Chapter 1 The IMF and the Asian Crisis: A View from the Executive Board
- International Monetary Fund
- Published Date:
- January 2001
I want to look back, and tell you, briefly, how the Asian crisis looked from the perspective of a member of the Executive Board of the International Monetary Fund. Thanks to the IMF’s vaunted secrecy, many of you may not even know that there is an Executive Board—24 directors representing 182 member countries—which decides all major fund policies and approves all programs and disbursements of fund resources. Several of my board colleagues are here tonight.
I will also touch on the policy debates which took place in Washington this week during the Annual Meetings of the Board of Governors of the International Monetary Fund and World Bank, but which also included meetings of G-7 and G-10 finance ministers and central bankers and the ad hoc Group of 22 industrial and emerging market countries organized by Secretary Rubin and Chairman Greenspan at the behest of President Clinton. One can discern in these debates, certain common themes with regard to IMF reforms and the new financial architecture more generally.
2. WHAT WE SAW BEFORE THE CRISIS
The IMF has understandably been criticized for not having anticipated and prevented the Asian crisis. The fact that we are in good company offers little comfort; ensuring the stability of the international monetary system is the IMF’s job. Our annual surveillance reviews of every member’s economic policies and performance, the so-called Article IV consultation, is supposed to provide an early warning of trouble ahead.
Let me describe what we on the board saw in the Asian Article IVs, what I think we overlooked, and what was hidden from view.
The macroeconomic fundamentals in Asia by conventional definition looked strong—low inflation, fiscal balance or surplus, strong private savings, high rates of capital formation, strong export performance, ample foreign direct investment, stable currencies, large foreign exchange reserves, modest debt/GDP ratios. And, not least, the region had achieved a dramatic improvement in standards of living for a significant portion of the population.
As we discussed the Asian performance, some on the board questioned the sustainability of twenty-five to thirty percent or more rates of private credit expansion year after year and wondered about the soundness of the underlying investments. But the weight of opinion was that this had worked well so far, and one could see no obvious reason it could not continue. Dramatic year-on-year growth and investment rates seemed to be the norm for Asia, the standard for “the Asian model.”
There were, nevertheless warning signs in Thailand, with a clear indication of overheating. Thailand was developing a classic real estate bubble, and its current account deteriorated sharply, heading for an 8 percent deficit in 1997. The weakening export performance suggested an exchange rate misalignment. However, the IMF’s warnings, delivered with mounting intensity over a period of almost two years, fell on deaf ears in Bangkok.
It is fair to say the IMF did not pay sufficient attention to other indicators that were visible at the time, most notably the rapid build-up of foreign, short-term obligations by banks and the nonbank private sector, especially in Korea and Thailand. Although the Bank for International Settlements’ data on cross-border bank claims has a long lag, and the coverage is incomplete, there was enough information in the BIS tables, especially on interbank claims on Korea, to hint of the possibility of serious trouble ahead, or at least significant vulnerability.
The IMF obviously pays close attention to exchange rate policies, which are at the center of our surveillance. But in this context, we did not worry enough about the incentives pegged or managed exchange rates given to both borrowers and creditors to accumulate unsustainable cross-border, cross-currency exposures.
3. WHAT WE OVERLOOKED
The IMF has only recently begun to cover systematically the financial sector and banking supervision in its Article IV reviews. As Asian problems were building, we overlooked weaknesses in bank and corporate balance sheets in much of Asia: The fund was unaware of the extraordinary leverage of Korean companies, which in some cases reached a ratio of 600/1 debt to equity; we did not focus on the weak accounting and disclosure practices of banks and nonbanks; or the loose loan loss provisioning and generous rollovers of banks to their key clients.
To the extent these weaknesses posed systemic risks to the financial sector, many of the losses would of course end up on the books of the governments. The losses accumulating on private sector accounts thus constituted contingent liabilities, or quasi-fiscal losses of the public sector. And consequently, the “fiscal fundamentals” in many Asian countries were far less sound than they appeared. The costs of cleaning up the banking systems in Thailand, Korea, Indonesia could go as high as twenty to thirty percent of GDP.
The IMF also underestimated the impact of the Japanese government’s contractionary fiscal stance on Japan’s fragile economic recovery. In this regard, my U.S. authorities’ gloomy predictions were closer to the mark. Obviously, Japan’s renewed slump, plus the depth of problems in Japanese banks, which are major creditors in the region, have been a further devastating blow to the crisis countries.
I think we also underestimated the effect of political factors. “Political risk” is unfashionable in the sophisticated financial world of the 1990s. Private sector financial analysts, too, largely discounted the fragility of the political underpinnings of the Asian economies and did not fully comprehend the extent to which rampant corruption was discrediting regimes in the eyes of the people, as well as weakening economies directly, especially in Indonesia.
