Progress and Prospects: A Simple Framework and Review of the IMF Programs of Brazil, Indonesia, Republic of Korea, and Thailand
Testimony before the Subcommittee on International Trade and Finance
United States Senate
Thank you for the invitation to come before this Subcommittee to review the progress that Brazil, Indonesia, Republic of Korea, and Thailand have made in implementing their IMF programs and the overall effect of each country's program on its current and future economic prospects. The invitation asks me to address, in particular, eleven areas of reform.
In my testimony today, I will start by very briefly distinguishing among the four countries the proximate cause for the economic crisis that engendered the IMF program. I will then present a simple framework for grouping and reviewing the eleven areas of reform. Each country's progress and prospects will be assessed within this framework. Finally, I will briefly comment on the role of international private capital flows in triggering the crises.
Proximate cause of each country's economic crisis
The four countries to be reviewed today all face an economic crisis triggered by a rapid and sustained outflow of private capital. The countries differ in terms of what mainly precipitated the outflow of private capital. Yet, underpinning the proximate cause are three factors that are present in each country to a greater or lesser degree:
- Macroeconomic imbalances in the domestic or external accounts, including: Fiscal deficit, current account deficit, build-up of short-term obligations, combined with an unsustainable exchange rate regime. Brazil and Thailand evidence these kinds of imbalances.
- Microeconomic or structural rigidities in the conduct and performance of the marketplace, including: Weak financial institutions and systems, compounded by insufficient oversight; lack of true competition among firms, compounded by non-transparent accounting and insufficient corporate mobility through entry and exit; and inflexible labor markets, compounded by culture of job stasis and little support for job losers. Korea, Thailand, and Indonesia evidence these kinds of problems.
- Electoral cycle, compounded in some cases by political uncertainty and social unrest. All of the countries to some degree evidence this issue, since all were in the midst of an election period. Clearly Indonesia is the country with the greatest on-going problems.
The ultimate objective of a robust market system operating in a sustainable macroeconomic environment requires progress on all three fronts. But the focus of domestic policy response and the main thrust of the IMF program will differ somewhat depending on the proximate cause of the economic crisis.
Simple Framework for Analysis
In its invitation, the Subcommittee emphasized eleven areas of particular interest, which are principally microeconomic and structural in nature. I will emphasize these in my framework for analysis, but it is important to acknowledge that macroeconomic imbalances and misalignments have been a key ingredient in some of the crises. Moreover, there are key links between some structural reforms and macroeconomic policies. Finally, there are two tenors, or time-dimensions, to policy reforms which is a particularly important distinction when reviewing progress and prospects.
The eleven areas of interest can be combined into three groups, with some overlap, particularly in the area of transparency:
- Financial sector reform, such as resolving the bad debts of domestic financial institutions, elimination of government-directed credits, and strengthening of prudential standards;
- Corporate sector reform, such as reform to bankruptcy law, trade and investment liberalization, restructuring, deregulation, and privatization, and elimination of show-case projects;
- Labor market reforms, including deregulation and, though not explicitly mentioned by the Subcommittee, creation or reform of the social safety net.
- Macroeconomic reforms, not specifically mentioned by the Subcommittee, but including fiscal federalism, taxes vs. expenditures policies, conduct of monetary policy and exchange rate regime.
The two tenors or time-dimensions to policy reforms are emergency policies that respond to the short-term consequences of the crisis and institutional or market-oriented policies that are designed to increase the robustness of economic systems to avoid future crises. The two policy sets are related, but not the same. In particular, the government's role is different.
In the short-term, the emergency responses are often government-directed, whereas in the longer-term, legislation should be designed to release the initiative and enhance the flexibility of a robust private sector. Many of the policies of greatest interest to the Subcommittee represent reforms to the operation of the marketplace.
For example, weak banking systems and their current load of bad debts are the focal point for emergency financial sector reforms in the three Asian countries in the group. Government-directed approaches to resolving the bad debts of domestic institutions "wipe the slate clean", and thus respond to the immediate consequences of the crisis. Similarly, privatizing firms, forcibly restructuring corporations, and shuttering show-case projects represent short-run, government-directed responses that make the corporate sector appear to be populated by more private firms, even if they do not act that way.
