PROVISIONAL TRANSLATION
-- Risks Related to Short-Term Capital Movement and
the "21st Century-Type" Currency Crisis --
Introduction: Identifyingthe Issues
The Asian region in generalenjoyed a high rate of economic growth until recently. However,the currency crisis and economic turmoil, which began in Thailandin July 1997, rapidly spread to neighboring countries. The subsequentAsian currency crises came into being against the backdrop ofcontinued globalization of financial and capital markets and themassive cross-border capital movement. These crises are beingreferred to as the "21st century-type" currency crises,characterized by an abrupt reversal in the private capital flowsdue to a shift in the market participants' perception of the investmentenvironment, which engendered a plunge in currency values andstock prices.
The Subcommittee on AsianFinancial and Capital Markets has analyzed the causes and backgroundof the Asian currency crises and has summarized its discussionsof how the Asian region can return to a path of self-sustainingeconomic growth and measures that should be taken in preparationfor future crises.
Note: In this report, theterm "Asia" is used to denote the Pacific coastal regionsof East Asia from South Korea in the north to Indonesia in thesouth.
Chapter 1 Causes andCharacteristics of the Asian Currency Crises
1. Developments and Causesof the Asian Currency Crises
While there is a tendencyto speak of the Asian currency crises as a single event and phenomenon,background factors and causes are not necessarily identical amongthe affected countries.
In the case of Thailand, althoughthe failure of financial institutions and the movement of speculativefunds certainly played a part in generating the crisis, the primarycause of the collapse of the foreign exchange market is to befound, more fundamentally, in the nation's macroeconomic imbalancewhich had reached unsustainable proportions. The economic turmoilin Thailand spread to the neighboring countries of Indonesia,Malaysia, and the Philippines. However, macroeconomic conditionsin these countries did not appear to warrant the currency andfinancial crises. Moreover, unlike Thailand, there were no advancesigns in the markets that a crisis was looming. Notwithstandingthese factors, a "contagion effect" was generated dueto a radical shift in market perceptions, triggered by the steepdrop in the value of the baht. In the case of South Korea, variousproblems related to the country's industrial structure and itsfinancial sector had surfaced well in advance of the currencycrisis. Confidence in the South Korean economy was rapidly erodedby these developments. Then, foreign creditors who had becomeincreasingly concerned with the possibility of not being ableto recover their investments as a consequence of the Asian currencycrises opted to pull out their funds from South Korea at a highlyaccelerated pace. In Indonesia, the country most seriously affectedby the currency crises, the depreciation of the rupiah rapidlyincreased the debt burden of foreign-currency denominated privateborrowings and cast doubts on the country's ability to honor itsexternal debts. This gave rise to growing market uncertaintieswhich in turn triggered a new round of currency devaluation inwhat became a highly detrimental vicious cycle. The Indonesiancrisis was characterized by suspicions on the government's stancetoward policy implementation and a marked difficulty in gainingan overall view of the crisis because the principal problem consistedof foreign-currency denominated borrowings by non-bank privatecorporations.
2. Features of the RecentCurrency Crises
(1) Rigidity of the ForeignExchange Regime: Many Asian countries had opted to virtually linktheir currencies to the dollar without regard to the closenessof each economy's trade ties with other economies. The recentcrises revealed the risks inherent in this approach.
(2) Rapid Outflows of Short-TermCapital: Given the globalization of financial and capital marketsand the growing liberalization of capital movements, a shift inmarket perceptions can trigger an abrupt reversal in the capitalflows. In instances where there is a high dependence on short-termforeign funds, currency depreciation increases the burdens offoreign-currency denominated external debt. This exerts a negativeimpact on liquidity in the currency market, resulting in largechanges in the exchange rate. It then affects the real economy,which in turn exacerbates the currency crisis through the dynamicsof a self-fulfilling prophecy.
