International policy responses to Asian crisis need re-evaluation

In light of the continued severity of the Asian financial crisis, the UNCTAD Secretary-General has questioned the efficacy of the international policy response to the crisis. Speaking at a high-level segment of the UN ECOSOC, he called not only for developing countries to adopt a prudent approach towards financial liberalization but also for systemic international-level controls and regulations going beyond conventional prudential measures.

by Chakravarthi Raghavan

GENEVA: The UN Conference on Trade and Development (UNCTAD) called for an "honest re-evaluation", without any preconceptions or prejudice, of the international policy response to the Asian crisis and extending the current IMF flexibility towards budget deficits to all areas of economic policy-making.

The UNCTAD view was presented at the UN in New York on 6 July by UNCTAD Secretary-General Rubens Ricupero, during the high-level segment of the Economic and Social Council (ECOSOC).

Warning against short-term capital flows, and that recourse to them, if at all, should be limited, Ricupero said that if future crises are to be prevented, developing countries should not be pushed or pressured into premature financial liberalization, but rather assisted and guided to introduce (financial and economic) reforms "thoughtfully and progressively", backed up at the international level by "much- improved controls and regulations that go beyond conventional prudential measures."

Distinctions among capital flows

Earlier, in opening the session, UN Secretary-General Kofi Annan said while debate continued on the interpretation of the Asian crisis and the conclusions to be drawn from it, "we have all learnt the hard way that there are important distinctions to be made between short-term, speculative capital flows and long-term commitments such as foreign direct investment."

Though Annan drew this distinction, studies, including that by staff at the World Bank and the IMF, have brought out that with the explosive growth of derivatives and their use, no distinction can really be made between "bricks-and-mortar" FDI, and other capital flows. And while neo-liberalists use this to argue for liberalization of all capital flows, the Asian crisis seems to point to the need for regulating all foreign capital and financial flows and investments, and for special responsibilities to be imposed on transnational corporations.

Referring to the trade front, the UN head came out against the "social clause" and said that the trade liberalization process should continue, and that the trade system and rules should not be used to achieve labour, environment and human rights goals. Instead, Annan said, the UN system should be used to pursue such goals.

Ricupero recalled UNCTAD views about the growing divergences and disagreements at international meetings, the warnings about the course of the world economy and the causes and effects of the Asian crisis, and said the crisis had, for the time being, called into question the best success stories of development - those few cases of countries demonstrating the possibility of bridging the North-South income gap. The crisis has had the perverse effect of hitting the poor particularly hard - in terms of sharp falls in commodity prices and export prices for their goods - while benefiting the wealthy through the anti- inflationary impact of cheap imports. There has also been increasing divergence at international levels with respect to globalization, as evidenced by the anti-WTO demonstrations in Geneva in May, and the suspension of the MAI negotiations at the OECD due to disagreements not only with NGOs but among member countries themselves.

But the crisis in Asia had also brought everyone closer to cope with the heightened dangers, with much more agreement now on the nature of the problem. Far from agreeing to disagree, "it is now our duty to improve this still imperfect intellectual agreement and build consensus, not only on the causes of the disease... but also on finding and improving upon cures... guided by reason and objectivity."

UNCTAD's raison d'etre for 30 years, Ricupero said, has been the search for timely and appropriate policies to help developing countries attain sustainable economic development. Among the most encouraging developments over this period has been the success of the East Asian economies in managing their integration into the global economy through foreign trade.

This conclusion was unshaken by the current crisis. For the severe damage inflicted on these economies by volatile financial flows was not because of what had been done right - the prudent and skilful way they managed trade liberalization and gradually and carefully opened up their markets to maximize the benefits of globalization - but rather "because the governments concerned failed to manage their countries' integration into the capital markets with the same talent they had shown in other areas of the economy."

Policy responses

UNCTAD believed that "well-calibrated" national policies could help manage such crises, limit their potential for lasting damage, and re-establish economic growth.

"But when economic crises become a systemic problem, action is also needed at the global level," said the UNCTAD head. "The East Asian crisis is only the latest in a string of financial crises that has disrupted the global economy since the breakdown of the Bretton Woods system. The reality, it is becoming apparent, is that the international community has still to learn how to manage such turmoil, let alone prevent it."

Ricupero noted that the speed with which the most successful East Asian economies had been derailed by the adverse financial flows had taken everyone by surprise. Countries that year after year had enjoyed 8-10% annual growth rates, maintained full employment and gone a long distance to eradicating poverty were now suffering severe economic contraction.

