Chapter

VI. Rebalancing Growth in China

Author(s):
International Monetary Fund. Asia and Pacific Dept
Published Date:
May 2006
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In recent months, increasing attention has been focused on how to rebalance China’s economy away from heavy dependence on exports to lead growth towards domestic demand. As part of this, discussion has focused on making domestic demand more self-sustaining by shifting its composition from investment to consumption. This chapter analyzes the factors behind China’s low consumption and discusses some policy and structural reforms that can raise it over the medium term.

From the Chinese policymakers’ point of view, the current drivers of growth, namely investment and exports, are seen to be unsustainable. Higher rates of investment run the risk of creating overcapacity, leading to deflationary pressures and non-performing loans in the coming years. Meanwhile, excessive reliance on exports exposes the economy to sudden changes in external conditions. From an international perspective, boosting consumption is seen by a growing chorus of policymakers and analysts to be an important way of reducing China’s growing external surplus. But such considerations risk prompting a string of ad hoc policy actions that at best can only provide a temporary boost to consumption, but no lasting, productive solution.

China: Consumption and Savings

(In percent of GDP)

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

Aggregate statistics paint a very stark picture: last year Chinese households consumed only around 40 percent of GDP.1 However, this was not always the case. The consumption-to-GDP ratio stood at 51 percent back in 1980 when the liberalization of China’s economy had just begun, but it has steadily declined since then. At the same time, there has been a steady increase in domestic investment. Investment’s share in GDP was around 44 percent of GDP in 2005.

On the flip side, China’s low consumption to GDP ratio is mirrored in high savings. Household savings is high at around 19 percent of GDP. It fell slightly through the 1980s and the 1990s, only to rise modestly since then.2 Corporate and government savings, on the other hand, has steadily increased, with the pace of increase picking up in recent years. During the past five years, enterprise and government saving each rose by around 4 percentage points of GDP, and they now represent around 20 and 10 percent of GDP, respectively.

China: Domestic Savings by Sectors

(In percent of GDP)

Sources: National Bureau of Statistics of China; and IMF staff estimates.

The decline in the share of consumption in GDP was mainly due to a falling share of household disposable income in GDP, with the household saving rate remaining high. Disposable income, despite rising at a rapid clip, has lagged GDP as both labor and investment incomes have fallen as a share of GDP due to a number of structural factors. At the same time, the household saving rate remained around 30 percent of disposable income, reflecting, among other factors, uncertainties surrounding public pension, rising health care and children’s education costs, the limited scope to finance durable consumption through bank borrowing, and the prospective aging of the population.

What Accounts for Consumption’s Declining Share of GDP?

To be sure, a decline in consumption relative to GDP was to be expected, as China’s development took off in the 1980s. A significant increase in the rate of capital accumulation has been the major driver of growth, as experienced by almost all other countries in the initial stages of development. Thus, a high saving rate was, as many economists would argue, necessary for economic catch up. What has surprised analysts and drawn their attention to China’s experience is the extent of the decline in the share of consumption in GDP.

It should be emphasized, however, that consumption growth in fact has been high. Since the early 1990s, real consumption has grown at an average annual rate of 8 percent. Nonetheless, consumption growth has lagged the average annual rate of GDP of around 10 percent over this period, such that consumption’s share in GDP has fallen by around 7 percentage points.

China: Household Disposable Income and Consumption

Sources: National Bureau of Statistics of China; and IMF staff estimates.

Much of decline in the consumption-to-GDP ratio coincides with the fall in the share of disposable income in GDP. Since the early 1990s, the ratio of household disposable income to GDP declined by 10 percentage points. During the latter half of the 1990s, much of the decline in the disposable income-to-GDP ratio was due to a fall in investment income, while in the period since, a declining share of wages in GDP was an added factor. The decline in investment income largely reflected low interest rates on bank deposits, which has been the dominant vehicle of household savings, and limited transfers of corporate profits to households (discussed below). Wages, which are increasingly determined by market conditions, have been kept from rising rapidly by the vast number of excess workers in the agricultural sector. Moreover, the fast pace of investment growth in recent years has increased the capital intensity of production, and has led to a slowdown in net job creation.

China: Household Disposable Income and Components

(In percent of GDP)

Sources: National Bureau of Statistics of China; and IMF staff estimates.

China: Contribution to Average GDP Growth

(In percent)

Sources: IMF, WEO database; and staff estimates.

It is striking how very little of the strong rise in corporate profits has been transferred to households. This has largely reflected the ownership structure and dividend policy in China.

  • Over the last two decades, the share of the private sector in China has increased, and the public sector has slowly diluted its ownership through listings in the stock market and sales to foreign investors. However, stocks are not held widely by households. Lately, the Chinese stock market has languished, mired in a number of scandals, and it suffers from an overhang of non-tradable shares.3 This has driven well-known Chinese firms to list in foreign exchanges, making investments in equity even less attractive to households. Moreover, even those firms that are listed on the exchange typically do not distribute any significant amount of profits as dividends. Instead, they have kept these large and growing internal savings as a cheap source of financing for investment.

  • A narrow household shareholding base, of course, is not special to China. However, in many countries where shareholding is limited, dividends are transferred indirectly either through institutional investors or through the government budget. Neither channel works well in China. First, institutional investors (such as mutual funds, unit trust, and pension funds) are not very active and households do not save any significant portion of their savings through them. Second, unlike in many other countries where firms pay corporate taxes and profitable state-owned enterprises (SOEs) pay dividends to the government, which are then used to provide income transfers to households or services that are substitutes for private consumption, neither of these things is large in China. Profitable SOEs do not pay dividends to the government, although their profits have been significant and have risen sharply in the last few years. Corporate tax has stayed around 3 percent of GDP, despite the rapid rise in corporate profits as a share of GDP. At the same time, net budgetary transfers to households amount to only around ½ percent of GDP.

As a result, household income, and hence consumption in China has reflected neither the rise in profits, which has been the fastest growing component of national income, nor the likely substantial increase in corporate net worth.4

Despite the fall, the ratio of disposable income-to-GDP in China is comparable to that in other countries, while the consumption to GDP ratio is relatively low. Such international comparison, however, should be done cautiously with considerations for institutional differences across countries. While several countries, including Australia, Canada, and Korea have quite modest personal disposable income-to-GDP ratios, they often reflect institutional differences that are not captured in aggregate national account data. For example, households in Australia and Canada transfer a much higher proportion of GDP as income taxes to the government. In return, households receive substantial publicly provided goods that are privately consumed, such as health and education, that are not included in measures of personal consumption in national accounts. In contrast, income-related taxes are relatively low in China, while government provision of health and education services has declined and is one of the lowest in the sample of countries. Once such institutional differences are accounted for, the gap between China’s consumption-to-GDP ratio and that in other countries is even greater.

Selected Countries: Consumption, 2004(In percent of GDP, unless otherwise indicated)
Personal disposable incomeTaxes on personal income1Personal consumption/disposable incomePersonal consumptionLabor Income incomeGovernment consumption on health and education2Adjusted consumption3
United States7499570572292
United Kingdom66109865561378
Australia581210360491575
Canada58129656501672
Korea5439551441465
Ireland499144401256
France6289056521672
Germany6698857511674
Italy679060421474
Japan5989657511269
India8427667
Singapore5228243
China601694156344
Sources: OECD; CEIC Data Company Ltd; IMF country desks.

The household saving rate has been high, despite the decline in the share of disposable income in GDP. Saving as a percentage of disposable income was around 12 percent in 1980 and rose steadily in the next 10 years (Modigliani and Cao). While moderating somewhat in the 1990s, it has risen again in the last five years, returning to its early 1990s level of around 30 percent.

China: Household Savings

(In percent of disposable income)

Sources: National Bureau of Statistics of China; CEIC Data Company, Ltd; and IMF staff estimates.

Part of the increase in the saving rate may reflect the rise in the proportion of the population crossing the subsistence income threshold. Although disposable income has not kept pace with GDP growth, households have seen an unprecedented increase in their income over the last 15 years. As a result, the proportion of households crossing subsistence levels of income has increased, which has led to a rise in the saving rate.

China: Per Capita Consumption

(In percent of per capita income, Urban households)

Sources: National Bureau of Statistics of China, Household survey; and IMF staff estimates.

China: Urban Household Savings Ratio and Income Growth (1993-2004)

Sources: National Bureau of Statistics of China, Household survey; and IMF staff estimates.

China’s demographic changes have also affected the saving rate. The decline in China’s dependency ratio since 1980 was seen as an important factor contributing to the rise in the saving rate. Moreover, the anticipated rise in the dependency ratio, in part due to China’s one child policy, has encouraged individual asset accumulation as the traditional source of old-age support from the extended family has become increasingly limited (Modigliani and Cao).5 However, as the dependency ratio begins to rise after 2010 (United Nation Population Division), the aggregate saving rate could decline.

China: Dependency Ratio

(In percent)

Sources: CEIC Data Company Ltd; and World Bank Population Forecast.

