GEI Newsletter Issue No. 7

David Vines

[footnote - David Vines is Director of the Global Economic Institutions Programme, Fellow in Economics at Balliol College Oxford, and a Research Fellow of the Centre for Economic Policy Research in London. This paper consists of an edited version of remarks made at a conference on Asia and Europe: A New Agenda after the Crisis? held at CEPII in Paris on 11 and 12 May 1998.]

The GEI Programme has participated in the hosting of three meetings on Financial Crises in the past twelve months. The first of these meetings was a joint ESRC-CEPR conference on "The Origins and Management of Financial Crises", in Cambridge on 11/12 July 1997, and in London, on 14 July 1997. A report of this conference is presented on page * of this Newsletter. On 4^th and 5^th February 1998 a meeting on Financial Crises and Asia was organised by CEPR and funded by the UK Foreign and Commonwealth Office; HM Treasury; the Bank of England and the GEI Programme, and hosted by the Bank of England. On 4 - 5 May a meeting on Financial Crises: Contagion and Market Volatility was organised by the CEPR and the World Bank, in conjunction with Credit Suisse First Boston and the GEI Programme. A report on that conference will appear in the next issue of this Newsletter.

One year ago - before the fateful summer of 1997 - popular discussion of the Asia Pacific region was still concentrated on the Asian miracle. The central issues of concern were about trade liberalisation. Scholars debated how the motor of East Asian growth had been the opening of markets. The well known paper by Sachs and Warner documented how openness leads to growth and the major topic of consideration was how trade openness in Asia had increased the rate of return on investment for export sectors serving the world market, and how this had led to export-led growth. The key policy issue for the region seemed to be how to sustain the Asia Pacific strategy of AOpen Regionalism@: how could links between liberalising markets in the Asia Pacific region and impetus for liberalising markets in World Trade organisation be sustained and strengthened. How could the agenda be pushed forward for a new round of global trade negotiations at the beginning of the new millennium?

How things have changed. One year later, discussion of the Asia Pacific region is concerned very little with trade. For the crisis that has struck the region has been a crisis not to do with trade liberalisation, but with financial liberalisation.

Many are now asking why is financial liberalisation desirable when these countries were saving and investing so much already. Any answer has to include the fact that developing countries such as the Asian Tigers and Asian Dragons have been countries which are capital poor, with low wages; and liberalisation enables part of growth to be externally financed. They are also economies with low technology, and capital inflow can bring technological improvements. And exposure to world markets enforces external price discipline and can make the whole process of capital allocation more efficient. Each of these points mean that it would be quite wrong to draw the long-run lesson that financial liberalisation is in the abstract a mistake, and not a desirable long-run goal.

But is Asia Pacific experience of financial liberalisation contains some salutary lessons about the desirable path to this long-run goal. At this very early stage we can draw four long run lessons.

Lessons about Policies

Macroeconomic policy.

The East Asian experience of the last ten years teaches us that liberalisation in the face of flawed macroeconomic policies can be very dangerous. With an open liberalised financial system open to mobile international capital flows, monetary policy cannot be based on pegged exchange rate systems. Accounts of macroeconomic policy making in Thailand and Indonesia during the early 1990s show very clearly how important it is to learn this lesson.

This is not a lesson which had been learned in the early 1990s. A paper on Thailand ***

One might say that this is a lesson which we should all have learned long ago. The text-book Mundell-Fleming model shows that the trilogy of fixed exchange rates, autonomous national monetary policy, and open international capital markets is inconsistent. And yet many other countries have failed, before the recent experience in Asia, failed to learn this lesson. For example, monetary policy in the United Kingdom in the late 1980s and early 1990s contained contradictions of a very similar kind (an attempt to both control inflation and peg the exchange rate at a low level in the mid 1980s, and an attempt to promote a recovery from recession and maintain a fixed exchange rate within the ERM link in the early 1990s; both ended in catastrophe).

In the Asia Pacific region, recent accounts of macroeconomic policy in Thailand describe how policy makers tried to damp the boom in the early 1990s by raising interest rates, even although the Thai bhat was pegged to the dollar. The effect was to stimulate capital inflow, as Thai companies and banks borrowed abroad at lower dollar interest rates, and to leave the economy with a large outstanding stock of unhedged foreign debt, without succeeding to dampen the boom in the economy. (Such policy may even have fuelled the boom. With credit constraints within the domestic economy, higher interest rates on domestic credit may have it actually encouraged financial intermediaries to borrow abroad and to increase the supply of lending.) Similar errors were made in Indonesian and Korean macroeconomic policy.

