Disclaimer: This is a working paper, and hence it represents research in progress. It is not meant to represent the official position or opinions of the Group of Fifteen or its Members, nor the official position of any of its staff members. The designations and terminology used are those of its author or authors. Any errors or omissions in the paper are also the sole responsibility of its author or authors.
This paper has been prepared by Bank Negara Malaysia and was first presented to the VIII Summit of the G-15 held on 11-13 May, 1998 in Cairo, Egypt, as a background document to facilitate discussions on the East Asian crisis. Permission to reproduce this document in the form of a G-15 Working Paper for wider circulation was obtained through the Permanent Mission of Malaysia to the United Nations at Geneva. The G-15 Working Paper version of this document was edited by Mr. Lim Aik Hoe of the Technical Support Facility of the Group of Fifteen.
ABSTRACT: This paper examines the serious financial crisis in East and Southeast Asia, which emerged in the middle of 1997. The paper highlights that the financial crisis cannot be attributed to any single factor and that several domestic and international factors were responsible for triggering the crisis. Amongst the various policy responses cited, the paper stresses the need for a comprehensive review of the present architecture of the international monetary system, with a view to developing a framework to prevent, manage and resolve future crises, within the context of a global environment of liberalized capital flows. In this regard, several areas are recommended for further consideration.
KEYWORDS: East and Southeast Asia, financial crisis, financial and banking reforms, globalization of capital flows, international monetary system, lessons, issues and policy responses.
Copies of this and other working papers can be obtained from the Technical Support Facility of the Group of Fifteen at the following address, 54-56 rue de Montbrillant, case postale 2403, 1211 Geneva 2, Switzerland, Tel: (022) 730 0319 or (022) 730 0564; Fax: (022) 730 0806; E-mail: hoe@g15-org.ch.
TABLE OF CONTENTS
- INTRODUCTION
- CAUSES
- POLICY RESPONSES
- LESSONS AND ISSUES
- CONCLUSION
InTRODUCTION
The world has witnessed a serious financial crisis in East Asia, which emerged in the middle of 1997, and involved significant downward adjustments in the regional currencies and equity prices, with severe economic and financial dislocations in the affected countries. Although, the visible impact of the crisis appeared to be limited to a number of economies in the East Asian region, the crisis is seen as having a global impact that cannot be regarded as negligible given the region's growing integration with the rest of the world. This integration arising from the rapid process of globalization in international capital flows and the inexorable trend towards free markets, was made possible by the liberalization and deregulation that had been undertaken by emerging market economies. The crisis occurred at the time when the emerging market economies were attempting to adapt to the globalization of capital flows and had begun to implement more market-oriented economic policies. The crisis has raised important questions on the relative benefits of liberalization as the recipe for sustained development and global economic growth.
CAUSES
The outbreak of the East Asian crisis has prompted much debate on the causes of the crisis. The crisis cannot be attributed to a single factor. A combination of factors contributed to the crisis. While the crisis was triggered by speculative attacks on East Asian currencies, the depth of the contagion highlighted the build-up of vulnerabilities in the regional economies to reversals of capital flows. To some extent, the crisis reflected the flaws of the market mechanism and inadequacy of risk assessment by international lenders. During the first half of the 1990s, financial euphoria among international lenders led to massive capital inflows into East Asia. This was subsequently followed by widespread panic and capital outflows when the currency crisis occurred.
Amid the multitude of explanations of the causes of the crisis, a number of factors could be seen as triggering or creating the adverse conditions for a crisis to erupt and subsequently to become prolonged:
POLICY RESPONSES
- The downward adjustments in the regional currencies against the US dollar, to a certain extent, reflected the global realignments in the exchange rates of the major currencies vis-a-vis the US dollar, particularly in the case of the Japanese yen and the Deutsche Mark since 1995.
