Economic and Financial Situation in Asia: Latest Developments

Introduction In the year after the Asia-Europe Finance Ministers Meeting in Bangkok in September 1997, the serious, but apparently isolated, crisis faced at that time by Thailand was followed by worldwide turbulence. Situations of similar severity developed elsewhere in Asia, and Russia's unilateral debt moratorium in August 1998 led to a broader increase in risk aversion among financial investors, and to the drying up of private financial flows to emerging markets. Fears arose that crisis would spread to several major emerging market economies in Latin America. At first largely insulated, the industrial countries also began to feel the effects of the crisis during the third quarter of 1998, which together with signs of deepening recession in Japan, gave rise to concerns about a global credit crunch. By the time of the IMF/World Bank Annual Meeting in October 1998, fears had escalated that the current economic slowdown might continue to widen and deepen in 1999. By the end of 1998, signs were emerging that the worst of the crisis in Asia was over, and that conditions were emerging for renewed growth later in 1999. The key challenge now is how to ensure that these tentative signs of recovery can be turned into a sustained recovery of strong high-quality growth. After a brief review of recent global developments (Section II), this paper assesses Asia's programs, performance, and prospects (Sections III and IV). Finally, noting that Asia was the first to encounter the effects of the crisis, and has for some months begun to show positive responses to the policy programs, Section V explores the characteristics of the revitalized Asia that may emerge from this experience. Recent global developments Although a number of downside risks linger, the risk of worldwide recession was diminished by several positive developments during the last quarter of 1998, most of them considered policy actions by countries around the world, which helped to restore a measure of calm to financial markets. These actions include:

Easing of interest rates by central banks in most industrial countries; New policy measures in Japan to address banking sector problems and announcements of further fiscal stimulus; Commitments by Brazil to a program to address its economic imbalances with extensive support from the international community, agreed in mid-November; Continued progress with stabilization and reform in the Asian crisis countries suggesting that the conditions are emerging for a recovery of growth;

Progress toward implementing the IMF quota increase, the activation of the New Arrangements to Borrow, and the Miyazawa Initiative to provide additional assistance to the Asian crisis countries; The proposal by G-7 Finance Ministers and Central Bank Governors, in their endOctober statement, to enhance financing facilities in the IMF and World Bank to help ward off financial market contagion, along with their reaffirmed commitment to move forward with the agenda to strengthen the architecture of the international financial system.

Overall, therefore, there is some evidence that conditions in capital markets have eased since early October. But there are still signs that perceptions of risk are considerably greater than has been normal in recent years. These conditions are reflected in the IMF's latest projections1 that point to growth in both 1998 and 1999 of about 2 1/4 percent, well below the strong growth of previous years, followed by a recovery to about 3 1/2 percent in 2000. Even if the risk of recession has abated, the international community still confronts an imperfect international financial system, some elements of which have not been adapted sufficiently to keep pace with the rapid evolution of the markets in recent years. The Asian crisis demonstrated clearly that, in addition to problems in the countries themselves, the international system still lacks many of the standards and the transparency that characterize well-developed financial markets at the national level. The Asian Crisis, Programs, and Responses2 1. The background revisited As a broad generalization, the crises in East Asian countries were the result of interaction among shortcomings in the global system, flawed national financial systems, and deficient corporate and public governance. As global financial markets developed, especially in the early 1990s, capital was attracted to East Asia in large part because of its exceptional record of growth and macroeconomic management. However, serious weaknesses that had been concealed in part by the magnitude of the flows, and in part by the inadequacy of risk assessment by foreign creditors and weak supervisory practices in some creditor countries, eventually came to light with the onset of the crises. The conjunction of these long-term trends led to the most critical weaknessthe immediate cause of the crisisthe accumulation of very large amounts of short-term debt. In the years prior to the crisis, large capital inflows contributed to a variety of problems including overinvestment, inflated domestic asset prices and, deteriorating loan quality. These weaknesses, in turn, reflected more fundamental problems, including weak domestic bank supervision and regulation, a history of political interference and the lack of sound commercial standards in the allocation of credit, and pervasive explicit or implicit government guarantees. Short-term inflows were also drawn in by the perceived implied guarantee represented by the exchange rate regimes that were viewed as de facto pegs.

