1. 1 Lessons of The East Asian Crisis Joseph E. Stiglitz Senior Vice President and Chief Economist, Development Economics The World Bank August 26, 1998

2. 2 Outline of the Talk 1. Introduction 2. The East Asian Crisis 3. Financial Systems and Growth 4. Responding to International Capital Flows

3. 3 Table 1: Fiscal Costs of Selected Banking Crises (percentage of GDP) Country (Date)Cost (percentage of GDP) Argentina (1980-82)55.3 Chile (1981-83)41.2 Uruguay (1981-84)31.2 Israel (1977-83)30.0 Cote d’Ivoire (1988-91)25.0 Senegal (1988-91)17.0 Spain (1977-85)16.8 Bulgaria (1990s)14.0 Mexico (1995)13.5 Hungary (1991-95)10.0 Finland (1991-93)8.0 Sweden (1991)6.4 Sri Lanka (1989-93)5.0 Malaysia (1985-88)4.7 Norway (1987-89)4.0 United States (1984-91)3.2 Source: Caprio and Klingebiel 1996.

4. 4 Figure 1 GDP Growth Before and After Banking Crises, 1975-1994 Mean GDP growth (annual percent) SOURCE: Caprio 1997

5. 5 Key Aspects of the East Asian Crisis 1. Not public sector profligacy, but private sector borrowing. 2. Not overall indebtedness, but the type of borrowing and use of funds. 3.Not just borrowers, but also lenders.

6. 6 Figure 2 Public Sector Balances: Latin America versus East Asia SOURCE: World Development Indicators, 1998

7. 7 Figure 3 Inflation: Latin America versus East Asia SOURCE: author’s calculations based on World Development Report 1998

8. 8 Figure 4 Total External Debt-Exports Ratio in 1996 Percent SOURCE: Global Development Finance 1998

9. 9 Figure 5 Office Vacancy Rates, 1996 (% of space vacant) SOURCE: JP Morgan Data and Estimates 1996 1997-99 (projected)

10. 10 Figure 6 Short-term Debt-Exports Ratio in 1996 Percent SOURCE: BIS, World Development Indicators 1998, and author’s calculations.

11. 11 Figure 7 Non-Performing Loans (as a % of total loans) Percent

12. 12 Table 2 Foreign Currency Debt Ratings Country June 1996 June 1997 March 1998 IndonesiaBBB B KoreaAA- BB+ MalaysiaA+ PhilippinesBBBB+ ThailandAA BBB- SOURCE: Standard and Poor’s

13. 13 Importance of Financial Markets Collecting and aggregating savings Brain of the Economy: Allocating capital, selecting investment projects Monitoring Other Functions: Reducing risk Increasing liquidity Conveying information

14. 14 Why the Financial Sector is Different Financial sectors are essentially concerned with information General Theorem: Whenever information is imperfect, markets are not constrained Pareto optimal Two Information Problems: Selection Monitoring Information is Like a Public Good Free rider problems

15. 15 Principles of Reform 1. Rules contracts, bankruptcy, disclosure. protections for shareholders in securities 2. Information 3. Regulation ensuring safety and soundness promoting competition consumer protection promoting access to underserved groups 4.Incentives eg. enhance franchise value in banks

16. 16 Figure 8 Long-term Capital Flows to Developing Countries 1997 SOURCE: Global Development Finance 1998

17. 17 Evidence on Capital Account Liberalization Increases risks No discernable benefit for growth or investment Short-term flows: volatility costs of sterilization

18. 18 Figure 9 Economic Growth, Investment, and Capital Account Liberalization SOURCE: Dani Rodrik (forthcoming). These are the residual growth and investment/GDP that are not explained by per-capita income, secondary education, quality of government institutions, and regional dummies for East Asia, Latin America and Caribbean, and Sub-Saharan Africa.

19. 19 Policies to Reduce Vulnerability to Capital Volatility Traditional policies: Good macroeconomic management. Sound financial regulation and oversight. Transparency. Policies to affect composition of capital flows Eliminate distortions favoring short-term flows. Prudential regulations to restrict currency exposure. Possibly inhibitions on short-term flows (Chile).

20. 20 Managing Crises Expected return = promised return X probability of repayment. Additional considerations: Risk adjustment. Insiders vs. outsiders. Adverse selection and credit rationing. General equilibrium credit crunch.