Chapter

I. Overview

Author(s):
International Monetary Fund. Asia and Pacific Dept
Published Date:
November 2008
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Implications of the Global Financial Crisis for Asia’s Outlook

The global economy is projected to enter a major downturn amid a significant and deepening financial crisis. The credit turmoil that began in advanced countries has spread to emerging and developing economies, raising concerns over a synchronized slowdown and a global credit squeeze. Extraordinary policy actions globally have helped to shore up confidence, but financial markets are likely to remain under considerable stress as the process of deleveraging continues for some time and growth slows markedly. Aggressive policy easing, some stabilization in the U.S. housing market next year, and lower commodity prices should lay the groundwork for a recovery to take hold in late 2009. However, the pace of the recovery is likely to be very gradual given the considerable financial constraints on activity. Moreover, there is great uncertainty about the duration and depth of the expected downturn. Against this backdrop, growth in Asia is expected to slow substantially along with that in the rest of the world, as exports weaken and spillovers from the global financial turmoil weigh on domestic activity. The risks to the outlook are significant and firmly tilted to the downside, stemming mainly from a deeper and more-protracted global slowdown and tighter financial conditions from continued deleveraging. With commodity prices projected to ease, inflation should subside, providing room for policies to support growth and stabilize financial conditions.

The Deepening Global Financial Crisis

The turmoil in financial markets intensified in September 2008 following the bankruptcy of Lehman Brothers and other institutions and the extension of emergency credit lines to American International Group (AIG), as market participants lost confidence that the case-by-case approach to defaults adopted so far would prove effective in the face of mounting systemic risks. Money markets, interbank markets, and markets for short-term commercial paper in the United States and Europe largely froze, as reflected, inter alia, in bank credit default swap (CDS) and corporate bond spreads, which rose to unprecedented levels (Figures 1.1 and 1.2).

Figure 1.1.Bank CDS Spreads

(5-year, in basis points)

Source: Bloomberg LP.

Figure 1.2.U.S. Corporate Bond Spreads

(10-year AAA-rated, in basis points)

Source: Datastream.

As the turmoil intensified, financial institutions accelerated their process of deleveraging, which, together with deepening fears that the crisis was spreading into the real economy, led to a sharp sell-off in global equity markets and the largest-ever spike in measured equity volatility. At the same time, dollar liquidity dried up as financial institutions around the world refused to lend to each other (Figure 1.3), with banks heavily dependent on wholesale funding particularly affected.

Figure 1.3.Cross-Currency Basis Swaps with U.S. Dollar

(1-year tenors, in basis points)

Source: Bloomberg LP.

The deepening crisis led countries to take decisive policy actions, including the public recapitalization of financial institutions and extension of deposit guarantees. Central banks also introduced new facilities to inject liquidity into financial institutions or in some cases directly into money markets or commercial paper markets, resulting in a large expansion of their balance sheets (Figure 1.4). As a result of all these initiatives, liquidity strains in the main financial centers have eased, as seen in substantial drops in money market spreads (Figure 1.5).

Figure 1.4.Total Assets on U.S. Federal Reserve’s Balance Sheet

(In billions of U.S. dollars)

Source: U.S. Federal Reserve.

Figure 1.5.Money Market Spreads

(3-month LIBOR minus government bond yields, in percent)

Sources: Bloomberg LP; and Datastream.

The modest easing in financial conditions seen in recent days will not, however, prevent the major slowdown in real economic activity already underway in the industrial countries. High-frequency data such as those for industrial production growth are now in negative territory (Figure 1.6), and forward-looking indicators signal more pain ahead.

Figure 1.6.Industrial Production

(Year-on-year percent change)

Source: Haver Analytics.

With the crisis intensifying in industrial countries, strains have spread to emerging markets. These markets, which for a while had seemed relatively insulated from the crisis, are now reeling as investors fly to safety in a context of deep uncertainty about global growth prospects. Equity markets in emerging countries have fallen substantially more than those in industrial countries, some 50 percent from 2007 peaks (Figure 1.7). At the same time, emerging markets’ sovereign spreads have increased dramatically in response to heightened anxiety about their ability to meet their debt obligations (Figure 1.8).

Figure 1.7.MSCI Equity Markets

(January 1, 2007=100)

Source: Bloomberg LP.

Figure 1.8.Emerging Market CDS Spreads

(5-year sovereign spread, in basis points)

Source: Bloomberg LP.

Key Risks to Asia from the Deepening Global Financial Crisis

Compared to other regions, Asia would have appeared a priori better placed to weather the storm with its substantial cushion in official reserves, improved macro policy frameworks, and generally robust corporate balance sheets and banking systems. Nevertheless, Asia is being rattled by the crisis as a result of its close trade and financial integration with the rest of the world, and any hope that the region would escape the crisis unscathed has by now evaporated. Looking ahead, the key financial risks for Asia stem from volatile capital flows, tighter external financing, and disruptive spillovers to domestic markets, which could lead to a sharp credit squeeze and slower growth.

The Global Turmoil Has Led to Significant Equity Declines

Asian equity markets have been hit hard this year by the global turmoil. Contrary to 2007, when Asian equity markets were the top performers, share prices this year have fallen sharply, as the growth outlook for the region has weakened. The MSCI emerging market Asia index has declined in line with other regions, falling by 49.6 percent from end-2007 to October 2008, compared to 34.1 percent for the United States, 58.5 percent for emerging Europe, and 41.3 percent for emerging Latin America. The equity declines have been led by heavy net selling, primarily by foreigners, but in some cases, such as in China, also by local residents (Figure 1A.1). From August 2007 through October 2008, net equity outflows amounted to US$160 billion, while Asia-focused hedge funds were the worst performers worldwide, with their returns consistently below those of other emerging market funds. With redemption pressures rising, the loss of several key prime brokers, and the recent bans on equity short selling (including in Australia, Korea, and Taiwan Province of China), hedge funds, including those in emerging Asia, remain under intense pressure to deleverage and reduce positions.

External Financing Is Likely to Remain Tight

With the rise in global risk aversion, external financing conditions have tightened substantially. Since June, CDS spreads for Asian sovereign, corporate, and financial borrowers have widened in line with global trends. For a number of countries, basis spreads for cross-currency swaps have also increased, reflecting both increased counterparty risk and heavy demand for U.S. dollar liquidity (Box 1.1). The cost of wholesale financing, particularly on external debt, has risen significantly. This has affected all countries that have made use of such funding (notably Australia, Korea, and New Zealand). With U.S. dollar and euro bond markets affected by the global credit squeeze, corporates in Asia have increasingly turned for alternative financing to the samurai bond markets in Japan, as well as the Malaysian ringgit market, but these markets have also dried up with the distress among major global banks that serve as key underwriters.

Box 1.1.The Widening of Basis Spreads in Asia

Cross-currency basis swap spreads (“basis spreads”) have widened for a number of Asian currencies, reflecting market stress over and beyond the volatility signaled by spot exchange rates. Basis spreads provide a useful indication of market funding pressures, and the recent negative shift suggests greater difficulties in obtaining U.S. dollar funding in the midst of the global credit crisis.

What Are Basis Spreads?

Basis spreads measure the deviation between the market interest rate and the interest rate implied by spot and forward exchange rates. For example, if one-year interest rates in the United States and Japan are 4 percent and 1 percent, respectively, the spot exchange rate is ¥103 to the dollar, and the one-year forward exchange rate is ¥100 to the dollar, then the basis spread is zero. The 3 percent interest rate advantage for the U.S. dollar matches the expected 3 percent appreciation of the yen, and the Japanese market interest rate is equivalent to that implied by the forward and spot rates.1 In practice, however, the forward exchange rate is likely to entail a nonzero basis spread and would then represent riskless profit that would be available to an arbitrageur with no transactions costs and full access to all interbank markets.