For longer-term robustness of the private sector, legislation must set the stage for improved performance in the marketplace; it cannot create by fiat private actors. For example, deregulation, trade and investment liberalization, and competition policy which facilitates entry and exit (where bankruptcy law plays a key role), encourage a more robust private corporate sector that can withstand and absorb shocks. In addition, appropriate government programs that enhance labor market flexibility relieve corporations and the financial sector from being the main purveyors of the social safety net.
Similarly, the withdrawal of government credit guidance and the development of prudential regulation and oversight remove roadblocks preventing the development of a financial sector that can discipline and direct corporate investment. But, to truly encourage a financial sector that allocates credit according to risk and return may require an activist liberalization of investment in the financial sector to include foreign participants that bring with them the technical knowledge and best practice to "do better banking."
Macroeconomic reforms, particularly to the fiscal accounts, are a backdrop to these sectoral measures. In some cases, sectoral reforms, particularly the emergency measures, can influence the macroeconomic balances. For example, recapitalizing the banking system may involve fiscal expenditure via government bonds. Creating a social safety net to increase labor market flexibility may entail fiscal outlays. On the other hand, privatization receipts can make the fiscal accounts appear stronger than they really are.
Monetary and exchange rate policies will affect the success of sectoral reforms, both in the short- and long-term. Failure to control money growth will lead to inflation, doom the financial sector, and make corporate restructuring more difficult. Private sector actors or foreign investors will focus on evading or profiting from inflation instead of from their core business activity. Similarly, maintaining a fixed exchange rate in the face of inflation or structural change will encourage both domestic and foreign investors to arbitrage the "one-way bet," with the collapse of the exchange rate (at minimum) a certain outcome.
Progress and Prospects
The framework discussed above offers a two dimensional approach to analyzing the progress and prospects for reforms. Along one dimension are the sectors in need of reform: fiscal, financial, corporate, and labor markets. Along the second dimension are the two tenors of reform: short-term or emergency reform, which will be mostly government-directed; and long-term legislative or institutional reforms that develop and enhance market conduct and performance. While progress on the first is a prerequisite for near-term stability, achievement of the second set of reforms is crucial to avoiding a recurrence of the proximate causes of the crises.
Brazil: Fiscal imbalances and fiscal federalism are key problems;
progress is good
The proximate cause for the economic crisis in Brazil was macroeconomic imbalances, particularly in the fiscal system but also in the external accounts, compounded by a "structured" exchange rate regime (that is, a crawling peg within a band). Electoral issues played a role as well. Political tensions between the newly re-elected President Fernando Henrique Cardoso and the thwarted presidential hopeful Itamar Franco (who is the former President and newly elected governor of Minas Gerais) contributed to the economic brinksmanship in the early part of this year between the Congress and the President. Perhaps to emphasize to Congress the need pass key legislative reforms in the fiscal area, President Cardoso allowed the Real float, sacrificing the centerpiece of his economic plan.
What progress has Brazil made to improve fiscal balances in the short-term and to put in place policies to stabilize the fiscal system in the long-term? The current focus remains on emergency revenue raising measures. However, institutional reforms and policies of a longer-term nature that balance federal and state fiscal responsibilities are on the table. More important, the various political parties finally appear to realize that such reforms are necessary for the sustained macroeconomic health of the country.
With respect to the structural issues, Brazil is far ahead of the other countries considered today. Deregulation, trade liberalization, and the withdrawal of government ownership over the 1990s have increased the robustness of corporate and financial sectors. Brazil has weathered its current difficulties relatively well on account of these on-going structural reforms.
Details: The fiscal measures of an emergency nature focus on raising taxes rather than rationalizing expenditures. Examples are the increase in the tax on financial transactions (CPMF), extending the tax on corporate turnover (COFINS) (a part of which will be creditable against corporate income tax), raising the social security tax to the highest-paid retired civil servants as well as extending this tax to other civil retirees.
