Asia's Fate in the New World Order

Published March 6, 2009 

If 2008 was the year of the global financial crisis, 2009 is turning out to be the year of the real economy fallout: a case of Après Lehman, le déluge. It now seems almost unavoidable that 2009 will see the world economy contract in real terms, producing the worst performance for global growth since World War II. International trade and capital flows have been falling so precipitously that deglobalization is threatening to replace globalization as the best description of our current international economic environment. Soft protectionism—in the form of local content provisions and financial mercantilism—is on the rise. Commodity prices have crashed. Unemployment is climbing, as is social unrest, and governments have started to topple.

Despite initial hopes that Asia might escape the worst consequences of a crisis that had its origins in the United States’ housing market, the region is now suffering extensive collateral damage. The crisis has driven a stake through the heart of the decoupling thesis—that overly optimistic proposition that Asia would be relatively immune from a recession in the world’s largest economy. It’s true that large stocks of foreign-exchange reserves and banking systems that appear to have had only limited exposure to some of the most toxic financial assets both provided some initial protection against financial market contagion. But the implosion of rich country demand has since been transmitted rapidly across the region’s supply chains, contributing to a dramatic downturn in economic activity. Final-quarter GDP readings for 2008 have been dismal for almost all of East Asia’s economies, dragged down by plummeting exports and industrial production. Small, open economies like Singapore have been particularly badly hit, but so too has Japan, turning in its worst quarterly performance in more than three decades. Even an economic powerhouse like China probably saw growth stall toward the end of last year. In South Asia, India, less dependent on global trade than East Asia, has nevertheless seen its growth prospects undermined by the deteriorating global environment and a reversal of capital flows, while Pakistan has had to turn to the International Monetary Fund.

With export and industrial production readings for the start of this year continuing to signal evaporating demand, early indicators for the current quarter present little cause for optimism for many Asian economies. One positive is that although developed Asia, led by Japan, is facing recession this year, the fact that China and India will keep growing over 2009 means that emerging Asia will avoid the outright contraction in output that is the fate of the rich world. Even so, the sharp declines in growth rates now in prospect will push up poverty and unemployment in economies which still contain many of the world’s most vulnerable people.

Such is the magnitude of the current shock, and of the policy responses to date, that it’s clear that the world economy is changing, and Asia’s fortunes with it. But, the question is, by how much?

It’s now glaringly apparent that the financial carnage is going to take a heavy toll on global economic activity. It’s similarly apparent that East Asia is the victim of a second major crisis in little more than a decade. Does this also mean that we should expect a fundamental change in the long-term trajectory of the international economy? If so, what will that mean for the region?

A Tale of Five Stories

One way to think about these questions is to look at some of the key drivers of the precrisis world economy, and ask how the crisis has changed things. We can begin by setting out five stories that helped describe the previous situation.
Story No. 1 was the story of the Great Convergence, a tale of rapid, sustained economic growth in the developing world, particularly in the two giant, billion-people plus economies of China and India, and the resultant gradual narrowing of the income-per-head gap between the more than one-third of the world’s population found within their borders and that much smaller share of the global population fortunate enough to be living in the rich world. One consequence was a shift in the geographic distribution of economic activity in the world economy toward Asia in general, emerging Asia in particular and China most of all. A whole series of forecasts and scenarios, beginning with the now famous Brazil, Russia, India and China (BRICS) projections of Goldman Sachs, predicted a great overtaking of developed by developing economies in the economic league tables, albeit in terms of absolute GDP rather than in GDP per capita terms. Where economic weight went, geopolitical influence followed, prompting expectations of both an Asian Century and an Emerging Market Century.

Story No. 2 was about a resource-constrained world economy, or what happened when the Great Convergence met resource and environmental constraints. Rapid industrialization and urbanization in China, and to a lesser extent India, contributed to a surge in commodity prices, as well as to growing concerns about resource security and environmental constraints. By July 2008, as the commodity supercycle was peaking, oil prices had climbed to more than $147 per barrel, and forecasts of $200 per barrel were widely viewed as credible. Meanwhile, a run-up in food prices had seen rice prices exceed $1,000 per ton, creating fears of social unrest across Asia and prompting worries about a new Malthusian age. In a resource-constrained world, both environmental and resource-security issues were grabbing attention in the developed and developing world, albeit to different degrees. Voters and policy makers in the rich world were paying more attention to environmental sustainability, manifested in growing public concern about climate change, while the food crisis and a soaring oil-import bill meant that emerging Asia was increasingly preoccupied with securing access to the energy and raw materials needed to power its factories, and the price of the food required to sustain its populations.

