Evaluation Report

IMF and Recent Capital Account Crises
Indonesia, Korea, Brazil

Independent Evaluation OfficeInternational Monetary Fund
Washington, D.C.
July 2003

IMF and Recent Capital Account Crises: Indonesia, Korea, Brazil
The report was prepared by a team headed by Shinji Takagi and including Ali
Mansoor, Kevin Barnes, and Benjamin Cohen. The team was assisted by AfonsoBevilaqua, Stephen Grenville, Mohamad Ikhsan, Jai-won Ryou, and Takashi Shiraishi;
sections of the report have also benefited from comments and other inputs from Jeffrey
Frankel, Takatoshi Ito, Yung Chul Park, and David Peretz. However, the final
judgments are the responsibility of the IEO alone. Research assistance from Misa
Takebe, Shauqie Azar, Minkyung Kim, and Leandro Rothmuller; administrative support
by Annette Canizares, Arun Bhatnagar, and Florence Conteh; and editorial work by Ian
McDonald and Esha Ray are gratefully acknowledged.
The Independent Evaluation Office (IEO) was established by the International
Monetary Fund’s Executive Board in July 2001. The office operates independently of
IMF management and at arm’s length from the IMF’s Executive Board. Its mission is toprovide objective and independent evaluation of issues related to the IMF’s mandate andthereby support the Executive Board in its governance and oversight responsibilities, tocontribute to enhancing the learning culture of the IMF, and to promote understandingof the IMF’s work.

EXECUTIVE SUMMARY
This report evaluates the role of the IMF in three recent capital account crises, in Indonesia(1997-98), Korea (1997-98), and Brazil (1998-99). These crises have been the subject ofextensive external commentary and have also been studied in detail by IMF staff. A numberof important lessons have already been learned and corresponding corrective steps taken in
the form of revised IMF policies and procedures. Nevertheless, it is appropriate for the
Independent Evaluation Office (IEO) to conduct an independent assessment of the role of the
IMF in these crises, taking advantage of its unique access to internal IMF documents while
also taking note of earlier work where relevant. The evaluation seeks to draw lessons for the
IMF, supplementing those that have already surfaced, and also to contribute to transparency
by evaluating the internal processes by which important decisions were made.
The findings of this evaluation report are subject to three important limitations. First, anyevaluation inevitably benefits from hindsight and while this can be an advantage in drawing
lessons for the future, much of what we know now may not have been known at the time tothose who had to make the relevant decisions, often under extreme pressure. These
considerations must be borne in mind in determining accountability. Second, any evaluation
implies a comparison with a counterfactual, i.e., what might have happened with alternative
policies. This is very difficult to establish rigorously. Third, the behavior of an economy isalways subject to uncertainty and the uncertainties are much greater in crisis situations. In theface of uncertainty, a program cannot be judged to represent a mistaken choice ex ante justbecause it failed ex post. The relevant criterion is whether the ex ante probability of success
was high enough.
The report consists of two parts. The main report presents our assessment of the role of the
IMF in the three crises and the lessons to be drawn from the experience, with some specificrecommendations going beyond the steps already taken. The annexes contain the three
country studies that form the basis for our judgments in the main report.
A. Overall Assessment of the Role of the IMF
The three country cases studied share several features common to capital account crises; ineach case the crisis was triggered by massive reversal of capital flows, short-term flows
played a prominent role, and contagion was an important factor. However, there were also
notable differences. The nature of the crisis differed in the three cases, with Indonesia andKorea exemplifying “twin crises” in which the external crisis coincided with a banking crisis.
There were also differences in the policy mix advocated, the political environment in which
the crisis was managed, and the effectiveness of implementation. All three programs failed intheir initially stated objectives, but the subsequent experience under the revised programs
was very different. Our overall assessment of the role of the IMF in each of the three crises is
as follows:-2-

