Chapter 10 Outline

Recent Activities and the Future of the IMF

Many observers initially believed that the collapse of the Bretton Woods system in 1973 would diminish the role of the IMF within the international monetary system. The IMF's original function was to provide a pool of money from which members could borrow, short term, to adjust their balance-of-payments position and maintain their exchange rate. Some believed the demand for short-term loans would be considerably diminished under a floating exchange rate regime. A trade deficit would presumably lead to a decline in a country's exchange rate, which would help reduce imports and boost exports. No temporary IMF adjustment loan would be needed. Consistent with this, after 1973 most industrialized countries tended to let the foreign exchange market determine exchange rates in response to demand and supply. No major industrial country has borrowed funds from the IMF since the mid-1970s, when Great Britain and Italy did. Since the early 1970s, the rapid development of global capital markets has allowed developed countries such as Great Britain and the United States to finance their deficits by borrowing private money, as opposed to drawing on IMF funds.

Despite these developments, the activities of the IMF have expanded over the past 30 years. By 1997, the IMF had 182 members, 75 of which had IMF programs in place, and the institution was implementing its largest rescue packages, committing over $110 billion in short-term loans to three troubled Asian countries--South Korea, Indonesia, and Thailand. The IMF's activities have expanded because periodic financial crises have continued to hit many economies in the post-Bretton Woods era, particularly among the world's developing nations. The IMF has repeatedly lent money to nations experiencing financial crises, requesting in return that the governments enact certain macroeconomic policies. As in the case of Zaire, which was profiled in the opening case, critics of the IMF claim these policies have not always been as beneficial as the IMF might have hoped and in some cases may have made things worse. With the recent extension of IMF loans to several Asian economies, these criticisms have reached new levels and a vigorous debate is under way as to the appropriate role of the IMF. In this section, we shall discuss some of the main challenges the IMF has had to deal with over the last quarter of a century and review the ongoing debate over the role of the IMF.

Financial Crises in the Post-Bretton Woods Era

A number of broad types of financial crisis have occurred over the last quarter of a century, many of which have required IMF involvement. A currency crisis occurs when a speculative attack on the exchange value of a currency results in a sharp depreciation in the value of the currency or forces authorities to expend large volumes of international currency reserves and sharply increase interest rates to defend the prevailing exchange rate. A banking crisis refers to a loss of confidence in the banking system that leads to a run on banks, as individuals and companies withdraw their deposits. A foreign debt crisis is a situation in which a country cannot service its foreign debt obligations, whether private sector or government debt. These crises tend to have common underlying macroeconomic causes: high relative price inflation rates, a widening current account deficit, excessive expansion of domestic borrowing, and asset price inflation (such as sharp increases in stock and property prices).¹⁴ At times, elements of currency, banking, and debt crises may be present simultaneously, as in the 1997 Asian crisis.

To assess the frequency of financial crises, the IMF recently looked at the macroeconomic performance of a group of 53 countries from 1975 to 1997 (22 of these countries were developed nations, and 31 were developing countries).¹⁵ The IMF found there were 158 currency crises, including 55 episodes in which a country's currency declined by more than 25 percent. There were also 54 banking crises. The IMF's data, which are summarized in Figure 10.3, suggest that developing nations were more than twice as likely to experience currency and banking crises than developed nations. It is not surprising, therefore, that most of the IMF's loan activities since the mid-1970s have been targeted toward developing nations.

Four crises have been of particular significance: in terms of IMF involvement, the Third World debt crisis of the 1980s, the crisis experienced by Russia as it moved toward a market-based economic system, the 1995 Mexican currency crisis, and the 1997 Asian financial crisis. All four of these crisis were the result of excessive foreign borrowings, a weak or poorly regulated banking system, and high inflation rates. These factors came together to trigger simultaneous debt and currency crises. Checking the resulting crises required IMF involvement.

Third World Debt Crisis

The Third World debt crisis had its roots in the OPEC oil price hikes of 1973 and 1979. These resulted in massive flows of funds from the major oil-importing nations (Germany, Japan, and the United States) to the oil-producing nations of OPEC. Commercial banks stepped in to recycle this money, borrowing from OPEC countries and lending to governments and businesses around the world. Much of the recycled money ended up in the form of loans to the governments of various Latin American and African nations. The loans were made on the basis of optimistic assessments about these nations' growth prospects, which did not materialize. Instead, Third World economic growth was choked off in the early 1980s by a combination of factors, including high inflation, rising short-term interest rates (which increased the costs of servicing the debt), and recession conditions in many industrialized nations (which were the markets for Third World goods).

