Feature Stories | May 11 2007
By Greg Peel
In July 1997, the Thai baht collapsed. The crisis quickly spread to Indonesia, Malaysia and by October hit South Korea. By 1998 the effects had spilt over into Hong Kong, Taiwan, Singapore, the Philippines and China. Currencies collapsed, stock markets collapsed, and the “Tiger” economies entered into a period of painful recession.
It’s just as well that things are different this time.
Nouriel Roubini is a professor of economics at the Stern School of Business at New York University. He is also the founder of economic consultancy Roubini Global Economics. It would be fair to say that Roubini is a bear. For the past couple of years he has railed against the perilous US current account deficit, only to see the global economy continue to fire. That growth has been led by Asia, and it is in Asia where Roubini sees building problems.
Asia learnt from its mistakes after the 1997-98 crisis, Roubini notes. If anything, too well. While those factors which brought down Asian financial markets a decade ago are no longer a problem, it doesn’t mean that a new set of problems hasn’t surfaced. In short, were the US economy to suffer a harder landing than it is so far experiencing, there could be trouble. Big trouble.
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In the mid-90s the Tiger economies of Asia were firing along. They wanted to be part of the global economic community. But in their desire to be so, inexperienced governments failed to appreciate that which must accompany surging economic growth.
Exchange rates were fixed or partially fixed to a rising US dollar. Large current account deficits were being run. Short term foreign currency debts were very large while foreign exchange reserves were extremely low, following futile attempts to defend overvalued, pegged currencies. Sovereign risk spreads were high.
Capital investment was excessive, up to 35% of GDP. Returns were low. There was a race for size, but productivity was falling. Corporate governance was poor, leading to excessive borrowing and excessive capital spending. There was a liquidity drought, leading to cashflow-based insolvencies. Capital controls were Draconian.
The IMF was forced to step in and deal with the liquidity runs and crunches by imposing austere fiscal and monetary tightening. And then (with a little help from George Soros) currencies collapsed and severe recessions ensued.
By 1998, China and India were in trouble. Japan was in the midst of its own long recession. Brazil was in trouble, and the Russian financial system collapsed. China had already started on its economic growth revolution, but in 1998, growth fell to only 4%. For China, that is a hard landing. The massive yen carry trade (yes it was around then too) collapsed.
But now – with the exception of the yen carry trade – things are very different.
Today in Asia, currency floats or managed floats exist and currencies are undervalued. Terms of trade have improved. Short term foreign currency debt has been minimised. Foreign exchange reserves are massive – so massive as to be many multiples of what the West considers a prudent level of capital adequacy.
Today investment rates are some 10% lower than they were (with the exception of China and Vietnam) yet growth rates are only modestly (about 2%) lower. Returns are thus higher. Corporate governance and banking structures are much improved.
Were downward financial pressures to return, there is plenty of insurance in foreign currency holdings. So much so as to render the IMF and its austerity measures superfluous. It is capital inflows, not outflows, that need controlling. Given recent moves to pool and control forex reserves across the region, an Asian Monetary Fund is quietly emerging. Japan tried this in 1997 but the US crushed the idea.
Economies are growing, currencies are rising, stock markets, housing and other asset prices are surging, and sovereign risk spreads are very low. China is booming, India is following, and Brazil and Russia are growing fast. Even Japan has turned the corner. As Roubini exclaims:
“What a difference a decade makes!”
So God’s in his heaven and all’s right with the world. Or is it?
There is a problem, says Roubini, with the Bretton Woods II system. Bretton Woods II is the label economists have given to the Asian currency regime which ultimately emerged from the ashes of the 1997 crisis and exists today. It is not a formal arrangement – merely a name given to the system that has established itself. (Economists like their little jokes.)
The original Bretton Woods system was a formal arrangement which was established after World War II and effectively pegged the value of foreign currencies to within a small range based on the price of gold. When the US government went broke after the Vietnam War, President Nixon suspended the conversion of US dollars into gold and the system collapsed. What emerged was the current system whereby the US dollar acts as the world’s reserve currency, rather than gold.
When the IMF imposed its presence on the Asian economies a decade ago it was formally agreed that Asian governments would no longer peg their currencies to the US dollar and instead they would be allowed to float. Thus could not transpire the same level of artificial currency overvaluation which was the root of the original problem. Good idea.
