Chapter

I Overview

Author(s):
Timothy Lane, Marianne Schulze-Gattas, Tsidi Tsikata, Steven Phillips, Atish Ghosh, and A. Hamann
Published Date:
June 1999
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Author(s)
Timothy Lane and Marianne Schulze-Ghattas

The crisis that erupted in Asia's financial markets in 1997 has had dramatic effects on the countries involved: it precipitated deep recessions in these “tiger economies,” resulting in a sharp drop of living standards together with rising unemployment and social dislocation. Moreover, the turbulence in financial markets has spread to other regions, and this, together with the sharp recession in Asia, constitutes an appreciable drag on world economic growth and has at times threatened to create an even wider crisis.

The Asian crisis differs from previous crises in key respects, and it may indicate fault lines in an increasingly integrated global economic and financial system. Unlike the typical case in which the IMF's assistance is requested, these crises did not result mainly from the monetization of fiscal imbalances and only in Thailand were there substantial external current account imbalances. Instead, they were rooted mainly in financial sector fragilities, stemming in part from weaknesses in governance in the corporate, financial, and government sectors, which made these economies increasingly vulnerable to changes in market sentiment, a deteriorating external situation, and contagion.

These distinctive features of the crisis needed to be taken into account in designing the policy responses in the context of IMF-supported programs. Macroeconomic policy adjustment was an essential element of the programs: monetary policy was aimed mainly at preventing a spiral of depreciation and inflation from emerging, while fiscal policy was initially intended mainly to provide some modest support for external adjustment and make room for the noninflationary financing of the carrying costs of the needed bank restructuring. But more than in previous IMF-supported programs, structural reforms, particularly in the financial sector and related areas, assumed a central role. These reforms were intended to address the root causes of the crisis, with a view to restoring market confidence and creating conditions for a sustainable resumption of growth. The strategy chosen, given the nature and scale of the crisis, entailed an unprecedented commitment of financial resources to break a self-reinforcing cycle of capital outflows, exchange rate depreciation, and financial sector weaknesses.

The IMF's support was organized under the Emergency Financing Mechanism. This mechanism, with a shortened period of negotiation, review, and approval by the IMF's Executive Board, permitted the programs to be put in place very quickly in response to immediate and overwhelming market pressures. At the same time, it forced exceptionally quick analysis by IMF staff and negotiations with country authorities. At times, decisions had to be based on more than usually incomplete information.

Economic events during the crisis have been dramatic and have defied expectations. As capital flows reversed, currencies depreciated precipitously. While the inflationary consequences of the depreciations in Korea and Thailand were reasonably well contained, in Indonesia inflation rose sharply. Growth plummeted in all three countries (as well as in other countries in the region), and external current accounts underwent abrupt swings. In several respects these outturns were much worse than expected: in particular, in all three countries there were sharp revisions to projections for growth and exchange rates, which necessitated significant changes in program targets. The revisions took into account new information about the magnitude of capital outflows, the deteriorating external environment more generally, and the worsening financial circumstances of domestic banks and corporations—as all of these developments exercised a self-aggravating influence over domestic demand and production. Some important economic vulnerabilities—notably the foreign exchange exposure of the financial and corporate sectors—became fully evident only as economies came under stress.

At this time, there remain risks to all the programs, with regard to both developments within the countries themselves and the external environment. The recession has continued to deepen in these countries as the balance sheet effects of the crisis work themselves out, and the success of reforms in tackling structural weaknesses and reestablishing growth on a sustainable basis is still not assured. Global economic developments, including the weakness of the Japanese economy, turbulence in emerging markets in other regions, and the sharp decline in commodity prices, also pose risks to the stabilization process and could delay economic recovery. There are signs, however, that the recessions in these countries are bottoming out and financial market conditions are stabilizing.

