Apr 22, 1998
UNITED NATIONS: ASIAN CRISIS, EMU COULD RESULT IN DEFLATION
Geneva, 21 Apr (Chakravarthi Raghavan) -- The conjunctural effects of the crisis in Asia and the impending introduction of the European Monetary Union and its Euro will strengthen the deflationary forces in the world economy, and may even result in deflation in the world economy, a UN regional body suggests in a cautiously worded warning.
The outlook for 1998 for the ECE region, is currently projected to be 2.7% GDP growth in Europe, and a slowing down in the US to about 2.5%, the UN Economic Commission says in its Economic Survey of Europe.
The outlook, ECE says, depends to a considerable extent on how serious the ramifications of the 1997 Asian crisis is likely to be, and whether it will have much larger negative effects on real activity than is currently allowed for.
The ECE region comprises the whole of Europe (east and west), and including the Baltic States and the Commonwealth of Independent States (of the former Soviet Union), North America and Israel.
While the projections take account of current national projections, and the IMF's October 1997 estimates, the IMF itself has further revised downwards the projections on the eve of the interim committee meetings earlier this month in Washington.
The latest IMF projections (purchasing power parity basis) are for a world GDP growth of 3.1% in 1998 (down from 4.3% earlier), with the industrialized countries growth expected to rise 2.4% (down from 2.9%).
The IMF has taken a slightly more optimistic view of recovery in the affected Asian countries.
The generally optimistic view of the world economy tends to emphasize the relatively low trade dependence of most western market economies on South-East Asia. But this ignores a number of issues. There are many items in the external account, other than merchandise trade, that may be affected.
Many western companies make large profits from Asia without exporting there, as do banks by their investments in the area. The net impact of the crisis on all these flows is uncertain.
The Asian crisis is complex and is likely to affect a large number of variables not all of which are easy to estimate or included in standard forecasting models, the ECE notes.
And the timing and effectiveness of a recovery in Asia would depend on the effectiveness of a financial rescue package and domestic policy responses, and the time it will take to restructure the banking and financial sectors to ensure adequate financial intermediation.
The ECE survey identifies two major uncertainties in the world economy: the direct and indirect effects of the Asian crisis, and the planned introduction on 1 January 1999 of the European Monetary Union (EMU) and its single currency, the Euro, among 11 of the 15 member-states.
This impending introduction would mean the EU member-states would maintain a restrictive monetary and fiscal stance in the runup to the Euro, and even thereafter - given the Maastricht criteria and the 1997 Amsterdam pact of the EU countries orienting their policies towards a balance budget or budget surplus and reduce the adverse policy mix.
Apart from the EMU effects on European growth and demand, the ECE report also raises some questions about the long-term benefits and costs of the EMU, and the long-term viability without a mechanism for transfer of resources within the EU to areas and regions facing asymmetric effects of the single currency.
The direct and indirect effects of the crisis, and the external adjustment process in the Asian countries, would have both positive and negative effects on the industrialized countries, though it is difficult to quantify them at present, the ECE says.
To service and repay their debts, the Asian countries could borrow money, which is not so feasible. Or, they could boost exports and cut imports in order to generate the necessary foreign exchange. That increase in exports must find a higher level of demand elsewhere in the global economy.
But the stance of the EU members, focusing on the impending EMU, would restrain demand, while Japan faces fragility in its banking sector and in demand for goods and services.
The US economy too is expected to slow down this year. In western Europe, where macroeconomic policies are focused on meeting the EMU requirements and are unlikely to be relaxed, growth will remain more or less unchanged from last year.
In such a situation, the greatly increased competitiveness of Asian exporters may lead to a much sharper fall in trade balances of the developed market economies than is currently expected.
For western Europe and Japan it would mean a reduction in their trade surpluses and for the US a much larger trade deficit - although for Japan the opposite is now happening.
Since trade links of Asia with US are stronger than with Europe, and since the Japanese economy (a major outlet for Asian exports) may hardly grow in 1998, most of the increase in Asian exports will go to the US. This may not present a major problem given the current strength of the US economy, but this last may be deceptive.
[Media reports from Tokyo on Tuesday said that the wholesale price index in Japan fell 2.1% (on a year-to-year basis) in the first ten days of April, giving rise to fears of deflation.]
An important risk to the short-term outlook, the ECE said, is the sustainability of existing exchange rate parities in China and Hong Kong, and the fragility of Japan's banking sector and strength of demand for goods and services.
[Other observers note that China, in effect set off the Asian crisis with its own devaluation of the yuan in 1993-94, while the now affected Asian countries held on to their dollar-linked values, even as the Japanese yen was losing ground. However, China has repeatedly announced that it would maintain the value of its currency, and is using it as an argument to gain entry into the World Trade Organization.