It is noteworthy that the Philippines, which had gone through a wrenching democratization phase some years back, has fared relatively better in the recent financial turmoil than some of its neighbors. Fortunately, in Thailand and Korea important political transitions took place relatively peacefully shortly after the financial crisis began, and this has undoubtedly helped the economic stabilization effort. Indonesia suffers still from an incomplete process of democratization.
4. WHAT WAS HIDDEN FROM VIEW
We missed other signs of the incipient Asian crisis for the simple reason that they were hidden from view. The IMF did not know of the desperate efforts by some governments/central banks to defend their exchange rates in the summer and fall of 1997. We did not know, because their governments hid the fact that Thailand and Korea had completely exhausted their foreign exchange reserves by time the authorities came to the IMF for help.
We did not know that on May 14, the Thai central bank spent more than $10 billion intervening in the spot, forward, and swap markets. The fund did not know that between May 1 and May 14, Thailand’s reserves had dropped from $24.3 billion to $2.5 billion. The facts are laid out in the Thai government’s Nukul Commission Report, just published last March (1998). The report makes fascinating reading.
Similarly, the IMF was not told that the Korean central bank had deposited a large part of its foreign exchange reserves with Korean commercial banks to cover the withdrawal of foreign credit lines and foreign bank deposits.
These acts of desperation by the Thai and Korean central banking authorities attest to the severity of the markets’ assault on their currencies in the months before the IMF appeared on the scene. Therefore, the charge that the IMF and its adjustment policies are somehow responsible for the steep currency depreciation that followed is patently absurd.
Another important facet that was hidden from view was the extent of hedging of local currency risk by foreign lenders and investors with unhedged Thai, Korean, Indonesian (and Russian) banks and corporations and sometimes the governments themselves, as counterparties. This hedging activity was not limited to the specialized “hedge funds,” but was apparently a central feature of the 1990s credit and portfolio investment boom in emerging markets. Now, of course, many of these hedges turn out to offer no protection at all. This aspect was hidden from view because there are limited disclosure requirements for off-balance-sheet transactions.
It is fair to say that derivatives are the black hole of this crisis. We are only now beginning to take its measure, as the losses on these kinds of transactions begin to show up on creditors’ balance sheets. As Chairman Greenspan has said, we don’t yet fully understand the nature of the global financial contagion. This is particularly true of the role of derivatives and hedging instruments as “vectors” of this contagion, to quote one of tomorrow’s panelists, Martin Mayer. Indeed, the speed and virulence of the international financial contagion has caught everyone by surprise, including the IMF.
5. THE IMF’S CRISIS RESPONSE
I will not dwell on the IMF’s response to the Asia crisis. You are all familiar with its main elements. I do want to touch on two controversial aspects of the IMF’s rescue efforts in Asia. First, we have been criticized for fiscal over—killinsisting on too much fiscal adjustment in the face of recession. I would just say that our fiscal policy recommendations made sense in the context of very high growth and apparent overheating that we saw in Thailand. Once it became evident that we were dealing with a different phenomenon, and that the program countries faced very sharp declines in demand and growth, the IMF quickly adjusted its program conditionality to allow for less fiscal stringency.
The IMF has been more roundly criticized—attacked even—for choosing tight monetary policy over letting exchange rates go. I think it is not telling tales out of school to say this debate has raged inside the fund as well—at the board and among staff. It is still a subject of controversy.
At the very outset, with Thailand, and then Indonesia, we debated heatedly whether high domestic interest rates or steep currency depreciation would do less damage to the economies we were trying to save, given that the private sector had both large short-term debt exposures and large foreign currency obligations.
We chose higher interest rates as the less damaging option. The logic of tightening monetary policy in the circumstance is simple—it raises the cost of getting out while you go about fixing what makes people want to flee the currency in the first place. If you move quickly, a brief period of very high rates should not do major damage to an economy. If, however, you don’t put in place credible corrective measures for the underlying problems, the interest rate response obviously will impose a heavy burden on the real economy.
In the event, the Asian crisis countries did not at first follow the monetary trajectory agreed with the fund, but instead pursued an on again, off again, monetary policy that confused investors and undermined the credibility of the whole stabilization effort. Their currencies continued to weaken. Only later as monetary policy firmed and governments moved more decisively on structural problems—which admittedly are not susceptible to a quick fix—have exchange rates recovered, giving scope for monetary easing. Nominal interest rates are now in single digits in Korea and Thailand where inflation also remains subdued.
I have personally come to the conclusion that the argument over tight monetary policy versus letting the exchange rate go is a phony debate in the Asian context. By the time the IMF entered the picture, the vulnerabilities of the corporate and banking sectors in Thailand, Korea and Indonesia to either an interest rate shock or an exchange rate shock were so great that either would seriously damage the real economy.
