Asian Economic Recovery

Paper forthcoming in Asia Perspectives Published by Mansfield Center for Pacific Affairs Based on remarks made at Keidanren Tokyo, Japan

September 22, 1999

I would like to thank Mina Kim for research assistance.

Asia is today emerging from the financial crises that swept the region in late 1997. Although economic performance in 1999 has proven more robust than nearly anyone expected, the sustainability of the region's recovery is questionable. Actions undertaken locally will largely determine future outcomes in each country. Nevertheless, as the crises have amply demonstated, no country is an island economically, and developments in some countries could have effects throughout the region.

Japan is the largest and richest economy in Asia, and it has the greatest capacity to influence the course of events in the rest of the region. Although most observers expect growth to slowly return, the country faces three problems in declining order of immediacy (Table 1). First, there is the need to maintain aggregate demand which is complicated by the country's deflation. Second, outstanding financial sector problems must be addressed. Third, there is a need for deregulation and restructuring outside the financial sector.

With regard to the immediate aggregate demand problem, the conventional response is fiscal stimulus, and Japan has pursued an expansionary fiscal policy largely in the form of increased public works expenditures. However, the pattern of expenditure is questionable: projects have been undertaken for political reasons, and many of these projects have low or even negative rates of return. Indeed, the problem of "pork barrel" politics is such that it would be preferable for fiscal stimulus to take the form of tax cuts instead of direct public expenditure. Although some of the tax cuts would go into saving, not all would be saved, and the resultant expenditures would be on goods and services wanted by households - not those that bureaucrats and politicians find most advantageous. The impact on the composition of demand would reinforce the restructuring of the Japanese economy toward greater efficiency. To the extent that the tax system also embodies inequality, tax cuts would enhance equity.

On paper, net government debt (assets less liabilities) is relatively low, but it is questionable whether some public assets are worth their reported value. Moreover, given that most observers expect two more fiscal stimulus packages before elections next year, some question the ability of the bond market to absorb additional government debt.

Monetary policy is the other tool of macroeconomic management, and Japanese monetary policy has been the subject of considerable controversy as of late. The basic problem is that although nominal interest rates are near zero, real interest rates remain relatively high due to deflation. The Bank of Japan argues that, under these circumstances, monetary policy is relatively ineffective - increased injections of liquidity would not reduce interest rates or increase the demand for credit. Increasing the money supply would amount to "pushing on string."

The counterargument is that the Bank of Japan could monetize government debt. This would contribute to inflation, which would reduce real interest rates and encourage the depreciation of the yen. (Some commentators have advocated explicit "inflation targeting" in which the Bank would print yen until a specified rate of inflation, say two percent, were attained.) Indeed, concerns about the recent run-up in the yen have been the main impetus for the Bank of Japan to relax monetary policy. These concerns may be misplaced, however.

Since most of Japan's output is not traded internationally, the exchange rate should really be a secondary concern. Besides, at its level today, Japan's real effective exchange rate is in the middle of the range of values that it has taken in the 1990s - the yen today is not overvalued (Figure 1). As evidence of this, Japanese exporters have not been raising their dollar prices for exports, but instead have been absorbing the yen appreciation in reduced profit margins. Finally, to the extent that a stronger yen encourages imports from the rest of Asia this is a good thing - the Asian countries are recovering from severe crises and are poorer with less stable social and political systems than Japan. Conversely, a weak yen could harm the rest of Northeast Asia. South Korea, in particular, would be harmed, as a weak yen would reduce South Korean competitiveness both in Japan and in third country markets such as the United States.

