May 23, 2007
What Asians learnt from their financial crisis
The Asian financial crisis of 10 years ago taught two contrasting lessons: the one the majority of western economists thought the Asians should learn; and the one Asians did learn.
The western economists concluded that emerging economies should adopt flexible exchange rates and modern, well-regulated and competitive financial markets. The Asians decided to choose competitive exchange rates, export-led growth and huge accumulations of foreign currency reserves. The question is whether the Asians need to change their choice. The answer, I believe, is “yes”.
The remainder of Martin Wolf’s column can be read here (FT.com subscription required). Discussion from our guest economists is free.
Andrew Smithers: Martin comments that China’s accumulation of reserves is neither desirable nor sustainable and he promises to tell us what should be done about it next week.
The problem is of course different from a Chinese and a US perspective. A rising Chinese real exchange rate is the obvious and indeed inevitable solution and, from a Chinese perspective, it will be preferable if this comes mainly from a rising nominal rate and only to a small degree from a domestic inflation rate which is significantly above the world average.
From the US viewpoint, however, any combination will reduce the downward pressure on prices that has come from external sources and thus amplify the inflationary pressures that are already coming from the fall in the dollar.
To balance this, the US will need to reduce domestic inflationary pressures by running the economy with a higher output gap than would otherwise have been needed. This is likely to have two important consequences. Profit margins are likely to fall and unemployment to rise. These changes will be unwelcome on Wall Street and Main Street.
Congress has been pressing for a rising real Chinese exchange rate. They are likely to get what they wanted and regret it.
Posted by: Andrew Smithers | May 23rd, 2007 at 4:01 pm | Report this commentMartin Wolf: I agree with Andrew. The disequilibria are becoming so large that it is becoming harder to imagine a smooth landing. At the global level it is becoming increasingly difficult to control the growth in liquidity, largely because foreign currency intervention is now so large.
Posted by: Martin Wolf | May 24th, 2007 at 4:11 pm | Report this commentEdwin Truman (guest): The Wolf/Roubini lessons Asians learnt from their financial crisis contains a lot of useful analysis. However, they are completely off base when they say that the accumulation of foreign exchange by Asians “compels” US monetary authorities to follow an easy monetary policy to fight the leakage from domestic demand. I would put the matter quite differently.
The dollar has been declining for five years even though much of the decline has not been against Asian currencies, and had been declining for 2 and a half years before the FOMC began to tighten in mid-2004. The problem is and was that the Federal Reserve adopted a policy that ran against the textbook prescription by continuing an increasingly easy monetary policy (indexed by real interest rates). They were not compelled to do so by anything other than their midguided analysis, certainly they were not compelled by the fixity of Asian exchange rates in the period prior to mid-2004.
Edwin M. Truman was assistant secretary of the US Treasury for international affairs from December 1998 to January 2001
Posted by: Edwin Truman | May 28th, 2007 at 10:10 am | Report this commentNouriel Roubini: Ted, thanks for your comment. Just one clarification: in my paper i did not argue that the Asian/Chinese policies compel the Fed to “to sustain easy monetary policy, in order to offset the leakage from domestic demand caused by the huge current account deficits.” That may or may not be Martin’s view but it is not mine.
I rather argued that the leakage of liquidity from China, Japan and East Asia has in part fuelled asset inflations in other parts of the world, including the US. Indeed the bond conundrum - that stimulated US real estate investment and higher home prices until 2006 - was partly due to the excess of savings relative to investment in China and in other members of BW2. In this sense, I argued, there was a spillover from Chinese/Asian monetary policies to financial and asset price conditions in the US and in other adavanced economies. But i did not argue that such Asian policies affected Fed policy.
Posted by: Nouriel Roubini | May 29th, 2007 at 2:03 am | Report this commentMartin Wolf: I want to apologise for getting back to Ted Truman’s important comments on this column so belatedly. Moreover, as Nouriel Roubini points out, the mistake – if mistake it was – was mine alone. It is I who believe that the currency intervention policies of capital surplus countries significantly affect the Federal Reserve’s monetary policy. Indeed I find it difficult to understand how a man as experienced and sophisticated as Ted can believe otherwise. This is not the same thing as saying that the monetary policy pursued by the Federal Reserve has been optimal. It is perfectly possible that it has been too loose.
I have taken up some of the issues in subsequent columns, notably “Villains and Victims of Global Capital Flows” (June 12 2007). But I have two comments to make directly to Ted’s comments.
The first is that the depreciation of the US dollar is not itself a decisive indication of an excessively loose monetary policy. As we all know, the price of a currency is more than the price of its money. Most of us believe that the dollar had become fundamentally overvalued by (i.e. incompatible with the maintenance of internal and external balance in the long term, on any plausible assumptions) by the early 2000s. Its depreciation was necessary and desirable, provided it did not compromise the maintenance of price stability at home.
The second comment is that the incorporation of China into the US monetary area (which is where it now effectively resides) must affect Fed policy.
