June - July 1998

by Martin Khor

Penang, 29 June -- As the East Asian crisis continues to deepen, the debate on the role of the International Monetary Fund's contractionary policies has heated up. There are also increasing calls to the IMF and Western countries to allow the affected Asian countries to reflate their economies.

 The IMF's top officials have continued to defend their macroeconomic approach of squeezing the domestic economies of their client countries through high interest rates, tight monetary policies and cuts in the government budget.

 Their argument is that this "pain" is needed to restore foreign investors' confidence, and so strengthen the countries' currencies. However, some economists had already warned at the start of the IMF "treatment" for Thailand, Indonesia and South Korea that this set of policies is misplaced as it would transform a financial problem that could be resolved through debt restructuring, into a full- blown economic crisis. 

That prediction has come true, with a vengeance. The three countries under the IMF's direct tutelage (Thailand, Indonesia and South Korea) have slided into deep recession. Partly due to spillover effects, other countries such as Malaysia and Hong-Kong have also suffered negative growth in the year's first quarter.  

Even Singapore is tottering on the brink of minus growth. As the economic crisis worsens, some political leaders, researchers and activists in the region are increasingly questioning the IMF policies. 

Prominent among the critics has been Malaysian Prime Minister Dr Mahathir Mohamad who has blamed the IMF's policy of high interest rates, credit squeeze and tighter definition of non-performing bank loans for worsening the recessionary conditions. 

Although, unlike the other three countries, Malaysia has not sought an IMF rescue package, and thus is not obliged to follow the Fund's policies, the IMF staff have been giving advice, along the same orthodox lines, to the country's finance and central bank officials. 

"Initially we though the IMF's strategies were very good, so we adopted them, only to find they damaged our economy. To go back would be difficult," Dr Mahathir said at a press conference in Kuala Lumpur last week. 

"We are trying to figure out how to manage the economy after the damage has been done through the shortening of the period of non- performing loans, credit squeeze and raising interest rates. They have damaged a lot of companies." 

For the Asian countries afflicted with sharp currency depreciations and share market declines, the first set of problems involved the much heavier debt servicing burden of local banks and companies that had taken loans in foreign currencies, the fall in the value of shares pledged as collateral for their loans, the resulting weakening of the financial position of banks, and inflation caused by rising import prices. 

But then came a second set of problems resulting from the high interest rates and tight monetary and fiscal policies that the IMF imposed or advised. 

For companies already hit by the declines in the currency and share values, the interest rate hike became a third burden that broke their backs. 

But even worse, there are many thousands of firms (most of them small and medium sized) that have now been affected in each country. 

Their owners and managers did not make the mistake of borrowing from abroad (nor did they have the clout to do so). The great majority of them are also not listed on the stock market. So they cannot be blamed for having contributed to the crisis by imprudent foreign loans or having over-borrowed on the basis of inflated share values. 

Yet these many thousands of local companies are now hit by the sharp rise in interest rates, a liquidity squeeze as financial institutions are tight-fisted with (or even halt) new loans, and the slowdown in orders as the public sector cuts its spending. 

In Thailand, "domestic interest rates as high as 18% have been blamed for starving local businesses of cash and strangling economic growth," according to a Reuter report of 3 June.

In South Korea, thousands of small and medium companies have gone bankrupt as a result of high interest rates. Although the country has about US$150 billion in foreign debts, its companies in January also had double that (or more than US$300 billion) in domestic debt. 

According to the Wall Street Journal (9 Feb), the Korean economy was facing fresh agony over this huge domestic debt as thousands of companies file for bankruptcy as they find it harder to get credit. "The blame for the tighter liquidity are higher interest rates, a legacy of the IMF bailout that saved Korea's economy from collapse, and a sharp economic slowdown."

In Indonesia, whilst top corporations with foreign currency loans have been hit hardest by the 80 percent drop of the rupiah vis-a-vis the US dollar, the majority of local companies have been devastated by interest rates of up to 50 percent. 

The rates were raised as part of an IMF agreement and were aimed at strengthening the rupiah. However the rupiah has not improved from its extremely low levels, whilst many indebted companies are unable to service their loans. 

In Malaysia, interest rates are lower than in the three IMF client countries. Nevertheless they have also been going up. According to Central Bank data, the average bank lending rate rose from 10.4

percent in May 1997 to 11.5 percent in December 1997 and 13.3 percent in March 1998. Currently, many customers are charged 15 percent, and some even higher. On interest rate policy, countries subjected to currency speculation face a serious dilemma. They have been told by the IMF that lowering the interest rate might cause the "market" to lose confidence and savers to lose incentive, and thus the country risks capital flight and currency depreciation. 

However, to maintain high interest rates or increase them further will cause companies to go bankrupt, increase the non-performing loans of banks, weaken the banking system, and dampen consumer demand. 

These, together with the reduction in government spending, will plunge the economy into deeper and deeper recession. And that in turn will anyway cause erosion of confidence in the currency and thus increase the risk of capital flight and depreciation. 

A higher interest rate regime, in other words, may not boost the currency's level but could depress it further if it induces a deep and lengthy recession. 

It is also pertinent to note that a country with a lower interest rate need not necessarily suffer a sharper drop in currency level. Take the case of China. Since May 1996, it has cut its interest rates four times and its one-year bank fixed deposit rate was 5.2% in May (according to a Reuters report). But its currency, which is not freely traded due to strict controls by the government, has not depreciated. 

