[Economic Report of the President (1999)]
[Administration of William J. Clinton]
[Online through the Government Printing Office, www.gpo.gov]




CHAPTER 6
Capital Flows in the Global Economy

International financial developments last year posed serious
challenges for the world economy. What began in the summer of 1997 as a
regional currency crisis in developing Southeast Asia erupted into a
wider and deeper economic disturbance in 1998. By late summer the
turmoil had extended to many other financial markets and to a number of
economies around the globe. The outbreak of financial and economic
turmoil in Russia in August immediately threatened to spread the
contagion to Latin America. Interest rates in these and other emerging
market countries rose sharply, and large-scale capital flight raised
risk premiums on their sovereign bonds. Several countries experienced
sharp depreciations of their currencies or strains on their foreign
exchange reserves. Prices of stocks, bonds, and other financial and real
assets fell. Commodity prices continued to fall, engendering talk of
global deflation. Ultimately the financial turbulence led to a general
flight from risky assets even within the United States and Western
Europe. Japan's hopes for recovery from a long-enduring slump were
dashed.
Prompt policy action and signs of a turnaround in Asia improved the
outlook later in 1998. Even so, by late 1998 a third of the world's
economies were in recession or experiencing markedly slower growth. The
International Monetary Fund (IMF) has estimated world economic growth at
only 2.2 percent in 1998 and projected that it would remain at that
level in 1999, in stark contrast to robust growth of 4.2 percent in
1997. Those estimates indicate a deceleration of global growth to levels
not seen since the pronounced world slowdowns of 1974-75, 1980-83, and
1990-91. The risk of such a global slowdown poses new challenges to
economic policy.
The widespread financial turmoil--perhaps the most severe
experienced by the world economy during the last 50 years--followed a
period of increasing global integration of goods and financial markets.
World trade has increased dramatically as trade restrictions have
steadily fallen and many countries have made a historic commitment to
opening their economies to international trade. Restrictions on
international capital transactions have also been eased, and the
integration of financial markets has led to an unprecedented volume of
cross-border capital flows.
The recent turbulence should not cloud the benefits of this ongoing
trend toward globalization. The integration of markets has provided

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greater opportunity, faster growth, and rising standards of living for a
large share of the world's population. Trade among countries has fueled
growth by harnessing the benefits of international comparative advantage
and providing a dynamic stimulus to productivity. Financial integration,
too, offers advantages. Open capital markets have promoted growth by
allocating capital to those countries whose domestic investment
opportunities exceed domestic saving. The ability of capital to flow to
all corners of the world has allowed global investors to diversify the
risk in their portfolios. And the knowledge that these investors are
watching over their shoulders may have helped governments achieve
discipline in their monetary and fiscal policies.
The promise of these long-term benefits should not, however, lead us
to neglect the real costs of the current crisis--or the possibility of
new crises years hence. Therefore the United States, together with other
industrial and developing countries and the international financial
institutions, has taken a number of important steps. To support
continued growth in a context of low inflation and to restore confidence
in unsettled financial markets, the Federal Reserve and other central
banks worldwide have reduced key interest rates. To support economic
stabilization in Brazil and to head off further contagion, the IMF has
assembled a $41 billion stabilization package for that country. To
ensure the IMF's continued ability to respond to financial crises, the
Congress has approved the Administration's request for $18 billion in
new funding, the U.S. share of a roughly $90 billion international
package. To secure financial stability and help avoid crises in the
future, Indonesia, the Republic of Korea, and Thailand have undertaken
serious structural reform of their economic and financial systems. To
resolve its long-festering banking problems and stimulate its economy,
Japan has passed bank reform legislation and a program of fiscal
stimulus. Finally, to strengthen the international financial system and
make it less crisis prone, the international community is working
together to foster reforms of the international financial architecture.
These measures serve to promote confidence and improve the prospects for
growth in the world economy in 1999.
This chapter analyzes the factors that have led to increased global
financial integration. Next it considers the causes of the Asian crisis
and its contagion to other economies, the policy response to the global
turmoil, and the role of Japan. The chapter concludes with an analysis
of the effects of the international financial crisis on the United
States.
Chapter 7 is devoted to a discussion of developments in the
international financial system and proposed reforms to its architecture
aimed at reducing the likelihood of future crises and promoting the
orderly resolution of those that do occur. That chapter also discusses
the prospects for the recently launched monetary union in Europe and the
implications of the creation of the new European currency, the euro, for
the U.S. dollar.

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INTERNATIONAL CAPITAL FLOWS, THEIR CAUSES, AND THE RISK OF FINANCIAL
CRISIS

TRENDS IN FINANCIAL INTEGRATION

The phenomenal growth of international capital flows is one of the
most important developments in the world economy since the breakdown of
the Bretton Woods system of fixed exchange rates in the early 1970s.
Their growth can be traced to the oil shock of 1973-74, which spurred
financial intermediation on a global scale. Mounting surpluses in the
oil-exporting countries could not be absorbed productively within those
economies, and at the same time the corresponding deficits among oil
importers had to be financed. The recycling of ``petrodollars'' from the
surplus to the deficit countries, via the growing Euromarkets (offshore
markets for deposits and loans denominated in key currencies,
particularly the dollar), produced the first post-Bretton Woods surge of
international capital flows. As a result, many developing countries
gained access to international capital markets, where they were able to
finance their growing external imbalances. Most of this intermediation
occurred in the form of bank lending, as large banks in the industrial
countries built up large exposures to developing countries' debt.
The buildup of these external liabilities eventually became
excessive and, together with loose monetary and fiscal policies in the
borrowing countries, sharp declines in their terms of trade, and high
international interest rates, triggered the debt crisis of the 1980s.
Starting in Mexico in 1982, that crisis rapidly engulfed a large number
of developing countries in Latin America and elsewhere. The rest of the
1980s saw a period of retrenchment, with a significant slowdown in
capital flows to emerging markets (especially in Latin America) as
burdensome foreign debts were rescheduled, restructured, and finally
reduced with the inception of the Brady Plan in 1989.
The resolution of the 1980s debt crisis led to new large-scale
private capital inflows to emerging markets in the 1990s. Several
factors encouraged this renewed surge of international financing. Many
Latin American countries were adopting policies emphasizing economic
liberalization, privatization, market opening, and macroeconomic
stability. Countries in Central and Eastern Europe had embarked on their
historic transition toward market economies. And rapid growth in a group
of economies in East Asia had caught the attention of investors
worldwide. Net long-term private flows to developing countries increased
from $42 billion in 1990 to $256 billion in 1997.
The largest share of these flows took the form of foreign direct
investment--investment by multinational corporations in overseas
operations under their own control. These flows totaled $120 billion in
1997 (Chart 6-1). However, bond and portfolio equity flows accounted

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for 34 percent of the total in that year, amounting to $54 billion and
$33 billion, respectively. In contrast, commercial bank loans
represented only 16 percent of net flows to developing countries, or $41
billion, in 1997, compared with about two-thirds in the 1970s. To the
extent it went to bond rather than equity flows, this massive relative
switch out of bank lending, which is characterized by a small number of
substantial lenders, would eventually pose a problem not encountered in
the 1980s, namely, how to coordinate the actions of a large number of
creditors (an issue discussed further in Chapter 7).
Table 6-1 reports gross inflows and outflows of both foreign direct
investment and portfolio investment (two of the main components of
capital flows) for both developing and industrial countries over several
decades. Two points are noteworthy. First, although net flows have been
large and growing, the magnitude of gross flows may be a better
indicator of financial integration. As investors in one country
diversify their portfolios by purchasing foreign assets, and as foreign
investors increase their purchases of assets in the first country, gross
flows may increase substantially without net flows changing nearly as
much. And in fact gross cross-border inflows and outflows have grown
even faster than net flows. Second, the rise in cross-border capital
flows has occurred in developing and industrial countries alike.
Although the Mexican peso crisis of December 1994 led to a modest
slowdown in capital flows to emerging markets in 1995, they surged again
thereafter until the Asian crisis erupted in the summer of 1997.

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Further evidence of the trend toward global financial integration is
the sharp expansion of foreign exchange trading. This growth has been
evident both in spot markets (where currency transactions are settled
within 2 business days, or ``on the spot'') and in the use of derivative
instruments (where trading is for future delivery of currencies, or in
options to buy or sell currencies). Most purchases and sales of foreign
exchange are related to financial transactions rather than merchandise
trade, and indeed foreign exchange trading has grown much faster than
international trade in goods over the last two decades (Box 6-1).

THE CAUSES OF INCREASED CAPITAL FLOWS

Several factors have undoubtedly contributed to this phenomenal
growth of international capital flows. First, countries have opened
their financial markets, both domestically and internationally, as
governments in industrial and developing economies alike have phased out
restrictions on financial activity and progressively reduced or
eliminated controls on cross-border capital transactions. In many
instances, this financial liberalization has been accompanied by
macroeconomic stabilization, privatization, trade liberalization, and
deregulation. These structural reforms in capital-scarce developing
countries have created significant investment opportunities, attracting
a surge of foreign capital with the expectation of high rates of return.
Growth in international trade has also increased the

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Box 6-1.--The Explosive Growth of Foreign Exchange Trading

The single statistic that perhaps best illustrates the dramatic
expansion of international financial markets is the volume of trading in
the world's foreign exchange markets. The Bank for International
Settlements (BIS, an international institution in Basle, Switzerland,
that acts as a kind of central bankers' bank) released in October 1998 a
preliminary compilation of a triennial survey of 43 foreign exchange
markets. It shows that, in current-dollar terms, the volume of foreign
exchange trading in these markets grew 26 percent between April 1995 and
April 1998, following a 45 percent increase between 1992 and 1995. That
volume now stands at $1.5 trillion per day (after making corrections to
avoid double counting). By way of comparison, the global volume of
exports of goods and services for all of 1997 was $6.6 trillion, or
about $25 billion per trading day. In other words, foreign exchange
trading was about 60 times as great as trade in goods and services.
In the BIS preliminary survey, spot market purchases amounted to
40 percent of foreign exchange transactions in 1998, down from 44
percent in 1995. Forward instruments continued to grow in importance
relative to spot sales. Over-the-counter derivatives, although still a
smaller fraction of total transactions, have been the fastest-growing
segment of the market.
A striking feature of the foreign exchange market is the small
percentage of trades made on behalf of nonfinancial customers. In the
most recent survey, transactions involving such customers represent only
20 percent of total turnover.
Trading also tends to be focused geographically in a few major
centers. Arguably there is a natural equilibrium consisting of one major
center in each of the world's three 8-hour time zones. New York is the
major center in the Western Hemisphere, with U.S. volume now equal to
$351 billion per day (18 percent of world turnover). Tokyo established
itself in the 1980s as the major center in the third of the world that
includes Asia. Its turnover, however, has fallen off recently, as
markets in Singapore have gained. Average daily transactions totaled
$149 billion (8 percent of the world total) in Japan and $139 billion in
Singapore. London continues to handle the greatest volume of foreign
exchange transactions, with its share of world turnover increasing to 32
percent, at an average daily volume of $637 billion.
To summarize, the volume of world trade in foreign exchange has
continued to grow. Derivatives far exceed spot market transactions. Most
trades take place between professional traders at banks and other
financial institutions; only a fraction of foreign exchange sales and
purchases directly involve those who import and export goods and
services.

