The Road to the Revival of the AsianEconomy and Financial System(3/4)

In view of the causes and lessonsof the currency crisis examined in the previoussection, in order to build stable economic andfinancial systems that can support sustainableeconomic growth, we believe that approaches mustbe made from three levels: (1) domestic efforts atthe national level, (2) global efforts tostrengthen the international financial system, and(3) regional efforts within the Asian region.

An important point that was madeclear by the currency crisis is that as a resultof the increasing interdependence in trade andinvestment in the Asian region, if a currencycrisis occurs in the region it can spread rapidlyto many countries, and there is a risk that thiswill cause intraregional economic activity tocontract in a vicious cycle. To build stableeconomic and financial systems that can supportsustainable economic growth, region-wide effortsare indispensable.

In the course of surmountingeconomic difficulties in the wake of the currencyand financial crisis, common recognition of theimportance of regional cooperation has grown upamong Asian countries. Based on this commonrecognition, an informal ASEAN + 3 (Japan, China,the Republic of Korea) summit was held in Manilain November 1999, at which in a joint statement onEast Asia cooperation it was agreed to"strengthen policy dialogue, coordination andcollaboration on the financial, monetary, andfiscal issue of common interest." That was anextremely important first step towardsstrengthening regional cooperation in Asia.

Our previous report includeddetailed discussions and proposals concerningdomestic and global efforts, and various reviewsand steps such as those described below havealready begun. Therefore, in this report we reviewthese various domestic and global efforts and makeproposals on such matters as further measures thatshould be taken, and focus our discussions andproposals on regional efforts that were notdiscussed in depth in the previous report.

1. Domestic Efforts Takenwithin Individual Asian Countries

(1) Reform of financial andcorporate sectors

In the wake of the Asian currencyand financial crisis, many Asian countries havebeen taking vigorous steps to rehabilitate theirfinancial and corporate sectors (including throughthe liquidation of failed financial institutions,recapitalization of financial institutions,disposal of NPLs, and restructuring of corporatedebt). Although there are disparities between thecountries concerned, as a result of these effortsthe NPL ratios in many countries declined in 1999,and certain progress has been made in the reformof their financial and corporate sectors,reflected in the fact that gradual progress inrestructuring corporate debt is beginning to bemade. Nevertheless, many problems remainunresolved. We believe that the continuedrehabilitation and strengthening of those sectorsis also an important issue to be addressed.Furthermore, the fiscal situation in thesecountries is deteriorating as a result of factorssuch as the cost of rehabilitating the financialsectors, and therefore fiscal consolidation isalso an important issue.

Economic recovery is providing anenvironment that will enable the structural reformof their financial and corporate sectors to becarried out in a robust manner. It is essentialfor Asian countries not simply to satisfythemselves in the recovery of their economies, butto make vigorous use of the opportunity thiscreates to further accelerate structural reform.

It has generally been the casethat national governments have played the leadingrole in the steps that have been taken hitherto,such as the liquidation of failed financialinstitutions, recapitalization of financialinstitutions, resolution of NPLs, andrestructuring of corporate debt, owing to the needfor rapid rehabilitation of financial sectors amidthe continued economic and financial turbulencethat followed in the wake of the currency andfinancial crisis. Some observers take the viewthat countries that have proceeded with the reformof their financial and corporate sectors undergovernment guidance, such as the Republic ofKorea, have made more rapid progress.Nevertheless, now that the financial and economicturbulence has subsided, and reviews are nowproceeding with the strengthening of marketfunctions of the financial sector and thereorganization of financial institutions, webelieve that financial and corporate sector reformshould switch to being market-led. Countries suchas the Republic of Korea are already moving inthis direction.

Market-led reforms in pursuit ofthe strengthening of market functions, such asinstitutional development and human-resourcedevelopment, take some time to achieve, butnevertheless it is necessary to create anenvironment in which markets can reach maturity,for example by making active use of informationtechnologies - one of the advantages enjoyed bylatecomers - to increase transparency, and bybuilding up experience of dialogue betweencompanies and investors.