It has also been pointed out by Yilmaz Akyuz, UNCTAD's chief macroeconomist, in a paper on the Asian crisis, that "although Indonesia and Thailand have kept their interest rates higher than Malaysia, they have experienced greater difficulties in their currency and stock markets." 

According to Akyuz, there is not a strong case for a drastic reduction in domestic growth (as advocated by the IMF) to bring about the adjustment needed in external payments. 

Instead of the orthodox IMF policies, Akyuz provides the example of a different set of policies that the United States had successfully adopted when it also faced conditions of debt deflation in recent years. 

In reaction to the weakness in the financial system and the economy, the Fed started to reduce short-term interest rates in the early 1990s, almost to negative levels in real terms, thus providing relief not only for banks, but also for firms and households, which were able to ride the yield curve and refinance debt at substantially lower interest servicing costs. 

This eventually produced a boom in the securities market, thereby lowering long-term interest rates, and helping to restore balance-sheet positions, producing a strong recovery at the end of 1993. 

Recounting the above episode, Akyuz concludes: "Clearly, the US economy is unlikely to have enjoyed one of the longest post-war recoveries if the kind of policies advocated in East Asia had been pursued in the early 1990s in response to debt deflation." 

Another interesting contrast is that between the IMF's contractionary policies prescribed for its East Asian clients, and the strong criticisms of Japan from Western leaders for not doing more to reflate its ailing economy. They are calling for more effective tax cuts so that Japanese consumers can spend more and thus kick the economy into recovery. 

The yen has been sharply dropping, causing grave concerns that this will trigger a deeper Asian crisis or world recession. These concerns led the US to intervene in the foreign exchange market to stop the yen's further decline. Yet neither the IMF nor the Western leaders have asked Japan to increase its interest rate (which at 0.5% must be the lowest in the world) to defend the yen. Instead they want Japan to take fiscal measures to expand the economy. 

This tolerance of low interest rates in Japan as well as the pressure on the Japanese government to pump up the economy is a very different approach than the high-interest austerity-budget medicine prescribed for the other East Asian countries. 

Could it be that this display of double standards is because it is in the rich countries' interests to prevent a Japanese slump that could spread to their shores, and so they insist that Japan reflate its economy whilst keeping its interest rate at rock bottom?  

Whereas in the case of the other East Asian countries, which owe a great deal to the Western banks, the recovery and repayment of their foreign loans is the paramount consideration? 

In the latter case, a squeeze in the domestic economy would reduce imports, improve the trade balance and result in a strong foreign exchange surplus, which can then be channelled to repay the international banks. 

This is in fact what is happening. As recession hits their domestic economies, Thailand, South Korea, Indonesia and Malaysia have seen a sharp contraction in imports, resulting in large trade surpluses. 

Unfortunately, this is being paid for through huge losses in domestic output and national income, the decimation of many of the large, medium and small firms of these countries, a dramatic increase in unemployment and poverty, and social dislocation or upheaval. 

A price that is extremely high, and which in the opinion of many economists (including some top establishment economists) is also unnecessary for the people of these countries to pay. 

They argue that instead of being forced to raise interest rates and cut government expenditure, the countries should have been advised by the IMF to reflate their economies through increased public spending and interest rates that are lower than the present levels. Last week the Financial Times carried a strongly worded opinion article entitled "Asian water torture" with this sub- heading:

"Unless the IMF allows the region's economies to reflate and lower interest rates, it will condemn them to a never-ending spiral of recession and bankruptcy." 

Written by Robert Wade, professor of political economy in Brown University (US), the article blames the IMF for failing to grasp the implications of imposing high interest charges on Asian companies that are typically far more indebted than western and Latin American companies. 

"High rates push them much more quickly from illiquidity towards insolvency, forcing them to cut back purchases, sell inventories, delay debt repayment and fire workers. Banks then accumulate a rising proportion of bad loans and refuse to make new ones. The IMF's insistence that banks meet strict Basle capital adequacy standards only compounds the collapse of credit. "The combination of high interest rates and Basle standards is the immediate cause of the wave of insolvency, unemployment and contraction that continues to ricochet around the region and beyond. The uncertainty, instability and risk of further devaluations keep capital from returning despite high real interest rates." 

Wade finds the IMF's contractionary approach "puzzling" as the United States authorities after the 1987 stock market crash had acted to keep markets highly liquid whatever the cost, yet in Asia the Fund acted to contract liquidity. 

"Is this because it knows only one recipe? Or because it is more interested in safeguarding the interests of foreign bank creditors than in avoiding collapse in Asia?" 

Concluding that the IMF's approach is not working, Wade calls on governments in the region to change tack away from the current approach of very low inflation, restrained demand and high real interest rates as the top priorities. "They need to take a tougher stance in the rescheduling negotiations with the creditor banks, lower interest rates to near zero, and step on the monetary gas," he says. 

He also proposed that governments reintroduce some form of cross-border capital controls. They should then channel credit into export industries, generate an export boom, and let the ensuing profits reinforce inflationary expectations and reflate domestic demand. 

The west, meanwhile, should stop pushing developing countries to allow free inflow and outflow of short-term finance as they are simply not robust enough to be exposed to the shocks that unimpeded flows can bring. 

There should also be reconsideration of the constitution of money funds (whose priorities are short-term results) and over- guaranteed international banks, which lie at the heart of the problem of destabilising international financial flows. "Until Asian governments lower interest rates, take control of short-term capital movements, and cooperate within the region, the crisis will go on and on like water torture. That will bring poverty and insecurity to hundreds of millions and turn parts of Asia into a dependency of the IMF and the US, its number one shareholder." 

(Martin Khor is the Director of Third World Network.)

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