(3) Private-Sector Debt asa Central Problem: At the center of the Asian currency criseswas the problem of the short-term foreign liabilities of the privatesector (banks and non-bank corporations). Although such privateclaims and liabilities should basically be resolved through theefforts of the parties involved, public intervention may be neededwhen the banking system, having a "public good"-likefeature, is placed in jeopardy.
(4) Weaknesses in the PrivateFinancial Sector: The affected countries had liberalized capitalmovements in the course of their economic development. In additionto foreign direct investments, these countries have come to beheavily dependent on short-term foreign funds in the form of bankloans since the 1990s. However, capital liberalization in thesecountries had preceded the advanced development in their financialand capital markets, with the result that the banking systemsof these countries were not yet equipped to absorb effectivelyserious external shocks.
(5) Contents of the AdjustmentPrograms and Providing a Social Safety Net: In order to respondto the currency depreciation brought about by the continuing currencycrises, the affected countries have had little choice but to adopteconomic austerity policies. Thus, these countries can be expectedto experience substantially lower economic growth rates. Thishas increased the number of bankruptcies, aggravated the problemof non-performing assets, and generated massive unemployment.
Chapter 2 New ChallengesPosed by the Asian Currency Crises
1. Why the Currency CrisesWere Not Predicted and Prevented
One of the problems of theAsian currency crises was that the scope and the magnitude ofshort-term capital flows was not fully recognized in the lendingcountries and by international organizations, as well as in theborrowing countries. Any effort to anticipate a crisis throughprior analysis of economic conditions must pay special attentionto accessing, among other macroeconomic indicators, those relatedto capital transactions (particularly the cross-border flows ofprivate capital). There is a need to examine early warning systemsmore closely. The disclosure of accurate information regardingthe economic conditions in the emerging market economies willplay an important role in formulating correct market perceptionsand in preventing abrupt changes in the capital flows.
The countries of a given regionhave an immediate and real interest in the economic managementand economic conditions of their neighbors. This adds to the importanceof continuing regional surveillance by the countries.
In view of the advantagesof capital liberalization, it is desirable that all restrictionson capital movements be abolished over the long run. However,given that the movement of short-term capital can have a seriousnegative impact on currencies and economies, and in light of thefact that the financial structure of a bank or corporation isweakened if it has massive foreign-currency denominated debts,it would be efficacious in certain cases to institute restrictionson capital inflows in the form of prudential regulations for maintainingfinancial soundness.
2. Issues in Currency CrisisManagement
A more flexible approach bythe International Monetary Fund (IMF) in tailoring the conditionalitiesto the situation in individual countries is desirable. Particularlywith regard to structural reform, a more flexible approach shouldbe taken so that the requirements of a long-term agenda for reformcan be differentiated from the urgent issues related to an ongoingliquidity crisis.
The Asian currency crisesrequired massive amounts of financial support to match the massivecapital outflows which had occurred. Hence, there is now an essentialneed to create an international framework for assistance involvingadvanced economies and the members of the affected region to complementthe efforts of the IMF. By the same token, there is an urgentneed for the IMF to strengthen its capital resources. The WorldBank, the Asian Development Bank (ADB) and other multilateraldevelopment banks (MDBs) must now consider the formulation ofnew types of assistance schemes and the recruitment of appropriatestaff in order to address the two separate challenges of supportingmedium- to long-term structural reform and providing necessaryliquidity in currency crises of the recent Asian type.
It has been argued that inorder to avert moral hazard, the private sector (both lendersand borrowers) should share some burden in resolving a crisis.Due consideration must be given to the possibility of interventionby international organizations as moderators in the settlementof private-sector debts and the establishment of a general setof rules for the disposal of private-sector debts.
The Asian countries affectedby the currency crises have experienced a contraction in tradefinancing. There is a need to consider how trade financing canbe supplemented to ensure that exports, which must play a keyrole in the recovery from the crises, are not hampered. Likewise,provisions must be made for relief measures (social safety net)for vulnerable groups who are affected by the economic crises.
