Speech

Address by Shigemitsu Sugisaki
Deputy Managing Director of the International Monetary Fund
at the 1998 Harvard Asia Business Conference

Harvard Business School, January 30, 1998

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I. Introduction

Today's topic--Economic Crises in Asia--is one of the most urgent matters faced by the international financial community. The recent developments break new grounds due to the origin and depth of the problems and the contagion impact on the world economy. An analysis of these problems will inevitably be flawed by the fact that we are still in the middle of the events and therefore cannot benefit from stepping back and putting developments into proper perspective. This being said, I will still attempt to distill some preliminary lessons from the perspective of the IMF.

We are used to studying the reasons for the success of the so-called Asian Tigers and the other high growth performers in east and southeast Asia. For decades, these economies have been the envy of the rest of the world. We have sought to derive policy lessons for high and sustainable growth that could be replicated by other developing countries. But as we enter 1998--the year of the Tiger--we are trying to understand whether the Asian miracle has come to an end and these countries can again grow at the rates of the past.

To address these questions, it is useful to put the current crises into perspective by first addressing the factors behind the strong growth performance in the past; second, explaining the reasons for the current crises; and third, discussing the policy reforms that are needed to ensure sustained economic growth in the future. Finally, I will touch on external financing issues.

II. What Accounted for the Strong Growth Performance in the Past?

During the past 20 years, the high growth performers in east and southeast Asia have persistently grown at 6-8 percent per annum. At the same time, social indicators have improved markedly as measured by a lengthening of life expectancy, a decline in the proportion of the population living in absolute poverty, and major improvements in education and health standards. This outstanding performance is well above that experienced in other developing countries.

What explains this performance? Resource endowment and the geographical location seem to have played only minor roles. By contrast, demographic trends such as increasing life expectancy and a rising share of the working population in the total population have contributed positively to the growth performance. Economic policies, however, were by far the main factor. A combination of policies contributed to this performance. Let me single out four main categories, many of which are interrelated:

• First, macroeconomic stabilization policies. Throughout the period of strong growth performance, the countries maintained prudent fiscal policies and monetary policies aimed at low inflation rates. Governments also showed flexibility in adjusting policies to terms of trade shocks and other exogenous events so as to restore or maintain macroeconomic stability. Although the currencies of some countries, such as Thailand, were pegged to the U.S. dollar for long periods following the breakdown of the par system in the early 1970s, the authorities in these countries generally adjusted the rate when required. Other countries--with the exception of Hong Kong SAR--pursued a policy of managed floating. As a result of these economic policies, inflation was generally significantly below that in other developing countries. This, in turn, provided a conducive framework for private savings and investment.
• Second, strong savings and investment performance. In addition to strong public sector savings, private household savings were also high. They were promoted by a rising share of the working population in the total population, rising incomes, and certain aspects of public policy providing incentives to savings and perhaps the lack of government funded pension schemes. Public investment aimed at ensuring a proper infrastructure. Private investment, benefitted--apart from macroeconomic stability--from a relatively open and liberal trading system, in particular low import tariffs on intermediate goods and capital goods, a flexible labor market in most economies, and a well-educated labor force.
• Third, openness of the economies. While some countries initially pursued a policy of import protection, most countries lowered import tariffs early on, and liberalized trade and capital movements. The degree of openness, however, varied among the countries, with Singapore and Hong Kong SAR being the most open economies to both trade and investment, and Korea and Malaysia maintaining barriers to foreign direct investment, including in the banking sector. In general, however, all these economies were clearly more open than developing countries in general. Most economists would agree that these policies were essential for achieving the remarkable export performance. Opinions are more divided, however, about the effectiveness of specific export promotion policies that were also pursued. They included measures such as export processing zones, tax breaks, and direct export subsidies. It should be noted, however, that in none of the countries were these incentives allowed to endanger macroeconomic stability, as they did in some other developing countries. Moreover, they did not result in significant price distortions, as most domestic prices continued to be close to world market prices. Finally, they were administered by an efficient and well-trained civil service.

This leads me to the fourth and final main point.

