Currency crisis triggered by inefficient investment
By Vincent Lingga
HONG KONG (JP): The thousands of economists, monetary pundits and securities analysts who gathered here for the annual meeting last week of the International Monetary Fund and World Bank, and the dozens of seminars and panel discussions held before the meeting, came up with almost the same diagnosis of the disease which led to the recent currency crisis in Southeast Asia.
They cited a weak financial system, especially the banking industry, too heavy a dependence on foreign capital, notably portfolio funds, widening current account deficit and a too-rigid exchange rate regime.
The solution obviously focuses on a cure for these ills, in addition to the standard advice on sound macroeconomic policy.
The same solution has also been central in the policy recommendations provided by the various reports issued by the IMF and the World Bank, as well as its affiliate institutions.
Several economists went deeper, by analyzing the capital productivity and profitability, or in the context of what Indonesia's most senior economist Sumitro Djojohadikusumo usually calls the incremental capital output ratio (ICOR).
Daniel Franklin, the editorial director of the Economic Intelligence Unit -- the think tank of the Economist group in London -- questioned the trumpeted praise of the high domestic savings rate in and large capital flows to the major emerging markets in Southeast Asia.
"It is the quality and not the quantity of investment that should attract analysts' attention," Franklin said in a seminar that discussed the myths of emerging markets and their hidden risks.
David Roche, president of Independent Strategy research institution, said in the South China Morning Post daily that it was an anomaly that the major economies in Southeast Asia which have massive domestic savings rates of up to 35 percent, still used foreign capital of up to 6 percent and 9 percent of their gross domestic product.
Roche raised a puzzling question as to why the steadily big imports of capital goods by the Southeast Asian economic tigers have no longer been able to generate sustainable growth and steady expansion of exports.
His conclusion was that in the major economies in Southeast Asia, the superior capital productivity and profitability -- the equation of cheap labor combined with new machinery -- does not hold any more.
Roche estimated that in the past five years, it took US$4.60 of capital investment in Indonesia and Malaysia to produce just $1 of output (an ICOR of 4-to-6).
Roche's estimate is not much different from the incremental capital output ratio made last year by Sumitro for Indonesia.
Sumitro has repeatedly called for more concerted efforts to improve the efficiency and productivity of investment in Indonesia, to reduce the country's dependence on foreign capital (official and private borrowings and private investments).
In Thailand and the Philippines, according to Roche's study, the ICOR was even higher. It required $5.50 of capital to generate $1 of output.
Hence, the key problem, according to Roche, is that the productivity of investment in Southeast or East Asia in general has been worsening.
He estimated that quite a portion of the large domestic savings in Southeast Asia had ended up in companies which undertake real estate and property development financing.
John Greenwood, chief economist at Chancellor LGT Asset Management, came to the same conclusion, saying that since 1993, the excessively high credit growth in Southeast Asian countries had partly been wasted through inefficient investment.
Greenwood noted the annual credit growth in the ASEAN four (Indonesia, Malaysia, Thailand and the Philippines) rose from 14 percent in 1993 to more than 30 percent in 1995.
He said even the dynamic economies of these countries could not have absorbed such a massive credit expansion without overheating: strong domestic demand growth, widening current account deficit and over-extended markets for equity and real estate.
So, their key advice is for Southeast Asian countries to increase the efficiency and productivity of their investment in order to narrow the gap between domestic savings and investment, which has been mainly responsible for their large current account deficit.
Further down the road, less dependence on foreign capital would reduce their vulnerability to currency volatility. An added benefit is that more productive capital investment would reduce the inflationary risk of high growth.
American financier George Soros, who also addressed one of the seminars here, voiced similar advice.
Soros, who has made tons of money from the international currency market, said financial markets are inherently unstable and international financial markets are even more so because capital flows are notorious for their boom-bust pattern.
"So, the best way to achieve (currency) stability is to mobilize domestic savings for domestic capital formation in an efficient fashion," Soros said.
Greenwood cited the promotion of many government-orchestrated projects of dubious commercial viability in Malaysia and Indonesia as examples of grossly inefficient investment.
Franklin noted that in several Southeast Asian countries where domestic savings have been abundant and capital flows significant, the temptation for politicians to funnel investment into pet, large projects and even to pick industrial winners is great.
The bottom line of these economists' analytical observations is that governments are making the mistake of plowing domestic savings into prestige projects when what is needed is increased investment in education to overcome the shortage of skills badly needed to develop industries of higher value-added products.
Sadly, though, the strong capital inflows from overseas so far had created an atmosphere of over-confidence, which resulted in excess investment in a variety of sectors, which now have to be cut back after the currency turmoil.