I. Overview

International Monetary Fund. Asia and Pacific Dept
Published Date:
October 2007
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Recent Macroeconomic Developments

Macroeconomic developments in Asia were broadly positive through mid-2007. Growth was better than expected across most of the region, with domestic demand making an increasing contribution in a number of economies, and strong momentum continuing into the third quarter. That said, exports continued to be an important driver of growth despite a relatively weak performance from the electronics sector. Inflation pressures remained largely contained, although food price developments have added volatility to the headline numbers. Effective exchange rates strengthened modestly, the region’s current account surpluses remained large, and reserve growth continued apace.


Growth across much of the region continued to rise in the first half of 2007, exceeding expectations. This was especially the case in emerging Asia. While China and India continued to lead the pack with growth rates over the period of 11½ percent and 9¼ percent (y/y) respectively, the pace of overall activity trended modestly higher in the newly industrialized economies (NIEs) and ASEAN-5 as well. In industrial Asia, Australia and New Zealand reported strong, broad-based growth; however, output in Japan contracted in the second quarter, reflecting lower capital expenditure.

Figure 1.1.Emerging Asia: GDP Growth

(Year-on-year percent change)

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

Figure 1.2.NIEs: Contributions to GDP Growth

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

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

Figure 1.3.ASEAN-5: Contributions to GDP Growth 1

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

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

1 Excludes Vietnam.

The growth performance in emerging Asia reflected an increasing contribution from domestic demand. This was particularly true in the NIEs, where both consumption and investment have been robust, as Hong Kong SAR and Singapore continue to experience strong growth in the financial services sector, with construction and manufacturing quite buoyant in the latter’s economy as well. Growth in the ASEAN-5 featured a large and rising contribution from net exports, although consumption has remained strong with the exception of Thailand, where political developments continue to weigh on confidence. After a soft patch earlier this year, exports have picked up recently but the recovery in electronics has lagged (Box 1.1).

Box 1.1.Asian Electronics Exports: Recent Trends and the Outlook

Asian electronics exports slowed markedly in the first half of 2007, but signs of a strong turnaround have emerged as European demand has picked up significantly and prices, which had been declining steeply, have stabilized. In terms of exporting countries, this pattern was most notable in China, with (sequential) growth rebounding sharply. Signs of a turnaround in the momentum of electronics exports appear to be across the board in Asia, although the outlook is mixed, and depends on developments in the global economy, particularly the United States.

Asia: Electronics Exports

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

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

Selected Asia: Exports of Electronics by Commodity1

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

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

1 “Selected Asia” consists of Japan, Korea, Singapore, Hong Kong SAR, Taiwan POC, and China.

In terms of goods exported, current trends are positive. There has been a sharp recovery across all goods in recent months after a weak first half. Growth in telecom equipment exports had decelerated sharply in the second quarter, while other categories showed varying degrees of improvement.1 The sharp sequential slowdown in telecoms in part reflected data reclassifications in Japan (relating to LCD parts for mobile phones, which had the effect of raising the growth rate of the “other” category), resulting in slower growth in the first quarter. Since midyear, exports of electrical machinery (particularly from Taiwan Province of China) and office machine shipments have turned around noticeably.

The resurgence of European demand for Asian electronics is noteworthy. While all major trading partners showed a sequential decline in demand for electronics exports from Asia earlier this year, only Europe has bounced back with annualized growth of nearly 80 percent. The export destination data indicate a slowdown in Japanese demand for Asian electronics exports through mid-year, and the decline in exports to the United States seems broadly consistent with the drop in consumption growth there in the second quarter. In addition, electronics exports may have fallen owing to U.S. dollar and yen weakness vis-à-vis Asian currencies over the period. Also noteworthy is the modest turnaround in shipments to the rest of the world, which includes significant exports from China for reprocessing in Hong Kong SAR (not in the sample).

Selected Asia: Electronics Exports to Major Partners1

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

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

1 “Selected Asia” consists of Japan, Korea, and China.

Indicators for the sector suggest a mixed picture ahead. The sequential slowdown in Japanese machinery and equipment sales reversed course in May, although the overall pace of growth remains modest, and orders data for the third quarter suggest demand may be softening. In the United States, indicators of retail and wholesale electronics demand bottomed in the second quarter, although the U.S. purchasing managers index has turned down sharply. Both the German and Singaporean purchasing managers indices have softened as well. The continued deceleration of the U.S. semiconductor equipment book-to-bill ratio reflects the surge in capital investment last year.

External Demand for Electronics

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

Sources: Haver Analytics; and IMF staff calculations.

Electronics: Forward-Looking Indicators

(3-month moving average)

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

The prices for semiconductors—a key electronics component—have stabilized and there are signs that prices for memory chips may have bottomed. A 20 percent surge in capital investment by memory chip makers last year, driven by solid profits, led to an oversupply of memory chips, while demand for personal computers with more powerful chips following the launch of Microsoft’s Windows Vista operating system has been below expectations. While overall demand for memory chips is expected to remain high, excess supply conditions are expected to continue through 2008. As a result, industry analysts note that downward pressure on prices is expected to remain.

Asia-Pacific Semiconductor Shipments and Prices

Seasonally adjusted, 3-month moving average)

Sources: Haver Analytics; Semiconductor Industry Association; and IMF staff calculations.

DRAM and Flash Memory Prices

(In U.S. dollars, 5-day moving average)

Source: Bloomberg LP

Note: The main author of this box is Sumiko Ogawa.1 Of the total, telecoms comprise 25 percent, electrical machinery 40 percent, and office machinery 20 percent.

Higher-than-expected growth in China and India continued to be investment-led. In China, growth picked up from an already high base despite the authorities’ efforts to slow the pace of overinvestment. Meanwhile, the contribution to growth from net exports, while still below investment, is rising while consumption continues to expand at a healthy pace (although the consumption-to-GDP ratio continues to trend down).

