Global Financial Turmoil, the IMF, and the New Financial Architecture
Released: 2001-11-15T00:00:00

Introduction

The economies of the world appear to be heading into a simultaneous slowdown and possibleglobal recession that could bear significant consequences for U.S. and world employment,government finances, stock markets, international trade, and capital flows. The poor economicoutlook has been clouded even further following the terrorist attacks on September 11, 2001 in theUnited States, even though industrialized nations around the world have taken action to easemonetary policies in an attempt to forestall further declines in economic growth rates. There hasbeen a sharp curtailment of activity in industries such as travel and tourism, a drop and slow recoveryin stock markets, and sagging consumer confidence not only in the United States but in numerousother countries.

Unlike the Asian financial crisis of 1997-99 when economic strength in the United States and Europe offset weakness in Asia, Russia, and Brazil, this time all major economies seem to beslowing at the same time. The U.S. response to this global downturn has entailed and may requireadditional action by the U.S. Federal Reserve, the Bush Administration, and the Congress in concertwith the International Monetary Fund (IMF) and other multinational organizations.

Congressional interest in this issue is related to: (1) the effects of global economic turmoil on the U.S. economy, (2) operations of the International Monetary Fund, (3) U.S. responses toglobalization, and (4) U.S. policies to stimulate the economy. Among these policy issues, this reportwill focus on the spread and effects of the economic turmoil with a focus on Asia. For informationon globalization, see CRS Report RL30955(pdf) , The Issue of Globalization - an Overview , by Gary J.Wells and CRS Report RL30891 , Global Markets: Evaluating Some Risks the U.S. May Face , by[author name scrubbed]. For information on the IMF, see CRS Report RL30635 , IMF Reform and theInternational Financial Institutions Advisory Commission , by J.F. Hornbeck; CRS Report 98-987(pdf) , Brazil's Economic Reform and the Global Financial Crisis , by J.F. Hornbeck, and CRS Report RL30467(pdf) , IMF and World Bank Activities in Russia and Asia: Some Conflicting Perspectives .

Declining Economic Growth Rates

Following the 1997-99 Asian financial crisis, most countries seemed to be on the path towardrecovery and sustained growth. The dip in economic growth rates was short-lived, and except forIndonesia, countries in Asia which had been the hardest hit by the crisis began recovering relativelyquickly. In 2000, world economies grew by an average of 4.0% with strong growth in grossdomestic product (GDP) in the Former Soviet Union (7.8%), North America (4.1% in the U.S., 4.6%in Canada), Asia/Oceania (4.0%), South America (3.3%), and Western Europe (3.5%). For 2001,world growth is slowing. The growth rate in global GDP is expected to drop by more than half. TheEconomist Intelligence Unit forecasts 1.7% for the year, while DRI-WEFA projects 1.4% (both areeconometric forecasting firms). Anything below 2% is considered to be recessionary for the world. This would be the most rapid deceleration in world economic growth since the 1974 oil price shockand includes truly recessionary economic conditions for many countries.

As shown in Figure 1 , according to DRI-WEFA, world economic growth is forecast to dropfrom 4.0% in 2000 to 1.4% in 2001 and then to recover somewhat to 2.0% in 2002. The drop ingrowth in 2001 is expected to be slightly greater in the United States (1.0% growth in GDP in 2001),Canada (1.3%), and in Japan where growth is expected to drop into negative territory (-1.2%). InWestern Europe, the average growth rate for the Big Four - France, Germany, Italy, and the UnitedKingdom - combined is expected to drop to a sluggish 1.8%. For Latin America, Mexico's growthrate likewise is dropping from 6.9% in 2000 to an expected 0.1% in 2001, while the average forseven South American countries (Argentina, Brazil, Chile, Columbia, Ecuador, Peru, and Venezuela)also drops from 3.3% in 2000 to 1.0% in 2001. The middle-income countries of Asia are dominatedby India and China. Beijing and foreign investors are pumping enough money into the economy tokeep China at 7.2% growth in 2001, while India's growth is holding at about 5.0%. Among otherAsian countries, growth in Hong Kong is expected to plummet from a phenomenal 10.5% in 2000to -0.3% in 2001. Taiwan is in similar straits as growth is dropping from 6% in 2000 to arecessionary -2.1% in 2001. The economic growth rate in South Korea also is plunging from 8.8%in 2000 to 2.0% in 2001.

During the 1997-99 Asian financial crisis, the United States served as an export market of last resort. In 1998, countries in Asia were able to begin recovery largely by exporting to the boomingU.S. market. This time, however, the slowdown in the United States is being spread to many of thecountries in Asia that depend on exports to the U.S. market. Particularly in information technology,as the bust in U.S. information technology markets has proceeded, some of the first suppliers to becut off have been those overseas. Taiwan, in particular, is dropping into recession partly becauseits exports to the United States of electrical machinery (including integrated circuits) and computersare down. As other countries have slowed, moreover, their demand for imports from the UnitedStates also has turned sluggish. Even though overall U.S. exports are declining only slightly, overthe first eight months of 2001 U.S. exports to Taiwan dropped 23% and to South Korea fell by 19%. Some of this is attributable to the strong U.S. dollar, but deteriorating growth abroad is a majorcause. This is combined with declining consumer confidence and problems still unresolved fromthe previous financial crisis. Still, the drop in U.S. imports because of the weak U.S. economy ismore than offsetting the decline in U.S. exports to cause the overall U.S. balance of trade to improvesomewhat.