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volume of trade-related financing and bolstered trade in derivative
instruments, as buyers and sellers seek to hedge their exposures to
currency and commercial risk.
At the same time, financial innovations in the United States and
other industrial economies have rendered cross-border investments more
accessible to institutional and individual investors. Revolutionary
advances in information and communications technology, together with
significantly lower transportation and transactions costs, have
underpinned this rapid development. Mutual funds, hedge funds, and the
growth of new financial instruments, including derivatives, have enabled
investors to choose which risks they will and will not accept in their
quest for higher returns. A radical increase in the available range of
instruments and assets has afforded investors unprecedented
opportunities to increase returns and decrease risks through global
diversification. Although most wealth is still primarily invested in
domestic assets, international portfolio diversification is now an
option for both institutions and households.

THE FINANCIAL CRISES OF THE 1990s

Although financial crises have a long history and have recurred
throughout the century, the same two decades that have seen spreading
financial liberalization and ever-growing global capital flows have also
witnessed such crises, which imposed serious real costs on the economies
affected. Since the resurgence of these flows after the 1980s debt
crisis, three more financial crises of at least regional importance have
struck. The first occurred in 1992-93, when several currencies in the
Exchange Rate Mechanism (ERM) of the European Monetary System
experienced speculative attacks. Italy and the United Kingdom were
forced to abandon the ERM in the fall of 1992 and allow their currencies
to depreciate; Sweden, whose currency was effectively pegged to the ERM
currencies, was obliged to follow suit shortly thereafter. A series of
devaluations of several other ERM currencies ensued, and the ERM
exchange rate bands for France and the remaining members had to be
widened in the summer of 1993, to cope with the speculative pressure on
their currencies.
The collapse of the Mexican peso in December 1994 touched off the
second crisis. Other Latin American currencies quickly came under attack
through what became known as the tequila effect. The third crisis of the
1990s, the Asian currency and financial crisis that has now spread to
Russia, Latin America, and beyond, was triggered by the devaluation of
the Thai baht in July 1997. (The history and causes of that crisis are
described in detail below.) Although each of these crises had distinct
characteristics and causes, several common elements, which factor
significantly into current debates surrounding the reform of the
international financial architecture, can be identified.

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Recent Financial Liberalization

In most crisis countries, significant liberalization of
international capital transactions and the progressive elimination of
capital controls preceded the crisis. Italy and France had fully
liberalized capital movements in the years just before the ERM crisis.
Mexico had progressively liberalized its domestic and international
financial regime in the early 1990s. Similarly, several East Asian
economies had embarked on financial liberalization, both domestic and
international, over the course of the 1990s.

Semi-Fixed Exchange Rate Regimes

All three crisis episodes occurred under semi-fixed exchange rate
regimes. Each country that fell victim to crisis had attempted to
stabilize the value of its currency with respect to those of its key
trading partners. None, however, had fixed its exchange rate in a rigid
way. For example, exchange rates in the ERM had been permitted to move
against one another within a band (typically plus or minus 2G percent
from a central parity rate), in an arrangement designed as a step toward
European monetary integration. Similarly, the Mexican peso had followed
a crawling band against the dollar, which allowed it to escape the very
high inflation rates the country had suffered in the 1980s. Finally, the
currencies of several Asian economies were loosely pegged to currency
baskets in which the dollar had an effective weight of at least 80
percent. Although all these arrangements may have speeded integration
into the world system of trade and finance and helped curb inflation in
some episodes, they also, in the Mexican and Asian cases, may have
hindered the adjustment of real exchange rates in the face of large
trade deficits. The sudden abandonment of relatively fixed exchange
rates in time of crisis reinforced negative market expectations,
intensifying financial market pressures and producing severe recessions
in the presence of large foreign currency-denominated debts.
The rigidly fixed exchange rate regimes of Argentina and Hong Kong
are organized as currency boards, in which only as much domestic
currency is issued as is backed by holdings of U.S. dollars (see Box 7-1
in Chapter 7). Their exchange rate regimes have successfully withstood
the recent crisis, but at some cost to their economies.

Contagion

In all three episodes, a crisis that began in one country quickly
spread beyond its borders. In some cases the next victims were neighbors
and trade partners; in others they were countries that shared similar
policies or suffered common economic shocks. At times, as in the summer
of 1998, changes in investor sentiment and increased aversion to risk
contributed to contagion within and across regions. (The causes of
contagion are discussed further in a later section.)

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Concurrent Banking Crises

The currency crises of the 1990s have often been associated with
banking and financial sector crises. This is most clearly evident in the
Asian and Mexican episodes, but weaknesses among financial institutions
also played a role in the ERM devaluations. In Finland and Sweden,
banking crises emerged in conjunction with the currency turmoil, whereas
in Italy some segments of the banking system experienced financial
distress. The Asian crisis provides a striking example of the link
between currency and banking crises, underscoring the profound
vulnerability to which fragile financial and banking sectors subject an
economy. The causal links between banking crises and currency crises are
complex and often reciprocal: financial weaknesses may contribute to a
currency crisis, and a currency crisis can exacerbate a financial crisis
by increasing the burden of foreign currency liabilities.

THE ASIAN CRISIS AND ITS GLOBAL REPERCUSSIONS

THE ASIAN ECONOMIC MODEL

For over two decades, beginning in the 1970s and in some cases
earlier, a number of East Asian economies grew at very rapid rates, in a
phenomenon widely hailed as the ``Asian miracle.'' Thirty years ago it
might have seemed that industrialization was a privilege reserved, with
the sole exception of Japan, for the European countries and a few others
where Europeans had settled. The East Asian miracle economies not only
disproved this notion but industrialized far more quickly than their
predecessors had. Starting from 1780 (roughly the beginning of the
industrial revolution), the United Kingdom took 58 years to double its
income. The United States and Japan took almost as long (47 years,
starting from 1839, and 35 years, starting from 1885, respectively). Yet
Korea accomplished the same feat in 11 years and China in just 10
(starting in 1966 and 1977, respectively).
These economies' remarkable success served to enhance living
standards, reduce poverty, and expand economic opportunities for
multitudes of the region's inhabitants. Perhaps even more impressive,
these economies maintained a more equal distribution of income and
wealth than did many developing countries that lagged behind. East
Asia's success was achieved through a focus on the fundamentals--the
factors that most economists consider critical to economic growth. These
include high rates of saving and investment, sustained investments in
education (with particularly high completion rates for basic education
and high literacy), a pronounced work ethic, and an outward orientation
characterized by heavy involvement in international trade

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and investment (although openness to imports and foreign investment was
in some cases highly selective). The East Asian strategy also emphasized
sound macroeconomic management, including low budget deficits and
inflation rates.
The East Asian recipe for economic success, with its clear focus on
the underpinnings of economic growth, has served and should continue to
serve as an inspiration for countries seeking to escape poverty, the
recent crisis notwithstanding. Indeed, as developing countries around
the world increasingly opted for capitalism over state planning in the
1980s and 1990s, they were not merely reacting against the conspicuous
failures of state planning in their own economies and in the former
Soviet bloc; they were also attracted to East Asia's inspiring example.
Their enormous strengths notwithstanding, it is now commonly recognized
that the East Asian economies concealed structural weaknesses, which
eventually contributed to the crisis. Arguably, Asian governments relied
too much on centralized state coordination rather than decentralized
market incentives to maintain their progress. Government favoritism
toward selected industries and exports was widespread, as was protection
of domestic industries against foreign competition. Other practices
distorted private sector lending and investment incentives. For example,
relationship-driven banking (Box 6-2) hindered capital market discipline
and flexibility. Financial institutions in general were often poorly
supervised and inadequately regulated; implicit and explicit government
bailout guarantees fostered moral hazard in the financial sector (as
discussed below). A heavy dependence on bank debt rather than equity (as
securities markets in some countries were underdeveloped) led to
excessive leveraging of firms. The activities and balance sheets of
corporations and financial institutions lacked transparency, as
reflected in weak accounting and disclosure standards. Enforcement
mechanisms were informal rather than formal: effective bankruptcy and
foreclosure laws were lacking. Box 6-3 presents a further analysis of
the Asian growth model.

A HISTORY OF THE CRISIS AND ITS CONTAGION

In the summer of 1997, financial turmoil in Thailand spread to
several neighboring economies with outwardly similar features at similar
stages of development: Indonesia, Malaysia, and the Philippines. This
contagion took the form of declines in both equity and currency markets.
Next, Singapore and Taiwan, concerned about the competitive effects of
these four economies' currency depreciations, decided to let their
currencies float rather than resist the speculative pressure building
against them. By October the contagion was affecting Hong Kong (whose
return to China that summer had already increased the political
uncertainty about its future), putting pressure on the Hong Kong dollar
and sharply depressing local stock markets. The first bout of truly
global contagion then ensued, as stock markets in the United

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States and Europe fell sharply, and as other emerging market economies
were forced to raise interest rates to prevent a run on their
currencies. The spread of the crisis to Korea and further deterioration
in Indonesia led to a severe and worsening crisis in the winter.
Investor sentiment seemed to improve by March 1998, as the Thai and
Korean currencies stabilized and Korea successfully converted its short-
term bank debt into longer term loans. Also, higher interest rates and
tighter monetary policy in Latin America following the October episode
helped stabilize investors' confidence in that region. In April,
however, several negative developments led to a new loss of investor
confidence. Plunging commodity prices, resulting in part from the
deepening recession in Asia, hurt a wide range of commodity exporters.
Oil exporters such as Ecuador, Mexico, Russia, and Venezuela were hit
hard by plunging oil prices. Agricultural exporters such as Argentina,
Australia, Canada, and New Zealand were also affected, as the crisis in
Asia and abundant global supply led to a sharp fall in agricultural
prices. Mineral producers such as Chile and Peru suffered damage as
well.
Violence in May surrounding the collapse of the Suharto regime
devastated confidence in Indonesia and again shook confidence in the
rest of East Asia. Currency pressures on economies as far removed as
South Africa, a sharp deterioration of business conditions in Japan, and
the continued fall of the yen added to the pessimism. The yen's weakness
led to concern that China might devalue its currency in response and
that the Hong Kong peg would collapse, causing another round of currency
depreciations in Asia. However, China gave assurances that it would not
devalue, and the pegs held. These adverse developments, however, led to
another round of sharp declines in emerging market equities starting in
May.
Financial turmoil spread next to Russia, where the fall in the price
of oil (one of the country's biggest exports) fed a growing current
account imbalance in an economy already weakened by inadequate tax
collection, a large fiscal imbalance financed by short-term ruble debt,
and disappointment at the slow pace of structural reform. The
manifestations included a sharp fall in the Russian stock market,
speculative pressure on the ruble, and a sharp increase in the interest
rate on ruble-denominated public debt. Despite negotiation in July of an
IMF package aimed at reducing the fiscal deficit, the Russian government
failed to restore confidence. It proved unable to implement its
anticrisis program in the face of opposition from the legislature, from
powerful business interests, and from advocates of a return to
communism. The deterioration in market conditions culminated in a
comprehensive breakdown in confidence in the first weeks of August.
On August 17 the Russian government, faced with growing losses of
foreign reserves triggered by capital outflows, decided to devalue the
ruble, to restructure its short-term public debt unilaterally in a form

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Box 6-2.--Market-Based (Arm's-Length) Versus Relationship-Based
(Insider) Finance

