Figure 1:
Thai Equity Market Index
Weekly, January 3, 1997 –
March 5, 1999
Source: Bloomberg
Figure 2:
South Korean Equity Market Index
Weekly, January 3, 1997 –
March 5, 1999
Source: Bloomberg
INTERNATIONAL FINANCIAL CRISIS
By Moore, Terbeek, Thym
INTRODUCTION[1]
Recent events in the global financial marketplace have underscored how inter-linked the world’s economies really are. As information technology and media coverage have become ubiquitous, it is impossible for any country’s economy to “hide” from economic and political scrutiny. These economic interdependencies heighten the need for impartial, objective mediators to watch the world’s financial decision-makers.
But
what role should these organizations play?
Should they merely record and report the world’s economic transactions,
or should they play a more direct role in regulating and assisting these forms
of exchange? Should these institutions
promote free exchange or should they step in and help countries in need? The answers to these questions are quite
complicated and, not surprisingly, opinions of the world’s economic leaders
regarding these issues differ significantly.
The need for organizations like the International Monetary Fund (IMF) and the World Bank became evident during the Great Depression that rocked the world’s economies in the 1930s. The Depression was devastating to all forms of economic life; banks failed by the thousands, factories stood idle, ships waited indefinitely in their harbors for cargoes that never arrived, and millions of people searched for jobs that did not exist. This devastation also manifested itself in the world of international finance and monetary exchange. Many nations’ value of money was questioned as the gold standard was abandoned. Exchange became almost impossible between countries that remained on the gold standard and those that did not. Nations hoarded gold and freely-exchangeable currencies, further restricting the amount of monetary transactions between countries which eliminated jobs and lowered living standards. Other governments, desperate for foreign buyers of their goods and services, sold money below its real value to cheapen the apparent costs of their domestic products. In turn, this strategy was copied by other trading partners and the relation between money and goods became quite confusing. Similarly, the exchange rates between countries were questioned broadly. Under these conditions, the world economy continued to suffer and the prices of goods plummeted by 48% and the value of international trade dropped by 63%.
In order to establish world economic and financial order as a result of the Depression, delegates of 44 nations founded the IMF and the World Bank during the Bretton Woods Conference in July 1944. The delegates of the conference consciously established a division of labor between the organizations and granted them separate charters. However, these organizations share many common elements and are quite often confused by the general public. For example, both are owned and directed by their member nations (virtually all countries are members) and both institutions focus on economic issues and attempt to strengthen and grow the economies of their member nations.
Despite
these similarities, the organizations perform very distinct tasks. The IMF is a cooperative organization that
attempts to maintain an orderly system of payments and receipts between
nations; in essence promoting fluid exchange mechanisms to promote free
trade. The World Bank focuses primarily
on helping to develop countries’ economies.
Each institution “has a different purpose, a distinct structure,
receives its funding from different sources, assists different categories of
members, and strives to achieve distinct goals through methods particular to
itself.”[2] Below, each of these institutions is
explained in greater detail.
The
international community established the IMF as a reaction to the unresolved
financial issues that initiated and prolonged the Great Depression of the
1930s. These issues included sudden,
volatile and unpredictable variations in exchange rates between national
currencies and a widespread disinclination among governments to allow their
currencies to be exchanged for foreign currencies. “Set up as a voluntary and cooperative institution, the IMF
attracts to its membership nations that are prepared, in a spirit of
enlightened self interest, to relinquish some measure of national sovereignty
by abjuring practices injurious to the economic well-being of their fellow
member nations.” [3]
This
goal is accomplished by a set of institutional rules. These rules, signed by all members, include a code of conduct
that requires all members to allow their currency to be exchanged for foreign
currencies freely and without restriction, to keep the IMF informed of changes
they contemplate in financial and monetary policies that will affect fellow
members’ economies, and, to the extent possible, to modify these policies on
the advice of the IMF to accommodate the needs of the entire membership.
To help
nations follow these rules, the IMF administers a fund of money that member
banks can borrow from when they are in trouble. However, this is not the IMF’s primary purpose. The IMF is an overseer of its member’s
monetary and exchange rate policies and a keeper of the code of conduct. The IMF receives frequent reports from its
members concerning their policies and prospects. It debates, comments on, and communicates its findings and
opinions to its entire membership so that all members have full disclosure on
the relevant issues and can understand how these issues may affect their
economies.
The IMF
is relatively small, housing only 2,300 staff members. Its professional staff is comprised of
mostly economists and financial experts and its headquarters are located in
Washington D.C.
While
the IMF is not a bank (like the World Bank), it does administer a large sum of
money that is presently valued at over $215 billion. These revenues are derived from member fees paid in by the 182
member nations. These fees are
determined in a proportionate manner to economic size and strength. The IMF acts like a credit union at
times. Members are able to access
resources equal to their total contributions in times of need.
All
member nations have the right to financial assistance from the IMF. This assistance typically comes in the form
of balance of payment relief. In order
to maintain an orderly and efficient international monetary system, the IMF
requires all members to fulfill their financial obligations to the other
participants. If a member country
cannot fulfill its obligations because of a shortage of foreign exchange, this
country may borrow from this pool in order to complete its pending transaction.
Money
received in these transactions must be repaid within three to five years, and
no longer than ten years. Interest
rates are slightly lower than market rates, but are still meaningful enough to
require timely retirement. Through the
use of these IMF funds, member countries are theoretically able to buy time to
fix their economic policies and to restore growth without having to undertake
drastic actions that could be harmful to other members’ economies.
The IMF
operates in three main ways. First, the
institution urges its members to promote and respect currency exchanges without
restrictions. Currently, there are
about 115 member nations that have agreed to full convertibility. Second, the IMF oversees the economic
policies that influence its members’ balance of payments in the presently
legalized flexible exchange rate environment.
The goal of this monitoring is to detect early warning signs of any
exchange rate or balance of payment problems.
Third, the IMF continues to provide short and middle term financial
assistance to member nations that run into temporary balance of payment
difficulties. The IMF believes its role
in these cases is not to subsidize further deficits, rather it is to help a
country transition to living within its own means.
