The Asian Financial Crisis and the IMF Interventions - Case Study Example

THE ASIAN FINANCIAL CRISIS AND THE IMF INTERVENTIONS Introduction The International Monetary Fund was established with the aim of avoiding the possibility of another Great Depression and the outbreak of another war. It was hoped that with the establishment of a permanent body and forum on international monetary problems, the world would be able to avoid competitive devaluations, exchange restrictions and destructive economic policies that brought about those event. Despite great changes in the international economy since its founding, the IMF still stands firm on the objectives as found in its Articles of Agreement, which are: 1. To facilitate . . . the balanced growth of international trade and to contribute to . . . high levels of growth and real income; 2. To promote exchange rate stability, maintain orderly exchange arrangements among members , and to avoid competitive exchange depreciation; and 3. To provide members “with opportunities to correct maladjustments in their balance of payments, without resorting to measures destructive to national or international prosperity. This paper seeks to discuss the Asian Financial Crisis of 1997 with a view to tracing the causative events and analyzing the role that the IMF played in intervening and helping resolve the crisis. A discussion of criticisms against IMF policy prescriptions on affected countries will also be made. The IMF through the years before the 1970s The IMF has encouraged members to pursue sound economic policies and open their economies to trade and investment. At the same time it closely monitors developments in these countries for early signs of trouble so that these countries can be advised to take preventive action. As the record shows, the IMF has not always been successful in this task, justifying the body’s failure as due to the concerned countries not heeding or the body unable to grasp the full implications of what was taking place as in the case of the Asian Financial Crisis. Against criticisms of its failures, IMF is quick to point out that it did succeed in some of its efforts. It has cited its effective role in preventing chaos as result of the energy crisis of 1973-74 when it established a mechanism for recycling the surpluses oil-rich exporters and helping finance the deficits of affected countries. In 1989 and thereafter, after the Soviet Union disintegrated, it helped design and finance massive assistance to 26 countries in the process of transition from central planning to liberal market structures. In 1994-95, it played a central role in helping stave off Mexico’s financial collapse and in preventing the spread of the crisis to other markets. Despite the hardships that the IMF imposed on countries it assisted, it has continued to justify its actions by saying that without its help the consequences would have much worse. The International Monetary Fund (IMF), along with the International Bank for Reconstruction and Development, was established in July 1944 with the burden of regulating he monetary relationships among member economies, or private financial flows, and balance of payments adjustments. It was to oversee the exchange rate mechanism, the international payments system , and serve as the main source of liquidity for these countries and to facilitate international trade. Member countries contributed resources through a quota system in proportion to the relative sizes of their economies, and their votes in the Fund were likewise so apportioned. The Bretton Woods agreement was to be a regime where exchange rates were to be fixed though adjustable depending on the circumstances. If countries had difficulty defending their par value and experiencing foreign exchange shortages, they could borrow from the Fund in order to finance their balance of payments deficits without disturbing domestic macroeconomic policies or the stability of the international monetary system. If a country began to exceed its borrowing quota, the Fund imposed onerous conditions (known also as conditionality) backed by its richest members, principally the United States. These conditions pertained to domestic economic policies the Fund imposed on the borrowing country leading towards structural adjustment necessary to overcome the balance of payments deficit and thus maintain the fixed exchange rate system and the world payments equilibrium The IMF in the 1970s and after The problems in the international economic system under the fixed exchange rate system became worse in the early 1970s, and a de facto situation of floating rates of currencies emerged in 1973. In Jamaica, in 1976, the Fund’s charter was amended to usher in the era of floating exchange rates. In the 1980s IMF played a central role in the management of the debt crises of less developed countries, as coordinator of lending from developed countries to facilitate debt repayment, and in the process conditionality would be imposed in the form of painful restructuring programs that could help maintain stability of the international financial system but at a great short-term sacrifice for the borrowers.. Such a role of the IMF being the front of the developed countries holding the biggest number of votes in the fund became even more prominent in the late 1980s with the collapse of the Soviet bloc and the consequent increase in