the financial crisis in asia - charles sturt...

21THE FINANCIAL CRISIS IN ASIA

The Financial Crisis in Asia

How has the Asian financial crisis developed over the last 12 months? What caused the crisis? Did itresult from basic structural weaknesses in the affected countries or was it merely the result of inves-tors panicking? Did the policy response by the International Monetary Fund (IMF) ameliorate orexacerbate the situation? This chapter closely analyzes these important questions. It concludes byshowing that whatever the answers, a fundamental need is to strengthen the international financialarchitecture and proposes a necessary, minimum set of reforms within the existing institutional setting.

The collapse of the Thai baht in July 1997 markedthe beginning of Asia’s financial crisis. It began

modestly enough. After a series of speculative attacks,Thailand was forced to let its currency float on 2 July,but within weeks what had been a local financial cri-sis became a regional problem. Equity markets andcurrencies throughout Southeast Asia were underpressure as contagion raged and foreign capital fled.Within months Indonesia, the 4th most populouscountry in the world, and the Republic of Korea(henceforth referred to as Korea), the world’s 11thlargest economy, were engulfed in crisis.

Financial turmoil spread with a ferocity thatnone foresaw. Asia’s once vibrant economies, used todecades of rapid growth, were plunged into deep re-cession. For many countries the economic hardshiphas been similar to that suffered during the GreatDepression of the 1930s. In many Asian economies,this economic collapse has forced an unprecedentedreappraisal of policies ranging from corporate gover-nance to exchange rate management. In addition, thecrisis managers, particularly the IMF, have come under

criticism. Intense debate continues about whether IMFpolicies helped or hindered economic recovery. Finally,Asia’s crisis has spawned wide-ranging discussion aboutthe basic design of today’s international financial sys-tem. Suggestions for reform and blueprints for improv-ing the international financial architecture abound.

These debates are far from settled. This chapterreviews the progress achieved so far in a number ofareas. Given that Indonesia, Korea, Malaysia,Philippines, and Thailand suffered the most severeadverse impacts as a result of the crisis, the analysis inthis chapter largely focuses on these countries, col-lectively referred to as the crisis-affected countries.While other countries in the region also suffered invarying degrees because of the spillover effects of thecrisis, terms such as Asian crisis and Asian policiesrefer to this former group of countries. After anaccount of the crisis in 1998, the chapter critically ex-amines competing explanations of what caused Asia’sturmoil, and points out that no simple interpretationsuffices. The causes of Asia’s problems were complex,and understanding them fully will require a new

ASIAN DEVELOPMENT OUTLOOK 199922

generation of academic models. It then reviews someof the priorities that Asia’s governments now face andanalyzes the debate about policy responses to date.Here too the truth is more complex than many com-mentators allow. Finally, it addresses the global archi-tecture debate. It analyzes the various proposals forinternational financial reform and discusses what islikely to emerge from what could be the biggest reap-praisal of international finance since the BrettonWoods Conference of 1944.

THE EVOLUTION OF THE CRISIS IN 1998

Asian financial markets began 1998 on a pessimisticnote. With confidence eroded by Korea’s near defaultin December 1997, the region’s financial marketsreached record lows in January 1998 (see figure 1.6).However, by early February markets had bounced back,largely on the hope that foreign confidence in the re-gion was returning. On 2 February, for instance, HongKong’s Hang Seng Index rose 14 percent, its second

largest one-day point gain ever, while other regionalexchanges saw strong rallies. But this optimism didnot last long, partly because of turmoil in Indonesia,and partly because of increasingly poor economic per-formance in Japan.

Indonesia’s economic crisis began to worsensharply in February. Mixed policy signals, gallopinginflation, and a vast debt overhang scared investorsand sent the rupiah plummeting. That same monththe Suharto government proposed establishing acurrency board, but eventually abandoned the ideaunder strong pressure from various quarters. Politicaluncertainties and civil unrest compounded thecountry’s difficulties. Eventually, the combination ofsoaring prices, civil protests, sharply rising unemploy-ment rates, and widespread corporate defaults preci-pitated a major political crisis. On 21 May PresidentSuharto resigned; however, this did little to rally themarkets.

Japan’s woes compounded the region’s troubles.In early February 1998, the Japanese government


declared the economy “stagnant” in a monthly reportthat offered the bleakest assessment of the country’sbusiness climate in more than 20 years. Respondingto the turmoil in Asian markets in mid-February, thegovernment unveiled a long-awaited package of stimu-lus measures designed to support the stock market andboost the economy. It proved insufficient. Theeconomy continued to contract, despite an increasein the fiscal stimulus measures in April. Moody’s rat-ing agency revised Japan’s sovereign debt rating down-ward, and by 12 June the yen had declined to aneight-year low of ¥145 to the US dollar.

The tumbling yen triggered declines in otherAsian currencies in June (see figure 1.7), includingthe Malaysian ringgit, the Thai baht, the Korean won,and the New Taiwan dollar (which hit an 11-year low).Stocks throughout the Pacific Rim fell sharply as inves-tors worried that falling currencies would worsen theregion’s economic difficulties. Hong Kong’s Hang SengIndex and Seoul’s composite index tumbled to their low-est levels since February 1995 and June 1987, respectively.

Worried by the regional impact of a plummet-ing yen, Japan and the United States turned to offi-cial intervention. On 17 June, in coordination withthe Bank of Japan, the United States spent an esti-mated $2 billion to bolster the value of the yen. Newsof the intervention—which represented a markedchange of American policy toward the yen—had thedesired effect. It soared to ¥138 to the US dollar, andAsian markets rallied.

Unfortunately, the rally did not last. By mid-August the yen had fallen to a new low of ¥147 to thedollar. Pressure on the Chinese yuan and the HongKong dollar mounted as investors feared a new roundof regional devaluations. Another major shock hit fi-nancial markets on 17 August: the Russian centralbank devalued the ruble and the government effec-tively defaulted on its internal debt. This action had adramatic and deleterious impact on all financial mar-kets. Investors fled all types of risk, from emergingmarket bonds to noninvestment-grade corporatebonds in developed markets.


As capital fled policymakers were forced to re-sort to unorthodox responses. The Hong Kong, Chinaauthorities intervened directly in the stock market tocounter what they viewed as market manipulation,and spent an estimated $15 billion of public funds onthe Hong Kong Stock Exchange. On 1 SeptemberMalaysia’s government decided to impose exchangecontrols to counter speculative attacks on the ringgit.

As investors fled to the safety of cash and trea-sury bonds, interest rate spreads widened on all debtinstruments, and highly leveraged hedge funds thatspecialized in arbitraging risk hit trouble. The nearcollapse of the Connecticut-based hedge fund, LongTerm Capital Management, and its rescue organizedby the Federal Reserve Bank of New York, showedthat by the end of September 1998 the crisis had movedwell beyond Asia.

By this time financial markets were clamoringfor a coordinated G7 interest rate cut to calm the panic.Although no coordinated move took place, the USFederal Reserve cut interest rates three times, by atotal of 0.75 percent, between September and Decem-ber 1998, and European central banks cut their bench-mark rates. Markets were also reassured by the decisionto enhance the IMF’s capital base or “quotas” in Oc-tober, which had been held up by political oppositionin the US Congress.

Since October 1998 conditions in Asia haveimproved substantially. Japan has made progress onthe much needed reform of its banking sector and isimplementing the fiscal stimulus package. The yenstrengthened dramatically to ¥113 to the US dollar bythe end of December. Buoyed by progress in Japan, byinterest rate cuts in the industrial countries, andespecially by the gradual implementation of their ownreform programs, other Asian markets began torecover.

October was a particularly good month: onaverage, the region’s equity markets rose by almost18 percent. Since then the Korean stock market hasbeen the strongest performer (see figure 1.6), thoughit is still far from its precrisis levels. As stock marketsrebounded, currencies also strengthened. Between theend of September 1998 and January 1999 the Indone-sian rupiah rose by just over 20 percent, the Koreanwon by 18 percent, the Philippine peso by 15 percent,and the Thai baht by 7 percent.

By the beginning of 1999 one could say that theAsian economies seemed to have stabilized. In Koreaand Thailand especially, the bitter economic medicinewas beginning to work. Attention was shifting fromimmediate crisis management to accelerating recov-ery. Debt restructuring, corporate workouts, and bank-ing reform moved to the top of the agenda. In thisregard, the announcement of a $30 billion assistancepackage from Japan under the Miyazawa Plan im-proved the region’s economic prospects. While emerg-ing markets remained fragile—as evidenced by thecollapse of Brazil’s currency, the real, in late January1999—the worst in Asia seemed to be over.

INTERPRETING THE CRISIS

As Asia’s crisis deepened, so the search for explana-tions intensified. What exactly caused these once vi-brant economies to fall victim to such a financialdisaster? The issue is not simply one of academic in-terest, because the appropriate policy responses de-pend in large part on an understanding of what causedthe crisis.

Competing Explanations:

Panic versus Fundamentals

Two general interpretations dominate the debate. Oneblames poor economic fundamentals and policy in-consistencies. The other argues that Asia fell victimto a financial panic, where negative sentiment becameself-fulfilling.

According to the “fundamentalist” view, theAsian crisis (along with most other financial crises)was caused by basic economic weaknesses. Proponentsof this view argue that Asia’s healthy macroeconomicindicators—low inflation, fiscal balance, low stock ofgovernment debt, high rates of domestic saving andinvestment (see table 1.2)—painted a misleading pic-ture. They argue that in reality, Asia’s economies suf-fered from serious structural problems as well as policyinconsistencies. They point out that warning signalsexisted: for instance, in Thailand the current accountdeficit was dangerously large and rising fast. More-over, benign macroeconomic indicators, such as ahealthy budget balance, could mask real economicweakness. Many Asian governments provided implicit


guarantees to the banking system, which often en-gaged in lending practices that favored financiallyunqualified borrowers. These implicit guarantees ledbanks to lend recklessly. This, in conjunction with poorcorporate governance in many of these economies,created a large stock of nonperforming loans, therebyrisking the banks’ collapse. This meant that the gov-ernments’ implicit guarantees created a sizable “con-tingent fiscal liability.”

By contrast, the panic interpretation views theself-fulfilling pessimism of international lenders as theroot cause of the crisis. The most sophisticated ver-sion of this argument interprets Asia’s crisis as a classicbank run. In a bank run, if enough investors aresuddenly seized with panic and demand immediatepayment, then financial intermediaries are forced todestructively liquidate long-term assets at a great loss.In the classic model of a panic, the central bank can

Table 1.2 Macroeconomic Indicators, Selected Asian Economies, 1990-1997(percent)(percent)

Growth rateGrowth rate Inflation rateInflation rate Fiscal balance/GDPFiscal balance/GDP

EconomyEconomy 1990-19951990-1995 19961996 19971997 1990-19951990-1995 19961996 19971997 1990-19951990-1995 19961996 19971997

Korea 7.8 7.1 5.5 6.6 5.0 4.5 0.2 0.5 -1.4

Indonesia 8.0 7.8 4.9 8.7 7.9 6.6 0.2 0.2 0.0

Malaysia 8.9 8.6 7.7 3.7 3.5 4.0 -0.4 0.7 1.8

Philippines 2.3 5.8 5.2 10.6 9.1 6.0 -1.1 0.3 0.1

Singapore 8.6 6.9 7.8 2.7 1.4 2.0 9.4 6.8 3.3

Thailand 9.0 5.5 -0.4 5.0 5.9 5.6 3.2 2.4 -0.9

Hong Kong, China 5.0 4.5 5.3 9.3 6.3 5.9 1.6 2.2 6.5

PRC 10.7 9.6 8.8 11.3 8.3 2.8 -1.0 -0.8 -0.7

Taipei,China 6.4 5.7 6.8 3.8 3.1 0.9 -5.0 -6.6 -6.3

Savings/GDPSavings/GDP Investment/GDPInvestment/GDP Current Account/GDPCurrent Account/GDP

EconomyEconomy 1990-19951990-1995 19961996 19971997 1990-19951990-1995 19961996 19971997 1990-19951990-1995 19961996 1997

Korea 35.6 33.7 33.1 36.8 38.4 35.0 -1.2 -4.7 -1.8

Indonesia 31.0 27.3 29.9 31.3 30.7 31.3 -2.5 -3.4 -1.4

Malaysia 36.6 42.6 43.8 37.5 41.5 42.0 -5.8 -5.0 -5.3

Philippines 16.6 18.5 20.3 22.4 23.1 23.8 -3.7 -4.7 -5.3

Singapore 47.0 51.2 51.8 34.9 35.3 37.4 0.6 15.4 15.4

Thailand 34.4 33.7 32.9 41.0 41.7 35.0 -3.9 -7.9 -2.0

Hong Kong, China 33.6 30.7 31.8 29.6 32.1 35.4 — — —

PRC 40.8 40.5 41.5 38.8 39.6 38.2 1.2 0.9 3.2

Taipei,China 26.9 25.1 24.8 24.0 21.2 22.0 4.2 4.0 2.7

— Not available.

GDP Gross domestic product.PRC People’s Republic of China.

Sources: Statistical Appendix Table Nos. A1, A7, A8, A9, A16, and A23.


prevent such a destructive bank run by acting as lenderof last resort and providing liquidity to the market.However, in the international version of a bank run,if a country’s exchange rate is fixed and foreignexchange reserves are limited in relation to short-termexternal debt, as was the case in some Asian crisis-affected countries, no mechanism for stemming panicis available. In Indonesia, Korea, and Thailand short-term external debt exceeded international reservesimmediately before the crisis (see table 1.3), andindeed, for more than two years prior to the crisis.

Economic fundamentals, such as inflation, un-employment, and the budget deficit, are unimportantin this interpretation, although fears about economicweaknesses might cause the initial investor shift fromoptimism to pessimism. What matters is the maturitystructure and currency denomination of external andinternal debt. If, for instance, a large proportion of acountry’s debt is denominated in foreign currency andis of a short maturity, as it was in much of Asia, therisks of a crisis arise.

Which Explanation

Fits Asia Best?

At first sight, the past stellar economic record of theAsian economies does not support the fundamental-ist interpretation. However, closer inspection clearlyshows that these countries’ economic success was builton a particular kind of economic strategy that em-phasized export orientation, centralized coordinationof production activities, and implicit (or even explicit)government guarantees of private investment projects,as well as a close operational relationship andinterlinked ownership between banks and firms.Widely referred to as Asian industrial policy, this strat-egy allowed firms to rely heavily on bank credit. Byinternational standards, firms in crisis-affected coun-tries were extraordinarily highly leveraged. In Koreaand Thailand, for instance, the average debt-to-equity ratios in 1996 were above 200 percent. InHong Kong, China; Indonesia; and the Philippinesdebt-to-equity ratios were lower, but nevertheless highby international standards (see table 1.4).

The financial sector was also exhibiting signifi-cant problems. Weak prudential regulation, lax andinexperienced supervision, low capital adequacy ra-

Table 1.3 Short-Term External Debtand International Reserves

Prior to the Crisis,Selected Asian Economies,Second Quarter of 1997

Short-termShort-term InternationalInternationaldebtdebt reserves reserves Debt-reserveDebt-reserve

EconomyEconomy ($ billions)($ billions) ($ billions)($ billions) ratioratio

Korea 70.18 34.07 2.06

Indonesia 34.66 20.34 1.70

Malaysia 16.27 26.59 0.61

Philippines 8.29 9.78 0.85

Singapore 196.60 80.66 2.44

Thailand 45.57 31.36 1.45

Taipei,China 21.97 90.02 0.24

Sources: Short-term debt: Bank for International Settlementsdata; reserves: IMF (1998a); staff estimates.

tios, lack of adequate deposit insurance schemes, dis-torted incentives for project selection, and sometimesoutright corruption all rendered the region’s financialsystems weaker than they appeared.

For many years, most Asian economies kept theirfinancial systems relatively closed. Foreign borrowingwas limited and capital inflows were controlled. Thesecontrols ensured that the region’s financial sectors re-mained immune from external shocks despite theirdomestic fragility. Most important, controls preventeddomestic fragility from being translated into externalvulnerability in the form of short-term, unhedged for-eign debt. This changed during the 1990s. As inter-national capital markets were gradually opened anddomestic markets were deregulated, supervision andregulatory oversight did not improve in tandem. Forexample, Thailand’s now infamous finance companiesgrew rapidly during the 1990s with virtually no regu-latory oversight.

The 1990s also saw a dramatic increase in for-eign borrowing. While Asian companies maintainedtheir strong bias in favor of debt financing, foreign debtfinancing became increasingly important (see table 1.5for corporate debt composition in selected Asianeconomies in 1996). The pegged exchange rate elimi-


financial institutions. Second, domestic banks lent todomestic firms in local currency, while borrowing shortterm in foreign currencies without hedging. This cre-ated a significant currency denomination mismatch.Third, the easy availability of credit fueled investmentin increasingly risky assets. In some countries the creditboom was translated into bubbles in real estate andproperty. In other countries financial resources weredirected toward overinvestment in narrowly special-ized industries such as electronics or large, prestigiousprojects with unclear benefits. These poor and riskyinvestments, in turn, worsened the quality of the port-folios of domestic financial institutions, thereby in-creasing the risk of panics and subsequent crises.

At the same time, several factors combined dur-ing the 1990s to worsen the fundamental economicoutlook for the region. The rapid appreciation of theUS dollar since 1995, to which most of the region’scurrencies were pegged in some way; the increasingcompetition from the People’s Republic of China(PRC) in export markets; and the prolonged slowdownof the Japanese economy were all reflected in slowerexport growth, rising current account deficits, de-pressed stock markets, and widespread corporate dif-ficulties long before the outbreak of the crisis. In 1996,

nated exchange risks in borrowing in dollars. At thesame time international investors were falling overthemselves to lend: interest rates in the industrialcountries were low, prompting a search for higheryields elsewhere, and optimism about Asia’s prospectswas high. Between 1991 and 1996 overall borrowingdoubled in Malaysia and Thailand and grew by onethird in Korea (World Bank 1998a). The fundamen-talist interpretation of the crisis links this extraordi-nary optimism among foreign investors to their beliefthat the borrowing was ultimately guaranteed, eitherby Asian governments or by international institutions.The panic interpretation regards the optimism as ra-tional, based on the correct judgment that theseeconomies were fundamentally sound.