3. What Should Be Donein the Future
A stable exchange rate regimemust be considered which matches the economic realities of individualcountries, responds flexibly to changes in the international foreignexchange markets and which, in light of growing economic linkagein the region, effectively contributes to the development of intra-regionaltrade and investment.
Programs for the reform ofthe financial systems in Asian countries should contain the followingobjectives: augmenting the functions of financial intermediationthrough the reform of financial institutions; proper developmentof the capital markets; and, nurturing of intra-regional investorswho are important participants in the capital markets. It is desirablethat programs for capital liberalization and the introductionof foreign capital be properly sequenced and implemented withdue flexibility as determined by the developmental stage and scaleof the domestic financial sector and the maturity of its supervisoryand regulatory systems. It should be noted that foreign directinvestments could make a major contribution to economic developmentby facilitating the transfer of management know-how, technologies,and other pertinent factors in business. In the process of capitalliberalization, it is desirable that restrictions on foreign directinvestments be abolished as aggressively as possible, with dueattention being paid to specific local conditions.
It is an exaggeration to claimthat all systems and institutions, which supported past developmentand growth, must now be overhauled. However, the financial sectorwhose problems were exposed in the Asian currency crises mustbe reformed and economic structural reform must be undertaken.The lack of transparency of management and financial conditionsin the private sector is a particularly serious problem whichrequires reforming. The Asian countries must transform and upgradetheir industrial structures to match the requirements of the industrialsectors in which they enjoy international advantages. Likewise,the infrastructure needed to support more sophisticated industrialstructures must be developed. However, the Asian countries arecoming up against more stringent fiscal and Official DevelopmentAssistance (ODA) limitations. Thus, it is critically importantto promote private infrastructure development and to achieve higherefficiencies in infrastructure development and the provision ofrelated services, while at the same time maintaining an acceptablelevel of reliability and stability. International developmentfinancing organizations and Japan and other providers of bilateralaid must now pay closer attention to environmental issues thanin the past.
Chapter 3 RecommendationsBased on the Lessons Learned from the Asian Currency Crises
1. Recommendations to EmergingMarket Economies
(1) Coping with Short-TermCapital Movements
Sound macroeconomic managementis a vital factor in raising and maintaining investor expectationsfor emerging market economies at stable levels. Similarly, itis important to maintain transparency in economic policies andto disclose information regarding economic management and principaleconomic indicators in a timely fashion.
The introduction of prudentialregulations should be considered for maintaining financial soundnesswhen massive amounts of short-term foreign funds have entereda country. Governments should implement appropriate risk managementmeasures when individual financial institutions or the entirefinancial sector have accumulated large volumes of foreign liabilities.As a prerequisite to such measures, systems must be developedfor monitoring cross-border capital flows, as well as the overseasoperations of the private sector.
Prior to lifting the restrictionson the foreign capital inflows, measures must be taken to bolsterthe domestic financial and capital markets to render the financialfoundations of financial institutions less vulnerable to externalshocks. Moreover, liberalization and deregulation measures mustbe properly sequenced.
Restrictions on the long-termforeign capital inflows should be lifted. In particular, restrictionson foreign direct investments should be abolished within feasiblelimits as soon as possible. Furthermore, the domestic stock marketand the long-term government and corporate bond markets shouldbe developed to promote the efficient allocation of long-termcapital to appropriate industries.
(2) Foreign Exchange Regimes
In order to maintain a degreeof autonomy in domestic monetary policies while promoting capitalliberalization, it is necessary to change the foreign exchangeregime to a more flexible one at a certain juncture. It is desirablefor the Asian countries to adopt an appropriately flexible foreignexchange regime through which undue overvaluations and undervaluationsmay be averted, while at the same time avoiding volatility. Specifically,currencies can be linked to a basket of foreign currencies whosecomposition is weighted according to the closeness of economicties, such as trade relations.
