A quarterly magazine of the IMF

March 2001, Volume 38, Number 1

It is now nearly four years since the Asian financial crisis began. Initially, the crisis involved a run on regional currencies closely linked to the U.S. dollar, beginning with the Thai baht in mid-1997. The loss of confidence spread to other financial and asset markets throughout the region. Exchange rates fell sharply in Thailand, Indonesia, Malaysia, the Philippines, and Korea, while regional stock and property markets also suffered large losses.

The impact of the financial crisis on economic activity proved to be considerably more severe than expected, both reflecting and revealing weaknesses in domestic financial and corporate sector institutions and practices. Output in the most affected economies—those of Hong Kong SAR, Indonesia, Korea, Malaysia, the Philippines, Singapore, Taiwan Province of China, and Thailand—fell by more than 6 percent in 1998. At the same time, the steep falls in domestic demand reduced imports and allowed current account balances to strengthen rapidly (see chart).

The recovery

Although economic activity and financial market sentiment in the region showed signs of bottoming out by late 1998, a strong rebound in activity was not generally expected in view of continuing distress in the financial and corporate sectors. Nonetheless, the economic recovery that followed was remarkable. In the most affected economies, the average increase in real GDP was more than 5 percent in 1999 and 6¹/2 percent in 2000. A number of factors contributed to the rebound:

• strong growth of exports reflecting both the impact of substantial currency depreciations on external competitiveness and the surge in global demand for electronic equipment produced in the region;
• restoration of more orderly financial market conditions, partly in response to current account improvements and external financing support;
• fiscal stimulus to support domestic demand; and
• significant recoveries in regional stock markets, mainly in the information technology and communications (ITC) sectors.

The pace of recovery, however, has varied considerably from one country to another. Over the past two years, Korea's real GDP growth has been particularly impressive, averaging 10 percent a year, and average growth has also been rapid in Singapore, Malaysia, Hong Kong SAR, and Taiwan Province of China. In contrast, recoveries in Thailand, the Philippines, and Indonesia have been less robust, with annual rates of GDP growth averaging less than 5 percent. Some explanations for these differences in economic growth rates are the following:

• recovery has been most rapid in economies where financial sectors were sound prior to the crisis, such as Hong Kong SAR and Singapore, or in those that have made the most progress with financial and corporate sector restructuring and reform in the wake of the crisis—notably Malaysia and Korea;
• Singapore, Malaysia, Taiwan Province of China, and Korea have relatively large electronics manufacturing sectors, so they have benefited more from the global electronics boom than other countries in the region; and
• in lagging economies, political uncertainties have played a role in delaying and dampening the restoration of confidence.

New challenges

During the course of 2000, external economic developments became much less favorable for the Asian economies than in 1999. Because most of the region's economies are heavily dependent on oil imports, the sharp rise in world oil prices adversely affected their growth rates and trade balances. (As oil exporters, Indonesia, Malaysia, and Brunei have benefited from higher oil prices.) In addition, the global sell-off of ITC sector shares since early 2000 has led to sharp declines in regional stock markets, reversing most of the gains made in 1999. Sentiment in international capital markets has also become more cautious, leading to some widening of spreads between regional rates and U.S. interest rates. Finally, the recent slowing of the U.S. economy contributed to a slump in both demand for electronic components and their prices late in 2000, which is already being reflected in lower exports from Asian countries.

The risk that these developments could trigger a renewed regional financial crisis appears modest. Over the past few years, Asian emerging market countries have significantly reduced their short-term external debts and boosted their international reserves (see chart). In addition, most of them have adopted more flexible exchange rate arrangements, making them less susceptible to speculative attacks. Nonetheless, the more difficult external economic environment and policy slippages in some countries have already contributed to a scaling back of projected 2001 growth for the region.

The deterioration in the near-term outlook and in international capital market sentiment underscores the importance of pressing ahead with restructuring and reform in the financial and corporate sectors. Indeed, some of the deterioration in sentiment toward countries in the region may reflect a perceived slackening of reform efforts.

Continuing IMF involvement

Early in the crisis, the IMF was at the center of international efforts to contain the crisis, providing substantial financial support to Thailand, Indonesia, and Korea and reviving its program with the Philippines. With the recovery in the region over the past 2¹/2 years, the IMF has scaled back financial support. IMF-supported programs in Korea, the Philippines, and Thailand have ended, and those countries are repaying their loans. Only Indonesia continues to have an IMF-supported program.

Nonetheless, the IMF remains fully engaged in the region. As part of its post-program monitoring, it is closely watching developments in Korea, the Philippines, and Thailand. The IMF has maintained resident representative offices in these countries and a regional office based in Tokyo, and an IMF office was recently established in Hong Kong SAR. The IMF also actively supports regional surveillance groups such as the Manila Framework Group and provides a continuing program of technical assistance and training in member countries throughout the region.

Scott Roger is a Senior Economist in the IMF's Asia and Pacific Department.

