September 19, 1997
Thank you, Chairman.
Well, I was a bit more fortunate than some of the discussants today, because I was able to receive Professor Ueda's paper before dinner yesterday. After dinner, I went through it and did a commentary. I disagree with more of the written paper than I disagreed with Professor Ueda's presentation, so it's bad luck that I had a chance to go through the written paper, but I will give my comments in written form to Betty Huang, so they will be available to those who want to follow them. I've got a couple of tables in there that I shall spare you the tedium of going through in my presentation now.
Within my commentary, I want to address the question, "What does the recent crisis in Southeast Asian financial markets tell us about the sustainability of rapid growth in the region and in particular about the sustainability of growth in the epicenter of the recent instability—Thailand, Malaysia, and Indonesia?" I think this is the biggest question in the world economy this year.
In the commentary, I suggest that the 1997 crisis has its origins in the management of short-term economic policy and has little to do with long-term structural factors with inexorable implications for the sustainability of growth over long periods. In the written paper, Professor Ueda refers to the Krugman discussion about total-factor productivity changes and also refers to a "China factor"—the growing competition from China, increasing the difficulties of sustaining growth in Southeast Asia. There is also a suggestion that these developments are related to the recent financial problems of Southeast Asia.
I am going to argue that you can explain the financial instability without reference to those structural factors which, if they were true, would have large implications for long-term economic growth.
Nevertheless, I acknowledge that, as we have all long recognized, a high degree—well, a reasonable degree—of macroeconomic stability is necessary for sustaining rapid economic growth, and instability of the kind we have seen recently in Southeast Asia is inimical to growth. The instability can be explained without reference to any inherent failure in long-term growth capacity. But if macroeconomic instability persists over long periods, obviously, it will have implications for long-term growth.
I would just like to see how far we can go in explaining the recent Southeast Asian financial difficulties—the "crisis,"with familiar simple explanations before we look at whether there is any large, unexplained development to which we must turn for longer-term structural factors.
The simple explanation begins with the exchange rate regime. There are two polar types of exchange rate regime—the rate that is firmly fixed against one or another external currency or basket of currencies, and the freely floating rate. Between the two extremes are an infinite variety of hybrids. At lunch, Stanley Fischer seemed to prefer some of the hybrids not very far from the middle.
The fixed exchange rate regime has some advantages. First, if the currency against which the rate is pegged is of major importance for external transactions, then stability in that rate can reduce the cost of international trade and investment. This is said to be a motive for the European Monetary Union.
Second, if the authorities are firmly committed to maintenance of the fixed rate, that commitment can provide an anchor for macroeconomic stability, assisting in the maintenance of fiscal and monetary discipline by providing a focus for demand management.
The disadvantages of the fixed rate arise when the authorities are unable to manage demand within the limits required to validate the rate, or where inflexibility in the economy prevents downward adjustment of cost when validation of the rate requires contraction of domestic demand. The consequence in either case is a misaligned real exchange rate. This is inflationary if the real exchange rate is too low, with the inflation sometimes emerging as a bubble in asset prices; it is directly damaging to growth and can precipitate even more damaging instability in financial markets if the real exchange rate is too high.
While a floating rate is not vulnerable, to the same extent, to large and sustained misalignment, it can be subject to short-term misalignment or overshooting. A country with demonstrated incapacity to manage demand within the limits of a firmly fixed rate has little choice but to head in this direction—that is, in the direction of a floating rate—sometimes at the cost of diminished discipline on expenditure and higher cost of international trade and investment transactions.
The costs of real exchange rate misalignment with a fixed rate, and therefore the risks of the fixed rate, have increased with greater international capital mobility in recent times—a fact that we keep coming back to through the discussions of this seminar. As a result, it is now more likely that the misalignment with a fixed rate will be more quickly converted into a crisis by speculative capital flows.
There is a great deal of evidence that it is easier to manage the exchange rates near the extremes of a firmly and credibly fixed rate like the Hong Kong dollar peg or a reasonably freely floating rate, and it is clear from experience that the credibility of a fixed rate regime is weakened for a long time by an adjustment forced by market pressures.
The Southeast Asian currencies that have run into trouble are hybrid variations on the fixed rate theme. Each of the three economies I am focusing on had fixed the exchange rate against a basket, but have a high U.S. dollar weighting—in the case of Thailand, an overwhelming dollar weighting. The Indonesian hybrid involved steady moderate depreciation against the chosen basket.
Over the past couple of years, three main influences have come together to generate misalignment of the Thai, and (to a lesser extent) the Malaysian, and (to a lesser extent again) the Indonesian, exchange rates.
The first factor is the strength of the U.S. dollar against the yen and other major currencies, which generated a large—very large—nominal effective appreciation of currencies pegged to baskets with high U.S. dollar weighting. At the same time, domestic demand in the Southeast Asian countries we are focusing on was run at a high rate in each of them, generating inflation that was higher than the low levels now ruling in the main industrial countries—in 1996, 8.5 percent in Indonesia, 4 percent in Malaysia, and 5 percent in Thailand. Some additional inflation—well, a lot—was evident in asset prices, and—not showing up in the general price indexes—the asset price inflation driven by speculative capital inflow and speculative bank lending.
I've got a table in the paper that will be available, showing the extent of the real exchange rate appreciation over the past couple of years against major industrial countries and against Japan. It is very large, for example, in Thailand, with the real exchange rate index based on 1990 equals 100. There was an appreciation of the baht from 127 to the yen in 1995—an index of 127—to 107 in 1996. That's the baht-yen real exchange rate.
