International Monetary Fund VOLUME 29 NUMBER 5

March 6, 2000 www.imf.org In this issue Executive Board selection process 65 Fischer, Koch-Weser, Sakakibara are nominated Nominations for IMF Managing Director for position of next IMF Managing Director 65 Interview with he IMF Executive Board has received three nomi- currently holds the presidency of the European Claudio Loser nations for the post of the next Managing Union. A supporting statement was made by Bernd T 66 Director to succeed Michel Camdessus, who resigned Esdar, Executive Director for . The IMF’s Tribute to Sir Joseph effective mid-February (see page 67). Executive Directors are in consultation with their Gold On February 22, the Board received the nomina- respective authorities on the nominations received. 67 tions of Stanley Fischer, the current Acting Managing Also, statements by the nominating Directors have Pacific Island Director of the IMF, and Eisuke Sakakibara, former been posted on the IMF’s website (www.imf.org). technical assistance Vice Minister of Finance of Japan. On February 29, it Stanley Fischer has served as First Deputy Manag- 67 received the nomination of Caio Koch-Weser, State ing Director of the IMF since September 1994. Born Finance & Secretary for International Finance of Germany. in Zambia, he was educated at the London School of Development Fischer was nominated by José Pedro de Morais, Jr., Economics and the Massachusetts Institute of Tech- March issue Executive Director for a number of African member nology (MIT). He was then successively an assistant 68 countries; Sakakibara was nominated by Yukio professor of economics at the Sugisaki on the Yoshimura, Executive Director for Japan; and. Koch- and a professor of economics at MIT. He has also Caribbean Weser was nominated, on behalf of the member states held visiting professorships at the Hebrew University, 71 of the European Union, by Joao Santos, an Advisor in Jerusalem, and the Hoover Institution, Stanford Uni- Conference on contagion the Board constituency that includes Portugal, which versity. He is the author (Please turn to the following page) 75 Emerging market Interview with Claudio Loser prospects

Caribbean countries face both challenges and 77 Korean economic opportunities as they pursue integration recovery he Caribbean was the focus of a recent high-level semi- West Indies, and the private sector. Many IMF repre- and . . . T nar, held in Barbados on February 8, in which the IMF sentatives also attended, including IMF Deputy 70 and several other international organizations participated, Managing Director Shigemitsu (Continued on page 68) Selected IMF rates along with national and regional officials. The IMF’s 78 Western Hemisphere Department has also stepped up its Recent publications activities in that region, as part of a “Caribbean initiative.” 80 The editors of the IMF Survey met with Claudio Loser, New on the web Director of the Western Hemisphere Department, to dis- cuss important issues in these countries from both a national and an international perspective.

What was the focus of the high-level Barbados semi- nar and its chief message? LOSER: This seminar was organized and cosponsored by the IMF and the Caribbean Development Bank. Participants included prime ministers, regional finance ministers, and central bank governors, as Loser: “In view of its size, the Caribbean cannot be self-suf- well as representatives from the regional and multi- ficient; its economies have to be very closely associated lateral organizations, the University of the with the rest of the world.” 65

©International Monetary Fund. Not for Redistribution (Continued from front page) of numerous books and arti- Bank President Robert S. McNamara, Deputy Trea- cles in the field of economics. surer, Director for West Africa, Division Chief for Eisuke Sakakibara is currently a professor at Keio China, and Vice President for the and University and a special advisor to the Japanese Min- North Africa, before being appointed Managing istry of Finance. He holds degrees from the universi- Director for Operations in 1996. ties of Tokyo and Michigan and served in a number Under the terms of Article XII of the IMF’s Articles of Agreement, the Executive Board has the responsibility of selecting the Managing Direc- tor, who should be neither a governor of the IMF nor an Executive Director. Once selected, Picture not the Managing Director serves as both chairman of the Board—where he exercises no vote except available a deciding vote in the case of an equal divi- sion—and chief of the operating staff of the IMF. The Board’s aim is to reach agreement on the selection of the next Managing Director by con- sensus through discussion and through a process Stanley Fischer Eisuke Sakakibara Caio Koch-Weser in which flexibility takes precedence over formal- ism. To this end, the Board held an informal straw of positions in the Ministry of Finance before being poll by secret ballot on March 2. In the poll, Caio appointed Vice Minister of Finance for International Koch-Weser received the largest share of voting Affairs in 1997. He was also an economist at the IMF power; Stanley Fischer received the second largest; from 1971 to 1975 and a visiting associate professor and Eisuke Sakakibara, the third largest. Executive of economics at Harvard University during 1980–81. Directors will continue to consult with each other and Sakakibara is the author of a number of publications their national authorities on the next steps. Although on the Japanese economy and other economic topics. the poll can be only indicative, it enables the Board, Caio Koch-Weser has been State Secretary for and in particular its Dean—Abbas Mirakhor, Execu- International Finance at the German Finance Min- tive Director for the Board constituency that includes istry since May 1999. Prior to that, he served for the Islamic Republic of Iran—to gauge the support 25 years with the in a number of posi- for different candidates and judge the emergence of a tions, including those of personal assistant to then consensus.

Sir Joseph Gold is memorialized as authority on international law Following his retirement in 1979, Sir Joseph worked for the Sir Joseph Gold, a leading authority on international monetary IMF until last year as a Senior Consultant, a position from law, who for many years was General Counsel of the IMF, died which he continued to write extensively on the legal frame- at his home in Maryland on February 22 at the age of 87. work of the IMF and the international monetary system. He Acting Managing Director Stanley Fischer paid tribute to was knighted by Queen Elizabeth II in 1980. Sir Joseph in a statement to the IMF Executive Board, as While on the staff, Sir Joseph was the principal draftsman “this extraordinary man who was so of the First Amendment of the IMF’s Articles of Agreement, important in the life of the Fund for so which created the SDR, and of the Second Amendment, long....Sir Joseph occupies a distinguished which revised the Articles after the termination of the par place in Fund history. His many contribu- value system. He represented the IMF in various international tions will remain as a lasting memory.” forums, including a number concerned with the reform of the A U.K. national, Sir Joseph was one of international monetary system. the central pillars of the IMF staff from its Sir Joseph was a prolific writer on a wide range of legal issues earliest days, serving in different capacities pertaining to the IMF and the international monetary system. for 53 years and making a lasting contribu- He was a legal lecturer at many universities, including the Uni- tion to developing the law of the IMF and versity of Michigan and Columbia School of Law. Sir Joseph to the better understanding of the IMF was a founding member of the editorial committee of the The through his writings. He joined the staff as Modern Law Review, a member of the Advisory Board of the a Counselor in October 1946, just three months after the George Washington University Journal of International Law and IMF’s doors were opened, and served in a number of senior Economics, and a member of the Advisory Board of Law and March 6, 2000 positions before being appointed General Counsel in 1960. Policy in International Business at Georgetown University. 66

