The Role of IMF Advice: A Postcrisis Examination
- Alexander Swoboda, and Peter Kenen
- Published Date:
- December 2000
The Asian currency crises have raised questions about the effectiveness and appropriateness of IMF conditionality demands imposed upon crisis countries. The IMF has been accused of failing to predict a currency crisis in Asia, to halt the collapse of the exchange rate, to stop contagion spreading from Thailand to the rest of the emerging markets, and to prevent crisis countries from falling into deep recessions. Critics argue that much of the fault for the failures was due to misguided conditionality demands imposed on crisis countries by the IMF. Criticism of IMF conditionality can be categorized into three types: questioning tight fiscal policy, tight monetary policy, and the appropriateness of structural policies.
The IMF contends that it had warned Thailand of imminent danger as far back as early 1996, and that Thailand came to the IMF to ask for help after all of its foreign reserves had been spent on forward contracts and after domestic markets were a mess. Both Thailand and Indonesia did not follow through with their first IMF-supported programs as declared in their Letter of Intent, so that market confidence was lost. The IMF admits that fiscal policy was too tight, but only with the benefit of hindsight. It maintains that what went wrong was an overly optimistic forecast. A crisis is a time of opportunity to press for structural reforms that may be politically unpopular.
The following discussion is about whether IMF conditionality should include the so-called structural issues, namely financial sector reform, corporate governance, trade and industrial policies, and other matters lying outside the domain of exchange rate and macroeconomic policies. The appropriate division of labor between the IMF and other international organizations, such as the World Bank and the Basel Committee, is also considered as well as ways for the IMF to strike that careful balance between confidentiality and transparency.
An Assessment of the IMF-Supported Programs in Asia
One of the important functions of an IMF-supported program for a crisis country is to rebuild market confidence in the country’s policy. The IMF and the country’s government agree on what path policies will take in the following years (typically three years) with IMF monitoring. Even though the benefits of policy reform will not materialize for more than a year or so, the effects on the market may be immediate. If the market is convinced that good policy will be enacted, the market will take that into account, and behave accordingly. For example, if the market is convinced fiscal reform will be put into place to eliminate budget deficits, long-term interest rates would come down immediately; if the exchange rate is expected to stabilize, then foreign direct investment may flow back into the country; and if the structural reforms of the banking sector are agreed upon, depositors would be assured that banks will be strengthened, so bank runs would then stop. These kinds of changes in expectations are very important in fighting the twenty-first century type of financial crisis—that is, crisis caused by capital flows rather than current account deficits. Confidence in an IMF-supported program would stop panicky capital outflows and convince foreign creditors to roll over their loans. Correspondingly, the success of IMF-supported programs can be measured by responses in the exchange rate or interest rate.
By looking at the market’s response to the program announcements, we can gain some insights into how effective the market deems the programs to be. This section attempts to quantify how the foreign exchange market responded to announcements of the IMF-supported program with crisis countries, using the event study method.
The value of a program country’s currency (amount of local currency per U.S. dollar) is standardized at 100 on the benchmark day, usually the day that the agreement between the IMF and the crisis government is reached and announced. This agreement date precedes the IMF Executive Board meeting on the program by one day to three weeks. The agreement, however, is rarely turned down or amended in the Executive Board meeting, so we can regard the market as being given full information on the agreement date.
The currency movements before and after the benchmark date are then compared. An effective agreement would be one where the currency had been depreciated before the IMF agreement (because support programs tend to be formulated in response to depreciation); but would then appreciate after the agreement because the program would restore confidence. This methodology is further explained below.
Table 1 shows the one-week, two-week, and one-month changes both before and after the key IMF agreement announcement dates for Thailand, Indonesia, and Korea.
|Agreement Announcement Date||IMF Board||Exchange Rate on the Announcement Day||Exchange Rate on July 1, 1997|
|Thailand||Aug. 11, 1997|
|(Tokyo meeting)||Aug. 20, 1997||B 32.6||B 25.905|
|Indonesia||Oct. 31, 1997||Nov. 5, 1997||Rp 3605||Rp 2431.5|
|Korea||Dec. 3, 1997||Dec. 4, 1997||W 1196.0||W 887.85|
|Dec. 24, 1997||na||W 1962.5||W 887.85|
|Indonesia||Jan. 15, 1998||na||Rp 8950||Rp 2431.5|
|Exchange rate changes, before and after the announcement dates|
|1 month||2 weeks||1 week||IMF Event Day||1 week||2 weeks||1 month|
|96.2||101.9||101.0||Aug. 11, 1997||102.1||108.6||113.0|
|93.4||96.9||96.6||Aug. 20, 1997||104.4||115.5||113.5|
|90.7||99.4||99.2||Oct. 31, 1997||91.7||95.4||101.2|
|80.3||86.5||92.8||Dec. 3, 1997||130.8||123.8||148.2|
|59.0||85.2||80.6||Dec. 24, 1997||92.1||95.1||95.0|
|64.8||61.4||112.8||Jan. 15, 1998||148.0||122.3||105.0|
Two cases are shown for Thailand, because it is difficult to decide whether August 11 (the date of the Tokyo meeting to determine the outline of the package) or August 20 (the date of the IMF Executive Board decision) is appropriate to use as the benchmark. If the Tokyo meeting is taken as a benchmark, the baht depreciated about 4 percent one month prior to the meeting, and it depreciated more than 13 percent after the Tokyo meeting. The meeting did not halt the depreciation trend. If August 20 is taken as the benchmark, the currency depreciated about 6 percent in the one month before the program, and depreciated 13 percent after the program. In either case, the IMF-supported program for Thailand did not have a major impact on the currency depreciation, or maybe depreciation worsened afterwards. The fact that the size of the depreciation after the program was larger than before shows the failure of the IMF-supported program in Thailand to restore market confidence and stop further depreciation.
In the Indonesian program, which was agreed to on October 31 and approved by the IMF Executive Board on November 5, the benchmark date should be October 31. On the day of the agreement, closures of 16 banks were also announced, and concerted intervention to prop up the value of the rupiah was implemented on November 3. Before the IMF agreement, the value of the rupiah had been basically flat for two weeks, while it had depreciated by 10 percent compared with its value a month earlier at the end of September. The rupiah would appreciate by 10 percent on the day after the agreement mostly because of the concerted intervention. The Indonesian program looks like a textbook case for an IMF-supported program if we compare the rupiah two weeks before and after the agreement. After one month, however, the appreciation gained by the October 31 agreement had disappeared. A confidence effect is detected in the short run (two weeks), but not in the long run (one month).
In the case of Korea, the won had depreciated by 20 percent in November. IMF support was requested at the end of November and the program was presumably put together hastily. An agreement was reached on December 3, and approved by the Executive Board on December 4 (unusually short notice). December 3 was chosen as the benchmark (but it would not have mattered much if it had been December 4). This program was a disaster in the won market—the value of the won went down by 30 percent in the week following the announcement of the program, and by 50 percent in the month following December 3.
In response to the ineffectiveness of the December 3 program, the IMF and G-7 devised another agreement on December 24. Movements of the exchange rates before and after December 24 fit a clear pattern for an effective IMF-supported program. The won depreciated about 40 percent before the December 24 program, and appreciated after the program. Even after a month, the level of the won stayed 5 percent above its December 24 level. The difference between the December 3 program and the December 24 program is suggestive of what the market wanted to hear. The most important part of the December 24 program is the agreement that the developed countries would “forcefully guide” their banks to roll over their loans to Korea.
