Download The International Monetary Fund and East Asian Financial Crisis

Dimitre Grozdev
CSUB Economics Alumnus
[email protected]
The CSUB Economic Report
www.csub.edu/kej
September 7, 2010
The International Monetary Fund and East Asian Financial Crisis
The International Monetary Fund (IMF) is an institution, whose purpose is to keep the
international financial system stable by financing capital account deficits of developing
countries. Countries are able to obtain loans from the IMF by agreeing to follow prescribed
economic policies known as “conditionality.” Although IMF’s financial packages placed burden
on the poor through fiscal austerity and monetary contraction, they were successful in solving
the balance of payment problems that some developing countries had experienced in the 1980s
and 1990s. However, the East Asian financial crisis demonstrated the weaknesses of the IMF’s
economic policies. The problem is that IMF’s policies were based on the outdated and
questionable principles that only “free markets” lead to efficient economic outcomes, and fail
to allow for necessary government intervention.
The East Asian financial crisis began on July 2, 1997, when Thailand’s currency, the baht,
collapsed. Historically, the bath was fixed to the U.S dollar and traded about 25 baht to the
dollar. Subsequently, currency devaluation hit Korea, Malaysia, the Philippines, and Indonesia.
The sentiment of investors changed almost overnight and billions of foreign portfolio capital
left these countries. In the first half of 1997, capital outflows reached $12 billion. However,
capital outflows totaled $109 billion in the second half of the year, which accounted for 10
percent of the combined GDP of these countries. As a result domestic central banks could not
defend the fixed exchange rates of their currencies and had to devaluate them.
The single most important factor that contributed to this crisis was rapid capital account
liberalization. In the early 1990s, the IMF pushed the East Asian countries to open their financial
markets to foreign capital. Representatives of the IMF argued that capital account liberalization
would allow for greater diversification of sources of funding. The IMF believed that
unrestrained movement of capital would allocate funds to their most productive uses, speeding
up economic growth. But the affected East Asian countries had no need for additional capital
because they had managed to save and invest in productive activities. Moreover, East Asian
governments channeled national savings into private export-oriented industries, producing
impressive economic results.
The quick capital liberalization that East Asian countries completed was unsuitable for their
long-term economic growth. It allowed domestic banks and firms to borrow as much as they
wanted abroad, where interest rates were lower than in their respective countries. The method
of borrowing foreign funds was problematic because a large portion of foreign debts consisted
of short-term capital that could be called back by lenders at any time. The easy money obtained
from abroad led to imprudent investment, leading to over-capacity in many industries.
Furthermore, an increased percentage of bank loans went to construction, real estate, stock
markets, and other services. Since these sectors often lead to speculative bubbles, many East
Asian governments had placed limits on excessive growth in sectors like real estate. But, the
IMF believed that such government controls distorted economic efficiency and domestic
advised policy-makers to remove such controls.
Corruption played a big role in the East Asian financial crisis. Easy access to foreign funds
allowed domestic banks to lend money to politically-connected companies without worrying
about the soundness of their operations. Bankers believed if these companies were in danger
of failing, the government would bail them out. Such behavior led to “crony capitalism” where
government officials in the affected countries implicitly guaranteed loans to corporations that
were closely connected to them. However, prior to capital account liberalization, East Asian
countries had impressive economic growth trends within existing economic and political
frameworks. Although there is no doubt that corruption had a role in the crisis, the easy access
to foreign funds made possible by capital liberalization further shady political systems of East
Asian countries.
The IMF came to the rescue of the affected countries with huge loans. The loans were
accompanied by typical IMF policies that included fiscal austerity, monetary contraction, and
deregulations, all based on the premise that markets are most efficient in eliminating economic
deficiencies without much government intervention. Except, this assertion is not necessarily
true all the time. The first mistake of the IMF in East Asia was the imposition of fiscal austerity.
Representatives of the IMF maintained that fiscal austerity would raise the necessary money to
pay out the IMF and other foreign lenders. The IMF believed that paying off foreign lenders
quickly would restore confidence, drawing foreign investment back. Unfortunately, the fiscal
austerity programs caused an excessive economic contraction and a collapse in tax revenues,
thus prolonging the financial crisis.
A wide range of factors caused a substantial in the domestic aggregate demand: collapse of
exchange rates, capital flight causing a dramatic decrease in investment, breakdown of the
stock markets, and real estate bubbles. But, a few governments of East Asia had budget
surpluses and foreign exchange reserves. They could have used these funds to stimulate the
demand in their economies, helping to bring about a quick economic recovery. However, the
IMF, regarding active government stimulation of the economy as undesirable, did not advise
such actions.
Monetary contraction imposed by the IMF was perhaps the biggest mistakes that prolonged
economic recovery of East Asia. The IMF expected that higher interest rates would reverse
capital outflows and attract back international investment due to the higher rate of return.
Except, the IMF’s reasoning did not include bankruptcy and its consequences. Many domestic
businesses were highly indebted, and had high debt to equity ratios. As a result of the
contractionary monetary policies, many firms went bankrupt because they could not keep up
with the sudden increase in interest rates. Non-performing loans increased as a percentage of
total loans on the balance sheets of domestic banks, putting the financial sector in distress. This
led to debt-free and profitable firms could not get credit for expansion or even to keep up the
pace of current production. Thus, higher interest rates did not attract back foreign capital
because investors were very uncertain whether the corporate bankruptcies would lead to bank
failures as well. Instead, the East Asian governments should have allowed to lower interest
rates, which would have decreased the number of bankruptcies in the corporate and financial
sectors and to restore business confidence.
IMF policies were responsible for causing the crisis and protracting recession in East Asia.
Firstly, the IMF pushed the affected economies to quickly adopt capital account liberalization.
Secondly, the IMF actions of fiscal austerity and monetary contraction decreased both supply
and demand, thus prolonging the adverse effects of the East Asian financial crisis.
In order to prevent severe economic crises in the developing world, the IMF should reform its
free-market approach to economic stabilization. A modified approach must incorporate active
government intervention within the framework of free market transactions in order to dampen
the effects of recessions, thus allowing for timely recovery.
Works Cited
Lee, Eddy, The Asian Financial Crisis: The Challenge for Social Policy, Geneva: International Labor
Organization, 1998.
Pate, Carter, “Turnaround Topics: The IMF Rescue,” Asian Economies Propose Turnabout
Plans to Obtain Financing,” American Bankruptcy Journal, 1998
Prakash, Aseem, “The East Asian Crisis and Globalization Discourse,” Review of International Political
Economy, 2001
Stiglitz, Joseph, Globalization and its Discontents, New York: W.W. Norton & Company, 2003.