©International Monetary Fund. Not for Redistribution IMF Executive Board receives nominations for Managing Director, conducts straw pole

n two press releases, the IMF Executive Board announced Caio Koch-Weser, Germany’s State Secretary for I that it had received, on February 22 and February 29, for- International Finance, was nominated on behalf of the mal nominations for the post of the next Managing Director European Union member states by Joao Santos, an of the IMF. In addition, in a press release issued on March 2, Advisor in the Executive Board constituency that the Executive Board announced that it had held an informal includes Portugal, which currently holds the presi- straw pole. The full text of Press Release Nos. 00/10, 00/12, dency of the European Union. Bernd Esdar, Executive and 00/15 is available on the IMF’s website (www.imf.org). Director for Germany, made a statement in support of Stanley Fischer, IMF First Deputy Managing Direc- the nomination of Koch-Weser. tor, and currently Acting Managing Director, was Statements by the Executive Directors are posted nominated for the post by José Pedro de Morais, Jr., on the IMF’s website. the Executive Director representing Angola, Botswana, Burundi, Eritrea, Ethiopia, The Gambia, Kenya, Lesotho, Liberia, Malawi, Mozambique, Namibia, Nigeria, Sierra Leone, South Africa, Swazi- land, Tanzania, Uganda, Zambia, and Zimbabwe. FINANCEPUBLISHED BY THE Eisuke Sakakibara, former Vice Minister of Finance in INTERNATIONAL MONETARY FUND DEVELOPMENT the Ministry of Finance of Japan, was nominated by Mr. Yukio Yoshimura, Executive Director for Japan. The March issue of Finance & Development,which will be available shortly, focuses on the remarkably successful reform and recovery in and the Caribbean in the wake of the economic crises of the past Pacific island countries receive help few years. The articles, including several by finance in strengthening financial sectors ministers or central bank governors from the region, dis- cuss the progress made in these countries and the global The authorities of eight Pacific island countries—Federated implications of their experiences. States of Micronesia, Fiji , Republic of the Marshall Islands, An article by IMF Historian James Boughton offers a Papua New Guinea, Samoa, Solomon Islands, Tonga, and preliminary assessment of Michel Camdessus’s 13 years Vanuatu—have agreed to the final text of a declaration on as Managing Director of the IMF, highlighting his per- cooperation, intended to foster confidence in their financial sonal qualities and his contributions in the interna- sectors and in that of the region as a whole. The declaration tional sphere. Among the articles in this issue are was jointly drafted by staff from the Pacific Financial Latin America and the Caribbean: The Long Road Technical Assistance Centre (PFTAC) and the Reserve Bank to Financial Stability of Fiji, together with supervisory agencies that participate in Claudio M. Loser and Martine Guerguil the Pacific Islands Prudential Regulation and Supervision ’s Structural Reforms of the 1990s Initiative (PIPRSI), according to a press release issued by the Pedro Pou PFTAC on March 1. A joint project of the United Nations Development Pro- Monetary Policy During the Transition to a Floating gram and the IMF, the PFTAC is playing a key role in advanc- Exchange Rate: ’s Recent Experience Arminio Fraga ing regional cooperation and coordination in financial sector regulation and supervision in the Pacific (see IMF Survey,Jan- Chile in the 1990s: Embracing Development uary 10, page 15). The PIPRSI was formed because the Pacific Opportunities island countries, despite improvements in their regulatory sys- Eduardo Aninat tems and supervision over the last decade, remain vulnerable Mexico: Recent Developments, Structural Reforms, and to financial sector volatility and illegal financial operations. Future Challenges They therefore decided to reinforce their commitment to José Angel Gurría financial sector soundness and stability. Specifically, the coun- The Dollarization Debate tries will take steps to bring their domestic regulatory envi- Andrew Berg and Eduardo Borensztein ronment and supervision in line with international best prac- Is the U.S. Current Account Deficit Sustainable? tice. They will also commit to establishing more formal and Catherine L. Mann extensive arrangements for closer cooperation and coordina- Finance & Development is published four times a year by the tion among the members of the initiative. International Monetary Fund, in English, Arabic, Chinese, French, and Spanish. Subscriptions are free of charge. To For more information, contact Klaus-Walter Riechel, receive Finance & Development, please write to IMF Publication E-mail: [email protected] or [email protected]. Services, Box FD 99, Washington, DC 20431, U.S.A. March 6, 2000 67

©International Monetary Fund. Not for Redistribution Loser discusses achievements of Caribbean countries (Continued from front page) Sugisaki, who delivered a lun- most of the countries in the region. This restructuring cheon address [see below]. gives us a better regional focus and helps us develop The seminar dealt with key issues in the region, in regional studies and to provide more specialized services the context of the Caribbean initiative, and was to the region. intended to bring into focus the IMF’s interest in all The initiative also involves closer cooperation and the areas of activity affecting the Caribbean. an enhanced policy dialogue with the authorities. In particular, we can offer the countries a better under- You mentioned the Caribbean initiative. What exactly standing of the key issues involved in the new inter- is this and what is the IMF’s role in it? national financial architecture that the IMF is helping LOSER: The Caribbean initiative was put in place in to establish. One very important element of our rela- response to a number of concerns voiced by the author- tionship with the Caribbean economies is technical ities of our Caribbean constituency. There was a percep- assistance, and we are seeking ways to increase its vol- tion on their part that the IMF was not paying sufficient ume and effectiveness. As part of this effort, we are attention to the region, which is made up of small, vul- working on the development of a Caribbean Techni- nerable states, and they felt they had been left behind in cal Assistance Center, in conjunction with the United the process of globalization. Our response has been, par- Nations Development Program. We are hoping to ticularly since last year, to push for a closer relationship bring in the World Bank, the Inter-American Devel- with them. We began in the Western Hemisphere opment Bank, and other agencies on this project. A Department by restructuring our work on the similar model has already demonstrated its potential Caribbean. We established two divisions that regroup in the Pacific [see IMF Survey, January 10, page 15].

Sugisaki outlines new initiatives in IMF-Caribbean cooperation millennium? Let me briefly mention three: bolstering domestic financial systems, strengthening fiscal policies, and Following are edited extracts from an address given by IMF boosting competitiveness. Deputy Managing Director Shigemitsu Sugisaki at the High- Many countries in the Caribbean are already addressing Level Seminar on the Caribbean in Barbados, February 8. these challenges with courage and conviction. Reform The full text is available on the IMF’s website (www.imf.org). efforts will succeed only when governments and electorates Caribbean nations have achieved some alike are committed to them and recognize their long-term important economic successes over the last two benefits. Our role at the IMF is to provide support and decades, in often unpromising circumstances. assistance where we can and where we are wanted. For the most part, the region has enjoyed eco- Our deliberations here this week will help the IMF in its nomic and political stability, its social indica- efforts to develop a research agenda that is more relevant to tors are good, and on average incomes are high the needs and circumstances of Caribbean nations. We relative to other developing countries in the already have work under way on several relevant topics like Western Hemisphere. But growth has been rel- bank supervision and regulation, fiscal reforms, labor mar- atively modest. And crucially, it has not been ket and competitiveness, interest rate and exchange rate strong enough to bring about significant policy, and external debt management and vulnerability. reductions in what remain distressingly high Another initiative is the creation of the Caribbean rates of unemployment and poverty. Regional Technical Assistance Center. This will bring This mixed picture makes it more impor- together several regional and international institutions to tant now than ever for the Caribbean to tackle improve the range and quality of technical assistance avail- head on the policy challenges that confront it. Sound poli- able to Caribbean nations. It will concentrate on budget cies are especially important in the Caribbean, because management; tax reform; tax and customs administration; economies here are more vulnerable to external shocks than bank supervision; and monetary, fiscal, balance of payments, most. Many countries have made progress in diversifying and national accounts statistics. This collective approach will their economies over recent years. But in many cases the allow the pooling of resources, permit greater collaboration structure of exports remains concentrated on just a few between institutions, and provide for more effective follow- products. Many countries also rely on preferential access to up between the users and providers of assistance. markets for these exports. This is likely to be eroded and I hope that these efforts make clear the IMF’s determina- eventually lost as trade liberalization continues. The tion to improve the service that we offer to our members in Caribbean is also seeing inflows of external assistance the region. Ultimately, the destiny of any nation lies in its own decline steadily. hands. But, together with our colleagues in other international In the face of these vulnerabilities, what are the key institutions, we hope and believe that we can play our part in March 6, 2000 challenges policymakers face on the threshold of the new helping the Caribbean fulfill its economic potential. 68