Of a longer-term nature, Brazil's fiscal system has inherent weaknesses that have persisted through many reform efforts. First, the social security component of fiscal spending (at both the federal and state levels) is in a situation of unsustainable net outflow, with the bulk of benefits going to former civil servants. Reform efforts focus on making the social safety net less generous to some and more inclusive to others.
Second, there is insufficient discipline on fiscal spending by regional governments, particularly in payroll and benefit spending, and their deficits and behavior rebound to the federal level. A stark example is the recent implicit default by Minas Gerais on eurobond borrowing in which the federal government made good on the debt in order to preserve its own name.
One approach to try to rein-in state deficits includes the continuation of the fiscal stabilization fund (FEF) through 2006 instead of terminating in 1999. This allows the federal government to retain 20 percent of state and municipal funds against federal transfers. While not yet passed, more permanent reforms are on the administrative agenda. The Lei Camata caps payroll spending as a share of government revenues at all levels of government; federal transfers may be suspended if the cap is exceeded. Other penalties and requirements are outlined in the Law on Fiscal Responsibility.
Brazil's difficulties are primarily macroeconomic, but it has a noteworthy program of corporate and financial restructuring.With respect to corporate restructuring, Brazil has made substantial commitment to privatization and has prepared a schedule through 1999 for sales in sectors ranging from telecommunications to petroleum to electricity to container terminals to banks (see below). Foreign participation and consummation in the auction sales is viewed as positive, not with suspicion as is the case with some of the Asian countries. Examples include: an electricity generating company (Gerasul) was purchased by Belgian group Tractebel (US firms bowed out because of inability to obtain financing). Emprese Bandeirante de Energie (EBE), an electricity distribution company, was purchased by a consortium of a domestic and Portuguese firms.
On the downside, the privatization receipts are a large, but obviously fragile, component of the fiscal balance. Moreover, in some of these cases, such as the container terminals, the privatization represents a consolidation of state assets with another private firm in a similar market niche. Insufficient competition could be a future problem, and Brazilian regulatory authorities are reviewing their mandate in these sectors.
Promoting competition through trade liberalization has been the approach fostered by the government over the 1990s. In recent months, there has been some resort to administrative guidance on certain kinds of imports, particularly of consumer goods.
In the financial sector, bank privatization and consolidation are an important part of the privatization program. Banco do Estado de Minas Gerais (Bemge) was purchased by Banco Itau. Chase Bank purchased Patronias Investimentos, and ABN-Amro purchased Banco de estado de Pernambuco. Compared with the other countries in the group of four analyzed today, Brazil has a stable and robust banking sector in part because of on-going consolidation and foreign participation in the financial sector.
Moreover, the financial supervisory and regulatory regimes have been in place for numerous years, and by and large are respected. Capital adequacy ratios among the top private banks are 15 percent or higher and all banks are required to have capital ratios of 11 percent from January 1 this year. Through the Credit Risk Center, the financial authorities have a consolidated view of a borrower's exposure to domestic financial institutions. Credit derivatives also are tracked. On-site and on-going supervision of financial institutions are part of the regime.
Korea : Structural rigidities in all aspects of the marketplace and continued government guidance remain as key problems
The proximate cause for the economic crisis in Korea was the financial sector, but there were complementary problems in other aspects of the economy, particularly the lack of market-orientation of industry and labor. Moreover, the presumption of a fixed exchange rate exacerbated the financial system's vulnerabilities to external shocks.
Korea and other Asian "tigers" have followed a development strategy that relied on tight and interwoven government, industry, and labor relations. Government guidance to corporations on where to invest meant that industry did not need transparent accounting or decision making. The financial system played no role in assessing or allocating credit. It was a "silent partner" and bank supervision and regulation lagged. So long as industry prospered, labor did too, and the government did not need to create a social safety net or enable labor toward greater flexibility.
