Learning the Right Lessons From 97

The learned Nouriel Roubini of Roubini Global economics wrote an insightful piece on how Asian economies were learning the wrong lessons from the 97 financial crisis. Mainly the concern was many Asian countries now save up too much forex reserves which could have dire consequences later on. The Economist did a follow up piece which further clarifies Roubini's thesis and added some useful caveats on that line of thinking. The following excerpts could probably be the most required piece of reading for all Asian central bankers:

... the optimists are right to say that Asia is stronger and more resilient. The region is far less vulnerable to a balance-of-payments crisis than it was ten years ago, when all the crisis-hit countries had large current-account deficits. Now they all have current-account surpluses and much less foreign debt. They also have vast foreign reserves to protect them against any future speculative attack. As a rule of thumb, a country should have enough reserves to cover its short-term foreign debt. On the eve of the crisis in June 1997 South Korea's reserves were only one-third as big as its short-term debt; today they are twice the size. In most of the other countries, reserves are also two to three times bigger.

These large war chests mean that a repeat of 1997 is unlikely. However, some economists, such as Nouriel Roubini, of Roubini Global Economics, argue that the build-up of reserves is itself creating new hazards. East Asian policymakers, says Mr Roubini, failed to learn the most important lesson of the crisis. Exchange rates are once more, in effect, tied to the US dollar. This, he argues, risks creating a new, but different financial crisis—not a balance-of-payments shock like last time, but booms and busts in asset markets.

As governments try to keep their currencies cheap, developing Asia's total reserves have jumped from US$250 billion in 1997 to US$2.5 trillion this year. The desire to build up reserves is understandable, but they are now excessive. Asian economies' policy of tracking the dollar and the consequent rapid increase in reserves, argues Mr Roubini, is leading to excessive growth in money and credit, inflationary pressures and asset bubbles in shares and housing. This, he concludes, will eventually lead to vulnerabilities similar to the massive capital inflows, credit boom, overheating and bubbles that preceded the 1997 crisis.

His grim prediction is based on the “impossible trinity”: an economy cannot control domestic liquidity and manage its exchange rate if its capital account is open. If it holds down its currency, foreign-exchange inflows will boost money growth. The central bank can try to “sterilise” the impact of bigger reserves by selling securities to mop up the excess liquidity. The snag is that bond sales will tend to push up interest rates and so attract yet more capital inflows. Mr Roubini believes that the room for sterilisation by Asian central banks is severely limited and so rising reserves mean even greater excess liquidity.

The big difference

However, these economies may be able to sustain today's policies for longer than Mr Roubini expects. This is because many of the economic characteristics he describes—such as fixed exchange rates, massive current-account surpluses and asset-price bubbles—certainly apply to China, but not to most of the smaller East Asian economies. To begin with, the chief victims of the crisis have let their currencies appreciate against the dollar by much more than China has. Only Hong Kong still pegs to the dollar. The South Korean won has risen by 42% since 2002 and the Thai baht by 28%. China accounts for most of the increase in Asian reserves. Since December 2004 the combined reserves of Indonesia, Malaysia, the Philippines, South Korea and Thailand have risen by only one-third; China's have doubled.

Second, the common claim that these economies have big current-account surpluses, which proves their currencies are undervalued, is much exaggerated. China has a big surplus, but of the former “crisis countries” only Malaysia has a large surplus (11% of GDP). South Korea, Thailand and Indonesia have an average surplus of less than 1% of GDP (see chart 2). Indeed, Morgan Stanley reckons these currencies (Korea, Thailand, Indonesia) are now overvalued against the dollar.

Third, in most countries the build-up of foreign-exchange reserves has not hugely pushed up the growth of money and inflation. The broad-money supply in the crisis economies is up by just over 10% on average over the past year, much less than China's 17% and well below their money growth of more than 20% in the mid-1990s. Inflation also remains tame. In its Asia and Pacific Regional Economic Outlook, the IMF concludes most emerging Asian economies are not on the verge of overheating. It sees little evidence of housing bubbles in most countries: average house prices have not risen by much more than incomes in recent years. Share prices have soared, but those gains follow sharp declines. With the notable exception of China, price-earnings ratios in East Asia remain below those in developed markets.

Foreign-exchange inflows are not causing money and credit to explode partly because central banks' sterilisation has been relatively successful in mopping up liquidity. One important difference between now and the years leading up to the crisis is that the upward pressure on currencies and the increase in foreign reserves almost entirely reflects current-account surpluses and inwards foreign direct investment, not net inflows of hot money. According to David Carbon at DBS, a Singapore bank, net capital inflows into the crisis economies have averaged only 0.5% of GDP since 2004, compared with 6.5% during 1991-96.

Only Thailand has seen large net capital inflows and last year it ran into trouble. Inflation started to rise, leading the central bank to lift interest rates. This pulled in yet more capital and pushed up the exchange rate. In December, to stem the rise of the baht and regain control of liquidity, the government made a bungled attempt to slap a tax on inward portfolio investment. The stockmarket plunged. In most of the other small Asian economies, however, central banks have not been deluged by net inflows of short-term capital. This may be why countries have been able to sterilise large amounts of foreign reserves without attracting yet more capital.

Thus neither of the two commonly held views about the victims of the Asian financial crisis ring true. The economies hit hardest by the crisis have not fully recovered: their growth remains much slower than before 1997. But nor are they awash with excess liquidity and heading for another financial meltdown.

One big change over the past decade is the emergence of China as an economic power. Other Asian economies have lost some exports to China, but it imports large amounts of capital equipment and components from within the region. China's demand for raw materials has also pushed up commodity prices, benefiting some South-East Asian producers. China now takes 22% of the exports of the rest of emerging Asia, up from 13% in the late 1990s. Smaller East Asian countries have seen a slight decline in their share of global trade as China's has risen, but their exports have continued to grow rapidly. In the late 1990s, foreign direct investment in South-East Asia fell, stoking fears that China was stealing investment. However, over the past few years it has rebounded strongly. Overall, China has almost certainly been a net boost for the rest of Asia.

Nevertheless, the fear of losing competitiveness relative to China has played a big role in these countries' reluctance to allow their exchange rates to appreciate any more rapidly. If China allowed its currency, the yuan, to rise, they would have less need to intervene.

Wrong lessons

Could China be the source of the next crisis? China was less affected in 1997-98, thanks to strict capital controls. Indeed, by not devaluing its currency it helped to prevent a worsening of the financial contagion. But China, more than its neighbours, may have drawn the wrong lesson—namely the need to keep its exchange-rate stable and to build up massive reserves. China's monetary policy has been overly lax and low interest rates on bank deposits have encouraged a huge shift of money into its stockmarket. Thus Mr Roubini's diagnosis of Asia does apply to China.