Speech The Asian Crisis and Regional Co-operation
Talk to International Seminar on East Asia Financial Crisis
Ross Garnaut has described the Asian crisis as: ‘a defining event in the economic history of East Asia. Like the Great Depression in the West, it has the capacity to change thought about economic development and economic policy in fundamental ways.’ (Garnaut 1998, p 23).
In examining any complex set of events, we impose some order on the messy reality, by fitting the events into prefabricated paradigms. We accept that the fit will not be perfect, but we need to simplify, compare and contrast. Let me pose three questions, which might help to orient the subsequent discussion.
- Was the extraordinary growth performance seen in Asia over the past three decades (the ‘economic miracle’) a temporary growth spurt, not capable of being sustained or regained?
One of the problems in assessing this is the use of the word ‘miracle’. Instead of implying that there was some kind of magic involved, the paradigm should be explained in terms of the application of capital, education and technology to abundant labour supply. Very large productivity gains were reaped from this. This is not magic, but the sensible application of old-fashioned economics. Seen in these terms, then the paradigm is still intact and relevant to the countries in crisis. Even the most technologically advanced of these countries – Korea – still has a capital output ratio less than half that of the United States, so there is still plenty of room to increase productivity before arriving at the technological frontier. That said, as economies become more complex, the investment allocation decisions become more difficult: it becomes more important that they be made by parties operating at arm's length and on the basis of economic criteria.
- What have we learnt about the ‘efficient markets’ paradigm, that says that the free working of markets will generally produce a set of price signals which reflect the economic fundamentals?
The Asian crisis gives a reminder – if this was needed – that financial markets are not only driven by fundamentals, but also by more nebulous issues of confidence. Jeff Sachs has observed: ‘In a matter of just a few months, the Asian economies went from being the darlings of the investment community to being virtual pariahs. There was a touch of the absurd in the unfolding drama, as international money managers harshly castigated the very same Asian governments they were praising just months before but, as often happens in financial markets, euphoria turned to panic without missing a beat.’ (Sachs 1997). Alan Greenspan talks of a ‘massive disengagement of investors and declines in Asian currencies that have no tie to reality.’ (Greenspan 1998).
- Was the crisis largely home-grown (‘domestic’), or were there significant problems in the international linkages?
Clearly there were many domestic factors. But the size and volatility of the foreign capital flows presented a formidable challenge to policy-makers. The large private capital flows to emerging markets were driven, to an important degree, by the easy liquidity conditions overseas, particularly in Japan. It was not current account deficits as such (after all, neither Korea nor Indonesia was running big current account deficits), but rather the volatility of capital flows which created the problem. Private inflows into the five countries which have come under pressure were running at about US$40 billion in 1995, rose to not-far-short of US$100 billion in 1996, and recorded an outflow of more than US$30 billion in the last quarter of 1997.
Let me extract from this thumb-nail sketch of the crisis some conclusions, which can form the basis for the subsequent discussion of the international dimension:
- good rates of growth are achievable, although there is no assurance that all of these countries can easily return to it. The ability to put in place structural and governance reforms will be one of the important criteria for success;
- markets form the core of the only feasible framework for arranging the myriad of complex transactions which make up a modern economy. But markets – particularly financial markets – can be spooked by non-rational fears and herd behaviour;
- the Asian crisis reflects various deficiencies of domestic policy-making, but the fatal combination was a juxtaposition of large and volatile foreign capital flows, with fragile domestic financial systems.
The main job, in getting growth going again, lies with the policy-makers of the countries involved – to re-establish the preconditions of ‘a reasonable level of macro-economic stability; and political coherence around the growth objective’ (Garnaut 1998). This must be done with a keen eye on the micro foundations of the financial systems in these countries – certainly keener than in the past. Those of us not directly involved in this process can do more than wish the policy-makers well. The international community can do something to address the volatility of capital flows that left them, to use Stiglitz's image, like rowboats on a wild and open sea (Stiglitz 1998).