Turning again to Indonesia, the rupiah’s fall in December and January was spectacular. The exchange rate level of the rupiah sank from 4,000 at the beginning of December to 9,000 by January 15. An agreement was put together on January 15 but it did not restore confidence either. As shown in Table 1, the rupiah’s fall continued even after January 15, depreciating by 50 percent after the announcement. This is not confidence building.
In summary, the most effective IMF program shown in Table 1 was the Korean program of December 24, which must have contained some good elements in it from the market’s perspective. The disastrous programs were the December 4 Korean program and the January 15 Indonesian program. Thailand’s program in August did not build confidence either, judging from a slow decline in the baht following the program. A curious case is the November 5 Indonesian program because it had a positive effect for two weeks, but the effect was not sustained.
Of course, this is only one way to look at IMF-supported programs through the market’s reaction. The method employed in this section does not examine the contents of the program or its long-term impact. Details of the programs will be examined below.
On the Methodology
Possible criticisms of the before-and-after method are examined here.1 First, the method may be criticized on the grounds that the success of programs is not properly measured in the before-and-after comparisons. What would be proper is to conduct a “with” and “without” comparison, and to compare output or growth losses, instead of exchange rate changes, for some extended period. Second, my evaluation of the IMF program can be challenged on the question of “alternatives” to the IMF program.
On the first point, high-frequency (that is, daily) data are used to analyze confidence effects, because the crisis is caused by capital flows. Restoring investors’ confidence is key for the success of IMF-supported programs. Capital flows are quick to move into and out of a country, and the success of the program should be judged in days, not years. The IMF, to some extent, played the confidence game—window dressing the size of packages (using the second line of defense) and producing a highly visible announcement ceremony for the agreement—in order to stop the capital outflows so that the value of the currency would stop falling and, in turn, to make it possible to lower interest rates to help recovery. Capital flows or its best proxy during the crisis, namely the currency value, are the best variable by which to judge the success of the IMF-supported program. Surely, if the crises in question are of a traditional type—current account deficit—then the best measure of success and failure would be output losses or growth in annual data. But, we have a new type of crisis—capital flows—and we need a new method. This is the justification for adopting the method of using daily exchange rate movements. Although there could be alternative criteria for gaining more information on the effectiveness of the IMF-supported programs for crisis countries, I maintain that the before-and-after analysis gives a good record of financial market responses to the IMF program announcement.
If we use the “with” and “without” methodology, a comparison of Indonesia “with” an IMF-supported program and Malaysia “without” an IMF-supported program seems to be a natural choice. Malaysia compares favorably with Indonesia in terms of exchange rate movement, inflation record, or output losses from July 1997 to December 1998. Both countries were threatened by contagion from Thailand and were adopting similar austerity programs in the fall of 1997. Malaysia was seen as a country that was adopting an IMF-type program without a formal agreement. A policy of fiscal austerity was adopted without extensive structural reforms in the fall and winter of 1997. Later in 1998, Malaysia deviated more radically from its austerity program and imposed capital controls. Malaysia seems to present the case that comes closest to a “counterfactual.”
An earlier IMF study uses the “with” and “without” methodology as applied to large countries, and basically shows that the “with” countries did better than the “without” countries. Cases analyzed in this study fall in the category of traditional-type crises. Note that there is a problem of sample bias from the so-called “mean reversion” phenomenon for this type of study. If a country has been doing badly, for example, in terms of its current account, the latter will tend to improve at some point due to natural market forces. Even without an IMF-supported program, the current account would be corrected by a currency depreciation (once foreign reserves were exhausted). So, the IMF program is favored to succeed given this tendency toward mean reversion.
Assessment and Discussion2
There are widespread perceptions that the IMF operations in Asia could have been better. There are three types of questions about the IMF’s advice. The first concerns crisis prevention—could the IMF have forecast a crisis in Asia and prevented it? The second is why the IMF could not stop the currencies from overshooting. When the IMF’s help was requested by a crisis country in Asia, the exchange rate had already depreciated to some extent; further depreciation was not justified by the fundamentals. The third concerns contagion from one country to another. Crisis epicenters seem to have shifted from Thailand to Indonesia, to Korea, and then back to Indonesia over the 12 months following the Thai devaluation. Given what happened in Thailand, why couldn’t the IMF prevent contagion and the sharp economic downturn in the Asian region?
After the Mexican crisis in 1994–95—the first financial crisis of the twenty-first century—the IMF knew that another similar crisis would eventually occur. The IMF was supposed to prepare for the future crisis and prevent it from happening or to contain it when it did happen. But the IMF could not prevent Thailand and other Asian countries from suffering the same rate. The IMF’s surveillance and advice on crisis prevention must be questioned.
The usual answer to this criticism is that the IMF was aware of Thailand’s dangerous situation and had warned Thailand accordingly.
In the case of Thailand, the crisis, if not its exact timing, was predicted. Beginning in early 1996, a confluence of domestic and external shocks revealed vulnerabilities in the Thai economy that, until then, had been masked by rapid economic growth and the weakness of the U.S. dollar to which the Thai baht was pegged. But in the following 18 months leading up to the floating of the Thai baht in July 1997, neither the IMF in its continuous dialogue with the Thai authorities, nor increasing market pressure, could overcome their sense of denial about the severity of their country’s economic problems.3
In fact, at the end of 1996, it was easy to detect that Thailand was indeed in trouble, because the current account deficit was about 8 percent of GDP, which was too large to sustain, and export growth had plummeted from 25 percent in 1995 to zero in 1996.
However, the IMF does not seem to have warned other Asian countries in advance. Indonesia, Malaysia, and Korea, in particular, did not receive warnings either from the IMF or the market, even after the Thai devaluation. In August 1997, Thailand’s neighboring countries—Indonesia, the Philippines, and Malaysia—dropped their currencies’ de facto peg to the dollar. This was done, however, without major losses in reserves. The fundamentals in these countries were considered better than Thailand’s. Some fund managers moved assets from Thailand to Indonesia in August and September. The contagion from Thailand to Indonesia did not turn serious until late September, and contagion to Korea did not occur until mid-October.
Crisis Management in Thailand
Given that Thailand made mistakes in maintaining the de facto dollar peg regime too long, and that Thailand lost the foreign reserves because of a large speculative attack in mid-May, what could the IMF have done in August? The Thailand program was approved by the IMF Executive Board on August 20, 1997—seven weeks after the July 2 devaluation—and the baht had depreciated by “only” 20 percent. This contrasts with the 50 percent depreciation of the Mexican peso within one week of the Mexican devaluation on December 20, 1994. The peso had already depreciated by 50 percent by the time the IMF came in, so the overshooting had already occurred. Unlike Mexico, the IMF had the chance to induce a soft landing in Thailand, by preventing overshooting of the currency beyond where it was at the time of IMF involvement. Moreover, Thailand’s growth in 1998 turned out to be much lower than the IMF had forecast in August 1997. However, the Fund did not succeed in maintaining growth at the level that it had targeted.
The IMF’s program for Thailand in August was composed of the usual fiscal austerity measures (fiscal surpluses of 1 percent of GDP) and high interest rates. The fiscal surplus was intended to finance the losses that were expected to result from financial sector cleanup and the interest rate increase was supposed to defend the currency. The IMF must have thought that a 20 percent depreciation was enough to restore price competitiveness, and, therefore, from a macroeconomic fundamentals point of view, there was no reason to depreciate the baht further. In addition to the macroeconomic conditionality, the program emphasized quick resolution of the nonperforming loans problem among the finance companies. Before the IMF-supported program was introduced, 58 finance companies had been “suspended” (16 at the end of June and 42 in early August), but they were essentially still operating by collecting from old loans only (no new loans or new customers) and the management of these companies was not replaced. The IMF demanded that the finance companies be either liquidated or rehabilitated. The plan was to have the appropriate decisions taken within a month, but they were not.