Figure 1.4.Asia: Industrial Production

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

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

Figure 1.5.Emerging Asia: Retail Sales Volume

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

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

1 Proxies used for Malaysia (manufacturing sales), Philippines (car sales), and Thailand (composite consumption).

India’s growth appears to be on a solid footing and confidence remains high. This buoyancy has benefited from strong investment and productivity gains, which have translated to higher potential growth. Consumption and net exports remain strong, but their contribution to growth has eased recently.

Figure 1.6.Emerging Asia: Exports of Goods

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

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

Figure 1.7.Asia: Electronics Exports

(In percent; unless otherwise indicated)

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

Domestic activity across much of Asia has remained robust so far in the third quarter and exports have continued to recover. The most recent data suggest that investment looks healthy with industrial production generally robust. Business confidence remains buoyant and capacity utilization continues to rise gradually. That said, the picture regarding consumption is less clear, as broadly favorable trends in retail sales (which remain weak in the NIEs) are clouded by mixed readings on consumer confidence. Export growth has continued to pick up in recent months, with electronics exports accelerating.


Inflation pressures remain broadly stable in emerging Asia. Core inflation across most economies remains well behaved, although headline inflation has risen to 4.7 percent at end-July, up from 3½ percent at end-2006 mostly owing to food price pressures in China (see below). In India, wholesale price index (WPI) inflation has come down by almost 3 percentage points as the authorities have tightened policy settings, raising reserve requirements by 200 basis points so far this year. Vietnam is an outlier on the upside as inflation continues to be exacerbated by demand pressures stemming from a loose fiscal stance and rapid money and credit growth despite a doubling of reserve requirements.

Figure 1.8.Emerging Asia: Core CPI

(12-month percent change)

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

Figure 1.9.Emerging Asia: Food CPI

(12-month percent change)

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

Food prices have contributed to more volatile headline inflation numbers in some economies. China saw food price inflation reach 18 percent in August, with headline inflation accelerating to 6.5 percent, a 10-year high. However, nearly all of this is attributable to pork and egg prices reflecting supply factors, which are not expected to have second-round effects. In an effort to preempt inflationary expectations, the authorities have raised both reserve requirements and lending rates. Food prices have also risen in India, Indonesia, Taiwan Province of China, and Vietnam owing to weatherrelated events. Developments in the global commodity markets—wheat, corn and dairy—have played a role in food prices in Asia as well. Oil has not been a factor in Asian inflation so far in 2007 as international prices eased in the first half of this year and the recent pick-up has yet to feed into domestic prices, in part reflecting administrative controls in some countries.

Producer and other input prices have also been well behaved. Indeed, the wedge with consumer prices turned negative in the second quarter for the first time in recent years. The continued trend decline in producer prices reflected muted wage pressures—with real wages continuing to decline in a number of economies in emerging Asia—as well as lower import costs owing in part to more appreciated exchange rates in some economies. This decline has taken place across all groupings in emerging Asia, although less so in the NIEs.

Figure 1.10.Emerging Asia: Consumer and Producer Prices

(12-month percent change)

Sources: CEIC Data Company Ltd; IMF staff calculations.

External Sector

Most countries in the region continue to experience large current account surpluses. With exports generally surprising on the upside, and the decline in oil prices helping to reduce oil import bills, the region’s current account surplus reached an estimated 5 percent of GDP in the first half of 2007. China again accounted for most of the region’s higher outturn, with its surplus reaching 11 percent of GDP reflecting a burgeoning trade surplus, mainly with the United States and Europe.1 Japan reported a larger-than-expected surplus on higher investment income, while India contributed as well with a lower-than-projected deficit.

Table 1.1.Asia: Current Account Balances

(In percent of GDP)

REO April 2007Latest proj.
Industrial Asia2.
New Zealand-8.6-8.7-8.4-7.6-8.5-8.6
Emerging Asia4.
Hong Kong SAR11.410.89.69.311.29.5
Taiwan POC4.
Emerging Asia excl. China3.
Source: IMF, WEO database.

Exchange rate developments were dominated by ongoing current account surpluses and continued capital inflows to the region in the first half of 2007. The ASEAN-5 currencies, the Indian rupee, and the Australian and New Zealand dollars appreciated significantly against the U.S. dollar, but somewhat less in nominal effective terms. The Chinese renminbi also appreciated in the first half of 2007, by 2½ percent against the U.S. dollar, and by 2 percent in nominal effective terms (and by 5 percent in real effective terms owing to relatively high inflation). While part of these cross-country differences reflects foreign exchange flows, intervention by some central banks in the region also played a role.

Figure 1.11.Selected Asia: Nominal Effective Exchange Rates

(January 1, 2007=100)

Source: IMF staff calculations.

Figure 1.12.NIEs: Nominal Effective Exchange Rates

(January 1, 2007=100)

Sources: IMF staff calculations.

Swings in capital flows since mid-July have altered the pattern of exchange rate developments in the region. Most noticeably, there was an unwinding of carry trade positions as evidenced by a sharp rise in the Japanese yen and an even sharper drop in some of the “target” currencies—e.g., the Australian and New Zealand dollars—particularly between the onset of the turbulence and mid-August.2 Portfolio outflows related to a reduction in risk appetite featured as well. Since then these trends have reversed, although volatility across the various asset classes remains high. Recent capital and financial market developments are discussed more fully in the next section.