In recent years, access to cheap foreign credit allowed Korean, Thai, and Indonesian banks to sustain the flow of cheap domestic credit to the corporate sector as losses mounted, unrecognized, in their loan portfolios. And the flow of cheap domestic credit and perpetual rolling over of old loans is what sustained the chaebols and many other enterprises even as the marginal rates of return on their investments eroded. One need only look at the return on assets and return on equity of Korean, Thai, and other banks in the region before the crisis hit, to see that this true. The withdrawal of cheap, ample, short-term foreign capital and credit pulled the legs out from under these economies.
In short, it is doubtful the alternative strategy of easy money and letting exchange rates go without any monetary defense would have had a significantly different outcome for these countries, even if events did not play out as expected under the IMF programs. The loss of access to foreign financing would have produced a severe credit crunch even without a deliberate policy to drive up interest rates. Likewise, devaluation by itself would have blown a large hole in Asian balance sheets.
Let me say finally on this point that I agree fully with Mike Dooley’s comments today that until losses are allocated and recognized, there will be no recovery. Warehousing bad assets to try to shield asset prices overall will guarantee protracted weakness in these economies. One need only look at Japan.
6. LOOKING FORWARD
There are no magic bullets, no simple formulas for curing what ails the international financial system today. But a number of themes were sounded in Washington this week that point to some corrective measures. These were outlined most clearly in the reports of the G-22’s three task forces, which were released during the Bank-fund meetings.
First, we are redefining economic “fundamentals” to encompass the health of the financial and corporate sector, particularly the soundness of banks because of their systemic impact and the fact that they can create contingent claims on the public sector. And it is not enough to point the finger at emerging markets which do indeed have a long way to go before they meet internationally accepted standards of corporate governance and banking supervision. One must also examine the supply side of the equation that led to the current crisis: authorities in the major financial centers also have work to do, as is recognized in the G-22 reports.
Second, there will be an effort to give economic actors fewer places to hide their mistakes, through a general call for greater transparency. There will be a push for central banks to disclose not only gross but net reserves on a regular and frequent basis; for government accounts to be transparent; for banks to be subject to better supervision; and for corporations of all types to be subject to more stringent accounting and disclosure standards. Investment institutions could conceivably be subject to more oversight, as well, or at least more disclosure or reporting.
The IMF should and will become more transparent in its own activities. Jeffrey Sachs wants to be able to critique the IMF’s economic policy advice, and I think we should let him. (He has done a lot of critiquing even without full access.) There is growing support among members, as reflected in the G-22 reports, for more public disclosure of IMF policy decisions, agreements with countries on economic programs, and the conclusions of our annual economic consultations. A lot of this information is already available on the IMF’s website. I hope there soon will be more.
There is great determination to ensure that private creditors contribute to the resolution of financial crises. This is essential from a practical standpoint; there isn’t enough official money to do the job. There is also concern about moral hazard. Measures might include bond covenants or clauses making it easier to organize investor workouts. There have been discussions about establishing more systematic contacts between the IMF and the private financial sector to exchange views on a regular basis, before crises erupt and in order to have channels of communication already well established if they do. However, we must be mindful of the potential insider information problem, given the IMF’s access to confidential information from member governments. The IMF is considering ways to clarify its policies with regard to lending into arrears. Even capital controls are getting another look, although these are still regarded with great skepticism and wariness.
More serious consideration is being given to the pace and sequencing of opening capital markets that have been closed for a long time and the need to adequately prepare the financial sector and supervisory framework. Exchange rate regimes have to be looked at carefully in this context.
How do we deliver this new regime? It is worth pointing out that most of the proposed reforms and solutions, are not economic or financial, but legal/political. Finding global solutions to a global crisis presents a fundamental political challenge: how to reconcile the economic imperatives of global integration with the political reality of independent sovereign states. President Clinton articulated this very clearly during G-22 discussions. There is no simple answer. We are groping for a solution to this political dilemma. The current focus is on voluntary “standards,” “codes of conduct,” “best practices,” in banking supervision; fiscal management; corporate governance; and financial reporting.
International standards, codes of conduct, or best practices may seem like a tame response to a global financial crisis. They certainly aren’t the whole answer. But my Indian colleague, Mr. Sivaraman, likes to cite the International Civil Aviation Organization as an example. Under the ICAO’s auspices, a large number of countries at different levels of development, acting out of obvious mutual self-interest, have voluntarily adopted common standards for air safety, aircraft inspections, and airport operations. This voluntary regime has been surprisingly effective in reducing the number of air fatalities around the world.
Mr. Sivaraman’s example may be particularly apt, for if there is one thing we have all learned over the recent period of severe turbulence, it is that we are all passengers on the same plane.