A. Recent Developments and Emerging Pressures
Over the first two quarters of 2010, economic activity in Asia continued its rebound from the global financial crisis. The speed of the recovery, as well as its composition, have remained quite different across Asia, with smaller export-dependent economies generally experiencing more pronounced cycles than larger economies with sizable domestic demand (Figure 1.1). In particular:
NIEs and export-oriented ASEAN economies posted very strong GDP outturns, as exports grew faster than expected, private consumption remained robust, and the investment cycle that began in late 2009 continued to mature. The sharp, V-shaped business cycle experienced with the global financial crisis appears to be over, and output levels have returned to precrisis trends (Figure 1.2). In Korea, growth benefited from continued inventory accumulation and a pickup in business investment. In Singapore, export growth boosted both inventory and investment cycles, as economic activity accelerated to double-digit growth in the first half of 2010.
In Japan, the recovery remained slow but became more broad based. Rising exports helped improve business sentiment among large export-oriented firms, which are further upgrading their capital spending plans, and private consumption accelerated thanks to the impact of new fiscal stimulus measures. Overall, however, growth remains insufficiently strong to return output to precrisis trends and move inflation into positive territory.
Private domestic demand was strong in the first half of 2010 in emerging Asian economies that did not experience sharp downturns in 2009, such as India and Indonesia. In India, capital goods production and spending on consumer durables remained robust during the first half of 2010. In Indonesia, strong private demand offset a slowdown in exports and lower government spending, so that GDP growth accelerated in the second quarter of 2010.
In China, output growth remained very rapid, with robust growth in private consumption and exports, although it moderated in the second quarter, as infrastructure-related investment decelerated and real estate investment slowed under measures adopted to cool the property market (Figure 1.3).
Economic activity continued to rebound in Australia and New Zealand, driven by external demand for their commodities that raised the terms of trade to near historically high levels in Australia. In Australia, growth was also boosted by high consumer confidence and tight labor market conditions, which supported private consumption, and public spending on infrastructure. In New Zealand construction investment provided an additional boost to growth.
Economic activity also accelerated in many Asian low-income countries (LICs) thanks to higher external demand, particularly for garment exports (Bangladesh, Cambodia, Vietnam); investment in the mining sector (Lao PDR, Mongolia); and accommodative macroeconomic policies (Lao PDR and Vietnam). In Sri Lanka and Mongolia the economic outlook improved markedly.
More recent indicators, however, suggest that activity in Asia likely peaked in the first half of 2010. Asia has regained all of the ground that it lost with the export collapse during the crisis. Indeed, by August 2010, overall Asian exports were at about precrisis levels, although still about 10 percent below precrisis trends (Figure 1.4). Subsequently, the growth momentum in industrial production and exports has slowed from these cyclical highs toward rates that are closer in line with historical averages (Figure 1.5). Export growth slowed more markedly in Japan and ASEAN economies than in China and NIEs, partly reflecting stronger currency appreciation in the former cases.
The moderation of Asia’s export growth in recent months partly reflects the completion of the inventory cycle. Asia’s domestic inventory cycle has probably come to an end, as the inventory-to-shipment ratios in Japan, Korea, and Taiwan Province of China have returned to levels more in line with precrisis averages (Figure 1.6). The global inventory cycle, too, likely peaked in the first half of 2010. U.S. imports of information technology (IT) products have already passed their precrisis levels, and the inventory-to-sales ratio of U.S. IT wholesalers and retailers appears to have stabilized in recent months (Figure 1.7).
The slowing of China’s domestic demand since the second quarter of 2010 may also have contributed to the deceleration of exports from other Asian countries. A geographical breakdown of Asia’s exports indicates a marked moderation in intraregional exports to China in recent months (Figure 1.8). The slowing of intraregional exports to China may partly reflect the high degree of vertical integration of the Asian production chain, whereby China imports inputs from several Asian countries for the production of exports to advanced economies. But it also likely reflects slower final demand from China, as the pace of exports from China to the United States has actually picked up in recent months.
Sequential growth of retail sales in some Asian economies has also moderated in recent months, but remains generally robust (Figure 1.9). In particular, in the ASEAN-5 economies and in China, retail sales are still growing at double-digit rates, while in India passenger vehicle sales have accelerated in recent months.
