Chapter

I. Overview

Author(s):
International Monetary Fund. Asia and Pacific Dept
Published Date:
April 2007
Share
  • ShareShare
Show Summary Details

Recent Developments and the Outlook

Asia recorded another year of strong growth in 2006, and the prospects are for the favorable economic performance to continue into 2007. That said, there has been somewhat less rebalancing of growth than expected, which leaves much of the region exposed to changes in external conditions. Indeed, weaker U.S. growth in recent quarters and ongoing inventory corrections led to a loss in export momentum in late 2006. Lower oil prices combined with modest domestic demand growth have helped to reduce inflation pressures in parts of the region, while overheating as well as real estate and equity price rises are a concern in some economies. Real sector risks have diminished in line with a more balanced G-3 growth profile. Meanwhile, financial risks are seen to have risen somewhat owing to possible spillovers from weakness in the U.S. mortgage market.

Growth

GDP growth strengthened further across most of Asia in 2006, with China and India continuing to lead the way. Growth in the region as a whole was up by 0.4 percentage point from a year earlier to 7.6 percent, while emerging Asia’s growth rate rose by a similar amount to reach 9 percent. Emerging Asia exceeded the growth projections of the previous outlook by 0.6 percent. China’s rapid growth continued to be largely investment led, although net exports have been contributing a growing share. Meanwhile, India’s domestic demand gained further momentum, taking growth there to more than 9 percent. Led by Singapore and Korea, the pace of activity in the NIEs rose to 5.3 percent while growth in ASEAN-5 rose modestly.1 In industrial Asia, growth rose to 2.3 percent as the recovery in Japan gained traction, but remained below previous projections.

Table 1.1.Asia: Real GDP Growth(Year-on-year percent change)
200520062006200720072008
REO Sept '06Latest Proj.
Industrial Asia2.02.32.72.32.42.1
Japan1.92.22.72.12.31.9
Australia3.02.43.13.52.63.3
New Zealand2.21.51.31.72.52.6
Emerging Asia8.69.08.48.28.58.1
Hong Kong SAR7.56.86.05.55.55.0
Korea4.25.05.04.34.44.4
Singapore6.67.96.94.55.55.7
Taiwan POC4.04.64.04.24.24.3
China10.410.710.010.010.09.5
India8.79.18.37.38.47.8
Indonesia5.75.55.26.06.06.3
Malaysia5.25.95.55.85.55.8
Philippines5.05.45.05.45.85.8
Thailand4.55.04.55.04.54.8
Vietnam8.48.27.87.68.07.8
NIEs4.75.34.94.44.64.6
ASEAN-55.55.75.35.85.86.0
Asia7.27.67.37.17.26.9
Sources: IMF, APDCORE and WEO databases; and staff estimates.

The more favorable outturn for growth mainly reflected higher-than-projected exports. Exports outperformed across much of the region (India being the main exception), particularly in most of the ASEAN-5 group as the effects of somewhat stronger exchange rates were outweighed by robust foreign demand as U.S. consumption remained resilient and the recovery in Europe gained pace. Investment fell short of projections in ASEAN-5, reflecting higher interest rates and implementation constraints in Indonesia, and political uncertainties in Thailand, but picked up pace in the second half of the year in the NIEs. Outside of China and Singapore (where the outturn was weak), private consumption grew broadly as expected in 2006, helped by lower oil prices and continued low unemployment. This was buttressed, particularly in some ASEAN-5 countries, by strengthening consumer confidence. Overall though, consumption growth continues to run below GDP growth in most countries such that, in combination with the softer investment outturn, the rotation to domestic demand has been less than expected.

Table 1.2.Asia: Real Export Growth(Year-on-year percent change; national accounts basis)
200520062006200720072008
Prel.REO Sept. '06Latest Proj.
Industrial Asia6.18.68.45.34.45.2
Japan7.09.59.45.14.55.0
Australia2.33.53.66.33.67.0
New Zealand-0.52.00.76.32.33.5
Emerging Asia18.317.417.416.616.016.2
Hong Kong SAR11.29.97.26.16.76.3
Korea8.512.413.510.87.99.6
Singapore11.310.48.96.97.28.4
Taiwan POC7.310.17.57.69.07.1
China22.423.321.120.220.419.5
India18.511.018.217.714.216.3
Indonesia16.49.27.36.58.09.1
Malaysia8.66.38.37.88.77.2
Philippines4.212.17.67.510.910.4
Thailand4.38.56.45.05.36.8
Vietnam20.523.012.711.710.616.9
NIEs8.611.310.69.08.08.4
ASEAN-510.910.77.97.18.29.5
Asia15.715.615.714.513.714.2
Sources: IMF, APDCORE and WEO databases; and staff estimates.
Table 1.3.Asia: Investment Growth(Year-on-year percent change; constant prices)
200520062006200720072008
Prel.REO Sept. '06Latest Proj.
Industrial Asia3.33.95.63.83.72.4
Japan2.63.75.53.94.12.7
Australia7.76.37.54.21.91.2
New Zealand3.6-2.7-2.2-3.4-1.00.9
Emerging Asia13.112.513.111.712.41.4
Hong Kong SAR4.67.911.69.910.08.3
Korea2.43.21.84.04.23.9
Singapore0.111.58.08.06.86.7
Taiwan POC1.20.30.55.05.07.0
China17.115.918.015.014.313.1
India13.514.510.28.313.910.7
Indonesia10.82.96.07.79.112.1
Malaysia4.77.96.97.89.58.8
Philippines-3.90.65.010.06.69.0
Thailand11.14.06.89.56.87.8
Vietnam9.78.619.717.011.112.2
NIEs2.13.42.95.25.35.5
ASEAN-57.44.07.69.68.410.2
Asia11.010.711.710.210.79.7
Sources: IMF, APDCORE and WEO databases; and staff estimates.
Table 1.4.Asia: Private Consumption Growth(Year-on-year percent change; constant prices)
200520062006200720072008
Prel.REO Sept. '06Latest Proj.
Industrial Asia1.81.22.02.11.82.1
Japan1.60.91.92.01.61.9
Australia3.03.13.23.13.43.0
New Zealand4.61.91.50.52.02.1
Emerging Asia7.26.37.78.39.17.9
Hong Kong SAR3.35.15.55.35.34.7
Korea3.64.24.43.63.33.5
Singapore3.12.54.44.23.13.8
Taiwan POC2.71.52.03.32.74.2
China9.17.29.810.912.310.3
India6.47.07.06.36.75.2
Indonesia4.03.23.04.84.75.0
Malaysia9.27.05.35.65.76.9
Philippines4.95.54.95.35.45.5
Thailand4.33.13.54.14.04.0
Vietnam7.37.55.78.28.88.8
NIEs3.33.43.83.73.33.9
ASEAN-55.24.54.05.25.35.5
Asia6.15.36.67.27.76.8
Sources: IMF, APDCORE and WEO databases; and staff estimates.

Figure 1.1.NIEs: Contributions to GDP Growth

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

Sources: IMF, APDCORE database; and staff calculations.

Figure 1.2.ASEAN-5: Contributions to GDP Growth 1

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

Sources: IMF, APDCORE database; and staff calculations.

1 Excludes Vietnam.

Export momentum eased in late 2006. The reduction of export momentum was concentrated in the tech sector (Box 1.1), most notably in Korea, Singapore, and Taiwan Province of China. There was also some softening in the growth rate of exports destined for the United States, consistent with below-trend growth there late in the year, as well as a reported drawdown in inventories. Reductions in inventories for some tech goods were reported in Japan as well. The decline in Asian tech export momentum began to reverse in early 2007 and forward-looking indicators on balance suggest prospects for a recovery.

Box 1.1.Asia’s Electronic Sector: Looking Back and Ahead

Asian economies have steadily raised their share of the global electronics market, from 38 percent in 1990 to 42 percent in 2005. The increase is more marked for sales of semiconductors, for which Asia’s share has more than doubled from 20 percent in 1995 to 47 percent last year.

