Since the mid-1980s, Western academics and policymakers have regarded
the "tiger" economies of East Asia as an interesting intellectual
laboratory for debating theories about the causes of economic growth.
Advocates of laissez-faire economic policies have pointed to the
region's prolonged export boom as a triumph of market-led growth.
Advocates of interventionist policies have regarded the successes of
South Korea and Singapore as a vindication of government industrial
targeting, inspired in part by Japan's postwar economic take-off.

In the mid-1990s, however, Asia experienced a growth slump that has
called into question both its export dependence and its traditional
development formula of achieving growth through high levels of
domestic savings and investment. In 1996, in particular, there was
such a sharp deterioration in the corporate profitability and stock
market performance of Thailand and South Korea that many analysts now
regard their economies as structurally flawed, not just cyclically
depressed. The experience of 1996 suggests that Asian governments and
business leaders will have to make a number of microeconomic
adjustments in both public and private sectors if the region is to
regain the economic vitality apparent during the late 1980s and early
1990s. In all likelihood, the tiger economies will do so.

If East Asia can enter the new century with its business confidence
restored, the debate about the region's future will probably shift
from today's obsession with conventional economic issues, such as
corporate profitability and current account deficits, to the
geopolitical implications of a region accounting for over half of the
world's population and nearly a third of its economic output. Indeed,
if things go reasonably well, the twenty-first century will be the
first period since the Industrial Revolution in which Asia's share of
world output is likely to correlate roughly with its population size.
That, obviously, has major geopolitical as well as economic
implications, and they are ones that are likely to confront us sooner
rather than later. In the early stages of the Industrial Revolution,
it took Britain and the United States fifty to sixty years to double
their per capita incomes. The countries of East Asia have been
doubling theirs every ten years. Japan currently accounts for about
8.0 percent of world output and developing Asia for another 24.4
percent. The United States accounts for about 21.3 percent and the
European Union for another 20.7 percent.

Where will these ratios stand in ten to fifteen years? That depends
in large part on how those who run East Asia's expanding economies
manage their way out of the recent doldrums. And that, in turn,
depends on how we and they understand the reasons for their successes
and recent difficulties. Before we can say much about the future,
therefore, a brief revisiting of the debate over the "Asian miracle"
is in order.

How Did It Happen?

Paul Krugman has suggested that the Asian economic take-off of recent
decades was similar in many ways to the large rise in Russian
economic output that occurred during the two decades after the Second
World War. According to Krugman, the countries of East Asia had such
high investment rates that no one should have been surprised that
they enjoyed high rates of output growth. The Asian miracle, he
maintains, was the "result of perspiration, not inspiration";
practically all of the growth in Asian output can be explained by the
growth of factor-inputs such as capital and labor. The so-called
"residual for technical progress" has been close to zero in
Singapore, and only 1.7 percent per annum in Korea, 2.1 percent in
Taiwan, and 2.3 percent in Hong Kong--compared to growth rates of
8-10 percent in all four countries.

Many pundits have found the Krugman thesis reassuring because it
suggests that Asia has not experienced an economic miracle by
pioneering some new formula for growth, that what has happened there
does not, after all, negate the universality of basic classical
economic analysis. Perhaps so, but there are still several serious
problems with the Krugman thesis as a practical guide to
understanding Asia's economic future.

First, there is no detailed consensus among economists about how to
account for economic growth. While Krugman distinguishes generally
between perspiration and inspiration in the growth process, others
contend more specifically that the critical issue is the quality of
the investment and the secondary impact that it has on wages, human
capital, and other factors of production. In this respect, IMF
economists have tested many of the statistical assumptions in the
research that Krugman cites and have concluded that it was wrong.
Michael Sarel, for example, reports that the growth of total factor
productivity in many East Asian countries was much higher than the
data quoted by Krugman.

