A Three-Step Remedy For Asia's Financial Flu

Robert E. Litan

Brookings Intitute

February 1, 1998

Monday morning quarterbacking of how the International Monetary Fund(IMF) and the Clinton Administration handled the Southeast Asian crisishas become a favorite pastime in Washington. And a strange coalition ofpolitical bedfellows in Congress now threatens the replenishment of theIMF's reserves--the $3.5 billion Congress failed to approve last year, plusanother $14.5 billion in new funds.

A close look at what caused the crisis, and at the IMF and the Administration'sresponses, suggests that Asia's troubles are not insoluble and that theIMF is not, as some critics claim, obsolete. What's needed is a three-stepprogram of triage, liquidation or merger, and workouts for troubled corporations and banks. These will begin restoring confidence to the regionand help prevent future crises. Quick action is critical, however, to preventthe Asian flu from spreading.

To say that the Asian currency andeconomic crisis surprised the world is an understatement. The Asianeconomic miracle had become the stuff of legend--the transformation of oncepoor countries like Indonesia, Malaysia, Thailand, and South Korea in lessthan a generation into economies on the threshold of realizing a Westernmiddle class standard of living. The countries in the region had high ratesof saving and investment, hard working and impressively educated laborforces, and lean governments committed to fiscal prudence. How did it allunravel so quickly?

Neither of the two most popular explanations is, by itself, fully satisfactory.The conventional macroeconomic diagnosis pins the blame on overvalued exchangerates that effectively were pegged to a rising dollar, pricing exports out of world markets while enabling local citizens to buy goods from other countries at increasingly attractive prices. The countries had to finance their large current account deficits by borrowing from abroad, much of it in short-termmaturities.

The numbers provide much support for this story, but there are some gaps.Figure 1 shows, for example, that the countries that have suffered thegreatest currency collapses indeed had sizeable current account deficitscompared to local gross domestic product (GDP). But these figures alonecan't explain how countries with current account surpluses--likeTaiwan and Singapore--also have seen their currencies caught in the undertow.Moreover, three of the countries that have suffered currency troubles--SouthKorea, the Philippines and Thailand--had sharply lower current accountdeficits in 1997 than they did in 1996.

Table 1: Southeast Asian Current Account Balances And Currency Movements

Nation	Current Account Balance		Currency Decline
	As Percent of GDP		Relative to US Dollar (%)
	1996	1997	7/1/97 - 2/2/98
Indonesia	-3.4	-4.5	-76
Malaysia	-6.3	-9.9	39
Philippines	-4.5	-2.9	-36
Singapore	15.2	16.2	-16
S. Korea	-4.9	-2.7	-43
Taiwan	4.0	1.8	-17
Thailand	-7.9	-4.2	-49

Source: J. P. Morgan, World Financial Markets, First Quarter 1998

If current account balances alone can't explain the crisis, then thedata on short-term foreign indebtedness (Figure 2) helps fill in some otherpieces of the puzzle. Three of the countries hardest hit by the crisis--Indonesia,South Korea, and Thailand--had short-term foreign debt outstandingat the end of 1997 that approached or exceeded the country's level of hardcurrency reserves. But this was also true of the Philippines, where thecurrency has not fallen nearly as far. Meanwhile, how does one explainthe fact that Taiwan--which at year end 1997 had currency reserves almostthree times its level of short-term foreign debt--also suffered an erosionin the value of its currency?

Table 2: Southeast Asian Foreign Debt and Reserves in Billions of Dollars

Nation	Total Debt	Short-TermDebt	Reserves
China	152	42	141
Hong Kong	...	...	75
Indonesia	131	27	28
S. Korea	155	60	17
Malaysia	39	14	24
Philippines	58	15	9
Singapore	...	...	88
Taiwan	46	29	81
Thailand	102	32	20

Source: J. P. Morgan, World Financial Markets, First Quarter 1998

The other explanation for the crisis, spelled out recently by MIT ProfessorPaul Krugman, is that the Southeast Asian flu was brought on by the collapseof banking systems in the region. The villain in this story is cronycapitalism--the close links between Southeast Asian banks, their majorborrowers, and the region's governments, which often directed where loansshould be made and thus implicitly guaranteed them. A large influx of foreigninvestment, in search of high returns and encouraged by glowing reportsabout the Asian miracle, helped finance this profligacy, which manifesteditself in glitzy office buildings and plant expansions that could neverhave recovered their costs. With the markets awash in cash, asset pricesspiraled, only to eventually burst--first in Thailand and then in othermarkets as holders of domestic currencies lost faith and ran to the dollar.

