How the Tigers Lost Their Tale

Thursday, April 30, 1998
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Currency crises . . . competitive devaluations . . . IMF bail-out programs . . . ripples to American

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and European stock markets . . . prime ministers ousted . . . foreign speculators and political opponents blamed for domestic political consumption. These are some of the headlines to which American investors, executives, and workers woke each morning for the last several months.

Are Southeast Asia's economic woes likely to spread to Hong Kong and China? How much of an impact will they have on the American economy? I have long insisted that prognosticators have been far too sanguine in their forecasts of uninterrupted growth in Asia's economies. Their naive extrapolation of trends gained credence because it seemed to fit current circumstances and because too many people were willing to ignore the laws of economics or reject the lessons of economic history. No economy is immune to basic economic forces and laws: not Thailand, not Indonesia, not Japan, not the United States.

How Asia Rose

The most significant contributor to Asian growth for the last two decades has been a rapid rate of capital formation. Perhaps two-thirds of Asian economic growth is because of increased capital, a modest amount because of increased labor and improved human capital, and a tiny fraction because of technological advances. The high rates of capital formation are in turn made possible by high rates of saving and attractive domestic investment opportunities, for both foreign and domestic investors.

Asia's economic woes remind us not to take economic growth for granted. Even high rates of saving and investment do not guarantee continued growth when other problems go unattended.

The attractiveness of investment opportunities in Asia has been driven by the explosion of trade with the rest of the world and within the region. From 1976 to 1996, imports and exports from developing Asian nations with the rest of the world increased almost twentyfold, after adjustment for inflation.

These countries have become far more open and far more market oriented in recent decades, although most still have a long way to go. Particularly important are the greater enforcement of property rights and the rule of law, including contract law, transparent accounting standards, and reasonable supervision of financial institutions.

Why Asia Fell

Throughout history, periods of rapid growth have usually been accompanied by structural imbalances that, when finally resolved, caused economic disruption, even recession. Such is the case in these Asian economies. When investment projects--high-rise buildings in major cities, for example--are economically justified by assuming a continuation of 7 or 8 percent growth, it doesn't take much of a slowdown to send many projects underwater. A few years of 4 or 5 percent growth would cause serious downward pressure on real estate prices and problems for the financial institutions that financed the projects.

These problems would have occurred anyway, but they were compounded by the currency problems that started in Thailand and spread to Malaysia, Indonesia, South Korea, and Taiwan. Many of the countries have, like some in Latin America, tied their currencies either to the dollar or to a basket of currencies including the dollar. Exchange rates were more or less fixed, and, equally important, private decision makers assumed that they would remain fixed for the foreseeable future.

Such currency regimes can produce tangible benefits--inflation credibility for the monetary authority, for example--that can be an important part of the policy environment supporting growth. But when fundamentals get out of line, something has to give. Either exchange rates have to adjust or a substantial adjustment of domestic economic policy must be undertaken to support the (now out of line with fundamentals) exchange rate.

Unfortunately for some of the countries in Asia, the fundamentals got too far out of line. Although following a different policy path might well have prevented this, it would have implied slower growth along the way. Politicians and policymakers were not anxious to slow the torrid pace to something more sustainable.

What lies ahead for the countries of Southeast Asia? Clearly, construction activity has ground to a halt and the financial sectors are in serious trouble. The currency declines should stimulate exports, although export financing will be an issue. Thailand and Indonesia are likely to be most severely affected. Although the International Monetary Fund programs promise financial support, it is essential that these economies reform their banking sectors, including supervision and regulation.

Thai bankers were borrowing at 6 percent in dollars and lending at 12 percent in baht, the Thai currency. What a moneymaking machine, so long as the value of the baht relative to the dollar stayed constant. The collapse of the baht, combined with the thin capitalization of Thai financial institutions, left many of them insolvent or at least in trouble.

The Asian crisis is a wake-up call. It reminds us that we have considerable unfinished business in tax, entitlement, education, regulatory, and legal reform.

The adjustment will be painful--slower growth or recession. But these economies can right themselves, as the example of Mexico attests.

These problems may well be considerably less severe in Singapore, Hong Kong, and China because their fundamentals are noticeably better--although China faces the daunting challenge of transforming state-owned enterprises, along with bad loans of state banks.

What the United States Can Expect

There are several mechanisms by which problems in Asia will affect the U.S. economy:

First, about $300 billion of U.S. exports are at stake. That is especially important to California. Had it not been for the enormous increase in the state's Asian exports and the jobs they supported, California's recession may well have continued into 1995 rather than bottoming out in late 1993.

Japan is much more exposed by trade and investment to Southeast Asia than is the United States. A further deterioration of the Japanese economy would also reverberate in the United States because of our considerable exports to Japan.

American multinational companies derive considerable revenue from Asia. Those whose costs are not simultaneously offset by the decline in the Asian currencies will suffer a hit to their bottom lines.

So far, investments in U.S. Treasuries have proved a safe haven for investors seeking stability from the Asian turmoil. So long as this continues, a strong dollar is likely to be an important factor in holding down inflation and interest rates as the economy expands with low unemployment. There is a remote possibility, however, that the central banks of several Asian countries might need to dump their substantial U.S. Treasury holdings for other purposes. Although this is unlikely, if it did occur, it would cause a spike in interest rates and more substantial economic problems here.

Most forecasters had expected America's economic growth to decline in 1998, from the 3.8 percent rate for 1997 to the 2.5 percent range. Many are now revising those forecasts down by about 0.5 percentage points because of the problems in Asia's economy. (I am a little more bullish than the consensus.)

Asia's economic woes remind us not to take economic growth for granted. Even high rates of saving and investment do not guarantee continued growth when other problems go unattended. In our relatively good economic times, that should remind us that we have considerable unfinished business in tax, entitlement, education, regulatory, and legal reform.