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The Asian Crisis and the World Economy

Address by Alassane D. Ouattara
Deputy Managing Director of the International Monetary Fund
at the Ministry of Finance and Planning Conference on
Economic Recovery through Capital Market Development

Kingston, Jamaica, March 6, 1998

Mr. Deputy Prime Minister, Minister Davies, Madam Financial Secretary, Ladies, and Gentlemen, it is an honor for me to join you today, at a time when Jamaica is debating how best to position itself for the challenges of the 21st century. The globalization of the world’s financial markets certainly offers unprecedented opportunities: the chance to quicken the pace of investment, job creation, and growth. But it also poses some serious risks: a greater vulnerability to shifts in market sentiment, which can trigger massive shifts in capital, and in turn, precipitate banking sector crises with spillover effects in other economies. Moreover, some countries are not well equipped to take advantage of the expansion of world trade and capital flows, and therefore risk becoming marginalized from the world economy.

Some of these risks seem all too real now, in light of the Asian financial crisis, raising questions about the best path for countries to take. Thus, this seems to be a good time to step back and assess the origins of the crisis, its likely impact on the world economy, efforts to contain the situation, and lessons we all can learn.

Origins of the crisis

How could events in Southeast Asia unfold as they did, after so many years of such outstanding economic performance?

The region’s problems began in Thailand, where there were numerous signs of impending crisis. Macroeconomic indicators pointed to substantial imbalances: the real exchange rate had appreciated substantially; exports growth had slowed markedly; the current account deficit was persistently large and increasingly financed by short-term inflows; and external debt was rising quickly. These problems, in turn, exposed other weaknesses in the Thai economy, including substantial, unhedged foreign borrowing by the private sector, an inflated property market, and a weak and over-exposed banking system. Markets also warned of the unsustainability of Thailand’s policies, as seen in lower equity prices and mounting exchange rate pressure.

The IMF, for its part, was in continuous dialogue with the Thai authorities for 18 months prior to the floating of the baht last July, stressing these problems and pressing for the adoption of urgent measures. But after so many years of outstanding macroeconomic performance, it was difficult for the authorities in Thailand—and other countries—to recognize that serious underlying deficiencies could jeopardize their track record.

If macroeconomic imbalances provoked the crisis in Thailand, how then did it spread to economies such as the Philippines, Indonesia, Malaysia, and Korea? To begin with, developments in Thailand naturally affected economic conditions in neighboring countries. For example, in expectation that the depreciation of the baht would erode the competitiveness of Thailand’s trade competitors, other currencies in the region also weakened. And as these currency slides persisted, the debt service costs of the domestic private sector increased. Uncertainty about how far these currencies would decline and how much debt service costs would increase encouraged a rush to hedge external liabilities that only intensified exchange rate and interest rate pressures.

At the same time, problems in the Thai economy prompted markets to take a closer look at the risks in other countries. And what they saw—to differing degrees in different places—were many of the same problems affecting Thailand. These included: overvalued real estate markets, weak and over-extended banking sectors, poor prudential supervision, substantial private short-term borrowing in foreign currency, and frequently, special relations between banks and businesses that seriously jeopardized the overall quality of management. Moreover, after Thailand, markets began to look more critically at weaknesses they had previously considered minor, or at least manageable in an orderly way, given time.

Two other factors also undermined market confidence.

One was the lack of transparency about government and central bank operations, about the true state of financial sectors, and about the links between banks, industry, and government and their possible impact on economic policy, a problem that was particularly serious in Korea. In the absence of sufficient information, markets fear the worst and doubt the capacity of governments to take corrective action.

The other factor was the controls—and threat of controls—on market activity, which not only made investments riskier, but tended to reinforce the view that governments were addressing the symptoms, rather than the causes, of their problems, and accelerated investors’ run for cover and set back other efforts to restore confidence.

Global impact of the crisis

So what does all of this imply for the global economic outlook? Overall, the world should see a significant slowdown in economic growth this year, in large part due to the Asian crisis. But this slowdown is likely to be much less pronounced than those of 1974-75, 1980-83, and 1990-1991. It would have been more serious, for sure, with much higher costs to the people of many countries, and much greater risks to the international economy, without the support provided to the crisis countries by the international community, through the IMF, the World Bank, the Asian Development Bank, and bilateral sources. Inflation is expected to remain low in the industrial countries, and to moderate further in the rest of the world. Although the growth of world trade volumes is expected to slow in 1998, it should still be above the average for the 1990s.

