Trigger, Aggravator, or Rescuer?

Criticisms on the controversial roles of IMF in East Asia Financial Crisis

Introduction

Now and then, nation to nation, financial crises are inevitable: Mexico in 1994, the whole East Asia region in 1997, Brazil in 1999, and the most recently Argentina in 2001. Looking back to the victims of such financial crises, we found that most of them are labeled as the developing countries, whose financial sectors were still weak at that time yet were impetuously exposed to the advocated ‘Liberal financial market’ which was supported by the Neoclassical Liberalism social economists.

Among all these financial crises, the financial storm in East Asia, starting from the year of 1997, wreaked beyond doubt the greatest havoc on the Asia and the world economy as a whole, dragging down the ‘Asian tigers’ (Thailand, Malaysia, Indonesia, Philippine, Hong Kong, Korea, Taiwan and Singapore) from the peak of the glorious ‘Economic Miracle’ in the past few years. Because of the severity and contagion of the East Asia Crisis, important questions have been raised such as the causes of the crisis, the role of the International Monetary Fund (IMF), and the financial architecture of international capital markets.

As one of the most important international organizations, IMF has its great impact on the world economy. In this paper, the influence of IMF before the eruption of the crisis and its role in the recovery of East Asia economy will be presented. The paper then focuses on the criticisms on IMF’s roles and adopted policies before and after the eruption of the financial crisis from the view of two main research camps ----Neoclassical and Keynesian. Thus, the paper elaborates the contradictory roles of IMF which was viewed as both a powerful international forces associated with both the creation and the attempted resolution of the East Asian crisis.

I. IMF, the creator of East Asia economy crisis

‘In theory, IMF supports democratic institutions in the nations it assists. In practice, it undermines the democratic process by imposing policies.’ --------- Joseph Stiglitz

As the world most important international organization that oversees the global financial systems and provides financial and technical assistances, IMF played the controversial roles in purporting the principle of ‘liberalized market’ and at the same time intervening the national/regional economic and financial operation by their imposing policies before the collapse of East Asia crisis. Keynesian economists criticized the ‘Washington Consensus’ based policies IMF adopted before the crisis. They claimed that the enforcement of capital account liberalization as a sequel to the process of trade liberalization conduced to the ‘overheating’ economy, irrational investment and speculative bubbles, resulting in the eruptive collapse in 1997. On the other hand, IMF was also criticized by neo-classical researchers about its political impacts on Asian countries. From their point of view, the East Asia crisis has never been simply an economic event but shaped domestic policy responses between IMF and these Asian countries.

Neo-classical liberalism and IMF policies

The IMF carries out series of policies under the discipline of the Neo Liberalism and its ‘Washington Consensus’. Deriving from Neo-classical theories, Neo Liberalism extends the ‘Liberal market’ philosophy to the global aspect. Besides a pretension of the deregulation of government in economy, Neo-Liberalism advocates privatization as well as a market-centered global trade liberalization in a way of competitive exchange rate, low tariff and active foreign direct investment (FDI) (see John Williamson’s 1989 Washington Consensus). With the content of Neo-liberalism’s ‘Washington Consensus’, IMF required the membership governments to assume ‘carefully defined and consistently applied obligations’ with regard to capital account liberalization for the ultimate goal of a complete market liberalization where every action of every being is a market transaction so that the government power and discrimination against small business are tempered. However, the slapdash action of opening financial account as a main requirement of IMF brought more dangers to Asian countries with an undeveloped financial systems and a lack of regulation and control of international financial flows.

