Is it over?

After years of extraordinary growth, East Asia's emerging economies are showing signs of fatigue. Are they exhausted? Or just resting before springing forward again?

THE rapid expansion of the East Asian tigers--many by an average of more than 8% a year over the past three decades--has provoked fear in the West and pride back home. Never before in world history has any region sustained such rapid growth for so long. The four original tigers (Hong Kong, Singapore, South Korea and Taiwan) have almost joined the ranks of developed economies in terms of GDP per head (Hong Kong and Singapore are both richer than Britain, (see table)). China, Indonesia, Malaysia and Thailand have started to chase the leaders' tails, though from much lower levels of income; and the Philippines (a slow starter) has just joined the pack. But unprecedented rates of growth are not all this disparate group of countries has in common.
     In the past year, almost all them have come down to earth with a bump. Export growth in East Asia was only 5% last year--feeble compared with the roughly 20% growth achieved in 1994 and 1995. Malaysia, South Korea and Thailand are running current-account deficits of 5-8% of GDP. South Korea has been disrupted by strikes; stockmarkets in Bangkok and Seoul have plunged; and financial systems through the region look wobbly. Singapore's GDP growth rate fell to 5.8% in the year to the fourth quarter of 1996, down from an average of 9.5% in 1994 and 1995. Average GDP growth in the region slowed from almost 9% in 1995 to 7% in 1996--a rate Americans or Europeans would die for. But industrial production in the richest tigers, Singapore and Hong Kong, tumbled by 5% during that year.
     Reactions to the slowdown fall into two broad categories. In the first are the pessimists. They are unsurprised. They thought Asia's rapid expansion was unsustainable all along because (they claim) it has been based on massive inputs of capital and labour--and not on gains in efficiency. To them the slowdown is structural. The tigers were bound to seize up sooner or later; the recent figures show this happening.
     The optimists, on the other hand, are unfazed. They give little weight to the argument that something is structurally wrong with the tigers. They reckon the growth of past decades has been rooted in the wise policies of the governments and the profit-seeking behaviour of the people. As for the recent showdown, they explain that away as cyclical. Sooner or later, the optimists think, the cycle will turn and the Asian miracle will start amazing the world again. As usually happens when people are exaggerating to strengthen their case, the truth lies somewhere in between--but nearer the optimistic extreme.

Krugman and his critics
The pessimists' case was first and most forcefully put two years ago by Paul Krugman, an American economist at MIT. In a provocative article called 'The Myth of the Asian Miracle` (Foreign Affairs, Vol. 73, No.6), Mr Krugman argued that there had been no economic miracle in East Asia. The region's growth, he said, had largely been achieved through heavy investment and a big shift of labour from farms into factories, rather than from productivity gains based on technological advance or organisational change. He cheekily likened the Asian economies to the Soviet Union: once inputs are exhausted and capital-to-output ratios rise towards rich-country levels, diminishing returns will set in and growth will slow sharply.
Even though recent trends might appear to confirm this thesis, Mr Krugman's argument has been ripped up at the roots by other economists. The critics make three arguments:

The numbers. His critics have questioned the statistics on which Mr Krugman's conclusions rest. He based his arguments on the work of Alwyn Young, another American economist. Mr Young looked at 118 countries over 1970-85, and attempted to split GDP growth into the part attributable to increased inputs of labour and capital, and that attributable to more productive use of those inputs (which economists call total factor productivity, or TFP). Surprisingly, Mr Young found that the growth of TFP was generally no higher in East Asia than in the rich industrial economies. Singapore's productivity growth, he said, was close to zero.
     Many other economists, however, reckon Mr Young's numbers were just wrong. The problem is that TFP growth is estimated as a residual--ie, the bit left over which cannot be explained by increases in capital and labour. It is therefore subject to big measurement problems--which helps explain why other studies have produced higher estimates of productivity growth.
     For instance, a recent report by UBS, a Swiss bank, repeated Mr Young's analysis using more up-to-date figures for 1970-90, and came to a very different conclusion*. In this study, five East Asian countries (Hong Kong, Thailand, Singapore, South Korea and Taiwan) ranked in the top 12 countries (out of 104) for average TFP growth. In all five, productivity was roughly as important as investment in explaining growth. In a study of ASEAN countries, Michael Sarel of the IMF(*) also found higher productivity growth. He estimated that Singapore, Malaysia and Thailand all had annual TFP growth of 2-2.5% between 1978 and 1996, compared with only 0.3% in America. Moreover, TFP growth increased in most ASEAN countries between the 1980s and the 1990s.
     The Asian performance may have been even better than this. In doing their studies, it is hard for economists to distinguish between TFP growth and capital investment because much technological progress and better ways to organise production are actually embodied in capital equipment imported from rich economies. As a result, both these studies may underestimate true productivity growth in high-investing Asian countries. Some of the effect that Mr Krugman dismisses as just capital-investment growth may actually be productivity growth in another form.

