Chapter 14 Asian Crisis: Causes and Remedies
- International Monetary Fund
- Published Date:
- January 2001
First, let me tell you a fable:
Once upon a time and far away, a litter of little tiger cubs was born. And foreigners came from far and wide to admire the cubs, and comment upon the growth potential in their sturdy limbs and the irresistible allure of their shiny coats. The keepers were proud of their small charges, and set up open zoos with no restrictions and invited everyone to come. Foreign visitors rushed in bearing a formula of milk fortified with vitamins and growth hormones for the cubs, and clamored for the privilege of filling their bowls which, fashioned for a trickle, cracked and leaked under the sudden surge. The cubs grew at an astounding rate, and newspapers and scholarly journals marveled at the miracle of their growth. Before long, the cubs were tigers, and still they grew until they burst out of their flimsy cages and roamed unfettered through the streets, howling for the surfeit of milk and hormones on which they had come to depend. Seeing the tigers at such close range, the visitors began to criticize their less-than-perfect coats, their tendency to purr, their unorthodox values. The food, which had flowed like a river, began to dry up. The keepers, in their confidence that the flow was endless, had not repaired the bowls to safeguard the milk they still had, and watched helplessly as the tigers sickened and gnashed their teeth. Then the IMF doctors were called in to wean the tigers off their rich diet and offer alternative lifestyles. As the tigers limped back into their shattered cages, a rowdy crowd of professors gathered to denounce the cruelty of international civil servants in white coats.
This story serves to remind us that the Asian-crisis countries, which include Indonesia, Korea, Philippines, Malaysia, and Thailand, have indeed had an impressive record of economic performance over the past three decades: very high rates of growth, relatively low inflation rates, especially during the 1990s, macroeconomic stability and strong fiscal positions, very high rates of saving, open economies, and high export orientation.
It is therefore not too surprising that no one really predicted this crisis. That is not to say that we, at the IMF, did not in our work with these countries point out some of the underlying problems, but we did not really predict the crisis, certainly not of such magnitude. The real question then is, what went wrong? Now that the crisis has unfolded, it is, of course, much easier to identify the problems. In fact, there is a general consensus on the causes of the crisis, in sharp contrast to the diversity of views on the appropriate remedies.
To a large extent, these countries were victims of their own success. What do I mean by that? Because of their success throughout the early 1990s, all of these countries went through a denial stage when the first signs of the problem emerged. We have all heard the arguments why the problems which existed in Latin America in the 1980s did not really apply to the Asian countries because they did not suffer large government deficits and public debt, rapid rates of monetary expansion, and structural impediments. Consequently, these countries did not deal in earnest with the emerging problems until it was too late in the game.
The Thailand story is very telling in this regard, particularly since this was the first case, which started the whole process of contagion. The problems in Thailand started in 1996. I know for a fact that we gave the authorities a very strong warning on the emerging problems in early 1997, but it was very difficult to convince them that there were serious problems lurking behind the scenes. We were not, of course, in a position to give a public warning, lest we actually precipitate the crisis by our warning.
And, we were not aware of the full extent of potential problems at the time, because, as is generally known by now, the baht was initially supported by heavy intervention in the forward market. So we were looking at a level of international reserves, which, indeed, seemed quite comfortable, not knowing that pretty much all of the international reserves had already been committed in the forward market. This process went on until mid-1997, when the authorities realized that usable reserves had been all but depleted. At that stage, the authorities came to the IMF, and we had to negotiate a program under tremendous time pressure. Similarly, we were not aware that Korea’s foreign exchange reserves had been all but depleted until we were called to the scene and had to put together an adjustment program in a matter of two weeks.
The underlying causes of the crisis are well identified by now. The most important element was the dynamic relationship in the capital markets. On the external side, substantial funds were available at relatively low interest rates, reflecting the paucity of investment opportunities in Europe and other developing countries. So the funds shifted into the fast growing Asia region, in retrospect, recklessly. All the investors in the industrial countries thought that this was a fantastic opportunity. And, in the early stages, as in all boom cycles, stock and real estate prices shot up, attracting even more funds. No one seemed worried.
