1 Over Mac A Study of Financial Market

The East Asian Crisis:
Macroeconomic Policy Design

and Sequencing Issues
Pradumna B. Rana and Joseph Anthony Y. Lim
Pradumna B. Rana is Manager of the Regional Economic Monitoring Unit,

Asian Development Bank.
Joseph Anthony Y. Lim is Professor of Economics at the School of Economics,
University of the Philippines.
2 A STUDY OF FINANCIAL MARKETS
Summary Policy Issues: Design and
○
○
Sequencing of Policies and
○
Introduction
○
Their Effects
○
○
The East Asian crisis has revived the longstanding Early in the crisis, the affected countries undertook
○
○
debate on the causes of currency crises. According to implement orthodox monetary and fiscal tighten-
○
○
to one view, a currency crisis results from weak ing and comprehensive structural reforms. In the case
○
○
macroeconomic fundamentals; in other words, it is a of Indonesia, Korea, and Thailand, these reforms
○
○
question of solvency. The competing view holds that were part of rescue packages led by the Interna-
○
○
currency crises are the outcome of self-fulfilling tional Monetary Fund (IMF). On the other hand, “vir-
○
○
prophecies and financial panic, and include bank runs, tual” IMF-type policies guided fiscal and structural
○
○
fickle investors, and hot money; in other words, they reforms in Malaysia and in the Philippines, until the
○
○
are crises of liquidity, which can occur even when launching of the National Economic Recovery Plan
○
○
the traditional fundamentals appear to be sound. Cri- in mid-1998.
○
○
ses of the latter type have become more frequent
○
○
since the early 1980s and have been associated with ORTHODOX MONETARY AND
○
○
the volatility of private capital as financial markets FISCAL TIGHTENING
○
○
integrate globally. Tight demand management policies were believed to

○
○
The emerging consensus seems to favor the cri- be necessary at the start to complement the current-
○
○
sis-of-confidence-cum-structural-weaknesses view. account adjustment required because of the large

○
○
The East Asian crisis differs from previous crises capital outflows: deficits in the current account had
○
○
in several key respects. First, it is a crisis of confi- to be reduced and converted into surpluses to offset
○
○
dence, a capital-account crisis, not a traditional cur- the negative net outflows in the capital account. Ini-
○
○
rent-account crisis. Second, unlike other crises of tially, therefore, domestic spending had to be reined
○
○
confidence of the 1980s and the 1990s, its root in, and monetary and fiscal tightening had to be insti-
○
○
causes are structural—premature financial liberal- tuted. Tight monetary policies were also needed to
○
○
ization (liberalization of financial markets without stem capital outflows, to support exchange rates, and
○
○
adequate supervision and regulation), crony capi- to curb inflation. In addition, fiscal tightness was re-
○
○
talism, and policy mistakes in managing private quired to generate government funds for financial
○
○
capital inflows—and not weak macroeconomic

○
rehabilitation and to restore confidence in the affected

○
○
fundamentals. The crisis involves private-to-pri- countries.

○
○
vate capital flows, not fiscal profligacy or mon- The macroeconomic components of these policy
○
○
etary expansion. Third, it is a liquidity crisis, not a packages have, however, proved to be controver-
○
○
solvency crisis. sial. The crisis-of-confidence-cum-structural-weak-

○
○
This crisis-of-confidence-cum-structural-weaknesses view argues that high real interest rates and
○
○
nesses nature of the East Asian crisis has a number fiscal restrictions, while appropriate in the Mexican
○
○
of important implications. First, it explains why the case or even during the Latin American debt crisis
○
○
East Asian crisis has been protracted and has had of the 1980s, are not appropriate in East Asia, where
○
○
high social costs. Second, it has raised new issues the root causes of the difficulties are structural. The
○
○
related to the design and sequencing of macroeco- Latin crises were mainly due to inappropriate mac-
○
○
nomic policies. Third, it has strengthened the case roeconomic fundamentals including large fiscal and
○
○
for regional solutions to complement global and indi- current-account deficits, and the cure, quite plausi-
○
○
vidual country efforts. bly, was fiscal and monetary austerity.

○
MACROECONOMIC POLICY DESIGN AND SEQUENCING ISSUES 3
The IMF now supports the crisis-of-confidence- cal evidence put forward by the IMF to justify the mon-
○
○
cum-structural-weaknesses view of the crisis. But in etary and fiscal tightening. They argue that, for meth-
○
○
its first systematic assessment of its programs in In- odological reasons or the difficulty of establishing what
○
○
donesia, Korea, and Thailand, the IMF rejected criti- would have happened without a given policy action,
○
○
cisms that the monetary and fiscal stringency imposed the evidence does not conclusively show that tight
○
○
in the initial stages of its bailout programs had plunged monetary and fiscal policies stemmed capital flight and
○
○
the affected countries into deep recession. While ad- supported exchange rates, as has been generally
○
○
mitting that it had badly misjudged the severity of the claimed. Providing their own evidence to show the
○
○
East Asian crisis, the IMF argued that the crisis pre- negative effects, proponents of the crisis-of-confi-
○
○
cluded any alternative to orthodox policies. It claimed dence-cum-structural-weaknesses view say that a
○
○
that monetary tightening had achieved the objectives policy of monetary and fiscal loosening would have
○
○
of avoiding a depreciation and inflation spiral despite been the appropriate response. The affected countries
○
○
some adverse impact on output. Indeed, given the had already tightened monetary and fiscal policy to
○
○
prevalence of foreign-currency-denominated debt, the reduce overheating caused by large amounts of capi-
○
○
alternative of easing monetary policy and allowing the ○
○
tal inflows. In the outflow period, therefore, a looser
exchange rate to depreciate further could have had monetary and fiscal stance was required to boost ag-
○
○
an even stronger contractionary effect. The IMF went gregate demand.

○
○
on to argue that fiscal policy had not been a major

○
○
factor dampening economic activity. EXCHANGE-RATE POLICIES

○
○
The crisis-of-confidence-cum-structural-weak- Coming out of the crisis, the affected countries, whose
○
○
nesses view, however, challenges this assessment reserves had been depleted in the effort to ward off
○
○
for a number of reasons. First, the East Asian crisis speculators, adopted a policy of managed “dirty” float
○
○
started out as a crisis of liquidity rather than one of and allowed market forces to determine the exchange
○
○
solvency. A run on the currency and on domestic rate. The IMF supported such regimes, at least in
○
○
assets by creditors left borrowers unable to continue the short run. Deep devaluations followed. Despite
○
○
financing their loans. The crisis began to build as the lengthy adjustment period, however, the devalu-
○
○
creditor banks and other lenders started calling in ations have yet to be translated into higher export
○
○
their loans and firms cut operating costs and sold off earnings. Increases in export volumes have been
○
○
assets, causing unemployment and a drop in asset offset by lower prices. Surpluses in the current ac-
○
○
values. The imposed cuts in demand and liquidity count have been due mainly to sharp cuts in imports
○
○
accelerated the bankruptcy or radical devaluation of which have depressed production. According to the
○
○
firms—not only those that were unprofitable but also crisis-of-confidence-cum-structural-weaknesses

○
○
those that were efficient and profitable. Second, the view, on the other hand, sharp devaluation has a num-
○
○
tight monetary and fiscal policies were inappropriate ber of adverse effects, including the decapitalization
○
○
for Asian financial structures. Unlike financial sys- of banks and firms with large unhedged foreign-ex-
○
○
tems in Latin America and other developing regions, change exposure. A vicious cycle between panics
○
○
Asian financial systems had high ratios of bank de- and decapitalization of banks and firms could occur,
○
○
posits and loan intermediation to gross domestic prod- so say proponents of the view.
○
○
uct (GDP) and of corporate debt to equity. They were

○
○
therefore vulnerable to shocks that depressed cash CAPITAL-ACCOUNT LIBERALIZATION

○
○
flows or the supply of bank or portfolio capital. AND CAPITAL CONTROLS

○
○
Those who hold the crisis-of-confidence-cum- To deal with balance-of-payments problems in the
○
○
structural-weaknesses view also challenge the empiri- current account, the Bretton Woods system allowed
○
the temporary use of capital controls, and the IMF, in based measures of financial restructuring were used
○
○
fact, published a study supporting this measure in 1995. without considering the unique link between
○
○
It was only in 1997 that capital-account liberalization corporates, banks, and governments in East Asia
○
○
was included among the purposes of the IMF. Strict and the systemic nature of the banking crisis. How-
○
○
implementation would not permit controls on capital ever, it is one thing to undertake such reforms where
○
○
flows. The timing was a bit unfortunate because, as real interest rates are very low and indebtedness is
○
○
the East Asian crisis has showed, opening up the capital not high (as in the US) and another to undertake
○
○
account too quickly has its dangers. the reforms where both real interest rates and le-
○
○
The case for free capital movements is the same veraging are high. In the latter case, the result is
○
○
as that for the free flow of goods and services across closures and layoffs, deflating the economy and ac-
○
○
borders: free flow of goods, services, and capital is celerating capital flight. Closing bad banks could
○
○
best for a small open economy as long as no infor- lead to runs on good banks. If the country is suffer-
○
○
mation asymmetries exist; there is a complete set of ing from a systemic banking crisis, the credit crunch
○
○
competitive international markets for goods, factors, must first be resolved by providing fresh liquidity to
○
○
and assets; and lump-sum redistribution is feasible in banks (through government-assisted mergers, tem-
○
○
the economy for achieving any distributional objec- porary nationalization, or even, all else failing, bail-
○
○
tives. Bhagwati (1998) and Stiglitz (1998b), among outs) before banks are restructured through mar-
○
○
others, have distinguished between markets for goods ket-based methods.

○
○
and financial markets, and argued that the case for

○
○
free trade in goods does not necessarily carry over SLUGGISH EXPORTS AND
○
○
to free financial flows. Information problems create INTERNATIONAL CAPITAL FLOWS

○
○
panics and manias in financial markets. Irrespective of who is right or wrong in the debate, it
○
○
The policy implication is that countries must be is a fact that export-led recovery did not begin some-
○
○
prudent in liberalizing their capital account and must time in the second half of 1998 as hoped. Interna-
○
○
sequence it properly. The preconditions for success- tional capital flows have been restored only to a lim-
○
○
ful liberalization are: a sound macroeconomic frame- ited extent. There is, therefore, a consensus between
○
○
work consistent with the choice of exchange-rate the contending groups that the path to economic re-
○
○
regimes, a strong and well-regulated domestic finan- covery lies in a more broad-based approach com-
○
○
cial sector, and a strong autonomous central bank.

○
prising exports and domestic demand. The IMF also

○
○
Therefore, the consensus in the literature on the se- supports the move to an expansionary stance be-
○
○
quencing of economic reforms still holds. Another cause the austerity measures of the initial program
○
○
implication is that, while exchange controls may be did not succeed in restoring the minimum levels of
○
○
ineffective as a long-term instrument of macroeco- foreign reserves and exchange-rate stability.

○
○
nomic stability, they may be effective in ensuring

○
○
economic stability in the short term.

○
Policies Implemented by
○
○
the Affected Countries

○
FINANCIAL SECTOR REFORM

○
○
Although the topic is covered more fully in the sec- The affected countries responded at first by institut-
○
○
tion on the banking sector, it is useful to mention here ing monetary and fiscal belt-tightening measures. They
○
○
very briefly that the design of financial sector re- tightened liquidity and raised interest rates as part of
○
○
forms in the initial package has also turned out to be the IMF-led rescue packages and the “virtual” IMF-
○
○
controversial. It is argued that the standard market- type policies in Malaysia (until mid-1998) and the Phil-
○
ippines. Interest rates in Indonesia, Philippines, and FISCAL STIMULUS
○
○
Thailand started rising sharply in the middle of 1997 • Relax fiscal deficit targets.
○
○
following speculative attacks on the baht and other
○
○
Southeast Asian currencies. Korea joined in later FINANCING FISCAL DEFICITS
○
○
(around November 1997) when its own currency • Higher fiscal deficits should be financed with the
○
○
came under attack. The policy response also included least cost to the economy.
○
○
fiscal belt-tightening measures as all five countries • In the medium and long term, the increase in the
○
○
aimed for fiscal surpluses. But the countries were national debt due to higher fiscal deficits incurred
○
○
obliged to scale back their fiscal targets when it be- during the crisis should be addressed.
○
○
came clear that the need to provide social funds and • Since the goal is to increase demand and cope
○
○
to reflate their economies was more urgent. with recession, both fiscal and monetary policies
○
○
Also, after achieving currency stability in the sec- should be loosened. Lack of credit, in a regime
○
○
ond quarter of 1998, and to revive their financial sec- of tight money, will not allow sufficient reflation
○
○
tors which languished in the regime of high interest and recovery to occur.
○
○
rates and tight liquidity, most countries loosened their ○
○
monetary policies and lowered interest rates. Indone- EXCHANGE-RATE MANAGEMENT

○
○
sia alone kept interest rates high, partly to counter the • As long as capital accounts are partly open, a
○
○
massive speculative attacks on its currency during the crawling-peg system is recommended to avoid
○
○
political crisis of mid-1998 and partly to hold in check currency overvaluation at a time of significant
○
○
its high inflation rate, which was close to 80 percent. current-account deficits and to discourage
○
○
But even Indonesia started to reduce its interest rates unhedged foreign borrowings.
○
○
in September 1998, by which time interest rates in • Currency boards must be credible to succeed. If
○
○
most countries were close to their precrisis levels. credibility is achieved in the medium term, a cur-
○
○
Despite the looser macroeconomic policy stance, how- rency board system could be considered more
○
○
ever, the credit crunch continues and unless this prob- seriously.
○
○
lem is alleviated the full effects of expansionary mac- • Stop depleting foreign reserves to defend cur-
○
○
roeconomic reforms will not be realized. rencies.

○
○
○
Major Policy Recommendations

○
SEQUENCING OF CAPITAL-ACCOUNT
○
for the Affected Countries

○
LIBERALIZATION AND
○
○
MONETARY POLICY: DEALING WITH EXCHANGE/CAPITAL CONTROLS

○
○
THE CREDIT CRUNCH • In correctly sequenced reform, the precondi-

○
○
• Loosen monetary and interest-rate policies and tions of macro stability, current-account liber-
○
○
ensure that they do not result in high inflation alization, financial and prudential regulation, and
○
○
and capital flight. a sufficiently flexible exchange-rate regime

○
○
• Implement an expansionary policy in the region. must be present before the capital account is
○
○
• Call for more workout arrangements, rollover of opened up.

○
○
loans, and restructuring of short-term foreign • Although ineffective as a long-term instrument

○
○
loans into medium- and long-term loans. of macroeconomic stability, exchange/capital

○
○
• Implement measures to alleviate the credit controls may ensure economic stability in the
○
○
crunch. short term.

○
○
○
EXPORT STIMULUS count deficits. In contrast, the macroeconomic fun-
○
○
• Make export credit and financing available. damentals of the PRC are strong: inflation is at a
○
○
• Improve the productivity and efficiency of ex- record low and fiscal and current-account surpluses
○
○
port production. are manageable.
○
○
• Diversify export markets and reduce over- All four countries, however, have a very weak
○
○
dependence on a few product lines. financial sector—the PRC and Viet Nam because
○
○
of the close link between state-owned enterprises
○
○
REGIONAL AND INTERNATIONAL EFFORTS (SOEs) and banks which the SOEs use as “milking
○
○
At the regional level, the Association of Southeast cows”; India and Pakistan because of the inefficien-
○
○
Asian Nations (ASEAN) has created a Surveillance cies of the Soviet model of development which they
○
○
Coordinating Unit at the ASEAN Secretariat, and adopted soon after independence but which they have
○
○
the Asian Development Bank (ADB) has established since abandoned. All four countries have to improve
○
○
a Regional Economic Monitoring Unit. In addition, their financial strength and prudential regulation. But
○
○
the following proposals merit serious consideration: even with either or both macroeconomic and finan-
○
○
• Set up regional funding and/or guarantee mecha- cial sector weaknesses, these countries have been
○
○
nisms. shielded from crises of confidence of the East Asian
○
○
• Adopt a two-stage approach to a full currency type because of stringent capital-account restrictions
○
○
union like the European Monetary Union. which have limited the external exposure of banks
○
○
• Expand the membership of the Asian Clearing and corporates.

○
○
Union or establish a new East Asian Clearing Reflecting the indigenous macroeconomic forces
○
○
and Payments Union. as well as the East Asian contagion, by early 1998
○
○
• Set up an Asian Monetary Fund. the currencies of India, Pakistan, and Viet Nam
○
○
At the international level: had depreciated by about 10 percent against the

○
○
• International assistance and loans are required dollar from the June 1997 levels. The depreciation
○
○
to alleviate the credit crunch, to finance fiscal was faster in India and Pakistan because of the
○
○
deficits, to provide safety nets, and to reflate the adverse impact of the sanctions imposed after the
○
○
economies. nuclear tests, and in Viet Nam because of an ex-

○
○
• Many have emphasized the need to create a new port slowdown and the withdrawal of foreign in-
○
○
international financial architecture. Issues per-

○
vestment. By the end of 1998, the currencies of

○
○
taining to this should be discussed further. these three countries had depreciated by around 20
○
○
percent versus their mid-1997 levels. The PRC has

○
Lessons for the

○
so far resisted pressures to devalue the yuan. It

○
Vulnerable Countries
○
last devalued the yuan by around 50 percent in

○
○
People’s Republic of China (PRC), India, Pakistan, 1994, gaining a head start in the export markets.
○
○
and Viet Nam are vulnerable to a currency crisis Although its export growth declined in 1998, this
○
○
either because of fundamental macroeconomic was mainly due to the contraction of the Japanese
○
○
weaknesses or the fragility of their financial sector, and East Asian markets rather than competitive
○
○
or both. The sanctions imposed on India and Paki- devaluations. Because imports fell more sharply, its
○
○
stan after the nuclear tests of early 1998 have made trade surplus actually improved. The country had
○
○
these countries even more vulnerable. India and US$145 billion in international reserves toward the
○
○
Pakistan have very high fiscal deficits. Pakistan and middle of 1998. Since a yuan devaluation would be
○
○
Viet Nam have had persistently large current-ac- catastrophic for East Asia, the PRC can gain a lot
○
of political mileage and aim for Asian leadership if by the affected countries, while the fourth traces the
○
○
it can successfully resist a devaluation and emerge path to economic recovery in East Asia including the
○
○
relatively unscathed. scope for regional and international efforts. Finally,
○
○
One lesson for these countries from the East Asian the chapter ends by deriving lessons from the crisis
○
○
crisis is that capital-account liberalization should for the other vulnerable economies.
○
○
strictly follow the proper sequencing of financial and
○
Causes of the East Asian Crisis
○
then capital-account liberalization. Thus, it is not ad-
○
○
visable for these four countries to open up their capi- The East Asian crisis has revived the longstanding
○
○
tal account too hastily and in full force. Prudence in debate on the causes of currency crises. According
○
○
the capital account, however, does not mean being to one view, a currency crisis results from weak
○
○
complacent and freezing the reform process because macroeconomic fundamentals; in other words, it is a
○
○
the benefits of globalization are large. It means adopt- question of solvency. The competing view holds that
○
○
ing a pace of liberalization consistent with the state currency crises are the outcome of self-fulfilling
○
○
of development of the financial system and the de- prophecies and financial panic, and include bank runs,
○
○
gree of soundness of macroeconomic management. ○
○
fickle investors, and hot money; in other words, they
Another lesson is that it would not be wise for are crises of liquidity, which can occur even when
○
○
these countries to undertake complete financial lib- the traditional fundamentals appear to be sound. Cri-
○
○
eralization—particularly liberalizing the entry of for- ses of the latter type have become more frequent
○
○
eign banks and expanding credit (especially foreign since the early 1980s and have been associated with
○
○
credit) and intermediation activities—without creat- the volatility of private capital as financial markets
○
○
ing the necessary institutions for prudential regula- integrate globally. Earlier examples include the South-
○
○
tion and supervision, and a desirable price and eco- ern Cone countries in the 1980s—Argentina (1981),
○
○
nomic incentive system in the real sector. Chile (1982), and Uruguay (1982). More recent ex-
○
○
amples in the 1990s are the demise of the target-