So what elements in the international architecture could be improved to assist with these problems? There are two elements: crisis prevention – what could be done to make international capital flows more stable? Second, crisis mitigation: even when all practicable measures have been taken, from time to time there will still be very disruptive changes of confidence. This has many of the characteristics of an old-fashioned bank run or liquidity crisis: inflows suddenly become outflows, and enterprises which had relied on such inflows find themselves illiquid, even though they may still be solvent. Those who put their money in think, as soon as there is a whiff of trouble, that the best course of action is to be the next one to get their money out. In the case of a domestic liquidity crisis, the basic solution was suggested last century by Bagehot – ‘lend freely, but at a penalty rate’. So this raises the question that if lender-of-last-resort is the correct prescription for a domestic liquidity crisis, where is the international lender-of-last-resort?
The International Architecture
The international response to these problems pre-dates the Asian crisis – it goes back to the 1994/95 Mexican crisis. To complete the picture, we need a quick synopsis of the Mexican story. Mexico relied heavily on short-term capital flows (principally government debt instruments), and there was a progressive loss of confidence during 1994. When the break came, the IMF and the United States (with a minor contribution from Canada) put together a package of US$50 billion of rescue funds. Not all of this was needed, but the central point is that this was a classic Bagehot-type response – a very large amount of money was made available immediately to replace the funds which had left. Seen in isolation, this was a successful rescue. To be sure, Mexico went through considerable pain in 1995, but the economy bounced back quickly.
But for all its success, there was a feeling that Mexico could have been handled better. Prevention is better than cure: to address the question of volatility of capital flows, it was thought that improved data availability would help – uncertainty about the levels of Mexico's foreign exchange reserves had contributed to the loss of confidence in 1994. As well, there were concerns that the rescue operation – which many saw as ‘bailing out’ foreign investors – set a dangerous precedent in terms of ‘moral hazard’ – where investors are protected from the consequences of risky investment, their decisions are distorted.
The Mexican experience – supplemented by the subsequent Asian experience – has gone a long way to setting the agenda for the reform of the international architecture. The G22 meeting held last week in Washington focussed on three elements:
- transparency (i.e. greater information to help markets make more rational decisions);
- strengthening of financial systems to make them more resilient in the face of changes of sentiment;
- how to ensure that the private sector bears a proper share of the burden of any rescue operation, to combat moral hazard.
These are issues which are best handled in worldwide, multilateral arrangements. Of the existing international agencies, the IMF is best placed to enforce greater transparency, make a contribution in strengthening financial markets, and devise new rules which will ensure more adequate private sector burden-sharing. By introducing a new quick-draw facility, the Fund has made at least a first response to the need for a Bagehot-type facility. So the major burden of redesigning and implementing a new international architecture is taking place at the multilateral level. Jacob Frenkel will be talking about the IMF's role in more detail, so I will not trespass on his territory. Instead, I want to explore the question of whether some kind of regional arrangements could supplement the IMF, or address some of the problems encountered with the IMF rescue operations.
Let me go from the general to the particular, to talk about the experience of the regional central bankers' group – EMEAP – over the period of the Asian crisis. I make no apologies for putting central bankers in the forefront of this discussion, because the issues here – international capital flows and strengthening the prudential framework of the financial system – are the bread-and-butter of central bankers. EMEAP is a grouping of eleven East Asian central banks, which get together twice a year at Deputies' level, once a year at Governors' level, and which sponsors three Working Groups which meet two or three times a year. EMEAP has been going for more than five years, and in that time we have all got to know each other very well, and have had frank and very useful discussions. These discussions identified the issues which subsequently proved critical in the crisis – the large capital flows and weaknesses in the financial sectors. When the Governors met in Shanghai in July 1997, it was very clear not only that Thailand was in deep trouble, but this would have important implications for the rest of the region, via contagion effects. This Shanghai EMEAP meeting was very important – it set the stage for the extraordinarily quick pledges which occurred in the August Tokyo meeting for the Thai support group. And yet it was very clear at the Shanghai meeting that EMEAP, itself, would not be able to act as effective lender-of-last-resort. There were two problems:
- this was a central bankers' group, and the pledging of large sums of money for international uses required governmental decisions, not just from central banks;
- it was recognised that any lender-of-last-resort process would also require a co-ordinator or ‘policeman’, which would impose various conditionalities on the recipient country, in the way that has been well accepted over the years by IMF programs.