Although specific characteristics varied, apattern of increasing vulnerability to external shocksemerged in all the region’s economies prior to the crisis.First, short-term borrowing to finance long-termprojects became increasingly important, especially inKorea, Malaysia, and Thailand. This created a sizablematurity mismatch in the balance sheets of domestic

Table 1.4 Selected Indicatorsof Corporate Financing,

Selected Asian Economies, 1996

Debt-to-equityDebt-to-equity Ratio of short-termRatio of short-termratioratio debt to total debtdebt to total debt

EconomyEconomy MeanMean MedianMedian MeanMean MedianMedian

Hong Kong, China 1.56 1.42 0.60 0.64

Indonesia 1.88 1.83 0.54 0.57

Japan 2.21 1.92 0.58 0.59

Korea 3.55 3.25 0.57 0.59

Malaysia 1.18 0.90 0.64 0.70

Philippines 1.29 0.93 0.48 0.49

Singapore 1.05 0.81 0.58 0.59

Taipei,China 0.80 0.74 0.59 0.61

Thailand 2.36 1.85 0.63 0.67

Note: Data are derived from a sample of 5,550 Asian firms.

Source: Claessens, Djonkor, and Lang (1998).

Table 1.5 Corporate Debt Composition,Selected Asian Economies, 1996

(percent)(percent)

Foreign debtForeign debt Domestic debtDomestic debt

Short-Short- Long-Long- Short-Short- Long-Long-EconomyEconomy termterm termterm termterm termterm

Indonesia 20.5 19.6 31.4 28.5

Korea 29.4 17.0 27.7 25.8

Malaysia 32.1 11.0 35.7 21.2

Philippines 19.7 21.3 25.5 33.5

Taipei,China 22.3 19.2 23.9 34.6

Thailand 29.6 12.3 32.0 26.1

Note: Data are derived from a sample of 5,550 Asian firms.

Source: Claessens, Djankov, and Lang (1998).


for instance, 20 of the largest 30 Korean conglomer-ates had rates of return below the cost of invested capi-tal, and in the first months of 1997, 7 of the 30 largestconglomerates were effectively bankrupt.

As these financial difficulties emerged, somegovernments played an increasingly active role in re-assuring international investors about their willingnessto back domestic financial firms. A case in point isthe collapse of the large Thai finance company,Finance One. In the months preceding the crisis, theBank of Thailand repeatedly confirmed to foreign in-vestors its willingness to “back Finance One all theway” (Financial Times 12 January 1998).

In the first half of 1997, despite the worseningfinancial environment, capital inflows did not slowdown, but increasingly took the form of short-term,interbank loans that could be readily withdrawn andcould count on formal guarantees in the interbankmarkets. However, once the crisis began, internationalbanks suddenly stopped lending and began to call intheir loans. A huge amount of private foreign capitalfled the region in the second half of 1997. Betweenthem, Indonesia, Korea, Malaysia, Philippines, andThailand received a net capital inflow of about $76billion in 1996, but suffered a net capital outflow ofaround $36 billion in 1997. This implies a differenceof approximately $112 billion, or about 12 percent ofthe countries’ combined gross domestic product(GDP). Commercial banks withdrew about $26 bil-lion from the crisis-affected countries in 1997, afterlending them about $63 billion in 1996.

The suddenness and speed with which capitalfled the region in the second half of 1997 gives cre-dence to the panic interpretation of the crisis. How-ever, as this section has shown, it was the region’sstructural weaknesses that initially created the vul-nerability to crisis.

Academic Theories of Currency Crises

The competing interpretations of Asia’s crisis are mir-rored in debates between academic economists.Economists have developed an entire literature thattries to analyze currency crises using formal models.These models of currency crises fall into two broadcategories, appropriately called “first generation” and“second generation” models.

First generation models (also known as exog-enous policy models) show how fundamentally incon-sistent domestic policies lead an economy inexorablytoward a currency crisis. In the most popular versionof this model, a currency crisis in a country with afixed exchange rate is caused by an excessively largebudget deficit. To finance the budget deficit, thegovernment prints money. At the same time, thecentral bank is committed to defending the exchangerate; however, it can only do so as long as it has thenecessary foreign exchange reserves. As the govern-ment continues to print money to finance the budgetdeficit, reserves will fall because the private sector iswilling to hold all the new money the governmentprints, and therefore exchanges some local currencyfor foreign currency. At some point a currency crisisoccurs. The analysis does not focus on predictingwhether or not the currency will collapse—becauseeventually it certainly will—but on the timing of aspeculative attack on the currency. Deteriorating eco-nomic fundamentals and inconsistent policies are thecause of the crisis.

By contrast, second generation models (alsoknown as endogenous policy models) stress that acurrency crisis can occur even when macroeconomicpolicies are apparently consistent with a fixed ex-change rate policy. These models show how a sponta-neous speculative attack on a currency can cause acrisis, even if fiscal and monetary policies are consis-tent. In these models, rational governments choosetheir macroeconomic policies and choose whether ornot to retain a fixed exchange rate on the basis of acalculus of costs and benefits. The benefits of main-taining a fixed exchange rate include reduced infla-tionary pressure and a stable environment thatfacilitates trade and investment. The costs of a fixedexchange rate can include high interest rates and highunemployment (if wages are rigid).

Self-fulfilling expectations play an important rolein this model. If the public does not believe that agovernment will maintain its fixed exchange rate, thendomestic bondholders will demand a higher interestrate in anticipation of a currency devaluation. Laborunions might demand higher wages, thereby render-ing domestic industries uncompetitive. Such actionswould raise the government’s costs of maintaining afixed exchange rate, encouraging it to abandon the


peg. The public’s concern about a devaluation wouldbecome a self-fulfilling prophecy.

The second generation models do not imply thatevery country can be a victim of speculative attacks.Countries are only vulnerable when economic funda-mentals—such as foreign exchange reserves, thegovernment’s fiscal situation, and the political com-mitment to defend the peg—are sufficiently weak.When a country’s fundamentals are obviously strong,a crisis will not occur. When they are extremely weak,it will certainly occur. In between a currency peg mightsurvive, or it might fall victim to a speculative attack.Box 1.4 explains the logic behind such sudden lossesof confidence.

The fundamentalist interpretation of Asia’s cri-sis is closely related to the first generation of currencymodels. The implicit (and later explicit) governmentguarantees to failing banks implied a large fiscal bur-den to Asian governments. To the extent that such arising fiscal burden raised the likelihood that govern-ments would eventually resort to printing money tofinance growing deficits, the currency crisis is exactlywhat first generation models would predict. The panicinterpretation of the crisis is derived from the secondgeneration models. These models underscore the ideathat a regime of fixed exchange rates that is not per-fectly credible is intrinsically unstable and subject tosudden swings in market sentiment.

POLICY RESPONSES TO THE CRISIS:

AN OVERVIEW OF THE DEBATE

The principal responsibility for dealing with the Asiancrisis at an international level was assumed by the IMF,the institution charged with safeguarding the stabilityof the international financial system. The IMF’s goalwas to quickly restore confidence in the three hardesthit Asian economies—Indonesia, Korea, and Thailand—through a combination of tough economic condition-alities and substantial financial support. In 1997 the IMFapproved $35 billion of loans for these countries, andin addition, mobilized commitments worth $77 billionfrom the Asian Development Bank (ADB), the WorldBank, and bilateral sources. In 1998 the IMF arrangedfurther loans worth $6.3 billion for Indonesia.

The IMF’s economic strategy had two key com-ponents. The first, in keeping with its usual practice,

concentrated on macroeconomic policy, the maincomponent of which was to be tighter monetary policy.Higher interest rates were designed to defendexchange rates, and so stem (or reverse) the capitaloutflows. Modestly tighter fiscal policy was designedto support current account adjustment and providethe funds that would be necessary to bail out sick bank-ing systems. The second, complementary, componentof the strategy was substantial structural reform. TheIMF demanded deep reform of the region’s bankingsystems, the breakup of monopolies, the removal ofbarriers to trade, and substantial improvements in cor-porate transparency. This marked a significant depar-ture from past IMF practice, when conditionalities hadbeen more closely confined to macroeconomic poli-cies alone. The IMF saw the structural reforms as es-sential for a long-term solution to Asia’s financial crisis.

Both components of the IMF’s strategy havecome under heavy fire. Some critics have gone so faras to argue that the policies the IMF initially imposed,far from ameliorating the situation actually made theregion’s problems worse. Not surprisingly, such accu-sations have led to a vigorous defense of its actions bythe institution and its supporters.

Two difficulties plague any evaluation of theIMF's policies. The first is the insoluble problem ofthe counterfactual. Knowing precisely what wouldhave happened if the IMF had adopted a differentapproach is impossible. The second difficulty is thatthe IMF’s targets and tactics changed over time. Asthe situation in Asia progressively worsened, the IMFeased its approach and required less fiscal contrac-tion. In Indonesia, for instance, it relaxed its initialrequirement of a budget surplus in 1997 to allow for asizable budget deficit. Similar, if less dramatic, relax-ation occurred in the cases of Korea and Thailand.The crucial question is whether these changes in policywere an implicit admission of initial misjudgments bythe IMF, or whether they simply represented a flexibleresponse to changing conditions.

Did Tight Monetary Policy and High

Interest Rates Exacerbate the Crisis?

In crisis-affected countries, the IMF recommended asharp increase in interest rates to restore confidence,stem capital outflows, and stabilize the currency. The


The logic of self-fulfilling, speculativeattacks and bank runs can beillustrated by a simple example.Suppose that a country pursues afixed exchange rate, but its monetaryauthorities have only 10 units ofinternational reserves to defend theexchange rate. For simplicity, supposethat before the speculative attack,1 unit of domestic currency isexchanged for 1 unit of foreigncurrency. There are two identicalagents (or speculators) who canattack the currency. Each can use atmost 6 units of domestic currency.Thus no agent alone can deplete theinternational reserves of the countryand force the central bank toabandon the defense of the peg.Nonetheless, the stock of reserves islow enough to make the countryvulnerable to a joint speculativeattack by both agents.

Attacking the currency involvesa fixed cost equal to 1 unit ofdomestic currency. Clearly, if one ofthe agents decides to attack, thepayoff will depend on the behavior ofthe other agent in the economy. Alone, and therefore unsuccessful,attack is costly to the agent.Conversely, a joint attack will yield anet payoff equal to the amount ofreserves that each agent can buy atthe existing exchange rate—say halfthe central bank’s stock of reserves—times the size of the devaluation,minus the fixed cost. For an exchangerate depreciation to take place, theremust be a sufficiently largespeculative movement in the foreignexchange market. The size of thedepreciation, of course, depends onunderlying economic fundamentals.

The figure shows the agents’possible payoffs, expressed in units ofdomestic currency. Each cell reportsthe payoff from the variouscombinations of the two actions theagents can take, that is, whether ornot to attack the currency. If both

agents decide to attack the currencyand the currency is devalued by60 percent, then the net payoff toeach agent (that is, the payoff afterpaying the transaction cost) is2 units. If the attack is unsuccessful,the speculating agent ends up with anet payoff of -1 unit. The figureshows that two outcomes are likely asfollows:n If one agent attacks the

currency, it also pays the other agentto attack, as both will make netpayoffs of 2 units. Thus one possibleoutcome is a simultaneousspeculation leading to a collapse ofthe currency. (This is shown in theupper left-hand cell of the diagram.)n By the same logic, if one agent

does not attack the currency, then itdoes not pay the other agent tospeculate, as this would merely givethe latter a net loss of 1 unit. In otherwords, the attacking agent wouldsimply incur the fixed cost. (Theseare the cases shown in the bottomleft-hand and the upper right-handcells.) Thus, the outcome would beno attack on the currency (thebottom right-hand cell).

Consequently, the actualoutcome depends on whether or notthe agents coordinate theirexpectations. Note that in both casesdiscussed above, the fundamentals—the size of the international reserves,the “firepower” available to theagents, and the size of thedevaluation when the peg isabandoned—are the same.

This provides a simple exampleof how an otherwise sustainablecurrency peg can be vulnerable toself-fulfilling speculative attacks.Note that in this example, no attackwould ever take place if theinternational reserves in the centralbank were more than12 units (so that the firepower of thespeculator would be relatively low),while the currency would certainlycollapse if international reserves wereless than 6 units. However, neitherthis example nor the moresophisticated economic literatureprovide any explanation of howagents coordinate their decisions, nordo they explain the factors that swingmarket confidence.

More important, for a givenstate of fundamentals, the likelihoodof a speculative attack increases ifinformation is incomplete. In thisenvironment, even news events thatare unrelated to economicfundamentals can shift agents’expectations and help triggerspeculative attacks (the trouble inthe province of Chiapas before the1994 Mexico crisis is a case in point).The theory reaches the importantconclusion that more information, orgreater transparency, decreases thelikelihood of a self-validating crisis,and thus ensures currency andfinancial stability.

Sources: Morris and Shin (1998); Obstfeld(1996).

Box 1.4 The Logic behind Confidence Crises

Attack Not attack

Attack

Notattack

Agent I gains 2Agent II gains 2

Agent I loses 1Agent II gains 0

Agent I gains 0Agent II gains 0

Agent I gains 0Agent II loses 1

Agent IIAgent II

Agen

t I

Agen

t I


IMF maintained that because of the time needed forother (structural) reforms to take hold, the only wayto stabilize a crisis situation quickly was to raise inter-est rates with sufficient resolve.

Critics of the IMF argue that this approach wasmisconceived and counterproductive. They point outthat high interest rates forced highly leveraged cor-porations into bankruptcy. Widespread bankruptciesin the corporate sector led to bank insolvencies as thebanks’ corporate customers failed to repay their loans.These bankruptcies weakened the financial system andencouraged capital flight, and thus caused a furtherdecline in the exchange rate. All this had a tremen-dous negative impact on the real sector of theeconomy. Given this negative spiral, the critics claimthat a more appropriate policy response to the crisiswould have been a looser monetary policy, that is, afall rather than a rise in interest rates. Lower interestrates would have made it easier for firms to maintainproduction, thereby restoring investors’ confidencethat the economy would recover quickly, and wouldthus have caused currencies to appreciate. That wouldhave created a virtuous circle. Many of the critics pointout that Japan followed just such a policy when deal-ing with its domestic crisis.

The IMF, however, feared that a lower interestrate policy would cause a vicious downward spiral. Ascurrencies plummeted, so the real burden of debt de-nominated in foreign currency would rise. Because theAsian firms had high leverage ratios, a much higherforeign debt burden could have forced insolvenciesand caused even larger collapses in production. Un-like Japan, which is a net foreign creditor, the size offoreign debts was a much greater concern in Asia'scrisis-affected countries.

Some of the critics who advocated lower inter-est rates to reflate the domestic economy and relievethe financial situation of heavily indebted firms ac-knowledge that a lower interest rate might not havestrengthened the exchange rate or brought back de-parted capital. In that case, the only remaining alter-native would have been for countries to suspendservice on their external debts and impose exchangecontrol measures. Such actions could have had anextremely detrimental and long-lasting effect on thecountries’ ability to access international capital mar-kets. With the exception of Malaysia, which imposed

selected exchange controls in September 1998, thisoption was not pursued.

Available empirical evidence does not necessar-ily support the view that interest rates were persis-tently high. Indeed, several of the crisis-affectedcountries pursued low interest rate policies well intothe crisis. Despite continued worsening of the foreignexchange market, Korea maintained official ceilingson interest rates through December 1997, and Indo-nesia reduced its interest rates in September 1997 asthe rupiah was declining. The real interest rate inIndonesia remained negative until mid-1998. Malaysia,another country that was affected by the crisis but didnot seek IMF assistance, waited until December 1997,when its currency value had fallen by 40 percent, be-fore it tightened its monetary policy. Supporters of theIMF’s position further point to Indonesia as an ex-ample of the disastrous consequences of loose mon-etary policy. Indonesia manifestly failed to tighten itsmonetary policy in late 1997. The result was a col-lapse in the exchange rate, galloping inflation, andthe bankruptcy of much of the corporate sector. Koreaand Thailand, which eventually adopted a tight mon-etary policy—even though it was not extremely tightin degree or duration in relation to that in other coun-tries elsewhere outside Asia in the past that were facedwith exchange rate instability—succeeded in stabiliz-ing their economies. In these economies interest ratesbegan to fall during 1998 while exchange ratesstrengthened. Moreover, a recent IMF analysis (IMF1999) indicates that the costs of tighter monetarypolicy may have been lower than many suggest. It es-timates that in Korea and Thailand, the effects of themonetary tightening may account for less than a quar-ter of the expected decline in economic growth ratesbetween 1997 and 1998.

Did the IMF Force Unnecessary

Fiscal Adjustment?

Unlike many other crises that have required IMF in-tervention, the Asian crisis was not caused by profli-gate government spending. Thus fiscal imbalanceswere not a major concern in the initial IMF programs.Nonetheless, the IMF’s approach in the crisis-affectedcountries was to demand a tightening of fiscal policybased on two arguments. First, it argued that in the


presence of rapid capital flight these countries neededto reduce domestic demand in order to reduce theircurrent account deficits. Tightening fiscal policy wasan effective way to do this. Second, and more subtle,was the argument that government spending neededto be cut to make room for the expected expenditurenecessary to bail out insolvent banks. Some estimatessuggest that the cost of bailing out financial institu-tions in some crisis-affected countries could eventu-ally reach 20 to 30 percent of GDP, which underreasonable assumptions about the interest rate wouldentail an annual cost of about 3.0 to 3.5 percent ofGDP (see table 1.6). Eventually, the Asian economieswould need to run budget surpluses high enough tocover this cost. Therefore beginning a modest tight-ening of fiscal policy early on was prudent.

Critics, however, claim that the fiscal tighteningsimply exacerbated the enormous economic contrac-tion that was already taking place in the region. Inthe face of collapsing output, they argue, fiscal expan-sion, that is, a small budget deficit, would have beenmore appropriate. Even if the region’s economiesneeded to run surpluses over the long run to pay fortheir banking bailouts, worsening a severe recessionwith immediate fiscal tightening was unnecessary. Inshort, they charge, the IMF failed to gauge the sever-

ity of the crisis and the fiscal conditions it imposedmade matters significantly worse.

This is an easy criticism to make with hindsight.Clearly the fact that the IMF relaxed its fiscal targetsover time suggests that its priorities changed as theregion’s economic outlook worsened. However, it ishard to blame the IMF for failing to gauge the depthand likely persistence of the region’s problems. Fewpolicymakers or commentators foresaw the depths ofthe crisis.

Even if running a looser fiscal policy had mademore sense for Asia’s governments, fiscal flexibility wasseverely constrained by the lack of access to interna-tional credit at reasonable rates. If international insti-tutions and industrial countries made more liquidityavailable, Asian countries’ fiscal flexibility would im-prove significantly.

