Chapter 46 Lessons from the Asian Crisis for the International Financial System
- International Monetary Fund
- Published Date:
- January 2001
One of the criticisms of the International Monetary Fund programs for the Asian crisis countries that is often heard concerns the very high interest rates the programs demand. The Asian countries complain that these high interest rates seriously depressed the regional economy. I will begin by commenting on the pros and cons of the very high interest rate policy, especially in relation to the management of the exchange rate. I will then move on to measures to overcome the dilemma between monetary policy easing and exchange rate stability.
1. THE DEFENSE OF THE EXCHANGE RATE
The IMF advised the Asian countries to sharply raise their interest rates in order to defend their exchange rates during the currency crisis. A fundamental question in this regard is whether a very rigid exchange rate regime, such as a fixed rate, was appropriate. The crisis has taught us a very important lesson about exchange rate regimes. It now seems that a majority of us do not support rigid exchange rate regimes for emerging market countries, except for the currency board arrangement. In the case of the currency board arrangement, it is recognized that certain strict conditions should be met. Generally speaking, a flexible exchange rate arrangement has merit for emerging market countries as it does not expose their currencies to the risk of a one-sided bet by speculators.
If the Asian countries had moved to a flexible exchange rate regime before the crisis, their stake in defending a specific level of exchange rate would not have become so high, and the interest rates might not have had to be raised so much. However, while flexibility in exchange rate management is desirable, a large and rapid depreciation of the currency is devastating for a country. As was widely seen during the Asian crisis, the rapid depreciation of currencies caused a large expansion of the external debt of banks and corporations, and a number of them failed. As Stanley Fischer says, “while the burdens imposed by higher interest rates were temporary, those caused by bigger devaluations would have been permanent.”1 I will go back to the issue of prolonged high interest rates later.
On balance, I think we can conclude that a certain amount of stability of exchange rate is an essential element of a sound economic framework. A sharp rise in interest rates is a necessary tool to defend a currency. When a currency is heavily attacked, a sharp rise in interest rates is necessary, or confidence in the currency could collapse. As the Asian countries were not generally accustomed to very tight monetary policy, their interest rates did not rise quickly and long enough to stabilize their currencies, especially in the early stages of the crisis.
However, in order to defend currencies, other effective tools should also be mobilized. Official market intervention can be effective especially when market sentiment is diverse, and it would strengthen tight monetary policy if the intervention is not sterilized. It is true that some Asian countries wasted a large amount of their foreign reserves vainly trying just to maintain the fixed rates. And it was strongly felt that official market intervention would not have been useful for these countries. This view also strengthened the belief that currencies should be defended solely through raising interest rates. But, the use of official market intervention should not have been ruled out.
2. VERY HIGH INTEREST RATES FOR A PROLONGED PERIOD OR FOR AN ENTIRE REGION
The next question is, if instability in foreign exchange markets does not abate, should very high interest rates be maintained for a prolonged period of time. This is a special concern for Asian countries, because their corporations generally borrow heavily relative to their equity capital, and very high interest rates would eat up their profits. It can be argued that such a corporate financing structure should be changed. However, this is a long-term agenda item for the Asian economies: it is not something that can be done overnight. A more acute issue in the short run is to avoid widespread corporate failures, as these would further depress the economy and increase social tension.
Concern about very high interest rates will increase if a crisis spreads beyond a particular country. Then the tight monetary policy of one country would adversely affect the economic conditions of others, and vice versa. If interest rates are very high, the interplay among the countries in the region would seriously affect the regional economy as a whole. For an individual country, tight fiscal and monetary policies are usually the right response to a currency crisis. However, if an entire region is in crisis, and if each country pursues tight economic policies, the region may become trapped in a depression, and no country will be able to escape from the crisis. This is a fallacy of composition.
As the current crisis is spreading to Latin America and to large investors in the industrial countries, it could now threaten the stability of the global economy. Reflecting the growing concern about global deflationary pressure, global easing of monetary policy is being widely suggested. Why could we not have promoted such reflationary measures when the crisis began to spread throughout Asia? Certainly, a key player in the Asian region is Japan, and Japan’s continued recession is very disappointing. But, could the other countries of the region have taken a reflationary stance by reducing their interest rates? Regrettably, the answer is no, since the easing of monetary policy in one country would have led to a depreciation of its currency and, in a regional context, the depreciation of one currency would have provoked others to follow suit, and the fear of competitive devaluation would quickly have grown. This is another kind of fallacy of composition.
