VII Countries That Avoided a Financial Crisis

International Monetary Fund
Published Date:
April 2002
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Austria: Integration into Regional and Global Markets

Economic policy in Austria has for a considerable time sought to facilitate noninflationary growth, high employment, and increasing economic integration within Europe. The cornerstones of this policy have been the close link of the Austrian schilling to the deutsche mark (both Germany and Austria are presently participants in the Euro area), and since the mid-1980s, fiscal sustainability and harmonization with European norms governing, inter alia, trade, international capital transactions, and the financial system.

These policies have led to a progressive deepening of economic linkages with Europe. Developments in real GDP, prices, and interest rates have paralleled those in Germany, a country that has long been Austria’s largest trading partner. Moreover, the sequencing of changes in macroeconomic policies, liberalization of international financial transactions, and domestic financial sector reforms was carefully designed to preserve internal and external stability as the Austrian economy became more closely linked with its neighbors. Austria thus has avoided the crises afflicting many other small economies integrating into regional or global markets (for example, Sweden and Finland among the advanced countries).

Capital Account Liberalization

Exchange controls and restrictions on international capital movements were removed in several stages. First steps toward capital account liberalization were taken in 1959 in the context of OECD membership, but a considerable number of reservations under the OECD liberalization code remained in place.80 In 1971, some capital controls were temporarily reimposed against the background of the breakdown of the Bretton Woods system, rising inflation, and declining foreign exchange reserves. A major initiative to remove, step by step, virtually all remaining controls on international capital transactions was launched in late 1986 and completed in 1991 (Box 13). The start of this initiative broadly coincided with a determined and prolonged effort to reduce large public sector deficits that threatened to undermine fiscal sustainability and potentially exchange rate stability.

Liberalization was sequenced both with respect to types of participants and transactions. Transactions by domestic banks and insurance companies were for the most part liberalized first, followed by those undertaken by corporations (operating through banks); restrictions on transactions by the general public were generally removed in the final stage. The purpose of this sequencing was to foster the development of banks’ expertise and familiarity with international financial transactions, with banks then helping to ease other market participants into the new environment. Also, by and large, long-term transactions were liberalized before short-term flows. This step-by-step approach to liberalization allowed the authorities to observe market reactions and provided them opportunities to make necessary adjustments to the content and timing of further steps. Moreover, many transactions were tacitly and de facto liberalized during an “observation period” by granting authorizations more liberally; based on this experience, the authorities were able to judge whether and when to proceed with their de jure liberalization.

The liberalization of capital flows in 1986–91 was accompanied by strengthened statistical reporting requirements, to improve the information available both to market participants and policymakers. The changes included broadening the range of transactions subject to reporting, and introducing a breakdown of transactions by currency and country, and by institutional sector.

The effect of liberalization on capital flows appears to have been limited. Gross nonreserve inflows remained approximately constant at 6 percent of GDP on average during the pre- and post-liberalization periods (1980–86 and 1987–99, respectively), while gross nonreserve outflows increased slightly on average, from 6¼ percent to 7 percent of GDP. The increase in gross flows in 1999, following the inception of European monetary union, was significantly larger than that observed during and immediately following the liberalization of capital flows. There was very little increase in the year-to-year volatility of gross capital flows in the period immediately following liberalization (Figure 2).

Figure 2.Austria: Capital Flows, 1980–99

(Percent of GDP)

Source: IMF, Balance of Payments Statistics.

Box 13.Austria: Capital Account Liberalization, 1986–91

November 1, 1986, Forward transactions were allowed for up to 18 months (instead of 12 months); and the major banks were permitted to borrow foreign currency from nonresidents over the medium and long term. The free purchase of securities quoted on an official stock market was extended to cover all securities quoted on a recognized securities exchange. Long-term borrowing from nonresidents for investment purposes was further liberalized; and long-term borrowing by domestic enterprises from nonresident equity holders was permitted up to a loan-to-equity ratio of 3:1. Supporting these measures, restrictions on certain current international transactions and related payments and transfers were also removed. The amount of Austrian notes and coins residents were permitted to take out of the country was raised from S 15,000 to S 50,000 for each trip. The limit on foreign exchange that residents were permitted to purchase from authorized banks for travel purposes was also raised to S 50,000 a trip. If a resident required more foreign exchange for travel, additional amounts could be authorized by the Austrian National Bank (OeNB). Furthermore, licensing requirements for tourism payments, including the use of credit cards, were eliminated altogether. Credit cards, like other means of payment, could now be used freely in the purchase of goods imported for personal use.

February 1, 1989. Austrian residents were permitted to make any type of long-term investment abroad (authorization by the OeNB continued to be required, but was granted freely). Financial institutions were permitted to engage in nearly all types of business for their own account. Domestic enterprises were permitted to borrow, in foreign or domestic currency, funds from domestic and foreign banks for a period of three years or more. Domestic companies were also permitted to receive loans with a maturity of at least three years from their foreign shareholders. The buying and selling of foreign shares, bonds, and investment certificates were also fully liberalized. Residents were still required to deposit foreign securities with an authorized resident agent (bank). Operations in real estate purchase or building abroad by residents were liberalized. In addition to these general measures, specific transactions were liberalized, including: (i) transfer abroad of gifts and endowments up to a limit of S 50,000; (ii) transfer of funds for charitable purposes by relief organizations; (iii) disposal of foreign inheritances by residents; and (iv) entry into insurance contracts denominated in any currency, including Austrian schillings, with residents or nonresidents, and free transfer of premia and annuities.

