econ essay
*Professor of Economics, Harvard University, and President of National Bureau of Economic Research
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Forthcoming in Foreign Affairs March/April 1998
Refocusing the IMF
Martin Feldstein*
In the Asian currency crisis, the International Monetary Fund (IMF) is risking its
effectiveness by the way that it now defines its role as well as by how it is handling the specific
problems of the affected countries. The IMF's recent emphasis on imposing major structural and
institutional reforms as opposed to focusing on balance of payments adjustments goes beyond its
proper role and is likely to have adverse consequences in both the short term and the more
distant future. The IMF should stick to its traditional task of helping countries cope with
temporary shortages of foreign exchange and with more sustained trade deficits.
The emphasis on fundamental structural and institutional reforms has not always been
part of IMF programs. The IMF was founded in 1945 to assist in the operation of a system of
fixed exchange rates based on a gold-dollar standard that experts then considered necessary to
encourage international trade. Although that system succeeded temporarily, intercountry
differences in inflation forced many countries to alter their currency values. When the fixed rate
system collapsed completely in 1971, the IMF was forced to find a new raison d'etre.
The IMF found a new and important role in the 1980s after changes in economic
conditions led Mexico and then other Latin American countries to announce they could not meet
the interest and principal payments on their large borrowings from overseas commercial banks.
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------------------------------------------------------------------------------------------------------------------ ---- *Professor of Economics, Harvard University, and President of National Bureau of Economic Research
To prevent a default on those obligations that would have wiped out the net capital of many
leading banks in the United States, Europe and Japan, the American government provided a
temporary "bridge" loan that allowed Mexico to meet its imminent obligations. Immediately
after that, a negotiating process began between the Mexican government and representatives of
the lending banks. The banks agreed to restructure the debts, lengthening maturities, and lending
additional money with which the borrowers could meet part of their interest obligations. Similar
negotiations were later conducted with the other Latin American countries.
To meet their interest obligations and reduce their outstanding debt, the Latin American
countries had to earn more foreign exchange by increasing their exports or decreasing their
imports. So the Latin American governments raised taxes, cut government outlays, and tightened
credit to reduce domestic uses of national output. The IMF monitored these adjustments and
provided moderate amounts of credit as an indication that it was satisfied with the policy
progress that the debtors were making. But the primary provision of credit was left to
negotiations between the foreign banks and each of the debtor countries.
Over time the process was successful. The region's economic growth eventually resumed
and the countries were generally able to service their rescheduled debts. The commercial banks
wrote off some debt of small heavily indebted countries. In the end the banks swapped their
remaining loans balances for so-called Brady Bonds that had government guarantees but paid
lower interest or a reduced principal. This approach succeeded because of a general recognition
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that the problem of the major Latin American countries was one of liquidity rather than
insolvency, i.e., that they temporarily were unable to pay current foreign obligations but were
not
permanently unable to earn enough foreign currency by exporting to service and repay their
debts.
The next major chapter in the IMF's history began with the collapse of the Soviet Union
and the liberation of its former European satellites. These countries needed to shift from
communism to a market economy and to integrate themselves into international financial
markets. Their officials, bankers, and economists had little or no experience with market
economics. The IMF could therefore provide useful advice on a much wider range of economic
issues than it had previously done in Latin America or elsewhere in the world. Much of this
advice - about the strategy of privatization, about banking systems, about tax structures - was
useful. Much of the specific advice was also controversial. But while economists outside the
fund had a variety of views about the right way for Russia and the other countries of Eastern
Europe and the former Soviet Union to proceed, the IMF was generally able to get its way
because it brought substantial financial rewards to countries that accepted its advice.
The IMF is now acting in Southeast Asia and in Korea in much the same way that it did
in Eastern Europe and the former Soviet Union. It is going beyond macroeconomic
conditionality and insisting on fundamental changes in the economic and institutional structures
as a condition of receiving IMF funds. It is doing so even though the Asian situations are very
different from that in the former Soviet Union and Eastern Europe. In addition, the IMF is
applying its traditional mix of fiscal policies (higher taxes, less government spending) and credit
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tightening (implying higher interest rates) that were successful in Latin America. To assess the
appropriateness of these policies, it is necessary to understand what is happening in Asia.