There is no question that the weaknesses in the region's banking systemscontributed to the loss of confidence as currencies began falling. Butthere is more to the Asian crisis than a problem with its banks. Asia wasthe focus of irrational exuberance. Though the term was coined by Fed ChairmanAlan Greenspan for the U.S. financial markets, it is much more accuratelyapplied to Asia. Virtually everyone concerned--leaders and residents ofthe affected countries, and foreign investors--played their part.

The IMF and Its Critics

At the end of the day, it is unnecessary to choose betweenthe chicken and the egg--currency misalignment and flaws in the bankingsystem. Both were at fault and both are in the process of being corrected,currencies at the behest of the market, and banking systems at the behestof the IMF. However, the results, at least so far, have been hardly idealor free from criticism.

Despite the IMF's willingness to lend hard currency to countries thatare short of it, Figure 1 illustrates that the currencies of the most affectedcountries have plunged deeply and almost certainly are well below any long-termequilibrium level. It is difficult to believe, for example, that the Indonesianrupiah--the currency hardest hit--is truly worth less than one-fifth of itsvalue relative to the dollar just six months ago. At this level, accordingto recent press reports, roughly 90 percent of the companies listedon the Indonesian stock exchange--companies that were viable only six monthsago--are now technically bankrupt. The problem, in a nutshell, is that themarket is susceptible to precipitous and contagious declines, even whenthe IMF purports to come to the rescue.

In part, confidence has been undermined because government officialsin the affected countries have vacillated about accepting the IMF's conditions.Another reason is that the IMF itself is now under attack, especially inthis country, from both the right and the left. The IMF is charged withfailing to warn investors that the crisis was about to occur. It is blamedfor planting the seeds of the Southeast Asian crisis by rescuing Mexicoin 1994-95, thereby lulling banks and other investors outside the developedworld into believing that they couldn't lose. And it is accused of imposingconditions on its lending that arguably are making matters worse, in theprocess straying far from its original mission, which was to provide short-termliquidity to countries having balance-of-payment difficulties.

The critics may have a point about the IMF's failure to warn. But theyfail to note that a number of sophisticated analysts had been raising redflags, cautioning that the combination of pegged exchange rates and inadequatebanking supervision one day would lead to a crisis. As MIT economist LesterThurow has recently suggested, it is one thing to say that a financialearthquake is likely to happen, as Thurow, to his credit, warned severalyears ago. It is quite another to predict exactly when. Economists, likegeologists, are much better at doing the first than the second. In anyevent, IMF officials--who were understandably worried about triggering acrisis themselves with more visible public alarms--claim that they wereprivately warning Asian leaders, well before the crisis, of theeconomic perils they faced from lax banking practices and inadequate supervision.

The assertions that the Mexican rescue package made the Southeast Asiancrisis inevitable--and, in turn, that the IMF rescues of Asian countriesnow may plant the seeds for future crises--go too far. To be sure, any lender-of-lastresort loan entails a moral hazard to the extent it lets the beneficiariesof the loan escape any losses. But there is no assurance against currenciesbecoming overvalued or speculative bubbles forming even without any bailoutexpectations. Moreover, the Mexican experience surely must have demonstratedto Asian governments and investors in their stock markets that they wouldnot be insulated against loss. After all, the Mexican government had toadopt a wrenching macroeconomic belt tightening program (that itself hasbeen the subject of heavy criticism) as a condition for getting its IMFloans, while investors in peso-denominated securities suffered major losseswhen the peso was devalued. More broadly, the IMF's harshest critics, nowcalling for its abolition, fail to come to grips with how much farthertroubled currencies would fall if there were no international lender-of-last-resort.The deeper foreign currencies plunge in value, the more difficulty U.S.firms would have competing with exporters from those markets both hereand abroad. The worldwide economic costs of any particular crisis wouldbe potentially far greater, not to mention the political and security risksof further economic collapse in such countries as South Korea.