Precautionary savings motives are also likely to have contributed to China’s high saving rate. Despite the phenomenal growth in income over the last 25 years, the economic transition has increased uncertainties. Since the mid-1990s, state-owned enterprises have increasingly been relieved of their social responsibilities, including the provision of pensions, health care, and schooling. These responsibilities have been transferred to local and central governments. Many of the poorer provinces have found it financially difficult to deliver these services. Indeed, government spending on education is only about 2¼ percent of GDP, the lowest among Asian economies, while that on health care is even lower, accounting for about ½ percent of GDP. As a result, health and education expenses have been the two fastest growing components of household consumption. Reflecting this, the share of out-of-pocket health spending in total health care cost has increased from around 20 percent in 1978 to above 58 percent in 2002 (China National Health Accounts Report, 2005). Notwithstanding the increase in current spending in these categories, uncertainty over how the future retirement, health care, and children’s education costs will be met has contributed to an increase of households’ precautionary savings. Those approaching retirement may be among the most vulnerable to these uncertainties, contributing to the relatively high savings rate by this cohort (Chamon and Prasad, 2005).

China: Urban Household Expenditure on Health and Education

(In percent of total expenditure)

Sources: Household survey; National Bureau of Statistics of China; and IMF staff estimates.

Apart from limited public provision of health and education, inadequate provision of basic infrastructure in interior provinces has reduced the scope for higher consumption of durable goods and services. Although food and clothing make up a sizeable portion of household spending, the main drivers of higher consumption are likely to come from increased purchases of durable goods and services. Nevertheless, the consumption of durable goods and services depend on the availability of infrastructure, including the provision of electricity, roads, telecommunications, and health services. While China has made considerable investments in these areas, regional disparity between the coastal (more prosperous) and the interior (poorer) provinces in such infrastructure remains large. Consequently, a large section of the population, albeit with relatively low income, lacks the opportunity to avail what are potentially the fastest growing components of consumption.

Households have very limited access to consumer or business financing, increasing the need to save. The banking system has so far played only a small role in consumer lending, with consumer loans accounting for only 14 percent of total bank lending, a smaller share than most other Asian economies. The small size and reach of consumer lending has imposed serious liquidity constraints on households, such that they have been forced to save before undertaking major purchases for durable goods and housing, and this has been particularly important in keeping the saving rate of the younger cohorts high. In addition, bank credit has generally chased large enterprises and SOEs and shied away from small and medium-sized enterprises. Instead, owners of these businesses have drawn on savings of their own or family members to expand operations and for working capital.

China: Corporations and Households Lending, 2004

(In percent of GDP)

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

The underdeveloped capital market also played a role in keeping the consumption rate low and the saving rate high. Returns on household financial assets are relatively low. Financial instruments for saving and pooling risks are few. Banks dominate the financial system, and bank deposits are the main vehicle for household savings, accounting for nearly three-quarters of annual financial savings. In addition to the relatively small size of the stock market and the narrow shareholding base, China’s insurance market is also underdeveloped, offering few opportunities to households to pool individual risks, such as those related to labor income and life expectancy. In the absence of such risk pooling, households have saved “excessively”, i.e., more than what would have been the case had these markets functioned efficiently.

China: Borrowing of Nonfinancial Institutions, 2004

(In percent of total)

Source: People’s Bank of China, China Financial Stability Report, 2005.

China: Deposits and Interest Rates

(Deposits in billions of Renminbi and interest rates in percent)

Source: People’s Bank of China.

China: Stock Market Capitalization, 2004

(In percent of GDP)

Sources: CEIC Data Company Ltd; China Financial Stability Report; and IMF staff estimates.

China: Total Assets of Insurance Industry, 2004

(In percent of GDP)

Sources: CEIC Data Company LTD; OECD Insurance Yearbook; China Financial Stability Report; and IMF staff estimates.

1End of 2003

What Needs to be Done?

Consumption and savings behavior in China reflect basic institutional and structural factors. Rather than looking for short-term, ad hoc policy measures that might give a temporary boost to consumption, the focus should be on structural reforms that would stimulate a more permanent increase in consumption and make GDP growth more balanced over the medium term.

  • On the macroeconomic policy front, greater exchange rate flexibility will help to improve investment decisions, and a likely appreciation in the near term could raise consumption by boosting households’ purchasing power, although some sectors in the economy (such as the agricultural sector) may be vulnerable to employment loss.

  • Fiscal policy has a major role in reducing uncertainties in the provision of education, health care, and pensions, which should substantially lower precautionary savings and help to increase consumption. Such reforms would likely require higher budgetary spending. In addition, ensuring that local governments are provided sufficient funds will be important to assure households of public delivery of social services.

  • In the banking sector, a wider range of household credit instruments would enable better intertemporal smoothing of consumption by facilitating borrowing against future income, helping to bring down saving rates. Ongoing banking sector reforms, especially the implementation of the improved risk management systems, should also help banks to cater to the lending needs of the small and medium-scale enterprises that, in turn, should help to reduce household savings over time. Reforms to enable farmers to sell their and borrow against their land use rights at market prices and borrow against their land would help meet the financing need of the rural households.

  • These reforms need to be supplemented by developing the capital markets further. A rejuvenated equity market with greater household participation would allow households to diversify their portfolios and benefit from the rising profits and market values of firms, and enable them to increase consumption. In addition, better insurance products will help households to pool risks and protect themselves against adverse shocks such as job losses or large healthcare expenses without saving excessively.

Box 1.The Revival of Japan

Japan’s recovery has strengthened and deepened in recent quarters. Following a very rapid expansion in the first half of 2005 and a slight deceleration in the third quarter, the economy raced ahead again at the end of the year, bringing overall growth for 2005 to 2¾ percent. It is now three straight years that Japan has grown above its potential growth rate, currently estimated at around 1.5 percent but likely to be revised higher. Equally encouraging, growth has been increasingly broad based, with domestic demand’s contribution rising substantially in 2005.

Japan: GDP Growth

(Q/Q percent change, SAAR)

Sources: IMF APDCORE database; and staff calculations.

1Contribution to GDP growth.

The foundation of this recovery has been corporate restructuring. Industrial firms have gradually moved away from costly and inflexible life-time employment practices, and for many years limited investment spending to deal with the overhang of fixed assets and debt created in the bubble years. At the same time, stronger regulatory pressure forced financial firms to deal with the non-performing loans in their balance sheets. Overall profitability has consequently risen to levels last seen in the late 1980s, and this is in turn allowing for stronger investment and hiring. In January, the ratio of job offers to job seekers—a closely watched indicator of labor market strength—reached unity for the first time in thirteen years. And as slack has disappeared from the labor market, wages have begun to increase, thereby lifting household incomes and stimulating a recovery in private consumption.

As domestic demand has revived, deflation in Japan has begun to wane. Core CPI (which excludes fresh food but includes energy) increased 0.5 percent y/y in February, somewhat faster than expected. This was the largest increase since 1998 and the fourth monthly increase in a row. Excluding special factors (electricity, gas, communication charges, rice, and petroleum products), the index rose by 0.1 percent y/y. Other indices, including the GDP deflator and the personal consumption expenditure deflator, remained weak. But this progress in ending deflation has been sufficient to allow the Bank of Japan to declare in mid-March an end to its policy of quantitative easing.

Japan: Current Profit/Sales of Corporate Sector

(In percent, four-quarter moving average)

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

Japan: Employment and Wages

(Year-on-year percent change, 3-month moving average)

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

Still, large challenges remain. Fiscal consolidation is proceeding faster than expected, with the general government deficit in Japan estimated to have fallen for the third consecutive year in 2005, to 5.8 percent of GDP from 6.6 percent in 2004. The authorities have consequently moved up by one year the target date for achieving primary balance excluding social security. However, more remains to be done. The general government debt to GDP ratio has increased by eight percentage points since 2003 despite the recovery and progress on fiscal consolidation, and at 175 percent it remains the highest by far among advanced economies. Moreover, the fiscal position will suffer significant strain in decades to come from the aging of the population, since dependency ratios are rising fast and Japan’s population is already on the decline.

Population aging will challenge economic prospects more generally, and higher productivity growth will be needed to secure rising living standards. Productivity growth remains low in the non-manufacturing sector, particularly in agriculture, wholesale, and transportation. The authorities are currently advancing plans for structural reform in these areas.

Box 2.Australia And New Zealand: Developments and Outlook

Australia

In Australia, growth is projected to quicken to around 3 percent in 2006 from 2½ percent last year, driven mainly by an acceleration in domestic demand. Business investment is expected to expand rapidly, as firms try to alleviate the bottlenecks that have emerged in the wake of a commodity price boom, triggered by China’s growing demand for raw materials. Meanwhile, private consumption is likely to remain subdued in the face of a flat housing market and high gasoline prices.

Inflation has been contained. Prices have been under pressure from rising energy costs and a tightening labor market—at 5 percent, unemployment is the lowest it has been in about three decades. But inflation was limited to 2¾ percent last year and should remain around this level in 2006, within the Reserve Bank’s 2-3 percent long-term target range. Consequently, the central bank has maintained a wait-and-see stance since March 2005.

