The response of the international community

The international community is supporting the efforts of countries affected by the crisis to adjust economic policies. The rescue package for Thailand may total $17 billion, including support from bilateral donors, the IMF, the Asian Development Bank, and the World Bank. (The World Bank’s contribution is envisaged to be a $1.5 billion structural adjustment loan and a technical assistance project to address the immediate needs of the financial sector.) The IMF has agreed to extend the Philippine $1.05 billion Extended Fund Facility, which had been set to expire in July 1997. The emergency aid package for Indonesia, including funds from the IMF, the World Bank, the Asian Development Bank, and bilateral donors, totals $33 billion. (The World Bank is preparing $2 billion in adjustment lending and a $15–20 million technical assistance project to support the banking sector, in addition to the $2.5 billion that was already planned to be disbursed over the next three years.) Most recently, the largest ever international financial rescue package was organized for Korea, with bilateral and multilateral contributions expected to total $57 billion, including a three-year, $21 billion standby arrangement from the IMF and up to $10 billion from the World Bank. The Bank approved an initial $3 billion economic reconstruction loan for Korea in late December. Combined, international rescue packages for Indonesia, Korea, and Thailand could total some $107 billion, with the World Bank contributing up to $14 billion.

International financial institutions have an important—and difficult—role to play in responding to the crisis. They must strike a balance between responding promptly to requests for financial support (which may be required to reduce systemic risk) and ensuring that governments commit to strong corrective actions to address fundamental weaknesses. Moreover, these actions must be carefully designed to restore confidence and address the problems that caused the crisis. A priority in many countries is to strengthen financial institutions and corporate governance.

At the same time, the ready availability of funds to support countries suffering financial crises raises concerns about moral hazard, and the extent and conditions of financing offered during economic crises have been the subject of much debate. Official institutions can provide crucial support for resolving a crisis, but they can also undermine market discipline if support for other countries is anticipated in times of difficulty. When that happens, investors may take on more risk (including more leveraged positions) than is warranted and asset prices may become overvalued, increasing systemic risk. Note that this problem influences private sector decisions, not public sector ones. The possibility of international support in the event of a crisis is unlikely to be viewed as sufficient compensation for the difficulties that governments confront in the event of a crisis —witness the recent experience of governments in East Asia.

Moral hazard can be mitigated if financing is provided in the context of strong policy reforms, including measures to ensure greater prudence in future borrowing. Moral hazard will also be reduced to the extent that investors are made to absorb some of the losses. There can be a tradeoff between establishing the right incentives for the future and responding to immediate problems. Future incentives are improved if owners of insolvent domestic banks bear the first losses (to the extent of their equity). But in the absence of adequate regulation, falling net worth could encourage further risky behavior, and failing banks could further contract the economy.

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In the current crisis, portfolio equity investors in the countries affected have generally lost large amounts as a result of steep price declines and currency depreciations. Bondholders have experienced defaults, and the market value of their holdings has declined precipitously. By contrast, short-term lending by foreign commercial banks has generally been protected, and in some countries governments have provided implicit or explicit guarantees of short-term debt incurred by domestic corporations and financial institutions. While such actions may be needed to maintain financial stability, they adversely affect the composition of flows to emerging markets and the level of risk that market participants are willing to take. Socializing private sector losses that otherwise would have been borne by foreign lenders could also be perceived as unfair to taxpayers, especially if workers bear the costs through higher unemployment and lower real wages. Ensuring that commercial banks roll over debts as a condition for international assistance would facilitate adjustment and reduce moral hazard by having them shoulder some of the risk. For example, during the debt crisis of the 1980s commercial banks were required to absorb losses through the restructuring of countries’ debt in conjunction with the provision of international assistance under the Brady initiative.

Recent financial crises have prompted international initiatives to help prevent future crises. For example, emerging market economies and countries in the Group of Ten (G-10) are working together to strengthen financial systems in developing countries (box 2.4). The IMF is helping governments improve transparency by establishing voluntary standards that countries can use when disclosing economic and financial data to the public; 43 countries (including 19 developing countries) have subscribed to the Special Data Dissemination Standards. The IMF also has formalized procedures for activation of the Emergency Financing Mechanism, which helps countries that are experiencing large and sudden capital outflows.

