FROM THE OFFICE OF PUBLIC AFFAIRS

HOUSE COMMITTEE ON BANKING AND FINANCIAL SERVICES

Mr Chairman. I am pleased to have this opportunity to discuss recent developments in Southeast Asian financial markets, which I know to have been of considerable interest to this committee and other members of Congress.

The Treasury Department, working with the Federal Reserve, has for several months been actively involved with other countries in the Asia-Pacific region in supporting efforts to restore financial stability to Thailand, Indonesia and other economies and contain the broader impact of these countries’ crises. While it would be inappropriate, in the very midst of these events, to hazard definitive judgments on the future course of these events, it is important that this Committee and other interested members of Congress have a clear understanding of the Administration’s approach and objectives.

Let me address three aspects of recent developments in Southeast Asia:

the background and causes of the crises, structural and cyclical

the short and longer-term interests of the United States in these developments

and the response to the crises, on the part of the countries themselves and the international community.

I. Background and causes of the crises

1. The longer term record of success

It is important to see recent events in emerging market economies against the backdrop of the quite remarkable changes in the global capital market in recent years:

last year over $250 billion in private capital, in the form of direct investment, portfolio flows and bank loans flowed to emerging market economies, compared to $25 billion in 1986. Such markets now account for almost 40 percent of global foreign direct investment flows, and almost 30 percent of cross-border portfolio flows -- compared with 15 percent, and 2 percent respectively at the start of the decade. As recently as five years ago, official flows to these countries exceeded private investment.

in 1992, only 16 countries were able to issue sovereign debt in the international capital market. In the last two years alone, 31 countries have tapped global financial markets for the first time, bring the total number with access to 56.

along with rapid growth in these economies has come tremendous growth in asset prices, and rising market capitalization of stock markets, as more companies have gone to the capital market for finance. Many of these successful firms are now themselves investing abroad. In line with these changes, bond prices have increased sharply.

at the same time there has been rapid technological innovation in the nature of financial instruments available and rapid integration of international financial systems, all of which has dramatically increased the speed and extent to which disturbances in one financial market can spread to others.

Emerging markets partly have a benign external environment to thank for this remarkably large, and sustained inflow of resources. With the budget deficit heading downward in the United States and inflation stable or declining around the world, for much of this decade international capital markets have been characterized by low interest rates and a rising investor appetite for higher yields.

And yet, if these economies saw a sharp increase in their relative attractiveness to outside investors, it was also in large part due to their success in reforming and opening their economies to make that foreign capital more welcome. Nowhere has this been more true than in Southeast Asia. With high rates of savings and investment, a strong outward orientation and prudent macroeconomic policies, per capita income roughly quadrupled in the industrializing Southeast Asian economies in the 30 years after 1965. In Hong Kong, Singapore, South Korea and Taiwan, incomes rose more than sevenfold.

2. Causes of instability

For as long as there has been finance there has been instability. And, in a world where developing countries have a growing weight in the international economy, domestic financial instability in these economies has the potential to become international instability. In recent months we have seen serious problems arise, first in Thailand, then Indonesia, with a potentially important impact on other emerging markets -- not merely among neighboring countries but across Asia and in other important developing country markets.

I should note at the start that each country faces its own unique set of circumstances. Over time their differing strengths and weaknesses are likely to reassert themselves as they seek to take the steps necessary to restore stability. The same common strengths that fueled rapid growth and development in the past leave these economies well-placed for a rapid return to growth once stability has been restored. But to achieve this it will be necessary for them to work to address the common vulnerabilities which have helped fuel and prolong these crises. Let me list briefly the most important of these.

The first weakness was the tendency of both foreign and domestic investors toward excessive enthusiasm about the volume of worthwhile investment these economies could sustain. The large inflows of capital into these economies during the 1990s, coupled with already high rates of growth and high current account deficits, fueled a lending boom in which companies built up very large short-term foreign currency exposure, much of it backed by unproductive assets, notably in the real estate sector. When external competitive forces turned less favorable in 1995 and 1996, these loans proved increasingly difficult for domestic firms to repay.

The second common feature contributing to these crises was the weakness of the domestic financial system in many of the economies. To varying degrees, lax lending standards, weak supervisory regimes, inadequate capitalization, excessive inter-connected lending and the more general lack of a credit culture all helped to permit those large-scale imbalances to develop -- and to disguise their true extent once they had done so. As in Mexico, the very weakness of the financial system further exacerbated the eventual crisis, requiring a more complex monetary policy response after the crisis had begun. In Thailand, Indonesia and other countries, the authorities’ perceived reluctance to reveal the full extent of losses in the financial sector and address these effectively has been a key factor undermining efforts to restore market confidence.

