ORIRIN, ONSET AND SPREAD OF THE RECENT

ECONOMIC CRISIS IN EAST ASIA

Tarun Das
Economic Adviser, Ministry of Finance, Government of India

1. Anatomy of the crisis

South East Asian economies - Indonesia, Malaysia, Philippines, South Korea and Thailand
recorded very high growth rates during 1980s and early 1990s. However, these economies
had also large current account deficits as a result of very large trade deficits and interest
payments on foreign debt. In fact, in most of these countries the current account deficit
was as high as or even higher than that in Latin American economies.

These current account deficits were financed by short term capital inflows that led to a
sharp accumulation of foreign currency denominated and largely unhedged foreign
liabilities. These imbalances reflected a demand boom driven by excessive investment into
speculative and unproductive assets.

In all of these affected economies, there was a boom bust cycle in the asset markets that
preceded the currency crisis. Stock and property prices soared, then plunged leading to
the currency and financial crisis, and plunged even more after the crisis leading to deep
and wide spread economic crisis. The financial intermediaries, both banks and non-bank,
were the creators of this asset cycle.

Liabilities of these financial intermediaries were perceived as having an implicit

government guarantee, but they were essentially unregulated. These institutions borrowed
short term money, often in dollars, then lent money to highly leveraged speculative
investors, largely in real estate. The excessive risky lending of these institutions created
inflation of asset prices. The overpricing of assets was sustained partly by a sort of circular
process, in which proliferation of risky lending drove up the prices of risky assets, making
the financial condition of the intermediaries seem sounder than its real balance sheet
position.

Subsequently when the price bubble burst, the effects of the fall in the asset cycle began to
show by early 1997, the macroeconomic variables had already seriously deteriorated in
most of these economies. As the asset prices fell further, it became increasingly doubtful
whether governments would really stand behind the deposits and loans that remained.
Both the depositors and lenders rushed to withdraw their money. Foreign investors
stampeded to recover their loans and investments, forcing currency devaluation, which
worsened the crisis even further as banks and companies found themselves stuck with
assets in devalued baht or rupiah, but with liabilities in US dollars.

The crisis has led to dramatic depreciation of the nominal exchange rates (Table-9.1). The
sharp movement of the exchange rate has greatly complicated the macroeconomic policy
choices by raising the cost of repaying foreign debt, weakening the financial and corporate
sectors. Remarkably, the CPI inflation rate since June 1997 has been in the range of 5-12
per cent with the exception of Indonesia. Mexico, by way of comparison, experienced a 40
per cent surge in inflation during first ten months of its crisis in 1995. Despite large
increases in nominal interest rates in some countries, only Korea and Thailand have been
able to maintain real interest rates as a significantly higher levels than those before the
crisis.

Table-1.1 Exchange rate changes and inflation rate in Asian crisis economies
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In June 1997 - May 1998 (in per cent)

Items Indonesia Korea Malaysia Philippines Thailand Mexico*

CPI inflation rate 54.5 9.8 6.4 8.4 11.5 50.5

Change in US dollar -7.4 -35.6 -33.9 -33.0 -33.4 -48.5

exchange rate
Import share in CPI 30 18 20 16 30 …

Percent change in Real -57.1 -30.9 -29.0 -25.3 -28.5 …

effective exchange rate
since June 1997
Percent change in real 13.6 13.4 12.1 10.5 19.8 …
effective exchange rate
since Jan 1998
Source: Kalpana Kochhar, Prakask Loungani, and Mark R. Stone (August 1998).

Table1.2: Annual growth rates of broad money supply, 1996-1998

In Asian crisis countries (in per cent)

Country December January December January April

1996 1997 1997 1998 1998

Indonesia 30 38 27 206 156

Korea 16 17 15 14 10

Malaysia 21 27 20 16 -1

Philippines 16 36 10 26 -3

Thailand 13 15 0 21 -1

Source: Kalpana Kochhar, Prakask Loungani, and Mark R. Stone (August 1998).

Economic activity has slowed more sharply than expected in all affected countries due to
lack of both internal and external demand (Tables-3.3 and 3.4). Crisis countries including
Japan account for 45 to 55 per cent of the exports to the region. Imports have declined by
4 to 13 per cent in volume.

Most countries have experienced sharp slowdowns in money and credit growth by varying
intensity and duration during the adjustment period (Table-9.2). These reductions in
monetary growth reflect the declines in demand and more cautious lending behaviour by
the banks. Banks attempt to strengthen their balance sheets in the context of dropping
collateral guarantees, more stringent credit rating of loans, stringent provisioning
requirements, improved credit risk assessment techniques and generally more risky
financial environment.

2 Origins of the crisis

The crisis unfolded against the backdrop of several decades of outstanding economic
performance in Asia, and the difficulties that the East Asian countries face are not
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primarily the result of macroeconomic imbalances. Rather, they stem from
weaknesses in financial systems and, to a lesser extent, governance. A combination of
inadequate financial sector supervision, poor assessment and management of financial risk,
and the maintenance of relatively fixed exchange rates led banks and corporations to
borrow large amounts of international capital, much of fit short-term, denominated in
foreign currency, and unhedged. As time went on, this inflow of foreign capital tended to
be used to finance poorer-quality investments.

Although private sector expenditure and financing decisions led to the crisis, it was
exacerbated by governance issues, notably government involvement in the private sector
and lack of transparency in corporate and fiscal accounting and the provision of financial
and economic data. Developments in the advanced economies, such as weak growth in
Europe and Japan that left a shortage of attractive investment opportunities and kept
interest rates low in those economies, also contributed to the build-up of the crisis.