Example of a Cross-Currency Swap

Note: Initial exchange of principal is made at the prevailing spot rate.

Basis spreads can also be calculated from cross-currency swaps, where parties exchange regular interest payments in two different currencies using the London Interbank Offered Rate (LIBOR) or a similar interbank benchmark rate. In a cross-currency swap, as opposed to a currency forward, the basis spread is generally quoted directly. In a basis swap—defined as a cross-currency swap in which the interest rates on both sides of the swap are floating and therefore not known in advance—the basis spread is quoted with respect to interbank rates as, for example, a five-year swap of floating yen against floating dollars at three-month yen LIBOR minus 30 basis points (the basis spread).2 Cross-currency swaps are often used to borrow foreign currency, but the swaps themselves are not an original source of funding. For example, if a Korean firm wishes to obtain dollar funding using cross-currency swaps, it must first borrow in local currency, such as through the repo market, and then swap the proceeds into U.S. dollars. Although data are limited (as cross-currency swaps are traded mainly over the counter), cross-currency swap markets have emerged as important funding and/or hedging channels for both domestic and foreign players in Asia.

Why Do Basis Spreads Arise?

Nonzero basis spreads—representing a departure from a fundamental arbitrage condition—can arise for a number of reasons:

  • Arbitrage constraints. The persistence of large spreads could indicate constraints on the free movement of capital. In the absence of capital account impediments, as with global currencies such as the euro or the yen, basis spreads rarely exceed 50 basis points. Basis spreads could thus be an indicator of currency pressures that are not being reflected in the spot market on account of capital account restrictions.

  • Funding pressures. Just as basis spreads may signal demand for one currency, they may also reflect the difficulty of borrowing in the other currency in the swap or forward markets (i.e., relative shortage). Market volatility can also play a role in the widening of basis spreads.

  • Counterparty risk. Concerns over the creditworthiness of a borrower would give rise to a risk premium in the basis spread. For example, during the banking crisis of the late 1990s, Japanese banks, with their lower credit rating relative to overseas banks, faced a premium in borrowing in foreign currency using cross-currency swaps.

  • Foreign exchange intervention. Market intervention by a central bank can influence basis spreads, depending not only on whether the bank is buying or selling reserves, but also on whether the intervention is in the spot or forward market.

Basis Spreads in Asia Have Widened

In Korea, basis spreads have long been negative, mainly as a result of strong demand to hedge into domestic currency. Exporters, particularly shipbuilders, have sold U.S. dollars forward to domestic banks to hedge their long-term contracts. The banks in turn have hedged their exposure by borrowing U.S. dollars and exchanging them for won in the spot market. Since July 2007, Korean basis spreads have fluctuated widely (to as much as minus 400 basis points) during periods of financial stress when the onshore availability of U.S. dollars has dried up (consistent with the close correlation between Korean basis spreads and sovereign CDS spreads). Also, recent intervention through the foreign exchange swap markets may have widened the basis spread by driving up the forward rates relative to the spot rate.

Basis spreads in India have also widened amid greater volatility. Basis spreads in India have tended to persist, partly because of capital account controls that make cross-border arbitrage difficult. In early 2008, basis spreads widened to as much as minus 400 basis points as a result of an onshore shortage of U.S. dollars prompted in part by the earlier tightening of restrictions on external borrowing by Indian firms. Following a loosening of this restriction in May 2008, basis spreads narrowed but have remained negative, signaling continued U.S. dollar funding pressures.

Cross-Currency Basis Spreads1

Sources: Bloomberg LP; and IMF staff calculations.

1 Japan, Australia, and Korea are priced from 1-year basis swaps; India is priced from 3-month currency forwards.

2 Indian basis spreads are computed from 20-day moving average.

In Japan, the widening of basis spreads reflects both U.S. dollar funding pressures and concerns over counterparty risk. Historically, yen–U.S. dollar basis spreads have been quite tight, reflecting the openness of Japan’s capital account. However, in October, one-year basis spreads widened to as much as minus 70 basis points, reflecting both growing U.S. dollar funding pressures onshore and Japanese banks’ concerns over the creditworthiness of foreign banks using swaps as a source of U.S. dollar funding. In April 2008, after the collapse of Bear Stearns, basis spreads for longermaturity yen-dollar swaps, such as for 10 years, swung in the opposite direction, turning sharply positive, by as much as 50 basis points, as foreign banks scrambled to repay yen obligations through the swap market as the exchange rate surged to a 13-year high of ¥96/U.S. dollar. This development stood in contrast to the “Japan premium” of the late 1990s and early 2000s, when Japanese banks had to pay a premium on their U.S. dollar borrowing from foreign banks on account of Japan’s lower credit rating.

Note: The main author of this box is Chris Walker.1This is equivalent to covered interest parity, that is, (1 + i) = (1 + i*)(S/F), where i is the U.S. dollar interest rate, i* is the local currency interest rate, S is the spot exchange rate in units of local currency to the dollar, and F is the forward rate. The basis spread can be thought of as the measured deviation from covered interest rate parity.2In other words, Bank B lends yen at 30 basis points below yen LIBOR to Bank A, and Bank A lends dollars at the current dollar LIBOR rate to Bank B.

Emerging Asia private external financing (bond, equity, and loan issuance) has fallen steadily this year, reaching only US$137 billion through the third quarter of 2008, compared to US$211 billion over the same period last year (Figure 1.9). In addition, the domestic initial public offering (IPO) market, such as that in Hong Kong SAR, has collapsed (Figure 1.10). As funding has become more difficult, Asian corporations have delayed new bond issuances, refinanced at short maturities, or turned to local banks. If current trends continue, corporations are likely to face greater scrutiny of their ability to refinance their obligations, particularly during 2010–2012, when more than half of corporate bonds are estimated to fall due (Figure 1.11). Countries with sizable short-term external debt will also face greater difficulties in refinancing.

Figure 1.9.Asian External Financing: Bond, Equity, and Loan

(In billions of U.S. dollars)

Sources: IMF, Bond, Equities, and Loans database; and Dealogic.

Figure 1.10.Hong Kong SAR: Stock Market IPO

(In billions of Hong Kong dollars)

Source: Hong Kong SAR Securities and Futures Commission.

1 Shares of companies incorporated in mainland China that are traded on the Hong Kong Stock Exchange.

Figure 1.11.Emerging Asia: Amount of Maturing Corporate Debt, 2008–2018

(In billions of U.S. dollars)

Source: Morgan Stanley.

Note: Includes bonds and loans.

Capital Flows Are Likely to Remain Volatile

Portfolio outflows this year have significantly weakened currencies in some countries. In general, countries with projected current account deficits for 2008 have experienced much larger depreciations in nominal effective terms (Australia, India, Korea, New Zealand, and Vietnam), while surplus countries, like China, Japan, and Singapore, have seen their currencies gain (Figure 1.12). Several countries in the region have experienced substantial reserve losses as they have intervened in the markets to support their currencies in the face of capital outflows (Table 1.1).1 Amid increased volatility, yen carry trades have also declined.

Figure 1.12.Current Account Projections versus Change in Nominal Effective Exchange Rate (NEER), 2008

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

Table 1.1.Asia: Official Reserves(In billions of U.S. dollars, end-period)
200620072008

October1
Industrial Asia9641,0181,021
Japan895973978
Australia552729
New Zealand141715
Emerging Asia2,4773,2593,628
NIEs775848813
Hong Kong SAR133153161
Korea239262212
Singapore136163162
Taiwan POC266270278
China1,0731,5341,912
India177275258
ASEAN-5226301322
Indonesia435751
Malaysia82101110
Philippines233436
Thailand6787102
Vietnam112124
Emerging Asia excl. China1,4051,7251,716
Emerging Asia excl. China and India1,2281,4501,457
Asia3,4424,2774,649
Source: CEIC Data Company Ltd.

