East Asian Financial Crisis By Tarun Das

ORIRIN, ONSET AND SPREAD OF THE RECENT ECONOMIC CRISIS IN EAST ASIA Tarun Das Economic Adviser, Ministry of Finance, Government of India 1. Anatomy of the crisis South East Asian economies - Indonesia, Malaysia, Philippines, South Korea and Thailand recorded very high growth rates during 1980s and early 1990s. However, these economies had also large current account deficits as a result of very large trade deficits and interest payments on foreign debt. In fact, in most of these countries the current account deficit was as high as or even higher than that in Latin American economies. These current account deficits were financed by short term capital inflows that led to a sharp accumulation of foreign currency denominated and largely unhedged foreign liabilities. These imbalances reflected a demand boom driven by excessive investment into speculative and unproductive assets. In all of these affected economies, there was a boom bust cycle in the asset markets that preceded the currency crisis. Stock and property prices soared, then plunged leading to the currency and financial crisis, and plunged even more after the crisis leading to deep and wide spread economic crisis. The financial intermediaries, both banks and non-bank, were the creators of this asset cycle. Liabilities of these financial intermediaries were perceived as having an implicit government guarantee, but they were essentially unregulated. These institutions borrowed short term money, often in dollars, then lent money to highly leveraged speculative investors, largely in real estate. The excessive risky lending of these institutions created inflation of asset prices. The overpricing of assets was sustained partly by a sort of circular process, in which proliferation of risky lending drove up the prices of risky assets, making the financial condition of the intermediaries seem sounder than its real balance sheet position. Subsequently when the price bubble burst, the effects of the fall in the asset cycle began to show by early 1997, the macroeconomic variables had already seriously deteriorated in most of these economies. As the asset prices fell further, it became increasingly doubtful whether governments would really stand behind the deposits and loans that remained. Both the depositors and lenders rushed to withdraw their money. Foreign investors stampeded to recover their loans and investments, forcing currency devaluation, which worsened the crisis even further as banks and companies found themselves stuck with assets in devalued baht or rupiah, but with liabilities in US dollars. The crisis has led to dramatic depreciation of the nominal exchange rates (Table-9.1). The sharp movement of the exchange rate has greatly complicated the macroeconomic policy choices by raising the cost of repaying foreign debt, weakening the financial and corporate sectors. Remarkably, the CPI inflation rate since June 1997 has been in the range of 5-12 per cent with the exception of Indonesia. Mexico, by way of comparison, experienced a 40 per cent surge in inflation during first ten months of its crisis in 1995. Despite large increases in nominal interest rates in some countries, only Korea and Thailand have been able to maintain real interest rates as a significantly higher levels than those before the crisis. Table-1.1 Exchange rate changes and inflation rate in Asian crisis economies

2 In June 1997 - May 1998 (in per cent) Indonesia

Korea

Malaysia

Philippines

Thailand

Mexico*

CPI inflation rate

54.5

9.8

6.4

8.4

11.5

50.5

Change in US dollar exchange rate Import share in CPI

-7.4

-35.6

-33.9

-33.0

-33.4

-48.5

30

18

20

16

30

…

Items

Percent change in Real -57.1 -30.9 -29.0 -25.3 -28.5 … effective exchange rate since June 1997 Percent change in real 13.6 13.4 12.1 10.5 19.8 … effective exchange rate since Jan 1998 Source: Kalpana Kochhar, Prakask Loungani, and Mark R. Stone (August 1998). Table1.2: Annual growth rates of broad money supply, 1996-1998 In Asian crisis countries (in per cent) Country

December 1996

January 1997

December 1997

January 1998

April 1998

Indonesia

30

38

27

206

156

Korea

16

17

15

14

10

Malaysia

21

27

20

16

-1

Philippines

16

36

10

26

-3

Thailand

13

15

0

21

-1

Source: Kalpana Kochhar, Prakask Loungani, and Mark R. Stone (August 1998). Economic activity has slowed more sharply than expected in all affected countries due to lack of both internal and external demand (Tables-3.3 and 3.4). Crisis countries including Japan account for 45 to 55 per cent of the exports to the region. Imports have declined by 4 to 13 per cent in volume. Most countries have experienced sharp slowdowns in money and credit growth by varying intensity and duration during the adjustment period (Table-9.2). These reductions in monetary growth reflect the declines in demand and more cautious lending behaviour by the banks. Banks attempt to strengthen their balance sheets in the context of dropping collateral guarantees, more stringent credit rating of loans, stringent provisioning requirements, improved credit risk assessment techniques and generally more risky financial environment. 2 Origins of the crisis The crisis unfolded against the backdrop of several decades of outstanding economic performance in Asia, and the difficulties that the East Asian countries face are not

3 primarily the result of macroeconomic imbalances. Rather, they stem from weaknesses in financial systems and, to a lesser extent, governance. A combination of inadequate financial sector supervision, poor assessment and management of financial risk, and the maintenance of relatively fixed exchange rates led banks and corporations to borrow large amounts of international capital, much of fit short-term, denominated in foreign currency, and unhedged. As time went on, this inflow of foreign capital tended to be used to finance poorer-quality investments. Although private sector expenditure and financing decisions led to the crisis, it was exacerbated by governance issues, notably government involvement in the private sector and lack of transparency in corporate and fiscal accounting and the provision of financial and economic data. Developments in the advanced economies, such as weak growth in Europe and Japan that left a shortage of attractive investment opportunities and kept interest rates low in those economies, also contributed to the build-up of the crisis. After the crisis erupted in Thailand with a series of speculative attacks on the Baht, contagion spread rapidly to other economies in the region that seemed vulnerable to an erosion of competitiveness after the devaluation of the Baht or were perceived buy investors to have similar financial or macroeconomic problems. As the contagion spread to Korea, the world’s eleventh largest economy, the possibility of default by Korea raised a potential threat to the international monetary system. The build-up to the difficulties in east Asia, which eventually lead to the present economic and financial crisis in these economies and elsewhere can be traced in four major factors. They relate to: •

high growth and commendable economic success resulted in underestimation of risk;