Story No. 3 was second thoughts on globalization. It was about the way in which the globalization-friendly international-policy environment that had dominated the world economy since at least the late 1980s was under challenge. That challenge originated mainly in the developed world, and to a large extent reflected rich-world fears about the competitive and strategic challenges posed by the globalization-powered rise of China and India. The shifting balance of economic power produced by the Great Convergence was reflected in a changing pattern of global trade and—especially—financial flows. The developed world’s economies found themselves struggling to adapt to an international financial environment where Sovereign Wealth Funds (SWFS) and other state-directed investment flows originating from emerging markets, particularly in Asia and the Middle East, were playing an increasingly important role in crossborder capital movements. Used to investment flowing from the developed to the developing world, many in the former were disconcerted when it turned out that capital could flow both ways. Meanwhile, prominent trade economists and rich-country politicians fretted over whether booming trade with emerging Asia was contributing to rising inequality within the rich countries. The consequences of this changing environment were visible in the waning commitment to further liberalization evident in a repeated failure to progress the Doha trade round and fears of developed-country financial protectionism, prompted by cases such as the negative reaction to CNOOC’s bid for Unocal.

Story No. 4 concerned the return of the state to a more important role in the international economy. All three of the preceding stories indicated a greater prominence for government, suggesting that the long swing toward the market that got underway in the 1980s and intensified during the 1990s had started to move into reverse. The Great Convergence and the shift in economic power toward countries like China that allocate a relatively large economic role to the state was part of this story. But it also reflected the consequences of a resource-constrained world—seen in the demand for more policy action on the environment. Similarly, the rethink on globalization has produced a demand in the developed world for either new or extended regulation or protection(ism), or both.

Finally, there was one more powerful story to tell about the precrisis world economy. Story No. 5 was the story of financial globalization and the consequent emergence of global financial capitalism. As we now know all too well, this last story has ended in tears. But what does the unhappy ending of this final story mean for the other four? And what does this mean for Asia?

Reading Between the Lines

Taking the first four stories described above in reverse order, it seems obvious that one consequence of the global financial crisis has been to make story No. 4—the return of the state—even more compelling. The response of governments to the economic disaster now unfolding has been both dramatic and extensive, ranging from bans on short selling through the bailout of individual institutions and on to the extension of blanket deposit guarantees and widespread financial support and partial nationalization, now supplemented by substantial fiscal pump-priming. Such has been the scale of the shift in the U.S., for example, that the U.S. economist and blogger Brad de Long has quipped that while the Bush administration may have entered office as social conservatives, they found themselves leaving it as conservative socialists.

The crisis has accelerated significantly the swing in the pendulum back towards a greater role for government. That swing was already underway, but it is now happening much faster, and in countries that had hitherto been closely associated with the move to reduce the economic role of government. The size of the change will now be appreciably greater as well: While the return of the state may have been on the cards before the current crisis, it’s hard to believe that the nationalization of much of the British banking sector was.

For Asia, the implications of this trend are likely to be mixed at best. On the one hand, the dramatic extension of state intervention in North America and Europe may mean that some of the past protestations from Washington, London and Brussels about the way some in Asia manage their economies are toned down in favor of a greater acceptance of diverse economic models. On the other, we have already seen signs that the new extension of government control, at least in some respects, may prove inimical to open global markets. So, for example, the use of taxpayers’ money to prop up domestic banks or national car companies has already brought with it the politically logical but economically destructive demand for jobs and capital in the subsidized industries to be kept “at home.” Local content provisions tagged on to government stimulus packages are another sign of this process at work. Given that Asian economies have been particularly big winners from the expansion of world trade, this is a worrying trend.

Similarly, Story No. 3, the reconsideration of globalization, has been reinforced by the financial crisis. If the side-effects deriving from globalization’s successes—the fear of powerful new trade competitors, the angst over SWFs, environmental strains and resource-security fears—were enough to prompt second thoughts, then it seems hard to believe that the massive failure that is the global financial crisis will not produce an even greater emphasis on globalization’s downside. If a sizeable proportion of the electorate in the rich world were skeptical about globalization even before the U.S. housing market went belly up and triggered the subprime crisis and all that followed, then the biggest international financial crisis since the 1930s is hardly going to temper that skepticism. The bigger the real economy fallout—that is, the higher unemployment rates go—then the bigger the likely antiglobalization backlash. The backlash could also spread to Asia: East Asia has now been the victim of two major crises in the space of roughly a decade, and many in the region feel, particularly in the case of the current crisis, that it has been a largely innocent bystander.

