The free rider problem

The free rider problem
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First Published: Tue, Apr 24 2007. 02 26 AM IST
Updated: Tue, Apr 24 2007. 02 26 AM IST
A couple of days ago, my seven-year-old daughter came back from school with a worried look on her face. Her teacher had told the class that the polar ice caps were melting due to global warming and that there was a danger of the world being flooded and eventually drowned.
She had two concerns. The first was that it might happen during her lifetime and she felt that was unfair since her parents had already lived at least half their life in a world that floated instead of drowning. In that sense, she was implicitly drawing attention to the responsibility of the present generation to the future. Second, when I told her that we could delay it if we took some action (for example, if we walked or cycled instead of taking the taxi or the car), she was not persuaded—she was not sure that everyone else would do it. In other words, she was alluding to the free-rider problem that is usually associated with free-market economics where benefits are privately accrued and costs are passed on to the public. This is about the shared burden of costs.
On the day it announced that its annual GDP growth in the first quarter of 2007 exceeded 11%, we also heard that China could overtake the US in absolute levels of greenhouse gas emissions by 2008. This was one year earlier than originally anticipated, which itself was advancement from earlier estimates. China is passing on the costs of its growth to the present and future generations. It is a free rider.
The half-yearly update on East Asia and Pacific released this month by the World Bank provides a wealth of information on how the East Asian economies are faring 10 years after the economic and financial crisis struck the region in 1997. The assessment is not particularly encouraging.
The report quotes two detailed studies conducted in the US, which remains the main market for the Asian countries. Ahearne, Fernand and others studied the impact of China on trading patterns in the US market in 47 sectors between 1989 and 2005. China increased its market share in 41 of these sectors while the market share of the four Newly Industrialized Economies (NIE)—Korea, Taiwan, Singapore and Hong Kong—fell. Southeast Asian economies appeared to buck the trend up to 2001 but could not resist the erosion of market share subsequently. A study by Caroline Freund published in 2006 focused on how China’s exports to a particular third country in a given product category affected East Asian exports. East Asian export growth to third countries in industrial products was lower when China’s exports of these products were large and growing. This effect was rather strong more recently (between 2001 and 2004) than before.
Along with the loss of export share and slowing export growth, East Asian economies have also witnessed slowing investment growth and rising domestic savings surplus. The report correctly notes that cyclical explanations for the absence of investment growth became less and less plausible in the years that rolled by since the crisis. A more plausible explanation is the uncertainty caused by the emergence of China and the time it took to identify sectors and areas where countries in the region could benefit from growth in China.
The loss of export competitiveness in the rest of East Asia to China in recent years is no coincidence. It has a lot to do with Chinese yuan’s undervaluation, which has intensified at the same time as the real exchange rates of other East Asian countries appreciated. Just to illustrate, while the Chinese yuan real effective exchange rate weakened by 3% to 4% between 2002 and March 2007, during the same period, the real effective exchange rate of the Korean won appreciated by over 22%.
The imbalances caused by the emergence of a large economy as an export powerhouse with a distorted exchange rate are not confined to the rest of East Asia. The resulting export surplus and the vain attempts of other regional central banks to delay their currency strength has swelled foreign exchange reserves, kept US interest rates low and has mothered housing and asset price bubbles across the globe. Arguably, China’s growth model remains the single most important source of global economic, financial and other imbalances. The disconnect between the quality of economic growth globally and asset prices has probably been at its peak in the past five years.
So far, China has paid only lip service to rebalancing its growth. As and when it takes action or is forced to, it would induce short-term pain for many who have benefited from the asset bubbles spawned, as described above. The party has been heady, but the coming hangover will be equally, if not more, severe.
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 baretalk@livemint.com
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First Published: Tue, Apr 24 2007. 02 26 AM IST
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