Financial economists have long distinguished between market-based
and relationship-based financial systems, broadly characterizing the
Anglo-American system as the former and citing many Asian economies as
examples of the latter. This generalization can provide useful insights
for understanding Japan's persistent financial problems as well as the
crisis in East Asian emerging markets. The details, however, differ
widely within Asia. In Japan the best example is the ``main bank''
relationship that many established firms traditionally have with their
primary lenders. In Asian developing countries the relationships that
underpinned financial transactions were often based more generally on
personal or political connections. Loans from a bank to an affiliated
firm are called connected lending; loans guided by the government are
called directed lending.
Although securities markets are more important in market-based
systems, commercial banks are prominent in both systems. A crucial
distinction concerns the roles that they play. In a market-based system,
banks are one of many sources of external finance for firms. They
compete with bond and commercial paper markets, along with markets for
equity, to provide funds to companies. In such a system, bank loans are
typically provided through arm's-length market transactions. Loans are
contracted for specific periods, and interest rates are competitively
determined on the basis of independent assessments of risk.
A decade ago, economists commonly emphasized the benefits that
were thought to result from a relationship-based system. It was argued
that main banks in Japan, for example, were better able to distinguish
between temporary and fundamental problems when affiliated firms got
into financial trouble. They could therefore continue to lend to those
firms whose problems were only temporary, under circumstances where
impatient, market-based financial systems would be unable to tell the
difference, and therefore could not lend.
It was also argued that relationship banking improved young firms'
access to funds. In market-based systems, competition
that implied material default, and to impose a 90-day moratorium on
private sector payments of foreign liabilities. These decisions led to a
profound financial crisis, which in turn sparked a dramatic spread of
investor pessimism to Latin America and other emerging markets and a
sharp downturn in equity markets in the United States and other
industrial countries. The contagious spread of turmoil from Russia to
Brazil and other Latin American countries arguably signaled a degree

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Box 6-2.--continued

limited a bank's ability to take chances, since nothing prevented
its competitors from subsequently stealing its customers if business
went well. In relationship-based systems, on the other hand, long-term
relationships promised handsome payoffs for banks from those firms that
succeeded.
Some credited this financial system with promoting the Asian
economies' high rates of investment and growth. But along with their
strengths, relationship-based systems also possess weaknesses, which the
Asian crisis has now exposed. Relationship-based systems neglect the
information encapsulated in market prices. This information, the product
of numerous independent assessments of profitability and risk, possibly
becomes more important as economies develop and attractive opportunities
for further investment become relatively more scarce. Relationship-based
systems might also foster the corruption and abuse that have become
known as ``crony capitalism.''
Long-term banking relationships create value when they facilitate
the transfer of funds to profitable firms that are either young or
temporarily distressed. Perhaps they are also unavoidable if an
ineffective legal system forces investors to maintain some type of
control to prevent their funds from being misused. They destroy value,
however, when they misallocate resources.
The Asian crisis seems to offer numerous examples of such
misallocation. Borrowers that should have been foreclosed upon, or at
least cut off from further lending, were allowed to continue borrowing,
which increased their losses and those of their banks. Lack of
transparency in financing practices may have enabled bankers and
corporate managers, shielded from market constraints, to invest in
pursuit of personal priorities rather than in their firm's best
interest. It appears, for example, that some Asian firms, unchecked by
external market discipline, developed excess capacity in industries such
as steel and electronics. Many Asian economies are currently struggling
to overcome the adverse real consequences of these misguided financial
decisions.
of financial panic, as investors apparently withdrew capital
indiscriminately from most emerging market economies regardless of their
strength. This sharp loss of confidence may have partly originated in
the perception that the IMF had few resources left, or that it was not
willing to use them to rescue a country that until then had been
considered ``too important to fail.'' If this is the case, it appears
that investors drew the wrong lesson from the IMF's enforcement of

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conditionality in the face of unsound Russian macroeconomic policies.
The loss of confidence may also have been partly caused by the
perception that other countries might follow Russia down the path of
unilateral default, debt moratoria, and capital controls.
Although the major Latin American economies were structurally much
stronger than the Russian economy, investors now sought to avoid risk
everywhere. Emerging market sovereign spreads (Box 6-4) over U.S.
Treasuries rose to about 1,500 basis points (15 percentage points) by
September (Chart 6-2). In all probability this signaled an

Box 6-3.--The Asian Growth Model in Perspective

The Asian crisis caught most analysts by surprise. Some had warned
of economic policy flaws in Asia, but few expected them even to produce
a sharp slowdown, and no one predicted the profound crisis that actually
materialized. Until recently many observers thought that the East Asian
countries possessed the strong economic fundamentals and structural
characteristics necessary for sustained long-run growth.
If structural weaknesses in the Asian economic system lie at the
origin of the crisis, as many observers contend, a natural question is
why the crisis occurred when it did. One hypothesis is that countries
pass through natural stages of economic development, and that the Asian
financial system, based on such practices as relationship banking, is
better suited to countries in the early stages. After all, financial
intermediation by banks (even in the context of relationship banking) is
a tremendous step to take for countries where firms are used to
financing all investment out of family savings or retained earnings.
Relationship banking may mimic the close ties of extended family lending
and thus ease the transition to a more arm's-length financial system.
Moreover, as long as growth is rapid, high leverage (that is, a high
ratio of debt to equity) is sustainable. But when growth slows, the
financial system needs to adapt, and firms need to reduce their high
leverage.
Some slowdown in East Asia's growth was probably inevitable at
some point, after the breakneck growth of the preceding decades, for the
simple reason that economic convergence served as one of the driving
forces of that growth. An economy that starts out behind the world
leaders in income per capita can close part of the gap over time by
growing more rapidly, provided of course such fundamentals as an outward
orientation and investment in physical and human capital are in place.
Convergence occurs for two reasons: the high rate of return on capital
in labor-abundant economies, and the opportunity to emulate the most
advanced technology and management practices of the leaders. But as the

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extreme rise in investor risk aversion, and large-scale flight from
emerging markets and other risky investments in favor of ``safe
havens,'' notably U.S. Treasury bills. The sharp increase in the
preference for liquidity, together with attempts to unwind highly
leveraged positions, added to pressure on the prices of a wide range of
risky assets. As described in Chapter 2, capital markets within
industrial countries, including the United States, were also affected by
the flight to quality: as yields on safe government securities fell, the
spread of high-yield securities (junk bonds) over Treasuries increased
sharply.

Box 6-3.--continued

income gap closes, this impetus to growth diminishes. Economies
encounter diminishing returns to capital, limits on labor supply growth
from rural-to-urban migration, and infrastructure constraints. Also, as
they draw closer to the technological frontier, they have less to learn
from those who have gone before. Japan had achieved convergence by the
1980s, and Hong Kong and Singapore by the 1990s. Korea and the others
still had some way to go--a very long way in some cases. Nevertheless,
the basic principle remains that the smaller the remaining gap, the less
the forces of convergence contribute to further growth.
One controversial view is that East Asia's growth from the
beginning had more to do with the rapid accumulation of the factors of
production--both labor, through increased labor force participation
rates, and capital, due to very high investment rates--than with growth
in the productivity of these factors. Some studies have found only
modest underlying growth rates of multifactor productivity (a measure of
increased efficiency in the use of all factors, resulting in part from
technological progress). If this view is correct, it means that East
Asia's high growth rates were not sustainable in the long run, given
that the rate of employment growth must at some point decline, and given
an expected reduction in the rate of investment. However, even this view
implies at worst a gradual slowdown of growth, not the sudden and severe
crisis that occurred.
The answer to why the East Asian crisis struck when it did is thus
probably a complex one. As discussed below, it appears that, around mid-
1997, the factors working to produce an eventual slowdown in growth
interacted in unfortunate ways with existing financial sector
weaknesses, excessive corporate leverage, financial fragility resulting
from poorly designed capital market liberalization, foreign
indebtedness, a slowdown in export markets, worsening terms of trade,
and the development of overcapacity in many sectors. The crisis was the
result.

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Box 6-4.--Sovereign Spreads in Emerging Markets

The Asian crisis has introduced into popular parlance a number of
terms formerly encountered only in arcane financial discussions among
bankers and economists. One of these is ``sovereign spread.'' A simple
definition of sovereign spread is the difference between yields on bonds
issued by the government of one country (for example, an emerging market
country) and those (safe) bonds issued by the government of a major
industrial country. The yield in question is the yield to maturity, or
the rate of return earned by holding the bond until it matures
(including all interest and principal payments), and the bonds being
compared must be of the same maturity and currency denomination for the
comparison to be valid.
Using the prices of bonds issued by governments in emerging market
economies, one can measure the implicit risk premium that the market
demands to compensate for the extra default risk entailed in holding a
bond from a particular emerging market. (Default risk is the risk that
the debtor will fail to pay all principal and interest on its obligation
on time. The bonds of the major industrial country governments are
considered to carry little or no default risk.) The sovereign spread on
foreign currency-denominated bonds measures only the default risk of a
country's obligations--not currency risk, because payments are to be
made in foreign currency.
During the periods of extreme market turbulence following the
Mexican peso crisis in 1994 and the Russian default in 1998, sovereign
spreads rose sharply. In the latter episode these spreads reached about
1,500 basis points by mid-September (Chart 6-2). Estimates of the
default probabilities incorporated in emerging market bond prices can be
derived fairly easily from their sovereign spreads, given the assumption
that U.S. government bonds are default risk-free. At their height, these
spreads implied very high default probabilities for many countries,
leading to the conclusion either that markets were exceptionally
pessimistic or that investors were becoming exceedingly risk averse.
A second interesting comparison relates to the difference in
yields on dollar- and local currency-denominated bonds. As long as the
default risk on these bonds is the same, this differential measures the
market's assessment of currency risk, that is, the risk deriving from
changes in the international value of the currency. Interestingly, even
under most ``fixed'' exchange rate regimes, a positive currency risk
premium can be observed, suggesting that investors expect a devaluation
at some point or that they require an implicit ``insurance'' premium to
compensate for that possibility.

