Most East Asian countries followed some variation of Japan's export-led development model. Those that did also developed a chronic dysfunctionality between the international and domestic sectors of their economies. To a considerable degree, the exaggerated differentiation in internal and external sectors contributed to their respective economic woes and is a common thread that links the "crisis" economies. Although exports can make an important contribution to material advance, they cannot be the main engine of growth. In the most open economies, foreign trade only constitutes about 25-30 percent of total GDP. It is impossible for such a small fraction of the total economy to pull along a domestic sector that is mired in a growth slowdown or is actually shrinking.
Consider Japan's international sector that continues to boom and records large trade surpluses amid a pernicious and persistent deflationary recession. While its multinational enterprises engage and defeat global competitors, the willful repression of internal and external sources of competition has rendered domestic banks and businesses to a point where they need radical restructuring. Just as loose credit of the 1980s led to the "bubble" economy, Japan's development policies created an illusion of full and permanent employment. The bills for this party are finally coming due, but most of the hangover will be suffered by future generations who will be burdened by an enormous public-sector debt.
Economies around East Asia reveal similar results. China offers the next worst case. Its coastal provinces are deeply engaged in the global marketplace while enjoying relatively high and constantly rising per capita incomes. Most of the rest of China's economy is held back by its unprofitable state-owned enterprises that are a legacy of communist central planning.
Beijing considers the divisions of the local economy to be based upon geography and is trying to encourage investment in the interior provinces. But, as elsewhere, this misses the point. What is needed is for the domestic economy to become more competitive with greater private entrepreneurial initiatives. The mere fact that the government must urge investors in China to "look West" confirms that few profitable opportunities are available there.
Ironically, China's uneven geographic and sectoral development is itself an outcome of meddling with investment decisions that its government constantly engages in. Inroads for faster and more evenly distributed growth would be made if the regime focused upon exorcising the rot of corruption from its ranks while implementing a rule of law that protects and promotes private enterprise. Korea's economy and those in Southeast Asia suffer from the same sort of partitioning of their domestic and foreign trade sectors, if with less severe results. Policies of export-led development are based upon a misdirected neo-mercantilist belief that only exports contribute to economic growth. Indeed, imports are perhaps an even more important factor behind sustainable growth. This is because an inflow of imports allows producers and consumers to buy from least-cost providers that enhances efficiency and increases real purchasing power as a basis for growth.
Similarly, the presence of foreign competition provides domestic producers with an incentive to become more innovative and efficient. Such improvements lead to gains in labor productivity and higher wages that contribute to rising household incomes and higher consumption. Productivity gains also boost profits due to declining unit costs. These enhancements in shareholders wealth also boost domestic consumption.
These benefits then extend to the international sector because export sectors can import inputs or intermediate goods that lower their operating costs. Falling costs and rising productivity make it easier to export. Rising profits allow domestic multinational enterprises to buy overseas production facilities and sources of raw materials. Another thread that links Japan's economic hardships to its neighbors in East Asia is its underdeveloped and heavily-regulated domestic capital market. Government-imposed restrictions on domestic capital markets meant that the bulk of investment funds were lent through banks.
Unlike capital markets where lending only takes place when there is substantial transparency, banks tend to be vulnerable to political pressures.
Since few firms raised capital through bond issues or equity sales and with limits on full foreign ownership of enterprises, foreign investors found thin markets where relatively small flows of funds had exaggerated effects on valuations of traded instruments. In the end, extensive government controls on domestic capital markets insured that many of East Asia's economies remain heavily dependent upon and vulnerable to movement of foreign funds.
At the same time, politicized capital markets allowed investment funds to be diverted to favored industries or cronies. Government support for these ventures encouraged banks to make loans without undertaking commercial-risk analysis. There were spectacular failures from these misdirected investments since rewards tended to go into private hands while political linkages caused losses to be shifted to taxpayers.
Many of the remedies to the economic problems may reproduce or exacerbate them. For example, forcing interest rates down may encourage more misdirected investments that would further weaken the balance sheets of financial institutions. Capital controls might give some breathing space without resolving structural deficiencies. Government intervention in equity markets, in Hong Kong and Taiwan and now being discussed again in Japan, has considerable exit risks while it distorts market valuations and increases volatility.
Asian economies can return to high growth if their governments eschew interventionist policies that support export-oriented sectors. Instead, they should install an "institutional infratructure" that encourages their domestic sectors to be more competitive while liberalizing local financial markets with accompanying legal and regulatory oversight.
When domestic enterprises operate as competitively as multinationals do, the emerging market economies of Asia can be more confident of stable and sustainable growth.
Christopher Lingle is Global Strategist for eConoLytics
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