©International Monetary Fund. Not for Redistribution What are the major policy challenges that the policies, which has been reflected in their good Caribbean region faces today and what are the macroeconomic performance in recent years. There prospects for meeting these challenges in the medium are several types of exchange rate regimes in opera- and long term? tion among the Caribbean countries, including a fully LOSER: Let me start on a positive note: if we compare functional currency union. But despite the different the recent performance of the Caribbean countries regimes, the policies behind them are nearly uni- with that of Latin America, we see that they have formly strong, and in that sense, they are well shown much stronger growth—close to 5 percent managed. during the period 1996–99—lower inflation, overall The Eastern lower public sector deficits, and higher levels of invest- Caribbean currency ment. This is in spite of the fact that the region is union encompasses mostly made up of small countries that are more vul- eight members, six of nerable to external shocks and that have in fact suf- which are indepen- fered from a number of them in recent years. The dent countries and Caribbean economies also display lower poverty levels members of the and have a much more equitable distribution of Fund. operating income than the Latin American economies. However, under the authority they do tend to have a lower level of savings, so they of the Eastern depend much more on foreign savings, and they have Caribbean Central higher external current account deficits. Bank (ECCB). In That said, what are the major challenges facing the practice, the ECCB Caribbean? First, even though these countries have a rel- functions like a atively high per capita income, compared to, say, coun- quasi-currency board, tries in Africa or in South Asia, they are small and have and member coun- vulnerabilities that other countries do not have. Second, tries have to follow for many years they were heavily dependent on foreign prudent fiscal policies. The same cautious policies are assistance or on the preferential treatment of certain true of other countries, like Trinidad and Barbados. exports, like bananas and sugar. However, these preferen- Jamaica, too, has been strengthening fiscal discipline. The region’s tial arrangements are being phased out over time by the The region’s financial systems have features that financial European Union and others, and the Caribbean coun- make them well placed to benefit from globalization, systems have tries now need to diversify their exports. Foreign assis- including a number of foreign-owned banks with features that tance is also drying up, with a reduction in the level of close links to major banks abroad. There are also make them aid to the Caribbean. Since these economies cannot many local banks, which raises the issue of the quality well placed to depend on foreign resources to the same degree as in the of bank supervision. However, the various central benefit from past, they have to develop their own resource base and banks have been taking important steps to strengthen globalization. strengthen their own savings, in order to grow on a sus- financial supervision and prudential regulations. In — Loser tained basis. This is the major challenge. We believe that fact, it is interesting to notice that during the episodes the new technical assistance center and the Caribbean of financial turbulence of 1998 and 1999, no initiative can help catalyze these restructuring efforts. Caribbean country suffered any serious problems because of financial contagion. Another important policy challenge facing the coun- tries of the Caribbean is their integration into the Is all this sufficient to gain the confidence of the inter- globalized economy. What policy actions need to be national capital markets? taken, for instance, with respect to domestic financial LOSER: The Caribbean economies have to maintain sup- systems, exchange rate policy, and capital account lib- portive macro policies; but they also must advance with eralization? structural reforms—for instance, making their labor LOSER: First of all, the Caribbean economies are very markets more flexible. Fiscal policy needs to be less strategically located: they are close to the United dependent on import duties, and many of the countries States, easily accessible, with low transportation costs. are moving to broaden their tax base. Barbados, for Further, their population is on average highly edu- example, has introduced a value-added tax that has cated. Also, these countries are already well integrated worked very well, and others may follow that example. into the world economy through their links to their There are other issues in the area of taxation, including main traditional trading partners, which gives them the level of property taxes and the possible introduction strength for new sources of growth. of user fees for services such as health and education. With a few exceptions, these countries have tradi- The Caribbean countries are generally open in terms March 6, 2000 tionally pursued very prudent monetary and fiscal of capital flows, with only few, limited restrictions. One 69

©International Monetary Fund. Not for Redistribution interesting possibility for these countries would be to arguably seen as a less reliable source of foreign unify their capital markets. This would raise some exchange than Europe or North America. The larger operational issues, because of the countries’ differences Caribbean countries are working on establishing in terms of size and output; but there is still significant closer links with Latin America, but there is a fair way scope for higher integration of capital markets in the to go before Latin America would be considered a Caribbean. In fact, the Caribbean economies are major source of their foreign exchange earnings. In view of their already much more integrated than other regions at small size, it the political and social levels. There are many contacts What role do the regional organizations, like CARI- would be among them and a larger sense of community than COM and OECS (Organization of Eastern Caribbean impossible to you would find, for instance, in Latin America. States) play? How effective are they? Can they be helpful fully insulate in narrowing the wide differences in growth and per- the Caribbean Many of the Caribbean countries are heavily dependent formance among countries in the region? How helpful economies on tourism, which itself is vulnerable to economic fluc- would narrowing differences and banding together be? from tuations in the major markets. What is being done or LOSER: In terms of regional organizations, the OECS is developments what more can be done to diversify these economies ? the institution through which the eight members of the in their large LOSER: We have to understand that tourism is already a ECCB have institutionalized their economic and politi- partners. source of diversification. These countries started as cal cooperation. As noted, for this group of countries, — Loser monoproducers, producing a single or only a few agri- the ECCB is a major source of discipline and policy har- cultural commodities. Tourism has been an agent of monization. The CARICOM is also very important. Its diversification and modernization, although it is, member countries are involved in a major process of admittedly, a cyclical industry. But in view of their small trade integration and tariff rationalization. These efforts size, it would be impossible to fully insulate the are helpful as long as they foster trade and higher inte- Caribbean economies from developments in their large gration with the rest of the world. A key issue here is partners like the United States, Canada, and the that the Caribbean is not a large region. The region’s European Union. There are a number of areas into GDP—excluding the Dominican Republic and Haiti— which they can diversify further, however. An example is $27 billion, compared to about $1.9 trillion for the is the high-tech data processing industry, as for instance whole of Latin America and the Caribbean. So we are in Jamaica, where this sector has been growing strongly, not talking about large numbers. Still, integration helped in part by the relatively high skill level of the efforts, including through the provision of common ser- population. Another area of development has been off- vices in areas like agriculture and transportation, help in shore financial sector activity, which can be a valuable creating new opportunities. But in view of its size, the source of growth as long as it operates within the prin- Caribbean cannot be—and its people know this—self- ciples of transparency and adequate supervision. sufficient; its economies have to be very closely associ- ated with the rest of the world. And to make the best of The costs of globalization include an increased vulner- this situation, they need to continue with strong macro- ability to fallouts from financial crises elsewhere and economic policies that will help them absorb the impact to the overall fluctuations of the world economy. How of external shocks, while maintaining as open a trade can the countries of the Caribbean build up defenses and financial system as possible. against, say, a slowdown in the U.S. economy, or a financial crisis in a major center? Selected IMF rates LOSER: These countries depend a lot on what happens Week SDR interest Rate of Rate of in North America, of course; but if you come to think beginning rate remuneration charge of it, there are less reliable places to depend on than February 21 4.14 4.14 4.71 North America. They also have important links with February 28 4.18 4.18 4.75 Europe in the areas of trade, services, and tourism. The SDR interest rate and the rate of remuneration are equal to a weighted average of interest rates on specified short-term Links with Latin America are weaker, for two main domestic obligations in the money markets of the five coun- tries whose currencies constitute the SDR valuation basket (as reasons: first, the absence of common roots, which led of May 1, 1999, the U.S. dollar was weighted 41.3 percent; euro each region to develop very different trade links; and (Germany), 19 percent; euro (France), 10.3 percent; Japanese yen, 17 percent; and U.K. pound, 12.4 percent). The rate of second, the fact that up until relatively recently, Latin remuneration is the rate of return on members’ remunerated reserve tranche positions. The rate of charge, a proportion America was fairly unstable from an economic point (currently 113.7 percent) of the SDR interest rate, is the cost of of view. Then, in the Caribbean, Latin America is using the IMF’s financial resources. All three rates are com- puted each Friday for the following week. The basic rates of remuneration and charge are further adjusted to reflect burden-sharing arrangements. For the latest rates, call Photo Credits: Denio Zara, Padraic Hughes and Pedro (202) 623-7171 or check the IMF website (www.imf.org/exter- Márquez for the IMF, pages 65, 66, 68, 69, and 71–75; nal/np/tre/sdr/sdr.htm). March 6, 2000 Apichart Weerawong for Reuters, page 66. Data: IMF Treasurer’s Department 70