○
Introduction
○
zone system in Europe in 1992–1993, the Mexican

○
○
The East Asian crisis, by virtue of its being different crisis of 1994–1995, the Czech crisis of 1997, the
○
○
from previous crises in several key areas, has given August 1998 Russian crisis, and the ongoing pres-
○
○
rise to a number of interesting issues related to the sures on the Brazilian rial. The fundamental view, on
○
○
design and sequencing of macroeconomic policies. the other hand, takes issue with large current-ac-
○
○
This overview chapter discusses the newer issues in count and fiscal deficits and credit growth.
○
○
the five affected countries—Indonesia, Korea, Ma- At first, there were roughly two views on the East
○
○
laysia, Philippines, and Thailand. Lessons are also Asian crisis. The October 1997 issue of the IMF’s
○
○
drawn for four other countries that are vulnerable to World Economic Outlook, as summarized on the
○
○
but have not been directly hit by the crisis: PRC, Internet, notes:
○
○
India, Pakistan, and Viet Nam. In Asia, despite the region’s impressive growth
○
○
The introductory section is a review of the causes performance in recent years, several countries have
○
○
of the East Asian crisis and the reasons why it has recently experienced financial market pressures
○
○
turned out to be more protracted than expected. The linked to concerns about large external deficits;
○
○
second section discusses the ongoing debate on the in many cases, currencies linked to the appreciat-
○
○
design and sequencing of macroeconomic policies ing US dollar have aggravated the tensions.
○
○
and provides evidence for each side. The third sec- This view has since changed and the IMF now
○
○
tion of the chapter reviews the policies implemented explains the crisis in terms of the financial imbalances
○
caused by government interventions and institutional foreign-currency borrowing. Short-term debt grew
○
○
weaknesses in the credit and financial markets. faster than other types of external loans from 1993
○
○
Some of these deep-seated structural weaknesses, to 1996, and this growth brought two very grave vul-
○
○
according to the IMF (1997), are policy loans and nerabilities. First, currency and maturity mismatches,
○
○
guarantees for corporate debtors, which obviated the wherein liabilities were in dollars and were short-
○
○
need for thorough risk assessment; implicit guaran- term while assets were in domestic currency and
○
○
tees on banks’ liabilities, which did not encourage were medium- to long-term (e.g., real property, con-
○
○
close monitoring of financial institutions by deposi- struction), created the probability of self-fulfilling li-
○
○
tors and other creditors; and a lax regulatory frame- quidity attacks analogous to the possibility of bank
○
○
work, which failed to set and enforce standards for runs in the absence of deposit insurance. Second,
○
○
sound banking operations. This environment created the borrowing bank or corporation bore the whole
○
○
incentives for lenders to take high risks, and fostered brunt of the foreign-exchange risk. Speculative at-
○
○
excessive borrowing to finance risky and often doubt- tacks leading to currency depreciation cause wide-
○
○
ful investment projects. As a result, banks’ balance spread insolvency and hasten capital flight.
○
○
sheets showed substantial amounts of nonperforming The situation became volatile when the growth rates
○
○
loans, increasing exposure to the property sector, of Korea and Thailand decelerated in 1996 because
○
○
large holdings of corporate stocks, and low capital- of a slowdown in export growth and overcapacities
○
○
asset ratios. Many insolvent financial institutions were created by the investment boom in 1994–1995. The
○
○
permitted to continue operations. In Korea and Thai- slowdown in export growth affected Indonesia and
○
○
land, large corporations were highly leveraged, aided, Malaysia as well, mainly because of the cyclical turn
○
○
among other things, by a complex system of debt in the terms of trade against the East Asian countries,
○
○
guarantees within chaebol (Korea) and the relatively as manifested in the slump in the world semiconduc-
○
○
generous tax treatment of corporate debt compared tor market in 1996, and secondarily because of the
○
○
with equity (Thailand). moderate real appreciation of these countries’ cur-

○
○
In academic parlance, problems of moral hazard, rencies, especially vis-à-vis the yen. At the same time,
○
○
adverse selection, and asymmetric information in the current-account deficits were high in Malaysia and
○
○
financial and credit markets of the affected countries, Thailand and increasing in Korea, contributing to the
○
○
combined with weak prudential regulation and finan- perception that things were going awry. In the Philip-
○
○
cial supervision, shifted a disproportionate amount of

○
pines and Thailand, the significant overvaluation of

○
○
credit funds to highly vulnerable sectors, such as real currencies accompanying the current-account defi-
○
○
property, and other “risky investments,” ultimately lead- cits heightened expectations of a depreciation in those
○
○
ing to a rise in nonperforming loans and increasing currencies and rendered them particularly vulnerable
○
○
weakness and instability in the financial system. to speculative attacks.

○
○
At the same time, the global financial system, ex- As growth slowed down, the quality of loan port-
○
○
periencing low interest rates and weak financial su- folios deteriorated, particularly in Korea and Thai-
○
○
pervision as well, poured funds into these East Asian land, and the aforementioned weaknesses in the fi-
○
○
financial markets, particularly their vulnerable and risky nancial sector began to manifest themselves in rising
○
○
sectors. Part of this inflow may be attributed to the nonperforming loans. The financial weaknesses led
○
○
countries’ seemingly good investment prospects, strong directly to asset price deflation, before the July 1997
○
○
macroeconomic stability, and high economic growth. floating of the baht, in the stock and property mar-
○
○
The danger intensified as weak prudential regula- kets of both Korea and Thailand. The asset price
○
○
tion allowed massive inflows of unhedged short-term deflation and the slowdown in economic activity in-
○
creased the number of bankruptcies and bank fail- percent of GDP, according to one study) and aver-
○
○
ures, and caused further deterioration in the loan age recovery time (about 2.6 years, compared with
○
○
portfolios of the East Asian Five, particularly Indo- 1.5 years for a currency crisis and 1.9 years for a
○
○
nesia, Korea, and Thailand. banking crisis) have also risen (World Bank 1999).
○
○
The speculative attacks that ultimately led to the Since developing countries have limited experience
○
○
floating of the currencies and their sharp deprecia- with institutional and prudential safeguards for mini-
○
○
tion caused near financial collapse in the hard-hit mizing the risks of globalization, financial crises are
○
○
countries, as nonperforming loans increased further, expected to continue occurring with increasing fre-
○
○
precipitating massive bankruptcies and bank failures quency and at rising costs as globalization and re-
○
○
and deep recessions in the affected economies. The forms in developing countries progress.
○
○
crisis necessitated huge IMF packages for Indone- The crisis-of-confidence-cum-structural-weak-
○
○
sia, Korea, and Thailand. The goal of the IMF was nesses nature of the East Asian crisis (see, for ex-
○
○
to provide sufficient financing to replace international ample, Krugman 1998a, Radelet and Sachs 1998b,
○
○
reserves lost to capital outflows, as well as foreign- Sachs 1998, Wade and Veneroso 1998, Stiglitz 1998a
○
○
currency funds to repay the short-term loans of debt- ○
○
and 1998b, McKinnon and Pill 1998, and ADB and
ridden economies. It was a financing and policy re- World Bank 1998 manuscript) has a number of im-
○
○
form package to restore investors’ confidence in the portant implications. First, it explains why the East
○
○
system and to encourage creditors to continue roll- Asian crisis has been protracted and has had high
○
○
ing over a significant part of current loans. social costs. Second, it has raised new issues related
○
○
to the design and sequencing of macroeconomic poli-

○
Summary and Implications

○
cies. Third, it has strengthened the case for regional

○
○
The emerging consensus, therefore, is that the East solutions to complement global and individual coun-
○
○
Asian crisis differs from previous crises in several try efforts.

○
○
key respects. First, it is a crisis of confidence, a capital- The crisis in East Asia is now one-and-a-half years
○
○
account crisis, not a traditional current-account cri- old, but the recessionary trend continues. The social
○
1
○
sis. Second, unlike other crises of confidence of the costs of the crisis, in terms of rising unemployment
○
○
1980s and the 1990s, its root causes are structural— and poverty levels, have been massive. There has
○
○
premature financial liberalization (liberalization of fi- been a steady torrent of downward revisions in the
○
○
nancial markets without adequate supervision and region’s prospects (Figure 1). GDP in most East
○
○
regulation), crony capitalism, and policy mistakes in Asian countries is expected to bottom out sometime
○
○
managing private capital inflows—and not weak in 1999. Figure 2 gives the GDP growth rates of the
○
○
macroeconomic fundamentals. The crisis involves East Asian Five from 1995 to 1998 plus the first quar-
○
○
private-to-private capital flows, not fiscal profligacy ter of 1999. The recession seems to have bottomed
○
○
or monetary expansion. Third, it is a liquidity crisis, out in late 1998: first-quarter data for 1999 suggest
○
2 3
○
not a solvency crisis. lower economic declines for Indonesia and Malay-
○
○
This newer type of crisis has occurred with greater sia and positive growth for Korea, Philippines, and
○
○
frequency in developing countries since the 1980s, Thailand. But except for Korea, whose growth rate
○
○
reflecting the challenges posed by the globalization in the first quarter of 1999 unexpectedly reached 4.6
○
○
of financial markets (World Bank 1999). Many re- percent, the other countries’ recovery has been weak,
○
○
cent crises, including the East Asian and the Mexi- with GDP growth rates lower than 1.5 percent. A
○
○
can crisis, have, in fact, been twin crises—banking more credible recovery would require higher posi-
○
○
as well as currency crises. Their costs (about 18 tive growth for more than a quarter.
○
October it had moved northeast to Korea. In mid-
○
Figure 1: Evolution of Consensus Forecasts of 1998
○
GDP Growth in the Affected Countries, November, it moved back to Southeast Asia and af-
○
June 1997 to August 1998 (%)
○
fected Indonesia with a particular vengeance. The
○
○
East Asian contagion spread to Russia and Latin
○
○
America in the first half of 1999, and has now en-
○
○
gulfed all the emerging markets, which together ac-
○
○
count for roughly one fifth of world GDP. In the
○
○
middle of 1998, the question on everybody’s mind
○
○
was whether the flu was virulent enough to plunge
○
○
the entire world into a recession. Such fears turned
○
○
out to be unfounded because of the coordinated in-
○
○
terest-rate cuts in the US and Europe beginning in
○
Source: World Bank, Global Economic Prospects 1998/99.
○
the third quarter of the year. The East Asian crisis
○
○
Figure 2: GDP Growth Rates of the East Asian Five, has, however, exacted a serious toll on the global
○
○
1995 to First Quarter 1999 (%)
growth rate. One year ago the world economy was
○
○
expected to grow by 4.5 percent in 1998. This fore-
○
○
cast has now been revised downward to 2 percent,

○
○
but even this could turn out to be too optimistic mainly

○
○
because of the crisis. The downward revision trans-

○
○
lates into an output loss of US$600 billion–US$800

○
○
billion, most of it attributable to the East Asian crisis.

○
○
Figure 3 presents the inflation rates for the East

○
○
Asian Five from 1995 to 1998, plus the latest avail-

○
○
Sources: IMF, International Financial Statistics, various issues; ADB, Key Indicators able three-month data for 1999. For all five coun-
○
of Developing Asian and Pacific Countries, 1998; ADB, Asia Recovery Information
○
Center web site.

tries, the data show that, while inflation was on a
○
○
The Mexican crisis began in December 1994 when downward trend in 1997, on the eve of the crisis,
○
○
the peso was devalued sharply. Similarly, the East there were significant inflationary pressures in 1998
○
○
Asian crisis began on 2 July 1997 when the Thai following the currency depreciation in late 1997 and
○
○
baht was floated. The baht depreciated by 15 per-

○
early 1998. Except for Indonesia, however, the infla-

○
○
cent in the first week alone. The crisis spread quickly tion rates were kept below the 10 percent level, indi-
○
○
to Indonesia, Malaysia and Philippines and by mid- cating strong pressures to keep aggregate demand
○
○
○
Figure 3: Inflation Rates of the East Asian Five, 1995 to First Quarter 1999 (%)
○
○
○
○
○
○
○
○
○
○
○
○
○
○
○
○
○
○
As measured by the consumer price index.

○
Sources: IMF, International Financial Statistics, various issues; ADB, Key Indicators of Developing Asian and Pacific Countries, 1998; ADB, Asia Recovery Information Center web site.
○
Figures 6 to 9 present comparative data on vari-
○
Figure 4: Export Growth Rates of the East Asian
○
Five, 1995 to First Quarter 1999 (%) ous financial and real sector variables in Mexico dur-
○
○
ing 1994/1995 and East Asia during 1997/1998. The
○
○
figures present both pre-and postcrisis data in index
○
○
number terms to facilitate comparative analysis. Al-
○
○
though not shown in the figures, it is well known that
○
○
initial conditions were more favorable in East Asia
○
○
than in Mexico in the sense that savings and invest-
○
○
ments were higher and resources, including human
○
○
resources, were more abundant. Also, the magni-
○
○
Sources: IMF, International Financial Statistics, various issues; ADB, Key Indicators tude of the shock was relatively less severe in East
○
○
Center web site. Asia. For example, Figure 6 shows that by the third
○
○
month of the crisis, the Mexican stock market (in
○
Figure 5: Import Growth Rates of the East Asian
○
Five, 1995 to First Quarter 1999 (%) dollar terms) had plunged by about 70 percent. The
○
○
○
○
corresponding figures were lower in the case of East
Asia. Similarly, Figure 7 shows that within the fourth
○
○
month of the crisis, the Mexican peso had fallen by

○
○
over 50 percent. Again, in the East Asian case, the

○
○
corresponding figures were less.

○
○
Despite these differences, economic recovery

○
○
began earlier in Mexico than in East Asia. In Mexico,

○
○
the stock market began to recover four months after

○
○
Sources: IMF, International Financial Statistics, various issues; ADB, Key Indicators the crisis and five months later it had reached almost
○
○
Center web site.

50 percent of its November 1994 level. The exchange
○
○
rate began its recovery a month later and has since

○
○
down. Data from early 1999 show a slowdown in more or less stabilized. In the East Asian countries,
○
○
inflation for all countries. In fact, except for Indone- on the other hand, currencies in four of the five af-
○
○
sia and the Philippines, the inflation rates of the East fected countries, except Indonesia, began to recover
○
○
Asian countries fell sharply in early 1999 to below only seven or eight months after the crisis.
○
○
1996 levels, indicating deflationary pressures from

○
Figure 6: Mexico 1994/1995 vs. East Asia

○
very weak aggregate demand. 1997/1998—Composite Stock Price

○
Indices (monthly data, with t0 = 100)

○
The fall in aggregate demand and economic ac-

○
○
tivity was aggravated by a significant decline in ex-

○
○
port growth in 1998 (Figure 4) and reflected in sharp

○
○
declines in imports in the same year (Figure 5). It

○
○
must be pointed out that import contraction was much

○
○
sharper than export contraction in 1998, indicating

○
○
strong current-account adjustments to the reversal

○
○
of capital flows. These current-account adjustments

○
○
(via a massive contraction of imports) were effected

○
○
by the sharp currency depreciation as well as by the t0 is defined as end of June 1997 for the affected Asian countries and end of November
○
1994 for Mexico.

○
Source: Adapted from Bloomberg.

strong contraction of aggregate demand.
○
Partly because of the North American Free Trade
○
Figure 7: Mexico 1994/1995 vs. East Asia 1997/1998—
○
Exchange-Rate Indices (monthly data in Area (NAFTA) agreement, Mexico’s exports con-
○
US$/local currency, with t0 = 100)
○
tinued to surge during the crisis period (Figure 8). In
○
○
the East Asian case, exports have slumped (except
○
○
in the Philippines) mainly because of the higher cost
○
○
of capital and imported inputs, the shortage of trade
○
○
finance (particularly in Indonesia), and the recession
○
○
in the regional countries. Also, while foreign capital
○
○
inflows in Mexico recovered to their precrisis level
○
○
six months after the crisis, international capital flows
○
○
have yet to be restored in East Asia.
○
○
t0 is defined as end of June 1997 for the affected Asian countries and end of November Finally, GDP bottomed out in Mexico four quar-
○
1994 for Mexico.
○
ters after the crisis and started to recover in the
○
○
fifth quarter (Figure 9). In East Asia, the real sec-
○
○
Figure 8: Mexico 1994/1995 vs. East Asia tor is not expected to recover until later for some
○
1997/1998—Export Value Indices
○
countries, depending on the pace of economic re-
○
(monthly data, with t0 = 100)
○
forms. Fixed investment fell by around 60 percent

○
○
in the first quarter of 1998 in Korea, three times the

○
○
fall in Mexico in the first quarter of 1995 (World

○
○
Bank 1998).
○
○
The IMF attributes the protracted nature of the

○
○
crisis to the delayed implementation of its programs

○
○
on account of a lack of firm resolve which under-

○
○
mined credibility (IMF 1997). Indonesian authori-

○
○
ties, deviating from the tight monetary policies pre-

○
t0 is defined as end of June 1997 for the affected Asian countries and end of November
○
1994 for Mexico.

scribed, injected funds to rescue the failing finan-
○
Sources: Various central banks.

○
cial sector. Externally, the depth of the Japanese

○
○
economic and financial decline and its adverse ef-

○
Figure 9: Mexico 1994/1995 vs. East Asia

○
1997/1998—Indices of Gross Domestic

○
fect on the East Asian economies were largely un-

○
Product at Constant Local-Currency

○
Prices (quarterly data, with t0 = 100) derestimated.

○
○
Beyond the lack of political will and political insta-

○
○
bilities, other causes of the delayed effects, accord-

○
○
ing to the IMF (1997), were the following:

○
○
• Financial rehabilitation could not be achieved im-

○
○
mediately. Recapitalization took some time to de-

○
○
sign and implement, and there was skepticism

○
○
regarding the ability of the governments and pro-

○
○
grams to achieve this successfully. Furthermore,

○
○
much of the external debt was private. Thus,

○
○
t0 is defined as the second quarter of 1997 for the affected Asian countries and creditors reacted not only on the basis of the
○
third quarter of 1994 for Mexico.

○
Sources: International Monetary Fund, International Financial Statistics (CD-ROM) countries’ conditions but also on the basis of the
○
for Mexico and the Philippines, and country sources for the other affected Asian
○
economies.
conditions of individual debtors, which had, of
○
course, deteriorated during the crisis. The lack confidence takes time to restore. The political con-
○
○
of clear rules concerning government guaran- sensus necessary to implement the reforms is diffi-
○
○
tees—the lack of deposit insurance companies cult to obtain, especially in the middle of the crisis, as
○
○
and government’s initial wavering in guaran- structural reforms involve painful adjustments includ-
○
○
teeing all bank deposits (especially in Indone- ing mergers and layoffs. Also, even if they are imple-
○
○
sia)—caused bank runs (again especially in In- mented expeditiously, structural reforms need time
○
○
donesia) and further deterioration of confidence to take effect. This is because, compared with de-
○
○
in the system. mand, supply elasticities are generally low and re-
○
○
• The markets also became aware of the extent forms take time to bear fruit. In addition, however,
○
○
of the financial and external weaknesses only the crisis-of-confidence-cum-structural-weaknesses
○
○
when the crisis was already unfolding. The deple- view argues that some early policies may not have
○
○
tion of foreign reserves in Korea and Thailand in addressed the root causes of the crisis, and were
○
○
the defense of their currencies only became therefore misguided and had perverse effects (see
○
4
○
known quite late in the game, as the countries the next section).
○
○
belatedly asked for IMF help. The extent of ○
Policy Issues: Design

○
unhedged short-term borrowings also became

○
○
known only as the crisis was unfolding.

and Sequencing of
○
○
• The IMF-led rescue packages to Indonesia, Ko-

○
Policies and Effects

○
rea, and Thailand totaled US$118 billion, about

○
○
10 percent of their combined GDP, similar in Early in the crisis, the affected countries undertook
○
○
magnitude to the Mexican rescue package in to implement orthodox monetary and fiscal tighten-
○
○
1995. They, however, included sizable pledges ing and comprehensive structural reforms. The re-
○
○
by bilateral creditors—“second lines of defense forms comprised financial and corporate sector re-
○
○
(SLOD).” forms, competition and governance policies, trade

○
○
• There were weaknesses in the communication reforms, and social policies. In the case of Indone-
○
○
of the rationale and substance of the IMF pro- sia, Korea, and Thailand, these reforms were part of
○
○
grams. There was “at the outset the absence of rescue packages led by the IMF. On the other hand,
○
○
an effective government economic spokesper- “virtual” IMF-type policies guided fiscal and struc-
○
○
son, available to explain the program to the pub- tural reforms in Malaysia, as well as in the Philip-
○
○
lic, underscore the government’s support for it pines until the launching of the National Economic
○
○
and respond to public concerns as events un- Recovery Plan in mid-1998.

