It is nearly 10 years after the Asian economic crisis of 1997-98. Investors are in love with Asia again. They were in love the last time, too, and it hurt. It might be no different this time.
Emerging from the shock of the technology bust and 9/11, most major economies slashed interest rates to historically low levels, which boosted their domestic consumption and Asian exports. Current account surpluses emerged and foreign-exchange reserves grew. Exports were unaffected by currency appreciation initially as global demand stayed healthy, stock prices went up and so did real estate. The money flowing into Asian bonds lowered yields everywhere and credit rating improved. It was fairy-tale stuff.
All good things come to an end. Slowly, the higher interest rate available on Asian currencies began to exert upward pressure on these. Their central banks resorted to reserves accumulation so they could at least slow the pace of appreciation. The accumulation continues and has gone well beyond what could be justified by import payment or crisis prevention needs.
But this has proved to be no match for investors lavishing funds on Asian assets. Currencies have appreciated in real terms and lost competitiveness in recent years. Much of the inflow has gone to finance portfolio assets, not real investment spending. Asia exports capital to the US and invests it in US treasuries. That helps to keep interest rates low in the US. Overseas investors take advantage of low rates and invest in higher-yielding Asian bonds, stocks and real estate. In other words, Asian central banks are offering their balance sheets to foreign investors for them to profit from investing in Asian financial and speculative assets.
Investment in real assets has not really recovered after the crisis. One reason for sluggish domestic investment is lingering excess capacity. But, after several years of growth, that sounds not-so-persuasive. The second is that the fear of global terrorism creates risk aversion for real investment spending. If so, the fear is not unique to Asia. Third, Asian countries, excluding China, are not confident of standing up to China’s competitiveness. This sounds more plausible. Given its hunger for commodities and its export-led growth model, China competes with other regional economies. Deng Xiaoping openly wished to emulate the East Asian growth model. Unfortunately for the rest of East Asia, China has done it too well. Unless China changes its strategy, the rest of the region would struggle to grow. The investment community’s love for Asia appears blind to these challenges that Asia faces. Asset prices in Indonesia and the Philippines do not reflect these growth headwinds. South Korean economic prospects appear unexciting and Taiwan’s manufacturing is largely hollowed out.
The erosion of the exchange-rate competitiveness of Korea, Indonesia, Philippines and Taiwan in the face of snail-paced Chinese yuan appreciation is significant. Moreover, China’s export thrust is built on domestic cost advantages. Its vast labour pool keeps wage growth restrained. The latest World Bank quarterly survey of Chinese economy shows that, in communist China, the wage share of GDP has declined from over 50% to just over 40% in the last 10 years.
It should, therefore, come as no surprise that Thailand had to resort to capital controls last December to arrest and reverse the 16% gain in the baht against the US dollar in 2006. Recently, the deputy prime minister and finance minister of Thailand called on China to shoulder its share of responsibility for global exchange-rate adjustment. Others are more reticent.
For now, the bulk of Asia remains tied to global and US growth. With its large size and huge exports, China is the most vulnerable to a global slowdown. A large country with a current account surplus of 10% of GDP is unheard of and that is both a necessary and sufficient proof of its undervalued currency and external dependence. Therefore, the belief/fear/hope that China is a self-sustaining economic engine is yet to be fully stress-tested.
Unfortunately for the rest of Asia, while its boom did not really help them, China’s economic slowdown, when it arrives, would drag the rest of Asia down. Contagion from investors fleeing reality would not spare the rest of East Asia. At that point, their failure to boost domestic drivers of growth during the good times would expose their vulnerabilities.
The good news is that there is still time. Barring a catastrophe in US housing or a flu pandemic or a nuclear conflagration in West Asia, global economic growth is chugging along nicely. So, there is time to boost investment, raise productivity and bolster defences against a global downturn. The bad news is that good things usually happen only after crises strike and not before.
V. Anantha Nageswaran is head, investment research, Bank Julius Baer (Singapore) Ltd. These are his personal views and do not represent those of his employer. Your comments are welcome at firstname.lastname@example.org