Macroeconomic Factors and Growth: Theory and Case Studies Lecture 3: Case Studies

1. Ulrich Fritsche Bernhard Seidel DIW Berlin Macroeconomic Factors and Growth: Theory and Case Studies Lecture 3: Case Studies

2. Structure • Lecture 1: The „Washington Consensus“ (Fritsche) • Lecture 2: The Struggle for a “Post-Washington Consensus” (Seidel) • Lecture 3: Case studies • Basic aim of this lecture: Empirical evidence of Asian crises and lessons for development strategies

3. Agenda • Asian Crisis as an example for the fight about the „Post-Washington Consensus“ • Background • Onset of the Crisis, Macroeconomic Factors • Coping with the Crisis • Countries with IMF and Worldbank Programs • Countries with Capital Controls • Discussion • What did the discussion about the „Post-Washington Consensus“ brought about?

4. Asian Crisis: Background • „The Asian Miracle“ was the title of a 1993 World Bank publication • In contrast to Latin America over some decades this region seemed to be „crisis prone“. • High growth rates, low inflation, fiscal discipline, export-led growth • Poverty rates dropped

5. The Miracle: High (Per Capita) Growth Rates

6. Poverty Source: Furman, Stiglitz et al. 1999

7. Fiscal Deficitsin % of GDP

8. Inflation, in %

9. Macroeconomic Factors • Current account balances • Productivity • Exchange rates • Bank lending and capital flows

10. International Solvency divide by GDP growth rates Legend: B...Debt, T...Trade Balance, Y...GDP r ... interest rate g ... growth rate b ... Debt/GDP  ... Trade Balance/GDP

11. Resource Gap 1996 Current trade balance minus required trade surplus to stabilize the debt to GDP ratio In all countries, trade balance did not stabilize debt to GDP in the long run Source: Corsetti/Pesenti/Roubini 1998

12. Current Accounts Balance in % of GDP

13. Fall in Productivity • Krugman argued some years before the crisis, that the Asian model was mainly driven by extensive production, not intensive one • Source of the strong growth since the 80s • Increasing labor supply (demographics) • (Physical) Capital stock accumulation • but NOT so much productivity • Figures from Korean „chaebols“ from 1996 would indicate a fall in the return on capital

14. = D S Y f ( K ) D K r gradient: = S I f ( Y ) a gradient: (s+ ) y* The Declining ICOR

15. Return on Investment Source: Corsetti/Pesenti/Roubini 1998

16. Exchange Rate Appreciation • Exchange rate appreciation did not seem to be too problematic • However, Japan was in crisis since the beginning of the 90s and the weak demand lead to a significant slowdown of Asian exports • Furthermore the increasing weight of China in total exports from the region enhanced competitive pressures

17. Exchange Rates and Current Accounts Real effective exchange rate 1995=100 Current account balance in % of GDP Official exchange rate US-$ per LCU, 1995 = 100

18. Bank lending and short-term debt • Sustained lending boom in some countries (Philippines, Singapore) • Falling productivity growth created bad loans • Supervision, regulation was poor • Foreign debt burden increased, short-term debt became more important • Domestic banks borrowed heavily from foreign banks and lent mostly to domestic investors

19. Short-term debt (% of external debt)

20. Short-term debt / foreign reserves

21. Lending agreements with Thailand (Aug 97), Indonesia (Nov 97) and Korea (Dec 97) Financial commitments by IMF, World Bank, ADB and diverse countries Loans to the central bank and the government Macroeconomic framework (budget balance, high nominal interest rates, tight credit) targeted at exchange rate stability Financial sector restructuring ‘Good governance’ and ‘structural’ measures (trade reform, demonopolization, privatization etc.) IMF-Response to the CrisisAgreements Bill. US $

22. Policy Events and the Exchange Rate, July 1997 to March 1998 Korea Thailand Source: Radelet/Sachs 1998

23. Policy Events and the Exchange Rate, July 1997 to March 1998 Indonesia Source: Radelet/Sachs 1998

24. Forecasts of GDP Growth during the Asian Crisis

25. Socialization of private loans Repayments to foreign creditors Central bank became debtor of the IMF creditor of commercial banks Intervention in the exchange market to lower the Dollar-price for domestic currency (Indonesia) Consequences

26. Failure of Re-establishing Market Confidence • IMF’s arrival strengthens feelings about the gravity of the situation • IMF focused on deep fundamental weakness of Asian economies, mainly of financial sector • Announcement of restructuring financial sector (closing banks, tightening regulation etc.) • Budgetary discipline meant heavy contractionary impact (Thailand 2.6 %, Indonesia 1-2 %, Korea 1.5 % of GDP); Raising interest rates fuels fear of crashes • Uncertainties about the prompt availability of commitments and about IMF as lender of last resort

27. before... after crisis and devaluation Debt in local currency Debt in local currency (1) (2) Assets Assets Equity Magnification: Balance Sheet Problems and Appreciation Equity (negative)

28. Total debt service (% of GNI)

29. Savings-Investment-Balance, in % of GDP Gross domestic savings Gross fixed capital formation Current account balance

30. Investment to GDP and Real Interest Rate Gross fixed capital formation Real interest rate

31. Malaysian Capital Controls (CC)in Consequence of Financial Crisis Aims of Capital Controls • Provision of stability • Independence of monetary policy from exchange rate fluctuation • Insulating national economy from external shocks • Avoiding contagion effects of the crisis in neighbouring countries

32. Measures by Bank Negara Malaysia (BNM) I • September 1, 1998 • One-year waiting period on repatriation of portfolio investment • Mandatory repatriation of Ringgit held abroad • Restriction on transfers of funds between external accounts • Limits of transport of Ringgit by travelers • Prohibition of resident/non-resident Ringgit credit arrangements • Prohibition of trade settlement in Ringgit • Prohibition of resident/non-resident offer side swaps and similar hedge transactions • Freezing CLOB (Central Limit Order Book) share transactions • September 2, 1998 • Fixing the exchange rate of Ringgit at 3.8 to the Dollar

33. Measures by Bank Negara Malaysia (BNM) II • February 15, 1999 • replacement of ban on portfolio flows by graduated exit taxes • September 1999 • further liberalization of exit taxes • 10 % tax only on repatriated profits • October 27, 2000 • limitation of exit taxes on repatriated profits on assets held for less than one year • control of residents’ capital exports still to be approved by BNM

34. Effects on Capital Flows Source: World Bank (2001)

35. Consequences • Sovereign spread 300 basis points higher than in other crisis countries, going down to 150 basis points in May 150 • Low FDI flows into Malaysia as well as into the other countries (no significant influence of CC) • Exodus of portfolio capital, reversed in 2000 to inflows • Efficient and effective controls • Exchange rate fixed at an under-evaluated level • Regulatory and supervisory reform of financial sector and capital market • Safeguard of political stability

36. Exports, Inflation and GDP-GrowthPost-Crisis Development Exports Inflation Growth

37. Conclusions I • Asian financial crisis was a result of latent macroeconomic weakness, receding confidence, high vulnerability of banking systems, overshooting reactions and herding • The crisis hit the real economies hard by decreasing GDP, raising poverty • Neither large support programs with bail-outs for the creditors nor reversing capital market liberalization and re-introducing capital control could help to avoid economic and financial distortions

38. Conclusions IIReducing vulnerability as political Agenda • Priority for market forces • Liberalization • Regulation and supervision • Proper organization of banking system and financial markets • Flexible exchange rate regime • Provision of infrastructure • Sound fiscal and monetary policy • Proper institution building