January 1,1990. The new exchange control regulations that came into force on this date were based on the principle that transactions not explicitly prohibited would henceforth be permitted. This substantially reduced the number of remaining restrictions and simplified the regulations. The following important areas remained subject to authorization by the central bank: domestic nonbanks’ accounts abroad and all related transactions; loans raised by domestic nonbanks from nonresidents (although authorization is automatically granted on application); securities issued by nonresidents in Austria and by residents abroad. Also, as in the past, foreign securities could only be acquired at and deposited in domestic banks; and all capital transfers had to be intermediated by a domestic bank.

November 4, 1991. All remaining restrictions on capital movements were lifted, with the exception of purchase of land and secondary residences in Austria (a five-year transition period for phasing out restrictions on the purchase of secondary residences was granted to Austria when it joined the EU in 1995).

Source: IMF, Annual Report on Exchange Arrangements and Exchange Restrictions, various issues; and information provided by the authorities.

Capital account liberalization had only a modest macroeconomic impact. The conduct of monetary policy was unaffected, although short-term portfolio flows (for example in 1993–94) briefly raised mild concerns; and there was a short-lived and unsuccessful speculative attack on the schilling in 1993, a time marked by considerable exchange market turbulence in Europe. Contrary to the experience in the early 1990s of some other European countries whose currency was pegged to the deutsche mark, the differential between short-term interest rates in Austria and Germany was lower and almost disappeared following the completion of capital account liberalization (Figure 3), reflecting more complete arbitrage, the credibility of Austria’s exchange rate peg, and a high degree of parallelism in macroeconomic developments in Germany and Austria.

Figure 3.Austria: Short-Term Interest Rate, 1980–99

(Percent per annum)

Source: IMF, International Financial Statistics.

Financial System Policies

The soundness and stability of the banking system at the time of liberalization helped to support the smooth and uneventful transition to an open capital account. Although the revisions of the Kreditwesen-gesetz (banking law) in 1979 and 1986 introduced a number of changes that gradually increased competition, including greater freedom to establish branches, the banking system was not yet fully liberalized in the mid-1980s, when the remaining restrictions on international capital flows began to be lifted. Interest rates continued to be controlled by agreement among the banks and with the support of the government (although these agreements gradually lost relevance owing to growing competition among the banks). Most banks were publicly owned or controlled or organized in the form of cooperatives. This ownership structure made it difficult for-foreign banks to enter the Austrian market through acquisitions. Strong pressure to conform to accepted standards of business conduct could be brought to bear on individual banks not only by regulators and supervisors, but also by the government and by the official and recognized representatives of the economy, notably the Chamber of Labor and the Chamber of Commerce and Industry.

The further amendment of the banking laws in 1993 provided for a full liberalization of the financial system, and all EU guidelines for the financial markets were incorporated into Austrian law. The role of public ownership has been substantially reduced (with central government holdings now accounting for less than 0.1 percent of banking system assets). As in other European countries, however, there is still a large share of banks with cooperative or mutual ownership. Financial system liberalization has been followed by a number of large bank mergers, considerable internal restructuring, and a cumulatively significant increase in competition and foreign participation. Even so, the European Commission launched an investigation into whether price fixing remained an issue despite the formal abolition of the interest rate cartel.

Prudential regulation and supervision of both banks and other financial services were already well developed at the time capital account liberalization began. Both during and following the 1986–91 liberalization of capital movements, prudential policies were progressively strengthened in accordance with internationally accepted practices. The changes were shaped in particular by EU guidelines and directives; and by the standards and recommendations issued by the Basel Committee on Banking Supervision and other international regulatory associations. While formal responsibility for banking supervision rests with the Ministry of Finance, the de facto implementation of banking supervision has largely shifted to the Austrian National Bank. The government is considering the establishment of an independent supervisory agency responsible not only for banking, but also for insurance and capital markets; such a reform of supervision would further strengthen its operational independence and effectiveness.

The internal and external liberalization of financial transactions and markets has exposed the Austrian banking sector to much stronger competition. Although stronger competition and tighter margins have presumably been beneficial to consumers, continuing efforts are needed to restructure the financial system and reinforce its supervision.81 The issues facing Austria in this area must be seen within the broader context of the large-scale systemic changes now affecting banks and other financial institutions throughout the European Union.82


Austria avoided many of the problems with capital account liberalization affecting other small advanced and emerging market economies. Regarding the sequencing of capital account liberalization with other policies, Austria first established a framework for macroeconomic stability, then liberalized capital account transactions step by step (with transactions perceived to be riskier being liberalized later), and only in the final stage embarked on a gradual but eventually wide-ranging liberalization and restructuring of the financial sector. Structural changes in the financial sector are ongoing and are likely to represent an important policy challenge in the years to come.