A characteristic feature of thefinancial systems of Asian countries is the veryimportant role played by indirect finance (i.e.bank lending) in financial intermediation. Sincedisclosure and other systems tend to beundeveloped in developing countries, indirectfinance is regarded as being more appropriate thandirect finance. Also, for Asian countries todevelop supporting industries that havefundamental technologies, the supply of funds tolocal SMEs is important. In view of this, indirectfinance is likely to continue to play an importantrole in the financial systems of Asian countries,particularly ASEAN countries, and thus the mostimportant issue to address when reforming theirfinancial and corporate sectors is that ofrestoring and strengthening the financialintermediation functions of financialinstitutions.

However, the currency andfinancial crisis cast light on the fact thatfinancial systems that place excessive emphasis onindirect finance are vulnerable when hit by suchcrises. Many Asian countries were caught in avicious circle in which the balance sheets offinancial institutions and companies deterioratedunder the growing burden of foreign-denominateddebt resulting from exchange rate devaluation.This brought about a credit crunch in whichfinancial institutions slashed lending, and thatin turn caused economic activity to decline stillfurther.

Therefore, in order to minimizethe impact of currency and financial crises it isnecessary to develop means of supplementingindirect finance, specifically by developingdomestic capital markets, particularly bondmarkets. We also believe that policy-based finance(i.e. financing through government-owned financialinstitutions), in particular financing for SMEs,should be developed if necessary.

(a) Strengthening the functions offinancial institutions

Foreign-investment-ledindustrialization of the type seen in ASEANcountries has enabled even developing countrieswith undeveloped domestic financial systems andindustrial bases to pursue industrialization bycircumventing those problems. But, as a result ofthis the problem of the immaturity of localfinancial institutions and local companies haspersisted. For ASEAN countries to achieve ongoingindustrial development while actively utilizingforeign direct investment it is also necessary forthem to overcome these problems by putting themanagement of local financial institutions andcompanies on a sound basis, and strengtheningtheir capabilities.

In order to prevent the kind ofinefficient and unproductive allocation of fundsby local financial institutions that was one ofthe causes of the Asian currency crisis, it isessential to strengthen prudential regulationssuch as regulations governing capital adequacyratios and lending to affiliates, and indeed sincethe currency crisis Asian countries have beentaking steps to strengthen the regulation andsupervision of financial institutions. Of course,strengthening the regulation and supervision offinancial institutions cannot totally preventinefficient and unproductive allocation of funds,but increasing the self-discipline of financialinstitutions may reduce that risk.

However, seeking greatermanagement soundness will not by itself resolvethe fundamental problems of local financialinstitutions, such as the backwardness of forms ofownership and management, lack of funding, andlow-grade financial techniques. Moreover,strengthening the prudential regulations indeveloping countries may cause the attitudes offinancial institutions to shift towards short-termismand the avoidance of risks in their use of funds.To foster the development of industrial finance,including the supply of the long-term funds thatthese countries need, it is necessary to takemeasures aimed at developing and strengtheninglocal financial institutions. We propose thefollowing measures.

(b) Promoting finance to SMEs

SME lending is important fordeveloping local industries such as supportingindustries that shoulder grounds for fundamentalindustrial technologies. However, given that manySMEs have lower creditworthiness than large-scalecorporations and lack adequate collateral forborrowing, we believe to foster the supply offunds to them, some kind of policy is necessary.

Below we describe three possibleways of policy support to promote lending to SMEs.The types of support that should be used will varyaccording to factors such as the stage of economicdevelopment and industrial structure of eachcountry, and the state of its private andgovernmental financial institutions. In Thailand,for example, the economic stimulus packageannounced in August 1999 incorporated measures tostrengthen the Small Industry Credit GuaranteeCorporation (SICGC) and the Small Industry FinanceCorporation (SIFC), and to establish aventure-capital fund; through a combination ofthree measures, the government is promoting thefinancing of SMEs. However, no matter whatcombination of measures is adopted, the use ofprivate financial institutions is the cornerstone,and thus we consider it to be of the utmostimportance to increase the capacity of privatefinancial institutions to extend credit to SMEs,and to develop an environment conducive to that.

