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Asia: Sustainable recovery needs developmental State

UNCTAD, in its recent Trade and Development Report, has cautioned against “excessive exuberance” over the post-crisis speed of recovery in Asia or excessive reliance on foreign resources and markets, and has advocated a “more inclusive growth” pattern to resume the fight against poverty.

by Chakravarthi Raghavan


Geneva, 19 Sep 2000 -- The UN Conference on Trade and Development has cautioned against “excessive exuberance” over the post-crisis speed of recovery in Asia or excessive reliance on foreign resources and markets, and has advocated a “more inclusive growth” pattern to resume the fight against poverty.

The UNCTAD assessment over the crisis and recovery in East Asia is in its Trade and Development Report 2000 (TDR) issued on 19 September.

The assessment of the UNCTAD economists both on the Asian crisis, and the recovery, as well as how to resume a fast growth path and the fight against poverty is in sharp contrast with the World Bank’s assessment (“East Asia: Recovery and Beyond”), which seemed to do a complete 180-degree turn from its East Asia miracle (1993) study, to blame the governments for the very qualities of their institutions and economic management that it had once praised in its earlier study.

That earlier study about the East Asian success in outperforming Africa and Latin America (in regard to the so-called Total Factor Productivity, TFP, growth rates), had said that the highly performing Asian economies (HPAEs) “have been apparently more successful in allocating the resources they accumulated to high productivity activities and in adopting and mastering catch-up technologies”

The World Bank's latest report (May 2000) called for improved institutions and policies in the Asian countries for managing globalization - especially financial, trade and investment integration - revitalizing business and forging a new social contract and role for government. It seemed to hue the new, post-Stiglitz Washington-Summers line for developing countries to open up to liberalization and financial integration, with prudential regulations and transparency and disclosures, and opening up to foreign investment and trade.

In an overview, UNCTAD Secretary-General Rubens Ricupero notes that the financial crisis in East Asia had brutally exposed the combined influence of global imbalances and speculative pressures. While the speed of recovery in the region over the past year was encouraging, “the fact that neither the depth of the crisis nor the speed of recovery was anticipated, even by those responsible for policy, should caution against excessive exuberance.”

In a chapter of the report, “Crisis and Recovery in East Asia”, the UNCTAD economists say that the speed of recovery in the East Asian emerging markets most affected by the financial crises had astounded the most optimistic observers - even though a Mexican-style V-shaped recovery was widely predicted for most economies in the region.

The UNCTAD economists also point out that the recovery and growth, with per capita incomes reaching pre-crisis levels, has however been accompanied by less equal distribution of incomes.

Even institutions like the IMF, which have had first-hand information on the state of the economies concerned, and exerted a major influence on the policies pursued in response, now see their original projections of economic growth exceeded by a large margin.

The speed of recovery has also belied forecasts of other institutions and observers, including the UNCTAD secretariat which disagreed with the orthodox diagnosis and policy response to the crisis, the economists concede.

There are conflicting claims regarding the origin and nature of the recovery, notes TDR. On one view, the speed of the recovery represents a vindication of the international policy approach to the crisis; on another view, it discredits orthodox diagnosis that the economies suffered from serious structural and institutional shortcomings and that they would be unable to resume growth unless these shortcomings were effectively addressed.

Both during the crisis and the recovery, a common theology from western media and the Fund/Bank neo-liberalists had been to frown upon Malaysia which, after briefly following the orthodox policies, changed course, instituted some capital and foreign controls, lowered interest rates and enabled quick recovery and growth. Prime Minister Mahathir Mohammad was portrayed, and more so in the light of the domestic controversies relating to his former Deputy, as a maverick and predicted doom for Malaysia.

Ricupero in the overview notes that the East Asian economies bounced back only when austerity policies were reversed and governments were allowed to play a positive role, and that this policy reversal was brought about by the depth of the crisis and by the widespread criticism, rather than as part of a carefully sequenced policy package.

The UNCTAD head then adds: “...in this respect, the positive influence on the entire region of the example of Malaysia in pursuing policies on autonomously set objectives and priorities cannot be emphasized strongly enough.”

Other commentators and experts in the region have noted that it was the success of the unorthodox Malaysian policies—policies for pegging the currency to the dollar and lowering interest rates, with some capital controls to buttress the policies, and providing credit to crisis-hit enterprises—that forced the IMF and others to quickly reverse course and to permit Thailand and Indonesia to relax the conditionality targets on government expenditure and interest rates etc, lest others follow Malaysia and get out of IMF clutches. The IMF justified the relaxation with the argument that the IMF's earlier policies had succeeded, and no capital controls were needed or warranted.