○
○
folded.”
○
Orthodox Monetary and

○
An alternative view of why the East Asian crisis

○
Fiscal Tightening
○
has been protracted is provided by those who hold

○
○
the crisis-of-confidence-cum-structural-weaknesses Tight demand management policies were believed to

○
○
view. According to this view, the sharp reversal of be necessary at the start to complement the current-
○
○
capital flow and the structural nature of the crisis account adjustment required because of the large
○
○
are by themselves enough to explain the protracted capital outflows: deficits in the current account had
○
○
nature of the recovery process. Crises of confidence to be reduced and converted into surpluses to offset
○
○
are self-fulfilling and lead to herd behavior and ex- the negative net outflows in the capital account.
○
○
change-rate effects are much more severe than what Initially, therefore, domestic spending had to be
○
○
vulnerability indicators alone can explain. Investor reined in, and monetary and fiscal tightening had to
○
be instituted. Tight monetary policies were also of easing monetary policy and allowing the exchange
○
○
needed to stem capital outflows, to support ex- rate to depreciate further could have had an even
○
○
change rates, and to curb inflation. In addition, fis- stronger contractionary effect. The IMF went on to
○
○
cal tightness was required to generate government argue that fiscal policy had not been a major factor
○
○
funds for financial rehabilitation and to restore con- dampening economic activity. Cline (1998) also de-
○
○
fidence in the affected countries. fends the tight monetary policy:
○
○
The macroeconomic components of these policy Critics of high interest rates argue that they
○
○
packages have, however, proved to be controver- failed to keep East Asian currencies from collaps-
○
○
sial. The crisis-of-confidence-cum-structural-weak- ing. There are two problems with this critique. The
○
○
nesses view argues that high real interest rates and first is that exchange rates might have fallen even
○
○
fiscal restrictions, while appropriate in the Mexican further without monetary tightening. The second
○
○
case or even during the Latin American debt crisis is that there were significant rebounds in the cur-
○
○
of the 1980s, are not appropriate in East Asia, where rencies that probably would not have occurred,
○
○
the root causes of the difficulties are structural. The or would have been smaller, without high interest
○
○
Latin crises were mainly due to inappropriate mac- rates.
○
○
roeconomic fundamentals including large fiscal and The crisis-of-confidence-cum-structural-weak-
○
○
current-account deficits, and the cure, quite plausi- nesses view, however, challenges this assessment
○
○
bly, was fiscal and monetary austerity. for a number of reasons. First, the East Asian crisis
○
○
In East Asia the situation was very different. Bud- started out as a crisis of liquidity rather than one of
○
○
gets had long been in balance and inflation was rela- solvency. A run on the currency and on domestic
○
○
tively low. The current-account deficit in Thailand assets by creditors left borrowers unable to continue
○
○
was close to the Mexican level of 9 percent of GDP, financing their loans. The crisis began to build as
○
○
but this was not due to fiscal profligacy or monetary creditor banks and other lenders started calling in
○
○
expansion. Rather, it was due to the weak regulatory their loans and firms cut operating costs and sold off
○
○
framework of the financial and corporate sector assets, causing unemployment and a drop in asset
○
○
which allowed large amounts of short-term capital values. The imposed cuts in demand and liquidity
○
○
into the system. accelerated the bankruptcy or radical devaluation of

○
○
The IMF now supports the crisis-of-confidence- firms—not only those that were unprofitable but also
○
○
cum-structural-weaknesses view of the crisis. But

○
those that were efficient and profitable (Sachs 1997).

○
○
in its first systematic assessment of its programs in Second, the tight monetary and fiscal policies were
○
○
Indonesia, Korea, and Thailand, the IMF rejected inappropriate for Asian financial structures. Unlike
○
○
criticisms that the monetary and fiscal stringency im- financial systems in Latin America and other devel-
○
○
posed in the initial stages of its bailout programs had oping regions, Asian financial systems had high ra-
○
○
plunged the affected countries into deep recession tios of bank deposits and loan intermediation to GDP
○
○
(Lane et al. 1999). While admitting that it had badly and of corporate debt to equity. They were there-
○
5
○
misjudged the severity of the East Asian crisis, the fore vulnerable to shocks that depressed cash flows
○
○
IMF argued that the crisis precluded any alternative or the supply of bank or portfolio capital. The deeper
○
○
to orthodox policies. It claimed that monetary tight- the intermediation of debt (that is, the higher the ra-
○
○
ening had achieved the objectives of avoiding a de- tio of bank deposits to GDP and the higher the ratio
○
○
preciation and inflation spiral despite some adverse of corporate debt to equity), the more likely that any
○
○
impact on output. Indeed, given the prevalence of depressive shock will cause illiquidity, default, and
○
○
foreign-currency-denominated debt, the alternative bankruptcy (Wade and Veneroso 1998). In East Asia,
○
high real interest rates in countries with high levels mixed results. Kraay’s (1998) study of some 186
○
○
of private indebtedness and low inflationary expec- speculative attacks in nearly six dozen middle- and
○
○
tations led to corporate bankruptcies and capital out- high-income countries found that interest-rate in-
○
○
flows regardless of the attractiveness of high inter- creases are necessary to ward off speculative at-
○
○
est rates. They also resulted in massive contractions tacks. The study was unable to reject the hypothesis
○
○
in domestic demand. In Indonesia, gross domestic of no significant relationship between interest-rate
○
○
investment in real terms fell by 43 percent in the first policies and the success or failure of speculative cur-
○
○
quarter of 1998 and by 65 percent in the second. rency attacks. Goldfajn and Gupta (1998) found evi-
○
○
The corresponding figures in Korea were 66 and 54 dence for a positive link between interest rates and
○
○
percent, respectively (Lee 1998). Growth in private exchange rates, but this link is reversed when a coun-
○
○
consumption was also anemic. try faces a banking crisis.
○
○
The World Bank (1999) holds similar views: Higher interest rates are designed to halt depre-
○
○
Higher interest rates should strengthen ex- ciation of exchange rates and stem capital outflows.
○
○
change rates by making it more attractive to hold But they come at a potentially high cost, since higher
○
○
financial instruments denominated in the particu- ○
○
interest rates make it more difficult for firms to ser-
lar currency. Under certain circumstances, how- vice loans, thus increasing nonperforming loans and
○
○
ever, this mechanism may not represent the full weakening the balance sheet of banks. The issue,
○
○
(or general equilibrium) impact of interest rates therefore, is whether the benefits from higher inter-
○
○
on exchange rates. If tighter credit and higher est rates are likely to be larger than a panic. The
○
○
interest rates worsen the financial condition of IMF took this as a matter of faith. But Furman and
○
○
already weak banks and corporations, an in- Stiglitz (1998) cast doubt on this view. They argue
○
○
crease in the probability of default on financial convincingly that Asian financial structures make it
○
○
instruments issued by them could weaken the ex- far less likely that high interest rates were the appro-
○
6
○
change rate by increasing the risk premium at- priate actions in East Asia.
○
○
tached to the currency. Monetary tightening could Those who hold the crisis-of-confidence-cum-
○
○
also weaken the exchange rate by reducing the structural-weaknesses view argue that interest-rate
○
○
expectations of future output, demand for money, hikes did not slow down currency depreciation, but
○
○
and interest rates. rather amplified the crisis by causing widespread

○
○
Those who hold the crisis-of-confidence-cum- banking and corporate bankruptcies. The effects
○
○
structural-weaknesses view also challenge the em- have been in the form of a vicious circle: the credit
○
○
pirical evidence put forward by the IMF to justify crunch resulted in severe financial losses for other-
○
○
the monetary and fiscal tightening. They argue that, wise solvent companies, and the widespread fall in
○
○
for methodological reasons or the difficulty of estab- profitability increased nonperforming loans and credit
○
○
lishing what would have happened without a given risk, worsening crisis-induced recessions and, in turn,
○
○
policy action, the evidence does not conclusively show causing further contraction in the supply of credit.
○
○
that tight monetary and fiscal policies stemmed capi- Proponents of the crisis-of-confidence-cum-struc-
○
○
tal flight and supported exchange rates, as has been tural-weaknesses view say that a policy of monetary
○
○
generally claimed. They provide their own evidence and fiscal loosening would have been the appropri-
○
○
to show the negative effects. For example, the World ate response. The affected countries had already
○
○
Bank (1999), after considering the correlation be- tightened monetary and fiscal policies to reduce over-
○
7
○
tween exchange rates and interest rates in Korea, heating caused by large amounts of capital inflows.
○
○
Malaysia, Philippines, and Thailand, came up with In the outflow period, therefore, a looser monetary
○
and fiscal stance was required to boost aggregate against the yen and fueled export-led growth in East
○
○
demand. Critics, on the other hand, argue that loose Asia. Second, low exchange-rate variability and the
○
○
monetary policy at the early stages of a crisis wors- predictability of exchange rates under the de facto
○
○
ens depreciation and increases the foreign-currency pegged regime reduced the foreign-exchange risk
○
○
liabilities of firms and banks. for debtors and creditors and led to surging inflows
○
○
While the appropriate interest policy at the onset of short-term capital held in unhedged positions.
○
○
of a crisis is still subject to debate in view of the Coming out of the crisis, the affected countries,
○
○
severity of the East Asian crisis, most would agree whose reserves had been depleted in the effort to
○
○
that high interest rates maintained beyond an “emer- ward off speculators, adopted a policy of managed
○
○
gency period” have a destabilizing effect. “dirty” float and allowed market forces to determine
○
○
Some observers have argued that the IMF plans the exchange rate. The IMF supported such regimes,
○
○
imposed a fiscal policy that was harmful—and un- at least in the short run. Deep devaluations followed.
○
○
necessarily strict. But the other side counters that Despite the lengthy adjustment period, however, the
○
○
loose policies at the onset of the crisis would have devaluations have yet to be translated into higher
○
○
raised doubts about the policymakers’ commitment. export earnings. Increases in export volumes have
○
○
One-and-a-half years after the outbreak of the cri- been offset by lower prices. Surpluses in the current
○
○
sis, most observers share the view that the IMF may account have been due mainly to sharp cuts in im-
○
○
have been too slow in revising its fiscal targets. Only ports which have depressed production.
○
○
after the deep recessions of 1998 did it progressively The crisis-of-confidence view argues that ex-
○
○
loosen its fiscal targets. The debate rages on. change-rate overshooting (that is, depreciation be-
○
○
yond a level that could be explained by real eco-

○
○
Exchange-Rate Policies nomic factors alone) is the norm—witness the sharp

○
○
Inappropriate exchange-rate policies are not a root depreciation of East Asian currencies within the first
○
○
cause of the East Asian crisis but have nonetheless few weeks of the crisis. Such depreciations led to
○
○
8
contributed to it (Rana 1998b). By the early 1980s, decapitalization of banks and firms with large
○
○
all of the affected countries had moved away from unhedged positions, and to further panic. In other
○
○
the old policy of pegging against the US dollar to- words, panic tends to lead to bank and firm
○
○
ward more flexible exchange-rate regimes of bas- decapitalization, which, in turn feeds panic, and so
○
○
ket pegging or managed “dirty” float. But the ex-

○
on, in a vicious circle. Soon after the crisis, letters of

○
○
tensive intervention policies of the central banks credit issued by banks in Indonesia and Thailand had
○
○
meant that exchange rates were de facto pegged difficulty being accepted in international markets.
○
○
to the dollar. Figure 10 shows that the sharp currency depre-

○
○
It is argued that this policy contributed to vulner- ciation in the East Asian countries in 1998 brought
○
○
ability in two ways. First, the strengthening of the their real exchange rates (the ratio of the nominal
○
○
dollar vis-à-vis the yen after mid-1995 led to an ap- exchange rate to the consumer price index, with a
○
○
preciation of the affected currencies and, thus, to value of 100 for 1990, the base year) above the Chi-
○
○
decreased export competitiveness and to current- nese renminbi despite the PRC’s sizable devaluation
○
○
account pressures. Also, by increasing the relative in 1994. The only exception seems to have been the
○
○
profitability of the nontradable sector, the fixed ex- Philippines.

○
○
change rate encouraged investments in real estate. McKinnon (1998b), for one, believes that as of
○
○
In contrast, the dollar-peg policy had served well from March 1998, the currencies of the affected coun-
○
○
1985 to mid-1995, when the dollar had weakened tries were severely undervalued—on the order of
○
tral bank—to prevent massive institutional fail-
○
Figure 10: Real Exchange Rates of Various East
○
Asian Countries, 1990–1998 (1990 = 100) ure or a complete seizing up of short-term trade
○
○
credit or both could hardly be avoided.
○
○
○
Capital-Account Liberalization
○
○
and Capital Controls
○
○
○
To deal with balance-of-payments problems in the
○
○
current account the Bretton Woods system allowed
○
○
the temporary use of capital controls, and the IMF,
○
○
in fact, published a study supporting this measure in
○
○
1995 (IMF 1995). This study supported the view that
○
○
capital controls were effective in Chile and Colom-
○
○
bia. After surveying the experiences of a wider set
○
○
20–30 percent in most countries and 60 percent in of countries, including those that imposed prudential
○
○
Indonesia. According to him, such devaluations ○
○
regulations on the financial sector (e.g., Indonesia
wreaked macroeconomic havoc and impeded the nec- and Thailand) and controls on capital outflow (e.g.,
○
○
essary banking reforms, for the following reasons: Mexico and Thailand), it concluded that such mea-
○
○
• Excessive inflation. Because so much of world sures were, at least in the short run, effective either
○
○
trade is invoiced in dollars, these devaluations in reducing the volume of capital inflows or in af-
○
○
led to an eventual doubling of domestic price lev- fecting their composition, or both. The longer the
○
○
els in the affected countries. This was inconsis- controls persisted, however, the greater the chances
○
○
tent with the “reasonable” inflation targets which that they would be ineffective. The other finding of
○
○
the IMF was trying to impose. Government was the IMF study was that reserve requirements ap-
○
○
therefore forced into overly contractionary mac- peared to be more effective. The “command and
○
○
roeconomic policies. control” type of restrictions and controls on inflows

○
○
• High interest rates. The out-of-control rounds tended to be more effective than controls on out-
○
○
of devaluations led people to expect that these flows because the latter were generally resorted to
○
○
currencies would only depreciate or, at best, stay during crisis periods. It was only in 1997 that capital-
○
○
at current (undervalued) levels. Because of these account liberalization was included among the pur-
○
○
adverse exchange-rate expectations and a risk poses of the IMF. Strict implementation would not
○
○
premium, interest rates on assets denominated permit controls on capital flows. The timing was a
○
○
in each domestic currency stayed well above bit unfortunate because, as the East Asian crisis has
○
○
world rates to stem further capital outflows. The showed, opening up the capital account too quickly
○
○
capital of domestic banks, which had lent long has its dangers.
○
○
and borrowed short, eroded further. Rodrik’s (1998) analysis of IMF data shows that,
○
○
• Bankruptcy of dollar debtors. Even otherwise among the Asian countries included in his sample,
○
○
sound banks, finance companies, and industrial Hong Kong, China and Indonesia have had open
○
○
enterprises found that their earnings in baht, pe- capital accounts since 1973. Similarly Malaysia has
○
○
sos, ringgit, rupiah, and won suddenly became had an open current account since 1974 and
○
○
woefully inadequate to service their dollar debts. Singapore, since 1976. The World Bank’s (1997) glo-
○
○
Emergency financial transfusions from the cen- bal financial integration index, which takes into ac-
○
○
tral government—usually represented by its cen- count a country’s openness to international financial
○
markets, and the volume of capital inflows and di- six months), from an inflow of US$103.2 billion in
○
○
versification (Table 1), indicates that Indonesia, Phil- 1996 to an outflow of US$1.1 billion, was equivalent
○
○
ippines, and Thailand had increased their integration to about 10 percent of the precrisis GDP of the five
○
○
during the late 1980s to the early 1990s. By the be- countries. Further outflow continued in 1998. This
○
○
ginning of the 1990s, all of the affected countries sharp reversal of capital was perhaps the largest such
○
○
were labeled “highly integrated” with global finan- reversal and loss of investor confidence witnessed
○
○
cial markets. Private capital therefore started surg- in recent economic history.
○
○
ing to the affected countries sometime in the late The case for free capital movements is the same
○
○
1980s and the early 1990s (Rana 1998c). On a cu- as that for the free flow of goods and services across
○
○
mulative basis, by the end of 1996, Korea had re- borders: free flow of goods, services, and capital is
○
○
ceived US$80 billion in private funds, followed by best for a small open economy as long as no informa-
○
○
Thailand with about US$75 billion, and Indonesia and tion asymmetries exist; there is a complete set of
○
○
Malaysia with about US$68 billion–US$69 billion. The competitive international markets for goods, factors,
○
○
Philippines, where the integration process had begun and assets; and lump-sum redistribution is feasible in
○
○
later, received only US$23 billion. Volatile flows the economy for achieving any distributional objec-
○
○
(short-term debt, portfolio equity, and bonds) com- tives. Bhagwati (1998) and Stiglitz (1998a), among
○
○
posed nearly three quarters of the flows in Korea, others, have distinguished between markets for goods
○
○
and nearly one half of the flows in the other coun- and financial markets, and argued that the case for
○
○
tries. In Malaysia, however, it constituted only about free trade in goods does not necessarily carry over to
○
○
one quarter of total flows. free financial flows. Information problems create
○
○
In 1997 and 1998, there was a sudden withdrawal panics and manias in financial markets.
○
○
of private capital from the affected countries. Ac- Rodrik (1998) uses a GDP per capita growth equa-
○
○
cording to the Institute of International Finance tion and a simple index of capital-account openness
○
○
(1999), the five affected countries suffered net pri- with a sample of almost 100 industrial and develop-
○
○
vate capital outflows of US$1.1 billion in 1997 and a ing countries for 1975–1989 and finds that capital-
○
○
further outflow of US$28.3 billion in 1998, compared account convertibility has no significant impact on
○
○
with a net inflow of US$103.2 billion in 1996. The growth once other effects are taken into account.
○
○
turnaround of US$104.3 billion in 1997 (actually just Carrasquilla (1998) finds similar results for 1985–
○
○
○
○
Table 1: Asian Countries—Changes in Degree of Global Financial Integration, 1985–1987 to 1992–1994

○
○
○
Country 1985–1987 Country 1992–1994

○
○
Korea, Republic of High Thailand High

○
Malaysia High Korea, Republic of High

○
○
Thailand Medium + Indonesia High

○
India Medium Malaysia High

○
○
Indonesia Medium Pakistan High

○
Sri Lanka Medium - Philippines High

○
○
Philippines Medium - India Medium +

○
Pakistan Medium - China, People’s Republic of Medium +

○
○
Myanmar Low Sri Lanka Medium -

○
○
China, People’s Republic of Low Myanmar Low

○
Bangladesh Low Bangladesh Low

○
○
○
Based on an overall index of integration which takes into account a country’s access to international financial markets, ratio of private capital to GDP, and the diversification of a
○
country’s financing based on the composition of flows.

○
Source: World Bank (1997).

○
1995 for 19 Latin American countries using more started only in the 1980s. Despite this, the country’s
○
○
direct measures of capital controls. economic performance until recently was very good
○
○
The policy implication is that countries must be with around 7 percent GDP growth per year and
○
○
prudent in liberalizing their capital account and must with impressive success in reducing poverty. Using
○
○
sequence it properly. The preconditions for success- a computable general equilibrium (CGE) model for
○
○
ful liberalization are: a sound macroeconomic frame- counterfactual analysis, Azis (1998) found that
○
○
work consistent with the choice of exchange-rate Indonesia’s GDP growth and employment levels
○
○
regimes, a strong and well-regulated domestic finan- would have been higher had a conventional sequenc-
○
○
cial sector, and a strong autonomous central bank. ing been followed. Income distribution, however, would
○
○
Therefore, the consensus in the literature on the se- have been slightly worse.
○
○
quencing of economic reforms still holds (e.g., Another implication is that, while exchange con-
○
○
Edwards 1987, McKinnon 1991). If the domestic fi- trols may be ineffective as a long-term instrument of
○
○
nancial system has not been liberalized, and there macroeconomic stability, they may be effective in
○
○
are interest-rate controls and financial repression, ensuring economic stability in the short term (ADB
○
○
then liberalizing the capital account will result in ○
○
1998). For example, the Malaysian government’s
heavy capital outflows. Even if interest-rate controls earlier effort to stabilize the economy through a com-
○
○
were removed and domestic interest rates were bination of monetary and fiscal policies had not yielded
○
○
above world levels, if credit allocation does not ad- the desired results. Sustained high interest rates,
○
○
equately reflect economic fundamentals—say, be- which were considered necessary to contain pres-
○
○
cause of mispricing of risk or directed credits—the sures on the currency, appeared to accentuate cor-
○
○
capital inflows induced by the capital-account liber- porate sector distress. In the pursuit of an alterna-
○
○
alization may lead to the financing of unproductive tive to IMF-type policies, Malaysia introduced strin-
○
○
activities. If trade is not liberalized prior to the capi- gent exchange controls and pegged the currency in
○
○
tal account, then the higher inflows may be funneled September 1998 (Box 1). Monetary and fiscal policy
○
○
into inefficient nontraded sectors. Alternatively, if the were made much more expansionary through inter-
○
○
current and capital accounts are simultaneously lib- est-rate cuts, lower reserve requirements, and higher
○
○
eralized, the capital inflow, and the potential real ex- fiscal surplus targets. So far, the measures have not
○
○
change-rate appreciation that accompanies it, may unduly harmed the economy, as many had expected.
○
○
adversely affect the tradable sector and generate an Declines in industrial production and employment lev-
○
○
expansion in the nontradable sector. If the apprecia- els are stabilizing and reserve levels are increasing.
○
○
tion is large and persistent, it may jeopardize me- Planned foreign direct investment in the country, how-
○
○
dium-term objectives, such as the development of ever, fell by 12 percent in 1998; whether actual in-
○
○
the nontraditional export sector. Similar arguments vestment also fell remains to be seen. The full impli-
○
○
apply to macroeconomic stabilization: if fiscal con- cations of these measures and their efficacy will,
○
○
solidation and reform have not taken place, the capi- however, be known only over time. Krugman (1998b)
○
○
tal inflows will be funneled to an inefficient public supports these measures provided they are short-
○
○
sector and temporarily help finance an unsustainable term and proreform.