The Asian Meltdown
The Southeast Asian currency collapse that began in Thailand was an inevitable
consequence of persistent large current account deficits and of the misguided attempt of
Thailand, Indonesia, Malaysia and the Philippines to maintain fixed exchange rates relative to
the dollar.
Thailand's current account deficit, the sum of its trade deficit and the interest on its
foreign obligations, had exceeded four percent of Thailand's GDP since 1990, implying that
Thailand had to attract that much foreign capital each year to pay for its net imports and its
foreign interest payments. Experience shows that such large current account deficits are not
sustainable and inevitably end in a sharp decline in the local currency's value. This occurs
when foreign creditors and domestic investors become concerned that the country will be unable
to service its debts. Thailand's large current account deficit persisted surprisingly long because
creditors believed that Thailand might be "different" since much of the capital inflow came as
direct investment by Japanese manufacturing firms and lending by their affiliated banks.
Creditors also took courage from Thailand's high saving rate and its government budget surplus,
noting that the current account deficit reflected enormously high business investment rather than
government or consumer profligacy. But the primary thing that kept foreign funds coming to
Thailand and local funds staying there was the combination of relatively high interest rates on
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Thai bhat deposits and a promise that the bhat's value would remain fixed at 25 bhat per dollar.
It looked like too good a deal to pass up.
But the bhat's fixed value relative to the dollar could not be sustained. The pressure for a
devaluation of the bhat increased in 1996 and 1997 when the Japanese yen declined by 35
percent relative to the dollar. Since Japan is Thailand's major trading partner, the sharp rise in
the value of the dollar (and therefore of the bhat) relative to the yen made Thai products less
competitive and pointed to even larger trade deficits in the future. Foreign speculators as
well as local investors began to sell the Thai bhat. The Thai government secretly bought bhat to
support its value. But eventually the run on the bhat became so large that the government had to
abandon its effort. At that point the IMF stepped in with a multibillion dollar rescue plan.
The Thai currency collapse spread to Indonesia, Malaysia and the Philippines as financial
investors became worried about their large current account deficits, high ratios of foreign debt to
local GDP, and deteriorating trade competitiveness. Each country was forced to abandon its
fixed exchange rate policy and let the market determine the currency's value. Indonesia lacked
the reserves to meet its short term obligations and called in the IMF. Malaysia has not done so
while the Philippines was already in an IMF program when the crisis began.
It is clear that all of these countries need to shrink their current account deficits by
increasing exports and reducing imports. That in turn requires reductions in public and private
consumption and investment. The right prescription is therefore a country specific variant of the
traditional IMF medicine - some combination of reduced government spending, higher taxes,
and tighter credit. Even in those countries where government budgets are already in surplus, an
increase in taxes or a reduction of government spending will shrink the current account deficit.
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The experience in Latin America provides a useful model of what can be done.
But the IMF's role in Thailand and Indonesia went far beyond the role that it played in
Latin America. Instead of relying on private banks and serving primarily as a monitor of
performance, the IMF took the lead in providing credit. In exchange it has imposed programs
that required the governments to reform their financial institutions and to make substantial
changes in their economic structures and political behavior. The conditions imposed on
Thailand and Indonesia were more like the comprehensive reforms imposed on Russia, including
the recent emphasis on reducing Russian corruption, than like the macroeconomic conditions
that were required in Latin America. In Indonesia, for example, in exchange for a $40 billion
package (more than 25 percent of Indonesia’s GDP), the IMF has insisted on long list of
reforms, specified in minute detail, including such things as the price of gasoline and the
marketing of plywood. The government has also been required to end the country's widespread
corruption and curtail the special business privileges that are used to enrich President Suharto's
family and the political allies that maintain the current regime. Although such changes may be
desirable in many ways, past experience suggests that they are not needed to maintain a flow of
foreign funds to Thailand and Indonesia.
