“The Past is Never Dead. It’s Not Even Past”: Global Imbalances in South East Asia and the Impact of the US

Subprime Crisis

Nigel F. B. Allington*^ and John S. L. McCombie*

Economic Policies, Governance and the New Economics ConferenceSt Catharine’s College,

University of Cambridge, 12th April, 2012

*Cambridge Centre for Public and Economic Policy Research

and Downing College, University of Cambridge

^ Research Professor of Applied Macroeconomics

Ecole de Management, Grenoble

INTRODUCTION

• This paper extends an earlier one of ours that considered the position of China in the subprime crisis

• This one looks at South East Asia, including China• One factor in 2007 financial crisis is the large trade surpluses in

China, but generally whole of South East Asia• The concomitant of the trade surpluses is savings imbalances and

China in 2007 accounted for 20% of these • Savings were channelled into US keeping interest rates low leading

to a credit explosion• Low rates led to a search for yield and an increase in the creation of

fancy derivatives through securitisation• These developments partly precipitated the financial crisis and

contagion• Conclusion: China is to blame through her policy of undervalued

renminbi

MONETARY POLICY VERSUS GLOBAL IMBALANCES• Evidence weak that imbalances to blame• Lax monetary policy increased consumption and led to US current

account deficit• Capital inflows to US also led to investment outside the country and

a flow of capital back into the US (Lane & Milesi-Ferretti, 2007)• Asian economies did not buy toxic debt either, rather US Treasuries• Also, higher rate of US savings could have led to other bubbles

developing• Whelen (2010) argues global savings glut exaggerated (global rate

rose from 20.7 to 24.7%: 2002-2007)• If rates too low the Fed could have raised them• Corden (2009 & 2010) argues convincingly that China’s trade

surplus not a deliberate strategy, imports fell, joined WTO and increased outsourcing from other Asian economies

MONETARY POLICY AND GLOBAL IMBALANCES

• Corden argued corporate savings also rose and exchange rate determined endogenously

• Private precautionary savings high (low social security and poor provision of health-care and pensions)

• The role of export-led growth wildly exaggerated (Prasad, 2009)• Need to build up reserves in Asia generally to weather a crisis like

1997• But there is evidence that reserves are too high in Asia (see

Vujanovic, 2011)• Reserves in Asia $2.5tr in 2007 and $5.78tr in 2011• Exchange rate policy linked to Bretton Woods II and the

accumulation of reserves (Dooley, various articles)• China not a currency manipulator (Cheung et al. 2009) and any

under-valuation marginal (3%)

WHAT CAUSED THE GLOBAL IMBALANCES?• Familiar accounting identity:• (S – I) + (T – G) = X – M = 0 • For world, X=M thus if government budget balanced or small

relative to GDP: no ex post world savings glut• But in US, M>X financed by international borrowing at low interest

rate• Result: a credit boom• If productive investment had been undertaken probably no crisis• Low interest rates merely reflect lax monetary policy (see Taylor

rule as applied after 2001 in US, Taylor 2011)• US consumption and investment led to ‘twin deficits’ financed by

foreign savings• To correct the deficits through an adjustment in the exchange rate

would be painful – 30% devaluation (Obstfeld & Rogoff, 2005)

GLOBAL IMBALANCES AND MONETARY POLICY

• Conflicting views:• House prices not sensitive to monetary policy (Taylor, 2007)• While others disagree (Del Negro & Otrok, 2007 & IMF, 2009)• Aizenman and Jinjarak (2009) find capital inflows raise house prices

and (Reinhart & Reinhart, 2008) that they cause equity bubbles• In an important study, Merrouche & Nier (2010) review impact of

macroeconomic variables on financial imbalances• Find: current account deficit and capital inflow led to greater

leveraging by banks• But monetary policy that deviates from Taylor Rule no effect on

leverage• Also weak supervision and regulations exacerbated situation

ASIAN IMBALANCES

• South East Asia has high reserves and a savings glut partly private (precautionary) and partly government (China’s case)

• Economic opportunity cost: suboptimal current account surplus and excessive foreign exchange reserves with low rate of return

• Implication more consumption required and investment in infrastructure

• In Asia private savings inconsistent with permanent income life cycle hypothesis (Park & Shin, 2010)

• 2011 China rate of 53.8% and Singapore 45.8%, rest of Asia over 30% except Philippines (24.8%)

• Asian growth has depended too much on domestic savings• Weaknesses in global recovery now place extra pressure on Asia to

consume more

THE IMPACT OF THE CRISIS ON ASIA

• Financial crisis has had a differential impact, but those with large current account surpluses more insulated (Rose & Spiegal, 2010)

• Level of global integration an important determinant of effects of crisis

• Singapore 5th in KOF Globalisation Index, Malaysia 29th , Thailand 54th , Korea 60th , China 73rd and Indonesia 87th

• In case of China, firms limited access to capital markets and foreign exchange sterilisation takes place

• Various types and levels of capital controls (see ADB, 2011)• Growth rates, industrial production and exports all fell, so Asia not

decoupled from crisis• Bond spreads widened and stock markets fell (fell 17% over crisis

period)• Fragility of recovery in US and Europe dented Asian growth in 2011

CRISIS IN ASIA

• Over the crisis period 2007-2009 growth in Asia fell 6.8% (smaller than fall in 1997 of 10.4%)

