The worst is past but the Sun is still to rise on the East Asian economies

Until there is a significant revival of land prices either in Hong Kong or Tokyo, the East Asian recovery is not secure

HONG KONG - Is the East Asian economic recovery really secure? The International Monetary Fund thinks it is, witness its sharp upgrading of its forecasts for the region earlier this week. It upgraded its growth estimate for the newly industrialised Asian economies to 5.2 per cent, up from a mere 2.1 per cent predicted last May. In relative terms, this is the sharpest improvement of any of the major regions of the world.

If that is right it will be great news for what was, until two years ago, the most vibrant part of the world economy. But how does the eagle's eye view of the region from the IMF square with the worm's eye view from the region itself?

Here in Hong Kong the majority view is certainly that the worst is past. On the balance of probability that may be right. Hong Kong has just released figures that show decent growth in the second quarter of this year, so officially the recession, as far as this place is concerned, is over. But there are two enormous tests still to come and until these are past there remains a strong possibility that there will be a second leg to the East Asian recession.

The tests are China and Japan. China obviously looms largest on the radar here in Hong Kong. The statistics say that it has continued to grow throughout the regional recession, and in one sense it probably has. If you have a command economy - and much of Chinese output is still produced by state- controlled companies - you can carry on producing things. But if you carry on producing things and demand falls off, then the goods pile up and have to be dumped at knock-down prices.

The statistics confirm that there has been massive price deflation in China. Both producer and consumer prices have been negative now for more than two years. In other words, deflation had already taken hold even before the East Asian downturn - it had been a reaction to the surge in inflation that had taken place in China during the early 1990s. The issue now is whether China can continue to pump up its economy, suffer the pressures of deflation and trade through to the next upturn in world demand. Or will something crack?

The "something" on everyone's minds here is a Chinese devaluation. If there is insufficient demand at home, devaluation will increase exports. Never mind the fact that China already has a record (and probably unsustainable) trade surplus with the United States. It has suffered severely from the downturn in demand for its exports in East Asia following the devaluations of most of its trading partners, and devaluation wold be the obvious way of coping with this.

It is obviously impossible to be completely confident but it does look very much as though China is preparing for a devaluation, probably early next year. Here are two bits of evidence.

This is the view of the business community in Hong Kong. One company here, negotiating prices for foreign products to be delivered to China next spring was told by the state-controlled purchasers that of course the prices would have to try to accommodate the forthcoming devaluation. Now since the goods would have to be paid for in dollars, this could have been a negotiating ploy, but the exporting company did not think so. The one thing you can be sure of is that state-owned importers would not mention the possibility of devaluation if they were not authorised to do so.

The second bit of evidence comes from the Hong Kong government. A top official was briefing a foreign envoy. He particularly sought to make the point that were China to devalue it would benefit Hong Kong. On the previous occasions when this had happened, Hong Kong (whose currency is pegged to the dollar) had always done well out of the change in rate: it seems that the boost it gave to the mainland economy more than offset any widening of the cost differential between Hong Kong and China. It just speeded up the switch from local manufacturing to supplying services to China.

Again, whether this is right or wrong is less relevant than the fact that Hong Kong officials do not say things on Chinese economic policy to important foreigners unless they are confident that Peking is happy for them to do so. Clearly China wants to put into the market the possibility of devaluation. That does not mean it will. I suspect it wants to test the water, make a judgement of how a devaluation might be received, and then decide later this year.

Would a Chinese devaluation lead to a second leg of the East Asian recession? Not necessarily, but it would put pressure on it because, in as far as it increased Chinese exports and depressed imports, other smaller nations would be under pressure to have another round of devaluations themselves. Put at its lowest, it would add a new uncertainty.

And Japan? Well, Hong Kong is a great place from which to watch Peking, but not the best place to watch Tokyo. It is interesting to hear of the extent to which Japan has disengaged from Hong Kong since the takeover. It is not just that there has been a sharp fall-off in tourists from Japan: more that Japanese companies have pulled back both their investments and their presence.

But the general point about Japan is that it too, like China, is facing the possibility of a discontinuity. On paper the recession is over, for it has had two quarters of growth. But there was an element of artificiality about this, for it has been driven by an unsustainable level of public spending, and in particular public borrowing. As a result of its recent borrowing surge, Japan will pass Italy as having the highest debt to GDP ratio in the world and, like Italy, will be forced to run a string of surpluses to rein this back.

Put aside the concern over the impact of the rising yen, the markets' current worry. The fiscal crunch is a real disaster. It may be a way off yet, but it looms larger every day. While there is this overhang of debt, which will have to be paid off by an ageing population with a smaller workforce, the pressure will mount on ordinary Japanese to save and not spend - and maybe lead to a second leg of recession. All this sounds a touch negative.

The reassessment of East Asia's growth prospects by the IMF reflects both the excessive pessimism earlier this year and the current revival of share prices across the entire region, including here in Hong Kong.

But there has not been a significant revival of land prices either here or in Tokyo. Until that happens, the East Asian recovery is not at all secure. So fingers should remain crossed, despite the optimism of the IMF. In any case, I suspect the next bout of problems for East Asia will be next year, not this.