Remarks by Edgardo B. Espiritu
Secretary of Finance, Republic of the Philippines

I would like to thank the Pacific Basin Economic Council for this opportunity to share with you my ideas today. The world economy is now facing the worst threat it has experienced since the end of the Second World War. It is clear that most of us, including those from the crisis economies themselves, have underestimated the magnitude and duration of the crisis that started in Asia. But now, I think that even the industrialized countries of North America and Europe whose economies have been performing rather well in recent years and months, particularly the United States, have already realized the gravity of the problem. It is clear that most, if not all, countries will be affected by the crisis and that things are likely to get worse before they get better. That is, if no strong and positive action is taken, not just by the crisis economies but by all countries, acting individually and through the multilateral institutions and regional and international organizations.

I have been requested to remark on what governments should do to address the crisis. But before going into the measures that have to be undertaken, it is logical to first look into the causes of the crisis, or the factors that precipitated it.

There are, I believe, two sets of factors:

The first set relates to changes in the world economic and financial systems resulting from global trends in the last few decades.

The second set pertains to the character of the internal structures and policy regimes in individual countries, matters relating to systemic deficiencies and governance issues.

With regard to recent global trends, the most significant of all the context of the present crisis, is of course the much greater integration of the world's financial markets, as reflected by the geometric increase in the volume and speed of capital flows across international borders. The factors behind this trend are well-known:

First, dramatic advances in telecommunication and information technology have made possible the almost instantaneous exchange of information, funds and values around the globe. Now, it is possible for someone with a personal computer to transfer millions of dollars from one market to another in a matter of seconds.

Second, much of the world, particularly the industrialized economies as well as the emerging economies, has undergone substantial financial deepening in the last two decades. More people have their savings in the form of stocks and bonds. This is certainly true in the United States today, such that swings in the stock market, for example now affects the wealth position of a much larger proportion of the population than they did before. Moreover, investors in one country do not limit their holdings toassets denominated in their own currency. They now hold, either individually or through giant investment funds, assets denominated in foreign exchange. And most of the time, these assets are held not just for their intrinsic rates of return, but more importantly for possible foreign exchange gains.

Third, the emerging economies, to whom much of the capital flows have been directed, have themselves facilitated the process by quickly liberalizing their capital accounts. In particular, short-term capital inflows into their equity and bond markets were encouraged.

The greater integration of financial markets, to be sure, has a good side. It enables the usually capital-short developing countries to pursue useful, productive but otherwise unaffordable programs and projects that will help speed up the process of growth. It facilitates the efficient allocation of capital worldwide by allowing funds to go to uses where they will earn optimal rates of return. It provides a more manageable and less socially and politically complicated alternative to the movement of other resources, such as labor which also tends to move to where more and better employment opportunities are.

But the accelerated movement of capital, particularly short-term capital, clearly also has its downside. First, this meant greater volatility in capital flows. The so-called "hot money" can leave just as quickly as it came in. Moreover, this is aggravated by what has come to be known as "herd mentality" or behavior among international investors, particularly the large fund managers. During good times, investors tend to outdo each other in rushing into a particular market for fear of being left behind in capturing the gains; but with a slight reversal of confidence, they again try to rush out for the opposite fear of being left holding the bag. This kind of behavior has, as we have seen resulted in the sudden and drastic drying up of foreign capital in the crisis economies when investor perceptions changed.

The second set of factors pertain to deficiencies in the internal structures and policy frameworks of individual economies. These weaknesses make these economies and their currencies susceptible to speculative attacks and to limit their ability to cope with the crisis. The first of these refer to macroeconomic imbalances in the form of external or current account deficits and internal or fiscal deficits that some of these economies were running for prolonged periods. These imbalances often imply that these economies are depending substantially on foreign funds to finance growth at a rate that is faster than what their internally generated funds can afford. This is not necessarily a bad strategy. But the important question that has to be addressed is that of sustainability. Problems arise when capital flows are mostly in the form of short-term portfolio inflows rather than of the more stable foreign direct investments; or when the stock of foreign debt has become so large that debt service eats up a big part of foreign exchange receipts. A country faces an even bigger problem if the foreign capital were not used for productive purposes in the first place. Moreover, the situation is exacerbated if the risks and returns on foreign exchange denominated assets are not properly evaluated by investors as a result of a managed exchange rate regime adopted by the government.

Secondly, a country may have weaknesses in its financial system. Its banks and other financial institutions may be inadequately capitalized. Bank supervision and regulation may be weak. Bank examiners may be inadequately trained and inexperienced. There may be a lack of consistent and generally accepted accounting standards, or these may be unevenly applied. The result would be limited transparency in the operations and actual financial condition of banks. This would mean inability on the part of the authorities and the public to detect potential problems regarding these banks. Likewise, the banks may have weak credit policies and processes that lead to a Iow-quality portfolio. Moreover, banks' exposures may be heavily concentrated in certain areas such as real estate. Another kind of overexposure is in terms of foreign exchange-denominated loans, which again is partly due to the adoption by the authorities of a managed exchange rate system.