Another factor in the August IMF-supported program for Thailand was the disclosure of the outstanding forward contracts (to sell dollars) that the Bank of Thailand had with investors (or speculators). The massive attack on the baht occurred in May, and even in August, it was revealed, the Bank of Thailand still had contracts amounting to $23.4 billion. The IMF package of $17.2 billion did not impress the market, partly because the IMF program was smaller than the revealed contracts.4
The program, as a whole, did not impress the market, as the baht did not respond favorably. The soft landing of the baht would have been easy if the crisis had been caused by fundamentals. The 20 percent depreciation was probably close to the right magnitude to correct the large current account deficits. Admittedly, the crisis in Thailand was not a traditional type but a new twenty-first century type, one caused by massive capital flows. The IMF tried to give confidence to the market and prevent further capital outflows, counting on rollovers, but failed.
Critics argue that neither the content nor the size of the package impressed the market. First, the high interest rate policy and tight fiscal policy in Thailand’s August program meant that the economy would be heading toward a recession. Second, the financial system reforms, which were emphasized, would take a long time and the deadline set by the IMF may have been too optimistic. When the deadline was not met, the market reacted negatively.
Thailand traditionally had fiscal surpluses. When capital inflows were quite large, one policy option Thailand adopted was to increase fiscal surpluses to lessen the need for foreign capital.5 The reason for the large current account deficits in Thailand was large private capital flows into the private sector, not the government sector. Fiscal austerity in Thailand should not have been as important a factor in confidence building as it was in Latin American countries. Critics argue that fiscal austerity was a mistake for Thailand, because fiscal deficits were not on the list of the precrisis weaknesses. Moreover, it contributed to “overkill” in the economy and worsened the nonperforming loans problem. The economic growth forecasts for 1998 were frequently revised downward.
Critics also point out that cleaning the financial sectors caused a decline in bank lending. Combined with a prolonged period of high interest rate, bank loans were shrinking sharply. A severe credit crunch occurred from August 1997 to the spring of 1998. Many small and medium-sized firms could not obtain working capital or trade credits because banks were cutting down on credit availability irrespective of projects or the viability of businesses.6 Few major policy steps were taken to mitigate the severe credit crunch. This partially explains why exports did not grow faster despite a large depreciation.
The IMF response to the criticism7 is that the Thai baht did not appreciate because the financial system reforms that were supposed to be carried out in the few months following the August agreement were never completed. For example, the resolution of the problem involving finance companies was originally scheduled to be completed within one month, but it actually took four months before the fate of the 58 suspended companies was decided under another government. Backtracking by the government on financial reforms was viewed as harmful by the market.
It should also be pointed out that other crises occurred in Indonesia and Korea, which influenced the Thai baht’s value. Had the crises not occurred elsewhere, the baht’s depreciation would have been contained.
As for the criticism against fiscal austerity, the IMF’s response is that, first, it was thought necessary to finance bad loan losses, and second, fiscal austerity was the correct prescription based on the growth forecast, which only later turned out to be overly optimistic. Once the growth “forecast” was revised downward in February 1998, the IMF quickly allowed fiscal deficits. However, the “forecast” was also done by the IMF, not by an external source. Fiscal austerity has to be part of the set of assumptions that are built upon in the process of obtaining a growth forecast. Therefore, a mistakenly optimistic forecast is really a mistake (or internal inconsistency) in the model that the IMF used.
Regarding monetary policy, the IMF argues that high interest rates contribute to defending the exchange rate. As soon as weakness in the exchange rate has abated, the interest rates can then be lowered. But this contributed to a credit crunch and slowdown of the real economy. Critics point out that the exchange rate had already been floated in Asian countries when the IMF came to the rescue. The interest rate defense of the exchange rate has to be measured against the danger of overkill in the economy. It can be argued that a prolonged period of high interest rate policy is more harmful than beneficial. The decline in interest rates did not materialize in Thailand until February 1998, and a substantial decline did not occur until the summer of 1998. The credit crunch between the summer of 1997 and the summer of 1998 was not seriously dealt with in the IMF program.
In my judgment, the Thai program should have included a larger support package, and fiscal deficits should have been allowed. Since the mistake of defending the fixed exchange rate had already been committed and the exchange rate, after being floated, depreciated by 20 percent, the IMF’s support in early August should have been a financial package large enough to repay all of the forward contracts to speculators (US$23.4 billion at the time the IMF-supported program was announced). In return, the IMF should have required that financial sector reforms were to be implemented quickly and measures taken to strengthen the current account.
A standard criticism of a large financing package is that it would cause moral hazard on the part of lenders and borrowers. If moral hazard by lenders is feared, forced rollovers, or capital controls could have been an alternative. If moral hazard by borrowers is feared, and I think it should be taken very seriously, then strengthening financial supervision, strengthening prudential regulation, and imposing more controls over financial markets would have been the answer. But the pains of reform do not necessarily have to be accompanied by an acute foreign exchange crisis.
It seems that the crucial difference between the critics and the defenders lies in the feasibility and possibility of reforms without a crisis. The IMF argues that pressing for structural reforms in times of crisis is “grabbing a window of opportunity,” while critics hope that financial and structural reforms are better attained during peaceful times in the economy.
Crisis Management in Indonesia, October-November 1997
In the Mexican crisis of 1994–95, contagious effects to other Latin American countries were limited. There was a period of pressure on the currency and stock markets throughout Latin America, but there was no widespread collapse of exchange rate regimes. Argentina and Brazil succeeded in keeping their respective currency regimes in 1995. Contagion in Asia in 1997–98 was much stronger and was a factor in both the Indonesian and Korean currency crises.
The baht continued to depreciate after the IMF-supported program to Thailand in August. As the baht depreciated continuously through July, August, and September, other currencies in neighboring countries were also dragged down. The Philippines, Indonesia, and Malaysia all abandoned their rather rigid exchange rate arrangements by the end of August. They did so voluntarily, and without losing much foreign reserves. The collapse of the de facto dollar peg was already evident by the time Thailand agreed to an IMF-supported program.
When Indonesia asked for an IMF-supported program in October 1997, there was a sense that the program was “precautionary” in nature because the country was not under imminent threat of crisis. Macroeconomic fundamentals were relatively strong (at least in comparison with Thailand), foreign reserves had not been lost (unlike in Thailand), and the regime shift to a floating exchange rate had been smooth.
The rupiah had depreciated by about 50 percent (from the precrisis level on July 1, 1997) when the IMF and the Indonesian government reached an agreement on October 31. The program was expected to prevent further depreciation or even strengthen the overdepreciated currency. The October agreement contained four elements that should be highlighted: tight macroeconomic policy, foreign exchange market interventions, the closing of 16 banks, and structural reform conditionality.
Tight monetary and fiscal policy was agreed on, as usual. The high interest rate was introduced to prevent the currency from sliding down further, and tight fiscal policy was introduced to restore the confidence of investors and to pay for the costs of financial sector reforms. This element is exactly the same as in the Thai program. Second, interventions to buy the rupiah were conducted on November 3. These measures produced confidence in the rupiah and it appreciated by 10 percent immediately—this was new.
