Stock market crash will impact on global demand
In this analysis of the origins and impact of the current financial crisis, Professor Jan Kregel argues that among the lessons to be drawn from the recent collapse of stock markets in Asia, is that 'getting the fundamentals right' is not a defence against speculators. He contends that the current crisis has disrupted a whole process of co-ordinated growth in South-East Asia which has been a source of global growth and demand. Coming at a time when the US economy is itself moving to a position of fiscal balance, and therefore generating a reduction in demand, the risks of a sharp fall-off in global demand and of global economic instability are very great.
THE collapse of stock markets in the emerging economies of Asia, followed by the crash on Wall Street in the last week of October have raised a number of questions about the state of the world economy, with many comparisons being drawn to the 1994 Mexican peso crisis and the earlier 1987 Wall Street meltdown. There are a number of lessons that can be drawn from this.
The first is the increasingly close relationship between currency market values and asset market values. In Asia currency weakness was accompanied by asset market weakness, and even in the United States the sell-off in the stock market produced a marked fall in the dollar.
The second is that getting the 'fundamentals right' is not a defence against speculation. In Asia currency weakness was experienced independently of the position of a country's current account, or the direction of change. For example, the chart (see box) shows the difference in the rate of growth of exports relative to imports as a rough classification of countries who were taking measures to improve their current account balances. Even those countries that were markedly improving their positions, such as Taiwan and Hong Kong, were not immune from the crisis.
Third, the crisis was independent of the source of financing current account deficits. The currencies of countries that rely primarily on foreign direct investment were subject to the same speculative pressures as those who had higher proportions of portfolio investment.
The fourth is the close relationship between the stability of the banking system and financial crises. The current crisis, which had its proximate cause in perceived weakness in Thailand's domestic banks, has exposed weakness in most other countries in the region, and in particular in Indonesia and China. This is very similar to the Mexican experience, and suggests a close relation between rapid stabilisation, rapid capital inflows and financial sector instability.
These particular lessons raise some more important general issues for the development of Asia. The model of development which has been employed in the region has been represented by the metaphor of 'Flying Geese', to represent the application of what might be called 'comparative cooperation'. As countries grow and raise their relative standards of living and real wages, they move into higher value added sectors of production. This leaves space for lesser advanced countries to expand production into those areas. The lead country provides expanding export markets and financing for those that are coming behind. This kind of organisation is based on changes in real incomes and productivity, and thus requires a fixed standard of comparative value in the form of stable exchange rates. Devaluations can change the relative positions of countries and disrupt investment plans and coordination. The currency instability that has been experienced in the region is thus important not only because of its impact on wealth and asset values, but because it represents a disruption of the entire process of coordinated growth which has been so successful in the region.
From this point of view, the current crisis can be said to have had its origin in the devaluation of the Chinese currency several years ago, and was aggravated by the more recent volatility in the Yen-Dollar exchange rate.
[From a value of US$1 to 1.5 in 1981, the Chinese currency was gradually depreciated through the 1980s to around 3.72 in 1988, 4.72 in 1990, 5.43 in 1991, 5.75 in 1992, to 8.62 in 1994, and a slight appreciation to 8.31 in 1995 and 8.32 in 1996.]
For most countries in the region, their export markets are primarily dollar denominated, so that it was sensible to link their currencies to the dollar. On the other hand, most capital flows into these countries are denominated in Yen, so that changes in the dollar/yen exchange rate have an impact on capital costs and financial stability. Thus, from the point of view of the region, an appreciation of the dollar has no impact on competition between them, and decreases the value of the outstanding yen borrowing. On the other hand, it reduces their competitiveness vis-a-vis other global regions and China. There are thus some positive benefits to offset the loss of competitiveness in third markets and relative to other producers.
The foreign exchange market seems to have ignored these benefits and concentrated on the loss of competitiveness which is far from evident from looking at the figures cited above. Of rather greater importance for the fall in the growth of exports from most of these countries was the decline in the propensity to import of the developed countries (analysed in the UNCTAD Trade and Development Report, TDR 1997). But, this is a problem of global demand, not of global relative prices. Relative price adjustments through exchange rate adjustments can only reallocate demand, they cannot do anything to increase it.