The significance of investment. Critics claim that Mr Krugman underestimated the significance of some of the changes he described. Mr Krugman tried to play down the notion of an Asian miracle by arguing that the countries merely invested a lot. But that 'merely` is misleading. Asia's ability to invest more effectively than other developing countries and to import technology from the rest of the world was itself an achievement. Investment in East Asia amounts to an average of 35% of GDP, almost twice as much as in Latin America.
True, the Soviet Union also invested a lot. But it was different in other ways. Endless studies suggest that high saving, low taxes and government spending, flexible labour markets, strong commitment to education and openness to trade (and hence foreign technology) are all vital to growth. These are areas in which most East Asian economies excel. Relatively open economies, for example, ensured that workers and capital were allocated more in response to price signals than by bureaucrats, as happened in the Soviet Union. So long as East Asia retains these policy advantages, growth should outpace that in the rich industrial economies for many years.
Whatever the precise estimates of East Asian productivity growth, it remains true that low-income countries can grow faster than those further up the development ladder by copying rich countries' technology. But as East Asia approaches rich-country levels of capital per worker and educational standards, growth will tend to slow. The process can already be seen in Hong Kong and Japan. East Asian economies will have to become more innovative themselves to grow faster than today's leaders. Which leads to the third line of criticism:

The future. Mr Krugman's critics claim he was too quick to write off Asia's future prospects. Their opportunities for catch-up remain immense. In virtually all the tigers, the amount of capital per worker is considerably lower than in rich industrial economies. The average South Korean, for example, works with only two-fifths the amount of capital available to his American counterpart. As he gets fancier equipment, his output will rise. Asian workers' education could improve too, and their productivity with it. In 1994, the average worker had received only seven years of education (ranging from four years in Indonesia and Thailand to nine years in South Korea). In contrast, workers in most industrial countries get at least ten years, often much more. The conclusion is that even if Mr Krugman were right--and most Asian growth had come from adding capital and labour--the limits to growth based on this would still be a long way off. In theory, East Asia's growth can remain faster than rich economies for many decades before the need to innovate, instead of copy, limits growth.
     So if Mr Krugman's dire predictions are unwarranted, what is responsible for the slowdown in growth and exports (see chart)? Most economists in Asia blame various cyclical, rather than structural, factors.
     First, demand from rich countries was weak as the rate of growth in industrial production slowed in 1995 and early 1996. Historically, Asian exports move closely in line with the strength of the developed economies.
     A second development that has depressed exports is the appreciation of the dollar, to which many Asian currencies are, in effect, linked. The dollar's weakness in 1994-95 had helped to boost exports but last year the effect was reversed. The dollar has risen by 50% against the yen from its low point in April 1995, eroding many East Asian exporters' competitiveness against Japanese producers.
     A third depressing factor was the slump in the world semiconductor market; memory-chip prices fell by more than 80% in 1996. This hit South Korea and Singapore especially hard because electronics account for a big chunk of their exports. And last, regional demand and hence intra-Asian trade, which accounts for an increasing share of East Asian countries' total trade, was squeezed by tight monetary policies to cool overheating in China, Malaysia and Thailand. From this point of view, the slowdown was to some extent a welcome pause.
     The argument that Asia's export slowdown was largely caused by cyclical factors rather than an underlying loss of competitiveness is supported by two persuasive pieces of evidence. One is that imports fell as sharply as exports; if competitiveness had been the problem, imports would have accelerated. South Korea's annual rate of export growth slowed from 30% in 1995 to 4% in 1996, but its import growth also slowed, from 32% to 11%. The second piece of evidence is that the export growth of other developing countries, such as in Latin America, also slowed last year. As a result, East Asia's share of American and Japanese imports hardly changed in volume terms.