There are at least two valid critiques, however, of IMF and Administrationpolicy during the crisis. From publicly available reports, the IMF wasinitially too tough in requiring government budget tightening, which notonly contributed to the downturns in local economies but ignored the factthat budgets were not a problem in the first place. The Fund appears tohave since backed off from prescribing its stiff fiscal medicine. Whetherthe Fund also has erred by insisting on monetary tightening is a much toughercall. Higher interest rates are required for countries to attract investorsin their currencies. In theory, without those higher interest rates, thestricken currencies might free-fall, increasing the debt burden in domesticcurrency of borrowers within the countries who are paying off their foreigncurrency obligations. In fact, though, the higher rates have depressedlocal economies without preventing major erosions in currency values.

The second critique is that the Fund and the U.S. government have gonetoo easy on the banks. In the case of Korea, for example, foreign bankshave demanded local goverment guarantees on bank loans before rolling themover, without forgiving any amounts due. To be sure, some of the bankshave added modestly to their loan loss reserves to account for possiblefuture writeoffs, while claiming to be charging interest rates that donot fully reflect the risk of the loans rolled over. Still, the new ratesreportedly are higher than those the banks were previously charging.

The hard line taken by the banks is short-sighted. It risks a politicalbacklash in the countries where they are now lending, while providing powerfulpolitical ammunition to those in this country who oppose authorizing anynew funds for the IMF. If the IMF funding is not approved by Congress,other countries may not approve their contributions either, potentiallyshrinking the world's economic safety net by so much that it will be uselessin a future crisis, or even in containing the current one. That's not inthe banks' interest, or in anyone else's.

A Way Out

Arguments about IMF and Administration policy aside,the real challenge now is to find ways of restoring confidence in Asianeconomies and currencies as quickly as possible. If we delay, the crisiscould spread to other regions of the world, such as Latin America and emergingmarket countries, where currencies may buckle as Southeast Asian goodsbegin flooding world markets at reduced prices. At the same time, it isessential that any measures taken do not invite future crises nor undulythreaten the political and foreign relationships that the United States,and the West generally, have with the affected countries. There isgrowing resentment within those countries against the United States andthe West for imposing tough reforms as a price for assistance.

In the affected Asian economies, even at some hypothetical equilibriumexchange rate, many borrowers do not have assets that meet their liabilities.If these were U.S. firms, the solution would be readily handled by Chapter11 of our bankruptcy laws, which enable creditors either to liquidate thecompany, accept a writedown of some of their debt, or convert a portionof their debt into equity so that the restructured firm can survive. Thesame thing needs to be done--but on a massive scale and as rapidly as possible--inSoutheast Asia, as well as in Japan, where the banking system is in direstraits.

The Asian plan must be sensitive, however, to the politically powerfulaccusation that liquidation of insolvent firms and banks is allowing foreigninvestors to take advantage of fire sale prices. To be clear, increasedforeign direct investment remains necessary in these countries. But inthe current environment, there is considerable risk that our long-termpolitical interests in these countries will be jeopardized if their citizensperceive foreign investors as opportunistic.

The proposed strategy has three parts:

First, each country should establish a mechanism for quickly performingtriage on all firms (above a certain size, for administrative practicality)and banks facing bankruptcy, using an exchange rate assumed to be somesignificant level below the rate before the crisis began, but abovecurrent, excessively depressed market levels. In principle, the ratesshould reflect the long-run competitive position of the economies in theregion, or failing that, some arbitrary level--say, halfway between theircurrent and pre-crisis levels.