- The build-up of vulnerability of domestic currency to external shocks. Three areas of concern were identified:
(i) The general export slowdown in the region since 1996 raised fears that the current account deficits of the regional economies would deteriorate further, thereby exerting pressure on the currencies. The expectations of the downward adjustments in the currencies were fuelled by the fact that the export slowdown was prompted not only by cyclical factors but also by structural factors that contributed to the lost of export competitiveness.(ii) The financing of the region's current account deficits also heightened risks, as the maturity structure of the capital inflows changed from long-term foreign direct investment (FDI) to short-term portfolio funds and loans. The build-up of such investments in the domestic economy can make a country vulnerable to a sudden reversal of flows.
(iii) Accumulation of external debt by the private sector particularly of short-term maturity. Prior to the crisis these debts were easily repaid due to strong export performance and strong growth in domestic revenues. In addition, risks of foreign exposure were minimal as exchange rates were previously stable.
- As the crisis deepened, market concerns shifted to the stability of the banking system. The fragility of the banking system in the region was related to the excessive growth of credit, of which the allocation was increasingly skewed towards the non-tradeable and risky sectors, namely the property and stock markets. In addition, short-term external debts held by the banking sector in several regional economies were accumulating. These short-term external debts had been used to finance domestic economic activity. The domestic economic slowdown and higher domestic interest rates in turn adversely affected the property and stock markets and pressured the debt servicing capacity of domestic borrowers, making the regional banks vulnerable to the deterioration in their asset quality.
- Nevertheless, the contagion effects of the crisis cannot be fully explained by the global exchange rate realignments vis-a-vis the US dollar. The vulnerabilities of the domestic economy to external shocks and fragility of the banking sector differed significantly across the region. Changes in market sentiments and investor confidence also played a central role in magnifying the crisis. Initially, the region enjoyed massive capital inflows amidst the euphoria surrounding the region, given the economic prosperity and booming asset markets. The prospects of high reforms led to inadequate risk assessments and this was bolstered by market perceptions of implicit guarantees provided by the government. As adverse developments began to emerge in several of the regional economies, the market immediately reappraised the economic and financial situation for the whole region. This contributed to the perception of a build-up of vulnerabilities, which in turn adversely affected market sentiments and investor confidence. The "herd behaviour" that had earlier prompted the massive capital inflows led to an equally massive reversal of capital flows on the outbreak of the crisis. Exacerbated by subsequent developments, the ensuing financial market volatility created a vicious cycle of deteriorating sentiments and confidence, namely:
(i) Credit downgrades by international rating agencies.
(ii) Political uncertainties creating concerns over commitment to undertake the drastic policy measures to stabilize the macroeconomic situation and reform the banking sector.
(iii) Blanket downward revision on the short-to-medium term outlook for the regional economies and banking sectors by private sector analysts.
(iv) Emergence of external debt repayment problems in some of the regional economies.
During the initial stage of the crisis, the regional authorities attempted to stabilize their currencies and curb speculative pressures in currency and equity markets, namely through direct intervention in foreign exchange markets, raising domestic interest rates and introducing selective capital and foreign exchange controls. However, these measures proved insufficient to arrest depreciation and stem speculative pressures in currency and equity markets. Intervention in foreign exchange markets became very costly as it resulted in the depletion of foreign exchange reserves at a time when regional economies were experiencing an export slowdown which adversely affected the inflow of foreign exchange earnings. Raising domestic interest rates to support the local currencies had the adverse effects of exacerbating the current phase of economic slowdown and contributed to the decline in the equity markets. In addition, the introduction of selective capital and foreign exchange controls had undermined market confidence, as the move was interpreted or perceived as indicating a reversal in commitment to liberalization and the adoption of a market-oriented economy.
