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Web-only Exclusives
November 30, 2000

From Our Correspondent: Hirohito and the War
A conversation with biographer Herbert Bix

From Our Correspondent: A Rough Road Ahead
Bad news for the Philippines - and some others

From Our Correspondent: Making Enemies
Indonesia needs friends. So why is it picking fights?

Asiaweek Time Asia Now Asiaweek story

A YEAR OF UPHEAVAL

The IMF was right on high interest rates and immediate restructuring

By Stanley Fischer, First Deputy Managing Director, International Monetary Fund


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THE ASIAN CRISIS HAS BEEN all the more of a shock because it came after a sustained period of superb economic performance, so outstanding that it lulled policymakers, borrowers, lenders and economic analysts into complacency. While historians will have the last word on causes and responses, we need to make decisions in real time - yet recognizing that we must continually re-examine our conclusions and adjust policies as circumstances change. Here are some tentative judgments.

What brought on the crisis?

The build-up of structural problems in the financial and corporate sectors, and, to varying degrees, inadequate macroeconomic policies, caused the crisis in East Asia. Movements in the yen-dollar rate and large-scale - particularly short-term - capital inflows, funded at low rates from the major capital markets, were contributors. Contagion effects helped the crisis spread.

In Thailand, the current-account deficit was very large. The baht had appreciated along with the dollar, to which it was virtually pegged. Export performance worsened sharply at the end of 1996. There were many signs of domestic overheating, including a property boom. Thailand's weak financial condition made the situation more difficult. The pegged exchange rate and the encouragement of foreign borrowing through the Bangkok International Banking Facility led to excessive exposure to foreign-exchange risk among domestic financial institutions and corporations. Lax prudential rules and oversight permitted bank loan portfolios to deteriorate sharply. Corporations were highly leveraged, making them and their creditor banks extremely vulnerable to both devaluation and the higher interest rates needed to contain it.

These also applied to Indonesia and Korea. The baht devaluation not only affected the competitive positions of others in East Asia, but also occasioned a closer look at the financial situation of these countries. The conclusion was that they shared many of Thailand's structural problems. The crisis spread rapidly to the neighbors.

Developments in the advanced economies and global financial markets contributed to the crisis. Low interest rates in Europe and Japan encouraged large-scale private capital flows to emerging markets in search of higher yields, in many cases without due regard for the potential risks. Currencies pegged to the dollar strengthened along with the dollar-yen rate in 1995 and 1996, helping worsen East Asian export performance. Most important, the weakness of the Japanese economy after the second quarter of 1997 made it more difficult for the crisis countries to export their way out of recession, as Mexico had done in 1995. The weakening of the yen in recent weeks threatens to intensify the crisis.

How the IMF responded

Interest-rate policy has been the most controversial element in IMF-supported programs. In Thailand, as later in Korea, the central bank's unwillingness to defend the local currency by raising interest rates meant that net foreign-currency reserves had essentially disappeared by the time governments turned to the IMF. They then faced a choice: raise interest rates temporarily to stabilize the currency and rebuild reserves, or keep interest rates low and let the currency devalue further. There would be a burden either way: the temporary one of higher interest costs, for the first alternative, and the permanent burden of servicing dollar debt with a more devalued currency, for the second. The choice depended on how far the exchange rate had moved. East Asian exchange rates had certainly moved much more than justified by any estimates of their initial overvaluation.

The decision to try to stabilize exchange rates by temporarily raising interest rates was the right one. In both Thailand and Korea, the exchange rate has now stabilized and interest rates are coming down. It is an illusion to imagine that there is some painless way of restoring confidence and stability once a country has lost its reserves and is in a crisis. It is also an illusion to imagine that by keeping interest rates low, East Asian countries could have avoided the difficult tasks and costs of financial and corporate restructuring, as the case of Japan illustrates. The real issue is how rapidly the underlying structural problems in the financial and corporate sectors are dealt with. The faster that is done, the shorter the period of pain, and the sooner the return to growth.

Except in Thailand, where the current account deficit was large, the initial fiscal adjustments in IMF-supported programs were small. They were designed to cover the interest costs of financial-sector restructuring. Subsequently, as economic activity slowed, budget deficits widened as automatic stabilizers were allowed to operate. Indeed, in some crisis countries, the IMF staff has found itself in the unusual position of urging larger deficits than government officials wanted.

Safety nets for the poor

The crisis has caused social distress in the affected countries, most profoundly in Indonesia. The best remedy is to return to economic growth as soon as possible. That requires firm implementation of IMF-supported programs. But we also need to mitigate the hardships of the poor. When national budgets were cut, the IMF tried to preserve essential social spending. In Indonesia, fuel price increases were concentrated on products most used by the better-off. The prices of cooking oil and kerosene bought by the poor were not raised as much. The price of rice was kept unchanged. In the IMF's most recent Indonesian program, large subsidies are maintained to protect the poor. We are also working closely with the World Bank in helping maintain food supplies and distribution, and better targeting of subsidies.

The governments that took Korea, Indonesia and Thailand into crisis have not survived. That is not because citizens in a democratic society will not accept difficult measures. It is because governments that allow crises to develop - or have otherwise lost their legitimacy, perhaps because of concerns about governance - have lost support. For a long time it was argued in Latin America that only authoritarian governments could stabilize and reform economies. Now, with the entire continent democratic, with Argentina and Brazil among others having achieved miracles of stabilization and reform, that argument is no longer heard.

Why restructuring should continue

One year on, what should we have done differently? No doubt, many things. We should have been more insistent in our warnings to the Thai government before the crisis. We should have emphasized the dangers of financial fragility to the Korean government. We should have paid more attention to the rapid build-up of external short-term debt. We should also have been more alert to the magnitude of possible contagion and spillover effects. But before we overdo the self-flagellation, we should also remind ourselves that we did warn countries about their structural vulnerabilities, and that if they had acted sooner, this crisis would not have been as deep or as far-ranging as it has been. The credit crunch that has emerged has been caused less by high interest rates and more by the underlying difficulties of restructuring the economy.

The notion that IMF-supported programs should have delayed tackling financial and corporate restructuring is therefore profoundly wrong. Of course, these are immensely difficult and lengthy processes. All the more reason to attack them vigorously and immediately, for these problems do not go away if they are not tackled. They fester. We have certainly seen that in Japan.

Restructuring the banking and financial sector has been at the heart of the IMF-supported adjustment programs in Asia. The use of public funds to protect depositors and recapitalize banks is unavoidable. But foreign capital and expertise can play an important role in recapitalization and improvement of efficiency. Fears of a foreign takeover are exaggerated. Asian countries have a long way to go before they need to worry about excessive foreign ownership. Unfortunately, foreigners are not flocking to buy banks and firms. It would be better if they were, for this would make restructuring cheaper - and more rapid - for the citizens of the countries in crisis.

While we do not know how long this crisis will last, we do know it will be over sooner if countries get on with their economic programs and the international community provides financial support. The Philippines is still growing. Expansion could return to Korea and Thailand late this year or early next year. Although it is more difficult at this stage to know when the recovery will begin in Indonesia, there should be no doubt about the determination of the Indonesian team of ministers to implement the nation's economic program. But the future depends not only on the policies pursued by the crisis countries. It also depends very importantly on the policies of others in the region, most of all Japan.


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