The consequence was a Third World debt crisis of huge proportions. At one point it was calculated that commercial banks had over $1 trillion of bad debts on their books, debts that the debtor nations had no hope of paying off. Against this background, Mexico announced in 1982 that it could no longer service its $80 billion in international debt without an immediate new loan of $3 billion. Brazil quickly followed, revealing it could not meet the required payments on its borrowed $87 billion.

Figure 10.3

Incidence of Currency and Banking Crises, 1975 - 1997

Source: International Monetary Fund, World Economic Outlook, 1998 (Washington, DC: IMF, May 1998), p. 77.

Then Argentina and several dozen other countries of lesser credit standings followed suit. The international monetary system faced a crisis of enormous dimensions.

Into the breach stepped the IMF. Together with several Western governments, particularly that of the United States, the IMF emerged as the key player in resolving the debt crisis. The deal with Mexico involved three elements: (1) rescheduling of Mexico's old debt, (2) new loans to Mexico from the IMF, the World Bank, and commercial banks, and (3) the Mexican government's agreement to abide by a set of IMF-dictated macroeconomic prescriptions for its economy, including tight control over the growth of the money supply and major cuts in government spending.

However, the IMF's solution to the debt crisis contained a major weakness: It depended on the rapid resumption of growth in the debtor nations. If this occurred, their capacity to repay debt would grow faster than their debt itself, and the crisis would be resolved. By the mid-1980s, it was clear this was not going to happen. The IMF-imposed macroeconomic policies did bring the trade deficits and inflation rates of many debtor nations under control, but it created sharp contractions in their economic growth rates.

It was apparent by 1989 that the debt problem was not going to be solved merely by rescheduling debt. In April of that year, the IMF endorsed a new approach that had been proposed by Nicholas Brady, the US Treasury secretary. The Brady Plan, as it became known, stated that debt reduction, as distinguished from debt rescheduling, was a necessary part of the solution and the IMF and World Bank would assume roles in financing it. The essence of the plan was that the IMF, the World Bank, and the Japanese government would each contribute $10 billion toward debt reduction. To gain access to these funds, a debtor nation would once again have to submit to imposed conditions for macroeconomic policy management and debt repayment. The first application of the Brady Plan was the Mexican debt reduction of 1989. The deal reduced Mexico's 1989 debt of $107 billion by about $15 billion and until 1995 was widely regarded as a success.¹⁶

Mexican Currency Crisis of 1995

The Mexican peso had been pegged to the dollar since the early 1980s when the International Monetary Fund had made it a condition for lending money to the Mexican government to help bail the country out of a 1982 financial crisis. Under the IMF-brokered arrangement, the peso had been allowed to trade within a tolerance band of plus or minus 3 percent against the dollar. The band was also permitted to "crawl" down daily, allowing for an annual peso depreciation of about 4 percent against the dollar. The IMF believed that the need to maintain the exchange rate within a fairly narrow trading band would force the Mexican government to adopt stringent financial policies to limit the growth in the money supply and contain inflation.

Until the early 1990s, it looked as if the IMF policy had worked. However, the strains were beginning to show by 1994. Since the mid-1980s, Mexican producer prices had risen 45 percent more than prices in the United States, and yet there had not been a corresponding adjustment in the exchange rate. By late 1994 , Mexico was running a $17 billion trade deficit, which amounted to some 6 percent of the country's gross domestic product and there had been an uncomfortably rapid expansion in the countries public and private-sector debt. Despite these strains, Mexican government officials had been stating publicly that they would support the peso's dollar peg at around $1 = 3.5 pesos by adopting appropriate monetary policies and by intervening in the currency markets if necessary. Encouraged by such public statements, $64 billion of foreign investment money poured into Mexico between 1990 and 1994 as corporations and mutual fund money managers sought to take advantage of the booming economy.

