Macroeconomic policymakers in emerging Asia are facing several broad challenges. First, central banks need to deal with inflationary pressures arising from the surge in international oil prices, without endangering the recent improvements in domestic demand. Second, governments are trying to reduce their debts, while attempting to create the fiscal space needed to meet the costs of population aging and upgrading public infrastructure.
Monetary Policy
Central banks in emerging Asia are facing a delicate balancing act. They are addressing the inflationary pressures that have arisen from the doubling of international oil prices between the end of 2003 and end-2005. But at the same time they are being careful to avoid undermining the nascent recovery of domestic demand.
Monetary policy actions have varied according to country-specific circumstances. Since the start of the current U.S. tightening cycle in June 2004, some countries have raised policy rates aggressively in response to an upturn in inflation. In Indonesia, policy rates have risen by around 550 basis points, while in Thailand they have increased by 325 basis points. In other countries, where inflationary pressures have been less pronounced, policy rates have been raised by less. Examples are Korea, where the cumulative rise in policy rates has amounted to 25 basis points, and China, which has not raised policy rates at all.1 In many cases, the fact that exchange rates have been strengthening recently has given authorities greater room for maneuver on interest rate policy.
Cumulative Hikes in Policy Rates
(Since start of Fed tightening cycle; May 2004 - March 2006, in percent)
Sources: CEIC Data Company Ltd; and IMF staff calculations.Emerging Asia: Real Policy Rates, Jan. 03 - Feb. 06
(Policy rates minus contemporaneous core inflation, in percent)
Sources: CEIC Data Company Ltd; and IMF staff calculations.The rate increases have effected a modest tightening of the monetary stance. While the increases have essentially matched the rise in headline inflation, they have exceeded the rise in the more relevant index—core inflation, excluding the inevitable impact from the doubling of world energy prices. Relative to core inflation, real policy rates have increased by 1.3 percentage points in emerging Asia since the start of the current tightening cycle, with over half of the increase—0.8 percentage points—occurring since the middle of 2005.2 Within the region, the largest increase in real rates has occurred in India (4.4 percent), reflecting a marked decline in core wholesale price inflation.
Headline inflation is projected to subside over the course of 2006. One reason is that expectations of inflation seem generally well-anchored. As of March of this year, the private sector consensus forecast for average inflation in emerging Asia in 2007, when base effects from fuel price increases will have come off, is just 3.4 percent. For the ASEAN-4, the consensus forecast for 2007 has increased to 4.7 percent, 1.1 percentage points higher than the 2005 forecast made two years ago—a significant increase, but still small compared to the large increase in headline inflation.3
Evolution of Private Sector Inflation Forecasts
(Annual percentage change)
Sources: Consensus Economics.Policy challenges remain, however, since the inflation outlook is not without risk. One key risk lies in the narrowing interest differential between emerging Asia and the United States. This differential has narrowed to around 50 basis points, from above 240 basis points before the current tightening cycle began. Even for the ASEAN-4, where the nominal increases in policy rates have been the largest, the interest differential remains well below its historical average.
Emerging Asia: Policy Rate Differential with U.S.
(Jan. 2003 - Mar. 2006, in percent)
Sources: CEIC Data Company Ltd; and IMF staff calculations.So far, the small interest differential has proved sustainable because risk premia have fallen, especially for the ASEAN-4. Using the uncovered interest parity condition to recover a one-year-ahead local currency risk premium relative to the U.S. dollar suggests that the risk premium for the ASEAN-4 had fallen below 2 percent as of February 2006, compared to an average of above 4 percent since mid-2003.4 Excluding Indonesia, this premium had fallen to just 0.3 percent. To a certain extent, the decline in risk premia reflects a recognition of ongoing reforms that are improving macroeconomic stability and growth prospects. But it is also due to abundant global liquidity.
ASEAN-4: Local Currency Risk Premium
(Mar. 2003 - Feb. 2006, one-year-ahead, in percent)
Sources: CEIC Data Company Ltd; Consensus Economics; and IMF staff calculations.Consequently, risk premia could rise again as global liquidity conditions tighten. If the U.S. Federal Reserve and other major central banks continue to raise policy rates, further eroding Asia’s interest spreads, the regional balance of payments may weaken and currencies could begin to face downward pressure. As a result, even taking into account the dampening effects from a jump in risk premia on domestic demand, headline and core inflation rates could rise, and inflation expectations could increase, as well. The dangers are particularly high in countries which still need to pass on the global oil price increase into domestic prices, for in these countries external pressures could coincide with supply-side shocks from domestic price adjustments. (Countries where pass-through remains incomplete include China, Malaysia, India, and Indonesia.)
