IMF and Financial Crisis

“INTERNATIONAL MONETARY FUND AND FINANCIAL CRISIS IN DEVELOPING COUNTRIES”

CHAPTER ONE

1.1 INTRODUCTION OF THE INTERNATIONAL MONETARY FUND

The International Monetary Fund (IMF) came into formation in July 1944 when representatives of 45 countries met in Bretton Woods, New Hampshire, a town in the north-east of the United States. In December 1945, the IMF formally came into existence when 29 member states signed the articles of agreement. The IMF began its operations on 1st March 1947. Its main purpose was to guarantee the stability of economic growth and the maintenance of living standards in developing countries. To accomplish this purpose it was very important for the countries to exchange goods and services. The IMF is also known as a social institution, whose central role is to provide primary social provisions such as access to currency reserves, the cost of such access, exhaustible social resources and trade currencies. [1]

In the 1970’s the World Bank lent billions of dollars to the poorer nations – specifically Latin America and Asia. However, this process of lending money led to crisis. Developments in the 1970’s exposed the external and internal economic difficulties being faced by the developing world. Internal difficulties included the growing economic deficits while the external included vigorous increases in the prices of energy products, fluctuations in the world market prices of primary products produced by the non-oil exporting developing countries and slow growth in industrial countries. [2]

To overcome this problem of mismanagement and economic instability, the IMF launched stabilization and structural programmes to minimise macroeconomic distortions and to strengthen the economic structure in these countries. However the role of the IMF has been transforming vigorously since the 1970’s. Nowadays the IMF has more structural creditors and debtors. The developing countries are borrowing more consistently from the IMF and in return they must submit their policy demands. Most of the IMF’s programmes are conducted in developing and emerging market countries.

The IMF’s fund authority is based on an International Treaty called the Articles of Agreement[3] which came into existence in December 1945; the articles of agreement outline the main purpose of the fund[4] By laying down a complete set of rules in the agreement, the fund makes sure that its main purpose and procedure is straight forward without creating any confusion for the member states. By joining the IMF, and accepting the articles of agreement, member states accept obligations that limit their monetary sovereignty and in return receive benefits. However it puts mutual responsibility on both sides to deal with the circumstances as required by IMF procedure, which aids international cooperation. The IMF’s programmes for structural adjustment or stabilization are known as ‘conditionality’. These programmes include calculated targets and budget deficits, external arrears, foreign borrowing and international reserves. However they also include policies which the member states intend to pursue. Conditionality was scrutinised during the 1980’s, as more developing countries started structural adjustment programmes therefore allowing them to comply with the terms of the agreement. It was strongly argued that the fund was too orientated towards the industrial economies and was not adaptable to developing countries. The fund also provides

assistance to member states in the form of training and technical assistance. In 1950 the fund offered training courses on the balance of payments and on international economics. Institutes formed by the IMF have provided training courses for officials from member states in subjects such as financial analysis and policy, the balance of payments methodology, public finance and government finance statistics. In providing technical assistance to the member states, the IMF puts emphasis on giving training to government officials in macroeconomics management, improving the tax system and its administration, and improving statistical data. The IMF’s governance and decisions are taken by the executive board – the International Monetary and Finance Committee. However, analysis reveals that the majority of the countries in discussion with the IMF for debt relief and structural adjustment are hardly represented in the IMF decision making process. Developed countries hold a larger proportion of board seats than developing countries and the voting system which is allocated according to the country’s strength in the world economy is skewed in favour of the richest countries. As a consequence of giving more control to the developed countries in decision making, the developed countries decision makers are largely unaffected by the decisions they take. This undermines the legitimacy of decisions taken and affects their quality as the views of developing countries are not taken into account and board decisions are sometimes less favourable to them.[5] Member states in the IMF are given quotas. These quotas are considered an important part of the monetary system.

