III. Macroeconomic Policy Issues

Published Date:
October 2006
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While the monetary tightening cycle appears to be nearing its peak in most Asian economies, the outlook for inflation remains uncertain, and monetary authorities will need to remain attuned to the emergence of stronger inflationary pressures. A further rise in global perception of risk could also require additional monetary tightening in countries where capital flows remain volatile. On the fiscal front, performance has generally remained on track, and risks to the outlook appear low. However, difficult longer-term fiscal challenges remain in many countries.9

Monetary Policy

The principal factors influencing monetary policy in the region are broadly as outlined in the May 2006 REO, although relative risks have changed somewhat.

  • Limiting the potential impact of high and rising oil prices on inflation has remained the primary challenge faced by macroeconomic policymakers in the region. So far, the impact of this price rise (and of that for other commodities) on headline inflation has remained fairly small in most countries, and core inflation remains under control.10 However, there are risks to the inflation outlook, related primarily to higher oil prices, but also to more general supply-side pressures.

  • Domestic demand has continued to face constraints in most countries, increasing the risks to growth associated with monetary tightening. Although domestic demand is expected to firm across Asia, slowing external demand could hold this back. China and India present notable exceptions to this trend, with robust domestic demand adding to concerns about overinvestment in the former, and inflationary pressures in the latter.

  • The yield differential between Asia and the United States has continued to decline. This has mattered more for some countries in Asia than for others. In those where the pass-through from exchange rates to inflation is relatively high (e.g., Indonesia and the Philippines), U.S. monetary policy matters quite a bit: to the extent that a decline in the interest rate differential depresses capital flows and weakens the exchange rate, monetary authorities need to factor in U.S. interest rate changes. But in other countries, where inflation is less sensitive to the exchange rate, or capital flows are less sensitive to interest rates, the yield differential is less relevant for monetary policy.

Monetary policy response

Most regional monetary authorities have remained proactive in addressing inflationary pressures. Although their rate increases have on the whole continued to lag those of the Fed (in some cases by quite a lot), they have in general exceeded the increase in inflation. As a result, real policy rates in Asia (based on contemporaneous core inflation) have risen to about 2¼ percent in the NIEs, and roughly 2 percent in the ASEAN-4. In recent months, however, real policy rates have eased somewhat. By comparison, the real policy rate in the United States had reached about 2½ percent at midyear.

Cumulative Increases in Policy Rates

(Since the rate tightening cycle began in each country, in percentage points)

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

Emerging Asia: Real Policy Rates

(Policy rates minus contemporaneous core inflation, in percent)

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

Abstracting from these broad trends, there has been some variation in monetary policy across the region since the May 2006 REO. Most countries have raised policy rates further (by ¼ to ½ percentage point), to keep inflationary expectations in check. Indonesia, which has faced the highest inflation in the region, has been an exception to this general trend, lowering its policy rate by 150 basis points (from a peak of 12¾ percent in May) as price pressures have eased. And in the Philippines, the policy rate has remained on hold (at 7½ percent) since late 2004, reflecting a gradual moderation of inflation and positive external developments. In China, where inflation has remained low, the primary policy concern has been rapid credit and investment growth in certain sectors, and the risks this may pose to banking sector health.11 To address this concern, monetary policy has been tightened (via interest rate and reserve requirement increases), and administrative controls have been adopted (including sector-specific investment bans and restrictions on lending to excess capacity sectors).

In Japan, with inflation better established, monetary policy has normalized. Following the end of quantitative easing in March 2006, the Bank of Japan (BoJ) increased its overnight policy rate to ¼ percent on July 14. The move brought an end to almost five years of ZIRP—the unprecedented policy of effectively zero short-term interest rates aimed at reversing deflation and reviving the economy. The beginning of a tightening cycle was well anticipated by markets, with the modest removal of accommodation broadly viewed as an appropriate step toward a more neutral monetary stance. BoJ statements have helped reassure markets that, going forward, interest rates will be adjusted gradually.

Exchange rates and reserves

In most of Emerging Asia, exchange rate appreciation had, until recently, contributed (in some cases significantly) to tighter monetary conditions, thus reducing the need for interest rate hikes. While regional exchange rates depreciated during the mid-year global financial market turbulence, most have recovered at least partially since then. Looking ahead, financial markets expect most Asian currencies to appreciate further. In the case of China and Malaysia, various indicators—including persistent and large current account surpluses—suggest that further appreciation is warranted. In other emerging Asian economies, appreciation pressures are likely to be weaker, reflecting generally narrowing current account surpluses. However, financial markets suggest that any renminbi appreciation is likely to be followed by that of other regional currencies, given the strong trade linkages in the region (Chapter II).