The Keynesian criticism on IMF policies

Beyond the phenomena of East Asia Crisis, researchers concluded the causes of the crisis into several categories: Reliance on short-term capital flows (over-borrowing), decline in foreign exchange earning capacity due to the shrink of exports (over-producing regardless demanding), and speculative bubbles in asset markets such as real estate and stock market (over investment) (e.g., Beeson & Robison, 2000; Lim, 1999; Zhang,1999). IMF was then criticized by Keynes’s camp about the endorsement of capital account liberalization in developing countries without prudential regulation and sound financial construction. They claimed that opening up the capital account aggravated the volatility from increasing short-term foreign loans and portfolio as well as exaggerated inflows to risky and speculative sectors (Lim, 1999). They introduced Keynes’s analysis to explain the current wave of speculative inflows and attacks in East Asia. From Keynes’s view, individuals are not rational investors as Neo-classical economists’ assumed. The short-term horizon and get-rich-quick mentality of human beings drives to a speculation not necessarily related to real yields of perspective investments. It is intrinsic also to speculation to depend on ‘mass psychology’ to get bubbles up, make large winnings, and then get out ahead before the bubbles burst. Keynes then indicated that the capital control in the form of prudential regulation is central to reduce the harmful effects of short-run speculative activities (Lim, 1999). In the case of East Asia crisis, IMF was criticized for its inconsistency in the imposing policies. It required the regulation of the domestic financial markets but not the control and supervision of the international financial flows, thus catalyzing the irrationality of domestic and foreign investors’ behavior in borrowing and investing, under the name of ‘capital account liberalization’. Owing to the lack of prudential regulation and supervision, the speculative bubbles in the stock and real estate market grew bigger. Following Lietar’s report, more than 97 percent financial capital is speculative and unconnected the production of goods and services (Lietar, 1997). Moreover, because most of these short-term debts came from hedge funds, given a liberalized financial market combined with new high-tech international financial instruments, hedge funds become an important source of disturbances of the financial markets, as they move in and out not only quickly but also massively (Zhang, 1999). The Keynesian economists finally asserted that the capital opening up advocated by IMF was one major root cause of the financial crisis in East Asia.

The Neo-classical criticism of IMF’s political impact With the standing point of Neo-liberalism’s ‘Liberal market’, IMF in practice played a role of ‘exogenous agency’ regarded as a Keynes’s way of institutionalization. Therefore, IMF was also criticized by Neo-classical school due to its external intervention of regional economy, which violates the principle of a ‘Liberal Market’. In the opinion of Neo-classical economists , the IMF’s role is indicative of the essentially political impact of nominally economic policy advice. The IMF has provoked both resistance and enthusiasm, influencing the struggle over policy agendas throughout the region, and being instrumental in the downfall of the governments of Korea, Thailand and, most dramatically, Indonesia. Hence, it is clear that the crisis is an inescapably political phenomenon with the constellations of power and interest in shaping outcomes in Asian countries. From the Neo-classical opinion, it was IMF that led the East Asian countries to a managed and governed market instead of a complete liberal market and thus initiated a powerful institutional forces associated with the creation of the East Asia crisis (Beeson & Robison, 2000). In summary, IMF was viewed as the main cause of the East Asia crisis by both camps of economists because of its controversial roles played in the East Asia economy. However, the criticisms on IMF did not cease in the financial recovery in East Asia. In fact, IMF became the target of criticism in relieving the financial crisis in East Asia.

2. IMF, the exacerbating factor of East Asia crisis

After the explosion of Asia financial crisis, IMF adopted the same bailout package succeeded in mitigating the Mexico financial crises, nevertheless, this package failed to restore the market confidence but halt the exodus of capital from Asia-5 economy. This time, the austerity approach IMF adopted to tackle the crisis, which was in the teeth of more fierce criticism from academics, politicians and NGOs.

The bailout remedy of IMF in East Asia crisis

Following the successful experience in dealing with the Mexico’s financial crisis in 1994-1995, IMF continued the tight monetary and fiscal policies supported by the Neo-classical theories. IMF required Asian countries first to raise the interest rates to defend and stabilize the exchange rates and set a surplus government budget to reduce inflation and capital flight, as an exchange of financial support from IMF. However, the austerity remedy worked well on solving the Mexico financial crisis yet worsened the situation in East Asian countries.