October data except for the following countries, for which data end in September: Australia, China, Hong Kong SAR, New Zealand, and Vietnam.

Source: CEIC Data Company Ltd.

October data except for the following countries, for which data end in September: Australia, China, Hong Kong SAR, New Zealand, and Vietnam.

In this environment, capital flows are expected to remain volatile, driven both by changes in global risk aversion and by the growth outlook. Given Asia’s close financial integration and high foreign participation in local markets, a further deterioration in global sentiment could trigger further capital outflows and weaken currencies across the region.

Domestic Credit Markets Have Come Under Pressure

In financial centers (Hong Kong SAR, Singapore, Tokyo), interbank spreads over comparable government yields (“TED spreads”) have risen (though they remain below those in Europe and the United States), reflecting concerns regarding counterparty risk as well as a flight to quality. Asian banks remain wary of lending to European and U.S. financial institutions, resulting in price tiering and liquidity shortages in some market segments. The global shortage of U.S. dollar liquidity is also spilling over to affect local currency markets, such as those for swaps and repos, leading to some market dysfunction and higher domestic funding rates. At the same time, the introduction of deposit guarantees in advanced economies may also have squeezed Asian credit markets, by accelerating the flight to safety.

Concerns over Asian banks’ exposures to highly leveraged overseas institutions have affected market confidence. A few banks in Asia experienced brief runs on deposits triggered by rumors over exposures to impaired overseas assets and other credit losses. With the exception perhaps of those in Japan, Asian financial institutions overall have limited exposure to overseas structured products, including U.S. subprime mortgages and monoline insurers.2 Although Asia is a major holder of U.S. government-sponsored enterprise (GSE) debt (US$794 billion as of June 2008, or 61 percent of non-U.S. exposure), most GSE debt is held as official reserves, with commercial banks holding only limited amounts. Japanese banks had the largest exposures to Lehman Brothers (US$4.2 billion) within the region, but the size of these banks’ exposures was very small compared to their overall assets. Financial institutions in China, Japan, Korea, Taiwan Province of China, and Singapore have reported losses on their overseas securities portfolios, but these losses have so far been well within their capital and operating earnings.3

Policymakers in the region have responded with a range of measures to stabilize financial conditions. For example, in addition to providing exceptional short-term liquidity, the Hong Kong Monetary Authority has taken steps to broaden the range of collateral and increase the attractiveness and maturity of its liquidity support. In India, the Reserve Bank has cut banks’ cash reserve ratio requirement to relieve pressures in the interbank market. Central banks in India and Korea have also tapped their official reserves to supply U.S. dollar liquidity through local foreign exchange swap markets, and several countries have been assisted by swap arrangements with the U.S. Federal Reserve. Australia and New Zealand have announced guarantees of bank deposits and have also covered wholesale bank funding in international markets, while Hong Kong SAR, Indonesia, Korea, Malaysia, and Singapore have also raised guarantees or implemented a full guarantee on bank liabilities (Table 1.2).

Table 1.2.Asia: Selected Intervention Measures on Deposit Insurance and Debt Guarantees
Measure
AustraliaThe government will guarantee total deposit balances up to a limit of $A 1 million per customer per institution held in Australian banks, building societies and credit unions, and Australian subsidiaries of foreign owned banks, for three years at no charge. The guarantee covers all types of deposits, regardless of the account through which the deposit is made, both retail and wholesale, held by any type of legal entity, and denominated in any currency.
The government will guarantee, for a fee, eligible wholesale borrowing and deposits above the $A 1 million threshold (new and existing term issuance of up to five years) of Australian-owned banks, Australian subsidiaries of foreign-owned banks, building societies, and credit unions. This is a temporary measure, to be withdrawn when markets normalize. Foreign bank branches are also able to apply for coverage for their domestic deposits and wholesale funding, subject to additional conditions, including a limit on the amount that can be guaranteed and that the $A 1 million fee-free threshold does not apply to their domestic deposits.
Hong Kong SARThe government will guarantee all customer deposits until 2010.
IndonesiaThe government has increased the amount of guaranteed deposits to rupiah 2 billion from rupiah 100 million, while at the same time raising the maximum rupiah guaranteed deposit rate by 75 basis points to 10 percent.
KoreaThe government will guarantee domestic banks’ external debt incurred between October 20, 2008, and mid-2009 for three years, up to a total of $100 billion. Deposit insurance has been extended to foreign currency deposits. Credit guarantees for small and medium-sized enterprises have been increased.
MalaysiaAll local and foreign currency deposits with commercial, Islamic, and investment banks and deposit-taking development financial institutions regulated by Bank Negara will be fully guaranteed by the government until December 2010. The guarantee covers all domestic and locally incorporated foreign banking institutions, and in the event of spillovers from external developments, would be extended to interbank obligations.
New ZealandAll retail deposits in banks and nonbank deposit takers are now covered up to $NZ 1 million per depositor per guaranteed institution for two years. There is a fee for the guarantee which depends on the credit rating of the institution. Nonresident deposits in New Zealand branches of overseas banks and subordinated debt of building societies and credit unions are also covered. Collective investment schemes that invest in government debt or government-guaranteed institutions are also covered subject to conditions. The country has also introduced a guarantee on wholesale funding for financial institutions with investment grade credit rating (BBB– or better). For branches of foreign banks, only issuance in New Zealand dollars is covered. The wholesale guarantee facility will operate on an opt-in basis, by institution and by instrument. A guarantee fee will be charged for each issue, differentiated by the riskiness of the issuer and the term of the security being guaranteed, up to the maturity of the issue or for up to five years, whichever is earlier. Locally incorporated registered banks will be required to maintain an additional 2 percent tier 1 capital buffer, above the 4 percent regulatory minimum.
SingaporeAll Singapore dollar and foreign currency deposits of individual and nonbank customers in banks, finance companies, and merchant banks licensed by the Monetary Authority of Singapore will be guaranteed through December 31, 2010. The government guarantee will also be extended to deposits placed with credit cooperatives registered with the Registry of Cooperative Societies. The guarantee will be backed by S$150 billion in reserves of the Singapore government.
Taiwan POCThe government will provide a temporary unlimited insurance guarantee on all bank deposits and interbank lending.
ThailandThe cabinet has approved an extension of the existing blanket guarantee on all domestic deposits of local and foreign financial institutions until August 2011. The guarantee has been in effect since the 1997 crisis.
Sources: National authorities.
Sources: National authorities.

Despite the global turmoil, conventional bank lending has so far held up, as corporates have shifted away from market financing towards domestic bank credit. Private credit growth has declined across the region but still remains robust, except in Vietnam, where credit expansion has decelerated sharply in part because of policy tightening. However, in some countries, pressures are being felt in local funding markets, such as for commercial paper and low-rated bonds, where spreads have widened. The cash market for domestic structured products also remains effectively shut down as investors continue to turn away from securitized instruments. Most worrisome for a region highly dependent on external trade, trade financing may be drying up. For instance, data from Swift, the global payments platform, indicate that the number of letters of credit in Singapore dropped by 30 percent between January and September 2008.

Looking ahead, global financial conditions are expected to tighten further, forcing corporates and households to rely more heavily on local markets and domestic banks for their funding. Therefore, there is heavy reliance on the health and soundness of the domestic banking core to provide this function. Despite banks’ relatively sound capital positions, the economic slowdown will likely raise credit costs for banks and could scale back lending growth. Corporate default rates appear to be rising in countries where domestic demand has weakened (Figure 1.13), pointing to higher levels of nonperforming loans (NPLs) ahead, while cooling housing markets in some countries could affect bank asset quality. All in all, a major deterioration in regional banking conditions is not expected, but the combination of a protracted period of global financial stress and rising domestic defaults is a clear downside risk and could cause economic growth to decelerate more rapidly than expected.