Second, East Asian countries did not pursue a Soviet-style economic
program to maximize output solely through the creation of new
productive capacity. They promoted a high level of savings and
investment while exposing most of their industry to global market
forces. As a result, they allocated resources in response to world
price signals, not the bureaucratic directives of state planners. It
is true that some countries, such as the Republic of Korea, rigged
their credit allocation policies to favor certain industrial sectors
and large capital intensive enterprises over small ones, but the
focus was still on export-led growth.

In addition to using world prices to allocate resources within their
economies, the East Asian countries have heavily emphasized
investment in critical public goods such as primary education.
Singapore, Hong Kong, Taiwan, and South Korea introduced universal
primary education in the 1960s; Thailand, Malaysia, and Indonesia
soon followed. Korea increased its average schooling period from 3.3
years in 1960 to 9.4 years in 1992, and in this same period Singapore
advanced from 2.9 years to 7 years, Taiwan from 3.2 years to 7.2
years, and Indonesia from 1.1 years to 4.1 years. (The major
education laggards have been Thailand and India.) One major challenge
for Asia during the late 1990s will be to follow up with greater
investment in high school and university education. Thailand, for
example, already has severe shortages of skilled labor because it has
not invested adequate money in secondary schooling.

If one accepts the premise that a high level of savings and wise
investment strategies are essential prerequisites of economic growth,
the economic outlook for Asia still appears to be promising. On the
basis of official data, savings rates are high: China's is 44.8
percent, Indonesia's 37.3 percent, Korea's 38.0 percent, Thailand's
36.9 percent, Malaysia's 32.9 percent, and Singapore's 52.3 percent.
In addition, some countries can draw upon the large wealth of their
overseas Chinese communities, whose collective net worth according to
some estimates exceeds $500 billion. The low savings countries in the
region are the Philippines (15.6 percent), Pakistan (15.0 percent),
and India (18.5 percent).

If educational levels keep pace, Asia's high level of investment
should continue to promote rapid income growth by boosting ratios of
capital to labor and increasing the overall technological
sophistication of the economy. Research and development spending has
risen sharply during recent years and many Asian companies have
strong links to the American university system as well as to the
multinational companies that are leading the way in the development
of new technology. Singapore produces almost one-half of the world's
computer disk drives, while Taiwan and Korea have become important
factors in global semi-conductor production. Asia's export mix is
rapidly becoming as capital intensive as the output mix of more
mature industrial countries, and stands to play a more creative role
in the world economy's technology "food chain."

The recent debate about the origins of East Asia's economic success
has made it clear that, indeed, there was no East Asian economic
"miracle" after the 1960s. Nothing that has occurred contradicts the
classical textbooks, or obviously owes anything to some ineffable
Asian cultural qualities. But at the same time, the success that the
region has enjoyed encompasses far more than gross levels of
investment: It was essentially the result of good public policy,
demographic trends, as well as some luck. Governments pursued
policies designed to maximize private savings and investment while
providing important public goods such as universal education.
Declining birth rates and maturing populations helped promote higher
savings rates. And in those countries where there was more
bureaucratic intervention in the process of investment decision
making, governments were fortunate to be constrained from making
large mistakes by a heavy emphasis on export success and limited
fiscal tolerance for losers.

East Asia's rate of economic growth should continue to run at levels
at least two to three times above the Organization for Economic
Cooperation and Development (OECD) average for some time. There will
be cyclical corrections in response to slower growth of the world
economy or to domestic monetary adjustments to contain inflationary
pressures, but the basic trend of output growth should remain in the
6-9 percent range for the major ASEAN countries and China; Korea and
Taiwan are likely to achieve rates in the 5-7 percent range. India
should enjoy a growth rate of 4-6 percent through a mixture of
population expansion and steady growth of domestic spending, but if
Indian politicians could agree on a more radical economic (and
educational) reform program, the country could achieve a growth rate
of 8-10 percent.

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.