However, many currency traders concluded that the peso would have to be devalued, and they began to dump pesos on the foreign exchange market. The government tried to hold the line by buying pesos and selling dollars, but it lacked the foreign currency reserves required to halt the speculative tide (Mexico's foreign exchange reserves fell from $6 billion at the beginning of 1994 to under $3.5 billion at the end of the year). In mid-December 1994, the Mexican government abruptly announced a devaluation. Immediately, much of the short-term investment money that had flowed into Mexican stocks and bonds over the previous year reversed its course, as foreign investors bailed out of peso-denominated financial assets. This exacerbated the sell-off of the peso and contributed to the rapid 40 percent drop in its value.

The IMF stepped in again, this time arm in arm with the US government and the Bank for International Settlements. Together the three institutions pledged close to $50 billion to help Mexico stabilize the peso and to redeem $47 billion of public and private-sector debt that was set to mature in 1995. Of this amount, $20 billion came from the US government and another $18 billion came from the IMF (which made Mexico the largest recipient of IMF aid up until that point). Without the aid package, Mexico would probably have defaulted on its debt obligations, and the peso would have gone into free fall. As is normal in such cases, the IMF insisted on tight monetary policies and further cuts in public spending, both of which helped push the country into a deep recession. However, the recession was relatively short-lived, and by 1997 the country was once more on a growth path, had pared down its debt, and had paid back the $20 billion borrowed from the US government ahead of schedule.¹⁷ (The accompanying Management Focus details how this crisis affected the US automobile industry, which before the crisis, was experiencing booming sales in Mexico.)

Russian Ruble Crisis

The IMF's involvement in Russia came about as the result of a persistent decline in the value of the Russian ruble, which was the product of high inflation rates and growing public-sector debt. Between January 1992 and April 1995, the value of the ruble against the US dollar fell from $1=R125 to $1=R5130. This fall occurred while Russia was implementing an economic reform program designed to transform the country's crumbling centrally planned economy into a dynamic market economy. The reform program involved a number of steps, including the removal of price controls on January 1, 1992. Prices surged immediately and inflation was soon running at a monthly rate of about 30 percent. For the whole of 1992, the inflation rate in Russia was 3,000 percent. The annual rate for 1993 was approximately 900 percent.

Several factors contributed to Russia's high inflation. Prices had been held at artificially low levels by state planners during the Communist era. At the same time there was a shortage of many basic goods, so with nothing to spend their money on, many Russians simply hoarded rubles. After the liberalization of price controls, the country was suddenly awash in rubles chasing a still limited supply of goods. The result was to rapidly bid up prices. The inflationary fires that followed price liberalization were stoked by the Russian government itself. Unwilling to face the social consequences of the massive unemployment that would follow if many state-owned enterprises quickly were privatized, the government continued to subsidize the operations of many money-losing establishments. The result was a surge in the government's budget deficit. In the first quarter of 1992 the budget deficit amounted to 1.5 percent of the country's GDP. By the end of 1992 it had risen to 17 percent. Unable or unwilling to finance this deficit by raising taxes, the government found another solution--it printed money, which added fuel to the inflation fire.

With inflation rising, the ruble tumbled. By the end of 1992, the exchange rate was $1=R480. By the end of 1993 it was $1=R1,500. As 1994 progressed, it became increasingly evident that due to vigorous political opposition, the government would not be able to bring down its budget deficit as quickly as had been thought. By September the monthly inflation rate was accelerating. October started badly, with the ruble sliding more than 10 percent in value against the US dollar in the first ten days of the month. Then on October 11, the ruble plunged 21.5 percent against the dollar, reaching a value of $1=R3926 by the time the foreign exchange market closed!

Despite the announcement of a tough budget plan that placed tight controls on the money supply, the ruble continued to slide and by April 1995 the exchange rate stood at $1=R5120. However, by mid-1995 inflation was again on the way down. In June 1995 the monthly inflation rate was at a yearly low of 6.7 percent. Moreover, the ruble had recovered to stand at $1=R4559 by July 6. On that day the Russian government announced that it would intervene in the currency market to keep the ruble in a trading range of R4,3000 to R4,900 against the dollar. The Russian government felt that it was essential to maintain a relatively stable currency. They announced that the central bank would be able to draw upon $10 billion in foreign exchange reserves to defend the ruble against any speculative selling in Russia's relatively small foreign exchange market.

In the world of international finance, $10 billion is small change and it wasn't long before Russia found that its foreign exchange reserves were being depleted. It was at this point that the Russian government requested IMF loans. In February 1996, the IMF obliged with its second largest rescue effort after Mexico, a loan of $10 billion. In return for the loan, Russia agreed to limit the growth in its money supply, reduce public sector debt, increase government tax revenues, and peg the ruble to the dollar.