At the same time, the whole process of borrowing from abroad and allocating the resources domestically was being undermined by a very weak banking system that had not kept pace with the rest of the economy. There were also serious problems of governance and transparency that interfered with efficient allocation of funds.
Another factor was a fixed exchange rate policy that encouraged investors to borrow dollar-denominated debt at very low interest rates with the false security that there was no the exchange rate risk. The rigidity of exchange rate was an issue, which was of concern to the IMF. In most of these countries, we were advocating more exchange rate flexibility which, during this period, would, in fact, have resulted in an appreciation. But a more flexible exchange rate policy would have removed the security of an implicit guarantee and would have eliminated the one-way bet that may have motivated excessive reliance on foreign financing.
There were also a number of factors contributing to a weakness of exports in these countries in mid-1990s. These included: the depreciation of the U.S. dollar against the yen since mid-1995; the devaluation by China, and then NAFTA.
In the meantime, the substantial capital inflow was naturally absorbed through a widening of the current account deficits. And, critically, much of this borrowing was done at short term, amplifying vulnerability.
In hindsight, it’s clear that there was a big accident just waiting to happen, and it was just a question of what was going to trigger it. Once the Thai crisis broke in the middle of 1997, the Asian countries were all vulnerable. And the markets, not having reacted to the underlying problems for a long time, overreacted as everyone thought. If this can happen in Thailand, it is bound to happen in the rest of Asia too. Market participants looked at the problems Thailand was facing—weak financial and corporate sectors, large current account deficit, and large external debt, particularly short-term—and realized all of these countries shared these problems to varying degrees. As creditors withdrew funds from the region, the Thai crisis spread to the Philippines, Indonesia, and Korea.
Let me now turn to the adjustment phase and the role of the IMF. I will briefly outline the main elements of IMF programs, which have a fair bit in common, although there are also differences. In addition to their traditional focus on monetary and fiscal policies, IMF programs with the Asian countries also included important structural reforms, as the root cause of the problem in all of these countries was essentially structural.
The immediate issue in all of these countries was to provide adequate financing to deal with the liquidity crisis that was created by the sharp withdrawal of funds and the collapse of the currency. Thus, the main, common element of all of these programs was for the fund to provide substantial resources, much larger than usual. At the same time, we sought to arrange for additional funds from other countries in the region, as well as the G-7, to both substitute for the withdrawing capital inflows and give confidence to the market.
Given that the Asian crisis was initially manifested in the collapse of the currencies, it is not surprising that the formulation of monetary policy was considered to be a key element of all of the programs. Ironically, fund programs have been criticized from both sides of the spectrum: some have held the view that interest rates should have been raised more to defend the currency, while others have advocated vociferously that the rise in interest rates was the main source of subsequent problems.
Frankly, it’s very difficult to see how interest rates can be reduced in the middle of a currency crisis. A number of academics have made the point that, in a recession, the orthodox policy would be to lower interest rates and allow the exchange rate to slide to boost economic activity. For example, one commentator has observed that “we cheerfully let the dollar slide from 240 yen to 140, from three Deutsche marks to 1.8; the Fed even helped the process along by cutting interest rates.” But this observation overlooks an important fact: the dollar decline was spread over a period of one and half years, while the drop in the won from less than 1000 per dollar to nearly 2000 took place in only one month. In such an extreme situation, the first priority has to be to stabilize the exchange rate before a vicious inflationary cycle sets in. Once domestic prices begin to skyrocket, the monetary tightening required to reestablish price stability would be extremely costly.
