Managing Globalization: In Asia, How to Manage the Boom?

Globalization has brought wealth to much of Southeast Asia over the past decade, but it has also brought economic crisis. Now, as the region approaches another period of rapid growth, is it equipped to handle the side effects?

In the 1990s, the free flow of money and goods turned Malaysia and Thailand into middle-class economies, made Singapore rich and helped Vietnam start transforming its centrally planned economy. The 1997-98 crisis showed the other edge of the sword; abuse of credit and the rapid flow of money into and out of the region spelled disaster for its currencies and their corresponding financial systems.

Almost a decade later, the boom times are coming back. China's world- beating growth and Japan's resurgence promise to deliver much more demand for goods and services all across the region. The countries are preparing in some noticeable ways - for example, Vietnam is encouraging some students to learn Japanese rather than English. But fiscal and financial policies may be harder to conceive and, importantly, harder to stick with.

The main challenge for the Asian economies will be to commit themselves to restraining their economies before they overheat. With so much demand chasing their products, inflation is likely to rise, potentially putting currencies in jeopardy.

Oil shocks aside, inflation in the region is generally spurred by demand from abroad, said Wong Keng Siong, a senior economist at DBS Bank in Singapore.

"Traditionally, for most of the Southeast Asian economies, growth is led by exports and not so much by domestic demand," he said.

Asian countries' approaches to the problem are varied. Since May 2000, the Bank of Thailand has used a system of inflation targeting. The bank gears its decisions on short-term interest rates toward keeping annual "core" inflation, which excludes changes in prices for energy and raw food, under 3.5 percent.

A target range limits the extent to which factors like unemployment and politics can influence the bank's decisions. But the economy still has some room to overheat. Though core inflation in February was 2.7 percent, at an annual rate, overall inflation was 5.6 percent, which is higher than most industrialized economies would tolerate. The bank has been raising interest rates to try to calm things down.

In Indonesia, the situation is more dire. Prices rose almost 18 percent in the 12 months to February. The government initially set progressively lower inflation targets for 2005, 2006 and 2007.

Yet in light of the economic forecast - at least, that is the reason given by the central bank - the target for 2006 has been raised to a range of 6.5 percent to 8 percent from 4.5 percent to 6.5 percent. This kind of flexibility can send mixed signals to the markets, though: Is it realism, or just a loss of nerve?

Malaysia, where overall inflation was just 3.2 percent in the year to February, need not have such worries. The central bank has been raising short- term rates in anticipation of faster economic growth this year. Though it does not have a public inflation target, it does have something the other economies don't: capital controls.

Malaysia was not alone in reacting to the Asian financial crisis of 1997 and 1998 by trying to regulate the flow of money across its borders. Thailand and Indonesia also tried to stop investors from fleeing their free-falling currencies. But Malaysia's controls, enacted in September 1998, were intended to create a healthy new reality rather than to stanch a gaping wound.

At the time, many economists and pundits predicted severe consequences. Why would investors put their money in Malaysia if they couldn't pull it out whenever they wanted to?

The answer came with time: Malaysia's investment opportunities were clearly profitable enough to justify any risk implied by the controls.

Still, the controls were not an unalloyed success. Research by Simon Johnson of Massachusetts Institute of Technology and Todd Mitton at Brigham Young University in Provo, Utah, suggests that the controls gave politically connected companies an unfair advantage in financing. Other studies have indicated that the controls can lead to black markets and hurt companies' competitiveness.

Now the controls may serve as something of an automatic stabilizer for the economy. As inflation rises, investors' nerves are likely to fray, and the risks of the controls may loom larger. If investors start to hold back financing, it could have much the same effect as an increase in interest rates by the central bank.

Yet the controls may not be as important as they once were, said Ahmad Zubaidi Baharumshah, a professor of economics at Putra Malaysia University in Serdang.

"During the unstable period, they needed to put everything in the proper order and organize," he said of the government in Kuala Lumpur. "Now it's much more open."

And while the controls have relaxed slightly, the rising value of Malaysia's oil exports - in addition to growth in China, Japan and India - may be adding to the inflationary pressure. "It's going to affect prices, but we are not very sure how much the increase will be," Baharumshah said.

Meanwhile, the rest of the region will be bracing for new demand. Growth in China is attracting plenty of imports, Wong of DBS Bank said, but Japan's reawakening could have more far-reaching effects.

"Revival in the Japanese economy is seen as very important to the region as a whole," he said. "Traditionally the Japanese are major investors," both in terms of portfolios and foreign direct investments.

And if prices do start to rise more quickly in Southeast Asian countries, Wong predicted that their governments would be serious about taking action. "There may be problems with inflation," he said, "but most of the regional central banks are trying to get on top of the situation."