After the crisis erupted in Thailand with a series of speculative attacks on the Baht,
contagion spread rapidly to other economies in the region that seemed vulnerable to an
erosion of competitiveness after the devaluation of the Baht or were perceived buy
investors to have similar financial or macroeconomic problems. As the contagion spread to
Korea, the world’s eleventh largest economy, the possibility of default by Korea raised a
potential threat to the international monetary system.

The build-up to the difficulties in east Asia, which eventually lead to the present economic
and financial crisis in these economies and elsewhere can be traced in four major factors.
They relate to:

• high growth and commendable economic success resulted in underestimation of risk;

• various features of their external economic environment that at first were favourable,
but that turned sour in several respects in 1996-97;

• shortcomings and inconsistencies in domestic macroeconomic and exchange rate

policies; and

• various structural weaknesses, particularly in the financial sector, that made these
economies and especially their financial systems increasingly fragile and vulnerable to
adverse developments.

(a) Victims of their own economic success

During 1992-95, the group of countries known as the ASEAN-4 (Indonesia, Malaysia,
Thailand and Philippines), Singapore and Korea experienced unparalleled impressive GDP
growth rates. Inflation was moderate, at least by developing country standards. The
absence of significant fiscal imbalances in most cases confirmed the discipline of
macroeconomic policies. Rapid, outward-oriented growth attracted large foreign
investment. With fiscal positions healthy in most cases, the sizeable current account deficit
being run up persistently in some cases - most notably in Malaysia and Thailand - reflected
shortfall of private saving relative to private investment and a significant part of this
investment was being financed by foreign capital attracted by relatively high return. This
brought mixed blessings. Absorption of the capital inflows posed challenges in terms of
their productive deployment and their prudent intermediation through financial systems
that were not well developed. These challenges were more severe with short-term flows,
especially flows into banks and other financial institutions. The scale of difficulties that
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arose therefore depended on macroeconomic policies and the soundness
of financial system.

(b) Changes in External Environment

The surge in capital inflows to emerging markets in the early 1990s was contributed by the
decline in asset yields in the industrial economies. There was also sharp narrowing of
asset yields. Apart from contributing to the surge in inflows and associated challenges,
these developments magnified the potential reversal when yields turned upward in the
industrial countries in early 1997. Movements in exchange rates among the major
currencies in recent years have been another significant external factor. When the US
dollar weakened during 1994 and 1995, especially against the Japanese Yen, these
economies generally gained competitiveness as their currencies depreciated in trade
weighted terms. Conversely, when this decline in dollar was reversed over the two years
beginning in mid-1995, these countries suffered substantial losses in competitiveness with
adverse effects on net exports and growth. These swings in competitiveness have tended
to affect the current and capital accounts of BOP and investors’ expectations of future
exchange rate changes. Besides, a number of developments contributed to the slowing in
export markets. Among them, a widespread deceleration of imports by the industrial
countries, a glut in the global electronic markets that resulted in a sharp fall in prices, and
a slow down of growth in much of the Asian region itself.

(c ) Macroeconomic Management and Exchange Rate Arrangements

The macroeconomic performance of the Southeast Asian economies raised common

concern about the risk of overheating, which in turn raised questions about the
sustainability of exchange rate policy. There were signs of higher inflation in output
prices, substantial and growing external current account deficits. These indicated that the
growth of demand was indeed pressing on resources, and possibly also the
competitiveness problems were building. But a more important source of demand
pressure was the growth of financial system credit to the private sector. The increasing
growth of private sector credit was largely attributable, in turn, to burgeoning capital
inflows, including directly into the banking system, which were reflected in rising official
foreign exchange reserves, increasing commercial bank liquidity and expanding foreign
liabilities of commercial banks. Among the incentives encouraging borrowing from abroad
were the relatively high domestic interest rates by international standards and exchange
rate policies that appeared to provide assurance that the price of foreign currency would
not increase to outweigh the interest differential.

(d) Financial Sector and other Structural Weaknesses

As events unfolded, weaknesses of the financial sector became particularly stark in

Thailand, Indonesia, and Korea, although lack of transparency delayed public realisation
of the scale of the problems. Inadequacies in the regulation and supervision of financial
institutions as well as limited experience among financial institutions in the pricing and
managing of risk, lack of commercial orientation, poor corporate governance, and lax
internal controls - all in the face of movements toward liberalisation and increased
competitive pressure , had contributed to imprudent lending, including lending associated
with relationship banking and corrupt practices. Non-performing loans, net of reserves,
relative to equity were very high. Another source of vulnerability was the investment of
banks in non-bank financial institutions with large-scale exposure to the domestic property
market. Encouraged by the relatively fixed exchange rate system, the financial
intermediaries borrowed on a large scale from the international capital market in order to
extend credit to domestic borrowers. Thus, there was serious problem of currency
mismatch in the asset-liability structure, in that a substantial fraction of liabilities of these
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companies was denominated in US dollars, while their assets consisted of loans in terms
of local currency. The borrowers from the international market did not hedge themselves
by entering into forward contract or ensuring future flow of earnings in terms of foreign
currency. Besides, the structure of foreign debt had become highly unbalanced with a
preponderance of short-term borrowing.

3 Onset of the crisis

The financial crisis that began to erupt in Asia in mid-1997 has resulted in sharp declines in
the currencies, stock markets, and other asset prices of a number of Asian countries;
threatened these countries’ financial systems; and disrupted their real economies. In
addition to its severe effects in Asian, the crisis has put pressure on exchange rates in
emerging markets outside of the region, and is expected to knock somewhat more than 1
per cent off the rate of world growth in 1998.

