(FORTUNE Magazine) – The superlatives are flying. Singapore Prime Minister Goh Chok Tong calls it "Asia's worst crisis since the Second World War." Others say it may pose the biggest threat to world economic and political stability since the OPEC oil shocks of the 1970s. All of which suggests that however painful Asia's agony is now, the key question is: How bad will it get?

What's certain is that things are going to get a lot worse before they get better. For one, the credit squeeze in Asia is ferocious and shows no sign of easing anytime soon. Most banks and corporations simply cannot get the loans they need to conduct business. Money remains tight in part because the IMF rescue programs have not done what they are supposed to do. And that's because the bureaucrats at the IMF have never before seen a meltdown quite like this. They're used to handling a very different kind of crisis, in which the problem involves public-sector fiscal failings and is limited to one country. By contrast, Asia's troubles have arisen from a hugely complicated private-sector banking collapse that's spread across an entire region.

Nor is Asia likely to quickly export its way out of trouble. Over the past six months most Asian currencies have plummeted. The one virtue of a collapsing currency, in the short run anyway, is that it normally gives an immediate boost to exports, thus helping begin a virtuous cycle of economic recovery. Over time this may well happen: J.P. Morgan, for instance, predicts that Thailand's current-account balance will swing from a deficit of 4.2% of GDP last year to a surplus of 4.8% this year, with South Korea and Indonesia experiencing similarly huge swings into surplus. But that isn't happening yet. Foreign trade in Asia, long the region's great engine of growth, seems actually to be contracting. Crippled by the credit crunch, Asian companies are finding it difficult to obtain financing to produce and export their goods. As early as December, Japanese marine insurers were reporting year-on-year drops of 40% in premium income from policies they were writing for cargo on Japanese ships. Add it all up, and you get the makings of a deep recession. Layoffs are mounting throughout Southeast Asia and particularly in Indonesia, where one analyst guesses that 500,000 workers in construction alone have already lost their jobs. The Thai and Malaysian governments have made clear their intention to start sending home many if not most of the millions of migrant workers from neighboring countries who man construction and other low-skill jobs.

Economists scramble every couple of weeks to downgrade their estimates of East Asian GDP growth for 1998. Many now expect severe contractions in Thailand, Indonesia, and South Korea--declines of anywhere from 4% to 8%--and no better than zero growth in Japan, Malaysia, and the Philippines, with slight expansions in Hong Kong and Singapore. Only China and Taiwan should remain fairly robust.

Raising the odds that the pain will get even worse, many Asian countries now face the demon of double-digit inflation. In an effort to keep financial institutions from going under, the central banks of Thailand, Indonesia, and Malaysia over the past few months have engineered an explosive growth of money (they're printing it) and credit (they're lending heavily to commercial banks). Ironically, this has not helped companies or even second-tier banks; because they are such high credit risks, virtually none of the money is being lent to them. Yet the alarming buildup in the money supply means that the danger of further devaluations and eventual hyperinflation is rising sharply.

How can things be going this badly? Isn't the whole purpose of an IMF rescue to stabilize a currency and ease short-term liquidity pressures? It is, but the IMF has grown used to working with a crisis-solving template that fits Asia's situation only haphazardly. "The IMF's medicine," says Simon Ogus, the chief economist for SBC Warburg Dillon Read in Hong Kong, "is normally aimed at countries with an inflation and a budget problem, whereas Asia's problems are ones of debt deflation, excessive private-sector leverage, and weak financial systems."

An insistence on budget surpluses, for instance, seems inappropriate for countries where inflation--whatever the long-term threat--has heretofore been largely a nonissue and whose governments have for years been running nearly balanced budgets. In fact, at a time of collapsing private-sector demand, it seems to make more sense for most Asian governments to start running deficits rather than surpluses.

To be fair, the IMF already seems to be backing away from that one in both Thailand and Indonesia. And its longer-run aims are on the mark. As this magazine has argued before (FORTUNE, Nov. 24), the root cause of Asia's turmoil is the overwhelming dominance of the American economy in the 1990s. This de facto "dollarization" of the world economy means that Asian companies must ultimately meet the standards of corporate and financial performance set in the U.S., the world's most advanced economy. Otherwise, Asian businesses will never be able to offer high enough returns to investors to attract capital in an increasingly globalized market. Seen in this light, the IMF's recent attacks on Asia's structural rigidities such as monopolies and the absence of workable bankruptcy laws make sense.

The challenge, however, is to solve Asia's escalating banking and debt crisis in the short run. Economists Ron McKinnon of Stanford and Paul Krugman of MIT (a regular FORTUNE columnist) have both pointed out that the whole of Asian banking was for years based on extreme "moral hazard." Depositors in, shareholders of, and lenders to Asian banks all assumed that Asian governments would pick up the tab if the banks themselves faltered. The result: too much lending at too little profit.

