The Joint Conference of African Ministers of Finance and Ministers of Economic Development and Planning

ECA's Thirty-third session of the Commission/Twenty-fourth meeting of the Conference of Ministers/Seventh Conference of African Ministers of Finance
6 - 8 May 1999 Addis Ababa, Ethiopia

VIII. The Impact, Lessons and Policy Implications for Africa of the Asian Crisis

93. Asia has been the world's economic miracle for the last 30 years, experiencing dramatic economic growth and poverty reduction: stable growth in per capita income of 5 per cent and above with few downturns, and a fall in poverty from 64 per cent in 1975 to 11 per cent in 1995. But significant gains from decades of progress were wiped out remarkably quickly by turmoil in the region’s financial and currency markets. Combined GDP growth in Korea, Indonesia, Malaysia, Thailand and Philippines declined from a pre-crisis level of 7 per cent to negative 7 per cent in 1998, and unemployment has reached 18 million, up from 5.3 million in 1996. Africa has as much to learn from the development strategy that created the miracle as from the errors that undermined it.

94. The East Asian crisis, which began in 1997, had ripple effects throughout the world economy. It occurred despite a benign international economic environment, with low international interest rates and solid global growth of output and trade (World Bank, 1998a). As is usual with most financial sector crises, the East Asian crisis was generated by multiple factors, which were rooted mainly in private sector financial decisions against the backdrop of financial sector weaknesses, easy global liquidity, external sector and foreign currency problems and contagion from Thailand to other countries. Public sector borrowing was not a factor in generating the crisis (Goldstein, 1998). A synopsis of what went wrong is essential for a discussion of issues and lessons of relevance to Africa.

95. The growth of bank and non-bank credit to the private sector exceeded by a wide margin the already rapid growth of the real economy. The credit boom, which was fueled in part by large net private capital inflows, was directed to real estate (and largely to other non-tradable) and equities. This over-extension and concentration of credit in non-exportable goods and services sectors left the economies vulnerable to a shift in credit conditions or to a reversal of capital flows. When the shift came, it brought down property prices and increased the share of non-performing bank loans in bank asset portfolios. In addition, the 1990s were a time of bountiful global liquidity conditions with over $420 billion in net private capital flows to Asian developing countries alone, which reduced spreads, lengthened maturities, and weakened loan covenants (Goldstein, 1998). This was in addition to the fact that most of the affected countries already had run moderate-to-large current account deficits in the 1990s. Furthermore, competitiveness of the affected countries was waning as a result of the appreciated real effective exchange rate, sharp slowdown in merchandise export receipts and a perceived shift in regional comparative advantage vis-à-vis China. Thailand was hit first. Then the contagion of financial disturbance quickly engulfed the economies of South Korea, Indonesia, Malaysia and the Philippines.

96. Africa is impacted by the East Asian crisis through the contagion effects, which are transmitted through three major channels: trade, financial flows and the international environment in which African countries operate. The Asian countries most directly affected account for a relatively modest share of global economic activity — 3.6 per cent of world GDP, about 7 per cent of world trade, 6 per cent of global foreign direct investment (FDI) inflows, 4 per cent of FDI stock and less than 4 per cent of gross international bank lending. What is also known is that no country outside Asia relied on the markets of the five most affected countries for as much as 10 per cent of their total exports, or received as much as 10 per cent of its total merchandise imports from these countries. South Africa and Mozambique, which have the most extensive trade relations with Asian countries, contributed only 4.8 per cent, and 1.5 per cent, respectively, to imports of the Asian five in 1996. In the same year, the share of the Asian five in South Africa's imports was 4.1 per cent.

97. The crisis has had variable impact on different countries. Oil producers in Africa have carried the major burden. By the first quarter of 1998, oil prices had fallen by 21 per cent, as Asia was the largest net fuel-importing region since the early 1990s. Consequently, slower Asian growth has kept the price of oil under pressure, which has had a dramatic effect on Nigeria, Angola and Gabon, reducing their terms of trade by 23 per cent and their incomes by 8 per cent. Other commodity prices, which collapsed in 1996 and had not recovered at the onset of the Asian crisis, plummeted further due to falling demand in Asia. The fall in the price of minerals, agricultural products, and livestock prices—due to declining Asian demand — have negatively affected non-oil producing countries (Stiglitz, 1998). On the other hand, the same group of countries benefited from offsetting cheap oil imports. Primary product exports, which are linked to most of the FDI flows to Africa, have suffered.