The examination of the recovery process, the UNCTAD economists say in their chapter on East Asia, supported a number of conclusions:

*        The policy response in terms of monetary tightening aggravated the impact of the currency crisis on the financial and corporate sectors, and served to depress production and employment further without bringing stability. Currencies were stabilised not as a result of the increase in interest rates, but of the building up of reserves due to massive import cuts and the reduction in foreign claims resulting from debt rescheduling and also of the imposition of capital controls.

“Thus in retrospect, provision of adequate international liquidity to replenish reserves, together with exchange controls, debt standstill and maturity rollover (i.e. the kind of measures advocated in TDR 1998), would have been a much more effective response than a policy of high interest rates.”

*        The speed of recovery owed a great deal to policies pursued after the initial tightening. The strong response of the economies concerned to subsequent fiscal and monetary easing suggests that the initial policies created an unnecessarily tight squeeze. The economies bounced back rapidly when the policy of austerity was reversed and governments were allowed to play a more positive role in recovery.

“The policy reversal was brought about by the deepening of the crisis and widespread criticism, rather than constituting part of a carefully sequenced policy package.”

*        The speed of recovery was not due to the elimination of structural weaknesses, that were given great weight in explaining the crisis. Indeed, despite their subsequent reversal, the raising of interest rates caused serious dislocations in the corporate and financial sectors, aggravating rather than eliminating structural weaknesses. Financial and corporate restructuring has just started.

“This suggests that the recoveries are not firmly based and that the structural difficulties may reassert themselves, possibly leading to a W-shaped recovery.”

*        Although in most countries seriously affected by the crisis, per capita incomes are now above or close to prior levels, income appears to be less equally distributed. In particular, employment and labour earnings have lagged behind aggregate income, and poverty has remained considerably above pre-crisis levels.

“On some accounts it could take East Asia a decade to eliminate the poverty created by the financial crisis."

“This is consistent with the general pattern observed in emerging markets that boom-bust-recovery cycle tend to be regressive in terms of income distribution and poverty, even when their overall impact on economic growth may be neutral.”

*        The crisis has longer-term implications for the economic development of the region not only because it has led to structural dislocation in the corporate and financial sectors, but also, and above all, because it has laid bare the kind of vulnerability that the region is exposed to as a result of its excessive reliance on foreign markets and capital for economic growth.

“This may call for a reconsideration of the development strategy.”

Analysing the policy response to the crisis and the recovery process, the UNCTAD economists say that a close examination of the evolution of policies and economic performance in the region provide valuable lessons on the limits of orthodox macro-economic policies under conditions of payments crisis originating in the capital account, as opposed to traditional crises associated with macro-economic imbalances and difficulties in financing current account deficits.

The report notes that evidence suggests that currency depreciation inflicted much less damage on firms than a rise in interest rates and cutbacks in domestic credit lines, because many firms with large foreign indebtedness were export-oriented.  If credit lines had been maintained, greater competitiveness and growing export revenues would have provided a cushion against rising liabilities in domestic currency as a result of depreciations.

While rising interest rates failed to stabilize currencies by restoring confidence (bringing in or back foreign funds), the sharp recovery in foreign exchange reserves due to improved current payments produced by a slump in imports, together with declines in foreign claims by rescheduling short-term debts, brought currency stability and reversal of tight monetary policy.

Analysing the Malaysian experience, of first adopting orthodox policies and then changing course when it did not succeed, the TDR comments:”The Malaysian experience also demonstrates that fixing the nominal value of the currency does not necessarily lead to appreciation, provided that such a policy is accompanied by effective control over capital flows.”

Looking at the Korean experience, where the restructuring of private debt has resulted in the government holding more than 50% of total shares in the largest surviving banks, TDR says: “Thus, contrary to expectations, recovery has taken place without any major financial and corporate restructuring.” However, the report cautions that the Korean recovery is “probably more fragile than it may appear.” Exports were unlikely to continue at the recent pace, the initial surge having a one-off element associated with sharp swings in exchange rates.

Not only the speed, but the sources of the current recovery are quite different from that expected on the basis of orthodox diagnosis and interpretation of the crisis.

In fact the IMF baseline scenario expects recovery driven by private investment - even though many countries have significant excess capacity.

On the growth prospects, and the various IMF, World Bank policy advices and projections based on total factor productivity (TFP) growth rates—and comparing them with past assessments and advices on these—the UNCTAD Report says: The conflicting views regarding the past and potential TFP growth performance of East Asia, together with conceptual and empirical difficulties associated with this concept, “cast serious doubts on the reliability of TFP growth as a guide to policy.”