The economic and financial crisis that erupted in Southeast Asia in July 1997 has
continued to deepen and broaden through December 1997. In early 1998, there were
encouraging signs in the Asian crisis countries that financial market confidence was
beginning to return. In May and June 1998, however, there was renewed volatility in
financial markets with exchange rates depreciating significantly in Indonesia because of
political turmoil and in Japan amid persistent policy uncertainties. As a result, economic
conditions in Asia have weakened considerably, with repercussions elsewhere. The
economies most affected directly by the crisis experienced drying up of private foreign
financing, together with large currency depreciation and decline in asset prices. Large
exchange rate depreciation and falling equity prices in turn have exposed and exacerbated
financial sector fragility in many countries. Between July 1997 to July 1998, currencies of
Southeast Asian countries depreciated in the range of 4 per cent (Singapore) to 70 per
cent (Indonesia) in real effective exchange rate terms (using INS weights). The crisis is
causing sharp contraction in domestic demand in these countries, with decline in real GDP
and lowering of near-term growth prospects.

The contagion and slipover effects have affected the outlook for other emerging market
countries, including Latin America and Russia. Reduced availability of foreign financing,
increased interest spreads on foreign borrowing, lower stock market prices, and policy
tightening to reduce vulnerability to disruptive changes in market sentiment have generally
weakened near-term growth prospects for emerging market countries in all region,
including some of the transition countries. The scope for speculative pressures to spread
across countries and the degree of contagion / slipover effects tend to depend:

• on domestic economic conditions and policies (such as overborrowing for

unproductive uses, a fragile financial sector, or an inflexible exchange rate system);

• on trade and capital market linkages (for example, a devaluation in one country
adversely affecting the international competitiveness of other countries);

• because of inter-dependence in creditors’ portfolios (for example, liquidity in one

market forces financial intermediaries to liquidate assets in other markets);

• creditors’ change in sentiment to re-evaluate the fundamentals of other economies with

a view to reducing the risk of their portfolios and or simply herding by investors
resulting from bandwagon effects.

4 Spread of the crisis

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The world output growth in 1998 is projected to decelerate to 2.4 per cent in
comparison with the growth of about 4.2 per cent each in 1997 and 1996. The sharp
deceleration in projected world output growth is mainly because of the sharp decline /
deceleration in real GDP growth rates of the Southeast Asian economies. Table below
gives the projections of real GDP growth rates for countries most affected in the region:

As noted above, the drying up of private foreign financing, large currency depreciation,
and decline in asset prices in these countries are causing sharp contraction in domestic
demand, which will be only gradually counterbalanced by increased net exports.

Contagion and slipover effects have been felt by many emerging market countries in other
region in the form of declining stock markets and intense pressures on exchange rates and
have adversely affected the outlook for these economies. In general, the adverse effects
seem likely to be moderate, with growth remaining positive, but there are risks of a
sharper slowdown if the crisis in Asia were to deepen or other adverse internal or external
disturbances were to affect these economies. The effect of the crisis are also being felt
through weaker commodity prices, including oil. For developing countries that are net
importers of these products, there will be a helpful terms of trade gain, but for many net
exporters there will be negative impact on growth, and on current account and fiscal
positions, that will be significant in some cases. Contributing to the pressures was the
growing evidence that output in Japan, having faltered in 1997, was falling quite markedly
in the first half of 1998, and that activity was slowing more sharply throughout much of
Asia, including China and Hong Kong SAR.

The sharp slowing of world growth predominantly reflects developments in Asia, while
growth in the rest of the world generally has been well sustained. In the United States,
consumer spending and business fixed investment have remained buoyant. In Western
Europe, recovery has taken firmer hold in Germany and France and in most other cases
growth remains robust. The encouraging strength of domestic demand in North America
and Europe is underpinned by low inflation, high equity prices, generally supportive
monetary conditions, improved fiscal position, and strong business confidence.

Japan, which is the market for about one sixth of the exports of the ASEAN-4 and
Korea bears a particular responsibility to support recovery in Asia by ensuring resumption
of solid growth in domestic demand. The authorities have taken measures in the fiscal,
monetary, financial sector, and other structural areas in order to further the revival of the
economy, but policy design and implementation are assessed to have fallen short in clarity,
timeliness and forcefulness.

Indonesia has barely begun to re-establish financial stability. Macro-economic conditions

remain very difficult, with output expected to contract sharply in 1998 and price pressures
continuing. The rupiah has strengthened somewhat in recent weeks in large part due to a
tight monetary stance, progress in bank re-structuring, and additional external financial
assistance from the IMF and other multilateral and bilateral donors. The task ahead -
including the rehabilitation of the financial system, restoration of confidence to foster the
reversal of capital flight, restructuring of the corporate sector, and the repair of the
distribution system and market mechanism - are formidable, requiring bold action across a
range of policy areas. Assuming that the current programme is implemented as planned,
output is expected to bottom out toward the end of the year.

In Korea, the recession has deepened considerably and unemployment has risen sharply.
The Korean won has depreciated recently, but remains stronger than several months ago.
Interest rates have already come down sharply, but cautious monetary policies will
continue to be needed to maintain exchange market stability. Significant progress has
been made in financial sector restructuring and in corporate debt work-outs.
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Consolidation of merchant banks is well advanced, that of commercial banks is under
way, but the restructuring of large banks and corporations is yet to be initiated.

Malaysia is better positioned externally than the other crisis countries, because of a
smaller short-term debt burden. Economic growth has contracted sharply in 1998, but
inflation has remained low. The authorities’ response to the deteriorating situation has
included a reversal of earlier fiscal tightening, combined with efforts to stimulate private
sector credit partly by lowering bank’s reserve requirements and also by dealing with non-
performing loans and recapitalization needs. It will be important to ensure that increases
in public spending are productive. More active use of interest rate policy is considered
desirable to defend and strengthen the exchange rate and guard against rising inflation. A
key uncertainty is financial sector fragility in the face of a sharp downturn in activity and
asset prices.

