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."

That's a dangerous illusion. Historically, policy dithering as inflationary spirals build has magnified the havoc they ultimately wreak. Unless tackled quickly, price spikes in commodities lead to demands for higher wages which push up the general price levels, particularly in fast-growing economies. Central banks can head off such a spiral by moving early to tighten money supply through higher interest rates. But real interest rates in Asia are still low or even negative, while bank lending is up sharply thus far in '08. Daniel Melser, a senior economist at Moody's economy.com in Sydney, says the focus of Asian central-bank policy is designed to "suit exporters."

Despite this effort, the export boom is slowing. While China's exports officially rose 21.4 percent in the first quarter of 2008 to $306 billion, the problem with that number is that China, like much of Asia, tallies its exports in fast-depreciating U.S. dollars. Measured in euros or yen (the coinage of Beijing's largest and third largest trading partners respectively), China's exports ticked up just 4 percent during the first quarter of 2008. Hardly a global economy-saving performance.

The real trade story is surging imports—much of it $130-per-barrel crude—into Asia. Last week Lehman Brothers said China's trade surplus peaked in the first quarter, and that, excluding China and Japan, the rest of Asia is already running a trade deficit, thanks to a "ballooning import bill" for food and fuel, much of it subsidized by government (at least for now). So far in 2008, Vietnam has already spent $38 billion on imports, more than it did in all of 2007, tripling its trade deficit.

When those subsidies are cut, as they undoubtedly will be, the rest of the world will begin to feel Asia's inflationary pain in the form of rising prices on consumer goods. The fast-growing economies that were supposed to help prop up the rest of the world would instead pull it down. Unless food and oil prices come down sharply, a number of Asian economies including Indonesia and the Philippines could see growth forecasts slashed by 4 to 5 percent, according to the ADB's James. "The answer," he says, "is for governments to accept slower growth in the short run and control inflation." That would hammer exporters, and slow job creation. Still, "inflation is more likely to cause riots than joblessness," says Felipe Medalla, former head of the National Economic and Development Authority in the Philippines. "People blame the government for higher prices, but when they get laid off they blame their bosses." If stagflation takes root in Asia, there will be plenty of blame to go around.