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The IMF and Recent CapitalAccount CrisesIndonesia, Korea, Brazil

I n t e r n a t i o n a l M o n e t a r y F u n d • 2 0 0 3

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Evaluation Report

© 2003 International Monetary Fund

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The IMF and recent capital account crises: Indonesia, Korea, Brazil—[Wash-ington, D.C.]: International Monetary Fund, 2003

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“Evaluation Report.”Includes bibliographical references.ISBN 1-58906-188-8

1. Capital movements—Indonesia. 2. Capital movements—Korea. 3. Capi-tal movements—Brazil. 4. International Monetary Fund—Evaluation. I. Inter-national Monetary Fund. Independent Evaluation Office.

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Foreword vii

Abbreviations and Acronyms ix

THE IMF AND RECENT CAPITAL ACCOUNT CRISES:INDONESIA, KOREA, BRAZIL

Executive Summary 1

MAIN REPORT

1 Introduction 9

2 The Three Crisis Cases 11

Indonesia 11Korea 16Brazil 20

3 Precrisis Surveillance 25

The Diagnosis Role of Surveillance 25The Impact of Surveillance 27The Role of Transparency 27Recent Initiatives and Further Steps to Strengthen Surveillance 28

4 Program Design and Implementation 30

Macroeconomic Framework and Projections 30Fiscal Policy 32Monetary Policy 33Official Financing and Private Sector Involvement 36Bank Closure and Restructuring 39Structural Conditionality 41Communications Strategy to Enhance Ownership and Credibility 43

5 Internal Governance 45

Human Resource Management 45The Role of Major Shareholders and the Executive Board 46The Relations with Other International Financial Institutions 46

6 Conclusions and Recommendations 48

Conclusions 48Recommendations 51

Contents

iii

CONTENTS

Appendix 1. The IMF’s Financial Arrangements with Three CrisisCountries, 1997–2002 55

Appendix 2. List of Interviewees 56

Box

4.1. Conditionality for Structural Reforms in an IMF-Supported Program 42

Figures

2.1. Indonesia, Korea, and Brazil: Exchange Rate Movements Againstthe U.S. Dollar Under IMF-Supported Programs 12

2.2. Indonesia: Key Economic Variables 142.3. Korea: Key Economic Variables 192.4. Brazil: Key Economic Variables 22

Tables

2.1. Indonesia: Key Economic Indicators 132.2. Korea: Key Economic Indicators 172.3. Brazil: Key Economic Indicators 214.1. Real GDP and Investment Projections and Outturn in Crisis Countries 314.2. Real Interest Rates in Selected Countries 344.3. Official Financing Assumed in Initial IMF-Supported Programs 38

ANNEXES

1 Indonesia 61

Introduction 61Precrisis Surveillance 61Program Design 65The Mode of Operations 79Conclusions 83Appendix A1.1. Indonesia: Selected Conditionality Under IMF-Supported

Programs: Evolution and Implementation, 1997–98 87Appendix A1.2. Indonesia: Timeline of Major Events 91

2 Korea 93

Introduction 93Precrisis Surveillance 93Program Design 99Program Financing and the Debt Rollover 111Conclusions 115Appendix. Korea: Timeline of Major Events 118

3 Brazil 120

Introduction 120Precrisis Surveillance 120Program Design 129Conclusions 140Appendix A3.1. Brazil: Selected Conditionality Under IMF-Supported

Programs, 1998–2000 142Appendix A3.2. Brazil: Timeline of Major Events 144

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Contents

Annex Boxes

A1.1. Indonesia: Was Monetary Policy Tight? 70A2.1. Merchant Banks in Korea 94A2.2. The IMF-Supported Program in Korea 100A2.3. Recent Studies on the Impact of High Interest Rate Policy in Korea 103A3.1. Brazil: The Real Plan 121A3.2. Brazil: The Evolution of Exchange Rate Policy 124

Annex Figures

A1.1. Indonesia: Selected Macroeconomic Indicators 62A1.2. Indonesia: Monthly Nominal Interest Rates 69A1.3. Indonesia: Monthly Real Interest Rates 71A1.4. Indonesia: Daily Movements of the Rupiah–U.S. Dollar

Exchange Rate 71A1.5. Indonesia: Base Money Outcomes and Targets Under

IMF-Supported Programs 72A2.1. Won–U.S. Dollar Exchange Rate and Korean Equity Prices 96A2.2. Korean and Emerging Market Borrowing Spreads 98A2.3. Won–U.S. Dollar Spot and Forward Rates 98A2.4. Korea: Overnight Call Money Rate and Inflation 102A2.5. Daily Volatility of U.S. Dollar Exchange Rates Against Korean

Won, Japanese Yen, and Deutsche Mark 105A3.1. Brazil: Real Effective Exchange Rate 125A3.2. Brazil: Foreign Exchange Reserves 127A3.3. Brazil and Emerging Markets Bond Index Spreads 129A3.4. Brazil: Debt Sustainability Projections 132A3.5. Brazil: Composition of Federal Domestic Securities 132A3.6. Short-Term Interest Rate and Real–U.S. Dollar Exchange Rate 134

Annex Tables

A1.1. Indonesia: Fiscal Outcomes and Targets 66A1.2. Indonesia: Balance of Payments Projections and Outcomes 73A2.1. Korea Balance of Payments and Financing Requirements 112A3.1. Brazil: Fiscal Developments 122A3.2. Brazil: Factors Affecting Net Public Debt 133A3.3. Brazil: Financing Assumptions and Outturns 137A3.4. Brazil: Macroeconomic Projections 139

Bibliography 145

MEMORANDUM FROM FIRST DEPUTY MANAGING DIRECTOR,STATEMENT BY MANAGING DIRECTOR, IMF STAFF RESPONSE,AND SUMMING UP OF IMF EXECUTIVE BOARD DISCUSSION

BY ACTING CHAIR

Memorandum from First Deputy Managing Director 155

Statement by Managing Director 156

IMF Staff Response 157

Summing Up of IMF Executive Board Discussion by Acting Chair 160

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CONTENTS

vi

The following symbols have been used throughout this report:

– between years or months (e.g. 2000–01 or January–June) to indicate the years ormonths covered, including the beginning and ending years or months;

/ between years (e.g. 2000/01) to indicate a fiscal (financial year).

“Billion” means a thousand million.

Minor discrepancies between constituent figures and totals are due to rounding.

Some of the documents cited and referenced in this report were not available to the publicat the time of publication of this report. Thus, they have not been listed in the bibliogra-phy. However, under the current policy on public access to the IMF’s archives, some ofthese documents will become available five years after their issuance. They may be refer-enced as EBS/YY/NN and SM/YY/NN, where EBS and SM indicate the series and YYindicates the year of issue. Certain other documents are to become available ten or twentyyears after their issuance depending on the series.

This report, The IMF and Recent Capital Account Crises, is the second evaluationreport produced by the Independent Evaluation Office (IEO). The report focuses onthe role of the IMF in three recent currency crises in Indonesia (1997–98), Korea(1997–98), and Brazil (1998–99).

The three cases exemplify the new type of balance of payments crisis, character-ized by a sudden reversal of capital flows, which are increasingly seen as posing spe-cial risks for emerging market countries. All three cases have been the subject of con-siderable debate both within and outside the IMF and, in revisiting these episodes,this report covers ground that will be familiar to many readers. However, it alsobrings a fresh perspective because of the IEO’s access to internal IMF documentswhich cast new light on various aspects of each crisis, both in the buildup to the crisisand in the crisis management phase.

The primary purpose of the evaluation, in keeping with the IEO’s mandate, is todraw lessons for the future. The report therefore recommends a number of stepsaimed at making the IMF’s surveillance and program design more effective in theprevention and management of future capital account crises. The report recognizesthat many important lessons have already been learned from the cases studied and anumber of changes have been made in IMF procedures and policies. The recommen-dations in the IEO report seek to build on the many steps already taken.

The preparation of the report followed the IEO’s established procedures. A draftissues paper was posted for comments on the IEO’s website (www.imf.org/ieo) andwas later revised, on the basis of inputs from a range of groups and individuals, toform the final terms of reference for the evaluation. This was posted on the websiteand interested parties were invited to submit material relevant to items included in theterms of reference. Several seminars were held to interact with outside experts andstakeholders and comments on early drafts were obtained from staff. The final IEOreport, as approved by the Director, was submitted to management for comments andalso circulated simultaneously to Executive Directors. The report was discussed in theExecutive Board on May 30, 2003, along with comments from management andstaff.

In line with IEO procedures, the report, as discussed in the Board, is being pub-lished along with the Summing Up of the Executive Board discussion by the ActingChair and the statements by management and staff to the Board. The staff statementdraws attention to positive developments in Indonesia and Brazil in the period follow-ing the end of the programs covered by this report. The IEO was precluded from eval-uating these developments because our mandate does not allow us to review ongoingprograms.

Montek S. AhluwaliaDirector

Independent Evaluation Office

Foreword

vii

FOREWORD

viii

The IMF and Capital Account Crises: Indonesia, Korea, Brazil

The report was prepared by a team headed by Shinji Takagi and includingAli Mansoor, Kevin Barnes, and Benjamin Cohen. The team was assisted byAfonso Bevilaqua, Stephen Grenville, Mohamad Ikhsan, Jai-won Ryou, andTakashi Shiraishi; sections of the report have also benefited from commentsand other inputs from Jeffrey Frankel, Takatoshi Ito, Yung Chul Park, andDavid Peretz. However, the final judgments are the responsibility of the IEOalone. Research assistance from Misa Takebe, Shauqie Azar, MinkyungKim, and Leandro Rothmuller; administrative support by AnnetteCanizares, Arun Bhatnagar, and Florence Conteh; and editorial work by IanMcDonald and Esha Ray are gratefully acknowledged.

The Independent Evaluation Office (IEO) was established by the Interna-tional Monetary Fund’s Executive Board in July 2001. The office operatesindependently of IMF management and at arm’s length from the IMF’s Ex-ecutive Board. Its mission is to provide objective and independent evalua-tion of issues related to the IMF’s mandate and thereby support the Execu-tive Board in its governance and oversight responsibilities, to contribute toenhancing the learning culture of the IMF, and to promote understanding ofthe IMF’s work.

ADB Asian Development BankAPD Asia and Pacific Department (IMF)APEC Asia-Pacific Economic CooperationASEAN Association of South East Asian NationsBCBS Basel Committee on Banking SupervisionBI Bank IndonesiaBIS Bank for International SettlementsBLBI Bank Liquidity from Bank IndonesiaBOK Bank of KoreaBPK Supreme Audit Agency (Indonesia)CBA Currency board arrangementCCL Contingent Credit Line (IMF)CD Certificate of depositCPMF Financial transactions tax (Brazil)EFF Extended Fund Facility (IMF)EMEAP Executives’ Meeting of East Asia–Pacific Central BanksERM Exchange rate mechanismFDI Foreign direct investmentFSAP Financial Sector Assessment Program (IMF)FSC Financial Supervisory Commission (Korea)FSS Financial Supervisory Service (Korea)G-7 Group of Seven countriesGDP Gross domestic productIBRA Indonesian Bank Restructuring AgencyICM International Capital Markets Department (IMF)IDB Inter-American Development BankIEO Independent Evaluation Office (IMF)IFI International financial institutionIIF Institute of International FinanceIMF International Monetary FundINDRA Indonesia Debt Restructuring AgencyITC Investment trust company (Korea)JIBOR Jakarta interbank offered rateKAMCO Korea Asset Management CorporationKDB Korea Development BankKDIC Korea Deposit Insurance CorporationLIBOR London interbank offered rateLOI Letter of intent (IMF)LOLR Lender of last resortMAE Monetary and Exchange Affairs Department (IMF)1

MEFP Memorandum on economic and financial policies (IMF)

Abbreviations and Acronyms

ix

1Effective May 1, 2003, name was changed to Monetary and Financial Systems Department.

ABBREVIATIONS AND ACRONYMS

MOF Ministry of financeMOFE Ministry of Finance and Economy (Korea)NDA Net domestic assetsNIR Net international reservesNPL Nonperforming loanOECD Organization for Economic Cooperation and DevelopmentPC Performance criteria (IMF)PDR Policy Development and Review Department (IMF)PEDT Private External Debt Team (Indonesia)PIN Public Information Notice (IMF)PSBR Public sector borrowing requirementPSI Private sector involvementRES Research Department (IMF)ROSC Report on the Observance of Standards and Codes (IMF)SBA Stand-By Arrangement (IMF)SBI Bank Indonesia certificateSDDS Special Data Dissemination Standard (IMF)SDR Special drawing right (IMF)SME Small and medium-sized enterpriseSRF Supplemental Reserve Facility (IMF)URV Unit of real value (Brazil)VAT Value-added taxWHD Western Hemisphere Department (IMF)WTO World Trade Organization

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The IMF and Recent Capital Account Crises:Indonesia, Korea, Brazil

T his report evaluates the role of the IMF in threerecent capital account crises, in Indonesia

(1997–98), Korea (1997–98), and Brazil (1998–99). These crises have been the subject of extensiveexternal commentary and have also been studied indetail by IMF staff. A number of important lessonshave already been learned and corresponding cor-rective steps taken in the form of revised IMF poli-cies and procedures. Nevertheless, it is appropriatefor the Independent Evaluation Office (IEO) to conduct an independent assessment of the role ofthe IMF in these crises, taking advantage of itsunique access to internal IMF documents while alsotaking note of earlier work where relevant. Theevaluation seeks to draw lessons for the IMF, sup-plementing those that have already surfaced, andalso to contribute to transparency by evaluating theinternal processes by which important decisionswere made.

The findings of this evaluation report are subjectto three important limitations. First, any evaluationinevitably benefits from hindsight and while this canbe an advantage in drawing lessons for the future,much of what we know now may not have beenknown at the time to those who had to make the rele-vant decisions, often under extreme pressure. Theseconsiderations must be borne in mind in determiningaccountability. Second, any evaluation implies acomparison with a counterfactual, that is, whatmight have happened with alternative policies. Thisis very difficult to establish rigorously. Third, the be-havior of an economy is always subject to uncer-tainty, and the uncertainties are much greater in cri-sis situations. In the face of uncertainty, a programcannot be judged to represent a mistaken choice exante just because it failed ex post. The relevant crite-rion is whether the ex ante probability of successwas high enough.

The report consists of two parts. The main reportpresents our assessment of the role of the IMF in thethree crises and the lessons to be drawn from the ex-perience, with some specific recommendationsgoing beyond the steps already taken. The annexescontain the three country studies that form the basisfor our judgments in the main report.

Overall Assessment of the Role of the IMF

The three country cases studied share several fea-tures common to capital account crises; in each casethe crisis was triggered by massive reversal of capi-tal flows, short-term flows played a prominent role,and contagion was an important factor. However,there were also notable differences. The nature ofthe crisis differed in the three cases, with Indonesiaand Korea exemplifying “twin crises” in which theexternal crisis coincided with a banking crisis. Therewere also differences in the policy mix advocated,the political environment in which the crisis wasmanaged, and the effectiveness of policy implemen-tation. All three programs failed in their initiallystated objectives, but the subsequent experienceunder the revised programs was very different. Ouroverall assessment of the role of the IMF in each ofthe three crises is as follows.

Indonesia

IMF surveillance did identify the vulnerabilitiesin the banking sector that would later become crucialto the evolution of the crisis, but it underestimatedthe severity and the potential macroeconomic risksposed by them. In designing its crisis managementstrategy during October 1997, the IMF misjudgedthe extent of ownership at the highest political leveland underestimated the resistance to reform likely tobe posed by vested interests. This underestimation ofpolitical constraints was perhaps a reflection of theearlier failure of surveillance in recognizing thechanging nature of corruption and cronyism.

The single greatest cause of the failure of the No-vember 1997 program was the lack of a comprehen-sive bank restructuring strategy, which led to a rapidexpansion of liquidity to support weak banks. The re-sulting loss of monetary control in turn contributed toa weaker exchange rate and greater distress in thecorporate sector. The crisis became intensely politi-cal, following the illness of the President in early De-cember, making crisis management even more diffi-cult. At this stage, the IMF negotiated a revised

Executive Summary

1

EXECUTIVE SUMMARY

program in January 1998, which focused heavily onstructural conditionality to signal a clean break withthe past. The focus on structural conditionality wasbased on the assumption that this was necessary torestore confidence. It failed to do so, partly becauseof visible lack of political commitment to the policiespromised and partly because of the failure to addressthe critical banking and corporate debt problems.

The Indonesian crisis was clearly the most severeof the three under review, with GDP declining by 13percent in 1998 and a large increase in poverty. Thisdevastating outcome cannot be attributed solely toshortcomings on the part of the IMF. The lack offirm implementation of the November program, andespecially the reversal of some of the critical steps ata very early stage, eroded market confidence and thesituation soon got out of control as political uncer-tainty increased and riots occurred against the ethnicChinese community. These exceptional circum-stances explain much of the severity of the crisis ex-perienced by Indonesia. However, our evaluationsuggests that the IMF’s response to the failure wasalso inadequate in many respects.

Korea

In Korea, IMF surveillance failed adequately toidentify the risks posed by the uneven pace of capitalaccount liberalization and the extent of banking sec-tor weaknesses, owing to the adoption of a conven-tional approach that focused on macroeconomicvariables. There were gaps in the data needed tomake a full assessment, though available data onshort-term debt and financial market indicators werenot fully used. While concerns over Korea’s weakbanking sector had prompted international banks toreview their lending to some Korean institutionseven before the onset of the Asian crisis in July1997, the IMF was optimistic until virtually the lastminute.

The first Korean program was clearly underfi-nanced, but this was due primarily to the unwilling-ness of major shareholder governments either to takeconcerted action to involve the private sector or toprovide the necessary financing upfront to resolvewhat, of all the three cases, was most clearly a liquid-ity crisis. When this strategy failed, the major share-holder governments moved quickly to initiate con-certed action to involve the private sector—anapproach that eventually worked well. It could be ar-gued that the first strategy needed to be tried andproven to have failed before the rollover agreement ofDecember 24, 1997 could be secured. The IMFplayed a useful role as crisis coordinator in drawingattention to the problem and later facilitating informa-tion exchange among major governments and helpingto set up a monitoring system to ensure compliance.

The Korean adjustment process involved a se-vere downturn, with GDP declining by 6.7 percentin 1998, compared with a forecast of positivegrowth. However, unlike Indonesia, this was fol-lowed by a robust recovery in 1999. The greater-than-expected downturn reflected the impact ofnegative balance sheet effects, which were clearlyunderestimated. In retrospect, the fiscal tighteningin the program was unnecessary, as the IMF staffhas itself concluded.

Brazil

In Brazil, IMF surveillance was successful inidentifying the key vulnerabilities that were at thecore of the crisis, in part owing to the fact that theywere largely macroeconomic in nature. However, itprogressively downplayed the scale of overvalua-tion, and had little impact in persuading the Brazil-ian authorities to take sufficient corrective actioneven in areas where the diagnosis was correct. WhenBrazil faced intense speculative pressure on its for-eign exchange reserves from mid-1998, the IMF re-luctantly supported the authorities’ preference formaintaining the existing exchange rate regime. How-ever, intense pressure on the real developed in De-cember 1998, and the program soon failed with thecollapse of the peg in January 1999.

A major justification for defending the exchangerate was that an exit from the peg at that time wouldhave unsettled international financial markets al-ready nervous after the Russian default and theLong-Term Capital Management crisis. With thebenefit of hindsight, it can be argued that this con-cern was overplayed. An earlier exit from the peg,widely perceived to be unsustainable, probablywould not have had major systemic effects if it hadbeen made under an IMF-supported program. Thehedge provided to the private sector by the govern-ment, through the use of foreign exchange reservesand exchange rate–indexed bonds, ensured that thesharp depreciation that followed the floating of thereal in January 1999 had little adverse effect on theBrazilian economy. However, this was at the cost ofa substantial increase in the stock of public debt,which stored up problems for the future.

The revised 1999 program fared fairly well in theshort run. Contrary to program expectations of nega-tive growth in 1999, Brazil actually experienced posi-tive growth of 0.8 percent. This was largely becauseof the healthier state of the banking system, combinedwith the provision of the hedge, which mitigated bal-ance sheet effects on the private sector. The IMFplayed a useful role in facilitating Brazil’s transitionto an inflation-targeting monetary regime as well as amore disciplined fiscal policy regime, but in retro-spect, fiscal vulnerabilities were not fully eradicated.

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Executive Summary

Precrisis Surveillance

IMF surveillance was more successful in identify-ing macroeconomic vulnerabilities than in recogniz-ing and analyzing in depth the risks arising from financial sector and corporate balance sheet weak-nesses and the governance-related problems thatcontributed to those weaknesses. Insufficient candorand transparency limited the impact of surveillanceon policy, even in areas where the diagnosis wasbroadly accurate.

In Indonesia, the IMF did identify banking sectorweaknesses as a problem, but surveillance reportsunderestimated the potential adverse macroeco-nomic consequences of these weaknesses. Surveil-lance also paid insufficient attention to the changingnature of corruption and the macroeconomic risks itposed, and surveillance reports were less candid onthese issues.

In Korea, the IMF failed adequately to recognizethe vulnerabilities created by the uneven sequence ofcapital account liberalization and the risk that achange in investor sentiment could cause a severedrain on foreign exchange reserves. While the crisisalso came as a surprise to many other observers, theIMF was slow to catch the rising concerns of inter-national banks over Korea’s banking sector prob-lems, which had begun to surface several months be-fore the onset of the full-blown crisis. In retrospect,surveillance proved too sanguine about these grow-ing risks.

IMF surveillance effectively diagnosed the majorvulnerabilities in Brazil, largely because Brazil’s vul-nerabilities manifested themselves primarily asmacroeconomic phenomena, such as the rising stockof public debt and real exchange rate appreciation,which were part of the IMF’s traditional tool kit.

In all three countries, the IMF’s role as confidentialadvisor was not very effective in persuading countriesto modify their policies even when key vulnerabilitieswere identified. The IMF was not provided with muchsensitive information required for effective surveil-lance. While it is difficult to generalize from threecases, or to test the counterfactual concretely, the IMFprobably could have been more effective in influenc-ing policy if it had made its analyses public so as tocontribute to a wider policy debate.

Program Design and Implementation

Macroeconomic framework and projections

In all three cases, macroeconomic outcomes turnedout to be very different from program projections. InIndonesia and Korea, the initial projections wereoverly optimistic, leading to a design of macroeco-

nomic policies that turned out to be too tight given theoutcome in aggregate demand and output. In contrast,the initial projections for Brazil in 1999 were too pes-simistic, which contributed to fiscal adjustment thatturned out to be insufficient, in light of that country’sadverse public debt dynamics.

Part of this problem arises because macroeco-nomic projections in an IMF-supported program arenecessarily the outcome of negotiation. However,there were also analytical weaknesses since fore-casts were not derived from an analytical frameworkin which the key determinants of output, and theirlikely behavior during the crisis, could be dealt withadequately. In particular, there was insufficient ap-preciation of (1) the large currency depreciationwhich might occur in view of the possibility of mul-tiple equilibria, and (2) the severe balance sheet ef-fects that might result. It is inherently difficult toforecast macroeconomic outcomes reliably, espe-cially in crisis situations, but these problems couldhave been reduced if there was a more explicit focuson the key factors affecting aggregate demand, par-ticularly private investment.

In light of the considerable uncertainties, a moreexplicit discussion in program documents of themajor risks to the macroeconomic framework, with aclear indication of how policies would respond if therisks materialized, would have been helpful. In prac-tice, subsequent program reviews on Indonesia andKorea did show flexibility, but an upfront recognitionof risks would have sent a more transparent signal onthe expected stance of policies.

Fiscal policy

All three programs involved fiscal tightening. Theextent of tightening was mild in Indonesia andKorea, while it was fairly strong in Brazil. In view ofoutput developments, the initial tightening of fiscalpolicy in Indonesia and Korea was not warranted,and it was in fact relaxed quickly when the extent ofoutput collapse became evident. In any event, in bothcountries, the initial fiscal tightening was not thecause of the output collapse. This was the result ofbalance sheet effects, which were not factored intoprogram design. In Brazil, fiscal tightening wasmuch sharper. This was appropriate because fiscalsustainability was a major issue driving the evolutionof the crisis. However, it turned out to be insufficientto achieve the objective of stabilizing, and then re-ducing, the debt-to-GDP ratio.

Monetary policy

The stance of monetary policy in all three coun-tries was initially set tight, with an explicit recogni-tion of the trade-off between higher interest rates and

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EXECUTIVE SUMMARY

a weaker exchange rate. However, the experience ofthe three countries varies and does not provide a de-finitive answer to the ongoing debate on the effec-tiveness of high interest rates in stabilizing the ex-change rate.

In Indonesia, the maintenance of tight monetarypolicy envisaged in the program was simply not im-plemented, as the monetary base expanded rapidlyand real interest rates became increasingly negativeduring the early months of the program. The assertionby some critics that the tight monetary policy advo-cated by the IMF was a cause of the output collapse isnot warranted for the simple reason that it was not im-plemented for most of the crisis period. Exchangerate stability returned in March 1998, when the rupiahhad sufficiently depreciated and interest rates wereraised and monetary control regained.

In contrast, Korea implemented the tight mone-tary policy envisioned in the initial program by rais-ing domestic interest rates and the penalty ratecharged to banks for central bank foreign currencyadvances. These moves were appropriate to defendthe currency, but they were not by themselves suffi-cient to stabilize the exchange rate, because much ofthe capital outflow was in fact driven by credit con-siderations rather than yield. It can be argued thatreal interest rates were kept higher than might havebeen necessary in early 1998, when the exchangemarket had stabilized. However, the still uncertainsituation understandably called for some caution.Given the contractionary impact of bank restructur-ing on credit flows, the few months of higher thannecessary interest rates could not have been thedominant cause of the recession.

In Brazil, the excessive easing of interest rates—over the IMF’s objections—may have contributed tothe timing, if not the eventuality, of the collapse ofthe crawling peg. A decisive tightening of monetarypolicy in March 1999 coincided with the restorationof stability in the foreign exchange market. How-ever, one must be careful about the causality, giventhe fact that an informal agreement by major interna-tional banks to maintain credit lines to Brazil wasreached around the same time. High interest ratesdid not have a major negative impact on the privatesector, because of the sound state of the banking sys-tem and the low leverage of the corporate sector,compared with the situations in Asia. Subsequently,the IMF supported Brazil’s transition to an inflation-targeting regime, which allowed for price stabilityand a rapid reduction in interest rates.

Official financing and private sector involvement

The size and format of the official financing pack-age were inadequate in Korea and contributed to the

failure of the first program. The ambiguity over theavailability of US$20 billion in bilateral assistancepledged as a “second line of defense” in Korea cre-ated uncertainty in the market about the ability of theprogram to meet the country’s immediate liquidityneeds.

In the other two countries, the programs failed forother reasons. The failure of the initial Indonesianprogram was due, not to inadequate financing, but toother factors, including nonimplementation of thekey elements of the program by the authorities andthe subsequent explosion of liquidity because of thefailure to resolve the banking crisis. Once the pro-gram had failed, the crisis became intensely politi-cal, leading to a large amount of capital flight by do-mestic residents, and the sharp depreciation of therupiah began to create solvency concerns. No rea-sonable amount of official financing could have re-stored confidence at that time. In the case of Brazil,the initial program failed because the key policy,namely, that of supporting the crawling peg, was notcredible with the markets.

In Korea and Brazil, the IMF’s role as crisis coor-dinator in organizing private sector involvement(PSI) was limited by the unwillingness of majorshareholder governments to use nonmarket instru-ments to influence the behavior of private sector in-stitutions and concerns that such action might pre-cipitate an exodus of capital from emerging markets.However, when a decision was made by the majorshareholders to involve the private sector, the IMFplayed a useful role in facilitating information ex-change among major governments and helping to setup systems of monitoring compliance.

An earlier attempt to involve the private sector inKorea would have been warranted, but given the ini-tial unwillingness of the IMF’s major shareholdergovernments to take concerted action, there wasprobably little the IMF could do. The agreement bymajor international banks to roll over interbank debton December 24, 1997 was a turning point in the cri-sis. The success of this approach owed much to thefact that most of the short-term external debt was in-terbank credit. The Brazilian experience in the sec-ond program suggests that a program with a high de-gree of credibility is necessary for the “voluntary”approach to PSI to work. In Indonesia, the IMF pro-vided technical assistance for corporate debt restruc-turing, but its role was limited.

Bank closure and restructuring

The experiences of Indonesia and Korea suggestthat a successful bank closure and restructuring pro-gram must include a comprehensive and well-com-municated strategy in which transparent rules are con-sistently applied. The Korean program by and large

4

Executive Summary

achieved its objectives, largely because a comprehen-sive strategy was developed at the outset. The Indone-sian banking sector program, by contrast, initially suf-fered from the lack of a comprehensive strategy andthe failure to communicate the logic and outline of thepolicy to the public. As a result, the closure of 16banks in November 1997, with subsequent reversalsexacerbated, rather than dampened, the crisis. Bankclosures in Indonesia in April 1998, however, weremore successful because they were done as part of acomprehensive strategy that was well communicatedto the public and was based on the consistent applica-tion of uniform and transparent criteria.

The issue of whether a blanket guarantee, insteadof the partial guarantee actually offered, should havebeen introduced in Indonesia in November deservescareful consideration. Our evaluation suggests thatthe banking crisis was not yet systemic in Novem-ber, so that the partial guarantee was appropriate. Inthe end, the blanket guarantee introduced in Januarywas subject to abuse and consequently raised the fis-cal cost of bank restructuring. The problem in bankrestructuring was more with the initial lack of acomprehensive and well-communicated strategy,and not the nature of the guarantee.

Structural conditionality

All three programs involved structural condition-ality, but the experience with conditionality was verydifferent. The Indonesian and Korean programs werecharacterized by extensive structural conditionality(especially the January 1998 Indonesian program)covering several areas that were not macro-critical.The scope of structural conditionality in the Brazil-ian program was limited to structural fiscal reformand prudential regulation. Part of this difference re-flected the absence in Brazil of many of the distor-tions that had been present in Asia.

Measures to rehabilitate and reform the financialsector were necessary in both Indonesia and Koreaand were appropriately included in the programs. InIndonesia, it was also important to tackle corporaterestructuring by reforming the legal system, but thiselement was missing in the first two programs. Asfor the various nonfinancial structural reform mea-sures included in the Indonesian and Korean pro-grams, many of these may have been beneficial inimproving long-run economic efficiency, but theywere not necessary.

In Indonesia, many governance-related measureswere included in the January 1998 program at theurging of some of the IMF’s major shareholders inthe belief that confidence could only be restored bysignaling a clean break with the past. However, theevaluation suggests that the proliferation of nonfi-nancial structural conditionality led to a loss of

focus on critical reforms in the banking sectorwhich was more important for restoring stability.Proliferation of structural conditionality may alsohave led to lack of ownership at the highest politicallevel and nonimplementation, both of which dam-aged confidence.

Communications strategy

A program for restoring confidence must include astrategy to communicate the logic of the program tothe public and the markets, in order to enhance coun-try ownership and credibility. None of the three pro-grams initially contained such a strategy.

Effective public communications are essential tobuild broad support for the program. Likewise, ef-fective dialogue with the markets would improveprogram design through understanding the expecta-tions of market participants, and also help buildcredibility for the program. For this purpose, it is im-portant for the IMF to explain clearly the logic andstrategy of the program, including spelling out themajor risks, with a broad indication of how policieswould respond to them.

Internal IMF Governance and theMode of Operations

The evaluation identified a number of weak-nesses in the IMF’s internal governance and modeof operations. In the area of human resource man-agement practice, the effectiveness of surveillancewas reduced by the lack of sufficient internal incen-tives to make judgments that were frank and poten-tially unpopular (with country authorities), result-ing in a tendency for sharper elements of adiagnosis to be diluted in final Executive Board pa-pers. In crisis management, the quality of the IMF’sresponse was compromised by a delay in the reallo-cation of staff resources to the Asia and Pacific De-partment (APD) whose staff was overstretched bymultiple regional crises; the insufficient integrationof staff from the Monetary and Exchange AffairsDepartment (MAE) and the area department; insuf-ficient utilization of available internal knowledge;and the failure to mobilize staff members with up-to-date country knowledge.

The role of the Executive Board and the IMF’smajor shareholders was particularly prominent dur-ing the crises, when major decisions needed to bemade quickly, calling for close collaboration withstaff and management. While the close involvementof the Board and the major shareholders was properand necessary, close contacts at multiple layers un-necessarily subjected staff to micromanagement andpolitical pressure, contributing to a blurring of tech-

5

EXECUTIVE SUMMARY

nical and political judgments. For example, the visi-ble presence of major country officials close to theIMF negotiating teams sometimes created a misper-ception of the motives behind IMF involvement, thusweakening the sense of country ownership.

In all three programs, the IMF collaborated, bothin financing and technical work, with other interna-tional financial institutions (IFIs). When there was aclear separation of responsibilities, as in Brazil, nomajor problems occurred. In Asia, however, wherethe IMF and the other IFIs all worked in the financialsector, tensions developed over the role they shouldplay in an IMF-supported program. While a goodworking relationship eventually developed, it de-pended too much on personalities, and not on a well-defined procedure. Moreover, existing procedures toresolve differences of view between the IMF and theWorld Bank on key policy matters were not effectivein avoiding public criticism by the Chief Economist

of the World Bank; indeed, as far as the evaluationteam can tell, these procedures were not utilized.

Recommendations

Since these crises, the IMF has taken numerousinitiatives to strengthen surveillance and program de-sign. Many of the weaknesses in surveillance andprogram design identified by the evaluation have al-ready been addressed by the IMF in its revised poli-cies and procedures. Nevertheless, additional stepswill be necessary to further enhance the effectivenessof the IMF in surveillance and crisis management.We make six broad recommendations, which are setout in the final chapter of the report along with theirrationale. Rather than summarize them again here,we suggest that Chapter 6 be read in conjunction withthis Executive Summary.

6

Main Report

T he decade of the 1990s saw a succession ofcurrency crises in emerging market economies,

against the background of the increasing integrationof these economies with global capital markets.These crises were preceded by large private capitalinflows and triggered by sudden shifts in marketsentiment, which led to massive capital flow rever-sals. They are often described as capital accountcrises to distinguish them from the more conven-tional crises which have their origins mainly in the current account. The IMF was called in to help in several cases, and its role has been thesubject of much study and comment. Contrary to the expectation that IMF support would serve to certify the effectiveness of an adjustment pro-gram and help achieve a smooth adjustment, manyof the IMF-supported programs failed to achievetheir initially stated objectives. Capital outflowscontinued, leading to severe exchange rate deprecia-tion and, in some cases, an exceptionally large con-traction in output. Not surprisingly, the IMF waswidely criticized both for its failure to anticipatevulnerabilities through surveillance and for the subsequent failure to restore market confidencequickly.

This evaluation seeks to throw light on the role ofthe IMF in three capital account crises, in Indonesia(1997–98), Korea (1997–98), and Brazil (1998–99).In undertaking this evaluation, we recognize that weare entering into grounds that are unusually well-trodden. These crises have been extensively studiedby numerous outside observers and also by IMFstaff. A number of lessons have been learned andmany corrective steps have been taken in the form ofrevised IMF policies and procedures, as well asbroader initiatives related to the international finan-cial architecture. Nevertheless, it is appropriate thatthe Independent Evaluation Office (IEO) should re-visit these cases in order to provide an independentassessment. In keeping with the IEO’s terms of ref-erence, the principal focus of the evaluation is todraw lessons for the IMF in its future operationalwork. It will also contribute to transparency by eval-uating the internal processes by which important de-cisions were made.

Three aspects of the evaluation that limit thescope of its conclusions must clearly be stated at theoutset:

(i) Any evaluation necessarily benefits fromhindsight. This can be useful in drawinglessons for the future but, in evaluating thepast and especially determining accountabil-ity, it must be kept in mind that much of whatwe know now may not have been known tothose who had to make the relevant decisions.It is important to distinguish cases in whichcritical information was not available fromthose in which the wrong conclusions weredrawn from the available information. In theformer case, the evaluation should highlightgaps in data availability which need to be cor-rected. In the latter, it may suggest a need toreexamine and improve analytical approachesand assumptions.

(ii) To be meaningful, evaluation of an IMF-sup-ported program must imply comparison withan alternative set of policies that may haveproduced better results. However, it is ex-tremely difficult to establish rigorously sucha counterfactual. This is especially so in areaswhere there is lack of consensus in academicand policymaking communities. We indicateareas where this appears to be the case, andthe learning process in such cases must pro-ceed on the basis of best judgment.

(iii) The behavior of an economy is always sub-ject to uncertainty, but the uncertainties aremuch greater in crises. A program cannot bejudged to represent mistaken decisions exante just because it failed to restore confi-dence as envisaged. The relevant criteria forjudging such decisions ex post are: (1) wasthere a reasonable ex ante assessment of theprobabilities, with the information availableat the time; (2) could more useful informa-tion have been obtained if different proce-dures had been used; and (3) could differentpolicies have enhanced the probability of

Introduction

9

CHAPTER

1

CHAPTER 1 • INTRODUCTION

success. These problems are especially diffi-cult to handle if the crisis involves the possi-bility of multiple equilibria where it is diffi-cult to predict the circumstances under whichone or the other equilibrium can come intobeing.

The evaluation makes extensive use of primaryinformation made available to the IEO. This includesstaff reports for Article IV consultations,1 briefingpapers and back-to-office reports for staff missionsand visits, internal memoranda exchanged amongstaff or between staff and management, minutes ofExecutive Board meetings, comments by manage-ment and review departments on briefing papers, andpolicy papers prepared by staff for the Board.2 TheIEO, however, is not given automatic access to docu-ments that are purely internal to management or thatcover management’s exchanges with national au-thorities, except when such documents were sharedwith staff.3 Inevitably many policy decisions duringthe crises were made by management in close con-sultation with its major shareholder governmentsand the records available to us do not cover these

consultations. Our judgments on certain policy mat-ters are therefore based on limited information.

The evaluation team has extensively interviewedthose involved in decision making in the IMF (in-cluding former IMF staff and management) as wellas some current and former officials of membercountries. Statements made in the text about posi-tions or views of IMF staff and management arebased on the evidence from internal documents andinterviews. The team has also interacted with anumber of individuals who have expressed views on the IMF’s role in these cases. The list of those in-terviewed by the evaluation team appears in Appen-dix 2.

The report comprises two parts. The main reportpresents a summary of our major findings on the roleof the IMF in the precrisis surveillance phase and thecrisis resolution phase in each country and our rec-ommendations. The annexes contain three detailedcountry case studies that form the basis for our judg-ments in the main report.

The main report is organized as follows. Chapter 2presents a brief overview of the IMF’s involvement inIndonesia, Korea, and Brazil. The subsequent threechapters summarize major findings from the countrycase studies. Chapter 3 presents our assessment ofprecrisis surveillance. Chapter 4 discusses our assess-ment of the IMF experience in seven central areas ofprogram design and implementation, that is (1) themacroeconomic framework and projections, (2) fiscalpolicy, (3) monetary policy, (4) official financing andprivate sector involvement, (5) bank closure and re-structuring, (6) structural conditionality, and (7) com-munications strategy to enhance ownership and credi-bility. Chapter 5 addresses internal governance issueswithin the IMF. Finally, Chapter 6 presents conclu-sions and recommendations.

10

1Under Article IV of the Articles of Agreement, the IMF holdsconsultations, usually every year, with each of its member coun-tries on the country’s economic policies and potential vulnerabili-ties. This “surveillance” function of the IMF is conceptually dis-tinct from its role in providing financial support for adjustmentprograms.

2Some of these Board policy papers have been published, in-cluding on the IMF’s website. These papers are cited in footnotesexcept when they are also available in print form, in which casethey are listed in the bibliography.

3Management refers to the group of senior IMF officials con-sisting of the Managing Director, the First Deputy Managing Di-rector, and two Deputy Managing Directors.

T he three cases covered by this evaluation shareseveral features common to capital account

crises. In each case the crisis occurred because ofmassive reversals of capital flows triggered by ashift in market sentiment. Short-term flows played aprominent role in the process, and contagion was animportant factor. All three crises led to IMF-sup-ported programs involving large amounts of IMF re-sources (see Appendix 1), supplemented by bilateraland other sources.

There were also notable differences that are worthsummarizing at the outset. In Indonesia and Korea,IMF surveillance failed to signal alarm because thecrisis occurred against the background of soundmacroeconomic fundamentals, including good exportgrowth performance, relative price stability, andbroad fiscal balance. There were vulnerabilities inboth cases in the form of financial sector weaknesses,highly leveraged corporate balance sheets, weak pub-lic and corporate sector governance, and rising short-term unhedged external indebtedness. These poten-tial vulnerabilities were in varying degrees identifiedin IMF surveillance but their seriousness or their im-plications were not adequately appreciated, becausethese vulnerabilities were rooted in the private sectorand the financial system in particular, which were notyet core areas of IMF surveillance. The fragile stateof the financial sector in both Indonesia and Koreameant that the crisis in each case was a “twin crisis,”in which a balance of payments crisis takes place si-multaneously with a banking crisis.

Brazil, on the other hand, showed clear evidenceof critical macroeconomic imbalances in the form ofa chronic deficit in the fiscal account, rising publicsector debt, and real exchange rate appreciation. TheIMF’s surveillance was much more effective in iden-tifying these vulnerabilities because they were rootedin macroeconomic policies and the public sector, theareas of its traditional focus. Unlike the case in In-donesia and Korea, banking sector weakness was nota serious problem in Brazil at the time of the crisis.

All three original programs failed in their initiallystated objectives, but the subsequent experience ofcrisis management was very different. All threecountries experienced sharp declines in currency

values, but the fall of the Indonesian rupiah far ex-ceeded that of either the Korean won or the Brazilianreal, reflecting the exceptional nature of the Indone-sian crisis (Figure 2.1). Output fell sharply in Koreaand even more so in Indonesia, where there was alsoa significant increase in the incidence of poverty.While in Korea there was a strong rebound in thesecond year, the recovery in Indonesia was delayedand in some ways has not yet been fully achieved.Brazil appeared to weather the crisis better than ex-pected, with the economy showing positive growthin the year following the crisis, but underlying vul-nerabilities resulting from unfavorable debt dynam-ics were not eradicated and surfaced again in 2002.

The political environment in the three cases wasalso very different, and this had a profound impacton the effectiveness of crisis management in eachcountry. In Brazil and also in Korea, after some ini-tial uncertainty, there was strong political commit-ment to the program, which helped to achieve credi-bility. In Indonesia, on the other hand, politicalcommitment was lacking over a prolonged period,rendering crisis management ineffective.

In the following sections, we present a brief sum-mary of the crisis and the role of the IMF in eachcountry, drawing on the detailed case studies in theannexes.

Indonesia

The background to the crisis

Before the 1997 crisis, the Indonesian economywas characterized by strong economic performance(Table 2.1). From 1989 to 1996, annual real GDPgrowth averaged 8 percent, led by strong investmentbehavior. Macroeconomic fundamentals also ap-peared to be strong. The overall fiscal balance was insurplus after 1992 and public debt fell as a share ofGDP as the government used privatization proceedsto repay a large amount of foreign debt. Inflation, atnear 10 percent a year, was a little higher than inother East Asian economies, but it was still low bydeveloping country standards. Credit growth was

The Three Crisis Cases

11

CHAPTER

2

CHAPTER 2 • THE THREE CRISIS CASES

strong, however, and asset prices rose steadily dur-ing the 1990s and kept rising until their peak in earlyAugust 1997.

IMF surveillance in the precrisis period generallyapplauded the strong performance but it did identifysome areas of vulnerability: (1) large capital inflowsand the associated foreign debt; (2) the fragile stateof the banking system, which was linked to gover-nance problems; and (3) a creeping return to moreinterventionist policies that restrained the free opera-tion of markets and created rent-earning opportuni-ties for the well-connected. However, the amount ofshort-term debt was underestimated, and the extentof the weaknesses, particularly in the banking sector,but also more generally because of cronyism andcorruption, was not adequately recognized. The IMFstaff also perceived medium-term risk to be the po-litical uncertainty associated with the eventual suc-cession to President Suharto.

Indonesia’s response to the crisis before the program

The crisis began in July 1997 with contagionfrom Thailand, which led to pressure on the rupiah.

On July 11, 1997, the central bank, Bank Indonesia(BI), surprised the markets by widening the inter-vention margins of the crawling peg regime from 8percent to 12 percent.1 Speculation continued,however, and the authorities responded by tighten-ing liquidity, raising interest rates, and interveningin the foreign exchange market. In mid-August, BIdecided to float the currency, a step that the IMFstrongly endorsed.

Following the float, BI raised the interest rate onone-month central bank certificates (SBI) to 30 per-cent from 11.625 percent and also tightened liquidityby transferring a large amount of public sector de-posits out of commercial banks.2 In early September,the government announced a delay in infrastructureprojects with a total cost of US$13 billion. Despitethese measures, the exchange rate continued to de-preciate and moved beyond Rp 3,000 per U.S. dollar,more than 20 percent below the average value for thefirst six months of the year (Figure 2.2).

Worried by these developments, in mid-Septem-ber 1997, the Indonesian authorities opened discus-sions with the IMF on a “precautionary” arrange-ment to restore confidence.3 On their way to the IMFAnnual Meetings held in Hong Kong SAR in Octo-ber, the First Deputy Managing Director and a seniorstaff member visited Jakarta to see the economicteam and President Suharto.4 The economic teamsaw some worrying parallels to Thailand and hopedthat an IMF-supported program would help to pushdecisions on dealing with the troubled banks andalso to accelerate structural reform in the areas thatthe team felt were important and that IMF surveil-lance had earlier identified as needing correction.The First Deputy Managing Director impressed onthe President the urgency of dealing with financialsector problems, further trade and agricultural re-forms, deregulation, and governance issues that hadled to perceptions of an uneven playing field. Presi-dent Suharto acknowledged the need for substantialpolicy adjustments and said that some banks would

12

–24 –8 t=0 8 24 40 56 72weeks

88 104 120 136 152

–50

0

50

100

150

200

250

300

350

400

Korean won

Brazilian real

Indonesian rupiah

Figure 2.1. Indonesia, Korea, and Brazil:Exchange Rate Movements Against theU.S. Dollar Under IMF-Supported Programs(Percentage change from the date of program approval)

Source: Datastream.Note: In each case, t = 0 refers to the week in which the program was

approved, that is, the week of 11/5/97 for Indonesia, 12/4/97 for Korea, and 12/2/98 for Brazil.

1See Soesastro and Basri (1998) and Djiwandono (2000) fordetails.

2From September 4 to September 22, the rate was reduced to21 percent in several steps.

3In IMF terminology, a financing arrangement is classified as“precautionary” if the authorities indicate an intention not to drawon the resources provided. However, there is no legal distinctionbetween precautionary and regular arrangements since the au-thorities have the right to use the available resources, should cir-cumstances change.

4In the academic literature on Indonesia (e.g., Cole and Slade,1996; Booth, 2001), a group of Western-trained economists in thegovernment are generally called the “technocrats” as opposed tothe “technologists” who favored big state-sponsored projects. Inthis report, we use the term “economic team” to refer to the groupof senior officials in the Ministry of Finance and Bank Indonesia,as the direct counterparts of the IMF staff.

Chapter 2 • The Three Crisis Cases

be closed or merged to protect the solvency of the fi-nancial sector. In a memorandum to the ManagingDirector, the First Deputy Managing Director indi-cated that the President seemed interested in IMFadvice but not in its financial assistance.

In early October 1997, against the growing per-ception of a major crisis in Southeast Asia, parallelmissions from the Asia and Pacific Department(APD) and Monetary and Exchange Affairs Depart-ment (MAE) were sent to Jakarta to work on thecontent of a program to be supported under a precau-tionary arrangement. En route, however, the missionwas notified that the Indonesian authorities, alarmedby the continuing depreciation of the rupiah, had sig-naled a desire for a regular (nonprecautionary)arrangement. A deputy director of APD was sent tojoin the staff already working in the field.

The November 1997 Program

During October, the IMF negotiated a 36-monthStand-By Arrangement (SBA) for about US$10 bil-lion, which was approved by the Executive Board onNovember 5.5 Disbursements would be front-loaded,with two tranches of US$3 billion each by the end of

March 1998.6 The program also assumed US$8 bil-lion in lending from the World Bank and the AsianDevelopment Bank (ADB). The press notice alsomade a reference to the availability of additional fi-nancing from bilateral sources, if required, withoutincluding it in the headline figure.

At this stage, the IMF believed that the crisis wasa moderate case of contagion in which the exchangerate had overshot, so the program’s key macroeco-nomic objective was to correct this overshooting.The staff recognized that, if one questioned thisbasic assumption, an entirely different approachwould be necessary, though it never explored com-prehensively what that alternative would imply. In-ternal documents show that both staff and manage-ment perceived the crisis as an opportunity to assistthe reformist economic team in carrying out finan-cial sector reform and deregulation, both areas thatwere earlier emphasized in IMF surveillance.

The November program aimed to restore marketconfidence by (1) maintaining already prudent macro-

13

Table 2.1. Indonesia: Key Economic Indicators1

1994 1995 1996 1997 1998 1999 2000 2001

Real GDP growth (percent) 7.5 8.2 7.8 4.7 –13.1 0.8 4.9 3.4Real private consumption (percent) 7.8 12.6 9.7 7.8 –6.2 4.6 1.6 4.4Real fixed investment (percent) 13.8 14.0 14.5 8.6 –33.0 –18.2 16.7 7.7

Real private fixed investment (percent) 13.8 18.9 16.6 5.4 –33.0 –40.3 . . . . . .

Inflation (CPI, Dec./Dec., percent) 9.6 9.0 6.0 10.3 77.6 1.9 9.3 12.5Base money (end-period, percent) 22.02, 3 34.02, 3 13.92 68.12 32.52 35.5 22.8 2.1Broad money (M2, end-period, percent) 20.2 27.6 29.6 23.2 62.3 11.9 15.6 13.0

Current account balance (US$, billion) –2.8 –6.4 –7.7 –4.9 4.1 5.8 8.0 6.9Export growth (US$, percent) 8.8 13.4 9.7 7.3 –8.6 –0.4 27.7 –16.1Import growth (US$, percent) 12.9 27.0 5.7 –2.9 –34.4 –12.2 39.6 –7.5

External debt (US$ billion, end-period) 100.9 113.7 121.1 146.6 159.8 158.4 149.6 139.8International reserves (US$ billion, end-period) 12.1 13.7 18.3 16.6 22.7 26.4 28.5 27.2Exchange rate (Rp/US$, end-period) 2,198 2,294 2,362 4,375 7,850 6,988 9,675 10,450Real effective exchange rate4 100.2 100.0 103.9 62.1 65.8 72.7 62.9 66.3

Central government balance (percent of GDP)5 0.2 0.9 1.1 –1.3 –2.3 –1.5 –1.1 –3.7

Sources: IMF database, supplemented by APD staff estimates; and Datastream.1Calendar years, unless noted otherwise.2Fiscal years.3Foreign currency stocks measured at constant exchange rates to avoid valuation changes.4End-period; average of 1990 = 100.5Fiscal years. Fiscal year 2000 covers nine months from April to December, as Indonesia’s fiscal year changed from April–March to a calendar year in April 2000.The

fiscal balance excludes privatization proceeds and includes the interest rate cost of bank restructuring.

5SDR 7,338 million or 490 percent of quota.

6The front-loading factor of the Indonesian SBA was similar tothat of the 18-month SBA agreed with Mexico in February 1995,in which 63 percent of the funds were disbursed in the first sixmonths. However, the duration of the Indonesian program wasthree years. Thus, one can argue that it was even more front-loaded than the Mexican program.


economic policies through a mild increase in the tar-geted fiscal surplus combined with a limit on basemoney expansion; (2) addressing fundamental weak-nesses in the financial sector, including the closure of16 banks (along with a partial deposit guarantee) as aprior action; and (3) undertaking structural reformsthat would enhance economic efficiency and trans-parency. In line with the judgment that Indonesia wasfacing a moderate case of contagion, the program as-sumed that growth would remain positive, though itwould decelerate to 5 percent in 1997/98 and 3 per-cent in 1998/99. Continuing the tight monetary policyalready in place, combined with limited foreign ex-change market intervention, was expected to bringabout an appreciation of the rupiah to a soft-edge tar-get zone of Rp 3,000 to Rp 3,500 per U.S. dollar,compared with the average of about Rp 3,600 per dol-lar over the period of the negotiation and about Rp 2,400 per dollar for the first six months of the year.Because of the staff assessment that the problems inthe private banking system were limited to a smallsegment, the program did not include a comprehen-sive bank restructuring strategy.

The initial market reaction was positive. The ru-piah strengthened strongly in the first two days afterthe program was announced, in part owing to coordi-nated foreign exchange market intervention withJapan and Singapore, but this rise was short-lived.Public confidence was undermined when the Presi-dent’s family publicly challenged the bank closureand one of his sons effectively reopened his closedbank by transferring assets to another bank he had ac-quired. The government also reversed earlier deci-sions on projects that were to be delayed or canceled,including a power project involving the President’sdaughter. Moreover, the government announced, ap-parently at the behest of the President, that no morebanks would be closed. This effectively reversed anearlier announcement by the Finance Minister thatbank managements must put their house in order orface the consequences. Instead, it ensured that thecentral bank would provide liquidity to keep banksafloat.

These sudden reversals of decisions that wereearlier seen as critical elements of the programcalled into question the commitment of the govern-ment and undermined the program’s credibility.There were sporadic runs on some of the privatebanks in mid-November, which progressively be-came widespread. The decision that banks wouldnot be closed meant that BI continued to provideunlimited liquidity support, leading to a loss ofmonetary control.7 By the end of November, base

14

14

15

16

17

18

19

20

21

0

20

40

60

80

100

120

2000

4000

6000

8000

10000

12000

14000

16000

18000

Figure 2.2. Indonesia: Key Economic Variables

Sources: Datastream; Bloomberg; and IMF database.

Exchange rate(In Indonesian rupiah per U.S. dollar)

Call and JIBOR rates(In percent)

Foreign exchange reserves(In billions of U.S. dollars)

Call rate

Three-month JIBOR

1997 1998

1997 1998

1997 1998

7Much of this liquidity support was later determined by officialaudits to have been used for questionable purposes.


money had exceeded the end-December target by 45percent and inflationary pressure began to build.Disagreement over policies between the close asso-ciates and family of the President on the one handand the reformist economic team and the IMF onthe other gave the impression that the governmentwas not committed to the program.

The changing nature of the crisis

The IMF became aware at a very early stage thatthe November program was not going well, and theManaging Director used a previously planned mid-November visit to draw the attention of PresidentSuharto to the reversal of the program’s early gains.He urged the President not to ease interest rates pre-maturely, in view of intense pressure on the rupiah,and also emphasized to the President the importanceof pressing ahead with reforms that would adverselyaffect his family and associates.8 The IMF staff alsopressed the authorities to raise interest rates, but tono avail.

The illness of the President in early Decemberadded a new dimension to the crisis. It not only re-minded the markets that succession might take placeearlier rather than later, but also changed the waypresidential decisions were made. As the Presidentwas confined to his private residence, those lackingclose ties to the family—including the economicteam—were effectively cut off from access to thePresident. Increasingly frequent riots directed at theethnic Chinese minority further weakened businessconfidence. By end-December, it was evident notonly that the IMF-supported program had failed butalso that the Indonesian crisis was much worse thanthose elsewhere in the region. The rupiah had depre-ciated beyond any of the East Asian currencies thatexperienced regional contagion and was continuingto fall.

The collapse of the program, and especially thebacktracking on individual reforms affecting vestedinterests close to the President, created a climate inwhich public attention focused on corruption andcronyism as defining characteristics of the economicsystem that had evolved in Indonesia. This aspect ofthe Indonesian economy had received increasing at-tention in the press and some academic writing buthad been underplayed in IMF surveillance, becauseof the prevailing institutional conventions that con-strained such governance issues to be discussed onlyobliquely. The Executive Board, reflecting prevail-ing opinion in some of the IMF’s major shareholdergovernments, pressed the staff to push for extensive

structural reform measures with greater specificityand a definite timetable.

As a mark of the importance assigned to resolvingthe growing crisis, the staff team in Indonesia negoti-ating the revised program in January 1998 was joinedby the First Deputy Managing Director. There wasalso a presence of senior officials from some of theIMF’s shareholder governments. With the heightenedfocus on governance problems, the strategy adoptedwas to strengthen structural conditionality as a signalof change in the belief that this was necessary to re-store confidence. The World Bank’s Jakarta office,which felt that it had played only a limited role in for-mulating the November 1997 program, was activelyinvolved in designing the conditionality on structuralreform in the revised program.

On January 15, 1998, in a widely publicized cere-mony attended by the Managing Director, PresidentSuharto personally signed a new letter of intent(LOI) outlining a strengthened structural reform pro-gram.9 Recognizing the ongoing decline in eco-nomic activity, the revised program relaxed the fiscaltargets for the 1998/99 budget from the surplus of1.3 percent of GDP envisaged in the November pro-gram to a deficit of 1 percent. The revised programalso included a much more detailed structural reformagenda, with a specific timetable for implementa-tion. However, the announced package did not in-clude any new strategy to deal with bank or corpo-rate debt restructuring. It was only at the end ofJanuary that the measures in the LOI were supple-mented by a comprehensive bank-restructuring strat-egy, including the introduction of a blanket guaran-tee on bank liabilities and the creation of anIndonesian Bank Restructuring Agency (IBRA) totake over banks facing liquidity problems. Initialmeasures to deal with corporate debt were also an-nounced at this later date.

The January program was never presented to theExecutive Board because it failed to halt the collapseof the exchange rate. The rupiah continued to depre-ciate to levels that made the revised budget targets al-most immediately irrelevant.10 The rapid expansionin the monetary base, to levels far exceeding programtargets, also continued. These failures were com-pounded by actions of the President in January indi-cating lack of commitment to the program. He was

15

8As reported by the Managing Director to the Executive Boardupon his return to Washington.

9The ceremony, intended to demonstrate the commitment ofPresident Suharto to the program, turned out to be a public rela-tions disaster. The much publicized photograph of the Presidentsigning the LOI under the gaze of the Managing Director becamethe subject of hostile comment as exemplifying a humiliating lossof sovereignty.

10By January 17, the rupiah had already reached Rp 5,000 perU.S. dollar, but there were news reports that unless the rupiah sta-bilized at Rp 4,000, there would be widespread corporate bank-ruptcies, which obviously would have systemic consequences.


reported to have indicated that (1) he would wage a“guerrilla war” against the IMF; (2) he would notnecessarily fulfill all agreed conditions in the LOI;and (3) he would adopt an “IMF-Plus” strategy cen-tered on a currency board arrangement (CBA). Theprotracted CBA controversy not only added uncer-tainty but also served to distract the Indonesian au-thorities and IMF staff from moving ahead with im-plementing reforms and regaining monetary control.

Amid the worsening crisis, President Suharto wasreelected for a seventh term in mid-March 1998 andappointed a new cabinet, which included his daugh-ter and close associates. Thereafter, there was achange in the government’s stance. With the rupiahtrading at around Rp 10,000 per U.S. dollar, the newEconomic Coordinating Minister and some close as-sociates of the President were able to convince himthat there was no alternative to vigorous implemen-tation of the IMF-supported program. Dialogue withthe IMF was reestablished, with a focus on regainingmonetary control and implementing structural re-forms to underpin recovery. As a result of pressurefrom the IMF and its major shareholders,11 as wellas with some opposition from within the govern-ment, the CBA proposal was finally abandoned anda revised program agreed in April 1998.

The April 1998 program differed from the Janu-ary program in two respects. The fiscal stance wassubstantially more relaxed, as by then the extent ofoutput collapse was more evident. There was also amajor change in the monetary stance. Interest rateswere raised sharply for the first time since the startof the IMF’s involvement. Monetary control was re-gained, as IBRA began taking over troubled banks,thus limiting the provision of BI liquidity support.Real interest rates remained negative, however, asinflation continued to soar. The IMF switched itsperformance criterion for monetary policy from basemoney (with partial adjustment for reserve loss) to amore conventional target for net domestic assets(NDA) in order to better control liquidity support.

However, political developments soon came to aboil, as fuel price increases introduced in early Maysparked civil unrest. This ultimately led to the resig-nation of the President on May 21.12 Vice PresidentHabibie took over the presidency in accordance with

the Constitution and he maintained continuity by re-taining the Economic Coordinating Minister, whowas responsible for implementing the IMF-sup-ported program. The rupiah continued to depreciatethrough June 1998, reaching Rp 15,250 per dollar,but it began to strengthen thereafter, and inflationbegan to stabilize.

A new program was negotiated with the govern-ment of President Habibie in August 1998, sup-ported under the Extended Fund Facility (EFF). The26-month EFF arrangement covered the remainingundrawn amount under the initial SBA, equivalent toUS$6.3 billion. The authorities took decisive mea-sures to deal with the banking sector problems andsuccessfully secured relief for the corporate sectorfrom foreign creditors and a rescheduling of externalpublic sector debt through the Paris Club.

The policies adopted after the spring of 1998brought Indonesia back from the brink of hyperinfla-tion, and led to a significant appreciation of the ru-piah. However, progress was uneven and bank andcorporate restructuring proved difficult, owing to thecontinued influence of powerful vested interests.Output continued to contract until the second half of1998, primarily because of a collapse in private in-vestment. The combination of the earlier massive ex-change rate depreciation and financial sector weak-ness, along with violence against the minorityChinese community, led to a collapse in businessconfidence which was reflected in a 33 percent de-cline in private investment in 1998/99. This in turnled to a decline of 13 percent in GDP, making the In-donesian downturn the most severe of all the EastAsian crisis countries.

Korea


The crisis in Korea occurred when most of thecountry’s key macroeconomic indicators—growth, in-flation, and the public sector deficit—pointed to aneconomy in robust health (Table 2.2). Real GDPgrowth was around 7 percent and was projected tocontinue its rapid pace in 1998. Inflation was low. Thebudget was expected to be in surplus and sovereigndebt, both domestic and external, was small relative toGDP. The current account deficit had widened in1996 with the decline in high-tech exports, but hadnarrowed again in the first half of 1997. The exchangerate did not seem overvalued by most measures.13

16

11From early March to early April, frequent visits in support ofthe IMF-supported program were made by political leaders andsenior economic officials from the IMF’s major shareholder gov-ernments, including Germany, Japan, and the United States.

12Internal documents indicate that the decision to accelerate thefuel price increase was against the advice of the IMF, which hadagreed a gradual approach with the economic team. A senior In-donesian official interviewed by the evaluation team explainedthat this action, taken against IMF advice, reflected the Presi-dent’s renewed confidence that he was fully in charge of the eco-nomic and political situation.

13Chinn (2000) concluded that the won was either 9.2 percent(using producer prices) or 2.4 percent (using consumer prices)undervalued relative to purchasing power parity in May 1997.An investment bank study cited by Goldfajn and Baig (1998)


There were structural weaknesses below the sur-face and some of them were identified during IMFsurveillance, but their seriousness, as a potential trig-ger for an external crisis, was not fully analyzed orstressed in surveillance reports. The large conglom-erates (chaebol) that dominated the economy werevery heavily leveraged, mostly through long-termborrowing from local banks.14 The banking systemalso suffered from serious problems. For manyyears, the banks’ lending decisions had been heavilyinfluenced by the policy choices of government offi-cials rather than by commercial considerations ofrisk and return. Bank prudential controls and theirregulatory enforcement were lax, particularly in theareas of provisioning, concentration of lending risks,and liquidity management. In the absence of effec-tive oversight by shareholders or creditors, managersof chaebol made excessive investments in “prestige”industries such as automobiles and semiconductors.The result was an accumulation of questionableloans on bank balance sheets. Because of limitationson capital account transactions (see the Korea coun-try annex), a large part of the banks’ liabilities tookthe form of short-term obligations denominated inforeign currencies.

There were some early warning signals in 1996and early 1997. A shock to the country’s terms oftrade (reflecting in part a fall in semiconductorprices) led to a widening of the current accountdeficit to 4.75 percent of GDP in 1996, much of it fi-nanced through short-term debt. Several chaebolwent bankrupt in the early months of 1997, culmi-nating in the failure of the Hanbo Group. In early1997, Korean banks began to experience some diffi-culty in rolling over their short-term credit lines withinternational banks, causing the Bank of Korea(BOK) to provide advances of foreign exchange totheir overseas branches. Nevertheless, the crisis con-ditions that hit Thailand and other Southeast Asianeconomies starting in June 1997 did not immediatelyspread to Korea, at least in a visible way.

Confidence began to be shaken more openly inAugust 1997, as evidence of problems in the bank-ing system grew and regional contagion from Thai-land became more evident. Some foreign bankschose not to renew credit lines to Korean institu-tions, not only because of the earlier worries overtheir health but also because they now found this tobe the easiest way to reduce their overall exposure tothe East Asian region. In an attempt to provide sta-bility, the authorities at the end of August announceda guarantee of foreign currency–denominated bankdebt. However, this guarantee was not backed by anyspecific measures approved by the National Assem-bly, so its legal status remained ambiguous.

IMF management and staff shared many of theseconcerns. The Article IV consultation mission thatvisited the country in October 1997 included a bank-

17

estimated that the won was 3.3 percent overvalued in June 1997.In October 1997, the IMF Article IV consultation mission deter-mined that the won’s real effective exchange rate was close toits five-year average.

14The debt-equity ratio for the manufacturing sector averagedsome 400 percent in 1997, and that for the top 30 chaebol morethan 500 percent (Chopra and others, 2002).

Table 2.2. Korea: Key Economic Indicators

1994 1995 1996 1997 1998 1999 2000 2001

Real GDP growth (percent) 8.3 8.9 6.8 5.0 –6.7 10.9 9.3 3.1Real private consumption (percent) 8.2 9.6 7.1 3.5 –11.7 11.0 7.9 4.7Real fixed investment (percent) 10.7 11.9 7.3 –2.2 –21.2 3.7 11.4 –1.8

Inflation (CPI, Dec./Dec., percent) 5.6 4.8 4.9 6.6 4.0 1.4 2.8 3.2Reserve money (end-period, percent) 9.2 16.3 –12.2 –12.5 –8.1 37.6 –0.9 16.3Broad money (M2, end-period, percent) 21.1 23.3 16.7 19.7 23.7 5.1 5.2 8.1

Current account balance (US$, billion) –3.9 –8.5 –23.0 –8.2 40.4 24.5 12.2 8.2Export growth (US$, percent) 16.8 30.3 3.7 5.0 –2.8 8.6 19.9 –12.7Import growth (US$, percent) 22.1 32.0 11.3 –3.8 –35.5 28.4 34.0 –12.1

External debt (US$ billion, end-period) 97.0 127.1 164.4 159.2 148.7 137.1 131.7 118.8International reserves (US$ billion, end-period) 25.6 32.7 33.2 20.4 52.0 74.0 96.1 102.8Exchange rate (W/US$, end-period) 789 776 845 1,695 1,204 1,138 1,265 1,314Real effective exchange rate1 95.2 99.1 97.3 62.5 76.0 80.7 81.3 82.3

Central government balance (percent of GDP) 0.1 0.3 0.0 –1.7 –4.3 –3.3 1.3 0.6

Sources: IMF database, supplemented by APD staff estimates; and Datastream.1End-period; average of 1990 = 100.


ing expert who examined carefully the vulnerabilitiesin the financial sector, to a degree that was unusual forsuch missions at that time. Nevertheless, the missionconcluded that Korea would avoid being seriously af-fected by the crisis then spreading through SoutheastAsia, provided that the authorities moved promptly toaddress the problems in the financial sector anddemonstrated a firm commitment to reform.15

The onset of the crisis

Two events in October 1997 helped to transformgrowing unease about Korea into a full-fledged crisis.One was the bankruptcy and government-supporteddebt rescheduling of the Kia Group. Investors, partic-ularly inside Korea, perceived the authorities’ actionsas excessively interventionist and, in view of the ap-proaching presidential elections in December, politi-cally motivated. This dented confidence in the au-thorities’ ability to pursue sound reform-orientedpolicies or to avoid potentially huge exposures toother troubled conglomerates. The second event wasthe failed speculative attack on the Hong Kong dollarand dramatic decline in the Hong Kong SAR stockmarket at the end of October. These events accompa-nied an increase in the perceived riskiness of Koreain the eyes of many international investors, particu-larly bank lenders. The Korean stock market fell bymore than a quarter in the month of October, and thewon came under increased pressure.

The authorities reacted by supporting the wonthrough intervention in the spot and forward foreignexchange market in the early weeks of November, andby moderately increasing overnight interest rates(from about 13.5 percent to 16 percent). The BOK ac-celerated its advances of foreign exchange to thebanks’ overseas branches. Despite these efforts, thewon weakened further. An increasing number of for-eign banks chose not to roll over their short-term loansto Korean institutions and instead reduced their creditlines. The maturity of existing lines was shortened,and interest rates on longer-term loans were raised.

Faced with the rapid depletion of foreign ex-change reserves, the authorities quietly contacted of-ficials from the United States, Japan, and the IMF inan attempt to secure emergency financing. At the au-thorities’ request, the Managing Director of the IMFsecretly visited Seoul for discussions with the Minis-ter of Finance and Economy and the BOK Governoron November 16. At this meeting, the Managing Di-rector indicated that the IMF would be willing toprovide support in exchange for appropriate policycommitments by the authorities.

In an effort to demonstrate its commitment to fi-nancial sector reform, the government also pressedthe National Assembly to approve a bill implement-ing some of the recommendations of the PresidentialCommission on Financial Reform. This bill was ef-fectively rejected when no action was taken duringthe final parliamentary session on November 17,prompting the resignation of the Minister of Financeand Economy the following day. His successor ini-tially denied the government’s intention to approachthe IMF, but on November 21, as conditions contin-ued to deteriorate, the authorities officially requestedIMF support. This announcement was followed byfurther dramatic declines in the currency and thestock market, and further downgrades from themajor credit rating agencies. The fact that the an-nouncement of the approach to the IMF came sosoon after the authorities had denied making such anapproach gave the impression of a government indisarray.

The IMF team that arrived in late November hadplanned to conclude an agreement on an SBA byaround mid-December. The team very soon discov-ered that the position was much worse than it ap-peared. Official foreign exchange reserve figures in-cluded advances that had been made to the overseasbranches of Korean institutions and were highlyilliquid. Korea’s “usable reserves”—calculated byexcluding deposits in overseas bank branches—wereonly around US$7 billion, which was very small inrelation to maturing short-term debt and other oblig-ations (Figure 2.3). Unless new financing was pro-vided quickly, Korea might have to impose a stand-still on foreign exchange payments, a move thatstaff, management, and key shareholders fearedwould have serious regional and international impli-cations. The program was negotiated and agreed inrecord time, under the exceptional procedures of theEmergency Financing Mechanism.16

The December 1997 program

On December 4, the IMF’s Executive Board ap-proved the program to provide about US$21 billionunder a three-year SBA.17 The disbursements were to

18

15The staff report for the 1997 Article IV consultation was pre-pared but never presented to the Executive Board, as it was over-taken by events.

16The Emergency Financing Mechanism, introduced in 1995following the Mexican crisis, is a set of exceptional proceduresfor close communication with the Executive Board when man-agement intends to bring a proposed arrangement to the agendamore quickly than under the usual procedures.

17SDR 15.5 billion, equivalent to 1,939 percent of Korea’squota. This was a record size in relation to quota, reflecting thefact that Korea’s quota was small in relation to its weight in theworld economy. After the Supplemental Reserve Facility (SRF),then under consideration by the Executive Board, was put inplace, disbursements were provided through that channel. TheSRF was approved on December 17, 1997.


be substantially front-loaded, with US$5.6 billionavailable immediately and an additional US$5.6 bil-lion released during the following seven weeks. In ad-dition, the World Bank and the ADB were to lendUS$14 billion in support of restructuring efforts in thefinancial sector, and a group of bilateral donors indi-cated that, if necessary, they would be willing to lenda further US$20 billion as a “second line of defense.”