Second, firms and banks that are nonetheless insolvent under this exchangerate by some threshold margin (such as negative net worth in excess of20 percent of assets) should be subject to a presumption of liquidationor forced merger, unless creditors quickly accept an equity-for-debtswap. Liquidation or merger would be accomplished by the surviving banksor creditors themselves in the case of private borrowers, or in the caseof deeply insolvent banks, by the equivalent of the Resolution Trust Corporation(RTC) that was set up in this country to clean up the savings and loanmess. The reason not to compel liquidation or merger of all insolvent firmsand banks is to avoid the political dangers associated with a massive firesale of all assets held by troubled firms. Nonetheless, to make more productiveuse of the assets of bankrupt firms, there should be a presumption thatdeeply insolvent entities (or their assets) will be taken over by thoseunburdened by crushing debt.

Third, all insolvent firms and banks not subject to liquidation, aswell as banks with capital below regulatory standards, should be eligiblefor Chapter 11-type workouts, with lenders required to exchangesome portion of debt for equity to give the restructured firm a reasonablechance of survival. Again, banks and other lenders would do this themselvesfor their borrowers, or an appropriate ministry or new government entitycould function as the equivalent of a bankruptcy court to quickly imposea restructuring plan. The Finance Ministry (or its equivalent) would presumablycarry out this function for potentially viable banks. This would mean thatforeign banks would automatically take haircuts. In lieu of an equity-for-debtexchange, governments could extend guarantees on the loans once they'vebeen partially forgiven. To soothe ruffled feathers abroad: the restructuringplans could provide local firms with options to later repurchase at leastsome of the equity after creditors have earned some reasonable return ontheir new equity.

Significantly, this plan does not envision local governments infusingequity into troubled concerns, as the Japanese government has proposedfor its banks, and as the Reconstruction Finance Corporation did in theUnited States during the Depression. Putting government money on the line--otherthan to pay off depositors and prevent a bank run--would only perpetuatethe kind of excessive government micromanaging of the economy that helpedget these countries into trouble in the first place.

More importantly, there is no need for a grand, new internationalbankruptcy agency or mechanism, as some have proposed. The debt problemsare internal to each country and, unlike the Mexico crisis, stem from borrowingsby the private sector rather than by governments. Of course, once a commonapproach is applied to insolvent Asian entities, important internationalprecedents will have been set. To be sure, enunciating these three principlesis a lot simpler than implementing them. Southeast Asian countries havepoorly developed bankruptcy laws, if any. But that needn't be a deal-killer.Each of the countries should quickly pass simple bankruptcy legislation(if none exists now), giving time-limited emergency powers to relevantgovernment authorities or newly created entities managed by individualsrespected for their financial acumen.

While it is critical that the affected countries take the lead, theIMF (if necessary, pressed by U.S. government leaders) should add implementationof the program as a condition to providing its lending support. Furthermore,the IMF, World Bank and possibly other outside experts could provide technicalassistance with any triage, liquidation, and workout functions. It is importantthat the United States, in particular, not be the key interlocutor. Inaddition, it is essential that the remedial mechanisms be set up quicklyand carry out their job on a potentially very large scale. That could requireextensive outside assistance, the relatively small cost of which wouldbe well worth the benefit.

An active liquidation and workout program would restructure entire economies,while achieving four important goals.

• It would help stop the growing cascade of failures, which is driving down both the economies and their currencies.

• It would help restore confidence in the economies by assuring a rolefor new foreign investment, helping to better assure payback of at leastsome existing debts. That would provide stronger incentives for fresh equityto return to the countries, while offering the prospect of upside gainsto former creditors who exchange their debt for equity.

• It would associate the IMF with a program of active and flexible aidrather than with the rigid austerity measures that have been so heavilycriticized here and abroad.

• And it would send a message to all creditors that the days of toobig to fail are over and that pain must be widely shared if all areto feel comfortable with the outcome. That is a critical message for Congress,in particular, to hear in order to better assure the refunding of the IMF,a step that is also sorely needed to help restore confidence to investorsaround the world.