The current account deficit is slowly shrinking but remains among the highest in the region, despite favorable terms of trade. The current account deficit is projected to decline by around ½ percent of GDP to around 5½ percent of GDP in 2006, on the back of further improvements in the terms of trade. But export volumes are expected to grow by only 2¼ percent, about the same as last year, the result of capacity constraints.

New Zealand

The economy is slowing down after years of strong growth. Growth in 2006 is projected to decline to around 1 percent, with rising mortgage rates contributing to a downturn in domestic demand that was already underway; residential investment is expected to contract sharply this year.

Inflation has risen slightly above the 1-3 percent target range on account of rising oil prices and rises in housing construction costs, and is projected to stay at that level in 2006. However, recent evidence suggests that resource pressures and inflation expectations are now easing, allowing the Reserve Bank to maintain its policy rate at 7¼ percent, 225 basis points above its early 2004 level.

With the release of weak economic data and concerns about the end of the global carry trade, the New Zealand dollar has weakened sharply in recent months from its exceptionally high levels. Consequently, the current account deficit is expected to remain at 9 percent of GDP this year, then narrow substantially over the medium term.

Box 3.The Asean-4 And The Electronics Cycle

The ASEAN-4 countries have lagged behind the recent upturn in the electronics cycle, even as electronics exports from elsewhere in the region have surged. This lag is particularly pronounced in Indonesia and the Philippines, which has been causing concern that the electronics sector in both countries is becoming less competitive. For the Philippines, where electronics account for over two-thirds of total exports, a loss of competitiveness would have especially large implications.

ASEAN-4 Versus NIEs: Electronic Export Growth

(y/y percent change, 3mma)

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

However, electronics exports from the Philippines, and to a lesser extent Indonesia, have historically been less correlated with the global electronics cycle. This could be because the electronics sector in both countries is more heavily geared towards production of intermediate inputs, causing electronics exports to lead the global electronics cycle. For the Philippines, statistical evidence provides some support for this hypothesis, since electronics export growth becomes more correlated with the global electronics cycle as the lead between exports and the global electronics cycle increases, with the correlation peaking at a lead of four months. For Indonesia, and other countries in the region, electronics export growth tends to be more synchronized with the global cycle. Of course, the low correlation could also reflect the possibility that both countries’ electronics sectors are geared towards different products than the rest of the region, so that export performance is driven by developments in different market segments. Moreover, the low correlation could also be due to manufacturing capacity coming online or being shut down, which may have caused exports to move out of synch with global electronics demand at different points in time. These considerations suggest that concerns over near-term export performance may be overblown.

Emerging Asia: Importance of Electronics in Total Exports

(Average of January 2003-September 2005, in percent)

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

Correlation of Electronics Exports with Global Semiconductor Receipts1

(in percent)

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

1 Based on 3-month moving average of year-on-year growth.

Over the medium term, however, regional and technological factors could pose a challenge for the ASEAN-4. At the regional level, electronics exports from China have grown dramatically over the last decade, at the expense of other countries in the region. This shift is driven by the emergence of China as a final assembly point for electronics produced in the region, with higher value-added work such as design and manufacturing of integrated circuits as well as semiconductors remaining elsewhere. Indeed, over the past few years, this shift has benefited the ASEAN-4 countries, as exports of components to China boomed. However, over the medium term, the ASEAN-4 are threatened by the backwards integration of China into other production areas, a shift that is already diverting investment in new capacity from Southeast Asia. Investment in new fabrication plants in China shot up to $16 billion over the period 2001-2004, up from $4 billion in 1997-2000, while investment in Southeast Asia fell to just $5 billion, with even sharper declines in Taiwan POC and the U.S. More recent data tend to underscore this point. In 2004, 29 new fabrication plants were announced with a total value of $31.3 billion. In terms of value, most of these announcements were in Japan ($8.5 billion), followed closely by China ($6.3 billion), with Southeast Asia a distant last ($0.1 billion).1

Share in Electronics Exports from Asia

(In percent)

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

Net Exports of Integrated Circuits and Semiconductors, 2003

(In billions of U.S. dollars)

Sources: WITS; and IMF staff calculations.

This regional factor is compounded by the rapid pace of technological innovation. For example, the electronics sector in the ASEAN-4 countries tends to be heavily geared towards production of hard drives, which over the medium term may be increasingly replaced with flash memory. Indeed, Apple recently made the decision to replace hard drives in the latest generation of iPods with flash memory, a shift that will benefit primarily Japan, Korea, Taiwan Province of China, and the United States. As the capacity of flash memory evolves further, hard drives may become increasingly relegated to more mature products (such as servers), where market growth will be slower.

Value of New Construction Started on Fabrication Plants

(In billions of U.S. dollars)

Source: Strategic Marketing Associates, The Quarterly Spot Report on Semiconductor Fab Projects (October 2004).

Over the medium term, each country could address these challenges by building on its competitive advantages. Thailand is an important producer of hard drives, for which demand may gradually wane. But it will benefit from the emergence of an automotive sector, which produces mainly Japanese cars for export to the rest of ASEAN. Meanwhile, Malaysia’s competitive edge lies in the shorter delivery times that its infrastructure allows. This advantage may erode over time as China’s infrastructure continues to improve. Indonesia benefits from low wage costs, but weak investment in the export sector since the Asian crisis may signal a longer-term structural problem. Finally, the Philippines benefits from its English-speaking labor force, but investment has been weak and three electronics multinationals announced last year that they are moving production elsewhere in the region. While each country should try to build on its competitive advantages, the region as a whole may also benefit from obstacles to investment in China, which include weak intellectual property protection, the spiraling cost of increasingly scarce skilled labor, and unreliable power supply.

Fabrication Plant Announcements in 2004

(In billions of U.S. dollars)

Source: Strategic Marketing Associates, The Quarterly Spot Report on Semiconductor Fab Projects (October 2004).

Thailand: Importance of Vehicles and Parts in Total Exports

(In percent)

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

1 Fabrication plants produce integrated circuits and semiconductors.

Box 4.The Impact of Oil on Growth

As oil prices soared in 2004-05, concerns mounted about the potential impact on Asia’s growth. These concerns sprang from several sources. To begin with, Asian economies are particularly energy-intensive, because of their large manufacturing sectors. And for this energy they generally depend on imported oil (with Malaysia and Indonesia being notable exceptions). Consequently, most simulations made in 2004 showed that the oil price shocks would have a sizeable impact on real incomes and GDP. IMF staff estimates, for example, indicated that GDP growth in Asia might decline by ¾ percentage points for every $10/barrel increase in the price of oil, merely from the direct effects of the increase. Since oil prices increased by roughly $30 dollar/barrel, the impact could have been three times larger.

In the event, however, higher oil prices did not seem to make much of a dent in the region’s growth. To the contrary, emerging Asia grew by about 7 percent in 2004-2005, slightly faster than in 2003. This remarkable performance begs a question: why was the apparent impact so small? We focus on five economies—Japan, Hong Kong SAR, Korea, Thailand and Malaysia—to find out.

Oil Prices and GDP Growth

(Annual percentage change)

Sources: IMF, WEO database; and staff calculations.

1Comprises Japan, Hong Kong SAR, Korea, Malaysia, and Thailand.

In principle, high oil prices affect economic activity through two main channels. On the demand side, higher oil prices lower households’ real incomes, prompting them to reduce their consumption. On the supply side, an increase in oil prices raises production costs and induces firms to reduce output.

Looking first at the demand side, oil import bills have certainly increased in all five economies. But the rise in costs has not been as great as expected. In fact, actual import prices increased by only about half the rise in international prices, since importers have secured significant amounts of oil on long-term contracts and have hedged the cost of other supplies through derivatives. In addition, higher prices have prompted a fall in energy consumption, reducing import volumes both in 2004 and 2005. As a result, the increase in oil imports relative to GDP since 2002 has been limited to 1½ percentage points, bringing costs to an average of nearly 4 percent of GDP in 2005.

Selected Asia: Oil Import Bill and Exports1

(In percent of GDP)

Sources: IMF, WEO database; and staff calculations.

1 Comprises Japan, Hong Kong SAR, Korea, Malaysia, and Thailand.

The impact on household incomes, moreover, has been limited because domestic fuel prices have increased by much less than import costs. From end-2003 to end-2005, domestic prices in the five countries increased by only 35 percent, on average. One reason is that local currencies have generally appreciated against the dollar, a particularly important factor in Korea. But the most important reason is that crude import costs account for a relatively small portion of the retail price of petroleum products - less than one-third in Japan, Hong Kong SAR and Korea. (The rest is due to taxes, refining, and distribution costs.) Also, in Malaysia, pass through was limited by government administered prices.

Selected Asia: Contributions to GDP Growth

(In percent)

Sources: IMF, WEO database; and staff calculations.

1Comprises Japan, Hong Kong SAR, Korea, Malaysia, and Thailand.

Furthermore, the impact of these price increases on the overall CPI was relatively small. Petroleum products account for only about 3 percent of the CPI on average; even including related categories such as electricity and transportation, the weight is only 10 percent. More to the point, increases in energy costs were offset across the region by falling prices for food, which has a much larger weight in the CPI. Consequently, average inflation remained around 1 percent in 2004-05, although higher than in 2003.