Contagion in World Financial Crises

How does a financial crisis in one country, such as Thailand in 1997, set off global responses,destroy billions of dollars in wealth, throw millions of people into poverty, and even set off eventsleading to changes of governments? In the current economic scene, how does economic weaknessin one country get transmitted across borders to bring down economic activity in another? What arethe roads of contagion for economic conditions?

Economies always have interacted with each other, but globalization has added a new dimension to the international pathways among them. Financial markets today are international inscope and are more linked, volatile, leveraged, and of greater size than at any time in history. Theeconomies of the world have become more interconnected not only through trade in goods andservices but through flows of investment capital, speculative financial activities, and bank loans. These extensive linkages have combined with rapid communications to make currency and stockmarkets more volatile and easily influenced by events and economic conditions in other countries. Financial investments also have become more leveraged with borrowed funds. When marketssuddenly turn, these highly leveraged positions can generate enormous losses (or gains).

The magnitude of the flows of capital among countries also has become huge and unprecedented. A study by the Bank for International Settlements indicates that the volume offoreign exchange transactions in 43 markets has exploded to an estimated $1.5 trillion per day (aftermaking corrections for double counting) -- or about 60 times as great as world trade in goods andservices. (2) Private capital flows have grown to theextent that many countries no longer can maintainadequate foreign exchange reserves to handle sudden outflows or to keep such outflows frompushing down exchange rates. Between 1990 and 1998, the assets of mature market institutionalinvestors more than doubled to reach $30 trillion - about equal to world gross domestic product. In 2000, net inflows into the United States, the world's largest recipient of capital flows, exceeded$400 billion. This included a record level of foreign portfolio investment in U.S. equities andcorporate bonds.

These increased levels of trade and investment provide the pathways by which business cycles are transmitted from one economy to another. The extent to which foreign economic conditions canaffect a particular economy, however, depends on how large the economy is, how large the foreignsector is relative to the rest of the economy, and whether domestic monetary and fiscal policies aswell as economic activity go counter to or complement that which is happening in other economiesof the world. Each country will experience economic shocks that can be purely domestic, such asthe crash of the information technology market in the United States. Other economic shocks can beglobal, such as a spike in oil prices or a simultaneous downturn in Europe and Asia.

The larger an economy, the less it is likely to be affected by international economic fluctuations. In a world economy of $31 trillion, the economies of the United States ($9.8 trillion GDP), theEuropean Union ($7.8 trillion), and Japan ($3.4 trillion) are large enough that their domesticeconomic conditions tend to affect other economies more than they are affected by them. Still, theyare not immune to international economic conditions, and international commodity prices, such asthat for petroleum, are transmitted to them directly.

For particular countries, the larger its international trade flows relative to the size of its economy, the greater the role trade is likely to have in transmitting effects of foreign business cycles. In the United States and Japan total trade (imports and exports of goods and services) accounts forabout 20% of GDP. In major European countries, total trade accounts for more of GDP (about 50%),but much of this is trade within the European Community. Canada's trade dependence at about 70%of GDP is quite dependent on trade - particularly with the United States, while smaller,export-oriented countries, such as Singapore, in which trade may account for more than 100% ofGDP, are heavily dependent on trade and quite susceptible to fluctuations in external economicconditions.

Over the past three currency crises -- the European crisis in 1992, the Mexican Peso crisis in 1994, and Asia financial crisis in 1997 -- the best predictor of the path of contagion has been alongtrade lines. Currency crises have tended to be regional -- among those countries that trade the mostwith each other or trade with similar markets. (3) Themajor reason that currency crises spread alongtrade lines is that once a country devalues its currency, its neighbors suffer a competitivedisadvantage in export markets and in selling to that country.

Causes of Financial Crises, The Case of Asia

How do financial crises begin? In the case of the 1997-99 Asian case, the global economicturmoil can be traced to many factors - most of them problems with either the financial system oractivities by actors in the system. First, there were foreign exchange rates in Asia tied to theappreciating U.S. dollar and too inflexible to adjust to changing trade and capital flows. Secondwere bankers and corporations who borrowed short-term on international markets to financelong-term investments - some of dubious value - in booming local economies. Third were emergingmarkets without developed financial infrastructure and with insufficient regulation and marketdiscipline in which the allocation of capital and resources was influenced excessively by personalconnections and politics (cronyism). Fourth were highly confident businesses that overbuiltmanufacturing capacity and office buildings in Asia and began to default on bank loans. Fifth werereal estate and stock market bubbles by which excess liquidity was poured into land and corporateequities creating a euphoria as prices rose but also generating huge losses as prices fell.

Some of the above problems have been corrected as part of the reforms following the Asian financial crisis, but some are so deep-rooted in economies that they remain today. The most progresshas been made with exchange rate regimes. Countries now rely on a variety of exchange rateregimes that allow for more flexibility. Some countries, such as China/Hong Kong, Argentina,Estonia, and a number of smaller nations still peg their exchange rate against a single or compositeof currencies. Most large economies allow their currencies to fluctuate either freely or withinspecific crawling bands.

