Chapter

I. Recent Developments and Outlook

Published Date:
October 2006
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Asia’s growth prospects remain bright. Some modest rebalancing of growth is likely, as exports moderate with slowing global growth and domestic demand, in particular investment, firms. China is becoming an increasingly prominent driver of growth in the region, and Japan’s continued expansion is also contributing to buoyant economic activity. Inflation should stay subdued even with persistent high oil prices, as second-round effects are likely to remain modest. However, risks to the outlook are tilted to the downside, in particular for 2007. While growth in China could continue to exceed expectations, an abrupt slowdown in the U.S. economy, higher oil prices, and increased risk aversion toward emerging markets pose potential challenges for Asia’s growth momentum.1

Growth

Growth in Asia so far this year has been robust, especially in China and India. Real GDP in China grew by 11 percent in the first half of 2006, led by strong investment and net exports. India’s economy expanded by 9½ percent in the first quarter, driven by buoyant domestic demand. Notwithstanding a slowdown in the second quarter, Japan’s expansion continued through the first half of the year, with private domestic demand remaining strong on the back of robust corporate investment and a firming labor market. Improving employment conditions supported income and consumption growth in the NIEs, while net exports remained the key driver of growth. Net exports have also surged in the ASEAN-4 countries, reflecting both an export boom and import compression amid weak domestic demand.

Emerging Asia: GDP Growth

(Year-on-year percent change)

Sources: IMF, APDCORE database; and staff calculations.

NIEs: Contributions to GDP Growth

(Year-on-year change in percent of previous year’s GDP)

Sources: IMF, APDCORE database; and staff calculations.

ASEAN-4: Contributions to GDP Growth

(Year-on-year change in percent of previous year’s GDP)

Sources: IMF, APDCORE database; and staff calculations.

Looking ahead, Asia’s growth prospects are bright, spurred by firming domestic demand.2 Growth is forecast at 7¼ percent in 2006, declining marginally to about 7 percent next year. Compared with projections in the May 2006 REO, this represents an increase of about ½ percentage point in each year for the region as a whole, as sizable upgrades for China and India more than offset the less sanguine outlook for Korea and Taiwan Province of China. Growth in China and India is set to remain very rapid this year and next, driven by strong domestic demand. In the NIEs, the still positive outlook for exports, in particular electronics, should help investment remain solid. And a recovery in domestic demand is expected in the ASEAN-4 countries—in particular on the investment side—helping to maintain the growth momentum in the region.

Real GDP Growth(Year-on-year percent change)
200420052006200720062007
May-06 Proj.Latest Proj.
Industrial Asia2.52.62.82.22.72.3
Japan2.32.62.82.12.72.1
Australia3.52.52.93.23.13.5
New Zealand4.31.90.92.11.31.7
Emerging Asia8.48.58.07.78.58.3
Hong Kong SAR8.67.35.54.56.05.5
Korea4.74.05.54.55.04.3
Singapore8.76.45.54.56.94.5
Taiwan POC6.14.04.54.54.04.2
China10.110.29.59.010.010.0
India7.38.27.37.08.37.3
Indonesia5.15.65.06.05.26.0
Malaysia7.25.25.55.85.55.8
Philippines6.25.05.05.65.05.4
Thailand6.24.55.05.44.55.0
NIEs5.94.55.24.54.94.4
ASEAN-45.85.15.15.75.05.6
Asia7.17.26.96.67.37.1
Sources: IMF, APDCORE and WEO databases; and staff estimates.
Sources: IMF, APDCORE and WEO databases; and staff estimates.

Emerging Asia’s exports are expected to moderate next year in line with the slowdown in industrial country growth. The U.S. economy is expected to slow modestly, amid a cooling housing market and high oil prices, while the pace of economic activity in Japan and the euro area is also projected to decelerate toward potential. Nevertheless, most countries in Asia will likely see only a mild slowdown in export growth, reflecting in part the growing importance of intra-regional trade. While the United States remains emerging Asia’s main trading partner, accounting for 17 percent of total exports, China’s share is rising rapidly—it now accounts for one-fourth of the NIEs’ total exports, and 10 percent of the ASEAN-4 countries’ export market. China’s imports from Asia grew by 21 percent in the first half of this year relative to the same period last year. Given China’s role in regional trade, robust growth in Chinese consumption and infrastructure investment should offer some cushion to the slowdown in industrial country growth. In addition, although emerging Asia’s exports of electronics may soften in response to a weaker external environment, a sharp slowdown is unlikely thanks partly to China’s growing demand for consumer electronics and the continued strengthening of Asian global brands (Box 1.1).

Box 1.1Outlook for Asia’s Electronics Sector1

Most economies in emerging Asia are benefiting from strong external demand for their electronics products.