How will the countries of East Asia modify their exchange rate
policies to prevent inflationary overheating? A variety of solutions
are possible. They could introduce wider exchange rate target bands
in order to let their currencies appreciate modestly when capital
flows are large, or to depreciate if the current account deficit
increases significantly. They could also develop new exchange rate
pegs spread over a basket of currencies, not just the dollar. As a
result of East Asia's rapidly increasing trade and investment links
with Japan, there has been some discussion of replacing dollar pegs
with yen pegs. It is doubtful that any Asian country will link its
exchange rate to the yen during the foreseeable future because of the
extreme fluctuations in the yen's value during the past decade.
Nonetheless, the increasing economic integration between Japan and
East Asia could still make the yen a more important reserve currency,
despite East Asia's traditional preference for the dollar as a policy
anchor.

Such a trend could have major implications for the United States and
for U.S.-Japanese relations, and the trend seems clear enough. In the
case of trade with Southeast Asia, the yen now denominates 52.5
percent of exports and 25.7 percent of imports, compared to 41
percent and 11.5 percent in 1987. The yen-denominated share of
Japan's international bank loans has also expanded from only 10
percent in 1980 to 43 percent in 1990 and 65 percent in 1994. A large
share of these loans are made to Japanese companies, but many
non-Japanese firms now have yen loans as well. The yen's share of
foreign exchange reserve is still only about 7.1 percent on a global
basis, but it is much higher in several East Asian countries with
growing financial links to Japan--30 percent or higher in Indonesia,
Taiwan, Singapore, and the Philippines, and in the 15-25 percent
range in China, Korea, and Malaysia.

In recent months, the Japanese government has announced plans to
liberalize Tokyo financial markets and promote greater use of the yen
as a global currency. This policy was prompted by concern about
Tokyo's stagnation as a financial center during the 1990s, and by the
movement toward the creation of a new European currency in 1999. But
even though the Japanese government is now supporting the emergence
of the yen as a reserve currency, it is difficult to imagine the yen
challenging the dollar's role during the next decade. The Japanese
payments system is much less developed than America's. Japan lacks
large liquid markets for short-term government debt, while its
long-term government bond market is dominated by public sector trust
funds. The Bank of Japan estimates that less than 5 percent of yen
bank notes circulate outside of the country, compared to 60 percent
of America's dollar bank notes and 35 percent of Germany's Deutsche
Mark currency. If America reverts to inflationary monetary policies
that jeopardize confidence in the dollar, the changes now occurring
in Japan's financial policies will increase the potential for the yen
to become a more important global currency. But at present it appears
that the yen's evolution as a reserve currency will be gradual and
incremental, not rapid.

The dollar's entrenched role is not the only barrier to the yen's
emergence as a more important reserve currency. The movement toward
monetary union in Europe could produce a new currency supported by
well developed financial institutions, large domestic government debt
markets, and an existing offshore bond market with a market value of
$500 billion--compared to $680 billion for the U.S. dollar and $260
billion for the yen. If European monetary union actually occurs in
1999, the euro will rank as the world's second most important
currency during the first decade of the twenty-first century, not the
yen.

Microeconomic Challenges

The macroeconomic challenges that will confront Asia during the next
few years should be manageable because of the region's high savings
rate and potential for sustaining investment with domestic resources.
But Asia will also have to address the microeconomic challenges of
how to finance its infrastructure boom and how to encourage efficient
resource allocation within its private sector. As Asian economies
become more mature, they will not be able to sustain high rates of
growth merely through high levels of savings. They will also have to
develop corporate governance systems capable of producing adequate
levels of profitability and of reallocating resources when the return
on assets declines.

As noted earlier, the World Bank estimates that East Asia will need
to spend $1.5 trillion on infrastructure during the next decade.
Private investors will no doubt finance most of that amount. Indeed,
many Asian countries have already privatized their phone companies
and some of their electricity-generating companies, but the share of
infrastructure-related investment in the Asian stock markets varies
greatly by country. Despite China's massive investment needs,
infrastructure companies account for only 3 percent of Hong Kong's
stock market capitalization, while utilities and telecommunications
companies account for 20-30 percent of stock market capitalization in
Indonesia, Singapore, Malaysia, Thailand, and the Philippines.

