Lessons from the Asian Crisis -- Keynote Address by Anne O. Krueger, First Deputy Managing Director, IMF
February 12, 2004Lessons from the Asian Crisis
Keynote Address by Anne O. Krueger
First Deputy Managing Director
International Monetary Fund
Sri Lanka, February 12, 2004
One of the many advantages of modern technology is that I am able briefly to join you all in your conference. My pleasure at being able to address you by video recording is, however, tempered by my very great regret at not being able to be there in person. I had been looking forward to my visit to Sri Lanka, after such a long absence, and to participating in what I am sure will be a stimulating day or two of discussion. So I was disappointed when pressing business obliged me to stay here at the Fund.
Much as we appreciate technological advance, it has not, as yet, produced a substitute for human interaction. For me, at any rate, speaking by videotape is a poor substitute for being there. So I am grateful for the forbearance and understanding of Governor Jayawardena and his colleagues at the Central Bank; and for the opportunity to speak as a remote participant.
Back in the summer of 2003, when I first received the invitation to speak, I was struck by the theme of the conference—how central banks can respond to external shocks. It seemed to me not only an appropriate topic but a timely one for central bankers to address. We are in a period of relative calm in the global economy. The recovery is strengthening. Financial crises are, by and large, notable for their absence.
This is precisely the juncture at which responsible policymakers should be looking to the future—seeking to prevent disturbances wherever possible, and exploring ways of responding to shocks when they do occur. And let us be clear: crises will erupt. Unfortunately, we do not know where, or when.
But we have learned at the Fund that we cannot prevent every crisis, nor do we seek to do so. Eliminating every single risk would be disproportionately costly. Our concern, and that of national policymakers, should be to reduce the risk to an acceptable minimum: and to strengthen policy frameworks so that in those—we hope rare—cases when crises do occur, the economic and social costs will be as low as possible.
Policymakers should always be on the lookout for trouble; and for ways of preventing it; and, in the worst case scenario, for ways of minimizing the adverse impact of crises. But productive concern about the future involves an understanding of the past. So the present conjuncture is a useful opportunity to reflect on some of the lessons of the Asian financial crisis—and to reflect, too, on the policy steps still needed to benefit from the experience of 1997-98.
The current outlook
For some in the region, the turmoil of the late 1990s must be a distant memory. Most Asian economies recovered swiftly from the crisis years. Asia, excluding Japan, is set to be the most rapidly-growing region for the fourth consecutive year. We expect growth of around 7 per cent in 2004. The strengthening recovery in the United States, continuing rapid growth in China, and rising domestic demand in many Asian economies is underpinning the region's impressive performance. Estimates suggest Sri Lanka grew by about 5 and a half per cent last year, and there were signs that this strong growth carried over into the beginning of this year.
Such a benign outlook is precisely when the risk of complacency is greatest—which is why, as I said, I judge the theme of this conference to be a timely one.
A period of healthy expansion offers the best opportunity to consolidate progress, and to reinforce the safeguards against future problems. At some point, another slowdown in the global economy is inevitable. Well-judged and well-timed reforms can ensure that economies are less vulnerable to future downturns—reducing both their severity and length.
Far-reaching economic reform often occurs in the immediate aftermath of a crisis. But reform is less painful if carried out in more favorable economic circumstances—however much policymakers are tempted to postpone difficult decisions.
The Asian crisis
This is not the place for a detailed examination of the events of 1997-98. But it is worth reminding ourselves of some of the important facts. The key feature was the sudden sharp reversal of capital flows to the region. Net inflows to the Asian crisis countries were roughly 6.3% of their GDP in 1995, and 5.8% in 1996. In 1997, net outflows were 2% of GDP, a figure which rose to 5.2% the following year. The economic dislocation caused by the sudden reversal was considerable.
But it is worth emphasizing that the change in investor sentiment was not, as some have argued, wholly capricious. There had been a huge expansion of credit over a relatively short period of time. Rapid credit growth is almost always indiscriminate and, in many Asian countries, the result had been a sharp rise in the number of bad loans. These bad loans had reduced the rate of return on capital, and, in time, they reduced the rate of growth. Once the international capital markets recognized that credit had been misallocated, it was inevitable that they would reassess the risks involved in lending to countries whose fundamentals were less sound than they had previously appeared.
Once investor sentiment shifted, several factors conspired to make the situation worse. Fixed exchange rates compounded the problem. Poor regulation of the banking and financial sector in many countries had enabled banks to build up liabilities in one currency with assets in another. Government assurances that exchange rate pegs would be sustained left currency mismatches unrecognized. Devaluation then left financial institutions facing massive losses, or insolvency. Once the cushion of foreign capital was removed, the failures of domestic banking systems were revealed—as was the impact on economic performance.
The contraction in GDP that most crisis countries experienced made things even worse, of course, because the number, and size, of non-performing loans grew rapidly. The further weakening of the financial sector inevitably had adverse consequences for the economy as a whole. In short, the crisis economies found themselves in a vicious downward spiral.