The rights of a member state are given according to its quotas and the higher percentage of quotas a country has, the higher number of rights given to it. At the moment the United States

has the largest quota – about $58.2 billion[6]. Member voting power and decision making is determined by the quota. Every member in the IMF has 250 initial votes and one additional vote for every Special Drawing Rights (SDRs) 100,000 of quota.[7] A country can borrow up to three times its quota in a three year period, however this rule has not always been followed. For example, in 1997 a package for South Korea was 19 times more than its original quota.[8]

1.2 BACKGROUND OF THE ASIAN FINANCIAL CRISIS

The crises were largely a result of several decades of outstanding economic performance in Asia. The problems faced by Eastern Asian countries were not the result of macroeconomic imbalances, rather they stemmed from weaknesses in the financial systems and the governance. This amounted to a package of inadequate financial supervision and poor management of financial risk and assessments. Maintaining fixed exchange rates allowed corporations and banks to borrow large amounts of international capital and in time the foreign capital was used to finance poor quality investments. Private sector expenditures, poor financing decisions and poor governance led to the crisis; however the crises were enhanced by the involvement of the government in private sectors and a lack of transparency in fiscal accounting and corporate areas.[9] In 1994 a well known economist Paul Krugman published an article called the “Asian economic miracle”. He stated that economic growth has been the result of increasing capital investment and total factor productivity has only increased marginally or not at all. However only growth in total factor productivity rather

than capital investment could lead to long term prosperity.[10]It is important to understand what caused the Asian financial crisis. To understand this we have to keep in mind two important factors which contributed to enhancing it. The first was lack of transparency, due to which the investors and economic agents assumed an Asian financial stability. They mislead the economic policies and did not try to solve the deficit in debt and balance of payments.[11]

The Asian financial crisis started on July 2 1997 with the devaluation of Thailand’s Baht. About 15 to 20% of devaluation took place in two months after which the currency was heavily affected and after almost a month Thailand’s largest finance company “Finance One” was bankrupted. The devaluation of the Thai Baht led to a series of devaluations in different countries[12]. Figures 1A and 1B (below) show the monthly evolution of the currencies of different Asian countries during the period July 1997 to May 1998.

CHAPTER TWO

2.1 FINANCIAL CRISIS IN THAILAND

Thailand had a very strong economic status from 1987 to 1995 which averaged about 10% per year.[14] Having a low wage/low skilled labour in the country Thailand attracted a lot of foreign direct investment (FDI) programmes which were aimed at building production plants to export to developed countries.[15] Moreover the Thai Baht was pegged to the US dollar, i.e. if the dollar appreciated, the Baht would also appreciate and so forth. In those years, Thailand was an attractive platform for the FDI and foreign portfolio investment in its securities market.[16] The country became overconfident about its currency and its government embarked on excessive official spending and allowed the banks to lend large amounts of money with longer payback periods for private estate and other spending[17]. Domestic companies were also encouraged to borrow extensive amounts from foreign countries. However most of the loans were made in US dollars; Thailand assumed that borrowing money from the countries where the interest rate was low, would give them an edge since the currency exchange was connected directly with the dollar. The US dollar was to mask the weaknesses in the Thai economy but this couldn’t last forever. As the U.S dollar appreciated, Thailand’s net exports declined and became less competitive in the market.

As a consequence of the decline in exports, Thailand discarded the dollar peg and devalued its currency to promote exports. The debts had arisen due to the losses in revenue and the

total outstanding external debt rose from 28.8 billion US dollars[18] in 1990 to 94.3 billion US dollars[19] by the end of 1996.[20] This shattered the international markets’ confidence in the Thai economy and investors started to sell the Thai Baht in the summer of 1997. As a result the Thai Baht depreciated from 25 Baht/US dollars to over 55 Baht/US dollars. By early January 1998[21], the country was facing serious financial crisis. As a result of this many newly established finance companies went bankrupt by 1996. Though the Thai government could have lowered the domestic currency exchange rate to stabilise the economy in 1996 many domestic companies stopped the government from taking this step, believing paying back foreign currency loans with a lower value Baht would cause more problems.[22] This was especially the case as most of Thailand’s debt was in the private sector and the newly formed companies had no effective debt management policy or mechanism to overcome the problems.[23] Many companies with high debt closed down which caused a large amount of unemployment in the country. Though the county’s foreign reserves increased from $16.5 billion in 1990 to $46.5 in 1996, the financial crisis meant that the foreign reserves became highly drained. The Bank of Thailand used a great amount of the reserves to defend the Baht against speculative attacks and the country couldn’t build its defence on the reserves alone. On 2nd July 1997, the world market forced the Bank of Thailand to give up its defence of the Baht.[24]

