Can Asia Emerge Stronger?

By Ajay Chhibber

Asia is being hit by financial tsunami whose epicenter is in the developed countries, but which has had an impact so far on hundreds of millions of people worldwide. Unlike the Asian financial crisis of 1997 caused by poor macroeconomic policies and weak financial systems in the region, this time most Asian countries are being affected despite strong macroeconomic fundamentals and sound banks and corporations. The richer Asian economies of Japan, Hong Kong, Taiwan and Singapore are all currently in recession. The rest of Asia is still growing, but regional growth will decline in 2008 and 2009 by as much as three to four percentage points -- more sharply than expected -- sending millions of people whose lost jobs back into poverty.

This is especially bad news because of the good news that preceded the crisis. In the past decade, Asia was able to lift some 300 million people out of extreme poverty. And it had brought its economic house in order. But now, all these gains are under threat from the current crisis. Given that almost 900 million people still live in extreme poverty in Asia -- living on less than $1.25 per day -- the current turmoil has the potential to become a social disaster and increase political tensions. Instead of further progress in the fight against poverty, even the recent gains are at risk of reversal unless Asian countries take urgent action. As late as September this year, Asia appeared headed to achieve the United Nation's Millennium Development Goals by 2015, but that assessment now seems to be in doubt and could be derailed.

There are three immediate needs for Asia: first, to have an Asian monetary facility which builds on the Chiang Mai Initiative and whose establishment will help stabilize markets and ease pressure on exchange rates. Second is better coordination on financial and trade policies in Asia and more intra-Asian trade. Finally, Asian nations need to boost demand in 2009 and strengthen targeted programs to help the poor and needy. Asia cannot hope to export its way out of the impending crisis, but instead must find its own solutions.

For sustaining growth, Asia has so far relied relatively more on exports than any other region in the world. The Asian export-led model has worked well. On average, emerging Asia's exports to the United States are about 16% of its GDP. Exports to the U.S. account for about one-third of GDP in Malaysia and Singapore. This ratio is also high in Hong Kong (22%), Vietnam (19%), Thailand (15%), Taiwan (16%), the Philippines (12%) and China (12%). Among emerging economies, India is the least exposed -- exports to the U.S. account for only 3% of its GDP. Similar patterns can be observed for exports to the European Union, which has surpassed the U.S. as the main trading partner for many in the region.

The headline story is that the direct financial impact of the crisis on Asia has been small, but a closer look reveals that Asia's financial integration with Western economies, particularly with the U.S., has increased dramatically over the last decade. More Asian money is now invested in Western countries than at any point in history. Emerging Asia held as much as 28% of GDP worth in U.S. Portfolio Securities -- both debt and equities -- in 2006 compared to 10% in 1994.

Similarly, 13% of GDP worth of Asian Portfolio Securities is owned by the U.S. This partially helps explain the huge decline in Asian equity and currency markets in the last two months. The financial exposure to the U.S. as percentage of GDP is relatively high for Singapore, Hong Kong, Taiwan, China, Korea and Malaysia. Only Vietnam and India are relatively less integrated with Western financial markets.

The growing integration of Asian financial markets with the rest of the world explains why equity markets in Asia have fallen as sharply as elsewhere. Nevertheless, the overall impact on real markets in Asia will not be as bad as in 1997-99, when the crisis was largely home-grown. While the trench will not be as deep as the crisis that the region suffered during 1997-99, neither will the recovery be as straightforward. What's needed is a new, domestic demand-led recovery, instead of the old reliance on an export-led recovery. China's $580 billion stimulus package for infrastructure and social spending is a strong step in that direction. China has also started to lower interest rates to boost demand, recognizing that its spending may take time to kick-in. Other East Asian countries with strong fiscal positions could follow the Chinese example in bolstering domestic demand. On the other hand, South Asian countries, such as India and Sri Lanka, are encouraging domestic demand through low interest rates, as they have relatively high fiscal deficits.

There's already a silver lining for Asia, and that is falling food and fuel prices. These price drops will reduce trade imbalances by helping contain inflation, which allows Asian countries to ease monetary policy. Inflation rates have started to decline sharply in recent weeks. Of course, commodity exporters like Malaysia, Indonesia, Cambodia, Laos and Vietnam, which had benefited from high commodity prices, will likely feel the price declines more, especially in rural areas. Unlike 1997-98 when Asia's urban population took the brunt of the crisis, this time the impact will be more widespread with rural incomes already falling sharply on the back of declining food and commodity prices.

Using this to their benefit, Asia can take some confident steps forward. More intra-Asian trade will generate demand and help the smaller Asian countries deal with lower export demand. For instance, Bangladesh, Cambodia, Nepal, Sri Lanka, Pakistan and Vietnam are highly dependent on the U.S. and European markets, and trading more with Asia will give them a lifeline. For these low-cost producers, more intra-Asian trade offers a way out. But the same path is not obviously available to higher wage economies such as Korea, Malaysia and Thailand. For them, moving into higher end products to compete with a share of Asia's higher end market, now dominated by Europe, offers a solution, but one which will require bold and strategic investments.

