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Will East Asia suffer the US slowdown?

Alessandro Magnoli Bocchi's picture
In the past few years, the world economy has done very well. Almost every nation has grown richer. In the last six months, however, bad news has been pouring in.  
  • In the US, the housing bubble burst. The value of houses fell (by 9.1% just last December), triggering defaults in the sub-prime mortgage market and unfolding a financial turmoil. The banking system - uncertain about where, and how big, the risks are - put on the brakes, and got credit into a crunch.  In simpler words, banks now lend very carefully, and getting a loan is not as-easy-as-it-was one year ago. To ease borrowing and kickstart a recovery, the Fed has intervened and drastically lowered interest rates to 3%. Meanwhile, the US dollar keeps depreciating vis-à-vis the other major currencies. The steady sell-off of dollars on the currency markets is triggered by grim expectations about the economic outlook and by the chronic twin deficit, that is: a) a deficit in the current account (i.e.: the country is importing more than it is exporting); and b) a deficit in the public budget (i.e.: the fiscal revenues don’t keep up with expenditures). The economy is in dire straits: inflation is skyrocketing (in January, prices jumped by 13.5% for producers and 6.4% for consumers). Jobs are being lost (January witnessed the first net loss in 4 years). Consumer confidence, income, and sales are distressed. Bottom line: for all the above reasons, a US recession is possible. 
  • In the high-income countries, economic growth is easing (except for Japan), due to lower internal demand (i.e.: consumers spend less, as they are worried about tomorrow), decelerating industrial production, and declining exports. For example, in Europe, a strong Euro and weaker US demand are taking a toll. Additionally, the US credit crunch is going global: sub-prime losses (up to $150 billion, for now) hit a few big international banks. As a consequence, credit conditions are getting tighter everywhere. Equity markets are increasingly volatile, and stocks tumbled badly in January, when $5.2 trillion were burned and emerging markets lost more than 10%. In Europe and in the US the risk of companies defaulting on their debt is now higher than ever. Finally, inflation is taking a painful toll everywhere (and limiting the action of fiscal and monetary policies), because of the rising prices of energy and food. The price of oil jumped to more than $100 a barrel. Coal prices are soaring. Food is becoming more and more expensive: while grain (corn, soybeans, and wheat) stocks are low, the cost of key farming inputs - energy and fertilizer - is high. The markets are rushing to secure assets - a safe hedge against inflation: the price of gold soared to more than $960 an ounce, a record high. The value of silver is the highest in thirty years.
Is this a storm in the making?   The answer to this question depends on where you stand in the current debate.   If you think the US economy has still a lot of influence on the world economy, you might fear dire global repercussions from the US slowdown. If you forgive my oversimplifying, here is a rough metaphor: if the world were to be a ‘family’, you would look at the US as the ‘bread winner’; and sure, when such a key person “gets sick”, the flu spreads, and the family is in trouble. Otherwise, if you think the US economy is not as influential on the rest of the global economy as it used to be, you might believe that the developing world will get by, even if the US is struggling or in a recession. In the above metaphor: “the kids have grown up”; the poor(er) countries can now make it on their own, and will keep growing fairly robustly - even with weaker prospects in industrialized nations.   Let’s analyze the two positions with some detail:  
  1. The developing economies will suffer the US turmoil, because they are interlinked – via economic and financial ties - with the high-income countries. Some commentators feel that for the developing world the key-word is “export”. For them, local growth comes - above all - from selling to the industrialized countries what they need: energy, commodities, and electronics (think of oil, coffee, and cheap computers, and you will get their point). In other words, the demand in rich countries is what drives production – and growth - in poor(er) nations. In the global economy these links are so deep, that the performance (i.e.: in terms of consumption) of the industrialized economies is crucial for global prosperity. Hence, a likely recession in the US (the world’s biggest consumer market) and mounting uncertainty in high-income countries should get us really worried about the developing countries and the global economy. A crisis is highly plausible. This is the view, for example, of the recent UN “World Economic Situation and Prospects 2008, and of Martin Wolf, in recent Financial Times columns (see Article 1 and Article 2). 