Figure 2 shows the value of the Thai baht, Indonesian rupiah, South Korean won, Japaneseyen,Brazilian real, and Russian ruble relative to the U.S. dollar. The currency depreciation that beganin Thailand in July 1997 rapidly spread across southeast Asia and affected other currencies as well. The dramatic fall in the value of the ruble did not occur until August 1998. By March 2000, theSouth Korean won and Thai baht had recovered to about 80% and the Brazilian real to about 60%of their pre-crisis values. The Indonesian rupiah was at about 32% and the Russian ruble at about20% of their 1997 values, while in 1999-2000 the Japanese yen had appreciated to a level higher thanits pre-crisis level.

Following the September 11, 2001 terrorist attacks, most of these currencies dipped momentarily before recovering. Despite the direct attack on the United States, the lowering of U.S.interest rates, and the prospect that the Federal Government could return to deficit spending, thevalue of the dollar has been rising. The Japanese yen, in particular, has declined in value. Still, therehave been no precipitous drops in exchange values, except that of Brazil, whose rate declined andthen recovered. The most precarious situation in late 2001 was in Argentina. It must chose betweendevaluing its currency, fully dollarizing its economy (adopting the dollar as its domestic currency),or taking similar drastic action.

What is the mechanism by which weakness in one currency drives down the values of other currencies? In order to understand the process, one must recognize that trade flows no longerdominate foreign exchange markets. In times past, foreign exchange was bought primarily for usein foreign trade transactions -- for the international buying and selling of goods and services. Nownon-trade transactions dominate foreign exchange markets. Capital flows completely overshadowtrade flows in value and effect on exchange rates. Foreign currencies are bought by investors seekinghigher rates of return, by wealth-holders seeking safety from political or economic instability, bymultinational corporations building manufacturing or distribution facilities abroad, by speculatorsbetting on movements in exchange rates, and by others for a variety of reasons. Trade flows remainimportant, but they are only one factor in determining foreign exchange values.

Because currencies play such a variety of roles in the world financial system, their value fluctuates as underlying financial conditions, macroeconomic variables, investor expectations, andactions of central monetary authorities change. Like stock markets, there is no sure method ofpredicting short-term movements in exchange rates. Many economists have concluded that, whileunderlying financial and macroeconomic conditions -- such as interest rates, trade deficits, andeconomic growth rates -- influence exchange rates over the long run, in the short run, fluctuationsare more random and unpredictable in nature. (4)

For example, in 1997, once Thailand allowed the value of its currency to fall, Malaysia, the Philippines, and Indonesia -- neighboring countries that compete in similar export markets --suddenly found their exports significantly more expensive than those of Thailand. Not did this affecttheir balance of trade, but speculators and other buyers of foreign exchange placed financial bets thatthose other countries would have to allow their currencies to depreciate also. This unleashedtremendous downward pressures on exchange rates in these countries. In the Asian financial crisis,the lines of transmission led from Thailand to Malaysia, the Philippines, and Indonesia, then laterto Hong Kong and South Korea. After that, the problem became more global as it spread to EasternEurope, Russia and Brazil.

Since underlying macroeconomic conditions affect the long-run exchange rate of a country, speculators and investors may target certain currencies for devaluation if their countries exhibitmacroeconomic and financial features similar to the country that has devalued its currency. Forexample, since Thailand's main problems in 1997 were its weak banks, a rising current accountdeficit, and an accumulation of short-term foreign currency loans, countries with similarmacroeconomic and financial conditions were targeted by speculators. This is one of the reasons thatcountries with scanty trade ties with a country in crisis also can find themselves subject to currencyspeculation or capital flight by their own citizens seeking a safe haven to store their wealth. In 1997,for example, as Hong Kong's currency came under attack, speculators also descended upon Estonia'scurrency. Like Hong Kong, Estonia also has a currency board. In South Korea's case, its currencycame under attack because it too had a weak banking system, an accumulation of short-terminternational loans, and other economic conditions that resembled those of the countries of SoutheastAsia.

Securities Markets

Fluctuations in currency markets also affect stock and securities markets. The process istwo-fold. First, when a currency depreciates it also reduces the value of any asset denominated inthat currency such as stocks and bonds. If investors (both foreign and domestic) in national equitymarkets anticipate a currency depreciation, they may sell their stocks and convert the proceeds intoa foreign currency before the depreciation or before the currency depreciates further. Second, whena country is facing a rapidly declining currency, the country's monetary authorities may raise interestrates (to stem capital flight) and adopt restrictive fiscal policies (to raise savings and reassureinvestors) which may slow economic growth, reduce corporate profits, and raise the return on bondsor money market accounts relative to stocks. Both higher interest rates and lower profits tend toreduce equity values. As funds are moved from a troubled economy to a safer haven (such as theUnited States or Europe), equity values or bond prices may well be bid up in those safe-havencountries.

During the Asian financial crisis, values on equity markets fluctuated almost as much ascurrency values. Figure 3 , shows indices of stock market values on exchanges in the UnitedStates,Japan, South Korea, Hong Kong, and Russia over the period of the worst of the Asian financial crisis- from its onset in July 1997 to June 1999. The similar behavior of the Asian markets as well asboth the positive and negative effects on the U.S. stock market as measured by the Dow-Jones indexis apparent. The market that has recovered the least is the Russian.