Indonesia
IMF surveillance did identify the vulnerabilities in the banking sector that would later
become crucial to the evolution of the crisis, but it underestimated the severity and thepotential macroeconomic risks posed by them. In designing its crisis management strategy
during October 1997, the IMF misjudged the extent of ownership at the highest political leveland underestimated the resistance to reform likely to be posed by vested interests. This
underestimation of political constraints was perhaps a reflection of the earlier failure ofsurveillance in recognizing the changing nature of corruption and cronyism.
The single greatest cause of the failure of November 1997 program was the lack of acomprehensive bank restructuring strategy, which led to a rapid expansion of liquidity tosupport weak banks. The resulting loss of monetary control in turn contributed to a weakerexchange rate and greater distress in the corporate sector. The crisis became intensely
political, following the illness of the President in early December, making crisis management
even more difficult. At this stage, the IMF negotiated a revised program in January 1998,
which focused heavily on structural conditionality to signal a clean break with the past. The
focus on structural conditionality was based on the assumption that this was necessary to
restore confidence. It failed to do so, partly because of visible lack of political commitment
to the policies promised and partly because of the failure to address the critical banking andcorporate debt problems.
The Indonesian crisis was clearly the most severe of the three under review, with GDP
declining by 13 percent in 1998 and a large increase in poverty. This devastating outcome
cannot be attributed solely to shortcomings on the part of the IMF. The lack of firm
implementation of the November program, and especially the reversal of some of the criticalsteps at a very early stage, eroded market confidence and the situation soon got out of control
as political uncertainty increased and riots occurred against the ethnic Chinese community.
These exceptional circumstances explain much of the severity of the crisis experienced byIndonesia. However, our evaluation suggests that the IMF’s response to the failure was also
inadequate in many respects.
Korea
In Korea, IMF surveillance failed adequately to identify the risks posed by the uneven paceof capital account liberalization and the extent of banking sector weaknesses, owing to theadoption of a conventional approach that focused on macroeconomic variables. There were
gaps in the data needed to make a full assessment, though available data on short-term debt
and financial market indicators were not fully used. While concerns over Korea’s weakbanking sector had prompted international banks to review their lending to some Korean
institutions even before the onset of the Asian crisis in July 1997, the IMF was optimistic
until virtually the last minute.
The first Korea program was clearly underfinanced, but this was due primarily to theunwillingness of major shareholder governments either to take concerted action to involve

-3-

the private sector or to provide the necessary financing upfront to resolve what, of all thethree cases, was most clearly a liquidity crisis. When this strategy failed, the major
shareholder governments moved quickly to initiate concerted action to involve the private
sector—an approach that eventually worked well. It could be argued that the first strategy
needed to be tried and proven to have failed before the rollover agreement of December 24
could be secured. The IMF played a useful role as crisis coordinator in drawing attention to
the problem and later facilitating information exchange among major governments andhelping to set up a monitoring system to ensure compliance.
The Korean adjustment process involved a severe downturn, with GDP declining by
6.7 percent in 1998, compared with a forecast of positive growth. However, unlike Indonesia,
this was followed by a robust recovery in 1999. The greater than expected downturn reflected
the impact of negative balance-sheet effects, which were clearly underestimated. In
retrospect, the fiscal tightening in the program was unnecessary, as the IMF staff has itself
concluded.
BrazilIn Brazil, IMF surveillance was successful in identifying the key vulnerabilities that were at
the core of the crisis, in part owing to the fact that they were largely macroeconomic innature. However, it progressively downplayed the scale of overvaluation, and had little
impact in persuading the Brazilian authorities to take sufficient corrective action even inareas where the diagnosis was correct. When Brazil faced intense speculative pressure on its
foreign exchange reserves from mid-1998, the IMF reluctantly supported the authorities’
preference for maintaining the existing exchange rate regime. However, intense pressure on
the real developed in December 1998, and the program soon failed with the collapse of thepeg in January 1999.
A major justification for defending the exchange rate was that an exit from the peg at thattime would have unsettled international financial markets already nervous after the Russiandefault and the LTCM crisis. With the benefit of hindsight, it can be argued that this concern
was overplayed. An earlier exit from the peg, widely perceived to be unsustainable, probably
would not have had major systemic effects if it had been made under an IMFsupported
program. The hedge provided to the private sector by the government, through the use offoreign exchange reserves and exchange rate-indexed bonds, ensured that the sharp
depreciation that followed the floating of the real in January 1999 had little adverse effect on
the Brazilian economy. However, this was at the cost of a substantial increase in the stock ofpublic debt, which stored up problems for the future.
The revised 1999 program fared fairly well in the short run. Contrary to program
expectations of negative growth in 1999, Brazil actually experienced positive growth of
0.8 percent. This was largely because of the healthier state of the banking system, combinedwith the provision of the hedge, which mitigated balance-sheet effects on the private sector.
The IMF played a useful role in facilitating Brazil’s transition to an inflation-targeting

