16 March, 1998

The IMF meets its match in East Asia

By S.M. Naseem THE IMF has come in for a lot of adverse criticism over the years for its heavy-handed approach in developing countries over the last half century of its existence. Much of this criticism, however, has often come from those who question the credentials of its advice and assistance primarily on political, rather than economic grounds.

Increasingly, however, the IMF's critics have come from the academia, many of them from reputed US universities, some of whom have in the past been closely associated with the IMF as its senior policy advisors.

These include, among others, Professors Jeffrey Sachs and Martin Feldstein of Harvard University.

The new criticism being faced by the IMF differs from the rhetorical censure it has received at the hands of populist demagogues (generally, when they are out of power) in the Third World, where IMF-bashing had become a street (or seminar-hall) sport, which could be cavalierly dismissed in the past.

The new critique of IMF policies has come in the wake of the continuing economic and financial turmoil in East and South-East Asia.

The critique is significant because many of the critics are not unsympathetic to the past policies of the IMF but do not seem to concur with its handling of the East Asian crises both in their diagnostic and their prescriptive aspects.

Indeed, the East Asian crises are perhaps, the most serious challenge that the IMF has ever faced and it could well prove to herald its own reformation, if not undoing.

The IMF is not new to facing systemic crises in its apex role in international monetary management, since it was founded in 1945.

Its primary function then was to help operate a system of fixed exchange rates, in which all currencies were pegged to the dollar, in turn fixed with respect to gold, that experts then considered necessary to encourage international trade.

Although that system worked for a considerable period, differences in inflation between countries made exchange rate stability increasingly difficult to achieve.

When the fixed exchange-rate system collapsed completely in 1971, the IMF was forced to find a new rationale for its existence. Fortunately for it, the oil shocks of the 1970s and the stagflation that came in its wake, provided the Fund and the World Bank considerable opportunities to peddle that advice and honest broker role in the recycling of petrodollars and in providing assistance to oil-importing countries which were hard hit by the oil shock.

However, the IMF found a new and important role for itself, in the 1980s with the onset of the Latin American debt crisis.

Changes in economic conditions led Mexico and Latin American countries to announce they could not meet their obligations on the large borrowings from overseas commercial banks which were keen to lend the oil revenue surpluses deposited with them by the OPEC countries. A default on those obligations would have wiped out the capital of many leading banks in the United States, Europe, and Japan.

The IMF and the World Bank played an important role in overcoming the Latin American debt crisis by ensuring the rescheduling of the debts which were to be repaid through earning more foreign exchange by increasing their exports or decreasing their imports.

The Latin American governments raised taxes, cut government outlays, and tightened credit to reduce domestic uses of national output.

The IMF monitored these painful adjustments and provided moderate amounts of credit as a sweetener to swallow the bitter pill of adjustment. However, the primary provision of credit was left to negotiations between the foreign banks and each of the debtor countries.

Although the Latin American adjustment process was slow and painful and resulted in almost a decade of foregone development, the region's economic growth eventually resumed, and the countries were generally able to service their rescheduled debts.

The cost of such adjustment was undoubtedly high, but the IMF could congratulate itself that it had averted a major disaster to the global economy.

It also provided the IMF and its Western sponsors the opportunity to spread the gospel of the Washington consensus, with its emphasis on market mechanism, privatization, deregulation and trade and financial liberalisation.

However, the gospel ran into serious difficulty since the most successful group of countries, later epitomised as the East Asian miracle, did not subscribe to most of the tenets of the Washington consensus. Other Third World countries, used to decades of state intervention in the economy, were also reluctant to embrace the Washington consensus with open arms.

However, the end of the cold war and the disintegration of the former Soviet Union provided the IMF the opportunity it was itching for. It embarked on a hastily planned mission to 'rescue' these shattered economies.

At the rather abrupt end of the cold war, these countries decided to uncritically embrace the market economy and to integrate themselves into international financial markets, without even the feeblest institutional infrastructure for such a change.

This gave the IMF a much broader agenda to work with in drawing its programmes for assistance, although much of it was highly controversial. However, the IMF was generally able to ignore any criticism because it brought substantial financial rewards to governments that accepted its advice.

The main criticism of the IMF in the context of the East and South-East Asian crisis is that it has failed to take into account the specifics of the situation in that region which differ widely from that in the former Soviet Union or Latin America.

Notwithstanding their impressive growth record and strong fundamentals, the IMF insisted on fundamental changes in economic and institutional structures as a condition for receiving IMF Funds.

