CIAO DATE: 1/99

The Asian Economic Crisis and Energy Demand

Observations on the Crisis

It is a measure of evolving perceptions of the problem that in his important Sept. 14 Council on Foreign Relations speech Clinton, who last November referred to the Asia crisis as “a few glitches in the road,” now aptly described the current predicament as “the biggest financial challenge facing the world in half a century.”

Fourteen months after the collapse of the Thai baht initiated a spiral of events leading to a protracted and deepening East Asian economic meltdown, what began as a currency crisis has become the most severe economic turmoil since the 1930s. What some view as the first crisis of the twenty-first century has illuminated the flaws of the global financial system as much as the fault lines in East Asian politico-economic systems.

A wide array of Asian economies (Indonesia, South Korea, Thailand, Malaysia), are contracting dramatically--the International Monetary Fund (IMF) projection for -8.7 percent in 1998, or facing more modest recessions (Japan, Hong Kong). There are precious few signs of upturn on the horizon. China has resorted to extraordinary Keynesian measures to sustain growth, steps that deepen its own banking problems and set back reforms for the longer term. The IMF has cut its 1998 world growth forecast by more than half, from 4.3 percent to 2 percent, a hint of the global impact of Asia's predicament. An engine of global growth has become a drag on the world economy. The specter of a prolonged Asian recession--perhaps even depression--has shattered the assumptions, confidence and buoyancy surrounding what was known as the Asian “economic miracle,” and with it, conceits about “Asian values” and an “Asian way of capitalism.”

Indeed, longstanding assumptions about development, finance, politics, and security have all been called into question. For nearly a quarter century, all discussion of Asia-Pacific security was premised on sustained, dynamic economic growth that has been the central preoccupation of all major players in the region. The legitimacy of many governments--dramatically illustrated by the demise of Suharto in Indonesia--has been in large measure, performance-based. The notion of an East Asian economic miracle was taken for granted. It generated the hope of an emerging Pacific community and the nascent regional institutions designed to foster such a sense of community. The impact of the Asian financial malaise on domestic body economic and politic now appears to be of a structural and long-term nature. Already there have been four changes of governments (Thailand, South Korea, Indonesia, and Japan), Malaysia is now embroiled in unprecedented political turmoil. The impact of the Asian recession on regional security is only beginning to be felt in multifaceted and unexpected ways yet to fully play out.

Genesis of the Crisis

Fathoming why and what caused the hiatus--if not demise--of the economic dynamism so central to regional stability is essential to understanding its implications. Some have differing emphases on the various factors that precipitated the crisis. But Asia’s predicament is more than a problem of corrupt politicians, banks too easily lending, and greedy companies all linked together. Its virulence and duration suggest more powerful forces at work. Indeed, in recent months, as witnessed in Russia and in Latin America, the contagion factor has turned it into a global financial crisis.

In sum, the causal factors were the intersection of: excessive capital flows misallocated in the affected countries; fixed exchange rates; and over-guaranteed, under-regulated and untransparent domestic financial markets. These elements led to a contagion snowballing after the Thai crisis, producing an overcorrection by panicked global financial markets:

• Capital flows. The protracted, dynamic, export-oriented growth in East Asia attracted international investors, with the region becoming a magnet for lending and direct investment. China alone has received nearly one-third of global foreign direct investment during the past several years. The 1994 Mexican bailout is cited by some analysts as a precedent that fostered an environment leading to unduly large capital flows to the region. In any case, during the 1990s, by the time of the Thai crisis, Asian developing economies had accumulated some $420 billion in net capital flows. A large proportion of this was short-term money in cases such as South Korea. Much of this money was lent in local currencies via poorly supervised and untransparent, dirigiste financial institutions. It led to overvalued property and stock markets, lavish investment in property development (30 to 40 percent), and created excess capacity and intense competition amongst regional exporters.
  

• Exchange rates . East Asian economies operating on exchanged rates fixed to the dollar and in an environment of open capital markets were trapped by the unprecedented and unanticipated yen-dollar shifts from 1995 to 1997. In that space of time, the dollar rose 60 percent and the yen fell 60 percent, developments profoundly affecting global competition. In addition, the Chinese 1994 devaluation of the renminbi, was a factor precipitating the Thai crisis, as it undercut Thai exporters in labor-intensive export industries. That in turn, hit other southeast Asian currencies. Korean, Thai, and Indonesian banks and companies were hit by the currency shifts that eroded their national wealth.
  

• Weak financial sectors . The structural weaknesses of financial sectors and misallocation of resources in rapidly modernizing economies were also a contributing factor. In affected countries, banks tended to be largely instruments of industrial policies. Lack of transparent accountability camouflaged tight links between the finance sector, business, and government and tended to facilitate high-risk lending. This made it more difficult to attain ‘early warning’ of unsustainable current account deficits, and the dependency on such capital flows to maintain political equilibrium led to a tendency of governments to deny burgeoning economic problems. These structural weaknesses in the financial sector, business culture, and government policies were accumulating inefficiencies brought into sharp relief by the pressures of globalization.
  

