The IMF's Response to the Asian Crisis

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 primarily the result of macroeconomic imbalances. Rather, they stemmed 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 it 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 made worse 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 buildup 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 by investors to have similar financial or macroeconomic problems. As the contagion spread to Korea, the world's eleventh largest economy, the possibility of a default by Korea raised a potential threat to the international monetary system.

The IMF's Role in the International Monetary System and in Financial Crises

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 fora. The IMF's priority was also clear: to help restore confidence to the economies affected by the crisis.

The IMF's Immediate Response to 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-arrange programs of economic stabilization and reform that could restore confidence and be supported by the IMF;¹

• approving in 1997 some SDR 26 billion or about US$35 billion of IMF financial support² 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 (see Box 1). 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; and

• intensifying its consultations with other members both within and outside the region that were affected by the crisis and needed to take policy steps to ward off the contagion effects, although not necessarily requiring IMF financial support.

The IMF's immediate effort to reestablish confidence in the affected countries entailed:

• a temporary tightening of monetary policy to stem exchange rate depreciation;

• concerted action to correct the weaknesses in the financial system, which contributed significantly to 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. Once the severity of the economic downturn in the affected countries became clear, fiscal policy was oriented toward supporting economic activity and expanding the social sector safety net.

Forceful, far-reaching structural reforms are at the heart of all the programs, marking an evolution in emphasis from many of the programs that the IMF has supported in the past, where the underlying country problem was imbalances reflecting inappropriate macroeconomic policies.

Because 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:

• 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 systems.

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 ensure that the integration of the national economy with international financial markets is properly segmented. Transparency is being increased, both as regards economic (on external reserves and liabilities in particular) and fiscal data, and in the financial and corporate sectors.

The reform efforts have been invaluably aided by the World Bank, with its focus on the structural and sectoral issues that underpin the macroeconomy, and the Asian Development Bank (ADB), with its regional specialization. The IMF's Interim Committee reviewed and endorsed the overall strategy adopted by the international community in dealing with the Asian crisis at the 1998 Bank-Fund Annual Meetings in October.

Boxes 2, 3, and 4 provide details on the programs of economic reform, chronological highlights, and economic indicators for Thailand, Indonesia, and Korea, respectively. For all three countries, the programs have been adapted, reinforced, or accelerated, as economic developments have unfolded and as economic and financial conditions have warranted.

Additional Measures Taken by the IMF in Response to the Crisis

In addition to the IMF's first line of response-assisting in the design of the programs and providing financial resources for their support-the following steps have also been taken:

• The Executive Board made use of the accelerated procedures established under the emergency financing mechanism and the exceptional circumstances clause³ to meet the exceptional needs of the member countries in terms of approval time and access.

• The Supplemental Reserve Facility (SRF) was created, for the special circumstances of members experiencing exceptional balance of payments difficulties owing to a large short-term financing need resulting from a sudden loss of market confidence.

• The coordination of the IMF with the other international financial institutions, notably the World Bank and the Asian Development Bank, and with bilateral donors was intensified, to muster truly international support for the affected countries' economic reform programs.

• A strengthened level of dialogue between the IMF and a variety of constituencies in the program countries was initiated, including consultations with labor groups and extensive contacts with the press and the public.

• The IMF programs have been associated with coordinated efforts between international creditor banks and debtors in the affected countries to resolve the severe private sector financing problems at the heart of the crisis, and the IMF has provided support to this process as appropriate. Thailand reached an early understanding on debt roll-over with key Japanese creditor banks in August 1997. Talks between Korea and a group of foreign creditor banks on the voluntary restructuring of short-term debt began in late December 1997 and were finalized in March 1998. In June 1998, Indonesia and a steering committee of its foreign bank creditors agreed on a framework for the voluntary restructuring of interbank debt, trade credit, and corporate debt.

• IMF member countries have attained new levels of transparency through the release to the public of the letters of intent describing their programs of economic reform. With the permission of the respective authorities of Indonesia, Korea, and Thailand, the IMF has posted the letters of intent on the IMF website so that details of the programs are readily available to all interested parties. Korea and Thailand have also issued Public Information Notices (PINs), a relatively new means for countries to make known to the public the views of the IMF Executive Board on national economic policies. All three countries are subscribers to the IMF Special Data Dissemination Standard (SDDS), and Indonesia and Thailand have established hyperlinks from the IMF Dissemination Standards Bulletin Board (DSBB) to their respective national economic and financial data.

