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Global Economic Prospects and the Developing Countries 1998-1999

with   Joseph Stiglitz  /Elliott J. Riordan  /Milan Brahmbhatt  /Mark Malloch-Brown -Washington, DC, December 2, 1998

Introduction by Mark Malloch-Brown
Presentation by Joseph Stiglitz            (on the global economic crisis)
Presentation by Elliott J. Riordan        (on the global outlook)
Presentation by Milan Brahmbhatt      (the evolution of the crisis in East Asia)
Questions from the Media


MR. MALLOCH-BROWN: Good morning. Thank you all for being here. I notice immediately two differences which I am sure are connected. One, my colleagues tell me I've been heard to grumble that we got much too much coverage from the wire services and those print guys; where was television? Well, clearly, thank you all for joining us in the back row, and I should have known this was happening, because I found Joe Stiglitz in a new suit.


MR. MALLOCH-BROWN: So, I should have realized that this was sort of--that Joe sort of lifted us clearly to new levels, superstar levels.

Well, welcome. This is the ninth GEP. It's the World Bank's authoritative survey of the world economy, and it has got a particular emphasis, obviously, on our clients, the developing countries. Let me just remind you that the embargo is for 3:00 p.m. tomorrow afternoon--today, today, today.


MR. MALLOCH-BROWN: I'm reading my notes here; today; just that the entire report and all of the supporting briefing materials are available at the online address at the bottom of the press release.

Let me then introduce my colleagues who are going to speak about this. Joe Stiglitz needs little introduction. You all, I think, know him very well at this point, and he will lead off, followed by Mick Riordan, one of the two authors of the GEP whom we have with us today. Some of the other authors are on the road in Europe, I think, this week and Milan Brahmbhatt, who also has been involved in writing the report. Joe?

MR. STIGLITZ: Welcome to this discussion of our Global Economic Prospects for 1998-99. There is a single set of events which predominates the world economic scene today, as it has for more than a year: the global economic crisis that began in Thailand on July 2, 1997; spread from there to Indonesia and Korea and then to Russia; then to Latin America. Few countries have not been touched by the global forces which this crisis--by some accounts, the worst that the world has experienced since the Great Depression--has unleashed.

Some countries have gone, in the space of a few short months, from robust growth into deep recession or even depression. The social consequences of this economic downturn are already manifest in interrupted education, increased poverty and poorer health.

The global capital flows, the expansion of which so many wrote so proudly just a short time around, have not only shriveled but are now recognized to be at the center of the crisis. As this version of the Global Economic Prospects goes to press, we cannot tell for sure either how long the crisis will last or how deep it will be. In the midst of this great uncertainty, it is important for us to have a sense of where the economy is going; what has brought us to this juncture; and what can be done both to enhance our current prospects and to make another such global calamity less likely.

Global Economic Prospects and the Developing Countries 1998-99--as was mentioned, the ninth in an annual series--lays out the anatomy of the crisis in a clear and concise fashion and assesses both the short and long-term outlooks for the world economy in the aftermath of the crisis. A current snapshot of the world economic shows an economic situation dramatically different from just a year ago. What started as a regional economic slowdown blossomed into a global crisis.

According to the report, 36 countries that account for more than 40 percent of the developing world's GDP and more than a quarter of its population will see negative per capita growth in 1998 as compared to only 21 countries in 1997. Some other numbers that the report highlights show the other aspects of this dramatic slowdown. Global output growth will go from 3.2 percent in 1997 to 1.8 percent in 1998, and we're forecasting a slight increase to 1.9 percent in 1999.

For the developing countries, the downturn is more dramatic, from 4.8 percent in 1997 to 2 percent in 1998. Per capita growth, of course, is down even more. We are expecting per capita growth to be only 0.4 percent in 1998.

It is easier to describe where the world's economy is today than to forecast where it will be in the coming year. The art and science of economic forecasting is always risky. It is on particularly shaky grounds when it comes to trying to forecast turning points. But while forecasting is inevitably highly risky, the task of putting together the forecast, including exploring the links among the various parts of our integrated world economy, both among countries and markets, helps draw attention to sources of weaknesses and strength. By focusing on the downside risks and upside opportunities, it helps focus attention of policy makers on not only the actions which they should take today but on the kinds of contingencies for which they should be prepared.

As a development institution, the World Bank is especially concerned with the long-term prospects. Though we cannot predict with any accuracy when the world economy will fully recover from the current downturn, we do know this: there have been crises before, and the world has always recovered from them, and after recovery, the determinants of long-term growth are underlying forces, such as savings, demography, the pace of technological change. Crises can have long-lasting effects. European unemployment rates have yet to return to the levels of 20 years ago. Many analysts attribute this to the attrition of skills that accompanies prolonged unemployment. Similarly, undoing the effects of the massive corporate failures that have plagued several of the affected countries will not be easy.

This report argues, however, that while 1998-1999 will be very difficult years for the developing countries, in the long-term, growth could still reach the record-setting paces of the early 1990s, but this will happen only if policies to prevent a deeper global slump are implemented quickly. In recent weeks, the G-7 countries have taken a number of important policy steps in this direction to foster world economic recovery and prevent a global recession.

Understanding the nature of the East Asian crisis and the response of the international community is vital to shaping how well we rise to the challenge of crises in the future. Last year, when it became clear that there would not be a magic bullet to fix Asia's financial crisis quickly, we were encouraged to launch a research project to provide an in-depth examination of the causes of the crisis and an impartial analysis of the world's response and some guidance on how we could make crises such as this less frequent and less painful.