2.2 IMF SUPPORT AND CONDITIONS IN THAILAND

When the country was running short of the foreign reserves to meet the obligations and there was not enough currency in the country to repay the loans, floating the Baht and seeking assistance from the IMF was unavoidable. Thailand could not be a part of the international community economically without having enough foreign reserves; therefore one of the main priorities of the IMF programme was to handle the problem of the complete depletion of the foreign reserves. In order to support Thailand financially the IMF announced a lending package of US $ 16.7 billion[25]. This loan however was a short term liquidity support and the repayment of each drawing was due within three years. Though Thailand needed a strict reform package which could turn around its foreign reserves, the package in return should have generated sufficient net inflows of foreign currencies to build the confidence that Thailand could meet the conditions as to its foreign currency.

In 1999 the country was on its path to recovery from its bankruptcy situation in terms of the foreign exchange, but the net drawings from the IMF package were also increasing by the end of March 1999. It was suggested that Thailand should not make further withdrawals from the IMF package[26] and there was an agreement between the Thai government and the IMF that the letter of intent dated March 23, 1999 would be the last.[27] The IMF was to carry on monitoring Thailand’s economic situation every six months but no formal letter of intent

would be required. The IMF package also focused on the reversion of the devaluation process by restoring confidence in the currency; as a consequence Thailand made its currency attractive by raising interest rates temporarily.[28] By raising interest rates Thailand’s currency depreciation was halted. It also helped in reducing expenditures in all economic sectors of Thailand due to which the deficit was reduced. The country’s national savings levels were increased, which lead the economy towards a surplus. As confidence was regaining the interest rates were returning to a more normal level.

The financial sector of Thailand was weak before the Baht float due to the great amount of inappropriate credit extensions to non-viable projects. The IMF programme included many measures to restructure and reform the financial sector. However this was a new experience for the IMF and many questions were created by the way the IMF went about it, specifically with regards to the impact on the financial sectors. There was also a great amount of criticism as to the measures taken by the IMF in this restructuring.[29] The measures taken included a full guarantee of all depositors and creditors of financial institutions. This full guarantee meant to generate confidence in the financial sector, amending the prudential regulations on financial institutions to reach international standards by the end of the year[30], issuance of bonds up to the amount of Baht 500 billion to help in the financial institution development fund[31] and also issuance of bonds up to Baht 300 billion to help the re-capitalisation of

financial institutions, as well as the making of new laws especially on bankruptcy procedures and foreclosure to help to encourage debt restructuring.[32]To assist in the debt restructuring process the IMF proposed new laws such as bankruptcy and foreclosure which were passed by the government.[33] These laws were meant to shift the balance between the creditor and debtor towards the creditors and under the new law the timeframe for claiming a debt to be paid was shortened.[34] But in order for this law to be successful the balance of power that it brings should lead to a high percentage of voluntary debt restructuring. The IMF and Thailand worked to create a programme which was successful because of the dedication of Thailand. Therefore in the short term the Thai economy was constricted due to the decline in manufacturing and private investment, however one of the main reasons for this contraction was the high interest rates imposed as a part of the IMF’s rescue programme[35].

2.3 CRITICISM AND FUTURE REFORM

Since the Baht was floated and Thailand embarked on the IMF programme, it could be said that the country was no longer bankrupt. However the initial predicted adjustment scenario did not materialise. The country recovered from its bankruptcy through standard depreciation but this resulted in a scenario of depression in the economy sector. There was a lot of pressure to produce the stability quickly and more stress was given to upgrading prudential standards in the financial sector. Therefore in short there was a severe malfunctioning of the financial sector which led to a cycle of recession. There was a lot of criticism of the IMF as to

how they handled the situation in Thailand[36]. It was largely consensual between the critiques that panic in the financial sector partially explained and definitely amplified the institutional weaknesses and bad policies, including non -domestic ones.[37]Critics also stated that while the countries got into trouble because of reckless monetary policy, the IMF probably made the problems worse.[38] Most people have a view that the long term effects which the monetary policy left on the country were more dangerous and it was also contested that the punishment was much larger than the crime. The IMF’s intervention in Thailand resulted in insufficient demands and high interest rates. The country needed an increase in investment in education and infrastructure which were essential for economic growth. Lack of attention to this meant that the recession deepened.