Box 1.1.Thailand: Crisis and Adjustment

Pressures on the baht, which had been evident already in late 1996, built up in the first half of 1997 against the background of an unsustainable current account deficit, significant appreciation of the real effective exchange rate, rising foreign debt (in particular, short term) a deteriorating fiscal balance, and increasing difficulties in the financial sector. Reserve money growth accelerated sharply as the Bank of Thailand provided liquidity support for ailing financial institutions. The policy response to the pressures in the exchange market focused on spot and forward intervention, introduction of controls on some capital account transactions, and limited measures to halt the weakening of the fiscal situation.

The exchange rate was floated on July 2, 1997, following mounting speculative attacks and concerns about the reserve position. The accompanying policy package was inadequate and failed to bolster market confidence. The baht depreciated by 20 percent against the U.S. dollar during July, while short-term interest rates were allowed to decline sharply after a temporary increase.

On August 20, 1997, the IMF's Executive Board approved a three-year Stand-By Arrangement with Thailand, amounting to $4 billion (505 percent of quota). Additional financing was pledged by the World Bank and the Asian Development Bank ($2.7 billion), which also provided extensive technical assistance. Financial support by Japan and other interested countries ($10 billion) was pledged at a meeting in August, hosted by Japan. Bilateral financing has been disbursed in parallel with the purchases from the IMF. The underlying adjustment program was aimed at restoring confidence, bringing about an orderly reduction in the current account deficit, reconstituting foreign exchange reserves, and limiting the rise in inflation to the one-off effects of the depreciation. Growth was expected to decelerate sharply, but to remain positive. Key elements of the policy package included measures to restructure the financial sector (including closure of insolvent financial institutions); fiscal adjustment measures equivalent to some 3 percent of GDP to bring the fiscal balance back into surplus and contribute to shrinking the current account deficit; and control of domestic credit, with indicative ranges for interest rates. The baht continued to float and foreign exchange market intervention was to be limited to smoothing. Upon approval of the program, Thailand drew $1.2 billion from the IMF and received a further $4 billion from bilateral and multilateral sources.

In the subsequent months, the baht continued to depreciate as rollover of short-term debt declined and the crisis in Asia spread. While macroeconomic policies were on track and nominal interest rates were raised (albeit subject to considerable short-term fluctuations), market confidence was adversely affected by delays in the implementation of financial sector reforms, political uncertainty, and initial difficulties in communicating key aspects of the program. By the time of the review under the emergency financing procedures (October 17, 1997), there were also signs that the slowdown of economic activity would be more pronounced than anticipated. A new government took office in mid-November 1997.

To help stabilize the exchange market situation, the program was strengthened at the first quarterly review (December 8, 1997). With weakening economic activity constraining revenues, additional fiscal measures were introduced to achieve the original fiscal target for 1997/98.1 Reserve money and net domestic assets of the Bank of Thailand were to be kept below the original program limits, the indicative range for interest rates was raised, and a specific timetable for financial sector restructuring was announced.

After falling to an all-time low against the U.S. dollar in early January 1998, the baht began to strengthen in early February as improvements in the policy setting revived market confidence amid an upturn in regional markets more generally. Growth projections, however, were marked down further. Contracting domestic demand helped to keep inflation in check and contributed to a larger-than-expected adjustment in the current account.

In view of stabilizing exchange market conditions and the changed economic outlook, the program was revised significantly at the time of the second quarterly review (March 4, 1998). Under the revised program, monetary policy continued to focus on the exchange rate, with interest rates to be maintained high until evidence of a sustained stabilization emerged. Fiscal policy shifted to a more accommodating stance, allowing automatic stabilizers to take effect. In addition, the program included measures to strengthen the social safety net, and broadened the scope of structural reforms to strengthen the core banking system and promote corporate restructuring.

