Chapter 13 Causes and Implications of the Asian Crisis: The Role of Financial Sector, Domestic Policies and Contagion
- International Monetary Fund
- Published Date:
- January 2001
Time does not permit me to touch on all issues relating to the causes and implications of the Asian Crisis. Therefore, I will confine myself to some observations as to how the situation has been aggravated into a deeper and more prolonged crisis than initially envisaged, and thus turned out to be extremely difficult to resolve.
In my remarks, I will basically draw on experiences with which I am familiar, namely the case of Thailand. Most of the issues are, nonetheless, relevant to other cases as well.
2. CAUSES OF THE CRISIS
Let me start with a note on the causes of the crisis. I can be very brief at this point as it has already been well documented and in fact will be covered by many other speakers in this Conference. In my view, the important factors that contributed to the crisis, in order of development, include:
- Overreliance on foreign capital by the Asian emerging economies;
- Weakness of the financial system;
- Inappropriate macroeconomic policy responses to external problems and pressures;
- Sudden shift in foreign investors’ confidence, and overreactions in some cases, which led to contagion; and
- Vicious circle of the interactions between the banking crisis and weakening real economies, which led to a deeper and deeper recession.
A particular observation that I would like to draw your attention is that in the process of solving the problems that emerged in a country or a group of countries, a number of practical issues have arisen in the implementation of corrective policies and measures that were difficult to deal with. Therefore, the problems may not have been addressed in time or in some cases even deteriorated.
Among the important areas of crisis solution that I would like to discuss are (1) the reform of the financial sector; (2) the shift in macroeconomic policies; (3) the restructuring of the real economies; and (4) external factors outside the control of the authorities.
3.1 Reform of the financial sector
To correct the weaknesses in the financial sector, which were perhaps the most significant cause of the crisis, the strategy and set of policies are somewhat familiar. Among them are the closure of unviable financial institutions and the strengthening of the remaining institutions through recapitalization and improvement of asset quality. The action needs to be both decisive and comprehensive in order to quickly restore public confidence in the soundness of the banking system.
However, in practice, there are several obstacles to the implementation of desirable policy measures. Let me cite two specific examples.
First, on the closure of unviable institutions, while various options are available as regards implementation depending on the circumstances and the legal framework, there are some cases where the legal framework for banking supervision in a particular country does not allow an immediate intervention by the authorities to close troubled financial institutions. In Thailand, temporary measures, e.g., suspension of operations, had to be resorted to while the process of legal amendment was taking place. Such temporary measure was certainly not an optimal solution to the prevailing problem. On the contrary, it prolonged the problem and led to continued loss of confidence or even panic. The problem was further compounded by the deterioration of asset quality as a result of weakening economic activities, thus pushing more institutions into insolvency. As the solution was delayed, instability in the financial sector persisted and precipitated a fast deterioration of the real sector when the remaining financial institutions tried to protect themselves or took a defensive approach that led to a sharp curtailment of credit and subsequent problems in the real economies.
Another example is the recapitalization of financial institutions. While the need for recapitalization is clearly recognized, implementation at the time of an unstable financial environment is extremely difficult. Domestic sources of capital become scarce due to the reduction of wealth as well as the declining equity market. At the same time, foreign capital is not forthcoming, even without any restriction on foreign ownership, as the majority of investors adopt a wait-and-see attitude so long as the financial situation in the recipient country remains unstable.
These two examples illustrate the difficulties in taking immediate or timely actions to address financial sector weaknesses that partially accounted for the deepening and prolonging of the crisis.
3.2 Shift in macroeconomic policies
When the economy drifts into a recession, it is accepted that tight macroeconomic policies need to be relaxed to prevent a deeper recession.
On the fiscal side, some degree of relaxation is a natural process because tax revenue cannot be collected anyway and the shortfall contributes to a fiscal deficit. There are instances, however, when even a conscious effort to increase government spending to help stimulate the economy cannot be implemented immediately due to bureaucratic operational constraints. Often, government agencies need time to draw up a new activity program and actual disbursement of funds will lag even further. In this regard, a fiscal stimulus may not be as strong and effective as designed.
