Asia's Big Chill

Caught between Japan's weak-yen policy and the steep U.S. downturn, the region's fragile economies may see their recent gains swept away

The move was certainly a startling about-face for the Bank of Japan. On Mar. 19, the central bank announced a return to the zero-interest-rate policy it abandoned just last August. Now, the BOJ says it will massage the money supply to slay deflationary dragons that threaten to push the world's second-largest economy back into recession. The idea is to utilize money-market instruments and government bonds to push Japan's steadily eroding consumer prices back above the waterline. Will it work? Probably not, unless it is accompanied by serious restructuring of Japan's debt-laden banks and inefficient corporations. What the policy will mean, though, is even more downward pressure on the yen, a policy Washington seems to have accepted. The result: cheaper Japanese exports.

The U.S. is clearly worried about Japan falling into a catastrophic slide. But Washington may not have a clear view of another huge problem: How decisions in Tokyo could undermine the precarious economic state of other Asian nations. In South Korea and also in Southeast Asia, the export-led recovery of the past two years is starting to slow because of the downturn in the U.S. economy. Growth in Korea, Thailand, Malaysia, Singapore, and Indonesia is expected to slow this year to between 3% and 4%.

CHINA CARD. The last thing these economies need is to compete for a dwindling export market with a Japan now reliant on a weaker yen. Already, the optimism that buoyed Asian executives and policymakers after the financial crisis of 1997-98 is reverting to long-term pessimism. "The decades before the crisis were a unique period of Southeast Asian growth," says Chumpol NaLamlieng, president of Siam Cement, Thailand's largest maker of construction materials. "Now," he says, "I don't think the region is conducive to fast growth."

It's easy to see why Chumpol is pessimistic. Many of the economies of East and Southeast Asia are reeling from a triple blow: First, the U.S. slowdown is putting a dent in the exports that have kept Asia going since the crisis. Second, Japan is yanking investment from the region, and now there's the yen threat. Finally, China is soaking up a growing slice of foreign investment, a trend that will accelerate once it enters the World Trade Organization.

No one predicts a reprise of the 1997 meltdown. Thanks to three years of brisk exports, Asia has a pile of hard currency. And it no longer has mountains of short-term debt. But you don't need a crash-and-burn crisis to harm a fragile region. Fact is, Asia cannot prosper on growth of 3% to 4%. Its struggling democracies require high-speed development to thrive--perhaps even to survive.

Just take a look around the region. In Korea, the government is still trying to stave off the collapse of several corporate giants, among them the Hyundai group. In Thailand, a populist Prime Minister is moving ahead with a bank bailout that may bust the budget. Next door, in Malaysia, some of the currency controls instituted during the crisis remain in effect. As for Indonesia--well, what is not wrong? Guerrilla warfare, government scandal, policy drift, and shattered relations with the International Monetary Fund. And did we mention the banking morass? Problem loans still make up 20% or more of the portfolios of the banks in each of these countries.

The worst-case scenario is a prolonged period of slow growth and stagnation for a region that for the better part of two decades outperformed the rest of the world. The hard-won gains that have lifted tens of millions of Thais, Malaysians, and Indonesians out of poverty since the 1970s could grind to a halt--or even lurch into reverse.

And there are signs that Japan-style deflation could infect the region. Indeed, thanks to falling prices, much of the post-crisis recovery is illusory. While output was surging, the prices of goods being shipped to the U.S. were falling by as much as 20%, according to Chen Zhao, chief emerging-market strategist for Montreal's Bank Credit Analyst Research Group. At the same time, he estimates, corporate profits are still 75% below pre-crisis levels. So it has been profitless growth, meaning companies haven't been creating the wealth required to invest in facilities and technology. "They're chasing their tails," says Chen. With U.S. demand falling, a glut of inventory has built up around the world. That means prices for everything from consumer electronics to computer chips will continue to fall.

The fate of the region hangs largely on what happens in Japan and the U.S. over the next few months. In the best of all worlds, the U.S. would pull off a V-shaped recovery before yearend and lift Asia with it. On Mar. 20, the Federal Reserve slashed its official discount rate by half a percentage point in an attempt to kick-start the U.S. economy. Unhappy investors hoping for a steeper cut drove markets down.

Even if rate cuts, tax cuts, and other measures begin to turn the U.S. around, few expect America's appetite for Asia's high-tech exports to revive quickly. That's because of the global glut and because U.S. repairs will take time to translate into new spending. President Masayoshi Son of Tokyo's Softbank Corp. believes high-tech stock market woes--and, by extension, IT spending plans--won't hit bottom for "at least 18 months or more."

"SURVIVAL." That's harsh news for Asian tech exporters--especially the South Korean chaebol. Consider Hyundai Electronics Industries Co., the world's second-largest memory-chip maker. Burdened with $6.2 billion of debt, it is unlikely to sidestep a liquidity crunch unless semiconductor demand revives. Says Lee Son Seok, marketing manager at Hyundai Electronics: "We are making contingency plans for survival."