Demand from major markets such as the United States and Japan remains firm. Exports of electronic goods have been robust, especially for the NIEs, fueled by a booming market for digital consumer electronics, in particular semiconductors, mobile phones, and flat panel displays. In Korea, exports of flat panel displays have seen triple-digit growth for over a year. Most of these displays are used in the production of digital TVs in Japan. In Singapore, buoyant demand for music players and mobile phones has generated profit gains for component makers. Export growth appears to be holding up well in Malaysia and Thailand. There has also been a sharp turnaround in electronics exports in the Philippines and Indonesia, although it was not sustained in the latter.

ASEAN-4 Versus NIEs: Electronic Export Growth

(y/y percent change, 3mma)

Sources: CEIC Data Company Ltd; and IMF staff calculations.

However, there are some initial signs of a slowdown in Asia’s electronics sector. The sustained climb in the book-to-bill ratio for semiconductor equipment to its highest level since February 2004 and strong new electronics orders in the United States point to positive momentum in the tech sector. This is also supported by continued high levels of the global book-to-bill ratio. However, the picture is not all bright. Recent sharp corrections in tech stock indices in the United States and Asia (Japan, Korea, Singapore, and Taiwan Province of China) in response to poor earnings reports from major technology companies, as well as a weakening of U.S. purchasing managers’ index for manufacturing, suggest a moderation in electronics demand going forward. In addition, recent trade data show a drop in China’s tech imports, reflecting a correction in inventories that had been accumulating since the second half of last year. This is likely to have negative repercussions on the NIEs, particularly Korea and Taiwan Province of China, which supply parts and component inputs for tech products in China, their largest export market. Already, Taiwan Province of China is experiencing a sharp slowdown in exports of precision machinery (particularly flat panel displays) as well as in tech export orders and production. Singapore’s purchasing managers’ index generally points to an expansion in the tech sector, except for one month of contraction. Moreover, prices of personal computers, mobile phones, and flat panel displays have been sliding, squeezing profit margins of many manufacturers.

Tech Sector Indicators

(3-month moving average)

Sources: CEIC Data Company Ltd; and VLSI Research Inc.

Purchasing Managers1 Index and Electronic Export Orders

Sources: CEIC Data Company Ltd;

1 Exports orders on hand.

The key risk to electronics exports would be a sharper-than-expected slowdown in the United States. Those countries that depend most heavily on electronics exports, including Malaysia, the Philippines, Thailand, and Korea, would tend to be the most affected by any such slowdown. But the impact would also vary across countries depending on their product specialization and the relative importance of the U.S. market. China, which accounts for one-third of the region’s electronics exports, has the largest share of U.S. imports of high-tech products. Thus, sluggish U.S. demand could undermine China’s electronics exports, which would reverberate to its Asian suppliers of parts and components. However, China’s growing consumption of consumer electronics may help cushion softening demand from advanced economies. In addition, Korea and Taiwan Province of China have become more resilient to the tech cycle by establishing their own niche markets and brand names.

Longer-term prospects for producers of memory chips are promising. The Semiconductor Industry Association (SIA) revised up its 2006 forecast for worldwide semiconductor sales growth to 9.8 percent in June from 7.9 percent in November 2005. This reflects better-than-expected growth in key end-markets for semiconductors, notably mobile phones. According to the SIA, global sales growth is projected to continue at this pace before slowing down in 2009, propelled by strong demand for analog products.2 The anticipated release of Microsoft’s operating system Windows Vista by year-end, coupled with greater DRAM usage in mobile phones and gaming applications, is likely to boost DRAM sales.3 Increasing demand for flash in mobile phones, more advanced iPods (Apple’s portable music player), and personal computers will also spur the memory chip market. As a result, Asia’s share of the global semiconductor market is expected to increase from 40 percent in 2006 to 49 percent in 2009, with the main beneficiaries being Japan, Korea and Taiwan Province of China.

In addition, capital equipment spending in the semiconductor industry is surging on the back of robust demand and high capacity utilization rates, especially in Asia. This could lead to excess supply in some segments, especially flash memory, with expected falls in prices and profit margins.

Electronic Exports in 2005

(In percent of total exports)

Sources: CEIC Data Company Ltd; and IMF staff estimates.

Asia’s Electronic Exports in 2005

(Shares of total)

Sources: CEIC Data Company Ltd; and IMF staff calculations.

1India and Australia.

U.S. Imports of Electronics from Asia in 2005

(In percent of total electronic imports)

Sources: CEIC Data Company Ltd; and IMF staff calculations.

