1           Strong economic growth in the ASEAN-3 countries since the late 1980s has led to rising inflation and widening current account deficits as excess domestic demand spills over into imports. Malaysia, Thailand, and Indonesia experienced a worsening of their current accounts in the 1990s, culminating in a marked deterioration in 1995. Malaysia's and Thailand's current account deficits reached 8% of GDP, while Indonesia's was 4% of GDP. The deterioration in the current account deficits had raised concerns about overheating and the sustainability of the external positions particularly in light of the Mexican crisis in 1994.

2           This paper addresses the sustainability of current account deficits in these countries from the saving-investment and trade perspectives, and assesses the manner in which these deficits have been financed.

3           Our analysis is based on an intertemporal perspective that current account imbalances per se are not undesirable; on the contrary, it may be efficient for a country to run deficits at particular stages of its development. In assessing the sustainability of current account deficits, what matters is whether (i) external imbalances are underpinned by a declining saving rate or rising investment need, and whether these are incurred by the private or public sector; (ii) imports are derived from consumerism or productive investments; and (iii) current account deficits are funded by short-term capital inflows or long-term investments such as FDI. This is especially relevant in increasingly integrated financial markets, where a change in market sentiment can have severe destabilising consequences on financial markets and the real economy.

4           We also draw some lessons from Singapore's experience with current account deficits prior to the mid-80s. As was the case in Singapore, the recent deterioration in the current accounts of the ASEAN-3 was underpinned by worsening trade balances.

5           Singapore incurred current account deficits averaging 10% of GDP during 1965-85. These were associated with large imports of capital goods during its industrialisation process and did not pose a serious problem because they reflected investments in the economy's future earning capacity. The surge in imports was linked to a surge in domestic investment, rather than a fall in the saving rate, which trended upward throughout the period.

6           The shortfall in saving over investment was largely confined to the private sector, as the fiscal position was in surplus, suggesting that external imbalances reflected the optimising outcome of consumption and investment decisions of private agents. The openness of the Singapore economy also assured that there was little distortion in domestic prices, and that the resulting resource allocations and trade patterns (and hence current account deficits) were efficient outcomes.

7           Singapore's current account deficits prior to 1986 were sustainable as they were financed by long-term capital rather than volatile short-term funds - FDI amounted to 83% of the deficits during 1972-84. With the completion of major infrastructure projects and continued rise in the saving rate, Singapore has enjoyed current account surpluses since 1986. Singapore's experience highlights how a country's current account position changes over time depending on the particular stage in its economic development.

8           Current account deficits in the ASEAN-3 economies resulted from rapid growth in domestic investments, which exceeded increases in the saving rates. Fiscal positions were either in balance or surplus, unlike in the early 1980s when budget deficits in Malaysia and Thailand exacerbated the private sector imbalances. Like Singapore, the high degree of openness of the ASEAN economies provided confidence that the current account deficits were also efficient market outcomes. A brief comparison of the ASEAN-3 experiences with Mexico's during the period just prior to its crisis in 1994 shows little similarities. Economic fundamentals of the ASEAN-3 were much stronger than those of Mexico in terms of growth, exports, saving, investments, and the debt service ratio.

9           Developments in the current accounts of the ASEAN-3 were closely related to changes in their trade balances. In the early years, when commodity based products comprised the bulk of exports in the ASEAN-3, movements in the terms of trade were a major determinant of developments in the trade balance. This link weakened after the mid-80s, however, as the share of commodity exports declined sharply across all three countries, and manufacturing exports increased in prominence. The deterioration in the trade and current account balances since the mid-1980s has reflected strong import growth associated with the surge in FDI inflows into these countries. Most of these imports comprised capital goods to strengthen their productive capacity; the share of consumer goods has declined. Our econometric tests show that import growth leads to higher export growth.

10           Current account deficits of the ASEAN-3 since the mid-1980s have thus been financed through long-term equity capital and FDI. We argue that these current account deficits were efficient market outcomes, reflecting the flow of international capital to countries with the highest returns. The relatively low incremental capital-output ratios (ICORs) in the ASEAN-3 suggest higher marginal products of capital (and hence higher rates of return) in these economies relative to the industrial countries. Indeed, US MNCs' investments in the ASEAN-3 have yielded higher rates of return than their investments in the European Community, Japan or the NIEs.

11           While the current account deficits of the ASEAN-3 are firmly rooted in their industrialisation drive, large external imbalances increase the ASEAN countries' vulnerability to exogenous shocks, including a sudden change in market sentiments. While Singapore's industrialisation drive took place in an era when capital mobility was more limited, countries today are faced with an additional risk arising from the volatility of short-term capital. This risk is especially relevant for Thailand, which has seen a surge in short-term capital in recent years. The resulting accumulation of short-term debt led Moody's Investors Services to downgrade Thailand's short-term sovereign debt rating from Prime-1 to Prime-2 in September 1996. In response to the widening in current account deficits, the governments of the ASEAN-3 have tightened financial policy since 1995. This has contributed to the recent slowdown in economic growth and some improvement in external imbalance.