The second line of defense was a controversial el-ement in the program. The balance of payments pro-jection in the approved program did not actuallyshow that this financing would be necessary but, aspointed out in the Korea country annex, this presenta-tion was a relatively late decision responding to theinstructions conveyed to the staff that the programshould not rely on this source of financing. The stafftherefore arbitrarily reduced the financing gap by in-creasing the assumed rollover rate for short-term debtto unrealistically high levels. In this respect, the pro-gram as presented was clearly underfinanced, al-though this fact was not explicitly acknowledged.

The program incorporated a tight monetary pol-icy, a small fiscal surplus, a comprehensive strategyto restructure, recapitalize, and reform the financialsector, and measures to reform corporate gover-nance, trade, and the labor market. Nine of the mosttroubled merchant banks were closed, with their de-positors protected by a newly established deposit in-surance scheme. Seoul Bank and Korea First Bank,the two most troubled of the large commercialbanks, were to be placed under “intensive supervi-sion” and were required to submit a rehabilitationplan within four months.

The initial market response was moderately posi-tive, but after a few days the situation took a turn forthe worse.18 Confidential program documents,leaked to the Korean press, revealed the critical dataon Korea’s reserves and short-term debt, which theIMF and the authorities had been keeping from themarkets for fear of damaging confidence. The docu-ments showed that usable reserves were even lowerthan the market had feared and were decliningrapidly. The political environment also created un-certainty since elections were being held. The threemajor presidential candidates had stated their sup-port for the program at the time it was announced,but subsequent statements led many to question theircommitment. As the market absorbed these develop-ments, rollovers of short-term debt continued to fall,and the won weakened further, falling by 39 percentin the two weeks after the program was approved(see Figure 2.3).

19

700

900

1100

1300

1500

1700

1900

2100

0

10

20

30

40

50

10

15

20

25

30

Figure 2.3. Korea: Key Economic Variables

Sources: Datastream; IMF database; and Bank of Korea.

Exchange rate(In won per U.S. dollar)

Overnight call rate(In percent)

Foreign exchange reserves(In billions of U.S. dollars)

1997 1998

1997 1998

1997

Usable reserves

1998

18The won moderately appreciated from W 1,249 to W 1,156per U.S. dollar from December 4 to December 5, followed by arenewed slide.


After winning the presidential election on De-cember 18, President-elect Kim Dae-jung an-nounced his determination to carry out the IMF-sup-ported program and his subsequent actions helpedbuild credibility. A transitional team, including rep-resentatives of the outgoing and incoming adminis-trations, began to negotiate a strengthened programinvolving accelerated disbursement of funds and amore aggressive timetable for restructuring the fi-nancial system.

The rollover agreement

The IMF staff and management had earlier con-veyed to the IMF’s major shareholders that, in the ab-sence of sufficient financing, it might be necessary toconsider some initiative to persuade banks to rollover lines of credit. This was not accepted at the timebut, with the evident failure of the earlier strategy, theauthorities in the IMF’s major shareholder govern-ments began to contact their banks and urged them toannounce jointly that they would maintain theircredit lines to Korea. It was hoped that a joint publicannouncement by the largest international bankswould stabilize markets by eliminating the fear thatKorea would soon run out of foreign exchange.

Three initiatives—the strengthened reform pro-gram, the accelerated disbursements, and the coordi-nated private sector rollover of short-term debt—were announced on December 24, 1997. The IMFplayed a useful role in the more concerted approachto maintaining private sector exposure by setting upsystems to monitor daily exposure and facilitating in-formation exchange among the major governments.

Markets remained volatile for several weeksthereafter but, in retrospect, December 24 proved tobe the turning point of the Korean crisis. The inter-national banks by and large kept to their rolloveragreement, which was renewed in mid-January 1998and extended to the end of March. Shortly thereafter,the banks agreed to exchange their short-term claimsfor sovereign debt of between one and three yearsmaturity. With the success of the rollover and matu-rity extension and moves by the authorities to imple-ment the financial and corporate reform programs,the market’s view of Korea improved dramatically.The won recovered from an all-time low of W 1,965to the dollar on December 24, 1997, to a range of W 1,600–1,800 in January 1998, W 1,400 by the endof March, and W 1,200 at the end of the year. InApril, Korea issued US$4 billion in internationalbonds, cementing the country’s return to interna-tional capital markets. The IMF facility would neverbe fully drawn, and would eventually be paid backahead of schedule.

The macroeconomic effects of the crisis turnedout to be severe but short-lived. Real GDP declined

by 6.7 percent during 1998, and unemployment roseto 7.4 percent by year-end. Yet signs of recoverywere already visible by the end of 1998 and growthrebounded to 10.9 percent in 1999, belying fears ex-pressed by many that the recovery would be L-shaped.19 The authorities moved quickly to rebuildreserves, which totaled US$52 billion at the end of1998. Following the peak in early 1999, unemploy-ment began to decline steadily, and the growth ofreal wages picked up strongly.

In retrospect, the Korean experience can be char-acterized as one in which the original program failedbecause it was underfinanced, given the absence of acoordinated rollover agreement and the immediatenonavailability of the second line of defense. How-ever, the basic macroeconomic stance of the programwas sufficiently credible to restore confidencequickly, once the immediate liquidity pressure waseased. The strong political commitment of the newgovernment of President Kim to the adjustment pro-gram, which was in sharp contrast to what was seenin Indonesia, was critical in restoring confidence.

Brazil


The origins of the Brazilian crisis of 1998–99 can be traced to the set of policies adopted followingthe start of the Real Plan, a stabilization programlaunched in 1994 (see Box A3.1 in the Brazil countryannex). High inflation was successfully reduced, butother problems emerged both as an inherent outcomeof the disinflation strategy and as a result of policy de-cisions. Fiscal deficits widened sharply, as a result ofasymmetric indexation of expenditures and revenue(which increased the nominal value of expendituresfaster than that of revenue) and the loss of controlmechanisms that had relied on high inflation to erodethe real value of budgeted expenditures. The mix ofloose fiscal policy combined with tight monetary pol-icy led to a real appreciation of the currency and, cou-pled with a strong increase in domestic demand re-sulting from initial rapid credit expansion and the lossof the inflation tax, to the emergence of large currentaccount deficits (Table 2.3).

The policy mix had implications for the sustain-ability of fiscal policy. High interest rates had a severe impact on state and municipal government accounts and, despite moderate economic growth,

20

19The IMF’s quarterly review, dated November 18, 1998, pro-jected that Korea’s GDP would decline by 1 percent in 1999.Likewise, the World Bank’s projection for 1999, released in De-cember 1998, was for moderate growth of 1 percent (World Bank,1999a).


caused the public sector net debt to increase to 34.4percent in December 1996 from 30.0 percent ofGDP in December 1994. By early 1998, some acad-emic observers saw the fiscal stance as unsustainablein terms of making the public debt-to-GDP ratioconverge to some predetermined level.20

Another consequence of the policy mix was anovervaluation of the real. Following the nominal ap-preciation to R$0.84 per U.S. dollar in late 1994, thereal was managed in a narrow range around R$0.85from October 1994 to March 1995, when a crawlingpeg was adopted with a band. Although inflationcame down dramatically during the early months ofthe Real Plan, it remained higher than that in Brazil’smajor trading partners. According to a contemporaryIMF staff estimate, the real appreciated in real effec-

tive terms by 33 percent between June 1994 andFebruary 1995, in terms of the general price index.While the introduction of a new currency under theReal Plan made it difficult to measure Brazil’s realexchange rate, there was a broad consensus that thereal was overvalued throughout the post-stabiliza-tion period.

The IMF’s surveillance in the precrisis period cor-rectly identified the overvaluation of the real andother vulnerabilities associated with Brazil’s policymix in the post-stabilization era and argued for fasterexchange rate depreciation. The IMF’s leverage waslimited during the precrisis period and had little im-pact on policy but, from about 1997, dialogue be-tween the IMF and the Brazilian economic teambegan to improve. As a way to improve the relation-ship, the IMF was actively engaged in technical as-sistance work in Brazil, particularly in the areas ofdebt management, fiscal statistics, and fiscal account-ing. In the process, however, there was increasing ac-commodation of the Brazilian position that down-played the possible overvaluation of the currency.

After mid-1997, turbulence in the global econ-omy and presidential election politics limited the op-tions of the Brazilian government in addressing fis-

21

Table 2.3. Brazil: Key Economic Indicators

1994 1995 1996 1997 1998 1999 2000 2001 2002

Real GDP growth (percent) 5.9 4.2 2.7 3.3 0.1 0.8 4.4 1.4 1.5Real general consumption

(percent) 5.5 6.9 4.6 3.1 0.4 1.2 2.5 4.2 . . .Real fixed investment (percent) 13.9 3.2 –3.7 6.5 –0.7 –3.2 6.5 5.2 . . .

Inflation (IPCA, Dec./Dec., percent) 916.6 22.4 9.6 5.2 1.7 8.9 6.0 7.7 12.5Base money (Dec./Dec.,

percent, in real) 3,322.4 22.6 –8.7 60.8 23.1 23.6 –1.5 11.7 37.6Broad money (M2, Dec./Dec.,

percent, in real) 1,196.7 34.8 5.6 27.0 6.3 7.8 3.3 13.1 24.0

Current account balance (US$, billion) –1.8 –18.4 –23.5 –30.5 –33.4 –25.3 –24.2 –23.2 –7.8

Export growth (US$, percent) 12.9 6.8 2.7 11.0 –3.5 –6.1 14.7 5.7 3.7Import growth (US$, percent) 31.0 51.1 6.8 12.0 –3.4 –14.7 13.4 –0.4 –15.0

External debt (US$ billion,end-period) 148.3 159.3 179.9 200.0 241.6 241.5 236.2 209.9 212.9

International reserves (US$ billion,end-period) 38.8 51.8 60.1 52.2 44.6 36.3 33.0 35.9 37.8

Exchange rate (R$/US$, end-period) 0.844 0.971 1.039 1.116 1.208 1.788 1.955 2.320 3.533Real effective exchange rate1 137.7 141.6 144.1 145.6 133.0 96.8 98.2 89.8 68.4

Public sector borrowing requirement(percent of GDP) 44.3 7.1 5.9 6.1 7.9 10.0 4.6 5.2 4.7

Primary balance (percent of GDP) 4.3 0.3 –0.1 –1.0 0.0 3.2 3.5 3.7 3.9Net public debt (percent of

valorized GDP)2 30.0 30.6 33.3 34.4 41.7 48.7 48.8 52.6 56.5

Sources: IMF database; Datastream; and Central Bank of Brazil.1Central Bank, INPC-based, end-period, June 1994 = 100.2Valorized GDP is expressed in prices of December of each year.

20For example, Bevilaqua and Werneck (1998a) presented ascenario in which the debt-to-GDP ratio would explode from lessthan 40 percent in 1998 to over 55 percent by 2002. They empha-sized the difficulty of growing out of fiscal problems because ofthe growth-inhibiting effect of the tight fiscal stance through pub-lic investment deficiencies and a likely gradual reduction in inter-est rates during transition to tighter fiscal policy (see also Car-doso and Helwege, 1999).


cal and exchange rate issues. Following the onset ofthe Asian crisis in the fall of 1997, the real cameunder intense pressure, which prompted the authori-ties to raise interest rates to defend the exchange rateand to intervene heavily in the spot and futures ex-change markets. They also announced a package offiscal adjustment measures. At this time, the IMF ex-plored with the Brazilian authorities the possibilityof supporting the package with an IMF arrangement.The authorities, however, were unwilling to seek anarrangement at this stage, in part because they fearedthat it might weaken domestic political support forthe measures.

Early 1998 saw strong capital inflows, includingforeign direct investment (FDI), and short-term flowsattracted by the opportunity to arbitrage between highdomestic and low international interest rates, giventhe widespread presumption that the crawling pegwould be maintained at least until the presidentialelection in October. Reserves increased from US$52billion at the end of 1997 to US$75 billion in April1998 (Figure 2.4). However, markets also became in-creasingly concerned about the fiscal outlook as theadministration’s implementation of the fiscal packagefaltered in the face of electoral pressures.

In the summer, market pressures on Brazil greatlyintensified, following the Russian crisis and the diffi-culties of Long-Term Capital Management in theUnited States, which led to a sharp decrease in liquid-ity in international capital markets. Spreads onBrazil’s external debt rose steeply along with thosefor most other major emerging market borrowers. Thecentral bank doubled interest rates in early September(Figure 2.4), but failed to stem capital outflows.

The December 1998 Program

Preliminary work began on the main componentsof an IMF-supported program in early September1998, based on Brazilian proposals which empha-sized fiscal tightening.21 As Brazil still had overUS$50 billion in foreign exchange reserves, theBrazilian authorities were initially interested in aprecautionary arrangement or a Contingent CreditLine (CCL), which was then in the process of beingformulated.22 However, this gave way to the viewthat, in order to convince the markets, real moneywas needed.

22

1.0

1.2

1.4

1.6

1.8

2.0

2.2

2.4

10

20

30

40

50

60

70

80

10

20

30

40

50

60

70

80

Exchange rate(In real per U.S. dollar)

Selic rate(In percent)

Foreign exchange reserves(In billions ofU.S. dollars)

1997 1998 1999

1997 1998 1999

1997 1998 1999

Figure 2.4. Brazil: Key Economic Variables

Sources: Datastream; and IMF database.21In late September, just before the presidential election, Presi-

dent Cardoso gave a high-profile speech outlining the tough fiscalmeasures that would need to be undertaken early in his secondterm.

22CCLs are designed to provide, in the absence of an existingneed to use IMF resources, a precautionary line of credit to amember country with an agreed package of policies.


Contacts intensified after the presidential electionin early October, in which President Cardoso was re-elected for a second term. The most controversialissue was the Brazilian economic team’s desire tomaintain the crawling peg, despite the fact that therewas a widely held perception in the markets that thereal was substantially overvalued. The IMF staffshared this view and had indicated as much in sur-veillance reports, though its estimates of the extentof overvaluation were moderated over time and wereconsiderably lower than those of most market partic-ipants. The Brazilian economic team, on the otherhand, believed that any overvaluation was modestand that the real appreciation that might have oc-curred was offset by strong productivity gains.Moreover, the team held a strong belief in the needto maintain the peg as a nominal anchor. Given thehistory of inflation in Brazil, they feared a rekindlingof inflationary expectations and reindexation, if thepeg was let go.

A preliminary understanding between the IMFand the authorities had already been reached duringthe Annual Meetings that the existing exchange rateregime could be maintained, provided that reservesdid not fall too low. Nevertheless, the IMF staff andmanagement pressed the authorities for a fastermonthly depreciation, a wider band, or both, toachieve greater real depreciation within the crawlingpeg regime. However, the authorities remainedstrongly opposed to any modification of the regime.The Brazilian position was supported by some majorshareholders, who were concerned that a change inthe exchange rate regime at that time might have se-vere regional and global consequences. Many mem-bers of the IMF’s Executive Board, however, re-mained unconvinced of the sustainability of thecrawling peg, and some expressed dissatisfactionthat there had not been a more comprehensive dis-cussion, in the Board, of alternative options (see theBrazil country annex).

The program, approved by the Board in early De-cember 1998, envisaged maintenance of the existingexchange rate regime, but did not specify any imme-diate change in the rate of crawl.23 The possibilitythat exchange rate policy might be modified at sub-sequent program reviews was left open. The pro-gram included strong, front-loaded fiscal adjustment(amounting to over 4 percent of GDP) and a commit-ment to supportive monetary policy. Conditionality

on structural measures was limited mainly to criticalareas in public finance and financial sector regula-tion. There was a very limited effort to coordinatethe actions of private creditors, as the authoritiesfeared that any stronger action would likely have ad-verse consequences for future flows. They onlysought the voluntary support of private lenders forthe program in meetings in a number of internationalfinancial centers. There was a generally favorable re-sponse to these requests, but rollover rates for inter-national bank credits averaged only 65–70 percent.

Collapse of the peg and the revised March 1999 program

The IMF’s decision to support the crawling peginvolved significant risks. The business communitywas not entirely in favor of the peg and had beenputting pressure on the President to correct the over-valuation of the currency. Moreover, the IMF deci-sion did not fully impress the markets, and some in-ternational investors took this as an opportunity topull out of Brazil, if they had not done so already.General skepticism prevailed in the media coverageof the IMF decision. Contemporary Brazilian ob-servers doubted “if the package . . . [would] sufficeto prevent a devaluation” (Garcia and Valpassos,1998, p. 39).

Soon after the program was approved and an-nounced to the public, the exchange rate came underrenewed pressure following setbacks in securingcongressional approval for some of the fiscal mea-sures in the program. Interest rates were also easeddespite IMF misgivings and contrary to an under-standing that there would be consultation with theIMF on interest rate policy, and the program’s NDAtarget was exceeded by a wide margin. Fiscal ten-sions between the federal government and the statessurfaced, and in early January 1999 the governor ofthe state of Minas Gerais publicly stated that therewould be a moratorium of 90 days on state debt pay-ments. In mid-January 1999, the Central Bank Gov-ernor, who had been adamantly opposed to anychange in the exchange rate regime, was replaced bya new Governor, who then introduced a complex ex-change rate system incorporating a wider exchangerate band in an attempt at a smooth exit from thecrawling peg (see the Brazil country annex for de-tails). IMF management was only informed of thisdecision the night before the action was to takeplace, and its efforts to dissuade the authorities wereunsuccessful. After losing about US$14 billion of re-serves in two days, Brazil moved to a de facto float-ing exchange rate regime on January 15.

The collapse of the peg signaled that the originalprogram had clearly failed in its central objective. In

23

23The financing package supporting the program provided IMFresources of SDR 13.6 billion (about US$18 billion, or 600 per-cent of quota). In addition, bilateral loans arranged through theBank for International Settlements (BIS) and a bilateral loan fromJapan amounted to a further US$15 billion, and the World Bankand the Inter-American Development Bank (IDB) offered addi-tional loans of about US$4.5 billion each.


an emergency weekend meeting between the Brazil-ian economic team and IMF management in Wash-ington, it was decided that the best policy was tofloat the real, effective January 18. Both sides thenbegan to revise the program in the light of thechange in the exchange rate policy. To arrest and re-verse the depreciating trend, the IMF encouraged theCentral Bank to raise interest rates sharply. An in-crease in interest rates to nearly 40 percent at thestart of February was followed by a further increasein the overnight rate to 45 percent in March.

A revised program was agreed in March 1999.The new program, which pioneered the use of infla-tion targeting as the basis for conditionality in IMF-supported programs, also tightened fiscal policy fur-ther, with the aim of ensuring debt sustainability.The indicative target of 2.6 percent of GDP for theprimary balance in 1999 was replaced by a target of3.1 percent as a performance criterion in the revisedprogram. Major international banks voluntarilyagreed to maintain trade and interbank lines toBrazil at end-February levels for six months. TheIMF played a facilitating role in this by monitoringcredit lines and participating in “road shows” de-signed to explain the IMF-supported program to theinternational banks. Against the background of highinterest rates, stepped-up sales of foreign exchangein the market, and greater market confidence gener-ally, the exchange rate stabilized. This allowed inter-est rates to be eased relatively quickly.

Progress was also made on structural reforms, al-though the pace was slower than envisaged in theprogram. While there were no structural perfor-mance criteria, a number of structural benchmarkswere included in the program, most notably submis-sion to Congress of draft legislation for the FiscalResponsibility Law (by end-December 1998) and itsenactment (by end-December 1999).24 In the event,the Fiscal Responsibility Law was not passed until2000, but it contributed significantly to fiscal disci-pline by establishing a general framework to guidebudgetary planning and execution, including the fi-nancial relationship between the federal and stategovernments. Through the program, the IMF playeda constructive role in Brazil’s transition to a moredisciplined fiscal regime.

The revised program of March 1999 was unex-pectedly successful in terms of its impact on theprice level and output. A takeoff in inflation, whichwas greatly feared following the depreciation, wasaverted, and consumer price inflation was held at 9percent during 1999. Stronger-than-expected exter-

nal financing, particularly larger FDI inflows, facili-tated a smoother external adjustment. In contrast topessimistic projections of a decline in GDP of 3.8percent in 1999, real output grew by 0.8 percent. Thefinancial sector weathered the crisis well, in partowing to the extensive hedge against depreciationprovided by the public sector, which also bore thebrunt of temporarily increased interest rates.

Given strong ownership by the authorities, sharplyhigher primary fiscal surpluses were achieved in linewith program targets. However, the program did notachieve its central declared aim of reducing the ratioof net public debt to GDP, in large part owing to thegreater-than-expected depreciation of the currency,which increased the domestic currency value of exter-nal and foreign currency–linked domestic debt. Therewas also unexpected slowdown in growth in 2001, be-cause of an electricity crisis.

The financial support package was largely repaidahead of schedule, and the arrangement was treatedas precautionary from March 2000. Before the pro-gram could be completed, however, concerns overthe external environment, including developments inArgentina, led the authorities to draw again on thearrangement and to request a further SBA. Thearrangement was canceled in mid-2002, and re-placed by a new arrangement, as worries over thecontinuity of policy following the approaching elec-tions led to a large increase in spreads on Brazil’s ex-ternal debt and exchange rate depreciation. Thesefactors in turn contributed to renewed concerns overthe sustainability of Brazil’s public debt burden.

While the public image of the December 1998program is largely colored by its failure to defendthe crawling peg, the IMF’s overall strategy can bejudged to have been a success in many respects. Al-though contrary to the program’s own pessimisticexpectations, the adverse impact of the crisis on out-put and prices was limited. Through the program,which was revised to take account of the floating ofthe real, the IMF facilitated Brazil’s transition to amore disciplined fiscal regime and a new monetaryregime based on inflation targeting. One aspect ofthe December program, however, proved to be asource of later vulnerabilities: it maintained the largetransfer of exchange rate risk from the private to thepublic sector, which had resulted from issuing alarge amount of foreign currency–linked debt. Thecentral declared objective of fiscal adjustment—toreduce the ratio of public debt to GDP—was under-mined by the large fiscal cost—amounting to asmuch as 10 percent of GDP—of providing thishedge and defending the crawling peg. Subse-quently, the exchange rate depreciated more than an-ticipated, while the IMF’s efforts to encourage theauthorities to reduce the proportion of exchangerate–linked debt had limited impact.

24

24See Box 4.1 in Chapter 4 for the operational difference be-tween structural performance criteria and structural benchmarksin IMF-supported programs.

In this chapter, we present our assessment of IMFsurveillance in the precrisis period in the countries

covered in this evaluation, focusing on two aspects:how informative was surveillance about the risksthat each country faced, and how much impact did ithave on the authorities’ policies.

The Diagnosis Role of Surveillance

Predicting a crisis accurately is inherently diffi-cult, especially in circumstances where there arepossibilities of multiple equilibria. Surveillanceshould therefore be evaluated not in terms of its abil-ity to predict the crisis, but rather in terms of effec-tiveness in identifying the vulnerabilities that couldlead to a crisis. Judging from this perspective, ourevaluation indicates that the IMF staff was, in vary-ing degrees, aware of most of the vulnerabilities inall three cases. Surveillance was particularly effec-tive when the vulnerabilities were of macroeco-nomic nature, reflecting the fact that the focus ofIMF surveillance during the precrisis period was onmacroeconomic issues. The extent of the problemsin some cases, however, was seriously underesti-mated and the surveillance reports failed to link per-ceived vulnerabilities to an accurate assessment ofthe risk and the likely dynamics of a crisis.

In Indonesia, staff reports in the period before thecrisis noted that the weakness of the banking sectorand the buildup of external debt had increased thecountry’s vulnerability to external shocks. But thetrue extent of problems in the banking sector, and thedegree to which financial system weaknesses hadcontributed to the poor quality of private investment,were not fully appreciated. While the growth of totalexternal debt was noted, the magnitude of short-termdebt and the associated vulnerability were not ade-quately recognized. The IMF also did not focus at-tention sufficiently clearly on the increasingly ram-pant corruption and cronyism that characterized theIndonesian economy. Admittedly, this phenomenonwas difficult to document using the usual sources onwhich surveillance reports rely, but it was a subjectof growing concern in academic writing and in the

press, as documented in the Indonesia countryannex. Downplaying of these issues may have re-flected the prevailing approach to governance issuesat the time, but it clearly led to an inadequate appre-ciation of underlying vulnerability.

In Korea, while many of the vulnerabilities thatwould later contribute to the crisis were identified,the overall assessment turned out to be excessivelyoptimistic. In large part, this was due to the poorquality of the data provided by the authorities onbank loan quality, reserves, and external debt. How-ever, the data that existed, such as those availablefrom the Bank for International Settlements (BIS),were also not adequately utilized.1 At the same time,the surveillance team (in common with most ob-servers in the public and private sectors at the time)was overly sanguine in its interpretation of the data.In particular, there was insufficient appreciation ofthe risks introduced by Korea’s financial liberaliza-tion strategy, which encouraged the buildup of short-term external borrowing by weak, poorly regulatedfinancial institutions. Some internal staff communi-cations raised concerns over the level of short-termexternal debt. The maturity structure of external debtwas an issue raised in discussions with the authori-ties, but efforts to clarify these concerns, for exam-ple by pressing the authorities more forcefully forthe appropriate data, do not seem to have been pur-sued until the crisis had already broken out.

In contrast with Indonesia and Korea, surveil-lance for Brazil was essentially accurate in assessingmost of the elements of the eventual crisis. From asearly as 1995, the staff had recognized the vulnera-bility of the crawling peg to a shift in market senti-ment. The staff was critical of the loose fiscal stanceand consequent excessive burden on monetary pol-icy, while acknowledging the political obstacles to


25

CHAPTER

3

1While coverage was imperfect, both residency-based and na-tionality-based data on loans extended by banks based in majorcountries were available from the BIS. On the borrowing side, thedata were classified according to the country of residence andtherefore excluded, in the case of Korea, the liabilities of Koreanoverseas affiliates. Some of this information, however, was avail-able from the U.K. and U.S. national sources.

CHAPTER 3 • PRECRISIS SURVEILLANCE

tightening fiscal policy. Over time, the staff increas-ingly downplayed the degree to which the real wasovervalued relative to historical levels, but continuedto advocate accelerating the rate of downward crawl.Until 1998, however, relatively little attention waspaid to capital account issues.

The following shortcomings were found to becommon to surveillance exercises in two or all threeof the countries studied:

• In Indonesia and Brazil, staff reports for ArticleIV consultations were often insufficiently can-did about potential vulnerabilities, which wereraised in a more pointed manner in internal doc-uments and the internal review process—reflect-ing a tendency to give the authorities the “bene-fit of the doubt” on issues where assessments ofrisk were inevitably of probabilistic nature. In-ternal incentives, which were generally not seento reward candor if it led to contentious relationswith the authorities, contributed to this tendency(see below and also Chapter 5).

• In Indonesia and Brazil, surveillance reportswere not sufficiently frank in bringing to the at-tention of the Executive Board political factorsthat might influence the ability of the authoritiesto implement agreed policy measures. In thecase of Indonesia, this reflected a general hesi-tancy at that time by the Board to delve deeplyinto governance issues.2

• In all three cases, crucial data, particularly on thesize and composition of external debt and on thehealth of the financial sector, were not availableor could not be relied on. In some cases, this wasbecause key information was withheld or not col-lected by the authorities. In other cases, availabledata were not adequately utilized.

• In Indonesia and Korea, not enough attentionwas paid to the underlying fragility of the finan-cial sector and the likely impact on capitalflows. While some in the IMF expressed con-cerns in these areas, particularly in internal re-views and through multilateral surveillance ex-ercises (mainly, World Economic Outlook andInternational Capital Markets reports), theseconcerns were not fully incorporated into the as-sessments contained in staff reports for ArticleIV consultations.

• In Indonesia and Korea, balance sheet risks, in-cluding those arising from currency and matu-rity mismatches, were not sufficiently explored.

This shortcoming was corrected to some extentin Brazil, as the staff correctly analyzed the bal-ance sheet effects of possible devaluation.

• In all three cases, but particularly in Korea, thepossibility that a shock elsewhere in the interna-tional financial system could be transmitted tothe country in question through global portfolioshifts or changes in risk tolerance (as opposed tomore conventional channels such as trade links)was recognized, but surveillance failed to ex-plore the consequences for the specific countrybeing analyzed if such transmission were tooccur.

• In Korea and Indonesia, the IMF drew too muchcomfort from analyses indicating that the ex-change rate was not overvalued or was onlymoderately so. The possibility of multiple equi-libria, that is, the possibility that a change inmarket sentiment could cause a sharp deprecia-tion even without a major initial overvaluationwas not investigated. In Brazil, the IMF dididentify significant overvaluation but moderatedits own assessment over time.

• In all three cases, there was not generallyenough engagement with the private sector, ei-ther regarding its analysis of country conditionsor regarding factors influencing their globalportfolio allocations and appetite for risk. (Inthis respect, the dialogue with the private sectorin the case of Brazil seems to have been greaterthan in the Asian cases.) Since country-level di-alogue was necessarily concentrated on a smallgroup of senior economic officials, the staff didnot always recognize the broader range of viewsprevalent among current and potential policy-makers which would condition policy choices.

• In all three cases, more effort was put into esti-mating the likelihood of shocks occurring thaninto exploring the consequences if a shock wereto occur. This reflected an understandable desireon the part of staff members to present manage-ment and the Executive Board with a “bottomline” risk assessment as an output of the surveil-lance process. Yet, once a crisis had begun, thestaff’s previous characterization of a crisis as“likely” or “unlikely” in a given country undergiven circumstances was not of much use to de-cision makers at the IMF or its shareholder gov-ernments. While the surveillance reports pro-duced for the three cases studied here containedelements of a stress test–oriented analysis, anddid lead to efforts to improve data collection onareas of potential vulnerability, there were alsomany topics about which the staff found itselfill-prepared once the crisis had begun, both ana-

26

2As discussed in the section “Structural Conditionality” inChapter 4, the Executive Board adopted a revised approach togovernance issues in mid-1997.

Chapter 3 • Precrisis Surveillance

lytically and in terms of the availability of cru-cial information.

The Impact of Surveillance

Even where vulnerabilities were identified, theIMF’s surveillance in the period leading up to the cri-sis tended to have little practical influence on criticalpolicies and was generally not successful in promot-ing remedial action to address these vulnerabilities.This should not be interpreted necessarily as a short-coming. As previous internal and external reviewshave noted, IMF surveillance is only one influence oneconomic policies in member countries, and generallynot the predominant one.3 While it is too much to ex-pect IMF surveillance to achieve more than it is capa-ble to do, evidence from the three case studies is nev-ertheless useful in pointing out several factors thatcontributed to the limited impact of surveillance.

First, surveillance suffered from a reluctance tostate candidly difficult or embarrassing facts andviews, for fear that this would alarm the markets orgenerate conflict with national authorities. As docu-mented in the country annexes, the evaluation teamhas identified a number of occasions when importantconcerns were raised in internal documents or dur-ing the internal review process, but these issues werenot adequately reflected or were discussed only in anoblique manner in the documents later prepared forthe Executive Board (e.g., concerns raised by the Re-search Department on banking sector problems inKorea, or identification by MAE of serious gover-nance problems in the Indonesian banking sector).Interviews with staff members suggest that there wasa perception that frank, critical assessments, in situa-tions where information was inevitably partial andrequired an element of judgment, would not receivebacking from management or the Board should theauthorities object strongly.4 Even if members of thestaff or the Board knew of and discussed these issuesoff-the-record, the fact that these discussions werenot contained in written reports hindered effectivediagnosis and decision making and made it difficultto transfer country-based knowledge among staffmembers.

Second, in some cases country authorities werenot receptive to the IMF’s policy advice, typicallyreflecting domestic political constraints (e.g., dereg-

ulation in Indonesia). When an issue of highly sensi-tive nature was involved, such as exchange rate pol-icy in Brazil, there were honest differences of view.

Third, the impact of IMF advice was necessarilylimited when no program was involved. This meantthat the IMF’s influence was particularly limited bythe general strength of capital flows to emergingmarkets in the period preceding the crisis. The IMF’sviews did not figure strongly until the crises were athand.

Fourth, information weaknesses affected not onlythe quality of surveillance, but also its impact. As a1999 review of surveillance by an IMF-commis-sioned group of outside experts (Crow and others,1999, henceforth “the Crow Report”) noted, the ab-sence of hard numerical evidence on financial sectorweaknesses, reserves, and external debt limited thestaff’s ability to make a forceful case to the authori-ties about the vulnerabilities in Korea. The same alsoapplied to Indonesia, particularly in the area of bank-ing data.

The Role of Transparency

In practice, few of the IMF’s assessments duringthe precrisis period entered the public domain, apartfrom generally muted references in multilateral sur-veillance reports such as the World Economic Out-look and International Capital Markets reports. Onereason is that the IMF was wary of the risk of precip-itating a crisis through too public a discussion of vul-nerabilities. Furthermore, there is a potential conflictbetween the IMF’s role as “confidential advisor” tothe authorities and its role as an information providerand “watchdog” for the international financial com-munity, if its assessments are published.

Although it is not possible to test the propositionrigorously, the evaluation team is of the view that theIMF’s influence would have been strengthened ifstaff reports for Article IV consultations had beenpublished, so as to influence the public policy debateand promote better risk assessment by private in-vestors and lenders.5 The vulnerabilities that broughtabout all three crises were widely recognized, if gen-erally underappreciated, in the public and privatesectors, so an open discussion would not have comeas much surprise to the markets. Instead, the fact thatthe IMF did not publicize its concerns may havecontributed to the market’s tendency toward exces-sive optimism. Regarding the IMF’s role as a confi-dential advisor, in practice, in none of the three

27

3See, for example, “Biennial Review of the Implementation ofthe Fund’s Surveillance over Members’ Exchange Rate Policiesand of the 1997 Surveillance Decision,” SM/97/53, February1997.

4The existence of perverse internal incentives was also noted inthe IEO’s evaluation of prolonged use of IMF resources (IEO,2002).

5Under current policy, the IMF encourages the publication ofstaff reports for Article IV consultations, but the ultimate decisionon publication is left to the authorities.

CHAPTER 3 • PRECRISIS SURVEILLANCE

country cases—except perhaps Brazil in late 1997and in 1998—was the IMF effective in this area inits surveillance (as opposed to program negotiation)role. Thus, by not publishing its assessments, theIMF had the worst of both worlds. In some cases, thesensitivity of the authorities to the public dissemina-tion of IMF staff views also diminished the staff’sincentives or ability to undertake analytical work,further reducing the impact of surveillance on pol-icy. While it is difficult to generalize from the threecases examined here, the evidence suggests that thebenefits of making the IMF’s views public outweighthe costs.

Since the crises, each of the three countries hasagreed to the publication of Public Information No-tices (PINs)6 and background Selected Issues papersfollowing their Article IV consultations, as well asLOIs and supporting documents when IMF-sup-ported programs have been operative. Nevertheless,up to 2002, none of the three countries covered inthis study had agreed to the publication of staff re-ports, a step that remains voluntary under the IMF’stransparency policy.7 While the publication of PINsrepresents considerable progress in putting IMF sur-veillance assessments in the public domain, thesenotices typically remain somewhat anodyne. With-out the publication of staff reports, the full argumen-tation and nuanced judgments of IMF surveillanceare not available to the public.

Recent Initiatives and Further Steps to Strengthen Surveillance

Previous internal and external reviews of the roleof surveillance in crisis cases have highlighted manyof the same issues discussed above. In particular, a re-view of surveillance in Mexico before the 1994–95crisis, which was discussed in the 1995 IMF AnnualReport,8 stressed the need for improved data collec-tion; more constructive dialogue with national author-ities, including more candid assessment of potentialrisks; greater frankness at the Board level in assessingmember policies; and more attention to financial sec-tor issues. Following the Asian crisis,9 in 1999, the

Crow Report recommended, among other things, anincreased emphasis on the domestic financial sector,the capital account, and global market conditions; im-provements in cross-departmental information ex-change; and a focus on identifying vulnerabilities.

The IMF has moved to address many of theseconcerns in the last several years.

• Procedures have been put in place to alert man-agement to, and promote greater cross-depart-mental discussion of, prospects faced by coun-tries identified as particularly vulnerable. In thisconnection, analytical work has been done onthe design and use of various types of earlywarning systems, although it has not yielded anoperationally robust tool for surveillance pur-poses. Nevertheless, the findings of this workhave sharpened the diagnostic capacity of theIMF in the context of surveillance, such as fi-nancial soundness indicators, external vulnera-bility indicators, and, more recently, debt sus-tainability analyses.

• The IMF has strengthened its analysis of country-level financial sector issues, most notably throughthe Financial Sector Assessment Program(FSAP) in collaboration with the World Bank.

• Reports on the Observance of Standards andCodes (ROSCs) are regularly prepared, and gen-erally published. These reports examine nationalauthorities’ adherence to internationally acceptedstandards and codes in a number of areas, includ-ing especially financial supervision, corporategovernance, and data dissemination.

• The International Capital Markets Department(ICM) was formed, and efforts have been madeto recruit staff with financial market experience,in order to give a more prominent role to theanalysis of global financial market conditionsand of the capital account.

• A Capital Markets Consultative Group has beenestablished to provide a formal channel for con-sultations with the private sector, though thesediscussions currently do not cover conditions inspecific countries. According to staff membersinterviewed by the evaluation team, informal con-tacts with private sector analysts have also be-come more common and accepted in the past fiveyears.

28

6Publication of PINs began in May 1997.7Beginning with the 2002 Article IV consultation, however,

Korea agreed to the publication of staff reports. Some 60 percentof staff reports for Article IV consultations have been publishedin recent years.

8The underlying confidential report “Mexico—Report on FundSurveillance, 1993–94,” EBS/95/48, was prepared in March1995, and is generally referred to within the IMF as the WhittomeReport after its author.

9At the height of the Asian crisis in March 1998, there was apreliminary internal review of surveillance in countries affectedby the crisis, including Thailand, Indonesia, and Korea (“Review

of Members’ Policies in the Context of Surveillance—Lessons forSurveillance from the Asian Crisis,” EBS/98/44). This reviewidentified five key lessons, namely, the importance of timelyavailable data, the need to extend focus beyond core macroeco-nomic issues, the need to pay attention to policy interdependenceacross countries, the importance of policy transparency, and thebenefits of supportive peer pressure.

Chapter 3 • Precrisis Surveillance

• Quarterly vulnerability assessment experienceswere initiated in May 2001 to provide an opera-tional framework for assessing crisis vulnerabil-ities in emerging market countries, by integrat-ing bilateral and multilateral surveillance aswell as market intelligence and IMF-wide coun-try knowledge.

• Revised guidelines for surveillance were issuedin September 2002. Among other things, the newguidelines emphasize the importance of candiddiscussions of exchange rate issues, comprehen-sive assessments of crisis vulnerabilities, andmeasures to alleviate the vulnerabilities that areidentified. The guidelines also mandate fullerdiscussions of the capital account, governance is-sues, data deficiencies, and the authorities’ re-sponsiveness to previous consultations.

These are valuable steps. However, the currentevaluation suggests that the following additionalsteps would enhance further the role of surveillancein crisis prevention:

• Surveillance should be oriented toward lookingfor points of vulnerability, and developing andanalyzing stress test scenarios, rather than to-ward simply trying to predict the future. A fulldiscussion of the real and financial consequencesof a menu of possible shocks—such as a worsen-ing of the global macroeconomic environment, aterms of trade shock, a large domestic bank-ruptcy, or a financial crisis in a neighboringcountry—would clarify the risks ahead, andwould be a useful input to later decision making.If and when one of the identified shocks occurs,the groundwork will have been laid for a moreinformed exploration of options on the part ofIMF management and the Board, as well as thecountry authorities. A full discussion of scenar-ios can also help to expose gaps in informationand analysis that staff would then attempt toclose in advance of a potential crisis. Some IMFsurveillance exercises have already begun to usesuch an approach, for example debt sustainabil-ity analyses and stress-testing undertaken in anumber of FSAP exercises.10

• IMF surveillance should identify those struc-tural policies that are most critical to crisis pre-vention and mitigation and present an assess-ment in Article IV consultations of the quality ofthe dialogue with the authorities in these areas,including progress made over time. In many

countries, there is an extensive outstanding re-form agenda but relatively little effort is madeuntil a crisis occurs to assign priorities to spe-cific reform measures. While continuing to en-courage policies that contribute to long-termgrowth, which may range over a wide area, IMFsurveillance should put special emphasis onthose policies that would reduce the likelihoodand seriousness of a crisis. The revised surveil-lance guidelines suggest that policy discussionsshould focus on such issues if “crisis vulnerabil-ities are non-negligible.” However, it can be ar-gued that such crisis-prevention measuresshould have a high priority in surveillance of allcountries with significant access to internationalfinancial markets, since, as the country casesstudied here indicate, the seriousness of poten-tial vulnerabilities often do not become apparentuntil a crisis is imminent.

• Analysis of balance sheet positions and mis-matches has become increasingly common insurveillance reports, but this is not yet done in asystematic or standard fashion. The staff, inAllen and others (2002), has analyzed the roleof balance sheet effects in financial crises, andoutlined the different mismatches that are mostrelevant. This could serve as a guide for moresystematic analysis of these issues in surveil-lance reports. More explicit guidelines shouldbe established for the kinds of mismatches thatshould be examined at the levels of the public,private, and external sectors. This, in turn,would guide the development of statistical re-porting systems in support of surveillance andimprovements in the timeliness of statistics.

• Procedures should be introduced to ensure thatstaff assessments are as candid as possible. Tothe extent that the staff avoids controversialstatements out of fear of a negative response, ei-ther directly from national authorities or at theBoard level, the Executive Board must play a keyrole in changing the environment in which sur-veillance assessments are generated and re-ceived. This may mean improving the incentivesto produce candid surveillance reports (seeChapter 5). A sharper delineation of the issuessurveillance is expected to cover in this area (seeabove) will also help to promote candor.

While these efforts will undoubtedly reduce theprobability of surveillance failing to recognize therisks of a crisis that materializes, the same efforts mayalso increase the probability of surveillance exagger-ating the risks of a crisis that does not materialize. It isimportant that, with these efforts, surveillance re-mains realistic in assessing the likelihood of a crisis.

29

10A framework for assessing external and fiscal sustainabilityis suggested in “Assessing Sustainability,” SM/02/166, May2002.

G iven the nature of capital account crises, theprimary objective of crisis-management pro-

grams in such cases should be to restore confidenceas quickly as possible in order to restore normalcy tothe capital account. This was indeed the approachadopted in all three cases. In each case, the crisis-management strategy relied upon a mix of fiscal andmonetary policies combined with a range of struc-tural reform measures, supported by a large financ-ing package. In this chapter, we present a summaryassessment of the critical elements of program de-sign and implementation in the three country cases.

Macroeconomic Framework andProjections

Adjustment programs are designed to achieveparticular macroeconomic outcomes, and severalpolicy measures are calibrated around these out-comes. However, the key determinants of macroeco-nomic outcomes are not always well understood andare in any case subject to large uncertainty. This canlead to macroeconomic outcomes that are very dif-ferent from program projections. This was evident inboth Indonesia and Korea, where the initial projec-tions were overly optimistic, leading to the design ofmacroeconomic policies that turned out to be tighterthan necessary (Table 4.1).1 In contrast, the initialprojections for Brazil in 1999 were too pessimistic,which contributed to fiscal adjustments that turnedout to be insufficient, in light of that country’s ad-verse public debt dynamics.

In Indonesia, the November 1997 program pro-jected GDP growth in 1998/99 at 3 percent. This wasthen revised downward to zero percent in January1998 and to –5 percent in April, while the actual out-come was even worse at –13 percent. The original

optimism was due to the assumption that the crisiswas a moderate case of contagion in which the ex-change rate had overshot. It was thought that, with acombination of tight macroeconomic policies andstructural reform, the exchange rate would appreci-ate quickly. This did not happen, and the resultingcurrency collapse had severe negative effects on thebalance sheets of corporations and banks. Such neg-ative balance sheet feedback was further exacerbatedby the political developments affecting the minorityChinese community, which had a dominant role inbusiness. Fixed investment in Indonesia, which wasexpected to decline by only 0.4 percent in 1998/99 inthe November program projection, actually declinedby a massive 33 percent, explaining much of theturnaround in GDP performance.

In Korea, the IMF was of the view that the macro-economic outcome would be worse than projected,but the government was reluctant to accept a lowerfigure for GDP growth. Growth in 1998 was thereforeprojected at 2.5 percent in the initial program,whereas it actually declined by 6.7 percent. Invest-ment, which was projected to decline by 14.2 percent,actually fell by 21.2 percent, again indicating that thenegative balance sheet impact was underestimated.

In the case of Brazil, the IMF staff correctly iden-tified a number of the elements that proved critical inthe country’s relatively strong growth performanceafter the exit from the exchange rate peg, such as arelatively strong financial sector, and a corporatesector with limited leverage and little foreign ex-change exposure. In part reacting to the overopti-mistic projections in East Asia, the projections foroutput were deliberately cautious, although in linewith outside forecasts and considered by some to beon the optimistic side. It was felt that this would helppersuade the markets that the targeted path of theprimary surplus was consistent with sustainable debtdynamics even under relatively adverse develop-ments in output.

Part of the problem arises because macroeco-nomic projections in an IMF-supported program arenecessarily the outcome of a negotiation. In the caseof Korea, the authorities were reluctant to accept agrowth projection lower than 2.5 percent for 1998; in

Program Design andImplementation

30

CHAPTER

4

1Overoptimism appears to be a feature of most large IMF-sup-ported programs. Musso and Phillips (2001) find a significant op-timistic bias in real GDP projections for the first year of adjust-ment programs for which access is large or where the economy islarge. This bias, however, is not present in their sample of IMF-supported programs as a whole.

Chapter 4 • Program Design and Implementation

Brazil, the authorities deliberately wanted to be cau-tious. More important, forecasts were not derivedfrom an analytical framework in which the key deter-minants of output and their likely behavior during thecrisis could be dealt with adequately. In particular,there was insufficient appreciation of (1) the largecurrency depreciation which might occur in view ofthe possibility of multiple equilibria and (2) the se-vere balance sheet effects that might result, whichwould affect macroeconomic outcomes adversely. Inretrospect, these can be called analytical weaknessesin light of the new type of crises. Balance sheetanalysis was not yet in the tool kit of most macro-economists in the economics profession, let alone inthe IMF, at the time.2

Assessment

In both Indonesia and, to a lesser extent, Korea,much attention has focused on whether the initialstance of fiscal policy was appropriate in view of theoutput collapse that subsequently occurred. Fiscaltightening was said to have been unnecessary andhave damaged market confidence when output wasbeginning to fall, and we turn to this issue in the nextsection. However, this was the direct consequence of

the overoptimistic projection of output for the rea-sons indicated above. Thus, the key questions in thisrespect are: (1) were the initial macroeconomic pro-jections a good guide for judgments on the fiscalpolicy stance? (the answer is no in the case of In-donesia and Korea); and (2) was program design suf-ficiently flexible to respond reasonably quickly to adifferent macroeconomic situation? (in our view, theanswer, as discussed further in the next section, is aqualified yes. However, the flexibility was not suffi-ciently transparent and gave mixed signals, espe-cially in Indonesia). These problems did not arise inBrazil because the projections were deliberately pes-simistic and the outcomes were actually better,which was probably less damaging to market confi-dence. However, routinely making pessimistic pro-jections cannot be the answer, not least because themarkets would then quickly learn to discount thepessimistic bias in IMF projections.

Growth projections that are overoptimistic notonly call into question the credibility of the IMF, butthey can also lead to macroeconomic policies thatare either too tight or too loose. It is inherently diffi-cult to forecast macroeconomic outcomes reliably,most of all in crisis situations. However, these prob-lems could be reduced if there was a more explicitfocus on the key factors that will have significant im-pact on aggregate demand, particularly private in-vestment. It is well known that forecasting privateinvestment over a business cycle is extremely diffi-cult even under normal conditions. This difficulty iscompounded by greater uncertainty during a capitalaccount crisis, making accurate projections difficulteven with best practice. It is thus important thatquantitative targets and benchmarks in an IMF-sup-ported program should incorporate that uncertainty.In particular, a more explicit discussion was needed

31

Table 4.1. Real GDP and Investment Projections and Outturn in CrisisCountries

Original RevisedProjections Projections1 Outturn

Indonesia (1998/99)GDP 3.0 –4.7 –13.6Fixed investment –0.4 –26.8 –33.0

Korea (1998)GDP 2.5 . . . –6.7Fixed investment –14.2 . . . –21.2

Brazil (1999)GDP –1.0 –3.8 0.8Fixed investment –9.5 –18.2 –3.2

Sources:Various IMF staff reports.1March 1999 for Brazil, April 1998 for Indonesia.

2Balance sheet analysis began to figure more prominently in thethinking of the economics profession after the East Asian crises,with the emergence of the so-called third-generation model ofcurrency crisis (Allen and others, 2002). However, the idea thatdevaluation could have contractionary output effect when there isnet external debt denominated in foreign currency was well-known in the academic literature for at least 35 years, most fre-quently associated with the works of Carlos Diaz-Alejandro(1963, 1965). Similar balance sheet issues, such as unhedged for-eign currency exposure and their effects on private aggregate de-mand, were raised following the Mexican crisis of 1994–95.

CHAPTER 4 • PROGRAM DESIGN AND IMPLEMENTATION

in the program documents of the major risks to themacroeconomic framework, with a clear indicationof how policies would respond if the risks material-ized. This could have helped facilitate subsequentprogram reviews (which did show flexibility) andwould also have sent a more transparent signal onthe expected stance of policies.

Fiscal Policy

Some critics have accused the IMF of mechani-cally applying to East Asia the tight fiscal policiesthat it had traditionally recommended in Latin Amer-ica. The three countries studied suggest that the ap-proach adopted was more nuanced. In both Indonesiaand Korea, the staff recognized that the underlyingfiscal position was sound, and the fiscal tighteningenvisaged was therefore mild. The November 1997program in Indonesia targeted an increase in the fis-cal surplus from 0.5 percent in the budget for1997/98 to 0.75 percent, with a further tightening toyield a surplus of 1.3 percent in 1998/99. The initialprogram therefore involved a turnaround of 0.8 per-cent of GDP over an 18-month period. For Korea, theprogram incorporated only a small fiscal surplus of0.2 percent of GDP for 1998, compared with a deficitof 0.2 percent of GDP projected for 1997, that is, afiscal turnaround of only 0.4 percent of GDP. Insharp contrast, the Brazilian program involved a turn-around of over 4 percentage points of GDP for 1999,relative to the fiscal position expected to prevail inthe absence of adjustment measures.

The IMF staff justified the mild tightening of fis-cal policy in Indonesia and Korea on the groundsthat countervailing measures were needed to lessenthe burden of the private sector in external adjust-ment and to cover the carrying cost of the public-debt burden arising from recapitalizing the financialsector. Moreover, fiscal tightening has traditionallyserved as a signaling device, indicating the govern-ment’s resolve to take corrective action. The signal-ing role was particularly pertinent in Indonesia,where the tightening largely reflected the elimina-tion or postponement of prestige projects linked tothe family of the President. The need for a fiscal cor-rection to cover the cost of bank restructuring cannotbe disputed, because the potential quasi-fiscal costsof the banking crisis were very high. Nevertheless,with the benefit of hindsight, it can be argued that,certainly in Korea, this adjustment could have beendeferred by accepting a slightly higher public debtprofile in the medium term, which would not havebeen a problem given the relatively low initial debtposition. There was less justification for deferringthe adjustment in Indonesia, where the cost of bankrestructuring was higher.

The real problem with the fiscal targets in Indone-sia and Korea was the growth assumptions built intothe program, which proved unrealistic because of thecontractionary forces generated by the sharp ex-change rate depreciation and the resulting balancesheet effects. In Indonesia, these were compoundedby a developing political crisis. Failure to take theseinfluences sufficiently into account led to unneces-sary fiscal tightening. Better anticipation on thiscount would have called for a more countercyclicalstance in fiscal policy.

The fiscal targets in both countries were quicklyadjusted as the contractionary effects became evident.

• In the case of Indonesia, the January 1988 LOIrelaxed the fiscal policy target from the surplusof 1.3 percent of GDP initially envisaged to adeficit of 1 percent for 1998/99, and this wasfurther relaxed in April (at the start of the fiscalyear) to a deficit of 4.7 percent, on the assump-tion that GDP would decline by 5 percent. Theactual deficit achieved in 1998/99 was only 2.1percent of GDP, indicating that the fiscal targetwas not a binding constraint. The lack of auto-matic stabilizers, such as social safety nets, andthe weak capacity of the government to achievethe increases in expenditure that were targetedin a number of social sectors made it difficult touse fiscal policy countercyclically even withinthe limit permitted by the revised program.

• In Korea, as early as late December 1997, withina month of the approval of the program, the staffrecommended that the authorities should not ad-here to the fiscal targets but let automatic stabi-lizers work. However, the Korean authoritieswere reluctant to deviate from their balancedbudget philosophy despite urging from the IMFstaff, who favored a more expansionary fiscalpolicy once the extent of the economic downturnbecame apparent. In the event, government con-sumption expenditures fell by 0.4 percent in realterms in 1998, but Korea ended up running abudget deficit of 4.3 percent of GDP in 1998, be-cause tax revenues fell even further.

Fiscal policy was much more restrictive in Brazil,where the fiscal adjustment of over 4 percent wasprogrammed for 1999 relative to the outcome pro-jected to prevail in the absence of adjustment mea-sures.3 This was appropriate, as fiscal sustainabilitywas a factor driving the evolution of the crisis. The

32

3According to the November 1998 program document, the fis-cal balance for 1999 was expected to deteriorate on account ofseveral factors, including the “disappearance of once-off tax rev-enues,” “retroactive wage increases,” and “the effects on the so-cial security finances of the acceleration of early retirements.”


main objective of the 1998 program was to stabilizethe ratio of net public debt to GDP, in order to ensuremedium-term debt sustainability. To achieve this, aperformance criterion was set for the public sectorborrowing requirement (PSBR), with an indicativetarget for the primary surplus that involved an in-crease of 2.5 percentage points over the previousyear. The depreciation of the real following the col-lapse of the program in early 1999 raised the debt-to-GDP ratio from 43 percent at the end of 1998 to52 percent in February 1999 because of the revalua-tion of external debt and high levels of foreign ex-change–indexed domestic debt.

The revised March 1999 program set a perfor-mance criterion on the primary surplus, with an in-dicative target for the net debt of the public sector,and an informal target for the proportion of domesticdebt indexed to the U.S. dollar that would be rolledover. Moreover, it raised the primary surplus to 3.1percent of GDP in 1999, 3.25 percent in 2000, and3.35 percent in 2001. While all the primary balancetargets were achieved, the targeted debt-to-GDP ra-tios were not achieved, in large part owing to thegreater-than-expected depreciation of the currency,which raised the local currency value of external andforeign currency–linked domestic debt.

Assessment

The three country experiences studied for the re-port suggest that the fiscal policies recommended bythe IMF did differ depending on the initial position,but the real reason for the inappropriateness of thefiscal policy in Indonesia and Korea was the failureto take account of the key factors that would affectaggregate demand during a crisis, notably the impactof balance sheet effects and confidence factors onprivate investment. The fiscal stance in Korea, giventhe low initial stock of public debt, can be said in ret-rospect to be too contractionary. The governmentcould have drawn on its spare borrowing capacity tooffer its obligations in exchange for those of thetroubled financial sector—as eventually happened.In contrast, the similarly low outstanding stock ofdebt in Indonesia probably did not present a strongcase for an ambitious countercyclical fiscal policybecause the banking sector was much weaker than inKorea, with serious solvency rather than mainly liq-uidity problems, and posed large contingent liabili-ties for the government. The absence of a bond mar-ket also limited the ability of the government tofinance expenditures without resorting to inflation-ary means. There was little scope for a substantiallyexpansionary fiscal policy.

The Indonesian and Korean programs have beencriticized for pursuing tight fiscal policy in Indone-sia and Korea, on the grounds that this was unneces-

sary and may have been partly responsible for the se-vere output contraction that followed (Furman andStiglitz, 1998; Sachs, 1998). Our evaluation suggeststhat, while the initial fiscal tightening may have beenmisguided, the severe output contraction experi-enced by these countries was not due to the fiscalstance but to the operation of other contractionaryforces, linked to the impact of balance sheet effectsand confidence factors on private aggregate demand,which were clearly underestimated.

The fiscal correction in the Brazilian program wasmuch stronger, but this was appropriate under the cir-cumstances, since fiscal weakness and debt sustain-ability were critical issues driving the evolution ofthe crisis. A balance sheet perspective, however, sug-gests a weakness in another area of the program. InBrazil, from late 1997, the government was effec-tively providing the private sector with a hedge forexchange rate risk by issuing foreign currency–linked debt, intervening in the foreign exchange fu-tures market and, latterly, by selling foreign exchangereserves. While the exchange rate policy maintainedin the 1998 program thus helped mitigate any adversebalance sheet impact of exchange rate depreciation, itwas a form of expansionary fiscal policy in the faceof an impending currency crisis. Unlike the case ofKorea, however, this policy had serious consequencesfor Brazil’s medium-term debt sustainability.

Monetary Policy

Some of the strongest criticisms of the role of theIMF in the capital account crises of the 1990s havebeen in the field of monetary policy. The IMF hasbeen criticized for requiring countries to pursue an ex-cessively tight monetary policy, thereby damaging thebalance sheets of banks and corporations, disruptingthe flow of credit to small and medium-sized enter-prises, and constraining aggregate demand unduly at atime of recession (Furman and Stiglitz, 1998; Sachs,1998). The IMF and its defenders have responded thata tight monetary policy was necessary in the crisiscountries in order to support the exchange rate (atleast in part through a signaling effect), combat infla-tionary pressure from depreciation, and limit the ex-ternal financing gap through a combination of reducedcapital outflows and a lower current account deficit(Lane and others, 1999; Corsetti and others, 1999).

Internal documents reveal that, in all three cases,monetary policy targets were set on the basis of anexplicit consideration of the trade-off betweenhigher interest rates and a weaker exchange rate. Thecases differed, however, in the emphasis placed onmonetary policy in program strategy and the per-ceived impact of high interest rates on the private fi-nancial and nonfinancial sectors (see Table 4.2 for

33


the comparative level of real interest rates in thesecountries).

In Indonesia, the November 1997 program did notcall for a substantial monetary tightening, mainly be-cause monetary policy had already been tightenedprior to the program. Internal documents and staff in-terviews make clear that there were considerable dif-ferences of view on this issue within the IMF, withsome arguing for a further tightening of monetary pol-icy, and some arguing that the initial tightening wassufficient to send the necessary signal, taking into ac-count the potential impact on leveraged balancesheets. In the event, and given the political constraintsfaced by the authorities, the strategy adopted in theprogram was to maintain the relatively tight monetarystance, with the understanding that it would be tight-ened further if necessary. No explicit target was speci-fied for interest rates. To allow the authorities to inter-vene in the foreign exchange market without affectingthe overall liquidity position, the November programhad the unusual feature of including a base money tar-

get as a performance criterion, instead of a more con-ventional NDA ceiling combined with a floor for netinternational reserves (NIR).

In practice, the monetary policy envisaged in theprogram was never implemented. A significant loos-ening of monetary policy took place almost immedi-ately, with extensive unsterilized liquidity assistanceto troubled banks, leading to increasingly negativereal interest rates. The IMF staff objected strenuouslyto this loosening of monetary policy, with little effect.While this calls into question the quality of the IMF’sdialogue with the government, it cannot be said thatthe overall stance of monetary policy was tightthrough the early months of the program.4 Monetary

34

Table 4.2. Real Interest Rates in Selected Countries1

Month ofCountry Average High Highest

January 1990–June 2002 (except where indicated)

United States 1.9 3.7 Nov. 97United Kingdom 3.8 8 Aug. 92Japan 1.1 3.6 Aug. 91Italy 4.6 13.6 Sep. 92Germany 2.8 7.7 Aug. 90France 4.2 9.8 Jan. 93Canada 3.7 9.3 Apr. 90Sweden2 4.6 15.2 Sep. 92

Indonesia 4.9 49.1 Aug. 97Korea 6.2 18.1 Jan. 98Brazil3 18 40.6 May. 95

Philippines 5.5 17 Oct. 97Malaysia 2.6 8.6 Jul. 97Thailand 3.9 15 Sep. 97Mexico 5.5 29.6 Mar. 95

In the first six months after the adoption of an IMF-supported program4

Mexico 1/95–6/95 11.5 29.6 Mar. 95Philippines 7/97–12/97 9.4 17 Oct. 97Thailand 8/97–1/98 8.3 15 Sep. 97Indonesia 11/97–4/98 –8.4 0.5 Jan. 98Korea 12/97–5/98 14.8 18.1 Jan. 98Brazil 11/98–4/99 33.7 37.5 Mar. 99

Source: IMF database.1Interest rates are 3-month treasury bill rates for G-7 (except for Japan) and Sweden; 60-day government securities rate for

Japan; 3-month interbank rates for the Philippines, Malaysia, Korea, and Thailand; overnight interbank rate for Indonesia; overnightSelic rate for Brazil; and Cetes 90-day rate for Mexico. Real interest rates are calculated as the difference between the averagedaily nominal interest rate during a given month and the rolling 12-month CPI inflation rate centered on that month.

2Until December 2001.3From January 1995.4For each country, the starting month of the program is the month in which the letter of intent was signed by the authori-

ties. For the Philippines, this represented the extension and augmentation of an existing arrangement.

4Higher nominal interest rates, however, affected different sec-tors of the economy differently, because sharp changes were tak-ing place in relative prices, even though real interest rates mea-sured using average inflation were negative. These issues ofmonetary policy in Indonesia are explored in greater detail in theIndonesia country annex.


control and exchange rate stability were only reestab-lished after March 1998 when a sharp interest rate in-crease was specified under the new program, basemoney targets were replaced by NDA targets as per-formance criteria, and the new cabinet acted deci-sively to end the central bank’s liberal liquidity sup-port to the financial sector. At that stage the rupiahhad depreciated to Rp 10,000 per U.S. dollar, ar-guably a sufficiently overshot level at which therestoration of monetary control was likely to yield theresults that it did in terms of exchange rate stability.Although the economy undoubtedly suffered enor-mous damage in November and December 1997, theblame cannot be put on the tight monetary policy ad-vocated by the IMF since this was not implemented.

The Korean experience with monetary policy isvery different. In this case, a substantial increase inthe central bank’s main policy rate was a key compo-nent of the IMF-supported program approved inearly December 1997. Despite initial resistance bythe authorities, significant increases in interest rateswere implemented, though with a delay at one pointbecause of the need to repeal an interest ceiling setby an anti-usury law. A penalty rate was also set oncentral bank advances of foreign exchange to thebanking sector. While the monetary targets includedan NDA ceiling, it was the specification of interestrate increases that had the central role to play in theKorean program. An inflation target was also in-cluded, but it was not part of formal conditionality.

The application of higher interest rates did notinitially produce the desired results in terms of halt-ing the capital outflow and easing pressure on theexchange rate. Foreign banks continued to reducecredit lines to Korean institutions and the exchangerate remained weak and volatile. The authorities ex-pressed concerns at this time about the impact ofhigh interest rates on heavily indebted corporationsand, through them, on the banking sector, but theIMF staff assigned a higher priority to the immediateneed to stabilize the exchange rate. In the monthsafter the revised program was adopted in late De-cember 1997, the policy rate was slowly but steadilylowered, as currency market conditions stabilizedand inflation proved quiescent.

In retrospect, it would appear that, while highrates were necessary in December 1997 to prevent acomplete collapse of the exchange rate, they werecertainly not sufficient to resolve the crisis, as stabil-ity did not begin to be restored until after the rolloveragreement was reached. Hindsight also suggests that,in the early months of 1998, interest rates were main-tained too long at high levels, at a time when corpo-rate sector balance sheets were fragile and a looserpolicy might have supported a faster recovery in do-mestic demand. However, the period of time whenreal interest rates may have been higher than they

needed to be was at most a few months, and it is diffi-cult to believe that this delay contributed significantlyto the recession. Besides, the speed with which mar-kets stabilized in early 1998 came as a surprise, andsome caution was therefore understandable, given theunsettled market situation in East Asia and the needto ensure that price and exchange rate stability wouldnot be put at risk from lower interest rates.

In Brazil, the December 1998 program prescribeda tight monetary policy to support the crawling pegregime, but the prescribed policy was not followedinitially. Instead, interest rates were reduced towardthe end of 1998—excessively and prematurely in theview of the staff—and the programmed target forcentral bank credit was substantially exceeded. Thisis not to say that pursuit of the prescribed policywould have succeeded in maintaining a peg that waswidely seen to be overvalued.

Interest rates were increased again after the ex-change rate peg was abandoned in early 1999—ten-tatively at first but later more decisively—in an ef-fort to stabilize the exchange rate and prevent theexchange rate depreciation from sparking reindexa-tion and a takeoff in inflation. As in Korea, rateswere eventually brought down again (though at asomewhat quicker pace) as it became evident thatthe exchange rate had stabilized and the pass-through to inflation was modest. In contrast toKorea, the impact of high interest rates on invest-ment through their effect on corporate balance sheetsturned out to be limited, because of the low degreeof leverage in the corporate sector. However, thepublic sector, which had issued increasing amountsof floating rate debt, was exposed to an excessive de-gree of interest rate risk.

The contrasting cases of Korea and Brazil point tothe importance of having a clear framework to guidemonetary policy in the poststabilization period. InKorea, the high interest rate policy was subject topublic criticism in early 1998 because the criteria formaintaining it—exchange rate and price stability—were not clearly defined. In Brazil, by contrast, theguiding principles of monetary policy were clearlycommunicated by the Central Bank. Once the formalinflation targeting framework was put in place, itprovided a measurable benchmark that could beused both to guide monetary policy and to explain itto the market and to public opinion. These experi-ences illustrate the value of straightforward, publiclystated frameworks guiding the return to a less re-strictive monetary stance in helping to clarify expec-tations and improve public acceptance.

Assessment

Most economic policymakers at the time of the1997–99 crises accepted the existence of a positive

35


link between interest rates and exchange rates. Thisapproach conformed to the practice in other coun-tries that faced currency crises in the 1990s, notablythose affected by the European exchange ratemechanism (ERM) crisis of 1992. During the Asiancrisis, economies with IMF-supported programs,such as Indonesia, Korea, the Philippines, and Thai-land, and those without IMF-supported programs,such as Malaysia and Taiwan Province of China,used high interest rates to try to reduce downwardpressure on their currencies. Interest rates in HongKong SAR rose sharply on several occasions in1997 and 1998, owing to both deliberate policy ac-tions and the automatic provisions of its currencyboard arrangement.5

Since the Asian crisis, a large theoretical and em-pirical literature has reexamined the question as towhen, and under what conditions, high interest ratescan be effective in defending the exchange rate. Theo-retical work has tended to show that effects in both di-rections are plausible.6 Empirical research has beenunable to settle the matter.7 However, researchershave established that the relevant issues and relation-ships differ depending on whether one is defending anexchange rate in the midst of a crisis, or attempting tomanage real appreciation in the aftermath of anepisode where the exchange rate has overshot its equi-librium level. If it is judged that there has been an ex-cessive real depreciation, one function of monetarypolicy is to ensure that the subsequent real apprecia-tion occurs through nominal appreciation rather thanthrough inflation (Goldfajn and Gupta, 1999). Thiswould argue for maintaining a tight monetary policy.Yet the resolution of a crisis in the financial sectorwould call for a loose monetary policy.

This highlights the fact that interest rate policyposes special problems in situations of “twin crises,”in which a balance of payments crisis triggered bycapital outflows takes place simultaneously with a

banking crisis. As Krueger (2002) put it: “To confronta balance of payments crisis, the appropriate policyresponses entail an exchange rate change, tighteningof monetary policy, and tightened fiscal policy. Tostem a financial crisis, by contrast, entails looseningof monetary policy, maintenance (or even apprecia-tion) of the nominal exchange rate, and financial re-structuring. . . . To a significant degree, in the pres-ence of twin crises, whatever is done to address onewill, in the short run, make the other worse.” [paren-theses in original]. In the light of these considera-tions, it is difficult to pronounce definitively on theappropriateness of monetary conditionality in thethree crisis countries. The IMF was aware that tightmonetary policy designed to stabilize exchange ratescould have an adverse impact on the corporate andbanking sectors, if they were highly leveraged. How-ever, it was also concerned about the adverse impacton the economy of excessive exchange rate deprecia-tion if the corporate sector had a large unhedged debtposition in foreign currency. In a twin crisis, it re-mains an unresolved issue how to reconcile the twoconflicting objectives of monetary policy.

Official Financing and Private Sector Involvement

The size of financing needed in a capital accountcrisis is inherently difficult to determine for two rea-sons. First, the ex ante estimate of the financing gapdepends upon the speed with which confidence is re-stored and capital flows return to normalcy, which isdifficult to predict. Confidence is a psychologicalphenomenon and depends on both the technicalsoundness of the adjustment program and also onwhether the markets believe it will be implementedand be effective. Second, the financing requirementin a capital account crisis is typically very large, ex-ceeding what the IMF can provide from its own re-sources, given the role of quotas in limiting accessand also the constraints on total resources availableto the IMF. Fischer (1999) has pointed out that theIMF, therefore, has to perform two functions: to actas a “crisis lender” providing financing from its ownresources, and also to act as a “crisis manager” ar-ranging supplementary resources from othersources, for example, multilateral and bilateral offi-cial financing, and encouraging private sector in-volvement to the extent possible. This is indeed theapproach it adopted in all three cases.

The scale of IMF financing

In all three cases, the IMF was able to provide alarge volume of its own financing combined with a

36

5Subsequently, Hong Kong SAR and Malaysia resorted to lessconventional measures: purchases of stocks in the secondary mar-ket and controls on capital outflows, respectively.

6Lahiri and Végh (2002), for example, show that high domesticinterest rates can induce a portfolio shift towards the domesticcurrency under the right circumstances but there is a range inwhich sufficiently high interest rates can also weaken the cur-rency by contracting domestic output and by raising the govern-ment’s debt-servicing costs.

7For example, Kraay (1998) finds that tighter monetary policydoes not have a statistically significant impact on whether specu-lative currency attacks succeed or fail, even when one controls forthe endogeneity of the policy response. Goldfajn and Gupta(1999) find some evidence that tighter monetary policy in the af-termath of currency crises helps to ensure that an undervaluedreal exchange rate returns to its equilibrium level through nomi-nal appreciation rather than higher inflation. But their results arenot robust to different specifications and do not hold when a cur-rency collapse is accompanied by a banking crisis.


substantial recourse to official financing from otherinternational financial institutions (IFIs) and bilat-eral sources (Table 4.3). The scale of total official fi-nancing in each case was comparable in terms ofGDP to the financing provided to Mexico in 1994.All three programs involved highly front-loaded dis-bursements, reflecting the need to make resourcesavailable quickly.8 As a proportion of quota, IMF as-sistance to Korea was exceptionally large, made pos-sible by the introduction of the SRF at that time.Nevertheless, all three programs failed to restoreconfidence initially.9

In Indonesia and Brazil, it is difficult to argue thatthe failure of the initial program was due to the fi-nancing package. The failure in Indonesia resultedlargely from the evident lack of commitment of thegovernment to implement the program and the rapidemergence of a major political dimension to the cri-sis, which accelerated not only the reversals in capi-tal flows but also capital flight by domestic resi-dents. The first Brazilian program failed because theinitial objective of maintaining the crawling peg wasnot perceived as credible, particularly given the lackof sufficiently supportive policies and the overvalua-tion of the real.

