Mr Stals talks about the international economic environment
Central bank: sarb | Type: speech | Date: 1999-04-25

## Mr Stals talks about the international economic environmentAddress by the Governor of the South African Reserve Bank, Dr Chris Stals, at the Conven the Institute of Life and Pension Advisers (ILPA) in Johannesburg on April 12, 1999.

## 1.

The international financial crises of 1997/98The past eighteen months witnessed disrupting turbulences in world financial markets th the collapse in financial structures in many countries, and to a serious decline in econ in the world at large.A chronic weakness in the Japanese economy over a prolonged period of time should perha regarded as the major cause of the financial crisis, which is generally linked to the c economies of a number of countries in East Asia.

These included Thailand, Korea Philippines, Indonesia and Malaysia -- countries that managed their economies with great for many years.

What went wrong in these countries is now part of history, and some co has been found on an ex post basis of the reasons for the collapse in the economies of to be referred to as the East Asian Tigers.

In general, the following can be offered a of mistakes that were made in the economic management of the afflicted countries:* Governments failed to react timeously to overheating economies.

This was manifest unsustainable high levels of economic growth, inflated property and share prices, a large deficits on the current account of the balance of payments.* Prolonged pegging of currencies to the United States dollar at unsustainable level monetary policy less effective and making the exchange value of domestic currency to be guaranteed.

This encouraged huge external borrowing, leading to excessive ex to foreign exchange risks for borrowers in the public and in the private sectors.* Insufficient supervision of financial institutions and poor enforcement of pruden reinforced by cronyism.* Lack of sufficient and accurate data to enable market players to make a correct as of economic fundamentals.* In the situation, international investors under-estimated risks as they searched income yields.

In particular, investors failed to grasp inevitable links betwe (liquidity) risks and credit risks.* The expanding world financial market and lax controls over multi-national fin institutions encouraged excessive leveraging based on a relatively small capital hedge funds and certain banking institutions.* A herd-like reaction by international investors, once the bubble burst, that led t panic-withdrawal of funds from economies that could not in a short period of time the shock of the turnaround in the sentiment of international investors.The adverse developments in East Asia almost immediately affected emerging markets all a the world.

Initially, that is from the middle of 1997 up to the second quarter of 1998, other emerging markets succeeded in keeping afloat and there was still a chance to keep restricted to the East Asian region.

The situation was exacerbated, however, by the collapse of the situation in Indonesia, and by the early signs of an emerging seconRussia.

The effective devaluation of the rouble and unilateral restructuring announced by R in August 1998, triggered a further series of sharp market corrections, indicating a gener increase in perceived risk or risk aversion.A third threat to a major collapse of the global financial system came towards the end of la with the deterioration of the financial situation in Brazil, mainly because of chronic imbalances and large-scale speculative attacks on what markets perceived to be an overvalu currency.In general, the immediate effect of a loss of confidence of investors in any specific econom reflected in a decline in the inflow of foreign capital or, in many cases, a large withdrawal residents of previously invested funds from the country.The widespread flight to quality and liquidity gave rise to a severe tightening of credit co in the affected countries: equity prices fell sharply; yields on bonds rose to extremely hig followed by soaring interest rates in general, and exchange market pressures intensifie exchange rates went in an uncontrollable tumble.

As a by-product of these developments, man international investors and banks suffered substantial losses, especially on highly lev investment positions.Gradually, the worsening conditions in the financial markets also affected real economic act The International Monetary Fund (IMF) revised its outlook for world economic growth in 1998 first from 3 to 2½ per cent (in August 1998), and then to 2 per cent (in October 1998).

For the projection was similarly reduced from 3¾ per cent to 2¼ per cent at this stage.

## 2.

The contagion effect of the financial crisisA special feature of the financial crisis of the past two years has been the contagion effec spill-over of the economic problems of a few important emerging market economies to othe countries, and eventually to the world economy.The transmission mechanism, or the conduit followed in the contagion process, was not the sa for all countries.

Initially, with countries in East Asia, perceptions played an important p process.

Once the Thai baht came under pressure in the middle of 1997, it did not take before international investors discovered many similarities in the economies of Korea, Philippines, Indonesia and Malaysia.The serious collapse of the Russian financial system, and particularly the action taken b Russian Government in the unilateral restructuring of its sovereign debt, gave rise t indiscriminatory withdrawal of funds previously invested in sovereign debt of other emerg market governments.

