conomist

THE COLLAPSE OF THE GROWTH TIGERS

Following in the footsteps of Japan, many other east Asian countries followed suit and generated unprecedented growth rates that averaged about 10% per year Hong Kong and Taiwan were first, followed by South Korea and Singapore. More recently, Thailand, Malaysia, and Indonesia posted growth rates of close to 10%. All of these countries maintained these superheated growth rates for at least two decades. Thus it came as a major shock to economists and investors around the world when the Thai baht uncoupled from the dollar and devalued in July 1997. The Malaysian ringgit, Indonesian rupiah, and the South Korean won quickly followed suit, with all of these currencies falling more than 50% relative to the dollar during late 1997 and early 1998. The currencies of Singapore, Hong Kong, and Taiwan also came under pressure but were not devalued. Not only did the superheated growth rates of the growth tigers suddenly come to a halt, but these countries plunged into recession. Real GDP declined sharply in 1998 for all these countries except Singapore, although most of them recovered in 1999. Further details are given in table 14.1. According to the simple demand-side arguments of international trade, a devaluation should boost exports and reduce imports, hence raising GDP. This is perhaps the classic example of how this relationship does not hold: a 50% depreciation was accompanied by a major recession. That should be the final nail in the coffin of the argument, if indeed any further evidence were needed, that reducing the value of the currency does not help a country boost its growth rate. Nonetheless, a devaluation does not usually cause the economy to collapse completely, so other factors must have been at work. Korea can be considered a typical example. In the decade before the devaluation, the inflation rate in Korea was 2 1 2% higher than in the US: 6.1% compared to 3.6%. Because Korea was growing faster than the US, one would expect real interest rates to be at least 2 1 2% higher in Korea. That was in fact the case; the spread ranged from about 5% on long-term bond rates to as much as 10% for short-term money rates.

Thus Korean businesses had a choice: they could borrow money at 5% in the US, or at 10% to 15% in Korea. That sounds like a no-brainer – as long as the won remained fixed relative to the dollar. If it devalued, Korean companies could find themselves in the position of having to pay back twice as much (in won) as they borrowed, essentially consigning them to bankruptcy. Thus while interest rates in Korea were correctly priced, the currency was not. If it had declined an average of 2 1 2% to 5% per year relative to the dollar, most of those foreign loans would not have taken place, and Korea would not have suffered such a major hit. A country can grow rapidly only if the ratio of saving and investment to GDP is unusually high. That by itself doesn’t guarantee rapid growth, but it is not possible to have rapid growth with a low investment ratio. The source of the funds for saving and investment can, of course, either be domestic or foreign. In its most rapid growth phase, Japan relied primarily on domestic saving to boost the growth rate. The other Asian growth tigers, however, relied primarily on foreign saving. Unless the country in question has a key currency, that method of growth involves two major risks. First, exports must keep rising at an increasing rate to generate the increasing amount of foreign exchange needed to service the debt payments on foreign capital. Such countries could have a huge trade surplus but a current account deficit because of the outflow of net investment income. Second, to the extent that domestic firms borrow in foreign markets, the value of the currency must be held constant, or these firms will find their indebtedness in terms of local currency has skyrocketed. For example, suppose a firm borrows 1 billion won when the exchange rate is 5 won to the $, but it later declines to 10 won to the $; the firm would have to pay back 2 billion won, which at least in the short run would probably be impossible. Cracks in the system began to appear as early as 1996. Because of the sharp decline in the price of semiconductors that year, the value of Korean exports declined even though volume continued to rise. The price index for Korean exports fell 4% in 1996, and the current account deficit, which had been in surplus as recently as 1993, zoomed from $8.5 to $23.0 billion. The combination of somewhat higher inflation in the growth tigers, weakness of the Japanese market, and lower export prices put downward pressure on the currencies. The only way these countries could repay these massive loans to the US and other hard-currency countries was to keep exports and real growth rising at superheated rates. Once inflows of foreign exchange diminished, the whole house of cards collapsed. After these currencies plunged 50% or more, it became clear that loans from US, European, and Japanese banks could not be repaid on schedule. The IMF then stepped in with multi-billion dollar loans to help firms repay some of their short-term obligations, and permitted the rest of the loans to be rolled over into long-term instruments, payable over the next ten years. The price the IMF exacted was an austerity campaign: slower growth, a major cutback in imports of consumer goods, and cutbacks in government spending. The former growth tigers had little choice other than to accept these terms; otherwise, their international credit ratings would have been suspended indefinitely. When the collapse occurred, it revealed a rotten infrastructure that had heretofore been well hidden. Many of the largest firms had been losing money steadily, but were bailed out by ever-increasing loans from their cronies at the big banks, which were also technically insolvent. The infrastructure would have to be rebuilt before these countries could once again achieve rapid growth. We can see what happened in terms of the basic growth, or supply-side, model. The sharp decline in investment and saving reduced capital stock growth, cutting the overall growth rate by more than half. Gains in technology were also reduced because firms were no longer able to borrow money to create new businesses and innovate. But what happened in terms of the basic demand-side model? Net exports did rise slightly, although that was more through cutting imports than expanding exports. However, monetary policy became much tighter, a condition imposed by the IMF. Also, foreign investment dried up, and in some cases, domestic capital fled the country. Hence autonomous investment also declined due to worsening expectations. As a result, total aggregate demand declined – in spite of the much lower level of the currency. Initially, even exports declined although the currencies had depreciated by 50% or more. In order to produce exports, firms first needed to import crucial parts and materials – but they could not obtain the credit to buy these goods, since the local banking system had collapsed, and no foreign banks wanted to lend money in these circumstances. Thus not only did domestic demand collapse, but exports fell as the wheels of industry ground to a halt. That particular situation was remedied within a year, which is why real GDP rebounded in 1999. The growth tigers were living on borrowed money without giving serious consideration about how it would be paid back; implicitly assuming that a 10% growth rate would continue forever. We know from the neoclassical growth model that a 10% growth rate is unsustainable in the long run even if nothing else had gone wrong. Hence even if the currencies had been fairly valued, and if Japan had not headed into a recession, growth in these countries would have declined to about 5%. It was also a mistake for these countries to fix their exchange rates to the dollar at the same time that the rate of inflation was substantially higher than in the US. Either they should have instituted a crawling peg, or reduced the rate of inflation. These alternatives would have meant slower growth over the past few years – but would have forestalled the collapse that eventually did happen. When any country is saddled with (a) a large budget deficit, (b) an increasing current account deficit, (c) a fall in the ratio of foreign exchange reserves to GDP, and (d) a rise in the ratio of foreign debt to GDP, it is almost certain that rapid growth cannot long endure. All these signals were present in southeast Asia, yet they were almost uniformly ignored by investors. Superheated rates of growth can be achieved only with abnormally high rates of saving and investment. The saving may be generated from domestic sources, or it may come from foreign investors. In the latter case, these funds can quickly dry up if expectations change. At the first sign of accelerating inflation or a weaker currency, several years of rapid growth may disappear almost overnight. That is the lesson of the Asian growth tigers.