Meanwhile, household incomes benefited from an upswing in world growth and the global electronics cycle. From 2003 to 2005, exports in the five countries increased by 4½ percentage points to GDP to 31½ percent of GDP—much more than the increase in the oil import bill. Consequently, average household incomes increased by about 10 percent in 2004-05, faster than in 2003. With average inflation minimal, real incomes rose by a similar amount, sustaining consumption. At the same time, strong exports also stimulated investment, further contributing to domestic demand.

Finally, on the supply side, the external boom also helped companies absorb rising fuel costs without curtailing output or passing the price increases on to consumers.

Box 5.The Consumer Finance Boom: Is ItA Problem?

Consumer credit has begun to take off in Asia over the past few years, growing by 40 percent since 2001. This important development has been driven by changes in both supply and demand. On the supply side, lenders have turned to consumers as a new outlet for portfolio growth, in an environment where liquidity has been ample while corporate demand for funds has been depressed by deleveraging coupled with historically low investment rates. Meanwhile, on the demand side, growing per-capita income, financial sector reforms, and government policies in support of consumer and rural credit brought previously unbanked households to the formal sector. The resulting expansion in consumer lending has helped to restore bank profitability and reduce NPL ratios. But it has also brought about new risks and challenges for regulators.

Emerging Asia: Growth of Household Credit(Annual percentage change)
20012002200320042005
Hong Kong SAR2.9-1.5-4.11.02.0
Korea28.028.51.96.19.9
Singapore9.84.117.47.73.3
Taiwan POC-0.64.011.918.012.8
China63.952.847.326.310.3
Indonesia36.335.733.837.827.9
Malaysia14.523.311.820.715.2
Thailand7.57.920.914.719.7
Sources: CEIC Data Company Ltd; and IMF, APD country desks.

Housing loans and credit card lending have both contributed to the expansion of consumer credit. Mortgage markets have been buoyant in several countries in the region, contributing to the revival of the construction industry and rising housing prices. While often starting from a very low base, non-secured credit-card debt has also risen sharply, partly replacing informal credit.

The expansion of consumer lending has led to a marked shift in the composition of bank portfolios in several Asian countries. The strong performance of household credit has often occurred in the context of stagnant or decreasing credit to corporates. This resulted in a substantial increase in household credit as a share of total credit to the private sector, which now approaches 50 percent in several countries in the region. However, even in countries such as China where the share has not increased because corporate lending has also been buoyant, booming consumer credit has resulted in a noticeable rise in household leverage ratios.

Emerging Asia: Credit to Households(In percent of total credit to private sector)
1999200020012002200320042005
Hong Kong SAR38.038.540.541.541.039.938.4
Korea155.858.465.669.965.468.569.3
Singapore38.641.142.644.949.551.151.6
Taiwan POC34.635.737.739.841.643.444.7
China1.54.36.28.19.911.211.3
Indonesia21.525.931.936.740.544.345.5
Malaysia22.923.726.029.931.631.030.4
Philippines15.114.214.414.313.916.016.5
Thailand23.331.838.235.340.043.548.1
Sources: CEIC Data Company Ltd; and IMF, APD country desks.

Household debt has risen relative to income, but with a few exceptions (such as Korea and Singapore) has remained well below its level in advanced economies. In addition, housing loans, which often represent over 50 percent of household debt, have typically enjoyed very low rates of default. That said, a still limited “credit culture” in vast segments of the market may have led some households to overborrow. And increased household indebtedness carries risks, as leverage amplifies shocks. For example, as the upturn in the global interest rate cycle increases debt service costs, consumption and asset prices may be threatened.

Selected Countries: Household Debt

(In percent of household disposable income)

Sources: CEIC Data Company Ltd; and IMF APD desks.

A too limited information-sharing framework on household debt and credit-worthiness has exacerbated the risks associated with fast credit expansion. Credit booms and the expansion of the formal sector into previously unbanked market segments have been associated with increased prudential risk. Banks may have loosened lending standards to compete for market shares in what they perceived as a strategic market for the medium-term,2 while at the same time they may have struggled to process large numbers of applications for products for which they, as well as the borrowers, had little experience. The absence of well-developed credit bureaus has exacerbated these dangers. In addition, although credit-card loans are still a small fraction of total credit in most Asian countries, they are often concentrated at a small number of institutions relying on interbank and wholesale markets for financing. As such, they may be of systemic relevance.

The experience of Korea testifies to these risks. Korea’s credit-card industry expanded rapidly from 1999 to 2002, with the number of active cards more than doubling to over 100 million, an average of 4 cards per adult. Insufficient information sharing among banks and credit-card companies allowed borrowers to hold multiple cards and “kite” payments from one lender to another. The consequences of this excessive expansion were a large number of household delinquencies (about 17 percent of the economically active population) and several credit-card companies in financial distress (including the largest, LG Card, eventually the object of a bailout). The subsequent consumer credit crunch put the economy into a recession.

Taiwan Province of China has experienced similar, albeit much less severe, problems. In Taiwan Province of China, non-mortgage consumer loans grew at an average annual rate of about 20 percent in 2000–05. Credit-card loans and cash-card loans—often promoted to poorer market segments than the traditional targets for bank products—were among the main drivers of this expansion, with the number of credit cards per adult rising from 0.1 in 1992 to 2.8 in 2005. But as consumer loans expanded, so did non-performing loans. The average annualized charge-off ratio on credit- and cash-card loans rose to about 13 percent in November 2005 from about 5 percent in 2004, implying that most lenders are currently making losses on their card lending. In response, the authorities have tightened prudential standards on the credit-card industry, including by imposing administrative penalties if the ratio exceeds 3 percent and suspending a lender from issuing new cards if its delinquency ratio exceeds 8 percent. (Indeed, the increase in charge-offs is in part an attempt by banks to keep delinquency rates below the regulatory thresholds imposed by the authorities.) In addition, the dissemination of borrower information has been improved.

Partly in response to such problems, supervisory authorities have imposed tighter lending standards and regulatory curbs on consumer lending. Income-based eligibility criteria and limits on credit-card outstanding balances have been introduced in Malaysia, Singapore, and Thailand. Several economies (including China, Korea, Hong Kong SAR, Taiwan Province of China, and Thailand) have taken measures to improve the reporting and sharing of information on household debt and credit-worthiness by introducing or revamping credit bureaus. Loan-to-value limits on housing lending have also been imposed. These measures, jointly with a shift toward monetary policy tightening, have had some success in curbing the expansion of household credit. However, since such credit continues to grow at double-digit rates in most countries in the region, continued vigilance is necessary.

Emerging Asia: Growth of Credit Card Debt(Annual percentage change)
200020012002200320042005
Hong Kong SAR30.212.8-6.3-3.75.019.4
Korea78.5122.935.0-44.9-28.5-10.9
Singapore25.821.815.54.43.07.0
Taiwan POC11.17.519.231.415.42.7
Malaysia36.817.922.012.117.218.3
Thailand-3.526.376.830.125.621.1
Source: CEIC Data Company Ltd.
2 See Dell’Ariccia and Marquez, “Lending Booms and Lending Standards,” Journal of Finance, forthcoming.

Box 6.Dealing with Avian Flu

The third wave of avian flu began in late 2003/early 2004 and continues today. The number of human cases has increased and spread beyond Asia to Africa, the Middle East and Europe. Within Asia alone, there have been more than 160 human victims since the third wave began, of whom more than half have died, and the economic impact of avian flu across Southeast Asia alone has already exceeded $10 billion. If the virus were to adapt itself to human-to-human transmission, millions of lives may be threatened. Although neither the timing nor severity of a pandemic can be predicted with any certainty, the scientific community believes that the risk of a human pandemic is high, potentially causing a large number of deaths and straining health, social, and economic systems in Asia and around the world.2

Asia: Confirmed Human Cases of Avian Flu, 2003-061

Source: World Health Organization.

1 As of April 12, 2006.

Facing the challenge of macroeconomic disruptions

The experience of the 2003 Severe Acute Respiratory Syndrome (SARS) outbreak in Asia highlights how damaging an unexpected international health threat may be in today’s global economy. In the economies hit by SARS, tourist arrivals collapsed by 20-70 percent and retail sales growth dropped by 5–10 percent in the second quarter of 2003—though the economies quickly rebounded once SARS subsided. Overall, the temporary economic impact of SARS was estimated at 0.6 percentage points of GDP for the region, varying from 0.2 percentage points in Korea to 1.8 percentage points in Hong Kong SAR. As substantial as these numbers may be, they could pale in comparison with the potential impact of an avian flu pandemic: while SARS infected about 8000 people worldwide, killing 800, deaths from avian influenza could be in the millions, and spread over a much wider geographical area.