According to some recent estimates, the decline in output is expected to exceed 15% in Indonesia, and be between 6-8% in South Korea and Thailand. Apart from China and Taiwan, barely any economy in the region is projected to register a positive growth rate this year. The extent of decline and hardship was unprecedented, surpassing even that experienced after the collapse of communism in Central and Eastern Europe.

There are no simple recipes for dealing with this situation and, as UNCTAD suggested a year ago, policy advice should be offered with a degree of humility and a healthy dose of pragmatism. Everyone appeared to have failed to appreciate sufficiently the gravity of the situation.

"Thus, in the light of the persistent severity of the crisis, would it not be useful to conduct an honest re- evaluation of the international policy response - without any preconceptions or prejudice - so as to assess achievements and failures? And why not consider extending the willingness to be flexible in relation to budget deficits, recently demonstrated by the IMF, to other areas of economic policy-making, as required?"

"Justice would not be served," the UNCTAD head added, "if the living standards of ordinary people and the stability and prosperity of countries were to be sacrificed by a colossal failure of the global market and by measures to bail out international creditors and local financial institutions."

The new poor

In East Asia, the decades-long trend of rising incomes has been reversed, and unemployment, underemployment and poverty are rising to alarming levels. Many of the lost jobs have been in sectors of economy that in the past reduced poverty by absorbing low-skilled workers of rural origin. This is particularly so in the small and medium-sized enterprise sectors. More than large conglomerates, it is these firms that are being decimated by the full impact of the credit crunch and high level of interest rates. And sharply higher food prices and reduced social expenditures have further aggravated social conditions and contributed to the growth of poverty.

According to UNCTAD's estimate, the proportion of the Indonesian population living on incomes below the official poverty line in 1998 is expected to be 50% higher than in 1996, and similarly, absolute poverty in Thailand is expected to rise by a third. And these may turn out to be conservative predictions, according to other highly-respected sources.

As the crisis drags on, it will be difficult for the new poor to recover from deprivation and regain previous occupations and living standards, and social harm could persist long after economic recovery has been achieved. In terms of child malnutrition and declining primary-school enrolments, with spillover effects into the next generation, this may already be happening in Thailand.

Referring to the Latin American experience during the debt crisis of the 1980s, Ricupero said that according to the UN Economic Commission for Latin America and the Caribbean (ECLAC), between 1990 and 1996, with recovery underway, poverty in the region only declined from 41% to 39% - much higher than the 34% level in 1982.

Safety-net measures act as palliatives to cushion the impact of the crisis, but they cannot be treated as lasting solutions. Only the resumption of rapid and sustained growth can bring unemployment and poverty levels back to pre-crisis levels. It is hence necessary to harmonize two complementary goals: to reform and strengthen local financial institutions in affected countries, and simultaneously to reflate domestic economies through an appropriate reduction of interest rates and a necessary expansion of liquidity and increase in public expenditures.

Counter-productive response

As the World Bank's Chief Economist, Joseph Stiglitz, has argued recently, where a currency turmoil is the consequence of a failing financial sector, the conventional policy response to increase interest rates may be counter-productive. Stiglitz has also cited empirical studies by IMF and World Bank economists that interest-rate rises tend to increase the probability of banking crises.

As for the arguments that temporary increases in interest rates are needed to restore confidence and that they would do little damage, the UNCTAD head further cited Stiglitz for the view that the evidence was not fully conclusive.

In any event, Ricupero added, Thailand and Indonesia have been pursuing high-interest-rate policies for considerably longer than the average four months considered to be the maximum reasonable duration.

"Indeed, it appears that when confidence depends on other factors, totally independent of interest rates, excessive reliance on this kind of measure will do much harm to the economy, without any guarantee of success for the ends to which it was intended."

"If we really want to break the vicious circles that could otherwise lead to irreversible economic collapse, we need to give the highest priority to support for debtors and the unemployed."

Since the crisis, the downward revisions in GDP growth have been more substantial for developing than for developed countries. Economic growth in developing countries in 1998 is expected to be halved compared to 1997, falling to almost 2%. And UNCTAD expects a widening of the North-South income gap.

The global ramifications of the crisis have not been felt so acutely in the industrial world, since the benefits of declining commodity prices and improved terms of trade appear to outweigh the loss of incomes and jobs. But developing countries in most other parts of the world have begun to feel the adverse consequences. And because of the risk of contagion, many emerging markets elsewhere have undertaken pre-emptive monetary and fiscal restrictions to maintain market confidence and reduce vulnerability to reversal of capital flows.