“The financial crisis,” the UNCTAD economists say, “has shown that excessive reliance on external resources and markets leaves growth prospects in the region vulnerable to potentially sharp shocks and reversals in trade and finance, particularly when integration is not properly managed.”

On the latest policy advice for financial integration, accompanied by measures designed to increase disclosure and transparency and to strengthen prudential regulation and supervision of the financial system, the UNCTAD economists comment:

“The continuing incidence of financial instability and crises in industrial countries with state-of-the-art practices in these areas suggests that such reforms are unlikely to provide fail-safe protection. The appropriate management of integration into the global financial system calls for measures that go beyond information disclosure and prudential regulations, and should include close supervision over private borrowing abroad, as well as tight control over speculative capital flows. As experience has shown, such forms of control are quite compatible with continued access to foreign capital.”

The events leading to the crisis, the economists add, also highlight the increased risk of vulnerability to trade shocks.  While the emergence of new competitors in labour-intensive products was an important factor in the weakness of export performance for some second-tier Newly Industrializing Economies (NIEs), there was a sharp decline in terms of trade for the first-tier NIEs between 1995 and 1997 -- partly the result of excess capacity in high-tech sectors (such as semi-conductors), further complicated by re-emergence of imbalances in global demand.

However, underlines the report, the increased vulnerability to trade shocks in manufactures is the result of far-reaching changes in the world economy in the past few decades. International trade flows and prices have become more unstable partly because of increased instability of growth and persistent demand imbalances in major industrial countries, and partly due to sharp swings in exchange rates and competitiveness.

“Moreover, as more and more developing countries opt to outward-oriented development strategies, the vulnerability to trade shocks and the risk of fallacy of composition has been increasing.”

The report calls for more balanced long-term growth path for countries in the region, reducing their dependence on foreign markets and resources.

With less than 10% of the labour force in agriculture and with per capita incomes two-thirds of the Western European average, Korea, it notes, has now entered a more demanding catch-up stage, similar to that of countries on the Western European periphery in the early 1950s (Austria, Finland, Italy and Germany). Domestic savings are high enough to bring this about without relying on foreign capital.  Also, the experience of Japan underscore the problems associated with heavy reliance on export-oriented industrial growth. The successful experience of the Western European periphery, and the strategy of reliance on domestic markets with stronger social dimensions, offered a viable option, UNCTAD says. The policies should include a rise in wages, a reduction in working hours and an increase of public expenditure on health and education.

For the second tier NIEs, opportunities for catch-up are greater and their external linkages likely to remain stronger. An annual growth rate of 7% may not be unrealistic for them. With abundant labour still in agriculture and domestic savings at over 30 percent, heavy reliance on foreign savings would not be necessary for them.

New investment would be needed to upgrade manufacturing activities, including in more technology-intensive sectors where import dependence is very high, and to ensure that a higher share of value added from manufactured exports is returned to the domestic economy.

In countries like Malaysia, this would be consistent with a significant reduction in share of imports in GDP as the domestic value-added content of exports increases. A healthier integration into the global trading system would be consistent with an emphasis on capital formation in areas such as information infrastructure, transportation and training - areas where much of the investment would require public expenditures.

And given the way high-tech sectors are organized internationally, industrial, trade and financial policies would be required to bring about the desired growth through a conscious effort by policy makers to direct and coordinate foreign and domestic investments and to develop local technological skills.

“Thus,” concludes the report, “contrary to the mainstream view, renewing catch up in the second-tier NIEs would still require the involvement of a developmental State, albeit with new,and in some respects, even more demanding policy agendas.”

Says Ricupero in his overview: “A fundamental lesson of the financial crisis is surely that excessive reliance on foreign resources and markets leaves growth prospects vulnerable to external shocks. Policy makers have rightly rejected a retreat into protectionism, but it would be just as wrong to allow global market forces to dictate future growth and development."

“With domestic savings likely to remain high, dependence on foreign capital to close the income gap with the leading industrial nations will be that much less. Greater attention also needs to be given to domestic sources of growth, such as rising wage shares and higher social spending. There is a major role for public investment and involvement of a developmental State, with new policy agendas."

“Regional economic ties are likely to remain important and should be strengthened, inter alia, through collective mechanisms against systemic financial instability and contagion.”-SUNS4744

The above article first appeared in the South-North Development Monitor (SUNS) of which Chakravarthi Raghavan is the Chief Editor.

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