Friday 8 June 2012

Asia's lessons for debt-trapped Europe

By Linda Lim, Published The Straits Times, 7 Jun 2012

TODAY'S euro crisis is far greater in scale, scope, complexity and global impact than the Asian financial crisis of 1997-98. Yet comparing the two can help us understand why the European crisis is so much more difficult to resolve.

Both crises remind us that a country cannot simultaneously have monetary policy autonomy, exchange rate stability (a fixed currency), and free capital mobility.

Euro zone countries have sacrificed national monetary policy (where countries determine their own money supply and interest rates) to share a fixed currency among themselves, and allow capital to flow freely across borders.

The United States retains monetary policy autonomy and capital mobility, but at the cost of a volatile currency. China maintains monetary policy autonomy with both currency controls and limited capital mobility.

Both crises remind us that external imbalances reflect domestic macroeconomic imbalances. A current account (trade) deficit that must be funded by net capital inflows is caused by private sector investment exceeding domestic savings and/or a government budget deficit.

In a deficit country with a fixed exchange rate (Thailand, Malaysia and South Korea in 1997, and Greece, Spain and Portugal since 1999), the currency cannot depreciate to make exports and assets cheaper for foreign buyers and investors. So all adjustment to a crisis must be borne by fiscal and monetary austerity - the standard 'IMF prescription' - if the country wants to allow free capital mobility.

In the Asian crisis, all the affected countries recovered quickly except for Indonesia (which took five years). They had fallen into crisis because their currencies were pegged to the US dollar, which strengthened as the Federal Reserve raised rates to cool off a booming US economy. Asian governments did not run excessively large budget deficits. But domestic investment was funded by foreign borrowing, made cheaper by strong currencies and lower offshore interest rates. Strong currencies also reduced exports and encouraged imports.

The Asian crisis was eased with countries floating their currencies, which promptly depreciated 40 per cent against the US dollar. Imports collapsed while boosting now-cheaper exports and inward foreign investment. Most countries also imposed monetary austerity - sharp increases in domestic interest rates - which limited further capital outflow, currency depreciation and inflation.

Monetary austerity also increased domestic savings and reduced investment, resulting in a sharp but relatively short-lived recession. Cheaper currencies, together with reduced domestic costs, increased the competitiveness of these export-led economies, turning their persistently large current account deficits of the 1990s into current account surpluses in the 2000s (helped by undervalued exchange rates). The 'IMF prescription' worked so well that most repaid their emergency loans from the International Monetary Fund before they were due.

But while crisis-hit Thailand, Philippines, Indonesia and South Korea gave up fixed currencies while retaining monetary policy autonomy and free capital flows, Malaysia chose a different path. After an initial currency depreciation followed by a repeg to the US dollar at a lower rate, it imposed temporary capital controls, giving up free capital flows in order to allow fiscal and monetary policy stimulus at home, through a budget deficit and lower interest rates. This turned out to be as effective in crisis recovery as the standard 'IMF prescription'.

But it worked only because exports were such a large proportion (over 70 per cent) of Malaysia's gross domestic product (GDP), and there were high domestic savings (over 30 per cent of GDP). The price Malaysia paid was a loss of global investor confidence resulting in lower post-crisis investment inflows and GDP growth compared with before the crisis.

Threatened by contagion, Singapore also allowed its currency to depreciate, and used fiscal stimulus to fight domestic recession. In the recent crisis, the US and China also employed massive monetary and fiscal stimulus to spur recovery from recession, with the US hoping that a weakening dollar would increase its exports. China is already re-enacting monetary stimulus at home in response to the euro crisis damaging its export prospects abroad.

These options are not available to Greece, Spain, Portugal, Ireland and Italy. They cannot devalue the euro, which has been kept relatively buoyant by the much larger and very competitive German economy.

Nor can they pursue stronger monetary stimulus which is in the hands of the European Central Bank, also dominated by Germany. Their large national deficits and debts make fiscal stimulus impossible. Austerity - tax increases, spending cuts - is a condition of IMF and European Union bailout funds.

All euro countries must keep budget deficits under 3 per cent and national debts under 60 per cent of GDP. Before 2007's global financial crisis originating on Wall Street, all except Greece were at or well within the deficit limit and most were within the debt limit. The crisis and ensuing recession tipped nearly all of them, France and Germany included, over these limits. France, Germany, Italy and Greece also breached these in 2002-04.

Austerity, like recession, shrinks GDP by reducing overall demand in the economy. This worsens the budget deficit itself as tax receipts fall with declining employment, income and profits, while government expenditures increase, for example, on the unemployed.

Welfare state excesses are not primarily to blame for Europe's current crisis any more than 'crony capitalism' was for Asia's in 1997-98. Within and outside the euro zone, European countries not in crisis (Germany, the Scandinavian and Baltic states, the Netherlands, Switzerland) do not have smaller welfare systems than those currently in crisis. Rather, they are richer and more productive, so better able to compete regionally and internationally despite relatively strong currencies.

Germany's persistently large current account surpluses (well over 3 per cent) and other euro members' large deficits indicate the euro is 'too weak' for Germany and 'too strong' for the rest. Without currency depreciation, countries in crisis must suffer painful internal wage and price deflation instead, to compete with Germany. Structural reforms are also necessary, particularly to reduce labour market rigidity and increase productivity. But these take time and are politically difficult to achieve, particularly in a recession.

What about supposedly 'prudent' high-saving Germans and 'profligate' high-spending southern Europeans? German savings went largely into German, Swiss and other European banks, which invested in risky US subprime mortgages, Irish and Spanish real estate, and Greek sovereign debt.

German prudence enabled Greek profligacy, rendering Europe and the world vulnerable to a possible Greek default. German, EU and IMF 'bailouts' of euro countries are essentially rescues of German and other international banks by their own governments - a clear case of 'moral hazard' converting private sector losses into sovereign debt that must be covered by the taxpaying public.

Some of these same banks, such as Germany's Commerzbank, got into similar problems in the Asian crisis, when they were bailed out by the IMF. But they do not seem to have learnt the lesson that major Asian banks have, as JP Morgan's recent massive trading loss also shows. Banks' internal controls and risk management practices leave much to be desired. More regulation - or more crises and contagion - are only to be expected.

Following the global financial crisis, several emerging economies hit by the earlier Asian crisis - Indonesia, Malaysia, Thailand and Brazil - imposed temporary restrictions (mainly taxes) on short-term capital inflows which had led to rapid currency and asset price rises. That the IMF did not object reflects the recent questioning in professional circles of the universal desirability of free capital flows.

Tighter regulation and higher taxes from fiscal austerity in other countries make Singapore an even more attractive tax haven for foreigners. But capital inflows also bring with them the contagion risks highlighted by the Asian, global and euro crises, including vulnerability to international banks.

The Monetary Authority of Singapore's recent addition of interest-rate management to its usual exchange-rate management is an attempt to exert more monetary policy control while preserving the capital mobility which underpins Singapore's open economy and its financial services sector.

Raising interest rates may have the perverse effect of worsening asset inflation by attracting capital inflows, which also strengthen the currency and may aggravate income inequality. Like every other country, Singapore too is subject to the trilemma of international finance. Being 'too attractive' may require even more fiscal austerity to control inflation at a time when Singapore's population is demanding better services from its government, and many sectors struggle with the challenge an appreciating currency poses to export competitiveness.

The writer is professor of strategy at the University of Michigan.

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