Washington, DC—A comprehensive new analysis by Institute Senior Fellow Morris Goldstein of the causes of, and remedies for, the Asian economic crisis reveals the existence of a major flaw in the international financial system: the problem of "moral hazard" namely, that IMF-led rescue packages have bailed out large uninsured creditors of banks in the crisis countries and thereby prompted excessive risk-taking by such creditors and more crises in the future. Resolution of this problem is essential to win congressional support for pending IMF legislation, which is critically important in light of the prospect that new financial crisis could erupt at about any time, as well as to avoid such crises.

In The Asian Financial Crisis: Causes, Cures, and Systemic Implications, Goldstein argues that the moral hazard problem can be reduced by reforming official safety nets and by making earlier and heavier recourse to private debt rescheduling. This equitable burden-sharing during the resolution of a crisis, return official rescue packages to a more reasonable size, and supply market discipline across a broader spectrum of emerging-market financial instruments. Specifically, Goldstein recommends international agreement that:

• informal debt standstills, reschedulings, and IMF "lending into arrears" be accepted in crisis countries with unsustainable debt burdens;
• bond holders create standing steering committees and include sharing and majority voting clauses in bond contracts, to facilitate needed debt restructuring;
• governments seeking IMF rescue packages recognize that any "blanket guarantee" announcements they issued before the IMF arrived may not be honored;
• emerging economies adopt deposit insurance systems, modeled along the lines of recent US banking law, that cover small retail depositors and put large uninsured creditors of banks at the back of the queue when failed banks are resolved;
• no protection be extended to finance companies and merchant banks, and that any emergency guarantees extended to commercial banks carry a strict time limit (say, no more than one year).

Goldstein also examines and rejects the other criticisms of the IMF that have surfaced during the heated congressional debate on the IMF's role in the Asian crisis, on the Clinton administration's request for an increase in the IMF's resources, that the IMF's prescriptions were counterproductive because the Asian crisis countries were merely innocent bystanders to a financial panic, that changes in international monetary arrangements have removed the raison d'être of the IMF, that IMF conditionality should be less "intrusive" by staying clear of recommendations on structural policies, that huge currency declines in the crisis countries can be arrested without a temporary period of high interest rates, that the Fund closed too many banks in Indonesia, and that it was the tightness of the original monetary and fiscal targets in Fund programs that limited the rebound observed so far in the crisis countries.

Goldstein does lay out, however, a set of "Halifax II" reforms that should be addressed by the next several G-8 economic summits and the IMF's Interim Committee. In addition to reducing moral hazard, and increasing the orderliness and flexibility of private debt rescheduling, these reforms should concentrate on:

• strengthening prudential standards in developing countries, setting time deadlines for the adoption of those standards, and increasing the incentives for countries to implement these standards sooner;
• improving transparency and disclosure in financial markets;
• giving IMF surveillance more punch; and
• shoring up risk management at the world's largest banks and securities houses.

Goldstein traces the origins of the Asian crisis to three interrelated sets of problems: financial-sector weaknesses in the crisis countries along with easy global liquidity conditions, mounting external-sector problems in these countries, and contagion running from Thailand to other economies.

In analyzing financial-sector weaknesses in the four Southeast Asian economies (Thailand, Indonesia, Malaysia, the Philippines, and South Korea), the author highlights the credit boom in the first half of the 1990s (stoked by large capital inflows and directed in good measure to real estate and equities), liquidity and currency mismatches on the part of banks and corporations (linked to foreign borrowing at short maturities and denominated in foreign currency), and long-standing weaknesses in banking and financial-sector supervision (e.g., high levels of connected lending, excessive government ownership and involvement in banks, poor loan classification and provisioning practices, etc). When credit and cyclical conditions changed, this vulnerability was transformed into crises.

Large external deficits in these countries were previously viewed as "benign", since they did not result from large public-sector imbalances and since foreign borrowing was being used mainly to increase investment, but concerns mounted in 1996 and 1997. Motivating these concerns were a marked export slowdown in 1996, modest appreciations in real exchange rates, deteriorating quality of investment, overproduction in certain industries, a perceived shift in regional comparative advantage toward China, and worries about intense export competition in the period ahead.

Goldstein shows that bilateral relationships with Thailand are too small to explain the widespread contagion in the Asian crisis. Two other channels provide more plausible mechanisms. One is that Thailand acted as a "wake-up call" for international investors to reassess the creditworthiness of Asian borrowers and, when they did that reassessment, they found that other economies had weaknesses similar to those in Thailand (weak financial sectors with poor supervision, large external imbalances, appreciating real exchange rates, a 1996 export slowdown, etc.). The dynamics of devaluation were the second channel of contagion: as one country after another undergoes a devaluation, the countries who have not devalued experience a deterioration in competitiveness and increased vulnerability.

Because the Asian crisis did not arise from a single source, there is no single silver bullet that will fix it. A multi-pronged strategy is required:

• financial sector with an emphasis on resolving insolvent banks and finance companies, recapitalizing institutions to meet international standards, liberalizing foreign-ownership limits, and signing the Basle "Core Principles of Effective Banking Supervision;"
• recovery and banking reform in Japan. Japan has to become part of the solution to the crisis rather than a tinder box that deepens it. Domestic demand needs to be revived, and the banking system must finally resolve its massive bad loan problem. The 16 trillion yen fiscal stimulus package should be weighted much more heavily toward permanent tax cuts, and public funds should be should be used to close weak banks rather than prop them up.
• China should continue to resist the temptation to devalue its own currency, at least until the region's recovery from the crisis is more firmly established; and
• the major industrial countries should pledge not to adopt any new trade restrictions in the wake of the Asian crisis.

The author concludes that a sustained turn in the Asian financial crisis will only come when the crisis countries have made enough progress in implementing structural reforms (particularly in the financial sector) to convince markets that things have really changed, and when there has been enough rescheduling of private debt to make creditors comfortable enough to provide new lending.