In recent weeks, many Asian countries -- even those with strong macroeconomic balances, including current-account surpluses on their balance of payments -- have come under pressure on their currencies and equity markets. This has been driven by a flight from perceived risks largely toward U.S. dollar fixed-income securities. Only the Chinese yuan and the Japanese yen have strengthened against the dollar-backed by huge reserves and, in the case of Japan, the unwinding of yen carried trade when yen was borrowed at very low interest rates and invested onward into other higher-yielding assets in other currencies. The announcement of a credit-swap arrangement with the U.S. Federal Reserve has helped stabilize the Singapore dollar and the Korean won, but others remain vulnerable.

Indonesia looked comfortable in mid-2008, holding $60 billion in reserves -- almost six months of imports and much larger than its short-term debt. Indonesia also had a current-account surplus, low debt ratios and a small fiscal deficit, and an economy growing at over 6% per annum. Poverty and unemployment were falling and the future looked bright. But since the crisis began to bite, the Indonesian rupiah has lost around 25% of its value and now looks vulnerable.

One reason for market worry is that although Indonesia has strong macroeconomic balances, nevertheless it has large foreign liquid liabilities and needs to rollover substantial amounts of public debt in 2009. Indonesia had expected to finance almost 60% of this through bond issues in foreign and domestic markets, but these would now have to be financed at a very high premium if they could be done at all. Indonesia cannot rely so much on market financing and needs special financing from multilateral and bilateral sources, as well as the confidence boosting capacity of a backup facility.

Sharp increases in emerging-market spreads reflect a generalized retreat from emerging markets not weak macroeconomic fundamentals. To deal with this, Asia needs an expanded monetary facility. The IMF has announced a new $100 billion credit facility to help emerging markets; however, the political and social stigma of an IMF bailout makes most Asian countries reluctant to engage with the organization. In the absence of such a multilateral body, bilateral swap arrangements are being hotly pursued but remain an ad hoc mechanism. The Chiang Mai Initiative, which has pooled $80 billion to help the Association of Southeast Asian Nations Plus Three countries in crisis, needs to be expanded.

After expensive cleanups, Asian countries in general face this crisis with relatively clean banks and corporations. They are not undercapitalized or overleveraged, but are nevertheless vulnerable if there are sharp currency swings which will lead to mismatches. Some corporate holders of unhedged foreign-currency debt, who would otherwise be solvent, may need bridge financing to more balanced positions. In addition, most Asian property markets had overheated in recent years -- just as those of the U.S. and Europe -- and now face a sharp decline in demand as credit tightens and foreign money starts to pull out. This will have a huge knock-on effect on the construction sector which helps employ large numbers in most Asian countries. Stock markets have also fallen sharply in lip sync with equity markets in the U.S. But unlike in the U.S., Europe and Japan, the impact on consumer demand due to the negative wealth effect of stock losses remains relatively limited since only a small proportion of the population hold equity.

In addition to a larger currency facility, what's also needed is better coordination on financial and monetary policies. Many Asian economies have injected liquidity through reduction of cash statutory ratio and introducing new facilities, extending the range of collateral, or easing access to the central banks' discount windows. With inflation pressures easing, a number of economies such as China, India, Korea, Taiwan and Vietnam have cut policy rates. India, Japan and Hong Kong also announced plans for bank recapitalization contingency funds. The decision by Korea, Taiwan, Hong Kong and Singapore to provide a blanket guarantee on deposits, led Malaysia to follow in their footsteps, putting enormous pressure on other Asian countries, like Indonesia, to do the same. Such actions could benefit from better coordination.

Finally, there is an urgent need for stronger social programs that will ensure Asia's future. Asian countries need to help children stay in school, ensure that basic health care and vaccination initiatives are maintained, and provide food to the very needy to help them deal with the downturn. Targeted conditional cash programs -- which give cash to families to ensure that children, especially girls, remain in school and are vaccinated -- have not been tried much in Asia, but are a good way forward. Some Asian countries have large but very inefficient food-distribution systems. And although many have midday-meal schemes in schools that will help, they are not enough in a crisis.

Asia lacks well-developed social-security systems, such as those in Europe, and so a decline in growth will deepen the social effects of this crisis. As jobs are cut and workers have lost their rural links, many in China increasingly wish for the "iron rice bowl" policies of the Mao era, which at the very least provided basic food, health care and education. India recently launched a massive rural-employment guarantee scheme expected to cost about 2% of its GDP. If successful, the scheme could be the answer to increasing unemployment, at least in rural areas, and help keep people from adding to the ranks of the urban unemployed. But there are huge concerns about how much of the money will actually reach the needy. Some say better targeted programs-such as conditional cash transfers-should be tried instead. Such programs will also help keep Asia on track to meet the MDG by 2015 by helping children stay in school and ensuring that health care is not neglected.

Many Asian governments derive their legitimacy from a social contract in which their populations expect continual high growth, more jobs and rising incomes. This is especially true in countries where the population is young and growing. If these expectations are dashed too strongly and many drop into the ranks of the unemployed -- even temporarily -- we could see an explosive tension in many countries. Asia lacks the social-safety nets and institutionalized coordination mechanisms to deal with such tensions. Next year will be crucial for Asia's handling of this crisis.

If Asian nations can work together, keep trade open and strengthen social-safety nets, they will not only be able to deal with this financial tsunami, but also lay the groundwork for a powerful future, one in which greater coordination prepares the path for the eagerly awaited Asian century. This time, Asia can't expect solutions from outside-it must find some of its own and, by doing that, help the rest of the world.

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Mr. Chhibber is director of the UNDP Regional Bureau for Asia and the Pacific, and U.N. assistant secretary-general