Chapters two and three present our interim report on these research findings. There are inevitably a multiplicity of factors which contribute to any complex phenomenon such as the crises that have beset East Asia. This is especially the case because the situation in each of the countries differed, in some respects markedly. But our research concludes that the origins of the crisis lay fundamentally in the interaction between institutional weaknesses in managing domestic financial liberalization and problems of international capital markets.

Unlike the Latin American debt crisis of the 1980s, the East Asian crisis is not characterized by excessive sovereign borrowing or severe macroeconomic imbalances.

The report concludes that the heart of this current crisis, as I have said, is the surge of capital flows: the surge in followed by a precipitous flow out. Few countries, no matter how strong their financial institutions, could have withstood such a turnaround, but clearly, the fact that the financial institutions were weak and their firms highly levered made these countries particularly vulnerable.

The fact that one has to confront is that the frequency and cost of financial crises, always significant, have risen in recent decades. When there is an isolated accident on a road, one tends to blame the driver; but when accidents occur repeatedly at the same bend in the curve, one begins to suspect something is wrong with the road. This report is devoted to understanding precisely what is wrong with the road and how we can make it safer both for the countries and especially for the poorest within them and how best to respond to the accidents which inevitably will occur.

The report suggests that one of the lessons to be learned from the past year is that in responding to crises, we need to focus even more on the individual circumstances of each country; for instance, the appropriate policy responses need to be tailored to the degree of leverage of the firms within the country and to its initial state of macro balance or imbalance. We need, too, to focus both on the aggregate demand and aggregate supply.

On the demand side, not only is it difficult to restore confidence in an economy as it plunges into a deep recession or even depression, but the bankruptcy which such economic downturns give rise to has long-run disruptive effects. Aggregate demand and aggregate supply thus become intertwined.

On the aggregate supply side, we need to focus on recapitalization of banks and restructuring of corporations, but this restructuring is made all the more difficult in any country by a precipitous economic downturn.

We have also learned about the central importance of social safety nets, the provision of which has become one of the central foci of the Bank's programs. We need to remember first that less-developed countries typically have weaker social safety nets--if they have them at all--than more developed countries. This needs to be taken into account both in the design of the responses as well as in the design of policy more broadly. The willingness to expose oneself to risk should be tailored to how well one can handle those risks.

Finally, we have also been reminded of the importance of strong feedback effects. The downturn in one country has contributed to the weaknesses in others. These negative feedbacks, combined with the supply-side effects that I referred to earlier, help explain the failure of exports to grow anywhere near to the extent that one might have hoped, especially in the light of the large devaluation.

The final chapter of the report explores how to avoid future crises. In an age of large-scale private capital flows, developing countries face very complex problems managing these flows but have little experience with the institutional and regulatory safeguards necessary to prevent crises. But even developed countries have, in recent years, faced financial crises of increasing frequency and severity. Some of the most recent crises have occurred in countries with advanced institutional structures and high levels of transparency. We know, too, that establishing the strong institutional infrastructure required to make markets work effectively to enable the economy to experience stable and sustained growth are tasks that will not be accomplished overnight, even in countries with a high level of commitment to make the necessary reforms.

In order to deal with the risks posed by large capital flows, especially significant when financial systems are weak, the report suggests that reforms must be comprehensive and include a combination of more flexible macro policies, tighter financial regulation and, where necessary, restrictions on capital inflows. In some cases, it may be necessary to reverse the excesses of financial sector deregulation, especially in situations where countries lack the capacity for the required regulatory oversight.

In each case, we need to ask what are the benefits and costs of the proposed reforms? We need to look at the impacts on growth, stability and poverty. The balance of benefits and costs of different policy reforms may differ in different countries. We need to recognize that in many of the poorest countries, we are not likely to have in the immediate future robust safety nets. We have seen the devastation to the lives and livelihoods of millions of people that financial crises can have on innocent bystanders. We are seeing poverty increase overnight, undoing the slow progress that has been taking place year by year. For the poor people in these many less-developed countries without an adequate safety net, the risks are indeed high, perhaps unacceptably so.

While the consequences of the crisis have been severe, the report ends on a positive note. Events over the past year may well herald a new, more realistic and stable environment for developing countries. We now have a better understanding of the institutional infrastructure that is required to make market economies work. The international community is giving serious attention to necessary improvements in the international financial architecture, from better bankruptcy laws; a greater willingness to accept standstills and arrangements entailing more equitable burden sharing to a greater receptivity to interventions designed to stabilize capital flows, to a greater recognition of the need for responses to crises that are better adapted to the circumstances of the country and to protecting the most vulnerable within them.

The two together: improvements in domestic institutions and in the international financial architecture, will enable greater numbers of countries to be able to enjoy more of the benefits and minimize the peril of the global economy.

Now, I would like to turn the microphone over to Mr. Riordan, who will present a more detailed look at the prospects for developing countries.

MR. RIORDAN: Thank you, Joe.

I would like to take a few minutes and just walk through some of the numbers and some of the issues in the global outlook. There is little doubt that a period of sluggish global growth is ahead. Although we are not looking for an outright recession in 1999, there are a number of important risks that tend to concentrate on the down side. In 1998, developing countries, as Joe had mentioned, in and outside of East Asia are being hit hard, with 36 countries experiencing negative per capita GDP growth.