Korea's increasing integration into the global system via trade flows meant increasing participation in international financial markets too. However, the manner in which foreign capital could participate in the Korea economy was circumscribed to portfolio instruments or to on-lending through domestic financial institutions. For liberalized foreign inflows to be used wisely, the domestic financial system would have had to be much stronger.
What structural reforms have been undertaken by Korea and how far has Korea proceeded beyond emergency government-directed reform to achieve institutional reforms that are designed to develop a more market-oriented economy? The bottom line is that Korea has made relatively little progress toward reforms that will create a more market-oriented economy. In fact, institutional reforms, such as to bankruptcy law and to the social safety net, have tended to impact the smaller chaebol the most, while leaving the large chaebol unscathed. This may hollow-out from the Korean economy the firms that could pose a competitive threat to the biggest chaebol. In this environment, developing an active financial system that allocates credit according to risk and return will be difficult, if not impossible. Indeed, some of the large chaebol are looking to buy banks.
Details: In the financial sector, the emergency response of the government effectively nationalized the two major commercial banks through capital injections and through the purchase of bad loans by the Korean Asset Management Corp. In addition, central bank liquidity support in the face of depositor runs was generally at below market rates, instead of at punitive rates. Finally, the consolidation of smaller and weaker banks into larger banks gives the appearance of a stronger financial sector. But, merging weak banks together and using government funds to buy-back bad loans does not create a stronger institutional culture for credit discipline. More recently, the government has announced possible foreign purchases of controlling stakes in Korea First Bank by a consortium of GE Capital and Newbridge and of Seoul Bank by HSBC Holdings.
In terms of long-term reforms to the credit culture, it is notable that as long ago as 1992 Korea had promulgated reforms to supervision and regulation. The 1992 Financial Reform Plan required banks to achieve the BIS capital adequacy guidelines of 8 percent and introduced a CAMEL-based reporting concept for commercial banks to assist in early-warning of problems. Thus, the issue has not been the language of the law but the spirit of adherence to the law. In this regard, can new foreign partners remake their institutions into viable credit-allocating and risk-managing banks when a very large share of the institutions and perhaps the decision-making authority remain firmly in government's hands?
Another approach to institutional reform and the development of a broader base to the financial sector is the Korea Asset Management Corp. KAMCO was set up to buy, package, and sell as securities the bad debts of banks. Selling these securities to private investors could create clients to participate actively in corporate restructuring and financial system discipline. In the end, KAMCO has bought relatively few assets, probably at a relatively high price, and has packaged and sold essentially none of them. Thus its role in restructuring has been minimal.
In the corporate sector, some restructuring is taking place among the smaller chaebol, with foreign purchases or participation part of the action. For example, Halla's subsidiary Mando Machinery, which makes car parts, received an injection of funds from the investment bank Rothschild. Halla Pulp and Paper subsidiary was purchased by the US newsprint firm Bowater. Symbios, a US subsidiary of Hyundai, was purchased by LSI Logic. Seagram increased its stake in Doosan. MetLife and Korea Life are in joint-venture negotiations.
On the other hand, several other small chaebol have been receiving life-support loans from their local banks. This points out the complex relationship between corporate restructuring and financial restructuring. The two must go hand-in-hand.
Moreover, restructuring among the large five chaebol has been difficult to essentially impossible. Indeed, the government-directed solution-the so-called "self reform" pledge of last December-has only barely broken the ice. The chaebols would not restructure themselves, the forces of competition from at home and abroad were too weak, so the Korean government's Financial Supervisory Committee presented to each chaebol a detailed plan of divestiture, area of specialization, change in financial leverage, and greater financial transparency. In the end, if these reforms go through, Korea will have fewer firms in each line of business, and maybe lower leverage and greater transparency. But it is unlikely to have a much more competitive or market-oriented economy.
Thailand: Corporate restructuring and financial restructuring must go hand-in-hand and neither are going well
Thailand's economy evidenced both macroeconomic difficulties and structural problems. In contrast to Brazil fiscal imbalance though, Thailand's macroeconomic imbalance was generated more by excessive investment by corporations than by excessive government expenditure. Much of the investment was financed externally and intermediated through the banks. So, when the corporations went under, the obligations went unserviced, and the banks' bad debts ballooned. The apparent commitment to a fixed exchange rate contributed to the rush to borrow abroad and to the maturity and currency mismanagement.
