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Bracing For A Downturn

Even before the horrific events of September 11, Asia was preparing for a global economic slowdown. But now, the region's economies will have to navigate a longer and more painful path to recovery

By Tom Holland/HONG KONG

Issue cover-dated October 11, 2001

IF ANYONE IN ASIA thought the atrocities of September 11 were distant events--tragic but far-removed, with no real impact on their daily lives--they have surely changed their minds by now.

Already the economic downdraft from the United States tragedies is fanning a chill wind across the Asia-Pacific region. As trade evaporates and investment flows dry up, Asia is beginning to experience the flip side of globalization. Now, through no fault of their own, Asian countries are facing a slump likely to last six months longer, and with a trough far deeper, than anyone had expected.

Worst of all, there's very little Asia can do about it. The region's central banks can cut interest rates in response to cuts in the U.S., governments sitting on spare cash can raise public spending and countries with floating exchange rates can try to massage their currencies lower. But with confidence inside the U.S., the world's biggest economy and long the engine of global growth, hammered hard by the attacks on New York and Washington, such measures can only cushion the blow, not deflect it.

"Asia is very exposed to the U.S. If there's slower growth in the U.S. it will impact on Asia directly," explains David Robinson, senior adviser to the International Monetary Fund's research department. Slower growth in the U.S. would be bad enough, but many economists believe September's assaults have tipped the American economy into outright recession. Certainly the U.S. Federal Reserve isn't taking any chances. On October 2 the Fed made its second 0.5% interest rate cut since September 11, taking its benchmark federal funds target rate to 2.5%, the lowest level in nearly 40 years.

In the short term the Fed's rate cuts will have little impact on the real economy either in the U.S. or in Asia. But in the longer run, monetary easing in the U.S., together with President George W. Bush's fiscal largesse and measures to boost liquidity in the world's other major industrial economies, offer Asia its best chance of recovery. With domestic demand within the region too weak for it to haul itself out of the downturn, Asia needs a revival in external demand to generate robust growth. The good news is that with the massive amounts of liquidity injected into world markets since September 11, that pick-up is only a matter of time.

But the next six months will be tough. Solid data are hard to come by so soon after the tragedy, but analysts agree the attacks have shattered consumer confidence in the U.S. Wall Street investment bank Goldman Sachs, for example, now expects private consumption to drop by 3.5% in the fourth quarter of the year. Before the attacks, it was projecting growth of 4%.

With spending by businesses already down sharply after the bursting of the U.S. technology bubble last year, consumers' cash was the only thing keeping the U.S. economy afloat. Today, with confidence crushed, economists are falling over themselves to slash their GDP forecasts. Goldman's analysts are now predicting the U.S. economy will shrink an annualized 2.5% in the last quarter of 2001, in sharp contrast to the 2.5% growth they were forecasting before September 11.

The impact of U.S. recession will be felt keenly by Asia's export-led economies. The region's smaller, more open countries had already suffered bitterly from the slowdown in external demand caused by the global technology slump. After seeing record double-digit declines in electronics exports during the first half of the year, Singapore and Taiwan have already been pushed into recession.

Those downturns are now going to get even deeper. And Malaysia and Hong Kong look set to follow into recession, as sinking consumer confidence in the U.S. suppresses demand for Asian exports across a whole range of market sectors, not just in electronics. First to fall will be Malaysia, one of the most trade-dependent economies in the region, where exports are worth more than 100% of GDP.

The government in Kuala Lumpur has acknowledged the threat, with Prime Minister Mahathir Mohamad downgrading the official GDP growth target for the year to between 1% and 2%, from an earlier 2%-3%. Some private-sector economists, however, believe that even this bleak outlook is too optimistic. They forecast a slump into recession in the final two quarters of the year, with an economic contraction of around 0.5% for 2001 as a whole.

Even China's exporters, long shielded by deep cost advantages and low exposure to the technology cycle, will feel the chill. "If the attacks have a negative impact on consumer confidence and spending in the U.S., that means less demand for consumer goods. China exports a lot of consumer goods to the U.S., so I expect difficulties in the export sector over the coming months," says Yiping Huang, China economist at Salomon Smith Barney in Hong Kong. Without the pull of U.S. demand, Salomon expects China's export growth to slump to just 5.5% this year, down from a massive 28% in 2000.

