Ms. Rivlin remarks on lessons drawn from the Asian financial crisis  (Central Bank Articles and Speeches, 23 Apr 98)
Central bank: fed | Type: speech | Date: 1998-04-23

Ms. Rivlin remarks on lessons drawn from the Asian financial crisis Remarks by the Vice-Chair of the US Federal Reserve System, Ms. Alice M.

Rivlin, before the Hym Minsky Conference on Financial Structure at The Levy Institute in Annandale-on-Hudson, York on 23/4/98.

## Toward A Better Class of Financial Crises: Some Lessons from AsiaDrawing

lessons from the Asian financial crisis has become a minor indus partially offsetting the impact of the crisis on developed economies -- at least for ec contributes to conference budgets, airline revenues, bar tabs, and the length of academi The opining classes can turn almost any bad news into an excuse for more meetings in be settings like Bard College.Some of the talk has been devoted to the blame game.

Was the crisis (or rath rolling set of interrelated crises) home-grown, that is, brought on by ill-conceived over-leveraged companies, lax banking supervision and crony capitalism in the borrowing cou Was it the greed, inattention, or herd instinct of the lenders?

Or was it the inherent international capital flows?

Did the IMF step in just in time to avert total meltdown or provide early enough warning?

Did the conditions imposed on borrowers help restore in confidence or further undermine it?The quick answer is that all of the alleged culprits bear part of the resp International flows of capital can be unstable -- what flows in can quickly flow out -- a enormous escalation in the volume of private capital flows, coupled with the advent of sim communication in all the world's markets, has greatly increased the exposure of economies turnarounds in cross-border flows.

Decades of rapid growth and apparently unending capital had made the Asian emerging markets, until recently known as 'tigers', believe they were from the reversals of investor confidence that beset other parts of the world and pr incaution that led to over investment in some sectors, inflated equity and real estate pric ill-thought-out projects, public and private.

Close relations between companies, ba governments created false senses of security, as well as uneconomic 'policy' loans and inv Weak supervision of financial institutions and markets, on top of traditions of secrecy and governmental transactions, aggravated the crises when things turned down.

At the sam foreign investors and creditors asked too few questions, were hesitant to reign in the gal that had laid so many golden eggs, and reinforced each other's reluctance to be the first As tensions were developing, the IMF pointed to some of the dangers without getting response, and missed some others, as did the much-vaunted market gurus and rating agencies the crises hit, the IMF quickly crafted rescue packages that imposed serious structural conditions of aid, inevitably making some mistakes in the process, but arresting the downward spiral and restoring enough confidence to allow the countries to get their policie to support the climb back to economic health.

No one thinks the climb will be easy, but t is that the worst is over.Now the talk has shifted to the more difficult subject of what the inter community can do to prevent, mitigate and manage financial crises in the future.

The stakes for industrial and emerging market countries alike.

When international capital markets func they help achieve rising standards of living for both creditor and debtor countries.

When crash, they bring incredible hardship to ordinary workers and their families -- often peopl been pulled out of their traditional occupations and communities by economic change and ma nothing to fall back on.Two sets of prescriptions are relatively uncontroversial, albeit deceptively achieve.

First, the world's capital markets and the machinery designed to stabilize th function better with more complete, accessible and timely information flows.

Investors c better decisions and lenders can exercise more discipline over borrower behavior if they accurate and more complete information and have it sooner.

Both international and do officials can monitor, supervise and warn of impending danger only if they know the Improving transparency should apply not only to businesses and banks, but to official bod national and international.

It's important to know what a country's budget deficit really i and off budget) and what its exchange reserves really are, including any operations in t markets.

The Asian crisis was certainly exacerbated by lack of information of many sorts, accurate data on reserves.There is currently a great flurry of activity in various international for standards of accounting and reporting on business, banking and governmental activity and sheets.

Progress will be made.

But one should not expect too much.

Although post morte financial crises, especially reviews of investor decisions that went sour, feature a g if-only-we-had-known rhetoric, in actual fact a great deal of information usually turns been available which no one ever looked at or effectively analyzed.

For transparency to people need to actually want to look -- and too often those who are making high profits wo not hear bad news.Second, a major sustained international effort is needed to strengthen the s functioning and supervision of financial systems in emerging market countries.