I would like to make four brief points relating to the global outlook, and as we can see--we have these messages on the chart over here. The first is that the deflationary impulse coming from East Asia was about twice what we had expected at the turn of this year. Because of this and other developments, including the much worse than expected situation in Japan, the world economy is in the midst of a slowdown, as Joe noted, from growth of 3.2 percent in 1997 to what we estimate to be 1.8 percent this year, and sluggish growth is likely to continue into 1999 at 1.9 percent as economies in East Asia stabilize but as growth slows in the United States, in the European Union and especially in Latin America.

The second point is that for developing countries, the outlook for export earnings and for external finance is now very weak. Exports are being affected by slowing of world trade volumes and the sharp declines in oil and non-oil commodity prices that we've seen in recent months. Private capital flows to developing countries have come to a virtual halt in recent months, and spreads in secondary markets for emerging market bonds skyrocketed in the wake of the Russian devaluation of mid-August.

The third point is that due to these external factors as well as circumstances in the countries themselves, growth across all developing regions will be slowing in 1998 and 1999 compared to 1997.

Finally, in terms of the main points, the short-term projections of the base case or the most likely outlook remain cautiously optimistic that a world recession can be averted, and an important reason, as Joe alluded to, was the recent series of policy initiatives, of which the most significant are the interest rate reductions in the United States, the United Kingdom, Canada and smaller European countries in preparation for EMU; the passage of a financial restructuring program amounting to some 12 percent of GDP in Japan and additional stimulus measures amounting to 24 trillion yen; also, increased availability of official finance to emerging markets, including funding for the IMF and a new Japanese and multilateral funding package for the Asian crisis countries.

Given the importance of Brazil, the world's eighth largest economy, the agreement on the broad outlines of a package of fiscal consolidation and international assistance for that country was another major development.

These policy steps have caused confidence to improve. They will prove vital in supporting world economic activity over the next year or so. They also significantly reduce the likelihood that recession, which affects a large part of the developing world, will spread to industrial countries. Unfortunately, however, policies take time to work, and the momentum of world economic activity is still on a deceleration path at present.

The next slide, which shows the evolution of forecasts for 1998 GDP and current balances for the most affected East Asian countries and highlights the slow but inexorable deterioration in view, and on East Asia recently, there have been some more encouraging macro signs, largely for external and financial indicators, suggesting that the potential for slowing of output contraction in several countries exists. And among these, briefly, are the massive current account swing of some US$120 billion, which represents 2 percent of world trade from 1996 to 1998, which, though quite painful, has built a general framework of improving confidence.

And building on this, we have seen stabilization and subsequent appreciation of exchange rates, which is serving to restore a degree of purchasing power to these economies. We have seen large declines in interest rates to precrisis levels in some countries and, more recently, pronounced recovery in equity markets. Export volumes continue to grow in the region, although they are starting to slow, and that has been a major source of stimulus for these countries, but importantly, among recent developments, more stimulative fiscal policies are now underway.

This indirect evidence lends some support to the view that after declining by 8 percent, GDP for the four most affected middle-income countries and Korea in 1999 may come to stabilize. Projections range, for individual countries, range from a continued decline of 2.5 percent in Indonesia to a gain of similar magnitude in the Philippines. While signs of increasing stability are emerging, it is still too early to be sure that we will not suffer another setback, since the external environment remains quite murky at present, and the recovery, in any event, is likely to be slow and drawn out.

Briefly, in this regard, at the micro level in these countries, the financial viability of banks and firms will need to be restored, while international debt workouts proceed. And given the difficulties inherent in many of these processes, recovery in the crisis-affected countries is expected to be relatively protracted, and the potential growth rates, long-term growth rates, to which they return, may be more tempered.

We currently anticipate growth for these economies of 3 percent in 2000 and averaging about 5 percent in the long-term, but this compares with a 7 percent track record for the last 20 years.

The next slide shows that for developing countries, as a group, in 1998, GDP will slow from almost 5 percent in 1997 to about 2 percent in 1998. As illustrated in the chart for this group, excluding the transition economies, this is the worst growth out-turn since the early 1980s, the start of the debt crisis.

In looking at the major industrial countries briefly, growth is likely to slow in the United States and Europe moving into 1999, while in Japan, stimulus measures are hoped to limit the recession, which yielded a 2.5 percent decline in GDP this year. We currently anticipate a modest output contraction for Japan in 1999.

In the United States, slowing of growth from the rapid pace of 1998 is likely to be driven, in part, by the crisis in Asia and elsewhere, as exports continue on a declining trend that they started this year but also as consumers retrench, given their current overextension, and some slowing of investment spending as well. Recent Federal Reserve measures are likely to achieve a soft rather than a hard landing next year.

All Western European countries are also likely to show some modest slackening of growth in 1999 as export growth has diminished and business confidence has softened. Next slide.

Returning to the second point, that developing countries face difficult conditions in the external environment, the anticipated slowing of industrial country growth into 1999 may accentuate the adverse trends that we have already seen dominate in world trade and the commodity markets. In recent months, there appears to be a further slowdown in world trade volumes. Trade probably grew at 3 percent year-on-year rates in the 3 months to August of this year as opposed to double-digit gains in 1997 and early 1998.

Oil and non-oil commodity prices, some of the effects of which we see in this chart, have, for the most part, remained near their historic lows, and several have continued on a further downward trend. Abrupt shifts in commodity prices carry large differential effects across developing regions, and changes in the terms of trade--here, we picture them as--the income effects as a proportion to GDP in 1998--show that oil exporters in the Middle East and North Africa, Russia and several in the CIS are hard-hit, as are some of the countries that suffered large devaluations in East Asia.

Some countries benefit from these terms of trade changes. Industrial and developing countries that are importers of oil and foods.

