Imf, The Right Stuff

When the IMF was called in to assist both Thailand and Korea, their reserves were dangerously depleted and investor confidence was crumbling. Once a crisis erupts, easy solutions are not available, and a growth slowdown is inevitable.

The necessary first step is to rebuild confidence, which takes time and steady adherence to the economic programme, just as in Mexico. Perhaps even more so as financial sector restructuring, rather than macroeconomic stabilisation, is at the core of the IMF programmes in Thailand, Indonesia and Korea. Not the same old medicine, but medicine to deal with the ills of each patient.

On the macroeconomics of programme design, Fund programmes must estimate a growth rate for output. Usually this projection is reasonably optimistic, assuming only a moderate slowdown of growth. In the Korean programme, the growth rate assumed for 1998 is 2.5-3 per cent. Considering the deep crisis in which the programme began, this cannot be viewed as a contractionary goal. Rather is an effort to prevent an inevitable slowdown from being worse than necessary.

 

But why ask for fiscal tightening and higher interest rates at all? We ask for no more fiscal adjustment than necessary to cover the costs of financial sector restructuring and to help restore a sustainable balance of payments.

The extent of fiscal tightening differs between programmes. In Thailand, which was running a large (8 per cent of gross domestic product) current account deficit, the initial fiscal adjustment was 3 per cent of GDP. In Korea, where the current account deficit was shrinking, the adjustment is 1.5 per cent of GDP, largely to amortise the public sector costs of financial sector restructuring. The budget allows for the amortisation costs, not the upfront capital costs, of the restructuring, because it is sensible to spread the budgetary costs over time rather than pay for them through an excessive immediate fiscal contraction.

Why not use an expansionary fiscal policy to offset the inevitable growth slowdown? External financing available only a few months ago has evaporated. Worse than that, a capital inflow has turned into a massive capital outflow. This is not the time to try to increase government borrowing. That can be done, and fiscal policy can turn a bit easier, when market confidence returns as it inevitably will.

Turning to interest rates, recent Asian programmes started after lengthy periods when monetary policy had sought to keep interest rates low, and reserves either poured out or the value of the currency plummeted, or both. International institutions and foreign governments then provided loans to the affected countries to help them maintain and rebuild reserves, and to restore confidence. These loans were not provided to finance a continuing capital outflow, driven by low domestic interest rates. People need to be persuaded to keep their money at home or not to withdraw it. Interest rates need to be raised, not excessively, not permanently, but to help restore stability. Of course, higher interest rates create problems for the banking system, but the banking systems were in trouble at the start of the IMF -supported programmes, not as a result of them. As stability is restored, interest rates will come down.

Why not, as some argue, keep interest rates low and allow the exchange rate to depreciate further, thus relieving the economy of the strain of higher interest rates? First, exchange rates have already depreciated too much by 30-50 per cent in the affected countries, more than any calculation of initial over-valuation. Second, devaluati-on strains companies that have borrowed abroad. Third, and critical, excessive devaluations would help the crisis spread worldwide. The IMF was set up in part to prevent a repetition of that disastrous syndrome and we will not ignore the systemic implications of actions tak-en under programmes we support.

Turning to financial sector liberalisation, each of the recent programmes in east Asia provides substantial official support to the country in difficulty. It would be strange, with the country desperately short of forex, for the government to take steps to keep out private foreign capital. South Korea has long been touted as an example of the virtues of not opening of financial sector. One of the things to learn from the current crisis is that protecting the financial sector is in part simple protectionism, with all its familiar consequences of inefficiency and a failure to meet world standards.

Koreas decision to allow foreign banks to buy domestic banks and foreigners to buy 50 per cent of the shares in Korean companies are surely moves in the right direction. Some express concern at the elimination of restrictions on foreign borrowing by Korean companies and at the opening of domestic bond and money markets. But, in fact, the mistake was to allow domestic banks and corporations to borrow extensively abroad without prudential controls on their foreign exchange exposure.

The Korean programme will seek to correct this through mechanisms that will be put in place in conjunction with the programmes of the World Bank and the ADB. This is consistent with past IMF support for market-based controls on short-term capital inflows though that is hardly the prime problem at present. There are many uncertainties about how to deal with the situation in east Asia. These IMF-supported programmes differ from more traditional programmes, particularly in their focus on financial sector restructuring. We have always learned from out critics. And we will continue to do so.

Bailouts in Asia are designed to restore confidence and bolster the financial system, says Stanley Fischer