A third element, in many cases, has been the presence of an increasingly unsustainable exchange rate regime. Economists have long argued over the merits of different kinds of exchange rate regimes -- with little clear verdict. But in the Thai and other cases, the attempt to maintain a fixed nominal exchange rate without concomitant monetary policy commitments -- against a backdrop of mounting current account deficits and weak and over-extended financial systems -- was an invitation for trouble. Given a decline in market confidence in the sustainability of policy, Thailand and others increasingly faced a choice between raising interest rates to save an exchange rate peg -- or cutting interest rates to keep insolvent banks afloat. In many cases, the very delay meant that their actions were insufficient to achieve either objective.

A fourth weakness of these economies we have seen played out in these crises is the fragility of their core domestic institutions. In the space of barely two generations, the region has achieved more in the way of basic economic development than many of today’s mature economies achieved in the entire century after the industrial revolution. The advantages of this rapid growth are obvious -- but it also gives people a much shorter track record of sound government and policies to refer to in evaluating and addressing a shock to the system.

Being relatively new players on the world economic stage has been less of a handicap where governments have worked to make their policies and institutions more transparent, through domestic liberalization and deregulation, transparent public accounting, and generally improved governance. Yet in many of the Southeast Asian countries, these kinds of structural changes have lagged behind other market reforms. As a result, the highly visible collapse of one policy -- a fixed exchange rate -- led foreign and domestic investors to doubt the continuation of the entire set of policies which had previously sustained growth.

What did NOT cause these crises

In the wake of these events some have stated that they constitute an argument against open capital markets. But time and again, careful studies of the causes of financial problems -- such as the G10 study of the European currency crises and IMF analysis of the Mexican crisis -- have found that short-term speculative flows were not the major source of the pressure on governments. Overwhelmingly, these flows were driven by domestic investors losing confidence in their own country’s currency and seeking to diversify their holdings, often in response to new information.

II. The United States’ stake in restoring stability

Our financial system is sufficiently robust, and the total exposure of American financial institutions to these countries sufficiently small, that we do not foresee significant risk to United States financial institutions or to domestic financial stability as a whole as a result of the turbulence to date. However, these countries account for a growing share of world output -- and a growing share of our trade. Emerging Asia accounted for one-fifth of our exports last year -- Japan a further 12 percent. As a result, the direct and indirect trade impact on our economy of a prolonged period of slower growth in Southeast Asia, and the large decline in its currencies, is potentially significant.

It is difficult to reach a precise gauge of what that impact will be, given the great many uncertainties involved. The overall effects will depend on a range of factors: the extent of the slowdown in growth, and the speed of recovery, which will determine the decline in United States exports to the region; the impact of the depreciation of Southeast Asian currencies (and more recently, the decline of the Korean and Taiwanese currencies) on United States import volumes and prices; the impact of the crises on Japan, and indirect effects of slower growth in Japan on our own economy; and the size of the multiplier effect of reduced export demand on domestic spending.

Bearing in mind these uncertainties, private estimates of the impact on the United States of the turbulence to date accord with Chairman Greenspan’s suggestion that it will be "modest, but not negligible". However, this will depend heavily on stability being restored as soon as possible -- both to limit the long term impact in the countries concerned and, critically, to limit the risk of further contagion across Asia, and across other emerging markets.

In recent months we have seen very real signs of contagion through three, related channels:

through market generalization, where a crisis in one country leads investors to expect crises in countries perceived to be facing similar circumstances -- as occurred in Indonesia, Philippines and Malaysia in the weeks after the Thai devaluation in the summer.

through the knock-on pressure on public and private liquidity in other markets, as has been seen, to varying degrees, in emerging markets around the world in response to the Southeast Asian crises, as investors have apparently rethought their appetite for emerging market risk. This has the potential to spark repayment and debt rollover problems even in countries where the underlying fundamentals are basically sound.

through the risk of countries becoming caught in a deflationary spiral, as several suffer increased competitive pressures due to depreciations elsewhere, and others enter post-crisis recessions.

The United States has a very strong stake in the restoration of confidence, sustainable flows of capital and a return to growth in countries where financial problems have become most serious. Equally, we have a strong stake in avoiding further contagion to other emerging economies. It is a stake based on the growing importance of these countries as markets for our exports. And it is a stake based on our recognition that a prosperous, integrating Asia is very much in a broader strategic interest.