In Korea, however, the initial failure of the pro-gram was more directly related to deficiencies on thefinancing side. The package as announced in thepress note included US$20 billion of bilateral assis-tance as a second line of defense, but there was con-siderable lack of clarity as to whether this amountwas really available. The program was originallybased on the assumption that this amount would beneeded to fill the estimated residual financing gap,but it was communicated to the staff at a fairly latestage that it should not count on this amount beingavailable. The estimated financing gap was, there-fore, reduced by arbitrarily increasing the assumedrollover rate of short-term debt.

There was lack of transparency in dealing with theproblem, since details of the residual financing gap,and the rollover assumptions on which it was based,were not made public, and the second line of defensewas included in the press announcements to give theimpression that the actual resources being madeavailable were larger than they were. However, themarkets doubted the availability of the second line ofdefense and perceived the program to be underfi-nanced. The IMF recognized this fact and immedi-ately pressed its major shareholder governments to

achieve a rollover of bank credit lines, but to no avail(see “Private sector involvement” below). Outflowscontinued unchecked, and it was only when arollover agreement with the banks was reached thatthe financing problem was effectively resolved. Theconclusion is that if a rollover was not feasible, theamounts included in the second line of defenseshould have been made more readily available.

Critics have argued that large front-loaded pack-ages of the sort used in these crises are subject tomoral hazard, in that future investors may conse-quently lend imprudently in the expectation that theywill be bailed out by the public sector in the event ofadverse developments. This is possible in principle,but the empirical evidence is mixed.10 Certainly, pri-vate capital flows to emerging market economieshave been very subdued since these capital accountcrises, a trend that may partially reflect the percep-tion that the official sector will be less amenable tolarge packages and more insistent on private sectorburden sharing in the future. This suggests that themoral hazard impact of official support in thesecases was at best very limited.

Private sector involvement

The three country experiences provide some indi-cation of the potential role for private sector involve-ment (PSI) in different circumstances. In Korea, theeffort to encourage PSI in the second program washighly successful, because the short-term interbankcredits covered by the agreement accounted for alarge proportion of potential outflows. The direct in-volvement of the authorities of the major industrial-ized countries made it possible to orchestrate therollover. The IMF was involved in consultations withthe authorities and played a useful role in establish-ing quickly the comprehensive reporting system thatenabled compliance with the rollover agreement tobe monitored.

In Indonesia, the scope for PSI was more limitedbecause the predominant form of capital inflows wasforeign exchange borrowing by private nonfinancialfirms. The need for an initiative in this area to estab-lish a framework for negotiations and workout ofsuch debts by the private sector was noted by thestaff at an early stage but no action was taken. At alater stage, the authorities, with IMF technical assis-tance, tried to facilitate restructuring by establishing

37

8In the fast-moving crises of Indonesia and Korea, the proce-dures under the Emergency Financing Mechanism were invokedto allow the IMF to agree on a program quickly.

9These experiences confirm the conclusion of earlier studiesthat the “catalytic” effect of IMF programs on private capitalflows is typically small (Cottarelli and Giannini, 2002).

10See Ghosh and others (2002) for a brief summary of the litera-ture. Essentially, empirical work has focused on the presence or ab-sence of significant market reactions (typically measured by bondspreads) to actions or decisions that are expected to affect the ex-pectations of private investors that they will be “bailed out,” includ-ing the announcement of a large IMF-supported financing package,a large-scale default, and a sovereign debt restructuring.


a voluntary framework for negotiations betweencreditors and corporations that could not servicetheir debts, but progress was hampered by the ab-sence of an effective bankruptcy system and otherweaknesses in the legal system. Dealing with the ex-ternal debt of nonfinancial firms is understandablymuch more difficult, but earlier attempts could havebeen made, at a minimum, to initiate the collectionof data. Efforts should also have been made to pro-tect the financing of exports and essential importsthrough official guarantees and other schemes forkey trade credits, as was done in the summer of 1998with Japanese bilateral assistance.

By the time of the Brazilian program, the poten-tial role of coordinated private sector action in miti-gating the impact of capital account crises waswidely recognized. The Brazilian authorities, how-ever, were extremely reluctant to appear to coercethe private sector, fearing that such action might ac-celerate the capital outflows and have adverse conse-quences on Brazil’s future access to internationalcapital markets. The IMF made clear that its supportwould depend in part on the private sector response,but limited its role to helping to develop informationsystems and presenting the program to private credi-tors. Coordinated action was kept “voluntary,” andonly informal pressure was exerted on internationalbanks to maintain credit lines. The response fromprivate creditors under the original program wasonly moderate but a renewed effort in the context ofthe more credible revised program proved muchmore effective. This suggests that a program with ahigh degree of credibility is necessary for the “vol-untary” approach to PSI to work.

Assessment

Despite initial failures, the large official packageswere helpful in easing the adjustment to normalcy in

both Korea and Brazil. In Indonesia, on the otherhand, the depth of the collapse makes it difficult toargue that things would have been worse without theIMF, but the evolving circumstances made the sizeof access immediately irrelevant. In Korea andBrazil, official support was quickly repaid, in partahead of schedule.

The role of the IMF in promoting PSI was fairlylimited in all three cases. In Korea, the rolloveragreement was a decisive factor, but this was onlypossible when initiated by the major shareholders.Under the circumstances, there was probably littlealternative to the case-by-case approach to PSI actu-ally adopted. Establishment of clear rules in thiscontext might encourage an exit of capital in theearly stages of the crisis. It may be useful for theIMF to have a menu of several well-defined optionsto use in a way most appropriate to the circum-stances of each crisis, but some constructive ambigu-ity about the action to be followed in each case is de-sirable.

The three country cases thus suggest the follow-ing lessons:

• The IMF can play a critical coordinating role incapital account crises, including vis-à-vis otherproviders of official and private financing. Theability of the IMF to perform this task, how-ever, is limited by the reluctance of majorshareholder governments to provide large bilat-eral financing and to use nonmarket instru-ments to influence the behavior of private in-vestors in the absence of well-established rules.In other words, the lack of a clear mandate orframework for how the IMF should operate insuch circumstances forced an ad hoc response.While a case-by-case approach may be to someextent inevitable, the lack of clear rules of thegame create uncertainty.

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Table 4.3. Official Financing Assumed in Initial IMF-Supported Programs(In millions of U.S. dollars)

World BankDate of and Other

Arrangement IMF Multilaterals Other Total

Indonesia November 1997 10,083 8,000 18,0001 36,083Korea December 1997 20,990 14,200 23,1002 58,290Brazil December 1998 18,262 9,000 14,5383 41,800

Memorandum item:Mexico February 1995 17,843 0 33,957 51,800

Source: Ghosh and others (2002).1Not included in the financing assumptions.2Including US$20 billion in the second line of defense, which was included in the press release, but was not part of the pro-

grammed package.3BIS-coordinated bilateral financing and Japanese assistance.


• Large access is difficult to justify when the pro-gram being supported lacks credibility in themarkets in terms of policy sustainability. Thedecision to support Brazil’s unsustainablecrawling peg, justified on the basis of globalsystemic considerations, is one example.

• Markets tend to discount the availability andadditionality of official financing from otherIFIs and bilateral sources during the time ofcrisis, particularly if the non-IMF resources aresubject to separate and vague conditionalityand the country concerned already maintainsongoing financial relationships with the IFIsand the additionality is difficult to establish.11

Use of non-IMF resources in these circum-stances to boost the “headline” size of the offi-cial financing package can damage the credi-bility of the program and distract attentionfrom addressing the issue of involving the pri-vate sector, if necessary.

• A dialogue with the private sector is necessaryfor the IMF to serve its facilitating role in in-volving the private sector. The Korean case il-lustrates that a more concerted approach toovercome “collective action” can work in somecircumstances (e.g., when the relevant obliga-tions are relatively concentrated), but it is notpossible to say, within the context of the evalu-ation, how far such a conclusion can be gener-alized to other cases. Even when full-scale PSIis not feasible or necessary, concerted effortsshould be made at the outset to make sure thattrade credits for creditworthy firms are pro-tected through official guarantee and otherschemes.

Bank Closure and Restructuring

In both Indonesia and Korea, a weak banking sys-tem greatly contributed to the onset as well as theseverity of the crises. Problems in the banking sectorin these countries were further compounded by thedistress of the highly leveraged corporate sectorsbrought about by sharp currency depreciations andthe associated interest rate hikes.

Lessons from the East Asian experience

An important difference in how the bankingcrises were handled in Korea and Indonesia was thespeed and decisiveness with which a comprehensivestrategy began to be implemented. In Korea, a fullguarantee for deposits and other bank liabilities wasintroduced before the IMF agreement, which wasthen immediately followed by the announcement ofa comprehensive strategy, with appropriate enablinglegislation. The functions of the Korea Asset Man-agement Corporation (KAMCO) were enhanced,and a new consolidated system of supervision wasestablished under the new Financial SupervisoryCommission (FSC), which included a unit speciallycharged with bank restructuring. Even with best ef-forts, bank restructuring was a complex and pro-longed process. It took Korea three months to estab-lish the FSC and a full year to complete the settingup of the new regulatory framework. Bank restruc-turing is still an ongoing process. Nevertheless, theexistence of a comprehensive strategy that was im-plemented, albeit with slippages in the timetable,helped ensure that there was no loss of monetarycontrol and probably helped contain the magnitudeof the crisis.

The restructuring effort in Indonesia was muchless effective. A partial deposit guarantee was ini-tially introduced for deposits of the closed banks,covering most of the accounts but only 20 percent oftotal deposits; this was followed three months laterby a blanket guarantee for all bank liabilities, cover-ing both depositors and creditors. The failure to in-troduce a full guarantee has been much discussed(and we return to this subject below), but the moreimportant lacuna was the failure to adopt a compre-hensive strategy for bank restructuring that waswell-defined and well-communicated, and to applyconsistently uniform and transparent interventioncriteria to deal with problem banks. In the absence ofsuch a strategy, the public saw inconsistency in theNovember 1997 closure of 16 banks (representing 3percent of total banking sector assets), correctly be-lieving that there were other banks in similar diffi-culty. Indeed, the IMF itself had identified 10 morebanks that needed to be closed. The authorities’ in-sistence on secrecy, particularly regarding the 10banks under BI-supervised rehabilitation that werenot closed, prevented the public from understandingthe whole picture.

Given weak implementation capacity and therushed process, the logic and content of the bankclosure were not well communicated to the public,and execution was less than satisfactory. As dis-cussed, public confidence in the banking strategywas undermined by conflicting signals from the gov-ernment. In contrast, the April 1998 action was com-

39

11In the case of Indonesia, while the ADB agreed to provideUS$2.8 billion in quick-disbursing loans, it also canceled existingloans amounting to about US$900 million in 1998 and aboutUS$660 million in 1999–2000 in view of “the reduced availabil-ity of counterpart funds and the changed priorities after the crisis”(ADB, 2001a). In Brazil, the emergency loans to be provided bythe IDB included a loan of US$1.2 billion that had already beenapproved in September 1998 but had not yet been disbursed(IDB, 2001).


petently executed by the IBRA, which took over theassets of 7 banks (representing 16 percent of total)and closed 7 smaller banks without causing any dis-ruption. This was done under a comprehensive strat-egy in which uniform and transparent criteria wereapplied, and was accompanied by a professionallymanaged public relations campaign, better arrange-ments for meeting depositors’ claims, and a blanketguarantee. The failure to implement such an ap-proach effectively in November 1997 proved to beone of the major weaknesses of crisis management.

The blanket guarantee

The issue of whether a blanket guarantee shouldhave been offered in Indonesia in November 1997deserves careful consideration. The lesson drawn bythe IMF staff from the Indonesian experience is that“a blanket guarantee, rather than a limited depositguarantee, is needed to restore confidence in the fi-nancial system” (Lindgren and others, 1999). Else-where in the same report, however, the staff recog-nizes that a blanket guarantee involves largecontingent liabilities of uncertain value for the gov-ernment, and that it can have regressive implicationsfor wealth distribution—as taxpayers’ money is usedto protect large depositors and even foreign credi-tors. The report concludes that the benefits of theblanket guarantee must be weighed against its poten-tial costs.

In the case of Indonesia, the partial guarantee didnot lead to a general loss of confidence in the bank-ing sector. A large share of the banking system wasaccounted for by foreign banks as well as by statebanks that enjoyed an implicit government guaran-tee, and the flight to quality in late 1997 took theform of a shift of deposits from private banks to for-eign and state banks within the banking system(Enoch and others, 2001). The banking crisis was,therefore, not yet systemic (in the sense of affectingthe whole banking system), and a blanket guaranteewas, therefore, not essential. Under these circum-stances, a partial guarantee was reasonable, thougharguably the amount of the guarantee could havebeen increased, particularly to cover some institu-tional deposits, and extended to all banks at thattime. Besides, in a corrupt banking system, wherewell-connected insiders had benefited both fromhigh deposit rates and from questionable lendingpractices, a blanket guarantee would have given thesame insiders an additional means of benefiting fromabusive and corruptive practices. This is exactlywhat eventually happened with unlimited liquiditysupport.

In the end, the blanket guarantee was subject toabuse and consequently raised the fiscal cost of bankrestructuring, which is now estimated at over 50 per-

cent of GDP. The blanket guarantee in Indonesia wasintroduced as an act of desperation when the bank-ing crisis seemed to be going out of control. Giventhe lack of adequate preparation, the guarantee wasill-conceived and was even made to cover some in-sider claims and interbank credits extended with fullprofessional judgment and risk taking, including ex-posure in derivatives. It can be argued that the initialpartial guarantee was too low. However, a higherguarantee introduced within the context of a well-communicated comprehensive strategy could haveyielded a similar outcome without the fiscal cost andregressive distributional implications of the blanketguarantee.

The institutional setup for bank restructuring

The Asian experience also offers no clear lessonson the appropriate modality of government involve-ment in bank restructuring. Different institutionalapproaches were taken in Korea and Indonesia. InKorea, responsibility for bank restructuring (given tothe FSC) was separated from that for asset manage-ment (given to the KAMCO). In Indonesia, the func-tions of bank restructuring and asset managementwere consolidated in a new agency.

In establishing the IBRA, the IMF staff believedthat (1) BI needed to be protected from the fiscalcost of bank restructuring and the associated politi-cal pressure, in order not to impair its ability to con-duct monetary policy, and (2) the new agencyneeded to be protected from the allegations of cor-ruption plaguing BI. As a centralized public asset-management company, moreover, the IBRA offeredthe advantage of consolidating scarce financial ex-pertise and the prospect of giving special legal pow-ers to expedite loan recovery (Lindgren and others,1999). As it turned out, however, the IBRA wasplagued by problems from the outset. As a newagency, it was not given a clear mandate and was ini-tially handicapped by lack of legal and regulatorypowers. Moreover, the centralization of bank re-structuring and asset management functions in oneagency subjected the IBRA to tremendous politicalpressure and accusations of corruption; as a charac-teristic of a centralized public asset managementcompany, there was also little incentive to maximizerecovery values for the acquired impaired assets. Onthe other hand, the KAMCO was made to operate oncommercial principles and, as a specialized agency,it could focus its sole attention on that function andwas effective in rapidly selling the impaired assets.

Given the weak legal system and prevailing cor-ruption in Indonesia, it may well be that no alterna-tive could have worked better than the IBRA. In thelight of the Korean experience, however, the fact thata better outcome was achieved after the establish-

40


ment of the IBRA than previously cannot be used toconclude that the IBRA solution was the best strat-egy, something that should be adopted in all similarsituations.

Assessment

When bank restructuring was launched with theimmediate closure of the least viable institutions inIndonesia and Korea in the fall of 1997, there was nointernationally accepted best practice for handlingbank restructuring in emerging market economies.The IMF staff (and others for that matter) had onlylimited experience in dealing with a banking crisis,particularly within the context of an IMF-supportedprogram designed to deal with a capital account cri-sis. The contrasting outcomes of the Indonesian andKorean experiences have since formed an importantbasis for the IMF staff’s emerging views of best prac-tice in dealing with a systemic banking crisis, as ar-ticulated in a recent policy paper by MAE.12 As thispaper clearly states, the experience of East Asia sug-gests that a successful bank closure and restructuringprogram must include a comprehensive and well-communicated strategy in which uniform and trans-parent intervention criteria are consistently applied.

The experience of Indonesia and Korea, however,is less clear on the exact modality of public sector in-volvement in the restructuring process (i.e., consoli-dated versus nonconsolidated restructuring supervi-sion), nor is it definitive in suggesting that a blanketguarantee, rather than a limited deposit guarantee,must be introduced at the outset of a banking crisis. Ablanket guarantee may not stop runs motivated bywider confidence concerns than just banking sectorproblems, while it involves large contingent liabili-ties for the government with serious regressive impli-cations for burden sharing. Its benefits must thereforebe carefully weighed against its potential costs,within the specific context of the economy in ques-tion. In either case, the coverage of any guaranteescheme must be well designed and, particularly in aweak legal and supervisory system, early steps topreserve and correctly value assets are essential.

Structural Conditionality

Structural conditionality was present in all threecases, and has been the subject of much controversy(see Box 4.1 for how structural conditionality is typ-ically included in an IMF-supported program). One

view holds that the structural reform measures in theIMF-supported programs with Indonesia and Koreawere unrelated to the immediate problem of crisisresolution; they distracted attention from the coremacroeconomic and financial issues; and they werewidely felt to be an encroachment into domestic de-cision making, creating an unnecessary opposition(Feldstein, 1998). Some have even argued that theextensive structural adjustment agenda had a per-verse effect on confidence by signaling to the mar-kets that the situation was much worse than they hadfeared (Radelet and Sachs, 1998a and 1998b). How-ever, there is an alternative view, which holds thatrestoring market confidence required addressing thestructural cause of the problem (Summers, 1999;Goldstein, 2002).

In the case of Indonesia, structural conditionalitywas linked primarily to governance-related objec-tives. It has been argued that this was essential to sig-nal a clean break with the past, namely, that a newway of doing business was being established (Khanand Sharma, 2001). A guidance note issued by theIMF Executive Board in July 1997 indicated thatIMF involvement in governance issues was justifiedwhen “poor governance [would] have significant cur-rent or potential impact on macroeconomic perfor-mance. . . . and on the ability of the government tocredibly pursue policies aimed at external viabilityand sustainable growth.” 13 This certainly provided asomewhat open-ended mandate to pursue governancereforms if they had a significant impact on “poten-tial” macroeconomic performance or on the credibil-ity of policies aimed at external viability. The criticalquestion is whether the scope of conditionality pre-scribed for Indonesia was indeed necessary.

Critical versus noncritical measures

One way of determining whether structural condi-tionality was excessive is to distinguish those struc-tural measures that were critical to crisis resolutionfrom other measures that, while potentially useful ineliminating distortions, were not critical to crisis res-olution. In both Indonesia and Korea, as already dis-cussed, deficiencies in the financial sector were cen-tral to the crises, and tackling these was crucial toregaining market confidence. They were correctly amajor focus of the programs, though in Indonesia im-plementation was flawed and there were also designdeficiencies, particularly, the absence of a compre-hensive strategy for bank restructuring.

41

12“A Framework for Managing Systemic Banking Crises,”SM/03/50, February 2003. Also see Andrews and Josefsson(2003).

13“The Role of the Fund in Governance Issues,” EBS/97/125,July 1997. According to Goldstein (2002), some IMF staff inter-preted this guidance note to imply that the Executive Boardwould not support programs that did not address serious andwidespread governance and corruption problems.


Instead of limiting conditionality to these criticalareas, the Indonesian programs, especially the re-vised January 1998 program, included a large num-ber of additional structural reforms. The rationale foradopting extensive structural conditionality in theJanuary program was that it was necessary to restoreconfidence—the problems of cronyism and corrup-tion, which had not been explicitly dealt with thusfar, were brought to the forefront both by extensivepress commentary and by major shareholder govern-ments. It was an atmosphere in which it came to bebelieved that confidence could only be restored if theSuharto regime demonstrated a radical change in itsway of doing business.

It is difficult to establish the counterfactual as towhether confidence would indeed have been re-stored had all the reforms identified been imple-mented. What is known is that there was no positiveannouncement effect. Despite affirmation by Presi-dent Suharto in the form of a public signing cere-mony, the markets remained unconvinced about hispersonal commitment. Besides, the January programdid not address the macro-critical areas of bank andcorporate debt restructuring. In retrospect, the basicapproach of loading the programs with an overlylarge agenda of structural reforms, however desir-able they may have been on merit, seems ill-advised

from a standpoint of restoring confidence. The elab-oration of such an extensive agenda, much of whichdid not seem critical for stabilization, may have hurtconfidence, once it became clear that the measureswere not owned at the highest political level. Itwould have been better to concentrate on macro-crit-ical areas, along with greater insistence on credibleupfront action in those core areas.

In Korea, too, the agenda of reform was broaderthan seemed necessary, covering not only financialsector reforms but also trade liberalization, corporategovernance, and labor market reform. Stabilizationwas achieved well before the reforms could be im-plemented and indeed the pace of structural reformin nonfinancial areas slowed when the economy re-bounded from the crisis. It is difficult to say whetherthe authorities’ initial commitment to the broad re-form agenda helped to restore market confidence,but certainly immediate progress in reform in someareas was not perceived by the markets to be neces-sary. This is not to say that these reforms did nothave a significant longer-term beneficial effect onthe economy. They may well have done so. But theywere not critical to resolving the crisis.

The program in Brazil did not suffer from theseproblems. The focus of structural conditionality wason macro-critical reform, particularly covering struc-

42

Box 4.1. Conditionality for Structural Reforms in an IMF-Supported Program

IMF-supported programs treat structural reform measures in one of four ways. We usethe Indonesian program of November 1997 to illustrate how structural measures are in-cluded in a program. Some conditions are short term in nature (i.e., they must be met be-fore the next review, while others are longer term (i.e., they should be completed by theend of the program).

• Measures are targets with no conditionality attached. For example, the program en-visaged a broad range of structural reforms, many linked to issues of governance, in-cluding elimination of export taxes and restrictions, dismantling of domestic monop-olies, and greater private sector participation in the provision of infrastructure.

• Structural benchmarks do not directly govern disbursement but trigger discussionon corrective action if not met. These included the introduction of full tax-deductibil-ity of loan loss provisions, completion of a public expenditure review and audits ofstate-owned banks by internationally recognized accounting firms, and the reductionof tariffs.

• Performance criteria govern disbursement (i.e., if they are not met, disbursementsare automatically interrupted). These included the closure of certain unviable banksunder central bank–supervised rehabilitation, establishment of quantitative perfor-mance targets for state-owned banks together with monitoring mechanisms, issuanceof implementation regulations on procurement and contracting procedures, and elim-ination of subsidies by raising electricity and petroleum prices.

• Prior actions are measures required before a program request or review can be con-sidered by the Executive Board. The Indonesian program included the closure of 16banks as a prior action.


tural fiscal reform and prudential supervision. Thepaucity of extensive structural measures in otherareas reflected the fact that many of the distortionsrelevant in Asia did not exist in Brazil, at least to thesame extent. There was also strong ownership by theauthorities. The Fiscal Responsibility Law was par-ticularly helpful in establishing a general frameworkto guide budgetary planning and execution, with dis-ciplinary mechanisms for any failure to observe itstargets and procedures, and contributed to the greatercredibility of fiscal policymaking in that country.

Assessment

Two important lessons to be drawn from thesecases are now well recognized within the IMF:

• First, ownership defined as broadly as possible(but especially at the highest political level) iskey to the successful implementation of a struc-tural reform program. But assessments of own-ership can be very complex, requiring a goodunderstanding of the political economy context.Even highly symbolic acts—such as the Presi-dent signing the LOI—may be misleading.

• Second, detailed and extensive structural condi-tionality, particularly in areas that are notmacro-critical, is not helpful to crisis resolution.This is so because it is more difficult to demon-strate commitment in the short term to an exten-sive agenda and because the risks of subsequentdisputes on implementation, which blur themessage of commitment to a coherent strategy,are greater. Perhaps more important, a detailedstructural program also tends to distract atten-tion from the immediate macroeconomic issues.This conclusion supports the recent initiativesby IMF management to streamline conditional-ity and enhance ownership by applying condi-tionality more sparingly to “structural measuresthat are relevant but not critical, particularlywhen they are not clearly within the IMF’s coreareas of responsibility and expertise.”14

The evaluation also suggests the following addi-tional messages:

• When action in areas that are not macro-criticalis nevertheless deemed to be important, a “sec-ond-best” policy package that is strongly ownedmay be more likely to help restore confidencethan a “first-best” package that is painfully ne-gotiated and over which there are substantial do-

mestic reservations. The possibility of suchtrade-offs needs to be recognized.

• The crisis should not be used as an opportunityto seek a long agenda of reforms just becauseleverage is high, irrespective of how justifiablethey may be on merits. This should be the ap-proach even if reformist groups within the gov-ernment are keen to use the leverage of the pro-gram to push reforms. When significantdistortions are known to exist, and the govern-ment is committed to reform, laying out a roadmap for these reforms as an indicative directionby the government is appropriate, but thesemeasures do not need to be the focus of IMFconditionality. The principle of parsimonyshould guide IMF conditionality in such situa-tions. In large part, this was the approach takenin the Brazilian program.

Communications Strategy to Enhance Ownership and Credibility

Restoring confidence involves more than just pro-gram design. It is also necessary to have an effectivecommunications strategy to enhance country owner-ship (with the public) and credibility (with the mar-kets). All three programs initially suffered from thefailure to communicate their logic to the public andthe markets.

Building country ownership

Country ownership generates domestic politicalsupport for an agreed program, hence making it morelikely to be implemented. Ownership, however, is abroad concept. While program negotiations mustnecessarily be conducted with a small group of seniorofficials in the finance ministry and the central bank,successful implementation depends on the supportfrom other stakeholders, including the head of gov-ernment, key officials from other ministries, the bu-reaucracy that must implement the program, the par-liament that must approve the necessary legislation,and civil society at large (Khan and Sharma, 2001;Boughton and Mourmouras, 2002). An effective pub-lic communications strategy is needed to buildbroader public support, hence stronger country own-ership, during a crisis, when speed is of the essenceand wider consultation is therefore not feasible.

Building credibility

Given the need to restore market confidence, thecommunications strategy must also address the needto build the credibility of a crisis management pro-

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14“Managing Director’s Report to the International Monetaryand Financial Committee—Streamlining Conditionality and En-hancing Ownership,” IMFC/Doc/4/01/6, November 6, 2001.


gram with the markets. In designing a program to re-store confidence, the IMF must understand what themarkets are looking for in a program and to explainthe logic of the program. Particularly in a capital ac-count crisis, the IMF may not necessarily have moreinformation on critical issues than the markets, ne-cessitating some dialogue with the markets(Cottarelli and Giannini, 2002). For example, themarkets may become nervous if there is a perceptionthat concerted action may be taken to involve the pri-vate sector, including a restructuring of sovereigndebt. In such cases, it is important to disclose the fi-nancing assumptions when explaining the logic ofthe program. When concerted action is taken, ofcourse, communication with the markets is the cru-cial ingredient.

At the time of the East Asian crises, the publica-tion of LOIs was not yet customary. The failure topublish the LOI in a timely fashion in Indonesia inlate 1997 undermined the potential impact of theprogram in restoring confidence, as private investorsbegan to speculate on the details of the program.This lesson was quickly learned, and subsequentLOIs were published in all three cases. However, thestaff reports supporting the requests for use of IMFresources were not published. The publication ofsuch reports could have been particularly effective incommunicating the logic of programs to the markets,hence helping to build credibility.

In building credibility, transparency can be apowerful tool. In the repeated game in which theIMF is engaged, relevant information should be dis-closed even if it may cause negative shifts in marketsentiment because, in the long run, the IMF cannotexpect to be effective if it is perceived as willing togo along with hiding information from the markets.In Korea, a confidential staff report was leaked to theKorean press a few days after the program was ap-proved, revealing that the level of usable reserveswas very low and that the stock of short-term exter-nal debt was substantially higher than generally be-lieved. Although this undermined the initially posi-tive market response, it would have been betterpublicly to acknowledge these facts at the outset andto design the program accordingly.15

Assessment

Given the high degree of uncertainty regardingboth economic and political developments during acrisis, events often do not develop as planned. Theright communications strategy can ensure that thisdoes not cause damage to credibility. For example,an effective communications strategy is necessary tomake sure that the markets do not misinterpret thedegree to which the authorities’ policy actually con-forms to their commitments under the program. InIndonesia, the January 1998 announcement of a1998/99 budget confused the markets, because it ap-peared to violate the programmed fiscal target (seethe Indonesia country annex). Such confusion couldhave been avoided, if the content of the program hadbeen explained to the investors, and if the IMF andthe authorities had agreed on a public communica-tions strategy to be followed when program-relatedinformation would be announced.

As discussed earlier, such a communicationsstrategy would be facilitated if Board papers were tospell out the major risks to a program and the broaddirection in which policies would respond under dif-ferent scenarios. It is sometimes argued that explicitdiscussion of the risks could itself undermine confi-dence. We do not find this argument convincingsince (as the experience of the three country casesshows) financial market participants will usually bewell aware of them. To the contrary, a communica-tions strategy that explains how policies would re-spond to key risks is likely to enhance credibility.

Since the crises, the IMF has come to recognizethe importance of public communications in its roleas crisis coordinator. Important steps have beentaken in recent years by the IMF, particularlythrough its External Relations Department, to im-prove the effectiveness of its “external” communica-tions strategy, designed to enhance country owner-ship and transparency.16 While these steps arevaluable, it is also necessary to emphasize the needto design an effective communications strategy to befollowed in a capital account crisis, including appro-priate ways in which public communications exper-tise—especially with financial markets— can be in-tegrated quickly into the program negotiation andimplementation process.

44

15In this context, the former First Deputy Managing Director ofthe IMF has acknowledged the need for transparency, citing theloss of credibility that occurred in a similar situation in Thailand(Fischer, 2001).

16See, for example, “A Review of the Fund’s External Commu-nications Strategy,” SM/03/69, February 2003.

The evaluation of experiences in the three casesstudied reveal some important lessons relating

to internal process issues. These involve human re-source management, the role of major shareholdersand the Executive Board, and relations with other in-ternational financial institutions. Many of these is-sues are general in nature and also arise in othercases.

Human Resource Management

Our evaluation revealed a tendency for the sharper,more candid elements of a diagnosis to be diluted infinal Board papers—whether in the context of an as-sessment of vulnerabilities during the surveillanceprocess or judgments of the potential risks and theprobability of success in program-related documents.This problem, which has been noted in other contextsincluding in the recent IEO evaluation report on pro-longed use of IMF resources, raises the issue ofgreater internal incentives to encourage frank presen-tations of problems. Interviews with staff members in-dicated a perception among some that it was difficultto make assessments on issues that were inevitably ofa probabilistic nature and could not, therefore, be eas-ily proved or disproved, especially in the short term.They feared that efforts at candor were unlikely to besupported fully within the institution if the authoritiesconcerned were to object strongly.1

Second, APD’s staff was overstretched by thecrises simultaneously occurring through the region,but the IMF’s system of internal budgetary andhuman resource management delayed the realloca-tion of resources to APD. A reallocation did eventu-

ally occur, but only once the crises were already wellunder way.

Third, there was a tendency to split responsibilitieswithout clear lines of command, as manifested in theinsufficient integration of APD and MAE in theircountry work during the crises. In particular, staffwith special expertise should have been integratedmore fully into the negotiating missions. The lack offull integration was most costly in the case of Indone-sia. The idea of having a single MAE/area departmentteam in crisis situations has been noted in a recent re-view of MAE by a Managing Director–appointedpanel of outside and inside experts.2 This review hasresulted in a broader reorganization of MAE, one ofthe aims of which is to provide a strengthened centerof expertise responsible for banking crisis manage-ment and resolution issues.

Fourth, available internal knowledge was notfully used in formulating the programs, particularlyin Indonesia and Korea, in part owing to the reorga-nization of the Asia-Pacific operations of the IMF inearly 1997.3 Only a relatively small number of par-ticipants in the missions, including those assignedfrom outside APD, had previous experience with In-donesia or Korea. Although the problems were lesspronounced in Brazil, because of the continuitymaintained at the senior level, short tenure also char-acterized staff assignments with that country in boththe surveillance and the program phases. These ex-amples are a reflection of a broader problem with theexcessive turnover of country teams within the IMF,

Internal Governance

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CHAPTER

5

1Several staff members referred to previous occasions (not in-volving any of the three country cases under study here) where, intheir view, staff had made candid assessments but had not beensupported by the Executive Board when the country concernedobjected. While the IEO makes no judgment on the validity ofsuch assertions, the perception that there is insufficient backingfor candor clearly does matter. These issues have also surfaced inprevious evaluations of surveillance, including the Whittome Re-port and the Crow Report.

2“Review of the Monetary and Exchange Affairs Department,”November 2002. This review also flagged some more generalconcerns about the role of MAE in supporting area departmentsin tackling financial crisis situations and resolving problems indistressed banking systems. Issues raised, which go beyond thethree country cases evaluated here, included: (1) MAE tended tomove too slowly in reaching a firm position on policies that wereneeded to address urgent problems; and (2) there were problemswith the consistency of advice between different crisis countries.See also “Report of the Task Force on the Review of the Mone-tary and Exchange Affairs Department,” December 2002.

3The Central Asia Department and the South Asia and PacificDepartments were merged to form what is now APD, effectiveJanuary 1, 1997.

CHAPTER 5 • INTERNAL GOVERNANCE

as has previously been noted by a report of the Of-fice of Internal Audit and Inspection as well as bythe IEO’s evaluation of prolonged use of IMF re-sources (IEO, 2002).

While these managerial issues need to be tackledfor the sake of improving performance, however,most of the weaknesses in program design and im-plementation identified by the evaluation did notarise primarily from human resource managementproblems. Thus, the evaluation team does not believethat these issues fundamentally altered the outcomeof the programs.

The Role of Major Shareholders andthe Executive Board

The need to respond quickly to deal with thecrises required close collaboration of staff and man-agement with the Executive Board, particularly inthe cases of Indonesia and Korea where the acceler-ated procedures under the Emergency FinancingMechanism were invoked. Frequent informal ses-sions served to facilitate a flow of information, andprovided Executive Directors with opportunities tovoice their inputs into the program at differentstages. Such close consultation was necessary for theExecutive Board to fulfill its governance role inthese large-access cases, in which political judgmentplayed an even greater role than usual and speed wascritical.

The major shareholders also interacted directlywith management during the negotiation phase onwhat should be the key elements of program designand also with the authorities in the country con-cerned. This involvement is entirely understandableand appropriate given the exceptional size of accessinvolved and the concern about possible systemic ef-fects, the fact that any strategy is risky, and also thefact that bilateral support may have to be provided.In the case of Korea, the close involvement of theUnited States in the earlier stages probably facili-tated the later U.S. decision to take a leadership rolein organizing a rollover agreement among interna-tional banks. Likewise, it was the close earlier in-volvement of the other major shareholders that al-lowed them to respond promptly to that U.S.initiative by exercising moral suasion on banksbased in their countries.

However, in order for the IMF to undertake itsrole as crisis coordinator effectively, two elementsare critical. First, Executive Directors (and, throughthem, key shareholders and other potential sourcesof official financing) need to be given candid as-sessments of the probability of success of the pro-posed strategy, including frank feedback when partsof the strategy favored by some shareholders lower

this probability. Second, it is important that thetechnical assessments of the staff and political judg-ments by the Executive Board not be blurred. It islegitimate and important for the Executive Boardand shareholders to communicate their expectationsto management and also to interact with manage-ment on what might be the contours of an accept-able program. In certain situations, shareholdersconcerned with an evolving crisis may wish to dealdirectly with the authorities, as the authorities mayalso wish to deal directly with them, and there wereexamples of such interactions in all three cases.However, any appearance of shareholders dealingdirectly with IMF missions in the field can be mis-interpreted.4

In the case of Indonesia, interviews with staff andinternal documents indicate that there was extensivefeedback from members of the Executive Board onthe need to strengthen structural conditionality. Thiswas not inconsistent with the framework envisagedby the July 1997 guidance note, which explicitlystated that the IMF “should collaborate with othermultilateral institutions and donors in addressingeconomic governance issues” and also endorsed useof informal channels of interaction with ExecutiveDirectors to keep them “informed on a timely basisof developments in significant cases involving gov-ernance issues, including those in which third par-ties’ governance concerns have implications for pro-gram financing.”5 However, our assessment revealsthat this feedback from the Board may have con-tributed to the excessive structural conditionalitybuilt into the Indonesian program. This suggeststhat, while greater involvement by the Board in thesecases is appropriate, ways must be found to ensurethat it does not lead to micromanagement of opera-tional details.

The Relations with OtherInternational Financial Institutions

In its role as crisis coordinator, the IMF supple-mented its own resources with additional financingfrom other IFIs, including the World Bank, the ADB,and the IDB, and also drew upon the analyses ofthese institutions in specific areas of their expertise.The relationship was not always smooth, however,and public disagreements sometimes erupted, devel-opments that could not have been supportive of theefforts to restore confidence.

46

4The country annexes provide some examples where such in-teraction did take place and had some adverse effects.

5“The Role of the Fund in Governance Issues,” EBS/97/125,July 1997.

Chapter 5 • Internal Governance

Very little difficulty arose in this respect in Brazil,where both the World Bank and the IDB worked al-most exclusively in the social sector. In Asia, theworking relationship with the World Bank and theADB was more difficult, as all three institutionsworked in the financial sector and their areas of re-sponsibility necessarily overlapped. While goodworking relationships eventually developed as theareas of responsibility became more clearly definedover time, much depended on the personalities of themission members. The lack of an effective mecha-nism to resolve differences of view led the ADB tosuspend temporarily its collaborative relationshipwith the IMF in Indonesia in late January 1998 be-cause of a disagreement over the establishment ofthe IBRA.

This experience suggests that when future arrange-ments call for similar collaborative efforts with re-gional development banks, it is important that theterms of reference for their engagement in IMF-sup-ported programs be agreed at the very outset, so thatthere is a clear understanding of the demarcation ofresponsibilities. Staff from these IFIs should be givenaccess to all relevant information that is at the dis-posal of the IMF and be invited to comment on thecontent of the program in areas where these institu-tions have particular expertise and are expected toprovide financing.6 A procedure should also be estab-lished to resolve any difference of views, so that allrelevant IFIs can speak with one voice on matters ofsubstantive policy.

In the case of IMF–World Bank collaboration,there were significant frictions in the case of Indone-sia. The IMF initially obtained information from theWorld Bank as inputs into structural conditionality,without having the Bank staff’s direct involvement in

the drafting and negotiation of the program docu-ments. Given its preference for more direct involve-ment, the January 1998 program ensured that theWorld Bank, and especially its Indonesia-based staff,was actively involved in formulating the detailedstructural conditionality. In the future, it will be nec-essary to have a clearer understanding on the role ofthe World Bank in the structural component of anIMF-supported crisis-management program. Themanagements of the IMF and World Bank have al-ready acted to put in place strengthened procedures.7

Despite the active involvement of World Bankstaff in the IMF-supported programs in Asia, therewas public criticism of the IMF strategy (especiallyon fiscal and monetary policy) from the Chief Econ-omist of the World Bank, which attracted consider-able attention. It is relevant to ask whether these crit-icisms were appropriately considered within theIMF. The IMF and the World Bank had earlieragreed, in the so-called Concordat on Fund-BankCollaboration, on a general procedure to resolve dif-ferences of view between the two institutions oneconomic issues. The evaluation team has not beenable to uncover any evidence of dissenting opinionsfrom the World Bank surfacing formally through theprocedures established under the Concordat. It ispossible that this may be because differences of viewon strategy did not follow a simple IMF–WorldBank divide.8 It is difficult for the evaluation team todraw any general conclusion except to say that theestablished collaborative procedures clearly brokedown at one of their major tests, with significant ad-verse consequences.

47

6For example, the Indonesian case study notes complaints fromADB staff that it was not sufficiently informed and consultedabout the evolution of the strategy in areas where it was involved.Some IMF staff suggested that this reflected confidentiality con-cerns as well as the fast-moving nature of the negotiations, whichcreated time pressures that led to incomplete communicationamong the IFIs.

7See “Strengthening IMF–World Bank Collaboration on Coun-try Programs and Conditionality,” SM/01/219, August 2001;“Strengthening IMF–World Bank Collaboration on Country Pro-grams and Conditionality—Progress Report,” SM/02/271, August2002; and “Staff Guideline Note on Operationalizing Fund-BankCollaboration in Country Programs and Conditionality,” April2002.

8In this context, the World Bank’s Operations Evaluation De-partment provides its own analysis of the Bank’s crisis responsein Indonesia, showing that there were differences between the as-sessment of the Office of the Chief Economist and that of theBank’s regional staff (World Bank, 1999b).

In this final chapter, we first present our conclu-sions on major issues discussed in this report. We

then draw from our findings six recommendations,designed to enhance the ongoing efforts to improvethe effectiveness of IMF surveillance and programdesign in a capital account crisis.

Conclusions

Precrisis surveillance

The effectiveness of IMF surveillance varied inthe three countries. Surveillance identified the cen-tral problems in Brazil reasonably accurately, but itwas less effective in Indonesia and Korea. It identi-fied specific weaknesses in these countries, but un-derestimated their seriousness and thereby failed toprovide sufficient warning. This difference in effec-tiveness partly reflected the fact that Brazil sufferedfrom macroeconomic imbalances, a traditional focusof IMF surveillance, whereas in Indonesia and Koreathe problems lay in the weaknesses in the financialand corporate sectors. Surveillance identified theseweaknesses, but it did not produce an accurate as-sessment of the extent of vulnerabilities they posed.Surveillance reports were insufficiently candid aboutpotential vulnerabilities, especially those related togovernance issues. In part, these problems reflectedweaknesses in data availability that subsequent ini-tiatives have made a major effort to correct, but theyalso reflected internal incentives that discouragedcandor. More generally, there was an insufficient ap-preciation of the fact that weak balance sheets canpose substantial macroeconomic risks, even whenmost macroeconomic indicators suggest no obviousmajor problems.

The impact of surveillance was generally limited,because of (1) a reluctance to state difficult or embar-rassing facts and views, for fear that this would alarmmarkets or generate conflict with national authorities,especially when hard evidence on some of these is-sues was lacking; (2) lack of receptiveness of countryauthorities to the policy advice of the IMF, whenthere were political constraints or honest differences

of view; (3) limited IMF leverage in a nonprogramsetting, particularly in an environment of buoyantcapital flows to emerging markets; and (4) failure toinfluence the public policy debate or promote betterrisk assessment by private creditors by not makingthe IMF’s views better known to the public.

Macroeconomic framework and projections

The three country cases illustrate the enormous dif-ficulties in designing macroeconomic policy in capitalaccount crises, which stem from (1) the possibility ofmultiple equilibria which implies the potential forlarge exchange rate changes; and (2) the negative im-pact of balance sheet effects on aggregate demand.These difficulties are intrinsic to the nature of a capi-tal account crisis, and the IMF’s conventional ap-proach was not well-suited to dealing with them.

In all three country cases, at least part of the pro-gram design problems resulted from growth projec-tions that turned out to be incorrect. In both Indonesiaand Korea, the initial projections were overly opti-mistic. In contrast, the initial projections for Brazilwere too pessimistic. In Brazil, overpessimism re-sulted in insufficiently ambitious fiscal targets. Themain cause of these problems was the absence of ananalytical framework in which all key factors thatlikely affect aggregate demand during a crisis are con-sidered, notably the impact of balance sheet effectsand confidence factors on private investment. Thesenegative forces were very strong in Indonesia andKorea and led to a sharp decline in private investment,which had a severe contractionary impact. These ef-fects were not present in Brazil because private sectorbalance sheets were well hedged and hence less vul-nerable to a change in the exchange rate.

Even if macroeconomic projections for programdesign are improved in this way, the problem of un-certainty will remain. The nature of this uncertainty isparticularly difficult to handle when there are possi-bilities of multiple equilibria leading to bimodal dis-tributions of outcomes. This in turn implies that themere fact that an IMF-supported program failed doesnot necessarily mean that the decision to provide fi-nancial support was unreasonable ex ante. However,

Conclusions andRecommendations

48

CHAPTER

6

Chapter 6 • Conclusions and Recommendations

in each of the three cases studied, it does appear thatthere were important elements of the initial strategythat lowered the probability of success—either be-cause the program was perceived by the markets asunderfinanced (e.g., the first Korea program), or notfully owned by the authorities (e.g., Indonesia), orhaving an unsustainable policy package (e.g., the ex-change rate regime in the first Brazil program).

Fiscal policy

Fiscal policy was tightened in response to the cri-sis in all cases, but to different degrees and with dif-ferent effects. The initial tightening of fiscal policyin Indonesia and Korea was moderate and was pro-posed on the assumption that growth would remainpositive. It was justified on the grounds that sometightening was necessary to lessen the burden on theprivate sector in external adjustment and to pay forthe interest cost of bank restructuring. This reason-ing proved to be mistaken, as the IMF has itself ac-knowledged, given the severe collapses that fol-lowed in aggregate demand and output. The lowinitial stock of government debt also made it unnec-essary for the interest cost of bank restructuring tobe translated immediately into an improvement inthe fiscal position.

In Korea, there was scope for a “debt for debt”swap in which the government could draw on itsspare borrowing capacity to offer its obligations inexchange for those of the troubled financial sector.In Indonesia, the weak banking sector presentedlarge contingent liabilities to the government, whichin turn faced severe financing constraints. There wasthus less scope for substantially expansionary fiscalpolicy. However, the initial fiscal tightening was notthe primary cause of the contraction in either coun-try. The contraction was largely due to balance sheeteffects that had not been taken into account in mak-ing macroeconomic projections. In any event, thetargeted tightening was quickly reversed as it be-came clear that aggregate demand and output expec-tations were way off the mark.

In Brazil, the fiscal adjustment was much moresubstantial than in Indonesia or Korea, and this wasappropriate because public debt sustainability wasindeed the major factor driving the evolution of thecrisis. However, it turned out to be insufficient inachieving the objective of stabilizing and then reduc-ing the debt-to-GDP ratio, leaving Brazil vulnerableto further shocks that materialized soon after the pe-riod covered by our evaluation.

Monetary policy

Monetary policy under the IMF-supported pro-grams shared similar objectives, but ultimately dif-

fered in implementation and impact in each country.In Indonesia, the program envisaged a continuationof already tight monetary policy, but this intentionwas completely reversed in actual implementation.The open-ended provision of liquidity support totroubled banks led to a substantial loosening of mon-etary policy, resulting in increasingly negative realinterest rates. In Korea, monetary policy was tight-ened as intended, but this proved ineffective untilafter a rollover agreement was put in place. It can beargued with hindsight that the tight monetary policyin Korea was continued for too long in face of theunexpectedly sharp output contraction. However, theperiod in which rates may have been higher thannecessary was relatively short and the delay in mon-etary loosening was not the major factor causing therecession. In Brazil, there was an initial failure totighten monetary policy to protect the peg as envis-aged in the program, but policy was tightened againafter the currency was floated and proved effectivein stabilizing the situation. The relatively sound con-dition of corporate and financial sector balancesheets in Brazil meant that there was only a limitedimpact on investment and aggregate demand. How-ever, a disproportionate share of the interest rate bur-den was borne by the public sector, which had seen alarge increase in the share of the public debt linkedto short-term interest rates.

It is difficult to draw simple conclusions about theefficacy of an interest rate defense of the exchangerate in a capital account crisis from these country ex-periences. This is not surprising since the broadertheoretical and empirical literature has also not pro-vided a definitive answer on the question. As is nowwell recognized, the health of the banking sector is acritical factor, and the effectiveness of interest ratesin stabilizing exchange rates is reduced when a twincrisis is involved. This was the case in both Indone-sia and Korea.

Official financing and private sector involvement

Our evaluation suggests that availability of offi-cial financing can potentially lead to better outcomesin capital account crises, provided that underlyingtrends and policies are sustainable. The chance ofsuccess is always uncertain, but the IMF should notlimit itself only to backing “sure things”—indeed,IMF financing would not be needed if the probabil-ity of success of adjustment programs were near 100percent, since markets would respond very rapidly tosuch situations.

The scale of financing needed in a capital accountcrisis is often very large, making it difficult for theIMF to meet the entire financing requirements on itsown. In such cases, it is possible to supplement IMF

49

CHAPTER 6 • CONCLUSIONS AND RECOMMENDATIONS

resources with financing from other IFIs or bilateralsources. However, it is important to ensure that thepredictability of such financing meet the scrutiny ofthe markets. Including in the financing package re-sources that are not perceived to be available on anassured basis can actually reduce the credibility ofthe program. This has implications for the conditionsunder which bilateral or other multilateral financingcan be relied upon.

The role of the IMF in promoting PSI was fairlylimited in all three cases, largely reflecting the pre-vailing rules of the game that did not give the IMFany special mandate to be proactive in this area. InKorea, the rollover agreement was a decisive factor,but this was essentially initiated by the major share-holders, with the IMF playing an important role bysetting up systems to monitor changes in exposureon a daily basis, thereby facilitating information ex-change among governments. The IMF performed asimilar role in Brazil. However, exhortations for“voluntary” PSI (as in the case of the first Brazil pro-gram) had limited impact when the program lackedcredibility.


The three country cases reaffirm the importanceof having a sound banking system in order both tominimize vulnerability to crisis and to mitigate theadverse impact of a crisis when it does occur. In In-donesia and Korea, a weak banking system signifi-cantly contributed to the onset as well as the severityof the crises. The experiences of both countries sug-gest that successful bank restructuring requires acomprehensive and well-communicated strategy, inwhich uniform and transparent criteria are consis-tently applied to bank closure and other interventiondecisions. The Indonesian experience in particularshows that, where the legal system and bank super-vision are weak or corrupt, early steps to preserveand correctly value assets are essential. The experi-ence of the two countries is less clear on the exactmodality of public sector involvement in the restruc-turing process (i.e., consolidated versus nonconsoli-dated restructuring supervision).

The nature of the deposit guarantee to be intro-duced during a crisis requires careful consideration.A blanket guarantee may be sufficient to stop runsprompted by a perceived weakness of the bankingsector, but it involves large contingent liabilities forthe government, and can have serious regressive im-plications for burden sharing. In a poorly regulatedbanking system where governance problems are seri-ous, a blanket guarantee can also lead to abuse if it isextended to banks that are left under the control ofexisting managements. In introducing a blanket guar-antee, benefits must be weighed carefully against po-

tential costs, and country-specific factors must befully taken into consideration.

Structural conditionality

Our review of the three country cases reaffirmsthe need for structural conditionality to focus on crit-ical areas and the importance of country ownershipof the resulting policy measures. This conclusionsupports the recent initiatives by IMF managementto streamline conditionality and enhance ownershipby applying conditionality more sparingly to “struc-tural measures that are relevant but not critical, par-ticularly when they are not clearly within the IMF’score areas of responsibility and expertise.”1

Reform in macro-critical areas is usually essentialto restore market confidence, as in the case of finan-cial sector reform in Indonesia and Korea, as well asfiscal policy reform in Brazil. The crisis should notbe used as an opportunity to seek a long agenda ofreforms with detailed timetables just because lever-age is high, even though such reforms may be bene-ficial to long-run economic efficiency. If reform inareas that are not generally regarded as macro-criti-cal is required (in the sense that they are not directlylinked to domestic and external sustainability)—when for example widespread distortions are wellknown and the authorities are committed to re-form—the principles of parsimony and focus shouldapply. This implies a broad approach of identifyingsuch areas of reform, but providing maximum flexi-bility to the authorities on implementation details asa means of enhancing ownership.

Communications strategy

Restoring confidence involves more than just pro-gram design and must include an effective communi-cations strategy to enhance country ownership andcredibility. Effective communications with the publicare necessary to build broad support during a capitalaccount crisis, when time is of the essence and widerconsultation to build ownership is therefore not feasi-ble. Communication is also needed with the markets,in order to understand what they are looking for in aprogram and to explain the logic of the program. Inthis effort of building credibility, transparency can bea useful tool. In a capital account crisis, the IMF doesnot necessarily have more information than the pri-vate sector. Without disclosure of critical informationfor the investors, for example concerning the financ-ing assumptions, or how policies might be adjusted to

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1“Managing Director’s Report to the International Monetaryand Financial Committee—Streamlining Conditionality and En-hancing Ownership,” IMFC/Doc/4/01/6, November 6, 2001.


evolving developments, it is difficult to expect themarkets to perceive the program to be credible.

Internal governance

The IMF’s mode of surveillance, as well as its cri-sis response, particularly in Asia, revealed some in-ternal process weaknesses. These are of general rele-vance but emerged particularly strikingly in thesecases. First, there were insufficient incentives for thestaff to be forthright in discussing risks and gover-nance issues in a candid manner. Second, the organi-zational structure prevented the expeditious deploy-ment of human resources or a sufficient integration ofthe work and views of technical departments withthose of area departments. Third, as a reflection ofthe broader problem with excessive turnover of coun-try teams within the IMF, very few staff memberswith previous country experience worked on the cri-sis-related programs in each of the three countries.

In a crisis of confidence, when it was desirable forall to speak with one voice, the failure to resolve dif-ferences of view among IFIs was damaging. Thisseems to have reflected a lack of clear procedures forresolving disputes (in the case of the Asian Develop-ment Bank) or because such procedures were notfollowed (in the case of the World Bank).

Recommendations

Since the three crises reviewed in this report, agreat deal of learning has already taken place withinthe IMF. New guidelines have been issued, or arebeing discussed, to incorporate that learning intopolicies and operational procedures, particularly inthe areas of surveillance, conditionality, access pol-icy, bank restructuring strategy, IMF–World Bankcollaboration, and external communications strategy.These initiatives will help to improve the effective-ness of IMF surveillance and program design. Nev-ertheless, our evaluation suggests some specificareas where these initiatives could be enhanced.These are set out below as six recommendations,covering precrisis surveillance, program design, andthe role of the IMF as crisis coordinator.


Recommendation 1. To increase the effectivenessof surveillance, Article IV consultations should takea “stress-testing” approach to the analysis of acountry’s exposure to a potential capital accountcrisis. The current guidelines, revised in September2002, already suggest that surveillance should in-clude “comprehensive assessments of crisis vulnera-bilities,” covering “economic fundamentals that may

have an impact on market sentiment,” “risks arisingfrom global market developments,” and “factors af-fecting a country’s ability to deal with a sudden shiftin capital flows.” We recommend extending and sys-tematizing this approach.

• Staff reports for Article IV consultations coulditemize the major potential shocks that the econ-omy could face in the near future, explore thelikely real and financial consequences of each ofthese shocks—including balance sheet effects—and discuss the authorities’ plans for dealingwith them should these shocks arise.2 Such dis-cussion should cover the effectiveness of anyexisting social safety nets both as automatic fis-cal stabilizers and as a means of mitigating theimpact of a crisis on the most vulnerable sec-tions of society.

• Staff should try to develop a greater understand-ing of the political constraints that may affectpolicymaking and of market perspectives onpolicy. Article IV consultation missions to sys-temically important countries should thereforeseek a wider dialogue with individuals beyondsenior economic officials, including especiallythose in the domestic and international financialcommunities. This is already done in “best prac-tice” cases, but it would be desirable to formal-ize the process. In this context, it would be use-ful to include separate sections in staff reportswhere market views and political economyanalyses are provided. Expertise available inICM could be tapped on the former. ResidentRepresentatives should also be incorporated intothe preparation of staff reports in a more sys-tematic way.

Recommendation 2. Management and the Execu-tive Board should take additional steps to increasethe impact of surveillance, including through makingstaff assessments more candid and more accessibleto the public, and providing appropriate institutionalincentives to staff.

• The recently revised surveillance guidelines callfor Article IV consultation reports to contain amore systematic assessment of what happenedas a result of the IMF’s previous policy advice(along with an opportunity for the authorities to comment on the advice). To make such as-sessments more operationally relevant, manage-ment could develop modalities for escalated sig-naling when key identified vulnerabilities are

51

2Allen and others (2002) set out much of the framework thatwould be necessary for such an analysis.


not addressed over several rounds of surveil-lance. While it is beyond the scope of this evalu-ation to spell out a detailed proposal on how thiswould be achieved, the aim should be to providethe Executive Board with a vehicle for signalingwhen failures to address identified vulnerabili-ties have become an increasing source of con-cern. In this context, escalated signaling wouldhelp strike a right balance between the role ofthe IMF as confidential advisor and its role as avehicle for transmitting peer reviews on mem-bers’ policies and for providing quality informa-tion to markets. Escalated signaling would givemember countries enough time to address un-derlying vulnerabilities, while also progressingtoward greater candor as a means of increasingthe effectiveness and impact of surveillance. Itwould also help to create an environment inwhich there is a clearer perception of the majorvulnerabilities that would need to be suitablyaddressed as part of program design, should acrisis occur and IMF support be requested.

• Management and the Board should explore thepossibility of seeking “second opinions” fromoutside the IMF as part of the surveillanceprocess when the authorities disagree with thestaff ’s assessment on issues that are judged tobe of systemic importance.3 This would improvethe degree of objectivity with which contentiousissues are handled in the surveillance processand may enhance the impact of surveillance. Itwould also serve as a building block for the ideaof escalated signaling.

• While we recognize that there are risks in gener-alizing from a small number of cases, the expe-rience of the three countries supports the casefor a presumption that staff reports for ArticleIV consultations should be published.4 Publiciz-ing such information will help to generate amore informed debate on the need for structuralreforms oriented toward crisis prevention. Thepublic would also be better informed about theunderlying rationale of the reforms that the IMFmight subsequently deem necessary in the eventof a program. Concerns have been expressedthat publication of staff reports may compro-mise candor in terms of both what the authori-ties are willing to share with the IMF and whatstaff is willing to disclose in public. But the

country experiences discussed in this report sug-gest that, without publication, there is also a riskthat the IMF can have the worst of bothworlds—with limited impact as a “confidentialadvisor” and limited scope for making its viewsknown in the broader policy debate.

• Encouraging publication of country-level analyt-ical work by staff will contribute to the quality ofIMF advice and public policy debate. Existingguidelines are ambiguous about whether publi-cation, with the appropriate disclaimers, ofcountry-related Working Papers by staff requiresclearance by the relevant Executive Director. It isdesirable to create a presumption that publicationis encouraged.

• To encourage greater candor in the assessment ofcountry risks and vulnerabilities, managementand the Executive Board should agree on a sys-tematic plan of action to provide staff with ap-propriate institutional incentives, possibly in-cluding measures to give greater independenceto teams conducting surveillance. The recentlymodified guidelines call for greater candor insurveillance reports, but such guidelines are un-likely to yield fundamental change unless theyare compatible with internal incentives.

• The biennial reviews of surveillance should,inter alia, focus on assessing the impact of sur-veillance on key systemic issues in membercountries. As part of this assessment process,the existing Surveillance Guidelines should bemade public, so that the criteria against whichthe IMF expects to judge its own performanceare clear to all.

Program design

Recommendation 3. A comprehensive review ofthe IMF’s approach to program design in capital ac-count crises should be undertaken. The IMF’s owninternal reviews have already generated many im-portant lessons for program design and this evalua-tion has highlighted a number of others. The pro-posed review or redesign should be oriented aroundtwo key elements: (i) the objective of a crisis man-agement program is first and foremost to restoreconfidence; and (ii) the interaction of balance sheetweaknesses and key macroeconomic variables iscritical to how the economy will respond. This broadapproach suggests the following specific initiatives:

• It is necessary to pay much greater attention tobalance sheet interactions and their conse-quences for aggregate demand, especially incapital account crises where possibilities of

52

3The Executive Board has already indicated its acceptance inprinciple of such an approach in the discussions following theevaluation of the prolonged use of IMF resources.

4The Crow Report also recommended routine publication of allstaff reports for Article IV consultations.


multiple equilibria exist. With the associatedprospect of a large change in the exchange rate,an obvious message from the case studies is thatdesigning programs around a single real GDPgrowth projection, which is inevitably the resultof negotiation, can lead to significant problemsin macroeconomic program design. It is noteasy to ensure that all relevant determinants ofgrowth are adequately taken into account, but amore systematic framework should be elabo-rated to ensure that program design should takeaccount of how the status of balance sheetswould influence aggregate demand, as well asthe role of interest rates and exchange rates inparticular cases.

• Program design should allow for a sufficientlyflexible response, in case unfavorable outcomesmaterialize. Although reviews and waivers canbe said to serve this purpose in a conventionalcrisis, large potential changes in key variables ina capital account crisis may render the originalprogram irrelevant very quickly, and the appear-ance of persevering with a failed program can bedamaging to market confidence. This suggeststhat the major risks to the program should beidentified explicitly, along with a broad indica-tion of how policies will respond. In the area offiscal policy, for example, if public sector debtsustainability is not a constraint, program designcould allow for countercyclical fiscal policy—either by adjusting quantitative fiscal targets au-tomatically to allow explicitly for the operationof automatic fiscal stabilizers or by targeting thelevel of discretionary expenditures rather thanthe fiscal deficits per se. More generally, pro-gram documents should spell out explicitly howmacroeconomic policies will respond in theevent of sharper-than-programmed economicdownturns, and this should be clearly communi-cated to the public.

• The conventional framework of conditionalitybased on financial programming (includingquantitative monetary targets) should be re-viewed to see if, and how, it should be adaptedto the circumstances of capital account crises.Quantitative performance criteria (PCs) areoften not useful as a guide to policy in a capitalaccount crisis when the behavior of key eco-nomic variables can be highly uncertain andvolatile and large deviations can develop, whichmay be difficult to correct later. It may bepreferable to agree, in addition to performancecriteria, to a mechanism of triggering consulta-tions on monetary and fiscal policy, with someunderstanding on how the mix of policy needs

to change in light of evolving circumstances.Just such an approach was taken in Korea in De-cember 1997 in the setting of interest rates andin Indonesia in March 1998 when specific inter-est rate actions were specified. The approach toprogram conditionality in countries with formalinflation targeting frameworks for monetarypolicy is also evolving in this direction.

• A crisis should not be used as an opportunity toforce long-outstanding reforms, however desir-able they may be, in areas that are not critical tothe resolution of the crisis. When political judg-ment necessitates addressing significant distor-tions that are known to exist, and the govern-ment is committed to reform, it should besufficient to lay out a road map for these reformsas an indicative direction outside IMF condi-tionality, and this fact should be communicatedto the public. Parsimony and focus should be theprinciples to guide the design of structural con-ditionality in a program whose objective is to re-store confidence quickly. In this respect, we en-dorse the current initiatives of the IMF tostreamline conditionality, while stressing that, ina capital account crisis, the critical test of a par-ticular measure involves whether or not it helpsto restore confidence.

• Program design should include an agreed strat-egy to communicate the logic of the programand any subsequent program-related informa-tion to the public and the markets. Such a strat-egy should be characterized by a high degree oftransparency, including the immediate publica-tion of LOIs and early disclosure of any unfa-vorable information.

The IMF as crisis coordinator

Recommendation 4. Since restoration of confi-dence is the central goal, the IMF should ensure thatthe financing package, including all components,should be sufficient to generate confidence and alsoof credible quality.

• Financing packages prepared by the IMFshould not rely on parallel official financing,unless the terms of access are clear and trans-parently linked to the IMF-supported strategy.Attempts to inflate the total amount of financ-ing by including commitments made under un-certain terms would risk undermining the cred-ibility of the rescue effort. This implies that ifthe IMF is to play an effective role as crisis co-ordinator, either it must have adequate finan-cial resources of its own or the availability of

53


additional official financing should be madesubject to a single, predictable framework ofconditionality.

• When parallel financing is sought from otherIFIs, the terms of reference for their engagementshould be specified at the very outset, includingmechanisms to resolve differences of view andthe manner in which their inputs are reflected inprogram design. This is particularly important inthe case of collaboration with regional develop-ment banks, for which no established proce-dures exist.

Recommendation 5. The IMF should be proactivein its role as crisis coordinator. Such a proactive rolewould include the following elements:

• Management should provide candid assess-ments of the probability of success and a frankfeedback to the Executive Board and sharehold-ers if some elements of the strategy are signifi-cantly lowering the probability of success.

• While involvement of shareholders is necessaryand appropriate, particularly in large accesscases, management should ensure that the tech-nical judgment of staff be protected from exces-sive political interference.

• While decisions on the nature of private sectorinvolvement will have to be made on a case bycase basis, the IMF should play a central role inidentifying circumstances where more concertedefforts (as was eventually undertaken in Korea)can be useful in overcoming “collective action”constraints. This should be based on a meaning-ful dialogue with the private sector, building onthe new mechanisms for such a dialogue thathave been established in recent years.

Recommendation 6. Human resource manage-ment procedures should be adapted further to pro-mote the development and effective utilization ofcountry expertise within the staff, including politicaleconomy skills, and to ensure that “centers of exper-tise” on crisis management issues allow for a rapidapplication of relevant expertise to emerging crises.Some important steps are already being taken in thisarea (including encouraging greater training in polit-ical economy), but a broader effort, based on long-term strategic planning, is needed. It is also desirableto formalize the procedure for encouraging candor incountry work.

• New institutional arrangements within the IMFshould be established to ensure that the IMF isin a position to deliver a rapid response, in termsof policy advice, to member countries facing

crises and to assist in program design in suchcases. A variety of organizational approachescould be used to achieve this objective, and wedo not propose to suggest a specific structure.However, the aim should be to ensure that dedi-cated resources are maintained to respond to cri-sis management situations and to learn frompast experience. This is precisely the approachproposed by management in the reorganizationof MAE. The same principles should be adoptedon an IMF-wide basis to deal with crisis casesinvolving large access.

• The length of staff assignments to country desksshould be monitored to ensure that sufficientlyrecent country expertise is maintained withinthe staff. This information should be reportedperiodically to the Board.

• The terms of reference of Resident Representa-tives should be modified to encourage them toplay a more central role in surveillance and pro-gram design (see also Recommendation 1,above). This already happens in some, but notall, cases.

• Internal guidelines and human-resource proce-dures should be modified to protect missionchiefs and others who raise uncomfortable is-sues through any authorized channel andthereby attract complaints from the authorities.For example, the internal Annual PerformanceReview exercise could be enhanced to givegreater weight to the ability and willingness tomake independent, candid judgments.5 Ex postassessments of surveillance (see Recommenda-tion 1, above) could be used as a basis for eval-uating senior staff performance in this regard.

• A medium-term IMF-wide program should beestablished to develop a critical mass of staffmembers with significant country expertise ineach of the emerging market economies thathave been identified as systemically important,including mechanisms to allow staff to makevisits to these economies for professional de-velopment and systematic efforts to assign rel-atively junior members as Resident Represen-tatives. An information system to track thisexpertise should be established.6

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5The Annual Performance Review form for IMF managers al-ready contains sections calling for the assessment of competen-cies that are relevant to this issue (e.g., sound judgment/analyticalskills, and strategic vision) but does not address it directly.

6For example, at present there is no central system that wouldallow management to ascertain easily which staff members haveworked on particular countries in the past.

The IMF’s FinancialArrangements with Three CrisisCountries, 1997–20021

APPENDIX

1

55

Overview

Board Expiration or Amount Percent of Amount AmountApproval Cancellation Agreed Quota Drawn Outstanding

IndonesiaStand-By Arrangement 11/5/1997 8/25/1998 7,3382 490 3,669 367Extended Arrangement 8/25/1998 2/4/2000 4,6693 312 3,798 3,798

KoreaStand-By Arrangement 12/4/1997 12/3/2000 15,500 1,938 14,413 0

Of whichSupplemental

Reserve Facility 12/18/1997 12/17/1998 9,950 1,244 9,950 0

BrazilStand-By Arrangement 12/2/1998 9/14/2001 13,025 600 9,471 2,687


Reserve Facility 12/2/1998 3/10/1999 9,117 420 6,512 0Stand-By Arrangement 9/14/2001 9/5/2002 12,144 400 11,385 8,068


Reserve Facility 9/14/2001 9/5/2002 9,951 328 9,951 6,634

Disbursements

Indonesia Korea Brazil_____________________ _____________________ _____________________Date Amount Date Amount Date Amount

11/10/1997 2,201 12/5/1997 3,843 12/15/1998 5435/7/1998 734 12/8/1997 257 12/15/1998 2,876

7/20/1998 734 12/19/1997 1,570 2/1/1999 08/28/1998 706 12/22/1997 750 4/6/1999 3,6368/31/1998 28 12/23/1997 280 12/9/1999 8149/30/1998 684 12/30/1997 800 6/28/2001 1,602

11/12/1998 634 12/31/1997 700 9/28/2001 3,31711/13/1998 50 1/9/1998 1,320 9/28/2001 35912/18/1998 684 1/12/1998 180 6/21/2002 6,6343/30/1999 337 2/20/1998 1,407 6/21/2002 1,0766/10/1999 337 2/27/1998 938/6/1999 337 5/29/1998 935

6/3/1998 4658/28/1998 250

` 9/2/1998 47512/17/1998 7254/12/1999 1815/20/1999 181

Source: IMF database.1Financial positions are as of January 31, 2003. The figures refer to millions of SDRs.2The arrangement was augmented by SDR 1 billion for a total of SDR 8,338 million on July 15, 1998.3The arrangement was augmented by SDR 714 million for a total of SDR 5,383 million on March 25, 1999.

We have spoken to more than seventy current andformer members of IMF management, staff, and theExecutive Board. In addition, the following individ-uals have provided their views to the IEO, mostlythrough personal interviews but also through semi-

nars and workshops. We express our gratitude fortheir generosity in making their time available to us,and apologize for any errors or omissions. They as-sume no responsibility for any errors of fact or judg-ment that may remain in the report.