In the end, however, it was the Indonesian rupiah that depreciated the most. The rupiah reached a low of 15,000 per U.S. dollar on January 23, 1998, compared with 2400 at the precrisis level. The fall in the currency value to one-sixth of its precrisis level cannot be justified by movement in the fundamentals. Something went wrong between the IMF and the Indonesian government in the period extending from October 31 to mid-January 1998.
With the announcement of the Indonesian agreement, 16 national banks were closed. This was decisive action, compared to Thailand’s “suspension” of 58 finance companies. In fact, the slow resolution of the problem of the finance companies in Thailand might have convinced the IMF to require decisive actions in Indonesia. Some aspects of the closures caused controversy afterward: the criteria for selecting the 16 banks were not transparent; not all of the deposits in the 16 banks were protected; and there was no announcement about the fate of other banks. The explanation was that action was needed to eliminate moral hazard by bank managers, to hasten the bank restructuring, and to send a message to the market that reforms were coming. Indeed, closing the banks that were connected to the family of President Suharto was considered to be a very tough job.
In addition to banking reforms, several structural reforms were also emphasized. These reforms included eliminating subsidies to various goods and commodities industries, including energy and rice; breaking up monopolies, including the national automotive industry; and reforming the distribution system of some products.
These structural reforms were based on both economic efficiency and economic equity. The monopolies were considered, on the one hand, to be misallocating resources and harming consumers and users of these products, and, on the other hand, to be enriching the family members and friends of President Suharto. The structural issues might be at the heart of economic efficiency in Indonesia, but a relationship to capital flows in crisis was, on the surface, unclear. The logic was that “market confidence” in Indonesia would be strengthened by (a pledge of) tough actions to correct policy problems that had plagued the economy for so long. Deadlines for these actions reportedly were not immediate or strict. Most of the structural reforms were planned as gradual reforms with target dates several years away.
Critics have argued that the role of the IMF in the Indonesian crisis was more questionable than in Thailand’s program. Thailand’s fundamentals (in particular, the large current account deficits) were obviously weak before the crisis, and the Bank of Thailand made the error of losing most of its foreign reserves. By the time they approached the IMF, the economy was already very “sick.” In contrast, Indonesia, even in late October was still relatively “healthy.”
There are three specific points that critics make. First was the excessively tight monetary and fiscal policy, which was already discussed in the earlier section on Thailand. The justification of fiscal surpluses is to enhance confidence and to pay for financial sector reform. If the economy is heading for a recession, however, fiscal surpluses may not build confidence. Tight monetary policy was recommended to prevent inflation and to restore a more reasonable level for the exchange rate (recall that the rupiah was down by about 50 percent in late October).
Second, to close 16 banks without full deposit protection or a comprehensive statement about the rest of the financial sector was a mistake, because it caused a bank run and general distrust in the financial system in the following months. The criteria for selecting the 16 banks were unclear. It was well known among the informed, rich depositors that there were other banks that were just as weak as the 16 selected. Sudden death for the 16 banks showed that more of the same could happen in the near future. Therefore, with deposits not fully guaranteed, depositors thought it wise to move their money to stronger banks or overseas.
A better policy would have been either to enact more sweeping action or to take a more gradual approach. For example, the authorities could have closed more weak banks, but with a public announcement on the health of the remaining banks and a full guarantee of deposits in them. A more gradual approach would have been to set up the capital adequacy criteria first and allow banks to submit rehabilitation plans. The latter option was not attractive, however, in the light of the Thai example with its record of slow progress. The IMF defends its recommendation of the quick closure of the 16 banks, without full deposit guarantee, because it says it was necessary to prevent “moral hazard.” To rescue depositors would have increased the cost of financial sector reforms, and it would have caused bank management to relax. I assert, however, that in order for there to be market discipline to prevent moral hazard, more information on the conditions of banks had to be provided.
Third, structural reforms were extremely difficult to achieve in the short run. The problems highlighted in the November program were well-known problems, and target dates were typically set far enough in the future that they did not cause any sense of urgency.
Although the critics view Indonesia’s economy as having been relatively healthy, this does not mean that it did not have problems. The Indonesian macroeconomic situation was relatively strong at the time of its first program, but the economy did have weaknesses. And with prolonged uncertainty in the exchange rate markets in the region, the Indonesian economy became more fragile. Weakness in the exchange rates reflected deteriorating macro fundamentals. Moreover, the fact that the rupiah had appreciated since November 3, for about two weeks, shows the initial success of the IMF-supported program. It was only after the backtracking on policy commitment that the exchange rate started to fall. One of the banks that closed in November was reopened (by its purchasing another bank’s license) within one week at the same location. Because the bank was controlled by one of President Suharto’s sons, the market viewed it as backtracking on the part of the government.
Disagreement between the IMF and the Indonesian government caused most of the exchange rate depreciation, and it is difficult to assign the blame to either side. Some could say that failure to meet the IMF’s deadlines was the fault of the government. Others could view the IMF as overly optimistic about the government’s ability or willingness to fulfill its commitments. Adjustment and structural reforms take time. The IMF may take the view that a crisis is a window of opportunity to press through politically difficult structural reforms. Critics argue, however, that when an acute crisis is at hand, structural reforms should not be the focus of attention. If investors “wake up” to structural vulnerability before comprehensive measures are crafted, pressures on the foreign exchange market could worsen.
What would have been an alternative? In my judgment, the initial program of November 1997 could have been crafted a little more carefully on the financial market reform. At the end of October 1997, there was no acute shortage of foreign exchange. The financial sector reform should have been more comprehensive, addressing problems in state banks and private sector banks altogether, while maintaining public confidence in the financial system during the period of financial sector reforms. It is also my view that the November program was too ambitious, trying to achieve too many things at the same time. The program in early November should have been more focused on measures to maintain a relatively strong macroeconomy and bringing up foreign reserves, in order to prevent contagion from Thailand.
Crisis Management in Indonesia, December 1997-April 1998
The rupiah again became the focus of investors’ attention in December 1997 and January 1998. The rupiah plummeted in December in response to a rumor that President Suharto’s health was declining and Mr. Habibie would be named vice president in the upcoming election in March 1998. The exchange rate depreciated from Rp 4,000 per U.S. dollar to Rp 5,500 per U.S. dollar. Then in January, it went into a free fall. There was a spectacular clash between the IMF and the Indonesian government over fiscal policy. On January 6, 1998, President Suharto presented a budget for the following fiscal year with more than a 40 percent increase in size. The IMF objected to this budget, and a battle ensued. In the IMF’s view, this budget violated the tight fiscal policy goal, causing loss of confidence in Indonesia, and as a result the rupiah quickly lost value from Rp 5,500 per U.S. dollar on January 1 to Rp 10,100 per U.S. dollar on January 8, a loss of half of its value in just one week.
Another agreement was reached on January 15, 1998, in an attempt to correct the problem. The agreement was hastily put together in response to the rift over the fiscal budget, and it included a list of structural policies. The January 15 agreement was unusual in two respects. First, it was announced at a highly visible signing ceremony attended by President Suharto and IMF Managing Director Michel Camdessus. Second, the documents contained a long list of structural reforms. The purpose of the agreement was to stop what appeared to be a free fall of the rupiah, and the list of structural reforms seemed only remotely related to the exchange rate issue. The largest decline in the rupiah occurred following the IMF agreement on January 15. Ironically, the rupiah, which was considered to be relatively strong among the Association of South East Asian Nations (ASEAN) currencies, became the weakest currency in the region.