The fiscal impact of a pandemic could be large. Public health measures to prevent the emergence or spread of the disease and to treat its effects would entail an immediate burden on governments’ budgets. Experts estimate that establishing an effective system of monitoring and prevention in Asia would cost between $250–$500 million, a trivial amount compared with the likely benefits. However, relief packages could be significantly more costly. Following the SARS outbreak, some countries offered financial support to hard-hit sectors costing some 1 percent of GDP. In addition to the short-run costs, longer-term investment to restructure the poultry sector, strengthen health and other infrastructure in rural areas, scale up vaccine research and production, and enhance emergency management capacity could pose additional fiscal pressures in the medium term. While budgetary costs should be manageable in advanced countries, they could pose problems for low-income countries in the region. To ensure that needed external assistance will be available, donors at a January conference in Beijing pledged $1.9 billion to combat Avian flu at the country, regional, and global levels.

In the context of a pandemic, accommodative macroeconomic policies would likely be appropriate. While the situation would vary significantly across countries, the potentially large impact on domestic demand and the relatively short-run nature of the shock (albeit likely longer than that of SARS) suggest that a loosening of fiscal and monetary policies would be helpful in cushioning the macroeconomic impact of the flu. While prices of specific products (e.g., food substitutes for chicken, medicinal supplies) might rise, a pandemic would likely lead to a fall in the overall price level in the short run, on declining consumer demand for services such as tourism, retail sales, hotels, and restaurants. Policy management would become more complicated if the pandemic resulted in strong capital outflows in individual countries. In this case, countries may need to draw down foreign exchange reserves, or secure external assistance.

Financial sector disruptions

An avian-flu pandemic could cause breakdowns in financial systems. Besides increased cash withdrawals and credit demand in advance of problems, absenteeism of key personnel could result in severe disruptions to payments systems, including breakdowns in check-clearing and securities settlement. It would consequently be important to develop contingency plans in order to minimize these disruptions. Key elements of a plan include building up cash stocks, developing special lines of credit from the central bank and arrangements to ease liquidity recycling among banks, insuring availability and back-ups of key personnel, and creating emergency payments systems. An alternative to face-to-face financial services could be needed were the pandemic to last longer than expected.

Where does Asia stand on financial sector preparedness? In most Asian countries, financial authorities and institutions have developed business continuity plans encompassing some of the points mentioned above. However, these plans were for the most part drawn for general emergencies, and would need to be updated to take into account the particularities of an avian flu pandemic. In contrast, a few economies have prepared avian-flu specific plans, including Hong Kong SAR, Singapore, and Vietnam—although the last focuses on actions to be taken in the health and agriculture sectors.

The Fund is encouraging central banks and financial regulators to ensure that they and private financial institutions have appropriate contingency plans to deal with the consequences of an avian flu pandemic. The Fund is raising awareness by disseminating information, discussing preparations with country authorities, and organizing information- sharing regional seminars for country officials.

2 Drawing from the pandemic experiences of the last century, the WHO estimates that 2-7 million people could die, while other estimates are much higher, exceeding 100 million deaths.

Box 7.The End of Quantitative Easing in Japan—Implications for the Yen Carry Trade in Emerging Asia

Over the past several years, there has been a significant expansion of the yen carry trade as Japan and the U.S. have pursued diverging monetary policies. In Japan, monetary policy has for the past several years been very accommodative in order to end deflation, with short-term interest rates set near zero. At the same time, Fed Fund rates in the United States have been raised by 375 basis points since the beginning of the U.S. tightening cycle in May 2004. The rising spread encouraged yen carry trade activities, whereby international investors borrow yen to invest in higher-yielding currencies2, including in emerging Asia. It also fueled purchases of foreign bonds by Japanese investors, such as uridashi bonds3, which resulted in a weakening yen, thereby making the carry trade activities even more profitable, especially at a time of benign international financial environment and declining spreads on emerging market debt and other high-yielding assets.

Japan: Exchange and Policy Rate over U.S.

Source: CEIC Data Company Ltd.

1U.S. Federal funds rate minus Japan overnight call rate.

On March 9, 2006, the Bank of Japan (BoJ) announced that it was exiting from its quantitative easing policy. This decision was taken as the BoJ noted that its necessary conditions for an exit, namely stable positive y/y core CPI inflation and expectations that this would continue, had been met. Accordingly, banks’ excess reserves held at the BoJ will be reduced through short-term operations, and the central bank will shift its monetary framework to the targeting of the overnight call rate, which it expects to remain near zero for the time being and to rise gradually in light of economic developments.

The end to quantitative easing in Japan is not expected to have much impact on financial markets. The end of the quantitative easing policy is unlikely to change the underlying conditions for the yen carry trade in a material way: any decline in liquidity will affect only excess reserves held at the BoJ, and the spread with U.S. rates is not expected to diminish soon as the BoJ has committed to maintain short-term interest rates near zero for some time. Any rise in long-term rates may also be contained, as the BoJ intends to continue its purchases of long-term government bonds. Moreover, thanks to consistent signaling from the BoJ, this policy move has been largely discounted by markets. Indeed, since the day of the announcement of the end to the quantitative easing policy, the yen has not moved much, and the rise in short and long-term rates has been limited.

Japan: Interest Rates

(In percent)

Source: Bloomberg LP.

However, changes in global financial conditions could still potentially bring about some disorderly unwinding of the yen carry trades. Yen carry trade activities have been attractive thanks to the current benign international financial environment and the relative strength in the U.S. dollar, especially against the yen. However, any change in dollar/yen exchange rate expectations that could arise in case of an earlier end to monetary tightening in the United States, or a rise in emerging market spreads, could potentially affect the attractiveness of these trades, thereby leading to some unwinding and volatility in financial markets. Such a situation occurred in 1998, when triggered by some weakening of the dollar and a rise in emerging market spreads following the Russian crisis, yen carry trades unwound abruptly leading to a rise in volatility in financial markets, and reinforcing the initial rise of the yen against the dollar and the rise in risk aversion. Recent developments in the United States, such as the rise in long-term yields to their highest since the beginning of the monetary tightening, and the impact it could have on emerging market spreads could give cause for caution.

In any event, the impact of an unwinding of the yen carry trades on emerging Asia should be manageable. First of all, since 1998, G-10 supervisors have taken steps to improve the regulation of highly-leveraged activities and therefore, financial market volatility as the yen carry trades are unwound should be limited. But also, emerging Asian economies have become more resilient to shocks on their capital accounts as external vulnerabilities have been reduced: external debt levels have declined, foreign reserves are ample, and exchange rates have become more flexible. Therefore, any unwinding of the yen carry trade is not expected to have much of an impact on regional economies, as long as this is not accompanied by a sharp slowdown of the world economy.

2 Precise estimates of the magnitude of the yen carry trade are difficult, as the trades involve often offshore banks and over-the-counter derivatives for which data are difficult to obtain. But some private estimates indicate that it may be as large as $100 billion.3 Uridashi bonds are bonds issued to retail investors in Japan by foreign entities in foreign currency. Total issuance in 2005 was more than Y3 trillion. Given their high yield, the Australian and New Zealand dollars have been the main currencies of issuance.

Box 8.The Boom in Asian External Corporate Bonds

The Asian external (i.e. fx-denominated) corporate bond market has grown substantially over recent years, taking a significant step away from traditional forms of bank finance. Issuance grew nearly 50 percent between 2003 and 2004, and stayed at around the 2004 level last year. As a result, the stock of non-government external bonds outstanding has risen steadily and at the end of last year had risen by almost three-quarters to reach some $269 billion. This represents a significant change for firms in the region who previously relied for the most part on banks for their (non-internally generated) financing.

Asian Corporate FX-Denominated Bond Issuance

(In billions of U.S. dollars)

Source: JPMorgan.

The development of local currency markets has grabbed headlines in recent years, but issuance in foreign currencies remains extremely relevant for many firms. Some borrowers, such as exporters, have fx-denominated streams of revenues that they want to match with similarly denominated liability streams. Others need the foreign currency for import-intensive fixed asset investment. Increasingly, Asian corporates have operations outside the countries in which they are headquartered, and may need foreign exchange to service those operations. More broadly, some see the current low global interest rate environment as offering a unique opportunity lock in long-term funding at rates that have not been seen for many years. External bond markets offer the opportunity to place larger, longer-term, and more structured bonds than can be sold in local markets. For the region’s bigger firms with heavier borrowing needs, the external markets therefore offer an attractive option.

International Private Debt Outstanding(In billions of U.S. dollars)
Dec-97Dec-01Dec-05
China
Financial institutions11.09.621.0
Corporates1.82.21.0
Total12.811.822.0
Hong Kong SAR
Financial institutions17.127.841.6
Corporates5.510.415.5
Total22.638.257.1
Indonesia
Financial institutions14.37.910.3
Corporates2.80.90.3
Total17.18.810.6
Japan
Financial institutions182.8198.3215.5
Corporates125.450.159.0
Total308.2248.4274.5
Korea
Financial institutions30.622.352.0
Corporates18.019.425.4
Total48.641.777.4
Malaysia
Financial institutions2.33.718.5
Corporates8.99.96.5
Total11.213.625.0
Philippines
Governments4.63.14.3
Financial institutions3.94.55.3
Corporates8.57.69.6
Singapore
Financial institutions2.811.724.8
Corporates1.56.010.0
Total4.317.734.8
Taiwan Province of China
Financial institutions1.21.65.0
Corporates5.26.519.3
Total6.48.124.3
Thailand
Financial institutions7.85.64.4
Corporates4.83.33.8
Total12.68.98.2
Total ex. Japan
Financial institutions91.793.3181.9
Corporates52.463.187.1
Total144.1156.4269.0
Source: Bank for International Settlements.