-4-monetary regime as well as a more disciplined fiscal policy regime, but in retrospect, fiscal
vulnerabilities were not fully eradicated.
B. Pre-crisis Surveillance
IMF surveillance was more successful in identifying macroeconomic vulnerabilities than inrecognizing and analyzing in depth the risks arising from financial sector and corporate
balance-sheet weaknesses and the governance-related problems that contributed to those
weaknesses. Insufficient candor and transparency limited the impact of surveillance on
policy, even in areas where the diagnosis was broadly accurate.
In Indonesia, the IMF did identify banking sector weaknesses as a problem, but surveillance
reports underestimated the potential adverse macroeconomic consequences of theseweaknesses. Surveillance also paid insufficient attention to the changing nature of corruption
and the macroeconomic risks it posed, and surveillance reports were less candid on theseissues.
In Korea, the IMF failed adequately to recognize the vulnerabilities created by the unevensequence of capital account liberalization and the risk that a change in investor sentiment
could cause a severe drain on foreign exchange reserves. While the crisis also came as asurprise to many other observers, the IMF was slow to catch the rising concerns ofinternational banks over Korea’s banking sector problems, which had begun to surface
several months before the onset of the full-blown crisis. In retrospect, surveillance proved toosanguine about these growing risks.
IMF surveillance effectively diagnosed the major vulnerabilities in Brazil, largely because
Brazil’s vulnerabilities manifested themselves primarily as macroeconomic phenomena, suchas the rising stock of public debt and real exchange rate appreciation, which were part of the
IMF’s traditional toolkit.
In all three countries, the IMF’s role as confidential advisor was not very effective inpersuading countries to modify their policies even when key vulnerabilities were identified.
The IMF was not provided with much sensitive information required for effective
surveillance. While it is difficult to generalize from three cases, or to test the counterfactual
concretely, the IMF probably could have been more effective in influencing policy if it had
made its analyses public so as to contribute to a wider policy debate.
C. Program Design and Implementation
Macroeconomic framework and projections
In all three cases, macroeconomic outcomes turned out to be very different from program
projections. In Indonesia and Korea, the initial projections were overly optimistic, leading toa design of macroeconomic policies that turned out to be too tight given the outcome inaggregate demand and output. In contrast, the initial projections for Brazil in 1999 were too

-5-

pessimistic, which contributed to fiscal adjustment that turned out to be insufficient, in lightof that country’s adverse public debt dynamics.
Part of this problem arises because macroeconomic projections in an IMF-supported program
are necessarily the outcome of negotiation. However, there were also analytical weaknesses
since forecasts were not derived from an analytical framework in which the key determinantsof output, and their likely behavior during the crisis, could be dealt with adequately. In
particular, there was insufficient appreciation of (i) the large currency depreciation whichmight occur in view of the possibility of multiple equilibria, and (ii) the severe balance-sheet
effects that might result. It is inherently difficult to forecast macroeconomic outcomesreliably, especially in crisis situations, but these problems could have been reduced if there
was a more explicit focus on the key factors affecting aggregate demand, particularly private
investment.
In light of the considerable uncertainties, a more explicit discussion in program documents ofthe major risks to the macroeconomic framework, with a clear indication of how policies
would respond if the risks materialized, would have been helpful. In practice, subsequent
program reviews on Indonesia and Korea did show flexibility, but an upfront recognition ofrisks would have sent a more transparent signal on the expected stance of policies.
Fiscal policy
All three programs involved fiscal tightening. The extent of tightening was mild in Indonesia
and Korea, while it was fairly strong in Brazil. In view of output developments, the initialtightening of fiscal policy in Indonesia and Korea was not warranted, and it was in fact
relaxed quickly when the extent of output collapse became evident. In any event, in bothcountries, the initial fiscal tightening was not the cause of the output collapse. This was theresult of balance-sheet effects, which were not factored into program design. In Brazil, fiscal
tightening was much sharper. This was appropriate because fiscal sustainability was a major
issue driving the evolution of the crisis. However, it turned out not be sufficient to achieve
the objective of stabilizing, and then reducing, the debt-to-GDP ratio.
Monetary policy
The stance of monetary policy in all three countries was initially set tight, with an explicit
recognition of the tradeoff between higher interest rates and a weaker exchange rate.
However, the experience of the three countries varies and does not provide a definitive
answer to the ongoing debate on the effectiveness of high interest rates in stabilizing theexchange rate.
In Indonesia, the maintenance of tight monetary policy envisaged in the program was simply
not implemented, as the monetary base expanded rapidly and real interest rates became
increasingly negative during the early months of the program. The assertion by some critics
that the tight monetary policy advocated by the IMF was a cause of the output collapse is notwarranted for the simple reason that it was not implemented for most of the crisis period.

