IV. Asia’s External Imbalances

International Monetary Fund. Asia and Pacific Dept
Published Date:
May 2006
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Over the last few years, the rise in global current account imbalances has cast a spotlight on Asia’s external surpluses. These surpluses have been large and sustained, but they have also been evolving, and in many countries diminishing as of late. This chapter considers the outlook for Asia’s external imbalances, and in particular, the role that macroeconomic and structural policies can play in helping to reduce them, notably by stimulating still-weak domestic demand.

Background and Outlook

Since the late 1990s, the region’s current account balance has been in significant surplus—about 3 percent of GDP on average—reflecting an excess of saving over investment.1 While a positive saving-investment gap has featured in nearly all countries in the region, the dynamics driving this gap have differed markedly across the region. In emerging Asia (excluding China), saving rates have been relatively stable, but investment rates collapsed in the late 1990s and have remained depressed since then. One reason why investment has continued to be sluggish is that investment risk in the region has increased, due primarily to a sharp rise in the volatility of Asia’s growth (Chapter V).

In stark contrast to the rest of Asia, China’s investment rate has been high and rising—reaching 40½ percent of GDP in 2005. But because the saving rate has risen even faster—to 47½ percent of GDP in 2005—China’s saving-investment gap has widened considerably (Chapter VI). The steady rise in national saving can be attributed to a sharp increase in the saving rates of government and enterprises, which each rose by about 4 percentage points of GDP in the last five years. In the household sector, the saving rate has also risen (to about 30 percent of disposable income), in large part because the need for precautionary balances has grown sharply in the wake of significant cut backs in the provision of social services by state-owned enterprises.

Emerging Asia excl. China: Saving and Investment

(In percent of GDP)

Sources: IMF, WEO database; and staff calculations.

China: Saving and Investment

(In percent of GDP)

Sources: IMF, WEO database; and staff calculations.

Since 2003, saving-investment balances have narrowed in most countries in the region. The main factor has been the oil price shock, which has hit household and corporate saving, though rising investment has also contributed to the narrowing of current account surpluses in some countries.

  • In emerging Asia (excluding China), the current account surplus narrowed to 3½ percent of GDP in 2005, from over 5 percent of GDP in 2003. The decline was somewhat larger (nearly 2½ percentage points of GDP) in the ASEAN-4 economies, on account of their weaker export performance. But current account surpluses have been falling in the NIEs as well (by about 1 percentage point of GDP on average), and especially in India, where a swing of 3½ percentage points of GDP has returned the current account to deficit, amounting to 1¾ percent of GDP in 2005.

  • Japan’s current account surplus narrowed modestly to 3½ percent of GDP in 2005, after rising marginally in 2004.

  • China presents a notable exception to this regional trend, with its current account surplus soaring as exports have boomed. The current account surplus jumped to just over 7 percent of GDP in 2005 from 2¾ percent of GDP in 2003.

Asia: Current Account Balances

(In billions of U.S. dollars)

Sources: IMF, WEO database; and staff calculations.

1Includes India.

Over the medium term, Asia’s external surpluses should decline further, but only by modest amounts under current policies. In Japan, the current account surplus is expected to narrow by about ¾ percentage point of GDP, to 3 percent of GDP by 2011. While investment is expected to recover gradually, saving is forecast to remain stable, with rising corporate saving (reflecting improving business profitability) offsetting declining household saving (reflecting an aging society). For emerging Asia, IMF staff project the current account surplus to decline by about 1¼ percentage points of GDP by 2011, to about 1¾ percent of GDP. As investment continues its recovery, its share in GDP is forecast to rise by 2¼ percentage points (though it will remain several percentage points below its pre-crisis level). But this will be partly offset by an increase in government saving as fiscal consolidation continues, increasing the national saving rate by 1 percentage point of GDP over the medium term.

China’s current account surplus is also expected to decline modestly over the medium term. Under baseline assumptions, it is forecast to narrow by 1 percentage point of GDP by 2011, to about 6 percent of GDP. The persistence of large current account surpluses reflects expectations that saving will remain high, at about 49 percent of GDP, while investment will rise modestly, to about 43 percent of GDP. Beyond 2011, however, the rapid aging of China’s population is expected to have a significant negative impact on the current account balance. While model estimates of this impact vary considerably, recent IMF research suggests that it could be on the order of 3 percentage points of GDP by 2050.2

What Role for Economic Policies?

The discussion above suggests that if Asia’s external imbalances are to be reduced more rapidly than forecast under baseline assumptions, policy action is needed on two fronts. In emerging Asia and Japan, measures are called for to bolster the recovery in investment, while in China, measures are needed to encourage private consumption. This section assesses the steps that have already been taken by regional policymakers towards meeting these objectives, their plans for the future, and what more could be done.

