East Asian economies

 

East Asian economies

 

Gold from the storm

 

Jun 28th 2007 | HONG KONG, MANILA AND SEOUL
From The Economist print edition

 

Ten years after Asia's financial crisis, the region is booming again. Has it fully recovered or are economic mistakes being repeated?

Reuters

 

IT IS an unhappy anniversary: July 2nd 1997, the official start of the catastrophic Asian financial crisis. on that day Thailand ran out of foreign-exchange reserves trying to defend its currency from a huge speculative attack. It was forced to float the Thai baht, which promptly plunged. The meltdown quickly spread as investors pulled their money out of countries with similar economic symptoms?especially Indonesia, Malaysia and South Korea.

 

Hong Kong, the Philippines, Singapore and Taiwan were also hit by the maelstrom. Never before had the world seen capital flight on such a scale and speed, causing financial markets and economies to collapse. Ten years on, many believe that these economies have fully recovered. But others think East Asia may be heading for another financial shock.

 

The crisis of 1997 was different from earlier troubles. Unlike in Latin America, where most emerging-market crises had happened, East Asia boasted low inflation, balanced budgets and a remarkable record of almost 8% average growth over three decades. This made the shock all the more unexpected and dramatic.

 

Looking back, however, Asia's flaws had been plain to see: a combination of weak financial systems, a hasty opening of economies to foreign capital and a policy of tying local currencies to the dollar. The expectation that currencies would remain fixed encouraged banks and other local firms to borrow heavily in dollars at lower interest rates than at home. As capital flooded in, these borrowings soared, as did property values and share prices.

 

Much of this cheap money was squandered, as prestigious offices and swanky apartments sprouted across the region. As the dollar rose between 1995 and 1997 so did East Asian currencies, causing current-account deficits to widen. In 1996 Thailand's deficit reached 8% of GDP. once investors realised that this was unsustainable, capital took flight and the country's foreign reserves dwindled.

 

Once Thailand and others devalued, the crisis was about more than currencies. Devaluation caused foreign-currency debts to swell in local terms, resulting in widespread bankruptcies. Construction sites fell silent and their giant cranes stopped working as property bubbles burst and banks' bad debts soared. Feeble regulation and supervision had allowed alarming mismatches between assets and liabilities, so banks started to fail, prompting yet more capital outflows.

 

In desperation Thailand even encouraged people to hand over their gold jewellery to be melted down to boost the central banks' reserves (pictured above). At its low point the Indonesian rupiah had fallen by 86% against the dollar. The currencies of Thailand, South Korea, Malaysia and the Philippines were all down by 40-60%; stockmarkets suffered losses of at least 75% in dollar terms. Thailand, Indonesia and South Korea were humiliatingly forced to go cap in hand to the IMF.

 

In 1998 Indonesia, Malaysia, South Korea and Thailand saw their real GDP per head shrink by an average of 11%. Many millions lost their jobs. Thailand and Indonesia, the two worst hit, suffered a slump in GDP during 1997-2002 of around 35% relative to their potential output (assuming growth at its previous pace)?as bad as America's output loss during its Great Depression in the early 1930s.

 

Some foreigners were quick?too quick?to pronounce the Asian economic miracle dead. Rapid growth, they claimed, had been a sham based on governments pouring cheap money into favoured firms. Over-borrowing and over-investment had artificially boosted growth. Doomsayers predicted a decade of lost growth, as in Latin America after its 1980s debt crisis. one notorious sceptic of the Asian miracle was Paul Krugman, who had argued before the crisis that Asia's growth was the result of “perspiration rather than inspiration”, based on increasing inputs of capital and labour rather than productivity gains, and would therefore prove unsustainable.

 

But the slump came from financial excesses, not poor productivity growth. Indeed, most estimates suggest that productivity growth in East Asia had been much higher than in other emerging or developed economies. It is true that strong growth concealed wasteful investment, inadequate bank regulation and corruption, but the chief ingredients of growth?a high saving rate to finance investment and open markets?remained in place.

 

This is one reason why most East Asian economies recovered more quickly than many expected. The IMF bail-outs also helped to restore confidence, bolstered by reforms to restructure and strengthen banking. Income per head returned to pre-crisis levels in South Korea and Malaysia by 2000; in Thailand and Indonesia it took until 2003 and 2004 respectively.

Asia vu?

 

Ten years later, Asia's financial markets are booming again and the region is once more the envy of the world. Emerging Asia has grown by an annual average of 8% over the past three years?as fast as before the crisis. Thus it might seem there has been a full recovery. Some economic commentators believe that, thanks to all that restructuring and reform, the victims of the crisis are now more dynamic and resilient than ever. Others, however, fear another crisis is in the making. Who is right?