The rise in market share has largely been driven by the rise of China as a production platform for these products. China’s share of electronics exports among Asian countries has more than tripled since 2000. In fact, although the electronic sector remains an important domestic source of growth for many Asian economies, its share in total exports has stabilized or even fallen in recent years. This reflects both export diversification as well as vertical diversification through outsourcing of low-end electronics production to low-cost countries, including China. At the same time, several countries, in particular NIEs, have moved up the value-added chain within the electronics cluster.

Turning to more recent trends, the regional electronics sector experienced overall solid growth during 2006. This reflected robust demand from major markets such as the United States, Japan, and emerging Asia. Sales growth was largely driven by popular consumer products; indeed, sales in the United States of flat panel TVs is estimated to have doubled in 2006 due to a sharp drop in prices and expansion of available high-definition programs. Exports from NIEs were supported by strong demand for MP3 players, mobile phones, and flat panel displays. In Korea, flat panel displays and flash memory products continued to benefit from buoyant demand while Singapore’s semiconductor industry benefited from strong demand for inputs to mobile phones and music players, although other product segments such as disk drives experienced a marked drop in activity, partly related to sector consolidation. Increased penetration of computers and other electronics in emerging economies also supported electronics exports.

Global Trade Shares in Electronics

(In percent of world total)

Source: World Bank and UNCTAD, World Integrated Trade Solution.

1 Excludes Hong Kong SAR.

Electronics: Relative Trade Shares

(In percent)

Source: World Bank and UNCTAD, World Integrated Trade Solution.

Asia: Share of Electronics in Total Exports

(In percent)

Sources: Statistics Singapore; CEIC Data Company Ltd; and Haver Analytics.

Notwithstanding the solid performance for 2006 as a whole, momentum waned in most economies late in the year in line with the slowdown in external demand, but also reflecting inventory drawdowns in the United States and Japan. For NIEs, electronics exports decelerated towards year-end. In Singapore, the slowdown was broad-based, while for Korea it was more concentrated on telecom equipment, including handsets. ASEAN-5 countries also generally saw slower momentum in exports, except for Thailand, while China and Japan experienced stronger activity, in the latter case supported by buoyant demand for semiconductor equipment.

The near-term outlook for the electronics sector is generally favorable, although the moderation in global growth is expected to dampen exports during the first half of 2007, especially for more cyclically sensitive consumer electronics and related inputs. There are also questions regarding the ultimate extent of the ongoing inventory correction. Reflecting these uncertainties, forward-looking indicators give a mixed picture of the outlook. On the positive side, U.S. book-to-bill ratio has increased in recent months, and U.S. electronics orders are holding up. However, sector stock indices and sentiment indicators have been mixed. With the global slowdown expected to be relatively shallow and shortlived, tech export growth will likely pick up during the latter half of 2007. Launches of new products and software, including Microsoft’s Vista, will also support activity during the year. Of course, a larger-than-anticipated slowdown in the global economy would act as a drag to such an outlook, especially if driven by a consumption-led slowdown in the United States.

Tech Sector Indicators

(3-month moving average)

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

Asia: Tech Stock Indices

(January 2004=100)

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

1 Simple averages.

Asia: Electronic Export Growth

(3-month moving average of 3-month percent change, SAAR)

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

Electronic PMI and Export Orders

Source: CEIC Data Company Ltd.

Over the medium term, the Asian electronics sector faces a broadly positive outlook, partly supported by increased penetration of electronic products in emerging markets, including India and China. However, increased competition on price and technological innovation will impact the relative performance for individual countries. The Semiconductor Industry Association (SIA) projects that global semiconductor sales will be supported by continued strong demand for consumer electronics, which increasingly use semiconductors. SIA projects the annual growth in global sales to rise from around 9 percent in 2006 to almost 11 percent in 2008 before slowing to 6 percent in 2009. Among regions, Asia-Pacific is projected by SIA to remain the fastest growing, with their global market share rising modestly to around 48 percent in 2009.

Note: The main author of this box is Leif Eskesen.

Figure 1.3.China and India: Exports of Goods

(3-month moving average of 3-month percent change, SAAR)

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

Figure 1.4.Emerging Asia: Exports of Goods

(3-month moving average of 3-month percent change, SAAR)

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

The outlook for 2007 is for the overall pace of activity to moderate to 2004–05 levels. This forecast assumes a successful tightening of policies in China and India, a firming of domestic demand elsewhere in emerging Asia and a modest reduction in foreign demand. The last of these is based on slower growth in the U.S., offset in part by steady growth in Europe and a continuation of recent momentum in Japan. In line with this relatively favorable external environment and strong fundamentals, IMF staff expects emerging Asia’s growth to ease only slightly to 8½ percent in 2007. China and India should again lead the way with growth of 10 percent and 8½ percent, respectively. Growth in the NIEs should decline modestly to 4½ percent reflecting somewhat softer exports, while growth in ASEAN-5 and industrial Asia are seen as broadly unchanged.

Once again, only a modest rebalancing of growth toward domestic demand is in prospect for emerging Asia in 2007. Net exports, particularly outside of China and India, will continue to be the main engine of growth. Consumption growth for the region is expected to increase, reflecting a strengthening in China in light of efforts there to rebalance growth, as well as a recovery in ASEAN-5 on improved sentiment. In contrast, investment growth in the region should remain broadly unchanged as increases in most of the NIEs and ASEAN-5 (reflecting a normalization following last year’s slowdown in Indonesia and the Philippines) are offset by policy-induced lower investment growth in China (through a mix of administrative measures and monetary measures) and India (largely through higher interest rates).

Figure 1.5.Emerging Asia: Consumer Confidence

(January 2004=100)

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

Inflation and Prices

Inflation pressures remain low in much of emerging Asia, albeit less so in India and Vietnam. Through early 2007, relatively weak domestic demand, continued competitive pressures and modest real wage growth have contained consumer price increases in the NIEs and China to around 2 percent, while inflation in ASEAN-5 has dropped back to around 5 percent as the spike in Indonesian prices in late 2005 has fallen out of the data. Trends in core CPI across the region are broadly similar, with somewhat lower readings than headline CPI in the ASEAN-5 and China. Producer prices are also contained across much of emerging Asia, and the wedge with consumer prices has narrowed. India and Vietnam are the outliers in the region. India’s WPI—its main inflation measure—has risen from around 4 percent in late 2005 and early 2006 to over 6 percent at present as growth remains above potential, capacity constraints have started to bind and nonfood credit growth continues to expand at around 30 percent per year. In Vietnam, inflation is running at 6½ percent reflecting wage pressures, adjustments in administered prices and unsterilized capital inflows.

Figure 1.6.Emerging Asia: Consumer Prices

(12-month percent change)

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

Figure 1.7.Emerging Asia: Producer Prices

(12-month percent change)

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

Figure 1.8.Emerging Asia: Growth in Real Wages

(Q/Q percent change, SAAR)

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

The effects of the drop in global oil prices since the summer of 2006 on consumer prices have been, for the most part, modest. In Hong Kong SAR and Singapore, the drop in crude prices in the second half of 2006 was small relative to domestic taxes on petroleum products, limiting the effects on final prices. In other economies, unchanged administered prices had the effect of transferring the potential gains from lower global oil prices from end-users to the budget or state enterprises. Exceptions to these trends were Australia and New Zealand, where petrol taxes are relatively low, pump prices are flexible, and lower prices were passed on to consumers.2

A rise in food prices in some economies has partially offset the modest benefits of lower oil prices. Increases in food prices have been most pronounced in Australia, India, Indonesia and Taiwan Province of China, and have been related to weather events. While the weight of food in consumer price indices across the region is typically much higher than that of oil products, food has historically contributed less to the volatility of CPIs. Moreover, these shocks, unlike oil, are local in nature and therefore are expected to have only a minor impact on regional price pressures.