A clear recent economic history (and not just in emerging market countries) is the crucial impo strong banks and other financial institutions, adequately capitalized and able to ma overseen by serious prudential supervision and an independent well managed central bank.

In countries can ill-afford to be sanctimonious on this score -- many of us have experienced t effects of poor prudential supervision or lack of political will to close failing financia but good management and strong supervision of financial institutions is clearly a key to wi economic shocks.Here, too, consensus is strong and serious activity is underway under the ae variety of international bodies, perhaps too many, to evolve clear rules for financial sup help countries implement them.

The task will require time, patience and resources.

It is n examiners, but bankers who need training in how to do their jobs in modern, fast internationally exposed economies.

Strengthening financial systems, including improving co governance, goes hand in hand with efforts to improve transparency and information flow investors, shareholders, supervisors and international agencies -- and both will requir effort and run into significant resistance.The first two prescriptions are preventive, designed to reduce the frequen amplitude of financial crises.

But no one with a sense of history -- or reality -- belie can be eliminated.

Hence, a third prescription also appears on everybody's list, albeit w agreement on what it means, namely, private creditors should take on a greater portion of of resolving future international financial crises.

Sharing the burden is a far more diff come to grips with conceptually than either the need for greater transparency or the stronger, better supervised financial systems.

Not much intellectual structure yet exists about burden-sharing in international financial crises.

Moreover, cross-border financing so rapidly and market instruments are morphing so fast that designing ways of sharing the like changing the tires on a moving car -- pretty exciting and not obviously doable.The task cannot be set aside, however, for at least two reasons.

First, th resolving international financial crises is outrunning the likely resources available for The volume of cross-border flows has grown precipitously and the cost of breakdown has es with it.

High speed traffic on a six lane freeway moves a lot of people to their destinat the pile-up in a wreck is a lot more expensive than on a winding two lane road.

If rec continue, managing the next crisis will call for more resources than taxpayers in the Un and other developed countries are likely to feel comfortable turning over to the IMF international organizations, even if they are reasonably confident that the borrowing cou pay the loans back, as experience indicates they will.Second, and far more important, the perception that official resources can be on to bail out creditors (directly or indirectly) arguably generates moral hazard.

It c excessive risk-taking by lenders and funding of less economically defensible projects.

I channel financing into less stable forms whose overuse makes crises more likely to occur. episodes, direct investors and holders of equity and long-term debt have taken serious l short-term lenders, especially interbank lenders, have been largely protected.

While a trouble has understandable reasons for not wanting to cut itself off from short-term bank for using its scarce international resources to keep this lifeline attached, the resu reinforce excessive dependence on debt rather than equity and on short, rather than lo financing.Both reasons combine to create an urgent need for serious and creative thought part of the international community about how to 'bail in' private sector financiers, reduce the impact on the financial resources of official institutions like the IMF, the Wor the regional development banks, to reduce moral hazard leading to excessive risk-taking, short-term inter-bank borrowing, and to improve risk assessment.Designing mechanisms for appropriate burden sharing among private secto investor/creditors is inherently hard because it runs into some very sticky and fu dilemmas.

The basic principle from which all borrowing and lending must proceed is that who use other people's money have a firm obligation to pay it back.

Hence, a suspens payments or a work-out arrangement must be clearly rare and exceptional, resorted to extreme situations.

Raising fears that suspensions are likely or work-outs normal could unn increase the cost of capital, cause drastic reductions in cross-border flows and dimi incomes of debtors and creditors alike.

Yet having no known or understood process for deal default can, as has been seen in Asia, lead to inequitable burden sharing, high offici potential future moral hazard.A related basic dilemma involves the timing of a suspension of payments.

Autho have to hold off long enough to be sure there is no other choice, but not wait so long th are running for the doors and irreversible damage is already done.The problem is, of course, not entirely new.

International borrowers have gott trouble before, and precedents for workouts have been developed -- Paris Club procedu resolving sovereign debts to public creditors; London Club for resolving sovereign debts banks.

But each crisis is different from the last.

A critical element in the Mexican cris was the threat of default on dollar-indexed Mexican short-term bonds (tesebonos 1 ) for which no work-out process existed.