As shown in Figure 4 , the September 11 terrorist attacks on the World Trade Center and Pentagon caused U.S. equity values to drop, despite the additional liquidity provided by the FederalReserve and reduction in short-term interest rates. By mid-October, however, major stock marketshad pretty well recovered to their pre-attack levels. Figure 4 also shows that since July 1997, theDow Industrial average has risen about 25%. Japan's Nikkei and South Korea's composite averages,however, still are at 75% to 80% of their July 1997 levels, while those on markets in Russia,Indonesia, and Hong Kong remain at about 50% of their 1997 amounts.

Stock markets can serve as an early barometer and a reflection of the state of economies. For an individual company, if the outlook for its profits diminish, the price of its stock relative toexpected earnings will rise, making its stock price expensive relative to other investments such asmore secure government securities. This is reflected in the price-earnings ratio (PER or P/E) forstocks. A PER of 20 is roughly equivalent to an investment that pays a return of 5%, since a $20investment at 5% would generate a $1 return each year. In the case of Japan's stock market bubblein the 1980s, PERs reached twice or three times normal levels. For the NASDAQ until its crash in2000-01, some PERs were as high as 100 or meaningless because firms were not generating anyprofits at all. Their high stock values were being justified on the basis of future profit potential,much of which never appeared.

In assigning blame for the Asian currency crisis, some pointed the finger at speculators -- even though speculators certainly were not to blame for the underlying economic conditions thatcontributed to the perceived overvaluation of the currencies in the first place. Speculators, oftenmanagers of large international investment funds, generate gains by taking advantage of perceivedweaknesses in exchange rates. They place financial bets on depreciation (or appreciation) based ontheir perceptions of underlying forces of demand and supply. They also combine currencyspeculation with financial maneuvering in derivatives, stocks, securities, and money markets. Forsmaller emerging markets, these financial actions may trigger currency crises and may be paralleledby similar maneuvering by other investors and businesses engaged in currency transactions.

The mechanics of currency speculation are complicated. Essentially the process involves currency buyers and sellers generating profits from fluctuations in exchange rates by using spotmarkets (markets for current delivery of foreign exchange), forward or futures markets (markets forfuture delivery), currency swaps, loans, and other financial maneuvers. The key to this process isthat when speculators expect a depreciation in a local currency, they begin short sales (without thecurrency in hand) of forward or future contracts to deliver that currency at a future date in the hopethat they will be able to buy the currency at a lower price before they have to deliver it. They alsocan speculate in stock market futures by amassing holdings of a currency to dump on the market inorder to elicit a response from monetary authorities who often will raise interest rates in order tomaintain the exchange rate. The higher interest rates, in turn, cause equity values to fall.

Once a currency begins to show signs of weakening, astute investors and speculators who profit from volatility in exchange markets take actions to minimize losses and maximize gains. Theensuing flight from investments in and holdings of the local currency pushes its value down evenfurther until it often overshoots what would be considered an equilibrium rate. Recovery may beslow.

The International Monetary Fund

The International Monetary Fund began operations in 1947 and now has 183 countries who aremembers. Its quotas (financial base) are the equivalent of $272 billion, following a 45% quotaincrease in 1999. The IMF plays a key role during international financial crises in coordinatingsupport packages for its member countries experiencing balance of payments difficulties. Thesepackages include loans and secondary lines of credit. The IMF was created to promote internationalmonetary cooperation; to facilitate the expansion and balanced growth of international trade; topromote exchange stability; to assist in the establishment of a multilateral system of payments; tomake its general resources temporarily available to its members experiencing balance of paymentsdifficulties under adequate safeguards; and to shorten the duration and lessen the degree ofdisequilibrium in the international balances of payments of members. As of June 30, 2001, the IMFhad credit and loans outstanding to 90 countries worth about $65 billion.

The financial assistance provided by the IMF enables countries to rebuild their international reserves, stabilize their currencies, and continue paying for imports without having to impose traderestrictions or capital controls. Unlike development banks, the IMF does not lend for specificprojects. IMF loans are usually provided under an "arrangement," which stipulates the conditionsthe country must meet in order to gain access to the loan. All arrangements must be approved by theExecutive Board, whose 24 directors represent the IMF's 183 member countries. Arrangements arebased on economic programs formulated by countries in consultation with the IMF and are presentedto the IMF Executive Board in a letter of intent (with permission of the borrowing country, lettersof intent are posted on the IMF's Internet site). (5) Loans are then released in phased installments asthe program is carried out. (6)

Financial support packages are initiated by a request to the IMF from the country experiencing financial difficulty. This request then requires an assessment by IMF officials of the conditions inthe requesting nation. If a support package is approved, the IMF usually begins with an initial loanof hard currency to the borrowing nation. Subsequent amounts are made available (usually quarterly)only if certain performance targets are met and program reviews are completed. During the Asianfinancial crisis, the support packages were designed to restore investor confidence -- bothinternational and domestic -- in the economies of the recipient nations. The packages constituteda three-pronged approach to the problems: (1) immediate efforts to restore liquidity in currencymarkets, (2) structural reforms aimed at strengthening financial sectors, and (3) governance issuesunderlying the crisis which included improving the efficiency of markets, breaking the "cronycapitalism" links between business and government in several of the distressed countries, liberalizingcapital markets, and providing for more transparency (in disclosing data on external reserves andliabilities).