Figure 1.9.Emerging Asia: Food CPI

(12-month percent change)

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

Notwithstanding largely favorable price developments for goods and (to a lesser extent) services, housing price pressures have become more pronounced in some parts of Asia. Housing price developments and the associated policy options are explored in Chapter III.

External Sector

External positions remained strong across most of the region in 2006 with outturns uniformly higher than expected. For the year, Asia’s overall current account surplus reached 4.3 percent of GDP, nearly 1 percentage point of GDP higher than the 2005 outcome and earlier projections for 2006. As noted above, exports generally outperformed for the year, while lower oil prices in the second half of the year reduced imports across much of the region by ¼ to ½ percent of GDP. The bulk of the increase in Asia’s overall current account surplus in 2006 came from China’s trade balance, which has again begun to rise further in early 2007 on a surge in export growth. In nominal terms, China accounted for about two-thirds of the region’s higher current account surplus compared with 2005. Current account balances in Indonesia and Thailand increased sharply in 2006 stemming from a combination of stronger exports, and lower imports owing to domestic fuel price hikes.

Table 1.5.Asia: Current Account Balances(In percent of GDP)
200520062006200720072008
REO Sept. '06Latest proj.
Industrial Asia2.12.32.22.02.11.9
Japan3.63.93.73.53.93.6
Australia-5.7-5.4-5.6-5.3-5.5-5.6
New Zealand-9.0-9.0-9.6-9.1-8.4-7.6
Emerging Asia4.86.14.64.56.16.2
Hong Kong SAR11.410.78.77.89.69.3
Korea1.90.70.40.30.30.0
Singapore24.527.528.527.327.126.6
Taiwan POC4.67.15.85.97.17.1
China7.29.17.27.210.010.5
India-1.1-1.1-2.1-2.7-2.4-2.3
Indonesia0.12.60.20.61.81.3
Malaysia15.317.115.615.715.314.3
Philippines2.04.32.41.72.11.9
Thailand-4.51.6-0.8-1.31.50.9
Vietnam0.40.30.3-1.5-1.2-1.5
NIEs5.65.65.04.95.35.1
ASEAN-52.04.92.92.73.83.2
Asia3.44.33.53.44.34.4
Emerging Asia excl. China3.03.82.72.42.82.5
Sources: IMF, APDCORE and WEO databases; and staff estimates.

Figure 1.10.China: Twelve-Month Trade Surplus

(In billions of U.S. dollars)

Source: CEIC Data Company Ltd.

Reserve growth picked up pace in 2006, bringing the regional stock to over $3 trillion. As in recent years, almost all of the increase took place in emerging Asia, and within that group China accounted for the bulk, although some economies (Korea and Thailand) experienced a late-year jump in reserves.3 With reserves in many economies beyond the level needed for liquidity purposes and cushions against plausible external shocks, there has been some movement in the region toward allocating a portion of reserves to more aggressively managed portfolios broadly along the lines adopted by Singapore. The authorities in China have recently moved in this direction, while the Korean Investment Corporation has already been launched.

Table 1.6.Asia: Official Reserves(In billions of U.S. dollars, end-period)
200420052006
Industrial Asia888899964
Japan845847895
Australia374355
New Zealand7914
Emerging Asia1,6011,8512,252
Hong Kong SAR124124133
Korea199210239
Singapore113117137
Taiwan POC242253266
China6198261,073
India131137177
Indonesia363543
Malaysia677083
Philippines151823
Thailand505267
Vietnam6911
NIEs677705775
ASEAN-5174184227
Asia2,4902,7503,216
Source: IMF, APDCORE database.

Risks

As in the previous Regional Economic Outlook: Asia and Pacific (henceforth, the Regional Economic Outlook), the balance of risks is tilted toward the downside:

  • The main risk remains uncertainty surrounding U.S. growth prospects (in particular, weakness in residential investment spilling over to consumption), but this has moderated somewhat given the downward revision in the central scenario. The latest World Economic Outlook forecasts 2.2 percent growth for the United States this year, while the consensus forecast stands at 2.4 percent.

  • As noted in the April 2007 Global Financial Stability Report, the turbulence that hit financial markets in late February underscored concerns that periods of expanded risk appetite, compressed spreads, and low volatility can lead to investor complacency and disruptive reversals of capital flows. While in the recent moderate correction emerging Asia has again performed modestly better than its peer group, a reappraisal of risks in combination with sharply lower U.S. growth expectations could require larger asset price adjustments and spill over to the real sector through financial and household balance sheet channels.

  • While world oil prices have declined from their mid-2006 highs in response to slowing global growth and a warmer-than-expected winter, the risks are skewed on the upside owing to the combination of tight capacity, and supply concerns related to unresolved geopolitical tensions.

  • Within-region risks are, on balance, on the upside, relating to the potential growth performance of China and India. Both countries have outperformed relative to expectations in recent years, and continued strong growth would have positive spillovers to the rest of the region, particularly through China’s linkages in the regional supply chain. However, these effects may be weakening as the local content of China’s exports appears to have risen (Box 1.2).

  • Beyond the near term and depending in part on the fate of the Doha Round, protectionism remains a risk. To the extent that protectionism contributes to a rise in regional and bilateral, rather than multilateral, trade agreements, it carries potentially distorting “spaghetti bowl” effects on trade. More serious, to the extent that growing public concerns about the negative effects of globalization lead to punitive tariffs or other trade-dampening measures, Asia’s more open economies would be adversely affected. That said, progress in trade liberalization continues to be made as evidenced by Vietnam’s recent accession to the WTO (Box 1.3).

Box 1.2.Assembly Platforms in Asia: Is China’s Role Changing?

In recent years, China has often been described as the assembly line of the world, combining expensive high-tech imported inputs with cheap domestic labor to assemble final goods that are exported predominantly to developed markets in Europe and North America, with some portion being retained for the domestic market. The availability of low-cost labor and the potential expansion of the domestic market have in turn attracted vast amounts of foreign direct investment, notably from within the region, supporting this development of intricate production networks. According to this view, as long as China retains its comparative advantage in cheap labor, movements in external demand and the exchange rate would have a limited impact on China’s trade balance, as any change on the export side will be offset by a similar change in imports.

However, the situation may already be evolving, as a result of increased production capacity and capability within China and the evolution of vertical specialization of production in the region. According to this alternative view, the domestic content of Chinese exports is rising fast and the link between Chinese exports and imports is therefore becoming weaker. Although exports continue to be an important engine of growth, they are now increasingly reliant on domestically sourced components rather than imported intermediate goods, while imports are increasingly driven by domestic demand. As a result, the trade balance is likely to be more responsive to movements in the exchange rate and fluctuations in external demand.

The dramatic shift in China’s trade and production structure observed in recent years lends support to the latter view. Over the last two years, China’s current account surplus has risen by nearly 5½ percent of GDP, as import growth has begun to lag export growth by a significant margin. In particular:

Recent Trade Developments

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

Manufacturing Trade Balance

(In percent of GDP)

Source: UN Comtrade.

  • While its deficit in primary products continues to expand gradually, its manufacturing trade surplus has risen sharply, primarily reflecting an acceleration in net exports of machinery and transport equipment and manufactured goods. Indeed, the six most important contributors to the expansion in the trade surplus over the last two years were: electronics (1.8 percent of GDP), machinery (1.0 percent of GDP), iron and steel1 (0.9 percent of GDP), textiles and clothing (0.8 percent of GDP), organic chemicals (0.3 percent of GDP), and automobiles (0.2 percent of GDP).

  • Imports of intermediate goods have slowed considerably. Parts and components and semifinished goods accounted for almost half of the slowdown in import growth between 2004 and 2005. In addition, there has been a significant slowdown in capital equipment imports, as domestic fixed asset investment continued to expand sharply in 2005 and 2006.