The weak-yen policy poses additional dangers. The Japanese currency fell 12% in 2000 and has fallen a further 5% this year. If the yen tumbles too far too fast, it could deal a blow to world markets. In the rest of Asia, a cheap yen could undermine the competitiveness of local industry. Nearly half of Korean exports--including chips, telecom equipment, and steel--compete head-on with Japanese goods.

Of course, other Asian currencies are falling, too: The Korean won was down 3.5% in March, the Thai baht about 2.2%, and the Indonesian rupiah some 6.4%. If the Korean and Southeast Asian central banks learned one thing during the crisis, it was not to waste their reserves supporting their currencies. That means these nations' exporters may not be so severely affected by a weak yen. But falling currencies could put a further chill on investment. And Japan, with its huge foreign reserves and larger economy, can withstand such a development far better than Southeast Asia. If currencies fall too far, imported machinery and raw materials become expensive, as does servicing foreign debt.

Of most concern to Southeast Asia, however, is the dearth of foreign investment. Private capital flows have contracted in Indonesia, Malaysia, and Thailand for three years running. This year, they will probably fall again. And multinational manufacturers are cutting back. This month, Seagate Technologies Inc. said it would shutter a Malaysian plant making hard-disk drives. It earlier scrapped plans for a new factory in the Philippines.

Much of the foreign money is heading to China. It could absorb $40 billion in new investment this year. By contrast, the members of the Association of Southeast Asian Nations (ASEAN) receive half that. They can't hope to compete with China's cheap labor and mass domestic market. Says Gerry Kania, Bangkok-based president of Ford Motor Co.'s ASEAN operations: "Look at ASEAN investment 10 years ago vs. China." Over the past decade, he says, their positions as a destinations for foreign investment "have completely reversed."

Today, China is home to a fifth of Japanese high-tech and component plants, vs. 11% in Malaysia and 5% each in Thailand and Indonesia. "China boasts a big established manufacturing base," says Yukio Shohtoku, a managing director overseeing foreign operations for Matsushita Electrical Industrial Co. "We have to look at our operations in ASEAN in a new light." Matsushita hopes to double its foreign revenues by 2003, and China will account for most of the expansion.

Turning around that kind of sentiment won't be easy. Getting serious about the on-again, off-again ASEAN Free Trade Area (AFTA) might help. It was supposed to drop intra-regional trade barriers, slash tariffs, and make investing in the region a better prospect for multinationals. But with growth slowing, protectionist forces are reasserting themselves. Last October, a deal to widen AFTA by including Australia and New Zealand fell apart. Singapore officials had hoped the pact would influence other ASEAN members to adopt a more rapid schedule of tariff reductions. But Malaysian Prime Minister Mahathir Mohamad resisted the move because he wanted to protect the Proton national car program. When countries such as Malaysia raise barriers, the appeal of a regionwide strategy diminishes. Without AFTA, pro-free-trade nations such as Thailand can't achieve sufficient economies of scale to attract investment. "The Fortress Malaysia mentality is a blow for the whole region," says Ford's Kania.

RACE TENSION. The social implications of a prolonged slowdown could be immense. While Japan has weathered a decade of virtually zero growth without serious political instability, such nations as Thailand and Indonesia are home to legions of young people who will become increasingly restive without jobs. Every year in Indonesia, where population growth is 1.6% annually, some 2 million young workers enter the job market. Moreover, racial tensions, carpeted over during the boom of the 1980s and '90s, are on the rise both there and in Malaysia.

For its part, Indonesia must post average growth of 5% over the next half-decade just to get back to pre-1998 levels of per capita income. It will be lucky to grow 4% this year. "Economic growth isn't greatly outpacing population growth, which will only make it more difficult for the political leadership to cope with a difficult situation," says David L. Cohen, an economist at Standard & Poor's/MMS in Singapore.

As growth fizzles, more and more white-collar professionals are leaving Asia--and such people will be difficult to replace. This exodus, says Robert C. Broadfoot, managing director of Hong Kong's Political & Economic Risk Consultancy Ltd., could balloon if growth continues to slow. It's even happening in South Korea. Although the nation boasts such world-class technology contenders as Samsung Electronics Co. and an increasingly entrepreneurial culture, more and more middle-class families are emigrating to Canada, New Zealand, and Australia. Says Park Kyung Min, CEO of fund-management firm Hangaram Investment Management Co.: "The real crisis in Korea is diminishing hope for the future."

There are plenty of measures Southeast Asian and Korean leaders can take to stay in the game. They can clean up the bad loans. They can sell more distressed assets to foreign investors. Both measures would free up capital that would generate fresh growth. Periods of expansion, such as 1999 and 2000, should have been used to push economic reform, when the pain is easier to bear. Over the past 10 years, Japan has proved a master of procrastination. But it is still rich enough to dither while not inflicting world-class hardship on its citizens. That is a luxury Asia's poor to middling economies don't enjoy.

By Brian Bremner in Tokyo, with Frederik Balfour in Bangkok, Michael Shari in Singapore, Moon Ihlwan in Seoul, and Pete Engardio in New York

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