The next slide also highlights the fact that external finance from private sources has also become more expensive and more scarce. Just in the last month or so, following the Russian devaluation, we began to see a large decline in spreads pictured in the chart, the Brady bond spreads and also U.S. high yield spreads, and there have also been some signs of a life-end (phonetic) bond issuance. However, bond issues have been a fraction of its earlier levels this year. It's only been by the best borrowers and at very high spreads; furthermore, commercial bank lending, which had only declined moderately in August and September, appears to have staged a retreat in October, as banks prepare their balance sheets for the end of the financial year.

For a sample of large emerging markets, private capital flows, excluding foreign direct investment, during August and September stood at 40 percent of their monthly average levels in January to July of this year, which were already quite low, so the situation is quite serious at the moment.

The third point, again, is that this combination of developments is likely to result in a significant slowing of GDP growth across all developing regions in 1998 and continued sluggish or falling growth in 1999. Briefly, looking at the chart in East Asia, what appears to be a very sharp rebound is simply the fact that the rate of decline in the most affected countries is slowing in 1999, and China continues to grow at a very rapid pace. But looking at the Europe and Central Asia region, the uncertainties surrounding the outlook in Russia and the likelihood for continued declines there are bringing growth lower in 1999 than they were in 1998.

And finally, in Latin America, the implementation of fiscal measures in Brazil and the slowing of growth in the U.S. is likely to result in some additional slowing of growth in that region.

Finally, there still exists a risk of world recession in 1999, although, following on some important policy steps in the last 2 months that we touched on briefly, the probability of recession has receded somewhat. It still remains a possibility, and it especially concerns developing countries, which would, again, be the worst-affected. The possibility of a world recession, defined as world growth less than 1 percent, exists, in part, because there are three distinct sources of risk that, in this case, tend to be strongly mutually reinforcing.

They are: an even deeper recession in Japan; a large correction in the stock markets of the United States and some European countries and the possibility of prolonged withdrawal of capital flows from emerging markets. Right now, we remain cautiously optimistic that the worst will be avoided, provided we do not have another setback in a large emerging market; providing that the conditions, economic conditions, in Japan don't deteriorate further, we should see a gradual resumption of capital flows after the turn of the year. But even against the background of this scenario, capital flows are likely to be much lower in 1999 than they were in 1998.

Growth in developing countries may take some time--maybe by 2001--to return to the rapid pace that they enjoyed during the first half of the 1990s. But this period of renewed growth may be a more sustainable one, with improved institutional capabilities to reap the benefits of globalization while mitigating some of its risks.

At this point, I would like to turn to my co-author, Milan Brahmbhatt, to address some issues on East Asia.

MR. BRAHMBHATT: Thanks, Mick.

I'm just going to talk very briefly about some of the conclusions that the report draws about the evolution of the crisis in East Asia and about the policy responses that were adopted in response to this crisis.

One of the central messages we derived from this study is the large extent to which these crises were different from the debt crisis of the 1980s, which originated in excessive government fiscal deficits and borrowing and for which a well-rehearsed, even though painful, response already existed.

The East Asian crisis was new in many respects, occurring in the private sector and in the context of this new, 1990s world of private capital flows; that is, from international private lenders to emerging market private borrowers. As Joe noted, it was really the interaction of home-grown institutional weaknesses with imperfections in international capital markets, which are prone to large swings between euphoria, on the one hand, and panic on the other, which laid the groundwork for the crisis, as well as ensuring that their macroeconomic consequences would be very severe.

One of the most critical manifestations of vulnerability was the excessive buildup of unhedged, short-term foreign currency borrowing by recently liberalized but poorly supervised financial institutions and also corporations in the crisis countries during the boom of the 1990s. This buildup made countries very vulnerable to the kind of sudden swing or reversal in its international capital market sentiment that actually occurred in the second half of 1997. In several countries, these surging capital inflows and these weaknesses in financial sector regulation and supervision contributed to huge lending booms by domestic financial institutions.

These credit booms augmented already high levels of corporate leveraging. They fostered speculative investments; they fueled bubbles in asset prices, and they weighed down banks' portfolios with doubtful quality loans. Banks and corporations, therefore, became highly vulnerable to shocks affecting their cash flow and net worth, such as the bursting of asset price bubbles or the slowdown in export growth that took place in 1996.

When the reversal in capital flows and in exchange rates occurred then, it was activity and demand in the private sector, in particular, private investment and consumption that suffered a collapse and is that which is at the core of the current recessions.

Now, the initial policy responses to the crises, which might have worked in the very different context of the 1980s government debt crises, proved much less effective in restoring confidence than anyone initially expected. Indeed, much or most of the depreciation in currencies occurred after the initial policy measures were taken. The much larger than expected deterioration in financial and real economic conditions then required several quick changes in these initial policy packages. Initial fiscal policies turned out to be more restrictive than was originally the intention, in part, because of the underestimation of the severity of the downturn in the private sector.

As this became clear, fiscal policies were relaxed in favor of a much more stimulative stance. Tight monetary policies designed to stem currency devaluation also generates some very tough policy dilemmas, having an adverse impact on ailing banks and highly leveraged firms and increasing the risk perceptions attached to financial instruments issued by these bodies.

The report stresses the critical role of fiscal and monetary policies now in alleviating the collapse in aggregate demand, as well as in providing resources for expanding the social safety net and in recapitalizing the financial system. As is too often the case, the collapse in economic activities is having its most dramatic impacts on the poor. Unemployment in Indonesia, Korea and Thailand is expected to more than triple, while the numbers falling below poverty could reach 25 million in Indonesia and Thailand alone.