In addition, the IMF has adopted New Arrangements to Borrow, under which G-10 and other countries with sufficient financial capacity will provide resources to forestall or cope with impairments of the international monetary system or to respond to a situation that threatens the stability of the system. These arrangements will go into force when participants (including the five largest) with credit arrangements totaling SDR 28.9 billion ($41 billion) have agreed. The IMF also has approved the Supplemental Reserve Facility, under which financing will be available to member countries experiencing exceptional balance of payments difficulties due to a large short-term financing need resulting from a sudden and disruptive loss of market confidence.

A cooperative regional financing mechanism is being prepared in East Asia to enhance prospects for regional stability. This framework will establish a mechanism for regional surveillance to complement IMF activities, enhance economic and technical cooperation among member states (particularly for financial sector regulation and supervision), consider measures to strengthen the IMF’s ability to respond to financial crises, and establish a cooperative financing arrangement to supplement IMF resources.

Prospects for private capital flows in 1998

The collapse in investor confidence and the uncertainty about prospects for recovery in East Asia, combined with the possible implications for other regions, are likely to reduce net long-term private flows to developing countries in 1998 relative to 1997. Countries that rely on these flows for new financing will likely face considerable difficulties in the near term. If the crisis in East Asia is bottoming out, however, the extent of this decline may be moderated by the continued favorable external environment, the return to markets of countries with strong economic fundamentals, and changes in the composition of capital inflows that may have made them more resilient.

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External and domestic factors

World Bank projections prepared in mid-January 1998 anticipate that the international economic environment will remain broadly favorable to developing countries for the year. International interest rates, which have a significant influence on flows—especially portfolio flows (Taylor and Sarno 1997)—will likely remain low in 1998, with the London interbank offered rate (LIBOR) averaging about 5.7 percent (in dollar terms). World output growth rates should decline to 2.6 percent, from 3.2 percent in 1997. World trade volumes are expected to rise 6.4 percent in 1998.

Once the initial impact of the crisis has been fully absorbed, sharp downturns in flows may occur in only a limited number of countries. Flows to countries with stronger fundamentals will be less affected. For the countries most affected by the crisis, access to capital markets will depend on the policy response. In Indonesia, Korea, and Thailand measures to close insolvent institutions should be followed up over the medium term with determined policies that establish more robust financial systems, which are essential to the efficient mobilization of domestic savings and external finance, and that channel these resources to productive investments.

Composition of flows

The crisis will have different effects on different types of flows, so sharp downturns in some flows may be offset by increases in others. In the short term portfolio equity flows (13 percent of net long-term private flows to developing countries in 1997; table 2.8) will likely be undermined by the severe volatility in many emerging stock markets, as well as by uncertainties about corporate earnings in the countries most affected by the crisis. The recovery of bond finance (21 percent of net long-term private flows in 1997) may also be slow, as riskier borrowers may be shut out from bond markets for some time (the loss of investment-grade ratings will close off some markets) and a number of creditworthy borrowers may postpone borrowing to avoid issuing bonds at a higher spread than they have obtained in the past. Over time, however, inflows should recover to take advantage of asset price declines that are deeper than is justified by market fundamentals.

Table 2.8 Composition of private flows, 1990–97
(billions of U.S. dollars and percentage of shares)

Source: World Bank data.

Foreign direct investment (47 percent of net long-term private flows in 1997), which has longer-term objectives, may remain stable or even increase in 1998 in response to the low asset prices and production costs resulting from currency devaluations—particularly in sectors producing tradable goods. Foreign direct investors that are closely linked to local markets may postpone new projects, however, if they believe that the economic downturn is likely to become protracted.

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Outlook for 1998

Prospects for flows are uncertain and will depend largely on policy responses in the countries most affected by the crisis. There is, however, reason to believe that the slowdown in flows will not last too long. Although it took Latin American countries seven to eight years to regain access to international markets after the debt crisis of the early 1980s, flows to Argentina and Mexico picked up within six months of the 1994–95 peso crisis (table 2.9). Furthermore, although flows of foreign direct investment in Mexico dropped somewhat after its recent crisis (following a temporary surge in 1994), they remained well above the levels of the early 1990s (thanks in part to the North American Free Trade Agreement).

Table 2.9 Private flows to Argentina and Mexico, 1994–96
(billions of U.S. dollars)

Source: Euromoney and World Bank.

