Emerging Asia's sombre era

Some Asian tigers seem to be picking up nasty Mexican habits

"A MASSIVE current-account deficit, a crippling foreign-debt burden and excessive monetary growth encouraged speculators to attack its currency." Thus a description of Mexico before its financial meltdown in December 1994. But it could now sum up a number of fast-growing Asian economies. Thanks to economic woes and political turmoil, the currencies of Thailand, Malaysia and Indonesia have all been attacked this year. Could these economies be going down Mexico's way?
     The obvious parallel between these three tigers and Mexico on the brink is that they have large current-account deficits. Their governments are anxious to play down fears that they are heading for a balance-of-payments crisis--just as Mexico's did for most of 1994. Cynics could argue that such denials often prove excellent predictors of a crash. But can one be more precise about the indicators that might give an early warning of a Mexican-style problem in South-East Asia?
     Morris Goldstein, an IMF economist currently on leave at the Institute for International Economics, a think-tank in Washington, thinks so. Using lessons from Mexico's crisis, he has produced a list of potential danger signals. Our table on the next page draws on some of these to examine how five Asian economies today compare with Mexico in 1994.
     There are seven signals to watch for, starting with the one that Mr Goldstein thinks is most important:

A mismatch between short-term debt and foreign reserves. If investors are doubtful about a country's ability to repay its debts, they will be reluctant to roll over maturing loans. This was Mexico's Achilles' heel. At the time of its liquidity crunch, the country's foreign-exchange reserves covered only 20% of its short-term foreign debt. In the five Asian economies, the reserve cover is much higher, ranging from 73% in Indonesia to 186% in Malaysia. The second line of the table measures how many months' imports are covered by a country's reserves. This shows that the tigers also have plenty of ammunition with which to defend their currencies.

A big current-account deficit. Such deficits are not necessarily bad. It makes sense for emerging economies with profitable investment opportunities to import capital from richer ones. However, at some level a deficit becomes unsustainable. That depends upon several things. The lower a country's foreign debt and the faster its economic growth, the easier it will find financing a big deficit.
Worryingly, the table shows that Indonesia, Malaysia, the Philippines and Thailand already have larger foreign debts as a share of GDP than did Mexico in 1994. True, fast-growing Asian countries should be able to run bigger current-account deficits than more sluggish Latin American ones. But Mr Goldstein says the Asians are playing with fire if they continue to run deficits greater than 5% of GDP. Forecasts for 1996 suggest that Thailand's could be 8% of GDP (the same as Mexico's in 1994); Malaysia's may be even bigger, at almost 10%.

Investment or consumption? If a current-account deficit mainly reflects higher investment, which will increase an economy's ability to repay debt, it will be more sustainable than a deficit driven by consumer spending. In the four years to 1994, four-fifths of the increase in Mexico's current-account deficit reflected lower savings and increased consumption. In contrast, the widening of most of these Asian economies' deficits reflects higher investment, not consumption. In Malaysia's case, however, serious doubts remain about how much of its investment is truly productive. How, for example, will the fortune being spent on a new capital or ever taller office buildings boost economic growth?

A budget deficit. According to the "Lawson Doctrine", named after Nigel Lawson, a former British chancellor of the exchequer, a current-account deficit is a cause for concern only if it reflects a budget deficit. If, on the other hand, it reflects private-sector decisions about savings and investment, it is benign. Thailand, Malaysia, the Philippines and South Korea all have comfortable budget surpluses, but Indonesia is running a deficit, forecast at 2.4% of GDP this year. Mexico too had a modest budget deficit in 1994.

The composition of capital inflows. Is the current-account deficit financed by foreign direct investment (FDI) or flighty portfolio capital? The higher the share of FDI, the less vulnerable the recipient country is to sudden outflows. The table shows net FDI plus the current-account balance as a percentage of GDP. The more negative the number, the more dependent a country is on "hot" money. Malaysia, Indonesia, the Philippines and South Korea look better than Mexico did in 1994. Thailand, however, is even more worrying: virtually all of its current-account deficit is financed by short-term capital.

An overvalued exchange-rate. The more overvalued a currency, the greater the incentive for speculators to attack it. Most of these Asian countries' currencies are linked to the dollar. The recent rise in the greenback has therefore lifted their real trade-weighted exchange rates, but only by 5-8% over the past two years. Indeed, on most estimates of purchasing-power parities (PPPs, which equate the prices of a basket of goods and services in different countries), most Asian currencies are undervalued.
Our Big Mac index provides a crude guide to PPPs. It suggests that the Thai baht and the Malaysian ringgit are undervalued against the dollar by 20% and 36% respectively. And since the dollar is itself still undervalued against most other main currencies, this implies that the Asian currencies are still more undervalued against the yen and the D-mark. In contrast, in 1994 the Big Mac index suggested that the Mexican peso was perhaps 5% overvalued against the dollar.
This raises a paradox: how can a country run a current-account deficit if its currency is massively undervalued? For an answer, consider the United States, which has had a persistent current-account deficit despite widespread agreement that the dollar is cheap. Current-account deficits reflect a country's imbalance between domestic savings and investment, not the relative value of its currency.

Rapid monetary growth. This is especially dangerous if it inflates an asset-price bubble that then bursts, leaving banks with huge bad loans on their books. Like Mexico in 1994, several Asian countries have too much money sloshing around.
     In fact, there is no single figure that can accurately predict trouble. As the table shows, on some indicators these Asian countries do better than Mexico; on others they look just as bad; on a few, they look worse. So which of them is most likely to become Asia's Mexico? Malaysia looks dodgy on the basis of its current-account deficit, but it is saved by strong FDI inflows and reserves almost twice as big as its short-term debt. A second contender is Indonesia: although its current-account deficit is a modest 3.7% of GDP, its reserves are equivalent to only three-quarters of its short-term debt, which could leave it vulnerable.
     It is, however, Thailand that has more Mexican symptoms than the rest: a huge current-account deficit; a heavy debt-to-GDP ratio; rapid monetary growth; and a worrying dependence on "hot money" to finance its deficit. To be fair, it has some way to go before it develops the full Mexican disease. The country has a comfortable cushion of reserves, a healthy budget surplus, and its currency is undervalued.
     Nevertheless, Thailand's economic policymakers, and those of other emerging Asian countries, would still do well to remember that there is one more unwelcome difference between themselves and Mexico. If investors fled their markets, they would have no willing, deep-pocketed neighbour ready with a bail-out.

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