The program (disbursement) was suspended in March; resumption of funding was agreed to in April, but with further structural programs agreed to by Indonesia. Elimination of energy-related subsidies, among others, was often cited as a trigger for the social unrest that followed.
Critics argue that a list of structural measures did not build much confidence at this point. The program failed to address the essential part of market anxiety—the rupiah’s free fall, caused by political uncertainty and a rift between the Indonesian government and the IMF. How investors could be reassured or encouraged to stay in Indonesia was not addressed. The IMF thought that having President Suharto commit to tough reforms would restore confidence, but instead, the result was a loss of confidence by investors as shown by a further fall in the exchange rate. First, structural reforms had little economic link to the level of the foreign exchange rate. Second, the logic that tough structural measures would enhance confidence in the market does not work when the market has become skeptical about the government’s ability to deliver, as was the case in Indonesia in view of the government’s track record since October. The tougher the measures were, the more skeptical the market became—the exact opposite of the intended effect.
It is difficult to imagine what could have been an alternative path for Indonesia if we could do it all over again. The initial IMF program had some flaws—such as the closing of 16 banks without assurance about deposits in other institutions—but this was not a critical problem, although in my judgment, it would have been much better to close more banks, say, forty, in order to clear out the weak institutions in one stroke, but with a guarantee of deposits in the rest of the financial system. As mentioned above, a series of events made investors doubt the commitment of the Indonesian government after the October 31 agreement. First, one of President Suharto’s sons reopened a closed bank, shedding doubt about the commitment to financial reform and abolishment of crony capitalism. And the rumored health problems of President Suharto caused a sharp depreciation in the rupiah in December. Still, closer surveillance from late November to December might have saved the original program. Unfortunately, the IMF was fighting on two fronts: one in Indonesia and another in Korea. As a result, insufficient attention might have been paid to keeping the program on track in December.
Consider events in and after January 1998, when the Indonesian government announced a budget that included an increase of 43 percent in spending for the following fiscal year. The IMF openly criticized that budget for not being consistent with the fiscal austerity program agreed on earlier, and the disagreement resulted in further depreciation of the rupiah.
It is surprising that the Indonesian government crafted a budget that was not consistent with the IMF-supported program, without the IMF being aware of it, because, usually, the budget is prepared in close consultation. In this case, there was a lack of communication between the Indonesian government and the IMF. Did the Indonesian government deliberately hide the process? Or was the IMF looking the other way?
It is not clear what the IMF could have done in December and January, but if the program was to be saved, a lot more consultation should have taken place, and any disagreement should have been kept behind closed doors.
Remember that Indonesia came to the IMF with ample foreign reserves and relatively better macroeconomic fundamentals than Thailand, which is often criticized for approaching the IMF very late, that is, after having lost most of its foreign reserves (through Bank of Thailand forward contracts), after having committed public money to defunct financial institutions (through FDIF assistance to finance companies), and after having guaranteed all deposits, thereby causing “moral hazard.” None of these “too-late” problems were present when the IMF was invited to Indonesia. Yet, the outcome was much worse in Indonesia than in Thailand. Defenders of the IMF cannot argue that Indonesia came to the IMF too late and too sick. Something went terribly wrong there.
Crisis Management in Korea
Korea started to experience a sharp depreciation of its currency in November 1997. The IMF-supported program for Korea was agreed to on December 3, 1997 and approved by the Executive Board on the following day. The won had been falling by 35 percent from its precrisis level. The contents of the program were similar to Indonesia’s: tight monetary policy, tight fiscal policy, financial sector reform, trade and capital account liberalization, and structural issues centered around corporate governance, corporate ownership structure (chaebols), and labor market reforms.
In Korea, the problem at the beginning of December was the acute liquidity crisis, as foreign commercial banks refused to roll over short-term lending to Korean commercial banks. It was feared that Korea, as a country, would run out of dollars and default on its dollar liabilities. The package did not address this problem, and it repeated traditional fiscal and monetary tightening. The only innovation in addressing the liquidity problem was that the size of the package was boosted to twenty times Korea’s quota.
Not only did the program fail to stop depreciation of the won, but the largest depreciation came just after the program was in place. This shows that the IMF-supported program of December 4 did not restore confidence in the market at all. It was an instant failure. The program neither provided enough foreign currencies to pay back huge banking liabilities nor did it suggest a standstill on the hemorrhage of short-term banking liabilities. The latter had to wait until the IMF program of December 24, 1997.
Critics argue that addressing structural policies in the midst of an international liquidity problem was irrelevant and did not deal with the heart of the capital flow problem. It may even have been harmful because the market took it as a signal that the country’s capital problem would not be solved until the structural issues were solved, which would take a long time. Directing the markets attention toward structural issues did not work in programs in the December 3, 1997, Korean program, or in the Indonesian program of January 15, 1998.
Critics see the Korean predicament as arising mainly from a liquidity problem in bank lending. Although it was a mistake to create vulnerability by increasing bank borrowing to a level twice the size of foreign reserves, the weakness in the economy was not at the level that would precipitate the acute foreign exchange shortage. Buying time to increase foreign exchange should have been a central goal of an IMF-supported program.
The Korean experience also showed that having only a tight monetary policy did not work when lenders were rushing to get out of the country in a panic. Some tight monetary policy would have been desirable but in conjunction with either large financing or explicit cooperation from creditors in rollovers. The alternative to the December 3, 1997, Korea program would have been either a program with a larger dollar amount, to impress the bankers who were refusing rollovers, or a decisive standstill arrangement that resembled the subsequent December 24 program.
Comparing the Russia and Brazil Programs with the Asia Programs
To offer some contrast to the Asian programs, the Russian program in the summer of 1998 and the Brazilian program of November 1998-January 1999 will be mentioned briefly. The major difference between the programs is twofold. First, exchange rates were already floated in Asian countries when their IMF packages were negotiated, while in Russia and Brazil exchange rates were pegged to the dollar. It was quite strange that the IMF put together rescue packages for Russia and Brazil in order to defend the dollar peg, while the IMF earlier scolded Asian monetary authorities for sticking with the dollar peg too long. After one month in Russia and a few months in Brazil, the dollar peg collapsed. Second, fiscal deficits were very large in Russia and Brazil, while they were a nonissue in Asia. Fiscal tightening was indeed the right prescription this time for Russia and Brazil.
Critics argue that there are fundamental difficulties in the IMF-supported programs with Russia and Brazil and that the IMF was quite “soft” toward Russia, compared with its programs in Asia, in several respects. First, when the IMF-supported program was given to Russia, with an attempt to defend the fixed exchange rate in July 1998, the lessons of the Asian crises had still not been learned. It was quite obvious to many that maintaining the fixed exchange rate regime was not feasible at that point. Fiscal deficits were overwhelming and foreign reserves were declining fast. Both fiscal and current account deficits were filled by sales of GKO (short-term government debt instruments) to foreign investors. In contrast, Asian currencies were all floated before the IMF-supported programs (e.g., the Thai baht was floated on July 2, and the program was decided on August 20). Yet, Asian central banks, especially the Bank of Thailand, were criticized for maintaining the de facto regime too long. It looked very “soft” when the IMF supported Russia without insisting on floating (a de facto devaluation) the currency. The same argument applies to Brazil.
Second, at least seen from outside, the danger of issuing GKOs was not adequately pointed out to the Russian authorities, or alternatively to investors. Financing fiscal and balance of payments deficits by issuing GKOs, with an interest rate higher than 40 percent, was not sustainable by any calculation. The lesson of the Mexican tesobonos (short-term bonds the supply of which increased sharply in the last days leading to the Mexican peso crisis of 1994) was not learned. This point will be elaborated on below.