For many borrowers, it is important to have a multiplicity of sources of finance should any one of their traditional sources dry up temporarily. They are therefore keen to keep their names known on international, as well as local, markets. Governments have been supportive of these strategies and have been willing to issue sovereign external debt that provides a risk-free benchmark against which their corporates can be priced. Meanwhile, local interest rates in several key Asian countries have been ratcheted up in recent quarters as the authorities there bear down on inflation. One of the advantages of local market borrowing has therefore waned and borrowers have turned again to the external market.

External debt outstanding is now somewhat more balanced across the region (see table). Korean quasi-sovereigns and banks have been very active issuers over recent years, as they were before the crisis, and Korea has retained its position as having the largest stock of external bonds. The sovereign has been active in maintaining a benchmark curve, and Korean borrowers are widely recognized names in the market. The region’s financial centers of Hong Kong SAR and Singapore have shown large rises in issuance in recent years, principally from their financial institutions as economic recovery has become more established, and the earlier problems of non-performing loans have been tackled.2 Taiwan Province of China has shown a particularly rapid rise in external issuance, driven mainly by a surge in borrowing by technology companies.3

Demand has been strong and the spreads on benchmark corporate bonds have tightened steadily over recent years. The main factors driving external corporate spreads tighter are the generally supportive environment for emerging markets, the strength of the “Asian bid”4, and growth in the region’s of savings and investment institutions. Asia is seen as having good supply-demand dynamics, low volatility, and limited risk of credit deterioration driven by M&A activity (which is often seen as pushing up debt levels to the detriment of bondholders). That said, the region’s external fixed income market is generally seen as expensive compared with other regions, and prospects of benefiting from ratings upgrades are often seen as higher in other parts of the world.

Asian Bond Spreads

(In basis points)

Source: Bloomberg LP.

The development of the Itraxx Asia index of regional credit default swaps has made it much easier and cheaper for investors to hedge or adjust their positions. It has therefore made it possible to express a much broader range of credit views than the traditional buy-and-hold, ‘long-only’ investors that have dominated in the past. Analysis of credit default swaps, and the ‘basis’ (broadly, the gap) between CDS spreads and the spreads on the underlying bonds are an integral part of credit analysis in the region.

Outlook and Risks

Looking ahead, a number of trends will require careful attention. First, the global credit cycle is turning, and Asian corporates are considered to be in the vanguard of this trend as the region has been growing rapidly for several years. Asia’s ratings upgrade-to-downgrade ratios have compared favorably with other emerging market regions over recent years, and are expected to hold up in coming quarters, but there will come a point at which the trend will turn. Second, some analysts argue that the Asia bid is weakening as issuance continues at a strong pace and banks are increasingly finding other uses for their surplus funds. Korea, Thailand, and Malaysia are seen as the countries where the appetite for external corporate debt might fall most. Third, it is not yet clear when Asian banks will adopt the Basle II ratings approach. When this happens, some analysts believe it will require an increase in the capital requirements for many banks as they have relatively more of the assets that will attract higher capital charges under Basle II. Some argue that banks in Indonesia, the Philippines, and Thailand will face the largest challenges during the transition to Basle II.

The main risks for holders of Asian external corporate bonds are a broader sell-off in emerging market assets amid a general increase in risk aversion. A fall-off in the prices of a broad range of commodities are also potentially negative for the region and for its corporates, especially if this is as a result of a slowdown in the pace of global growth. Even so, this is likely to affect Asian external credits less than credits in some other countries that have been more heavily favored during the run-up of emerging market assets in recent months. Some even believe the region’s external bonds will display some defensive qualities in the event of a sell-off in emerging market assets.

2 For these borrowers, a particular attraction of the external debt market is the ease with which they can offer subordinated debt, including “upper tier 2” capital.3 For high-tech companies, the possibility of issuing convertible bonds is important as it allows them to capture some of the valuable option premiums on their shares. It is easier to issue convertible bonds in the external market, where investors are familiar with these structures, than in the local markets.4 The “Asian Bid” refers to the deposits that the regional banks hold in excess of those they need to meet loan demand and reserve requirements. Much of these are invested in debt from their own country, or other countries in the region.

Box 9.Regional Financial Integration Initiatives—An Update

Recent efforts to advance regional financial integration have focused on two areas. First, local currency bond funds are being introduced under the Asian Bond Market Initiatives (ABMIs). And second, existing arrangements to swap foreign exchange reserves in case of liquidity crises are being expanded under the Chiang Mai Initiative (CMI).

Asian Bond Market Initiatives

Historically, bond markets have not played much of a role in regional financial systems. This is largely because governments have traditionally maintained strong fiscal positions and have not had to issue much debt, while large corporations have been able to secure sufficient financing at low interest rates from commercial banks. But bond market underdevelopment also reflects deficiencies in market infrastructures and regulatory environments. It is these deficiencies that the Asian Bond Market Initiatives aim to address, in the expectation that more developed local bond markets could reduce countries’ exposure to maturity and exchange rate risks.2

A key aspect of the Asian Bond Market Initiatives has been the development of the Asian Bond Funds (ABFs). The first ABF aimed at stimulating demand for U.S. dollar bonds issued by members of the Executive Meeting of East Asia and Pacific (EMEAP) by using the region’s foreign exchange reserves to buy them.3 The second ABF, launched in June 2005, aims to promote local currency bond markets, by establishing a Pan-Asian Bond Index Fund (PAIF) and eight single-market funds (SMFs).4 Initially, the EMEAP authorities invested $1 billion in the PAIF and are committed to invest a total of $1 billion in the SMFs.

These funds have now been opened to the public, with the aim of offering investors a low-cost/low-risk way of entering local bond markets. The PAIF is now trading on the Hong Kong Stock Exchange as an open-ended bond fund, managed privately and benchmarked to iBoxx Pan-Asia Index. As of mid-April 2006, about three-fifths of the index was comprised of bonds issued in Korea, Singapore, and Hong Kong SAR, giving it an average credit rating of A-/BBB+ and duration of four years.5 As for the eight SMFs, three have been listed so far as exchange-traded funds (Hong Kong SAR, Malaysia, and Singapore), with the Thailand fund also recently publicly offered. In addition, SMFs have been set up (but not yet publicly offered) in Korea and Indonesia, with China and the Philippines expected to follow by mid-2006.

Both the PAIF and SMFs have been well received by the market, but initial private investments have been small. The net asset value of the PAIF was just $1.2 billion as of mid-April 2006 (including the $1 billion from EMEAP), and daily trading volume has been low. However, the three SMFs funds have been growing rapidly since their initial listings, since they provide an attractive way for investors to enter specific markets of interest.

Despite this slow start, the ABFs have also spurred bond market development. For instance, the ABF-II has led to the creation of local-currency bond indices which can be used to benchmark investment funds, including the ABF-II SMFs. The ABFs have also encouraged the establishment of other exchange-traded funds in several countries, and are expected to foster development of local-currency fixed-income derivatives, including bond futures.

Meanwhile, on the supply side, the Asian Bond Market Initiatives continue to be aimed primarily at improving market efficiency and activity. Steps have been taken over the past year to extend the benchmark yield curve (Indonesia, Korea, and Malaysia), improve trading infrastructure (China and Thailand), and attract offshore investors (China, Malaysia, and Vietnam).6 Further steps envisaged under a progress report issued by ASEAN+3 group in November 2005 include: (i) creating new securitized debt instruments; (ii) studying new credit guarantee mechanisms, including possible regional ones; (iii) examining regional settlement issues, in particular impediments to cross-border bond investment and issuance; and (iv) enhancing the credibility of local credit ratings agencies.

Chiang Mai Initiative

As for the CMI, this initiative continues to expand and evolve. The CMI aims to reduce the risk—and alleviate the consequences—of liquidity crises by establishing a network of bilateral swap arrangements between select ASEAN members and China, Japan, and Korea (the +3 countries).7 In Istanbul in May 2005, the ASEAN+3 agreed to double the size of these arrangements, resulting in a $30 billion increase over the past year, to $71.5 billion. In addition, the draw-down mechanism has been changed. The amounts that can be activated without linkage to an IMF facility has been increased from 10 percent of the maximum amount of drawing to 20 percent, in the event that swap-providing countries deem the swap-requesting country as facing short-term liquidity problems owing to sudden market irregularities.

The Istanbul Agreement also laid out a path for further development. Eventually, the CMI could be “multilateralized”, by establishing a clearly defined process for activating the swaps and a collective decision-making mechanism for doing so, and potentially also by pooling some of the group’s reserves. To lay the groundwork for this, the ASEAN+3 is planning to develop its regional surveillance, in concert with the surveillance provided by existing institutions, such as the IMF. Over the longer term, a further objective is to make more intensive use of local currencies in the CMI framework.