Figure 1. Japan's Real Effective Exchange Rate

Of the economies most heavily affected by the 1997-8 crisis, South Korea appears to have made the best progress to date. The economy is expected to grow strongly in 1999, though concerns remain about the sustainability of its recovery into 2000 and beyond. Much of the current growth has been due to a rebound in consumption from extremely depressed levels in 1998, inventory restocking, and fiscal stimulus. Employment in the core sectors of the economy (industry, agriculture, and services) has remained weak with much of the recent increase in jobs coming from self-employment and the public sector. While considerable amount of restructuring has occurred among the smaller chaebol and in the small and medium enterprise (SME) sector driven by the credit crunch, restructuring in the largest chaebol has dragged. The question for South Korea, like Japan, is whether fiscal stimulus in the absence of restructuring and improvements in efficiency is an adequate recovery strategy. Again like Japan, South Korea faces elections next year. The government has announced another expansionary budget, and there are concerns that, with the immediate crisis receding, so will the impetus for reform. Indeed, some argue that a Grand National Party victory in the National Assembly elections could retard reform even further.

At the other end of the spectrum, Indonesia has been plagued by economic and political instability. However, the election in late 1999 of a new president could be a turning point, strengthening the legitimacy of the office of the presidency, and providing the necessary political prerequisites for successful economic reform.

China was able to largely avoid the turmoil of past two years, but the Chinese economy has been slowing under the twin pressures of waning international competitiveness and ongoing restructuring of the state-owned enterprise (SOE) sector. Between 1992 and 1998, employment by SOEs and urban collectives fell by 30 million workers. During the same period, employment in private and foreign-invested enterprises increased by 31 million. Some of the decline in SOE employment was illusionary as SOEs were converted into joint stock companies without fundamentally changing managment or financial operation. Nevertheless, a tremendous transformation of the Chinese industrial landscape is ongoing.

Unemployment has increased significantly. There is an imperative to maintain aggregate demand to absorb displaced labor and new entrants into the work force. During the Asian financial crisis, China received considerable praise for not devaluing the reminbi (RMB) during the Asian financial crisis. However, the price paid has been declining international competitiveness and increasing balance of payments pressure. No one believes that the current policy of nominally pegging the value of the RMB to the US dollar is the optimal exchange rate policy for China. A managed float or some kind of basket peg in which non-dollar currencies such as the yen receives a significant weight would be preferrable. As a consequence, it it likely that China will move to a new exchange rate policy sometime in the future and attempt to engineer a modest devaluation at that time. It is unlikely that such an action will occur during sensitive negotiations over China's accession to the World Trade Organization (WTO). Instead China could be expected to wait until the WTO negotiations have been concluded successfully (or until it concludes that successful completion is unlikely) before moving on exchange rate policy.

A devaluation of the RMB would improve China's international competitiveness and have a modest negative impact on Japan and South Korea. A five percent real depreciation of the RMB would increase China's trade surplus by around $20 billion. Exports from Japan and South Korea would decline modestly as Chinese enterprises substituted domestically produced industrial intermediates for imports. The economies of Southeast Asia would also be adversely affected as Chinese exporters took market share in third country markets such as the US. Of course the real question is how currency markets would react to a Chinese devaluation. Although the situation in Asia today is better than a year ago, a Chinese devaluation could re-ignite financial market turmoil and another round of competitive devaluations.

Table 1: Growth Forecasts

    1998 (act.) 1999 2000     1998 (act.) 1999 2000


Japan -2.9     South Korea -5.8    
  Blue Chip   0.2 0.9   Blue Chip   6.3 5.9
  FT   1.2 1.8   FT   6.1 4.3
  ADB   - -   ADB   8.0 6.0
  IMF WEO   1.0 1.5   IMF WEO   6.5 5.5
China 7.8     Taiwan 4.8    
  Blue Chip   6.5 6.8   Blue Chip   4.5 4.9
  FT   6.2 6.5   FT   4.9 3.6
  ADB   6.8 6.0   ADB   5.5 6.3
  IMF WEO   6.6 6.0   IMF WEO   5.0 5.1
Hong Kong -5.1     Russia -4.6    
  Blue Chip   -0.5 2.4   Blue Chip   - -
  FT   -0.2 2.1   FT   -1.8 0.2
  ADB   -0.5 1.5   ADB   - -
  IMF WEO   1.2 3.6   IMF WEO   0.0 2.0

Sources: Blue Chip Economic Indicators (Sept 10, 1999); Financial Times Currency Forecaster (Oct 1999); Asian Development Bank (Sept 1999); IMF World Economic Outlook (Oct 1999).