Initially the package seemed to have the desired effect. Inflation declined from nearly 50 percent in 1996 to about 15 percent in 1997; the exchange rate stayed within its predetermined band; and the balance of payments situation remained broadly favorable. And in 1997, the Russian economy grew for the first time since the breakup of the former Soviet Union, if only by a modest half of 1 percent of GDP. However, the public sector debt situation did not improve. The Russian government continued to spend more than it agreed to under IMF targets, while government tax revenues were much lower than projected. Low tax revenues were in part due to falling oil prices (the government collected tax on oil sales), in part due to the difficulties of collecting tax in an economy where so much economic activity was in the "underground economy," and partly due to a complex tax system that was peppered with loopholes. Currently available estimates indicate that in 1997, Russian federal government spending amounted to 18.3 percent of GDP, while revenues were only 10.8 percent of GDP, implying a deficit of 7.5 percent of GDP, which was financed by an expansion in public debt.

The IMF responded by suspending its scheduled payment to Russia in early 1998 pending reform of Russia's complex tax system, and a sustained attempt by the Russian government to cut public spending. This put further pressure on the Russian ruble, forcing the Russian central bank to raise interest rates on overnight loans to 150 percent. In June 1998, the US government indicated that it would support a new IMF bailout . The IMF was more circumspect, insisting instead that the Russian government push through a package of corporate tax increases and public spending cuts in order to balance the budget. The Russian government indicated that it would do so, and the IMF released a tranche of $640 million that had been suspended. The IMF followed this with an additional $11.2 billion loan designed to preserve the ruble's stability.

Almost as soon as the funding was announced, however, it began to unravel. The IMF loan required the Russian government to take concrete steps to raise personal tax rates, improve tax collections, and cut government spending. A bill containing the required legislative changes was sent to the Russian parliament, where it was emasculated by anti-government forces. The IMF responded by withholding $800 million of its first $5.6 billion tranche, undermining the credibility of its own program. The Russian stock market plummeted on the news, closing 6.5 percent down. Selling of rubles accelerated. The central bank began hemorrhaging foreign exchange reserves as it tried to maintain the value of the ruble. Foreign exchange reserves fell by $1.4 billion in the first week of August alone, to $17 billion, while interest rates surged again.

Against this background, on the weekend of August 15 - 16, top Russian officials huddled together to develop a response to the most recent crisis. Their options were severely limited. The patience of the IMF had been exhausted. Foreign currency reserves were being rapidly depleted. Social tensions in the country were running high. Moreover, the government faced upcoming redemptions on $18 billion of domestic bonds, with no idea of where the money would come from.

On Monday, August 17, prime minister Kiriyenko announced the results of the weekend's conclave. Russia, he said, would restructure the domestic debt market, unilaterally transforming short-term debt into long-term debt. In other words, the government had decided to default on its debt commitments. The government also announced a 90-day moratorium on the repayment of private foreign debt, and stated that it would allow the ruble to decline by 34 percent against the U.S. dollar. In short, Russia had in effect turned its back on the IMF plan.

The effect on Russia was immediate. Overnight, shops marked up the price of goods by 20 percent. As the ruble plummeted, currency exchange points were only prepared to sell dollars at a rate of 9 rubles per dollar, rather than the new official exchange rate of 6.43 rubles to the dollar. As for Russian government debt, it lost 85 percent of its value in a matter of hours, leaving foreign and Russian holders of debt alike suddenly gaping at a huge black hole in their financial assets.¹⁸

The Asian Crisis

The financial crisis that erupted across Southeast Asia during the fall of 1997 has emerged as the biggest challenge ever. Holding the crisis in check required IMF loans to help the shattered economies of Indonesia, Thailand, and South Korea stabilize their currencies. In addition, although they did not request IMF loans, the economies of Japan, Malaysia, Singapore, and the Philippines were also badly hurt by the crisis.

The seeds of this crisis were sown during the previous decade when these countries were experiencing unprecedented economic growth. Although there were and remain important differences between the individual countries, a number of elements were common to most. Exports had long been the engine of economic growth in these countries. From 1990 to 1996, the value of exports from Malaysia had grown by 18 percent annually, Thai exports had grown by 16 percent per year, Singapore's by 15 percent, Hong Kong's by 14 percent, and those of South Korea and Indonesia by 12 percent annually.¹⁹ The nature of these exports had also shifted in recent years from basic materials and products such as textiles to complex and increasingly high-technology products, such as automobiles, semi-conductors, and consumer electronics.