The Korean situation is different from that of the four Asean countries and is more
important because its economy is the 11th largest in the world. Korea's problem did not stem
from an overvalued exchange rate and an excessive current account deficit. The value of the
Korean won had not been fixed in recent years but had gradually adjusted to maintain Korea's
competitiveness. A collapse of the semiconductor market, a major Korean export, had caused
Korea's current account deficit to jump from 1.7 percent of GDP in 1995 to 4.7 percent of GDP
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in 1996. But by mid 1997 it was already back to a 2.5 percent annual rate and heading lower.
The Korean economy was performing well: real GDP grew at 8% in the 1990s, as it had
in the 1980s; inflation was below 5 percent; and the unemployment rate was less than 3 percent.
Although there were recent bankruptcies among the smaller business conglomerates (chaebol)
and merchant banks, this was clearly an economy to envy.
Korea got in trouble in mid-1997 because its business and financial institutions had
incurred short-term foreign debts that far exceeded Korea's foreign exchange assets. By October
the U.S. commercial banks estimated that Korea’s short term debts were $110 billion and more
than three times Korea's foreign exchange reserves. With investors nervous about emerging
markets in general and Asia in particular, it's not surprising that the Korean won came under
attack.
Since Korea's total foreign debt was only 25% of GDP (one of the lowest among all of
the developing nations), this was clearly a case of illiquidity rather than insolvency. Moreover,
since the current account deficit was very small and rapidly shrinking, there was no need for the
traditional IMF policy of reduced government spending, higher taxes, and tight credit. Yet
something needed to be done to stop Korea's loss of foreign exchange and to maintain bank
lending to Korea and to its healthy businesses. Because of the overhang of excess short-term
foreign liabilities, each foreign bank acting independently had a strong incentive not to roll over
its loans. Investors, seeing that this would gradually drain Korea's reserves and depress the won,
had strong incentives to anticipate the process by selling Korean won immediately.
What Korea needed was coordinated action by foreign creditor banks to restructure its
short-term debts, lengthening their maturity and providing additional temporary credits to permit
2 During November the interest rate on ten year dollar bonds issued by the government- backed Korea Development Bank varied between two percent and four percent above the interest rate on U.S. treasury bonds. Even a four percent premium on a completely restructured Korean foreign debt would have been only about one percent of Korea’s GDP and about four percent of its exports.
3In fact, the IMF later did just that with the help of the national central banks in late December after its original plan had not succeeded; I return to this below.
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meeting its interest obligations. The creditors should have been willing to do this rather than
have the borrowers default on their loans, just as they did 15 years earlier in their negotiations
with the Latin American debtors. The rate of interest required to attract such long-term foreign
lending on a voluntary basis, and therefore avoid a withdrawal of private lending to other
emerging market countries, was about 4 percentage points above the interest rate on U.S.
treasury bonds and therefore well within Korea’s ability to finance by its exports. 2 The IMF
could have helped by providing a temporary bridge loan and then organizing the banks into a
negotiating group.3
Instead, the IMF organized a pool of $57 billion from official sources (the IMF, World
Bank, the US and Japanese governments, etc.) to lend to Korea so that Korea's private corporate
borrowers could meet their foreign currency obligations to the U.S., Japanese and European
banks. In exchange for those funds, the IMF demanded a fundamental overhaul of the Korean
economy and a contractionary macroeconomic policy of higher taxes, reduced spending, and
high interest rates.