Did the Closure of Insolvent Banks

Precipitate Runs on Solvent Banks?

Given the parlous state of the financial sector in thecrisis-affected countries, there is little doubt that manybanks in Indonesia, Korea, and Thailand needed tobe restructured, merged, or simply closed. The IMFbelieved that speedy and concerted action in this di-rection would, by weeding out the bad financial apples,help restore investors’ confidence. In all three coun-tries, therefore, the operations of a number of clearlyinsolvent financial institutions were suspended or theinstitutions were closed early on. In Thailand 58 fi-nance companies were suspended in July and August1997, in Korea 14 merchant banks were suspended inDecember 1997, and in Indonesia 16 banks were closedin November 1997.

The IMF’s critics charge that this abrupt closureof insolvent banks panicked the public and precipi-tated a run on sound banks. Concerned that theirbanks might be closed next, depositors withdrew theirmoney from healthy banks in a classic banking panic.Although only Korea had a formal deposit insurancescheme prior to the crisis, the general perception inall three countries was that government guaranteescovered most of the deposit base. When this percep-tion turned out to be false, panic ensued.

Indonesia is the most dramatic example of this.The closure of 16 banks—which between them con-

Table 1.6 Cost Estimates by the IMFof Bank Restructuring in Asia, Selected Asian Economies

November 1998November 1998

Debt issuesDebt issues Interest paymentsInterest payments

$$ PercentagePercentage $$ PercentagePercentageEconomyEconomy billionsbillions

aaof GDPof GDP billionsbillions

aaof GDPof GDP

Indonesia 40.0 29.0 5.4 3.5

Korea 60.0 17.5 6.4 2.0

Thailand 43.0 32.0 4.0 3.0

Malaysia 13.0 18.0 0.9 1.3

Philippines 3.0 4.0 0.3 0.5

a. At the exchange rate of 30 November 1998.

Sources: IMF (1998b,e).


tained less than 3 percent of total deposits—led to anear collapse of the entire banking system as inves-tors switched funds from private banks to the statebanks, which they considered to be safer. Thus, thecritics argue, the IMF’s policy made matters muchworse.

Clearly in Indonesia the decision to close banksdid precipitate a public panic. However, the IMF’s sup-porters argue that the lack of clear government policycaused the panic, not the bank closures themselves.The Indonesian government promised only a smalldeposit guarantee, did not publicize it widely, and didnot explain publicly how depositors in banks that hadnot yet been closed would be treated. Similarly, theIMF’s defendants point out, the closure of banks inKorea and Thailand did not result in such severe runs.That is true, but it is also true that the financial insti-tutions that were closed in these countries were mainlymerchant banks that did not take personal deposits.

Was the IMF too Intrusive?

Some critics question the IMF’s insistence on far-reaching structural reforms in Asia’s economies. Theyhave suggested that the IMF went well beyond itsmandate of ensuring prudent macroeconomic policies.Instead it was intervening excessively in the domesticaffairs of sovereign governments by demanding large-scale restructuring in the corporate and financial sec-tor, as well as improvements in governance, labormarkets, and competition policy.

The IMF’s proponents argue that this critiquedoes not sit well with the facts of the Asian crisis. Ifreckless monetary and fiscal expansion was not at theroot of the Asian financial crisis, as those who viewthe IMF as being too intrusive also accept, devising aresponse focusing on these areas made no sense. How-ever, if, as is widely acknowledged, structural weak-nesses in corporate governance and the financialsystem lay at the core of Asia’s problems, then theIMF’s loan programs would have had little chance ofsuccess if they had not addressed structural reform.Providing large-scale financial assistance to supportthe region’s currencies would have been irresponsibleif the root cause of the problem was left unaddressed.Continued financial and corporate weakness wouldhave undermined macroeconomic policy, investors

would have continued to flee, and the IMF’s ultimategoal—a quick return to economic growth—wouldhave been impossible. The IMF’s demands wereintrusive, but necessary.

Did IMF Bailouts Increase

Global Moral Hazard?

While much of the criticism directed at the IMF hasfocused on its strategy in Asia, some criticize the veryexistence of IMF support. This argument is based onthe concept of moral hazard. Moral hazard impliesthat investors and borrowers behave imprudently be-cause they believe they will be bailed out if their in-vestments go sour. IMF loans, argue some critics,exacerbate moral hazard in two ways: they absolvegovernments from the consequences of profligate poli-cies, thereby encouraging them to continue the prof-ligacy in the future, and they reward reckless investors.Because the IMF’s loans to the crisis-affected Asiancountries were unusually large, the critics argue thatthey set a dangerous precedent that will increase moralhazard worldwide.

Although multibillion dollar support packagesclearly run some risk of changing investors' incentives,three reasons support the view that the critics haveexaggerated the moral hazard argument. First, mostinvestors in Asia, whether foreign or domestic, suf-fered substantial losses. Typical investors in Asia haveseen the value of their investments reduced to a thirdor a quarter of their precrisis value. Second, it is hardto believe that governments relish the tough condi-tions the IMF imposes on them. Many governmentsthat turn to the IMF later lose power, as they are forcedto implement politically unpopular changes. Third, thecosts of not intervening in Asia’s crisis would havebeen extraordinarily high. Investors would have fledeven more quickly, countries would have been forcedto default on their debts, and the region (and perhapsthe world) could have been plunged into an even moreserious crisis.

THE NEXT STEPS

As the region’s economies began to stabilize during1998, the full impact of the crisis on corporate andbanking sectors gradually became apparent. Large


parts of the corporate and financial sectors in the crisis-affected countries were either insolvent or in deepfinancial trouble. Statistics provided by private sectoranalysts paint a considerably gloomier picture thanofficial estimates. Analysts at the Deutsche Bank, forinstance, have estimated that the ratio ofnonperforming loans to total loans is as high as 60 per-cent in Indonesia and is above 30 percent in PRC,Korea, Malaysia, and Thailand (Deutsche BankResearch various issues). At these levels, if non-performing loans were written off against bank capi-tal the net worth of the whole banking system wouldbe negative. To recapitalize these banks in order toreach the minimum 8 percent capital adequacy ratiorecommended by the Basle standards would costbetween 20 and 30 percent of GDP (World Bank1998d).

A simulation analysis on the effect of the de-valuation and of credit and interest rate shocks under-taken by the World Bank (1998a) shows that onaverage, firms in the crisis-affected countries lost abouthalf of their equity value. One firm in three had loansthat exceeded its equity value. Given these figures, itis clear that improving the health of the financial andcorporate sectors must be a top priority across theregion.

The need to restore the appropriate conditionsfor viable financial institutions and firms to operatenormally as quickly as possible dominates the short-run agenda. That means drawing a distinction betweenviable and nonviable firms; restructuring domestic andforeign debt; allocating losses between creditors, debt-ors, and taxpayers; and reorganizing corporate con-trol, in particular, through mergers and acquisitions.

Exactly how these various steps occur will de-pend crucially on each country’s legal and regulatoryframework. Both financial and corporate restructur-ing involve many complex issues. The World Bank(1998a) lists four principles for bank restructuring.First, only viable institutions should stay in business,and losses should be allocated transparently whileminimizing the cost to taxpayers. Second, financialdiscipline should be strengthened and moral hazardminimized by ensuring that shareholders take lossesfirst, followed by creditors, and only lastly by depositholders. Third, the restructuring process should main-tain credit discipline on existing borrowers and pro-

vide incentives for new investors to provide fresh capi-tal to the bank. Fourth, the restructuring processshould be speedy, to restore normal credit flows andconfidence in the banking system quickly.

So far, the crisis countries have had varying suc-cess in financial restructuring. Most have introducedlegislation to strengthen prudential regulation andimprove banking supervision. Throughout the region,disclosure requirements, auditing standards, loan clas-sification, and provisioning rules are being improved.All the crisis countries have created financial restruc-turing institutions, such as the Indonesian Bank Re-structuring Agency and the Thai Financial SectorRestructuring Authority. All have provided substan-tial public money for bank recapitalization, and allhave closed down some insolvent institutions. None-theless, they still have a long way to go before theirfinancial sectors are fully restructured.

Unfortunately, progress in corporate restructur-ing has been much slower than in the financial sector.The region’s firms are heavily indebted both to localbanks, and in some cases to foreign banks. In Indone-sia, in particular, corporate foreign debt is huge, thoughvirtually all firms have stopped servicing their debt.Corporate indebtedness is slowing down productionand investment dramatically (because insolvent firmscannot borrow), and it is also preventing a speedy so-lution to the region’s financial restructuring (becausemost banks’ loans are to local firms).

However, corporate restructuring in the regionis plagued with problems. Most important is the weak-ness of bankruptcy law and its enforcement. Eventhough the crisis-affected countries have revampedtheir bankruptcy laws in the past year, they do nothave enough trained people to implement them.Second, the sheer logistics of restructuring hundredsof companies are formidable. Although some of theregion’s governments have promoted voluntary debtrestructuring between firms and banks—by, forinstance, removing tax disincentives and legal barri-ers—few formal institutions to organize corporaterestructuring exist.

The sentiment that existing shareholders shouldlose control of the firms is widespread. However, someargue that such a view skirts two important consider-ations. First, insiders possess knowledge specific to thefirm, and removing them would remove an important


asset of the firm. Second, the crisis-affected countriesface a shortage of domestic equity capital. As banksare largely in public hands, surrendering corporatecontrol to creditor banks would be equivalent tonationalization. These concerns may be exaggerated,but experience suggests that reforming corporategovernance is a long and difficult process, stronglyopposed by those currently in control. Because exist-ing owners have better information, and often strongpolitical ties, dramatic and rapid corporate restruc-turing is unlikely.

Slow corporate restructuring has negative im-plications for the cost and sustainability of financialsector restructuring. As most financial sector assetsare corporate liabilities, the existence of insolvent firmsundermines the rationale for injecting new capital intobanks. There is little justification for propping up banksif their debtors are all bankrupt. The result may sim-ply be more fiscal transfers to cover new losses lateron. In this respect, unfortunately, the experience ofMexico and Eastern Europe is not particularly encour-aging. There bank restructuring took longer and costthe taxpayer more than anyone had envisaged.

STRENGTHENING THE INTERNATIONAL

FINANCIAL ARCHITECTURE

The severity of Asia’s financial crisis, the speed withwhich it spread, and the shortcomings of the interna-tional response have all contributed to a wide-ranging debate on the basic rules and institutions thatgovern global finance. How can this global financialarchitecture be improved so that crises can be avoidedand can be better managed when they do occur?

Background

Recent efforts to improve the global financial archi-tecture began at the Halifax Summit of the G7 lead-ers in 1995. In the wake of Mexico’s financial crisis,policymakers already felt that global institutions andrules needed to be updated to cope with a modernworld of integrated capital markets. The existingBretton Woods architecture had originally been de-signed for a world where capital mobility was limited(box 1.5). Even though it had evolved over the years,financial markets had changed far more profoundly.

As official discussions on an international finan-cial architecture have proliferated since 1995, so anincreasing number of organizations have become in-volved (box 1.6). In addition, a number of individualacademics and other commentators have put forwardtheir own reform proposals. The result is a plethora ofideas. However, few concrete changes have occurred.This is partly because international institutions andpolicymakers have been preoccupied with the imme-diate task of crisis management, but mainly becausethe issue of international financial reform is extraor-dinarily complex.

US Deputy Secretary of the Treasury LawrenceSummers recently referred to the “integrationtrilemma” (Summers 1999). He noted that in the yearsahead the central task of international politicaleconomy will be to reconcile as well as possible thethree goals of greater integration, proper public man-agement, and national sovereignty. In effect, policy-makers would like the international financial systemto fulfill a number of goals. They would like to fostercapital market integration, they would like interna-tional financial markets to be regulated and supervisedjust as national markets are regulated and supervised,and they would like to maintain national sovereignty.Unfortunately, these three goals are incompatible:maintaining national sovereignty in a world of freecapital means forfeiting market regulation and sup-port. Conversely, to create regulations and a lender oflast resort at the international level implies overrid-ing national sovereignty. The only way that a countrycan regulate and support its financial markets whilemaintaining national sovereignty is by controlling capi-tal flows.

This incompatibility of goals is particularly strik-ing in the area of exchange rate management.Policymakers want the benefits of capital market in-tegration, they want exchange rate stability, and theywant each country to be able to pursue its own macro-economic policy. Unfortunately, these three goals areat odds. They form what economists Obstfeld andTaylor (1998) have called the “open economytrilemma.”

To understand why, consider figure 1.8. Eachcorner of the triangle represents one of thepolicymakers’ three goals, and each side of the tri-angle indicates a possible regime. “Adjustment” means


The IMF and the World Bank wereset up at the Bretton WoodsConference in 1944 to prevent arepeat of the international financialproblems that had occurred duringthe Great Depression. The IMF wasto oversee the Bretton Woods systemof fixed exchange rates and theWorld Bank was to provide capitalfor postwar reconstruction, and laterfor projects in developing countries.Plans for a third institution, theInternational Trade Organization,foundered in 1947 when the USCongress refused to accept it. In itsplace, the “provisional” GeneralAgreement on Tariffs and Tradetook on the role of reducinginternational trade barriers througha series of eight multilateralnegotiating rounds. Eventually,on 1 January 1995, the WorldTrade Organization came intoexistence.

The World Bank’s goal was toprovide foreign exchange andtechnical assistance for developmentprojects, particularly physicalinfrastructure such as bridges anddams. During the past 50 years itsrole has broadened to includevirtually all aspects of the

development process. Later a numberof regional banks were founded,including the ADB. Their regionalproximity and smaller size led themto be more innovative in some respects.

The IMF oversaw the BrettonWoods exchange rate regime. Theaim of the Bretton Woods system wasto enable countries to achieve fullemployment and balance-of-payments equilibrium simultaneously.Temporary deficits were to becovered from a country’s ownreserves and, if necessary, by loansfrom the IMF. Only fundamentalbalance-of-payment problems, that is,ones that could not be correctedwithout excessive unemployment orinflation, were to be corrected byexchange rate changes. The IMF’sArticles of Agreement called forconvertibility of current accounttransactions only. Article VI, section3, gives members the right to applycontrols on capital flows. In 1997 theInterim Committee—the advisorybody that oversees the IMF—recommended that the Articles ofAgreement be amended to extendjurisdiction to issues relating toorderly liberalization of capitalmarkets.

The Bretton Woods systemdepended on countries’ willingnessto hold their reserves in US dollars.This, in turn, was conditional ontheir expectation that they couldconvert dollars into gold at a fixedprice. In the mid-1960s, as USinflation rates rose, partly becauseof the cost of the Viet Nam War,confidence in the dollar'sconvertibility began to erode.The system collapsed afterPresident Nixon abandoned theUS dollar’s convertibility in 1971and the fixed exchange rate regimebroke down.

After the breakdown of theBretton Woods regime, the IMFformally began to oversee the new“system” of floating exchange rates.In practice, its focus moved to thedeveloping world. It played acentral role during the debt crisisof the 1980s, coordinating lenderbanks and providing adjustmentfinance. In the 1990s it has assistedformerly communist economies intheir transition to marketeconomies and has played acentral role in combatingfinancial crises.

Box 1.5 The Existing Bretton Woods Financial Architecture

that a country can pursue independent macroeco-nomic policies. If the economy is slowing down, forinstance, the country can adjust by reducing interestrates. “Confidence” denotes the ability to protect ex-change rates from destabilizing speculation. With con-fidence, trade and investment flows are encouraged.“Liquidity” refers to the ability to borrow money fromabroad through the free flow of capital. For countriesto have this liquidity, international capital flows mustbe free. Unfortunately, it is only possible to achievetwo of these goals at once.

Suppose a country wants a stable exchange rateas well as liquidity (that is, free access to international

capital). To achieve these goals it must either establisha currency board or join a monetary union. That, inturn, means giving up the policy independence associa-ted with a flexible exchange rate. In a world of freelymobile capital, fixed, but adjustable, exchange ratepegs are unsustainable, because they would immedi-ately be tested by currency speculators. The only waya country can maintain confidence (currency stabil-ity) and adjustment (the ability to run an independentmacroeconomic policy) is by restricting capital flows.That was the combination chosen by policymakersunder the original Bretton Woods regime. For the first25 years after the Bretton Woods agreement, the glo-


At the last major restructuring ofthe international financial systemin 1944—the Bretton WoodsConference—all the majorparticipants were comfortablyhoused in a single rural hotel inNew Hampshire. The views of justtwo people, John Maynard Keynesrepresenting the United Kingdomand Harry Dexter White for theUnited States, dominated theconference. A comparableconference today would probablyneed every hotel room in a mediumsized American city. With so manydifferent agendas and vestedinterests, discussion on anyproposals (if, indeed, anyagreement could be reached) wouldtake far longer than thedeliberations at Bretton Woods.

Today a number of officialgroups are involved, all of whichhave their own ideas on how toproceed. The best known of these isthe G7, which consists of the sevenmost influential industrialcountries, and whose currentmembership was determined at asummit meeting in 1976. Thisgroup has become the focal pointfor international cooperative

efforts. Indeed, it was the G7 thatcoined the term financialarchitecture in 1995, and the G7finance ministers have workedregularly on this issue. The mostrecent initiative of the G7 in thisregard is the creation of a financialstability forum.

The G10 is an older group, setup in 1962, and includes 11industrial countries (Switzerlandjoined later, but the name was notchanged). It consists of central bankgovernors and finance ministers, andconsequently focuses oninternational financial matters. Thegroup is closely related to the BasleCommittee on Banking Supervision,and both groups are based in theoffices of the Bank for InternationalSettlements. Europe tends todominate the group, with 8 of the 11members being European countries.

The G22 is an ad hoc group ofcountries set up by the United Statesin April 1998 and includes a numberof emerging market countries. At itsfirst meeting three working groupswere set up to examine issues ofenhancing transparency andaccountability, strengtheningfinancial systems, and managing

international financial crises. Theseworking groups delivered theirreports in October 1998. At therequest of several small Europeancountries, the G22 was expanded tobecome the G26; however, it has notmet formally again.

Despite their overlappingmemberships, the various groupsbring a wide range of different viewsand perspectives to the discussions ofthe international financialarchitecture. While these differentviewpoints no doubt enrich thediscussions, whether this plethora ofarchitects will eventually contributeto a more solid architecture or merelygenerate too much dissension anddivergence about the blueprintremains to be seen.