Overall Financial Conditions Are Still Accommodative
External financial conditions have been volatile in recent months and are somewhat tighter than they were a year ago. Net capital inflows to Asia have moderated so far in 2010, from their very high levels of 2009, although the pattern varies across the region (Figure 1.10). In particular:
Portfolio equity inflows have resumed in recent months, after a sharp reversal in May 2010 owing to the spike in global risk aversion amid sovereign debt concerns in advanced economies, but they remain volatile. In recent months, equity inflows have moderated in a few economies, including Korea and Taiwan Province of China, as uncertainty about the global recovery has weighed on export prospects (Figure 1.11).
After slowing in April—May 2010, foreign bond issuance by Asian economies has rebounded subsequently. External appetite has picked up further for Asian debt, particularly sovereign, against the backdrop of positive interest rate differentials, market expectations of exchange rate appreciation, and relatively sound fiscal positions of Asian governments (Figure 1.12).
Stock market performance has varied across the region, partly reflecting differences in the degree of integration of various economies with global markets. The spike in global risk aversion in May 2010 caused a broad decline of stock prices in Asia, as it did in other regions, but equity markets have since rebounded (Figure 1.13). The rebound has been particularly notable in ASEAN economies, where, as of September 2010, equity valuations were about 30 percent above their levels at the beginning of the year. In NIEs, by contrast, equity valuations have remained broadly stable in 2010, partly reflecting their stronger integration with advanced equity markets. In Japan, stock market performance has been weighed down by still weak growth prospects, and equities have lost about 10 percent since the start of the year. In China, equity valuations have also declined since early 2010, perhaps reflecting market expectations of a tighter monetary stance.
In real effective terms, most regional currencies have appreciated so far in 2010 (Figure 1.14). Despite the moderation in capital inflows, upward pressures on Asian exchange rates have remained generally strong, owing partly to higher trade surpluses in the region. Some notable features are as follows:
In China, the authorities’ decision in mid-June 2010 to allow more flexibility of the renminbi has been followed by a nominal appreciation of the currency against the U.S. dollar of about 2 percent as of early October 2010. In real effective terms, although the renminbi has appreciated during 2010, it is still at roughly its level of the late 1990s. The rapid pace of reserve accumulation, high trade surplus, and positive productivity differential vis-à-vis trading partner countries over this period suggest that the renminbi remains substantially below the level consistent with medium-term fundamentals.
Among emerging Asian economies, India, Indonesia, Malaysia, and Thailand have experienced the strongest real effective exchange rate appreciations so far in 2010, and their currencies were close to 10-year highs in August 2010. The real effective appreciations largely reflect higher nominal exchange rates, although in India inflation has also played a significant role. The Singapore dollar also appreciated to reach a 10-year high in real effective terms in August, following the authorities’ move in April 2010 to tighten the policy stance by recentering upward the policy band and returning to a modest, gradual appreciation of the nominal effective exchange rate. Over the last few months, a few Asian currencies have lost some upward momentum amidst higher volatility in mature financial markets (see Box 1.1).
Renewed global risk aversion has further fueled an appreciation of the Japanese yen in recent months, partly reflecting its status as a “safe haven” currency. Since April 2010, the yen has appreciated by 10 percent in real effective terms and about 8 percent in nominal effective terms (see Box 1.2). The rapid appreciation and increased volatility of the yen in recent months prompted the authorities in September 2010 to intervene in foreign exchange markets, for the first time since 2004.
Global Volatility and Forex Returns in East Asia
Volatility shifts in mature markets transmit to emerging market foreign exchange returns through various channels, including through movements in investment portfolios across asset classes, which in turn induce shifts in capital flows across countries. This happens because investors—at home and abroad—readjust their portfolios along risk-return frontiers. These developments are often couched as “search-for-returns” and “flight-to-safety” hypotheses. The higher levels of volatility, therefore, have implications for asset markets in emerging markets, including foreign exchange markets. The relationships, in turn, have implications for monetary and exchange rate management in these countries.