(3) Addressing the FinancialSector and Other Structural Issues
There is a need to bolsterthe financial foundations of financial institutions and to installrisk management systems while strengthening the supervisory systemfor this sector. Risk management systems, particularly for themanagement of foreign-currency denominated liabilities, are alsoimportant for non-bank private corporations. Standards of corporategovernance, particularly in relation to the financial aspectsof corporate behavior, must be upgraded. Similarly, proceduresfor the disposal of non-viable financial institutions and corporations(bankruptcy laws) must be improved, and deposit insurance systemsmust be established or upgraded.
In order to overcome the effectsof the currency crises, sustained economic growth must be achievedby increasing the sophistication of industrial structures andnurturing core industries. For this purpose, it is important todevelop the social infrastructure and to promote the nurturingof human resources by reforming the educational systems. The developmentof human resources for employment by the monetary supervisoryauthorities, financial institutions, and corporations requiressufficient time and should be dealt with persistently. Properattention must also be paid to the environment and income distribution.
2. Recommendations to InternationalFinancial Institutions (IFIs)
(1) Recommendations to theIMF
[1] Prediction and Prevention
It is hoped that the SpecialData Dissemination Standard (SDDS) will be expanded and upgraded,so that through which the market and other pertinent parties cangain timely access to accurate information. The April 1998 recommendationsof the IMF Interim Committee to include in the SDDS data concerningnet foreign reserves, external debts (particularly short-termdebts), and indicators of the stability of the financial sectorconstitute a highly appropriate first step.
With regard to surveillance,greater emphasis should be placed on structural issues, and thetransparency of the results of surveillance must be improved.A majority of countries currently publish a summary of IMF ArticleIV consultations in Press Information Notice (PIN) form. Whilethis has improved the transparency of IMF policy advice, it ishoped that efforts will be made for achieving yet greater transparency.
It is hoped that the IMF willpromote the development of early warning systems. However, duecaution must be exercised in deciding whether or not to issuea public warning when the IMF detects evidence of the heightenedrisk of a currency crisis.
[2] Crisis Management
A thorough empirical studymust be undertaken to determine whether it was indeed necessaryto direct the Asian countries to adopt fiscal austerity when businessconditions were already deteriorating in response to the introductionof tight monetary policies designed to cope with the currencycrisis. In deciding contents of the conditionalities, the IMFshould pay careful attention to the historical background of existingeconomic policies and social constraints. In order to restoremarket confidence, sequence and speed of implementing conditionalitiesshould be carefully considered. Furthermore, the IMF should takeinto consideration the negative side effect of conditionalitieson business conditions and vulnerable groups. This requires priorknowledge of the prevalent conditions in the affected country.For this purpose, the IMF must bolster its capabilities for collectingand analyzing local information.
In order for a financial supportprogram to win the confidence of the market, the IMF must be ableto muster very large volumes of funds. To meet this requirement,there is an urgent need to strengthen the IMF's financial resources.It is urged that prompt action should be taken both on increasingthe IMF quotas under the Eleventh General Review and on establishingthe New Arrangements to Borrow (NAB). In addition to quota increase,thought should be given to the possibility of the IMF's directfunding from the markets.
In cases where liquidity problemshave been generated by the existence of private sector liabilities,further consideration should be given to the creation of a systemenabling the orderly workout of these liabilities.
[3] Addressing InstitutionalIssues
While the IMF is now workingon the amendment of the Articles of Agreement to promote the liberalizationof capital movements, due attention must be paid to allow adequateflexibility in the implementation of capital liberalization. Specifically,liberalization should be allowed to advance with proper sequencingto match the strength and developmental stage of the domesticfinancial sector and the maturity of the supervisory systems.Furthermore, the IMF should examine various models of desirableforeign exchange regimes for developing countries and considerspecific options for a smooth exit from fixed exchange rate regimes.