When a
country is in trouble, it can turn to the IMF for consultative and financial
assistance. Working together, the
country and the IMF attempt to isolate the root causes of the balance of
payments problem. Once the causes are
identified, the country and the IMF will collaborate to design a program aimed
at restoring the country’s financial matters.
However,
reorganizing the nation’s economy to implement these reforms is disruptive and
not without cost. Therefore, the IMF
will lend money to subsidize policy reforms during hard periods of
transition. To ensure the money is
invested properly, the IMF works closely with the country and provides
technical assistance and further consultative advice as necessary.
Finally,
the IMF also helps by providing technical assistance in organizing central
banks, establishing and refining tax systems, and setting up agencies to
gather, analyze and publish economic statistics. The IMF is also authorized to issue special money, called the
special drawing right (SDR), in order to provide its members with additional
liquidity. The SDR can be retained by
members as part of their monetary reserves or be used in place of national currencies
in transactions with other members.
Each
member nation is required to contribute funds according to its economic size
and strength. In proportion to their
the funding requirements, nations are awarded votes which determine the overall
policy of the institution. All members
receive votes. However, the voting
results often follow a block pattern that is typical in geopolitical contexts. The table on the following page analyzes
which countries and blocks of countries have the largest voting power.
|
Country |
Voting (%) |
|
United States |
20.6% |
|
All of Europe |
30.4% |
|
European Union |
24.5% |
|
Asia |
9.9% |
|
Latin America |
7.2% |
|
Rest of World |
31.9% |
While
the largest block of votes resides with the Rest of World countries, they are
geographically, politically, economically and religiously diverse. We expect small sub-groups could bind
together and vote as a block, however we do not expect them to garner much
momentum or support form the other nations.
Europe is the most interesting group of countries. As of January 1, 1999, the European Monetary
Union is now official (the currencies have all been permanently pegged to the
Euro). This united economic block has a
coordinated monetary policy now.
Therefore, it is not a stretch to believe this group may vote as a block
on IMF issues. If this happens, the EU
will have the most power and votes. If
they can gain support from other countries, similar to the U.S. in the past,
then they can emerge as a new driver of policy initiatives. All member nations will have to consider
this when interacting with the IMF in the future.
Purpose
The
World Bank’s formal name is The International Bank for Reconstruction and
Development (IBRD). The World Bank is
primarily responsible for financing economic development. Its central purpose is to “promote economic
and social progress in developing countries by helping to raise productivity so
that people may live a better and fuller life.”[4]
The
World Bank made its first loans to war ravaged Western Europe just following
WWII to help finance these economies’ reconstruction. As these nations were recovering, the World Bank turned its
primary attention to helping the world’s poorer nations. Since the 1940s, the World Bank has loaned
more than $330 billion to these developing countries.
The
World Bank’s structure is much more complex than the IMF’s structure. The World Bank consists of two
organizations, the International Bank for Reconstruction and Development and
the International Development Association (IDA). Also, the International Finance Corporation, which raises funds
for private enterprises in developing countries, the International Center for
Settlement of Investment Disputes and the Multilateral Guarantee Agency are
associated with, but separate, from the World Bank.
The
World Bank has over 7,000 employees in over 40 offices around the world,
although 95% of the staff is in Washington D.C. The Bank has a very diverse employee base, ranging from
economists to lawyers, to statisticians, to experts in telecommunications,
water treatment and health care.
The
World Bank serves as an investment bank, brokering between investors and
recipients, borrowing from one and lending to the other. The 180 member governments own equity stakes
in the Bank and its current valuation is over $175 billion. The Bank obtains most of the funds that it
lends to its member nations by borrowing through the issuance of AAA bonds that
are guaranteed by the member governments.
The proceeds of these bond sales are lent in turn to developing
countries at affordable rates of interest to help finance projects and policy
reform programs that are deemed necessary.
The IDA is financed mostly by grants from member countries.
The World Bank lends only to creditworthy governments of developing nations. The poorer the country, the more favorable the conditions under which it can borrow from the Bank. These loans carry an interest rate slightly above the market rate at which the Bank itself borrows and must be repaid within 12-15 years. The IDA focuses on very poor developing countries whose per capita GNP is below $1,305. These loans are interest free and have a maturity of 35 or 40 years.
The
World Bank exists “to encourage poor countries to develop by providing them
with technical assistance and funding for projects and policies that will
realize the countries’ economic potential.
The Bank views development as a long-term, integrative endeavor.”[5]
The
Bank focuses most of its efforts on funding projects that can directly benefit
the poorest people in a developing country.
The direct involvement in economic activity is being promoted through
lending for agriculture and rural development, small-scale enterprises, and
urban development. The Bank is helping
the poor to be more productive and to gain access to such necessities as safe
water and waste-disposal facilities, health care, family-planning assistance, nutrition,
education and housing. The World Bank
provides most of its assistance to developing countries by supporting specific
projects.
Every
project financed by the Bank is designed in close collaboration with national
governments and local agencies, and often in cooperation with other multilateral
assistance organizations. In fact,
about half of all Bank-assisted projects also receive cofinancing from official
sources, such as governments, multi-lateral financial institutions,
export-credit agencies that directly finance the procurement of goods and
services, and private sources such as commercial banks.
While
making these loans, the Bank does not compete with other financing
sources. It will only assist projects
where capital is not available from other sources on reasonable terms. The goal of the Bank is to help these
developing countries graduate from needing special assistance. At this point, these countries would be able
to raise funds for undertaking key projects from conventional sources of
capital. Over the life of the IBRD and
IDA, 34 poor countries have borrowed money from the IDA. More than 24 have made enough progress for
them to no longer need IDA money, leaving more resources for many new members
who have recently joined. Similarly,
over 20 countries that borrowed from the IBRD.
The
Bank also helps developing countries with macroeconomic analyses and
strategy. As the Bank studies its
member nations in order to effectively disburse loans, it learns which sectors
are best and worst off. It can then
help these countries by designing policies to invigorate these nascent sectors.