•

various features of their external economic environment that at first were favourable, but that turned sour in several respects in 1996-97;

•

shortcomings and inconsistencies in domestic macroeconomic and exchange rate policies; and

•

various structural weaknesses, particularly in the financial sector, that made these economies and especially their financial systems increasingly fragile and vulnerable to adverse developments. (a) Victims of their own economic success

During 1992-95, the group of countries known as the ASEAN-4 (Indonesia, Malaysia, Thailand and Philippines), Singapore and Korea experienced unparalleled impressive GDP growth rates. Inflation was moderate, at least by developing country standards. The absence of significant fiscal imbalances in most cases confirmed the discipline of macroeconomic policies. Rapid, outward-oriented growth attracted large foreign investment. With fiscal positions healthy in most cases, the sizeable current account deficit being run up persistently in some cases - most notably in Malaysia and Thailand - reflected shortfall of private saving relative to private investment and a significant part of this investment was being financed by foreign capital attracted by relatively high return. This brought mixed blessings. Absorption of the capital inflows posed challenges in terms of their productive deployment and their prudent intermediation through financial systems that were not well developed. These challenges were more severe with short-term flows, especially flows into banks and other financial institutions. The scale of difficulties that

4 arose therefore of financial system.

depended

on macroeconomic policies and the soundness

(b) Changes in External Environment The surge in capital inflows to emerging markets in the early 1990s was contributed by the decline in asset yields in the industrial economies. There was also sharp narrowing of asset yields. Apart from contributing to the surge in inflows and associated challenges, these developments magnified the potential reversal when yields turned upward in the industrial countries in early 1997. Movements in exchange rates among the major currencies in recent years have been another significant external factor. When the US dollar weakened during 1994 and 1995, especially against the Japanese Yen, these economies generally gained competitiveness as their currencies depreciated in trade weighted terms. Conversely, when this decline in dollar was reversed over the two years beginning in mid-1995, these countries suffered substantial losses in competitiveness with adverse effects on net exports and growth. These swings in competitiveness have tended to affect the current and capital accounts of BOP and investors’ expectations of future exchange rate changes. Besides, a number of developments contributed to the slowing in export markets. Among them, a widespread deceleration of imports by the industrial countries, a glut in the global electronic markets that resulted in a sharp fall in prices, and a slow down of growth in much of the Asian region itself. (c ) Macroeconomic Management and Exchange Rate Arrangements The macroeconomic performance of the Southeast Asian economies raised common concern about the risk of overheating, which in turn raised questions about the sustainability of exchange rate policy. There were signs of higher inflation in output prices, substantial and growing external current account deficits. These indicated that the growth of demand was indeed pressing on resources, and possibly also the competitiveness problems were building. But a more important source of demand pressure was the growth of financial system credit to the private sector. The increasing growth of private sector credit was largely attributable, in turn, to burgeoning capital inflows, including directly into the banking system, which were reflected in rising official foreign exchange reserves, increasing commercial bank liquidity and expanding foreign liabilities of commercial banks. Among the incentives encouraging borrowing from abroad were the relatively high domestic interest rates by international standards and exchange rate policies that appeared to provide assurance that the price of foreign currency would not increase to outweigh the interest differential. (d) Financial Sector and other Structural Weaknesses As events unfolded, weaknesses of the financial sector became particularly stark in Thailand, Indonesia, and Korea, although lack of transparency delayed public realisation of the scale of the problems. Inadequacies in the regulation and supervision of financial institutions as well as limited experience among financial institutions in the pricing and managing of risk, lack of commercial orientation, poor corporate governance, and lax internal controls - all in the face of movements toward liberalisation and increased competitive pressure , had contributed to imprudent lending, including lending associated with relationship banking and corrupt practices. Non-performing loans, net of reserves, relative to equity were very high. Another source of vulnerability was the investment of banks in non-bank financial institutions with large-scale exposure to the domestic property market. Encouraged by the relatively fixed exchange rate system, the financial intermediaries borrowed on a large scale from the international capital market in order to extend credit to domestic borrowers. Thus, there was serious problem of currency mismatch in the asset-liability structure, in that a substantial fraction of liabilities of these