• Ad hoc measures have been taken as necessary, including the appointment of former IMF Deputy Managing Director Prabhakar Narvekar as a Special Advisor to the Indonesian authorities; the establishment of resident representative posts in Korea and Thailand (and the expansion of the existing post in Indonesia); and various activities through the IMF's newly opened Asia and Pacific Regional Office.

• The IMF has been responding to the requests it has received from its members, from its own Interim Committee and from multilateral fora such as the Group of Seven and the Group of Twenty-Four nations, to investigate aspects related to the financial crisis, from the role of hedge funds, to promoting financial sector soundness and strengthening the architecture of the international monetary system.⁴

Amid the urgent need for a concerted international response to the crisis situation, the great uncertainty in Asia, and the unexpectedly virulent financial contagion, the IMF-supported programs have, as would be expected, come under scrutiny from a wide range of commentators, and a healthy debate is taking place. The IMF has undertaken and made public a rigorous, albeit preliminary, internal review of the design and early experiences with IMF-supported programs in Indonesia, Korea, and Thailand, in part to contribute to this debate.⁵ However, some criticisms of the programs are based on fundamental misunderstandings about the IMF's response to events in Asia. Three major misunderstandings are addressed in Box 5.

Early Results and the Outlook

The crisis in Asia is still unfolding and further disturbances cannot be ruled out, especially in light of significant, unanticipated setbacks. The magnitude of the recessions in the affected Asian countries has exceeded all initial expectations. Political instability and the related social and economic disturbances in Indonesia in May 1998 hindered progress there. The further weakening of the Japanese economy has had a particularly large, negative impact on demand in the region and on international financial market sentiment. Following the several waves of pressure on emerging markets since 1997 that had emanated mainly from Asia, Russia became a new source of contagion during August 1998, causing confidence to deteriorate further globally. Brazil, which has taken steps to address its chronic fiscal imbalances and obtain large-scale financial support for its program of economic reform from the international community, has been susceptible to market contagion and volatility. It is a real risk that market confidence may not recover for some time, which could imply significant net outflows of foreign capital from many economies, as witnessed in the Asian crisis countries, with prolonged depressive effects on trade and activity. However, this risk can be contained, as long as the Asian crisis countries and other affected economies continue to implement the right stabilization and reform policies that will help to generate recovery.

Despite the significant setbacks that have occurred in the resolution of the Asian crisis, there has also been notable progress in some countries in the implementation of corrective policies and the stabilization of exchange rates:

• The exchange rates of the Asian crisis economies have strengthened from their lows, which were reached in the first part of 1998. While the Indonesian rupiah remains deeply depreciated, it too has recovered significantly.

• In Korea and Thailand, interest rates have declined markedly since January as currency pressures have eased. In fact, in both countries, interest rates have fallen to pre-crisis levels.

• Korea and Thailand, in particular, have made significant progress in macroeconomic stabilization and have begun to implement structural reforms. In Indonesia, the modified policy program in effect since late June 1998 has been implemented broadly as planned, with some positive results.

• The turnarounds in current account positions, from deficit to surplus, have been rapid and large for all three countries.

• Equity prices rose significantly from their lows in Korea and Thailand in 1998.

• Reserves have strengthened substantially in Korea and Thailand, and Korea made repurchases to the IMF under the Supplemental Reserve Facility totalling US$2.8 billion in December 1998, indicating the progress made in the country's emergence from its foreign exchange crisis one year earlier.

Amid these signs of progress, the IMF remains acutely concerned about the greater-than-anticipated contractions in economy activity in the affected countries, and is well aware that much hard work remains to be done in terms of economic restructuring and the temporary adverse effects that it can have on output and employment. It is focusing efforts on its intermediate goal of shortening and easing the adjustment period in the program countries, including:

• the alleviation of the social costs of adjustment, including through strengthening and expanding the social safety net and encouraging a social dialogue among employers, employees, and government; and

• the easing of the effect of credit tightness and reductions in trade financing on exporters and small and medium enterprises, and other measures to support domestic demand.

