Cautionary tales from East Asia

In the current revulsion towards “emerging markets”, global investors are pointing (as usual) to economic mismanagement in these countries as the proximate reasons for their current woes. It is being argued either that some of the economies failed to make the best of the years of the commodity boom to set their economic house in order, or that others (especially large manufactured goods exporters such as China) allowed excess capacity creation and over-investment.

Certainly there is some truth in these criticisms. Yet they miss the whole picture, and in particular the global and national policy context in which both the past boom and the current bust are unfolding.

Most of all, they ignore the crucial role of internationally mobile private finance in creating these booms and busts, and in the process not only generating economic instability but also reducing future growth prospects.

To understand how this works, it may be useful to look at some economies that are not currently in the firing line of global investors, but have been there before, and been dramatically altered by that experience. One of them — South Korea — has managed to become a high per capita income country, yet its recent growth performance has been less than stellar, and is approaching the secular stagnation characteristics of the advanced economies, though with still lower levels of average living standards.

The other — Malaysia — showed dramatically rapid growth for a while but now appears to be caught in a “middle income trap”. Both show the perils of financial liberalisation that messes with macroeconomic processes in unforeseen ways.

Both these economies were celebrated as examples of export-led growth success, South Korea as a first generation “Asian tiger”, and Malaysia as one of the second tier of Southeast Asian rapidly growing economies. High growth rates over the 1980s and most of the 1990s was driven by high investment rates (enabled by active state intervention) that fed into rapidly growing exports.

The Asian crisis of 1997-98 was both a crisis of the slowdown in export markets, but more crucially a financial crisis resulting from the excess external debt exposure in Korea and the heavy reliance on portfolio investments in Malaysia.

The crisis perversely led to an intensification of financial liberalisation in both countries, with even greater integration into global capital markets and greater foreign ownership of banks and other financial institutions.

The implications of this have stretched far beyond the obvious concerns with respect to fragility and volatility, into affecting crucial macroeconomic variables like savings and investment, which determine future growth prospects.

Most of all, it is evident that 1998 marks a clear break after which domestic investment rates have stagnated or fallen in both countries, even as savings rates have remained high. Income growth has suffered in consequence, and more recent growth has been fed by speculative financial bubbles such as stock market and real estate booms, rather than genuine increases in productive capacity that would improve overall standards of living and complete the development project.

Chart 1 shows how this played out in the case of South Korea. It is evident that annual GDP growth decelerated significantly after the slump of 1998. Investment rates that had risen sharply in the 1970s and 1980s, and remained high until 1997, experienced declines.

Meanwhile, savings rates, which had also risen sharply before the crisis but generally remained lower than investment rates (with the balance being met by capital inflows) remained high at around 35 per cent of GDP, generating savings surpluses that were channelled out of the country by internationally-owned financial institutions.

Chart 2 provides an indication of how the financial liberalisation also encouraged “animal spirits” in the country’s stock market, even though both investment rates and GDP growth were down compared to the earlier period. For the most part of the 1990s until 2003, stock market capitalisation as a percentage of GDP was relatively subdued, between 25 and 40 per cent of GDP. (The exception in 1999 reflected the collapse of GDP rather than a sudden boom in the stock market.)

However, from 2003 onwards, stock market valuations started rising, averaging around 100 per cent of GDP by the late 2000s and earlier part of this decade. It should be noted that this was not accompanied by any increase in investment rates; rather, investment rates in the decade up to 2014 averaged 31 per cent compared to 35 per cent in the decade preceding the crisis.

A very similar –and possibly even more extreme — scenario has unfolded in Malaysia, at lower levels of per capita income. As Chart 3 shows, the gap between savings and investment rates in Malaysia became especially large since the Asian crisis, averaging as much as 20 percentage points of GDP in the 2000s.

Financial globalisation meant that most of these savings were then exported, earning significantly lower rates of return than the returns available to foreign investors in Malaysia, and not allowing domestic savings to power domestic investment as it had before.

Meanwhile, GDP growth has also settled into much lower “new normal” rates of around 5 per cent. Stock market capitalisation has been even higher than in South Korea, amounting to more than 150 per cent of GDP in recent years, with no discernible effect in terms of increasing real investment rates.

The Malaysian case — like that of a number of other emerging market economies — provides another way of interpreting what has been called the “middle income trap”. This has conventionally been used to refer to the situation in which an economy loses its low-wage advantage to cheaper competitors without gaining the productivity advantage that exists in the advanced economies that are able to retain monopoly of their knowledge.

There could be another way of looking at this: as a trap created by the pressures for financial liberalisation in an economy with a still incomplete development project.

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