Volatility in mature equity markets has risen since late 2006, with a noticeable spike in mid-2007 in the wake of the subprime crisis in the United States and the unfolding global credit crunch.1 Volatility levels rose further toward end-2008 to the highest levels in a decade and then subsided, before rising again in mid-2010 as the European crisis unfolded. What was the impact of these shifts in volatility on Asian forex markets? Did this relationship change in the wake of the global financial crisis?
To examine these issues, we analyzed daily forex returns (defined as the percentage change in spot exchange rate against the U.S. dollar), for five East Asian countries—Indonesia, Korea, the Philippines, Singapore, and Thailand—for the period 2001—10 in a generalized autoregressive conditional heteroscedasticity (GARCH) framework.2
The sample period was then subdivided into 2001-07 and 2008-10 to see whether the relationships had changed during the latter period of high volatility in mature markets. The main results of this analysis include the following:
For East Asian economies, an increase in mature market equity volatility is generally associated with lower forex returns. In other words, an increase in mature market volatility generates a tendency for East Asian exchange rate depreciation, suggesting a “flight” from East Asian currency denominated assets.
The sensitivity of exchange rates to mature market volatility varies across countries, with Indonesia at the higher end of the spectrum, Korea and Singapore forming the middle, and Thailand at the lower end. These differences reflect a combination of factors, including the depth of countries’ forex markets, the degree of integration into the global financial system, and the extent of country exposure to cross-border financial flows. A 5 percentage point increase in the VIX index (close to a 1 standard deviation change) was associated, on average over the whole period, with 0.15-0.35 percentage point exchange rate depreciation.
Relative to the average impact over the last decade, the spike of global volatility during the late 2008 global financial crisis had a stronger impact on the Korean won, possibly reflecting the sharp tensions in wholesale external funding. By contrast, the impact was lower in Indonesia, Singapore, and Thailand, possibly reflecting a stronger role for the global search for yields, as asset returns in mature markets declined and capital flows turned increasingly to emerging markets.
Domestic financial conditions generally remain accommodative across the region. The process of monetary policy normalization in Asia has continued over the last few months, with several central banks in the region increasing policy interest rates since the start of 2010. Still, increasing inflationary pressures have pushed real interest rates lower in a number of economies, particularly India, Korea, and Thailand (Figure 1.15). Moreover, outside China, bank credit to the private sector has picked up further in 2010 (Figure 1.16) and bank lending spreads have also generally declined since the April 2010 Regional Economic Outlook (Figure 1.17), suggesting that banks may have become more willing to extend credit as the recovery has continued.
The Yen’s Appreciation and Its Implication for Japan’s Outlook
Over the period between April and early October 2010, the yen has appreciated by about 12 percent against the U.S. dollar and 10 percent against the euro, prompting the government to intervene in the foreign exchange market. The immediate effect was some weakening of the yen, but in effective terms the yen is still close to its peaks following the Lehman shock. This box examines the factors behind the yen’s rise and the implications for Japan’s recovery.
Factors behind the yen’s rise
While it is inherently difficult to pin down causes of short-term exchange rate movements, the recent rise of the yen appears to have been mainly driven by external factors.
During periods of heightened global uncertainty, the yen—much like the swiss franc—tends to appreciate on account of safe haven flows.1 In the current episode, concerns about European sovereign debt appear to be a major driver behind the yen’s appreciation. In late April, as uncertainty about the Greek debt crisis peaked, the bilateral exchange rate rose in a very short period and has remained high since then.
At the same time, a weakened U.S. growth outlook helped narrow the interest differential with Japan. Empirical studies show that the yen/U.S. dollar rate is sensitive to movements in the interest rate differential between Japan and the United States, reflecting the relative returns of fixed income investments. Since May, the 2-year U.S. Treasury and Japanese government bond yield difference declined from about 80 basis points to 40 basis points, driven almost entirely by U.S. developments. A weaker U.S. growth outlook and expectations of additional quantitative easing by the Federal Reserve lowered expected policy rates in the United States and weakened the U.S. dollar against most currencies, and particularly against the yen.
Unlike in 2009, the unwinding of leveraged carry trade positions does not appear to have been the main contributor to the recent yen appreciation. This is not surprising given that the risk adjusted returns on carry trade have remained low since May.