Fiscal and monetary policies

In most of the region (outside China and India), policymakers have been attempting to encourage domestic demand. However, the scope to do this has been constrained by high public debt levels. The recapitalization of banking systems in the wake of the 1997 crisis had caused public debt to increase sharply in several countries, while in others, public debt has been high for many years already. As a result, fiscal consolidation has remained a policy imperative for most economies in the region.

Emerging Asia: General Government Debt1

(In percent of GDP)

Sources: IMF, APDWEO database; and staff estimates.

1 Excludes Singapore.

Given the limitations on fiscal policy, the burden of stimulating aggregate demand has fallen on monetary policy. With inflationary pressures generally remaining subdued, regional central banks were able to relax monetary policy significantly, reducing policy rates to historically low levels (in some cases below zero in real terms), which in turn resulted in an expansion of the monetary base. However, despite the monetary stimulus, aggregate demand has recovered only moderately.

Asia: Real Policy Rates

(In percent)

Sources: IMF, APDCORE database; and staff calculations.

Exchange rate policy

Since 2004, exchange rates have become more flexible in most Asian economies. A statistical comparison of exchange rate behavior shows that in most countries, the daily range of movement vis-à-vis the U.S. dollar has increased since mid-2004. The fluctuations over time have risen as well (as evidenced by the rise in the standard deviation of exchange rates), especially for the Korean won and the Taiwan dollar. In real effective exchange rate terms, the flexibility of Asian exchange rates has increased by even more, with most currencies showing a significant rise (as measured by the standard deviation of monthly rates).

Asia: Average Daily U.S. Dollar Exchange Rate Movements

(In percent)

Source: Bloomberg LP.

Several factors have contributed to increased exchange rate flexibility in the region. In March 2004, Japan’s cessation of intervention signaled the potential for yen appreciation.3 Subsequently, the renminbi’s (and the ringgit’s) move to a managed float in July 2005 further eased the transition of other Asian currencies to greater flexibility, by dampening speculative capital flows that had been motivated by expectations that these currencies would appreciate. Below, we consider in greater detail how exchange rate policy has varied across the region.

Asia: Standard Deviation of U.S. Dollar Exchange Rates1

(In percent of average exchange rate for each period)

Source: Bloomberg LP.

1 Calculations are based on daily U.S. dollar exchange rates.

Asia: Standard Deviation of Real Effective Exchange Rates1

(In percent of real effective exchange rate for each period)

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

1 Calculations are based on monthly real effective exchange rates.

Since the initial 2.1 percent revaluation in July 2005, the renminbi has continued to be tightly managed, and has appreciated by only about 1¼ percent against the U.S. dollar. In recent weeks, however, there have been some signs of increasing movements in the renminbi-dollar exchange rate, although daily fluctuations have remained well within the +/- 0.3 percent band. Meanwhile, in real effective terms the renminbi has appreciated by about 4¼ percent, mirroring the appreciation of the U.S. dollar against other currencies.

The Chinese authorities have taken further measures to liberalize and develop the foreign exchange market, which should contribute to greater flexibility going forward. These measures include increasing the number of financial institutions licensed to participate in the interbank foreign exchange market (including foreign banks) and allowing trading of forward foreign exchange contracts to foster the development of instruments to hedge foreign exchange risk. In early January 2006, over-the-counter trading of spot foreign exchange was introduced with 13 banks designated as market makers. The centralized spot trading system remains operative, but the central parity rate (against the U.S. dollar) is now based on a weighted average of interbank market transactions. Partially because of these measures, the exchange market has shown signs of increased flexibility in recent months.

While these are encouraging signs, the persistence of China’s large current account surplus suggests that still greater renminbi flexibility is warranted. The authorities should utilize more fully the flexibility available under the new exchange rate arrangement as greater exchange rate flexibility continues to be in China’s best interest. In the near-term, this would imply an appreciation in the currency, which, in turn, could help in rebalancing growth by boosting households’ purchasing power. Given the strong state of China’s economy, currency appreciation should not create major economic disruptions. Over the longer horizon, appreciation should improve investment decisions and thereby further contribute to rebalancing growth towards consumption. More generally, greater exchange rate flexibility would give China more control over its monetary policy, and increase the economy’s resilience to external and domestic shocks.

The Malaysian ringgit also exited its peg on July 21, 2005. However, as the central bank has continued to intervene heavily in the foreign exchange market, the regime remains a de facto peg. The ringgit has only appreciated by 2¼ percent against the U.S. dollar since the regime change. While a reversal of short-term capital flows in late 2005 had temporarily put downward pressure on the ringgit, various indicators (including the substantial current account surplus) suggest that the currency remains undervalued. Greater flexibility will be needed to broaden Malaysia’s policy options in maintaining price stability, promoting economic efficiency, and managing economic shocks and volatile capital flows.