The Investment Boom

The wealth created by export-led growth helped fuel an investment boom in commercial and residential property, industrial assets, and infrastructure. The value of commercial and residential real estate in cities such as Hong Kong and Bangkok started to soar. This fed a building boom the likes of which had never been seen in Asia. Heavy borrowing from banks financed much of this construction. As for industrial assets, the success of Asian exporters encouraged them to make bolder investments in industrial capacity. This was exemplified most clearly by South Korea's giant diversified conglomerates, or chaebol, many of which had ambitions to build a major position in the global automobile and semiconductor industries.

An added factor behind the investment boom in most Southeast Asian economies was the government. In many cases, the governments had embarked on huge infrastructure projects. In Malaysia, for example, a new government administrative center was being constructed in Putrajaya for M$20 billion (US$8 billion at the pre-July 1997 exchange rate), and the government was funding the development of a massive high-technology communications corridor and the huge Bakun dam, which at a cost of M$13.6 billion was to be the most expensive power generation plant in the country.²⁰

Throughout the region, governments also encouraged private businesses to invest in certain sectors of the economy in accordance with "national goals" and "industrialization strategy." In South Korea, long a country where the government played a proactive role in private-sector investments, President Kim Young-Sam urged the chaebol to invest in new factories as a way of boosting economic growth. South Korea enjoyed an investment-led economic boom in the 1994 - 95 period, but at a cost. The chaebol, always reliant on heavy borrowings, built up massive debts that were equivalent, on average, to four times their equity.²¹

In Indonesia, President Suharto had long supported investments in a network of an estimated 300 businesses owned by his family and friends in a system known as "crony capitalism." Many of these businesses were granted lucrative monopolies by the president. For example, Suharto announced in 1995 that he had decided to build a national car and the car would be built by a company owned by one of his sons, Hutomo Mandala Putra, in association with Kia Motors of South Korea. To support the venture, a consortium of Indonesian banks was "ordered" by the government to offer almost $700 million in start-up loans to the company.²²

By the mid-1990s, Southeast Asia was in the grips of an unprecedented investment boom, much of it financed with borrowed money. Between 1990 and 1995, gross domestic investment grew by 16.3 percent annually in Indonesia, 16 percent in Malaysia, 15.3 percent in Thailand, and 7.2 percent in South Korea. By comparison, investment grew by 4.1 percent annually over the same period in the United States and 0.8 percent in all high-income economies.²³And the rate of investment accelerated in 1996. In Malaysia, for example, spending on investment accounted for a remarkable 43 percent of GDP in 1996.²⁴

Excess Capacity

As the volume of investments ballooned during the 1990s, often at the bequest of national governments, the quality of many of these investments declined significantly. The investments often were made on the basis of unrealistic projections about future demand conditions. The result was significant excess capacity. For example, Korean chaebol's investments in semi-conductor factories surged in 1994 and 1995 when a temporary global shortage of dynamic random access memory chips (DRAMs) led to sharp price increases for this product. However, supply shortages had disappeared by 1996 and excess capacity was beginning to make itself felt, just as the South Koreans started to bring new DRAM factories on stream. The results were predictable; prices for DRAMs plunged through the floor, and the earnings of South Korean DRAM manufacturers fell by 90 percent, which meant it was difficult for them to make scheduled payments on the debt they had taken on to build the extra capacity.²⁵

In another example, a building boom in Thailand resulted in excess capacity in residential and commercial property. By early 1997, an estimated 365,000 apartment units were unoccupied in Bangkok. With another 100,000 units scheduled to be completed in 1997, years of excess demand in the Thai property market had been replaced by excess supply. By one estimate, by 1997 Bangkok's building boom had produced enough excess space to meet its residential and commercial needs for five years.²⁶

The Debt Bomb

By early 1997 what was happening in the South Korean semiconductor industry and the Bangkok property market was being played out elsewhere in the region. Massive investments in industrial assets and property had created excess capacity and plunging prices, while leaving the companies that had made the investments groaning under huge debt burdens that they were now finding it difficult to service.