Taking a breather
But even if Mr Krugman's thesis is exaggerated and even if the main causes of the recent slowdown were cyclical, that slowdown has still exposed several structural problems which need to be tackled if East Asia is to sustain rapid growth. These weaknesses vary from country to country, and are not necessarily the ones that doomsters commonly focus on.
     Some economists point to rising wages and large current-account deficits as evidence of falling competitiveness. This is far too simplistic. Miron Mushkat, chief Asian economist of Lehman Brothers, an American investment bank, points out that rising wages go hand in hand with the upgrading of production in Asian economies. Higher wages or rising exchange rates provide an incentive for firms to move into more productive, higher-value activities. This is necessary because the new tigers can no longer rely on cheap labour alone. With China, Vietnam or Eastern Europe able to undercut them in labour-intensive goods, they need to move up the ladder, from the manufacture of shirts and shoes to things like semiconductors and consumer electronics.
     But what if rising labour costs reflect overheating or skill shortages? Some economies have indeed been overheating in recent years, notably Malaysia and Thailand. In part the blame lies with lax monetary policies as a result of heavy capital inflows. These have stoked up domestic demand and pushed up wages. Likewise, current-account deficits mainly reflect overheating rather than evidence of dwindling competitiveness or currency overvaluation.
     It is true that real exchange rates have risen in many East Asian economies over the past couple of years as a result of their links to the dollar and their inflation (which has been higher than America's). The Thai baht, for example, has gained 15% in real trade-weighted terms over the past two years. In general, though, Asian currencies are not overvalued. Before their recent appreciation, many currencies were significantly undervalued, and rising real exchange rates are normal for developing countries with rapid productivity growth.
     Governments' efforts to resist rises in nominal exchange rates as foreign capital floods in are largely to blame for the excessively loose monetary polices which caused economies to overheat a few years ago. Governments need to shift to more flexible exchange-rate systems to regain monetary control. For years, Singapore has successfully followed a policy of allowing its exchange rate to appreciate.
     Easy money is partly to blame for over-investment and hence excess capacity in several areas, including semiconductors, consumer electronics and petrochemicals. In many countries the problem has been compounded by governments' attempts to pick winners by directing cheap credit to favoured industries, while small firms are starved of cash. Government meddling in capital markets is to blame for the current fragile state of banking in almost every country in the region with the exception of Hong Kong and Singapore. Such distortions may not matter so much in the early stages of development, but become increasingly important as economies mature.
     Infrastructure bottlenecks are widespread because transport and power systems have failed to keep pace with industrial expansion. An even more serious bottleneck is a shortage of skills. Thailand, in particular, lags behind in the educational standards and skills needed to move up the ladder to higher-tech industries. In Thailand only 38% of 14-year-olds attended school in 1993, fewer even than in China (though recent reforms have led to children staying in school longer).

Riding the tigers
But perhaps the biggest challenge to the Asian economic miracle is not economic but political: the risk that governments take bad policy decisions in response to the current slowdown. Either because of lobbying by the heads of protected industries, or because of their own unwillingness to see growth falter, governments may be tempted to 'do something`. Last year, for example, Malaysia hinted at import controls to help curb its current-account deficit. That would have tackled the symptoms only, not the disease.
     Both the problems and the policies will differ from country to country. South Korea is too heavily concentrated on a few industries, such as electronics and petrochemicals. Its economy needs to be opened up to more competition, the power of the overweening and indebted chaebol (conglomerates) must be reduced, and labour-and capital-market rigidities should be relaxed. Thailand and Malaysia also need to liberalise their financial sectors. Thailand and Indonesia need to invest more in infrastructure. Indonesia is particularly hampered by red tape and corruption.
     In contrast to South Korea, Hong Kong, Singapore and Taiwan have flexible labour markets, less government intervention, and small, nimble firms. Taiwan is pushing ahead with deregulation more swiftly than South Korea; and its more flexible industrial policy is more suited to fast changing business conditions.
     To the extent that a country's long-term growth potential depends partly upon its stage of development (see chart), East Asian economies' growth will inevitably tend to slow. This has already happened in the original four tigers: Hong Kong's GDP, for example, grew by an average of 9% in the 1960s and 1970s, 7.5% in the 1980s and 5% in the 1990s.
Nevertheless, growth is likely to remain faster than industrial economies' average of around 2.5% so long as savings remain high, economies are kept open and education remains a priority. The original tigers are likely to see growth slow to an average of 5-6% over the next decade. China, Malaysia, Thailand and Indonesia should be able to grow by 7-8% over the next ten years.
Then what? Hong Kong and Singapore are already as rich, in terms of GDP per head, as many G7 countries. But they are special cases: as highly sophisticated city-states, they might well be able to enjoy higher growth rates and overtake America's income per head. After all, Hamburg has an income per head 60% above the United States, even though the figure for Germany overall is 20% below America.
     Indeed, there is no theoretical reason why in the longer term some other East Asian economies cannot overtake income levels in America and Europe, even as their growth rates slow, by making even better use of the latest technology. The UBS study points to experience in rich economies which suggests that inventing new technology may be less important than being quick to adopt the best available technology across all sectors. The bank suggests that the slowdown in growth in rich economies is partly explained by policies which subsidise or protect sunset industries or tax policies that distort capital and labour costs, rather than a shortage of new technologies. If (a big if) East Asian economies avoid these pitfalls, some of them might one day overtake the rich West.

* 'The Asian Economic Miracle`, UBS International Finance, Issue 29, Autumn 1996.

(*) 'Growth and Productivity in ASEAN Economies`, presented at an IMF conference in Jakarta, November 1996.

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