Exchange rates in the rest of emerging Asia have shown greater flexibility. On average, bilateral U.S. dollar exchange rates have appreciated by about 5½ percent since 2003.4 The appreciation has been significantly greater in real effective terms over the same period—about 11 percent on average—and more varied. In some economies, the real effective appreciation has been quite large—the Korean won and the Philippine peso have strengthened by about 24 and 22 percent, respectively—while in others, such as Hong Kong SAR and Taiwan Province of China, effective exchange rates have actually depreciated modestly.

Selected Asia: Real Effective Exchange Rates

(January 2003=100)

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

Emerging Asia: Real Effective Exchange Rates

(January 2003=100)

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

In Japan, the exchange rate has shown considerable flexibility in the recent period. While the yen initially appreciated against the U.S. dollar following the end of intervention in March 2004, the steady rise in U.S. interest rates since then caused the dollar-yen interest rate differential to widen, thereby stimulating capital outflows which caused the yen to weaken.

Looking ahead, further exchange rate appreciation in Asia will play an important role in resolving global imbalances. During 2005, pressures for exchange rate appreciation had eased considerably as emerging Asia’s external surpluses—both in the current and the capital account—moderated. As noted in Chapter II, this reduction in appreciation pressures was reflected in a sharp slowdown in foreign reserve accumulation across the region, with the notable exception of China. More recently, however, there have been two sharp spikes in capital inflows, which have triggered renewed rounds of intervention. In January 2006, official reserves in emerging Asia (excluding China) increased by $25 billion—significantly more than the $3½ billion monthly average accumulation in 2005 (and the $1½ billion accumulation in January 2005). China’s official reserves also increased significantly, by $26¼ billion. Then in April, another wave of equity inflows put further pressure on regional exchange markets. These episodes suggests that most Asian economies remain wary of allowing their currencies to be fully market-determined.

While further currency appreciation remains critical, appreciation on its own will not be sufficient to ensure an orderly adjustment. IMF staff have performed a simulation of the possible economic effects of an exogenous 10 percent appreciation of the renminbi, accompanied by a 5 percent appreciation of the currencies in the rest of Asia.5 The results indicate that such an appreciation would have a relatively small impact on Asia’s current account surplus in the near term—reducing it by less than ½ percentage point of GDP—in part because of the knock-on effects of appreciation on output and incomes (lowering both). Over the longer term, other analyses suggest that the current account adjustment would likely be larger, reflecting adjustments in the economy to the change in relative prices.6 While the results are sensitive to a range of assumptions, they illustrate the point that exchange rate appreciation will need to be accompanied by a strengthening of domestic demand in Asia to ensure that an orderly adjustment takes place. It should also be noted that current account positions, and hence the need for adjustment, differs significantly across Asian economies.

Structural policies

Structural reforms are expected to play a critical role in bringing about a rebalancing of domestic demand. Many of the structural reforms already undertaken in the region since the mid-1990s are improving the conditions for domestic demand growth, with reform in the banking sector of particular note. But further efforts are needed to strengthen capital markets and improve the investment climate, in order to compensate for the risks that have been deterring investment. In this section, we look at a few recent examples of such structural reforms.

Stimulating investment in emerging Asia

To bolster investment, reforms need to advance on two broad fronts. First, the financial sector needs to be developed further, to promote its ability to transfer risk from the corporate sector to the wider investing public. Second, the investment climate needs to be improved, to reduce the costs of doing business in Asia—and increase the rate of return on investment.

Across the region, wide-ranging banking sector reforms are already strengthening banks’ ability to intermediate savings and transfer investment risk. In China, for example, considerable progress has been made in improving bank financial positions and operations. Three of the large state-owned commercial banks have already been recapitalized and are being opened to foreign ownership. By selling ownership stakes to foreign strategic investors, the authorities are trying to improve governance and accelerate the transfer of technology and management practices. Reform efforts have also focused on smaller banking institutions, in particular the rural credit cooperatives, to improve the delivery of financial services to credit-constrained groups. In the area of bank supervision, steps have been taken to strengthen on-site examinations and monitoring of large exposures and connected lending.

Meanwhile, efforts to broaden and deepen capital markets are also underway. The Asian Bond Market Initiatives are an important regional effort that aims to promote the development of local and regional bond markets.7 A key objective is to reduce countries’ exposure to maturity and exchange rate risks and “sudden stops” in access to international capital markets. Additional benefits envisaged are lower reliance on domestic bank lending and improved corporate governance. Under the first phase, foreign exchange reserves of participating economies have been used to acquire U.S. dollar-denominated Asian sovereign bonds. Under the second phase, the objective is to promote greater regional harmonization of bond market infrastructure and legal, regulatory, and tax arrangements. Two additional bond funds were launched in June 2005, with the aim of promoting local-currency bond markets.

