Chapter 2 New Challenges Posedby the Asian Currency Crises
Based on the foregoing analysis of the causesand characteristics of the Asian currency crises, let us nextturn to identifying the various challenges and issues which thecrises have posed. In undertaking this exercise, the followingconclusions of the foregoing analysis should be kept in mind.First, the Asian currency crises were spawned in an environmentmarked by the growing globalization of international financialand capital markets and the ongoing liberalization of capitalmovements. Second, within this environment, abrupt and dramaticreversals in capital flows were engendered by shifting marketperceptions. In particular, the rapid outflows of private foreigncapital from the affected countries triggered mounting turmoilin the currency and financial markets. Third, although some similarphenomena were observed in the Mexican crisis of 1994-1995, theAsian crises has been different in terms of the severity, scope,and unexpected scale of these phenomena.
1. Why the Currency Crises Were NotPredicted and Prevented
The Mexican currency crisis had left behindthe following observation. That is, the IMF had failed to graspthe significance and the impact of Mexico's growing current accountdeficits and the beginning of the outflows of foreign capital.Moreover, the market was also overlooked this respect. Followingon this bitter lesson, efforts were being made by the IMF andothers to examine the formulation of an early warning system whichwould effectively function to anticipate a crisis. Notwithstandingthese efforts, currency crises of greater gravity than the Mexicancrisis struck a region which was being lauded as the growth centerfor the world economy. Why weren't the Asian crises predictedand prevented?
(1) Information on Current Conditions
Drawing on the Mexican experience, currentconditions in Thailand were adequately known and understood, atleast on the macroeconomic level. What was not fully appreciatedwas the direction and volume of short-term capital flows whichto a large extent characterized the Asian crises. This failurecan be said to have exacerbated the crises and the subsequenteconomic turmoil. As previously noted, the Asian crises were centeredon private-sector liabilities. The problem was that the scopeand magnitude of these liabilities were not fully known in theborrowing countries, as well as in the lending countries and byinternational organizations. Financial globalization and the developmentof innovative technologies have rendered this information increasinglydifficult to access. The South Korean case reveals that cross-bordercapital flows are not the only source of exposure. Borrowingsby South Korean financial institutions and corporations, evenwhen they were not brought into South Korea, influenced domesticfunding positions and affected liquidity conditions. Similarly,it has been pointed out that the introduction of derivative financialinstruments (derivatives) and other new financial products inrecent years have heightened the vulnerability of markets.
Regarding early-warning systems, it has beenpointed out that such systems depend on the quality of statisticaldata generated by national governments. If high-quality statisticsare generated and made publicly available, the markets would beexpected to anticipate developments by taking advance signalsinto consideration. In view of the fact that market informationcannot be expected to be complete and data from early warningsystems would be useful to the IMF and other international organizationsin formulating policy advice, further study of early warning systemsis needed. Such systems could be quite effective in defusing currencycrises of the Mexican and Thai type, where macroeconomic imbalancesact as the principal cause.
(Lesson)
The contagion of currency crises spread over large areas at unexpectedlyhigh speeds. Any effort to anticipate a crisis through prior analysisof economic conditions must pay special attention to accessing,among macroeconomic indicators, those related to capital transactions.In view of the Asian crises, there is a pressing need to developa system for following the inflows and outflows of private capital.Ideally, such a system would draw its information from both borrowersand lenders. Some say that hedge funds and other sources of massiveliquidity appear to have influenced the Asian currency crises.As such, there is a growing need to follow the movement of financialderivatives which in recent years have grown at a rapid pace.
(2) Disclosure of Information
A review of the causes of the Asian currencycrises indicates that inadequate disclosure of information fannedpanic among foreign investors and accelerated the capital outflows.Following the crisis in Mexico where information on foreign reserveswas not even available, efforts have been made to promote properdisclosure (by establishing SDDS). While the Asian countries whichwere struck by the crises were disclosing some information, thelevel of disclosure remained inadequate. For instance, in thecase of Thailand, foreign reserve statistics were published onlyin gross terms and did not include data on amounts committed tosale in the forward markets. This statistical lapse invited widespreadspeculation and had an unfavorable impact on the markets. It hasbeen pointed out that information disclosure contains such risksas actually expanding the opportunities for speculative flowsand causing an even earlier outflows of capital. On the otherhand, by speeding up the response of the market, the availabilityof information may expose existing problems while they are relativelyminor and more manageable. As such, disclosure can facilitatethe correction of problems.
Note: SDDS is the abbreviation of "SpecialData Dissemination Standard" which defines the IMF standards(items, frequency and speed of reporting) for the disclosure ofeconomic and financial data by IMF member countries accessing,or seeking to access, the international capital markets.