Note: The G7 consists of Canada, France,Germany, Italy, Japan, the United Kingdom,and the United States. The G10 includes theG7 plus Belgium, the Netherlands, Sweden,and Switzerland. The G22 comprises the G7and 15 emerging market economies (Argen-tina; Australia; Brazil; PRC; Hong Kong,China; India; Indonesia; Korea; Malaysia;Mexico; Poland; Russia; Singapore; SouthAfrica; and Thailand). The G26 consists ofthe G22 plus Belgium, Netherlands, Sweden,and Switzerland, that is, the four countriesincluded in the G10 but not in the G7.

Box 1.6 Too Many Architects Spoil the Blueprint?

bal financial architecture was based on a system offixed exchange rates and strict capital controls.

During the 1960s, however, private investorsgradually began to evade these capital controls, andinternational capital movements increased. As capi-tal mobility increased, countries were forced to choosebetween the ability to maintain macroeconomic policyindependence and exchange rate stability. The break-down of the Bretton Woods system of fixed exchangerates in the early 1970s shows that industrial coun-tries chose to maintain independence by forfeitingfixed exchange rates. Since then, the world’s majorcurrencies—the US dollar, the yen, and the European

currencies—have all floated. However, in recent years,some European industrial countries have shifted inthe opposite direction. They have solved the openeconomy trilemma by giving up exchange rate flex-ibility entirely and creating a single currency, the euro.

In developing countries capital flows remainedtightly controlled for much longer. However, in the1980s, and particularly in the 1990s, the trend towardgreater capital mobility has spread worldwide. Thusever more countries face the choice between exchangerate stability and policy independence. Most havemoved toward exchange rate flexibility. In 1976, forinstance, 86 percent of developing countries pegged


their currency to a single currency (such as the USdollar or the French franc) or to a basket of currencies.Twenty years later only 45 percent of developing coun-tries still had pegged exchange rates.

The Asian financial crisis, as well as recent crisesin Brazil, Mexico, and Russia, hit countries with peggedexchange rates and heavy inflows of foreign capital.They were a direct result of the open economytrilemma. Thus at the heart of the debate on improvingthe international financial architecture is the thornyquestion of which of the three goals to give up.

Proposals for Strengthening

the Architecture

Proposals for strengthening the international finan-cial architecture abound. These proposals differ sig-nificantly in terms of their nature and scope. Someproposals are radical and demand a total overhaul ofthe existing structure, some are conservative and rela-tively easy to implement within the existing structure,some suggest more forceful responses to the crisis fromthe international community, while others would relymore on the market for crisis resolution. The follow-ing section reviews a set of salient proposals.

Controlling Capital Flows. One group of financial re-form proposals hopes to solve the open economy

trilemma by controlling capital mobility. Some com-mentators question the very goal of free capital flows,arguing that free trade alone should be the main ob-jective of development and growth policies. They of-ten put forward two arguments to support this view.First, countries can reap the benefits of free trade ingoods and services without simultaneously opening uptheir financial markets to foreign competition. Accord-ing to this view, capital mobility is an optional extra.Second, several commentators argue that the theo-retical benefits of free capital flows, such as increasedinvestment and more efficient use of funds, do notoccur in reality, because the efficiency gains that acountry reaps from opening up to foreign capital aremore than offset by increasing uncertainty and greaterrisk of financial crises. Because financial markets areplagued by imperfect information and a tendency toovershoot, they bring developing countries more risksthan rewards. Some economists claim that there is noempirical evidence that countries perform better withcapital mobility than without.

As Part III of the Outlook shows, these argumentssit uneasily with both economic theory and facts. His-tory shows that countries that try to pursue free tradewhile maintaining capital controls suffer a number ofproblems as people try to evade the capital controls.Importers, for instance, often overinvoice their ship-ments to smuggle capital out of the country. As econo-

Figure 1.8 Open Economy Trilemma

Adjustment

Floating exchange rate

LiquidityGold standard,currency board,

and currency union

Confidence

Bretton Woods

Source: Krugman (1998).


mies develop and become more open, capital controlsnot only foster corruption, but also restrict the growthof trade.

Increasing global integration increases uncer-tainty. However, this also occurs as trade is liberal-ized. Terms of trade shocks—the sudden rise or fall ina key export or import price—are potentially as un-settling as the contagious spread of financial crises.Moreover, the claim that there is no empirical evi-dence of any measurable impact of capital accountliberalization on a country’s welfare is overstated, al-though the empirical work in this area is nascent.

Market integration is an ongoing multilateralprocess. While analyzing the costs and benefits for asingle economy is possible, the ultimate benefits ofintegration will depend on policies followed by allcountries and their evolution over time. While onecountry might not suffer too much by slowing downor reversing its capital mobility, the negative impactof many countries doing this could be much higher.For all these reasons, reforms of the financial archi-tecture that are based on a broad move away fromcapital mobility make little sense.

However, this does not imply that all capitalaccount liberalization is good. The record of financialcrises, especially in Asia, shows that ill-planned libera-lization of capital flows—without the appropriate mar-ket reforms—can result in financial instability andimply large economic costs. The Asian crisis showedthat when countries open up their capital accountswithout effective supervision and regulation of finan-cial intermediaries, they become more vulnerable tocrisis, because the access to foreign capital magnifiesthe weaknesses and distortions of the domestic finan-cial system.

This suggests that financial liberalization mustbe carefully sequenced. A number of architecturalreform proposals are designed to assist that process.Some concentrate on improving market regulation,bank supervision, and transparency standards. Othersconcentrate on minimizing the risks associated withcapital flows, focusing on measures to discourage short-term borrowing in foreign currency, which is widelyregarded as the most dangerous form of foreign capital.

The goal is not to proscribe international finan-cial transactions, but simply to increase their relativecost. This can be done in a number of ways. The most

widely supported is to tax foreign borrowing. Chile isthe most well-known example of this approach. Until1998, any company that borrowed abroad had to place30 percent of the proceeds at the central bank for oneyear. This unremunerated reserve requirement was theequivalent of a hefty tax on short-term borrowing.Over a longer-term horizon it became much lesspunitive. In addition, only Chilean companies with acredit rating equivalent to that of the sovereigngovernment could borrow abroad. Alternative waysto discourage short-term borrowing include placinglimits on open foreign currency positions by domesticbanks and instituting high-risks weights in the capitalrequirements for foreign currency loans to domesticfirms.

These proposals raise a number of questions.First, should the rules apply only to banks or also tothe broad corporate sector? Banks are clearly the mostvulnerable institutions, but a regulation narrowly fo-cused on banks might simply shift the foreign borrow-ing to firms. Second, how can such rules be effectivein a financial system that lacks adequate supervisionand regulation? Third, how can such prudential regu-lations be implemented without jeopardizing acountry’s broad commitment to liberalization? Finally,and most important, do they work? Evidence fromChile suggests that the main effect of the controls wasnot on the level of incoming flows, but on their distri-bution across assets of different maturities. In otherwords, while overall capital inflows were not affected,short-term inflows were effectively discouraged(Valdes-Prieto and Soto 1997).

While prudential controls on capital inflows mayhelp prevent a crisis, they are not much use once acrisis occurs. However, some commentators suggestthat different capital controls—this time, controls onoutflows—may be an important component of crisisresolution. Imposing controls on capital outflowsallows policymakers to sever the links betweendomestic interest rates and exchange rates. Thus theycan lower interest rates and stimulate the domesticeconomy without incurring the cost of a currencydevaluation. While capital controls themselves do notsolve the fundamental economic problems underlyinga currency crisis, their proponents argue that they cangive policymakers time to address the relevant reformissues. (See Part III for more discussion on this issue.)


Such a strategy carries considerable risks. First,there is the risk of a strongly negative market reac-tion. Once a country resorts to controls on capitaloutflows, investors will worry that politicians couldintroduce them again. They will therefore demandhigher returns to invest in that country again. Worse,the introduction of capital outflow controls couldunsettle markets more broadly and have negativeconsequences for the market access of other develop-ing countries.

Second, capital outflow controls are not oftenimplemented and managed by benevolent govern-ments, but by partisan policymakers in a distortedenvironment. They create the incentives for corrup-tion and reduce the pressure for politicians to intro-duce politically unpopular structural reforms. If“temporary” controls on capital outflows remain inplace for long, the negative implications for a countryquickly rise. For all these reasons, proposals to sanc-tion the broad use of capital outflow controls are un-likely to find much support among internationalfinancial architects.

Improving Regulatory Standards. One of the maincauses of the Asian financial crisis was poor regula-tion and supervision of financial institutions. Henceit is not surprising that much of the effort to improvethe international financial architecture has concen-trated on finding ways to improve international stan-dards of financial regulation and supervision.

Two of the G22 working group reports were con-cerned with these issues: one concentrated on trans-parency and accountability (G22 1998c), the other onstrengthening financial systems (G22 1998b). The re-port on transparency contained a variety of sugges-tions ranging from the uncontroversial (for instance,that private firms should adhere to national account-ing standards) to the ambitious (that wide-ranging dataon the international exposure of financial institutionsand firms should be compiled and published). Thereport on strengthening financial systems enumeratedmajor weaknesses in many domestic financial sectors,such as inadequate risk management, faulty depositinsurance schemes, and mismatched assets and liabili-ties. It found that international consensus existed inmany areas of banking supervision and securities regu-lation, but that in some areas best practices and stan-

dards needed to be defined, and noted that standardsshould be defined in a collaborative manner so thatboth industrial and developing countries have a voice.

The Basle Capital Accords are widely regardedas a model for international supervisory standards.Although originally agreed on by the G10, the Baslestandards for minimum capital adequacy for banks arenow widely accepted. To ensure that banks are ad-equately capitalized, the Basle standards are specifiedagainst banks’ risk-adjusted-assets rather than theirtotal assets. The Basle Capital Accords provide aframework for classifying assets according to their riskcategories, specifying different risk weights for differ-ent risk categories, and calculating risk-adjusted-assets. Since 1997 they have been supplemented by abroader set of core principles of banking supervision.

One way to encourage countries to adopt suchstandards is through IMF surveillance. The G22 work-ing committees, for instance, recommended that theIMF issue a transparency report along with its regularArticle IV economic assessment of member countries.Another approach is to improve coordination betweenregulatory bodies, or even to introduce a system ofpeer review, whereby national regulators could super-vise each other. Improved regional surveillance wouldbe another option. In this connection, the Asian De-velopment Bank has established a Regional EconomicMonitoring Unit to support the recently initiated re-gional surveillance activities of the ASEAN.

Another set of reform proposals focuses on im-proving existing regulatory standards. Some sugges-tions concentrate on tightening the rules on foreignborrowing in developing countries. Others focus onchanging the incentives lending banks face, in par-ticular, by updating the Basle capital adequacy accords.Regulating lending banks has two positive effects. Thefirst is realism: regulators of borrowing banks (in de-veloping countries) are generally less sophisticatedthan those of lending banks (in industrial countries).The second effect is that better regulation might im-prove the incentives facing lending banks.

The existing Basle capital standards contain sev-eral perverse incentives. For instance, risk weightingsfor short-term loans are considerably lower than forlong-term loans, which gives lending banks a clearincentive to supply short-term rather than long-termloans to emerging markets. The ongoing revision of


the Basle capital standards may well contain changesto these risk weightings. The Basle supervisors are alsoconsidering the issue of banks’ internal risk assessmentfor regulatory purposes. As the banks themselvesshould have the strongest incentive to act with pru-dence, some economists and policymakers have ar-gued that the greater use of banks’ own methods ofrisk assessment (value-at-risk models) can be ex-tremely useful for this purpose. Also under discussionin this regard is the need for regulatory purposes ofincreased reliance on market discipline through themandatory issuance of subordinated debt, that is, debtthat has a “junior” claim on a firm’s assets in the eventof bankruptcy.

Compared with banking regulation, the prob-lem of regulatory standards becomes much more se-vere when it comes to auditing and accounting,insolvency codes, and corporate governance. In theseareas, a number of private sector bodies are active.The International Accounting Standards Committee,a committee with members from more than 100 coun-tries, formulates international accounting standards.The International Federation of Accounts and theInternational Organization of Supreme Audit Insti-tutions formulates auditing standards and issues au-diting guidelines. Committee J of the International BarAssociation has been concerned with bankruptcy lawsand insolvency guides. The International CorporateGovernance Network deals with issues of corporategovernance. While all these organizations have donemuch useful work, much remains to be accomplishedin improving standards in these areas.

To improve regulatory standards in the finan-cial and corporate sectors internationally, some havesuggested that the international financial organizationsshould work in harmony with these private sectorentities. The international financial organizationsshould recognize these standards, urge adoption bytheir memberships, and monitor compliance. Thisdecentralized approach to regulatory reform has muchto recommend it.

More radical regulatory reform ideas include thecreation of global regulatory institutions. Proposalsinclude a world financial authority that would be theequivalent of the World Trade Organization for finan-cial institutions and a board of overseers of interna-tional financial markets. In each case, given that the

goal is to create a global supervisor and regulator con-sistent with global capital markets, countries wouldhave to surrender substantial amounts of national sov-ereignty. That requirement renders these ideas unre-alistic, at least for the moment.

Finally, in this regard, a recent institutional in-novation of the G7 has been the creation of the Fi-nancial Stability Forum. This forum, which will bringtogether central bankers, finance ministers, financialregulators, and representatives of multilateral organi-zations, has an ambitious mission, that is, to assessthe issues and vulnerabilities affecting the global fi-nancial system and to identify and oversee the actionsneeded to address them. It is too early to say whatrole the forum will play in the evolving internationalfinancial architecture. However, if it can create amechanism for improving information sharing, surveil-lance of and agreements on standards, codes of con-duct, and transparency requirements, then it wouldsignificantly increase the efficiency of global financialmarkets and reduce systemic risks. To achieve thisobjective successfully, the forum will need to expandits membership to emerging economies.

Rethinking Exchange Rate Regimes. The Asian crisishas shown that pegged, but adjustable, exchange ratesare difficult to sustain in a world of increasing capitalmobility. Sooner or later they are likely to be tested bya speculative attack, forcing—at the very least—highinterest rates and budget cuts. The Asian crisis hasalso reinforced another traditional argument againstfixed, but adjustable, exchange rates: by creating anillusion of permanent currency stability, they reinforcethe incentive for financial institutions and firms to bor-row from abroad without hedging.

Given these problems, the consensus now amongeconomists is that only the extremes of exchange ratemanagement are likely to succeed. Today’s conven-tional wisdom suggests that countries must eitherrigidly and irrevocably tie their currency to another byadopting a currency board or entering into a currencyunion, or they must allow their currency to float.

Three related arguments support flexible ex-change rate regimes. First, countries with floating cur-rencies are less likely to suffer sudden crises of investorconfidence. By definition, they will not waste preciousreserves defending an exchange rate peg. Empirical


studies confirm that serious currency crises are gener-ally associated with the collapse of a fixed exchangerate regime. On average, countries that see a suddendepreciation of a floating currency suffer less macro-economic distress.

Second, a flexible exchange rate regime allowsthe government more room to act as a lender of lastresort to the financial sector. Countries committed todefending a currency peg cannot provide domestic li-quidity freely without risking a loss of reserves. Coun-tries with a flexible rate need not worry about losingreserves, because the exchange rate will simply de-preciate as more domestic liquidity is created. Thisflexibility does not mean that countries with a flexibleexchange rate can prevent financial crises generated,for instance, by large capital outflows. In fact, if theburden of external debt is high, the scope for increas-ing liquidity domestically may be limited.

Third, a flexible exchange rate allows a countrymore autonomy in regard to its macroeconomic policy.This is the classic argument in favor of floating rates(see the earlier discussion of the open economytrilemma). However, exaggerating this benefit, espe-cially for developing countries, is easy. A developingcountry with significant policy autonomy may havetrouble gaining credibility in international financialmarkets. Too often in the past governments have usedtheir discretion to pursue imprudent, inflationary poli-cies. Countries with floating exchange rates often haveto keep interest rates high to maintain investors’ con-fidence. Mexico’s experience in mid-1998 makes thepoint. The peso fell by 20 percent in response to tur-moil in Asia and Russia, yet Mexican interest rateswere considerably higher than those in Argentina, acountry with an extremely tough currency board.

The choice of currency regime will depend on acountry’s size, history, and geographical location. InEurope, for instance, it is likely that more countrieswill ultimately adopt the euro. In Latin America,Argentine policymakers are talking seriously ofdollarization. In Asia, the future is much more uncer-tain, and the political and practical hurdles to anyregional currency union are high. Yet the costs of ex-cessive volatility and competitive devaluation are animportant concern in Asia’s highly open economies.

Some economists have recently advocated theneed for strong coordination of exchange rates among

Asian currencies. According to this view, recoveryfrom this crisis could be strongly facilitated if the crisis-affected countries could re-adopt a dollar exchangerate target, as they did before mid-1997. While ex-change rate policy does have international spillovereffects, it does not mean that explicit coordination isrequired to achieve stability. In addition, the rootcauses of the current crisis were largely domestic andstructural. Therefore any attempt at internationalexchange rate coordination without first addressingthose structural problems will be based on shaky foun-dations and is likely to be counterproductive.

Finally, the crisis-affected countries differ signifi-cantly in terms of their history of exchange rate re-gimes. Before the crisis hit, exchange rate regimes inAsia were not identical. Indonesia and Korea hadadopted a more flexible system (close to a crawlingpeg) than Malaysia and Thailand. Although thepostcrisis period has seen a general movement towardgreater exchange rate flexibility, the diversity in ex-change rate regimes continues. This suggests thatAsian economies are unlikely to see complete unifor-mity in exchange rate management soon.

Creating an International Lender of Last Resort.A number of reform proposals focus on preventingcontagion in international financial markets by creat-ing an international lender of last resort. The argu-ment in favor of an international lender of last resortis based on an analogy with the role central banksplay in national economies. When a banking panichits a domestic financial system, the central bank canlimit contagion by providing liquidity to the system.In a world of integrated capital markets, many arguethat a similar institution is needed at the internationallevel. By providing limited liquidity in return for policyconditionality, the IMF already plays a similar, if highlycircumscribed, role. Most advocates of an internationallender of last resort suggest that the IMF should playthis role.

However, the proposal to create an internationallender of last resort is plagued with conceptual andpractical difficulties. Conceptually, scholars do notagree on exactly what a lender of last resort does. Theclassic definition stems from Bagehot (1873): thelender of last resort should lend freely, at a penaltyrate, on good collateral in a time of financial panic.


Thus the lender of last resort must be able to distin-guish between healthy and insolvent institutions, in-tervening only to stop unwarranted panics and leavinginsolvent institutions to fail.

