ICM Conference
Presentation by
Kunio Saito
Director, IMF Regional Office for Asia and the Pacific
Kuala Lumpur, Malaysia
December 2, 1998

Mr. Chairman, ladies and gentlemen,

Good afternoon. I am pleased to be here and have the opportunity to speak to this distinguished group.

The subject of my presentation this afternoon is "The IMF's Role in the International Financial System and in Financial crisis". But what I will talk about is essentially the IMF in the Asian crisis. This is the subject that I have talked about a lot over the last twelve months. And I am supposed to be pretty good at it. Nevertheless, I don't feel quite comfortable with it. For one thing, there is always something new to add. But more importantly, I have never been sure what people want to hear from me. Do people want to hear that the IMF has been doing too little? Or too much? Do people think that the IMF has not done enough in one area - for example in providing money - while doing too much in some others - for example, in imposing conditionalities? Well, my answers to these questions - and the conclusion of my presentation this afternoon - are clear. The IMF has done exactly what it should do - no more and no less. Of course, there are many areas where the IMF could have done better and improvements can be made. The IMF, and the international community in general, are now addressing them.

So, in the remainder of my presentation, I will address two broad topics (i) what the IMF has been doing in helping countries affected by the crisis, and (ii) what improvements are being considered for the IMF and the international financial system. In the process, I will try to respond some of the questions and criticisms that have been raised in the recent past. But, before doing that, let me try to put the Asian crisis in perspective by briefly going over what has happened since the middle of last year.

The Asian Crisis in Perspective

So many things have happened since mid 1997. In sum, and in very broad terms, the financial crisis that began in Asia has spread to Russia and Latin America. Economic slowdowns that were first felt in Asia have become global. These developments invoked fears of a truly global crisis and a global recession. More recently, however, a number of policy actions have been taken, especially by the G-7 countries, and there have been signs that the situation has eased. Although the risks of another period of turbulence and further economic weakening remain, one can be cautiously optimistic about immediate prospects.

Underlining this broad picture were a number of episodes that are still fresh in our minds. In early spring, Indonesia's economic crisis worsened, and in May, there were a series of riots and a change of the Government. In June, pressures mounted on the Japanese yen, generating fears of a devaluation of the Chinese yuan and another round of a downward realignment of regional currencies. Then, in August, Russia announced a moratorium and devalued its currency. This had immediate repercussion in terms of increased market pressures in Latin America, especially Brazil, and deteriorating financial positions of many financial institutions in industrial countries, including the widely publicized case of LTCM. Also, financial institutions became more selective in their lending, and the spreads of emerging market country debts rose sharply, causing a virtual cessation of capital flows to these countries. So, by the time of the annual meetings of the IMF and the World Bank in early October, the fears of a global crisis that I mentioned earlier became very real. So did the risks of a severe recession, not only in Asia but in the rest of the world, including industrial countries.

Then, the situation started to improve, reflecting a number of key policy actions. Following the G-7 communiqué of October 3, the US lowered short-term interest rates on three occasions, and this was followed by a number of industrial countries. Japan set in motion its banking reform, supported by newly approved restructuring legislation and the accompanying budgetary arrangements. More recently, an IMF-supported program for Brazil has been agreed and approved by the IMF Board. These factors helped improve market perceptions and restore confidence. The Japanese yen and many other regional currencies strengthened, and the spreads on emerging market country bonds began to narrow.

So, what is the likely overall outcome for 1998 as a whole, which is about to end. It is by now widely known, I think, that the Fund staff has estimated world output growth for 1998 to be 2 percent, almost half what was projected about a year earlier. This growth comes mostly from outside the region. The region's growth is likely to be mostly negative, ranging from minus 15 percent for Indonesia, minus 6-8 percent for Korea, Thailand, and Malaysia, about minus 3 percent for Japan, and virtually no growth for the Philippines and Singapore. These numbers reflect a series of substantial downward revisions - for example, Indonesia's growth was revised down from 6 percent a year earlier to minus 15 percent, and Japan's, from plus 2 percent to minus 3 percent. It was a tough year for many countries in the region. It was also a tough year, I must add, for forecasters.

What about the prospects for 1999? A short answer is a moderate pick-up in global growth. For the Asian region, one can be cautiously optimistic and say that the worst is over and the economies are now about to bottom out. Nevertheless, output growth is likely to be limited or close to zero for many countries, including Indonesia, Korea, Malaysia, and Thailand, as well as Japan. 1999 is going to be a year of consolidation, pushing ahead with structural reforms and preparing the ground for faster growth in later years. While fiscal policy would remain supportive of aggregate demand growth, private demand is likely to remain weak, for a number of reasons. Most importantly, the structural reforms, especially in the financial sector, have a strong recessionary impact in the short run, although they will raise growth potential over the longer run. The credit crunch, which is resulting from the need for financial institutions to strengthen their balance sheets, will ease only gradually. Furthermore, the inflow of foreign capital is likely to be limited, despite continued narrowing of the spread on emerging market bonds, and despite the help from official schemes such as Japan's new Miyazawa plan.

