Market Advisory Features

War and Iraq

The economic risks

“IRAQNOPHOBIA”—fear of the consequences of a probable war with Iraq—is being blamed for the sick state of the world economy and for the fall this year in the dollar and in most big stockmarkets. If fear is to blame, then a short, successful war should remove the uncertainty that is holding back consumer and corporate spending, allowing economic activity and share prices to bounce back again. Alan Greenspan, the chairman of America's Federal Reserve, appeared to suggest as much last week. But Iraq is only one of the problems facing the global economy. Others will continue to weigh it down even after the tanks and bombers have gone home.

An American-led attack on Iraq looks highly likely. But trying to assess the economic consequences of such an attack is tricky because of the vast number of unknowns and contingencies. For instance, how long will the conflict last? Will it escalate outside Iraq? Will there be any damage to oilfields, as there was in the Gulf war in 1991? Will other OPEC countries increase their oil production to compensate? And how badly will business and consumer confidence be hit? These are not questions that can be answered by plugging numbers into a computer model. Yet several investment banks and think-tanks have made a stab at it.

Most of them maintain that the likeliest scenario is a short, successful war. Oil prices would spike briefly at around $40 a barrel, but then plunge as the war ends. In turn, share prices and the dollar will rally, and confidence will revive, spurring a strong economic recovery. Several economists reckon that a war might actually be good for the world economy: it will eliminate today's mood of uncertainty, boost government spending, and push oil prices lower in the medium term as new Iraqi production comes on stream.

John Llewellyn, chief economist at Lehman Brothers, is much less sanguine. He argues that the risks to the global economy, taken together, are now greater than at any time since the 1973-74 oil crisis. Even if the war goes well, he argues, it will probably not be the panacea that investors are hoping for. The aftermath of war will be uncertain; the risk of terrorist acts will remain; and there are plenty of other worries too, not least over North Korea.

The economic costs of a war can be broken into three types. First, there are the direct military costs. The six-week Gulf war in 1991 cost $80 billion in today's prices (most of it paid for by America's allies). Assuming a similarly short war, America's Congressional Budget Office and the House Budget Committee have both estimated a total military cost of around $50 billion, or 0.5% of America's GDP. Others reckon that a more protracted war could cost America as much as $150 billion.

Second, there are the potentially far larger indirect costs of peacekeeping, humanitarian assistance and reconstruction. William Nordhaus, an economist at Yale University, thinks that these could cost America between $100 billion and $600 billion over the next decade*.

Last but not least, there are the macroeconomic costs of lost output. Especially if the war goes badly, these could be far bigger than the others, which are really just efficiency losses from the diversion of resources. Mr Nordhaus estimates that the total cost of a war to America could range between $100 billion and $1.9 trillion, spread over a ten-year period. That could be as much as 2% of American GDP for every year of the decade.

The hardest of the three to pin down is the macroeconomic cost—to the world economy, not just America's. Broadly speaking, a war in Iraq could affect economies through four main channels: oil prices; stockmarkets; the dollar; and business and consumer confidence.

Oil prices have already reached their highest level for two years. West Texas Intermediate has risen above $36 a barrel, up almost 50% from last June. So far, though, this is a much smaller rise than in the run-up to the 1991 war. In real terms, oil prices today are less than half their 1980 peak. The conventional wisdom is that prices will fall sharply once a war is over, just as they did in 1991. Then they fell from over $40 to below pre-war levels after the ground war had begun. Optimists today argue that a victory will liberate Iraqi oil as well as its people. (This assumes that the Iraqis do not sabotage their own oilfields or those of their neighbours.)

So it is widely hoped that oil prices might this time also fall towards $20 a barrel once war is under way. But is 1990-91 the appropriate model? Even if the war is as short, oil prices may not fall as much this time because the background environment is different. Economists at Goldman Sachs argue that the recent rise in oil prices has had more to do with the disruptions in Venezuela than with worries about Iraq.

Venezuela's oil-industry strike may be over, but the country is unlikely to restore more than two-thirds of its output this year. Goldman Sachs reckons that the combined impact of Venezuelan and Iraqi disruption has the potential to be the biggest shock in oil-market history, even after allowing for some offsetting increases in supply from other producers.

Another reason why oil prices may not fall as sharply as in 1991 is that the oil market is much tighter. An exceptionally cold winter right across the northern hemisphere has boosted demand at a time when American oil stocks are at their lowest level since 1975. In 1991, oil stocks were well above normal.

OPEC also has less spare oil-production capacity this time to fill the gap. The cartel had spare capacity of 6m barrels a day when Iraq invaded Kuwait in 1990, compared with only 2m today. The continuing shortfall in Venezuela, plus even a small loss of output from Iraq, could rapidly exhaust that. In any case, Iraq will not be able to turn its oil taps on fully the moment that war ends. Goldman Sachs estimates, therefore, that oil prices may average no lower than $27 over the next 12 months.

Although the rich world uses half as much oil per dollar of GDP as it did in the 1970s, higher oil prices still have the power to hurt its economy. According to the IMF's ready reckoner,a $10 increase in oil prices, if sustained for a year, reduces global GDP by 0.6% after one year. That impact sounds fairly modest, but the snag with all such calculations is that they consider only first-round effects. They ignore the potentially much bigger impact on confidence and stockmarkets, and they ignore the effects that follow from changes in monetary and fiscal policy.

Even taking account of such factors, however, most forecasters still reckon that the American economy will slip into a new recession only if there is a more prolonged war, a much sharper rise in oil prices than now expected, and a stockmarket slump of at least 20%. Yet in the past, economists have consistently underestimated the economic impact of oil shocks.