  1. The developing economies will get by, because they are well advanced in the process of de-linking from the industrialized economies. Other commentators feel that the developing economies have become resilient, i.e. able to operate and prosper despite the turmoil. The keyword here isn’t ‘export’, but “domestic demand”: the engine of local growth is a strong domestic spending – so strong that it could even offset a decline in exports to high-income countries. In other words, the emerging economies ‘are fine’. Over the years, they have grown vigorously, improved their macroeconomic stability, and accumulated large foreign exchange reserves. Also, they are increasingly trading amongst themselves: for example, China has replaced the US as India’s largest supplier of imports. In Russia, India and Brazil, imports are growing faster than in the US. In short, the emerging economies - driven by the rapid growth of China and India – are less tied to the industrialized world, and more interdependent.  This is the view, for example, of the recent IMF “World Economic Outlook (for the IMF, in 2008 developing countries will grow at 6.9%, and China at 10%), of the latest World Bank “East Asia Update, and of a couple of recent posts in this blog (see Justin Lin Yifu, the new World Bank Chief Economist, and David Dollar on China). 
Which of the two positions is more convincing?   Of course, picking just one might not be the right choice. The truth - in today’s world economy - is that both 1. and 2. above are strong forces in interplay, happening at the same time. The key point is to understand which one will get the upper hand.   And what about East Asia? At first glance, the region should have limited exposure to sub-prime mortgage securities, and a fair amount of liquidity in the domestic economies. Moreover, the latest data don’t point to a slowdown related to the US economic struggles. Indeed, in the US, in the last three months of 2007, imports weakened and the economy decelerated from 4.9 to 0.6%. Over the same period, in Japan growth raised from 1.3 to 3.7% because of strong exports, mainly to East Asian neighbors. In the Philippines, imports grew at 19.7% and the economy at 7.4%. In Korea, growth went from 5.2 to 5.5%. In Malaysia, the economy expanded at 7.3%, benefiting from higher commodity prices and increased government spending. The Thai economy also accelerated to 5.7%, pushed by robust exports. Growth cooled a little in China (from 11.5 to 11.2 %, because of lower exports) and in Indonesia (from 6.5 to 6.3%), and decelerated in Singapore (from 9.5 to 5.4%). In short, in East Asia economic growth held up well, mainly pushed by strong domestic demand. However, it is too early to declare victory.   What is my position? I tend to be optimistic, and think that East Asia will get by. This is not to say that there is nothing to worry about.   The worst case scenario - a global financial crisis leading to a world recession - is indeed possible. The ongoing depreciation of the US dollar might have risky consequences, as the big global imbalances are still there. First, in East Asia the central banks have amassed huge foreign currency reserves, held mostly in dollars. A weaker dollar will reduce the value of these reserves, and erode their “protective buffer” against a potential financial panic and a prolonged recession. Second, more than 20% of China’s exports go to the US, and about 54% to the high-income economies; sooner or later, the decreased purchasing power of the dollar and the global slowdown might take their toll. Finally, the next round of sub-prime losses could fall on small financial institutions in the developing world.   But such a scenario, while possible, doesn’t seem the most likely. Today, most East Asian countries face a favorable outlook: a strong domestic demand, sound macroeconomic conditions, and buoyant commodity prices. And the de-linking from the western economies – if not (yet) well under way – seems at least to have started. Here – once again – the price of oil can be used as a revealing indicator. While, in the past, a US recession brought about a reduction of oil and other commodity (i.e.: metal) prices, this is not what’s happening today. Actually, it’s just the opposite: this might show that global demand is still strong, and that the demand in the emerging markets doesn’t depend much on international factors.   Would you agree? Or you think that there is trouble ahead for East Asia?   If you are interested on how will East Asia react to this storm, stay tuned. This blog, and - in late April - the new World Bank “East Asia Update, will provide you with the latest data and analysis.

