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EAST ASIAN FINANCIAL CRISIS LEADS TO TUMULTUOUS YEAR IN EMERGING
WASHINGTON, March 24, 1998 Private capital flows to developing countries experienced a rollercoaster year in 1997, rising strongly during the first half of the year before colliding with the East Asian financial crisis and the subsequent turmoil in global stock markets, and falling sharply in a general retreat from new investments in emerging markets, according to a new report by the World Bank released today.
Over the year as a whole, net long-term private flows rose for the seventh straight year to reach a total of $256 billion, up from $247 billion in 1996. In addition, the report shows that official assistance to the poorest developing countries continues to fall as result of tighter aid budgets in donor countries and a decision by many governments to reduce direct lending as private capital flows to developing countries have increased.
The reportGlobal Development Finance 1998predicts that a combination of wary investors and uncertain prospects for recovery in East Asia, as well as possible further contagion effects, are likely to reduce net long-term private flows to developing countries in 1998. If, however, the crisis in East Asia is bottoming out, this decline will be tempered by the continued robust health of the global economy, investors returning to markets in countries with strong economic fundamentals, and changes in the composition of capital inflows that may have made them more resilient.
Assessing the likely impact of the East Asia crisis on growth rates for the region in 1998, the World Bank suggests that Malaysia and the Philippines could produce positive rates of 3.5 and 3 percent respectively this year. In the case of Indonesia, Thailand, and South Korea, the Bank forecasts economic contraction, or zero growth, although positive growth should return to all five countries by 1999, unless the situation in Indonesia changes such predictions.
"This is a year when we saw not just the opportunities, but also the risks of international capital flows," says Joseph Stiglitz, World Bank Chief Economist and Senior Vice President for Development Economics.. "Last year, long-term private capital flows rose yet again, and are now six times higher than official flows. This increase represents additional funding for investment, growth, and continued success in lifting people out of poverty in the developing world. However, the decrease in foreign aid threatens many of the poorest countries in the world, which are in most need of capital but have least ability to attract private money. Also, the East Asian crisisand its worldwide ramificationsreminds us of the risks that private capital poses for all countries," he added.
The report also investigates the causes and evolution of the East Asian financial crisis. It chronicles the sharp currency depreciations that began in Thailand in early July, and how, together with falling stock market prices and restricted access to international capital markets, these quickly spread throughout the region. By October, developing countries in Latin America and Eastern Europe also began to feel the effects of the crisis with plunging stock markets and rising interest rates.
The Bank also predicts that the Asia crisis will cut Latin America's growth this year by 1.0 percentage point. Growth is now expected to slow to 2.7 percent, down from 5 percent in 1997. While regional economies are not immune from the same problems that affected Asia, the Bank says that, on balance, Latin American economies look stronger than their Asian counterparts.
A Rollercoaster Year
Prior to the crisis, high volumes of international capital together with a strong performance by major borrower countries produced a sharp rise in commitments (including syndicated loans and bond issues) to developing countries. According to the report, commitments from January to September exceeded the 1996 total by 10 percent, and portfolio equity flows increased strongly, accompanied by booming stock markets in Latin America and Eastern Europe. In 1997, developing countries relied on sophisticated market instruments more often than in the past, including greater use of derivative instruments and emerging markets mutual funds, and instruments to attract institutional investors and encourage greater participation by private firms.
However, following the turmoil in global stock markets in October, flows from international capital markets fell sharply. Bond issues were particularly hard hit. Only one developing country, Argentina, issued a sovereign eurobond during the last two months of 1997, compared to 35 countries in the previous ten months of the year. In a number of other countries, outflows of portfolio equity investment were coupled with sharply falling stock prices. For the year as a whole, net long-term flows from capital markets were $127 billion, about the same as 1996. However, total external finance was significantly smaller in 1997 because of short-term outflows and capital flight in the fourth quarter of 1997.
The same factors that drove flows led to marked changes in the secondary market prices of developing countries' debt. Spreads or interest rate risk premiums on sovereign bonds narrowed markedly in the first part of the year, as low international interest rates encouraged lenders to increase yields by seeking out the more risky developing country assets. But spreads increased to all major borrowers in October, and rose by 200 basis points or more to some borrowers, before declining slightly in December.
Foreign direct investment (FDI), which often is more stable than other capital flows, totaled $120 billion, about the same as in 1996 and five times the level in 1990. Of this amount, privatization revenues accounted for $15 billion. Although FDI fell in East Asia, the decline was offset by a rise in Latin America as a result of privatization transactions (notably in Brazil), improved economic performance, and continued progress on liberalization.