Priority actions to protect the poor, including ensuring food supplies to the poor through direct transfers or subsidies; generating income through cash transfers or public works; preserving the human capital of the poor through maintaining basic health care and education services and increasing training and job search assistance for the unemployed are all important actions.

Finally, restructuring and recapitalizing the banking systems and fostering corporate restructuring are also essential for revitalizing investment and growth. Large parts of the financial and corporate sectors in the most affected crisis countries in East Asia are insolvent or suffering severe financial distress. In several countries, the cost of recapitalizing banking systems is expected to rise to at least 20 to 30 percent of GDP. Cross-country experience suggests that restructuring on this scale will require government intervention within a comprehensive plan for the financial sector, including the injection of substantial public funds.

At the same time, countries have undertaken the long process of putting into place or strengthening the laws and institutions needed to provide high-quality prudential supervision and regulation of their domestic financial systems. Over time, this is likely to improve the likelihood that countries can enjoy the benefits of greater global financial integration while reducing some of the risks of crises that come with these benefits.

Thank you.

MR. MALLOCH-BROWN: Well, we will now--thank you all very much.

We'll take questions. Can I just ask you, one, to wait for the microphone, and two, although we know who you all are, to identify yourselves by name and organization for the transcript of this? Just--yes, there.

MR. WOOD: Barry Wood, Voice of America.

Mr. Stiglitz, you say that capital flows in and out caused the crisis. I wonder if you would elaborate on that. On page 168, you mention Chile, but you don't really say much about it. But implicit in your remark would be that some kind of Chile tax on short-term flows must be useful, and I wonder, also, if you would elaborate where you speak about capital controls having no apparent effect on growth.

MR. STIGLITZ: Well, the point that I made in my introductory remarks was the fact that these countries have experienced a huge change in flow in and then flow out, and that kind of change in investor sentiment obviously is very disruptive to an economy and would be disruptive even if it had strong financial institutions. Obviously, if it has weaker financial institutions, the adverse effects are all the greater in destabilizing the economy.

The changing sentiment, of course, is partly a response to weaknesses within the economy itself. So, one can't separate those, but I think the general sense is that most of the information relevant to, say, Thailand that led to the crisis in July was available in May and June. There were a few pieces of information that were not available, but most of the information was available. Yet, in the month before the crisis, the spreads over LIBOR rates for borrowing in Thailand were very small; and then, immediately after the crisis, they increased enormously.

This just illustrates the large shifts in investor sentiment that can occur in very short spans of time without the release of news of commensurate magnitude that would fully justify that kind of shift, and that has led--that, combined with one other observation, the fact that the social risks associated with these disturbances are far greater than the risks borne by the individuals who engage in these activities; that there is a discrepancy between social and private returns or social and private risk-bearing that, in general, is the kind of discrepancy that motivates government intervention to try to bring the two into balance.

The analogy that I sometimes give is that constructing a dam that stops--that you're going to have water flow from the top of the mountain down to the ocean, and if you construct--without the dam, you can have floods and destruction and death. The dam doesn't stop the flow. It eventually goes from the top of the mountain down to the ocean. But by putting the dams that stabilize it, you convert this water, which is such a source of destruction, into actually a very productive source, a source of productivity.

So, the bottom line is that our objective here is to try to look for interventions that can help stabilize these flows and, therefore, impose less risk on them. There are a number of examples under discussion. One that is of most interest is the Chilean tax on inflows, which is designed to stabilize, and it is very much designed to stabilize. Let me emphasize that; as in the current situation, where the problem is they need more inflows, they've dropped the tax rate down to zero. So, the tax is there when there is a surge to try to stop the surge, but now that they need the flow, they have dropped the tax rate down to zero. So, it really is an intervention designed for stabilizing short-term flows.

MR. MALLOCH-BROWN: Take down here in the bottom right.

MR. ESQUIVEL: Jesus Esquivel from the Mexican News Agency. I have a couple of questions, Mr. Stiglitz.

First of all, in Latin America, the report says that the forecast for 1999 is 0.6 percent of growth. That means Latin America is going to be in a recession. And can you please be more specific about the perspectives of growth in Mexico, Venezuela, Brazil and Argentina, and also, do you fear that this kind of crisis could motivate another social unrest in the developing countries?

MR. RIORDAN: I'll take a first crack.

The slowdown in Latin America that we have projected for 1999 is largely based on a number of factors. The first is the likely effects, the short-term effects of the fiscal austerity measures undertaken in Brazil, which will be somewhat contractionary. The second case is that we do have continued weak oil prices, in particular, and other commodity prices that are affecting countries such as Venezuela and other oil exporters.

The third is that the U.S. economy is likely to slow next year, and as a source of exports for Latin America, this will have some moderating influence on exports from the region.

We can't comment directly on individual countries. It's a matter of World Bank policy in terms of projections, in terms of forecasts, but we could speak later for some more information.

MR. STIGLITZ: Let me address the second part of your question.

You know, in general, there really are systematic relationships between severe economic downturns and political and social unrest, and we have already seen one manifestation of that in one of the countries in East Asia. So, it is obviously a source of concern, and it's one of the backdrops to the World Bank's commitment to trying to develop social safety nets so that the poorest at least have some degree of protection against the severe economic circumstances.