Against this background, the way in which capital flows were liberalized contributed to financial sector weakness: banks and corporations gained ready access to large amounts of short-term external borrowing that was not adequately monitored by authorities, while longer-term capital flows were being liberalized more gradually and deliberately. In short, the countries had become highly vulnerable to sudden shifts in investor sentiment. The domestic vulnerabilities came to a head as growth slowed in 1996, largely as a result of adverse terms-of-trade shocks, a loss of competitiveness associated with currency pegs that were maintained in the face of a sharp dollar/yen appreciation, declining export demand, and growing over-capacity in certain sectors. In Thailand, which also had a relatively large fiscal imbalance, the developments were reflected in a widening current account deficit. Policy responses in early 1997 were not adequate. The growth slowdown, in turn, was reflected in sharp declines in equity and property prices, which aggravated financial sector weaknesses and acted as a further brake to growth. Finally, the crisis began in the financial sector because of excessive maturity mismatches in balance sheets. One striking feature of this episode was the speed and virulence with which crisis spread through the region, and threatened to extend worldwide. Four influences may explain this phenomenon: (i) common factors in the external environment, specifically the features in the global financial system that led to the large flows of volatile capital to the region; (ii) the spillover effects from trade and financial linkages among the countries; (iii) a true contagion effect, as the crisis in one country caused investors to reassess the fundamentals in other countries; and (iv) a number of unexpected exogenous factors, including weaker terms of trade and the deepening of the recession in Japan. 2. Basic strategy of programs Since the countries faced an immediate liquidity crisis coupled with profound structural problems, the programs required a comprehensive focus embracing structural and macroeconomic policies:

First, structural reform, particularly in the financial and corporate sectors, assumed a central role. While clearly onerous in such difficult economic conditions, structural reform was essential to address the root causes of the crisis, to restore market confidence, and to set the stage for a sustainable resumption of growth. Second, macroeconomic policies were designed initially to stabilize the economy and subsequently to support economic recovery. Monetary policy aimed to prevent a spiral of depreciation and inflation; once a measure of stability had returned to exchange markets, interest rates began to decline. Fiscal policy aimed to complement monetary policy, and to make room in the budget for the costs of bank restructuring. Later, as recession deepened and social costs escalated, fiscal policies were relaxed. Third, large official financing packages were seen as an essential complement to the macroeconomic and structural policies adopted to help break the self-reinforcing cycle of capital outflows, exchange rate depreciation, and financial sector weakness.

There has been criticism of IMF-supported programs in Asia, principally on three grounds; first, the appropriate focus of monetary policy as between exchange rate stabilization and the real economy; second, the stance of fiscal policy; and third, the introduction of structural reforms as part of programs. In addressing these criticisms, two points about the design of IMF-supported programs need to be borne in mind. The first is that policies adopted in response to each stage of the crisis must be seen in the context of the options available in the circumstances. By the time the Fund was called in to help design stabilization and adjustment programs in the three countries most severely affected, the immediate priority was to restore shattered investor confidence. The second point is that policy responses were adapted rapidly to changing circumstances after the onset of the crisis. 3. Macroeconomic effects - an overview The countries at the heart of the crisis have suffered deep recessions in 1998, although by yearend signs were emerging that the worst was over. Real GDP is estimated to have declined in 1998 by 7 percent in Korea, 8 percent in Thailand, and 15 percent in Indonesia (Table 1). Only in the Philippines was output contraction avoided. The slowdown was dramatically different from that assumed in formulating the programs, and its magnitude, once appreciated, prompted substantial revisions in economic policies. Associated with the downturn and capital outflows were large current account adjustments which far exceeded original program projections. Current account balances strengthened by 5 percentage points of GDP in Indonesia, 15 percentage points in Korea, 6 percentage points in the Philippines, and 13 percentage points in Thailand relative to 1997, largely due to a sharp compression of imports. The response of exports was constrained by weak demand throughout the region, falling export prices, and simultaneous depreciations in partner countries. There was an even sharper decline in domestic demand, which was largely a reflection of a precipitous drop in fixed investment and, to a lesser extent, in private consumption. 4. Macroeconomic policies Monetary and exchange rate policies. Monetary policy in the programs sought to tread a narrow path between preventing a spiral of depreciation and inflation on the one hand, and avoiding a severe liquidity squeeze that could excessively weaken economic activity on the other. At the very start of the crisis, the currencies depreciated sharply, and, in view of the countries' large unhedged external debt, they were concerned about the further damage that would be caused by an even steeper slide in currency values. Although the key decision was made to allow exchange rates to continue to float, interest rates were raised sharply to restore some stability to foreign exchange markets. This, together with inflows of official financing, limited the extent of further depreciation. Once the currencies began to strengthen, interest rates were reduced, and by the summer of 1998 they had returned to pre-crisis levels in Korea and Thailand, and were on a downward trend in Indonesia. A tight monetary policy was appropriate and inevitable at the outset of the programs to support an early return to external balance, and to contain and then reverse excessive currency depreciation. Given the prevalence of foreign currency-denominated debt, the alternative of