The volume of loans provided by the IMF has fluctuated significantly over time. The oil shock of the 1970s and the debt crisis of the 1980s were both followed by sharp increases in IMF lending.In the 1990s, the transition process in Central and Eastern Europe and the crises in emerging marketeconomies led to another surge in the demand for IMF resources. Over the years, the IMF hasdeveloped a number of loan instruments, or "facilities," that are tailored to address the specificcircumstances of its diverse membership. Non-concessional loans are provided through five mainfacilities: Stand-By Arrangements (SBA), the Extended Fund Facility (EFF), the SupplementalReserve Facility (SRF), the Contingent Credit Lines (CCL), and the Compensatory FinancingFacility (CFF). Low-income countries may borrow at a concessional interest rate through thePoverty Reduction and Growth Facility (PRGF).

Except for the PRGF, all facilities are subject to the IMF's market-related interest rate (currently about 4%) which is based on short-term interest rates in the major international markets. The IMFdiscourages excessive use of its resources by imposing a surcharge on large loans. Countries areexpected to repay loans early if their external position allows them to do so.

The major facilities used for stabilizing currencies and preventing financial crises are the Stand-By Arrangements and Extended Fund Facility. The SBA is designed to address short-termbalance-of-payments problems and is the most widely used facility of the IMF. The length of a SBAis typically 12-18 months. Repayment must take place within a maximum of 5 years, but countriesare expected to repay within 2-4 years. The EFF was established in 1974 to help countries addressmore protracted balance-of-payments problems with roots in the structure of the economy. Arrangements under the EFF are longer (3 years) and the repayment period can extend to 10 years,although repayment is expected within 4ï¿½ -7 years. Table 1 summarizes the IMF's Stand-By andExtended Fund Facility loans.

As shown in Table 1 , the largest current borrowers are Argentina, Brazil, Turkey, Indonesia, and the Ukraine. Total Stand-By Arrangements totaled the equivalent of $37.0 billion, whileExtended Arrangements summed to $12.5 billion.

As a result of the Asian financial crisis, the IMF introduced two new facilities to cope with needs for huge amounts of funds for relatively short terms. Introduced in 1997, the SupplementalReserve Facility is designed to meet needs for very short-term financing on a large scale. Countriesmust repay the loan after a maximum of 2.5 years, but are expected to repay one year earlier. AllSRF loans carry a surcharge of 3-5 percentage points.

Also established in 1997, Contingent Credit Lines differ from other IMF facilities in that they aim to help members prevent crises. They are designed for countries implementing sound economicpolicies, which may find themselves threatened by a crisis elsewhere in the world economy becauseof "financial contagion." The CCL is subject to the same repayment conditions as the SRF, butcarries a smaller surcharge.

Table 1. IMF Lending from Its General Resources AccountUnder Stand-by Arrangements and Extended Fund Facilities As of August 31,2001 (In U.S. Dollars)

Note: IMF SDRs (Special Drawing Rights) converted to dollars at 1.28 dollars per SDR.

Source: International Monetary Fund

During the 1997-99 Asian financial crisis, the IMF arranged support packages initially for Thailand, Indonesia, and South Korea and augmented a credit to the Philippines to support its exchange rateand other economic policies. Later, the IMF extended support to Brazil and Russia. The fivesupport packages are summarized in Table 2 . The total amounts of the packages are approximatebecause the IMF lends funds denominated in special drawing rights (SDRs), and because pledgedamounts often change as circumstances change. The initial support package for Thailand was $17.2billion, for Indonesia about $43 billion, and for South Korea $57 billion. The United States pledged$3 billion for Indonesia and $5 billion for South Korea from its Exchange Stabilization Fund (ESF)as a standby credit that may be tapped in an emergency. The U.S. Treasury lends money from theESF at appropriate interest rates and with what it considers to be proper safeguards to limit the riskto American taxpayers.

In addition to IMF support, recipient countries during the Asian financial crisis tapped funds pledged by the World Bank, the Asian Development Bank or, in the case of Brazil, theInter-American Development Bank, and by certain industrialized nations. The World Bank, inparticular, played a key role in attenuating the negative effects of the financial crises on poorerpeople who are less able to shield themselves from recessions. In 1998, the World Bank created aSpecial Financial Operations Unit (SFO) to help respond to financial sector crises. Working closelywith the country departments, the SFO's mandate is to provide immediate support to governmentsto help them stabilize their financial systems, followed by support for structural reforms andresolution of non-viable financial institutions. (7)

Table 2. IMF Support Packages During the Asian Financial Crisis (Amounts in U.S.$Billion)

Note: ADB = Asian Development Bank. IDB = Inter-American Development Bank. Actual amounts disbursed by the IMF's are in SDR's. Development bank figures are for structuraladjustment and exclude funds for customary projects.