Third, the collapse of the tax collection system was at the core of the crisis. Structural reforms targeted at the tax system would have enhanced “confidence” in the market. Fiscal austerity should have been pushed vigorously in Russia, but not in Asia; the IMF got the prescriptions backward.
Fourth, mismanagement of foreign reserves by the Russian central bank seems to rival that of Asian countries, and is even worse if what is reported in the media about the central bank’s accounts being diverted to tax havens abroad is correct.
Let me elaborate on the point about the mushrooming issues of GKOs. The unsustainability of financing deficits with GKOs at 40 percent interest was well-known in the market. Investors tended to regard the high yields of GKOs as high returns with little risk, because they assumed the IMF would bail out the country no matter what, which turned out to be false. Purchasing high-yielding GKOs was even called a “moral-hazard play” in the market, implying that the market well understood that the Russian government would not be able to finance its debts, but that the IMF would bail out the Russian government anyway.
The IMF seems to have been either complacent because of an apparently controlled money supply and inflation rate, or too timid in pressing the issue with the authorities and threatening to warn the market. The danger of short-term government bonds with high interest rates being issued to foreigners became quite apparent in the Mexican crisis. The lesson is that using a monetary approach, which focuses on the money supply, and applying it to the emerging market problem does not work in an environment prone to capital flow crises. Was this forgotten in Russia?
Brazil is also interesting when compared with Asian cases. Again, fiscal deficits and overvaluation due to the dollar peg were the sources of weakness. Instead of addressing these problems, the IMF allowed Brazil to stick with a fixed exchange rate regime. The regime collapsed when investors reacted negatively to news that one of the state governors opposed the fiscal reform plan. Because Brazil had lost billions of dollars in speculative attacks prior to the IMF-supported program, Brazil and the IMF knew that they were racing against time. Confidence building by implementing fiscal reforms did not instantly work.
In my judgment, the IMF should have insisted on some fiscal deficit reduction before giving financial support to Russia and Brazil. The IMF was also misguided in allowing the fixed exchange rate to continue when it provided billions of dollars as a part of the programs.
Compared with the Asian crises, the root problems of the Russia and Brazil crises were more of the traditional type resulting from fiscal deficits. Tight fiscal policy and structural reforms aimed at correcting fiscal deficit problems would have worked in Russia and Brazil, unlike in Asia. Yet, the conditionality for these two countries seems to have been “soft,” because the program was designed to defend their fixed exchange rate regime, while many in the market thought that the fixed exchange rate had to go. The program stance was also questioned in light of heavy IMF criticism of the Asian authorities’ (especially the Bank of Thailand’s) behavior in defending the fixed exchange rate too long.
The effectiveness of the IMF programs in Asia has been questioned because of several “failures.” Overshooting of the Thai baht was not avoided despite IMF intervention. The IMF also failed to stop contagion spreading from Thailand to Indonesia and Korea. In Indonesia, the IMF-supported program again failed to prevent overshooting of the currency. The health of the banking sector became especially weak in Thailand, Indonesia, and Korea and economic growth rates in the region plummeted in 1998. Many thought fiscal tightening was not necessary, because the Asian countries had rather respectable records of fiscal balances, and the market was not concerned about lack of fiscal discipline. With tight monetary policy, fiscal tightening surely contributed to the severity of the economic downturn.
Structural policies are the most controversial. Support packages made conditional structural reforms ranging from reform of financial institutions, relevant to a currency crisis to privatizing government institutions, or to eliminating subsidies and monopolies. The Indonesian program of January 15, 1998, supposedly contained forty items on structural reforms. Critics argue that such a list of structural reforms (except financial sector reforms) has little relevance to a balance of payments crisis or to alleviate an acute need of foreign exchange. Some suspect that the list was put together just to impress the market, in an attempt to regain confidence in the Indonesian government’s and IMF’s resolve to carry out tough measures. Contrary to intent, the long list of structural reforms also gave the impression that reforms were impossible to achieve quickly, so confidence was lost instead of gained.
The IMF argued that the crisis period provided a window of opportunity to press a politically unpopular reform program that was good for the economy, though its relationship to the balance of payment crisis may have been remote. In reality, one can argue that some of the structural policies in Indonesia made social and political situations worse and contributed to an already chaotic situation. Table 2 summarizes the disputes between critics and the IMF.
|Typical IMF Prescriptions||Critics’ View|
|Tight fiscal policy||Needed in order (1) to enhance “confidence,” (2) to pay for financial reforms (cover losses of dealing with weak and insolvent institutions).||(1) Since Asian countries have a record of sound fiscal policy, surpluses are not needed to maintain “confidence.”|
(2) Faced with an imminent recession due to a currency crisis, fiscal deficits should be adopted.
|Tight monetary policy||Needed in order (1) to prevent further depreciation, (2) to prevent inflation from depreciation.||(1) Sustained high interest rate policy is harmful in causing a credit crunch or a domestic liquidity crisis, and defaults will rise. (2) Exchange rate was floated, so that there is no need to be too tight. The “interest defense” of the exchange rate does not work.|
|Exchange rate policy||Little intervention (except for Indonesia, Nov. 3).||If some level of the exchange rate should be defended, enough reserves have to be there to reassure investors.|
|Financial sector reform||(1) Weak and insolvent institutions should be separated and dealt with (liquidation, capital injection, or merger; auction of bad assets or institutions).|
(2) Remaining banks should be strengthened. (3) Moral hazard should be prevented by limiting payout to depositors.
|(1) Which banks should be closed must be decided by a transparent, independent supervision agency. (2) Depositors should be protected to prevent chaos and a bank run, until the strengthened system is established with a transparent deposit insurance system. (3) Credit crunch during the process of financial sector reform should be avoided, if necessary by public institutions.|
Lane and others (1999)
|Radelet and Sachs (1998)|
What Advice for Preventing Crises
Of course, it is better to prevent a crisis than to manage one after it happens. Many lessons were learned from crises in Mexico, 1994–95; the Asian countries, 1997–98; and Russia and Brazil, 1998–99. First, sound macroeconomic fundamentals such as fiscal balance, small current account deficits, low inflation, and high growth are most important. This is not a controversial point. Second, whatever the exchange rate regime is, prolonged overvaluation must be avoided. On the one hand, the Asian currency crises showed that the dollar peg regime for a country with significant trading relationships with partners other than the United States does not work. On the other hand, it is simplistic to say that only free-floating exchange rate regimes would avoid speculative attacks. Third, structural issues are better dealt with during noncrisis times, if possible. Even those who advocate facing structural reform issues during crises would agree that pushing for structural reforms during noncrisis times is better. They would argue, however, that structural reforms are more difficult to achieve politically in noncrisis times.
Sound Macroeconomic Environment
The importance of sound macroeconomic policy is uncontroversial. To any macroeconomist, there is a standard checklist of what constitutes sound macroeconomic performance: low inflation, low unemployment, high (but not excessive) growth, a balanced fiscal budget, and a balanced current account. To achieve these results, monetary and fiscal policies have to be adjusted in response to internal and external shocks.
In general, the track record of the IMF on giving advice on these macroeconomic policies has been very good. Its advice on monetary policy and fiscal policy (both expenditures and tax cuts) is well-grounded on long experience and economic theory. Sometimes, disagreements occur between the IMF and countries over growth forecasts, appropriateness of the inflation target, and the size of fiscal deficits. These disagreements are relatively minor, however, and the resolution of minor disagreements usually does not have significant consequences.