Amid the intensification of selling pressures in currency and equity markets, the authorities began to look at the imbalances and structural weaknesses in the domestic economy and banking sector. This shift in the focus of policy response resulted in the implementation of a comprehensive stabilization programme with the aim of regaining market and investor confidence, and restoring stability in the financial markets. Restructuring and reforms in the economy and the banking sector were undertaken while macroeconomic fundamentals were strengthened. In the case of Thailand, Indonesia and South Korea, this effort was part of the conditional international financial assistance led by the IMF, which included the participation of other international agencies, namely the World Bank and the Asian Bank Development (ADB), as well as the Asia-Pacific and industrialized countries. The financial assistance package, amounting to a total of US$118.6 billion (US$17.2 billion to Thailand, US$43 billion to Indonesia, and US$58.4 billion to South Korea) provided the liquidity to replenish these countries' foreign exchange reserves to enable them to fulfil their short-term financial obligations. The Philippines extended its existing participation in the IMF programme and obtained the assistance of the World Bank and the ADB for additional financial assistance. Meanwhile, Malaysia launched a self-initiated macroeconomic adjustment programme and announced measures to strengthen the banking sector. These were essentially embodied in the Budget 1998 and augmented further by subsequent policy announcements.
The regional policy response to the crisis involved the following key elements:
LESSONS AND ISSUES
- Macroeconomic stabilization programme through the imposition of tight fiscal and monetary policies, involving spending cuts, tax increases, postponement of non-essential infrastructure projects and control on monetary/credit growth, with the primary aim of containing the current account deficit and reducing inflation.
- Liberalization and market-oriented reform measures, particularly in the areas of domestic and international trade, which among others include the abolition of monopolies, price controls and tariffs, as well as allowing greater foreign investment and equity participation in the domestic economy and financial sector.
- Comprehensive reforms and restructuring in the banking sector to address the weaknesses in the sector. In Thailand, Indonesia and South Korea, the measures had involved the closure of insolvent banks and finance companies, while weak but viable financial institutions were rehabilitated through recapitalization or mergers. In several economies, special institutions were established to administer the financial restructuring process and the management of bad assets, such as Thailand(s Financial Restructuring Agency (FRA) and Asset Management Corporation (AMC), and the Indonesian Bank Restructuring Agency (IBRA). In Malaysia, the central bank coordinated the consolidation of the banking sector through mergers and recapitalization of financial institutions. In addition, prudential regulations and the regulatory framework in the region were tightened in accordance with international standards, particularly in relation to the classification of non-performing loans, provisioning and capital adequacy requirements. Disclosure requirements were also enhanced to provide more information and to promote greater transparency.
- Restructuring of the external debt also became an important agenda of the policy response in the regional economies affected by the crisis, as the sharp depreciation of regional currencies, domestic liquidity shortage and economic downturn increased the overall costs of debt-servicing. On 29 January 1998, South Korea had successfully concluded the negotiations with its international creditors to roll over and reschedule the settlement of its short-term external debt maturing at the end of 1997 and the first quarter of 1998, while the effort is still ongoing in Thailand and Indonesia.
The main lesson from the crisis is the inescapable need to maintain macroeconomic and financial discipline given the swiftness with which the market responds to economic and financial developments, penalizing any perceived transgression or deviation from prudent and sound macroeconomic and financial sector management. The move by the regional economies to implement a programme of macroeconomic stabilization and banking sector reforms sends a clear message to the market of the commitment to lay the foundation for the new phase of sustainable growth in East Asia, and forms the best defence against any contagion effects from future economic or financial crisis in emerging market economies.