This raises the other structural aspect of the current crisis. As pointed out in TDR 1997, aside from the Anglo Saxon countries (especially the US and the UK) most developed countries are experiencing a disappointing growth performance. The impact of the introduction of Economic and Monetary Union in the European Community has caused rising fiscal surpluses, rising unemployment and falling consumer demand and stagnant investment. Exports are the only source of demand and growth in these economies. At the same time, the Latin American countries recovering from the effects of the Tequila crisis are introducing similar policies in order to reduce foreign deficits, so that they are all actively seeking to expand exports. In Asia, a number of countries that had positive balances on foreign account have seen these disappear and have been actively seeking to retain structural balance. This has led to a position in which most of the developed and developing world is dependent on demand for their exports from the US and the UK. One of the results of this was the fall in the rate of growth of world trade relative to the rate of growth of global income for the first time in a number of years. This was clearly an unstable situation, for the imbalanced distribution of demand will eventually lead to an unsustainable foreign deficit in the US.
In this situation, an appreciation of the dollar, such as occurred during 1997 as a result of the attempt of European countries to reverse the appreciation of their currencies, and the belief that higher growth in the US would lead to monetary tightening, meant that those countries which were linked to the dollar - in particular South-East Asia - would have a harder time attracting US demand. They would thus be required to reduce their growth to achieve equilibrium, or to break their link to the dollar. If the first occurred, then their equity markets were overvalued and should be sold; if the second, then their currencies were overvalued and should be sold.
This is the sort of reasoning which was applied in Hong Kong. It was the last currency in Asia still linked to the dollar, so it was faced with a policy choice - devalue to remain competitive with the rest of Asia, in which case the HK dollar should be sold, or keep the link to the dollar and introduce a restrictive internal policy of increasing interest rates, in which case the Hang Seng index was overvalued, and should be sold. Of course, these decisions were not independent - if stocks were sold, the proceeds would be converted into US dollars and the exchange rate would come under pressure; if the currency devalued, stocks were worth less to foreign holders and should be sold. It became what speculators call a 'no-brainer': sell Hong Kong stocks and buy dollars.
It was the collapse of the Hang Seng and the failure of the Hong Kong Monetary Authority to devalue which led to the collapse in US equity prices. But, a number of Latin American economies are in a similar position. Brazil keeps an adjustable peg relative to the US dollar like much of South-East Asia before the crisis and Argentina keeps a fixed link via a currency board, similar to that operated in Hong Kong. All of these countries, including Mexico, are operating stabilisation plans which rely on stability relative to the dollar and thus continuing appreciation relative to the dollar. The decline in the Asian currency has made that appreciation much larger. Thus, the same sort of conditions which led to the decision to sell in Hong Kong also apply in the major Latin American countries. Up to this time the major difficulties have been caused by the sharp rise in the risk margins applied to Latin American sovereign, corporate and Brady debt, and declines in stock markets, but no concerted speculative pressure. It would be surprising if this were not to occur before the present crisis has passed.
The basic problem which aggravated these structural demand problems was then the inappropriate reaction of the US dollar during 1997 which was increasing in value while global equilibrium required the US foreign account to worsen dramatically in order to supply sufficient global demand to allow satisfactory growth in the rest of the world. More or less the same thing was happening during the past year in the only other country showing satisfactory growth, the UK. Part of the explanation for this movement in exchange rates is in the behaviour of European investors, selling their domestic currencies against the dollar and sterling (as well as the Swiss Franc) in the run up to EMU and the policy of European central banks attempting to use currency policy to offset the negative impact on growth of their excessively restrictive fiscal policies. The other part of the explanation is a simple reflection of the instability inherent in the global demand imbalance - the high rate of growth in the US, which is to be the source of the required global demand itself, was the source of expectations of inflation and rising interest rates in the US relative to the slower growing economies in the rest of the world, and an increase in the demand for dollar assets.