Lessons for policymakers
The experience of the Asian economies—and for that matter many of the other countries that experienced capital account crises in the 1990s—reminded us all of some things we knew. Above all, it reinforced the importance of policies aimed at delivering macroeconomic stability.
But the crises also underlined the need to pay more than lip service to fundamental truths we thought we all understood. In doing so, it changed how we define sound economic policies.
Sustained rapid economic growth should remain the principal objective of policymakers. It is the best means of reducing poverty: we only have to look at global economic performance over the past sixty years to see how great the rise in living standards has been almost everywhere. Nothing in the experience of the crisis countries suggests the need to deviate from that aim.
But it is clear that rapid growth is not enough by itself. The right policy framework should be in place to ensure that rapid economic expansion can be sustained.
Sound monetary and fiscal policies are essential—of course. That need not be a prescription for austerity. Indeed, appropriate fiscal policies can make a substantial positive contribution to economic growth and poverty reduction. Sound policies can free up scarce resources, introduce appropriate liberalization and create the right incentive signals by reducing tax distortions.
Sound fiscal policies should also be anti-cyclical. We have seen in too many recent cases how difficult it is for countries to avoid their fiscal policies being pro-cyclical: usually because they have failed to exploit the opportunities provided during economic upturns to put the public finances in order.
Sustainability also requires careful debt management. Governments must be able to demonstrate that they can service their debts, and that their policies are designed to enable them to continue to meet their debt obligations. It is important to remember that debt can be in the form of contingent liabilities of the government when the exchange rate is, de facto, fixed.
So sound sustainable policies generally include flexible exchange rates. The benefits of short-term exchange rate stability are greatly outweighed by the risks that pegged or tightly-managed exchange rate regimes bring—not least from the danger of currency mismatches in the corporate and the banking sectors.
A strong, well-regulated financial sector has to be a key element in a sustainable policy framework. That means addressing often difficult issues such as non-performing loans; capital adequacy; and effective supervision. Financial institutions need the appropriate incentives to develop the skills required to assess and manage credit risk and returns. Effective bankruptcy laws—that strike the right balance between creditors' and debtors' rights—need to be in place.
And going beyond bankruptcy, countries need to have a legal and institutional framework that respects and protects property rights, upholds the rule of law, and combats corruption.
I spoke earlier about the need to consolidate progress. There is no doubt that much has been accomplished in past few years. One sign of how far we have come is that all the Asian crisis economies have completed their Fund-supported programs—Indonesia was the last to do so at the end of 2003.
Most countries now have sound macroeconomic frameworks in place. Monetary policy has become more focused. Fiscal policy reforms are under way in several countries. And flexible exchange rate regimes are the order of the day in most countries in the region.
But that said, much remains to be done, especially in the area of structural and institutional reform. Hence my emphasis at the outset on the need to seize the opportunity which this period of economic expansion offers for pursuing the necessary reforms with renewed vigor.
Perhaps the most urgent need is the further strengthening of the financial sector. In many countries, banks and companies are still struggling with weak balance sheets. This weakness undermines growth opportunities. It is no coincidence that those countries that have been more aggressive in the area of financial sector reform have enjoyed better growth performance.
And in many Asian countries, much work still remains to be done to put in place effective bankruptcy laws, and to improve prudential oversight and governance in the capital markets. In general, we are still some distance from the open and competitive environments which can best foster the sustainable, rapid growth we all seek.
At the same time, more effort is needed to deepen financial markets—to extend the number and variety of instruments available, for instance. A more rapid shift towards equity and bond financing would reduce reliance on the banking sector. It would improve the assessment and management of credit risk. And it would help in the creation of a thriving financial market which is, of course, the lifeblood of capitalism.
A healthy financial sector is crucial. But so too is a healthy corporate sector—and the two are more closely related than is often recognized. A weak financial sector cannot be nursed back to health if corresponding weaknesses in the corporate sector are ignored—any remedy will turn out to be no more than a short-term fix as more corporate loans go bad.
Improved corporate governance is a requirement of corporate sector health. As has become clear in all too many countries around the world, lax standards can undermine business performance and, in turn, economic growth prospects when investor confidence is damaged.
The IMF response
I want to return to some of these issues in a moment. But I want first to outline some of the ways in which the IMF itself has responded to the lessons of the 1990s. Our fundamental objective has not changed. It did not need to. Right from its inception, the IMF has been charged with facilitating the expansion of international trade and, I quote from our Articles of Agreement: "to contribute thereby to the promotion and maintenance of high levels of employment and real income". These are, we are instructed, "primary objectives of economic policy".
So the development of sustainable economic policies has always been at the heart of our work. What's changed is how we define sustainability. We now pay particular attention to debt sustainability, for example—and debt sustainability analyses are standard. Capital account crises invariably involve the market concluding that a country will not be able voluntarily to continue to service its debts. Assessing a country's debt burden, and its ability to service that debt, is one important way in which we can seek to prevent crises.
But we also pay close attention to the financial sector, not least because of the contingent liabilities involved. There are several important ways in which we can make a judgment about the robustness of the financial sector. These include the health of the banking system—and here the level of non-performing loans is relevant; the extent to which risk is clearly defined in the financial system; and the systems' transparency.