PAINKILLERS MUCH IN NEED

It's not only exports that will be affected by the September 11 attacks, investment is also at risk. The sharp sell-off in global stockmarkets over the second half of September emphasizes the heightened sense of risk aversion among portfolio investors. The contagion has been particularly brutal across much of Asia. Whereas the benchmark Dow Jones Industrial Average dropped by 8% over the three weeks following the attack, Singapore's Straits Times index lost a whopping 15%.

And it's not only portfolio flows into the region that are likely to be affected. Direct investment is also expected to suffer as company earnings fall, stock prices slide and risk rises. Following the attacks, the Institute of International Finance, a Washington-based trade association comprising the world's largest banks, scaled back its forecasts for capital flows to emerging markets. The IIF now expects direct equity investment into Asia next year of $48.7 billion, a steep fall from the $58.5 billion it forecast in May.

In the face of such a stiff headwind, policy responses can do little. "Asia is very trade dependent, so if exports plunge, it is difficult for governments to make up the difference through policy measures," says Eddie Wong, chief economist for Asia at ABN Amro Bank in Hong Kong. "The most they can do is to try and ease the pain a little."

Some have been quicker than others to administer painkillers. Korea and Taiwan and the Philippines all get high marks from economists for cutting interest rates and allowing their currencies to depreciate, easing monetary conditions early on in the downturn. Despite limited budgetary resources, all three countries also raised public spending ahead of the attacks.

Other countries were slower off the blocks. In recent weeks both Thailand and Malaysia have announced emergency public spending packages worth over $1 billion. Economists remain sceptical, however, saying that monetary conditions in both countries remain too tight, despite a 0.5% interest rate cut from the Malaysian central bank on September 20. Singapore, meanwhile, is set to announce a fresh batch of stimulus measures in early October, to follow July's modest $1.2 billion package.

China is also expected to raise public spending, to counter the slide in export growth. But while government-directed spending will almost certainly succeed in supporting China's headline economic growth rate at above 7% next year, Beijing will pay a heavy price.

Economists warn that past state spending splurges have actually reduced the economy's efficiency as public funds are frittered away on unproductive projects. Official growth rates may be maintained, but the government cannot match the private sector in generating high-quality economic growth. And pumping money into the economy via the state banks will only increase their non-performing loan ratios, storing up yet more problems for the future.

In all, Asia's best hopes for recovery lie outside the region. Since the attacks on New York and Washington, the U.S. Federal Reserve has pumped tens of billions of dollars into U.S. financial markets in the biggest and fastest liquidity injection ever, far outstripping the measures taken in response to the collapse of hedge-fund Long-Term Capital Management in 1998 or the Y2K precautions.

USE ALL AVAILABLE MEASURES

Nor is the U.S. alone. The European Central Bank has embarked on its own, albeit more modest, liquidity injections, leading some economists to suspect a coordinated attempt to reflate the global economy. Japan, too, is taking tentative steps towards reflation.

"Some mild inflation would do the job," says Koichi Hamada, president of the Economic and Social Research Institute, a cabinet-office think-tank. Hamada argues the Bank of Japan should start printing money in an attempt to reflate the Japanese economy, itself suffering recession and deflation. "This is a semi-emergency," he says. "We should use all measures."

Coordinated reflation by the industrialized economies would allow Asia's economic policymakers to cut their own interest rates further while depreciating their currencies to ease monetary conditions. And sooner or later the excess liquidity sloshing around in the world's major economies will begin to fuel fresh demand for Asian exports. Even so, no significant recovery is likely to emerge before the second or third quarter of next year, and when it does, it will look anaemic compared with the vigourous rebound of 1999.

"We think the current economic slowdown in East Asia will be prolonged by one or two quarters more than it would have been" without the attacks on the U.S., says Pradumna Rana, head of the regional economic-monitoring unit of the Asian Development Bank in Manila. "And when growth does pick up in the second half of 2002, the recovery will be weaker."