## Mr. Sherwin reviews economic prospects and challenges for Asia and the Pacific
region Address by the Deputy Governor of the Reserve Bank of New Zealand, Mr. Murr Sherwin, to the New Zealand Institute of International Affairs in Wellington on 15/10/98.
I was asked to discuss the economic prospects for Asia and the Pacific. I'm g take a fairly liberal interpretation of the topic. You will not be surprised that my c framed within a high degree of uncertainty about the direction of the global economy. Even past year or more have been dominated by a growing sense of contagion spreading from the Thai problems, and now affecting most parts of the world. Even over the last couple of mo have seen Russia and Latin America faltering, and a substantial re-rating of corpora prospects in the USA and Europe. As we look forward to 1999 and 2000, we can do no better guess at when these downward influences will run their course, and when robust, susta recovery will commence within the Asian region.
However, I will offer a few guesses on Asia's prospects. I will also offe observations on the nature of the adjustments and transitions now being worked through especially within the financial sectors of the affected countries.
## The Asian Growth Story
The Asian growth story, over three decades or more, has been extraordinary, sustained annual expansions of the order of 7 to 10 percent. That is more than just a stati Not only has Asian economic success supported growth in the rest of the world, it has driving force in the most profound process of poverty alleviation in human history. By Wor estimates, where 60 percent of East Asians lived in absolute poverty (i.e. less than US$1 1975, 20 percent were living in absolute poverty in 1995. The numbers living in pover declined, the severity of poverty has declined, life expectancy has climbed, infant mortali literacy indicators have all improved in tandem with economic growth. Growth created jobs poor, and provided opportunities to expand their productivity. The Asian miracle was r tangible.
Of course, Paul Krugman made himself famous, and unpopular in some parts, b arguing that while Asia had generated extraordinary growth over an extended period, there magic formula that the rest of us could borrow in order to imitate that growth performanc Krugman's now-famous line, perspiration, rather than inspiration, was the Asian secret. In well-organised economies, simply adding more inputs will lead to more outputs. Certainly, Asians became wealthier, and were able to enjoy rapidly improving material well-being. Bu was, in Krugman's view, no miracle. There was no productivity steroid.
The last year or so has generally given strength to Krugman's analysis. In cru rather simplistic terms, the Asian formula worked so long as those new inputs were dire areas where the real value added, at the micro level, was sufficient to support real gr macro level. Asia was able to generate high savings rates, and to maintain similarly hig investment. But as investment increased, to 30 or 40 percent of GDP in many cases, the q that investment began to deteriorate. Returns on investment were driven below the cost o The legacy is a huge amount of surplus, and essentially redundant, capital stock.
Inevitably, that surplus capacity has been repriced. The internationally capacity has been repriced by way of local currency depreciations in most cases. As curren output becomes more competitive in foreign currency terms. The non-tradable component, l surplus real estate investment, emerges in the form of sharply reduced asset prices, enormous stock of bad debts.
The Asian crisis has so far appeared largely as a financial crisis, at least i casual observers from abroad. The volatility in financial asset prices - exchange rates, i equity prices - has been spectacular, and it is not surprising that attention has been at direction. Perhaps less visible, and certainly less reported, is the still emerging Industries throughout the region now face declining markets, after years of unrelenting rap As already noted, the surplus capacity in many industries implies that asset values mus Companies will fail, or will if they are allowed to. Unemployment is rising, and will r Poverty levels will rise again, and the welfare of, quite literally, hundreds of millions deteriorate. Many will return to the absolute poverty that, a year ago, was a rapidly fadin
That will not be a permanent deterioration. But the next couple of years promi harsh.
## Prospects
In the longer term, I have no doubt that the region will return to robust almost certainly not as rapid as has been experienced in the past two or three decades, sorts of growth rates that the rest of the world envies. As a guess, and it is no more than suggest a future of something closer to 4 to 6 percent annual growth rather than the 7 to rates of old. Lower debt levels, and closer attention to risk, will likely feature in this Asia, and desirably so.
## What gives me confidence of resumed growth?
Firstly, one of the largest investments, and without doubt the most important, Asia in recent decades has been in human capital. The Asian commitment to education has immense, and the benefits of that will be durable. To put it crudely, the wheels may have the Asian economy for now, but the engine and chassis are still there, willing and abl again. It is the human capital base that will provide the engine for recovery.
Secondly, despite the vast strides made in the past, Asia still has some 'cat do. Average per capita incomes remain well below OECD levels in most of non-Japan Asia, there remains scope for technology transfer into the region. Macro-economic management is to remain sound, and that provides the basis for believing that the process of catch-up can
But the short-term economic prospects are more difficult.