Over the past three decades, oil prices have jumped sharply on four occasions: in 1973, after the first OPEC embargo; in 1979, after the Iranian revolution; in 1990, after Iraq's invasion of Kuwait; and in 1999-2000 as the world economy boomed and OPEC cut its production. Each time the price more than tripled, contributing to a global recession.

Higher oil prices hurt the economy in two ways. In the first place, the increase acts like a tax, raising firms' costs for any given output price. So if demand is unchanged, prices rise and firms produce less. Secondly, higher oil prices transfer income from oil-importing countries to oil producers, squeezing spending in the oil importers. In the economic jargon, both the aggregate demand and aggregate supply curves shift backwards. Output falls, but the impact on underlying inflation, and hence the appropriate policy response from central banks, is uncertain.

Whether central banks should raise interest rates to curb inflation, or cut rates to cushion output, depends on the cyclical position of the economy. The four previous oil shocks all took place during booms, when economies were already overheating and inflation was rising. This forced central banks to raise interest rates.

Today, the rise in oil prices is occurring in an environment of excess capacity and falling inflation. Firms have little pricing power, so it is harder for them to pass on higher costs. Rising oil prices are therefore more likely to erode profits than to push up inflation. That, in turn, would further delay a recovery in corporate investment and hiring. The correct response at such a time is to reduce interest rates, not raise them.

The Fed seems to understand this better than the European Central Bank, which frets more about its inflation target. But with interest rates at 1.25%, the Fed has little room to cut further. Euro-area rates (at 2.75%) leave more room to cut, but the ECB is likely to be slow to act. At its most recent press conference (earlier this month) its president, Wim Duisenberg, declared that “a rate cut now would be a mere drop that would drown in the sea of uncertainties”, referring to oil prices and geopolitical risks. Yet Germany, the euro area's biggest economy, may be back in recession again. The Bundesbank confirmed this week that German GDP fell slightly in the fourth quarter of 2002. And many private-sector economists reckon that output will shrink again in the current quarter.

America has more room to ease fiscal policy. Indeed, a successful war will help George Bush to get congressional approval for his tax cuts. On the other hand, Japan (thanks to its already hefty public debts) and the euro area (thanks to its stability pact) have little room to ease policy, even in the event of a further downturn.

Underpinning the hope of a strong economic rebound after a war is the unstated assumption that America's economic fundamentals are sound. However, America has yet to complete its post-bubble adjustment. Record consumer debt leaves the economy vulnerable to shocks. American consumer confidence is at a nine-year low. Some blame this on the threat of war (in which case confidence could later rebound). But, in fact, more of it may be due to consumers' heavy debts, poor underlying job prospects, and falling stockmarkets.

Economists are using war fears as a convenient explanation for slower than expected growth—just as they (wrongly) blamed America's recession in 2001 on the September 11th attacks. Bill Dudley, an economist at Goldman Sachs, argues that war fears are not the biggest reason why the economy is soft. Instead, the problems lie deeper: in the excesses built up during the bubble years, such as huge private-sector debts, excess capacity, low saving, and a massive current-account deficit.

America's over-indebted households, Japan's deflation and its crippled banks, Europe's structural rigidities and its overly tight fiscal and monetary policies: all these mean that the world economy is horribly vulnerable to shocks of any kind. Moreover, after the Gulf war America's initial recovery was sluggish, due to the need for firms to reduce their debts from the excesses of the 1980s. Yet the excesses of the 1990s were much larger. America's fragile economy is, in a manner of speaking, being held together by duct tape. The 1.3% jump in retail sales (excluding cars and petrol) in January may partly reflect precautionary stockpiling of canned foods, bottled water and other goods.

Most stockmarkets have fallen in each of the past three years, and many investors are hoping that getting the war out of the way will stop the rot. Between the start and finish of the Korean war, American share prices rose by 28%. In 1991, the S&P 500 rose by more than 20% within four months of the start of the air attack.

But America's stockmarkets looked cheaper in 1991 than they do today. A market with a p/e ratio of 28 on historic profits, and an average forecast of double-digit profit growth despite slow nominal GDP growth, is not exactly discounting bad news. Another big difference from 1991 is that analysts have already assumed a quick and painless war. Before the Gulf war they were much less confident. So the downside risk today is much greater. A prolonged war could drive property and share prices sharply lower.

How might exchange rates react? The sharp fall in the dollar in recent months may in part be related to war worries. So a quick victory, it is argued, would help the dollar to rally. The dollar bounced by 10% in trade-weighted terms within two months of the end of the Gulf war.

However, there is a big difference this time. In 1990-91 the net cost of the war to America was reduced from $80 billion, at today's prices, to only $4 billion after contributions from friendly Arab countries and Japan. These transfer payments flattered America's current-account balance in 1991 and so helped to lift the dollar. This time, America will have to foot most of the bill itself. In 1991, it had a small current-account surplus. Today, with its deficit running at more than 5% of GDP, any dollar recovery is likely to be short-lived.

Beyond the macroeconomic fall-out from war, there is one other big concern: that diplomatic tensions between America and Europe over Iraq could spread beyond war to trade. The two sides already have a string of bilateral trade disputes: over America's steel tariffs and its tax breaks for foreign sales by big multinationals; and over the EU's ban on imports of hormone-treated beef and genetically-modified foods, for instance.

German firms are particularly worried about a loss of business in America. Last week, the American Chamber of Commerce in Germany celebrated its 100th anniversary. In between the champagne and canapés there was much talk that the political rift between the two countries could harm commercial links. A few American congressmen have already called for restrictions to be imposed on the import of European wine, cheese and military equipment.

There is also talk that American firms might shift their future investments from “old Europe”—France and Germany—into “new European” countries—such as Britain. More realistically, however, Germany and France are already seen as hostile business environments because of their high labour costs and taxes, and their rigid markets. To some extent, the political rift is just another excuse.