In a world of high capital mobility it is essential that the exchange rate be floating. This enables monetary policy to damp booms by raising interest rates and appreciating the exchange rate, and to alleviate slumps by doing the opposite. And it avoids the issuing of implicit exchange rate guarantees, which can lead to large unhedged borrowing. Of course conducting macroeconomic policy with floating exchange rates requires a whole new policy structure. The exchange rate peg as a nominal anchor is removed, meaning that the credibility of anti-inflation policy must depend on the competence of the Central Bank, on its ability to dampen inflationary booms and ameliorate slumps, so as to steer a stable non-inflationary course. This is no trivial task. But the lesson is that liberalisation of the capital account of the balance of payments must await upon the ability of macroeconomic policy makers to pursue just such a course.

Microeconomic policies.

The Asian experience also shows that liberalisation in the context of flawed microeconomic can be very painful. The previous financial system in Asia involved high domestic savings, cheap domestic credit, high investment and high growth. It worked in an enviable way. Until recently we all believed, or almost all believed in the AAsian Miracle@. The return on the investment might not have been very high - many since Krugman’s famous 1994 paper drawing on the work of Allyn Young have argued that the productivity of investment in the Asia Pacific region left much to be desired - but with very high savings and investment, growth remained at rapid rates. Savers received low returns, some investors were favoured, many received guarantees, either implicit or implicit. But the system delivered rapid growth.

Liberalisation involved offering to outsiders access to aspects of the old style financial system - high returns with guarantees. Like the insiders they came to get access to cheap credit; they obtained access to a banking system which was guaranteed; and the fixed exchange rate system enabled (as already noted) borrowing in international currency with an implicit guarantee. This involved opening up to outsiders an unreformed financial system designed for the privileged channelling of credit to insiders. In retrospect the contradictions are obvious.

We have learned from the Asia Pacific experience that crisis can explode with particular violence when macroeconomic and microeconomic weaknesses interact. The way in which this has happened has differed from country to country.

Thailand’s crisis was initially primarily a macroeconomic crisis in which - with a fixed exchange rate - monetary policy was unable to damp boom and ameliorate the ensuing slump. (See Chote, 1998) There had been a long period of very large current account deficits which became more serious in 1996 in the face of a downturn in export revenues. At the same time, although price inflation was under control, buoyant demand over a number of years had led to rising wage costs in the export sector. The Thai authorities were reluctant to abandon their pegged exchange rate during the boom phase, even although the need for this became increasingly obvious in 1996 as the slump set in, and even though they were urged to do so by the IMF. But once they had done so, with the onset of the crisis in the middle of 1997, there was great uncertainty about the ability of the authorities to take the corrective action. The Thai authorities were reluctant either to tighten fiscally by a sufficient amount, or to suspend bankrupt finance companies, or to pursue a consistently tight enough interest rate policy. All of these actions were needed to stem the devaluation. But once the exchange rate began to collapse, the large unhedged foreign borrowing in dollars could not be honoured, ushering in a full-blown financial crisis.

By contrast the Korean crisis appears to have been primarily a financial crisis, but one that has provoked a deeper macroeconomic crisis. Thailand acted - Morris Goldstein’s phrase - as AWake Up Call to investors in Korea, prompting them to fear that the financial system was like that in Thailand. " This contagion led to an unwillingness to rollover debts. Creditors attempted to move out of the national currencies into dollars, ahead of other creditors. As the crises developed and currencies plummeted, the value in domestic currency of outstanding obligations rose beyond what companies could afford to pay, making creditors all the more unwilling to roll loans over. Countries suffered from what were effectively national "bank-runs". A similar process of contagion appears to have affected Indonesia. At the time of writing it is possible that Malaysia may be next in suffering a full-blown crisis.

Lessons about Crisis Management.

Whatever the new way in which these crises have been caused, they have also posed completely new problems in crisis management. Suddenly the crises have caused a large number of losses; debts which cannot be repaid immediately, and which may never be repayable. These have fallen upon the banks, and have explicitly in Korea and implicitly elsewhere become socialised through the state guarantees offered to the banking system. The debt has been incurred in foreign currency, and is worth much more in home currency as a result of the currency collapse.

The crucial task of crisis management is to allocate these wealth losses.

