To achieve such continued success, however, economic managers will
need to navigate several macroeconomic risks and overcome some
significant microeconomic challenges. The next two sections of this
essay discuss these matters in turn, highlighting the many
implications of Asia's choices for the United States and its
non-Asian allies.

Macroeconomic Risks

Despite the stellar economic performance that much of East Asia has
enjoyed since the 1970s, the region is not immune either to global
economic shocks or the misallocation of resources that can result
from overly accommodating economic policy and easy access to the
world's surplus liquidity. Indeed, many Asian stock markets have
performed significantly below the U.S. stock market in recent years
because of the region's vulnerability to external economic shocks,
and also due to the failure of the corporate sector in some countries
to maintain adequate levels of profitability.

Asia's greatest macroeconomic vulnerabilities are the region's heavy
dependence upon exports and the increasing role of the electronics
sector in driving export growth. Exports have been an important
growth locomotive for many years, averaging 11.8 percent during the
1960s, 24.6 percent during the 1970s, 9.5 percent during the 1980s,
and 11.8 percent during the 1990-95 period. (The major industrial
countries, by contrast, had corresponding export growth rates of 9.5
percent, 19.0 percent, 6.0 percent, and 6.1 percent.) But fast
locomotives can be accident-prone. Asian exports slowed sharply
during 1996 because of the electronics industry recession in the
United States and the sluggish growth of the other major industrial
countries.

Indeed, despite the large increase in Japanese trade with Asia during
the past decade, the United States still poses the greatest business
cycle risk to East Asia. The American market remains so large and so
open in comparison to Japan that exports to the United States account
for one-third of Singapore's GDP, one-quarter of Hong Kong's, 16
percent of Malaysia's, and 9 percent of the Philippines'. China is
also increasing its exposure to the U.S. economy: exports to the
United States now account for 5 percent of China's official measure
of GDP compared to less than 1 percent during the 1980s. While South
Korea has reduced its U.S. export share of GDP to only 5.4 percent
from 7.7 percent five years ago, its large electronics industry
remains highly sensitive to business cycle shocks emanating from the
American economy. In 1996, for example, South Korea's current account
deficit rose sharply because the price of semi-conductor chips, which
now account for 20 percent of the country's exports, fell by almost
75 percent as a result of inventory excesses in the major industrial
nations. The electronics sector has grown so rapidly on the back of
the 1990s computer boom that it now accounts for 51 percent of
Singapore's total exports, 44 percent of Malaysia's exports,
one-third of Korean and Philippine exports, and over one-quarter of
Thai and Taiwanese exports.

Asia's second great vulnerability is its huge pent-up demand for
infrastructure investment and the capital needs that will go with it.
The region's investment needs are so large that some countries have
become major capital importers despite their high domestic savings
rates. The World Bank estimates that the region will have to spend
$1.5 trillion on highways, electricity plants, and other
infrastructure projects during the period 1995-2004--a sum equal to
about 6.8 percent of the region's GDP. China will account for about
$744 billion of that investment, followed by Korea with $269 billion,
Indonesia with $161 billion, and Thailand with $145 billion.

In 1995, several East Asian countries had large current account
deficits simply because their private investment exceeded savings.
The current account deficit of Malaysia and Thailand was 8-9 percent
of GDP, that of Indonesia 4 percent, and that of the Philippines 2.6
percent. As a result of robust foreign investment, the four
developing economies of ASEAN had a collective external deficit of
over $30 billion last year, compared to a small surplus in the late
1980s. The current account deficits of Thailand and Malaysia appeared
so large and intractable during 1996 that some global financial
publications, including The Economist, began to make comparisons with
Mexico in 1994.