List of Interviewees

APPENDIX

2

56

International Organizations

World Bank

Sri-Ram Aiyer Laura Ard Mark BairdShahid Javed Burki Lily Chu Denis de TrayBert Hoffman Masahiro Kawai Lloyd KenwardAnupam Khanna Gobind Nankani Vikram NehruGuillermo Perry Richard Roulier David ScottJoseph Stiglitz

Asian Development Bank

Robert Boumphrey V.V. Desai David EdwardsSrinivasa Madhur Khaja Moinuddin Aftab Qureshi

Inter-American Development Bank

Ricardo Santiago

Organization for Economic Cooperation and Development

Yutaka Imai Val Koromzay Pierre PoretEva Thiel

Member Country OfficialsIndonesia

Saleh Afiff Heri Akhmadi Moh Arsjad Anwar Boediono Hendro Budiyanto Dorodjatun Kuntjoro-JaktiMiranda Goeltom Djunaedi Hadisumarto Ginandjar KartasasmitaBacharuddin Jusuf Habibie Sri Hadi Cyrillus HarinowoKwik Kian Gie Jimly Asshiddiquie Mar’ie MuhammadMoerdiono Anwar Nasution Benny PasaribuRadius Prawiro Putu Gede Ary Suta Rizal RamliSjahril Sabirin Bambang Soedibjo Soedradjad DjiwandonoBambang Subianto Surjadi Sudirdja Ali WardhanaBambang Widianto Widjojo Nitisastro Agus Widjojo Wiranto Glenn Yusuf

Korea

Il-Sang Bae Soonhoon Bae Yangho ByeonBuhm-Soo Choi Joong-Kyung Choi Duck-Koo ChungKyuyung Chung Myung-Chang Chung Jaesung HurKyung Wook Hur Kyong Shik Kang In-Ho KimJae Chun Kim Kihwan Kim Tae-Dong KimHun-Jai Lee Kyu Sung Lee Jang-yung LeeKyungsik Lee Chang-Yuel Lim Jaehong SuhJae-Hoon Yoo

Appendix 2

57

Member Country Officials (concluded)

Brazil

Pérsio Arida Edmar Bacha Fábio BarbosaAmaury Bier Clovis de Barros Carvalho Antônio Delfim NetoArminio Fraga Gustavo Franco Daniel Luiz GleizerIlan Goldfajn Antonio Kandir Joaquim LevyFrancisco Lopes Gustavo Loyola Pedro MalanAloizio Mercadante Arno Meyer Hélio MoriAlkimar Moura Maílson da Nobrega Marcos Caramuru de PaivaPedro Parente Beny Parnes Affonso PastoreDemosthenes Pinho Paulo Yokota

Other countries

Hiroshi Akama Kenji Aramaki Caroline AtkinsonJenny Bates Terrence Checki John ClarkStephen Collins Gerard Dages John DrageTim Drayson Karen Ellis John GarrettDoris Grimm Andrew Haldane Takuma HatanoTadashi Iwashita Takatoshi Kato Andrew KilpatrickHaruhiko Kuroda David Lipton Colin MilesAdrian Penalver Eisuke Sakakibara Rintaro TamakiKok Peng The Edwin Truman Haruko WatanabeTatsuo Watanabe Lindsey Whyte John Young

Academics and Other Private Sector Individuals

Tony Addison Sri Adiningsih Arif ArrymanMarcos Arruda Tadahiro Asami Shinji AsanumaOrley Ashenfelter Haryo Aswicahyono Raymond AtjeRodrigo Azevedo Iwan Aziz Dominic BartonFaisal Basri Mohamad Chatib Basri Paul BlusteinAnne Booth Charles Calomiris Yunje ChoGongpil Choi Susan Collins Charles DallaraTenji Dobashi Michael Dooley Martin FeldsteinAustregésilo Ferreira Kristin Forbes Naoto FujitaYukiko Fukagawa Mayling-Oey Gardiner Edimon GintingRachmat Gobel Morris Goldstein Anton Hermanto GunawanSteve Hanke Koichi Hamada Hartojo WignjowijotoBara Hasibuan Ricardo Hausmann Shinichi IchimuraRaja Iyer Hasung Jang Paul Murray JohnJoseph Joyce Fikri Jufri Ceci Vieira JuruaChungwon Kang Soedjai Kartasasmita Hasan KatadjoemenaYuzuru Kato Kazunari Kawashima Peter KenenTaejoon Kim Toshihiko Kinoshita Nobutaka KitajimaTakeshi Kohno Masataka Komiya Bayu KrisnamurthiFabian Lefrancois Jongwha Lee Keat LeeKyu-Hwang Lee Muhammad Lutfi Nono Anwar MakarimRajeev Malik Suhadi Mangkusuwondo Carlos Mariani BittencourtPeter McCawley M. Bert McPhee Yasuhiro MoritaRiefgi Mura Nopirin Cherie NursalimKenichi Ohno Raden Pardede Jae Ha ParkCelso Pinto Farid Prawiranegara Teddy RachmatChangyong Rhee William Rhodes Sung-tae RoDavid Roland-Holst Nouriel Roubini Kurya RusadMohamad Sadli Felia Salim Pedro Moreira Salles

APPENDIX 2

58

Academics and Other Private Sector Individuals (concluded)

Sam Santoso Shahputra Sekarjati Roberto SetubalPalgunadi Setyawan Jeffrey Shafer Takuya ShikataniSayuri Shirai Pande Radja Silalahi Djisman SimandjuntakDavinder Singh Douglas Smee Natalia SoebagjoHadi Soesastro Steve Sondakh Ernest SternHenry Stipp Ana Maria Stuart Nancy SuhutHariyadi Sukamdani Widigdo Sukarman H. Tjuk Kasturi SukiadiSuryo B. Sulisto Sudarno Sumarto Anton SupitAtmono Suryo Tugagus Mangara TambunanTulus Tambunan Petrus Tjandra Andres VelascoJeremy Wagstaff Mark Walker Sofjan WanandiYunjong Wang Thee Kian Wie Dooyong YangJunssok Yang Masaru Yoshitomi

Annexes

Introduction

This annex presents the detailed assessment of therole of the IMF in Indonesia’s capital account crisisof 1997–98, which forms the basis for the analysis inthe main report. It covers the role of the IMF in theprecrisis surveillance phase and the crisis manage-ment phase. Issues related to the ongoing programwith Indonesia, which began in February 2000, areoutside the scope of our enquiry.

The Indonesian crisis was particularly severe andprolonged, compared with the other crisis cases re-viewed in this report. GDP fell by 13 percent in 1998and there was a substantial increase in the percentageof the population in poverty. Subsequent recovery wasslow, with an average annual growth rate of just above3 percent from 1999 through 2002, so that at the endof 2002, GDP remained about 2 percent below the1997 level. It is useful to recall that the crisis, whichlargely started out as economic, became increasinglypolitical. Particularly, between December 1997 andthe spring of 1998, while it was apparent that the firstprogram had failed, political issues related to the suc-cession of President Suharto and growing social un-rest made it difficult to design a credible alternative.Our evaluation suggests that the exceptional severityof the Indonesian crisis is in large part a reflection ofthe confluence of economic and political crises,which limited the ability of conventional policy toolsto address economic problems.

This annex is organized as follows. It first evalu-ates the effectiveness of surveillance prior to the cri-sis. It then discusses issues of program design, in-cluding (1) fiscal policy, (2) interest rate policy andmonetary targets, (3) exchange rate policy and capi-tal controls, (4) official financing, (5) bank closureand restructuring, (6) deregulation, (7) corporatedebt restructuring, and (8) the initial strategy and itsadaptation. The following section discusses theIMF’s mode of operations, covering such issues ascountry ownership, the decision-making process,human resource management, and the role of majorshareholders and collaboration with the World Bankand the ADB. The final section presents conclusionsand an overall assessment.


This section discusses the effectiveness of IMFsurveillance in three areas of potential vulnerability:macroeconomic performance, banking sector weak-nesses, and corruption and cronyism. The IMFbroadly identified the potential vulnerabilities in allthese areas, but it failed adequately to recognizetheir seriousness and adverse implications.1

Macroeconomic performance

Indonesia’s performance before the 1997 crisiswas characterized by strong economic growth andapparently sound macroeconomic fundamentals(Figure A1.1). IMF surveillance, however, noted therisks associated with the large capital inflows,which averaged 6 percent of GDP during 1992–96.As a result, the stock of private foreign debt in-creased rapidly from about US$38 billion in 1995 toUS$65 billion just before the crisis and US$82 bil-lion at the end of 1997. Moreover, short-term pri-vate foreign debt was a large proportion of the total,reaching US$33 billion, just before the crisis in1997, equivalent to 1.5 times the stock of gross in-ternational reserves. However, IMF surveillancegrossly underestimated the magnitude of short-termdebt, hence the vulnerability of capital flows to ashift in market sentiment.2

Both the IMF and the Indonesian authorities rec-ognized that the volume of capital inflows was un-comfortably large. This was a frequent subject ofdiscussion at official meetings (e.g., the EMEAPCentral Bank Governors’ meeting in early 1995) and in the academic literature (Radelet, 1995). As a counterpart of the increasing capital inflows, the

Indonesia

61

ANNEX

1

1At a meeting of the Indonesia Consultative Group held in Tokyoon July 16–17, 1997 for example, the IMF representative statedthat “financial market confidence in Indonesia [remained] strong,”while noting the “need to guard against changes in market senti-ment, weaknesses in the banking system, relatively high externaldebt and increased financial market turbulence in the region.

2Although no precise figure is given, the staff report for the1997 Article IV consultation noted that the stock of short-termdebt was “low,” suggesting a range of US$10 billion.

ANNEX 1 • INDONESIA

current account deficit widened from 1.8 percent ofGDP in 1992/93 to 3.3 percent in 1995/96, and to3.5 percent in 1996/97.

The policy advice from the 1996 Article IV con-sultation mission, endorsed by the Executive Board,was that the authorities should follow tight fiscal andmonetary policies, combined with faster externaldebt repayment. According to a former senior In-donesian official, Bank Indonesia (BI) made at-tempts to measure the capital inflows, an idea alsoendorsed by the Executive Board. This, however,sparked protests from the financial community, fear-ing that it was a precursor to imposing capital con-trols. Limitations were placed on the overseas bor-rowings of state enterprises, but the effectiveness ofthis initiative was uncertain.

The 1997 Article IV consultation report notedthat the country was vulnerable to external shocks,and warned that excessive demand pressures werecontributing to higher inflation and a wider currentaccount deficit. The IMF advocated a tighter fiscaland monetary policy stance, greater exchange rateflexibility, and accelerated structural and bankingsector reforms to maintain progress in reducing in-flation, contain current account deficits, and mini-mize external risks. The IMF argued for a smallercurrent account deficit than the amount consideredacceptable by the Indonesian authorities, whothought that a deficit of up to 4 percent of GDP wassustainable.

The authorities’ views were based on the follow-ing factors:

• There were no strong indications of exchangerate overvaluation and non-oil exports were reg-istering robust growth;3

• The current account deficit remained smallerthan those in most ASEAN countries and was nohigher than in 1991/92 and was significantlylower than the levels in Thailand (5–8 percent ofGDP) and Mexico (6–7 percent) in the threeyears prior to the crises in those countries;

• The counterpart of the higher current accountdeficit was an increase in private sector invest-ment to 27 percent of GDP in 1996 from 20 per-cent in 1992, likely contributing to faster eco-nomic growth; and

• Although debt was high by regional standards, itwas evolving favorably with a stable and rela-tively low debt-service ratio of just over 30 per-cent, accompanied by a reduction of total exter-nal debt to under 50 percent of GDP in 1996/97from 56 percent in 1991/92.

In retrospect, the elements that were missed in theauthorities’ analysis—and underemphasized by IMFsurveillance—were the macroeconomic implicationsof short-term capital flows that were vulnerable to asudden shift in market sentiment and the underlyingweakness of seemingly buoyant private investment,much of which was in fact supported by imprudentlending and of questionable productivity.

Banking sector weaknesses

The risks from large and potentially volatile capi-tal inflows were amplified by the poor quality of do-mestic financial intermediation and governanceproblems in the corporate and banking sectors. Thefragile state of the banking system mainly resultedfrom the rapid deregulation following the so-calledPakto reform of 1988, which allowed a substantialincrease in the number of banks without adequateprudential regulations.4 Entry to the banking indus-try was made possible with a small amount of capi-tal, but there were no adequate provisions for weakbanks to exit.

A reasonable structure of prudential regulationshad been put in place, in part with extensive techni-

62

–0.15

–0.05

0.05

0.15

0.25

0.35

–15

–10

–5

0

5

10

Figure A1.1. Indonesia: Selected MacroeconomicIndicators

Source: IMF.

1990/91 92/93

Precrisis Crisis

94/95 96/97 98/99 200099

Real GDP growth(in percent a year;

left scale)

Current account balance(in percent of GDP;

left scale) Non-oil/gas exports growth(in percent; right scale)

Overall fiscal balance(in percent of GDP;

left scale)

3According to IMF data, the annual average real effective ex-change rate was 97 in 1994/95, 99 in 1995/96, and 105 in1996/97, with the base of 100 for 1990.

4In this context, Pincus and Ramli (1998) argue that Indone-sia’s fundamental mistake was to deregulate the banking sector in“deeply entrenched patrimonial state structures.”

Annex 1 • Indonesia

cal assistance received over the years from the WorldBank, but this had little impact on the quality ofbanking, because enforcement was poor. Apart fromthe general problem of weak public administration,attempts to impose rules ran into stiff oppositionfrom politically well-connected vested interests.This was demonstrated most clearly in the removalof the head of prudential supervision at BI in 1993,when he attempted to enforce connected lendinglimits on the largest of the private banks, which hadclose political connections. With this precedent,banks flouted prudential rules with impunity. Theeasy flow of financial resources to conglomeratesthrough the banking system was facilitated by an in-ternational environment that encouraged flows offoreign capital into emerging markets.

Some academic researchers have argued that thePakto reforms were designed to provide the well-connected with access to cheap money and created aprocess of financial flows closely approximating a“Ponzi” game (Cole, 2002). Indeed, banks affiliatedwith large conglomerates owned by the well-con-nected tapped the large pool of household savingsand used the deposits to fund their own affiliatedfirms, often in risky or questionable ventures. Manyof the loans were never repaid, while the ownerspaid themselves high interest rates on their deposits(Gie, 1993). BI dealt with the resulting insolvencyby “nursing” the banks to health through long-termlow-interest loans. The maturity of these loans couldbe as long as 30 years, with a grace period as long as10 years and an interest rate as low as 1 percent.

The IMF correctly perceived that there weremajor problems in the state banking sector, an areawhere the World Bank was in the lead in the effortsto promote reform.5 In several surveillance reports,the IMF staff alerted the Executive Board to the seri-ous governance issues in the state banks and encour-aged the authorities to move forcefully in this area. Itis understandable against this background that thestaff perceived the shift from public- to private-sec-tor banks as a positive contribution to dealing withthe problems of the banking sector. However, thedangers of poor governance in private sector banksappear to have been underplayed.

There were serious governance problems in theprivate sector banks. These problems first came tothe knowledge of the IMF in 1994, when a technicalassistance mission from MAE visited Indonesia.Upon examining the supervision data provided by

BI, the MAE mission identified serious solvencyproblems in a number of private banks and learnedthat the problem banks were being effectively recap-italized with subsidized loans provided by BI, creat-ing enormous moral hazard. The mission also cameto view the “losses” of the banking system as largelyrepresenting transfers to conglomerates run by thewell-connected. Despite these suspicions of corrup-tion, however, there were no hard data to make thelink between balance sheet weaknesses in the banksand governance failures. The confidential nature oftechnical assistance work meant that it was neverpresented to the Executive Board or widely dis-cussed within the staff. However, the area depart-ment also did not explore the implications of warn-ings made by RES during the interval review processthat there would be serious macroeconomic conse-quences from these vulnerabilities if there were con-fidence shocks.

These concerns were noted in surveillance reportsbut they were not adequately addressed, for exam-ple, by stress testing or exploring their potential pol-icy implications. Drawing on the work of MAE, thebackground paper for the 1997 Article IV consulta-tion observed that the main problems of the Indone-sian banking sector were reflected in a high share ofNPLs, incomplete compliance with prudential re-quirements by some banks, concentrated bank own-ership and connected lending, continued operationof problem banks, and large exposure of banks toproperty loans. While the paper offered precise tech-nical measures to address these problems, the gover-nance and moral hazard issues identified by the ear-lier MAE missions were understated. A depositinsurance scheme, an idea recommended by MAE asa measure to increase confidence in the banking sys-tem, was taken up by the Selected Issues paper butwas not followed up in the staff report.

In short, the nature of the main problem was iden-tified and signaled to the Executive Board, but in amuted fashion. In line with the prevailing conventionof the time that corruption should not be directly dis-cussed, Board papers did not present an explicit as-sessment of the cronyism and corruption that createdmoral hazard in the banking sector. They also failedadequately to analyze the potential macroeconomicimpact of shifts in market sentiment.

IMF surveillance noted that a number of reformswere being initiated by the authorities. For example,in 1996, six private banks were merged into three,and the authorities were considering merging theseven state banks. BI was encouraging problembanks to address their NPLs and the President issueda decree in December 1996 on the procedures for re-voking the business licenses of banks and their dis-solution and liquidation. In February 1997, the Pres-ident approved the closure of seven banks to be

63

5The World Bank became engaged in the restructuring of largestate banks through a Financial Sector Development Project.While the purpose of the World Bank project was to recapitalizeand improve the operations of the problem state banks, the Bankbecame aware of serious governance problems in the summer of1996 and eventually decided to suspend the project.


implemented after the elections, and BI strengthenedthe prudential regulations by requiring (1) a gradualincrease of the capital-adequacy ratio to a minimumof 12 percent by 2001 and a minimum Rp 150 bil-lion (around US$60 million) of paid-up capital foreach foreign exchange bank; (2) rating of commer-cial paper issued and traded through banks; and (3)tougher selection standards for bank managementpositions. However, with the benefit of hindsight, theIMF appears to have been overly impressed by theinitiatives that did not contribute substantively to ad-dressing the underlying problems.

The weak banking system proved highly vulnera-ble to external shocks. Once the Thai crisisprompted a reassessment of potential risks through-out the region, foreign investors began to pull out ofIndonesia, thereby drying up the previously plentifulsource of low-cost financing to the corporate sector.The heavily indebted corporate sector found itselffacing liquidity problems,6 which were then com-pounded by a sharp exchange rate depreciation thatraised the cost of servicing foreign debt. Conglomer-ate after conglomerate stopped servicing their loans,as the value of foreign currency debt doubled andthen quadrupled in value. Foreign lenders rushed toclose their exposure to Indonesia. At the time of thecrisis, the banking system thus faced a huge portfo-lio of potential NPLs. This risk was on top of thesystem’s own severe internal difficulties.

Of course, it is not possible to say with any cer-tainty that the banking system would have been ableto survive the massive exchange rate shocks of1997–98, even if it had been stronger financially andwith more robust governance. Nor is it possible tosay that a more candid discussion of these issues aspart of surveillance would have significantly af-fected domestic policies. Nevertheless, it is the casethat the potential risks were not sufficiently flaggedor analyzed. As a consequence, the knowledge of theunderlying balance sheet vulnerabilities was rela-tively limited, when the crisis did hit.

Corruption and cronyism

Indonesia’s vulnerability to crisis was greatly in-creased by the increase in corruption and its changingnature (Pincus and Ramli, 1998; Kenward, 2000; Lee,2000; Booth, 2001; Cole, 2002). In the 1990s, thereemerged a creeping return to restrictive business prac-tices and rent-creating opportunities for the Presi-dent’s family and well-connected businessmen, with acorresponding weakening of regulatory and supervi-sory controls. For example, in 1996, the palm oil sec-tor was closed to foreign investment, export bans and

restrictions were introduced in a wide range of prod-ucts, and impediments were placed on intraregionaltrade in livestock; in April 1997, the preshipment in-spection system, a customs procedure designed toprevent corruption and managed by a foreign firm,was canceled although it had proved highly effective.

Originally, corruption in Indonesia was akin to atax on the cost of a project, charged by and paidthrough established channels to maintain the stabilityof the political system (Charap and Harm, 1999).Even such corruption raises moral and equity con-cerns, but its impact on efficiency was said to be lim-ited by the certainty and relatively low levels of thecharge. In the early 1990s, however, the media beganto see a change in the system of corruption, and todraw links with the empire building of the President’schildren and well-connected businessmen.7 Corrup-tion was being transformed into an ever-widening sys-tem of deliberate rent-creation for the well-connected,including the creation of monopolies and monop-sonies, and exclusive rights to large industrial or infra-structure projects, such as the National Car Project.

These issues surfaced in discussions with the au-thorities in the precrisis period, and the staff consis-tently supported the World Bank’s view that slip-pages in structural areas were damaging Indonesia’smedium-term prospects. As noted, much of it in-volved favored treatment given to the First Familyand close associates of the Palace, but some simplyrepresented a continuation of the dirigiste tendenciesthat were still the way of doing business in Indone-sia. The staff reports for the 1996 and 1997 ArticleIV consultations recommending renewed deregula-tion received broad support within the IMF, includ-ing from the Indonesian chair on the ExecutiveBoard. The 1997 report identified a list of structuralreform measures that would later become the coreelements of structural conditionality in the IMF-sup-ported program (see Appendix A1.1).

It is difficult to determine the extent to which thestaff was aware of the growing scale of corruptionand its deleterious effects because it was customaryat the time for governance issues to be dealt withonly obliquely and indirectly in surveillance reportsand Executive Board discussions. The staff took atechnocratic approach of dealing with symptoms(i.e., creeping regulation) without explicitly address-ing their underlying causes (i.e., cronyism), therebyblunting their analysis and Board discussion. An ex-

64

6Indonesia’s average debt to equity ratio was high at 250 per-cent (Ghosh and others, 2002).

7See, for example, articles that appeared in the Asian WallStreet Journal, April 13 and October 24, 1994, and June 29 1995;and in the Far Eastern Economic Review, July 11, 1991, June 23,1994, and February 9, 1995. The topic of changing business prac-tices, particularly in Asia, also began to receive an increasingfocus of attention in the academic literature (e.g., Fukuyama,1995; Weidenbaum and Hughes, 1996).


plicit focus and candid Board discussions mighthave brought out more clearly the changing nature ofcorruption in Indonesia, and the macroeconomicrisks it posed. Whether it would have had an impactin Indonesia is an open question, but at least it wouldhave better prepared the IMF to deal with the crisiswhen it broke out.

Program Design

This section reviews major elements of programdesign in the IMF-supported programs in 1997 and1998, with a focus on how the emphasis in programdesign changed from November 1997 to January1998. The initial program was designed on the as-sumption that the crisis was essentially a moderatecase of contagion and the implementation of a rela-tively conventional IMF-supported program wouldbring the rupiah back into a reasonable range. Theseexpectations were belied and, toward the end of De-cember, it became clear that the crisis in Indonesiawas much more severe than elsewhere in the region.The crisis at this stage had become intensely politi-cal and there were doubts about whether the govern-ment was committed to the program. This led to therenegotiation of the program in January and a newLOI. The emphasis in program design switched tothe establishment of structural conditionality to sig-nal a new way of doing business in the hope that thiswould restore confidence.

Fiscal policy

Prior to approaching the IMF, the Indonesian au-thorities had already responded to the crisis by cut-ting public spending on low-productivity projects.This was meant both to facilitate the required currentaccount adjustment and, more important, to help re-build international confidence by signaling the au-thorities’ determination to reduce dependence oncapital inflows while improving governance.

The November 1997 program broadly endorsedthis approach. In internal discussions, the FirstDeputy Managing Director moderated the fiscal tar-gets proposed by staff and rejected proposals to in-crease the value-added tax (VAT), in order to avoidfiscal overkill at a time when output developmentswere uncertain. The program planned for a modestimprovement in the fiscal position in fiscal year1998/99 to cover partially the unknown carrying costof bank restructuring (Table A1.1).8 Specifically, the

initial program, based on growth assumptions of 5 percent for 1997/98 and 3 percent for 1998/99,targeted:

• An overall budget surplus of 0.75 percent ofGDP for 1997/98, compared with a surplus of0.5 percent projected during the 1997 Article IVconsultation, and a surplus of 1.3 percent during1996/97;

• An overall budget surplus of 1.3 percent of GDPfor 1998/99, though this was to be reviewedlater in the light of developments before beingfixed as a performance criterion;

• A reduction of capital spending amounting to0.5 percent of GDP in 1997/98 and a further 0.5percent cut in 1998/99 through postponing orcanceling low-productivity projects (such asinter-island bridges);

• Cuts in operations and maintenance expendituresamounting to 0.25 percent of GDP in 1997/98and a reduction in fuel subsidies amounting to 0.5percent of GDP in 1998/99; and

• Various tax and expenditure measures, includinghigher excise taxes on tobacco and alcohol;lower transfers to state-owned enterprises andimproved tax administration.

The Indonesian program has been extensively criti-cized for an overly contractionary fiscal and monetarystance which, according to some critics, actuallymade matters worse. As far as fiscal policy is con-cerned, the tightening proposed for 1997/98 was mod-est and reflected the basic assumption that Indonesiawas suffering from a moderate case of contagion. Theimplementation of the program was expected to bringabout a quick restoration of confidence and a recoveryof the exchange rate, while growth would deceleratebut still remain respectable.

The growth assumption on which the Novemberprogram was based turned out to be far too opti-mistic and this was a fundamental weakness of theinitial program design. While GDP growth in1997/98 was 4.8 percent, only marginally lower thanthe 5 percent rate projected in the program, therewas a collapse in 1998/99 with GDP declining by 13percent instead of growing by 3 percent as projected.Some critics have attributed the collapse in output tothe pursuit of tight fiscal and monetary policies incircumstances where these were not warranted, butthe problem arguably lay elsewhere. The output col-lapse in 1998/99 was driven not by the stance of fis-cal policy but by the near-collapse of private invest-ment in the first and second quarters of 1998. Privateinvestment is difficult to forecast over a businesscycle and earlier studies have shown that IMF-supported programs tend to be overoptimistic about

65

8Until fiscal year 2000 (April–December), Indonesia’s fiscalyear ran from April 1 to March 31 of the following year. There-after, it corresponded to the calendar year.

AN

NEX

1 • IND

ON

ESIA

66

Table A1.1. Indonesia: Fiscal Outomes and Targets(In percent of GDP)

1997/98_________________________________________________ 1998/99November _______________________________________________________________

1997 November November January April June November1996/97 Article IV without 1997 1997 1998 1998 1998 1998________

Outcome Budget projection measures program Outcome program program program review review Outcome

Revenue 15.2 14.0 14.7 15.1 15.2 16.2 14.7 . . . 12.6 14.1 12.6 15.3

Expenditure 13.9 14.2 14.2 15.4 14.4 17.2 13.7 . . . 17.3 24.2 18.6 17.4Of which:

Subsidies 0.3 0.0 0.3 0.7 0.7 3.1 0.2 . . . 2.3 6.2 4.3 4.2Capital 5.7 5.9 5.3 6.2 5.6 6.6 5.2 . . . 5.7 7.1 7.1 5.1

Overall balance 1.3 –0.2 0.5 –0.3 0.8 –1.0 1.0 –1.0 –4.7 –10.1 –6.0 –2.1

Memorandum item:GDP growth 8.0 8.0 8.0 5.0 5.0 4.6 3.0 0.0 –5.0 –12.1 –13.6

Sources: IMF staff reports; and IEO staff estimates.


private investment (Goldsbrough and others, 1996).In Indonesia, the collapse of private investment wasespecially severe because of (1) the unexpectedlylarge exchange rate depreciation in a situation wherecorporations had borrowed heavily in foreign ex-change, and (2) the impact of political develop-ments—including especially rioting against the eth-nic Chinese community—on business confidence.

The role of fiscal policy in the Indonesian crisisneeds to be evaluated in this broader context oflarger forces driving developments in the real econ-omy. The November 1997 program implied modesttightening in 1997/98 and further tightening in1998/99, but it also stated that the fiscal target for1998/99 would be updated and converted to a perfor-mance criterion at the time of the first review in Jan-uary 1998, taking into account, inter alia, output de-velopments (see Appendix A1.1). Unfortunately,these provisions incorporating flexibility were notmade public. The 1998/99 draft budget presented bythe government on January 6, 1998, which proposedzero deficit, appeared to violate the terms of theagreement with the IMF and triggered speculation inthe press that it might signal a possible withdrawalof IMF support.9 In fact, by the time the 1998/99draft budget was put together in the latter part of De-cember, it was known that the growth forecast for1998/99 would need to be revised downward and in-ternal documents and interviews make clear that aconsensus had emerged within the IMF that a sur-plus was not appropriate under the conditions thatwere then prevailing or were likely to prevail in In-donesia.10 The IMF did issue a statement of supportfor the announced budget within two days. The con-fusion could have been avoided if the authorities hadconsulted with the IMF before they released thedraft budget, explaining that the overall balance dif-fered from that in the November program becausethe situation had changed and that this was done infull consultation with the IMF.

The second LOI agreed in mid-January 1998 re-duced the earlier 3 percent growth projection to zerogrowth and provided for a relaxation of the fiscalstance to a deficit of 1 percent of GDP for 1998/99.The third LOI signed in April 1998, which was theoperationally relevant one for the 1998/99 budget,further raised the programmed overall deficit to 4.7

percent of GDP, acknowledging the need for tempo-rary subsidies to protect the poor, while proposing afurther cut in low-priority projects in the develop-ment budget. As the sharper output decline becamemore evident in the following months, the subse-quent LOI in June 1998 further relaxed the fiscal tar-get to a deficit of 10.1 percent of GDP, the largest inany IMF-supported program.

The actual budget deficit in 1998/99, at 2.1 percentof GDP, was much smaller than programmed. Fiscalpolicy was therefore much more contractionary thanallowed under the program. In part, this resulted frominstitutional inflexibilities in using fiscal policy in acountercyclical manner, in the absence of preexistingsocial safety nets that would automatically be acti-vated in an economic downturn. The failure of the au-thorities to use all the fiscal room provided in the pro-gram also reflected the fiscal conservatism of theMinistry of Finance and the limited implementationcapacity of the Indonesian government in general. Theabsence of a government bond market also limited theability of the authorities to finance expendituresthrough noninflationary means, imposing anotherconstraint in operating fiscal policy countercyclically.Thus, the main countercyclical element realized wason the revenue side, as the targeted increases in spend-ing were not met (Table A1.1).

In retrospect, the IMF was slow to recognize thatthe decline in GDP was being driven in large part bythe collapse in investment. In April 1998, when thesharp contraction in investment should have beenclear, the staff report for the first review simply notedthat economic activity had fallen off “markedly” dur-ing the second half of 1997/98, “especially in con-struction and services,” without mentioning the be-havior of private investment. It is only in August1998 that this feature was noted and the EFF requestprojected a remarkable decline of private investmentfrom an estimated 22.5 percent of GDP in 1997/98 to9.2 percent of GDP in 1998/99. Even then, there wasno explanation of why investment had collapsed tothis extent, suggesting that the IMF may not have fo-cused sufficiently on one of the key forces driving theadverse macroeconomic outcome.

Interest rate policy and monetary targets

Contrary to the widespread image that the IMFmechanically pushed for high interest rates, internaldocuments make clear that there was in fact consider-able debate among staff on the best way to deal withthe situation. The staff was fully aware of the basicdilemma: a large exchange rate depreciation wouldbankrupt many firms (and thereby adversely impactthe banking system), while any interest rate highenough to support the exchange rate was also likely tohave similar adverse effects on balance sheets.

67

9A Washington Post article of January 7, 1998 emphasized thelack of commitment to the reform program and only mentioned inpassing that analysts perceived that the budget unveiled by the au-thorities had made suspension of the program more likely.

10In late December 1997 and early January 1998, the staff ex-pected no growth in 1998/99 and did not yet anticipate collapse ofoutput in the first and second quarters of 1998. The output col-lapse was in large part driven by political developments. Therewere also negative balance sheet effects on investment, resultingfrom the sharp depreciation of the rupiah.


Interest rate policy

The Policy Development and Review Department(PDR) and MAE argued for tight monetary policywith high interest rates. PDR argued that the corpo-rate and banking sectors could not bear the addedcosts from any further depreciation, and recom-mended foreign exchange market intervention sup-ported by tight monetary policy. Interest rates wereto be raised temporarily at the outset of the programto signal the commitment of the authorities to ex-change rate stability and to encourage nominal ap-preciation of the exchange rate following the inter-vention. MAE supported high interest rate policy toachieve an early exchange rate appreciation, but ex-pressed reservations on the benefit of extensive earlyforeign exchange market intervention.

On the other hand, RES and APD argued againstfurther tightening monetary policy and raising inter-est rates. RES was concerned that an interest rate de-fense was not feasible with a weak banking systemand a vulnerable corporate sector. It pointed out thatif confidence remained low, the agreed interventionlimits would be reached and higher interest rateswould be required to defend the exchange rate. Buthigher interest rates would damage the corporate andbanking sectors, thereby further eroding confidence.

During the program negotiations, the APD mis-sion argued that it would not be desirable to supportthe exchange rate solely through monetary tighten-ing, especially because monetary conditions were al-ready tight. Instead, it advocated a policy of givingthe authorities more flexibility to intervene whennecessary, without further tightening monetary con-ditions. The mission also pointed out that, on a prac-tical level, BI was reluctant to raise SBI rates, whenit had already done so unsuccessfully in August1997. The mission noted that, as early as September,the central bank Governor had begun to reduce inter-est rates and was still talking in terms of further re-ducing the rates.

The business community in Indonesia was callingfor lower interest rates, and market participants werediscussing the problems associated with maintaininghigh interest rates for a long period. By early Septem-ber 1997, market commentary was suggesting that thebalance sheets of Indonesian firms had been severelydamaged by high interest rates and the weaker ex-change rate. By the end of the month, tight liquiditywas a serious concern for the banking sector, as thebanks’ portfolios had deteriorated rapidly as a resultof their exposure to corporate borrowers with a largeamount of unhedged foreign currency–denominateddebt.11

The differences between RES and APD, on theone hand, and PDR and MAE, on the other, reflectthe dilemma of designing crisis management poli-cies in the face of a twin crisis affecting both the ex-ternal sector and the banking sector, with policiesaimed at addressing one problem causing problemsin the other. However, while the problem was posed,there was no satisfactory way of resolving thedilemma. The policy that finally emerged from thedebate represented a compromise: to keep monetarypolicy tight without setting specific interest rate tar-gets. BI would maintain the one-month SBI rate at20 percent but would raise it if needed to supportforeign exchange market intervention. In approvingthe program, no Executive Director explicitly op-posed the strategy; several Directors, however, ex-pressed strong dissatisfaction with the lack of spe-cific and sufficiently tight monetary action.

Less than a week after the program was launched,the staff was alarmed by the apparent loosening ofmonetary policy reflected in a fall in interbank ratesand urged BI not to lower interest rates prematurely.Initially, during the first week of November, the ru-piah had appreciated from Rp 3,600 to Rp 3,250–3,300 per U.S. dollar, supported by coordinated for-eign exchange market intervention (with Japan andSingapore), and the Jakarta interbank offered rate(JIBOR) began to rise. These gains, however, werenot supported by sustained high interest rates, withthe SBI rate remaining virtually constant (FigureA1.2).12

BI argued that JIBOR was not a good measure ofthe stance of monetary policy. The interbank mar-ket had become more segmented than usual be-tween foreign and state banks with adequate liquid-ity positions, on the one hand, and private bankswith increasingly difficult liquidity positions, onthe other. BI was urging first-tier banks to lend toother banks with assurances that there would be nosecond round of bank closures. At the same time,BI was providing liquidity to second- and third-tierbanks at a rate lower than JIBOR. Staff was con-cerned that the injection of liquidity might causemonetary targets to be breached. In the second halfof November, a mission was dispatched to assessthe situation.

The strategy of intervening in foreign exchangemarkets presented a further complication, given thealready tight liquidity situation caused by the mone-

68

Peregrine in Jakarta and Hong Kong SAR) and September 26,1997 (quoting an analyst at Merrill Lynch Asia Pacific).

12In fact, BI took only a small interest rate action. What hap-pened was that interbank interest rates rose sharply when BI onlypartially sterilized intervention. When BI found some banks fail-ing to clear at settlement, it injected liquidity, causing interbankrates to decline.

11See, for example, investors’ comments reported in theBloomberg News on September 4, 1997 (quoting analysts at


tary squeeze of August.13 Intervention of some US$5billion in the last quarter of 1997 was equivalent toone-third of the stock of base money at the end ofSeptember 1997. As the intervention was to be onlypartially sterilized, this left a large segment of thebanking sector short of liquidity when settlementcame. BI claimed to have no alternative but to pro-vide liquidity but, as a result, the rupiah onlystrengthened for two days before sliding, by the endof November, to its level of October.

With the exchange rate sliding almost continu-ously, it was clear that the original expectation of aquick recovery would not be realized. The IMFurged an immediate rise in the SBI rate by 5 percent-age points as a first step and by more if needed, inaccordance with the understanding on which theprogram was based. The IMF also urged that, asagreed in the program, liquidity support should onlybe offered at market rates and against collateral andthat additional banks should be closed if necessary.However, President Suharto ordered an immediatereduction of 5 percentage points in the SBI rate(which the economic team did not implement). Healso signaled that there should be no more bank clo-sures. With conflicting demands on monetary policycoming from the IMF and the President, the eco-nomic team by this time had all but lost access to thePresident and could take no effective action.

Our evaluation suggests that the criticism that thehigh interest rate policy pushed by the IMF was re-sponsible for the collapse in Indonesia is not wellfounded for the simple reason that the IMF’s recom-mendations in this respect were never implemented.Interest rates were not raised despite repeated IMFurging. Instead, liquidity was expanded and resultedin a loss of monetary control (Box A.1). As a result,real interest rates were substantially negative (FigureA1.3). It was only after March 23, 1998 that the neweconomic team was able to raise nominal interestrates, pushing up the one-month SBI rate to 45 per-cent from 22 percent. The exchange rate steadily ap-preciated from Rp 9,750 per U.S. dollar the previousweek to Rp 7,500 by mid-April and remained below

Rp 8,000 until the May troubles, which provoked afurther depreciation (Figure A1.4).

Monetary targets

Performance criteria for base money were set forend-December 1997 and end-March 1998, and in-dicative targets for end-June 1998 and end-September1998. Base money was to grow by 4 percent in the lastquarter of 1997 and to remain more or less flat in thefirst quarter of 1998. In the event, unlimited liquiditysupport from BI to the banking sector led to a virtualexplosion in base money, which grew by 14 percent inthe last quarter of 1997 and a further 32 percent in thefirst quarter of 1998, before its growth slowed downto 12 percent in the second quarter and finally to 2percent in the third quarter (Figure A1.5).

While central bank liquidity support expandedsharply during the IMF-supported program, BI wasalready providing lender of last resort (LOLR) sup-port to several banks experiencing shortages of liq-uidity well before the program. As the crisis devel-oped, LOLR support was provided under a variety ofschemes, which were later consolidated under thegeneral title of Bank Liquidity from Bank Indonesia(BLBI) early in 1998. With the greater segmentationof the interbank market in the final quarter of 1997,the LOLR role of BI became all the more important.By the end of January 1998, total support underBLBI had reached 5 percent of GDP, or close to 100percent of base money.

BI operated under severe constraints. When abank had a shortfall at clearing, BI had to either sup-ply the needed liquidity, or else close down or takeover the bank immediately (Djiwandono, 2002). InNovember 1997, the Cabinet had decided, in accor-

69

0

20

40

60

80

100

Figure A1.2. Indonesia: Monthly NominalInterest Rates(In percent a year, at the end of the month)

Sources: Bloomberg; and University of Indonesia, Institute for Economic and Social Research.

1997 1998 1999

SBI rate(one-month)

JIBOR(overnight)

IMF-supported program

13According to the BI Governor, liquidity problems in the bank-ing sector developed as a result of monetary and fiscal tightening inAugust 1997. Weak banks began to experience distress and bankruns emerged in the second half of the month. Interbank rates in-creased from an average of 22 percent to more than 80 percent (seeFigure A1.2). By the end of August, “more than 50 banks had failedto comply with the minimum reserve requirement of 5 percent”(Djiwandono, 2000). In the technical files of MAE, however, thereis nothing to indicate a systemic liquidity problem and it is notclear if the whole system became illiquid or if the problem was lim-ited to weak banks and those subject to runs. Market segmentation,however, does seem to indicate that at least the first-tier banks (e.g.,the JIBOR banks) were not short of liquidity.


dance with commitments under the program, to pro-vide LOLR only to solvent banks, but both the BIGovernor and the Minister of Finance were certainthat the President did not want any more banks toclose. Without willingness on the part of BI to inter-vene in some other way, these two objectives weremutually incompatible.

In this climate, liquidity support served both legit-imate LOLR and fraudulent purposes. Together withthird-party depositors withdrawing funds in a “flightto safety,” some bank owners were stripping assets.In parallel, liquidity support also went to cover large

off-balance-sheet exposures in foreign exchange.This was particularly evident in early 1998, whenthe exchange rate plummeted and the banks could nolonger borrow foreign exchange in the interbankmarket. This led to an explosion in liquidity supportduring that period. The increasingly negative inter-mediation spreads, as banks tried to keep paymentscurrent, added to insolvency and illiquidity that con-tributed to a buildup in liquidity support.

By the time the situation stabilized in mid-1998,the volume of liquidity injected through BLBIamounted to around Rp 144 trillion (or 14 percent

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Box A1.1. Indonesia:Was Monetary Policy Tight?

IMF staff has argued that monetary policy was nevertight in Indonesia, because most standard measures ofreal interest rates were negative from the inception ofthe program to early 1999 (Lane and others, 1999;Boorman and others, 2000; Ghosh and others, 2002). Itis true that, for the first five months of the program, theIndonesian authorities hardly raised the policy interestrate despite urging from the IMF. It was only in March1998 that, for the first time under the program, BI sub-stantially increased the SBI rate. The one-month raterose from 22 percent to 45 percent and reached, afterseveral rounds of increases, 70 percent in August 1998.

The assessment of monetary policy under the IMF-supported program is made difficult by several factors:

• Before IMF assistance was requested, in August1997, BI had already raised the one-month SBI ratefrom 10–12 percent to more than 30 percent. How-ever, under pressure from the President, BI wasforced to reduce the rate to around 20 percent inSeptember 1997.

• With a sharp depreciation of the currency, relativeprices in the economy were rapidly changing andthe impact of interest rates was different in trad-able and nontradable sectors. Real interest ratesfaced by the nontradable sector likely remainedpositive—and substantially so—during this pe-riod, while they were substantially negative forthe tradable sector.

• The banking crisis led to a greater segmentation ofthe interbank market with a shift of deposits withinthe banking system. At least initially, 24 of themajor institutions—the so-called JIBOR banks—had plentiful liquidity, while other banks found itdifficult to raise funds at any interest rate. The highnominal interest rates faced by these banks re-flected a large risk premium, not a particular stanceof monetary policy.

• BI provided liberal liquidity support to all banksexperiencing liquidity problems, so that high inter-bank interest rates did not present an issue for thesebanks.

• Continued pressure on the rupiah meant that In-donesian interest rates included a component re-flecting the expected rate of depreciation.

It is fair to say that while high real interest rates werefaced by some potential individual borrowers at differ-ent points in time, the stance of monetary policy as atool of macroeconomic policy was never tight and,contrary to the wishes of the IMF, did not become anytighter as a result of the IMF-supported program.Moreover, market segmentation, always a feature ofthe Indonesian system, worsened markedly and inter-mediation spreads in the banking system became nega-tive as banks attempted to keep payments current.There was, however, a period of tight monetary policyprior to the inception of the program which, accordingto the BI Governor and market observers, had adverseconsequences for the corporate and banking sectors.

A related issue is whether or not high interest ratepolicy caused a credit crunch, a situation where exist-ing demand for credit is not fully satisfied at a given in-terest rate. In the case of Indonesia, as banks experi-enced liquidity and then solvency problems, the supplyof credit clearly fell. At the same time, as the balancesheets of many firms were adversely affected by thesharp depreciation of the rupiah, the number of credit-worthy borrowers also declined. To identify a creditcrunch is inherently a difficult exercise, because it re-quires the identification of both demand and supply. Astudy by IMF staff argues that there was a creditcrunch in Indonesia as the banking crisis deepened, butthat the crunch disappeared when the demand forcredit fell (Ghosh and Ghosh, 1999). The aggregatepicture, however, may not tell the whole story aboutpotential individual borrowers, particularly small andmedium-sized enterprises (SMEs) with no recourse tononbank financing (Yoshitomi and Ohno, 1999). Therewas evidence of some unsatisfied credit need, mainlyreflecting supply factors (Bank Indonesia, 2001).Given the likely impact on the ability of banks to pro-vide financial intermediation, a strategy to deal withthe financing needs of viable SMEs would have beenhelpful, although it is inherently difficult to designsuch a strategy.


of GDP). In the initial phase, penalty rates were im-posed on BLBI, which were then capitalized, lead-ing to a steady rise in the outstanding volume ofBLBI. When it was recognized that this was notserving any purpose, the rates were reduced. AsBLBI was unsecured, the bank owners were re-quired to provide personal guarantees, which laterbecame the basis of the shareholder settlements ad-ministered by IBRA.14

Once BLBI support became routine, moral hazardbecame real. According to the official report of theSupreme Audit Agency (BPK), irregular practicesdominated the administration of BLBI, with Rp 82trillion out of total Rp 144 trillion judged to havebeen misused.15 It should be noted that the reporttook a legalistic approach and thus characterized anyviolation of central bank rules as fraudulent, which

71

–60

–50

–40

–30

–20

–10

0

10

20

30

Figure A1.3. Indonesia: Monthly Real InterestRates(In percent a year)

Source: University of Indonesia, Institute for Economic and Social Research.1The lending rate is for working capital, deflated by actual two-month-ahead

CPI inflation.

1997 1998 1999

SBI(one-month)

Lending rate1

IMF-supported program

–100

–80

–60

–40

–20

0

2000

4000

6000

8000

10000

12000

14000

16000

2000

4000

6000

8000

10000

12000

14000

July Aug. Sept. Oct. Nov. Dec.1997

1997 1998 1999

1998Jan. Feb.

Widening thecurrency band

Floatingthe rupiah

IMF-supportedprogram launched

IMF-supportedprogram launched

Suharto resigns

Suharto resigns

Invitingthe IMF

Jan. 6budget

announcement

Jan. 15programsigning

Nov. 4 programannouncement

Reopening ofSuharto’s son’s bank

Cancellation of Suharto’s tripto the ASEAN summit

Level (In rupiah per U.S. dollar)

Cumulative depreciation from the January–June 1997 average(In percent in rupiah terms)

Figure A1.4. Indonesia: Daily Movements of theRupiah–U.S. Dollar Exchange Rate

Source: University of Indonesia, Institute for Economic and Social Research.

14While liquidity support in principle required collateral, for avariety of reasons, there was little collateral available in 1997–98,which necessitated the pledge of personal guarantees from thebank owners that their banks met the conditions for liquidity sup-port. With the subsequent discovery that many of these pledgeswere in fact invalid, in most cases because the banks hadbreached the legal lending limits, the owners became liable formaking the repayment. Under the so-called shareholder settle-ments, IBRA was to recover such funds from the respective own-ers, but the nonimplementation of commitments and manipula-tion of the process resulted in large LOLR losses.

15The report was prepared at the request of Parliament, in coop-eration with the Finance and Development Supervisory Body(BPKP), with Price Waterhouse serving as a consultant. BPK au-dited all allocations of BLBI to 48 troubled institutions as well asthe use of funds by 5 “Take Over Banks” (BTOs) and 15 liqui-dated banks (BDLs). BPKP audited the use of BLBI by 10“Frozen Operation Banks” (BBOs) and 18 “Frozen Trading Ac-tivities Banks” (BBKU).


likely overestimated the economic cost of corrup-tion. However, it is certain that BLBI not only raisedthe cost of saving the banking system, but also con-tributed to greater exchange rate depreciation by ef-fectively funding capital flight.

Almost all of the BLBI went to private banks, ex-cept for the special case of the state-owned BankEXIM. The liquidity support to Bank EXIM was notin response to deposit withdrawals but rather tofraudulent losses in the bank’s treasury operations.BLBI was concentrated in a handful of institutions,with EXIM and three private banks (BCA, Dana-mon, and BDNI) receiving 75 percent of the total.This concentration of BLBI implies that pressurewas not necessarily on the overall financial system.The case of Bank EXIM is particularly noteworthy,as state banks benefited from the shift of depositsfrom the private banks (given the implicit depositguarantee by the government).

Interviews with staff and a review of internal docu-ments make clear that the staff was not fully aware ofgovernance problems in the injection of liquidity untilJanuary or February of 1998. Thus, although the IMFstaff was in daily contact with the authorities andmonitored the amount of liquidity support, the IMFdid not capture the extent of irregularities in the sup-port operations during the crucial months of Novem-ber and December, when monetary control was lost.

Exchange rate policy and capital controls

The rupiah was floated in August 1997 at the out-set of the crisis before the IMF program was negoti-ated, and this decision was welcomed by the IMF.Nevertheless, in view of sustained downward pres-sure on the rupiah, the IMF staff, during the review of

the brief for the October 1997 mission, discussed theidea of introducing capital controls. The idea wasquickly dropped because of the likelihood that con-trols could not be administered effectively in a coun-try with widespread corruption and weak administra-tive capacity. The Indonesian authorities told theevaluation team that they had never considered intro-ducing capital controls, knowing that there was no in-frastructure to administer such a system effectively.They also pointed out that one of the reasons forabolishing controls in the 1970s in the first place hadbeen their ineffectiveness due to corruption.

By December 1997, the rupiah had depreciatedsubstantially more than the currencies of the othercrisis-hit economies of the region, and was continu-ing to depreciate, indicating that the Indonesian cri-sis was exceptional. In part, this reflected politicaldevelopments. The illness of President Suharto inearly December injected new sources of uncertaintyas succession concerns surfaced prominently, andpolitically motivated attacks on the ethnic Chinesecommunity also intensified.

With the currency in virtual free-fall from De-cember through January, even after the signing of therevised LOI, both the IMF and President Suharto in-dependently began to consider introducing a cur-rency board arrangement (CBA). In Indonesia, busi-ness interests close to the President initiated the ideaand invited an American academic expert to adviseon the subject (Hanke, 1998b). The idea of formallyintroducing a CBA was declared by the President inFebruary 1998. There was widespread though un-substantiated concern, including within the IMF, thatif the CBA were adopted, the rate would be Rp 5,000per U.S. dollar, around half the going market rate,and that its supporters would use it to convert theirrupiah holdings into U.S. dollars.

There were some advocates for the CBA within theIMF, but a consensus soon emerged that the existingconditions in Indonesia, including the weak bankingsystem and the absence of respect for rule of law,were not appropriate for a CBA, at least over the shortto medium term. On February 11, the IMF took a firmstance on the issue by sending a letter to the Indone-sian authorities opposing the CBA and explainingwhy it was not appropriate for Indonesia at that time.A stalemate continued until the major IMF share-holder governments, including Germany, Japan, andthe United States, stated their unequivocal opposition,through high-level contacts with President Suharto.

Official financing

As noted in the main report, determining the sizeof access in a program designed to build confidenceis an inherently difficult exercise, because the resid-ual financing need is endogenous to the effectiveness

72

40000

50000

60000

70000

80000

SBA

ActualSBA, first review

SBA, third review

SBA, second review

Sep. Dec.1997 1998 1999

Mar. Jun. Sep. Dec. Mar.

Figure A1.5. Indonesia: Base Money Outcomesand Targets Under IMF-Supported Programs

Source: IMF documents.


and speed with which confidence is restored. Thisalso makes difficult our evaluation of the size of ac-cess in Indonesia, which was based on a projectionof the likely balance of payments need under certainassumptions.

The IMF assumed that the current account deficitin 1997/98 would show a small improvement of aboutUS$2 billion compared to the previous year, but thiswould be accompanied by a large deterioration in thecapital account of about US$14 billion, reflecting fail-ure to rollover short-term debt, withdrawal of portfo-lio investment, and lower net FDI flows (Table A1.2).The program also aimed to stabilize the level of grossforeign assets of BI at about US$26 billion.

Given these assumptions, the IMF determinedthat an amount equal to one-third of the short-termdebt of US$33 billion (i.e., US$11 billion) wouldneed to be financed over the two years 1997/98 and1998/99. In calculating access, however, it used themore conservative figure of US$22 billion (or two-thirds of the total short-term debt) as the amountthat was required to meet short-term obligationsover the first year of the program. Access from the

IMF was thus set at US$10 billion (490 percent ofquota), after taking account of additional multilat-eral financing of about US$8 billion from the WorldBank (US$4.5 billion) and the ADB (US$3.5 bil-lion), and the use of US$5 billion of BI’s own re-serves if needed.16 Of the US$10 billion to be pro-vided by the IMF, US$8.7 billion was to bedisbursed over the first two years, with US$6.1 bil-lion for 1997/98 and US$2.6 billion for 1998/99.

The program also incorporated a substantial for-eign exchange market intervention of up to US$7.5billion over the first three months of the program,with up to US$5 billion during the month of Novem-ber alone. In the event, the improvement in the cur-rent account was much larger, at US$6 billion, andthe reversal of capital flows was much worse thanprojected. Compared with the net inflow of someUS$14 billion in 1996/97, the November programhad projected a net outflow of US$0.5 billion for

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Table A1.2. Indonesia: Balance of Payments Projections and Outcomes(In billions of U.S. dollars)

1997/98 1998/99_____________________________ _____________________________November April November April

1996/97 program program Actual program program Actual

Current account –7.7 –5.8 –2.3 –1.7 –4.9 4.3 4.3Exports 52.1 55.6 56.3 56.2 60.8 58.8 48.3Imports –50.9 –50.4 –48.5 –47.4 –55.6 –42.3 –33.7Goods and services –8.9 –11.0 –10.1 –10.5 –10.1 –12.2 –10.3

Capital account 13.8 –0.5 –13.5 –11.7 0.9 –14.2 –1.8Long term 4.5 3.1 2.3 3.2 2.1 5.0 6.7

Official –2.0 –0.4 0.5 1.4 –1.0 4.5 6.6Direct investment 6.5 3.5 1.8 1.8 3.1 0.5 0.1

Other 9.3 –3.6 –15.8 –14.9 –1.2 –19.2 –8.5Errors and omissions 1.6 0.5 –0.1 . . . 0.0 0.0 . . .Other 7.7 –4.1 –15.7 . . . –1.2 –19.2 . . .

Oil/gas export credits 0.1 0.1 . . . . . . 0.1 . . . . . .Portfolio investment 1.7 –1.7 . . . . . . –1.0 . . . . . .Other private capital 8.3 –1.6 . . . . . . –0.3 . . . . . .Monetary movements of commercial

banks –2.4 –0.9 . . . . . . 0.0 . . . . . .

Overall balance 6.1 –6.3 –15.8 –13.4 –4.0 –9.9 2.5

Change in gross foreign assets of Bank Indonesia –6.1 0.2 10.2 10.2 0.5 –6.7 –9.4

Financing need 0.0 6.1 5.6 3.2 3.5 16.6 6.9IMF 0.0 6.1 3.0 3.1 2.6 5.3 6.8Asian Development Bank, World Bank

and exceptional financing 0.0 0.0 2.6 0.1 0.9 11.3 0.1

Memorandum item:Gross foreign assets of Bank Indonesia

(end of period) 26.6 26.4 16.4 16.4 25.9 23.1 25.8

Sources: IMF Staff Reports; and IEO staff estimates.

16In view of the high level of reserves, it was assumed that BIcould temporarily cover delays in the disbursement of multilateralresources from the other IFIs.


1997/98. The actual outcome was a net outflow ofsome US$12 billion in 1997/98, including capitalflight by domestic residents.

The working assumption that only one-third of theshort-term debt would be rolled over was not unrea-sonable, as were the rest of the balance of paymentsassumptions. In retrospect, the projections were be-lied by large-scale capital flight by domestic resi-dents, which became ever larger over time. As a re-sult, what had seemed a reasonable package ex antebegan to look inadequate as confidence collapsed.

In our view, the size of financing was not the causeof the failure of the November program. The origin ofthe failure was the inadequacy in program implemen-tation and the associated rapid expansion of liquidity,and this technical failure was soon transformed into apolitical crisis, which undermined business confi-dence especially among the ethnic Chinese businesscommunity. At the technical level, the main oversightwas the failure to take into account the unknown butlarge amount of short-term interbank lines of creditessential to finance imports. Trade credits were notrolled over and this exacerbated the crisis until thespring of 1998, when explicit efforts began to be madeby the IMF and its major shareholder governments toencourage major commercial banks to do so.


The need to reform the banking system had beenidentified in surveillance and measures to this effectwere rightly included in the program. As noted in themain report, in October 1997, the MAE team, col-laborating with teams from the World Bank and theADB, examined the supervisory data provided by BIand concluded that at that time intervention wasneeded for only a limited number of private banks.This assessment turned out to be a serious underesti-mation of the true state of the banking sector. The re-ality at the time was that, except for foreign banks,state banks, and a few large private banks, much ofthe rest of the banking system was illiquid and possi-bly on the verge of insolvency.17

The IMF reached its assessment in the followingmanner. Using the June 1997 data, the World Bank re-viewed all 7 state banks (accounting for 40 percent oftotal banking sector assets); the ADB, 13 out of 27 re-gional development banks (2 percent of total bankingsector assets); and MAE, 72 out of 160 private banks(43 percent of total banking sector assets and 87 per-cent of total private banking sector assets). Taken to-

gether, the combined IFI team investigated 92 out of238 banks, accounting for 85 percent of market share.

Exclusive reliance on BI data proved to be amajor problem for two reasons. First, the June 1997data were not the right basis for making solvency as-sessments, given the exchange rate depreciation thathad occurred since then. Second, supervisory infor-mation from BI was flawed by the low level of su-pervisory skills and, according to some observers,suspicions of corruption. This was clear from awidely known academic work (Cole and Slade,1996) as well as from the findings of the WorldBank’s financial sector mission in 1996. The IMFstaff did go beyond official data and asked the headsof large banks how the crisis had affected their bal-ance sheets and also discussed the likely current bal-ance sheets of banks with BI supervisors, bank bybank. However, these inquiries did not in most caseslead to a significantly more negative assessment.

The combined team identified 50 vulnerablebanks, of which 34 banks were judged insolvent, in-cluding 26 private banks, 2 state banks, and 6 re-gional development banks. Another 3 private bankswere on the borderline of solvency, requiring reha-bilitation. The remaining 13 (out of the 50 vulnera-ble) banks were found to have diverse weaknesses,including capital adequacy ratios below the requiredminimum for some, and needed to be placed underintensified supervision. According to MAE, the 34banks identified as insolvent accounted for about 15percent of total banking sector assets, with the 26private banks alone accounting for 5 percent.

The extent to which the IMF missed the scale ofthe problem is obviously crucial in making an ex postevaluation. Internal documents and interviews indi-cate that there was a considerable debate within thestaff over the extent to which Indonesia faced a sys-temic banking problem. Some APD staff argued thatthe MAE analysis was too sanguine because it as-sumed that (1) there were a relatively few bad banksin an otherwise sound banking system, when thewhole banking sector had become vulnerable as theexchange rate had depreciated and interest rates hadrisen; and (2) runs were caused by small and ignorantdepositors, while it was in fact the high-wealth indi-viduals with inside information who were withdraw-ing deposits.18 However, these concerns were down-played and therefore not reported in the staff reportaccompanying the November SBA request to the Ex-ecutive Board. MAE insisted until January 1998 thatthe banking system was sound except for the 50 banks

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17Some on the IMF staff hold the view that most banks wouldhave remained solvent if the exchange rate had recovered to theprogrammed target range of Rp 3,000 to Rp 3,500.

18For example, Bank Danamon, a large retail bank, had experi-enced sporadic runs even before the IMF was called in and, byend-October 1997, had already received Rp 3.5 trillion of liquid-ity support.


identified, and that no data existed to support the con-trary view. Even so, the MAE mission did note in itsback-to-office report, dated November 11, 1997, thatthere might be other problem banks than the samplereviewed; NPLs might have been underestimated; andsome banks not identified for action might have dete-riorated since June 1997.

In any case, it is unlikely that identification ofdeeper sickness would have led to corrective ac-tion. BI argued that it could only close 16 of the 26insolvent private banks (accounting for only 3 per-cent of total banking sector assets) because theother 10 had “nursing” agreements with BI, whichlegally prevented closure unless rehabilitation ef-forts failed.19 Among the banks to be closed werethree connected with the President’s family: BankAndromeda, in which one of his sons had a minor-ity ownership; Bank Industri, with partial owner-ship by a daughter; and Bank Jakarta, with someownership by his half-brother.

A critical program design decision was the na-ture of a guarantee for depositors of closed banks.There was a consensus between the authorities andthe IMF staff that a blanket guarantee would not bedesirable on grounds of both fiscal cost (empha-sized by the Indonesians) and moral hazard (em-phasized by the IMF). It was agreed that depositorsof the closed banks would receive up to Rp 20 mil-lion (about US$6,000), covering 93 percent of theaccounts and 20 percent of the deposits in theclosed banks.

Initially, the closure of the 16 banks and thetough statement from the Minister of Finance thathenceforth all banks allowed to become insolventby their owners would be closed down was wel-comed, as it seemed to imply a new way of doingbusiness. However, several factors undermined thecredibility of this policy. Most important, the Presi-dent’s family challenged the closures. His sonarranged for the business operations of Bank An-dromeda to be shifted to another bank in which hehad acquired an interest. The President’s half-brother initiated a legal challenge to the closure ofhis bank. The public also saw some inconsistencyin the closure of 16 banks, when it was widely—and correctly—believed that many other bankswere also in a similar condition. The authorities in-sisted on secrecy regarding the nursed banks and,as a result, the public had no idea of what wasbeing done to address the wider problem.

BI also did not make an adequate effort to com-municate its bank-closure policy to the public. There

were flip-flops in announced government policy.Under pressure from the President, the Minister ofFinance soon reversed his previously announcedtough position, saying that there would be no morebank closures. Some private individuals told theevaluation team that uncertainty had been com-pounded by lack of clear information on how andhow quickly depositors would have access to theirfunds. In the event, by the end of November 1997,two-thirds of the 222 banks had experienced runs.Rp 12 trillion (or about US$2.7 billion) of rupiah de-posits shifted to large private banks, foreign banks,and state banks, and about US$2 billion of U.S. dol-lar funds left the banking system entirely.

It was not until the end of January 1998, in theface of continuing banking sector problems, that theauthorities accepted the banking strategy proposedby the IMF, involving a comprehensive bank restruc-turing plan, a general guarantee scheme, and the cre-ation of the IBRA as a combined bank-restructuringand centralized-public-asset-management agency.The new strategy initially succeeded in stemmingthe exit of deposits from the banking system, and theappreciation that followed the announcement of theend-January banking and corporate debt measureswas not fully reversed for almost four months, untilthe ethnic riots in May 1998.

The negative experience of November 1997 canbe contrasted with what happened in early April1998, when 7 banks representing 16 percent ofbanking sector assets were taken over by the IBRAand another 7 smaller banks were closed. The April1998 operation differed from the November 1997action in the following ways: (1) the existence ofbetter arrangements for meeting depositors’ claimsand a professionally managed public relations cam-paign designed to calm the public; (2) an assurancethat the interventions were based on uniform andtransparent criteria and that no banks failing thesecriteria were excluded; (3) a full guarantee that cov-ered all deposits, as well as all liabilities in otherbanks; and (4) the existence of a comprehensivebanking sector strategy within which the operationswere carried out. The failure to have all these ele-ments in place in November 1997 was a major fac-tor contributing to the deepening of the crisis. Whilethe IMF alone was not responsible for this failure—since the unwillingness of the government at thehighest level to back key parts of the strategy wasalso critical—it does point to important lessons (seealso the discussion in the main report).

Many, including IMF staff, have increasinglycome to accept the view that the decision not to in-stall a blanket guarantee was the critical mistake of the November 1997 bank closure (Lindgren andothers, 1999). However, the question of a blanketguarantee, particularly in the context of Indonesia,

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19BI had an understanding that the 10 banks being rehabilitatedwould be closed if they did not demonstrate the capacity to be-come viable within six months to a year.


requires careful consideration.20 In November, bankruns were associated with a shift of rupiah depositsfrom weak private banks to foreign banks, statebanks (with an implicit guarantee), and some largeprivate banks, with no decline in the assets of thebanking sector as a whole. Large withdrawals fromthe banking system from the start of the crisis re-flected the running down of foreign currency de-posits.21 It is only with the presidential successioncrisis in May 1998 that the real value of rupiah de-posits began to decline, owing to a loss of confi-dence in the banking system as a whole. At that time,the blanket guarantee could do little about the crisisof confidence in the entire economic and politicalsystem (Booth, 2001), let alone the ability of thegovernment to honor that guarantee.

Deregulation

The need to reverse the creeping increase in rent-creating regulation over the past several years hadbeen identified as a major issue by the World Bankand also in IMF surveillance. It was also on theagenda of the reformist economic team and had fre-quently been advocated by commentary in the localpress. IMF management also viewed the program asan opportunity to assist the reformist team in push-ing desirable reforms and the team viewed the pro-gram as providing leverage to do so.

Internal reports and interviews with staff indicatethat, as the negotiations progressed in October 1997,the mission was under increasing pressure fromWashington to include structural measures directedat dismantling the system that had given rise to ex-tensive rent-seeking and cronyism in Indonesia. Inpart, this reflected the prevailing atmosphere of do-mestic politics in some of the major shareholdercountries, where support was lacking for a large fi-nancing package without addressing the increasinglywell-known governance issues in Indonesia.

Although several deregulation measures were in-cluded in the November program, a key feature of

structural conditionality at this stage was the ab-sence of both specificity and a clear timetable. Al-most all agreed measures were general in nature andwere to be implemented over the program’s three-year lifespan. This provided the reformists with thenecessary leverage to pursue reform but gave themdiscretion to push when and where they felt theycould achieve results. This feature of the Novemberstructural conditionality, however, was not well un-derstood by the public because, as was customary atthe time, the LOI was not published.22 Without ac-cess to the LOI, the public began to speculate on thecontent of structural conditionality in the Novemberprogram. Given the press references to certain dereg-ulation measures, this led to an excessive focus ongovernance-related measures in public debate.

The failure of the initial program, combined withfrustration over the lack of progress in structural re-form, led to increased emphasis on the need for re-forms as a key element of the strategy to restore con-fidence. Some of the IMF’s major shareholderspressed for greater specificity in structural condi-tionality. At the time of the Executive Board meetingon November 5, 1997, several Executive Directorshad expressed their unhappiness with what they re-garded as the vague and general nature of the struc-tural conditionality, arguing that no progress wouldbe likely in needed reforms without specificity and aclear timetable. The lack of progress in structural re-form under the initial program reinforced their senseof misgiving.

This led to a much more specific and time-boundapproach to structural conditionality in the January1998 program. The World Bank’s Jakarta-based stafftook the lead role in drafting the structural condi-tionality for the January LOI, and the IMF teamwent out of its way to ensure that all concerns of theBank were fully met. By this time, the Indonesianeconomic team had all but lost direct access to thePresident (Boediono, 2001). Negotiations were car-ried out directly with the President, at his own re-quest. On the IMF side, the First Deputy ManagingDirector was personally engaged in finalizing theunderstandings with the President.

Contrary to what the IMF had expected, PresidentSuharto did not openly oppose the expansion of struc-tural conditionality or the inclusion of specific mea-sures, including the cancellation of the National CarProject in which his son was involved. Indeed, Presi-dent Suharto publicly signed the revised LOI in an at-tempt to indicate his commitment publicly. However,

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20Some representatives of the Indonesian authorities told theevaluation team that they had not been adequately informed onthis issue by the staff, especially regarding the blanket guaranteethat had been provided in Thailand. Within the Indonesian gov-ernment, however, the Ministry of Finance was adamantly op-posed to a blanket guarantee on grounds of both equity and cost.In Washington, following criticism of the blanket guarantee inThailand, there was strong opposition to establishing a blanketguarantee in Indonesia. Some former Executive Directors andU.S. government officials interviewed told the evaluation team, asa matter of their personal opinion, that a program for Indonesiawould not have been approved by the Executive Board if the pro-gram had included a blanket guarantee.

21The balance of foreign currency deposits is estimated to havedeclined from about US$30 billion in August 1997 to aboutUS$15 billion in June 1998.

22PDR, however, explicitly recommended that the IMF shouldlearn from the mistakes made in Thailand and publish the LOI.The IMF thus sent an annotated version of the LOI suitable forpublication to the authorities, who in turn agreed to make it pub-lic. However, it was never published.


the President’s opposition was expressed in otherways. The President is reported to have said in a high-level meeting of his advisers that not all agreed mea-sures needed to be respected, and that he would“wage a guerrilla war against the IMF.” Later, he ex-pressed the view that some of the reforms violated theConstitution. In February 1998, the staff reported in amemo to management that “all of the deregulationand liberalization measures relating to wood, cloves,BULOG, palm oil, wholesale and retail trade, and in-terregional trade [were] being subverted by variousgroups close to the President.”

The inclusion of extensive governance-relatedstructural measures in the IMF-supported programswith Indonesia has been widely criticized as havingbeen counterproductive in dealing with a financialcrisis (Feldstein, 1998). A former U.S. Federal Re-serve Chairman, during his visit with the Presidentin early January 1998, is reported to have criticizedthe structural conditionality as irrelevant to financialstabilization by facetiously calling the conditions onmarketing deregulations in cloves, oranges, andother foodstuffs a “recipe” (Kenward, 2000; Blu-stein, 2001).23 Likewise, a high-ranking Indonesianofficial remarked that “things might have turned outdifferently” if the conditionality had been confinedto the macro-critical areas more relevant to dealingwith the crisis, including comprehensive bank re-structuring (Boediono, 2001).

In assessing these criticisms, it is important to rec-ognize that structural conditionality became a seri-ously contentious issue only in January 1998. It wasnot the cause of the failure of the November program,which had more to do with the nonperformance ofconditionality relating to bank restructuring andmonetary control. In the wake of the collapse of theNovember 1997 program and the accelerated cur-rency collapse in December, the IMF and officials ofsome key shareholder governments came to believethat more extensive structural conditionality was theonly hope of restoring confidence by signaling a de-cisive break with the past, a view shared by somemembers of the academic community (Frankel,2000; Goldstein, 2002) and the press (FinancialTimes, January 14, 1998).

The problems with the structural conditionality inthe January 1998 LOI concern the lack of focus andownership of the reform program, rather than its in-trinsic usefulness to the Indonesian economy or thecapacity to implement it. First, a number of thestructural measures were popular with the public and

did have beneficial effects on the economy whenthey were implemented. According to recent acade-mic research, for example, the dismantling of mo-nopolies and monopsonies, implemented from lateJanuary, substantially raised the farm-gate prices ofmajor agricultural crops, and, as the IMF had hoped,helped minimize the adverse impact of the crisis onpoverty (Montgomery and others, 2002). However,the program clearly did not benefit from ownershipat the time it was announced and the ready percep-tion of this lacuna made it completely ineffective.Second, the government’s capacity certainly was nota binding constraint in the implementation of struc-tural conditionality (Boediono, 2001). This is borneout by the fact that once the new Cabinet installed inMarch 1998 had convinced the President that therewas no alternative to the IMF-supported program,the “50-point” program announced in January beganto be implemented more fully.

The January LOI also failed to impress the mar-kets because it did not simultaneously address thekey macro-critical issues of bank and corporatedebt restructuring. In this respect, the focus on ex-tensive structural conditionality in areas outside theconcern of the IMF can be said to have distractedattention from some core reforms that were indeedmacro-critical.

Corporate debt restructuring

In early October 1997, before the negotiationsbegan, PDR had expressed concern that uncertaintyabout the size of private sector short-term debt wasnot being addressed, and had suggested action oncorporate debt, including the creation of a mecha-nism to identify firms needing assistance. However,because the IMF lacked expertise in this area, andgiven the optimism that the program would rapidlyrestore confidence, the IMF-supported program didnot actively address the corporate debt issue untilJanuary 1998. The World Bank was also slow to getinvolved and it was only in the middle of 1998 that itbegan to assume a major role in supporting the dia-logue between creditors and Indonesian conglomer-ates. The slow start on corporate debt restructuringpartly stemmed from the authorities’ view that theissue should be left largely to the private sector.

Starting in January 1998, the IMF provided tech-nical assistance to a Private External Debt Team(PEDT). This had been set up in late 1997 as a vol-untary initiative with the encouragement of the In-donesian authorities to provide a framework for thenegotiations between creditors and corporations un-able to service their debts. The role of the govern-ment was only indirect in this framework, and waslimited to strengthening the legal and regulatorymechanism to enforce contracts. The debtors set up a

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23At the suggestion of Singapore’s Senior Minister, this formercentral banker was invited by President Suharto to provide an in-dependent assessment of the IMF package. Kenward (2000) sus-pects that this negative assessment of the package may have influ-enced the President’s subsequent actions.


committee to work with the PEDT but made it clearthat little progress could be made without strongergovernment involvement, including financial support.

In the second half of March, a consensus emergedbetween creditors and the PEDT that some limitedgovernment involvement was necessary in the formof an exchange rate guarantee similar to that used inMexico’s so-called FICORCA scheme.24 This posi-tion was endorsed by the IMF, with the caveat thatthere should be no subsidies to the corporate sector,a position shared by the authorities. The proposedvoluntary approach aimed to protect debtors andcreditors against exchange rate risk and to give as-surance that foreign exchange would be available fordebt-service payments in return for the restructuringof debt on specified minimum terms. Negotiationswould seek to limit the exposure of the governmentto exchange rate risk.