[[Page 235]]


Even the spreads between Treasuries and high-grade corporate bonds rose
to some extent, reflecting the generalized increase in risk aversion.
The huge losses and near-collapse of a prominent hedge fund contributed
to the panic. By early October there were hints of a generalized global
credit crunch: rising spreads on the entire range of bond instruments
from high-quality corporate bonds to junk bonds and emerging market
sovereign instruments; an interruption of access to international
capital markets for most emerging economies; a drying up of bond
financing in all emerging markets and a shrinkage in new bond issues in
industrial countries; evidence of a tightening of lending standards by
commercial banks in the United States; a slowdown in reported earnings
growth; and a contraction in stock markets worldwide. However, by the
middle of November, conditions in international and domestic capital
markets had improved noticeably, thanks to a number of positive
developments:

 The Administration, as discussed in Chapter 1, took the lead in
proposing a comprehensive set of steps to contain and resolve
the crisis. These proposals included measures to support growth
in the industrial countries, as well as policy reforms in
emerging markets to promote their recovery; creation of a
precautionary facility within the IMF to support countries
subject to speculative pressures despite good economic
fundamentals; measures to support the accelerated systemic
restructuring of Asian banks and corporations; significant
increases in the support by multilateral financial institutions
of

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social safety nets in the crisis countries; increases in trade
financing to the affected countries; and reform of the
international financial system architecture to make it less
crisis prone.
 On October 30 the leaders of the Group of Seven (G-7) nations
(Canada, France, Germany, Italy, Japan, the United Kingdom, and
the United States) issued a joint statement affirming their
strong commitment to growth and the resolution of the crisis;
endorsing the U.S. proposal for an enhanced IMF facility to
provide contingent short-term lines of credit for countries
pursuing strong, IMF-approved policies; presenting concrete
proposals to implement initial reforms to the system; and laying
out areas for further consideration in the effort to strengthen
the international financial architecture. The G-7 finance
ministers and central bank governors issued a more detailed
statement that same day.
 The Federal Reserve reduced the Federal funds rate three times:
at the end of September, in mid-October, and again in mid-
November. These moves helped restore confidence and liquidity.
Interest rate reductions in a number of other industrial
countries, including Canada, Japan, and most of the European
countries, significantly eased monetary conditions in the world
economy.
 In October the Congress approved an $18 billion funding package
for the IMF, opening the way for about $90 billion of usable
resources to be provided by all IMF members to the liquidity-
strapped institution.
 In November, negotiations leading to an IMF-led support and
stabilization package for Brazil were concluded. The G-7 and 13
other countries agreed to support this country's adjustment
efforts.
 Japan passed legislation to address the problems of its banking
sector, and the Japanese government proposed a supplemental
fiscal package, restoring some confidence in Asian markets.
 The yen appreciated sharply in October, reducing the risk of a
devaluation by China that might have led to another round of
devaluations in Asia. The stronger yen will also stimulate the
exports of other East Asian countries to Japan and third-country
markets, although it will raise debt-service costs for East
Asian countries that have large amounts of yen-denominated debt.
 In mid-November the leaders of the member nations of the Asia-
Pacific Economic Cooperation embraced a comprehensive strategy
to accelerate recovery and restart growth. They undertook
commitments to pursue prudent, growth-oriented macroeconomic
policies, strengthen domestic financial institutions, and
further liberalize trade and investment. The crisis-affected
countries reaffirmed the importance of

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restructuring the corporate and financial sectors to help
revitalize the private sector. These countries also committed
themselves to building and strengthening social safety nets to
protect the poor and economically dislocated, with support from
the multilateral development banks and the international
community.

THE CAUSES OF THE CRISIS

Identifying the cause or causes of the Asian crisis has engendered
heated debate. Countries that experienced currency and debt crises in
the past, such as the Latin American countries in the 1980s, typically
shared several common characteristics. These included large budget
deficits and a large public debt, high inflation as a result of
monetization of those deficits, slow economic growth, and low saving and
investment rates. (A deficit is said to be monetized when the central
bank finances it by printing additional currency.) In Asia, in contrast,
most of the economies engulfed by the crisis had enjoyed low budget
deficits, low public debt, single-digit inflation rates, rapid economic
growth, and high saving and investment rates.
The absence of the macroeconomic imbalances typical of past crises
has led some to argue that the Asian crisis was not due to problems with
the economic fundamentals. These analysts contend that the crisis
represented an essentially irrational but nevertheless self-fulfilling
panic, akin to a bank run, fueled by hot money and fickle international
investors. (See Box 6-5 for a discussion of domestic bank runs.)
Although speculative capital flight certainly exacerbated the crisis, it
is now commonly agreed that, along with their many strong fundamentals,
the East Asian crisis economies also shared some severe structural
distortions and institutional weaknesses. These vulnerabilities
eventually led to the crisis in the summer of 1997.
First, connected lending and, at times, corrupt credit practices
rendered the financial sectors of the crisis economies fragile. Loans
were often politically directed to favored firms and sectors. In
addition, regulation and supervision of banking systems were notably
weak, and implicit or explicit guarantees that the government would bail
out financial institutions in trouble created moral hazard (see Box 6-
5). These weaknesses contributed to a lending boom and overinvestment in
projects and sectors, especially real estate and certain other sectors
not exposed to international competition, that were risky and had low
profitability; excess capacity also accumulated in some sectors whose
goods were internationally traded. Before the crisis, speculative
purchases of assets in fixed supply fed an asset price bubble in some
economies, with equity and real estate prices rising beyond levels
warranted by the fundamentals. Poor corporate governance and what has
come to be called ``crony capitalism'' fed the distortions in the system
and fueled the investment boom. Domestic and international capital

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Box 6-5.--Moral Hazard in Financial Institutions

Moral hazard is a key concept in the economics of asymmetric
information, the study of transactions in which buyers and sellers
differ in their access to relevant information. In general terms, moral
hazard occurs whenever economic actors covered by some form of insurance
pursue riskier behavior as a consequence.
Examples of moral hazard abound: insured homeowners, for instance,
are more likely to build homes in a flood plain or in areas prone to
wildfires, and less likely to install alarms and antitheft systems;
insured drivers might drive more recklessly. If insurers can observe
such behavior, they can penalize it through higher premiums. But if they
cannot, they may try to regulate their clients' behavior and make sure
that the client bears a portion of any losses. Sometimes these
strategies are enough to mitigate moral hazard, but in extreme cases
moral hazard may cause insurance markets to disappear entirely.
Banks are subject to a rather unique risk that both requires
insurance and creates moral hazard. The risk is that a bank's depositors
might suddenly, with or without good reason, lose confidence in the
institution and seek to withdraw their funds en masse. Given that most
of the assets of any bank are tied up in loans to clients, even a well-
managed bank will quickly exhaust its cash reserves in the face of such
a run. And any attempt to liquidate its other assets prematurely will
diminish their value. Thus, even strong banks can fail if a bank run
occurs, and the failure of one bank can cause runs on others.
Banks, of course, play a pivotal role in all modern economies, not
only through their intermediation between saving and investment, but
also through their operation of the economy's payments system.
liberalization may have aggravated the original distortions by allowing
banks and firms to borrow more money at lower rates in international
capital markets.
In Thailand, restrictions on entry into banking led to the growth of
unregulated, nonbank finance companies, whose excessive borrowing
intensified the real estate boom. Liberalization of international
capital restrictions, for example through the establishment of the
Bangkok International Banking Facility, enabled Thai banks and firms to
borrow heavily abroad, in foreign currency, at very short maturities. No
fewer than 56 of these heavily indebted finance companies were in
distress even before the crisis and were eventually closed after the
crisis broke.
In Korea, excessive investment was concentrated among the chaebols,
the large conglomerates that dominate the economy. The

[[Page 239]]

Box 6-5.--continued

Most governments therefore provide both a system of deposit
insurance, to discourage bank runs, and lender-of-last-resort
facilities, to assure banks ample access to liquidity in emergencies. In
addition, governments frequently rescue troubled financial institutions
that are deemed ``too big to fail,'' that is, whose failure could do
damage to the broader financial system or provoke a run on other
institutions.
By reducing the risk faced by banks, however, such insurance
mechanisms create moral hazard. With their loans largely funded from
government-insured deposits, banks have an incentive to gamble by
purchasing excessively risky assets. When things turn out well,
shareholders reap the rewards; if things turn out badly, the government
bears most of the cost. Bank depositors are similarly subject to moral
hazard: if deposit insurance protects them from loss in the event their
bank fails, they have little incentive to monitor the bank's risk
taking.
Insurance against bank runs thus comes at the inevitable expense
of increased moral hazard. Even so, its provision may still be
justified. What is clear, however, is that either implicit or explicit
government guarantees call for effective prudential supervision and
regulation of banks and the maintenance of strong capital adequacy
standards to mitigate the effects of moral hazard.
In East Asia, implicit and explicit government guarantees were
coupled with inadequate prudential supervision and regulation of banking
systems. Perceived government guarantees may have encouraged foreign
investors to lend more to Asian banks and monitor their loans less
carefully than they would have otherwise. Moral hazard thus contributed
to Asian banks' excessive borrowing from abroad and excessively risky
investing at home.
chaebols' control of financial institutions, together with government
policies of directed lending to favored sectors, led to overinvestment
in such industries as automobiles, steel, shipbuilding, and
semiconductors. By early 1997, well before the crisis hit Korea, 7 of
the 30 main chaebols were effectively bankrupt.
In Indonesia, a large share of all bank credit consisted of directed
credit, channeled to politically privileged firms and sectors. Although
Indonesia had already suffered a banking crisis in the early 1990s, such
practices remained widespread. Moreover, most of the borrowing was in
foreign currency terms, compounding debtors' inability to repay when the
local currency depreciated. A large fraction of foreign banks' lending
to Indonesia was not intermediated through the domestic banking system
but went to firms directly.

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Empirical studies confirm that, by the eve of the crisis, the return
to capital had fallen sharply in East Asia as the result of excessive
investment. Studies document a rapid buildup of fixed assets throughout
Asia between 1992 and 1996, with particularly rapid growth in Indonesia
and Thailand. With most of this growth financed by debt (especially in
Korea and Thailand), many corporations were already heavily leveraged by
1996, well before the currency crisis increased the burden of that
portion of the debt denominated in foreign currency. At the same time,
moderate to low profitability severely impaired the ability of many
Asian firms to meet their interest obligations. In Korea, the average
debt-to-equity ratio of the top 30 chaebols was over 300 percent by the
end of 1996; by 1997 the return on invested capital was below the cost
of capital for two-thirds of the top chaebols.
In spite of high saving rates, the investment boom in East Asia led
to large and growing current account deficits, financed primarily
through the accumulation of short-term, foreign currency-denominated,
and unhedged liabilities by the banking system. Exchange rate regimes
entailing semi-fixed pegs to the dollar exacerbated the problem in two
ways. First, as the U.S. dollar appreciated between 1995 and 1997, so
did the semi-pegged currencies. This worsened the trade deficits of
those economies whose currencies were closely following the dollar.
Second, the promise of relatively fixed exchange rates led borrowers to
discount the possibility of a future devaluation, and thus to
underestimate the true cost of foreign capital. Also, although budget
deficits were low in most of the region, the implicit and explicit
government guarantees of a bailout of the financial system in a crisis
implied large and growing unfunded public liabilities, which only
emerged once the currency crisis had triggered a wider banking crisis.
Disturbances originating outside of East Asia made these economies
still more vulnerable to crisis. One such development was, for several
economies, a slowdown of export growth in 1996 and a worsening of the
terms of trade, partly associated with a slump in the world price of
semiconductors. Another was the persistent stagnation of the Japanese
economy throughout the 1990s. The resulting weakness of the yen caused
an appreciation of those Asian currencies that were effectively pegged
to the dollar. Yet another exogenous event was the emergence of China as
a major regional competitor.
In 1997 the bubble burst. Stock markets dropped, and the emergence
of widespread losses, and in some cases outright defaults, revealed the
low profitability of past investment projects. Nonperforming loans,
already on the rise before the currency crisis, escalated, threatening
many financial institutions with bankruptcy. In addition, the firms,
banks, and investors that had relied heavily on external borrowing were
left with a large stock of short-term, foreign currency-denominated,
unhedged foreign debt that could not be easily repaid. The ensuing
exchange rate crisis intensified this problem, as the