• Contagion. The synergy between these first three factors produced the fourth: contagion on the part of international financial markets. The Thai devaluation, in retrospect, appears to have served as an alarm bell leading international creditors to reassess their posture toward other Asian debtors with similar weaknesses as a result of fixed exchange rates, poor quality loans, large deficits, and underdeveloped financial institutions. The result was capital flowing out of the region as rapidly as it had flowed in during the 1990s. Restoring the confidence of investors is a key challenge to the East Asian recovery.

Into the second year of the economic crisis, large-scale injections (roughly $120 billion) of capital from the IMF have not stabilized the situation. Alterations to initial--and flawed--IMF reform prescriptions were made in a host of cases, particularly Indonesia, but also in Thailand and South Korea. It is important to note that, in many cases, the economic fundamentals--savings rate, fiscal policies, education base--are nowhere as bad as the continued recession might indicate. It has become apparent that in assessing the socioeconomic impact of the crisis, prospects for recovery, and consequences for regional security, it is necessary to differentiate among affected countries. It also appears that the sum of factors producing East Asia's predicament is more than its parts. One effect is that the renewal of significant levels of capital flows are unlikely to resume before formulas for debt write-downs are developed.

In beginning to assess the impact on energy demand, it must be noted that the related problems of overcapacity and deflation have yet to be addressed. In China, for example, auto production is 2.1 million, but only 1.4 million in sales;. TV tubes already have 40 percent overcapacity. A measure of the problem is the price fall in Asian markets since January: steel, -18 percent; petrochemicals -22 percent; electronics, -35 percent; autos, -25 percent; shipping, -20 percent; airlines, -40 to -50 percent. This begins to suggest the magnitude of impact on oil and gas demand in the near and perhaps medium-term.

In broad terms, we are probably looking at a 5 to 7 year timeframe before the region on the whole is likely to resume steady, sustainable growth. One key variable is whether piecemeal, ad hoc efforts to write down and sell off bankrupt firms and assets, debt for equity is the principle manner affected countries find a new equilibrium, or whether wider systemic efforts that succeed in arriving at formulas to write down debt are developed. Though the situation is very different, some variation of the “Brady Plan,” developed for Latin American debt in the 1980s, would be an analogy.

There are several strains of the Asian flu, some far more severe than others. One must desegregate this picture look at the various categories of the problem, and also differentiate on a country-by-country basis to obtain a clear sense of the economic trajectory ahead. Those impacted by the crisis fall into four main categories:

• The most affected countries--Thailand, South Korea, Indonesia, and perhaps Malaysia;

• Those spillover countries--Singapore, Philippines (some might put Malaysia in this category);

• Japan whose profound and unique problems are in a class by themselves;

• Those indirectly impacted--China and India.

Let me briefly assess the situation and prospects for some of these countries:

• Thailand: The baht has stabilized in the 38 to 42 range, the stock market remains volatile, and short-term interest rates have dropped almost in half. However, the economy will contract at least 8 percent this year and likely in the 2 to 7 percent range in 1999. Non-performing loans at banks are still increasing, the government recapitalization plan is slow off the boards, and little new lending is expected before the latter half of 1999; restructuring is still piecemeal. But the Thai have shut down all but 23 of 91 troubled financial institutions, and are thus positioned better than others to restructure their financial system. The Thai have done better than most in selling off troubled assets. Its posture toward foreign investment--even though its new law opens new areas for Foreign Direct Investment (FDI) (albeit with conditions)--is still somewhat ambivalent. It will likely be another 18 to 24 months before Thailand is stabilized, with sustained growth likely to resume roughly in the 2001-2002 timeframe.
  

• Korea: Before the crisis the eleventh largest economy in the world, $10,000 per capita GNP (now about $6000). The won has stabilized in the 1300 range, the stock markets remain volatile, and Korea has racked up some $40 billion in foreign reserves, but the economy is still in a muddling-through rather than restructuring mode. Banks are still lending to the chaebol, fearful of the risk of bankruptcies. Corporate debt is about $500 billion (twice annual GDP). Radical restructuring and recapitalization of the banking system, writing down debt and obtaining new liquidity, all remain over the horizon. As Korea is competitive with Japan in a wide array of sectors, Japan’s malaise has perhaps the most negative impact on Korea. The Korean economy will contract by roughly 6 to 8 percent in 1998 and begin to level out in the 1999-2000 period, with sustained growth likely in a 2002-2003 timeframe. Unfortunately, there is a political/security wildcard in South Korea’s future: growing tension and the risk of confrontation with North Korea.

• Indonesia: This is by far the worst case, a full-blown depression and a broken-down political system, while at the same time a major oil and gas producer. It is not far from the edge of complete chaos. Indonesia, the fourth-largest nation in the world and largest Moslem state, is in a situation already worse than that of the United States in 1932. Ninety percent of its stock market has disappeared, its currency massively devalued. It has gone from 70 percent of its population above the poverty line to the opposite, with unemployment zooming above the 25 percent the United States had during its depression. Ethnic strife and various score-settling abounds, secessionist forces are building. Yet there is unlikely to be a stable coalition of forces in a new political system for at least another 10 to 12 months. All in all, not a pretty sight. The banking system needs to be rebuilt from the ground up. Its $84 billion corporate debt appears impossible to deal with, with the rupiah at 10,800 (2,500 prior to the crisis.) It will likely be late 1999-2000 before there is a stable enough environment to begin attracting substantial lending, and likely 2003-2004 before there is a political and economic equilibrium and resumed growth.

