerging market countries has deteriorated, not only has the crisis spread to several other economies in Asia, but spillover effects have been felt throughout the global financial system.

The crisis has brought downward pressures on the currencies of countries perceived as vulnerable—typically those countries whose competitive positions have deteriorated as a result of the large currency depreciations in southeast Asia, those that exhibit potentially unsustainable current account deficits, and especially those that have relied heavily on short-term borrowing. In addition, many emerging market economies have witnessed sharp declines in stock market prices, with generally smaller stock market reverberations experienced in the advanced economies. Large exchange rate depreciations and falling equity prices in turn have exposed and exacerbated financial sector fragilities in many countries, including most recently in Korea.

Banking sector problems have also intensified in Japan, where the fragile economic recovery, which had already suffered a setback following the withdrawal of fiscal stimulus in the first half of 1997, will be further undermined by spillovers from the crisis affecting many of Japan’s Asian trading partners.

The repercussions in regional and global financial markets of what began as an adverse shift in market sentiment toward Thailand and several other members of the Association of South-East Asian Nations (ASEAN) have proven much deeper and more extensive than seemed likely only a few months ago. The economic implications also can now be expected to be more serious. As a result of sharply reduced capital inflows and the need for strong measures to correct domestic and external imbalances and to help restore and maintain confidence, many emerging market countries are likely to experience a slowdown in domestic demand and activity during the period ahead, with significant declines in imports and reductions in external deficits. This slowdown will adversely affect activity in other economies. Among the advanced economies, Japan will be particularly affected, although North America and Europe are also likely to experience a dampening of foreign demand.

At the time of writing, it is far from clear that market turbulence has ended, and more uncertainty than usual applies to any assessment of the most likely future course of developments. The staff’s revised baseline projections assume that investor sentiment toward the emerging market countries will begin to turn around in the course of 1998 and that the countries most affected, after a significant slowdown in growth in 1998, will witness a gradual pickup during 1999, even though the upturn may not be quite as rapid as the V-shaped recovery experienced by Mexico and Argentina following the 1994–95 “tequila crisis.” Provided that macroeconomic adjustment, financial sector restructuring, and other reform efforts are implemented without undue delay, such an outcome is clearly possible—and indeed seems most likely—not least in light of the strength of the medium-term macroeconomic fundamentals of the Asian economies. In this scenario, the economic slowdown in Asia and the spillovers to the rest of the world would be relatively moderate and temporary. If policy and reform efforts are inadequate, however, the crisis of confidence may persist and continue to spread to other emerging market countries. In that case, there would be more serious implications for financial flows to these countries for a more extended period, their economic slowdown would be deeper and more protracted, and the adverse spillovers to the advanced economies would be more serious.

This Interim Assessment contains a preliminary analysis of the Asian crisis. It first examines the background to the present difficulties and analyzes the various stages of the growing contagion within Asia and to other emerging market countries. It then discusses economic developments and financial conditions in the major advanced economies, highlighting changes in the assessment relative to the October 1997 World Economic Outlook. This is followed by a review of revisions to the staff’s global projections and a discussion of alternative scenarios for the depth of the crisis. The concluding section considers policy responses to help contain the crisis.