Fascinating analysis of the asian crisis. Best I've read so far.
Global Intelligence Update
Red Alert
September 14, 1998
Asian Forecast: Toward a New Asian Bloc
Late last week, the Japanese government indicated that it would oppose an
IMF plan for bailing out Ukraine. The reason: Japan was tired of the
West's willingness to help CIS countries when it is unwilling to bail out
Indonesia and other Asian nations. Japan is certainly correct. The West
is being far more helpful to the CIS than it is to Asia. What the Japanese
clearly don't understand is the reason. The West simply has more to lose
in Russia than it has in Asia. That is an odd thing to say, since the
collective economy of the CIS is but a fraction of Asia's. Nor can it be
explained by nuclear weapons. China is a nuclear power just as much as is
Russia. Why is the United States and the West so indifferent to Asia and
so responsive to Russia? The answer lies in a simple fact: Asia has
structured its economies in such a way that its decline poses only a
marginal threat to the West. The West worries, but it is simply not
motivated to act.
Asia protected itself so effectively against non-Asian economies that the
rest of the world never dramatically profited from its relationship with
Asia. As a result, the collapse of Asia left the rest of the world with
relatively little exposure. The United States, in particular, was left
with little to lose from Asia's collapse. It therefore did little to
prevent it or to help Asia recover from it. Like all tragedies, Asia's
success contained the seeds of its own downfall. It also points to the
fact that Asia will have to save itself. No one else is motivated to help
out.
* The Roots of Japan's Economic Miracle
During the 1970s, the United States and Europe suffered from a massive
capital shortage. Interest rates went into the double digits, along with
unemployment and inflation. The effect on the American economy was both
devastating and a tonic. Coupled with changes in the tax code, high
interest rates triggered a vicious recession that destroyed under-
performing businesses while forcing others to radically restructure their
operations in order to make them more efficient. This brutal process
continued throughout the 1980s, culminating in the massive American boom of
the 1990s.
Japan chose a different course. While world interest rates soared, Japan
kept its domestic interest rates low. It did this by forcing extremely
high saving rates. The reason for Japan's high savings rates had nothing
to do with culture. Rather, it had to do with the fact that Japanese
workers were forced to retire at 55 and 60, which kept aggregate wage rates
low. In addition, Japan had virtually no public retirement system at that
time, and corporate retirement plans would not sustain retirees in a
country with the highest longevity rate in the world. As a result, workers
had no choice but to save for retirement.
Japanese banking laws prevented consumer access to savings instruments
paying world interest rates. Most Japanese workers saved at the government
postal bank, which was paying 2-3 percent on consumer savings, while in the
U.S. consumers were receiving above 10 percent. The postal bank money was
then loaned to Japan's large "City Banks" at a fraction of a point above
consumer rates. These funds were in turn lent to companies linked to the
"City Banks" via the keiretsu system of informal cartels. As a result,
Japanese automakers were building new facilities using money costing less
than 5 percent a year, while U.S. automakers were forced to borrow money at
rates as high as 16 percent. Not surprisingly, Japanese automakers enjoyed
tremendous advantages over U.S. automakers in the 1980s.
Also not too surprisingly, Japanese workers had one of the worst standards
of living in the industrialized world. Between early retirement and lack
of decent retirement, Japanese workers could not consume much of what they
produced. In order to sustain the economy, Japan had to turn to exports to
maintain its economic miracle. Exports not only soaked up Japan's
productive capacity, but also stabilized the banking system. Because
Japanese banks were lending money at a fraction of world interest rates,
export-oriented businesses enjoyed a tremendous price advantage when
competing with companies forced to borrow money at world rates. This
tremendous short-term advantage had an even larger long-term cost.
Because interest rates were so low, Japan had no effective money-rationing
system. Underneath the invincibility, Japan was suffering a hidden
disease. Tremendous growth was taking place, but it was an increasingly
profitless growth. While American businesses were undergoing ruthless
scrutiny from capital markets, Japan's businesses were being protected.
Capital was not being allocated in a rational manner to the most efficient
businesses, but in a political matter, to businesses properly linked to
banks. Because banks were concerned about repayment, no one was noticing
that Japanese businesses were increasingly incapable of generating the
capital needed to renew themselves. They were living on loans from banks
that were living on cash flow from loan repayments. The system could not
sustain itself, and capital fled from Japan. Japanese investors would
rather buy golf courses in California than invest in Japan. This capital
flight was confused with Japanese economic power. It really represented
the preface to economic calamity.
By the early 1990s, the inefficiencies of Japanese industry were becoming
manifest. Japanese companies were incapable of generating sufficient cash
to cover even the artificially low interest payments demanded by Japanese
banks. The traditional strategy of surging exports ran into two brick
walls. First, China was beating Japan at its own game. Second, the
fantastic regeneration of American business made the U.S. more than
competitive with Japan. With business inefficiency increasing and exports
blocked by market realities, the Japanese economy began to slowly collapse
under the weight of its own inefficiency. The Japanese, who used to
congratulate themselves on their indifference to "short-term profits," now
discovered that their inattention to the bottom-line was choking them.