Figure 1.13.ASEAN-5: Nominal Effective Exchange Rates

(January 1, 2007=100)

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

Reserves continued to grow strongly in the region, again led by China, as countries continued to intervene in the face of trend appreciation pressures. Emerging Asia’s official reserves as a whole reached $3 trillion at end-August, up from $2½ trillion at end-2006, despite a modest drawdown of reserves in the wake of the financial market turmoil. Compared with last year, the rate of reserve accumulation in China has roughly doubled so far this year, reflecting for the most part large trade surpluses. The rate of reserve accumulation in the ASEAN-5 has also accelerated in 2007, driven by both current and capital account developments. In India, reserve growth reflected both stronger FDI and portfolio inflows fed by optimism on the growth outlook, while in Korea inflows reflected short-term borrowing by commercial banks to square their books against forward purchases from exporters.3Chapter III looks at the extent to which central bank intervention in the foreign currency markets has been effective in emerging Asia.

Box 1.2.“Other Investment” Flows in Asia: Why the Large Changes?

A number of Asian economies have experienced substantial changes in nonportfolio, non-FDI capital flows in recent years. While “other investment” flows are usually viewed as a rather uninteresting category of the external financial account, they have in fact accounted for much of the recent action in financial flows in Asia.1 To wit, the average absolute change in net other investment between 2003 and 2006 across Asia equaled 4.4 percent of GDP, and restricting the analysis to the six economies with the largest changes2—Japan, Korea, Malaysia, New Zealand, the Philippines, and Taiwan Province of China—the average absolute change amounted to 6.5 of GDP (see figure). To put these changes in perspective, the average absolute current account change across Asia over this period equaled 2.6 percent of GDP, and for the six featured economies was 3 percent of GDP.

It is tempting to ascribe these large swings in other investment flows to the rise in carry trades across the region, but this is only part of the story. A priori, the direction of changes in other investment balances seem to match the carry trade explanation: large declines in net other investment in Japan and Taiwan Province of China, two economies characterized by lower-than-average domestic interest rates, and large positive swings in countries like Korea or New Zealand thought to be target destinations. While the complex nature of carry trades and other structured financial flows makes it impossible to determine their exact contribution to the balance of payments, best estimates are that carry trades have explained some of the change in net other investment in the region but by no means all of it. Other country-specific factors may have also played an important role:3

  • Japan. Besides carry trade–related flows, lending from domestic to foreign banks for yen-yen transactions, notably those arbitraging the relative steepness of Japan’s yield curve, is thought to have accounted for some of the 11 percent of GDP decline in net other investment in Japan between 2003 and 2006. Bank lending associated with rising direct investment abroad as well as the decision by some Japanese banks and other corporations to repay external debts in the face of rising interest rates in the United States also played a part in this decline.

  • Korea. Inflows related to domestic banks’ on-shore lending in foreign currency, the bulk of which is in U.S. dollars but with some in yen (carry–trade related) as well, are estimated to have accounted for about one-fourth of the jump in net other investment, while about one-half was due to domestic banks borrowing abroad to square the large increase in their long forward U.S. dollar book. This latter increase, in turn, was due to a combination of surging export orders by Korean shipbuilders and their growing desire to hedge future foreign receipts against won appreciation. Finally, the sharp rise in hedging overwhelmed relatively thin forward markets in Korea and triggered sizable deviations from covered interest parity, thereby leading to additional banking inflows seeking to benefit from these pure arbitrage opportunities.

  • Malaysia. A decision to repay public external debt partly explains the large decline in net other investment. In addition, some of the portfolio diversification taking place in the country as a result of a liberalization of controls on outflows is thought to have been recorded under other investment, as banks have increased their placement of assets abroad.

  • Philippines. The decline in net other investment is in part due to lower recourse to external borrowing given large remittance inflows. In the case of the Philippines, indications are that carry trade flows have been small.

  • Taiwan Province of China. Most of the fall in net other investment resulted from a large decline in the external liabilities of the central bank.4

Selected Asia: Other Investment, Net





New Zealand

Taiwan Province of China

Recent large movements in “other investment” pose a number of policy challenges. In countries like Korea and New Zealand, the recent spike in “other investment, net” has translated into a significant increase in short-term external debt. While some of this debt may be in domestic currency, hedged, or accompanied by a concomitant increase in foreign exchange assets—such as in the case of hedging-related inflows in Korea—this may not always be the case, perhaps reflecting a growing degree of cross-border risk-taking among banks in the region. Similarly, many of these “other investment” flows appear to be highly interest rate–sensitive, and may point to increasing difficulties in conducting autonomous monetary policy in the face of large and volatile capital flows in the region.

Note: The main author of this box is Jacques Miniane.1 “Other investment, net” is defined here as the financial account balance minus net FDI and portfolio flows, not including errors and omissions. In most countries the main categories under “other investment” are banking flows and trade credits. We exclude derivatives flows to ensure cross-country consistency, as some countries record them under “portfolio investment,” others under “other investment,” and others not at all.2 Not including Hong Kong SAR, which is considered a regional money center.3 Here we focus on the six countries with the largest absolute changes in other investment balances over 2003–06, except for New Zealand where most of the large increase is thought to have resulted from carry trades.4 These include nonreserve securities sold under repurchase agreements and accrued interest paid. Note that recording monetary authorities’ nonreserve transactions above the line is consistent with the IMF’s Balance of Payments Manual, fifth edition.
Table 1.2.Asia: Official Reserves

(In billions of U.S. dollars, end-period)

Industrial Asia8888999641,007
New Zealand791417
Emerging Asia1,7762,0352,4792,997
Hong Kong SAR124124133137
Taiwan POC242253266261
Source: CEIC Data Company Ltd.

With reserves in many Asian economies well above the levels needed for liquidity purposes, a number of central banks have launched or are considering launching sovereign wealth funds. The objective of these entities is to increase returns on foreign currency holdings, although in some cases (e.g., Korea) they have a secondary objective to help develop local capital markets. Box 1.3 looks at the current state of play regarding sovereign wealth funds in Asia.