Hungary: Resilience to Contagion from the 1998 Russian Crisis

By early 1995, Hungary seemed to have lost most advantages of an early start in the transition process,83 as a full-fledged crisis had developed with high unemployment, a nearly stagnant economy, persistent inflation in excess of 20 percent, increasing budget deficits, and financial repression. Furthermore, a managed floating regime with no pre-announced exchange rate path, which was intended to contain inflation in the face of large capital inflows, resulted in the real appreciation of the forint and a subsequent loss of external competitiveness. As a result, the external current account deteriorated, seriously aggravating an already burdensome external debt position.84

In early 1995, in response to these adverse developments, the authorities decided to speed up the transition process and implement adjustment measures. The measures included a sharp fiscal adjustment and a shift to a crawling peg exchange rate system with a relatively narrow band of ± 2.25 percent. The economy responded well to the sustained implementation of the macroeconomic adjustment.85 Inflation fell from 28 percent in 1995 to 14 percent in 1998; and real GDP growth rose from 1.5 percent to about 5 percent (Figure 4). External developments were also generally favorable during the period. The current account deficit fell from about 10 percent of GDP in 1994 to 2 percent of GDP in 1997 before rising to almost 5 percent in 1998; foreign debt (in convertible currencies and including intercompany loans) declined from 71 percent of GDP in 1995 to 56 percent of GDP in 1998 (Figure 5); and short-term foreign debt (by remaining maturity) remained at a level equivalent to the stock of net reserves.86

Figure 4.Hungary: Real GDP and Consumer Prices, 1990–98

(Annual percentage change)

Source: IMF, World Economic Outlook.

Figure 5.Hungary: Current Account Balance, Reserves in Convertible Currencies, and Gross External Debt in Convertible Currencies, 1991–98

Sources: IMF, World Economic Outlook; and data provided by the authorities.

In 1990–97, a number of structural measures were taken, notably in the banking sector, the price system, taxation, and foreign trade. The privatization program was supported by the enactment of a new bankruptcy law, liberalization of foreign direct investment (FDI) and exchange controls, and amendments to commercial banking, securities, and accounting laws. These structural measures and sound macroeconomic fundamentals helped the country withstand the adverse effects of the 1998 Russian crisis.

Financial Sector Reforms

Financial sector reforms in Hungary were implemented quickly. The process started in 1987 with the breaking up of the mono banking system consisting of the National Bank of Hungary (NBH), which was not only the central bank but also the biggest commercial bank, and a few other banks. Unlike many other transition economies, early on in the process foreign financial institutions were allowed to invest in the domestic financial sector, with the first foreign-owned institutions being established before the start of the transition process.87 This strategy resulted in increased competition, early transfer of risk management and other know-how and, ultimately, a decrease in intermediation margins. By end-1997, the share of foreign ownership in commercial banks exceeded 70 percent of the banking system’s registered capital.

In addition to encouraging foreign participation in the banking sector, modernization of the banking system has progressed through the three rounds of government-led bank restructuring.88 The first round, at end-1991, attempted to improve the quality of commercial banks’ loan portfolios by providing state guarantees for about half of the credits transferred mostly from the NBH to the banks when they were formed. The second round, in 1992–93, replaced banks’ nonperforming loans (about 4 percent of GDP) with government paper. The last round, in 1993–94, recapitalized banks through issuing 30-year government bonds in exchange for a corresponding increase in government equity in banks. It was the most far-reaching bank restructuring and included strict conditions requiring participating banks to develop and implement strategies for their reorganization and to participate in the enterprise debt resolution program.

Furthermore, the decision to restructure the banking sector eventually led to the privatization of most of the banks. By the time of the 1998 Russian crisis, only about 20 percent of the sector remained in the public sector. Moreover, securities firms and insurance companies became primarily privately owned, with the latter predominantly foreign owned. Regulatory reforms included the adoption of new laws on banking, securities, supervisory, and housing savings associations, and modifications to the insurance and mutual fund laws, which were completed at the end of 1995. In drafting the laws and implementing regulations, particular attention was given to prudential considerations, so that the elimination of exchange restrictions would not lead to excessive risk taking. In particular, the required minimum capital for credit institutions was raised; provisioning requirements were tightened; stringent limits were placed on large credit exposures; rules for calculating regulatory capital and open foreign exchange positions were improved; and the agencies supervising banks and securities firms were amalgamated.