(2) Recommendations to theWorld Bank, the ADB, and Other MDBs
Currency crises, such as theAsian ones, require a swift and massive injection of financialsupport. It is the original mission of MDBs to provide necessaryassistance in such cases to prevent a deepening currency crisisfrom derailing the economic development of a country and fromexacerbating problems related to poverty. To enable MDBs to provideswift and massive financial support when necessary, the activeutilization of guarantee facilities and various other methodsfor promoting the flows and efficient use of private capital mustbe considered.
MDBs should expand and upgradetheir medium-term assistance strategies. Working from a full understandingof the prevalent conditions in affected countries, MDBs shouldgive due consideration to clarifying their policy objectives anddetermining the sequence of implementing their assistance programs.While cooperating with the IMF, it is desirable for the positionof the MDBs on these matters to be more clearly reflected in thefinancial support packages.
Measures for promoting thedevelopment of the securities markets should be a key elementin financial-sector assistance. In this process, necessary stepsshould be taken to promote the inflows of foreign direct investmentsand long-term capital. MDBs should also take a more active interestin providing support and advice concerning the issuance and ratingof long-term bonds and prevalent conditions in the stock exchangesand relevant transaction rules. It would be worthwhile for MDBsto consider the issuance of bonds in emerging market economiesas a means of promoting the development of their securities markets.IFIs do not necessarily have an adequate number of specialistswith the required expertise in financial sector affairs. For thisreason, steps should be taken to expand and upgrade the availablestaff for financial-sector assistance. In this context, personnelwith specialization in certain markets should be hired to theutmost.
MDBs should play a more activerole in supporting the improvement of the standards of corporategovernance. Better accounting systems and a more fully developedcompetitive environment are indispensable elements in improvingthe standards of governance. In this connection, it is also importantto improve the overall environment for tax execution, since promotingthe disclosure of accurate corporate information is closely linkedto proper tax execution.
MDBs should also play a moreactive role in assisting in the field of education and infrastructuredevelopment. It is important for MDBs to provide reliable informationconcerning the implementation of private-sector participationpolicies and regulatory systems of individual countries as a meansof mitigating country-risk ratings. Furthermore, it is importantfor MDBs to provide advice to governments which are formulatingpolicies related to private infrastructure development and restructuringtheir regulatory framework and to support infrastructure developmentprojects by local governments in developing countries. From theperspective of lowering foreign exchange risks, it is importantthat MDBs strengthen their support for the development of localfinancial and capital markets in order to encourage local-currencyborrowing.
In designing its assistancepackage for Thailand's social-sector reform program currentlyunder preparation, the World Bank is considering combining assistanceto the government's social development projects with assistancethrough local governments and non-governmental organizations (NGOs)to anti-poverty and social development programs (two channel approach).This approach by the World Bank is highly appreciated.
For the World Bank to be ableto act flexibly as a unified organization in response to currencycrises like the recent ones, crisis management systems centeredaround World Bank headquarters must be improved and informationgathering functions through local offices must be strengthenedand utilized.
3. Recommendations on RegionalCooperation
It is hoped that the ManilaFramework will be strengthened. Specifically, due considerationshould be given to the intensification of the discussion for regionalsurveillance of the Manila Framework and its financial supportschemes. Whereas surveillance meetings of the Manila Frameworkare currently conducted on the level of deputy finance ministersand deputy central bank governors, we recommend that considerationbe given to organizing a meeting of finance ministers and centralbank governors.
Key requirements in effectiveregional surveillance include the collection of data, its thoroughanalysis, and proper evaluation. Because Tokyo is home to theoffices of the IMF (the only one in Asia), the World Bank andthe ADB, as well as the ADB Institute, Tokyo provides a readyframework for possibly pursuing inter-organizational coordination.As such, it is hoped that Tokyo will emerge as a center for regionalsurveillance in the future. A review of the Asian currency crisesindicates that some problems were common to the entire regionwhile others had developed out of factors which were specificto individual countries. In light of this fact, it is importantto utilize the Tokyo offices of IFIs to provide more extensiveadvice, taking into consideration the salient features of individualcountries.
