The Asian Monetary Crisis: Proposed Remedies
by C. Fred Bergsten, Peterson Institute for International Economics
Testimony before the Committee on Banking and Financial Services
United States House of Representatives
November 13, 1997
The Causes of the Crisis
In assessing the ongoing monetary and economic crisis in Asia, which has already had a major global effect (including on the United States) and could well have even more disturbing impact in the near future, it is useful to distinguish among three sets of countries in the region:
The underlying origins of the crises are multifaceted and date back to at least early 1994, when China effectively devalued by about 40 percent. From early 1995 to late 1996, the yen depreciated by over 25 percent. The sharp declines of the two key currencies in the region put tremendous competitive pressure on the rest of Asia, eroding their trade positions and producing large deficits in Korea and throughout southeast Asia.
The crisis broke last summer when markets, as with Mexico in 1994-95 and many other countries in the past, began to doubt the sustainability of the external positions of the southeast Asians—especially in light of the increasingly apparent weakness of their domestic financial systems. The initial attack on Thailand quickly widened to the rest of southeast Asia, where underlying structural problems already existed as well, and to northeast Asia in light of its ongoing problems.
The contagion should have stopped at this point because the "strong center" countries, still enjoying huge trade surpluses and strong economic growth, could neither be forced to devalue nor did they need to do so for competitive reasons. However, Taiwan chose to let its currency join the decline after a minimal defensive effort. This in turn added enormously to the pressure on Hong Kong—which was already vulnerable because of a substantial appreciation of its currency, its maintenance of a fixed exchange rate after all other countries in the region had abandoned their pegs, the sizable exposure of its financial institutions to property lending and the close links between those institutions and the stock market. The result was a precipitous decline in the Hong Kong stock market and the resultant global reverberations—including the largest one-day drop in the history of the New York Stock Exchange.
One can only speculate as to Taiwan's motives for taking the action that reignited and escalated the global crisis. They could have been seeking to force Hong Kong to abandon its exchange rate peg, the key symbol of its success and stability, to undercut "the one country, two systems" regime that China clearly hopes will succeed so dramatically that the world will start urging Taiwan to accept a similar formula. It may not have been coincidental that Taiwan took this action on the eve of President Jiang Zemin's visit to the United States, hoping to embarrass China and discredit what it sees as one of its greatest modern accomplishments—the smooth and successful reversion of Hong Kong to the mainland.
On the purely economic side, Taiwan's action represented a clear competitive devaluation reminiscent of the 1930s. Taiwan is running a current account surplus of about 4 percent of its GDP ($8-10 billion). Its reserves of almost $100 billion are the third highest in the world, behind only Japan and China. On every measure, its competitive position remained very strong even after the depreciations in southeast Asia and Korea. Hence its action was totally unnecessary and violated every norm of international cooperative behavior.
The crisis then took on a wholly new dimension. If Taiwan had decided to devalue, would the other "strong center" countries do so as well? In particular, wouldn't Hong Kong be forced to act—given its close economic ties with Taiwan and the intense (political as well as economic) competition between them? Some business voices in Hong Kong in fact began to call for abandonment of the peg. The leadership of Singapore chimed in with a statement that they too might have to let their currency fall.
Thus arose the specter of a spiral of competitive devaluations. The Taiwan action prompted renewed depreciation in Korea, its closest competitor, and further roiled the markets in southeast Asia. Any significant depreciations by others in the "strong center" would clearly lead to renewed runs on all the weaker currencies in the region—and almost certainly in Latin America and elsewhere as well. It is no surprise that markets tumbled throughout the world, including in the United States—where our trade deficit already stands at a record level of $200 billion and would worsen much further as a result of all this.
Fortunately, the rest of the "strong center" has held to this point. Hong Kong has successfully defended its peg (though it is unclear how long it can maintain its current level of interest rates in view of their adverse impact on the economy, and on the crucial property sector in particular). China and Singapore have avoided any significant downward movements in their currencies. Thailand has installed a new government that pledges to fulfill its IMF program and thus to have access to the agreed financial support package. Indonesia has also adopted an IMF program and received sizable international financial support.
The situation has thus stabilized—for the moment. But it has not been resolved by any means. Much more is required to put the crisis definitively behind us.
Resolving the Crisis
Two major sets of policy implications emerge from this analysis, one to deal with the immediate situation and another for the longer run.
The most crucial policy requirement for the foreseeable future is to avoid a new spiral of competitive currency depreciations. Taiwan's wholly unjustified depreciation was the major source of pressure on Hong Kong and the ruminations by Singapore's leadership that it might have to follow. But depreciations by these strong countries, which are running large trade surpluses and possess massive foreign exchange reserves, would produce a new wave of market pressure, and subsequent matching depreciations, by the weaker countries—in both southeast and northeast Asia (including Korea, Japan and possibly even China). The move would almost certainly spread to other emerging markets, including Brazil and probably others in Latin America. It would be very difficult to stop the new spiral and global markets—including ours in the United States—would be devastated.