Philippines has been affected to a lesser degree by the Asian crisis, but the economic
conditions seem to have deteriorated recently. The growth projection for 1998 has been
revised downward, fiscal deficit is widening, and market pressures have pushed up interest
rates. The focus of structural reforms is on the banking sector and the plans to reform
public finances and strengthen the banking system need to be firmly implemented to
reduce the economy’s vulnerability.

Singapore has been hit less hard by the regional turmoil, reflecting the country’s strong
macro-economic positions and sound financial sectors. A fiscal stimulus package
introduced in late June 98 should help growth remain positive.

Thailand is in the midst of severe recession. Relative exchange rate stability in the past
few months has allowed an easing of the policy stance, with interest rates declining
sharply. Structural reforms have focused on bank and corporate debt restructuring. A
financial sector restructuring package announced in August 98 deals with insolvent banks
and recapitalization of viable banks.

Chinese economy has been subject to significant strains, despite the currency remaining
stable. In China, growth in 1998 is expected to slow significantly, because of both
weakening of external demand and evidence of overbuilding and excess inventory
accumulation in the past. Further cuts in interest rates in recent months and proposed
increases in infrastructure spending will provide worthwhile support for activity in the
period ahead. The slowing of growth has heightened the importance of accelerating
structural reforms, especially in the financial and public enterprise sectors.

Hong Kong SAR has suffered a much more severe weakening of activity, reflecting the
economy’s greater openness, the reversal of the previous sharp runup in asset prices, and
the temporary tightening of monetary conditions that have been required to maintain the
peg under the currency board arrangement. The authorities have introduced fiscal
measures to support activity, and the flexibility of domestic wages and prices and the
strength of the banking system, together with a gradual return of confidence, should help
limit the slowdown and promote recovery.

Latin America: The risk of the contagion spreading to Latin America is real. A number of
Latin American countries are now running current account deficits as large as those of the
afflicted Asian countries before their collapse (for example, Chile’s is 7.5 per cent of GDP,
Brazil’s is 4.1 per cent of GDP, Colombia’s is 7.7 per cent of GDP). In Brazil and
Mexico, the ratios of short-term debt to foreign exchange reserves are similar in those of
adversely affected Asian economies. The ratio of short-term debt plus amortisation as per
cent of foreign exchange reserves is 196 per cent for Mexico and 159 per cent for Brazil.
Brazil is the key since it accounts for 45 per cent of Latin America’s GDP. US $12.7
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billion of capital fled the country in September. The foreign exchange reserves
lost in last few months has been of the order of about US $20 billion. The fiscal deficit
has been 7.8 per cent of GDP over the past year. Interest rates have been increased to 50
per cent to support the currency, and this is considered to be unsustainable.

Russia: There have been intense recurrent financial market pressures in Russia and
Ukraine, as a result of persistently large fiscal imbalances, significant short-term foreign
liabilities and delays in implementation of structural reforms. In Russia, market sentiments
have been weakened further by concerns about the effect of the decline in oil prices on the
current account position. Substantial hike in interest rates have at times been needed to
defend the rouble; but interest rates have been left for long periods at extremely high levels
that have limited confidence in the sustainability of confidence. This has contributed to
sharp losses in stock market values.

5 Current economic and social situation in crisis economies

Five “crisis” countries: Indonesia, Thailand, Korea, Philippines and Malaysia are impacted
to different degrees; also, all countries in the region are affected (Indochina, PNG), and
China is more and more involved, both the problems and the solutions. The economic
situation has continued to deteriorate since last July 1998, the forecast for end 1998
appears somber and outlook for 1999 is uncertain. Nevertheless, the economic policies
continue to evolve in the right direction. Further, though the IMF and the World Bank
have not been able to stop the economic decline, they have certainly shown the ability to
respond quickly.

All the countries are now in the midst of an important recession that will strongly affect
the economies in 1998. The forecast for 1999 is uncertain.. As of August 1998, stock
markets are down between 58 percent (Korea) and 38 percent (Indonesia). Exchange rates
are down between 84 percent (Indonesia) and 35 percent (Korea). After a long slide down
in the months to January of this year, exchange rates and stock markets had started to
recover (with the major exception of Indonesia which took a 40 percent hit within a few
days early January). But further shocks reappeared in 1998 as concern at the situation in
Japan impacted more and more negatively the markets. On the whole, the markets have
strongly reacted both regional and local events.

After a slowdown in growth in 1997, but still positive, (second half the year compensated
by first half of the year) negative growth is forecast for 1998 with the Philippines and
perhaps Malaysia less adversely affected than others. Thailand and Korea are likely to see
negative growth of around 5 percent, while for Indonesia the number is likely to be
between negative 10 and negative 15 percent.

Main causes of economic recession

Three main factors as indicated below are responsible for the current recession:

(a) Lack of external demand as a result of several factors such as:

• An effective collapse of the regional market. Imports are down between 4 and 13
percent in volume. The crisis countries including Japan 45 and 55 percent of the
exports to the region This explains that the performance in volume is not at the level it
should be (between negative 0.6 percent for Indonesia, 5 percent Malaysia and 24
percent Korea).
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• Prices of exports are going down significantly. So, performance in value is
very low, given the decline in exchange rates: (decline in Malaysia and Indonesia,
positive 1.4 percent in Thailand, positive 5 percent in Korea).