The other broad issue is that--a concern to me--is that there not be a swing of the pendulum on the policy side if part of the problems that we are confronting today are a result of excessive zeal in deregulation in countries that were not at the stage where they had the adequate financial and regulatory capacity, institutional capacity; the real danger now is that there will be a withdrawal from international markets from the advantages of globalization, and what we would very much hope is that we can get a balance here where we can go forward in ways that will enable countries to take advantage of globalization but reduce the risks that are imposed by it on them.

MS. SCOTT: Heather Scott with Market News Service.

Mr. Stiglitz, back to the short-term capital flows issue: could you elaborate a little on which countries are most likely to need that kind of control? The larger economies, smaller economies and any in particular that you would care to mention.

Also, you mentioned that some countries might be required to reverse the process of liberalization somewhat. Can you elaborate on that, what you mean exactly? And don't you think that might erode confidence further rather than improve it?

MR. STIGLITZ: Let me answer the second question first and answer by way of analogy. I think there is a general sense that in the United States in the 1980s, financial market deregulation was carried to an excess, and that excess led to the S&L crisis and that beginning in 1989, with a new law that was passed and strengthened financial market supervision, there was a step back from the lax regulatory policies and excesses of deregulation that had led to the very severe S&L crisis, which did lead, I think, in a very important way, to the economic downturn in the United States in 1990, 1991, 1992.

So, that is exactly what I have in mind. In less-developed countries, these problems are more severe, because their regulatory capacities are more restricted, and the risks that they face are greater. So, the difficulties are greater, and their institutional capacities are weaker, and the regulatory structure that one designs, the overall system, the financial system, has to take into account both the risks the countries faced and their regulatory capacity.

On the first question, I'm very careful in using the word interventions rather than the word controls. Controls has the overtone of heavy-handed interventions. The kinds of actions that I have in mind are actions like that of Chile, where they are trying to stabilize through a tax measure, effectively, a tax measure, and the tax measure is correcting for a discrepancy between social and private costs and benefits. Just like we recognize in the area of environment that private incentives are distorted; firms do not have an incentive to control air pollution, and as a result, we have to take actions to try to control air pollution; here, we have an example of where private markets may have an incentive to undertake excessive risks, which puts a real burden on the economy, and we have to take actions to try to mitigate that kind of excessive risktaking.

A major vehicle for doing that is through adequate, appropriate financial sector regulation. If the financial sector is doing its job well, it is limiting the extent of leverage of the private firms, so you don't have huge leverage that makes a country more vulnerable; you don't have firms that are borrowing very heavily abroad that don't have balanced earnings to offset that foreign exposure. So, many forms of intervention are through appropriately-designed financial sector regulation.


MR. SITOV: Andre Sitov from TASS.

Chapter two of the report is entitled Responding to the East Asian crisis. The question, sir, is are the policy responses relevant to other countries such as Russia, for instance?

MR. STIGLITZ: Well, I tried in my introductory remark to extract some of what I view as the general lessons that are applicable to all countries, and Mr. Riordan, in his introductory remarks, also pointed out the fact, for instance, that the circumstances in East Asia were different from those in Latin America meant that whereas, in Latin America, you began with a situation of very large macro imbalance, heavy debt, heavy deficits on the part of governments; inflationary policies on the part of monetary authorities. So, you had a macro imbalance.

An appropriate response to the crisis was to try to restore that balance. In the case of East Asia, you began in a situation of rough macro balance. Inflation in Korea had been brought down from 5.5 to 4 percent, you know, not a bad picture. In that context, you have to be very careful, in the face of a crisis, of excessive contractionary policies, because inevitably, in a crisis, you are going to have large falls in aggregate domestic demand; falls in investment and, quite often, falls in consumption, and that means that if you begin with a situation of balance, you decrease aggregate demand; you are going to put yourself into a deep recession.

The consequences of that depend on the circumstances of the country. If you are in a highly-levered country, which Korea was, for instance, you know that if you go into a recession in a highly-levered country, you are going to have high levels of bankruptcy. High levels of bankruptcy, then, are going to contract the potential supply of the economy.

So, the other lesson that we've learned is you focus not only on aggregate demand but also on the micro foundations of the economy, the supply side of the economy, and you have to keep that picture in mind as well. So, I think those are examples of general lessons that apply rather universally.

MR. MALLOCH-BROWN: Number three here.

MR. MILVERTON: Damien Milverton from Dow Jones.

Just in the report, you mention along the same sort of lines that a substantial share of losses of restructuring, in particular, the banking sector, should be allocated to those who benefitted the most from past risk taking, such as bank shareholders and managers. How would you actually allocate the share of that sort of loss? What are you actually thinking of there when you mention that?

MR. STIGLITZ: This is just a general proposition. We are not talking here about precise numbers of this is the percentage of benefit; therefore, this is the percentage of cost you have to bear. Rather, the point that one is trying to emphasize is that we know that in these crises, a very large part of the burden is being paid by workers and small businesses that did not have any share in or a limited share in the benefits. What we are saying is that the process of restructuring has to be such that some of the old shareholders, some of the people who lent; some of those parties have to bear some of the significant costs.

MR. MILVERTON: How do you allocate them?

MR. BRAHMBHATT: Yes; part of the motivation there also is that when you are undertaking a financial rescue package or recapitalizing the banks, you want to make sure that you don't end up simply bailing out the risk takers who are responsible in large part for the problems that have arisen, because that is really going to increase the moral hazard of the financial rescue package. So, this is really quite a standard prescription that is put forward when financial restructuring is taking place that those who benefitted in the past should bear some of the burdens, in order to minimize future moral hazard arising from the financial rescue operation.

MR. MALLOCH-BROWN: Way back, back row.