Emerging Asia: NEER Comparisons

(Percent change)

Sources: IMF, Information Notice System; and staff calculations.

In some Asian countries, greater exchange rate flexibility is important for addressing the significant pressures on liquidity stemming from large foreign exchange inflows. Asian official foreign exchange reserves surged by $220 billion in the first half of 2006, reaching $2.9 trillion.12 In China—which accounts for one third of Asian reserves—strong inflows primarily reflect a burgeoning trade surplus. In the rest of emerging Asia, while current account balances have generally been narrowing, capital inflows have been buoyant, despite a temporary reversal in May and June.13 In these countries, the strong reserve accumulation this year marks a turn-around from late 2005. While part of the overall increase in Asia’s official reserves can be attributed to valuation gains on non-U.S. dollar holdings, the majority reflects intervention by monetary authorities.14

Emerging Asia: Sources of Reserve Accumulation1

(In billions of U.S. dollars)

1 Excludes China.

2 Implied capital flows include valuation gains on existing official reserves.

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

Foreign Exchange Reserve Accumulation

(In billions of U.S. dollars)

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

Monetary policy outlook

For most Asian economies, the central outlook is for the monetary tightening cycle to end this year. Headline inflation is generally expected to remain modest or decline in 2007—especially in countries where base effects have played a large role in the increase (e.g., Indonesia and the Philippines)—reflecting well-anchored inflationary expectations. Against this backdrop, some monetary authorities may even be in a position to begin easing (with Indonesia expected to ease further). And in Japan, with inflation unlikely to rise quickly (as growth appears to be moderating), monetary policy is expected to remain accommodative.

Private Sector Inflation Forecasts

(Annual percentage change)

Sources: Consensus Economics.

China and India present exceptions to this central outlook. In China, although there are signs that credit and investment growth may be moderating, both remain robust, and more monetary policy tightening is likely to be needed. Given concerns that such tightening could attract additional capital inflows (and hence expand liquidity), allowing more rapid appreciation of the renminbi, combined with an intensification of open market operations, is warranted. In India, although core inflation remains low, there are considerable price pressures in the pipeline, emanating principally from rapid credit growth (running at about 30 percent per annum), and possibly also from rising wage pressures.15 In addition, the decline in the yield differential with the United States (which has fallen by 2¾ percentage points since May 2005) may depress capital inflows, which play a significant role in financing India’s current account deficit.16 Further monetary tightening is therefore likely to be needed.

This central policy outlook could face a number of challenges.

  • As discussed in Chapter 1, there are upside risks to inflation. Continued attention to the possible emergence of inflationary pressures is therefore warranted, especially where inflationary expectations are less firmly anchored. The experience of Indonesia in late 2005 shows the potential costs of delayed policy reaction to rising inflationary pressures.17

  • Another potential challenge stems from the narrowing of the interest differential between emerging Asia and the United States, which could reduce portfolio inflows, depress regional currencies, and thus increase imported inflation. The declining rate differential has been sustainable so far because risk premia had fallen sharply (especially in the ASEAN-4), though it should be noted that this decline may have been driven to a large degree by liquidity rather than a decline in perceptions of risk. While risk premia have remained low (despite the May-June financial market turbulence), further tightening of global liquidity conditions would likely usher in a rise in these premia.

  • The most challenging scenario could be if growth slows sharply (reflecting a weaker world economy),but inflationary pressures remain in the system (for example, if oil prices are driven even higher due to supply constraints). In this situation, policymakers will need to weigh the trade-offs between easing, in the interest of supporting domestic demand, and tightening, in the interest of containing inflation. To a large extent this trade-off will depend on the underlying strength of domestic demand.

  • Finally, while the persistence of rapid credit growth may not generally pose an inflationary risk (except in the case of India), in some countries it may raise concerns about banking sector health.18 In China, for example, there are risks that the newly-recapitalized state-owned banks may be on yet another lending spree, under less than ideal regulatory and supervisory conditions. In addition, a number of Asian economies have recently experienced rapid household credit growth, including India, Malaysia, the Philippines, and Thailand. While stability-related concerns remain minor in these countries, Korea’s financial sector problems (and economic slowdown) in the wake of the 2000-02 credit card boom, and more recently problems on this front in Taiwan Province of China, underscore the importance of monitoring household credit growth closely, and tightening prudential measures where necessary. A related concern is the increase in property prices—and possible risks of price speculation—that has accompanied the sharp rise in mortgage lending in many Asian economies, given that such price increases expose banks to asset price corrections.19 And because most mortgages are variable-rate, banks are also exposed to credit risk via this channel. All these issues highlight the critical importance of strong prudential policies.