IMF as the aggravator of East Asia crisis

It has been widely argued that the failure of the IMF to understand the specific nature of East Asia crisis and the extreme urgency for action worsened the financial situation in East Asia. The cause of East Asia financial crisis was different from that in 80s Latin America and its extending crisis in Mexico in 1994. Both the 80s Latin America and 94 Mexico crises were mainly the result of wrong ‘fundamentals’. The expansionary fiscal policies bloated public deficits and loose monetary policies led to runaway inflation (Palma, 1998). Therefore, the austerity policy imposed on the governments of these countries was correct. But before the crisis in 1997, the East Asian countries still maintained a budget surplus, moderate inflation rates of about 6%, high saving rates of over 32%, trade openness indicators of nearly 39% and credit ratings that were higher than investment grade (Karunaratne, 1999). In fact, in East Asia, the detonators were not a traditional balance-of-payments crisis due to a reserve depletion and falling credit ratings in a hasty financial liberalization as in Latin American, but the bankruptcies of banks and companies as well as the shortage of foreign reserves drew into a sudden collapse of confidence, panic capital outflows, depreciating currencies and falling asset prices. Because of the ‘herd mentality’, these panics and loss of confidence disseminated from countries to countries, immediately turning into a region-wide panic and financial collapse (Lim, 1999; Palma, 1998). As Joseph Stiglitz indicated, ‘austerity measures would not revive the economies of East Asia—it would plunge them into recession or even depression.’ (Stiglitz, 2000). High interest rates might devastate highly indebted East Asian firms, causing more bankruptcies and defaults and ensuing a credit crunch. Reduced government expenditures would further shrink the economy. What’s more, even after a tight monetary policy, the currencies of the affected countries continued to depreciate for extended periods of time (Lim, 1999; Palma, 1998). All these consequences of the austerity strategies utilized by IMF intensified the panic among investors and subsequently leaked away more capital flows. The financial situation in these Asian countries was thus mired more deeply.

Criticism of IMF’s remedy Based on the negative facts, IMF was criticized for its wrong approach of tackling East Asia crisis. The Neo-classical methods were proved wrong by Keynesian economists. They emphasized that Asian countries did not need economic austerity, but indeed expansionary policies to restore the confidence and prosper the gloomy economy in East Asia region. In the time of recession, Keynes’s contended that expansionary policies referring to government expenditure injection (also the allowance of a moderate deficit ), tax cutting and the raise of interest are crucial for stemming loss of confidence, panic and negative contagion. As a vital variable in his theory, the speculative demand for money is very sensitive to interest rates, because it pits demand for liquidity against for interest-yielding bonds. People do not want to invest in bonds or credit instruments and preferred to keeping the additional money as speculative demand. This results in a credit crunch (Lim, 1999). Given that the embedded cause of East Asia crisis was more about the psychological panic and loss of confidence, carrying out an austerity policy aggravated the credit crunch in countries and the growing ‘liquidity trap’ inflicted a vaster outflow of capital which accelerated the slide towards recession rather than recovery due to its failure of providing the liquidity required to avoid insolvency of financial institutions and calming creditor panic. In a whole, Keynes’s theories justified the criticism on IMF’s austerity policies in exacerbating the financial crisis in East Asia and delaying the recovery of East Asia economy.

A convert of IMF programs

Faced to a worsening financial situation in East Asia and numerous criticisms, IMF finally confessed its mistakes that the program projections badly misgauged the severity of downturn. In the second-phase (1998) of the bailout, the IMF drastically revamped its strategy by converting its policies from a Neo-classical aspect to the Keynesian expansionary strategies, attempting to re-instil market confidence. Although these modified policies helped relieve the financial crash in East Asia countries, the controversy of IMF’s remedies and its flunk in tacking with the East Asia crisis made it understandable why it was still the target of the criticisms from different schools of economists.

Conclusion

During the whole financial crumble period in East Asia, IMF was generalized into three roles: a trigger, an aggravator and a rescuer. It is no doubt that IMF boomed the economy in East Asia as well as provided tremendous support before and after the financial crisis. For example, IMF injected US$110 billion in total funding of the Asian countries in trouble and also assisted the local government to rebuild their financial market. We can never deny the rescuing role of IMF in pulling East Asian countries out of the financial crisis. On the other hand, IMF has to bear the blame for its controversial roles in impacting the East Asia economy and lack of experience in the financial retrieval. It is hard for every international organization to be completely neutral without any influence from powerful developed countries such as United States. Nevertheless, IMF should learn from the lesson of East Asia financial crisis not to apply indiscriminate policies to different regions and countries without a decent consideration of the realism of the aiding objects. Last but not least, it is also a necessity of IMF to have a reform that will engage in more effective use of its policy instruments of surveillance and conditionality, in order to establish a new global financial architecture that will countermand the casino economies that have emerged in a global economy governed by massive capital inflows and outflows as market sentiments fluctuate.

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