Background
The
Asian crisis differs from previous crises in many respects. Unlike the typical situation in which the
IMF’s assistance is requested, “this crisis did not result mainly from the
monetization of fiscal imbalances and only in Thailand were there substantial
external current account imbalances.”[6] As a broad generalization, the crises in
East Asian countries were the result of interaction among shortcomings in the
global system, flawed national financial systems, and deficient corporate and
public governance. As global financial
markets developed, especially in the early 1990s, capital was attracted to East
Asia in large part because of exceptional record of growth and macroeconomic
management. However, serious weaknesses
that had been concealed in part by the magnitude of the flows, and in part by
the inadequacy of risk assessment by foreign creditors and weak supervisory
practices in some creditor countries, eventually came to light with the onset
of the crises. The crisis was not
overnight in the making. Its approach
had been overshadowed and concealed by the economic boom in the area. Weaknesses in governance in the corporate,
financial and government sectors, which made these Asian economies increasingly
vulnerable to changes in market sentiment, a deteriorating external situation
and contagion all contributed to the crisis.
The
combination of these long-term trends led to the most critical weakness – the
immediate cause of the crisis – the accumulation of very large amounts of
short-term debt. In the years prior to
the crisis, “large capital inflows contributed to a variety of problems
including overinvestment, inflated domestic asset prices and deteriorating loan
quality. These weaknesses in return
reflected more fundamental problems, including weak domestic bank supervision
and regulation, a history of interference and the lack of sound commercial
standards in the allocation of credit and pervasive explicit or implicit
government guarantees.”[7] Short-term capital inflows were also drawn
in by the perceived implied guarantee represented by the exchange rate regimes
that were viewed as de facto pegs.
Adding to these inherent problems in East Asia, the method by which capital flows were liberalized contributed to weakness in the financial sector. Through this liberalization, banks and corporations gained unprecedented ready access to large amounts of short-term external borrowing that was not adequately monitored by authorities. At the same time, longer-term capital inflows were liberalized more gradually and deliberately. The consequence of sudden, rapid liberalization of short-term capital inflows and the slower, more deliberate liberalization of long-term capital inflows made countries in East Asia highly vulnerable to sudden shifts in investor sentiment.
“The domestic vulnerabilities came to a head as growth slowed in 1996, largely as a result of adverse terms-of-trade shocks, a loss of competitiveness associated with currency pegs that were maintained in the face of sharp dollar/yen appreciation, declining export demand and growing over-capacity in certain sectors.”[8] In Thailand, the first crisis to “blow up,” the developments were reflected in a widening current account deficit (see Table 2). Added to that, Thailand already had a relatively large fiscal imbalance going into 1996. The policy responses in early 1997 were not adequate. The slowdown in Thailand’s economy, in turn, was reflected in sharp declines in equity and property prices, which aggravated financial sector weaknesses and acted as a further brake on growth. Finally, the crisis began in the financial sector because of excessive maturity mismatches in balance sheets. Much has been written about what happened in Thailand, Indonesia and Korea. A brief summary of events leading to the crisis and policies implemented for each country follows.
Thailand
Pressures on Thailand’s currency, the baht, which had been evident already in late 1996, increased dramatically during the first half of 1997. Primary contributors to this built up pressure were an unsustainable current account deficit, significant appreciation of the real effective exchange rate, rising foreign debt (in particular short-term), a deteriorating fiscal balance, and increasing difficulties in the financial sector. Reserve money growth accelerated sharply as the Bank of Thailand provided liquidity support for ailing financial institutions. “Most of the policy responses to the pressures in the exchange market focussed on spot and forward intervention, introduction of controls on some capital account transactions and limited measures to halt the weakening of the fiscal situation.”[9] On July 2, 1997, following more and more speculative attacks on its currency, Thailand’s Central Bank decided to float its exchange rate. However, the policy changes introduced with the floatation of the baht were inadequate. Market confidence failed to return and the baht depreciated by 20 percent against the U.S. dollar during. On August 20, 1997, the IMF’s Executive Board approved financial support for Thailand of up to SDR 2.9 billion or about $4 billion, equivalent to approximately 505 percent of Thailand’s quota, over a 34 month period (see Table 5). Additional financing in the amount of $2.7 billion was pledged by the World Bank and the Asian Development Bank while Japan and other interested countries pledged another $10.5 billion. “The underlying adjustment program was aimed at restoring confidence, bringing about an orderly reduction in the current account deficit, reconstituting foreign exchange reserves and limiting the rise in inflation to the one-off effects of the depreciation.”[10] Growth was expected to slow down dramatically, but still remain positive. Key elements of the initial economic reform package included restructuring of the financial sector (focusing on the identification and closure of insolvent financial institutions; included 56 finance companies); fiscal measurers equivalent to about three percent of GDP to correct the public sector deficit to a surplus of one percent of GDP in 1997/1998[11] and contribute to shrinking the current account deficit; and control the domestic credit, with indicative ranges for interest rates.
In subsequent months, the baht continued to depreciate as roll-over of short-term debt declined and the crisis in Asia spread. Despite the fact that macroeconomic policies were on track and nominal interest rates were raised, market confidence further declined because of delays in the implementation of financial sector reform, political instability and poor communications of the key aspects of the program. In light of a larger than expected depreciation in the baht and a sharper than anticipated slowdown in the economy, the bailout program was strengthened at the first quarterly review on December 8, 1997. The indicative range for interest rates was raised and a specific timetable for financial sector restructuring was announced. In early February 1998, the baht started to strengthen as improvements in the policy setting revived market confidence. At each subsequent quarterly review (March 4, 1998; June 10, 1998; September 11, 1998), the program was again revised. Real GDP growth projections were continuously revised downward, reaching a projected decline of 4-5 percent in 1998 as of June 10 and a decline of 6-8 percent as of September 11. From February to May, the baht strengthened markedly (almost 35 percent vs. the U.S. dollar from the low in January), but the economy fell into a deeper than expected recession. In order to stimulate growth (or more appropriately, curb the real GDP contraction), further adjustments were made to allow for an increase in the fiscal deficit target for fiscal-year 1997/98. The fiscal deficit target for 1997/98 was raised from two percent to three percent of GDP.
Interest rates started to slowly decrease in late March of 1998. Additional measures to strengthen the social safety net were planned and the program for financial sector and corporate restructuring was further specified. By the fourth quarter review completed September 11, 1998, foreign exchange market conditions were relatively stable, allowing room for further lowering of interest rates. The following table provides a snapshot of select economic indicators for Thailand.