So the EMEAP group could take the problem only so far, and then pass it on – in this case, to the IMF-sponsored Tokyo support group. This might, in other circumstances, have produced a regional assistance group which could have used the IMF as an implementing agent while retaining regional identity and autonomy for the bilateral funds. But the regional ties were not sufficiently developed for this to occur.
Yet there was still a residual feeling that a regional group had a role to play, for two reasons. First, a regional group could mobilise the strong forces of self-interest and immediate concern that are felt within a small geographically-contiguous group – it would have to be said, quite frankly, that in the case of Australia (which contributed US$1 billion to each of the three support operations in Asia), we would not have been as ready to contribute such relatively large sums outside our region. I am sure the same motivation lay behind the very large contributions made by a number of regional economies. Secondly, there was some feeling that a worldwide rescue operation may lack the specific knowledge to tailor programs precisely for the needs of these countries, and that the decision-making is inefficient because of the large number of parties involved. This turned out to be the case. For many Fund members, the problems of Asia were ‘a small problem, in a distant region about which we know little’. In contrast, within the region there was a better understanding of the problems. In Australia, for example, there was a well-informed and bipartisan discussion when these issues came before the Australian Parliament recently, with both sides of politics exhibiting a depth of knowledge which has simply been absent from the legislative debate in either America or Europe. There is, of course, a need for balance here: too much ‘understanding’ may result in programs that are not sufficiently rigorous to do the job. That said, when it came to tailor the details of the Indonesian program, for example, I doubt that a regional decision-making framework would have made crony capitalism so high-profile and central an issue as it was in the IMF's Indonesian program, which was an important factor in moving the program away from the more immediate economic issues – the collapse of the banking system; the exchange rate; and the foreign debt problem. This is not to argue that there is unanimity within the region on ‘an Asian way’ of doing things, or that the broad lessons of economics learnt around the world in a variety of experiences have no application to Asia, or that reforms on ‘governance’ issues are not needed. Rather, it is to argue that the format of IMF programs reflects earlier experiences (see, for instance, the analysis by Martin Feldstein on the importance of the Russian experience for the design of the IMF Asian programs), combined with the usual difficulties of decision-making where there are a large number of participants. Either this becomes mired in endless debate or (as happens more often in the Fund) the debate is dominated by the largest players. If a reasonably unanimous regional voice emerged over time, and could be effectively articulated, this might be heard more clearly in forums such as the IMF.
To some extent, the development of EMEAP was a reaction to the feeling that Asia was under-represented in the Councils of the World. When we look at the G10, it includes three countries which are substantially smaller than a number of countries in this region. To get things into perspective, EMEAP economies' population is five times that of the European Union, its combined GDP is bigger, it saves much more and its foreign exchange reserves are larger. Of course, various tentative responses to this imbalance are being explored, and the G22 (Willard) meeting in Washington last week might turn out to be a small step in that regard – it is certainly more representative of overall world economic positions than the European-oriented G10 (it includes nine EMEAP economies, whereas G10 includes only one). But I want to leave these multilateral issues aside, to focus on what might be done in the region.
One response which stemmed directly from Bernie Fraser's suggestion of an Asian BIS was that the BIS itself looked further afield and took aboard four new members from the region – China, Korea, Hong Kong, Singapore (plus India). All this is well and good, and a proper response to the imbalances which had developed. These have not yet been fully redressed, but the task is underway.