(b) Lack of internal demand as a result of several factors such as:

• impact of loss of wealth (market capitalisation down by 16 percent in Indonesia, to

145 percent in Malaysia);
• capital flight equivalent to about 10 percent of GDP;
• unemployment and losses of revenues in the working population.

None of this has been compensated so far by sharp increases in public demand, either in
terms of investment or current expenditures.

(c ) Problems on the supply side: The corporate sector face considerable difficulties in
responding to demand, mainly due to collapse of financial sector. There is also the problem
of trade finance and internal credit crunch due to various factors such as:

• lack of competitiveness, and industrial restructuring taking time (Korea, Thailand);

• corporate distress due to sharp increase of foreign debt (Indonesia) or high real
interest rates (everywhere but in Indonesia) and lack of trust on the banks side; banks
reducing their exposure because of capital adequacy requirements, and not enough
capital to bring in ;
• No credit available for specific categories of enterprises such as SMEs because banks
supporting them have collapsed and nobody wants them. In general SMEs have been
hit more than large exporting corporate.

Each country is, in effect, exporting its recession to its neighbours. At the same time, there
is no obvious engine of growth to pull the region from recession. Recent speculation about
the devaluation of the yuan and constant fears regarding possible collapse in Hong-Kong,
with a resulting devaluation of its currency, have fueled destabilising fears of another
round of devaluation. Recent interventions and events around the Japanese yen and Russian
ruble have also created further problems in international trade and capital flows.

Political and social factors

Political and social events have played a significant part in the crisis. Political changes in
Thailand and Korea have assisted in stabilising of the exchange rate, with the establishment
of a clearly understood and supported reform programme. Political uncertainty in Indonesia
played an important role in the opposite direction. Sustainability of the reform effort
depends heavily on real progress being achieved on the social front. There are signs of
social unrest almost everywhere, though to different degrees.

Unemployment rates are now between 3 percent (Malaysia), 6 percent (Korea) and 15
percent (Indonesia). Poverty is therefore increasing at an alarming rate. Indonesia, which
had such an impressive record of poverty reduction, is the most worrying case with real
fears that the proportion of the population under the poverty line could increase to 11 or 12
percent in 1998. This is compounded by drought impacts, not only in Indonesia.

The greatest concern is the real fear of major reversals in the achievements of East Asian
over the past generation. Social areas, including ensuring food and medicine supplies,
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keeping children in school, and protecting women’s health are key targets for
interventions by the government and multilateral funding agencies.

6 Role of multilateral financial institutions

The IMF is charged with safeguarding the stability of the international monetary system.
Thus, a central role for the IMF in resolving the Asian financial crisis was clear, and has
been reaffirmed by the international community in various multilateral forum. The IMF’s
priority was also clear to restore confidence to the economies affected by the crisis. In
pursuit of its immediate goal of restoring confidence in the region, the IMF responded
quickly by:

• helping the three countries most affected by the crisis Indonesia, Korea, and
Thailand to formulate and implement programs of economic reforms that could
restore confidence. The Philippines extended and augmented its existing IMF
supported program in 1997, and arranged a stand by facility in 1998;

• approving in 1997 about US$35 billion of IMF financial support 1 for reform
programs in Indonesia, Korea, and Thailand, and spearheading the mobilization of
some US$77 billion of additional financing from multilateral and bilateral sources
in support of these reform programs. In July 1998, committed assistance for
Indonesia was augmented by an additional US$ 1.3 billion from the IMF and an
estimated US$5 billion from multilateral and bilateral sources.

The reform efforts have been invaluably aided by the World Bank, with its focus on the
structural and sectoral issues that underpin the macroeconomic, and the Asian
Development Bank (ADB), with its regional specialization.

The IMF’s immediate effort to reestablish confidence in the affected countries entailed:

• the introduction of flexibility to exchange rates, where it did not already exist;

• a temporary tightening of monetary policy to stem pressures on the balance of

payments;

• concerted action to correct the obvious weaknesses in the financial system, which
constituted the major element in the crisis;

• structural reforms to remove features of the economy that had become impediments to
growth (such as monopolies, trade barriers, and nontransparent corporate practices)
and to improve the efficiency of financial intermediation and the future soundness of
financial systems.

• Efforts to assist in reopening or maintaining lines of external financing; and

• The maintenance of a sound fiscal policy, including through providing for rising
budgetary costs of financial sector restructuring, while protecting social spending.

Forceful, far-reaching structural reforms are at the heart of all the programs. As financial
sector problems were a major cause of the crisis, the centerpiece of the Asian programs
has been the comprehensive reform of financial systems. While tailored to the needs of
individual countries, in all cases the programs have arranged for:
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• the closure of unviable financial institutions, with the associated write down
of shareholders’ capital;
• the recapitalization of undercapitalized institutions;
• close supervision of weak institutions; and
• increased potential for foreign participation in domestic financial system.

To address the governance issues that also contributed to the crisis, the reform of the
financial systems is being buttressed by measures designed to improve the efficiency of
markets, break the close links between business and governments, and prudently liberalize
capital markets. Transparency is being increased, both as regards economic data (on
external reserves and liabilities in particular) and in the fiscal and corporate sectors, as well
as in the banking sector.