-6-

Exchange rate stability returned in March 1998, when the rupiah had sufficiently depreciatedand interest rates were raised and monetary control regained.
In contrast, Korea implemented the tight monetary policy envisioned in the initial programby raising domestic interest rates and the penalty rate charged to banks for central bankforeign currency advances. These moves were appropriate to defend the currency, but they
were not by themselves sufficient to stabilize the exchange rate, because much of the capitaloutflow was in fact driven by credit considerations rather than yield. It can be argued that
real interest rates were kept higher than might have been necessary in early 1998, when theexchange market had stabilized. However, the still uncertain situation understandably called
for some caution. Given the contractionary impact of bank restructuring on credit flows, thefew months of higher than necessary interest rates could not have been the dominant cause of
the recession.
In Brazil, the excessive easing of interest rates—over the IMF’s objections—may havecontributed to the timing, if not the eventuality, of the collapse of the crawling peg. A
decisive tightening of monetary policy in March 1999 coincided with the restoration ofstability in the foreign exchange market. However, one must be careful about the causality,
given the fact that an informal agreement by major international banks to maintain credit
lines to Brazil was reached around the same time. High interest rates did not have a major
negative impact on the private sector, because of the sound state of the banking system andthe low leverage of the corporate sector, compared with the situations in Asia. Subsequently,
the IMF supported Brazil’s transition to an inflation-targeting regime, which allowed forprice stability and a rapid reduction in interest rates.
Official financing and private sector involvement
The size and format of the official financing package were inadequate in Korea andcontributed to the failure of the first program. The ambiguity over the availability of
US$20 billion in bilateral assistance pledged as a “second line of defense” in Korea createduncertainty in the market about the ability of the program to meet the country’s immediateliquidity needs.
In the other two countries, the programs failed for other reasons. The failure of the initial
Indonesian program was due, not to inadequate financing, but to other factors, including
nonimplementation of the key elements of the program by the authorities and the subsequent
explosion of liquidity because of the failure to resolve the banking crisis. Once the program
had failed, the crisis became intensely political, leading to a large amount of capital flight bydomestic residents, and the sharp depreciation of the rupiah began to create solvency
concerns. No reasonable amount of official financing could have restored confidence at thattime. In the case of Brazil, the initial program failed because the key policy, namely, that ofsupporting the crawling peg, was not credible with the markets.
In Korea and Brazil, the IMF’s role as crisis coordinator in organizing private sector
involvement (PSI) was limited by the unwillingness of major shareholder governments to use

