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Symposium on Capital Flows and Financial System Stability in Asia--Address by Shigemitsu Sugisaki
December 8, 1997
I. Introduction
It is a great pleasure to address this symposium chaired by Mr. Gyohten, who has made such distinguished contributions to international economic cooperation and to the role of Japan in such efforts, including in the formative days of policy cooperation and coordination among the G-7, and in Japan's relations with the IMF. Today's topic, Capital Flows and Financial System Stability in Asia, is one of the most urgent preoccupations of the International Monetary Fund. From our perspective, let me address the roots of the crisis and the extent of global contagion, and the need for policy action at the national, regional, and international level.
II. What caused the crisis?
The crisis in Thailand came as no surprise. The erosion of Thailand's international competitiveness resulting from the pegging of the baht to the rising U.S. dollar and insufficient progress in structural changes compared with competing countries accounted for a collapse of export growth last year and a widening of the already large external current account deficit. The large capital inflows, including an increasing share of short-term external debt, were intermediated through a weak banking sector and partly invested in the property market, thereby grossly inflating property prices. These macroeconomic warning signals had been evident for some time, and particularly since 1996. The IMF had provided repeated warnings to the Thai authorities. But unfortunately the advice was not followed and adequate remedial action was delayed until the crisis had occurred. This proved very costly for both Thailand and its regional partners.
The contagion effects have been large, both regionally and globally. The crisis in Thailand has spread to and continued to affect financial and currency markets in Hong Kong SAR, Indonesia, Malaysia, and the Phillippines, and Korea, most recently. But the effects on regional economies were not due only to contagion. It is true that the other East Asian countries were characterized by lower external current account deficits than in Thailand, but market expectations were also affected by concern about the fundamental health of these economies. Let me mention three factors:
First, the other East Asian countries suffered from many of the same structural and governance weaknesses, as did Thailand, including the soundness of the financial sector and overvalued property markets.
Second, once the exchange rates were no longer pegged to the U.S. dollar, market participants have paid close attention to the tightening in monetary policy and the willingness of the authorities in the concerned countries to raise interest rates. The legacy of low interest rates in these countries is only too well-known.
Third, East Asian countries have a long tradition of government intervention in the development process. This may have served them well in the past, in particular when markets were less integrated than now. However, in a globalized world with integrated trade and capital flows, market participants--both domestic and foreign--fear government interference in the operations of the financial institutions and in the enterprise sector and the reimposition of controls that are inconsistent with a level-playing field. The historical links between the government, banks, and enterprises in the East Asian economies are typically close. For those Asian governments, there is a need for a fundamental revisiting of these links to match the requirements of a globalized world economy.
What will be the impact on the world economy?
We are in the process of revising our projections. The short-term growth prospects for the countries affected by the financial crisis are being revised down because of reduced funding by private investors abroad and contractions in domestic demand. But as the experience in Mexico has shown, the slowdown need not be prolonged. The direct effect of the crisis on the net exports of the industrial countries and activity in their economies as a group is expected to be moderate although for some countries such as Japan it will not be insignificant. Fortunately, growth has proven stronger than expected this year in North America and Europe. But clearly in Japan the problem of an already weak cyclical position is compounded by the difficulties in the financial sector, falling equity prices, and the impact of the problems in the region.
The short-term forecasts are subject to great uncertainties. Much will depend on the full implementation of the adjustment policies in the East Asia economies themselves. In addition, it will be important that no further withdrawal of fiscal stimulus take place in Japan although further efforts are needed later on to make progress on fiscal consolidation. I welcome the consideration that is being given to the use of public money to restore the health of the financial system. It will be important that such public support be extended to protect depositors and to promote an effective restructuring of the banking system in a transparent manner. For other major industrial countries, the temptation to tighten monetary policy should be resisted. Finally, a great deal will depend on the restoration of the confidence of international capital markets in the emerging market economies. Clearly, investors and portfolio managers are reevaluating the risks of all borrowing countries and this poses a major downside risk to any projections that assume a resumption of capital flows at their earlier high levels in the near term.
III. Lessons--Policy action at the national level
What are the key policy lessons? Let me briefly recall the main areas at the national level where the authorities need to be alert to imminent risks in the economic situation.
First, the authorities should pursue sound macroeconomic policies. In particular, if required by changes in economic fundamentals, authorities should not cling too long to a pegged exchange system but be prepared to pursue a flexible exchange rate policy and a supportive tight monetary policy immediately following the floating of the exchange rate to stem capital outflows. There is often no viable alternative to this painful measure. But we also recognize that this imposes a difficult dilemma for most authorities since high interest rates are likely to slow down economic growth in the short term. In addition, a prudent fiscal policy needs to be pursued so that the private sector is not alone in being responsible for a correction in the external current account deficit. It also has to take account of the costs of possible restructuring of the financial and enterprise sectors.
Second, the authorities should pay due attention to structural policies, including the soundness of the domestic banking system. The financial system problems have been at the heart of the recent crisis. There is a need for authorities to take prompt action to close insolvent financial institutions and improve banking supervision and prudential standards. This is a sine qua non in a world of globalized financial markets.
Third, since a strong adjustment program might be associated with a slowdown of economic activity in the short run--albeit less than in the absence of such policies--there is a need to consider the social implications of policy options and possibly build in a social safety net and in some cases protect government expenditure in basic education and health and other social services.
Fourth, greater transparency in the provision of economic information is necessary, both internally within the government and vis-à-vis the general public. Private markets cannot function efficiently without such information.
Finally, the importance of good governance cannot be overemphasized. Transparency is only one element of good governance. Others pertain to the creation of institutions and systems that limit the scope for ad hoc decision making, for rent seeking activities, and for undesirable preferential treatment of economic entities. Good governance is essential for restoring market confidence in an economy.
This has been a learning process for us all. Even the countries that have been the envy of other developing countries in terms of strong macroeconomic performance for more than a decade need to be alert to imminent risks stemming from those key areas and to be prepared to take policy action on a timely basis once required by the economic situation. There is no room for complacency.
IV. Policy coordination at the regional level
Recent events have demonstrated that countries in the region can be severely affected by adverse developments in other countries in the region. This suggests to us that regional surveillance -- peer pressure by the closest neighbors of the country concerned -- may have an important role in promoting timely policy action. It is possible, for example, that Thailand would have taken earlier action if it had been exposed to peer pressure from neighboring countries. It is therefore important that countries in the region exchange information, discuss policy responses to economic developments, and provide policy advice to each other. This has worked well in other fora such as in the European Union and in G-7, where the IMF has also helped the process of regional surveillance.
I therefore welcome the agreement reached in Manila on November 18-19 at the meeting of Asian Finance and Central Bank Deputies on a new framework for enhanced Asian regional cooperation to promote financial stability, which was subsequently endorsed by APEC's economic leaders in Vancouver. We, in the IMF, are certainly willing to play a central role contributing to regional surveillance, including through our newly opened Tokyo office.
V. International coordination
The problems of East Asia have global ramifications that require international coordination. The IMF has the responsibility to assist in reducing the considerable systemic risks to the entire international financial system. The assistance of the IMF in the current crisis has taken several forms:
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