Four major developments could significantly affect the world economy over the next one to three years. All stem to some extent from the current Asian crisis although all but the first have independent causes as well.
Zero Growth in Asia?
Japan accounts for about two thirds of the entire Asian economy. It is already in recession and is likely to experience zero or negative growth in 1998. Despite the government's recent initiatives, there seems to be little chance that sufficient policy changes will be adopted either to restore stability to the banking system, and thus an effectively functioning credit market, or to convert the country's restrictive fiscal policy into the needed stimulus.1
Korea is the third largest economy in Asia. It too will almost certainly experience zero or (more likely) negative growth at least in 1998.
Virtually every major economy in Southeast Asia--including Indonesia, Thailand and Malaysia--is likely to experience zero growth or less in 1998. As with Korea, these recessions are not the results of explicit "IMF demands" (or, in the case of Malaysia, to avoid IMF demands) but rather the consequence of the required structural reforms in financial systems and corporate governance.
The one major exception is China, where growth should remain solidly positive. Taiwan and Hong Kong are likely to continue expanding as well. Even in these countries, however, growth will decline sharply as a result of the regional slowdown. Moreover, necessary long-term adjustments are being accelerated--with additional adverse growth effects in the short run--to keep the crisis at bay, especially in China. The "strong center" will remain insulated to some extent from the countries on its northeast and southeast flanks but it too will experience a considerable slowdown.
Growth in Asia as a whole could thus drop to or near zero in 1998 and 1999 (and possibly beyond).2 Asia has accounted for almost one half of all world growth throughout the 1990s. Several other major countries, such as Brazil and Russia, will probably experience zero growth or less as well--in part because of adjustment actions they were forced to take to avoid even greater contagion from the events in Asia. Global prospects must therefore be scaled back sharply as a result of the Asian crisis.
Renewed Trade Conflict?
The huge currency depreciations in Asia will sharply improve the competitive position of virtually every country in the region, starting with Japan and Korea. Along with their plunging economies, driving down import demand and intensifying export efforts, these exchange-rate swings will produce very large changes in national trade balances.
A new study by my Institute colleagues Marcus Noland and Ligang Liu, along with Sherman Robinson and Zhi Wang, uses a computable general equilibrium (CGE) model to assess the prospects for trade even if the Asian currencies rebound to some extent from their present levels.3 Their results include:
- an increase in the United States deficit of about $50 million in nominal dollars and almost $100 billion in real terms;4
- a similar reduction in the surplus of the European Union;
- an increase of about $50 billion in the surplus of Japan; and
- a swing of perhaps $40 billion in the position of Korea, converting it from large deficit to large surplus.
These swings will occur at a time when trade policy is already under substantial pressure in many major countries. The US Congress failed to approve new "fast track" negotiating authority for the President in 1997 despite the stellar performance of the American economy, and the prospects for resurrecting the legislation this year are highly uncertain. Europe continues to face unacceptably high unemployment and is preoccupied with the creation of the euro. A rash of antidumping cases is likely, in both the United States and Europe, to combat rising imports from "cheap currency countries" in Asia. Brazil and its Mercosur partners raised their common external tariff by a quarter as part of their effort to avoid contagion from Asia.
The biggest problem is Japan. As the world's largest surplus and credit country, it should be reducing its trade surplus by sizable amounts rather than increasing it. Instead of proposing new funds that would make $100 billion of capital available for the rest of Asia, it should be importing an additional $100 billion worth of products from the region. As noted above, however, the prospects for a turnaround of Japanese policy on anything like the needed scale seem remote.
The first trade policy casualty of this process could be the Second Summit of the Americas, in Chile in April. Negotiations to create a Free Trade Area of the Americas could still be launched but nothing serious will happen until the United States obtains fast track authority and Mercosur decides to extend its liberalization beyond the grouping itself. A second casualty could be the WTO Ministerial Conference in Geneva in May; the fiftieth anniversary celebration of the GATT/WTO could be reduced to nostalgic platitudes rather than commencing serious planning for Sir Leon Brittan's Millennium Round.