(c) Developing domestic bondmarkets

Asian countries have high savingratios but owing to the lack of development ofdomestic capital markets, particularly bondmarkets, domestic savings flow overseas forlong-term investment. Therefore it would bepossible to reduce short-term foreign-currencyexposure by developing domestic bond markets andmaking effective use of these savings at home. Thedevelopment of domestic bond markets is importantfrom the standpoint of debt management, insofar asit promotes borrowing of long-term debtdenominated in home currencies.

In order to foster the developmentof domestic bond markets, necessary steps includethe strengthening of accounting standards anddisclosure criteria, the development of settlementsystems, the establishment of fair and impartialtax systems, and the development of ratingagencies and institutional investors. In additionit has been pointed out that in order to createhighly liquid secondary markets it will benecessary to take steps such as introducingcurrent value accounting for institutionalinvestors, further developing repo markets andsecurities-lending systems, and developinggovernment bond markets so as to form long yieldcurves to act as benchmarks. Judging from theexperience of Japan and the Republic of Korea itmay take some time to do this, but we believe thatin order to develop a balanced financial systemwith both a robust banking system and capitalmarkets to supplement it, Asian countries mustmake steady efforts to develop their domestic bondmarkets.

In Asian countries stock marketsare generally more advanced than bond markets,reflected in the fact that in Singapore and HongKong the gross market capitalization of the stockmarkets exceed the outstanding balance of banklending. However, attention has been called toaspects such as the need to make disclosuresystems and insider-trading regulations morestringent, and the lack of development ofsecondary markets; thus the reform of stockmarkets is also an important issue to address.

(d) Strengthening the operationof bankruptcy laws

Asian countries have been tacklingthe development of bankruptcy laws in the wake ofthe currency and financial crisis, with the resultthat today all of them have abankruptcy-legislation infrastructure with atleast bankruptcy and composition provisions. Forexample Indonesia has introducedreconstruction-type composition proceedings andhas established a commercial court to take overallcharge of bankruptcy procedures, and Thailand hasmade revisions to its bankruptcy laws to includethe introduction of reconstruction-typecorporate-rehabilitation procedures, and theestablishment of a bankruptcy court.

Nevertheless there areconsiderable disparities between countries withregard to the history of administering ofbankruptcy laws. There are some countries thatalready have decades of experience inadministering the laws, and have built up know-howto levels that befit their legal systems and areon a par with those in industrialized countries,and there are others such as Indonesia - wheresince independence there had effectively been nodeclarations of bankruptcy - which after thecurrency and financial crisis revamped their lawsand have only just started to administer them. Asregards China it has been pointed out that thereare structural problems in the civil court system,which is said to frequently hand down judgementsfavorable to local companies.

To minimize the impact of currencyand financial crises it is essential to rapidlyresolve financial institutions' NPL problems andthe corporate debt problems, and the key to thatis to improve market discipline by rigorouslyapplying bankruptcy laws - the last resort in therecovery of assets.

For Asian countries to resolve thepresent corporate debt problem and at the sametime to enhance their ability to deal with futurecurrency and financial crises, it is important forthem to build up a record of achievement inadministering bankruptcy proceedings accurately,by such means as continuing to develop theirbankruptcy laws and to increase the competence oftheir courts.

(e) Strengthening corporategovernance

With respect to corporategovernance in Asian countries, problems that havebeen pointed out include family-type corporategovernance based on concentrated corporateownership structures, and intimate relationshipsbetween governments, financial institutions, andcompanies. Some observers insist that it isnecessary to switch to capital-market-typecorporate governance. However, as is stated in theOECD's principles of corporate governance, thereis no single model for good corporate governance.There are various models corresponding with thestage of economic development and social andcultural forms in individual countries, and it hasbeen pointed out that in the process during whichdeveloping countries catch up with theindustrialized countries, family-type corporategovernance could be effective.

