Mr. Chairman, and other distinguished members of the Subcommittee, I am delighted to testify today on the response of the International Monetary Fund to the Asian financial crisis. My colleagues at the Heritage Foundation and I look forward to working with you on this and other important issues.
I have prepared remarks that I wish to deliver, but, with your permission, Mr. Chairman, I would like to submit for the record a written version of my testimony.
THE ASIAN FINANCIAL CRISIS IN PERSPECTIVE
Because I am more familiar with the Asian experience, I focus on the crisis in Korea, Thailand and Indonesia. My testimony reviews the evolution of the Asian financial crisis; examines the programs of the International Monetary Fund (IMF) to address the crisis; assesses the IMF programs in light of reforms enacted by Congress last year; and assesses the accountability of the IMF. I begin with an overview of the Asian financial crisis.
As is well known, the crisis began in mid-1997 in Thailand and by year-end it had spread from Thailand to Indonesia and South Korea, as well as other countries. The details varied in each of the countries affected by the crisis. Typically, there was a collapse in currency values after a period of turmoil in the foreign exchange markets. Asset values declined sharply in all the countries and economic activity turned negative.
In a number of countries, political upheaval followed economic dislocation. In Indonesia, a longtime political leader resigned in the face of violent political protests. In Thailand and South Korea, there were peaceful changes in the respective governments. In Malaysia, an heir apparent was ousted from power. As Hong Kong’s flexible and resilient economy was tested as never before, its new political system was also stressed.
The turmoil has occurred at great economic cost in these countries, whether measured in terms of output, investment or jobs. In Indonesia, violence and loss of human life accompanied political upheaval.
The common economic factor in each country was a conjunction of currency and banking crises. There is a reason for this conjunction. Each country had an exchange-rate system that linked its currency to the U.S. dollar. Systems that fix or peg a local currency to the dollar provide a guarantee to short-term investors that they can make a quick exit with their funds a little or no cost to themselves. That assurance, in turn, tends to diminish risk monitoring by investors. Exposure to loss generates risk management, while financial guarantees anesthetize investors to underlying risk.
As short-term funds (so-called hot money) surge into countries with already questionable banking systems, lax banking practices will be exacerbated and ever more dubious lending will be funded. Any shock that undermines investor confidence will likely lead to a run on both the currency and the banking systems.
To understand what occurred in much of Asia in 1997, we must look back to Mexico in 1995. Mexico was both a watershed for global public policy and a turning point in international capital markets. First, the size and scale of the Mexican bailout was unprecedented. Second, after Mexico, investors perceived that the International Monetary Fund (IMF) would henceforth bailout any large international debtor-country. The resolution of the Mexican peso crisis established global moral hazard.
After Mexico, traders began consciously to invest based on perceived IMF guarantees. In 1995, for instance, an official of a major investment house told me that he viewed investments in Russia as coming under an IMF guarantee. Colleagues have told me of similar conversations they had with traders.
Moral hazard occurs when the provision of insurance against a calamity, such as fire, alters behavior so as to increase the probability of the calamity. Insurance policies typically contain provisions constraining the behavior of those insured to mitigate against moral hazard. By analogy, the concept has been extended to behavior in financial markets when insurance-like guarantees are provided to investors.
The existence of moral hazard in international lending is not the speculation of free-market economists but a fact in capital markets. That its existence is still questioned by some within the IMF is testimony to a continuing state of denial within that agency.
If Russia, otherwise a financial black hole, was now to be viewed as a safe investment, still more were the Asian countries. Countries like Thailand, Indonesia, and South Korea were viewed as fundamentally sound. Even if some doubted their ability to absorb all the incoming capital, no need for investors to worry in the post-Mexico world of IMF bailouts. Similarly, officials in countries experiencing large capital inflows were under no pressure to engage in any needed financial reforms.
As a consequence of ill-advised policy in Mexico, much of Asia is in economic shambles. Political instability is on the rise. To the extent that important regional allies have been weakened economically, U.S. national security interests in the region may have been damaged. Yet at each step in the crisis, the IMF repeatedly applied solutions that had contributed to the crisis in the first place. The agency is thereby laying the groundwork for future such crises.
THE ASIAN FINANCIAL CRISIS IN DETAIL
The Crisis Develops
The crisis began in Thailand in mid-1997. IMF officials have publicly stated that they in fact observed early warning signs of a real-estate bubble and a sharply deteriorating current account. They delivered warnings to Thai officials for two years prior to the crisis, but the warnings went unheeded. Given the moral hazard scenario outlined above, it is not entirely surprising that the warnings went unheeded.
Nonetheless, IMF officials should be credited with identifying financial problems in Thailand. These officials did not, however, anticipate a full-blown regional financial crisis. Nor were they prepared for the magnitude of the banking problems.