• Fourth, human capital formation. It is a well-known fact that households in east and southeast Asia place great emphasis on promoting education of the children and therefore spend a significant part of their incomes on education. Public funding of education was facilitated by declining population growth and thereby a decline in the growth rate of school-age population. In addition, east and southeast Asian countries consistently allocated a relatively high share of education expenditure to basic education followed by secondary education compared with other developing countries of the same income level. Thereby, the Asian countries achieved virtually universal primary schooling and a large proportion of the population also benefitted from secondary education.

While each of the high growth performers in Asia broadly followed the mentioned policies, there was not a single prescription--"the Asian formula"--pursued by all of them. Moreover, a combination of many factors, including the institutional structure of the economies, accounted for the strong growth performance.

III. What Went Wrong ?

Why was this prolonged period of strong economic performance interrupted? It is important to get the analysis straight in order to identify the necessary remedy to the crisis.

The reversal of capital flows was the immediate reason for the eruption of the crisis first in Thailand followed by Indonesia and Korea--the three countries among the high-growth performers that have adopted an economic program supported by the IMF. Following a protracted period of strong economic growth, the east and southeast Asian countries had attracted massive inflows of foreign capital during the early 1990s, including of short-term nature. In Thailand, for example, the short-term inflows alone accounted for as much as 5 percent of GDP on average during 1994-96. They were partly promoted by relatively weak economic growth in Europe and Japan in the early 1990s and possibly the desire of international investors to diversify their portfolio following the financial crisis in Mexico in 1995. Domestic financial institutions, however, were not in a position to effectively intermediate these resources into productive uses. Consequently, banks ended up investing in property and equity and prices on these assets became inflated. In Indonesia, private enterprises were the main debtors of short-term external debt. In Korea, where the scope for enterprises to borrow directly from abroad was limited, banks and their foreign subsidiaries were the main debtors. Once doubts arose about the solvency of the borrowers, investors began to withdraw short-term financing. Exchange rates plummeted and so did stock and property prices to an extent that has shocked most observers. The problems intensified as the crisis became regional and global in nature.

One of the reasons for the turnaround of short-term flows was the pegging of the exchange rates to the U.S. dollar and the resulting decline in competitiveness after the strengthening of the dollar in mid-1995. Export growth weakened in Indonesia and Thailand, and the current account deficits rose. Only belatedly, once exchange rate pressures had already mounted, did the authorities abandon the peg and let the exchange rate float.

Although fiscal policy was not the root of the crisis, as government budgets were mostly in surplus or balance, in some countries there were extra budgetary funds that camouflaged looser fiscal policy and entailed problems of accountability for use of public resources. Periods of overheating had preceded the crisis in some countries as a result of the capital inflows and a reluctance on behalf of the authorities to dampen the effects through sterilization of the inflows, tightening of fiscal policy, and raising of interest rates.

Structural factors were at the heart of the economic problems. First and foremost, the crisis was a financial sector crisis. There were several weaknesses:

• The financial sectors in Indonesia, Korea, and Thailand lacked proper prudential standards and supervision. For instance, financial institutions had been allowed to borrow from abroad because of inadequate prudential controls on their foreign exchange exposure.
• The sizeable capital inflows had given rise to investment in equity and property and the risks associated with price bubbles.
• In the case of Korea, foreign borrowing--channeled through the banks--had financed excessive investment of the conglomerates, the so-called chaebol. These conglomerates suffered from very high debt/equity ratios. In addition, a large terms of trade decline during 1996-97 hurt the profitability of the conglomerates and resulted in a string of bankruptcies in 1997 to the detriment of the financial sector.
• The authorities had in some instances come to the rescue of insolvent financial institutions and prevented them from being liquidated.

Other structural problems included:

Trade restrictions, such as the maintenance of trade monopolies, quantitative restrictions on trade, and other trade barriers;

Capital controls, including restrictions on foreigners' access to the equity and corporate bond markets; restrictions on foreign borrowing by corporations (thus, foreign banks could not evaluate the underlying commercial risk associated with their lending).

Close links between the government, banks, and the corporations. This was a problem in all three countries as economic decisions and financial relations lacked transparency and accountability, and inappropriate investment decisions undermined the health of the financial sector.

Finally, there were important governance issues associated with the implementation of policies, including lack of transparency. Financial institutions and corporations also suffered from poor governance.