A third set of internal factors are those that concern public sector and corporate sector governance. Again, lack of transparency may be a problem, with scanty information on the finances and activities of corporations. Also, certain corporations may not be internalizing the full costs of their ventures in terms of risks as a result of both explicit and implicit guarantees or subsidies from the government. This would lead them to over-expand and to engage in very risky activities. In certain countries, moreover, there exists very close albeit not very obvious links between the government and certain large corporations. In the extreme case, this comes in the form of cronyism. A more traditional and more obvious problem is graft and corruption. But equally important as sources of wastage in the use of public resources are bloated bureaucracies and inefficient public corporations.

What I have been discussing is a sort of stylized description of the characteristics of the crisis countries. But we must realize that there are significant distinctions among these countries. In the case of the Philippines, it may be noted that in spite of its being in the center of the region where the crisis began, it has shown considerable resilience.

The numbers show this Economic growth in the Philippines remains positive. Although the first semester 1998 GDP growth is very modest at 0.2%, this still stands out compared with the negative 3% average growth rate for the ASEAN region. Moreover, this growth was achieved despite a 7.5% drop in agricultural output, which came as a result not of the regional financial crisis but of the El Nino drought. Inflation remains moderate, at 8.4% for the first eight months of the year using the old 1988 CPI basket or 9.3% using the 1994 basket. Exports continue to be a bright spot in the economy, growing robustly at 19% for the first seven months of the year, the highest export growth in the region where almost all the other countries are experiencing falling exports. The Philippine banking sector likewise remains strong and stable. The average capital adequacy ratio of Philippine banks is 14%, compared with the range of 8%-12% for other ASEAN countries. The nonperforming loan ratio is also relatively Iow at 9.7%, compared with the ASEAN range of 18%-46%, or even 75% (in the case of Indonesia).

The Philippines has certain key distinguishing characteristics that enabled it to weather the crisis well. First, it has undertaken reforms much earlier on that improved the structure of the economy. These reforms include the liberalization of trade, investments and the foreign exchange markets; the deregulation of the financial system and of the oil and power industries; tax reform; and privatization.

The second distinguishing characteristic of the Philippines is its working democratic political system. The new government assumed power with one of the most popular mandates in Philippine electoral history. This smooth, peaceful transfer of power, which has taken place in the Philippines thrice since 1986, can hardly be found among the other countries in the region.

Third, the prudent management of the country's external debt position has resulted to the continuous improvement in debt service ratios, which steadily declined from 17% in 1992 to about 12% currently.

Fourth, as I already mentioned the Philippine banking sector remains strong as a result of comprehensive banking reforms that have already been undertaken. These reforms started in the early 1980s, when the Philippines went through a difficult financial crisis. Further reforms are currently being pursued aimed at greater transparency, enhanced capital adequacy and asset quality, and stronger bank management.

Fifth, Philippine trade with countries in the region makes up a relatively small proportion of its total trade, at only 12% compared with 15%-23% for other ASEAN countries. This indicates that the downturn in the region is not expected to affect Philippine exports that significantly.

But we have not escaped the effects of the regional crisis. We are feeling them. And we are exerting all efforts to respond to the crisis. This brings me to the question at hand, which is what governments should do to address the crisis.

I think the answer already flows from the analysis of the causes and factors behind the crisis. Let us go to the internal factors first. If the problem lies in weak structures and policies, then what must be done is to strengthen those structures and rationalize the policies. First of all, governments must maintain sound macroeconomic policies. They must adopt prudent fiscal policies, meaning they should aim for fiscal balance. But the qualification here is not if it would mean pushing the country into a recession. A manageable amount of fiscal deficit is justified as a counter-cyclical measure, that is, to take up the slack in private demand during an economic slowdown, such as what is happening today in Asia. But in the medium-to-long term, governments must aim to balance their budgets. And this will be done through government expenditure reform aimed at greater efficiency in the use of government resources and a clear definition of priorities, as well as through tax reform aimed at increasing the efficiency of the tax administration system and broadening the tax base. And since the tax system significantly influences business and investor behavior, governments must also pay attention to the equity aspects of the system. Taxes that put an unduly heavy burden on savers and investors, for instance, should be removed or rationalized.

Governments must likewise maintain prudent monetary policies aimed at keeping inflation Iow and limiting the growth of liquidity to what is needed for the steady, sustained expansion of business. We all know that excessive inflation will hit the poor hardest and will eventually translate into higher interest rates, and thus also to a slowdown in the economy.

Basically to address the other imbalance, namely the current account deficit, the government must adopt a truly market-based exchange rate policy and continue to promote exports. As a reaction to the speculative attacks on currencies that they have experienced, governments may be tempted to impose currency controls. But they must resist this temptation. Whatever short-term gains that may be achieved, if any, are not worth the long-term harm on the economy that will result from such controls. Controls will only breed corruption and lead to capital flight.

Just by keeping the foreign exchange markets free, the government in many cases is already helping exports, for then they will not be disadvantaged by an overvalued currency. But some positive action should also be taken to help exporters remain competitive, and this can be done primarily by helping them modernize and update their productive facilities and technology.