Table 2: Selected
Economic Indicators for Thailand
|
|
1996 |
1997 |
1998(1) |
1999(2) |
|
percent change |
||||
|
Real GDP Growth |
5.5 |
-0.4 |
-7 to –8 |
1.0 |
|
Consumer Prices (period avg.) |
5.9 |
5.6 |
8.9 |
2.5 to 3.0 |
|
percent of GDP; a minus
signifies a deficit |
||||
|
Central government balance(3) |
1.9 |
-1.4 |
-2.4 |
-3.0 |
|
Current account balance |
-7.9 |
-2.0 |
11.5 |
8.5 |
|
(billions U.S. dollars) |
||||
|
External debt |
90.5 |
93.4 |
73.0 |
N.A. |
Source: Thai
authorities and IMF staff estimates
(1)
Estimate
(2)
Program
(3)
Fiscal
year, which runs from October 1 to September 30
Indonesia
In July 1997, soon after the floating of the Thai baht, pressure on the Indonesian rupiah intensified. While the key macroeconomic indicators in Indonesia were stronger than in Thailand (the current account deficit had been modest, export growth had been reasonably well maintained, and the fiscal balance had remained in surplus), Indonesia’s short-term private sector external debt had been rising rapidly. Increased evidence of weakness in the financial sector raised doubts about the government’s ability to defend the currency peg.
On July 11, 1997, Indonesia widened the exchange rate intervention band. On August 14, 1997, the rupiah was floated. The exchange rate depreciated sharply and despite a temporary small recovery, the rupiah fell further against the U.S. dollar. By early October, the cumulative depreciation of over 30 percent since early July became the largest in the region. On November 5, 1997, the IMF’s Executive Board approved a three-year stand-by arrangement with Indonesia totaling $10 billion, equivalent to approximately 490 percent of the country’s quota (see Table 5). Key objectives of the IMF program included restoring market confidence; bringing about an orderly adjustment in the current account; limiting the unavoidable decline in output growth; and containing the inflationary impact of exchange rate depreciation. After an initial brief strengthening of the rupiah, the exchange rate fell again during December 1997 and January 1998. Poor implementation of proposed structural changes signaled a lack of commitment to the program. Coupled with political uncertainty due to the President’s health problems and the upcoming presidential election, capital outflows increased and reserves declined sharply.
A revised strengthened program was announced on January 15, 1998 in an attempt to stop and reverse the decline in the rupiah, but market reaction was skeptical. Despite the revised rescue program by the IMF, implementation of the structural reforms continued to lag again and the macroeconomic program quickly ran off track. The economic downturn deepened and inflation accelerated sharply. Indonesia’s economy was on the verge of a vicious circle of currency depreciation and hyperinflation. The first review of the IMF programs was completed on May 4, 1998, after the new government headed by re-elected President Soeharto was formed, and resulted in several modifications to the original program. “In order to stabilize the exchange rate, reduce inflation and limit the decline in output (and eventually restore growth), the revised program included: tight monetary policy with drastically higher interest rates and strict control over the central bank’s net domestic assets; expanded far-reaching structural reforms, including privatization and dismantling of monopolies and prices controls, to improve efficiency, transparency and governance in the corporate sector; adjusted fiscal framework that took into account the less favorable outlook for growth; and a revised plan for the restructuring of the banking system.”[12] Unfortunately, the program was once again steered off course, this time by civil unrest which culminated with the resignation of President Soeharto on May 21, 1998. “While food prices sky-rocketed, production, exports and domestic supply channels were disrupted and banking activities came to a virtual standstill.”[13] The rupiah hit an all time low against the U.S. dollar in mid June 1998, with a cumulative depreciation of approximately 85 percent since June 1997.
On June 4, 1998, a critical agreement with private creditors was reached which covered the restructuring of interbank debt falling due before the end of March 1999. The government also established a framework for the voluntary restructuring of corporate debt involving a government exchange guarantee scheme. By the time of the IMF’s second program review in July 1998, output for fiscal year 1998/99[14] was expected to decline by 10-15 percent and inflation was projected to average 60 percent. On August 25, 1998, the IMF’s Executive Board replaced the previously agreed upon stand-by agreement with an extended arrangement with access to the same capital amounts of the original agreement. Additionally, the World Bank and Asian Development Bank pledged $2 billion and bilateral sources close to $1 billion of additional financing sources (see Table 5).
Since then, macroeconomic policies have been generally speaking on track and policies regarding financial and corporate sector restructuring have been further strengthened. The last major hurdle seems to have been overcome on September 23, 1998, with an agreement on the rescheduling or refinancing of Indonesia’s principal payments on official debt and export credit for the period from August 6, 1998 to March 31, 2000, totaling $4.1 billion. In recent months, the rupiah has appreciated significantly, allowing interest rates to be lowered. Inflation has decreased to reach 80 percent at year-end. Some of the key economic indicators for Indonesia are summarized in the table below:
Table 3: Selected
Economic Indicators for Indonesia(1)
|
|
1996/97 |
1997/98 |
1998/99(2) |
1999/00(2) |
|
percent change |
||||
|
Real GDP Growth |
8.2 |
2.0 |
-16.0 |
-2.0 to 1.0 |
|
Consumer Prices (period avg.) |
5.2 |
12.9 |
65.0 |
17.0 |
|
percent of GDP; a minus
signifies a deficit |
||||
|
Central government balance |
1.2 |
-0.9 |
-4.5 |
-5.7 |
|
Current account balance |
-3.3 |
-1.2 |
4.1 |
1.5 to 2.0 |
|
(billions U.S. dollars) |
||||
|
External debt |
112.7 |
137.9 |
148.1 |
N.A. |
Source:
Indonesian authorities and IMF staff estimates
(1)
Fiscal
year, which runs from April 1 to March 31
(2)
Program
Korea
Through
the beginning of the crisis in Thailand and Indonesia, Korea appeared
relatively unaffected. Its exchange
rate remained generally stable through October 1997. However, high amounts of short-term debt and only moderate levels
of international reserves made the economy very vulnerable to a shift in market
sentiment. Concerns about the soundness
of financial institutions and chaebol had increased significantly after several
large corporate bankruptcies earlier in the year. Korean banks started to experience difficulties in rolling over
their short-term foreign liabilities.