The IMF's program emphasized eight structural problems of the Korean economy that it
said had to be changed: (1) Foreign investors are not able to acquire Korean businesses by
purchasing their shares or to own majority stakes in Korean businesses. (2) Korea's domestic
financial markets are not fully open to foreign banks and insurance companies. (3) Imports of
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some industrial products are still restricted, especially Japanese cars. (4) Korean banks do not
apply good western banking standards of credit evaluation but follow what might be called the
Japanese development model in which the government guides banks to lend to favored industries
in exchange for an implicit guarantee of those loans. (5) The Korean central bank is not
independent and does not have price stability as its only goal. (6) The corporate structure
involves large conglomerates (the chaebol) with an extremely wide range of activities and
opaque financial accounts. (7) Korean corporations generally have very high debt to capital
ratios that make them risky debtors to domestic and foreign lenders. (8) Korean labor laws make
layoffs very difficult and provided strong impediments to the flow of workers among firms.
The IMF said that it would provide credit only as Korea altered these central features of
the Korean economy. It predicted that economic growth in 1998 would be only half the previous
level and that the unemployment rate would double. This would be exacerbated by the IMF's
requirement for high interest rates and for tighter fiscal policy aimed at reducing the budget
deficit between 1997 and 1998. Many private observers estimated that the adverse effects on
output and employment would be substantially worse.
Evaluating IMF Strategy
The most fundamental issue is the appropriate role for an international agency and its
technical staff in dealing with sovereign countries that come to it for assistance. It is important to
remember that the IMF cannot initiate programs but develops a program for a member country
only when that country seeks help. The country is then the IMF's client or its patient but not its
ward. The legitimate political institutions of the country should determine the nation's
economic structure and the nature of its institutions. The fact that a nation is in desperate need
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of short-term financial help does not give the IMF the moral right to substitute its technical
judgements for the outcomes of the nation's political process.
The IMF should provide the technical advice and the limited financial assistance
necessary to deal with the country's current funding crisis and to place the country in a situation
that makes a repeat of that crisis unlikely. It should not use the opportunity to impose other
economic changes that, however helpful they may be, are not necessary to deal with the balance
of payments problem and that are the proper responsibility of the country's own political system.
In deciding on whether to insist on any particular reform, the IMF should ask three
questions: Is this really necessary to restore the country's access to international capital markets?
Is this a technical matter that does not interfere unnecessarily with the proper jurisdiction of a
sovereign government? If the policies to be changed are also practiced in the major industrial
economies of Europe, would the IMF think it appropriate to force similar changes in those
countries if they were subject to a fund program? The IMF is justified in requiring a change in a
client country's national policy only if the answer to all three questions is yes.
The Korean case illustrates this very well. Although many of the structural reforms that
the IMF included in the program for Korea that it announced at beginning of December would
probably improve the long-term performance of the Korean economy, the mandated changes are
generally not needed to gain access to capital markets and are among the politically most
sensitive issues: labor market rules, regulations of corporate structure and governance,
government-business relations, and international trade. The specific policies that the IMF insists
must be changed are not so different from those in the major countries of Europe: labor market
rules that cause 12 percent unemployment, corporate ownership structures that give banks (and
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governments) controlling interests in industrial companies, government subsidies to inefficient
and loss making industries, and trade barriers that restrict Japanese auto imports to a trickle and
block foreign purchases of industrial companies.
Imposing detailed economic prescriptions on legitimate governments would remain
questionable even if economists were unanimous about the economically correct way to reform
the countries' economic policies. In practice, however, there are substantial disagreements about
what should be done. And even when there is near unanimity about the appropriate economic
policies, experience shows that such agreements about policy can change radically. It is useful
to recall that the IMF was created to defend and manage a fixed exchange rate system that is
now regarded as economically inappropriate and practically unworkable. Similarly, for a long
time the advice to developing countries that came from the World Bank (the IMF's sister
institution) and from leading academic specialists emphasized national plans for
government-managed industrial development. And the very influential U.N. Economic
Commission for Latin America preached the virtues of protectionist policies to block industrial
imports in order to encourage countries to develop their own manufacturing industries. Now the
consensus of professional economists and international agencies calls for the opposite policies:
flexible exchange rates, market determined economic development, and free trade.