-7-nonmarket instruments to influence the behavior of private sector institutions and concernsthat such action might precipitate an exodus of capital from emerging markets. However,when a decision was made by the major shareholders to involve the private sector, the IMF
played a useful role in facilitating information exchange among major governments andhelping to set up systems of monitoring compliance.
An earlier attempt to involve the private sector in Korea would have been warranted, but
given the initial unwillingness of the IMF’s major shareholder governments to take concerted
action, there was probably little the IMF could do. The agreement by major internationalbanks to roll over interbank debt on December 24, 1997 was a turning point in the crisis. The
success of this approach owed much to the fact that most of the short-term external debt wasinterbank credit. The Brazil experience in the second program suggests that a program with ahigh degree of credibility is necessary for the “voluntary” approach to PSI to work. In
Indonesia, the IMF provided technical assistance for corporate debt restructuring,but its role was limited.
Bank closure and restructuring
The experiences of Indonesia and Korea suggest that a successful bank closure andrestructuring program must include a comprehensive and well-communicated strategy inwhich transparent rules are consistently applied. The Korean program by and large achieved
its objectives, largely because a comprehensive strategy was developed at the outset. The
Indonesian banking sector program, by contrast, initially suffered from the lack of acomprehensive strategy and the failure to communicate the logic and outline of the policy tothe public. As a result, the closure of 16 banks in November 1997, with subsequent reversals
exacerbated, rather than dampened, the crisis. Bank closures in Indonesia in April 1998,
however, were more successful because they were done as part of a comprehensive strategy
that was well communicated to the public and was based on the consistent application of
uniform and transparent criteria.
The issue of whether a blanket guarantee, instead of the partial guarantee actually offered,should have been introduced in Indonesia in November deserves careful consideration. Ourevaluation suggests that the banking crisis was not yet systemic in November, so that thepartial guarantee was appropriate. In the end, the blanket guarantee introduced in January
was subject to abuse and consequently raised the fiscal cost of bank restructuring. The
problem in bank restructuring was more with the initial lack of a comprehensive and wellcommunicated strategy, and not the nature of the guarantee.
Structural conditionality
All three programs involved structural conditionality, but the experience with conditionality
was very different. The Indonesian and Korean programs were characterized by extensive
structural conditionality (especially the January 1998 Indonesian program) covering several
areas that were not macro-critical. The scope of structural conditionality in the Brazilian
program was limited to structural fiscal reform and prudential regulation. Part of this-8-difference reflected the absence in Brazil of many of the distortions that had been present in
Asia.
Measures to rehabilitate and reform the financial sector were necessary in both Indonesia andKorea and were appropriately included in the programs. In Indonesia, it was also important totackle corporate restructuring by reforming the legal system, but this element was missing in
the first two programs. As for the various nonfinancial structural reform measures included in
the Indonesian and Korean programs, many of these may have been beneficial in improving
long-run economic efficiency, but they were not necessary.
In Indonesia, many governance-related measures were included in the January program at theurging of some of the IMF’s major shareholders in the belief that confidence could only berestored by signaling a clean break with the past. However, the evaluation suggests that the
proliferation of nonfinancial structural conditionality led to a loss of focus on critical reforms
in the banking sector which was more important for restoring stability. Proliferation of
structural conditionality may also have led to lack of ownership at the highest political leveland nonimplementation, both of which damaged confidence.
Communications strategy
A program for restoring confidence must include a strategy to communicate the logic of the
program to the public and the markets, in order to enhance country ownership and credibility.
None of the three programs initially contained such a strategy.
Effective public communications are essential to build broad support for the program.
Likewise, effective dialogue with the markets would improve program design throughunderstanding the expectations of market participants, and also help build credibility for the
program. For this purpose, it is important for the IMF to explain clearly the logic and strategyof the program, including spelling out the major risks, with a broad indication of how
policies would respond to them.
D. Internal IMF Governance and the Mode of Operations
The evaluation identified a number of weaknesses in the IMF’s internal governance andmode of operations. In the area of human resource management practice, the effectivenessof surveillance was reduced by the lack of sufficient internal incentives to make judgmentsthat were frank and potentially unpopular (with country authorities), resulting in a tendency
for sharper elements of a diagnosis to be diluted in final Executive Board papers. In crisis
management, the quality of the IMF’s response was compromised by a delay in thereallocation of staff resources to the Asia and Pacific Department (APD) whose staff wasoverstretched by multiple regional crises; the insufficient integration of staff from MAE andthe area department; insufficient utilization of available internal knowledge; and the failure tomobilize staff members with up-to-date country knowledge.

-9-

The role of the Executive Board and the IMF’s major shareholders was particularly
prominent during the crises, when major decisions needed to be made quickly, calling for
close collaboration with staff and management. While the close involvement of the Boardand the major shareholders was proper and necessary, close contacts at multiple layers
unnecessarily subjected staff to micromanagement and political pressure, contributing to a
blurring of technical and political judgments. For example, the visible presence of majorcountry officials close to the IMF negotiating teams sometimes created a misperception of
the motives behind IMF involvement, thus weakening the sense of country ownership.
In all three programs, the IMF collaborated, both in financing and technical work, with otherinternational financial institutions (IFIs). When there was a clear separation of
responsibilities, as in Brazil, no major problems occurred. In Asia, however, where the IMF
and the other IFIs all worked in the financial sector, tensions developed over the role theyshould play in an IMF-supported program. While a good working relationship eventuallydeveloped, it depended too much on personalities, and not on a well-defined procedure.
Moreover, existing procedures to resolve differences of view between the IMF and the WorldBank on key policy matters were not effective in avoiding public criticism by the Chief
Economist of the World Bank; indeed, as far as the evaluation team can tell, these procedures
were not utilized.
E. Recommendations
Since these crises, the IMF has taken numerous initiatives to strengthen surveillance andprogram design. Many of the weaknesses in surveillance and program design identified by
the evaluation have already been addressed by the IMF in its revised policies and procedures.
Nevertheless, additional steps will be necessary to further enhance the effectiveness of the
IMF in surveillance and crisis management. We make six broad recommendations, which are
set out in the final chapter of the report along with their rationale. Rather than summarize
them again here, we suggest that Chapter VI be read in conjunction with this Executive
Summary.