Comments

Submitted by Guy de Jonquieres on
The evidence strongly suggests that talk of Asian "de-coupling" is greatly exaggerated and that the region would suffer from a serious US slowdown. However, the severity of the impact would vary widely between countries. The recent growth of intra-Asian trade gives a misleading picture of the region's ability to weather a downturn in the OECD area. Much of this growth is due, not to consumption in the countries concerned, but to trans-shipment and processing of components for assembly and final sale elsewhere. The Asia Development Bank calculates that more than 60 per cent of the region's direct and indirect exports end up in the US, EU and Japan. Since domestic consumption in Japan remains extremely weak, that implies that the US and EU are the main markets. Furthermore, Asia's dependence on exports is large - equivalent to 55 per cent of total GDP - and growing. Correspondingly, domestic demand in the region remains limited. According to Goldman Sachs, it contributes only one fifth as much as exports to overall growth. This implies that the effects of a sharp US slowdown would be transmitted rapidly to the region in the form of reduced demand. To some extent, China and other regional exporters have been able to compensate so far by diverting exports to the EU, where they also reap the benefits of the stronger euro in higher margins. But that is unlikely to continue indefinitely. There are growing pressures in the EU for measures - anti-dumping and possibly special safeguards against China - to check the trend. Any idea that China could make up for lower demand in the west looks far-fetched. Not only has exports' contribution to its own growth risen sharply since 2004; its final demand for Asian exports is only a quarter of the US level. That said, China would seem relatively well-placed to weather a severe US slowdown. Exports' contribution to its recent growth, though growing, was still only about a quarter last year. Furthermore, some of China's fastest-growing export activities, notably electronics, involve low levels of local value-added. Other East Asian countries whose economies depend heavily on parts and components exports to China would probably be far harder-hit. Among the most exposed are Singapore, Malaysia, Thailand and the Philippines. Of course, there are many other variables in this equation. Would slower external demand lead to a fall off in the high levels of fixed asset investment that have been the main driver of Chinese growth? Would a lower Chinese growth rate lead to a sharp rise in NPLs and the threat of another banking crisis? Right now, one can only guess... All this makes more important the need for other Asian countries to stimulate domestic consumption. However, in Japan, despite massive fiscal stimulus packages and years of loose monetary policy, it remains stubbornly weak. In Korea, high levels of private debt probably mean domestic consumption is at or past its peak. Scope for further growth also looks limited in Malaysia.

Submitted by Homi Kharas on
I agree with Guy de Jonquieres that Asia is not "de-coupling" from the rest of the world. In fact, the essence of an open, globalized region is that it is closely linked to the rest of the world and inevitably affected by what happens elsewhere. The real question is whether the world ecnoomy is best described as a hub-and-spoke system, where damage to the hub affects the integrity of the system as a whole, or as a networked system where weaknesses in one area can be compensated to a degree by use of other network links, and the integrity of the system is retained. I would argue that East Asia today finds itself closer to a networked world. Of course the US is important and of course the economies in the region will slow if there is a US recession. But as long as this recession is mild, I think it is unlikely that this will alter the strong growth fundamentals now being demonstrated across East Asia. There are several reasons for this optimism. The first reason is that the main channel through which the US problems are being exported to other countries is through credit and banking markets. Several European banks have been hard hit. But in Asia, exposure to sub-prime losses has been small, and there is no evidence of any credit crunch. So the mechanisms that can take a shock and amplify it into a crisis are absent in East Asia. Second, it is worth emphasizing that growth in China has historically been completely divorced from growth in the US. Although today China's exports are much larger than ever before--so the past may not be a good prelude to the future-- there is no statistical evidence that China will slow dramatically if the US enters a recession. If anything, a US recession could reduce China's current account surpluses and overheating in selected sectors, and help that economy regain a more predictable, stable growth path. A reduced likelihood of a hard landing in China is very good news for other East Asian economies. Third, even if East Asian export growth slows, domestic demand can be sustained because there is ample space for more aggressive fiscal and monetary policy across the region. After a long period of underinvestment in public infrastrucure, the economies of south east Asia are gearing up for a new round of much needed public investments. Fourth, the large regional supply networks that dominate production of electronics ensure that the pain from slower exports to the US is distributed across several East Asian countries, making it more manageable. In summary, a US recession is bound to slow Asian growth to some degree. That is a necessary corollary of participating in the global economy. But as long as this is confined to real economy shocks the impact will be manageable. As the world still looks as if it will grow reasonably this year, as evidenced by continued strength in commodity prices, the chilling effects on Asia might be moderate. It is too early for Asia to panic about losing growth momentum.