[[Page 241]]

fall in local currencies dramatically increased the domestic currency
value of the foreign-denominated debt, unleashing further financial
pressures on banks and firms. The free fall of currencies was
intensified by the sudden rush of firms, banks, and investors to cover
their previously unhedged liabilities. Thus, accelerating depreciation
aggravated the original foreign currency debt problem, creating a
vicious circle.
Concern among investors about the commitment of governments to
structural reforms heightened their uncertainty about policy,
contributing to massive capital outflows. Although problems with the
fundamentals likely triggered the crisis, currency and stock markets may
also have overreacted, with panic, herd behavior, and a generalized
increase in risk aversion producing a sudden reversal of capital flows,
exacerbating the crisis.
The sharp reversal of capital flows to East Asia in the second half
of 1997 is clearly evident in the data. Table 6-2 shows that net private
flows to five Asian crisis countries (Indonesia, Korea, Malaysia, the
Philippines, and Thailand), which had averaged $90 billion per year in
1995-96, experienced a dramatic turnabout in 1997 to a net outflow of $1
billion. This sharp reversal, amounting to about 10 percent of the
combined GDPs of these countries, took place entirely in the second half
of the year, as foreign investors fled and international banks sharply
contracted their short-term loans. Commercial banks  [TIFF
OMITTED]

[[Page 242]]

withdrew $26 billion in 1997. Although equity investments also lost
value in 1997, the decisions by international commercial banks not to
roll over their loans to Indonesia, Korea, and Thailand worsened the
financial crisis and the currency collapse. It is estimated that net
private outflows in 1998 were even larger than in 1997, amounting to
some $28 billion, driven again by large-scale bank withdrawals.
The drastic reversal of capital flows required a wrenching
adjustment of the current accounts of the affected countries. Deficits
in the current account (the aggregate of goods and services trade,
investment income, and transfer transactions) can only be sustained as
long as foreign lending is available to finance them. The withdrawal of
that financing therefore resulted in higher domestic interest rates,
depreciated currencies, and a sharp economic contraction, producing a
substantial decline in imports and an abrupt about-face in the current
account from deficit toward surplus. The aggregate current account
balance of the five crisis countries moved from a deficit of $55 billion
in 1996 to one of only $26 billion in 1997 (with most of the adjustment
in the second half of the year) and an estimated surplus of $59 billion
in 1998. As private capital flows have fallen sharply, the role of
financing external obligations has been transferred to the official
sector (the IMF and other multilateral as well as bilateral official
creditors) and to foreign reserves. Whereas in 1996 the five Asian
countries made small net transfers to official creditors, in 1997 and
1998 they received net official flows of $30 billion and $28 billion,
respectively. Moreover, whereas in 1995 and 1996 net private inflows in
excess of current account imbalances led to sharp increases in the five
countries' foreign exchange reserves, the turnaround of capital flows in
1997 led to a loss of reserves equaling $33 billion.
The fundamentals in the crisis countries and the policies they
followed thus go a good way toward explaining the reversal of capital
flows in 1997. But the size of those flows and their concentration in
the second half of 1997 suggest that, in addition to the debtors'
excessive reliance on short-term bank debt, investor flight, especially
by commercial banks, contributed to worsening the crisis. Calls for
greater private sector involvement in crisis resolution (as proposed,
for example, in the reports of the G-22 working groups, discussed in
Chapter 7) recognize that the private sector needs to be involved in
preventing financial crises and, should crises occur, needs to
contribute constructively to their containment and orderly resolution.
Indeed, the Korean crisis eased in early 1998 when commercial banks
agreed to roll over about $20 billion in loans to Korean banks by
turning them into medium-term loans.

THE CAUSES OF CONTAGION

Contagion, or the spread of market dislocations from one country to
the next, has been observed in the behavior of exchange rates, stock

[[Page 243]]

markets, and the sovereign spreads of emerging market economies. Some
observers interpret this contagion in the same way they do the crisis
itself, namely, as proof that markets are irrational and prone to
unjustified panic. Various explanations based on economic fundamentals
can also be adduced, however.

Common Shocks

Contagion may be due to common economic shocks. For example, falling
commodity prices hurt commodity-exporting countries. This can explain
why the same shocks affected countries as distant from each other as
Canada, Chile, Indonesia, Russia, and New Zealand.

Trade Linkages

When one country devalues its currency, its competitive position
improves relative to that of its major trading partners. The trading
partners' currencies may then experience pressure as speculators
recognize that their trade deficits are likely to rise. Another channel
of contagion via trade occurs through income effects: a downturn in
Japan depresses Asian exports to Japan, and vice versa. Trade linkages
fostered the spread of the currency crisis within East Asia in 1997.
Evidence suggests that contagion is related to the strength of trade
links and regional factors.

Competitive Devaluations

Contagion may also have resulted from the prospect, or simply the
fear, of competitive devaluations among countries competing in third-
country markets. For example, the first wave of currency declines in
Asia in the summer of 1997 worsened the cost competitiveness of other
economies throughout the region that initially maintained their nominal
exchange rates fixed. This led to attacks on many of these currencies.
Concerns about loss of competitiveness help explain, for example, the
decisions of Taiwan and Singapore to allow their currencies to fall as
the other regional currencies were depreciating. The weakness of the yen
in 1997 and much of 1998 may also have provoked fears of competitive
devaluations in the region.

Other Real and Financial Linkages

Other links between countries' real and financial sectors may also
serve as a conduit for contagion. If one country invests in and lends
heavily to another, bad economic news in the latter will upset markets
in the former. Pressures in the financial and currency markets of Hong
Kong, Korea, and Singapore, for example, were related to the fact that
these economies had heavily lent to, invested in, and traded with firms
in Indonesia and the other crisis economies. Losses of this nature also
affected banks and other financial firms in Japan, Europe, and the
United States that had invested in East Asia, Russia, and Latin

[[Page 244]]

America, and these linkages partly account for the contagion to
industrial countries' financial markets.

Imperfect Information and Investor Expectations

Yet another channel of contagion involves alterations in investors'
perceptions concerning common structural conditions in different
economies or likely policy responses. For example investors' belief in
the strength of the Asian economic model may have changed when one of
the star performers stumbled. The failure of financial institutions in
one country may lead investors to believe, in the absence of better
information to the contrary, that institutions in similar countries in
the same region might be facing the same problems. Similarly, the
unwillingness or inability of several Asian economies to defend their
currencies more aggressively may have altered investors' views
concerning the policy preferences of other economies in the region.
Contagion may also have resulted as investors changed their
assessments of the odds of official bailouts. In mid-August 1998, Russia
decided to devalue its currency, default on its debt, and impose
exchange controls. Although Russia had been considered the classic
example of a country deemed too important to fail, its inability to meet
the conditions of its IMF program and its policy actions led to the
interruption of further official assistance. These events shook
international investors' confidence and, rightly or wrongly, increased
their concern that other emerging markets might follow similar policies
or might not be bailed out. Spreads on emerging market sovereign
instruments had not previously priced in this possibility, and the
resulting contagion to Brazil and the rest of Latin America was rapid
and sharp.

Market Illiquidity

Some large, highly leveraged financial institutions (including some
hedge funds) lost money when Russia defaulted. They then, in effect,
faced margin calls that forced them to liquidate their positions in
other markets, providing yet another avenue of contagion. In markets
that are imperfectly liquid, such sales will force down prices. The
phenomenon thus points to the role played by market illiquidity in
propagating contagion.

Shifting Risk Aversion and Investor Sentiment

The explanations of contagion just outlined can be categorized as
involving rational assessments on the part of market participants, based
either on the actual fundamentals or their perceptions thereof. Other
hypotheses advanced to explain the phenomenon are based on
``irrational'' investor behavior. Some argue that, as volatility in
financial markets increased, investors simply withdrew en masse, without
distinguishing among emerging markets according to their fundamentals.
Phenomena such as financial panic, herd behavior, loss of

[[Page 245]]

confidence, and a generalized increase in risk aversion may indeed have
played some role in the spread of the crisis in 1997-98 within Asia,
from Asia to Russia, from Russia to Latin America and other emerging
markets, and eventually to G-7 capital markets.
One indication of increased risk aversion among investors is the
sharp increase in sovereign spreads in the summer of 1998 (see Box 6-4).
Explaining so large an increase in spreads in many countries without
resort to increased risk aversion requires the unlikely assumption that
the perceived probability of sovereign defaults had risen to very high
values in many emerging markets. For example, the sharp increase in
spreads experienced by Argentina, whose probability of default was
surely not extremely high, provides evidence of an increase in risk
aversion.

THE POLICY RESPONSE TO THE CRISIS

THE ROLE OF THE INTERNATIONAL COMMUNITY

The international community (chiefly the IMF, the World Bank, the
Asian Development Bank and the G-7) moved quickly to stem the spreading
financial crisis. The United States encouraged the rapid development of
financial stabilization packages to respond to requests for support,
first from Thailand in July 1997 and later from Indonesia and Korea. As
a condition for financial assistance, the IMF has generally required
substantial economic reforms, including banking sector restructuring
and, initially, fiscal discipline and the maintenance of high interest
rates to curb capital outflows and currency attacks. The objective of
these programs has been to restore investor confidence by tackling the
root causes of the crisis in each country. For this reason, the programs
went beyond addressing major fiscal, monetary, or external imbalances,
and sought to strengthen financial systems, improve government
policymaking and corporate governance, enhance transparency of policies
and economic data, restore economic competitiveness, and modernize the
legal and regulatory environment. The IMF's practice of making its
lending dependent on such policy programs, which it continues to monitor
and enforce as funds are being disbursed, is termed ``conditionality.''
The IMF makes every effort to work with countries to identify reforms
consistent with their circumstances, and the conditions negotiated can
be altered over time if the economy does not respond as expected.
In the Asian crisis, the IMF-supported programs evolved as the
dimensions of the crisis became clearer. The Indonesian case provides a
striking example. The initial IMF package of October 1997 required
strict fiscal discipline. In June 1998 a renegotiated agreement allowed
the country to run a budget deficit of as much as

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8.5 percent of GDP in 1998. Indonesia's economic performance had
deteriorated, as policy uncertainty, political turmoil, and violence
worsened the economic outlook through the summer of 1998. As a result,
budget deficits had automatically risen. The IMF recognized that, in
this context, the additional fiscal stringency needed to counter such a
passive deterioration of the budget deficit would prove
counterproductive.
In those countries that implemented IMF policy reforms most
assiduously, particularly Korea and Thailand, the stabilization packages
were successful in calming financial markets and creating the basis for
growth to resume. A measure of financial stability returned in these
countries in 1998 as the packages were implemented. Both countries saw
their currencies appreciate in the first half of 1998 after sharp drops
in 1997; domestic interest rates fell back to precrisis levels by the
summer; trade balances improved substantially; and foreign reserves
began to increase again. The financial crisis produced severe real
consequences in both countries, as economic activity dropped sharply in
1998 and recessions began. However, by the late fall of 1998 some
signals suggested that both economies may have bottomed out and that
economic recovery might start in 1999. In particular, both economies saw
an increase in real exports and some tentative signs of a recovery in
economic activity.

THE MOTIVATION OF THE IMF PROGRAMS IN ASIA

The severity of the Asian crisis has led some critics to challenge
the IMF's approach and the wisdom of the measures that it imposed.
Several criticisms can be distinguished.