lending activity. This new regime of floating exchange rates and more liberalized global financial flows helped bring about frequent and severe crises to which developing countries were particularly vulnerable. Countries facing balance of payments problems ran to the IMF for financial assistance and they had to accept the bitter medicine of conditionality imposed by Fund. This by no means always led to stable economic conditions, and often they had to face another round of crisis and structural adjustment. Growing global liberalization, to some observers, has been accompanied by more poverty and increasing gap between the rich and poor countries. For this reason, the IMF has been the target of numerous criticisms regarding its policies and the powerful countries behind it. The Asian Financial Crisis During the previous decade prior to the 1997 Asian Financial Crisis, the Asian economies were leading the world in terms of export growth and growth in the gross domestic product. Countries such as Hong Kong, Singapore, Thailand, Malaysia, and South Korea were experiencing double digit growth in the external trade, composed mainly of high-technology products such as automobiles, semi-conductors and electronic products. Other countries such as the Philippines and Viet Nam were also experiencing growth not seen in years. The export-led growth resulted in an investment boom in an investment boom in commercial and residential real–estate industry as well as industrial assets and infrastructure in these countries. These construction projects were often financed from bank borrowings, and banks were willing to lend as optimism prevailed. The governments in Southeast Asia particularly were also involved by embarking on huge infrastructure projects. Governments also encourage the private sector of these countries to invest in the secondary sector in line with national development strategies, but often these were financed from foreign debt. Gross domestic investment in Southeast Asian countries Thailand, Indonesia and Malaysia grew in double-digit figures (but less than 10 per cent in South Korea), compared to 4 per cent in the United States and less than 1 per cent in highly developed economies. Because many of these industrial and real estate investments were based on very optimistic, and therefore unrealistic, projections, overcapacity soon developed as markets failed to grow as expected. In Thailand, particularly, an excess capacity in residential and commercial property caused many apartment units to be unoccupied. The excess the boom created was such that it was estimated that it would take 5 years for the vacant spaces to be filled. When markets fail to respond, prices drop, and the investors in the region, who borrowed funds both domestically and abroad, groaned under the huge burden of debt. They were not able to repay their huge amount of liabilities denominated in US dollars. Most of their governments had pegged their currencies to the US dollar, which policy became unrealistic; the governments found the pegs difficult to defend, so that their currencies had to depreciate against the US dollar. With the depreciation, it would take more local currency to buy the US currency with which to pay foreign loans. Currency depreciation also acted to increase the cost of borrowing, further exacerbating the risk of companies defaulting on their obligations. The high level of imports to finance industrial expansion and development projects also caused the balance of payments deficit to soar. The dollar peg could no longer be defended as current account deficits increased in Indonesia, Malaysia and Thailand on account of their imports from the United States, Japan and Europe. The Meltdown The Asian financial meltdown began in Thailand in mid-1997 when Thai financial institutions were nearing default as property developers, suffering from poor market response, failed to repay their loans. These financial institutions had borrowed US dollars from their counterparts abroad at low interest rests and re-lent them to domestic borrowers. Sensing the impending default, foreign investors fled the Thai stock market and converted their investments into US dollars for repatriation, causing the value of the baht to fall and the stock market to plunge 45 per cent. The baht dropped more than 50 per cent, which meant it would take twice the amount of baht to pay US dollar obligations. Consequently, the Thai government asked the International Monetary Fund for assistance in order to support the local currency, enable it to service its debt and finance international trade, and generally to restore the international credibility of the Thai baht. The IMF responded by lending the Thai government $17.2 billion in loans. The IMF required the Thai government to increase taxes, cut public spending, privatize some state-owned companies and raise interest rates. It also asked that insolvent financial institutions be closed. By December 1997, more than 56 financial institutions were shut down, laying off 16,000 workers, making the recession even worse. A wave of speculation hit other currencies in the region, not sparing the robust economies of Malaysia and Singapore, whose currencies also dropped significantly. Indonesia suffered the worst when its currency dropped steeply from Rp. 2,400 to Rp. 10,000, a fall of 75 per cent. In October, 1997, the IMF, together