5 companies was denominated in US dollars, while their assets consisted of loans in terms of local currency. The borrowers from the international market did not hedge themselves by entering into forward contract or ensuring future flow of earnings in terms of foreign currency. Besides, the structure of foreign debt had become highly unbalanced with a preponderance of short-term borrowing. 3 Onset of the crisis The financial crisis that began to erupt in Asia in mid-1997 has resulted in sharp declines in the currencies, stock markets, and other asset prices of a number of Asian countries; threatened these countries’ financial systems; and disrupted their real economies. In addition to its severe effects in Asian, the crisis has put pressure on exchange rates in emerging markets outside of the region, and is expected to knock somewhat more than 1 per cent off the rate of world growth in 1998. The economic and financial crisis that erupted in Southeast Asia in July 1997 has continued to deepen and broaden through December 1997. In early 1998, there were encouraging signs in the Asian crisis countries that financial market confidence was beginning to return. In May and June 1998, however, there was renewed volatility in financial markets with exchange rates depreciating significantly in Indonesia because of political turmoil and in Japan amid persistent policy uncertainties. As a result, economic conditions in Asia have weakened considerably, with repercussions elsewhere. The economies most affected directly by the crisis experienced drying up of private foreign financing, together with large currency depreciation and decline in asset prices. Large exchange rate depreciation and falling equity prices in turn have exposed and exacerbated financial sector fragility in many countries. Between July 1997 to July 1998, currencies of Southeast Asian countries depreciated in the range of 4 per cent (Singapore) to 70 per cent (Indonesia) in real effective exchange rate terms (using INS weights). The crisis is causing sharp contraction in domestic demand in these countries, with decline in real GDP and lowering of near-term growth prospects. The contagion and slipover effects have affected the outlook for other emerging market countries, including Latin America and Russia. Reduced availability of foreign financing, increased interest spreads on foreign borrowing, lower stock market prices, and policy tightening to reduce vulnerability to disruptive changes in market sentiment have generally weakened near-term growth prospects for emerging market countries in all region, including some of the transition countries. The scope for speculative pressures to spread across countries and the degree of contagion / slipover effects tend to depend: •

on domestic economic conditions and policies (such as overborrowing for unproductive uses, a fragile financial sector, or an inflexible exchange rate system);

•

on trade and capital market linkages (for example, a devaluation in one country adversely affecting the international competitiveness of other countries);

•

because of inter-dependence in creditors’ portfolios (for example, liquidity in one market forces financial intermediaries to liquidate assets in other markets);

•

creditors’ change in sentiment to re-evaluate the fundamentals of other economies with a view to reducing the risk of their portfolios and or simply herding by investors resulting from bandwagon effects. 4 Spread of the crisis

6 The world output growth in 1998 is projected to decelerate to 2.4 per cent in comparison with the growth of about 4.2 per cent each in 1997 and 1996. The sharp deceleration in projected world output growth is mainly because of the sharp decline / deceleration in real GDP growth rates of the Southeast Asian economies. Table below gives the projections of real GDP growth rates for countries most affected in the region: As noted above, the drying up of private foreign financing, large currency depreciation, and decline in asset prices in these countries are causing sharp contraction in domestic demand, which will be only gradually counterbalanced by increased net exports. Contagion and slipover effects have been felt by many emerging market countries in other region in the form of declining stock markets and intense pressures on exchange rates and have adversely affected the outlook for these economies. In general, the adverse effects seem likely to be moderate, with growth remaining positive, but there are risks of a sharper slowdown if the crisis in Asia were to deepen or other adverse internal or external disturbances were to affect these economies. The effect of the crisis are also being felt through weaker commodity prices, including oil. For developing countries that are net importers of these products, there will be a helpful terms of trade gain, but for many net exporters there will be negative impact on growth, and on current account and fiscal positions, that will be significant in some cases. Contributing to the pressures was the growing evidence that output in Japan, having faltered in 1997, was falling quite markedly in the first half of 1998, and that activity was slowing more sharply throughout much of Asia, including China and Hong Kong SAR. The sharp slowing of world growth predominantly reflects developments in Asia, while growth in the rest of the world generally has been well sustained. In the United States, consumer spending and business fixed investment have remained buoyant. In Western Europe, recovery has taken firmer hold in Germany and France and in most other cases growth remains robust. The encouraging strength of domestic demand in North America and Europe is underpinned by low inflation, high equity prices, generally supportive monetary conditions, improved fiscal position, and strong business confidence. Japan, which is the market for about one sixth of the exports of the ASEAN-4 and Korea bears a particular responsibility to support recovery in Asia by ensuring resumption of solid growth in domestic demand. The authorities have taken measures in the fiscal, monetary, financial sector, and other structural areas in order to further the revival of the economy, but policy design and implementation are assessed to have fallen short in clarity, timeliness and forcefulness. Indonesia has barely begun to re-establish financial stability. Macro-economic conditions remain very difficult, with output expected to contract sharply in 1998 and price pressures continuing. The rupiah has strengthened somewhat in recent weeks in large part due to a tight monetary stance, progress in bank re-structuring, and additional external financial assistance from the IMF and other multilateral and bilateral donors. The task ahead including the rehabilitation of the financial system, restoration of confidence to foster the reversal of capital flight, restructuring of the corporate sector, and the repair of the distribution system and market mechanism - are formidable, requiring bold action across a range of policy areas. Assuming that the current programme is implemented as planned, output is expected to bottom out toward the end of the year. In Korea, the recession has deepened considerably and unemployment has risen sharply. The Korean won has depreciated recently, but remains stronger than several months ago. Interest rates have already come down sharply, but cautious monetary policies will continue to be needed to maintain exchange market stability. Significant progress has been made in financial sector restructuring and in corporate debt work-outs.