  • Exports of final goods have remained robust. In many sectors—notably aircraft, home electrical appliances, industrial machinery, precision apparatus and automobiles—exports of final products have continued to grow strongly, despite the recent slowdown in imports of associated intermediate inputs. This does not appear to reflect a slowdown in domestic demand; retail sales grew by over 13 percent in 2006, with car sales rising by nearly 25 percent and sales of mobile phones and most household electrical appliances up by 15 to 30 percent.

  • Domestic production in a number of intermediate sectors has picked up significantly, spurred by rapid investment during the early 2000s. Domestic production capacity in steel, plastics, electronic components, industrial equipment and chemical fiber has expanded rapidly in recent years. In some industries, foreign direct investment has played a major supportive role in this process. For example, FDI into the chemicals industry from the U.S. increased from around $37 million in 1999 to $520 million in 2005. Over the same period, FDI flows from Taiwan Province of China increased from $538 million to $2.4 billion in the electronics sector and from $28 million to $373 million in the precision instruments sector.

Contribution to Import Growth

(Year-on-year percent change)

Sources: UN Comtrade; and IMF staff estimates.

Ratio of Final Exports to Imported Components

(2001=100)

Sources: UN Comtrade; and IMF staff estimates.

Domestic Production

(2000=100))

Souce: CEIC Data Company Ltd.

China’s trade with the rest of Asia and its role in regional production chains are also changing. As China’s role within Asia’s production networks appears to be expanding vertically, it is becoming less reliant on other Asian economies for inputs. While China’s trade surplus with the United States and the European Union continues to grow, its trade deficit with the rest of Asia, traditionally an offset, has begun to shrink over the last two years.

Trade Balance

(In percent of GDP, Custom basis)

Source: CEIC Data Company Ltd.

China’s Trade with Asian Partners(Year-on-year percent change)
JapanKoreaTaiwan POCSingapore
20042005200420052004200520042005
Exports2414382650224331
Imports276442331153318
Organic chemicals4413573161314313
Plastics2010391627121822
Iron and steel308349
General machinery40247111223910
Electronics234522150192637
Transportation equipment20-1160356-23-51-20
Source: UN Comtrade.
Note: The main author of this box is Murtaza Syed.1 The trade balance in steel products, traditionally in deficit, moved into surplus for the first time in 2006.

Box 1.3.Vietnam’s WTO Accession: What Does It Imply for Vietnam and the Rest of the Region?

On January 11, 2007, Vietnam became the 150th member of the World Trade Organization (WTO) following more than ten years of negotiations. Vietnam’s integration with the global economy preceded its WTO accession. Since 1993 Vietnam’s trade openness (the sum of exports and imports in relation to GDP) more than doubled, while its export market share more than quadrupled. With exports a leading engine of growth, real GDP has increased on average 7½ percent a year during 1993–2006, and poverty has fallen sharply. Given this impressive record, it is worthwhile to assess how WTO accession will affect Vietnam’s future, and how Vietnam’s development may affect the region.

What Will Change for Vietnam?

WTO accession can be expected to facilitate further global integration over the medium term, improving Vietnamese exporters’ access to foreign markets. This should be particularly beneficial for the key textile and footwear export industries, in which Vietnam can now compete on an equal footing with other WTO member countries, which have enjoyed quota-free treatment since the beginning of 2005. The benefits to export performance, however, could take some time to be fully realized.1 Vietnam will also face greater competition from foreign producers on its domestic markets for garments and footwear, as import tariffs and subsidies in these sectors are substantially reduced. However, with improving access to cheaper imports of raw materials and semi-processed inputs, and with greater scope for joint ventures with major international producers and distributors, the textile and footwear sectors are expected to reap efficiency gains that should help preserve their comparative advantage.

Import barriers in most other sectors will also decline, albeit in a more gradual fashion. Vietnam has committed to bound tariff rates on most products ranging from zero to 35 percent, although tariffs on cars and motorbikes are to remain somewhat higher, and certain sensitive products (such as eggs, tobacco, sugar, and salt) will be further protected with tariff quotas. Reductions in most bound rates—from 17.4 percent on average in 2007 to 13.6 percent by 2019—are to be phased in over periods of up to 12 years.

Vietnam: Indicators of Trade Openness

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

1/ Vietnam's exports as a percentage of world imports.

Vietnam: WTO Commitments on Trade in Goods
2005WTO initialWTO finalWTO
MFN rates 1/bound ratesbound rates 2/implementation
Simple Average18.517.413.6up to 12 years
Agricultural products29.427.321.7up to 5 years
Nonagricultural products17.016.012.5up to 12 years
Steel9.717.713.0up to 2 years
Petroleum14.627.227.1up to 2 years
Textiles and clothing36.613.613.5upon accession
Footwear45.035.827.2upon accession
Cars63.684.858.7up to 12 years
Motorbikes100.0100.074.3up to 12 years
Electronics machineries13.313.99.55 years
Maximum tariff15015085
Number of lines10,68910,44410,444
Sources: WTO, Vietnamese authorities, and IMF Staff calculations.

From a broader perspective, WTO accession should have largely positive macroeconomic effects. While the reduction in import tariffs can be expected initially to lower import duty receipts by some 0.3 to 0.6 percent of GDP, this should be tempered over time as the removal of trade barriers spurs import growth. With exports continuing to grow rapidly as access to foreign markets improves, and with continued dynamism of foreign investment, the overall balance of payments should remain strong. Increasing access to cheaper imports should also help contain inflation, which, at 7.5 percent in 2006, is still higher than in other emerging markets in Asia. IMF staff estimates (Tumbarello, 2007) also point to welfare gains from trade liberalization, rising over time to reach some 0.6–1.2 percent of GDP a year by 2019.

Vietnam is also likely to derive important productivity gains from trade liberalization and other market-friendly reforms to be introduced in the context of WTO accession. A new law providing a common regulatory framework for domestic and foreign enterprises has been introduced, and Vietnam has also moved to harmonize its rules on trading rights for foreign and domestic traders. WTO accession could also serve as a catalyst to promote restructuring of unprofitable state-owned enterprises (SOEs). Increased competition with foreign banks can also be expected to prod the government to speed up the restructuring of state-owned commercial banks (SOCBs) and the implementation of its banking sector reform roadmap. These reforms should help increase the efficiency and profitability of investment. Indeed, the prospect of accession has already bolstered the investment climate, and with FDI approvals reaching a record $10 billion last year, Vietnam is well-placed to take full advantage of its ongoing global integration to sustain the rapid pace of its economic growth.

WTO accession is, of course, not a panacea and presents challenges as well as opportunities. Heavily-protected industries and SOE sectors, notably auto-assembly and motorbike plants, and the financial sector, will need to undertake significant reforms to remain viable. In this process, there may well be a compression of profit margins and, possibly, labor-shedding or even bankruptcies in loss-making SOEs and declining industries. Although adverse effects should be manageable as long as more efficient sectors offer growing employment opportunities, it will be important to put in place adequate retraining programs and social safety nets to minimize dislocations. The authorities will also need to resist the temptation to support financially those industries with declining profitability. Such support, which could take the form of fiscal incentives or directed lending by state-owned banks, could turn out to be very costly especially if, in the end, these industries are found to be non-viable.

What Will Be the Impact on the Region?