7 Summary of Structural Reforms in Crisis Countries

The IMF supported programs and policy advice to the crisis countries have placed
particular emphasis on broad ranging structural reforms of the financial and corporate
sectors, competition and governance policies, and trade regimes. In broad terms the
suggested reforms may be summarized as follows:

(a) Financial and Corporate Sector Reforms

• Closure of insolvent financial institutions, with their assets transferred to a resolution

or restructuring agency (Korea, Indonesia and Thailand); together with recapitalization
and mergers of other (all countries). The reform programs in Malaysia and Thailand
place particular importance on the finance company sector.
• Announcement of limited use of public funds for bank restructuring actual funds used
to be made explicit in the budget (all countries)
• Measures to significantly strengthen prudential regulation, including loan classification
and provisioning requirements, and capital adequacy standards (all countries).
• Measures to strengthen disclosure, accounting and auditing standards, and the legal
and supervisory frameworks (all countries).
• Liberalization of foreign investment in domestic banks (Korea, Indonesia and
Thailand)
• The introduction of more stringent conditions for official liquidity support (Indonesia,
Malaysia and Thailand).
• Strengthening of prudential regulations on loan exposure (all countries).
• Introductions of funded deposit insurance scheme (planned in Indonesia and Thailand;
under consideration in Malaysia, already in place in Korea and the Philippines)
• Restructuring of domestic and external corporate debt (Indonesia, Korea, Thailand)
and closure of nonviable firms (Korea).

(b) Competition and Governance Policies

• Liberalization of restrictive marketing arrangements for a variety of key commodities

(Indonesia)
• Establishment of competitive procedures for privatization of government assets and
for procurement (Indonesia, planned in Malaysia and Thailand)
• Announcement of bans on limits to the use of public funds to bail our private
corporation ( Indonesia, Korea, Malaysia and Thailand)
• Introduction or strengthening of bankruptcy laws and exit policies (Indonesia, Korea,
and Thailand)
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• Acceleration of privatization or closure of non-viable public enterprises (Indonesia)
• Strengthening of corporate disclosure standards (Korea)
• Liberalization of foreign investment in ownership/management in sectors other than
the financial sector (Korea, Indonesia, Malaysia and Thailand)

(c) Trade Reforms

• Reduction of import tariffs and export taxes (Indonesia).

• Easing of quantitative import and or export restriction (Indonesia and Korea).

(d) Social Policies

• Labour intensive public works programs (Indonesia, Thailand), and expansion of

unemployment insurance system (Korea).
• Protection of low income groups from increases in prices of food and other essential
(Indonesia, Malaysia, the Philippines, Thailand).
• Provision of higher spending for health and education (Indonesia) and reallocation of
budgetary expenditures to health programs for the poor (Thailand).
• Expansion of scholarship and loan programs to minimize number of student dropouts
(Thailand, Malaysia)
• Provision of subsidized credit for small and medium size enterprises (Indonesia,
Malaysia).

10.4 Thailand: The IMF-Supported Program of Economic Reform

The financial crisis first started in Thailand, with the baht coming under a series of
increasingly serious speculative attacks and the markets losing confidence in the economy.
On August 20, 1997, the IMF’s Executive Board approved financial support for Thailand
of up to US$4 billion, equivalent to 505 per cent of Thailand'’ quota, over a 34-month
period.

The initial program of economic reform envisaged:

• financial sector restructuring initially focusing on the identification and closure of

unviable financial institutions (including 56 finance companies), intervention in the
weakest banks, and the recapitalization of the banking system;
• fiscal measures equivalent to about 3 per cent of GDP to correct the public sector
deficit to a surplus of 1 per cent of GDP in 1997/98, support the necessary
improvement in the current account position, and provide for the costs of financial
restructuring including an increase in the VAT tax rate from 7 per cent to 10 per
cent.
• A new framework for monetary policy, in line with the new managed float for the
baht, and
• Structural initiatives to increase efficiency, deepen the role of the private sector in
the Thai economy, and reinforce its outward orientation, including civil service
reform, privatization, and initiatives to attract foreign capital

The program was modified on November 25, 1997, in light of a larger than expected
depreciation of the Baht, a slowdown of the economy that was sharper than anticipated,
and severe adverse regional economic developments. The modifications included:
 13
• additional measures to maintain the public sector surplus at 1 per cent of GDP.
• Establishment of specific timetable for implementing financial sector restructuring
including strategies for the preemptive recapitalization and strengthening of the
financial system, and
• Acceleration of plans to protect the weaker sectors of society.

The program was further modified on February 24, 1998, to give clear priority to
stabilizing quickly the exchange rate while limiting the magnitude and negative social
impact of the larger than expected economic downturn, and to set the stage for Thailand’s
return to the international financial markets. Among the modification were;

• accelerating financial system restructuring including the privatization of the

intervened banks;
• adjusting fiscal policy targets from a targeted public sector surplus of about 1 per
cent of GDP to a deficit of 2 per cent GDP in response to the weaker economic
activity and larger than anticipated improvement in the current account in part to
finance higher social spending;
• ensuring an adequate availability of credit to the economy to help foster an
economic recovery, while maintaining a tight monetary stance in support of
exchange rate stability;
• strengthening the social safety net; and
• further deepening the role of the private sector, including initiatives to attract
foreign capital

The program was again modified on May 26, 1998, with main priority minimizing any
further decline of the economy and bringing about an early recovery, while preserving
progress made in stabilizing the exchange rate and fostering confidence. The modified
program called for:

• allowing further cautious reductions in interest rates and somewhat higher

monetary growth rates, in line with recovering money demand;
• adjusting the fiscal target by increasing the public sector deficit target to 3 per cent
of GDP in view of the larger current account surplus and in order to minimize any
further decline of the economy;
• implementing concrete measures to strengthen the social safety net and allocating
an additional 0.5 per cent of GDP in the budget for this purpose;
• accelerating corporate debt restructuring by strengthening the legal and
institutional framework including through reform of the bankruptcy act,
foreclosure procedures, and foreign investment restrictions with the latter intended
to increase resources for restructuring.
• Continuing to focus financial sector reforms on the need for the banking system to
strengthen its capital; and
• Designing strategy to strengthen the finance company sector and resolving the
status of the four intervened banks to minimize the need for any future public
support for these institutions.

