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The case for international rescue packages

Gavyn Davies On the IMF's role in the Asian crisis
A few years ago, the International Monetary Fund (IMF) had become a rather obscure institution, focusing mainly on bail-out programmes for impoverished African countries, and wondering whether it would ever again find a use for the massive funds at its disposal. The opening of global capital markets meant that private sector banks and securities firms were increasingly providing the balance of payments financing which had previously been the preserve of the IMF. And the "vigilantes" of the international bond markets were even usurping the IMF's traditional role as the chief policy disciplinarian in the global economy.

Then along came the Mexican crisis in December 1994, described rather ominously at the time by the IMF's managing director, Michel Camdessus, as "the first financial crisis of the 21st century". Three years later, with "21st Century" crises prematurely savaging Thailand, Korea and Indonesia, the IMF has suddenly become the most important economic institution on the world stage.

Fame never comes without a price. In this case, the price has been an eruption of strident criticism from politicians and academics about the way the IMF conducts its business. It has been denounced as an undemocratic institution, obsessed with secrecy. And it is variously accused of inappropriately bailing out private sector banks, of imposing needless recessions on Asian economies, and of giving a helping hand to precisely those industrial competitors which most threaten jobs in the West.

Naturally, not all of these criticisms can be valid at the same time. The easiest to dispose of is the last, which emanates primarily from the protectionist wing of the Democratic Party in the US. It is certainly wrong to suggest that the IMF rescue packages in Asia will cause higher unemployment in Europe or America. In the absence of these programmes, Asia would have fallen into an even deeper recession, and its currencies would have become even more undervalued against both the dollar and European exchange rates. For all these reasons, the immediate threat to Western jobs would have been much more severe in the absence of IMF packages.

Furthermore, in the longer-term, it is quite wrong to suggest that a healthy and thriving Asian economy need imply that Europe and America will suffer accordingly. In fact, the opposite will be true - in an open trading system, all sides will make gains in their potential GDP from rapid expansion in trade flows. The idea that Asian success must equate with failure in the West is just crass.

What about the question of bailing-out Western and Asian banks? It is clear that by providing necessary liquidity in foreign exchange markets, the IMF has reduced bankruptcy risks within Asia, thereby protecting the shareholders of many Western banks. US Republicans are up in arms about this, arguing not only that public money has been used to protect these banks from the consequences of their own foolishness, but also that this will increase their propensity to burn money in the future. Robert Rubin's 1995 Mexican rescue package, which looked so successful at the time, is now castigated for encouraging Western banks to take reckless risks in Asia two years later.

This problem, known to economists as "moral hazard", is a real one. However, many of the Asian banks and corporations whose bankruptcy has been prevented by the IMF were viable institutions facing severe liquidity crises, not solvency crises. It was certainly appropriate to rescue such institutions.

Furthermore, when Western governments looked "over the brink" at the possibility of sovereign defaults in Asia, they very rapidly concluded that the risks to the world's financial system, especially the payment system, were too great to contemplate. No one should be in any doubt that the decision to disperse more IMF money to Asian governments in recent weeks has been taken not out of any sense of global altruism, but out of a strong sense of self interest by Western governments.

It is therefore difficult to sympathise with people who have argued that the IMF should have "kept its nose out of Asia". In fact, a more important concern is that the IMF may be forced to stay away from similar situations in future, simply because it does not have the resources to discharge its role. In the wake of recent Asian packages, Goldman Sachs reckons that the IMF now has only $45bn of resources available for use on new situations.

Since no prudent institution can go right to the wire and use up all of its money, the margin available to handle new crises is becoming worryingly slim. In the next couple of weeks, both Robert Rubin and President Clinton will argue strongly that Congress should approve new financing tranches for the IMF, but there is a significant risk that these pleas will fall on deaf ears. This would be a worrying mistake.

Finally, what about the recent criticisms (notably from Jeffrey Sachs of Harvard University) about the nature of the IMF conditions imposed on Asian governments? Essentially, the main thrust of Sachs' argument is that the tightening in fiscal and monetary policy required by the IMF packages was entirely inappropriate for the Asian economies. The genesis of the Asian currency crises had nothing to do with excessive budget deficits or profligate growth in the monetary aggregates, but stemmed instead from massive private sector capital inflows leading to a bubble in domestic asset prices. The real problem, according to Sachs, was a collapse in market confidence - a problem which could be made worse by a tightening in macro-economic policy. Higher interest rates, for example, will make asset price deflation worse.

Given that most Asian governments have achieved continuous budget surpluses over the 1990s, Sachs clearly has a point. The IMF programmes have variously required fiscal tightenings of around 1.5 to 3 per cent of GDP, figures that will be extremely difficult to achieve given the collapse in the economic growth which is now under way. Asia 1998 is not Latin America 1982, and in this new situation it might have been better for the IMF programmes to have required little or no fiscal tightening.

In fact, there is a clear need to use the healthy state of public sector balance sheets to absorb some of the debt of Asian financial systems, thus allowing banking sectors to support a resumption of growth at the earliest possible date. Contrary to the requirements of IMF Letters of Intent, this means that budget deficits may need to rise for a while.

However, as Stanley Fischer of the IMF has argued, there is clearly also an offsetting issue of policy credibility which cannot be ignored. If monetary policy is not held reasonably tight in the aftermath of massive exchange rate shocks, there is obviously a risk that the collapse in currencies could become self-feeding. Not only might this cause hyper-inflation, but it would further increase bankruptcy risks in the financial sector, by inflating the domestic currency value of foreign debt. This would make recessions worse, not better.

There is necessarily a balance to be struck here. Sachs is probably right to argue that budget balances should be higher than the IMF is permitting. But Fischer is right that higher interest rates may be needed to prevent further currency collapses. Expansionary budgetary policy, combined with contractionary monetary policy, may be the best way out of this mess.