Chapter 17 Comment on “Asian Crisis: Causes and Remedies”
- International Monetary Fund
- Published Date:
- January 2001
The IMF has been barraged by criticism from all sides—from debtor countries and creditors, from the left and from the right, for doing too much and for doing too little. Some want the IMF abolished. Others want it to have greatly augmented resources. In the face of such pervasive and sweeping criticism one perversely wonders if the IMF may not have been doing something right after all. Aghevli makes the case that it has.
The international financial markets did not foresee the outbreak of the crisis. But the IMF got it partly right. The fund saw that Thailand was headed for a crisis. Indeed the classic signs had been apparent for at least a year—slowing export growth, a currency appreciating in real effective terms, a growing current account deficit financed by short-term capital inflows, rapid domestic credit growth, and a banking system decapitalized by the collapse of a real estate bubble. Unfortunately, the fund was unable to persuade the government to take corrective action and it failed to anticipate that other Southeast Asian countries would be vulnerable to contagion from the crisis in Thailand. The collapse of the Thai baht led investors to ask which other countries were also vulnerable. They first focused on countries that competed with Thailand in export markets—Indonesia, the Philippines, and Malaysia. And then, investors pondered which countries shared the vulnerability of Thailand and Indonesia to a crisis because of a weak financial sector. Like Thailand, Korea had a decapitalized banking system with large short-term foreign-currency-denominated liabilities and it too succumbed. The IMF did not predict a crisis of such magnitude, as Bijan Aghevli admits, and did little to prevent it.
I largely agree with Aghevlis’ assessment of what went wrong, although I would place a greater emphasis on the weakness of the financial and corporate sectors. Excessive exchange rate rigidity was clearly part of the problem, but there were deeper structural problems as well. If an overvalued exchange rate had been the only problem, a quick depreciation should have restored equilibrium. But the exchange rate crisis interacted with an already weakened banking system. This was the Achilles’ heel of the Asian miracle. The Asian model of development emphasized high savings channeled through a protected banking system to highly leveraged firms with close ties to the banks and the government. The Asian Tigers achieved remarkable, sustained growth rates for three decades with this model. But it proved inadequate for the complexities of a modern industrial economy competing in world markets. Insulation from market discipline—competition from other financial institutions and the threat of corporate takeover—has meant that a significant amount of investment had been unproductive. Examples include the creation of a car industry in Indonesia, still more steel mills in Korea, but most of all commercial real estate bubbles. A real estate bubble undermined the creditworthiness of banks before the foreign exchange crisis in each of the most seriously affected countries. Banks thought they had good real estate collateral and, indeed, relied on it rather than credit analysis for many corporate loans. And when the financial system was liberalized to permit banks to finance this kind of investment partly with short-term foreign borrowing the countries’ vulnerability to a foreign exchange crisis grew.
With the benefit of hindsight, a darker side of the Asian miracle is apparent. High leverage and the lack of transparency raise concerns about solvency of firms and their bank lenders when a shock occurs. Lack of external audits and consolidated accounts make firms opaque to their lenders and the public. Weak accounting practices and minimal disclosure standards make it difficult to distinguish sound firms from unsound firms and exacerbate credit rationing. The cooperation between business and government, which some Western observers found so attractive, begins to look more like collusion, cronyism, and corruption. Concern over the soundness of the financial system and the ability of the government to make good on implicit guarantees led to capital flight and when governments ran out of reserves to support the exchange rate, they turned to the Fund.
As Aghevli reports, the IMF responded with massive loans to countries in order to mitigate the collapse of the exchange rate conditional upon (1) tighter fiscal policy, (2) tighter monetary policy, and (3) structural reform of the financial and corporate sector. The fund has been heavily criticized on all three aspects of these programs. The fiscal targets gave rise to the charge that the IMF was applying a one-size-fits-all policy, originally developed for fiscally profligate Latin American countries, to fiscally conservative Asian countries. The fund was undoubtedly correct that restructuring costs facing governments will be huge—probably well over twenty percent of GDP in the most seriously affected countries. Indeed, the market’s recognition of the magnitude of these future claims on taxpayers may have contributed to capital flight. But the depth of the crisis was surely not an appropriate time to start paying for the clean up, particularly at a time when Japan was in recession and growth had virtually halted in the other ASEAN countries. To its credit, the IMF quickly reversed course and eased fiscal conditions.