Box 1.3Sovereign Wealth Funds

Sovereign wealth funds have attracted considerable interest in Asia and elsewhere. While the assets constituting sovereign wealth funds can in principle come from any public source, they tend to be generated in three ways: (1) the proceeds from natural resource exports, mainly, but not limited to, oil; (2) accumulated fiscal surpluses; and, most recently, (3) foreign exchange reserves, typically beyond what is deemed necessary for liquidity purposes or financial contingencies. Total assets in sovereign wealth funds (globally) are estimated to have grown from about $500 billion in 1990 to $2.5 trillion as of May 2007, and are expected to reach $10 trillion by 2012.

Sovereign Wealth Funds in Asia

(In billions of U.S. dollars)

CountryAssetsAmountSource of Funds
AustraliaFuture Fund0.049Fiscal surplus
ChinaChina Investment Corporationup to 200Current account surplus
Hong Kong SARExchange Fund (Investment Portfolio)120Fiscal surplus
KoreaKorea Investment Corporation20Current account surplus
SingaporeGeneral Investment Corporation100Multiple1
Sources: Country authorities; and IMF staff estimates.

Sovereign Wealth Funds in Asia

A number of countries in Asia have already established such funds, with China being the most recent.

Singapore. The Government Investment Corporation (GIC), whose sole shareholder is the ministry of finance, was established in 1981 to invest Singapore’s fiscal reserves in assets outside Singapore. It is also responsible for investing excess foreign exchange reserves and proceeds from the sale of government bonds to the Central Provident Fund (CPF). The GIC invests across many asset classes and makes decisions on where and how to invest, with its board providing the guidelines on the broad benchmark consistent with the overall objective of enhancing the international purchasing power of the reserves. The government is also the sole owner of Temasek, which was set up in 1974 as a private holding company. Temasek invests in various industries, both in Singapore and abroad.

Hong Kong SAR. The investment portfolio of the Exchange Fund—those assets not serving as backing for the monetary base as required by the currency board arrangement—includes the accumulated fiscal surpluses of the government and the former Land Fund, plus the interest thereupon. These assets have been actively managed by the Hong Kong Monetary Authority since 1998 following a rules-based strategy with high degree of transparency. The emphasis is on preserving capital and controlling the risks arising from the investment process. The Exchange Fund Advisory Committee sets the benchmarks, which provide targets and guidelines to ensure that the investment strategy matches the purpose of the fund.

Korea. The Korea Investment Corporation (KIC)—which invests on behalf of the Bank of Korea and the Korean government—was established in 2005. At $20 billion, it is relatively small, but the government plans to double its investment. The KIC is somewhat different from the other recent sovereign wealth funds in emerging Asia because the Bank of Korea retains the option to recall these assets in case of an emergency and the diversification is limited to relatively liquid instruments. Aside from enhancing returns, an important secondary objective of the KIC is to help develop Korea as a major regional financial hub and asset management center.

Australia. The Australian Government Future Fund, established in May 2006, is funded from budgetary surpluses. The fund was started with an initial transfer of A$18 billion. The purpose of the fund is to meet the government’s future liabilities for the payment of pensions to retired public servants, expected to amount to A$140 billion by 2020. It is overseen by an independent Board of Guardians selected on the basis of their expertise in investment management and corporate governance.

China. The China Investment Corporation (CIC) was established earlier this year to manage the investment of excess foreign reserves. Total funds under management are expected to reach $200 billion from the current $1.4 trillion of official reserves, with additions to be based on the pace of future reserve accumulation. The first investment, a 9 percent nonvoting stake for $3 billion in a New York–based private-equity firm, was completed in June.

Some Issues Regarding Sovereign Wealth Funds

  • Size. Sovereign wealth funds are likely to grow over time, perhaps quickly. This seems particularly relevant for those sovereign wealth funds funded by reserve accumulation. This size, combined with the public nature of these funds, suggests that the level of scrutiny they face will be correspondingly larger than for private entities. That said, portfolio management is assumed to be relatively passive, suggesting that sovereign wealth funds may “punch below their weight” in terms of turnover (in contrast to, say, hedge funds).

  • Market impact. While experience to date suggests that sovereign wealth funds managers have been generally conservative in terms of the risk-return trade off they are willing to carry on their portfolio, they have been allowed a higher risk tolerance than official reserve asset managers with the aim of bolstering returns. One can therefore expect these entities, over time, to invest in a wider class of assets and to move down the credit curve. To the extent that these markets are thinner markets than those for safer assets, the presence of sovereign wealth funds will be more prominent. As a counterfactual, demand for safer assets would be correspondingly lower than in the absence of sovereign wealth funds.

  • Transparency and governance. Few sovereign wealth funds, with the exception of those in Australia, Hong Kong SAR, Norway, and New Zealand, provide details about their operations and the type of investments they make, although some funds are professionally managed. As the size of sovereign wealth funds increases and the range of assets they purchase broadens, development of operational best practices, focused on governance, transparency, and accountability, could help to disseminate information about their risk mismanagement practices and how closely they follow their mandates, help to ensure financial stability, and counter any potential pressures for financial protectionism.

Note: The main author of this box is Nita Thacker.

Recent Financial Market Developments

Asia was not at the epicenter of the global financial market turbulence that broke out in July. As a result, markets and financial institutions in the region have been less affected to date—although they were not entirely immune from difficulties—than those in the United States and Europe. This reflects the relatively small direct exposure to U.S. subprime mortgages and, more broadly, to leveraged and complex structured credit products, including by hedge funds.