However, in countries thatsuccumbed to the Asian currency and financialcrisis there was excessive investment in the realestate sector and excess capital investment basedon dubious demand forecasts and profitability,which shows that the screening abilities offinancial institutions and stock markets withregard to corporate investment decisions wereinadequate. This is because as family-ownedcompanies grew, they became increasingly heavilydependent upon external funds such as the proceedsof bank borrowings and shares, but theirmanagement lacked transparency. Accordingly, it isobvious that there are problems inherent inpresent-day corporate governance, and thus forAsian countries to build stable economic andfinancial systems that can support sustainablegrowth, it is essential for them to strengthencorporate governance by means of measures such asthe following, although there will be variationsaccording to factors such as the state ofdevelopment of each country's financial system andwhether a company is listed or not.

(2) Reviews of appropriateexchange rate regimes

It is not possible to make anygeneralizations about the kind of exchange rateregimes that are appropriate for Asian countries,as the countries differ in regard to aspects suchas their economic scale, dependence on trade,trade structure, and the stage of sophisticationof their financial systems. Furthermore, thiswould change in response to the development oftheir financial systems.

The exchange rate regimes ofdeveloping countries began with fixed exchangerate systems, and as monetary policy grew moresophisticated, and financial and other systemsdeveloped, they shifted to more flexible exchangerate regimes, moving gradually towards floatingexchange rate systems. Asian countries appear tobe in that transition phase at present.

As regards which kind of exchangerate regime Asian countries should adopt, that isup to each country itself to decide, taking intoconsideration the points referred to above, andother factors such as its economic situation andthe policy goals it allocates to its exchange ratepolicy. However, in view of the fact that theexchange rate regimes that Asian countries adoptedprior to the currency crisis, which were virtuallypegged to the dollar, destabilized trade and ledto excessive capital inflows, we believe that itis necessary for Japan to collate the thinking inAsian countries about appropriate exchange rateregimes, and discuss these whenever necessarythrough policy dialogue with those countries.

In addition, as a result of thegrowth of interdependence within the region, animportant issue to address is that of the creationof a regional exchange rate stabilizationmechanism aimed at ensuring the mutual stabilityof exchange rates within the region. We believethat to achieve that it will be necessary to makethe kind of regional efforts referred to below.

(a) Fixed and floating exchangerate regimes

One argument that emerged in thecourse of overcoming the Asian currency crisis isthe view that because international capital flowshave become very vigorous, the only exchange rateregimes that can be maintained are either freelyfloating exchange rate regimes or very hard pegs(e.g., currency boards).

However, given the advance ofglobalization, the option to fix the exchange ratewith broad-ranging capital regulations willeventually cease to be available. Furthermore,because only countries that have adequate officialreserves, robust financial systems, and strictfiscal and monetary discipline can adopt currencyboards, and owing to factors such as the cost ofexiting and withdrawing from pegs, we believe thatmany Asian countries would find it very difficultto adopt a currency board.

On the other hand numerousparticipants from Asia in the Subcouncil'sdiscussions pointed out that many Asian countriesface the following problems with regard to freelyfloating exchange rate regimes.

(b) Present exchange rateregimes in Asian countries

Since the currency crisis,Malaysia and Hong Kong have officially adoptedfixed exchange rate regimes, Singapore and Chinahave officially adopted managed float systems, andother countries have adopted free floatingregimes. (Singapore's managed float is based on abasket of currencies, and China's exchange rate isvirtually pegged to the dollar.)

With regard to the exchange ratesof Asian countries it was pointed out thatregression analyses with the dollar, the yen, andthe euro showed that since the second half of 1998the regression coefficients have been returning totheir patterns prior to the currency crisis, andthat Asian countries exchange rate regimes arethus reverting to the regimes - virtually peggedto the dollar - that existed prior to the crisis.

