A crash foretold

The collapse in the currency and stock markets of East and South-East Asia has one obvious message for other emerging markets - any growth strategy relying primarily on the inflow of international capital is inherently flawed.

JAYATI GHOSH

EVEN by the volatile standards of the 1990s, it was an extraordinary week for the world's stock markets. The turmoil in Asian currency and securities markets spilled over into the stock markets operating at the epicentre of the international capitalist system, causing wild gyrations in the space of a few days. On October 27, the Dow Jones Industrial Average, which monitors stock prices in New York, experienced its most precipitous decline, diving by 554 points (or by 7.2 per cent of its value) in a single day. Even as the world waited breathlessly for the apparently inevitable large-scale crash, the market recovered the very next day, with the Dow Jones index showing its largest increase in a single day, of 337 points or 4.7 per cent.

By the end of the week, the index had fallen by only 3.8 per cent over the week, and at least in New York the stock market appeared to have stabilised. But elsewhere problems continued, with European bourses showing declines of between 4 and 6 per cent; the most depressing news coming from East Asia, where even the previously invulnerable Hong Kong market was under serious threat. The story of current stock market movements is certainly not over, and it may be foolhardy even to hazard guesses about these seemingly wild patterns and their implications.

But when the dust has settled, some important features which are now half-hidden in the haze may become more apparent. The forces behind this dramatic plunge and even more remarkable upswing on Wall Street over those three days may never be fully understood. But there is a more significant feature: the collapse in the securities and currency markets of East and South-East Asia, amounting to an average fall of around 40 per cent of the previous value of stocks in this region in dollar terms in the past four months. It is really this differential movement, rather than the fluctuations in all regional stock market indices over the week, which is important, and which has critical implications for other emerging markets.

Consider first the timing of this particular proto-crash. For more than a month prior to it, business newspapers across the world had been talking about the tenth anniversary of the Black Monday crash of October 1987 and speculating on the possibilities of a repeat (Frontline, October 17). This is completely absurd - there is no reason at all why stock market behaviour should replicate itself every decade, especially to the day. Yet the concerted discussion certainly suggested that the stock market was being "talked down", and when there was a sharp decline on October 27 this year, it seemed to confirm this. It is true that by several indicators, such as the price-earnings ratio or the 'q' ratio which relates share prices to the replacement costs of firms' assets, New York stocks were (and remain) overvalued.

But the emphasis in the talking down was continuously on the international aspects, on the worldwide repercussions of a downward movement of the Dow Jones index and the negative effects this would have especially in the already tottering Asian markets. Indeed, this now appears to be the chief result of the week's hectic activity - a further fall in the dollar value of Asian stocks, even relative to those in the U.S. and Western Europe. The decline on Wall Street was rapidly countered, partly because of the continued faith of small investors, and partly because of the bullish expectations generated by U.S. Federal Reserve Chairman Alan Greenspan, who argued that this was a "welcome correction" in the U.S. and helped its prospects for future growth. Greenspan was at pains to dissociate Wall Street movements from those in Asian stock markets, which he suggested differed in their fundamentals.

This theme has been continuously repeated in the international financial press: the problems in Asian capital and currency markets are primarily domestic in nature, and the contagion effects can spread within the region but not to the markets of the industrial countries. There is, in fact, a basic truth in the latter argument, which reflects the essential nature of international capital flows. But the point about fundamentals determining stock market variables in troubled Asian economies is more problematic and hard to justify.

THE origins of the problems in Thailand and Malaysia are now too well known to be repeated here. But the recent capital outflows have not been restricted only to countries for whom the unsustainable nature of growth is evident. Rather, the adverse effects of falling investor confidence are being felt in economies where all the conventional macroeconomic criteria are very positive, simply because they are in the same region.

Thailand is obviously the worst affected, with projections of falling GDP in the coming year, a large current account deficit and rapidly diminished foreign reserves, so that it is not surprising to see continued pressure on the baht. But the indicators for other countries are less grim. Malaysia too has had problems of decelerating exports and large external deficits, but GDP growth targets in Malaysia are still in the region of 4 per cent, well above those for any industrial country, and the country's foreign reserve position is actually better now than it was a year ago. Indonesia, the latest country to fall into line with an enormous IMF deal worth some $23 billion in exchange for major reform of domestic industrial policy and privatisation, also has foreign reserves (of $27 billion, or nearly six months' worth of imports) which would be considered more than comfortable elsewhere, and its GDP is expected to increase by at least 6 per cent next year.

WHAT makes private capital so uneasy about continued investment in these economies, which have always had "investor-friendly" regimes with marked preference for encouraging private capital?

The question is even more glaring for other economies in the East and South-East Asian region, which were the neighbours' envy and owners' pride just a few months ago. South Korea, which has experienced a big decline in the stock market and a record fall in the value of the won against the dollar, admittedly has a large current account deficit, but it holds large external reserves and the growth of exports and GDP continue to be strong. Singapore has a current account surplus, external reserves in excess of $80 billion and expected GDP growth of 8 per cent this year, but investor pressure has driven the stock market down to its lowest level in the past decade.

The most striking case is that of Hong Kong, which holds nearly $90 billion of foreign reserves, is growing at more than 6 per cent, has a current account broadly in balance and the explicit support of the huge $128 billion reserves held by the Central Bank of China to support the currency board, which regulates the fixed relationship of the Hong Kong dollar to the U.S. dollar. Despite these very strong props, the Hang Seng index in Hong Kong took the most severe beating of all in that momentous week and the downward pressure on both stock market and currency continues in Hong Kong, where the crisis is not yet resolved.

These movements in capital markets in South-East Asia have to be seen in conjunction with the reform measures (increasingly under IMF supervision) that these economies are being forced to undertake. Even as speculative capital flows trigger crises, these countries are now further liberalising capital markets, privatising public companies and increasing foreigners' access to all domestic assets. Whatever be the intention, the result of such policies is evident, in terms of providing international investors a chance to pick up major bargains in the form of newly cheapened and available assets in what still remains the most dynamic part of the world economy.

These capital movements have otherwise been explained in terms of the "contagion" effect and the "flight to quality". But such an explanation seems bizarre when the flight is to the U.S., whose macro-economic indicators appear far less healthy than any of these countries. The U.S. GDP growth is only 3.6 per cent this year and is projected to be even lower next year. The U.S. still has an enormous current account deficit, its foreign reserves are tiny in relation to imports or even trade balance and all indications are that stock markets remain grossly overvalued. Why do investors still remain faithful to U.S. securities?

The answer must be in terms of the greater confidence that the U.S. dollar still commands internationally, which is essentially what gives the U.S. its stronger "fundamentals". One does not have to be a conspiracy theorist to accept the argument that as long as the dollar retains its pre-eminent position in the world economy, international capital will also behave as a homing pigeon that seeks out other markets periodically, only to drop them and punish them for declared policy inadequacies, and to utilise the consequent crisis situations for the acquisition of cheap assets. One obvious message for other emerging markets is that any growth strategy relying primarily on the sustained inflow of such capital is inherently problematic.