This task makes these crisis with open international capital markets very different from the orthodox balance of payments crisis with which the International Monetary Fund is used to dealing, in which problems are those of excess domestic absorption and a lack of national competitiveness. For those "orthodox" crises the correct remedies are tight fiscal and monetary policies to curb the excess absorption, and to steer the exchange rate to the appropriate, modest, level of depreciation required for expenditure switching so as to promote net exports. Critics of the Fund have argued that these orthodox remedies do not address the problem of allocating losses. Indeed, it has been argued that Fund remedies may have actually made the problems worse. (See Stiglitz, 1998) Tight monetary policies will reduce, not improve, the creditworthiness of indebted firms. And fiscal contraction, by exacerbating the downturn in the face of panic, causes revenues to fall. The Fund has replied that halting and reversing currency collapse is a precondition of crisis resolution, and that traditional polices are essential for that purpose because there is no effective alternative. (See the discussion in Chote, 1998). Many have nevertheless argued that urging interest rates of 25% in Thailand when inflation was expected to rise from 5% to 10% was excessive, that interest rate conditions were excessively tightened in Korea, and that the fiscal tightening required in the packages was excessive.

There are two types of problems in allocating these wealth losses. How are foreign creditors to be treated? How are domestic creditors to be treated? How these problems are dealt with give rise to essentially three cases.

In this scenario foreign creditors are repaid, and taxpayers meet the bill. This AMexico Solution" can be quick. The task of crisis management is to provide sufficient liquidity to enable immediately outstanding debts to be rolled-over, and to reassure international creditors that indeed all debts will be repaid in full, so that a continuing orderly rollover of debts by the private sector can proceed. In the Mexico crisis of 1995, Mexico received a $17.8 billion stand-by program (amounting to what was then an unprecedented 688 per cent of Mexico’s quota in the IMF), in combination with $20 billion from the US Stabilization Fund and $10 billion from the G10. But this funding enabled Mexico’s debts to be rolled over in full, and the loans are in the process of being paid in full. Mexico quickly regained access to private capital markets and output is back above its pre-crisis level within two years.

When the Mexico crisis hit at the end of 1994 it was hailed as the first crisis of the 21^st century, and everyone believed that a major task had been accomplished in dealing with it. But in retrospect solving the Mexican crisis looks to have been really easy. This is because the debts were sovereign debts. The solution of deciding to honour these sovereign debts, and quickly raising the revenue to do so through taxation is not an inevitable outcome of a sovereign debt crisis - as the Latin American crisis of the 1980s shows. But with three years of hindsight it looks to be comparatively easy. If, however, the debts are private it is very hard to follow this route.

In the second scenario foreign creditors are repaid, but within the country there remains a need for domestic crisis resolution. There is a need for bankruptcy proceedings to resolve the financial position of heavily indebted private firms, for bank reorganisation which does the same for the banking system, and for recapitalisation of those parts of the financial system that are saddled with unredeemable debts of bankrupt firms. This is the Korean situation at present. Until this domestic crisis resolution really happens, it is not clear which firms and which banks are financially viable, and it is not clear which are attractive to foreigners to continue to own or to purchase through inward investment. Continuing capital inflow, the rolling-over of debts, and the resumption of investment in growth will not happen until decisive steps are taken to resolve these uncertainties.

Many in Korea now complain that they are ill-treated in that capital inflows have not resumed, even though the country has been scrupulous in honouring its foreign debts. The lesson of the Korean case is that the resolution of domestic debts is necessary also. This is difficult. The shutting of bankrupt chebol, and the reorganisation of banks takes time. And yet a full resolution of the crisis awaits significant action on this score.

In the third case foreign creditors are not to be repaid and bankruptcy and crisis resolution procedure is required domestically. This is by far the most difficult case to organise. It appears to be what now needs to happen in Indonesia. There is to be debt reduction by banks, a loss taken by shareholders, the government needs to assume some of the debt, roll it into bonds and sell it off, and to take it upon itself the task to repay some, but not all of the debt owed to foreign creditors. What proportion of the loss will be taken by shareholders, domestic taxpayers, and foreign banks (and perhaps foreign taxpayers) becomes an extremely difficult bargaining problem. The resolution of this bargaining problem, with at least three sides, may take years. The problem is that there is no orderly workout procedure available to allocate the losses. In the Latin American debt crisis of the early 1980s, rescheduling and partial default led to a problem which took ten years to solve - Latin America’s "lost decade". The crisis greatly added to poverty and there were ten years of low investment. Resolution took so long both because of free-rider problems - each lender seeking to profit from concessions made by competitors - and because creditors held out for injection of funding from the governments of advanced countries. It will be principle an even more difficult task to organise an orderly workout of Indonesian debt than the task which was posed by the Latin American debt crisis (even putting aside the severe political difficulties apparent at the time of writing). Although all Indonesian debtors are hit by the same macroeconomic crisis, the positions of individual borrowers are all different. Thus, as well as the free-riding and hold-up problems already mentioned, lenders are reluctant to initiate rescheduling because of fears that offering concessions to one debtor will encourage others to demand similar treatment.