However, looking at the movementsof the regression coefficients we can see thatsince the second half of 1998 the relationshipbetween Asian currencies and the dollar hasstrengthened again, but that there are also phasesin which the regression coefficient is declining,and that the coefficient is unstable, so it cannotbe said that the currencies have reached the stageof returning to the same pattern as before to thecurrency crisis. Furthermore, regression analysesalone does not permit the actual state of theexchange rate policies of individual countries tobe adequately grasped. For example marketparticipants associated with foreign exchangemarkets point out that the exchange rate policy ofthe monetary authorities of the Republic of Koreais to give importance not only to stabilityagainst the dollar, but also the yen.

(c) Currency-basket systems andvirtual dollar-peg systems

We believe that a persuasiveoption for many Asian countries is an exchangerate regime in which the currency is held stableagainst a currency-basket made up of componentssuch as the dollar, the yen, and the euro, eachbeing assigned a weight in light of trade andother economic factors. Such currency-basketregime should also ensure flexibility by suchmeans as having a sufficiently wide band in whichto move.

Looking at exchange rate systemsin countries throughout the world showed us thatmany countries whose systems are officiallyfloating exchange rate regimes utilize what are toall intents and purposes exchange ratestabilization policies. We observed that there wasa tendency to maintain currencies stable against asingle currency or a currency basket comprising anumber of currencies.

If Asian countries need tostabilize their exchange rates owing to theproblems with their floating exchange rate regimesreferred to above, which currencies would it bedesirable for them to use as the stabilizingcurrency? Should they opt for the dollar alone, ora currency basket comprising the yen, the dollar,and the euro? If major currencies such as the yenare traded in floating exchange rate systems, ifmonetary authorities try to make their exchangerates stable against a specific major currency, itwill be difficult to maintain stability againstother major currencies. Given that Asian countrieshave diverse trade and other economic dealingswith Japan, the United States, and Europe, thereal effective exchange rates will be more stableif a currency basket comprising the yen, thedollar, and the euro is selected, rather than thedollar alone.

Many of the participants from Asiain the Subcouncil's discussions pointed out theproblems with systems virtually pegged to thedollar, and voiced opinions in support ofcurrency-basket systems.

On the other hand participantsfrom two Asian countries voiced support forfloating exchange rate regimes, stating that theadoption of a form of system midway between acurrency board and a floating exchange rate regimeraised the risk of policy inconsistencies andexposure to speculative attack. Against this, itwas argued that it is possible for a country tocope with the risk as in normal times the exchangerate is virtually held stable against a basket ofcurrencies, while retaining flexibility, and inthe event of abrupt currency speculation theexchange rate floats freely.

In addition, the followingobservations were made in the Subcouncil withregard to points to heed in the event a countrytransfers to a currency-basket system.

Also, there was a view in theSubcouncil that if exchange rate-stabilizationpolicies need to be implemented, it is politicallyeasier to explain this domestically if theexchange rate is stabilized against a specificcurrency. Therefore, if a transfer is to be madeto a currency-basket system, it is necessary todevise how to explain to the public.

(3) Capital liberalization andcapital controls

(a) Appropriately sequencedcapital liberalization

The fact that economies thatmaintain wide-ranging capital controls and are notintegrated into the international financial systemwere not greatly impacted by the recent currencycrisis suggests that appropriately sequencedcapital liberalization is important for emergingmarket economies. When carrying out capitalliberalization it is essential not only to havesound macroeconomic policies, but also to developthe domestic financial system, including throughthe strengthening of the regulation andsupervision of financial institutions. Inaddition, long-term capital liberalization shouldprecede short-term capital liberalization, and itis particularly vital to remove regulations ondirect investment as quickly as possible. In thisregard, there was a view in the Subcouncil thatAsia can keep a relatively high growth ratewithout foreign capital because of the highdomestic saving rate. Another view held that evendirect investment may also cause selling pressureagainst local currencies when companies try tocover their local currencies investment positionin forward markets against the risk of a currencydevaluation.

(b) Control of capital inflowsand outflows

In economies in which progress hasalready been made with capital liberalization, butthe financial systems are insufficientlydeveloped, what should be done as regardscontrolling capital inflows and outflows?