*The IMF cancelled the 1998 program after disbursing $4.8 billion. In July 1999, it announced anew program worth $4.5 billion to be paid in tranches of about $640 million each. The first wasdistributed immediately, but the others have been delayed.

Source: IMF, World Bank, ADB, IDB.

In Asia, the Association of Southeast Asian Nations plus Japan, South Korea, and China (ASEAN + 3) have established what is called the Chiang Mai Initiative. This is a regional financingarrangement to supplement existing international facilities. The Initiative involves an expandedASEAN Swap Arrangement for currencies that would include ASEAN countries and a network ofbilateral swap and repurchase agreement facilities among the participating countries.

Japan has a special interest in the Asian financial crisis since it occurred within its region and not only affected its close trading partners and competitors but also threatened bank loans andinvestments by Japanese companies in the area. Japan has been providing financial assistance underwhat it terms the Miyazawa Initiative (named after their Finance Minister). It includes $30 billionin loans to Thailand, Malaysia, the Philippines, Indonesia, and South Korea. This was augmentedin 1999 with a commitment by Japan to assist Asian nations to mobilize another 2 trillion yen (about$17 billion) in domestic and foreign private-sector funds for Asia. (8)

Criticism of the IMF

Following the Asian financial crisis, the IMF came under increased scrutiny and criticism. Various groups and commissions have recommended changes to the methods and scope of itsoperations. For Congress, on March 8, 2000, the congressionally mandated International FinancialInstitution Advisory Commission submitted its report. (9) The Commission considered the future rolesof seven international financial institutions: the International Monetary Fund, the World Bank, threeregional development banks, the World Trade Organization, and the Bank for InternationalSettlements. With respect to the IMF, the Commission made the following recommendations:

The IMF should be restructured as a smaller institution with three major purposes: (1) to serve as a quasi lender of last resort (standby lender to prevent panics) to emergingeconomies, but its lending operations should be limited to the provision of liquidity (short-termfunds) at penalty interest rates (above the borrower's recent market rates) to solvent membergovernments when financial markets close; (2) to collect and publish financial and economic datafrom member countries and disseminate those data in a timely and uniform manner; and (3) toprovide advice (but not impose conditions) relating to economic policy as part of regularconsultations with member countries.

The IMF should be precluded from making other than short-term loans to member countries, particularly long-term loans in exchange for compliance with conditions set bythe IMF.

The IMF's Poverty and Growth facility should be closed and its long-term assistance to foster development and encourage sound economic policies be the responsibility of areconstructed World Bank and regional development banks.

The Commission listed four "pre-conditions" for a country to quality for IMF assistance: (1) a competitive banking system that allows a greater presence for foreign financial institutions; (2) theregular publication of information regarding that nation's outstanding debts and liabilities; (3)commercial banks that are adequately capitalized, and (4) proper fiscal policy. The Commissionsuggested that these rules be phased in over a five-year period and that they be suspended ifnecessary for global stability in the event of a major crisis.

Several members of the Commission dissented from the recommendations of the report. The dissent with respect to the IMF centered on the constraints placed on the IMF in combating financialturmoil and on who would qualify for assistance. The four dissenters, for example, argued that thesuggested pre-conditions for crisis loans would ignore the macroeconomic policy stance of thecountry in turmoil, because the IMF would not be authorized to negotiate policy reform. In short,the IMF might end up supporting countries with runaway budget deficits and profligate monetarypolicies. The pre-qualifying conditions also might preclude support for countries that are critical forglobal financial stability. (10) Other objections bycommission members were that it did not addressworker rights or sustainable development issues and that it might undercut the fight against globalpoverty.

Other studies in the aftermath of the global financial crisis have made recommendations similar to those of the Advisory Commission. In June 1999, the finance ministers of the G7 (Group ofSeven Industrial Nations) recommended reforms in six priority areas:

strengthening and reforming the international financial institutions and arrangements;

enhancing transparency and best practices;

strengthening financial regulation in industrializedcountries;

strengthening macroeconomic policies and financial systems in emergingmarkets;

improving crisis prevention and management, and involving the private sector,and

promoting social policies to protect the poor and mostvulnerable. (11)

In February 1999, the G7 established the Financial Stability Forum which has endorsed a broad range of concrete policy actions to address concerns related to highly leveraged institutions, volatilecapital flows, and offshore financial centers. The Forum aims to promote international financialstability through enhanced information exchange and co-operation in financial supervision andsurveillance. It comprises national authorities responsible for financial stability in significantinternational financial centers, international financial institutions, international supervisory andregulatory bodies, and central bank expert groupings. (12)

A separate study by the Council on Foreign Relations chaired by Carla Hills and Peter Peterson makes recommendations aimed at altering the behavior of emerging-market borrowers and theirprivate creditors in ways that would reduce vulnerabilities in the exchange rate systems of emergingeconomies; inducing private creditors to accept their fair share of the costs of crisis resolution;reforming the IMF's lending policies; and refocusing the mandates of the IMF and the World Bankon leaner agendas. (13)

Treasury Secretary Paul O'Neill, in a statement before Congress, put forth the following as policy considerations for the IMF:

The IMF should focus more on its core objectives which are to: (1) promote sound monetary, fiscal, exchange rate and financial sector policies, (2) carefully monitor economicconditions, and (3) deal with critical problems in the international financial system as soon as theyare detected in order to provide greater financial stability and facilitate trade.

