Reforming the International Monetary and Financial System

Comments: The Balance Between Structural and Macroeconomic Adjustment

Alexander Swoboda, and Peter Kenen
Published Date:
December 2000
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My comments on the issue of the balance between adjustment and financing will be based on the recent experiences of Korea and other East Asian countries.

If we look at what has actually happened in the East Asian countries since the crisis, it is obvious that the balance between adjustment and financing was unduly shifted to adjustment. But it is also obvious that when the IMF programs were designed and negotiated with these countries, nobody expected that there would be such severe economic contractions. That is, the shift in the balance was neither intended nor expected. For instance, when the program was negotiated in Korea, the IMF and the Korean authorities projected about 3 percent annual economic growth and a current account deficit about US$4 billion. What actually happened, however, was growth of about minus 6 percent and a US$40 billion current account surplus. That is, the current account position changed from minus 2 percent of GDP to 13 percent of GDP within a year. Similar experiences are observed in other East Asian countries. This happened in spite of the fact that the IMF programs were revised substantially in the middle of 1998 from stabilization toward expansion. Why then did this happen?

The main reason for such severe contractions was a drastic reversal of short-term capital flows and the insufficient size of the financing packages available to these countries, which failed to stabilize the exchange market. Consequently, exchange rate depreciation was much larger than expected, and this had an enormous balance sheet effect on the corporate sector, which had a large amount of foreign-currency-denominated debt. In other words, with such a drastic reversal of capital flows and almost completely depleted foreign exchange reserves when the IMF program started, the major burden of adjustment had to fall on the current account balance and on economic activity.

Second, the high interest rate policy in the initial period of the IMF program—although inevitable in such a situation and although the increase in interest rates was not exceptionally high—had a very strong contractionary effect. Corporate entities in these economies are highly leveraged, and their debts are mostly short term. Thus, high interest rate policy caused a market expectation of high future bankruptcy rates and an increase in nonperforming assets of the banking sector, and thereby sharply discouraged investment demand. That is, it discouraged not only the borrowings in local currency for speculation on foreign currencies, but also foreign investment by aggravating the prospects for domestic economic performance. Consequently, it failed to stabilize the exchange market. The exchange market in Korea, for instance, started to stabilize only after the rescheduling of short-term bank loans.

Third, the initial tight monetary policy was implemented simultaneously with financial restructuring measures. The recent IMF programs have increasingly emphasized structural adjustment measures. This is the right approach, given the nature of problems faced by the crisis-hit countries. The crisis in Korea and other Asian countries, for example, had been caused more by structural weakness than by macroeconomic imbalances. Thus, it is reasonable to emphasize structural adjustment, especially financial restructuring measures. But when the financial restructuring was implemented within a tight timetable, its effects reinforced those of the high interest rate policy and became very contractionary. The high interest rate policy made the problem of nonperforming assets of banks more serious and increased the risk and uncertainty involved in loans by financial institutions. What should be done to achieve a better balance between adjustment and financing?

First, a larger amount of emergency financing should be available to the countries that have been hit by a sudden reversal of short-term capital flows. In this connection, the resources of the IMF should be substantially increased. The current size of IMF resources, when the present quota increase is completed, is only about one-ninth of what it was in 1945, when compared to the value of global trade, and one-third when compared to the output of its member states (Fischer, 1999). But at the same time, of course, the problem of moral hazard that can arise from this availability should be properly addressed, although it would be impossible to eliminate it completely. The alternative would be for countries to accumulate large amounts of foreign reserves. But this would be very costly to the countries and to the global economy, since it can cause trade frictions and contraction of global trade.

Second, macroeconomic adjustment under IMF programs can become better adapted to individual countries’ economic structure and can be better coordinated with the structural adjustment programs. The sharper-thanexpected contraction of the East Asian economies might have something to do with the more open and private-sector-oriented nature of these economies in comparison with those of Eastern Europe or Latin America, where the IMF has dealt with crises in the past (see Table 1). The openness and private sector orientation of the Asian economies may have allowed their current account adjustment to be much more responsive to the austerity programs than economies that are more closed and dominated by the public sector (see Cho and Rhee, 1999). As economies the world over are becoming more open and more private sector oriented, adjustment programs may need to be better aligned with these changing circumstances. Furthermore, macroeconomic adjustment programs could be less tight when there is also an urgent need for financial restructuring, because the latter itself would be contractionary.

Table 1.Openness and Private Sector Orientation in Selected Countries(Government expenditures)

as Percent of GDP
Government Expenditure

as Percent of GDP
Source: International Financial Statistics, IMF.
Source: International Financial Statistics, IMF.

Third, establishing regional financing facilities to complement IMF and other multilateral institutions’ resources can also be of help. The East Asian crisis was accelerated by the simultaneous contraction of the individual countries in the region. Thus, it would be of collective benefit for the regional economy if regional funds or facilities were available to prevent a severe contraction of an economy that is facing a crisis. Also, it would benefit the global economy by preventing competitive devaluation and trade frictions (McKinnon, 1999).

Fourth, strong adjustment nevertheless has its own merit. Strong adjustment and severe economic contraction entail big costs to the economies involved in terms of intensified social tension and aggravated income distribution. At the same time, however, the sharp adjustment itself laid the groundwork for a quick economic recovery in these countries. The only source of foreign exchange for the East Asian economies during the first year of the crisis was the current account surplus. Without such a sharply expanded current account surplus, it would not have been possible for these economies to build up their foreign exchange reserves and recover foreign confidence that quickly. Thus, while a careful balance between adjustment and financing should be sought, the importance of strong adjustment in crisis-hit countries in the current international financial market environment—where private foreign investors’ assessments on the health of the economy matter greatly—should also be underlined.

Finally, we should also pay attention to the balance between structural adjustment and financing, not just the balance between macroeconomic adjustment and financing. Here, also, there is a trade-off. But here the trade-off is between pressure on the progress of structural adjustment and the availability of private financing, rather than official financing. If we look at the progress of structural adjustment in the Asian crisis countries, we may not be able to give the same answers, namely, that the balance was shifted unduly toward adjustment. Further structural reforms have to be carried out in most of these economies. If private capital starts to flow in again, the structural adjustment efforts may slow down. That is, we may still need the private capital market to play a greater disciplinary role in the future than it has done in the past. The availability of private financing should be more closely linked to the actual progress made or to the prospects of structural adjustment, rather than to the prospect for short-term stock market performance. Large-scale official financing that bailed out private creditors has given rise to moral hazard and undermined the disciplinary role of the private capital market. When there are signs of economic recovery in a crisis-hit country, private capital starts to rush into the country even without significant progress in structural adjustment, which could reduce the pressure for the adjustment. One way to address this problem is to “bail in” the private creditors when a crisis occurs, a topic which will be discussed in detail in the next chapter.


    ChoYoon Je and ChangyongRhee1999“Macroeconomic Views of the East Asian Crisis,”Working Paper No. 99–03 (Sogang Institute of International and Area Studies) April.

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    FischerStanley1999“On the Need for an International Lender of Last Resort,”Journal of Economic PerspectivesVol. 13 (Fall) pp. 85104.

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    McKinnonRonald1999“The East Asian Dollar Standard: Life after Death?” paper presented at workshop on “Rethinking the East Asian Miracle” Economic Development InstituteWorld Bank, WashingtonFebruary.

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