Why Asia Won’t Save The World

Not long ago, investors hailed Vietnam as a dynamic, export-driven "China-killer." But in recent months, it has moved ahead of its giant neighbor for a less laudable reason: it's the Asian economy most likely to crash in 2008. With suddenness only the world's fastest-growing region can deliver, Vietnam's economy has lurched off course. Its main stock exchange has plunged 55 percent this year, inflation topped 25 percent in May, wage protests are erupting at scores of factories and the national budget is cracking under the weight of imported energy. In May, ratings agencies Standard & Poor's and Fitch lowered Vietnam's credit rating on fears of financial instability. Morgan Stanley warned of a possible "devaluation episode" centered on its embattled currency, the dong, cautioning that such a development "could trigger a contagion throughout the region" similar to the 1997–98 Asian financial crisis.

Vietnam may turn out to be the canary in Asia's coal mine. Like the rest of the region, its economy is export-driven, energy-dependent and labor-intensive. The formula worked well as long as energy remained cheap and American consumption steamed ahead. But as Western consumers spend less, and rising oil and food prices lead to double-digit inflation throughout the region, the economic tables have turned. The burgeoning middle class that was supposed to create self-sustaining growth for Asia and help buoy the world in a global downturn looks beleaguered, and the poor are becoming desperate.

Imported oil has outraced export earnings, staining the national trade balance red. Meanwhile, leaders in Hanoi and elsewhere have proved themselves unable to raise interest rates, tighten the money supply or adjust its dollar-pegged currency sufficiently to avert an inflation-induced meltdown. "They panicked," says William James, a senior economist at the Asian Development Bank in Manila, referring to the Vietnamese government's imposition of a rice-export ban and various domestic price controls this year. He adds: "[Vietnam] is a real ground zero for what's going to happen with inflation" in Asia.

From Seoul to Jakarta to Islamabad, policymakers are making the same missteps. Faced with their toughest economic challenge in a decade—surging inflation—governments have yet to embrace the proven macroeconomic-policy response: aggressive monetary tightening. Instead, they favor stopgap administrative measures like price caps, based on the flawed logic that today's price surge is temporary, so overreacting to it could undermine economic growth that (truth be told) is already weakening, thanks to declining Western consumption and deteriorating terms of trade. The problem, argues Sailesh Jha, an economist at Barclays Capital in Singapore, is that inflationary momentum is stronger than it's been in nearly two decades in Asia, and likely to rise—not stabilize—well into 2009. "Asia's central bankers are sitting on the fence when they should be reining in inflation," he says. "That's the same fundamental mistake the Americans made in the 1970s."

That historic blunder added the terrifying word "stagflation" to the modern economic lexicon. It means slow growth coupled with persistent price rises, evidence of which is already appearing in Asia's economic data. In industrial powerhouse South Korea, for example, the official inflation rate stands at 4.9 percent, but national income is growing by 1.3 percent. Thailand's consumer price index has tripled over the last year and Indonesia's has doubled despite slower real growth in both nations. Inflation in China and India is approaching 10 percent, even as both economies are slowing: China from 11.9 to 10 percent and India from 9 to 8 percent.

The juxtaposition may not seem alarming yet—but economists agree that official figures in Asia understate inflation and overstate growth significantly, creating the false impression that Asia is maintaining high growth while keeping prices in check. In April, former Reserve Bank of India deputy governor S. S. Tarapore noted that the indices used in his country (as well as in many other parts of the region) "greatly underestimate the extent of inflation."