The IMF should put more effort into crisis prevention, including the pursuit of sound policies by countries, the development of robust financial sectors, and the adoption ofinternationally accepted standards and codes.

The IMF needs more transparency, particularly in releasing information and assessments to the private sector in order to enable markets to make informed judgements and togive countries strong incentives to pursue sound policies.

The IMF should increase its accountability to IMF shareholders and taxpayers.

The IMF should not create expectations that reduce the incentives for countries and for individuals to take policy actions essential to prevent crises. Expectations of continued oradditional financial support in the case of poor policy decisions in a country reduce the incentivesto make good economic decisions. Moreover, expectations that countries can and will use IMFfinancial support to meet payments on debt instruments held by the private sector reduce duediligence required to make sound financial decisions.

The IMF should focus its work on areas in which it has expertise and responsibility rather than to use conditions on its loans to go beyond relevant macroeconomicreforms within its expertise. (14)

The IMF Response and New Financial Architecture

The IMF, along with the World Bank and member governments, have been addressing the above criticisms and problems in the international financial architecture. This architecture is theinstitutions, markets, and practices that governments, businesses, and individuals use when theycarry out economic and financial activities. The underlying goal is to build a stronger, more stableinternational financial system that will make the world less vulnerable to financial crises, whileallowing all countries to benefit from the process of globalization.

To date, the most progress by the IMF has been in:

the increase in the quality and candor of economic information that governments and other institutions are making available to the public;

the growing implementation of codes of good practices that are essential to a well-functioning economy; and

the creation of Contingent Credit Lines (CCL), an IMF facility that enables the Fund to lend preemptively to help prevent a crisis. (15)

A fundamental criticism of IMF and governments during the Asian financial crisis was that insufficient information was available to the public to protect their investments and to determinewhat actions the IMF and government were taking. Some also asserted that the IMF keptinformation confidential that might have warned investors of potential problems, although releaseof such information, itself, might trigger precisely the financial crisis the country and the IMF wouldbe attempting to avoid. Governments also were not gathering sufficient data on financialtransactions to assess their exposure to a tightening of credit or financial panic. The IMF nowreleases (with member government permission) Public Information Notices and staff reportsfollowing consultations (under article IV) with member countries, Letters of Intent, and otherdocuments. The Letters of Intent, in particular, provide detail on the actions being required as acondition of loans. The IMF also is releasing statements of the Chairman of its Executive Boardsummarizing the board's views following discussions of a member's use of Fund resources. Mostof these documents are available on the IMF Internet site.

The IMF also claims that substantial progress has been made in developing and assessing internationally accepted financial standards. Standards and codes of good practices help ensure thateconomies function properly at the national level, which is a key prerequisite for a well-functioninginternational system. In consultation with others, the IMF has developed Special Data DisseminationStandard; the Code of Good Practices on Fiscal Transparency; the Code of Good Practices onTransparency in Monetary and Financial Policies; and guidelines concerning financial sectorsoundness. Currently, 47 countries subscribe to the IMF's Special Data Dissemination Standard,which encourages member countries to provide detailed and reliable national economic and financialdata.

A third area of focus for the IMF is in financial sector strengthening, particularly the ability of banks and other financial institutions to improve internal practices, including risk assessment andmanagement; and upgrading supervision and regulation of the financial sector to keep pace with themodern global economy. The IMF and the World Bank have intensified and enhanced theirassessment of countries' financial systems through joint Financial Sector Assessment Programswhich serve to identify potential vulnerabilities in countries' financial systems. The BasleCommittee on Banking Supervision also is addressing gaps in regulatory standards.

A strong criticism of the financial support programs coordinated by the IMF during the Asian financial crisis is that those programs may have created a moral hazard (causing more risky behaviorby reducing the adverse consequence of it). If lenders know the IMF will "bail out" countries unableto repay international debts, for example, lenders may extend loans with risks higher than thosereflected in the interest rate and other terms of the loans. The IMF claims, however, that it worksunder the basic operating principle that its financing should not relieve debtors or creditors of theirresponsibility for the risks they take. Holders of equity incur financial losses immediately as valueson stock markets decline. Holders of loans, however, may not see immediate losses because IMFloans may provide the foreign exchange for countries to service foreign loans. In the resolution offinancial crises, therefore, the IMF is to involve the private sector more in the resolution of crises,particularly lenders and holders of bonds. This may require actions such as debt restructuring bycreditors.

During the Asian financial crisis, the IMF was criticized severely for imposing conditions on its loans that were viewed as too severe for the countries in turmoil. Many blamed IMF conditionsthat resulted in fiscal stringency and high interest rates for causing economies to turn downwardmore than was necessary and throwing millions of people into poverty. A particular complaint wasthat the IMF tended to require that central government budgets be balanced or in surplus despite theneed for fiscal stimulus to combat recessions and to provide a social safety net for the growingnumbers of unemployed workers.