1 The main author of this box is Varapat Chensavasdijai.2 Analog chips are used in communications, computer, automotive, and industrial and medical equipment applications.3 Analog chips DRAM and flash memory chips are commonly used to store data in computers and electronic devices. Unlike DRAM, flash memory chips have a limited lifespan. However, flash is nonvolatile, which means that data can be retained without electric power, whereas DRAM requires constant power to maintain the stored information. Because of its heat and shock resistance, smaller size, lower power consumption, and faster speed, flash is more flexible in its use in mobile applications such as handsets, digital cameras, and iPod music players. Flash chips are also becoming less costly to produce.

Trading Partners’ GDP Growth

(Year-on-year percent change)

Source: IMF, WEO database.

Emerging Asia: Direction of Exports

(In billions of U.S. dollars, 3mma)

Sources: IMF, Direction of Trade Statistics; and IMF staff calculations.

Export Growth(Year-on-year percent change)
2004200520062007
Proj.Proj.
Industrial Asia12.46.28.45.3
Japan13.97.09.45.1
Australia4.02.03.66.3
New Zealand5.5−0.20.76.3
Emerging Asia25.018.917.616.7
China28.422.421.120.2
India28.023.018.217.7
NIEs17.78.410.69.0
ASEAN-413.16.77.36.5
Asia22.216.215.714.5
Sources: IMF, APDCORE and WEO databases; and staff estimates.
Sources: IMF, APDCORE and WEO databases; and staff estimates.

Domestic demand is projected to strengthen in several countries in the region, as a number of impediments to investment and consumption lift. So far this year, world oil prices have jumped by more than 30 percent, and central banks across the region have continued to raise benchmark interest rates to curb inflation. In Thailand, these factors have contributed to lower consumer confidence, while large public infrastructure projects have been delayed. In Indonesia, fuel prices and interest rates were increased sharply last year, leading to an economic slowdown. In Korea, private consumption has moderated in response to monetary tightening, while government policies aimed at curbing real estate speculation have contributed to a contraction in construction activity. Political turmoil and a credit card bust in Taiwan Province of China have weakened consumption and investment. Going forward, these factors are likely to unwind. In particular, interest rates may be nearing their peak (see Chapter III). A stabilization of oil prices would aid this process and provide an additional incentive for corporates to step up investment. Indonesia has already lowered its policy rate by 150 basis points this year, which should contribute to a recovery in domestic demand. In Korea, an early end to monetary tightening and higher public investment should aid a recovery in construction. Resolution of political uncertainties in some countries would also improve consumer and business sentiment. Meanwhile, strong remittances should continue to bolster consumption in the Philippines.

Investment Growth(Year-on-year percent change)
2004200520062007
Proj.Proj.
Industrial Asia2.33.95.63.8
Japan1.13.35.53.9
Australia7.87.47.54.2
New Zealand12.85.1−2.2−3.4
Emerging Asia13.013.413.211.8
China15.118.218.015.0
India12.411.410.28.3
NIEs7.61.72.95.2
ASEAN-410.47.06.18.6
Asia10.611.411.710.2
Sources: IMF, APDCORE and WEO databases; and staff estimates.
Sources: IMF, APDCORE and WEO databases; and staff estimates.
Private Consumption Growth(Year-on-year percent change)
2004200520062007
Proj.Proj.
Industrial Asia2.62.32.02.1
Japan1.92.11.92.0
Australia5.83.13.23.1
New Zealand6.64.61.50.5
Emerging Asia6.77.07.88.4
China7.89.09.810.9
India6.85.47.06.3
NIEs2.33.13.83.7
ASEAN-46.14.93.84.8
Asia5.86.06.67.2
Sources: IMF, APDCORE and WEO databases; and staff estimates.
Sources: IMF, APDCORE and WEO databases; and staff estimates.

In China and India, domestic demand is projected to continue its robust growth. In the former, the tightening of monetary policy and administrative controls—including increases in reserve requirements and benchmark interest rates, and measures to cool down the property market—have so far had little success in reining in investment. In the latter, domestic demand remains strong despite some modest monetary tightening, as a growing middle class raises its consumption and corporates continue to build capacity following several years of successful restructuring. While investment growth is expected to moderate in response to administrative policies in China and some further monetary tightening in India, domestic demand will likely remain quite strong.

Japan’s continued expansion is expected to benefit the region. Further strengthening in domestic demand, particularly business investment, and stronger trade linkages between Japan and the rest of Asia should continue to boost imports from Asia as well as encourage Japanese investment in other Asian economies (Box 1.2).

Box 1.2.The Impact of Japan’s Recovery on Asia1

Japan’s expansion—stretching well into its fourth year—is having positive spillovers on the rest of Asia. Since the start of the recovery in 2002, Japan’s GDP growth has added, on average, 1 percentage point to regional growth. This trend is anticipated to continue into 2006, and faster growth in Japan should help maintain growth in Asia as economic growth globally moderates.

