The ADBI-IFMP Workshop on Current Asian Financial Developments

Executive Summary

Restoring confidence in East Asian economies was the topic of this workshop, sponsored by the ADB Institute and the Institute for Fiscal and Monetary Policy of the Ministry of Finance, Japan. It was held in Tokyo on 2 February 1998 at ADBI's facilities.

The Japan Workshop was attended by senior representatives of the Bank of Japan, the Bank of Tokyo-Mitsubishi Ltd., Mitsui & Co., Morgan Stanley Japan, Citibank, Bankers Trust Company, Standard & Poor's, Nomura Research Institute, the Federal Reserve Bank of San Fransisco, The Export-Import Bank of Japan, The Overseas Economic Cooperation Fund of Japan, University of Tokyo, Hitotsubashi University, Keio University, Saitama University, Hosei University, the Institute of Fiscal and Monetary Policy, and the Asian Development Bank.

I. Diagnosis and Outlook

II. Short Run and Long Run Prescriptions

III. Macroeconomic Policies

IV. Financial Sector Measures

V. International Responses

VI. Workshop Participants

VII. Workshop Papers

I. Diagnosis and Outlook

Participants highlighted some stylized facts associated with financial turmoil in Asia. Near pegs to the U.S. dollar, high domestic interest rates and deregulation of foreign borrowing contributed to export expansion, capital inflow surges, and economic booms during the period the yen was strong - up to 1995. Pegged exchange rates encouraged excessive capital inflows by providing implicit guarantee against exchange rate risk.

Weak financial systems resulted in credit being allocated to ultimately unprofitable investment in property markets in Southeast Asia, and plant and equipment in Korea. The reasons include inadequate bank supervision and regulation; inadequate accounting disclosure; government interference in many areas of the economy; implicit government guarantees, which encouraged investment to be directed to sectors with improbably high returns (their "Pangloss" value, as suggested by Paul Krugman in a recent essay).

Adverse shocks changed investors' perceptions about the region. Exports slowed, reflecting a strong dollar and a slump in the semiconductor market. Bubbles in property markets burst in Southeast Asia, while over-investment in plant and equipment became apparent in Korea, leading to increases in non-performing loans. This in turn raised concerns about the financing of large current account deficits in Southeast Asia, or contributed to liquidity constraints due to falling credit ratings in Korea triggering currency crises. A vicious cycle resulted, in which capital outflows contributed to financial instability, economic contraction, and further capital outflows.

The initial spread of speculation seemed to partly reflect fundamentals, as currencies of less advanced economies such as Malaysia, the Philippines and Indonesia were affected more, while the Singapore dollar, the New Taiwan dollar and the Hong Kong dollar were affected less. However, fundamentals do not seem to explain the severity of subsequent depreciation, particularly of the Indonesian rupiah and the Korean won.

One participant objected to the current negative views about Asian economic arrangements. First, financial sector arrangements in Asia were for a long time associated with rapid growth. Second, pegged exchange rates supported growth when the yen was strong, only ex-post were pegs seen as a problem. Third, objections to lack of transparency appear to be voiced when funding is being pulled out rather than when it is brought in.

Some positive elements of this recent episode were mentioned. For one thing, it has promoted greater international cooperation, as in the Korean rescue, involving Japan, the United States and Europe. In addition, conditions in Korea and Thailand appear to be improving, although some uncertainty remains in the case of Indonesia. However, one obstacle to early recovery is a "credit crunch" limiting the supply of credit to investors with sound projects, including those in the export sector.

II. Short run and long run prescriptions

Participants agreed that the restoration of confidence in Asian financial markets is the key to recovery. There was extensive discussion of how this could be accomplished, summarized by the topics below.