The impact of such a spiral on the United States would be substantial. As just noted, our markets could suffer severe additional hits. Moreover, all of Asia would in essence be trying to export its way out of its current problems—and most of those exports would be targeted at the United States. If the dollar remained at current levels, or strengthened further as a result of "safe haven" effects, our huge trade deficit would rise even further: from a projected $250-300 billion in 1998 to even higher levels. This could subtract upwards of a full percentage point from our annual economic growth. With such deficits looming, passage of fast track legislation would become even more difficult—though a definitive Congressional rejection of fast track, raising the specter of a US retreat into protectionism, would further cloud the prospects for recovery of the Asian (and Latin American) countries and intensify the pressure on their economies and currencies (see below for more on the implications for trade policy).
Alternatively, a new round of currency depreciations in Asia (and thus elsewhere) could trigger a sharp run out of the dollar. Markets would at some early point recognize the adverse impact on our trade position, the unsustainability of the deficits that would ensue—since the United States is not immune to ultimate market sanctions for running huge external imbalances— and the inevitable political backlash from the United States. A new dollar fall, in addition to further escalating the global spiral, could bring our current economic euphoria to a crashing halt: inflation concerns would soar, interest rates would follow them upward, and the financial markets would experience a very substantial "correction."
Hence it is essential to hold the line at the present level of exchange rates in the region. The strong countries, notably Hong Kong and China but also Singapore and especially (in light of its recent performance) Taiwan, have no reason to depreciate from current levels. Given its economic weight, Japan must also firmly resist any further weakening of the yen—overcoming its traditional proclivity to export its way out of (largely self-induced) economic stagnation via additional depreciation. All these countries have huge international reserves so should be quite able to defend their rates. If necessary, however, external support should be provided to enable (and encourage) them to do so. Some of the depreciations in the region may in fact have overshot their long-run equilibrium levels so some retracement of the recent declines may well occur if the situation can be stabilized on a lasting basis.
In southeast Asia, the Indonesian support package is essential in helping to stop the downward spiral. Every effort must be made, including by the United States, to assure that Indonesia and Thailand faithfully implement their IMF programs and thereby restore confidence in their currencies. US participation in the Indonesia package is wise and vital, and our abstention from the support program for Thailand was (and remains) a serious mistake (see below).
In northeast Asia, Korea and Japan must quickly launch the fundamental structural reforms that they have needed for some time. Korea is the next crisis candidate. A further sharp fall of its exchange rate could trigger a new currency spiral, including perhaps in the "strong core" (and thus throughout the world). Its banking system is extremely fragile and further deterioration there, particularly given Korea's extensive financial relationships with Japan, could have far-reaching repercussions.
New policy actions are particularly essential in Japan. Its economy has been stagnant for most of the past five years and looks to be headed into a new recession. There is little prospect of Japanese recovery until its government launches a comprehensive restructuring of the financial system, including an infusion of substantial government capital to take the huge volume of bad loans off the books of the banks. Japan also must reverse its abysmal fiscal policy: its tax increases earlier this year took 2 percent of GDP out of the economy and are a major source of the current slide.
Absent such steps, the Japanese stock market could fall sharply. This would in turn erase much of the capital of the banking system, bankrupting many of the individual institutions. They would then have to liquidate large volumes of existing loans, further weakening the Japanese economy and—since many of those assets are held abroad—affecting our own markets as well. Japan could thus trigger a new series of shocks unless it acts promptly.
By contrast, after having triggered the difficulties in an underlying sense with its devaluation in early 1994, China has performed quite well during the crisis. It has held its exchange rate, encouraged Hong Kong to do so as well, reduced interest rates, maintained solid growth while bringing inflation under control, and contributed to the new financial packages despite its low level of per capita income. Its positive leadership must be maintained but, so far at least, augurs well for a successful resolution of the crisis.
Avoiding Future Disruptions
The second set of policy requirements relates to the longer run. There is a clear need to launch new regional arrangements to reinforce the efforts of the International Monetary Fund to help prevent and respond to future monetary crises in the region. The Asia Pacific Economic Cooperation (APEC) forum is the logical institutional home for the "Asian monetary fund" that has been discussed so widely since the onset of the current financial problems in Southeast Asia and should initiate such arrangements at its summit meeting in Vancouver on November 25.
The primary goal would be prevention of future crises. After Mexico exploded in early 1995, there were extensive efforts to improve the "early warning system." But that system failed again in Thailand. Moreover, the contagion to neighboring countries is far worse now than in Latin America in 1995.