In addition, the IMF is applying its traditional mix of fiscal policies (higher taxes, less government spending) and credit tightening (implying higher interest rates) that have been successful in Latin America and have been tried with lesser success in other countries. The appropriateness of these policies in East Asia has also been widely questioned.

The IMF's role in Korea, Thailand and Indonesia has transcended the role that it played in Latin America and was much closer to that it played in 'reforming' the countries of the former Soviet Union.

Instead of relying on private banks to ensure the stoppage of the outflow of foreign funds and rescheduling short-term credits to solve the liquidity crisis and primarily providing the monitoring role, as it did in Latin America, the IMF took the lead in directly providing credit to these countries.

On the other hand, it has imposed comprehensive programmes requiring governments to reform their financial institutions and to make substantial changes in their economic structures and political behaviour.

The IMF's handling of the Korean situation, which was considerably different from those of the three troubled South- East Asian countries; Malaysia, Indonesia and Thailand, was even more controversial.

Although Korea experienced a temporary jump in its current account deficit in 1996 because of the collapse of the world semi-conductor market, Korea, unlike the South-East Asian countries, did not have a chronic current account problem, neither did it have a fixed exchange with the dollar.

What Korea did have in common with Thailand and Indonesia was that its banks and finance companies had borrowed too much in foreign currencies with short-term maturities, thereby accumulating much more short-term foreign debt than Korea had reserves.

The general trouble in Asian financial markets caused investors around the world to focus on that imbalance and to seek to take their own funds out and repay their loans before Korea exhausted its reserves.

However, Korea was already heading toward a current account surplus by last summer and really only needed a temporary restructuring of its foreign bank loans to give it time to accumulate the reserves needed to service the short-term debts.

There are two major problems with the IMF's financial activism in the East Asian crisis.

The first relates to the bail-out funds that it has arranged to get the countries out of their liquidity crunch to enable them to service their short-term debts.

This has raised the problem of 'moral hazard' as the banks which had lent the money to financial institutions are being absolved of their responsibility for making bad loans and will have little incentive to do so in the future, if they are convinced that they will be bailed out by similar rescue efforts by the IMF in future, even though it looks unlikely that the IMF will be able to mobilize additional resources it has requested to meet similar emergencies in the future.

Instead of assuming the responsibility of large bail-out arrangements itself, the IMF should encourage borrowers and the lending bankers or bondholders to bear primary responsibility for resolving the problems that arise when countries or their corporations cannot meet their international debt obligations.

The IMF should primarily act as a monitor of the success that the country is making in moving toward self-sustainable liquidity, providing its own funds as an indication of its confidence in the country's progress rather than as a bailout of international lenders and domestic borrowers.

If the IMF can focus its attention on a less ambitious agenda than it has shown the propensity to, it can devote more of its scarce staff resources to the problem of crisis prevention, which, in the globalized economy of today, is the greatest need.

A clear lesson of 1997 was that countries with large reserves could not be successfully attacked by financial speculators.

Hong Kong, Singapore, Taiwan, and China all have very large reserves, and all emerged relatively unscathed.

Accumulating large reserves, however, is a rather expensive means of avoiding financial disaster (and subsequently IMF conditionalities) for poor countries whose capital needs for development are large. The IMF should, therefore, play a much larger role in crisis prevention than in crisis management.

The second problem is that the IMF has used the carrot of large rescue packages in East Asia to impose conditionalities which the borrowing countries were unwilling to accept otherwise.

The IMF has used the currency crises as an opportunity to force fundamental structural and institutional reforms on East Asian countries through the pressure from the United States, Japan and other developed countries to make their trade and investment agenda part of the IMF funding conditions.

The ideological hegemony that the IMF and the World Bank have exercised in the past is ill-suited in the East Asian context.

Their autonomous development which has produced outstanding performance combining persistently high growth, low inflation, and low unemployment suggests that the current structure of their economies is in consonance with their cultural values of thrift, self-sacrifice, patriotism, and worker solidarity.

It would be a considerable folly to disturb it except through their own choice as it may well undermine the very basis of the East Asian miracle which has been in the past credited as being the most dynamic source of growth in the world economy.

It is high time that the IMF realises the negative effects its over-ambitious reform programmes are having on those who really need its assistance, especially the poor developing countries. It is beginning to act as a deterrent on their seeking the IMF's assistance.

Malaysia is now doing just that, even though its conditions are roughly similar to those of Thailand and Indonesia.

However, if the IMF is seen more as a client-focused and supportive organization than as the imposer of painful and socially infeasible remedies, it is likely to find its assistance used by countries which need it most.