Current and Capital Account Liberalization

The liberalization of foreign exchange payments and transfers, which was initiated in 1989, was accelerated significantly only from 1996, shortly after the introduction of a crawling peg exchange rate system in the spring of 1995 (Box 14). Hungary’s wish to join the OECD played a significant role in this regard. Current account payments and transfers were generally liberalized, but the capital account was only partially opened up until mid-June 2001 as Hungary availed itself of transitional liberalization periods under the OECD code.89

Capital account liberalization was guided by the following basic principles:

  • Liberalizing long-term capital flows before short-term flows. A number of short-term capital transactions were restricted, including almost all derivative transactions;

  • Liberalizing inward FDI early (that is, in 1989, before the initiation of the transition process), including the elimination of most sector specific restrictions for foreign ownership;

  • Liberalizing transactions with the accompanying transfers;90

  • Prohibiting transactions abroad in domestic currency. The authorities considered that the internationalization of the forint was the last step in the process of liberalization (that is, at the time or after the complete liberalization of short-term flows); and

  • Prohibiting transactions in foreign currency between residents.

Effects of the Russian Crisis

The 1998 Russian crisis resulted in large capital outflows from Hungary, putting strong downward pressures on the exchange rate, and resulting in higher interest rates and lower equity prices. Six brokerage houses failed, a number of others suffered heavy losses, and some foreign-owned brokerage firms received capital infusions from their parent companies.91 By the end of the third quarter of 1998, nonresident holdings of Hungarian government bonds had decreased by more than 60 percent (Figure 6 on page 60).

Figure 6.Hungary: Outstanding Stock of Nonresident Holdings of Government Securities, 1997–99

(Billions of forints)

Source: Data provided by the Hungarian authorities.

However, the impact of the Russian crisis was short-lived in Hungary. By October 1998, the confidence of nonresidents in the Hungarian stock market had already returned, with net portfolio flows becoming positive. With intervention in the foreign exchange market, 92 the authorities successfully maintained the crawling band regime. By the end of 1998, the pressures on the exchange rate subsided, with the nominal exchange rate moving back to the lower limit of the band (Figure 7 on page 60).

Figure 7.Hungary: Nominal Exchange Rate, 1997–99

(Forint per U.S. dollar)

Source: Data provided by the Hungarian authorities.

During the Russian crisis, the authorities continued to monitor closely the market and credit risks of banks. They applied moral suasion and sanctions against banks attempting to circumvent the restrictions on nonresident holdings of short-term Hungarian forint assets. Although controls on short-term capital outflows were not effective, those on short-term inflows (by restricting access of nonresidents to short-term domestic instruments) helped reduce the volatility of capital flows.

Box 14.Hungary: Current and Capital Account Liberalization Prior to the Russian Crisis

I. Current Account Liberalization

The current account was first partially opened up in 1989, when import payments were liberalized. By 1991, several other current transactions were gradually freed. Comprehensive liberalization took place on January 1, 1996, in the new Foreign Exchange Law, when all payments and transfers were freed, including the elimination of restrictions in the form of foreign exchange allowances for tourist travel.

II. Capital Account Liberalization

1. The first steps toward capital account liberalization were also taken in 1989, when controls on FDI inflows were lifted (excluding a few sector specific restrictions). Also at this time, domestic natural persons were allowed to open and credit foreign exchange accounts freely, without specifying the source of the proceeds placed in these accounts. In 1993–95, capital flows were partially liberalized.

2. Further major steps were taken in conjunction with OECD accession during 1996–97 when the following transactions were liberalized:

January 1996

  • FDI by residents abroad;

  • Sales and issues of securities to nonresidents with an original maturity of more than one year;1

  • Commercial credit transactions with nonresidents;

  • Borrowing by resident juridical persons in the form of financial credits from nonresidents with a maturity of one year or longer;2

  • Opening of foreign exchange accounts in domestic banks by resident juridical persons and crediting these accounts with the proceeds of all liberalized or authorized transactions;

  • Creation of convertible and nonconvertible forint accounts by nonresidents;3 and

  • Personal capital movements.

July 1997

  • Purchase by residents of OECD central government bonds, and bonds (in both cases with a maturity of one year or longer) and shares of OECD-based enterprises; and

  • Local issues of bonds with a maturity of one year or longer issued by OECD governments and investment grade OECD-based enterprises.

January 1998

  • Establishing branches in all sectors by nonresident companies; and

  • Purchasing real estate abroad by residents without a foreign exchange license.

Source: IMF, Annual Report on Exchange Arrangements and Exchange Restrictions, various issues.

1 Initially the liberalization encompassed securities with a remaining maturity of one year or more. Owing to technical difficulties in implementation, however, in July 1996 the liberalization was changed to cover securities with an original maturity of one year or longer.2 The notification requirement for these credit transactions was retained.3 Convertible forint accounts were allowed to be credited with the proceeds of all liberalized or authorized transactions, while any other forint proceeds had to be placed in nonconvertible forint accounts. The balance of the convertible forint account could be used for any purpose, including conversion and transfer, while the balance of nonconvertible accounts could essentially be used for spending in Hungary.


Hungary’s experience shows that early implementation of financial reforms combined with sound macroeconomic fundamentals can significantly increase resilience to external shocks. When the Russian crisis unfolded, structural reforms in Hungary were already largely under way or completed, in particular the privatization of the banking system and bank consolidation, and the macroeconomic framework was sound. Furthermore, significant progress had been made in enhancing the prudential framework, although the failure of the brokerage houses indicated some weaknesses. These achievements, combined with controls on short-term capital flows, helped mitigate the spillover effects of the Russian crisis. Hungary’s experience also illustrates that allowing foreign participation in the financial sector can help speed the process of financial modernization and ultimately increase the resilience of the financial sector to shocks, as evidenced by the short-lived adverse effects of the Russian crisis.