It was in the banking system of the Asian economies that all the flaws of the Asian model evidenced themselves. Banking policy and practice were the linchpin of the Asian model of economic development. To varying degrees, Asian governments utilized the banking system to direct funds into favored investments or toward favored investors.
There were certainly differences in the economic policies of Korea, Thailand and Indonesia. The Korean government, for instance, pursued policies to upgrade the skills of its labor force, and shift output from low-wage, labor-intensive activities to high-wage, capital-intensive production.
The Thai government relied on a large supply of low-wage, relatively unskilled workers to produce goods such as apparel, footwear and toys. Pegging the baht to the U.S. dollar was a key policy decision by the Thai government to maintain Thailand’s competitiveness.
In Indonesia, much of industrial policy was aimed at insuring that the family and friends of President Suharto benefited from new investment funds. It was perhaps in Indonesia that the system of "crony capitalism" reached its apogee.
While the specifics of development policy differed in each of these countries (as well as other Asian countries), the common thread was the use of the banking system and foreign-exchange policy to manage development. And, in each case, the cumulative effects of the policies led to unsustainable borrowing and investments. In each country, there was a crisis waiting to be triggered by an economic event.
It must be noted that, in contrast to Latin American debt crises, the Asian economies did not generally have fiscal deficits. These economies did have large current-account deficits, which reflected high private-sector demand for foreign capital. Though annual savings rates in Korea and Thailand exceeded 30 percent (as a percent of GDP), private investment was even higher. (Indonesia was an exception, with its savings and investment rates roughly equal in 1996.)
A pegged exchange rate fueled private sector borrowing. Asian borrowers preferred borrowing in U.S. dollars at low, short-term interest rates, even to finance long-term projects. In Thailand, for instance, foreign capital inflows supported rapid growth in private-sector lending, much of it to finance a property boom. Thailand’s foreign debt rose to 50 percent of GDP, of which 80 percent was private-sector borrowing.
The Thai case illustrates, as do those of other Asian countries, that there is plenty of blame to be apportioned in the Asian financial crisis. It is eminently understandable why, provided the opportunity, a Thai borrower would prefer cheap, short-term loans denominated in U.S. dollars to more expensive local sources of credit, denominated in Thai bahts. Thailand, by pegging the baht to the dollar, facilitated such international arbitrage. That action, while a necessary condition for the eventual crisis, was not a sufficient one.
Here is where the Mexican peso crisis, and U.S. and IMF policy responses to that earlier crisis, becomes key. Foreign investors had to be convinced that they had a quick exit in the event of a crisis. Thailand’s exchange-rate policy certainly provided a level of comfort. But Thailand lacked the credibility to alone guarantee that foreign investors could as readily withdraw dollar credits as they had made them. Only the implicit backing of a credible international agency, like the IMF, -- backed by the U.S. Treasury and Federal Reserve System -- could have provided the required level of comfort. Mexico was the test case, and investors drew their comfort from that episode.
As an executive director of the IMF recently put it: "Banks and other financial institutions have the IMF very much in mind as a source of comfort when making decisions about whether to lend to risky countries, where higher yields can be obtained."
Much blame has legitimately fallen on the lax lending practices of Korean, Thai and Indonesian banks, poor banking supervision in these countries and financial accounting that was anything but transparent. If Korean banks were lax in their lending practices, however, what do we say of the European and U.S. banks that provided interbank funding to Korean banks? That Western banks willingly lent is testimony to a series of guarantees that the banks felt they had been provided. First, they believed that Asian countries would not permit their banks to fail. Second, European and American banks believed that fixed exchange rates insured against currency risk. Third, they had come to believe that there was an IMF guarantee in the event the first two guarantees were insufficient.
The seeds of the crisis were sown by the decision to peg local currencies to the dollar. In 1994, a weakening dollar improved the price competitiveness of Asian exports. In that year, however, China devalued its currency in order to maintain its competitiveness. That put competitive pressure on exporters in Southeast and Northeast Asia. In 1995, the foreign-exchange value of the U.S. dollar began to rise. By 1996, growth rates for exports slowed in Asian countries, even declining in Thailand.
Early in 1997, the Thai baht came under pressure as traders began to doubt the viability of its peg to the dollar. The Thai central bank intervened actively on foreign-exchange markets, and imposed capital controls in May 1997. On July 2, 1997, its reserves nearly exhausted, the Bank of Thailand floated the baht. The currency fell 10 percent immediately, and weakened further. On July 28, 1997, Thailand formally sought IMF assistance.