7 Consolidation of merchant banks is well advanced, that of commercial banks is under way, but the restructuring of large banks and corporations is yet to be initiated. Malaysia is better positioned externally than the other crisis countries, because of a smaller short-term debt burden. Economic growth has contracted sharply in 1998, but inflation has remained low. The authorities’ response to the deteriorating situation has included a reversal of earlier fiscal tightening, combined with efforts to stimulate private sector credit partly by lowering bank’s reserve requirements and also by dealing with nonperforming loans and recapitalization needs. It will be important to ensure that increases in public spending are productive. More active use of interest rate policy is considered desirable to defend and strengthen the exchange rate and guard against rising inflation. A key uncertainty is financial sector fragility in the face of a sharp downturn in activity and asset prices. Philippines has been affected to a lesser degree by the Asian crisis, but the economic conditions seem to have deteriorated recently. The growth projection for 1998 has been revised downward, fiscal deficit is widening, and market pressures have pushed up interest rates. The focus of structural reforms is on the banking sector and the plans to reform public finances and strengthen the banking system need to be firmly implemented to reduce the economy’s vulnerability. Singapore has been hit less hard by the regional turmoil, reflecting the country’s strong macro-economic positions and sound financial sectors. A fiscal stimulus package introduced in late June 98 should help growth remain positive. Thailand is in the midst of severe recession. Relative exchange rate stability in the past few months has allowed an easing of the policy stance, with interest rates declining sharply. Structural reforms have focused on bank and corporate debt restructuring. A financial sector restructuring package announced in August 98 deals with insolvent banks and recapitalization of viable banks. Chinese economy has been subject to significant strains, despite the currency remaining stable. In China, growth in 1998 is expected to slow significantly, because of both weakening of external demand and evidence of overbuilding and excess inventory accumulation in the past. Further cuts in interest rates in recent months and proposed increases in infrastructure spending will provide worthwhile support for activity in the period ahead. The slowing of growth has heightened the importance of accelerating structural reforms, especially in the financial and public enterprise sectors. Hong Kong SAR has suffered a much more severe weakening of activity, reflecting the economy’s greater openness, the reversal of the previous sharp runup in asset prices, and the temporary tightening of monetary conditions that have been required to maintain the peg under the currency board arrangement. The authorities have introduced fiscal measures to support activity, and the flexibility of domestic wages and prices and the strength of the banking system, together with a gradual return of confidence, should help limit the slowdown and promote recovery. Latin America: The risk of the contagion spreading to Latin America is real. A number of Latin American countries are now running current account deficits as large as those of the afflicted Asian countries before their collapse (for example, Chile’s is 7.5 per cent of GDP, Brazil’s is 4.1 per cent of GDP, Colombia’s is 7.7 per cent of GDP). In Brazil and Mexico, the ratios of short-term debt to foreign exchange reserves are similar in those of adversely affected Asian economies. The ratio of short-term debt plus amortisation as per cent of foreign exchange reserves is 196 per cent for Mexico and 159 per cent for Brazil. Brazil is the key since it accounts for 45 per cent of Latin America’s GDP. US $12.7

8 billion of capital fled the country in September. The foreign exchange reserves lost in last few months has been of the order of about US $20 billion. The fiscal deficit has been 7.8 per cent of GDP over the past year. Interest rates have been increased to 50 per cent to support the currency, and this is considered to be unsustainable. Russia: There have been intense recurrent financial market pressures in Russia and Ukraine, as a result of persistently large fiscal imbalances, significant short-term foreign liabilities and delays in implementation of structural reforms. In Russia, market sentiments have been weakened further by concerns about the effect of the decline in oil prices on the current account position. Substantial hike in interest rates have at times been needed to defend the rouble; but interest rates have been left for long periods at extremely high levels that have limited confidence in the sustainability of confidence. This has contributed to sharp losses in stock market values. 5 Current economic and social situation in crisis economies Five “crisis” countries: Indonesia, Thailand, Korea, Philippines and Malaysia are impacted to different degrees; also, all countries in the region are affected (Indochina, PNG), and China is more and more involved, both the problems and the solutions. The economic situation has continued to deteriorate since last July 1998, the forecast for end 1998 appears somber and outlook for 1999 is uncertain. Nevertheless, the economic policies continue to evolve in the right direction. Further, though the IMF and the World Bank have not been able to stop the economic decline, they have certainly shown the ability to respond quickly. All the countries are now in the midst of an important recession that will strongly affect the economies in 1998. The forecast for 1999 is uncertain.. As of August 1998, stock markets are down between 58 percent (Korea) and 38 percent (Indonesia). Exchange rates are down between 84 percent (Indonesia) and 35 percent (Korea). After a long slide down in the months to January of this year, exchange rates and stock markets had started to recover (with the major exception of Indonesia which took a 40 percent hit within a few days early January). But further shocks reappeared in 1998 as concern at the situation in Japan impacted more and more negatively the markets. On the whole, the markets have strongly reacted both regional and local events. After a slowdown in growth in 1997, but still positive, (second half the year compensated by first half of the year) negative growth is forecast for 1998 with the Philippines and perhaps Malaysia less adversely affected than others. Thailand and Korea are likely to see negative growth of around 5 percent, while for Indonesia the number is likely to be between negative 10 and negative 15 percent. Main causes of economic recession Three main factors as indicated below are responsible for the current recession: (a) Lack of external demand as a result of several factors such as: •

An effective collapse of the regional market. Imports are down between 4 and 13 percent in volume. The crisis countries including Japan 45 and 55 percent of the exports to the region This explains that the performance in volume is not at the level it should be (between negative 0.6 percent for Indonesia, 5 percent Malaysia and 24 percent Korea).

•

9 Prices of exports are going down significantly. So, performance in value is very low, given the decline in exchange rates: (decline in Malaysia and Indonesia, positive 1.4 percent in Thailand, positive 5 percent in Korea).