At the Reserve Bank, we do not undertake independent forecasts of the economie our trading partners. Rather, we look to the local experts, and rely on Consensus Forecas are essentially a survey of local forecasters' views for each country.
Table 1 summarises the Consensus view of industrial production for the reg economies. For 1998, I have included the results of the latest Consensus survey (Septemb along with the corresponding forecasts of a year earlier. For 1999, the table shows numbers, plus the results of the first survey of 1999, which was taken in January of this y
## Table 1
## Consensus forecasts of industrial production annual average
| Calendar 1998 Country | Calendar Share of | 1999 Forecast as at: | Forecast | as at: |
|-------------------------|---------------------|------------------------|------------|----------|
| NZ | Exports Sep-97 | Sep-98 | Jan-98 | Sep-98 |
| Australia | 19.3 | 4.3 2.9 | 3.3 | 2.4 |
| United States | 11.0 | 2.8 3.3 | 2.2 | 2.4 |
| Japan | 14.4 | 2.4 -6.4 | 1.6 | -1.9 |
| TWI Weighted | 53.5 | 3.2 0.7 | 2.6 | 1.3 |
| South Korea | 3.9 | 7.9 -8.1 | 4.3 | 1.6 |
| Taiwan | 2.6 | 6.4 4.6 | 6.0 | 4.7 |
| Hong Kong* | 2.8 | 5.4 -4.7 | 4.0 | -2.8 |
| China | 2.8 | 15.1 9.4 | 12.8 | 9.9 |
| Indonesia | 1.3 | 9.8 -16.2 | 5.9 | -0.3 |
| Malaysia | 2.2 | 10.1 -5.1 | 7.1 | 0.5 |
| Thailand | 1.2 | 4.8 -13.1 | 3.0 | 0.3 |
| 14 countries | 71.7 | 4.4 -0.5 | 3.4 | 1.4 |
| Export Weighted | | | | |
* GDP
Two points are striking. Firstly, the extent and pervasiveness of the redu expected output over the course of the last year are enormous. By any historical standards, has suffered a very serious growth shock.
Secondly, the current Consensus view for 1999 does not envisage any substan recovery for the region. At best, it is suggestive of stabilisation at the new, lower, le Note that the track of the past year or so has been one in which the Consensus growth fore been repeatedly revised downward as they incorporated emerging news and data. There is no sense yet that that process has run its course. Note also that the latest growth outlook s fairly benign, and frankly implausibly optimistic, growth path for China, the USA and Europ
As noted earlier, it is impossible to get a firm grip on the near-term prospe the contagion unleashed in Thailand in July of 1998 is still working its way around the going well, China, the USA and Europe will be able to sustain their positive growth paths provide the pillars around which the affected countries can resume their growth. I think the most likely scenario. But other, realistic, and much less comforting, scenarios can be with disturbing ease. Developments in financial markets over the past couple of weeks balance even more in the direction of the pessimists.
Even the scenario of continued modest growth involves some very harsh transit for Asia. I will focus on primarily one aspect of that transition - namely the enormous d has been wrought to balance sheets in the region and what will be required to remedy that.
## Financial Sector Adjustments
What has been highlighted by the Asian crash is the extent to which Asian growt been debt fuelled and has proceeded on structures that were inherently risky. Assumptio made about the ability of Asian governments to shelter entrepreneurs from those risks assumptions proved ill-founded.
Deals that involved borrowing in low-interest foreign currency terms to inv rapidly inflating domestic property assets, for example, were premised on exchange rates r fixed, and property prices continuing to inflate. Other investments in manufacturing capa
based around assumptions of continued rapid growth in demand, continued access to loan fu plus stable interest and exchange rates. It was a good formula while it lasted, but it coul
Estimates of the extent of balance sheet damage done in the Asian collapse wide margins of error, largely because asset prices remain uncertain and accounting and conventions do not always provide reliable guidance as to the health of entities. Howeve accepting those wide margins of error, it seems plausible that, within the region's finan alone, losses have been incurred which are equivalent to something of the order of 25 to of GDP. Even for Japan, non-performing assets of the banking system (not all of which will 'losses') are estimated by one of the credit rating agencies at 30 percent of GDP. The USA estimates for total non-performing assets of Japan's banks run to a more modest 20 percent
By comparison, the USA savings and loan problems of the early 1990's involv losses of around 3 percent of USA GDP, and the Scandinavian financial sector collapses of period ran closer to 6 to 8 percent of GDP. To find anything comparable to what has happ Asia, we have to look to the Argentinian crisis of the early 1980's which led to loan lo order of 50 percent of GDP.