98. On the whole, Africa has escaped the worst of the financial contagion effects. There are a number of reasons for this. First, as a result of the steadily improving policy environment, Africa is now less susceptible to external financial crisis. In contrast to Asian and Latin American countries, foreign capital inflows are mostly long term and government guaranteed, while private firms have relatively little exposure in foreign currency. Second, African countries are less integrated in the world economy than many other countries. Africa's escape from the financial contagion can be attributed in part to the fact that it has lagged behind other regions in opening up to world trade and private capital flows. Third, Africa's financial systems are still relatively underdeveloped — notwithstanding the financial liberalization in many countries. Banking systems in many countries are just emerging from long periods of weakness; and asset markets are rudimentary in many countries. While escaping the crisis is good news, the main reason for escaping is not such good news. It shows that despite the positive growth performance of African economies since the mid-1990s, little structural transformation and integration in the global economy has taken place.

99. Besides being bypassed by the crisis, the other good news is the lessons Africa can learn from it. As Calvo (1998) put it, for Africa, which has not yet suffered from capital flow volatility, the recent crisis has considerably improved the understanding of the issues and, thus, the continent’s capacity to cushion their effects. Moreover, while the immediate overall impact of the crisis appears minor there are likely to be second-round impacts in the medium-to-long run that could be far-reaching for Africa, as are some of the issues and lessons to be learned from the crisis by Africa. The crisis is a wake-up call to Africa as financial liberalization proceeds ahead of proper globalization.

100. How to cope with surges of capital inflows as Africa gears up for foreign direct investment and capital flight reversal for growth is critical to attaining macroeconomic and social stability. Even when the overall macroeconomic conditions look good, financial markets can create two kinds of illusion that channel money into wrong investments. One kind is produced by capital inflows themselves. Economic reforms and financial liberalization produce a spurt of capital inflows, which chase high rates of return. The inflows in turn lead to currency appreciation while the spending boom financed by the foreign flows leads to higher prices of non-traded goods, services and real estate — mainly non-traded goods and services that do not provide the wherewithal for future servicing of external debt. The short-run currency appreciation offers an incorrect reading of future relative prices. Given the fact that capital inflows must in the long run be paid for through increased net exports, the exchange rate is most likely to depreciate in real terms in order to service the capital inflows. Another kind of illusion can be created by financial market liberalization, which typically stimulates large-scale capital inflows. The deregulation and privatization of banks may give greater latitude to borrow from abroad. Such banks may operate under distorted incentives, borrow abroad and invest in the domestic economy with reckless abandon.

101. For Africa to avoid the above pitfalls, besides appropriate counter-cyclical macroeconomic policies, financial institutions must be strengthened and strict transparency standards in financial transactions and decisions must be enforced, including with respect to credit policies, disclosure rules, loan documentation and bank portfolio management. The supervisory and regulatory functions of central banks must be strengthened in order to enforce the rules and norms of prudent financial management among financial institutions and to ensure consistency of monetary aggregates with sustainable balance of payments and other macroeconomic account profiles.

102. The potentially destabilizing effect of short-term debt has been demonstrated by the Asian crisis. Virtually every country with short-term debt greater than reserves had serious financial trouble in 1997 (Stiglitz, 1998). The composition of foreign borrowing is as important and deserves as much attention as the overall debt burden. In particular, a high and rapidly rising share of short-term debt to net international reserves has become a red flag for financial operators (Goldstein, 1998). This is a situation African countries should avoid. Debt management must be vigilant in order to avoid an unsustainable term structure of private and public debt obligations.

103. A second-round impact on Africa’s exports and output in the real sectors is a real possibility. The demand for Africa’s commodity exports could be more severely affected than the evidence hitherto shows. The devaluation of currencies of some Asian countries that produce commodities in competition with Africa — e.g., oil palm — could result in lower demand for African exports because of higher costs in foreign currency terms of buying from Africa. So, Africa must take the necessary steps to remain competitive in light of currency realignments in the wake of the Asian crisis. What are the most appropriate steps to take in preparation for this possible eventuality?

104. The Asian crisis and its spillover effects have also revealed weaknesses in the international financial system of which Africa needs to be aware, including the folly of leaving development finance purely to "international financial markets". Experience has shown that these markets are not always able to perform this function properly, not only for the majority of poor countries, which are typically bypassed by international capital flows, but also for the so-called emerging markets. In these markets, benefits of surges in capital inflows can be more than wiped out by outflows that follow. This makes the process of managing and financing development extremely difficult. Any discussion of the reform of the "international financial architecture" would need to focus on its role in the provision of "development finance" rather than just managing financial instability per se.