The IMF still views conditionality as indispensable for safeguarding the Fund's resources. It requires certain actions by member governments to ensure that its loans are used appropriately topromote adjustments considered to be necessary to prevent future crises. The IMF, however, alsoclaims that it recognizes that countries cannot carry out major structural changes overnight. TheFund, therefore, asserts that, henceforth, it intends to focus conditionality on those measures that arecritical to the macroeconomic objectives of country programs. The IMF states that will not weakenconditionality but make it more efficient, effective, and focused. There also is broad agreementwithin the IMF that the Fund must promote good governance in borrowing countries, both throughinitiatives - such as the work on standards and codes - and through specific measures to improvethe decision making and administrative processes in government and the private sector.

In 2001, as world economies have been slipping into recession, the IMF is taking measures to keep the world economy on track. (16) It particularlyis working closely with countries such asArgentina to ensure that slowing world economic activity does not trigger another internationalfinancial crisis. This is a test to see if the new international financial architecture is able to preventanother global financial crisis. (17)

U.S. Economic Policy

Since the United States is the largest economy in the world, global economic conditions dependgreatly on the state of the U.S. economy. As the developing recession in the United States has pulleddown other economies, a strong recovery could do much to lift the economies in the rest of theworld. This can be pursued primarily through monetary and fiscal policies - both domestic andcoordinated with those of other nations - and international trade policy being pursued to increaseglobal market efficiency and to ameliorate the adverse effects of foreign unfair trade practices. Withrespect to monetary policy, while Congress plays an important oversight role, actual policy isdetermined by the U.S. Federal Reserve in accord with its own assessments. From mid-1999 thoughmost of 2000, inflation remained a threat, and labor markets were tight. The Fed raised interest ratesseveral times to ease labor and price pressures and to provide alternative investments to thehigh-rising U.S. stock market. As the U.S. economy has slowed, the Federal Reserve has droppedinterest rates aggressively. It lowered, for example, its discount rate (the interest rate it chargesbanks) from 6.0% in 2000 to 5.75% in January 2001 and executed ten more rate cuts until the ratereached 1.5% in November 2001.

With respect to fiscal policy, the 107th Congress has been considering various stimulus packages. In September 2001, Congress passed a $40 billion emergency supplemental appropriation( P.L. 107-38 ) and the $15 billion Air Transportation Safety and System Stabilization Act ( P.L.107-42 ). Various tax cuts provided for by the Tax Relief Reconciliation Act ( P.L. 107-16 ) also areslated to be automatically phased in on January 1, 2001. On October 24, 2001, the House passed theEconomic Security and Recovery Act ( H.R. 3090 ) which seeks to stimulate theeconomy through several tax reductions including changes in capital depreciation deductions, repealof the corporate alternative minimum tax, acceleration of the phase-in of the 25% marginal incometax bracket adopted in P.L. 107-16 , and a supplemental income tax rebate for those who did notreceive a full rebate under that law.

As for international trade policy, pressures are building in two areas. The first is in the size of the U.S. trade deficit. The merchandise trade deficit reached a high of $328.8 billion in 1999 andincreased further to a record $436.1 billion in 2000. The U.S. current account deficit likewisereached $324.4 billion in 1999 and a record $444.7 billion in 2000. While these deficits currentlyare being matched by inflows of capital into the relatively safe U.S. market, the trade imbalancereflects growing pressures on U.S. industries that export to the troubled economies or compete withimports. While reducing the trade deficit, itself, is not necessarily an objective of U.S. trade policy,increasing U.S. exports, enhancing market efficiency through reducing import barriers abroad, andensuring that imports into the American market are traded fairly are U.S. policy goals. The UnitedStates can open markets abroad through trade negotiations, coordinate monetary and fiscal policiesto encourage other nations to stimulate their economies more, and impose import barriers to protectU.S. industries from unfair foreign trade practices - particularly dumping.

Appendix: Archive of News Topics (18)

MEXICO Mexico's real investment was down 2.9% year over year (y/y) inthe first seven months of the year. On a monthly basis, real investment contracted 4.8% y/y in July,which is an improvement from June's 8.5% drop. July's relative improvement was due to a smallercontraction of construction investment (-2.7%). This sector was hit hard in the first half of the yearbut currently seems to be benefitting from lower interest rates and higher public spending. Meanwhile, investment in equipment and machinery contracted 6.6% y/y in July. (Oct. 9,2001)

TERRORIST ATTACKS on the World Trade Center and Pentagon caused sharp declines in stock values and are expected to cause consumer confidence to decline andeconomic activity to slow. (Sept. 20, 2001)

TREASURY SECRETARY O'NEIL at the APEC Finance Ministers meeting stated that the United States could not shoulder the burden of reversing the global slowdown on itsown, and that other nations must do their share - particularly Japan, which needed "decisive action"to cure the decade-long economic malaise that has sapped the economic health of the entire region. (Sept. 7, 2001)

IMF AND WORLD BANK ANNUAL MEETINGS scheduled to be held in Washington, D.C. on September 29-30, 2001, were cancelled following the September 11 terroristattacks. (Sept. 17, 2001)

BRAZIL The IMF approved a 15-month US$15.58 Billion Stand-By Credit for Brazil in support of the government's economic and financial program through December 2002. (Sept. 14, 2001)

ARGENTINA IMF Managing Director Horst KÃ¶hler recommended that Argentina's Stand-by Credit be augmented by $8 billion to a total of about $22 billion. (Aug. 21,2001)