It was also noted at the time that the IMF, the World Bank, an Governments of other countries were rather reluctant to provide the massive amount of assist needed for propping up the Russian balance of payments problem.

The following quotation from a recent IMF publication summarises the Russian events of mid-1998:'More important was the role of Russia's default as a defining event that challenged widely views about the default risks associated with all emerging market investments, and willingness and ability of the international community to provide assistance to countri difficulty.'(World Economic Outlook and International Capital Markets, December 1998)The flight to high quality assets and, at a later stage, a major 'de-leveraging' proc national investment institutions, reduced international capital flows in general, an provided a second conduit for contagion.

It is estimated at this stage that net private from the industrial countries to the developing and emerging markets, including coun central and Eastern Europe 'in transition', declined from US $118 billion in 1997 to $ in 1998.

In the case of the Asian countries, it changed from an $100 billion net inflow an $18 billion outflow in 1998.A third obvious conduit for the transfer of the economic ills of the East Asian economi countries, and particularly countries with vulnerable balance of payments position deterioration of current account positions caused by the generally depressed world environment.

The negative effects of this development are only now beginning to filter t some of the poorer, developing countries in the world that do not have developed f markets but are nevertheless dependent on the exports of basic commodities, metals and m Examples in Southern Africa can be found in Botswana (diamonds), and Zambia (copper).Finally, the weakening or full collapse of the banking systems in a number of the economies has had a major impact on the global banking sector.

Not even financial insti the major industrial countries have been immune to this problem.

The near-collapse of Term Capital Management Fund in New York towards the end of September 1998, provided stern warning to the world that the East Asian crisis had indeed become a worldwide f problem.

Quick action by the American Federal Reserve and the major New York ban prevented serious problems for other financial institutions, including many multination institutions with similar over-leveraged positions.

## 3.

Policy reactions to the global financial crisisThe initial 'fire-fighting' reactions of countries in the midst of the crisis obviously country to country.

Led by initiatives from the IMF, however, a relatively standar procedure was adopted that required of countries, firstly, to adjust important macro fundamentals to new levels as dictated by market forces; secondly, to restore some st financial markets, and thirdly, to introduce structural and other remedial adjustment regain the confidence of international investors.In the process, the countries directly afflicted by the crisis had to accept:* a sharp depreciation in the external value of their currencies;* a substantial tightening of liquidity conditions in domestic financial markets;* a tightening in fiscal policy, mainly through significant reductions in go expenditure.In some countries, inflation also increased to higher levels and necessitated even more monetary policies.These developments obviously depressed real economic growth, and led to incre unemployment in the affected economies.

It is estimated, for example, that the rate of growth in the ASEAN Countries (Indonesia, Malaysia, Philippines and Thailand) changed positive growth of more than 7 per cent in 1996, to negative 'growth' of more than 10 p 1998.In the case of two important countries also afflicted by the crisis, a different approa followed with macroeconomic policies to address the problem.

In the case of Malaysia, t Government preferred a route of self-protection by the reintroduction of exchange controls international capital flows.

The wisdom of this policy was severely criticised at the tim history will eventually provide a final verdict on the issue.

There is general belief, howe international investors will in future be much more reluctant to invest again in Malaysia th example, in the other East Asian countries that were more prepared to bite the bullet extremely painful and costly macroeconomic adjustment processes.The second country to follow a different route, Russia, perhaps had no alternative but to int an almost complete moratorium on the repayment of its foreign debt.

Private market invest have more or less written off their Russian exposures as a complete loss.

It will take adjustments before these bitten investors will ever return to Russia.

## 4.

Promising signs of a reversal in the financial marketsIt would seem as if the global financial crisis reached a lower turning point in about Octo year and, although still very fragile, there are encouraging signs of a return of greater s the global financial markets.

In retrospect, the demise of the Long Term Capital Manageme Fund of New York at that time may have triggered the required concerted international acti also from the major industrial countries, to help restoring a measure of calm to financial m Actions taken since October 1998 included:* The easing of interest rates by central banks in most industrial countries, includin United States, United Kingdom, and the newly-established European Central Bank.* In Japan, new policy measures to address banking sector problems and announcements of further fiscal actions to stimulate demand.