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 has been targeted at about 8 percent of GDP per annum, with a projected fiscal deficit to accommodate the social spending. The social spending includes funding to help increase the availability of food, fuel, and medicine to those in need; 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.

Amid the sharp recessions and heavy social costs of the crisis, there are nonetheless indications that if countries persist in implementing programs of economic stabilization and reform, and if financial market confidence gradually returns --which depends on, among other things, Japan implementing its planned fiscal stimulus and bank restructuring-- the affected Asian economies could begin to recover in the course of 1999.⁶ Small declines in output or modest recoveries are in prospect, except for Indonesia, where the reform process is less advanced and political uncertainties have complicated economic difficulties. While the situation in all the countries is tenuous, there have been some signs of bottoming out in Korea and Thailand. The rate of decline in industrial production has begun to moderate in recent months; recently, the unemployment rate in Korea has declined slightly, and the sale of new vehicles in Thailand, an indicator of consumer confidence and of the strength of the nonbank financial sector, rose on a 12-month basis for the first time since the beginning of the crisis.

Lessons from the Crisis and the Way Forward

While the Asian financial crisis is still unfolding, the IMF has already begun to draw lessons from the crisis on how to strengthen the architecture of the international financial system to lessen the frequency and severity of future disturbances. The Asian crisis has once again highlighted the importance of a sound macroeconomic policy framework, and the dangers of unsustainably large current account deficits. Beyond this, the IMF has identified six major areas where initiatives already under way should be strengthened:

• one, more effective surveillance over countries' economic policies and practices, facilitated by fuller disclosure of all relevant economic and financial data. The IMF has established, and will further improve, data standards to guide members in releasing reliable and timely data to the public. The Fund is presently engaging in a consultative process with all interested parties concerning the reporting of data on monetary authorities' foreign reserves, amid the growing recognition after the developments in Asian financial markets of the importance of gross reserve and related data;

• two, financial sector reform, including better prudential regulation and supervision. Working with the Basle Committee on Banking Supervision and the World Bank, the Fund has helped develop and disseminate a set of "best practices" in the banking area;

• three, ensuring that the integration of international financial markets is orderly and properly sequenced (supported by, among other things, a sound financial sector and appropriate macroeconomic and exchange rate policies) in order to maximize the benefits from and minimize the risks of international capital movements;

• four, promoting regional surveillance;

• five, a worldwide effort to promote good governance and fight against corruption, including the adoption by the Interim Committee of the Board of Governors of the IMF on April 16, 1998 of the "Code of Good Practices on Fiscal Transparency - Declaration on Principles" to serve as a guide for members, and to enhance the accountability and credibility of fiscal policy as a key feature of good governance; and

• six, more effective structures for orderly debt workouts, including better bankruptcy laws at the national level and better ways at the international level of associating private sector creditors and investors with official efforts to help resolve sovereign and private debt problems.

These efforts need to be supported by adequate financial resources for the IMF, supplemented in case of need by other bilateral and multilateral resources, that can be deployed in support of strong adjustment programs. Progress toward implementation of the IMF quota increase and the New Arrangements to Borrow (NAB) have improved the international community's ability to assist countries in the resolution of financial crises.

All of the above steps support the long-term objective of the IMF's response to the Asian financial crisis, which is to enable the affected Asian economies to emerge more strongly to resume development and to help strengthen the international monetary system to meet the challenges of the next century.

¹The Philippines extended and augmented its existing IMF-supported program in 1997, and arranged a stand-by facility in 1998.
²Amounts denominated in the IMF unit of account, the Special Drawing Right (SDR), have been converted to dollar amounts at an exchange rate of 1SDR=US$1.35.
³The emergency financing mechanism strengthens the IMF's ability to respond swiftly in support of a member country facing an external financial crisis and seeking financial assistance from the IMF in support of a strong economic adjustment program. The exceptional circumstances clause allows the IMF to grant a member access to its resources in excess of the usual limits.
⁴See, "The Report of the Managing Director to the Interim Committee on Strengthening the Architecture of the International Monetary System," October 1998.
⁵See, "IMF-Supported Programs in Indonesia, Korea, and Thailand: A Preliminary Assessment," January 1999.
⁶See the December 1998 IMF World Economic Outlook.