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APPENDIXRECOMMENDATIONS
Since the three crises reviewed in this report, a great deal of learning has already taken place
within the IMF. New guidelines have been issued, or are being discussed, to incorporate thatlearning into policies and operational procedures, particularly in the areas of surveillance,
conditionality, access policy, bank restructuring strategy, IMF-World Bank collaboration,and external communications strategy. These initiatives will help to improve theeffectiveness of IMF surveillance and program design. Nevertheless, our evaluation suggests
some specific areas where these initiatives could be enhanced. These are set out below as six
recommendations, covering pre-crisis surveillance, program design, and the role of the IMF
as crisis coordinator.
Pre-crisis surveillance
Recommendation 1. To increase the effectiveness of surveillance, Article IV consultations
should take a “stress-testing” approach to the analysis of a country’s exposure to apotential capital account crisis. The current guidelines, revised in September 2002, alreadysuggest that surveillance should include “comprehensive assessments of crisis
vulnerabilities,” covering “economic fundamentals that may have an impact on market
sentiment,” “risks arising from global market developments,” and “factors affecting acountry’s ability to deal with a sudden shift in capital flows.” We recommend extending andsystematizing this approach.
•Staff reports for Article IV consultations could itemize the major potential shocks thatthe economy could face in the near future, explore the likely real and financial
consequences of each of these shocks—including balance-sheet effects—and discuss
the authorities’ plans for dealing with them should these shocks arise.1 Suchdiscussion should cover the effectiveness of any existing social safety nets both asautomatic fiscal stabilizers and as a means of mitigating the impact of a crisis on themost vulnerable sections of society.

•

Staff should try to develop a greater understanding of the political constraints that
may affect policy making and of market perspectives on policy. Article IVconsultation missions to systemically important countries should therefore seek awider dialogue with individuals beyond senior economic officials, including
especially those in the domestic and international financial communities. This isalready done in “best practice” cases, but it would be desirable to formalize theprocess. In this context, it would be useful to include separate sections in staff reports
where market views and political economy analyses are provided. Expertise available

1

Allen et al. (2002) sets out much of the framework that would be necessary for such ananalysis.

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APPENDIXin ICM could be tapped on the former. Resident Representatives should also be
incorporated into the preparation of staff reports in a more systematic way.
Recommendation 2. Management and the Executive Board should take additional steps
to increase the impact of surveillance, including through making staff assessments morecandid and more accessible to the public, and providing appropriate institutional
incentives to staff.
•

The recently revised surveillance guidelines call for Article IV consultation reports tocontain a more systematic assessment of what happened as a result of the IMF’s
previous policy advice (along with an opportunity for the authorities to comment on
the advice). To make such assessments more operationally relevant, management
could develop modalities for escalated signaling when key identified
vulnerabilities are not addressed over several rounds of surveillance. While it isbeyond the scope of this evaluation to spell out a detailed proposal on how this would
be achieved, the aim should be to provide the Executive Board with a vehicle forsignaling when failures to address identified vulnerabilities have become anincreasing source of concern. In this context, escalated signaling would help strike aright balance between the role of the IMF as confidential advisor and its role as avehicle for transmitting peer reviews on members’ policies and for providing quality
information to markets. Escalated signaling would give member countries enoughtime to address underlying vulnerabilities, while also progressing toward greater
candor as a means of increasing the effectiveness and impact of surveillance. It would
also help to create an environment in which there is a clearer perception of the major
vulnerabilities that would need to be suitably addressed as part of program design,
should a crisis occur and IMF support be requested.

•Management and the Board should explore the possibility of seeking “second
opinions” from outside the IMF as part of the surveillance process when theauthorities disagree with the staff’s assessment on issues that are judged to be ofsystemic importance.2 This would improve the degree of objectivity with which
contentious issues are handled in the surveillance process and may enhance theimpact of surveillance. It would also serve as a building block for the idea of
escalated signaling.

•

While we recognize that there are risks in generalizing from a small number of cases,
the experience of the three countries supports the case for a presumption that staff
reports for Article IV consultations should be published.3 Publicizing such

2

The Executive Board has already indicated its acceptance in principle of such an approachin the discussions following the evaluation of the prolonged use of IMF resources.
3

The Crow Report also recommended routine publication of all staff reports for Article IVconsultations.