• Largest falls in Hong Kong, Malaysia, Singapore and Taiwan• 2009 negative growth in five of the Asian economies: Hong Kong,

Malaysia, Singapore, Taiwan and Thailand• Rebound in 2010 to average growth rate of 8.2%, but only 4.9% in

2011 – W-recovery?• Slow growth linked to collapse in foreign trade • Exports fell over the period 2007-2009 by an average of 18%• Biggest falls in China (-28.3%); Thailand (-26.6%); Hong Kong

(-18.5%) and Taiwan (-18.3%)• Fortunately fall in imports exceeded fall in exports• Terms of trade also improved marginally• No country ran current account deficit during the crisis (unlike 1997)• All currencies bar China’s and Hong Kong’s depreciated against US

dollar

CRISIS IN ASIA

• Financial stress indicator shows Asia more affected than other Emerging Economies (Balakrishnan et al. 2009)

• Authors uses stress indices to show transmission mechanism• EMFSI = β+ βAEFSI+ βOEMFSI + βGF estimated 1998-2009• where EMFSI represents financial stress in Emerging Market i,

AEFSI is financial stress in the Developed Economies as a single group of 17 or three regions namely US and Canada; Western Europe; Japan and Australia, OEMFSI is financial stress in other Emerging Markets and GF represents control variables including yearly changes in commodity prices and industrial production and the three month LIBOR

• In LTCM and dot com crises US and Europe equal effect on Asia• 2007 Subprime Western Europe greater effect: most affected were

China, Korea, Philippines, Malaysia and Thailand

CRISIS IN ASIA• Helbling et al. (2007) uses VAR to show the trade spillovers between

US and Asia, as do Guimaraes-Filho et al. (2008)• A 1% slowdown in US reduces Asian growth by 0.2 to 0.5%• What are Asia’s Vulnerabilities?• 1. Currency and maturity mismatches: unlike 1997 little effect, except

Korea with large depreciation. Reason less dependence on commodity exports (Anderson, 2008), more reserves and current account surpluses (roll-over risk low)

• Only Thailand large foreign currency denominated debt, but even this low by Emerging Market levels

• 2. Trade: more dependent on manufactures and high technology ones• High income elasticity for manufactured goods• Given goods availability of credit has impact (cars, electronics and

capital goods)

CRISIS IN ASIA• Intra-regional Asian trade equivalent to 30% of GDP and China assembly

hub• IMF (2007) estimated Asian exports to the US 2001 to 2005 collectively

sum to 15.5% of the regions GDP and correlation between US imports and Asian intraregional trade is high

• Some Asian economies controlled currencies to limit appreciation and sustain export dominance

• But Asian growth not export led (Prasad, 2009)• 2000 to 2008 contribution of net exports to GDP growth less than 11%

(rises to 15% if China is excluded). In 2007 exports 20% Chinese growth• Largest contributors to growth are domestic: consumption 61% and

investment 27%

• Only Germany unambiguously export led growth – 64% of growth• Nevertheless still more consumption needed because calculations hide

differences between countries and differences over time

ASIAN CRISIS• 3. Financial integration: Western European Economies dominate

bank lending and US dominates portfolio lending• From 1997 to 2007 Asia reduced reliance on bank lending, but

increased use of portfolio investment from the US • The largest reduction in portfolio investment took place between

2005-2007 (Danninger et al., 2009) • Tong and Wei (2009) using firm data for 24 Emerging Economies

2007-2009 find bank loans were more volatile than portfolio investment and FDI

• Asia (ex-Japan) less exposed to US subprime assets with losses on credit estimated by the Asian Development Bank (2009) at less than 2% of bank capital in the whole region

• 4. Capacity for countercyclical macroeconomic policies: high

MACROECONOMIC POLICIES

• From June 2008 interest rates were lowered with the average reduction 2% - rates rose on average by 7.4% in the 1997 Asian crisis

• Fiscal stimulus, mainly on infrastructure: large in China, Malaysia, Singapore and Korea, but smaller in Thailand, Indonesia and Philippines

• Bank lending increased in China and Indonesia, but fears about quality of the lending and the ability of the borrowers to repay

• Stimulus expansionary because of favourable fiscal positions (deficit and Debt) of Asian economies and subdued inflationary expectations outside China

• Absence of hard currency pegs meant more interventionist monetary policy possible avoiding the impossibility trilemma

• IMF (2009) estimates fiscal surplus needed for Asian economies to stabilise debt/GDP ratio less than 1% for China, Indonesia and Philippines, marginally above 1% for Korea and Malaysia

• US requires a primary surplus of 3.9% and the UK 2.6%

MACROECONOMIC POLICIES

• ADB (2009) shows Asian banks in better shape with respect to non-performing loans, profitability and risk-weighted capital ratios

• Nevertheless Credit Rating Agencies give Asian banks low ratings, except for Hong Kong and Singapore

• CONCLUSIONS

• The retardation of growth in Asia lower than that in other Emerging Markets and the Advanced Countries or indeed that in the Asian crisis countries of 1997

• Asia not decoupled from the crisis • The spillover effects place Asia in an intermediate position on the

scale of severe to low impact of the subprime crisis• The costs of dealing with the crisis lower for Asia because more

room for remedial macroeconomic policies• Recovery looked to be V-shaped because dependence on net exports

overestimated, but now (post-2011) looks W-shaped