The third quarterly review (June 10, 1998) took place against the background of a marked strengthening of the baht during February-May 1998 (some 35 percent vis-a-vis the U.S. dollar from the low in January), and stronger-than-expected foreign exchange reserves, but a deepening recession. The revised program was on track, but with real GDP now projected to decline by 4–5 percent in 1998 and inflation subdued, further adjustments were made to allow for an increase in the fiscal deficit target for 1997/98 from 2 percent to 3 percent of GDP. Monetary policy continued to focus on maintaining the stability of the baht. While the cautious reduction of interest rates since late March 1998 was viewed as consistent with exchange market developments, it was understood that interest rates would be raised again if necessary. Additional measures to strengthen the social safety net were planned, and the program for financial sector and corporate restructuring was further specified.

The exchange rate weakened somewhat during June-July 1998 amid growing concerns about the growth outlook, and renewed signs of strain in the financial sector. Fiscal and monetary policy had been tighter than programmed, activity was weaker than expected, and exports had failed to pick up. The large adjustment in the current account (projected to amount to over 10 percent of GDP in 1998) reflected a sharp compression of imports. Restructuring of financial institutions was complicated by growing difficulties in the corporate sector.

The fourth quarterly review (completed on September 11, 1998) focused on adapting the policy framework to support the recovery without sacrificing stabilization gains. With output now projected to decline by 6—8 percent in 1998, efforts were stepped up to utilize the scope for fiscal easing provided under the program. Foreign exchange market conditions were relatively stable (in spite of the Russian crisis), providing room for a further lowering of interest rates. The program for financial and corporate sector restructuring was broadened significantly, and the structural reform agenda in other areas (privatization, foreign ownership, and social safety net) was strengthened.

As of October 19, 1998, $12.2 billion of the total financing package for Thailand ($17.2 billion) had been disbursed, including $3 billion from the IMF and $9.2 billion from other multilateral (World Bank and Asian Development Bank) and bilateral sources.

1 The fiscal year begins in October.

This paper represents the first systematic review within the IMF of the policy response to the crisis, and possible lessons for future practice.1 Given the fact that events are still unfolding and programs are still in the process of revision, it will necessarily be selective in the questions it addresses and provisional in the answers it provides. The study covers the period through October 1998. The paper also takes a narrow approach in the countries examined: it focuses primarily on events in Indonesia, Korea, and Thailand (Boxes 1.11.3), even though further useful lessons might be drawn by examining other countries in the region—notably Malaysia and the Philippines—in which many of the same forces were at work. Malaysia is excluded because it did not have an IMF-supported program, the Philippines (although it has had a program) because its recent history was quite different from the other crisis countries.

Section II briefly reviews the origins of the Asian financial crisis in financial sector fragilities—notably the large short-term foreign currency debt of domestic financial institutions and corporations, together with inflated domestic asset prices and deteriorating loan quality—that made these economies vulnerable to a deteriorating external situation and market contagion, particularly given the volatility of short-term capital flows in international markets. The monetization of fiscal imbalances and evident exchange rate misalignments, prevalent in many countries that seek IMF support, played a lesser role, except in Thailand.

The basic strategy of the programs formulated to address the crisis are discussed in Section III. Macroeconomic policies were an essential element of these programs; and large official financing packages were assembled to help break a self-reinforcing cycle of capital outflows, exchange rate depreciation, and financial sector weakness. But more than in previous IMF-supported programs, structural reforms, particularly in the financial sector and related areas, took a central role. Indeed, it was structural reforms that were needed to address the root causes of the crisis, restore market confidence, and set the stage for a sustainable resumption of growth. The section also examines the decision to allow exchange rates to continue floating, arguing that there was no viable alternative since repegging would have required subordinating monetary policy exclusively to the defense of the currency and, given available reserves and financing, the rate that would be defensible against short-run market pressures would have been too depreciated to be appropriate for the medium term.

