As the world looks to full stabilisation and a rebound from the crisis due to the efforts of governments, clearly, it is finance rather than the real economy that has benefited more from those initiatives. In fact, the turnaround in the financial sector, which was responsible for the crisis in the first instance, has been faster and more noticeable than in the real economy. What is more, as the popular concern about swelling bonuses for financial managers illustrates, the recovery of finance is seeing a return to practices that generated the imbalances that underlay the crisis.
This is not true just at the level of individual institutions or countries, but globally as well. Thus, the financial recovery has resulted in a revival of capital flows to emerging markets since March 2009 (Chart 1), even while the flow of credit to the real sector in the developed countries is still limited.
Much of these flows are concentrated in Asian emerging markets that have been less adversely affected by the crisis than other countries, and therefore promise quick returns to a financial sector that is yet to write off a large volume of bad assets. The surge is clearly feeding on itself inasmuch as it has generated an asset price boom in recipient countries, encouraging further speculative flows. As the International Monetary Fund’s Regional Economic Outlook released in October reports, “emerging Asia . . . has especially benefited from equity market inflows, which have not only exceeded those to other regions, but have also returned to levels prevailing before the crisis. External equity and bond issues by emerging Asian economies have also returned to pre-crisis levels, a much stronger rebound than in other regions. Even inflows of syndicated loans have resumed to emerging Asia — unlike elsewhere, primarily reflecting the healthier state of banks in the region.”
This turnaround is worsening an imbalance that was seen as being a medium-term influence that triggered the crisis of 2008: the imbalance in the distribution of global reserves. The surge in capital inflows to Asian emerging markets puts upward pressure on the currencies of these countries, which can ill-afford currency appreciation at a time when they are just recovering from the decline in exports that the recession generated. Such appreciation makes their exports more expensive in foreign currency terms and erodes export competitiveness.
Not surprisingly, central bankers have stepped in to manage exchange rates and stall or dampen appreciation by buying up dollars and adding it to their reserves. According to the IMF, from March through September 2009, emerging Asian countries accumulated US$510 billion in reserves, compared with US$69 billion in emerging Europe and US$17 billion in Latin America. Cumulatively, emerging Asia’s stock of reserves has risen from about US$3.4 trillion at end-August 2008 to about US$3.9 trillion at end-September. This makes the stock of reserves in Asia much higher than in other emerging markets in absolute dollar values and as a share of GDP (Chart 2).
When reserves accumulate rapidly, central banks look for liquid and safe assets. And since the dollar remains the world’s reserve currency and the US the world’s leading political and military power, the flight to safety is biased in favour of dollar-denominated assets. In the case of Asia this seems to be true even when the dollar is weak and depreciates. Data from the US Federal Reserve relating to US Government agency bonds held by foreign official institutions shows that while they increased by $119 billion in 2007, in the wake of the crisis they fell by $31 billion in 2008 and by another $31 billion in the first seven months of 2009. However, not only was the contribution of non-oil exporting Asian countries even more significant, it actually continued to be positive even in 2008. Asian holdings of US public bonds increased by $131.6 billion in 2007 and by $32.4 billion in 2008. Even in the first seven months of 2009, total Asian holding of US government bonds remained largely stable, with a small increase of $2.3 billion for Middle Eastern oil exporters and a small decline of $2.5 billion for all other Asian countries.
This reverse flow of capital from developing to developed countries had in the past been held responsible for the excess liquidity, credit and consumption in the US, which was seen as absorbing the excess savings from Asia. Thus a significant part of the blame for the debt-financed consumption that led to the crisis of 2008 was placed at Asia’s door. In particular, it was argued that some Asian countries were using undervalued exchanged rates to generate the trade and current account surpluses that accumulate as reserves and then flow to US.
What the recent Asian experience illustrates is that financial rather trade flows often generate the imbalances reflected in the uneven distribution of global balance of payments surpluses and foreign exchange reserves. If those reserves are seen as contributing to a process that leads to a financial and economic crisis, then the fault possibly lies in the structures created by the financial policies of the developed countries rather than in the exchange rate policies of the developing countries.