If we look ahead to future changes, there is a lot to be implemented to bring a sustainable recovery, such as the IMF’s programmes in strengthening management, financial sector regulation and supervision, governance and competitiveness. A lot of debate has taken place regarding strengthening the international financial structure[39] and more effective measures and guidelines along which the programme should be followed and needs to be developed. As an experience from Thailand, there should be internationally recognised guidelines on the management of short term capital inflows and this should be an essential part of the structure.[40] Many suggest that there is a need for capital control as an instrument of adjustment during the currency crisis.[41]

CHAPTER THREE

3.1 FINANCIAL CRISIS IN KOREA

Korea’s financial situation started to become unstable when in 1990 the current account balance started to depreciate[42] because of increasing inflation, the recession of the world economy and the appreciation of the Korean currency.[43] To overcome the deficit in the current account the government encouraged capital inflows. However the policymakers were more concerned about the effects of inflows on the competitiveness of the Korean exports via appreciation of the Korean Won but they rather overlooked the resulting financial instability that was caused.

Through having high levels of short-term debts and only reasonable international reserves, the economy of Korea was vulnerable to a shift in the market, however financial institutions and chaebol[44] was greatly increased in several large corporate bankruptcies in previous years. When the Korean banks started to face difficulties in paying short-term foreign debts, the foreign exchange reserves were shifted[45] to offshore branches and Korean banks started to borrow from foreign banks. In October 1997 financial conditions declined significantly, the

Korean Won declined sharply and foreign reserves were also depleted. The Won depreciated about 20% over the U.S dollar and foreign reserves declined to $6 billion.[46]There was a lack of confidence in foreign investors to invest in Korea. Many banks and foreign investors feared that there was a lack of transparency in Korean firms as regards to their financial reports. Like many other Asian governments, Korea also developed an unclear financial system in which the outsiders didn’t know where the state ended and the corporation began.[47]However, the Korean government made a last ditch effort to gain its foreign investors’ confidence by introducing a financial reform bill package passed by the national legislature. All the political parties[48] rejected the reform package fearing the adverse effects of doing so near the presidential elections. This was the straw that broke the camel’s back and the withdrawal of foreign funds started to increase vigorously. The country was in crisis by now and the officials were putting pressure on the government to gain help from the IMF.[49]

3.2 IMF’S SUPPORT IN TERMS OF CRISIS

Due to excessive external debt the Korean crisis was a typical traditional crisis of balance of payment but was rather a liquidity crisis due to a mismatch in currency and capital structure in the balance sheets of non-financial and financial sectors of the economy[50], therefore a quick infusion of currency reserves was highly critical.

Therefore IMF’s executive board approved a three year Stand-by arrangement[51] with Korea to help with regards to its financial crisis by announcing $21 billion[52], $14 billion was committed by the World Bank and Asian Development Bank and $23.4 billion was pledged by G-7 countries. The overall package amounted to $58.4 billion. IMF’s package was focused to gain early market confidence. The underlying programme aimed to reduce the current account deficit, increase foreign reserves, inflation via strict monetary policy and some fiscal measures. The programme also especially focused on structural reforms in corporate and financial sectors. The amount that Korea was allowed to withdraw immediately was $5.6 billion[53] and an additional $3.5 billion was also withdrawn[54].The total amount that Korea withdrew in a 15 day period was $9.1 billion.[55] The IMF reform programme gave Korea an opportunity to get rid of chronic economic problems such as inefficient huge non-performing loans[56], loose accounting systems, a weak corporate sector with low profitability and high levels of debt. The IMF’s reform package was based on the view that the crisis basically originated from structural weaknesses in the Korean economy, especially in the financial sector.[57] On December 30th 1997 Korea requested Stand-By arrangements for the admission of advance drawings and the structural reform agenda started to accelerate and strengthen the financial sector providing capital inflows into the domestic stock and bond market. As a consequence interest rates rose vigorously and support to the banks for foreign currency liquidity was tightened. However there were signs of improvement on the Won against the