Imports from Asia have risen sharply in the upswing, reflecting Japan’s stronger domestic demand and tighter trade and investment linkages. The share of Asian goods in the economy has expanded by 50 percent over the past three years. Much of this increase has come from trade with China—reflecting a steady outsourcing of production. In fact, China—along with Hong Kong SAR—accounts for over 50 percent of Japan’s FDI flows to Asia. Japan’s engagement in the region has been broad-based, though: over 2004 and 2005, Japanese firms have doubled their business investment in other Asian economies. As a result of a steady presence in the region, Asian subsidiaries of Japanese corporations are tightly integrated with their parent companies, and they derive nearly one-quarter of their sales from trade with Japan.2

Deeper financial linkages between Japan and the rest of Asia are also being laid out.3 Stronger balance sheets at home have provided the foundation for the return of Japanese banks to the region. Over the last three years, Japanese banks’ credits to non-Japan Asia have expanded by 14 percent per year on average, the fastest market expansion in all regions where Japanese banks are active (except for specialized lending to offshore centers). The Asia/Pacific market is still small—about one-sixth of that in North America and Europe—but it is gaining prominence in the banks’ operations, rapidly.

For the most part, Japanese banks have been focused on providing loans, derivatives, and cash management services to Japanese companies operating in Asia. China, South Korea, and the largest South East Asian economies have been the main areas of interest. More recently, however, India and Vietnam have joined the group. While “following-the-clients” may have provided a beachhead for a re-engagement in Asia, the banks’ strategy may be evolving. There is growing interest among Japanese banks in expanding their presence in specific domestic markets, such as banking services to non-Japanese clients, syndicated loan arrangements, and structured finance products for local investors.

Japan: Domestic Growth Impact on Asia

(Annual percentage change)

Source: IMF, WEO database.

1Using PPP-adjusted real GDP for Asia and Japan.

Japan: Imports of Goods, by Region

(In percent of GDP)

Sources: Haver Analytics; and IMF staff calculations.

1 The main author of this box is Chris Faulkner-MacDonagh.2 In contrast, Japanese subsidiaries located in other parts of the world only derive around 2 percent of sales from trade with Japan. Source: Ministry of Economy, Trade, and Industry, Quarterly Survey of Overseas Subsidiaries.3 IMF Country Report No. 06/276.

In Australia and New Zealand, prospects are increasingly shaped by macroeconomic developments in Asia. Australia, in particular, will continue to benefit from the boom in commodities demand from China (Box 1.3).

Box 1.3.Spillovers From Asia Are Affecting Australia and New Zealand1

Cyclical prospects are unusually divergent in Australia and New Zealand, but in both cases macroeconomic and financial forces emanating from Asia are important influences.

Australia

Asia’s ravenous demand for commodities is driving an investment-led strengthening in growth. Growth eased to 2½ percent in 2005 as consumption slowed and residential investment declined following a welcome cooling of the housing market. But strong Asian demand for “hard” commodities has lifted Australia’s terms of trade by 30 percent in the past three years, to their highest level in three decades. Business investment has jumped 80 percent over the same period in response, cushioning the slowdown in 2005, and underpinning expected growth of about 3 percent in 2006. With export sector capital projects starting to come on stream, growth is projected to rise to about 3½ percent in 2007.

Monetary policy has been tightened to lean against inflationary pressures. Core CPI inflation rose to just under 3 percent y/y in June, after remaining steady at the center of the 2 to 3 percent inflation target during 2004-05. Firming growth in credit and retail sales also suggests that any needed consolidation in household balance sheets may be largely completed. With unemployment down to 4.8 percent and capacity utilization high, the Reserve Bank of Australia projects that core inflation will remain at the high end of its medium-term target during 2006 and 2007. As a result, interest rates were hiked by 25 basis points in both May and August, to reach 6 percent, and financial markets expect a further tightening by the end of 2006.

New Zealand

Low international interest rates, especially in Japan, exacerbated the recent economic cycle. Growth averaged 4¼ percent in 2002-04, driven by strong domestic demand partly due to booming house prices. Monetary policy was tightened substantially, with the cash rate rising to 7¼ percent, but the transmission lags were lengthened by cheap external financing for mortgage lending, partly reflecting large purchases of NZ$ bonds (Uridashi) by Japanese households. By 2005, the NZ$ hit record highs, exports fell, and the external current account deficit reached 9 percent of GDP.

