18566 notes East Asia’s financial crisis has already had but will not be nearly as damaging as a significant effect on developing coun- earlier global shocks, such as the two oil tries: growth is slower, risks are higher, and price rises of the 1970s. patterns and terms of trade and capital • The risks facing developing countries flows have changed. This note summarizes have increased significantly. recent projections by the World Bank’s Although these developments are trou- Development Prospects Group of the bling, it is important to maintain a global longer-term effects of the crisis. The note’s perspective when assessing East Asia’s cri- key messages: sis. In 1997 the United States showed • Adjustment in the five East Asian remarkable momentum in its eighth year countries most affected by the crisis— of noninflationary expansion. In 1995–97 Indonesia, the Republic of Korea, growth averaged nearly 3 percent. Europe Malaysia, the Philippines, and was also a favorable surprise, with a broad Thailand—will be deep and protracted. and robust recovery since mid-1997, espe- Trade will drive the recovery. cially in France and Germany. (Japan’s • The crisis will affect developing coun- incipient recovery came to a halt, how- tries more than high-income countries. ever, largely because of increases in the Reductions in growth will be about value added tax and cuts in public invest- twice as large in developing countries ment.) Helped by growing U.S. and because of high trade multipliers, large European imports, world trade volumes terms of trade movements, and mone- grew 7.8 percent in 1997, well above tary and fiscal policy tightening in expectations and one of the fastest rates in countries that rely on private capital 30 years. flows. • Algeria, Brazil, and Russia stand to lose the most. Oil importers, such as Turkey, Although the crisis is far from over, finan- will benefit from lower oil prices. cial market indicators in East Asian coun- Outside East Asia, the hardest-hit tries—except Indonesia—show signs of regions in lost GDP growth will be Latin stabilizing. Cur rencies and stock markets America, the Middle East and North have begun to steady after the plunges of Africa, and Sub-Saharan Africa. recent months. In Indonesia, however, • The crisis will have a significant effect market rates continue to be volatile. And on the world economy—global output uncertainty remains high in the region’s growth will be 0.5 percent less in 1998— five hardest-hit countries, with the worst of The real effects of the Asian crisis are becom- KOREA. Bankruptcies and unemployment ing evident: Poor outcomes in Indonesia are on the rise. Eight of the thirty biggest chae - because of drought and soaring food prices. bol (industrial conglomerates) have filed for Rising unemployment in Korea. And indus- bankruptcy. Unemployment in November trial slump in Thailand, mitigated by a strong showed the highest monthly increase in 15 agricultural response. years, and is expected to reach 5 percent (1.2 million workers, from 0.5 million now). INDONESIA. Prices of essential foodstuffs are soaring—increasing 25 percent in a sin- THAILAND. The slump in industry is severe. gle week in January, for example. The price Monthly sales of motor vehicles, steel, con- of rice, a key commodity, has risen 20–25 per- sumer electronics, and durable goods are down cent in major urban areas and even more in 35–75 percent, and industrial output growth in drought-affected areas (leading to food riots 1997 was half that in 1996. Urban unemploy- in East Java). Unemployment is rising sharply ment is expected to increase to about 6 percent and will increase poverty—perhaps almost (1.8 million workers), although rural growth— doubling the number of poor, from 23 mil- due to bumper harvests and rising prices and lion to 40 million. exports—is offsetting that. the downturn in real sector activity still ahead (box 1). External stabilization in these five coun- tries will require current account balances to swing sharply into surplus in the near future. Indonesia, Korea, and Thailand are expected to recover to surpluses on their current account in 1998, from deficits of 2–8 percent of GDP in 1996 (figure 1). For all five countries the projected change is from a deficit of $35 billion in 1997 to sur- pluses of $7 billion in 1998 and $30 billion in 1999. Korea and Thailand have already posted surpluses of $1–2 billion a month. However, these have mainly reflected a slowdown in imports (by as much as 30 per- cent in dollar terms), and will have to be accompanied by a recovery in exports if growth is to resume. Exports from all five countries are projected to gain a 0.8 per- centage point share in world exports— about half the growth rate of Mexico’s exports in 1995 after the peso crisis. Lack of available credit for exporters could severely hamper export recovery. Severe economic downturns and finan- cial restructuring are already in evidence. Reduced capital inflows, higher interest rates, and real exchange rate depreciation (ranging from 35–70 percent) will lower domestic demand and GDP growth in the five most affected countries in 1998. Overall GDP growth is expected to be dated by a widening current account about 7 percentage points lower than was deficit