Ten years after the Asian financial crisis: New challenges?

The Jakarta Post ,  Jakarta   |  Mon, 07/23/2007 11:40 AM  |  Opinion

Jusuf Wanandi, Jakarta

Ten years after the crisis, the big question is whether we have now become better prepared to face a financial shock. Have we learned enough from the crisis to improve on our weaknesses, especially in the financial field, and are we able to prevent another crisis in the future?

In some countries, including Indonesia, the crisis has not been fully overcome in terms of unemployment and poverty. Even on the political front some lingering weaknesses are being felt. Only China, Singapore, Vietnam and, recently, Hong Kong are exuberant economically.

The economic situation in the region looks quite different from that in 1997/1998. Economic recovery has been largely on track, some sectors are booming and bubbles may be developing, accompanied by stronger currencies, rising stock markets and a record low sovereign spread.

It could be argued that Asia has learned some lessons from the financial crisis of 1997/1998 by addressing many of its own sources of vulnerabilities. But according to some experts the region may also have learned some wrong lessons from the crisis. In that sense, it may have planted some seeds of new and different financial vulnerabilities. This could lead to a different crisis in the medium term, or even in the short term, in the event of a global shock such as a hard landing in the U.S.

What has created this new vulnerability? According to the economist Nouriel Roubini from New York, there has been a major change in the Asian growth model. The change is from a capital importing one with large current account deficits and a reliance on domestic demand (investment and consumption), to a capital exporting one with export-led growth based on undervalued currencies, external surpluses and reliance on net exports and investment directed toward the production of tradeables.

This model was chosen first by China, and followed by other East Asian countries, as they become more dependent on the Chinese economy.

There are however real weaknesses in this model, although temporarily it looks successful from the outside.

First, it leads 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 in pre-1997 in a region of semi-fixed exchange rates).

This could trigger a financial crisis that is different from that of 1997/1998 but could be just as severe, because of a severe slowdown in Asia's and the world's economic growth, starting with China, in reaction to a hard landing or slow growth in the U.S.

Second, excessive reliance on an economic growth model based on rising external demand is dangerous for several reasons. It has made Asia now reliant on U.S. and global demand from outside Asia for its growth. In view of the current risk of a U.S. hard landing or even a serious U.S. growth slowdown, it is a dangerous and vulnerable growth model for the future.

Third, reliance on an ever increasing level of net exports increases the risks of a protectionist backlash in the U.S. and EU and even trade wars and trade conflicts. It also means capital losses on the holding of dollar reserves and dollar assets.

Thus, this export-led only growth model is unsustainable and a more balanced growth pattern with greater reliance on domestic demand is critical for the long-term growth and stability of the region.

Even if a soft landing happens in the U.S., while China and Asia continue to grow at strong and sustained rates, it is in the medium-term interest of China and Asia to change their strategies. They should create conditions that allow domestic demand to grow rather than excessively relying on net exports and being hostage to U.S. growth.

This requires a move to genuinely flexible exchange rates, moving out resources from traded sectors into non-traded services, fiscal stimulus, greater public investment in infrastructure, creation of social safety nets and greater financial sector liberalization, development and deepening that will allow households to spend more, and a better allocation of Asian savings to greater real investments for a more balanced growth that is more immune to a volatile global economy.

The key to this rebalancing of Asian growth is a faster rate of appreciation of the Chinese yuan, greater currency flexibility in China, followed by an appreciation of Asian currencies relative to the U.S. dollar once China shows the way.

Otherwise these economic and financial imbalances and the vulnerabilities mentioned above will become more serious and could build up over time into a new and different type of financial crisis in Asia, once the shocks become disorderly rather than orderly.

It could be concluded that Asia should not worry about fighting the last war, but rather it should be better prepared for the next financial stresses that could hit the region given its financial and currency policies.

The policies taken under the Chiang Mai Initiative (CMI) ""to defend Asia against speculative attacks"" are second order problems compared to the first order: one of adding US$450 billion of reserves a year (2006) to an existing pile of $2.5 trillion.

The policy of semi-fixed exchange rates, supported by the accumulation of massive foreign exchange reserves to neutralize export-led growth, is creating massive financial imbalances, namely excessive monetary and credit growth, a variety of financial asset bubbles, an excessive dependence on net exports and on U.S. economic growth, and an imbalanced pattern of aggregate demand.

This could eventually end in a new and different type of financial crisis, which could occur sooner rather than later if the U.S. experiences a hard landing.

The above is a list of new challenges that are different from 1997/1998, but have some similarities too, especially the inflexibility of currencies and dependency on the U.S. dollar.

Actually these are the new challenges that have to be taken up at the CMI in the context of the ASEAN Plus Three cooperation, to find a way out together in the region, especially with China as the main actor.

So much will depend on China's initiative, since the rest of the East Asia economies are part of the regional manufacturing platform, with China at the center. China knows that it has to act but is still hesitating on how to do it and by how far.

Although we do not know for sure whether the U.S. economy will experience a hard landing in the near future, we need to take this into account and adopt policies that gradually can be accepted and implemented to change the strategy and model of economic and financial growth in East Asia particularly.

But we first have to discuss and agree on the new challenges to the financial health of the region.

The writer is vice chairman of the Board of Trustees of the Centre for Strategic and International Studies (CSIS), Jakarta.

Copyright © 2008 The Jakarta Post - PT Bina Media Tenggara. All Rights Reserved.