Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Will Asia go on a fiscal binge?

In my last post, I argued that Asian currencies are likely to witness a
round of competitive devaluations. The purpose of this post is to consider
whether this could be accompanied by a fiscal binge as well.

But first some elaboration of my two fold argument for Asian
devaluations. The first part of the argument is that reserves are
large but not infinite – reserves may be drained rather quickly
if the country tries to defend the currency. The Koreans found this
out quickly. (My definition of Asia does not include Russia, but the
Russians may also be in the same boat right now. Their half trillion
dollar reserves are the third largest in the world, but they have
already lost a tenth of it and clearly, this rate of reserve loss can
not last forever).

Faced with this reality many countries will let the currency find
its level and let the rest of the world deal with its
consequences. Korea is today telling the rest of Asia what US Treasury
Secretary, Jim Connally told his European counterparts back in the
1970s: “The dollar may be our currency, but it is your
problem.” The added twist is that Korea is also telling its own
corporate sector that the won is their problem, not that of the
government. Many Asian companies will hear the same message. Any
emerging market company with lots of foreign currency debt will
lilkely find itself staring into the abyss.

The second part of the argument was that faced with a global
recession that threatens to be a global deflation, currency
depreciation becomes a desparate attempt to maintain
exports. Commentators on my earlier post asked whether this can
succeed. Of course, beggar thy neighbour cannot succeed if everybody
tries it as the world found in the great depression, but that does not
prevent everybody from trying it.

There will therefore be two kinds of currencies – those that
are taken down by the markets and those that are taken down by their
own governments. Some currencies will be somewhere in between –
the markets will begin the job and the governments will finish
it.

Now back to the fiscal implications. During the 1997 crisis, the
discipline of currency markets was a strong factor in favour of fiscal
restraint. This time around, that restraint will be lacking. In fact,
the governments will be tempted to use fiscal boosts to lift the
economy out of recession. Two statements from the just concluded
Seventh Asia-Europe Meeting were interesting in this regard:

  • Indian Prime Minister Manmohan Singh stated quite
    bluntly: “As a counter cyclical device, increased infrastructure
    investments in developing countries, if backed by increased resources
    flows from multilateral financial institutions such as the IBRD and
    Regional Development Banks, can act as a powerful stabilizer.”
    India has still not let go of its currency and so the call for support
    from the world bank makes sense. But the day the government decides
    that the rupee is somebody else’s problem, this support will be
    less important. Elsewhere in his speech, Dr Singh also quoted Keynes
    with approval.
  • The statement
    of the Seventh Asia-Europe Meeting on the International Financial
    Situation contains this line: “Leaders called on all countries
    to pursue responsible and sound monetary, fiscal and financial
    regulatory policies, enhance transparency, inclusiveness, strengthen
    oversight, and improve crisis management mechanisms so as to maintain
    their own economic development and the stability of the financial
    markets.” This was remarkable for not talking about price
    stability or orderly exchange rates. One could argue that financial
    markets include currency markets, but in today’s context, the
    terms refers more to credit markets.

The fiscal binge (particularly when financed by the printing press)
is just the currency debasement strategy applied internally rather
than externally. It is a very powerful weapon against “debt
deflation”, but the remedy can sometimes be worse than the
disease.

Can the fisc substitute for the lost foreign demand? The fisc is
ill suited to buying the stuff that Asia is used to selling to the now
retrenching American consumer. The fisc is best suited to building
roads to nowhere providing some support to the steel and cement
industries which are now gasping for breath.

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