IMF/World Bank Response to Asian Crisis - Assignment Example

IMF/World Bank Response to Asian Crisis Since the first signs of the impending financial crisis appeared in Asian countries financial sectors, one wonders if the International Monetary Funds (IMF) and the World Bank (WB) understood from the outset what was happening, and whether their remedies were timely and appropriate; or, conversely, if prescriptions of IMF and WB made a bad situation worse. One of the underlying causes of earlier financial crises in Central and Latin America and in Africa had been excessive spending by governments. Chronic public sector budget deficits had generated price inflation and trade account imbalances that led to overvalued currencies and the flight of capital. The WB and IMFs conventional prescription in such cases called for reducing central government expenditures and increasing revenues by improving tax collections, raising interest rates to dampen speculation and keep funds in the country, devaluing the countrys currency to increase exports and contain imports, improving governance and reforming banking. Although serious doubts have been expressed about the Funds overall, longer-term impact, these remedies appear to have helped restore a degree of fiscal and financial equilibrium in the short run in countries able to muster the political will and public support needed to implement them. The crises in East Asian countries, however, reflected few of the characteristics of earlier financial crises in Central and Latin America. Government budgets had been recording substantial surpluses, price inflation had been modest, real interest rates were positive, saving rates were high, and current account balances were positive. For most of their "miracle" period, in fact, these Asian countries had experienced, besides stunning rates of domestic growth, rapid expansion of exports and trade account surpluses and a build-up of their foreign exchange reserves [World Bank, 1998, passim]. To promote their exports, the East Asian countries had liberalized their current accounts, but not their capital accounts, and had made their national currencies freely convertible into foreign exchange for current account transactions. Most had also pegged their national currency to the U.S. dollar, thereby all but eliminating exchange risks and the cost of hedging for traders and investors. While it was acknowledged that a corresponding liberalization of capital account transactions would be beneficial in the longer term, these countries central bankers recognized that large, sudden movements of capital could be risky without a banking system able to prevent such transactions from destabilizing the countrys financial sector and economy. Nor was it overlooked that restrictions on capital transactions protected owners of domestic firms and industries--usually members of powerful extended families, government officials and, in the case of Korea, the chaebols--from equity dilution and unfriendly takeovers. In the so-called Asian model, enterprises were in any case highly leveraged, and borrowing rather than equity had long been their main source of fresh capital. The debt/equity ratio of South Korean corporations, for example, was over 317 percent in 1996, twice the U.S. level. Since interest yields were higher in these East Asian countries than in the industrialized countries capital markets, and since their currencies had been pegged to the U.S. dollar, Japanese, European and American banks and other intermediaries began to pile up what they considered to be risk-free, high-yielding loans. At the same time, domestic banks, start-up financial institutions, corporations and a variety of other private intermediaries in these Asian countries found that they could borrow capital more cheaply and more readily abroad than they could at home. In the mid-1990s, for example, a run-of-the-mill Asian investor could borrow Japanese yen at nearly zero interest, invest in a Bangkok skyscraper, and expect to earn a 20 percent annual return. From the perspective of both borrowers and lenders, East Asia became the modern-day version of the California gold rush. While world trade grew on average by about 5 percent a year between 1990 and 1997, aggregate global private capital flows grew at nearly six times that rate. Between 1990 and 1997, private capital flows to developing countries rose five-fold, from $42 billion to $256 billion. Nearly two-thirds of that amount went to East Asia. In the absence of reporting and monitoring requirements and of virtually any other requirements for transaction transparency, the central banks of these Asian countries had no way of knowing how much their banks, business firms and individuals were borrowing overseas. Even if they had had this information, they lacked the experience, skills and legal system that would have permitted them to moderate or check excessive capital inflows. Nor did the central banks of Japan, the United States, or European countries take soundings of the large amounts of capital moving electronically to East Asia. By 1996, annual net private capital inflows to these four East Asian nations amounted to between 5 percent and 15 percent of their annual gross domestic product (GDP). The Bank for International Settlements reported that in 1996 European Union banks loans outstanding in East Asia amounted to $318 billion. The corresponding figure for Japanese banks was $261 billion, and for U.S. banks it was $46 billion. The combination of speculative domestic borrowers and abundant, but mostly short-term foreign capital overwhelmed these Asian countries understaffed, inexperienced and immature financial institutions. By 1996, problems that had been obscured or ignored while the good times rolled began to show up. The pace of economic growth faltered, trade surpluses turned to deficits as imports rose and competitiveness eroded. The supply of fresh foreign credits slowed from a flood to a trickle; and when the inflated collateralized property bubble burst, non-performing assets on the books of borrowers and lenders multiplied. Expectations and confidence quickly switched from positive to negative as foreign bankers and money managers began to question the ability of their borrowers to service their debts and of the countries to maintain the pegged value of their currencies. The most egregious sin in the bankers craft is to be the last one out, and the herd instinct quickly took over. Foreign lenders refused to renew outstanding short-term loans, began to dump assets and headed for the nearest exits. Despite costly but futile efforts to prop them up, starting with the Thai baht, these countries currencies began to tumble, property and equities prices crumbled, and liquidity dried up as bankers called in outstanding loans in an attempt to cover their mounting negative asset positions. The involvement of IMF and WB in the Indonesian crisis began a few months after Thailand and followed an essentially similar pattern. The Funds initial response followed traditional lines: reduce central government budget expenditures, increase interest rates and float the rupiah. As in the