The shift in a monetary policy stance is more controversial. Tight monetary conditions and high interest rates are needed at an initial stage of the crisis in order to help stabilize foreign exchange markets. The difficult part in policy decision is how temporary this restrictive stance should be. When a satisfactory degree of stability in exchange markets is achieved, monetary policy should be eventually relaxed and interest rates allowed to decline to help relieve pressure on both financial institutions and corporate borrowers.
There are criticisms that tight monetary policy has been maintained for too long which acted to aggravate the problem and that relaxation has come too little and too late. It is indeed easy to assess the situation ex post, i.e., with the benefit of hindsight. For policymakers, the timing of a decision to shift the monetary policy stance early is not crystal clear and involves risks in both directions. If relaxation comes too soon, there is a risk of creating instability in exchange markets, which is undesirable. On the other hand, if relaxation comes too late, i.e., only after exchange rates have really been stabilized, there is a risk of exacerbating financial sector problems and recession. Therefore, the timing for the shift in monetary policy is always controversial and one cannot win both ways.
3.3 Restructuring of the real economies
At the initial phase, problems in the real sector were attributed mainly to the factors pertaining to the financial sector, e.g., the lack of credit availability and high debt servicing burden due to high interest rates and depreciating currencies. As the crisis persisted, however, other factors pertaining to the real sector itself started to exert their impacts, namely, the rising cost of production, the weakening demand for products from both external and domestic sources, and the decline in world commodity prices which adversely affected commodity exports. These explain why the real economies have deteriorated so fast and the prospect of recovery has drifted further away.
It is essential that actions be taken to resolve the real sector and financial sector problems simultaneously in order to break the vicious circle. This is not a matter of shifting macroeconomic policies only, but an action at the micro level is also essential. In the context of an industrial economy, it may sound unconventional and undesirable for the government to interfere with the functioning of market mechanisms and get involved with the problems at the sectoral level. In developing countries, on the other hand, there is scope for government involvement in the restructuring or rationalization of the corporate sector. There are several programs designed by international development organizations, such as the IBRD and ADB, for this purpose. Recently, the authorities in several countries have started to engage in the corporate debt restructuring process.
Notwithstanding the recognition of the need for real sector restructuring and the scope for government involvement, the process of policy implementation remains very difficult as the legal system, institutional framework, and infrastructure are not always readily available and the solution is most often sector-specific. Moreover, the completion of such process is long-term in nature and thus may delay other actions needed to accelerate economic recovery.
3.4 External factors
As part of the solution, the countries in crisis still need the resumption of foreign capital to help improve liquidity, recapitalize weak financial institutions and corporations, and stabilize exchange rates. Of course, it is desirable to obtain a better pattern and quality of capital inflows this time, i.e., more of long-term rather than short-term capital. However, the process of capital reflows has been slow so far, thus prolonging the crisis. This is understandable since once confidence has been lost, it is difficult to be regained in a short period of time. The wait-and-see or cautious approach seems to be adopted as foreign investors would prefer to see the economy bottoming out before starting to reinvest. At present, this seems like a moving target, as evidenced by the continued downward revisions of the WEO forecast or successive downward revisions of the recessionary trend in countries under fund programs. External financial assistance needed is slow to come and not contributing enough to the solution of the crisis situation.
4. CONCLUDING REMARKS
To conclude my observations regarding the delays in crisis resolution, I would like to note some common features that seem to emerge:
- Some crisis solutions are long-term in nature, or take time to accomplish; thus, one should not expect any quick outcomes, for example from financial sector reform and industrial restructuring.
- The countries in crisis are not prepared for quick implementation due to institutional, legal, and infrastructural constraints. This is because in good times or booming period, the weakness in the system is masked by superficial success and the authorities fail to lay appropriate groundwork to avert any possible crisis.
- Economic management of the crisis situation is often complicated by political uncertainties. Political factors serve as both the cause and the effect of the crisis. Therefore, political stability and political will to implement necessary and painful adjustments are yet another key to the solution of the crisis.