The Asian crisis of 1997–98 presented the international community with a volatile mixture of economic problems that defied traditional policy prescriptions. The combination and seriousness of balance of payments crises and financial system crises forced international organizations and governments to come up quickly with responses.
Even as the Asian economies return to the growth path, the debate over the response to the crisis continues. A leading figure in the academic community of economists has added her voice to the discussion of the causes of the crisis—and the policy response. Anne O. Krueger, professor of economics at Stanford University and director of the Stanford Institute for Economic Policy Research, presented her findings at an IMF Institute seminar on March 31. Her presentation, “Cronyism, Financial Fragility, and Exchange Rate Regimes: Lessons from Asia,” offered a wide-ranging view of the crisis, as well as a set of policy prescriptions potentially relevant to future emerging market crises.
Krueger, who is also a senior fellow at the Hoover Institution and a former World Bank vice president of economics and research, supported her presentation with two papers. The first, “Why Cronyism Is Bad for Economic Growth,” demonstrates that state-owned enterprises and cronyism have a similar impact on an economy and shows how “the role of domestic credit expansion in an environment of cronyism can play much the same role as a fiscal deficit in countries where state-owned enterprises predominate.” The second paper, “Conflicting Demands on the International Monetary Fund,” analyzes the difficulties presented by the confluence of factors during the Asian crisis.
Krueger blended these themes, but focused mainly on the policy response to the conflicting challenges of the external crisis represented by the collapse of Asia’s system of fixed exchange rates and the internal crises in financial systems. Complicating the Asian crisis—in contrast to what Krueger termed the “traditional” balance of payments crisis—was the underdeveloped state of the region’s financial systems.
The huge increase in domestic credit throughout Asia in the mid-1990s brought about a corresponding sharp rise in foreign borrowing, Krueger said. These developments were exacerbated by cronyism and the assumption by borrowers that they were not facing a foreign exchange risk because of the region’s system of pegged exchange rates. The devaluations that began with the Thai baht in July 1997 led to the rapid impairment of balance sheets throughout the region.
The correct policy response to the combined crises, in Krueger’s view, should have been to address the balance of payments crisis first. She recognized that the traditional remedy—an exchange rate devaluation and tighter fiscal and monetary policy—increased the foreign liabilities of Asian banks and corporations and exacerbated the ensuing financial system crisis. In her view, however, balance of payments problems can be addressed in the short term, but banking crises inevitably will involve difficult and long-term solutions.
Krueger offered several policy lessons that she said could help prevent future crises.
First, the Asian crisis underlined the limited options now available in terms of foreign exchange regimes. There is no alternative to either a “genuine float” or dollarization, she said, and “no middle ground” that can successfully accommodate and adapt to derivatives, rapid communications, the impossibility of restricting short-term borrowing abroad, and the ease of money transfers.
Second, Krueger said, countries need to maintain high levels of reserves, ideally along with a current account surplus, to reduce the potential for a crisis similar to the one that struck Asia. While a freely floating currency would reduce the risk of speculation against a country’s currency, it would not eliminate it altogether. Thus, the continued need for reserves. Unless a country maintains enough reserves to cover more than four months of exports, Krueger said, it is ill-advised to post current account deficits larger than 3 percent of GDP.
Third, rapid expansion of domestic credit is extremely dangerous, Krueger said. Such growth for longer than one or two years is not sustainable—in large measure because it is not possible to check the quality of lending even in well-supervised financial systems. Thus, it is essential that adequate prudential supervision be put in place, along with appropriate levels of bank capitalization. Supervision is crucial to the broader issue of maintaining a well-functioning financial system to fund a high real rate of return, which, in turn, requires not only well-run domestic banks but also access to the domestic market by foreign banks.
Mitigating future crises
Krueger offered a simple but controversial proposal intended to reduce the cost of future crises. She suggested that financial crises be “delinked” from balance of payments crises. Mechanisms to protect borrowers from foreign currency liabilities should be in place to augment an appropriate foreign exchange regime and a strong banking system. She proposed a system under which domestic borrowers would no longer be required to repay international borrowings in foreign currency. Rather, they would be required to repay such loans in their own currency. Under this system, the lender would be obliged to accept the foreign exchange risk. To reinforce this approach, international lenders would not be permitted to seek enforcement of contracts in local courts. Krueger suggested that such reforms could be put in place if the Group of Seven nations backed them. Although it is impossible to prevent balance of payments crises or financial system crises from ever happening, she argued that her proposal would make combined crises less likely.