Extending these conditions from banks tocountries and from national authorities to interna-tional institutions is extremely difficult. The first prob-lem is that of distinguishing between illiquidity andinsolvency. An international lender of last resort shouldprovide limitless liquidity in the case of the former,and demand restructuring and adjustment in the caseof the latter, but as the Asian crisis highlighted, dis-tinguishing between the two is extremely difficult.

The second problem is that of moral hazard.National central banks put in place prudential regula-tions on domestic financial institutions to limit reck-less behavior. They also retain the power to close ormerge insolvent or weak financial institutions. Neithercapacity exists at the international level. As yet, no bind-ing global rules of financial behavior exist, and theIMF certainly cannot close down a recalcitrant country.

The final issue is that of resources. If necessary,a domestic central bank can provide limitless liquid-ity simply by printing money (unless it is constrainedby a fixed exchange rate regime). The IMF has nocapacity to issue fiat money. Its resources are limited,and despite the recent capital increase and introduc-tion of the New Arrangements to Borrow (an emer-gency credit line from donor countries to the IMF),they are insufficient to make it a credible lender oflast resort. To fulfill this role the IMF would need asubstantial increase in its resources. Whether thiswould be politically feasible is unclear.

Some observers suggest that only countries thatmeet a stringent set of requirements, especially as con-cerns their banking systems, should have access to IMFfunds (Calomiris 1998a). To those countries that ful-fill the requirements, the IMF should lend withoutpolicy conditionality, but should demand collateral inthe form of government bonds. One academic sug-gests that only countries that have complied with anagreed risk control strategy should qualify for IMFfunds (Dornbusch 1998). These suggestions suffer fromthe problem that few countries would fulfill the re-quirements. Given the contagious nature of financialcrises, it is unlikely that large countries would be leftunaided even if they failed to meet the criteria. More-

over, by announcing that a country no longer fulfilledthe criteria for assistance, the IMF might actually pre-cipitate a crisis. More modest proposals suggest thatthis risk can be reduced by charging countries withlower financial standards higher interest rates for as-sistance (Fischer 1999).

A proposal put forward by the United States inSeptember 1998, and subsequently endorsed by theG7, moves the IMF cautiously in the direction of beinga lender of last resort. The goal is to set up a contin-gency financing facility, where countries in good eco-nomic health can set up a precautionary credit linewith the IMF to reduce the chances of being hit byfinancial contagion. Although the idea is still underdiscussion, the difficulty of distinguishing betweenunwarranted panic and fundamental economic prob-lems will make this facility extremely difficult toimplement.

Finally, Japan has recently proposed the creationof regional currency support mechanisms to comple-ment the role and function of the IMF. The mecha-nisms are institutions that would provide liquidity intimes of financial crisis. These mechanisms, whichcould be established in Asia, the Western Hemisphere,and Eastern Europe, could be regionally funded bycountries that are economically interlinked with eachother by trade, investment, and so on, and are en-gaged in policy dialogue with each other. Nonregionalcountries with political and economic interests in theregion could also participate. This idea of regionalcurrency support mechanisms, which found an ear-lier articulation in the proposal for establishing anAsian Monetary Fund (box 1.7), is in the initial stageof discussion and development.

“Bailing In” the Private Sector. Another popular goalamong the architects of international financial reformis that of bailing in the private sector. The idea is tominimize moral hazard and spread the burden of fi-nancial crisis by ensuring that private investors andbanks bear some of the cost.

One approach that Argentina and Mexico havesuccessfully pioneered is to set up private sector creditlines before a crisis. Argentina has negotiated $6.7 bil-lion worth of repurchase arrangements with interna-tional banks. Against the collateral of domestic bonds,these arrangements give Argentina access to capital


in the event of a financial crisis. They are, in effect, alimited form of private lender of last resort. Such ar-rangements have considerable potential, particularlyif multilateral development banks guaranteed someportion of the risk involved, and thereby encouragedmore private banks to participate in such schemes.

In September 1997, before the fullinternational implications of theAsian crisis had become apparent,Japan proposed the establishment ofa new Asian Monetary Fund (AMF).Far from undermining the role of theIMF, the AMF could act as a regionalcomplement to the IMF in the waythat, for example, the ADBcomplements the work of the WorldBank. The sources of thiscomplementarity are essentiallyfourfold:n The Asian crisis has

demonstrated the need for an earlywarning system. While the problemsof one or two of the Asian countrieswere anticipated before July 1997, theextent of the meltdown andcontagion took internationalinstitutions by surprise. Thus ways toprovide forewarning of impendingproblems are needed, and could bemost effectively undertaken at theregional level, through the AMF, asthe participating countries wouldhave detailed knowledge of problemsin their area.n Once a problem has been

identified in a country, thegovernment of that country needs toaddress it speedily. Given the damagethat contagion can produce, regionalpeer pressure through the AMF couldbe an effective method of ensuringthat this is done.n Given its informational

advantage and regional location, anAMF would likely be morereceptive—hence geared to earlyaction—to a regional crisis than aglobal institution.

n The resources the IMF initiallymade available were insufficient tohead off the Asian crisis andadditional packages had to behastily assembled as the crisisunfolded. The AMF could providesuch a line of defense on apermanent basis.

The initial proposal for the AMFsuggested funding of $100 billion, halfof which was to come from Japan andthe remainder from PRC; Hong Kong,China; Singapore; and Taipei,China.The argument was that such a sumwould provide sufficient liquidity toforestall speculative attacks on theregion’s currencies. Unlike the IMF’sloans, the AMF’s assistance wouldnot come with economic conditionsattached.

Despite strong support fromMalaysia, the proposal did not get far.Only two months after it had firstbeen suggested, it was turned downat the fifth Asia-Pacific EconomicCooperation meeting in Manila.One objection was the fear thatfinancial support without anyconditions attached would raise therisk of moral hazard. Anotherrisk was lack of coordinationand of potential conflict withthe IMF.

Nevertheless, during the IMF/World Bank Annual Meeting in 1998,Japan returned with a more modestrevised proposal, the Miyazawa Plan.This proposed a $30 billion packagefor the region. Half of the money wasto facilitate short-term tradefinancing, the other half was topromote economic recovery through

medium and long-term projects.Japan suggested that the JapanExport-Import Bank, the WorldBank, and the ADB could allparticipate in the undertaking.In addition to the $30 billionassistance plan, at the October1998 Asia-Pacific EconomicCooperation meeting, Japanand the United States, with thesupport of the ADB and the WorldBank, launched the Asian Growthand Recovery Initiative thatenvisages a package of $10 billionfor the crisis-affected countries.

In the face of increasinginstability of global financialmarkets, the need for regionalinstitutions to dampen financialcontagion is being increasinglyacknowledged. Western Europehas a comprehensive regionalfinancial infrastructure in the formof the Economic and MonetaryUnion. However, no suchinstitutions exist in Asia, in theWestern Hemisphere, and in EasternEurope. Along with similarinstitutions for the WesternHemisphere and Eastern Europe,the AMF could play a potentiallyimportant role as a complement tothe IMF in providing funds to crisis-affected countries and developingan early warning system. Theimplementation of such regionalinstitutions as the AMF as part of thenewly emerging financialarchitecture will help both toenhance the efficiency of globalfinancial markets and to minimizetheir systemic risk.

Box 1.7 Is There a Case for an Asian Monetary Fund?

More controversial are proposals to forcibly bailin private investors once a crisis has struck. Oneproposal, advocated by the G22, is to encourage “lend-ing into arrears” by the IMF. Since the 1980s the IMFhas been able, in certain circumstances, to lend to acountry that was in arrears on its commercial bank


The most radical ideas for bailing in the privatesector focus on creating an international bankruptcycourt. Just as domestic bankruptcy courts can preventcreditor grab-races; decide on a hierarchy of claimants;and allow an insolvent, but viable, firm access to newfinancing, so some commentators suggest there shouldbe an international bankruptcy court to restructurecountries’ debts. This idea stands little chance of beingimplemented. First, it would demand a huge surren-der of national sovereignty. Second, national bankrupt-cy codes differ enormously, and reaching internationalagreement on a single code is highly unlikely.

Toward an Agenda of Minimum

Necessary Reforms

Massachusetts Institute of Technology economistRudiger Dornbusch has noted that in the aftermathof every crisis, whether a war or a currency collapse, asoul-searching effort to build a better world ensues.This is a great occasion for bad ideas or impracticalones (Dornbusch 1998). The Asian financial crisis isjust such an occasion: it has prompted scores ofproposals for a new international financialarchitecture.

Many of these ideas are interesting, yet imprac-tical. Many are innovative, but often inconsistent witheach other. The reason is that different reformerschoose different combinations of national sovereignty,financial market regulation and support, and capitalmobility. Given these incompatible goals, internationalpolicymakers are unlikely to agree on radical changesto today’s financial architecture. Nonetheless, effec-tive reforms can take place within the existing insti-tutional system. These include the following:n Negotiating minimum international standards of fi-

nancial practice. Despite considerable progress at cre-ating international norms, auditing and accountingpractices still vary considerably across countries. Thismakes it difficult for lenders to gauge the financialconditions of borrower banks and corporations. Dif-ferences in corporate governance practices, investorprotection laws, and laws relating to insider trading insecurities markets also make international capitalmarkets less transparent and more dangerous thanthey need be. While individual countries should imple-ment reforms in these areas as they deem appropri-

debt. Now this idea has been extended to countriesthat are in default to other private creditors, includ-ing bondholders. Provided that the country is willingto undertake strong policy adjustment and is makinggood-faith efforts to work with creditors to solve itsfinancial problems, the IMF can lend to the country.This effectively sanctions a default. The goal behindthis approach is to encourage recalcitrant creditors tonegotiate, and thereby to promote orderly andresponsible debt restructuring rather than chaoticdefault.

The G22 working group also recommended thatbond contracts be modified to facilitate restructuring.By including so-called collective action clauses, suchas the collective representation of creditors, designat-ing a trustee to speak for creditors, binding majoritydecisions, and formulas for sharing the costs of work-outs in all sovereign bond offerings, involving the pri-vate sector in the resolution of financial crises wouldbe easier. While an orderly workout is clearly superiorto a disorderly one, the risk involved in changing bondcontracts is that the market for such bonds will shrinkand the cost of funds will rise.

More radical proposals along similar lines includeimposing “haircuts” (mandatory losses) on investorsif they flee during a financial crisis. One proposal sug-gests a mandatory debt rollover option with a penaltyon all foreign currency lending (Buiter and Sibert1998). This option would entitle the borrower to ex-tend or roll over the debt at maturity for a specifiedperiod, say three or six months, at a penalty rate. Thepenalty would have to be big enough to ensure thatthe borrower would not want to exercise the rolloveroption under orderly market conditions. If crisis con-ditions still prevailed when the rollover period expired,the option could be exercised again at an even higherpenalty. This proposal would only be useful when oth-erwise solvent borrowers are unable to roll over theirforeign currency debt because of a liquidity crisis orcredit crunch. It only helps when a country is solvent,willing to pay, but prevented from doing so becauseinternational financial and credit markets are tempo-rarily closed to it. Given the difficulty of distinguish-ing between insolvency and illiquidity, it is not clearthat a market for such options would emerge. Thisproposal, too, might simply raise the cost of capitalfor borrowing countries.


ate, minimum international standards would help pre-vent national problems spilling over to the interna-tional level.n Introducing prudent regulation of capital accounts.

While developing countries should aim for integrationinto the international financial system, this should notimply a reckless rush to capital account convertibility.The gradual and cautious removal of capital controlsmay be appropriate for countries whose domesticcapital markets are underdeveloped and whosecapacity to regulate excessive risk taking by domes-tic institutions is limited. For many developingcountries, Chilean-style taxes on capital flows may behelpful.n Reforming exchange rate regimes. Large unexpected

swings in the exchange rate can bring serious finan-cial distress to domestic banks and corporations withunhedged debt exposure. This problem can be mini-mized in two ways. First, a floating exchange rate willinduce banks and corporations to hedge their foreigncurrency debt. Second, a currency board or currencyunion will permanently eliminate unexpected currencyfluctuations. International financial institutions, par-ticularly the IMF, can push the agenda of an appropri-ate exchange rate regime without any fundamentalinstitutional change.

n Creating the framework for an orderly restructuringof problem debts. Debt restructuring today is a difficult,protracted process. Modest changes—includingclauses for majority voting and the provision of atrustee to represent and coordinate creditors—couldeasily be introduced. If industrial countries includedsuch provisions in their bond contracts, they couldbecome standard practice, then developing countrieswould not incur a price penalty when they introducedthem.n Encouraging private sector credit lines. Given the

IMF’s limited resources and the conceptual difficul-ties surrounding the notion of an official internationallender of last resort, limited credit lines with the privatesector appear promising. Argentina’s contingencyfinance arrangements with private banks seem to haveserved it well. With multilateral guarantees thisapproach might prove useful for more countries.

These modest proposals do not constitute a newBretton Woods. They do not call for a massive newbureaucracy nor a huge investment of public funds.However, they could help to reduce the risk of finan-cial crises and reduce their severity should they occur.That alone would bolster, rather than hinder, the pro-cess of financial integration from which both indus-trial and developing countries have so much to gain.

1

Economic Developmentsand Prospects

The world economy moved down two divergent tracks in 1998. Many devel-oping economies contracted, as currency chaos buffeted markets on several

continents. Contrary to their experience in recent decades, the more openand dynamic developing economies fared badly, with many having to confrontpanicked investors and large capital outflows. In marked contrast, Europe andNorth America continued to grow strongly. In the United States, low inflationand seemingly limitless faith in the expansion of corporate earnings droveequity markets to record heights.

World output growth fell sharply to 2.2 percent in 1998, from a strong4.2 percent in 1997. The slowdown had several causes, including the crisis-induced contraction of many Asian developing economies, the Russiandevaluation and default, the fiscal problems and currency instability in Brazil,and the deepening recession in Japan. Spells of turmoil in Russia, Asia, andLatin America reverberated throughout world trade and financial networks asinternational flows of private capital slowed.

After many years of progress, globalization took a step backward in 1998.Total world trade, measured in value terms, fell from 1997 to 1998 after severalyears of near double-digit annual increases. International capital flows toemerging markets continued to drop precipitously as private lenders moved toreduce their exposure to the turbulence prevailing in many developingeconomies.

Yet despite these developments, few now doubt the inevitability of in-creasing integration in world trade and finance. Even after the upheavals of1997 and 1998, most governments still regard trends toward globalization asdesirable. However, the recent economic turbulence has brought with it ahealthy awareness of the risks involved in financial integration and the problemsinherent in relying heavily on short-term private capital to fund development.

2 ASIAN DEVELOPMENT OUTLOOK 1999

Industrial Countries

With the exception of Japan, growth in the industrial countries was strong in1998. The United Kingdom and the United States maintained growth rates of2.5 and 3.9 percent, respectively, despite some reduction in external demandbecause of recession in Asia and Latin America. Growth in the countriesjoining the euro common currency scheme (“Euroland”) varied from 1.5 percentin Italy to 3.8 percent in Spain, with an average for the group of 2.8 percent.Meanwhile, Japan’s troubles with weak domestic demand and banking sectorinsolvency worsened, contributing to an economic contraction of 2.8 percent.

The industrial economies generally fared well in the face of the Asianfinancial crisis. For a time that did not seem to be a likely outcome. Russia’sdefault in August prompted a wave of panic selling in both developing andindustrial country stock markets, as investors shunned assets they deemed tobe risky, but US Federal Reserve intervention in September and October calmedthe markets. On the trade side, estimates indicate that lower Asian demandfor industrial country exports reduced output in the United States and Europeby 0.5 percent. The impact on Japan has been somewhat greater.

Asian and Pacific Developing Economies

The slowdown in Asian growth that began with the export deceleration of1996 and worsened with the 1997 currency crisis turned into a widespreadregional contraction in 1998. Growth in the developing economies of Eastand Southeast Asia, excluding the People’s Republic of China (PRC), was thelowest since World War II, averaging –6.9 percent in the economies of South-east Asia and –1.4 percent in the newly industrialized economies (NIEs)(see table). Private capital flows to emerging Asia turned negative as foreigninvestors scrambled to move money out of supposedly risky markets.

The richer and traditionally more dynamic Asian economies generallyfared the worst during the year. Southeast Asia remained at the center of thecrisis, with Indonesia suffering a huge contraction and Malaysia and Thailandhit by substantial declines. Of the four newly industrialized economies, onlyTaipei,China weathered the storm with little damage. The Republic of Korea(henceforth referred to as Korea) suffered a major contraction, whileHong Kong, China and Singapore were unable to avoid the impact of theregional slowdown on their trade- and financial service-based economies.

Currency devaluations drove up inflation rates in several crisis-affectedAsian countries. Across Asia, the average rate of consumer price inflation rose

3ECONOMIC DEVELOPMENTS AND PROSPECTS

Selected Economic Indicators: Developing Asia,1996-2000(percent)

Indicator and subregion 1996 1997 1998 1999 2000

Gross domestic product growthDeveloping Asia 7.4 6.2 2.6 4.4 5.1

NIEs 6.3 6.0 -1.4 2.3 4.3

PRC and Mongolia 9.6 8.7 7.8 7.0 6.5

Central Asian republics 1.1 3.5 0.4 — —

Southeast Asia 7.1 4.0 -6.9 0.8 2.8

South Asia 7.2 4.7 5.7 5.5 5.8

The Pacific 3.1 -3.4 0.1 — —

Inflation rateDeveloping Asia 7.3 4.6 6.5 3.7 4.1

NIEs 4.3 3.5 3.8 1.1 2.3

PRC and Mongolia 8.4 2.8 -0.8 2.0 3.0

Central Asian republics 42.3 21.6 10.1 — —

Southeast Asia 6.6 5.6 21.0 8.3 6.4

South Asia 9.5 7.3 13.0 7.6 7.2

The Pacific 8.6 4.0 8.6 — —

Current account balance (relative to GDP)Developing Asia -1.3 0.5 3.6 2.5 1.4

NIEs 0.3 1.7 9.2 4.9 2.8

PRC and Mongolia 0.9 3.2 2.5 0.9 0.4

Central Asian republics -6.0 -4.2 -7.2 — —

Southeast Asia -5.5 -3.3 5.2 4.4 3.2

South Asia -2.3 -2.2 -2.0 -3.1 -2.5

The Pacific 4.4 -1.1 -1.6 — —

Debt-service ratioDeveloping Asia 14.2 16.0 19.2 17.7 13.5

NIEs — — — — —

PRC and Mongolia 6.7 9.8 — — —

Central Asian republics 15.7 22.2 — — —

Southeast Asia 15.6 17.6 17.0 15.9 11.1

South Asia 30.2 29.6 29.0 25.3 23.9

The Pacific 10.7 12.2 0.6 — —

— Not available.