(b) Lack of internal demand as a result of several factors such as: • • •

impact of loss of wealth (market capitalisation down by 16 percent in Indonesia, to 145 percent in Malaysia); capital flight equivalent to about 10 percent of GDP; unemployment and losses of revenues in the working population.

None of this has been compensated so far by sharp increases in public demand, either in terms of investment or current expenditures. (c ) Problems on the supply side: The corporate sector face considerable difficulties in responding to demand, mainly due to collapse of financial sector. There is also the problem of trade finance and internal credit crunch due to various factors such as: • •

•

lack of competitiveness, and industrial restructuring taking time (Korea, Thailand); corporate distress due to sharp increase of foreign debt (Indonesia) or high real interest rates (everywhere but in Indonesia) and lack of trust on the banks side; banks reducing their exposure because of capital adequacy requirements, and not enough capital to bring in ; No credit available for specific categories of enterprises such as SMEs because banks supporting them have collapsed and nobody wants them. In general SMEs have been hit more than large exporting corporate.

Each country is, in effect, exporting its recession to its neighbours. At the same time, there is no obvious engine of growth to pull the region from recession. Recent speculation about the devaluation of the yuan and constant fears regarding possible collapse in Hong-Kong, with a resulting devaluation of its currency, have fueled destabilising fears of another round of devaluation. Recent interventions and events around the Japanese yen and Russian ruble have also created further problems in international trade and capital flows. Political and social factors Political and social events have played a significant part in the crisis. Political changes in Thailand and Korea have assisted in stabilising of the exchange rate, with the establishment of a clearly understood and supported reform programme. Political uncertainty in Indonesia played an important role in the opposite direction. Sustainability of the reform effort depends heavily on real progress being achieved on the social front. There are signs of social unrest almost everywhere, though to different degrees. Unemployment rates are now between 3 percent (Malaysia), 6 percent (Korea) and 15 percent (Indonesia). Poverty is therefore increasing at an alarming rate. Indonesia, which had such an impressive record of poverty reduction, is the most worrying case with real fears that the proportion of the population under the poverty line could increase to 11 or 12 percent in 1998. This is compounded by drought impacts, not only in Indonesia. The greatest concern is the real fear of major reversals in the achievements of East Asian over the past generation. Social areas, including ensuring food and medicine supplies,

10 keeping children in school, and protecting women’s health are interventions by the government and multilateral funding agencies.

key targets

for

6 Role of multilateral financial institutions The IMF is charged with safeguarding the stability of the international monetary system. Thus, a central role for the IMF in resolving the Asian financial crisis was clear, and has been reaffirmed by the international community in various multilateral forum. The IMF’s priority was also clear to restore confidence to the economies affected by the crisis. In pursuit of its immediate goal of restoring confidence in the region, the IMF responded quickly by: •

helping the three countries most affected by the crisis Indonesia, Korea, and Thailand to formulate and implement programs of economic reforms that could restore confidence. The Philippines extended and augmented its existing IMF supported program in 1997, and arranged a stand by facility in 1998;

•

approving in 1997 about US$35 billion of IMF financial support 1 for reform programs in Indonesia, Korea, and Thailand, and spearheading the mobilization of some US$77 billion of additional financing from multilateral and bilateral sources in support of these reform programs. In July 1998, committed assistance for Indonesia was augmented by an additional US$ 1.3 billion from the IMF and an estimated US$5 billion from multilateral and bilateral sources.

The reform efforts have been invaluably aided by the World Bank, with its focus on the structural and sectoral issues that underpin the macroeconomic, and the Asian Development Bank (ADB), with its regional specialization. The IMF’s immediate effort to reestablish confidence in the affected countries entailed: •

the introduction of flexibility to exchange rates, where it did not already exist;

•

a temporary tightening of monetary policy to stem pressures on the balance of payments;

•

concerted action to correct the obvious weaknesses in the financial system, which constituted the major element in the crisis;

•

structural reforms to remove features of the economy that had become impediments to growth (such as monopolies, trade barriers, and nontransparent corporate practices) and to improve the efficiency of financial intermediation and the future soundness of financial systems.

•

Efforts to assist in reopening or maintaining lines of external financing; and

•

The maintenance of a sound fiscal policy, including through providing for rising budgetary costs of financial sector restructuring, while protecting social spending.

Forceful, far-reaching structural reforms are at the heart of all the programs. As financial sector problems were a major cause of the crisis, the centerpiece of the Asian programs has been the comprehensive reform of financial systems. While tailored to the needs of individual countries, in all cases the programs have arranged for:

• • • •

11 the closure of unviable financial institutions, with the associated write down of shareholders’ capital; the recapitalization of undercapitalized institutions; close supervision of weak institutions; and increased potential for foreign participation in domestic financial system.

To address the governance issues that also contributed to the crisis, the reform of the financial systems is being buttressed by measures designed to improve the efficiency of markets, break the close links between business and governments, and prudently liberalize capital markets. Transparency is being increased, both as regards economic data (on external reserves and liabilities in particular) and in the fiscal and corporate sectors, as well as in the banking sector. 7 Summary of Structural Reforms in Crisis Countries The IMF supported programs and policy advice to the crisis countries have placed particular emphasis on broad ranging structural reforms of the financial and corporate sectors, competition and governance policies, and trade regimes. In broad terms the suggested reforms may be summarized as follows: (a) Financial and Corporate Sector Reforms •