Figure 1.13.Japan: Number of Corporate Bankruptcies

(3-month moving average)

Source: CEIC Data Company Ltd.

Local Banks Have Gained Market Share, Including Overseas

The global credit turmoil has also provided opportunities for Asian financial institutions to expand their overseas investment and business. With their relatively strong capital positions, Asian financial institutions have actively participated in capital increases by their European and U.S. counterparts. Since mid-2007, total capital injections from Asia have reached almost US$57 billion, representing nearly 15 percent of the total capital raised by European and U.S. institutions. Asian sovereign wealth funds, especially from China and Singapore, initially led the way, but more recently they have been joined by large Japanese banks and securities firms.

At the same time, Asian banks have gained market share in the global credit markets as European and U.S. banks have pulled back. In particular, Japanese banks have expanded their overseas lending (growing more than 20 percent year on year), mainly in the form of syndicated loans (Figure 1.14). Looking ahead, the capacity of Asian banks to expand their overseas lending will depend in part on their capital positions and ability to access international financing and/or hedge their foreign exchange exposure.

Figure 1.14.Overseas Lending by Japanese Banks

(Year-on-year percent change)

Source: Bank for International Settlements.

2009 Baseline Forecast: Continued Slowdown in the Face of a Global Financial Shock

In addition to our assumptions concerning the financial markets, our baseline scenario for Asia rests on a couple of assumptions regarding the global economy and commodity prices:

  • According to revised forecasts released by the IMF in November, global growth is expected to slow sharply to its lowest pace since the 2001 recession. Global growth is projected to decline from 3.8 percent in 2008 to 2.2 percent in 2009, with industrial economies contracting next year (Figure 1.15). Growth in emerging and developing economies is also projected to decelerate and remain below trend. A recovery is expected to take hold in late 2009 but is likely to be very gradual by past standards on account of the significant financial strains.

  • Despite recent declines, oil prices are expected to stabilize at relatively high levels as the underlying fundamentals of tight supply and robust demand, particularly from emerging economies, have not changed significantly. Oil options markets indicate a great deal of uncertainty surrounding future prices but on balance point to some increase from current values in 2009 and beyond (Figure 1.16). Food and other primary commodity prices have, like oil prices, come down significantly.

Figure 1.15.World Real GDP Growth

(Year-on-year percent change)

Source: IMF, WEO database.

Figure 1.16.Brent Crude Oil Prices

(From futures options on November 4, 2008; in U.S. dollars per barrel)

Sources: Bloomberg LP; and IMF staff calculations.

Against this backdrop, our revised baseline forecast sees growth in Asia slowing sharply along with the global economy. On an annual average basis, growth in Asia is projected to slow from 7.6 percent in 2007 to 6.0 percent this year and 4.9 percent in 2009. The likely profile of the slowdown and consequent recovery can be seen more clearly by examining growth on a quarterly basis, which decelerates (and is below potential for many countries) through much of 2009 before gradually picking up in the second half of the year (Figure 1.17). The recovery is expected to be somewhat faster for the newly industrialized economies (NIEs)—where the slowdown is sharpest—while shallower for China, India, and industrial Asia. The uncertainties about the outlook for growth are particularly large, however, and the risks squarely on the downside.

Figure 1.17.Emerging Asia: Quarterly GDP Growth Forecasts

(Year-on-year percent change)

Source: IMF, WEO database.

Exports from Asia are expected to slow sharply. Beyond indications of cooling global demand, forward-looking indicators of global trade such as the Baltic Dry Index of shipping costs show large declines. Exports have already slowed in much of the region (Figure 1A.2). In volume terms, growth has turned negative for Korea, Hong Kong SAR, and Taiwan Province of China (Figure 1.18). Moreover, intraregional exports to China are slowing, suggesting that the weakness in advanced economies may be feeding through the regional supply chain. Forward-looking indicators for electronic exports, such as the book/bill ratio for U.S. semiconductor equipment and new electronics orders from the euro area, also point to a marked slowdown in momentum.

Figure 1.18.Selected Asia: Export Volume Growth

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

Source: CEIC Data Company Ltd.

1 The data for Hong Kong SAR refer to reexports.

The outlook for domestic demand depends in part on the changes in the terms of trade (Figure 1.19) and on the spillovers from the global slowdown and financial turmoil. For commodity importers, such as Japan, Korea, the Philippines, and Taiwan Province of China, expected improvements in the terms of trade should support real incomes and domestic demand.4 This being said, high-frequency indicators such as industrial production, retail sales, and consumer and business confidence point to a broad-based slowdown in domestic activity in tandem with cooling exports (Figure 1A.3).

Figure 1.19.Changes in the Terms of Trade versus Growth in Domestic Demand

(2007:Q2–2008:Q2)

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

Note: Latest data where available; for Vietnam, annual data are used.

Overall, growth next year is expected to rely on a modest increase in domestic demand, in part supported by lower commodity prices and, in some cases, more-accommodating macroeconomic policies (Figure 1.20). The contribution from net exports is expected to be slightly negative. However, the aggregate current account surplus for the region is projected to increase by half a percentage point to 4.9 percent in 2009, mostly on account of lower commodity prices.

Figure 1.20.Emerging Asia: Contributions to GDP Growth

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

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

Looking within the region, growth in emerging Asia is expected to slow to 6½ percent in 2009 (Table 1.3).

  • China’s growth in 2009 is projected to decline to 8½ percent. With exports likely to fall sharply and the property sector weakening, risks to China’s outlook are firmly tilted to the downside. Much will depend on the effectiveness of the policy response, including the large fiscal stimulus package announced in November.

  • Growth in India is expected to decline to around 6¼ percent next year, as tighter financial conditions weigh on domestic activity, particularly investment.

  • Our projection for the NIEs is for growth to slow to around 2 percent in 2009, with a recovery beginning towards the end of the year. The large decline in the growth rate results, in part, from these countries’ higher-than-average dependence on exports.

  • Growth in ASEAN-5 economies is expected to decline to around 4¼ percent in 2009. Consumption and investment should slow, especially in Vietnam, where monetary tightening has depressed activity.

  • For industrial Asia, growth is projected to fall to around 0 percent in 2009 from about 1 percent this year. Growth in Japan is expected to turn negative on account of a contraction in exports and investment, while private consumption is likely to stay sluggish in the face of weak confidence and low wage growth. In Australia, growth is slowing below potential because of tighter credit conditions and the easing in commodity prices. In New Zealand, growth is expected to begin to recover in response to an easing in monetary and fiscal policies but to remain below trend as the reduced availability of credit constrains spending.

Table 1.3.Asia: Real GDP Growth(Year-on-year percent change)
2007200820092008200920082009
Latest projectionsDifference from October WEOFourth quarter1
Industrial Asia2.40.80.1-0.2-0.60.00.6
Japan2.10.5-0.2-0.2-0.7-0.30.4
Australia4.42.41.8-0.1-0.41.82.0
New Zealand3.20.71.50.00.00.01.5
Emerging Asia9.57.76.5-0.1-0.86.86.8
NIEs5.63.92.1-0.1-1.12.24.4
Hong Kong SAR6.43.72.0-0.4-1.51.04.4
Korea5.04.12.00.0-1.52.43.7
Singapore7.72.72.0-0.9-1.41.64.4
Taiwan POC5.73.82.20.0-0.32.55.6
China11.99.78.5-0.1-0.89.08.3
India9.37.86.3-0.1-0.66.66.0
ASEAN-56.35.44.2-0.1-0.74.65.4
Indonesia6.36.04.5-0.1-1.05.45.1
Malaysia6.35.73.80.0-0.94.74.4
Philippines7.24.43.50.0-0.33.93.6
Thailand4.84.54.0-0.2-0.52.66.3
Vietnam8.56.35.50.00.07.58.0
Emerging Asia excl. China7.35.94.4-0.1-0.84.75.3
Emerging Asia excl. China and India5.94.63.1-0.1-0.93.44.9
Asia7.66.04.9-0.1-0.75.15.3
Sources: CEIC Data Company Ltd; and IMF, WEO database.