Vietnam’s WTO accession and its emergence on the world stage can have significant impact on the region. The NIEs are likely to gain from Vietnam’s accession, as they have invested heavily in the country and do not have the same comparative advantage as Vietnam in their exports. However, major exporters of textiles and garments (such as Bangladesh, Cambodia, the Philippines, and Sri Lanka) may face new competitive challenges as the end of the textile quota implies increased market access of Vietnamese products in the United States. In addition, as Vietnamese producers penetrate a broader range of manufacturing sectors, including low-end electronics, the rest of the ASEAN-5 are likely to come under increasing pressure to move towards the production of higher value-added products. With respect to foreign investment, it is difficult to ascertain how WTO membership will affect FDI in other Asian countries. Vietnam has already established itself as an appealing destination for foreign investors prior to accession, including in the IT sector, and the reduction of its MFN tariffs, together with improved access to foreign markets, should enhance its integration into regional production networks. Cost reductions from increasing FDI in Vietnam could thus improve the profitability of regional networks.

…and on the Rest of the World?

Industrial countries are likely to accrue considerable net gains from Vietnam’s WTO accession. Consumers in the United States, EU, and Japan, which are major net purchasers of textiles, footwear, and other low-cost manufactures from Vietnam, can be expected to reap growing gains in welfare from the continuing integration of Vietnam’s productive and low-cost labor force into the global economy. In addition, as Vietnam transitions towards middle-income status, there should be increasing scope for an expansion of industrial countries’ exports in technology-intensive manufactures and high-end services (e.g., finance), in which advanced economies still have a comparative advantage. While preliminary data suggest that, in the short run, FDI is set to increase most strongly in the sectors in which import barriers will fall most rapidly (as in textiles), over time, it is likely that there will also be growing foreign investor interest in higher-value-added manufacturing and services sectors.

Note: The main author of this box is Patrizia Tumbarello.1 It will take Vietnam 12 years to gain full “market economy” status, which could make it more difficult for it to guard against the imposition of anti-dumping measures in these sectors.

Recent Financial Market Developments

The late February–early March financial market turbulence, while initially virulent, subsided quickly. Despite the sell-off, foreign investor sentiment towards the region remains strong, bolstered by solid growth prospects, mostly sound fundamentals, and still supportive global liquidity conditions. Inflows into the region are projected to stay buoyant, albeit largely offset by increased outflows, and should be generally supportive of all asset classes. Upward pressure on regional currencies is likely to persist, reinforced by renminbi appreciation pressures and widespread balance of payments surpluses.

The February–March Correction

Asian equity markets continued to perform well through early 2007, notwithstanding the correction that began in late February. Solid growth trends, still favorable liquidity conditions, and mostly sound fundamentals have guided the sharp rise since mid-2006 lows in most markets.

Figure 1.11.Emerging Asia: Equity Inflows

(In billions of U.S. dollars)

Source: Bloomberg LP.

Despite some slowing in net foreign equity inflows into emerging Asia since the second half of 2006, relatively strong domestic buying propelled many markets to near-record-highs earlier this year. For most economies in emerging Asia, valuations remain somewhat elevated, although not out of line with historical trends or with emerging markets outside Asia. Large initial public offerings—mainly related to China’s financial sector—were instrumental in driving Hong Kong SAR and mainland markets, although this activity is likely to taper off in 2007.4

The late February 2007 sell-off, nonetheless, is a reminder that market performance in emerging Asia remains closely linked to external conditions. While no single trigger for the sell-off emerged, renewed concerns about U.S. growth prospects, particularly in relation to developments in the housing sector, appear to have weighed heavily on investor sentiment toward regional markets. The initial sharp fall in Chinese equities prices likely did not influence other Asian markets, given the weak transmission channel owing to limited foreign participation.5 However, within a span of several days, most emerging Asian markets fell by 7 to 10 percent (although Indian equities had already declined from record highs beginning in mid-February on inflation concerns). The most affected markets appear to be those where trades—and, importantly, potential exits from those trades—had reportedly become crowded; particularly, the Philippines and Malaysia. The latter experienced a shift in foreign equity flows out of Thailand following the imposition of capital controls there in December 2006.6

Figure 1.12.Emerging Asia Equity Performance

(Percent change)

Source: Bloomberg LP.

As in May–June 2006 equities bore the brunt of the sell-off, with hedge fund activity prominent and “real money” investors reportedly playing a stabilizing role. Hedge funds—particularly net-long equity funds—were reportedly active in both the May–June 2006 and the February–March 2007 sell-offs. In both episodes, the resulting pick-up in market volatility also fed into some momentum trading (reportedly mainly by global macro funds based outside the region). In contrast, investors with longer-term horizons such as pension and insurance funds again played a stabilizing role by not exiting Asian markets in great numbers. Japanese retail investors reportedly maintained their foreign exposures as well, and domestic investors were for the most part not seen as liquidating positions once the turbulence set in. As in the 2006 episode, equities sustained the largest losses of any asset class. Bond and currencies were less affected owing to a combination of foreign investors staying on-shore (in various short-term fixed income products) even while equities were sold, central bank intervention (in the Philippines and Malaysia), and some position closing by domestic agents.

Unlike May–June 2006, investor nervousness centered on the prospects for U.S. growth, rather than inflation, and the yen carry trade. While the 2006 sell-off was driven by a reassessment of the path of U.S. interest rates (as the Federal Reserve was seen as raising rates more than previously thought given persistent inflation fears), the early 2007 episode was driven by U.S. growth prospects—in particular, unexpectedly persistent weakness in the U.S. housing sector and an unfavorable report on durable goods orders. Also different was the apparent prominence of carry trades, which became increasingly popular in late 2006 and early 2007 (Box 1.4). Though data are partial, the unwinding of equity and currency positions funded by borrowing in Japanese yen appeared to have played some role in increasing market turbulence. Carry trade target countries in the Asia region were seen to be New Zealand, Australia, and, to a lesser extent, Indonesia, Korea and the Philippines.

Box 1.4.Carry Trades: Getting Carried Away?

The recent global market sell-off has focused attention on the role played by the unwinding of the yen carry trade.1 For much of 2006, the yen depreciated, reflecting large capital outflows from Japan. But more recently, during the period of global market turbulence that began in late February 2007, the currency appreciated abruptly, reportedly on significant unwinding of yen carry trades. At the same time, the increase in the volatility of both currency and equity markets may have contributed to the yen appreciation as well. Observers have drawn parallels with the experience of rapid appreciation of the yen during a period of financial market volatility in 1998 marked by the Russian debt default and the LTCM crisis.

Exchange Rate and the VIX

(In percent)

Source: Bloomberg LP.

What Is Carry Trade?

In its pure form, a “carry trade” is a currency strategy that exploits opportunities presented by expectations of low borrowing costs in one market combined with expected high returns in another. These types of trades are not new and their popularity with investors waxes and wanes depending on the constellation of global interest rates. Recently, the term has been used more broadly to denote any investment strategy—ranging from unleveraged ones to complex off-balance sheet transactions—involving a low interest rate currency and a high interest rate currency. (This contributes to differences and uncertainties in measuring the size of carry trades, as will be seen below.) The successful use of this strategy by investors is somewhat puzzling as the theory of uncovered interest rate parity implies that investors should enjoy no excess profit as the returns from high-interest country should be offset by the depreciation of its currency. However, the carry trade seems to be profitable, at least at certain times.

Three key factors influence carry trades: (i) size of carry; large spreads tend to attract investors; (ii) exchange rate expectations, market views on the likely direction of exchange rate movements often diverge from what is implied by uncovered interest rate parity. Also, low volatility is conducive to carry trade as this suggests large future changes in exchange rates are not expected; and (iii) risk appetite, related to low volatility; an environment of risk-seeking or high risk appetite tends to be supportive of carry trades. Importantly, carry trades are normally unhedged, leaving the investor exposed to volatility in the form of an appreciation in the funding currency.

A major concern associated with the carry trade is that it could unwind rapidly if investors decide to close out short-term positions in response to a change in expectations. This occurred in October 6–9, 1998, when the U.S. dollar fell by almost 15 percent against the yen because of a large-scale unwinding of the yen carry trade. While the effects on the real sector were minimal, the unwinding of short yen positions by hedge funds and large financial institutions led to a rapid drying up of liquidity in key markets. This resulted in unprecedented price disconnects and market seizures.