The rest of Asia followed this Japanese model. The model had three parts:
Keep domestic interest rates below world market rates and ration money
politically rather than through the market. Support this policy through
high savings rates and low consumption. Export production while limiting
imports through market barriers and other devices. In China and Southeast
Asia, this strategy had a fourth element: increase growth rates by
attracting foreign investments. This was done by linking foreign investors
with domestic sources of money at below-market rates. These joint ventures
attracted foreigners who hoped to take advantage of cheap money. In fact,
they themselves became trapped by the irrationalities of host-country
capital allocation.
* Asia's Self-Isolation
The development policy we describe here has had an interesting and
unintended consequence. Asia has developed domestic capital markets that
foreigners found difficult to penetrate. The entire point of these
domestic capital markets was to provide a competitive advantage to domestic
businesses. Foreign investors could get access to these resources only
under specially controlled circumstances, and only to the extent necessary
to entice investment. As a result, foreigners developed only a very
limited dependence on Asian capital markets for their own development and
operations. Asian money was invested overseas, but this was primarily
money seeking a safe haven. This money is certainly not going to be
withdrawn now. Asian money that is safely ensconced in U.S. Treasury
instruments is not going to be repatriated now to save Asian businesses
that are beyond recovery.
By isolating their domestic capital markets from world capital markets, the
Asians failed to instill any dependency on their markets among foreigners.
The dependency went the other way. Asian investors became dependent on the
safety of U.S. and other Western debt instruments. Westerners were not
permitted to become dependent on low-cost Asian money. Asian investors
were locked into place. Western borrowers, oddly, were not. Add to this
the fact that Asians became dependent on U.S. markets, while the United
States was not permitted to become dependent on Asian markets, and we begin
to see the nature of the problem.
Asian development policy has created an asymmetrical relationship, in which
the very factors that allowed Asia to surge in the 1980s make the rest of
the world relatively indifferent to Asia's fate today. Put simply, the
Asians played the game so well, and protected themselves so effectively,
that the rest of the world benefitted relatively little from their success.
As a result, the rest of the world was hurt relatively little by their
failure. That is why, as French Finance Minister Dominique Strauss-Kahn
said today, the U.S. economy has been relatively untouched by Asian
turmoil. It also explains why the United States and the rest of the world
are not interested in helping Asia.
Moreover, the Asian countries pose little military threat. A Russia
reawakened immediately threatens Europe and the Middle East. Asian powers,
including China, primarily threaten each other. Therefore, Asia is very
much on its own. With East and Southeast Asia in collapse and Hong Kong
approaching the breaking point, China will shortly follow. Thus, the
question at hand is what Asia will do on its own.
* Toward a New Asian Reserve Currency
The central problem for Asia is intra-regional trade. Instability and
weakness in regional currencies have forced intra-Asian trade to remain
dollar-denominated. A shortage of dollars in the region, caused by the
dramatic increase in the cost of imports from outside the region, has left
several nations in a position where they can no longer conduct trade among
themselves. Singapore, whose banks would normally finance intra-regional
trade, is not in a position to absorb the risks that such financing now
involves. This has meant that the regional depression has gotten much
worse than it needs to be. Asia is still enormously productive, financial
problems notwithstanding. However, dependence on the U.S. dollar as the
main reserve and trading currency has created a downward spiral from which
many countries simply cannot recover. Moreover, given the indifference of
the United States and of multilateral institutions to the problem, the
political benefits of remaining on a dollar regime no longer outweigh the
economic costs.
The logic of the current situation points in an obvious direction: Asia
will have to create a regional reserve currency to facilitate intra-
regional trade and investment. Otherwise, the somewhat artificial calculus
of dollar reserves limits its recovery. Unlike Europe, however, which is
made up of a group of relatively healthy equals, including currencies like
the pound, franc, and mark, Asia does not have such a basket of currencies
to draw on. Most of Asia's currencies are in a shambles. Hong Kong's
dollar has now fallen into this class. Singapore's dollar remains
relatively healthy, but its float is much too small to serve as a true
reserve currency. China's yuan is not convertible and not likely to become
convertible. Thus, Asia is left with only one credible alternative to the
dollar: the yen.
The Japanese, for obvious reasons, do not want the yen to become a regional
currency. First, they do not want to lose control over their monetary
base, which tends to happen when currencies are held in reserve. Second,
Japan is heavily dependent on its trade with the United States, which is by
nature dollar-denominated. The rest of Asia cannot absorb all of Japan's
exports. Thus, yen-based intra-regional trade and dollar-based inter-
regional trade would leave Japan in the worst of all possible worlds.
Japan would have to conduct its monetary policy with an eye toward regional
responsibilities, while also making sure that the yen did not appreciate in
value relative to the dollar, thereby decreasing Japanese competitiveness
vis-a-vis the United States. This is why we have seen the Prime Minister
of Malaysia floating the idea of a regional economic structure built around
the yen while the Japanese have resisted the idea.