Recently, Korea has announced additional details of its plan to develop Seoul into a Northeast Asian financial hub. To spur the development of the foreign exchange market, regulations were eased on foreign exchange transactions earlier this year, including on won-denominated borrowings and bond issues by non-residents. A new law for the integration of capital markets is expected to be submitted to parliament later this year. The law will allow the establishment of financial investment companies (i.e, U.S.-style investment banks), expand the scope of financial products, and encourage rationalization and competition in the financial services market. The government also plans to unveil further deregulatory measures for the insurance sector. In the corporate sphere, a new unified insolvency law, due to come into effect in April 2006, will help to accelerate corporate restructuring, thereby freeing up resources for new investment.

At the same time as risk is reallocated, the investment climate in Asia is being strengthened. Notable efforts are being made in three areas: trade barriers, regulatory burdens, and infrastructure.

On the trade front, the fact that Asian economies are highly integrated into a regional supply chain—with final goods often destined for export outside the region—makes intra-regional trade tariffs act like a cascading tax on the final output. Therefore, regional trade agreements can help advance the process of integration by reducing costs. In the last five years, 23 free-trade agreements have entered into force in the region; about 30 are currently under negotiation.8 However, the proliferation of regional and bilateral trade agreements risks creating an “Asian noodle bowl effect”, especially if there are overlapping agreements among members of different free-trade agreements. To the extent that this raises barriers to multilateral liberalization, trade and investment may be diverted.9

To address regulatory burdens and other hurdles to investment, Indonesia recently launched a comprehensive Investment Climate Policy Package. The policy initiatives announced in March 2006 cover all aspects of the investment process, including customs, taxation, labor practices, and increasing the competitiveness of small and medium scale enterprise and cooperatives. Aside from increasing incentives and facilities for investment, as well as reducing the amount of time required for investment and business approvals, the package also aims to increase synchronization between the central and regional governments. Until now, the lack of synchronization has contributed to a lack of legal certainty and a significant expansion of the government approval process. The package should complement other government initiatives aimed at accelerating infrastructure investment, improving access to financing and lowering the cost of finance.

With regard to infrastructure, many countries in the region have announced ambitious plans to ramp up both public and private investment.10 While infrastructure needs in Asia are certainly great—the ADB estimates that up to $1 trillion in new investment is needed by 2010—public investment should be targeted carefully, to ensure that it does not crowd out private investment or have deleterious macroeconomic consequences where implementation capacity is limited.

Bolstering household consumption in China

With regard to China, further reform efforts are needed on a number of fronts to encourage household consumption. As discussed in Chapter VI, the focus should be on reforms that stimulate a permanent increase in consumption and make GDP growth more balanced over the medium term. Reform of fiscal relations between the center and the local government will be important to improve the delivery of social services and reduce the need for precautionary savings, thereby enhancing the benefit of planned increases in social expenditure. China’s ongoing capital market reforms can also contribute toward boosting consumption by enabling households to earn higher returns on alternative investment vehicles and thereby reduce the reliance of their consumption decisions on disposable wage income. The development of consumer lending products (including mortgages) and of insurance instruments would also have a similar impact.

Chapter III in the August 2005 Asia-Pacific Regional Outlook contains a detailed discussion of Asia’s saving and investment patterns.

World Economic Outlook (September 2004, p. 149). See also P. Heller and S. Symansky (IMF Working Paper, WP/97/136) and R. Brooks (IMF Staff Papers Vol. 50, No. 2).

During 2003 and early 2004, intervention (at times substantial) was an important tool in Japan’s fight against deflation. By containing appreciation pressures on the yen, the risk of importing deflation was reduced.

This average excludes China and Malaysia, as well as Hong Kong SAR (which maintains an exchange rate peg). Since July 2005, the average appreciation has been about 4 percent.

Annex III in the August 2005 Asia-Pacific Regional Outlook contains a detailed analysis of the impact of Asian currency appreciation on regional current account balances.

See the September 2005 World Economic Outlook for an analysis of the adjustment of external imbalances and exchange rates over a longer time horizon.

Box 9 discusses regional financial sector initiatives.

These include the impending ASEAN-Korea free-trade agreement, and bilateral agreements between Japan and Indonesia, the Philippines, and Thailand.

See Box 10 for an analysis of whether Asian regional trade agreements have been trade- creating or trade-diverting.

Recent initiatives on this front are discussed in Chapter III.

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