Speech

Asia and the IMF: 10 Years After the Asian Crisis, Speech by David Burton, Director of the Asia & Pacific Department, IMF

May 16, 2007

Good morning. It is a great pleasure to be here today at this interesting conference on the tenth anniversary of the Asian financial crisis.

Both Asia and the IMF have changed in many important ways in response to the Asia crisis and its aftermath. A decade later, Asia has made considerable progress in strengthening its economic foundations, and is once again the most dynamic region in the world economy. For its part, the IMF has retooled itself to better help its membership cope with increasing economic and financial globalization. Today, I will talk about these changes, focusing on those aimed at adapting to financial globalization. But let me first go back briefly to the crisis itself.

The crisis

The Asia crisis was unprecedented in its nature and virility. With the exception of Thailand, traditional macroeconomic imbalances were not evident beforehand, and did not play a major role. Instead, financial and corporate sector weaknesses, not fully apparent at the time, were at the root of the crisis. Other ingredients included pegged exchange rates that encouraged excessive unhedged foreign borrowing; inadequate reserve levels; and a lack of transparency, not least about the true levels of usable reserves. Indeed, lack of information really was a major impediment to understanding what was happening and making appropriate policy recommendations.

This mixture set the stage for the sudden reversal of investor sentiment and international capital that took place and exacerbated its effects. Doubts about the soundness of financial institutions and corporates spread quickly across national borders. This set off a vicious circle of capital outflows, plummeting exchange rates, and crippling balance sheet effects. Private demand collapsed and output in the most affected countries declined sharply. And the underdevelopment of social safety nets exacerbated the social and economic impact of the slumps.

As private creditors were stampeding for the exists, the international community, working through the Fund, provided substantial financing. At the same time, governments in the region adjusted policies, increasingly taking strong and appropriate actions. Also, steps were taken to involve the private sector in providing financing. After some initial adjustments, the approach eventually turned the tide; confidence began to recover and capital to return, though not before substantial damage had been done by the crisis. As you can see from the slide, output recovered quickly, with the most determined reformers—notably Korea and Malaysia—performing the strongest (see chart 1)

What were the lessons learned from the crisis, and what progress has been made in applying them? Here I will focus on questions related to financial liberalization and openness:

• First let me mention one wrong lesson that fortunately was not drawn—namely that it was safest for Asian countries to withdraw from globalization. Despite the crisis, Asia has continued to embrace globalization, and today the region plays an even bigger role in the world economy than in the mid-1990s. Instead, the reforms undertaken in the region over the past decade have been geared to equip it to benefit more from globalization and to cope with its attendant risks, especially those associated with mobile international capital.
  
  
• In this connection, an important lesson we have learned, supported by work done at the Fund and elsewhere, is that to reap the potential gains that financial globalization offers and to avoid the attendant risk of higher volatility, macroeconomic frameworks and financial sectors must be robust. This means meeting certain standards of institutional quality, governance and transparency—preconditions that were not adequately met in Asia prior to the crisis.
  
  
• We have also learned much more about the interlinkages between the balance sheets of the financial, corporate, government, and household sectors, and about how disturbances in one sector can quickly spread to the others. This has helped to improve the ability of country authorities and the Fund to identify weaknesses and vulnerabilities that previously might have gone undetected.

Changes in Asia

Countries in Asia over the past decade have made considerable progress in applying these lessons. They have strengthened their policy and institutional frameworks to an impressive extent, reducing vulnerabilities.

Let me first mention three key areas where improvements have been made at the national level.

First, many countries have strengthened macroeconomic policy frameworks in several respects. In particular:

• Substantial reserve cushions have been built up, as an important line of defense against possible future market volatility. Up to a point this is good, although too large a buffer of this type can be costly to maintain. Also, continued reserve buildups can come at the expense of an unbalanced and unsustainable pattern of growth.
  
  
• Many countries have adopted more flexible exchange rate systems. This has allowed for more effective absorption of shocks, including shifts in investor sentiment. Flexible exchange rates also allow interest rates to be set more in response to domestic conditions, and help to avoid an under assessment of exchange risks by banks and corporations. The move toward exchange rate flexibility, however, has not been uniform in Asia, with some countries moving faster than others—as is evident from chart 2. In particular, the limited flexibility so far in China makes it more difficult for other countries to allow their exchange rates to strengthen. And this has been reflected in continued reserve buildups in some cases.

A second area is transparency, where transparency of policies and availability of information have improved markedly. Asian authorities, with the help of the IMF under its transparency initiatives, now routinely publish more high frequency information, including about their external debt and reserves. With many of the region's central banks having moved to inflation targeting frameworks, statements about monetary conditions and policy developments are also now regularly published.

Third, Asian countries have undertaken important efforts to reform financial sectors and improve corporate governance. These reforms include overhauling regulatory and supervisory systems, raising accounting standards, and strengthening shareholder rights. In the banking system, this has been reflected in a marked reduction in non-performing loans—this is true for all the countries most affected by the crisis. At the same time, overgeared corporations have substantially reduced their debt levels, with debt equity ratios sharply reduced across the board (see chart 3). The lessons of the crisis have also spawned a number of regional initiatives aimed at increasing the financial integration and resilience of the region through increased policy dialogue, reserve sharing arrangements and capital market development.

