To reach this objective they stored up cash. Many governments built up ôlarge protective buffersö against the balance of payment shocks that had put them under so much pressure in the late-90s, says Subir Gokarn, chief economist for Asia-Pacific at Standard and PoorÆs, in a report published in early November. Basically, they created war chests of accumulated foreign exchange reserves, by absorbing their current and capital account surpluses. As a result, ôhealthy foreign exchange reserves are likely to buffer most Asia-Pacific economies during the (current) global slowdownö.
And despite foreign investors leaving regional equity markets in droves, as they either unwind yen carry trades and deleverage, or simply switch into the ôsafe-havenö of US Treasury securities, the drain on reserves hasn't been that severe.
Among the emerging economies in Asia, Vietnam has suffered the biggest fall in foreign exchange reserves û they now amount to almost 15% less than the 2008 peak û and among the developed economies New Zealand has experienced a 25% decline. The falls in China, Hong Kong, the Philippines and Taiwan have been non-existent or negligible.
Gokarn argues that one reason why the reserves have not declined more is that the region's emerging economies typically used the capital outflow to allow their currencies to depreciate, which meant they could offset the sharp appreciation that most of these currencies experienced in 2007.
He points out that AsiaÆs growth during the past 10 years has made it an ôattractive destination for global investment flows that have been, in turn, facilitated by capital market reforms in many of these countriesö. Large current account surpluses and net positive capital inflows would normally have put tremendous appreciation pressure on the regionÆs currencies û and made them exposed to a rapid depreciation if and when conditions changed.
Restraining currency appreciation
Twin surpluses should have put upward pressure on their currencies, but the authorities sold them and then sterilised the excess domestic currency in their financial systems to avoid monetary instability by issuing shorter-dated central bank bonds.
The depreciation has been particularly sharp since August 2008, when outward capital flows rose significantly. Six months ago, economists worried that any depreciation of domestic currencies might reinforce inflationary pressures due to rising commodity, oil and food prices. But, of course, the subsequent dramatic decline in these prices means that is not an issue now.
Comparisons have been made with the 1997-1998 crisis, although the problems then were largely home-grown whereas today the region is suffering from a deleveraging, liquidity drought and credit contraction that originated in the US and Europe. This contagion, which largely rebuts the de-coupling argument posited by some economists at the beginning of the year, has been exacerbated by a much closer integration between the financial systems worldwide.
The recurrent debt and currency crises associated with sudden withdrawals of Western money led to a rethinking by governments in Asian countries, inspired largely by China. In the past theyÆd followed orthodox thinking by borrowing from wealthy nations to finance domestic investment and drag their populations out of poverty. But China insisted that foreign capital should be injected as direct investment. Rather than simply providing debt to fund industrial development, the Chinese persuaded foreigners to build factories that couldnÆt suddenly be up-rooted when confidence slipped.
Financial imbalances
Paradoxically, it has largely been re-routed Chinese savings which have financed much of ChinaÆs investment. Cash from household savings or corporate retained profits have been lent to the United States, fuelling that countryÆs consumer spending boom, and have then been channelled back to China as export earnings.
To ensure that its exports stayed cheap, China has kept the renminbi from appreciating beyond a prescribed rate by buying billions of dollars in world markets. Today China has foreign exchange reserves of more than $1.9 trillion and has surpassed Japan as the biggest holder of US treasury securities. Other Asian countries have adopted a similar strategy. For example, India entered the current crisis with around $300 billion of foreign reserves, which provide a comfortable level of ôself-insuranceö against capital flight.
This has led some commentators, such as the economic historian Niall Ferguson, to argue that these ôfinancial imbalancesö are the main cause of the excesses that produced the current crisis. Asia kept lending and the US (and Europeans) kept borrowing. The Asian savings glut supported a surge of consumer and corporate leverage, funding hedge funds and private equity firms, and of course, the US mortgage market which fuelled the rapid growth of derivative instruments.
Nevertheless, as Gokarn says, ôit is now evident that for almost all the region's economies those handy reserves have allowed countries to avoid a potential balance-of-payments meltdown, especially as the flow of capital has reversed so sharply in the past few monthsö.
Whether this will hold true for the future is another matter. There is a standard Greenspan-Guidotti rule that says that reserves should cover external debt falling due within one year û but that is insufficient when foreign borrowings by private companies and overseas holdings in equity markets are taken into account. Also, debt coverage can soon disappear.
Korea, for instance, had about $240 billion of reserves û the sixth biggest in the world û at the beginning of November, which easily covers the $80 billion of short-term debt owed and even exceeds the $235 billion total external loans owed by Korean banks. But the central bank has been spending up to $280 million a week to inject liquidity into the countryÆs banking system, and in the first six months of the year, net foreign direct investment turned negative for the first time since 1980 as investors pulled out a net $886 million, according to the Bank of Korea.
Spending the reserves
ôFor Asia, the problem is not inadequate foreign exchange reserves,ö says TJ Bond, Asia economist at Merrill Lynch. ôIt is uncertainty about how existing reserves will be used to meet maturing debt obligations and foreign sales of domestic assets.ö Already, however, some of that uncertainty is being resolved.
Transparent foreign exchange intervention and currency swap agreements between the US Federal Reserve and Korea and Singapore worth $30 billion each have helped. Plus, regional currency swap agreements between 13 Asian countries (led by China, Japan and Korea) have created a pool of foreign exchange reserves to be tapped to protect their own currencies û an extension of the 2005 "Chiang Mai Initiative". The deal allows them to lend each other money at favourable terms if help is needed to stabilise exchange rates.
Capital controls restricting resident capital flight might also be an option. This was the approach taken by Malaysia a decade ago which protected the country from the worst of the crisis which afflicted other Asian economies.
But another problem is that by building up foreign exchange reserves by promoting export earnings through a competitive exchange rate, Asian economies make themselves vulnerable to growth slowdowns in the countries they export to.
On the other hand, although currency depreciation wonÆt help exporters as economies throughout the world fall into recession, they should be able to take advantage of any eventual recovery in consumer spending in major export markets.
Certainly, intraregional trade has lessened the export dependence on the US over the past decade, as richer Asian countries have proved increasingly significant markets for Asian exports. But, this affluence has had a cost which would make the region especially vulnerable, had it not been for policies introduced to prevent a repeat of the devastation that afflicted the region at the end of the last century.
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