Change from fourth quarter of preceding year.

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

Change from fourth quarter of preceding year.

With Commodity Prices Stabilizing, Inflation Pressures Are Expected to Ease

Headline inflation across the region has shown signs of moderating along with the recent declines in commodity prices. The main source of inflation over the past year has been higher food and fuel prices, which make up nearly 35 percent of the consumer price index (CPI) baskets (for emerging Asia), compared to 20 percent in the euro area and the United States (Figure 1.21). The sharp rise in global food and fuel prices explains nearly two-thirds of the recent rise in inflation, with the impact being greater for countries with higher CPI shares of food and fuel, particularly ASEAN-5 and low-income countries (Box 1.2). Some of the recent increases also represent greater pass-through of higher import prices from the reduction in fuel subsidies (India, Indonesia, Malaysia, Taiwan Province of China), as well as weaker currencies.5 However, inflation has shown signs of decreasing along with declining commodity prices. Sequential indicators of inflation (seasonally adjusted three-month moving averages) suggest that inflation has already peaked in many countries, notably in India and in China, where CPI inflation in September fell to around 4½ percent, mainly in response to lower food prices (Figure 1A.4).

Figure 1.21.Food’s Contribution to Inflation versus Its Weight in CPI, August 2008

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

1 Data for India refer to wholesale prices.

Moreover, there are few indications of second-round price effects from the earlier commodity price run-up. Core consumer price inflation (excluding food and fuel) has increased for ASEAN-5 countries and India (6½ percent and 10 percent year on year, respectively, in September), but less so in China and the NIEs (Box 1.3). However, on a sequential basis, core inflation also shows signs of peaking (although less so than for headline inflation), while wage and employment growth appear to be weakening. Although still higher than at the beginning of the year, consensus forecasts for 2009 inflation have also stabilized and, for some countries, have started to decline.

Box 1.2.The Impact of High Food and Fuel Prices in Low-Income Asia—Implications for Inflation, Poverty, and Policies

Despite their recent decline, food and fuel prices remain well above historical levels. High food prices have undermined past gains in poverty reduction throughout the region, jeopardizing the achievement of the Millennium Development Goals. Going forward, further easing in commodity prices is expected to reduce inflationary pressures and could help alleviate their impact on poverty in low-income Asia.

Impact on Prices

Inflation has been rising in low-income Asia. Fueled by spikes in commodity prices, headline inflation has picked up since end-2007. Inflation is for the most part imported, driven by sharp increases in food and fuel prices, whose impact has been magnified by their large share in the consumer price index. In addition, for low-income countries, much of the food basket includes products that are unprocessed or have little value added, resulting in a relatively high pass-through of imported food prices.

Some supply-side factors have added to inflation. Adverse weather in Bangladesh has caused substantial crop damage, while Pacific Island countries that rely almost exclusively on oil-based fuel for their energy needs face limited scope for substitution in production.

Domestic demand pressures have also played a role. Credit growth remains high in some countries (Cambodia, Lao People’s Democratic Republic, Papua New Guinea, and the Solomon Islands), while fiscal policies have turned expansionary in several economies (Bangladesh, the Solomon Islands, Sri Lanka, Timor-Leste, and Vanuatu).

Higher commodity prices have spilled over to core inflation. Second-round effects are emerging in Papua New Guinea, Sri Lanka, the Solomon Islands, Timor-Leste, and Tonga as higher costs for inputs (e.g., animal feed, fertilizer, and energy) have created upstream pressures on prices. Wage pressures also appear to be increasing in Papua New Guinea and the Solomon Islands.

Impact on Poverty

Inflation is of particular concern in low-income Asia because of its substantial social implications. Inflation, especially in food prices, increases income inequality by acting as a regressive tax that hits the poor the hardest (Easterly and Fischer, 2001). Because the poor do not generally have financial assets that provide an adequate hedge against inflation, and instead hold only cash and bank deposits, inflation can quickly erode their purchasing power.

Low-Income Asia: Headline Inflation

(Year-on-year percent change)

Sources: Country authorities; and IMF staff calculations.

1 Includes countries for which monthly inflation data are available (Bangladesh, Cambodia, Fiji, Lao P.D.R., Mongolia, Nepal, Solomon Islands, Sri Lanka, Timor-Leste, and Tonga).

Low-Income Asia: Food Inflation

(Year-on-year percent change)

Sources: Country authorities; and IMF staff calculations.

Note: Data for 2008 refer to August, except for data for Papua New Guinea and Vanuatu, which refer to June.

Core Inflation1

(Year-on-year percent change)

Sources: Country authorities; and IMF staff calculations.

1 Quarterly data.

The urban poor are most affected by high food and fuel prices, as the rural poor are more likely in the short term to be partially self-sufficient in food supplies (IMF, 2008b). However, those living in remote areas, especially landless farmers, are also highly exposed. Food-related expenditure represents a large share (about 50 percent) of household spending in low-income Asia. Higher expenditure on food crowds out spending on health and education and agricultural inputs, further undermining the needed supply-side response (Asian Development Bank, 2008a). Most low-income countries have only limited social protection systems to shield the most vulnerable segments of the population.

On balance, the empirical evidence suggests that the impact of food prices on poverty will be substantial in some low-income Asian countries. A World Bank study shows that the first-round effects of food inflation on urban poverty are higher than average in Bangladesh and Cambodia (Dessus, Herrera, and de Hoyo, 2008). For example, a 20 percent increase in the relative price of food is estimated to increase the poverty rate—defined as the proportion of the population below the “dollar-a-day” poverty line—by almost 6 percentage points in Cambodia and 5 percentage points in Bangladesh, compared to an average of 3.7 percentage points for the 20 most severely affected countries. The Pacific Islands are also at risk. According to the Asian Development Bank, a 10 percent reduction in real income of low-income households would bring an additional 5 percent of the population of the Pacific Islands below the poverty line in 2008 (Asian Development Bank, 2008b).

Countries’ Policy Responses

Responses to cope with high food and fuel prices have varied across low-income Asia. Most countries have allowed full pass-through of commodity price increases for gasoline, but in a few countries, pass-through has been incomplete. The pass-through of diesel and kerosene prices has been much lower, since typically kerosene and diesel carry higher subsidies than gasoline, reflecting their importance for poor households. In Bangladesh, fuel subsidies on kerosene and diesel remain substantial. Additional measures introduced to limit the impact of higher prices include

Low-Income Asia: Food Weight in the CPI Basket(In percent)
Bangladesh164.5
Cambodia42.7
Fiji35.4
Lao P.D.R.40.9
Marshall Islands46.7
Micronesia45.5
Mongolia41.1
Myanmar68.3
Nepal53.2
Papua New Guinea40.9
Samoa50.3
Sri Lanka45.5
Solomon Islands42.9
Timor-Leste57.8
Tonga44.4
Emerging Asia31.3
Sources: Country authorities.

Includes tobacco and beverages.

Sources: Country authorities.

Includes tobacco and beverages.

Impact of a 20 Percent Food Price Shock on Poverty1(In percent)
Before shockAfter shock
Poverty rateChange in the poverty rate
Bangladesh8.75.0
Cambodia25.15.8
Lao P.D.R.2.71.0
Sri Lanka0.61.2
Most-affected countries218.73.7
Source: Dessus, Herrera, and de Hoyo (2008).

Refers to a 20 percent change in the relative price of food.

Average for the 20 most affected countries.