Section IV addresses issues related to program financing and market reactions. Financing needs were dominated by the huge potential volume of capital outflows. In each of the programs, very large official financing packages, together with sound economic policies, were intended to restore confidence and limit private capital outflows. However, the programs were not initially successful in restoring confidence, and private capital outflows far exceeded program projections. Restoring confidence quickly was intrinsically difficult given the state of their reserves, the volatility of market sentiment, and the array of structural problems that had to be dealt with. Several factors contributed to weak confidence, including hesitant program implementation, political uncertainties and other factors casting doubt on the authorities' commitment to the programs, the revelation of market-sensitive information, problems with the coverage of government guarantees, and uncertainties surrounding the financing packages. The experience underscores the importance of further work on the architecture of the international financial system, including more effective ways of involving the private sector in the event of a crisis.

Box 1.2.Indonesia: The Deepening Crisis

In July 1997, soon after the floating of the Thai baht, pressure on the rupiah intensified. Key macroeconomic indicators in Indonesia were stronger than in Thailand (the current account deficit had been modest, export growth had been reasonably well maintained, and the fiscal balance had remained in surplus), but Indonesia's short-term private sector external debt had been rising rapidly, and growing evidence of weaknesses in the financial sector raised doubts about the government's ability to defend the currency peg.

Following a widening of the intervention band on July 11, 1997, the rupiah was floated on August 14, 1997. The exchange rate depreciated sharply but recovered temporarily in response to a tightening of liquidity and measures to prevent a deterioration of the fiscal balance as economic activity began to slow. Exchange market pressures heightened again in late September as monetary conditions were eased in view of increasing strains in the financial sector. With the rupiah falling further against the U.S. dollar, by early October, the cumulative depreciation since early July (over 30 percent) became the largest in the region.

On November 5, 1997, the IMF's Executive Board approved a three-year Stand-By Arrangement with Indonesia equivalent to $10 billion (490 percent of quota). Additional financing commitments included $8 billion from the World Bank and the Asian Development Bank, which also provided extensive technical assistance, and pledges from interested countries amounting to some $18 billion as a second line of defense. The key objectives of the underlying adjustment program were to restore market confidence, bring about an orderly adjustment in the current account, limit the unavoidable decline in output growth, and contain the inflationary impact of exchange rate depreciation. The main elements of the policy package included tight monetary policy, combined, if necessary, with exchange market intervention to stabilize the rupiah; measures to strengthen the underlying fiscal position to facilitate current account adjustment; a plan to strengthen the financial sector (including closure of nonviable institutions); and an initial set of structural reforms to enhance efficiency and transparency in the corporate sector. Upon approval of the program, Indonesia drew $3 billion from the IMF.

The initial response to the program was positive, and the rupiah strengthened briefly. A tightening of liquidity and concerted exchange market intervention temporarily boosted market confidence and the exchange rate.

Difficulties soon reemerged, however, and the exchange rate fell precipitously during December 1997-January 1998. While the current account improved, capital outflows increased and reserves declined sharply. Key factors contributing to the deterioration included stop-and-go monetary policy, vacillating between support for the exchange rate and strong liquidity expansion in the face of financial sector strain and runs on deposits; uneven implementation of important structural measures, signaling lack of commitment to the program; and political uncertainty in light of concerns about the president's health and the forthcoming presidential election. The budget for 1998/991 announced on January 6, 1998 reinforced market concerns about the government's commitment to the program.

A strengthened program was announced on January 15, 1998 to reverse the decline of the rupiah, but market reaction was skeptical. The program included a commitment to tight monetary policy and a comprehensive package of structural reforms prepared in cooperation with the World Bank; a comprehensive bank-restructuring plan followed soon after (although in hindsight the program did not move quickly enough to address the problems of corporate debt). Implementation of the structural reform agenda, however, continued to lag, and the macroeconomic program quickly ran off track, with base money growing rapidly, fueled by Bank Indonesia's liquidity support for financial institutions. Program implementation was sidetracked by discussions about the introduction of a currency board and preparations for the March presidential election. The economic downturn deepened, while inflation accelerated sharply. In view of the political situation, the first quarterly review was delayed until April 1998.