In June 1998, adapting the FICORCA-typescheme to the conditions of Indonesia, a frameworkfor the voluntary restructuring of debt was agreed inFrankfurt, and the Indonesia Debt RestructuringAgency (INDRA) was set up in August. Severalproblems remained, however. First, there was a needto reform the regulatory and legal framework, in-cluding removing restrictions on debt-to-equity con-versions, eliminating tax disincentives for restructur-ing, streamlining approval procedures for FDI, anew arbitration law, and measures to provide for theregistration of collateral. Second, the insurance pro-vided by INDRA against further exchange rate de-preciation was not attractive to many market partici-pants, given the extent of exchange rate depreciationthat had already occurred, for which market partici-pants wanted some compensation. Third, as debt re-structuring would take time, firms would remainshort of working capital. Fourth, given the financialcondition of many enterprises belonging to con-glomerates, there were strong incentives for assetstripping by shifting assets to those entities bettersheltered from the creditors.

On September 9, 1998, a “Jakarta Initiative” wasfinalized and became operational a month or twolater. The initiative provided a framework to promotevoluntary restructuring of debt through INDRA andto complement the amendments to the bankruptcylaw aimed at providing incentives for debtors andcreditors to negotiate. It included provisions forcreditors to provide interim financing to distressedcompanies. Government involvement, however, waslimited to the role of facilitator, including serving asa forum for the one-stop approval of regulatory fil-

ings. Despite all these initiatives, however, delays inimplementing regulatory changes and difficulties inobtaining redress through the Indonesian legal sys-tem limited the progress of private sector debt re-structuring. Well-placed interlocutors saw the failureto tackle the corporate debt issue as an important de-ficiency, as these debtors brought political pressureto bear on other issues. In this process, the IMFplayed a relatively limited role.

Initial strategy and its adaptation

Because the Indonesian crisis went through sev-eral phases, it is necessary not only to assess itsconventional program design issues, but also toevaluate how effectively the IMF responded toemerging signs of failure and revised the initialprogram accordingly.

The initial strategy reflected the assumption thatthe crisis was a moderate case of contagion in whichthe rupiah had overshot. This view, which appearsoverly sanguine in retrospect, was widely shared bymajor market players at that time.25 Market insidersinterviewed told the evaluation team that some im-portant hedge funds had in fact been betting in favorof the rupiah at the time the program was being ne-gotiated, indicating their expectations that the IMF-supported program could work. The strategy, how-ever, was a risky one and the staff recognized that ifthe basic assumption that the rupiah had overshotand could be nudged back to a more reasonable levelwas questioned, an entirely different approach wouldbe necessary. However, the staff never explored whatthis alternative might imply.

In this regard, in the light of the Mexican experi-ence, one Executive Director representing a majorshareholder government encouraged the staff to havea fallback plan. There is no evidence, however, tosuggest that the staff either prepared or discussed acontingency plan with the authorities. While it is notrealistic to expect the IMF and the authorities to ne-gotiate a comprehensive alternative strategy whentime is short and the ability to take key political deci-sions is limited, it should have been possible to iden-tify at an earlier stage more comprehensive measuresto deal with a bankrupt corporate sector and a sys-temic banking crisis, both of which were quite likelyoutcomes.26 In responding to emerging signs of fail-ure in mid-November, the IMF was handicapped bythe absence of an agreed fallback plan.

When the original program failed to restore confi-dence, the underlying assumptions of the strategy

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24In the FICORCA scheme, creditors and debtors were pro-vided a guarantee against further depreciation of the exchangerate from its value at the time the debt was restructured.

25See, for example, Goldman Sachs, “Emerging Markets Cur-rency Analysis,” November 1997.

26Indeed, the quite prescient memorandum from PDR in Octo-ber 1997, referred to earlier, did call for such action.


needed to be reassessed. In the latter part of Novem-ber, a mission was dispatched to assess the situationand to consult with the authorities. However, themission’s brief was largely focused on implementa-tion within the logic of the original program andblamed the failure on nonimplementation. While thelack of implementation was undoubtedly part of thestory, the original premises of the strategy wererapidly overtaken by events and there was a need fora more fundamental shift of strategy. The IMF’s con-tinued attempts to push the unwilling Indonesianeconomic team to raise interest rates led to a publicdisplay of disagreement, which was not helpful tobuilding market confidence.

A critical oversight was the failure to follow upon the close monitoring of BLBI undertaken by staffin the field. IMF staff was monitoring liquidity sup-port bank by bank on a daily basis and keeping se-nior staff at headquarters informed. However, theIMF did not immediately take a firm position on theissue. For example, it did not press the authorities onthe staff’s suggestion that BI should take control ofbanks receiving excessive support so as to preventasset stripping. Given the culture of forbearance atBI and the lack of political support, little was done tocontain the explosion of liquidity support. The IMFstaff was prevented from knowing what was takingplace within the recipient banks, particularly whencollusion of some BI staff with bank owners was in-volved. Remedial action likely would have includeda comprehensive intervention mechanism to dealwith insolvent or illiquid banks, relying on the exist-ing regulatory framework. In the event, it took theIMF staff four or five months to find out that corruptand abusive practices were involved in the allocationof BLBI.

At the root of these problems was the lack of afallback strategy to be pursued if the original some-what sanguine assumption about an easy recovery ofthe rupiah proved misplaced. The IMF did revise thefiscal policy aspects of the program, but there was noreassessment of the underlying strategy itself. In par-ticular, there was no comprehensive strategy to dealwith the fundamental issues driving the crisis,namely, the collapsing banking and corporate sec-tors. While the issues were under constant reviewand various “Plan B” options were considered inter-nally, existing differences of view within the IMFwere not resolved until late January 1998.

In part, this delay reflected the lack of interna-tionally accepted best practice in bank restructuringand the onset of a major crisis in Korea in late 1997,which took part of the attention and resources awayfrom Indonesia. As a result, the IMF made a prema-ture announcement of a package in mid-January,which focused heavily on deregulation and nonfi-nancial structural reform, but without including a

comprehensive strategy to deal with banking systemproblem. With the benefit of hindsight, the signingof the second LOI should have been postponed fortwo weeks, to coincide with the announcement ofcomprehensive banking reform and corporate debtrestructuring initiatives.

The Mode of Operations

This section discusses issues related to the IMF’smode of operations, including country ownership,the decision-making process, human resource man-agement, and the role of major shareholders and col-laboration with the World Bank and the ADB.

Country ownership

Indonesia poses a paradox regarding countryownership. Management took the view that theIMF should support the reformist economic teambecause they shared common views of economicpolicy. Moreover, most of the reform measureswere almost universally applauded within Indone-sia, except by a small number of powerful elites.27

Nevertheless, the program failed because the keypolitical authority, the President, did not buy intothe reform process.

The IMF misjudged the commitment of the Presi-dent and underestimated the pressures likely to comefrom his family and some of his influential associ-ates. On several previous occasions, the economicteam had received the full backing of the Presidentto deal with economic crises and often successfullyimplemented the required reforms against opposi-tion from powerful vested interests. With the in-creasing presence of the First Family and other com-peting stakeholders among the Indonesian elites,however, the economic team had lost much of thatinfluence by the time of the crisis in 1997 (Booth,2001). At the time of the crisis, this was well knownto close observers of Indonesia.

The Indonesian economic team was very awareof its own limited influence in the country’s deci-sion-making process. In part, this was precisely thereason why the team needed the leverage of anIMF-supported program to implement the reforms.Knowing its limitations, the economic team alsomade sure to secure the personal commitment of thePresident to measures agreed in the IMF-supportedprogram. One can only speculate what outcomewould have resulted, had the President not received

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27When the package of reforms was announced to the press inJanuary 1998, Indonesian journalists spontaneously congratu-lated the IMF officials for their achievement.


the kind of opposition from his children and theirclose associates that he did in the last weeks of 1997, particularly following his illness in earlyDecember.

As it was, the program implied that firms andbanks should be allowed to fail if they were insol-vent. However, the President, under pressure fromhis children and close associates, was unwilling tolet this happen. He also faced difficulty in allowingthe structural reforms to go too far because theycould undermine the very basis of his regime. Ac-cording to some political observers interviewed bythe evaluation team, the President wrongly came toview the IMF-supported program as an instrumentof foreign powers seeking to undermine him.

How to secure ownership in such circumstancesand what to do in its absence remains one of the un-resolved issues arising from the Indonesian experi-ence. To enhance ownership, the IMF did begin torecognize the need both to engage the Presidentand to engage in a wider dialogue with variousstakeholders. In January 1998, as noted, the FirstDeputy Managing Director visited Jakarta to nego-tiate directly with the President. Following thesigning of the second LOI in mid-January, in whichhe himself participated, the Managing Director re-quested a retired member of management to serveas his personal representative to the President on anongoing basis. The Indonesian team initiated con-scientious efforts to talk to a wider group of people,both inside and outside the government. By then,however, the crisis had become largely political,overshadowing any consideration of ownership ofeconomic policy.

Could a different approach have produced a bet-ter result? It is, of course, impossible to say. Itcould well be that no strategy would have been suc-cessful in separating the political and economic di-mensions of the crisis. Nevertheless, a number oflessons on the ownership dimension do suggestthemselves. First, an earlier assessment of thebroader political economy issues underlying key el-ements of the program would have been useful.Second, a smaller set of structural measures thatwere fully owned could have reduced the scope forimmediate implementation problems that damagedmarket confidence. Third, whatever the final judg-ments on ownership and the scope of the structuralreform package, the January program should haveincluded all of the measures judged macro-criticalin order to be credible.

Decision-making process

In retrospect, it was probably a mistake to ignorethe advice of PDR and the Resident Representative,and to rush the negotiation process in October

1997.28 The decision to rush was understandable,given the prevailing perception of a major regionalcrisis in Southeast Asia. However, Indonesia still hadsufficient foreign exchange reserves to last for severalmonths, as indicated by the fact that the program in-cluded use of Indonesia’s own reserves. The rushedprocedure compromised quality in program design,particularly relating to the formulation of a compre-hensive banking strategy and even possibly the as-sessment of insolvent banks, and prevented the IMFfrom fully benefiting from the safeguards of the inter-nal review process. It is not possible to say whether amaterially different assessment would have emergedfrom the established procedures.29 With less pressure,however, the IMF could have given greater time to ex-amine the full implications of each policy optionbeing considered, including a fallback option.

The rushed procedure had additional conse-quences. Management often worked directly withthe mission in the field, bypassing the safety mecha-nism inherent in a bureaucratic organization. Somesenior review department officers told the evaluationteam that they had often felt sidelined and excludedin the decision-making process. Moreover, the Exec-utive Board became involved in day-to-day and verydetailed aspects of the program negotiations throughinformal sessions. Along with communications espe-cially from major shareholders, this subjected thestaff to considerable political pressure.

By the end of November 1997, the IMF had anurgent need to make a fundamental reassessment ofits strategy. However, the IMF’s modus operandi,namely, short and intense country interactions, oftenwith a pre-set and tight agenda, made it difficult forthe staff to undertake such reassessment. Under theconditions prevailing in Indonesia at that time, themore permanent presence of a high-level team on theground may have been beneficial as a mechanism forclosely monitoring developments, providing timelypolicy advice and, if required, rapidly and smoothlymodifying the strategy.

Human resource management

The Indonesian crisis, occurring as it did alongwith the other Asian crises, inevitably placed greatstrains on IMF resources and key decision makers

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28PDR’s comments on the brief included a proposal that a two-step approach of fact-finding followed by program design shouldbe pursued. Likewise, the Resident Representative also advisedstrongly against rushing into a program, as it would unnecessarilypanic the markets.

29For example, given the assumption that the exchange ratewould quickly bounce back, use of BI’s September data (avail-able in early November) may not have given a substantially dif-ferent diagnosis of the banking sector than did the June data, par-ticularly because the staff was not allowed in any case to examinethe loan files of individual banks.


within the institution. In many respects, the IMF re-sponded very rapidly and with considerable flexibil-ity. However, some aspects of the internal manager-ial approach, compounded by the IMF’s modusoperandi discussed above, did have an adverse im-pact on the effectiveness of the response. First, man-agement took some time to reallocate human re-sources to APD, whose staff was overstretched bythe simultaneous crises in Indonesia, Korea, andThailand. When the Korean crisis erupted a fewweeks after the Indonesian SBA was approved, moreof management’s attention and the institution’savailable human resources were shifted from In-donesia. Some senior staff members have indicatedthat the simultaneous pressures on resources proba-bly contributed to the delay in the reformulation ofthe program from December 1997 to January 1998.

Second, APD took time to mobilize experts to thefield. Even after a banking expert had been identified,it took months before he was formally assigned as aResident Representative in Jakarta. This appointmentwas made in May 1998, over six months after thebanking crisis had come into the open.

Third, available internal knowledge was not effec-tively used in formulating the program. Part of thiswas an unfortunate outcome of the reorganization ofthe Asia-Pacific operations of the IMF in early1997.30 The mission chief for the just-concluded 1997Article IV consultation was not included in the mis-sion that negotiated the program in October 1997 andhad little input into the subsequent discussions on pro-gram formulation. Moreover, only a limited numberof staff members of the first and subsequent APD mis-sions had previous experience with Indonesia; the fewwith previous experience had not worked on the coun-try for many years. This reflected a broader problemwith excessive turnover of country teams within theIMF, as also noted in the IEO’s evaluation of pro-longed use of IMF resources (IEO, 2002).

Fourth, financial sector expertise was not fullyshared within the missions. No one from MAE was aformal member of the negotiating mission, and theMAE technical assistance mission worked side-by-side with, but independently of, the APD mission.This arrangement was costly because the views of in-dividual members of the MAE mission were not nec-essarily brought to the attention of the negotiatingteam.31

Fifth, there was little rationale for splitting re-sponsibilities without defining clear lines of com-mand in the staffing of the October 1997 mission,which was simultaneously headed by two missionchiefs. With a separate MAE mission, this meant thepresence of three mission chiefs with different chan-nels of communication with mission members andsenior officers in Washington. Likewise, in February1998, a decision was made to alternate two missionswith two separate mission chiefs. This arrangement,which lasted only briefly from February to March1998, was an understandable attempt to create a per-manent high-level presence on the ground withoutcreating the family and other personal pressure asso-ciated with permanent relocation at short notice.However, despite cooperation between the twoteams, such an arrangement was not ideal in terms ofmaintaining continuity during a crisis. According tosome of the mission members interviewed, the mis-sion chiefs had slightly different points of emphasis,and the transfer of information from one team to thenext was inevitably incomplete. Some Indonesianofficials interviewed told the evaluation team thatthey had often needed to repeat the same informa-tion twice.

The role of major shareholders andcollaboration with the World Bank and the ADB

Major shareholders and the Executive Board

Broad agreement existed on the strategy for In-donesia among most of the IMF’s major sharehold-ers who played an active role in the design of theprogram. Working through numerous informal ses-sions of the Executive Board, Executive Directorsrepresenting the major shareholders generally advo-cated tight fiscal and monetary policies and urgedthe adoption of structural reform measures aimed atimproving governance. If there were dissentingviews, they were not expressed at the formal Boardmeetings.32 Once the depth of the recession becameclear, however, the Board supported the loosening offiscal policy.

Frequent informal sessions facilitated a flow ofinformation between the staff and the Board. Execu-

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30The Central Asia Department (CTA) and the South Asia andPacific Department (SEA) were merged to form what is nowAPD, effective January 1, 1997. Staff coming from CTA, whichpreviously had not covered the country, assumed the crisis man-agement of Indonesia.

31The banking strategy announced in January 1998 was basedon a January 13, 1998 memo prepared by a member of the MAEtechnical mission while the second LOI was being drafted. This

memo was circulated to the negotiating mission late in theprocess and almost by chance. Perhaps a broader dialogue onbanking sector ideas in October could have provoked an earlierformulation of the key elements of that strategy.

32Since the minutes of informal Board meetings are not kept,the evaluation team could only rely upon interviews with thosepresent to ascertain what was said. There were also meetings ofthe Executive Directors for the G-7 countries, for which no min-utes were kept.


tive Directors could not only receive information onrapidly changing developments at these meetings butalso express their views relatively freely. While thedissemination of information may not have been per-fect, the informal sessions nonetheless provided theExecutive Directors with opportunities to voice theirinputs into the program at different stages. However,detailed involvement by the Board in specific ele-ments of program design probably went too far. Al-though it was appropriate for the Board to define thepolicies and principles to be applied to the IMF-sup-ported program, the staff and management shouldhave been given greater freedom to pursue a strategybased on their judgment of country ownership, tech-nical merits, and political feasibility. Detailed in-volvement by the Board or a subgroup of majorshareholders appears to have added to the pressuresfor an extensive list of detailed structural reform andderegulation measures in the January and April 1998programs.

The World Bank

Management explicitly instructed staff to consultWorld Bank staff on program design, particularly re-garding structural conditionality, and to cooperateclosely in reviewing the financial condition of thebanks. During the October 1997 mission, IMF staffwas given a series of notes the Bank’s Jakarta-basedstaff had prepared for the authorities during Augustand September 1997, advising them on how to dealwith the crisis. The IMF staff also formally re-quested the World Bank for comments on the pro-posed content of conditionality but received no writ-ten response. However, some of the World Bankstaff, including a senior official of its Jakarta office,felt that the IMF was not fully drawing on their re-sources and expertise.

Early difficulties between the IMF and WorldBank teams in Jakarta in part resulted from the dif-ferences in the way the two institutions operate. IMFstaff members involved in the negotiations said thatthey had initially found it difficult to work withBank staff when tasks needed to be performed withtight deadlines since, in their view, the operationalapproach of the Bank often did not fit with such atimetable. Bank staff felt excluded because it wasnot informed of or invited to policy discussions. ByJanuary 1998, however, the working relationship hadimproved markedly, and the Bank’s Jakarta teamwas fully involved in designing the structural condi-tionality of the revised program. Moreover, from lateJanuary 1998, the MAE team worked closely withits financial sector counterparts from the WorldBank. World Bank staff participated fully, and wasidentified as co-authors in the series of reports pre-pared by the MAE staff during the crisis. As part of

this close collaboration, the World Bank took thelead in the financing of the mid-1998 audits of the“IBRA banks.”

Despite the active involvement of World Bankstaff in much of the program negotiations and design,dissenting voices were heard from the Bank’s Wash-ington headquarters, and the Bank’s Chief Economistpublicly criticized the IMF-supported program. Todeal with precisely this type of situation, the IMF andthe World Bank had earlier agreed, in the so-calledConcordat on Fund-Bank Collaboration prepared inMarch 1989, on a general procedure to resolve differ-ences of view on economic issues. The Concordatstipulates a five-tiered procedure, starting with work-ing level staff and ending at the Executive Boards;each additional tier comes into play only after bestefforts to resolve differences have failed at the previ-ous level. On an ad hoc basis, moreover, it envisagesthe possibility of establishing a study group, underthe direction of the IMF’s Director of Research andthe Bank’s Vice President, Development Economics,to examine analytical issues that may arise in areas ofshared interest.33 However, this procedure was notutilized to resolve the differences of view, in part be-cause the differences did not follow a simple IMF-World Bank divide.

The ADB

The relationship with the ADB was also difficult.Its participation was initially conceived in the con-text of a technical assistance mission, given its ear-lier work on regional development banks. As a con-sequence, once a decision to negotiate a programwas taken, the ADB’s inputs, if any, were channeledthrough the MAE technical assistance mission. Inaddition to examining the balance sheets of regionaldevelopment banks, the ADB was put in charge oflooking at the nonbank financial institutions regu-lated by the Ministry of Finance, and not by BI.

Citing confidentiality, however, the IMF staff didnot keep the ADB team fully informed of issues beingdiscussed with the Indonesian authorities. The rela-tionship was cool at best and continued to deteriorateuntil the end of January 1998, when the ADB tem-porarily pulled out of the collaborative relationshipwith the IMF over disagreement on the creation of theIBRA. The first ADB program loan, for US$1.4 bil-

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33When the Concordat was discussed in the Executive Boardsin 1989, however, the Bank’s Executive Directors expressed seri-ous reservations, so that the Bank did not consider it to be institu-tionally binding. More recently, in September 1998, the Manag-ing Director of the IMF and the President of the World Bankissued a joint statement, reaffirming the principles underlyingFund-Bank collaboration as set out in the 1989 Concordat. SeeBoughton (2001), pp. 1003–05, 1055–61.


lion, was not approved until June 1998. Subsequently,working relationships were established again. ADBstaff was involved in financial sector work with MAE,and took the lead in the audits of the “non-IBRAbanks.”

Conclusions

This section provides a summary of major find-ings and our assessment of the role of the IMF in theIndonesian crisis, as reviewed in this annex.


IMF surveillance of Indonesia in the precrisis period had limited effectiveness in terms of both di-agnosis and impact. Although it identified the key is-sues, it did not emphasize the risks and assess com-prehensively the impact if these risks were tomaterialize. The weaknesses of surveillance wereparticularly evident in the underestimation of gover-nance problems in the banking sector, and the failureto analyze the implications of risks and corruption inan explicit and candid manner. Data weaknesses alsohampered the effectiveness of surveillance, althougha more systematic effort to analyze the potential vul-nerabilities would have highlighted these weak-nesses earlier.

Regarding the banking sector problems, the IMFidentified the key issues but did not take a strongenough position, perhaps owing to the judgment thatthe weaknesses did not pose a systemic risk in an en-vironment of strong macroeconomic growth. TheIMF was not alone in this failure. In fact, even someof the closest observers had a generally positive as-sessment of the Indonesian banking system, whilebeing well aware of pervasive corruption (Cole andSlade, 1996). The staff was handicapped by prevail-ing conventions that required it to approach gover-nance issues with obliqueness. Moreover, bankingsector issues were identified as part of technical as-sistance work, a voluntary process in which the IMFacts as the authorities’ confidential advisor for theirexclusive benefit. There was thus tension over howmuch of what was uncovered could be used to raisedifficult questions during surveillance. Nevertheless,a more candid discussion of these issues in the Exec-utive Board would have been helpful in highlightingthe dangers of poor supervision, the moral hazard in-herent in Indonesia’s banking policy, and the ur-gency of dealing with insolvent banks while condi-tions remained favorable.

The lack of candor in discussing the implicationsof vulnerable balance sheets and pervasive corrup-tion was another area of weakness in precrisis sur-veillance. As early as 1995, internal reviewers, espe-

cially those in RES, had pointed out that the adverseimpact of a shift in market sentiment for the corpo-rate sector and its macroeconomic consequences inan economy with a weak banking system, but theseconcerns were not pursued by exploring their impli-cations.34 As a result, the staff made only a limitedattempt to collect data on corporate balance sheets.35

While it is unlikely (and impossible to test) thatgreater candor would have led to a marked change inthe authorities’ policies, such a candid discussionwould have allowed the IMF and the authorities toconsider worst case scenarios in an atmosphere freeof crisis.

The failure to present a candid analysis of the ex-tent and nature of corruption in Indonesia led to un-realistic expectations about the ease with which re-forms could be implemented and misled the IMF onthe potential adverse short-run impact of the drive toderegulate. Corruption had always existed in Indone-sia, but it did not prevent the economy from growingat an impressive rate over many years. This mayhave caused the IMF to overlook the changing na-ture of corruption in the 1990s, when both foreignand domestic investors began to focus on links to thePalace, rather than on the intrinsic economic meritsof projects, in their investment decisions. By notopenly discussing this aspect of the buoyant capitalinflows, the IMF failed to perceive that Indonesiawas particularly vulnerable to a sudden shift in in-vestor confidence that might result, for example,from presidential succession concerns.

These weaknesses in part reflected a failure totake account of the wide range of views that mightaffect policy options and to grasp the broader polit-ical economy context within which presidential de-cisions were made. The surveillance dialogueplaced too much faith in the ability of reformists todeliver policies, and failed to explicitly considerthe various political constraints on policymaking. Afocus on the reformist economic team was under-standable. They had, after all, delivered important

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34There is a striking parallel to what happened at the WorldBank. According to the Country Assistance Note on Indonesiaprepared by the Operations Evaluation Department (World Bank,1999), in February 1997, the office of the Chief Economist“stressed that risk factors had been underestimated, that theBank’s strategy should not be limited to the optimistic base-casescenario, and that a ‘downside analysis’ was needed in view ofthe high country risks.” According to this note, as late as August20, 1997, Bank country staff and management downplayed theserisks and communicated to the Executive Board that there was nocause for concern.

35The staff was aware of the importance of corporate debt re-structuring. However, the few attempts made at corporate datacollection were not sustained because of the inherent difficulty ofobtaining such data as well as the perception that the corporatesector was outside the IMF mandate and in the purview of theWorld Bank.


policy corrections during earlier crises and the IMFclearly has to interact primarily with its officialcounterparts. Nevertheless, staff could have soughtinformal inputs from a much wider set of people inorder to obtain a broader sense of the political con-straints for economic reform. The Resident Repre-sentative, who had significant local knowledge,could have been better integrated into the surveil-lance process. In practice, surveillance was largelyconducted, with short country visits, by IMF staffin Washington.

Program design and implementation

The November program was based on a criticalassumption that the crisis was a moderate case ofcontagion and that a program of tight macroeco-nomic policies and banking reform, supported byforeign exchange market intervention, would suc-ceed in restoring stability with only a temporarydeceleration in growth. This proved grossly opti-mistic as the rupiah depreciated uncontrollably,owing initially to implementation failures and laterto political developments. The initial assumptionthat the crisis would be easily controlled was at best fraught with risk, given the possibility ofmultiple equilibria. These risks were underesti-mated because the extent to which the crisis was atwin crisis, with severe weaknesses in the bankingand corporate sectors, was not recognized earlyenough.

Given the initial highly optimistic assumptions ongrowth, fiscal policy was not inappropriate. One canargue in retrospect that, given the low initial level ofpublic debt, it was misguided to include in the budgetthe carrying cost of bank restructuring, as the costcould have been financed by a slightly higher stockof debt over the medium term. However, the bankingsector presented large contingent liabilities for thegovernment, so that there was in fact less room thanthe formal public debt figures might have suggestedfor a massively countercyclical fiscal policy. Indone-sia also faced the financing constraints resulting fromthe absence of a government bond market and the inherent difficulty of financing expenditures with issuance of debt during a crisis. In the case of In-donesia, the only recourse the government had to fi-nancing expenditure was drawing down its depositsat the central bank and foreign borrowing. Use ofcentral bank deposits would have been counterpro-ductive when base money was already explodingwith liquidity support to the banking sector. Foreignborrowing was not an option when foreign lenderswere fleeing from the country. Thus, while initialtightening was not necessary—and should not havebeen part of the program if a more realistic estimateof short-term growth prospects had been incorpo-

rated—there was little feasibility for a markedly ex-pansionary fiscal policy.

As the crisis evolved, fiscal policy was continu-ously relaxed and the targets were never opera-tionally binding. The fiscal program in 1998 also in-cluded adequate social considerations, as subsidieswere increased on essential goods, while price in-creases were targeted toward goods and servicesconsumed by higher income groups.

Monetary policy was never tightened during theearly months of the program, despite the urgings ofthe IMF to the contrary. Most reasonable measuresof real interest rates became increasingly negative,because the monetary base was expanding out ofcontrol with the provision of unlimited liquidity sup-port to the collapsing banking system. As part of thissupport was used to fund capital flight, it placeddownward pressure on the rupiah. Exchange rate andprice stability only returned when monetary policywas tightened and nominal interest rates raised in thespring of 1998. In this respect, the adoption of basemoney targets, rather than conventional NDA tar-gets, was not helpful as it allowed intervention andliquidity to get out of hand.

More generally, quarterly targets for any quantita-tive measure of base money (or its NDA component,for that matter) proved to be of little operational usein monitoring the conduct of monetary policy on aday-to-day basis during the crisis. Base money, con-sisting largely of the public’s currency holdings, hasa large endogenous component and is thus difficultto control in the short term, even under normal cir-cumstances. During a banking crisis, base money iseven more difficult to control, as there is a portfolioshift of unpredictable magnitude from deposits tocurrency. In the case of Indonesia, this difficulty wascompounded by unlimited liquidity support, whichcaused base money to go out of control. A more di-rect discussion and explicit agreement on interestrate policy, as happened in the spring of 1998, alongwith a closer monitoring of the liquidity support op-erations, might have provided a better framework formonetary policy.

In this respect, a critical mistake in the initial strat-egy was to settle for an ill-defined “understanding”on interest rates without fully specifying what actionwould be required, given the unwillingness of the In-donesian economic team further to raise interestrates. This papering over of a fundamental disagree-ment about the appropriate approach subsequentlyled to a constant public display of disagreement be-tween the IMF and the economic team, further dam-aging public confidence. The monetary policy theIMF advocated would have involved higher interestrates, and one can argue whether this would indeedhave been appropriate, but the fact is that high inter-est rates were not applied.

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The size of financing was based on conservativeassumptions and may have appeared small in rela-tion to the large capital outflows that took place.The IMF did not anticipate the magnitude of capitalflight by local residents, but it is difficult to arguethat the initial IMF-supported program should havebeen designed to take account of all such capitaloutflows. A number of staff members interviewedhave argued that the relatively small amount of of-ficial financing available in the first few months ofthe program lowered the probability of success.However, in our view, shortage of financing wasnot the critical factor, especially since key aspectsof the initial program were not implemented. Muchof the capital flight that occurred can be attributedto political uncertainties, which were in turn exac-erbated by the failure of the initial program. Addi-tional official financing would not have helped toaddress any of the underlying issues and wouldhave only allowed such flight to take place at amore appreciated exchange rate.

The initial design of structural conditionality innonfinancial areas, mainly addressing governanceissues, was reasonable, as almost all agreed mea-sures were general in nature and were to be imple-mented over the three-year lifespan of the program.Structural reforms in nonfinancial areas became acontentious issue only in January 1998, when theinitial program had failed and the crisis had turnedpolitical. By January 1998, key shareholders andthe press no longer saw deregulation as just anissue of microeconomic inefficiency, but had begunto perceive the governance-related reforms assomething necessary to restore confidence by sig-naling a clean break with the past. The extensivestructural conditionality, a widely criticized featureof the IMF response, was not the cause of the fail-ure of the initial program, but a response to it.While many of the measures were popular with thepublic and undoubtedly had beneficial effects onthe economy, in retrospect, the extensive structuralconditionality in the January 1998 program becamea distraction from taking much needed action onbank and corporate debt restructuring, which wasmissing from the January program.

In bank closure and restructuring, there was no in-ternationally accepted best practice at the onset of theIndonesian crisis. While the initial strategy of closing16 banks was consistent with the program’s logic (in-cluding the expectation of an exchange rate apprecia-tion), it was based on a gross underestimation of thesystemic nature of the banking sector problems. TheIMF concluded that no other private banks needed tobe intervened beyond the 10 under rehabilitation andthe 16 being closed whose deposits represented only 3percent of total banking sector assets, believing thatthe private banking system was sound beyond the

troubled banks in the initial sample.36 In retrospect,the mistake was not the closure of the 16 banks whichwas initially well received, but the absence of a com-prehensive strategy to deal with insolvent or illiquidbanks. Such a strategy was only introduced at the endof January 1998.

The question of the partial deposit guarantee in theNovember program requires careful consideration.Arguably, the amount of Rp 20 million was too smalland should have been expanded to cover some legiti-mate institutional deposits. However, the concept of apartial guarantee was entirely reasonable in a corruptbanking system, where the well-connected insidershad benefited both from high deposit rates and fromquestionable lending practices. In the early months ofthe program, moreover, confidence was maintainedin the banking sector, where state banks with an im-plicit government guarantee accounted for a largeshare. What was happening in November was a shiftof deposits from those private banks that were per-ceived to be weak to state, foreign and larger privatebanks, so that the banking crisis was not yet systemic(in the sense of affecting the whole banking system).

In the end, the blanket guarantee enormouslyraised the fiscal cost of banking sector restructuring,which is now estimated at over 50 percent of GDP,and allowed the same insiders who had benefitedfrom the system an additional way to profit fromabusive and corrupt practices. Would the introduc-tion of a blanket guarantee in November have haltedthe banking crisis? It is impossible to test such acounterfactual. However, the evidence discussedhere suggests that the most damaging aspect of theNovember crisis was not the nature of the guaranteeitself, but the lack a well-communicated, compre-hensive strategy to deal with problem banks.

Finally, corporate debt restructuring was a miss-ing element of the IMF-supported program. It startedlate and did not progress very far. Restructuring ofcorporate debt was a difficult process, particularly ina corrupt system lacking an adequate legal infra-structure. Even so, something could have been doneearly in the program, when Indonesia’s corporatedebt compared favorably with that of Korea, Thai-land, and Brazil (Ghosh and others, 2002). If debt re-structuring had been enforced with strong support ofthe President—clearly, a very big “if”—it mighthave gone a long way toward an equitable sharing oflosses among various stakeholders, including thewell connected, their foreign financiers, and the tax-paying public. In the end, the burden was almost en-tirely passed on to future generations through an in-creased stock of public debt.

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36The staff knew that the state banks were in serious difficulty,but determined that they could more appropriately be dealt withseparately.


The mode of operations

The failure of surveillance and weaknesses inprogram design and implementation in part reflectedthe IMF’s mode of operations. The IMF overesti-mated the extent of country ownership, particularlyin structural reforms. While most of the measureswere endorsed by the economic team and popularwith the general public, the program lacked the own-ership of those who counted the most in the deci-sion-making apparatus of Indonesia. Greater under-standing of the political economy dynamics mighthave contributed to a different program design. Nev-ertheless, it must be recognized that separating theeconomic and political elements that made Indone-sia’s crisis so toxic would have been very difficultwith any program.

The quality of program design was affected bythe rushed procedure. While such a procedure may

be necessary in certain cases, and the decision torush was understandable under the conditions ofgreat concern about a regional meltdown, the case ofIndonesia—which initially had substantial re-serves—does not seem to fall in that category. Therushed procedure led to detailed involvement by theExecutive Board, subjecting the staff to greater polit-ical pressure. Management often worked directlywith the missions in the field, bypassing the normalreview mechanisms inherent in a bureaucratic orga-nization. These problems were compounded bysome weaknesses in human-resource managementpractices, which resulted in the failure to utilizeavailable skills and resources in an efficient manner.The IMF showed flexibility in responding withspeed, but there was a significant cost in terms ofquality, especially in terms of understanding the na-ture of the crisis and the degree to which the pro-gram was owned and hence would be implemented.

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Annex 1 • Indo

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Appendix A1.1

Indonesia: Selected Conditionality Under IMF-Supported Programs: Evolution and Implementation, 1997–981

A. November 1997 Letter of Intent

Other conditions forPerformance criteria Benchmarks Targets completing the next review

End-December 1997 and end-March 1998 By end-March 1998, introduce full tax Commit to liberalize foreign trade and invest- Finalize understandings for FY1998/99base money target.* deductibility of loan loss provisions.** ment, including gradual phase out of export and establish performance criteria

taxes and restrictions; dismantle monopolies (PC) for June and September End-December 1997 and end-March 1998 By end-March 1998, complete public and price controls; allow greater private sector 1998.2 **overall central government balance to expenditure review. participation in provision of infrastructure andachieve surplus of #/4 percent of GDP for privatization. Update indicative targets to PC for 1997/98 compared with 1.2 percent in By end-March 1998, complete audits of 1998/99 budget and for end-June1996/97.* state-owned banks by internationally Overall fiscal surplus of 1 percent of GDP for and end-September base money, net

recognized accounting firms.* 1998/99 to be updated at time of first review.** international reserves, and externalEnd-December 1997 and end-March 1998 debt.2 **floor on net international reserves.*/* By end-April 1998, reduce tariffs in line Reduce VAT exemptions from April 1998 and

with ongoing 1995–2003 tariff reduction consolidate off-budget funds into budget Limit use of Reforestation Fund toEnd-December 1997 and end-March 1998 program. within three years.** intended uses.limit on new external debt.**

By end of program (in 2000) eliminate Protect social spending and increaseEnd-December 1997 and end-March 1998 quantitative restrictions on trade. targeted aid to poor villages.limit on short-term debt outstanding.*

By end-December 1997, closure of “nursed”banks or those under conservatorship that do not submit rehabilitation plans orwhose plans are not approved by BI.

By end-December 1997, establishment ofquantitative performance targets for state-owned banks together with monitoring mechanisms.

By end-December 1997, issuance ofimplementation regulations on procurement and contracting procedures.

By end-March 1998, 30 percent increasein electricity prices** and petroleum prices raised to eliminate subsidies. **d

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B. January 1998 MEFP and Letter of Intent

Other conditions for Prior actions Performance criteria Benchmarks Targets completing the next review

By April 1998, begin to increase By end-April 1998, reduce tariffs Avoid a decline in output, while petroleum prices to eliminate subsidies in line with commitments in containing inflation to 20 percent inwith large initial rise (except for kerosene October 1997 MEFP. 1998/99* and single digits in 1999/2000.and diesel to protect the poor).**

Overall fiscal deficit of about 1 percentBy end-March 1998, increase electricity of GDP for 1998/99.*prices by 30 percent.**

Accounts of Restoration andEnd-March 1998 base money target. Investment Funds to be brought into

budget in 1998/99.**End-March 1998 overall central governmentbalance to achieve deficit of 1 percent to Twelve infrastructure projects to be2 percent of GDP for 1997/98. canceled.**

End-March 1998 floor on net international Budgetary and extrabudgetary support reserves. and credit privileges granted to IPTN’s

airplane projects to be discontinued,End-March 1998 floor on new external effective immediately.**ddebt.

All special tax, customs, and creditprivileges for the National Car Project to be revoked, effective immediately.**d

Bank Indonesia to be given full autonomyto conduct monetary policy and to begin immediately to unilaterally decide interestrates on its SBI certificates.*

Virtually all of the restrictions that hadbeen put in place over time to beeliminated.• From February 1, BULOG’s monopoly over

the import and distribution of sugar, as well as over the distribution of wheat flour,to be eliminated.**

• Domestic trade in all agricultural products to be fully deregulated.

• The Clove Marketing Board to be eliminated by June 1998. **

• All restrictive marketing arrangements tobe abolished. Specifically, the cement, paper,and plywood cartels are to be dissolved.**

• All formal and informal barriers to foreigninvestment in palm oil plantation andwholesale and retail trade to be lifted.**

Annex 1 • Indo

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C.April 1998 Supplementary MEFP


Introduction of full tax deductibility By end-June 1998, increase in prices of By end-June 1998, audit Monthly targets for end-May through By the end of September 1998;of loan loss provisions (by end- petroleum products to eliminate state-owned banks by June and quarterly targets through end- • Complete action plans for all March 1998). subsidies.** internationally recognized March 1999 for NDA;** base money;** 164 state enterprises.**

accounting firms (*). liquidity support;** short-term • Initiate sales of additional Transfer to IBRA control seven By end-June 1998, increase in electricity external debt; * and NIR floor. ** shares in listed state enterprises banks accounting for over 75 prices by 30 percent.** By end-June 1998, complete including, at a minimum, the percent of BI liquidity support, and public expenditure review. domestic and international freeze licenses of seven other banks. May 15, 1998 NDA; ** base money; * telecommunications

and liquidity support.*/* corporations. ***Implement first stage increase in • Eliminate subsidies on sugar,SBI interest rates (from 22 per- End-April 1998 overall central wheat flour, corn, soybean cent to 45 percent on March 23). government balance to achieve deficit of meal, and fishmeal.**d

3.8 percent of GDP for 1997/98.*/* • Complete divestiture of two Implement further increases in state enterprises that areinterest rates as necessary to May 15, 1998 floor on net international presently unlisted.*strengthen the rupiah and to keep reserves.*/* • Complete action plans forNDA in line with the program restructuring banks under target. Keep NDA and base money End-June ceiling 1998 on short-term auspices of IBRA.*in line with their program paths external debt.*/*during the period before the Board By the end of December 1998:meeting. End-June ceiling 1998 on net external • Reduce export taxes on logs

debt.** and sawn timber to 20 Lift restrictions on foreign percent.investment in wholesale trade. Merging Bank Bumi Daya and BAPINDO • Complete audits of nonviable

and transferring problem loans to the public enterprises.Raise prices of sugar, wheat flour, asset management unit of IBRA, by • Complete divestiture of two corn, soybean meal, and fishmeal. June 30, 1998. additional state enterprises

that are presently unlisted.Identify seven new state enterprises • Complete transfer of problem to be privatized in 1998/99 loans of IBRA banks to asset (including steel, toll road, and coal management unit.*mining companies; port and airport • Submit to Parliament draft law management companies; and a palm on competition to prevent theoil plantation). abuse of dominant position and

practices that restrict or Extend to private sector subsidies distort free competition.on food items previously given only to BULOG (incomplete). By the end of March 1999:

• Complete sales of additionalIntroduce resource rent tax on shares in listed state forestry products and reduce enterprises.export tax on logs and sawn timber • Complete divestiture of three to 30 percent. additional state enterprises

that are presently unlisted.

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C.April 1998 Supplementary MEFP (concluded)


Issue criteria for determining • Restore IBRA banks to 8 remaining locational restrictions on percent capital adequacy investment in palm oil plantations ratio.for environmental reasons. • Prepare plans for privatization

of at least one quarter of IBRA Make loan loss provisions fully tax banks in 1999.deductible, after tax verification.

Replace quantitative restrictions on palm oil, olein, and stearin with an export tax of no more than 40 percent.

Announce dismantling of joint marketing body for plywood.

Issue instructions to provincial governors to eliminate all local export taxes.

Announce minimum capital requirements.

Issue to IBRA an initial tranche of Rp 80 trillion in indexed government bonds.

Enact government regulation in lieu of law to amend the Bankruptcy Law and establish a Special Commercial Court.

Publish weekly key monetary data,including base money, NDA, and NIR.

Provide historical data on the accounts of the Reforestation Fund.

Note: Unless italicized, all the structural measures were included in the 1997 Article IV consultation report.1*** = subject to revision during subsequent reviews; ** = fully satisfied conditionality without delay; **d = fully satisfied conditionality with delay; */* = partially satisfied conditionality; and * = unsatisfied conditionality.

When no mark is attached information was considered insufficient to judge.2PC for April and June 1998 were established.


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Appendix A1.2

Indonesia:Timeline of Major Events1

Date

7/9/97 IMF Executive Board meets for the 1997 Article IV consultation.2

7/11/97 The authorities widen rupiah trading band to 12 percent from 8 percent.

8/14/97 Indonesia abolishes its currency band and allows the currency to float. The rupiah falls to Rp 2,755 per U.S. dollar.

8/19/97 Central bank raises the one-month SBI rate to 30 percent from 11.625 percent.

8/29/97 BI governor announces limits on forward foreign currency trading by domestic banks to nonresident customers at US$5 million.

9/3/97 Reform measures introduced, including removing 49 percent limit on foreign investors’ equity purchase for IPOs andraising luxury goods tax rate.

Government announces delays for infrastructure projects of US$13 billion to curb widening current account deficit.

9/4/97 Central bank lowers the one-month SBI rate to 27 percent from 30 percent.




10/8/97 IMF sends a technical assistance mission on the financial sector and mission to discuss a three-year IMF-supported program.

10/20/97 Central bank lowers the one-month SBI interest rate to 20 percent from 21 percent.

10/31/97 IMF announces a US$23 billion financial package to help Indonesia stabilize its financial system.2

11/1/97 The government closes 16 banks. Guarantees payment of up to Rp 20 million per deposit starting November 13.

11/3/97 The rupiah strengthens by 7 percent following intervention by monetary authorities of Indonesia, Singapore, and Japan.

11/5/97 PT Bank Andromeda, part-owned by President Suharto’s son, files lawsuit against Finance Minister and BI Governorchallenging bank closure.

IMF Executive Board approves 36-month Stand-By Arrangement for SDR 7.34 billion.2

11/7/97 Fifteen mega-projects quietly reinstated.

11/11/97 IMF Managing Director visits Jakarta.

11/23/97 The President’s son buys a small bank and starts its banking business on the old premises of Bank Andromeda.

11/25/97 IMF mission arrives in Jakarta.

12/5/97 President Suharto begins an unprecedented 10-day rest at home.

12/12/97 President Suharto cancels a plan to attend the ASEAN summit in Kuala Lumpur.

12/23/97 President Suharto calls on a retired technocrat to help private companies deal with their debt crises.

12/30/97 The Jakarta court decides to delay the liquidation of PT Bank Jakarta owned by Suharto’s half-brother Probosutedjo.

1/6/98 Rupiah falls 11 percent ahead of the budget announcement. President Suharto announces 32 percent increase ingovernment spending for 1998/99, perceived as violating IMF targets.

1/8/98 Rupiah falls after comments by U.S. Deputy Treasury Secretary that Indonesia needs to show commitment to reform.

1/9/98 U.S. President Bill Clinton calls President Suharto to insist that IMF program must be followed.

1/13/98 The government is reported in local press to be considering introducing a currency board.

1/14/98 The rupiah rises 9 percent in expectation of an agreement on the IMF-supported package.

1/15/98 Rupiah loses 6 percent as President Suharto signs agreement to dismantle monopolies and family-owned businesses.

1/19/98 President Suharto emphasizes that National Car Project and plan to develop Indonesian jet plane will continue withoutstate funding or assistance.

1/27/98 Government announces (i) full guarantee of commercial bank deposits and credits and new agency to restructure thebanking sector, and (ii) “steering committee” to handle negotiations between foreign lenders and Indonesian debtors andfreeze on debt payments pending new framework. There will be no debt moratorium since corporations must servicedebt if able to do so. Rupiah gains 18 percent.

Central bank raises the one-month SBI rate to 22 percent from 20 percent.

2/11/98 Finance Minister says that Indonesia will soon establish a currency board and is finalizing the legal and institutionalframework.

2/14/98 Fifty-four banks are brought under the auspices of IBRA and restrictions placed on their operations.

2/20/98 Government guarantees all deposits—Rp 3.1 trillion—in 16 liquidated banks. Previously covered up to Rp 20 million peraccount, totaling Rp 1.7 trillion.

2/22/98 Finance ministers from G-7 countries reportedly urge Indonesia to reconsider its plan for a currency board.


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Indonesia:Timeline of Major Events (concluded)

Date

3/2/98 President Suharto reports implementation of structural reforms under IMF program is incompatible with Indonesia’sconstitution.

3/3/98 Senior U.S. officials say the United States will not support the IMF’s next loan disbursement without “adequate” progressin reforms.3

3/5/98 The European Union reportedly urges President Suharto to follow through the crisis with commitment to reforms underthe IMF-led package.

3/10/98 President Suharto is reelected.

3/16/98 President Suharto’s new cabinet sworn into office.

3/23/98 Central bank raises the one-month SBI rate to 45 percent from 22 percent.

4/4/98 IBRA takes over seven large banks with liquidity support exceeding Rp 2 trillion each and freezes licenses of seven smallunsound banks.

4/8/98 IMF and Indonesia agree on new IMF-supported financial package that allows the government to maintain costly budgetsubsidies.2


4/22/98 Economic Coordinating Minister says Indonesia implemented all the reforms due under deadline agreed with the IMF.

5/5/98 IMF Executive Board meeting approves US$1 billion loan disbursement to Indonesia. Board recommends tight monetarypolicy, strengthening banking restructuring, and providing a framework for addressing debt problems of privatecorporations.2


5/21/98 President Suharto announces his resignation and immediately hands power over to Vice President B.J. Habibie.

5/22/98 President B.J. Habibie announces his cabinet, consisting of 23 ministers from the previous cabinet and 16 new appointees.

5/28/98 Bank of Central Asia put under IBRA control after massive run.

IMF reportedly arranges meetings with Indonesian opposition leaders and activists in an effort to make ties across a broadspectrum.3

6/4/98 Indonesian debt negotiation team and creditor banks in Frankfurt agree on a comprehensive program to addressIndonesia’s external debt problem, including creation of an Indonesia Debt Restructuring Agency (INDRA).3

6/18/98 The Export-Import Bank of Japan announces that Japan signed US$1 billion trade credit facility for Indonesia.

6/24/98 Government signs another agreement with IMF, the fourth in nine months, promising further reforms.2

7/2/98 INDRA is established to tackle private debt problems.

7/15/98 IMF Executive Board meeting approves a US$1 billion loan disbursement.2

8/19/98 The one-month SBI rate reaches 70 percent after several rounds of increases over three months.

8/25/98 IMF Executive Board approves next credit tranche of US$1 billion and an Extended Fund Facility (EFF) arrangement forUS$6.2 billion.2

9/23/98 Paris Club reschedules US$4.2 billion of sovereign debt.3

Sources: Bloomberg, Reuters, IMF, and local newspapers.1Local time, unless noted otherwise.2U.S. eastern standard time.3Western European time.

Introduction

This annex provides a detailed assessment of the role of the IMF in Korea’s capital accountcrisis of 1997–98, focusing on the role of the IMFin precrisis surveillance and in the process of crisismanagement.

The annex is organized as follows. First, it evalu-ates the effectiveness of IMF surveillance in identi-fying underlying vulnerabilities and the potentialrisk of crisis. It then discusses issues of program de-sign, including monetary and exchange rate policy,fiscal policy, financial sector reform, and nonfinan-cial structural reforms. Next, it examines the appro-priateness of program financing and the role of theIMF in the debt rollover agreement of late December1997. The final section presents conclusions.


With the benefit of hindsight, one can identifyseveral weaknesses in the IMF’s surveillance ofKorea during the period leading up to the crisis. Thissection discusses two areas in which these shortcom-ings proved to be most damaging: the analysis of thevulnerabilities introduced by the uneven process ofcapital account liberalization; and the initial assess-ment of the risk that the crisis spreading throughAsia in the fall of 1997 would soon hit Korea.

Underlying vulnerabilities

Throughout the 1980s and the first half of the1990s, the Korean authorities alternately liberalizedand restricted both inward and outward capital ac-count transactions in pursuit of their policy goals forthe external sector.1 Thus, in the early 1980s, capitalinflows were liberalized and capital outflows re-stricted to assist the financing of current accountdeficits. Later in the decade, when Korea began torun substantial current account surpluses, controls

were reimposed on inflows and controls on outflowswere eased. The environment of current account sur-pluses also contributed to the authorities’ decision,in 1988, to fully liberalize current account transac-tions and thereby accept the obligations of ArticleVIII of the IMF’s Articles of Agreement.

When current account deficits reappeared in theearly 1990s as a consequence of the strong won andthe global recession, the Korean government againimposed controls on purchases of foreign exchangeby residents and removed controls on certain cate-gories of capital inflows. The stock market wasopened to foreign investors in 1992, though withceilings on the fraction of a given company’s sharesthat could be held by any foreigner individually andby foreigners in aggregate. FDI was partially liberal-ized. Short-term borrowing by banks and certainnonbank financial institutions was liberalized in themid-1990s. Merchant banks, which would later playa central role in the 1997 crisis, were at the forefrontof institutions taking advantage of the easier rules onoverseas borrowing (Box A2.1).

As a result, capital inflows surged, which led toupward pressure on the currency. Significantly,rather than attempting to restore balance by reimpos-ing controls on inflows, as might have been done inthe past, the authorities instead chose to liberalizeoutward portfolio investments by Korean residents.A Foreign Exchange System Reform Plan was is-sued in December 1994, which outlined a gradual,staged liberalization process for the capital accountand the foreign exchange market.

In spite of the overall commitment to freeing capi-tal flows, this process had not moved very far by1997. Korea still maintained substantial controls onmany capital account transactions, particularly on theexternal issuance of long-term bonds and long-termcommercial loans by financial and nonfinancial enti-ties. Limits also remained on foreign participation indomestic equity and bond markets. The decision topursue liberalization of capital inflows had in part re-sulted from lobbying by the business community,which wanted to take advantage of relatively lowshort-term interest rates in global markets. Yet manyreform-minded officials, while favoring the liberaliza-

Korea

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ANNEX

2

1Much of the background material in this section is drawn fromKim and others (2001) and Johnston and others (1997).

ANNEX 2 • KOREA

tion of financial markets as a general principle, re-sisted measures to allow firms to raise funds directlyfrom foreign bond investors. It was feared that thiswould enhance the power of the large conglomerates(the chaebol) at the expense of small and medium-sized enterprises. As a result, in the mid-1990s, a newpolicy was initiated that deliberately steered capitalinflows through domestic financial institutions.

Even Korea’s accession to the Organization forEconomic Cooperation and Development (OECD) inDecember 1996 did not lead to a substantial addi-tional opening of capital markets. Joining the OECDwas seen as an important political goal and as a wayto reduce borrowing costs,2 but in the accession talksthe authorities resisted efforts to bring Korea’s capitalaccount regulations in line with those of other OECDmembers.3 In taking this stance, the authorities citedtheir concern about the consequences of a sharp in-

crease in capital inflows, given prevailing interestrate differentials. The policy of permitting short-termborrowing and restricting long-term flows allowedthe authorities additional flexibility vis-à-vis theOECD’s rules, which grant members the right to “rollback” previously adopted liberalization measureswith respect to most short-term capital movementsbut not those regarding long-term movements.

The decision to liberalize short-term transactionsbefore long-term ones had unintended consequences.Given the opportunity, the chaebol and the bankswould probably have strived to secure long-term fi-nancing even at the expense of a small term premium.If a greater share of Korea’s external debt in 1997 hadbeen in the form of long-term instruments, issued by amix of financial and nonfinancial institutions, ratherthan in the form of short-term bank debt, the characterof the December crisis would have been different andprobably less damaging. For one thing, a diversity offinancing channels might have made the system moreresilient to a breakdown in one channel, in this caseinterbank loans to overseas branches and subsidiaries.If the international market for the long-term debt ofKorean nonfinancial corporations had been deeperand possessed a lengthy, successful track record, thenforeign investors might have been willing to continuefinancing investment by healthy borrowers, whileavoiding troubled corporations and banks.4

Moreover, if more of Korea’s external debt hadbeen at longer maturities, the sudden drop in themarket’s confidence in the Korean financial systemmight have led to an explosion of spreads and a se-vere credit crunch, but not a liquidity crisis. This isbecause holders of maturing short-term debt can de-mand payment from the original issuers, forcing thelatter to rush to obtain cash or liquid assets, whileholders of long-term debt that has been downgradedbut has not yet matured can only sell the obligationsto other investors (or simply write down the loss).

The distinction is important because liquiditycrises tend to spread more rapidly and have a broaderimpact than do incidents where perceived levels ofcredit risk merely rise sharply. In a foreign exchangeliquidity crisis, there is the further risk that the author-ities will impose a standstill on payments. As a result,the risk premium imposed by foreign investors on allborrowers increases, regardless of their creditworthi-ness. Creditors, concerned over whether any borrowerwill be able to honor their foreign exchange–denomi-nated obligations, may demand repayment as soon asthese obligations mature. Once some creditors start totake this approach, all creditors find themselves forced

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Box A2.1. Merchant Banks in Korea

The merchant banks, most of them owned bychaebol, had been created from short-term financecompanies, which in turn had been established in1972 to facilitate “curb market” transactions, that is,those not permitted to the established commercialbanks. The policy of liberalizing short-term flowsbefore long-term flows and restricting direct capital-raising by nonfinancial firms gave the merchantbanks a profitable market niche. They acted as inter-mediaries for chaebol-affiliated firms, discountingcommercial paper and reselling it to commercialbanks. They also offered cash-management accountsand other instruments to investors, and dealt in cor-porate promissory notes. These opportunities provedto be so lucrative that 24 new merchant banks wereestablished between 1994 and 1996. The merchantbanks were required to keep their currency exposuresin balance, but there were many loopholes in theserules and supervision was poor. For their part, com-mercial banks felt pressure to compete with the mer-chant banks, and began to borrow abroad at shortmaturities as well.

2The capital accords agreed by the Basel Committee on BankingSupervision in 1988 allowed a lower capital charge for obligationsof (or guaranteed by) OECD member governments and for short-term loans to banks based in OECD member countries. However,the accords only prescribed a minimum charge. Regulators werefree to set a higher charge for specific borrowing countries.

3Members of the OECD agree to adopt the organization’s legalinstruments, including the Code of Liberalization of Capital Move-ments and the Code of Liberalization of Current Invisible Opera-tions (covering cross-border financial services). These codes incor-porate a commitment to move toward full liberalization and not tointroduce new restrictions. The existing members of the organiza-tion make the final decision on accepting new members, based onthe recommendation of the OECD secretariat and committees.

4This indeed occurred to some extent at the domestic level inthe first half of 1998, but could not happen at the internationallevel because Korean borrowers were not well enough establishedon international capital markets.

Annex 2 • Korea

to do so, introducing dynamics that are strongly remi-niscent of a bank run (Radelet and Sachs, 1998a). Bycontrast, in a credit crunch that is not a liquidity crisis,the market’s ability to distinguish between good andbad borrowers eventually returns, even if risk premi-ums may increase for a time on all borrowers. Credi-tors do not demand repayment from creditworthy bor-rowers simply because they fear that liquidity will runout. The extent of damage to the real economy istherefore likely to be less.

The IMF followed Korea’s capital account liberal-ization process closely and, through Article IV con-sultations, regularly urged the authorities to establishand follow a steady timetable for liberalization. How-ever, staff papers and Board discussions were con-cerned primarily with the speed of liberalization (typ-ically recommending a faster process) and withwhether it should be contingent on the convergence ofKorean interest rates to international levels (typicallyconcluding that it should not). Issues of sequencingand supervision were inadequately addressed in thesurveillance process, though these topics were attract-ing increasing attention elsewhere in the IMF.5 Ac-cording to staff members interviewed by the evalua-tion team, the focus on capital account liberalizationin Korea reflected the IMF’s belief that liberalizationof its external accounts would encourage the authori-ties to pursue genuine reforms of the domestic finan-cial sector, including improvements in supervision.

One reason why surveillance failed to highlightthe potential vulnerabilities in Korea’s external ac-counts was that the IMF—along with many others atthe time—thought of the capital account solely interms of transactions between residents and nonresi-dents. For this reason, short-term borrowing by over-seas bank branches and subsidiaries was not recog-nized as an important issue. For example, a study ofcapital account liberalization in Korea and threeother countries conducted by MAE and published inNovember 1997 exhaustively catalogued the liberal-ization measures undertaken by each country and theassociated developments in transaction volumes(Johnston and others, 1997). Yet this paper did notdraw attention to the growth in borrowing by Koreanoverseas bank affiliates, except to mention that theestablishment of overseas branches and subsidiarieshad been permitted as part of the liberalization ofoutflows of direct investment. The authors did nottreat borrowing by the affiliates as potentially equiv-alent to borrowing by their parent institutions.6

Assessment of the risk of crisis

The prevailing IMF view in the early months of1997 was that, while Korea faced problems in its fi-nancial sector that were potentially very serious andthat needed to be addressed promptly, there was norisk that this would lead to a loss of confidence andcrisis-inducing capital account outflows. There wassome concern at the widening current account deficit,but these concerns dissipated as the deficit narrowedin the first half of 1997. The failure of Hanbo Steelwas treated as a political matter, because of its impacton the standing of the ruling party, rather than in termsof the impact of further failures of chaebol on thehealth of the banking sector. The IMF’s view, whichwas shared by many (though not all) other public andprivate sector observers at the time, was influenced byKorea’s strong macroeconomic record and its provenability to raise foreign funds with little difficulty.

As the East Asian crisis spread in the summer andfall of 1997, there were grounds to reassess thisview. Because of the activity of their overseasbranches, Korean banks faced a maturity mismatchbetween their foreign currency assets and liabilities,while the chaebol to which the banks had lent in dol-lars faced a currency mismatch. Much of the Koreanbanks’ debt was at short maturities and was vulnera-ble to a decision by foreign lenders not to roll it over.Their situation was reminiscent of those of the finan-cial sector in Thailand and the corporate sector in In-donesia. Market commentary and credit spreads in-dicated that international investors and bank lenderswere reappraising the riskiness of their exposure tothe East Asian region as a whole.

The IMF was aware of these issues. In internalmemos circulated in August and September 1997,the staff criticized the support package put togetherby the authorities in response to growing financialsector problems, on the grounds that the package fellfar short of what needed to be done to restructure thefinancial sector. The guarantee extended to the exter-nal liabilities of Korean banks in late August was es-pecially troubling. In the staff’s view, the guaranteeraised the risk of a spillover of domestic financialdifficulties into the external sector, because to honorthe guarantee the authorities would either have toborrow on international capital markets or dip intoforeign exchange reserves.

The Article IV consultation mission that visitedKorea in October 1997 included a staff member fromMAE, who produced a detailed analysis of financial

95

5See for example Folkerts-Landau and Lindgren (1998), a draftof which had begun circulating internally in late 1997.

6The same report noted that increased net private inflows hadbeen associated with increased domestic credit growth, inflation,and current account deficits in Korea, Thailand, and Indonesia,but not in Chile, where capital inflows seemed to substitute for

domestic credit growth. One reason for this, the authors suggested,was that Chile had done more to improve prudential standards be-fore starting to liberalize its capital account. At the time the paperwas written, Thailand had already been hit by a crisis, and In-donesia had started to experience its own difficulties. But the ap-propriate parallel to Korea’s vulnerability was not drawn.

ANNEX 2 • KOREA

stability issues. Yet, while acknowledging the possi-bility of a spillover from the financial sector to thecapital account, the mission concluded, in its back-to-office report, that Korea was “relatively wellequipped” to handle further external pressures.7 Be-cause of this assessment, which was heavily influ-enced by incomplete reporting on the part of the au-thorities about their reserve position (see below), therewas no attempt to analyze rigorously Korea’s vulnera-bility to a cutoff of external short-term financing untilafter the country’s usable foreign exchange reserveswere all but depleted. Had such an analysis been at-tempted earlier in 1997, important data gaps mighthave been recognized sooner, particularly in suchareas as the nature of the BOK’s advances to commer-cial banks, the ability of the authorities to access thesefunds in a crisis, and the multiple strains on Korea’sdwindling stock of foreign exchange reserves.

The failure of IMF bilateral surveillance to iden-tify Korea’s vulnerability to a crisis was not unique.Other observers in the private sector were also caughtoff guard. In retrospect, one can attribute the failureon the part of the IMF to five misconceptions, whichwere compounded by critical information gaps.

First was the misestimation of the degree of flexi-bility in the country’s exchange rate policy. The brief-ing paper for the October Article IV consultation mis-sion lists, as one of the reasons for the staff’s view thatKorea faced only a “moderate” risk of a foreign ex-

change crisis, “the relatively flexible exchange ratepolicy and absence of indications of exchange rateovervaluation.” It noted that the Korean won had de-preciated almost 17 percent against the dollar sincethe beginning of 1996, reversing an earlier period ofappreciation. Yet, depreciation up to that point in re-sponse to the Asian crisis had been very limited (Fig-ure A2.1). At the time the paper was written, the wonhad depreciated barely 2 percent since July 1, 1997,after having weakened 8 percent from October 1996to July 1997. The behavior of other Asian currenciesat that time could have offered evidence that the wonwas being artificially supported. Singapore, whichpursued a more flexible managed float from the be-ginning of the crisis, allowed its currency to depreci-ate 7 percent from the beginning of July 1997 to theend of September. Malaysia’s currency fell 29 percentover the same period.

With regard to exchange rate policy, the missionteam misconstrued the authorities’ willingness to letthe currency weaken further if foreign demand forKorean assets fell significantly. Internal documentssuggest concern at the degree of foreign exchangemarket intervention, and particularly at the possibil-ity that Korea might have adopted a large forwardexposure, as had been the case for Thailand. At theend of the Article IV consultation mission, the staffadvised the authorities to scale back such interven-tion. Yet, perhaps because of their judgment that thewon was not overvalued, the staff did not put muchemphasis on this issue. Instead, the IMF’s policy ad-vice to the Korean authorities focused more on theneed to accelerate structural reforms than on macro-economic policy. The staff at that point did not viewan excessive commitment to support the won as afactor hindering Korea’s ability to respond effec-tively to the crisis. The authorities’ failure to sharecritical information with the staff about the extentand nature of their intervention, and about the actualstatus of their reserves, was central to the staff’s mis-diagnosis of the situation. In the event, the authori-ties’ attempts to support the won during Novemberthrough intervention would prove to be a criticaldrain on Korea’s foreign exchange reserves.8

There was also excessive optimism regardingKorea’s ability to prevent speculative pressure on thewon. In September, the staff found reassurance inthe fact that “the remaining capital controls [limited]the ability of international investors to take short po-sitions in won.” Yet the Thai experience should haveshown that capital controls of this type cannot pro-

96

7The staff report for the 1997 Article IV consultation was neverpresented to the Executive Board because its relevance was over-taken by subsequent events.

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Figure A2.1. Won–U.S. Dollar Exchange Rateand Korean Equity Prices

Source: IMF database.

Seoul compositestock index(left scale)

Won per U.S. dollar(right scale)

Jul. Sep. Nov.1997 1998

Jan. Mar. May200

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8As an example of an alternative response to the regional crisis,Taiwan Province of China successfully fended off a potential cri-sis by moving to a more flexible exchange rate policy in mid-Oc-tober. The New Taiwan dollar weakened roughly 8 percent in thethree days following this policy shift.

Annex 2 • Korea

tect a currency when domestic and foreign investorsmove decisively out of domestic assets throughwhatever channels are available. For example, asRES pointed out at the time, foreign investors couldtake short won positions in offshore derivatives mar-kets. Downward pressure on the won would then betransmitted to the domestic market through hedgingby the domestic Korean institutions that acted asmarket-makers in these instruments. In other words,pressure on the won, if it developed, would takewhatever form it could.

Second, the staff underestimated the risk of abreakdown in funding the capital account. The staffrecognized that such a risk was present, particularlyin the crisis conditions then prevailing in East Asia,but concluded that the authorities could handle anypressures by making renewed efforts in the area offinancial reform, by addressing financial sectorweaknesses, and by loosening controls on long-termexternal borrowing. In part, this risk was underesti-mated because there was insufficient data on Korea’sshort-term external obligations (though some rele-vant data sources were overlooked). While the staffwas concerned at the level of short-term externaldebt and pressed the authorities to lengthen the ma-turity structure of this debt, efforts to clarify theseconcerns, for example by requesting the appropriatedata more forcefully, do not seem to have been pur-sued until the crisis had already broken out.

More fundamentally, the staff (and most other ob-servers at the time) did not foresee the degree towhich market sentiment would swing against Korea,and the consequences this would have for the provi-sion of credit of all kinds. This shift in sentimentrendered the recommendation for looser controls onlong-term borrowing moot; surely, if Korea had dif-ficulty rolling over its short-term external debt, itwould have even more difficulty refinancing itsshort-term debt at longer maturities.

Third, the potential short-term impact on growth ofproblems in the financial sector was underestimated.The September 1997 briefing paper contained threescenarios for macroeconomic developments in Korea:a “baseline” scenario positing growth of about 6 per-cent in both 1997 and 1998; a scenario assuming theadoption of the IMF’s “preferred policies,” underwhich growth would fall to 5.3 percent in 1997, thenrise to 6.7 percent in 1998 (after which the outlookwould remain higher than in the “baseline”); and “dis-orderly adjustment,” a scenario supposedly incorpo-rating a possible spillover of the domestic financialproblems to external financing, resulting in growth of4.0 percent in 1997 and 4.5 percent in 1998.9 Slower

growth in this last scenario resulted, not from a break-down in financial intermediation or a fall in invest-ment reflecting a drop in confidence, but from tightermacroeconomic policies in response to downwardpressure on the won. Yet the experiences of othereconomies in the 1990s, such as Japan, Sweden, andFinland, showed that broad-based financial sector re-structuring can have a serious impact on growth ratesover a period of several years. The narrow range ofgrowth estimates across the three scenarios, a reflec-tion of the remarkable stability of Korea’s growthrates over the previous decades, prevented the stafffrom exploring the possibility or, more importantly,the consequences of a more serious slowdown.

Fourth, not enough attention was paid to relevantmarket indicators, for example, the yield spread ofKorean Development Bank (KDB) bonds (state-guar-anteed obligations denominated in dollars) over U.S.treasuries, and the expected won depreciation im-plied by prices in the offshore nondeliverable for-ward market. As noted in Park and Rhee (1998), bothof these began signaling profound market uneaseover events in Korea as early as August 1997 (FigureA2.2, top panel; and Figure A2.3, top panel). FromAugust to October 1997, the bond spread widenedand the nondeliverable forward rate indicated in-creased expectations of depreciation (though thesemovements would be dwarfed by developments dur-ing the crisis period).10 Nowhere in the briefs leadingup to the November program-negotiation mission canone find a reference to the negative signals emanatingfrom these sources.

Finally, and more generally, bilateral surveillancein the years preceding the crisis was not sufficientlysensitive to the short-term stability implications of fi-nancial sector liberalization.11 The prior experienceof liberalization in other countries, such as the Nordiccountries or the savings and loan crisis in the UnitedStates, was that liberalization tended to be followedby excessive lending and radical restructuring of thefinancial industry, with firms, consumers, and regula-tors learning the ins and outs of the new systemthrough trial and error. The long-term benefits of such

97

would be little or no growth in the fourth quarter, and growthbelow potential in 1998.

10Under conditions of full capital mobility and liquid moneyand bond markets, the forward won-dollar exchange rate wouldsimply correspond to interest rate differentials between Korea andthe United States, but these conditions were not present for Koreaat that time. The forward rates in the nondeliverable forward mar-ket were more depreciated than those in the relatively thin on-shore won-dollar forward market during this time, implying thatthe onshore rates were being artificially supported by official in-tervention (Park and Rhee, 1998).

11However, many of the relevant issues were well known to theIMF staff, having been addressed in studies such as Lindgren andothers (1996) and Alexander and others (1997).

9Given the strong growth that had already occurred in the firstthree quarters of 1997, this represented a prediction that there

ANNEX 2 • KOREA

liberalization came only after a period of experimen-tation and instability. The advice offered to Korea inthe late summer and early fall of 1997, to the effectthat the solution to the immediate problems of the fi-nancial sector lay primarily in strengthening and ac-celerating the reform agenda, may have been validfrom the perspective of the long-term health and effi-ciency of the system, but did not offer much guidanceas to how the Korean authorities should secure thesystem against the external shocks that had alreadystarted to hit nearby countries.12 The Article IV con-

sultation mission did urge the authorities to assess theextent of the banks’ NPLs and the scope for provi-sioning. Relatively little advice was offered, however,toward the formulation of a strategy for restructuringand recapitalizing the banking sector in the face of apossible crisis, beyond general principles such asavoiding regulatory forbearance, limiting public sup-port to the minimum necessary, and broadening therole of the KAMCO. This reflected the IMF’s lack ofexperience at that time in the resolution of domesticfinancial sector crises.

While these factors were not adequately assessedin the IMF surveillance reports, there was recogni-

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EMBI (bp)

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KDB 71/4% due5/15/06

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January 1–October 15, 1997

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Figure A2.2. Korean and Emerging MarketBorrowing Spreads(In basis points over comparable U.S. treasury rates)

Source: Datastream.

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October 16, 1977–June 30, 1998

Three-month forward rate

Figure A2.3. Won–U.S. Dollar Spot and ForwardRates1

Source: Reuters.1The forward rates are implicitly derived from offshore nondeliverable

forward prices.

12The briefing paper prepared for the 1997 Article IV consulta-tion identified four priorities for reform of the Korean financial sector: removing nonprudential controls on balance sheets, whichhad served as vehicles for political involvement; removing theimplicit and explicit guarantees against bank failures; ensuring “a well-targeted safety net,” an apparent reference to deposit

insurance; and facilitating merger and acquisition activity in the fi-nancial sector.

Annex 2 • Korea

tion internally that they may pose serious problems.A team from the RES Capital Markets Division hadvisited Korea earlier in the year, as part of theirpreparation for the annual International CapitalMarkets report, and had identified several weak-nesses in the Korean financial system. Expandingon these findings, a member of the team later pre-pared an internal note detailing some of the vulnera-bilities, including the NPL problems. Commentingon the Article IV pre-mission brief, RES cited theauthorities’ “widespread and unconditional” supportfor troubled financial institutions, the poor state ofsupervision and regulation, and the rapid rise inshort-term debt as potential sources of risk. RESalso expressed skepticism over the willingness ofthe authorities to allow the exchange rate to adjustin the way envisaged in the briefing paper, giventheir history of intervention.