The International Monetary Fund (IMF) did its job in foreseeing and warning of the impending problem. The systemic difficulty was that Thailand balked and no one pressed it to act.
The IMF on its own demonstrably cannot get emerging economies to adjust preemptively. It is unlikely that the industrial countries as a group, through the Group of Seven, or individual powers like the United States or Japan can do so. The best prospect is neighboring countries: because they are so likely to be hurt themselves by fallout from a crisis, their intervention is both legitimate and apt to be delivered forcefully. This is now particularly true in Asia in light of the contagion from Thailand that has engulfed the entire region and provided an objective lesson on the wider effects of a failure by one country to adjust responsibly.
APEC can provide the institutional locus for such efforts. It is already developing a process of "peer pressure" or "friendly persuasion" through which individual members encourage others to act responsibly, in the interests of the broader group as well as their own. APEC is using this approach to pursue "free and open trade and investment in the region by 2010 (for the advanced countries) or 2020 (for the rest)," the commitment undertaken at the Bogor summit in 1994. The most dramatic success came at last year's Subic summit when peer pressure persuaded a number of members to eliminate their tariffs on a wide range of high-tech products, enabling APEC to galvanize the Information Technology Agreement (ITA) on $500 billion of global trade in the World Trade Organization a few weeks later.
The APEC Finance Ministers have been meeting regularly since the Seattle summit in 1993 instructed them to do so. Their deputies have convened even more often, and will get together in Manila next week to consider this very topic. They have already discussed the currency and related issues in depth. They should begin systematically assessing national economic outlooks and pressing members to adopt good advice, from the IMF and elsewhere, that would head off future crises and thereby avoid new disruption in the region.
APEC should also create a standby funding arrangement to support further IMF programs in the region. The current cases are only the latest reminders that such crises inevitably occur from time to time. International rescue packages will be required in the future as in the past.
It is also clear that IMF lending by itself will never be adequate. The IMF has plenty of money, including from the latest increases agreed at Hong Kong and the standby General Arrangements to Borrow and (when implemented) New Arrangements to Borrow. But IMF credits to any individual country are limited by that country's quota at the Fund; even the unprecedented multiples for Mexico (700 percent of quota) and Thailand (500 percent) produced only one-quarter to one-third of the amounts needed. The IMF could and should remedy the situation by sharply expanding those multiples but the Europeans, who already have their own regional arrangements and continue to argue that both the Mexican and Thai rescues were inappropriate, would almost certainly oppose that alternative.
Widespread support has therefore developed for an "Asian monetary fund" to supplement the IMF. But Japan's proposal for an Asia-only facility was rejected by all concerned, including its intended beneficiaries, and has now been withdrawn. ASEAN is obviously too small. The "Six Markets Group" (or G-6) that met last spring included the United States but excluded many key Asian countries. The IMF itself has reportedly proposed that a regional grouping be created and staffed by its own new office in Tokyo.
APEC is the logical institutional venue for such arrangements. It includes all the Asian countries that might need help. It includes all the potential creditors, including the United States and Canada as well as Japan, China, Hong Kong, Taiwan and Brunei. Its Latin American members would be helpful, Mexico with its crisis and dramatic recovery experience and Chile as a healthy role model. As noted, its Finance Ministers have already developed an extensive cooperative relationship and have discussed the relevant issues at length. It could use the IMF's Tokyo office, as proposed by the IMF itself, to administer this phase of its activity.
The United States has a particular interest in lodging any "Asian monetary fund," whether limited to new forms of multilateral surveillance ("peer pressure") or encompassing additional funding arrangements as well, in APEC. A central thrust of American foreign policy, including foreign economic policy, has been to avoid any institutional devices that—to use the words of former Secretary of State James Baker—"would draw a line down the middle of the Pacific and threaten to divide East Asia and North America." We have thus firmly, and successfully so far, rejected Malaysian and other proposals for an East Asian Economic Group or any other "Asia only" devices.
But our failure to participate in the support package for Thailand, permitting it to proceed on an "Asia only" basis, kindled widespread Asian resentment and questions about the willingness of the United States to put its money where its mouth was. That sequence of events in turn led directly to Japan's proposals for an Asia-only "Asian monetary fund," which would exclude us from the most crucial area of cooperation with(what are still) the world's most dynamic economies (as well as the largest potential source of security problems). The costs of any such outcome, to the broad national security as well as economic interests of the United States, would play out over many years and could be huge. The United States should not play the dominant role in responding to Asian monetary disturbances, as it did with respect to Mexico in 1994-95, but should actively support IMF stewardship of the process (and might on occasion even have to provide leadership if Japan and other possible alternatives are bogged down by their weak economies or otherwise unable to perform effectively).