[However, some of these analysts suggest, it is not at all clear how long China could hold on, and face loss of export competitiveness, and whether, even while holding to the nominal value of its currency, there would be de facto devaluation of tradeable exports. They note that this may be achieved by a number of means at enterprise levels in China, given the non-transparency of price formation in its economy. But they concede that at the moment there are no hard facts to back up these fears.]
Taking account of only five directly affected countries (Indonesia, South Korea, Malaysia, the Philippines and Thailand), the WTO suggested in March that the countries account only for a relatively modest share of global economic activity, and the crisis there would not have much impact on the world economy.
The ECE takes account of the weight of a larger number of the countries affected the NIEs of Asia (Hong Kong, .Korea, Taiwan, the ASEAN-4, Indonesia, Malaysia, the Philippines, and Thailand) and China and points out that in 1996 they account for 14% of world merchandise exports and imports and 18% of world output, with the hitherto dynamic domestic demand of these countries having been a dynamic source of growth for the world economy. Hence the financial and economic crisis of the region would have potentially adverse effects for the rest of the world.
The external adjustment process in East Asia would have implications for changes in net exports, output growth, business profits and inflation in the rest of the world.
The crisis in East Asia has also triggered a process of portfolio redistribution in global financial markets, which may affect capital flows to other emerging markets and have a bearing on long-term bond yields in industrialized countries.
The exposure to non-performing loans in the region may also have significant risks for banks in industrialized countries.
Korea and the ASEAN-4 have experienced a net capital outflow of $12 billion in 1997, compared to a net inflow of $93 billion in 1996 or a swing of $105 billions. The combined current account deficit of these countries fell to some $26 billion in 1997, compared to the $54.9 billion in 1996, with the difference in external financing and current account deficit being accounted for by the fall in reserves.
The net outflow of capital is expected to continue in 1998, with the combined current account of these countries moving from deficit to surplus.
Presently, the current account adjustment is being brought to a large degree by a fall or a substantially smaller increase in domestic demand. There will also be an adjustment via real depreciation of their currencies, improving the price competitiveness of the export sector of these countries and amplifying the dampening of import demand. These will have adverse changes in real net exports in other countries, reducing their own aggregate output growth.
These direct trade effects on economic activity in the rest of the world, the ECE notes, will be enhanced by indirect effects - the negative multiplier effects of changes in the real net exports on domestic incomes and employment and this will also feed through to the non-tradeable sector.
There will also be an international transmission of these effects -- the effects on Japan and USA will affect via trade the economic performance in western Europe and vice versa.
In addition, the Asian crisis will also have price effects - on oil and non-oil commodity prices and export earnings of the exporters. The excess capacities in East Asia and the sizeable currency depreciation will stimulate companies from the region to cut prices to boost exports.
The overall effect will be to strengthen the disinflationary forces in the world economy. But given the already very low levels of inflation in the industrialized world, concerns have already been expressed (by among others the US Federal Reserve Chairman, Mr. Alan Greenspan) about the possibility of deflation in the world economy.
Earlier, in analysing the factors behind the crisis, the ECE says.
The Asian crisis has provided another example of the potential fragility of fixed exchange rates under conditions of high capital mobility, the ECE says while analysing the factors behind the crisis.
The crisis is also a reminder that capital inflows have two faces: they can help accelerate process of enhancing viable capital stock, but also a major source of financial and monetary stability.
In an economic boom, the economic consequences of excessive borrowing and ensuing exposure to high and rising debt are often ignored by economic agents; and the resulting overall damage to the economy when the boom comes to an end can be quite damaging -- an experience common to developed and developing countries.
But the mirror image of excessive borrowing in recipient countries is the excessive lending by banks in capital exporting countries.
In the case of a financial crisis in the recipient countries, there are negative externalities in the capital exporting countries as well.
"A case can therefore be made for the close monitoring of capital flows to prepare timely and adequate policy responses, including capital controls, to prevent such excesses," the ECE adds.
Unlike in the Mexican crisis of 1994/95 which was predominantly a government debt crisis, in the case of Asia, the crisis reflects a combination of excessive private sector borrowing in a context of weak financial intermediation and imprudent exposure to exchange rate risk.
In a private debt crisis, as in Asia, the number of major actors involved tend to be larger than in a sovereign debt crisis, and this makes it increasingly difficult for official financial assistance to insulate creditors and debtors from adverse consequences of poor investment decisions.
Available evidence, the ECE notes, shows that the private sector credit boom in East Asia was mainly for financing investment projects. But given the limited absorptive capacity of these countries and serious weaknesses in financial intermediation, there was an inevitable asset price deflation, giving rise to speculative bubbles specially in the real estate market.