Following the formation of a new government after the reelection of the president, the first review was completed on May 4, 1998 on the basis of a modified program. With the economy now on the verge of a vicious circle of currency depreciation and hyperinflation, the main objectives of the revised program were to stabilize the exchange rate at a more realistic level and to reduce inflation. In addition, the program sought to limit the decline in output, eventually restore growth, and protect the poor from the worst effects of the crisis. The policy package included a tightening of monetary policy, with sharply higher interest rates and strict control over the central bank's net domestic assets; an adjusted fiscal framework that took into account the less favorable out-look for growth and allowed for the cost of bank restructuring as well as expenditures to cushion the impact of the crisis on the poor; a strengthened plan for the restructuring of the banking system; and an expanded set of far-reaching structural reforms (including privatization and the dismantling of monopolies and price controls) to improve efficiency, transparency, and governance in the corporate sector. In addition, talks on agreements with private creditors regarding the restructuring of corporate sector obligations and the rollover of short-term bank debt were under way. To enhance program monitoring, a temporary move to monthly reviews was agreed.

The program was cast off track by severe civil unrest, which led to the resignation of President Suharto on May 21, 1998. Production, exports, and domestic supply channels were disrupted, banking activities were paralyzed, unemployment was rising, and food prices were soaring. The rupiah nose-dived and hit an all-time low of 16,650 against the U.S. dollar in mid-June 1998, with a cumulative depreciation of 85 percent since June 1997.

An agreement with a steering committee of private creditors was reached on June 4, 1998. The agreement covered the restructuring of interbank debt falling due before end-March 1999, a trade facility to help restore normal trade financing, and a framework for the voluntary restructuring of corporate debt involving a government exchange guarantee scheme (INDRA scheme).

By the time of the second review (July 15, 1998) the program had to contend with major dislocations. Output was now expected to decline by 10–15 percent in 1998/99, and inflation was projected to average 60 percent. Restoration of the distribution system and a strengthening of the social safety net became key immediate priorities. Monetary policy remained focused on inflation and the exchange rate, while the fiscal deficit target was adjusted significantly in view of the sharp contraction of output and special expenditure requirements. Bank-restructuring plans were strengthened to deal with the deteriorating conditions in the financial system, and further steps were taken to facilitate corporate debt restructuring. Access under the Stand-By Arrangement was increased by the equivalent of $1 billion.

In view of the deep-seated nature of Indonesia's structural and balance of payments problems, the IMF's Executive Board on August 25, 1998 approved the authorities' request to replace the Stand-By Arrangement by an Extended Arrangement with the same access ($6.3 billion, or 312 percent of quota, for the remaining 26 months)2 and phasing as envisaged under the Stand-By Arrangement. Additional financing sources included $2 billion from the World Bank and the Asian Development Bank, close to $1 billion from bilateral sources, and a prospective rescheduling of external debt to official creditors. Macroeconomic policies were broadly on track and commitments concerning structural policies were strengthened in several areas, notably in the subsidy and distribution system and financial and corporate sector restructuring. The program has been monitored closely, with the second monthly review completed on October 30, 1998.

On September 23, 1998, an agreement was reached on the rescheduling or refinancing of Indonesia's bilateral external debt to official creditors. The agreement covers principal payments on official debt (excluding public enterprises) and export credit for the period August 6, 1998 to March 31, 2000 ($4.1 billion in total).

As of October 1998 market sentiment had improved and the rupiah had appreciated significantly, providing room for lowering interest rates. Fiscal targets were eased further in light of the deteriorating economic outlook. The output decline in 1998 is expected to be contained at 15 percent and year-end inflation at 80 percent, with a marked deceleration in the last months of 1998. The current account is expected to register a surplus of some 4 percent of GDP. The structural reform agenda has been broadened further, but implementation has been somewhat uneven, particularly in the area of corporate restructuring.