permitting sharper currency depreciation through an easing of monetary policy could have had an even stronger contractionary effect. Experience with these programs has underscored the need, to which the Fund assigns high priority, to examine the role of monetary policy in the context of a financial crisis in countries with weak banking systems. Fiscal policy. The initial programs planned some fiscal adjustment to offset a weakening of fiscal positions, to make room for financing the costs of bank restructuring and to support external adjustment (mainly in Thailand). Credible steps toward these objectives were also expected to contribute to restoring confidence. In early 1998, as the recession deepened and current accounts shifted into large surplus owing to sagging domestic demand and large currency depreciations, fiscal policy was oriented toward supporting economic activity. Program reviews encouraged some enlargement of fiscal deficits to accommodate part of the effects of greater social spending and the exchange-rate depreciation. Programs turned progressively more expansionary, with the end result that fiscal deficits have been allowed to increase considerably. In practice, it proved difficult for the countries to use fully the scope afforded them for more expansionary budget policies, in part because of the time needed to develop effective new social spending programs. 5. Structural reforms The programs in the Asian crisis countries stand out by the large number and broad range of structural reforms they included. These reforms were intended to address the underlying causes of the crisis, which were predominantly structural, and to create the basis for a return to sustainable growth. Close collaboration among the World Bank, the Asian Development Bank, and the IMF were an essential feature in developing the structural components of the programs. Financial sector and corporate restructuring. Given the role financial sector weaknesses played in the emergence of the crisis, financial sector restructuring was, from the outset, at the top of the structural reform agenda. The strategy included two broad strands of measures: first, steps were needed to handle the immediate crisis, and second, economies had to be reformed to minimize the likelihood of recurrence. Measures were introduced to deal with insolvent financial institutions, strengthen the capital base of weak but viable institutions, and address the twin risks of bank runs and excessive liquidity expansion. An overhaul of prudential regulations and supervision was initiated together with steps to enhance transparency and governance in the financial system. The restructuring of the highly indebted corporate sector began to be considered in earnest only some months after the programs were launched, and these are expected to be central issues in the second and subsequent years of the reform programs. Other structural policies. The programs also included a large number of measures to address deficiencies in governance and market discipline, ranging from steps to enhance transparency and disclosure requirements to the dismantling of restrictive trading arrangements and privatization. In addition, steps were taken to advance trade and capital account liberalization in order to eliminate the distortions that had emerged as a result of incomplete and poorly sequenced previous reforms. In general, these measures were aimed at removing the structural

weaknesses that accounted for the vulnerabilities in the financial and corporate sectors, thereby creating an environment for the resumption of sustainable growth.
Prospects

Across Asia, the concern almost everywhere is to ensure that a new momentum is established for growth. The precise macroeconomic policies that are appropriate differ somewhat from country to country. There is greater uniformity in the need for decisive structural reform throughout the region. Despite different political systems, virtually every country faces an array of structural, institutional, and legal challenges that are strikingly similar. In part this reflects innate weaknesses in many countries. But each country in Asia, indeed around the world, currently faces the challenge of ensuring that its economic institutions keep pace with the demands of the globalized economy. 1. Asian countries implementing IMF-supported programs Reviews of the programs with Indonesia, Korea, and Thailand were completed by the IMF's Executive Board in mid-December; it emerged that each program was on track, and each country made purchases on schedule. A review of the Philippines program was also completed earlier in the fourth quarter. Major progress was noted in stabilizing key financial variables, but concern was expressed at the depth of recession that the countries had experienced. While an upturn in production may still be some months away, at this juncture the prospects are favorable for a return of growth during the course of 1999. In order to ensure that this recovery takes hold, and develops into a new period of sustainable growth, it is essential to press ahead with the structural reforms that have been initiated and are beginning to take effect. It is encouraging that the ASEAN's Hanoi Plan of Action (December 1998) continues to emphasize the importance of structural reform, more liberal trade, and open capital flows. In this forum of Asian and European countries, it is appropriate to highlight ASEAN's call for action by other constituencies in the global economy to do their part in strengthening national and international financial systems. Although the contraction in Korea in 1998 was severe, the pace of decline in economic activity has now moderated. In view of the sharp economic downturn, macroeconomic policies were eased in an effort to support a recovery. Interest rates have been reduced to well below pre-crisis levels, although bank lending rates have been slower to adjust. Some scope exists for further gradual easing. After near balance in 1997, the budget deficit is targeted at 5 percent of GDP both in 1998 and 1999. Assuming progress on financial and corporate restructuring, and a more favorable external environment, the economy is expected to begin a recovery. Korea's progress is amply demonstrated by the authorities' capacity to begin prompt repayment of its obligations to the IMF. It may be recalled that Korea was the first country to use the Supplemental Reserve Facility, under which repayments begin to fall due within one year. Its action sends out a clear signal of the recovery that is under way. Over the medium term, the Korean economy is expected to resume a high growth path, albeit at lower rates than it had enjoyed in the past two decades. While strong savings and improved productivity will play a key role in returning Korea to sustainable growth, the deep structural

problems affecting the economy will take several years to resolve. Financial and corporate restructuring remain at the heart of the Fund-supported program, and reform is most advanced in the financial sector where significant steps have been taken toward rationalizing and recapitalizing the financial sector. Corporate reform is under way, but much remains to be done especially with regard to restructuring the top five chaebols. Initially, these chaebols had not been included in the debt workout process and had made limited progress in restructuring, but a recent agreement among the top chaebols, creditors, and the government has been announced. The pace of restructuring will need to be accelerated further over the coming months.