Economic Report President

confidence, and a generalized increase in risk aversion may indeedhave played some role in the spread of the crisis in 1997-98 withinAsia, from Asia to Russia, from Russia to Latin America and otheremerging markets, and eventually to G-7 capital markets.One indication of increased risk aversion among investors is thesharp increase in sovereign spreads in the summer of 1998 (see Box6-4). Explaining so large an increase in spreads in many countrieswithout resort to increased risk aversion requires the unlikely assumptionthat the perceived probability of sovereign defaults had risen tovery high values in many emerging markets. For example, the sharpincrease in spreads experienced by Argentina, whose probability ofdefault was surely not extremely high, provides evidence of an increasein risk aversion.THE POLICY RESPONSE TO THE CRISISTHE ROLE OF THE INTERNATIONAL COMMUNITYThe international community (chiefly the IMF, the World Bank,the Asian Development Bank and the G-7) moved quickly to stemthe spreading financial crisis. The United States encouraged therapid development of financial stabilization packages to respond torequests for support, first from Thailand in July 1997 and later fromIndonesia and Korea. As a condition for financial assistance, theIMF has generally required substantial economic reforms, includingbanking sector restructuring and, initially, fiscal discipline and themaintenance of high interest rates to curb capital outflows and currencyattacks. The objective of these programs has been to restoreinvestor confidence by tackling the root causes of the crisis in eachcountry. For this reason, the programs went beyond addressingmajor fiscal, monetary, or external imbalances, and sought tostrengthen financial systems, improve government policymakingand corporate governance, enhance transparency of policies and economicdata, restore economic competitiveness, and modernize thelegal and regulatory environment. The IMF’s practice of making itslending dependent on such policy programs, which it continues tomonitor and enforce as funds are being disbursed, is termed “conditionality.”The IMF makes every effort to work with countries toidentify reforms consistent with their circumstances, and the conditionsnegotiated can be altered over time if the economy does notrespond as expected.In the Asian crisis, the IMF-supported programs evolved as thedimensions of the crisis became clearer. The Indonesian caseprovides a striking example. The initial IMF package of October1997 required strict fiscal discipline. In June 1998 a renegotiatedagreement allowed the country to run a budget deficit of as much as245