Asian financial crisis of 10 years ago taught two contrasting lessons: the one the majority of western economists thought the Asians should learn; and the one Asians did learn.
The western economists concluded that emerging economies should adopt flexible exchange rates and modern, well-regulated and competitive financial markets. The Asians decided to choose competitive exchange rates, export-led growth and huge accumulations of foreign currency reserves. The question is whether the Asians need to change their choice. The answer, I believe, is "yes".
When downward pressure on the Thai baht started 10 years ago, nobody expected what followed - its devaluation in early July. That seemingly small event generated a financial tsunami that engulfed most of east Asia and overwhelmed Indonesia, Malaysia, the Philippines, South Korea and Thailand. Exchange rates collapsed, financial systems went bankrupt, governments teetered on the edge of default and economies succumbed to deep recessions. Officials from the International Monetary Fund raced from one crisis-hit country to the next. In its last movements, the crisis went global, overwhelming Russia in August 1998 and Brazil in early 1999.
As surprising as the onset of the Asian crisis has been its aftermath. With the important, but geographically limited, exceptions of Argentina and Turkey in 2001, the crises of 1997-98 have so far been the last in the long series of financial crises that afflicted emerging economies in the 1980s and 1990s. Today, the desire of outside investors to put their money in these economies is overwhelming, as is shown in the strength of their financial markets, the low spreads on external borrowing and the size of the private capital inflow: in 2006, for example, net private capital flow to emerging economies was $256bn. The IMF is now almost entirely out of business.
What explains this new stability? As Nouriel Roubini of New York University's Stern School of Business argues, the Asians did not learn the lessons most western economists thought they should.* This is not to deny that there have been substantial structural improvements in Asian economies, notably in the capitalisation and regulation of financial systems. But this is not the heart of the matter. The big event has been elsewhere: the great mistake, Asian policymakers concluded, was not pegged, but overvalued, exchange rates. That error was what had brought the humiliating dictation by IMF officials operating under the thumb of the US Treasury.
"Never again" became the watchword. Never again has been the result. Now the east Asian emerging economies are mostly creditor nations. Moreover, much of their accumulation of external assets is in official hands (see chart). By February of this year, the foreign currency reserves of east and south Asian countries had reached $3,280bn, up by $2,490bn since the beginning of 1999. China's reserves alone reached $1,160bn, up by $1,010bn over the same period. While a substantial accumulation of reserves seemed a justified (if expensive) form of insurance in the aftermath of the crisis, today's levels look excessive. In most east Asian economies the ratio of reserves to short-term foreign currency debt is four or five to one.
The scale of the reserve accumulation demonstrates the obvious: these countries have refused to adopt the freely floating exchange rates many outside economists recommended. They have, instead, chosen to keep their exchange rates down. This, in turn, has generated current account surpluses. Sustaining such surpluses requires a stable excess of savings over domestic investment. One instrument they have used has been sterilisation of the monetary consequences of reserve accumulations, to prevent the normal expansion of money and credit, overheating, inflation and so loss of external competitiveness.
If a substantial part of the world economy is generating huge current account surpluses, somebody else has to run offsetting deficits. That conclusion became still more potent when oil prices soared, since this shifted income to countries that painful experience has taught not to spend their additional revenue quickly. In a world of fluctuating currencies, however, accumulating large quantities of net foreign liabilities is easiest for countries able to borrow freely in their own currencies. The reason is simple: only such countries can borrow without risking significant currency mismatches inside their financial systems. It is no accident then that the US has emerged as the world's chief deficit country - its "borrower of last resort". It alone is able to be a vast net borrower without risking the health of its financial system.
So is what some economists have called "Bretton Woods Two" - a fixed exchange rate system anchored on the US dollar - both the answer to financial instability in emerging market economies and a basis for sustainable export-led growth?
Mr Roubini argues that it is not. The policy generates ultimately unsterilisable increases in foreign currency reserves. This causes excess monetary growth, domestic asset price bubbles, overheating, inflation and the loss in competitiveness that governments had tried to prevent by suppressing the rises in nominal exchange rates. It distorts domestic financial systems, by pushing interest rates below equilibrium levels. It generates a waste of resources in accumulation of low-yielding foreign currency assets exposed to the likelihood of huge capital losses. It makes Asian economies excessively dependent on demand from outside the region. It exacerbates US protectionism. Finally, it compelsUS monetary authorities to sustain easy monetary policy, in order to offset the leakage from domestic demand caused by the huge current account deficits.
The post-crisis policy system has proved more durable than many (including myself) expected. At its heart, however, is China. Though not affected directly by the crisis, it was one of the countries that learnt its lessons in the Asian way. Today's result is a dynamic behemoth accumulating foreign currency reserves at a rate of $50bn a month in the first quarter of the year and expected by the IMF to generate a current account surplus of 10 per cent of gross domestic product this year.I do not believe these astonishing trends are desirable or sustainable. Why that is so and what to do about it I intend to discuss next week.