There are problems in managing all this money, but unless there is a
major rise in the level of global interest rates that cripples the
access of all capital importing countries to the world's surplus
liquidity, it is difficult to imagine a Mexican-style financial
crisis in the ASEAN region during the 1990s. This is because most
East Asian economies possess structural characteristics that provide
them with major advantages over Mexico in coping with external
liquidity shocks. First, the capital importing countries of East Asia
have relied far more heavily on foreign direct investment and bank
lending to finance their external deficits than did Mexico. The
Mexican crisis resulted because foreign and domestic investors
suddenly suspended purchases of tradable securities after a five-year
foreign investment boom dominated by purchases of relatively
short-term Mexican equities and bonds. Second, the countries of East
Asia have huge foreign exchange reserves both in absolute terms and
in relation to their external deficits. Even excluding Japan, the
countries in the region have increased their reserves to $450 billion
from $237 billion since 1991, thanks to a mixture of trade surpluses
in some countries and the popularity of the whole region as a magnet
for foreign investment. Third, the exchange rates of East Asian
economies do not appear to be as overvalued or commercially
uncompetitive as were some Latin American exchange rates two years
ago. According to The Economist's Big Mac index of exchange rate
comparisons (the price of a McDonald's meal around the world), the
currencies of Malaysia, Indonesia, Thailand, and the Philippines are
undervalued by 20-40 percent. Fourth, the intervention by the U.S.
Treasury and the IMF to rescue Mexico helped to lessen investor
concern that the Mexican crisis would touch off a systemic financing
crisis for all developing countries. The loan to Mexico was the
largest international aid program since the Marshall Plan in 1948 and
was a convincing statement that the economic stability of developing
countries was a major objective of U.S. foreign policy.

Finally in this regard, East Asia may reduce further its potential
vulnerability to future global liquidity shocks through greater
monetary cooperation within the region. Shortly after the Mexican
crisis began, the monetary authorities of Hong Kong and Thailand
organized a meeting of several central banks in the region to discuss
potential monetary cooperation. These discussions culminated in a
communiqué in late 1995 in which several countries (Hong Kong,
Australia, Thailand, Malaysia, Indonesia) pledged to cooperate in the
event of a future crisis. If the countries of Asia can agree on rules
for regional monetary cooperation and lender of last resort, the
impact on investor confidence could be significant. As officials in
Hong Kong explained after the monetary agreement was announced, it is
ironic for the East Asian region to be vulnerable to an external
liquidity shock simply because it deploys its surplus savings in the
world financial system through institutions whose decision makers
reside in London or New York. The region has such a high savings rate
and large foreign exchange reserves that it should not have to rely
on the IMF or other multilateral financial institutions as lenders of
last resort. Indeed, the IMF hopes to borrow more from East Asia in
the future because of its inability to obtain adequate funding from
the U.S. government.

There has not yet been a test of the 1995 monetary cooperation
agreement signed by the East Asian central banks. In the second half
of 1996, Thailand experienced a sharp rise of interest rates and a
stock market slump because of investor concern about the stability of
the baht, but the central bank stabilized the currency by selling a
small portion of its $40 billion of foreign exchange reserves.
Thailand also has been suffering from economic overheating and
inflationary pressures in part because it has pegged its exchange
rate to the dollar while financing the current account deficit
through a large inflow of dollar-denominated bank loans. The ability
of Thailand to borrow so easily produced a low cost of capital for
companies, and that encouraged excessive investment in some sectors.

The Thai experience suggests that Asia's third great vulnerability is
not the risk of a Mexican-style financial shock but ineffective
exchange rate and bank supervision policies for managing the side
effects of surges in global liquidity. The severity of Japan's
recession and the structural stagnation engulfing much of Europe
during the 1990s has created a global financial environment
characterized by surplus liquidity, low interest rates, and
exceptionally easy access to capital for many borrowers. The upsurge
in U.S. growth and Fed tightening briefly punctured this environment
during 1994, but the subsequent U.S. slowdown set the stage for a
further major boomlet in world financial markets and expansion of
global capital flows via stock markets and bank lending. Several East
Asian countries found it so easy to import capital during the first
half of the 1990s that they ceased to have effective price screens
for allocating investment. Contradicting the Krugman thesis, they did
not have a declining return on capital resulting from excessive
domestic savings and investment. They had monetary management
problems and inefficient allocation of investment because they had
become magnets for the international financial system's surplus
liquidity. As a result of their high domestic savings rates, these
countries have not become as addicted to foreign capital as Latin
America, but during the 1990s, the ease with which they attracted the
world's surplus savings caused their businessmen to pursue far more
risky investment projects than they did in the past.