What is clear, however, is that the spat over Iraq will not help to speed up trade negotiations in the Doha round, which already seem to be heading for gridlock. Last weekend, trade ministers meeting in Tokyo made almost no progress towards liberalising farm trade. Yet agriculture is the central issue for the Doha round. Failure to liberalise farm trade would be a big blow to the poor world. Even worse would be an associated tit-for-tat trade battle between the rich.

Three years after the bear market started, stockmarkets in Europe, America and Japan are, if anything, more volatile than ever. Almost every economic statistic, every snippet of news about the imminent war, sends them sliding once again. European markets hit their lowest levels for six years earlier this week, and news that consumer confidence in America appeared to have collapsed reinforced investors' nervousness.

It is the same on the currency markets. Against the euro, the dollar has lost nearly a quarter of its value since its high point in 2000, with much of the slide taking place in the last few months. Only suspected Japanese intervention to slow the appreciation of the yen has slowed the dollar’s fall there. Sterling has also begun to slip sharply, as worries have grown about the outlook for the British economy.

Perhaps most important, the oil price has continued to climb, with occasional fluctuations doing little to temper the underlying rise. Traders are obviously worried about the impact of a war on oil supplies; but they are also bothered by the continuing shortfall in supplies from Venezuela, by Malaysia’s talk of an embargo on supplies from Islamic countries, and by the tightness of the current market, reinforced by high demand during the unusually cold winter in the main consuming countries. All the data show that sharp rises in oil prices have a significant dampening effect on economic activity.

Volatility is an inevitable result of the current geopolitical uncertainty. It is not just a question of whether there will be a war, but how successful military intervention would be, and how long it might last. One school of thought reckons that a short, successful war would have a positive impact on the global economic outlook. Alan Greenspan, chairman of the Federal Reserve, America’s central bank, recently suggested that an end to the uncertainty could have a beneficial impact on America’s economy. He even went so far as to suggest that the Bush administration’s fiscal stimulus was premature because it was designed to tackle a problem that might fade once war was over.

But even Mr Greenspan acknowledged that nobody can be certain. Indeed, plenty of economists argue that it would be mistaken to assume all will be well once the war is over. In some cases, at least, it is hard to dispute this assessment. Japan’s economic difficulties long pre-date the Iraq crisis. They are deep-seated and will take a good deal of time and effort to tackle. This week’s announcement that a monetary-policy conservative, Toshihiko Fukui, had been nominated as the next governor of the Bank of Japan did nothing to encourage Tokyo-watchers. Most thought this showed that the prime minister, Junichiro Koizumi, had either failed in his resolve to push ahead with economic reform or had lost a power struggle behind the scenes.

Europe, too, is another clear case of worries about war exacerbating underlying economic problems. The euro-area’s underwhelming economic performance over the past few years has made it far more vulnerable to unexpected shocks—the slowdown in America’s economy in 2001, the collapse in share prices and, now, the prospect of war. European businesses must also be wondering whether the quarrel between America and “old Europe”, led by France and Germany, will have any lasting economic impact. In America’s Congress, there has been talk of blocking some European imports in retaliation for the lack of diplomatic support among some key allies.

The urgent need for structural reform in Europe and Japan is undisputed by most economists. Opinion is more divided when it comes to America. The optimists insist that, with war over, America’s economic recovery will gather speed. They accept that such factors as the big drop in consumer confidence this week are cause for concern. But they point to the difficulty of judging how far such surveys translate into actual spending decisions by consumers. The housing market, for instance, remains relatively buoyant, as figures published on February 25th show. In recent years, housing has underpinned much consumer spending in the world’s biggest economy.

None of this convinces the pessimists. For a start, they point to studies showing that the cost of the war could well be very high, both in cash terms and in its long-term impact on the economy. One analysis suggests that in the worst case, the war could cost the equivalent of 2% of GDP for each of the next ten years. That would hardly help bring the government’s budget deficits under control. These are already projected to be so big that some economists think they will push up interest rates in the longer term.

Add to this the conviction of a growing number of economists that America’s current-account deficit—now about 5% of GDP—is unsustainable, and the sense of structural malaise becomes stronger. Financing this huge shortfall without considerable belt-tightening by Americans requires the continuation of massive capital inflows from abroad. Foreign investors, for example, might be less willing to provide such funds if America’s economic prospects seemed relatively less favourable in the future than they have been in the past.

Mr Greenspan is right to say that short-term anxieties make a proper assessment of America’s economy difficult. In any case, war, or the threat of it, is a useful scapegoat for longer-term problems. But it would be unwise to assume that when the war is over, those problems will have disappeared.

IF THERE is a quintessentially Chinese industrial product, it is the bicycle. But the bicycle has also become a symbol of what the rest of the world fears most about China—that its phenomenally fast growth can be sustained only at the expense of other economies, both developed and developing. China's success at building bikes has undermined production of two-wheeled vehicles everywhere. The Chinese now manufacture 60% of the world's bicycles, and 86% of those sold in America.

All over the world the price of bikes is falling. In Ghana, for example, the cost of a low-end mountain bike has plunged from $67 to $25 in the past two years. The only country with a chance against China's infamously low wages, it is said, is India. Rival manufacturers in Latin America and Africa are struggling to survive.

After bicycles, what next? The pessimists fear that a string of other industries will follow. The labour-intensive textile and clothing sector is already in a panic. For years, rich countries have been distorting world trade in garments with a complicated system of import quotas. As a result, many people in poor countries—such as Indonesia, Mauritius, Mexico and Pakistan—nowadays depend on making as much as their textile quotas allow. Even rich-country firms—in the Carolinas, notably—have continued to do well behind their quota walls.