Thai case, this prescription failed to account for the fact that Indonesias financial and economic stress had originated in excessive borrowing by the private sector rather than by the government. Unlike the Thai case, however, in Indonesia the borrowing spree had involved private individuals, families and corporations rather than banks. Again, the Fund underestimated the severity of the economic downturn and (notwithstanding years of visits and consultation) failed to grasp the breadth and depth of the countrys cronyism. Fund staff assumed that the economy could be turned around with conventional remedies. Instead, the crisis deepened and spilled out into the streets in the form of angry rioting and looting. Back in Washington, the IMF Executive Board approved an initial program of financial assistance for Indonesia early in November 1997. Financial support of some $10 billion was committed for a three-year period and $3 billion was released for immediate disbursement. The IMF program was one of fiscal restraint. It included a budget surplus target of 1 percent of GDP; restructuring the financial sector, including closing a large number of undercapitalized private banks and merging of state banks; and a plan for improving the institutional, legal and regulatory framework of the financial system. In addition, foreign trade and investment were to be liberalized, a flexible exchange rate policy introduced and interest rates raised. During the following months it became clear that the Funds reform prescriptions and financing were unable to restore confidence in either the economy or in the rupiah. The economys slide deepened. Following another IMF review, a "Memorandum of Economic and Financial Policies" was issued early in January 1998. Its main new features were a reversal in fiscal policy from contractionary to expansionary, the cancellation of several capital expenditure projects of questionable origin and priority and, in response to public demonstrations, emergency measures to ensure more adequate food supplies at affordable prices. The rupiah continued to fall and economic conditions continued to deteriorate. Three months later, in April 1998, yet another review was held, and another "Supplemental Memorandum of Economic and Financial Policies" was issued. It continued the structural reforms of the financial sector and began to address the need for restructuring foreign exchange indebtedness and the problems of bank closings and domestic liquidity shortages that were stifling Indonesias banking and corporate sectors. The countrys social safety net was also to be strengthened through added support for small and medium-sized firms and new public works programs. For many of the same reasons, South Korea had also become vulnerable to the contagious financial crisis. Responding to pressures from the Uunited States and the IMF, the Korean Government had removed a number of restrictions on foreign participation in the manufacturing and banking sectors. Conclusion IMF and WB need reforms to dead the future financial crises of the world. A proposal would make the future IMF a combined international lender of last resort and a manager of potential financial crises, corresponding in essence to the Federal Reserve System in the United States. The Fund, it is argued, is well positioned to perform both functions. As a crisis manager, the Fund would take the lead in formulating and negotiating rescue and workout plans with member countries and their public and private sector creditors in order to forestall financial problems. As a crisis lender, the Fund would take the lead in mobilizing and disbursing country-specific financial rescue packages. To function as a lender of last resort, the Fund would have to be granted authority to create and issue Special Drawing Rights (SDRs) on an as-and-when needed basis and to allocate them directly to countries in need rather than to countries based on their IMF quotas [Fischer, 1999]. There is a strongly held contrary view that patching up an antiquated system is not the answer. What is required instead is a new Bretton Woods Conference that will visualize and create policies and institutions to meet the future needs of a global financial/economic system. A core institution to be established under this formulation would be a global central bank with the authority to oversee the international financial activities of all member countries, much as the Federal Reserve does for the 50 American states [Soros, 1998]. A step in that direction was in fact taken with the inauguration of the European Central Bank in 1999. The Bank was established to coordinate the monetary and fiscal policies of its eleven member countries--to establish a single currency, the euro, and to prescribe exchange rate bands, budget deficit ceilings, and convergent interest rates for the European Community as a whole. Since high-visibility matters of national sovereignty are at stake at nearly every turn, it remains to be seen how the scope and responsibilities the European Central Bank develop. There is also a suggestion that we are already on the way to the de facto creation of three currency areas--a European euro area, an Asian yen area and a North American dollar area. Whatever its pros and cons, this type of trilateral arrangement would surely facilitate the coordination of international financial policy. These micro-measures would no doubt help ensure greater international financial stability and, presumably, fewer contagious financial crises. But on the larger question of architecture for the future, reams of papers and hours of discussions have produced little in the way of over-arching concepts or consensus. What has been produced so far comes nowhere near the vision and intellectual content of the architecture that emerged from Bretton Woods a half-century ago. This suggests that the needs and designs for such future architecture are too opaque and complex to be captured by a series of ad hoc meetings, papers and piece-meal proposals. What is required is an approach that is consecutive, comprehensive, and systemic. In the view of many observers, that can happen only if and when the United States takes seriously its role as leader of the new global economy. A decisive step in that direction would be for the United States to convene a "Bretton Wood II" Conference and invite leading experts from all major nations to contribute to the design of the economic and financial architecture for the coming decades. Works Cited Fischer, S. On the Need for an International Lender of Last Resort. Washington, D.C.: IMF. Lecture delivered at Joint Meeting of the American Economic Association and the American Finance Association, New York, 3 January 1999. Available at: http://www.imf.org/external/np/speeches/1999/010399.htm Soros, George (1998) The Crisis of Global Capitalism: Open Society Endangered. New York, Public Affairs. World Bank. East Asian Crisis: An Overview; and The Financial Sector: At the Center of the Crisis. East Asia: The Road to Recovery. New York: Oxford University Press, 1998, passim. Available at: http://www.worldbank.org/html/extpb/annrep98/env.htm Read More