Source: Asian Development Outlook 1999.


to 6.5 percent from 4.6 percent in 1997. Average inflation should moderate toabout 3.7 percent in 1999 as the shock of the late 1997 depreciations dies out.Current accounts improved throughout the region as capital flowed out. Fromapproximate balance in 1997, Asia’s aggregate current account moved to asurplus of 3.6 percent of GDP in 1998. Most of that improvement came fromimport reductions, while overall exports failed to increase as expected. Theregion’s aggregate current account should remain in surplus in 1999.

Weak and ill-regulated banking systems contributed heavily to Asia’sinitial vulnerability to capital flow reversals. Although many of the worst hitcountries—including Korea, Thailand, and to some extent Indonesia—haveinstituted significant financial sector reforms since the crisis began, the ratioof nonperforming loans to total lending continued to rise in 1998. The re-gional nonperforming loan ratio of 20 to 30 percent represented an equiva-lent share of output, as financial leverage in Asian economies remained atabout 100 percent of gross domestic production (GDP).

Newly Industrialized Economies. The crisis engulfed emerging Asia’s richesteconomies in 1998, spilling over to the financial centers of Hong Kong, Chinaand Singapore. Steep drops in regional trade, tourism, and financial activityslowed both economies and prompted Hong Kong, China’s monetary author-ity to intervene in the equity market. Korea took firm steps to pull its way outof the late 1997 financial chaos, causing the won to stabilize and then strengthen.Taipei,China reaped the benefits of a strong financial system, a large stockof foreign reserves, and flexible factor markets in resisting the regionalcontagion.

Aggregate growth for the NIEs was negative, and two of the four econo-mies suffered recessions in 1998. Only Taipei,China managed to achievesubstantial growth. At the same time, inflation in the NIEs rose in 1998,primarily because of price increases in Korea stemming from the won’s steepdepreciation.

World capital flows will continue to exert a major influence on the NIEsin 1999. Recovery of the Japanese economy and a stronger yen would helpstimulate recovery in this group of economies. The web of close trade andinvestment ties in the region also makes recovery in the NIEs partly dependenton Southeast Asia. Projections indicate that Korea will grow by 2 percent in1999; Hong Kong, China will experience a contraction of 0.5 percent in GDP;Singapore should recover some of its momentum and post 1 percent GDPgrowth; while growth in Taipei,China will remain stable at around 5 percent.Current account balances should remain in surplus in 1999.

5

People’s Republic of China and Mongolia. The PRC’s growth slowed in 1998,largely because of a drop in foreign export demand. Nevertheless, the PRCfared substantially better than most of its neighbors, with 7.8 percent GDP growth.Domestic investment demand remained strong, as the country’s exchange restric-tions allowed the economy to resist the high domestic interest rates forced onmany other Asian countries by world capital flows. Domestic consumptiongrew more slowly than in previous years. Government spending stayed undercontrol, with the consolidated budget deficit remaining close to balance.

Domestic savings remained at more than 40 percent of GDP, providingthe PRC with adequate investment capital to maintain positive growth. Thecountry made limited progress on its structural reform agenda in 1998, butsome financial reform took place in 1998, as evidenced by the introduction ofa new loan classification scheme for commercial banks. The Asian crisis gavethe PRC little incentive to reduce trade barriers or eliminate its still extensiveexchange restrictions. Export growth, which averaged 20 percent annually overthe last five years, registered a mere 0.5 percent increase in 1998. The slow-down reflected sharply lower demand from Japan and the rest of Asia. Al-though the drop in export demand reduced the PRC’s trade surplus from theprevious year, it still managed a surplus on the current account for the fifthconsecutive year. The PRC’s unwillingness to rely on short-term capital flowsand its strict regulations controlling capital movements helped save it fromthe large capital outflows experienced elsewhere in Asia.

The outlook for the PRC in 1999 is positive, with continued growth ofabout 7 percent. Inflation will remain under control and the current accountwill stay positive. The combination of large reserves and stringent restrictionson foreign capital movements means that the PRC is unlikely to face a finan-cial panic of the kind that struck so many of its neighbors. Over the next fewyears, however, to maintain high growth rates the PRC will need to acceleratethe pace of privatization and financial reform.

Mongolia’s GDP grew moderately in 1998, by 3.5 percent, despite lowerinternational prices for the country’s two main exports, copper and cashmere.Economic reform has proceeded well since 1991, but Mongolia still needs toprivatize several state-owned enterprises and strengthen its financial sector.Growth is expected to remain relatively strong in 1999.

Central Asian Republics. Aggregate growth in the four Central Asian mem-ber countries of the Asian Development Bank slowed in 1998 because of theRussian economic crisis and the depreciation of the ruble. To achieve sus-tained growth these nations will need to make further progress on structural

ECONOMIC DEVELOPMENTS AND PROSPECTS


reform and macroeconomic stabilization. They will also need some relief fromexternal shocks, as economic ties left over from the former Soviet Union makethis group of countries highly dependent on events in Russia.

Southeast Asian Economies. Southeast Asia’s economies remained at the vortexof the Asian financial crisis in 1998. Civil unrest and an unexpected change ofgovernment in Indonesia heightened the sense of instability as the subregion’slargest country struggled to regain its economic footing. The first to be struckby speculative attack in 1997, Thailand moved decisively to reverse capitaloutflows in 1998 through financial and other structural reforms. Malaysiachose a different path, introducing capital controls and expanding thegovernment’s economic role in an attempt to shield the domestic economyfrom the volatility of international capital flows. Having participated less inthe economic boom than its neighbors, the Philippines was proportionatelyless affected, while the countries of Indo-China were even less affected, butdid suffer export demand shocks.

After 4 percent growth in 1997, the region contracted by about 7 per-cent, underperforming even the most pessimistic expectations for the year.More than $30 billion fled Indonesia, Malaysia, Philippines, and Thailand in1997 and 1998. Indonesia continued to bear the brunt of the crisis as exportsand investment collapsed, reducing output by 13.7 percent. Thailand imple-mented a series of financial reforms, but still suffered an 8 percent contrac-tion. Malaysia at first appeared to avoid the worst effects of the crisis, butcapital outflows late in the year brought growth down to –6.2 percent. In thePhilippines tight monetary policy to defend the peso constrained investmentdemand, while poor agricultural performance caused by bad weather limitedgrowth from the supply side. However, the Philippines’ relatively low level offinancial leverage and continued strong export demand helped save it fromsome of the worst effects of the crisis. Growth in the Lao People’s DemocraticRepublic and Viet Nam slowed from the previous year, as the former was hurtby the baht’s depreciation and the dropoff in Thai investment, and the lattersuffered from a fall in foreign direct investment from the NIEs. Cambodiangrowth was flat in 1998 from 2 percent in the previous year.

Inflation in 1998 increased fourfold from the previous year, driven bycurrency devaluations and, in some cases, food price increases arising fromthe impact of the El Niño drought. Indonesia—stricken by shortages of basicproducts and import price increases—contributed most to the regional priceincrease. Fiscal constraints limited governments’ ability to cushion the effectsof depreciation, resulting in higher food, gas, and electricity prices.

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The situation of the corporate and banking sectors continued to deterio-rate, particularly in Indonesia and Malaysia. The proportion of nonperformingloans rose and more financial institutions found themselves insolvent. At theend of 1998, of Indonesia, Malaysia, Philippines, and Thailand, Indonesiahad the highest level of nonperfoming loans at 35 percent or more of loansoutstanding, followed by Thailand at upwards of 30 percent, Malaysia at 25percent, and the Philippines at 10 percent or more.

The economic slowdown caused a significant import contraction, whichbolstered current accounts throughout Southeast Asia. For the first time in adecade the aggregate current account for the region registered a surplus. Whileexport revenues weakened as some creditors refused to roll over trade loans,export volumes started to pick up in the second quarter of 1998, possiblypointing the way to an export recovery.

Of the four crisis-affected economies, Malaysia and the Philippines arethe most likely to grow in 1999, albeit at a modest rate. Indonesia will con-tinue to perform the worst among the group. On the assumption that curren-cies will stabilize and aggregate demand will remain weak, inflation rates shoulddrop. With the exception of Cambodia, Indonesia, and the Lao People’s Demo-cratic Republic, Southeast Asian countries will experience single-digit infla-tion. Reduced domestic demand will bring continued improvements to tradeand current account balances in 1999.

South Asia. Together with the PRC, South Asia managed to evade the mainimpact of the Asian financial crisis. India’s growth was slightly higher than in1997, while growth picked up in Pakistan in 1998. As a result of the impact ofmassive flooding on agricultural and manufacturing output, Bangladesh’s 5.7percent growth was slightly lower than expected for the year. Sri Lanka man-aged a fairly robust 5.3 percent growth rate, down slightly from 1997.

Restrictions on trade finance lines imposed as part of the nuclear testsanctions reduced the amount of capital available to fund current accountdeficits in the region. Exports contracted, but imports grew little as the fall inworld oil prices reduced India’s import bill for oil by 25 percent. India’s cur-rent account deficit expanded slightly to 1.8 percent of GDP. With new reluc-tance from foreign lenders to provide financing, Pakistan had little choice butto reduce its current account deficit by more than half, to about 3 percent ofGDP. Bangladesh—relatively unaffected by either the Asian crisis or the im-pact of nuclear test sanctions—continued to run a current account deficit ofabout 1 percent of GDP. Sri Lanka’s current account deficit was 3.1 percent ofGDP in 1998.

ECONOMIC DEVELOPMENTS AND PROSPECTS


Pakistan’s budget deficit expanded with the loss of aid flows that hadmade up as much as 6 percent of government expenditures in previous years.The higher deficit weakened market confidence in the country. India also hada large budget deficit, yet its more positive external position and conservativemonetary policy helped it increase its reserves to the relatively comfortablelevel of $22 billion, or about 15 percent of GDP. Despite an extensive networkof licensing rules and regulations, India made some progress in structuralreform, which gave the economy a supply-side boost.

Severe flooding struck most of Bangladesh in 1998, damaging riceproduction and reducing livestock herds. The flooding took out much of thecountry’s infrastructure, destroying more than 6,500 bridges and washing out11,000 miles of roads. Food production in this largely agricultural country fellby about 10 percent as a result. Although the flooding had a strong adverseimpact on fiscal accounts, emergency loans from aid donors bridged much ofthe gap.

Aggregate growth in South Asia in 1999 is forecast at 5.5 percent, aboutthe same as in 1998. In the short run, weather fluctuations of the kind thatthe La Niña phenomenon might cause will have a large impact on actualgrowth results in South Asia. Over the longer run, growth will depend on acceler-ated progress in privatization, deregulation, and trade liberalization. Inflationwill fall and current account deficits will be fairly low at 3.1 percent of GDP.

The Pacific. Most Pacific countries were mired in slow growth even before theAsian financial crisis, and on average, the crisis itself had little effect on them.However, Papua New Guinea, the largest economy in the group, was an excep-tion on both counts: it managed to achieve relatively strong growth despitefalling commodity demand from Asia. Elsewhere in the Pacific, the shockwaves from Asia hit the Solomon Islands the hardest, while Fiji, Nauru, andVanuatu felt some adverse effects. The remaining countries had limited directexposure to Asia, and so received little fallout from the crisis.

Risks and Uncertainties

The financial and exchange rate crisis remains the main source of uncertaintyin Asia. While some currency and equity markets staged partial recoveries in1998 and current accounts moved into surplus, conditions continued to dete-riorate in most economic sectors. For example, bad loan rates kept rising in1998 as corporate failures exacerbated banking sector problems, even as manyAsian countries initiated significant financial sector reforms.

9ECONOMIC DEVELOPMENTS AND PROSPECTS

The speed and volatility of the Asian crisis makes it difficult to forecasthow soon fresh portfolio capital and banking credit will begin to flow todeveloping economies again. The danger of predicting a rapid recovery be-came clear in August, when Russia’s devaluation and default prompted a newround of capital flight and falls in stock markets around the world. Interna-tional bond markets again demanded huge spreads for emerging market debtover “safe” issues, and bank credits contracted. As in 1997, shocks from finan-cial markets quickly spread to economies at large as governments tightenedtheir fiscal and monetary policies to constrict the capital outflows. As long asinternational capital markets remain shaky, developing countries in Asia andthe world will be vulnerable to investor panic.

Brazil and Russia are two developing economies outside Asia with dem-onstrated potential to disrupt Asian markets. While the initial impact on Asiaof Brazil’s large devaluation in January 1999 was less severe than many hadfeared, continuing financial turmoil in Brazil and the rest of Latin Americacould increase volatility in Asian currency markets. Worse, if Brazil were todefault on its sovereign debt, risk premiums on emerging market debt wouldrise again and capital flows to many developing countries would evaporate.

Developments in the industrial countries are also likely to affect Asia’sprospects for recovery. A large enough stock price drop in the United Stateswould damage consumer confidence and reduce US import demand. Withthe United States being the first or second largest market for many export-dependent Asian countries, a US recession could spark another round ofcontagion in the region. A recession in Europe could have the same impact,though perhaps a smaller one. Asia’s crisis-driven trade surplus could alsoprovoke a protectionist response in the United States or Europe, with poten-tially severe consequences for Asian exporters.

In Asia, if Japan could pull itself out of its current recession, highergrowth would raise import demand, which would provide a large trade boostto the region. Given the large volume of Japanese lending to the region beforethe crisis, substantial progress in resolving Japan’s banking difficulties underthe current financial sector rescue package would increase the flow of privatecapital to Asian banks and firms. The Miyazawa initiative to create a $30billion Asian recovery fund may increase official capital flows to make up forlost private capital.

The economic crisis has spawned political uncertainties. Salient amongthese is the possibility of social unrest leading to regime changes, as happenedin Indonesia. However, even when a government’s survival is not at stake,political forces arising from the crisis may determine policy. For example, to


cushion the social costs of recession, inflation, and unemployment, govern-ments have been tempted to resort to higher subsidies, increased regulation,and other direct government interventions. Such responses are inevitable, andin some cases are desirable. However, governments need to be careful thatemergency measures do not slow the adoption of needed structural reformsor, in an extreme case, lead to fiscal insolvency.

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The Financial Crisisin Asia

The financial turmoil that began in Thailand in July 1997 spread with aferocity that none foresaw. Asia’s once vibrant economies, used to de-

cades of rapid growth, were plunged into deep recession. This economic col-lapse has forced an unprecedented reappraisal of policies in many Asian econo-mies from corporate governance to exchange rate management. In addition,the crisis managers, particularly the International Monetary Fund (IMF), havecome under criticism. Intense debate continues about whether IMF policieshelped or hindered economic recovery. Finally, Asia’s crisis has spawned wide-ranging discussion about the basic design of today’s international financialsystem. Suggestions for reform and blueprints for improving the “interna-tional financial architecture” abound.

The Evolution of the Crisis in 1998

Asian financial markets began 1998 on a pessimistic note. With confidenceeroded by Korea’s near default in December 1997, the region’s financial mar-kets reached record lows in January 1998. However, by early February marketshad bounced back, largely on the hope that foreign confidence in the regionwas returning. But this optimism did not last long, partly because of turmoilin Indonesia, and partly because of increasingly poor economic performancein Japan. Indonesia’s economic crisis began to worsen sharply in February.Eventually, the combination of soaring prices, civil protests, sharply risingunemployment rates, and widespread corporate defaults precipitated a majorpolitical crisis. On 21 May President Suharto resigned; however, this did littleto rally the markets.

Japan’s woes compounded the region’s troubles. In early February 1998,the Japanese government declared the economy “stagnant” in a monthly report


that offered the bleakest assessment of the country’s business climate in morethan 20 years. Responding to the turmoil in Asian markets in mid-February,the government unveiled a long-awaited package of stimulus measures designedto support the stock market and boost the economy. It proved insufficient.The economy continued to contract, despite an increase in the fiscal stimuluspackage in April. The tumbling yen triggered declines in other Asian curren-cies in June, including the Malaysian ringgit, the Thai baht, the Korean won,and the New Taiwan dollar.

Worried by the regional impact of a plummeting yen, Japan and theUnited States turned to official intervention. On 17 June, in coordinationwith the Bank of Japan, the United States spent an estimated $2 billion tobolster the value of the yen. Asian markets rallied, but unfortunately, the rallydid not last. By mid-August the yen had fallen to a new low. Another majorshock hit financial markets on 17 August: the Russian central bank devaluedthe ruble and the government effectively defaulted on its internal debt. Thisaction had a dramatic and deleterious impact on all financial markets. Inves-tors fled all types of risk, from emerging market bonds to noninvestment-grade corporate bonds in developed markets.

As capital fled policymakers were forced to resort to unorthodox re-sponses. The Hong Kong, China authorities intervened directly in the stockmarket to counter what they saw as market manipulation. On 1 SeptemberMalaysia’s government made the decision to impose exchange controls tocounter speculative attacks on the ringgit. The near collapse of the Connecti-cut-based hedge fund, Long Term Capital Management, and its rescue orga-nized by the Federal Reserve Bank of New York, showed that by the end ofSeptember 1998 the crisis had moved well beyond Asia.

The US Federal Reserve cut interest rates three times between Septem-ber and December 1998, and European central banks cut their benchmarkrates. Markets were also reassured by the decision to enhance the IMF’s capi-tal base or “quotas” in October, which had been held up by political opposi-tion in the US Congress. Since October 1998, conditions in Asia have im-proved substantially. Japan has made progress on the much needed reform ofits banking sector and is implementing the fiscal stimulus package. Buoyed byprogress in Japan, by interest rate cuts in the industrial countries, and espe-cially by the gradual implementation of their own reform programs, otherAsian markets began to recover.

By the beginning of 1999 one could say that Asia’s economies seemed tohave stabilized. In Korea and Thailand especially, the bitter economic medi-cine was beginning to work. While emerging markets remained fragile—

13

as evidenced by the collapse of Brazil’s currency, the real, in late January 1999—the worst in Asia seemed to be over.

Interpreting the Crisis

Two general interpretations dominate the debate on the cause of the crisis.One blames poor economic fundamentals and policy inconsistencies. Theother argues that Asia fell victim to a financial panic, where negative senti-ment became self-fulfilling.

According to the “fundamentalist” view, the Asian crisis was caused byserious structural problems along with policy inconsistencies. Many Asiangovernments provided implicit guarantees to the banking system, which oftenengaged in lending practices that favored financially unqualified borrowers.This meant that the governments’ implicit guarantees created a sizable “con-tingent fiscal liability.”

