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In the aftermath of the financial crisis in East Asia

24 August 1998

In the aftermath of the East Asian financial crisis, the world economy is on a knife-edge...unless the region switches from deflation to reflation, and European countries and Japan boost global demand for goods and services, there could be a full-blown global recession, UNCTAD warns in its Trade and Development Report, 1998 (260 pages), released today. Resolving a crisis of over-investment and systemic financial fragility by reducing domestic demand will only add to the difficulties. Justice is not served when the costs of market failure and measures taken to bail out creditors are paid by developing countries and at the expense of the living standards of ordinary people. This statement underlies novel proposals by UNCTAD to better manage financial crises (see TAD/INF/PR/9821).

The current Asian economic crisis is more serious, in terms of its scope and repercussions, than any other such crisis in the past three decades, and its full effects have yet to be felt. The cost of the crisis in East Asia is about 1 per cent of global output this year alone, or some US$260 billion, equivalent to the annual income of sub-Saharan Africa. Growth in the world economy is expected to be 2.0 per cent this year, a drop of 1.2 percentage points from the 1997 figure. Moreover there is a risk that further policy errors could drive the world economy into a deep recession.

Virtually the whole developing world is affected

The Report’s detailed analysis of world economic performance and prospects shows that developing countries as a group have so far been hit more severely by the consequences of the crisis than developed ones, although there are important regional variations. For the first time in many years, growth in the developing world will fall below that in the developed economies, to less than 2.5 per cent (half that of 1997). The slowdown has also reached China, where growth is unlikely to be much above 6 per cent -- about half its average growth rate since the beginning of the decade.

Latin America, having achieved in 1997 its best growth performance in a quarter of a century, is set for a marked slowdown this year to around 3 per cent. Even so, rising current-account deficits in a number of countries signal the region’s vulnerability to declines in capital inflows, and an even sharper contraction.

Africa should exceed last year’s growth of 3.3 per cent, but without matching the figure reached in 1996 and still well short of the 6 per cent growth target set by the United Nations to reverse the marginalization of the region. Vulnerability to commodity price shocks and weak growth in some of the continent’s biggest economies continue to raise concerns. The Asian crisis will directly affect a number of African countries with trade links to that region. Export expansion may also suffer from the indirect effect of the crisis on the continent’s major trading partners in Europe and North America. In addition, it is also not certain that the effects of the El Niño weather system on the African continent have worked themselves out.

South Asia has escaped the fall-out from the East Asian financial crisis because of restrictions on capital account convertibility in the major economies and more limited exposure to short-term foreign debt. Growth in 1998 should pick up given better weather conditions than those which contributed to slow growth in 1997.

These trends have been overshadowed by the tremendous swings in output in East Asia. The decline in output is expected to be over 12 per cent in Indonesia, 6 to 8 per cent in the Republic of Korea and Thailand, and 2 per cent in Hong Kong, China. Recovery in the region is not now expected for several years to come.

The picture for the developed economies is blurred

Growth accelerated in the United States last year while inflation continued to decline. However, the excess of private spending over incomes which has driven recent growth cannot continue. Just how quickly the economy will slow is difficult to predict. But, according to the Report, "a rougher landing than currently foreseen" is a distinct possibility.

Growth in Western Europe picked up in 1997, but with the exception of the United Kingdom, faster growth was driven by exports. While in 1998 France and some other European countries were beginning to experience growth based on internal demand, it is still expected that the Asian crisis will reduce both GDP and export growth in the European Union by over 0.5 percentage points this year. Moreover, the monetary policy of the European Central Bank cannot be expected to stimulate demand in the early stages of its operation. In the immediate future we can expect to see a strong Euro, deflationary pressures and persistent unemployment.

Japan entered recession in 1998 and growth is expected to be negative for the year. The recently announced fiscal stimulus package is unlikely to have a significant impact this year. Future success will depend on resolving structural weaknesses in the financial sector and reversing the decline in private spending. According to UNCTAD, this will require a fundamental rethinking by policy makers on the determinants of growth.

To date, Japan’s economic woes have prevented it from playing a more prominent role in the Asian crisis. But UNCTAD sees no reason why the country could not provide a large amount of external financing in the form of long-term lending.