South Africa: Contagion from the 1997–98 Financial Crises

Over the past 20 years, South Africa has experienced large swings in its capital account (Figure 8). The country recorded large net private capital inflows in the period 1980–84, followed by significant net outflows in the period 1985–94 and large net inflows in 1995–99. The deterioration of the capital account in the mid-1980s reflected difficulties in rolling over external loans following the debt standstill and the imposition of international sanctions.

Figure 8.South Africa: Net Private Capital Flows, 1981–2000

(Percent of GDP)

Source: IMF, World Economic Outlook.

The short-term foreign currency exposure arising from intervention by the South African Reserve Bank (SARB) in the forward foreign exchange market became an important source of external vulnerability. In an attempt to encourage external borrowing and contain the fluctuations in the capital account and the nominal exchange rate, the SARB has intervened in the forward market since the 1960s, resulting in a large uncovered position. Market participants have regarded this open position as a source of vulnerability. In the 1990s, the authorities made several concerted efforts to reduce the open position.93

The 1990s were otherwise characterized by macroeconomic stability, financial consolidation, and gradual external liberalization. Inflation was reduced from 16 percent in 1987 to 5 percent in 1999, and the fiscal deficit of the national government was reduced from 7 percent of GDP in 1992/93 to 2 percent of GDP in 1999/2000; substantial trade reforms and capital account liberalization were also both implemented (see below). The banking sector was well regulated and supervised, with the capital adequacy ratio averaging about 12 percent and nonperforming loans amounting to 4.5 percent of total loans at end-1998.94

Financial Sector Reforms

Following the 1985 external and banking crisis,95 the South African authorities implemented a comprehensive program of financial sector reforms. The consolidation of the financial sector was completed in the early 1990s, merging nearly all nonbank financial institutions into large banking groups.96 As the economy began to open up in the mid-1990s, the financial sector grew rapidly, and South Africa has developed a modern, sophisticated financial system that offers a wide range of services. As a result, non-residents’ participation in the highly developed securities and stock markets has increased markedly, and foreign banks have reentered the South African market, albeit at a somewhat more gradual pace.97

A strengthening of the prudential framework preceded deregulation of the financial sector. Before the opening of the financial sector to foreign investors, South Africa established and has subsequently maintained a legal and accounting infrastructure comparable to that in many advanced countries. Disclosure standards were well developed, and considerable efforts were made to ensure that financial statements were in line with the International Accounting Standards (IAS). Moreover, effective supervision was conducted by two agencies, with the Banking Supervision Department (BSD) of the SARB regulating and supervising banks, and the Financial Services Board (FSB) the financial markets and nonbank financial institutions. Over time, the BSD has developed a prudential system that is sound and in broad compliance with the Basel Core Principles.

Capital Account Liberalization

In 1995, virtually all capital controls on nonresidents were removed by eliminating the dual exchange rate system (Box 15).98 This fast-track approach was facilitated by a well-developed financial infrastructure that included sound domestic banks and strong prudential standards and practices in the financial and corporate sectors.

However, capital controls on residents have been lifted more gradually, in part reflecting the weak foreign exchange reserve position of the SARB. The strategy has been to allow a wider array of transactions, with each subject to a quantitative limit, which has been progressively raised over time, to the point where many have become nonbinding and in some cases have been abolished.

Effects of the Asian and Russian Crises on South Africa’s Financial Sector

The impact on South Africa of the 1997–98 financial crises in Asia and Russia was short-lived and did not lead to a financial crisis. The spillover effects of the Asian crises reached South Africa in October 1997. Initially, the authorities intervened heavily in the foreign exchange market to defend the rand. During May-August 1998, the rand depreciated by 25 percent against the U.S. dollar, interest rates rose by about 670 basis points, and share prices declined by close to 50 percent in U.S. dollar terms (Figure 9).

Figure 9.South Africa: Stock Exchange Index, Nominal Exchange Rate, and Interbank Rate. 1997–99

Sources: IFC Emerging Markets Database; and IMF, International Financial Statistics.

Box 15.South Africa: Exchange and Capital Account Liberalization, 1995–98

March 1995: The dual exchange rate system consisting of commercial and financial exchange rates was abolished, virtually eliminating all capital controls for nonresidents.

March 1996: Cash cover in foreign currency was permitted as security for securities lending transactions, provided that the amount was held in a nostro account of a South African authorized dealer.

June 1996: Virtually all quantitative limits on current payments and transfers were doubled. Offshore investment expansion by corporations was permitted (if financed by profits generated offshore). Conditions on FDI by corporations in countries outside the Common Monetary Area (CMA) were eased. Institutional investors were permitted to invest in asset swaps up to 10 percent of local assets (5 percent previously), and to make foreign currency transfers in 1996 up to 3 percent of net inflow of funds during 1995. Access to domestic credit by foreign-controlled entities was relaxed.