On August 20, 1997, the IMF announced an assistance package for Thailand. Thus began the IMF’s involvement in the Asian financial crisis. As the crisis spread, so did the IMF’s commitments. In Thailand, Indonesia and Korea, the IMF established a list of reforms to be implemented ("conditionality"). These reforms were designed to deregulate and liberalize the economy; open up the economies to trade and investment; restructure the corporate sector; and resolve the bad loans in the financial sector. Success at implementing the reforms has varied by country.
Thailand responded quickly to some of the recommendations. On December 8, 1997, the government permanently closed 56 out of 58 suspended finance companies. A government agency assumed control of the assets for liquidation. On February 9, 1998, the government nationalized two banks that did not submit acceptable recapitalization plans. The capital of two, previously nationalized banks was written off.
The government’s efforts at reforming the bankruptcy laws were thwarted in 1998 by strong opposition. Since then, the first of a series of laws reforming bankruptcy have been passed.
The Thai case illustrates the limits of the IMF’s influence. The IMF deals with sovereign nations and cannot impose its policies at will. In democratic countries, opposition parties must be placated. Even when a government is genuinely committed to implementing reform, as is Thailand, progress can be slow.
Even in countries with strong leaders and weak democratic institutions, political opposition can halt reform. Indonesia is another example of the limits of the IMF’s influence. A severe economic contraction lead to political upheaval. Many observers now believe that IMF reforms in Indonesia were overly harsh and attempted to transform an economy too quickly. Political reaction to the IMF reforms has slowed if not halted the reform process there.
Korea has been a model in Asia for democratic political reform and political liberalization. Comparatively little economic reform has been implemented, however. Korean policy had been to promote economic development through large conglomerates, the chaebol. At the time of the economic crisis, the 30 largest chaebol accounted for 80 percent of output. Their growth had occurred at the expense of small- and medium-sized firms. Admittedly, it is a daunting task to break up these conglomerates and foster a more entrepreneurial economy. The Korean government has taken only tentative first steps in that process.
It is generally true that Asian economies relied excessively on debt-finance, making too little use of equity investment. That result is a by-product of using the banking system as the mechanism by which investment was directed into favored sectors (and, by implication, denied to other parts of the economy). In Korea, however, leverage reached astounding levels. The average leverage ratio for the 30 largest chaebol was 330 percent.
The entire Korean economy was leveraged like the U.S real-estate sector. No market economy can weather normal volatility with such leverage, and the Koreans have paid the price in bankruptcies and business failures. The real-estate analogy actually points the way to an alternative, free-market approach to resolving international debt crises.
Operating as they do with high leverage, many American real-estate developers periodically find themselves unable to service their debts. Frequently the projects are viable if debt-service payments can be reduced. And it is often the case that the original developer is the most qualified individual to complete the project.
In such cases, lenders and borrowers agree to a loan workout, in which debt is reduced (or the term of the loan extended), and often debt is swapped for equity. Additional funds may be injected by investors as needed. And some short-term lenders may become medium-term lenders. As the saying goes, "in for a dime, in for a dollar." And, it might be added, "in for six months, in for six years."
In essence, the entire Korean economy, along with other affected Asian economies, needs a debt-for-equity swap to reduce leverage. IMF programs are not geared for that solution. IMF programs emphasize additional lending, and that is sovereign lending. What is needed in Korea and elsewhere is new private equity investment. The IMF cannot be the source of such funds, and has no expertise in securing them.
American lenders and law firms are masters at real-estate workouts. Instead of calling in international bureaucrats, countries would be well advised to call in American bankers and lawyers who are veterans of U.S. real-estate workouts. The outcome would not only avoid international bailouts, but also contribute to the efficiency of the economies. In fact, the seemingly hopeless debt problems of one major Indonesian conglomerate, Bakrie & Brothers, was recently resolved precisely by bringing in a skilled U.S. bankruptcy lawyer to do a corporate workout.
Given the choice, of course, lenders will always prefer a simple bailout to the tedious process of working out individual bad loans. All the banks and savings and loans in the American Southwest would have been delighted to have had the equivalent of an IMF bailout during that region’s real-estate bust. And, so too, would have lenders in New England’s downturn. Even though regional banking crises were a consequence, U.S. policymakers did no such thing because of the demonstrable moral hazard problem that such policies would have engendered. And the economies and financial systems of both regions are demonstrably stronger as a consequence. Yet U.S. policy makers are complicit in wreaking harm on other countries that they would not inflict upon their own.
In each country receiving IMF support, the agency has established conditions for the banking and financial systems. As already indicated, Thailand has made great progress. Indonesia’s political upheaval has prevented reform. Korea has laid the groundwork with political reform, but the promise of opening up the banking system to competition has been slow to occur.