To make matters worse, much of the borrowing had been in US dollars, as opposed to local currencies. This had originally seemed like a smart move. Throughout the region, local currencies were pegged to the dollar, and interest rates on dollar borrowings were generally lower than rates on borrowings in domestic currency. Thus, it often made economic sense to borrow in dollars if the option was available. However, if the governments could not maintain the dollar peg and their currencies started to depreciate against the dollar, this would increase the size of the debt burden, when measured in the local currency. Currency depreciation would raise borrowing costs and could result in companies defaulting on their debt obligations.

Expanding Imports

A final complicating factor was that by the mid-1990s, although exports were still expanding across the region, imports were too. The investments in infrastructure, industrial capacity, and commercial real estate were sucking in foreign goods at unprecedented rates. To build infrastructure, factories, and office buildings, Southeast Asian countries were purchasing capital equipment and materials from America, Europe, and Japan. Many Southeast Asian states saw the current accounts of their balance of payments shift strongly into the red during the mid-1990s. By 1995, Indonesia was running a current account deficit that was equivalent to 3.5 percent of its GDP, Malaysia's was 5.9 percent, and Thailand's was 8.1 percent.²⁷ With deficits like these, it was increasingly difficult for the governments of these countries to maintain their currencies against the US dollar. If that peg could not be held, the local currency value of dollar-dominated debt would increase, raising the specter of large-scale default on debt service payments. The scene was now set for a potentially rapid economic meltdown.

The Crisis

The Asian meltdown began in mid-1997 in Thailand when it became clear that several key Thai financial institutions were on the verge of default (see the closing case to Chapter 9 for more details). These institutions had been borrowing dollars from international banks at low interest rates and lending Thai baht at higher interest rates to local property developers. However, due to speculative overbuilding, these developers could not sell their commercial and residential property, forcing them to default on their debt obligations. In turn, the Thai financial institutions seemed increasingly likely to default on their dollar-denominated debt obligations to international banks. Sensing the beginning of the crisis, foreign investors fled the Thai stock market, selling their positions and converting them into US dollars. The increased demand for dollars and increased supply of Thai baht, pushed down the dollar/Thai baht exchange rate, while the stock market plunged.

Seeing these developments, foreign exchange dealers and hedge funds started speculating against the baht, selling it short. For the previous 13 years, the Thai baht had been pegged to the US dollar at an exchange rate of about $1=Bt25. The Thai government tried to defend the peg, but only succeeded in depleting its foreign exchange reserves. On July 2, 1997, the Thai government abandoned its defense and announced it would allow the baht to float freely against the dollar. The baht started a slide that would bring the exchange rate down to $1=Bt55 by January 1998. As the baht declined, the Thai debt bomb exploded. The 55 percent decline in the value of the baht against the dollar doubled the amount of baht required to serve the dollar-denominated debt commitments taken on by Thai financial institutions and businesses. This increased the probability of corporate bankruptcies and further pushed down the battered Thai stock market. The Thailand Set stock market index ultimately declined from 787 in January 1997 to a low of 337 in December of that year, on top of a 45 percent decline in 1996.

On July 28, the Thai government called in the International Monetary Fund. With its foreign exchange reserves depleted, Thailand lacked the foreign currency needed to finance its international trade and service debt commitments and desperately needed of the capital the IMF could provide. It also needed to restore international confidence in its currency and needed the credibility associated with gaining access to IMF funds. Without IMF loans, the baht likely would increase its free fall against the US dollar, and the whole country might go into default. The IMF agreed to provide the Thai government with $17.2 billion in loans, but the conditions were restrictive.²⁸ The IMF required the Thai government to increase taxes, cut public spending, privatize several state-owned businesses, and raise interest rates--all steps designed to cool Thailand's overheated economy. The IMF also required Thailand to close illiquid financial institutions. In December 1997, the government shut 56 financial institutions, laying off 16,000 people, and further deepening the recession that now gripped the country.

Following the devaluation of the Thai baht, wave after wave of speculation hit other Asian currencies. One after another in a period of weeks, the Malaysian ringgit, Indonesian rupiah, and the Singapore dollar were all marked sharply lower. With its foreign exchange reserves down to $28 billion, Malaysia let the ringgit float on July 14, 1997. Before the devaluation, the ringgit was trading at $1=2.525 ringgit. Six months later it had declined to $1=4.15 ringgit. Singapore followed on July 17, and the Singapore dollar quickly dropped in value from $1=S$1.495 before the devaluation to $1=S$2.68 a few days later. Next up was Indonesia, whose rupiah was allowed to float August 14. For Indonesia, this was the beginning of a precipitous decline in the value of its currency, which was to fall from $1=2,400 rupiah in August 1997 to $1=10,000 rupiah on January 6, 1998, a loss of 75 percent.

