Is the Asean growth miracle hitting the rocks?
Monday 04 August 1997
The onset of this crisis was triggered by the slowdown in export activity last year, and more recently by the increases in local interest rates which have been needed to protect the Asean currencies from sharp depreciation. For several years before the onset of the current crisis, there had been massive capital account inflows into the Asean region from the rest of the world, reflecting relatively easy global monetary conditions, and the apparently secure prospects of very rapid GDP growth across the region.
In 1996, the capital account inflow from abroad amounted to 5 per cent of GDP in Indonesia, 9 per cent in Malaysia, 11 per cent in the Philippines and 10 per cent in Thailand. As the graph shows, a large proportion, generally more than half, of these capital account inflows came in short-term categories (rather than in long-term direct investment), increasing the vulnerability of the region to a subsequent sudden reversal.
The allocation of these surging capital inflows became a severe problem, with booming asset prices, especially for real estate, becoming a common phenomenon.
Faced with these difficulties, the central banks of the regions were unable to slow domestic activity by raising interest rates, for fear of attracting still greater capital inflows. Furthermore, the fiscal authorities generally shied away from tightening fiscal conditions, mainly for political reasons.
By the beginning of this year, it was becoming clear to equity investors that the situation was getting very risky, and the equity markets of the region began to underperform the world market in an extreme way.
In retrospect, these collapses in equity prices served as a warning that the domestic imbalances in the Asean-4 had become quite severe, with dangerous build-ups of debt in some cases, and extreme exposures of local banking sectors to the risk of asset price collapses, made worse by currency depreciations which would increase the local currency value of foreign debt.
Since the currency slide started in earnest a month ago, the depreciations against the dollar have been as follows - 8 per cent for the Philippine peso, 6 per cent for the Indonesian rupiah, 4 per cent for the Malaysian ringgit, and 32 per cent for the Thai baht.
Since the external debt burden of these economies is extremely high - generally around 40-50 per cent of gross domestic product - these incipient devaluations obviously increased the financial vulnerability of the domestic private sectors, bank and non-bank alike. The appropriate policy response to this situation would seem relatively clear-cut, though that is not to say that the politics of implementing the necessary changes will be at all easy. The required policy changes are several-fold.
First, confidence must be restored to the currency markets, since in the absence of this there will be a further build-up of debt ratios, either through the impact of depreciating currencies on external debt, or through the impact of higher domestic interest rates on internal debt. Since the local currencies are not significantly overvalued against the dollar or other developed currencies, the task of restoring confidence is not impossible, but it does need decisive policy action.
Second, action is needed to narrow current account imbalances, and this will almost certainly involve some fiscal retrenchment, particularly reductions in current public expenditure as a share of GDP. This has proved difficult in the past in several of the Asean-4 economies, and it may be even more difficult in the future, given the slowdown in growth that is now likely to occur, and the political calls for higher public spending across the region to combat this slowdown.
Third, a combination of measures is needed to restore confidence and health to the financial sectors. As Sun Bae Kim of Goldman Sachs has pointed out in a recent article on Thailand, these measures are likely to have three features:
r Damage control, involving action to secure the confidence of depositors, and to make transparent the difference between solvent and insolvent institutions;
r Loss allocation, involving measures to recapitalise the banking system; and
r Rebuilding profitability, involving measures to reduce short-term interest rates, and increase spreads in the financial system.
If the experience of financial restructuring in other countries serves as any guide, a significant portion of the loss allocation will probably take the form of a larger fiscal deficit, which increases the need for budgetary retrenchment in other areas.
Finally, there may be a need to access some form of external official capital, either from the IMF or from some sub-group of developed economies, perhaps involving Japan. Although there is plenty of potential for renewing large-scale private sector capital inflows, once the other necessary economic measures have been taken, the trigger for renewed confidence in similar situations in the past has often been the involvement of the IMF or other international institutions. Such involvement is likely to prove to be an important signal that the worst may be over for financial market returns in the region.
Provided these measures are taken, the long-term growth miracle in the Asean-4, and the rest of Asia, can resume as early as next year. After all, the basic driving forces for strong growth - high investment, and a shift of the population from agriculture to manufacturing - are still present. But what if the correct policy measures are not followed? What would be the impact of a more severe Asean recession on the rest of the world? Japan is the most vulnerable large nation to an Asean recession - 12 per cent of Japanese exports go to the Asean-4, and 37 per cent to the whole of Asia. The US is much less vulnerable, with equivalent figures of 4 per cent and 15 per cent respectively. The EU would be hardly affected, with equivalent figures of 2 and 6 per cent respectively.
For the sake of illustration, let us assume that in the case of a deep recession, the growth of real domestic demand in the region might fall from about 5 per cent (Goldman Sachs' main case forecast) to zero. In this case, the growth of imports might fall by around 10 per cent. The direct impact of this shock on the rest of the world would be to reduce real GDP growth in Japan by 0.11 per cent, while US as well as EU GDP growth would fall by 0.04 per cent.
These effects are obviously pretty negligible. If the Asean recession spread to the whole of Asia, the effects could be up to three times as large as those just mentioned, but even this would be relatively minor, except perhaps for Japan. So talk in the financial markets of large potential effects on the monetary policy, bonds or currencies in the developed economies seems misplaced.
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