• Information exchange and policy dialogue have been stepped up since the crisis through various for a including ASEAN and ASEAN+3, with the crisis perhaps creating a stronger sense of regional identity.
  
  
• Under the ASEAN+3 framework, a system of bilateral swap arrangements (the Chiang Mai Initiative) was set up after the crisis. Earlier this month, a plan was announced to strengthen this mechanism by turning it into a reserve pooling arrangement. The IMF supports this initiative, seeing it as a useful complement to its own financing.
  
  
• In order to broaden and deepen regional capital markets, efforts are underway to promote local bond markets, with a view to developing and diversifying sources of funding in Asia. Government initiatives in this area, including under the Asian Bond Market Initiative and the two Asian Bond Funds, are facilitating a bottom up process of integration.

As a result of these changes at both the national and regional level, the strength and resilience of Asia's financial sectors have been enhanced, making the region better placed to benefit from the globalization of finance. Indeed, over the past year emerging Asia has been able to handle well two moderate bouts of global financial market turbulence, recovering quickly from each episode. However, the regional economy remains to be tested by a major disturbance to global financial markets.

Continuing challenges from capital flows

Nevertheless, Asia continues to face challenges from its increasing financial integration at the global and regional levels. One issue that officials in many countries are currently grappling with is how to deal with surges in capital inflows. While net inflows have been relatively constant in recent years, gross inflows and outflows have both risen sharply (see chart 4). The increase in outflows is particularly noteworthy. It reflects a growing desire of Asians to invest outside their home countries. This is a natural and healthy result of Asia's growing financial integration with the global economy.

As well as increasing in scale, gross capital flows in the region have also become more volatile. A particular concern here is that surges in inflows can put strong upward pressure on currencies; can provide additional—sometimes unwanted—loanable funds in the financial sector, potentially contributing to asset price bubbles; and, perhaps most importantly, can create a risk that funds might flow out more quickly than they came in.

A temptation may be to address these concerns by imposing some form of capital controls to discourage speculative inflows. While the use of capital controls cannot be entirely ruled out, it can be very difficult to do in practice in these circumstances, and is often counterproductive. There is evidence to suggest that capital controls tend to be particularly easily circumvented when they are imposed on previously liberalized systems. Also, in those circumstances controls can create doubts about the future direction of policy, potentially discouraging foreign direct investment.

Surges in capital inflows seem for the time being to be a feature of financial globalization. And there is no "magic bullet" for dealing with them. The best short-run policy response appears to be a combination of exchange rate flexibility, and limited intervention to smooth exchange rate movements. Over the longer term, further steps to develop and deepen financial markets, including in the context of regional financial integration, can also help. Further liberalization of restrictions on outflows, as warranted by the pace of financial market reform, can also support deeper integration and potentially offset swings in capital inflows.

Changes at the Fund

I would now to turn to how the IMF has changed in response to the Asia crisis, touching on just a few areas.

First, we have substantially raised the importance of financial sector surveillance, and of integrating this work more closely with our traditional macroeconomic analysis. The focus is on identifying potential vulnerabilities in the financial sector, and appropriate policy responses. This is now a central part of our dialogue with member countries. We have done a lot of work over the last decade to better understand how vulnerabilities in the financial sector can be transmitted to other sectors of the economy, and vice versa. We also follow developments in capital markets more closely than before, and analyze their potential implications for economic and financial stability.

Second, we now do more analysis at multilateral and regional levels, to complement our country-level work. The goal is to better capture common trends and actual and potential spillovers, especially from financial market developments.

Third, we are also assessing whether our financing tools for crisis prevention can be improved, and whether we can agree on a new liquidity instrument that would be both useful to, and used by, emerging market countries.

Fourth, we have learned better the importance of country ownership. We give prominence to the government's own priorities in program design. And we have streamlined the conditions attached to our lending so that they cover only issues critical to macroeconomic stability and growth.

Finally, we are moving ahead with governance reform. The objective is to ensure that voice and representation in the Fund better reflect the realities of today's global economy. We took an important step at our Annual Meetings in Singapore where the Fund's Governors agreed to a two-year program of change, starting with increases in quotas for China, Mexico, Korea, and Turkey. The Governors also agreed that the next stage should involve further increases in quotas for the Fund's most dynamic members, while making sure that the voice of low income countries is protected. The second stage is to be completed no later than September 2008. Dynamic emerging market countries, including those in Asia, must feel that they have an adequate voice in the Fund—that the Fund is their institution, and not one run by others and in which they have inadequate voice.

Concluding thoughts

I would like to conclude by touching on the role now of the IMF in Asia. This has changed a lot since the Asia crisis. We no longer have programs with emerging market countries, as you know. But this is in fact a normal and desirable state of affairs—it was the Asia crisis and the aftermath that were the aberrations. We continue to be closely engaged with our members in Asia, both at a national level and in regional for a. This engagement is based very much on two-way dialogue, in which the Fund can bring global economic perspectives and the experience of the membership at large to bear on national and regional economic issues; and in which the Asian perspective can be brought to global economic questions. We also provide considerable technical assistance and training to members in the region. The primary objective in all of this is to ensure financial stability both in the region, but also at the global level where Asia in an increasingly important player.

Thank you.