8 Indonesia: The IMF Supported Program of Economic Reform

The shift in financial market sentiment that originated in Thailand exposed structural
weaknesses in Indonesia's economy, particularly the size of short-term foreign debt owned
by the private corporate sector. On November 5, 1997 the IMF approved financial support
 14
of up to US$10 billion equivalent to 490 percent of Indonesia's quota over the next
three years.

Initial reform programmes included the following measures:

• financial sector restructuring, including closing unviable institutions, merging state

banks, and establishing a timetable for dealing with remaining weak institutions and
improving the institutional, legal, and regulatory framework for the financial system.
• Structural reforms to enhance economic efficiency and transparency, including
liberalization of foreign trade and investment dismantling of domestic monopolies, and
expanding the privatization program.
• Stabilizing the rupiah via the retention of a tight monetary policy and a flexible
exchange rate policy; and

• Fiscal measures equivalent to about 1 per cent of GDP in 1997/98 and 2 per cent in
1998/99 to yield a public sector surplus of 1 per cent of GDP in both periods, to
facilitate external adjustment and provide resources to pay for financial restructuring.
The fiscal measures included cutting low priority expenditures, including postponing
or rescheduling major state enterprise infrastructure projects removing government
subsidies, eliminating VAT exemptions; and adjusting administered prices, including
the prices of electricity and petroleum products.

Against a background of continuing loss of confidence in the Indonesian economy and

further sharp declines in the value of the rupiah, the Indonesian authorities announced a
reinforcement and acceleration of the program on January 15, 1998. Key reinforcing
measures included:

• Adjustments to the 1998/99 budget that would result in a public sector deficit of about
1 per of GDP, in order to accommodate part of the impact on the budget of the
economic slowdown;

• The cancellation of 12 infrastructure projects and the revoking or discontinuation of

privileges for the IPTN’s airplane projects and the National Car project;

• Further bank and corporate sector restructuring including the subsequent

announcement of a process to put in place a framework for creditors and debtors to
deal on a voluntary, case by case basis with external debt problems of Indonesia
corporations; the establishment of the Indonesian Bank Restructuring Agency (IBRA):
and a government guarantee on bank deposits and credits;

• Limiting the monopoly of the national marketing board to rice, deregulating domestic
trade in agricultural produce, and eliminating restrictive market arrangements; and

• Measures to alleviate the suffering caused by the drought, including ensuring that
adequate food supplies are available at reasonable prices.

Due to policy slippage and other developments, the rupiah failed to stabilize, inflation
picked up sharply, and economic conditions deteriorated. The government issued a
Supplementary Memorandum of Economic and financial Policies on April 10, 1998. The
measures included the following:

• A strong monetary policy to ensure stabilization of the rupiah;

 15
• Accelerate bank restructuring with IBRA to continue its take over or closure
of weak or unviable institutions and be empowered to issue bonds to finance the
restoration of financial viability to qualified institutions the elimination of existing
foreign ownership restrictions on banks; and the issuance of a new bankruptcy law.

• A comprehensive agenda of structural reforms to increase competition and efficiency

in the economy, reinforcing the commitments made in January and including the
further privatization of six major state enterprises and the identification of seven new
enterprises for privatization in 1998/99.

• Accelerated arrangements to develop a framework with foreign creditors to restore

trade financing and to resolve the issue of corporate debt and inter-bank credit.

After the economic situation was worsened and the economic program driven off track by
social disturbances and political change in May, 1988, the government issued a Second
Supplementary Memorandum of Economic and Financial Policies on June 24, 1998. The
envisaged measures are given high priority to strengthening the social safety net
comprehensively restructuring the banking system and include:

• Increasing social expenditure to a level equivalent to 7.5 per cent of GDP with
measures comprising the provision of food, fuel, medical, and other subsidies, the
expansion of employment generating programs, supported by the World Bank, ADB
and bilateral donors.

• Taking measures to limit the budget deficit to 8.5 per cent of GDP, a level that can be
financed with foreign funds, including cuts in infrastructure projects and improvements
in the efficiency of state run operations.

• Rehabilitating and strengthening the distribution system following the disruption

caused by social disturbances, to ensure that there are adequate supplies of essential
commodities, including the establishment of a special monitoring unit to identify
potential shortages of foodstuffs or distribution bottlenecks;

• Restructuring the banking system through measures to strengthen relatively sound

banks partly through the infusion of new capital while moving swiftly to recapitalize
merge or effectively close weak banks while maintaining the commitment to guarantee
all depositors and creditors. A high level Financial Sector Advisory Committee to
advise on the coordination of actions for bank restructuring is being established;

• Establishing an effective bankruptcy system, as an essential part of the corporate debt

restructuring strategy.

9 Korea: The IMF Supported Program of Economic Reform

Over the past several decades, Korea transformed itself into an advanced industrial
economy. However, the financial system had been weakened by government interference
in the economy and by close linkages between banks and conglomerates. Amid the Asian
financial crisis, a loss of market confidence brought the country perilously close to
depleting its foreign exchange reserves. On December 4, 1997 the IMF approved
financing of up to US$21 billion, equivalent to 1,939 percent of Korea’s quota, over the
next three years. The initial program of economic reform assumed a growth rate of 2.5 per
cent in 1998 and included the following measures:
 16
• Comprehensive financial sector restructuring that introduced a clear and
firm exit policy for financial institutions, strong market and supervisory discipline, and
independence for the central bank. The operations of nine insolvent merchant banks
were suspended. Two large distressed commercial banks received capital injections
from the government and all commercial banks with inadequate capital were required
to submit plans for recapitalization;

• Fiscal measures equivalent to about 2 per cent of GDP to make room for the costs of
financial sector restructuring in the budget, while maintaining a prudent fiscal stance.
Fiscal measures include widening the bases for corporate, income and VAT taxes.