III. Macroeconomic policies

Some participants questioned IMF policy prescriptions, seeing them as excessively austere and deflationary, and designed for Latin America, not Asia. A number of participants argued for greater fiscal and monetary policy stimulus. In particular, one participant suggested that Asian economies should stimulate domestic demand because they cannot rely on exports to support the recovery. It was also suggested that high interest rates have not been accompanied by specific measures to prevent regional currencies from depreciating excessively. Other participants noted that the IMF has softened its terms in response to weakening economies, and that there is a need to avoid easy money in providing support to the financial sector.

Participants also discussed alternative exchange rate policies. One presenter explored the pros and cons of a currency board for Indonesia based on Hong Kong's experience. On the one hand, a currency board could help stabilize expectations; on the other, such an arrangement has exposed Hong Kong to cycles of expansion and contraction that are associated with its U.S. dollar peg (see diagnosis above). A number of participants questioned the advisability of a currency board arrangement for Indonesia, particularly since it is a relatively large economy.

Some participants would like to see the stabilization of yen-dollar fluctuations, but since that is not likely to happen, an alternative is for East Asian economies to adopt a basket peg designed to stabilize their currencies against both the dollar and the yen. The optimal basket peg will vary from country to country and is not necessarily based on trading partners, but on competitor weights. Under this proposal, the more advanced Asian economies that compete with Japan should assign more weight to the yen than the less advanced ASEAN economies. The less advanced ASEAN economies compete more directly with China and should assign some weight to the Chinese yuan. There was some discussion of optimal weights, and it was suggested that weights should also be based on FDI competitiveness. The possibility of using a basket peg to stabilize intra-regional exchange rates was also discussed. It was noted, that in the context of ASEAN, the Singapore dollar may play a different role in setting a basket peg, as its trade composition is very different from that of its neighbors.

One participant suggested that the relative merits of a pure float are also worth exploring, particularly as pegging may be very difficult in the current environment. The question then is what operating instrument to target (Mexico used a narrow monetary aggregate), or whether it might be desirable to focus on some macroeconomic nominal policy target such as inflation, or nominal GDP.

The workshop also explored alternative policies towards capital flows. One participant objected to Stanley Fischer's view that globalization is a fact and countries should just accept it. Drawing on a recent World Bank report on private capital flows in emerging markets, he called for a two-part approach. First, match financial liberalization to a country's policymaking and institutional capabilities. Second, improve these capabilities over time. The benefits of globalization, while significant, in this view, are overstated, while the risks are understated. Globally, the IMF should adopt a mechanism to balance benefits and costs of globalization. The benefits include new options for financing, a disciplining effect, and learning from foreign investors. The costs include import instability of global financial markets, contagion, the fact that mistakes are magnified, and inequitable distribution if capital allocation is left to the market.

Another participant suggested that the imposition of a Tobin tax on international transactions may be advisable to curb speculative capital flows. While interest in the Tobin tax was revived after the speculative attacks on European currencies in 1992-1993, participants raised a number of questions. One participant said that liquidity, or reserve requirements, on short-term capital inflows are more attractive than a Tobin tax. Still another participant pointed out that the Tobin tax is just like a securities tax, which people have sought to eliminate, for example, in Japan. Finally, there were questions raised about the effectiveness of the tax.

IV. Financial Sector Measures

There was general agreement that measures to deal with the financial situation are a priority. One participant suggested that any fiscal stimulus be directed to the restructuring of the financial sector, so as to prevent further deposit runs. Another pointed out that government intervention will not suffice. Markets are about trust, which can be restored only if there are real changes in the economy. One key issue is whether market forces will be allowed to work freely. Specifically, will failing institutions be made to actually exit the market? This is a highly sensitive issue.

Participants noted that staffing constraints posed a major obstacle to repairing and managing the financial sector in Asian economies. Some central banks lacked the capability to enforce their prudential rules, such as limits on lending to an individual. However, it was also suggested that the problem may not be lack of adequate staff, as some of the central bank staff are highly qualified, but lack of supervisory independence, or political pressures. International organizations may also lack the personnel to provide support in bank supervision and regulation. G-7 central banks could help by supplying technical expertise.