First it is necessary to recognizethat capital controls are not substitutes forsound macroeconomic policies and structuralpolicies, and that they go hand in hand with costssuch as inefficiencies in resource allocation.Also, as the necessity for capital controls dependheavily on the economic situation, the state ofdevelopment of the financial system, and otherpolicies that are being implemented at that time;it is impossible to generalize.

However, it is said to have beeneffective in the case of Chile as part of themanagement of the composition of its debt -controls imposed an obligation for a certainproportion of funds flowing into the country to beplaced on deposit - if price-based control ofcapital inflows are combined appropriately withother measures such as increased exchange rateflexibility, they may have the effect ofpreventing short-term speculative capital inflows.In economies in which financial systems areinsufficiently developed, these kinds of controlsof capital inflows are a possible option in theevent of sudden large-scale short-term capitalinflows.

With regard to control of capitaloutflows, the case of Malaysia during the currencycrisis can be said to be success. Withoutreceiving IMF aid it limited external shocks andheld its exchange rate stable, bringing abouteconomic recovery by means of macroeconomicpolicies and structural reform. Naturally the samekinds of controls are not always warranted, andcareful study must be given to aspects such as thepossibility of the avoidance of such controls.Although the same kinds of controls cannot beapplied immediately to other countries, it is apossible option when faced with a crisis caused byabrupt short-term capital outflows.

It is essential for allgovernments to conduct appropriate risk managementwith regard to external debt, and prerequisitesfor that are the improvement of data relating tocapital flows and external debt, and theestablishment of a monitoring structure. In thisconnection we consider it important to develop aregional monitoring structure such as thatdescribed below. There is also a view that smalleconomies should control capital flows with makingthe share of debt outstanding and short-term debtper GDP, and their changes into certain targets.

(4) Appropriate social safetynets

(a) The necessity for creatingsocial safety nets

For social safety nets to functionwell during times of currency crises, it isnecessary to put appropriate ones in place priorto the occurrence of the crises. If governmentswant to develop such safety nets once a crisis haserupted they will be too late, or the nature ofthe safety nets will be inadequate, owing tofactor such as the time taken to set up therequired systems, and limitations on funding andpersonnel owing to the need to use these to combatthe crisis.

It was pointed out that thedevelopment of appropriate social safety nets notonly has the short-term effect of providing reliefto the socially disadvantaged affected by shockssuch as currency crises, but also has thelong-term effects of raising productivity andfostering growth. This is because it enablespeople to adapt to market changes and to be activein taking necessary risks, and it enables the poorto continue investing in education and health careduring crisis periods. It may also make structuraladjustments easier in times of crisis, and help togenerate support for necessary reforms.

(b) Appropriateness to thesituation in each individual country

An adequate social safety net canguarantee basic human needs, but as Asiancountries are at differing stages of economicdevelopment and have different cultures andtraditions, they have developed their own uniquesystems and practices to resolve social problems.In view of this, when developing social safetynets it is necessary for them to conform with therealities of the situation in each country.

For example it has been reportedthat the following programs have been effective indeveloping countries, and thus consideration couldbe given to arranging a program of this kind.

It was pointed out that, as seenin the employment adjustments that took place inthe recent currency crisis, involving the movementof labor from urban to rural areas, families andcommunities act as social safety nets in Asiancountries. It has become clear that where economicshocks were very large during the currency crisis,these traditional safety nets were unable toabsorb the shocks adequately. When developing newsocial safety nets, the relationships with theseexisting social safety nets must be taken intoconsideration.

In addition, in many Asiancountries the fact that the informal sector formsa relatively large part of the economy gives riseto problems. For example, formal social securitygives only partial coverage to the poorer sectionsof society. Nevertheless, it is necessary to studysocial security systems as a medium to long-termissue.

(c) Technical assistance frominternational development financial institutionsand other sources

We believe that technicalassistance from international developmentfinancial institutions and industrializedcountries is important in the development ofsocial safety nets referred to above. In addition,in the development and operation of social safetynets it is important to engage in dialogue withNGOs and other entities outside the governmentsector.

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