By Martin Khor
Third World NetworkOctober, 1998
Summary: A new report by the United nations agency, UNCTAD, says that despite the current problems, the East Asian development model is not dead. It wasn't so much that the Asian economic style caused the crisis, but more the deviation from its previous practice. The report shows that financial crises are very much part of the global system and the Asian case is only one. It gives an incisive critique why the IMF approach converted a liquidity problem into a solvency crisis. Finally, UNCTAD also proposes a range of crisis management measures, including a debt standstill and capital controls.
A pathbreaking report on the Asian crisis was released in mid- September 1998 by the United Nations Conference on Trade and Development (UNCTAD).
Previous UN reports by other agencies had focused more on the social aspects of the crisis, or were mainly descriptive on the economic issues. Thus much of the institutional economic analysis receiving wide publicity had come from the International Monetary Fund.
The UNCTAD study (its Trade and Development Report 1998) is unique in its professional and comprehensive treatment of the crisis.
It examines the causes of the crisis, locating these in the very system of global finance. It criticises the IMF-led international response to the crisis. And it provides several proposals for the appropriate management and prevention of such crises.
Among the suggestions are the establishment of a mechanism allowing countries on the brink of crisis to declare a "debt standstill," during which creditors are obliged to give time for a restructuring of debt repayments, similar to the Chapter 11 procedures in the United States bankruptcy law.
Another proposal is that developing countries make use of capital controls as part of their "armory" in preventing or helping resolve financial crises. The details of this part of the Report will be of special interest to those grappling with proposals for crisis prevention and damage control.
On the causes of the crisis, UNCTAD presents an economic analysis that goes beyond the simplistic and superficial to probe into the root causes.
It argues that the East Asian experience is only one of a series of many financial crises (for example, in Southern Cone of Latin America in the late 1970s and early 1980s, Latin America in the 1980s, European countries in 1992, Mexico in 1994) of the past two decades.
These crises are caused by the intrinsic and volatile nature of the global financial system, after the closure of the fixed exchange rate system in the early 1970s.
The Asian crisis, says UNCTAD, began with financial liberalisation, causing a build-up of vulnerability of the countries to external forces. When large inflows of short-term capital took place, it led to an asset price bubble that broke when speculative currency attacks caused sharp depreciations which then spread via contagion to other countries.
Once the countries fell into crisis, the IMF's response (monetary and fiscal tightening and high interest rates) made it worse.
In one of the deepest critiques of the IMF approach, UNCTAD says: "The situation was characterised by a stock disequilibrium rather than a flow imbalance that could be corrected by expenditure reduction.
"Since most of the external borrowing had been undertaken in foreign currency without adequate hedging, the fall in the currency created a balance sheet disequilibrium for indebted banks, property companies and firms.
"At the new exchange rates the stock of outstanding foreign debt became too large to be supported by expected income flows. The value of firms, and asset prices more generally,thus declined. Since these assets had been the collateral for much of the increased lending, the quality of bank loans automatically deteriorated.
"Rather than ease the burden of refinancing on domestic firms by granting additional credit, the recommended policy response was to raise interest rates. This depressed asset prices further and increased balance sheet losses of firms and their need to repay or hedge their foreign indebtedness quickly by liquidating assets and selling the domestic currency."
Moreover, says the Report, instead of the IMF loans going to support the new exchange rates, in East Asia the exchange rates were left to float.
"Thus rather than guaranteeing the new exchange rate, the Fund's lending has been aimed at ensuring the maintenance of the domestic currency's convertibility and free capital flows, and guaranteeing repayment to foreign lenders. "The latter, unlike domestic lenders, emerge from the crisis without substantial loss, even though they had accepted exposure to risk just as other lenders had done."
According to UNCTAD, the crisis was initially one of liquidity rather than of solvency. As long as they were given sufficient time to realise their investments, the countries would have been able to generate foreign exchange to repay their external debt with an exchange rate adjustment needed to restore competitiveness (which UNCTAD estimates at only 10-15 percent, instead of the very sharp currency drops that took place).
However, "the use of high interest rates, the extent of currency devaluation and the reduction in growth rates that created conditions of debt deflation quickly acted on financial institutions and company balance sheets to create a solvency crisis."
