Is the West cured of Asian flu?

News Analysis: As optimism returns to markets in the Far East, experts warn against ignoring the lessons of history

TWO YEARS ago this Friday, Thailand decided to float its currency, the baht. The apparently innocuous move, aimed at relieving huge pressures on its economy, in fact almost triggered a global depression.

As the second anniversary approaches, optimism is growing among investors that the worst is over and that south-east Asia is ripe for the picking ... again.

But is the West ignoring the lessons of history and set to repeat its mistakes?

It is worth recalling what happened on 2 July two years ago. Thailand, which had attracted $257bn in foreign capital in 1997, was beginning to face a downturn.

As confidence started to dip and capital fled the country, the Thai government finally accepted it had to devalue.

The move was seen at the time as a mature way to deal with huge pressure on its fixed currency in the face of a mammoth currency flight.

In fact it triggered a vicious spiral. As the currency plunged, interest rates went up, leaving firms unable to service either their dollar or their baht debts.

This in turn forced massive cuts in investment and consumption that plunged Thailand into recession, raising the spectre of a wave of bankruptcies and mass unemployment.

The Asian flu swept like wildfire through south-east Asia as investors foresaw the same pattern being repeated across the region.

Then, in October last year, just when calm seemed to return, Russia defaulted on its debt. The impact on confidence in the global capitalist system was by now so severe that by the time Russia - with an economy the size of Belgium - succumbed, wholesale panic set in.

Then in January this year, Brazil caught the flu. Economists began forecasting deflation.

Two years on and the picture looks more benign. The economies of the five core emerging nations - Indonesia, Korea, Malaysia, Thailand and the Philippines - show positive trends.

South Korea and the Philippines enjoyed positive annual growth in the first quarter, Malaysia and Thailand are back on a growth curve and even Indonesia has reported quarterly growth.

Commentators and investors are positive. Ng Kok Song, the deputy head of the Singapore government's fund management arm, said: "In my judgement, the worst is over. Going forward, the Asian stock market is probably the best money-making opportunity."

The currency markets have certainly recovered. The Thai currency, which was 25 baht to the dollar before flotation, is trading at about 37, having troughed at 55.

The Indonesian rupiah trades at about 7,000 to the dollar after slumping to 17,000 at one point.

IDEAglobal.com, the market intelligence and research firm, said: "The future looks extremely bright and we expect a return to near potential output within the next 18 months.

"Domestic confidence has returned, evidenced by - and forming a virtuous cycle with - extraordinary stock market performance."

Last week Robert Fleming, the investment bank, said it was upbeat about Asia - even as it announced a halving of profits. "We firmly believe in the long-term potential of Asia and are confident that our ... expertise in the region will ensure we benefit from the recovery," said the bank's chairman, John Manser.

However, other economists threw in a note of caution. Deutsche Bank said several factors indicated that the recovery was sustainable, but only if Asian countries pressed ahead with financial reforms.

Angus Armstrong and Michael Spencer, Asia economists at Deutsche, forecast annual GDP growth for all of the Asia-five bar Indonesia this year.

"As long as governments pursue financial system reforms, we expect the economies will recover and gradually strengthen," they said.

But growth will accelerate below trend and Deutsche warned there would be a serious risk if governments were tempted to boost growth rates by relaxing disclosure rules on banks, deferring corporate reforms or postponing corporate recovery.

"This is a significant risk as the economies recover. the cost will be that when the next recession arrives governments will be ill-prepared to deal with the consequences," they warned.

"Avoiding another crisis requires the single-minded pursuit of efficient financial institutions."

Paul Krugman, the eminent Professor of Economics at the Massachusetts Institute of Technology, believes the West could repeat its past mistakes.

In his gripping account of the crisis, The Return of Depression Economics, he points out at that, at the time, investors believed that Thailand was simply about to suffer a little embarrassment.

"Most people thought that the devaluation of the baht would pretty much end the story - a humiliation for the government, perhaps a nasty shock for some overstretched businesses but nothing catastrophic. There would not be a devastating recession," he says.

While the renewed investor enthusiasm for Asia should create a virtuous circle in the same way that the collapse of confidence fuelled the last slump, Professor Krugman believes that it is dangerous to pass the blame for the crash on to the victim: Indonesia's rulers being too corrupt, for example, or Japan's banks too careless.

He points that out when Brazil crashed in January, officials in Washington and elsewhere were "starting to exhibit a peculiar smugness".

"It was as if they were saying `Korea seemed to be over the worst, Japan was showing signs of a bit of growth - see these policies were working'."

Even as Brazil teetered on the brink of recession, the International Monetary Fund's imposed tough medicine of higher interest rates to prop up the real currency, a move that had the opposite effect as anxiety turned to despair in the face of spiralling borrowing costs.

He says that, were a similar crisis to recur, the answer is simple: "Cut interest rates drastically, without hesitation."

Even the bulls temper their enthusiasm with caution. Mr Kok Song said that Japan, which is just climbing out of recession, had not yet resumed its role as a major regional importer, while the political situation in Indonesia was still uncertain. On top of that, a recession in the US, which is acting as consumer of last resort for the rest of the world's economies, would hit the Far East.

But the last word has to go to Professor Krugman. "The most immediate risk from the return of depression economics is, of course, the possibility that the malaise will spread - that Argentina, or South Africa, or Turkey or - God help us - China will be added to the list of casualties, that deflation in Europe or a stock market crash in the United States will create Japanese-style conditions across the advanced world as a whole.

"Even if the damage is contained, more subtle risks to economic progress remain because generally free markets are unlikely to survive in a world where insufficient demand is a continual threat."