The NZ$ fell in 2006 and demand is slowing, with a soft landing appearing most likely. As international interest rates began to rise and weaker data suggested that monetary tightening in New Zealand was over, the NZ$ dropped by 10 percent during February and March, to stand about 5 percent above historical average levels by August. Growth is expected to be only 1 to 1½ percent in 2006 as retail sales are slowing and investment is declining, but downside risks are cushioned by the strong labor market. As exports begin to respond to the improvement in competitiveness, growth is projected to strengthen to about 2 percent in 2007. The Reserve Bank of New Zealand is not expected to hike rates further, even though core inflation is at the top of the 1 to 3 percent target range, because core inflation will likely ease as growth softens. However, a significant decline in the current account deficit is not expected until 2007, suggesting that downside risks to the NZ$ remain.

1 The main author of this box is Craig Beaumont.

The economic outlook for low-income countries in Asia is generally good. Growth is expected to remain robust in the Mekong region, particularly in Vietnam. In South Asia, remittances continue to play an important role in supporting consumption and growth (Box 1.4). While the Pacific island countries have considerable potential for development, structural impediments continue to limit growth (Box 1.5).

Box 1.4.Workers’ Remittances: A Gravity Model1

Workers’ remittances have recently attracted much attention in policy circles, owing to their scale and properties. They are the largest source of foreign financing for developing economies after FDI. In 2005, remittances to developing countries amounted to $167 billion. Asia and the Pacific is the main destination region for remittances, accounting for 45 percent of the global total. A number of regional economies, including Nepal, the Philippines and several Pacific Islands, have reported remittances of 10 percent of GDP or more. Remittances are a particularly attractive source of foreign financing as they have proved much more stable over time than private capital flows and they do not create obligations in the future.

Remittances, 2004

(In percent of GDP)

Sources: IMF, Balance of Payments database; and staff estimates.

A better understanding of what determines remittances is warranted to help address challenges confronting policymakers in this area. These include identifying what policies may encourage remittances, their cyclical properties, and their potential role as both a shock-absorber and as part of an anti-poverty policy. So far, the study of remittances has been constrained by the lack of data on bilateral flows. However, a recent IMF paper creates the first dataset of bilateral remittance flows for a limited set of developing countries in Asia and Europe over the period 1980-2004 and estimates a gravity model for remittances.2

The study finds that the gravity framework is very powerful in explaining remittance inflows. Indeed, a few key variables such as partner countries’ income, distance, a common border and common language can explain more than half of the variation in remittance flows across time and countries. This is broadly in line with results from more common gravity models for trade. Perhaps surprisingly, despite the importance of remittances in Asia, South and East Asia actually receive lower remittances than predicted by the model.

What motivates remittances? The evidence is mixed, but altruism may be less of a factor than commonly believed. The paper does find a positive association between remittance receipts and the dependency ratio in the home country, suggesting that helping those at home is an important motive. Higher inflation in the home country is also found to encourage remittances to compensate for the loss of purchasing power at home. However, remittances do not appear to increase in the wake of natural disasters and appear positively aligned with the business cycle in the home country, suggesting an investment motive. Remittances are also sensitive to the investment and political climate in the home and host countries, again suggesting that investment considerations play an important role.

The results suggest that remittances can play some role, but perhaps not a major one, in limiting vulnerability to shocks. In particular, remittances are positively correlated with oil prices, offering a hedge against oil shocks. This is particularly important in some Asian countries, such as Sri Lanka, with over 80 percent of its migrant population working in the oil rich Gulf States. However, remittances may be less of a shock absorber than commonly believed. Being pro-cyclical, remittances tend to falter when exports weaken and GDP growth slows. They also decline when the home investment and political climate worsens and do not seem to respond to adverse shocks at home. Moreover, depreciation of the home country’s currency tends to reduce remittances, suggesting they may provide only limited insurance against balance of payment crises.

Earlier evidence on the importance of transaction costs for explaining remittances is confirmed and extended to conditions in the host countries. Both underdeveloped financial sectors and current account restrictions in the home country may discourage remittances through official channels, as do dual exchange rates in the worker’s host country. In fact, countries that restrict current account transactions receive 40 percent lower remittances on average than countries with fully liberalized current accounts. And up to 80 percent fewer remittances are sent through formal channels from host countries with dual exchange rates.

Remittances should be encouraged but should not be seen as a panacea. Remittances can yield important economic benefits to recipient countries, providing financing and supporting consumption and investment. But they may be of only limited value in absorbing shocks and reducing vulnerability to crisis. To encourage remittances and maximize their economic impact, policies should be directed at reducing transaction costs, promoting financial sector development, and improving the business climate.

1 The main author of this box is Marta Ruiz Arranz.2 See E. Lueth and M. Ruiz Arranz, “A Gravity Model of Workers’ Remittances,” IMF Working Paper (forthcoming).