in the United States. projected in mid-1997. Even under opti- GDP growth for all developing countries mistic assumptions, recovery to long-term is now projected to be 3.9 percent in 1998, growth trends will probably take two or 4.7 percent in 1999, and 5.1 percent in three years. Interest rates remain high in 2000—1.0, 0.4, and 0.2 percentage points the five countries (between 18 and 35 per- less than was projected in mid-1997 (table cent, except in Malaysia), and fiscal poli- 1). Growth in 1998–2000 is still projected cies are tight. to be well above that in 1991–96, thanks to Weaknesses in domestic banking and better policy performance, recovery in financial sectors—which grew rapidly just transition economies, and solid demand in before the crisis—will take time and industrial countries. Outside East Asia, the require considerable fiscal resources to regions with the largest adjustments to the resolve, further slowing recovery in out- previous forecast are Latin America, Sub- put. During 1975–94 banking crises in Saharan Africa, and the Middle East and developing countries were followed by an North Africa. The transition economies of average drop in growth over the next five Europe and Central Asia also lose signifi- years of 1.25 percentage points a year. And cantly—a 0.5 percentage point loss of GDP East Asia’s recovery will likely be slower growth in 1998. than, say, Mexico’s, which benefited from In Latin America, Brazil’s growth is a cyclical upswing in a large, high-income expected to be 2.5 percentage points lower neighbor (the United States) and had less because of recent fiscal consolidation and deep-seated banking problems. higher interest rates. In Sub-Saharan Growth will also slow in the rest of East Africa, oil- and mineral-exporting coun- Asia. In China growth is projected to slow tries (Nigeria, South Africa, Zambia) will by about 1 percentage point, to 7.5 per- be hurt by sizable terms of trade losses. In cent, because of reduced demand for the Middle East and North Africa, lost exports, increased competition in world trade and worsening terms of trade will markets for manufactures, and some dis- slow growth in Algeria, Iran, and the Gulf ruption of foreign direct investment flows, countries. In transition economies, tight- much of which come through Hong Kong. ening measures to support exchange rates Within China, Hong Kong will grow by (Russia) or to cool domestic demand about 2 percent in 1998, down some 3–4 (Poland) will slow growth. percentage points. In Singapore and East Asia’s financial crisis will affect Taiwan, China, the drop will be about 2 other developing countries in five main percentage points. And Vietnam, which ways: by shrinking foreign private capital devalued its currency, faces much stronger flows, reducing trade volumes, lowering export competition and a likely slowdown the prices of traded goods, widening in foreign direct investment. spreads for borrowers, and depressing international interest rates. External adjustment by the five hardest-hit Smaller capital flows East Asian countries will be large in 1998— The crisis has already limited the availabil- their combined current account deficit ity of foreign private capital. New interna- will compress by about $45 billion relative tional market transactions fell about to projections in Global Economic Prospects one-third in November and December 1997 (completed in June 1997). Relative to 1997, and cross-border bank lending is those projections, this adjustment repre- expected to be much lower in 1998. The sents a 12 percent drop in imports and a 9 reduction in private flows has caused percent increase in exports. This correc- macroeconomic tightening in many devel- tion is expected to be partly accommo- oping countries, leading to a multiplier effect on the slowdown in growth and a East Asia and export displacement else- reduction in the need for external finance. where will cause growth in world export Brazil, the Czech Republic, Russia, and volumes to drop about 0.7 percent in 1998 Poland have raised short-term interest relative to previous projections (figure 2). rates and, in some instances, cut budget As a result developing country growth deficits. Reduced access to external capital should fall about 1.0 percent. Besides East has been exacerbated by domestic capital Asia, the two most affected regions are the flight. Because most large developing Middle East and North Africa and Latin economies depend on private capital America and the Caribbean—each suffers flows, these developments have the poten- about a 1.0 percent drop. (These data refer tial to cause a widespread recession. to the first-round partial equilibrium effect. In practice, some of the adjustment Reduced trade volumes will come through price.) The direct effect External adjustment and currency devalu- on China and India will be small because ations in the five most affected East Asian of their enormous economies and limited countries will lower exports from the rest trade ties to East Asia, but they will lose of the world by about 1.5 percent. moderately from competition in third Combined, reduced import demand in markets. (percentage change unless otherwise noted) Global Economic Indicator Current Prospects 1997 a Difference