What is more the revival of financial flows has been accompanied by tendencies the full import of which has been ignored, in the complacence generated by the recovery in Asia. It is now well accepted that the recovery of the world economy from the worst recession since the Second World War is being led by Asia, which thus far has displayed a V-shaped short-term growth trajectory. The sharp rebound has many causes to it, including the fiscal stimulus in countries like China, which has played a role nationally and regionally. But one that has been important, at least in some countries, is the effort of central banks and governments to reduce interest rates and push credit. Besides opting for a fiscal stimulus to combat the recession that was imported into Asia from the developed industrial countries, policy makers in Asia have persuaded central banks to pump liquidity into the system and stimulate credit offtake by cutting interest rates.
Not surprisingly, the IMF reports that evidence for the year since September 2008 indicates that, unlike the developed countries where bank credit flows froze in the wake of the crisis, bank credit growth in Asia has only slowed and that in some cases such as China it has, in fact, risen sharply (Chart 3).
There are many benign explanations for this, including the strong balance sheets of the banks that have recapitalized themselves since the 1997 crisis and been more cautious in their practices. As the IMF puts it: “Unlike in Europe, Asian banks had little exposure to U.S. toxic assets, and the rise in domestic non-performing loans has been modest, so the damage to their capital positions from the crisis has been relatively small. Moreover, they have been quick to replenish their buffers, raising more than US$106 billion in capital since fall 2008. As a result, the declines in their capital-asset ratios have been negligible; in some countries, capital ratios have even risen compared with pre-crisis levels. So as liquidity conditions improved, Asian banks were in a strong position to resume lending.” To this we must add, the lower leverage in a restructured corporate sector that had burnt its fingers in 1997.
There is, however, some danger. Whenever credit remains high or surges because of easy liquidity, some of it flows into risky assets. This is visible in China, which was not a victim of the 1997 crisis and had not seen restructuring of the kind noted above. The evidence suggests that credit growth in China has accelerated since the beginning of 2009, facilitated by the government’s decision to relax informal quantitative limits on bank credit growth as a response to the growth slowdown resulting from the deceleration in export growth. The resulting credit boom raised the level of net new bank credit by 50 per cent compared with its level of 2008 as a whole.
Such credit has financed a surge in public investment which when mandated by government is not constrained by expectations of market demand and profitability. But it has also hiked private consumption as well as private investment, particularly in real estate. According to estimates, about 40 per cent of the private investment undertaken in the first eight months of 2009 went into real estate. There is reason to believe that this is true in other Asian countries as well, where the liquidity resulting from the return of capital that had initially exited the country has helped sustain a regime of easy liquidity and credit with low interest rates.
Needless to say, a credit surge of this kind encourages speculation, leads to asset price inflation and runs the risk of fuelling a bubble based on loans of poor quality. This not only questions the sustainability of the resulting recovery but makes the growth process partially one that rides on a bubble. As and when governments seek to reduce their fiscal deficits and exit from the fiscal stimulus they chose to provide, this aspect of the growth process could come to dominate. If that happens, Asian growth would increasingly take on characteristics similar to those displayed by the developed industrial countries in the years before the onset of their financial crisis with real economy expansion being driven by debt-financed private (particularly housing) investment and consumption. Such growth is obviously vulnerable, since a credit surge cannot be sustained for long without undermining the confidence of lenders and of those willing to carry risk on their behalf.
C.P. Chandrasekhar is Professor at the Centre for Economic Studies and Planning at Jawaharlal Nehru University. He also sits on the executive committee of International Development Economics Associates. Jayati Ghosh is Professor of Economics at the Centre for Economic Studies and Planning at Jawaharlal Nehru University. Chandrasekhar and Ghosh co-authored Crisis as Conquest: Learning from East Asia. This article was first published by MacroScan on 18 November 2009; it is reproduced here for non-profit educational purposes.