Box 1.5.Pacific Island Countries: Regional Issues and Prospects1

The Pacific island region has considerable potential for development, especially in the areas of tourism, fisheries, forestry, mining and agriculture. An important task for economic policymakers is to exploit these resources to achieve faster sustainable growth and alleviate poverty. This will require the continuation of macroeconomic stability together with greatly increased emphasis on structural reform, including improved public sector efficiency and greater private sector activity.

Real GDP growth has been modest over the past decade, averaging only 3 percent annually, barely above the rate of population increase. In recent years, governance problems surfaced, control of public expenditure was progressively weakened, and spending was misdirected. Ethnic tensions contributed to coups in Fiji and civil conflict in the Solomon Islands, although economic recovery has been underway since the arrival of the Australian-led Regional Assistance Mission to the Solomon Islands (RAMSI) in 2003. Lack of employment opportunities contributed to increased crime and lawlessness in Papua New Guinea, and emigration from various island countries.

The Pacific islands face many challenges in seeking to improve living standards, especially given their small size, remoteness, openness, limited production diversification, lack of regional cooperation, and vulnerability to natural disasters. While recognizing that economic, political and cultural differences exist between the countries, there are a range of policy recommendations that are widely applicable throughout the region. These can be implemented while preserving the traditional way of life.

Real GDP Growth(Year-on-year percent change)
2004200520062007
Proj.Proj.
Emerging Asia8.48.58.58.3
Pacific Islands2.62.92.83.1
Fiji4.11.62.52.5
Kiribati−3.70.30.80.8
Marshall Islands4.71.40.93.5
Micronesia−4.41.5−0.73.0
Palau4.95.55.75.0
Papua New Guinea2.93.13.74.0
Samoa2.85.44.63.5
Solomon Islands8.05.05.34.3
Tonga1.42.31.90.6
Vanuatu4.82.63.03.5
Sources: Data provided by country authorities; and IMF staff estimates.
Sources: Data provided by country authorities; and IMF staff estimates.

Pacific leaders are already committed to structural change over the medium term. A comprehensive agenda has been spelt out in the Pacific Plan which was approved in late 2005, with the endorsement of Australia and New Zealand, who are major donors and play a leadership role in the region. The key to success of the Plan’s proposals will be their pace of implementation, which will depend crucially on the island countries themselves. However, the process will inevitably be a lengthy one, given the deep seated nature of many impediments to growth.

One major issue is the large size of the public sector throughout the region. In particular, the government wage and salary bills are in the range of 10–25 percent of GDP, far higher than in other regions. Another concern is the role of public enterprises, which frequently operate at a loss. This reduces the availability of budgetary funds for other types of spending more conducive to faster growth, including for health, education and infrastructure, especially in the telecommunications and transport sectors.

By contrast, the private sector is very small in most of the islands. Complicated regulatory requirements impede the opening of new businesses, impose substantial restrictions on their operations, and discourage foreign direct investment. A shift is also required from communal land ownership to a blending with long-term leases for commercial use. Economic integration should be expanded from its present small base, including through the regional free trade arrangements that recently came into force, further partnerships with foreign airlines to improve air service, and greater labor mobility.

Few Pacific island countries have consistently pursued structural reforms. One notable exception is Samoa, which embarked on a wide-ranging program one decade ago, leading to higher investment and growth. Fiji and Palau have succeeded more recently in promoting foreign and domestic investment in tourism. However, firm and persistent application of the medium-term policy framework outlined above is essential for improved economic performance throughout the region.

1 The main author of this box is Christopher Browne.
Real GDP Growth(Year-on-year percent change)
2004200520062007
Proj.Proj.
Bangladesh6.16.26.26.2
Bhutan7.57.412.714.3
Cambodia10.013.45.06.5
Lao P.D.R.6.47.07.36.6
Mongolia10.76.26.55.5
Myanmar13.613.27.05.5
Nepal3.82.71.94.2
Sri Lanka5.46.05.66.0
Timor-Leste0.32.30.94.6
Vietnam7.88.47.87.6
Low-income countries in Asia7.57.86.56.5
Sources: IMF, APDCORE and WEO databases; and staff estimates.
Sources: IMF, APDCORE and WEO databases; and staff estimates.

Inflation

Despite the continued rise in oil prices, inflation generally has been benign thanks partly to prompt monetary policy action and currency appreciation in the region. Average headline inflation in the ASEAN-4 countries remains at double-digit levels, mainly reflecting the sharp rise in administered fuel prices in Indonesia last October, but has moderated recently. Indeed, second-round effects have so far been modest throughout the region and core CPI inflation was little changed during the first half of 2006. Exchange rate appreciation in Korea, Indonesia, and Thailand has absorbed some of the increase in the prices of oil and other imports, while the strong monetary policy response in a number of countries has also kept inflation under control. Less than full pass-through of oil prices, for example in India, Indonesia, and Malaysia, has also contributed to lower inflation, albeit with a fiscal (or quasi-fiscal) cost. Meanwhile, strong corporate profits have helped insulate several countries, including India and Korea, from inflation pressures as firms have managed to absorb higher costs. In addition, stable food prices have helped keep a lid on inflation in China and the NIEs.