Another important lesson from the crisis is the need for countries to increase transparency and disclosure of their policy formulation, and to improve the timeliness, coverage and reliability of economic and financial information disseminated by the authorities. However, equally important is the responsible use and accurate analysis of the information disclosed or disseminated. The failure of the end users, namely market participants and the media, to accurately assess the economic and financial situations and understand the underlying objective of policy measures can lead to incorrect decision making. Misleading news can exacerbate market instability and have potentially adverse consequences on otherwise sound economies. It can also be very discouraging for countries that have made significant progress in enhancing the dissemination, transparency and the disclosure of information, and to closing the (information gap( with their leading peers. To this end, misinterpretations can be minimised by regular analysis and explanation of data or policy by the relevant authorities. In addition, the market is encouraged to lengthen the horizon of their assessment and not to overreact to events. To facilitate the fair assessment of countries and to improve surveillance, minimum accepted global standards and principles for the disclosure, coverage and dissemination of information should be established for adoption by all countries. The present framework of the Special Data Dissemination Standard (SDDS) of the IMF and various other international standards could form the basis of this endeavour.
Given that the crisis took place during the era of globalized international capital flows, in explaining the crisis one cannot discount the role of capital flows and the exposure of economies to the volatility of these flows, and the consequent impact on the economy and financial markets. Although the crisis in itself should not impede ongoing efforts at liberalizing the domestic financial system, the issue that must be appreciated is the importance of the speed and sequencing of the liberalization process. One of the main lessons from the crisis is the need to put in place the appropriate regulatory and supervisory framework to ensure a strong financial system before embarking on a liberalization programme. In addition, the pace and the depth of the programme must also be commensurate with the stage of financial sector development in the economy. This is to ensure that the benefit of liberalization would be maximized while the inherent risks of larger and volatile capital flows are minimized.
The crisis has also prompted calls for a comprehensive review of the present architecture of the international monetary system, with a view to developing a framework to prevent, manage and resolve future crisis, within the context of a global environment of liberalized capital flows. In this regard, some reforms of the IMF, the premier international financial institution, may be necessary to reduce contagion effects of similar crises in the future. There are several key areas for consideration:
Meanwhile, the industrial countries have an important role to play in addressing the global impact of the crisis. At the same time, with the notable exception of Japan they have tended to down play the impact of the crisis on their individual economies. Given the severe economic and financial dislocations that occurred in the aftermath of the crisis and the adverse impact of the policy responses, East Asian economies most affected by the crisis will rely on export growth to initiate economic recovery. This is especially the case, as domestic demand would take some time to recover. Therefore, the macroeconomic policy mix of the industrial countries must be supportive to the recovery process in East Asia, primarily by ensuring sufficient growth in their economies to absorb East Asian exports. The biggest threat to the recovery prospects in East Asia is Japan, in view of the stagnating domestic economy. However, the recent announcement of a fiscal stimulus package to stimulate domestic demand, in addition to the maintenance of an accommodative monetary policy, should augur well for the Japanese economy and the rest of the world. In addition, the industrial countries must not succumb or give in to the "protectionist rhetoric" of domestic special interest groups.
- Strengthening surveillance of financial markets and international capital flows to increase transparency and understanding of the dynamics of international capital flows. However, enhancing transparency is not the panacea to addressing the vulnerabilities of economies. As governments become more transparent, market participants should also analyze and interpret correctly the plethora of data being released by South East Asian countries.
- More importantly, greater attention should be given to the risks posed by the potential large reversals of capital flows, which has characterized the East Asian crisis, particularly on the role of currency traders and hedge funds in influencing currency and asset price movements. In this regard, the possibility of extending large trade and position reporting systems (now practised in future trades) to cover currency trading and hedge fund activities should be explored.
- Malaysia's position on currency trading and hedge funds is not intended to promote controls on these activities, but to raise their operational transparency. Calls for nations to be more transparent should also be reciprocated by the markets as well. The efficient allocation mechanism of the free market system that brings about maximum economic and social returns is based on the key premise that information is symmetric, complete and perfect. As timely and accurate information on the macroeconomic and financial situation of a country facilitate the decision making in financial markets, a transparent market structure and operations would enable the authorities to implement appropriate, correct and market-friendly regulations and policies.
- In relation to the above, there should be coordination of information sharing between national regulators, including those with supervisory oversight of the institutions operating in major financial centres and offshore centres. This would encourage global cooperation between national regulators, greater disclosure and transparency of market operations and international capital flows, and regular contacts between the operators of leveraged funds and regulators.
