Academic journal article Federal Reserve Bank of New York Economic Policy Review

Asia Crisis Postmortem: Where Did the Money Go and Did the United States Benefit?

Academic journal article Federal Reserve Bank of New York Economic Policy Review

Asia Crisis Postmortem: Where Did the Money Go and Did the United States Benefit?

Article excerpt

* In the crisis years of 1997-98, the hardest-hit Asian countries experienced net capital outflows of more than $80 billion.

* Almost all of the outflows originated as banking flows. The majority went first to offshore center banks and then to banks in Europe.

* Much of the capital eventually reached the United states, but in the form of foreign direct investment or portfolio investment rather than banking flows.

* An equilibrium analysis of supply- and demand-side channels suggests that the overall effect of the crisis on U.S. GDP was positive but small.

The recent currency crises in Asia have raised important questions about the sensitivity of industrialized-country economies to financial turmoil in emerging markets. In late 1997 and in 1998, Indonesia, Korea, Malaysia, the Philippines, and Thailand experienced net capital outflows of more than $80 billion, plunging them from "growth-miracle" status into their worst recessions in decades. GDP growth rates in Korea and Malaysia in 1998 were -5.8 percent and -7.5 percent, respectively, and in Indonesia and Thailand the rates were worse than -10 percent. By comparison, GDP growth in the United States was a healthy 4.3 percent that year.

These contrasting experiences are puzzling at first glance, because it was widely believed that the downturn in Asia would have a negative effect on the U.S. economy.(1) Recessions in the crisis countries, according to this logic, in conjunction with sharply depreciated currencies, would reduce the countries' demand for U.S. exports. In addition, the depreciated currencies would lead to a surge in U.S. imports from these countries. Hence, through these international trade channels, the Asia crisis was expected to contribute negatively to U.S. growth. The U.S. net export deficit did, in fact, increase, contributing -1.2 percentage points to U.S. GDP growth in 1998. However, the increase in the deficit was more than offset by increased spending on consumer goods and producers' durable equipment, so that employment and production rose. Quarter by quarter, U.S. GDP growth in 1998 consistently exceeded projections.

In our view, this apparently surprising immunity of the U.S. economy to the Asia crisis reflects the fact that the original way of thinking about the crisis was flawed. First, it focused only on demand-side channels and ignored the supply side. Second, the depreciation of the Asian currencies against the dollar and the recessions in the crisis countries represented endogenous responses to a large and sharp reallocation of capital out of the Asia crisis region. From the point of view of the United States, this reallocation of capital is the appropriate starting point--rather than the depreciations and recessions--for considering the implications of the crisis.

What, then, precipitated the large and sharp reallocation of capital out of Asia? We believe that increased expectations of private sector bankruptcies and currency depreciations are likely forces. These expectations could have been grounded in fundamental information about conditions in the private sector. They could also have been influenced by nonfundamental forces such as rational or irrational herding behavior. As we indicate below, it is immaterial to our framework whether the change in expectations was driven by fundamentals or nonfundamentals. In either case, there was a large decline in demand for Asian assets. A large capital outflow occurred, and all the macroeconomic consequences for the United States ensued from this outflow.

The reallocation of capital toward the United States generated the above-mentioned negative trade effects on the country's GDP. But the capital inflows also created a positive effect by financing a rise in U.S. spending, directly through increased financing for liquidity-constrained firms and consumers as well as indirectly through a drop in interest rates. The capital inflows also led to an appreciating dollar, which made imported inputs cheaper. …

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