ASEAN-4: Local Currency Risk Premium

(One year ahead, in percent)

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

Emerging Asia: Credit to the Private Sector

(Year-on-year percent change)

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

Fiscal Policy

Fiscal consolidation is set to continue in most Asian economies in 2006, as anticipated in the May 2006 REO. In the Philippines, higher revenue following the VAT reform, combined with expenditure constraints related to failure to pass the 2006 budget, is forecast to lower the deficit for the second year in a row. The deficit is also forecast to fall in Malaysia (due to buoyant oil-related revenues) and in Thailand (as public investment projects are postponed). In India, where the fiscal deficit has been considerably higher than in the rest of emerging Asia, consolidation is expected to be fairly modest this year, though somewhat larger in 2007. Deficit reduction is also expected in Japan, where public debt remains high and population aging will heighten already strong spending pressures. In contrast to this consolidating trend, Indonesia’s fiscal deficit is expected to widen this year, as fiscal policy aims to boost flagging domestic demand.

Selected Fiscal Indicators(In percent of GDP)
General Government Gross DebtCentral Government Fiscal Balance
Industrial Asia154.8154.7154.0-4.2-4.2-4.1
New Zealand23.822.821.
Emerging Asia37.735.834.1-1.6-1.5-1.3
Hong Kong SAR1.
Taiwan POC38.538.938.9−1.9−1.7−1.7
Indonesia 246.540.937.3−0.3−1.2−0.9
Malaysia 246.245.345.4−3.8−3.0−3.0
Thailand 6747.345.
Sources: IMF, APDWEO database; and staff estimates.

Fiscal year ending June. Fiscal balance includes net surplus from state-owned enterprises.

Central government only.

Consolidated central government debt including government guaranteed debt for financial sector restructuring.

Net debt.

Fiscal year ending March; privatization receipts excluded from revenues.

Public sector debt.

Fiscal year ending September.

Sources: IMF, APDWEO database; and staff estimates.

Fiscal year ending June. Fiscal balance includes net surplus from state-owned enterprises.

Central government only.

Consolidated central government debt including government guaranteed debt for financial sector restructuring.

Net debt.

Fiscal year ending March; privatization receipts excluded from revenues.

Public sector debt.

Fiscal year ending September.

The fiscal stance across Asia is broadly neutral this year, which appears warranted in most countries given that growth is at or near potential. In some, however, significant off-budget oil subsidies entail a more expansionary fiscal policy than the headline deficit numbers would suggest. This could cause some tension with monetary policy where inflationary pressures require tightening (e.g., India).

Risks to the near-term fiscal outlook appear relatively minor at this stage, and relate primarily to expenditure.

  • If higher-than-expected inflationary pressures require a further tightening of monetary policy, domestic debt service can be expected to increase along with interest rates. For most countries, however, interest payments have fallen as a share of GDP in recent years, so the expected impact on the budget would likely be small.20 Of course, for countries with a higher share of domestic debt, or whose debt has a shorter maturity, the impact would be larger.

  • If investors’ perception of risk should increase, this could drive up the cost of external debt issuance. Although emerging Asian external debt performed relatively well during the financial turbulence in May-June, reflecting strong fundamentals, this could change if risk aversion rose across the board (see Chapter II). But even if external issuance conditions should become more difficult, the average maturity of Asia’s sovereign external debt is quite high, suggesting that the actual impact on refinancing should not be too great (and in any case, plans for external borrowing during the remainder of 2006 are relatively small).21

  • In countries that still maintain administered prices for energy (China, India, Indonesia, and Malaysia), high and rising oil prices present a more serious expenditure risk. Energy-related subsidies (which in some cases may be off-budget) have been forecast as high as 2 percent of GDP this year in India and Malaysia. To the extent that oil prices rise further, and the price increases are not passed through, the fiscal costs of regulated energy prices will rise.

  • Finally, on the revenue front, the only downside risk at this juncture is the impact of slowing economic growth.

Sovereign External Issuance in 2006(In billions of U.S. dollars)
Emerging Europe17.911.86.1
Latin America18.422.3−3.9
Middle East & Africa6.12.04.1
Sources: JP Morgan; and IMF staff estimates.
Sources: JP Morgan; and IMF staff estimates.

Over the longer term, significant challenges remain on the fiscal front, primarily related to much-needed upgrades to infrastructure and costs related to aging societies. As discussed in the May 2006 REO, the infrastructure needs of emerging Asia are significant, and will require a considerable step-up in public investment in the coming years. In addition, the NIEs and industrial Asia are likely to face significant costs over the medium to long term as old-age dependency ratios rise. To the extent that regional economies are not making the most of the current favorable economic conditions to accelerate fiscal consolidation, an important opportunity to address these medium- to longer-term fiscal challenges is being missed.

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