 

The boosters are guilty of over-optimism. The 8% average for regional growth includes China and India, which are the fastest sprinters and also have much bigger economies than they did ten years ago. The Asian Development Bank (ADB) estimates that in the five East Asian economies worst affected in 1997-98, the trend annual growth rate since 2000 has slowed by as much as two and a half percentage points, compared with 1990-96, to an average of just over 5%.

 

 

The main reason for this is that investment has not recovered. Capital spending accounted for an average of only 24% of GDP in these economies last year, down from 35% in 1995 (see chart 1). This compares with an investment rate of more than 40% in China and is little higher than in many rich economies where investment opportunities should be much lower. Before the crisis, investment was probably too high; now it is too low.

 

Public infrastructure, particularly in Thailand and Indonesia, is worse than a decade ago and business spending has been hurt by economic and political uncertainty. Having had their fingers badly burnt, firms are still cautious about taking on debt. The ADB argues that governments could do much to change this: from investing more in education and infrastructure, to stamping down on corruption and improving the regulatory environment. For all the rhetoric about bold change, the truth is that reform has been relatively limited outside the financial sector.

 

Several studies suggest that quality of governance is important for investment and growth. And sadly, some aspects of East Asian governance have worsened. The ADB uses data compiled by the World Bank to rate Indonesia, Malaysia, the Philippines, South Korea and Thailand relative to the rest of the world on six measures of governance: accountability, political stability, government effectiveness, regulatory quality, the rule of law and control of corruption. Comparing 2005 with 1996, the scores for East Asia have got worse in 22 of the 30 comparisons (ie, six measures for five countries). If international rankings are compared, these countries have fallen in 28 of the 30 comparisons. only in South Korea did governance scores improve on more than half of the measures.

 

Even in the financial sector more needs to be done. Banks are more resilient thanks to better internal controls and supervisory standards. Capital ratios have increased and non-performing loans have fallen sharply: in Thailand from 43% in 1998 to 8% last year. However, the healthier state of banks' balance sheets is partly due to favourable macroeconomic conditions, Philip Turner, of the Bank for International Settlements, points out. Strong growth and unusually low real interest rates have boosted banks' profits. And yet risk management remains poor in some countries. Capital markets, an alternative source of funds, are underdeveloped.

 

On the external side, however, the optimists are right to say that Asia is stronger and more resilient. The region is far less vulnerable to a balance-of-payments crisis than it was ten years ago, when all the crisis-hit countries had large current-account deficits. Now they all have current-account surpluses and much less foreign debt. They also have vast foreign reserves to protect them against any future speculative attack. As a rule of thumb, a country should have enough reserves to cover its short-term foreign debt. on the eve of the crisis in June 1997 South Korea's reserves were only one-third as big as its short-term debt; today they are twice the size. In most of the other countries, reserves are also two to three times bigger.

 

ReutersThat was then

 

These large war chests mean that a repeat of 1997 is unlikely. However, some economists, such as Nouriel Roubini, of Roubini Global Economics, argue that the build-up of reserves is itself creating new hazards. East Asian policymakers, says Mr Roubini, failed to learn the most important lesson of the crisis. Exchange rates are once more, in effect, tied to the dollar. This, he argues, risks creating a new, but different financial crisis?not a balance-of-payments shock like last time, but booms and busts in asset markets.

 

As governments try to keep their currencies cheap, developing Asia's total reserves have jumped from $250 billion in 1997 to $2.5 trillion this year. The desire to build up reserves is understandable, but they are now excessive. Asian economies' policy of tracking the dollar and the consequent rapid increase in reserves, argues Mr Roubini, is leading to excessive growth in money and credit, inflationary pressures and asset bubbles in shares and housing. This, he concludes, will eventually lead to vulnerabilities similar to the massive capital inflows, credit boom, overheating and bubbles that preceded the 1997 crisis.

 

His grim prediction is based on the “impossible trinity”: an economy cannot control domestic liquidity and manage its exchange rate if its capital account is open. If it holds down its currency, foreign-exchange inflows will boost money growth. The central bank can try to “sterilise” the impact of bigger reserves by selling securities to mop up the excess liquidity. The snag is that bond sales will tend to push up interest rates and so attract yet more capital inflows. Mr Roubini believes that the room for sterilisation by Asian central banks is severely limited and so rising reserves mean even greater excess liquidity.

