Allow Asia to reflate, IMF told

by Martin Khor, Director, Third World Network


As the East Asian financial crisis now transforms into a full-blown recession (or even depression), the International Monetary Fund's policies have come under even stronger attack not only from social activists but also from the establishment. Among the main criticisms is that the IMF has prescribed recession, bankruptcies and unemployment. Many mainstream economists are now calling the IMF, the West and Asian governments to change course and adopt a different set of policies to reflate the ailing Asian economies. (Second in a two-part series).  


As the East Asian crisis worsens, and as it threatens to spread to other regions, there has been a louder and louder chorus of mainstream economists and editorial commentators speaking up against the policy prescriptions of the International Monetary Fund which, they argue, have made the countries more ill. 

The criticisms of the growing number of these economists provide a solid basis for demanding a review and change of the approach that is taken by the IMF Secretariat (and the rich nations that back or direct it) to resolve the crisis. 

Last week the Financial Times (London) 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 notes that the IMF imposed very high interest rates on the basis that a sharp shock rise in rates would stabilise currency markets, dampening pressures for competitive devaluations and making it easier for client governments to repay foreign creditors. 

The argument has a theoretical basis, says Wade, but it assumes conditions not presesnt in Asia. When financial inflows did not resume, the Fund's response was to give it more time and make the pain sharper. 

"Investors on the contrary took the high rates as a signal of great dangers ahead, making them all the more anxious to get out and stay out," says Wade. "High rates and the associated austerity policies have caused so much damage in the real economy as to validate the perception of great dangers." 

Wade 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. 

This proposition might be found by many to be too bold. What if the markets react negatively and the local currency drops further? To take this into account, Wade complements his proposal with another: that the governments have to reintroduce some form of cross-border capital controls. 

They should then 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." 

The Wade article is the latest in a series of increasing academic articles calling for a change in IMF policies. 

The Harvard professor, Jeffrey Sachs, has been attacking the IMF ever since early November 1997, when he predicted that the bailout packages for Thailand and Indonesia, if tied to orthodox financial conditions like budget cuts and higher interest rates, could "do more harm than good, transforming a currency crisis into a rip- roaring economic downturn." 

The predicted downturn has now turned out to be much worse than anyone imagined. Another prominent critic is Martin Feldstein, economics professor at Harvard University, president of the National Bureau of Economic Research and formerly chief economic advisor to the government. 

In the "Foreign Affairs" journal (March/April 1998), he says the IMF's recent emphasis on imposing major structural and institutional reforms, rather than focusing on balance-of-payments adjustments, will have short-term and longer-term adverse consequences. 

The main thrust of his article is that the IMF has strayed from its mandate of helping countries resolve their balance of payments problems (which could be best done by organising debt rescheduling exercises between the countries and their foreign creditors) and instead has been imposing conditions relating to their economic, financial and social structures which are not relevant to resolving the debt and balance of payments problems at hand. 

This is a subject that needs separate treatment. However, Feldstein also criticises the IMF's short-term macroeconomic policies for Korea, which calls for budget deficit reduction (by raising taxes and cutting government spending) and a tighter monetary policy (higher interest rates and less credit availability), which together depress growth and raise unemployment. 

Asks Feldstein: "But why should Korea be required to raise taxes and cut spending to lower its 1998 budget deficit when its national savings rate is already one of the highest in the world, when its 1998 budget deficit will rise temporarily because of the policy- induced recession, and when the combination of higher private savings and reduced business investment are already freeing up the resources needed to raise exports and shrink the current account deficit?" 

Feldstein notes that under the IMF plan, the interest rate on won loans was 30 percent whilst inflation was only 5 percent (at the time the article was written, earlier this year). 

"Because of the high debt typical of most Korean companies, this enormously high real interest rate of 25 percent puts all of them at risk of bankruptcy," he says. 

"Why should Korea be forced to cause widespread bankruptcies by tightening credit when inflation is very low, when the rollover of bank loans and the demand for the won depend more on confidence than on Korean won interest rates, when the failures will reduce the prospect of loan repayment, and when a further fall in the won is an alternative to high interest rates as a way to attract won- denominated deposits?  

"Although a falling won would increase the risk of bankruptcies among Korean companies with large dollar debts, the overall damage would be less extensive than the bankruptcies caused by very high won interest rates that would hurt every Korean company. 

"Finally, why should Korea create a credit crunch that will cause even more corporate failures by enforcing the international capital standards for Korean banks when the Japanese government has just announced that it will not enforce those rules for Japanese banks in order to avoid a credit crunch in Japan?" 

The questions raised by the IMF's policies, and now about the severe effects they are having in the region, are very serious indeed, as they relate to the shape of the national economies of East Asia and the very future of the countries. 

Fortunately, Malaysia has not been forced by circumstances to seek an IMF rescue package, and thus we have more degrees of freedom to determine short and longer term policies to get out of the crisis. 

For those countries already taking IMF loans, it is most difficult (if not almost impossible) to make or modify policies or to change course if things go wrong, as the IMF is always ready to threaten to stop its loans (which are given in small installments) if these countries try to veer even a little from the IMF path. 

Malaysia's policy makers have an unenviable task of going through the pros and cons of each policy choice, for each policy option carries both advantages and disadvantages, and thus there are many trade-offs to carefully consider. 

Whilst the immediate objective must be to prevent mass bankruptcies of local companies hampered by the credit squeeze, high interest and lower demand, there are also the imponderables such as how "the markets" will react to any policy, and the wider environment of regional developments. 

In any case, whilst the orthodox advice of the IMF should be listened to (even if Malaysia is not directly under its tutelage), the criticisms against the IMF approach (especially those made by very establishment economists) and the critical events on the ground (in terms of corporate difficulties especially of the small and medium sized companies, and in terms of the negative growth and job losses) must also figure prominently in the decisions on policy and strategy.