It is far from certaináwhether this monetary reflation will be sufficient to sustain a new bull market and boost economic growth in Asia. Global leading economic indicators, especially the US, are still falling, suggesting the economic slowdown still has some way to go. Crucially, it is uncertain how effective monetary easing will at easing the supply side pressure plaguing the global system.
Excess capacity, little profits
The current economic down cycle in Asia reflects more than just deterioration in the external environment. The region is still plagued by continued excess capacity, despite the strong growth reboundáof the past two years. This is due to insufficient reform despite what has been done. The Asian recessionáof 1997-98 did remove some economic excess, but oversupply remains.
Hence, investment efficiency remains poor. This can be seenáfrom Asia's marginal return on investment, which has not improved despite capital destruction during the regional crisis. Indeed, between late 1998 and early 1999, every one-unit increase in investment generated an estimated extra three to five units of output, compared with two to four units before the crisis. But the marginal output per unit of investment has dropped steadily towards zero since then, suggesting the surge in marginal output was only a temporary post-crisis cyclical rebound with little structural underpinning.
Over capacity has squeezed corporate profits. The narrowing gap between consumer price and producer price inflation indicates that profits have not recovered in Asia, due to continued erosion of pricing power that excess capacity has brought. Shrinking profits have led to a spurt of layoffs, especially in the tech sector, damaging consumer confidence and spending.
The Japanese drag
Weakness in Japan's financial system is another drag on Asia's growth and markets. Intense deflationary pressure is hampering JapanÆs restructuring effort, as vigorous economic workout will risk a vicious deflation spiral. The new accounting requirements for Japanese banks to mark their assets to market will debase asset value and force them to cut lending and sell cross-shareholdings. This could drive the Nikkei down, erode banks' capital base (which includes stocks) further and threaten their existence. A downward spiral for falling stock prices and credit contraction could develop.
With a dysfunctional banking system, interest rate cuts in Japan will be ineffective to boost demand, as banks are too shy to lend and the lack of confidence constrains credit demand. The yen will thus have to fall to generate an exogenous momentum via exports to achieve the monetary easing effect on growth. But a weaker yen will put competitive pressure on Asia and drag down the regional currencies.
A wobbling Japanese economy will also result in reduced demand for Asian imports. NE Asia is more vulnerable than SE Asia, due to its bigger exposure to Japan. Finally, Japan's financial fragility will reduce her capital flow, hence investment funds, to Asia. Even after the Asian crisis, Japan remains the second largest creditor to Asia, accounting for 21% of its total foreign loans, down from one-third before the crisis.
New dynamics
Thus, there will continue to be a downward bias for Asian interest rates and currencies, despite further US rate cuts. Tighter money does not necessarily support the currency market anymore. Korea refused to cut rates recently, but the won has continued to slide. On the other hand, Taiwan cut interest rates before the Fed's first rate cut on January 3, but the New Taiwan dollar has risen since then. The Fed also cut rates twice in January, but the US dollar has not weakened. Similar situations are alsoáoccuring in some Latin America and Eastern European centres.
These unconventional currency moves suggest that the dynamics between monetary policy and currency markets has changed. Growth is tough to come by under deflation. Hence, any policy that promotes growth and facilitates economic reform will attract investment inflow and benefit the currency of the corresponding country. In a dis-inflationary environment, real economic variables, such as earnings and real interest rates, determine exchange rates and asset markets, because the price extraction problem stemming from rising inflation that distorts investment decision is kept to a minimum.
The badly needed structural reforms are a dynamic process to piece together economic and asset market growth and capital flows to restore investor confidence in Asia. The Fed's rate cuts alone may be less effective in Asia's excess supply environment, but the resultant global reflation does improve the macro backdrop for economic retrenchment. It is up to Asia to grasp the opportunity to reinvent itself. Asian economies that combine interest rate cuts with reforms, such as China and Hong Kong, will see their markets perform relatively better than others that fail to catch the opportunity that global reflation provides.
Chi Lo, regional head of research (NE Asia), Standard Chartered Bank Global Markets, Hong Kong.