The Recent Turbulence

Asian financial markets continue to be broadly guided by global developments (for details, see the October 2007Global Financial Stability Report). Following a run-up to record highs across most equity markets in mid-2007, a sharp sell-off ensued in late July in response to concerns over rising defaults in U.S. subprime mortgages and their implications for U.S. growth. With global leverage and risk appetite reduced, Asian equity markets declined in the range of 10–20 percent by mid-August. Investors from outside the region, who had begun to exit equities mid-year, led the selling, with monthly net equity flows across all major markets highly negative in August 2007. Markets have since recovered much or all of this loss. Equity prices in China have continued to soar, affected little by the sell-off, given limited foreign ownership owing to capital controls and buoyed by interest in new initial public offerings (IPOs) that have been coming to the market and given investor views on future earnings prospects in China.

Figure 1.14.Emerging Asia: Net Equity Inflows

(In billions of U.S. dollars))

Source: Bloomberg LP.

As noted above, since the onset of the turbulence in July, Asian currencies faced downward pressure, including related to a substantial unwinding of yen carry trades. The pick-up in implied market volatility reduced the attractiveness of these trades, with riskadjusted returns falling to levels not seen since early 2006.4 A number of central banks in the region intervened (buying the local currency) to smooth exchange rate volatility and ensure orderly markets. In Australia, the failure of a large financial conduit to roll over asset-backed commercial paper (ABCP) in the United States added to downward currency pressures in mid-August, while the New Zealand dollar was pushed lower as only an estimated onefifth of Uridashi bonds maturing were rolled over.5 Since then, both currencies have appreciated significantly as risk appetite has returned and carry trade positions have been reestablished.

Figure 1.15.Sharpe Ratios1

Source: Bloomberg LP.

1 The Sharpe ratio (defined as 1-month interest rate differential divided by implied volatility in bilateral exchange rate) is a measure of the risk-adjusted return on yen carry trade.

Figure 1.16Yen Trading Positions

Source: Bloomberg LP.

Figure 1.17Yen Carry Trade Return (Short JPY, Long Listed Currency)

July 19, 2007–August 17, 2007; in percent)

Source: Bloomberg LP.

Figure 1.18Yen Carry Trade Return (Short JPY, Long Listed Currency)

(August 17, 2007–September 28, 2007; in percent)

Source: Bloomberg LP.

Money and credit market conditions have tightened considerably since the start of the recent market turmoil, especially at the short end, after doing so only modestly in first half of 2007. However, trading has remained generally orderly. After a spike in mid-August, local interbank rates have normalized, although they remain higher than pre-August levels in some cases.6 Against this background, a number of central banks announced their readiness to provide liquidity if needed in response to the turmoil, although so far in the region only those in Japan and Australia have made substantial liquidity injections. Yield curves have generally flattened on expectations of some growth moderation. External debt spreads widened in Asia in line with global trends (rising temporarily by as much as 80 basic points), and credit default spreads on sovereign bonds also increased in tandem, reflecting liquidity conditions as well as heightened uncertainty. However, both have come down recently, although they remain somewhat elevated compared with early July.

Figure 1.19Credit Default Swaps: 5–Year Sovereign Spreads

(Basis points)

Source: Bloomberg. LP.

Figure 1.20EMBI Global Sovereign Spreads

(Basis points)

Source: Bloomberg. LP.

Regarding longer-term financing, local and foreign currency yields have fallen for Asian sovereigns recently as investors sought safer returns. The major exceptions are Indonesia, the Philippines, and Thailand, although in each case, external funding needs have already been met for 2007. Corporate yields crept up—both in local and overseas issues, generally reflecting greater global risk aversion—but have since recovered ground. In the case of India, restrictions on external commercial borrowing (ECB) by corporations issued in early August coupled with modestly higher spreads in overseas markets are expected to force more firms to tap the local rupee market.7 Overseas bond issuance by some Korean firms was postponed. However, in a sign that concerns about the fallout are receding somewhat, foreign capital inflows to Asia have resumed and an Indian bank was able to issue new debt in late September, albeit at a somewhat higher spread than in the first half of the year.

Reported Exposures in Asia

Information provided to date by financial institutions in the region points to limited direct exposure to the U.S. subprime market and structured debt products. This limited exposure reflects a combination of factors, namely, Asian financial institutions are relatively unsophisticated compared with their counterparts in the developed countries and therefore less likely to purchase these products; prudential regulations have steered investments toward high-grade instruments; and relatively high domestic yields in some countries in the region have lessened the need to “search for yield” by investing elsewhere. However, these data are mostly self-reported and, given the complexity of some of the financial instruments involved, classification of exposures may not always be straightforward. Moreover, the situation remains fluid as the downgrading of credit tranches by rating agencies is ongoing.

Regarding exposure to U.S. subprime debt, available information shows that banks in India, Indonesia, Malaysia, and Thailand have virtually no direct exposure. Banks in China, Hong Kong SAR, Japan, Korea, and Singapore have reported some exposure but this is small compared with the size of their balance sheets and appears manageable given strong earnings.8 In Australia, a number of banks were required to provide liquidity to bail out conduits that could not fund themselves in the asset-backed commercial paper market, while in New Zealand five small consumer finance companies went into receivership. Insurance companies in Taiwan Province of China and some regional banks in Japan reported losses, but in both cases the magnitude was small and not considered systemic. A similar story holds for holdings of structured debt products by financial entities in the region.9

Turning to hedge funds, Asian-focused funds generally fared well in the recent turbulence. This reflects less complex trading strategies (primarily long-short equity) and some move toward cash positions as a precautionary measure, including to address possible redemption pressures as value-atrisk has increased. Moreover, leverage levels reported by Hong Kong SAR–based hedge funds are considered low––40 percent of funds are not leveraged––and industry groups report that levels decreased further recently (Securities and Futures Commission, 2006b). On market structure, it is noteworthy that despite rapid growth in recent years, hedge funds in the region have mostly been operating from Hong Kong SAR and Singapor—two well-regarded financial centers—with the industry at the regional level still relatively small compared with the United States and the United Kingdom (Box 1.4, p. 15).