So big changes in nominal exchange rates and differential inflation rates—the second a smaller factor—contributed to large real exchange rate appreciation.
The third factor was a slump in the international market for some particular products that were very important in the exports of Thailand and Malaysia, particularly electronic products.
These three factors precipitated a contraction in overall export growth that had been a flywheel of general economic growth for Southeast Asia through the 1990s. Most dramatic was the reduction in export growth to Japan—in the case of Thailand, from almost 20 percent to about zero, when previously, export growth from Southeast Asia to Japan had remained strong right through the Japanese recession because of the stronger yen in earlier periods. And again, I have that data in a table: Southeast Asian total export growth in U.S. dollars was 25 percent in Thailand in 1995, and only 1 percent in 1996—this is total export growth; Malaysia, 22 percent in 1995, 5 percent in 1996; Indonesia, 18 percent and 4 percent.
The loss of competitiveness in the export industries greatly reduced incentives for direct foreign investment, and this is a set of issues that Professor Ueda correctly draws attention to. Again, this was most pronounced in relation to Japan, where direct investment was closely related to trade with Japan. Japan had been a major source of direct foreign investment in Southeast Asia in the first half of the 1990s, and so the radical reduction in incentives for that direct investment had a major effect on flows, a point that Professor Ueda has been through.
Some of the reduction in competitiveness and continued strong growth in nominal demand was reflected in high—and in the case of Thailand, still growing—current account deficits through 1996. Thus was the scene set for the events of 1997.
Once anxieties about the exchange rate began to precipitate a reversal of the large inflows of capital, the changes of sentiment fed upon themselves, eventually forcing the changes in exchange rate regimes that we have seen.
The depreciations have gone far enough and probably a good deal farther than is necessary to correct the misalignment, even when allowance is made for the likelihood that direct foreign investment flows will be abnormally low for some time. That does not mean that normal Southeast Asian growth rates will necessarily be quickly restored to a percentage point or two below the heated rates of the mid-1990s. The weakness of the excessively and poorly regulated banking systems of the region may prolong the real economic effects of what otherwise would have been short-term financial instability, as a similar weakness in Japan in the 1990s has prolonged recession and slowed growth, in contrast to the speedier adjustment of the earlier 1990s in the banking sectors of the less-regulated English-speaking countries.
What room is left for the argument that the problems of 1997 in Southeast Asia indicate its fundamentally weak capacity to sustain high growth into the future—the Krugman factor and the China factor? I think there is none on the Krugman factor, and not much on the China factor.
The statistical problems of separating the contribution to growth of capital accumulation from the contribution of growth in total factor productivity are so large that we should be cautious about drawing strong conclusions in the best of circumstances. The difficulties are greatest when much technological improvement is embodied in new investment, including direct foreign investment; Professor Ueda in his paper touches upon the relevant points.
But in any case, growth results from the combination of high levels of capital accumulation and moderate total-factor productivity growth, and does not suddenly run into a structural brick wall because of the supposedly diminishing marginal returns to investment. If there were such an effect, it would emerge gradually; yet the experience of East Asia has been one of rapid growth, to be maintained until the frontiers of productivity and income levels in the advanced countries have been approached.
Certainly, a sudden end to growth would not arise at the same time in countries of such widely varying levels of development as Indonesia, with a per capita income last year just above $1,000; Thailand, a bit above $3,000; and Malaysia, about $4,500.
What, then, of Professor Ueda's suggestion that China's competition is a factor in the current economic problems in Southeast Asia? This could be an issue if China’s economy were integrated across its regions, and if China and the southeast Asian economies were growing from similar levels in step with each other, and at similar levels of development and comparative advantage. China's competition might also be a factor if its growth were irrelevant to the expansion of other economies that are important economic partners of Southeast Asia.
There are reasons for doubt on every point. China is a highly fractured and regionally diverse economy. Its eastern and southeastern coastal provinces, from Guangzhou to around Shanghai, with a population of almost one-quarter billion, have grown rapidly through deepening integration into the international economy for almost two decades. Already, labor is becoming relatively much less abundant, wages and other costs are rising, and export growth is shifting from labor-intensive products competing directly with the new exports of Java or the Philippines to more technologically complex and capital-intensive products that can be absorbed into much larger and more diverse international markets. Structural change in these coastal provinces is opening opportunities for specialization in line with comparative advantages in the poorer inland provinces of China and in the lower-income range of industrializing economies in Southeast and South Asia, much as structural change earlier in Japan, Hong Kong, Taiwan, and Korea opened the way for coastal China.
Even in the coastal provinces that have been growing with unprecedented strength, the availability of capital per worker and the capacity to utilize more productive technology fall well short of Thailand and even shorter of Malaysia. This could change over time, but by then, as long as macroeconomic and financial sector management supports a return to growth, the graduation into more sophisticated and diverse exports will elevate Thailand and Malaysia beyond vulnerability to direct competition from a single competitor.
Also relevant is the contribution that sustained, strong growth and structural change in mainland China have made to the growth prospects elsewhere in East Asia, most notably in the economies of Hong Kong, Taiwan, and Korea. Prosperity in these economies is important to trade and investment expansion in southeast Asia. Through these processes, the China boom in the early 1990s was a major reason why East Asian developing economies were able to keep growing strongly for the first time through an Organization for Economic Cooperation and Development (OECD) recession.
None of this is to say that the return to strong growth in Southeast Asia is guaranteed. It does indicate, however, that there is no basis for seeing the contemporary crises as evidence in support of one or another of the popular theories that predict the end of strong growth in Southeast Asia.