The links between corporate restructuring and financial sector restructuring are particularly obvious in Thailand. Difficulties in proceeding with the one stymie progress on the other. Rifts between two policymaking groups on the appropriate course of action make a credible environment difficult to achieve. These rifts are particularly apparent in asset sales, and in trade and investment liberalization. All told, Thai policymakers have been mired in emergency treatment of the consequences of the crisis. They have made little progress toward the reforms to the corporate environment and to the conduct and performance of the financial sector that would develop a market-oriented economy.
Details: Two government organizations explicitly link restructuring of corporate and financial sectors. The Corporate Debt Restructuring Support Committee, which is a part of the Bank of Thailand, identifies which loans need to be restructured. It supposedly leaves to the creditors and debtors the negotiation of terms. One problem is that some of these loans are being carried on the books of nationalized financial institutions. Other loans are being carried by institutions that are being recapitalized by government funds. How the "London Approach" (so-called because it originated with the Bank of England) works when one of the two parties is not acting in its private interest is unclear.
A second organization that links corporate and financial restructuring is the Finance Sector Restructuring Authority. It is supposed to package and auction the assets of bankrupt finance companies, which includes both real estate and business loans. Very few of the tranches of loans have been successfully auctioned because most bids were considered too low. Concern that fire-sale prices would foment national outrage was augmented by on-going financial entities that did not want to write-down further their own assets. The outcome, however, is that when there is no market price for old financial assets, it is quite difficult to price new financial assets, which contributes to the lack of lending and the deep economic recession in Thailand.
Changes in the 1972 Foreign business law were approved in September that in theory make many more sectors of the Thai economy available for foreign investment. While numerous deals are pending, the exact parameters and modalities for foreign participation remain unknown, particularly with respect to the percentage ownership that will be allowed to foreign investors. If these laws are interpreted generously, a more vibrant private sector could emerge. But preliminary assessment is not sanguine. Moreover, particular sectors that are still closed include accountancy and legal services. Given the obvious and real need for accountants and lawyers to help price assets and creatively resolve debts, it is hard to understand these limitations.
Similarly, an aggressive schedule of privatization in the energy, telecommunications, water, and transport sectors could raise important funds for the fiscal authority as well as enhance efficiency in delivery of these key infrastructures. Yet, given the political constraints, as well as resistance from management and workers, substantial privatization seems unlikely any time soon.
Indonesia: Overwhelming political uncertainty and collapse of the economy prevent reform
Whereas the proximate cause of the economic crisis in Indonesia remains a bit of a puzzle, the current state of economic collapse, political uncertainty, and social unrest clearly prevent even emergency economic policies from taking hold. Indonesia has made little progress even in emergency treatment of financial or corporate sectors of the economy. Much policy effort by international financial institutions has focussed on alleviating the human consequences of the crisis.
Details: Resolving corporate debt is the most challenging economic issue facing Indonesia. Two approaches to restructuring corporate debts have been proposed, but neither has been effective. The Indonesian Debt Restructuring Agency is supposed to assist the negotiation of terms between Indonesia debtors and their foreign creditors by selling foreign exchange to debtor companies, presumably at a favorable rate. However, this "Frankfurt Agreement" merely extends the terms of the debt with continuing interest service required. Moreover, the exchange rate offered is not concessional at current exchange rates. The second approach, the "Jakarta Initiative," is a sort of bankruptcy court that is supposed to assist creditors and debtors to negotiate terms of standstill and a restructuring plan, possibly to include takeovers and mergers. This initiative has been stymied as well by political developments.
Similarly, emergency financial sector reforms have not gone beyond effective nationalization through the Indonesian Bank Restructuring Authority. Once classified as undercapitalized, banks have almost no way to improve themselves, with stock issuance, mergers, and foreign participation all essentially off limits.