• • • • • • • •

Closure of insolvent financial institutions, with their assets transferred to a resolution or restructuring agency (Korea, Indonesia and Thailand); together with recapitalization and mergers of other (all countries). The reform programs in Malaysia and Thailand place particular importance on the finance company sector. Announcement of limited use of public funds for bank restructuring actual funds used to be made explicit in the budget (all countries) Measures to significantly strengthen prudential regulation, including loan classification and provisioning requirements, and capital adequacy standards (all countries). Measures to strengthen disclosure, accounting and auditing standards, and the legal and supervisory frameworks (all countries). Liberalization of foreign investment in domestic banks (Korea, Indonesia and Thailand) The introduction of more stringent conditions for official liquidity support (Indonesia, Malaysia and Thailand). Strengthening of prudential regulations on loan exposure (all countries). Introductions of funded deposit insurance scheme (planned in Indonesia and Thailand; under consideration in Malaysia, already in place in Korea and the Philippines) Restructuring of domestic and external corporate debt (Indonesia, Korea, Thailand) and closure of nonviable firms (Korea). (b) Competition and Governance Policies

• • • •

Liberalization of restrictive marketing arrangements for a variety of key commodities (Indonesia) Establishment of competitive procedures for privatization of government assets and for procurement (Indonesia, planned in Malaysia and Thailand) Announcement of bans on limits to the use of public funds to bail our private corporation ( Indonesia, Korea, Malaysia and Thailand) Introduction or strengthening of bankruptcy laws and exit policies (Indonesia, Korea, and Thailand)

12 • • •

Acceleration of privatization or closure of non-viable public enterprises (Indonesia) Strengthening of corporate disclosure standards (Korea) Liberalization of foreign investment in ownership/management in sectors other than the financial sector (Korea, Indonesia, Malaysia and Thailand) (c) Trade Reforms

• •

Reduction of import tariffs and export taxes (Indonesia). Easing of quantitative import and or export restriction (Indonesia and Korea). (d) Social Policies

• • • • •

Labour intensive public works programs (Indonesia, Thailand), and expansion of unemployment insurance system (Korea). Protection of low income groups from increases in prices of food and other essential (Indonesia, Malaysia, the Philippines, Thailand). Provision of higher spending for health and education (Indonesia) and reallocation of budgetary expenditures to health programs for the poor (Thailand). Expansion of scholarship and loan programs to minimize number of student dropouts (Thailand, Malaysia) Provision of subsidized credit for small and medium size enterprises (Indonesia, Malaysia). 10.4 Thailand: The IMF-Supported Program of Economic Reform

The financial crisis first started in Thailand, with the baht coming under a series of increasingly serious speculative attacks and the markets losing confidence in the economy. On August 20, 1997, the IMF’s Executive Board approved financial support for Thailand of up to US$4 billion, equivalent to 505 per cent of Thailand'’ quota, over a 34-month period. The initial program of economic reform envisaged: • •

• •

financial sector restructuring initially focusing on the identification and closure of unviable financial institutions (including 56 finance companies), intervention in the weakest banks, and the recapitalization of the banking system; fiscal measures equivalent to about 3 per cent of GDP to correct the public sector deficit to a surplus of 1 per cent of GDP in 1997/98, support the necessary improvement in the current account position, and provide for the costs of financial restructuring including an increase in the VAT tax rate from 7 per cent to 10 per cent. A new framework for monetary policy, in line with the new managed float for the baht, and Structural initiatives to increase efficiency, deepen the role of the private sector in the Thai economy, and reinforce its outward orientation, including civil service reform, privatization, and initiatives to attract foreign capital

The program was modified on November 25, 1997, in light of a larger than expected depreciation of the Baht, a slowdown of the economy that was sharper than anticipated, and severe adverse regional economic developments. The modifications included:

• • •

13 additional measures to maintain the public sector surplus at 1 per cent of GDP. Establishment of specific timetable for implementing financial sector restructuring including strategies for the preemptive recapitalization and strengthening of the financial system, and Acceleration of plans to protect the weaker sectors of society.

The program was further modified on February 24, 1998, to give clear priority to stabilizing quickly the exchange rate while limiting the magnitude and negative social impact of the larger than expected economic downturn, and to set the stage for Thailand’s return to the international financial markets. Among the modification were; • •

• • •

accelerating financial system restructuring including the privatization of the intervened banks; adjusting fiscal policy targets from a targeted public sector surplus of about 1 per cent of GDP to a deficit of 2 per cent GDP in response to the weaker economic activity and larger than anticipated improvement in the current account in part to finance higher social spending; ensuring an adequate availability of credit to the economy to help foster an economic recovery, while maintaining a tight monetary stance in support of exchange rate stability; strengthening the social safety net; and further deepening the role of the private sector, including initiatives to attract foreign capital

The program was again modified on May 26, 1998, with main priority minimizing any further decline of the economy and bringing about an early recovery, while preserving progress made in stabilizing the exchange rate and fostering confidence. The modified program called for: • • • •

• •

allowing further cautious reductions in interest rates and somewhat higher monetary growth rates, in line with recovering money demand; adjusting the fiscal target by increasing the public sector deficit target to 3 per cent of GDP in view of the larger current account surplus and in order to minimize any further decline of the economy; implementing concrete measures to strengthen the social safety net and allocating an additional 0.5 per cent of GDP in the budget for this purpose; accelerating corporate debt restructuring by strengthening the legal and institutional framework including through reform of the bankruptcy act, foreclosure procedures, and foreign investment restrictions with the latter intended to increase resources for restructuring. Continuing to focus financial sector reforms on the need for the banking system to strengthen its capital; and Designing strategy to strengthen the finance company sector and resolving the status of the four intervened banks to minimize the need for any future public support for these institutions. 8 Indonesia: The IMF Supported Program of Economic Reform