By contrast, the panic interpretation views the self-fulfilling pessimismof international lenders as the root cause of the crisis. The most sophisticatedversion of this argument interprets Asia’s crisis as a classic bank run. In a bankrun, if enough investors are suddenly seized with panic and demand immedi-ate payment, then financial intermediaries are forced to destructively liqui-date long-term assets at a great loss. The problem in an international contextis that there is no lender of last resort who can step in to provide the necessaryliquidity that will end the panic. In Indonesia, Korea, and Thailand short-term external debt exceeded international reserves immediately prior to thecrisis. Economic fundamentals, such as inflation, unemployment, and thebudget deficit, are unimportant in this interpretation, although fears abouteconomic weaknesses might cause the initial investor shift from optimism topessimism.

Which Explanation Fits Asia the Best?

At first sight, the past stellar economic record of the Asian economies doesnot support the fundamentalist interpretation. However, closer inspectionshows that these countries’ economic success was built on a particular kind ofeconomic strategy that emphasized export orientation, centralized coordina-tion of production activities, and implicit (or even explicit) government guar-antees of private investment projects, as well as intimate relationships betweenbanks and firms. During the 1990s several factors combined to worsen thefundamental outlook for the region. The rapid appreciation of the US dollar

THE FINANCIAL CRISIS IN ASIA


since 1995, to which most of the region’s currencies were pegged; the increas-ing competition from the PRC in export markets; and the prolonged slow-down of the Japanese economy were all reflected in slower export growth,rising current account deficits, depressed stock markets, and widespread cor-porate difficulties long before the outbreak of the crisis.

The financial sector was also exhibiting significant problems. Weak pru-dential regulation, lax and inexperienced supervision, low capital adequacyratios, lack of incentive-compatible deposit insurance schemes, distorted in-centives for project selection, and sometimes outright corruption all renderedthe region’s financial systems weaker than they appeared. This did not presenta major problem until the 1990s, when closed capital markets were graduallyopened.

The 1990s also saw a dramatic increase in foreign borrowing. Asiancompanies maintained a strong bias in favor of foreign short-term debt financ-ing. Although specific characteristics varied, a pattern of increasing vulner-ability to external shocks emerged in all the region’s economies prior to thecrisis.

In the first half of 1997, despite the worsening financial environment,capital inflows did not slow down, but increasingly took the form of short-term, interbank loans that could be readily withdrawn and could count onformal guarantees in the interbank markets. However, once the crisis began,international banks suddenly stopped lending and began to call in their loans.A huge amount of private foreign capital fled the region in the second half of1997.

The suddenness and speed with which capital fled the region in thesecond half of 1997 give credence to the panic interpretation of the crisis.However, it was the region’s structural weaknesses that initially created thevulnerability to shocks.

Policy Responses to the Crisis: An Overview of the Debate

The IMF, the institution charged with safeguarding the stability of the inter-national financial system, assumed the principal responsibility for dealing withthe Asian crisis at the international level. The IMF’s goal was to quickly re-store confidence in the three hardest hit Asian economies—Korea, Indonesia,and Thailand—through a combination of tough economic conditionalities andsubstantial financial support.

The IMF’s economic strategy had two key components. The first, inkeeping with its usual practice, concentrated on macroeconomic policy, the

15

main component of which was to be tighter monetary policy. The second,complementary, component of the strategy was substantial structural reform.The IMF demanded deep reform of the region’s banking systems, breakup ofmonopolies, removal of barriers to trade, and substantial improvements incorporate transparency. This marked a significant departure from usual IMFpractice, when conditions are more closely confined to macroeconomic poli-cies alone. The IMF saw the structural reforms as essential for a long-termsolution to Asia’s financial crisis.

Did Tight Monetary Policy Exacerbate the Crisis? Critics of the IMF arguethat the tight monetary policy approach was misconceived and counterpro-ductive. They point out that high interest rates forced highly leveraged corpo-rations into bankruptcy. Widespread bankruptcies in the corporate sector ledto bank insolvencies as the banks’ corporate customers failed to repay theirloans. Lower interest rates would have made it easier for firms to maintainproduction, thereby restoring investors’ confidence that the economy wouldrecover quickly, and would thus have caused currencies to appreciate. Thatwould have created a virtuous circle. Many of the critics point out that Japanfollowed just such a policy when dealing with its domestic crisis.

The IMF, however, feared that a lower interest rate policy would cause avicious downward spiral. As currencies plummeted, so the real burden of debtdenominated in foreign currency would rise. Because the Asian firms hadhigh leverage ratios, a much higher foreign debt burden could have forcedinsolvencies and caused even larger collapses in production. If lower interestrates did not work, countries’ only alternative would have been to suspendservice on their external debt and impose exchange control measures. However,with the exception of Malaysia, governments did not pursue this option.

Available empirical evidence does not necessarily support the view thatinterest rates were persistently high. Indeed, several of the crisis-affected coun-tries pursued low interest rate policies well into the crisis without any success.The IMF estimates that in Korea and Thailand, the effects of the monetarytightening may account for less than a quarter of the expected decline ineconomic growth rates between 1997 and 1998.

Did the IMF Force Unnecessary Fiscal Adjustment? Unlike many other cri-ses that have required IMF intervention, the Asian crisis was not caused byprofligate government spending. Thus fiscal imbalances were not a major con-cern in the initial IMF programs. Nonetheless, the IMF’s approach in thecrisis-affected countries was to demand a tightening of fiscal policy based on



two arguments. First, it argued that in the presence of rapid capital flight,these countries needed to reduce domestic demand to narrow their currentaccount deficits. Tightening fiscal policy was an effective way to do this. Second,and more subtle, was the argument that government spending needed to becut to make room for the expected expenditure necessary to bail out insolventbanks.

Critics, however, claim that the fiscal tightening simply exacerbated theenormous economic contraction that was already taking place in the region.In the face of collapsing output, they argue, fiscal expansion, that is, a smallbudget deficit, would have been more appropriate. However, this is an easycriticism to make with hindsight.

Did the Closure of Insolvent Bank Precipitate Runs on Solvent Banks?Given the parlous state of the financial sector in the crisis-affected countries,there is little doubt that many banks in Indonesia, Korea, and Thailand neededto be restructured, merged, or simply closed. The IMF believed that speedyand concerted action in this direction would, by weeding out the bad financialapples, help restore investors’ confidence. In all three countries, therefore, theoperations of a number of clearly insolvent financial institutions were sus-pended or closed early on.

The IMF’s critics charge that this abrupt closure of insolvent banks pan-icked the public and precipitated a run on sound banks. Concerned that theirbanks might be closed next, depositors withdrew their money from healthybanks in a classic banking panic. Thus, the critics argue, the IMF’s policymade matters much worse.

Clearly in Indonesia the decision to close banks did precipitate a publicpanic. However, the IMF’s supporters argue that the lack of clear governmentpolicy caused the panic, not the bank closures themselves. The Indonesiangovernment promised only a small deposit guarantee, did not publicize itwidely, and did not explain publicly how depositors in banks that had not yetbeen closed would be treated. Similarly, the IMF’s defenders point out, theclosure of banks in Korea and Thailand did not result in such severe runs.That is true, but it is also true that the financial institutions that were closedin these two countries were mainly merchant banks that did not take personaldeposits.

Was the IMF too Intrusive? Some critics question the IMF’s insistence on far-reaching structural reforms in Asia’s economies. They have suggested that theIMF went well beyond its usual role of ensuring prudent macroeconomic

17

policies. Instead it was intervening excessively in the domestic affairs of sover-eign governments by demanding large-scale restructuring in the corporate andfinancial sector, as well as improvements in governance, labor markets, andcompetition policy.

This criticism does not sit well with the facts of the Asian crisis, the IMFproponents argue. If reckless monetary and fiscal expansion was not at theroot of the problem of the Asian financial crisis, devising a response focusingon these areas made no sense. Continued financial and corporate weaknesswould have undermined macroeconomic policy, investors would have contin-ued to flee, and the IMF’s ultimate goal—a quick return to economic growth—would have been impossible.

Did IMF Bailouts Increase Global Moral Hazard? While much of the criti-cism directed at the IMF has focused on its strategy in Asia, some criticize thevery existence of IMF support. This argument is based on the concept ofmoral hazard. Moral hazard implies that investors and borrowers behave im-prudently because they believe they will be bailed out if their investments gosour. IMF loans, argue some critics, exacerbate moral hazard in two ways: theyabsolve governments from the consequences of profligate policies, therebyencouraging them to continue the profligacy in the future, and they rewardreckless investors. Because the IMF’s loans to the crisis-affected Asian coun-tries were unusually large, the critics argue that they set a dangerous precedentthat will increase moral hazard worldwide.

However this argument is not convincing for three reasons. First, mostinvestors in Asia, whether foreign or domestic, suffered substantial losses.Second, it is hard to believe that governments relish the tough conditions theIMF imposes on them. Third, the costs of not intervening in Asia’s crisiswould have been extraordinarily high. Investors would have fled even morequickly, countries would have been forced to default on their debts, and theregion (and perhaps the world) could have been plunged into an even moreserious crisis.

Strengthening the International

Financial Architecture

The severity of Asia’s financial crisis, the speed with which it spread, and theshortcomings of the international response have all contributed to a wide-ranging debate on the basic rules and institutions that govern global finance.How can this global financial architecture be improved so that crises can be



avoided or can be better managed when they do occur? Many proposals havebeen put forward. The major ones are discussed below.

Controlling Capital Flows. Some commentators question the very goal offree capital flows, arguing that free trade alone should be the main objectiveof development and growth policies. They often put forward two argumentsto support this view. First, countries can reap the benefits of free trade ingoods and services without simultaneously opening up their financial mar-kets to foreign competition. According to this view, capital mobility is anoptional extra. Second, several commentators argue that the theoretical ben-efits of free capital flows, such as increased investment and more efficient useof funds, do not occur in reality, because the efficiency gains that a countryreaps from opening up to foreign capital are more than offset by increasinguncertainty and greater risk of financial crises.

History shows that countries that try to pursue free trade while main-taining capital controls suffer a number of problems as people try to evade thecapital controls. As economies develop and become more open, capital controlsnot only foster corruption, but also restrict the growth of trade. While increas-ing global integration does increase uncertainty, this also occurs as trade isliberalized. Terms of trade shocks—sudden rises or falls in a key export orimport price—are potentially as unsettling as the contagious spread of finan-cial crises.

However, this does not imply that all capital account liberalization isbeneficial. The record of financial crises, especially in Asia, shows that ill-planned liberalization of capital flows—without appropriate market reforms—can result in financial instability and large economic costs. This suggests thatfinancial liberalization must be carefully sequenced. A number of proposalsare designed to assist that process. Some concentrate on improving marketregulation, bank supervision, and transparency standards. Others concentrateon minimizing the risks associated with capital flows, focusing on measures todiscourage short-term borrowing in foreign currency, which is widely regardedas the most dangerous form of foreign capital.

Improving Regulatory Standards. One of the main causes of the Asian finan-cial crisis was poor regulation and supervision of financial institutions. Henceit is not surprising that much of the effort to improve the international finan-cial architecture has concentrated on finding ways to improve internationalstandards of financial regulation and supervision.

19

The Basle Capital Accords are widely regarded as a model for interna-tional supervisory standards. One way to encourage countries to adopt suchstandards is through IMF surveillance. Another approach is to improve coor-dination between regulatory bodies, or even to introduce a system of peerreview, whereby national regulators could supervise each other. Improved re-gional surveillance would be another option. An alternative set of reform pro-posals focuses on improving existing regulatory standards. Some suggestionsconcentrate on tightening the rules on foreign borrowing in developing coun-tries. Others focus on changing the incentives lending banks face, in particu-lar, by updating the Basle accords.

More radical regulatory reform ideas include the creation of global regu-latory institutions. Proposals include a world financial authority that wouldbe the equivalent of the World Trade Organization for financial institutionsand a board of overseers of international financial markets. In each case, giventhat the goal is to create a global supervisor and regulator consistent withglobal capital markets, countries would have to surrender substantial amountsof national sovereignty. That requirement renders these ideas unrealistic, atleast for the moment.

Rethinking Exchange Rate Regimes. The Asian crisis has shown that pegged,but adjustable, exchange rates are difficult to sustain in a world of increasingcapital mobility. Sooner or later they are likely to be tested by a speculativeattack, forcing—at the very least—high interest rates and budget cuts. The Asiancrisis has also buttressed another traditional argument against fixed, butadjustable, exchange rates: by creating an illusion of permanent currencystability, they reinforce the incentive for financial institutions and firms toborrow from abroad without hedging. Today’s conventional wisdom suggeststhat countries must either rigidly tie their currency to another by adopting acurrency board or entering into a currency union, or they must allow theircurrency to float.

Some economists have recently advocated the need for strong coordina-tion of exchange rates among Asian currencies. According to this view, recov-ery from this crisis could be strongly facilitated if the crisis-affected countriescould re-adopt a dollar exchange rate target, as they did before mid-1997. Whileexchange rate policy does have international spillover effects, it does not meanthat explicit coordination is required to achieve stability. In addition, the rootcause of the current crisis was largely domestic and structural. Therefore anyattempt at international exchange rate coordination without first addressing



those structural problems will be based on shaky foundations and is likely tobe counterproductive. Moreover, the crisis-affected countries differ significantlyin terms of their history of exchange rate regimes.

Creating an International Lender of Last Resort. The argument in favor ofan international lender of last resort is based on an analogy with the rolecentral banks play in national economies. When a banking panic hits a domesticfinancial system, the central bank can limit contagion by providing liquidityto the system. In a world of integrated capital markets, many argue that asimilar institution is needed at the international level. By providing limitedliquidity in return for policy conditionality, the IMF already plays a similar, ifhighly circumscribed, role. Most advocates of an international lender of lastresort suggest that the IMF should play this role. However, the proposal tocreate this type of lender is plagued with conceptual and practical difficulties.

The lender of last resort must be able to distinguish between healthyand insolvent institutions, intervening only to stop unwarranted panics andleaving insolvent institutions to fail. Extending these conditions from banksto countries and from national authorities to international institutions is ex-tremely difficult. The first problem is that of distinguishing between illiquid-ity and insolvency. The second problem is that of moral hazard. Nationalcentral banks put in place prudential regulations on domestic financial insti-tutions to limit reckless behavior. They also retain the power to close or mergeinsolvent or weak financial institutions. Neither capacity exists at the interna-tional level. As yet, no binding global rules of financial behavior exist, and theIMF certainly cannot close down a recalcitrant country. The final issue is thatof resources. If necessary, a domestic central bank can provide limitless liquid-ity simply by printing money (unless it is constrained by a fixed exchange rateregime). The IMF has no capacity to issue fiat money and its resources arelimited.

Japan has recently proposed the creation of regional currency supportmechanisms to complement the role and function of the IMF. This idea ofregional currency support mechanisms, which found an earlier articulation inthe proposal for establishing an Asian Monetary Fund, is in the initial stage ofdiscussion and development.

“Bailing In” the Private Sector. Another popular goal among the architectsof international financial reform is bailing in the private sector. The idea is tominimize moral hazard and spread the burden of financial crisis by ensuringthat private investors and banks bear some of the cost.

21

One approach that Argentina and Mexico have successfully pioneered isto set up private sector credit lines before a crisis. These are, in effect, a lim-ited form of private lender of last resort. Such arrangements have consider-able potential, particularly if multilateral development banks guarantee someportion of the risk involved, and thereby encourage more private banks toparticipate in such schemes.

More controversial are proposals to forcibly bail in private investors oncea crisis has struck. One proposal, advocated by the G22, is to encourage “lend-ing into arrears” by the IMF. Since the 1980s the IMF has been able, in certaincircumstances, to lend to a country that was in arrears on its commercial bankdebt. Now this idea has been extended to countries that are in default to otherprivate creditors, including bondholders. The goal behind this approach is toencourage recalcitrant creditors to negotiate, and thereby to promote orderlyand responsible debt restructuring, rather than chaotic default.

More radical proposals along similar lines include imposing “haircuts”(mandatory losses) on investors if they flee during a financial crisis. However,this proposal might simply raise the cost of capital for borrowing countries.

The most radical ideas for bailing in the private sector focus on creatingan international bankruptcy court. Just as domestic bankruptcy courts canprevent creditor grab-races; decide on a hierarchy of claimants; and allow aninsolvent, but viable, firm access to new financing, so some commentatorssuggest there should be an international bankruptcy court to restructure coun-tries’ debts. This idea stands little chance of being implemented, however.First, it would demand a huge surrender of national sovereignty. Second, na-tional bankruptcy codes differ enormously, and reaching international agree-ment on a single code is highly unlikely.

A Minimum Necessary Set of Reforms for the Architecture

In the aftermath of every crisis, whether a war or a currency collapse, a soul-searching effort to build a better world ensues. The Asian financial crisis is noexception. It has prompted scores of proposals for a new international finan-cial architecture. However, effective reforms can take place within the existinginstitutional system. These include the following:n Negotiating minimum international standards of financial practice. Despite

considerable progress at creating international norms, auditing and account-ing practices still vary considerably across countries. This makes gauging thefinancial condition of borrower banks and corporations difficult for lenders.While individual countries should implement reforms in these areas as they



deem appropriate, minimum international standards would help prevent na-tional problems spilling over to the international level.n Introducing prudent regulation of capital accounts. While developing coun-

tries should aim for integration into the international financial system, thisshould not imply a reckless rush to capital account convertibility. The gradualand cautious removal of capital controls may be appropriate for countrieswhose domestic capital markets are underdeveloped and whose capacity toregulate excessive risk taking by domestic institutions is limited. For manydeveloping countries, Chilean-style taxes on capital flows may be helpful.n Reforming exchange rate regimes. Large unexpected swings in the exchange

rate can bring serious financial distress to domestic banks and corporationswith unhedged debt exposure. This problem can be minimized in two ways.First, a floating exchange rate will induce banks and corporations to hedgetheir foreign currency debt. Second, a currency board or currency union willpermanently eliminate unexpected currency fluctuations. International finan-cial institutions, particularly the IMF, can push the agenda of an appropriateexchange rate regime without any fundamental institutional change.n Creating the framework for an orderly restructuring of problem debts. Debt re-

structuring is a difficult, protracted process. Modest changes—including clausesfor majority voting and the provision of a trustee to represent and coordinatecreditors—could easily be introduced. If industrial countries included suchprovisions in their bond contracts, they could become standard practice, thendeveloping countries would not incur a price penalty when they introducedthem.n Encouraging private sector credit lines. Given the IMF’s limited resources

and the conceptual difficulties surrounding the concept of an official interna-tional lender of last resort, limited credit lines with the private sector appearpromising. Argentina’s contingency finance arrangements with private banksseem to have served it well. With multilateral guarantees this approach mightprove useful for more countries.