At the end of September 1998, $9.5 billion of the augmented financing package for Indonesia ($42 billion)3 had been disbursed (most of which—almost $5.7 billion—was disbursed since end-April 1998), including $6.8 billion from the IMF, $1.3 billion from the World Bank and the Asian Development Bank, and $1.4 billion from bilateral sources.

1 The fiscal year begins in April.2 Including augmentation of the IMF Stand-By Arrangement.3 Including debt rescheduling and new funds to be provided in lieu of rescheduling.

Section V discusses the macroeconomic developments associated with the crisis, notably the deep recessions related to massive current account adjustments. Domestic demand declined sharply, reflecting precipitous drops in fixed investment and, to a lesser extent, in private consumption, while external demand did not provide as much support for economic activity as had been hoped. The IMF, like most observers, misread the extent of the recession—in part because, as in all IMF-supported programs, macroeconomic projections were predicated on the programs' proceeding as planned.

Section VI discusses monetary policy, which sought to balance the goal of preventing a spiral of exchange rate depreciation and inflation against concerns that excessive monetary tightening could severely weaken economic activity. The policy adopted was to lean against the wind in the foreign exchange market rather than pursuing any particular exchange rate target. In Korea and Thailand, policies were tightened as envisaged in the monetary program; by the summer of 1998, interest rates had returned to precrisis levels, and over half of the sharp initial exchange rate depreciation had been reversed. In Indonesia, in contrast, monetary developments went seriously off track because of political turbulence and extreme financial system weaknesses; macroeconomic turmoil, spiraling inflation, rising risk premiums, continued capital flight, and a dramatic collapse of economic activity followed, with the situation stabilizing only in the latter months of 1998. The section assesses the stance of monetary policy in the three countries and concludes that in Indonesia, monetary policy was not tight—on the contrary, the authorities lost control of money and credit, and nominal interest rates and the exchange rate were driven by market risk premiums while underlying real interest rates remained negative. A more difficult question is whether the Thai and Korean programs' successful stabilization caused monetary conditions to become too tight, contributing excessively to the contraction in economic activity; a variety of monetary indicators examined in the section suggest that monetary tightening in these countries was not extreme (in degree or duration) in relation to other crises elsewhere. At the same time, reports of disruptions in credit allocation, possibly reflecting heightened perceptions of risk, while common to most crisis situations, are of concern; the section reviews some evidence on the nature of these disruptions.

Box 1.3.Korea: Crisis and Adjustment

Korea initially appeared relatively little affected by the crisis in the region, with the exchange rate remaining broadly stable through October 1997. However, with a high level of short-term debt and only moderate international reserves, the economy was vulnerable to a shift in market sentiment. While macroeconomic fundamentals were relatively favorable, concerns about the soundness of financial institutions and chaebol had increased significantly in the wake of several large corporate bankruptcies earlier in the year. As Korean banks began to face difficulties rolling over their short-term foreign liabilities, the Bank of Korea shifted foreign exchange reserves to the banks' offshore branches and the government announced a guarantee of foreign borrowing by Korean banks.

External financing conditions deteriorated significantly in late October 1997 and the won fell sharply while usable foreign exchange reserves declined rapidly. Monetary policy was tightened briefly, but was relaxed again in light of concerns about the impact of higher interest rates on the highly leveraged corporate sector. By early December 1997, the won had depreciated by over 20 percent against the U.S. dollar and usable foreign exchange reserves had declined to $6 billion (from $22.5 billion at the end of October 1997).

On December 4, 1997, the IMF's Executive Board approved a three-year Stand-By Arrangement with Korea, amounting to $21 billion (1,939 percent of quota). Financing amounting to $14 billion had been committed by the World Bank and the Asian Development Bank, which also provided extensive technical assistance. In addition, interested countries had pledged $22 billion as a second line of defense for a total package of $58.4 billion. To establish conditions for an early return of market confidence, the underlying program aimed to bring about an orderly reduction in the current account deficit, build up foreign exchange reserves, and contain inflation through a tightening of monetary policy and some fiscal measures. In addition, the program included a range of structural reforms in the financial and corporate sectors to address the root causes of the crisis. Upon approval of the program, Korea drew $5.5 billion from the IMF.