Could I take a different tack from Alessandro or Guy and make the somewhat nihilistic point that we probably know much less about what will happen in East Asia in the next year than we like to think? (This bleak wisdom is one of the few conclusions I draw from a career of more than 20 years in the prognostication business). Here are a few scattered factual observations that I personally find rather more interesting than big thoughts about recoupling, decoupling and all that. First, there is no simple or mechanical law about how East Asia actually performs during US recessions. It depends … In the 1991 recession, when US growth fell 2.1 percentage points (pp), growth among the larger East Asian economies actually went up a median 0.2pp. Exports and investment stayed rock solid. (That period was the happy dawn of the East Asian mega-boom that led, ultimately, to the financial crisis of 1997-98). Ten years later when US growth fell by only a little more – 2.9pp – median East Asian growth slumped by over 4 percentage points, with exports and investment going down much more. Of course after the event we all came up with really good explanations for what had happened. (Isn’t hindsight great?) We now understand that the impact of the US recession on East Asia in 2001 was especially harsh because it was led by a slump in business investment and in high tech spending in particular – East Asia’s leading export sector. Investment was especially sensitive to the export downturn because of huge over-capacity and horrible corporate balance sheets after the financial crises. For what it’s worth, conditions in East Asia today are rather different than in 2001. The US downturn is not high tech led and corporate conditions are better. So one might expect the elasticity of East Asian growth to US growth to be rather less than in 2001 – but not as low as in 1991. But reality will no doubt turn out much quirkier and more interesting than anyone expects. Then there’s the wisdom that East Asian exports to China won’t help in a US recession because those exports get largely repackaged into China’s own exports to the US. Sure, we ourselves laid out this argument at painful length long ago in the November 2006 East Asia Update. But what’re more interesting are recent anomalies that seem to run against the grain of this wisdom. China’s export growth was easing in the second half of 2007 but - instead of falling in line with exports, as the wisdom would suggest – China’s import growth was accelerating, responding more to strong domestic demand than to exports. China’s imports from the rest of East Asia were also accelerating in the latter half of 2007. It’s probably much too early to draw firm conclusions, but we should stay open to the possibility that China’s trade linkages with East Asia will continue to undergo rapid structural change. A recent paper by Cui and Syed from the IMF estimates that the link between China’s imports and its exports fell sharply in both size and statistical significance between 1994-99 and 2000-05, while the link between imports and domestic demand increased just as dramatically.* As we argued in the November 2007 EAP Update, “the new challenge for the rest of East Asia will be in successfully making the transition from supplying inputs for China’s exports - a process that was helped along by the international supply chains of multinational companies that have a foot in both China and the rest of East Asia – to also directly supplying the Chinese domestic market, something that might require significantly different research, production, branding and marketing skills and channels.” It remains to be seen how far along East Asia has gone in this transition. But there are some interesting – no doubt hopelessly superficial - correlations. China’s imports from East Asia were tightly correlated with its exports to the world in 2001-02. But the correlation seems to have become looser in more recent years. Perhaps we should all be much, much less marvelously confident about what is and is not going to happen to East Asia and the world economy? Maybe the true (and really boring) word of wisdom is just … wait and see! * Li Cui and Murtaza Syed: “The Shifting Structure of China’s Trade and Production.” IMF Working Paper WP/07/214. September 2007.