Inflation and Oil Price Pass-through

Emerging Asia: Core CPI

(12-month percent change)

Sources: CEIC Data Company Ltd; IMF, APDCORE database; and staff calculations.

Emerging Asia: Consumer Prices

(12-month percent change)

Sources: CEIC Data Company Ltd; IMF, APDCORE database; and staff calculations.

Inflation pressures are expected to remain well contained. Inflation in Asia is projected to remain at around 2¾ percent in both 2006 and 2007, virtually unchanged from the May 2006 REO projections. Monetary policy tightening has helped keep inflation expectations in check and oil prices are projected to rise only moderately through 2007. Inflation in the ASEAN-4 countries will also benefit in 2007 from an unwinding of base effects from previous increases in administered fuel prices. In India, still-strong domestic demand will likely continue to exert inflationary pressures, while in China, the booming domestic economy poses little immediate inflation risk owing to overcapacity in certain sectors.

CPI Inflation(Year-on-year percent change, average)
200420052006200720062007
May-06 Proj.Latest Proj.
Industrial Asia0.4-0.10.71.00.81.1
Japan0.0−0.60.30.60.30.7
Australia2.32.72.82.73.52.9
New Zealand2.12.23.12.83.83.4
Emerging Asia4.43.23.33.13.13.1
Hong Kong SAR0.01.21.82.12.32.5
Korea3.62.82.53.02.52.7
Singapore1.70.52.01.91.81.7
Taiwan POC1.62.31.81.51.71.5
China3.91.82.02.21.52.2
India16.64.73.84.74.55.2
Indonesia6.110.514.26.613.05.9
Malaysia1.43.03.12.73.82.7
Philippines6.07.77.44.76.75.0
Thailand2.84.53.62.24.92.6
NIEs2.42.32.22.32.22.2
ASEAN-44.67.58.94.78.74.5
Asia3.52.52.72.62.62.7
Sources: IMF, APDCORE and WEO databases; and staff estimates.

Wholesale price index for India.

Sources: IMF, APDCORE and WEO databases; and staff estimates.

Wholesale price index for India.

Nevertheless, there are both supply- and demand-side risks to this low-inflation scenario. Overall, supply-side pressures still appear limited, as trends in industrial capacity utilization so far do not point to upward price pressures. However, the gap between producer and consumer price inflation remains significant and, as profit margins begin to be squeezed—in part by higher interest rates and exchange rate appreciation in some countries—the pressure on companies to pass on higher production costs to consumers may rise. Also, labor market conditions have been steadily improving, with unemployment rates reaching 4- to 5-year lows in Hong Kong SAR, Korea, and Taiwan Province of China and the lowest level in Thailand since the Asian crisis. In Singapore, a record number of jobs was created in the first half of 2006, while the unemployment rate remains low. Even so, there are no clear signs yet of wage pressures in the region, with the possible exception of India, where survey results point to rapid increases in some sectors.

Emerging Asia: Capacity Utilization

(In percent, s.a.)

Sources: CEIC Data Company Ltd; and IMF staff calculations.

Emerging Asia: Consumer and Producer Prices

(12-month percent change)

Sources: CEIC Data Company Ltd; IMF, APDCOR database; and staff calculations.

Corporate Profitability: Return on Assets

(In percent)

Source: IMF, Corporate Vulnerability Utility.

Emerging Asia: Unemployment Rate

(In percent of labor force, s.a.)

Sources: CEIC Data ompany Ltd; and IMF staff calculations.

External Sector

Current account balances are expected to remain broadly stable in most of Asia, except for China and Korea. Emerging Asia excluding China is likely to see its current account surplus decline modestly in 2006, then stabilize in 2007. But China’s surplus is projected to rise further as exports continue to perform very strongly, reaching over $200 billion (7¼ percent of GDP) in 2007. In contrast, Korea’s current account surplus is expected to fall sharply, to less than ½ percent of GDP this year and next, from 2 percent of GDP in 2005, reflecting higher imports due to the recent recovery in domestic demand and won appreciation, and a rising oil import bill. India’s current account deficit is forecast to widen in 2006-07 amid vibrant domestic demand, while Thailand’s deficit is expected to expand next year with the resumption of infrastructure mega-projects. In both of these countries, the high proportion of imported oil is also contributing to the persistent current account deficits.