The big difference

 

However, these economies may be able to sustain today's policies for longer than Mr Roubini expects. This is because many of the economic characteristics he describes?such as fixed exchange rates, massive current-account surpluses and asset-price bubbles?certainly apply to China, but not to most of the smaller East Asian economies. To begin with, the chief victims of the crisis have let their currencies appreciate against the dollar by much more than China has. only Hong Kong still pegs to the dollar. The South Korean won has risen by 42% since 2002 and the Thai baht by 28%. China accounts for most of the increase in Asian reserves. Since December 2004 the combined reserves of Indonesia, Malaysia, the Philippines, South Korea and Thailand have risen by only one-third; China's have doubled.

 

Second, the common claim that these economies have big current-account surpluses, which proves their currencies are undervalued, is much exaggerated. China has a big surplus, but of the former “crisis countries” only Malaysia has a large surplus (11% of GDP). South Korea, Thailand and Indonesia have an average surplus of less than 1% of GDP (see chart 2). Indeed, Morgan Stanley reckons these currencies are now overvalued against the dollar.

 

Third, in most countries the build-up of foreign-exchange reserves has not hugely pushed up the growth of money and inflation. The broad-money supply in the crisis economies is up by just over 10% on average over the past year, much less than China's 17% and well below their money growth of more than 20% in the mid-1990s. Inflation also remains tame. In its Asia and Pacific Regional Economic Outlook, the IMF concludes most emerging Asian economies are not on the verge of overheating. It sees little evidence of housing bubbles in most countries: average house prices have not risen by much more than incomes in recent years. Share prices have soared, but those gains follow sharp declines. With the notable exception of China, price-earnings ratios in East Asia remain below those in developed markets.

 

Foreign-exchange inflows are not causing money and credit to explode partly because central banks' sterilisation has been relatively successful in mopping up liquidity. one important difference between now and the years leading up to the crisis is that the upward pressure on currencies and the increase in foreign reserves almost entirely reflects current-account surpluses and inwards foreign direct investment, not net inflows of hot money. According to David Carbon at DBS, a Singapore bank, net capital inflows into the crisis economies have averaged only 0.5% of GDP since 2004, compared with 6.5% during 1991-96.

 

Only Thailand has seen large net capital inflows and last year it ran into trouble. Inflation started to rise, leading the central bank to lift interest rates. This pulled in yet more capital and pushed up the exchange rate. In December, to stem the rise of the baht and regain control of liquidity, the government made a bungled attempt to slap a tax on inward portfolio investment. The stockmarket plunged. In most of the other small Asian economies, however, central banks have not been deluged by net inflows of short-term capital. This may be why countries have been able to sterilise large amounts of foreign reserves without attracting yet more capital.

 

 

Thus neither of the two commonly held views about the victims of the Asian financial crisis ring true. The economies hit hardest by the crisis have not fully recovered: their growth remains much slower than before 1997. But nor are they awash with excess liquidity and heading for another financial meltdown.

 

One big change over the past decade is the emergence of China as an economic power. Other Asian economies have lost some exports to China, but it imports large amounts of capital equipment and components from within the region. China's demand for raw materials has also pushed up commodity prices, benefiting some South-East Asian producers. China now takes 22% of the exports of the rest of emerging Asia, up from 13% in the late 1990s. Smaller East Asian countries have seen a slight decline in their share of global trade as China's has risen, but their exports have continued to grow rapidly. In the late 1990s, foreign direct investment in South-East Asia fell, stoking fears that China was stealing investment. However, over the past few years it has rebounded strongly. Overall, China has almost certainly been a net boost for the rest of Asia.

 

Nevertheless, the fear of losing competitiveness relative to China has played a big role in these countries' reluctance to allow their exchange rates to appreciate any more rapidly. If China allowed its currency, the yuan, to rise, they would have less need to intervene.

Wrong lessons

 

Could China be the source of the next crisis? China was less affected in 1997-98, thanks to strict capital controls. Indeed, by not devaluing its currency it helped to prevent a worsening of the financial contagion. But China, more than its neighbours, may have drawn the wrong lesson?namely the need to keep its exchange-rate stable and to build up massive reserves. China's monetary policy has been overly lax and low interest rates on bank deposits have encouraged a huge shift of money into its stockmarket. Thus Mr Roubini's diagnosis of Asia does apply to China.

 

If China's share-price bubble burst, the economic consequences in China?and among its neighbours?would probably be mild, since Chinese share-ownership is relatively low. Nervous investors might pull money out of other Asian stockmarkets, but large foreign reserves should prevent serious capital flight.

 

Rather than shielding themselves with big reserves, East Asia's governments should make their economies more pliable and their banks more resilient, and thus better able to cope with future volatility. They need more flexible exchange rates, which would not only prevent a further excessive build-up in reserves, but also help to shift growth towards domestic demand and away from exports. Governments must also restore business confidence and create a healthier investment environment. Asia has performed better than most people expected ten years ago. But it could have done better still.