One possible problem concerns the appropriate advice to give an emerging country that experiences large capital inflows. If a country experiences capital inflows without foreign exchange intervention, its currency will appreciate. If intervention keeps the exchange rate stable, then foreign exchange reserves increase, putting pressure on authorities to increase the domestic money supply. If intervention is unsterilized, then the interest rate will decrease and an economic boom will ensue, possibly resulting in a financial “bubble.” If intervention is sterilized, then the interest rate is maintained relatively high, resulting in more capital inflows, perhaps short-term. In summary, the country has a difficult choice to make among a large currency appreciation (which may damage export industries), excessive growth and inflation, or more short-term capital inflows.8
Exchange Rate Regime
One emerging school of thought believes only two extreme regimes are robust—a currency board system and a free-floating exchange rate regime.9 The observation that Hong Kong and Argentina have successfully survived the contagious effects of currency pressures supports the view that the currency board regime is robust. Under this system, monetary policy becomes totally dependent on capital flows. When capital comes in, intervention will increase foreign reserves, and the money supply will increase, resulting in a decline in the interest rate.10 That will discourage inflows. When capital flows out, the money supply will decrease, resulting in a higher interest rate, which automatically discourages capital outflows. With an automatic stabilizing mechanism, the currency board should work to stabilize capital flows. In addition, foreign investors feel secure that local currency is backed one-to-one by foreign currencies. This process holds during noncrisis times, but may not hold during crises. In a crisis situation, even a very high interest rate may not sufficiently compensate for the risk of currency depreciation.
The other possible regime, according to this emerging school of thought, is a free float. Is there no middle ground? The dollar peg without a currency board has a poor record as shown in Mexico, Asia, Russia, and Brazil. Moving to the other extreme of a complete free float, however, may have other risks. Even with a free float, there is no guarantee that capital inflows will not be large, with high exchange rate volatility harming export industries. One view is that excessive capital flows seem to cause harm regardless of the exchange rate regime. A compromise position would manage exchange rate within a loose band system (target zone).
A further limitation of the bipolar model is that it ignores the positive experiences with exchange rate-based stabilization programs. Some countries with hyperinflation have shown remarkable progress in reducing the inflation rate with the exchange rate as a nominal anchor. The question then is when and how to exit from that nominal anchor without a loss of confidence in the country’s monetary policy.
Suppose that we do find a middle ground and we believe there is a role for a nominal anchor. There is still an important question for a country of when to exit from its pegged regime, because history has shown that, sooner or later, pegged regimes develop distortions (such as free arbitrage opportunities for sophisticated investors, or overvalued currencies).
In this context, the IMF study on exit policy11 should be developed into a checklist for Article IV consultations. However, in light of what happened in Russia and Brazil, where it endorsed the defense of the currency peg, the IMF does not seem to be convinced of an appropriate exit strategy.
Early Warning Signals
An early warning system that predicts crises before they happen would be very helpful to the IMF, to its member countries, and also to investors and speculators. The present status of work toward developing such a system, however, shows that it is very difficult to forecast a crisis. Efforts to reduce the probability of false alarms will likely raise the probability of failure to predict future crises.12
Suppose, for example, an economist on Wall Street succeeds in developing a fairly accurate early warning indicator. The economist would act just before the crisis, and before anyone else noticed. By changing his behavior, the economist is destroying a once-reliable indicator. Therefore, successful indicators will not stay successful because of behavioral changes among investors. The so-called Lucas Critique applies here.13
Sequencing and Capital Controls
Another lesson from the Asian currency crises is that capital accounts must not be liberalized too quickly. There are preconditions for the successful opening of capital accounts. Macroeconomic stability has to be achieved, so that capital flight does not occur. Domestic money and securities markets have to be mature and deep. Supervision and regulatory frameworks for sound banking have to be established and tested in the liberalized domestic markets before exposing them to external shocks.
A die-hard liberalization advocate (or Washington consensus believer) may criticize this kind of gradual approach, saying the gradualism would be used as an excuse not to reform and that would only prolong financial repression and deny the country the benefits of capital inflows. Introducing foreign competition will speed up the establishment of effective supervision and regulations.
However, the danger of a “twin-crisis”—near simultaneous currency and banking crises, documented by Kaminsky and Reinhart (1996)—is too great. Experiences show that building supervision and regulatory framework takes time, and once a crisis happens, it is already too late. History has consistently shown that financial liberalization and competition, even only in domestic markets, often result in a boom and bust cycle. It is not advisable to liberalize the capital account prior to, or at the same time as, domestic financial liberalization, since it would increase the probability of twin crises. Opening of the capital account should occur after the domestic markets have gone through liberalization and have become deep and efficient. Domestic players have to learn to do business in a competitive environment, and borrowers and investors have to learn how to take risks. The IMF’s advice should reflect this wisdom in the literature.
When external liberalization is carried out, foreign direct investment should be liberalized first, and short-term capital flows (bank deposits and short-term government securities) can be the last thing liberalized. The exchange rate regime has to have enough flexibility to adjust the exchange rate to external shocks. For those who advocate the use of currency boards, enough foreign reserves need to be accumulated prior to adopting the currency board to withstand violent capital inflows and outflows.
The IMF’s role here is not to take the risk of pushing liberalization too far or too fast, but to push for domestic reforms first and to give technical advice for regulatory changes—such as building a legal framework to prevent moral hazard, and introducing risk management to domestic markets. Finding the correct order for sequencing liberalization and an appropriate speed for adjustment is a challenge for advisors to developing countries.14
Structural Issues and Division of Labor
I have argued that structural issues should be discussed as part of the IMF’s surveillance work, and the push for reforms should not be delayed until a crisis occurs. The task of mapping out the details of structural policies maybe divided among different international organizations: the IMF, World Bank, Asian Development Bank (or European Bank for Reconstruction and Development, Inter-American Development Bank, World Trade Organization, Organization for Economic Cooperation and Development, Bank for International Settlement, International Organization of Securities Commissions), and possibly other regional forums. Some coordination would be needed. The IMF should take the lead in the financial sector (banks, nonbanks, and securities firms) because of the link between banking and currency crises. The BIS, with input from the IMF and World Bank, has prepared guidelines for bank supervision called the Core Principles for Effective Bank Supervision. Specific steps for implementing the guidelines need more coordination.
The World Bank and regional development banks are more suitable for the work on safety net issues, which would become relevant when carrying out structural reforms such as abolishing food and energy subsidies. Advice on competition policies (say, abolishing monopoly businesses by “politically connected persons”) may be obtained from the World Bank, a regional development bank, and the World Trade Organization.
For regional financial issues, a regional organization could be charged with surveillance. Although some concerns have been raised about an Asian Monetary Fund, proposed in September 1997, the idea deserves fuller discussion. I will return to this topic. As noted above, an important task for international organizations is to study and push structural reforms during a noncrisis period, so that they can be considered seriously before a crisis occurs. In terms of political economy, a regional forum may have greater success in applying peer pressure and in securing mutual coordination to that end. For example, a free trade zone, a free investment treaty, or a mutual lending (swap) arrangement for a foreign currency liquidity crisis can originate in such a regional grouping.