The financing requirements of the five East Asian countries most affected by the crisis are likely to be about the same in 1998 as in 1997, reflecting a shift from a current account deficit to a surplus ($41 billion), no change in amortization payments on long-term debt, and a $42 billion change in reserves (table 2.10). Some buildup of reserves will likely be required after the $31 billion drop in 1997.

Table 2.10 Current account deficits, changes in reserves, and long-term amortization among major developing country borrowers, 1997–98
(billions of U.S. dollars)

Note: Data on net flows to these countries, which are partly based on data from international capital markets, are considerably larger than the estimates of financing requirements presented here. The difference reflects net flows on short-term debt, capital outflows, lags in reporting, and other statistical discrepancies (see box 1.1).
a. Indonesia, the Republic of Korea, Malaysia, the Philippines, and Thailand b. Argentina, Brazil, Chile, China, Colombia, the Czech Republic, Hungary, India, Mexico, Peru, Poland, Russia, Turkey, and Venezuela.
Source: World Bank, JP Morgan, and Consensus Forecasts.

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Still, the future of net long-term private flows to countries affected by the crisis remains uncertain. This projection of external financing requirements does not take into account the short-term debt ($150 billion in mid-1997) that may need to be rolled over. Some countries plan to borrow long-term funds on the international markets to retire short-term debt, implying the need for an increase in net long-term flows in 1998. But capital outflows (which are not reflected in the data on net private flows; see box 1.1) could decline in 1998 relative to 1997, and official financing may rise (as envisioned under international rescue packages for Indonesia, Korea, and Thailand). Moreover, the baseline projection of a moderate decline in private capital flows in 1998 is subject to several risks:

• Continued devaluations in the region would lower the competitiveness of countries whose currencies have maintained their parities (China, for example, has exports equal to about 70 percent of the value of exports from the five East Asian countries most affected by the crisis).

• Intensification of the crisis could cause a significant drop in international stock markets. Exports to the five most affected East Asian countries represent only 0.6 percent of European GDP and 0.7 percent of U.S. GDP, so any decline is unlikely to substantially affect valuations of firms quoted on European and U.S. exchanges (even after accounting for earnings of foreign subsidiaries in the region). But since price-earnings ratios are at high historical levels (especially in the United States), the markets are vulnerable to news that projected earnings growth might not materialize. A sharp drop in international stock markets would likely intensify the flight to quality that has already been observed, further reducing net flows to emerging markets.

• International banks with exposure in East Asia could be placed at risk. The assets of G-7 banks in the five East Asian countries hardest hit by the crisis accounted for about 27 percent of total capital in 1995. At 43 percent of capital, Japanese banks are the most exposed. Still, bank exposure to the five East Asian countries is a smaller share of capital than it was to the countries most affected by the debt crisis in the 1980s (more than 60 percent of capital in 1982).5

• Intensification of the crisis could heighten protectionist sentiment. Recent World Bank projections indicate that the United States will account for about half of the $100 billion increase in the current account surplus of the countries most affected by the crisis. Given that the U.S. public already believes that the current account deficit is large (although it is only 2.1 percent of GDP, well in line with historical averages and levels in other deficit countries), this additional increase could escalate trade friction. Developing countries may also feel pressures to raise trade barriers in response to the falling prices of Asian exports, or as a way to reduce balance of payments deficits. For example, Argentina and Mexico raised tariffs temporarily during the peso crisis in 1995, and Mercosur tariffs recently were raised 3 percentage points. Efforts to increase protection will most likely prove self-defeating, as happened in the 1930s, and could weaken confidence that developing countries that attract private capital flows can service their obligations.

Notes

1. The 12 emerging markets are Argentina, Brazil, the Czech Republic, India, Indonesia, the Republic of Korea, Malaysia, Mexico, the Philippines, Poland, Thailand, and Turkey.
2. This estimate differs significantly from that given in official sources. Real estate lending in the Philippines may have been less speculative than in the other countries, however, because buyers are required to make substantial downpayments.
3. These data come from Jardine Fleming. Official sources report that nonperforming loans in the Philippines were 4 percent of bank assets.
4. Although implicit or explicit government guarantees encouraged excessive risk taking and contributed to the crisis, the concern that public commitments to guarantees might not be supported by the legislature added to uncertainties over economic policy just before the crisis hit.
5. Those countries included Argentina, Brazil, Chile, Mexico, the Philippines, and Venezuela.

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