Today, there is nothing like unanimity about the appropriate policies for Korea or
Southeast Asia. Korea's outstanding performance combining persistently high growth, low
inflation and low unemployment suggests that the current structure of the Korean economy may
be well suited to Korea's stage of economic and political development and to the Korean
personal characteristics that stress thrift, self-sacrifice, patriotism, and "worker solidarity." Even
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if it were desirable for Korea to shift toward more American type labor, product and capital
markets, it may be best to evolve in that direction more gradually and with fewer shocks to
existing businesses. Making the transition in the midst of a currency crisis would be very poor
timing unless one were certain that the reforms must be done and can only be done under the
duress of an IMF program or that the reforms are needed to end the economic crisis.
The short-term macroeconomic policies that the IMF prescribed for Korea are equally
controversial. The program calls for the traditional IMF prescription of 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. Why should Korea be required to raise taxes and cut spending to achieve a
lower budget deficit in
1998 when its national saving 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 saving and reduced business investment are already freeing up the
resources needed to raise exports and shrink the current account deficit?
Under the IMF plan, the interest rate on won loans is now about 30 percent while
inflation is only five percent. Because of the high debt ratio typical of most Korean companies,
this enormously high real interest rate puts almost every company at risk of bankruptcy. 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 bankruptcies caused by high real interest
rates may reduce the prospect of loan repayment to the point where the expected return is
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actually reduced, 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 the 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 at a time
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 IMF faces a serious dilemma whenever it deals with a country that cannot meet its
obligation to foreign creditors. The IMF can encourage those creditors to roll over existing
loans and provide new credit by promising creditors that they will be repaid in full with full
interest. That type of guarantee was implicit in the IMF's $57 billion credit package for Korea
(although the continuing upward adjustment of the official estimates of short-term foreign
obligations quickly showed that even this unprecedentedly large credit package was inadequate).
But promising creditors that they will not lose in the current crisis also encourages those
lenders and others to take excessive future risks. Banks that expect that private loans will be
guaranteed by governments do not look as carefully as they should at the underlying commercial
credit risks. And when banks believe that the availability of dollars to meet foreign exchange
obligations will be guaranteed by the IMF, they won't look carefully at the foreign exchange risk
of the debtor countries.
There is no perfect solution to this "moral hazard" problem. In principle, the IMF and
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the Korean government should provide the guarantees needed to keep current creditors engaged
while swearing that this will be the last time that such guarantees will be provided! Although
there may be no way to achieve this completely, the IMF may have encouraged future lenders
too much by the speed with which it took control (without waiting for lenders and borrowers to
begin direct negotiations with each other). The call by IMF Managing Director Michel
Camdessus for member governments to provide an additional $60 billion in IMF resources (on
top of the $100 billion increase requested in September) just after announcing the Korean
program also encourages banks and other lenders to believe that they will be bailed out in the
future.
At the same time, the message to emerging market countries of the painful and
comprehensive programs was that they should seek to avoid calling in the IMF. Malaysia is now
doing just that even though its conditions are roughly similar to those of Thailand and Indonesia.
More generally, the tough program conditions make it difficult to get a country to work with the
IMF until it is absolutely necessary to do so. The IMF appears like the painful dentist of olden
days: just as potential patients postponed seeing the dentist until their teeth had to be pulled, the
countries with problems may wait too long to seek technical advice and modest amounts of
financial help.
The desire to keep out of the IMF's hands will also cause emerging market economies to
accumulate large foreign currency reserves. A clear lesson of 1997 was that countries with large
foreign exchange reserves could not be successfully attacked by financial markets. Hong Kong,
Singapore, Taiwan and China all have very large reserves and all emerged relatively unscathed.
A country can accumulate such foreign exchange reserves by running a trade surplus and saving
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the resulting foreign exchange. It would be very unfortunate if developing countries that should
be using their export earnings to finance imports of new plant and equipment are instead induced
to use their scarce foreign exchange to accumulate financial assets.