There have been three major problems with attracting private capital
to infrastructure and utility projects. First, some countries, such
as India, have had conflicts with investors over rates of the return
that should be permitted on investment in electricity generation.
Second, in some countries well-connected political families have
played an influential role in obtaining licenses for services such as
telecommunications or toll roads. The children of President Suharto
in Indonesia, for example, have major interests in toll roads,
telecommunications services, and broadcasting; they have been
indispensable allies in obtaining access to such businesses, but
investors are concerned that such relationships could become a
liability should the family lose power. Third, there is no
well-established history of Asian countries using stock markets to
finance infrastructure, and this is likely to make investors highly
sensitive to the performance of the first companies to go public. The
record of the early telecommunications companies on Asian stock
markets has so far been positive, but in China both toll roads and
electricity-generating companies have produced very mediocre results.
If these problems are not solved, and if the necessary large-scale
infrastructure investment is not forthcoming, Asian growth will be
stymied by supply bottlenecks such as traffic congestion, power
failures, and debilitating levels of air pollution.

The re-allocation of capital within Asia's private sector to adjust
to fluctuating profitability will pose other challenges, too. One of
the most striking features of the corporate sector in some Asian
countries during recent years has been a declining rate of return on
capital. In contrast to their American counterparts, Asian companies
have been emphasizing growth of assets and sales, not profitability.
In some countries, this bias has resulted from government credit
allocation policies (Korea) while in others it has resulted from
ownership structures that emphasize goals other than profitability
(Japan). Short-term business cycle factors explain some of the
divergence in profitability, but if one compares the performance of
corporate sectors during the 1990s as a whole, the U.S. corporate
sector has out-performed those of both Asia and Europe by a large
margin.

The return on capital is an important determinant of long-term
economic success because of its impact on a country's savings rate,
level of investment, and capacity for increasing future output. If a
country's business enterprises experience a long-term decline in
profitability, the national rate of savings and investment will
diminish over time as well. As a result, Asia's future economic
performance will depend heavily upon the ability of its corporate
sector to improve profitability and the strategies chosen to do so.
Will management emphasize share prices and profits by engaging in
American-style restructuring? Will Asian shareholder groups encourage
firms to emphasize profits over the interests of other stakeholders,
such as workers and customers? Will governments concerned about
declining profitability alter the regulatory policies that influence
corporate investment decisions? Will the rise of pension funds create
a new class of investors who attempt to influence corporate
governance through aggressive use of their proxies at company
shareholder meetings?

The answers to these questions will vary greatly by country. Several
Asian countries have large stock markets, but there is no established
tradition of outside shareholders playing an important role in
guiding corporate investment decisions through the threat of takeover
bids or proxy fights. In Japan, corporate shareholdings are dominated
by industrial groups and friendly financial institutions, including
banks and insurance companies. Japan's recession during the 1990s has
been the most intractable of the modern era precisely because the
interaction of the 1980s asset inflation with the cross-shareholding
system encouraged massive over-expansion of the capital stock and a
broad collapse in profitability when the economy sank.

South Korea, which has imitated many aspects of the Japanese model of
development, is suffering from similar problems. It has pursued
competition and credit allocation policies that have encouraged a
small number of large industrial groups to dominate the country's
capital intensive export industries. In 1993, the top thirty
conglomerates produced 43 percent of GDP and 70 percent of exports.
Korea's credit policies have turned the country into an extraordinary
industrial powerhouse--the world's second-largest producer of
consumer electronics, second-largest shipbuilder, third-largest
producer of semi-conductors, fifth-largest producer of autos and
petrochemicals, and the world's sixth-largest producer of iron and
steel. But despite these achievements, the Korean stock market has
been anemic in recent years because corporations have focused on the
growth of assets and market share, not profitability. Korea's system
of "stakeholder capitalism" has performed so poorly during the
mid-1990s that the government recently announced major changes in the
country's labor laws in order to give firms more freedom to reduce
employment. This led to major industrial labor disturbances, but the
Korean government has stuc