Saturday, October 25, 2008

How Low Will Asia Go?

Author:Brian P. Klein, International Affairs Fellow
October 23, 2008 - Far Eastern Economic Review

Asia is just beginning to feel the effects of shrinking export demand and capital flight while the worst of the economic crisis has yet to arrive even for the U.S. and Europe. As consumer sentiment declines, purchasing slows, and new orders shrink, most export dependent countries in Asia will feel the brunt of the downturn. The next few months will give a clearer indication of the depths of the recession as consumer spending leading into the U.S. holiday season becomes clearer and corporate quarterly results are announced. Asian countries will need to shift from financial-system intervention to more fundamental economic support measures as the crisis worsens.

The first wave response has been to concentrate on liquidity even though Asian banks were not exposed to toxic assets like Western financial institutions. Fear by association in terms of dollar-denominated debt obligations, rapidly falling currencies, and investments abroad affected Asia’s financial markets. India’s central bank pumped $4 billion into markets to ease difficulties as investors pulled out of mutual funds. South Korea has pledged $30 billion for its financial markets. China, anticipating slowing growth, reduced lending rates by 27 basis points, lowered reserve ratios for commercial banks and eliminated personal taxes on interest income.

The second wave of the crisis, a far broader slowdown, is just beginning to appear. China reported slower third-quarter growth with more expected by year’s end. Singapore has entered recession with much of Southeast Asia’s export dependent economies likely to follow. Dramatic declines in Western demand will hit export-dependent countries with already high inflation the worst.

Vietnam is particularly vulnerable. Rising domestic prices (soaring over 25% this past summer) due primarily to loose monetary policies will limit options to stimulate growth. Production inputs like energy and steel (roughly 20% of Vietnamese imports) may fall as world demand slows helping domestic manufacturers, however sales of garments and shoes (two of Vietnam’s largest exports) are likely to drop as well. The U.S., Japan, Australia and China, all experiencing significant slowdowns, account for almost 40% of Vietnamese exports. As the economy shrinks government investment in infrastructure, especially roads, ports, and power generation, would be the ideal policy prescription, but further injection of capital risks fueling more homegrown inflation.

India is in a similar policy bind facing 12% inflation driven primarily by food and energy costs. A fiscal stimulus package focused on improving infrastructure would prepare the overall economy for more substantial growth post-recession, but the political demands for short-term help to a majority poor population may be too great. So far basic commodity prices have been falling giving the government a bit more room to maneuver.

A potential third wave, social unrest, may affect some countries in Asia if the recession is deeper or longer than expected. China’s growth, while slowing from 12% to an estimated 9% (hardly significant in the eyes of developed economies), is a sudden shift of momentum that may fuel already growing resentment of the poorest with only modest improvement in their living standards during the boom years. GDP growth of 8% (the 25-year average) appears to be the minimum necessary to “tread economic water” in China, a level of growth inadequate to create the number of new jobs required.

There are several recent positive developments in China that may help alleviate some of these pressures. The recent decision to grant land rights for impoverished farmers who can now sell usage to agricultural companies or possibly use the land as collateral for loans is a significant step. Inflation, a previous policy concern, has been declining leaving room for fiscal stimulus programs including investment in health care.

Thailand faces a far more difficult political environment that would certainly be exacerbated by a lengthy economic downturn and fuel existing tensions between the rural poor and urban middle and upper classes. Plagued with demonstrations, a potential military coup, and a border conflict with Cambodia, there is little room for seriously addressing the pressing economic effects of the global slowdown.

There are some bright spots, though few and far between, as commodity prices drop and companies seek capital infusions to stay afloat. For China and Japan assets in much of Asia and the West are on sale. Through a cautious approach to the markets, high domestic savings rates, and limited market liberalization for foreign firms, both China and Japan’s financial sectors have remained largely immune to contagion. Japan’s banks are remarkably healthy. Nomura has bought Lehman’s European and Asian assets and Mitsubishi UFJ has taken a significant stake in Morgan Stanley. China’s sovereign wealth fund CIC is expanding its stake in Blackstone, the global venture-capital firm.

For policy makers one of the greatest risks in times of economic duress is to issue short-term cash give-aways to garner political support in lieu of substantial, albeit painful, fundamental economic reform. For those countries in Asia facing elections within the next year (Japan, India, Indonesia and potentially Thailand) this risk is particularly acute.

The other main risk is Asia’s continuing over reliance on export markets as a development strategy. To sustain long-term growth Asian countries need to focus on enhancing key infrastructure and stimulating domestic demand. Now is an opportune time to prepare for the future before the next inevitable cycle of boom and bust returns.