with the World Bank and the Asian Development Bank, put together a $37 billion rescue package for Indonesia. Indonesia was compelled to reduce public spending, remove subsidies on foodstuff and energy, balance the budget, close distressed banks, and dismantle crony capitalism. Soeharto vacillated over the terms of the IMF deal, which caused both the currency and the bourse to decline further. When Soeharto later relented and removed government subsidies, prices soared, causing riots on the streets, and he was forced to step down from power in May 1998. South Korea was not spared. Large amounts of investments to build up industrial capacity and inability to generate the sales to service debt, most of them short-term, caused South Korean companies to default on their obligations with banks and foreign lenders. The South Korean won dropped in value and stock market prices fell and many companies filed for bankruptcy. The won devalued from W1,000 to W1500 to the US dollar. With the economy in deep crisis, the government sought IMF help requesting $20 billion in standby credit. This was later found insufficient, and so the government and IMF agreed on $55 billion. The conditions imposed were: South Korea was to open its economy, would comply with the commitments to the World Trade Organization to eliminate trade-related subsidies and would remove restrictive import licensing requirements, among others. This meant opening up the economy to more foreign competition. IMF Policies and Conditions The amount of assistance provided by the IMF to three Asian countries Indonesia, South Korea and Thailand amounted to $110 billion, much bigger than the deal it had with Mexico in 1995 ($20 billion) and with Russia ($10 billion). All these loans had conditions attached. Mainly these addressed macroeconomic policies such as public spending and higher interest rates, privatization of state-owned assets, and deregulation to open up these economies to foreign trade and investments. The use of policy prescriptions regardless of specific, peculiar conditions obtaining in these countries has exposed the Fund to criticisms from many quarters. The standard solution to solve problems in countries with inflation and excessive public spending were being applied to countries suffering from private sector debt with deflationary implications. In the case of South Korea, the government had been running a healthy budget surplus for years prior to the crisis and inflation was low, yet it was forced to adopt solutions that logically should have applied to economies with high inflation. The IMF tried to refute these criticisms by saying that the objective was to restore the credibility of the Korean won by causing foreign investments to come in to buy Korean assets and thus improve the value of the yen. The IMF has apparently not been able to argue its case very convincingly and lacks defenders from the academic community. Harvard economist Jeffrey Sachs says that the IMF, with less than 1,000 members of its staff, lacks the expertise requited to do a good job. Proof of this is that it had been praising the Thai and South Korean economies before the crisis occurred, implying that it should have been forewarned and taken preemptive measures to prevent the crisis from happening. Dr. Sachs also proposed that the Fund also use the services of outside experts and that its operations be open to outside scrutiny. The Fund had become too powerful and “lacks any real accountability.”(Sacks, quoted in Hill, 2005) What is perhaps bothersome to many independent observers is the fact that the United States and other powerful economies are using the IMF for their purposes, dictating their policies on the body in order to open up foreign economies for easy pickings. Conclusions For the student of international trade and international business, the study of the Asian Financial Crisis is very instructive. International trade makes for efficiency and specialization to create benefits for both the importing and exporting countries based on the theory of comparative advantage. At the same time, the flow of money and capital can create problems of exchange rates and changes in currency values depending on demand and supply of currencies. When economies engage in over-optimistic investment spending and reckless borrowing, problems can result. This is exacerbated by panic and speculation. Coupled with balance of payments difficulties, when there is an imbalance between inflows and outflows of funds, all these factors can converge to trigger a financial crisis of the kind that occurred in Asia in 1997. Then the International Monetary Fund stands ready to provide assistance when requested, not only to help a country get back on its feet, but more importantly, in order to preserve international financial and economic equilibrium. Unfortunately, the implementation of IMF policies are not often perceived as fair to the affected economies, and the political control and influence of the powerful countries behind the IMF is often seen as unfavorable to developing countries. REFERENCES Hill, C.W.L (2005). International business: Competing in the global marketplace. New York: McGraw-Hill Krugman, P. R.& Obstfeld, M. (1991). International economics: Theory and policy. 2nd ed. New York, NY: HarperCollins Publishers http://www.imt.hk http://www.imf.org/external/np/exr/facts/asia.HTM Read More