(Lesson)
As in the case of the publication of net foreign reserve data,the disclosure of accurate information on the economic conditionsof developing countries plays an important role in formulatingappropriate market perceptions. This adds further importance tothe roles of the IMF and other international organizations asthey are in a position to have a comprehensive view of the economicconditions of various countries. The stance of individual countriesto information disclosure is also of importance.
(3) Surveillance
Economic management based on appropriateeconomic policies has become increasingly important consideringthe fact that the economic failure in any one country can spreadquickly and widely throughout the region. However, the implementationof economic policies remains the exclusive domain of the authoritiesof individual countries. Therefore, the policy advice and guidanceprovided by the IMF and other organizations have an extremelyvital role to play in rectifying problems which may arise in theeconomic management of a country. Given the fact that turmoilin the currency and financial markets of one country can veryeasily exercise a direct impact on neighboring countries, thecountries of a region have an immediate and real interest in theeconomic management and economic conditions of their neighbors.This adds further importance to continued surveillance of a regionby its member countries, to be undertaken in such manner as tomaintain due compatibility with the global surveillance conductedby the IMF and others.
In the Asian currency crises, the crux ofthe problem lied not so much in macroeconomic conditions as infactors related to the financial sector and other structural issues.As such, policy advice on these issues is of growing importance.
In relation to the foregoing points, theresults of surveillance should be made available to the market.By the same token, it is becoming increasingly important to evaluatethe economic conditions in individual countries and to provideinformation on future trends and directions.
(Lesson)
It is becoming critically important for the Asian countries toundertake continuing surveillance of the region and to apply peerpressure on each other. Various international fora already existfor discussing Asian regional economic conditions, including APEC,ASEM, G-22 and the Manila Framework. For the following reasons,it is desirable that meetings based on the Manila Framework createdin the course of the current crises be upgraded and utilized forsurveillance of the region. [1]The Manila Framework is optimumin its scale and a set of member economies. [2]The Manila Frameworkcontains provisions for financial support.
Surveillance should not be limited to macroeconomicissues. Rather, structural issues should also be closely examined.Discussions of financial systems, trade and investment shouldbe undertaken in such manner as to maintain due compatibilitywith ongoing discussions of the BIS and WTO.
A high standard of transparency should bemaintained for surveillance results to gain the full confidenceof the markets.
Box -- The Manila Framework
Proposals for an "Asian Monetary Fund"(AMF) took shape at the meeting of supporting countries for Thailandwhere a heightened interest was expressed in examining the feasibilityof a permanent institution created by Asian countries. This matterhad been already discussed among ASEAN countries in the springof 1997.
Note: Tokyo Meeting on Thailand: This meetingwas held in Tokyo on August 11, 1997 under the auspices of theIMF to respond to the Thai currency crisis. As the host country,Japan provided maximum support and assistance. As a result ofthe meeting, a total amount of approximately $16.0 billion waspledged in support of Thailand, exceeding the initially requiredsum.
The establishment of the AMF was again discussedat the time of ASEM meeting of finance ministers and the seriesof meetings in Hong Kong in late September. The discussion centeredon the implementation of regional surveillance to complement theIMF's surveillance, and a confirmation that financial supportwould be provided in accordance with the provisions of IMF economicadjustment programs. Following these meetings, the AMF conceptcontinued to be studied by the related countries, the IMF andother international organizations. By this time, the currencycrises which have started in Thailand were spreading to Indonesia,and other ASEAN countries and Indonesia turned to the IMF forassistance on October 8. (An agreement was reached on an economicadjustment program for Indonesia on October 31.)
Against this background, a deputy meetingof the ministers of finance and central bank governors of fourteencountries of and around Asia was held in Manila on November 18and 19. An agreement was reached at this timeconcerning "a framework for strengthening Asian regionalcooperation for financial and currency stabilization" (ManilaFramework).
Note: Participants in the Manila meetingconsisted of: Australia, Brunei Darussalam, Canada, China, HongKong, Indonesia, Japan, South Korea, Malaysia, New Zealand, thePhilippines, Singapore, Thailand, the United States, the IMF,the World Bank, and the Asian Development Bank.
The Manila Framework can be summarized inthe following four points which are in line with the AMF concept:(1)Implementation of regional surveillance to complement ongoingglobal surveillance. (2)Technical assistance and support for strengtheningthe financial sectors of related countries. (3)Call for strengtheningthe IMF's resources to cope with new crises. (4)Provision of assistanceby member countries of the region to complement the financialsupport of the IMF and other international financial institutions.
[1] Regional surveillance is to be undertakentwice a year with a candid exchange of views regarding macroeconomicpolicies, structural policies, foreign exchange policies and thestatus of the financial system of the member countries.