Quantifying the risks involved is difficult as there are no definitive statistics on the carry trade. The data on carry trades is fairly limited, and is frequently anecdotal, relying on market intelligence. This is further complicated because, as noted above, there is no standard definition of the carry trade and the underlying transactions can be conducted off-balance sheet. Both stock and flow estimates range widely. As a result, it is necessary to look at a number of different sources in seeking to gauge the size of the carry trade.

What Do We Know about Carry Trade from the Funding Side and the Target Currency Side?

Domestic Japanese investors have dramatically increased their holdings of foreign bonds. Historically, institutional Japanese investments in foreign bonds have tended to be the dominant source of private sector outflows. Recently, individual investors and pensioners have invested more overseas in search of higher returns. For example, the value of overseas investments by Japanese mutual funds in foreign bonds has grown rapidly over the last three years to reach $230 billion in 2006. This growth reflects in part a secular decline in the home bias of domestic investors, both institutional and retail. Of note, this element of the carry trade (broadly defined) is thought to be relatively stable given the lack of leverage and the longer-term horizon of the investors.

Hedge funds and other leveraged players are also key participants in carry trade. There is no single direct measure of such positions, but one useful indicator is the call money market liabilities of foreign banks in Japan. These liabilities increased by over ¥7 trillion ($63 billion), between January 2006 and January 2007. This is one possible channel through which foreign hedge funds might obtain yen funding, although the size of the actual carry-trade-related positions is unknown. Another potential indicator of carry trade positions is the net short positions in yen futures of noncommercial traders (financial institutions and speculators) on the Chicago Mercantile Exchange. These data show a buildup of net short yen positions in 2005 and first quarter 2006, followed by a complete unwinding of positions in Q2.2

Japanese Bond Outflows and Current Account

(In trillions of yen, 12-month moving sum)

Sources: Bank of Japan; and Japan Investment Trusts Association.

CME Yen Positions of Noncommercial Traders

Source: Bloomberg LP.

Call Money Market Liabilities of Foreign Banks in Japan

Source: Bank of Japan.

Within Asia, the most important destinations for yen-funded carry trades appear to be Australia and New Zealand, reflecting their high nominal interest rates and developed country status. In emerging Asia, the Indonesian rupiah has been the most commonly mentioned carry trade destination currency (although investor enthusiasm has waned in light of the steady decline in interest rates there), followed by the Korean won, Indian rupee, and Philippine peso. In the case of the won, much of the yen borrowing has been done by Korean residents themselves, largely in the form of loans to small- and medium-sized businesses. According to traders, carry trades into the Philippine peso have fallen off in the past few months, as market interest rates there have dropped sharply.

A look at total returns illustrates why carry trades have been popular (first figure). Total returns are calculated as the sum of the interest rate spread, without any hedging of the investment, and the annualized movement in the exchange rate. Given the persistence of low interest rates in Japan, ex ante interest rate carries have tended to be positive for several years. Moreover, yen depreciation over much of this time has often made ex post total returns substantial. Only on a few occasions has the return been negative.

Carry Trade: Total Returns

(3-month rolling window, annualized, in percent)

Source: IMF staff estimates.

Case Study: The Impact of the Carry Trade on New Zealand

New Zealand has attracted a disproportionate share of global liquidity in recent years, which has put upward pressure on the currency. One source of inflows has been through the issuance of New Zealand dollar denominated bonds in offshore markets: Uridashi and Eurokiwi. As the second figure shows, there has been a huge increase in these issues in the past few years. The transactions associated with these bonds have provided a mechanism for domestic banks to obtain funds at cheaper rates than they would be able to otherwise, putting downward pressure on domestic interest rates.3 The attractiveness of the New Zealand dollar to offshore investors reflects not only the interest rate spread but also investors’ views regarding its sustainability.

Offshore New Zealand Dollar Denominated Bond Issuance

(Eurokiwi and Uridashi Bonds, in billions of New Zealand dollar)

Sources: Bloomberg LP; and New Zealand authorities.

The New Zealand dollar has tended to strengthen when global risk appetite is high and general market volatility is low. This notion is consistent with the conventional wisdom that a non-G-7 currency like the New Zealand dollar tends to be shunned by international investors during periods of turbulence. Recent research has shown that the kiwi dollar tends to be relatively strong when general market volatility (using VIX) is low, with an average correlation coefficient of -0.70. Consistent with these results, when global volatility picked up in late February, the New Zealand dollar depreciated by 3 percent.

Note: The main authors of this box are Hali Edison and Chris Walker.1 The Swiss franc and, to a lesser extent, the Taiwanese dollar have also been reportedly used as carry trade funding currencies, although they will not be covered in this box.2 These futures contracts are nondeliverable and are settled in U.S. dollars. However, the exposure to exchange rate fluctuations is the same as it would be from a “pure” carry trade, making this measure a good proxy.3 For details, see Eckhold (1998).

The Outlook

In a number of countries, upward pressures on currencies are currently priced in given prospects for further renminbi appreciation and continued balance of payments surpluses. The pace of renminbi appreciation against the U.S. dollar picked up in the second half of 2006 and an annual appreciation of over 5 percent is currently priced in the nondeliverable forward market. Given the supply chain linkages as well as competition across production centers in Asia, other regional authorities are likely to (at least partially) allow their currencies to follow the renminbi higher, with some additional appreciation pressures stemming from current account surpluses and net portfolio inflows.7

Figure 1.13.Emerging Asia: Exchange Market Pressure Index1

Source: IMF staff calculations.

1 The exchange market pressure (EMP) index is the sum of the growth of the nominal exchange rate and the change in international reserves as a fraction of the monetary base.

A healthy pace of net private capital inflows to emerging Asia is expected to continue. Foreign investors remain attracted to emerging Asia’s fundamentals, and the region continues to benefit from the search for yield by global investors and is still considered a leveraged play on global, particularly U.S., growth. The structural decline in Japan’s home bias has benefited flows to emerging Asia as well. Moreover, prospects for further currency appreciation in the region, as evidenced by discounts in the forward markets, have reinforced the positive sentiment.

Figure 1.14.Net Private Capital Flows to Emerging Asia

(In billions of U.S. dollars)

Source: IMF, World Economic Outlook.

1 Data for 2003 include $45 billion in capital flows to China that were subsequently used to recapitalize two state-owned banks.

Foreign direct investment to emerging Asia is also likely to remain buoyant. Net FDI is projected at $87 billion in 2007, broadly unchanged from the previous year. However, the composition is changing, reflecting a continued rise in outflows from China, which has been evident now for a couple of years, along with a decline in FDI inflows to Thailand following the imposition of capital curbs and changes to the foreign investment regime there in late 2006. By contrast, flows are projected to increase again to India, with investments not only in the IT-related services sector but also in manufacturing—including steel and automotive. Elsewhere, flows are expected to remain strong, reflecting not only greenfield investments, but also an increase in mergers and acquisitions activity, private equity interest, and commercial real estate purchases. Additionally, intra-regional flows have picked up, with net outward direct investments now positive in Korea and Taiwan Province of China. Outbound investment from other economies—notably, Singapore and Hong Kong SAR—has also increased, although these economies are still net recipients of FDI. So far, intraregional flows have been mostly targeted towards China and India, although Singapore has benefited as well.

Figure 1.15.Emerging Asia: Net FDI Flows

(In billions of U.S. dollars)

Source: IMF, World Economic Outlook.

Reflecting a pick-up in outflows particularly from China, net portfolio and other investment flows are projected to weaken in 2007. Sizable gross outflows are in prospect from China as state-owned commercial banks have begun to build up assets abroad and corporations have acquired foreign assets through portfolio investments rather than just FDI.8 Elsewhere in emerging Asia, measures to liberalize various aspects of capital outflow regimes has led to a pick-up in the volume and volatility of outbound portfolio and other investment flows. Chapter II of this Regional Economic Outlook covers the issue of the evolving nature of capital flows in Asia.