March 1997: The limit on FDI in non-CMA countries was raised to R 30 million, and that on FDI into Southern African Development Community (SADC) countries to R 50 million.

March 1997: The surrender requirement period was increased from 7 days to 30 days. Limits on current payments were abolished except for limits on travel, study abroad, and gifts. Institutional investors were allowed to transfer in 1997 up to 3 percent of the net inflow during 1996. Unit trust management companies were allowed to invest abroad up to 10 percent of total assets.

July 1997: Taxpayers in good standing were permitted to invest R 200,000 abroad.

November 1997: The emigration allowance was increased from R 250,000/R 125,000 to R 400,000/R 200,000, per family unit/single person immigrating to South Africa.

January and March 1998: Various allowances (for business travel and study abroad) were increased. The limit on FDI outside the CMA was raised to R 50 million, and the ceiling on FDI into SADC countries was increased to R 250 million. The limit on foreign investment by individuals in South Africa was doubled to R 400,000 a year. The repatriation requirement period was extended from 30 days to 180 days. Outward portfolio investments for institutional investors were eased further.

Source: IMF, Annual Report on Exchange Arrangements and Exchange Restrictions, various issues.

In September 1998, however, financial market conditions in South Africa had already improved considerably; and the crisis in Brazil did not have a significant impact on financial markets.99 To strengthen the management of domestic liquidity, the SARB shortened the maturity of the repo operations (introduced in March 1998) to one day.

The Asian and Russian crises did not seriously affect the financial condition of South African banks. The banks remained well capitalized, with the capital adequacy ratio at 11 percent for the entire system and 9.5 percent for the largest four banks. Furthermore, nonperforming loans remained below 5 percent—low by international standards. The robustness of South African banks reflected a tradition of sound management, a reliable economic and legal infrastructure, and low corporate debt to equity ratios; all were supported by strong prudential regulation and supervision. In particular, low debt-equity ratios in the corporate sector contributed to the good quality of bank loan portfolios (Table 5).100

Table 5.Corporate Debt-Equity Ratios in Selected Emerging Economies(in percent as of end-1997)
South AfricaKoreaIndonesiaMalaysiaThailandPhilippines
Debt-equity ratio0.
Source: Claessens, Djankov, and Lang (1998). For Philippines, debt-equity ratio is for top 500 corporations, excluding banks. For South Africa, debt-equity ratio is for 303 companies that belong to 8 different sectors of production and trade their stock in the Johannesburg Stock Exchange.
Source: Claessens, Djankov, and Lang (1998). For Philippines, debt-equity ratio is for top 500 corporations, excluding banks. For South Africa, debt-equity ratio is for 303 companies that belong to 8 different sectors of production and trade their stock in the Johannesburg Stock Exchange.


South Africa’s experience shows that with sound macroeconomic policies, a strong banking system can withstand large volatility in capital flows and market prices. Although South Africa’s financial system was exposed to large swings in capital flows and financial market prices following the emerging market crises, sound macroeconomic and prudential policies helped the financial sector withstand adverse shocks. A critical factor in this regard was a well-capitalized banking system, which was operating in a context of low corporate debt to equity ratios.

South Africa adopted a cautious approach to capital account liberalization. A well-developed financial infrastructure, a robust banking system, and sound prudential practices in the financial sector allowed South Africa to lift capital controls on non-residents without adverse consequences. However, the authorities gradually liberalized the capital account for residents in order to preserve the central bank’s reserve position.

United Kingdom: The 1992 ERM Crisis

In the early 1990s, after nearly two decades of a floating exchange rate regime and more than a decade after full capital account liberalization, the United Kingdom effected a dramatic change in its macroeconomic policy framework. In October 1990, a floating exchange rate system was shifted to the pegged exchange rate mechanism (ERM) of the European Monetary System, under which monetary policy was principally guided by the need to maintain sterling’s parity within the ERM. In the first year of ERM membership, interest rates were cautiously reduced, resulting in an appreciable narrowing of interest rate differentials with respect to the deutsche mark (Figure 10). In September 1992, the U.K. authorities withdrew from the ERM in the wake of considerable exchange market turbulence and an increasing conflict between the policy stance suitable for the domestic economy and that required to maintain the exchange rate peg. Within a few weeks, sterling depreciated by 15 percent in real effective terms, returning to 1986 levels (Figure 11). Shortly after exiting the ERM, the authorities announced the establishment of an inflation targeting framework to serve as the nominal anchor.

Figure 10.United Kingdom: Interest Rates, 1989–94

(Percent per annum)

Sources: IMF, International Financial Statistics; and DataStream.

1For Germany, a 3-month interbank rate is used; for the United Kingdom, a 91-day treasury bill rate is used.

Figure 11.United Kingdom: Exchange Rates, 1985–941

Sources: IMF, International Financial Statistics; and Information Notice System.

1For the real effective exchange rate, an increase means an appreciation.

