The Asia crisis in perspective

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.