Trouble is, there's no quick fix. Merton Miller, a Nobel Prize-winning economist from the University of Chicago who has unofficially been advising Asia's leaders during the crisis, points out that a bank workout will be especially hard to manage because three kinds of risk have become entangled--and reinforce one another. First comes the severe interest-rate risk posed by the huge number of local firms and banks that borrowed short term and lent (or invested) long term. Like an undetected cancer, the size of this lump of exposed capital, it turns out, had grown far larger in the pre-crisis days than anyone dreamed possible. Total private short-term debt in South Korea, for instance, may be as much as $130 billion--twice as big as was thought just two months ago.

Second is currency risk. Many Asian companies and banks over the years, lured by their currencies' relative stability against the U.S. dollar, borrowed money in dollars. With the currency collapse, these debts have suddenly swollen as much as fivefold. Third and worst of all is credit risk. Many borrowers simply can't repay their loans. By one estimate, if the Indonesian rupiah falls to 15,000--which it did late in January--the entire Indonesian corporate sector will have negative equity. In these circumstances, naturally, nobody lends.

In a normal banking crisis, such interwoven problems can be tackled by a lender of last resort, who can see to the restructuring and recapitalization of the system. But in a world on the dollar standard, Asia's lender of last resort is Alan Greenspan, and while the Fed chairman has hinted pretty clearly that any deflationary pressures emanating from Asia will enter into his calculations about the appropriate level of short-term interest rates in the U.S., he is in no position to run a rescue operation for Asia's banks.

Harsh critics of the IMF, such as Jeffrey Sachs, a Harvard economist, and David Hale, chief economist of Zurich Group in Chicago, insist that the organization should be urgently focusing on the short-term banking problem instead of ignoring it. Criticism of the IMF by respected nonpartisan heavyweights such as Sachs and Hale is not going to make the Clinton Administration's task of winning congressional approval for increased IMF funding any easier. But even if that approval is forthcoming, it is highly unlikely that the IMF--which has neither the expertise nor the authority to run an Asia-wide bank restructuring--will mount one.

Can anyone? It's not clear, but if anyone can offer immediate help, it's Japan. What's needed is a decision by Japan's government to clean up and recapitalize its own banking system and to loosen fiscal and monetary policy significantly. Japan is the economy that Asia depends on most for trade and investment flows. On Japan's present tight policy course, the Japanese economy is likely to continue stagnating until at least the end of this year, and if so, this will surely worsen Asia's crash.

That is only part of the story. If Asia's ailing banks are truly to get healthy again, Western banks, along with some of the stronger institutions in Japan, Hong Kong, and Singapore, will have to take them over and restructure them. Yes, letting outsiders call the shots will rankle the locals. But to those who say foreign takeovers will trample on nationalist sensibilities, Merton Miller retorts, "They have a choice. They can get the money this way, or they can suffer."

Finally, though, Asia's problems are too deep and too complicated for foreign banks to solve matters on their own. One stumbling block is the strong aversion throughout Asia, save perhaps in Hong Kong, to acknowledging losses and cleaning them up. Asia needs an institution as ruthless as the Resolution Trust Corp. was in the U.S. during the savings and loan crisis of the late 1980s to consolidate and then sell off both the assets of busted banks and the collateral (almost always real estate) that backed those assets.

One idea for a grand solution comes from Stuart Gulliver, Hongkong Bank's head of treasury, who thinks the U.S., Japan, and Germany may need to fashion a 1990s-style Plaza Accord to reverse the dollar's rise. Gulliver also believes such a concerted G-3 effort should include the issuance of guaranteed dollar-denominated debt by regional countries, with the proceeds recycled through a multinational cleanup organization that would help manage bank restructurings.

Not every country, however, requires such radical medicine. South Korea's banking problems seem more manageable simply because far fewer troubled lenders and borrowers are involved than elsewhere in Asia. That means it could benefit just from a more conventional sort of restructuring. Already talks have started in New York between South Korea's government and its banks' international creditors to restructure the debt.

With the Korean patient apparently stabilized until the end of March, thanks to a rollover agreement with the country's creditors, where should a worried world's attention be concentrated? Answer: Indonesia and China--for opposite reasons. With Japan still sitting on the sidelines, China is widely seen as Asia's last bulwark. By contrast, Indonesia's position is so precarious that it could blow up at any moment, certainly jeopardizing the rest of Southeast Asia and likely sending renewed shock waves around the world's markets.

In what must have been a humiliating public session for him, Indonesian President Suharto personally signed a new IMF agreement on Jan. 15 as Michel Camdessus, the IMF head, looked on with arms folded. The agreement--extracted in exchange for the next slice of a $43 billion aid package--was most remarkable for the toughness of its assault on what Camdessus bluntly called "an accumulation of rigidities and monopolies."

Many of them had been accumulated by President Suharto's family and friends. Out went tax, customs, and credit privileges for the Timor "national car" project of the President's youngest son, Hutomo Mandala Putera (known as Tommy), which had allowed the Timor to undercut its nearest competitor by 30% to 50%. Out went a wheat-flour monopoly, a power plant, and a $1.8 billion coal-fired power plant that were all in the pocket of Suharto's oldest daughter, plus billions in other subsidized projects or cartel privileges that benefited the President's cronies and key ministers.