Inevitably (and often usefully), there are over-lapping regional constituencies, with different priorities. I have focussed on EMEAP, partly because it is the central banks' regional club and the one I know best. But its geographical reach is appropriate. What we are looking for is a degree of homogeneity and commonality of interest which means that discussions have real content. In the case of EMEAP, these economies are at quite different stages of development, but many of the policy-makers share a similar view on the desirable ‘model’ of economic growth. The economists who have played a large role in the individual economic successes of the region share a broadly common view on the role of market forces, which might be contrasted to the dirigiste and control techniques which we saw – at least until recently – in some other parts of Asia. In financial markets especially, there is a belief that reasonably freely operating financial markets – for all their faults – will be an important part of good resource allocation. Within this broad umbrella of similar views there is, of course, room for differences, just as there will be a range of views within each of these countries. But this strengthens the case for a forum of frank and vigorous discussion. So this group of eleven economies looks to be about right, in finding a balance between commonality of interests, sufficient size and importance to have a weight in the Councils of the World, and having a variety of experience which can be brought to bear on the task of moving along the road of development.
But of course this is not the only regional grouping. APEC represents a wider group which crosses the Pacific. The impending arrival of Russia will test its sense of cohesion and immediacy. Going to the other extreme, looking at smaller regional groups, one of the most effective has been ASEAN, whose original membership was confined to core South-East Asia, and which found great commonality because of the tightness of the geographical spread. Then there is the ‘Four Markets’ group (Japan, Singapore, Hong Kong and Australia) and its larger cousin, the ‘Six Markets’ group (the four, plus the United States and China). SEANZA, to some extent a left-over of an earlier era, covers a much wider geographical spread: it still has a role, especially for training. SEACEN, headquartered in Kuala Lumpur, is doing valuable work, particularly in training prudential supervisors.
What is the right geographical area? I think the answer must be that there are ‘different horses for different courses’. As Bernie Fraser put it: ‘What is important is that each group be capable of generating tangible and mutual benefits for its members’ (Fraser 1995). I would simply reiterate that the EMEAP coverage is a powerful one for operational financial issues, and for a wider range of objectives. There is the possibility that the Manila Framework may produce a roughly similar group, covering both Ministries of Finance and central banks, which can be more broadly representative of governments as a whole. This would provide the potential opportunity to hammer out common or co-ordinated positions which could be taken into multilateral forums such as the IMF (a process which already occurs, to some degree, with G7 and G10). There are good hopes, too, that the process of ‘peer surveillance’ within the Manila Group meetings might develop into a process which not only encourages good policies, but will allow each of us to learn more about our neighbours. But as membership widens (the Manila Group is fourteen economies plus three international financial institutions), commonality of interest is weakened, and as delegations get bigger, the meetings lose the intimacy and informality which has been one of the powerful pluses in the EMEAP process.
One of the unresolved issues is the question of regional leadership. In terms of GDP and technological sophistication, the obvious regional leader is Japan. Partly for historical reasons, and partly because of its internal focus, Japan has not exercised the sort of leadership which is commensurate with its economic clout. In terms of population and potential economic size in the long run, China might claim the role. Hong Kong, Singapore and Australia have sophistication of financial markets, but each of these economies is relatively small. While they can and do play an important role in providing an example of how financial markets gather sophistication over time, it is harder for them to take a major leadership role. This raises the issue of whether dominant leadership is, in fact, necessary for effective regional co-operation. Within ASEAN, while Indonesia is the largest in terms of population, there is no dominant leader, and yet this has worked well. The analogy sometimes put forward is of the Internet, where independent centres are linked together without ever specifying precisely where the centre of the network resides. This has worked well enough, but there have been times when strong leadership might have allowed a more vigorous role to be mapped out for EMEAP.
I can only record that, for Australia's part, there is a highly-developed recognition that we need to work very hard on our international relations (as a small country in a big world), and particularly on our relations with Asia (as a small country on the periphery of a culturally different and diverse region which is fundamental to our economic future, with two-thirds of our exports now going to Asia). I like to think that over the past twenty or thirty years, we have come a long way in our understanding of Asia. This process will not be quick, but the European Union and, closer to home, ASEAN, are examples of the eventual fruits of a long-term commitment to closer ties. There have been various side-tracks and bumps in terms of our relations with Asia, but opinion-leaders in Australia accept that this matters more to us than to most countries – we simply have to get along well in our geographical area: because we care more, we will try harder. I think this has been demonstrated in the recent Asian crisis, where the media coverage has been quite diverse (reflecting the full spectrum of opinion), while demonstrating a degree of understanding and, dare I say it, sophistication in international relations.