[2] In view of the importance of improvingthe financial sectors of the member countries, international financialinstitutions will be requested to provide technical assistanceto support efforts for strengthening the financial sectors andmarket supervision.
[3] In order to provide sufficient financialsupport to re-establish market confidence, the IMF will be requestedto review its access limits and to consider the creation of anew mechanism for short-term financing.
Note: Following the agreement on the ManilaFramework, in December 1997 the IMF created a new facility forproviding short-term financial support which was named the "SupplementalReserve Facility" (SRF). This facility was mobilized in supportingSouth Korea.
[4] Establishment of "Cooperative FinancingArrangement for the Stabilization of Asian Currencies"(CFA),in which a participating country would be given financial supportfrom other participants after it has agreed with the IMF on aneconomic adjustment program and the IMF has provided the countrywith its maximum assistance. The amount and the form of the supportbased on the CFA would be determined on a case-by-case basis.
The Second Manila Framework Meeting was hostedby Japan on March 26 and 27 in Tokyo. In this meeting, as thefirst regional surveillance of this area, the attendants exchangedviews on the recent economic developments of this area, mainlyfocusing on Thailand, Korea, and Indonesia, as well as discussedon various topics concerning the lessons from the Asian crisesand the international financial system.
(4) Restrictions on Short-Term CapitalMovements
As in the case of the Mexico, the Asian currencycrises witnessed large-scale and accelerated outflows of short-termcapital from the affected countries. We have seen that this phenomenonserved to significantly exacerbate the crises. While this typeof situation demands the accurate disclosure of pertinent informationas already indicated, there is no guarantee that investors willact rationally even when information has been fully disclosedand made available. Thus, the advanced industrialized nationsof the West with their well-developed disclosure systems havenot been immune from bubble phenomena in their capital and financialmarkets. When considering the serious impact which short-termcapital movements can have on currencies and economies, the criticalquestion is: Is there any room for considering the introductionof some form of restriction on these capital movements? It isnotable that the Asian crises most seriously affected Thailand,Indonesia and South Korea where massive short-term capital hadcome into the country with capital transaction liberalized, whilethe impact of the crises was smaller in such countries as Malaysiaand China which are more highly dependent on foreign direct investments.This observation lends weight to the emerging understanding thatcapital liberalization, especially the liberalization of short-termcapital transactions, can significantly raise the probabilityof currency crises in smaller economies.
The first matter to be considered is whetherrestrictions can be introduced after the onset of a crisis tostall the capital outflows. From the perspective of internationalinvestors, ex post restrictions on the outflows of foreign capitalwould constitute an unilateral revision of the rules mutuallyagreed upon at the time of the initial investment in bonds orstocks. Hence, such actions would invite strong opposition frominvestors. Even if a country is able to overcome the crisis throughsuch means, the process would certainly lead to a serious lossof trust and confidence. Furthermore, capital outflow restrictionscan be circumvented in various ways, leading to serious doubtsas to the efficacy of such restrictions.
The second possibility involves the introductionof certain types of "obstacles" when the scale of short-termcapital inflows is very large in comparison to the size of theeconomy. In view of the fact that large-scale short-term foreign-currencydenominated borrowings by banks and corporations of developingcountries renders their financial structures particularly vulnerableto external shocks, it is possible to justify restrictions oncapital inflows as a form of prudential regulation for maintainingfinancial soundness. Possible measures for countering the inflowof short-term capital include the raising of the reserve ratiosof banks and requiring a certain portion of foreign borrowingsto be deposited with the central bank with no remuneration. Theexperiences of Chile and other countries which have already implementedsuch restrictions would be instructive. While capital inflow restrictionsmay also be undermined by various forms of circumvention, it shouldbe understood that the objective here is not to stop completelythe capital inflows but rather to raise the cost of such flows.Opposition from investors would be minimized because the ruleswould be clearly defined before an investment is undertaken.
Box -- Capital Transaction Restrictionsin Chile
Chile has instituted various capital transactionrestrictions which are primarily aimed at short-term inflows.These restrictions have been generally strengthened over time.
The stabilization of the Chilean economyin the mid-1980s was followed by a marked increase in capitalinflows and by 1989, the country began to enjoy surpluses in itscapital accounts. However, these inflows exerted upward pressureson the value of the Chilean peso, while also triggering inflationaryconcerns. In response, in 1991 the government introduced a systemwhereby 20% of the value of foreign borrowings was forcibly depositedto the central bank with no remuneration for a period of one year.Because capital inflows continued to increase even after the introductionof this measure, the deposit ratio was raised to 30% in 1992.Simultaneously, the scope of the types of capital inflows subjectto this regulation was gradually expanded. By 1996, the rule wasapplicable to all capital inflows directed toward uses judgedto be non-productive.