In general, most major industrial countries, with Japan being the most significant exception, are well positioned to absorb the contractionary effects of the crisis. In Japan, recovery had stalled again before the Asian crisis hit, and the crisis will be exerting its effects at a most unwelcome time. But in the United States, as Chairman Greenspan has recently emphasized, and in the United Kingdom and some other industrial countries, the Asian slowdown will help to fend off inflationary pressures. Consumer spending and investment in the United States remain strong and the data continue to show robust growth of output and employment; consumer confidence is at 30-year highs, and unemployment is at its lowest rate for a quarter century.

For developing countries, economic growth overall is expected this year to fall below the 6 percent average of the 1990s, making it the slowest expansion for these countries since 1991. Those hardest hit, of course, will be in Asia—especially Indonesia, Malaysia, the Philippines, and Thailand. Most other emerging market countries may be expected to register a slowdown in growth followed by a mild strengthening next year.

As for the Western Hemisphere, your neighbors have weathered the Asian crisis relatively well, especially as it came on the heels of the Mexican crisis just three years earlier. In recent months, a number of emerging market economies—notably Brazil and Argentina—have successfully defused exchange rate pressures by taking quick and forceful action to raise interest rates or tighten fiscal policies, or both. Moreover, Latin America has benefitted from the substantial improvement in economic policies that has taken place over the past decade. Indeed, one of the most interesting, and, I would suggest, unsurprising features of the emerging market crisis of 1997-98 is that Latin America has been relatively little affected overall.

How about net private capital flows to developing and newly industrialized economies? After reaching a record high of $240-250 billion in 1996, with Asia attracting the largest share by far, they fell steeply late last year—by about $70-$100 billion—and it seems unlikely that we shall see again this century overall flows at the levels seen in 1996. Net capital flows to Asia are expected to recover only slowly, but the good news for the developing countries of the Western Hemisphere, and also for the countries in transition, is that their net flows seem to have been holding up fairly well. And prospects seem relatively good for this hemisphere, thanks partly to the extensive privatization programs and other reforms that are attracting rising flows of direct investment.

Steps to contain the crisis

Some positive notes. Nevertheless, it does not take a great deal of imagination to see how the problems in Asia could take on larger proportions, with more profound effects on global growth and financial market stability. That is why the international community has decided to work together with the IMF to try to overcome the crisis in a way that does the least damage to the world economy.

Thailand, Indonesia, and Korea have all now put economic programs in place, with the support of the IMF, the World Bank, and others. Many people assume that they must be the same kind of belt-tightening adjustment programs that the public has long associated with the Fund. Quite the contrary. These programs represent a marked departure from the kinds of programs we have traditionally supported in the past. Their emphasis is much less on the austerity measures required to restore macroeconomic equilibrium and much more on a package of firm, forceful measures of considerable structural scope aimed at establishing the preconditions for sustainable growth in the new context of globalization. These programs genuinely endeavor to attack problems at their roots. They are aimed at strengthening financial and governance systems, increasing transparency, opening markets, and, in so doing, restoring confidence.

To this end, nonviable financial institutions are being closed down, and other institutions are being required to come up with restructuring plans and comply, within a reasonable period, with internationally accepted best practices, including the Basle capital adequacy standards and internationally accepted accounting practices and disclosure rules. All these programs entail institutional changes to strengthen financial sector regulation and supervision, increase transparency in the corporate and state sectors, create a more level playing field for private sector activity, eliminate monopolies and cartels, and increase competition.

* * * *

What can countries that have still been untouched by the crisis do to avoid it and to maintain market confidence? Three key points come to mind.

First, countries have to guard against complacency concerning their economic problems and take an even more critical look at how they could reduce their vulnerability to a sudden change in market sentiment. In this regard, the first line of defense against crisis and contagion is a sound macroeconomic policy framework that promotes growth by keeping inflation low, holds the budget deficit in check, and favors a sustainable current account position. Even within such a framework, it is sometimes difficult to deal with large short-term capital inflows when these are a response to high domestic interest rates and exchange rate flexibility is limited. There is no easy answer to this problem, but the first response should be a tighter fiscal policy stance. Another option is to increase the flexibility of the exchange rate.

Second, countries must strengthen their financial sectors. In our surveillance of member’s economies, the Fund has had many opportunities to observe the causes of banking sector problems, including poor internal governance, a lack of transparency about operations and financial condition, government interference in credit decisions, and official complacency about problem banks. A sound financial system is a prerequisite for sustained growth, but a weak financial system is both a standing invitation to crisis and a guarantee of its severity.

