Managing economic risk in Asia: A strategy for Australia

Barry Sterland’s new Lowy Analysis explores the possibility of a future economic crisis in our region – this is not today’s problem, but something we should be prepared for. The paper benefits from his years of experience in the Australian Treasury and the International Monetary Fund. It sets out the weaknesses demonstrated by the historical experience, judges that things are much better now, and argues the case for further improvements.

Sterland makes the sensible case for the centrality of the IMF in any crisis management preparations. The Fund has the experience, expertise and objectivity to play a central role. But this may not be enough.

First, the next crisis might not be caused by external-sector problems which is the type the IMF has traditionally faced. In the days when most exchange rates were fixed, crises often took the form of current account unsustainability. More recently, with most exchange rates floating, the problem has been volatile capital flows: excessive inflows followed by sudden reversals, such as the 1994 Mexican Crisis and the 1997 Asian Crisis. But economies can get into trouble for reasons which don’t fit the IMF crisis protocols. The Fund was largely irrelevant in the 2008 financial crisis. It’s hard to see a key role for the fund if China’s financial sector gets into serious trouble or Japan’s huge government debt proves unsustainable (although in both cases the spill-over onto other countries might see a role for the Fund).

Second, in those cases where the problem does originate in the external sector, the Fund’s resources are quite modest, considering the size of current global capital flows. The Greek rescue in 2010 illustrates that even a small country can require far more support than the Fund can provide (its contribution is just over 10% of the total, with the bulk of the funding coming from the European Commission and European Central Bank). Asian economies’ own reserves-holdings are far greater than the Fund drawings that might be available to them in a crisis. Indonesia, for example, has reserves four times its potential IMF drawings.

There are additional resources potentially available – from the Chiang Mai Initiative Multilateralization (CMIM) and various other bilateral arrangements, set out in Table 2 of Sterland’s paper. However the formidable operational problems of coordinating these different sources have not yet been settled.

Third, even 20 years after the Asian financial crisis, memories of the Fund’s errors still rankle. Perhaps if a crisis is serious enough, a country in trouble would have to bear the political cost of going cap-in-hand to the Fund, but by that stage the crisis would be way beyond low-cost solutions. Speed is of the essence in responding to a crisis. The stigma of 1997 will prevent the Fund from being in the forefront of the response.

Keeping the focus just on external-sector crises, what more might be done? Prevention, of course, is better than cure. Much more active capital-flow management would reduce the likelihood of crisis. The Fund has come a long way in acknowledging a role for capital-flow management, but still sees this as being at the very bottom of the policy toolbox, to be used only when all other measures have failed. This lukewarm acceptance needs to be replaced by extensive exploration in policy papers of all the operational issues involved, to make it clear that the Fund endorses such policies. Pre-crisis, what types of foreign inflows have the best risk/benefit trade-off, and what can be done to tip the mix of inflows to favour these? What domestic borrowers are likely to attract stable foreign inflows and which borrowers are the most likely to get into trouble? What are the most effective forms of capital-flow management?

If the crisis does arrive and, as suggested above, there is not enough assistance to fund the outflow, what next? The answer in 1997 was that GDP had to fall far enough to turn the current account deficit into a surplus big enough to fund the outflow. This is, to say the least, not ideal.

The better answer is to take measures which reduce the volume of crisis outflow. A temporary stand-still on foreign capital outflow is enough to solve a liquidity crisis. This was the measure taken, belatedly, in the case of South Korea in 1997. Where the foreign debt is unsustainable, the amount has to be reduced with a ‘bail-in’ of creditors, reducing the size of the liabilities through a ‘haircut’. This was the still-incomplete response in Greece, again arrived at only after a two-year delay which made matters much worse.

This type of response is hardly novel, but has often been resisted, including by the Fund. At the August 1997 donors’ meeting, Fund Deputy Managing Director Sugisaki, chairing the meeting, specifically banned discussion of this possibility, whether because of Fund doctrine at the time or to help Japanese creditor banks. In 2010, pressure from European authorities prevented a timely bail-in of Greek creditors.

Morris Goldstein summed this up in his post-mortem of the Asian crisis:

Relying more and at an earlier stage on ad hoc debt rescheduling to handle private sector debt insolvencies is the only way to get these rescue packages back to a reasonable size.

Sovereign debt ought to be the easiest to resolve in a crisis, but the Fund’s strenuous effort to put in place rescheduling procedures has fallen afoul of the Wall Street lobby, which wants to see debt as sacrosanct, always repaid in full. This is a fine principle, but every country has its domestic bankruptcy procedures, which allow a failed enterprise to restructure debt. Why not have the same for international debt? We are still a long way from any proper resolution process: just last year Elliot Management, a so-called ‘vulture fund’, successfully used US courts to obtain full repayment (with interest) for the Argentine defaulted debt that Elliot had purchased at huge discount.

Effective international debt-resolution procedures would also discipline the pre-crisis excessive inflows, reminding investors of the risk of default. The German and French banks which invested so enthusiastically into Greek government debt before 2010 might have been less eager if they had been more conscious that they might lose some or all of their money.

Stephen Grenville