In response to the comments above I would like to reiterate a couple of points. In recent years the direct contribution of net exports to growth in China has been relatively modest – 2 to 3 percentage points of growth out of 10-11 percent growth rate. Already in the fourth quarter of 2007 this direct contribution had declined to close to zero, yet the overall growth rate remained above 11 percent. So, most of the growth is coming from domestic demand. However, this should not lead us to be sanguine, because a lot of that domestic absorption is investment. To the extent that investment is driven by export growth, then a slowdown in the US and global market could easily have large indirect effects. I agree with Milan that no one can predict these effects with much confidence. But the reason I remain cautiously optimistic is that China has tremendous fiscal strength. It had a small fiscal surplus last year and government debt to GDP is very low. So, if the effects of the global slowdown on China turn out to be larger than we expect, China could easily put together a stimulus package of tax cuts and expenditure increases that would keep the macro economy growing well. Of course the global cycle has some effect on China. But its trend growth rate is not related to US or other major economies. So the effect of the US slowdown should be modest.

I can't resist joining this interesting discussion and giving the perspective of South Asian countries. As pointed out in my blog http://endpovertyinsouthasia.worldbank.org/sub-prime-crisis-and-ending-poverty-south-asia , the impact of the subprime crisis and a U.S. recession is likely to be even less in South Asia (mainly India) than East Asia for three reasons. The U.S. is no longer India's largest trading partner; there is a fair amount of liquidity in the Indian domestic economy; and the current problem facing policymakers in India is managing the surge in capital inflows. Of course, if there is a massive recession in the U.S. (negative five percentage points of GDP, say), South Asia will be affected, but so will the rest of the world. Finally, the bigger problem facing South Asia is the rise in oil and food prices, which have led to an accumulated terms of trade loss of 8 percent of 2003 GDP since 2003. Managing this shock, rather than the fallout of the subprime crisis and a U.S. recession is the major challenge in the subcontinent.

Submitted by Rob Vos on
As the UN’s view was referred to in the original contribution to this discussion, let me weigh in as responsible for the World Economic Situation and Prospects (http://www.un.org/esa/policy/wess/wesp2008files/wesp2008.pdf), in which already in the 2006 and 2007 reports (released each year in January) we warned for the global repercussions of the emerging problems in the US housing and sub-prime mortgage markets. We also argued that despite the remarkably (by historical standards) broad-based and robust growth in the developing world over the past five years, the call for a decoupling of the rest of the world from US business cycles is too early. No doubt China’s high growth performance will not vanish over night because of a US recession, because of domestic growth factors. Yet, observers would be ill advised to ignore some of the more fundamental aspects of today’s woes, which will affect East Asia and with it the rest of the developing world directly or indirectly. Perhaps the discussion thus far ahs put insufficient emphasis on the problem of the global imbalances which are part and parcel of the global pattern of growth. A disorderly adjustment, including a hard landing of the dollar, would leave no one insulated. Strong developing country performance has in no small part been based on strong consumer demand in the United States. The US has been able to run increasing external deficits against rising trade surpluses in other parts of the world, especially in East Asia and the oil exporters. China’s overall trade surplus is in the order of $ 100 billion and its trade surplus with the US is even more than that. Nearly all of China’s exports today are manufactures, of which about 50% is characterized as “processed trade” (i.e. strongly dependent on intermediate imports from elsewhere, especially from the rest of Asia and raw materials from other developing countries). While the US market accounts for just about 20 to 25% of Chinese exports, more than half of Chinese exports go to industrialized countries. So here are the twists. According to our projections in an each day more likely outcome, the US would enter into a recession in 2008 and the growth for the year would be -0.1%. European economies and Japan would slow (without compensatory stimulatory action) to 1.0 and 0.7% respectively. The first implication of this finding is that no other major industrialized economy appears to stand ready to replace the US economy as the engine of global growth. As the industrialized countries still dominate world trade, growth of world trade would be halved from about 8 to 4% in 2008. In fact, this has already been felt in 2007 as growth of import demand in the industrialized countries slowed to 4.7 per cent in 2007, down from 7.8 per cent in 2006. This has caused a notable deceleration in growth