Can we survive another Asian shock?

If Western investment is dragged down, the `Goldilocks cycle' could grind to a halt
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The Independent Online
WITH THE JAPANESE economy teetering on the brink of a serious recession, and China musing about the possibility of devaluation, the financial markets are beginning to fear that a further slump in Asian growth will finally overpower the strength of final demand in the US and the EU.

GDP growth is now slowing in the OECD area, and corporate earnings are decelerating sharply. There are concerns that the strength of fixed investment spending in the US and the EU may be punctured, triggering a more serious downturn in world activity. If investment is dragged down in the West, the "Goldilocks economic cycle" could come to a grinding halt amid a serious shortage in global aggregate demand.

At this stage, such an outturn still seems on the pessimistic end of the possible range of out-turns. Domestic final demand is - if anything - accelerating rather than decelerating in both the US and the EU. Furthermore, several mitigating factors should be borne in mind when considering the likely impact of a further Asian downturn on GDP in the rest of the world.

First, a large part of the initial Asian shock ("Asia I") has now been absorbed by the OECD economies. When the shock first developed last year, Goldman Sachs estimated that the likely impact on OECD GDP growth, working primarily through trade, would be of the order of 0.5-0.75 per cent of GDP.

Looking at the recent behaviour of trade data in the US and the EU, it seems that most of this shock will already have been seen in the output figures by the middle of this year. (Of course, other associated developments such as the strengthening in the dollar, the weakness in commodity prices and the change in monetary policy triggered by the Asian crisis, have diluted these direct trade effects.)

The accompanying table gives the latest Goldman estimates of the impact of changes in trade balances on OECD GDP in the last 12 months, including the impact of Asia I. The estimated effect of Asia I on OECD GDP has been around -0.5 per cent, but the statistical information on which this is based is not ideal. The trade data relate to goods only, and consequently ignore the (probably sizeable) impact of the Asian shock on trade in services.

In addition, they are derived from the visible trade statistics of the OECD countries, which are measured in nominal terms, and which therefore fail to differentiate between price and volume effects. This tends to lead to a downward bias to the estimated impact of Asia I. If statistics were available in volume terms, and if they included services, it seems probable that the impact would be significantly larger.

Nevertheless, the impact of Asia I has certainly not been the dominant force determining the pattern of GDP growth in the major economies in the past 12 months. Variations in domestic demand, and changes in exchange rates within the OECD itself, have been much more significant. Furthermore, it is important to realise that, if Asia I now stabilises - ie if GDP growth in the crisis economies stays extremely low, and if the trade surpluses for these countries remain at present very high levels - then there will be no additional drag from a further deterioration in the net trade path for the OECD countries.

With the drag from net trade stabilising, the negative trade numbers in the table would disappear, and real GDP growth would rebound in line with the higher growth rates in OECD domestic demand. In other words, the Asian crisis needs to continue worsening at a rapid pace in order to prevent a rebound in GDP in the West.

Of course, the Asian crisis is in fact worsening again - as evidenced by the further downgrades to GDP growth in Japan and the crisis economies which have been made recently by most forecasters. Maybe a further significant Asian shock - "Asia II" - is now developing.

But would Asia II in fact be sufficient to drag the OECD economies into recession? Probably not. Apart from the fact that - as we have just seen - Asia II would need to be just as large as Asia I simply to prevent OECD growth rates from rebounding, it is important here to differentiate between the impact of downgrades in Asian GDP, as contrasted with further improvements in the Asian current account balances. In terms of the impact on GDP growth in the US and the EU, changes in the growth rates of the Asian economies are much less significant than changes in net trade volumes.

For illustration, bear in mind that exports to Asia (including Japan) account for only 4 per cent of US GDP, and for roughly 3 per cent of EU GDP. Given normal trade elasticities, a downgrade of one percentage point in growth in the whole of Asia (including Japan) would probably lead to a drop of around 2 per cent in Asian demand for US and EU exports. But a decline of 2 per cent in exports to Asia would have only a negligible effect on GDP in the West - in fact, it would curtail GDP in the US by 0.08 per cent, and in the EU by 0.06 per cent.

By contrast, further improvements in Asian trade balances would have a much larger negative effect on Western economies, since every dollar of trade improvement in the East is equivalent to a dollar of GDP deterioration in the West. For example, if the trade surplus of the whole of Asia (including Japan) improves by 1 per cent of GDP, then the direct contractionary effect on GDP in the US and the EU is around 0.3 per cent in both cases.

This implies that downgrades to GDP projections in Asia are not necessarily all that damaging for the rest of the world, unless they are accompanied by significant further increases in Asian trade surpluses. How likely is that to occur? Certainly, renewed financial crises in Asia would lead to GDP and exchange rate adjustments that would further increase Asia's trade surplus with the West, but the scale of these changes may not be as large as in the case of Asia I.

In the first place, Asian inflation is rising sharply, eroding the huge gains in competitiveness which followed the devaluations of Asia I. And second, the trade balances in the crisis economies have now improved sufficiently to finance the balance of payments outflow which has been triggered by the reversal of capital flows. This means that there is no need for further improvements in trade balances - the foreign exchange earned from any increase in Asian exports is likely to be put to good use financing a much-needed recovery in imports.

For all these reasons, Asia II - even if it occurs - may not have as large an effect on GDP in the West as Asia I. Provided that domestic demand in the US and the EU is not dragged down by the confidence effects of the economic implosion in the East, then the developed economies should be able to survive the Asian onslaught without an outright recession, though a period of below-trend growth does seem likely, especially in the industrial sector.

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