No Crisis, but a Liquidity trap instead

Merrill Lynch economists say the region is safe from a 1997-style crisis, but that the emergence of a ''liquidity trap'' will stunt East Asia''s growth prospects.

The simultaneous weakening of Europe, Japan and the US could lead global growth to its lowest rates in 30 years, with negative consequences for Asia, says Bill Belchere, Merrill Lynch's head of Asia Pacific economic & global fixed income strategy.

Merrill has cut its global growth forecast from by 2% to 1.3% this year and from 3.5% to 2.2% in 2002. This compares to an average growth rate of 3.7% for the last 30 years.

But, East Asia is generally safe from a repeat of the 1997 crisis Belchere comments, because there is less hot money, longer-term debt and less reliance on US dollar denominated debt, flexible exchange rates, current account surpluses and much larger foreign exchange.

Instead the region is in a 'liquidity trap'. Consequently, in Asia excluding China and India, Belchere forecasts growth dropping to less than 1% this year, and rising to just under 4% next year, with domestic demand contracting this year. Belchere expects the region to enter a recession at the end of the year, remain weak in the first half of next year, with a recovery in the second half of next year.

The liquidity trap is what many economists say has been afflicting Japan for the last decade. Nostradamus' prophecies, poor demographics, doomsday gas attacks in Tokyo's subways and the Kobe earthquake have all left Japanese consumers with a profound reluctance to remove their yen from their wallets and use the production of the world's second largest economy to anything like its full capacity.

A liquidity trap comes despite governments slashing interest rates to boost consumer spending. As in Japan, even zero interest rates can fail to dislodge money from bank deposits and under mattresses, or increase either the supply or the demand for bank loans. In Asia, Belchere believes the liquidity trap had been in place for the last nine months, with interest rates several hundred basis points lower than the beginning of the year, but with no corresponding pick-up in consumer spending.

"Additional liquidity by central banks has not sparked loan growth since loan growth is tied to consumption and investment activity, but sentiment has been negatively affected by the global cycle, so money is going offshore or into very low risk deposits," he points out.  

Nor are East Asian governments likely to be able to pick up the slack through massive government spending.

Firstly, Asia has small public sectors as percentages of GDP, but more importantly, many countries are trying to trim their budget deficits. The Philippines, Malaysia, and Taiwan for example, are already on budget deficits of around 4% to 5% of GDP, and deepening these deficits to 6% to 8% could destabilize them in the eyes of foreign investors. And Indonesia, Philippines and India are trying to work toward to a balanced budget in the medium term, so major government expansion would go counter to the government's existing objectives.

Nor is a stronger yen against the greenback likely to benefit the region's competing exports, since a weaker dollar reflects a weakening US economy, thus diminishing appetite for Asia's export. Indeed, export growth in Asia looks as if it will be down 2% compared to the end of last year, he says.

China, India and Australia, with their huge domestic markets are the best insulated from the global slowdown, while Taiwan and Singapore are already showing negative growth, and Hong Kong and Malaysia are on the verge of doing so.

However, investor confidence in the region is still reasonable he concludes. This, he says, is reflected in Asian bond spreads, which widened to 300bp over US treasuries after the Asian Financial Crisis of 1997, and 1000bp after the Russian default crisis in 1998, but are currently about 150bp over.