Again, this trend is problematic for Asia. Certainly, the region has suffered from some of the downsides of globalization: the volatile capital flows that contributed to the 1997-98 financial crisis are an obvious example. Yet crossborder trade and capital flows have played an important role in facilitating catch-up growth in emerging Asia, and in sustaining prosperity in developed Asia. A world where there are significantly more constraints on such flows may well be a world where Asian growth is appreciably lower.
What about Story No. 2? The proposition of a resource-constrained world is intellectually appealing when oil is at $147 per barrel. When that oil price has fallen by more than $100 per barrel, it is a much harder sell. Environmental concerns are also likely to be viewed as less pressing during economic hard times: Governments, elected and otherwise, are likely to be following their populations in worrying more about unemployment than climate change, at least in the near term.

Does the financial crisis completely undermine this second story? It does suggest that a fair proportion of the surge in prices was a product of an overheating global economy and likely some speculative excess. But that is not the same as saying that this explained all of it. If emerging markets in general, and emerging Asia in particular, are able to return to a similar kind of growth performance once the crisis is over, then some of the resource constraints that were occupying policy makers in recent years will once again start to bite.

Furthermore, the cuts in investment in capacity and delays to or cancellations of new projects that will be the product of the abrupt reversal of the price signals and evaporation of financing now underway could well end up laying the foundations for another commodity price spike—and renewed resource-security fears—in the future, provided that global growth is once again re-established at something approaching its previous tempo. The fact that China is using the opportunity afforded by lower asset prices and a relatively strong financial position to acquire resource assets in Australia and elsewhere suggests that Beijing is already thinking along these lines.

Environmental constraints will also still be with us once the current crisis has passed, and in the medium term will pose both China and India significant policy problems.

Rise of the Rest?

At first, the implications of the financial crisis for Story No. 1, The Great Convergence, and the consequent transfer in economic power toward emerging Asia, seemed both obvious and positive. Certainly, many observers initially appeared to view the global financial crisis as heralding the decline of the West and the rise of the rest. After all, its epicenter was the U.S., and much of the worst of the initial economic fallout was concentrated around the U.S. and Europe. Equally, there can be little doubt that the blow to U.S. prestige arising from the collapse of its financial system and the failure of its regulatory model is substantial, a blow reinforced especially in East Asia by the grinding of teeth occasioned by the marked difference in the kind of economic policies now being followed by Washington as opposed to those it propounded during the 1997-98 crisis.

Then there is the still-expanding cost to the rich world in terms of foregone growth and increased government debt. Finally, the decision to turn to the G-20—which brings China, India, South Korea, Indonesia and Australia to the global top table alongside Japan—as the appropriate international body to deal with the crisis, rather than the increasingly anachronistic and relatively Asia-light Group of Seven leading industrial nations, is a significant recognition of the changed economic and geopolitical landscape.

All that said, the consequences of the current crisis for the Great Convergence, and hence for Asia’s place in the world, are not quite that clear-cut. As already noted, the region itself is now suffering extensive collateral damage from the crisis. Depending on the depth of that damage, there could be political as well as economic consequences: One lesson from the 1997-98 financial crisis is that feedback effects between economic and political shocks can have powerful consequences for medium-term prospects. Indonesia is an obvious example.

Perhaps an even more important question relates to how the crisis is likely to change the nature of the world economy in the longer term. The international economic environment of recent years has been very helpful in terms of facilitating the catch-up growth that has so benefited emerging Asia in general, and China and India in particular. So if the financial crisis does turn out to trigger a fundamental change in the way the world economy operates, it is not obvious that this will necessarily result in an acceleration of the convergence process. It may do so. But it is also quite easy to tell stories in which the opposite is true: A world economy marked by more protectionism, slower growth, and greater economic nationalism is unlikely to be one that is going to stimulate rapid convergence, except insofar as we might all fall down together.

The most likely outcome remains one in which the current global turmoil represents only a temporary disruption to the Great Convergence, and that in time, catch-up growth will resume in emerging Asia. There is certainly still plenty of scope for rapid economic growth across many of the region’s economies. Still, this is not a foregone conclusion, and that in turn suggests that the region and, in particular, Beijing and New Delhi, have a pressing interest in working to ensure that the kind of global economy that emerges from the current turmoil is one that is at least as friendly to economic convergence as was its predecessor—they may even want to be more ambitious.

Despite its magnitude, the current crisis will not change everything. Even so, the future of the world economy today is up for grabs in a way that it has not been for decades. This represents both a great opportunity and a great challenge for policy makers everywhere, but particularly for those in Asia’s emerging powers. Until now, Beijing and New Delhi have largely been beneficiaries of a world order that was first shaped and then largely managed elsewhere. That order is now crumbling, and for the first time in perhaps two centuries, they have a real chance to have a powerful voice in helping to decide what comes next.

Mark Thirlwell is program director for international economy at the Lowy Institute for International Policy in Sydney, Australia. This article is based on a Lowy Institute publication.