Hence it is encouraging that the United States has "gotten back in the game" by participating fully in the Indonesian support package. It is even more encouraging that our officials are actively engaging in the discussions on the creation of any new "Asian monetary fund." Since APEC unambiguously includes the United States, and indeed several of our neighbors in this hemisphere, we should seek to use it as the locus for any such arrangements and to thereby defend some of our most fundamental national interests.
The main criticism of this proposal is that any standing fund would create "moral hazard," the risk that its very existence would assure future bailouts and thereby tempt countries to pursue profligate policies and private investors to continue pouring money into unsustainable situations. But there is a decisive answer to this concern (which is often simply an excuse from those who wish to avoid putting up money): to tie any APEC arrangements inextricably to IMF programs. No country would put itself through the wringer of a monetary crisis and subject itself to the tender mercies of the IMF simply because rescue funds were available. Nor would private investors keep coming, with countless alternative opportunities around the world, if the Fund requires them to share the costs of adjustment programs as it must.
Moreover, the alternative to standby arrangements is ad hoc bailouts as cobbled together by the United States for Mexico and Japan for Thailand. Their outcome is always highly uncertain, as when the Congress almost blocked the Mexican package. Their magnitude, sharing among donors and speed of delivery are purely fortuitous. Prepared standby funding is far preferable.
There is no definitive basis for judging the appropriate magnitude for such a new facility. However, the current programs for Thailand and Indonesia cumulate to about $50 billion. Any new program for Korea, which could be required soon, would bring the total close to $100 billion. These amounts are unlikely to decline in the future. Moreover, the primary objective of any such fund would of course be deterrence of crises so it should tilt toward larger rather than smaller levels of resources. Something on the order of $100 billion would probably represent a prudent minimum.
The other key systemic requirement is prompt and faithful implementation of the International Banking Standard proposed by my colleague Morris Goldstein (Morris Goldstein, The Case for an International Banking Standard. Institute for International Economics, Washington: 1997.) and agreed, in modified form as the Basel Core Principles, at the recent IMF annual meeting in Hong Kong. Weak financial sectors, as noted, were a central and pervasive cause of the crisis in virtually every troubled country. Countries must be held to the newly agreed norms, for adequate restructuring and supervision of their banking regimes, as part of any comprehensive program to avoid future disruptions of a similar type.
Two Implications for Trade Policy
I conclude by noting two important implications of these financial problems for trade policy.
First, all of the Asian countries that have been hit by the crisis—and the Latin Americans and others as well—must find ways to reduce their external deficits. They have the usual two choices: expand exports or restrict imports. It is obviously in our interest that they pursue the former course.
The President's failure to achieve fast track negotiating authority, if permitted to stand, could tilt the outcome in the wrong direction. Any lasting indication that the United States, by far the strongest economy and largest trading nation in the world, was reversing (or even seriously reconsidering) the basic thrust of its liberal trade policy could unleash a widespread protectionist reaction throughout the developing world. Crisis-impacted countries throughout Asia and Latin America would justifiably ask whether they should continue to pursue market-oriented, outward-directed development and adjustment strategies, by contrast with Mexico's staunchly pro-market adjustment strategy in 1995 that was "locked in" by its participation in NAFTA. The highly desirable and successful marketization trend of the past two decades could be halted or even reversed. The Congress must factor this consideration centrally into its thinking when taking up fast track again in early 1998.
Second, the members of APEC and the World Trade Organization have an early opportunity to use trade measures to help promote recovery from the crisis: the planned culmination by December 12 of the WTO negotiations on liberalization of financial services. It is clear, as noted above, that weak and inefficient financial sectors were a pervasive and central cause of the crisis throughout the region (including in Japan and Korea). Hence the modernization and liberalization of those sectors are essential elements of adjustment programs everywhere, and will be necessary to restore both internal and external confidence in their currencies and economies.
The WTO talks offer a fortuitous opportunity for the troubled countries to move together in this sphere, gaining the advantage of collective action and maximizing the market impact of their actions. The troubled Asian counties must therefore come forward with credible financial services reforms to deal with the wide-ranging problems of their banking and other financial industries. The United States must accept that, particularly in light of the fragile financial conditions in the region, the Asian countries will need both time to phase in such liberalization and technical help in establishing the essential supervisory systems. Fortunately, our Treasury has indicated its recognition of these requirements and it therefore seems likely that reasonable proposals from the Asians will be accepted. An agreement can be reached initially at the APEC summit in Vancouver and then, as a year ago with the Information Technology Agreement when APEC agreed and then persuaded the rest of the WTO to do so as well, in the global forum in Geneva.