Judging by the debate raging in Europe, there are only two options for fixing the problems of the eurozone’s struggling economies: austerity or growth.
The experience of the Asian crisis of 1997-98, however, suggests that this is a false choice. What happened back then is very similar to what is happening in Europe today: after relying on foreign investors to fund savings shortfalls during a period of loose credit and over-investment, that support has now evaporated, leaving the exposed countries to address their savings shortfalls internally.
Rebalancing has to happen one way or another, and the result is an inevitable decline in economic activity and deflation, according to a study by CLSA, Ten Asian lessons for Europe’s crisis, in which the broker has analysed data from Asia during the post-crisis years to establish how different approaches affected recovery.
One thing is clear: there are no quick fixes. “In making the adjustment people will suffer. They will lose their jobs,” said CLSA in the report, co-authored by Eric Fishwick and Ines Lam. “In the early years there will be more losers than winners, more people made poorer than are made richer.”
Compared to the adjustments in Asia after 1997, the peripheral European countries have barely started the process. Only Ireland looks like a country emerging from crisis, according to CLSA. Greece, Italy, Portugal and Spain are still running unsustainable current account deficits — at 9.8% of its GDP, Greece’s deficit is bigger than any of the Asian crisis countries in 1997.
“The imbalances in Asia were allowed to build because countries and investors had faith in currency pegs,” said CLSA. “In Europe people had faith that Greece and its creditors were using the same currency.”
CLSA reckons, with the benefit of hindsight, that Korea emerged strongest from the crisis in Asia — and that its experience demonstrates the scale of change needed in Europe’s periphery. David Cotterchio, CLSA managing director in Korea, recalled the degree of sacrifice: “The government asked people not to drive to save on the national oil import bill — they all stopped driving. They asked people not to buy imported goods — again that stopped overnight. They asked them to bring back into Korea (or out from under the mattress) any illegal or legal US dollar deposits and gave them assurances that they would not be prosecuted for doing so. People responded and the illegal and overseas-held money poured into the banks.”
“Korean people were not going to stand by idly and do nothing, they wanted and were compelled to chip in, in any way they could. The realisation had set in that the only way out of this would be for all people, rich, poor, private or public sector to give all they had to turn the country around. The streets were lined with people with signs calling for austerity and self-sacrifice as were the radio and TV airwaves.”
Having pored through reams of data and drawn on the collective memory of its staff, CLSA identifies 10 lessons for Europe.
1. Economic forecasts will be too conservative. Forecasts ahead of the Asian crisis grossly under-estimated the severity of the contraction, and then made similar mistakes about the speed of the recovery. “The Asian crisis shows that economic models, be they mathematical or heuristic, can be next to useless when the economy is pushed far from the ranges that the modeller has experienced.”
2. Countries don’t export themselves out of recession. Asian countries successfully turned their deficits into surpluses, but this was fuelled by a collapse in imports rather than a boom in exports — as the collapse in currency pegs made overseas goods too expensive. “The Asian crisis lesson is that export competitiveness doesn’t matter if a country’s credit system is broken.”
3. Imports will collapse, selling to crisis countries is bad business. Even Hong Kong, which maintained its currency peg and therefore avoided the rapid depreciation suffered in Thailand, eventually experienced deflation through a fall in local wages and profits.
4. Contagion will be worse and take longer than you think. Asset prices in Hong Kong didn’t come under pressure until more than a year after the baht was floated. It was successful in defending the currency peg because it convinced the market that it would go to any length to defend it. “The eurozone needs no less strong a commitment. The only immediate solution is the demonstration of absolute political conviction to the single currency.” Otherwise the market’s lack of faith will drag on for years.
5. Pegged or depegged you end up in the same place (but how quickly and how painfully?). During the crisis in Asia, currency depreciation (as in Thailand) or sticking with a peg (as in Hong Kong) had the same effect: a big contraction in economic growth, a hike in unemployment and a prolonged drop in consumer spending, among other things. Hong Kong’s experience was certainly less severe, but because the adjustment was made through deflating prices in markets that were slow to adjust — such as wages, consumer prices and real estate, instead of exchange rates — the rebalancing was gradual and prolonged.
6. Deleveraging is deflationary, even if achieved through currency weakness. This is an important observation for the eurozone countries. There is no way to deleverage without creating deflation “Irrespective of the course taken with the exchange rate, property prices will deflate quickly and be suppressed for a prolonged period of time.”
7. Focusing on real variables doesn’t work in deflationary environments. In Hong Kong during the Asian crisis, economists who focused on variables such as unemployment or real income growth expected a rebound in residential property prices as early as 1999. In fact, prices continued to fall until the end of the Sars outbreak in July 2003. “Investors will find that nominal variables will be more useful in forecasting than real. This is true of forecasting how households will behave and how profitable companies will be. In assessing companies it means a refocusing on margins.”
8. The credit environment and the investment environment matter most. Restoring health to the banking and credit system is paramount, which means aggressive action to tackle liquidity and solvency risk. “The Indonesian experience is critical in the eurozone context. Half measures, which erode the public’s confidence in a country’s ability to deal with a crisis, are as bad as doing nothing at all. And some problems are simply too large for individual countries to deal with. The eurozone needs an immediate supranational blanket deposit insurance scheme; national schemes are no longer credible.”
Only then can the process of recovery start. Korea’s growth rate in the five years before and after the crisis suggest that it did the best job of implementing the IMF’s supply-side reforms. Growth was 7.4% before the crisis and 6.7% after it. Malaysia, which was the second-biggest market in Asia in 1996, performed worst. Growth fell by almost four percentage points after the crisis and it remains uninvestable for many international investors even today.
9. Isolationism doesn’t work. The reason for Malaysia’s failure, according to CLSA, was the decision by Mahathir to reject the IMF rescue package and its associated austerity policies. “The economic history shows an economy in which private investment went from being an excessive (and imprudently funded) 32% of GDP to being barely there at all. Mahathir’s public spending projects were not even sufficient to keep Malaysia’s investment ratio at its 1998 level in the face of lower and lower private capex let alone restore pre-crisis levels.”
Exiting the euro would imply even greater isolation than Malaysia has forced on itself, with a correspondingly worse outcome.
10. It’s critical that everyone buys into the plan. The example of the Koreans demonstrates the level of commitment needed. Will Europeans be able to match it? “Seen from Asia, Europe’s biggest problem is that its people seem unwilling to sacrifice. Ask the man on the street in any Asian country about the eurozone crisis and the response will be the same: it will be difficult to resolve because Europeans are not used to saving.”