©International Monetary Fund. Not for Redistribution ASDB/World Bank/IMF conference Policymakers face major challenges in tracking and limiting spread of financial contagion ver the past decade, the global economy has are highly interdependent, regardless of the current Obeen rocked by major financial conflagrations economic climate, and the strong cross-country link- that started out as local brush fires. Many of these fires ages that exist after a crisis are not significantly differ- proved uncontainable, spreading rapidly and destruc- ent from those during more stable periods. tively across boundaries and flaring up on continents Building on the issues raised by half a world away, fueling fears of systemic failure and Forbes and Rigobon, Matt Pritsker of global meltdown. Policymakers at both the national the Board of Governors of the U.S. Fed- and international level have been searching for ways to eral Reserve System argued that the prevent the outbreak and spread of financial crisis or, channels through which a shock in one at least, to limit its duration and reduce the severity of country or market spreads to other its effects. A recent conference cosponsored by the countries or markets are not well World Bank, the Asian Development Bank (ASDB), understood. But this does not imply and the IMF, entitled “International Financial that markets are irrational. Rather, Contagion: How It Spreads and How It Can Be more channels for propagation need to Stopped,” addressed these issues. be theoretically modeled and empiri- cally tested. In his paper, he considered Matt Pritsker Theories of contagion several channels—including a common lender and In a session chaired by Guillermo Perry of the World the interaction of financial institutions and markets— Bank, participants considered some of the conceptual and found that none of them require irrationality for and empirical issues related to contagion. In their shocks to be transmitted. Nevertheless, excessive price analysis, Garry Schinasi of the movements in one market or country IMF and Todd Smith of the may arise as a result of contagion from University of Alberta noted elsewhere, due to market imperfections that theoretical contagion involving information asymmetries. models rely on market imper- Roberto Chang of the Federal fections to explain why Reserve Bank of Atlanta and Giovanni adverse shocks in one asset Majnoni of the World Bank attempted market might be associated to identify and evaluate the public pol- with asset sales in unrelated icy implications of financial contagion. markets. However, basic port- On the domestic level, Chang said, they folio theory can explain con- emphasized the need for policies aimed Roberto Chang Garry Schinasi tagion, without recourse to at reducing financial fragility—for market imperfections. example, reducing unnecessary short- Portfolio diversification and leverage, Schinasi said, term debt commitments. At the international level, may be sufficient to explain why investors would find the authors stressed the need for improving financial it optimal to sell many higher-risk assets in response standards. to a shock to one asset. Also questioning the Measuring contagion presence of contagion, In a session chaired by Yung Chul Park which they defined as “a of Korea University, theoretical issues significant increase in were explored further. Looking at the cross-market linkages experience of 20 countries with three after a shock,” Kristin crises—debt (1982), Tequila (late Forbes and Roberto 1994–95), and Asian “flu” (1997)—José Rigobon, both of the De Gregorio of the Universidad de Chile Massachusetts Institute of (and Minister of the Economy for Chile Technology Sloan School in the new administration taking office of Management, noted Kristin Forbes on March 11) and Rodrigo O. Valdés of José De Gregorio that recent empirical the Central Bank of Chile asked what the work has found little evidence of this phenomenon “propagation” channels of crises across countries are March 6, 2000 during crises. They concluded that many countries and whether there are useful policy instruments that 71

©International Monetary Fund. Not for Redistribution countries can use to shield themselves from contagion. Russia). However, Eichengreen said, although there is They concluded that although crises may be triggered ample evidence of changes in market sentiment, the by common shocks, transmission of their effects across dominant effect is within the region in which the cri- countries depends on regional trade, but also on the sis originates and on prices rather than quantities or countries’ macroeconomic characteristics—current maturities. Only in East Asia following the 1997 crisis account deficit, level of the exchange rate, and credit did changes in market sentiment have a large impact conditions. The increased financial integration in the on bond issues. The observed decline in bond flota- world suggests that contagion is more frequent and tions following the outbreak of the Mexican crisis can pervasive now than during previous episodes of finan- be fully ascribed to deteriorating fundamentals, cial turbulence, but although the causes of the crises according to the authors, as can, “to a surprising may have changed, the channels through which conta- extent,” the increase in spreads in Asia. The authors gion spreads have not. do not, therefore, deny a role for the “flight to qual- Considering the policy actions that countries might ity” as a channel for contagion, Eichengreen said, but take to narrow the transmission channels in times of suggest, rather, that its impact may be more limited crisis, De Gregorio said they found no evidence that than often assumed. capital controls are effective. In contrast, exchange rate flexibility and a maturity structure heavily weighted Role of investors toward long-term debt did have a lim- The role investors play in spreading contagion was iting effect. explored in the session chaired by Jung Soo Lee of the The literature on contagion, Asian Development Bank. The Asian crisis has high- according to Graciela Kaminsky of lighted the importance of strong domestic financial sys- George Washington University and tems, according to Linda Carmen Reinhart of the University of Goldberg, presenting the paper Maryland, has focused on attempts to she wrote with Gerard Dages document its presence and to dis- and Daniel Kinney, all of the criminate among the possible trans- Federal Reserve Bank of New mission channels of financial distur- York. There is less agreement, bances. However, the global or however, on the role of foreign Graciela Kaminsky regional consequences of a distur- banks in contributing to bance may depend on where the shock originates. strengthened financial systems. Analyzing the daily behavior of financial indicators Both Argentina and Mexico had for 35 countries, Kaminsky and Reinhart reached a opened up their financial sys- preliminary conclusion that the global or regional tems to direct foreign participa- Linda Goldberg consequences of a disturbance depend importantly tion through the ownership of on whether the shock originates in the periphery or local financial institutions, she said. The experiences of in the center. In the case of the Asian crisis, for exam- both countries suggest that foreign ownership of ple, Japanese banks’ exposure to Thailand played a domestic financial institutions contributes positively to prominent role in the spread of the crisis. If the shock the overall level and stability of domestic credit. never reaches the center, however, it is unlikely to International banks are a major source of financing become systemic, Kaminsky said. In the case of Brazil, for emerging economies, but they are also among the for example, financial market participants at the cen- most volatile, according to Caroline Van Rijckeghem ter countries were largely positioned of the IMF and Beatrice Weder of the University of for a devaluation of the real by early Basel. Banking centers may add to financial conta- 1999; as a result, this crisis was “more gion, Weder said, when two countries that depend on of a ripple in global capital markets a common bank lender are vul- than a tidal wave.” nerable to spillovers through Barry Eichengreen and Galina this linkage. Spillovers through Hale, both of the University of Cali- such “common bank lenders” fornia, Berkeley, and Ashoka Mody of were important in transmitting the World Bank looked at how nega- the Thai currency crisis, and tive shifts in market sentiment are felt possibly the Mexican and Russ- in the bond market and the country ian currency crises as well. In Barry Eichengreen characteristics associated with the the Russian crisis, however, the damage. They found a role for withdrawal of funds seems to March 6, 2000 changes in fundamentals and market sentiment fol- have been more generalized. 72 lowing three crises of the 1990s (Mexico, Asia, and It is often argued that foreign Beatrice Weder

