Have You Heard About the Incredible Recovery?

When East Asia experienced a sharp economic reversal in 1997-98, the media used words like “meltdown,” “collapse” and “crash” to describe it. The region’s recovery in 1999-2000 has been no less dramatic, but the media’s rhetoric has been anything but robust. An obvious explanation is the media’s predilection for bad news over good. Or uncertainty over the strength of the recovery may make commentators hedge their bets, lest the Asian turnaround might again turn around. The explanation could also be technical in nature. The 1997-98 economic shocks jeopardized the balance sheets of money-center banks in the United States, Europe and Japan, which had made billions of dollars in short-term loans in 1995-97 without adequate attention to their “due diligence” standards. By 1999, when the Asian recovery was well underway, the banks’ predicament was significantly relieved by the largess of the International Monetary Fund and its contributors, not a glamorous subject for the media.

In any case, there’s no question that the economic turmoil in East Asia was severe. Four Asian economies--Thailand, South Korea, Malaysia and Indonesia--that realized high growth rates in gross domestic product in 1996 sustained negative rates between 5% and 12% in 1997-98. On average, asset values in these countries plummeted by about 75%.

That makes Asia’s turnaround all the more extraordinary. South Korea, Thailand and Malaysia currently have annual growth rates about equal to those of 1996. Indonesia’s growth, about 3%-4%, is surprisingly high, though it’s shaky because of problems unrelated to the 1997-98 economic crisis: civil and military unrest in Timor, Aceh and the Moluccas, and the continuing ambiguous role of the military establishment in the country’s politics.

Other indicators of the recovery’s surprising strength abound. Capital inflows have resumed, mainly in the form of direct investment rather than debt. South Korea, almost closed to foreign direct investment before the turmoil of 1997, received $15.5 billion in outside investment last year, five times the 1996 inflow. The current accounts of the four economies are positive, and their foreign-exchange reserves are above 1996 levels (except for Indonesia). Their currencies have regained about 50% of their pre-crisis values, and foreign debt has been substantially restructured to favor long-term rather than short-term obligations.

The evidence of recovery is all the more impressive because the Japanese economy, long viewed by conventional wisdom as the engine of East Asia’s recovery, continues to stagnate for reasons unrelated to Asia’s financial crisis. Asia’s other major economy, China, continues to register significant growth, although it is still beset by problems largely independent of the 1997-98 crisis: the continuing heavy burden of its subsidized state-owned enterprises, a poorly managed and vulnerable banking sector, and widespread corruption.

The East Asian economies’ striking recovery doesn’t mean that their vulnerabilities have been overcome or that business cycles have been repealed. South Korea’s large and amorphous chaebols still require reform. In Thailand, one-third of the banking system’s loans are non-performing. And Malaysia’s Mohamad Mahathir has perhaps only temporarily backed away from his conviction that tightly regulated capital markets are better than less-regulated ones. Moreover, doubts have been expressed about the sustainability of the Asian recovery because of its reputed overdependence on exports to the United States and uncertainty about whether the U.S. market will maintain its momentum.

Nevertheless, the upward trajectory of the Asian economies is likely to endure because of five lessons learned from the debacles of 1997-98.

* As a form of foreign capital inflow, direct investment is far preferable to debt.

* When emerging-market governments or corporations borrow abroad, they should not borrow short-term and invest or re-lend long-term, a pervasive practice leading up to and precipitating the 1997 Asian crisis.

* Borrowing in foreign (“hard”) currency and re-lending or investing for purposes that do not generate foreign-currency earnings should be avoided unless ample foreign-exchange reserves are available to cover a possible currency squeeze.

* Domestic currency shouldn’t be pegged to the U.S. dollar, unless fiscal and monetary policies and institutions are strong enough to support the connection.

* In charting development strategy, what used to be known as the “Japan development model” should be eschewed. Much extolled in the 1970s and ‘80s, the model based resource allocations on nonmarket industrial policies favoring particular firms or industries, rather than on market criteria of costs and profitability.

While these lessons provide grounds for optimism, there is also a perverse lesson that unfortunately may be gleaned from yesteryear’s financial turmoil and the quick fixes adopted to remedy it. If events turn sour--whether as a consequence of mistaken public policies in emerging market countries or misguided lending practices of banking institutions in the wealthy countries--a belief has been nurtured that IMF or other government bailouts will charge to the rescue. The result of this “moral hazard” may be to encourage irresponsible behavior and subsequent crises. Notwithstanding the hoped-for reform of the IMF, its increased financial resources and heightened aspirations may actually intensify the dangers of financial irresponsibility in the future. *