Debate hots up on IMF and interest rate policy

by Martin Khor, Director, Third World Network


Last week Prime Minister Datuk Seri Dr Mahathir Mohamad stressed once again that interest rates charged to firms should be reduced to prevent the economy from choking. He also said the IMF's

advice on interest rates had been damaging. His comments are part of the broader debate going on in the region and in academic and policy circles globally on the role and effects of the IMF's contractionary policies that have deepened the crisis in many East Asian countries. (This is the first of a two-part series on the IMF's economic policies). 

As the East Asian crisis continues to deepen, the debate on the role of the International Monetary Fund's policies has heated up. The IMF's top officials continue 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.  

The prediction has come true, with a vengeance. The three countries under the IMF's direct tutelage have slided into deep recession. Partly due to spillover effects, other countries such as Malaysia and Hongkong have also suffered negative growth in the year's first quarter. Even Singapore is tottering on the brink of minus growth. 

For the countries afflicted with sharp currency depreciations and share market declines, the first set of problems involved:


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 fiddling with inflated share values. Yet these many thousands of 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 percent 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.

"To 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, which has fortunately not had to seek an IMF loan package, interest rates are lower than the three IMF client countries. Nevertheless they have also been going up. 

According to Bank Negara 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 reportedly charged 14 to 15 percent, and some even higher. The interest rate hike and the reluctance of many banks to provide new loans have caused serious difficulties for many firms and consumers. This has led to open complaints against the financial institutions by the business sector, and to calls by political leaders, including the Prime Minister, to find measures to reduce the lending rates. 

In this matter, 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 percent 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 UNCTAD's chief macroeconomist Yilmaz Akyuz 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. 

Indeed it is very strange that the IMF as well as the leaders of Western countries are shrilly criticising Japan 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 United States 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 per cent 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 its economy is a very different approach than the high-interest austerity-budget medicine prescribed for the other ailing 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 reflates 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 interest? 

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. The main bright spot for Thailand, South Korea, Indonesia and Malaysia is that as recession hits their domestic economy, there has been a 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 far too high to pay, 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.