Source: Dessus, Herrera, and de Hoyo (2008).

Refers to a 20 percent change in the relative price of food.

Average for the 20 most affected countries.

Low-Income Asia: Pass-Through of International Gasoline Prices1

(In percent)

Source: IMF staff calculations.

1 Absolute change of domestic retail prices in U.S. dollars between September 2008 (or latest available) and end-2007 divided by the absolute change of world prices over the same period.

  • Import duty and tax cuts. Many countries have lowered import tariffs or introduced exemptions for tariffs on food staples (Bangladesh, Marshall Islands, Mongolia, the Solomon Islands, and Timor-Leste) and fuel (Fiji). Mongolia, the Solomon Islands, and Timor-Leste have also cut the sales tax.

  • Price controls and subsidies to consumers. In Bangladesh, rice is being provided to the poor at subsidized prices. Fiji has introduced some price controls and delayed scheduled electricity tariff increases. In Timor-Leste, the government has spent more than 2 percent of gross national income on imported rice that is being resold with a 50 percent subsidy. The Lao People’s Democratic Republic introduced a reference rather than a market price on fuel products for assessing taxation, effectively turning ad valorem taxes into specific taxes.

  • Assistance/subsidies to farmers. In Bangladesh, Cambodia, and Timor-Leste, the governments have ensured adequate availability of agricultural inputs, including seeds, fertilizer, and diesel to farmers. In Sri Lanka, subsidies on fertilizer have increased in 2008 and are expected to cost around 0.6 percent of GDP.

  • Other measures. Bangladesh and Nepal have introduced a ban on rice exports. Food reserves have been built up in Bangladesh (rice), the Lao People’s Democratic Republic (rice), and Mongolia (meat). Two countries have promoted food self-sufficiency (Bangladesh and the Solomon Islands). In Bangladesh, existing safety net programs are being scaled up, and a new employment guarantee scheme and cash transfers have been introduced to help people in distressed areas.

Policy Responses to High Oil and Food Prices in Low-Income Asia
Reduce import dutiesBuild reserves/stockpilesExport restrictionPrice controls/consumer subsidiesAssistance/subs idy to farmersPromote self-sufficiencyCash transfer
BangladeshXXXXXXX
CambodiaXX
FijiXX
Lao P.D.R.XX
MongoliaXX
MyanmarX
NepalXX
Marshall IslandsX
Sri LankaX
Solomon IslandsXX
Timor-LesteXXXX
Sources: Asian Development Bank; World Bank; and IMF country desks.
Sources: Asian Development Bank; World Bank; and IMF country desks.

The monetary policy response has also varied across countries. Some tightening has taken place. In Sri Lanka, the central bank has slowed reserve money, mainly through the sale of government paper; Bangladesh raised its policy rates by 25 basis points in September. In Cambodia, the central bank doubled the reserve requirement for foreign-denominated deposits in June. Because most of the Pacific Islands economies either are dollarized or have pegged exchange rates, the exchange rate plays a minimal role in curbing imported inflation. In Papua New Guinea—a country with a more flexible exchange rate—the central bank has increased the policy rate three times since June, but real interest rates remain negative. The central bank of the Solomon Islands has introduced standing deposit facilities to mop up excess liquidity.

Inflation pressures pose special challenges to low-income countries. Ideally, targeted transfer programs—as part of an integrated social safety net—could reach the poor efficiently. In the absence of effective safety nets, a package of measures building on existing programs (e.g., school feeding programs, cash transfers to the most vulnerable populations, reduction in education and health fees, and public transport subsidies) could be identified. Ad hoc general increases in public sector wages or changes in the tax system to alleviate the effects of commodity price hikes are not well-targeted and should be avoided.

A more effective approach would include targeted demand- and supply-side responses, combined with donor support. In general, countries should allow full pass-through of higher food and fuel prices to domestic prices, while allowing for some time to adjust. Longer-term measures, such as in agriculture, rural transport, and other support services, can increase domestic supply and reduce price pressure. Donor support, preferably in the form of grants, would also help limit the harm to real incomes and poverty.

Note: The main author of this box is Patrizia Tumbarello.

Box 1.3.Measuring Underlying Inflation Trends

The recent volatility in commodity prices has raised the issue of whether to use headline or core inflation in setting monetary policy. Headline inflation has the advantage of being simple, widely recognized, and more representative in terms of covering household spending. At the same time, it also suffers from a number of limitations in guiding monetary policy—most critically, its short-run sensitivity to nearly every kind of economic shock. In this sense, underlying inflationary pressures may be better captured by measures that strip out from headline inflation the impact of temporary shocks over which the monetary authority has no control.1

The appropriate measure of core inflation ultimately depends on its purpose.2 Commonly used measures of core inflation that exclude volatile price components, such as food and energy prices, have the benefit of being simple, timely, and independently verifiable. These measures are well suited for communicating inflation developments to the public and for anchoring expectations, but may not be ideal for guiding monetary policy, as their construction may not sufficiently capture underlying trends in future inflation. Theory-based measures, such as the model-based measure proposed by Quah and Vahey (1995) and the persistence-weighted approach suggested by Cutler (2001), attempt to extract the permanent component of inflation and thus may be more useful for forward-looking analysis. Ideally these alternative measures of core inflation should be (i) “unbiased” (on average, equal to headline inflation); (ii) “cointegrated” (i.e., core and headline inflation should converge over time); and (iii) an “attractor” for headline inflation (headline should converge towards core inflation but not vice versa; i.e., core should be a leading indicator for headline inflation). One important drawback, though, is that these measures are rather complex and require faith that the model used is the right one.

The figure on the next page plots headline and alternative measures of core inflation for four Asian countries that have experienced significant increases in inflation—India, the Philippines, Sri Lanka, and Vietnam.3 In all four countries, the resulting measures of core inflation differ, but overall show underlying inflation subsiding. In India and Vietnam, most core inflation measures show underlying inflation running below the headline figure, while in the Philippines and Sri Lanka, they are running above the official measure of core inflation.4 When the alternative measures are evaluated, the results do not suggest one dominant measure of core inflation, but rather that monetary authorities would benefit from examining a broad range of core indicators when judging underlying inflation trends.

Core Inflation Measures

(In percent, annualized)

Sources: CEIC Data Company Ltd; Central Bank of Sri Lanka; and IMF staff estimates.

Note: The wholesale price index is used for India. Trimmed mean measures trim the tails of the distribution of the price changes. Reported trimmed mean measures differ across the countries depending on their desired statistical properties.

Note: The main authors of this box are Souvik Gupta and Magnus Saxegaard.1See Chapter 2 of this Regional Economic Outlook for a discussion of core versus headline inflation measures when exogenous shocks are persistent.2See, for example, Roger (2000), Heath, Roberts, and Bulman (2004), Mankikar and Paisley (2004), and Silver (2007).3These measures include (i) one that excludes the most volatile 10 percent of the components of the price index; (ii) one that trims parts of the tails of the distribution of price changes; (iii) one that reweights the components of the price index according to the estimated persistence of inflation; and (iv) one based on an approach by Quah and Vahey (1995) that identifies core inflation as that component of inflation that has no medium- to long-term impact on real output (i.e., movements in core inflation are output-neutral once financial and wage contracts have been written to take them into account).4In the Philippines and Sri Lanka, the official measure of core inflation excludes food and energy components from headline CPI. These account for 54.6 percent of the total weight in Sri Lanka’s CPI and 18.4 percent in the Philippines.