China is these workers' worst nightmare. It is already by far the biggest garment exporter in the world, with average wages in the industry of 40 cents an hour—less than a third of, say, Mexico's. Now that China belongs to the World Trade Organisation (WTO), moreover, it will benefit from an agreement by members to eliminate the quotas completely by 2005. As a result, according to estimates by the World Bank, China's share of world garment exports will increase from about 20% today to 50% by the end of this decade.

Shoes, semiconductors and televisions are expected to follow. China already makes over half of the world's shoes, and Malaysia frets over the exodus of electronics factories from Penang, an island once hyped as a potential Silicon Valley, to Guangdong and the Yangzi delta. Heinrich von Pierer, the boss of Siemens, a big German electronics and electrical conglomerate, has called the country “a global factory” for his company. Comparisons are made with Manchester during the Industrial Revolution. China, it is said, is becoming the “workshop of the world”.

Andy Xie, an economist with Morgan Stanley in Hong Kong, reckons that by 2005 China's exports could have exceeded those of Japan. He also thinks that China has a lot to do with deflation in other countries, because it causes price wars and pushes down profit margins of companies elsewhere. China's industrialisation, he says, “devalues manufacturing assets outside China”.

Before getting too gloomy at the prospect of China snatching jobs and foreign investment from everybody else, however, consider one of the reasons for its success at exporting bicycles—the fact that the Chinese themselves are getting off their bikes and into cars. According to Walter Hook, director of the Institute for Transportation and Development Policy in New York, 33% of all trips in Guangzhou, a rich southern city, were by bicycle in 1995; today, fewer than 20% are. Bicycle makers such as Shanghai Phoenix, one of China's biggest, have lost half their domestic market in recent years. They have no choice but to export.

On the other hand, sales of cars in China have started to take off. Last year they exceeded 1m for the first time, and they are expected to rise by another 20% this year. And who is making these cars? None other than the likes of Volkswagen and General Motors. China is now VW's biggest market outside Germany, and Ford expects China to become bigger for it than both Germany and Japan within five years. Even when they are assembled locally, many of these cars' components are imported.

China (including Hong Kong) already imports more from the rest of Asia than does Japan, and shopkeepers in Sydney and Singapore are beside themselves whenever buses of Chinese tourists pull up outside their stores. As China grows, it becomes a bigger market for other people's goods, as well as a bigger exporter of its own. If there is nothing to distort this process, everybody benefits.

China's economy is already enormous. In dollar terms, its GDP is the sixth largest in the world, just smaller than France's. In terms of purchasing-power parity (after adjusting for price differences between economies) it is second only to the United States with an 11.8% share of world GDP. Its growth rate too is extraordinary. Last year's official figure of 8% made it the most dynamic large economy in the world—by far. Many independent economists believe that this is exaggerated by several percentage points. Nevertheless, few doubt that the Chinese economy is booming.

It is China's strength as a trading nation, however, that most worries others—in particular, the more sluggish economies in the region. Japan's minister of finance and other government officials habitually accuse China of mercantilism, and of unfairly maintaining an undervalued currency in order to make its exports more competitive. In 2001, China's exports rose by 23% to $266 billion and accounted for 4.4% of all world exports. That is the highest level they have ever reached, but it is still a long way off Japan's record (of 10.1% of world exports) in 1986. It is even below Japan's figure for 2001 of 6.6%.

China's trade surplus in 2001 increased to over $30 billion. At 2.9% of GDP, it was relatively larger than Japan's (1.7%) but smaller than South Korea's (3.2%). Moreover, China's trade surplus as a percentage of GDP has declined every year since 1997 (see chart). The country has a substantial trade deficit with Malaysia, South Korea and Thailand, and since it joined the WTO, China's imports from Japan have been increasing at an annual rate of 40-50%.

The bottom line? China's trade is nowhere near historically unprecedented levels. Since its economic opening in 1978, the country's share of world trade has more or less quadrupled. But so did Japan's between 1955 and 1985, and the Asian tigers' between 1965 and 1995. Since China joined the WTO in December 2001, becoming subject to its rules on free and fair trade, accusations of mercantilist behaviour have sounded even more hollow than they did before.

Inevitably, as China grows, some countries will find their competitive position altered and the adjustment painful. They might even be tempted to retaliate. European bicycle producers, for example, have persuaded the EU to impose tariffs on Chinese imports, accusing the Chinese of dumping. There will, on the other hand, be some, such as the Philippines (see article), which will find their economies rising on the surging Chinese tide.

Another current concern about China is that it is hoovering up foreign direct investment (FDI) that, were it playing fair, would be destined elsewhere. Much of South-East Asia is paranoid about being sidelined by China in the competition for investment from rich countries. True, last year China surpassed America as the world's largest recipient of FDI, with $53 billion-worth. But that had more to do with the collapse of investment in America than with the rise in China. Inflows into America in 1999 and 2000 were $283 billion and $301 billion respectively. The figures for China in the same years were $40 billion and $41 billion, respectively.

Yasheng Huang, an associate professor at the Harvard Business School, argues that China's high level of FDI is a sign of weaknesses in China's own financial system and of an inability to make good use of its high level of domestic savings. Mr Huang points out that since the financial reforms of 1997, FDI has played a relatively diminishing role in China's economy.

Moreover, the raw numbers exaggerate the picture. A large amount of China's FDI is money that has been earned in mainland China but then booked to accounts in Hong Kong for tax reasons. It subsequently comes back to the mainland as FDI, in a process of “round-tripping”.