The strategy pursued in these countries was to raise short-term interest rates to arrest the deterioration in the exchange rate, and then gradually reduce it as the exchange rate stabilized. Here, I would like to point out an important fact that has been lost in the debate. Contrary to the prevailing conventional wisdom, the initial rise in interest rate in the Asian countries was quite moderate and short lived: in Thailand, short-term rates rose to a peak of twenty-five percent and, in Korea, to thirty-five percent, and they stayed at these peaks for only a few days before declining rapidly to their precrisis level. Furthermore, taking into account the impact of sharp exchange rate depreciation on inflationary expectations, the increase in interest rates was significantly lower in real terms than in nominal terms. Real interest rates (based on the consensus forecast of inflation as a measure of inflationary expectations), which were in the range of seven to eight percent before the crisis, rose to short-lived peaks of twenty-to twenty-five percent before dropping sharply. In both countries, real rates were above 15 percent for only two months, and they are presently about zero. At the same time, both the won and the baht appreciated substantially after the initial crisis, vindicating the approach adopted in these countries.
By contrast, Indonesia’s earlier efforts to stabilize the rupiah turned out to be futile. Indonesia’s experience, however, is the exception that proves the rule. During the first week of the program, the authorities engaged in unsterilized intervention and allowed short-term interest rates to double to thirty percent. As a result, the rupiah appreciated sharply. But within two days, contrary to understandings with the fund, Bank Indonesia was instructed to cut interest rates back to their initial level. The subsequent liquidity expansion, together with strong signals from the highest levels of the government that commitments under the IMF program would not be fulfilled led to the subsequent plunge of the rupiah. The resulting high inflation has necessitated much higher interest rates to reestablish financial stability. The adjustment cost would have been drastically smaller had the government persevered with the original program in November 1997.
To be sure, the weakness of the banking and corporate sectors in the Asian countries did constrain the scope for raising interest rates. However, while many critics of fund programs have pointed to the adverse impact of higher interest rates on domestic borrowers, they have neglected to take into account the impact of exchange rate depreciation on holders of external debt. A precipitous drop in the exchange rate raises the corresponding burden of external debt on the banking and corporate sectors to an intolerable level and undermines financial stability. Thus, the trade-off between exchange rate depreciation and interest rate increase shifts drastically in the presence of exchange rate overshooting. The negative impact of the exchange rate depreciation is particularly pronounced for Indonesia, Korea, and the Philippines, which have a relatively higher ratio of external debt to domestic credit.
I should also underscore that the liquidity squeeze in these countries was not just a consequence of high interest rates, as the banks have been reluctant to roll over their credits, given their large nonperforming loans and the weak position of the corporate sector. It is instructive to note that credit squeeze has not been alleviated even as interest rates in Korea and Thailand have fallen to well below their precrisis levels. An even clearer example of this phenomenon is Japan, where short-term interest rates have been essentially zero for some time, while the economy has been facing a credit crunch.
On fiscal policy, the budgetary positions of these countries were strong initially. The original fiscal targets envisaged a small surplus to help external adjustment and provide a cushion for financing the substantial cost of financial sector restructuring. However, as the economic conditions deteriorated, the initial fiscal targets were adjusted to allow for the working of automatic stabilizers and to finance additional social spending to protect the poorer groups. In fact, given the fiscal conservatism of these countries, in some cases we found ourselves in the unusual position of trying to convince them to undertake additional fiscal expansion. The fiscal targets in all of these countries now show substantial deficits. Thus, the criticism that the fiscal contraction under the fund program led to the economic contraction in the Asian countries is largely misplaced.
We could, of course, be faulted for having missed the depth of the recession initially. This is a fair point but I would note that there was no systematic bias in our growth forecasts, as they were broadly in line with the consensus forecast. It is perhaps too early to be definite about why every one missed the severity of the recession, but I would offer a few tentative explanations. First, we have learnt that when boom-bust cycles are superimposed on a very weak financial system and highly leveraged corporate sector, the amplitude and duration of the cycle is much more pronounced. We have seen this also in the case of Japan. Second, up until mid-1997 it had appeared that Japan was finally pulling out of its prolonged recession. But these hopes were dashed as the Japan’s economy plummeted, exacerbating the depth of recession in the Asian countries, which had close links with Japan. Finally, the impact of concurrent crisis in the Asian countries adversely affected general confidence and led to a sharp contraction of domestic demand, which far exceeded initial expectations.