105. Related to the special development funding requirements of the poor countries is the need to take a critical look at the applicability to developing countries of the liberalization of the capital account — a policy goal of recent years. The current financial crisis has demonstrated the inappropriateness of abrupt or premature liberalization of the capital account. It has proved too difficult for developing countries that liberalize the capital account to adapt to the conditions generated by volatile international capital flows. As pointed out by Stiglitz (1998a), capital account liberalization without the development of policies to protect, or insulate the domestic economy from the instabilities engendered by huge, external, and particularly short-term resource flows is a direct prelude to disaster. Capital account liberalization in developing countries has to be adopted in a gradual fashion. It should follow full liberalization of the domestic financial market, the development of a system of risk management and adoption of an appropriate exchange rate policy, and in all cases should not be undertaken before or simultaneously with action to float the exchange rate.

106. The above discussion indicates, as is now widely acknowledged, that the present system is badly equipped to prevent financial crises, and only partly equipped to manage them. (UN, 1999). There is a need to modernize the system to catch up with the rapid expansion of private capital flows, and to lessen its vulnerability to financial shocks. Reform must encompass a number of interrelated aspects of crisis prevention, management and resolution. Reforms should entail measures to strengthen global consistency of macroeconomic policies—in order to avoid at the global level inflationary and deflationary biases — financial regulations, private sector involvement in forestalling and resolving crisis situations (Ouattara, 1998), and the international institutional architecture. Institutional strengthening would aim at provision of key services more effectively: the coordination and surveillance of global macropolicy; enhanced transparency in financial transactions; a strengthened interface between financial institutions; provision and better management of adequate international liquidity, as well as development funds to the poor countries.

107. At the practical level, different proposals and issues associated with them are being actively debated, and will be a major item on the agenda of the forthcoming G-7 meeting in Cologne, Germany in June 1999. Africa should take a keen interest in the debate. Related to the essential elements of reforms outlined above, the debate focuses on how to strengthen or reform the present international financial system to prevent a recurrence of crises; to respond and resolve them quickly — should they occur, and to strengthen institutional mechanisms to best support stable global financial markets. Central to the crisis prevention debate is the question of fostering better policies and more effective institutions at the national level, including sound macroeconomic policies, robust financial system and sound infrastructure — economic, social, governance, judicial, accounting, auditing and reporting. The issue here is how to develop and agree on international standards, principles and practices on all aspects of national policy and institutions that are judged to be of central importance for successful integration in the international financial system. A key element in the crisis response and resolution debate is the contentious issue of how to strengthen the international-lender-of-last-resort function, while addressing moral hazard and ensuring that the private sector is sharing appropriately in the risks. Coping and transition issues for countries in crisis are also under active debate — provision of emergency financing, financial restructuring and mitigation of the social and human costs of financial crises. Institutional strengthening or reform has elicited hot and sometimes emotional debates, including calls — mostly by non-G-7 countries — to scrap the IMF and possibly start regional financial institutions to parallel the IMF. However, no proposals have been comprehensively and openly debated; nor have alternative architectural forms of a possible new system been unveiled to the public by G-7 countries, which hold the trump card. The G-7 meeting in Cologne is expected to look at these issues.

108. An important aspect of the package of reforms to the international financial system currently under debate is greater transparency on the part of all private, public and multilateral participants in the world economy. Towards this objective, new, stringent and streamlined reporting requirements are under consideration by the IMF. The General Data Dissemination System (GDDS) and the Special Data Dissemination System (SDDS) are intended to foster transparency of economic information and financial flows under globalization. From Africa, only South Africa is currently a participant in the systems, which are likely to become important disclosure mechanisms that private investors are likely to follow keenly in their decisions on where to invest. There is a clear need to widen Africa’s participation in the GDDS and SDDS. Already thin in statistical capacity, Africa will be hard pressed to comply with these requirements. A regional strategy is needed to build national capacities to enable active participation in these reporting and disclosure processes.

109. The Conference may wish to share views on the issues and options currently being debated in the international community with regard to how best to reform or strengthen the international financial architecture. Ministers may further wish to discuss and adopt a follow-up plan to make the voice of Africa heard in the deliberations and to strengthen regional capacity to participate in the new economic and financial information disclosure processes.

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Appendix Table 1: Africa: Macroeconomic Performance, 1990--1997

Source: IMF data, 1998

Appendix Table2: Summary Indicators of ODA Flows to SSA, 1975-1996

Source: World Bank, (1998/99), African Development Indicators, p.305 and p.309.

Appendix Table 3: Aid Dependency Measures

Note: * Aid as percent of GNP

** Aid as percent of Gross domestic investment

*** Aid as percent of Imports

Source: World Bank World Development Report, 1998

Appendix Table 4: African countries: A selected FDI stock indicators, 1987 and 1996

Source: UNCTAD, FDI/TNC database.

A Ranked according to 1996 values of the indicators; countries shown are those with values of at least one indicator exceeding the African average.