The IMF has released its first internal review of its policy approach to the crisis that erupted in Asia’s financial markets in 1997. Covering the period through October 1998, the review focuses primarily on events in Indonesia, Korea, and Thailand— the three countries most severely affected by the crisis. IMF-Supported Programs in Indonesia, Korea, and Thailand: A Preliminary Assessment, by the IMF’s Policy Development and Review Department, looks at the causes of the crisis, the IMF’s response in terms of policy advice and financial support for the three countries, and the reaction to the programs. The released report also includes the Chairman’s December 1998 summingup of the IMF Executive Board’s discussion of the review. It was the subject of press conferences on January 19, conducted by Jack Boorman, Director of the Policy Development and Review Department (see page 20).
The review notes that the Asian crisis differs from previous crises in a number of key respects and may indicate fault lines in an increasingly integrated global economic and financial system. Unlike so many other cases in which IMF assistance is requested, the Asian crisis did not result mainly from the monetization of fiscal imbalances. It was rooted, instead, in financial sector fragilities, stemming in part from weaknesses in governance in the corporate, financial, and government sectors. These weaknesses, given the increasing rapidity with which international capital movements can change course, made these economies increasingly vulnerable to changes in market sentiment, a deteriorating external situation, and contagion.
The IMF’s support to all three countries was organized under the Emergency Financing Mechanism. This mechanism, with a dramatically shortened period of negotiation, review, and IMF Executive Board approval, permitted the programs to be put in place very quickly in response to immediate and overwhelming market pressures. At the same time, it necessitated exceptionally quick analysis and negotiation, and decision making, at times, had to be based on unusually incomplete information.
Initial Attempts to Restore Confidence
The design of the policy responses in the context of IMF-supported programs was dictated by the distinctive features of the crisis, the report notes. The strategy chosen, given the nature and scale of the crisis, combined macroeconomic and structural policy measures, along with an unprecedented commitment of financial resources to break a self-reinforcing cycle of capital outflows, exchange rate depreciation, and financial sector weakness.
Another key element of the IMF-supported programs was the decision to permit exchange rates to continue to float—part of the initial response of the authorities in all three countries to the pressures that had emerged—rather than readjusting the pegs to rates deemed defensible and consistent with medium-term fundamentals. The decision to float exchange rates opened the door to continued market depreciation. A more orderly arrangement might well have been possible as well as desirable at an earlier stage, but in the heat of the crisis, no practical alternative was seen to floating, especially in Korea and Thailand, where the initial efforts of the authorities to defend their exchange rates resulted in the exhaustion of reserves and removed much of their room for maneuver.
The programs and their initial implementation did not restore confidence rapidly enough—particularly in Indonesia, but also in Korea and Thailand. In the climate of economic and political uncertainty, investors were not reassured, and a vicious circle of capital outflows, depreciation, and weakened corporate and financial sectors resulted. While the inflationary consequences of the depreciations in Korea and Thailand were reasonably well contained, inflation rose sharply in Indonesia. Growth plummeted in all three countries, and external current accounts underwent abrupt swings. According to the IMF report, the magnitude of the sharp economic downturns was largely forced on the affected economies by the substantial current account adjustment dictated by capital outflows for which it was impossible to compensate through even larger official financing.
Restoring confidence quickly was intrinsically difficult, given the state of the affected countries’ reserves, the volatility of market sentiment, and the array of structural problems that had to be addressed. Several factors contributed to weak confidence, including political uncertainties, irresolution in implementing policies, the revelation of information that further shook market confidence, the coverage of government guarantees of bank deposits, and uncertainties surrounding the financing packages.
It is clear in hindsight, the IMF review says, that the programs were not adequately financed to be carried out in an environment where the crucial effort to restore confidence failed. Two obvious alternatives would be more official financing or greater private sector bail-in. More official financing would have been problematic, however, given limited resources and moral hazard considerations. Earlier concerted involvement of the private sector could have been pursued, but if done too aggressively, could have had adverse consequences for emerging markets more generally if the private sector concluded that the rules of the game had changed.
The main lesson, the study suggests, is that such avenues should be explored in preparation for the next crisis—that is, instruments and mechanisms need to be found to elicit the maintenance of private sector exposure to a country facing a potential loss of market access without inducing adverse contagion. Even more important is prevention: inhibiting the buildup of financial vulnerabilities that made the crisis likely and complicated its resolution.
Monetary Policy. The basic objective of monetary policy in the Asian crisis programs was to avoid an inflation-depreciation spiral. Given concern that excessive monetary tightening could severely depress economic activity, however, the policy followed in the programs was intended as a middle course, leaning against the wind in the foreign exchange market, rather than as an all-out pursuit of an exchange rate target.