For 2009, our baseline forecast is for inflation to moderate back to 2007 levels. A key component of our forecast is the IMF’s commodity price baseline, which sees prices stabilizing in 2009. On this basis, headline inflation in Asia is projected to ease from 6 percent in 2008 to around 3 percent in 2009 (Table 1.4). Inflation in emerging Asia is projected to fall to 4 percent in 2009, while for industrial Asia inflation will be lower, at about ½ percent. In Japan, falling commodity prices are likely to push headline inflation down, possibly even below zero for a brief period, but inflation is expected to return to positive levels once commodity prices stabilize. The risks of more entrenched deflation seem low, given the improved balance sheets of banks and corporates and the supportive actions taken by the government and the Bank of Japan.

Table 1.4.Asia: Headline CPI Inflation(Year-on-year percent change)
2007200820092008200920082009
Latest projectionsDifference from October WEOLatest consensus
Industrial Asia0.42.00.4-0.1-1.02.11.5
Japan0.11.4-0.3-0.1-1.21.71.1
Australia2.34.63.60.10.04.53.2
New Zealand2.44.23.80.00.04.23.3
Emerging Asia4.37.34.0-0.4-1.07.04.7
Hong Kong SAR2.03.92.7-0.9-1.64.83.9
Korea2.54.73.0-0.1-1.04.83.6
Singapore2.16.53.10.0-0.16.43.0
Taiwan POC1.83.71.0-0.5-1.53.82.5
China4.76.23.4-0.2-0.96.43.6
India14.710.14.3-1.5-1.77.86.6
Indonesia6.310.09.00.20.310.58.2
Malaysia2.06.04.30.0-0.45.84.1
Philippines2.89.86.0-0.3-1.09.97.1
Thailand2.25.63.0-0.1-0.26.53.7
Vietnam8.424.015.00.00.023.812.9
Asia3.36.03.1-0.4-1.05.83.9
Sources: CEIC Data Company Ltd; Consensus Economics; and IMF, WEO database.

Wholesale price index data for India; 2008 and 2009 forecasts are on a fiscal year basis.

Sources: CEIC Data Company Ltd; Consensus Economics; and IMF, WEO database.

Wholesale price index data for India; 2008 and 2009 forecasts are on a fiscal year basis.

Financial Conditions Will Likely Tighten Further

As noted earlier, financial markets in Asia are expected to remain closely tied to developments outside the region. Exceptional policy responses by both advanced and emerging economies have helped to stabilize market conditions, but the financial impact from the sharp global downturn and credit turmoil has yet to be fully felt, as global deleveraging and rising corporate defaults are likely to continue through next year. As a result, Asia’s financial markets will likely remain under stress from the global credit turmoil and slowdown and represent an important downside risk to our baseline forecast.

Risks to the Outlook Are Firmly on the Downside

As already noted and as shown in Figures 1.22 and 1.23, the risks to our baseline forecast for the region are significant and tilted firmly to the downside.6 The main downside risks are external—stemming from a sharper-than-expected global slowdown that would affect Asia’s exports and a protracted period of financial turmoil that would tighten both external and domestic credit conditions (Figure 1.23). On the upside, further declines in commodity prices could give a boost to domestic demand and help to reverse some of the trend deterioration in the terms of trade, while larger-than-expected policy stimulus cannot be ruled out at this stage.

Figure 1.22.Asia: GDP Growth

(Central forecast and 50, 70, and 90 percent confidence intervals; in percent)

Source: IMF staff assessment of the balance of risks.

Figure 1.23.Risk Factors

(Contribution to balance of short-term risks for Asia’s growth forecast)

Source: IMF staff assessment.

The possibility of significant deviations from the baseline scenario are much greater than usual. A severe global recession that is deeper and more protracted than expected, combined with a significant global credit squeeze, would have significant spillover repercussions for Asia. Previous Regional Economic Outlook analysis has shown that, while spillovers from the United States to Asia have been modest on average, they have increased over time as a result of Asia’s increased trade and financial integration with the rest of the world.7 A larger-than-anticipated slowdown in China would also have a significant impact given the growing importance of intraregional trade. In this context, corporate distress in the region stemming from lower demand and tighter financial conditions could impair bank assets and feed into a vicious macro-financial circle.

Policy Challenges to Safeguard Macro and Financial Stability

In this highly uncertain environment, Asian policymakers face the difficult challenge of navigating their economies through a global downturn while safeguarding financial stability. Given the considerable downside risks, policymakers will need to remain vigilant in regard to spillovers from the global turmoil and be prepared to respond quickly and flexibly to a sharp slowing of domestic activity. Financial policies will need to focus on addressing spillovers from the global credit turmoil as well as domestic risks from a slowing economy. With inflation projected to moderate, monetary policy in most countries has room to ease to stabilize financial conditions and provide support to address significant downside risks. Greater exchange rate flexibility in some cases will provide more monetary policy autonomy and help mitigate the impact of volatile capital flows. Progress in fiscal consolidation has also created scope for fiscal policy to provide timely and well-targeted support.

Financial Policies to Safeguard Stability

Financial policies will need to focus on anticipating and addressing spillovers from tighter global financial conditions and domestic risks arising from weaker growth. Given the potential spillovers from individual country actions, financial policy coordination at the regional level may be more effective in stabilizing financial conditions. While precise policies will vary across countries, generally they should cover

  • Strengthening crisis management frameworks. Failures of several large distressed institutions have raised concerns over potential exposures to other highly leveraged players, including those in Asia. Further defaults can be expected, and policymakers should review contingency plans, including addressing possible fallout in interbank markets and ensuring the adequacy of deposit insurance and public recapitalization schemes. Early disclosure of exposures can help ease market concerns and help investors differentiate across institutions (and countries).8 Greater cross-border collaboration among the relevant authorities would help strengthen monitoring of financial distress overseas, while in countries whose financial systems are closely interconnected, coordinated policy action would be more effective and help prevent “beggar-thy-neighbor” consequences that would harm other countries. For countries that have implemented or are considering blanket guarantees on bank liabilities, the schemes should have firm deadlines for expiring, be sufficiently funded and transparent to enhance credibility, and include safeguards, such as enhanced supervision and limits on deposit rates, to prevent unfair competition nationally and across borders. While blanket guarantees may support financial stability and be a necessary response to guarantees introduced in other regions, they should be viewed as a temporary, not a final, solution to provide time for a more fundamental resolution of banking difficulties.

  • Enhancing liquidity risk management. Supervisors will need to ensure that banks have proper regulatory standards for liquidity risk management, such as through avoiding maturity mismatches, more extreme stress testing, and contingency planning in the event of an extended cutoff in external financing. Central banks should also consider reviewing the range of available liquidity instruments, including in foreign currency. Expanding the range of acceptable collateral and shifting to a regular auction-type facility for discount lending may help minimize the market stigma attached to emergency funding. Central banks should also consider contingency plans to expand access of their standing facilities to nonbanks, securities firms, and even nonfinancial corporations to address possible liquidity shortages.

  • Protecting access to cross-border funding, including trade financing. Foreign exchange and cross-currency swap markets have emerged as important U.S. dollar funding and hedging channels for both foreign and domestic players and have come under stress during the current period of high risk aversion. At the same time, the cost of trade financing and the demand for letters of credit and trade insurance have risen as international banks have scaled back their overseas lending. To ensure adequate cross-border funding, regulators should review plans to provide emergency foreign financing to banks and other intermediaries, including through swap arrangements, or possibly extend guarantees to cover trade credits in the event of a temporary cutoff in financing.

  • Promoting the smooth refinancing of maturing corporate and financial sector debt. Markets are likely to pay closer attention next year to the bunching of corporate bonds maturing starting in 2010. Countries with a banking system that relies on wholesale financing, especially short-term external debt, are also likely to continue to face repayment pressures. Collecting and disclosing information on the aggregate profile of maturing debt, particularly external debt, could help individual firms to manage their obligations better and alert banks to potential demands for short-term financing.