With the exception of Singapore, whose economy is probably the most stable in the region, these devaluations were driven by factors similar to those behind the earlier devaluation of the Thai baht--a combination of excess investment, high borrowings, much of it in dollar-denominated debt, and a deteriorating balance-of-payments position. Although both Malaysia and Singapore were able to halt the slide in their currencies and stock markets without the help of the IMF, Indonesia was not. Indonesia was struggling with a private-sector, dollar-denominated debt of close to $80 billion. With the rupiah sliding precipitously almost every day, the cost of servicing this debt was exploding, pushing more Indonesian companies into technical default.

On October 31, 1997, the IMF announced that it had put together a $37 billion rescue deal for Indonesia in conjunction with the World Bank and the Asian Development Bank. In return, the Indonesian government agreed to close a number of troubled banks, reduce public spending, remove government subsidies on basic foodstuffs and energy, balance the budget, and unravel the crony capitalism that was so widespread in Indonesia. But the government of President Suharto appeared to backtrack several times on commitments made to the IMF. This precipitated further declines in the Indonesian currency and stock markets. Ultimately, Suharto caved in and removed costly government subsidies, only to see the country dissolve into chaos as the populace took to the streets to protest the resulting price increases. This unleashed a chain of events that led to Suharto's removal from power in May 1998.

The final domino to fall was South Korea (for further details, see the Country Focus in Chapter 9). During the 1990s, South Korean companies had built up huge debt loads as they invested heavily in new industrial capacity. Now they found they had too much industrial capacity and could not generate the income required to service their debt. South Korean banks and companies had also made the mistake of borrowing in dollars, much of it in the form of short-term loans that would come due within a year. Thus, when the Korean won started to decline in the fall of 1997 in sympathy with the problems elsewhere in Asia, South Korean companies saw their debt obligations balloon. Several large companies were forced to file for bankruptcy. This triggered a decline in the South Korean currency and stock market that was difficult to halt. The South Korean central bank tried to keep the dollar/won exchange rate above $1 = W1,000 but found that this only depleted its foreign exchange reserves. On November 17, the Korean central bank gave up the defense of the won, which quickly fell to $1=W1,500.

With its economy of the verge of collapse, the South Korean government on November 21 requested $20 billion in standby loans from the IMF. As the negotiations progressed, it became apparent that South Korea was going to need far more than $20 billion. Among other problems, the country's short-term foreign debt was found to be twice as large as previously thought at close to $100 billion, while the country's foreign exchange reserves were down to less than $6 billion. On December 3, the IMF and South Korean government reached a deal to lend $55 billion to the country. The agreement with the IMF called for the South Koreans to open their economy and banking system to foreign investors. South Korea also pledged to restrain the chaebol by reducing their share of bank financing and requiring them to publish consolidated financial statements and undergo annual independent external audits. On trade liberalization, the IMF said South Korea will comply with its commitments to the World Trade Organization to eliminate trade-related subsidies and restrictive import licensing and will streamline its import certification procedures, all of which should open the South Korean economy to greater foreign competition.²⁹

Evaluating the IMF's Policy Prescriptions

By early 1998, the IMF was committing over $110 billion in short-term loans to three Asian countries: South Korea, Indonesia, and Thailand. This was on top of the $20 billion package the IMF gave to Mexico in 1995 and the $10 billion loan to Russia. All these loan packages came with conditions attached. In general, the IMF insists on a combination of tight macroeconomic policies, including cuts in public spending, higher interest rates, and tight monetary policy. It also often pushes for the deregulation of sectors formerly protected from domestic and foreign competition, privatization of state-owned assets, and better financial reporting from the banking sector. In general, these policies are designed to cool overheated economies by reining in inflation and reducing government spending and debt. Recently, this set of policy prescriptions has come in for tough criticisms from many Western observers.³⁰

