An ancient tale recounts the experience of a cat that is scalded with hot milk while still a kitten, and lives its life without ever tasting milk again. In the aftermath of the Asian financial crisis, regional authorities vowed that they would never again place themselves in a disadvantageous position with respect to foreign hot money, typified by avaricious hedge funds that were castigated for currency manipulation by many a leader.

The result of the crisis, which has yet to fully reverse itself when one looks at various indicators of credit-worthiness, has ironically been for Asian governments to emerge as the leading currency manipulators in the world, bringing in their wake a new financial crisis that threatens both America’s heartland and their own exporting industries.

In a series of recent articles, I wrote about the social impact of government manipulation on the economies of India and China [1], which are related to the issues of planned economies and currency manipulation [2]. The issue at hand is that being over-eager to manipulate currencies for the benefit of their exporters, even the two largest and fastest growing of emerging Asian economies are unable to provide enough economic growth for their underclass.

There is nothing to boast about having US$200 billion in reserves (India) or indeed more than a trillion (China), when basic infrastructure such as water and roads is lacking (India) and poor people still leave the country illegally in shipping containers in search of a better life (China). Perhaps the Indian government frets that if it provided roads and ports, its poor will also find their way into shipping containers as economic refugees even though that doesn’t explain why so many Indians still have no access to clean drinking water.

Southeast Asia

For those who came in late, the Asian financial crisis in 1997 was caused by significant current account deficits in Asia, that were almost entirely funded by short-term flows from banks, hedge funds and similar investors who were keen to grab the high interest rate differential on offer between the bonds issued by Group of Seven countries such as the United States and those issued by Asian banks. The underlying logic was that so long as Asian currencies remained stable against the US dollar, one could capture a substantial premium for essentially no risk of losing money.

However, as money flows accelerated and Asians started taking higher risks, there soon emerged an unsustainable gap between the maturity of assets and liabilities for Asian companies, and in turn, their governments that had either fully or partially guaranteed the banking system that was facilitating such transfers of money. Eventually, smart investors worked out that the risks were actually higher than returns, and initiated a series of attacks on Asian currencies with a view to forcing the governments to allow them to depreciate.

The countries at the epicenter of the Asian crisis were of course those of Southeast Asia, which is not surprising given that hedge funds first focused on pushing the Thai baht away from its unsustainable peg to the US dollar. Indonesia was the next country to be hollowed out, although most of the damage was done by locals as compared to foreigners.

That being so, it is also true that it was the resolute action of Malaysia to establish a new peg along with capital controls in 1998 that helped to reverse the tide from the Asian crisis and eventually usher in a stable macro-economic environment. Most observers though quibble about giving Malaysia any part in the turnaround, instead preferring to focus on Hong Kong’s intervention in its stock markets around the same time, as the action that broke the back of many hedge funds.

Whoever takes the credit for the reversal, it is perhaps beyond argument that Southeast Asia’s economic growth has generally lagged behind the rest of Asia in the past 10 years, as officials have focused on retaining stable currencies at the expense of pursuing higher economic growth. This comment will probably strike the officials as counter-intuitive as they still believe that the path to economic stability lies with exports despite the patent inability of such countries to compete with China in manufacturing or India in services.

A variety of factors, including language and education, have prevented Southeast Asian countries from moving to higher value-added products, such as what Japan and more recently South Korea have achieved. To a large extent, the dysfunctional set up of ASEAN itself is to blame, [3] as the main promise of economic co-operation has been realized in an overly staggered fashion that has done nothing for improving the competitiveness of local industry. In turn, that left many sectors such as textiles and auto parts too small and specialized thereby disallowing any advantage as Chinese manufacturers improved their product profile and production efficiency.

Allowing their countries to focus on areas of competitive strength, namely higher value industries, tourism, design and technology, logistics and other related businesses would have allowed Southeast Asia to emerge stronger than it currently is. Of course, that process also would have caused more painful structural reforms of the kind that Malaysia [4] has consistently eschewed in the name of illusory social cohesion. By freeing up the currency and domestic ownership constraints that allow its entrepreneurial Chinese minority to flourish, Malaysia could have easily added many percentage points to its overall economic growth in the past ten years, instead of playing second fiddle to Singapore on services and Indonesia on manufacturing.

Pointless reserves

Asia has accumulated significant reserves well above what is strictly required, because of enduring fears about being found short of money to repay debt ever again – the scalded cat argument. As most of the countries, with the significant exception of the Philippines, do not have any external debt to speak of anymore, the problem has become one of currency peg maintenance that displays the utter lack of imagination of the ruling elite in these countries.

These foreign exchange reserves are used to buy assets in developed countries, but are mainly deployed in bonds. Returns being earned on such holdings barely compensate Asian central banks for even the managed depreciation of the US dollar against their local currencies, let alone the opportunity cost of investing such proceeds more productively in their own economies or indeed, those of neighbors. For example, Asian central banks do not invest significantly within the Asian region, due to self-imposed constraints on credit quality requirements. In turn, this has prevented the development of a strong bond market in Asian currencies that has perpetuated the vicious cycle of having to invest purely in “hard” currencies such as the US dollar.

The rule of the markets is that no good deed goes unpunished for very long. True to form, the excessive investments in America and Europe have engendered over consumption in the case of the former that now stands to collapse sharply as the housing debacle reaches its crescendo. As millions of Americans find that they cannot afford even mortgage payments on their houses, they will default – but the American financial system will not have to pocket the losses as the risk has already been sold down to Asian central banks in the form of mortgage backed securities.

Thus, the release of excess liquidity into the American economy that caused locals to borrow too much money will come around full circle to hurt Asian lenders. The circle can be stalled for some time by continued intervention, but eventually it will have to obey the law of gravity. House prices are falling everywhere in America now, and this combined with rising interest costs will create a painful recession. Painful for creditors, that is : ironical given that the Asian financial crisis was more painful for borrowers rather than the lenders.

Thus Asia finds itself in the unenviable position of having to take losses on billions of dud securities issued by American companies and individuals in months to come. If any central bank chooses to take action now and sell down its holdings of American and European bonds, it risks setting off a panic sale by compatriots around the region. I assume that any central banker who initiates such an action can kiss his invitations to major golf tournament a firm goodbye.

A conspiracy of inaction thus rules the corridors of Asian central banks even as their citizens toil outside in sheer ignorance. If that’s called progress for 10 years, you can keep it. [4]

1. Pork-barrel politics ATol, June 16, 2007.
2. Pegged problems ATol, May 25, 2007.
3. Mid-life crisis for ASEAN ATol December 16, 2007. 4. When progress is against the law ATol jue 2, 2007.