World Bank: Asia faces risk of long depression

The following article is based on a presentation made by Jean- Michel Severino, World Bank vice president for East Asia and the Pacific in a business conference on East Asia's financial and economic turmoil. The conference, organized by the International Herald Tribune was held in Melbourne on June 16. This is the first of two articles.

MELBOURNE: The most simple way that I could characterize what has happened in East Asia since last year is that obviously globalization has revealed flaws in the growth patterns of East Asian countries hidden over the past 20 years. I think there are three major types of problems that the economies ran into in past years that are clearly the roots for what we are seeing today.

The first type of problem concerns competitiveness issues. This is something that is rarely mentioned but is critical for us at the World Bank. What we have seen in the past years in many of the countries is a succession of bad sectorial choices and bad public investments compounded by negative currency developments relative to the U.S. dollar.

If one does not view the major structural industrial problems that countries like South Korea and Thailand are facing today, it is not possible to understand why the recovery of these countries requires a longer period of time than one would hope. These countries are caught in a sandwich -- between developed or near developed competitors at the top of the market and other newcomers to international competition such as China and Vietnam at the lower end of the market. They have to struggle and to fight a very, very tough battle to find their niche.

The second type of issue that these countries have been facing is the global problem of the governance and structuring of a capitalistic system.

Obviously the links between corporations, banks, the public sector and government have led to corrupt practices which have caused business and bank losses. An over-protected family capitalism in these countries has hampered the development of their capital markets which looked to borrow from overseas sources.

One must also remember that these countries have been some of the closest to allowing direct foreign investment. But as they welcomed foreign funding, they stymied foreign participation in the corporate sector.

Unfortunately, these countries mismanaged their financial sector and the timing of the opening of the capital account at a time when supervision, prudential regulations and general governance of the business sector was sadly lacking. And this leads me to the third set of reasons for this crisis: the management of globalization.

I think we should recognize that these governments opened their capital accounts too quickly at a time when their capacities and, I would say, even the political basis for such an opening, were not there. They also did not allow for the transparency and quality of management required in a very competitive environment.

Macroeconomic mistakes were also made. It is clear that sticking to pegged or fixed rates, or pegging currencies to the dollar at a time when domestic interest rates were higher than on the dollar market clearly created an incentive for overborrowing while not integrating the exchange rate in the economy.

I think it is important to outline these three sets of issues because they more or less define the agenda needed for the restructuring of these economies.

It must be admitted that this reform process will have a limited impact on the crisis in the short term. Structural reform will address long-term issues which will take many, many years. Restructuring the governance and supervision of the banking and corporate sector and adjusting to the globalization process is not something that can be done easily.

So, where are we today? Where are we in this crisis and where are we heading to? A straightforward answer would be that we are probably at the end of a first cycle of the crisis and are entering into a deep recession, or even a "depression". This may be longlasting if these countries do not manage it very, very carefully. I would like to make four points in this regard.

The first is that this depression was unavoidable. Since the beginning of the crisis, about US$115 billion has fled out of the five major crisis-torn countries -- Korea, Thailand, Indonesia, Malaysia and the Philippines. This amounts to about 10 percent of the GDP of these countries.

In addition to that, bank credits have also been reduced $88 billion, which is approximately another 8 percent of the GDP. This means that about 18 percent of the GDP of these countries has just vanished from their economies. This withdrawal of funds has had a tremendous impact and has been reflected in the region's stock markets and currency exchange rates. The shock of this impact will be felt for many months to come.

Such a situation should trigger automatic corrections from the depreciation of the currencies' exchange rates and from increased exports. Right now, we should see exports booming in Southeast Asia and South Korea, but they are not. They are actually increasing in terms of volume but not in the proportion which is to be expected considering the amount these currencies have been depreciating.

There are precise reasons for this. One reason is that there is no longer any growth in the entire region. Japan, the main engine of the region's economy, is experiencing a recession itself. The total amount of credits the Japanese banking sector disbursed to the region is worth 40 percent of the five crisis- torn countries' capitals. Given the vulnerability of these economies, this is a major problem for the Japanese financial sector. At the same time, 20 percent of Japan's exports are directed to these countries. Japan's export performance in these countries has been severely hit due to the sharp decrease in consumer purchasing power.

Similarly, between 15 percent and 25 percent of the five crisis-hit countries' exports go to Japan. Japan's recession, therefore, is a major reason behind their sluggish export numbers. But it is not only Japan that is the problem, it is the region itself.

Regional trade has been cut in half since the beginning of the crisis. This trade represents about 20 percent to 25 percent of the total trade of these countries. Therefore, lower consumer demand from each crisis-hit economy is affecting the exports of their neighbors. It is a vicious circle that these countries have found themselves caught in.

This is a major difference compared to the Latin American crisis when these countries could rely on a buoyant U.S. economy. Also, it was only a few Latin American economies that were experiencing problems, not the entire region. Here, we have a whole region in trouble at the same time, where it has been difficult to export from one neighbor to another.

Now my third point. On top of these problems, there has been a major drought in many of the economically troubled countries. Few people talk about it, but the impact of this drought on the performance of the rural sector has been very significant. In Indonesia, it has not only had an economic impact, but also a great social impact. Currently, there are pockets of starvation in the country, though it is not a general phenomenon. But the fact remains that Indonesia will have to import as much as 5 million metric tons of rice this year. This will weigh heavily on the state budget at a time when it is already at a breaking point.

The drought's impact is significant in an economic climate where growth rates are declining anywhere between 2 percent and 3 percent for the countries least affected by the crisis, and between 10 percent and 15 percent in the worst-hit countries. Such numbers do not reflect a minor adjustment, but a major recession and probably a depression in this part of the world.

This comes at a great human price. Huge numbers of workers are being laid off, while inflation soars. More are being forced into absolute poverty.

In Indonesia, for example, absolute poverty may double, canceling out one of the country's major achievements over the past 30 years.

Right now, as many as 20 million children in Indonesia are at risk. Many have already dropped out of school, and, if nothing is done to address the situation, more will follow in their footsteps.

But one should not only keep the social dimension in mind, but also the political aspects of this crisis. We must remember that the hungry can become angry. The magnitude of the social impact of the crisis will create more and more problems for the region's governments while addressing reform.

Although all the governments in the region are heading in the right direction and making the right policy decisions, each are under political pressure from the terrible human consequences of the crisis.

Window A: So, where are we today? Where are we in this crisis and where are we heading to? A straightforward answer would be that we are probably at the end of a first cycle of the crisis and are entering into a deep recession, or even a "depression".

Window B: In Indonesia, for example, absolute poverty may double, canceling out one of the country's major achievements over the past 30 years. Right now, as many as 20 million children in Indonesia are at risk. Many have already dropped out of school, and, if nothing is done to address the situation, more will follow in their footsteps.