IV. Policy Reforms for Sustained Economic Growth

The problems experienced by the Asian countries differ from each other, and it is therefore not possible to prescribe one medicine that fits all. But there are certain common weaknesses that should be addressed for the economies to bounce back to high growth performance.

The key area that needs to be tackled as a first priority is the financial sector. As the experience of other countries has shown, reform of this sector is typically a lengthy and complex process. But since the restoration of confidence in the currencies is closely linked to the soundness of the financial sector, the problems should be immediately addressed. The comparison with the financial crisis in Mexico might be instructive. In Mexico, the financial sector was also hit by the depreciation of the currency (about 55 percent during the first year following the December 1994 devaluation) and the resulting losses of those banks or enterprises that had a foreign exchange exposure as well as by the recession. Depreciations of similar orders of magnitude have so far taken place in Thailand and Korea since mid-1997 and have even been exceeded in Indonesia (about 75-80 percent). In addition to the large depreciations, the financial institutions in Indonesia and Thailand have been hit by the decline in property prices.

What should be done? In the first instance, the financial institutions that are insolvent should be identified and closed. Then, the weak but solvent financial institutions should be restructured and recapitalized. This might involve changes in management. In addition, prudential standards and banking supervision need to be strengthened. When managing the banking crisis, governments should seek to avoid issuing guarantees that protect equity holders in financial institutions.

Another area is openness of the economy. As I mentioned earlier, the east and southeast Asian economies are relatively open. But further progress needs to be made to get them fully integrated in the world economy. This requires elimination of trade monopolies and other trade and investment barriers. For instance, in the case of Indonesia, the government is committed to eliminating the import and distribution monopoly of sugar and the distribution monopoly of wheat. To complement this action, domestic trade in all agricultural products will be fully deregulated. Moreover, all restrictive marketing arrangements will be abolished, leaving firms free to produce and export their products. In the case of Korea, trade-related subsidies, restrictive import licensing, and the import diversification program will be eliminated and steps taken to streamline and improve the transparency of the import certification procedures. All these measures serve to create a level-playing field for the private sector.

As concerns capital flows in Korea, the government has taken steps to accelerate capital account liberalization by increasing the limit for foreign ownership of listed Korean shares and it has liberalized foreigners' access to domestic money market instruments, corporate bond markets, and direct investment. In Indonesia, the government is also committed to eliminating barriers to foreign direct investment.

In all the Asian economies affected by the crisis, there is a need to review the close relationship among the government, banks and the enterprises and ensure that it reflects market conditions and is subject to greater transparency about the financial relations between the partners.

This leads me to the broader issue of governance. Improvements are needed in transparency in policy-decision making and in fiscal operations by bringing off-budget activities into the budget and subjecting public expenditure to scrutiny and accountability. Similarly, in the operation of banks and enterprises, there is scope for improving corporate governance, accounting standards and opening the books to the public. Greater transparency helps improve policy decisions, reduce rent-seeking activities, and promote investor confidence. Transparency might also foster consensus for reforms by keeping the social partners, including the trade unions, well-informed.

One particular aspect of good governance concerns the availability of economic information. Also in the case of Mexico was this a problem in the early detection of the financial crisis. In the case of the Asian economies in crisis, there were clearly shortcomings in the availability of data on external debt and official reserves with regard to forward obligations, swaps and other liabilities, and the usability of reserves. Disclosure of the financial situation of banks was also inadequate. Many of these specific areas are already being addressed in the context of the economic programs agreed with the IMF. However, what is needed more fundamentally is a change in the "information culture" that penetrates all areas of economic information. This would help policy makers make the right decisions on a timely basis and provide information to the private markets so that they can operate more efficiently.

The design of macroeconomic policies has been the subject of public debate. The degree of fiscal adjustment depends on the initial fiscal position and the size of the external current account deficit. For instance, in the case of Thailand, the current account deficit was relatively large at 8 percent of GDP and therefore the need for fiscal tightening was greater than in Korea and Indonesia. In all these countries, there was also a fiscal cost associated with restructuring the financial sector that would justify some tightening in the budget. But we agree that fiscal deterioration was not the primary cause of the crisis, and there is no need for a sharp tightening of fiscal policy. The fiscal program also needs to take into account the cyclical position of a country. During a sharp downturn in economic activity, built-in stabilizers should be allowed to work. Adequate provision should also be made for social expenditure, including social safety nets to protect the poor and the unemployed. This being said, the structure of the budget should be reviewed in all cases, e.g., a review of the investment program and other spending and the structure of taxation.