In part, the shortcomings of surveillance in the pre-crisis period reflected a shortage of analytical re-sources. Because of Korea’s record of stability, rela-tively few staff members were following the countryregularly during the time preceding the crisis.13 Koreawas usually covered either by the division that alsowas responsible for following Japan, or by the onethat covered China; in both cases, the bulk of analyti-cal resources was devoted to the larger country. Therewas little in the way of structural analysis of Korea’sfinancial and corporate sectors available from theWorld Bank, because Korea had “graduated” fromBank lending programs in the early 1990s.14 More-over, by the fall of 1997, APD was stretched thin bythe crisis spreading throughout the region, so seniorstaff had to be transferred from other country assign-ments to lead the Article IV consultation mission.

However, several of the lapses identified aboverepresented not so much a lack of familiarity with orknowledge of Korea, as a failure to draw the appropri-ate parallels with experiences in other economies.This was the case both for contemporaneous develop-ments—contrasts with Taiwan Province of China,Singapore, Malaysia, and Thailand have already beennoted—and for prior experience, as with bank reformand restructuring in the Nordic countries.

Surveillance also suffered from the poor quality ofthe available data, particularly on the vital topics ofNPLs, external debt, and usable reserves. The lack of

good data appears in part to have reflected the dataprovision policies chosen by the authorities. UntilNovember 1997, there was little internal discussionof the need to press the authorities to improve thequality of statistics on their debt and reserves.15 Atthe same time, certain data sources appear to havebeen overlooked. For example, the consolidated andlocational statistics compiled by BIS pointed to sharpincreases in interbank debt, and particularly short-term debt, in the years immediately preceding the cri-sis.16 As noted above, another key reason for the poorquality of the data was the tendency for both the staffand the authorities to think about capital flows onlyin terms of a “residence” concept rather than “nation-ality.” As a result, they relied on prevailing statisticaldefinitions that did not include the obligations of Ko-rean banks’ overseas branches among the liabilitiesof the Korean financial sector, although nationality-based data were available, albeit in limited form,from BIS and national sources.17

Program DesignThis section reviews the major elements of pro-

gram design in the IMF-supported program forKorea, as agreed at the beginning of December 1997and modified over the subsequent months (BoxA2.2), including monetary and exchange rate policy,fiscal policy, financial restructuring, and nonfinan-cial structural reforms.

Monetary and Exchange Rate Policy

Evolution of the IMF’s policy advice

The monetary policy section of the briefing paperprepared for the November 1997 negotiating missionwas the outcome of considerable internal debate. Incommenting on an earlier draft of this brief, RESsuggested that monetary policy should guide the ex-change rate to a range close to its then prevailinglevel, while MAE suggested that it would not bepossible to determine an appropriate exchange rate

99

13The 10 Article IV consultation missions from 1988 to 1997were headed by six different individuals, though the same personheaded the consultation missions in 1995, 1996, and 1997. Onlyone other staff member participated in more than 2 of the 10 con-sultation missions.

14On the other hand, with Korea’s accession in December 1996,the OECD was developing considerable expertise on Korea. Inview of this, the IMF later invited the OECD to provide inputsinto the structural conditionality of the December 1997 programin the area of corporate governance.

15The staff report for the 1995 Article IV consultation remarkedthat “Korea’s economic statistics [were] of high quality and[were] reported to the IMF on a timely basis.”

16In December 1997, data were available from the BIS consoli-dated banking statistics through the end of 1996. This put Korea’sliabilities to reporting banks at US$100 billion, of which US$67.5billion was short-term (by resident maturity). This represented anincrease in bank debt of US$22.5 billion over the previous year,including an increase of about US$13 billion in short-term debt.More up-to-date data were available from the “locational” series,published in November 1997, with data covering up to end-June1997. This suggested that borrowing from international banks hadcontinued to grow in the first half of 1997.

17For example, some of this information was available from theU.K. and U.S. national supervisory data.

ANNEX 2 • KOREA

target at that time. MAE argued that there was a riskthat targeting the exchange rate would prove unsus-tainable, because the high domestic interest ratesneeded to defend it would exacerbate the bad loanproblem over time.

The brief that emerged represented a compro-mise. It envisaged “a tightening of monetary policydirected at containing the impact of recent wonweakness on inflation and preventing a significantfurther weakening of the currency.” A target of 8.5percent growth in M3 was set for 1998, significantlylower than the 15.8 percent M3 growth projected for

1997. The proposed program also involved “an (im-plicit) [parentheses in original] target range for thewon’s nominal effective exchange rate with the un-derstanding that monetary policy [would] be tight-ened if the rate [fell] to the bottom of this range,”though the exact range was not specified.

By the time the program was finalized in earlyDecember 1997, the role envisaged for monetarypolicy had shifted. A nominal effective exchangerate target was no longer contemplated. Instead, theobjectives of monetary policy were defined to be tocontain inflation to 5 percent and to limit down-

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Box A2.2.The IMF-Supported Program in Korea

The policy actions undertaken by Korea in connec-tion with the SBA were detailed in a “Memorandumon the Economic Program” attached to the “Letter ofIntent,” which was signed by the Minister of Financeand Economy and the BOK Governor, and in a letteron “Prior Actions,” signed by the Minister of Financeand Economy alone. The Memorandum detailed theactions that the authorities intended to undertake andidentified performance criteria and structural bench-marks that they were committed to achieve. In fact,there were only two explicit performance criteria inthe initial program, namely, targets for NIR and forNDA, though there was extensive discussion of poli-cies that would be pursued in other areas. The prioractions letter detailed measures that had been taken orwould be taken in short order upon approval of theprogram by the Executive Board. These two docu-ments specified actions that had been or would soonbe taken in the following areas:

Monetary and exchange rate policy

1. Prior action

The overnight call rate, then roughly 12.7 percent,would be raised to 25 percent by December 5, 1997,and maintained there until the program’s inflation ob-jective had been achieved and the exchange markethad stabilized.

2. Performance criteria

a. A floor was specified for NIR and a ceiling forNDA.

b. New foreign exchange advances from the BOK tobanks were to carry a penalty rate of 400 basispoints over LIBOR, for at least the next fourweeks.

3. Other measures

a. The growth rate of M3 would be reduced, thenkept in line with an inflation objective in 1998.

b. The liquidity injection that had taken place in recent weeks in support of the banks would bereversed.

c. Exchange rate intervention would be limited tosmoothing operations.

Fiscal policy

1. Prior actions

Transportation and excise taxes were to be increasedimmediately.

2. Other measures

a. The public sector budget in 1998 would be closeto balance. To counteract the carrying costs of thefinancial sector cleanup and the impact of slowergrowth, this required contractionary measures of1.5 percent of GDP.

b. In addition to the tax increases already mentioned,measures would be formulated on both the rev-enue and the expenditure sides.

Financial sector restructuring

1. Prior actions

a. Nine troubled merchant banks were closed on De-cember 2, 1997, with depositors fully protected.

b. The remaining merchant banks would be requiredto develop plans to meet the capital adequacy stan-dards that had been established by the Basel Com-mittee on Banking Supervision (BCBS) by June1999, subject to the approval of the MOFE.

c. Two troubled commercial banks (widely under-stood, and later revealed, to be Korea First Bankand Seoul Bank) would be required to developplans to achieve the BCBS capital adequacy stan-dards by mid-1998, subject to the approval of theBOK. Until then, they would be “subject to inten-

Annex 2 • Korea

ward pressure on the won. There would be an im-mediate increase in interest rates to demonstrate the government’s resolve in the face of the crisisand to calm the markets. Interest rates would laterbe brought down somewhat, but would remain highenough to limit downward pressure on the won andto ensure that inflation would be no higher than 5 percent in 1998. A target for broad money growthwas set for the fourth quarter of 1997 but, unusu-ally for IMF-supported programs at that time,monetary policy for the following year was to beguided by an inflation target. An inflation target,

however, was not made part of formal conditional-ity in the program.

Two principal developments appear to have con-tributed to this change in focus. One was the sharpdepreciation in the won, from W 987 per U.S. dollaron November 17 to W 1,249 on December 4. Thismade it virtually impossible to determine an ex-change rate range that could be relied on as an an-chor for policy. A second factor was that the BOKcontinued to provide won liquidity to troubled banksat favorable interest rates, even while the programnegotiations were under way. As a result, the call

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sive supervision,” which might include mergers orasset sales.

d. Other commercial banks would be required tomake provision for loan losses by March 1998,and to develop plans by mid-1998 to achieve theBCBS capital adequacy standards by end-1999,subject to the approval of the BOK.

e. Losses were to be taken first by shareholders, thenby nonguaranteed creditors.

f. The ceilings on share ownership by foreignerswere to be increased.

g. Restrictions on hostile takeovers, friendly take-overs of financial institutions by foreign institu-tions, foreign ownership of merchant banks, andthe ability of foreign institutions to set up Koreanbranches and subsidiaries were to be removed.

h. The government would develop an action plan forbringing supervision and regulation up to interna-tional standards.

2. Other measures

a. The Bank of Korea was to be made independent,with a mandate for price stability.

b. Supervision of commercial banks, merchantbanks, securities firms, and insurance firms wouldbe consolidated in an autonomous agency.

c. A consolidated deposit insurance corporation, fi-nanced by the issuance of government-guaranteedbonds, would be set up.

d. Foreign access to the Korean money and bondmarkets would be liberalized.

e. A timetable would be established by end-February1998 to allow overseas borrowing by corporations.

f. There would be no government intervention inbanks’ management and lending decisions, ex-cept as required by prudential regulations. Wherethere was policy-oriented lending, the interestsubsidy would be included in the public sectorbudget.

Corporate sector, trade, labor market, andinformation provision

1. Other measuresa. Corporations would regularly prepare consoli-

dated, audited financial statements. Accountingand disclosure standards were to be brought upto internationally accepted levels, including in-dependent external audits.

b. The authorities would set up a timetable for elimi-nating trade-related subsidies, restrictive import li-censing practices, and the import diversificationprogram.

c. Korean legislation on takeovers would be harmo-nized with that of other countries.

d. The existing bankruptcy code would be allowed tooperate without official interference, with nobailouts of individual companies.

e. With the assistance of multilateral lending organi-zations, a plan would be formulated to reduce cor-porate leverage, develop traded capital markets,and change the system of cross-guarantees withinconglomerates.

f. Labor-market flexibility would be improved, in-cluding strengthening of the employment insur-ance system.

g. Provision of data, on such matters as foreign ex-change reserves, nonperforming loans, capital ad-equacy, ownership of financial institutions, exter-nal debt, and local government finances, would beimproved.

The above list formed the basis for the policies thatKorea would undertake over the next two years. A mod-ified program was agreed on December 24, 1997, alongwith a faster disbursement of IMF resources. The re-vised program specified additional measures that wouldbe undertaken (in most cases, this amounted to an ac-celerated timetable of agreed measures). Subsequentprogram reviews would convert some of the items listedinto explicit structural conditions, and add new reformmeasures in the same spirit as those listed.

ANNEX 2 • KOREA

money rate declined to 12.7 percent on December 2from 15.0 percent on November 17 (Figure A2.4).The staff felt that strong action would now be neces-sary, in part to stem the drop in the exchange rate,but primarily to reestablish monetary control and todemonstrate the authorities’ resolve to regain ex-change rate stability. Once the foreign exchangemarket had been stabilized, policy would be loos-ened, but would remain geared toward containingany inflationary effects of the weaker won and coun-teracting further depreciation.

Monetary policy, along with the closure of themerchant banks (discussed below), was one of theprincipal issues on which the authorities and theIMF disagreed most strongly during the first phaseof the negotiations. The authorities feared that exces-sively high interest rates would cause an increase inbankruptcies in the highly leveraged corporate sec-tor. Only with the intervention of the Managing Di-rector in the final stages of the negotiations did theKorean authorities agree to raise interest rates to thelevels thought necessary by the IMF.

The temporary nature of the rate increase was un-derscored in the letter on prior actions, signed by theMinister of Finance and Economy, that accompaniedthe request for an SBA. This letter specified that thecall rate would be raised to 25 percent, and “main-tained at that level until the time it [would] bejudged—in consultation with the IMF staff—that it[could] be progressively brought down to a range of18–20 percent.”

The call rate was duly raised to 25 percent inearly December 1997, but confidence was not re-

stored. Instead, the won remained extremely volatileand fell to record lows (Figure A2.1). The IMF urgeda still tighter policy, but this could not be imple-mented immediately because of a 35-year-old usurylaw that set a ceiling of 25 percent on the call moneyrate. A law increasing the usury ceiling was passedon December 14, after which this rate was promptlyraised to 30 percent. Further increases followed andthe call rate peaked at 34 percent in early January1998. However, by mid-December, it was clear tothe authorities and the IMF (particularly the missionteam in Korea) that this situation was not sustain-able, given the impact it had begun to have on corpo-rate balance sheets and given continued capital out-flows. This spurred the search for another solution,namely the strengthened program and coordinateddebt rollover announced on December 24.

The staff continued to endorse the maintenanceof relatively high real interest rates in the earlymonths of 1998, believing that the exchange ratehad not yet fully stabilized and that there was still arisk of accelerating inflation. The call rate wasmaintained in the 20–25 percent range for the firstthree months of the year, and then was loweredgradually in the spring and summer. There was astrong concern that premature loosening of mone-tary policy would lead to a loss of monetary controland renewed depreciation of the exchange rate, ashad happened in Indonesia.18 The staff acknowl-edged that the tight monetary policy (along withhigher capital adequacy requirements) contributedto a credit squeeze, but contended that the best wayto ameliorate the squeeze would be to implementthe accelerated timetable for financial sector re-structuring and to provide official liquidity tosound institutions against appropriate collateral. Inthe Executive Board reviews of the Korean pro-gram, comments tended to favor maintaining a tightmonetary policy in support of the exchange rate.However, in the February discussion, one chairwarned about “overkill” and suggested a more ac-tive willingness to ease policy once the exchangerate had stabilized.

Real interest rates during the first half of 1998were very high by the standards of most industrialcountries facing a recession, though not unusuallyhigh for emerging economies in crisis (see Table 4.2in the main report). Using the actual 1998 CPI infla-tion rate of 7.5 percent, the overnight call money ratereached a high of 26.5 percent in real terms in earlyJanuary, before falling to around 15 percent in Febru-ary, 10 percent in early May, and single digits for the

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0

5

10

15

20

25

30

35

40

Overnight call rate

Inflation (annual)

November 21

December 24

December 3

January 6

Jul. Sep. Nov. Jan. Mar. May1997 1998

Figure A2.4. Korea: Overnight Call MoneyRate and Inflation(In percent)

Source: Datastream.

18RES was opposed even to the gradual lowering of rates thatoccurred in early 1998, and continued to urge that policy be ori-ented toward a target range for the exchange rate.

Annex 2 • Korea

rest of the year.19 This represented a return to precrisislevels, which averaged about 8 percent in 1996–97.

The three-year corporate bond yield was 200–500basis points less than the call rate from Januarythrough May, after which the call money rate fellsubstantially below the corporate bond yield. Thisimplies, after appropriate allowance is made for thecorporate credit risk premium, that the latent domes-tic currency term structure moved from being in-verted to being upward-sloping either in May orsoon afterward, offering another indicator that themonetary stance loosened around this time.

Assessment

As in other crisis countries, monetary policy inKorea reflected a trade-off between, on the one hand,the need to reestablish external credibility, control in-flation, and stabilize the exchange rate, and, on theother, the need to support domestic demand at a timeof financial sector restructuring. As discussed in the

main report, most economic policymakers at the timeaccepted the existence of a link between higher inter-est rates and a stronger exchange rate. While this viewhas been challenged since the Asian crisis, the largetheoretical and empirical literature that has emergedhas yet to settle the matter (Box A2.3). The literature,however, does suggest that the relevant issues and re-lationships differ, depending on whether one is de-fending an exchange rate in the midst of a crisis, or at-tempting to manage the situation in the aftermath ofan episode where the exchange rate has overshot itsequilibrium level. In the latter case, the objective is toensure that the required real appreciation occurs notthrough domestic price increases but through nominalappreciation (Goldfajn and Gupta, 1999).

For Korea, this suggests that there are in fact twodistinct issues to consider:

• Were high interest rates justified as a means tostabilize the won at the outset of the crisis in De-cember 1997?

• Were high interest rates justified in the earlymonths of 1998, after the most critical stage ofthe crisis had passed but the exchange rate re-mained substantially weaker than its earlierlevels?

It is difficult to answer these questions conclusively,given the lack of consensus in the academic and pol-icy communities. However, we can look at which of

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19Independent inflation forecasts for 1998 were around 11 per-cent in the early months of that year, suggesting that real interestrates measured using expected inflation were only a few percent-age points below the levels cited here. See Bloomberg News,“Korea’s Consumer Prices Fall 0.2 percent in March,” March 31,1998. In terms of realized monthly inflation rates, the real call ratewas briefly negative in December because of the one-time jumpin prices resulting from the depreciation.

Box A2.3. Recent Studies on the Impact of High Interest Rate Policy in Korea

In the case of Korea, two recent empirical papers have yielded the result that higher in-terest rates (relative to their U.S. equivalents) had an appreciating effect on the won–U.S.dollar exchange rate during the 1997–98 crisis. Cho and West (2000) used daily data forthe period December 17, 1997–June 30, 1999 to estimate regression and vector-autore-gression (VAR) models and found that, with appropriate control for risk, liquidity, andsome external factors, a higher call rate was associated with exchange rate appreciation.Likewise, Chung and Kim (2002) applied a nonlinear econometric methodology (inorder to take account of both levels and changes in interest rates) to daily data for the pe-riod January 4, 1995–September 30, 1998 and found that, in a bivariate VAR framework,a higher certificate of deposit (CD) rate led to an initial depreciation of the exchange ratefor a few days, followed by an appreciation sustained over a few months, even during thecrisis period (December 1, 1997–March 31, 1998) when the level of interest rates washigh. It should be noted, however, that (1) a substantial portion of the sharp currency de-preciation of the crisis period had already occurred by the beginning of the sample pe-riod in the Cho-West (2000) study, with a trough on December 24, and (2) the parameterestimates of the Chung-Kim (2002) study come from a sample that include a relativelylong noncrisis period. Given these qualifications, the studies do not seem to present astrong case against the undeniable fact that the Korean won depreciated from W 1,163 toW 1,964 per U.S. dollar in December 1997 while the call rate was raised from 13 percentto 30 percent. More likely, these studies provide a confirmation of the conjecture thattight monetary policy maintained in the aftermath of the sharp depreciation helped to en-sure that the subsequent real appreciation took the form of nominal appreciation ratherthan higher inflation.

ANNEX 2 • KOREA

the identified effects were operating in Korea at thetime, and at whether the IMF took sufficient accountof the relevant issues in formulating its policy adviceto the Korean authorities.

Stabilizing the exchange rate

After the Korean authorities floated the currency,the immediate objectives of monetary policy were toarrest the sharp decline of the exchange rate and sta-bilize the foreign exchange market. However, theclosed nature of Korean capital markets limited thechannels through which monetary policy couldachieve those goals. Higher interest rates could nothave stabilized the won by increasing the cost ofspeculation against the currency. While the offshoremarket, mentioned earlier, was a potential source ofspeculative pressure, it was by no means the primaryreason for the won’s weakness. Korea faced in-creased demand for liquidation of foreign currencyclaims rather than a conventional speculative cur-rency attack. There was little risk of domestic capitalflight, because of limits on the ability of residents totake funds out of the country.20 Though foreign cur-rency deposits held by residents rose 267 percent inU.S. dollar terms from end-June to end-November1997, even at the end of November they totaled onlyUS$5.3 billion, so this trend had little impact.21 Con-versely, foreign entities did not have many vehiclesthrough which to invest in won-denominated assets.In practical terms, neither the long-term bond marketnor the short-term money market was open to for-eigners. It was possible to lend to Korean entities—but these were precisely the loans that foreign finan-cial institutions were rushing to liquidate. Foreignerscould also invest in the stock market, but higher inter-est rates would be likely to discourage foreign sharepurchases in conditions of panic, by lowering real-ized returns and thus depressing market sentiment.

In the view of IMF staff at the time, the main chan-nel through which the interest rate defense would op-erate was that higher interest rates would raise the op-portunity cost for Korean banks of not having theirforeign currency loans rolled over. A Korean bankwith an outstanding short-term dollar-denominatedloan about to come due could either promise to pay itsforeign lender a higher dollar interest rate, inducing

the latter to roll over the loan, or it could borrow wonon the domestic market––in effect, a loan from thecentral bank, given the guarantee mechanisms inplace––and use the won to buy dollars in order to payoff the loan. The second of these two options, if pur-sued by enough institutions, would cause downwardpressure on the won. A higher won interest rate mightinduce more Korean banks, at the margin, to choosethe former course rather than the latter. In this sense,the high won interest rates were a complement to thepolicy of having the central bank charge a penalty ratefor foreign exchange advances; both policies were in-tended to induce Korean banks to seek rollovers ratherthan drawing on central bank liquidity.

Given the nature of the Korean crisis, however,very high interest rates were necessary for this chan-nel to operate effectively. For many creditor banks,the rollover decision depended more on their assess-ment of credit risk—including the suddenly height-ened risk, not merely of their Korean positions, butof East Asian exposure in general—than on the in-terest rate their Korean counterparties offered them.It is not clear if any level of interest rates offered byKorean borrowers would have been high enough toinduce such banks to roll over their loans. This wasborne out by events, since capital outflows onlystopped when the high interest rates were comple-mented by the coordinated rollover agreement.

Thus, a tighter monetary policy may have beennecessary to slow the leakage of foreign exchangeand to prevent a full-scale collapse of the exchangerate, but it was not sufficient as a means to reversecapital outflows and resolve the crisis. If the staffhad come into the crisis with a better understandingof the nature of Korean capital markets, then it ispossible that less emphasis would have been placedon monetary policy in the initial formulation of theprogram, and more on finding an alternative solutionto the worsening liquidity crisis.

The recovery and the transition to lower rates

According to the objectives set out in the IMF-supported program, monetary policy during the firsthalf of 1998 had two goals: to stabilize the foreignexchange market and to counteract the inflationaryeffects of the depreciation. As regards the first objec-tive, one can argue, with the benefit of hindsight,that monetary policy was guided by an excess ofcaution rather than deliberate overkill. The wonstrengthened from W 1,964 to the U.S. dollar on De-cember 24, 1997 to around W 1,400 at the end ofMarch 1998, and remained at or near that level forthe next three months (see Figure A2.1). The volatil-ity of the exchange rate declined steadily in the firsthalf of 1998 (Figure A2.5). The volatility of thewon–U.S. dollar rate (measured as the standard devi-

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20However, residents could still circumvent these restrictionsby accelerating or postponing cross-border payments.

21Residents’ foreign currency deposits fell 31 percent in U.S.dollar terms in December 1997. This suggests that local residentsdid not try to flee the currency, but instead participated in theglobal run on the dollar holdings of the Korean banking system.Foreign currency deposits were stable as a fraction of total de-posits during December, as these withdrawals were balanced bythe won’s depreciation (which increased the value of dollar de-posits relative to won deposits).

Annex 2 • Korea

ation of daily logarithmic changes) fell to 0.7 per-cent in June 1998 from 8.1 percent in December1997. For comparison, the monthly volatility levelsof the Japanese yen–U.S. dollar and deutsche mark–U.S. dollar exchange rates during this time rangedbetween 0.4 percent and 0.8 percent.

Did high real interest rates contribute to this stabi-lization? It is difficult to answer this question with-out being able to test the alternative hypothesis. Cer-tainly it was important to maintain high real interestrates in order to prevent a flight from won-denomi-nated assets by Korean institutions and individuals,though, as noted above, there were few channelsthrough which this could occur. But the govern-ment’s prompt actions in starting to address theproblems in the corporate and financial sectors arelikely to have done more to rebuild the market’s con-fidence in the Korean economy.

The second principal motivation for the level of in-terest rates, namely the need for a tight monetary pol-icy to contain inflation, was open to question. Withunemployment at 7 percent, the gap between actualand potential GDP was probably quite large. The ex-perience of such countries as the Philippines andThailand in the late 1990s and Finland and Sweden inthe early 1990s shows that there is no reason to as-sume a large sudden depreciation will necessarily leadto a correspondingly large acceleration of inflation.Academic work produced after the crisis has investi-gated the reasons why “pass-through” tends to beweaker than expected in such situations. Burstein andothers (2001) cite two countervailing effects: first,consumers tend to substitute domestic for foreigngoods; and second, the component of the final price ofa “tradable” good that is sensitive to the exchange rateis often quite small relative to domestic cost compo-nents such as transportation and distribution. Ofcourse, these experiences, and the lessons that havebeen drawn from them, were not fully available or un-derstood at the time of the Korean crisis.

High interest rates undoubtedly imposed costs onthe domestic economy, but these are difficult toquantify. Given the short-term structure of corporatefinance, the transmission of high interest rates to thereal economy was rapid. At the time of the crisis,some 35 percent of domestic corporate debt had anaverage maturity of less than three months, andabout 70 percent had a maturity less than one year.One reason for this was the extensive use of three-month promissory notes as a means of paymentamong enterprises, especially among small andmedium-sized ones (Baliño and Ubide, 1999). In thecase of Korea, given the high leverage and exportorientation of the corporate sector, the adverse bal-ance sheet consequences of a lower exchange ratemay well have been much smaller than the cost ofhigher interest rates (Krueger and Yoo, 2002).

As the crisis developed, the IMF staff becamemore aware of these vulnerabilities and often men-tioned the impact of high interest rates on the corpo-rate sector in program reviews and communicationswith management. However, the collapse in businessand consumer confidence and the sudden, sharp con-traction in financial intermediation, which was dueto the need to clean up balance sheets and rebuildcapital levels, probably played a more important rolein creating the recession than did the level of interestrates per se. As the experience of Japan has shown,banks that are burdened with weak balance sheetsare usually reluctant to finance business investment,even when their cost of funds is very low. An alter-native financing channel, the corporate bond market,began to grow rapidly during this period, but it tooktime for the necessary market infrastructure to be de-veloped (Oh and Rhee, 2002).22

While the move toward a gradual reduction inpolicy rates in the aftermath of the crisis was justi-fied, the rates themselves remained above levels thatwould have been more appropriate to helping thecountry get out of recession. In this context, the lackof a clearly defined and well-announced frameworkto guide monetary policy was not helpful.23 TheIMF was aware that there was scope for further eas-

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0

0.02

0.04

0.06

0.08

Deutsche markJapanese yenKorean won

1997 1998

Figure A2.5. Daily Volatility of U.S. DollarExchange Rates Against Korean Won,Japanese Yen, and Deutsche Mark1

Source: Datastream.1Measured as standard deviations of daily logarithmic changes.

22Later events would show that the growth of domestic corporatebond issuance had been partially supported by lax supervision ofthe investment trust companies that were a primary vehicle for re-tail investors (see section on “Financial sector reform,” below).

23The program contained a broad inflation target, but no mech-anism was specified to achieve that objective.

ANNEX 2 • KOREA

ing and understood the effect the high rates werehaving on the corporate sector but, for fear of thecrisis returning, was reluctant to allow rates to fallmore quickly. In retrospect, an earlier easing ofrates would have been justified. However, it must berecognized that the IMF was faced with making avery difficult judgment, based on incomplete infor-mation, as to whether an earlier easing of rateswould have triggered renewed exchange rate pres-sures, particularly given the unsettled currency mar-kets in the East Asian region. Moreover, the periodof unusually high real rates was only a few months.Given other weaknesses of the economy, particu-larly the breakdown in financial intermediation, it isdoubtful that an earlier loosening of monetary pol-icy would, by itself, have prevented the recession,although hindsight now suggests that some earlierloosening would have been warranted.

Fiscal policy

Background

Korea’s public sector budget was essentially inbalance at the onset of the crisis. The authorities pro-jected a deficit of 0.2 percent of GDP in 1997 and asurplus of 0.25 percent in 1998, after surpluses of0.3 percent in the two previous years. Public debtwas only 6 percent of GDP.

Despite the very healthy position of public fi-nances at the start of the crisis, the staff’s initial ap-proach was to favor a tight fiscal policy. In a draftbriefing paper prepared before the program mission inlate November 1997, APD proposed fiscal measuresthat would not only pay for the carrying cost of debtissued for financial sector restructuring, but also resultin a surplus of 1.5 percent of GDP in 1998. Thetighter fiscal policy was meant to secure the neededcurrent account adjustment without increasing theburden on monetary policy and the exchange rate.Some review department comments urged a stillgreater fiscal adjustment, in order to signal the gov-ernment’s resolve and to be prepared if restructuringcosts were larger than expected. It was pointed outthat, given the experience of Thailand and Indonesia,the authorities could not always be trusted to maintaintight monetary policies under conditions of severe fi-nancial sector weakness, so that a greater burden ofadjustment should be placed on fiscal policy.24 How-ever, this latter approach was rejected by IMF man-agement in recognition of the fact that the precrisisfiscal situation was largely in balance and the need to

avoid fiscal “overkill.” As a result of management’sintervention, the proposed surplus for 1998 in the pre-mission brief was reduced to 1 percent from 1.5 per-cent of GDP.

Fiscal policy was not a major area of disagreementbetween the IMF and the authorities in negotiating theIMF-supported program. The eventual program envis-aged a surplus of about 0.15 percent of GDP in 1998,which was still smaller than in the premission briefingpaper. This figure incorporated the surplus of 0.25percent of GDP projected before the crisis; a 0.8 per-cent shortfall because of slower growth; 0.8 percent incarrying costs for the financial sector cleanup, basedon the assumption that the cleanup would eventuallycost a total of 5.5 percent of GDP;25 and offsettingmeasures of 1.5 percent. As a demonstration of the au-thorities’ resolve to undertake these offsetting mea-sures, an increase in the transportation tax and an ex-cise tax were among the “prior actions.” This fiscalstance was broadly supported by the Executive Boardwhen the program was discussed, with only one Exec-utive Director expressing concerns and suggesting amore expansionary fiscal stance.

Even the 0.15 percent projected surplus could besaid to incorporate an implicit assumption that Koreawould run a deficit under the policies stated in the pro-gram document. This is because the staff believed thatthe program’s growth assumption of 2.5 percent for1998, as agreed with the authorities, was overstated.According to staff members interviewed by the evalu-ation team, the staff expected growth in 1998 to bezero or even negative. It nevertheless agreed to includea positive growth forecast at the urging of the Koreanauthorities, who wanted this for political reasons.26

In the early months of 1998, as growth projec-tions worsened, the program assumed an ever greaterdeficit. The staff recommended that the authorities“let automatic stabilizers work,” in other words, thatthey take no action to offset the projected deficits.Internal documents show that IMF management wasapparently more keen than the staff to allow for flex-ibility in fiscal policy. An early draft of the staff re-port accompanying Korea’s late-December requestfor accelerated disbursements stated that fiscal pol-icy would “need to remain tight.” This conformed to

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24While there was no explicit discussion of fiscal sustainability,it was implicitly recognized that, given Korea’s low precrisis levelof sovereign debt, sustainability was not an issue, provided thatthe crisis was resolved quickly.

25The net fiscal costs of bank restructuring, now estimated at23 percent of GDP, have turned out to be still greater than hadbeen feared in 1997.

26However, if there was staff pessimism about near-term growthprospects, there was no evidence of this even in internal programdocuments before the late spring of 1998. The confidential premis-sion brief prepared on November 21, 1997, also projected 2.5 per-cent growth for 1998. The staff report accompanying the second bi-weekly program review, prepared on January 8, 1998, stated that,“[the] downturn in growth [was] likely to be sharper than previ-ously expected, particularly during the first quarter.” Yet, that re-view included a positive growth forecast for 1998, as did every sub-sequent program review until that of May 19, 1998.

Annex 2 • Korea

the authorities’ commitment, in the December 24LOI, that “the initial fiscal adjustment of the pro-gram [would] be maintained despite higher costs tothe government associated with the larger deprecia-tion of the won and with financial sector restructur-ing.” However, at the urging of management, the lan-guage in the staff report (but not in the LOI) wasreplaced by a statement that “the staff’s preliminaryassessment [was] that . . . automatic stabilizersshould be allowed to operate.”

The Korean authorities were reluctant to do so, inaccordance with their traditional inclination towardfiscal conservatism. Government consumption ex-penditures fell by 0.4 percent in real terms in 1998.Nevertheless, because tax revenues fell even furtherthan did government spending, Korea ended up run-ning a budget deficit of 4.3 percent of GDP in 1998,or 1.5 percent in cyclically adjusted terms. The pub-lic sector deficit was further augmented by the activ-ities of off-balance-sheet quasi-public entities suchas the KDB (Cho and Rhee, 1999).

Assessment

In terms of the role of fiscal policy, the Koreansituation in November 1997 differed from the typicalsituation in which IMF assistance is sought. Thelevel of outstanding public debt was very low. Thegovernment faced potentially very large contingentliabilities through its de facto guarantee of foreigncurrency bank debt.27 The bailout of Kia raised sus-picions that the government’s de facto domestic-cur-rency contingent liabilities were also large. How-ever, domestic and foreign investors did not doubteither the capacity of the public sector to maintaincontrol of its fiscal processes, or the political com-mitment of the authorities to maintain a sustainablelevel of sovereign debt. When international credit-rating agencies lowered Korea’s debt ratings sharplyat the end of 1997, they were careful to assert thatthis reflected the country’s dire liquidity situation,rather than the underlying strength of its economy orits overall debt position.

Under these conditions, there was scope for a “debtfor debt” swap, in which the government would drawon its extensive spare domestic and international bor-rowing capacity to offer its obligations in exchangefor those of the country’s troubled financial sector. In-deed, this is what eventually happened. Leaving aside

the admittedly important moral-hazard and burden-sharing issues of such an approach, the question forfiscal policy then comes down to whether the carryingcost of the government debt issued in this processshould have been paid for through current receipts, asthe IMF initially proposed, or through issuing addi-tional debt. A good argument could be made that therewas scope for the carrying costs, too, to be financedtemporarily by public borrowing, since Korea’s pastrecord was sound enough to convince the market thatsuch borrowing was unlikely to spiral out of control.

Another possible role for fiscal policy wouldhave been to counteract the contractionary effects ofthe restructuring of the financial sector. In thissense, the emphasis on “reducing the burden onmonetary policy” was misplaced. The drive for thebanks to write off bad loans and to rebuild their cap-ital adequacy as quickly as possible was exerting adeflationary pull far stronger than monetary policycould have provided.

The initial recommendation for a relatively tightfiscal policy was, in part, the result of an excessivelyoptimistic growth projection and in part a reflectionof the IMF’s traditional preference for fiscal tighten-ing in crisis situations. However, within a month ortwo from the outbreak of the crisis, once it becameclear that output would be well below program tar-gets, the IMF showed flexibility in recognizing theneed for a looser fiscal policy and transmitting thisadvice to the Korean authorities. The latter, however,were reluctant to act upon it.

The idea that a country engaged in financial sectorreform should pursue a loose fiscal policy in order tosupport aggregate demand was not unknown at theIMF; the 1998 Article IV consultation report forJapan, produced a few months after the Korean crisis,urged just such a policy. Of course, Korea’s ability toborrow during the crisis was limited by the need to re-build the confidence of foreign investors, while Japancould finance its deficits at home, and the role of fis-cal policy in Japan was itself a subject of considerabledebate. There was also a limit to how aggressively theIMF could have pushed for a looser fiscal policy,given the authorities’ preference for fiscal conser-vatism and the damage to credibility that might havecome from any public criticism. Nevertheless, it isstriking that such an approach was not consideredmore seriously at an earlier stage in the crisis.

Financial sector reform

Background

In the years preceding the crisis, Korean policy-makers pursued a slow but deliberate policy of finan-cial sector reform. The authorities announced a blue-print for financial liberalization in 1993. This led to

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27Ambiguity about the amount of liabilities covered by this guar-antee was a further source of difficulty. At end-September 1997,short-term external debt of domestic commercial banks resident inKorea was roughly US$24 billion, but a broader definition that in-cluded medium- and long-term debt, borrowing by foreignbranches of Korean banks, and borrowing by nonbank financial in-stitutions would raise this figure to roughly US$106 billion.

ANNEX 2 • KOREA

deregulating interest rates, liberalizing the issuanceof corporate bonds and commercial paper, andsharply reducing subsidized “policy lending” throughstate-owned institutions.

However, progress on many issues in 1997 re-mained incomplete, partly because of conflicts be-tween different interest groups in the public and pri-vate sectors, and partly because of a reluctance totake bold policy measures in the lead-up to the presi-dential elections in December. Many observersviewed apparent reform initiatives, such as the estab-lishment of a Presidential Commission on FinancialReform, as attempts to deflect criticism by postpon-ing concrete action until after the elections. IMFstaff members involved in surveillance before thecrisis told the evaluation team that, despite the manyreform initiatives, they were never sure how muchgenuine reform had actually taken place in Korea.Announced reforms often did not seem to have muchpractical effect on the behavior of financial institu-tions. Formal controls on transactions or activitieswere sometimes replaced by less transparent con-trols, or by informal channels of influence.

After the crisis hit, the Presidential Commission’srecommendations suddenly assumed much greaterrelevance. The Commission had recognized that re-form was needed, not just in the content of financialsector regulation, but also in the organizationalstructure of the bureaucracy responsible for regula-tion. For example, while commercial banks were su-pervised by the Office of Bank Supervision at theBOK, responsibility for supervising the merchantbanks lay with the MOFE. This contributed to theuneven quality of financial sector supervision acrossdifferent types of institutions.

There were three important differences betweenthe Commission’s recommendations and the restruc-turing program that was ultimately followed. First, theCommission did not specify the sequencing of the re-forms that it recommended. Second, the Commissiondid not offer recommendations on the resolution ofthe NPL problem, partly because it was charged withoffering a “big picture” vision of reform, but also be-cause its members, like most outside observers, werenot aware of the depth of the problem. Third, while itrecommended the establishment of a consolidated su-pervisor, the Commission did not fully address issuesrelating to the bureaucratic structure of supervision,with the result that political infighting stalled the re-form process at a crucial time.

The structural program for the financial sectorhad two distinct goals: to restore the health of the fi-nancial sector through the disposal of bad loans andclosing or rehabilitating insolvent institutions; and toinstitute reforms that would improve the sector’s ef-ficiency and stability and enable it to contribute toKorea’s growth in the longer term. Each of these as-

pects of the program are considered separatelybelow, although the measures taken in each areawere closely related.

Rehabilitating the financial system

With regard to cleaning up bank balance sheets,the strategy followed was similar (though not in allrespects identical) to that pursued by other countriesfacing banking crises in the middle and late 1990s.The key elements were the prompt closure of themost troubled institutions; the extension of the de-posit insurance system, funded by government-guar-anteed bonds, to protect depositors and prevent bankruns; the utilization of an asset management com-pany, also funded by government-guaranteed bonds,to buy and dispose of bad loans; and the requirementthat weak but solvent institutions submit a restruc-turing and recapitalization plan for approval by su-pervisors or face closure.28 A bridge bank was set upto buy and dispose of nonperforming assets held bythe merchant banks. The asset-management and de-posit insurance agencies had been set up prior to thecrisis but were given expanded responsibilities.

During the negotiations, the authorities initiallyresisted some aspects of the IMF’s strategy forcleaning up the financial sector, particularly theproposed closure of insolvent commercial and mer-chant banks. Such action was unprecedented in re-cent Korean history and the authorities were wor-ried about the consequences for systemic stability.IMF staff members had the impression that this of-ficial reluctance to confront Korea’s financial sec-tor problems influenced other aspects of their inter-actions with the Korean authorities, for example,the provision of data on NPLs. After the interven-tion of the Managing Director in the final stage ofthe negotiations, the authorities agreed as part ofthe first program to close nine merchant banks andto restructure two large commercial banks. Subse-quently, and particularly after the election, the au-thorities demonstrated a greater commitment to re-form, closing additional banks and accepting amore rapid pace of liberalization. What emergedwas a politically realistic, yet bold program of fi-nancial sector restructuring under a team of compe-tent administrators.

Some of the authorities’ actions did not meet theambitious timetable set by the two December pro-grams. Rather than being closed or sold off, SeoulBank and Korea First Bank were nationalized. Thegovernment also became a major shareholder in sev-eral other commercial banks. Five years later, the

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28Dookyung Kim (1999) and Baliño and Ubide (1999) reviewthe early stages of this process.

Annex 2 • Korea

privatization of these banks was still not complete.29

Five smaller banks were closed in June 1998, thefirst such closures in Korea’s recent history, but therehabilitation plans for other undercapitalized bankswere not finalized until September 1998. Legislationallowing supervisory authorities to write down theequity of failed banks without restriction was notpassed until August 1998.

Despite these delays, the IMF and internationalinvestors remained confident about the Korean au-thorities’ commitment to reform. This was because,even if measures were delayed or revised, the au-thorities were careful neither to backtrack from ear-lier pledges nor to take actions that ran counter to thespirit of reform. Between December 1997 andMarch 1998, 6 of the 26 commercial banks and 16 ofthe 30 merchant banks were closed or merged (Bal-iño and Ubide, 1999). As already mentioned, publicfunds totaling over 20 percent of GDP would eventu-ally be committed to cleaning up the banking sector.This included equity injections, purchases of subor-dinated debt, purchases of NPLs, restitution to in-sured depositors, and funds for recapitalization.

Reforming the financial system

Many of the financial sector conditions in theIMF-supported program called for carrying out rec-ommendations that had been made by the Presiden-tial Commission during 1997. These included creat-ing an independent, consolidated financial regulator;liberalizing the market for ownership rights in finan-cial institutions; removing restrictions on the activi-ties of financial institutions; modernizing monetarypolicy operations; and completing the deregulationof interest rates. According to interviews with Ko-rean officials, the fact that the financial sector ele-ments of the program were based upon a homegrownpolicy meant that the authorities were generallymore willing to implement these measures than theywould have been if they had been entirely imposedfrom outside. Essentially, what the IMF did in termsof financial sector restructuring was to tip the bal-ance of power in Korea in favor of advancing thehomegrown agenda. Starting in early 1998, theWorld Bank played an important role in advising theKorean authorities on reform policies and in outlin-ing operational measures.

Following the first IMF agreement in December,the previously failed legislation passed the NationalAssembly, establishing the independence of the BOKand consolidating financial sector supervision in a sin-gle agency. However, the institutional arrangement offinancial supervision continued to be a major area ofdispute among the Korean authorities. The IMF-sup-ported program, like the Presidential Commission, en-visaged an independent regulator, but did not resolvethe question of its relationship with the BOK and theMOFE. When the authorities began to draw up plansto implement this provision, the IMF at first took aneutral stance over the disposition of the new regula-tor, while insisting that it should remain independentof the MOFE. Ultimately, though, the IMF felt com-pelled to take a position in order to speed up the re-structuring program. With the IMF’s backing, the pro-gram ended up adopting the MOFE’s vision ofsubordinating the Financial Supervisory Service(FSS) to a government agency, the FSC. This setuphad some virtues. The new supervisory system wasnot formally part of the MOFE or the BOK, and thebureaucracy charged with managing and resolving thecrisis was separate from the ongoing supervision func-tion. However, the new framework had the disadvan-tage of allowing the MOFE to exercise influence oversupervision through the participation of its officials inthe FSC, a situation that was not entirely in keepingwith the preferences of the IMF and World Bank.

As with the cleanup, the actual implementation ofthe promised reform measures was somewhat slowerthan had been specified in the IMF-supported pro-gram. New loan-classification standards and provi-sioning rules were put in place in June 1998, but theFSS, charged with carrying out the supervisory func-tion, did not formally begin operations until January1999. Rules imposing stronger risk management forbanks’ foreign exchange operations also did not be-come effective until 1999. Limits on large credit ex-posures, intended to insulate the banking systemfrom the failure of a small number of large compa-nies, as happened in 1997, have been phased in onlygradually, in order not to disrupt credit flows to thecompanies concerned. At the same time, the cumula-tive progress of reform over the past five years hasbeen impressive, and there have been no attempts toroll back previously implemented reforms.

Assessment

Over time, the financial sector restructuring pro-gram achieved its goals of facilitating the relativelyprompt removal of bad loans from bank balancesheets and reducing the system’s vulnerability to ex-ternal shocks. The rapid restructuring of the banksand the short timetable for attaining high capital ade-quacy levels contributed to the severity of the eco-

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29Average government ownership stakes in commercial banks,weighted by bank assets, rose from 17 percent at the end of 1996to 58 percent at the end of 1998, then fell to 34 percent at the endof 2001. In January 2002, the authorities announced a plan tocomplete the privatization process over the next three to fouryears. A majority stake in Seoul Bank was sold to another Koreanbank in September 2002, with the government planning to sell theremaining 31 percent by March 2004.

ANNEX 2 • KOREA

nomic slowdown in 1998.30 Yet, a less rapid cleanupwould not necessarily have resulted in a better out-come. Other liberalization measures, such as thosethat made it easier for corporations to issue bonds di-rectly to investors, fostered the development of alter-native financing channels. This strengthened the Ko-rean economy by reducing the dependence ofinvestment on the health of the banking sector.

There were, however, gaps in the new supervisoryframework. A prominent example was the invest-ment trust company (ITC) sector. The pressure onthe banks to recapitalize and restructure led them toreduce their corporate lending and the returns theycould offer to savers. This provided a window of op-portunity to the ITCs, which channeled funds fromsmall investors into the rapidly growing corporatebond market (Oh and Rhee, 2002). ITC accountswere intended to behave like mutual fund holdings,but in practice many ITCs offered guaranteed yieldsto investors. In 1999, when corporate bond pricesfell following a large corporate bankruptcy, the ITCscould not meet the guarantees and the result waswidespread panic selling. This episode, while caus-ing losses to many investors and disruption to Ko-rean capital markets, did not have a substantial im-pact on the country’s overall investment and growthtrends—a sign that the system had become more re-silient, even though clearly more effort was neededin the area of improved supervision.

Nonfinancial structural reforms

Background

As was the case with the financial sector, there hadbeen an ongoing debate within Korean society beforethe crisis on the optimum design of the corporate sec-tor. Some reformers opposed the concentration ofeconomic power in chaebol. Influenced by theseideas, the authorities, in a dramatic reversal of policy,had begun to allow large corporate bankruptcies(such as that of Hanbo) to take place even before theonset of the crisis. But others in Korea advocated thepreservation of the chaebol system in light of its trackrecord in facilitating rapid economic growth.

Comprehensive reforms in the nonfinancial corpo-rate sector envisaged in the December 4, 1997 pro-gram included provisions on accounting standards,bankruptcy procedures, and governance mechanisms.

In the late December program and subsequent re-views, provisions were added mandating the appoint-ment of outside directors, liberalizing the market forcorporate control, and enhancing labor market flexi-bility. In the World Bank’s structural adjustmentloans, more specific measures were identified, such ascurtailing emergency loans, facilitating use of debt-equity conversions to address excessive leverageamong chaebol affiliates, reducing cross-guarantees,providing additional encouragement for corporatemergers and acquisitions, debt restructuring and assetdispositions, and improving procedures and coordina-tion for court-supervised insolvency (Mako, 2002;Joh, 2002). Thanks in part to these efforts, the debt-equity ratio of the manufacturing sector was graduallyreduced from nearly 400 percent in 1997 to 211 per-cent in 2000 (Im, 2002).

A common criticism of the Korean program,echoed at the time in the Korean press, was that cer-tain measures were included in the program at the in-sistence of major shareholder governments to servetheir particular national interests. For example, the re-quirement that Korea eliminate its “import diversifica-tion” program was said to be a response to Japanesepressure,31 while the measures to allow increased par-ticipation of foreign institutions in the Korean finan-cial system were alleged to reflect pressure by theU.S. authorities on behalf of U.S.-based institutions.

The IMF’s largest shareholder governments madeno secret of their view that IMF assistance should beaccompanied by strong reforms. The U.S. authorities,in particular, insisted that strong reform measuresshould be a condition for IMF support. However, in-ternal IMF documents do not support the allegationthat the specific policy measures mentioned were in-cluded solely because large IMF shareholder govern-ments demanded them.32 These governments may in-deed have had an interest in these measures, but theywere also on the agenda of policy reforms which hadsurfaced in the course of IMF surveillance and hadbeen discussed by the staff with the authorities. Forexample, increased participation by foreign financialinstitutions in the Korean financial system had longbeen on the list of IMF recommendations made in thesurveillance process and was among the measuresrecommended by the Article IV consultation missiontwo months earlier. It was in the briefing paper pre-pared by the staff on the eve of the negotiations, and isa policy recommended by the IMF for virtually all

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30Domaç and Ferri (1998) find evidence that the contraction ofbank credit and increase in bank lending spreads in Korea con-tributed to the fall in activity after the crisis. Hyun Kim (1999)finds that the decline in bank loans resulted from a contraction insupply (the willingness of banks to lend) rather than demand (thatis, a fall in investment), though Ghosh and Ghosh (1999) find theopposite result. Borensztein and Lee (2000) find that there was areallocation of credit from less efficient (including chaebol-con-nected) borrowers to more efficient ones.

31This program, which restricted imports from countries withwhich Korea had a large bilateral trade deficit, was designed toreduce certain categories of imports from Japan.

32According to former senior U.S. officials interviewed by theevaluation team, their only direct input was to introduce a penaltyrate for the BOK’s foreign exchange advances to Korean financialinstitutions.

Annex 2 • Korea

emerging market economies. After the crisis started,takeovers and other asset purchases by foreign institu-tions were seen as a way to improve bank governanceand to reduce the amount of public money needed to recapitalize the banking system. Similarly, theelimination of the import diversification program hadbeen included in the recommendations of the earlierArticle IV consultation mission and was incorporatedin the prenegotiation brief. The staff saw this as a vitaltrade liberalization measure that would demonstratethe authorities’ commitment to reform.

As with the financial reforms, the Korean authori-ties initially were eager to demonstrate their commit-ment to the program by moving forward rapidly onimplementation. However, after the economy sur-vived the initial phase of the crisis and began a quickrecovery, the government reduced its efforts to pursuepainful and costly restructuring. At the end of 2000,more than a quarter of manufacturing firms still hadearnings that were below their interest costs. Therewere also signs of persistent official favoritism towardchaebol. For example, when a large conglomerate ex-perienced financial difficulties in 2000, at a time whenilliquidity in the corporate bond market made it diffi-cult for companies to raise new capital, the Koreangovernment mobilized such means as “fast-track un-derwriting” (in which the KDB refinanced maturingcorporate bonds at a penalty interest rate) to preventthe company from going bankrupt.

Assessment

Some observers have argued that nonfinancialstructural reform measures were not crucial to theresolution of the crisis, and have cited the fact thatoutput recovery began well before many of the keyreforms were implemented (Feldstein, 1998; Park,2001). In particular, they argue that labor market andtrade measures were a distraction from the core pro-gram requirements, although they may well haveproven helpful to the long-term efficiency of the Ko-rean economy.33

The effectiveness of some of the structural mea-sures in the IMF-supported program can also be ques-tioned. Some of them appear to have been rushed intoimplementation because of the short time horizon.

Some staff members told the evaluation team that theyhad been under pressure to show quick results and hadknown that they would need to reduce intensive moni-toring once the crisis had passed. This led to a focuson measurable benchmarks that could be achieved inthe first six months or so of the program, at the ex-pense of more lasting but less visible actions. For ex-ample, companies listed on the Korea Stock Ex-change were required to appoint at least one outsiderto their boards of directors. Some have questionedwhether the newly appointed outside directors weretruly independent of management or able to exert in-fluence on corporate decisions (Joh, 2002).

Defenders of the IMF-supported program respondthat, aside from the intrinsic merits of the policiesfollowed, a demonstration of the authorities’ com-mitment to reforms in both the financial and nonfi-nancial fields was needed to restore internationalconfidence and promote rapid recovery. There werealso some cases where nonfinancial structural mea-sures were intended to facilitate a rapid recoveryfrom the crisis, and thus formed a vital element ofthe IMF-supported response. In particular, smootherbankruptcy procedures and labor market reformswere designed to promote the reallocation of indus-trial assets and reduce the consequences of the re-forms for employment.

It is difficult to evaluate these arguments becausethe objectives for many of these reforms were neverfully spelled out. While the weak governance andhigh leverage of the Korean industrial sector cer-tainly contributed to the crisis, the immediate needfor action in these areas was not as clear as the needto address solvency issues in the financial sector.

To the extent that the reforms in the nonfinancialarea were intended to facilitate other policies moredirectly linked to resolving the crisis, the argumentfor them would be much stronger. Even in this case,however, the IMF might have been better advised toconfine its advice and conditionality to a narrowerrange of issues, and then to let the Korean authoritiesdefine their own agenda for implementing this morefocused set of policy measures. This is particularlytrue of many of the trade and other external liberal-ization measures that were already mandated byagreements with the OECD and the World Trade Or-ganization (WTO). The role of formulating and fa-cilitating the needed reforms would then fall to insti-tutions that are better placed to do so.

Program Financing and the Debt Rollover

This section reviews the process by which the fi-nancing package associated with the December 4,1997 program was determined and whether the final

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33There were 21 “structural performance criteria” specified inthe course of the three-year IMF-supported program in Korea,that is, an average of seven a year (Chopra and others, 2002). TheLOI attached to the December 4, 1997 program identified five“prior actions” to be taken by the authorities before the ExecutiveBoard approved the SBA. The total number of structural condi-tions was close to the median for SBAs during this time period,and somewhat less than that for longer-term IMF arrangementssuch as the Enhanced Structural Adjustment Facility and thePoverty Reduction and Growth Facility. See “Structural Condi-tionality in Fund-Supported Programs,” SM/01/60, Supplement2, February 2001.

ANNEX 2 • KOREA

size of the package was appropriate for the circum-stances. Our overall assessment is that there wasconsiderable ambiguity surrounding the publicly an-nounced bilateral “second line of defense” and thisdamaged the program’s credibility. It forced the staffto adopt unrealistic assumptions in formulating theDecember 4 program, which led to underfinancing.Korea’s underlying liquidity shortfall was not re-solved until the coordinated rollover agreement atthe end of December.

The December 4 package

At the start of the negotiations with Korea in lateNovember 1997, the staff estimated the country’s fi-nancing gap during the years 1998 and 1999 atUS$25 billion, of which US$20 billion was for thefirst year (Table A2.1, columns 1 and 2). Funds wereneeded, it was thought, to finance the current ac-count deficit (estimated to be US$2 billion for1998), portfolio outflows (another US$3 billion),and a US$13 billion increase in reserves. These fig-ures were based on two crucial assumptions. First,Korea’s short-term external debt, then estimated tototal US$66 billion, was projected to be fully refi-nanced, though it was assumed that there would belittle or no new short-term borrowing. Second,Korea’s reserves of US$30 billion were thought tobe enough to cover the country’s obligations untilthe program funding was disbursed. No financingneed was envisioned for 1997.

These assumptions had to be revised radically al-most as soon as the IMF team arrived in Korea, be-cause of a combination of new information and re-

vised assumptions about the behavior of externalcreditors. It was discovered that Korea’s usable re-serves—that is, official reserves, minus the amountthat had been deposited at overseas bank branches tocover short-term debt repayments—were aroundUS$11 billion, and falling very fast. This pointed tothe fact that the major drain on the capital accountwas likely to arise, not from a reversal of portfolioinvestment, but from bank debt repayments.

The debt, in turn, was far larger than initiallythought, because it comprised obligations of over-seas borrowing by Korean institutions, which werenot included in residence-based debt data used bythe IMF. The most important component of this ad-ditional debt was some US$22 billion in offshoreborrowing by overseas branches of domestic banks.After correcting for double-counting and includingoffshore borrowing and the debt of Korean banks’foreign branches and subsidiaries, short-term exter-nal debt (bank and nonbank) was estimated ataround US$86 billion at end-September 1997, ofwhich banks owed US$62 billion. It was this compo-nent of the debt that triggered the crisis. By the endof November, short-term external bank debt hadfallen from US$62 billion at end-September toUS$49 billion, and further to US$33 billion at theend of December, representing an outflow of US$16billion in a month.

Estimating the amount of financing needed in thefast deteriorating situation that prevailed in November1997 was no easy task. In the event the staff reportsupporting the SBA request contained two differentestimates of the financing needed for the rest of 1997and 1998. In the text of the report, the total financing

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Table A2.1. Korea: Balance of Payments and Financing Requirements(In billions of U.S. dollars)

December 4Premission Brief Stand-By Request Actual________________ ________________ ________________

1997 1998 1997 1998 1997 1998

Current account (a) (– = outflow) –13 –2 –14 –2 –8 40Capital account (b) (– = outflow) 1 –5 –14 3 –28 –15Of which:

Portfolio investment –2 –3 8 1 14 –1Banks1 4 0 –16 3 –27 9

Change in reserves (c)2 (– = increase) 12 –13 17 –23 21 –40Financing gap (a + b + c) 0 –203 –11 –22 –16 –14

Provided by official financing 0 20 11 22 16 10Of which:

Net IMF purchases 0 4 9 10 11 5Market borrowing by government 0 0 0 0 0 4

Source: IMF database and documents.1Adjusted to include the impact of foreign currency liquidity support by the BOK to overseas branches of Korean banks.2Adjusted to exclude the impact of foreign currency liquidity support by the BOK to overseas branches of Korean banks.3An additional financing gap of US$5 billion was projected for 1999.

Annex 2 • Korea

needed was indicated as US$55 billion but the de-tailed estimates in Table 6 of the same report (repro-duced in columns 3 and 4 of Table A2.1) showed asmaller figure of US$33 billion. The difference be-tween the two estimates was not reconciled in the staffreport but interviews with the staff indicate that thelarger estimate resulted from the initial expectationthat the rollover rate on short-term bank credit wouldbe only 20 percent. It was recognized that providinglarge volumes of financing from the IMF to Koreawould be difficult because of the IMF’s resource con-straints and also because Korea’s quota was unusuallysmall relative to the size of the economy.34 However,the staff worked on the assumption that IMF financingcould be supplemented by additional amounts fromother IFIs (the World Bank and the ADB) and bilat-eral sources (i.e., the second line of defense).

The second line of defense

The incorporation of bilateral financing to supple-ment IMF and other IFI resources was in line withthe principles of the so-called Manila Framework,endorsed by the APEC summit meeting only a fewdays earlier on November 24, 1997, which envisagedthe provision of bilateral financing to support IMF-supported programs when necessary. However, theavailability of these resources turned out to be uncer-tain. There also appear to have been miscommunica-tions on the second line’s conditions and timing (inrelation to the disbursement of the IMF’s own re-sources) that compounded the problem.

The staff had initially incorporated a specific levelof bilateral financing in the proposed IMF-supportedprogram. At virtually the last minute, headquarters in-formed the mission that it could no longer count onthe second line of defense being available as part ofthe financing for the “baseline” program. Additionaldecisions would be needed before any part of the fi-nancing could be released, and the financing could inany case not be made available for several weeks.

IMF management and staff recognized that, with-out the assured availability of official bilateral fi-nancing, the program would be underfinanced. Theyaccordingly approached the major shareholder gov-ernments to explore the possibility of concerted ac-tion to involve the private sector in some form ofrollover. The major shareholders, however, were re-luctant to use nonmarket instruments to influencethe behavior of private sector institutions, given the

lack of clearly defined regulatory authority and thefear that such action might precipitate an exodus ofcapital from emerging markets.

Faced with these circumstances, the staff pre-sented a financing scenario in which the availabilityof bilateral financing was not essential. This wasachieved by modifying one of the key assumptionswhich determined financing need. Specifically, thefraction of short-term interbank loans from externalcreditors that was assumed to be rolled over wasraised from the 20 percent assumed initially to 80percent.35 This arbitrary adjustment ensured that theamount of financing provided in the December 4package would meet Korea’s ex ante needs as pro-jected in the program documents.

Although the program financing requirement wasreduced in this way, the package publicly announcedwas US$55 billion, including a second line of de-fense in excess of $20 billion. The press notice re-leased on December 4 announcing the ExecutiveBoard’s approval of the program specifically stated:

[A] number of countries (Australia, Belgium, Canada,France, Germany, Italy, Japan, the Netherlands, Sweden,Switzerland, the United Kingdom, and the UnitedStates) have informed the IMF that they are prepared, inthe event that unanticipated adverse external circum-stances create the need for additional resources to sup-plement Korea’s reserves and resources made availableby the IMF and other international institutions, to con-sider—while Korea remains in compliance with the IMFcredit arrangement—making available supplemental fi-nancing in support of Korea’s program with the IMF.This second line of defense is expected to be in excess ofUS$20 billion.

Market participants were highly skeptical as towhether the second line of defense would truly beavailable. Political opposition to “bailouts” of crisiscountries was running high in several of these con-tributing countries and, since there was no clarity onthe circumstances under which the amounts would bereleased, their availability was widely discounted.

The unrealistic rollover assumption implicitlycontained in the December 4 program lowered thepackage’s probability of success. It meant that, with-out a radical turnaround in confidence, the programwas likely to be underfinanced. When this turn-around did not materialize, the credibility of the pro-gram (and of the IMF more generally) was damaged,

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34The commitments made in Thailand, Indonesia, and else-where had already stretched resources thin. As of May 31, 1997,the IMF had approved financing arrangements totaling slightlyless than SDR 18 billion (or US$25 billion); six months later, be-fore the Korea package, this figure had risen to almost SDR 28billion (or US$38 billion).

35These percentages were provided to the evaluation team bystaff members and do not appear in the program documents. It isthus difficult to cross-check them and to determine which of thevarious possible aggregates the numbers refer to. Nevertheless, itis undoubtedly the case that a substantial change in the assumedrollover path took place at the last moment.

ANNEX 2 • KOREA

making the task of formulating a revised response tothe crisis more difficult.

Negotiations on a second line of defense betweenthe Korean authorities and those of the contributingcountries eventually took place in the early monthsof 1998. These negotiations did not lead anywhere,however. Those close to the talks have advanced dif-fering reasons as to why this was the case. Therewere differences of view regarding the appropriatepricing and technical conditions for the facility.However, the most likely explanation for the absenceof agreement is that private sector financing condi-tions by that time had improved substantially, so thatsetting up another official financing facility did notseem necessary.

The coordinated rollover

With the failure of the December 4 program, us-able foreign exchange reserves dwindled rapidly andthe won fell sharply in the first weeks of December.The staff projected that usable reserves, which hadbeen temporarily boosted by the IMF disbursementin early December, would fall from US$8.5 billion onDecember 14 to US$4.5 billion at year-end.36 Furtherofficial financing was neither politically nor practi-cally feasible. An attempted international bond offer-ing by the state-owned KDB failed and was hastilywithdrawn. A more vigorous and sustained increasein interest rates might have attracted some capitalback into the country, but it could also have caused somuch damage to Korea’s highly leveraged corporatesector that its impact on market confidence couldvery well have been negative. The IMF mission in thefield advised management that a restructuring ofKorea’s short-term debt would be necessary for re-solving the liquidity problem.

It was in this context that the idea of pressingKorea’s creditors to agree to a coordinated rolloverand a maturity extension of their short-term claimsgained renewed prominence.37 The idea had been cir-culating among IMF officials and the large share-holder governments, as well as in the private sector,virtually from the start of the crisis and, as noted, hadbeen raised by IMF management in its consultationwith the major shareholder governments. It was alsoraised by foreign bankers in Korea with the authoritiesand IMF staff in early December, but did not receivesupport at that time from the banks’ head offices.

The decision to urge the rollover on creditor banksappears to have arisen from discussions among Ko-rean, U.S., and IMF officials immediately after theKorean presidential election on December 18. ThePresident-elect’s statements in support of the IMF-supported program had boosted its credibility in themarkets. The incoming administration began to coop-erate with the outgoing administration in vigorouslyimplementing the program. Officials from largeshareholder governments put aside their earlier con-cerns about excessive intervention, because of thegravity of the situation and the evident failure of theapproach that had formed the December 4 program.Once the decision to pursue the rollover was made, itwas arranged relatively quickly and announced onDecember 24, 1997. Central banks and finance min-istries in the industrial countries contacted largebanks based in their jurisdictions, which in turn con-tacted other lenders. The banks agreed to maintaintheir existing credit lines while they negotiated to ex-tend the maturities of their claims on Korean banks.A system of daily monitoring of rollovers by individ-ual banks, established with substantial IMF inputs,proved crucial in ensuring compliance.

Negotiations between the Korean government andthe banks over the maturity extension began in earlyJanuary 1998.38 A tentative maturity-extensionagreement was concluded on January 28, and thefinal terms were settled in February. While these ne-gotiations were under way, a second rollover an-nouncement was made on January 16, which com-mitted the banks to maintain existing credit linesthrough the end of March 1998.

The pricing on the extended bonds shows that themarket’s confidence in the Korean economy had al-ready started to revive. In April 1998, some US$22billion of eligible bank debt maturing during 1998was exchanged for government-guaranteed loanswith from one to three years’ maturity and interestrates between 225 and 275 basis points over LIBOR.In early April, the Korean government issued US$4billion in 5- and 10-year global bonds, respectivelyat 345 and 355 basis points over U.S. treasuries. Thespreads on both transactions were well below that onthe JP Morgan EMBI+ index, which was neverlower than 464 basis points in April 1998. Even after

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36For comparison, Korea’s average monthly imports in 1997were US$12 billion.

37The written record on the evolution of this idea is thin. Mostof the information in this and the following paragraphs is from in-terviews with IMF staff and former U.S. and Korean officials, aswell as Kim and Byeon (2002). See also Blustein (2001).

38Two approaches were on the table. One involved a new bondissue that would simultaneously finance the maturity extensionand raise new money. The second proposal, which would ulti-mately be adopted, called for a sequential approach, with the ex-tension of the maturity of existing bank debts under a governmentguarantee to be followed by a new sovereign bond issue whenmarket conditions were more favorable. When asked by the Ko-rean authorities for their opinion, IMF management declined tofavor one approach or the other, and urged the authorities not toreject any reasonable proposal for the time being. Kim and Byeon(2002) recount the negotiating process.

Annex 2 • Korea

differences in maturity are taken into account, themore favorable borrowing terms offered to Koreasuggest that by that point the market already as-signed Korea a lower credit risk than most otheremerging market borrowers.

Subsequent events would justify the confidencethat international creditors showed in the Korean fi-nancial system in early 1998. All of the extendedloans would be repaid by the original borrowers; thegovernment guarantee was never exercised. AsKorea’s external financing conditions improved,most of the borrowers took advantage of prepaymentoptions to refinance the debt at lower interest rates.Although only 63 percent of the debt was scheduledto mature by April 2000, 90 percent of it would endup being repaid by that date.39

Assessment

It is of course easier to draw lessons on matters ofprogram financing after the fact than at the time,when information was incomplete, market reactionscould not be anticipated, and decisions needed to betaken rapidly. Nevertheless, three aspects of the ap-proach to financing and the role of the private sectorin the Korean case are worthy of note.

First, to the extent that the Korean economy in late1997 faced a shortage of liquidity rather than a long-term debt-sustainability problem, the successful reso-lution of the crisis depended as much on how and howfast new financing was to be provided as on whether itwould be provided. A delayed or highly conditionalcommitment of funds would do nothing to reverse thedrive by creditors to liquidate their investments whilethey still could. An immediate commitment of liquidfunds, from whatever source, would convince lendersthat their chances of repayment were reasonably highand that it would be worthwhile rolling over existingcredit lines, though perhaps at a higher risk premiumthan before the crisis.

In this respect, the ambiguity over the second lineof defense was clearly counterproductive. The IMFand the national authorities of the contributing coun-tries may have hoped that the mere announcement ofbroad international support, in conjunction withstrong IMF endorsement of the Korean authorities’policies, would be enough to restore market confi-dence and make any actual payout unnecessary.Given the absence of deeper solvency concerns, theannouncement of official financing could have hadthe intended catalytic effect, and one can argue that

this approach ex ante was worth the gamble. How-ever, staff calculations suggest that the assumed in-crease in the rollover rate was unrealistic, especiallyin a very short time. Had the second line of defensebeen firmly committed, with clear indications to themarkets that the funds would be automatically re-leased if needed, the large “headline” figure mighthave produced a catalytic effect. In the event, therewas too much uncertainty about their availabilityand the effort to influence the subtle dynamics ofmarket confidence backfired. By including someUS$20 billion that was not backed by actual com-mitments, the December 4 package only emphasizedthe extent of Korea’s cash shortfall. The market be-came skeptical, and the announcement of the IMFpackage failed to provide the boost to confidencethat had been hoped for.

The second lesson to be drawn is that, in the end,the coordinating role of the IMF in the context of therollover agreement proved to be at least as useful inresolving the crisis as its ability to provide or mobi-lize financial resources. The success of the coordi-nated rollover and private sector debt restructuringwould ultimately render the second line of defenseirrelevant. While the authorities of the IMF’s largeshareholder governments made the key decision topursue the rollover plan and to exert the necessarymoral suasion on banks, the IMF played a useful rolein facilitating communication among the differentactors, in providing information, and in certifyingthat the policies to be pursued by the Korean author-ities were appropriate. No single national govern-ment, nor any private sector institution, could haveplayed this role as effectively.

A third lesson is that, for the success of a large fi-nancing package, the IMF’s coordinating role mustbe complemented by strong engagement on the partof its large shareholders. The role of the UnitedStates in pressing for vigorous reforms has alreadybeen noted. As part of this process, officials of theU.S. and other large shareholders were in regularcommunication with IMF staff and managementduring and after the program negotiations. However,the public face of this involvement must be managedcarefully. The presence of a U.S. Treasury official inclose proximity of the negotiations caused some inthe public to have a wrong perception of the IMF in-volvement in Korea.

Conclusions

A definitive statement on the “success” or “fail-ure” of the IMF-supported program in Korea woulddepend on one’s criteria for success. In terms of sta-bilizing markets and reversing capital inflows, theprogram announced in early December was clearly a

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39The BOK’s facility providing advances of foreign exchangeat a penalty rate, the other vehicle by which the banks’ huge over-seas obligations were refinanced, was also repaid in full, and infact made a profit of some W 6 trillion over the period from De-cember 1997 to June 1998 (Baliño and Ubide, 1999, p. 42n).

ANNEX 2 • KOREA

failure, while the late December package can becalled a success. However, one should also acknowl-edge that the key features of the second program be-came acceptable to the international communityonly after the strategy of the first was tried andproven to have failed. The depth of the 1998 reces-sion may, in part, be attributed to the stringency ofthe financial sector restructuring measures requiredin the program—but significant restructuring wouldhave been necessary whether or not a crisis oc-curred, and in any case the economy’s subsequentstrong recovery suggests that these effects were tem-porary. The program induced the Korean authoritiesto take the necessary decisive steps toward reform-ing the economy and, in this sense, made a contribu-tion to building the foundation for Korea’s impres-sive recovery. However, some needed reforms werelater delayed or scaled back.

This annex has identified specific missteps in sur-veillance before the crisis, in the formulation of theadjustment program, and in the provision of financingthat suggest lessons for the future. These are summa-rized below. More specific recommendations, includ-ing a discussion of the extent to which these lessonshave already been identified and acted upon withinthe IMF, are discussed in the main report.

Surveillance

Partly because of Korea’s consistently strong eco-nomic performance, IMF surveillance did not fullyanticipate many of the elements that would contributeto the Korean crisis. With hindsight, shortcomings canbe detected at two levels: the analysis of the implica-tions of Korea’s capital account liberalization policiesin the 1990s, and the analysis of the vulnerabilitiesfacing Korea in the months immediately precedingthe crisis in 1997. Specifically, the IMF focused toomuch on the degree of capital market liberalization,and not enough on sequencing, thereby underestimat-ing the systemic vulnerabilities introduced by a policythat combined liberalization of short-term flows, con-trols limiting long-term flows, and poor supervisionof some of the institutions that borrowed externally.This was in keeping with the IMF’s standard approachat the time, which viewed financial sector issues interms of their impact on microeconomic efficiencyrather than in terms of whether they might increasethe risk of an external crisis.

