The entire world has a big stake in the successful resolution of the Asian financial crisis. If Asia enters a downward spiral of economic collapse and financial default, the consequences will be severe not only for the billions of people of Asia but for the rest of the world as well. Just last week, the credit rating agencies threatened to downgrade leading European banks because of their exposure to Asia. Growth forecasts for Europe and the United States in 1998 are already being scaled back, though still only modestly. The stock markets in the U.S. and Europe could easily suffer a sharp contraction if the Asian crisis intensifies.

For these reasons, we should care strongly about the quality and design of the "rescue" programs launched by the International Monetary Fund in Indonesia, Korea, and Thailand. While it is admittedly too early to declare victory or failure of these IMF programs, the initial results are discouraging. In all three countries, the currencies have continued to plummet even after the IMF offered tens of billions of dollars in rescue funds. Stock exchanges in these countries have similarly continued to fall. As of late December, all three countries had their credit ratings downgraded to "junk bond" status.

How can we account for this poor start to the IMF packages? The main problem is a failure of the IMF to diagnose the situation accurately. Asia is suffering from an acute financial panic, in which the once-euphoric international investors who poured money into Asia are now fleeing the region at a dramatic pace. They are fleeing partly because of newly-discovered weaknesses in Asia, but mostly because the other investors are fleeing. Nobody wants to be the last one caught with money in Asia if everybody else is withdrawing their investments. Since Asia’s banks borrowed short-term funds from abroad for long-term domestic investments, there are not enough short-term assets around to allow all investors to get their money out of Asia if all of the investors simultaneously decide to flee the region, as is now happening.

The financial panic is leading to a downward spiral of the banking system and economic output. As the investors flee, and the Asian currencies crumble, the banking systems of Asia are put against the brink of collapse. Since the banks are large net international debtors, who have borrowed from abroad in dollars (and yen) to re-lend domestically in local currency, the balance sheets of the banks worsen every time the Asian currencies fall further. The banks then stop lending funds, and the economies collapse further. This, in turn, incites the investors to flee even faster.

The IMF "remedy" so far has been to tighten credit and close banks, on the grounds that tight credit and high interest rates will attract funds from abroad. The bank closures are meant to prove the resolve of governments to get their financial houses in order, thereby "calming" the markets. Unfortunately, the outcomes have been different from the IMF’s theory. Bank closures have led to panic. As some banks have been closed, the other banks in Asia have stopped lending out of fear that they too will be closed. High interest rates, rather than inspiring confidence, have raised the specter of widespread bankruptcy. As a result of these factors, depositors (both foreign and domestic) have decided that it is time for them too to flee the country for fear that their own bank balances will be frozen or closed. An internal IMF document, reported in the New York times, acknowledged that the IMF-inspired bank closures in Indonesia in November actually produced a banking panic.

With confidence in Asia so deeply undermined, there is no easy remedy to the current crisis. It is clear, however, that restoring the functioning and confidence in the Asian banking system is a crucial priority. Rather than closing banks, the IMF should be focusing on helping the Asian countries to re-capitalize their banks so that the banking sector can once again do its crucial job of providing capital for industry. The Japanese Government, as the largest economy and major creditor in the region, can play a leadership role in fostering confidence and providing credit to the region so that the current panic does not turn into a collapse of economic activity.

Last week the Japanese Government wisely announced its intentions to use public funds to bolster its own banking system and to help support the Asian economies. This announcement led to a strong rally of the Asian currency and stock markets. Clearly, the financial markets hunger for more Japanese leadership in the region and less IMF-induced austerity.

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