Crisis in East Asia
Asia's crisis occurred despite a benign international economic environment, with low international interest rates and solid global growth in output and trade, and unlike the Mexican peso devaluation in 1994 or the debt crisis of the 1980s, the main factor in the crisis involved private sector financial decisions not public sector borrowing. The cause of the crisis reflects the huge shift in recent years from private-to-public sector capital flows towards private-to-private sector flows
"The general failure to predict the severity of the crisis owes much to the fact that analysts focused excessively on traditional indicators of sovereign risk, such as high savings and low inflation, and paid too little attention to indicators of business risk, such as high leverage, and maturity and currency mismatches," said Uri Dadush, head of the World Bank's Development Prospects Group.
The report attributes the crisis to the build-up of vulnerabilities in the East Asian economies that led to a loss of market confidence. The key problems were in the financial sector, where distorted incentives, lax regulatory standards, poorly managed financial liberalization, and inadequate disclosure and supervision encouraged excessive risk taking. These financial sector weaknesses led to poor investments and a proliferation of non-performing loans. Large capital inflows amplified these problems and fueled domestic demand which, coupled with the depreciation of the yen against the dollar, caused real exchange rates to appreciate.
This increase in vulnerabilities does not fully account for the unexpected spread and subsequent depth of the crisis. The low risk spreads and solid credit ratings prior to the crisis demonstrate that the market seemed relatively optimistic about prospects for the region. The rapid rise in spreads, together with the severity of currency and stock market declines, indicate that a self-fulfilling loss of confidence played an important role. The currency depreciation increased the local currency value of the external debts owed by banks and businesses, leaving many insolvent.
As their debts mounted, many firms attempted to reduce their foreign exchange liabilities by obtaining dollars to close out open positions. This further increased the demand for foreign exchange, thus leading to even greater currency depreciation. Both healthy and insolvent firms suffered because of the lack of transparency, the increase in the local currency value of dollar-denominated debt, increases in interest rates, the contraction in credit resulting from the rapid drop in equity of highly leveraged financial institutions and the economic downturn and increased uncertainty.
In the meantime, in its response to the crisis, the international community has arranged for some $110 billion in emergency financing for Korea, Indonesia, and Thailand, of which approximately $16 billion is from the World Bank.
Official Aid Continues to Fall
Net concessional assistance to developing countries continued its downward trend, falling from $40 billion in 1996 to $37 billion in 1997. This drop in aid is driven by a climate of greater budgetary restraint in most industrial countries, the declining strategic and military importance of development aid since the end of the cold war, and weak public support for aid in some major donor countries. Aid fell to an estimated 0.21 percent of donor countries' GNP in 1997, down from 0.35 percent in the mid-1980s.
"The decline in official development assistance is not new," said Masood Ahmed, World Bank Vice President for Poverty Reduction and Economic Management. "Nonetheless, there is a real danger thatin real terms we are reaching such new lows that we will not be able to provide the development needs of the world's poorest countries in today's global economy. Donors should not lose sight of the fact that official aid is both a lifeline for these struggling nations as well as investment in our shared future."
The report notes that the decline in aid has been accompanied by some efforts to improve its effectiveness. The increasing recognition of the importance of the policy environment for aid effectiveness has recently led donors to focus more attention on efforts to increase aid to good performers, for example through the Special Program of Assistance for Africa. Data on aid flows highlights that these efforts may be having some impact. The share of aid captured by the best performing countriesthe top 40 percent in a ranking of countries by the World Bank's ratings of policy performancerose from 38 percent in 1990 to 45 percent in 1995.
Progress in the HIPC Debt Initiative
The report details significant progress in implementing the Highly Indebted Poor Countries (HIPC) Debt Initiative in 1997. Its goal is to help heavily indebted poor countries achieve sustainable levels of external debt through improved economic and social policies and a coordinated approach to debt relief by all creditors. In its first year, seven countries which had established the required track record of good economic performance were considered for additional debt relief under the initiative, and agreements were reached to reduce the debt of four of these countries (Bolivia, Burkina Faso, Guyana, and Uganda) by $1.2 billion in present value terms. For all four countries, the normal three-year interim period between the decision point and the completion point was shortened in view of their strong policy performance.
As developed and developing countries reflect on the lessons of the East Asia crisis, and the volatility of global capital markets, World Bank Chief Economist, Joseph Stiglitz says that reforms are needed to make the world economy more resilient in the way it responds to the challenges of globalization, but that such reforms should not be rushed.
"We must reject ideology and over-simplified notions. I believe that there are reforms to the international economic architecture that can bring the advantages of globalization, while reducing their risks. Arriving at a consensus about those reforms will not be easy. But it is time for us to intensify the international dialogue on these issues," he added.