Assume that we consider China to be the 13th Federal Reserve district. (I know that this is too simple, but it is not entirely wrong either.) Assume, too, that the aim of Fed is to keep output in line with potential (the latter, of course, being a “guesstimate”) in the remaining 12. Now the new 13th member lends several hundred billions of dollars a year to the residents of the other 12, allowing the latter to consume substantially more than their own output. (In addition, the supply price, in dollars, of products from the 13th member is falling, thereby lowering dollar prices of competing goods in the remaining 12.)
What monetary policy must the Fed follow? The answer is one that generates demand in the remaining 12 districts equal to potential output, plus the net lending from the 13th. Then and only then would there be no large output gap in the remaining 12. The monetary policy that would then emerge would almost certainly have consistently lower nominal and real interest rates than if the 13th district was not behaving as it is. Indeed, one could argue that the constraint on monetary expansion now is not inflation in the 12 districts alone, but inflation in all 13. The Fed’s policy must not be so expansionary as to create significant inflation in China itself. For that would be transmitted to the remaining 12 districts, either via an accelerated appreciation of the renminbi or by high inflation in renminbi, both of which would raise prices of tradeable goods in the other 12 districts.
I am not suggesting that normal concerns about inflation do not continue to apply. Too weak a dollar would still be a problem, as Ted says, since it could lead to huge depreciation of the dollar (and so of the currencies of the extended dollar area) against other currencies. But, at the broadest level, the availability of very large capital inflows from the rest of the world surely affects both the real rate of interest and the optimal monetary policy in the US. I don’t see how that could not be the case.
Posted by: Martin Wolf | June 17th, 2007 at 10:22 am | Report this commentRobert McDowell: The Asian financial crises of the 1990’s beginning with Japan at the beginning of the decade and other SE Asian countries at the end of the decade (including comparable solvency problems for China’s banks) may be compared to the US sub-prime crisis insofar that property and construction bubbles formed and burst. This is less apparent looking at aggregate national property prices, but very apparent in major cities’ data.
The property bubbles were concentrated in the major cities (with most countries’ economies over-dominated by one major megalopolis, which, in efecft, developed economic arterial-sclerosis). Property developments and construction loans dominated retail bank lending as they do in most countries, but more so. Construction sectors were over 25% of GDP, even in industrialised Japan. It has taken 1-2 decades for property values and rents to recover. The bankruptcy of retail banking fed through to the internationally active banks and consequently the crisis was predominantly noticed in the west as a financial regulation modernisation problem and currency crisis (requiring large-scale IMF support). The roles played by property and construction sector bubbles (after 2 decades of roughly 10% annual GDP growth leading to large private current account deficits) were overlooked.
The Japanese government and central bank’s response was to refinance the banks to pay down loan loss provisions. Arguably, this fed money into the wrong end of the food chain; recovery might have come sooner if the financial injections had been applied to the construction sector such as by more public sector infrastructure and housing, or other construction incentives given its employment size in the economy (more than 5 times greater than in western economies and a major employer of immigrants to the cities from agricultural villages).
Export surpluses alone could not generate growth or feed through to domestic demand so long as property and construction recovered only slowly. When Japan’s national wealth increased for the first time in a decade, in 2006, National Debt stood at 175% ratio to GDP and is now about 150% ratio to GDP, more than three times EU levels. Even in China with over $1 trillion in foreign reserves, banks’ non-performing loans stood at over 40% ratio to GDP as recently as 2006 (and that ratio is based on China’s grossly over-inflated GDP estimates). Many, or most, of China;s banks were technically insolvent for years and relied on Government ownership and guarantees as now they rely on western FDI and imported expertise.
Other SE Asian banks had to live similarly with large non-performing loans for years. The Asian crisis was similar to the current USA, and comparable property bubble, high deficit economies in the EU (such as UK, Spain, Ireland, Netherlands and Greece). Here the banks too will generate large loan losses, but recoveries will be higher if borrowers believe recession will be short-lived. Delinquencies may soar, but may then over a few years net out to actually validate the rating agencies through-the-cycle risk ratings of economic loss values that are currently being heavily blamed. The length of recession is critical. The reason EU banks have been more conservative than Anglo-saxon banks is that they experienced a long period of low growth due to the fiscal pressures required to adopt to the new Euro currency.
The Asian Crisis like thaat currently of the USA was created by large quantities of under-priced credit (much of it to supply the poorest sections of society with mortgages) generating a highly-leveraged economic climate and large current account deficits while pushing up asset prices to an unsustainable level (domestically and externally).
When these asset prices began to collapse, individuals and companies defaulted on debt obligations and panic spread among international lenders too leading to a large withdrawal of credit from the crisis countries and their stock markets, i,e, a liquidity crisis credit crunch and a concertina of bankruptcies. Property and construction is particularly vital in developing countries and in all countries in spreading economic growth and in widening and deepening domestic economic activities via property as collateral for bank lending. Property is like finance, not just an economic sector, but intrinsic to all domestic wealth and credit creation. Property rises and falls do not trigger credit and economic cycles, rising and falling employment; they are the cycles.
Posted by: Robert McDowell, Edinburgh | April 12th, 2008 at 12:21 am | Report this comment