A condition for domestic demand-led growth
Asian ex-Japan’s share of global GDP rose from 14 percent in 2007 to 18 percent in 2010. The road Asia has taken so far is similar to that travelled by Japan and Germany before 1985. In the post-war era, both Japan and Germany focussed on boosting exports, benefitting from: 1) floating exchange rates from 1971 as the Bretton Woods system ended, since both JPY and the DM were undervalued against the U.S. dollars before the Plaza Accord; 2) Asia’s late industrialization; and 3) European economic integration.
It was not until the 1985 Plaza Accord that the two economies were pushed towards domestic-driven growth. The G5 statement of 22 September 1985 indicated awareness that the U.S. dollars was overvalued and that increased domestic demand in Japan and West Germany ― both of which were running current account surpluses ― was needed. Thereafter, for example, growth in Japanese domestic demand accelerated from its five-year average of 2.7 percent through 1985 to an average 5.4 percent over the next five years. As a result, Japan’s current account surplus, which had been around 4 percent of GDP contracted to just 1 percent.
Meanwhile, the U.S. current account deficit, which had been 3 percent of GDP, was almost eliminated in 1991. The global economy then received a boost as the increased purchasing power of the Japanese and German economies allowed them to use their FX reserves for more imports from the rest of the world and more direct investments overseas than otherwise would have been the case. However, both returned to export-led growth in 1990 after the Japanese bubble burst and Germany went through the process of reunification.
Holding huge FX reserves of $5.1 trillion (46 percent of Asia ex-Japan’s GDP in September), Asian policymakers could play a similar role to that of Japan and Germany after the 1985 Plaza Accord by allowing currency appreciation, increasing domestic demand and boosting the global economy. However, the G20 commitment to avoid persistent exchange rate misalignment and to refrain from competitive devaluation is not as binding as the Plaza Accord. We think Asian policymakers still fear sharp currency appreciation due to deep-rooted bad memories of the Asian crisis and the Japanese bubble bursting.
In this regard, strengthening its financial safety net and increasing its role in the international monetary system are crucial elements to support Asia’s use of its FX reserves for its own organic growth. One way to achieve this is to have Asian countries reduce G3 bonds and increase Asian bonds in their FX reserves.
Indeed, a number of steps have already been taken in this direction as Asian central banks and sovereign wealth funds have diversified their assets to the region. Korea has also agreed to increase its bilateral currency swap with China from $26 billion to $56 billion and with Japan from $13 billion to $70 billion. The IMF has extended a new precautionary and liquidity line to provide on a case-by-case basis, increased, more flexible short-term liquidity to countries with strong policies and fundamentals facing exogenous shocks, and a single facility to fulfil the emergency assistance needs of its members.
We sees the ongoing sovereign debt crisis – and the resulting negative banking sector feedback effect – as posing downside risks to global economic outlook. If there is a sharp downturn in the euro zone due to the credit crunch, the negative impact on Asia would be smaller than in 2008, but inevitable, as European banks have exposure to the region (3.5 percent of Asia ex-Japan’s GDP in June).
In this case, we would expect sizable fiscal stimulus and monetary easing in Asia. This should accelerate the region’s domestic-led growth through the wealth transfer from state such as FX reserves to the private sector, if this is associated with stronger Asian currencies supported by a strong financial safety net.