Following Istanbul, a study group was set up to consider possible routes toward multi-lateralization. This group submitted a report to the ASEAN+3 Finance and Central Bank Deputies meeting in April 2006, and further discussions will be held in the ASEAN+3 Finance Ministers meeting in India, in May this year.

2 The Asian Bond Market Initiatives comprise the Asian Bond Fund, the ASEAN+3 Asian Bond Markets Initiative, the APEC Regional Bond Market Initiative, and the Asia Cooperation Dialogue Asian Bond Market Initiative.3 The members of EMEAP are: Australia, China, Hong Kong SAR, Indonesia, Japan, Korea, Malaysia, New Zealand, the Philippines, Singapore, and Thailand.4 The PAIF and eight SMFs exclude in local currency bonds issued in Japan, Australia, and New Zealand.5 Country weights in this index take into account market capitalization, liquidity, and openness, as well as a country’s sovereign rating and trading infrastructure, and are rebalanced monthly.6 See the Asian Development Bank’s Asia Bond Monitor (November 2005) for further details.7 While all ASEAN members can participate in the CMI, the newest ones (Cambodia, Lao PDR, Myanmar, and Vietnam) in principle have access to concessional foreign assistance.

Box 10.Are Regional Trade Agreements In Asia Open or Closed Blocs?

Preferential trade agreements are proliferating around the world, including in the Asia and Pacific region. At least 23 such agreements among regional economies have entered into force in the past five years, and currently about 30 additional ones are under negotiation.

Conventional economic theory questions the benefits of Regional Trade Agreements (RTAs). In principle, preferential trade agreements are economically inferior to nondiscriminatory trade liberalization on most-favored-nation (MFN) basis. Indeed, there is a risk that they can easily turn into closed blocs, preventing progress toward further multilateral liberalization. RTAs could divert resources away from multilateral trade liberalization, including in the context of WTO negotiations, and could create incentives for regional trade partners to lobby against any MFN-based reforms that would reduce the value of their tariff preferences, thus undermining prospects for future broader trade reforms.

Consequently, it is useful to ask whether the recent proliferation of preferential agreements in Asia is a healthy development, or whether it will result in an unmanageable “noodle bowl” regionalism in the future, more likely to divert trade than to create it.

The results of a recent IMF staff study shed some light on this question. They suggest that trade among members in Asia’s RTAs has expanded very rapidly in recent years—but not at the expense of trade with nonmembers.2 In fact, trade among members seems to have grown in tandem with trade with other regions of the world so far. However, looking forward, a further proliferation of RTAs runs the risk of becoming a substitute for multilateral trade liberalization. To guard against this risk, Asian countries would be well-advised to continue to pursue broad-based trade liberalization both at the regional level and in the context of the WTO.

Preferential Trade Agreements in the Asia and Pacific Region, 20051
Regional Trade AgreementsBilateral Trade Agreements
Already in force:
AFTA (ASEAN Free Trade Area), 1992, 1993Australia-New Zealand (CER, Closer Economic Cooperation, 1983, 1983)
Australia-Singapore, 2003, 2003
ASEAN-China Free Trade Agreement, 2004, 2005Australia-Thailand, 2004, 2005
Australia-United States, 2004, 2005
China-Hong Kong SAR, 2003, 2004
Bangkok Agreement, 1975, 1976China-Macao SAR, 2003, 2004
China-Thailand, 2003, 2003
Pacific Island Countries Trade Agreement (PICTA), 2001, 2001India-Sri Lanka, 1998, 2001
India-Thailand, 2003, 2004
Japan-Mexico, 2004, 2005
SAARC Preferential Trade Agreement (SAPTA), 1993, 1995Japan-Singapore, 2002, 2002
Korea-Chile, 2003, 2004
Korea-Singapore, 2005, 2006
Trans-Pacific Strategic Economic Partnership Agreement (TPSEPA), 20052Lao PDR-Thailand, 1991, 2001
New Zealand-Singapore, 2000, 2001
New Zealand-Thailand, 2005, 2005
Singapore-European Free Trade Association, 2002, 2003
Singapore-Jordan, 2004, 2005
Singapore-United States, 2003, 2004
Sri Lanka- Pakistan, 2005, 2005
Vietnam-United States, 2000, 2001

A gravity model is used to assess the impact of RTAs on the level and direction of trade. The model is based on the idea that trade between two countries is analogous to the gravitational force exerted between two objects. Thus, trade is a function of the countries’ mass (in this case, GDP and GDP per capita) and the distance between them. Theories of trade under perfect competition can be used to justify the gravity equation: a country is more likely to trade with economically larger countries that produce a greater variety of goods to offer, while GDP per capita also has a positive effect on trade, since as countries become more developed, they tend to specialize more and, therefore, trade more.

The following gravity model was estimated in line with Wei and Frankel (1997):3

The dependent variable is bilateral trade (exports plus imports) between country pairs. The independent variables, beside GDP and GDP per capita, are: distance, common border, common language and two dummy variables that represent common membership in a regional agreement: RTA2, where the suffix 2 implies that both countries, i and j, are members of the same RTA, and RTA1, where the suffix 1 implies that either i or j belongs to the tested RTA.

The coefficients of RTA2 and RTA1 can be interpreted as follows:

  • A positive coefficient for the RTA2 variable indicates that an RTA tends to generate more trade among its members than any random country pair that does not belong to any RTA.

  • A positive coefficient on the RTA1 variable indicates that trade between an RTA member and a nonmember is higher than one would expect given their economic size, distance and other geographic and cultural characteristics; this could be taken as an evidence of an open trade bloc.

  • A negative coefficient on the RTA1 dummy, instead, implies that trade between a member of an RTA and a nonmember is smaller, on average, than that between two otherwise similar countries that are not RTA members, which may indicate possible trade diversion.

  • The difference between RTA2 and RTA1 dummies (when positive) can be interpreted as a measure of intraregional bias: how much more an RTA member trades with another member than with a nonmember.

The study considers the following preferential trade agreements with Asia: the Australia-New Zealand Closer Economic Relationship (CER), ASEAN, and the Agreement on South Asian Association for Regional Cooperation (SAARC) Preferential Trading Arrangement (SAPTA), which includes: Bangladesh, Bhutan, India, Maldives, Nepal, Pakistan, and Sri Lanka; and the following RTAs outside the region: the Eurasian Economic Community (EAEC), which includes: Belarus, Kazakhstan, the Kyrgyz Republic, the Russian Federation, and Tajikistan; the European Union—comprising 15 members (EU-15): Austria, Belgium, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Portugal, Spain, Sweden, and the United Kingdom; the Southern Common Market (Mercosur) which comprises: Argentina, Brazil, Paraguay, and Uruguay; and the North American Free Trade Agreement (NAFTA), which includes: Canada, Mexico and the United States.

Two different estimates were run. The first one includes only preferential trade agreements within Asia: CER, ASEAN, and SAPTA, while regression 2 includes also RTAs outside the region: the EAEC, the EU-15, Mercosur, and NAFTA. The data set covers 182 countries for a total of 45,863 country pairs for the period 1993-2003. The sample includes data for 1993, 1996, 1999, 2002, and 2003. Bilateral trade data are extracted from the UN COMTRADE database. An OLS panel regression technique, which allows for year-specific effects, is employed.

The results suggest that during 1993-2003 membership in major RTAs in Asia (CER, ASEAN and SAPTA) does not appear to have led to trade diversion. While trade has grown rapidly among members for RTAs, this was not associated with any decrease in trade with nonmembers, as the signs of each of the RTA2 and RTA1 dummies are positive when statistically significant. More specifically:

  • Bilateral intra-ASEAN trade is estimated to be 54 percent greater than the bilateral trade of ASEAN members with non-members [exp(1.33-0.90)-1=0.54]. CER countries show an even higher degree of intra-regional trade: Australia and New Zealand trade about 2.4 times more between themselves than with other countries [exp(1.35-0.11)-1=2.45], while the intra-SAPTA trade is estimated to be around 63 percent greater than the bilateral trade of SAPTA members with non-members (Regression 1).

  • Compared to other RTAs around the world, the results also suggest that the members of RTAs in Asia—especially ASEAN—showed a higher degree of openness with nonmembers than other RTA countries outside the region do. In particular, ASEAN countries trade 144 percent more [(exp 0.89)-1=1.44] with outside countries than one would predict given their size, GDP per capita income, and geographical and cultural characteristics. The EU-15 and Mercosur countries trade, respectively, 10 percent and 12 percent more with outside countries than the model’s prediction, while NAFTA countries trade on average 33 percent less with nonmembers than one would expect given the standard gravity determinants. The last result, which is in line with the findings of previous studies,4 can be explained by the presence of complementarily in production (i.e., NAFTA countries do not have the same comparative advantages), and by the fact that, in the case of Mexico, the majority of trade takes place under preferential rules.