  • Strengthening risk management. With growth slowing, corporate default rates and nonperforming loans within the region are expected to rise. Regional banks with exposures to sectors that are more vulnerable to a domestic slowdown, such as housing or small and medium-sized enterprises, may be at greater risk. Supervisors will need to ensure that local banks are properly classifying loans and setting aside adequate provisioning against problem loans. At the same time, Asian banks are helping to fill in the lending void created by the distress among major global banks. Having in place robust credit risk systems will help Asian banks to manage their growing overseas portfolios while guarding against possible risks.

  • Standing ready to recapitalize banking systems if needed. At this stage, the possibility of a larger than expected wave of corporate defaults leading to bank failures cannot be ruled out. Authorities should thus consider contingency plans in the event that public funds are required to prop up the capital base of financial institutions.

  • Implementing longer-term financial reforms. Although the crisis is still unfolding and its lessons still being learned, policymakers may take this opportunity to implement longer-term reforms that would strengthen their financial systems, such as those recommended by the Financial Stability Forum (FSF) and discussed in the IMF’s Global Financial Stability Report. For Asia, this would include addressing the procyclical risks from changes in leverage, further developing local bond and hedging markets, and enhancing the monitoring of systemically important institutions, including those outside the banking system.

Monetary Policy to Address Downside Risks to Growth

With the balance of risks having shifted towards slowing growth, most central banks in Asia have ended their tightening cycle and, in many cases, have started to ease while providing exceptional liquidity to stabilize market conditions (Figure 1A.5). Japan, Australia, China, India, Korea, New Zealand, Taiwan Province of China, and Vietnam have either lowered rates or eased reserve requirements in response to slowing growth. Some countries, including India, Indonesia, and Korea, have also intervened to support their currencies, while Singapore has moved to an exchange rate band with zero appreciation. In Sri Lanka, given the still-high level of inflation, the authorities remain committed to a tight monetary program, but have taken measures to accommodate the liquidity shock from the global turmoil.

Real policy rates in many countries remain negative, whether adjusted for headline or core inflation, suggesting that the monetary stance is supportive. Measures of real monetary conditions that incorporate exchange rate changes also show that conditions are looser compared to 12 months ago (a key exception being China). However, a broader measure that includes credit risk indicates that financial conditions have tightened and are more restrictive than suggested by the stance of monetary policy as a result of the global credit turmoil.

In this highly uncertain environment, central banks face the difficult challenge of navigating their economies through a major global downturn, while stabilizing financial conditions. Given its flexibility, monetary policy should be the first line of defense. With the global credit turmoil tightening domestic financial conditions, monetary policy should stand ready not only to stabilize market conditions, but also to ease in response to slowing growth. The appropriate stance would vary across countries and depend on the outlook for domestic demand, exchange rate regimes, and financial conditions.

  • In most countries, where domestic demand is weakening, financial conditions are tightening, and second-round price effects are modest, further monetary policy easing would be appropriate to address downside risks to growth. Central banks will need to respond flexibly in the event that domestic credit tightens appreciably and depresses activity.

  • For inflation-targeting countries, greater communication on the risks to the outlook and their implications for monetary policy would help reinforce policy credibility. Explaining how and when inflation would be expected to fall back within the target range would help anchor price expectations over the medium term (Figure 1.24).

  • More generally, excessive intervention creates the risk of one-way bets on the exchange rate and greater volatility. Countries where exchange rates have weakened in response to negative terms-of-trade shocks and capital outflows face the added challenge of containing the pass-through of the depreciation on domestic inflation. While a case can be made for intervention to smooth excess exchange rate volatility and address possible overshooting, sustained one-sided intervention may backfire, resulting in larger and more disruptive adjustments later. Instead, allowing exchange rates to adjust would help absorb market pressures and reduce the drain on reserves. In China, a key argument for greater flexibility would be to help rebalance growth towards consumption.

Figure 1.24.CPI Inflation: Inflation-Targeting Countries versus Non-Inflation-Targeting Countries1

(Year-on-year percent change)

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

1 Unweighted average. Inflation-targeting countries are Indonesia, Korea, Thailand, and the Philippines.

Scope to Ease Fiscal Policy

With growth slowing and fuel and food subsidies higher, the fiscal deficit in Asia is expected to widen modestly by about ½ percentage point of GDP in 2008 but remain small (Table 1.5). The turnaround is the greatest for emerging Asia, particularly for the NIEs, where the fiscal balance has shifted by 2¼ percent of GDP. In 2009, the fiscal balance for Asia is projected to widen further, reflecting the effects of slower growth and policy measures to offset higher food and fuel prices and, in some cases, to support aggregate demand. Public debt levels (as a share of GDP) should continue to decline in Asia, but remain high in India and Japan.

Table 1.5.Asia: Selected Fiscal Indicators(In percent of GDP)
General Government Gross DebtCentral Government Fiscal Balance
200620072008

Proj.
2009

Proj.
200620072008

Proj.
2009

Proj.
Industrial Asia163.9163.8166.1168.9-3.6-2.4-2.7-2.9
Japan194.7195.4198.9203.0-4.7-3.3-3.7-3.8
Australia18.67.87.36.61.61.51.81.6
New Zealand223.322.321.520.35.13.52.90.7
Emerging Asia36.737.735.234.0-1.10.0-0.6-1.3
NIEs29.028.328.029.60.62.2-0.1-0.6
Hong Kong SAR1.71.31.10.94.07.60.1-0.2
Korea3,432.232.132.434.2-1.30.4-1.3-1.5
Singapore7.69.06.15.7
Taiwan POC34.933.332.033.70.30.9-0.1-1.1
China516.520.917.115.8-0.71.00.8-0.6
India680.579.978.376.1-3.4-2.8-3.8-3.3
ASEAN-545.241.139.638.3-1.0-1.6-1.6-2.0
Indonesia339.035.033.331.2-1.0-1.2-1.0-1.0
Malaysia343.241.843.244.7-3.3-3.2-4.6-4.2
Philippines773.960.960.856.6-1.4-1.7-1.0-1.7
Thailand7,841.038.136.135.9-0.3-1.1-0.5-2.5
Vietnam742.943.138.236.01.1-2.2-2.2-2.0
Asia72.471.568.867.1-1.8-0.6-1.2-1.7
Sources: IMF, WEO database; and staff estimates.

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

Fiscal year ending June. Fiscal balance is defined as operating balance net of gains and losses. Figures exclude net New Zealand Superannuation Fund asset returns.

Central government only; balance excluding Social Security Fund.

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

Net debt.

Fiscal year ending March; privatization receipts excluded from revenues.

Public sector debt.

Fiscal year ending September. 2009 fiscal balance is budget number.

Sources: IMF, WEO database; and staff estimates.

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

Fiscal year ending June. Fiscal balance is defined as operating balance net of gains and losses. Figures exclude net New Zealand Superannuation Fund asset returns.

Central government only; balance excluding Social Security Fund.

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

Net debt.

Fiscal year ending March; privatization receipts excluded from revenues.

Public sector debt.

Fiscal year ending September. 2009 fiscal balance is budget number.

With progress in fiscal consolidation, many countries in Asia have room to ease to address downside risks to growth. Indeed, several countries have already announced fiscal policy measures to support aggregate demand, most notably China, which is commendably planning to undertake substantial spending in infrastructure and other areas over the next two years. Strengthening social safety nets to protect vulnerable households would also allow automatic stabilizers to play a more supportive role. In countries such as Japan or India where fiscal sustainability is an issue, it would be important not to lose sight of the need for medium-term fiscal consolidation. Despite progress in reducing deficits, the public debt ratios in these countries are expected to come down only slightly or remain at high levels.

Appendix

Figure 1A.1.Financial Developments

Figure 1A.2.Trade Developments

Figure 1A.3.Real Sector Activity

Figure 1A.4.Inflation Developments

Figure 1A.5.Monetary Developments

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