Following a brief overview this morning, and before moving on to our worldwide quarterly forecast tomorrow, first some detailsabout how the financial crisis will work out in East Asia.The Asian financial system operates on a different set of principles than its Western counterpart. In the West, the financial system is based on capital, which is allocated through borrowing and lending to achieve maximum efficiency, profits and growth. Credit is granted according to returns on investment, with borrowers promising collateral in case of default. Borrowers who fail to pay back debt probably will lose their collateral, and their future access to credit will be restricted. Capital is scarce in the Western system and therefore highly valued.
In East Asia, by contrast, the financial system focuses on labor rather than capital, and the authorities and banking cadres manage capital flows to maximize the number of jobs and minimize unemployment levels, thereby ensuring socio-political stability. In contrast to the West, easy access to cheap credit is central to this scheme, providing businesses with the tools to expand and employ more workers, and giving consumers the means to maintain or improve their standard of living. Such widely available credit, often at negative interest rates in real terms, rewards inefficiencies in the uses of capital throughout the system. It also encourages throughput rather than capital. Overall productivity suffers and corporate and government debts build up to extremely high levels ? but social coherence (if not harmony) is maintained.
From the Asian point of view, the social benefits of stability outweigh the fiscal costs of heaps of nonperforming loans. In many Asian states, stability must be achieved across a wide variety of ethnic and religious groups and formidable geographical obstructions. Islands, archipelagoes, mountains, thick jungles and peninsulas all form the landscape in which communal and political ties develop. Cheap credit is a means used by countries to achieve economic growth in the face of so many natural challenges.
East Asian states go to great lengths to maintain robust export sectors and trade surpluses. Japan, China, South Korea, Thailand, Malaysia and others manufacture goods to send to hungry markets abroad. The supply chains are often pan-Asian; Southeast Asia produces parts to ship to Japan and South Korea, which in turn make high-value-added products ? from cars to ships to electronics ? to sell to wealthier states and consumers worldwide. Large trade surpluses give these countries extra cash, which they then use to build up their reserves.
There is a disadvantage to the credit-rich Asian financial system. If exports slow down to the point that cash becomes scarce and banks cannot provide liquidity for the rest of the society, there will be a political reckoning. Once cheap credit and cash disappear from the system, the social glue comes undone and old rivalries emerge, sometimes toppling governments. Therefore Asian governments are often eager to use public funds, distributed according to the prerogative of the central political power, to stabilize their societies when markets appear to have failed. But they do not tend to accept the staggering losses that weed out inefficiencies in their economies, so the combination of government spending and inefficient uses of capital poses formidable challenges for them in the long run.
The Asian financial crisis of 1997-1998 revealed the weaknesses of this scheme ? and in its aftermath, several Asian countries sought reforms. But with few exceptions, Asian economies have not succeeded in altering their systems after the crisis, but they have created rainy-day funds, sovereign wealth funds and foreign exchange reserves to help preserve their own nation’s stability ? largely by means of liquidity injections ? when the next crisis comes.
Through expanded trade, these states have become more interlocked, more interdependent on each other and slightly less dependent on the West. Thus, as the West’s financial system melts down, Asia could offer its excess capital, putting itself in the role of supporter and lender. China has the biggest reserves, at $1.9 trillion, while Japan holds $1 trillion, though the amount of free liquidity that is not already tied up in Western assets is considerably smaller. But the primary imperative of every Asian state is its own economic well-being, and the mounds of reserves will mostly go toward maintaining their own growth as the world slows down.
Japan
Japan, with a gross domestic product (GDP) of about $4.4 trillion, is particularly vulnerable to economic downturn in the coming months. During the summer commodity inflation drove up energy and raw materials costs for Japanese industries, pushing the country to the verge of ? if not into ? recession. With the deepening of the credit crisis and the rapid appreciation of the yen, Japan’s export sector faces even gloomier prospects.
The best context for understanding Japan’s economy is the country’s banking disaster of 1990. At the time, Japan had an extraordinarily dynamic export-driven economy. Banks with loose lending practices drove the rapid growth, and megacompanies and banks became more and more intertwined. Yet high export volumes were essential, so when the United States fell into recession and exports dropped, the corporations could not make their debt payments and the overleveraged banks fell.
Tokyo then faced a choice. It could subject itself to a classic recession, allowing losses to run their course throughout the banking sector, leading to bankruptcies and massive layoffs. Or it could come to the rescue through deficit spending on bailouts, infrastructure projects and subsidies designed to keep the economy limping along.
The Japanese leadership and public were not willing to accept the social dislocation following a classic recession, and opted to spend themselves out of the mess. While the plan saved Japan from social upheaval, a decade of economic lethargy resulted, in which recession resumed as soon as each new publicly funded stimulus package wore off. During this period Japan went from being the world’s largest creditor nation to its largest debtor. Japan’s external debt ballooned to about $7.4 trillion, or 170 percent of GDP ? comparable in relative size only to Zimbabwe and Lebanon. This enormous debt, and the costs of financing it, greatly constrain the Japanese government’s fiscal policy and flexibility.