The Japanese Government indeed provided ¥60 trillion (about US $500 billion) to restructure the banking sector.* Commitments and actions by Brazil to address its chronic fiscal imbalances, and the lar scale support of the international community, agreed in mid-November, for a stron programme of assistance that would forestall a financial crisis in that country.* Continued progress with stabilisation and reform in the Asian crisis countries implement policy programmes supported by the IMF.

With current account balances having moved into surplus and financial market confidence having begun to recover, the strengthening exchange rates has allowed monetary policy to be eased, which in turn has helped to boo equity markets.* Recent increases in IMF quotas and other measures taken to replenish the funds of the I improved the international community's ability to assist countries in the resolutio financial crises.It would seem as if the first objective of macro-economic policy has therefore been achieve the major crisis centres (with the exception of Russia).

Some stability has now been resto the financial markets.

The attention of the world debate has now been shifted, firstly, to needed and prudent to re-stimulate the world economy and, secondly, what structural adjustme to national and global economic structures will be necessary to avoid a recurrence of the Asian crisis and its contagion effects in future.

## 5.

The lessons learned from the experience of the past two yearsThe analyses of the reasons for the financial markets' disaster of 1997/98 are still co the dissection of the major casualties is continuing.

Some consensus may be developing, that both at the macroeconomic and at the microeconomic level, important adjustmen necessary to strengthen the fibre of financial systems and markets in order to meet the of the irreversible process of globalisation.

These structural adjustments must include:* An improvement and standardisation of accepted institutional arrangements cov aspects of property protection, bankruptcy procedures and accounting standards.* Bank and other financial institution supervision and regulation must be upgraded, standards of adequate risk management must be introduced.* The architecture, role and policies of the multilateral institutions such as the and the IMF, not only on an ex post basis but also in the prevention of a crisi reviewed.* Policy makers must follow sound and credible economic and financial policies. experience in a number of countries, for example, warned against a policy of ex short-term borrowing by governments and by countries to finance chronic fiscal or of payments deficits.

Credibility comes from monetary policies aimed at achievin stability.

Macro-economic policies that are judged by investors to be responsible that allow free markets to work with undue intervention from governmental authoriti* The international exchange rate regime of floating exchange rates and its contribut increasing volatility of the global financial markets has come under the spotlight.* The need for greater transparency at the level of multinational institutions, go and public sector institutions and, very importantly, also from private sector par global markets has been identified.* The ability of countries to attract long-term foreign capital, e.g. direct foreig should be improved.

This once again leads to the conclusion that exchange controls excessive protectionist policies should be avoided by developing and emerging m countries that want to remain competitive in the global market environment.

## 6.

Prospects for the world economyAlthough there are still a number of downside risks in the global economy, there is optimism that some recovery will take place in most of the more seriously affected econ the East Asian crisis.

The main priorities in these countries are now to end the economic activity, limit the adverse impact of the crisis on the welfare of the most members of the community, promote the resumption of sustainable growth, and accelerati restructuring of financial and corporate sectors.

In Korea, Thailand, and more recently and the Philippines, the tightening of monetary policies that occurred in the wake of th achieved considerable success in re-establishing financial stability.

A strengthening o rates has indeed allowed interest rates to be lowered significantly.In Brazil, a determined and sustained implementation of a front-loaded fiscal adjustme accompanied by appropriately tight monetary policies and wide-ranging structural refmaking an essential contribution to sustaining the improvement in global financial mar sentiment.Russia continues to lack macroeconomic policies that would help to restore the confidence investors and establish the preconditions for sustainable growth.

Once again, however, financial markets of the world have marginalised the Russian situation, and seems to h discounted it as, for the time being, a lost cause.In Japan, the critical challenge for the authorities remains to find a quick and fo restructuring, including a recapitalisation, that will restore the financial health and prof the banking system.

It remains a problem to re-stimulate demand in the highly saving-consci community of Japan.For the other industrial countries, although there have been widespread downward revisions growth projections for 1999, the outlook in most cases is still fairly good.

Continuing inflation provides scope for monetary easing, if warranted, to support demand and out-put gro and also to help stabilise financial markets.There is, therefore, cautious optimism in general that the painful macroeconomic adjustment the past year have succeeded in restoring financial stability in most parts of the world, an basis has been laid now for some recovery in real economic activity in the depressed econom that suffered most from the East Asian crisis of the past two years.

## Note:Information used in this presentation has been taken mainly from: World Economic Outlook and International

Capital Markets - Interim Assessment, December 1998; published by the International Monetary Fund.