Basic Strategy

The policy response to the Asian crisis needed to be adapted to the distinctive features of the crisis. Understanding of the nature of the crisis was less clear when the programs were being formulated than it is now with the benefit of hindsight, but some broad aspects of the situation were apparent from the start. In contrast to the situations in many other countries with IMF-supported programs, the currency crises in East Asia did not reflect substantial fiscal imbalances. Rather, the proximate cause was a liquidity crisis, which called for a large financing package together with other steps intended to restore confidence and catalyze private capital flows along-side the financial support provided by the IMF and the official community more generally. But, at a deeper level, the origins of the crisis lay in serious vulnerabilities in banking and corporate sectors: including exchange and regulatory regimes that encouraged short-term foreign currency exposure, and stock imbalances within these countries, were problematic in conjunction with the volatility of short-term capital flows and external shocks—most notably terms of trade deteriorations and slowing growth of export markets. The programs therefore featured structural reforms that had few precedents in depth and breadth.

In these circumstances, and given the inherent uncertainties involved, the programs incorporated a three-pronged response. First, structural reforms were intended to build confidence and staunch capital outflows. Second, macroeconomic policies were to be adjusted: in order to ease the private sector's burden of adjustment to the capital outflows, a modest fiscal tightening was planned; and efforts to limit capital flight were to be buttressed by tightened monetary policies. Third, large financing packages were provided to help restore confidence.

The central focus of the structural reforms was to reestablish the financial systems on a sound footing, rectifying preexisting weaknesses that had been compounded by the crisis itself. Other reforms were intended to put in place conditions for a sustainable resumption of growth.

Fiscal policy was ascribed a rather modest role in these programs, since at the time the programs were formulated, the need for external current account adjustment was seen as relatively small (except in Thailand). Fiscal policies were thus intended to provide only limited support for a modest current account adjustment, mainly by reversing an initial deterioration of fiscal positions and covering the prospective carrying costs of financial sector restructuring.

Monetary policy was assigned the role of countering downward pressure on exchange rates to contain the overshooting of the exchange rate beyond the degree of real exchange rate adjustment needed in light of underlying fundamentals. It was thought that, if unchecked, such overshooting could trigger depreciation-inflation spirals; in addition, excessive depreciations could elicit corresponding exchange rate movements in competitor countries, with detrimental effects on the system as a whole. Moreover, continued depreciation imposed substantial burdens on both corporate and banking sectors, which were already suffering from their overexposure to foreign-currency-denominated liabilities.

The structural reform strategy in the programs was exceptionally comprehensive and went to the heart of the weaknesses in financial systems and in governance that were seen to be at the root of the crisis. Such a comprehensive strategy was needed principally because of the interdependence of reforms in different areas. For instance, if macroeconomic stabilization had been attempted without dealing with weak and insolvent financial institutions, monetary policy would have been thwarted by the need for liquidity support to these financial institutions, while fiscal positions would have been burdened by mounting liabilities associated with pervasive government guarantees; but dealing with weak institutions without establishing sound ground rules for financial supervision and regulation would have invited a repetition of the crisis; and financial Restructuring would have made little progress without effective mechanisms for working out corporate debt, which in turn required the establishment of effective bankruptcy procedures. For this reason, the credibility of the programs required moving quickly across a broad (and, in some areas, uncharted) front. In keeping with responsibilities among the international financial institutions, the World Bank and the Asian Development Bank were extensively involved in formulating and implementing these reforms.

Exchange Rates

Another key element of the programs supported by the IMF was the decision to permit exchange rates to continue to float—part of the initial response of the authorities in all three countries to the pressures that had emerged—rather than readjusting the pegs to rates deemed to be defensible and consistent with medium-term fundamentals. Floating exchange rates removed the main anchor for expectations, without putting anything comparable in its place.¹ Floating may have introduced an additional element of instability into the mix: given that countries in the region trade heavily with one another and compete in many of the same export markets, any depreciation of one currency would put downward pressure on the others. Arguably, the resulting spiral of depreciations might have been avoided—or at least slowed down—by pegging the currencies. More generally, as discussed below, given the high exposure of these countries' residents to exchange rate movements, depreciation had side effects that could be destabilizing: it swelled domestic money stocks (especially in Indonesia, where foreign currency deposits were particularly large); it weakened fiscal positions (by raising debt-servicing costs and costs of food subsidies and lowering corporate tax receipts from foreign-currency-indebted companies); and it deepened the problems of insolvency in banking sectors and nonbank corporations.

However, pegging these currencies in the midst of the crisis would have been difficult—if not impossible—for several reasons. It would have required a commitment of the authorities to use monetary policy unstintingly to defend their currencies—even if that required raising interest rates to ruinous levels. The reserves needed to defend the currencies were depleted (in Thailand in net terms; in Korea in usable terms); replenishing them to a level adequate to defend a new peg could have required financing on a scale that would not have been available. Pegging also would have carried the risk of losing more credibility by having to abandon a new peg under market pressure—as had happened with the Mexican devaluation of December 1994. Another concern about repegging was that a rate that could have been defended against short-run market pressures may have been much too depreciated to be appropriate to lock in for the medium term. More-over, the first failed attempts to deal with exchange market pressures also did not set the stage for credible action to defend the currencies. Thus, although at an earlier stage a more orderly adjustment might well have been possible as well as desirable, in the heat of the crisis there was seen to be no practical alternative to floating.

In the event, exchange rates depreciated considerably after the inception of the programs, and far overshot levels estimated to be consistent with medium-term fundamentals.² Monetary policy sought to lean against the wind to dampen the over-shooting of nominal exchange rates and avert depreciation-inflation spirals. There were no preannounced targets, but there were understandings about exchange rates, which were frequently revised in response to the changing market conditions.