Much of the fear of China's economic miracle is exaggerated. There are some respects, however, in which it is not entirely unfounded. The first has to do with the cost of labour. With manufacturing wages in China averaging about 60 cents an hour—5% of the American average, and 10% of that in some neighbouring Asian economies—and a seemingly infinite supply of workers, China does look as though it could out-compete other economies in the manufacturing of almost anything labour-intensive. And this is exactly what is happening: 70% of China's exports today are of garments, toys, shoes, furniture, and such like.

By contrast, when it comes to computers, cars or semiconductors—capital-intensive goods, in other words—China may increasingly be producing, but it is not exporting. And it is certainly not attacking foreign competitors in their home markets. Legend Group, for instance, is China's biggest computer brand by far and a stunning success in its domestic market. But Yang Yuanqing, its boss, concedes that it will be years before he would even think about going head-to-head with, say, IBM in America. In cars, all of the many announced joint-ventures between foreign multinationals and Chinese companies except one (Honda's, in Guangzhou) will sell only to the domestic market. Shanghai's semiconductor plants, too, are aiming at the booming demand for simple commodity chips inside China itself.

Economic theory says that differences in countries' wage rates should be reflected in differences in their productivity levels, and that any misalignment will be smoothed out over time. The fear is that, in China, that time could be painfully long. Millions of people are moving from the countryside to the cities. At the same time, state enterprises are shedding huge numbers of workers—just one of the four big state-owned banks has laid off 110,000 employees in the past few years. This huge pool of surplus labour helps explain why Chinese wages have been rising less quickly than productivity since 1996.

Another way to offset a country's rapidly rising productivity would be through currency appreciation. But China has a fixed exchange rate (of 8.3 yuan to the dollar—see chart) at a time when the dollar itself is depreciating against other major world currencies—in particular, against the yen and the euro. The black-market exchange rate in China suggests that the currency is only slightly undervalued. But a massive rise in China's reserves in recent years is evidence that the country has been holding its currency down artificially. Politicians in America and elsewhere are calling for the yuan to be revalued.

The Communist Party is, in fact, considering the idea of floating the currency, but it worries that full convertibility could expose China to the sort of currency crisis that hit South-East Asia in 1997. That affected first and foremost the countries' banking systems, and China's banks are in no fit state for a shock. Nicholas Lardy of the Brookings Institution reckons that there are about $500 billion-worth of bad debts in the system, or more than 50% of all loans.

A switch to a floating exchange rate, therefore, cannot happen without drastic reform of the banking system, and that looks to be several years away. Paul Volcker, a former chairman of America's Federal Reserve Board, has argued that China should maintain its dollar peg for the time being.

The enduring competitive advantage from its surplus labour explains why so many emerging economies that rely on labour-intensive industries are worried about China's new-found economic muscle. For rich economies with capital-intensive industries, by contrast, China offers enormous opportunities.

Even inside the country, economists sometimes refer to China as a “bicycle economy”. But by this they do not mean cheap mountain bikes in Ghana. Instead, they are talking about China's need to keep moving forward just to avoid falling down. As the country becomes more market-oriented, its state-owned enterprises must lay off millions of workers. Only booming businesses can absorb this labour. So a strong Chinese economy should not be a problem. Imagine, instead, what might happen were China, a military giant with international grievances, to stagnate economically. That would be enough to strike fear into everyone.

EAST ASIA'S financial crisis of 1997-98 is gradually being re-evaluated. Many analysts now argue that, however cataclysmic it seemed at the time, it was also the best thing that could have happened to the region. As Nicholas Kristof puts it in “Thunder from the East”, co-written with Sheryl WuDunn, his wife and fellow New York Times journalist:

It entailed a terrible human cost, but it is also helping to destroy much of the cronyism, protectionism and government regulation that had burdened Asian business. The crisis helped launch a political, social and economic revolution that is still incomplete but that ultimately will reshape Asia as greatly as the fall of the Berlin wall reshaped Europe.

Mr Kristof, indeed, thinks that this revolution is going to wrench economic, diplomatic and military power from an American-led West.

The belief that the crisis was a good thing for Asia is now taking hold at the region's brokerage houses and investment banks. They clearly have an interest in spreading the message, but it is not without substance. After all, the demographics that underpinned so much of the Asia-Pacific region's economic success for the past three decades or so still have some way to run. Since 1965, the ratio of the region's dependants—those 15 and under or 65 and over—to its working-age population has fallen from 80% (including lots of kids) to 55%. For the region as a whole it will reach its lowest point around 2015, at 49%. Yet in many of its constituent countries the ratio will be very much lower. By contrast, in the West the ratio is set to rise fast as the population ages (see chart 1).

This is what people mean by Asia's demographic dividend. Christopher Wood, equity strategist at CLSA Emerging Markets, compares the swelling cohort of working-age Asians (including India but excluding developed Japan) with America's post-war generation of baby-boomers. As that generation passed like a large animal through the digestive tract of the American economy (Mr Wood's herpetological metaphor), its numbers and sheer exuberance did much to drive America's consumption patterns and even its equity markets—at least until the bust at the end of the 1990s. Mr Wood predicts a similar effect on consumption and regional share prices from Asia's new baby-boomers.

There is nothing far-fetched about this. MasterCard's chief Asian economist, Yuwa Hedrick-Wong, says that, as a general rule, when an Asian's income passes $5,000 a year before tax, he has money in his pocket to burn. Very roughly, for every extra dollar earned over the $5,000 income threshold, 60 cents go on discretionary spending. How many discretionary spenders does that make? About 225m Asians outside Japan, Mr Wood reckons, using figures for GDP per head and adjusting them for the distribution of income.