III. The Response to These Crises To Date

Two programs of exceptional emergency international assistance have been provided in Southeast Asia in recent months -- both of them under the auspices of tough IMF-supported adjustment programs. In the case of Thailand, the support took the form of a $4 billion IMF standby facility, conditioned on the implementation of a major macroeconomic and financial reform program. A further $13.2 billion, also conditioned on the IMF program, was made available by the World Bank, the Asian Development Bank, and a range of Thailand’s closest trading partners in the Asia-Pacific region, including Japan.

In addition, to express additional strong support for the program, a number of countries, the United States among them, agreed to participate in providing short-term liquidity as a bridge to official disbursements, under the auspices of the Bank of International Settlements. To date the Thai authorities have not made a request for such support.

Just under two weeks ago, the IMF and the Indonesian government announced a substantial program of official emergency assistance for Indonesia, conditioned on a strong effort to achieve an orderly adjustment of the domestic economy and restore confidence to financial markets. The assistance centered around a $10 billion IMF standby facility, to be supplemented, in line with the IMF program, by $8bn from the World Bank and ADB, and a further $5 billion from Indonesia’s own reserves.

We joined a number of other countries in the region in expressing a willingness to provide contingent financial support for Indonesia -- as a temporary "second line of defense" -- in the event that unanticipated external pressures were to give rise to a need to supplement Indonesia’s own reserves and the resources made available by the IMF. In such circumstances, and assuming that Indonesia were able to meet the necessary conditions, including any additional policy measures that were deemed necessary, we have offered to extend up to $3 billion in temporary supplemental financing to help rebuild market confidence.

Our participation reflected our concerns about the risks of further contagion, our desire to join a number of other countries in showing support for the program, and our desire that it should succeed. The funds would be made available from the Exchange Stabilization Fund at appropriate interest rates, and if they were ever disbursed would carry proper safeguards to limit the risk to American taxpayers, ensuring that the Indonesians remained in a position to repay the funds in full and on time.

The adjustment program commits the Suharto government to implementing a radical restructuring of the domestic financial sector and significant measures to deregulate and open the economy and improve the quality of governance and transparency. In this sense, the program will directly affect a broad range of exclusive privileges that have been extended to Indonesia’s ruling elite. We are confident that rapid implementation of this strong adjustment program will offer Indonesia a strong chance of restoring stability and growth -- growth that would be all the more stable and widely shared for the structural and institutional reforms contained in the program.

I would like to note that the United States has spoken out within the World Bank and the IMF, in advancing the purposes of the Frank Amendment, to promote measures that would help improve the conditions of workers in Indonesia, Thailand and across the developing world. Workers’ rights issues will remain an important priority in the months ahead.

V. Going forward: the core elements of an effective response

The essence of an efficient global market is that prices reflect changing information about the investment opportunities available around the world and perceived risks. In such a market, prices will move -- in both directions. It is not the job of the international community to prevent these swings from taking place or to protect investors from their effects. However, in light of the Mexican crisis, countries have collectively recognized a need to safeguard the world financial system against the risk posed by whole economies, and entire regions, get caught in systemic crises as the result of cumulative financial market pressures.

As the world’s largest economy, with the world’s largest capital market, the United States has had a strong interest in promoting these efforts, which have included a major review of the international financial architecture initiated by President Clinton at the Halifax Summit. The importance of these initiatives has been underscored by events in Southeast Asia.

Although the precise means and modes of the international response to these situations are a subject of close and continuing review, there is broad agreement that an effective approach must comprise three core elements: prevention, a strong domestic response by the countries concerned and, finally, international support.

1. Prevention: improved transparency and surveillance

To guard against large-scale financial imbalances, and provide earlier forewarning when problems occur, countries need to develop effective formal and informal checks on imprudent behavior -- the very best, and simplest, of which are high levels of transparency and disclosure. To a far greater degree in than other markets, the ability of financial markets to work efficiently in channeling resources to their most effective uses stands or falls by the quality of information available to market participants. In addition, imprudent, or illegal behavior is much less likely where individuals and firms know that their actions will in time be revealed.

The special data dissemination standards (SDDS) developed by the IMF following the Mexican crisis have already made a significant contribution to governments’ efforts in this area. At the recent IMF/World Bank meetings in Hong Kong, the United States urged the exploration of ways of expanding these standards to include forward foreign exchange operations and more information on commercial banks, and encouraged their more widespread adoption.

More broadly, the international community needs to work to help countries develop the effective supervisory and regulatory systems, and the strong legal and financial infrastructures needed to underpin a robust financial system. The Basel "Core Principles for Effective Banking Supervision", the end result of a United States-supported initiative launched in the summer of 1996, now provide a basis for countries to enhance the safety and soundness of their financial system. Similar standards for regulating securities firms are also in the pipeline. It may also be useful for countries to explore effective ways to prevent very rapid increases in the short-term external liabilities of domestic banks and corporations.