However, having been bitten once the Asian economies, led specifically by China, decided the best way to ensure the same crisis could not unfold again was to actually go the other way – effectively peg currencies so that they were undervalued to the US dollar. Otherwise, as soon as Asia got back on its feet the whole cycle of appreciation could start again. This nature of pegging is thus what has become known as Bretton Woods II.
The result of this pegging was that current account deficits quickly turned into surpluses. This was not a bad idea in the short term, as a build up of foreign currency reserves meant that Asia would now have ammunition against any further economic downturns. The result was that the Asian growth model completely changed.
The growth of Asian economies in the 90s featured strong domestic demand growth in both investment and consumption. Capital was imported, and current accounts fell into deficit. But once currencies were undervalued current account surpluses began to build, and Asia began exporting capital. And it began exporting goods to the world.
What started out as a fairly prudent idea – Bretton Woods II – then got a tad out of hand. As we passed 2002 the trickle had turned to a flood. As Roubini puts it, the accumulation of reserves became solely explained by “mercantilist objectives”. By keeping currencies undervalued Asia was driving a massive economic boom that thrived on global exports.
It was then when China in particular began to swallow up the world’s commodities, and factories sprang up overnight to cash in on the bonanza. The cheap cost of labour also meant global companies shifted their manufacturing businesses to China. This poured out cheap exports which were voraciously consumed by the US and other Western economies. China became manufacturer to the world. The rest of Asia has followed suit.
So if BW2 has led to growth in Asia and strong global financial markets, what problem does Roubini have with this picture?
“First, this new economic and financial model is leading to excessive monetary and credit growth, asset bubbles in stock markets, housing markets and other financial markets that will eventually lead to a build up of financial vulnerabilities – like the capital inflows and bubbles that preceded the Asian crisis of 1997 in a region of semi-fixed exchange rates – that could trigger a financial crisis different from that of 1997-98, but that could be potentially as severe.”
Secondly, says Roubini, Asia’s low reliance on domestic demand and high reliance on net exports (and production capacity for those exports) means that were the US economy to even slow down more seriously than it has, or worse – head into recession, then Asia is left very vulnerable. To exacerbate the matter, the longer export-led growth continues the more pressure builds up for protectionist measures from the US and Europe, which, if applied, would have the same effect.
Furthermore, it is not just East Asia which has adopted this BW2 model. It extends through India to the Middle East, the Gulf Countries, Russia, Argentina, and even Brazil and other Latin American countries.
While Roubini has noted the reasons why this time the situation is very different, compared to 1997, he also suggests that Asia has not necessarily learnt its lesson at all, and is on the verge of creating a new financial crisis in the region.
The interconnection of fixed currencies, easy monetary conditions and excessive reliance on exports has led to price distortion – being undervalued real exchange rates. At the beginning of the rise out of the ashes currencies were only marginally undervalued, but now they are grossly undervalued. Capital inflows into Asian assets as well as “hot money” looking for inevitable currency appreciation have led to an unprecedented growth in forex reserves.
The stock of Asian forex reserves is now about US$2.5 trillion, compared to US$250 billion in 1997 (ten times bigger). Reserves grew by US$251 billion in 2005, and by US$418 billion in 2006. The growth rate continues to accelerate in 2007.
China was accumulating US$20 million per month in 2006, and is accumulating US$40 million per month in 2007. Capital inflows continue to surge into the stock market, chasing highly publicised IPOs in the banking and other sectors. The longer China doesn’t allow the renminbi to appreciate as it should, the more hot money flows in, in anticipation of the day it will have to. China is having a very hard time “sterilising” these inflows (issuing enough low-rate bonds). The government keeps having to lift bank reserve requirements, but still bank lending and credit grow.
If monetary and credit pressures increase, but the real exchange rate doesn’t give, this can only lead to domestic inflation. To date, domestic inflation has already been experienced in some Asian countries and particularly beyond – India, Russia for example. It hasn’t, however, developed in China.
The reason it hasn’t developed in China is because there is still an excess of supply of labour coming in from rural areas; bumper crops have been experienced, keeping food prices low; manufacturing productivity is high, keeping labour costs low; oil and energy costs are price-controlled; and rent inflation isn’t even measured.