Now for a bit of idle speculation. If Asia's annual average growth in per-head income between 2000 and 2020 were to equal the rate between 1980 and 2000 (that is, including the period of financial turmoil, when GDP in the crisis-hit economies plummeted), then the number of high spenders would rise to 340m in 2010 and 682m in 2020. But if income grew at the average rate in the ten years immediately before the crisis, the number would rise to 541m and 1.1 billion respectively.

Nor is that all. CLSA's regional economist, Jim Walker, has long argued persuasively that Asia's unofficial or black-market economy is as much as half the size of the official economy—and that it is a better engine of consumption because it is not taxed at source. After allowing for the black economy, the number of discretionary consumers in 2020 may have risen to as much as 1.4 billion. “Asia's billion boomers”, as CLSA puts it, no longer seems outlandish. It could lead to a virtuous circle as the high savings which hitherto have fuelled much of Asia's export-driven growth are drawn into domestic consumption. That, in turn, would encourage a more balanced regional development, less dependent upon exports and, above all, upon the increasingly unreliable-looking health of the American economy.

Not outlandish, and certainly desirable. Yet this survey will argue that post-crisis Asia is still very far from realising its economic potential; and that rickety and hugely inefficient financial systems remain the biggest economic constraint. The radical transformation of the region's financial systems needed to underwrite optimistic assumptions about future growth has, by and large, yet to take place.

Certainly, an economic recovery in the region has begun. In 2002, East Asian growth probably averaged nearly 5%, after 7% and 3% respectively in 2000 and 2001—a little wobbly, perhaps, but a vast improvement on the late 1990s. However, as Joan Zheng at J.P. Morgan Chase in Hong Kong points out, in dollar terms only two economies, China's and Hong Kong's, are now at higher levels than before the financial crisis—and these two economies were not directly hit by it. China escaped because its currency is only partially convertible (which meant that its technically insolvent banking system was not exposed), Hong Kong because of its first-world banking system and abundant foreign-exchange reserves. As for the rest of the region, most economies have not even clawed their way back to pre-crisis levels once steep falls in their exchange rates are taken into account.

For much of the region, the crisis destroyed wealth on a massive scale and sent absolute poverty shooting up. In the banking system alone, corporate loans equivalent to around half of one year's GDP went bad—a destruction of savings on a scale more usually associated with a full-scale war. In a number of countries, governments have helped to take these loans off banks' books, in the hope of cleaning up the banking system and encouraging banks to start lending again. Yet, notably in Indonesia and Thailand, they have often dithered over dealing with the bad loans and with the companies responsible for them—even though they know that putting off the problem ensures that the eventual cost will be very much higher.

Meanwhile, several economies are turning a blind eye towards banks that continue to lend to the politically well-connected, or that tolerate companies not keeping up with repayments, a nod-and-a-wink known in the trade as forbearance. Such practices prevent capital being allocated in the most efficient way. They stop the region from drawing a line under the past and looking to the future.

To be fair, in some quarters the lessons of the crisis have been swiftly learnt. South Korea—a country that by the mid-1990s appeared to have graduated permanently to the ranks of the developed world, only to find itself on the brink of bankruptcy in late 1997—is the clearest example of how quickly reforms can produce results if the initiative is seized. The government took many bad loans away from the banks and sold them to all comers, even foreigners, if necessary at knock-down prices. It drastically slimmed down the banking sector (again inviting in foreigners) and liquidated some of the most heavily indebted and least profitable Korean companies. As a result, the Korean economy has been transformed. Not only are today's export-oriented conglomerates, the chaebol, in far better health, but new sources of growth, notably domestic demand and consumer credit, have appeared, and foreign direct investment (FDI) has soared. Since the crisis, over 1m new jobs have been created, and the country appears to be climbing back towards a growth rate of 5-7% a year.

Some South Koreans compare the magnitude of the economic shock of 1997-98 to the Korean war. Women lined up to donate their wedding rings to saving the country's finances. It took a national crisis for South Korea to turn from an inward-looking nation to one that embraced foreign capital, change and competition. The country's economic transformation required radical political change, led by Kim Dae-jung, once an imprisoned dissident. Whatever the later mis-steps in Mr Kim's presidency, in his early days he helped to make Koreans face up to their economy's shortcomings. Still, South Korea is the exception, and questions remain even there—particularly about the continued high indebtedness of many companies, and about the adequacy of the banks' experience in dishing out credit to consumers.

In Indonesia, the crisis fostered a political revolution that unseated the long-standing dictator, Suharto, and ushered in democracy. Since then, no profound economic revolution has followed the political one. Instead, reforms have been introduced incrementally, amid much muddle and corruption, and have often appeared to make little progress.

The government, having taken over most of the banking sector's non-performing loans, now controls great swathes of the Indonesian economy, from telecoms to plantations, and has nationalised nearly all the banks as well. Yet it has done far too little to get these assets swiftly off its books. As a result, foreign investment continues to leave the country, Indonesian Chinese businessmen keep their flight capital in Switzerland or Singapore, banks refuse to lend money to those that have a use for it, and the fiscal situation, though better than it was, still looks difficult. “This is a country that was never ready for reform, but was asked to undertake multiple reforms at once,” says a senior Indonesian banker. Without political will and a national consensus, as in South Korea, that was bound to cause trouble.

Progress in financial reform matters, not least because the demographic window of a growing working-age population will not be open for long. It is not necessarily a bad thing for Asia's traditionally high savings rates to fall as consumption rises, but it does mean that savings will need to be allocated far more efficiently than in the past—at a time when rapidly ageing populations will be putting fresh demands upon financial resources. Smaller households and more working women mean that the traditional, extended Asian family, where the old move in with their children and expect to be cared for, is on its way out. Increasingly, people want to push the costs of caring for the elderly on to the state. For instance, by 2025, China's population, now 1.3 billion, will have risen to 1.5 billion, and will contain the same proportion of elderly people (one-fifth of the total) as the OECD economies have today. But whereas North America and Europe have had the best part of a century to organise their pension systems (and have yet to resolve huge problems), China has only a quarter of that time to get ready. As it is, the state faces a $100 billion-200 billion unfunded pension liability for its urban residents alone. What will happen when countryside folk dare to demand equal treatment?