IMF surveillance in the months preceding the cri-sis did identify many of the relevant vulnerabilities.However, it paid insufficient attention to issues thatwould prove central to the onset and evolution of thecrisis, and the overall assessment proved to be exces-sively optimistic. In retrospect, five misconceptionshindered the ability of the staff to offer a more accu-rate assessment:

• An overestimation of the flexibility in Korea’sexchange rate policies.

• An underestimation of the risk of a breakdown infunding the capital account. While recognizingthat such a risk was present, particularly in thecrisis conditions then prevailing in East Asia, thestaff concluded that the authorities could handleany pressures by making renewed efforts in thearea of financial reform, by addressing financialsector weaknesses, and by loosening controls onlong-term external borrowing.

• Excessive optimism about the short-term impacton growth of rehabilitating and reforming the fi-nancial sector. The narrow range of growth esti-mates considered, based on the remarkable stabil-ity of Korea’s growth rates over the previousdecades, prevented the staff from exploring theconsequences of a more serious slowdown.

• Insufficient attention to relevant market indica-tors, some of which (such as spreads on KDBissues) showed mounting wariness among in-vestors well before the crisis began in earnest.

• Advice in the area of financial sector reform thatwas primarily oriented toward improving thelong-term health and efficiency of the system.While this advice was generally well thoughtout, in the conditions of the summer and fall of1997 when investors had become significantlymore risk-averse, advice on securing the systemagainst a possible crisis and preparing for theconsequences of such a crisis might have beenmore helpful.

Several of these misconceptions had their originin, or were exacerbated by, incomplete informationand poor data availability. As discussed in the mainreport, this is an area in which substantial progresshas been made since the Asian crisis, through thevarious initiatives on standards and codes.

Program design

Monetary policy

Some increase in interest rates was justified at thetime of the crisis, given the need to prevent a collapseof the exchange rate and to maintain positive real ratesin the face of high inflation expected to result from thedepreciation of the won. The authorities also neededto demonstrate their determination to respond force-fully to the crisis. But, given the nature of the crisis,too much reliance was placed on high interest rates tostabilize the won. The key immediate issue in resolv-ing the crisis was Korea’s lack of liquidity, and therewere too few channels through which high interestrates could remedy this shortfall. The lack of owner-

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Annex 2 • Korea

ship of monetary policy on the part of the authoritiesno doubt further weakened its credibility and hence itssignaling effect. Hindsight suggests that rates weremaintained at a high level in early 1998 somewhatlonger than necessary, although an excess of cautionwas understandable under the circumstances. How-ever, the stance of monetary policy was not the majorcause of the steep output decline.

Fiscal policy

Given the low stock of public debt, the IMFcould have urged Korea to use fiscal policy tocounteract the likely contractionary effects of fi-nancial sector restructuring from the beginning ofthe crisis, rather than waiting until the early monthsof 1998 to start giving this advice. In any event, theKorean authorities, reflecting their tradition of fis-cal conservatism, were not very receptive to thisadvice and cut government expenditures. Fiscalpolicy nevertheless ended up being countercyclicalbecause tax receipts fell even further and becauseof off-budget activities.

Structural reforms

The financial and nonfinancial structural reformswere extensive, and had a positive effect in improv-ing the efficiency and stability of the Korean econ-omy. In retrospect, however, while the IMF was jus-tified in using its leverage to insist on such change asa condition for financial support, too much attentionwas paid to producing visible results quickly. Moreemphasis should have been placed on the overallstrategy, not on specific short-term measures, withthe authorities being given greater freedom in settingtheir own agenda. In the case of the financial sector,a home-grown agenda was already available in theform of the reports of the Presidential Commission,and efforts in this area benefited from the sense ofcountry ownership. In the case of nonfinancial re-forms, the extent of ownership was less clear. Theimmediate need for action in areas such as corporategovernance, while potentially important in the longterm, was not as apparent as the need to reformbankruptcy laws or address solvency issues in the fi-nancial sector.

As confidence rapidly returned to Korea, someaspects of financial sector reform were delayed,while many nonfinancial structural measures were inthe end never fully implemented. Particularly giventhe negative backlash some of these measures cre-ated on the public perception of their origin, the IMFmight have been better advised to confine its adviceand conditionality to a narrower range of issues, andthen let the Korean authorities define their ownagenda to implement this more focused set of policy

measures. This is particularly true of trade and otherexternal liberalization measures, which were alreadymandated by Korea’s agreements with the OECDand the WTO.

Financing and the debt rollover

The strategy adopted in the first program waspredicated on the hope that tough monetary and fi-nancial sector policy measures would be sufficient tobring about a spontaneous rebound in confidence. Insupport of this strategy, the announced package kepta large “headline figure” that included a componentwhose availability was uncertain and was discountedby the markets. The attempt to present the financingpackage in as favorable light as possible proved dam-aging on two levels: in the short term, to the market’sconfidence in Korea’s ability to overcome the crisisand, in the longer term, to the credibility of IMF-ledfinancing arrangements generally. If the IMF and theauthorities of the major shareholder governments hadacknowledged the limited availability of these fundsfrom the beginning, there might have been an earliereffort to seek alternative solutions, including a coor-dinated rollover of short-term debt.

Admittedly, it is difficult to be certain whether theprivate sector rollover and maturity extension ofshort-term bank debt could have been arranged ear-lier than they were. Some creditors wanted to elimi-nate their exposure to Korea under any circum-stances. Others might have been more receptive to acoordinated rollover, but would not have wanted tomake any further commitments in advance of theelections on December 18, 1997. Yet, according toindividuals in the private sector interviewed by theevaluation team, from the very beginning of the cri-sis, some—if not many—creditors expressed an in-terest in finding a collective solution of some kind.

If the interest of some private creditors in con-cerned action had been recognized from the start ofthe IMF’s involvement, there might have been agreater effort to establish contacts, think through thebroad outline of such an agreement, and follow upon private sector initiatives, such as those of theSeoul Foreign Bankers’ Association. IMF manage-ment appears to have understood that some con-certed action might be necessary from the outset andcommunicated this message to the major sharehold-ers, but the authorities of the IMF’s large share-holder governments were initially reluctant, fearingthat such action might set undesirable precedentsand adversely affect the flows to other emergingeconomies. Given the domestic political uncertain-ties prevailing before the elections, and the con-straints faced by the major shareholders, it may wellbe that the first strategy needed to be proven to havefailed before concerted action could be attempted.

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ANNEX 2 • KOREA

118

Appendix 2.1

Korea: Timeline of Major Events1

Date

1/23/97 Hanbo Steel goes bankrupt with US$6 billion of debt.

6/3/97 The Presidential Commission on Financial Reform submits its second report to the President, recommendingliberalization of the financial markets, independence of the central bank, strengthening of the supervisory system, andimprovement of information efficiency.

6/24/97 Moody’s states that the outlook for Korea’s credit rating has deteriorated, reflecting the country’s weakening financialhealth.2

The Korea Development Bank provides additional loans to prevent bankruptcy of the Kia group.

7/24/97 Seoul Bank applies for special loans from the Bank of Korea, saying that it can no longer borrow funds abroad.

8/13/97 Korea First Bank is reported to be facing a liquidity crisis as a result of the reduction of its credit rating to junkstatus.

8/24/97 The Korean government decides to provide special loans of W 1 trillion to Korea First Bank.

8/29/97 The government issues a public statement that it will ensure the payment of foreign debt liabilities by Korean financialinstitutions.

10/6/97 Start of an IMF mission (lasting until October 15) for the 1997 Article IV consultations with Korea.

10/8/97 The Bank of Korea decides to provide special loans to merchant banks in order to secure credibility and liquidity inthe financial market.

10/24/97 Standard & Poor’s downgrades Korea’s foreign currency long-term sovereign rating to A+ from AA–.2

10/29/97 The monetary authorities decide to accelerate capital account liberalization measures, including bringing forward theopening of the domestic bond market to foreign investors and easing restrictions on firms’ raising capital abroad.

11/1/97 Moody’s downgrades the credit ratings of four major Korean banks.2

11/2/97 The MOFE announces that it will supply up to US$2 billion in foreign exchange every day from the next day(November 3) for a week in order to stabilize the exchange rate.

11/7/97 A Korean newspaper reports that government financial experts are cautiously discussing the need for IMF-led rescueloans, because of a shortage of foreign exchange reserves. The Bank of Korea and the MOFE deny this.

The IMF Managing Director says that the IMF is ready to help Korea, if Korea requests support.2

11/13/97 The Director of the Institute for International Economics tells the U.S. House Banking Committee that Korea wouldneed at least US$50 billion to cope with the current financial crisis.2

11/18/97 A financial reform bill, setting up an independent, consolidated supervisory agency, fails to pass the National Assembly.

The MOFE denies requesting rescue loans from the IMF.

11/19/97 The Finance Minister resigns and a new minister takes office.

The new Minister of Finance and Economy announces measures to stabilize the financial market, including:(1) cleaning up nonperforming loans of the financial institutions by injection of public funds; (2) promotingrestructuring of the financial sector through mergers and acquisitions; (3) authorizing the Bank of Korea to buy foreignexchange from branches of foreign banks; (4) expanding the daily exchange rate band from +/– 2.25 percent to +/– 10 percent; and (5) liberalizing the long-term bond market.

The new Minister of Finance and Economy says the government will seek financial support from the U.S. and Japanesegovernments.

11/21/97 The Minister of Finance and Economy announces that the Korean government will ask the IMF for financial assistance.He suggests that the total amount of support could range from US$50 billion to US$60 billion, including loans fromG-7 countries.

11/22/97 Standard & Poor’s downgrades Korea’s foreign currency long-term sovereign rating to A– from A+.2

11/26/97 A staff team from the IMF arrives in Seoul to negotiate a program to be supported by a Stand-By Arrangement.

12/2/97 The penalty rate for new injections of foreign exchange by the Bank of Korea to Korean commercial banks is raised to400 basis points above LIBOR.

Nine technically insolvent merchant banks are suspended.

12/3/97 Negotiations on the IMF-supported program conclude. The authorities formally request a three-year Stand-ByArrangement from the IMF in an amount equivalent to SDR 15.5 billion (US$21 billion), as part of a multilateral andbilateral financing package totaling US$55 billion.

12/4/97 The IMF Executive Board approves the Stand-By Arrangement.2

12/5/97 The government announces W 4 trillion expenditure cuts in a revised 1998 budget.

12/8/97 Korean press reports state that, according to a leaked IMF report, Korea’s foreign reserves declined to only US$5 billion in the previous week.

Annex 2 • Korea

119

Korea:Timeline of Major Events (concluded)

Date

12/9/97 The Korean government offers to make special loans of W 1.18 trillion to Korea First Bank and Seoul Bank inexchange for layoffs of at least 1,500 personnel and a 10–30 percent expenditure reduction, and announces plans tonationalize the two banks.

The government suspends the operation of 5 additional insolvent merchant banks, bringing the total suspended to 14.

The Korea Development Bank postpones bond issues intended to raise US$2 billion. Foreign financial institutions arereportedly refusing to renew credit lines to the country.

12/11/97 A leading presidential candidate says he might renegotiate a deal with the IMF, reversing an earlier pledge to honor it.

12/15/97 The government announces that it will seek a foreign buyer for either Korea First Bank or Seoul Bank.

12/16/97 The government removes a 10 percent daily limit on the currency’s daily movements, allowing the won to float freelyagainst the dollar.

An increase in the interest rate ceiling from 25 percent to 40 percent is approved by the cabinet.

12/18/97 Kim Dae-jung wins the presidential election.

The IMF Executive Board completes the first review of the Korean program and activates financing of US$3.5 billion(SDR 2.6 billion) through the newly created Supplemental Reserve Facility.2

The government hires two U.S. investment banks as advisers in the restructuring of government-guaranteed overseasborrowing by domestic banks.

12/19/97 President-elect Kim Dae-jung pledges support for the IMF-supported program, and says that he wants to minimizeconditions that could lead to greater unemployment.

12/23/97 A high-level team led by the MOFE is established to enter into negotiations with foreign commercial bank creditors tofacilitate extensions of short-term debt.

12/24/97 The Korean government and the IMF agree to a revision of the Stand-By Arrangement, under which Korea willundertake additional or accelerated market-opening measures in exchange for faster disbursement of IMF resources.Roughly US$10 billion in funding from the IMF, the World Bank, and the Asian Development bank is to be madeavailable by early January.

Several major U.S. banks are reported to be willing to roll over their loans to Korean banks.

12/26/97 Korea First Bank and Seoul Bank are reportedly placed under intensive supervision by the Bank Supervision Office.

12/29/97 Banks from the United States, the United Kingdom, Japan, Germany, and the Netherlands pledge to roll over short-term loans to Korean banks.2

The National Assembly approves a package of important financial reform bills demanded by the IMF. As a result (1) the central bank will gain independence from the Ministry of Finance and Economy and (2) a new unified financialsupervisory agency to oversee the bank, securities, and insurance sectors will be placed under the Prime Minister.

12/30/97 Banks in France, Switzerland, Italy, and Canada agree to roll over short-term loans to Korean banks.2

The bond markets are fully opened to foreign investors. Investors will be allowed to take majority stakes in listedKorean companies and conduct “friendly mergers and acquisitions.”

The IMF Executive Board formally approves Korea’s request for modification of the schedule of purchases under theStand-By Arrangement.2

1/8/98 International banks tentatively agree to extend payment on as much as US$25 billion in short-term loans until March 31.2

1/15/98 A tripartite committee consisting of labor unions, business leaders, and the government is established to deal withlabor reform and social safety net issues.

1/20/98 Labor leaders reportedly agree that some layoffs will be needed to rescue the economy.

1/28/98 International banks and the government reach an agreement on the rescheduling of Korea’s short-term debt. Underthe plan, Korean banks will offer to exchange their short-term debt for new loans with maturities of one, two, orthree years.2

1/31/98 The government recapitalizes Korea First Bank and Seoul Bank, taking effective control of them.

2/17/98 The IMF Executive Board approves a review under the Stand-By Arrangement.2

2/18/98 Standard & Poor’s upgrades Korea’s foreign currency long-term sovereign rating to BB+ from B+.2

3/16/98 The plan to roll over financial institutions’ external debt into new loans with one–three year maturities is concludedsuccessfully.2

4/8/98 The government successfully launches its first international bond issue since the financial crisis, consisting of US$1billion of 5-year notes and US$3 billion of 10-year bonds.2

Sources: Bloomberg, Korean government official homepage, Moody’s, Standard & Poor’s, IMF, and local Korean newspapers.1Local time unless noted.2Eastern standard time in the United States.

Introduction

This annex provides detailed background for as-sessing the role of the IMF in anticipating and re-solving Brazil’s capital account crisis of 1998–99. Itfirst investigates the effectiveness of IMF surveil-lance in the precrisis period. The following sectiondiscusses program design issues, including (1) sup-port for the crawling peg, (2) fiscal policy and debtsustainability, (3) monetary policy, (4) structuralmeasures, (5) official financing and private sector in-volvement, and (6) program projections. It examinesboth the initial IMF-supported program that wasagreed in the fall of 1998, and the program as re-vised in March 1999. It also touches upon the suc-cessor program agreed in August 2001, which wascanceled in September 2002. The current program,beginning in September 2002, is outside the scope ofour enquiry. The final section presents conclusions.


This section assesses the role of the IMF in majorareas of precrisis surveillance, including fiscal pol-icy, exchange rate policy, banking sector issues, cap-ital account developments and vulnerability indica-tors, and the impact of surveillance.

Background

Many of the central issues of the precrisis periodhad their origins in the policies adopted in the after-math of the Real Plan, the stabilization programlaunched in 1994 (Box A3.1). The IMF chose not tosupport the Real Plan with a program because, in itsview, the proposed fiscal adjustment was insufficientto secure disinflation in a durable way.1 Instead, amonitoring arrangement, involving twice-yearly

staff visits, was established, in part as a face-savingmeasure.2 Not agreeing on a program adversely af-fected the relationship between the IMF and theBrazilian authorities, and weakened the impact ofIMF advice on Brazil’s policy formulation duringthe precrisis period.

The IMF’s skepticism about the ability of theReal Plan to reduce inflation appears ill founded inretrospect. The anti-inflationary gains were achievedand sustained over an extended period, albeit with amuch greater fiscal deterioration than the IMF hadfeared. However, the IMF was correct in recognizingthat weaknesses in the plan would pose challenges inconsolidating these gains. As early as the first half of1995, concerns emerged over the widening currentaccount deficit, which prompted the authorities totighten monetary policy in an attempt to contain thesurge in consumption. Over a longer time horizon,there were questions about the eventual exit strategyfrom an appreciated real exchange rate, and the riskthat the exit would reignite inflation.

Unlike East Asia, where the crisis took the IMF bysurprise, the vulnerabilities of Brazil were well identi-fied by surveillance, perhaps because they weremainly macroeconomic in nature. As early as Septem-ber 1995, a briefing paper expressed concern that theexternal current account deficit did not seem sustain-able and that its financing was highly vulnerable toshifts in market confidence. A prescient managementcomment on a briefing paper in October 1997 notedthat “the current strategy [was] a risky one, and onething far worse than a fiscal contraction a year beforean election [was] a foreign exchange crisis a week be-fore an election.” Staff reports for Article IV consulta-tions were typically less frank, but carried a reminderthat a relatively large current account deficit andheavy amortization commitments left Brazil vulnera-ble to shifts in investor sentiment. Even so, the IMFwas generally more optimistic than the private sector.For example, in mid-1997, management instructed the

Brazil

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3

1A program was being sought not for balance of payments rea-sons but in the context of a debt restructuring deal with interna-tional banks. See IEO (2002) for a discussion of the broadening ra-tionale for IMF-supported programs, the shifting of the boundarybetween programs and surveillance, and its possible consequences.

2Originally, a formal staff-monitored program appears to havebeen envisaged, but ultimately the closer monitoring relationshipestablished was informal. Staff reports to the Executive Board wereonly prepared after the annual Article IV consultation missions.

Annex 3 • Brazil

imminent mission “to consider why some in the mar-kets appear[ed] more skeptical about the Brazilianeconomy” than the IMF’s own analysis.”3

Public warnings of these vulnerabilities wererare, although the 1997 World Economic Outlooknoted, in a likely veiled reference to Brazil, thatcountries with insufficient fiscal consolidation, andtherefore with “excessive reliance on short-term in-terest rates to restrain domestic demand,” might be“more vulnerable to changes in market sentiment.”In June 1998, the International Capital Markets re-port noted a risk that “the re-evaluation of emergingmarket vulnerabilities [had] not run its course” andthat the terms and conditions of external financingcould worsen further, leading to a broadening of thecrisis to emerging markets outside Asia. Neverthe-less, the staff appraisal in the capital markets reportimplicitly downplayed the risks to Brazil, noting that“many Latin American economies” had strengthenedtheir financial systems, permitting the use of aggres-sive and credible interest rate defenses against conta-gion from Asia.

Fiscal policy

Brazil’s fiscal position weakened substantially in1995, owing in part to large increases in public sec-tor wages, public sector price freezes, and the lossof control mechanisms that had previously relied onhigh inflation to erode the real value of budgetedexpenditures (Table A3.1). The staff consistentlycalled for efforts to strengthen the fiscal stance, pri-marily in order to reduce the burden on monetarypolicy and permit a decline in interest rates and, as aconsequence, some real depreciation of the cur-rency. Given the high overall tax burden, staff con-sistently took the position that fiscal adjustmentshould be carried out mainly through expenditurerestraint.

From 1996, concerns about public debt sustain-ability were also cited as reasons for a tighter fiscalstance. Staff projections in successive reports never-theless consistently showed public debt on a down-ward path from progressively higher bases, implyingthat the debt at each stage was “sustainable,” if an ad-equate primary surplus could be achieved in the fu-ture. For example, projections in the staff report forthe 1995 Article IV consultation showed net debt de-clining to 15 percent of GDP by 2000. For 1996,these projections assumed a primary surplus amount-ing to 3.3 percent of GDP and a reduction in real in-terest payments equivalent to 2 percent of GDP,whereas the actual outcome was a primary deficit of

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Box A3.1. Brazil: The Real Plan

The Real Plan was a two-stage procedure of substituting the old currency, first by a unitof real value (URV) and second by a means of payment, the real, which was initially setequal to one U.S. dollar. The URV was a device designed to eliminate the backward-look-ing indexation by virtue of the fact that the URV itself was a price index. It was only afterall contracts had been converted into multiples of the URV that the new unit of account wasissued. All the steps were announced to the public, with no surprises or shocks (Franco,2000; Bacha, 2001). Unlike some of the previous stabilization plans, no price or wagefreeze was attempted; thus the Real Plan generated wide popular support. On March 1,1994, the URV was introduced and, after four months of contract conversion, the real wasissued by the Central Bank of Brazil (BCB) on July 1, 1994, with 30-days advance notice.

The IMF, however, was reluctant to support the Real Plan (and the 1994 Brady debt re-structuring program) with a financing arrangement. According to internal documents,there was skepticism in the IMF that the Real Plan would succeed in reducing inflation ina durable way. The IMF did not believe that the proposed fiscal stance was sufficient toproduce the envisaged reduction in inflation in 1994, and doubted its sustainability after1994. The response of government revenues to lower inflation was highly uncertain, andthere were doubts over planned structural fiscal reforms, which depended in part on ap-proval by Congress in a constitutional review.

Following its introduction in July 1994, the real was allowed to appreciate by about 15percent in nominal terms. Inflation fell from a monthly rate of over 40 percent in the firsthalf of 1994 to between 1 percent and 3 percent a month by the end of the year, but wasstill greater than in Brazil’s major trading partners. According to contemporary IMF staffestimates, the real effective exchange rate appreciated 33 percent in terms of the generalprice index between June 1994 and February 1995.

3Market views were by no means monolithic but, given the ap-preciated real exchange rate, some private sector observers fore-saw increasing strains on the exchange rate regime over themedium term, particularly if international capital market condi-tions became less buoyant. There was also growing market con-cern about fiscal sustainability and the prospects for fiscal consol-idation and structural reforms. See, for example, IIF (1997a).

ANNEX 3 • BRAZIL

0.1 percent of GDP, and real interest payments lowerby just 1 percent of GDP.

The persistently weak fiscal position and high realinterest rates led instead to a rapid expansion in theratio of public debt to GDP, despite the start of a far-reaching program of privatizations and sales of otherassets. The stock of net public debt rose to 33 percentof GDP at the end of 1996, from 30 percent in 1995,as neither of the assumptions (on the primary surplusand real interest payments) was fulfilled. The projec-tions in the staff report for the 1996 Article IV consul-tation were not so optimistic, but they still showed theratio declining to 28.3 percent of GDP by 2001, onthe assumption of a medium-term primary surplus of2 percent of GDP and substantially lower real interestrates.4 The report did not directly analyze why earlierprojections had not been realized.

The authorities typically accepted in principle theIMF’s advice that fiscal adjustment was necessarybut they were generally less ambitious in their ef-forts than the IMF recommended. Even the modestfiscal adjustment targeted by the authorities wasrarely achieved and little progress was made in prac-tice on fiscal consolidation between 1995 and 1998,with the fiscal accounts at best in primary balance.The authorities faced strong constitutional and insti-tutional constraints in implementing such a consoli-dation, in part because of heavy earmarking of taxrevenues and political pressures, including compet-ing priorities for the congressional agenda.5

From time to time, the IMF identified specific pol-icy measures to achieve adjustment, or to bring thefiscal balance back on track.6 However, instead of ad-dressing immediate fiscal adjustment, the authoritiesaccorded a higher priority to overcoming fiscal con-straints in the medium term by establishing mecha-nisms to increase the flexibility of public expenditure,exercise control over state and local finances, and re-form the pension and social security systems. The au-thorities were reluctant to seek congressional approvalof revenue measures when constitutional reformswere under consideration by Congress. This does notmean that the Brazilian authorities never took toughfiscal measures. For example, faced with a major in-ternational turbulence in November 1997, they an-nounced a package of fiscal measures (“the Packageof 51”), estimated to yield over 2.5 percentage pointsof GDP.7 Its implementation, however, faltered in theface of electoral pressures in 1998.

The IMF was generally realistic about the politicalconstraints, including risks to implementing agreedmeasures. In internal papers, for example, staff judged

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Table A3.1. Brazil: Fiscal Developments(In percent of GDP)

1994 1995 1996 1997 1998 1999 2000 2001 2002

Public sector borrowing requirement1 44.32 7.1 5.9 6.1 7.9 10.0 4.6 5.2 4.4

Operational balance3 0.5 –4.8 –3.9 –4.3 –7.4 –3.4 . . . . . . . . .Federal government + Central Bank4 1.6 –1.6 –1.6 –1.8 –5.1 –3.2 . . . . . . . . .States + municipalities –1.0 –2.3 –1.8 –2.3 –1.8 –0.5 . . . . . . . . .Public enterprises –0.1 –0.8 –0.3 –0.3 –0.5 0.3 . . . . . . . . .

Primary balance 4.3 0.3 –0.1 –1.0 0.0 3.2 3.5 3.7 3.9Federal government + Central Bank4 3.0 0.6 0.4 –0.3 0.6 2.4 1.9 1.9 2.4States + municipalities 0.4 –0.2 –0.6 –0.7 –0.2 0.2 0.6 0.9 0.8Public enterprises 0.9 –0.1 0.1 0.1 –0.4 0.7 1.1 1.0 0.4

Net public debt to GDP ratio 30.0 30.6 33.3 34.4 41.7 48.7 48.9 52.6 56.5

Source: Data provided by the Central Bank of Brazil.1The coverage of the consolidated public sector in Brazil is very comprehensive.2The 1994 PSBR is high because of the very high nominal interest payments in the first half of the year, reflecting an inflation rate of over 40 percent a month.3The operational fiscal balance is defined as the primary balance less the “real” component of interest payments.4Comprises central administration, the Central Bank, and the social security system.

4The real interest rate was assumed to fall from 17.3 percent in1996 to 6 percent in 2000.

5For example, the Constitution stipulated that income taxchanges could take effect only in the year after their approval.

6For example, in mid-1997, the staff suggested the eliminationof tax exemptions that were determined administratively, increasesin wholesale tax rates by decree, stronger efforts to collect tax ar-rears and cuts in budgeted appropriations, as well as efforts to re-duce payroll spending within existing constitutional constraints.

7The package included a surcharge on upper-bracket personalincome tax, increases in taxes on fixed income investments, andincreases in public sector tariffs. Regional tax incentives were re-duced. Discretionary federal government spending was fixed inreal terms, and the planned increase in the wage bill was substan-tially reduced. Limits on bank financing for state and municipalgovernments were tightened. Public enterprise spending, particu-larly on investment, was curtailed. Social security benefits wererestricted.

Annex 3 • Brazil

that the November 1997 package would deliver theprojected savings if implemented in full, but correctlypointed out the risk that spending pressures wouldbuild during the election year 1998 “particularly if ex-ternal constraints ease”; the limitations faced by thefederal government in controlling the states; and pos-sible slippage in securing congressional approval forfiscal measures. The Article IV consultation report inJanuary 1998 presented the implementation risks lessstarkly than did internal documents, although it didnote that steady implementation of the fiscal packagewould be essential to reduce Brazil’s vulnerability.

While progress was slow, enough groundwork onfiscal reform appears to have been done by theBrazilian authorities to facilitate fiscal adjustmentunder the 1999 program. Importantly, this includedmeasures to control fiscal relations between the fed-eral government and states and municipalities,which were linked to debt restructuring agreements.In this context, several Brazilian officials inter-viewed noted the useful contribution of IMF techni-cal assistance in this area, including public debt pol-icy and management. The experience of 1999 showsthat it was indeed possible to tighten fiscal policy,given sufficient political will.

Exchange rate policy

The case of Brazil posed a number of challengesto the IMF’s approach to exchange rate policy. TheArticles of Agreement have been interpreted as man-dating that the IMF should take the exchange rateregime preferred by the authorities as given and tryto ensure that other macroeconomic policies are con-sistent with it. Surveillance guidelines, however,state that Article IV consultation discussions and re-ports should include an accurate description of acountry’s exchange rate regime, a candid appraisalof its appropriateness and consistency with underly-ing policies, as well as a forthright assessment of theexchange rate level.

Throughout the precrisis period, the IMF remainedconcerned about substantial real exchange rate appre-ciation and its adverse impact on Brazil’s externalcompetitiveness, especially given the country’s poorexport performance. However, implicit in its policyadvice was the judgment that a gradual real deprecia-tion could resolve the overvaluations, as long as thiswas supported by fiscal adjustment. Earlier in 1995,particularly in the aftermath of the Mexican crisis,there was greater skepticism—and much internal de-bate—as to whether the exchange rate system couldbe sustained (Box A3.2). Even then, internal papersreveal that the IMF favored a gradual exchange rateadjustment, combined with a major tightening of bothfiscal and credit policy, rather than a step devaluationto counter current account problems.

Typically, the IMF’s policy advice was to acceler-ate the rate of depreciation within the de facto crawl-ing peg system. Staff feared that floating the cur-rency carried a substantial risk of overshooting. Astime went on, concerns about overvaluation weredownplayed, and the staff increasingly accepted theauthorities’ arguments minimizing the size of anyovervaluation, particularly in view of buoyant capitalinflows that more than financed the current accountdeficit. Although at times the authorities indicatedthat they were open to accelerating the rate of crawl,they generally took the position that this would notnoticeably benefit the current account and riskeddestabilizing market expectations and confidence.

The IMF was prepared to advise more drastic ac-tion in extremis, including a step devaluation orfloating the currency. For example, at the time of theAsian crisis in mid-November 1997, IMF staff pro-posed that if there was a strong attack on the real, theexchange rate regime should not be defended. Man-agement, however, advised against recommending afree float unless the band became totally untenable.The authorities reiterated their opposition to a dis-crete devaluation or a float, because of likely over-shooting. In the event, Brazil weathered strong mar-ket pressure by raising interest rates sharply,announcing fiscal measures, and intervening heavilyin the foreign exchange market.

Executive Directors generally supported thestaff’s advice for a gradual acceleration of the crawl,though some believed even such an accelerationwould be unnecessary or inadvisable. But there wereexceptions. For example, in the discussion of the Ar-ticle IV consultation in March 1997, one ExecutiveDirector argued that consideration should be givento allowing the exchange rate to float, so as to avoidan exchange rate crisis if investor confidence were toweaken. Most Directors, however, were of the viewthat, in the prevailing unsettled market conditions,any significant change in policy could lead to a lossof confidence. Some Directors encouraged the au-thorities to introduce greater flexibility into ex-change rate policy, once market conditions had sta-bilized. At a meeting of the Executive Board on theArticle IV consultation report in February 1998,staff orally disclosed that they had discussed a num-ber of options with the authorities, including a dis-crete currency devaluation, more flexible exchangerate management, an acceleration of the rate ofcrawl, and the possibility of using a currency basketas a reference currency. One Executive Director,however, expressed displeasure over the absence of aclear discussion of exchange rate options in the pa-pers prepared for the Board by staff.

While it was generally agreed that the currencywas overvalued, there was considerable disagreementabout the extent of the overvaluation (Figure A3.1).

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ANNEX 3 • BRAZIL

The IMF staff initially noted a strong real apprecia-tion when the Real Plan was launched. In February1995, the staff put the real appreciation since June1994 at 33 percent in terms of the general price index.By late 1996, however, there was a tendency to down-play these figures, possibly in response to the views ofthe Brazilian authorities who used a wide range of ar-guments to suggest that any overvaluation was at mostmoderate (see Franco, 2000).8 The staff argued thatthe currency had been undervalued at the outset of theReal Plan and the subsequent significant real appreci-

ation had been offset to some extent by productivityincreases which were not fully reflected in prices. Italso indicated that a pickup in export growth during1997 weakened their arguments in favor of accelerat-ing the rate of depreciation, although export volumegrowth of 10 percent in 1997 in fact was no greaterthan the increase in world trade volume.9

The net result was that, in late 1998, staff believedthat the exchange rate was overvalued by 15–20 per-cent. The behavior of the exchange rate, after it wasallowed to float in 1999, as well as comparison withoutside assessments, suggests that staff likely under-estimated the degree of overvaluation. Recent Central

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Box A3.2. Brazil:The Evolution of Exchange Rate Policy

In the period immediately preceding the introduction of the real, the exchange rate wasallowed to depreciate in line with contemporaneous inflation.

The real was introduced on July 1, 1994, with the unit of real value (URV) convertedinto the real at parity with the U.S. dollar. An exchange rate band of R$0.93 to R$1 =US$1 was initially established, but the exchange rate was ultimately allowed to appreciatein nominal terms to R$0.83 to US$1 in late 1994, with the floor of parity with the U.S.dollar maintained. The exchange rate was maintained at about R$0.84 per U.S. dollaruntil March 1995.

Exchange rate policy was altered on March 6, 1995 to a system of more depreciated ad-justable bands, with a preannounced substantial further widening of the band from May1995. This followed a rapid loss of reserves, reflecting a sharply widening current accountdeficit and weaker capital inflows following the Mexican crisis. However, in part owing toa lack of clarity about how the arrangement would operate and renewed pressures on theexchange rate, the policy was altered again on March 8, 1995, only two days later, withthe adoption of a band of R$0.88 to R$0.93 per U.S. dollar. An inner band was establishedwithin this framework, which began to be operated as a de facto crawling peg, depreciat-ing at an (unannounced) rate of about 0.6 percent a month. The outer band was periodi-cally adjusted (approximately annually) to accommodate this rate of crawl, but had littleoperational significance.

In April 1998, the authorities introduced a marginal change in exchange rate policy byannouncing a progressive widening of the inner band, initially just 0.4 percent wide, by0.1 percent a month for the following three years.

On January 13, 1999, the inner band was abolished and the outer band became the op-erational band. It was initially established at R$1.20 to R$1.32 per U.S. dollar. It was an-nounced that the band would evolve under a complex “endogenous diagonal band sys-tem” under which the rate of depreciation of the upper limit of the band would be fasterwhen the actual rate was close to the lower limit of the band and vice versa. As the ex-change rate fell immediately to the more depreciated boundary of the band, this involveda depreciation of about 9 percent.

On January 15, 1999, the exchange rate was allowed to float freely. This decision wasconfirmed on January 18, 1999, after consultations in Washington with IMF management.The program left some scope for Central Bank intervention in foreign exchange markets, al-though it was understood that this would not involve defending any specific exchange rate.

8The authorities’ argument was threefold. First, average-on-average price indices overstated inflation in the month of transi-tion to the new currency. Second, some of the change in relativeprices between tradables and nontradables was an equilibriumphenomenon typical of sudden disinflation and not a measure ofreal exchange rate misalignment. Finally, the substantial produc-tivity gains should have been taken into account over and abovetheir effects on price indices, as increased competitiveness of do-mestic producers might be reflected in higher profit marginsrather than lower domestic prices.

9In this context, an important presentational change was madeby the staff in late 1997, whereby the real effective exchange ratebegan to be calculated relative to the 1994 average, instead of theearlier use of the level prevailing prior to the introduction of thereal. This presentational change represented an upward adjustmentof almost 12 percent in terms of the base period, and may have re-inforced the perception that any overvaluation was manageable.

Annex 3 • Brazil

Bank estimates indicates that, measured by relativeconsumer prices, the real effective exchange rate hadappreciated by 45 percent between June 1994 and De-cember 1997, although this had fallen to 33 percent byDecember 1998. Contemporary analyses by the WorldBank estimated the real to be overvalued by about 30percent. The real effective exchange rate depreciatedby some 35 percent in 1999 after the currency wasfloated. The exchange rate has fluctuated since then—and no doubt overshot at times—but peak levels of thereal effective exchange rate have remained some 27percent below the level of December 1998.

In retrospect, the IMF should have encouraged anearlier exit from the crawling peg regime at an oppor-tune moment. This would have been consistent withthe messages emerging from the IMF’s own cross-country policy analysis of exit strategies from ex-change rate–based stabilizations.10 Indeed, therewere windows of opportunity to exit from a positionof strength in late 1996 or early 1997, and again inthe first half of 1998. The limited pass-through to in-flation of the eventual float in 1999 suggests that, ifwell handled, carefully timed and supported by ap-propriate policies, floating the currency would havebeen possible without reigniting rapid inflation. Ofcourse, at that time it was not clear that such a stepwould not lead to high inflation, although by thenprice stability had been established for some time.11

The immediate output impact of a float would likelyhave been greater than occurred in 1999 because theprivate sector was less hedged at that time. By thesame token, the adverse impact on public debt wouldhave been correspondingly smaller.

Banking sector issues

In the post–Real Plan period, some private sectorinstitutions encountered difficulties and three majorbanks failed as they lost income from the “float” after

inflation fell. The Brazilian authorities establishedtwo restructuring programs, which incorporated in-centives to encourage the acquisition of weak privatebanks and privatization of weak state banks, resultingin a consolidation in the banking system. With strongencouragement from management, staff closely moni-tored these banking sector issues. The staff report forthe 1996 Article IV consultation noted that the risk ofa systemic problem had been effectively reducedthrough improvements in supervision, recapitaliza-tion, mergers, and the entry of foreign banks. Thebanking system, however, remained vulnerable tomacroeconomic shocks and staff noted the desirabil-ity of further strengthening bank supervision.

By the time of the crisis, the IMF had analyzed indetail the risks to the financial system and rightlyconcluded that it was sound, with little foreign ex-change risk and little systemic exposure to creditrisks. The background Recent Economic Develop-ments paper for the 1997 Article IV consultation in-cluded a detailed assessment of risks in the Brazilianfinancial system. The supporting papers for the 1998SBA request included an annex on the soundness ofthe banking system. In relation to credit risk, staffconcluded that, given low levels of lending, highcapitalization, and strength of ownership, a furtherdeterioration in asset quality was unlikely to causestrains. Currency risk in the financial sector was alsosmall as a result of hedging through currency futuresand dollar-indexed government securities.12

125

60

80

100

120

140

160

1993 95 97 99 2001 03

Figure A3.1. Brazil: Real Effective Exchange Rate1

(June 1994 = 100)

Sources: Central Bank of Brazil; and IEO staff calculations.1Based on INPC consumer price index.

10For example, the 1997 International Capital Markets reportnoted that, while a significant part of the favorable capital marketconditions was likely to prove permanent, “a lack of flexibility inforeign exchange arrangements [put] individual emerging marketcountries at increasing risk of being tested through a speculativeattack on their exchange rate, combined with a potentially abruptloss of access, whenever there [were] uncertainties regarding thesustainability of macroeconomic policies and structural weak-nesses.” At the Executive Board discussion of the report, manyDirectors called for further analysis and recommendations on ap-propriate exit policies. A paper on this subject was prepared byDecember 1997, which stressed, inter alia, the importance of exit-ing “from a position of strength.”

11Cross-country historical data suggest that the pass-throughof an exchange rate devaluation to the price level is likely to besmaller if the initial real misalignment is substantial, and the de-valuation is supported by fiscal and monetary restraint. How-ever, Brazil’s unusual history of devaluation and pervasive in-dexation meant that the relevance of cross-country evidence wasquestionable.

12It is not clear whether the financial system was so well-hedged earlier in 1998, when many financial institutions engagedin the “carry-trade” by borrowing in dollars on the assumptionthat the crawling peg would be sustained until the election.

ANNEX 3 • BRAZIL

Problems in the state government-owned bankingsector and in federally owned banks (Banco do Brasiland Caixa Economica Federal) were more intractable.Directed loans and prolonged regulatory forbearancehad resulted in undercapitalized institutions with low-quality portfolios and operational inefficiencies. TheIMF argued for the privatization or closure of “state”banks as a means of enforcing fiscal discipline at thestate level. A restructuring scheme allowed states todeal with institutions under their control through pri-vatization, liquidation, transformation into a nonfi-nancial institution, or an approved restructuring plan.By the time of the 1998 program, staff judged that thegovernment had dealt comprehensively with the“stock” problem of the financial system in the states,and the risk that problems would reemerge had beenreduced by placing state banks under the same regula-tory framework as private banks.

Capital account developments andvulnerability indicators

Developments in capital flows, including the au-thorities’ efforts to influence such flows with changesin taxes and regulations, were covered in surveil-lance, but these issues were not a central focus of theanalysis. In response to comments from review de-partments, the staff appraisal of the 1996 Article IVconsultation did note that much current account fi-nancing was in the form of capital flows that werehighly susceptible to changes in investor sentiment.But elsewhere, the report downplayed these issues,taking comfort instead in an improvement in the“quality” of capital flows, noting that “volatile short-term flows” declined sharply, although the stock ofshort-term debt was still growing.13

Capital flow issues received greater focus in 1998,following the East Asian crisis. Management com-ments on a briefing paper in 1998 noted the impor-tance of closely monitoring capital flows, and theirpotential as a source of vulnerability, notwithstandingthe then strong foreign exchange reserve position.However, IMF staff was not fully informed of certainimportant indicators of vulnerability, including thecomposition of reserves, the extent of futures marketintervention, and the size and composition of short-term debt. In part, this reflected deficiencies in thecoverage of official data on short-term debt.

By early 1998, the IMF staff had become awarethat official estimates likely excluded certain cate-gories of short-term inflows, so that the stock of

short-term debt was being underestimated.14 It turnedout that much of the capital outflows that affectedBrazil between August and December 1998 werefrom sources that may not have been adequately re-flected in official short-term debt figures:

• “Leads and lags” in trade finance had built upstrongly in previous years, encouraged by arbi-trage between low international and high do-mestic interest rates, but this buildup was not re-flected in the official short-term debt figure.Reversals in “leads and lags” between Augustand December 1998 amounted to some US$10billion.

• After strong inflows in the first half of the year,there were outflows of US$6.5 billion fromfixed income funds, one of the weak areas of of-ficial figures already identified by staff.

• Another factor relates to “CC5 accounts,” that is,bank accounts denominated in local currency butfreely convertible to foreign currency. They wereformally only available to nonresidents, but banksalso offered their resident customers legal trans-actions through these accounts in order to takemoney out of Brazil. According to Central Bankreports, outflows of unregistered fixed income in-vestments of nonresidents through CC5 accountswere likely a significant component of outflows(Franco, 2000). Since the accounts were held bynonresidents, the balances in these accountsshould strictly have been included in externaldebt. To the extent that CC5 accounts were pri-marily a channel for outflows of resident capital,a broad assessment of vulnerability should havenoted the extensive outflows that had occurredthrough these channels in previous years.

In September 1998, the staff noted that a reliable as-sessment of the pressures on reserves was hamperedby gaps in information on short-term liabilities, lead-ing to an intensive dialogue and investigation onthese issues. Unlike Korea, however, these informa-tional weaknesses did not have a critical impact onassessing the likelihood that a crisis would occur. Inpart, this reflected the relatively large cushion of re-maining usable reserves (Figure A3.2).

There were also problems relating to the qualityof reserves, some of which staff only became fullyaware of during the intensive preprogram negotia-tions. These included:

• As of September 1998, some US$6.8 billion ofBrazil’s US$45.8 billion in reserves consisted of

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13There were numerous inconsistencies in the figures on short-term flows in the report, reflecting a lack of clarity in the data.For example, in medium-term projections, the stock of externalshort-term debt was shown as declining by US$6 billion in 1996when in fact it had grown strongly.

14In 1995, there was major discrepancy between short-termcapital inflows in the balance of payment (US$18 billion) and theincrease in short-term external debt (US$1.9 billion), which couldhave alerted the IMF to these shortcomings early.

Annex 3 • Brazil

holdings of Brazil’s own Brady bonds, valued attheir purchase price. Not only did these not con-stitute claims on nonresidents, but their marketvalue was lower and there were doubts abouttheir liquidity, particularly in a crisis when theymight be needed.

• Some US$5.8 billion of the reserves were held asdeposits in overseas branches of Brazilian banks,notably Banco do Brasil. Some of this was on-lent to exporters on greater-than-overnight matu-rities and so was not available for the authorities’use.

• The Central Bank’s futures position stood atabout R$35 billion in September 1998. A largefutures market position had been initiated ayear earlier, in September 1997, as the CentralBank intervened extensively, indirectly throughthe Banco do Brasil, to counter exchange ratepressures.15 From market sources, IMF staffquickly became aware of the possibility that theBrazilian authorities might be intervening in thefutures market through the Banco do Brasil, butfor a long time did not know the size of this po-sition. After being run down in the first half of1998, the position was substantially rebuilt inAugust and September 1998. The size of theposition was an important factor in assessingthe potential impact of a sharp exchange ratedepreciation on public debt, on the one hand,and on the financial and corporate sector, on theother. A further important consideration was theextent to which it posed a potential drain on re-serves. These considerations were analyzed in astaff paper at the time of the 1998 program,which concluded that as counterparties were al-most all residents hedging existing exposures,the unwinding of the Central Bank’s futuresbook did not pose a threat to official reservesdifferent from that posed by domestic liquidityin general.

However, in contrast to Korea, there was no disclo-sure of information that might have destabilizedmarket expectations.

Given the importance of informational issues inother capital account crisis cases, it is surprisingthat greater efforts were not made to obtain such in-formation earlier in surveillance. An initial effortby the IMF following the Mexican crisis to im-prove access to Brazilian data was not sustained. Inpart, this is the result of the IMF’s lack of authority

to compel disclosure of information, particularlywhen there was no program. The authorities werereluctant to disclose market-sensitive informationto the IMF because of the fears that it mightquickly lead to its dissemination to the market.While Brazil published a good deal of detaileddata, it was one of the few major emerging marketeconomies that did not subscribe to the IMF’s Spe-cial Data Dissemination Standard (SDDS). Formuch of the precrisis period, data on foreign ex-change reserves were only published with a lag ofabout seven weeks.

In this respect, recent initiatives may be beneficialin closing gaps in the information available to the IMFand to the markets, particularly concerning foreign ex-change reserves, provided that the SDDS is voluntar-ily complied with. The comprehensive “template” onforeign exchange reserves and potential drains on re-serves, which was added to the SDDS in 1999, and towhich Brazil now subscribes, would have required thedissemination of comprehensive detailed data on thecomposition and disposition of reserves, and the fu-tures market position, after only a short lag.

The situation is less clear for short-term debt,given the inherent difficulty of collecting such datacomprehensively in a timely manner. From March2003, the SDDS requires the disclosure of data onshort-term debt, and IMF guidelines for Article IVconsultations also note that there should be a discussion of any known shortcomings in the cov-erage of official data. Moreover, a new Guide hasbeen prepared by an IMF-chaired group of interna-tional agencies, providing comprehensive guide-lines for measuring and presenting external debt

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1994 95 96 97 98 99

Figure A3.2. Brazil: Foreign Exchange Reserves1

(In billions of U.S. dollars)

Sources: IMF database; Central Bank of Brazil; and IEO staff estimates.1Net of IMF and BIS-coordinated credit.

15One source of this pressure was the need for the offshore op-erations of Brazilian financial institutions to meet margin calls onaggressively leveraged positions in international assets, includingBrazilian Brady bonds.

ANNEX 3 • BRAZIL

statistics.16 These steps should contribute to thepublication of more timely and comprehensive dataon short-term debt in the future. However, the oper-ation of the SDDS to date suggests that a country islikely to be formally treated as in compliance if itpublishes timely short-term debt data, even if itscoverage or quality is lacking in some respects.

Impact of surveillance

The key themes of IMF policy advice during theprecrisis period were the urgency of fiscal adjust-ment and the need to boost competitiveness, typi-cally through more rapid depreciation of the crawl-ing peg. The extent to which these recommendationshad an impact on policy implementation was lim-ited. In practice, little was achieved in fiscal consoli-dation, with the consolidated public sector remain-ing in approximate primary balance—or running asmall primary deficit—between 1995 and 1998.Moreover, the modest exchange rate depreciation of7 percent a year was kept unchanged from March1995 until at least early 1998.

There were at least three reasons why the impactof IMF policy advice was limited. First, one expla-nation was the lack of effective dialogue between theIMF and the Brazilian authorities, particularly thoseat the Central Bank. Some participants interviewedby the evaluation team attributed this, at least in part,to the fact that the IMF did not back the Real Planwith a program, which made some of the architectsof the Real Plan less receptive to IMF advice. Ac-cording to staff, relations were satisfactory at theworking level, but a lack of endorsement from seniorlevels inhibited the flow of information from theCentral Bank, where the staff had limited direct ac-cess to sector experts.

On the central issue of exchange rate policy, theauthorities were generally unreceptive to outside ad-vice. Tensions within the Brazilian economic teamover exchange rate policy, in the early stages of theReal Plan, led to the resignation of a Central BankGovernor in early 1995. Subsequently, according tosome senior officials interviewed, discussion withinthe authorities of alternative exchange rate policieswas infrequent and limited. In this context, the IMFclearly faced significant challenges in influencingexchange rate policy.

The IMF made efforts to improve relations withthe Brazilian authorities from the mid-1990s, in partthrough providing technical assistance, and there issome evidence that the quality of dialogue—at leastwith the Finance Ministry—improved from about

1997 onward. Back-to-office reports in 1997 and1998 describe the dialogue with the authorities as“open and candid.” However, it also appears thatthere was some tendency to tailor advice at the mar-gins to build trust with the authorities, for example,in assessing exchange rate overvaluation. Accordingto some IMF staff members interviewed, the IMFwas inclined to give the Brazilian authorities thebenefit of the doubt, in part because it had earlierbeen too skeptical about the Real Plan.

Although IMF missions and contacts typically fo-cused on their direct counterparts in the Ministry ofFinance and the Central Bank, there were some ef-forts to reach out to other parts of the government.Owing to the centrality of state and municipal fi-nances to the key fiscal questions, surveillance mis-sions visited state and local governments. There wasalso some limited interaction with key members ofCongress with expertise in economic and financialissues. Broader and more formal interaction withCongress was viewed by the authorities as poten-tially counterproductive. Missions were aware ofprivate sector perspectives through market contactsin Brazil, and at times derived important informationfrom them, for example, on government interventionin futures markets.

Second, another reason why the impact of IMFadvice on economic policy was limited was the lackof transparency in these matters. Little or none of theIMF’s analysis of developments in Brazil was madepublic, apart from references in the World EconomicOutlook and International Capital Markets reports.

Virtually no analytical work on Brazil was pub-lished, given the sensitivity of the authorities, includ-ing the Brazilian Executive Director, to open discus-sion of policy issues involving Brazil. A higher-than-general degree of secrecy applied to Executive Boardpapers on Brazil, so that even staff reports for ArticleIV consultations were individually numbered andnamed to inhibit copying and leakage. There was alsoa high degree of sensitivity on the part of the authori-ties regarding the content of staff papers that, accord-ing to staff, inhibited the candid written expression ofstaff views, including to the Executive Board.

The IMF’s subsequent transparency initiativeshave enabled some progress to be made in this area.Even with these initiatives, however, explicit autho-rization from the authorities is required before thestaff’s detailed assessment and argumentation as ex-pressed, for example, in staff reports for the ArticleIV consultations may be released to the public. Al-though Brazil has agreed to the publication of PINsand Technical Memorandums of Understanding, ithas not yet agreed to the publication of staff reportsor the Financial Sector Stability Assessment.

Finally, a third reason why the IMF’s policy advicehad limited impact was the buoyant international cap-

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16The Inter-Agency Task Force on Finance Statistics, ExternalDebt Statistics: Guide for Compilers and Users (Washington: In-ternational Monetary Fund, 2002).

Annex 3 • Brazil

ital market conditions between mid-1995 and late1997. Private lenders and investors were willing to fi-nance the large current account deficit, irrespective ofthe IMF’s concerns on particular policy issues.Spreads on Brazilian bonds declined in line withglobal liquidity conditions, to around 400 basis pointsin October 1997 from around 1,000 basis points at thestart of 1996, although there was little evidence of im-proved macroeconomic fundamentals that would havewarranted this reduction (Figure A3.3).

Program Design

This section discusses major issues of program de-sign in the IMF-supported program, as agreed in No-vember 1998 and revised in March 1999 in light ofthe change in the exchange rate regime in January.

Support for the crawling peg

A central issue in program design was the decisionto proceed with a program in October–December1998, without substantial modifications to the ex-change rate system (while allowing for possible mod-ifications at the time of reviews). At an early stage informulating a possible program, management re-quested the staff to prepare a paper on the options forexchange rate policy. In this paper, staff recognizedthat the authorities would take all feasible steps toprevent a devaluation in advance of the presidentialelection, but believed that they might afterwards con-sider a modification within the context of an IMF-supported program. This and other papers indicatethat staff viewed greater depreciation as an essentialcomponent of a program and initially favored a com-bination of a faster crawl and a significant wideningof the band. Subsequently, program negotiations cen-tered on whether or not to accelerate the rate ofcrawl. From an early stage, staff preferred to avoid adiscrete devaluation (or float) for fear that it wouldresult in reindexation and reigniting high inflation. Incontrast, in the staff’s view, a faster rate of crawlcould improve competitiveness substantially, withless risk of rekindling inflation.

A preliminary understanding was reached duringthe 1998 Annual Meetings, immediately after thepresidential election, that the existing exchange rateregime could be maintained and that neither an up-front devaluation nor a float would be required, pro-vided that reserves did not fall too low.17 A jointpublic statement issued on October 8, 1998 empha-

sized the authorities’ “firm commitment to their cur-rent exchange rate regime” and IMF management’sfull support for that position. Nevertheless, IMF staffand management continued to press the authoritiesfor a faster monthly rate of crawl, a wider band, orboth, to achieve at least a 10 percent real deprecia-tion against the U.S. dollar in the first year of theprogram. The authorities strongly resisted accelerat-ing the rate of crawl, on the grounds that this wouldonly yield a marginal improvement in the alreadyexpected real depreciation and risked both destabi-lizing market expectations and dissipating domesticsupport for fiscal adjustment. Ultimately, the pro-gram announced on November 13 did not specifyany change in the rate of crawl.

There was considerable internal debate on ex-change rate policy within the IMF. RES suggested, inearly October, that management should consider thecircumstances in which Brazil should be encouragedto abandon the existing exchange rate policy. Someother review departments favored the option of main-taining the rate of crawl initially, but possibly acceler-ating it after a short delay when market conditionsmight be more favorable. These included PDR, whichsupported the authorities’ view that any change to theexisting policy would likely be counterproductive inthe aftermath of the Russian devaluation. A pure floatrisked overshooting and could lead to a devaluation-inflation spiral. The markets would be likely to judgeany “acceptable” step devaluation to be insufficient,and this would trigger further capital outflows.

The unstable global market conditions in August–December 1998 also had an impact on the decision

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0

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1993 95

EMBI BrazilEMBI composite

97 99 2001 03

Figure A3.3. Brazil and Emerging MarketsBond Index Spreads(In basis points)

Sources: JP Morgan Chase; and Datastream.

17In the event of unsustainable reserve pressure, the staff’s ini-tial tentative preference was for a discrete adjustment of the ex-change rate level, perhaps to the average 1994 level, followed bya renewed crawl with a wider band.

ANNEX 3 • BRAZIL

to maintain the peg. Staff interviews and internaldocuments suggest that there were three main as-pects. First, there was a view that an exit from thepeg under such circumstances would likely lead togreater exchange rate overshooting, and hence agreater risk of returning to high inflation, than anexit in calmer circumstances. Second, there weresystemic concerns about global liquidity followingthe Russian crisis and the Long-Term Capital Man-agement problems. In this context, maintenance ofBrazil’s exchange rate peg became identified withinternational stability. Finally, there was concern thatan exit from the peg under pressure could have a re-gional knock-on effect, particularly on Argentina.

The decision to support the peg was influenced bythe judgment that any overvaluation of the real wasmoderate, and could be offset by further real depre-ciation over a 9–18-month period, if the pace of thecrawl was accelerated. At a press conference follow-ing agreement on the program, management publiclycriticized the view that the exchange rate was over-valued by as much as 25 percent. Internal papersnoted that the 10 percent real depreciation the staffwas seeking over the first year of the program wouldbring the real effective exchange rate “close to its av-erage 1994 level.”

The IMF’s major shareholders were briefed on thestatus of negotiations with Brazil during the AnnualMeetings. The views of major shareholders on thesustainability of the peg diverged markedly. Accord-ing to staff interviews, the U.S. authorities, who inparticular kept close contact with IMF managementand staff, took the view that the Brazilian authoritiesshould not be forced to change the rate of crawl, al-though it would have been better to engage the sup-port strategy around an exit from the peg if Brazil hadbeen prepared to move. A number of other share-holder governments were in principle opposed tosupporting the peg. Although they were prepared toapprove the program when it was formally discussed,some Executive Directors expressed their frustrationat the lack of a discussion in the Executive Board onexchange rate issues before the key features of theprogram were determined.

The strategy to support the crawling peg wasknown at the time of adoption to be subject to con-siderable risk, although staff interviewed believed atthe time that the exchange rate regime probablycould be sustained for a period, given strong imple-mentation of the program. Ultimately, it was decidedto give the Brazilian authorities the benefit of thedoubt. The criteria for evaluating the decision there-fore should be: Did the decision have a reasonableprobability of success at the time? Were the condi-tions required for the success of the strategy cor-rectly identified and discussed frankly in the Execu-tive Board? In this context, did the IMF correctly

assess the ownership of the program, not only by thecounterparts with whom it was directly negotiating,but also by the wider political system? What werethe consequences of the failed attempt to support theexchange rate anchor, compared with the alternativeof a more immediate move to a flexible exchangerate regime in October or November 1998?

In our view, the probability of sustaining thecrawling peg was lower than IMF staff and manage-ment implicitly suggested to the Executive Boardand the wider public. In particular, the staff reportsupporting the request for the SBA was not fullyfrank about the risks that the program—and ex-change rate policy, in particular—faced,18 althoughthe Board discussion did highlight certain risks, par-ticularly to implementing the fiscal program. As dis-cussed below, the financing assumptions of the pro-gram were also overoptimistic, even allowing for thefact that they assumed that confidence would be re-stored rapidly.

The market’s initial reaction to the announcementof the program was favorable, although considerableskepticism remained about the medium-term credi-bility of the peg. The speed with which the programwent off track, however, resulted from a number ofadverse shocks. The staff paper for the program re-view in March 1999 identified these as delays in con-gressional approval of key components of the fiscalpackage, doubts about the commitment of the statesto meet their obligations to the federal government,and a premature and rapid reduction of interest rates.

These adverse developments resulted in part fromthe lack of broad ownership of the required support-ing measures by the wider political system and thecountry as a whole. For example, the failure of theCentral Bank to follow a sufficiently supportive mon-etary policy seems to have resulted from a lack ofownership of the monetary program at senior levelsin the Central Bank, however strong its ownership ofthe crawling peg was. Reportedly, contrary to an un-derstanding with the IMF, senior Central Bank offi-cials did not feel bound to consult with the IMF oninterest rate decisions. Concerns that interest rateswere being reduced too fast were apparent from thetime the Executive Board approved the program.

It is not clear if the IMF correctly judged thechanging priorities and commitment at the highestpolitical levels to maintaining the exchange rateregime. Initially, the ownership of the fiscal programwas underlined by a high-profile speech by the Presi-dent on September 23, 1998, just before the presiden-tial election, in which he outlined the tough fiscal

130

18For example, RES comments on the draft report noted thatthe tone was too glowing to be fully credible and the staff faceddifficulties in “squarely addressing the issue of the appropriatelevel of the real exchange rate.”

Annex 3 • Brazil

measures that would need to be undertaken early inthe second term. The President also expressed to IMFmanagement his commitment to the peg. Neverthe-less, the President’s commitment was subject to vari-ous political considerations. Powerful industrial cir-cles were pressing for a faster reduction of interestrates, abandonment of the exchange rate regime, anda more “developmentalist” policy approach. Accord-ing to some interviewed for the evaluation, a move toa more flexible exchange rate policy, linked with achange in the composition of the economic team, hadoriginally been planned for early in the President’ssecond term. No mention is made of these politicaltensions in internal papers seen by the evaluationteam, or papers for the Executive Board, until thestaff’s note on recent developments for an informalExecutive Board session in mid-December 1998.

The credibility of the IMF was clearly damagedby the rapid failure of a central element of the pro-gram. Some have argued that IMF support for the pegwas justifiable, even if it only postponed the collapseof the peg, including during the period of programnegotiations. International financial markets were ex-ceptionally nervous at the time in the aftermath of theRussian default and the Long-Term Capital Manage-ment crisis, and devaluation in Brazil would havetriggered major systemic effects. These considera-tions appear plausible and it is difficult to pronouncedefinitively on this issue. In retrospect, in view ofwhat actually happened, the IMF likely overesti-mated the adverse impact of an earlier exit. Our as-sessment is that an orderly exit, as part of an IMF-supported program, from a peg, which was widelybelieved to be unsustainable, would have had limitedsystemic impact. It is more difficult to say, however,what would have happened if Brazil had insisted onmaintaining the peg without the IMF support.

Some commentators have criticized the IMF-sup-ported program for helping to “bail out” the Brazilianprivate sector by allowing it to build a government-provided “hedge” against exchange rate depreciation,with serious consequences for the public sector debtposition. To the contrary, IMF staff and managementwere consistently critical of the authorities’ provisionof such a “hedge.” Moreover, as noted, most of the exchange rate hedge, in the form of exchange rate–indexed government securities and futures market in-tervention, was in place before the program wasagreed in November 1998. Between October and De-cember, the authorities substantially reduced their fu-tures market position (briefly to zero in early Decem-ber), and the proportion of securities linked to theexchange rate fell slightly. With renewed pressure onthe real, however, the Central Bank then rebuilt openfutures positions to US$10.5 billion (incurring a finalloss of R$8 billion) and used net reserves of US$13.7billion to defend the peg. The additional hedge that

was provided under the IMF-supported program wassubstantial, but it was made mainly during the finaldays of the peg and against the spirit of the program.

Fiscal policy and debt sustainability

Fiscal developments

The key fiscal issue in program design centeredon the sustainability of Brazil’s public debt. The ini-tial 1998 program stated that the main objective ofthe government’s fiscal adjustment program was tostabilize the ratio of net public debt to GDP at 47percent in the calendar year 2000, declining there-after (Figure A3.4). This was to be achieved throughhigher primary surpluses. Program projections,which assumed that domestic interest rates woulddecline to 17 percent by 2000 from an average 29percent in 1998, made allowance for substantial rev-enue from privatization to reduce net public debt, aswell as an allowance to recognize debt that had notpreviously been securitized.19

The revised program in March 1999 reaffirmedthat the main aim of fiscal policy was to ensure themedium-term sustainability of the public debt. Thesharp depreciation of the real in early 1999 had,however, substantially boosted the net public debtto GDP ratio to 52.2 percent in February 1999 from42.6 percent at end-1998. This reflected the revalu-ation of external debt and foreign exchange–in-dexed domestic debt, as well as the Central Bank’slosses on its open position in the futures market. Asa result, the target for the primary surplus wasraised to 3.1 percent from 2.6 percent of GDP inthe original program in 1999, with 3.25 percent in2000, and 3.35 percent in 2001.

The IMF-supported programs were critical in co-alescing support for a substantial and lasting im-provement in the fiscal stance. Program targets for asubstantial primary surplus were achieved in everyyear under the program, although the ratio of publicdebt to GDP increased markedly, from 34 percent ofGDP in 1997 to a peak of 62.5 percent in September2002, before falling back to 56.5 percent by the endof 2002. Indicative targets for the net public debtstock were frequently missed.

The root of the problem lay in the composition ofBrazil’s public debt, which now consists mainly ofdebt indexed to the short-term interest rate or the ex-

131

19 These so-called “skeletons” typically had their origins in im-perfectly transparent fiscal practices or in the suspension of in-dexation mechanisms under various historical stabilization plans.They included the recognition of losses related to the recapitaliza-tion of the workers severance payment fund (FGTS) and thehousing mortgage insurance/subsidy fund (FCVS). It was as-sumed that recognition of debt skeletons would be equivalent to1.7 percent of GDP in 1999 and 0.7 percent of GDP in 2000.

ANNEX 3 • BRAZIL

change rate (Figure A3.5). Following the Russian cri-sis, issuance of fixed-interest debt virtually stoppedas the yields rose substantially, and was replaced byissuance of interest rate–indexed debt as a way oflengthening maturity and thus to reduce the rolloverrisk.20 This, however, made the stock of public debthighly vulnerable to interest rate hikes. Moreover, thesubsequent depreciation of the real increased the do-mestic currency value of domestic debt indexed tothe exchange rate, issuance of which rose substan-tially following the Asian crisis as the markets beganto anticipate a devaluation of the real. Selling ex-change rate–linked debt also had the effect of miti-gating direct pressures on the exchange rate. In 2002,the growing debt burden, and increasing market con-cerns over whether it could be sustained, also led toan increase in the “Brazil premium,” related to therisk of potential default, although domestic debt wasnot affected as external debt was.

After the sharp impact in early 1999 resultingfrom the floating of the real, exchange rate deprecia-tion had only a moderate impact on the growth of thepublic debt stock in 2000 and 2001 (Table A3.2).There was a much greater impact in 2002, as thesharp exchange rate depreciation increased the netpublic debt stock by 9.5 percent of GDP. The effectof exchange rate changes on the debt stock was ap-proximately evenly divided between external debtand domestic debt indexed to the exchange rate. Pri-

vatization receipts also fell below projected levels.These receipts were equivalent to just 0.9 percent ofGDP in 1999, well short of the 2.9 percent of GDPprojected at the time of the 1999 program revision.

Conditionality

The original program included a performance cri-terion on PSBR and an indicative target on the pri-mary surplus of the consolidated public sector. In therevised program, it was the primary surplus—the fis-cal variable that was under the greatest control of theauthorities—that was instead subjected to a perfor-mance criterion. Indicative targets on the net debt ofthe consolidated public sector were also intro-duced.21 It was intended to take into account devia-tions from these indicative targets in finalizing per-formance criteria on the primary balance.

IMF staff pressed the authorities to reduce the pro-portion of domestic debt linked to the U.S. dollar, forexample, by rolling over a limited percentage of ma-turing securities. Rather than introducing a perfor-mance criterion, however, the IMF relied on specific,but informal, assurances from the authorities. TheIMF was concerned that specifying a performance cri-

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1995 Article IV

1997 Article IV

1996 Article IV

1999 revised

March 2001

August 2001

1998 SBA

1992 94 96 98 2000 02 04

Figure A3.4. Brazil: Debt SustainabilityProjections(Net public debt as a percentage of GDP)

Sources: IMF database; and Central Bank of Brazil.

0

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Fixed

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Inflation-indexed

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Figure A3.5. Brazil: Composition of FederalDomestic Securities1

Source: Central Bank of Brazil.1Held outside the Central Bank.

20 In terms of achieving these objectives, interest rate–indexeddebt was equivalent to exchange rate–indexed debt.

21There was a performance criterion in the original 1998 pro-gram, which specified a minimum level for the recognition ofpreviously unregistered liabilities, net of privatization receipts.From the March 1999 program revision, the indicative target forthe net debt of the consolidated public sector was automaticallyadjusted to the extent that debt recognition varied from the as-sumptions underlying the program.

Annex 3 • Brazil

terion for reducing the foreign exchange–indexeddebt, coupled with a binding floor on NIR, could ex-cessively tie the hands of the Central Bank with re-spect to the markets and make things worse if a lackof compliance with this target under unfavorable mar-ket conditions also forced an interruption in IMF dis-bursements. The authorities did at times make someprogress, as in the first half of 2000, but resorted tothe sale of dollar-linked securities when market condi-tions became more difficult, and failed to achievethese informal targets. At times, little alternative wasavailable to ensure the rollover of the domestic debt.At other times, however, a trade-off existed betweenthe cost of selling fixed rate securities—buying “in-surance” against the risk of future exchange rate de-preciation—and that of selling dollar-linked securi-ties, with a lower immediate interest rate cost, butwith the public sector bearing the risk of future depre-ciation. While a definitive conclusion can only bebased on the ex ante assessment of this trade-off in-volving probabilistic events, in the light of what actu-ally happened ex post, the IMF-supported programwould have been more successful in achieving its de-clared aim of reducing the debt-to-GDP ratio, therebyreducing the economy’s vulnerabilities, if it had in-cluded stronger incentives (e.g., through stronger con-ditionality) for reducing dollar-indexed debt, particu-larly during periods of favorable external conditions.

The primary surplus targets set in successive re-views were satisfied, often with some ease. How-ever, in some respects, these targets were unambi-tious and left insufficient leeway for the impact ofshocks. In particular, given the greater-than-ex-pected strength of economic activity in 1999 and2000, the fiscal targets proved to be less demanding

than was originally intended, and there was scope toachieve a larger surplus. In 1999, 2000, and 2001,fiscal targets were exceeded in the early part of theyear, but that was not sustained for the year aswhole. Seasonal factors played a part, but there wasalso a discretionary easing of expenditure restrainttoward the end of the year, once it became clear thatthe fiscal targets would be satisfied. Although theconsolidated net public debt deviated from the in-dicative targets at times and this triggered more am-bitious targets for the primary surplus, this processwas not automatic. Substantially more ambitious tar-gets would have been required to have a decisive im-pact on debt dynamics.

Sensitivity analysis

Staff papers for the 1998 SBA and its successor in-cluded analyses of debt sustainability and related sen-sitivity analysis. In many respects, these analyseswere more thorough than was common practice in theIMF at the time. Even so, they were not effective inpinpointing underlying vulnerabilities, owing to twokey factors. First, the analyses had a tendency to un-derestimate the degree of exchange rate depreciationrequired to produce a given degree of adjustment inthe external accounts. Second, there was a tendency toinvestigate only small deviations from the baseline as-sumptions, rather than the larger deviations that inpractice would have the potential fundamentally toalter the prospects for sustainability.

Recent proposals within the IMF to improve theassessment of sustainability through more demand-ing “stress-testing” offer some promise of redressingsuch shortcomings in the future.22 In the case ofBrazil, however, it is unlikely that more demandingstress testing would have led to major differences inprogram design. Even without such formal analysis,staff and the authorities were clearly aware that thecomposition of debt carried significant risks for debtdynamics.

The original debt sustainability projections inboth sets of programs were somewhat overopti-mistic, in particular about the likely extent of ex-change rate depreciation and its impact. Neverthe-less, despite the later recurrence of more intenseconcerns over debt sustainability, public debt sus-tainability problems were not sufficiently severe atthis stage to require a restructuring of public debt al-though, according to some market participants inter-viewed, there were expectations of such action forsome time following the floating of the real. Such ameasure would have had severe consequences forBrazil’s financial sector, and for future access to in-

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Table A3.2. Brazil: Factors Affecting Net Public Debt(In percentage of valorized GDP)1

2000 2001 2002

Primary surplus –3.4 –3.5 –3.4

Nominal interest 6.8 6.9 7.3

Exchange rate adjustment 1.6 3.0 9.5Indexed domestic debt 0.8 1.5 4.9External debt 0.8 1.5 4.5

Debt recognition 0.8 1.5 0.9

Privatization –1.8 –0.1 –0.2

Memorandum item:Net debt to GDP 48.8 52.6 56.5

Source: Central Bank of Brazil.1These ratios are expressed as a ratio of “valorized” GDP, that is, in prices

of December of each year.

22See, for example, “Assessing Sustainability,” SM/02/166, May2002.

ANNEX 3 • BRAZIL

ternational capital markets. In our view, these debtsustainability concerns could have been better ad-dressed by more prudent debt management policiesand possibly more ambitious fiscal adjustment.

Monetary policy

The initial program

Monetary policy in the initial program was in-tended primarily to be supportive of exchange ratepolicy. The monetary program incorporated a mech-anism through which a fall in international reservesbeyond the programmed level would be sterilizedonly partially, and progressively less than propor-tionately so. There was also an understanding thatthe authorities and staff would consult ahead of in-terest rate decisions or if there were a rapid loss ofnet international reserves.