During 1997, the authorities in all three program countries were somewhat reluctant to tighten monetary policies, both before and after the decision was made to float exchange rates. This initial vacillation, the IMF review notes, made the task of stabilizing more difficult later on. By early 1988, significant tightening had occurred in Korea and Thailand, with the effect of stabilizing and then strengthening the exchange rate. The tightening was not extreme—in either intensity or duration—when compared with previous crises elsewhere and, according to the IMF study, is unlikely to have been a major factor behind the output decline. In Indonesia, monetary developments went seriously off track, as the authorities lost control of money and credit in an environment of political turbulence and financial system collapse. The situation stabilized only in the latter part of 1998.
Fiscal Policy.The original programs in all three countries included some element of fiscal tightening to support the external adjustment and make room for part of the prospective costs of bank restructuring, thus bolstering confidence.
Fiscal plans were revised substantially during the course of the programs in response to changing economic conditions as it became clear that these countries were sliding into deep recessions. In the early program reviews, additional measures were introduced to offset part of the deterioration of the fiscal balance resulting from changing conditions. Later, the balance of priorities shifted toward supporting output and increasing the support available under social safety nets. From an early stage, fiscal deficits were allowed to expand to accommodate at least part of the automatic effect of declining activity and income and the exchange rate depreciations, providing support for economic activity from early 1998 on. In recent reviews, fiscal programs have been eased further to augment the automatic stabilizers. In some cases, however, it has proved difficult for the authorities to adjust government programs rapidly enough to provide the stimulus allowed under the programs.
Structural Reform.It was understood from the start that structural reforms needed to be a central pillar of the programs, in light of major weaknesses that underlay the crisis. The World Bank and the Asian Development Bank played essential roles in developing the structural components of the programs. In the financial and corporate sectors, there were two main strands to structural measures: dealing with the consequences of the crisis and establishing a prudential framework to help prevent a recurrence. Given the need for immediate action and the large number and variety of issues that had to be dealt with, the strategy for financial and corporate sector restructuring evolved with events and with deepening understanding of the nature and extent of the problems. Some key lessons that emerge, according to the IMF study, are a need to elaborate the IMF’s policies in the areas of financial crisis management as well as financial and corporate restructuring; the need to treat corporate restructuring as an integral part of financial sector restructuring; and the need to give early priority to addressing deficiencies in the institutional and legal framework for financial and corporate sector restructuring.
Indonesia, Korea, and Thailand: Real GDP Growth
1”Most Recent Review” refers to the latest available staff report showing full medium-term projections. (For Indonesia, August 1998; for Korea, November 1998; for Thailand, August 1998.)
Data: IMF staff reports
In addition to financial and corporate restructuring, structural reforms in a range of other areas, including governance, competition policy, and trade, were intended to establish a basis for sustainable growth. Social sector policies were regarded as an integral part of the program: concerns about the impact of the crisis on the poorest and most vulnerable segments of society were expressed from the outset and became more pressing as the domestic recession deepened.
Criticisms that the programs were overloaded with structural measures at a time of great economic weakness and that some might better have been delayed cannot, the study acknowledges, be entirely dismissed. And, indeed, as the programs evolved, the focus on the key financial and corporate issues sharpened. At the same time, the urgency of the crisis and complementarities among different reforms called for many steps to be taken simultaneously. Lasting recovery, the study asserts, hinged on comprehensive structural change. Nevertheless, such concerns may point to a need for further consideration of the appropriate pace and sequencing of reforms.
Given that events are still unfolding and programs are still in the process of revision, any conclusions must necessarily be tentative, the report cautions.
Of the three crisis countries, Korea and Thailand have been rather successful in implementing the programs as agreed, whereas in Indonesia, partly because of the severity of the underlying political crisis, the program has repeatedly veered off course and required substantial modification. While this period has been very difficult for all three countries, developments have been much more favorable in the two that have been able to stick with their programs. In Korea and Thailand, the challenge is to persevere with their adjustment and get through the difficult phase where measures have begun to bite but their credibility has not yet been established, into the phase where they can start to reap the benefits. Indonesia faces a more difficult task, due to the need to repair repeated policy slippages and arrest a slide into an increasingly difficult social situation. Its recent progress in this direction, the study notes, has, however, been encouraging.
At this time, there remain risks to all the programs, with regard to both developments within the countries themselves and the external environment. The recession has continued to deepen in these countries, and the success of reforms in tackling structural weaknesses and reestablishing growth on a sustainable basis is still not assured. Global economic developments, including the weakness of the Japanese economy, turbulence in other regions, and the sharp decline in commodity prices also pose risks to the stabilization process and could delay economic recovery. The IMF study concludes, however, that financial market conditions are stabilizing and there are now signs that the recessions in these countries are bottoming out, with some resumption of growth expected in the course of 1999.
The text of IMF-Supported Programs in Indonesia, Korea, and Thailand: A Preliminary Assessment, by Timothy Lane, Atish R. Ghosh, Javier Hamann, Steven Phillips, Marianne Schulze-Ghattas, and Tsidi Tsikata, is available on the IMF’s website (www.imf.org).
IMF Quota Increase Enters Into Effect
Press Release 99/4, issued January 22, is available on the IMF’s website (www.imf.org) and will be included in the February 8 issue of the IMF Survey.