However, as the Japanese problem grows more extreme, Japan is running into
limits on its ability to export to the United States. From a competitive
standpoint, the inability of Japan to reinvest in its own economy means
that its aging capital stock is increasingly non-competitive. Japanese
goods are no longer clearly better than American goods. From a political
standpoint, the willingness of the U.S. to tolerate Japanese dumping into
the American market is much lower than before. Particularly if, as seems
likely, the U.S. moves into a mild, cyclical recession in the next year or
so, the political logic inside the U.S. will be much less likely to
tolerate this behavior. Thus, an export surge of a magnitude needed for
even short-term solutions is simply not in the cards.
Without an effective export surge, Japan is in an impossible dilemma. If
it raises interest rates to encourage capital formation, it will trigger a
wave of bankruptcies that will swamp its banking system. If it keeps
interest rates low, it will continue to keep things barely afloat, without
any real solution. Put another way, if Japan tries to stimulate its
economy through consumer demand, it will cut savings and bring the banks
down. If it continues to force high savings rates, it will keep the banks
afloat by crippling economic growth.
If the Americans won't bail out the Japanese through financial contrivances
or increased purchases of goods, then Japan's only real choice is to
stimulate its own economy by linking itself closer to Asia. And if it is
to link itself closer to Asia, then it needs to stimulate an Asian recovery
in order to stimulate its own. And if it is to stimulate an Asian
recovery, it must allow Asia to decouple from the dollar. And that means
that it must create a yen-denominated regional currency for trade, possibly
linked to an Asiadollar, modeled on the Eurodollar of the 1960s.
* The End of Bretton Woods and the Re-emergence of an Older World Order
What we are talking about here is the end of the Bretton Woods agreement
that has defined international monetary relations since World War II.
Asian countries have no choice but to institute currency controls to
protect their currency for intra-regional trade. China has never abandoned
controls. Japan used to have fairly strict controls, as did the rest of
Asia. The other, inevitable side to yen-denominated trade are strict
controls, on a regional basis, over the convertibility of Asian currencies
to dollars. Indeed, the controls will likely precede the creation of a yen
bloc. Most Asian countries have no choice but to seek refuge in controls.
The only thing holding this up is the vain hope that the IMF will bail them
out and the knowledge that currency controls would end any chance of
multilateral help. Because the IMF is not going to bail anyone out, when
that realization finally sinks in, currency controls are inevitable.
Since we do not see China's internal political structure as sufficiently
robust to emerge unscathed from its inevitable bout with reality, it will
follow that Japan will emerge as both the regional reserve currency and the
regional political leader. Malaysia's Prime Minister Mahathir Mohamed,
whom we regard as one of the more insightful regional leaders (and
therefore, by definition, much maligned and unfairly dismissed), has
understood the inevitability of this process, and has long called for
Japanese leadership in both economic and political affairs. The Japanese
have resisted. They cannot resist for much longer.
The key to this is the coming upheaval in Japanese politics. Japan, like
Russia, is an avalanche society. The United States is a glacial society.
Because the U.S. has few social controls, it is constantly changing in
small, glacial amounts. There are few social upheavals. Japan and Russia
permit few changes, until strains build up and an avalanche occurs. Japan
is now fully ready for its avalanche. The current internal political
configuration cannot possibly survive. The internationalist, pro-Western
perspective that has dominated Japan since 1945 is completely bankrupt.
Indeed, it has bankrupted the country. A more nationalist, more Asian, and
more assertive government will replace it. We caught a whiff of this in
the Japanese response to the North Korean missile incident. There is more
to come.
More than Bretton Woods is about to change. The world is shifting from a
liberal, internationalist regime to a more conservative, regionalist
structure. Paradoxically, the region of the world most dependent on
liberal internationalism for its export-oriented economies has created the
conditions which will destroy that regime. The reasons behind Asia's
success are also the roots of its failure, and that is why no one is really
interested in saving Asia from itself. What will emerge from Asia's
debacle is a regional bloc built around Japanese economic and political
leadership. Now, where there is economic and political leadership,
military power must inevitably follow.
This is the problem. No one in Asia wants to see a resurgent Japan. The
Japanese do not want to undertake the burdens of leadership. But there is
no way out for Asia except to use the yen as a new, regional reserve
currency. This relatively small step will contain many unintended
consequences, not least of which will be a region shaped in ways none of
the players want. But Japan is the world's second largest economy and the
region's largest, dwarfing China's economy. It is also the most stable
country in the region. Leadership falls naturally and inevitably to Japan,
particularly as we expect China to slide into disorder as its economy
deteriorates.
Thus, the end of the New World Order will raise old questions everywhere.
In Europe, the German question will reemerge. In Asia, it will be the
Japanese question. The end of the New World Order brings us closer and
closer to an older world order, one which had a cataclysmic outcome last
time around.
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