Just a matter of time

Twenty years after the Asian financial crisis, the region’s economies are stronger and its finances more secure. While lessons have been learned, however, some flaws remain unresolved, and China’s dominance has brought with it new risks.

It was Georges Clemenceau, a French statesman and one of the architects of the Treaty of Versailles, who observed that the minds of military generals were constantly locked into the past, striving to win the last war they fought.

The same is often true with regulators responsible for mopping up after a messy financial crisis. Legislators in the US and Europe, fixated on preventing a repeat of the tumultuous events of 2008, continue to weigh down their once-errant banks with burdensome regulation, despite charges of overkill.

Asia’s politicians and regulators learned a different set of lessons from the bitter events of 1997. When Thailand devalued the baht on July 2 of that year it set in motion a barrelling series of events that no one expected. Across the region, currencies and growth rates slumped, governments fell, and stock prices tumbled, with the greatest shocks felt in Thailand, Indonesia and South Korea. Defaulted debt soared, especially as a result of the spike in foreign-currency debt that precipitated Bangkok’s fateful decision. The Asian financial crisis finally petered out two years later, but not before contaminating economies as far away as Russia and Argentina.

Across the region, governments studied their mistakes, diagnosed solutions and remedies, and implemented them, often ruthlessly well. In 1996, Asia’s foreign reserves were under US$1trn, leaving nation states vulnerable to currency speculators. By the end of 2016, the region’s cumulative reserves were well over US$6trn, a quadrupling in inflation-adjusted terms, accounting for more than half the world’s holdings. South Korea’s reserves alone have grown ten-fold, to US$378.5bn at the end of May 2017. Before the Asian financial crisis, many currencies were pegged to the US dollar, a situation that typically forced central banks to defend their currency at a given rate. Now, most countries have sturdier, floating exchange-rate systems.

SALUTORY EFFECT

“The countries at the centre of the Asian crisis are generally in much better shape than they were 20 years ago,” says Paul Sheard, global chief economist at ratings agency Standard & Poor’s. “Policy frameworks are more robust, banking systems better capitalised and regulated, and structural policies much sounder. And private sector players have learned to manage risk and maturity mismatches much better.”

For all the pain it caused, not least in terms of the sharp in immediate loss of income and jobs, the Asian financial crisis had “a lasting and salutory effect on the mindset and behaviour of policymakers and market participants”, adds Sheard.

Yet it is worth at this point remembering Clemenceau’s aphorism, if only for the point that he neglects to make. Namely: that while generals (and politicians and regulators) often go out of their way to learn from past mistakes, rarely do they ponder how future crises may stem from current actions.

Anniversaries matter, so it is worth asking whether Asia could suffer another calumny as damaging as the one that roiled the region 20 years ago. What has Asia learned? Has it come far enough? And has one set of stress factors simply been replaced with another, just as superficially benign, yet perfectly capable of bringing the region to a juddering halt?

First things first: a financial crisis (or at the very least, an economic emergency that mutates into one) is all but inevitable. As Jonathan Slone, chairman and chief executive officer of Hong Kong-based brokerage CLSA, notes: “Compared to 1997, we are obviously a different place. Governments have learned lessons and government debt levels are low. But we will have another down-cycle and we will have another crisis. It’s just that it will emerge in a place we don’t expect.”

The issue, then, is not whether Asia will suffer another financial crisis, but where, when and how it will happen. Such factors are impossible to predict, but the region remains worryingly fragile in a host of areas. Some of its flaws are long-standing and systemic; others are new arrivals, and can be viewed as both strengths and weaknesses. Any one could contain the seed of a future crisis.

MIDDLE-INCOME TRAP

So let’s take a look at them one by one. First up is the inability to translate buoyant economies into rising national incomes. After the events of 1997, Asian governments became obsessed with GDP. If growth rates expanded by, say, 5% or more a year, politicians reasoned that they were doing fine. If rates bumped along in the low single digits, they fretted.

In that context, the last 20 years have been good to the region. Over that period, Asian economies have by and large grown faster than their developed-world peers in Europe and North America. Africa and Latin America have been left for dead by a region that has never been more industrially, commercially and financially interconnected.

Yet in too many cases, rising overall wealth has refused to trickle down to the middle classes. In pure income terms, only South Korea has really managed to kick on since 1997. No other nation has managed to escape the so-called middle-income trap, where per-capita income stalls at or below the US$10,000 mark. Nominal per-capital income stood at the end of 2016 at US$9,360 in Malaysia, US$5,900 in Thailand, US$3,600 in Indonesia, and US$2,900 in the Philippines, according to data from the International Monetary Fund.

“We will have another down-cycle and we will have another crisis. It’s just that it will emerge in a place we don’t expect.”

Does this matter? Not if your focus as a developing market is solely on building an export-driven economy. Then, competitively low wages and a high rate of job creation go hand in hand. But too many governments, particularly in South-East Asia, seem not to have thought much about the future.

Innovation and productivity rates remain worryingly low. Few countries have many genuinely credible institutions. Corruption levels have, if anything, worsened. Thailand placed 104th in Transparency International’s 2016 Corruption Perceptions Index, down from 80th five years earlier. China’s ranking has fallen over that period, as has South Korea’s, a now-rich economy widely perceived as hostage to a handful of super-powerful, family-run conglomerates.

This relative lack of income growth has two knock-on effects. First, it leads to elevated income inequality – 14 of Asia’s 37 economies had a Gini coefficient of 0.4 or greater in 2016, considered the threshold for ‘high inequality’ – and low consumption rates, a longstanding weakness.

“Income equality is the biggest long-term obstacle in the way of regional growth,” says Michael Pettis, professor of finance at Guanghua School of Management at Peking University in Beijing. “I see too much saving and too little spending, and I can’t see that changing.”