One criticism is that the IMF's "one-size-fits-all" approach to macroeconomic policy is inappropriate for many countries. This point was made in the opening case when we looked at how the IMF's policies toward Zaire may have made things worse rather than better. In the recent Asian crisis, critics argue that the tight macroeconomic policies imposed by the IMF are not well suited to countries that are suffering not from excessive government spending and inflation, but from a private-sector debt crisis with deflationary undertones.³¹ In South Korea, for example, the government has been running a budget surplus for years (it was 4 percent of South Korea's GDP in the 1994 - 1996 period) and inflation is low at about 5 percent. South Korea has the second strongest financial position of any country in the Organization for Economic Cooperation and Development. Despite this, say critics, the IMF is insisting on applying the same policies that it applies to countries suffering from high inflation. The IMF is requiring South Korea to maintain an inflation rate of 5 percent. However, given the collapse in the value of its currency and the subsequent rise in price for imports such as oil, inflationary pressures will inevitably increase in South Korea. So to hit a 5 percent inflation rate, the South Koreans are being forced to apply an unnecessarily tight monetary policy. Short-term interest rates in South Korea jumped from 12.5 percent to 21 percent immediately after the country signed its initial deal with the IMF. Increasing interest rates make it even more difficult for companies to service their already excessive short-term debt obligations, so the cure prescribed by the IMF may actually increase the probability of widespread corporate defaults, not reduce them.

The IMF rejects this criticism. According to the IMF, the critical task is to rebuild confidence in the won. Once this has been achieved, the won will recover from its oversold levels. This will reduce the size of South Korea's dollar-denominated debt burden when expressed in won, making it easier for companies to service their dollar-denominated debt. The IMF also argues that by requiring South Korea to remove restrictions on foreign direct investment, foreign capital will flow into the country to take advantage of cheap assets. This, too, will increase demand for the Korean currency and help to improve the dollar/won exchange rate.

A second criticism of the IMF is that its rescue efforts are exacerbating a problem known to economists as moral hazard. Moral hazard arises when people behave recklessly because they know they will be saved if things go wrong. Critics point out that many Japanese and Western banks were far too willing to lend large amounts of capital to over-leveraged Asian companies during the boom years of the 1990s. These critics argue that the banks should now be forced to pay the price for their rash lending policies, even if that means some banks must shut down.³² Only by taking such drastic action, the argument goes, will banks learn the error of their ways and not engage in rash lending in the future. By providing support to these countries, the IMF is reducing the probability of debt default and in effect bailing out the banks whose loans gave rise to this situation.

This argument ignores two critical points. First, if some Japanese or Western banks with heavy exposure to the troubled Asian economies were forced to write off their loans due to widespread debt default, the impact would be difficult to contain. The failure of large Japanese banks, for example, could trigger a meltdown in the Japanese financial markets. This would almost inevitably lead to a serious decline in stock markets around the world. That is the very risk the IMF was trying to avoid by stepping in with financial support. Second, it is incorrect to imply that some banks have not had to pay the price for rash lending policies. The IMF has insisted on the closure of banks in South Korea, Thailand, and Indonesia. Foreign banks with short-term loans outstanding to South Korean enterprises have been forced by circumstances to reschedule those loans at interest rates that do not compensate for the extension of the loan maturity.

The final criticism of the IMF is that it has become too powerful for an institution that lacks any real mechanism for accountability.³³ By the end of 1997, the IMF was engaged in loan programs in 75 developing countries that collectively contain 1.4 billion people. The IMF was determining macroeconomic policies in those countries, yet according to critics such as noted Harvard economist Jeffery Sachs, the IMF, with a staff of under 1,000, lacks the expertise required to do a good job. Evidence of this, according to Sachs, can be found in the fact that the IMF was singing the praises of the Thai and South Korean governments only months before both countries lurched into crisis. Then the IMF put together a draconian program for South Korea without having deep knowledge of the country. Sachs's solution to this problem is to reform the IMF so it makes greater use of outside experts and its operations are open to great outside scrutiny.

As with many debates about international economics, it is not clear which side has the winning hand about the appropriateness of IMF policies. There are cases where one can argue that IMF policies have been counterproductive, such as Zaire, which we discussed in the opening case. But the IMF can point to some notable accomplishments, including its success in containing the Asian crisis, which could have rocked the global international monetary system to its core. Similarly, many observers give the IMF credit for its deft handling of politically difficult situations, such as the Russian ruble crisis, and for successfully promoting a free market philosophy.