The disparity between the cyclical positions of the U.K. and German economies played an important role in the U.K. authorities’ decision to withdraw from the ERM. In December 1991, Germany raised short-term interest rates to contain strong domestic demand. This interest rate rise was followed by other ERM member countries with the exception of the United Kingdom. The U.K. authorities, who were concerned about prolonged cyclical weakness and high real interest rates, instead reduced interest rates in steps, significantly narrowing interest rate differentials against Germany. The narrowing of interest rate differentials had a pronounced impact on private capital flows to the United Kingdom, which shifted from net inflows averaging more than US$31 billion a year in 1988–91 to net outflows of $6 billion in 1992 (Figure 12).

Figure 12.United Kingdom: Net Private Capital Flows, 1985–93

(Billions of U.S. dollars)

Source: IMF, World Economic Outlook.

Effect of the External Crisis on the Financial System

The turmoil surrounding the exit from the ERM occurred at a time when the condition of the banking system had for some time been deteriorating. In particular, loan growth was negative, asset problems were significant (resulting in a high level of loan loss provisions), and earnings growth was declining.101 Moreover, a spike in the number of bank failures occurred in 1991.102

With the flexibility created by the floating of sterling, and reinforced by earlier prudential actions, the monetary authorities were able to mitigate the adverse effects on the financial system of the measures that had been taken to defend the currency. Following the exit from the ERM, the Bank of England created temporary liquidity facilities for the repurchase of gilts and loans related to export and shipbuilding credit as a special (short-term) measure. These facilities were made available to the largest banks, building societies, and gilt-edged market makers to meet the large shortage of liquidity in the system as a whole that would otherwise have resulted from the extent of foreign exchange intervention. This action helped to mitigate the effects of the crisis on weak financial institutions. However, prior prudential steps had already helped to reduce some financial sector vulnerability.103

Enhancement of Market Discipline and Prudential Framework

The resilience of the financial sector to the currency crisis also reflected important structural developments that enhanced market discipline. The open economy (capital controls were eliminated fully in 1979) and London’s historic role as a major international financial center meant that British financial institutions and markets had for a considerable time been exposed to strong market discipline. Decisive deregulation of banks had begun with the elimination of quantitative monetary controls and a shift toward indirect monetary policy instruments in 1971. Subsequently, a number of additional reforms to market rules reinforced by the “big bang” of 1986 led to increased competition in the financial system.104 These changes, which bolstered London’s traditional attraction to a range of financial institutions in other countries as a place to do business, served to enhance efficiency, increase the liquidity of the United Kingdom’s already highly developed and sophisticated financial markets, expand the scope for risk diversification, and broaden the potential sources of earnings of individual institutions. Also, U.K. financial markets had become even more integrated with other financial markets as a result of the movement toward a single European Community capital market, which had intensified during the mid-1980s, and contributed to large net capital inflows in the late 1980s.

Market discipline in the banking sector was further reinforced by specific prudential policies. These included, in particular, allowing weak institutions to fail (where there was judged to be no systemic impact), applying strong licensing rules, and withdrawing authorization from existing institutions that failed to continue meeting licensing criteria. At the same time, the introduction of a limited deposit protection scheme under the Banking Act of 1979 reduced the risk of contagion from such failures. As a result of the strong market discipline and reinforcement of prudential regulation and oversight (see below), the United Kingdom was able to avoid the need for any systemic bank restructuring program despite the stress imposed by the prolonged recession in the early 1990s.105

In conjunction with deregulation to enhance competition, prudential regulation and oversight of banks had been continually upgraded. Legal responsibility for authorization of, and prudential oversight over, banks was formally conferred on the Bank of England by the Banking Act of 1979. A number of measures were taken in response to official inquiries conducted after some of the more notorious bank failures. In addition, a requirement for a published annual review of the banking sector from the supervisory perspective (Banking Act of 1987) created a formal framework for identifying and addressing issues, and enhanced the transparency of the supervisory process. A further stimulus to improvements in the prudential framework was the Bank of England’s participation in international efforts to examine and strengthen prudential frameworks and supervisory practices. These improvements occurred in the context of the work of the Basel Committee for Banking Supervision and actions to harmonize the prudential framework for banking in the European Community in preparation for a single capital market initiated in 1993.

A major feature of the upgrading of the prudential framework was the focus on improving the identification and measurement of risk and establishing an adequate cushion against risk. Risk-based capital requirements for banking organizations, including on a consolidated basis, were implemented early in the process.106 The resulting strengthening of capital provided a cushion to absorb the large loan loss provisions that became necessary as the business environment deteriorated during the recession. Other key supervisory requirements and guidelines covered risks associated with foreign currency exposures (1981), liquidity management (1982), and connected lending and large exposures (1983). A matrix to provide guidance on loan provisioning against problem country loans was established in 1987. These and other policies and guidelines were continually modified to take into account changing market developments and products and improved understanding of the risks involved.

