Business

Monday December 8, 2008

Can Asia spend its way out of the crisis?

IN PERSPECTIVE WITH BALJEET GREWAL


POLICYMAKERS very often confuse disenchantment with truth. The inconvenient truth in financial markets today is that government spending is crucial to jumpstart a beleaguered global economy.

The “invisible hand” of Adam Smith is more and more being replaced by perceptible government intervention as the tangled knot of economic problems becomes difficult to unravel.

Standard economic prescriptions call for raising interest rates when confronted with inflation, just as standard prescription calls for lowering interest rates when confronted with an economic downturn. But how do you do both at the same time, especially when confronted with the bleak prospects of depressed, deflationary growth? You spend your way out of a crisis.

Faced by the fallout of a global crisis, Asian governments are resorting to counter-cyclical measures in the hope that it will resuscitate domestic demand, i.e. boost domestic spending to replace declining external demand from the United States. The problem with this prescription, however, can be pinned down to a basic observation made by John Maynard Keynes (the founder of modern theoretical economics) in his Paradox of Thrift: everyone tightens his belt in a crisis, even though he knows that collectively this leads to economic disaster – therefore, government spending will have to be very big to make a difference.

Already, consumer consumption has slumped in Singapore and Japan, and China’s Purchasing Manager’s Index (a leading indicator of manufacturing) has turned sharply negative with inventory piling up and a wave of factory closures.

Real estate prices in Hong Kong have corrected and tight credit in Indonesia and the region sees halting economic growth. The East Asian development model – characterised by export orientation, especially to the United States, which supplied products and then sent back the proceeds of these sales in the form of investment fuelling Asia’s credit expansion – is faltering.

When the subprime crisis first broke, conventional wisdom had it that Asian economies were in much better shape to weather the risks – banks’ exposure to subprime assets was minimal, economies were flushed with liquidity and consumer spending sound. However, it has become clear that the United States is in a “systemic” financial crisis with credit markets effectively contracting. Still to come in the first quarter of next year is perhaps the biggest blow of all – rising unemployment, a contraction in fixed capital formation (read foreign direct investment) and asset price deflation.

The real problem for Asia is that this external shock coincides with the shrinking in domestic consumption, which had started to take a breather after a decade of growth and after helping to pull the region out of the 1997 crisis.

The danger now is that with the combination of external shocks, a fall in asset and commodity prices and demand shrinking, the Asian consumer is not able on his own to spend his way out of the crisis.

Interest rate cuts are far less productive in forestalling economic slowdown this time round due to: 1) rising uncertainty and counterparty risk; 2) uncertainty over accuracy of asset prices and financial institutions’ own exposure and liabilities – perpetuating a credit crunch; and 3) household wealth elasticity of spending overwhelms interest elasticity of demand.

No amount of rate cuts is going to stimulate the kind of spending required to revive growth. That comes from a massive stimulus package.

Governments need to get fiscal, and collectively. Policy measures have thus far been domestically driven and reactionary. A more concerted effort within the region in disseminating fiscal spending, its target sectors, and timelines will serve to boost confidence especially through fiscal measures that offer the prospect of boosting growth and disposable incomes.

Today’s credit crisis is far more than a symptom of a defective US financial system. It is a symptom of an unbalanced global economy. And so, Asia’s future must come from Asia first. If the Asian crisis taught us anything, it is that quick, decisive action is needed to prevent deflation from taking hold.

  • The writer is the managing director and vice-chairman of Kuwait Finance House. KFH, based in Kuwait, is one of the largest Islamic banks in the world

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