Former US Treasury Secretary Lawrence Summers warned yesterday that emerging Asian economies face stagnation if policymakers continue to focus on insulating their financial systems at the expense of deeper economic reforms.
In an exclusive interview with Emerging Markets, Summers said that the same problems that confronted Japan in the 1990s await much of Asia, as finance chiefs concentrate on the symptoms of past financial crises at the expense of addressing the underlying causes.
“The concerns now are less about a repeat of the 1997 Asia crisis, and more about the kind of failing that Japan experienced throughout the 1990s, where the aftermath of a period of easy money and reserve accumulation directed at exchange rate objectives proves to be the unearthing of weaknesses in the financial system and significant deflation,” he said.
“The risk of the sort of crisis that befell Thailand, Korea, or to a lesser extent Indonesia has been hugely attenuated by events, principally by the tremendous accumulation of reserves,” Summers added.
The erstwhile Harvard president argued that carefully sequenced financial liberalization, financial sector reform, and the reduced use of exchange rate targeting in Asia are crucial to guard against vulnerability.
His comments stand in stark contrast to the intense focus by Asian officials on reserve currency swaps and the risks of hedge fund activity. ADB president Haruhiko Kuroda said on Friday: “Small open economies, particularly Thailand and Malaysia, are countries that are affected by large capital inflows. We need greater financial cooperation to mitigate problems of volatile capital inflows.”
Summers’s views were echoed last night by Charles Dallara, managing director of the Institute of International Finance (IIF), the global association of financial institutions. “The accumulation of reserves was a natural response to what happened [in 1997], but we’ve gone way beyond that level now... In their effort to safeguard their systems, they’ve gone overboard,” he told Emerging Markets.
The IIF will today present its Asia regional overview, which will show that, although capital flows to Asia (ex-Japan) are likely to moderate in 2007, from a peak of $255 billion in 2006, foreign exchange reserves will continue to rise to around $1.9 trillion this year.
The surge in credit available through hedge funds and the use of derivative instruments makes financial market performance more difficult to assess as the cycle turns, but Gregory Fager, director of the IIF’s Asia-Pacific department, emphasized that the situation was “vastly different” from 10 years ago, and a serious economic shock resulting from the withdrawal of foreign capital flows looked “out of the question.”
Citing the turbulence that occurred in emerging markets in May/June 2006, Fager observed: “The Mumbai Stock Exchange saw a 30% fall, but the economy as a whole still grew by more than 9% for 2006 as a whole, which was unprecedented.”
The fund managers on the receiving end of suspicion from central banks and finance ministers also believe that fears over capital flow volatility are overplayed.
Michel Lahaie, who manages Hong Kong-based absolute return fund Axiom, argued that speculative attacks on Asian economies were now much less likely, as the markets are larger and more liquid. “Then, you could move a market like Thailand or China with $100 million. Today that’s more difficult, and in two or three years, maybe impossible,” he told Emerging Markets.
Lahaie also said that the days of the global economy catching a cold from tighter liquidity conditions in the US are “long gone.”
Goh How Phuang, who manages the $2 billion Schroder Asian Bond fund in Singapore, pointed to the strength of the local investor bid, especially in the Philippines, as a source of resilience to any downturn in global capital flows. “Asian banking systems are awash with liquidity, which precludes a major adjustment, short of the kind of credit event that is not on anyone’s short-term radar,” he concluded.
But fund managers warn that volatility could be induced - by policymakers rather than market players. Lahaie points to Asian central bank attempts to hold back currency appreciation, and to the investment restrictions on China “A” shares, as potential sources of bubbles.
“When was the last time a hedge fund set the level for the yen?” Lahaie asked. “We just play with the cards we’re dealt.”