The underlying supervisory approach also evolved to address changing circumstances. In particular, although observance of risk ratios and guidelines remained an important aspect of supervisory oversight, the focus shifted increasingly to evaluation of internal systems for measuring and controlling risk and the quality of the information underpinning such systems. This practice was codified in the Banking Act of 1987, which established explicit requirements for banks to maintain adequate records and internal management and risk control systems and for bank auditors to provide reports on compliance to the bank supervisors. Finally, the bank supervisors established formal arrangements with other national supervisory counterparts and with domestic supervisors of nonbank financial institutions. The need for both types of cooperation was essential for effective consolidated supervision of financial groups, given the international networks of the major U.K. banks, the presence in London of a large number of foreign banks, and the expanding range of increasingly sophisticated financial activities undertaken by large domestic and foreign banking organizations, especially after the “big bang.”


The resilience of the U.K. banking system in the face of a recession, a sharp depreciation of sterling, and the open capital account reflected several factors. These included, in particular, skillful management of the crisis, the presence of a well-capitalized and diversified banking system, highly developed money and capital markets and monetary instruments for meeting acute liquidity needs, a sound prudential framework subject to regular review and upgrading to address perceived weaknesses and newly emerging risks, and strong market discipline. Market discipline appears to have been particularly enhanced by the open capital account and financial liberalization. These factors, together with the increased scope for easing monetary policy following the exit from a pegged exchange rate regime, helped the U.K. financial system weather the tensions created by large speculative capital flows in the period before and after the ERM exit.

The liberalization of current payments and transfers began in 1954, and was completed in the early 1960s. Austria accepted the obligations of Article VIII in 1962. The limits on foreign exchange for travel that remained in place until 1986 were not considered to constitute a restriction.

It has been argued that by eliminating obligatory central planning for enterprises, the first step in the transition process was already taken in 1968.

Short-term foreign debt includes nonresident holdings of domestic bonds.

The first joint-venture bank was established in 1979.

Banking sector restructuring became necessary as the enterprise sector was restructured following severe disruptions in trade flows after the demise of the Council for Mutual Economic Assistance (CMEA) and the simultaneous adoption of a stringent bankruptcy law. By the end of 1993, an independent audit concluded that most of the largest state-owned banks were insolvent, and nonperforming loans in those banks exceeded 28 percent of total loans, of which about 13 percent were classified as unrecoverable. In view of the bankruptcy law, debtor consolidation entailed the closure of a large number of enterprises.

Hungary accepted the obligations of Article VIII, Sections 2, 3, and 4 of the IMF as of January 1, 1996. On June 15, 2001, Hungary lifted all foreign exchange restrictions and implemented full convertibility of the forint. Under the new regulation, (1) Hungarian residents are allowed to open forint and foreign currency accounts abroad; (2) foreign currency obtained under any title is permitted to be credited on foreign currency accounts; (3) direct acquisitions of enterprises abroad do not require prior notice; (4) restrictions on short-term portfolio transactions (including those for hedging purposes), lending maturity, financial collateral, transfer of claims, and assumption of debt are lifted; (5) gifts to nonresidents may be made freely; and (6) payments in foreign currency in Hungary between residents or between residents and nonresidents are permitted.

For example, when securities transactions were liberalized, restrictions on the conversion and transfer of associated proceeds (including that of the principal) were also lifted.

Intervention amounted to US$2.5 billion from August–October 1998.

However, heavy intervention by the SARB during the emerging market crises in 1998 increased the stock of the net open forward position by about US$10 billion to US$23 billion at end-1998. Subsequently, the stock was reduced to US$9 billion by end-March 2001, representing the lowest level since mid-1998.

The 1985 banking crisis was caused by the buildup of large short-term external borrowing that was encouraged by high domestic interest rates. When foreign banks began to reduce their exposure to South Africa, largely due to political factors, the depreciation of the rand and a liquidity squeeze resulted in a banking crisis.

By the mid-1990s, more than 95 percent of total assets were held by only four banking groups.

During the period July 1998-June 1999, about one-third of the turnover on the secondary market for shares represented trading by nonresidents, while foreign banks and branches accounted for 5.7 percent of total bank assets at end-June 1999. See IMF (2001c).

The remaining restriction relates to controls over the amount that institutions controlled by nonresidents may borrow domestically, although this too has been relaxed.

For a detailed review of the effects of the emerging market crises on South Africa, see IMF (1999c).

Loan loss provisions on exposures other than to developing countries had reached a record level of 3.5 percent of total lending in 1992.

In addition, other banks had their authorizations withdrawn because of failure to comply with supervisory requirements, including an increase in required minimum capital. See Jackson (1996). During the 1990–92 period, some 60 banks went out of business or were merged with or absorbed by other banks. See Quinn (1994).

For example, at the onset of the recession, about 40 small banks had been identified and put on a “watch list” because of problems arising from their heavy dependence on volatile wholesale sources of funding. As a result of corrective action applied by banking supervisors, many of these banks were able to withstand more readily the liquidity shock created by the exchange crisis. See George (1994).

For a list of major reform measures, see Sargent (1991).

The financial repercussion of the recession was also mitigated by developing corporate workouts that came to be known as “the London Approach.”

British banks had been subjected to risk-based capital standards for some years before the Basel Accord agreement of 1989 was reached.

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