Quotes of the Day

As asia's 1997 economic crisis painfully demonstrated, the region's export-centric growth model is not without pitfalls. While critical lessons have been learned from that wrenching period, Asia has lingering vulnerabilities. Two soft spots are likely to prove especially vexing: the region's dependence upon mainland China and the policies of the U.S. Federal Reserve. A looming slowdown in China's economy will undermine Asia's newest source of external demand, whereas the pending normalization of U.S. interest rates could convince American consumers, the region's oldest and most reliable source of external demand, to cut back on spending. Lacking in self-sustaining demand from homegrown consumers, Asia's economies could be facing new difficulties within the coming year.

Make no mistake, a China slowdown is approaching. Fueled by the excesses of bank lending, the mainland's runaway investment boom threatens balance and stability, and for many months authorities have been moving to bring the overheated economy under control. The objective of China's policymakers is to temper excesses by cooling the credit cycle. In recent weeks, Beijing has announced a number of administrative actions aimed at curtailing excess lending and rapid price increases at the provincial and local levels. I am convinced those actions will work and that China will experience a soft landing by the end of 2004.

But even a soft landing will be felt around the region. The mainland's 40% import surge in 2003 was the spark that ignited Asia's nascent cyclical rebound. When China slows down—as it likely will within months—a chill will settle over Japan, Asia's newest recovery story. Surging exports to China accounted for 32% of total Japanese-export growth in 2003. Japanese capital spending is also being driven in a significant way by capacity expansion in those industries trading with China. With annual private-consumption growth remaining anemic at about 1.5%, Japan has very little cushion against a falloff in mainland exports.

Other Asian countries are exposed, too. In South Korea, fully 36% of export growth in 2003 is traceable to sales into China. Given the postbubble travails of Korean consumers, a deterioration in a key source of external growth could have a major impact domestically. Dramatic effects can also be expected in Taiwan and Hong Kong—economies that have become appendages of the mainland's production platform. A slowdown in China puts all that at risk. Meanwhile, in America, the drumbeat grows louder for a shift in U.S. monetary policy, presaging higher borrowing costs. With the American economy surging at a 5.5% average annual rate since mid-2003 and employment finally on the rise, a 1% federal funds rate is a joke. A year ago, the Federal Reserve implemented an "emergency" policy stance in response to a full-blown deflation scare. That was the right thing to do at the time. But now the emergency is over, suggesting it's high time for the Fed to return interest rates to more normal settings.

Throughout the history of modern Asia, the Fed has been the only central bank that really matters. That's true partly because the Fed, by controlling borrowing costs, holds sway over the credit-loving American consumer, long the principal driver of Asia's external demand. In my view, Asia is deluding itself in believing that it has uncovered a new, autonomous source of growth in China. In the end, the American consumer remains very much in charge. That's especially true for China, whose economic health relies heavily on American consumers borrowing money to buy mainland-made washing machines, toys, consumer electronics and other goods. Take away U.S. shoppers and you reduce not only China's major source of demand to feed its factories but also the spending power of newly minted mainland consumers whose livelihoods depend, directly or indirectly, upon the assembly lines running at full throttle.

With the Fed now back in play and a slowdown just around the corner in China, it's déjà vu in Asia. The region's vulnerabilities stem from the long-standing deficiencies of internal demand—namely, the lack of support from private consumption. Until Asia establishes a better balance in its growth dynamic, the impacts of external disturbances will forever be magnified. The 1997 crisis drove this point home with a vengeance. Since then, Asia has concentrated its efforts on repairing the cracks in its financial architecture that proved so damaging back then. But no two crises are alike. The big risk for Asia, in my view, is that by focusing its attention on responding to the last crisis it may well be missing the risks of the next one. China and the Fed are the wild cards that a still vulnerable Asian economy is least prepared to face.

• Stephen Roach
• Asia's twin growth engines—China and the U.S.—have some problems