The IMF's Role in the Asian Crisis

Let me now move to the second broad subject - what has the IMF been doing to help countries affected by the crisis? Generally speaking, the IMF's role is to support its member countries in conducting policies to raise living standards, including, especially, to overcome balance of payments difficulties - and crises. The IMF's support comes through financial assistance and policy advice incorporated in a so-called IMF program (which, in more precise terms, should be called an IMF-supported program of, for example, Indonesia, Korea, or Thailand). An IMF-supported program covers all key policies, including structural reform. Let me now go over each of these policy areas, and respond to some questions and criticisms that have been raised.

The first is structural reform, and one of the questions raised was "Why are structural reforms included in the programs?" This is because structural weaknesses, especially in financial sectors, are one of the fundamental causes of the financial crisis and these weaknesses were what market participants focused on. It was the resulting loss of market confidence that triggered the crisis. To restore confidence and thus bring an end to the crisis, there was no choice but to address structural reform, especially in the financial sector.

Some people pointed out that structural weaknesses were not new in the region - they had been there for many years. But what was new at this time was that Asian economies were integrated in the global economy through capital markets, and markets were watching, with great concern, the increasing number of corporate failures and the resultant deterioration in the balance sheets of financial institutions. Addressing these weaknesses is bound to uncover some of the hidden problems and may well complicate the subsequent reforms. But the alternative of delaying would have made it even more difficult.

I would like to add here that many Asian countries have now accepted the challenge of reform, and that considerable progress is being made. As I mentioned earlier, this is a painful process, and comes with the cost of lower growth in the short-run. But it is an important and necessary step to bring economies back on to a longer-term growth path.

Second, monetary policy. And, specifically, why did the programs call for high interest rates? This is because the initial priority of the Fund-supported programs was the stabilization of foreign exchange markets. You would agree to this, once you remember how desperate it was during the final months of 1997 when the value of Asian currencies was dropping sharply. To stabilize the markets, monetary tightening was needed to restrict funding, and raise the cost, for those taking positions against domestic currencies. Also, monetary tightening, together with the firm commitment to structural reforms that I just mentioned, were the key messages needed to restore market confidence.

Once confidence is restored and markets stabilize, interest rates do come down and the central banks can shift policies to accommodate the declines and support recovery. The IMF not only endorses but encourages such a policy shift and, in fact, expected it from the start. And, in fact, interest rates have been declining in both Korea and Thailand since early spring, and are now below pre-crisis levels in both countries.

One tough question is whether the central bank should have induced a faster decline in interest rates when exchange markets were just beginning to stabilize but considerable uncertainties still remain. This was the situation in Korea and Thailand in late January-early February, when the criticism of the IMF for high interest rate policy became most pronounced. That was a situation that called for both patience and prudence. In the event, that is exactly what has happened, and I believe that people in both Korea and Thailand are now happy with the outcome.

Third, fiscal policy. I think that, by now, most people know that the fiscal targets in the original Fund programs were no tougher than these countries would have been aiming at in normal years and were very much in line with the region's tradition of sound budgetary management. People also know that the IMF has been very flexible in modifying fiscal targets. Consequently, budgetary deficits for this fiscal year are now budgeted to be 3-4 percent of GDP for Korea and Thailand and over 8 percent for Indonesia. This demand-supporting policy stance is now being adopted by many other countries in the region, including Japan.

So, the question that may be asked is why did not the IMF show flexibility from the beginning and go for a stimulative budgetary policy. Well, for one thing, a budget envisaging such a large deficit would have given a heart attack to many finance ministry officials of these countries who are used to more prudent budgets. Speaking more seriously, I believe that we would have done so, had we known that the region's economies would weaken so much. As I mentioned earlier, the weakening of the Japanese economy was beyond anybody's expectation. Also, all of us underestimated the negative impact of the loss of market confidence on private demand, as well as the short-term recessionary impact of structural reforms. The resultant slowdown of the region's economies, including Japan's, interacted, strongly and negatively, through a sharp drop in intra-regional trade.

The fourth area is the complex and interrelated one of exchange rate policy and reserve management. The key word here is "timing". By the time the IMF was asked to help, the three crisis-affected countries had virtually run out of usable reserves - or at least that was the perception of the markets who calculated usable reserves on the basis of published reserve data and estimates of short-term debts falling due. The authorities did not have the ability to defend their exchange rate - fixed or orderly floating - and, in fact, the rates were almost free falling. Consequently, exchange rates, which can be a powerful policy instrument for adjustment, became, instead, a policy objective in the Asian crisis. Clearly the situation would have been different, had adjustment efforts started earlier.

Under the IMF-supported programs, policy adjustments began with financial support. As I will come back to shortly, the appropriate mix of adjustments and financing has always been an issue. But, this time around, it was widely recognized that the nature of the crisis - involving large flows of short-term capital - called for larger financing. Accordingly, the IMF-supported programs for all three countries were accompanied with unprecedented amounts of financing. Furthermore, last December, the IMF established a Supplemental Reserve Facility to provide crisis-hit countries with much more financing than they would normally have access to. Korea, the first country to use this facility, borrowed 2,000 percent of its IMF quota. More recently, the IMF has been working toward establishing a precautionary facility for countries, which have no immediate financing need, but are implementing IMF-supported adjustment policies.

