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Asia’s Future and the Financial Crisis

The collapse of Lehman Brothers triggered a global credit shock that struck with surprising force in Asia. Before Lehman’s failure, many looked to the region as a bastion of economic stability. After all, Asia had high growth rates, large trade surpluses, and substantial foreign reserves. Its large companies were well capitalized and the books of its banks mostly free of the subprime loans and doubtful investments afflicting their Western peers.

Yet Asia couldn’t avoid the economic fallout from the troubles of Europe and the United States: the region’s stock markets plummeted, its currencies weakened, and its exports to the West slowed considerably. The impact of the crisis on the financial markets and real economies of Asia has largely ended speculation about its full “decoupling” from the West. The ties still bind. But the developments of the past few months reinforce our view that Asia should move more aggressively than ever to secure its economic future and improve its resilience in future crises. Asian governments must accelerate their plans to integrate regional economies—for instance, by boosting demand at home, speeding up intraregional trade and investment, and strengthening local and regional financial markets. Only through such initiatives can Asia hope to minimize the impact of future economic dislocations, whether they originate inside or outside the region.

Asia’s economies remain fundamentally sound. They will probably emerge from the global downturn more rapidly than economies in other regions will. Nonetheless, the crisis has exposed important linkages between Asia, on the one hand, and Europe and the United States, on the other. Asia depends heavily on external consumers: for example, in 2007, exports from Asian economies—excluding Australia, Japan, and New Zealand—reached a high of 45 percent of regional GDP, up a full ten percentage points since 1995.1 We estimate conservatively that Western consumers account for about half of these exports, including both direct exports and indirect exports through a growing intra-Asian reexport trade. Moreover, Western investors remain major players in most of Asia’s capital markets. Asian banks, except for those in China, are tightly linked to Europe and the United States through the interbank market and US dollar liquidity needs.

Increased exports to the United States played an important role in Asia’s relatively swift recovery from the 1997–98 crisis and helped China and India become economic giants. This time, however, US consumers, with their troubled mortgages and maxed-out credit cards, probably won’t provide much relief. Asia’s stock and bond markets have deepened significantly since the last crisis: the value of equity and debt markets in Asia, for instance, has soared to 140 percent of regional GDP, up from 50 percent, in the past five years. But along with this deepening has come significant foreign portfolio investment, representing, for example, 30 to 40 percent of the money invested in the financial markets of Hong Kong and South Korea. As margin calls came due and investors sold shares to cover severe liquidity needs in Western markets, capital fled Asia, battering regional equities. Moreover, as Western banks began to deleverage, reducing their $2.8 trillion of credit to Asia, dollar liquidity dried up, along with interbank markets and trade finance.

Although Asia’s foreign-exchange position has strengthened dramatically over the past decade, the sudden shift in foreign financing and the portfolio flows back to the West generated large exchange-rate shifts: currencies in India, South Korea, and other Asian economies depreciated significantly—by over 40 percent relative to the dollar in the case of the South Korean won. Adjustments of this magnitude caused significant losses on currency-hedging products, especially among Asia’s export-oriented small and midsize enterprises. Such losses, combined with the freezing of trade finance and other serious liquidity issues, began to force some of these companies into bankruptcy.

How should Asia respond? The answer will vary from economy to economy and sector to sector. China and India, with their large and growing domestic markets, will find it easier to weather the storm than will mature economies, such as Japan, or late developers, such as Vietnam. Companies in domestically focused industries, such as telecommunications and health care, will do better than those in export-driven sectors, such as electronics and consumer goods.

Nonetheless, choices made in Asia—the source of a third of global GDP—will play a crucial role in driving a global recovery.
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