Let me now turn to the structural elements of the programs, the most important elements of which were financial sector reform and corporate restructuring. In the case of Indonesia, there were also additional reforms designed to improve governance and signal to the market that resources would not continue to be channeled to connected groups.
The role of structural reforms in these countries has also been a point of debate. Some have argued that the fund should have focused only on macroeconomic policies, rather than structural reform, which is a medium-term process. But I would note that the main source of the problems in all of these countries was structural—the weakness of the financial and corporate sectors as well as governance and transparency issues. And, as the situation got worse, markets focused intensely on these problems. So the argument that “these problems were always there, why do we have to worry about them now” does not hold. Markets were worrying, and if these programs did not give assurance that important initiatives were being put in place, it would be very difficult to regain investor confidence. That is not to say that the structural problems could be solved overnight, but a critical mass had to be done up-front to instill confidence that the governments recognized the size of the problem and were committed to correcting it.
In addition, and this was particularly relevant in the case of Indonesia, the authorities themselves were keen to take advantage of the crisis to push through important reforms. The economic team in Indonesia was ultimately undermined by the connected parties who were threatened by the proposed reforms, and this led to the change in government. But the fund could hardly press the economic team to abandon its reform ambitions, lest they incur the wrath of connected parties. The myth that the IMF pushed unpopular reforms on the Asian countries is just that. Domestic support for IMF reforms was, in fact, strong and, ironically, criticisms were voiced mainly by outsiders.
A case in point is the closure of sixteen banks in Indonesia, which has often been cited by critics as a major mistake. The extremely weak position of Indonesia’s financial system was widely known even before the fund program was negotiated. In fact, the authorities had already identified seven banks to be closed before the arrival of fund mission in Jakarta in late October, 1997. There was concern, however, that closing only seven banks and leaving some of the other ones which were in even worse shape would be counterproductive, particularly as some of the excluded bankrupt banks were known to belong to connected parties. Given the shortage of expert manpower to undertake the complex task of closing banks with many branches, a decision was reached together with authorities to close sixteen banks, which clearly had negative net worth. At the same time, a limited guarantee was extended to small depositors.
In retrospect, it would have probably been better to have given a blanket guarantee to minimize the subsequent runs on banks, but the decision to limit the guarantee also took into account moral hazard considerations. In any event, the resulting run on banks was quite manageable had it not been for two serious problems. First, the owners of two of the closed banks who were related to the president refused to accept the authority of the minster of finance and attacked him publicly. This episode undermined confidence in the government’s commitment to push through the reform program, and started the subsequent capital flight. Second, Bank Indonesia proceeded to provide unchecked liquidity to banks well in excess of what was needed to accommodate the shift of deposits into currency. This unconditional provision of liquidity fueled the ongoing capital flight and set the stage for the collapse of the rupiah in early December when President Soeharto became ill. The problem with the closing of banks was therefore what it revealed about the lack of commitment by the government to follow through with reforms, rather than faulty program design. Had these banks not been closed, the original program would still have failed given the political problems, and the fund would then be criticized, probably by the same critics, for not having dealt with the fundamental structural problem which gave rise to the crisis in the first place.
The next question is, where do we stand now? In Korea and Thailand, the situation has turned around quite significantly. I wouldn’t say the crisis is over, but certainly these countries have turned the corner. Exchange rates have appreciated considerably, and interest rates have already declined to below precrisis levels, which will allow investment to start and growth to resume. But having said that, a very difficult period is still ahead. Much like the patient who is going to feel worse for a period after the surgery before he starts to recover. The important task now is to manage the situation carefully so that unemployment problems do not get out of hand and undermine the programs. Both of these countries will emerge from the crisis considerably healthier as long as they maintain their resolve to carry through with their financial and corporate sector reforms.