Allowing foreign banks and securities firms to establish branches in these countries is a critical element to reform the financial sector. That is true for four reasons. First, foreign firms bring well-capitalized institutions to the economy with fresh sources of funds. Second, foreign institutions basically import higher supervisory standards, since they must met the generally more stringent requirements of home-country supervisors. Third, in similar fashion, foreign institutions bring their more-transparent accounting standards with them. Finally, foreign financial institutions often have better business practices, which they bring with them.
Backlash to IMF Programs
To reiterate, when implementation of IMF recommendations on financial liberalization has fallen short, it often reflects the obstacles that national sovereignty places on internationally imposed reforms. Indeed, it is a fact of life that nationalist opposition is strengthened in reaction to internationally imposed reform, whatever its merits. Further, the IMF is perceived as a mere instrumentality of U.S. policy. Consequently, anti-American feelings are on the rise in these countries.
A visiting delegation of legislators from an Asian country recently observed that, in separate visits to the U.S. Treasury Department and the IMF, not only are the same policies recommended, but in the very same words. For foreigners, there is no doubt that the script for the IMF is written in the U.S. Treasury.
It is important to recognize that IMF intervention generates a nationalist and populist backlash. Many believe that international organizations, like the IMF, can force governments to implement needed reforms, which they could never accomplish on their own. IMF-imposed programs set in motion a complex political dynamic, however, which makes it difficult to pronounce confidently that the participation of the IMF in the domestic reform process is helpful.
The political dynamic may explain why the IMF must frequently revise its initial conditions, as happened during the current Asian financial crisis. IMF conditionality first brings economic pain and then political reaction. Political reaction slows reform, which leads the IMF to revise its conditions so as to conform to political reality in the debtor country. Instead of an externally imposed reform process, we witness a reform process adjusted to domestic political conditions.
On October 23, 1998, Congress passed the 1999 Omnibus Appropriations Act. Included in that legislation were actions mandated for U.S. officials to undertake before funds could be released. The limited steps toward reform of the IMF must be lauded even if much more needs to be done. Even more important, however, was the congressional debate. That debate shifted the focus from how much money should be provided to the IMF to whether such an organization is any longer necessary.
Unfortunately, the language in the Omnibus bill fails to specify concrete actions to be taken or specific reforms that must be implemented. Rather, the language requires certification that the Secretary of the Treasury has instructed the U.S. Executive Director to support congressional reforms. The language requires the U.S. Executive Director to use her "voice and vote" in support of reform. On numerous occasions in the past, Congress has adopted this approach to no avail. IMF policy has changed little in response to previous congressional reforms and is unlikely to do so as a consequence of the most recent congressional effort.
There are two major reasons why the "voice and vote" requirement is an ineffective means to achieve its stated goals. First, the IMF operates by consensus rather than formal votes.
Second, and more important, the U.S. Treasury Department exercises influence over IMF policy far in excess of the explicit percentage vote possessed by the United States. IMF policy does not and will not deviate in any important or fundamental way from the policy of the U.S. Treasury. If Congress is displeased with IMF policy, it should address its concerns to Secretary Rubin and Deputy Secretary Summers. That is where IMF policy originates and can be effectively altered.
Congress can influence IMF policy in the same way it influences policy in any Executive branch agency: through oversight hearings, like this one, and through the power of the purse. Any other route, such as requiring the U.S. Executive Director to use her "voice and vote" in IMF deliberations, diminishes congressional influence and is unlikely to have a significant impact on IMF policy.
In a real sense the long delay in effecting U.S. funding for the IMF and the vigorous congressional debate that took place in 1997 and 1998 had more impact within the IMF than "voice and vote" instructions can ever have. The IMF has become visibly more open and transparent about its policies. It publishes more information on its programs and policies, and does so in a more timely manner, than has heretofore been the case. What has not really changed, however, are the policies themselves.
The crucial problem for holding the IMF accountable is that, from a democratic perspective, it is an unaccountable organization. In a democracy, legislators are held accountable for their actions by an electorate. Executive branch officials are subject to legislative oversight. In constitutional systems, the judiciary’s independence is protected. In the United States, even judges can removed for cause. (And in many states, judges are subject to recall or election.) Independent agencies, such as the Federal Reserve System, are subject to congressional oversight and must stand ready to defend their policies.
International agencies, by their design, are insulated from democratic accountability. Yet they are amply funded, to the tune of many billions of dollars. Human beings, shielded from accountability or realistic financial constraints, will even with the best of intentions begin to behave irresponsibly. Nothing short of fundamental institutional reform will alter behavior. Congress did not accomplish that in the 1999 Omnibus Appropriations Act.
The only effective interim measure to gain some accountability is to look to the U.S. Treasury Department, to which the U.S. Executive Director of the IMF reports. It is here that accountability can be imposed.
Thank you, Mr. Chairman, for allowing me to present my views on this matter. I am happy to respond to any questions that you or other members of the subcommittee may pose.
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