The challenge, then, is to develop regional banking and capital markets that are efficient, deep and well-regulated, so that savings can be channelled to where they get the highest returns. Today, Asia's financial sectors are fragmented, parochial, illiquid and poorly policed; they misprice capital. In addition, capital markets are under-represented, because banks are unhealthily dominant. Although Asia (including Japan) accounts for over half of mankind, one-third of the world's GDP and one-quarter of its exports, the region's share of worldwide equity-market capitalisation is only 16%—or merely 5% without developed Japan. To the optimists at Asia's investment banks, that is just one more reason to forecast a secular bull market in Asian equities, as we shall see later. But it is also a measure of how much emerging Asia still has to do in the financial area.

Defining Asia is the stuff of many debates. Lumping together a region where annual income per head ranges from $280 (Laos) to $31,000 (Japan) is bound to be problematic. For the rest of this survey, Asia generally means East and South-East Asia, and in particular the economies of South Korea, the Philippines, Indonesia, Thailand and Malaysia that were hit hard by the crisis of 1997-98.

There is no need to worry too much about Singapore and Hong Kong. True, Singapore is finding itself in the wrong place at the wrong time, surrounded by struggling economies when its own specialities, high technology and electronics, are also being knocked by a slump in American demand; and Hong Kong is agonising loudly about its role in the Chinese economy. Yet the prosperity of the two city-states is pretty much secure, however much they like to fret about financial competition—from each other, or even Shanghai. By the same token, both offer useful examples for their poorer neighbours about how to develop financial markets, and how to think about their future challenges, even if they sometimes fall short in political imagination or public participation.

Japan, so overwhelmingly the region's biggest economy, enters this survey's calculations when it has lessons to teach the rest of Asia. Regrettably, the biggest lesson is the baneful effect on economic growth of not tackling bad debts in the banking system. The consulting arm of Ernst & Young estimates that Asia has $2 trillion of non-performing loans, of which $1.2 trillion reside in Japan—and that is over a decade after the country's asset bubble burst. What is more, the aggregate figure has not shrunk even though banks have got rid of around $300 billion of bad loans since 1997, so fast are other loans souring. The prime minister, Junichiro Koizumi, has now launched a last-ditch attempt to sort out the banks. It will fail, unless the country's deflation is cured at the same time.

Japan's domestic shortcomings also affect the region more directly, in that for most of the past decade, and particularly since 1997, stricken Japanese banks have withdrawn from the region, and their absence is now almost complete. Asians, in other words, have had to rebuild their financial systems without any private-sector help from their richest neighbour, at a time when foreign private investment is crucial for their transformation.

India, though a huge country, is not covered by this survey, partly because the line has to be drawn somewhere, and partly because it is still an inward-looking economy that attracts relatively little foreign investment, was scarcely affected by the regional crisis of 1997-98 and plays a very much smaller role in world trade today than it once did. For instance, despite its importance in software programming, India has no part in the production chains that are an increasingly striking aspect of regional trade patterns in East Asia. Cambodia, Laos, Myanmar, Vietnam and benighted North Korea, because of their isolation and socialist backwardness, are regrettably also left out of the calculations.

China, by contrast, plays a large and growing part in world trade and now accounts for nearly 5% of world exports, seven times as much as India. It is by far the biggest link in the East Asian production chain. China is the dominant recipient of foreign direct investment ($55 billion in 2002) going to developing countries, and last year may have surpassed even America as the world's biggest recipient. Its $600 billion of non-performing loans equal those of the rest of emerging Asia put together. The success or otherwise of China's financial reforms will have a bearing on the whole region. Although the country did not itself suffer a crisis in those dark days of 1997-98, it first acknowledged the huge shortcomings in its own financial system when it saw its neighbours' systems laid bare. It is emphatically included in this survey.

Even so, it would be wrong to read too much into the new data. As the government pointed out, January’s unemployment rate, though lower than that for December, was broadly in line with the average for 2002 as a whole. The rise of 143,000 in non-farm employment was the biggest monthly change for more than two years. But many of the new jobs came in the retail sector, some of which could reflect seasonal factors. These might not be fully accounted for in the adjustments statisticians make to try to exclude such factors.

In any case, it is always a mistake to make too much of one month’s figures, especially at a time of considerable economic uncertainty. Stockmarkets around the world remain weak and nervous, bothered by the prospect of war with Iraq but also by the continuing fallout from the accounting and other scandals that have plagued corporate America. Where possible, companies will continue to postpone investment decisions—and that includes hiring new workers. Laying off staff, by contrast, will continue to be tempting for managers looking to cut costs while orders remain elusive.

Despite weak performance in the last quarter of 2002, America’s economy is still one of the fastest-growing in the industrial world: GDP was up 2.8% compared with the last quarter of 2001. Over the same period, productivity growth was equally impressive, at 3.8%, though new figures published on Feburary 6th showed a slight fall in labour productivity in the fourth quarter compared with the previous three months, measured at an annual rate. The quarterly figures disappointed some economists and suggest that productivity growth may now be tailing off. Some, of course, have long suspected that America’s productivity miracle of the late 1990s was more of a mirage. They point to figures showing that European productivity has tended to grow faster than America’s over the long term.