The case of Indonesia, however, has proved to be much more complicated because of the volatile interaction of political and economic problems. As you know, the new government of President Habibie renegotiated the program in June and the IMF has just concluded the third monthly review of the EFF. This program aims to reverse the serious economic deterioration which has occurred in that country, prevent inflation from spiraling out of control, and extend the social safety net, so as to cushion the impact of the crisis on the poor. I am optimistic that Indonesia’s bold reforms will take hold gradually, as long as the political situation is not allowed to get out of hand.
The success of the reform programs of the Asian countries will depend importantly on the external environment. Here, unfortunately, we are all aware of recent deepening of the crisis in Russia and its repercussions in Latin America. So far, the impact of this latest crisis on the Asian countries has been relatively limited. One favorable factor is the continuing strength, albeit gradually weakening, of the economies of the United States and Western European countries. On the other hand, the situation in Japan is worrying, particularly given its critical importance for the region. It is essential that Japan moves expeditiously to rehabilitate its financial system and to provide adequate fiscal stimulus to kick-start its economy so as to ensure that the prospective recovery of the crisis countries is not jeopardized.
Before concluding, let me just say a few words about what lessons are to be learned and what we can do to avoid such crises in the future. I should first emphasize that we will not be able to avoid crises. As long as we have financial markets, we will continue to have boom and bust cycles. A better question is, what can we do to limit vulnerability.
First, we need better information to monitor the situation and act in a timely fashion. Had we known how weak the financial systems in these countries were, something could have been done much earlier. Similarly, had we known how rapidly international reserves were falling in Thailand and subsequently in Korea, policy adjustments could have been made before absolutely the last moment.
Second, in all of these boom-bust cycles—and this is not unique to developing countries, we have also seen it in the industrial countries—the financial sector plays a very critical role. It is essential that appropriate prudential and supervisory procedures are in place and banks are in a position to assess risk. There’s nothing wrong with taking large risk in the hope of larger returns. But, then you should know that’s what you are doing. So financial sector reforms are extremely important.
Third, one very important lesson we have learned is that it is a mistake to have a fixed exchange rate unless you are really prepared to do what it takes. What I mean by that is, in addition to sound macroeconomic policies, you also need to have a healthy banking system and a strong reserve position, which can withstand a defensive rise in interest rates to fend off speculators. But there are not many countries that can hold onto a fixed exchange rate when things go wrong.
Fourth, and this is an issue which is being debated actively, is the capital market liberalization. One common theme has been that Asian countries should not have liberalized their capital market so early. To my mind, however, the problem was not that the capital account was liberalized, but that the sequencing was wrong and liberalization was only partial. What I mean by that is that most of these countries liberalized short-term capital inflows before foreign direct investment, rather than the reverse, which is the appropriate sequencing. Furthermore, while capital inflows were liberalized, the financial system remained closed to competition from outside. Thus, the combination of partial liberalization of the capital account in the presence of structural rigidities led to a channeling of external funds without due regard to risk and contributed to the ensuing crisis.
Would it then be appropriate to impose capital controls now to deal with the problem? But this would be like closing the door after the proverbial horse has bolted. Furthermore, capital controls are much less effective in stemming outflows than inflows. It would be much more effective to move boldly to deal with the underlying problems in the financial and corporate sectors and to create the right environment for the resumption of capital inflows that can be used productively. After all, let’s not forget that these countries’ access to foreign capital in the past contributed significantly to their rapid growth. Even if output in the Asian countries declines by, say, ten percent, these countries would still have an impressive growth average over the last twenty years. What is important is that, when the capital market is opened, there is an appropriate sequencing so that the financial system is capable of channeling capital into productive investment.
Finally, IMF resources need to be replenished by the quota increase currently being considered by its members to ensure it is in a position to continue to perform its function effectively.