The Asia crisis in perspective

The following is a paper presented by Hubert Neiss, director for Asia and Pacific Department of the International Monetary Fund, at an IMF media seminar in Singapore on April 2.

SINGAPORE: The Asia crisis surprised and shook the world, both because of its sudden outbreak and its severity. The story of the unfolding of the financial panic in five countries still sounds like a nightmare: a collapse of confidence, huge capital flight, excessive depreciation, a precipitate loss of official reserves, and runs on domestic banks. It took a concerted effort by the governments in the crisis-hit countries and by the international community to stop the panic. In the wake of these chaotic events, an unprecedented decline in output occurred -- from 8 percent of growth before the crisis to -8 percent last year. This year, we expect a slow return to positive growth, as macroeconomic policies have switched to a strongly expansionary course, restructuring of banks and corporations is accelerated, and domestic and international confidence is gradually being restored.

While things have improved substantially, contrary to earlier pessimistic predictions of a deep depression, the crisis is not over yet. At this point in time, our perspective is still limited: some aspects of the crisis and some policy issues are still not fully clear and will probably be debated for years to come. However, we have gained sufficient experience of the unfolding of the crisis, to draw some lessons for the future, in particular, how to prevent another crisis or, at least, how to minimize its impact.

Popular explanations of the Asian crisis focus on "crony capitalism" in these countries, or on a "general crisis of capitalism" due to large and volatile global financial flows.

However, no single factor can provide a convincing explanation. The two main features common to all countries are:

-- the gradual erosion of banking soundness through imprudent lending policies (partly due to "governance" problems)

-- the rapid accumulation of short-term foreign borrowing by banks and enterprises

As the investment boom collapsed, the weaknesses in the banking system became more obvious, a change of sentiment occurred, and the rapid outflow of short-term funds triggered a panic. This panic made the unavoidable adjustment to a phase of overheating much more difficult than would normally be the case.

There were some additional, aggravating elements:

-- maintenance of a pegged exchange rate in the face of eroding competitiveness

-- in the case of Thailand and Malaysia, expansionary macroeconomic policies in the face of a growing current account deficit

-- political uncertainty in Thailand (unstable coalition), Korea (impending presidential elections) and Indonesia (growing doubts about the future of President Soeharto)

-- the spread of market panic to other countries in the region ("contagion") which were vulnerable because of similar problems of banking system weakness and excessive short-term external borrowing.

The crisis was, therefore, much broader than a traditional balance of payments crisis, and the response to it had to be commensurate with its dimensions. The objectives of policies were:

-- first, to stabilize the financial situation, and

-- second, to initiate and support a recovery.

The initial policy response to restore stability included

-- tightening of macropolicies, in particular a sharp increase in interest rates

-- initiating structural reforms, in particular the rehabilitation of the banking system.

With the strong emphasis on bank restructuring, the improvement of governance, and the establishment of social safety nets, the initial programs were much broader than typical IMF stabilization programs. But they were based on the right diagnosis of the problem, and they did restore stability over the months following the outbreak of the crisis.

-- devaluation-induced inflation was constrained

-- exchange rates recovered and stabilized

-- reserves were rebuilt

-- initially high interest rates could be relaxed

-- access to international capital markets

There has been an extensive ex-post debate on the policy response to the crisis, and a number of alternative proposals were made. The main elements of this debate are:

-- default vs debt renegotiation and official financing

-- controls vs maintaining openness and official financing

-- macro-stabilization only vs macro-cum-structural approach

-- high interest rate vs unlimited depreciation, and the impact on confidence of these alternative strategies.

These debates which were useful, and the progress made in all crisis countries, lead more and more to the conclusion that the strategy countries implemented was basically sound.

That should, of course, not detract us from analyzing the flaws in program design and implementation, since this is the basis for drawing lessons for the future. It also answers the frequent question "what would you do differently?"

Let me mention some of the drawbacks:

-- most importantly, governments reacted too late to the crisis. They called in the IMF only at the height of the crises, and policy measures had to be more drastic (the Philippines were an exception, where an IMF program had already be in existence)

-- private bank creditors also came in too late to help diffuse the panic (Thailand was an exception, where an informal roll-over agreement with creditors banks was made at the beginning of the program)

-- governments were slow in getting social programs going, thus undercutting public support of the programs

-- fiscal policies were initially too tight, because the depth of the crisis was not recognized at the outset

-- corporate debt restructuring was initiated only at a later stage, and this was one element delaying a return of market confidence

-- In the case of Indonesia, the first bank closures were not carefully enough prepared, and this contributed to the panic.

Beyond these factors, programs did not take hold for some time because of negative market perception of the ability and/or willingness of governments to implement the necessary measures, and of the adequacy of the financing packages.

After stabilization had been achieved, policies were shifted decidedly to promote a recovery, the main elements of the strategy are now:

-- an expansionary monetary policy, with lower interest rates than before the crisis

-- an expansionary fiscal policy, with deficits of 4 -- 7 percent, in particular to fund social programs

-- accelerated bank restructuring: closures, mergers, recapitalization

-- corporate debt restructuring as well as operational restructuring to eliminate excess capacity

Despite only moderately supportive international economic conditions, these policies are beginning to have an effect. Indications point to a turn around in output in the course of this year (it probably already happened in Korea). On average GDP will grow around 1 percent for the year as a whole. The situation is thus definitely better than last year, but the recovery will be slow because:

-- growth in external demand will only be moderate

-- bank and corporate restructuring is protracted process

What lessons can we draw?

First, crisis prevention is most important. Early warning signals must be obtained through closer monitoring of

-- the financial sector (banks and non-banks)

-- corporate finances

-- short-term capital flows

-- financial markets

Based on these signals, governments and the IMF must work together to take corrective measures at an early stage of emerging problems.

Second, once a crisis has broken out, countries have to react more promptly in all relevant policy areas. At the same time, the international financial community has to ensure that:

-- rapid and sufficient official financing is available; and, in addition,

-- that the private sector provides financing at an early stage, sharing the burden with the official sector.

Consensus by the international community on how best to achieve both objectives -- within the "new architecture" of future financial arrangements -- is an essential part in the evolution of a safer international financial system.