The sell-off in the stock markets of the United States, Japan and Europe was thus a response to this inherently unstable global situation which was exemplified in Hong Kong. There really was no trade-off between devaluation and domestic restriction; for, even after devaluation growth would be reduced throughout Asia and thus bring reduced earnings for companies operating globally in high technology sectors. As a result of globalisation, South-East Asia has played a crucial part in the reduction in costs and the rise in sales and profits for global firms operating in high technology products. These were also the companies that had produced the largest increases in earnings and thus in stock prices in the United States. For Europe, any reduction in global demand was automatically negative. Further, much of European exports to the region have been financed by favourable lending from European banks (German banks were exposed to Asian borrowers by over 5% of GDP in 1996, France over 4% and the Netherlands over 10%), so that there will be an impact not only in terms of lost exports, but also in terms of bank charge offs. Japan, on the other hand, has a more direct role as exporter and investor to the region - its exports would automatically drop and the loans of its banks to the region were worth less. It is surprising that the sell-off in Japan was not greater than it was.
The appropriateness of the size of the fall in developed country asset prices is impossible to evaluate - what is clear is that the change was in the direction indicated by the fundamental global demand imbalance and that the currency and equity market crises in Asia had made it much worse. It is also clear that a major element in the final outcome, the reaction of China, is still to be determined. The Chinese currency is still considered to be undervalued, but it is also clear that it has lost most of the benefit of its earlier depreciation, and that internal demand conditions cannot be considered as strong, considering that the rate of inflation has been reported to have fallen to zero.
Reduced US demand
The likely impact of the crisis must be judged against the fact that the US is currently moving to a position of fiscal balance, so that there is an inbuilt reduction in US demand aside from the Asian crisis. Given that there will be an increase in capacity in world markets as countries seek additional exports at lower dollar prices, this should mean that the US will be experiencing conditions of stable or falling prices and falling demand. If there is any negative reaction from US consumers or in company investment (Intel has already announced that it is postponing increased US production facilities) then growth in the US will be lower and inflation will be falling. This should reverse the recent monetary tightening, but probably not sufficiently rapidly to offset the impact of falling prices and demand. Lionel Robbins, in an analysis of the period preceding the Great Depression in the US, noted that it was a period of rising productivity and falling prices which produced rising interest rates in real terms. Given that the US is already undergoing a sharp adjustment in productivity, the risk of a sharp fall-off of demand is very great. This would mean that stability in the rest of the world would be impossible. The important point to recognise here is that no change in relative prices can remedy this shortfall. Thus, exchange rate adjustments are not the answer.
The role of free global capital markets in providing the 'correct' exchange rates cannot produce recovery, and to the extent that they attempt to do so can only increase volatility in such a way as to reduce the level of global investment. Further, by disturbing the basis of the flying geese- type development in Asia, they may have permanently eliminated a source of global growth and demand which has been of vital importance to both the process of globalisation, but also the increase in productivity growth in the US.
Neither can mobile capital bring about any improvements by reallocating capital - indeed all that is currently occurring is the global allocation of the losses incurred as asset prices fall to more accurately reflect a more realistic growth and earnings outlook. Again, excesses may increase volatility to the point that it produces reinforcing negative effects on consumption and investment spending. Such excesses may also make the natural weaknesses that build up in domestic financial systems worse.
The crisis has had some beneficial effects by resolving a number of open questions. It is now clear that Japan will not emerge from its current stagnation and return to the high growth rates seen at the end of the last fiscal year. It is also clear that the expected European recovery will be short-lived, especially if central banks continue to accompany fiscal policy restrictions with increasing short rates. This will make it even more difficult to meet the deficit conditions on convergence. It is clear that the Fed will not move to tighten monetary policy, and that inflation will not produce a surprise return to the US economy. It is also clear that the downward movement of long-term interest rates in the US is not over. Against this, it is also clear that earnings growth will not be as robust as expected. The question remains whether falling rates will be enough to offset the impact of falling earnings on stock prices. In its 1996 report the Bank for International Settlements noted that a policy of monetary stability meant avoiding both inflation and deflation. Part of the answer to the behaviour of the stock market will be in the ability of central banks to heed this warning. (Third World Resurgence No.89, January 1998)
Prof. Jan Kregel teaches at the University of Bologna and at the Johns Hopkins University overseas campus in Bologna, Italy; he has written extensively on macroeconomic and capital market issues. The above was written specially for the South-North Development Monitor (SUNS).