It is difficult to see how robust growth can resume in Asia before these equi are filled. The obvious question is how to achieve that. Specifically, where will the m from?
First, we need to recognise that not all such losses need to be 'replace financial sectors in much of Asia were almost certainly rather larger than needed and ther need to be fully 'replaced'. Indonesia, for example, had something like 240 banks serv economy which, at its peak, was little more than three times the size of New Zealand's. A parts of the region, most of those banks are insolvent. But it will not be necessary to capital base of each to BIS standards. Without wishing to diminish the magnitude of the ta if not most, of those banks can probably be allowed to disappear, through mergers or without impairing the effective functioning of the economy. Indeed, the priority throu region is to quickly resurrect functioning and trustworthy financial systems around a sma robust institutions.
Even that will require enormous equity injections. Where will that equity be fo
The options are reasonably clear cut:
- shareholders of banks
- the public purse
- creditors (i.e. depositors) of banks
- domestic investors
- foreign investors
But those options are somewhat constrained.
In essence, existing shareholders have, to use the vernacular, 'lost their shi private shareholders may be able to contribute additional capital, but most will not.
For the most part, the depositors of banks in the region have already receive guarantees on their deposits. There seems little prospect that they will be obliged or all directly in the losses accrued.
The public purse is the mostly likely source of substantial, and early, new Most countries in the region went into this crash with relatively light public debt loads probably absorb an additional debt burden of, say, 10 to 20 percent of GDP equivalent in recapitalise banks and deal, at least in part, with the bad debts. In so doing, they wou socialise the losses, and spread the impact of the economic collapse over the next decade course, as conditions improve, and perceptions grow that the worst of the shock is ove investors will be increasingly willing and able to reinvest, enabling the governments to from direct ownership and retire at least some of that debt.
Whatever view one takes of the desirability of public investment in fin institutions, it is difficult to see how this particular option can be avoided given the m problems that have emerged, and the profound lack of confidence on the part of private which now exists. Indeed, this process of public capital injections is already well un Korea, Thailand and Indonesia. Japan, it seems, is still struggling with the concept.
Asia's domestic private investors, for the most part, have taken such an enorm to net worth that it is difficult to imagine them being an early or substantial source of banks. In any event, the need for new equity extends well into the non-financial business and even with Asia's renowned savings capacity, the short-term need for private savin exceeds the local capacity to supply.
That leaves only foreign investment in Asian financial systems and industry substantial and available avenue for prompt recapitalisation and rapid economic recovery. investment would bring more than just capital. The region needs skills, experience, risk ma systems, accounting and auditing systems, diversification of ownership risk and, perhaps b else, high reputation and confidence in creditworthiness. Foreign investors can provide all
Certainly, foreign investment in the region's financial systems is already oc However, my impression is that it is not always openly welcomed. I am well aware of all national reservations about foreign investment, and I don't approach this issue with ideological view of the subject. But it does seem that without a more liberal and w approach to foreign investment, the recovery will be slower because the region's equity exceed the capacity of domestic sources - public and private - to provide.
Before private investors, of either domestic or foreign origin, are enti recapitalising the region's banks, there will have to be substantial progress on issues o standards, audit standards, transparency, and legal underpinning of bankruptcy proceedi commercial law more generally. Investors will not invest unless reasonably confident t understand the risks they are accepting (which, as recent events prove, isn't the same as investors will assess those risks accurately). Reducing those risks is one of the most activities that governments in the region can now engage themselves in.
## Concluding Comments
Asia has suffered a shock which, by any historical comparison, is severe. Re from that shock will take time and perhaps the most useful thing that can come from the e now is to extract the available lessons and try to ensure that recovery is sound, durab susceptible to such crises in future.
Asia 2000 Executive Director Philip Gibson in a recent speech pointed to fundamental strengths of Asian countries, in terms of their cohesiveness, willingness to invest, commitment to improvement, especially through education, and commitment to recovery
of those qualities are evident, and all will be necessary over the next couple of years takes root.
To my mind, there are two key lessons emerging from the Asian experience, these are now being reinforced by events elsewhere around the world.
- The crucial importance of a strong, well-capitalised financial sector, wit systems for recognising and managing risk. The experience is showing us ag just how financial system stress can amplify difficulties in the rest of the
- Asset price booms may be enjoyable on the way up, but are terribly destru when the bubble finally pops.
If those two lessons are well-learnt, and applied in future policy making, future will be even more robust and durable than its past.