The New Basel Capital Proposal for Banks
Jan van der Vossen

Historically, banks incurred credit risk mainly through direct loans and relationship financing. Setting capital requirements for these types of credit risk was relatively straightforward. Since 1988, the Capital Accord issued by the Basel Committee on Banking Super-vision has set guidelines for banks' financial buffers against unforeseen credit risk. The accord is intended to promote equal competitive conditions across countries for internationally active banks and to enhance banks' financial resilience. To date, more than a hundred countries have adopted the Basel approach. Major changes in the financial landscape since 1988 have necessitated a new approach. On January 16, 2001, the Basel Committee issued for public comment revised proposals on capital requirements for banks, upon which the IMF has also been asked to comment. The proposals are to be finalized around the end of 2001.

The development of secondary and derivatives markets, in which banks sell credit risk instead of retaining it as loans on their balance sheets, was largely unanticipated when the original Basel Accord was designed. Furthermore, experiences during recent years have highlighted the shortcomings of excessive supervisory focus on capital rules. The development of derivatives, global financial markets, and increased intragroup connections has made it much more difficult to supervise banks mainly on the basis of capital criteria. Since 1988, the prudential value of the capital-adequacy ratio has eroded in countries with advanced financial markets. Banks in the crisis countries of the late 1990s showed vastly overstated capital figures, mainly because they made insufficient loan-loss provisions.

The current proposals, made up of three sections, or "pillars," are a major advance over the 1988 accord. Pillar I links banks' capital requirements more closely to actual risk. Pillar II strengthens the supervisory process, and Pillar III seeks to enhance disclosure and market discipline. Pillars II and III thus go beyond bank capital regulations and underline that these are only one part of effective banking supervision.

Pillar I encourages better risk management by banks. It links capital-adequacy requirements more closely to risk. Banks may choose between what is termed the "standardized" approach, largely prescribed by the supervisor, or an "internal ratings based" approach, which, after supervisory agreement, allows banks to use elements of their own risk-management systems. However, the science of credit-risk measurement is still young and unproven over a full credit cycle, and much attention will need to be given to the quality of banks' internal systems. Pillar I also changes capital requirements for corporate credits and allows differentiation for risk quality. The new proposals can require that up to 12 percent capital be held against poor risks but can also allow capital held against good risks to drop from 8 percent to 1.6 percent. Within the internal ratings based approach, banks can choose a "foundation" or an "advanced" approach, depending on their risk-management sophistication. Importantly, the new proposal abandons the distinction between Organization for Economic Cooperation and Development (OECD) and non-OECD sovereign borrowers and banks by linking risk weightings to quality, rather than to OECD membership. The proposal also recognizes credit-risk-mitigation techniques.

Pillar II gives supervisors more responsibility for reviewing banks' risk-management and capital-adequacy systems. Supervisors will need to become fully conversant with modern risk-management techniques.

Pillar III reinforces market discipline and specifies what information must be disclosed by banks. Banks would, for instance, need to disclose detailed information on credit exposures, including impaired loans.

These changes can facilitate the IMF's work by strengthening financial sector stability. In the meantime, many countries will need to invest heavily in staff, training, and information technology. However, there is no way back. As markets become more sophisticated, so must bank managers and bank supervisors.

Jan van der Vossen is Deputy Chief of the Banking Supervision and Regulation Division in the IMF's Monetary and Exchange Affairs Department.

For a fuller discussion of this topic, written shortly before the new proposals were issued, see "Toward a New Global Banking Standard: The Basel Committee's Proposals," by Cem Karacadag and Michael W. Taylor, in the December 2000 issue of Finance & Development.

Recent financial crises and financial "contagion" across borders have emphasized the importance of sound national financial systems. In particular, they have drawn attention to the need to identify financial risks and vulnerabilities at an early stage to avoid crises whenever possible. To this end, banks and other financial institutions must improve their practices of risk assessment and management, while governments must improve their supervision and regulation of the financial sector to keep pace with the modern global economy.

For some time, the IMF has paid close attention to issues of financial sector soundness in its surveillance and lending, but it became evident that a deeper and more focused analysis in this area was needed. To strengthen their monitoring of financial systems in the context of bilateral surveillance, in May 1999 the IMF and the World Bank jointly introduced the Financial Sector Assessment Program (FSAP). The program is designed to help countries become more resilient to crises and contagion and to foster growth by promoting financial system soundness and diversity. Its value is increased by its collaborative nature, which ensures consistency of policy advice by the IMF and the Bank and economizes on expert resources. Staffs of collaborating central banks and other supervisory agencies also participate in the program and contribute to the assessments of individual countries.

The FSAP is relatively new, and many of its analytical techniques, tools, and methodologies are still evolving. Pilot assessments have now been conducted for 12 IMF member countries, and work with 24 more countries is proceeding. The IMF's Executive Board reviewed experience with the program in the spring of 2000 and again in December 2000. In the December discussion, the Board agreed that, based on the completion of staff missions to the 12 pilot countries, work to date on the second round of country cases, and the feedback from the countries themselves, it was timely to set some further guidelines for the continuation of the program. A summary of the Board's review was released in February 2001 as a Public Information Notice (available on the IMF website: www.imf.org).