MR. CHAPMAN: Irv Chapman from Bloomburg Television.

Dr. Stiglitz, you mentioned some 30 countries in addition to the ones that we have been focusing on for a year and a half, the Brazils and Russias and Indonesias and the East Asian tigers. Is there anything that these other countries, these developing countries, can do for themselves that would mitigate this effect of what's gone wrong in East Asia and Russia, or are they stuck until the East Asian tigers roar again?

MR. STIGLITZ: That's a very good question. I think in the initial stages of the crisis, the focus was very much on the fact that these particular countries had misguided economic policies in one way or another. As the crisis has unfolded and become a global crisis, many countries that have, I don't want to say faultless economic policies, because there are no countries that have faultless economic policies, but as reasonable as you will find, have been very adversely affected, and the recognition that the contagion that occurs affects countries whether or not they have undertaken undue risks, is a reality that has to be confronted.

They are affected in a number of different ways that have been talked about. One of them is this huge terms of trade effect, so a country like Chile that may be pursuing very good economic policy, its price of copper falls; it's going to be adversely affected. The oil exporting countries, regardless of whether they were pursuing good or bad economic policies, and some of them were pursuing bad economic policies, and some of them were pursuing good economic policies, have been very badly affected. So, that is one channel.

The other channel is the fall in exports at a global level that was depicted, and that means, you know, countries that are export-dependent, which are very many of the small, open economies, and we have encouraged that openness, are going to be adversely affected. And finally, the drying up of international capital markets means that the source of funds for investment in many countries is going to--is drying up, imposing enormous negative impact on these countries. The data for the last few months have been, quite honestly, very dismal.

And these have affected countries, no matter, again, whether they have good or bad economic policies. The ones with bad economic policies: weak institutions, weak financial systems, have had bigger effects and are more vulnerable, and the risks, therefore, are greater. So, to come back to your bottom line, what do they do? Well, the fact that you have good institutions; that you put into place a good safety net, these are things, these are policies--good financial regulation--that minimizes the down side. You cannot isolate yourself from these impacts, but you at least can make sure that the magnitude of the impact and the down side impact is minimized or less than it otherwise would be.

Secondly, on the capital market exposure, that is really what the third chapter of the report is about, and raising the question that perhaps they should think about imposing policies like the Chilean tax to stabilize the flow, so you are less vulnerable to this sloshing of money in and then money out. Foreign direct investment has been far more stable than the short-term capital flows. Foreign direct investment brings with it not only the capital but also access to markets; access to new technology and human capital. And so, it brings with it far greater benefits that can be identified.

The short-term flows, it's much harder to identify the benefits that are associated with those flows. The challenge is to find ways of stabilizing the flows that, at the same time, do not have adverse effects on long-term capital flows. The Chilean experience suggests that there are those kinds of actions.

MR. SANGER: David Sanger from the New York Times.

In the first two chapters of the report, there isn't much discussion of the role of the IMF and other major governments that were pressing some of the higher interest rate policies on Thailand and Indonesia and then, later, Korea, although there is some suggestion that those high interest rate policies contributed to the recessionary effect. Did you come to any conclusions about what might have happened to these economies and what kind of shape they would be in today had they ignored the advice; not increased the interest rates in order to defend the currencies?

MR. STIGLITZ: Well, let me--okay, issues of counterfactual history are always difficult, what would have happened if. We know what happened with the policies that were pursued, but some of our research has cast--not all of which is reflected in this report--has cast some light on that kind of issue. And let me illustrate what I have in mind. The debate at the time was centered around the following issue or sets of issues. Everybody recognized that one of the factors that was important in restoring strength was restoring confidence. One issue was could you restore confidence in an economy that was going into a deep recession, and particularly following up on one of the earlier questions, if that deep recession or depression is going to give rise to social and political unrest, is that an environment that is going to give rise to restoration of confidence, and confidence here is not only confidence of investors in the major money centers like New York and London and Frankfurt but also confidence of investors within the country that may have to make a decision to keep their money in the country or to engage in capital flight, and we know from some of the earlier experiences, like in Mexico, capital flight can be as or more important; so, domestic investors can be as or more important than investors in foreign countries.

The related set of issues is that in economies with high degrees of leverage, highly-levered firms, increases in interest rates, if sustained over a very long period of time, inevitably lead to high levels of bankruptcy, and interest rates have been high for long periods of time. The good news that was reported is that those interest rates have now come down, and contractionary policies--and fiscal policies are less contractionary; so, those policies are now quite changed from the way they were initially.

But high interest rates would inevitably, if sustained, lead to high levels of bankruptcy, and the levels of bankruptcy--some estimates are that levels of bankruptcy in Indonesia now are 75 percent, and, you know, you cannot have a country perform with 75 percent of its firms in bankruptcy.

The debate in some sense focused around the difficult issue, very difficult issue, of the adverse effects of further devaluation versus the adverse effects of higher interest rates, and there was, as I say, a real concern that further devaluation would have this very negative effect.

Now, as was commented, most of the devaluation occurred after the policies were initially put into place, and that raises the point that there may not have been a tradeoff, because the high interest rates, if they did not succeed in restoring confidence, would, in fact, lead to further--or be associated with a further devaluation and would, in any case, not stop the devaluation. They would only work in stopping the devaluation if they restored confidence. So, it was only if there was a tradeoff that you had a policy dilemma of whether you should have high interest rates or allow a devaluation. In fact, what one wound up with was both.