Dealing with bond holders (who are likely to be numerous and sc is more complex than dealing with lending governments or a relatively small (and known) g1 Tesebonos were technically denominated in pesos.international banks.

The recent Asian crises posed still another problem.

The borrowers governments, but private banks and corporations, a situation that may be typical of future one that adds greatly to the legal and organizational complexities of sharing the burden distress.When the debt in question is sovereign debt, whether to banks or other lend may not be hard to re-establish stability and confidence in the sovereign.

The IMF can le to solve the borrowing government's immediate liquidity problem while the government works debt restructuring with its creditors.

IMF rules permit 'lending into arrears' in these cirIf the creditors are bondholders, as they were in Mexico, the situation difficult.

IMF rules do not at present permit a government borrowing from the IMF when it to pay its bondholders.

Even a small minority of the bondholders can use their bargaining obstruct a resolution of the crisis in hopes of getting a better deal.

After the Mexican c resolved with the help of significant new official lending to Mexico, the international focused on how to improve the bargaining position of the debtor government with its bondho such a crisis should arise in the future.The 'Rey Report' on Sovereign Liquidity Crises (named for its author, Jean-Jac Rey of the Central Bank of Belgium) was a major effort by the G-10 countries to learn the l Mexico.

It recommended two new steps:- First, the IMF should expand its willingness to lend into arrears to co situation in which a sovereign was making a good faith effort to work out restructuring with its bondholders.- Second, it recommended that bonds issued in international markets cont clauses that would facilitate debt restructuring if it became necessary. could be added to provide for debt-holder representation in negotiations w sovereign or qualified majority voting on changes in terms.

Such clauses w make it harder for minority creditors to block restructuring or exact a price than necessary to satisfy the majority.Neither of these recommendations received much official attention until the crisis hit.

Although the recommendations were not actually germane to the situation in Asia reviewed the recommendations at its Interim Committee meeting in April 1998 and action near future seems more likely than a year ago.

Perhaps the official community will alway crisis late.Unlike the sovereign debt crises in Latin America, the situation in Asia i private debts (of banks in Korea, corporations in Indonesia, and some of each in Thailand) creditors, mostly banks.

Hence, it was inherently harder, as currency values plummeted and all but disappeared, to design ways either to restore stability or to organize work-outs.An additional complication was the fact that, although the debts were private of them involved varying types of implied government guarantees.

In Korea, the Finance M ill-advisedly volunteered that the Korean government would honor foreign debts of Korean When the Korean banks experienced difficulty rolling over their international bank loans, of Korea provided the reserves they needed to repay the loans, in effect delivering on the but rapidly depleting the central bank's reserves in the process.

Guarantees of this sort moral hazard.

Pre-crisis, they result in more bank lending than would otherwise have tak and when trouble begins they may accelerate a bank run.

But much less explicit guaranteestrouble as well.

Where governments are heavily intertwined with banks and companies, as ha normal throughout much of Asia, foreign lenders and investors may well assume that government will not allow favored operations to fail.

One of the challenges of mitiga managing future crises, therefore, is finding ways to discourage emerging market governmen guaranteeing private debts or being so closely involved with private enterprises that these are seen as immune from market forces.The expectation that future borrowers in international markets will be mostly enterprises, greatly increases the importance of the first two prescriptions -- increasing and strengthening financial system surveillance -- not just to prevent and mitigate cri manage them when they happen.In an economy that tolerates secrecy in business and financial dealings and information disclosures are limited, firms with fairly shaky fundamentals may be able t easily in a boom.

They will be carried along by the general optimism, since everyone w believe the best and there is no tradition of asking hard questions anyway.

But in a cr participants tend to believe the worst.

To contain the crisis and restore confidence, it both for managers and public authorities to be able to deliver the bad news and be belie markets.

If there is no tradition of accurate, high quality information that can be reli participants and bank depositors are likely to believe that things are substantially wor really are and proceed to prove it by their actions.

A culture of transparency and time information can serve as an economic stabilizer in both directions.

It can restrain th enabling investors to assess risk more accurately, and it can cushion over-reaction once a slide begins.

But such a culture cannot be built quickly, and even where it exists, assiduously maintained.Similarly, prudential supervision of financial institutions may be thought primarily valuable for crisis prevention -- useful for ensuring that financial inst adequately capitalized, don't take unacceptable risks with other people's money, and that ones are required to shape up or go under.