©International Monetary Fund. Not for Redistribution outflows lead to price overreaction and contagion, but 1993 in the transition economies of Central and East- many financial economists contend that international ern Europe, Russia, and the Baltics and concluded investors do not create or exacerbate crises; their trad- that with increased financial market integration, the ing behavior simply reflects their assessment of under- financial markets of the lying fundamentals. To test this contention, Kenneth A. more advanced transi- Froot of Harvard University, Paul G.J. O’Connell of tion economies were FDO Partners, LLC, and Mark S. Seasholes of Harvard behaving more and more University explored the behavior of daily international like their Asian and Latin portfolio flows into and out of 44 countries from 1994 American counterparts. through 1998—encompassing almost 4 million trades • Carlo A. Favero and by large institutional Francesco Giavazzi, both investors. Among their of Bocconi University, findings, O’Connell said, Milan, found evidence of was that international contagion in the 1992 investors engage in posi- Francesco Giavazzi exchange rate mechanism tive feedback or “trend crisis (ERM) following the June 1992 referendum in chasing”—that is, an which Danish voters rejected the Maastricht treaty. increase in today’s returns • The analysis of Ilan Goldfajn of Pontificia Uni- leads to an increase in versidade Catolica, Rio de Janeiro, and Taimur Baig of future flows. In addition, the IMF indicates that in the aftermath of the 1998 O’Connell said, inflows Russian crisis, Brazil’s residents led the flight of capital have a positive forecasting from their country and were subsequently followed Paul G.J. O’Connell power for future emerg- by foreign investors, resulting in the collapse of the ing market returns. Interestingly, their data revealed Brazilian real. The authors did not find support for that international investors did not abandon emerging the hypothesis that the contagion was triggered by markets during the Asian crisis, despite the steep some investors reducing their exposure to Brazil to decline that took place in emerging market equity balance their portfolio affected by losses from the prices. Russian crisis. Ilan Goldfajn Analyzing the behavior of another important • Analyzing the con- group of investors, Graciela Kaminsky, Richard Lyons tagion of Mexico’s of the University of California, Berkeley, and Sergio national markets from Schmukler of the World Bank examined the role of the crises of the past mutual funds in spreading crises. They found that three years, Santiago Baz- mutual fund managers take account of the features of dresch and Alejandro M. a country’s economy and financial markets when Werner, both of the Bank deciding whether to adjust their exposure in that of Mexico, said that the country. Economic fragility was not the only factor quick policy action taken triggering withdrawals from emerging market econ- by the Mexican govern- omies—the decision also hinges on liquidity. ment in the face of the Alejandro M. Werner adverse external environ- Case studies ment was sufficient to restore market confidence and The experience with contagion of individual coun- was responsible for Mexico’s healthy economic perfor- tries, groups of countries, emerging market econ- mance in 1998. omies, and transition economies was considered dur- • Yung Chul Park and Chi-Young Song of Kook- ing two sessions devoted min University noted that Korea’s initially strong fun- to case studies, chaired by damentals before the Asian crisis and its rapid post- Michael Mussa, Director crisis recovery suggested that herding behavior of of the IMF’s Research foreign investors panicking from the financial crises Department, and Gerard in Taiwan Province of China and Hong Kong SAR Caprio, Director of sparked the exodus of institutional investors from Financial Strategy and Korea that precipitated the crisis. Policy, World Bank. • Tilak Abeysinghe of the National University of • R. Gaston Gelos and Singapore investigated how the recessionary Chi-Young Song Ratna Sahay, both of the impulses generated by the Asian crisis were trans- IMF, looked at financial mitted across the borders of the eight crisis-affected March 6, 2000 spillover patterns since Ratna Sahay countries of East and Southeast Asia. Although trans- 73

©International Monetary Fund. Not for Redistribution mission plays an important role in the medium run, could take. IMF lending rates for countries seeking the immediate economic contractions are largely a financial assistance should be “risk-based.” Countries result of direct shocks attributable to pure contagion, should get rid of unsustainable exchange rates, pro- he noted. The postcrisis period, therefore, is likely to vide evidence of sound macroeconomic policy, and see intense competition adopt prudent standards and regulations. When a among the crisis-hit country in distress comes to the IMF for assistance, economies for export the IMF should impose normal access limits if the markets and foreign crisis is not systemic. Any restructuring or debt work- direct investment. out must involve the private sector, and no category •Michael D.Bordo of debt (like bonds) should be excluded from the new and Antu P. Murshid, contracts. If the crisis is systemic, Goldstein said the both of Rutgers Univer- IMF should apply a rough rule of thumb: if the crisis sity, examined financial is the fault of the country, then the country has to fix crises over the past 120 it (that is, enter into a program with the IMF). In the years for evidence of case of a temporary crisis that threatens the interna- transmission channels of Michael D. Bordo tional system, Goldstein recommended the establish- contagion. They con- ment of a new facility (to replace the IMF’s current cluded that the emphasis on contagion effects in the Contingent Credit Lines), funded with SDRs, available recent literature is “clearly overblown.” only to developing countries, and activated by a majority vote of the IMF’s shareholders. Roundtable on international The advice countries are given is often very difficult financial reform to implement, according to Yung Chul Park. For In a discussion chaired by Stefan Ingves, Director of instance, the dictum to avoid balance sheet problems the IMF’s Monetary and Exchange Affairs Department, is hard to carry out because the problems—like panel members considered ways countries could shore maturity mismatches and exchange rate pressures— up their defenses against the fallout from financial don’t surface until the crisis hits. Emerging markets crises in other countries, as well as strengthen their are enjoined to conform to Western monetary and fis- domestic financial systems and macroeconomic policy cal standards, Park said, but foreign investors do not actions to protect against crisis in their own econ- seem to care so long as the potential returns are Yung Chul Park omies. Rudiger Dornbusch of the Massachusetts promising. If emerging markets become too con- Institute of Technology said ministers of finance cerned about shoring up against crisis—say, by tight- needed to understand that, in the “new world out ening policy whenever a current account deficit there,” everything is correlated. If something big hap- threatens—they may not be pens, it happens everywhere, especially in the immedi- able to invest more than they ate neighborhood. Any government that operates a are saving. “sleaze house” is going to get hit hard. The only way to Prudent oversight, of both avoid the worst effects of contagion, he said, is to “clean the domestic and the interna- up your house.” Countries that do not want to take any tional financial system, can risks should get out of the domestic banking industry help make an economy more altogether, sell the banks to foreign countries, or offer resistant to contagious finan- offshore guarantees. The best way to avoid currency cial shocks, according to Philip crises, Dornbusch said, is for a country to divest itself Turner of the Bank for Inter- of its national currency altogether by establishing a national Settlements. How- currency board. An economy without a central bank ever, regulators and supervi- Philip Turner Rudiger Dornbusch and a domestic banking sors face several dilemmas in system, Dornbusch said, framing their policies and determining their actions in may not be able to avoid practice. Setting universal standards is probably impos- contagion altogether, but sible because degrees of sophistication in the banking at least the effects would system and depth and variety in the financial markets be less harmful. vary widely among countries. As a result, supervision Morris Goldstein of will, in practice, remain a responsibility of the individ- the Institute for Interna- ual country, Turner said. tional Economics offered a shopping list of actions The papers presented at the conference on international finan- cial contagion are available on the World Bank’s website at March 6, 2000 countries and the inter- www.worldbank.org/research/interest/confs/past/pstconfs.htm. 74 national community Morris Goldstein