of the volume of manufacturing exports from the developing world, particularly China, other parts of East Asia and Latin America. As said, the Chinese economy not likely will collapse under the circumstances, but its rate of growth will be affected. Slower growth in emerging manufacturing exporters will, in turn, cool demand in primary commodity and energy markets, with weaker prices affecting growth prospects, particularly those of poorer commodity-exporting countries. But perhaps the greater risks are in the financial markets even if East Asia is not directly involved in the sub-prime market debacle in the US. Ever increasing reserve holdings have been a counterpart to Asia’s continuous trade surpluses and to increasing US liabilities. The persistent US current-account deficit, which still amounted to $2 billion a day in the last quarter of 2007, has contributed to the prolonged, and recently accelerating, trend of dollar depreciation against other major currencies. Foreign holders of US assets, the Chinese not in the least, have seen the value of their wealth decline. The stock of assets invested by foreigners in the US had increased from $9 trillion in early 2002 to more than $15 trillion at present, but the dollar depreciation implies that, when measured in their respective currencies, foreign investors have on average taken a $2.8 trillion loss. The Fed has aggressively cut interest rates in over the past weeks in order to ease credit conditions. Yet, it does not look like the measure is taking effect and even more so interest rate cuts will create additional downward pressure on the dollar, thus adding to foreign investors’ concerns about continuing financial losses on their dollar-denominated assets. A change in investors’ sentiment towards the dollar (including the Chinese central bank) could precipitate a much sharper and faster drop in the value of the dollar with devastating consequences for the world economy. Clearly, the credit mechanism (supported by asset price rises in stock and real estate markets) that enabled the US economy to become the driver of global growth is now in jeopardy. No matter its size and internal strength, China and the rest of Asia unlikely can insulate themselves from the consequences in terms of much more severe global financial turbulence and a hard landing of the dollar. This scenario is not a reality as yet and I hope the optimists are right and things will not play out as badly. One would have to be hard headed though to believe that the risks for a worse case scenario are not clear and present.

I do not agree with your over-optimistis view on sustainable Asian countries high growth. Based on my 30 years global macroeconomic GDP, inflation, financial , currency, oil, commodities, housing, equities assets prices bubble burst financial crisis simulation indicating that high GDP, Capital Markets and Housing, oil, commodities Markets Growth, free float/peg currency are not, should and can not be sustainable and it is inflationary, will repeating eventual financial crisis, assets bubbles burst with or without central bank macro-economical control, even inflation stay below 3 % as happened in Japan 1990. Only these integrated proactive structural economic systems achieve GDP, capital markets growth, currency, price stability I accurately warned US housing price slump continuinto summer 2008 drag economics into recession,despite rate cuts , drive oil over 100, US, global stocks give up all their gain since 2006 despite rate cuts on Wall Street Journal Market beat Blog Sept. 19, 2007 Based on my 30 years research on proactive, structural simulation of global monetary , fiscal policy impact on economic, asset prices bubble burst, recession, financial market prices indicated Bernanke research has been limited to macro-financial credit flow. The missing link in industrial sectors asset bubbles, which are the primary reason for all the credit crisis , from IT asset to current housing asset and energy asset price bubble. Benanke and Greenspan choose to ignore asset price bubble in monetary policy resulted the burst of unprecedented housing price bubble burst resulted credit crisis and economic, recession. There is no way any rate cuts , stimulus can stop current housing price slump.ar until that slump is over, rate cuts, credit flow become effective .details can be found on www.osawh.com/centmaf.htm and www.osawh.com/riskm.html and www.osawh.com/Fedcrisab.htm Comment by Warren Huang - Wall Street Journal Real Time Economic,Market Beat Blog January 23, 2008 at 12:46 pm US housing price slump , credit crisis, recession stock market bear market correction will spreading into Asian stock market bear market correction, as most Asian stock indices already plunged 30 %, with housing, banking shares down 50 %. Most Asian countires already facing overheated housing bubble, (from China, Hong Kong, Taiwan to India, Singapore, Korea)will facing deflation/burst draged by falling equities prices,with shrinking wealth gain will cutting into consumer, business gain this year. details can be found www.osawh.com/mortdefa.htm and www.osawh.com/macro.html and www.osawh.com/shsz.htm and www.osawh.com/fund2008.htm

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