Since 1992 Japan has vacillated between low growth (at an average rate of about 1.5 percent) and six recessions. Consumers grew pessimistic, holding off on buying goods in constant expectation of lower prices, which resulted in a deflationary spiral. Finally, from 2003 to 2007 the economy gained momentum, but a new problem emerged: demographics. Japan’s population of 127 million is expected to dwindle by two-thirds by the end of the century. As the Japanese public grows old, few workers are growing up to replace them or generate wealth to pay for rising pensions and public outlays for the elderly. Domestic demand is bound to shrink, leaving Japan with nothing but exports to sustain its economy.
In 2008, another recession loomed on the horizon after five years of mild growth. GDP growth this year is expected to shrink to 1 percent from 2.2 percent in 2007. Commodity inflation, especially on energy products (Japan is a major net importer of energy), began pinching Japanese businesses and consumers. In July the cost of Japan’s imports of crude oil rose 69 percent, and natural gas and liquefied natural gas (LNG) rose 59 percent, from July 2007. Food costs spiked at the same time, and consumer confidence paled. For years Japan had struggled with deflation and hoped for a little inflation to revive domestic consumption, but the rapid increase of prices of essential materials was the “wrong” kind of inflation. Industrial production slowed by 6.9 percent year on year. The country stood at the brink of recession.
Then, in August, Japan reported its first monthly trade deficit since 1982 (at $3.2 billion), with the exception of occasional deficits in January and February (when Western consumption falls after Christmas). In September preliminary statistics point to the anomalous trade deficit worsening to an estimated $6 billion, a 63 percent contraction of the trade balance year on year. Moreover, America is now likely to experience a recession for at least one quarter, while Europe could be facing one for a year or more. This will have a drastic effect on Japan’s exporters, as the United States consumes 20.1 percent of Japan’s exports and the European Union consumes 13.5 percent.
Compounding the problems for Japanese exporters is the rapid and irrepressible appreciation in the value of the yen. The yen’s rise follows the unwinding of the international carry trade, with a total value roughly estimated at $1.3 trillion but possibly reaching as high as $2 or $3 trillion. The carry trade consists of loans that investors took out in yen at Japan’s notoriously low interest rates, which they then invested in assets abroad where returns were higher. This scheme has been thriving for more than a decade, resulting in massive amounts of foreign holdings. Early in October, as the credit crisis rapidly spread, investors began withdrawing their money from these riskier assets and buying yen to pay off their debts. This has resulted in a massive demand for the Japanese currency, pushing its value up 8 percent in the past month, stronger than the psychological threshold of 100 yen per U.S. dollar for the first time in 20 years.
The yen’s rise is terrible news for Japan because it will make Japanese products even less attractive for countries with weaker currencies ? which is everyone else, since the yen is currently the world’s strongest currency. Especially important are the euro and the dollar, with the latter remaining weaker than the yen despite a strong performance in the same period. The yen’s newfound strength will contribute to the easing of inflationary pressures as prices for raw materials fall. But, overall, it will do more damage than good to Japan by making Japanese products unattractive or unaffordable to foreign consumers.
The question for Japan therefore is whether the global slowdown and the strengthening of the yen will cause the unusual trade deficits to recur. If trade deficits become persistent and unavoidable ? a possibility given the recessions that Europe and the United States face ? then the country’s predicament will become dire indeed. Tokyo’s national debt is the heaviest in human history, and an attempt to repeat the public stimulus spending of the 1990s could lead to a very uncomfortable situation if the Japan’s primary source of income fails.
In such an extreme circumstance, it is not hard to imagine that Japan’s financial architecture could essentially rupture, forcing the country to undergo a fundamental change of economic behavior. Massive unemployment, should it occur, would cause serious transformations in Japanese society. But so far, unemployment rests at a two-year high of 4.2 percent, below the high of 5.4 percent in 2002. In the worst-case scenario, the one thing working in Japan’s favor is its relative ethnic homogeneity, which might serve to minimize strife during a major transition.
As for the best-case scenario, Japan may still face another drawn-out period of recession, followed by more vacillation between that and piddling growth. Tokyo’s enormous foreign exchange reserves (at about $970 billion, with $586 billion in U.S. Treasury securities) provide it with considerable leeway ? it could use free reserves to try to stimulate domestic demand and growth, back up regional banks or provide the international system with liquidity. Yet there remains a paradox inherent in any attempt to use U.S. dollar reserves to combat recession. Each dip into the foreign exchange pot will mean pulling Japanese capital out of the most secure place possible. Meanwhile selling Treasury bills would deprive the United States of badly needed liquidity, resulting in higher interest rates and reduced access to credit for American consumers. Any such moves would adversely affect all trade in U.S. dollars, including trade with major partners China, Korea, Taiwan and Hong Kong, which together make up 34.6 percent of Japan’s exports.