And developing countries are also expected to be affected more than the developed countries by negative trends in the volume and export prices of their goods. From Chile, Cuba, Ecuador and Peru in Latin America to Angola, Congo, Tanzania and Zambia in Africa, and to Kazakhstan, Russia and Romania, developing countries in all regions have depended on East Asia for an important part of their export earnings. The collapse of growth in East Asia has been the single most important factor in recent declines in prices of many commodities, including oil, agricultural raw materials and metals. For some of them, up to a quarter of export earnings may be lost.

Deepening crisis

Far from subsiding, the crisis seems to be deepening. Economic growth and exports are slowing down in China, alongside a decline in prices for the seventh consecutive month. Hong Kong recorded a 2% drop in GDP in the first quarter of 1998.

As a result of continuous depreciation of the yen, Pakistan has devalued its currency for the second time in nine months, the Australian dollar has fallen and Australian commodity exports will probably fall for the first time in 20 years, leading to a current account deficit expected to exceed 6.5% of GDP; and the New Zealand government has warned that its economy is "halfway down the road to recession". In the same period, Taiwan recorded its first quarterly trade deficit in 17 years.

The improvements in the current account balances of the countries at the centre of the turmoil are due essentially to import compression, rather than to an expansion of exports, and a major factor contributing to this is the credit crunch affecting companies in those countries.

The financial picture continues to be equally sombre.

Last year, the East Asian region suffered a net loss in capital flows of $109 billion or 11% of regional GDP. There were also precipitous declines in private flows to Africa and the Middle East. And the spreads required for any financing in developing countries are increasing, as well as risk premiums on government bonds in the Eurobond markets for Latin American and African nations.

Major problems could yet unfold if a new cycle of competitive devaluations starts, with increased danger of a protectionist backlash in major markets of North America and Europe.

To make a dent in unemployment and poverty, the world economy needs to grow at a rate of at least 3% a year - a figure attained in recent times only in 1996-97, though the growth was unevenly distributed even then. In last year's Trade and Development Report, UNCTAD had also drawn particular attention to the asymmetry between labour and capital, and pointed out that the exit option enjoyed by capital in comparison with labour was a major source of global instability and inequality. In UNCTAD's view, "the 'discipline' that financial markets undoubtedly exert on policy-makers does not favour the unemployed and under-employed, but rather holders of existing wealth."

Potency of short-term capital

Every major financial crisis was not a global one. When a crisis occurs, defaults are inevitable unless massive bailout operations take place, and these are increasingly becoming problematic. Since they are designed to prevent default, they protect creditors from bearing the full costs of poor lending decisions, thereby putting the burden entirely on debtors. And in doing so, they only create moral hazard for international lenders, encouraging imprudent lending practices. But the scale of funds required has been growing in step with the size of financial markets - and may be reaching the limits of political acceptability.

Referring to the dilemmas facing the developing world in trying to sustain rapid growth without a deterioration in the current account, Ricupero compared the volatile short-term capital flows to the "miraculous" pill, Viagra (the male potency pill), and said:

"In really desperate cases, or if you cannot help it, it may become unavoidable. But better manage it very carefully, or else it will create so much excitement that it will prove too much for weak hearts. In an ideal world, it would be better to avoid it altogether. As the latter course is not necessarily a practical option, one should bear in mind the Roman saying ... it is the dose that makes the poison."

Since short-term flows are inherently volatile, and since financial markets are not like potato markets, it is much more difficult to manage integration into international capital markets than it is to successfully insert oneself into the international trading system. That is why the Asian countries, including a recent graduate to OECD status, succeeded in the latter, but managed less well in the former.

That is also why "one should avoid pushing or pressuring developing countries into premature financial liberalization, thus denying them the option to protect their economies from international financial instability, and volatile and speculative capital flows."

Mature capitalist countries in Europe like France and Italy took a very long time until they adopted full convertibility of the capital account of the balance of payments. Some waited until as late as 1990.

"Until appropriate global checks and balances are in place, we should assist and guide the developing countries in recognizing the need for reforms, but these should be introduced thoughtfully and progressively. The same wise combination of realism and determination has to be applied to reforms at international level. The adoption of much-improved and effective controls and regulations that go beyond conventional prudential measures are badly needed, if we want to prevent future crises." (Third World Economics No. 189, 16-31 July 1998)

Chakravarthi Raghavan is the Chief Editor of the South-North Development Monitor (SUNS) from which the above article first appeared.