3. OPTIONS OTHER THAN CAPITAL CONTROLS
Thus, if we stick to the present policy framework we end up with no solutions. That is why Paul Krugman proposed a change of policy framework from plan A—the orthodox policies which are the current IMF prescription—to plan B—capital controls.2 He rightly argues that the free movement of short-term capital hampers the easing of monetary policy, which is necessary in order to avoid prolonged economic depression. However, before jumping to capital controls, we had better check carefully whether other approaches really are useless.
3.1 Private creditor involvement
In this context, the issue of earlier involvement of private creditors in crisis situations is something that could be considered. In the case of Korea, when private creditors accepted a voluntary roll over of short-term lending and the rescheduling of debt repayments at the end of last year, the outflow of funds subsided significantly. The Korean situation had improved by then, and the exchange rate has started to rise. If we had undertaken a bailing-in operation of private creditors earlier in the crisis, the amount of outflow could have been much smaller. We were hesitant to ask private creditors to take on the burden, however, as it would have changed their relationship with debtors away from the status of “business as usual.” In reality, however, the business as usual status could not be maintained as the crisis had already begun.
The issue of private sector involvement is a very complicated one, and there are many questions that have to be answered from the legal, technical, and practical standpoints. We have to study further in order to maximize the benefits and find a practical and workable solution. I would point out that private sector involvement could also have some side effects. For debtors, it could lesson their motivation to make their scheduled repayments, if they expect there will be semi-automatic refinancing or rescheduling in crisis situations. For creditors, it could hamper the provision of new money if they expect refinancing or rescheduling at an earlier stage. In essence, by formalizing the early bailing-in of private creditors, the constructive ambiguity of the creditors’ and debtors’ status could be lost.
3.2 Regional approach
Another approach is to explore more coherent policies region-wide as soon as a crisis becomes regional. Of course, regional surveillance is one vehicle for this purpose. In the case of Asia, many meetings have been held for the purpose of regional surveillance, but we can strengthen the surveillance by making our regional policy discussion more substantive. While we have had many discussions on individual countries, there has not been sufficient analysis of economic linkage and aggregate policy effects in the region. The discussion on policies and strategy for the economic recovery of the region as a whole should be pursued vigorously, reflecting the recent shift in global policy thinking from inflation prevention to fostering growth. A recent Japanese proposal, the so-called Miyazawa Plan, will contribute to regional recovery along these lines.
In this connection, I should like to comment on the controversial idea of an Asian regional financing mechanism, which was informally but actively discussed one year ago. If a crisis in one or two countries in a region appears likely to extend to the region as a whole, the injection of massive liquidity would help greatly avoid a region-wide crisis. If international financial institutions cannot provide the necessary liquidity because of limited resources, such a regional financing mechanism would be very useful in preventing contagion and mitigating a credit crunch. What needs to be discussed is how much liquidity is needed and how much could be provided by the region itself. When we discussed the idea of a regional financing mechanism for Asia last year, both the proponents and the opponents forgot to focus on the issue of liquidity, and unfortunately the discussion was confused by various geopolitical considerations.
4. CAPITAL CONTROLS
Finally, I would like to touch upon the issue of capital controls. What has been amazing in recent weeks is the shift in the financial community’s opinion of capital controls. Once it was taboo to even mention capital controls. But now it seems that many of us, albeit reluctantly, accept the idea of capital controls in extreme circumstances, provided measures are not taken unilaterally. It is surprising when we remember that even rather modest controls on capital inflow, as in Chile, were not universally accepted when we discussed the issue several months ago. The recent crisis in some hedge funds, and its serious adverse impact on leading private financial institutions, must have changed the financial community’s perceptions. To cope with the current very unusual circumstances, it is probably necessary to consider very unusual measures.
That said, our knowledge and analysis of capital controls are insufficient since this was for so long a taboo subject. We need more analysis on what kind of controls on capital movements would be most effective. We also need to look at possible economic and social distortions resulting from capital controls. Open discussion on this subject should be welcomed, as it would clarify the merits and limits of this unorthodox measure.
Acknowledgment The views expressed are those of the author and not necessarily those of the Japanese government or the IMF.