• Efforts to dismantle the nontransparent and inefficient ties among the government
banks and businesses, including measures to upgrade accounting, auditing, and
disclosure standards, require that corporate financial statements be prepared on a
consolidated basis and certified by external auditors, and phase out the system of cross
guarantees within conglomerates.

• Trade liberalization measures, including setting a timetable in line with WTO

commitments to eliminate trade related subsidies and the import diversification
program, as well as streamlining and improving transparency of import certification
procedures.

• Capital account liberalization measures to open up the Korean money, bond, and
equity markets to capital inflows, and to liberalize foreign direct investment.

• Labor market reform to facilitate the redeployment of labour.

On December 24, 1997, the program was intensified and accelerated as the financial crisis
in Korea worsened and concerns about whether international banks would roll over
Korean short term external debt placed additional pressures on international reserves and
the won. The revised measures, whose announcement was followed by a significant
voluntary increase in rollovers and extension of claims by international bank creditors on
Korean financial institutions, included the following:

• Further monetary tightening and the abolition of the daily exchange rate band;

• Speeding up the liberalization of capital and money markets, including the lifting of all
capital account restrictions on foreign investors access to the Korean bond market by
December 31, 1997;

• Accelerating the implementation of the comprehensive restructuring plan for the

financial sector, including establishing a high level term to negotiate with foreign
creditors and reducing the recourse of Korean bank to the foreign exchange window
of the central bank; and

• Speeding up trade liberalization measures, including making binding under the WTO
the liberalization of financial services as agreed with the ORCD.

The macroeconomic framework revised on further on January 7, 1988 and February 5,

1998 with projection of lower growth at 1 per cent for 1998 included the following:
 17
• Targeting a fiscal deficit of around 1 per cent of GDP for 1998 to accommodate the
impact of weaker economic activity on the budget and to allow for higher expenditure
on the social safety net,

• Moving forward to implement a broader strategy of financial sector restructuring

having contained the immediate dangers of disruptions to the financial system.

• Increasing the range and amounts of financial instruments available to foreign

investors, increasing the access of Korean companies to foreign capital markets, and
liberalizing the corporate financing market (e.g. mergers and acquisitions); and

• Introducing a number of measures to improve corporate transparency, including

strengthening the oversight functions of corporate boards of directors, increasing
accountability to shareholders, and introducing outside directors and external audit
committees.

On May 2, 1998 the Korean authorities updated the program of economic reform in view
of the progress made in resolving the external financing crisis and the even weaker
outlook for economic activity. Positive developments included the conclusion of the
restructuring of US$ 22 billion of Korean banks' short term foreign debt, a successful
return to international capital markets through a sovereign global bond issuance of US$4
billion, improvement in the current account to a substantial surplus, and an increase in
usable reserves to more than US$30 billion. The measures included:

• The accommodation of a larger fiscal deficit of about 2 per cent of GDP in 1998 in
light of weaker growth and through the operation of automatic stabilizers and
measures to strengthen the social safety net;

• Measures to strengthen and expand the social safety net including through a widening
of the coverage of unemployment insurance and increases in minimum benefit duration
and levels.

• Formation of an appraisal committee including international experts, to evaluate the

recapitalization plans of undercapitalized commercial banks.

• The publication by August 15, 1998 of regulation to bring Korea’s prudential

regulations closer to international best practices, including through strengthening
compliance with existing guidelines concerning foreign exchange maturity mismatches;
and

Further phased liberalization of the capital account including loosening restrictions on

foreign exchange transaction, foreign ownership of certain assets, and ceiling on foreign
equity investment in nonlisted companies.

10.7 Early Results and the Outlook

The crisis in Asia is still unfolding and new disturbances cannot be ruled out. The markets
began in early 1998 to distinguish better among the different country situations, with
progress in implementing economic reforms being seen by the markets as less steady in
Indonesia than in Korea and Thailand. In the latter two countries, exchange rates have
stabilized and the external financing situation has improved. In Indonesia, the social
disturbances and political uncertainty in May 1998, which were among the factors
 18
impeding economic reform in Indonesia and had impacts that further worsened
economic conditions, have subsided.

The IMF World Bank, ADB and bilateral donors have augmented, in July 1998, the
financing for Indonesia’s revised program of economic reform. It takes into account the
need to urgently repair the country’s distribution system and strengthen the social safety
net, as well as to act quickly to stabilize the economy and restructure the banking system.
While the global effects of the East Asian crisis appear to have been contained to date,
devaluation of the Russian Ruble, the recession in Japan and the weakness of the yen have
introduced some new uncertainties.

Additional measures are being undertaken in the affected countries in terms off economic
restructuring to mitigate the adverse effects on output and employment. These measures
include the following:

• budgetary flexibility so as not to worsen the output loss;

• mitigating the effect of credit tightness and reductions in trade financing on
exporters and small and medium enterprises; and
• alleviating the social costs of adjustment, including through strengthening the
social safety net and encouraging a social dialogue among employers, employees,
and government.

Targeted fiscal positions have been eased over time to allow for greater social spending in
all three affected countries. In Indonesia, for example, the overall budgetary cost of social
safety net programs is new estimated at about 7.5 per cent of GDP. It includes funding of
food, fuel, and medicine subsidies; employment-generating programs targeted to poor and
vulnerable regions and households; health expenditure, including on village health centers
and immunization programs, and student aid to minimize the decline in school enrollment.