What lessons did IMF learn from South East Asian crisis?

It wasn’t just monetary/fiscal policymakers that learnt their lessons from previous crisis. IMF learnt its lessons. In a very useful paper, Shinji Takagi of Osaka Univ tells us the lessons IMF learnt from South East Asian crisis and used these lessons in East Europe in this crisis. In all he says the nature of policies has not changed much. What has changed is the philosophy, flexibility and transparency of IMF policies.

The paper examines the recent European crisis management programs of the International Monetary Fund (IMF) to see how the lessons of Asia were applied. Compared to the Asian programs of 1997, the European programs of 2008 were better funded and their structural conditionality more focused. Other than these, the overall thrust of the programs was similar: fiscal and monetary tightening, coupled with banking reforms.

The real difference, however, was not so much about content but about philosophy. Relative to the Asian programs, the European programs were characterized by more emphasis on ownership, greater collaboration among stakeholders, more realistic assumptions and greater transparency about the risks and the logic of policy actions, and more built-in flexibility of targets and policy options.

This approach to crisis management, foreshadowing the major reform of conditionality in March 2009, incorporated the changes that had been made since the Asian crisis in the IMF’s policies and procedures to manage capital account crises more effectively. Despite these recent changes in the way the IMF does its business, Asia appears to remain unengaged. The lesson Asia should draw from Europe is that it should build a strong regional institution to complement, and catalyze the involvement of, the IMF. Only then can the lessons learned in Asia over 10 years ago be applied back in Asia to benefit its own people. 

He compares IMF financing in SE Asia vs E. Europe. The findings are relief packages are both quantitatively and qualitatively better in the case of E. Europe:

The IMF provided exceptional financing both in Asia and in Europe (Table 1). Relative to the standard metric of IMF quota, the European packages were about twice the size of the Asian packages (excluding the Republic of Korea whose quota was unreasonably small relative to the size of the economy). Relative to GDP, the European programs were as much as 3–5 times larger.

The difference between the Asian and European packages becomes more apparent when total official financing is considered (Table 2). Relative to GDP, the headline figure was 14.5%–35.7% for Europe, whereas the corresponding figure for Asia was 6.7%–12.6%. Total official financing for Latvia (35.7% of GDP) may well have represented a virtual bailout of the country.

The difference becomes even greater when what may be considered to be the quality of the financing (meaning both adequacy relative to need and the credibility of underlying numbers) is assessed. 

There are quite a few differences in the way IMF built credibility over lending programs in E. Europe. Read the paper for details.

In monetary policy application, I was surprised to see the same idea of tightening still applies. However, IMF was more flexible in E. Europe case. The difference is in procedure:

If there is any difference, it is about procedure. First, the documents for the European programs emphasized that high interest rate policy was the national authorities’ preferred policy. For example, the Hungarian authorities had already raised the policy interest rate in early 2008, and the IMF program simply maintained the stance of policy already chosen. In Iceland, the authorities had been raising the policy interest rate (before the reversal in mid-October) and pledged to reform the Housing Financing Fund (as a way of containing the provision of credit). Here again, the IMF program simply held on to the previously chosen course of policy. 

Second, the documents for the European programs specified the purpose and logic of high interest rate policy. In most cases, they stated that the purpose was to stabilize the exchange rate while noting the negative consequence of premature monetary easing for this purpose. At the same time, the documents also stated the need for banking sector restructuring as an objective of the program and, insofar as high interest rate policy conflicted with this objective, the need to manage monetary policy flexibly. In Ukraine, for example, the document stated the need for further monetary tightening but only after the pressing liquidity problem of the banking sector was resolved.

In fiscal policy also IMF stressed fiscal tightening but was flexible.

In short, the logic of fiscal conditionality in the European programs was that it would realistically allow deficits to remain or increase in the short run, but place fiscal consolidation as the central objective.

IMF was also more realistic with its macroeconomic projections. 

The primary reason for IMF conditionality in Asia to include fiscal tightening was that the IMF did not fully appreciate the nature of a capital account crisis, with attendant sharp capital flow reversals, and the negative balance sheet effect of exchange rate depreciation. The capital flow reversals were far greater than anybody had supposed. The magnitude of the reversal from 1997 to 1998 was especially large in the Republic of Korea (12% of GDP) and Thailand (13%). Instead, the IMF staff underestimated the capital flow reversals the three countries would experience and assumed them to be only 0.5%–2.5% of GDP (Table 4). 

The IMF underestimated the severe contractionary effect coming from the capital account and therefore failed to anticipate a possible negative output growth. It continued to believe that the Asian crisis countries would register positive output growth.

The author points IMF also underestimated the impact of depreciating currency. It thought a depreciating currency would boost exports. But it actually worsened corporate balance sheets as loans were mostly in dollars. IMF has now developed a very important tool – balance sheet approach (see India case study as well), which helps it assess the currency and maturity mismatches of the entire economy. This helped in Europe. So this time it was prepared.

In the end he says something more interesting. He says Asian policymakers have not really forgiven IMF for its poorly designed programs. IMF may have learnt the lessons but Asia prefers alternative arrangements in times of crisis:

Applying a lesson learned a while ago to a problem at hand is the implicit admission of a past error, but it is not the same as apology. Perhaps the discerning officials of finance ministries and central banks can see a repentant IMF and its new way of doing business, now loudly codified in the conditionality reform of March 2009. Does the Asian public know? Have they forgiven the IMF? The recent decisions of the Republic of Korea to approach the US, People’s Republic of China (PRC), and Japan for currency swap arrangements and of Indonesia to secure standby credit from a group of multilateral and bilateral donors prove that the problems of the past are not easily forgotten. This is a reminder that going to the IMF for financial assistance is still politically not acceptable for several Asian countries.

This is a curious state of affairs—the IMF has learned lessons from Asia and is applying them to benefit other regions of the world, but Asia wants to have little to do with the innovations that came to light recently. Asia should now learn a lesson from Europe: it was the regional institutions that catalyzed the involvement of the IMF even when the countries themselves were reluctant to approach the IMF. The recent experience of Europe shows that regional institutions, far from being competitors, can in fact be partners with the IMF in complementing resources and expertise. Another lesson of Europe is that no institution, regional or global, has sufficient resources to deal with a large crisis. There is room for everyone in this world, even including bilateral donors.

Asia then might as well continue to strive to build strong and viable regional institutions, especially a structure to multilateralize the Chiang-Mai Initiative with adequate resources. As an entity in which they see greater voice and ownership, the public and their governments would be less reluctant to approach and work with a regional institution in times of need. As part of working out a solution together, the IMF could then be invited to join in the cooperative efforts. Only then can the lessons learned in Asia over 10 years ago be applied back in Asia, to benefit its own people.

 Superb stuff. So much in so few words and pages.

One Response to “What lessons did IMF learn from South East Asian crisis?”

  1. I Don’t Like Espresso – I Like Real Coffee | Make The Best Coffee Says:

    […] What lessons did IMF learn from South East Asian crisis? « Mostly … […]

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