GDP growth World 2.6 3.1 –0.5 United States 2.4 2.1 0.3 Japan 0.8 3.0 –2.2 Major EU countriesb 2.8 2.7 0.1 Asian newly industrialized economiesc 2.2 6.3 –4.1 All developing countries 3.9 4.9 –1.0 Sub-Saharan Africa 3.4 4.1 –0.7 Asia and the Pacificb 5.7 7.1 –1.4 East Asia 5.7 7.7 –2.0 Indonesia, Republic of Korea, Malaysia, Philippines, Thailand –0.2 6.8 –7.0 South Asia 5.8 5.9 –0.1 Europe and Central Asia 3.0 2.9 0.1 Transition economies 3.2 3.7 –0.5 Latin America and the Caribbean 2.7 3.7 –1.0 Middle East and North Africa 2.7 3.6 –0.9 Maghreb 4.6 3.7 0.9 Mashreq 4.6 4.1 0.5 World trade growth 6.3 6.7 –0.4 d Commodity and manufactures prices Non-oil commodities –9.8 –2.4 –7.4 Oil –11.5 0.0 –11.5 G–5 manufactures unit value index 2.5 4.6 –2.1 Six-month dollar LIBOR (percent) 5.7 6.0 –0.3 Note: Forecast reflects all developments since mid-1997, not just the East Asian crisis. a. June 1997. b. Includes Central and Eastern European countries and republics of the former Soviet Union. c. Excludes the Republic of Korea. d. Change in dollars. Source: Development Prospects Group, January 1998. Lower prices 1998 will suffer a 12.5 percent loss in its The crisis will have a deflationary effect on terms of trade attributable solely to the cri- the prices of traded goods. Commodity sis. But oil importers, notably Turkey, gain prices (oil, natural rubber, timber, rice, substantially. Among other countries, and metals) have already fallen (on top of exporters of metals and primary com- other factors working in the same direc- modities will fare worse than exporters of tion). The five hardest-hit East Asian coun- manufactures. Many countries that will tries account for about 7 percent of world lose—Colombia, Peru, Russia, South trade in manufactures, and the dollar price Africa—are exporters of minerals and oil of their exports is expected to fall about 9 but also have a diversified export base, with percent. Besides East Asia, the regions suf- significant manufactures. Their terms of fering the largest terms of trade declines trade losses will range from 1–9 percent. are the Middle East and North Africa, Latin America, and Sub-Saharan Africa. Higher spreads Terms of trade effects vary widely by Developing countries have already seen a country (figure 3). The biggest losers are steep increase in the cost of borrowing, as oil exporters—notably Algeria, which in evidenced by higher spreads on inter- national bonds (figure 4). Since July 1997 spreads on East Asian eurobonds have risen The risks of spillover from the crisis are sig- from about 100 basis points to about 500 nificant but manageable. One is the risk of basis points. Latin American spreads have a cutoff in credit to Asia and contagion out- also risen. Markets now view East Asian bor- side the region. Given the intense pres- rowers as being about as creditworthy as sures facing corporate sectors in the five those in Latin America. hardest-hit East Asian countries, such developments would be disastrous. Depressed interest rates Stylized facts for a hypothetical Thai com- The disinflationary effects of the crisis will pany show that in 1998 it faces an 18 per- lower both short- and long-term interest cent drop in domestic demand, a 500 basis rates in industrial countries—a trend point increase in short-term interest rates, already in evidence. Central banks will adopt up to 100 percent more costly imported easier monetary policies than they other- inputs, doubled unhedged foreign cur- wise would have. Investors have engaged in rency debt, and reduced access to credit. a flight to quality, which has pushed down Already, we have seen in Korea a voluntary yields on U.S. Treasury long bonds. rescheduling of short-term commercial bank debt, and in Indonesia a quasi-mora- exposed—loans to East Asia account for torium on private debt. Thus the assumed nearly 40 percent of capital, on top of exist- trade turnaround in East Asia might not ing problem loans. The implication is that materialize quickly, because a debt over- resolving the problem exposure—that is, hang inhibits exporters’ access to credit cleaning up banks’ balance sheets—will and causes contagion. further undermine Japanese growth. Another risk is a weakening of the capi- tal base of international banks. The sys- This note, based on Global Economic temic risk to international banks is much Prospects Update, January 1998, was written lower now than in the early 1980s, however. by a Development Prospects Group team led by Then, exposure (loans outstanding) to Uri Dadush, Robert Lynn, Mick Riordan, debt-troubled countries (mostly in Latin Dipak Dasgupta, and Ronald Johannes. The America) equaled 65 percent of banks’ cap- Development Prospects Group can generate ital. Today exposure to the five hardest-hit detailed simulations of the effect East Asia’s cri - East Asian countries is 15–20 percent of the sis will have on individual countries. For more capital base. But Japanese banks are heavily details, call Robert Lynn at extension 33961. This note series is intended to summarize good practice and key policy findings in PREM-related topics. PREMnotes are distributed widely to Bank staff and will also be available on the PREM website (http://prem). 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