Structural Reforms

One criticism relates to the breadth of the restructuring efforts
that the IMF required. Critics contend that the IMF has intruded
excessively in the domestic affairs of crisis countries by insisting on
structural reforms, which lie beyond its traditional competence in the
area of macroeconomic adjustment. However, an effective rescue strategy
had to address the factors responsible for the crisis, and these were
primarily structural rather than macroeconomic. IMF lending would have
served little purpose if the weaknesses in the financial sector (ranging
from poor bank supervision and regulation to murky relations among
governments, banks, and corporations) were not addressed. Similarly,
improved corporate governance and an end to crony capitalism, on which
the IMF insisted, would help countries avoid future crises. Market
analysts had made it plain that halfhearted reform efforts would do
little to restore market confidence.
The IMF's focus in the Asian crisis on structural reform, rather
than only on macroeconomic issues, represents neither an unprecedented
expansion of its domain nor an unwarranted intrusion into areas

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beyond its competence. The IMF's approach to crisis management has
always evolved over time in response to the changing problems faced by
the world economy. For example, after 1973 the IMF turned its attention
from the balance of payments problems of the industrial countries, which
by then had abandoned fixed exchange rates, to the problems of
developing countries, many of which were newly independent. Similarly,
it adopted new approaches in response to the international debt crisis
of the 1980s and adapted its policies to aid the transition of the
former Soviet bloc countries to market economies after 1990. It is
appropriate and desirable that an international agency adapt and evolve
in response to developments in the world economic system.

The Prescription of Tight Monetary Policies

A second criticism relates to the IMF's monetary policy conditions,
in particular its insistence on high interest rates to limit currency
depreciation. Critics contend that high interest rates stifle growth and
lead to the bankruptcy of otherwise viable firms. The logic of the IMF's
high interest rate strategy was to contain the extent of currency
depreciation. Like high interest rates, a plummeting currency in
countries with large net external liabilities also stifles growth, by
increasing the debt burden of banks and other firms whose debts are
denominated in foreign currencies. The result is financial distress,
bankruptcy, and economic contraction. Arguably, the failure of Malaysia
and Indonesia to raise interest rates sufficiently following the run on
the Thai baht may have been responsible for the destabilizing
depreciations of their currencies that followed. Moreover, the surge in
Indonesia's inflation rate reminds us that a loose monetary policy can
rapidly ignite inflation expectations.

Restrictive Fiscal Policies

A third criticism is that the fiscal policy requirements in the IMF
plans were unnecessarily strict. At the onset of the crisis, the Asian
countries under attack were running small budget deficits or even fiscal
surpluses and had achieved relatively low ratios of public debt to GDP.
A loosening of fiscal policies as soon as the crisis broke would most
likely have raised doubts about policymakers' commitment to reduce
outstanding current account imbalances, jeopardizing the credibility of
their plans. Also, even though fiscal deficits and public debt were
typically low before the crisis, the crisis itself changed that picture:
the projected fiscal costs of financial bailouts in several Asian
countries were estimated in the range of 20 to 30 percent of GDP. Extra
public liabilities of this magnitude translates into a permanent
increase in the domestic interest bill paid by Asian governments of 2 to
4 percent of GDP per year. The IMF's fiscal plans, which were negotiated
on a country-by-country basis, were targeted to raise the neces-

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sary revenues to meet these extra interest costs. They were not just
fiscal discipline for fiscal discipline's sake.
However, when recessions in the crisis countries materialized during
1998, the IMF progressively loosened its fiscal conditions to permit
fiscal deficits on cyclical grounds and to accommodate programs to
address the social consequences of the crisis. Like those of other
countries, the economies of the crisis countries benefit from the use of
fiscal policy as a counterweight to recession. It must be acknowledged,
too, that the year's revelations about the size and depth of the
recessionary effects of the crisis surprised not only the Asian
governments and the IMF, but also the vast majority of country analysts.

Moral Hazard

Not all the IMF's critics claim that its measures have been too
austere. Indeed, some have argued that the generosity of the IMF's
rescue packages creates moral hazard, by leading international investors
to lend carelessly and inducing domestic governments to engage in risky
policies in the expectation that they would be insulated from the
adverse consequences of their decisions by international assistance.
However, several objections can be raised against the view that the
expectation of an IMF bailout contributed importantly to the crisis, and
against the overly simplistic view that the IMF in fact bailed out all
investors in Asia. On the borrower side, it is hard to imagine that the
availability of international support in the event of a crisis does much
to induce moral hazard on the part of governments. Governments have
strong incentives to avoid both the economic turmoil that a crisis
produces and the strict and politically unpopular conditions that come
with IMF support. Moreover, on the lender side, a majority of private
creditors, especially bondholders and equity investors, have sustained
huge losses even where official assistance was provided. By the end of
1997, foreign equity investors had lost nearly three-quarters of their
holdings in some Asian markets. Only commercial banks were spared, and
that only partially. For example, although foreign banks operating in
Korea demanded and got public guarantees on bank loans as a precondition
for rolling over existing loans, the conditions for these rollovers
entailed a burden on these creditors. Their short-term loans were
converted into medium-term loans at interest rates only a few hundred
basis points above U.S. Treasury rates. Finally, although some have
claimed that the Mexican rescue package in 1995 raised expectations of
future bailouts and thus encouraged the later surge of capital flows to
Asia, no direct evidence has been adduced to support this theory.
Even if these moral hazard concerns were judged to have some
validity, they would still need to be balanced against the heavy
economic and human costs of inaction. Failure of the international
community to respond to a crisis, leaving countries and creditors to
sort out their

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debts on their own, could well result in extraordinary costs all around.
A lesson from the debt crises of the interwar period and the 1980s is
that an official hands-off strategy requires that debtors and creditors
engage in complex negotiations over a long period. During that time
access to international markets is curtailed, long-term growth is
drastically reduced, and the human toll may be exorbitant. Also, the
experience of the 1990s suggests that highly interdependent economies
can be subject to the rapid transmission of speculative waves of
financial panic across regions. Therefore failure to address a local
crisis with an appropriate program of international assistance,
restoring market confidence promptly, may greatly increase the chances
of a systemic chain reaction.

U.S. SUPPORT OF IMF FUNDING

Since the crisis began, the United States has supported the IMF's
role in extending financial support to crisis countries on a conditional
basis. However, as the crisis progressed, it became apparent that it
threatened even those countries that had made great progress in
implementing sound macroeconomic and structural policies and had worked
to strengthen the fundamentals of their economies. To deal with such
threats, the United States was joined by the other G-7 countries in
proposing an enhanced IMF facility to support countries with good
economic fundamentals and sound, IMF-approved policies, to help them
fight off contagion. This initiative builds on the establishment, in
late 1997, of a new IMF facility to provide large-scale financing in
exceptional circumstances, at shorter maturities and higher interest
rates than under normal IMF financing.
The United States also recognized that if the IMF is to continue to
play its critical role in countering contagion, its resources had to be
expanded. With its nearly worldwide membership, broad experience, and
sophisticated skills in financial crisis management, the IMF is the
proper organization to take the lead in handling such episodes. Through
the IMF, moreover, the United States succeeds in leveraging its own
contributions toward crisis resolution. This Administration recognized
that the United States could not expect to exert leadership in resolving
the crisis unless it met its own fair share of the obligations of all
IMF members. Therefore, the President requested, and the Congress agreed
last year, to provide $18 billion in much-needed new funding to the IMF.
Of this amount, $14.5 billion represents the U.S. share of a quota
increase applying to all IMF members. The remaining $3.5 billion
represents the U.S. contribution to a new backup source of financing
called the New Arrangements to Borrow (NAB).
Many observers have misunderstood the consequences of IMF funding
legislation for the Federal budget. Corresponding to any transfer to the
IMF under the U.S. quota subscription or the NAB, the United States
receives a liquid, interest-bearing claim on that institution,

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which is considered a monetary asset. Thus, funds provided to the IMF
are not treated as outlays in the Federal budget.
The President urged the world's major economies to stand ready to
activate the $15 billion remaining in the IMF's existing emergency
fund--the General Arrangements to Borrow (GAB)--to ensure the IMF's
continued ability to support reform and fight contagion. The approval of
the NAB doubled these emergency funds. Under the NAB, as under the GAB,
IMF members whose currencies are relatively strong will stand ready to
lend to the IMF when supplementary resources are needed, to forestall or
cope with an impairment of the international monetary system, or to deal
with an exceptional situation that threatens the system's stability. The
resources available to the IMF under the GAB and the NAB combined will
amount to as much as $48 billion. The NAB was activated shortly after it
entered into effect on November 17, 1998, to help finance the IMF
arrangement for Brazil, which its executive board approved on December
2.

NEW INITIATIVES TO RESTORE GROWTH IN EAST ASIA

In addition to supporting the IMF, the United States has recognized
the need to do more to help crisis countries get back on their feet, to
restore growth, and to mitigate the suffering inflicted on so many
people in the countries affected.
The Asian Growth and Recovery Initiative, announced jointly by the
United States and Japan at the summit of APEC leaders in Kuala Lumpur in
November of last year, includes innovative financing schemes aimed at
accelerating bank and corporate restructuring in the crisis-afflicted
economies of East Asia. In Indonesia, Korea, and Thailand, for example,
the combination of initially high interest rates and illiquidity has led
to harsh recessions and a vast overhang of bad debt. Corporate debt-to-
equity ratios, which as we have seen were already very high before the
crisis, became unsustainable once the crisis struck, as a result of real
currency depreciation and the burden of high real interest rates. When
highly leveraged companies cannot service their debt, a self-reinforcing
spiral is created in which banks' cash flows are squeezed, forcing them
to contract new lending not only to the illiquid corporations but to
those in better health as well. The object of bank and corporate
restructuring is to restore the flow of credit and restructure corporate
balance sheets, so that firms in these countries can get back to
business, and to strengthen the corporate governance of these firms.
To ensure that the crisis-impacted countries maintain access to
critical imports, and to help American businesses continue selling
abroad, the Export-Import Bank will establish new short-term credit
facilities for critical Asian and Latin American markets. The United
States will coordinate its efforts with those of the other leading
industrial nations to ensure that trade credit continues to flow.
Moreover,

[[Page 251]]

the Overseas Private Investment Corporation (OPIC) has developed a new
financial instrument to help emerging market economies raise money in
international capital markets. Its aim is to keep private capital
flowing to crisis-impacted but deserving economies.
The severe economic downturn experienced in East Asia has caused
sharp increases in unemployment and poverty, jeopardizing the
substantial strides the East Asian economies had made over several
decades in alleviating poverty and raising real incomes. The social
costs of the crisis have been enormous, and made much worse by the
absence of developed social safety nets, such as unemployment insurance
and efficient welfare programs. The President has therefore asked the
World Bank and the Asian Development Bank to double their aid through an
expanded Social Compact initiative, with a focus on strengthening the
social safety net. The emphasis would be on job assistance, basic needs,
and aid to children, the elderly, and other groups especially vulnerable
to economic distress.

REFORM OF THE INTERNATIONAL FINANCIAL ARCHITECTURE

Even as it worked to mitigate the impact and contain the spread of
the crisis, the Administration collaborated with other countries to find
ways to strengthen the international financial system to make it less
prone to future crises. Discussions in 1998 concerning the reform of the
international financial architecture culminated in the October
publication of three reports on the subject. The reports were written by
working groups formed by the G-22, a group of systemically significant
industrial and emerging market economies, first brought together in
April 1998. The G-22 reports are discussed in Chapter 7.