Many of you will be familiar with some of the steps we have taken to formalize our financial sector assessments. The Financial Sector Assessment Program (FSAP) was introduced in 1999. The FSAP is a joint program with the World Bank—at least insofar as low-income countries are concerned. The program aims to help member governments strengthen their financial systems by making it easier to detect vulnerabilities at an early stage; to identify key areas which need further work; to set policy priorities; and to provide technical assistance when this is needed to strengthen supervisory and reporting frameworks. The end result is intended to ensure that the right processes are in place for countries to make their own substantive assessments.
The FSAP also forms the basis for Financial Stability Assessments (FSAs) in which IMF staff address issues directly related to the Fund's surveillance work. These include risks to macroeconomic stability that might come from the financial sector and the capacity of the sector to absorb shocks.
We have also worked with the World Bank to develop a system of Standards and Codes—using internationally-recognized standards—that form the basis for Reports on Standards and Codes (ROSCs). These cover twelve areas, including banking supervision, securities regulation and insurance supervision. The financial sector ROSCs are an integral part of the Financial Sector Assessment Program and are published by agreement with the member country. They are used to sharpen discussions between the Fund—and, where appropriate, the World Bank—and national authorities; and, in the private sector, including rating agencies, for risk assessment purposes.
I want to make a brief aside here. All too often, when I describe our work in this area, I sense the audience's eyes begin to glaze over. I need not fear that today—and not just because I am speaking via a video recording! As central bankers, you are all, I know, fully seized of the importance of financial sector soundness. You understand more than most that to see our work on FSAPs and ROSCs as worthy but dull is to miss the point completely. When financial crises erupt, they do so suddenly and brutally. As we have seen in some recent cases, they can quickly lead to panic and chaos on the streets. Anything we can do to reduce the risk of that happening is clearly of the utmost importance.
Words of warning
The Fund can do much to help member countries introduce and implement the policies needed for macroeconomic stability—itself a vital ingredient for sustained, rapid growth. We can assess, advise, and assist. We now provide technical assistance on a wide range of issues that, until recently, might not have been regarded as fundamental ingredients of macro policy.
The Fund also stands ready to provide financial assistance to members in difficulties. In recent years, we have refined the sorts of assistance we can provide to countries in distress, and we have sought to clarify the options available.
Crisis prevention is our objective, but, as I noted earlier, crisis resolution will inevitably be needed from time to time. And, just as inevitably, it will be by our work on crisis resolution that we are judged.
With all that in mind, I want to sound two warnings today.
The first is on the need to push ahead and complete the structural reforms that most countries embarked on after the crisis of the late 1990s. In particular, I make no apology for emphasizing, yet again, the importance of a sound financial sector. Postponing change will not make the need for it go away—quite the reverse. Asian countries need look no further than Japan if they want to see quite how high the price of prolonged inaction can be.
While financial sectors remain weak, economies remain more vulnerable than they need be to sudden external shocks. They also remain exposed to internal shocks, or shifts in investor sentiment.
I used the word complete—but of course in a very real sense, the reform process can never be complete. Talk of reform fatigue that one hears from time to time is essentially misguided. Reform must be an ongoing process. Even the largest and most sophisticated economies are constantly adapting to change—and their policymakers are having to adapt as well. Look at the radical reassessment of accounting standards and corporate governance practices now under way in America and Europe, for instance.
The other concern to which I want to draw attention today is the rising level of public debt in many emerging market economies—and many of those in Asia. This is disturbing, partly because high levels of government debt were not the prime cause of the 1997-98 crisis. But emerging markets as a whole have ratios of total debt to GDP that are now much higher than the industrial countries. And the growth in public debt since the late 1990s has been particularly rapid in emerging Asia—it rose from around 40% of GDP in 1996 to a peak of over 65% in 2001. Some progress in reducing debt levels appears to have been made in some countries. But for Asian countries as a whole, the debt to GDP ratio is now significantly larger than eitherLatin America or the transition economies.
High debt ratios are a drag on the economy. They keep borrowing costs high. They discourage private investment. And they constrain the flexibility of fiscal policy. They also make economies vulnerable to rising global interest rates—hardly, at this juncture, an unthinkable prospect.
It is all the more worrying that emerging market debt ratios are so high—and, in some cases, still rising—at a time of economic upswing. This is when governments should be seeking to restructure their public finances, to bring them nearer to balance.
I accept that a more benign outlook deprives policymakers of a sense of urgency. It can be more difficult to explain the need for unpopular economic policy decisions when growth is buoyant. But, as I said, adjustments are less painful when made from a position of relative strength. It cannot make sense to wait until circumstances require far more painful measures.
This is, after the upheavals of recent years, a more tranquil period for the world economy. The outlook is auspicious. But it is not the moment to sit back, relax and enjoy the flight. It is not the moment to decide that enough is enough, and to postpone further reform in the hope that the good times are here to stay.
Let me end by quoting the distinguished Roman poet, Horace:
While we're talking, envious time is fleeing: seize the day, put no trust in the future.
Thank you very much.