The good news is that the Asian adjustment programs all include important further liberalization of their import and investment regimes. Moreover, APEC decided at its Vancouver summit last November to eliminate or reduce trade barriers in nine major sectors--with a global trade value of $1.5 trillion--during 1998 for implementation in early 1999 (though some of this could also founder if the US Administration fails to obtain new negotiating authority from the Congress). The bicycle of liberalization is still moving ahead but could easily stall in the face of the Asian crisis.
A Trend Toward Monetary Ease?
Inflation is virtually nonexistent around the world (except in the Asian countries with sharply depreciating exchange rates). Fiscal contraction remains in vogue almost everywhere: the United States has balanced its budget, most Europeans are meeting the Maastricht criteria, Japan continues to tighten (despite the clear need for expansion) and most major emerging market economies (both in and outside Asia) are cutting deficits to help stabilize their currencies. Concerns about deflation have in fact become widespread.
Hence monetary policy is likely to be eased, perhaps substantially, around the world in 1998 and possible beyond. Japan needs to do so for domestic reasons. The Asian crisis countries need to do so as soon as their exchange rates level off. Europe needs to do so to accelerate growth.
In particular, there are strong reasons to believe that the next move by the Federal Reserve in the United States will be on the downside:
- inflation remains virtually nonexistent and even inflationary pressures are few and far between;
- the US yield curve is virtually flat, with a difference of only about 60 basis points between 3-month and 30-year paper;
- any new market crises, especially if they include a sharp correction in the US equity market, could induce Fed injections of additional liquidity; and
- the dollar is now substantially overvalued in trade terms and, as noted above, the US trade deficit is headed to record levels.
A severe slowdown in global growth, as suggested above, will accelerate these prospects. There could be a substantial shift in global monetary conditions over the next year or so.
The Next (Dollar) Crisis?
The next major disturbance to the world economy, once the world has safely surmounted the current Asian crisis, is likely to be another sharp plunge in the exchange rate of the dollar.
The short-term fundamentals continue to favor the dollar. The American economy remains stronger than Europe or (especially) Japan. American monetary policy is likely to remain firmer than theirs for at least a while longer.
But the long-term fundamentals, to which the markets always revert, are increasingly negative for the dollar. The American trade and current account deficits are likely to reach $250-300 billion in 1998-99--approaching the share of GDP of the previous record levels of the middle 1980s. The net debtor position of the United States, which has already passed $1 trillion, will shortly exceed $1.5 trillion. There is no apparent sign of a turnaround in these trends.
A forthcoming study prepared for the Institute by Simon Wren-Lewis and Rebecca L. Driver concludes that fundamental equilibrium exchange rates for the dollar in 2000 would approximate 1.50:1 for the DM and 85-90:1 for the yen. The trade-weighted dollar is now overvalued, in trade terms, by about 15-20 percent. The dollar has of course risen from its postwar lows, in early 1995, by about 40 percent against the DM and 60 percent against the yen. As noted above, these disequilibria could rise further in the short run.
As always, it is impossible to predict the turning point at which the long-term fundamentals will again dominate the short-term fundamentals. One possible trigger would be a sharp slowdown in the US economy, especially if accompanied by a substantial correction of its stock market and the predicted reduction in short-term interest rates by the Fed. Another would be a significant pickup in growth in Europe and, especially if they could ever get it going, in Japan. Credible recovery of other Asia economies would trigger reflows in their directions.
The other likely trigger for a reversal in the dollar's rise is the creation of the euro. The euro will almost certainly become a major international currency, based on the world's largest economic and trading unit and resting on a stability-oriented monetary policy by the new European Central Bank. Even if it takes several years (or longer) to truly rival the dollar, the euro will almost certainly attract substantial portfolio diversification early in its existence. This could bring the reversal of the dollar that must ultimately occur within the time horizon of this forecast (1998-2000).5
That dollar correction could of course be orderly rather than disruptive. Unfortunately, however, every major postwar dollar correction--1971-73, 1978-79, 1985-87--has been highly destabilizing. This is because the preceding overvaluations have been permitted to go much too far and last much too long. The lesson is of course that the world needs new arrangements to stabilize exchange rates within broad target zones among the major currencies.6 Absent such arrangements, another disorderly dollar decline is a real possibility once the current Asian crisis is resolved.