The shift in financial market sentiment that originated in Thailand exposed structural weaknesses in Indonesia's economy, particularly the size of short-term foreign debt owned by the private corporate sector. On November 5, 1997 the IMF approved financial support

14 of up to US$10 billion equivalent to 490 three years.

percent of Indonesia's quota over the next

Initial reform programmes included the following measures: • • • •

financial sector restructuring, including closing unviable institutions, merging state banks, and establishing a timetable for dealing with remaining weak institutions and improving the institutional, legal, and regulatory framework for the financial system. Structural reforms to enhance economic efficiency and transparency, including liberalization of foreign trade and investment dismantling of domestic monopolies, and expanding the privatization program. Stabilizing the rupiah via the retention of a tight monetary policy and a flexible exchange rate policy; and Fiscal measures equivalent to about 1 per cent of GDP in 1997/98 and 2 per cent in 1998/99 to yield a public sector surplus of 1 per cent of GDP in both periods, to facilitate external adjustment and provide resources to pay for financial restructuring. The fiscal measures included cutting low priority expenditures, including postponing or rescheduling major state enterprise infrastructure projects removing government subsidies, eliminating VAT exemptions; and adjusting administered prices, including the prices of electricity and petroleum products.

Against a background of continuing loss of confidence in the Indonesian economy and further sharp declines in the value of the rupiah, the Indonesian authorities announced a reinforcement and acceleration of the program on January 15, 1998. Key reinforcing measures included: •

Adjustments to the 1998/99 budget that would result in a public sector deficit of about 1 per of GDP, in order to accommodate part of the impact on the budget of the economic slowdown;

•

The cancellation of 12 infrastructure projects and the revoking or discontinuation of privileges for the IPTN’s airplane projects and the National Car project;

•

Further bank and corporate sector restructuring including the subsequent announcement of a process to put in place a framework for creditors and debtors to deal on a voluntary, case by case basis with external debt problems of Indonesia corporations; the establishment of the Indonesian Bank Restructuring Agency (IBRA): and a government guarantee on bank deposits and credits;

•

Limiting the monopoly of the national marketing board to rice, deregulating domestic trade in agricultural produce, and eliminating restrictive market arrangements; and

•

Measures to alleviate the suffering caused by the drought, including ensuring that adequate food supplies are available at reasonable prices.

Due to policy slippage and other developments, the rupiah failed to stabilize, inflation picked up sharply, and economic conditions deteriorated. The government issued a Supplementary Memorandum of Economic and financial Policies on April 10, 1998. The measures included the following: •

A strong monetary policy to ensure stabilization of the rupiah;

15 •

Accelerate bank restructuring with IBRA to continue its take over or closure of weak or unviable institutions and be empowered to issue bonds to finance the restoration of financial viability to qualified institutions the elimination of existing foreign ownership restrictions on banks; and the issuance of a new bankruptcy law.

•

A comprehensive agenda of structural reforms to increase competition and efficiency in the economy, reinforcing the commitments made in January and including the further privatization of six major state enterprises and the identification of seven new enterprises for privatization in 1998/99.

•

Accelerated arrangements to develop a framework with foreign creditors to restore trade financing and to resolve the issue of corporate debt and inter-bank credit.

After the economic situation was worsened and the economic program driven off track by social disturbances and political change in May, 1988, the government issued a Second Supplementary Memorandum of Economic and Financial Policies on June 24, 1998. The envisaged measures are given high priority to strengthening the social safety net comprehensively restructuring the banking system and include: •

Increasing social expenditure to a level equivalent to 7.5 per cent of GDP with measures comprising the provision of food, fuel, medical, and other subsidies, the expansion of employment generating programs, supported by the World Bank, ADB and bilateral donors.

•

Taking measures to limit the budget deficit to 8.5 per cent of GDP, a level that can be financed with foreign funds, including cuts in infrastructure projects and improvements in the efficiency of state run operations.

•

Rehabilitating and strengthening the distribution system following the disruption caused by social disturbances, to ensure that there are adequate supplies of essential commodities, including the establishment of a special monitoring unit to identify potential shortages of foodstuffs or distribution bottlenecks;

•

Restructuring the banking system through measures to strengthen relatively sound banks partly through the infusion of new capital while moving swiftly to recapitalize merge or effectively close weak banks while maintaining the commitment to guarantee all depositors and creditors. A high level Financial Sector Advisory Committee to advise on the coordination of actions for bank restructuring is being established;

•

Establishing an effective bankruptcy system, as an essential part of the corporate debt restructuring strategy. 9 Korea: The IMF Supported Program of Economic Reform

Over the past several decades, Korea transformed itself into an advanced industrial economy. However, the financial system had been weakened by government interference in the economy and by close linkages between banks and conglomerates. Amid the Asian financial crisis, a loss of market confidence brought the country perilously close to depleting its foreign exchange reserves. On December 4, 1997 the IMF approved financing of up to US$21 billion, equivalent to 1,939 percent of Korea’s quota, over the next three years. The initial program of economic reform assumed a growth rate of 2.5 per cent in 1998 and included the following measures:

16 •

Comprehensive financial sector restructuring that introduced a clear and firm exit policy for financial institutions, strong market and supervisory discipline, and independence for the central bank. The operations of nine insolvent merchant banks were suspended. Two large distressed commercial banks received capital injections from the government and all commercial banks with inadequate capital were required to submit plans for recapitalization;

•

Fiscal measures equivalent to about 2 per cent of GDP to make room for the costs of financial sector restructuring in the budget, while maintaining a prudent fiscal stance. Fiscal measures include widening the bases for corporate, income and VAT taxes.