©International Monetary Fund. Not for Redistribution IMF Institute seminar Emerging markets face a cautiously upbeat future; sound policy and improved information are key

he prognosis for emerging markets recovering from crisis levels, giving rise to concerns about competitive- Tthe financial crises of the past few years is guardedly ness. On the brighter side, all crisis countries have hopeful. At the same time, developments in industrial rebuilt their reserves to comfortable levels sufficient to country financial markets, especially the United States, cover short-term debt. bear close watching; the private sector can and should play an active role in crisis prevention and resolution; and improved information flows to the market from reliable and impartial sources, like the IMF, are of vital importance. These were some of the themes pursued in a recent IMF Institute seminar, featuring former IMF staff members who now head economic analysis units for leading investment banks and funds. The panel included Bijan B. Aghevli, formerly Deputy Director in the IMF’s Asia and Pacific Department and currently Director of Asia Economic and Policy Research for Participants in the IMF Institute seminar (from left): Mahmood Pradhan, Chase-Manhattan Bank; Mohamed A. El-Erian, for- Bijan B. Aghevli, IMF Institute Director Mohsin Khan, and merly Deputy Director of the IMF’s Middle East Mohamed A. El-Erian. Department and currently Managing Director, Pacific Investment Management Company; and Mahmood Market sentiment. The crisis-propelled deteriora- Pradhan, formerly Senior Economist in the Asia and tion in market sentiment prompted a shift from con- Pacific Department and currently Chief Emerging sumption to saving, which played a large part in Markets Economist with Tudor Proprietary Trading. restoring confidence. By 1998, Aghevli said, equity prices in Asian markets had risen beyond precrisis Recovery in Asia and prospects for Japan levels, while bond spreads, although higher than Describing the situation in Asia as “smooth sailing now, before the crisis, have narrowed. but still rough seas to navigate,”Bijan Aghevli said the Synergy. The simultaneous recovery in all countries Asian crisis countries had turned the corner earlier than created strong synergies among them, leading to even forecasters had predicted. Although the economies were stronger growth in the market for Asian exports, a recovering at different rates, all were doing well. Three trend that Aghevli said is expected to continue into factors lay behind this strong resurgence, Aghevli said: 2000. stimulative policies, a turnaround in market sentiment, Growth may slow in the medium term, however, and the synergistic relationship among the countries. Aghevli warned, since the recovery is cyclical rather Stimulative policies. All the countries included in than structural, and output levels are still well below his survey (China, Hong Kong SAR, Indonesia, potential. Countries that implement strong structural Malaysia, the Philippines, Korea, and Thailand) went reform, he said, will probably grow faster than those into the crisis with a strong fiscal position, low levels that lag behind. of domestic debt, and low inflation. Thus, the heavy Although it is not clear that Japan has reached the turn- deficits they incurred during the crisis were manage- ing point, Aghevli said he was bullish (or, at least “less able, while weak domestic demand and a regionwide bearish”) on the country’s prospects. As with the other fall in commodity prices kept inflation down. Fiscal recovering Asian economies, Japan has implemented sup- policy has supported the recovery, but at the cost of portive fiscal and monetary policy, although market senti- rapidly deteriorating fiscal positions, Aghevli said. The ment remains lukewarm. Nevertheless, the recovery in the authorities’ tightening of monetary policy—as a first region and the strong performance in Europe and the and necessary line of defense against assaults on the United States suggest that the same synergistic forces pro- domestic currency—has since been relaxed. With pelling the rest of the region will help pull up the Japanese exchange rates stabilizing, interest rates have now economy—a case, Aghevli said, of “the tail wagging the fallen sharply to precrisis levels, although they remain dog.”A potential concern, however, is the risk of a sharp relatively high. Coupled with considerable excess appreciation of the yen, whose movements, Aghevli said, capacity and little or no inflation, these interest rates are difficult to predict, since they do not always reflect fun- could cause problems. At the same time, real exchange damentals. In his opinion, however, the Bank of Japan will March 6, 2000 rates remain substantially depreciated relative to pre- intervene to keep the yen from rising too much. 75

©International Monetary Fund. Not for Redistribution A secure future for emerging markets? markets with timely and comprehensive information A year ago, Mohamed El-Erian said, emerging mar- is also very important, and the IMF can play a vital kets were in turmoil; investors were still reeling from role in this regard, El-Erian noted. the Asian and Russian financial crises; and the IMF The IMF could also provide an important service was on the receiving end of bad press from all quar- to the market, El-Erian said, by acting as an interna- ters. A year later, growth is picking up in most emerg- tional clearinghouse for information on how the ing market countries; investors are flocking back; and market is positioned. Information helps to smooth the IMF is winning praise for its handling both of out the market and prevent the abrupt reversals individual country problems and of the risk to the resulting from “betting on boxing matches staged in international financial system. the dark.” The IMF could also play a useful role as an Do these developments, El-Erian asked, signal the objective advisor in helping countries, rather than emergence of these economies as “islands of stability” investors, exploit market imperfections. in a turbulent international environment, or simply the upswing in a cyclical process that could downshift into Involving the private sector another round of turmoil and disruptions? Agreeing with his fellow panelists that the overall For many emerging market economies, El-Erian said, prospects for emerging markets are generally good, 1999 was a year when three “key stars” were in align- Mahmood Pradhan voiced similar concerns. A global ment: better country fundamentals as several countries economic slowdown could dampen the market’s newly strengthened their domestic policies; a supportive exter- restored enthusiasm for emerging market assets, even nal environment, as U.S. growth remained buoyant and in countries, like those in Asia, with strong economic picked up in Europe; and favorable market technicals fundamentals, he cautioned. For countries in Latin (that is, not only were cross-border flows returning to America, which are currently facing a steep external the emerging markets, but the deep devaluations that financing requirement, a worsening in the global envi- had driven these flows out in the first place had also ronment could have a seriously damaging impact. shaken out much of the over-indebtedness and over- Turning to recent developments in financial markets, leveraged investments built up in the mid-1990s). Pradhan said that for hedge funds and leverage institu- Despite these favorable developments, emerging mar- tions, the price of holding positions is back to precrisis kets face a “choppy” outlook, El-Erian said, as generally levels. There is now less of a risk of a systemic crisis, he supportive internal factors compete with more difficult said, but the potential remains for leverage positions to external ones. Because the recent policy strengthening get out of hand again if market volatility begins to rise. has been rooted in structural improvements and institu- Both the official and the private sector have been tional gains, domestic policy fundamentals are expected grappling with the knotty problem of damage control to continue to improve, El-Erian said. But private and reconstruction after a financial crisis. Pradhan said investors are keeping “three issues on the radar screen”: that private sector involvement was essential in this the risk of policy complacency; the difficulties emerging effort, because the official sector lacked the resources to markets typically face in “managing success”; and uncer- cover all the shortfalls, while the private creditor com- tainties about the sustained implementation of better munity could handle defaults relatively easily. What policies in some systemically important countries (such was lacking in current debt reconstruction strategies, as Argentina, Russia, and Turkey). Market technicals are Pradhan said, was the ability of the private sector to do expected to remain generally supportive, El-Erian said, its own credit risk assessment. This lack could be filled as the impact of low valuation is replaced by a broaden- by an open exchange of information between the IMF ing of the investor base, and crossover funds gradually and private creditors. The terms of IMF-supported flow back into the markets. programs for a country seeking financial assistance The external environment could be more problem- should be made public, including the proportion of atic, however. For one thing, the risks of a slowdown adjustment the country needs to make, how much of in world growth could be increasing. Also, perceived the financing gap the official sector is willing to pro- dislocations in major industrial country financial vide, and the conditions that need to be met before markets could lead to an increase in average investor this financing is disbursed. The more complete such risk aversion and a reduction in the relative attractive- information is and the more widely disseminated, the ness of emerging market assets. better equipped the public sector is to make its own For countries with IMF-supported programs, risk assessment and to decide how fully it wishes to El-Erian said, this murky outlook accentuates the participate. The price of not participating is a bigger importance of sound economic policies and appro- “haircut” all around, Pradhan said, so the IMF should priate contingency plans that lessen the economy’s remain firm and resist any attempts by small groups of March 6, 2000 vulnerability to negative contagion from disturbances creditors to negotiate better terms, since this could set a 76 in external financial markets. The need to provide dangerous precedent for future debt workouts.