○
○
accumulation of public-sector debt. An important lesson from the East Asian crisis is
○
○
In terms of sequencing, Indonesia appears to be that surges of private capital must be managed prop-
○
○
an exception because it did not follow the conven- erly. Most of the evidence suggests that the destabi-
○
○
tional style. Its capital account was open since the lizing effects of private capital movements depend
○
○
early 1970s, while trade and financial sector reforms on the degree to which a country’s macroeconomic
○
policies are sound and its financial sector is robust. well-thought-out financial restructuring plan in
○
○
The preferred solution, therefore, is to manage pri- place. The IMF’s initial program failed to include
○
○
vate capital flows properly so that inflows of short- provisions for deposit insurance, for managing
○
○
term capital are not excessive. But despite good man- the performing and nonperforming assets of these
○
○
agement, short-term capital flows could, on occasion, and other banks, or for securing and strength-
○
○
be destabilizing. Only in such cases and on a tempo- ening the rest of the banking system. The closures
○
○
rary basis should direct measures along the lines of set off a bank run that began to undermine the
○
○
the Latin-style unremunerated reserves be considered rest of the banking system including healthy
○
○
(Rana 1998a). banks. In the months that followed, the Indone-
○
○
sian central bank was forced to provide huge lines
○
Banking Sector Reform
○
of credit to keep the banking system liquid. These
○
○
Although the topic is covered more fully in the sec- credits added to the money supply and helped
○
○
tion on the banking sector, it is useful to mention here fuel inflation during the height of the crisis.
○
○
very briefly that the design of financial sector re- The IMF later admitted in an internal document
○
○
forms in the initial package has also turned out to be that its moves had backfired (reported in the New
○
○
controversial. The IMF began by closing several York Times article “IMF Now Admits Moves in In-
○
○
banks and financial institutions to show that East donesia Deepened the Crisis,” 14 January 1998).
○
○
Asian governments intended to introduce tough re- Once the bank reform program started, standard
○
○
form measures. In Indonesia, 16 banks were closed market-based measures of financial restructuring
○
○
very quickly on 1 November 1997. There was little were used without considering the unique link be-
○
○
doubt that these banks were in poor shape and tween corporates, banks, and governments in East
○
○
needed to be merged, closed, or recapitalized. How- Asia and the systemic nature of the banking crisis.
○
○
ever, as Jeffrey Sachs (1998) writes: Basle rules of capital adequacy were applied. Heavily
○
○
The problem was that the banks were closed indebted banks and firms were closed. Labor laws
○
○
very abruptly and without a comprehensive and were made more flexible. Similar measures had been
○
○
○
○
Box 1: Exchange Controls in Malaysia

○
○
○
The salient features of exchange controls introduced in Malaysia in early September 1998 are:
○
• Fixed exchange rate. The central bank pegged the Malaysian ringgit exchange rate at 3.8 against the US dollar. The ringgit
○
○
had fluctuated in the range of 2.52–4.88 after the onset of the regional economic crisis in July 1997, and, immediately
○
before the September changes, was trading at roughly 4.10 to the dollar.
○
○
• Ringgit no longer legal tender outside Malaysia. According to the government, the large quantity of ringgit held offshore
○
(unofficially estimated at US$5 billion–US$6.5 billion) was the major source of speculative trading. Therefore starting 1
○
○
October 1998, ringgit held offshore would cease to be legal tender. Transfers of ringgit held offshore to resident accounts
○
in Malaysia after 30 September 1998 would require prior approval, and residents would no longer be allowed to obtain
○
○
ringgit credit facilities from nonresident individuals.

○
○
• Restrictions on external accounts. Debits and credits into external accounts (ringgit accounts maintained in Malaysian
○
banks by nonresidents), which had not been restricted, would henceforth be subject to the following controls:
○
○
(i) payments for Malaysian exports could no longer be made in ringgit from an external account; (ii) funds in external
○
accounts could only be used for purchasing ringgit assets in Malaysia; and (iii) sources of funding for external accounts
○
○
would be limited to certain specified transactions such as the sale of foreign currency, salaries, or dividends, or as
○
proceeds from the sale of ringgit instruments, securities registered in Malaysia, or other assets in Malaysia.
○
○
• Payment restrictions. The ringgit would continue to be convertible for current transactions. However, residents traveling
○
abroad could pay in foreign currency through their credit cards only up to RM10,000; a resident traveler could carry a
○
○
maximum of RM1,000 and foreign currency equivalent to RM10,000; and prior approval was needed for payments by
○
residents to nonresidents for investments abroad in excess of RM10,000.

○
○
applied to resolve the US savings-and-loan crisis in time in the second half of 1998 as hoped. Interna-
○
○
the late 1980s—and they had worked. However, it is tional capital flows have been restored only to a lim-
○
○
one thing to undertake such reforms where real in- ited extent. There is, therefore, a consensus between
○
○
terest rates are very low and indebtedness is not high the contending groups that the path to economic re-
○
○
(as in the US) and another to undertake the reforms covery lies in a more broad-based approach com-
○
○
where both real interest rates and leveraging are high. prising exports and domestic demand (see “Export
○
○
In the latter case, the result is closures and layoffs, Stimulus” in the section entitled “Major Policy Rec-
○
○
deflating the economy and accelerating capital flight. ommendations for the Affected Countries”). The
○
○
Closing bad banks could lead to runs on good banks. IMF also supports the move to an expansionary
○
○
As Koo (1998) argues, if a country is suffering from stance because the austerity measures of the initial
○
9
○
a systemic banking crisis, the credit crunch must program did not succeed in restoring the minimum
○
○
first be resolved by providing fresh liquidity to banks levels of foreign reserves and exchange-rate stabil-
○
○
(through government-assisted mergers, temporary ity. The need for fiscal deficits is clear. First, essen-
○
○
nationalization, or even, all else failing, bailouts) be- tial social and human services must be maintained
○
○
fore banks are restructured through market-based ○
○
at a time when fiscal revenues are contracting sig-
methods. Otherwise the assets taken over from the nificantly and when economic decline increases the
○
○
failed banks cannot be sold back to the private sec- need for such services. Second, safety nets must
○
○
tor because all institutions will be facing capital short- be provided for those most vulnerable and affected
○
○
age. Koo goes on to argue that what is required is a by the crisis. Included here would be reskilling and
○
○
package of measures modeled after the Reconstruc- retraining programs for workers laid off by the cri-
○
○
tion Finance Corporation (RFC) of President Franklin sis. Also important is the need to compensate for
○
○
Roosevelt. In 1933, in the midst of the Great De- reduced private investments in health, education,
○
○
pression, President Roosevelt realized that capital was housing, and other local infrastructure as a result of
○
○
what US banks needed most, and so he offered to the crisis. Third, employment-generating programs
○
○
buy the preferred shares of banks through the RFC. and demand injection that will benefit the most vul-
○
○
This, together with Keynesian-type pump priming, nerable groups (such as rural infrastructure pro-
○
○
set the stage for the recovery of the US from the grams) would allow reflation of economies that are
○
○
depression, not market-oriented-type restructuring in deep recession.

○
○
(where compensation to the depositors does not ex- The first signs of economic difficulties in the af-
○
○
ceed that provided under existing deposit insurance fected countries occurred in 1996 when exports of
○
○
schemes), as in the savings-and-loan crisis. A re- these countries started to slow down from their peak
○
○
cent survey of eight bank restructuring exercises in growth in 1994 and 1995 (see Figure 4). The sharp
○
○
the 1980s and the early 1990s (Argentina, Chile, slowdown was caused mainly by cyclical movements
○
○
Colombia, Ghana, Malaysia, Spain, US, and Yugos- in world trade, which turned the terms of trade against
○
○
lavia) found that although market-based solutions these countries. The temporary slump in the semi-
○
○
were tried in most cases, there was government in- conductor market in 1996 and early 1997, for ex-
○
○
tervention in all eight (Sheng 1996). ample, had a strong downward effect on East Asian
○
○
exports. East Asian exports were also vulnerable

○
Sluggish Exports and

○
because of the real appreciation of the currencies of

○
International Capital Flows

○
the affected countries; the depreciation of the yen

○
○
Irrespective of who is right or wrong in the debate, it starting in 1995; strong competition from the PRC
○
○
is a fact that export-led recovery did not begin some- (including a sharp devaluation of the renminbi in 1994)
○
and other low-cost countries (South Asia, Eastern exports. The shares of exports going to East Asia
○
○
Europe, and Mexico which also devalued as much for the five countries range from 40 percent of total
○
○
as the PRC had, in 1994–1995) as world markets exports (the Philippines) to 58 percent of total ex-
○
○
opened up with the institution of the World Trade ports (Indonesia). This last factor is even more im-
○
○
Organization (WTO) and the Asia-Pacific Economic portant given the high level of intra-industry trade
○
○
Cooperation (APEC) and gave stiff competition to among the East Asian countries (see World Bank
○
○
the labor-intensive export products of the East Asian 1998 for a more detailed discussion).
○
○
countries such as garments, toys, and textiles; a slow- The natural automatic demand stimulus response
○
○
down in world trade growth; and high domestic costs, to the East Asian crisis, which consists of export
○
○
especially wages, interest costs, and rental costs. The stimulation and expansion as a result of massive de-
○
○
real appreciation of the currencies of the affected valuation, seems to be very weak at this moment.
○
○
countries and the depreciation of the yen were criti- The World Bank (1998), on the basis of previous
○
○
cally interrelated factors. With currencies pegged to studies, claims that, with the real depreciation of cur-
○
○
the dollar in fixed exchange-rate regimes, the appre- rencies reaching at least 40 percent, export volumes
○
○
ciation of the yen in the second half of the 1980s should have increased by 20 to 30 percent. Only
○
○
made the high-technology exports of the affected Korea and the Philippines have achieved this increase;
○
○
countries cheaper vis-à-vis the products of their Japa- the export volumes of the other three countries in-
○
○
nese counterparts, and gave these exports a bigger creased by less than 10 percent in the first half of
○
○
market in Japan because of their relative cheapness 1998.

○
○
in terms of the yen. But when the yen depreciated Furthermore, any increases in export volumes were
○
○
against the dollar starting in 1995, the continued peg offset by declines in the unit value of exports, particu-
○
○
to the dollar, aggravated by the real appreciation of larly for Korea and Thailand. The decline in the world
○
○
the currencies, reversed the above trend and made price of exports for East Asia is caused by the sharp
○
○
the East Asian exports more expensive vis-à-vis appreciation of the dollar, and the strong competition
○
○
Japanese products. The Japanese market for the East in exports between Korea and Japan (where the yen
○
○
Asian exports also began to slow down because of has also depreciated) and among the Southeast Asian
○
○
economic stagnation in Japan. countries. Among the affected countries, only the
○
○
The current poor performance of exports, despite Philippines seems to be less affected by export price
○
○
the massive devaluation of currencies, highlights the

○
declines and the loss of export markets (since it is less

○
○
negative environment that the major victims of the dependent on East Asia for its exports).
○
○
East Asian crisis still face: the continued but lessen- Figure 4 shows that in terms of dollar earnings,
○
○
ing slump in the international semiconductor market exports fell in 1998 for all of the East Asian Five
○
○
and the continued slowdown in world trade growth save the Philippines. The latest figures for 1999 show
○
○
(partly because of the East Asian crisis itself); the some slowdown in the export decline, but there is
○
○
credit crunch, which has hit all sectors (including the still negative growth in exports except for a small
○
○
export sector) of the affected economies; and the increase in Malaysia and a slower (though still sub-
○
○
huge decline in the East Asian market as a result of stantially high) growth in the Philippines.
○
○
the economic contraction in Japan (a major market Since the export stimulus seems to be very weak
○
○
for all East Asian countries), the affected countries, and the external conditions not conducive for an ex-
○
○
Hong Kong, China, and Singapore. The last factor is port-led recovery, the deep recessions in the affected
○
○
especially important since all the affected countries countries must be counteracted with strong monetary
○
○
depend heavily on the East Asian market for their and fiscal stimuli to reflate the economies.
○
The earlier policy package also had only limited ship between international financial institutions, gov-
○
○
impact in restoring international capital flows to the ernment, and private banks. As governments restruc-
○
○
affected countries. Some encouraging signs of in- ture their banks, the international financial institutions
○
○
vestor confidence had emerged in the region during should work with the commercial banks to make them
○
○
the first four or five months of 1998 following the part of the solution. Longer-term fundamentals in the
○
○
agreements to roll over and restructure Indonesia’s affected countries, however, are still strong, and the
○
○
and Korea’s short-term bank debt. The stock mar- financial integration of these countries should broaden
○
○
kets and currencies of the affected countries had and deepen over the coming decades.
○
○
stabilized and reversed somewhat. In April, the first
○
○
signs that international capital markets were again Policies Implemented by
○
○
accessible to the affected countries appeared. The
○
○
Philippines launched a US$500-million yankee bond
○
○
and Korea followed with a US$4-billion issue which The affected countries responded at first by institut-
○
○
was three times oversubscribed. Portfolio flows into ing monetary and fiscal belt-tightening measures.
○
○
the Philippines in the first quarter of the year were ○
○
They tightened liquidity and raised interest rates as
higher than the corresponding figure for the previous part of the IMF-led rescue packages and the “vir-
○
○
year. Since then, however, the resurgence of anti- tual” IMF-type policies in Malaysia (until mid-1998)
○
○
market sentiments in Hong Kong, China (where the and the Philippines (Figure 11). Interest rates in In-
○
○
government has been intervening in stock markets) donesia, Philippines, and Thailand started rising
○
○
and Malaysia (where, in early September, an alter- sharply in the middle of 1997 following speculative
○
○
native recovery strategy comprising sweeping capi- attacks on the baht and other Southeast Asian cur-
○
○
tal controls and fixed exchange rates was adopted) rencies. Korea joined in later (around November
○
○
has made foreign investors a bit apprehensive. 1997) when its own currency came under attack.
○
○
In the medium term, the prospects are not very Call-market interest rates increased from a monthly
○
○
encouraging. The affected countries are doing their average of 14 percent in November 1997 to 22 per-
○
○
part to restore investor confidence. They are under- cent in December 1997 and to 25.6 percent in Janu-
○
○
taking difficult structural reforms including restruc- ary 1998. In Malaysia, interest rates were raised in
○
○
turing banks and companies and improving their gov- January 1998.
○
○
ernance system. However, the foreign investors that

○
Figure 11: Short-Term Interest Rates in the Affected

○
have abandoned East Asia are still returning very Countries, 1996 to January 1999 (%)
○
○
cautiously and are still waiting for some signs of eco-

○
○
nomic revival. Signs are more encouraging in Korea

○
○
where the Seoul stock market was the world’s best-

○
○
performing bourse in 1998. Korea also attracted

○
○
US$8.8 billion in foreign direct investment in 1998.

○
○
Its credit rating was recently upgraded. The eco-

○
○
nomic prospects for the region and investor confi-

○
○
dence seem to be interrelated in some sort of vicious

○
○
circle. Improved investor confidence requires good

○
○
economic performance, of which foreign capital, at

○
○
least over the long term, is an important determinant.

○
Three-month money-market rates.

○

What appears to be required is a concerted partner-
○
The policy response also included fiscal belt-tight- balances achieved in earlier years. But once rev-
○
○
ening measures as all five countries aimed for fiscal enues started to decline and growth-rate figures be-
○
○
surpluses (Table 2). Fiscal policy was to be tight- gan to show a gloomy picture, higher fiscal deficits
○
○
ened considerably in Thailand from a deficit of nearly and the (perceived) unattainability of fiscal targets
○
○
1 percent of GDP in 1997 to a surplus of a similar reduced confidence in the countries tremendously.
○
○
amount in 1998. The situation was similar in Indone- The sharp drop in stock-market prices in the Philip-
○
○
sia where a 1 percent surplus was targeted for 1998. pines from April to September 1998 (larger than the
○
○
Korea and the Philippines targeted a balanced bud- declines in the crucial months of July 1997 to Janu-
○
○
get for 1998 while Malaysia was to retain its 2.5 ary 1998), and the Philippines’ depreciation during
○
○
percent fiscal surplus. this period, which cumulatively now exceeds that of
○
○
One of the surprises in East Asia compared with Thailand, were attributable, to a large extent, to de-
○
○
Mexico in 1994/1995 is how little immediate effect teriorating fiscal balances and the perception that
○
○
the initial policy responses appear to have had on actual results would be way off target.
○
○
reducing pressure on currencies and stabilizing in- The countries were obliged to scale back their
○
○
vestor confidence (World Bank 1999). On the con- fiscal targets when it became clear that the need to
○
○
trary, much or even most of the depreciation in cur- provide social funds and to reflate their economies
○
○
rencies occurred after these measures were taken. was more urgent. This decision was made in the sec-
○
○
Financial and real economic conditions deteriorated ond half of 1998 (corresponding to the second and
○
○
more quickly than expected and exports did not re- third revisions in Table 2). The most significant change
○
○
bound. Changes in the initial packages were, there- was made for Indonesia which needed to reflate its
○
○
fore, required and more expansionary monetary and economy the most, and provide safety nets to its hard-
○
○
fiscal positions were programmed. hit citizens. Fiscal austerity in the initial package
○
○
The initial conservative fiscal policies no doubt had (1 percent of GDP surplus for 1998) was replaced
○
○
more optimistic underlying assumptions based on by a still tight 1 percent fiscal deficit figure for 1998
○
○
higher growth and continuation of the growing fiscal in January 1998. When the gravity of the Indonesian
○
○
○
○
○
Table 2: Central Government Fiscal Balances, 1987–1998 (percent of GDP)

○
○
1998
○
○
Initial First Second Third

○
Country 1987–1991 1992–1996 1996 1997 package Revision Revision Revision

○
○
Indonesia
○
Fiscal balance -1.0 0.9 1.2 -0.2 1.0 -1.0 -3.0 -8.5
○
○
Primary balance 1.6 2.7 2.4

○
Korea, Republic of
○
○
Fiscal balance 0.0 0.2 0.5 0.3 0-0.3 0-0.3 -0.8 -1.8
○
Primary balance 0.7 0.8 1.1 0.8

○
○
Malaysia
○
Fiscal balance -3.9 0.7 1.1 2.6 2.5 0.5 -3.5

○
○
Philippines
○
Fiscal balance -2.6 -0.1 0.3 -0.9 0.0 -1.0 -3.0

○
○
Thailand
○
○
Fiscal balance 2.1 2.4 2.4 -0.9 1.0 1.0 -1.6 -2.4
○
Primary balance 4.3 3.0 2.5 -0.6

○
○
○
The primary balance includes interest on government debt. The data for Indonesia refer to the fiscal year starting in the year indicated (“1997” refers to FY 1997/98, April 1997 to
○
March 1998) and the data for Thailand refer to the fiscal year ending in the year indicated (“1997” refers to FY 1996/97, October 1996 to September 1997).
○

○
crisis became clear, this target was loosened to 3 end-1997 and 6.8 percent in 1998. The third letter of
○
○
percent of GDP in midyear. In the revision of No- intent (24 February 1998) retained this tight mon-
○
○
vember 1998, the fiscal deficit target was further etary stance. In the fourth letter of intent (26 May
○
○
loosened to 8.5 percent of GDP, to provide safety 1998), the targeted growth of M2 for 1998 was in-
○
○
nets and reflate an economy in severe recession. In creased to 9 percent, easing the monetary tightness.
○
○
Thailand the targeted 1 percent surplus for 1998 was The monetary targets were retained in the latest re-
○
○
retained in the November 1997 review but was review (1 December 1998). Short-term interest rates
○
○
laxed to a 1.6 percent deficit in the February 1998 (three-month money-market rates), which were in
○
○
review and to a 2.4 percent deficit in the May 1998 the low tens before the crisis erupted, jumped to close
○
○
review. As shown in Table 2, the 1998 targets were to 20 percent in July 1997, the month the baht suc-
○
○
revised quite substantially in all of the other coun- cumbed to attacks, and reached a peak of more than
○
○
tries as well. 30 percent in December 1997 and January 1998.
○
○
Also, after achieving currency stability in the sec- Interest rates quickly dropped after this as currency
○
○
ond quarter of 1998, and to revive their financial sec- movements became more stable, and high overnight
○
○
tors which languished in the regime of high interest ○
○
rates and reserve ratios were lowered. By Septem-
rates and tight liquidity, most countries loosened their ber 1998, short-term interest rates were below 10
○
○
monetary policies and lowered interest rates. Indo- percent, lower than precrisis levels. The decline in
○
○
nesia alone kept interest rates high, partly to counter interest rates indicates that there is more liquidity
○
○
the massive speculative attacks on its currency dur- available in the market. However, financial institu-
○
○
ing the political crisis of mid-1998 and partly to hold tions have not been lending to the real sector as
○
○
in check its high inflation rate, which was close to 80 stricter provisioning requirements and the increasing
○
○
percent. But even Indonesia started to reduce its in- number of nonperforming loans have made them
○
○
terest rates in September 1998, by which time inter- extremely loan-shy.