Second, if people can’t envisage a better life for themselves, it can lead to unrest, followed by unpredictable outcomes. In Thailand, a lack of economic and financial inclusion has led to two army coups since the 1997 crisis and the installation of a military junta. Malaysia’s scandal-plagued premier has become a drag on investment. The Philippines is ruled by a colourful populist more intent on ridding the country of drug lords than on boosting incomes. Two of South Korea’s last four presidents have been tried for impeachment, one successfully.

Then there’s the issue of Asia’s shifting identity. Scroll back 20 years and you find a region with one big economic beast, in the shape of Japan, as well as a host of smaller, ‘tiger’ nations, some a little more developed (Taiwan, South Korea), and some a little less (Malaysia, Indonesia, Thailand). All of these smaller nations shared one particular attribute, aside from their rapid pace of growth: they were all highly dependent on Japanese cash.

Between 1985 and 1997, according to IMF data, Japanese banks accounted for more than 40% of all lending to Asian corporates, lenders and governments. Tokyo was also the single largest source of foreign direct investment for these tiger economies. So when the Asian financial crisis hit, regional governments and corporates were left with a Japan-shaped hole in their funding plans.

DIFFERENT BEHEMOTH

What a difference 20 years makes to the financial, economic and geopolitical landscape. Japan has, notes S&P’s Sheard, “ceded its position of economic dominance in Asia to China, a trend that does not seem likely to be reversed”. Beijing’s development banks and commercial lenders bestride the region. As the US pulls back from world affairs under President Trump, China is reimagining the very concept of globalisation, through its Belt and Road initiative.

This creates a new set of challenges. To some, Asia has simply replaced one wealthy sovereign creditor and benefactor with another. It is hard to overstate the influence Beijing now wields in the region. Fraser Howie, co-author of Privatizing China, points to the speed with which the influence of mid-sized regional economies has waned.

“For the region, China now represents the epicentre of potential economic and financial risk.”

“Twenty years ago, the likes of Malaysia, Thailand and the Philippines all held tremendous promise,” he says. “Since then their relative significance has collapsed. Thailand frankly doesn’t matter anymore – certainly it’s inconceivable that it could ever again have the kind of impact on global events that it did in July 1997. The Asia story is ‘China-China-China’.”

This lopsided relationship yields its own splintered benefits. For economies like Vietnam and Malaysia, now tightly woven into mainland supply chains, China’s rise is in many ways a godsend. Its lenders and corporates are pushing into the region, putting cash to work wherever they go. Adventurous and wealthy mainlanders offer succour to hoteliers and tour operators.

But will it last? China’s economy has its own frailties, from capital flight and flat living standards, to an overleveraged banking system and chronic pollution. The Institute of International Finance said China’s ratio of total debt to GDP nudged past the 300% mark for the first time in May 2017, up from 260% at the start of the year, and 160% in 2008. It’s one of the reasons why Moody’s recently decided to downgrade China’s sovereign credit rating, warning that rising debt would “erode” its financial strength. “China’s problem isn’t external debt; it’s debt,” notes Peking University’s Pettis.

ONE-HORSE RACE

And while there is no reason to expect China to suffer the kind of systemic crisis that some have been predicting for the better part of two decades, the threat of a ‘hard’ slowdown remains.

“If China goes off the boil, all of Asia will suffer,” notes Howie. “They are so dependent on Chinese largesse. The region is now a one-horse race and that’s not a healthy position for anyone. If your largest trading partner has problems, you will have problems.”

S&P’s Sheard offers a direct then-and-now comparison. In 1997, Japan’s chronic banking crisis “added fuel to the fire of the Asian financial crisis”, he says, adding: “For the region, China now represents the epicentre of potential economic and financial risk.”

So what does the future hold? Some kind of financial or economic crisis? Almost certainly. One that involves China, either directly or very heavily? Again, the odds are high.

Much will depend on how the region reacts to the next crisis, be it a debt disaster or credit crunch. Will nation states respond by shaking up tackling corruption and vested interests, and strengthening domestic institutions? What if the region

suffers a genuine calamity: say, a trade war between the US and China, or a properly nasty surprise, such as a hot war involving North Korea, which disables Seoul and Tokyo, and shuts shipping lanes in the East China Sea?

Alternatively, a new crisis of some persuasion could be just what the doctor ordered. Peking University’s Pettis notes that Japan’s “great tragedy was that it didn’t have the kind of crisis” that would have forced it to deal with rising debts and inflated asset prices. “China may follow the same path, where it doesn’t suffer a debt problem, and doesn’t wind up with the kind of quality growth it needs.”

But despite these challenges and uncertainties, it’s hard to argue against Asia, a region that remains the most likely source of long-term global growth. The region accounts for more than 60% of the world’s population, mostly located in China and a resurgent-and-rising India. The region remains largely politically and economically stable, with big banks and corporates, and a surfeit of global cities, from Singapore and Shanghai to Hong Kong and Mumbai.

Besides, betting against Asia has long been a fool’s errand. Plenty of people saw the writing on the wall 20 years ago, when growth crumbled and trade slowed to a trickle. Investors and lenders pulled back in haste, only to repent at leisure. CLSA chief executive Slone remembers receiving a call from a good friend at the height of the Asian financial crisis, warning him not to lose faith in Asia as a whole, and Hong Kong in particular.

“He told me never to bet against Hong Kong,” Slone remembers. “It’s my most jarring memory of that time. I could have bought apartments in Hong Kong for less than HK$20,000 (US$2,560) apiece. If I’d done that, I’d be driving around in a fleet of Rolls-Royces right now.”