Under this deposit system, 30% of the fundsfrom abroad must be consigned to the central bank in US dollarsfor a period of one year with no remuneration. Additionally, capitalinflows are subject to a one-year waiting period before repatriation(remittancerestriction).
Chile continues to enforce stern financialrestrictions, and its macroeconomic fundamentals are in soundshape. The combination of capital transaction restrictions andgood economic performance has facilitated the management of thematurities of Chile's external debt. These restrictions are believedto have played an important role in minimizing the direct impactof the Asian currency crises on Chile.
However, it should be stated that capitalinflow restrictions cannot function as a substitute for fiscal,monetary and structural reforms. It is essential for economicfundamentals to be improved without becoming overly dependenton such restrictive measures.
Additionally, the introduction of transactiontaxes, or "Tobin taxes," has also been raised as a meansto suppressing short-term capital movements. This measure aimsto suppress speculative transactions by raising the cost of short-termcapital transactions. But the Tobin tax has some obvious limitations.First, unless an identical tax is instituted globally, the transactionsin question could simply move to an area which has not introducedthe tax. Secondly, derivatives can be easily designed to minimizetax exposure while maximizing market positions. Thirdly, a Tobintax would not be realistic because, for instance, a 0.1% tax wouldnot forestall speculation, while a tax rate capable of fully suppressingspeculation would also have a substantial impact on transactionsbased on real demand.
While most past initiatives for capital movementrestrictions have focused on massive inflows and outflows of foreigncapital at times of currency crisis, the fact of the matter isthat capital flight undertaken by residents has the most seriousimpact on currency depreciation. When capital flight starts, thereare few means available for suppressing this movement.
(Lesson)
Capital liberalization facilitates the optimal allocation of fundsin the world economy. As such, it promotes economic growth andcan be expected ultimately to contribute to achieving higher livingstandards and the elimination of poverty in emerging market economies.In view of these important benefits, it is desirable that allrestrictions on capital movements be abolished over the long run.However, it cannot be denied that massive and abrupt movementsof capital destabilize currencies and undermine the financialfoundations of domestic financial institutions and corporations.For this reason, in certain cases, it would be efficacious, asprudential regulations, to institute restrictions on capital inflows.
In a framework based on free movement ofcapital, countries must be aware of the importance of implementingmeasures at ordinary times for coping with foreign exchange shortagesas has been done by Argentina.
Box -- Argentina's Stand-By Agreements
In order to guarantee the availability ofadequate foreign exchange in times of emergency, the central bankof Argentina has standing agreements with several leading foreignbanks for securing US dollars. The role of the central bank asthe lender of last resort is curtailed by the existence of Argentina'scurrency board arrangement. As such, these standing agreementsare viewed as a necessary measure for guaranteeing an adequatesupply of liquidity to the domestic financial system in timesof emergency.
The Mexican currency crisis which occurredat the end of 1994 affected the Argentine economy and forced thegovernment to intervene in the foreign exchange market. As a result,foreign reserves were significantly depleted (from $14.3 billionat the end of 1994 to $8.5 billion at the end of March 1995).Under its currency board arrangement, the depletion of foreignreserves triggered a fall in domestic liquidity and a rise ininterest rates. These developments destabilized the country'ssmall and medium sized financial institutions.
In December 1996, the central bank enteredinto stand-by agreements with several leading foreign banks tobe able to stabilize the domestic financial system in times ofemergency. The agreements allow the central bank to borrow dollarswhenever necessary during the period of the agreement while usingdollar-denominated Argentine government bonds owned by the centralbank as collateral. The central bank pays a reservation fee forthe facility and separately pays interest whenever it actuallyborrows from the facility.
These stand-by facilities were expanded atthe end of 1997 to a maximum borrowable amount of $7.4 billion,equivalent to roughly 10% of total domestic deposits.
Argentina adopted the currency board arrangementin order to stop inflation and to restore confidence in its currency.Under this system, the government is committed to unlimited marketintervention to maintain an exchange rate parity of $1 = 1 Argentinepeso. Consequently, downward pressure on the currency is translatedinto a contraction of domestic liquidity. Because the monetaryauthority is not authorized to issue domestic currency which isnot fully backed up by foreign reserve holdings, downward pressureon the peso reduces the liquidity available in the domestic financialsystem and pushes interest rates upward. While this is seen asa necessary measure for maintaining the value of the currency,it generates difficult liquidity problems for banks and otherfinancial institutions.
Stand-by facilities are important becauseit is difficult to obtain foreign exchange in times of emergency.As such, these agreements allow room for providing the neededliquidity to the financial system and can act to prevent a currencycrisis from developing into a banking crisis.