As a response, the Bank of Korea shifted foreign reserves to the banks’
offshore branches and the government announced a guarantee of foreign borrowing
by Korean banks. As external financing
conditions deteriorated in late October, the won fell sharply while exchange
reserves declined rapidly. Monetary
policy was initially tightened, but concerns about the effect of high interest
rates on the highly leveraged corporate sector lead to a loosing of monetary
policy again. By December 1997, the won
had depreciated by over 20 percent against the U.S. dollar.
As a
response to Korea’s financial crisis, the IMF approved on December 4, 1997 a
three-year stand-by arrangement totaling $21 billion, equivalent to
approximately 1,940 percent of the country’s quota (see Table 5). The World Bank
and Asian Development Bank and other interested countries pledged another $14
billion and $22 billion, respectively.
Similar to the programs announced in Thailand and Indonesia, however,
positive impacts of the announced program were short-lived and the won
continued to fall. Adding to the
existing uncertainty, the leading candidates for the December 18 presidential
election all hesitated in publicly endorsing the program. With the won in a free fall and a sever
credit crunch, a temporary agreement was reached on December 24, 1997 with
private bank creditor to maintain exposure and discussions on voluntary
rescheduling of short-term debt were initiated. During the first two weeks of January 1988, roll-over rates
increased, the current account had moved into surplus and general signs of
stabilization emerged. However, due to
the large depreciation in the exchange rate, inflation increased above
projections and economic activity decreased more than expected. On January 28, 1998, Korea reached an
agreement with private bank creditor on a voluntary rescheduling of short-term
debt covering a total of $22 billion.
During
the next few months, the IMF rescue program remained on track and market
confidence increased as the new government stated its commitment to the bailout
program. Economic growth projections
were further revised downward, yet by July, Korea had made substantial progress
in overcoming its external crisis. By
the end of August, output was projected to decline by 5 percent in 1998, but
inflation had decreased significantly and was expected to average 8.5 percent
during the year. Fiscal deficit targets
were raised to four percent of GDP to stimulate growth through additional
expenditures, especially social programs and the won remained broadly stable
and appreciated against the U.S. dollar.
Table 4 below summarized some of Korea’s key economic indicators.
Table 4: Selected
Economic Indicators for Korea
|
|
1996 |
1997 |
1998(1) |
1999(2) |
|
Percent change |
||||
|
Real GDP Growth |
7.1 |
5.5 |
-7.0 |
-1.0 |
|
Consumer Prices (period avg.) |
4.9 |
6.6 |
5.5 |
3.5 |
|
Percent of GDP; a minus
signifies a deficit |
||||
|
Central government balance |
0.3 |
0.1 |
-5.0 |
-5.1 |
|
Current account balance |
-4.7 |
-1.8 |
13.3 |
6.6 |
|
(billions U.S. dollars) |
||||
|
External debt |
157.5 |
154.4 |
147.9 |
N.A. |
Source:
Korean authorities and IMF staff estimates
(1)
Estimate
(2)
Program
Criticism / Misunderstandings of the IMF Programs in Asia
In the
popular press, the IMF has been widely criticized for its role in the Asian
crisis. Below, we summarize two
often-cited criticisms, or misunderstandings as the IMF refers to them, and
give a brief rebuttal from the IMF. A
third criticism, that the IMF bails out reckless investors and thus creates a
moral hazard, is addressed in further detail in the third section of our paper.
(i)
The IMF failed to predict the financial crisis in
Asia; this proves that the surveillance methods used by the IMF don’t work. The IMF admits that it underestimated the severity of the
financial crisis that followed the events in Thailand. However, the IMF is quick to point out that
it did anticipate the events in Thailand.
The IMF stressed the unsustainability of the country’s policies and
pressed for urgent action during the 18 months leading up to the floating of
the baht. This, however, shows a basic
shortcoming of the IMF. The IMF can only advise, not force governments to
take any steps.
(ii)
IMF programs are structured wrong. The programs include high interest rates
that are inappropriate and overlook the private sector debt problems that were
at the heart of the crisis. The IMF argues that while an increase in interest rates has been
part of the countries’ economic programs, the centerpiece revolved around
far-reaching structural reforms. Also,
past experience shows that the temporary raising of interest rates makes the
currency more attractive to hold and avoids a depreciation-inflation spiral
effect. Regarding the private sector
debt problem, the IMF is only empowered to deal with sovereign governments, not
directly with private sector agents.
The IMF’s policy consisted of restoring confidence through policy
packages and official financing to induce private creditors to roll over their
claims voluntarily, but any other action is beyond the scope of the IMF.
Early Results and Outlook
To a
large extent, the full scope of the Asian crisis is still unfolding and further
setbacks cannot be ruled out. The
magnitude of recessions in the affected Asian countries has far exceeded all
initial estimates. The further
weakening of Japan’s economy has had a particularly large, negative impact on
demand in the region and on international financial market sentiment in
general. However, many of the still
existing risks can be mitigated as long as the affected economies continue to
implement the stabilization and reform policies specified by IMF programs and
financial support is maintained. Table
5 below summarizes the financial commitments and disbursements made by the
international community through January 1999.
Table 5: Commitments of the International Community and Disbursement of the IMF in Response to the Asian Crises
|
(billions U.S. dollars) |
Commitments
|
IMF Disbursements As of 1/17/99 |
|||
|
Country |
IMF |
Multilateral(1) |
Bilateral
|
Total |
|
|
Thailand |
4.0 |
2.7 |
10.5 |
17.2 |
3.1 |
|
Indonesia(2) |
11.2 |
10.0 |
21.1 |
42.3 |
8.8 |
|
Korea(3) |
21.1 |
14.2 |
23.1 |
58.4 |
19.0 |
|
Total |
36.3 |
26.9 |
54.7 |
117.9 |
30.9 |
Source: IMF
(1) World
Bank and Asian Development Bank
(2) Includes
augmentations since July 1998
(3) Disbursements
does not reflect Supplemental Reserve Facility repayments of $2.8 billion made
by Korea in December 1998
While the road to recovery has been more troublesome than anticipated, there has also been notable progress in Thailand, Indonesia and Korea in the implementation of corrective policies and the stabilization of exchange rates:[15]
n
Exchange rates have strengthened significantly from their
lows reached in the first part of 1998.
