Asia will survive with realistic economic policies

International Monetary Fund chief Michel Camdessus spoke to Southeast Asian business leaders in Kuala Lumpur last week. The following article is based on his speech. This is the first of two articles.

KUALA LUMPUR: The crisis that began in Thailand has now shaken a number of other economies in the region, and its aftershocks have been felt as far away as Latin America and Eastern Europe.

Countries that have been accustomed to, in some cases, decades of high growth now face the prospect of a marked slowdown in economic activity. This has prompted some observers to suggest that perhaps the so-called "Asian miracle" was only a "mirage". I do not hold that view.

In my opinion, the region's economic success over the last couple of decades can be described in many ways as outstanding, superlative, and certainly admirable. But it was no "miracle".

Rather, it was the result of good policies that fostered saving and investment, including in human development; encouraged innovation and entrepreneurship and a quick response to market signals; and promoted trade.

Recent developments have not wiped out past achievements. On the contrary, the region's longer-term fundamentals -- including its high domestic savings rates, strong fiscal positions, dynamic private sectors and competitiveness -- remain favorable. Moreover, most Asian countries still have a long way to go to catch up with advanced economies.

Thus, to all the prophets of doom and gloom I would reply that with a lucid diagnosis of the problems, without complacency and with appropriate economic adjustments now and sound policies in the future, they will be able to rekindle -- in a more sustainable way -- high rates of growth in the coming years.

In a situation like the current one that is evolving quickly, it is difficult to step back and take a longer view. But indeed that is what is required to get to the root of the region's problems and find appropriate solutions. In this spirit, I would like to talk very candidly about the causes of the current crisis and what they suggest about the requirements for rebuilding confidence in this dynamic region.

How could events in Southeast Asia unfold this way after so many years of outstanding economic performance? In the case of Thailand, the answer is fairly clear. To begin with, standard economic indicators revealed large macroeconomic imbalances: the real exchange rate had appreciated considerably; export growth had slowed markedly; the current account deficit was persistently large and was financed increasingly by short-term inflows; and external debt was rising quickly.

These problems, in turn, exposed other weaknesses in the economy, including substantial unhedged foreign borrowing by the private sector, an inflated property market, and a weak and over- exposed banking system.

Markets pointed to the unsustainability of Thailand's policies: equity prices declined and the exchange rate came under increasing pressure. The IMF stressed these problems and pressed for urgent action in a continuous dialogue with the Thai authorities during the 18 months leading up to the floating of the baht last July.

But after so many years of outstanding macroeconomic performance, it was difficult for the authorities in Thailand -- as in other countries -- to recognize that severe underlying problems could seriously jeopardize their track record. And this "denial syndrome" contributed to the delay in taking corrective measures. Finally, in the absence of convincing action, the crisis broke.

The more vexing question is why the crisis spread to other countries, such as Indonesia, Malaysia, the Philippines and Korea.

Developments in Thailand prompted market participants -- especially those who had initially underestimated the problems in Thailand -- to take a much closer look at the risks in other countries. And what they saw to different degrees in different economies were many of the same problems affecting the Thai economy, including overvalued real estate markets, weak and over- extended banking sectors, poor prudential supervision and substantial private short-term borrowing in foreign currency.

Moreover, after Thailand, markets began to look more critically at weaknesses they had previously considered minor, or at least manageable, given time. In other words, markets became less forgiving.

Market doubts were compounded by a general lack of transparency -- about the extent of government and central bank liabilities; about the underlying health of the financial sectors; and about the links between banks, industry and government and their possible impact on economic policy.

In the absence of adequate information, markets tended to fear the worst and to doubt the capacity of governments to take timely corrective action. The imposition of controls on market activity -- and the threat of future controls -- not only made investments riskier, but tended to reinforce the view that governments were addressing the symptoms, rather than the causes, of their problems. This sent investors fleeing to safe havens and set back other efforts to restore confidence.

But perhaps the most important factor in the depreciation of exchange rates was the rush by domestic corporations to buy foreign exchange. Expecting that exchange rates would remain stable indefinitely, and in the context of inefficient banking systems, domestic firms had borrowed heavily in foreign currencies in order to take advantage of lower interest rates available in other markets. Once they recognized that the peg might not hold and that their debt service costs might rise, perhaps dramatically, they hastened to sell domestic currency, extending the currency slide.

Finally, in some cases, the contagion can be traced in part to the "denial syndrome" that I referred to earlier -- to the conviction that "it couldn't happen to us".

Questions have also arisen about the role of hedge funds. The IMF has been looking into this question, talking to market participants and central banks about how hedge funds are set up and regulated, and what role they may have played in the crisis. But from what we know so far, it would be a mistake to blame hedge funds or other market participants for the turmoil in Asia. Turbulence in the market is only a symptom of more serious underlying problems which are now being addressed seriously in many countries.

It remains the case that there are things that can be done to promote a more orderly working of the markets. For instance, consideration could be given to strengthening large-trader reporting requirements, limiting position-taking by requiring bankers and brokers to raise collateral and margin requirements so as to limit the use of leverage by hedge funds and other large investors, and discouraging herd behavior and avoiding one-way bets.

This could be done by providing better information to markets on government policies and the condition of domestic financial institutions to encourage investors to trade on fundamentals rather than to run with the herd.

So what does all of this imply about the way in which governments should manage their economies and approach the markets?

The first implication is the most obvious one: the necessity to take early action to correct macroeconomic imbalances before they precipitate a crisis. This did not happen in Thailand despite timely and vigorous warnings. Instead, policymakers attacked the symptom of the crisis -- the pressure on the baht -- and accumulated large reserve losses and forward foreign exchange liabilities in the process.

This, together with delays in addressing Thailand's severe financial sector problems and lingering political uncertainties, clearly contributed to a deepening of the crisis and its spread to other economies in the region.

Second, countries may find that they are more vulnerable to crises in other markets than their own economic fundamentals would suggest. Consequently, they may need to take preemptive action to strengthen their policies. Several suggestions come to mind as to where such action might be needed.

* Maintaining an appropriate exchange rate and exchange rate regime. Clearly, there is no single "right" choice, but more flexible exchange rates can help provide early and visible signals of the need for policy adjustments and are less likely to invite reckless behavior on the part of borrowers and lenders;

* Maintaining an appropriate macroeconomic policy mix to ensure that fiscal positions do not lead to unduly high domestic interest rates, which, in many cases, have contributed to excessive amounts of short-term capital inflows;

* Strengthening structural policies -- especially the policies and institutions, such as prudential supervision, needed to underpin a sound financial system. In particular, it is important that fragilities in the financial system are not allowed to become so acute that the authorities are unwilling to use the interest rate instrument in times of international financial instability;

* Carrying out other supporting reforms -- what we call "second generation" reforms -- to promote domestic competition, increase transparency and accountability, improve governance, help ensure that the benefits of future growth are widely shared, and otherwise strengthen the foundations for future growth.

-- The Business Times