○
○
est rates in most countries were close to their Korea also shifted from a less restrictive mon-
○
○
precrisis levels. The only exceptions were the Phil- etary and fiscal stance to stimulate domestic demand
○
○
ippines (where interest rates were still 3 to 4 per- and promote economic recovery. As a result, inter-
○
○
centage points higher than before the crisis) and, of est rates dropped substantially, with the overnight
○
○
course, Indonesia. Even when currency instability call rate down to 6–7 percent in December 1998
○
○
resumed in mid-1998 and lasted until September from 21 percent a year ago. The benchmark mar-
○
○
1998, most countries did not significantly return to ket interest rate, the three-year corporate bond rate,
○
○
high interest-rate policies to defend their curren- declined from 24 to about 8 percent during the same
○
○
cies. Interest rates have continued to decline and period.

○
○
are now lower than their precrisis levels in Korea, Malaysia’s favorable initial macroeconomic con-
○
○
Malaysia, and Thailand. ditions, a financial sector that appeared to be rela-

○
○
The move first to tighten and then to loosen mon- tively strong, and low external debt exposure shaped
○
○
etary policy in Thailand is illustrative. The initial IMF the government’s response to the crisis in the early
○
○
program for Thailand (14 August 1997) scaled down stages. The assessment then was that standard de-
○
○
monetary (M2) growth from an actual growth of mand management measures, including high interest
○
○
around 20 percent in 1996 to a targeted 7 percent in rates and a tight fiscal policy, were adequate to deal
○
○
1997 and 8 percent in 1998. In the second letter of with the situation. In the first quarter of 1998, the
○
○
intent in November 1997, the targeted growth for government further tightened monetary and fiscal
○
○
M2 was further revised downward to 7.5 percent by policies, and adopted measures aimed at proactively
○
addressing financial and corporate sector weak- deeper recession. It announced exchange and capi-
○
○
nesses. However, the crisis proved to be more pro- tal control measures in early September 1998 in the
○
○
tracted than foreseen. Weaknesses in the financial belief that the domestic monetary policy was being
○
○
and corporate sectors assumed serious dimensions. held hostage to speculative activities in the open
○
○
The lingering instability in the economic environment, capital account. In particular, an active and grow-
○
○
the moderation of inflationary trends after June, the ing offshore market for ringgit kept the exchange
○
○
emergence of a current-account surplus, and increas- rate volatile and constrained monetary policy op-
○
○
ing emphasis on self-reliance in dealing with the cri- tions. Certain aspects of the rigid exchange control
○
○
sis led to a reorientation of the policy approaches of policies (e.g., the one year lock-in period) were re-
○
○
the government in mid-1998. The National Economic laxed in February 1999. Investors can now take
○
○
Recovery Plan (NERP) released in July 1998 is the their money out of the country but must pay an exit
○
○
cornerstone of the new policy framework. NERP is tax at a rate that declines with the duration the money
○
○
aimed at reviving the economy by relaxing fiscal and is kept in the country.
○
○
monetary policies, speeding up the restructuring of In the Philippines, interest rates were high at the
○
○
the financial sector, and stabilizing the ringgit. The beginning of 1998 as a result of the tight monetary
○
○
focus of monetary policy shifted from credit restric- policy. But following reductions in the key rates by
○
○
tion in the first half of 1998 to credit expansion in the the Bangko Sentral ng Pilipinas and cuts in reserve
○
○
second half of the year. The tight monetary policy requirements in mid-1998, interest rates gradually
○
○
followed in 1997 continued in the first half of 1998. declined during the year, although they still remained
○
○
The benchmark interest rate of Bank Negara Ma- at above the precrisis level at the end of 1998. Lower
○
○
laysia had increased by about 3.5 percentage points interest rates have helped the domestic banking sys-
○
○
by February 1998. Quantitative restrictions were tem cope with the high debt servicing costs, but have
○
○
imposed on bank credit. Money supply and credit not helped in reviving private investments. Owing to
○
○
growth, however, decelerated faster than expected. weak investment demand, a consensus has emerged
○
○
The broad money (M3) growth had slowed down to on the need for a fiscal stimulus, the major issue be-
○
○
4.3 percent by August 1998. The macroeconomic ing the magnitude of a budgetary deficit that can be
○
○
outlook worsened with real GDP contracting by 6.8 tolerated without jeopardizing the interest-rate reduc-
○
○
percent in the second quarter. Bank Negara relaxed tion program that has been adopted to revive private
○
○
monetary policy in the second half of the year. The

○
investments and manage the debt servicing problem.

○
○
increase in interest rates was gradually reversed to Close coordination between monetary and fiscal au-
○
○
ease credit flow. The base lending rates of banks thorities is called for.
○
○
were brought down below their precrisis levels. The Indonesia, with its 80 percent inflation, is actually
○
○
statutory reserve requirement for banks was low- experiencing negative real interest rates.
○
○
ered to ease liquidity and reduce the carrying costs But even with lower nominal and real interest rates
○
○
of bank reserves. Prudential norms, provisioning re- (compared with the early phase of the crisis), the
○
○
quirements for substandard assets, and disclosure weak and highly vulnerable financial sector and poor
○
○
standards of banks, which were tightened in 1997 investor confidence continue to create a credit
○
○
and the early part of 1998, were relaxed in the sec- crunch in these countries. A “liquidity trap” has
○
○
ond half of 1998. The government felt that some of arisen. Banks are reluctant to lend because the risk
○
○
these measures which had been introduced since the of loan default is high. Rather than lend to the pub-
○
○
start of the crisis had worsened the economic down- lic, they prefer to hold large amounts of govern-
○
○
turn, and if continued would push Malaysia into a ment securities in their portfolios.
○
Figure 12 gives a picture of real bank credit to loosening monetary targets, decreasing overnight
○
○
corporations (nonfinancial private sector) in Indone- rates, reducing required and liquidity reserve ratios
○
○
sia, Korea, and Thailand. The general picture is one which were raised in response to speculative attacks
○
○
of stagnation of real credit in the first half of 1998, on the domestic currency, and rescinding the require-
○
○
indicating that despite the easing up of monetary and ment that public funds be transferred from private
○
10
○
fiscal policies, the credit crunch persists. There is banks to the central bank. As has been the case in
○
○
a significant decline in real credit in Thailand, a stag- Malaysia, sometimes there may be a case for intro-
○
○
nation of real credit in Korea, and erratic move- ducing capital controls temporarily to discourage
○
○
ments (without an upward trend) in Indonesia. Much heavy capital outflows while monetary conditions are
○
○
of the credit in the three countries went to distressed being eased. Also, to avoid the risk of destabilizing
○
○
and failing companies. One can only imagine the flows from one country to another and the fear of
○
○
extent to which this credit rationing placed other- unfavorable investor confidence if only one country
○
○
wise viable small and medium firms at a disadvan- were to implement expansionary policies, there is a
○
○
tage. The same situation is most likely happening in strong case for implementing such policies through-
○
○
Malaysia and the Philippines. ○
○
out the region. The World Bank (1998) has estimated
that every 1 percent of GDP’s worth of fiscal stimu-
○
Figure 12: Real Credit Extended to Nonfinancial

○
Private Sector, December 1996 to lus throughout the region including the PRC and Ja-
○
June 1998 (December 1996 = 1)

○
pan would boost growth by 2 percentage points in

○
○
the affected countries.

○
○
The affected countries have followed these basic

○
○
recommendations as real interest rates have fallen

○
○
to near-precrisis levels. (Indonesia of course still

○
○
maintains very high nominal interest rates because

○
○
of its very high inflation rate. These very high rates

○
○
may complicate the move to normalize financial in-

○
○
termediation and resume credit flow.) But all the

○
○
countries still suffer from a credit crunch as low con-

○
○

fidence, increasingly high nonperforming loans, and
○
○
stricter prudential regulation (capital adequacy ra-

○
○
tios, loan-loss provisions) discourage the generation

○
Major Policy
○
of new credit in the financial system, despite the de-

○
Recommendations for
○
cline in interest rates.

○
○
Second, it has been shown in Korea and Thailand

○
○
that workout agreements between creditors and debt-

○
○
ors, which lengthened the loan maturity, reduced the

Monetary Policy: Dealing With
○
○
debt burden, and allowed the rollover of loans to hard-

the Credit Crunch
○
○
hit debtors, have significantly improved confidence

○
○
Various policy recommendations have been put for- in the economies of the region. Even the debt mora-
○
○
ward for dealing with the persistent credit crunch. torium in Indonesia, declared early in 1998, helped
○
○
First, monetary and interest-rate policies must be loos- ease the distress in that country and in the entire
○
○
ened to ease the credit crunch and pressures on region. There is much room for more workout ar-
○
○
nonperforming loans. Specific measures here include rangements, debt forgiveness, debt restructuring, and
○
debt rescheduling in all the countries, especially in antee on the performance of the better banks in the
○
○
Indonesia, Malaysia, and Philippines. Such resched- country rather than a direct and full credit guaran-
○
○
uling will reduce the tremendous strains on the fi- tee on particular loans or credits. This sovereign
○
○
nancial and corporate sectors of the countries in- guarantee might, in turn, be supported by third par-
○
○
volved, and shorten the period of their financial re- ties, such as backup guarantees from multilateral
○
○
habilitation. Short-term foreign debt must be con- development banks and other bilateral lenders.
○
○
verted into longer-term debt to avoid panic and im- (iii) Schemes aimed at boosting cash flows (e.g.,
○
○
mediate demand for dollars. Resumption of credit through tax relief, credit for collaterized transactions,
○
○
lines with foreign creditors, especially the rollover of and wage moderation) could also be useful. (iv) Swift
○
○
loans of illiquid but still solvent firms, will also ease and comprehensive financial and corporate restruc-
○
○
the credit crunch directly. Workout arrangements turing, including the introduction of foreclosure and
○
○
require some intervention from the individual gov- bankruptcy laws, would reduce uncertainty in the fi-
○
○
ernments, multilateral and foreign institutions, and the nancial markets more quickly.
○
○
international financial system.
○
Fiscal Stimulus
○
Third, because of the depth of financial distress
○
○
and loss of confidence in the system, there is a need Again, regardless of the debate on whether the IMF
○
○
for short-term interventions to stimulate credit flows was initially too harsh on its fiscal policy, the con-
○
○
in the contracting economies. Expansionary macro- sensus is that fiscal stimulus and pump priming of
○
○
economic policies will not succeed unless the effects the economies would be beneficial. A looser fiscal
○
○
are felt at the firm level. A number of actions are policy should be implemented in all the countries
○
○
therefore required: (i) Enhanced security must be affected so that they can raise their fiscal expendi-
○
○
provided for creditors who are willing to advance tures. The higher fiscal deficit targets should, how-
○
○
new money to operationally viable but financially ever, be temporary and should last only as long as
○
○
overextended debtors, with the concurrence of ex- there is a need to stimulate the economy, recapital-
○
○
isting creditors. This type of “debtor in possession,” ize banks, and provide basic human and social ser-
○
○
or DIP, financing is standard practice in market vices. High fiscal deficits for long periods will in-
○
○
economies for firms in reorganization. It could be crease the foreign and domestic liabilities of the
○
○
done on an emergency basis and for a large number government and will eventually lead to a foreign or
○
○
of firms. However, caution is necessary because in

○
domestic debt problem that may entail outward flows

○
○
the economies in the study the problem is much larger, of foreign exchange, inflation, or extreme crowding
○
○
the institutional capacity for corporate reorganiza- out of the private sector from credit funds. That is
○
○
tion is much weaker, and the discipline of repaying why immediate economic recovery is imperative,
○
○
old debts must be maintained for those borrowers and all-out attempts to revitalize and reinvigorate
○
○
who are able to pay. (ii) Specialized financing facili- the economies should be made.
○
○
ties might prove useful. In trade financing, Indone- Because funds are limited, it is important that gov-
○
○
sia, Korea, and Thailand have already established ernment expenditures be prioritized. Priority spend-
○
○
public support programs—the central banks purchase ing should be on:

○
○
notes collateralized by export receipts, while gov- • Vital basic social services and human develop-
○
○
ernment supports the commercial banks in issuing ment programs such as in education, health, sani-
○
○
letters of credit. Some countries may require further tation, environmental protection, and social wel-
○
○
government support for trade financing and working fare. The demand for these services to be pub-
○
○
capital. This support could take the form of a guar- licly provided will most likely increase as unem-
○
ployment and the fall in people’s incomes se- ments in infrastructure to protect the poor, in-
○
○
verely constrain their capability to provide these cluding rural infrastructure (such as irrigation
○
○
services privately for themselves. systems) and infrastructure for the urban poor
○
○
• Safety nets directed at the most vulnerable group. (such as low-cost housing). Government could
○
○
These include emergency food relief and aid pro- also invest in infrastructure for education, health,
○
○
grams (important in Indonesia); reskilling and re- and sanitation. Government policies to revive or
○
○
training of the unemployed; information centers generate investments in labor-intensive projects
○
○
for job vacancies and job placements; and pro- and enterprises would also increase the multi-
○
○
grams to assist indigent families that have lost plier effects of the demand injection.
○
○
their access to health, education, housing, and The government should then trim unnecessary
○
○
other services and facilities. government fat and expenditures, and include off-
○
○
• Key infrastructure projects and investments to budget accounts in fiscal accounting. There may
○
○
protect the poor and the vulnerable. Fiscal tight- be a need to cut down on these off-budget items
○
○
ness should minimize adverse effects on impor- for protected industries, state-owned firms, and other
○
○
tant infrastructure and public utilities (power sup- ○
○
projects, in the process freeing some funds for
ply, ports, water supply, key highways and roads, much-needed projects during the recession. Poten-
○
○
schools, hospitals). Four years of power outages tial cuts in the national defense budget, cuts in bud-
○
○
in the aftermath of a foreign and public debt cri- gets allotted to subsidies for overprotected indus-
○
○
sis and deterioration of infrastructure caused the tries, making the bureaucracy more efficient—all
○
○
Philippines to be inefficient and uncompetitive in these may incur the ire of powerful interest groups.
○
○
the world market until the mid-1990s. The reforms discussed in this chapter should there-
○
○
• Essential funds for bank restructuring and reha- fore be accompanied by matching political and bu-
○
○
bilitation. Massive amounts of funds will be reaucratic reforms to enable the governments to
○
○
needed to rehabilitate the financial institutions in implement the difficult and painful tasks efficiently
○
○
the affected countries. Preliminary private-sec- and autonomously.

○
○
tor estimates of bank recapitalization needs range The IMF and the various governments have al-
○
○
from 20 percent of GDP for Indonesia and Ma- lowed the relaxation of stringent fiscal targets for
○
○
laysia to 30 percent for Korea and Thailand the countries hit by the crisis. All the countries
○
○
(World Bank 1999). These will translate into high are now trying to increase fiscal spending, to pro-
○
○
fiscal deficits, especially if government is forced tect vulnerable groups, recapitalize banks, and pro-
○
○
to assume some of the bad debts in the system, vide some demand injection in their economies.
○
○
although it must be pointed out that this should There is a need to mobilize more international funds
○
○
be done only when necessary, such as in cases for this endeavor.

○
○
where there is loss of confidence in the system.

○
Financing the Fiscal Deficits

○
If the private sector, domestic or foreign, can

○
○
provide the funds for capitalization and mergers, The financing of fiscal deficits should minimize the
○
○
then no government funds should be used. use of domestic borrowing and Treasury bills and
○
○
• Employment-generating projects needed for de- bonds, as these tend to subvert efforts to lower in-
○
○
mand injection. Demand injection through invest- terest rates and to increase credit availability to the
○
○
ments and infrastructure building that will have private sector (the “crowding out” effect). How-
○
○
the biggest impact on the economy should be ever, with such large deficits, a certain amount of
○
○
undertaken. Priority should be given to invest- domestic borrowing may be unavoidable.

○
The deficit is financed in the following main ways: • As the currencies in the region stabilize and the
○
○
• foreign borrowings; pressure on inflation is lessened, finance the fis-
○
○
• domestic borrowings through the issuance of cal deficits through some amount of money cre-
○
○
Treasury bills and other government securities, ation. Care must be taken, however, that the
○
○
• money creation or credit from the central bank magnitude of money creation does not create
○
○
to the national government, and unnecessary inflationary pressures on the
○
○
• privatization of government assets and govern- economy, especially since the monetary increases
○
○
ment corporations. for financial rehabilitation may be substantial.
○
○
The following are therefore proposed: • Inasmuch as some domestic borrowing is un-
○
○
• Increase foreign borrowings and derive funds avoidable, issue more longer-term Treasury bonds
○
○
with longer-term maturity and with concessional and notes rather than short-term Treasury bills.
○
○
rates. This would not only provide funds for fis- Longer-term notes delay government repayment
○
○
cal spending but would also, in the short run, be to a future date when the expected higher eco-
○
○
similar to long- and medium-term capital inflows. nomic growth and higher tax revenues would
○
○
The only danger here would be possible currency improve repayment opportunities for the govern-
○
○
depreciation in the future, which would increase ment. Longer-term notes also require less
○
○
the debt burden. It would therefore also be ad- rollovers and would be less onerous to the gov-
○
○
vantageous if the borrowings were made on a ernment and to the financial system.
○
○
multilateral or bilateral basis, since these would In the medium and long term (although policies
○
○
provide more room for rescheduling and restruc- should be implemented immediately), tax reforms and
○
○
turing the loans. Perhaps the affected countries improvements in tax administration and collection
○
○
should strive for foreign financing of at least 50 should be undertaken to ensure fiscal balance and the
○
○
percent of their total deficit. This is not impos- capability to tackle the higher national debt in the fu-
○
○
sible, given the friendlier environment for offi- ture. As recovery occurs, the tax effort (ratio of tax
○
○
cial and bilateral loans offered by the World Bank, revenues to GNP) would naturally grow and the fiscal
○
○
the Asian Development Bank (ADB), the deficits would be reduced, especially if the government
○
○
Miyazawa Fund, and the Asian Growth and Re- debt incurred were longer-term. Countries with high
○
○
covery Program and social funds provided by deficits (such as those incurring public deficits of more
○
○
United Nations organizations such as the Inter-

○
than 4 percent of GNP for several years—if the crisis

○
○
national Labour Office (ILO) and the United is to last that long) would depend more on structural
○
○
Nations Development Programme (UNDP). tax reforms or on international assistance in the me-
○
○
• Privatize state-owned companies and enterprises dium and long term to finance the higher national debt.
○
○
that are better left to the private sector and dis- As economic recovery occurs and the export sec-
○
○
pose of nonperforming assets that fall in the tor regains its strength and current-account deficits
○
○
government’s lap as a result of the crisis, to obtain continue to decline (or current-account surpluses
○
○
additional funds to finance the fiscal deficits. The continue to be realized), the necessary foreign-ex-
○
○
disadvantage here is that, in view of the depth of change capacity to pay back long- and medium-term
○
○
the recession, the offer price for such assets may multilateral and bilateral loans will become available.
○
○
not be good. But there would be forward-looking 11

○
Exchange-Rate Management
○
investors (both foreign and domestic) that might

○
○
give attractive offers and take advantage of some There are two basic approaches to determining opti-
○
○
discount during the crisis. mal exchange-rate regimes. The early literature on
○
the subject was based on the theory of the optimum dominantly domestic nominal shocks (e.g., interest-
○
○
currency area, and focused on the characteristics that rate changes), whereas a flexible regime is prefer-
○
○
determined whether a country would be better off, in able if disturbances are foreign (e.g., terms of trade)
○
○
terms of maintaining internal and external balance, with or domestic real shocks (e.g., famines). The vari-
○
○
a particular exchange-rate regime. For example, small ous considerations and their implications for ex-
○
○
open economies are better served by a fixed exchange- change-rate regimes as summarized by the IMF are
○
○
rate regime. Also, the less diversified a country’s pro- given in Table 3.
○
○
duction and export structures are, the stronger the case How do the affected countries fare against the
○
○
for fixed exchange rates becomes. checklist in Table 3? At first glance, they are all rela-
○
○
Another approach to the choice of exchange- tively small, highly open economies: imports account
○
○
rate regime focuses on the effects of random dis- for more than 40 percent of GDP in these countries,
○
○
turbances on the domestic economy. The optimal twice the average for developing countries. Inflation
○
○
regime in this framework is the one that stabilizes rates are also modest by developing-country stan-
○
○
macroeconomic performance, that is, minimizes dards and labor markets are relatively flexible, at least
○
○
fluctuations in output, prices, or other macroeco- ○
○
in most of the countries. In other words, floating rates
nomic variables. This approach typically finds that are probably not the best option. But then again, these
○
○
a system of fixed exchange rates is superior if the are small open economies that have relatively open
○
○
disturbances impinging on the economy are pre- capital accounts and are vulnerable to external
○
○
○
○
Table 3: Considerations in the Choice of Exchange-Rate Regime

○
○
○
Characteristics of Economy Implications for the Desired Degree of Exchange-Rate Flexibility

○
○
Size of economy The larger the economy, the stronger the case for a flexible rate becomes.
○
Openness The more open the economy, the less attractive a flexible exchange rate becomes.
○
○
Diversified production/ The more diversified the economy, the more feasible a flexible exchange rate becomes.
○
○
export structure
○
○
Geographic concentration The larger the proportion of an economy’s trade with one large country, the greater is the
○
of trade incentive to peg its currency to that of the other country.