JAPAN'S ECONOMIC AND FINANCIAL CRISIS

Japan, the leading economy in Asia, inadvertently played an
unfortunate role in the emergence and spread of the Asian crisis.
Throughout the 1990s Japan has suffered a hangover from the bursting of
stock market and land bubbles at the end of the 1980s. In 1996, after 4
years of disappointing growth, it appeared that the Japanese economy was
finally recovering. But a large increase in the Japanese consumption tax
in April 1997, implemented to address Japan's large fiscal deficit and
longer term demographic pressures on its budget, caused the country to
lapse into recession in the second quarter of that year.
Japan's economic weakness likely contributed to the Asian crisis
through several channels. Weak growth at home reduced Japan's demand for
imports from the rest of East Asia. Japanese banks, in fragile condition
after the bursting of the 1980s bubble, were further weakened by a
stagnant economy in the 1990s. Facing low interest

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rates at home, they sought higher returns through large-scale lending to
the fast-growing East Asian economies. Although U.S. and European banks
had also lent extensively in the region, Japanese banks had the largest
cross-border and foreign currency lending of any industrial country
banks to the Asian crisis economies. Thus, Japanese banks and securities
firms were particularly hard hit when the crisis erupted. As the crisis
escalated, and as Japan's own economic crisis deepened in 1997 and 1998,
many Japanese banks, faced with significant losses, recalled foreign
loans in order to avoid a domestic lending squeeze.
Japan's role in the Asian crisis contrasts sharply with the U.S.
role in the Mexican crisis of 1995. Whereas a strongly expanding U.S.
economy helped Mexico avoid a worse outcome, the weakness of Japan's
economy and financial institutions undoubtedly added to Asia's woes. In
turn, the significant decline in Japan's own exports to the crisis
countries, along with the losses suffered by its financial institutions
on their Asian loans, have hit Japan's vulnerable economy hard, adding
to its domestic difficulties.
Japan remained in recession throughout 1998. Real growth over the
four quarters of 1997 amounted to -0.4 percent. Real GDP in the first
half of 1998 was down 3.8 percent at an annual rate, and few if any
signs of recovery were in evidence by the end of the year. Japan risks
descent into a deflationary spiral in which falling prices cause high
real interest rates, further discouraging spending.
In response to the deepening contraction and a growing credit
crunch, the Japanese government has taken several significant policy
steps. In the fall of 1998, legislation was approved providing public
funds to address the problems of the banking system. Of the 60 trillion
yen (about $500 billion) in the package, about 30 percent has been
earmarked for protection of depositors, 40 percent to recapitalize weak
banks, and 30 percent to purchase the shares of nationalized banks.
Although questions remain about its implementation and effectiveness,
the banking reform bill is a necessary step toward restructuring Japan's
financial system.
To stimulate growth, the Japanese government announced a 17-
trillion-yen fiscal stimulus package in April 1998, including both
public works expenditures and tax reductions. As the contraction
continued to intensify, however, the Japanese government proposed
further expansionary fiscal measures in the fall. In November it
announced a plan to pass a third supplementary budget aimed at
implementing over 17 trillion yen in additional public works and other
spending measures in 1999, along with more than 6 trillion yen in tax
cuts.
As the world's second-largest economy, Japan has a key role to play
in maintaining global economic growth. The United States has urged Japan
to take strong and sustained fiscal measures to stimulate domestic
demand, restore confidence, deal promptly and effectively

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with its banking problems, and open its markets and deregulate its
economy. Japan's performance will help determine the prospects for
Asia's recovery.

EFFECTS OF THE EMERGING MARKETS CRISIS ON THE UNITED STATES

MACROECONOMIC EFFECTS

The United States enjoyed strong economic growth before the onset of
the Asian crisis and has continued to do so since. But the crisis has
had an impact, both real and financial. One consequence has been a
marked decline in net exports and a widening of the trade deficit. The
growing trade deficit (Chart 6-3) is largely attributable to three
factors: faster income growth in the United States than in most other
industrial countries, which raises imports; outright contraction in
Japan and much of the rest of East Asia, which cuts U.S. exports; and an
appreciation of the dollar in both nominal and real terms relative to
both European and Asian currencies, and particularly the yen (from mid-
1995 until September 1998). Since the summer of 1998 the dollar has
depreciated against the yen, but the fall of the dollar against the
other G-10 currencies is still modest on a trade-weighted basis (Chart
6-4).
Two sectors adversely affected by the crisis were agriculture and
manufacturing. Shrinking exports and low prices (attributable partly to
the financial crisis, and partly to large global supplies of
agricultural commodities following bumper harvests), on top of bad
weather in some regions, led to a fall in farm incomes. In
manufacturing, both export industries and industries that compete with
imports sustained damage. The commercial aircraft industry, for example,
suffered from the fall of exports to Asia. The steel industry and the
textiles and apparel industry have come under import pressure as the
dollar's appreciation reduced the price of imports from the crisis
countries. As discussed in Chapter 2, U.S. financial markets also felt
the impact, and financial institutions have suffered losses on their
emerging market loans and investments.
The appreciation of the dollar since 1995 (illustrated in Chart 6-4)
also had a number of beneficial effects at home. Import prices have
fallen, especially for oil and other commodities, contributing to the
drop in inflation and improving the U.S. terms of trade (Chart 6-5). The
terms of trade is a measure of the prices at which we sell our goods
abroad, relative to the prices we pay for imports. An increase in the
terms of trade translates into increased purchasing power of U.S. goods
in world markets and higher real U.S. income. A strong dollar and
subdued inflation have also supported lower interest rates, both short
and long term, benefiting households, firms, and other borrowers.

[[Page 254]]



[[Page 255]]



THE TRADE AND CURRENT ACCOUNT DEFICITS

The Short-Term Behavior of the Trade Imbalance

In 1998, faster U.S. growth relative to growth in our trading
partners combined with the continued appreciation of the dollar to exert
a powerful impact on the U.S. trade balance. The deficit in trade in
goods and services rose substantially. Based on data for the first 11
months of the year, it now appears that the deficit for 1998 will be in
the neighborhood of $170 billion, up from $110 billion in 1997. Compared
with 1997, it appears that exports of goods and services in 1998 will be
down about 1 percent, whereas imports of goods and services will be up
about 5 percent. Relative to past trends, the decline in exports is by
far the more striking of the two figures.
A large fraction of the increase in the dollar value of the trade
deficit is related to the decline in exports to Asia; the contribution
of import growth to the increased nominal value of the deficit has been
quite modest thus far. The decline in exports to six key East Asian
countries (Indonesia, Japan, Korea, Malaysia, the Philippines, and
Thailand), measured at an annual rate, was running at $25 billion to $30
billion in the fall of 1998. Korea alone accounted for almost two-fifths
of the decline. Imports from these countries have also risen, continuing
an upward trend that has persisted for several years.

[[Page 256]]

The increase in the trade deficit and the negative contribution of
increased imports are larger when measured in real terms rather than as
nominal dollar values, because import prices have fallen more than
export prices. The dollar prices of imports from four East Asian
economies (Hong Kong, Korea, Singapore, and Taiwan) fell 10.8 percent
between August 1997 (at the onset of the Asian crisis) and December
1998; the dollar prices of U.S. imports from Japan declined by 4.7
percent over the same period. Although measures of import prices for the
other Asian crisis economies are not available, it is likely that they
fell by even more, because the depreciation of their currencies against
the dollar was greater. Sharp drops in the global prices of many primary
commodities have also exerted downward pressure on U.S. import prices.
Import prices for petroleum products were 43.0 percent lower in December
1998 than in August 1997; import prices for agricultural goods declined
3.3 percent over the same period. Despite their overall decline, the
prices of U.S. imports from the Asian economies have fallen by a smaller
percentage than the values of their currencies have against the dollar.
This implies that the pass-through from the depreciations to the decline
in import prices has so far been less than full. Because U.S. export
prices have also fallen, the decline in exports of goods and services
was more modest when measured in real rather than nominal terms.

A Longer-Term Perspective on the Current Account

International trade has contributed greatly to growth and well-being
in the United States. Nevertheless, some contend that the large and
growing U.S. trade deficit costs American workers jobs; others argue
that it reflects unfair trade practices of our trading partners or
signals a loss of U.S. competitiveness in world markets. The growing
trade deficit has indeed been associated with dislocations in some
manufacturing industries, but job gains in construction, services,
information technology, and other sectors not directly involved in
international trade have been greater than job losses in manufacturing.
Arguments about the adverse consequences of trade deficits are largely
misplaced: the rising U.S. trade deficit is primarily a reflection of
strong U.S. investment, employment, and output growth, not a symptom of
economic weakness.
The current account and the saving-investment balance. Unraveling
misconceptions about the trade deficit requires an understanding of the
trade balance and a closely related concept, the current account
balance. A country's trade balance is equal to the difference between
the value of its exports and the value of its imports--in other words,
the value of goods and services sold by its residents to foreigners
minus the value of the goods and services that its residents buy from
foreigners. The current account balance simply adds other sources of
foreign income to the trade balance, to arrive at a complete accounting

[[Page 257]]

of the economy's current transactions (as distinct from its capital
transactions, such as borrowing in the form of foreign loans). The most
important of these other sources are interest and investment earnings
received on foreign assets (and paid on foreign liabilities), and aid
grants and transfers.
A country's current account balance also equals the difference
between its gross national income (the sum of gross domestic production
and net income received from abroad) and its spending (the sum of
private and public consumption and investment spending). Since national
saving is the difference between gross national income and total
consumption, the current account is also equal to the difference between
national saving and domestic investment. If a country's national income
exceeds its spending, or, equivalently, if national saving exceeds
domestic investment, the current account will be in surplus. If instead
a country spends (that is, consumes and invests) more than its national
income, investment will exceed saving, and the current account will be
in deficit.
For the current account to be in deficit that is, for investment to
exceed saving--a country must be able to finance that deficit through
capital inflows (borrowing) from the rest of the world. A country's
current account deficit for a given period therefore equals the increase
in its net foreign liabilities in that period (or the decline in its net
foreign assets, if the country is a net creditor). Conversely, current
account surpluses, which reflect an excess of saving over investment,
increase a country's net foreign assets (or reduce its net foreign
liabilities).
Business cycles, long-run growth, and the current account. The
argument that current account deficits inevitably cause a net loss in
jobs and output is at odds with the evidence. Rapid growth of production
and employment is in fact commonly associated with large or growing
trade and current account deficits, whereas slow output and employment
growth is associated with large or growing surpluses. Chart 6-6 shows,
for example, that the U.S. current account improved during the
recessions of 1973-75, 1980, and 1990-91, but declined during the
cyclical upswings of 1970-72, 1983-90, and 1993 to the present. This
reflects both a decline in demand for imports during recessions and the
usual cyclical movements of saving and investment. During a recession
both saving and investment tend to fall. Saving falls as households try
to maintain their consumption patterns in the face of a temporary fall
in income; investment declines because capacity utilization declines and
profits fall. However, because investment is highly sensitive to the
need for extra capacity, it tends to drop more sharply than saving
during recessions. The current account balance thus tends to rise.
Consistent with this, but viewed from a different angle, the trade
balance typically improves during a recession, because imports tend to
fall with overall consumption and investment demand. The converse occurs
during periods of boom, when sharp increases in