With regard to the banking and financial services sector, we have already mentioned some of the appropriate reforms to be undertaken. The important objectives here are to ensure that banks are adequately capitalized and that the quality of their loan books and other assets is at an acceptable level. This can be achieved by, among others, requiring more adequate loan loss provisioning, hikes in minimum capitalization, and stricter monitoring of loan portfolios and credit processes. Another important objective is to foster greater transparency in banks' operations and financial position. This can be achieved through the adoption of consistent and internationally accepted accounting and auditing standards and a closer monitoring and supervision of banks' financials, including their foreign exchange position. Another objective is to ensure that banks' management meets a certain standard of competence.

Governments will also do well to continue liberalizing their banking and financial services sector, allowing more foreign players. But this should be done at a pace that is suitable to their particular markets and in a way that will ensure that the benefits of greater competition and transfer of technology are attained.

With regard to reforms in public sector and corporate governance, again, greater emphasis should be given to transparency, accountability and consistency in policymaking and implementation. The civil service must be reformed toward greater efficiency and graft and corruption must be fought. With regard to the latter, legal and other action must be directed not only to the erring civil servants but also to the corrupters from the private sector.

Systems must also be set up for the closer monitoring and supervision of the corporate sector. This can be done through the adoption of uniform accounting and auditing standards, strengthening of the securities and exchange regulatory bodies, and legislating and updating bankruptcy laws.

To address the "moral hazard" issues I mentioned earlier and ensure the proper assessment and bearing of risks, the subsidies, incentives or guarantees given to various firms under existing laws and policies should be reviewed and rationalized. One of the basic objectives here is to ensure a level playing field in all sectors. Relatedly, efforts should likewise taken to strengthen the systems of property rights, taxation, and laws governing general commercial and financial transactions.

Of course, what is important in all these reforms in governance are not so much the nature and direction of the reforms but the political will to strictly and consistently implement them. This political will, in turn, is often a function of the strength of the government's mandate from the people.

But the government's responsibility in the context of the crisis does not end with its good housekeeping functions and adoption of the correct economic policies and programs. The crisis has a large social dimension. It has severely affected large sectors of society and will continue to do so for some time before the correct economic policies put in place by government can bear fruit. It is therefore important for government to provide safety nets for these vulnerable sectors before the crisis can inflict permanent damage on them. Government should therefore ensure that these sectors are provided with basic social services, such as education, basic healthcare, nutrition and housing. It should likewise address the increasing unemployment and underemployment resulting from the crisis. This can be done through the government's pump-priming efforts, and in collaboration with the private sector, through various forms of temporary unemployment assistance, including retraining.

But to ensure efficient use of assistance funds, there should be a more focused targeting of the beneficiaries of the various programs. Specific sectors should be identified, such as the various types of urban poor, the small subsistence farmers, small entrepreneurs, and so on , and assistance programs most suited to them should be designed.

But no matter how sound a country's internal macroeconomic policies are and no matter how thorough and serious its housekeeping efforts are, it can still be affected by wild and sudden swings in investor confidence and international capital flows. It is true, however, that a country's ability to recover from the adverse impact of the crisis and to return to growth would depend on the extent it has put in place the structural reforms I talked about. On any event, I think that it is clear that the actions of no single country alone can lick the crisis. Coordinated and cooperative action by all countries, the multilateral financing and development institutions, and the various international groups is clearly needed to overcome this crisis. In the age of global integration, global solutions that involve everyone are required to address problems that affect a large number of countries.

The main roles of the various groups of countries and their governments can already be identified at this point:

Governments of the industrialized countries, including those in North America and Europe who are beginning to feel the pinch of the crisis only now, must endeavor to keep their economies open and expanding. This can be done through measures directed at stimulating demand as well as through longer term structural adjustment measures. In this regard, we were happy to hear about the 400 billion dollar package being put together by the Japanese government to recapitalize their banks. Going a bit further, the governments of the industrialized countries can help the crisis economies by, among others, helping to provide them with additional liquidity during these difficult times. In this regard, we were likewise glad to know that Japan, through the so-called Miyazawa initiative, is now providing a total of 30 billion dollars in various forms of assistance to its neighbors in crisis. We were likewise happy to hear from President Clinton in his speech before the joint meeting of the IMF and the World Bank of a package being put together by the G-7 countries.

As for the governments of the crisis countries themselves, they must continue to pursue the structural reforms and sound policies that we have already discussed extensively, as well as keep their economies integrated with the world economy.

In addition, governments of countries belonging to regional and other groupings can together explore various cooperative mechanisms for promptly detecting and responding to economic and financial crises. For instance, we in the ASEAN, together with certain other countries in the Asia-Pacific region, have come up with the so-called "Manila Framework" for this purpose. Under this framework, we have recently formed a Technical Surveillance Unit, which will be based in Manila for two years and which will be assisted by the Asian Development Bank. This Unit will provide technical and capacity-building assistance to ASEAN governments towards putting the surveillance mechanism into operation.

Let me conclude this presentation by reiterating that the return of global economic stability and growth should indeed be the concern of all countries. Everyone needs the help of everyone else. After all, it is merely stating a truism to say that the problems of an integrated global economy can be solved only within the framework of international cooperation.

Thank you.