Box 1.4.Growth in the Asset Management Industry in Hong Kong SAR and Singapore

The asset management industries of Hong Kong SAR and Singapore are still small globally, but have enjoyed rapid double-digit growth recently. At end-2006, Hong Kong SAR and Singaporean firms managed an estimated $780 billion (414 percent of GDP) and $580 billion (424 percent of GDP), respectively.1 Their combined market share of the global fund management industry in 2006, some $62 trillion, was about 2 percent. While this appears small, the United Kingdom’s share, with London as the world’s leading fund management center, was about 12 percent. However, growth in the fund management industry in both Singapore and Hong Kong SAR has clearly outpaced the global industry as a whole, increasing since 2003 by 92 percent and 101 percent (including valuation effects), respectively.

For both Hong Kong SAR and Singapore, supply-side factors appear to be the major drivers of this growth. The combination of a high concentration of financial institutions, well-functioning legal and regulatory systems, and skilled, flexible labor forces, along with the most open economic systems in Asia and favorable tax regimes, including tax exemptions for offshore funds, puts these two economies consistently at the top of various competitiveness indicators.2

On the demand side, Hong Kong SAR and Singapore are benefiting directly from the steady development in Asia of an institutional investor base. Pension reforms aimed at moving away from state-sponsored plans and allowing pension providers to better manage risk are feeding some of this growth. In addition, both cities have benefited from trends toward greater portfolio diversification and yield-seeking opportunities by global institutional investors. In 2006, for example, the growth in institutional funds accounted for well over half of the total growth in assets managed in Hong Kong SAR.

The predominantly outward orientation of asset managers is also enhancing the roles of Hong Kong SAR and Singapore as international financial centers in Asia. At end-2006, funds from abroad accounted for about 84 percent of total funds in Singapore, and 64 percent in Hong Kong SAR. At the same time, the proportion of investments allocated abroad is about three-fourths for each center. In this context, Hong Kong SAR and Singapore are playing a growing role in regional financial integration, with the share of investments in the Asia-Pacific region reaching 80 and 57 percent, respectively, at end-2006.

Growth in Overall Industry in Hong Kong SAR and Singapore

(In billions of U.S. dollars)

Sources: Securities and Futures Commission, Hong Kong SAR; and Monetary Authority of Singapore.

Funds Sourced from Overseas

(Share in percent)

Sources: Securities and Futures Commission, Hong Kong SAR; and Monetary Authority of Singapore.

Within the two financial centers, the distribution of assets under management (AUM) by asset class reflects their relative strength in various markets. While equities account for the bulk of investments in both Hong Kong SAR and Singapore, they play a more dominant role in the former, at 65 percent versus 47 percent of total AUM at end-2005. Growth in Hong Kong SAR’s equity market is increasingly linked to mainland China. Initial public offering (IPO) fundraising by mainland companies in Hong Kong SAR doubled to some $38 billion in 2006, raising the share of mainland companies in total market capitalization to 48 percent. On the other hand, bonds play a bigger role in Singapore, with one of the region’s deepest bond markets (fixed-income instruments account for some 40 percent of AUM at end-2005). Here, Singapore’s comparative advantage over Hong Kong SAR mostly reflects the dearth of public sector bonds in the latter, whereas private debt markets have comparable size.

For Hong Kong SAR, further integration with mainland China is expected to remain a major driver of asset growth. Under the latest round of the mainland and Hong Kong SAR Closer Economic Partnership Agreement, mainland fund managers, with approval of the China Securities and Regulatory Commission, will be allowed to establish wholly owned subsidiaries or joint ventures in Hong Kong SAR to serve mainland clients. Moreover, the Qualified Domestic Institutional Investor scheme is being expanded to allow mainland mutual funds and securities houses to invest in overseas stock markets (in addition to fixed income products previously). Finally, in mid-August, the Chinese authorities announced a pilot project under which local retail investors can directly invest in non-mainland securities. The first Chinese renminbi-based bond issuance in Hong Kong SAR in late June offers another avenue of growth, although prospects are limited for now owing to relatively unattractive yields.

For both Hong Kong SAR and Singapore, hedge fund operations have become important for asset management growth, albeit from a small base. Each now hosts more hedge fund managers than Japan, with their combined AUM also at the top for East Asia. As of end-2006, hedge funds in each accounted for 4–5 percent of total asset managers’ AUM—roughly tripling in size since 2004. A number of these hedge funds managers are Asia-focused, reinforcing financial integration within the region.3 Going forward, some industry observers see better hedge fund growth prospects for Singapore, owing to its lower tax rate, cheaper rents, and a regulatory environment viewed as relatively advantageous to new managers.4

Geographic Spread of Funds

(Share in percent)

Sources: Securities and Futures Commission, Hong Kong SAR; and Monetary Authority of Singapore.

Note: The main authors of this box are Olaf Unteroberdoerster and David Cowen.1 Includes advisory businesses and other private banking activities.2 For a detailed overview and analysis of competitiveness rankings and their relevance for financial centers, see Securities and Futures Commission (2006a).3 See also Box 1.4 in the IMF’s October 2007 Global Financial Stability Report.4 In Singapore, hedge fund managers with no more than 30 qualified investors do not need a capital markets services license. As a result, hedge funds take as little as a week to set up operations.

Figure 1.21.Hedge Funds: Total Return

(In percent)

Source: Bloomberg LP.