When the foreign exchange crisis hit Korea, the primary need was to persuade foreign
creditors to continue to lend by rolling over existing loans as they come due. The key to
achieving such behavior without the adverse "moral hazard" effect of an IMF guarantee of
outstanding loans was to persuade lenders that Korea's lack of adequate foreign exchange
reserves is a matter of temporary illiquidity and not permanent insolvency. The Fund's program
and the rhetoric that accompanied it, by emphasizing the structural and institutional problems of
the Korean economy, gave the opposite impression. Lenders who listened to the IMF could not
be blamed for concluding that Korea would be unable to service its debts unless its economy
had a total overhaul. Given the magnitude of the prescribed changes, lenders might well be
skeptical about whether Korea would actually deliver on the required changes, regardless of
what legislation it enacted. Even the $57 billion IMF fund did not promote confidence in
Korea's ability to pay since the IMF emphasized that this money would be released only as
Korea proved that it was conforming to the IMF program. It is not surprising that after the
program was announced the bond rating agencies downgraded Korean debt to junk bond status.
As a result, by late December Korea's reserves were almost gone and were shrinking at a
rate of one billion dollars a day. The U.S. government and the IMF recognized that the original
strategy had failed and agreed to accelerate $10 billion as a bridge loan to prevent a default by
Korean debtors. More important, the U.S. Federal Reserve and the other major central banks
called in the leading commercial banks and urged them to create a coordinated program of
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short-term loan rollovers and longer-term debt restructuring. The banks agreed to roll over the
loans coming due immediately and the crisis was averted. As I write this, the banks are meeting
with the Korean government to develop plans for a longer term restructuring. The situation in
Korea might have been much better and the current deep crisis avoided if such negotiations had
begun much earlier.
Several features of the IMF plan are replays of the policies that Japan and the United
States have been trying to get Korea to adopt for a long time. These include accelerating the
previously agreed reduction of trade barriers to specific Japanese products and opening capital
markets so that foreign investors can have majority ownership of Korean firms, can engage in
"hostile" takeover activity opposed by incumbent local managements, and can expand direct
participation in banking and other financial services. Although greater competition from
manufactured imports and more foreign ownership could in principle help the Korean economy,
this aspect of the IMF plan was seen by Koreans and others as a use of IMF power to force
Korea at a time of weakness to accept trade and investment policies that they had rejected in
previous years.
The IMF would be more effective in its actions and more legitimate in the eyes of the
emerging market countries if it pursued the less ambitious goal of maintaining countries' access
to global capital markets and to international bank lending. Its experts should focus on
determining whether the troubled country's problem is one of short-term liquidity and, if so,
should emphasize that in its advice and assistance. The IMF should eschew the temptation to use
currency crises as an opportunity to force fundamental structural and institutional reforms on
countries, however useful they may be in the long term, unless they are absolutely necessary to
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revive access to international funds. It should strongly resist the pressure from the U.S., Japan
and other major countries to make their trade and investment agenda part of the IMF funding
conditions.
The IMF should remember that the borrowers and the lending bankers or bond holders
should bear primary responsibility for resolving the problems that arise when countries or their
corporations cannot meet their international debt obligations. The IMF should provide technical
assistance on how the debtors can improve their current account balances and increase their
foreign exchange. It should act as a monitor of the success that the country is making in moving
toward self-sustainable liquidity, providing its own funds as an indication of its confidence in the
country's progress rather than as a bailout of international lenders and domestic borrowers. If
the IMF can focus its attention on this narrower agenda, it can devote more of its scarce staff
talent to the problem of crisis prevention by working with countries that have not yet reached a
currency crisis in order to prevent the large current account deficit or the excess short- term debt
that could
later precipitate such a crisis. And if the Fund is seen as a more client-focused and supportive
organization rather than as the imposer of painful contractions and radical economic reforms, it
is likely to find that countries will be more willing to invite its assistance when it can be most
helpful.
January 1998 Cambridge, MA