©International Monetary Fund. Not for Redistribution Building financial stability Korea’s crisis resolution strategy aims to restore confidence and promote sustained recovery ithin a two-year span, Korea’s economy plunged well as the largest financing package in IMF history. Winto a severe recession and now is recording a Combined with the IMF’s resources, the total package dramatic turnabout. What triggered the crisis? What amounted to $58 billion, including support from the prompted the recovery? And what remains to be done World Bank and the Asian Development Bank, and a to ensure that Korea’s economy sustains strong growth “second line of defense” pledge from bilateral donors. In within a stable macroeconomic environment? addition, Korea reached agreement with foreign banks Most observers in late 1997 were shocked to see in late 1997 to extend the maturity of short-term claims Korea—the world’s eleventh largest economy with an on its banks to avoid a default on external obligations. impressive record of macroeconomic performance— At the outset of the program, Korea’s macroeco- swept into the financial market turmoil then raging in nomic policies focused on a temporary interest rate Southeast Asia. In retrospect, however, the country’s hike aimed at stabilizing the won and avoiding a remarkable growth had masked a number of struc- tural weaknesses, in particular a weak financial sector Korea: interest and exchange rates and an overleveraged corporate sector. These weak- 500 35 nesses contributed to a sharp buildup of short-term 30 external debt (estimated in excess of $100 billion by mid-1997) that left the economy vulnerable to exter- 25 1000 Won/US dollar nal shocks and adverse shifts in investor sentiment. (inverted left scale) 20 Indeed, in the second half of 1997, there was a marked deterioration in Korea’s external financing sit- 15 uation following a number of large bankruptcies ear- 1500 10 lier that year and a series of downgrades of Korea’s Overnight call rate credit rating. In particular, new financing dried up, (right scale) 5 and it became increasingly difficult to roll over the large stock of short-term debt. With external reserves 2000 0 1997 1998 1999 2000 almost depleted by November 1997, Korea was at the brink of default. In the ensuing financial crisis, the Data: Bank of Korea country faced massive capital outflows, a sharp depre- ciation of the won, a collapse of confidence, severe distress in the corporate and financial sectors, and a depreciation-inflation spiral. This step helped restore substantial decline in private demand. financial stability by early 1998 (see chart, this page), To deal with the crisis, Korea agreed to a $21 billion and once the won was stabilized, macroeconomic Stand-By Arrangement with the IMF on December 4, policies quickly eased to provide stimulus to the econ- 1997 (see IMF Survey, December 15, 1997, page 385). omy. The overnight call rate progressively declined, Policies adopted under this program successfully falling below its precrisis level by July 1998 and below restored external stability, rebuilt reserves, and initi- 5 percent by March 1999. The authorities also ated reform of the financial and corporate sectors. adopted an expansionary fiscal stance early in the Following a sharp recession in 1998, the economy is program to mitigate the impact of the inevitable again growing rapidly and output is now above its recession. precrisis level. The won has strengthened substantially The government recognized early on that the after losing half its value soon after the crisis erupted, smooth implementation of adjustment policies would and the stock market has registered large gains pro- require broad social consensus. It fashioned a Tripartite pelled in part by purchases by foreign investors. Accord involving labor, business, and the government that ultimately paved the way for an array of important Crisis strategy measures that exposed corporations more fully to mar- The objectives of Korea’s crisis resolution strategy were, ket forces, created a more flexible labor market, and first and foremost, to restore confidence and stabilize attracted foreign investment. The authorities also financial markets, and second, to lay the foundation for strengthened the social safety net by expanding the the resumption of sustained recovery in the real econ- unemployment insurance system and providing direct omy. The program thus included a mix of macroeco- support through public works programs, temporary March 6, 2000 nomic policies and far-reaching structural reforms, as livelihood protection, and other social programs. 77

©International Monetary Fund. Not for Redistribution Structural reforms To liberalize the capital account, the authorities While a severe international liquidity squeeze triggered took steps to ease restrictions on portfolio invest- the crisis, structural weaknesses were at the heart of ments and direct corporate borrowing abroad to Korea’s problems. If the confidence of foreign investors attract much needed foreign capital and reduce the was to be regained, structural issues needed to be excessive amount of short-term debt. In addition, addressed. Korea realized that it would be critical to take they also liberalized regulations on foreign takeovers measures from the outset that would boost investor con- of nonstrategic Korean companies and restrictions on foreign ownership of corporations to promote foreign Korea: real GDP direct investment and impose greater market disci- (4-quarterly percent change) 15 pline on corporations. Korea’s financial restructuring sought to restore stability to the financial system quickly through li- 10 quidity support, a time-bound blanket guarantee, and closures of nonviable institutions. The financial 5 restructuring effort also aimed at resolving the prob- lem of nonperforming loans, recapitalizing banks, 0 and strengthening the institutional framework by bringing prudential regulations and supervision in –10 line with international best practices. The restructuring and recapitalization of weak banks have proceeded quickly. The Korean govern- –15 1997 1998 1999 2000 ment moved swiftly to close 5 commercial banks and 14 merchant banks, nationalize 4 commercial banks, Data: Bank of Korea and acquire sizable stakes in 7 other banks. The fidence and enhance the credibility of the stabilization authorities used public funds to facilitate the liquida- program. Its ambitious structural reform agenda tion of failed institutions, the restructuring of weak focused on liberalizing the capital account, restructuring but viable banks, the recapitalization of both commer- the financial and corporate sectors, enhancing labor cial banks and specialized and development banks, market flexibility, and improving data reporting. and the purchase of impaired assets from financial

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Publications are available from IMF Publication Services, Box X2000, IMF, Washington, DC 20431 U.S.A. Telephone: (202) 623- 7430; fax: (202) 623-7201; e-mail: [email protected]. For information on the IMF on the Internet—including the full texts of the English edition of the IMF Survey,the IMF Survey’s annual Supplement on the IMF, Finance & Development, an updated IMF Publications Catalog, and daily SDR exchange rates of 45 currencies—please visit the IMF’s website (www.imf.org). The full texts of all Working Papers and Policy Discussion Papers are March 6, 2000 also available on the IMF’s website. 78