Each of the four countries reviewed today have had elements of macroeconomic imbalances, structural rigidities, and electoral cycles that helped precipitate a crisis of domestic and international capital flows. The four countries have countered with both emergency, government-directed policies and, to a lesser degree, with longer-term legislative initiatives designed to improve the functioning of the marketplace.
Among the four countries, Brazil's prospects look the best. There is hope that it can move beyond emergency treatment of the fiscal imbalance and institute meaningful longer-term reforms. Its corporate and financial systems are relatively private, robust, strong, and competitive.
Korea prospects are good, but not particularly because of structural reforms. The government continues to direct emergency restructuring of the five largest chaebol. Smaller chaebol are being restructured, but unless active foreign participation is welcomed, these firms will not be competitive enough to discipline the largest chaebol and create a market-oriented economy. Similarly, unless financial firms can be made significantly stronger and develop quickly a culture of credit discipline, they will play only a minor role in the Korean economy in the future. Thus, while emergency reforms are well in hand in Korea, policymakers have not embraced the need for longer-term reforms to improve the operation of the marketplace.
Thailand and Indonesia have somewhat different problems. But political difficulties, as well as human tragedy are making even emergency economic reforms difficult.
Addendum: On international private capital markets
In today's global environment, national economic well-being increasingly relies on global production, distribution, consumption, and the web of international financial transactions that binds them all together. Limiting international capital flows is not without cost. Yet, it is clear that international capital markets have not worked well over the last several years, including not just the obvious turmoil of the last two years but also the breakdown of the European Monetary System in 1993. Avoiding such systemic financial distress requires that borrowers and lenders accurately price and manage risks in their own portfolios.
What makes financial markets work well? The recipe has these ingredients: Market participants with different tastes for risk, armed with full information, and offered "complete" markets of financial instruments. What has been missing in recent years? Arguably all three!
First, market participants have appeared more herd-like than heterogeneous. The very narrow risk spreads on emerging market debt in early 1997 and the huge risk spreads following the collapse of the Russian effort point to a lack of differentiation among borrowers as well a swing in collective sentiment completely out of line with changes in the underlying economic prospects of many of the countries caught in the financial maelstrom. Second, differentiation has been made more difficult by incomplete or wrong information revealed only very slowly by certain market participants, including for example both Korea and Thailand. Finally, the market for financial instruments is incomplete, lacking in particular financial insurance against the rare events of credit downgrade or restructuring (e.g. delay in payment or rollover) of, in particular, short-term obligations.
Could financial insurance instruments, such as credit risk insurance or restructuring insurance, help stabilize the international financial system? First, these instruments differentiate the market participants. Not all borrowers would offer insurance, not all lenders would buy it. But for those that did, when the financial crisis hits, the insured lenders would not abandon the insured borrowers, at least not for the duration of the policy. So, insurance could significantly alter the herd mentality in the market by diversifying the exposure of market participants and by moving risk from those who fear it to those who manage it. The change in the pace of race to the exits could dramatically alter the self-fulfilling nature of some financial crises.
Second, financial insurance splits the pricing of financial products into pieces which can then be priced separately. A financial relationship needs to consider two situations: the borrower-lender relationship during normal times and the relationship when the borrower is distressed. The interest rate on a loan or bond only prices the relationship during normal times. There is no interest rate high enough to pay off the principal of the loan or bond in the case where a borrower defaults. In contrast, financial insurance prices-in only the cost of default.
Who might develop these financial products? Private financial institutions have the technical ability to create financial instruments that will price default risk and diversify it to participants who can bear it. They performed a similar function in developing foreign exchange insurance after the breakdown of Bretton Woods.
A key aspect of the demand for financial insurance is the presence or absence of international bailouts or orderly (e.g. IMF or public-sector coordinated) workout agreements. To the extent that creditors are made whole or partially whole through non-market mechanisms, the demand for financial insurance instruments will not develop. The more difficult, drawn-out, ad hoc, and therefore costly are the financial-disaster workouts, the greater are the incentives for investors to demand and institutions to offer instruments ex-ante that will help avoid financial distress.