[[Page 258]]


investment demand typically outweigh increases in saving, producing a
decline of the current account. Of course, factors other than income
influence saving and investment, so that the tendency of a country's
current account deficit to decline in recessions is not ironclad.
The relationship just described between the current account and
economic performance typically holds not only on a short-term or
cyclical basis, but also on a long-term or structural basis. Often,
countries enjoying rapid economic growth possess structural current
account deficits, whereas those with weaker economic growth have
structural current account surpluses. This relationship likely derives
from the fact that rapid growth and strong investment often go hand in
hand. Whether the driving force is the discovery of new natural
resources, technological progress, or the implementation of economic
reform, periods of rapid economic growth are likely to be periods in
which new investment is unusually profitable.
Investment must, however, be financed with saving, and if a
country's national saving is not sufficient to finance all new
profitable investment projects, the country will rely on foreign saving
to finance the difference. It thus experiences a net capital inflow and
a corresponding current account deficit. The current account deficit is
then merely the result of thousands of individual firms issuing debt or
equity or borrowing from banks to finance investment. As long as these
individual decisions are sensible, the associated current account
deficit

[[Page 259]]

should promote, not detract from, economic welfare. If the new
investments are profitable, they will generate the extra earnings needed
to repay the claims contracted to undertake them. Thus, when current
account deficits reflect strong, profitable investment programs, they
work to raise the rate of output and employment growth, not to destroy
jobs and production.
Historically, countries at relatively early stages of rapid economic
development, such as Argentina, Australia, and Canada in the early part
of this century, have enjoyed an excess of investment over saving,
running large structural current account deficits for long periods. The
same general pattern has held in more recent times: faster growing
developing countries have generally run larger current account deficits
than the slower-growing mature economies.
The link between trade and current account deficits and growth is
also confirmed by comparing the U.S. trade balance with those of its G-7
partners since the recovery from the 1990-91 recession. Charts 6-7 and
6-8 show a clearly negative correlation between output growth and the
trade balance, and between employment growth and the trade balance,
respectively. The United States enjoyed the fastest output and
employment growth--and the largest trade deficit--among the countries
shown. Conversely, Japan had the largest trade surplus, but the second-
slowest rate of growth. Trade surpluses are also the norm in Europe,
where growth of output and employment has been disappointing. Similarly,
unemployment in the United States has been low and falling since 1993, a
period during which unemployment has remained high in Europe and has
been growing rapidly in Japan.
Budget deficits and the current account. Although current account
deficits are not usually a cause for concern when they reflect strong
investment opportunities, they may be worrisome if they instead reflect
a decline in national saving. Since national saving includes the
government's own saving or dissaving, one cause of a growing current
account deficit can be rising government budget deficits. Such deficits
may be harmful, resulting in an unsustainable buildup of foreign debt,
if the government spending they permit is devoted to current consumption
rather than productivity-enhancing public investment.
For example, in the late 1970s many developing countries ran large
budget deficits, borrowing heavily in world capital markets to finance
them, and accumulating large foreign debts in the process. Much of this
borrowing went to support excessive government spending in the face of
insufficient tax revenue. By 1982 many of these governments were having
difficulty servicing their foreign debts. A severe debt crisis erupted
in that year, forcing many countries to negotiate a rescheduling of
their foreign liabilities to avoid default.
The large U.S. current account deficits of the 1980s, also driven by
large fiscal deficits, were a matter of concern for the same reason.
These ``twin deficits,'' as they were labeled, led to high real interest

[[Page 260]]


rates, a crowding out of productive investment (as evidenced by a fall
in the national investment rate after its recovery from the 1982
recession), and a reduction in long-run growth opportunities. Chart 6-9
presents the U.S. current account deficit, the national and public

[[Page 261]]

(Federal Government) saving rates, and the domestic investment rate.
Conceptually, the current account is equal to net foreign investment,
which is the difference between national saving and domestic investment;
in practice, however, this equality may be obscured by measurement
errors, which have been large in recent years both in the international
transactions accounts and in the national income and product accounts.
Thus, although over time there is a strong correlation between the
current account balance and the saving-investment balance, in any given
period the two measures may move in different directions. Chart 6-9
clearly shows the twin deficits of the 1980s: as fiscal deficits
increased in an environment of tight monetary policy in the early 1980s,
the dollar appreciated in real terms, and the current account moved into
substantial deficit. The crowding out of productive investment, due to
the high real interest rates associated with the fiscal deficit, is
suggested by the fall in the investment rate between 1984 and 1990. The
current account improved during the 1990-91 recession as the investment
rate slumped sharply.
During the 1990s the Federal budget deficit first declined, then
disappeared, and finally turned to a surplus in 1998. National saving
increased as a consequence, despite a decline in the personal saving
rate. Even so, the current account deficit has again increased. However,
this increased deficit can be viewed as virtuous, because it has been
driven by an even stronger increase in the pace of domestic

[[Page 262]]

investment. The U.S. gross investment rate rose from a low of 12.2
percent of GDP in the middle of 1991 to 16.0 percent in the third
quarter of 1998.
The investment boom that the United States has enjoyed since 1993
has contributed to expanding employment and output and will provide
payoffs for many years to come. It could not, however, have been
financed by national saving alone: a current account deficit provided
the additional capital inflow needed to finance the boom. In the absence
of foreign lending, U.S. interest rates would have been higher, and
investment would inevitably have been constrained by the supply of
domestic saving. Therefore, the accumulation of capital and the growth
of output and employment would all have been smaller had the United
States not been able to run a current account deficit in the 1990s.
Rather than choking off growth and employment, the large current account
deficit, perhaps paradoxically, allowed faster long-run growth in the
U.S. economy.
The Asian crisis and the current account deficit. The experience of
the Asian crisis countries demonstrates that current account deficits
can be dangerous not only when they finance unsustainable budget
deficits but also when they finance investments of low profitability. As
already noted, the crisis-afflicted East Asian economies all enjoyed
high saving rates. Their large current account deficits were
attributable to their even higher investment rates. Even so, the buildup
of debt deriving from these current account imbalances became
unsustainable, because, as discussed above, distortions in the operation
of East Asian financial systems led to excessive investment in low-
profitability projects. Investment-driven current account deficits
enhance economic welfare only when expected investment returns exceed
the cost of the borrowed funds. Throughout the East Asian region the
rate of return to capital, although still positive, appears to have been
falling in the 1990s, signaling a deterioration in the quality of the
investment projects.
Moreover, foreign debt must be serviced and, at some point, fully
repaid. Therefore, debtor countries must ultimately run trade surpluses,
which may require adjustments in their real exchange rates. Borrowing in
world capital markets is perhaps least problematic when the new
investments it permits augment a country's capacity to produce goods for
sale in foreign markets. In contrast, many Asian countries borrowed
abroad to finance commercial and residential investments, producing
goods, such as office buildings and houses, that are not usually traded
internationally.
The U.S. international investment position. If current account
deficits continue year after year, creditor countries eventually become
net debtors: every year the stock of net foreign liabilities rises by an
amount equal to the current account deficit (ignoring valuation
effects). Not all of these liabilities consist of debt: the capital
inflows

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that finance current account deficits can take the form of equity
investment, as in foreign direct investment. Thus an increase in a
country's net foreign liabilities does not automatically translate into
an increase in foreign debt, strictly speaking, but rather a decrease in
the net international investment position.
Chart 6-10 shows the relationship between the U.S. current account
and the change in the U.S. net international investment position (where
direct investment is valued at current cost). In the 1970s the United
States was a net creditor country. However, the string of current
account deficits in the 1980s led to a reduction of net foreign assets
and eventually, in 1987, turned the United States into a country with
growing net external liabilities.
Because the U.S. current account deficits of the 1980s were
primarily driven by fiscal deficits and low national saving rates, the
accumulation of net foreign liabilities was greeted with some concern.
The large fiscal deficits were financed by government bonds, some of
which foreign investors purchased directly. Since 1993, however, current
account deficits have been driven by increases in investment, with
foreign financing taking the form of both direct and portfolio
investment. (Chart 6-11 shows trends in both inward and outward foreign
direct investment.) At present, U.S. net foreign liabilities amount to a
relatively modest 15 percent of GDP.

Policies Toward the External Imbalance

Calls for protection from import competition typically increase when
the U.S. trade deficit burgeons, as it has since the onset of the Asian
crisis. Although the crisis has caused dislocations in some export and
import-competing industries, overall employment growth remains strong in
the U.S. economy. As we have argued, the growing U.S. trade imbalance
primarily reflects strong investment and growth opportunities in the
United States in comparison with our trade partners, rather than
increased barriers to trade in foreign markets. Looked at another way,
the countries affected by the crisis have been forced to reduce their
own current account deficits by their sudden inability to finance those
deficits through foreign borrowing. The increased U.S. trade deficit, at
least through the first three quarters of 1998, primarily reflects
falling exports to these economies--declines in their imports engendered
by the sharp economic contractions those countries have suffered.
To restore world economic growth to its level before the crisis, the
United States and other industrial countries must maintain open markets.
Higher barriers to trade in the United States would not only hinder
recovery in Asia and other crisis countries but provoke emulation and
retaliation by our trading partners, which would hamper our own growth
prospects. It is worth remembering that it was a dramatic switch to
protectionist policies in the United States

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and other industrial countries that deepened the Great Depression. As
the crisis economies recover, their demand for U.S. goods and services
will increase as well, once again fueling our own export growth.
Recognizing the need to maintain open markets worldwide, the
President has called for a new consensus on trade, to continue to expand
America's opportunities in the global economy while ensuring that all of
our citizens enjoy the benefits of trade, through greater prosperity,
respect for workers' rights, and protection of the environment. The
President asked the Congress to join him in this new consensus by
restoring his traditional trade-negotiating authority (so-called fast-
track authority), to allow him to pursue an ambitious trade agenda. At
the top of this agenda is a far-reaching new round of global trade
negotiations within the World Trade Organization aimed at shaping the
world trading system for the 21st century.

CONCLUSION

During a period of great turmoil in the global economy, the first
imperative of the Administration has been to work with the international
community to sustain worldwide growth. That is a prerequisite for the
recovery of the countries now afflicted by crisis. No country, not even
the United States, is an island in the world economy. The growth
prospects of all the world's industrial nations will suffer unless all
do their part. The United States and its G-7 partners have clearly
recognized this imperative.
The United States remains committed to opening markets to
international trade, recognizing that an open trade environment will be
the best policy for domestic growth, support the recovery of the crisis-
afflicted countries, and ensure the continued growth of the world
economy. At the start of his Administration in 1993, the President
declared, ``The truth of our age is this--and must be this: Open and
competitive commerce will enrich us as a nation. . . . And I say to you
in face of all the pressure to do the reverse, we must compete, not
retreat.'' Now, as then, the Administration remains strongly committed
to outward-looking, internationalist policies.
Beyond working to ensure growth in the industrial world, the United
States has focused since this crisis began on the need to contain
financial contagion and restore market confidence so that capital flows
can continue, and on the need to promote recovery and alleviate
suffering in the crisis-afflicted countries. The Administration has
supported the IMF in its mission of providing financial assistance to
those countries in crisis that are willing to implement the often tough
reforms needed to strengthen the underpinnings of their economies. At
the same time, the Administration is collaborating

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with other countries to strengthen the architecture of the international
financial system, with the goal of enhancing its stability in a world of
continued integration of global product and financial markets. These
reforms of the international financial architecture are discussed in
Chapter 7.