international analysis and commentary

Asia Needs to Reform to Rise


Asian economies are weathering the present global crisis but long-term gains will be possible only if governments use the opportunity to carry out more reforms.

It has been almost exactly two years since Bear Stearns  & Company ignited the present world economic crisis by telling investors they could no longer withdraw their money from two subprime loan-exposed hedge funds. The slowdown has since affected every nation in the world except, perhaps, North Korea. But the nature of the impact has differed wildly from region to region. It is noticeable that most of the large economies that are still eking out growth are in Asia. But it is premature to say the present crisis has decisively shifted geoeconomic power to the East.

Four categories
As the crisis has evolved over the past two years it seems that the affected nations can be roughly divided into four different categories. The first category is those countries that were caught in the financial meltdown, whose economies are now deleveraging trillions of dollars of toxic assets. This includes the United States and much of Europe, most noticeably the United Kingdom. The second category is those economies whose growth was driven by exports. Most of these were in East and Southeast Asia. The third is commodity-based economies like Russia and the oil exporters of the Persian Gulf. The last are largely in Africa and have the additional burden of seeing overseas aid flows drop off.

Effect on Asia
The Asian Development Bank has calculated that GDP growth in Asia was pulled down by 6 to 10 percentage points by the present downturn. The main reasons for the loss are a roughly $80 billion drop in exports and an outflow of foreign portfolio capital.

The three largest Asian economies – Japan, China and India – suffered in slightly different ways. However, what they have in common is that the financial core of the present crisis has largely passed them by. As one May 2008 analysis showed, subprime losses represented 1.95% of the capital and 0.09% of the assets of Asian banks. Among all the advanced economies, Japan’s was the only one whose households saw almost no increase in net financial liabilities.

For China and Japan the virus of the economic crisis was transmitted largely through the medium of trade. Japan, whose automobile and electronics sector had indulged in an orgy of export driven growth, experienced the steepest fall in GDP growth of any OECD country – an annualized contraction of 12% in fourth quarter 2008. Now that its export sector has been purged of much of the bloat that it picked up the past three years, Japanese industrial production has actually begun to rise again. Chinese exports have fallen by some $30 billion and it has seen its growth forecasts fall to 9%, well below its 2007 high of 13%. Beijing has tried to compensate for the huge loss in demand with huge multi-billion dollar stimulus packages. Chinese fixed investment was a third higher in the January-May period than last year – itself representing a 30% increase over the year before. India has seen its economic growth fall from 9% a year to a forecast of 6 to 7% for this present year. India was affected by a quick outflow of private capital which depressed its stock market and caused the rupee to depreciate. This was followed by a slump in demand for India’s key exports like textiles and jewelry. Since India’s economy is largely domestic consumption-driven, the drop in exports has been less of a concern than capital outflows. The fact that foreign portfolio investment has turned positive over the past few months and foreign direct investment held steady has been a bigger confidence booster for India than anything else.

Asian imbalance
Asia seems to have survived the present crisis better than any other continent – only Latin America has done almost as well. But Asian governments have, with reason, been wary of claiming the world economic crown.

China is normally cited as the greatest winner of the present crisis. “Chimerica” and “G-2” are terms that reflect the view that the West’s retreat has meant China’s advance. This is only partly true.

First, “G-2” also reflects the fact that at the heart of the present global crisis was a fiscal imbalance whose two poles were US over-consumption and Chinese over-investment. China’s deliberate subsidization of US consumption over the past decade was a key reason for the housing bubble that followed.

As US and general Western consumption falls, China will have to decide how to find that missing demand. US household savings have risen from less than zero to nearly 6% of US GDP. To compensate for this loss of demand, as Michael Pettis of Beijing University has pointed out, Chinese households would have to increase their consumption by an impossible 40%.

So far, say most observers, China is carrying out its traditional response to a slowdown by using its enormous financial reserves to stimulate investment and wait until demand for exports resumes. If so, this would indicate Beijing is running away from the structural changes – and the resulting social unrest – that moving from an investment-driven to a consumption-driven economy would entail.
Not all economists agree. David Dollar of the World Bank is among those who argue China has been making progress on switching to a new growth model. Beijing’s use of government programs to support rural households, its investment in urban welfare and the like, have meant consumption contributed 4.3 percentage points to China’s first quarter 2009 growth of 6.1%.

The Indian story is different, but is also about finding the political will to carry out more reforms if it wishes to relive the glory of the recent past.

Just before Lehman Brothers went belly-up, the Indian government had begun to say 10% annual growth was within grasp. The reason: investment levels had passed 40% of GDP, indicating the economy was about to add a second engine to its existing consumption-based driver. This investment, much of it private sector-based, has now dropped several percentage points following the crisis. New Delhi has little fiscal space because of massive welfare expenses incurred to ride through a 2003-08 commodity-driven inflationary spike. So its stimulus packages have been relatively small, with the focus on compensating for the drop in private investment and expanding welfare benefits to hold up household demand. Getting the private sector to begin investing on the scale it was before the crisis began should be the government’s medium-term priority. This requires a reduction in interest rates – presently among the highest in the world, getting banks to lend to businesses again, and restoring consumer confidence.

Another issue is how to cover a current account which has turned negative for the first time in a decade. This requires foreign capital flows. Foreign portfolio investment has begun to flow in again, largely in the form of private equity. Remittances and direct investment have experienced mild declines. Getting all three flows to start rising again will require the government to open up the economy and carry out long-term reforms in education, health and urban development.

It is likely China will pick up extra votes at the IMF and that the G-20 will be given a degree of importance it never had before. However, much of this is merely an acceleration of what was already on the cards. If the present crisis is to be remembered as a time when power dramatically shifted to the East, the key emerging Asian economies need to accelerate a reform process that has been neglected because of the boom years of the past decade.


Paper prepared for The World Economy conference, Rome, June 22-23, 2009.