On monetary policy, when market confidence has not yet been reestablished, capital outflows persist, and the currencies continue to depreciate, high real interest rates on a temporary basis are unavoidable until stability has been restored. This is a very unpopular policy in all countries. We know that higher interest rates are likely to hurt the corporate sector, but an appreciation of the currency that follows a tightening of monetary conditions would greatly benefit those corporations indebted in foreign currency. There is no alternative in the short term. A relaxation of monetary policy would only lead to further depreciations of the currencies. And the currencies of Indonesia, Korea, and Thailand have already depreciated by much more than would seem appropriate from the standpoint of any economic analysis.

V. Financing of the Reforms

There has been a heated debate about the role of official financing--both multilateral and bilateral--in assisting the Asian economies in balance of payments difficulties. Many have recognized the need for such assistance. For instance, the IMF's shareholders, which represent 182 member countries, are fully supportive of the IMF's financial involvement. But others have argued that it involves bailing out of lenders and might encourage inappropriate lending in the future; they have argued that markets should be left alone and creditors and equity holders take losses from past lending decisions. It is extremely important to understand the role of the various players since this goes to the heart of the nexus between official and private lenders in a globalized market.

There is no doubt that the economic and social situation would have been considerably more severe if the countries in crisis had been left alone. This could not be allowed to happen. There are circumstances where the international financial institutions and also governments have to intervene in the international financial system to prevent the spreading of a systemic financial crisis to the detriment of the world economy.

Consequently, external financing by international financial institutions has been an important part of the economic programs once the governments were committed to implementing a painful process of reforms. Official lenders like the IMF, the World Bank, and the Asian Development Bank as well as official bilateral creditors have played an important role. However, such lending should not prevent foreign investors from incurring losses nor should it be a substitute for continuous private lending.

Foreign investors have indeed recorded losses associated with their past lending decisions. This applies particularly to equity holders as equity prices have plunged by 30-50 percent since the crisis erupted. International banks have also recorded losses, especially against their exposure to corporations. But banks have also a role to play in assisting economies emerging from the crisis. For instance, creditor banks to Korea have agreed to roll over short-term debts that fall due and to restructure such debt into longer maturities. In Indonesia, the government has just announced a voluntary framework to manage the external debt of corporations. These arrangements help the debtor countries and are also in banks' own interest. The Asian economies are closely integrated in the global financial markets and remain dependent on private financing. In the absence of such agreements, private creditors might suffer greater losses. Private lenders also benefit from a quick recovery of the economies and restoration of growth and trade, thus providing continuing opportunities for profitable bank lending. Finally, they profit from a quick resolution to the financing problems of the Asian economies in crisis that help contain the spreading of the financial consequences to other emerging economies.

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This has been a learning process for us all. The size of the financing problems linked to the capital account, the underlying structural and governance issues, and the spreading of the crisis have provided a serious challenge to the entire international community. But the ultimate responsibility for getting out of the crisis rests with the governments concerned.

One of the lessons that has been repeatedly confirmed is the necessity of commitment and ownership of the reform program. The government has to demonstrate that it is committed to implementing strong, and often unpopular, structural reforms and tackling difficult governance issues. Such reforms do not lend themselves to the same visibility to the general public as, for example, changes in prices and exchange rates. It is therefore important for governments to keep the markets informed about policy reforms as they are being implemented and about the latest economic developments in a transparent manner. This will form the basis for restoration of market confidence in their currencies, which is a sine qua non for the recovery of the economies.

As I mentioned at the beginning, in the past, the high growth performers in Asia have been characterized by strong fundamentals in terms of sound macroeconomic policies, strong savings and investment performance, relatively open economies, and strong human capital. These elements are still in place. The adjustment policies that have been introduced are already beginning to bear fruit in terms of a significant strengthening of the external current account balances, and restructuring of the financial sectors is underway. Challenges remain in some areas such as completing the financial sector reform and dealing with corporate debt. However, once confidence is restored, the currencies have stabilized, and policy reforms are well underway, there is no reason why these economies should not bounce back and once again record strong economic growth.