CIAO DATE: 2/00

The Handling of the Asian Crisis (Keynote Address)

Hubert Neiss

Conference on Crisis & Credit: Restructuring Asia’s Financial Sector Asia Society
October 1, 1999, New York

Speeches and Transcripts: 1999

Asia Society

 

Ladies and Gentlemen:

I am honored to speak to you tonight, and I thank the Asia Society for this invitation.

• Restructuring of Asia’s financial sector-the topic of this seminar-is a key element in the strategy of Governments and the international community to return the region to growth. As you know, at the heart of the Asian crisis was a banking crisis and, therefore, recovery from the crisis requires fundamental financial restructuring. However, before you examine the details of this experience tomorrow, I would like to step back and briefly review the complete policy strategy in the handling of the crisis, and the controversies that still surround it.

• By and large, countries adopted the same strategy to deal with two problems: a major balance of payments crisis accompanied by financial panic, and a sharp recession. The twin objectives of stabilizing financial markets and initiating a recovery were addressed in sequence. So countries went first through a stabilization phase and then through a recovery phase.

• Stabilization was sought principally through a sharp, but temporary, increase in interest rates to contain currency depreciations. This was and still remains controversial. Two extreme positions have been argued: that Governments should have maintained stable exchange rates (e.g. WSJ); and that they should have let currencies fall to whatever level they may (e.g., Jeffrey Sachs).

• Critics were silent on the likely consequences of their proposed actions. Maintaining stable exchange rates would have required even higher interest rates that could have crippled the economy, while a drastic erosion of the currency’s value would have triggered an inflationary spiral and would have damaged corporations which generally had large unhedged foreign debts. Of course, we can never know exactly what the outcome under different policies would have been, but I think governments were wise to choose a middle ground: letting the exchange rate take part of the balance of payments adjustment and accepting higher interest rates up to a point. (There can be debate, however, on the precise policy mix: a sharper rise in interest rates to stop the depreciation more quickly, versus a more modest interest rate increase and some further depreciation to mitigate the recession.)

• An initial tightening of fiscal policy to support a current account adjustment, strengthen market confidence, and prepare for the costs of financial sector restructuring was also part of the stabilization effort, and equally controversial. The alternative was to loosen fiscal policy to cushion the recession. Here, critics are on somewhat safer ground. With the benefit of hindsight, I think fiscal policy should have remained unchanged initially, but then should have moved much more rapidly to an expansionary course than it actually did.

• Initiating structural reforms was also a vital element of the stabilization phase. The controversy surrounding them concerned their sequencing. Some critics (including Feldstein, Bhagwati, and Japanese officials) argued for an initial macroeconomic policy focus to address the immediate crisis, and a focus on structural policies, once the crisis had passed, to avoid overburdening policymakers or straining the political feasibility of the program.

• There are several difficulties with these arguments. First, without coming to grips with the underlying causes of the crisis, governments would have failed to restore confidence-a necessary element of stabilization. Second, in the case of the banking system, the financial panic did not allow governments the luxury of postponing reforms. Third, while waiting for better times to undertake reforms sounds good, sadly, the historical experience is different. Governments usually undertake major reforms only under the pressure of a crisis. (Remember the Philippines’ reforms during the crisis in 1984-85, and India’s far-reaching reforms in the wake of the 1991 crisis.) In any event, Governments boldly, and in my view correctly, seized the opportunity to initiate long overdue reforms right away, with the full support of the International Financial Institutions (IFIs).

• The stabilization effort succeeded, and the results are clear for all to see. By mid-1998 exchange rates had stabilized, international reserves were being rebuilt, inflation had been contained, risk premia had fallen, and investor confidence and capital inflows returned. Of course mistakes were made on the way. The programs were certainly less than perfect, the political circumstances were difficult, and there were shortfalls in implementation. However, by and large, Governments got it right and created the stage for a recovery. (As far as the IMF is concerned, it was prominently criticized during the crisis, but curiously, its presence has been rarely mentioned during the recovery. Some critics, who forecast a disaster a year ago, now prefer to attribute the recovery to the “natural healing forces of the economy” e.g. Dornbusch, the Economist).

• Following stabilization, macroeconomic policy was then adapted to support recovery. It became more expansionary through the gradual lowering of interest rates and increased public spending, leading to unprecedented budget deficits. At the same time, financial sector and corporate restructuring were accelerated to build a solid base for the recovery. This two-pronged strategy-aggregate demand expansion and structural reform (centered on bank and corporate restructuring)-aroused little controversy. We can, in fact, say that there is now broad consensus.

• Again, results show that the recovery strategy is working: activity has turned around in all countries, and a recovery in output is clearly underway. Growth rates this year are positive, while inflation is kept under control, and the balance of payments remains strong. Of course, it is extremely important that the pace of bank and corporate restructuring is maintained, so that the recovery is not built on sand.

• I will not go into the details of bank restructuring, but would only emphasize one point: all the necessary changes-consolidation through closures and mergers, nationalization followed by privatization, introduction of internationally recognized standards-will be for nothing unless they are closely monitored and enforced by politically independent and qualified supervisors. It is effective bank supervision that will prevent a return to the practices of the past.

• Progress in Corporate restructuring has remained an area of concern. There are several reasons: institutional frameworks for restructuring were set up too late (a point that surprisingly was not taken up by the critics); there is no credible threat in encouraging serious negotiations between debtors and creditors because of the weakness of bankruptcy laws and the institutions to implement them; and the government’s role is also more limited than in bank restructuring.

Both financial sector and corporate restructuring will extend beyond the recovery phase, but there will also be other challenges. I would like to end my presentation by looking at the post recovery agenda. Let me specifically look at three broad areas:

• First, a legal commercial framework for a modern economy needs to be put in place. This has initially focussed on the adoption of new laws on bankruptcy and competition policy, as well as on central bank independence, and is now extending to the creation or strengthening of the institutions charged with enforcing them effectively. This requires highly motivated, well trained, and well remunerated judges and financial supervisors. They have to operate independently, without political interference.

• Second, social safety nets. Much has already been done on the design and implementation of country-specific programs, taking the form of targeted subsidies, employment creation, education and health programs, all directed at the most vulnerable and high risk families. The crisis showed that traditional family-based support networks have weakened. To preserve social stability, an institutionalized system of social protection will have to be developed. This will include the creation of effective unemployment insurance, health insurance, and old age pensions. In this endeavor, Asian countries can learn from the experience of more advanced countries how to avoid mistakes.

• Third, fiscal consolidation. Once recovery has taken hold, deficits will have to be eliminated and polices return to the principles of minimizing inflation and avoiding excessive public debt. This will be a major challenge given the high cost of bank restructuring and of social safety nets. A major reorientation of public spending is, therefore, needed, as well as a broadening of the revenue base. Asian countries will have one advantage in this effort. Most of them have a strong tradition of fiscal prudence.

In conclusion, governments have much to be satisfied with in the progress they have made so far. Indeed few would have predicted today’s situation and the outlook for Asia even less than one year ago. The impressive consensus for domestic reform and the strong support of the international community have been crucial elements in this success. However, we must remain cautious, and I would like to quote what President Kim Dae Jung recently said to a gathering of central bankers in the region: “It is too early to open the Champagne bottle.”

A large, unfinished agenda still lies ahead, but I am confident Asia will meet the challenge.