○
○
Divergence of domestic The more a country’s inflation rate diverges from that of its main trading partners, the greater
○
inflation from world inflation is the need for frequent exchange-rate adjustments. (But for a country with extremely high
○
○
inflation, a fixed exchange rate may provide greater policy discipline and credibility to a
○
stabilization program.)
○
○
Degree of economic/ The greater the degree of economic and financial development, the more feasible a flexible
○
financial development exchange-rate regime becomes.

○
○
Labor mobility The greater the degree of labor mobility when wages and prices are downwardly sticky, the
○
adjustment to external shocks becomes less difficult (and costly) with a fixed exchange rate.
○
○
Capital mobility The higher the degree of capital mobility, the more difficult it is to sustain a pegged but
○
adjustable exchange-rate regime.

○
○
Foreign nominal shocks The wider the prevalence of foreign nominal shocks, the more desirable a flexible exchange
○
rate becomes.
○
○
Domestic nominal shocks The wider the prevalence of domestic nominal shocks, the more attractive a fixed exchange
○
○
rate becomes.
○
Real shocks The more susceptible an economy is to real shocks, whether foreign or domestic, the more
○
○
advantageous a flexible exchange rate is.

○
○
Credibility of policymakers The lower the anti-inflation credibility of policymakers, the more attractive a fixed exchange
○
rate becomes as a nominal anchor.

○
○
○
Source: IMF, World Economic Outlook, 1997.

○
shocks. The affected countries also rely extensively by surges in capital flows. By allowing some uncer-
○
○
on foreign investors to finance their investment re- tainty about the exchange rate, the band would re-
○
○
quirements. Therefore, a rigid exchange-rate regime duce incentives for heavy currency borrowing. Chile,
○
○
may not be the most suitable. Israel, and Mexico have had favorable experience
○
○
The relative merits of alternative exchange-rate with the crawling-peg system (Helpman, Leiderman,
○
○
systems, therefore, cannot be resolved by theory and Bufman 1994).
○
○
alone. Credibility of regimes is also vitally important. The crawling-peg system is not, however, a pana-
○
○
In the context of the ongoing crisis with severe bank- cea and a magic solution to credibility problems. In-
○
○
ing sector problems and low levels of reserves, the donesia adopted the system in 1978 and widened the
○
○
return to an announced peg is an open invitation for band on several occasions, most recently in 1997 from
○
○
future speculative attacks. On the other hand, a float- 8 to 12 percent; nonetheless, the country was sub-
○
○
ing system, while reducing possible gains to traders ject to speculative attacks, most notably in early 1998.
○
○
from attacking a currency, would bring about con- Recently, Brazil also had to abandon a crawling-peg
○
○
siderable volatility in the exchange rates of affected system because of speculative attacks.
○
○
countries where financial markets are not well de- A number of countries have adopted currency
○
○
veloped and foreign markets are thin (see also Ohno boards as a means of enforcing financial discipline,
○
○
1999). In such a situation, a few large transactions especially from initial circumstances of financial in-
○
○
could cause large short-term exchange-rate move- stability. Although both standard peg and currency
○
○
ments. Exchange-rate overshooting carries real eco- board are aimed at maintaining fixed exchange rates,
○
○
nomic costs to traders and investors. By the process the currency board goes one step further: it limits the
○
○
of elimination, therefore, an intermediate regime of permissible increase in domestic currency to the

○
○
managed float emerges as most appropriate in the stock of foreign reserves, and allows free conver-
○
○
affected countries. sion between the domestic and the backing cur-
○
○
Under the managed-float regime, one possibility rency at the announced rates. The currency board,
○
○
is to retain the present “dirty” float regime in which in its pure form, cannot act as lender of last resort
○
○
the nominal exchange rate is essentially determined and extend credit to the government, banks, or any-
○
○
by market forces albeit with sporadic central bank one else. By sharply limiting the ability of the board
○
○
12
intervention. The other is to move to an officially to conduct discretionary monetary policy, it is hoped
○
○
determined—but better managed—exchange-rate

○
the credibility gains would be more pronounced and

○
○
regime within a band, or a crawling-peg system. The immediate.

○
○
difference between the two systems is that in the For the successful implementation of a currency
○
○
crawling-peg system, the monetary authorities make board, two preconditions have to be fulfilled. First,
○
○
specific commitments about the path of the real ex- the commitment to exchange monetary liabilities for
○
○
change rate, as well as about the range of variability foreign currency at the fixed rate requires that the
○
○
of the nominal exchange rate. Ohno (1999) does not currency board have sufficient foreign-exchange
○
○
see particular advantages in a rule-based system. reserves to honor this commitment. Ideally, this means
○
○
However, in the medium term and as the credibility that its foreign reserves should at least equal the value
○
○
of the affected countries is restored, the move to a of its monetary liabilities. Second, given the absence
○
○
crawling-peg system may be advisable as it com- of a lender of last resort, governments and banks
○
○
bines the advantages of both fixed and flexible ex- must show financial discipline. Governments must
○
○
change rates. It helps to impose discipline on poli- commit themselves to appropriately tight fiscal posi-
○
○
cies, and yet provides flexibility if the country is hit tions, and the banks must be adequately robust so
○
that they can function without additional credit from have to ease the credit crunch and loosen monetary
○
○
the lender of last resort. policies, implement strategies to diversify their ex-
○
○
Unless the above commitments are fulfilled, a port markets to reduce their dependence on the semi-
○
○
currency board would not be credible. This is critical conductor market and on the East Asian market (at
○
○
because, in the absence of confidence, the financial least while the recession in this part of the world
○
○
community may view the arrangement not as a lasts), and improve the efficiency and productivity of
○
○
mechanism for restoring stability but merely as an their export production.
○
○
opportunity to convert financial assets into foreign With respect to decreasing domestic costs to im-
○
○
exchange at an attractive rate. A currency board that prove export competitiveness, reducing interest rates
○
○
is not credible also provides an inviting target for specu- would be beneficial. Real wages would most likely
○
○
lators and hedge funds. The preconditions are difficult decline because of the recession in these countries
○
○
to meet, but once they are met in the medium term, and the reduction may be partly beneficial to export
○
13
○
concerned countries could consider more seriously the competitiveness. Rental costs would also fall be-
○
○
benefits and costs of a currency board system. cause of the crash in the property market. Unfortu-
○
○
However, neither crawling pegs nor currency ○
○
nately, efficiency improvements through a reduction
boards can be a panacea. A proper mix of mon- in the overprotection of firms and increased trade
○
○
etary sterilization, fiscal flexibility, and exchange- liberalization—a key policy of IMF programs—would
○
○
rate management is an appropriate response by the take time to materialize, and may need a more ro-
○
○
affected countries to maximize the benefits of glo- bust economy to have maximum impact. But this is a
○
○
balization of financial markets and to reduce its costs. step in the right direction. The large currency depre-
○
○
In the choice of exchange-rate regimes, countries ciation itself should eventually be felt and help ex-
○
○
must consider their differences with respect to other ports grow. Thus, it is essential that export markets
○
○
determinants such as size, diversification, and de- and products be diversified as soon as possible while
○
○
gree of openness. the East Asian currencies are still cheap internation-
○
○
ally. The US and European economies are still very

○
Capital-Account Liberalization
○
robust and should be able to absorb more East Asian

○
and Capital Controls

○
exports. Governments should intensify diplomatic and

○
○
As already discussed in the section entitled “Policy private initiatives in the search for other export mar-
○
○
Issues: Design and Sequencing of Policies and Ef- kets. Foreign direct investments can be given addi-
○
○
fects,” the debate on whether or not to open the capi- tional incentives to try to help the countries penetrate
○
○
tal account has two important implications. First, coun- the markets of other countries, and to diversify into
○
○
tries must be prudent in liberalizing capital accounts other export products.

○
○
and must sequence it properly. This is an important The adverse world and regional trade environment
○
○
lesson from the East Asian crisis. Second, there could (as discussed in “Sluggish Exports and International
○
○
be a case for temporary capital controls. Both of Capital Flows” in the previous section) has not al-
○
○
these implications were discussed in some detail in lowed exports to increase dramatically as the coun-
○
○
the subsection entitled “Capital-Account Liberaliza- tries had hoped they would. Current-account defi-
○
○
tion and Capital Controls.” cits have been reduced substantially mainly through
○
○
sharp import cutbacks. The expansion in export vol-

○
Export Stimulus
○
umes in Korea and Thailand has been offset by steep

○
○
To ensure that the export stimulus for growth and declines in export prices. It is hoped that these price
○
○
recovery is not lost, the East Asian countries will decreases will stop as the currencies stabilize, and
○
the increasing strength of the US dollar is checked. provide assistance to the ASEAN Secretariat in de-
○
○
The hard-hit countries have had their hands full with veloping its capacity for sustained regional surveil-
○
○
financial rehabilitation and the need to stave off lance. The unit will also respond to other requests
○
○
speculative attacks on their currencies to have for assistance that may be made by the ASEAN
○
○
enough time and effort to engage in export promo- Select Committee and Finance Ministers, and by other
○
○
tion. But sooner or later, they will have to do this developing member countries. In addition, there is a
○
○
since, after all, the East Asian “miracle” was based need to seriously consider the following proposals:
○
○
on high export growth. • Explore the possibility of establishing regional
○
○
funding and/or guarantee facilities. Some actions
○
Regional and International Efforts
○
are already being taken in this area. The Interna-
○
○
The East Asian crisis conforms in pattern to crises tional Finance Corporation of the World Bank is
○
○
of a similar nature in the 1980s and the 1990s. First, setting up an Asian Restructuring Fund which will
○
○
currency crises do not occur at random but are clus- invest in distressed Asian companies. Similarly,
○
○
tered with strong contagion effects. Second, a cur- the ADB has established an Asian Currency Cri-
○
○
rency crisis in one country significantly increases the sis Support Facility (ACCSF) financed by the Japa-
○
○
probability of crises in other countries, even after nese government under the New Miyazawa Ini-
○
○
controlling for domestic macroeconomic fundamen- tiative (Box 3). The ACCSF envisages guaran-
○
○
tals. Third, crises tend to cluster together geographi- tees, interest payment support, and technical as-
○
○
cally, e.g., Europe in 1992/1993, Latin America in sistance to the crisis-hit countries in conjunction
○
○
1994, and East Asia in 1997. Hence, there is a need with ADB operations. More needs to be done.
○
○
for regional efforts to complement international and • Use East Asian currencies in intraregional trade,
○
○
individual country efforts. as has been proposed recently. Under such an

○
○
arrangement, countries could minimize their hard-

○
○
REGIONAL EFFORTS currency needs by netting out their bilateral trade

○
○
The East Asian crisis has highlighted the fact that with each other and settling only the difference.
○
○
contagion tends to be most virulent among neighbor- The exchange rates used to value transactions
○
○
ing countries. Therefore, there is a need to comple- are, however, crucial. If the exchange rates are
○
○
ment national and global surveillance mechanisms not right, excess holdings of one currency or the
○
○
with regional efforts based on peer review. The po-

○
other might arise. Under these circumstances, it

○
○
tential virtues of monitoring based on regional peer may be more advantageous to use a liquid cur-
○
○
review are a better, more intimate knowledge of the rency like the US dollar in settling net balances.
○
○
participants’ economic situation, and, hence (it is It may be useful in this regard to study further
○
○
hoped), better advice; a greater attention to the pro- the experience of the Asian Clearing Union, es-
○
○
cess because of strong mutual self-interest; a smaller tablished in 1974 under the auspices of the Eco-
○
○
likelihood of economies being hostage to the views nomic and Social Commission for Asia and the
○
○
of dominant members; and a greater likelihood that Pacific (ESCAP) and headquartered in Tehran,
○
○
the moral suasion of friends will be effective in pro- to see whether it is desirable to expand mem-
○
○
moting good policies and sound institutions than “out- bership or whether a new East Asian Clearing
○
○
side” advice would be. To help support initiatives for Union should be established.
○
○
regional economic monitoring, the ADB has estab- • Since the recovery of any one country in East
○
○
lished a Regional Economic Monitoring Unit (Box Asia is very much tied to the recovery of the en-
○
○
2). It is envisaged that in its initial phase this unit will tire region, and since the IMF must negotiate
○
○
Box 2: Comparative Advantages of ADB in Regional Economic Monitoring
○
○
The IMF is responsible for developing a policy framework for the stabilization of macroeconomic conditions, whereas the
○
○
ADB is responsible for implementing sectoral policies and for creating an institutional framework in the financial and
○
nonfinancial sectors. In supporting a regional surveillance program (such as the ASEAN Surveillance Program, or ASP), the
○
ADB can play its unique role as a regional development institution. The ADB has close working relationships with the private
○
○
sector and is familiar with the thought processes of private-sector institutions. The ADB’s role in at least the following seven
○
areas can be cited as important value-added contributions to improving the efficacy of regional economic monitoring
○
activities:
○
○
• Globalization. As the region’s economies are being integrated into the world’s financial markets, performance indicators
○
for the financial and real sectors have become exposed to rigorous scrutiny by market players more than ever before.
○
Macroeconomic indicators remain important but sectoral performance measures have received more attention in the
○
○
postcrisis period. Globalization has shifted the relative importance of key indicators from macroeconomic areas to the
○
financial and real sectors, forcing a similar shift in the focus areas for effective monitoring. The ADB has comparative
○
○
advantage in sectoral and structural monitoring through its long-running experience in helping develop sectoral policies and
○
institutions as well as implementing investment projects.
○
• Perception of private-sector institutions. The ADB has been enjoying close working relationships with private-sector
○
○
organizations including commercial banks, nonbank financial institutions, institutional investors (pension and provident
○
funds, insurance companies, mutual and venture capital funds), and credit-rating agencies for joint investments,
○
cofinancing, venture capital business, and infrastructure projects. As a result, the ADB has acquired an intimate
○
○
knowledge of the way private-sector institutions perceive risks and rewards in their operations in the region. Therefore,
○
the ADB will be an effective organization in developing market-based solutions to address the concerns of market
○
○
institutions.
○
• Research support with regional perspectives. The ongoing crisis is not an isolated domestic problem for each of the crisis-
○
affected countries but a regional problem with the potential risk of systemic failure. Hence, in addition to the development of
○
○
early-warning systems, the major thrust of the ASP must be reinforced by promoting “peer monitoring” and “policy
○
coordination” among ASEAN members. To assist the ASEAN members in peer monitoring and policy coordination, the ADB
○
has spearheaded a comprehensive research program to produce issue-oriented research reports and sound-practice
○
○
reports which will be useful to central banks and finance ministries in the region. These reports will also be useful in
○
defining appropriate monitoring parameters as countries are at different stages of economic development. The ADB’s
○
initiatives in this type of research work with a regional focus will fill the gaps left by the IMF’s global and bilateral
○
○
surveillance work.
○
• Linkage between macroeconomic policies and sectoral performance. Although the IMF has become more flexible in
○
○
designing macroeconomic restructuring programs for the crisis-affected economies, its programs may be enhanced
○
further through well-defined linkages with the real and financial sectors. Specifically, policymakers in the region believe
○
that the full impact of the macroeconomic programs on the financial and key real sectors as well as their social
○
○
consequences should have been taken into account in the design of the original IMF rescue packages. Given the ADB’s
○
institutional familiarity with the real and financial sectors and social issues, it can provide valuable inputs in designing a
○
regional monitoring mechanism.

○
○
• Intersectoral linkages. The importance of intersectoral relationships has been recognized only recently, after the crisis
○
broke out in this region. Unless this particular aspect of intersectoral relationships is adequately considered, the overall
○
○
effectiveness of the macroeconomic restructuring programs may be questioned. The ADB has been involved with
○
evaluations of intersectoral linkages including, for instance, the relationship between the financial and real sectors. This
○
relationship is crucial for the sustainability of financial sector reforms.

○
○
• Dissemination of real and financial sector information and data. A lack of timely and accurate information and data on the
○
financial and corporate sectors has been blamed for international banks’ preference for short-term versus long-term
○
lending and the observed herding behavior of institutional investors, and the resultant contagion effect during the crisis. On
○
○
the basis of its long experience in sectoral and structural area work, the ADB can assist in creating and designing sector-
○
specific information and data and in disseminating these to market institutions on a timely basis, as the IMF has been
○
○
upgrading its capability for disseminating macroeconomic data through the Special Data Dissemination Standards.
○
• Capacity building and training. The ADB is assisting the ASEAN Secretariat in Jakarta, the ASEAN central banks, the
○
ASEAN ministries of finance, and other government agencies in capacity building for economic monitoring. This will cover a
○
○
wide range of areas including banking supervision, capital-market regulation, capital-market infrastructure, corporate
○
governance, corporate and bank restructuring, and accounting and disclosure standards, among others. The ADB has
○
○
taken a number of steps related to capacity building and training. The ADB and the IMF Institutes have been offering annual
○
joint training programs in macroeconomic and sectoral policies for senior officials of member countries. The ADB Institute,
○
established in December 1997 in Tokyo, is tasked to carry out capacity building in banking supervision, capital-market
○
○
regulations, corporate governance, and other issues relevant to economic monitoring. The ADB was mandated by the
○
APEC Finance Ministers to design and offer training programs in banking supervision and regulation.
○
○
○
○
Box 3: ADB’s Involvement in the New Miyazawa Initiative and the Asian Growth and Recovery Initiative
○
○
The ADB is actively involved in the implementation of the New Miyazawa Initiative (NMI) announced by the Japanese
○
○
government in October 1998 and the Asian Growth and Recovery Initiative (AGRI) announced by Prime Minister Obuchi and
○
○
US President Clinton in November. Under the NMI, the ADB will work together with the Export-Import Bank of Japan (JEXIM),
○
○
the Overseas Economic Cooperation Fund of Japan (OECF), and international financial institutions to strengthen the
○
economies hit by the currency crisis as well as their financial sectors, to accelerate the economic recovery in Asia, and to
○
○
address social, health, nutrition, and environmental issues during the crisis, specifically the needs of the poor. Under the NMI,
○
○
in addition to official cofinancing with JEXIM and OECF, ADB is also actively pursuing commercial cofinancing.
○
○
The ADB has so far approved two loans with US$600 million in cofinancing from JEXIM and OECF under the NMI. On
○
○
15 December 1998, ADB approved the Power Sector Restructuring Program loan, totaling US$300 million, to the Philippines,
○
○
together with JEXIM’s cofinancing of US$300 million equivalent. On the same date, ADB also approved the Metro Manila Air
○
○
Quality Improvement Sector Development Project totaling US$296 million, together with OECF’s cofinancing of US$300 million
○
equivalent. JEXIM and OECF cofinancing under the New Miyazawa Initiative is expected to reach US$3 billion–US$4 billion by
○
○
the end of 1999. The ADB will manage the Asian Currency Crisis Support Facility (ACCSF) financed by the Japanese
○
○
government under the NMI, totaling about US$3 billion equivalent. ACCSF envisages the provision of guarantees, interest
○
○
payment support, and technical assistance to the countries hit by the currency crisis, in conjunction with ADB operations
○
○
under the NMI. ACCSF became operational in April 1999.
○
○
In December 1998, the ADB participated in the first meeting for AGRI announced a month earlier by Prime Minister Obuchi and
○
○
President Clinton. A major component of the AGRI is the establishment of an Asian Growth and Recovery Program (AGRP).
○
The AGRP is to be set up with support from bilateral and multilateral sources, and will also seek to raise additional private
○
○
capital. Its objective is to mobilize additional financing to support the process of corporate and bank restructuring in the
○
○
crisis-hit countries. The ADB is coordinating with the World Bank and other financial institutions under the AGRI and will play
○
○
an appropriate role in support of the initiative.