•

Efforts to dismantle the nontransparent and inefficient ties among the government banks and businesses, including measures to upgrade accounting, auditing, and disclosure standards, require that corporate financial statements be prepared on a consolidated basis and certified by external auditors, and phase out the system of cross guarantees within conglomerates.

•

Trade liberalization measures, including setting a timetable in line with WTO commitments to eliminate trade related subsidies and the import diversification program, as well as streamlining and improving transparency of import certification procedures.

•

Capital account liberalization measures to open up the Korean money, bond, and equity markets to capital inflows, and to liberalize foreign direct investment.

•

Labor market reform to facilitate the redeployment of labour.

On December 24, 1997, the program was intensified and accelerated as the financial crisis in Korea worsened and concerns about whether international banks would roll over Korean short term external debt placed additional pressures on international reserves and the won. The revised measures, whose announcement was followed by a significant voluntary increase in rollovers and extension of claims by international bank creditors on Korean financial institutions, included the following: •

Further monetary tightening and the abolition of the daily exchange rate band;

•

Speeding up the liberalization of capital and money markets, including the lifting of all capital account restrictions on foreign investors access to the Korean bond market by December 31, 1997;

•

Accelerating the implementation of the comprehensive restructuring plan for the financial sector, including establishing a high level term to negotiate with foreign creditors and reducing the recourse of Korean bank to the foreign exchange window of the central bank; and

•

Speeding up trade liberalization measures, including making binding under the WTO the liberalization of financial services as agreed with the ORCD.

The macroeconomic framework revised on further on January 7, 1988 and February 5, 1998 with projection of lower growth at 1 per cent for 1998 included the following:

17 •

Targeting a fiscal deficit of around 1 per cent of GDP for 1998 to accommodate the impact of weaker economic activity on the budget and to allow for higher expenditure on the social safety net,

•

Moving forward to implement a broader strategy of financial sector restructuring having contained the immediate dangers of disruptions to the financial system.

•

Increasing the range and amounts of financial instruments available to foreign investors, increasing the access of Korean companies to foreign capital markets, and liberalizing the corporate financing market (e.g. mergers and acquisitions); and

•

Introducing a number of measures to improve corporate transparency, including strengthening the oversight functions of corporate boards of directors, increasing accountability to shareholders, and introducing outside directors and external audit committees.

On May 2, 1998 the Korean authorities updated the program of economic reform in view of the progress made in resolving the external financing crisis and the even weaker outlook for economic activity. Positive developments included the conclusion of the restructuring of US$ 22 billion of Korean banks' short term foreign debt, a successful return to international capital markets through a sovereign global bond issuance of US$4 billion, improvement in the current account to a substantial surplus, and an increase in usable reserves to more than US$30 billion. The measures included: •

The accommodation of a larger fiscal deficit of about 2 per cent of GDP in 1998 in light of weaker growth and through the operation of automatic stabilizers and measures to strengthen the social safety net;

•

Measures to strengthen and expand the social safety net including through a widening of the coverage of unemployment insurance and increases in minimum benefit duration and levels.

•

Formation of an appraisal committee including international experts, to evaluate the recapitalization plans of undercapitalized commercial banks.

•

The publication by August 15, 1998 of regulation to bring Korea’s prudential regulations closer to international best practices, including through strengthening compliance with existing guidelines concerning foreign exchange maturity mismatches; and

Further phased liberalization of the capital account including loosening restrictions on foreign exchange transaction, foreign ownership of certain assets, and ceiling on foreign equity investment in nonlisted companies. 10.7 Early Results and the Outlook The crisis in Asia is still unfolding and new disturbances cannot be ruled out. The markets began in early 1998 to distinguish better among the different country situations, with progress in implementing economic reforms being seen by the markets as less steady in Indonesia than in Korea and Thailand. In the latter two countries, exchange rates have stabilized and the external financing situation has improved. In Indonesia, the social disturbances and political uncertainty in May 1998, which were among the factors

18 impeding economic reform in Indonesia and economic conditions, have subsided.

had

impacts

that

further

worsened

The IMF World Bank, ADB and bilateral donors have augmented, in July 1998, the financing for Indonesia’s revised program of economic reform. It takes into account the need to urgently repair the country’s distribution system and strengthen the social safety net, as well as to act quickly to stabilize the economy and restructure the banking system. While the global effects of the East Asian crisis appear to have been contained to date, devaluation of the Russian Ruble, the recession in Japan and the weakness of the yen have introduced some new uncertainties. Additional measures are being undertaken in the affected countries in terms off economic restructuring to mitigate the adverse effects on output and employment. These measures include the following: • • •

budgetary flexibility so as not to worsen the output loss; mitigating the effect of credit tightness and reductions in trade financing on exporters and small and medium enterprises; and alleviating the social costs of adjustment, including through strengthening the social safety net and encouraging a social dialogue among employers, employees, and government.

Targeted fiscal positions have been eased over time to allow for greater social spending in all three affected countries. In Indonesia, for example, the overall budgetary cost of social safety net programs is new estimated at about 7.5 per cent of GDP. It includes funding of food, fuel, and medicine subsidies; employment-generating programs targeted to poor and vulnerable regions and households; health expenditure, including on village health centers and immunization programs, and student aid to minimize the decline in school enrollment.