Lessons for Global Economic Institutions

(i) Macro Policy design and surveillance, and the IMF.

The International Monetary Fund=s surveillance of mechanisms have been found wanting by this crisis. Internal studies within the Fund have already described the IMF was drawing attention to macroeconomic imbalances in Thailand, but that it did not foresee the impending severity of the impending crisis. More seriously, the Fund was essentially caught unawares by the crisis in Korea. There are also tasks for the Fund in modernising its advise in policy design. Advising countries about the need for, and the way to achieve, central bank credibility and the management of macroeconomic policy with floating exchange rates so as to produce a stable low inflation environment is an enormous task. One has only to think for example about the enormous amount of intellectual energy which has been expended on just this task in Britain, New Zealand, Australia and other OECD countries.

(ii) Financial Restructuring and Surveillance, and the World Bank

There are enormous tasks ahead for the World Bank in helping countries to restructure financial systems in the face of this crisis, and also to design a transparent, properly regulated financial systems which will curtail the kind of risky speculative investments that this episode gave rise to. If the Bank is to become deeply involved in financial reform in this way, this presents a difficulty for its division of labour with the IMF. The Fund has been responsible for macroeconomics and the Bank for microeconomic development issues, but these demarcations are essentially blurred when dealing with the banking and financial sectors. One other way of attempting to make the division of labour is to suggest that the Fund deals with monitoring, surveillance and short-run crisis resolution whereas the Bank deals with financial reconstruction and longer term structural reform. But these tasks are interrelated. For example, in dealing with the Indonesian crisis the IMF was forced to take rapid action and closed 16 banks. But it took this action without being able to say whether those banks which remained open were closure in the longer term reform process, and the result was widespread panic. There are suggestions that - because of the importance of sound financial systems to effective macroeconomic policy - all of the financial sector expertise of the Fund and the Bank should be concentrated in the Fund. This is unlikely - but much closer cooperation between the two institutions will be essential.

There are tasks ahead in risk management for the regulators of international banks in the lending countries, to discourage speculative lending of the kind that international banks engaged in during the runup to the Asian crisis. If, as it appears from both the earlier Mexican episode and the Asian crisis, banks will not take due care in the lending process, then it may be up to regulators to impose very significant risk weightings in lending to these markets so as to make lending more costly to these markets and discourage it . Such moves would help to tip the balance in the composition of investment in emerging markets toward equity , which this crisis has shown to be necessary.

4. Crisis Management

Finally the crisis has thrown up the need for international institutions of crisis management, especially in the case where foreign creditors are not all to be repaid. There is a gap in international architecture here, as US Treasury Secretary Rubin has recently forcefully argued. At present it seems that the IMF is confined, of necessity, to the role of providing liquidity financing to debtor countries, as a quid pro quo for a guarantee that international debts will be honoured. This was the case in the Mexican crisis where the sovereign debts were dealt with and have been honoured by the Mexican taxpayer. It also appears to be the likely outcome of the Korean crisis, where the Korean taxpayers will pick up the responsibility of servicing the debts of foreign banks. But when this is not possible, because the existing debts are too large, then a rescue package must involve a stay on payments to private creditors (whether the debtors are public sector or private sector), an injection of liquidity financing in the short-term and an orderly writing-down of the debts. If all three parts of the package are not available then liquidity injection from the IMF will simply finance capital flight, as creditors scramble to be first in obtaining what settlement of claims they can.

The IMF is now in a very difficult position. There are very significant obstacles - including serious legal ones - to organising the necessary workout process. And there is no clear agreement that the Fund is the right institution to oversee it, since the Fund would be required both to oversee the workout procedure and to advise and assist indebted countries Nevertheless some orderly workout seems essential, in order that a failure to repay in full does not lead to an extended period of debt deadlock, both in Indonesia, and in similar circumstances in the future. If such a workout process is not established, then it will go on being possible, as in the case of Korea, to argue that repayment is a less bad outcome than deadlock. Significant moral hazard will remain in the international system - lenders, continuing to point to the dire difficulties associated with debt deadlock - will continue to expect to be bailed out, and will continue not to take sufficient care in lending. In these circumstances, too, the IMF will come to be seen as a debt collecting institution. This cannot be good for the legitimacy of the Fund as an international institution.

The Newsletter of the GEI programme is published three times annually to inform policy-makers and the academic community of research, meetings, conferences, and Working Papers of the GEI programme.

To receive regular issues of the Newsletter of the Global Economic Institutions programme or to receive copies of back issues send an email containing your address and contact numbers to gei@cepr.org.