The IMF’s insistence on higher interest rates has been bitterly contested. Critics charge that higher interest rates are devastating to highly leveraged financial systems already encumbered by massive nonperforming loans. And, of course, they are correct. But what is the alternative? A plummeting exchange rate is also punishing on an economy with substantial unhedged foreign exchange liabilities. Moreover, it risks setting off a burst of inflation that will require still greater monetary austerity in the future. To my mind, the decisive argument is that higher interest rates are necessary to halt capital flight. They signal the authorities’ intent to stabilize the exchange rate and make clear to domestic residents that they cannot convert their liquid assets into foreign currency and still maintain control over other domestic assets. Moreover, higher interest rates can be reversed (and, indeed, have been in Korea and Thailand) with less disruption than an excessive depreciation of the exchange rate. Unfortunately, once a crisis erupts, hard choices are inescapable.
Feldstein and others have criticized the IMF’s insistence on structural reform of the financial sector as an unwarranted intrusion into institutional arrangements that are properly a matter of national choice. They would prefer that the IMF tend to its macroeconomic knitting and not meddle in structural and institutional reforms. But, it is hard to imagine a sustainable recovery that does not address the underlying problems of corporate governance, bankruptcy procedures, disclosure practices, financial supervision and regulation. I think that the emphasis on structural reform is crucial, but it is an enormously ambitious agenda that surely demands close cooperation with the World Bank.
Finally, I would like to raise a concern about the IMF programs that Aghevli does not address—the risk that a country’s access to the IMF engenders moral hazard. This has two aspects: moral hazard vis-à-vis borrower governments and vis-à-vis foreign investors. Does access to the IMF undermine incentives for countries to undertake needed structural reform? It is certainly true that no country approaches the IMF lightly. The kind of medicine that the IMF asks the government to administer will usually revive the economy in the long run, but is usually fatal to the government that administers it. Indeed, governments in Thailand, South Korea and Indonesia fell shortly after administering IMF remedies. Nonetheless, the fundamental rationale for IMF assistance is that it will make adjustment less painful than it would otherwise be. Because short-run elasticities are always lower than longer-run elasticities, financing permits adjustment to take place in a way that is less disruptive to the home country and the rest of the world. Those who emphasize perverse incentives for borrower governments note that Chile, which did not have access to the fund during the 1980s, took much more effective reforms than Mexico, which has had a series of IMF programs for the last two decades. (See Meltzer’s contribution to this volume.) They also note that Taiwan, which no longer belongs to the IMF, has pursued policies that largely insulated it from the Asian crisis. But even if one doubts the importance of the moral hazard problem vis-à-vis governments, the impact of IMF programs on international investors still deserves attention.
To be sure, not all foreign investors benefit from IMF stabilization programs. Usually equity investors and most bondholders suffer heavy losses when a country experiences a foreign exchange crisis. But short-term lenders, especially short-term interbank lenders have often been protected. This pattern was set in the 1995 Mexican bailout where all holders of Mexican Tessobonos were guaranteed. It was repeated most explicitly in the case of South Korea where IMF funds flowed through the central bank to Korean banks to foreign banks with breath-taking speed. Earlier this year an agreement was negotiated with bank creditors to South Korea in which the bank creditors agreed to reschedule their interbank claims for a three year term at the U.S. Treasury bill rate plus 250 basis points in return for a government guarantee. The IMF likes to boast that this is bailing-in the banks rather than bailing them out. Yet it surely appears to reward short-term lending which contributed to South Korea’s vulnerability to a foreign exchange crisis. The broader problem is that investors who believe they will benefit from an implicit guarantee in the event of a crisis have no incentive to monitor or discipline the borrower. This may contribute to making the whole system more vulnerable to crises.
Ironically, international capital adequacy rules also provide incentives for bank lenders to keep their maturities short. Bank lenders to banks in Thailand and Indonesia were required to hold only one-fifth as much capital against their short-term claims as against their claims with a maturity greater than one year.
How could this perverse incentive be corrected? Several policy changes are possible. Borrower countries could discourage short-term foreign borrowing by making use of controls on short-term capital inflows like Chile. In addition, borrower countries could discourage short-term foreign borrowing by eliminating the tax deductibility of interest payments on short-term foreign debt. The Basle Committee could eliminate the favorable treatment given to short-term interbank claims. And the IMF could require that countries enact legislation that would impose a haircut on short-term creditors who attempt to withdraw during a crisis. (See Litan’s contribution to this volume.)
Of course, the first rule of policy changes should be “Do no harm.” Would such measures make matters worse? One cannot dismiss fears that harsh treatment of creditors would worsen contagion. But neither can one dismiss concerns that increasing IMF resources without ameliorating the moral hazard problem will only succeed in increasing the frequency and severity of crises.
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