Experience has taught that permitting the participation of foreign financial institutions -- with all the competition, capital and expertise which that implies -- can enhance a country’s capacity to develop a strong and stable domestic financial system. We have discovered in America that inter-state banking is more diversified and more stable. In the same way, greater internationalization of finance can reduce risks at the same time as lowering the cost of capital.

2. A Strong Domestic Policy Response

As the Mexico crisis has shown, a credible commitment to sound policies is the first and vital prerequisite for restoring stability. And in the atmosphere of distrust that defines these episodes, credibility has to be earned, through rapid and transparent implementation.

Governments must prove to the markets that they are committed to making the macroeconomic policy adjustments needed to put their economies back on a sustainable path -- and that they have the political will necessary to translate that commitment into actions. And they will need to make equally credible commitments to undertake reforms to strengthen domestic financial systems, and to work to develop effective and transparent supervisory and regulatory institutions, and strong legal and financial infrastructures to underpin those institutions.

3. Careful Provision of International Assistance

There will be circumstances where it will be important to mobilize the capacity to provide international support to countries to restore stability and prevent contagion. But it is important to focus on three core principles in deciding how to provide this most effectively.

The first is the principle of country and investor responsibility. While external assistance can help restore market confidence and limit contagion when decisive domestic adjustments are being undertaken, the primary burden of responsibility for both preventing and responding effectively to crises must continue to fall on the countries concerned. It is critical that in a global capital market, investment flows are based on investors’ perceptions of the underlying fundamentals of each country -- not on the probability of some kind of international support.

The second principle, following from the first, is that the IMF must remain at the heart of any international response, as the principal source of conditioned, international support for countries facing external financial difficulties. Its unique ability to provide apolitical, conditioned finance in the context of, and only in the context of, strong reforms, makes it the appropriate vehicle for providing support when crisis comes. These conditions are essential for keeping the responsibility to reform firmly on countries and limiting moral hazard.

Of course, we must ensure the IMF has the financial means and modes to be most helpful. In the new IMF Emergency Financing Mechanism, and the increase in quotas recently agreed to at the October IMF/World Bank meetings in Hong Kong, the IMF will have improved capacity to respond decisively to crises. Important added resource capacity would be made available by the New Arrangements to Borrow. The Administration’s request to participate in the NAB is still pending before Congress, and we hope that Congress will act on it favorably before it adjourns for the year.

A fully operational NAB would serve the United States interest in safeguarding international financial stability and ensure that we do not have to carry a disproportionate share of the burden of responding to crises. At the same time, it would help keep the international community’s response to these situations firmly anchored around the IMF, and ensure we had maximum leverage in demanding strict conditionality for any assistance.

Our third principle is to ensure that any regional cooperative arrangements complement the global objective of safeguarding financial stability. To that end we are exploring arrangements that would give the countries of the Asia-Pacific region a larger stake and voice in decisions affecting them, and reinforce the IMF’s capacity to act quickly and effectively at times of crisis. In this context we believe a forum for enhanced surveillance among countries in the Asia-Pacific region would be a useful step.

Any cooperative regional financing arrangement would have to be designed carefully to limit moral hazard risks. It would have to be restricted for use in association with IMF programs, only being made available to supplement resources provided by the IMF and the country’s own reserves, not risk undermining the IMF’s position as the major global provider of such assistance, and give countries flexibility to determine whether their participation is appropriate in a given case.

IV. Concluding Remarks

Mr Chairman, we live in momentous times. Around the world, we have been witnessing the emergence of a truly global economy, one in which trade, investment, capital, information and know-how can flow ever more freely, to ever more countries. As the members of this committee know well, American investors, our banks and our other financial service providers have been at the very forefront of these developments, creating new products, and seeking out new markets and investments -- both here in the United States and around the globe. And nowhere has the thirst for these new opportunities been greater, in recent years, than in the emerging markets of Southeast Asia.

As the events of recent months have unfolded there has been a natural temptation to look less favorably on these Southeast Asian economies, with many suggesting that the optimism about their future prospects has been misplaced. But the turbulence must be set against many years of spectacular growth and rising investor confidence. Recent events do not bring that long-term success into doubt. They do underline the principle that being a member of a more integrated world brings risks as well as opportunities -- and that governments and investors in Southeast Asia are no more immune to those risks than anybody else.

The task, for all of us, is to develop policies and institutions to minimize such risks, and which permit us to deal with financial problems promptly and effectively when they emerge. I look forward to working with you, Mr Chairman, with this Committee and others in Congress, and with our partners in the Asia-Pacific region and elsewhere, as we seek to meet this vital challenge.