Third, the benefits of greater transparency for macroeconomic and financial stability cannot be overemphasized. When economic and financial information is available, policymakers have more incentive to pursue sound policies, and banks and corporations have more incentive to manage their firms prudently. Moreover, markets adjust more smoothly, and countries are less vulnerable to adverse market reactions when bad news eventually comes to light.

Looking ahead

In the initial months of Asia’s financial turmoil, much of the world’s attention was focused on containing the crisis. But today thoughts are turning to how best to strengthen the architecture of the international financial system. Let me share a few thoughts with you on this score.

First, we must continue to pursue good governance and intensify the fight against corruption. Indeed, in recent years, governance issues have moved not only to the forefront of discussion, but in many cases, to the top of the policy agenda. Why the change? There is more evidence about the harmful effects of governance problems on economic performance—for example, losses in government revenue, lower quality public investment and public services, reduced private investment, and the loss of public confidence in government policies.

Second, we are continuing to look for ways to make our surveillance more effective and to enhance transparency. The IMF must be more ambitious and demanding about the data provided to us and communicated to the markets. We need to know more about the structure of countries’ domestic and external debt, their reserve levels, how high the debt of their corporate sector is, and the level of nonperforming loans; and so do governments and markets.

As you may know, the IMF has established data standards to guide members in releasing reliable data to the public. Already, over 40 countries have subscribed to the Special Data Dissemination Standard, which provides guidance to countries participating in international markets, or aspiring to do so.The goal is to help reduce surprises for markets and help policymakers in implementing sound economies policies.

Third, financial and banking systems, as well as their supervision, must be strengthened. Over the past year or so, the Fund has been working to help develop and disseminate a set of "best practices" in the banking areas, so that standards and practices that have worked well in some countries can be adapted and applied in others. We must continue this work.

Fourth, we must promote more effective regional surveillance. As we have seen in Asia, spillover and contagion effects can be so rapid and so costly to countries with basically sound policies that every country has a strong interest in seeing that its neighbors manage their economies well. For that reason, it is very encouraging to see such initiatives under way in Asia, since experience shows that there is considerable scope for improving policies when neighboring countries get together on a regular basis to encourage one another—and, at times, to exert some peer pressure on one another—to pursue sound policies. The Fund stands ready to contribute its technical expertise to these efforts, as it already does in the G-7 and other fora.

Fifth, we must continue to liberalize international capital flows. This means neither a return to antiquated capital controls nor a mad rush to full immediate liberalization, regardless of the risks. We have to liberalize capital flows—but in an orderly manner. The Asian crisis has cooled the enthusiasm for liberalizing capital flows that was so evident at our Annual Meetings in Hong Kong. And although many may wish to evaluate it in light of the crisis, there are solid reasons not to abandon the effort.

Sixth, we have to see whether better ways can be found, in crisis situations, to involve the private sector in official efforts to resolve debt crises and avoid the problem of moral hazard, perhaps through orderly mechanisms for settling and restructuring debts.

Seventh, we need to significantly strengthen multilateral institutions, by ensuring more equitable representation of all countries on their boards, bolstering their authority, and of course, enhancing their resources.

As you can see, we have a very full agenda for the years ahead. And to this agenda, I should add that we must continue to move forward with full implementation of the IMF-World Bank debt initiative for the heavily indebted poor countries, most of which are in sub-Saharan Africa.

* * * *

In closing, I should like to ask what all this means for Jamaica? Certainly, not all of the lessons that we have drawn from the Asian crisis apply to all countries. But clearly some of the lessons apply to most. And it is incumbent on policymakers and financial market participants alike to identify those lessons that are relevant for them. We have been working with our Jamaican counterparts in developing policy alternatives that would strengthen the economy and avoid the most obvious pitfalls, and we will continue to encourage them to adapt the lessons from the Asian crisis to the specific conditions of Jamaica today. In this regard, the need for financial sector reform stands out. The Government has made substantial progress on this front and the Minister has spelled the objectives and program of the government in this area. I should add that much remains to be done to ensure macroeconomic stability and put Jamaica on a high quality, sustainable growth path.

Mr. Deputy Prime Minister, Minister Davies, Madam Financial Secretary, Ladies, and Gentlemen, I would like to thank you again for having given me this opportunity. I am grateful for your warm hospitality.


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