Mixed prospects for the economies in transition

Some green shoots are now visible in Central and Eastern Europe, which is expected to register its second straight year of moderate growth since the beginning of the transition. The effects of the Asian crisis on most countries in the region have been limited. The Russian economy was expected to post its strongest growth this year since 1989, but fragility in the financial system and the effects of the 30 per cent fall in international oil prices may yet upset this forecast.

Trade contagion

Trade has been a key factor in spreading the crisis; the growth of world trade (in volume terms) will drop well below the 1997 figure of 9.5 per cent. Latin America, where on average 10 per cent of exports have been going to East Asia, is particularly vulnerable. In some countries, such as Chile, close to 40 per cent of exports have been going to East Asia. Moreover, almost 60 per cent of Latin American exports to the OECD markets are vulnerable to Asian competition. The figures are less threatening for African countries, but even here some countries, such as the Democratic Republic of the Congo, the United Republic of Tanzania and Zambia, have relied on East Asia for between a quarter and a third of their export earnings.

Commodity-dependent exporters have most to fear. The crisis in East Asia has been the single most important factor in the recent slowdown in commodity prices. Between June 1997 and April 1998, non-oil commodity prices fell by some 10 per cent, with particularly sharp falls for metals and agricultural products. Earnings losses in some commodity-dependent countries could amount to as much as 12 per cent of GDP.

The major industrial countries have to date gained more from declining commodity prices and improving terms of trade than they have lost from cuts in exports to Asia. However, the longer-term impact is likely to be less rosy. Prior to the crisis, global growth depended on expansion in the United States and East Asia, where large external deficits were financed by private capital inflows. Elsewhere, countries in the North were depending on export-led growth which would offset their tight fiscal policies. These disparities resulted in exchange rate instability and trade imbalances, surpluses in Europe and Japan being offset by United States deficits.

Placing the burden on the victims

The Report’s analysis of the social consequences of the crisis in East Asia finds that the burden is being unfairly carried by the poorest and most vulnerable sections of the community. Jobs have already gone in sectors that in the past reduced poverty by absorbing the low-skilled rural poor, notably the small and medium-sized enterprise sector. The effects of unemployment are compounded by rising food prices and falling social expenditures. The impact could even spill over to the next adult generation if primary school enrolments decline and child malnutrition increases. Even on conservative estimates, the proportion of the Indonesian population living on incomes below the poverty line in 1998 is expected to be at least 50 per cent greater than in 1996. Poverty in Thailand can be expected to increase by at least one third.

Safety nets can help the victims of financial instability. However, only a policy change from deflation to reflation can bring lasting improvements; lower interest rates, expanding liquidity and higher public expenditure can help reverse economic and social collapse, UNCTAD argues.

To date, the gravity and the novelty of this situation have not been recognized and pronouncements on the alleged structural weaknesses of the economies in crisis and on the need for further accelerated liberalization have actually made things worse. Current approaches to crisis management have turned a liquidity crisis into a solvency crisis, the Report argues. A fresh approach to managing international financial crises in general is thus called for. (see TAD/INF/PR/9821).

Global risks

Financial flows to emerging markets outside East Asia do not appear to be slowing. But the price has been high. Pre-emptive monetary and fiscal restrictions have been introduced to choke demand and to maintain market confidence. Moreover, many emerging-market currencies are now trading at all-time lows against the dollar. According to the Report, "The fruits of the hard work of the developing world, both assets and goods, are now going for a song". Investment in assets sold at fire-sale prices is not the basis for faster growth and a sustained rise in living standards in the South.

The worst-case scenario for the world economy is further bouts of financial instability in emerging markets, a correction of equity prices in major industrial countries, together with a sharp slowdown in the United States, tight monetary policy in Europe, prolonged recession in East Asia and Japan, and increased trade imbalances in the major industrial countries. This could tip the world economy into a deep and possibly prolonged recession; it could also mean a reappearance of serious trade conflicts.

Avoiding such an outcome depends on increasing the contribution of developed economies, particularly those of Europe and Japan, to world demand, as well as reversing deflationary policies in East Asia.

For more information, please contact:
Chief, Yilmaz Akyüz
Macroeconomic and Development Policies, UNCTAD
T: +41 22 907 5841
F: +41 22 907 0274
E: yilmaz.akyuz@unctad.org
Chief, Carine Richard-Van Maele
UNCTAD Press Unit
T: +41 22 917 5816/28
F: +41 22 907 0043
E: press@unctad.org.


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