While the Indonesian rupiah still remains severely depreciated, it too
has recovered;
n
Interest rates in Thailand and Korea have returned to
pre-crisis levels as currency pressures have eased;
n
Significant progress has been made in macroeconomic
stabilization and structural reforms are beginning to be implemented;
n
Current account deficits have been reversed to surpluses
for all three countries;
n
Reserves have strengthened substantially in Korea and
Thailand, and Korea made repurchases to the IMF under the Supplemental Reserve
Facility, indicating the progress made in the country’s emergence from its
foreign exchange crisis; and
n
Equity prices increased significantly from their lows in
Korea and Thailand, yet they are still far below past highs.
Weekly, January 3, 1997 –
March 5, 1999
Source: Bloomberg
Weekly, January 3, 1997 –
March 5, 1999
Source: Bloomberg
While
Thailand’s and South Korea’s equity markets increased over 70 percent and 80
percent, respectively, from their lows at the beginning of September,
Indonesia’s equity market index only increased less (see Figure 3 below).
Figure 3:
Indonesian Equity Market Index
Weekly, January 3, 1997 –
March 5, 1999
Source: Bloomberg
It is remarkable to note that while the percentage increases and decreases in the above figures differ, the directional trends are remarkably similar over time, indicating the strong interdependence and linkage between the three Asian economies. For example, all three graphs show market lows around the beginning of September 1998 and the following recoveries exhibit extremely similar trends and spikes.
Lessons
Learned
The Asian crisis has reconfirmed the importance of
a sound macroeconomic policy framework and the dangers of unsustainably large
current account deficits. Some details
of the Asian crises are still in the process of unfolding. In a continuous effort to improve its
operations and effectiveness, the IMF has already started to analyze the events
leading up to the crisis and how it responded.
The IMF strives to learn from the crises “how to strengthen the architecture
of the international financial system to lessen the frequency and severity of
future disturbances.”[16] So far, the IMF has identified six distinct
areas where changes are already on the way:[17]
(i) More effective surveillance over countries’ economic policies and practices. The IMF will continue to establish new and improve existing data standards to guide members in releasing reliable and timely data to the public and require fuller disclosure of all relevant economic and financial data;
(ii)
Financial sector reform, including better prudential regulation
and supervision. The IMF is working
closely with the Basle Committee on Banking Supervision and the World Bank to
develop and communicate a set of “best practices” in the banking area;
(iii)
Ensuring that the integration of international financial
markets is orderly and properly sequenced.
This should maximize the benefits from and minimize the risks of
international capital movements;
(iv)
Promoting regional surveillance;
(v)
Worldwide effort to promote good governance and fight
against corruption. On April 16, 1998,
the Interim Committee of the Board of Governors of the IMF adopted the “Code of
Good Practices on Fiscal Transparency – Declaration on Principles,” which serve
as a guide for members on how to enhance the accountability and credibility of
fiscal policy; and
(vi)
More effective structures for orderly debt workouts. This includes better bankruptcy laws at the
national level and better ways at the international level of association
private sector creditors and investors with official efforts to help resolve
sovereign and private debt problems.
These
efforts must be supported by adequate financial resources for the IMF. Furthermore, continued cooperation of
bilateral and multilateral funding sources will be critical for the future
success of IMF policies.
One problem, however, that the
IMF continually faces is its dependence on the cooperation from the local
governments that are affected by crises.
The best programs in the world are of little use when they are not implemented
forcefully and at the right time. As
mentioned earlier, the IMF can only advise, not force governments to take
steps. The six initiatives mentioned
above are all improvements and steps in the right direction, but without the
proper commitment of local governments, even the best IMF programs will not be
able to rescue economies fallen on hard times.
A
situation of moral hazard exists when an actor does not bear all of the risks
of his actions. He has incentive to
take risky actions if he will receive all of the benefits of a positive result
but will only share part of the downside caused by a negative result. For example, insurance companies deal with
this when they insure property. The
property owner does not take the same level of care with the property that he
would if he were not insured. To
correct for this problem, it must be in the insured party’s interest to take
actions that the insurer would prefer.
The
moral hazard exists in a variety of ways in the world economy. Corsetti, Pesenti, and Roubini, in their
September 1998 paper, divide the moral hazard problem into three types:
corporate, financial, and international. [18]
The
corporate-level moral hazard problem occurs when companies are encouraged to
make uneconomic investments (that is, investments that return less than the
cost of capital) because of subsidies or bailouts that are expected from the
government if the project is unsuccessful.
The companies are not bearing all (or perhaps any) of the risk of the
projects, so they are not prudent in their risk taking. In Asia, for example, in order to encourage
high economic growth public money was used to finance private sector
projects. Sometimes the projects were
directly controlled by the government, sometimes the projects received
subsidies, and sometimes the companies in charge of the projects received
credits. As Corsetti, Pesenti, and
Roubini state:
“With financial and industrial policy enmeshed within a widespread business sector network of personal and political favorites and with governments that appeared willing to intervene in favor of troubled firms, markets operated under the impression that the return on investment was somewhat insured against adverse shocks.”[19]
This was true despite the actual low levels of profitability of the projects. In Korea, for example, 20 of the 30 largest consortiums had a 1996 return on invested capital that was less than the cost of capital. Some of these firms were effectively bankrupt by 1997. Clearly the market for capital was not operating efficiently.
Moral hazard
also exists within the financial sector.
Financial institutions are the intermediaries who channel capital between
lenders and borrowers. When they are
not prudent in their risk taking, capital is allocated to firms who are
investing it in marginally or totally unattractive projects. This is similar to what happened in the
above example of government money flowing to uneconomic projects. Financial institutions act in this way when
they are not (or at least, they believe they are not) bearing all of the risks
of the loans that they are making. This
would occur if they expect the recipients of the loans to be supported by public
funds if a crisis emerges. They then
make loans based on uneconomic factors, such as relationships they have with
borrowers or pressure that they are feeling from the government. Further, since they are not very worried
about the performance of the loans, they inadequately supervise them and hold
inadequate reserves to support them.