China
The Chinese economy underwent reforms in 1978, attempting to mimic Japan’s surging economy in previous decades. Beijing’s financial model is based closely on Tokyo’s ? namely, on easy credit and lots of exports ? but China has not yet experienced a major upset like Japan did. Rarely has it fallen below 10 percent growth since 1980, and it has rebounded rapidly after setbacks. (During the global recession of 1989-1990, Chinese growth fell to around 4 percent, but leaped back to 9 percent in 1991.)
In general China has maintained blistering rates of economic growth, which are crucial because momentum is the only thing keeping the society together despite massive inequalities of wealth and lifestyle. China must at all times maximize employment of its massive 1.3 billion population to maintain social coherence. If economic engines sputter and a wave of unemployment hits the streets and countryside, Beijing will have to worry about its very survival. It would not be able to maintain power amid the social disruptions that would ensue if between 740 million and 900 million poor farmers, urban laborers and migrants were pushed to the brink of ruin.
So far in the financial crisis, China’s export sector is performing well. Exports grew 21.5 percent in September from a year earlier, to $136.4 billion, and the trade surplus reached $29.3 billion the same month. But with the wealthy world sinking into recession, China’s exports look like they are about to take a nosedive. Some Chinese import and export companies have already had to cut their profit margins by as much as half, reporting that orders from Europe ? the top importer of Chinese goods ? have fallen by 20 percent. Profit growth in the textile industry, for instance, has fallen to 8 percent in 2008 so far, down 34 percent from the same period last year and the lowest rate since 2001.
It is the fall in exports rather than the credit crisis proper that instills fear in the Communist Party of China (CPC). While much of the world is parched for liquidity, China is sloshing around in it, with a strong trade balance, deep reserves and low debt. The country brings in large trade surpluses consistently, totaling $262.2 billion in 2007 and $180.9 billion in the first three quarters of 2008, which amounts to about 7 percent of GDP. China’s foreign exchange reserves, 54 percent of which are invested in U.S. Treasury and agency bonds, have now reached $1.9 trillion, and are building fast. Reserves have increased by nearly a third this year, and grew by almost 50 percent during 2007. China’s national debt consists of a respectable 20 percent ($680 billion) of its $3.4 trillion GDP.
In addition to its foreign exchange reserves and current account surplus, China has numerous regional and local banks and a massive underground banking sector ? which has a total value of loans estimated at up to $1.46 trillion. While such a large informal banking sector is a problem in many ways, these institutions have pools of liquidity of their own. In short, China is artificially capital-rich, and subsidized credit is widely available.
Another bulwark China has against the financial crisis is the political machinery it uses to govern the allocation of capital. In China, capital flows are guarded carefully, and banks have long been subject to strict controls. This allowed it to maintain 7.8 percent growth while wading through the Asian financial crisis in 1997-1998. Regulatory bodies such as the China Banking Regulatory Commission have tried to prevent Chinese banks and financial houses from developing or investing in the more sophisticated financial products, such as derivatives, that became popular in recent years in the United States and that precipitated the credit crunch. Though regulation has not always been successful, China’s lenders are not as exposed to troubled assets as most American investment houses.
But despite China’s resistance to the credit crisis, the country’s leaders are extremely apprehensive about the future. A major decrease in exports is coming, and even optimistic growth predictions for 2009 are falling to as low as 8 percent or 9 percent. With China’s most profitable industries at risk, rural reform is not likely to progress rapidly or to boost domestic demand in time to pick up the slack from falling orders (though Beijing will certainly make valiant efforts on this front). State researchers are growing increasingly negative in their estimates of the country’s economic performance in the short and medium terms.
Pessimism is particularly focused on the real estate sector. Some analysts believe that an asset bubble in Chinese real estate is about to burst, as major foreign investors sell off holdings in an attempt to free up liquidity or escape while they can. The Chinese government has moved to boost demand for housing by cutting taxes on property and easing regulations on first-time buyers. But foreign investors are spooked and there are some signs that domestic developers might be coming up short on capital. A sudden plunge in commercial and residential real estate prices could force massive losses upon China’s developers and regional and national banks, ultimately having major ramifications for the economy as a whole and perhaps requiring a sweeping government rescue of the market.
The traditional Chinese answer to a slowdown is to keep production going at all costs. Mass unemployment is an unacceptable solution ? far better from Beijing’s perspective to maintain production through subsidies. Accordingly China has increased export rebates for textiles as well as toys, furniture and plastic goods to keep production going despite falling sales. It will likely increase such measures as the news gets worse from its major centers of import and export. Of course, the problem with artificially maintaining production is that it leads to overproduction and deflation as stores become overfilled with goods and the Chinese are forced to either build more storage space or dump subsidized production on weak export markets. Expending vast amounts on subsidies to dig the country into a deflationary hole does not sound pretty, and will not replace real economic growth, but it may be China’s only option amid a global recession.
After two decades of growth, a slight slowdown would hardly bother most countries. But China is different. Its political and social stability rests on maintaining growth. Social pressures are rising due to the highly disproportionate distribution of wealth, and the Chinese leadership is worried about a combination of stresses acting at once, thus undermining the regime. The coming recession might not herald a crisis in the CPC, but the strains it exacerbates eventually will.