Summing it Up
Three major implications emerge from this analysis. First, world economic growth may turn out to be considerably slower that most forecasters now expect. Zero growth in Asia would eliminate the source of about half the world's expansion in recent years. A substantial slowdown in the United States could magnify this effect.
The outlook could be further clouded by the additional market disruptions that will almost certainly accompany the inevitable ups and downs of Asian adjustment. A further sharp depreciation of the yen, won, renminbi or even Hong Kong dollar could trigger sympathetic depreciations around the world that would roil markets and thereby dampen investor confidence and even consumer demand.
New uncertainties about global trade policy could represent an additional negative factor. Continued Congressional rejection of "fast track" negotiating authority could signal that the United States is not prepared to be the "importer of last resort" and could induce Asian policymakers to reconsider their commitment to outward-oriented strategies--especially with respect to portfolio capital flows but perhaps to trade liberalization as well. We know from history that a failure to keep the bicycle of liberalization moving forward can produce protectionist backsliding, especially in the face of such large swings in trade balances as will probably occur in 1998-99. The global economic prospects could be much worse than now anticipated.
Second, the unfolding events will pose major challenges to the world's economic institutions. The International Monetary Fund is already under severe attack, from the right for its "bailout programs" and from the left for its "unnecessary austerity." As with trade, there is a juxtaposition of these forces in the US Congress where opposition is considerable to both the latest increase in IMF quotas and funding for the New Arrangements to Borrow. The Fund will be in trouble if its current support operations fail to produce at least a few clear successes within the next few months.
In the slightly longer run, the Fund must adjust to the creation of the euro and the resultant shift from a dollar-centered world dominated by the United States to a bipolar structure with the European Union as a second key power. The GATT/WTO learned to embrace this construct long ago, since the EU has always spoken with a single voice on trade, but it will be a new phenomenon in the monetary world.
The World Trade Organization itself will also be severely challenged by the trade policy threat stated above. It has completed the carryover business from the Uruguay Round by working out sectoral agreements on telecommunications, information technology and financial services. Wholly new initiatives will now be needed to keep the bicycle moving forward and the still-new institution from becoming moribund for a prolonged period as its predecessor GATT did after completion of the Kennedy and Tokyo Rounds.
Finally, the putative steering committee for the world economy--the Group of Seven--has become virtually invisible. Just as APEC has taken the lead in the trading system, and may be doing so again with its sectoral liberalization agreement at Vancouver, its members have seized the monetary initiative with their Manila Framework that has already been applied in the Korean case and offers some hope for preventing future crises in the region. The Asian crisis may produce profound changes in the global institutional framework over the longer run, as it is doing to the world economic outlook in the short run, and therein may lie the deepest significance of the economic events of 1998-2000.
Third, all of this implies a major challenge to the continued march of globalization. Antiglobalization forces are mounting in both the industrial countries, where they are celebrating the defeat of fast track negotiating authority in the United States as a "historic turnaround in attitudes toward international integration," and in many emerging market economies due to the onslaught of yet another financial crisis. Both the intellectual underpinnings of globalization, and the policies to implement it, are likely to be questioned more severely than at any other time in the past two decades. The global outcome for several decades ahead will turn on the outcome.
1. Japan's structural budget deficit (including social security) declined from 3 percent of potential GDP in 1996 to 1.2 percent in 1997 and is estimated to fall further to 0.8 percent in 1998. See IMF, World Economic Outlook: Interim Assessment, December 1997, p. 53.
2. Goldstein and Reinhart, Forecasting Financial Crises, Institute for International Economics: Washington, forthcoming, conclude from their study of 125 crises since 1970 that recovery to the average growth rate of the two pre-crisis years takes, on average, two to two and a half years to achieve. The Asian recoveries could require a longer period because of the deep-seated structural changes that are the essence of their adjustment requirements.