Finally, in assessing the--if there were a tradeoff, one has to look carefully at the consequences of the two alternative policies, and here is where some recent data for Thailand is somewhat insightful. In the case of Thailand, we have looked at which were the firms that were highly in debt--had a high level of foreign indebtedness, and when you ask that question, you ask, you know, who would be affected by the devaluation versus who is affected by the high interest rates? We know that high interest rates have adverse effects on all firms in the economy that are in debt, and financial depth, which includes borrowing, is one of the central pieces of modernization of a capitalist economy. So, all firms in the economy were affected by high interest rates: small firms, medium-sized firms, firms that engaged in international trade; firms that did not. So, it was broadly across all sectors of the economy.

The foreign indebtedness in Thailand was highly concentrated in two groups. There was a lot of real estate borrowing and financial sector borrowing to finance real estate. Well, with the bursting of the real estate bubble in Thailand, those firms were dead, and there is a general proposition that you can only die once. I guess cats have nine lives, but they were already dead. So, no matter what happened, those firms were dead, and further devaluation would not have really made them deader, because there is this huge excess. We estimate the excess at the time of the crisis; throughout, the vacancy rate was already approaching 20 percent in Thailand.

The other group are the large exporters. These firms would lose on their exposure in foreign indebtedness, but they would gain from the devaluation in terms of export earnings. So, they were, to a large extent, protected.

So, when you do that kind of detailed microanalysis, you come up very clearly with the conclusion that the risk posed by the economy, the marginal risks, were greater with the interest rate policy than with the devaluation.

Finally, let me say that there is a lot of discussion about the moral hazard issue. I think the moral hazard issue is deeper and more profound than has often been recognized. The moral hazard has focused on the moral hazard associated with the bailouts, but there is also a moral hazard issue associated with trying to maintain exchange rates at higher levels than market-determined levels.

You asked the question who are you protecting when you try to maintain that exchange rate by having high interest rates? Who are you protecting? You're protecting firms that have gambled on the exchange rate. They have borrowed in an uncovered way. Those are the firms that you're protecting. And who is paying the price? The small businesses that did not gamble; the workers who are going to be put out of jobs. And so, this is the real moral hazard, that you say, if you gamble and expose, we will impose macroeconomic policies that will minimize your loss. That is the real moral hazard, and that is the one that has had an enormous--going forward, imposes enormous risks in setting examples in the future.

MR. MALLOCH-BROWN: We can only take one last question. A lot of you caught my eye. I'm going to--you caught it first. Let's just wait for the microphone.


QUESTION: Yes, I have, actually, two quick questions, one for Mr. Riordan. You created two scenarios, one baseline scenario and one low-case scenario, in which one, you have a recession in one, and maybe there is a recession in one and no recession in the other. I would like for you to give some probability to each of those scenarios.

And the second question, for Mr. Stiglitz: if this analysis that you just made regarding the tradeoff between exchange rate and interest rate could be applied nowadays in the Brazilian situation.

Thank you.

MR. RIORDAN: Regarding the low-case scenario, as we noted, the number of policy measures that have been enacted over the last 2 months have, we believe, decreased the probability of that happening. Japan--the measures implemented in Japan are hoped to provide some cushion to growth next year. The reductions in interest rates in the U.S. and in some European countries are likely to help engineer a soft landing in this country and potentially set the stage for smoother growth in Europe.

So, the industrial countries, the slow down in industrial country growth could have been much worse had these policies not been taken; we feel pretty strongly about that.

The other aspects in this low-case scenario were related to corrections in equity markets and the possibility that capital flows do not return to emerging markets, as we expect them to do in our most likely scenario after the turn of the year. We can't really assign probabilities to these. These are exercises that help us gauge what level of risks exist in the global economy, but we still believe that our baseline scenario continues to be most likely, although we still have to be aware, as the East Asian financial crisis has taught us, of the possible down side risks.

MR. STIGLITZ: Let me answer the second.

The general propositions that I described earlier, the general factors that one takes into account, apply in every country. The way that they are interpreted depends very much on the circumstances of the country, and I emphasized this in my introductory remarks, and let me just mention four circumstances that differ markedly from one country to another. The degree of leverage makes the country far more vulnerable, firms in the country--a high degree of leverage can make firms much more vulnerable.

Korea probably had the highest degree of leverage of its firms of any country in the world, and that made it particularly vulnerable. The maturity structure of the debt has a very big impact. If you have short-term debt relative to long-term debt, then, changes in the interest rate have a much more immediate effect and make it more difficult for firms to withstand periods of high interest rates.

The existence of special windows for access to capital make the economy less vulnerable to interest rate changes. Many economies have available, for instance, special windows for small and medium-sized enterprises or for agriculture that mean that when interest rates go up, the interest rates that you see, the interest rates that borrowers have to pay, may not go up in tandem. So, the fragmentation of the capital market in some senses can be a good thing in the face of this kind of a crisis.

One of the problems of East Asia was that it had actually less degree of fragmentation in the capital markets than many other countries less--fewer special windows to insulate the impact. And finally, on the side of the impact of exchange rate changes, the extent of exposure, the kinds of analysis that I gave in the case of Thailand needs to be done for each particular country: which are the firms that have borrowed? What is their exposure? Are they dead once already or not? That kind of detailed analysis has to be done to assess the appropriateness of the nature, the tradeoffs, in facing each country.

So, what I'm arguing for is a general framework for thinking about this but not a set of answers that is automatically applicable to any particular situation.

MR. MALLOCH-BROWN: Thank you all very much.

[Whereupon, at 11:13 a.m., the briefing was concluded.]

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