The detailed specification of the monetary pro-gram was somewhat unusual, owing to the narrowmonetary base in Brazil (at the time just 4 percent ofGDP) and strong day-to-day and seasonal fluctua-tions. The NDA targets were specified as an averageof daily closing balances for each month, while NIRtargets were specified as end-month balances. Thesetargets would be adjusted to make allowance for un-certainty about how far the demand for base moneywould respond to the changes in the financial trans-actions tax (CPMF).

In the event, the program’s performance criterionfor the end-December 1998 level of NDA of the Cen-tral Bank was exceeded by a substantial margin. Theprogram envisaged some gradual easing of interestrates as confidence returned, but from the time theprogram was approved there was concern that inter-est rates were being prematurely and excessivelyeased. At the same time, there were also concernsthat high rates would not be sustainable because ofthe impact on public debt. The loosening of monetarypolicy (as reflected in lower interest rates) may havecontributed to the timing—if not the eventuality—ofthe collapse of the crawling peg.

With the loss of the exchange rate anchor, mone-tary policy needed to be reformulated as the authori-ties, in consultation with the IMF, sought to preventexchange rate depreciation from setting off an infla-tionary spiral. The interest rate increases that accom-panied and immediately followed the floating of thereal in January 1999 were moderate and tentative,and the exchange rate depreciated rapidly amid mar-ket concerns that a debt restructuring might be forth-coming (Figure A3.6).

IMF staff and management gave some considera-tion to the option of a currency board arrangement(CBA) in January 1999 and also discussed the possi-bility with the authorities. The authorities showed

little enthusiasm, and IMF management did not pushthe option, seeing strong country ownership as anecessary condition for a credible CBA.

Inflation targeting under the revised program

It was agreed to adopt an inflation-targetingframework for the medium term. In the interim, aninformal approach was adopted, with the ultimateaim of rapidly returning inflation to single digits. TheIMF encouraged the Central Bank to raise interestrates sharply to arrest and reverse the depreciatingtrend in the very near term. An increase in interestrates to nearly 40 percent at the start of February ledto an appreciation, but this proved only temporary.The exchange rate only stabilized decisively after theCentral Bank under the new Governor increased theovernight rate to 45 percent in March 1999 and theexpectations of a debt restructuring dissipated.

The revised program approved in March, 1999 pi-oneered the use of inflation targeting as the basis forconditionality in IMF-supported programs, eventu-ally introducing consultation mechanisms with staff,and ultimately the Executive Board, in the event thatthe rate of inflation went outside the Central Bank’starget bands (Fraga, 2000; Blejer and others, 2001).To assist Brazil’s transition to a new monetaryregime, the IMF organized a conference in Brazil todiscuss the experiences of other countries that hadintroduced inflation targeting and invited high-levelcentral bank officials from a number of countries.Brazilian officials interviewed indicated that theIMF had played a positive role in facilitating Brazil’stransition to inflation targeting.

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Interest rate: Selic rate(in percent; left scale)

Real–U.S. dollarexchange rate(right scale)

Jul. Sep. Nov. Jan. Mar. May Jul. Sep. Nov.1998 1999

Real floated Approval of revisedprogram recommended

Figure A3.6. Short-Term Interest Rate andReal–U.S. Dollar Exchange Rate

Source: Datastream.

Annex 3 • Brazil

The transition was somewhat controversial, how-ever. How to accommodate inflation targeting in anIMF-supported program was a subject of consider-able debate within the IMF. The conventional NDAand NIR targets pose potential conflicts with the in-flation-targeting approach, but some viewed them asuseful as a disciplining and monitoring device and atrigger for consultation. Others viewed them as un-helpful to the credibility and transparency of mone-tary policy, because of the potential conflicts and theneed, under inflation targeting, to maintain flexibil-ity to respond to price developments.

In the event, NDA targets were maintained as per-formance criteria in the early part of the 1999 pro-gram, while the IMF relied informally on the credibil-ity of the management team at the Central Bank whiledetails were worked out. There were concerns, how-ever, that the NDA framework might not be too help-ful in an environment characterized, as in Brazil, by asmall and volatile monetary base. Over time, uncer-tainties over inflation expectations and the impact ofchanges in CPMF created a willingness to revise theNDA framework in the course of program reviews.23

Eventually, when the new framework became fullyoperational, NDA targets were downgraded to an in-dicative target in the fourth review, a few months afterthe inflation targets had been announced.

The inflation-targeting regime was successful inreducing inflation to just 8.9 percent during 1999,well below initial expectations (see “Program pro-jections” below). A further reduction to 6 percentwas achieved for 2000, although energy-market de-velopments and the pass-through from exchange ratedepreciation later caused inflation to rise and exceedthe target bands by a substantial margin. Even so, theapproach has been an effective mechanism for con-tinued consultation between IMF staff and the mone-tary authorities, which represents a marked improve-ment over a simple discussion of whether NDAtargets had or had not been met.

However, using measured 12-month inflation rel-ative to target as a trigger for such consultations wasprobably too backward-looking. The arrangementwould likely have been more effective if a more for-ward-looking mechanism (such as projected infla-tion) had been adopted. In January 2000, the Execu-tive Board endorsed a review-based approach toconditionality where inflation-targeting was in oper-ation, which incorporated a forward-looking elementof this sort. This approach was not implemented inBrazil, in part because of a lack of agreement on themethodology for forecasting inflation and the poten-tial resource costs.

With a rapid stabilization of the exchange rate andearly signs of relative price stability, high interestrates did not have to be sustained for long and, giventhe relatively low level of corporate and householdleverage, did not produce the recession that hadwidely been expected. As a result of the rapid in-crease in the proportion of floating rate public debt,the major balance sheet impact of the high interestrates was borne instead by the public sector, whichalso bore the brunt of the balance sheet impact of ex-change rate depreciation.

Structural measures

The structural content of both the initial programand its revision was modest. Policy measures werealmost entirely drawn from the authorities’ existingpolicy agenda, and conditionality was limited tomacro-critical areas (see Appendix A3.1). This wasin strong contrast to the broad structural conditional-ity found in the East Asian programs, and in linewith the principles of streamlining conditionalityand focus on the importance of ownership that wereadopted following the experience in East Asia. Therelatively modest structural conditionality also re-flected the fact that many of the distortions relevantin Asia did not exist in Brazil, at least to the same ex-tent. Progress in structural reform, however, wasmixed under the programs.

The initial program comprised a range of struc-tural measures, including a Fiscal ResponsibilityLaw, structural tax reform, labor market reform, so-cial security and pension reform, and improvementsin financial sector regulation. Formal structural con-ditionality in the program, as revised in March 1999,was more limited in scope, although the authorities’agenda of structural reform was largely unchanged.In particular, although tax reform and labor marketreform remained on the agenda and were mentionedin the Memorandum of Economic Policies, they werenot subject to formal conditionality, in the form ofperformance criteria, structural benchmarks, or spe-cific conditions for completing reviews.24 Improve-ments in financial regulation, including progress onresolving state banks, remained an important area forstructural conditionality throughout the program andthere was significant progress. Structural conditionsincluded requirements for statistical improvements,as well as for better provision of data to IMF staff.

Implementation of structural reforms was mixed,even when this process was subject to formal condi-tionality. In successive program reviews, only aboutone-half of the program’s structural benchmarks

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23The monetary base ultimately increased by 23.6 percent dur-ing 1999.

24A draft tax reform law was submitted to Congress in Decem-ber 1998, satisfying the conditionality of the original program.

ANNEX 3 • BRAZIL

were met, often because of difficulty in securing con-gressional approval. For example, passage of the finalimplementing legislation for the administrative re-form was originally established as a structural bench-mark in November 1999, with a target date of Febru-ary 2000. After a long delay, Congress passed a lawin June 2001 to complete the administrative reform,but this was not signed into law by the President.

The most critical structural measure under theIMF-supported program was the Fiscal Responsibil-ity Law, which played an important role in achievingthe program’s targets for primary fiscal surpluses.The law established a general framework to guidebudgetary planning and execution, with disciplinarymechanisms for any failure to observe its targets andprocedures. The Fiscal Responsibility Law estab-lished prudential criteria for public indebtedness, de-fined strict guidelines for control of public expendi-ture, and established standing rules to limit budgetdeficits. It also forbade further refinancing by thefederal government of state and municipal debt. Arevised draft was submitted to Congress in April1999. After some delay, the law was finally approvedin May 2000. Other structural fiscal reforms werealso subject to delays, as the authorities sought con-gressional approval for program measures and, insome cases, encountered judicial problems.

Progress on pension reform to link the level ofpension benefits to the age and contribution historyof workers was also slow. For example, there wasconsiderable delay in the planned establishment ofcomplementary pension funds for new civil servantsto allow the capping of their pension benefits and theintroduction of social security contributions for re-tired civil servants.

From an early stage, the authorities saw reform ofthe system of indirect taxation as the most difficult ofthe pending reforms. The aim was to limit the scopefor “fiscal wars” among the states, reduce evasion,and minimize the distortions caused by “cascading”taxes, by streamlining a variety of existing federal,state, and municipal indirect taxes into a national VAT,to be shared by the various levels of government,complemented by a low retail sales tax and selectedexcise taxes. The legislation ran into difficulty in Con-gress and little progress was made, although succes-sive IMF missions continued to press the authoritieson the issue. It is unlikely that making the tax reform astructural benchmark would have led to substantiallygreater progress on the issue.

In our view, the concentration of structural condi-tionality on a limited number of macro-critical mea-sures was appropriate. The limited progress in struc-tural reform largely reflects the limits on Brazil’spolitical implementation capacity, rather than short-comings in program design. However, at the margin,slightly more ambitious structural conditionality

(possibly including central bank independence)would likely have reduced Brazil’s vulnerability toconfidence shocks.

Official financing and private sectorinvolvement

Official financing

Calculations in October 1998 estimated the fi-nancing gap for the remainder of 1998 and 1999 tobe some US$27 billion, even if there were a 100 per-cent rollover of short-term debt, no further disinvest-ment by nonresidents, and no further capital flight.The gap could be double that size, if short-term debtwas only partially rolled over and other drains oc-curred. RES, however, argued that some US$100 bil-lion in usable resources (including remaining re-serves) was needed to deter capital flight and toprevent the program from failing. This would implysubstantial additional financing from bilateral offi-cial sources or new money to be raised by the privatesector, in addition to the rollover of existing expo-sure. RES further argued that the program was notsufficiently financed to restore confidence.

In the event, the original program assumed that theoverall capital account balance for 1999 was US$33billion (Table A3.3). The package thus provided theIMF’s own resources of US$18 billion, supplementedby a further US$15 billion in bilateral loans arrangedthrough the BIS and a bilateral loan from Japan, andsupport packages from the World Bank and the IDBtotaling about US$4.5 billion each.25 Brazil drew onboth the IMF and BIS lines at an early stage in De-cember 1998, in part to demonstrate that the an-nounced bilateral support was indeed available, andnot subject to the problems that bedeviled the “secondline of defense” for Korea.26

The financing assumptions of the original pro-gram proved to be much too optimistic about howthe program and the support package would affectmarket confidence and private capital flows. Theeventual capital account balance for 1999 wasUS$15 billion, even though FDI was underestimatedby some US$11 billion. There was an eventual netoutflow of US$7 billion in 1999 in “other” medium-and long-term capital compared with a program pro-jection of zero, in part because medium-term amorti-

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25Of this total, SDR 3.9 billion was from the credit tranches,with the remainder made available under the SRF. An innovativefeature of the original program was that all SRF drawings afterthe first could be brought forward within a given quarter, subjectto a separate Executive Board review, but this feature was not re-tained in the revised program.

26There were, however, some doubts over the continued avail-ability of Japanese bilateral assistance at the time of the programrevision in March 1999.

Annex 3 • Brazil

zation due for 1999 was underestimated by aboutUS$10 billion.27 Short-term bank flows were unreal-istically assumed to be substantially positive. More-over, some US$9 billion of positive flows (excludingCC5 outflows) had to be assumed in the residual“other flows” category, in order to complete the fi-nancing picture.

The revised program in March 1999 incorporated asubstantially less optimistic external financing picturethan the original program. Overall, these projectionsproved to be too pessimistic, because they again sub-stantially underestimated FDI. Other components ofthe financing projections, showing moderate net out-flows of both short-term and medium-term capital,turned out to be broadly accurate.

The staff shared the view of the Brazilian authori-ties that new capital controls on outflows—such aslimits on purchases of foreign exchange in the so-called “floating market”—should not be used, since

they were unlikely to be effective for more than ashort time in a financial system as sophisticated asBrazil’s, and would have implications not only forBrazil’s future market access, but also for othercountries in the region. Moreover, they feared thatthe imposition of extensive capital controls by Brazilcould have adverse systemic consequences. Therewas some brief discussion within the Central Bankof imposing capital controls as the exchange ratecame under pressure in December 1998 and January1999, but this option was not seriously pursued (seeLopes, 2000).

The support package was not at first successfulon its own in catalyzing private sector flows, al-though it probably contributed to some diminutionin the pace of private outflows. However, once amore credible revised program was in place, privateflows recovered and permitted emergency supportto be repaid ahead of schedule. One feature thathelped the support package eventually succeed wasthe assurance of market participants that the supportwas ready to be used, with NIR floors set so as topermit the use of some of the support for interven-tion. In arguing for such floors, management notedthat, in view of the authorities’ insistence on main-taining the existing exchange rate policy and mar-kets’ apparent doubts about its viability, it would benecessary to reassure potential lenders that theirmoney would not be wasted in an all-out defense ofthe exchange rate.

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Table A3.3. Brazil: Financing Assumptions and Outturns(In billions of U.S. dollars)

1999__________________________________1997 1998 Revised_________ _____________________

Outturn Program Outturn Program program Outturn

Current account balance –33.3 –32.9 –33.6 –26.0 –16.5 –25.1

Capital account balance 25.4 19.7 15.9 33.0 5.5 14.5Investments 20.8 19.7 20.6 22.3 18.6 30.0

Of whichForeign direct investment 16.9 23.9 25.9 18.8 17.0 30.0

Long-term capital 18.6 31.8 35.8 5.8 –6.8 –4.1Multilateral agencies 1.6 2.6 2.7 5.2 5.8 3.0Other 17.0 29.2 33.1 0.6 –12.6 –7.1

Other –14.0 –31.9 –40.6 5.0 –6.3 –11.4Of which

Brazilian lending abroad –1.8 –2.6 –2.8 0.0 –0.2 –0.7Short-term bank lines –14.9 –7.5 –2.8 8.0 –2.0 –0.5CC5 accounts {2.8} –24.4 –24.8 –12.0 {–4.1} –10.4Other 2.6 –4.7 9.0 –0.7

IMF + bilateral support 0.0 10.2 9.3 11.7 15.5 3.0

Change in reserves (– = increase) 7.9 3.0 8.4 –4.6 –4.5 7.5

Source: IMF database.

27By the time of the revised program in March 1999, amortiza-tions of medium- and long-term debt for 1999 had been revisedup to US$45.7 billion from US$34.7 billion in the original pro-gram. Some of the medium-term debt flows that surged in thefirst half of 1998 had a maturity of just over one year in order tomeet new Central Bank restrictions on minimum borrowing peri-ods. At the time of the original program, official data on the debtstock, and hence the amortization schedule, had not been updatedto include them. Staff papers in the first half of 1998 emphasizedthe strength of medium-term flows, and thus drew too sharp a dis-tinction between short-term and medium-term capital flows.

ANNEX 3 • BRAZIL

Private sector involvement

The original program included limited voluntaryPSI. Even before the agreement was concluded, theIMF staff believed that it would be desirable to con-vince major creditor banks to maintain their exposure,possibly through concerted moral suasion by the Cen-tral Bank of Brazil and the authorities of creditorcountries. The possibility of using some of the supportpackage to catalyze “new money” was also consid-ered. The Brazilian authorities, however, resistedpressure from some shareholder governments to in-corporate mandatory PSI in the program. They be-lieved that mandatory rollovers were unnecessary andrumors of such arrangements could increase uncer-tainty and cause creditors to retreat. They feared thatthe implementation of a mandatory rollover wouldhave a long-lasting adverse impact on Brazil’s abilityto borrow. Nevertheless, they agreed to visit a numberof financial centers to approach creditor banks for vol-untary commitments to maintain trade and interbanklines for Brazil. A number of Executive Directors,particularly those representing some of the Europeanshareholder governments, indicated that their contin-ued support for the program at the time of later re-views would depend on the achievement of an ade-quate rollover rate for private lending.

The IMF quickly helped establish a monitoringsystem based on the Central Bank’s existing infor-mation systems. The coverage of the monitoringsystem was limited primarily to interbank lines,with direct loans to corporations typically not cov-ered. Initially, only the largest borrowing bankswere included. Moreover, although bank lendingwas an important component of Brazil’s stock ofshort-term debt, there remained many other poten-tial drains on Brazil’s reserves.

Although capital outflows did ease for a while, theimpact of these “road shows” was limited, largely be-cause of market concerns over the credibility of theprogram, and continuing fears that a more coerciveapproach to PSI might be introduced subsequently.Rollover rates for interbank credits varied between 65percent and 71 percent between December 1998 andFebruary 1999.

In March 1999, the revised program incorporateda renewed effort to obtain voluntary commitmentsfrom creditor banks to support Brazil, with the au-thorities again reluctant to impose a Korean-stylerollover. In the event, major commercial bank credi-tors agreed to maintain their trade and interbank ex-posure at the level of the end of February 1999through the end of August 1999. Although the com-mitment remained voluntary, greater official andpeer pressure was invoked than had been the case inNovember 1998. Four senior international bankerswere appointed to coordinate the private sector’s re-

sponse to the request. Representatives of the officialsector were present at a series of meetings in majorfinancial centers in early March 1999, where thecommitments were made. The IMF facilitated bymonitoring developments and providing informationand technical support. It also put some pressure oncreditors to agree, with the Managing Director pub-licly announcing that the effort to secure voluntarycommitments “would be a key factor in the consider-ation of the program by the Executive Board.”

The agreement on the voluntary commitmentsstabilized markets, and expectations of a potentialdebt restructuring dissipated. In part, this wasachieved by demonstrating to investors that bankersbelieved the revised program to be credible. The rel-atively light touch employed both by the authoritiesand the official sector, including the IMF, minimizedany negative impact on future lending to Brazil. Theagreement was not extended after it expired at theend of August 1999, but this did not result in a re-newed reduction in exposure.

The voluntary approach to PSI was effective andbroadly appropriate in the case of Brazil, and liquid-ity problems were rapidly overcome. In March 2000,the authorities indicated that, in view of the im-proved external position and outlook, they wouldrepay in advance the purchases made under the SRF,along with the outstanding amounts received underthe BIS-Japan facility, and would treat the IMFarrangement as precautionary.

Before the program could be completed, however,concerns over the external environment, includingdevelopments in Argentina, led the authorities todraw again on the arrangement and to agree on a fur-ther SBA. This arrangement was canceled in mid-2002 and replaced by a new arrangement, as worriesover policy continuity after the approaching elec-tions led to a large increase in spreads on Brazil’s ex-ternal debt and an interruption in private capitalflows. The success of the earlier voluntary approachencouraged a private-sector-driven effort to maintainlines in mid-2002, which helped mitigate capital ac-count pressures for a time.

Program projections

Staff projections turned out to be too pessimisticin both the original 1998 program and, to a greaterdegree, the March 1999 program, notably in terms ofgrowth projections (Table A3.4). This was a markedcontrast to the experience with the crisis countries inEast Asia. Criticism of overoptimistic projections inEast Asia influenced the projections adopted forBrazil. Even so, errors in the projections for bothEast Asia and Brazil reflect similar weaknesses inmethodology. Staff noted, however, the difficultiesposed for GDP projections by weaknesses in the na-

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Annex 3 • Brazil

tional accounts available at the time, which madereconciliation of external developments with de-mand and output forecasts highly uncertain.28

In the original program, output was expected tocontract by 1 percent in 1999, owing to front-loadedfiscal adjustment and high interest rates, before re-covering. Staff drew attention to factors that werelikely to operate in favor of a strong output perfor-mance, particularly the relatively sound banking sys-tem and low corporate leverage, as well as expecta-tions of strong FDI. Inflation was expected to remainlow. Import volume was projected to fall, because ofweak demand and some real exchange rate deprecia-tion. This would result in a narrower current accountdeficit of US$26 billion.

Macroeconomic projections were altered substan-tially when the program was revised. The forecast forreal GDP was brought down to an average decline of3.8 percent for the year, owing to weaker external fi-nancing than was expected, which would require asubstantial narrowing of the current account deficit.The depreciation was also expected to affect corpora-tions’ balance sheets, but little was known about theextent to which these were hedged against exchangerate risk. The Western Hemisphere Department(WHD) viewed the forecast as deliberately cautious,in order to convince the markets that the targeted fis-cal path was consistent with sustainable debt dynam-ics, even if output developments were adverse.

Many observers, both within the IMF and outside,including a number of Executive Directors, never-theless regarded the growth projections as opti-mistic, possibly reflecting the experience from EastAsia. Internal comments from review departments,as well as some Executive Directors, also stressedthat overoptimistic projections risked the program’scredibility. The IMF’s projection was broadly in linewith those of the Brazilian private sector, but someinternational analysts were even more pessimistic.

In the event, the IMF projections proved overlycautious, and real GDP grew by 0.8 percent in 1999.Stronger-than-expected capital inflows resulted in alower current account adjustment, and hence higheractivity. An important reason for this outcome wasthat there was no financial crisis and the corporatesector was not dependent on debt finance. Because fi-nancial institutions were likely overhedged, the depre-ciation of the exchange rate and temporarily elevatedinterest rates had a limited (and possibly even benefi-

cial) impact on private sector balance sheets, albeit atthe cost of a substantial increase in public debt.Growth was projected to recover strongly in 2000 and2001, as confidence strengthened and external financ-ing constraints eased. Although growth accelerated to4.4 percent in 2000, this was not sustained. Growthdeclined to just 1.4 percent in 2001, owing to energyshortages resulting from drought.

The outcome in terms of inflation was unexpect-edly good. In the revised program, the IMF projectedan “average” rate of inflation of 8.6 percent measuredby the consumer price index, and some 11–12 percentmeasured by the general price index.29 This was con-sistent with inflation of 17 percent December-on-December, measured by the latter index. In contrast,RES had argued in light of the Mexican experiencethat inflation could reach 50 percent and warned thatan inflation forecast of less than 25 percent wouldlack credibility. Outside the IMF, in February 1999,many international analysts expected inflation of over50 percent, with local banks typically expecting about30 percent.

Consumer price inflation, at just 4.8 percent onaverage, was much lower than the 8.6 percent pro-jected in the program.30 However, the general priceindex rose 20 percent during the year, slightly morethan projected, because of higher price increases fornontradables. Several reasons have been suggested

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28Quarterly national accounts broken down by expenditure cat-egories were not available. Moreover, constant price data on ag-gregate demand components were based on 1985 prices, whichprobably substantially overestimated the weight of the foreignbalance in real GDP. In addition, no historical series were avail-able on the functional distribution of income, or the distributionof income between households and the corporate sector.

Table A3.4. Brazil: Macroeconomic Projections(In percent change; in billions of U.S. dollars)

1998 1999 2000 2001

Real GDP1998 SBA 0.5 –1.0 3.0 4.0Revised 1999 0.2 –3.8 3.7 4.5Outturn 0.2 0.8 4.4 1.4

Current account balance1998 SBA –32.9 –26.0 –25.7 –24.7Revised 1999 –34.9 –16.5 –16.7 –17.3Outturn –33.6 –25.4 –24.6 –23.2

Gross fixed investment1998 SBA 0.7 –9.5 7.3 10.7Revised 1999 –0.7 –18.2 7.4 10.9Outturn –0.7 –7.6 9.6 –0.2

CPI1998 SBA (end-period) 2.7 2.2 2.2 2.2Outturn (end-period) 1.7 8.9 6.0 7.7Revised 1999 (average) 3.8 8.6 7.8 5.2Outturn (average) 3.8 4.8 6.2 6.8

Sources: IMF database; Central Bank of Brazil; and IEO staff estimates.Note: The documentation for the first and second program reviews pro-

vides projections for consumer price inflation only in terms of “period aver-ages” rather than end-period comparisons, as in the original program.

29The IGP-DI of the Getulio Vargas Foundation.30Measured by the INPC index. The 4.8 percent average was

equivalent to 8.4 percent, December-on-December.

ANNEX 3 • BRAZIL

for this lower-than-expected inflation, including de-pressed domestic demand, the beneficial impact of agood harvest, and the relatively closed Brazilianeconomy. Whatever the reason, the stabilization ofthe exchange rate and limited immediate pass-through prevented inflation from reaching a thresh-old that would have prompted reindexation.

Conclusions

This section summarizes our assessment of the roleof the IMF in Brazil’s capital account crisis of1998–99 by highlighting the major findings in precri-sis surveillance, program design issues relating to theinitial program of November 1998 (principally, thecore strategy of supporting the crawling peg), andthose relating to the revised program of March 1999.


The IMF’s diagnosis of the policy stance, particu-larly the mismatch between loose fiscal policy andtight monetary policy, was broadly correct, but therewere important shortcomings. Despite the persistentlarge current account deficit, early concern about theextent of overvaluation was increasingly down-played, as the IMF accepted the authorities’ views onproductivity gains and other mitigating factors. TheIMF’s policy advice should have placed greater em-phasis on the need for the authorities to move quicklyto a more flexible exchange rate regime, when the en-vironment was favorable for such an exit.

Insufficient attention was paid to the buildup ofshort-term debt, as inflows were attracted by the dif-ference between high domestic and low internationalinterest rates. There were also some weaknesses inthe IMF’s knowledge base with regard to indicatorsof vulnerability prior to the crisis. This was due inpart to limited transparency on the part of the author-ities, but staff might also have pursued data limita-tions further. In the case of Brazil, however, such de-ficiencies were probably not critical, either inprecipitating a crisis or in adversely affecting pro-gram design in response to the crisis.

The IMF paid considerable attention to bankingsector issues, although it played little role in the re-structuring process. By the time of the crisis, it hadanalyzed in detail the risks to the financial systemand rightly concluded that it was sound, with littleforeign exchange risk or systemic exposure to creditrisks.

The impact of surveillance on policy implementa-tion was limited and the policy dialogue between theIMF and the authorities was ineffective. In this re-spect, the IMF got the worst of both worlds. It hadlittle influence as a confidential advisor, while at the

same time having little ability to influence the widerdebate by publishing its views. Greater transparency,for example in publishing staff reports, would havecontributed to a more open public debate and greaterleverage for the IMF’s policy advice, notwithstand-ing the generally buoyant international capital mar-ket conditions.

The initial program

The decision to maintain the crawling peg was thesingle most important element of the original pro-gram. In the event, the peg soon failed, resulting insome loss of credibility to large-access IMF-sup-ported programs. In our view, the probability of sus-taining the crawling peg was lower than IMF staffand management implicitly suggested to the Execu-tive Board. A number of adverse shocks did con-tribute to the speed with which the program wentoff-track, including setbacks in securing congres-sional approval for some of the programmed fiscalmeasures and the failure to implement supportivemonetary policy as envisaged in the program. Morefundamentally, the failure of the central element ofthe program reflected limited ownership by thewider political system.

As the program lacked credibility in the markets,rollover rates on short-term debt remained modest de-spite a limited attempt at voluntary PSI. Under thesecircumstances, tighter monetary policy would proba-bly not have been sufficient to counter pressures onthe exchange rate regime. The IMF staff and manage-ment should have placed greater weight on concernsabout wider ownership and signaled these risks moreclearly to the Executive Board. It would have beenbetter if there had been more transparent discussion inthe Board before determining key features of the pro-gram, including exchange rate policy.

The decision to support the crawling peg in the ini-tial program only postponed the exit from the peg.The fear that devaluation might rekindle inflation waswidely held at that time, and it was not unreasonablefor the IMF to share that view. It has also been arguedthat, in the very uncertain international climate at thetime, this delay may have led to a less turbulent exitthan might otherwise have occurred. With the benefitof hindsight, however, our assessment is that the IMFoverestimated the adverse consequences of abandon-ing the exchange rate peg. An earlier exit from a pegthat was widely believed to be unsustainable wouldlikely not have had major systemic effects, particu-larly if the exit was made in an orderly fashion as partof the IMF-supported program.

A government-provided “hedge” largely pro-tected the Brazilian private sector from the effects ofexchange rate depreciation but had serious conse-quences for the public sector debt position. In prac-

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tice, this exchange rate hedge had been in place be-fore the IMF-supported program was approved, andIMF staff and management were consistently criticalof it. Following the approval of the program, how-ever, additional hedge was provided as the authori-ties rebuilt futures positions in an attempt to defendthe peg. The additional hedge provided under theIMF-supported program was substantial, but it wasmade largely during the final days of the peg andagainst the spirit of the program.

The revised program

The revised 1999 program played a significantrole in coalescing support for a substantial and last-ing improvement in the primary surplus. This fiscalretrenchment was crucial to the success of the latertransition to a regime based on inflation targeting andfloating exchange rates. Nevertheless, the ratio of netpublic debt to GDP rose substantially by 2002, ratherthan declining as was the central declared aim of theprograms. This was largely due to the debt composi-tion and greater-than-anticipated exchange rate de-preciation. The IMF encouraged the authorities totake advantage of favorable circumstances to reduceexchange rate–linked debt, including through infor-mal agreements to limit rollovers. It would have beenbetter to use stronger conditionality to generategreater incentives for the authorities to reduce theshare of exchange rate–linked debt, particularly whenthe external environment was favorable.

Stress-testing of the debt projections was morethorough than was common practice at the time,but did not foreshadow the deterioration in thedebt-to-GDP ratio that occurred in practice. Evenso, more demanding stress-testing probably wouldnot have led to major changes in program design,given the existing awareness of the risks that thedebt composition posed for debt dynamics. Moreambitious targets for primary surpluses would havecontributed at the margin to more favorable debtdynamics, but the required tightening would haveneeded to be substantially more ambitious to have adecisive impact.

The voluntary approach to PSI was broadly ap-propriate. The voluntary approach encouraged arapid return to international capital market access,which contributed to the repayment of much of thelarge official support package after a little more thana year. Factors affecting the initial success of the re-vised program included the flexibility to use some ofthe official support package to intervene in foreignexchange markets, and the abandonment of the ex-change rate peg while foreign exchange reserveswere still relatively high.

After the exit from the peg, substantially higherinterest rates accompanied by judicious interven-

tion were effective in arresting and reversing theexchange rate depreciation. There was little adverseeffect on the private sector, which was not highlyleveraged, although there was some impact on the public debt position. In any event, interest rateswere quickly eased once the exchange rate stabi-lized. The transition to inflation targeting was flexibly and successfully handled. However, themaintenance of NDA targets in the transition to aformal inflation-targeting framework added little tothe credibility of policy, while compromising its transparency, because such targets were incon-sistent with the authorities’ own policy formulationprocess.

Implementation of the program was generallygood, although there was some slippage on struc-tural benchmarks, particularly during 2000 and early2001, and some informal understandings were notfully implemented. Structural conditionality of theprogram was appropriately limited to a small num-ber of macro-critical areas, with much of the author-ities’ agenda of structural reform not subject to for-mal conditionality. The Fiscal Responsibility Law,eventually passed in the spring of 2000, made a con-siderable contribution to achieving fiscal discipline.Progress on pension reform was more modest.Progress in structural reform outside the scope ofIMF conditionality was limited under both the 1998and the 2001 programs. In particular, little progresswas made in reforming the tax system, and centralbank independence was not established. The limitedprogress in structural reform largely reflects the lim-its on Brazil’s political implementation capacity,rather than shortcomings in program design.

Program projections were too pessimistic with re-spect to output. The staff identified many of the fac-tors that had contributed to the better-than-projectedoutcome, including limited leverage and the strengthof the financial system but, in the light of experiencein the earlier Asian programs, projections were overlyinfluenced by concerns that they would lack credibil-ity if they were seen to be as too optimistic. Weak-nesses in methodology also contributed to this exces-sive pessimism.

Under the revised program, the IMF facilitatedBrazil’s transition to a more disciplined fiscalregime and a new monetary regime based on infla-tion targeting. However, fiscal adjustment turnedout to be insufficient to achieve the debt manage-ment objectives. With a composition of public debtthat was highly vulnerable to exchange rate and in-terest rate risks, Brazil remained vulnerable to ex-ternal and domestic shocks that affected marketsentiment. Underlying vulnerabilities were nevereradicated, and concerns over the sustainability ofBrazil’s public debt burden led to renewed difficul-ties in 2002.

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Appendix A3.1

142

1998 Stand-By Arrangement

1. Quantitative performance criteria:• Ceilings on the cumulative public sector borrowing

requirement.• Ceilings on external debt of nonfinancial public sector.• Ceilings on new publicly guaranteed external debt.• Floors on net international reserves (NIR) of the Central Bank.• Ceilings on net domestic assets (NDA) of the Central Bank.

2. Indicative targets:• Floor on cumulative recognition of nonregistered public

debt, net of privatization proceeds.• Floor on the cumulative primary surplus of the federal

government.• Indicative ceilings on total (public and private) short-term

external debt.

3. Prior actions:For approval.• An increase in the rate of the Financial Transactions Tax

(CPMF) to 0.38 percent to be under consideration inCongress by end-November 1998.

For completion of first review (i.e., no later than February 281999).• Enactment of revenue and expenditure measures sufficient

to give confidence that fiscal targets for 1999 were likelyto be met.

• Enactment of a constitutional amendment for socialsecurity reform, for both the private sector social securitysystem and federal public sector social security system.

4. Structural benchmarks:The program included a number of structural benchmarks.There were no structural performance criteria. Thebenchmarks included:By end-December 1998:

• Submission to Congress of draft legislation for the FiscalResponsibility Law.

By end-March 1999:• Submission of draft legislation for labor market reform.• Submission to Congress of draft constitutional

amendments for the structural tax reform.By end-May 1999:

• Submission to Congress of draft legislation to regulatethe social security reform.

By end-August 1999:• Submission to Congress of multiyear budget plan.• Implementation of administrative reforms in the social

security system.By end-December 1999:

• Enactment of the Fiscal Responsibility Law, structural taxreform, and complementary legislation for the socialsecurity reform.

• Resolution of most state-owned banks.• Regulation of banks’ market risk, based on Basel core

principles.• Implementation of a forward-looking loan classification

scheme.

By end-December 2000:

• Full compliance with Basel core principles, especially inrelation to provision of resources for supervision by theCentral Bank.

Daily data on international reserves would be provided toIMF staff.

Revised Program (First and Second Reviews),March 1999

There were a number of changes in the quantitativeperformance criteria in the revised program. The ceiling on the cumulative borrowing requirement of the consolidatedpublic sector was replaced by a floor on its primary balance.The indicative target on the primary surplus of the federalgovernment was eliminated and an indicative ceiling on netpublic sector debt was included. The performance criteria onthe floor on net international reserves of the Central Bank was replaced by a monthly ceiling on sales of foreign exchange.The indicative target on short-term external debt wasmodified to cover only public sector debt. Conditionality wasalso introduced requiring the central bank to refrain from new operations in foreign exchange futures or forwardmarkets. The revised list of quantitative conditionality thuscovered:

5. Quantitative performance criteria:

• Floors on cumulative primary surplus of the consolidatedpublic sector.

• Ceiling on external debt of nonfinancial public sector.

• Ceiling on new publicly guaranteed external debt.

• Ceiling on short-term external debt of nonfinancial publicsector.

• Ceiling on Central Bank foreign exchange sales.

• Central Bank exposure in foreign exchange futures market.

• Central Bank exposure in foreign exchange forwardmarket.

• Ceiling on NDA of the Central Bank.

6. Indicative targets:

• Ceiling on net debt of the consolidated public sector.

7. Structural benchmarks:

The revised program incorporated “an accelerated andbroadened structural reform and privatization effort.” Formal conditionality on structural reforms was littlechanged, however, with much of the authorities’ plans forstructural reform remaining outside its scope. There wereonly moderate alterations in the coverage of structuralbenchmarks and no structural performance criteria wereintroduced. Labor market reform and reform of the taxsystem were no longer included as structural benchmarks.In the case of the tax reform, this was because a proposalwas submitted to Congress in November 1998. Submissionof laws on pension reform were introduced as benchmarks.Requirements for improvements in bank regulation weremaintained essentially unchanged, apart from minor timingquestions.

Brazil: Selected Conditionality Under IMF-Supported Programs, 1998–2000

Annex 3 • Brazil

143

By end-May 1999:

• Submission to Congress of a law on the complementaryprivate pension scheme.

• Submission to Congress of an ordinary law on pensionsystem for private sector workers.

• Presentation to Congress of the Fiscal ResponsibilityLaw.

By end-August 1999:

• New regulation on foreign exchange exposure of banks.

• Acceptance of obligations under Article VIII, with atimetable for removing any remaining restrictions.

• Action plan for statistical improvements to permit SDDSsubscription.

• Implementation of administrative improvements in socialsecurity system.

• Submission of a multiyear plan to incorporateimprovements in the budgetary process.

By end-November 1999:

• Submission of an ordinary law on the pension system forthe public sector.

• Resolution of state-owned banks.

• Implementation of a forward-looking loan classificationscheme.

• Implementation of a capital charge related to market risks,based on Basel Committee recommendations.

8. Provision of data:

The list of specific high frequency data to be provided to theIMF was extended to include: gross and net reserves andtheir composition; the Central Bank’s foreign exchangefutures position; the maturity composition of federal debt;individual bank data on balance sheets and foreign-currencyand off-balance-sheet exposure for the 50 largest banks; andresults of debt auctions.

Third Review, July 1999

9. Quantitative conditionality:

A performance criterion on NIR was introduced (US$3billion below the baseline path) replacing the earlier ceilingon Central Bank foreign exchange sales.

10. Other:

Authorities agreed to regular weekly consultations withmanagement and staff on the conduct of interest rate policy;and on the interest rate response to a loss of NIR.

Fourth Review, November 1999


Reflecting the implementation of the inflation targetingregime, a consultation mechanism was introduced in theevent of deviations of inflation from its targeted path.Excesses beyond the inner band (+ 1 percent) would triggerconsultations with IMF staff about the proposed policyresponse; excesses over the outer band would suspenddrawings until the Executive Board had reviewed theauthorities’ proposed policy response. In consequence, it

was decided to make the end-December 1999 target forNDA an indicative target, rather than a performancecriterion. The consultation mechanism would continue to besupplemented by indicative targets for NDA for the first halfof 2000.

12. Structural benchmarks:The following benchmarks were introduced for 2000:By end-February 2000:

• Removal of Article VIII restrictions by lowering financialoperations tax on credit card purchases abroad to lessthan 2 percent.

• Begin implementation of INSS reform with new formulafor calculating pension benefits.

• Complete enactment and start implementation ofregulatory legislation for administrative reform.

• Enact Fiscal Responsibility Law.• Ensure enforcement of regulation on capital charge.• Develop implementation plan and schedule for global

consolidated inspections (GCIs) of commercial banks and savings banks.

• Complete audits of federal banks; make progress inpreparing a comprehensive strategy to strengthen thesebanks.

By end-June 2000:

• Make progress in resolution of state-owned banks;conclude privatization of BANESPA.

• Make substantial progress in implementing theprivatization plan, including privatizations of electrical andreinsurance companies, and sales of some minorityshareholdings.

• Issue regulations to implement a capital charge related toequity and commodity risks.

• Define a comprehensive strategy for timely strengtheningof federal banks.

By end-July 2000:

• Enact a system to tax oil products to offset revenueimpact of scheduled liberalization of oil market.

By end-December 2000:

• First GCIs under way or completed for most financialinstitutions.

• Complete resolution of most state banks, includingprivatizing BEM, BEG, BEC, BEA, BEP, and BANESTADO.

In addition, a number of statistical benchmarks forpublication of weekly data on reserves; publication ofquarterly national accounts; and fiscal and debt statisticswere introduced for end-June 2000.

Fifth Review, May 2000


The indicative targets on ceilings on NDA were discontinuedfrom June 2000.

14. Structural benchmarks:

Some of the structural benchmarks were postponed,reflecting delays in the congressional approval of reformlegislation. In the remainder of the program, structuralbenchmarks were concentrated on financial sector reforms.

Brazil: Selected Conditionality Under IMF-Supported Programs, 1998–2000(concluded)

ANNEX 3 • BRAZIL

Appendix A3.2

144

Brazil: Timeline of Major Events

Date

10/28/97 Asian crisis sparks sharp fall in equity prices and pressure on currency.10/31/97 Interest rates are doubled to 40 percent.11/13/97 Fiscal package is announced.2/9/98 Brazil reaccesses international bond market after Asian crisis.7/1/98 Pension system reform postponed after congressional setbacks.7/20/98 First press reports of Long-Term Capital Management difficulties.8/17/98 Russian default and devaluation.8/24/98 Measures taken to encourage foreign capital inflows.9/3/98 Special “Regional Surveillance” meeting of Western Hemisphere Finance Ministers and Central Bank Governors with IMF,

World Bank, and IDB concludes in Washington.9/4/98 Moody’s downgrades Brazil’s sovereign credit rating from B1 to B2.9/17/98 Brazilian government confirms discussions with the IMF.9/23/98 President Cardoso makes speech affirming need for major fiscal adjustment.10/4/98 President Cardoso reelected in first round.10/8/98 Joint statement by IMF and Brazilian authorities that discussions would continue on a detailed program of macroeconomic

and structural policies.10/20/98 Joint statement by IMF and Brazilian authorities, announcing agreement on fiscal targets for primary surpluses.11/11/98 Informal Executive Board meeting on structural elements of program.11/13/98 Agreement on a Stand-By Arrangement announced. Letter of intent published.11/16/98 Meeting in New York of Brazilian authorities, including presentation by IMF management, with U.S. bankers who indicate a

willingness voluntarily to maintain exposure if program is firmly implemented.12/02/98 IMF Executive Board approves US$18.1 billion Stand-By Arrangement.

Congress rejects increases in tax on pensions and in pension contributions.12/18/98 US$4.7 billion from the IMF, and US$4.5 billion from BIS and Japan disbursed.12/30/98 The Ministry of Finance announces tax package to compensate for delays in approving the CPMF and higher civil service

pension contributions.01/06/99 Governor of Minas Gerais declares 90-day moratorium on the service of his state’s debt to the federal government.01/13/99 Central Bank Governor is replaced. Narrow band replaced by “endogenous diagonal band.” Exchange rate depreciates by

9 percent as it falls to the bottom of the new band amid heavy reserve losses, which continue on 1/14/99.01/15/99 Real allowed to float.01/16–17/99 Finance Minister and new Central Bank Governor meet in Washington with IMF management and staff.01/18/99 Exchange rate float confirmed.01/19/99 Interest rate increased to 32 percent.01/28/99 Interest rate increased to 35.5 percent.01/29/99 Interest rate increased to 37 percent.02/02/99 Interest rate increased to 39 percent.02/02/99 Central Bank Governor resigns and a new Governor is appointed.02/04/99 Announcement by IMF of agreement in principle on key elements of the policy framework for the rest of 1999 and over

the medium term. Policies include a formal inflation-targeting system for the medium term, and transitional arrangementsusing monetary policy to reduce inflation to a single-digit annualized rate by the end of 1999.

02/10/99 Federal government pays installment on Eurobond issued by the state of Minas Gerais.02/26/99 New Central Bank Governor confirmed by the Senate committee.03/08/99 IMF Managing Director recommends approval of revised program; Memorandum of Understanding published.03/30/99 IMF Executive Board approves disbursement.07/02/99 Revised Technical Memorandum of Understanding published; Managing Director recommends approval.07/08/99 Government issues US$700 million in Eurobonds.09/14/99 Standard & Poor’s upgrades Brazil’s credit rating to BB–.3/1/00 Standard & Poor’s upgrades Brazil’s credit rating from BB– to BB.4/12/00 Brazil repays borrowing under the IMF Supplemental Reserve Facility and the BIS and Japan loan facilities in full and partly

ahead of schedule.5/4/00 Fiscal Responsibility Law signed into force.7/5/01 Central Bank announces steady “linear” intervention in the foreign exchange market.8/3/01 IMF Managing Director recommends approval of a new US$15 billion Stand-By Arrangement for Brazil through December

2002. The authorities indicate that they intend to treat the arrangement as precautionary.8/7/02 Agreement announced on a new 15-month Stand-By Arrangement with financing of an additional US$30 billion.

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———, 2000, “Reforming the IMF: Lessons from Indone-sia,” Central Banking, Vol. 11 (November), pp. 38–44.

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151

Memorandum from First Deputy Managing Director

Statement by Managing DirectorIMF Staff Response

Summing Up of IMF Executive BoardDiscussion by Acting Chair

Subject: IEO Report on the Role of the IMF in Recent Capital Account Crises

Thank you for the opportunity to review this excellent report. Attached are com-ments prepared by Mr. Geithner on behalf of Fund staff.

Attachment: Memorandum from Director, Policy Development andReview Department to Director, Independent EvaluationOffice, April 30, 2003

I would like first of all to express our appreciation for this first report examiningthe Fund’s important and often controversial role in resolving capital account crises.The report is well-researched, interesting, readable, and balanced, and will be a valu-able contribution to the learning culture of the Fund.

The report focuses mainly on the Fund’s involvement in the early stages of thecrises. While this phase clearly holds important lessons—and has been the subject ofmuch previous attention, both inside and outside the Fund—it is not the whole story.The current report would have been all the stronger, and provided greater value addedover existing literature, if it had focused, not just on the initial crises, but also the latersuccesses of the programs in restoring confidence, stemming capital outflows, andputting in place structural reforms that have reduced vulnerabilities.

The report provides useful recommendations about crisis prevention and manage-ment, but it also confirms the impression that every crisis is unique in the problems itposes. Anticipating and managing crises will always require difficult judgments in thecontext of great uncertainty. The Fund faced enormous analytical and practical chal-lenges as it sought to help the authorities deal with the onslaught of the crises exam-ined. Stemming these crises would have required that Fund staff invent innovative so-lutions to problems that were clearly well beyond its control, such as a lack ofadequate finaning from bilateral donors and creditors. We should not expect futurecrises to be any less challenging, even with the benefit of these experiences.

We generally support the report’s conclusions. Management has asked us to pre-pare a staff buff for the Board meeting that would relate the report’s conclusions andrecommendations to the staff’s current work. We look forward to Executive Boarddiscussion of the report and expect the Summing Up of the discussion will providethe basis for taking forward the report’s recommendations in the Fund’s work.

MEMORANDUM FROM FIRST DEPUTY MANAGING DIRECTOR

TO DIRECTOR, INDEPENDENT EVALUATION OFFICE,APRIL 30, 2003

155

156

The Independent Evaluation Office (IEO) is to becommended for its well-researched, balanced, andinsightful account of the Fund’s role in recent capitalaccount crises. Circulation of this report within theFund has already been helpful in disseminating thelessons for Fund practice and enhancing the learningculture of the institution.

On the whole, I welcome the recommendations inthe report. I have asked staff to prepare a statementindicating how we envisage taking up the report’s

recommendations in the period ahead, subject to theconclusions of the Board discussion. Given thewide-ranging nature of these recommendations,some of them will be raised in the context of policydiscussions that are already on the Board’s agenda,while others, related to the internal management ofFund staff, are in the sphere of management.

I look forward to Board discussion of these papers,which will provide the opportunity to draw out theirimplications for the Fund’s policies and procedures.

STATEMENT BY THE MANAGING DIRECTOR ON THE EVALUATION BY THE

INDEPENDENT EVALUATION OFFICE OF THE ROLE OF THE IMF IN RECENT CAPITAL

ACCOUNT CRISES

Executive Board MeetingMay 30, 2003

157

1. This report by the Independent Evaluation Of-fice on the role of the IMF in recent capital accountcrises presents many lessons for improving the effi-cacy of the Fund’s efforts at crisis prevention andresolution, complementing previous studies under-taken both within and outside the Fund. Followingup on the staff’s response to the report (SM/03/171,Sup 1),1 this statement addresses the report’s mainrecommendations. Board discussions are scheduledon many of the areas covered by the recommenda-tions, and staff will reflect the conclusions of the Ex-ecutive Directors on this report in staff documentsfor these meetings.

2. The report focuses mainly on the Fund’s in-volvement in the early stages of the crises. Whilethis phase clearly holds important lessons—and hasbeen the subject of much previous attention, both in-side and outside the Fund—it is not the whole story.Most dramatically, in Korea, economic activity wasrecovering vigorously by the second half of 1998—less than a year after the worst of the crisis—follow-ing the restoration of market confidence and a re-sumption of private capital flows which permitted asubstantial easing of policies; in 1999, real GDP re-bounded by nearly 11 percent. In Brazil, the situa-tion began to improve within a few months of theabandonment of the exchange-rate peg in January1999, with the restoration of voluntary capital flowsand some monetary easing in the context of infla-tion targeting; in 2000, growth reached over 4 per-cent. But with the immediate crisis over, the debtdynamics remained fragile, contributing to thecountry’s vulnerability when market pressures re-emerged in 2002. Even in Indonesia, where the cri-sis was more severe, progress was made in tacklingthe fundamental problems in the financial and cor-porate sectors as early as the second half of 1998and, as the government’s ownership of the IMF-sup-ported program strengthened and as the policiestook hold, the economy’s performance improvedmarkedly. The current report would have been all

the stronger, and provided greater value-added overexisting literature, if it had focused, not just on theinitial crises, but also the later successes and chal-lenges in restoring confidence.

3. While we agree with the general thrust of thereport, there are some specific issues on which thereport’s conclusions differ somewhat from our own.The Executive Summary focuses almost entirely onwhat went wrong, without giving any sense of howthe Fund responded to the challenges posed by thecrisis; it also fails to reflect the complexities of pro-gram ownership and implementation which areamply examined in the main body of the report. Asdetailed in the staff’s own extensive reviews of thecrisis cases, there are cases where we conclude thatprograms put in place at the outset of the crisescould have been improved. The IEO report echoesmany of these conclusions: while it is broadly sup-portive of the overall strategy followed, it notes anumber of aspects of the programs that did not workas planned. However, some of the report’s criticismsof initial judgments in program design do not in ourview provide a sufficiently complete sense of thefeasibility and costs of the alternative policy optionsavailable at that time.

4. Although the report provides an in-depthanalysis of the IMF’s policy advice, it does not suffi-ciently explore why these crises were so severe. As aresult, it overstates the contribution of individual as-pects of policy design to the intensity of the crises. Inthe case of Indonesia, for example, the report, partic-ularly the Executive Summary, could leave the im-pression that poor policy advice from the Fund (e.g.,relating to bank restructuring) was a major factormagnifying the severity of the crisis. However, whilewith hindsight some aspects of the program mighthave been designed otherwise, the basic policy re-sponse advocated to address the early stages of thecrisis was generally appropriate for the evolving cir-cumstances. In the event, a confluence of factorsoverwhelmed the early program, causing what wasinitially viewed as a mild case of contagion to degen-erate into a full-blown crisis. These factors included,most notably, a worse than expected deterioration ofthe crisis in the region; a complete loss of monetary

STAFF RESPONSE TO THE REPORT BY THE INDEPENDENT EVALUATION OFFICE

ON THE ROLE OF THE IMF IN RECENT CAPITAL ACCOUNT CRISES

Executive Board Meeting 03/50May 30, 2003

1This refers to the attachment to the memorandum from the FirstDeputy Managing Director, as reproduced on page 155. —Ed.

STAFF RESPONSE

control caused by massive liquidity support to thebanking system after the government decided againstclosing additional banks; uncertainty over the com-mitment of senior political authorities to the policyprogram; political uncertainty caused, amongst otherthings, by the President’s ill-health; and the dynamicand self aggravating instability caused by the massiveforeign exchange exposure in the corporate sectors

5. The report provides useful recommendationsabout crisis prevention and management, but it alsoconfirms the impression that every crisis is unique inthe problems it poses. Anticipating crises will al-ways require difficult judgments in the context ofgreat uncertainty, and the capacity to prevent themwill always depend principally on the actions of ourmembers. The authorities and Fund staff faced enor-mous analytical and practical challenges as theysought to deal with the onset of crisis. Policy makingduring the crises frequently involved painful trade-offs—notably those associated with countering mar-ket pressures on the exchange rate in the presence ofbank and corporate balance sheet weakness. Muchof the economic trauma that followed was unavoid-able and our collective capacity to contain the dam-age was limited by problems that were beyond thecontrol of the member and the Fund. We should notexpect future crises to be any less challenging, butwe will be able to benefit significantly from a sys-tematic effort to incorporate into the work of the in-stitution the experience gained from these cases.With these general thoughts as a backdrop, thisstatement considers each recommendation of theIEO report in turn.

6. Recommendation 1: To increase the effective-ness of surveillance, Article IV consultations shouldtake a “stress testing” approach to the analysis of acountry’s exposure to a potential capital accountcrisis. The staff supports this recommendation, es-pecially on the need to integrate various dimensionsof vulnerability assessments and stress testing intothe regular surveillance role of the Fund. Consider-able effort is now being made to bring stress testingand other analytical techniques to bear in the Fund’swork. For instance, stress tests are an integral partof FSAPs, the vulnerability exercise, and the debtsustainability framework (which the Board will re-view in June 2003). There may be other areas towhich it would be beneficial to apply this approach,such as in the area of liquidity risk and for low-in-come countries particularly vulnerable to externalshocks, both of which are the topic of forthcomingstaff papers. Issues regarding financial vulnerabili-ties will be addressed in an informal Board seminaron the balance sheet approach in June 2003 and fur-ther work incorporating analytical developments invarious areas will be undertaken in the context ofthe 2004 Biennial Surveillance Review (BSR). The

critical challenge of course is not simply to explorethe resilience and sustainability of a member’s pol-icy framework in the face of various types ofshocks, but to identify the types of policy actionsthat can be taken in advance and in the event of cri-sis to mitigate those risks. These issues should rankhigh in the hierarchy of surveillance priorities. A re-lated recommendation is that surveillance pay moreattention to social and political constraints on policymaking and on market perspectives on policies: theSeptember 2002 Guidance Note on Surveillancecalls for particular attention to be paid to these is-sues in Article IV consultations, and staff will fol-low this matter up in the BSR in 2004.

7. Recommendation 2: Management and the Ex-ecutive Board should take additional steps to increase the impact of surveillance, includingthrough making staff assessments more candid andmore accessible to the public and providing appro-priate institutional incentives to staff. Improving thefocus and candor of staff assessments and encourag-ing more systematic public release of staff reportsand the analytical work that supports them can im-prove the impact of surveillance. The staff sees con-siderable room for further progress in these areas.The Board will have the opportunity to address manyof these issues in its review of transparency policy inJune 2003. The issue of greater independence forteams conducting surveillance may be discussed bythe Board in the July 2003 discussion on fresh per-spectives in surveillance; the issue will be revisited inthe 2004 BSR.

8. Recommendation 3: A comprehensive reviewof the Fund’s approach to program design in capitalaccount crises cases should be undertaken. Programdesign obviously plays an important role in deter-mining the success of programs, recognizing that abroader range of factors ultimately plays the decisiverole. Balance sheet interactions and the uncertaintyassociated with projecting the path of key variablesin capital account crises are recognized as presentingimportant complications in the initial design of pro-gram strategy and reinforce the importance of usingthe flexibility provided in the program architectureto adapt the strategy as events unfold. Building onthe work undertaken since the emerging marketcrises of the 1990s, the staff have initiated an exami-nation of various dimensions of program design. Aspart of this effort, PDR is preparing a paper distillinglessons from capital account crises and the implica-tions for program design. This paper will give us theopportunity to explore in detail the various recom-mendations included in the IEO report. The need toincorporate better assessments of financial vulnera-bilities into staff analysis could be taken up at theJune 2003 Board seminar on the balance sheet ap-proach. The revised Guidelines on Conditionality, as

158

Staff Response

the IEO report recognizes, specify that conditional-ity should be streamlined and focused; the 2004 re-view of Conditionality will include an assessment ofimplementation of these new guidelines. Staff willalso continue undertaking internal reviews of the ex-perience with crisis cases, for instance with theforthcoming paper reviewing Lessons from the Cri-sis in Argentina.

9. Recommendation 4: Since restoration of confi-dence is the central goal, the Fund should ensurethat the financing package, including all its compo-nents, should be sufficient to generate confidenceand also be of credible quality. The level, terms,timeliness, and quality of official financing can becritical to the success of a program. The IEO offersvaluable reminders about the uncertainty and dam-age to credibility created by some of the official fi-nancing packages that were announced in associa-tion with Fund arrangements in past crises. The staffsupports the IEO’s recommendations in this context,although in some cases their implementation de-pends on the actions of other official creditors. Theperiodic access reviews, as well as the forthcomingreview (early 2004) of the experience in applying thenew framework for exceptional access decisions,will provide an opportunity to consider experience inthese areas in the future.

10. Recommendation 5: The Fund should beproactive in its role as crisis coordinator. The keyrecommendations offered by the IEO in this con-text—that management should play a more proactiverole in identifying circumstances where concertedefforts can be useful in overcoming “collective ac-tion” constraints, that management should providecandid assessments of the probability of success (ofa program), and that the technical judgment of thestaff should be protected from excessive political in-terference—are welcome. The specifics of theFund’s role will have to be determined on a case-by-case basis, but several recent cases offer valuable

lessons on how the Fund can be more effective inthis area. The new framework for exceptional accessdecisions provides a mechanism for encouragingmore systematic early consideration of circum-stances in which the success of a program would beenhanced by voluntary efforts to address collectiveaction problems among private creditors and wheresteps to address an unsustainable debt burden needto be part of a strategy to restore growth and finan-cial viability. Steps have been taken to strengthen theFund’s institutional knowledge in this area, includ-ing through the establishment of the InternationalCapital Markets Department, and the Capital Mar-kets Consultative Group provides an important newvehicle for improving the Fund’s dialogue with theprivate sector.

11. Recommendation 6: Human resource man-agement procedures should be adapted further topromote the development and effective utilization ofcountry expertise within the staff, including politicaleconomy skills, and to ensure that “centers of exper-tise” on crisis management issues allow for a rapidapplication of relevant expertise to emerging crises.The proposed approach for establishing institutionalarrangements to deliver a rapid response is, as the re-port notes, being reflected in the reorganization ofMAE (with steps taken to provide dedicated and con-sistent support on crisis resolution matters), as wellas recent changes within PDR (with the establish-ment of the Crises Resolution Issues Division), and isalso being taken up in the review of Area Depart-ments. Steps are being taken to ensure that staff havethe necessary political economy skills. A WorkingGroup is examining the role of resident representa-tives, including their involvement in surveillance andprogram design. The proposal to ensure that staff areprotected from complaints from the authorities iswelcome. Although there are no internal guidelinesin this regard, there may be a need for greater positiverecognition for candor.

159

General Remarks

Executive Directors welcomed the second reportof the Independent Evaluation Office (IEO report),which offers a comprehensive and thoughtful analy-sis of the Fund’s role in capital account crises inthree important country cases—Brazil, Indonesia,and Korea—and of the lessons to be learned fromthese experiences. They considered the report a use-ful complement to previous studies undertaken bothwithin and outside the Fund. Directors broadlyagreed with the report’s analysis and conclusions,which they found to be generally consistent withthose of earlier studies.

Directors stressed that several caveats need to beborne in mind regarding the findings and conclusionsof the report. First, the report focuses mainly on theFund’s involvement in the early stages of crises.Many Directors considered that the report wouldhave been more useful if it had also examined thelater successes and challenges in restoring confi-dence, stemming capital outflows, and putting inplace structural reforms that have reduced vulnerabil-ities. For example, in Indonesia progress was made intackling the fundamental problems in the financialand corporate sectors as early as the second half of1998 and, as the policies under the Fund-supportedprogram took hold, the economy’s performance im-proved markedly. It was recognized, however, that, insome cases, the IEO’s mandate not to interfere in on-going operations constrained the extent to which thereport could examine longer-term developments.

Second, the Fund has already taken steps in recentyears to address many of the concerns raised in the re-port, in areas such as transparency, conditionality,standards and codes, financial sector surveillance,vulnerability assessments, and Fund-Bank collabora-tion. While the report acknowledges these changesand seeks to identify additional areas for improve-ment, some Directors felt that its usefulness mighthave been enhanced if it had spent more time assess-ing the adequacy of the changes that have alreadybeen made. However, Directors acknowledged thatassessing how these changes might have affected theearlier crises would have been a complicated task.

Third, the report confirms that every capital ac-count crisis is unique. Thus, anticipating crises willalways require difficult judgments in the context ofgreat uncertainty, and distilling lessons from pastcrises is no guarantee of future success. Directorsstressed that there is no standard solution to capitalaccount crises; the nature and adequacy of the policyadvice will need to take into account the causes andspecific circumstances of each crisis, and the capac-ity to prevent crises will depend to a large extent onthe actions of member countries.

With these caveats in mind, Directors noted thatmost of the Fund’s efforts to anticipate or deal withthe three crises went in the right direction. Neverthe-less, they shared the report’s view that the Fundmade some mistakes, and that the crises highlightedthe need for improvements in the Fund’s policies andprocedures. Directors considered that the report hasprovided useful recommendations on how to furtherimprove Fund surveillance and program design, andon how to enhance the catalytic role of Fund financ-ing and the role of the Fund in coordinating crisismanagement and resolution.

Directors noted that the Board will have the oppor-tunity to return to many of the issues discussed in thereport during the forthcoming discussions on trans-parency, surveillance, financial soundness indicators,the balance sheet approach, information reporting re-quirements under Article VIII, data standards, andsustainability assessments. They encouraged manage-ment to address some of the issues related to person-nel policies.

Recommendation 1. To increase the effectiveness ofFund surveillance, Article IV consultations shouldtake a stress-testing approach to the analysis of acountry’s exposure to a potential capital accountcrisis.

Directors agreed that it is essential to strengthenthe focus and effectiveness of Fund surveillance byextending and systematizing assessments of crisisvulnerabilities. Surveillance discussions shouldidentify major shocks that the economy could face inthe near future, explore the real and financial conse-quences of these shocks—including balance sheet

THE ACTING CHAIR’S SUMMING UP

EVALUATION OF THE ROLE OF THE FUND IN

RECENT CAPITAL ACCOUNT CRISES

REPORT BY THE INDEPENDENT EVALUATION OFFICE

Executive Board Meeting 03/69July 16, 2003

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Summing Up by the Acting Chair

effects—and discuss the authorities’ plans for deal-ing with these shocks should they materialize. Direc-tors emphasized that, within the general frameworkthat has been endorsed by the Board, vulnerabilityassessments—and, in particular, stress testing—should not be over-generalized and exhaustive, butshould focus on the key risks and economic realitiesfacing the member in question. Furthermore, the as-sumptions underlying such assessments should beset out clearly to allow a proper interpretation of theresults and to help inform the prioritization of re-forms by authorities.

Most Directors agreed that the Fund should try todevelop a greater understanding of the political con-straints that may affect program implementation in acrisis, while cautioning that this should not lead tointerference in domestic affairs. Some Directorsstressed that this policy should be applied uniformlyto all countries facing capital account crises. A num-ber of Directors cautioned that a political economyfocus could be counter-productive if it causes staff tolose focus and press for policies and reforms that arenot macro-critical.

Given that restoring market confidence is essen-tial to successful crisis resolution, Directors stressedthe need for Fund staff to heighten their awarenessof market perspectives on economic policies. Theysaw great value in systematic discussions with thedomestic and international financial and businesscommunities, including through the InternationalCapital Markets Department, to better understandtheir concerns—but emphasized that the staff wouldneed to assess private sector views critically.

Recommendation 2. Management and the ExecutiveBoard should take additional steps to increase theimpact of surveillance, including through makingstaff assessments more candid and more accessibleto the public, and providing appropriate institutionalincentives to staff.

Directors strongly supported greater candor in theassessment of country risks and vulnerabilities in staffreports, building on the increase in candor that has al-ready occurred. The provision of institutional incen-tives to the staff to facilitate such candor also was en-couraged. Nevertheless, Directors expressed a rangeof views regarding the potential conflict between can-dor and transparency, and the implications of the pro-posed shift from voluntary to presumed publication ofstaff reports. Many Directors warned that greater can-dor could adversely affect both the Fund’s dialoguewith countries and market confidence in the contextof the publication of staff reports. Some of these Di-rectors felt that what really matters is candor in face-to-face consultations with the key decision-makers ina country, rather than in the staff report. Many otherDirectors strongly supported presumed publication.

These believed that concerns about candor are over-stated, and that surveillance would be more effectivein building ownership and influencing policy if Fundanalyses and recommendations are made public. Itwas agreed that the Board would return to the issue ofpresumed publication of staff reports during the dis-cussion on transparency.

Many Directors considered that escalated signal-ing—a procedure the report recommends to be usedwhen key vulnerabilities identified over severalrounds of surveillance are not addressed—might bean idea worth pursuing. A number of these Directorsreserved judgment on the suggestion until they hadmore information about how it would work. A fewDirectors felt that escalated signaling would under-mine the Fund’s role as confidential advisor, anddoubted that it would help in preventing crises or de-signing more effective programs.

Many Directors were not in favor of inviting sec-ond opinions from outside the Fund when the au-thorities disagree with the staff’s assessment on keypolicy issues. Whereas some Directors consideredthat a second opinion would bring a fresh perspec-tive that could help resolve differences of opinionswith the authorities, many were concerned that itcould encroach on the role of the Board, and under-mine the work of the staff. Furthermore, if extendedto program cases, it would slow the process of de-signing Fund-supported programs and impair theability of Fund-supported programs to resolve finan-cial crises. A few Directors also noted that this ap-proach has been tried and has failed.

Recommendation 3. A comprehensive review of theIMF’s approach to program design in capital ac-count crises should be undertaken.

Directors recognized that program design plays acritical role in the determination of program success.They looked forward to the forthcoming staff paperson program design and the balance sheet approach,which they hoped would give due attention to the is-sues raised in the report.

Directors agreed that the primary objective of acrisis management program should be to help restoreconfidence by implementing a comprehensive set ofpolicies that effectively address the root causes ofthe crisis. Directors noted that the Fund’s increasedattention to financial sector surveillance has reducedthe risk that vulnerabilities in the financial sectorwill be neglected in program design. At the sametime, many Directors also concurred that muchgreater attention needs to be paid to the interactionof balance-sheet weaknesses and key macroeco-nomic variables, including the implications for ag-gregate demand, especially in capital account criseswhere the possibility of multiple equilibria exists—although it was acknowledged that the estimation

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difficulties may be formidable. Several Directors re-iterated that the balance sheet approach should beclosely linked to debt sustainability analysis and, inparticular, to the implications of the currency andmaturity structure for the debt dynamics. Directorscalled for more analytical work to design a frame-work for dealing with “twin” (exchange rate andbanking) crises, including the implications for thesovereign’s policies and financial position.

Directors agreed that program design should allowfor a flexible response in case unfavorable outcomesmaterialize; that conditionality should be reviewed tosee how it can be adapted to the rapidly evolving cir-cumstances of capital account crises; and that, at aminimum, the broad outlines of the program shouldbe communicated to the public and the markets. Thisis crucial to strengthening ownership, the Fund’scredibility, and market confidence. Program docu-ments should fully set out the assumptions underly-ing the central projections, identify and explain as faras possible the risks to the program, discuss alterna-tive scenarios, and spell out explicitly how macroeco-nomic policies will respond in the event that knownprogram risks materialize. Directors noted the criticalimportance of country ownership in ensuring suc-cessful program implementation, and saw continuedvalue in a formal mechanism to trigger consultationon monetary and fiscal policies. They also stressedthe importance of designing programs to fit the par-ticular circumstances of individual countries. Never-theless, a few Directors cautioned against excessiveemphasis on risks and alternative scenarios in pro-gram documents, since it would be difficult to knowall risks upfront and since such emphasis could erodethe program’s effectiveness in building confidence inthe chosen action plan.

Directors supported the recommendation that acrisis should not be used as an opportunity to forcelong-standing reforms, however desirable they maybe, in areas that are not critical to the resolution ofthe crisis or addressing vulnerability to future crises.They agreed that parsimony and focus should be theprinciples to guide the design of structural condi-tionality in a program whose objective is to restoreconfidence quickly. Directors noted that this recom-mendation is in line with recent initiatives by theFund to streamline conditionality, and looked for-ward to reviewing the experience with the imple-mentation of the conditionality guidelines.

Recommendation 4. Since restoration of confidenceis the central goal, the IMF should ensure that the fi-nancing package, including all components, shouldbe sufficient to generate confidence and also of cred-ible quality.

Directors agreed that, to the extent that financingpackages supporting the member’s program rely on

parallel financing from official or multilateralsources, it is essential that the terms of such supportbe clear and the amount be adequate. However, theynoted that there are limits to the Fund’s influenceover the conditions for parallel financing, which re-flect the structure and organization of partner institu-tions. Directors fully supported the idea of movingtoward more explicit procedures for collaborationwith regional development banks and others andclear delineation of responsibilities, while notingthat such procedures do not by themselves guaranteeeffective coordination.

Directors observed that experience with capitalaccount crises raises important issues relating toFund liquidity, exceptional access, and private sectorinvolvement. They stressed that the policy on accessto Fund resources in capital account crises agreed inSeptember 2002 has to be observed. More funda-mentally, Directors stressed that the high quality andcredibility of a program, together with adequate fi-nancing, should be at the heart of successful Fundinvolvement.

Recommendation 5. The IMF should be proactive inits role as crisis coordinator.

Directors emphasized the importance of all mem-bers’ working together constructively during the pe-riod when a program is being negotiated. They notedthat, for the Fund to play an effective role in coordi-nating efforts of other members, management shouldprovide the Executive Board and member countrieswith candid assessments of the probability of suc-cess of a proposed strategy, including frank feedbackwhen parts of a strategy favored by some memberslower this probability; and they should protect thetechnical judgment of the staff from excessive politi-cal interference. While Directors were in favor ofearly involvement of the Board in program discus-sions, a number of them observed that the Board andmajor members should not seek to micro-managethe operational details of programs or influenceFund missions in the field.

Many Directors attached particular importance tothe early involvement of the private sector in crisisresolution. They emphasized that the authorities, notthe Fund, should play the leading role in negotia-tions with the private sector. However, they notedthat the Fund has a responsibility to identify circum-stances in which a more concerted effort is needed toinvolve the private sector, recognizing that decisionson the nature of such involvement will have to bemade on a case-by-case basis.

Recommendation 6. Human resource managementprocedures should be adapted further to promote thedevelopment and effective utilization of country ex-pertise within the staff, including political economy

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Summing Up by the Acting Chair

skills, and to ensure that “centers of expertise” on cri-sis management issues allow for a rapid applicationof relevant expertise to emerging crises.

Directors generally agreed on the need to ensurethat the Fund is in a position to respond rapidly withrelevant expertise to member countries facing crises.While recognizing that proposals related to organi-zational and human resource activities are amongmanagement’s responsibilities, Directors expressedseveral views on these issues. Some Directors sup-ported the creation of “centers of expertise” in crisismanagement, whereas others put greater emphasison mechanisms for drawing upon available expertiseand experience in the event of a crisis. A number ofDirectors favored longer country desk assignmentsto ensure that sufficient country experience is main-

tained within the staff, while others noted the impor-tance of staff mobility in broadening the experienceand perspectives of the staff and maintaining its im-partiality. Most Directors favored a greater role forresident representatives in surveillance and programdesign, in countries with resident representative of-fices, with a few noting that only relatively seniorresident representatives would be sufficiently ac-ceptable to the authorities to play such a role. Direc-tors also favored modifying internal guidelines andhuman resource procedures to create incentives forgreater candor. They noted that management is al-ready moving to improve the Fund’s crisis manage-ment capability—for example, through the reorgani-zation of the Monetary and Financial SystemsDepartment and the review of the area departments.

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