Global Trends by Martin Khor

Monday 5 May 2008

How finance turmoil will affect Asia

The financial turmoil will cause a long adjustment period of slow growth in the United States.  Asian countries will be affected through trade and finance, said a world expert at an Asian UN meeting last week.


Asian developing countries can counter the ill effects of a global economic slowdown by boosting their domestic spending but several of them face serious risks from “bubbles” in credit, investment and in the equity and property markets, that were partly due to excessive inflows of foreign capital.

This was a main message given last week to Asian Ministers and policy makers at the UN Economic and Social Commission for Asia and the Pacific (ESCAP) in Bangkok by Dr Yilmaz Akyuz, former Chief Economist at UNCTAD and a leading authority on the global economy.

Akyuz was presenting a paper on the effects of the global financial turmoil on Asia and the possible policy responses open to Asian countries.

ESCAP Executive Secretary Dr. Noeleen Heyzer, who chaired the session, highlighted the need for Asian policy makers to understand the global financial crisis and to prepare to manage its effects on the region’s developing countries.

Replying to a question, Akyuz said no one knows how exactly the current US economic situation would evolve. “My hunch is the US will not have a deep recession and quick recovery, but a Japan-type situation of erratic and slow growth, over a longer period.”

To a question whether Asia can escape adverse effects of the global turmoil because it had its own growth locomotives but was also dependent on the US market, Akyuz said Asian countries could implement counter-cyclical economic policies, as it had done during the 2001 global slowdown. 

Asian developing countries now have the scope to undertake such counter-cyclical policies, said Akyuz.  Most major Asian countries had positive net foreign reserves and high domestic savings that enable them to increase domestic consumption as an alternative source of growth to offset the slowing of their exports.

Akyuz said what should worry Asian countries instead was the existence of “credit, asset and investment bubbles” in the countries, which is similar to the type of bubble in developed countries.  This makes them vulnerable to corrections in the form of sharp falls in the property and stock markets, and to difficulties faced by banks and companies in the private sector.

Akyuz said the main problem in many Asian countries was their openness to capital inflows, which had led to excessive inflows of various types of funds in recent years.

Significant parts of the Asian countries’ high foreign reserves had come from capital inflows, as contrasted with a growth of reserves resulting from trade surpluses.  While the build-up of earned reserves (from trade surpluses) is alright, said Akyuz, it does not make sense to add to the foreign exchange reserves by allowing large inflows of capital.

Akyuz traced the source of the current global turmoil to the “easy money” policy with low interest rates especially in the US and Japan, accompanied by speculative lending and a bubble in property markets, which sowed the seeds of current difficulties.

The same factors, including the search for yield by investors, led in recent years to the strong recovery of capital flows to emerging markets, contributing to currency appreciations, asset bubbles, credit expansion and growth in recipient countries.

Akyuz said that drawing from the lessons from the 1997 Asian crisis, there is need to guard against four types of vulnerabilities associated with surges in capital inflows:   (1) currency and maturity mismatches in private balance sheets and exposure to exchange rate risks;  (2) rapid credit expansion, asset bubbles and excessive investment in property and other sectors;  (3) unsustainable currency appreciations and external deficits;  (4) lack of self-insurance against a sudden stop and reversal of capital flows, and excessive reliance on outside help and policy advice.

He concluded that most Asian countries acted on the third vulnerability and the fourth (by accumulating foreign reserves to counter potential external shocks).

However, they have not been able to prevent capital inflows from generating asset, credit and investment bubbles, or maturity and currency mismatches in private balance sheets.

This is because the countries were unwilling to impose sufficiently tight controls over capital inflows.  This has generated economic fragility in the countries, and the countries are now exposed to certain risks, though not of the kind that devastated the region in the 1990s.      

Pinpointing the surge of capital inflows as a problem, Akyuz said inflows to Asian developing countries were $220 billion in 2005, $260 billion in 2006 and $208 billion in 2007.

The inflows have led to credit, asset and investment bubbles, said Akyuz.  The foreign share of transactions and holdings in equity markets is very high in several Asian countries.  Large capital inflows have led to a bubble in the equity markets.  There has also been a boom in property markets in many countries, including China, India, Korea, Singapore, Vietnam.   The surge in capital flows contributed to the rapid expansion in liquidity and to the bubbles.

In 2007, Asian developing countries had over $2 trillion in foreign currency reserves, and half of this is “borrowed reserves” built up from capital inflows.  The cost of having these borrowed reserves is high as the return earned on reserves is less than the cost of servicing the foreign capital. 

Akyuz estimated that Asian countries are losing $50 billion a year, which is the “carry cost” (of the borrowed reserves).  Also, countries with a large stock of US dollar reserves stand to incur considerable losses with the downward pressure on the dollar.

Akyuz’s paper analysed the possible effects of the global financial turmoil on Asia through the finance and the trade mechanisms.

On finance, he said Asian economies do not seem to have large direct exposure to securitized assets linked to sub-prime lending.  The finance-related impact on Asian countries will be transmitted through capital flows, in conditions of the existence of the bubbles in the countries.  

Large drops in equity markets in developed countries can cause sharp corrections in Asian markets, and if this is combined with a reversal of capital flows and contraction in exports, it can have serious impact on growth.

On the trade side, Akyuz examined the argument made by some about that Asian countries had “decoupled” their economic growth from the US economy, and thus they would not be significantly affected by a slowdown in the US market. 

However, Akyuz pointed out that the negative effects of a slowdown in the US would be felt not only directly through reduced exports to the US but also through reduced exports to Europe (which itself would be affected by the US developments).  Moreover, there would be significant indirect effects; in particular, if China’s exports to the US are affected, other developing countries in Asia that export to China would be affected.  For example, China’s imports of intermediate goods (that go into making its exports) from other Asian developing countries would be reduced.

Thus, the combination of severe trade and financial shocks from the sub-prime crisis with domestic fragilities linked to the credit, asset and investment bubbles could pose serious policy challenges for Asia, especially in China and India.

The appropriate policy response is to expand domestic demand through the fiscal stimulus, said Akyuz.  And if difficulties arise in the financial sector, governments may have to arrange for “lender of last resort” financing. 

There should be a shift from reliance on exports to expanding the domestic market through increases in consumer spending.

Akyuz warned that in Asia the spillover effects of the global financial turmoil will be felt when the region is facing fragility and imbalances arising from recent trade and financial policies, including credit, asset and investment bubbles and excessive reliance on foreign markets.

However, economic fundamentals are strong enough in Asian developing countries to allow them to have a positive policy response.  On balance, the countries can continue rapid but reduced growth -- provided they take counter cyclical and structural measures to address domestic fragility and imbalances and counter the adverse effects of external shocks, concluded Akyuz.