The central element in my brief, when I was asked to talk to this group, was to update Bernie Fraser's 1995 proposal for an Asian BIS. Looking back on that speech, there was much that was prescient. He said that: ‘the single most important argument for a new regional institution was the advent of global markets’. While acknowledging the benefits, he went on to say: ‘but it also promises a bumpy ride even sound domestic policies may not be sufficient in the face of massive short-term swings in cross-border capital flows. which are potentially volatile and likely to become more so as globalisation spreads. These flows can react quickly to changes in market expectations and news, often independently of changes in economic fundamentals.’. He warned, too, that: ‘assistance that might be available from an institution as large as the IMF (it has the interests of 179 members to reconcile) might not be available as quickly as it is required.’ (Fraser 1995).
Within two years of this speech, these concerns had become reality. And yet it is difficult to believe that, had an Asian BIS been put in place, it would have been able to produce a much better outcome. Perhaps the problem, as Bernie noted in citing the European example, is that it takes a long time to develop effective co-operation. The need is still there: it will take patience and steady application to build the myriad threads that form the fabric of co-operation. A start has been made, by way of EMEAP, the Manila Framework and earlier groups such as APEC, ASEAN and SEACEN. But there is a long way to go.
The IMF records ‘the failure to dampen over-heated pressures … manifested in large external deficits and property and stock market bubbles; second, the maintenance of pegged exchange rate regimes for too long, which encouraged external borrowing and led to excessive exposure to foreign exchange risk … ; and third, lax prudential rules and financial oversight’(Fischer 1998). He also talks about political uncertainties, reluctance to tighten monetary conditions and to close insolvent financial institutions. 
After all, the October 1987 share market crash occurred in a sophisticated, well-informed market. Greenspan observed that: ‘there is no credible scenario that can readily explain so abrupt a change in the fundamentals of long-term valuation on that day.’ (Greenspan 1998). 
To put the very considerable regional contributions into perspective:
The BIS remains a European-oriented institution, with thirteen of its seventeen Board members from Europe. 
It is interesting to note, in passing, that for instance in exchange rate regimes, every variation from currency boards (Hong Kong) to free floating (New Zealand) is represented in this group, and this diversity has given us vigorous and useful debates on important policy topics. 
This would mimic, at a regional level, the G7/BIS arrangements, in which a workable division-of-labour has been established between G7 (Ministries of Finance plus central banks) and BIS (exclusively central banks). 
In the same way that OECD ‘examinations’, over a period of years, encouraged policy improvement in Australia. 
Feldstein, M.S. (1998), ‘Refocusing the IMF’, Foreign Affairs, 29 February <http://www.foreignaffairs.org/feature.html>.
Fischer, S. (1998), The Asian Crisis: A View from the IMF, address at the Midwinter Conference of the Bankers' Association for Foreign Trade, Washington, DC, 22 January <http://www.imf.org/external/np/speeches/1998/012298.htm>.
Fraser, B.W. (1995), ‘Central Bank Co-operation in the Asian Region’, Reserve Bank of Australia Bulletin, October.
Garnaut, R. (1998), The Financial Crisis: A Watershed in Economic Thought About East Asia, paper presented at Economic Society of Australia (Canberra Branch), Canberra, 19 February. (To be published in Asian-Pacific Economic Literature.)
Greenspan, A. (1998), Statement of Chairman of the Board of Governors of the Federal Reserve System before the Committee on Banking and Financial Services, US House of Representatives, Washington, DC, 30 January.
Sachs, J.D. (1997), ‘The Wrong Medicine for Asia’, The New York Times, 3 November.
Stiglitz, J. (1998), The Role of International Financial Institutions in the Current Global Economy, address to the Chicago Council on Foreign Relations, Chicago, 27 February <http://www.worldbank.org>.