Advice and Conditionality
Experiences from Asia show that the following points are important for the IMF to consider when giving advice to countries in crisis:
(1) Fiscal surpluses may be inappropriate for countries in a currency crisis if the country has a good track record in fiscal management (e.g., fiscal surpluses in most of the past ten years). For countries with large fiscal deficits, it is most appropriate to require tight fiscal policy. The exact measures to be undertaken to increase revenues or to decrease spending depend on the country’s institutional arrangements.
(2) A high interest rate policy should not be sustained for too long. It is not desirable if corporations are highly indebted and financial statements and accounting standards do not carry precise information. A credit crunch could start because of asymmetrical information about borrowers’ conditions and the deterioration in banks’ balance sheets.15 A credit crunch will adversely affect corporations that may be viable otherwise. A high interest rate policy has to be measured against this risk, or if such a policy is absolutely necessary, policy intervention to alleviate its costs for viable corporations may be justified. For example, publicly owned banks, such as an export-import bank, may be used to expand credit to stop a downturn of the economy. If there are no publicly owned banks, a support package for the country from international financial institutions and bilateral programs should be considered as ways to help corporations directly.
(3) Financial sector reforms are important, but much of the work should be done during noncrisis periods. Although it is important to identify and to close insolvent banks, weak but viable banks should be strengthened with government money if necessary. And deposits could be protected during a crisis period.
(4) Including sectoral issues (other than financial sector reforms) in conditionality may or may not work during a crisis. When a sectoral agenda is too long and too tough, investors in the market may react negatively because they suspect that the government (or president) will not follow through.
Of course, specific advice needs to be tailored to specific countries, taking into consideration the history of economic policies, general economic conditions (such as the inflation rate, unemployment rate, and savings rate), political stability (or lack thereof), social safety nets, and external conditions. It is important for the IMF to establish a balance between its usual prescription—tight fiscal and monetary policies—and the specific state of health of the countries.
Is There a Role for a Regional Fund?
In view of the questions raised about the IMF’s advice to Asian crisis countries and the inadequate amount of resources extended by the IMF, the establishment of a similar regional institution in Asia may be desirable. The Asian countries have large foreign reserves and ample domestic savings. If these resources can be pooled in some way, they can provide a fund to supplement IMF-supported programs. Regional funds could play important roles in regional stability. Moreover, structural issues can be addressed more effectively with country peer pressure during noncrisis times, and regular regional surveillance of structural issues could be a key to supplement IMF advice.
Each region, for example, Asia, Latin America, and Central Europe, may be interested in setting up regional monetary and capital funds that could be used as “mutual insurance” for liquidity support and financial stabilization. The benefits of regional funds are threefold. First, a regional fund provides much-needed close surveillance and peer monitoring in the region. Second, a regional fund can supplement an IMF support package to a country in a financial crisis. Third, close ties in trade and investment in the region would make it possible to work out better regional solutions. Contagion is also mostly a regional phenomenon.
Regional surveillance could complement the IMF by filling gaps in expertise. Some policies may be regarded as insensitive to local conditions and institutions; ending food and energy subsidies in the midst of a crisis has resulted in deepening crises. The IMF is strong in macroeconomic analysis, but the World Bank enjoys a stronger reputation for directing structural reforms. How much to push reforms during the crisis must be based on careful analysis of the country’s sociopolitical background. Country peer pressure applied during noncrisis situations is better than pushing through reforms as a part of crisis management.
In a world of large capital flows, the financial support that the IMF can provide to any one country is naturally limited. Even after increasing quotas and raising access limits with the Supplemental Reserve Facility, there is a serious concern about whether IMF support is large enough. In Mexico, Thailand, Indonesia, Korea, Russia, and Brazil, the IMF’s contribution was only a fraction of what was calculated as being needed to stabilize the currency and financial markets.
Because “contagion” tends to spread to neighboring countries, those countries with strong trade and investment ties to a crisis country have great incentives to work out financial support programs. Understandably, Asian countries were seriously concerned about contagious effects from Thailand and many pledged themselves to a support package. It was a step in the right direction. After the Thai crisis appeared to have been contained, the Asian countries proposed an Asian Monetary Fund, a permanent institution set up to handle crisis containment. The idea was a good one and should have been pursued.
Criticisms abound. The usual objections to the idea of a regional fund can be summarized as follows. First, if a regional fund offers softer conditionality to a country, then this would cause moral hazard. Second, if a fund conducts regional surveillance, then it needs another international bureaucracy and that is duplication of work. Thus, critics feel that the IMF and an Asian Monetary Fund would compete in looser conditionality and that would be bad. Certainly, a “race to the bottom” is undesirable.
Counterarguments stress the need for regional surveillance. The IMF cannot be perfect all of the time. IMF advice can be improved, especially on structural policies and on social and political constraints surrounding structural policies. These points could be raised in discussions between the IMF and the regional fund. Discussions with regional experts would improve the quality of both IMF and regional advice. During noncrisis times, competition for advice may be a good thing. Regional country peer pressure is important in bringing political pressure to bear and to foster willingness for reforms. However, once a crisis occurs, the conditionality should be set with a united front. The financial resources of a regional fund would complement IMF resources, when larger funds are needed.
The IMF-supported programs for Asia did not prevent overshooting of the currencies and contagion from spreading to neighboring countries and their currencies. The currency crises turned into prolonged recessions. In many cases, the programs did not restore market confidence in crisis countries. The reasons for the failure seem to be that the conditionality in programs did not address the core problems in these countries. Critics of IMF conditionality can be categorized into three groups: those against tight fiscal policy, those against tight monetary policy, and those who question the appropriateness of structural policies. This paper has examined these criticisms and questions about the IMF’s advice and the appropriateness of the advice during both noncrisis and crisis periods. My principal conclusions about the IMF’s advice to Asian countries are that fiscal policy was too tight, high interest rate policy was maintained for too long, and structural policies sometimes seemed counterproductive when their implementation was questioned by market participants.
Advice to countries during noncrisis periods should be divided according to specialty among the IMF, the World Bank, a regional development bank, the Bank for International Settlements, International Organization of Securities Commissions, and others. A regional fund may have a role to play in Asia, in conducting regional surveillance during noncrisis periods and applying country peer pressure, and in providing additional funds to supplement IMF-supported programs during critical periods.
IMF advice during noncrisis times should be coordinated with that of other international organizations to strengthen structural policies. During crisis times, IMF advice should be more carefully crafted to accommodate differences among countries. The IMF learned, even during the Asian crises, about how to respond to evolving crises. It is also likely that the IMF will continue to adapt itself in response to criticism. Constructive discussions about IMF advice will generate changes in the organization’s operations when it conducts its next battle against another new type of crisis.
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The opinions in this chapter are author’s own, and do not necessarily represent those of the institutions which the author has been affiliated with at any time.
These criticisms were advanced by Mohsin Khan in his comments at the conference.
For the contents of IMF programs, see IMF (1998), press reports, and other IMF sources.
Thailand was indeed praised for its management of capital inflows during the emerging market boom. See Khan and Reinhart (1995).
See Ito and Pereira da Silva (1999) for an analysis of the credit crunch in Thailand.
For example, see Lane and others (1999).
See, for example, Eichengreen (1999; pp. 103–09).
See Williamson (1995) for the working of currency boards.
The Lucas Critique became famous in the context of rational expectations macroeconomic models. As the market participants adjust their behavior when policies change, it is inadvisable to formulate a new policy on the basis of behavioral patterns observed under a previous policy regime. The Lucas Critique analogy was first suggested in Ito (1998b).
See De Gregorio and others (1999) for arguments for a gradual approach.
See Ito and Pereira da Silva (1999) for the case of Thailand.