In other words, in this analysis, the crisis-stricken countries that sought IMF funds were never given a proper chance. What would that chance have looked like?
UNCTAD says that given the sharp attacks on the currencies, "the appropriate action would be to move quickly to solve the intertemporal problem by introducing a (debt) standstill and bringing the borrowers and lenders together to reschedule, even before the commitment of IMF funds."
It adds that a combination of rapid debt restructuring and liquidity injection to support the currency and provide working capital for the economy would also have made it possible to pursue the kind of policies that enabled the US to recover quickly from a situation of debt deflation are recession in the early 1990s.
Another part of the Report shows how the US got out of its crisis. Reacting to the weakness in the financial system and the economy, short-term interest rates were reduced in the early 1990s almost to negative levels in real terms, thus providing relief not only for banks, but also for firms and households, which were able to refinance debt at substantially lower interest-servicing costs.
This eventually produced a boom in the securities market, thereby lowering long-term interest rates and helping to restore balance sheet positions, thus providing a strong recovery.
"The policies pursued in the early 1990s were exemplary in the way they addressed debt deflation, making it possible for the US economy to enjoy one of the longest post-war recoveries."
UNCTAD's analysis thus shows the sharp contrast between the IMF's policy of tight credit and high interest rates, and the United States' own opposite policy of extremely low interest rates and provision of liquidity.
Reading the Report, one can't help wondering that since the US policy succeeded, it is curious why the IMF (which is after all so much influenced by the US Administration) imposed an opposite policy on the affected Asian countries.
The countries that have come under IMF loan conditions have little room to formulate their own policies. In this, Malaysia is one Asian country fortunate for not having to seek IMF aid, although it does receive IMF advice. Malaysia has been able to switch policy track from one which was close to the orthodox IMF line, to one which is now close to the US domestic line.
In another interesting section, the Report considers whether the Asian development model has been killed by the crisis.
It notes the view of some Western commentators that blamed the crisis on the Asian countries' structural shortcomings (such as the close government-business relation and market distortions that insulated business from competitive forces and market discipline).
Some commentators say the model is now outdated and overwhelmed by global market forces, although it had succeeded in the past.
UNCTAD however says that whilst the East Asian economies are run differently from the Western model, its present crisis does not differ from similar crises experienced by developed and developing countries, including those operating under the Western Anglo- American model.
The Asian crisis "is yet another episode in a series of crises that have been occurring with increasing frequency since the breakdown of the Bretton Woods arrangements, and with the introduction of floating exchange rates and the unleashing of financial capital."
As in the earlier episodes of financial crisis and currency turmoil in developing countries, the East Asian crisis "was preceded by financial liberalisation and deregulation which, in some cases, constituted a major break with past practices.
"In this sense the fundamental problem was not that there was too much government intervention and control, but too little."
To support this, the Report also quotes the World Bank chief economist Joseph Stiglitz: "The heart of the current problem in most cases is not that the government has done too much, but that it has done too little...The East Asian crisis is not a refutation of the East Asian miracle.
"The more dogmatic version of the Washington Consensus does not provide the right framework for understanding both the success of the East Asian economies and their current troubles."
Citing South Korea as an example, UNCTAD argues that the country broke away from its past policies and practices. The government had been very careful in regulating the private sector's borrowing from abroad, and had also coordinated the private sector's investment decisions to avoid excessive competition and excess capacity.
Recently, the South Korean government had abandoned its investment coordination role (which contributed to misallocation and overinvestment) and also relinquished its control over the financial sector (thus, the country became vulnerable to an external debt run and currency attack).
UNCTAD thus concludes that "it is the departure from the 'model' rather than its pursuit that is the main cause of the crisis in that country."
The Report draws the lesson that successful industrialisation depends on how profits and integration into the global economy are managed.
The Asian crisis confirms this: "When policies falter in managing capital and integration, there is no limit to the damage that international finance can inflict on an economy."
There is certainly considerable scope for national policies in preventing and better managing crises of this sort, says UNCTAD, but "these crises are a systemic problem, and action is therefore needed also at the global level."
Article Two: Indebted Countries Need Orderly Debt Workout
Article Three: Using Capital Controls to Deal With a Financial Crisis
More Information on UNCTAD
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