Is Asia Out Of Luck?

Its rebound is built on good fortune, not reform. Now, it may pay the price

Asia's politicians and tycoons like to claim credit for the region's remarkable economic rebound since the horrifying summer of 1998. And to be sure, domestic policy and private-sector dealmaking both have played an important role.

But in truth, many East Asian economies have owed much of their surprisingly speedy recoveries to a confluence of lucky breaks in the global economy. Sharp interest-rate cuts in late 1998 by Western central banks helped tremendously. So did the surging Japanese yen. There also was the unexpectedly strong boom of the import-hungry U.S. economy and a feeding frenzy for technology stocks that sent equity capital gushing into New Economy industries from Hong Kong to Tokyo.

Slowly but steadily, however, that glowing external environment has turned several shades darker. And the implications for Asia's nascent recovery could be troubling. The big wake-up call, of course, was the mid-April market bloodbath in the U.S. The plunges in Asia's bourses, ranging from a 7% drop on Tokyo's Nikkei to 11% on Korea's tech-heavy Kosdaq, are sending a stark signal that the region's prospects depend heavily on America's ability to engineer a soft landing for its overheated economy. At the same time, rising interest rates in the U.S. could put upward pressure on Asia rates and sharply raise the cost of foreign capital.

It is hard to imagine a reprise of 1998, when every major Asian economy, except for Taiwan and China, fell into recession. But it's not out of the question that growth could again stall. The reason: Most of the region's governments and corporations have not made full use of the past three years to root out all of the structural rot that brought their economies down in the first place.

The cancer is endemic to much of Asia. In South Korea, producers of everything from computer memory chips and telecom gear to cars and ships have used a booming stock market to raise cheap capital. But they have made glacial progress in unwinding a combined interest-bearing debt load of $554 billion, or 1.4 times gross domestic product. And Korea's banks remain a mess.

The same goes for Indonesia and Thailand, where many key industrial conglomerates are in operation only because they have refused to repay bankers and can't be forced into bankruptcy. The recent growth from China to Malaysia has largely been fueled by heavy public spending on everything from dams to telecom networks to highways. Meanwhile, in India and Japan, debt is swelling to ever more scary levels. Japan's public debt is expected to reach 120% of GDP, and its budget deficit will rise to 10% of GDP.

The signs are mounting that the easy phase of Asia's recovery has passed. China had hoped to offset declining foreign direct investment--which in 1999 fell by $5 billion, to $40 billion--by listing state-owned assets in the U.S. and Hong Kong. But the disappointing Wall Street listing of PetroChina Co., which on Mar. 31 raised only $2.9 billion of an expected $4.9 billion, shows that the appetite for China plays has waned. As a result, Beijing has had to delay the initial public offerings of state-owned China Petrochemical Corp. and Baoshan Iron & Steel Corp.

While much of the growth in China has been financed over the past two years by domestic banks, the same is not true in the rest of the region. Stock markets have largely displaced lenders, as well as bond investors, as the biggest source of fresh capital. According to Washington's Institute of International Finance, flows of foreign bank credit to Asian emerging markets continue to contract. But portfolio investment leaped tenfold, to about $40 billion, since 1998 and should hit $59 billion this year. Trouble is, that money can gush out as quickly as it gushes in.

The reversal of such bellwether Asian Internet stocks as Japan's Softbank Corp. and Hong Kong's Pacific Century CyberWorks, both down over 50% from recent highs, could make it harder for other startups to lure capital. Fred Hu, chief economist at Goldman, Sachs & Co. in Hong Kong, says foreign venture-capital firms are getting bearish on Asian Net plays. "Startups that could easily get capital before will now have a more difficult time," he says.

That could dampen high hopes in Japan, South Korea, Hong Kong, and Singapore for an investment boom led by information technology. Toshiba Corp. CEO Taizo Nishimuro, who has announced plans to invest $3.3 billion yearly in research and development for info-tech products, concedes that he might throttle back if market mayhem causes the "U.S. and world economy to fall into a decline."

Could that happen? According to the International Monetary Fund, the worst-case scenario is a 25% correction on Wall Street that pushes the U.S. into a mild recession in 2001. Most are betting that U.S. Federal Reserve Chairman Alan Greenspan can keep that from happening. But shaving even 1% or 2% off U.S. economic growth would make a critical difference to China and Japan. Apart from heavy state spending on infrastructure, much of China's growth came from exports, 40% of which go to the U.S. That's also true of Japan, which sends 30% of its exports stateside, Thailand (25%), and Korea (20%).

What's more, the medicine the Fed is applying could be painful for Asia, too. To engineer a soft landing, the Fed has hiked the overnight lending rate, the key benchmark for short-term rates, five times, to 6%, since June. That really hurts in Hong Kong, where the dollar is pegged to the greenback and a deflationary environment has pushed real interest rates to nearly 13.5%. In coming months, the price of money in Hong Kong likely will go even higher.

Of course, higher U.S. rates also could cause the dollar to rise against the yen. That would be good for Japanese exporters but bad for the rest of Asia. In 1996, just before the financial crisis, a cheaper yen helped prompt a sharp slowdown of exports from South Korea, Thailand, and Singapore.

Few observers see it turning out that way if things get ugly in America. That's because the U.S., with a current-account deficit roughly 4% of GDP, is heavily dependent on foreign capital to cover its low savings rate. According to the IMF's worst-case scenario, a Wall Street crash would send foreign investors fleeing and trigger a 20% devaluation of the dollar against the yen and other major currencies.

Then again, Japan might be tempted to help its exporters by engineering a weaker yen. The central bank has been under pressure from politicians to use monetary levers to secure the anemic recovery. Interest rates already are as low as they can go. So the Bank of Japan might crank up the printing presses and thus weaken the currency.

The gloomy scenarios may not come to pass. But Asian governments risk economic and social calamity if they continue to balk at healing sick banks and embarking on heavy-duty corporate restructuring. They can't count on lucky breaks forever.

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