○
○
○
○
one-to-one and cannot lend to the affected coun- • Since the battered economies need financial and
○
○
tries as a group, establish a regional exchange- moral support from the regional and international
○
○
rate stabilization fund, as McKinnon (1998a and communities and the assurance that they will not
○
○
1998b) has proposed, to stop the rounds of inad- allow financial and currency instabilities to rule
○
○
vertent beggar-thy-neighbor devaluations in the in the international financial markets, set up an

○
○
affected countries. The proposed fund would

○
Asian Monetary Fund to promote self-help

○
○
dampen the effects of the contagion. Ultimately, within the region, to address regional develop-
○
○
as in the case of Europe, full economic and cur- ment issues, and to boost confidence in the af-
○
○
rency union (with a single currency) could be fected countries.

○
○
established as policy harmonization occurs. In

○
○
the absence of a regional fund, which might take INTERNATIONAL SUPPORT

○
○
some time to set up, McKinnon has also pro- The IMF-led international assistance package was
○
○
posed that large players intervene in foreign-cur- the first to provide funding support for the crisis-hit
○
○
rency markets to achieve currency stability. A economies. Providing balance-of-payments support

○
○
case in point is the successful joint intervention and funds for debt payment, the IMF coordinated a
○
○
by the US Federal Reserve System and the Bank total of US$118 billion from bilateral and multilateral
○
○
of Japan in June 1998 which stopped a poten- sources to rescue Indonesia, Korea, and Thailand.
○
○
tially disastrous chain of currency devaluations The World Bank, the ADB, and the UN organiza-
○
○
in Asia. tions (UNDP and ILO, among others) are also pro-
○
viding funds for financial sector reform, essential The foregoing policy measures are summarized
○
○
social services, the reflation of the battered econo- in a matrix on the next few pages (see Table 4).
○
○
mies, and the creation of safety nets for the most
○
○
vulnerable groups. Lessons for the
○
○
Finally, there is widespread realization that finan-
○
Vulnerable Countries
○
cial crises cannot be eliminated altogether. There is
○
○
much, however, that can be done to predict and man- Suggestions to adopt expansionary monetary and fis-
○
○
age them better. This realization, together with the cal policies in the crisis-ridden East Asian countries
○
○
increased integration of financial markets globally, has should not be adopted wholesale by PRC, India, Pa-
○
○
led to further examination of the architecture of the kistan, and Viet Nam. These countries are vulner-
○
○
international financial system and efforts to strengthen able to a currency crisis either because of funda-
○
○
it. Such an examination was first urged by the Halifax mental macroeconomic weaknesses or the fragility
○
○
summit of G-7 leaders in 1995. At present, there is a of their financial sector, or both. The sanctions im-
○
○
plethora of such proposals (Box 4). posed on India and Pakistan after the nuclear tests
○
○
○
○
Box 4: International Financial Architecture

○
○
○
Economic history shows that financial crises occur with some regularity, and are followed by calls for reforming the
○
prevailing international financial architecture. But such calls are quickly forgotten once the crisis recedes. In the wake of the
○
○
East Asian crisis, a plethora of suggestions for redesigning the financial architecture has once again emerged. This time,
○
however, the situation is different. Capital markets around the world are becoming increasingly integrated. The environment
○
○
they operate in is actually different from that which the Bretton Woods system was designed to support. Earlier capital was
○
less mobile across countries. New international financial architecture has to be found and this should include regional
○
○
solutions and efforts. Recent proposals include the reform or abolition of the IMF, the establishment of a new international
○
institution, and the establishment of regional funds.

○
○
○
IMF Reform or Abolition

○
Although it is under criticism from all sides for its apparent mishandling of the recent crisis, perhaps the quickest way to
○
○
secure a new system would be to reform the IMF. The IMF is basically following this line of thinking based on the G-22
○
reports on transparency, strengthening financial sectors, and dealing with the crisis. More recently, on the basis of an
○
○
analogy of the role played by central banks in national economies, the IMF has put forward a case for an international lender
○
of last resort. This would require a sizable increase in the resources of the IMF.
○
○
○
Establishment of a New International Institution

○
The United Nations is the frontrunner in this regard. It has proposed the establishment of a World Financial Organization to
○
○
monitor the implementation of sound international principles and practices for accounting, payments and settlements, bank
○
supervision, security-market supervision, etc. It should also formulate acceptable forms of international regulations for short-
○
○
term capital movements to complement national measures, as well as formulate and apply international guidelines for short-
○
term lending and borrowing. The noted financier George Soros believes that financial markets are inherently unstable. He
○
○
has therefore recommended the establishment of an International Credit Insurance Corporation to ensure that financial
○
○
discipline is maintained internationally.

○
○
Regional Funds
○
○
The idea of an Asian Monetary Fund was first suggested by Japan at the IMF/World Bank annual meeting in September 1997.
○
The rationale was twofold: first, to mobilize the strong feeling of self-help because of the strong contagion effects within the
○
○
region; second, to benefit from the detailed knowledge about the region which would be available to the AMF but not
○
necessarily the IMF. The initial suggestion was a US$100-billion fund, half of which was to come from Japan and the remainder
○
○
from the PRC; Hong Kong, China; Taipei,China; and Singapore. The idea was turned down quickly because of fears that it could
○
provide funds with less rigorous conditionalities. There was also the problem of lack of coordination with the IMF which could
○
○
lead to potential conflicts. Japan, therefore, followed the route of the Miyazawa, Obuchi, and Asian Growth and Recovery
○
Initiatives.
○
○
38
A STUDY OF FINANCIAL MARKETS
Table 4: Macroeconomic Policy Matrix for the Affected Countries
Recommendations Specific Policy Measures Government Action
A. Monetary Policy: Dealing with the Credit Crunch

(a) Loosen monetary and interest-rate policies and Loosen monetary targets, reduce overnight Most countries have eased up on interest rates and liquidity.
ensure that they do not result in high inflation and rates, lower required reserve or required Indonesia still has high interest rates because of high
capital flight. liquidity ratios, avoid requiring public funds to inflation, which has, however, also been reduced from its
be transferred to central bank. peak in mid-1998.
(b) Implement an expansionary policy in the region. Most countries in the region are now implementing
expansionary policies. Avoid the risk of destabilizing flows
when only one country implements expansionary policies.
(c) Call for more workout arrangements, rollover of Lobby for more workout arrangements. Indonesia, Korea, and Thailand have completed some
loans, and restructuring of short-term foreign loans workout arrangements, but these have not been compre-
into medium- and long-term loans. hensive. Malaysia and the Philippines have not had subs-
tantial workout arrangements. Most successful is Korea.
(d) Implement measures to alleviate the credit crunch. Provide temporary guarantees for credit to
viable enterprises; government support for
trade and working-capital financing, with
some form of temporary sovereign guarantee
on the performance of selected banks; tax
credits; speedy implementation of financial
○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○
sector and corporate reforms including

○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○
foreclosure and bankruptcy laws.

B. Fiscal Stimulus
(a) Relax fiscal deficit targets. Increase government spending but prioritize Most governments have increased their fiscal deficit targets
expenditures. for 1998 and 1999.
Concentrate on projects with direct impact World Bank, ADB, UN agencies, and bilateral donors are
on employment generation and demand providing funds for these.
injection.
Implement projects where the poor and
unemployed would be helped most; e.g.,
rural infrastructure, reskilling programs.
Provide essential funds for bank
rehabilitation. Concentrate on providing
essential social safety nets and continue
essential social services and basic needs.
C. Financing the Fiscal Deficits
(a) Immediate sources of financing for fiscal deficits Give international aid and loans to the affected International funds available for the hard-hit countries, but not
Higher fiscal deficits should be financed with the countries, especially to fund social spending sufficient for demand injection.
least cost to the economy. and safety nets, and employment generation Share of foreign borrowings in total financing for deficits for
programs aimed at the most vulnerable. 1998 very low in Thailand (11%), moderate in Korea (31%),
Privatize and sell some government assets to and very high in Indonesia (84%). Korea and Thailand rely
derive revenue for the government. more on domestic borrowing. Indonesia in 1998 also relied on
Undertake some money creation without privatization (15.8%) and not at all on domestic borrowing.
unduly aggravating inflation. The Philippines also relied mostly on domestic borrowing for
Minimize domestic borrowing to avoid 1998 deficit.
tightening credit and increasing interest rates;
domestic borrowing should rely more on
longer-term securities.
(b) Financing for deficits and growing national debt in
the medium and long term
In the medium and long term, the increase in the Implement tax reforms and improve tax It is still too early to tell whether the various governments are
national debt due to higher fiscal deficits incurred collection efficiently and correctly implementing fiscal management
during the crisis should be addressed. Once economic recovery and increases in during the crisis.
incomes occur, increase revenue collection to
provide funds to pay the financing of past
debts. Recovery in exports and better current-
account and capital-account balances should
provide foreign exchange for the foreign
borrowings incurred.
(c) Coordination between fiscal and monetary policies
Since the goal is to increase demand and cope with In financing the deficits, minimize domestic The affected countries are already implementing looser fiscal
recession, both fiscal and monetary policies should borrowing that will increase interest rates and and monetary policies, but credit availability can still be
be loosened. Lack of credit, in a regime of tight crowd out the private sector. improved.
money, will not allow sufficient reflation and Loosen monetary policy together with fiscal
recovery to occur. policy.
D. Exchange-Rate Management
(a) As long as capital accounts are partly open, adopt a Widen intervention band.
crawling-peg system to avoid currency overvaluation Move peg away from US dollar to basket of Weight of US dollar is still very high in countries that use
at a time of significant current-account deficits and to currencies of major trading partners and basket of currencies.
discourage unhedged foreign borrowings. competitors.
(b) Make currency boards credible to help them For credibility, ensure sufficient resources to These have been discussed in Indonesia.
succeed. If credibility conditions are met in the support exchange rate and financial discipline.
medium term, a currency board system could be
considered more seriously.
(c) Stop using foreign reserves to defend currencies. Most countries have already stopped this.
E. Sequencing of Capital-Account Liberalization and

Exchange/Capital Controls
MACROECONOMIC POLICY DESIGN AND SEQUENCING ISSUES

○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○
(a) In correctly sequenced reform, the preconditions of East Asian countries hit by the crisis are strengthening
macro stability, current-account liberalization, financial and prudential regulation and institutions, but
financial and prudential regulation, and a sufficiently recession is weakening confidence and macro stability.
flexible exchange-rate regime must be present Governments are trying to reflate the system and restore
before the capital account is opened up. macro fundamentals.
(b) Although ineffective as a long-term instrument of Malaysia has imposed exchange controls.
macroeconomic stability, exchange/capital controls This is not an issue in the affected countries when capital
may ensure economic stability in the short term. outlow rather than inflow is the problem.
Deprotect preferred industries or sectors Countries are doing this at varying pace and with different
(e.g., state-owned enterprises). degrees of success (PRC, India, Pakistan, Viet Nam).
Liberalize trade. Sequencing does not mean that the liberalization process
Improve price and market mechanisms in the should be frozen.
financial, monetary, and bond markets.
Improve prudential regulation in the financial
markets.
Increase the efficiency of agencies enforcing
F. Export Stimulus and implementing rules and regulations.
(a) Make export credit and financing available.
(b) Improve productivity and efficiency of export Loosen monetary and interest-rate policies. All affected countries are doing this.
production. Reduce domestic costs. Real wages and rental costs have been naturally reduced
because of crisis.
Expose firms to competition, Reducing monopoly of firms, deprotecting firms, decreasing
Reduce protection of firms and industries. discretionary credit allocations—all, in various degrees, are
Liberalize trade. tackled in IMF programs for hard-hit countries (especially
Indonesia and Korea).
Continued next page
39
40
Table 4: Macroeconomic Policy Matrix for the Affected Countries (Cont’d)
A STUDY OF FINANCIAL MARKETS

Recommendations Specific Policy Measures Government Action
(c) Diversity export markets and reduce Intensify diplomatic and private initiatives to search for other Most countries are still too affected by crisis to
overdependence on a few product lines. export markets. tackle this. In general, efforts in this regard are
Use foreign direct investments to try to penetrate export still inadequate.
markets in other countries.
Diversify export products.
G. Regional and International Efforts
(a) Regional efforts
An ASEAN Surveillance Coordinating Unit has been
created at the ASEAN Secretariat, and the ADB has
established a Regional Economic Monitoring Unit. In
addition, the following proposals merit further
serious consideration.
(i) Set up regional funding and/or guarantee
mechanisms needed to indicate self-help efforts
within the region, to address regional
development issues, and to boost confidence in
(ii) Adopt a two-stage approach to a full currency
union like the European Monetary Union. In
foreign-exchange markets there are strong
○ ○ ○ ○
cross-effects from one market to another.
○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○
Contagion effects could be dampened if

concerted regional actions were taken.
(iii) Expand membership of the Asian Clearing Union
or establish a new East Asian Clearing and
Payments Union. Clearing unions promote
regional trade and cooperation and conserve
foreign-exchange reserves.
(iv) Set up an Asian Monetary Fund. Needed to
indicate self-help efforts within the region, to
address regional development issues including
financial contagion, and to boost confidence in
(b) International efforts
(i) Provide international assistance and loans to IMF, World Bank, ADB, and UN organizations should be at the IMF, World Bank, ADB, UNDP, ILO, and other UN
restore international capital, to alleviate the credit forefront of this. Bilateral aid and loans should also be agencies are providing loans and assistance: New
crunch, to finance fiscal deficits, to provide provided. Guarantee operations could be used. Miyazawa Initiative and Asian Growth and Recovery
safety nets, and to reflate the economies. Initiative are to help hard-hit East Asian countries.
(ii) Create a new international financial architecture. Reform and/or abolish IMF, establish new international Discussions ongoing; no plans yet in this direction.
institutions for various purposes, establish rules on short-run
capital inflows and outflows, settle liquidity and bankruptcy
problems involving foreign debt during financial crises, and
initiate beneficial workout arrangements and rollover of loans
to prevent illiquid situations from deteriorating into insolvency.
of early 1998 have made these countries even more cows”, India and Pakistan because of the inefficien-
○
○
vulnerable. India and Pakistan have very high fiscal cies of the Soviet model of development which they
○
○
deficits (7.8 percent of GDP for India in 1998 and adopted soon after independence but which they have
○
○
5.4 percent for Pakistan in 1998) (Figure 13). Paki- since abandoned. All four countries have to improve
○
○
stan has traditionally also had large current-account their financial strength and prudential regulation.
○
○
deficits (e.g., more than 6 percent of GDP in 1996, Pakistan’s financial weaknesses were partly to blame
○
○
down to 5.3 percent in 1997 and 2.8 percent in 1998). for the large capital withdrawals and capital flight
○
○
Viet Nam, too, has very high current-account defi- following the nuclear testing controversy and the
○
○
cits (11 percent of GDP in 1996, more than 8 per- imposition of capital controls by the state. Pakistan
○
○
cent in 1997, and nearly 7 percent in 1998) and should liberalized a great deal on capital inflows but restricted
○
○
therefore go slow on expansionary policies. In con- capital outflows. It found out that if reforms were
○
○
trast, the macroeconomic fundamentals of the PRC wrongly sequenced, money would still find its way
○
○
are strong: inflation is at a record low and fiscal and out. Again, the PRC and Viet Nam have a long way
○
○
current-account surpluses are manageable. to go (despite some gains) in using market and price-
○
○
All four countries, however, have a very weak ○
○
based allocative systems and instruments in the fi-
financial sector—the PRC and Viet Nam because nancial markets. Both these countries’ state banks
○
○
of the close link between state-owned enterprises suffer from bad and nonperforming loans owed by
○
○
(SOEs) and banks which the SOEs use as “milking SOEs and pressures will mount further as SOEs are
○
○
○
○
Figure 13: Macroeconomic Indicators for the Vulnerable Countries

○
○
China, People’s Republic of India

○
○
○
○
○
○
○
○
○
○
○
○
○
○
○
○
○
○
○
○
Pakistan Viet Nam

○
○
○
○
○
○
○
○
○
○
○
○
○
○
○
○
○
○
○
○
○
○
Source: Asian Development Outlook database.

○
reformed. Viet Nam itself suffered a mini–East Asian sures to devalue its currency (the renminbi or yuan).
○
○
crisis as external trade creditors, which had come in It last devalued the renminbi by around 50 percent
○
○
substantially before 1997, suddenly staged a mini- in 1994, gaining a head start in the export markets.
○
○
exodus. PRC, Pakistan, and Viet Nam, also have to Although its export growth declined in 1998, this
○
○
improve their financial procedures and timely data was mainly due to the contraction of the Japanese
○
○
reporting to improve transparency in their systems. and East Asian markets rather than competitive de-
○
○
But even with either or both macroeconomic and valuations. In the first half of 1999, the PRC’s ex-
○
○
financial sector weaknesses, these countries have ports declined by more than 4 percent while im-
○
○
been shielded from crises of confidence of the East ports grew by more than 15 percent. Thus, there
○
○
Asian type because of stringent capital-account re- could be renewed pressures on the currency espe-
○
○
strictions which have limited the external exposure cially if the yen depreciated further. But the PRC
○
○
of banks and corporates. Net private capital inflows has strong currency defenses—a closed capital ac-
○
○
to PRC during the period from the late 1980s to count, a large current-account surplus, and a
○
○
1996 totaled approximately US$260 billion, but only US$145-billion international reserve position, equiva-
○
○
about 17 percent of such flows were in the volatile lent to more than ten months’ worth of imports.
○
○
forms of short-term debt, portfolio equity, and bonds. The East Asian contagion has affected the other
○
○
The rest were mainly long-term foreign direct in- four countries included in this study (and many other
○
○
vestment. The other three countries received lesser countries for that matter) through two channels. First,
○
○
amounts of private capital—India (US$23 billion), as the affected countries compete for export mar-
○
○
Pakistan (US$9 billion) and Viet Nam (US$3.5 bil- kets, the sharp competitive devaluations will adversely
○
○
14
lion) (Rana 1998c). Despite stringent capital con- affect the export markets of the other countries. As
○
○
trols, an overall index of global financial integration shown in Figure 14, currencies in India, Pakistan,
○
○
calculated by the World Bank (1997) indicates that and Viet Nam have depreciated by a lesser amount
○
○
during the period from the late 1980s to the early than the currencies of the East Asian countries. The
○
○
1990s, the financial markets of the vulnerable coun- more competitive the country’s exports are with those
○
○
tries became more integrated, rendering them more of the affected East Asian countries, the more the
○
○
vulnerable to adverse developments in international country will be affected. This will be true particu-
○
○
capital markets (Table 1). larly for the PRC and Viet Nam, but will also be
○
○
The pressures for currency depreciation have

○
relevant to India and Pakistan, especially for gar-

○
○
been strong in all of the four countries. Reflecting ments, toys, and electronic exports.
○
○
indigenous macroeconomic forces as well as the As mentioned above, East Asian exports have not
○
○
East Asian contagion, by early 1998 the currencies taken off despite the massive currency depreciation.
○
○
of India, Pakistan, and Viet Nam had depreciated This problem, therefore, is not as urgent in the short
○
○
by about 10 percent against the dollar from the June run and may be limited to selected commodities. But
○
○
1997 levels (Figure 14). The depreciation was faster in the medium and long run, once the East Asian coun-
○
○
in India and Pakistan because of the adverse im- tries recover and the international market is more con-
○
○
pact of the sanctions imposed after the nuclear tests, ducive, the relatively cheaper exports from the affected
○
○
and in Viet Nam because of an export slowdown countries may give stiff competition to the exports of
○
○
and the withdrawal of foreign investment. By the other countries. India had to allow the rupee to depre-
○
○
end of 1998, the currencies of these three countries ciate in mid-1998, and this might be due partly to cheap
○
○
had depreciated by around 20 percent versus their competitive export products from the East Asian
○
○
mid-1997 levels. The PRC has so far resisted pres- economies.

