Size of Official Financing

The successful management of a capital account crisis (caused by a sharp reversal of cross-border capital flows) often requires international financial support to limit net capital outflows. If capital were allowed to flow out of the crisis economy freely, the requirement of external adjustment would cause a sharp contraction of output in order to compress imports and thereby generate a narrowing of the current account deficit. International financial support is also useful in minimizing the negative balance sheet effect of currency depreciation. Before the Asian crisis, many in the economics profession held the view that the contractionary impact of a large capital outflow on output would be offset to some extent by the expansionary impact of currency depreciation on net exports. This did not turn out to be the case in Asia because the exchange rate depreciation exerted a negative wealth effect on the private sector that had net liabilities denominated in foreign currencies.⁵

The IMF provided exceptional financing both in Asia and in Europe (Table 1 [ PDF 19.2KB | 1 page ]).⁶ Relative to the standard metric of IMF quota, the European packages were about twice the size of the Asian packages (excluding the Republic of Korea whose quota was unreasonably small relative to the size of the economy). Relative to GDP, the European programs were as much as 3–5 times larger.⁷ To some extent, this may be a reflection of the fact that the European economies are more open: relative to the value of imports, the size of the European packages was more comparable. Relative to the previous year's current account deficits, the European packages (especially for Hungary and Ukraine) were particularly large, indicating that they were better designed to deal with a capital flow reversal.

The difference between the Asian and European packages becomes more apparent when total official financing is considered (Table 2 [ PDF 78.6KB | 1 page ]). Relative to GDP, the headline figure was 14.5%–35.7% for Europe, whereas the corresponding figure for Asia was 6.7%–12.6%. Total official financing for Latvia (35.7% of GDP) may well have represented a virtual bailout of the country.⁸ For Iceland, however, the package (equivalent to 20% of GDP) may still have been insufficient given the magnitude of the problem. At the end of 2007, the size of the now defunct financial sector exceeded 1,000% of GDP, with the country's gross external liabilities estimated at 550%.

The difference becomes even greater when what may be considered to be the quality of the financing (meaning both adequacy relative to need and the credibility of underlying numbers) is assessed. In Thailand, total official financing of US$17.2 billion was less than half the amount of short-term external liabilities (US$38 billion at the end of May 1997); the foreign exchange reserves were nearly depleted; and the monetary authorities had a forward contract to sell US$23.4 billion over the coming months. The financing package was based on the IMF staff's optimistic assumption that quick restoration of investor confidence would limit capital outflows and that the country's financing needs over 1997–1998 would only be US$14 billion.

The problem was more serious for Indonesia and the Republic of Korea. First, though the World Bank and the Asian Development Bank (ADB) agreed to provide US$18 billion to Indonesia and US$14 billion to the Republic of Korea, these figures included the amounts that had already been agreed on before the crisis. The amount of additional financing was not certain. Second, bilateral financing (US$17 billion for Indonesia and US$20 billion for the Republic of Korea) was designated as the second line of defense, and was to be activated only when financing from all other sources proved insufficient. The conditions under which these funds would be made available were not specified, causing the market participants to question not only their availability but also, given the lack of transparency surrounding the World Bank and ADB loans, the credibility of the whole official financing packages.

In contrast, Europe's official financing packages appeared to have more substance. First, except perhaps for Ukraine, there was a clear backing for the numbers from the outset. The program documents clearly stated the amount of financing needs and how the gap was to be filled. The documents further stated that several stakeholders, such as the European Union, the European Central Bank, the World Bank, and Nordic countries, had participated in the preparation of the programs, giving credibility to the amount to be provided by these entities. In Asia, the programs were negotiated almost exclusively by the IMF staff and the authorities of the countries concerned, with limited direct participation by other stakeholders.

Second, in Europe, a type of private sector involvement (PSI) was attempted from the beginning. Especially in Hungary, Latvia, and Ukraine, foreign-owned banks constitute a significant share of the banking sector. In these countries, the programs were able to secure a commitment from the parent banks to maintain their exposure to the local subsidiaries (the participation of the Nordic authorities in Latvia's program negotiations was helpful in this regard). PSI was also tried in the Republic of Korea in 1997 and contributed to resolving the crisis quickly, but only after the initial program had failed; in Thailand, there was said to be an understanding that foreign banks would maintain their exposure during the crisis, but the commitments did not amount to much. In Europe, this was tried from the outset and, though the amount was not included in the headline figure, appears to have contributed to enhancing the credibility of the overall financing packages.

Finally, Iceland and Ukraine retained the restrictions they had introduced prior to approaching the IMF on capital outflows and payments for some current transactions; Latvia also retained the exchange control related to the frozen bank deposits.⁹ Exchange restrictions related to current transactions (except those approved under the transitional arrangements of Article XIV) are in violation of Article VIII of the IMF Articles of Agreement, and are normally not permitted in IMF programs as “measures destructive of national or international prosperity” (IMF 2002: 2).¹⁰ But they were permitted in Europe on the condition that they would be removed as soon as practical.¹¹ Though capital controls do not violate the IMF Articles as long as they do not restrict payments for current transactions, the IMF has generally taken a position unfavorable to any administrative measure that interferes with the free movement of capital.¹² Now the IMF appears to consider capital controls as a legitimate crisis management tool.¹³

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