The financial system gets weaker and weaker as more and more
unprofitable investments are made. In
the end, if the government can not actually bail out all of the providers of
capital, a crisis occurs. This is part
of what happened in Asia. Asian banks
borrowed heavily from abroad and lent heavily at home. They believed that their home governments
would always support the companies to whom they were lending. When crisis hit, however, even the
government did not have the money to offset all of the liabilities incurred by
companies.
There
is also moral hazard at the international level. This refers to the lending by foreign banks to local banks
under the assumption that the loans will be effectively guaranteed by either
the local banks’ government or the IMF.
Such banks may assume that short-term cross-border liabilities would be
the first to be protected in times of crisis.
In Asia, however, this was not the case. Indeed, the levels of short-term, cross border liabilities were
far too high to be covered by the governments.
By the end of 1996, short-term liabilities represented more than 50% of
total liabilities in Asia, and the ratio of short-term liabilities to total
foreign reserves was greater than 100% in Korea, Indonesia, and Thailand. The currency crisis made the situation even
worse. The IMF had to intervene to
cover these liabilities, and many others.
There had simply been no incentive for international financial
intermediaries to be prudent in their risk taking. In fact, as the situation worsened, they may have actually taken
on more risk since the likelihood of
an IMF bailout seemed even greater.
Together,
these three types of moral hazard have presented and will continue to present
obstacles to maintaining world financial stability. For as long as the incentives of capital providers are not
affected by the riskiness of the projects that they are undertaking, capital
will continue to flow to projects that are not economically justified. The moral hazard problem results in the
funding of projects that would not be funded in efficient capital markets in
which economic actors behave rationally.
There
are several ways in which the IMF can minimize the moral hazard problem, as
Stanley Fischer of the IMF explained in a recent paper.[20] First, the IMF can make funds available
only to the extent that they are guaranteed by sufficient collateral. Such collateral must have value in “normal
times,” i.e., not times of financial crisis.
This would limit risky investments, as such investments might not qualify
as acceptable collateral. Second, the
IMF can impose costs on borrowers who need funds. The IMF can make loans at penalty rates. Loans are then available if needed, but at
rates that are reasonably unattractive.
This limits risk taking because the potential borrower knows that cheap
borrowing will not be available in times of crisis. The IMF can also allow some insolvent institutions to fail – the
ultimate penalty. Third, the IMF can
lend to the market not the individual institution (i.e. lend to
Indonesia to boost reserves and improve liquidity, but do not bail out specific
financial institutions). The market
will then decide which institutions will survive, and it will presumable choose
the most competitive and solvent. Note
that this policy has its drawbacks because in times of financial panic, market
forces may not be effective and such policy will just increase confusion. Fourth, the IMF can be somewhat ambiguous
about its exact lending rates and policies.
Potential borrowers will be aware that the IMF may be prepared to bail them out in times of crisis, but they will
not be certain of it. They will be less
willing to take risks if there is no guarantee that the IMF will protect
them.
In
addition to IMF actions, there are actions at the country level that can
minimize the moral hazard problem. For
example, regulations that limit banks’ lending can be imposed. There can be limits on the size of deposits
covered by insurance, as there are in the U.S.
Additionally, the private sector can provide emergency credit lines
under strict terms. This would provide a
partial safety net and thus promote stability, without guaranteeing that risky
investments would be insured against disaster.
There
has been voluminous debate recently about what the IMF’s role should be and
whether it should exist at all. The
IMF has sought to implement some of the above policies. For example, emergency credit comes attached
with reform requirements and somewhat higher borrowing rates. But perhaps the IMF is not the appropriate
party to be outlining and enforcing reforms.
Should the IMF play this role?
There
are strong arguments in support of the world’s need for a lender of last
resort, and in support of the IMF playing that role. Capital mobility is beneficial for the world economy, but such
mobility will only exist if the risk of major financial crises is sufficiently
low. International capital flows and
the economic performances of countries are extremely volatile. Crises are contagious. The lender of last resort can help to
minimize volatility and contain crises.
There
are several compelling reasons why the IMF should continue to be, essentially,
the world’s lender of last resort. The
most compelling is that the IMF is in a better position than anyone else to
play this role. It has a broader reach
than any individual country. It has
access to human resources and financial capital from almost every country. Further, while large countries (US, UK,
Japan) dominate the voting within the IMF, numerous countries have a voice in
making IMF policy. A second reason is
that if the IMF does not play this role, it is unlikely that anyone will. Individual countries and private lenders
will not always are sufficient access to capital when crises arise. They might also be swayed by politics to
favor some countries more than others.
The IMF (ideally anyway) would act with the proper function of the
entire world economic system in mind, rather than individual country interests. The U.S. took the lead in the Mexico bailout
tin 1994/95, but there is no guarantee that the US will always find it in its
interests to play such a role. A third
reason is that when the IMF steps in, such action sends a very visible signal
to the world that economic reform is underway.
The IMF at least gets some
reform underway in places that may have been in need of reform for years. This helps restore credibility among
companies and financial institutions in times of crisis. A fourth reason is that with the IMF as
lender, borrowers need negotiate with only one large lender, rather than with a
variety of leaders with diverse interests.
In times of crisis, such simplification is crucial.
There
are, of course, two sides to every debate.
Perhaps the IMF should not be the world’s lender of last resort. There are several reasons for this. First, the IMF may simply be bailing out
financial institutions who made incredibly risky loans in the first place. Such institutions should be allowed to
fail. They would have kept the benefits
of risky projects for themselves, so they should incur the costs. Second, there is no apparent limit to the
amount of funds that the IMF will continue to demand in the name of mitigating
financial panic. Why should the IMF
have an automatic call on the capital of countries who are prudently managing
their own economies? Third, it is not clear
that IMF bailouts are beneficial at all.