4. Recommendations to AdvancedCountries and Creditors
Support must be provided bythe advanced countries in the form of bilateral assistance andadvice to complement the IMF's financial support programs. Advancedcountries in possession of extensive information and with closeeconomic ties with the affected countries must take a particularlyactive part in these bilateral efforts. In addressing such issuesas the reform of the financial sector, infrastructure development,the modernization of corporate management and the review of variouspertinent systems and institutions, both the government and private-sectorshould actively provide technical and human resources developmentassistance.
With regard to the short-termcapital movements, capital exporting advanced countries shouldconsider disclosure of cross-border activities by institutionalinvestors and hedge funds. International consideration shouldbe given to the establishment of surveillance systems to preventmarket manipulation with the exercise of undue influence.
5. Recommendations to Japan
(1) Steady Expansion of theJapanese Economy and the Stabilization of Its Financial System
The growing share of intra-regionaltrade and investment in the Asian region implies that the steadyexpansion of the Japanese economy and correction of excessivedepreciation of the yen is of vital importance to the economiesin this region. As such, the Asian countries are hoping that aJapanese recovery will boost Japanese imports from the region.It is of critical importance that maximum efforts be made to leadthe Japanese economy toward a robust recovery as soon as possible.The two recently enacted laws for financial stabilization arenow being implemented to stabilize the Japanese financial system.Full vigilance must be continuously exercised to ensure the successfulstabilization of the financial system.
In combination with the continuedpromotion of market liberalization, the broad range of economicand financial measures currently being pursued in Japan can makea real contribution to the recovery of the Asian economy.
(2) Contributing to Internationaland Regional Assistance
As Japan is in a particularlygood position to be well informed on Asian conditions, Japan shouldact on the IMF, the World Bank and the ADB to make sure that Japan'sviews are fully reflected in surveillance activities and in financialsupport programs in times of crises. Likewise, as the only countryparticipating in all principal forums pertaining to the Asianeconomies, it is hoped that Japan will play an even more activerole in the future. Specifically, Japan should actively promotestrengthening of Asian regional surveillance, particularly theone in the Manila Framework. Similarly, Japan should activelysupport the Tokyo offices of the IMF, World Bank, and the ADB,as well as the activities of the ADB Research Institute. Furthermore,it is highly beneficial to extend and upgrade Japan's policy dialogwith the Asian countries on such issues as structural and macroeconomicpolicies.
In times of crises, it isimportant to be able to provide actively Yen Loan Assistance ina responsive manner. In view of the fact that the Asian economicturmoil has undermined the region's trade financing, it wouldbe beneficial to utilize the Export-Import Bank's Two-Step Loansand Trade Insurance schemes to provide appropriate financial assistancewhen needed. Furthermore, thought should be given to a systemenabling the Export-Import Bank to guarantee the bonds issuedby the governments of Asian countries.
Japan should strengthen thefacilities of the Japan Special Fund for the World Bank and theADB to support the structural reform efforts of various countriesby expanding and bolstering its technical assistance programsto these countries. Moreover, the Japan Special Fund should bemore actively utilized in supporting research and human resourcesdevelopment programs. Specifically, greater support should begiven to the activities of the World Bank's Economic DevelopmentInstitute and the ADB Institute.
It is hoped that Japan willdevelop systems whereby it can more actively contribute to personnelneeds. It can be achieved by, for example, establishing a stand-bylist for quickly recruiting qualified financial experts with sufficientexperience.
(3) Improving the Environmentfor the More Extensive Use of the Yen
A more desirable foreign exchangeregime in Asia after the current crises are over would requirelarger role of the yen. In order to broaden the use of the yen,efforts must be made to improve the infrastructure of the Tokyomarkets by taking steps to facilitate the management of yen assetsby domestic and international investors with a highly diverserange of investment needs. From the perspective of creating anenvironment conducive to the more extensive use of the yen, itis hoped that Japan's Big Bang reforms will be steadily implemented.