Bond issuance has remained strong in the current low interest rate environment. Foreign buying interest has risen in treasury markets, most notably in Malaysia, the Philippines, and Indonesia—in the latter two, aided by rating-agency upgrades.9 Local currency issues have been limited, but activity is expected to pick up modestly in 2007 with further improvements to the bond trading infrastructure and with capital costs staying low. Recently, China announced plans to allow mainland financial institutions to issue renminbi-denominated bonds in Hong Kong SAR, but decisions remain on whether foreign investors will gain access to this market. Private placements have picked up in Asia, as elsewhere, although Taiwan Province of China is expected to tighten controls over its local market following some recent irregularities. The Samurai bond market, where non-yen-denominated instruments are issued to Japanese investors, and which is quite popular for industrial Asian currencies, is experiencing nascent activity in emerging Asia.10

Hedge funds continue to gain prominence in Asia’s markets, and new forms of funding continue to blossom. Both the size and number of Asia-focused hedge funds are expected to continue their recent rapid growth. By industry estimates, emerging Asia funds numbered approximately 1,150 at end-2006, with total assets under management of around $132 billion (up from $100 billion or so a year earlier). Other forms of local and cross-border funding have picked up as well, with investors entering new markets in their search for higher yield and greater diversification. More private equity funds, real estate investment trusts, and lately infrastructure funds have been taking aim at the region, with some reportedly attracting considerable interest from the Middle East. Islamic financing has become a new funding vehicle, particularly in Malaysia, including for non-Islamic companies (Box 1.5).

Box 1.5.Islamic Finance in Malaysia

Islamic finance is growing rapidly, and Malaysia is positioning itself to be a leading international hub for this budding asset class. Islamic products comply with Shariah, Islamic law, which bans interest and certain activities (such as consuming tobacco or alcohol, and gambling), requires that financial transactions refer to a tangible underlying transaction, and stipulates the sharing of profit/loss among the parties to a financial transaction. The industry globally is now viewed as an alternative form of funding and investment, no longer used exclusively by Muslims. Malaysia has taken the lead in several aspects of its development, including establishing the financial infrastructure and regulatory/supervisory framework, product innovation, and cultivating talent.

The Malaysian Islamic financial system is quite developed and is growing rapidly. Its main components are the Islamic banking system and the Islamic capital markets. Islamic banking is offered by Islamic banks, as well as via Islamic windows/subsidiaries of conventional banks, with the latter increasingly offering a Shariah-compliant version of each conventional product. As of June 2006, about 11 percent of the banking system assets were Shariah-compliant ($32 billion).1 In recent years, Shariah-compliant assets have grown at about 17 percent annually,2 more than double conventional assets. Three-fourths of banks’ Shariah-compliant funds come from deposits (compared with about half in the total banking system), and financing accounts for 60 percent of the uses (compared to about 40 percent in the total system) with a dominance of household financing, while financing of businesses concentrates in small and medium-sized enterprises.

Share of Shariah-Compliant Assets in Total Banking System Assets

(In percent)

Sources: Country authorities; and IMF staff calculations.

1 Share of Islamic banks assets only.

2 Share of total loans.

Malaysia's Islamic Banking System: Sources and Uses of Funds(End-2005, in percent)
Share in Total
Sources
Capital9.0
Deposits75.0
From other financial institutions4.0
Other12.0
Uses
Cash0.3
Reserves with central bank1.7
With other financial institutions18.2
Financing60.2
Securities18.6
Other0.9
Source: Bank Negara Malaysia, 2005 Annual Report.

Sharia-compliant products represent a sizable component of Malaysian capital markets. Malaysia’ s outstanding stock of Islamic bonds (sukuks) is about $38 billion (representing 31 percent of outstanding total bonds in the country) and is the largest Islamic bond market in the world, with about half of the estimated global stock. It has expanded rapidly in recent years—Islamic bond issues grew at 28 percent a year compared with 14 percent for total bond issues in 1995–2005. The Malaysian Islamic bond market has also seen issuance by multilateral financial institutions. Malaysian issuers have led in international sukuks, with Malaysian bonds heavily represented in global sukuk indices. Of the companies listed on the Malaysian equity market, 60 percent of market capitalization is represented by Shariah-compliant firms, and the exchange maintains benchmarks for Islamic equities.

Outstanding Stock of Bonds

Source: Malaysia's Securities Commission.

The authorities’ efforts to promote Malaysia as a leading international centre for Islamic finance culminated in the launch of the Malaysia International Islamic Finance Center in 2006—an initiative that covers financial institutional development, market infrastructure, the regulatory/supervisory framework, human capital development, and tax incentives.

Malaysia is addressing challenges to cement its international position as a center for Islamic finance, although some of these efforts are common to the industry. It is participating in international initiatives aimed at standardizing products, accounting, and supervisory and regulatory frameworks. In recent years, liberalization and international integration have intensified with new Islamic licenses issued and the entry of foreign players. The industry as a whole needs to expand the set of instruments, including derivatives, that can help manage risks, and deepen and develop markets. Private market participants highlight the importance of a few Malaysian banks becoming global leaders. They also emphasize further liberalizing the overall financial system, as Malaysia faces competition from Islamic finance centers in the Middle East, as well as from established conventional global financial centers such as Singapore and London, where the share of Islamic assets is small but product innovation is proceeding at a rapid pace. For example, London just started the first secondary market for Islamic bonds.

Note: The main author of this box is Laura Papi.1 Estimates of the size of the global Islamic finance industry vary widely. The Islamic Development Bank 2005 Annual Report puts it at $800 billion, including banking, insurance, other non-bank financial institutions and capital markets. The Financial Times, January 18, 2007, reported a $250–750 billion range. Malaysia International Islamic Financial Centre (November 2006) estimated $560 billion global Islamic banking assets (Malaysia would represent about a 6 percent share).2 This compares with estimates of 10–15 percent annual growth rates of Islamic finance globally.

Macroeconomic Policy Issues

The monetary policy picture across Asia is mixed. Inflation pressures remain largely under control in most NIE and ASEAN-5 economies with a gradual increase in real policy rates over the past two years, and there is some flexibility should the downside risks to growth materialize. However, in much of the rest of Asia (outside Japan) overheating and credit-fueled asset price rises remain a concern and the scope for easing the monetary policy stance if growth falters is much more limited. On fiscal policy, favorable conditions over the past few years have allowed for a strengthening of positions across much of Asia and there is scope for a countercyclical policy response, if needed, in those countries that have made progress in improving their public finances.

Monetary Policy

The interest rate cycle appears to have peaked in the NIEs and most of the ASEAN-5, and the outlook is for some potential policy easing. While the cumulative policy interest rate rises have been less than—and lagged—those by the U.S. Federal Reserve, real interest rates are now comparable to their U.S. counterparts. Inflation remains broadly under control, and, as a consequence Indonesia (beginning in early 2006) and Thailand (more recently) have been able to cut policy rates in response to falling inflation pressures and weak domestic demand. With inflation expectations well anchored and domestic demand relatively weak, the expected softening in the external outlook could provide scope for lower policy rates. It may also help to limit capital inflows owing to less favorable interest rate differentials.