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APPENDIX

information will help to generate a more informed debate on the need for structuralreforms oriented toward crisis prevention. The public would also be better informed
about the underlying rationale of the reforms that the IMF might subsequently deem
necessary in the event of a program. Concerns have been expressed that publicationof staff reports may compromise candor in terms of both what the authorities arewilling to share with the IMF and what staff is willing to disclose in public. But thecountry experiences discussed in this report suggest that, without publication, there isalso a risk that the IMF can have the worst of both worlds—with limited impact as a“confidential advisor” and limited scope for making its views known in the broader
policy debate.
•

Encouraging publication of country-level analytical work by staff will contribute to
the quality of IMF advice and public policy debate. Existing guidelines areambiguous about whether publication, with the appropriate disclaimers, ofcountry-related Working Papers by staff requires clearance by the relevant
Executive Director. It is desirable to create a presumption that publication is
encouraged.

•

To encourage greater candor in the assessment of country risks and vulnerabilities,
management and the Executive Board should agree on a systematic plan ofaction to provide staff with appropriate institutional incentives, possibly
including measures to give greater independence to teams conducting
surveillance. The recently modified guidelines call for greater candor in surveillance
reports, but such guidelines are unlikely to yield fundamental change unless they arecompatible with internal incentives.

•

The biennial reviews of surveillance should, inter alia, focus on assessing theimpact of surveillance on key systemic issues in member countries. As part of thisassessment process, the existing Surveillance Guidelines should be made public, sothat the criteria against which the IMF expects to judge its own performance are clear
to all.

Program design
Recommendation 3. A comprehensive review of the IMF’s approach to program designin capital account crises should be undertaken. The IMF’s own internal reviews havealready generated many important lessons for program design and this evaluation has
highlighted a number of others. The proposed review or redesign should be oriented aroundtwo key elements: (i) the objective of a crisis management program is first and foremost to
restore confidence; and (ii) the interaction of balance-sheet weaknesses and key
macroeconomic variables is critical to how the economy will respond. This broad approachsuggests the following specific initiatives:•

It is necessary to pay much greater attention to balance-sheet interactions andtheir consequences for aggregate demand, especially in capital account crises

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APPENDIX

where possibilities of multiple equilibria exist. With the associated prospect of a largechange in the exchange rate, an obvious message from the case studies is thatdesigning programs around a single real GDP growth projection, which is inevitably
the result of negotiation, can lead to significant problems in macroeconomic program
design. It is not easy to ensure that all relevant determinants of growth are adequately
taken into account, but a more systematic framework should be elaborated to ensurethat program design should take account of how the status of balance sheets would
influence aggregate demand, as well as the role of interest rates and exchange rates inparticular cases.
•

Program design should allow for a sufficiently flexible response, in caseunfavorable outcomes materialize. Although reviews and waivers can be said toserve this purpose in a conventional crisis, large potential changes in key variables ina capital account crisis may render the original program irrelevant very quickly, andthe appearance of persevering with a failed program can be damaging to market
confidence. This suggests that the major risks to the program should be identified
explicitly, along with a broad indication of how policies will respond. In the area offiscal policy, for example, if public sector debt sustainability is not a constraint,program design could allow for countercyclical fiscal policy—either by adjusting
quantitative fiscal targets automatically to allow explicitly for the operation of
automatic fiscal stabilizers or by targeting the level of discretionary expenditures
rather than the fiscal deficits per se. More generally, program documents should spellout explicitly how macroeconomic policies will respond in the event of sharperthanprogrammed economic downturns, and this should be clearly communicated tothe public.

•

The conventional framework of conditionality based on financial programming(including quantitative monetary targets) should be reviewed to see if, and how,
it should be adapted to the circumstances of capital account crises. Quantitative
performance criteria (PCs) are often not useful as a guide to policy in a capital
account crisis when the behavior of key economic variables can be highly uncertain
and volatile and large deviations can develop, which may be difficult to correct later.
It may be preferable to agree, in addition to performance criteria, to a mechanism oftriggering consultations on monetary and fiscal policy, with some understanding on
how the mix of policy needs to change in light of evolving circumstances. Just suchan approach was taken in Korea in December 1997 in the setting of interest rates andin Indonesia in March 1998 when specific interest rate actions were specified. The
approach to program conditionality in countries with formal inflation targeting
frameworks for monetary policy is also evolving in this direction.

•

A crisis should not be used as an opportunity to force long-outstanding reforms,
however desirable they may be, in areas that are not critical to the resolution of
the crisis. When political judgment necessitates addressing significant distortions thatare known to exist, and the government is committed to reform, it should be sufficientto lay out a road map for these reforms as an indicative direction outside IMF

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APPENDIX

conditionality, and this fact should be communicated to the public. Parsimony andfocus should be the principles to guide the design of structural conditionality in a
program whose objective is to restore confidence quickly. In this respect, we endorse
the current initiatives of the IMF to streamline conditionality, while stressing that, ina capital account crisis, the critical test of a particular measure involves whether or
not it helps to restore confidence.
•

Program design should include an agreed strategy to communicate the logic of
the program and any subsequent program-related information to the public andthe markets. Such a strategy should be characterized by a high degree oftransparency, including the immediate publication of LOIs and early disclosure of any
unfavorable information.