• Malaysia: Though most of its debt is internal, its problem of too much money in property and other overcapacity is serious. Now it has generated political turmoil as well. Capital controls will buy perhaps six months, but the economy will contract perhaps in the 6 percent range in 1998, and 1999 is unlikely to yield much improvement.

• Japan: It is now clear that Japan is in the midst of what is likely to be a 2 to 3 year deflationary period and prolonged recession. After a protracted period of denial, it is in the embryonic stages of coming to terms with a trillion dollar banking crisis (our Saving and Loan crisis was $250 billion and took three years to work through). The process involves fundamental changes in the Japanese system, which in turn requires political reform which will take at least one and perhaps two more elections. The Long-term Credit Bank (LTCB) problem is only the tip of the iceberg. Several other major Japanese banks may also be strong candidates for going belly-up. The recent bank package approved by the Diet appears similar to previous efforts, if larger in size. The ruling Liberal Democratic Party (LDP) appears determined to preserve the financial system rather than restructure it. One casualty along the way is likely to be the JNOC, state oil company, which is in serious financial trouble. In sum, the likely scenario is 2001-2002 before Japan begins to see light at the end of the tunnel and resumes sustained growth.

• China: The shoe that hasn’t dropped merits some attention. It is not the bastion of stability it has been portrayed as. Zhu Rongji’s ambitious reform agenda, shaped at last fall’s Party Congress and in March at the National Party Congress, is at best on hold. Fearful of social unrest, Beijing has embarked on a classic Keynesian pump-priming venture, including $240 billion infrastructure spending, ordering bankrupt banks to increase spending to inefficient and many money-losing state-owned enterprises. There is anecdotal evidence that even before the terrible floods, growth was well below the official 7 percent. Electricity use is only up 2 percent from the previous year. Moreover, consumer spending is allegedly up 6.3 percent, though Beijing reports continued deflation. They may push official growth up toward 8 percent, but it is increasingly being asked whether they are cooking the books for political purposes. Total bank lending now exceeds GDP. Officially, 25 percent are bad loans and some estimate figures as high as 40 percent. The data is very shaky, but with $140 billion in foreign reserves and little short-term debt, China has the ability to recapitalize its banking system, however painful it might be. Foreign investment is only down by about 25 percent from record highs of $40 billion annually last year. China could easily slip toward recession or at least much slower growth.
  

The Oil Dimension

What does all this mean for oil demand? When I began this project in early Fall 1997, surging Asian demand growth was the biggest new phenomenon in the energy debate. Asian demand was growing at 5.5 percent, compared to a world average of 1.5 percent. Prior to the current recession, the Asia-Pacific share of world oil consumption was projected to rise from 23 percent to 31 percent by 2010. Clearly, original projections that Asian demand would increase by one million b/pd are long gone with net figures now projected to be at least a 100,000 b/pd downturn. For example, China’s demand fell 5 percent in August. Let’s start with the near-term.

Comparing the first six months of 1998 with the previous year is instructive. Japan, for instance is down 5.4 percent. South Korea is down 13.5 percent. I can testify from driving on the streets of Seoul recently, it is now politically incorrect to drive to work. The monstrous traffic jams have disappeared. China showed modest 4.3 percent official growth in oil demand, but new curbs on imports may reduce that even if growth is sustained. Taiwan has also maintained modest demand at 1.1 percent growth. Similarly, India has not reduced its oil imports, being up 1.4 percent in the six month period from last year.

In Southeast Asia, Thai demand was down 11.2 percent in the first six months. The Philippines was down 2 percent. Broadly, Asian demand was down 2 percent in the first six months. There have been some oil and gas deals in the region, with Thailand and Malaysia agreeing to a $2.4 billion joint development of an offshore oil field, and Singapore and Indonesia agreeing to a 22-year, $4 billion gas deal to develop production on Natuna island. More broadly, the slowdown will delay a host of possible gas pipeline deals under consideration in the region.

While I do not pretend to have a crystal ball, if my rough prognosis of the timeframe for recovery is in the ballpark, I would say that Greater China (China, Hong Kong, Taiwan) and perhaps India are the only major consumers likely to show modest upswings in demand over the 1998-2002 period. Most of the Association of Southeast Asian Nation (ASEAN) states will see diminishing or flat demand. Japan will continue to reduce oil demand until 2001-2002. In the case of Japan, alternative technologies are already entering the transportation market, with Toyota selling some 2,500 fuel-cell cars a month. It is not improbable that as Japan moves toward renewed growth, new technologies may keep demand growth flat for the medium-term future as well.

With that, I will turn it over to Amy to flush out the oil and gas outlook from this Asian malaise.