These modest proposals do not constitute a new Bretton Woods. Theydo not call for a massive new bureaucracy nor a huge investment of publicfunds. However, they could help to reduce the risk of financial crises andreduce their severity should they occur. That alone would bolster, rather thanhinder, the process of financial integration from which both industrial anddeveloping countries have so much to gain.

23

Economic Openness:Growth and Recovery in Asia

Openness matters. By offering countries opportunities to trade with theoutside world, openness stimulates growth through easier access to new

technologies and skills and to international capital markets. Furthermore, itpromotes market discipline. Among developing regions, Asia has taken thelead in adopting outward-oriented development policies. However, the recentfinancial crisis in Asia has raised a number of serious questions about the roleof openness in promoting sustainable growth. While the case for opennesswith regard to trade, labor movement, and direct investment remains strong,developing Asia faces the challenge of ensuring that the global trading systemcontinues to evolve fairly and takes into account the interests of developingcountries. To meet this challenge, developing Asia will have to play a moreproactive role in future multilateral trade negotiations.

As regards openness to financial flows, the case seems compelling, yet atthe same time, it is complex and depends on the strength of domestic finan-cial systems. However, rather than providing a reason to postpone financialintegration, this means that reform of financial systems is imperative.

How open are the Asian developing economies (ADEs)? Individual ADEshave adopted different degrees of openness, and different country groups arecharacterized by varying degrees of openness in trade, investment, and otherfactor flows. The Asian Development Bank publication Emerging Asia calcu-lates trade openness indexes based on four important aspects of trade policy.A fully closed economy scores zero and a fully open economy scores one. Onthis set of indexes East Asia scores 0.97, Southeast Asia scores 0.73, and SouthAsia scores 0.06. The growth of the East and Southeast Asian countries hasbeen particularly strong until recently, reflecting their openness to trade.


Policies toward Foreign Trade

The average growth of trade in goods in the PRC, the NIEs, and SoutheastAsia outpaced that in South Asian countries, and even in the world as a whole. TheNIEs and the Southeast Asian countries maintained much lower average ratesof protection than South Asia and other non-Asian developing economies in the1980s, and so their spectacular economic performance is hardly surprising.

However, in the 1990s many developing countries—including the PRCand most South Asian countries—have attempted to emulate the trade andgrowth performance of the NIEs and Southeast Asian economies by graduallyadopting economic policy reforms, of which the most important is tradeliberalization. Thus the leadership of the East Asian economies in maintain-ing more open trading regimes than other developing countries has been erodedin recent years, particularly when judged against non-Asian developingeconomies.

Trade in services has been increasing in the ADEs, reflecting a globaltrend. Transport, travel, and insurance have long been associated with thegrowth of goods trade and tourism in Asia. Nevertheless, widespread restric-tions on international trade in services remain in effect, and services weresubject to separate negotiations during the Uruguay Round.

Foreign direct investment (FDI) is among the major forces propellingthe globalization of the world economy, and it is integral to the growth pros-pects of developing countries in the modern global economy. During 1985-1995, FDI in East and Southeast Asia represented a growing share of total FDIin developing countries (see figure). The main source of FDI in East and South-east Asia has been the region itself. The four NIEs were the largest singlesource of FDI for the PRC, Indonesia, and Malaysia between 1986 and 1992.In the case of Thailand, the NIEs were a close second to Japan during thesame period. In recent years, FDI flows to developing countries outside Asiahave begun to match those to the ADEs. An important question for develop-ment in Asia is whether the declining dominance of developing Asian coun-tries in FDI flows observed during the early to mid-1990s represents a perma-nent shift.

With the exception of East Asian NIEs, foreign investment regimes indeveloping Asia are not substantially more liberal than in other developingregions. Foreign investment regimes in PRC; Malaysia; Philippines; andTaipei,China are all substantially more restrictive than in some of the moredynamic non-Asian developing economies. In South Asia only Pakistan has arelatively liberal foreign investment regime.

25

The rapid growth of private capital flows, and of portfolio flows in par-ticular, to developing Asia in the last decade or so reflects the increasing fi-nancial integration of the ADEs internationally. This growth has been pro-pelled and facilitated by technological progress, which has reduced the trans-action costs of buying and selling financial assets. However, the liberalizationof policies on international capital flows in both industrial and developingcountries has also been critically important.

Hong Kong, China and Singapore are now ranked among the most openeconomies in the world in terms of capital account convertibility. By the early1990s, Indonesia, Philippines, Thailand, and even Pakistan had joined Koreaand Malaysia as economies with a high degree of financial integration. Giventhe small extent of financial integration in Pakistan and the Philippines in themid-1980s, the process of opening up to financial flows accelerated sharply in

ECONOMIC OPENNESS


these economies. This also seems to be the case for the PRC, which startedfrom a low degree of financial integration in the 1980s, but had caught upwith India by the early 1990s.

Gains from Trade: Theory

Free trade in goods can lead to significant efficiency gains in resource alloca-tion in trading countries. Moreover, it can lead to large dynamic gains byincreasing incentives to innovate, thereby enhancing growth and welfare inthe global economy.

The fundamental idea of trade theory—the theory of comparative advan-tage—is both simple and compelling. Countries trade so as to benefit fromtheir differences in factor endowments. Countries will specialize producingthose goods and services that best suit their natural resources and physicaland human capital endowments. They will trade the goods and servicesproduced at home for goods and services produced abroad. According to thetheory, free trade, with trade flows determined by comparative advantage, willyield the most efficient allocation of the world’s resources, and thereby maximizeglobal welfare, while restrictions on trade will reduce efficiency, and hence welfare.

Foreign Direct Investment and Labor. FDI brings benefits through four mainchannels:n For the host country, FDI is an additional source of capital. By adding to

domestic savings, it can help increase the rate of growth of output.n If the return to capital is higher in the host country than in the source

country, FDI will improve the international allocation of capital.n FDI can serve as a vehicle for technology transfer. Multinationals often

bring in new production technologies, which generate benefits for both hostand source countries.n In the area of services, such as banking, insurance, and telecommunica-

tions, FDI is the main instrument for promoting trade.Trade barriers undermine the benefits of FDI. In this case, some FDI

may represent tariff-jumping rather than efficient investment decisions, par-ticularly if the import-competing sector already has excess capacity because ofprotection.

The benefits of international labor mobility parallel those of FDI. In thehost country it can alleviate labor shortages. It also permits efficient alloca-tion of world resources and can help facilitate the flow of new technologythrough knowledge embodied in skilled workers.

27

Financial Capital. The case for international financial capital mobility is basedon four simple arguments as follows:n As capital is more productive in capital-scarce countries, capital mobil-

ity will increase income in both capital-rich and capital-scarce economies. In aworld of capital mobility, a lack of domestic savings need not constrain coun-tries with profitable investment opportunities.n Capital mobility allows households and firms to hold an internationally

diversified portfolio of assets. This reduces the vulnerability of income streamsand wealth to real and financial shocks that may hit the domestic economy.n Liberalization of capital flows can lead to efficiency gains because of

increasing returns to scale. The production of many wholesale financial ser-vices is subject to increasing returns to scale that may be exploited throughspecialization.n As the domestic capital market becomes integrated with the interna-

tional capital market, domestic policymakers become subject to scrutiny byglobal investors. Thus capital market integration is a powerful discipliningdevice for policymakers to pursue policies that are conducive to macroeco-nomic stability and ensure growth.

The foregoing points all seem to support a favorable view of internationalfinancial integration. However, experience during the 1920s and 1930s andthe recent Asian financial crisis indicates that private capital flows, particu-larly those relating to short-term debt, can be unreliable and excessively vola-tile. Depending on an economy’s stage of financial sector development, formany developing countries the cost of financial integration may exceed itsbenefits.

Gains from Trade: Empirical Evidence

The empirical evidence suggests that there are substantial gains from trade ingoods and services, from technology, from FDI, and from labor mobility. Theonly exception is financial flows, for which the evidence is inconclusive.

The gains from trade can be measured using two broad approaches: as-sessing static gains from trade and assessing dynamic gains from trade. Stan-dard estimates in the international trade literature suggest that in most cases,static gains from trade are equal to 1 to 2 percent of GDP, but in highlydistorted economies these gains can be as much as 5 to 6 percent of GDP.Such gains are far from insignificant. However, the performance of economiesover time clearly shows that the largest impacts of openness are dynamic innature. Overall, the evidence establishes a strong link between openness and

ECONOMIC OPENNESS


economic performance as measured by economic growth or total factor pro-ductivity growth.

A clear benefit of economic openness is that it gives a country access totechnology developed elsewhere in the world. New technology can be embod-ied in the capital goods used in actual production. A recent study shows thatcountries with a higher ratio of capital goods imports to investment growfaster in terms of GDP per capita. The implication is clear. Economies thathave erected barriers to the importation of capital goods have done so at asignificant cost to their economic growth.

A recent empirical study investigates whether FDI has promoted growthin developing countries and, if so, the necessary conditions under which ithas done so. The key finding is that the higher the stock of human capital inan economy (proxied by education levels), the greater the impact of FDI oneconomic growth. For the average developing country, the benefits of a dollarof FDI have exceeded those of a dollar of domestic investment. A number ofsurveys of companies in Southeast and East Asia have found that in terms ofpositive growth effects, the diffusion of knowledge through FDI is more im-portant than its general contribution to raising investment levels.

While the benefits of international mobility of financial capital are widelyacknowledged, surprisingly, rigorous quantitative estimates of these benefitsare lacking. However, historical evidence suggests that a number of Europeancountries benefited substantially from foreign financial flows. Two recent stud-ies have attempted to investigate the impact of capital account convertibilityon an economy’s macroeconomic performance, but come to contradictoryconclusions. This demonstrates the urgent need for more rigorous empiricalstudies in this area.

The results of a simulation study that estimates the impact of interna-tional labor movement in the world economy are dramatic. It shows that re-moving global controls on the free movement of labor and allowing labor tomove from poor to rich countries could double world output. The calcula-tions show that the efficiency gains from a marginal increase in labor mobilityare likely to outweigh the corresponding efficiency gains from either trade orinvestment liberalization. Thus the relaxation of controls on labor mobility isone of the most crucial policy issues facing the global economy.

Most of these efficiency gains result from labor movements between poorand rich regions, not between particular countries. For political reasons, thechance of large increases in labor movements from developing to industrialcountries in the foreseeable future is minimal. However, the simulations sug-gest that even minor increases in labor mobility could confer substantial gains.

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Openness, the World Trade Organization,

and Developing Countries’ Interests

International trade and open world markets are vital for the growth of Asianeconomies. Notwithstanding the Asian financial crisis, regional commitmentto open trade policies is strong. However, for the most part, the ADEs haveplayed a reactive rather than a proactive part in multilateral trade negotia-tions. Given the importance of openness and economic growth, it is time theADEs took a more proactive role in such negotiations.

A Comprehensive Round of Trade Liberalization. The General Agreementon Tariffs and Trade, now administered by the World Trade Organization(WTO), was designed to liberalize cross-border trade restrictions such as tariffsand quotas. It is in this area that multilateral trade agreements have been themost successful and the least controversial. The most important aspect of amore proactive ADE approach toward multilateral negotiations must be tokeep the process of trade liberalization moving forward. This could beaccomplished through a comprehensive, multilateral round of tradenegotiations.

Even though average tariffs in industrial countries are coming down tolevels of 3 or 4 percent following the Uruguay Round, there is still a long wayto go before free world trade in goods is achieved. While the ADEs have madegreat strides toward liberalization in recent years, they continue to have suffi-ciently high tariffs to give them the bargaining power to engage the industrialcountries in a new round of multilateral trade negotiations. Tariffs in SouthAsia remain extremely high. Tariffs in East and Southeast Asia are lower, butremain still high by industrial country standards.

Multilateral Agreements on Investment and on Labor Mobility. The estab-lishment of relatively open goods markets in the products that industrial coun-tries export means that they have shifted their attention from liberalizing goodsmarkets to liberalizing service and factor markets. The phenomenal expan-sion of FDI has created a powerful lobby in industrial countries for introduc-ing an international regime to smooth the flow of FDI.

The following four priorities should guide the ADEs in any future dis-cussion of multilateral investment agreements:n The ADEs should ensure that any agreement is strictly limited to FDI.

Trade and FDI are indisputably beneficial for developing countries, while thebenefits of other capital flows differ across countries.

ECONOMIC OPENNESS


n The ADEs should ensure that negotiations on investment include thePRC, which is the world’s second largest recipient of FDI, and among devel-oping countries is by far the largest recipient. The ADEs would limit theirbargaining power in negotiating on FDI without the PRC.n The ADEs should insist that any agreement contain provisions to end

subsidies for FDI.n The ADEs should link an investment agreement to one on labor mobil-

ity. Labor mobility is the area in which market access has, for obvious politicalreasons, been most restricted.

Competition Policy. Competition policy is concerned with restrictive busi-ness practices. A consensus has emerged between industrial and developingcountries in favor of initiating the work necessary for possible inclusion ofcompetition policy into the WTO. FDI by multinationals makes competitionpolicy both more important and more difficult. When the size of a nationalmarket is small, large multinationals can exert market power and engageinrestrictive business practices.

Nevertheless, despite the possibility of international restrictive businesspractices, whether the WTO needs a competition policy mechanism is debat-able. A mechanism to regulate goods exports from developing countries isunlikely to be needed, as most developing countries are too small to havemuch market power in world markets. Therefore, as long as the distributionsystem is competitive, free trade can largely substitute for a competition policy,as demonstrated by Singapore, which has no competition policy.

Antidumping. With the hands of WTO members increasingly tied with re-spect to conventional instruments of protection such as tariffs and quotas, theuse of safeguard measures, especially antidumping measures, has intensified.From the perspective of the ADEs, there are a number of concerns as follows:n The incidence of antidumping measures against ADEs is rising. From

July 1994 to July 1995, of 153 antidumping and countervailing investigationsinitiated or measures imposed, as reported to the WTO, nearly half weretargeted at the ADEs.n The industrial countries can use the sunset clause in the Antidumping

Code to legitimize antidumping duties for five years, even though the indus-try concerned may have recovered far more quickly from the injury that led tothe duties.n The prohibition by the Uruguay Round against using voluntary export

restraints could lead to increased antidumping actions that might be more

31

damaging than voluntary export restraints, and might fall disproportionatelyon developing countries.n The complexities of the system and the cost of compliance with anti-

dumping investigation proceedings may result in small and medium firms inthe ADEs encountering difficulties in defending their interests. ADE govern-ments can provide at best limited assistance to these firms. This helps explainwhy a larger share of cases result in prosecution for ADE firms than for indus-trial country firms.n The anticircumvention measures are of particular concern for the ADEs.

Circumvention occurs when firms subject to antidumping duties bring com-ponents rather than the final product into the importing country and as-semble the final product there, thereby circumventing antidumping duties.Alternatively, the same firms may take the components to a third country,assemble them there, and then export to the country where they face anti-dumping duties on direct exports from their home countries. The concern forADEs is that anticircumvention measures could become a highly potent in-strument of protection.

Regionalism. The global trading environment has been characterized by atrend toward regionalism. If this trend continues, then the ADEs stand tolose considerable market access and export demand, especially if the Euro-pean Union and the North American Free Trade Agreement expand to in-clude more countries. Therefore, ADEs should push for a sunset clause onregional arrangements that would discourage the formation of trade blocsthat intend to stay closed.

Conclusion

The ADEs’ best route for ensuring economic growth and prosperity is throughopenness and liberal economic policies.

Economic theory and empirical evidence clearly demonstrate that out-ward-oriented trade policies should be a central part of development strate-gies in poor countries. The financial crisis does not change this; however, itdoes raise questions about the desirability of completely free capital move-ment and full capital account convertibility.

ADEs should take a proactive rather than a reactive approach to multi-lateral trade negotiations. To maximize the benefits of economic openness asEast and Southeast Asia emerge from the financial crisis, the ADEs shouldpush collectively for a comprehensive round of multilateral trade negotiations

ECONOMIC OPENNESS


and develop a common negotiating strategy to promote Asian interests. Manyof the products that the ADEs export still remain subject to high tariffs.

Empirical studies suggest that the European Union and the North Ameri-can Free Trade Agreement have a large and increasing effect on trade diver-sion at the expense of the ADEs. Therefore, it is in Asia’s interests to push fora sunset clause on regional arrangements in the next round of multilateraltrade negotiations.

Finally, as the world nears the start of the new millennium, the globaleconomy faces a number of issues, and the ADEs, the traditional highperformers in the global context, are still in the throes of an ongoing eco-nomic turmoil.

Ironically, while the ADEs, in the face of tremendous economic difficul-ties, remain resolute in their commitment to trade liberalization and open-ness, the industrial countries vacillate and engage in restrictive trade practices.These negative protectionist tendencies in the industrial countries must bechecked. If global markets are kept open, the impending slowdown in theglobal economy will be short-lived, but if these negative tendencies triumphand markets are closed, the global slowdown is likely to be long, arduous, andpainful. Indeed, the path to continued global prosperity—and recovery fromthe ongoing economic crisis—lies in an open global environment and not in amove away from it. This is an important lesson the global economic leader-ship would be well advised to heed.

33

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35

Asian Development Bank

Publication Highlights

AsianDevelopmentOutlook 1999

Eleventh in an Annual SeriesAvailable 19 April 1999

Published for the Asian Development Bankby Oxford University Press


Contents

Part 1 Economic Developments and Prospects 1Industrial Countries 2Asian and Pacific Developing Economies 2Risks and Uncertainties 8

Part 2 The Financial Crisis in Asia 11The Evolution of the Crisis in 1998 11Interpreting the Crisis 13Which Explanation Fits Asia the Best? 13Policy Responses to the Crisis: An Overview of the Debate 14Strengthening the International Financial Architecture 17A Minimum Necessary Set of Reforms for the Architecture 21

Part 3 Economic Openness: Growth and Recovery in Asia 23Policies toward Foreign Trade 24Gains from Trade: Theory 26Gains from Trade: Empirical Evidence 27Openness, the World Trade Organization,

and Developing Countries’ Interests 29Conclusion 31

the financial crisis in asia - charles sturt...

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