China: Twelve-Month Trade Surplus

(In billions of U.S. dollars)

Source: CEIC Data Company Ltd.

Current Account Balances(In billions of U.S. dollars)
2004200520062007
Proj.Proj.
Industrial Asia125.4114.0116.1111.2
Japan172.1165.7167.3162.9
Australia−40.1−42.1−41.4−42.3
New Zealand−6.5−9.7−9.8−9.3
Emerging Asia183.7254.6269.9288.1
China68.7160.8184.2206.5
India1.4−11.9−17.6−25.1
NIEs88.786.178.580.1
ASEAN-424.919.624.826.7
Asia309.2368.5386.0399.3
Emerging Asia excl. China115.193.885.881.7
Sources: IMF, APDCORE and WEO databases; and staff estimates.
Sources: IMF, APDCORE and WEO databases; and staff estimates.
Current Account Balances(Percent of GDP)
2004200520062007
Proj.Proj.
Industrial Asia2.42.12.22.0
Japan3.83.63.73.5
Australia−6.3−5.9−5.6−5.3
New Zealand−6.7−8.9−9.6−9.1
Emerging Asia4.15.04.74.5
China3.67.27.27.2
India0.2−1.7−2.1−2.7
NIEs7.06.05.04.9
ASEAN-44.02.83.13.0
Asia3.23.53.53.4
Emerging Asia excl. China4.63.32.72.4
Sources: IMF, APDCORE and WEO databases; and staff estimates.
Sources: IMF, APDCORE and WEO databases; and staff estimates.

Risks

While the outlook for Asia remains positive, risks appear to have increased, in particular for 2007. Downside risks predominate, in particular with regard to the pace of slowdown in the United States, the future path of oil prices, and increased risk aversion toward emerging markets.

The key risk for Asia continues to be a more rapid than expected slowdown in the United States. A sharp slowdown in the housing market or a disorderly unwinding of global imbalances could hamper U.S. consumption and residential investment, with adverse consequences for growth in both Asia and the rest of the world.3 In previous cycles, including the 2001-02 global recession, a slowdown in global growth has typically been preceded by U.S. consumption-led downturns. Nevertheless, there are some indications that domestic demand is strengthening in the Euro area, which could partly offset weaker demand conditions in the United States going forward.

Oil prices could surge again due to growing supply concerns. Global oil prices remain near record levels and may rise further with greater output volatility for major producers and escalating geopolitical tensions. Futures markets suggest that prices for crude oil will remain elevated for the remainder of this year and next. While countries in Asia have so far been able to absorb higher fuel costs, this may change as exchange rates stabilize and corporate profit margins are squeezed on weaker global demand. Some countries (India, Indonesia, and Malaysia) could also come under pressure to reduce oil price subsidies, which could fuel inflation. A combination of slower growth and rising inflationary pressures arising from further hikes in oil prices would present a difficult macroeconomic policy choice, including on the desirability of renewed monetary policy tightening.

Oil Prices

(U.S. dollars per barrel)

Sources: Bloomberg LP; and IMF, Commodities Price System database.

1Futures price series are calculated using the current spread between Brent and Dubai forwards, Tokyo Commodity Exchange’s Middle East crude oil futures, and IPE Brent.

The increased financial market volatility seen in May-June points to risks from a deterioration in the global financial environment. The recent bout of financial turbulence appears to have represented largely an orderly correction in equity prices (see Chapter II). But if risk aversion toward emerging markets intensifies—triggered, for example, by negative news on the inflation-growth tradeoff in the United States—asset prices could decline more sharply and/or for a longer period, which could affect adversely household incomes and consumption, while pressures for currency depreciations resulting from capital outflows could push up inflation.

Faster than expected growth in China could be a mixed blessing for the region. China’s economy could continue to expand rapidly notwithstanding policies aimed at slowing investment, which would generate benefits for the region in the near term. However, the current pace of growth appears unsustainable and, as the effects of increasingly restrictive administrative measures materialize, a sharper-than-expected slowdown could ensue, with important knock-on effects, including from a decline in China’s demand for capital goods.

The recent suspension of the Doha Round has again raised concerns regarding the return of protectionism. Any dislocation in global trade would impose a particular risk to Asian economies in the medium term, given their still strong dependence on export-led growth. Also, with the weakening of the multilateral trading system, countries may resort increasingly to bilateral and regional trade agreements as alternatives, which could entail potential costs in terms of trade diversion and administrative burden, unless such agreements were designed in ways that complement multilateralism.

Finally, the risks from an avian flu pandemic remain large. As highlighted in the May 2006 REO, beyond the potential tragedy in terms of human life, any such outbreak could have a significant impact on regional economies and, in particular, their trade and financial systems.

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