Ten years ago, the Asian financial crisis of 1997–98 began to unfold. Few countries in the region were left untouched, and the aftereffects reverberated across the globe. A decade later, Asia shines in the global economic landscape, and its vitality stands out as a remarkable achievement. But what lies behind this success, and what are the new challenges for a region that has become a dynamo for the world economy?

At the same time, Asia has not turned its back to the outward-looking orientation that propelled its spectacular rise on the world's economic stage. Intraregional commerce is so far complementing—not substituting for—global trade. With deepening financial and trade connections inside and outside the region, Asia's economic vitality 10 years after the crisis stands out. The countries that were most affected by the crisis have made good progress in laying solid foundations for continued growth and their medium-term prospects are bright.

Over the past decade, inequality has risen steadily across the region. China displays now a more skewed income distribution than the United States or Russia.

What lies behind their success? The key to today's dynamism has been nimbler macroeconomic policy frameworks and comprehensive reforms in the financial and corporate sectors. More flexible exchange rate regimes have cushioned external shocks and an impressive war chest of official reserves has been built up; inflation targeting has provided a monetary anchor in many cases; and fiscal policies have taken on a longer-term perspective to safeguard debt sustainability. As for structural reforms, measures to deal with the immediate strains in the financial system have been complemented by steps to address the underlying weaknesses. Mechanisms to facilitate financial restructuring are now in place, regulatory and prudential frameworks have been upgraded, and corporate governance has been strengthened. More work lies ahead, but financial institutions and corporates in Southeast Asia have, on the whole, regained a solid footing.

While the hardest-hit countries were busy cleaning up the legacies of the crisis, the rest of Asia was not standing still. China and India have made further strides as regional powerhouses, the Philippines has weathered bouts of turbulence and gained considerable resilience, Vietnam has burst onto the global economic scene, and Japan has finally extricated itself from its "lost decade" and entrenched deflation.

The IMF has worked closely with economies in the region on their reform programs throughout the past decade. Increasingly, this has been done as part of the Fund's normal surveillance activities, including under new transparency and financial sector initiatives.

The causes of Asia's growing disparities are complex. Several factors may be at play, but skill-biased technical progress in the more advanced economies and the transition from agriculture to industry in developing ones appear to be the main forces shaping income distribution in the region. Globalization is of course providing the broader context for the changes in technology and patterns of production that are at the root of differential wage and sectoral developments. Besides ethical or social implications, worsening inequality is a concern for economic policymakers. If unattended, growing disparities could strain social cohesion and undermine the support for further engagement in the global economy, in spite of great potential benefits. More broadly, tears in the social fabric could lead to inferior economic outcomes—namely, lower long-term growth, macroeconomic instability, and dwindling room for maneuver when adverse shocks occur.

Asian policymakers are looking for ways to stem the trend. Specific measures depend on individual country circumstances, but in all cases need to be supported by sound macroeconomic management, which is necessary for sustainable growth. Growth holds out the greatest promise for lifting the poor out of poverty and providing better opportunities to the disadvantaged. Policy options to address inequality more directly include greater and more effective spending on education and infrastructure to build human capital and enhance the allocation of resources; labor market reforms that facilitate hiring and improve the employment conditions of nonregular workers; more equal access to financial markets to empower the poor and improve economic efficiency; and regulatory reforms to bolster the investment climate. Because the old tend to be poorer, steps to better absorb the fiscal impact of rapid population aging will also help redress income and geographical disparities in several countries.

Gross flows have also become more volatile in recent years. The increased importance of portfolio and other investments (notably bank lending and derivative transactions) explains the trend and underscores the possibility of financial swings in either direction. Surges in capital movements (at times, in the context of yen carry trades—the practice of borrowing yen to invest in higher-yielding assets denominated in foreign currencies) have become a policy concern. As the 1997–98 crisis made all too clear, rapid capital inflows carry the dangers of disruptive real appreciations, asset price bubbles, and imprudent domestic lending, on the one hand—and may lead to widespread economic and financial dislocations if they come to a sudden stop or turn into panic outflows, on the other.

No surefire policy tool exists to deal with potentially unstable financial flows, but mutually reinforcing and consistent policies hold the best promise. Greater exchange rate flexibility in the context of sound macroeconomic policies—and, perhaps, intervention to smooth exchange rate movements without undue "leaning against the wind"—may be the least costly approach to absorb surges in capital inflows, after all.

A complementary strategy for Asia is to push forward with the development of domestic financial markets, including in the context of intraregional financial integration. Regional financial markets outside Hong Kong SAR, Singapore, and Tokyo are small, especially bond markets, and equity markets are less liquid than those in mature economies. Deeper and broader capital markets will provide a first bulwark against disruptions from unpredictable capital movements and perhaps add a measure of stability by retaining Asian savings within the region. Intraregional financial integration can be spurred by further steps to strengthen market infrastructure, corporate governance, and risk management at financial institutions, as well as coordinated efforts to harmonize financial regulations and tax treatments. Government-led initiatives in these areas are providing helpful support to a market-driven, bottom-up process in the background. Further liberalization of remaining restrictions on outflows can also support deeper integration and potentially offset swings in capital inflows.

Growing income inequality and potentially erratic capital flows are but two examples of the challenges that globalization presents to Asia. The to-do list for Asia's policymakers is longer. Steps are needed in many cases to encourage household consumption and private investment to reinforce the domestic underpinnings of growth and limit the region's reliance on external demand. Stronger domestic demand will go hand in hand with stronger currencies throughout the region, facilitating a global rebalancing of world growth and an orderly resolution of current account imbalances.