©International Monetary Fund. Not for Redistribution institutions. Banks that benefited from public funds their independence, strengthened minority share- were required to provide a viable recovery plan and holder rights, improved bankruptcy procedures by write down shareholder capital. To date, public outlays strengthening creditor rights and streamlining the for recapitalization and purchases of nonperforming bankruptcy process, implemented accounting and assets have amounted to about 15 percent of GDP. auditing standards (with effect for 1999 accounts) Over the last two years, banks have made consider- consistent with international best practice, bolstered able progress in strengthening their capital base, but the Fair Trade Act on competitive business practices, they are likely to need additional capital in the period and greatly liberalized the foreign investment regime. ahead as accounting standards and loan classification criteria are strengthened. Tighter loan classification cri- Korea: Key macroeconomic indicators teria, introduced at the end of 1999, are expected to give rise to further provisioning requirements, as loans 1996 1997 1998 1999 are reclassified based on the ability to repay rather than Est. Real GDP 6.8 5.0 –5.8 10.0 the earlier delinquency criterion. In addition, ongoing Private consumption1 7.1 3.5 –9.6 9.0 corporate restructuring could identify additional non- Gross fixed investment1 7.3 –2.2 –21.1 4.4 performing loans that banks would have to resolve. Stockbuilding2 0.6 –2.0 –5.6 4.0 1 Korea has also taken important steps to improve its Exports 11.2 21.4 13.3 18.5 Imports1 14.2 3.2 –22.0 27.3 supervisory oversight and to bring its prudential regu- Inflation1 4.9 4.4 7.5 0.8 lations in line with best international practice. It Unemployment (percent) 2.0 2.6 6.8 6.3 strengthened the operational independence and Budget balance3 0.0 –1.7 –4.3 –4.6 4 autonomy of the Financial Supervisory Commission Current account balance –23.0 –8.2 40.2 25.2 Net capital inflows (+)4 5 23.9 –28.0 –14.3 9.1 (FSC) and unified functions of four separate supervi- Usable reserves4 29.4 9.1 48.5 74.0 sory agencies under the Financial Supervisory Service, Per capita GDP (in dollars) 11,423.0 10,361.0 6,905.0 8,962.0 the executive body of the FSC. Legislative action bol- 1Percent change. stered the independence of the Bank of Korea and 2Contribution to GDP growth. 3In percent of GDP, excluding privatization proceeds. allowed it to focus on maintaining price stability, while 4In billions of dollars. relinquishing direct supervision of the banking system. 5Balance on capital and financial accounts. Corporate restructuring efforts initially concen- Data: Bank of Korea, and IMF staff estimates trated on improving governance and competition policies. Subsequently, the focus shifted to financial and operational restructuring, with the goal of reduc- Economic recovery ing debt levels and strengthening capital structure. The severe disruption in financial markets and loss of Unlike past interventions, however, the government confidence that characterized the Korean crisis has limited its role to reforming the institutional prompted that country’s worst recession in over three framework to provide for a market-based restructur- decades, with real GDP falling by almost 6 percent in ing. The government has also signaled that no con- 1998. But the turnaround in economic activity follow- glomerate is “too big to fail.” The Daewoo Group— ing this severe contraction has been unexpectedly the second largest chaebol—has been forced to enter rapid (see chart, page 78). An easy macroeconomic into a workout program with its creditors. policy stance has helped to spur recovery, and progress The restructuring of the top five chaebol (Hyundai, made in implementing structural reforms has helped Daewoo, Samsung, LG, and SK) is taking place within restore market confidence and revive bank lending. the framework of capital structure improvement plans Real GDP is estimated to have grown by 10 percent reviewed by banks. With the exception of Daewoo, the in 1999 (see table, this page). Indeed, the Korean eco- top five chaebol have made significant progress in nomic recovery has been faster and stronger than in meeting their pledges under these plans. Equity issues, other countries that suffered similar financial crises in spin-offs, asset sales, and strategic alliances with foreign recent years (see chart, page 80). A strong rebound in investors have accounted for most of the improvement. private consumption, investment in new technology, For the Daewoo Group, the workout plans for its affili- and strong exports have led the recovery. Inflation has ates will restructure control of these affiliates and lead remained subdued following a temporary spike in early to strategic sales and other operational changes. A 1998, and in line with the fast economic recovery, creditor-led out-of-court debt workout process is over- unemployment fell sharply to about 5 percent in Janu- seeing restructurings of highly leveraged second-tier ary 2000 from close to 9 percent a year earlier. Given the chaebol and other large corporations. rapidly changing cyclical position of the economy, it will Korea has also taken major steps to strengthen be necessary to remain vigilant to demand pressures and market discipline and governance. It has clarified the inflation. In this regard, it is thus appropriate that March 6, 2000 responsibilities of corporate boards and enhanced Korea’s 2000 budget aims at withdrawing the stimulus. 79

©International Monetary Fund. Not for Redistribution Korea: comparison of output recovery Korea’s external position has also with other crisis countries (crisis = 100) improved notably. Strong external Real GDP demand and gains in competitiveness 125 have spurred exports and resulted in 120 sizable current account surpluses. Korea1 Capital inflows increased markedly in 115

1999, reflecting joint ventures and Mexico3 asset sales related to corporate restruc- 110 turing, and investors’ favorable out- 105 Finland2 look on Korea’s economic prospects. 100 Ian S. McDonald International reserves amounted to Editor-in-Chief $80 billion by the end of February Sweden2 95 Sara Kane 2000—sufficient to provide cover for Deputy Editor Sheila Meehan external short-term liabilities. 90 t–3t–2t–1 Crisis t+1 t+2 t+3 Senior Editor Elisa Diehl 1 Remaining agenda Estimate for 1999 and forecast for 2000–01; crisis year = 1998. Assistant Editor 2Crisis year = 1992. Sharon Metzger Over the past two years, Korea has 3Crisis year = 1995. Senior Editorial Assistant accomplished a great deal. Bold poli- Lijun Li Data: IMF, International Financial Statistics, and IMF staff estimates and projections Editorial Assistant cies and a commitment to reform Jessie Hamilton have made Korea a more open, competitive, and explicit attention to the bottom line will require Administrative Assistant market-driven economy. But the country must com- increasing profitability through cost cutting, the sale Philip Torsani Art Editor/Graphic Artist plete the process it has begun. For balance sheet of noncore assets, and strategic alliances. Carol Greer improvements to be sustained, banks will need to Much of the credit for Korea’s successful stabiliza- Graphic Artist strengthen business practices, especially with regard to tion and recovery belongs to the Korean people, who The IMF Survey (ISSN 0047- 083X) is published in English, risk analysis and lending practices. Priority will also sacrificed and worked hard, and to the Korean politi- French, and Spanish by the IMF need to be given to privatizing nationalized banks and cal leadership, who claimed “ownership” of the pro- 23 times a year, plus an annual Supplement on the IMF and an divesting government stakes in recently acquired gram from the outset and pushed forward relentlessly annual index. Opinions and banks. Further restructuring of the nonbank financial with tough reforms. The achievements to date have materials in the IMF Survey do not necessarily reflect official sector, particularly the investment trust industry, is been remarkable, but the sharp turnaround should views of the IMF. Any maps not deflect attention from the remaining agenda. The used are for the convenience of also urgently needed. On the corporate front, the readers, based on National process of lowering the level of debt needs to be accel- challenge ahead will be to avoid complacency and Geographic’s Atlas of the World, Sixth Edition; the denomina- erated, and financial restructuring will need to be but- maintain the momentum of reforms. tions used and the boundaries tressed by deeper operational restructuring and Dhaneshwar Ghura shown do not imply any judg- ment by the IMF on the legal improved disclosure. For companies, devoting more IMF, Asia and Pacific Department status of any territory or any endorsement or acceptance of such boundaries. Material from the IMF Survey may be Available on the web (www.imf.org) Letters of Intent and Memorandums of Economic and reprinted, with due credit given. Address editorial correspon- Financial Policies dence to Current Publications Press Releases Lesotho, February 3 Division, Room IS7-1100, Other IMF, Washington, DC 20431 00/10: IMF Board Receives Managing Director Nomina- U.S.A. Tel.: (202) 623-8585; tions, February 23 IMF’s Financial Resources and Liquidity Position, February 15 or e-mail any comments to Japan’s Nomination of Eisuke Sakakibara for the Post of [email protected]. The IMF 00/11: IMF Regularly Publishes Information on Sources of Survey is mailed first class in Financing, February 25 Managing Director of the IMF, February 23 Canada, Mexico, and the United Statement by José Pedro de Morais, Jr., Nominating Stanley States, and by airspeed else- 00/12: IMF Board Receives Third Nomination for IMF where. Private firms and indi- Managing Director, February 29 Fischer for the Post of Managing Director of the IMF, viduals are charged $79.00 00/13: IMF Approves $39 Million Stand-By Credit for February 23 annually. Apply for subscrip- Review of the Compensatory and Contingency Financing tions to Publication Services, Estonia, March 1 Box X2000, IMF, Washington, News Briefs Facility and Buffer Stock Financing Facility, February 25 DC 20431 U.S.A. Tel.: (202) 623-7430. Fax: (202) 623-7201; 00/11: IMF, People’s Bank of China Sign Memorandum of Notes: PINS are IMF Executive Board assessments of members’ eco- e-mail: [email protected]. Understanding to Establish Joint Training Program, nomic prospects and policies. They are issued following Article IV February 21 consultations—with the consent of the member—with background Public Information Notices on the members’ economies; and following policy discussions in the 00/10: , February 15 Executive Board at the decision of the Board. Letters of Intent and Memorandums of Economic and Financial 00/12: Bolivia, February 17 Policies are prepared by a member country and describe the policies 00/13: Panama, February 18 that the country intends to implement in the context of its request March 6, 2000 00/14: Switzerland, March 2 for financial support from the IMF. 80

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