East Asia must beware of equity trap?

By Dr Bharat Jhunjhunwala

NEW DELHI (JP): The Asian Development Bank has asserted that the deteriorating external payment situation among the Asian Tigers "need cause no alarm about an impending Mexico-like crisis". Maybe. Nevertheless, the very fact that such a statement had to be made is sufficient proof that such a danger does indeed exist. The fact that these countries continue to attain unprecedented high rates of growth at the present does not eliminate such a possibility because, after all, it took 20 years for the Mexican crisis to manifest itself.

Let us examine what Asian Development Outlook, 1996 and 1997 said about the four major economies of the region. The gross domestic savings in China was 42.2 percent of the gross domestic product (GDP) in 1995. This was more than adequate to meet the entire gross domestic investment of 39.5 percent and budgetary deficit of 1.2 percent. Why then the need for the massive foreign investment inflows of US$34 billion? And where did that money go if domestic savings were available in any case?

The explanation is interesting. The bank said that the true deficit was close to 8 percent as much of the government spending was through loss-making public enterprises. What has happened is the following. The government is unable to contain the hidden subsidies to these public enterprises and a good share of the domestic savings are being absorbed for meeting their losses.

This leads to a shortfall in the availability of savings for domestic investment, which is, in turn, met by foreign direct investment (FDI) inflows. In other words, FDI is providing the funds for financing the losses of the public enterprises rather than for incremental investments in the economy.

The inflationary pressures in Indonesia are building, in part, at least, due to the heavy increases in the wages of government servants which, the bank said, "could put upward pressure on private sector wages as well". These wage increases are, on the one hand, fueling a consumption boom and, on the other, eroding the competitiveness of their exports. Consequently imports rose by a whopping 40 percent between 1993 and 1995 while exports only by 22 percent. The outflows on account of profit repatriations, interest and other service charges is also increasing.

As a result, the external current account balance is deteriorating sharply: up to (-)4 percent of the GDP in 1995 from (-)1.3 percent in 1993. This external account deficit is being financed by foreign investments. In other words, the FDI is providing the funds for financing (1) an import-driven consumption boom; and (2) FDI profit remittances. It is like borrowing yet more to repay interest on loans taken earlier.

Easy availability of commercial credit stimulated private consumption in Malaysia, reports the bank. The growth rate of private consumption almost doubled to 13.7 percent in 1995. This, combined with import liberalization, "resulted in acceleration of import growth to 31 percent in 1995. With imports expanding faster than exports, the merchandise trade account moved into a deficit for the first time since 1982."

This external-account imbalance was compounded further by substantial outflows of FDI earnings -- $6 billion in 1995 -- marginally higher than current FDI inflows of $5.9 billion. In other words, current FDI is providing the funds for private consumption and meeting the requirements of profit remittances, much like Indonesia.

In Thailand, there was a substantial increase in domestic demand of consumption goods fueled by a rise in agricultural incomes and salaries and wages. The consumption boom lead to a "secular decline in household savings".

These "rising labor costs are already leading to a loss of competitiveness vis-a-vis labor-rich countries," said the bank. The result has been that imports at $61.9 billion in 1995 were higher than exports at $55.4 billion and rising faster by about 4 percent. The external current account was deteriorating. FDI inflows had also started faltering -- down to a measly $640 million in 1994 from a high of $2.4 billion in 1990. Thus, unlike other Tigers, Thailand does not seem to even have the option of financing current consumption by current FDI inflows.

This is the story of the four largest economies of East Asia, as reported by the bank. It has all the ingredients of the Mexican crisis; namely, a consumption boom, liberalization of consumer imports, expanding burden on account of profit remittances and a deteriorating external current account balance.

This external deficit is being financed, for the present, by FDI inflows. With export performance coming under stress, the alternative of meeting this deficit by improved performance of that sector is not available to these countries. They have only one option -- attract yet more FDI to meet their deteriorating external balance.

This is precisely what happened in Mexico -- a consumption boom, liberalized consumer imports, declining exports and increasing debt-service burden. The party went on as long as bankers were willing to extend further loans to meet the debt- service obligations on earlier loans. But the balloon burst as soon as such credit became inaccessible. The Asian Tigers are facing an almost identical situation. As long as current FDI continues to flow the crisis will be contained but the bubble will burst as soon as such flow ebbs.

There are two crucial differences in the Asian case. First, they have high rates of domestic savings. This may indeed enable them to service the FDI profit remittances better than Mexico. But that does not obviate the fact that these remittances will nevertheless eat up greater share of the same. Just as the oil revenues did not suffice to prevent the debt crisis in Mexico, higher savings may not prevent these countries from falling into an "equity trap".

Second, FDI is allegedly more productive-investment oriented than debt which suffered from problems such as capital flight. This too is suspect for four reasons: (1) much of the FDI in these countries is of the intrafirm nature and is susceptible to price manipulation; (2) FDI is susceptible to inflation of capital costs; (3) very often, the FDI lacks local linkages -- production is from imported raw materials, for foreign markets, thus the multiplier is weak; and (4) the flexibility of profit remittances cuts both ways -- it can become a vehicle for transmitting high remittances unlike debt where such service burden was fixed. Therefore, despite these differences the Tigers may not fare much better than Mexico, after all.

It is unfashionable in these days of FDI hoopla to raise doubts about the Tigers, who, with consistently high rates of growth in the last decade, have succeed in bringing down their levels of poverty substantially and are being touted as examples for all the developing world to emulate.

One should not forget, however, that a similar hoopla had accompanied the debt-financed growth of Mexico in the 1970s. Why, then, is the 1990s being called the lost decade? The problem is that the long term ill-effects of any foreign-financed consumption take time to appear.

It took two decades for the bubble to burst in Mexico. Let the other developing countries, therefore, not blindly emulate the Asian Tigers but seek growth by promoting better utilization of their own savings and curbing consumption rather than encouraging it.

The writer is a columnist based in New Delhi.