The Outlook and Risks

The baseline scenario for Asia features a modest reduction in growth in 2008 in response to policy tightening in the major emerging markets in the region and a slowdown in foreign demand. Assuming that credit markets gradually normalize, the fallout from the global financial turmoil should be manageable for emerging Asia owing to strong economic fundamentals and healthy corporate and banking sector balance sheets. This would leave trade as the main transmission mechanism to Asia from slower U.S. and euro area growth. The risks to this outlook are broadly balanced as the increased likelihood of financial market stress feeding into a sharper-than-expected slowdown in exports for most countries in Asia is offset by the possibility of continued growth outperformance in China and India.

The baseline macroeconomic scenario for Asia remains broadly favorable. Growth is foreseen to moderate during the remainder of this year and next on the assumption of an effective policy tightening in China (and to a lesser extent in India) as well as in response to a slowdown to external demand.10 Given the current strong momentum, growth for the region is projected to reach 8 percent in 2007 (broadly unchanged from 2006), declining to 7¼ percent in 2008. This decline is roughly twice the magnitude foreseen in the previous Regional Economic Outlook: Asia and Pacific (henceforth, REO), albeit from a higher initial growth rate. Growth in emerging Asia should fall by a full percentage point.

The bulk of the region’s growth slowdown would be attributable to the assumed moderation in China, which accounts for over 40 percent of Asia’s GDP.11 On the assumption that policies are effective in slowing the pace of investment, growth would fall by 1½ percentage points as the composition of activity gradually rebalances. A pattern of slower investment and exports and relatively buoyant consumption holds for much of the region. Exceptions are Indonesia and Thailand (which are projected to have a strong pick-up in investment for country-specific reasons) as well as Australia and New Zealand (where exports should rise on lower exchange rates and domestic demand slow). Growth is projected to fall by ½ percentage point in India and the NIEs and decline only fractionally in the ASEAN-5 group. Industrial Asia should see growth ease by ¼ percentage point.

The baseline financial market scenario assumes that normal credit market conditions are gradually restored, although somewhat higher spreads on riskier credits will persist. A gradual return of risk appetite would imply a return of capital flows to the region. Under these assumptions, the recent market turbulence is unlikely to pose systemic risks to Asian financial systems. This assessment reflects a number of factors that should help to limit the adverse impact from financial contagion on the region. These include robust banking and corporate sector balance sheets (which have improved substantially since the crisis—see Chapter II for a broader analysis of “lessons learned”) and the limited role of Asia-focused hedge funds in the global deleveraging process. With local ABCP markets limited to Australia and Japan, and relatively small and domestic financial institutions only beginning to play a role as issuers of structured credit products, the scope for homegrown problems should be contained.

Table 1.3.Asia: Real GDP Growth

(Year-on-year percent change)

REO April 2007Latest Proj.
Industrial Asia2.
New Zealand2.
Emerging Asia8.
Hong Kong SAR7.
Taiwan POC4.
Source: IMF, WEO database.
Table 1.4.Asia: Real Export Growth

(Year-on-year percent change; national accounts basis)

REO April 2007Latest Proj.
Industrial Asia6.
New Zealand-
Emerging Asia18.016.716.
Hong Kong SAR11.
Taiwan POC7.610.
Source: IMF, WEO database.
Table 1.5.Asia: Investment Growth

(Year-on-year percent change; constant prices)

REO April 2007Latest Proj.
Industrial Asia3.
New Zealand3.4-2.3-
Emerging Asia13.012.212.411.412.912.2
Hong Kong SAR4.67.910.
Taiwan POC0.
Source: IMF, WEO database.
Table 1.6.Asia: Private Consumption Growth

(Year-on-year percent change; constant prices)

REO April 2007Latest Proj.
Industrial Asia1.
New Zealand4.
Emerging Asia7.
Hong Kong SAR3.
Taiwan POC2.
Source: IMF, WEO database.

Given the reduction in the baseline growth forecast, the risks to the outlook are now broadly balanced. That being said, the risks are not uniform across countries. For China and India, the risks are on the upside on balance and relate to the pace of investment and its contribution to growth. For much of the remainder of the region, the risks are on the downside on balance and emanate from the effects of the recent financial market turbulence on demand from foreign markets. The main risks to the outlook for Asia, many of which are interrelated, are the following (in order of importance):

  • Persistent financial market turbulence leads to a muchsharper-than-expected slowdown in both the United States and the euro area, which spills over to Asia. If global financial markets remain volatile, liquidity and credit channels stressed, and risk aversion persistent, the impact could be felt on a broader range of households as well as banks and corporations in mature markets. The price and wealth effects of this scenario could involve sharply lower consumption and import growth. This, in turn, could have pronounced effects on growth in Asia as it would tend to outweigh any support from domestic demand. Indeed, in light of emerging Asia’s deepening integration into the global trading system—as analyzed in Chapter IV—any significant de-linking from foreign demand in a U.S.–euro area slow growth scenario appears unlikely.

  • Domestic demand in the region could prove more resilient than expected, providing an upside risk to growth. Lessthan-fully-successful efforts to slow investment in both China and India could lead to higherthan-projected growth, although this would not necessarily be beneficial. For the rest of emerging Asia, while (net) exports remain an important source of growth, domestic demand has played an increasing role and some governments have stepped up capital expenditure, including as a way to crowd in private investment. Household debt remains low in most countries (Korea is a notable exception) and middle-income consumers are not heavily exposed to financial markets, suggesting some potential upside to consumption spending.

  • Sustained risk aversion could lead to lower or more selective capital flows to Asia, although the effects on the region would be mixed. Countries requiring foreign savings to finance current account deficits would be negatively affected. So would higher-risk corporates that are unable to self-fund and would need to turn to the capital markets and pay higher interest rates. On the other hand, lower capital flows could ease pressure on currencies to appreciate, providing some relief on the competitiveness front.

