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November 30, 2000

From Our Correspondent: Hirohito and the War
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Asiaweek Time Asia Now Asiaweek story

DECEMBER 10, 1999 VOL. 25 NO. 49

Asia's 'Economic Y2K'
Key risks: A weak U.S. dollar and lack of credit growth
By CHI LO


photo
Chi Lo
is senior economist (Asia) for HSBC Economics & Investment Strategy in Hong Kong
photo: Asiaweek Pictures

The fact that Asia's economies have rebounded strongly this year does not mean that their recovery will be easy running in the year 2000. The "economic Y2K" risks that could damage the region's recovery include a renminbi devaluation, renewed weakness of the Japanese economy, a sharp fall in the U.S. dollar and the lack of credit growth in Asia. The former two threats seem to be fading, as the Chinese and Japanese economies are bottoming out. Thus a weak U.S. dollar and lack of credit growth are the two key risks to Asia's economic recovery next year.

The fundamental argument for a sharp fall in the dollar centers on the chronic U.S. current account deficit. Paul Krugman of the Massachusetts Institute of Technology also argues that beyond the current account problems, the potential role of "carry trade" could exacerbate a bear dollar market. This could happen when highly leveraged investors, who borrowed yen at low Japanese interest rates and invested the proceeds in higher-interest dollar assets, are forced to sell the dollar to cut losses when it plunges. This did happen in October last year when the unwinding of the carry trades worsened the fall in the dollar against the yen.

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The predictions of an economic hard landing for the United States, and the predicted dire impact on the global economy, were wrong during the last dollar crisis, when the greenback fell from 235.2 yen in 1985 to 138.3 yen in 1989. But Krugman argues that the global backdrop "is more troublesome" today because the business cycles in the U.S. and the rest of the world are out of sync.

In the supply-constrained U.S. economy, where robust demand is beginning to feed through the labor market with upward wage pressures, a sharp fall in the dollar will threaten to trigger a wage-price spiral. This could prompt the Federal Reserve to hike rates sharply and deliver a crash-landing to the economy, sending shock waves to Asia. On the other hand, Asia is still demand-constrained with a large part of the region growing below potential capacity. A drop in the dollar would be contractionary for the region, as it will make Asian exports less competitive. The strength of this will depend on the dollar's drop. If markets force the U.S. unit to fall fast to correct the current-account deficit, the impact on Asia could be severe. But it's not likely at this point.

Even an extremist like Krugman admits that Fed rate hikes might not kill the U.S. economy, due to the structural change in the relationship between economic and money supply growth. Further, for 20 years, U.S. current account balances have not responded to exchange rate movements in the manner depicted by classical theory. If this experience continues, Asian exporters will not suddenly find themselves unable to sell their goods to the U.S. as the dollar falls. And U.S. exports will not soar due to a cheaper dollar. It may not happen at all that a dollar crisis will wreck the global economy.

Asia's constrained demand is reflected in the lack of credit growth, which constitutes another major risk to economy recovery. It seems strange that rising credit growth did not precede the recovery, since the former is normally a leading indicator of economic activity. But this is not a normal time. Asian banks are going through a post-crisis transformation, and their woes are taking longer to heal after the Crisis than the revival in consumption and exports is taking. The crucial question is whether Asian banks have the ability to lend to sustain GDP growth when credit demand revives.

Actually, the banks have the capacity to lend, though they still need further reform. Liquidity has improved, as seen in rising deposit-to-loan ratios and capital ratios; a massive injection of public funds and some private capital have restored banks' capital base. Ironically, reforms have constrained lending, at least in the short term. Recapitalization programs require banks to shrink their balance sheets by selling loan assets to government agencies and writing off bad loans aggressively. Tighter regulations meant to improve credit-risk assessment practices have prompted banks to become ultra-conservative under a high credit-risk environment.

Meanwhile, there is insufficient credit demand. Asia's economic recovery has been driven by strong consumption (both private and public) at first, augmented by export growth later. Domestic investment growth has remained in the doldrums. As it improves in the coming months, demand for credit should pick up. Banks' conservatism will also relax as the macro-environment improves. Given banks' ability to lend, the current lack of credit growth should not worsen and thereby threaten Asia's economic recovery.

But the recovery process remains fragile. First, structural reforms will create periodic negative shocks. Second, a benign global environment (falling international interest rates and commodity prices) that has made recovery possible is not assured going forward. Finally, any lack of progress on reforms could deter or even reverse capital inflows and hurt economic growth. Though a dollar crisis derailing recovery is unlikely at this point, keep a close eye on global growth and the dollar exchange rate movement, plus the progress in banking reforms.

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