Once a crisis hits, however, it is important t distinguish strong from weak institutions, those that ought to be rescued from those that closed.

Unless supervision has been effective on an ongoing basis, however, the supervisor be able to tell strong from weak and will not be able to find out fast enough to prevent institutions then go down with the bad.

It is actually in the long-run interest of financ that aspire to be the survivors of a shake-out to insist that supervisors are well informed a high standard.Another lesson of recent events in Asia has been the importance of clear, enfo bankruptcy laws in dealing with a crisis, as well as helping to prevent one.

Bankruptcy p opportunity, not only for closing down truly insolvent enterprises in an orderly way, but troubled ones by allowing them to cut a deal with their creditors, restructure their obliga on operating on a sounder basis.

But bankruptcy procedures cannot be rapidly invented or fi in a crisis.

For bankruptcy procedures to mitigate crises effectively and help to get surv feet, there has to be a 'culture of bankruptcy' which operates in good times as well as ba creditors, lawyers and courts have to be used in the process, know what to do, be able, be have done it before, to cut the deals that will minimize the damage and keep potentially enterprises afloat.

Asian countries, most obviously Indonesia, found that since their mod experience had been primarily one of boom and growth, they had inadequate bankruptcy law little 'culture of bankruptcy' to help manage a sudden negative turn of events.Improving transparency, supervision and bankruptcy procedures will help emerg market economies grow more sustainably (albeit perhaps slower) and manage downturns bewhen they happen.

But the conceptually hard questions involve international collective a how it can manage major crises more effectively.Once a crisis hits one country, especially a country of significant size an with others, the whole international community has a strong interest in rapid action markets and prevent the contagion from spreading and engulfing others.

At this momen community looks to the IMF to act quickly, provide liquidity and restore confidence, espe confidence that the crises has bottomed out and will not be part of a continuing downwar Asia in 1997 was a demonstration of how fast the dominoes could fall.When the root cause of the problem is inappropriate macro-economic poli especially big budget deficits and easy money combined with a pegged exchange rate, it may difficult for the IMF to restore confidence by injecting enough liquidity to pay short-te foreign currency in return for rapid changes in policy.

When macro policy is not obviously culprit, restoring confidence may be harder and more expensive.Injecting new money in exchange for reforms may still be the primary answer, bu patience of taxpayers wears thin as amounts escalate and it is perceived that some c creditors are being bailed out with official international resources -- creditors who calculated the risks more accurately and should bear the cost of not having done so, so the it again.Some have asked whether official resources could be saved and moral haza reduced by designing an automatic international bankruptcy-like process, known in advan which a standstill could be triggered, followed by a set procedure for sharing the burden the relevant creditors.

Serious thought is being devoted to this issue.

It is not hard to i approach, but all crises are different and applying a cooky cutter solution could well do than good.The next few years will be a testing time for what I think of as the 'cros community', meaning the organizations, public and private, dedicated to making the cross relationships (especially business and financial ones) work better.

The 'cross-border co includes mega firms that produce goods and deliver financial services on a worldwide sc associations of accountants, lawyers, bankers, securities dealers, insurance underwriters kinds of financial regulators as well as general international financial institutions (th World Bank) and more specialized ones such as the Bank for International Settlements, regional development banks -- to mention only a few of the more obvious members of a burge species.The benefits of cross-border trade and capital flows for raising the world sta living are clear, but so are some of the costs -- especially the costs to ordinary people o in the backwash when there is a crisis.

If these costs are not taken seriously and methods mitigate and manage financial crises better, a wave of political backlash against c foreigners and what we all think is 'progress' could result.

One lesson of recent cri factories, banks, shiny buildings, and eager investors do not by themselves create the und of modern economic society able to withstand shocks with minimal damage.

That takes addition to good fiscal, monetary and other public policies -- an infrastructure of laws a and expectations that cannot be built overnight or imposed from the outside.

The challeng cross-border community will be to work closely with emerging market economies to help them this infrastructure in ways that work for them.

Wading in and saying, 'do it our way' wo The process will involve continuous interaction and adaptation and may well result i functioning economies in the so-called developed world, as well.