Figure 1.16.Cumulative Increases in Policy Rates

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

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

Figure 1.17.Emerging Asia: Real Policy Rates

(Policy rates minus contemporaneous core inflation, in percent)

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

Figure 1.18.Asia: Private Sector Credit Growth

(3-mma of 3-month percent change, SAAR)

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

In contrast, China and India have only begun to tighten monetary conditions, and more is likely required; given its exchange rate arrangement, Vietnam is more constrained. The Chinese authorities have raised reserve requirements and interest rates in an effort to try to slow investment to more sustainable levels, rebalance growth, and head off a possible wave of future nonperforming loans. While the pace of renminbi appreciation continues to pick up speed (it has averaged ½ percent month since the second half of 2006), excessive liquidity remains in the system as evidenced by low interbank interest rates. While the authorities have relied on administrative controls to restrain credit and investment growth, over time the effectiveness of these controls will diminish as the sophistication of the economy increases. A shift in the reliance toward market-based measures will be necessary, and will help in the development of financial markets and in creating a banking sector operating on a sound commercial basis. In India, the RBI has raised the repo rate (at which it lends) by 125 basis points since April 2006, and has raised the Cash Reserve Ratio by 150 basis points since December. That said, real interest rates remain close to zero, inflation pressures appear to be mounting, and further tightening will likely be required to forestall the risk of an inflation overshoot. In Vietnam, credit growth remains high and has led to a booming stock market; in response, the authorities have used prudential measures and doubled the width of the trading band of the dong (to +/- 0.5 percent) against the U.S. dollar. Going forward, credit growth will need to be monitored closely and the authorities should be prepared to tighten credit conditions and introduce more exchange rate flexibility.

New Zealand and Australia both face monetary policy challenges. Strong capital inflows—including those related to interest rate differentials vis-à-vis the Japanese yen—have helped finance high mortgage credit growth and support strong domestic demand. Policymakers in both economies have raised interest rates—in New Zealand most recently in March 2007—and maintained a tightening bias in an effort to stem inflation pressures emanating from tight factor and product markets and continued buoyancy in housing markets. Policy rates in both countries remain well above U.S. levels, and the current tightening bias is warranted given continued price pressures.

The Japanese authorities raised policy rates by 25 basis points in February 2007 and should continue to move gradually. With private consumption still sluggish and in the absence of inflation pressures, the Bank of Japan has proceeded cautiously on its path to normalizing interest rates. The continued expectation for low interest rates and interest rate volatility, coupled with higher rates elsewhere, has been a key driving factor behind the rise in yen-funded carry trades. Nevertheless, the Japanese authorities should withdraw monetary accommodation only gradually, being mindful of inflation expectations and domestic demand conditions.

Fiscal Policy

Fiscal policy continues to be run conservatively throughout much of the region, and debt levels have for the most part been managed prudently. Policymakers have taken advantage of the benign environment in recent years to further strengthen public finances. Led by the NIEs, the regional fiscal balance is projected to have improved by 0.3 percentage point in 2006 in line with the projections of the previous Regional Economic Outlook. Public debt levels have continued their trend decline, falling to their lowest level since 2000 and, as noted above, Indonesia and the Philippines have taken advantage of favorable market conditions to undertake further liability management.11 That said, public debt ratios remain high in Japan, India, and the Philippines, although in the latter the improvement has been much more pronounced owing an increase in the VAT rate in December 2005.

Table 1.7.Asia: Selected Fiscal Indicators(In percent of GDP)
General Government Gross DebtCentral Government Fiscal Balance
200520062007200520062007
Est.Proj.Est.Proj.
Industrial Asia154.7157.3154.3-4.5-4.7-4.7
Japan181.6184.8181.7-5.8-5.9-5.8
Australia 19.99.08.61.61.10.9
New Zealand 123.023.623.75.65.23.7
Emerging Asia38.936.034.1-1.6-1.1-1.3
Hong Kong SAR1.91.71.41.03.91.7
Korea 3436.236.537.21.91.81.9
Singapore7.86.45.3
China 517.716.815.9-1.3-0.7-1.0
India 683.180.176.1-4.2-3.8-3.6
Indonesia 345.638.635.8-0.3-1.2-0.9
Malaysia 346.245.446.1-3.8-3.5-3.4
Philippines 786.377.672.8-3.0-1.9-1.3
Thailand 7847.441.139.40.41.20.8
Vietnam 743.944.746.7-1.2-0.7-2.6
NIEs32.131.932.11.01.71.2
ASEAN-553.147.545.6-1.1-1.0-1.1
Asia64.361.558.3-2.2-1.9-2.0
Sources: IMF, APDWEO database; and staff estimates.

The fiscal stance across the region remains broadly neutral, and policymakers should permit automatic stabilizers to operate if required. The neutral stance is not only appropriate from a demand management perspective given that growth remains reasonably solid, it also provides a degree of fiscal space for an accommodative policy response should the downside risks materialize. This can be achieved by allowing fiscal balances to weaken as a result of (i) lower revenue and (ii) any automatic increases in expenditure triggered by slower growth. Where necessary and feasible, governments could also bring forward necessary infrastructure spending to underpin domestic demand. Less scope for fiscal stimulus exists for those economies still running sizable deficits (India, and to a lesser extent, Malaysia) or experiencing political gridlock (Taiwan Province of China and Thailand). Relatedly, but in a more structural vein, in much of emerging Asia social safety nets can be strengthened to reduce uncertainty and raise consumption, particularly in China, support more flexible labor markets (Korea), or further bolster the effectiveness of automatic stabilizers.

For those (mostly lower income) countries with publicly owned natural resources, the recent commodity price boom presents fiscal policy challenges relating to asset and wealth management. These issues are explored in Chapter IV. At issue is how to manage the rise in the revenue and public sector wealth, which for several low-income countries have increased substantially so far this decade. While the public infrastructure and human capital needs in this group are generally quite large, the prospective revenue flows could be volatile, arguing for a smoothing of expenditures over the longer term.

Figure 1.19.Change in Fiscal Revenue, 2002 and 2006

(In percent of GDP)

Source: IMF, APD country desks.

Note: The authors of this chapter are Paul Gruenwald, David Cowen, and Ranil Salgado.

Effective this edition of the Regional Economic Outlook, Vietnam has been added to the ASEAN group (and included in the historical data) and the group has been named “ASEAN-5.”

Malaysia is the sole country in the region that had a measurable negative fiscal impact from lower world oil prices, with the net loss estimated at 1 percent of GDP on an annual basis.

Including valuation changes, which tended to be positive owing to a weaker U.S. dollar.

Hong Kong SAR surpassed New York as the number two fundraising market in 2006 (behind London). However, its position could be exceeded by the Shanghai A-share market in 2007 since no large state-owned banks are planning to come to the market this year. Also, mainland Chinese regulators have plans to establish China Depository Receipts allowing resident foreign firms to sell shares in the local market.

Direct foreign participation through the Qualified Foreign Institutional Investors (QFII) schemes is around 1 percent of total market capitalization, although non-qualified investors play China through structured products linked to market indices and through Hong Kong-listed H-shares.

Rapid baht appreciation and the concerns about managing foreign exchange inflows led the Thai authorities to impose capital controls in December 2006. Market reaction was decidedly negative. Other central banks in Southeast Asian countries responded quickly by publicly stating that they would not follow the Thai example, and currency flows were reportedly diverted from Thailand to these economies. Subsequently, the Thai authorities removed the most restrictive controls, and have gradually begun to remove much of the remainder.

The March 2007 consensus forecast has most currencies in emerging Asia appreciating at less than one-half the pace of the renminbi over the coming year.

A significantly smaller contribution comes from the Qualified Domestic Institutional Investors schemes that were launched in April 2006, which allow banks and insurance companies to invest domestic funds overseas, mostly in fixed-income products; the total quota granted was near $20 billion in 2006, but a number of the funds were undersubscribed, partly reflecting expectations of renminbi appreciation.

In early 2007, both Indonesia and the Philippines successfully placed long-term bonds (respectively, 30 and 25 years in duration), with comparatively narrow spreads and well oversubscribed.

Most recently, a deal equivalent to ¥15 billion was struck with the Indian Railway Finance Corporation in mid-February.

Indonesia and the Philippines also repaid their obligations to the IMF in full in 2006 (in October and December, respectively).

    Other Resources Citing This Publication