As a basis for implementing longer term financial sector reforms, one participant provided an overview of the G-10 report on financial stability in emerging market economies and a list of core principles for effective banking supervision. The first of these reports identifies key elements of a robust financial system: an institutional setting and financial infrastructure for sound credit culture and effective market functioning; the promotion of the functioning of markets so that owners, directors, investors and other actual and potential stakeholders exercise adequate discipline over financial institutions; and the creation of regulatory and supervisory arrangements that complement and support the operation of market discipline. The report also offers suggestions on how these sound principles and practices may be developed.

The second report identifies what requirements must be fulfilled for banking supervision to be effective. Among these are operational independence and adequate resources for bank supervisory institutions, arrangements for information flows, and a suitable legal framework that includes powers to address compliance with laws and safety and soundness concerns. Bank supervision must be geared to ensure that financial institutions comply with a number of prudential regulations and requirements. These include capital requirements commensurate with the risks being borne, sound policies in the granting of loans and making of investments, limitations on lending to related companies and individuals, and adequate risk management, notably for international operations, and for market risk. The report also describes methods of effective banking supervision.

V. International Responses

Some participants pointed out that an economic recovery in Japan can play a key role in the recovery of ASEAN economies and Korea. In particular, deflationary influences in East Asia ( non-performing loans of financial institutions, high levels of external debt and weak exports,) and in Japan (the high cost economy and the aftermath of the collapse of the bubble economy,) can be mutually reinforcing, due to significant trade and investment links.

To bring about a Japanese recovery, the problem of non-performing loans of Japanese financial institutions needs to be urgently addressed, and one participant supported the issuance of national bonds for this purpose. The need to offset certain factors that have been dampening Japanese spending was also cited. These include insensitivity of private investment to interest rates and consumption, to wealth effects, and an apparent fall in the average propensity of the U.S. to import Japanese goods. In order to stimulate spending, it was suggested that the Japanese government adopt measures to encourage private investment (rather than public works), via government loans to small businesses.

One participant stressed the importance of exchanging information and coordinating efforts at the international, regional and sub-regional levels to confront the challenges faced by globalization of financial markets. This would involve coordination of IMF/World Bank-supported global forums, ADB-based regional forums, and ASEAN-led sub-regional forums, in line with the Manila framework agreed upon in November 1997. Also, discussions that may include a new scheme of credit guarantee or insurance to encourage the restoration of capital flows, and regional and sub-regional surveillance are required.

Surveillance could include (i) collecting and analyzing information about the composition of capital flows and financial developments in Tokyo, Hong Kong, Singapore, and other financial centers; (ii) the assessment of regional trade and service movements, structural issues such as labor market developments, business climate (corporate culture and governance and corrupt business practices) as well as socioeconomic problems (education, social welfare); and (iii) a critical review of the impact of adjustment programs, such as discriminatory or deflationary ones associated with IMF-supported or government-led austerity programs. These effects may threaten Asian social traditions that are worth preserving.

Another participant suggested that the G7 should support undervalued currencies through foreign exchange intervention (particularly by Japan and U.S.). This would be much easier than improving the Japanese economy. Stabilizing exchange rates would halt inflation, reduce the debt burden in domestic currencies, reduce competitive devaluation pressures and end contagion. The G7 could profit from this intervention by buying the currencies at low prices.

A number of other topics were also briefly discussed. One was the issue of sharing the burden of adjustment. One participant noted that those who lent at high interest rates with fixed exchange rates were earning risk premiums, and presumably should absorb some of the loss. In a related vein, another participant argued for measures to protect manufacturers, noting that bankers get free rides.

Finally, one participant made some suggestions for future research. These include (i) a comparison of East Asian versus Latin American experiences; (ii) the use of domestic saving in Asia for domestic and overseas financing; (iii) the role of foreign capital flows in the region; (iv) analysis of any differences between international liquidity crises involving public or private debt, and whether the nature of rescue packages or adjustment programs should differ in each case; and (v) the role of financial sector weaknesses in explaining the East Asian financial crises.