Should such a scenario materialize, it would present central banks with a policy dilemma, for further rate increases could undermine economic growth. The dilemma would be particularly acute in some of the ASEAN-4, where the rollover and foreign exchange risk associated with high levels of public debt (Philippines, and Indonesia and Thailand to a lesser extent) could force monetary policy to tighten even as domestic demand is weakening. This dilemma is less pronounced in the NIEs, where external positions are stronger, allowing monetary policy to accommodate still weak domestic demand. By contrast, in India, where domestic demand has long been strong, both robust credit growth and the growing importance of return-sensitive portfolio flows in financing the current account deficit suggest that further tightening may be needed going forward.
Emerging Asia: Growth Contributions of Domestic Demand
(Year-on-year change in percent of previous year’s GDP)
Sources: IMF, APDCORE database; and staff calculations.Finally, in Japan incipient price pressures have been welcomed, as they signal an end to a prolonged period of deflation and depressed demand. As a result, the BoJ in mid-March announced that it was exiting from its quantitative easing policy, under which it targeted sizeable excess reserves of commercial banks. In taking this step, the BoJ noted that the necessary conditions have been met: stable positive y/y core CPI inflation and expectations that this would continue. With this change, the central bank has returned to targeting the overnight call rate, which it expects will remain “effectively at zero” for the time being. As part of this change, the BoJ also announced a new framework for monetary policy, which includes defining price stability to be y/y CPI inflation between zero and two percent, a range that will be reviewed annually. The BoJ will also report on its monetary policy view in a semiannual report.
Fiscal Policy
On the fiscal side, governments have been trying to improve their fiscal positions. Across the region, there are a variety of reasons for doing so.
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First, some countries, such as India and the Philippines, have long had high debt levels, which they are seeking to address.
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Second, countries that were hit by the Asian crisis are trying to reverse the deterioration in fiscal positions that occurred in the late 1990s, initially because of the costs of repairing financial systems in the wake of the crisis and subsequently because of the lingering interest burden from the bonds issued at that time.
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Third, there is growing concern in the NIEs and industrial Asia over the need to create fiscal space for dealing with the costs of aging populations. In the NIEs, the old-age dependency ratio is projected to rise from 14 percent currently to 60 percent in 2050, led by Korea where it is expected to rise to 65 percent. In industrial Asia, the increase is expected to be more modest, but the aggregate obscures a sharp increase in Japan from an already-high level of 30 percent to an exceptionally-high 71 percent.5
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Fourth, emerging Asia is facing large infrastructure needs, and increasing public sector saving is one way to create fiscal space for the required investment. The Asian Development Bank (ADB) estimates that developing countries in East Asia will need to spend more than a trillion U.S. dollars in the next five years, including on roads, water, communications, and power, to cope with rapidly expanding cities, rising populations, and the growing demands of the private sector. Although the ADB expects China to require 80 percent of this investment, other countries in emerging Asia also have large requirements, as shown by a ranking of infrastructure quality in the Global Competitiveness Report.
General Government Debt and Population Aging
Source: CEIC Data Company Ltd; United Nations; and IMF staff calculations.Infrastructure Quality Ranking
(1=poorly developed and inefficient, 7=among the best in the world)
Source: Global Competitiveness Report 2003-04, World Economic Forum.Governments in emerging Asia have made some progress in improving their fiscal positions in the past year. For this region as a whole, government debt was cut by about 1¾ percentage points to an estimated 37 percent of GDP. Most significantly, the average debt to GDP ratio in the ASEAN-4 countries is estimated to have fallen by 4½ percent in 2005, bringing the ratio down to 51 percent, significantly below its 1997 level. Similarly, the stock of general government debt in India is estimated to have fallen by 2½ percentage points to 84 percent of GDP last year. Against this, the average debt-to-GDP ratio for the NIEs continued to rise last year, and is now well above pre-crisis levels, but at an estimated 32 percent of GDP it remains relatively low.
Emerging Asia: General Government Gross Debt
(In percent of GDP)
Sources: IMF, APDCORE database; and CEIC Data Company Ltd.1Excludes Singapore.Fiscal consolidation in emerging Asia looks set to continue in 2006. The region’s fiscal deficit is expected to decline to just below 2¼ percent of GDP, from just above that level last year, helping to bring debt to 35 percent of GDP. All of the major country groupings are expected to follow this trend: in the ASEAN-4, a small average deficit would reduce the debt ratio significantly to 47 percent of GDP, while in the NIEs, the average debt/GDP ratio is projected to decline for the first time since the Asian crisis. In India, despite rapid GDP growth, the debt of the general government is only projected to decline marginally in 2006/07, as the fiscal deficit is expected to remain sizeable, at above 7 percent of GDP.