U.S dollar. Stabilization of international reserves was apparent and the current account was also moving into surplus. The Stand-by arrangement focused on the improvement of exchange market conditions and against the emerging signs showing a decline in economic activity. The agreements with the banks creditors helped to make improvements in the financing conditions, the useable reserve was increased and there was appreciation in the Korean currency.[58] With the IMF’s reform package Korea was able to make substantial progress in overcoming its external crisis. The third review of the Stand-by arrangement focused on macroeconomic policies to mitigate the severity of the recession and strengthen structural reform. The IMF programme led Korea to reform longstanding structural weaknesses in the economy; the financial reforms restructured the weak financial system while supporting the prudential regulations. As a result of the restructuring programme supported by the IMF, the financial sector gained improvements in profitability, risk management and accounting disclosures.[59] However in some areas of chaebol, deep rooted problems still needed to be fixed.

3.3 CRITICISMS

The IMF acted like a pawn of the United States in the Korean crisis. It forced Korea to implement policies of trade liberalization and capital market opening, which the U.S had been consistently trying to push on Korea, even though the latter had been resisting. One of the senior officials of the Bill Clinton government was installed in the same hotel[60] as the IMF mission during the financial crisis phase, so as to conduct parallel negotiations with the

Korean authorities.[61] Rather than arriving as an organization designed to rescue a country from the point of bankruptcy, the IMF left an appalling impression on the Korean people. It did not serve the country as a client in need of money but instead, through lacing conditionality on the terms of the bailout package, tried to become a reformer of national economic structures. The IMF conditionality came under severe criticism as a way of dealing with the crisis. Its intervention results were severe, especially during the early stages with the IMF’s focus on the rapid implementation of harsh conditionality rather than swift payment of the arranged financial rescue package. As a consequence of high interest rates at the beginning of the crisis many companies were forced into bankruptcy and unemployment also increased throughout the country.[62] Many critiques also state that there was no fundamental reason for Asia’s financial calamity except financial panic itself and that the IMF had double standards of policies.[63]

CHAPTER FOUR

4.1 THE INDONESIAN FINANCIAL CRISIS AND IMF’S SUPPORT

The Crisis began in Indonesia during July 1997 with contagion from Thailand, which led to pressure on the Rupiah. The Indonesian macroeconomic position was stronger than that of Thailand but the short-term external debt was rising speedily and there was evidence of weakness in the financial sector which led to a fear that the government would try to defend the currency peg.[64] The central bank, Bank Indonesia[65]widened the intervention of the crawling peg regime from 8 % to 12%[66]. However the authorities responded by tightening liquidity, raising interest rates and intervention in the foreign exchange market. As a result the Rupiah[67] was floated on 14th August 1997. Though there was a great depreciation in the currency exchange it was temporarily stabilised by the tightening of liquidity and measures taken to prevent the aggravation of fiscal balance as economic activity started to fall. In late September the exchange market pressure started to rise again, putting more stress on the financial sector. The Rupiah was further depreciated against the U.S dollar, and from early July the cumulative depreciation[68] of the currency became the largest in the region. The two major causes of the Indonesian financial crisis were the large amount of short-term foreign debt owed by the private corporate sector and the depreciation of the Indonesian Rupiah.