Countries who have received IMF funds are generally in serious need of
economic reform (e.g., exterminating corruption, encouraging private sector
competition, etc.). Throwing capital at
their problems is not enough, and IMF-imposed reform measures do not seem to be
working. Witness the ongoing turmoil
in Indonesia and other parts of Asia.
Further, IMF bailouts actually enable countries to delay reform. The inflow
of IMF funds lessens the need for banks to deal with problem loans, governments
to adjust spending, and unprofitable, mismanaged firms to change hands.
With
such arguments in mind, some policy makers have argued that the IMF should be
replaced by the market in solving world financial crises. Governments and institutions should be
forced to work with private leaders in times of crisis. They must present
reform plans in order to receive funds.
If their reform plans are not viable, they should be allowed to
fail. They should not simply be allotted
funds. Failed enterprises should
confront bankruptcy, with assets transferred to managers who can manage them
more effectively than those who created crisis. Reforms would have to be implemented before the receipt of funding.
No longer would funding be freely available to anyone in need.
Conclusions About the IMF’s Role
The IMF tries to remedy existing problems, not create crises. Therefore, the best way in which to limit the role of the IMF in the world economy is to address the policies that result in the crises in the first place. It is up to local governments in each country to implement regulatory actions that limit the risk taking of financial institutions in their country. These governments will have incentive to do this if their access to international capital from other countries is tied to their maintenance of responsible fiscal policy. For example, the architects of the European Union have been working towards something along these lines by requiring member countries to stay within certain budget deficit limits. More measures like this will go a long way in promoting financial stability, and will require minimal IMF activity.
The fact remains, however, that there must be some last resort provider of capital to assist countries in times of severe financial distress. For the reasons listed above, it does make sense for the IMF – an institution governed by a broad spectrum of countries – to act in this role. No individual country or small number of countries can along be the world’s lender of last resort. The IMF should focus on being a capital provider, however, not a policy dictator. The IMF should infuse capital but should not jump in to determine fiscal policy.
The moral hazard problem will never disappear. It can, however, be minimized. The penalties attached to emergency funding must be severe. The amount of IMF funding must not be unlimited. There must not be a guarantee that the IMF will always bail out countries and institutions when they need funds.
REFERENCES
“Annual Report of the Executive Board for the Financial Year Ended April 30, 1998,” International Monetary Fund, Washington, D.C.
Camdessus, Michel, “The IMF and
its Critics,” The Washington Post,
November 10, 1998.
Camdessus,
Michel, “Economic and Financial Situation in Asia: Latest Developments”,
Background paper for Asia-Europe Finance Ministers Meeting, Frankfurt, Germany,
January 16, 1999.
Corsetti, Pesenti, and Roubini, “What Caused the Asian Currency and Financial Crisis? Part I: A
Macroeconomic Overview,” Second draft, September 1998.
Fischer, Stanley, “On the Need for an International Lender of Last Resort,” January 3, 1999. Paper
presented at lunch for the American Economic Association and the American Finance
Association. New York.
Fischer, Stanley, “The Asian Crisis and the Changing Role of the IMF,” Finance & Development, Volume 35, Number 2, June 1998.
International Monetary Fund, “International Capital Markets: Developments, Prospects, and Key Policy Issues,” World Economic and Financial Surveys, Washington, D.C., 1996.
International Monetary Fund, “World Economic Outlook, December 1997: A Survey by the Staff of the International Monetary Fund, World Economic and Financial Surveys, Washington, D.C., 1997.
Lane, Timothy et al, “IMF-Supported Programs in Indonesia, Korea and Thailand”, A Preliminary Assessment, January 1999.
Lindsey, Lawrence, “The
Benefits of Bankruptcy,” January 1998, Enterprise Institute for Public
Policy
Research.
“Memorandum
on Economic Policies of the Royal Thai Government,” Bangkok, February 24, 1998.
Neiss, Hubert, “In Defense of
the IMF’s Emergency Role in East Asia” International Herald Tribune,
October
9, 1998.
“Overview of World Bank
Activities,” www.worldbank.org/html/extpb/annrep98/overview.htm.
Schlafly, Phyllis. “Congress Should Just Say No to IMF
Funding,” Eagle Forum, January 7, 1998.
Summers, Lawrence. Text of
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RR-2916. January 27, 1999.
[1] The introduction borrows heavily from the IMF and World Bank websites
[2] “The IMF and World Bank: How Do They Differ,” www.inf.org/external/pubs/ft/exrp/differ/differ.htm
[3] Ibid
[4] Ibid
[5] “Overview of World Bank Activities,” www.worldbank.org/html/extpb/annrep98/overview.htm
[6] Lane, Timothy et al, “IMF-Supported Programs in Indonesia, Korea and Thailand,” A Preliminary Assessment, January 1999
[7] Camdessus, Michel, “Economic and Financial Situation in Asia: Latest Developments,” Background paper for Asia-Europe Finance Ministers Meeting, Frankfurt, Germany, January 16, 1999
[8] Ibid
[9] “The IMF’s Response to the Asian Crisis”, External Relations Department of the International Monetary Fund in collaboration with the relevant regional and policy departments, Washington, D.C., January 17, 1999
[10] Fischer, Stanley, “The Asian Crisis and the Changing Role of the IMF,” Finance & Development, Volume 35, Number 2, June 1998
[11] Fiscal year begins in October
[12] “The IMF’s Response to the Asian Crisis”, External Relations Department of the International Monetary Fund in collaboration with the relevant regional and policy departments, Washington, D.C., January 17, 1999
[13] Ibid
[14] Fiscal year begins in April
[15] Borrows heavily from IMF website and December 1998 IMF World Economic Outlook
[16] “The IMF’s Response to the Asian Crisis”, External Relations Department of the International Monetary Fund in collaboration with the relevant regional and policy departments, Washington, D.C., January 17, 1999
[17] Ibid
[18]Corsetti, Pesenti, and Roubini, “What Caused the Asian Currency and Financial Crisis? Part I: A Macroeconomic Overview,” September 1998
[19] Ibid
[20] Fischer, Stanley, “On the Need for an International Lender of Last Resort.” January 3, 1999, New York. Paper presented at lunch for the American Economic Association and the American Finance Association