A related issue is the rollover and rescheduling of private short-term debts. These have been facilitated by a set of voluntary and bilateral arrangements in Thailand and through some more formal collective arrangements in the case of Korea and Indonesia. In all cases, it took more time than desired to put these arrangements in place, prolonging the market turmoil. This experience, and related moral hazard considerations, gave rise to the idea of involving private sector entities in crisis resolution from an earlier stage. And this is now being considered in the context of the "new architecture" discussion, which I will come back to shortly.

Strengthening the IMF

I would now like to address the third and final topic - strengthening the IMF and the international financial system. People got frustrated at the slow progress the IMF was making in containing - and resolving - the crisis, and understandably, became impatient. Out of this frustration and impatience, they argued that the problem was not only in the specifications of IMF programs - which I have just talked about - but also in the ways the IMF and the international financial system have been set up. So they came up with proposals to restructure the system, which invited counter-arguments and counter-proposals. These were, indeed, very lively discussions.

One of the criticisms was that the IMF was too stingy in terms of the money it provided, and was too slow in doing so. These critics argued that the IMF should, instead, act like the world's central bank - a lender of last resort - providing a large amount of money, promptly, and without conditionalities. This would enable a country facing an attack on its currency to deal with the crisis at an early stage and stop contagion. Some even argued that there was a point in late 1997 in both Korea and Indonesia at which the IMF could have provided a large amount of money and thereby stopped the crisis there and then. I doubt it or I think this argument is only half valid. The causes of the crisis were more deep-rooted, requiring policy adjustments. Without addressing them, no amount of money could have resolved it. Besides, the idea of making the IMF a lender of last resort entails moral hazard problems, as it would enable a country to continue with wrong policies, and would provide a bail-out to private creditors who put money in the country without proper risk analysis.

Focusing on moral hazard issues, some people criticized the IMF for providing too much money. They argued that the IMF should stop its financing operations, and, instead, focus on surveillance activities, providing only policy analysis and advice to crisis-hit countries. One variation of this argument is that the IMF should become a super credit rating agency by publishing its analyses, and thereby letting the markets force necessary adjustments to the economy. However, as is well known, adjustment without financial support is extremely painful, both economically and socially, and is against the spirit of the Articles of Agreements of the IMF. I do not think that the world is ready to go that far.

These ideas - making the IMF a lender of last resort, and making full use of market forces for economic adjustments - are not, by any means, new. They have been explored and debated every time the world faced a crisis, and every time, did not get much support. This time is no exception.

However, this time around, there is a strong consensus that something must be done urgently to strengthen the IMF and the international financial system in resolving and preventing a crisis. The consensus is for what I call an evolutionary approach - reforming the present system, rather than dismantling it.

As I mentioned earlier, one area where progress has already been made is in increasing the amount of resources that the IMF provides to crisis-affected countries with an IMF-supported program. The IMF has established its Supplemental Reserve Facility, and is now working toward establishing a precautionary facility.

Another, and perhaps more important, area where progress is being made, is the work on building "a new international financial architecture". This work is carried out by the G-7, G-10, G-22 (G-26), APEC, ASEAN, etc. as well as the IMF, the BIS, and other international institutions. There are numerous working groups and task forces interlinking these groups and institutions. The objective of this exercise is to reform the present system into a new architecture, one which is more effective in preventing crises, and in resolving one, when it occurs. This will encompass efforts in several interrelated areas. These include: (i) improvements in data collection and dissemination by the IMF and others; (ii) strengthening policy surveillance, including over supervisory agencies of financial institutions; (iii) better monitoring of institutional investors and possible improvement of prudential regulations governing their activities; (iv) setting standards of good practice in a number of areas, including accounting, auditing, bankruptcy procedures, and corporate governance; and (v) involving private entities in the resolution of financial crises. The list is long, technically complicated, and to be honest, a bit boring. So, I will not go into detail. I would only say that some items - like involving private entities in crisis-resolution - involve sensitive and difficult issues, and that some others - like setting standards for bankruptcy procedures - take a long time to put in place. Nevertheless, work has started, progress is being made, and when completed, the world will have a much better system to deal with possible crises, and better still to prevent them.

Conclusion

I think I should now conclude my presentation. Mr. Chairman, you mentioned earlier that "the worst is over, and it is high time to look for opportunities ". I think that this is a very valid point and agree that this is the message that all of us here should take home after the conference. At the same time, I would like to add just a few words of caution. Yes, exchange rates have stabilized and interest rates have come down, and progress is being made in financial and corporate sector restructuring. But there are risks of further market turmoil and continued recession. In these circumstances, the policy priorities for Asian countries must be to consolidate the gains achieved so far and prepare the ground for sustainable growth, especially by pushing ahead with the remaining tasks of financial and corporate sector restructuring. These are difficult tasks. It is easier said than done. But I believe that the Asian countries will overcome these challenges and will return to the path of sustainable growth soon. I remain optimistic about Asia.

Thank you.