○
○
Figure 14: Weekly Nominal Exchange-Rate Indices for Affected and Vulnerable Asian Crisis, June 1997 to
○
January 1999 (in US$/local currency, with June 1997 = 100)
○
○
○
○
○
○
○
○
○
○
○
○
○
○
○
○
○
○
○
○
○
○
Source: Economics and Development Resource Center, Asian Development Bank (adapted from Bloomberg).
○
○
○
○
The second repercussion for the other countries ○
○
the capital account, however, does not mean being
would be the smaller absorptive capacity of the East complacent and freezing the reform process because
○
○
Asian economies in crisis to purchase exports from the benefits of globalization are large. It means adopt-
○
○
other countries. This is particularly true if one includes ing a pace of liberalization consistent with the state
○
○
Japan as one of the East Asian countries in trouble. of development of the financial system and the de-
○
○
Viet Nam is particularly vulnerable since 70 percent gree of soundness of macroeconomic management.
○
○
of its exports go to the East Asian market. This has Pakistan and Viet Nam have large current-account
○
○
been reflected in a slowdown of its exports, slower deficits while India and, again, Pakistan still have a
○
○
growth, and strong pressures for the dong to depreci- long way to go to close their large fiscal gaps. Both
○
○
ate. The same can be said about the PRC, whose the PRC and Viet Nam have lower fiscal deficits but
○
○
exports have also been affected by the contraction of suffer from problems in fiscal revenue-generating
○
○
the East Asian market and whose currency has simi- capacity as they are still largely dependent on rev-
○
○
larly been strained by pressures to depreciate. But the enues from SOEs and have yet to complete their tax
○
○
PRC is protected more than Viet Nam by a more di- reform agenda geared for market economies. Instru-
○
○
versified export market and by its sharp currency de- ments for financing deficits through government se-
○
○
valuation in 1994. curities issued in market auctions also still have to be

○
○
To counter these two effects, these countries have developed fully. State-owned enterprises will have
○
○
various options. They can allow their currencies to to be privatized and they will have to make their slow
○
○
depreciate on a case-by-case basis, diversify their move toward more market-based decision making
○
○
export markets and their export commodities, or before the option of opening them up to foreign fi-
○
○
implement policies that would improve productivity nancial markets can be considered.
○
○
and efficiency in their export production. For the four countries that have not opened up
○
○
One lesson for these countries from the East Asian their capital account, it is advisable to continue limit-
○
○
crisis is that capital-account liberalization should ing and controlling their short-term capital inflows
○
○
strictly follow the proper sequencing of financial and and outflows. Fry and Jun (1997) actually recom-
○
○
then capital-account liberalization. Thus, it is not ad- mend a gradual sequencing of capital-account liber-
○
○
visable for these four countries to open up their capi- alization by opening up first on long- and medium-
○
○
tal account too hastily and in full force. Prudence in term capital before short-term capital. After all, the
○
spillover benefits from long- and medium-term capi- the world economy. It is therefore crucial to under-
○
○
tal are quite significant. take necessary steps to stop the crisis and pave the
○
○
Another lesson from the East Asian crisis (and way for economic recovery in the affected coun-
○
○
the foreign debt crisis of the 1980s as well) is that tries and the region.
○
○
financial liberalization is only as good as the incen- A consensus has now emerged on the crisis-of-
○
○
tive structure in the real sector and the quality and confidence-cum-structural-weaknesses view of the
○
○
level of financial supervision and prudential regula- East Asian crisis. This has led to interesting de-
○
○
tion in the financial system. Thus, it will not be wise bates on the design and sequencing of macroeco-
○
○
for these countries to undertake complete financial nomic and bank restructuring policies in the affected
○
○
liberalization—particularly the liberalization of for- countries. While the debate continues, there is una-
○
○
eign bank entry and the expansion of credit (espe- nimity of views on the need to reflate these hard-
○
○
cially foreign credit) and intermediation activities— hit economies.
○
○
without creating the necessary institutions for pru- The immediate short-term policy required is to
○
○
dential regulation and supervision, and without cre- reflate the economies through accommodative mon-
○
○
ating a desirable price and economic incentive sys- etary and fiscal policies, making sure that the fi-
○
○
tem in the real sector. nancing of these policies will not cause undue infla-
○
○
It is therefore crucial that as these countries slowly tion, crowding out of private investments, and for-
○
○
liberalize their economic and financial sectors, they eign-exchange outflows in the future. The export
○
○
should not open up their capital account and that they response to the massive depreciation in currencies
○
○
should allow massive market-based loan transactions should be strengthened as the countries relearn and
○
○
only to the extent that their exchange rates are con- redo the export growth “miracle” they undertook in
○
○
sistent with their current-account deficits, their eco- the 1970s and 1980s. The investor confidence shat-
○
○
nomic fundamentals are strong, and the institutions tered by the debacle should be allowed to return, as
○
○
to undertake efficient prudential regulation in the fi- currency stability and successful financial rehabili-
○
○
nancial sector are in place. tation are achieved. The credit crunch has to be
○
○
alleviated.
○
Summary and Conclusion

○
In the medium and long term, the building up and

○
○
The East Asian crisis has been unprecedented in its rehabilitation of financial institutions will be vital for
○
○
length, width, and depth. As a regional crisis, it ranks

○
sustainable development. Bad debts must be written

○
○
among the worst in recent history, especially if one off and banks restructured. Strong prudential regu-
○
○
includes Japan’s woes. In addition to the five affected lation and supervision would also be required in the
○
○
countries, Hong Kong, China and Singapore are al- financial sector. Governments should ensure that
○
○
ready facing recessions and slowdowns directly be- short-term capital flows and short-term foreign loans
○
○
cause of the crisis. Its potential of wreaking further will no longer create harmful circumstances and price
○
○
havoc is great as the economies of PRC, Taipei,China, distortions in the system, contributing to asset bubbles
○
○
and Viet Nam and many surrounding countries have that make the financial sectors especially vulnerable.
○
○
slowed down because of the crisis. The spread of Partly to ensure this, exchange-rate policies will have
○
○
financial and currency instabilities to Russia and Brazil to become more practical (that is, a more flexible
○
○
following the East Asian debacle threatens to turn exchange-rate regime should be followed) and mon-
○
○
the regional crisis into a worldwide economic slow- etary policy should be allowed some independence
○
○
down. As in the previous year, the East Asian crisis in a world with relatively open capital accounts. An-
○
○
turned out to be the most significant event to affect other item on the long-term agenda will be to restore
○
competitiveness. This will require increased expen- battered countries back on their feet. In a crisis
○
○
diture on human resource development and technol- wherein one country’s lot depends on the other
○
○
ogy development. countries in the region, coordination of policies and
○
○
Finally, strong contagion, both within the region responses to external shocks is essential. The in-
○
○
and internationally, is a pattern which the East Asian ternational financial architecture should be able to
○
○
crisis shares with similar crises of confidence in effect orderly workout arrangements and rollover
○
○
the past. It is essential, therefore, that regional and of loans to prevent illiquid debtor countries from
○
○
international efforts continue. In a regional crisis of deteriorating into insolvency and financial collapse.
○
○
this magnitude, adequate regional and international These are areas where regional efforts and coordi-
○
○
assistance and loans will be necessary to get the nation have been wanting.
○
○
○
○
○
○
○
○
○
○
○
○
○
○
○
○
○
○
○
○
○
○
○
○
○
○
○
○
○
○
○
○
○
○
○
○
○
○
○
○
○
○
○
○
○
○
○
○
○
○
○
○
○
○
○
○
○
○
○
○
○
○
○
○
○
Notes nomic fundamentals in the affected countries which were
○
○
still good.
○
○
6Cited in Sachs (1998).
○
○
1See “Capital-Account Liberalization and Capital Con-
○
○
trols” in the next section for data on the sharp reversal of 7ADB and the World Bank (1998) provide a detailed dis-
○
○
international capital from the five countries in 1997 and cussion of how the affected countries responded to large
○
1998. Domestic investors also panicked and either kept inflows of foreign capital.
○
○
liquid positions or fled to safe havens, or both.
○
8Nonperforming loans have increased sharply in the re-
○
○
2In a recent article, Calvo and Fernandez-Arias (1999) com- gion. According to JP Morgan, nonperforming loans are
○
○
puted various indices of vulnerability: market fundamen- projected to rise to around 10 percent of total loans in the
○
tals, financial sector weaknesses reflecting “insolvency” Philippines, 10–20 percent in Malaysia, 30 percent in Ko-
○
○
problems, and financial sector weaknesses reflecting “li- rea, and 30–35 percent in Indonesia.
○
○
quidity” problems. Data from East Asian and Latin Ameri-
○
can countries show that the financial fragility index best 9Often defined as a situation of negative net worth in the
○
○
explained the East Asian crisis. banking system.
○
○
○
3Indonesia’s GDP growth rate in the second quarter of 10It must be noted, however, that lower bank lending may
○
○
1999 was reportedly a positive 1.3 percent. ○
○
reflect a fall in demand for credit, as firms scale back in-
vestment plans, as much as a greater unwillingness by
○
4An earlier instance when the appropriateness of policies banks to lend.

○
○
was questioned was during the 1970s and the 1980s when
○
11Based on Rana (1998b).

○
many argued that the balance-of-payments disequilibri-

○
ums in nonoil-producing countries were structural—

○
12De facto, the regime is closer to a free float because the

○
mainly adverse terms of trade because of the OPEC-in-

○
duced oil price increase—and not caused by expansion- affected countries are facing a serious shortage of inter-
○
○
ary monetary and fiscal policies. There was a general rec- vention currency.
○
○
ognition that orthodox monetary and fiscal tightening

○
therefore had to be complemented by structural reforms 13Higher unemployment and lower real wages, of course,
○
○
(see Rana 1985 for evidence from Asia). In the 1980s, the are painful results of the economic contraction and should
○
○
IMF introduced the Structural Adjustment Facility and be addressed in terms of social insurance, safety nets,
○
the Enhanced Structural Adjustment to deal with struc- and reskilling efforts.
○
○
tural crises.
○
14The corresponding figures were US$80 billion for Ko-

○
○
5This could be because the incidence and depth of the rea, US$75 billion for Thailand, and US$68 billion each for
○
○
crisis could not be predicted on the basis of macroeco- Indonesia and Malaysia.
○
○
○
○
○
○
○
○
○
○
○
○
○
○
○
○
○
○
○
○
○
○
○
○
○
References Helpman, E., L. Leiderman, and G. Bufman. 1994. “New
○
Breed of Exchange Rate Bands: Chile, Israel and
○
○
Mexico.” Economic Policy: A European Forum.
○
○
Asian Development Bank. 1998. “Exchange Controls: The
○
Path to Economic Recovery in Asia?” EDRC Briefing Institute of International Finance. 1999. “Capital Flows to
○
○
Notes Number 4. Emerging Market Economies.” 27 January.
○
○
○
__________. 1998. Key Indicators of Developing Asian International Monetary Fund. 1995. “International Capital
○
○
and Pacific Countries. Markets: Developments, Prospects and Policy Issues.”
○
Washington, D.C.
○
○
Asian Development Bank and World Bank. 1998. “Man-
○
○
aging Global Financial Integration: Emerging Lessons __________. 1997. World Economic Outlook, October.
○
and Prospective Challenges.” Mimeo. Internet Summary.
○
○
○
Azis, Iwan J. 1998. “Economic Reform and Unique Se- __________. Various Issues. International Financial Sta-
○
○
quencing: The Indonesian Experience.” Mimeo. tistics.
○
○
○
Bhagwati, J. 1998. “The Capital Myth: The Difference Be- ○
○
Koo, R.C. 1998. “The Weakening Yen and Japan’s Credit
tween Trade in Widgets and Dollars.” Foreign Affairs Crunch Problem: Implications for Economic Policies.”
○
○
77:3 (May/June). Paper presented at the Asian Bankers Association Semi-

○
nar on the Asian Financial Crisis and Its Impact on the

○
○
Calvo, Guillermo, and Eduardo Fernandez-Arias. 1999. “The World Economy, Taipei,China, 23–25 November.
○
New Features of Financial Crisis in Emerging Markets.”

○
○
Internet. Kraay, Aart. 1998. “Do High Interest Rates Defend Cur-
○
○
rencies During Speculative Attacks?” Mimeo.

○
Carrasquilla, Alberto. 1998. “On Regulating Capital Mar-

○
○
ket Transactions.” Mimeo. Inter-American Develop- Krugman, P. 1998a. “What Happened to Asia?” January
○
○
ment Bank. (http://web.mit.edu/krugman/www/#other)

○
○
○
Cline, William R. 1998. “IMF-Supported Adjustment Pro- __________. 1998b. “Saving Asia: It’s Time to Get Radi-
○
grams in the East Asian Financial Crisis.” Institute of cal.” Fortune, 7 September.
○
○
International Finance, May.

○
○
Lane, Timothy, et al. 1999. “IMF Supported Programs in

○
Edwards, S. 1984. “The Order of Liberalization of the Ex- Indonesia, Korea and Thailand: A Preliminary Assess-
○
○
ternal Sector in Developing Countries,” Essays in In- ment.” Washington, D.C.

○
ternational Finance, no. 156.

○
○
Lee, J.S. 1998. “Restoring Economic Growth in Asia:

○
○
__________. 1987. “Sequencing Economic Liberalization Priorities Areas of Reform and Prospects.” Paper pre-
○
in Developing Countries.” Finance and Development, sented at the OECD Seminar on Structural Aspects
○
○
March . of the East Asian Crises, Paris, France, 16–17 Nov-

○
○
ember.
○
Fry, Maxwell J., and Kwang Jun. 1997. “Opening Domestic

○
○
Markets for Fixed-Income Securities in Developing McKinnon, R. 1991. “The Order of Economic Liberaliza-
○
Countries.” Report commissioned by the International tion.” Baltimore: Johns Hopkins University.
○
○
Economic Department of the World Bank.

○
○
__________. 1998a. “Exchange Rate Coordination for Sur-

○
Furman, J., and J. Stiglitz. 1998. “An Economic Crisis: Evi- mounting the East Asian Currency Crises.” Keynote
○
○
dence and Insights from East Asia.” Brookings Paper speech, 6th Convention of the East Asian Economic
○
○
in Economic Activity. Forthcoming. Association, Kitakyushu, Japan, 4–5 September.

○
○
○
Goldfajn, Ilan, and Poonam Gupta. 1998. “Does Monetary __________. 1998b. “The IMF, the East Asian Currency
○
○
Policy Stabilize the Exchange Rate?” Mimeo. Crisis, and the World Dollar Standard.” Mimeo.
○
○
McKinnon, R., and H. Pill. 1998. “International Overbor- Rodrik, Dani. 1998. “Who Needs Capital Account Con-
○
○
rowing: A Decomposition of Credit and Currency Risk.” vertibility.” Princeton Essays in International Fi-
○
February. nance.
○
○
○
New York Times. 1998. “IMF Now Admits Moves in Indo- Sachs, J. 1997. “The Wrong Medicine for Asia.” New York
○
○
nesia Deepened the Crisis.” 14 January. Times.
○
○
○
Ohno, K. 1999. “Exchange Rate Management in Develop- __________. 1998. “What Have We Learned, So Far, from
○
○
ing Asia.” Asian Development Bank Institute. the Asian Financial Crisis?” Mimeo.
○
○
○
Radelet, S., and J. Sachs. 1998a. “The Onset of the East Sheng, Andrew. 1996. “Bank Restructuring: Lesosns from
○
○
Asian Financial Crisis.” Harvard Institute for Interna- the 1980s.” Washington, D.C.: World Bank.
○
tional Development, 30 March .
○
○
Stiglitz, J. 1998a. “Sound Finance and Sustainable Devel-
○
○
__________. 1998b. “The East Asian Financial Crisis: opment in Asia.” Keynote address at the Asia Devel-
○
Diag-nosis, Remedies, Prospects.” Harvard Institute for opment Forum, Manila, Philippines, 12 March.
○
○
International Development, 20 April.
○
○
__________. 1998b. “Boats, Planes and Capital Flows.”
○
Rana, P.B. 1985. “Sources of Balance of Payments Prob- The Financial Times, 25 March.
○
○
lems in the 1970s: The Asian Experience.” ADB Eco- ○
○
nomics Office Report Series No. 30, Manila, Philippines. Wade, R., and F. Veneroso. 1998. “The Asian Crisis: The
○
High Debt Model vs. the Wall Street-Treasury-IMF

○
○
__________. 1998a. “Controls on Short-term Capital In- Complex.” New Left Review 3–23, March–April.
○
○
flows: The Latin American Experiences and Lessons

○
for DMCs,” EDRC Briefing Notes No. 2. World Bank. 1997. Private Capital Flows in Developing
○
○
Countries: The Road to Financial Integration. Wash-

○
__________. 1998b. “The East Asian Financial Crisis: ington, D.C.

○
○
Implications for Exchange Rate Management.” EDRC

○
○
Briefing Notes No. 5. __________. 1998. East Asia: The Road to Recovery.
○
Washington, D.C.
○
○
__________. 1998c. “Surges and Volatility of Private Capi-

○
○
tal Flows to Asian Developing Countries: Implications __________. 1999. “Global Economic Prospects and the
○
for Multilateral Development Banks.” ADB Occasional Developing Countries 1998/99: Beyond Financial Cri-
○
○
Papers No. 19. sis.” Washington, D.C.

○
○
○
○
○
○
○
○
○
○
○
○
○
○
○
○
○
○
○
○
○
○
○
○
○
○
○
○
○
○

1 Over Mac A Study of Financial Market

Uploaded by

Document Information

Original Description:

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

1 Over Mac A Study of Financial Market

Uploaded by

Copyright:

Available Formats

The East Asian Crisis:

Macroeconomic Policy Design

Pradumna B. Rana and Joseph Anthony Y. Lim

Pradumna B. Rana is Manager of the Regional Economic Monitoring Unit,

Summary Policy Issues: Design and

integrate globally. Tight demand management policies were believed to

sis-of-confidence-cum-structural-weaknesses view. account adjustment required because of the large

capital inflows—and not weak macroeconomic

rehabilitation and to restore confidence in the affected

fundamentals. The crisis involves private-to-pri- countries.

solvency crisis. sial. The crisis-of-confidence-cum-structural-weak-

vidual country efforts. bly, was fiscal and monetary austerity.

an even stronger contractionary effect. The IMF went gregate demand.

on to argue that fiscal policy had not been a major

factor dampening economic activity. EXCHANGE-RATE POLICIES

firms—not only those that were unprofitable but also crisis-of-confidence-cum-structural-weaknesses

uct (GDP) and of corporate debt to equity. They were

therefore vulnerable to shocks that depressed cash CAPITAL-ACCOUNT LIBERALIZATION

flows or the supply of bank or portfolio capital. AND CAPITAL CONTROLS

others, have distinguished between markets for goods ket-based methods.

and financial markets, and argued that the case for

to free financial flows. Information problems create INTERNATIONAL CAPITAL FLOWS

cial sector, and a strong autonomous central bank.

prising exports and domestic demand. The IMF also

ineffective as a long-term instrument of macroeco- foreign reserves and exchange-rate stability.

nomic stability, they may be effective in ensuring

economic stability in the short term.

the Affected Countries

FINANCIAL SECTOR REFORM

ippines. Interest rates in Indonesia, Philippines, and FISCAL STIMULUS

monetary policies and lowered interest rates. Indone- EXCHANGE-RATE MANAGEMENT

roeconomic reforms will not be realized. rencies.

Major Policy Recommendations

for the Affected Countries

MONETARY POLICY: DEALING WITH EXCHANGE/CAPITAL CONTROLS

THE CREDIT CRUNCH • In correctly sequenced reform, the precondi-

and capital flight. a sufficiently flexible exchange-rate regime

• Call for more workout arrangements, rollover of opened up.

loans, and restructuring of short-term foreign • Although ineffective as a long-term instrument

loans into medium- and long-term loans. of macroeconomic stability, exchange/capital

crunch. short term.

EXPORT STIMULUS count deficits. In contrast, the macroeconomic fun-

• Expand the membership of the Asian Clearing and corporates.

At the international level: had depreciated by about 10 percent against the

economies. nuclear tests, and in Viet Nam because of an ex-

international financial architecture. Issues per-

vestment. By the end of 1998, the currencies of

percent versus their mid-1997 levels. The PRC has

Lessons for the

so far resisted pressures to devalue the yuan. It

last devalued the yuan by around 50 percent in

amples in the 1990s are the demise of the target-

zone system in Europe in 1992–1993, the Mexican

with equity (Thailand). moderate real appreciation of these countries’ cur-

cial supervision, shifted a disproportionate amount of

pines and Thailand, the significant overvaluation of

weakness and instability in the financial system. to speculative attacks.

to the design and sequencing of macroeconomic poli-

Summary and Implications

cies. Third, it has strengthened the case for regional

Asian crisis differs from previous crises in several try efforts.

October it had moved northeast to Korea. In mid-