The expected fiscal adjustment is driven largely by an increase in revenues, which is primarily due to new policy measures. This continues a trend of recent years, in which the revenue-to-GDP ratio has grown steadily. In India, a modest broadening of the tax base is planned, complementing an earlier drive to improve tax administration and the introduction last year of a VAT at the state level. In the ASEAN-4, the rise in the revenue to GDP ratio is expected to continue, reflecting measures such as an expansion of the tax base for VAT and a VAT rate hike in the Philippines. This continues a steady rise of the revenue to GDP ratio in the ASEAN-4, which has increased from 19½ percent in 2002 to an estimated 20¾ percent in 2005, reflecting a combination of additional tax measures, improved collection, and a revenue lift from high oil prices in the case of oil exporters (Indonesia and Malaysia). In the NIEs, revenue to GDP is expected to remain stable, while past increases in the revenue to GDP ratio were largely driven by improvements in tax administration, which also appears to be the case in China.
Meanwhile, spending is expected to remain stable, albeit with further marked shifts in allocations amongst expenditure categories. In recent years, interest payments have been shrinking, for several reasons including the reduction in debt stocks in the ASEAN-4, a strengthening of regional currencies, and a general fall in global and domestic interest rates. In the NIEs, interest payments, already low by regional standards, have fallen steadily in importance, while in the ASEAN-4 countries they declined to 2¾ percent of GDP, after peaking in 2001 at 4¼ percent. These reductions have created space for an increase in spending on social welfare outlays, notably for pensions, health insurance, welfare for poor households and unemployment insurance payments.
Looking ahead, capital spending, which has contracted sharply in the ASEAN-4 and the NIEs in recent years, is expected to grow rapidly in the coming years. To meet the challenge of growing infrastructure needs, countries in emerging Asia are adopting different strategies:
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One strategy is to boost infrastructure spending through the budget, of which Thailand is one example. There, the authorities have announced new infrastructure spending, called “megaprojects,” which will bring public investment to about 9½ percent of GDP over the medium term, around its historical norm but still short of its pre-crisis level of 12 percent. Spending will be centered on transportation, including mass transit, and communication, and will be financed mainly from the central budget, supplemented by domestic and foreign borrowing.
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Another strategy is to pursue public-private partnerships (PPPs). India is attempting to close its infrastructure gap through PPPs. To encourage further private sector involvement, the authorities have taken several steps, including setting up a special purpose vehicle, which would borrow domestically with a government guarantee to finance commercially viable projects with private participation. Korea last year began a second wave of PPPs, worth around $25 billion over the next 3-4 years, whereby the private sector builds social infrastructure projects (schools, barracks, prisons), which the government then leases for 20 to 30 years. Generally, PPPs can be catalytic in promoting infrastructure development, and can help shift the burden of risk from taxpayers to users. However, they have the disadvantage that potential risks to the government, including those related to guarantees and the commercial viability of projects, are not fully reflected in the fiscal accounts.
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A third strategy, particularly important in countries where the fiscal position allows little flexibility, is to increase user charges. For example, in the Philippines, meaningful tariff increases have already been undertaken in the power sector, though increases are also needed in the water and sanitation sectors.
Though the rate of remuneration on excess reserves was reduced in March 2005, and local currency deposit and lending rates were increased in October 2004.
These calculations are based on simple averages of real policy rates in emerging Asia.
Among the ASEAN-4, inflation expectations for 2007 are highest in Indonesia, and are above the inflation target in the Philippines, calling for continued policy vigilance.
Risk premia are calculated as (i-i*) - E(Δe) where i and i* are secondary market rates on a one-year local currency bond in an ASEAN-4 country and in the United States, respectively, while E(Δe) is the one-year-ahead expected depreciation of the exchange rate against the U.S. dollar from Consensus Economics. In contrast to the bond spreads in Chapter II, these risk premia capture currency risk in addition to sovereign default risk. See R. Balakrishnan and V. Tulin, “The Risk Premium on the U.S. Dollar,” (forthcoming).
The old-age dependency ratio is the ratio of the population aged 65 years or over to the population aged 15-64. These calculations are based on simple averages across economies of the change in old-age dependency ratio. The projected rise for the NIEs omits Taiwan Province of China, for which the United Nations do not publish population projections.