Pooled Estimations of the Gravity Model, 1993-2003
(1)(2)
Ln GDP0.980.99
(0.000)***(0.000)***
ln GDP per capita0.110.11
(0.000)***(0.000)***
ln distance-1.30-1.30
(0.000)***(0.000)***
common border0.710.68
(0.000)***(0.000)***
common language1.021.07
(0.000)***(0.000)***
ASEAN 10.900.89
(0.000)***(0.000)***
ASEAN 21.331.34
(0.000)***(0.000)***
CER 10.110.08
(0.093)*-0.26
CER 21.351.26
(0.093)*-0.116
SAPTA 10.210.21
(0.000)***(0.000)***
SAPTA 20.690.72
(0.000)***(0.000)***
EU-15 10.09
(0.000)***
EU-15 2-0.87
(0.000)***
EAEC 10.03
-0.501
EAEC 23.12
(0.000)***
MERCOSUR 10.11
(0.005)***
MERCOSUR 20.47
-0.152
NAFTA 1-0.44
(0.000)***
NAFTA 2-0.74
-0.114
Constant13.0512.98
(0.000)***(0.000)***
Observations45,86345,863
Adj. R-squared0.7370.739
Source: IMF Staff estimations.P-values in parenthesis. *, ** and *** denote significant at 10%, 5% and 1% level.

One main reason that could explain why RTAs in Asia appear to have been more trade-creating than other RTAs to date is the fact that regional trade integration in Asia followed a long period of unilateral liberalization during the 1980s and 1990s. Subsequently, regional integration efforts proceeded in parallel with multilateral liberalization. In fact, many Asian countries acceded to the WTO in the mid-1990s, and lowered their MFN tariff rates substantially, thereby limiting the risk of possible trade diversion under subsequently agreed RTAs. Moreover, as reported recently by Baldwin5, the implementation of ASEAN Free Trade Area (AFTA) appears to have had limited practical impact on trade flows to date, with only a small fraction of intra-ASEAN trade benefiting from AFTA’s preferences. One likely explanation for this is that the administrative costs associated with verifying that AFTA’s rules of origin have been observed may often be perceived to be too large compared with the differential between the Common Effective Preferential Tariff (CEPT) and the corresponding MFN tariffs.6

Simple Average MFN Tariffs1(In percent)
19972005
ASEAN10.18.8
CER5.53.3
EAEC10.98.4
EU-1510.06.5
MERCOSUR11.411.2
NAFTA8.89.5
SAPTA25.118.0
Memorandum item:
World15.511.4
Source: IMF Trade Policy Information Database (TPID).

Going forward, Asian countries need to recognize the risks associated with an excessive focus on regional trade arrangements that are no longer matched by multilateral liberalization. As noted in a number of recent studies and reports, the recent trend toward the negotiation and signing of multiple bilateral trade arrangements, including between ASEAN and other major Asian economies, could threaten the multilateral trading system, if regional integration is perceived as a substitute for multilateral liberalization.7 Therefore, Asian countries would be well-advised to continue pursuing concerted trade liberalization in accordance with the MFN principle, rather than focusing on regional trade preferences only. In particular, countries should guard against participation in multiple memberships in bilateral and regional trade agreements, which could have mutually inconsistent rules of origin that can substantially complicate production and sourcing decision by firms. Continuing to strengthen the outward-oriented policy vis-à-vis the rest of the world would be the best way to ensure that the Asia and Pacific region will reap the benefits from its ongoing international integration to the fullest extent possible.

2 Based on Tumbarello (2006): “Are Free Trade Agreements in Asia Building or Stumbling Blocs?” (forthcoming).3 Wei, S., and J. Frankel (1997), “Open versus Closed Regional Trade Blocks”, in Regionalism versus Multilateral Trade Arrangements, Ed. By T. Ito and A. Krueger (Chicago University Press).4 Wei, S., and J. Frankel (1997).5 Baldwin, R., 2006 “Managing the Noodle Bowl”, CEPR Discussion Paper, London.6 Rules of origin are established in free trade agreements to ensure that only goods originating in participating countries enjoy preferences. However, the administrative costs associated in proving conformity to these rules may lead to low utilization of the preferential trade scheme. Moreover, rules of origin can lead to trade diversion if they oblige partners to buy higher priced intermediate goods from a partner rather than on the lower-priced world markets.7 Baldwin op.cit. and AsDB, Asian Development Outlook 2006.

Box 11.Asia’s Investment Decline: Is it Real?

Investment in Emerging Asia outside China has declined sharply since the 1997 financial crisis. For example, comparing 1992-96 with 2000-04, private investment declined by 5-18 percentage points of GDP in Hong Kong SAR, Korea, Singapore, Malaysia and Thailand. This prolonged, sizeable, and broad-based decline raises an important question: is the investment decline real or has it simply reflected a fall in the price of capital equipment relative to the overall price of output?

To answer this question, it is necessary to first consider some simple identities. The nominal investment ratio is IY=PIQIPYQY where PI = price index for investment, QI = constant price quantity of investment, PY = price index for total output (GDP), and QY = constant price of output. Thus a fall in IY could reflect a decline in PIPY, or a fall in the relative price of investment goods.

A fall in the relative price of capital goods has in fact been occurring globally. Advances in technology have reduced the price of capital goods, particularly relative to the price of other types of goods. In the United States, for example, the ratio of the implicit price deflator of equipment and software to the overall GDP deflator declined by 40 percent between 1990 and 2004. Meanwhile, the relative overall price of investment goods has declined in emerging Asia excluding China, but much more moderately (only about a fourth as large). There are many possible reasons why the relative price decline has been more moderate in emerging Asia than in the United States, including considerable differences in statistical coverage and methodology (U.S. data are chain weighted and include hedonic adjustments for quality changes) and differences in the mix of investment goods.

In emerging Asia, real and nominal investment ratios have displayed broadly similar trends, suggesting that the investment slump is indeed real. During the crisis, the real investment ratio fell more sharply than the nominal ratio, but it has since recovered more rapidly. While the real ratio for the region as a whole is close to its 1990 level, this mainly reflects a sharp rise for India; for other countries, the ratio was on average about 5 percentage points of GDP lower in 2004 than in 1990. Moreover, the ratio of equipment investment to GDP has fallen more in real than in nominal terms.

Emerging Asia: Gross Fixed Investment1

(In percent of GDP)

Source: IMF, WEO database; and CEIC Data Company Ltd.

1 Excludes China.

It is unclear whether technical progress should result in a lower real investment rate. If the mix of capital goods has shifted towards more productive items, a lower aggregate investment rate would be warranted. At the same time, however, high-tech capital goods such as computers tend to depreciate faster than other capital goods, implying a need for a higher real investment ratio. Thus, technological innovation has an ambiguous effect on the optimal investment rate. Indeed, the nominal investment ratio in the G-7 countries actually trended upwards slightly over most of the 1990s, and the U.S. nominal investment ratio is presently somewhat above its 1990–2005 average.

Selected Asian Countries: Real Investment1

(In percent of real GDP)

Sources: CEIC Data Company Ltd; and IMF, World Economic Outlook.

1 Comprises Korea, Singapore, Taiwan Province of China, Philippines and Thailand.

References

All ratios to GDP are expressed in terms of expenditure-side GDP prior to the revision. Production side GDP was revised upwards recently due to greater coverage of the services sector. However, with the exception of 2004, the revised expenditure side GDP and components have not yet been published. Deflating the unrevised expenditure components with the revised and higher production-side GDP would lower all the ratios and leave nearly 10 percent of GDP unaccounted by expenditure components. Thus the historically consistent series of expenditure-side GDP is used as the denominator instead. The revised 2004 expenditure side data imply consumption and investment ratios very close to those prior to the revision, suggesting that the further expenditure-side revisions may not change the ratios significantly and should not alter the assessment in this paper.

Household savings for the period before 1992 are discussed in Kraay (2000), which showed a steady decline of the household savings to GNP between 1983 and 1995. The exact magnitude of the components of overall savings, i.e., savings by households, enterprises, and the government are difficult to disentangle, but estimates suggest that households save about 16-18 percent of GDP, with enterprises around 18-22 percent of GDP, and government between 6-10 percent of GDP (estimates by Kuijs (2005) and Chamon and Prasad (2005) are broadly similar).

Until recently, about two thirds of the shares of the listed companies in China’s stock market were nontradable. The uncertainties about how the issue may be resolved, in particular the concerns that these shares will flood the market, have resulted in depressed stock prices and low participation in recent years. The government recently launched a program to convert these nontradable shares into tradable ones.

Another source of household wealth is their housing assets, which have appreciated strongly in China during recent years (an annual average rate of 5 percent). While the larger wealth associated with higher housing prices may encourage some households to increase their consumption, others may be forced to save more for their future house purchases given their liquidity constraints. Thus, the impact of a booming housing market on the aggregate consumption in China is ambiguous.

The one-child policy, although less strictly implemented in rural areas, is held responsible for giving rise to the “2-4-1 problem” in the coming years. Loosely speaking, this refers to the fact that each 2-person working household will need to support 4 elderly parents and one child.

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