Singapore Hooked on External Demand

SINGAPORE'S official foreign reserves jumped 17 per cent last year to $163 billion, the biggest increase in a year since 1995. It sounds almost like old times.

IDEAglobal analyst Nizam Idris pointed out to The Straits Times last week that this extraordinary rise in our foreign reserves is not unusual compared with the rest of the region. Foreign reserves of all Asian countries jumped 33 per cent to breach the US$2 trillion (S$3.3 trillion) mark last year.

China's export growth got all the attention, but it wasn't the cause of the surge in foreign reserves. China's current account surplus (trade in goods and services) is likely to shrink to just 1 per cent of gross domestic product (GDP) last year - the result of a surge in imports as rapid growth fed into demand from the domestic economy.

Instead, what drove the rise in China's foreign reserves was an estimated net capital inflow of US$136 billion. This is a massive increase compared with an annual average net capital inflow of US$8 billion in the first half of the 1990s.

Where the rise in foreign reserves is propelled by growing trade surpluses is in South-east Asia. Thailand turned a deficit in its trade of goods and services, equivalent to 8 per cent of GDP in 1995, to an estimated surplus of 5 per cent last year.

Singapore's goods and services surplus ballooned to an astonishing 30 per cent of GDP during the first three quarters of last year, almost double the size of the surplus in 1995.

Such exports-driven growth in reserves contrasts with the situation in the early 1990s when foreign reserves in South-east Asia were driven by foreign capital.

Since then, an average net capital inflow of US$38 billion per year, during the first half of the 1990s, has turned into an annual net outflow of US$38 billion since 1997.

Arguably, international capital flows signal where prospects are deemed highest by investors, so the reduced role of capital flows into South-east Asia reflects their less enthusiastic view of the region's economic outlook.

Still, it's tempting to make the case that South-east Asia's greater reliance on trade surpluses in generating foreign reserves puts the region's economic recovery on a firmer footing.

But to think that this makes the region any less vulnerable to the vagaries of investor mood would be a mistake.

To the extent that South-east Asia's large trade surpluses suggest that their economic recoveries are already heavily dependent on external demand, then the risks associated with relying on this source of growth will grow larger. Since the flip side of South-east Asia's trade surpluses is the record United States trade deficit, it is the US that is behind the surge in the foreign reserves of South-east Asia. That's where the problem starts.

Monetary stimulus from the US Federal Reserve is supporting US demand for foreign goods. This is not unusual per se. Central banks play a critical role in inducing risk-taking behaviour to elicit an economic recovery. That is why economic recoveries tend to be credit-driven.

But the difference this time is the size of the US debt that is needed to support growth. At around 300 per cent of the country's GDP, it is even higher than the peak reached during the debt-deflation spiral of the 1930s.

And it doesn't look as though we are near unwinding this situation. Concerned about the persisting inability of the US economy to generate enough jobs, US Federal Reserve chairman Alan Greenspan signalled last week that the US economy isn't ready for a tightening of the easy credit conditions.

It's not that US economic growth hasn't recovered. GDP growth is expected to expand by what looks a robust 4.5 per cent in the first quarter of this year. It's a question of needing to grow even faster to create jobs.

Perhaps the economy needs more time. But surely, debt levels and debt ratios have a limit; and at some point, creditors will be turned off, demanding higher compensation to reflect the increased risk.

Mr Bill Gross, bond guru of Pimco, America's largest bond fund, thinks the US economy has become 'hooked on debt'. So he is worried. In his recent monthly investment newsletter, he reminded his clients of those limits.

It would be a hard landing for Asia when the carpet is pulled from under America's growth.

Yet, in a job-scarce economy, Mr Greenspan's job is not done. So now he's looking for all the help he can get, and the fall in the US dollar gets his tacit approval. The remaining question is in which currencies the greenback's weakness will show up.

So far, the burden has fallen mostly on the euro. But market analysts say the G7's stress on regions that 'lack flexibility' could mean renewed pressure on Asian currencies.

The obvious target is the Chinese yuan. But with the Chinese government still holding firm, the ripple effects have hit the other Asian currencies: the Singapore dollar rose to a four-year high of S$1.67 against the US dollar last week, and the Thai baht jumped to a four-year high of 38.8. So where the US dollar weakness leaks out is at the points of least resistance.

This could prove awkward for the small and open economies of South-east Asia dependent on external markets.

Take Singapore: During the first three quarters of last year, external demand grew 9 per cent, while domestic demand fell 1.5 per cent.

If the US economy is 'hooked on debt', then we may well have an addiction too.