- More frequent dialogue between the international agencies especially the IMF and market participants are also important to ensure that the IMF is aware of market perceptions on the economic and financial developments in its member countries, and at the same time to enable the market to fully understand the views of the IMF on the situation in countries concerned. One criticism that was levelled at the IMF is the lack of a pro-active role by the IMF to facilitate the market in the process of distinguishing the conditions between the different economies in East Asia, thus leading to the damaging generalization of risks in the region.
- There is a need to develop a mechanism to provide for an orderly resolution of any financial crisis in the future. In this regard, what is lacking is an effective rule-based and adequately funded international lender of last resort. The IMF should seriously consider assuming the role and make changes in the terms and conditions of its financial support facilities, so as to better assist countries affected by the crisis and effectively stabilize the economy and financial markets. However, the current dead-lock between the legislators and the executive branch of the Government in the United States on the issue of providing extra financing to the IMF is a source of concern and could hamper this intended role of the IMF, given the fact that the United States is the major contributor. The Government of the United States must take great efforts in convincing the legislators and the public that the "benefits" far outweigh the costs.
- There is also a need to put in place an effective procedure to involve the private sector creditors in resolving financial crises to limit the problems of moral hazard situation that could arise should the IMF assume the role of lender of last resort. While many private sector creditors have incurred losses in the recent episodes of financial crises, it is important that all creditors, including short-term creditors, bear the consequences of their excessive risk taking. In terms of preventive measures, there is a need for countries to introduce measures or guidelines to discourage over-reliance on short-term financing, rapid build-up of external debt and excess risk-taking by the creditors. However, in the event of a crisis that involves potential debt defaults, private sector creditors should be involved at an early stage. Furthermore, the IMF financing arrangement is meant to stabilize the economy and the financial system during a period of interruption in international capital flows, not provide bail-outs for either the affected countries or creditors. Several areas for consideration include:
(i) closer contacts with creditors in explaining the IMF arrangements, catalyzing the resumption of private sector financing and initiating debt restructuring and rescheduling programme;
(ii) encouraging formulation and adoption of strong bankruptcy systems for the operation of both domestic and international capital markets; and
(iii) countries to exercise caution in dispensing public guarantees to avoid the risks of a private debt problem turning into a sovereign debt problem.
There is also a need to critically review the policy prescriptions imposed by the IMF on countries that have obtained its financial assistance. It was obvious that the IMF had employed a similar policy package for the regional economies at the centre of the crisis - Thailand, Indonesia and South Korea. Nevertheless, the appropriateness of this "one cure for all" policy package hinges primarily on the assumption that causes of the financial crisis are always similar in nature. A misdiagnosis of the causes of future financial crisis may result in misguided policy prescriptions which would amplify the costs of adjustments and in the worse case scenario, render the measures totally ineffective. Thus rather than restoring confidence, the package may result in further deterioration of confidence. This was one of the criticisms levelled at the IMF policy package. Furthermore, the IMF policy prescription must also take into account the time frame and sequencing of the measures depending on the nature of the crisis faced by individual countries. The existing policy package is seen as forcing countries to do too much at the same time. In addition, the social dimension of the crisis, namely, the rapid increase in unemployment and poverty as well as the deterioration in living standards, was not properly assessed by the IMF before implementing its package.
CONCLUSION
While economies undertake structural changes at tremendous social costs, the international community has a role to play in addressing the inefficiency of the market mechanism. There is a need for greater global cooperation to enhance the operations of the capital markets. The work started by the IMF on the activities of the hedge funds should be continued. Unless there is greater order in the capital markets, the progress achieved so far in the liberalization of capital flows could be thwarted.
For any comments send e-mail to : mugajava@iname.com
Visit : http://geocities.datacellar.net/Eureka/Concourse/8751/