It seems that Asia's policymakers just cannot get it right. In their efforts to avoid a repeat of the 1997 financial meltdown, they have inadvertently created the conditions for a second and equally damaging regional crisis. Superficially Asia's economies appear in much better shape today than they did 10 years ago on the eve of the Thai devaluation. But according to noted US economist Nouriel Roubini, 'below the surface trouble is brewing and significant financial imbalances are building up'. Dr Roubini, a former adviser to both the US Treasury and the White House, warns in the first draft of a new paper dated this month that 'the currency and financial policies in Asia today risk planting the seeds of a new and different financial crisis in the region'. At first glance Asian governments appear to have successfully corrected the economic weaknesses that led to the 1997 crisis. They no longer peg their currencies at unrealistically high exchange rates against the US dollar. They no longer run large current account deficits which leave their domestic economies dependent on volatile short-term flows of foreign capital. And above all, their coffers of foreign exchange reserves are no longer dangerously depleted. On the contrary, most East Asian countries now have nominally floating, if undervalued, currencies. They operate sizable current account surpluses and have negligible foreign debt. And their central banks are stuffed to bursting with trillions of US dollars in foreign reserves. According to Dr Roubini, that is the problem. He argues that to ensure such a crisis never recurs, Asian countries changed their growth model after 1997. From a capital importing, domestic demand-led strategy, they took advantage of the competitiveness gained through devaluation and switched to an export-led, mercantilist model. That was fine for a while. Undervalued currencies, weak domestic demand and surging trade surpluses allowed them to rebuild their foreign exchange reserves in record time. But somewhere along the way, Asian governments forgot the most important lesson of the crisis: the need for floating currencies. Instead of allowing market forces to dictate the value of their currencies, Asian policymakers decided to pursue deliberate under-valuation. It seems they decided that since trade surpluses and foreign reserves were a good thing, then even bigger surpluses and more plentiful reserves must be better. As a result they ordered their central banks to intervene in the foreign exchange markets to hold down the value of their currencies, enhancing export competitiveness and accumulating foreign reserves in the process. Today, the costs of their policy are becoming increasingly apparent. With relatively under-developed financial systems, Asian economies are ill-equipped to cope with the domestic liquidity created by maintaining under-valued currencies and big trade surpluses. The region's central banks are issuing vast quantities of bonds in an attempt to mop up the domestic currency sold when they intervene in the foreign exchange market, but with limited success. The People's Bank of China, for example, is able to soak up only about 70 per cent of the yuan it sells. Even that causes problems. To soak up the money, the authorities borrow it back from the commercial banks at cut-rate interest rates, which eats into bank margins and weakens the financial system. Meanwhile, the other 30 per cent of the cash - somewhere between US$6 billion and US$12 billion a month - escapes into the financial system where it fuels massive money and lending growth. In China, the result has been a boom in investment which has risen to an unsustainable 50 per cent of gross domestic product and successive asset price bubbles, first in the Shanghai and Beijing real estate markets and now in the domestic A-share stock market. So far, an abundance of cheap labour, bumper crops and price controls on energy have helped keep the lid on consumer prices in China but other countries in the region have not been so lucky. Elsewhere, excess liquidity is pumping up inflationary pressure. The other side of the coin is that by suppressing domestic consumption and pursuing export-led growth, Asian governments have left their economies excessively reliant on external demand, especially from the US. That means any slowdown in the US could have a devastating effect in Asia. Dr Roubini estimates that a hard landing leading to recession in the US would reduce China's annual growth rate from 11 per cent currently to just 5 per cent. In turn that would reduce China's demand for imports, hammering producers of intermediate goods in North Asia and commodity exporters around the world. The resulting slowdown could prompt a return of protectionism, destabilising the currency markets. It would certainly cause a sharp rise in risk aversion, sending asset markets into meltdown. In short, Asia would be in crisis all over again.