The positive impact of the announcement of the program on exchange and stock markets was small and short-lived. In the two weeks to the first biweekly review, the won dropped sharply. Confidence was undermined by doubts about the commitment to the program as the leading candidates for the December 18, 1997 presidential election hesitated to endorse it publicly. Moreover, with new information becoming available about the state of financial institutions, the level of usable reserves, and short-term obligations falling due, markets became concerned about a widening financing gap.

With rollover of short-term debt down sharply, usable international reserves nearly exhausted, and the won in free fall, a temporary agreement was reached with private bank creditors on December 24, 1997 to maintain exposure, and discussions on voluntary rescheduling of short-term debt were initiated. Korea requested a rephasing of purchases under the Stand-By Arrangement on December 30, 1997, to permit an advancement of drawings. At the same time, the structural reform agenda of the program was strengthened to accelerate financial sector restructuring and facilitate capital inflows into the domestic stock and bond market. Interest rates had been raised significantly, and conditions for the provision of foreign currency liquidity support to banks had been tightened.

By the time of the second biweekly review on January 8, 1998, signs of stabilization emerged. Rollover rates increased significantly after the agreement with the banks; usable international reserves stabilized, and the won appreciated moderately against the U.S. dollar. The current account had moved into surplus, but owing to the large depreciation of the exchange rate, inflation was now expected to exceed original program projections. In addition, there were growing concerns about the deceleration of economic activity.

On January 28, 1998, Korea reached an agreement in principle with private bank creditors on a voluntary rescheduling of short-term debt. The agreement covered interbank deposits and short-term loans maturing during 1998, equivalent to some $22 billion.

The first quarterly review of the Stand-By Arrangement (February 17, 1998) took place against the background of an improving exchange market situation and growing signs of a pronounced decline in economic activity. The agreement with bank creditors had helped to improve financing conditions, usable reserves had increased, and the won had appreciated by nearly 20 percent from the low in late December 1997. With domestic demand contracting, the revised program was based on lower (but still marginally positive) growth projections. The fiscal target for 1998 was lowered from a surplus of 0.2 percent of GDP in the original program (including bank-restructuring costs) to a deficit of 0.8 percent of GDP. Monetary policy was expected to remain tight as long as the exchange market situation continued to be fragile. While a number of steps had already been taken to implement the program's comprehensive structural reform agenda, commitments in several areas, notably financial sector restructuring and capital account and trade liberalization, were further specified. In addition, based on a tripartite accord between business, labor, and the government, the agenda was broadened to include measures to strengthen the social safety net, increase labor market flexibility, promote corporate restructuring, and enhance corporate governance. A new government took office in late February 1998.

The program remained on track and market confidence in the new government's commitment strengthened, but growth projections were marked down further during the second quarterly review (completed on May 29, 1998). Korea had successfully launched a global sovereign bond issue, significant capital inflows into the domestic stock and bond market had been registered, and usable reserves exceeded $30 billion. The sharp decline in economic activity, however, was weighing heavily on corporations, necessitating an acceleration of structural reforms in the financial and corporate sectors. Interest rates had been lowered cautiously, but monetary policy continued to focus on maintaining exchange market stability. In view of the weaker outlook for growth, the fiscal target was lowered further to permit automatic stabilizers to take effect.

By July 1998, Korea had made substantial progress in overcoming its external crisis. Market sentiment weakened somewhat in June in view of growing concerns about the domestic recession and the impact of economic conditions in the region. The won remained broadly stable, however, and appreciated vis-a-vis the U.S. dollar in July, permitting a further easing of interest rates. Interest rates declined further to precrisis levels, and a supplementary budget was under preparation to support economic activity and strengthen the social safety net. Output was projected to decline by 4 percent in 1998, inflation had decelerated and was expected to average 9 percent during the year, and the current account surplus was expected to reach nearly $35 billion (over 10 percent of GDP).