The Chinese economy is growing at a real rate of 11%, or a nominal rate of 13%, with a nominal lending rate of 6%. No surprise then that investment is running at 50%. And the returns on that investment are likely to be low and falling given the amount of overinvestment and duplication of capital spending across provinces. Housing prices are rising rapidly. And the stock market has doubled in twelve months.
Chinese retail stock market investors (which Roubini describes as “clueless” about financial risk) now number over 100 million. Day-trading of the extent last observed during the US dotcom bubble is now prevalent across Asia.
And the longer China leaves its ultimately unavoidable move to allow the currency to appreciate, the worse the resulting outcome will be. At the current rate of accumulation foreign reserves would reach US$2 trillion in China alone. If the renminbi were to appreciate by 20% today, says Roubini, capital losses would be about US$200 billion or 10% of GDP. By 2009 a 30% appreciation would be needed. In 2002 the Chinese current account deficit was 2% of GDP. In 2006 it was 9%.
The Asian economies rely on the US being “the consumer of the first and last resort”, notes Roubini, spending well in excess of its income. China has become “the producer of the first and last resort”, spending well below its income. Were US spending to slow, the situation would become dire. Via trade with China, the rest of East Asia is in the same boat. Roubini also suggests it is a myth that the rapid growth of inter-regional trade has rendered the dependence on US growth less serious. It has made the US more critical to the entire region. China has merely acted as the Western world had previously – farming out parts of its manufacturing process to its lesser neighbours. The final goods are still intended ultimately for export to the US or Europe.
Just as this is occurring, protectionist pressures are building in both the US and Europe. The longer currencies are not adjusted as required, the greater the risk of “trade wars” breaking out.
Finally, the excessively easy monetary and credit conditions caused by BW2, in combination with excess Asian savings leading to low global interest rates, have exacerbated spending in the US and elsewhere. This has fed global asset bubbles across a variety of risky assets – from equities to corporate debt, emerging market spreads, global housing, stock markets and commodity prices. Excessive savings in Japan have provided for the ubiquitous yen carry trade, which has fuelled asset bubbles, hedge fund leverage and private equity buyouts. The world is in a state of imbalance.
Unless China takes control of its financial system, which is clearly now out of control, it runs the risk of its own implosion. But it is its vulnerability to a change in current global conditions that is the most worrying factor. If the US economy achieves a soft landing in 2007 (a result that is beginning to look more and more dubious), then the stable disequilibrium of BW2 can continue for a while longer, says Roubini. If the US suffers a hard landing – growth recession or worse still, outright recession – then disequilibrium will become unstable.
Goldman Sachs estimates that if US economic growth were to slow from 3.5% to 2%, as appears to be presently the case, Chinese growth should slow from 11% to 9%. If the US slowed to just 0.5% growth, China would fall to 7%. And if the US slipped to 1% negative growth (ie outright recession) China would fall to 5%. For China, that would represent a hard landing.
If China lands hard the rest of Asia lands hard. Demand for commodities would collapse. The effect would thus flow through to South America, Africa and the Middle East (and, of course, Australia).
What’s more, if the US economy recedes the US dollar will fall. If Asian growth thus recedes then Asia will begin withdrawing its US dollar investments. The US would spiral. A trade war would be even more likely.
Finally, the global financial bubble would burst.
Roubini notes that China does not show signs of being overly concerned with its burgeoning foreign exchange reserves. In fact, it appears to be spending more time recently trying to figure out just where to invest them. But the longer it fails to take substantive steps to appreciate its currency, the situation only deteriorates. Even if the US economy suffers only a soft landing in 2007, the inevitable will be merely put off.
Asia learnt many lessons from the financial crisis of 1997. But now it would appear it has created a new monster.
Note: While the views of Nouriel Roubini are shared by many across the global spectrum, others take a differing view. The investment consultants at GaveKal, for example, envisage global economic strength that could go on for decades yet. Although even GaveKal acknowledges that there could yet be factors – unforseen outside shocks such as terrorist attacks, nuclear proliferation , or earthquakes, for example, notwithstanding – that could destabilise the global imbalance. The price of food is one factor, as discussed in “Beware Food Inflation” (FYI; 04/05/07).