For now, though, Europe, along with Japan, continues to weigh down the world economy. Forecasts for GDP growth tend to suggest that America will grow by nearly double the pace Europe will manage this year—while Japan is likely to struggle to expand at all. President George Bush is even more optimistic: The Economist’s own poll of private forecasters shows that, on average, they expect America to grow by 2.5%, whereas Mr Bush has put his new budget together assuming 2.9% growth. In his annual economic report, issued on February 7th, the president suggested the economy would gather strength during the year.

That seems odd, given that Mr Bush is also pushing hard for Congress to approve his new economic stimulus package, most of the effects of which are not likely to be felt this year. Fiscal policy is always slow to have an impact on the economy, in part because of the time taken to approve and implement measures such as tax cuts.

Mr Bush is certainly thinking big—the tax cuts he wants will cost around $1.5 trillion over ten years. But he is facing opposition. Even some of his Republican supporters in Congress have voiced doubts. And on February 10th, 400 economists, including ten Nobel prizewinners, will release a statement arguing that Mr Bush’s plan will not create jobs and growth in the short run, but will generate chronic budget deficits. The deficits projected are so large that Mr Bush needs the optimistic growth assumptions he has made for this year and next. Without them, the deficits would look even bigger and would be even more difficult to sell to Congress.

Of course, a swift, successful war in Iraq with few unpleasant long-term consequences could deliver a more buoyant economy. An end to uncertainty—which might bring cheaper oil—could make business more relaxed about investing and encourage consumers to do more shopping. For now, though, one month’s better-than-expected unemployment figures will bring only temporary light relief.

BY NOW, can there be much doubt about what is coming? After rebutting America’s lengthy catalogue of “evasion and deception”, which was supposed to prove that Saddam Hussein has blown his last chance to give up his country’s weapons of mass destruction, the Iraqi dictator has given a little more and, perhaps, bought himself some time. Iraq now says it will allow its scientists to be interviewed without their minders. More concessions are expected this weekend as the United Nations' senior weapons inspectors return to Baghdad. But President George Bush is already convinced it is a waste of time. “The game is over,” he says.

The difficult bit will be convincing other countries that Iraq is still prevaricating. With more than 200,000 American troops either on their way to the Gulf region or already there, the launch of a military strike to bring down Saddam’s regime could be only weeks away. The “momentum is building” in favour of war, said Donald Rumsfeld, the American defence secretary, as he began a three-day trip to Europe on February 7th. Without a dramatic change of heart, he has said, Saddam will have to be disarmed by force. If other nations do not go along with that, then America has given warning that international bodies, such as the United Nations, risk losing their credibility and encouraging other rogue nations to threaten the world. North Korea, which has sparked another international crisis by withdrawing from the Nuclear Non-Proliferation Treaty after admitting it has a nuclear-arms programme, is “the leading example” of the problem, added Mr Rumsfeld.

In what will be another crucial moment, Hans Blix, the chief UN inspector, and Mohamed ElBaradei, the head of the International Atomic Energy Agency, will deliver an assessment of their visit to Baghdad to the Security Council on February 14th. Mr ElBaradei has said their report may well be critical in determining whether or not Saddam is disarmed by force. Mr Bush says that America would support a new UN resolution ordering tough action to be taken against Iraq, but he has long made it clear that if the UN does not act, then America would be prepared to invade on its own or at the head of a coalition of the willing.

Britain is America’s staunchest ally and has ordered a third of its combat jets to the region to support American forces. Australia has also dispatched troops, although John Howard, Australia’s prime minister, was censured during a confidence vote in the Australian senate for deploying units before a war had been declared. A number of other countries, like Italy and Spain, have also pledged support. Some that were wavering are now offering to co-operate: the Turkish parliament has voted to allow America to renovate military bases in its country for use by American forces.

For now, though, the countries that matter most are the members of the Security Council. Colin Powell, America’s secretary of state, told the council on February 5th there was no doubt that Saddam was in “further material breach” of UN resolutions. He presented a catalogue of examples of deception taken from satellite photographs, intercepted communications, statements from witnesses and material gleaned from other intelligence reports. Mr Powell also gave some of the reasons for America's claims that Iraq has links to the al-Qaeda terror network. The evidence for such links, however, is thin.

France, one of the leading sceptics on the Security Council, has continued to insist that the weapons inspectors should be given more time to search Iraq. But even French officials now appear to accept that the crisis is rapidly coming to a conclusion. Dominique de Villepin, France’s foreign minister, has stressed the urgency of Iraq complying by February 14th. France is one of the five permanent, veto-wielding members of the council. The others are China, which is also sceptical, Russia, Britain and America. While Russia has said that it too would like the inspectors to be given more time, it could swing behind America in order to protect its big oil interests in Iraq. America has said it will use Iraqi oil to help pay for rebuilding the country during a military occupation, which could last several years.

For a new Security Council resolution to be passed, nine votes need to be cast in favour and no veto used. Apart from the five permanent members, the council is comprised of ten countries that serve on a rotating basis. Presently these are Germany, Angola, Bulgaria, Cameroon, Chile, Guinea, Mexico, Pakistan, Syria and Spain. Only Spain and Bulgaria have shown much support for America. Yet by February 14th, positions could change. Despite some initial doubts, the council last year unanimously passed a resolution that ordered Iraq to accept the return of weapons inspectors.

Whatever Iraq comes up with over the next few days, it is bound to try to exploit the divisions on the Security Council. But for Saddam, that carries a great risk. There is no longer any doubt that America will go to war unless there is a dramatic transformation in Saddam's attitude—and that seems highly unlikely.

This raises the prospect that the Security Council could be faced with a war that renders the UN ineffectual in trying to resolve future international disputes. For that reason alone, some sceptical countries may grudgingly give their support to Mr Bush—or at least abstain from a vote rather than use their veto. For Saddam, the stakes are getting higher all the time.