The third quarterly review (August 28, 1998) focused on a further easing of macroeconomic policies to miti-gate the severity of the recession, and a strengthening of the structural reform agenda. Output was projected to contract by 5 percent in 1998, inflation had decelerated further and was expected to average 8.5 percent during the year, and the current account surplus was still expected to reach nearly $35 billion (10 percent of GDP). Exchange market conditions permitting, interest rates were to be lowered further. The fiscal deficit target was raised to 4 percent of GDP and a supplementary budget was introduced to increase expenditures, including, in particular, for social programs. Structural reforms emphasized the rationalization and strengthening of the banking system as well as corporate restructuring, which was to be broadened significantly with support from the World Bank.

At the end of October 1998, $27.2 billion of the total financing package for Korea ($58.2 billion) had been disbursed, including $18.2 billion from the IMF and $9 billion from the World Bank and the Asian Development Bank.

Fiscal policies are examined in Section VII. The initial programs, predicated on the assumption that the slowdown in growth would be modest, planned some fiscal adjustment to offset a weakening of fiscal positions, support external adjustment without an excessive squeeze on the private sector's financing, and make room for the costs of bank restructuring and social safety nets. If these deficit targets had been implemented under the macroeconomic conditions that emerged, they would have implied an excessively contractionary policy. However, beginning early in 1998, as the recession deepened and current accounts shifted into large surpluses owing to sagging domestic demand and large currency depreciations, fiscal policy became increasingly oriented toward supporting economic activity. Fiscal deficits were allowed to increase considerably in all three countries to accommodate part of the effects of the automatic stabilizers and the exchange rate depreciation on the fiscal positions. More recently, programs turned more expansionary, augmenting these automatic effects through discretionary measures. In Indonesia and Korea, however, it has proved difficult to adjust spending rapidly to use the leeway for fiscal stimulus allowed under the program ceilings.

Section VIII examines the strategy of structural reform in the programs, which were intended to address the structural weaknesses underlying the crisis and create the basis for a return to sustainable growth. The initial IMF-supported programs provided an overall framework of action for the next three years, including aspects to be dealt with—and spelled out in more detail—by the World Bank and the Asian Development Bank. The section first assesses the strategy of financial sector restructuring, which included two broad strands: handling the crisis and its aftermath and implementing reforms to minimize the likelihood of recurrence. Given the need for immediate action as well as the large number and variety of issues that had to be dealt with, the strategy for financial and corporate sector restructuring inevitably evolved with events and with deepening understanding of the problems. Some key lessons that emerge are a need to elaborate the IMF's policies in the area of financial crisis management (including the coverage of government guarantees) as well as financial and corporate restructuring; the need to treat corporate restructuring as part and parcel of financial sector restructuring; and the need to give early priority to addressing deficiencies in the institutional and legal framework for financial and corporate sector Restructuring. The section also discusses other aspects of structural reform, including measures to address deficiencies in governance and market discipline, as well as to advance trade and capital account liberalization. Social sector policies were regarded as an integral part of the programs: concerns about the impact of the crisis on the poorest and most vulnerable segments of society were expressed from the outset and became more pressing as the domestic recession deepened. The section notes that concerns that the programs were overloaded with structural measures, some of which might better have been delayed until later, cannot entirely be dismissed—and, indeed, as the programs evolved the focus on the key financial and corporate issues sharpened. At the same time, the urgency of the crisis and complementarities among different reforms called for many steps to be taken simultaneously. Such concerns may point to a need for further consideration of the appropriate pace and sequencing of reforms.

Section IX presents some concluding remarks.

The World Bank has published a report, entitled East Asia: The Road to Recovery reviewing the crisis and charting the way ahead.

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