  • Financial institutions in Asia encounter balance sheet stress following a mark-to-market repricing of structured products. While reported exposures appear small, as noted above, the risks may be understated. There is no comprehensive database on the issuance, transactions, and holdings of structured credit products, and reports from investment banks suggest that nonbank financial institutions and some corporate treasuries in Asia have been active buyers of CDOs, ABCPs, and other derivative products. Going forward, it will be critical whether the pricing of less liquid assets resumes and if asset managers face increased margin requirements and/or sizable redemptions. Further sell-offs and price corrections may also be triggered by the (further) downgrading of credit tranches.

  • Geopolitical tensions could create a supply-related oil price spike and inflation pressures. The pass-through from world oil prices to domestic prices has remained modest in much of emerging Asia, because domestic fuel prices are fixed, they constitute a small component of the final price of domestic fuel, or high corporate profits have allowed firms to absorb these costs. But any sharp increases are likely to be passed on to consumers, especially if corporate profits or budgetary revenues decline. On the other hand, if these risks do not materialize and global growth slows, then oil prices could moderate, providing a potential offsetting stimulus.

Policy Implications

The confluence of strong growth momentum, the ongoing financial market turmoil, and the associated risks present Asian policymakers with a number of challenges. Price pressures already in the pipeline will need to be balanced against the downside risks to growth, and many countries in the region appear to have room to ease if necessary on both the monetary and fiscal policy fronts. Uncertainty over the size and direction of capital flows and their implications for policymakers loom large as well. Also, while the episode of financial turmoil may still play out further, a number of lessons for policymakers are already apparent.

Monetary and Fiscal Policies

Inflation expectations are contained in much of the region, suggesting room for monetary policy action if needed. If the downside risks to growth materialize, then those countries with low and stable inflation (expectations) will likely have scope to ease policy settings. However, room for maneuver will be limited in those countries where inflation is still on the rise or where a deprecation of the exchange rate (which could accompany significantly slower growth) results in a loosening of monetary conditions.

In the event that the downside risks to growth do not materialize, overheating is likely to remain an issue in some counties. In particular, China needs to raise the real cost of capital through higher interest rates and lower the price of tradable goods through a more appreciated exchange rate in order to rebalance growth and put it on a more sustainable footing. This goal has become all the more pressing as China’s trade surplus has continued to grow. Vietnam remains behind the inflation curve and further reserve ratio increases and/or a widening of the band for the dong to allow for faster appreciation are likely to be required.

Table 1.7.Asia: Selected Fiscal Indicators

(In percent of GDP)

General Government Gross DebtCentral Government Fiscal Balance
200520062007Proj.2008 Proj.200520062007 Proj.2008 Proj.
Industrial Asia163.0164.2165.0165.0-4.5-4.7-4.8-4.8
New Zealand 223.524.
Emerging Asia38.836.634.432.7-1.6-1.0-1.2-1.1
Hong Kong SAR1.
Korea 3,429.532.232.832.
Taiwan POC35.835.636.135.3-0.70.0-2.0-1.0
China 517.716.615.214.2-1.3-0.6-0.6-0.8
India 684.180.576.373.1-4.2-3.7-3.5-3.3
Indonesia 345.638.836.434.8-0.3-1.0-1.7-1.9
Malaysia 346.245.446.046.5-3.8-3.5-3.4-3.4
Philippines 786.073.966.062.1-3.0-1.2-1.7-0.9
Thailand 7,847.441.139.839.
Vietnam 743.944.746.348.0-1.2-0.3-3.4-2.1
Sources: IMF, WEO database, and staff estimates.

Figure 1.22.Private Sector Inflation Forecasts

(Annual percentage change)

Sources: Consensus Economics; and CEIC Data Company Ltd.

Through prudent policy during the recent growth cycle, many countries in the region have created “fiscal space” that can be used to combat a growth slowdown. The main channel, as noted in previous REOs, would be to allow the automatic stabilizers to work. In addition, where debt levels are not a constraint, and conditions warrant, consideration can be given to bringing forward public investment expenditures, including as a means to crowd in private sector investment.

Responding to Changes in Capital Flows

Unlike other episodes of financial market turbulence over the past decade, strong fundamentals in most Asian countries this time around have led to continued capital flows into the region. While there were some outflows following the onset of the turbulence in July both from the unwinding of the carry trade and from bond markets, inflows have returned to the region although their future magnitude and volatility (and possible direction) are uncertain. While lower inflows—or even outflows—for some countries might present difficulties in financing current account deficits or relatively risky domestic corporates, in other cases a modest reduction in exchange market pressures would be a welcome development. Policymakers should continue to be pragmatic and allow for greater exchange rate flexibility in order to create two-way risk in the foreign currency markets and promote a rebalancing of growth where necessary, limiting any intervention to efforts to reduce volatility and ensure that market conditions remain orderly.

Financial Sector Lessons

While the impact of the financial market turbulence has been relatively minor in Asia, there are nonetheless a number of preliminary lessons to be gleaned from recent experience. At the most general level, while Asian financial systems are still bank-dominated and relatively conservative, nonbank financial institutions are increasingly gaining market strength and the complexity of instruments is almost sure to continue to increase. As recent events revealed, central banks and supervisory agencies in Asia and elsewhere had incomplete knowledge of how complex and deep the market for structured debt had become and the cascading nature of risks that were built into the system in the process. The system of guarantees (for example, through conduits and other special investment vehicles) and the risks these posed to bank liquidity were unclear as well. A preliminary list of actions in the regulatory regime could usefully include reporting requirements to ensure greater transparency, pricing and provisioning for risk to reduce liquidity and solvency risks, and improved disclosure requirements to inform investors of the risks involved in such investments. Of course, a complete discussion of lessons learned and the appropriate policy responses will take some time.

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