As a result of the crisis in the country, on November 5th 1997 IMF’s executive board approved a three year Stand-by arrangement of almost $10 billion[69]. The IMF’s adjustment programmes mainly focused on bringing change in the current account, regaining market confidence and controlling the depreciation of the exchange rates. However the main element of the package included having a tight monetary policy to stabilize the Rupiah. Steps were taken to strengthen the fiscal position, to restructure the financial sector and to place structural reforms in the corporate sector for the enhancement of efficiency and transparency.[70] At the start the Rupiah began to strengthen, and with the tightening of liquidity there was a temporary regaining of market confidence and the exchange rates. However, this situation couldn’t last long and there was a downfall in the exchange rates during December 1997- January 1998. As a result of this, on January 15th 1998 another strengthening programme was introduced which aimed to tighten the monetary policy and introduce structural reforms. This was prepared with the collaboration of the World Bank. However there was a lagging in the implementation of the structural reform agenda. A major reason for the implementation being sidetracked was the discussion of having a currency board and at that time, parties were preparing for the presidential elections. The first review of the arrangements took place on 4th May 1998 after the completion of the re-election of the president. The economy of the country was now on the cusp of a vicious circle of currency-depreciation and hyperinflation.[71] The IMF’s package for the reduction of the crisis in this situation was based on tightening the monetary policy with higher interest rates and plans for the restructuring of the banking system. However in regard to restructuring the corporate sector and turnover, the short-term bank debts were underway and to check the progress of the programme a monthly review agreement was agreed.

When the second review[72] took place, the key priorities became the restoration of the distribution system and the strengthening of the social safety net.[73] As a result the monetary policy was still focusing on inflation and the exchange rate, while the fiscal deficit was overcome by a sharp contraction of output and expenditure requirements. The bank restructuring programme was implemented to deal with declining conditions in the financial system and steps were taken to smooth the progress of corporate debt restructuring. On 25th August 1998, the IMF’s executive board approved the extended arrangement with $6.3 billion or 312 % of the quota for the remaining 26 months.[74] Now the macroeconomic policies were almost on track and there were also indications as to the strengthening of the structural policies in a number of areas. An agreement was also reached as to the refinancing of Indonesia’s external debt to the official creditors.[75] By the end of October 1998 the Rupiah appreciated significantly. Interest was lowered and about 4 % of the GDP surplus was expected, further extending the restructuring programme. By the end of September 1998, a $9.5 billion augmented financing package for Indonesia[76]was disbursed including $6.8 billion from the IMF. The IMF was criticised for forcing the Indonesian government to guarantee private debts owed to foreign creditors. Due to severe fiscal severity it caused a lot of Indonesian people to lose their jobs in return.

CHAPTER FIVE

5.1 MALAYSIAN CRISIS AND RESPONSE

For a country to maintain a fixed exchange rate, its currency must be pegged to some “hard currency”[77], Ramesh Ramsaran writes:

“The appropriateness of an exchange rate regime is determined by the structural characteristics of an economy and by policy objectives. The exchange rate links the domestic economy to the international economy, and therefore it plays a critical role in determining the ultimate impact of internal or external shocks.[78]

However, the Central Bank of Malaysia maintained the Malaysian Ringgit as a peg to the U.S dollar. Malaysia had been enjoying full growth in its economy, full employment and low inflation rates over a decade before it came under the shadow of the Asian financial crisis.[79]The Malaysian financial problems started to occur in July 1997. There was a severe decline in the stock market [80]and the Dollar-Ringgit rates plunged to over 37%. The dollar value of the Ringgit and stock prices were simultaneously falling before the crisis but became worse in the crisis period. The exchange rate was being affected by the flowing of foreign funds and the stock market was falling due to the behaviour of local investors. Corruption was another culprit in this situation; it played a role but not within the suffering economies and was situated with foreign fund managers.[81] When the exchange rate was out of

what the managers viewed as an equilibrium value, tentative action was expected.[82] Only about $108 billion left the country during the six months of the crisis. The situation in the stock market was aggravated by local investors but did not merely affect the chaos in the currency trading of the country.[83]

So far tradition shows that in order to overcome the financial crisis, countries have sought assistance from the IMF to rescue them, however to overcome the crisis countries have to undertake economic and financial reforms, show transparency in government spending and carry out macroeconomic adjustments.[84] Countries like Thailand, Indonesia and Korea tried to overcome their financial weaknesses but could not succeed in their mission so asked for the IMF’s assistance. As a consequence of the IMF’s assistance these countries had to strict