It all sounded fine on paper. But the key to whether Indonesia does or does not topple into disaster in the next few months is the level of the rupiah, and that depends crucially on whether the IMF agreement in particular and the political situation in general inspire confidence among Indonesians and investors.

The prognosis doesn't look good. Indonesia's currency woes are far worse than any other Asian country's. On Jan. 23, only a week after Suharto had signed the new IMF agreement that was supposed to begin restoring confidence in Indonesia, the rupiah hit 15,000, more than a fivefold decline in less than eight months. Even at 12,000 rupiah to the dollar, every bank in Indonesia (except the 43 branches of foreign banks) is insolvent. Loan rates are already at 35% to 40% and are set to go higher as the rupiah falls, especially since so much internal bank lending in Indonesia is dollar denominated. In these circumstances a bet that the rupiah will strengthen significantly and then stay firm is a brave one. Stephen Rogers, research director for UBS's Jakarta operation, reckons that the economy may contract by 5% this year.

If Indonesia is Asia's worst problem, Greater China--defined as Taiwan, Hong Kong, and China itself--may be its best hope. True, equities in all three have been battered every bit as much as stocks elsewhere in Asia. But judged by the one market that has become the litmus test for stability in Asia--the foreign-exchange market--the Chinese have been champs.

Though the New Taiwan dollar has fallen about 17% since July, that's still far less than most other currencies in the region. Moreover, Taiwan's fall has happened largely because Taiwanese officials did not want their exporters to be too disadvantaged by currency movements elsewhere in Asia (particularly in export archrival South Korea).

The Chinese yuan, protected by a closed capital account, has actually risen against the dollar since July, thanks to strong foreign investment, while the Hong Kong dollar has not flickered as its currency-board peg to the U.S. dollar has held firm despite intermittent speculative attacks.

Taiwan has become the envy of Asia only partly because of its skills at currency management. In stark contrast to beleaguered South Korea (to which Taiwan has now showily offered $2 billion in soft loans), Taiwan has a diffuse and flexible industrial structure dominated not by a few colossal conglomerates but by thousands of small and midsized enterprises. Again, unlike their South Korean counterparts, these businesses have been financed not so much by government-directed bank credit as by market-determined finance, and far less by debt than by equity. Taiwan has, in other words, precisely the right industrial and financing structures to thrive in a swiftly deregulating and liberalizing Asia. Its economic growth this year, at 5% to 6%, will surely be the highest in Asia save perhaps for China's.

Meanwhile, Hong Kong's dollar peg is doing exactly what it was intended to do: When there's pressure, the currency stays protected. Unfortunately, that also means that capital, land, and labor take the hit. With changes this huge, the adjustments are painful. The stock market has almost halved, and property prices are down 20% to 30%, with an ultimate fall by half not out of the question.

Retail firms are also weak, with many failures likely after the Chinese New Year's holiday in late January. Jobs are going too: At the top end it is a reasonable guess that 2,000 to 3,000 investment brokers will be thrown onto the streets. Cathay Pacific, Hong Kong's flag-carrier airline, has fired 700 ground staff. Economic growth may fall to 2% to 3% this year, from over 5% in 1997.

But it is China itself that has become Asia's new pivot. Many fear that if the yuan now substantially devalues, it will not only lead to a panicky downward spiral for other Asian currencies but could wreck already wobbly emerging markets from Russia to Brazil.

One reason the yuan may hold: Many multinationals, whose direct investments are a crucial source of foreign capital for China, are unlikely to up stakes for a place like Indonesia (the only country where labor costs might now be lower than China's) when stability there seems so elusive. Indeed, Kodak, which now counts China as its third-biggest national market, is expected to announce a large new investment there.

A yuan devaluation could, moreover, have serious domestic repercussions. China's leaders are engaged in a tricky process of trying to reform their debt-laden, state-owned enterprises and banks. Critical to carrying out the reforms is the maintenance of the banks' retail deposit base. Any whiff of a devaluation and that deposit base would be threatened by customers who in the past have shown themselves perfectly capable of finding other outlets for their savings (such as foreign currency and gold).

Happily, Asia's crisis seems if anything to be giving more urgency to China's struggle to effect deeper economic reform. Although China is not exposed the way other Asians have been to the whims of international portfolio managers, it is aware of what they look for. Chicago's ubiquitous professor Miller--who advises Zhu Rongji, China's economic supremo and almost-certain next Prime Minister come March--told Zhu in January to issue currency-guarding notes with payments guaranteed in U.S. dollars, to show it means business. China has deeper geopolitical reasons for following such advice. Should China survive this crisis with its currency intact, its regional influence would be mightily enhanced.

If China remains stable, the Asian crisis is far less likely to become a global one. For Asia itself to get out of jeopardy, however, requires far more: first and foremost a framework of calm exchange rates and functioning financial systems. Most of all, Asia's leaders have to show convincingly through actions and not just words that they are committed to a radical restructuring of their economies along more modern free-market lines. They must also be prepared to accept the painful adjustments this will require fully and swiftly. Only then can Asia realize its potential and begin to rise again.