The IMF as crisis coordinator
Recommendation 4. Since restoration of confidence is the central goal, the IMF should
ensure that the financing package, including all components, should be sufficient togenerate confidence and also of credible quality.
•

Financing packages prepared by the IMF should not rely on parallel official
financing, unless the terms of access are clear and transparently linked to the
IMF-supported strategy. Attempts to inflate the total amount of financing by
including commitments made under uncertain terms would risk undermining thecredibility of the rescue effort. This implies that if the IMF is to play an effective roleas crisis coordinator, either it must have adequate financial resources of its own or theavailability of additional official financing should be made subject to a single,
predictable framework of conditionality.

•

When parallel financing is sought from other IFIs, the terms of reference for
their engagement should be specified at the very outset, including mechanisms toresolve differences of view and the manner in which their inputs are reflected inprogram design. This is particularly important in the case of collaboration with
regional development banks, for which no established procedures exist.

Recommendation 5. The IMF should be proactive in its role as crisis coordinator. Sucha proactive role would include the following elements:•

Management should provide candid assessments of the probability of success and afrank feedback to the Executive Board and shareholders if some elements of thestrategy are significantly lowering the probability of success.

•While involvement of shareholders is necessary and appropriate, particularly in large
access cases, management should ensure that the technical judgment of staff beprotected from excessive political interference.

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APPENDIX

While decisions on the nature of private sector involvement will have to be made on acase by case basis, the IMF should play a central role in identifying circumstanceswhere more concerted efforts (as was eventually undertaken in Korea) can be usefulin overcoming “collective action” constraints. This should be based on a meaningful
dialogue with the private sector, building on the new mechanisms for such a dialoguethat have been established in recent years.

Recommendation 6. Human resource management procedures should be adapted
further to promote the development and effective utilization of country expertise within
the staff, including political economy skills, and to ensure that “centers of expertise” oncrisis management issues allow for a rapid application of relevant expertise to emerging
crises. Some important steps are already being taken in this area (including encouraging
greater training in political economy), but a broader effort, based on long-term strategicplanning, is needed. It is also desirable to formalize the procedure for encouraging candor incountry work.
•

New institutional arrangements within the IMF should be established to ensure that
the IMF is in a position to deliver a rapid response, in terms of policy advice, tomember countries facing crises and to assist in program design in such cases. A
variety of organizational approaches could be used to achieve this objective, and we
do not propose to suggest a specific structure. However, the aim should be to ensurethat dedicated resources are maintained to respond to crisis management situations
and to learn from past experience. This is precisely the approach proposed bymanagement in the reorganization of MAE. The same principles should be adopted
on an IMF-wide basis to deal with crisis cases involving large access.

•The length of staff assignments to country desks should be monitored to ensure thatsufficiently recent country expertise is maintained within the staff. This information
should be reported periodically to the Board.

•

The terms of reference of Resident Representatives should be modified to encouragethem to play a more central role in surveillance and program design (see also
Recommendation 1, above). This already happens in some, but not all, cases.

•

Internal guidelines and human-resource procedures should be modified to protect
mission chiefs and others who raise uncomfortable issues through any authorizedchannel and thereby attract complaints from the authorities. For example, the internal
Annual Performance Review (APR) exercise could be enhanced to give greater
weight to the ability and willingness to make independent, candid judgments.4 Ex

4The APR form for IMF managers already contains sections calling for the assessment ofcompetences that are relevant to this issue (e.g., sound judgment/analytical skills, andstrategic vision) but does not address it directly.

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APPENDIX

post assessments of surveillance (see Recommendation 1, above) could be used as abasis for evaluating senior staff performance in this regard.
•

5

A medium-term IMF-wide program should be established to develop a critical massof staff members with significant country expertise in each of the emerging market
economies that have been identified as systemically important, including mechanisms
to allow staff to make visits to these economies for professional development andsystematic efforts to assign relatively junior members as Resident Representatives.
An information system to track this expertise should be established.5

For example, at present there is no central system that would allow management toascertain easily which staff members have worked on particular countries in the past.