Implications for the outlook
In the past, strong increases in the yen have led to sharp equity market corrections and were followed by slowdowns in exports and GDP growth. A similar pattern appears to be playing out in the recent appreciation episode. The Nikkei stock market index has declined by more than 15 percent since end-April on weaker corporate earnings and may dampen investment looking ahead. Export growth has so far held up, as firms have absorbed falling yen prices by cutting profit margins, but this process is unlikely to be sustained.
The impact on near-term growth depends on the persistence of the current appreciation and the impact of the recent intervention. A sustained real effective appreciation of 5-6 percent (equivalent to the recent increase) could slow export growth by 2-2½ percent after two to three quarters, which would dampen GDP growth by 0.3—0.4 percent over the course of a year. The effect on growth could be significantly larger and reach 1 percent if the appreciation was signaling a significant slowdown in global growth.2 In the past, however, sharp and sudden yen appreciations have been partially reversed in following quarters, limiting their negative growth impact.
Longer-term implications of the recent yen appreciation appear so far to be limited. In real effective terms, the yen is still close to past averages. As of August 2010, the yen was about 4½ percent above its 1980-2010 average, and 2 percent below its 1990—2010 average, limiting concerns of a significant deterioration in competitiveness. Two factors have helped to moderate real yen movements: first, Japan’s persistently low inflation rate over time has offset the impact on competitiveness of the rise in the nominal yen rate. Second, Japan’s rising trade share with Asia (about 50 percent of total exports) at the expense of declining trade shares with the United States and the euro area, which has made Japan’s competitiveness less sensitive to exchange rate movements vis-à-vis the euro and the U.S. dollar.
The yen’s appreciation also poses a risk to deflation. On a year-on-year basis, core inflation (excluding food and energy) bottomed out at -1.2 percent in December of 2009 and gradually eased to -0.7 percent by August along with the recovery.3 Direct effects on inflation via falling import prices have been limited because the share of foreign products and services in the core consumption basket is relatively small.
The yen’s rise mainly affects deflation through a weakening of Japan’s export-led recovery, but the impact of the recent increase is unlikely to be large. As growth slows, the output gap closes more gradually, delaying a return to positive inflation. Japan’s Phillips curve relationship—an empirical association between inflation and the output gap— shows that such an effect tends to be small as core inflation is comparatively insensitive to fluctuations in the output gap. The estimated elasticity of -0.18 implies that a widening of the output gap by one percentage point would lower core inflation by about 0.2 percentage points, a rather small effect. However, a sustained further appreciation coupled with a significant global slowdown could accelerate downward price pressures, especially if such a shock was accompanied by a weakening of long-term inflation expectations.
The combination of accommodative domestic financial conditions and tightening external conditions leaves overall financial conditions in Asia still accomodative but slightly tighter now than at the beginning of 2010 (Figure 1.18). This pattern is borne out by a broad-based Financial Conditions Index that combines external and domestic financial indicators based on their relative contributions to economic activity (Box 1.3). While overall conditions are more accommodative in most economies than they were before the crisis, they seem to have tightened slightly. The tightening is particularly evident among export-oriented economies, where higher real effective exchange rates and lower stock prices growth have more than offset the positive contribution from lower real interest rates and stronger credit growth.
Inflationary Pressures Are Rising
With output growing above potential during the first half of 2010, output gaps are closing quickly, indeed faster than expected at the time of the April 2010 Regional Economic Outlook (Figure 1.19). With faster-than-expected growth and still accommodative financial conditions, inflationary pressures have continued to build in some economies:
Average CPI headline inflation in Asia, excluding Japan, accelerated to 4½ percent (year-on-year) in the second quarter of 2010 (Figure 1.20), from ¾ percent in 2009. The increase partly reflects higher commodity (particularly food) prices, but score inflation has also risen. The degree of acceleration has, however, varied considerably across the region. The uptrend of inflation has been most noticeable in India, where headline wholesale price index (WPI) inflation was still growing at close to double-digit rates in August 2010, while in other regional economies inflation remains more moderate.
A Financial Conditions Index for Asia
This box discusses a Financial Conditions Index (FCI) for Asia that takes into account both external and domestic financial conditions. The FCI suggests that overall financial conditions in Asia are still accommodative: although external financial conditions have tightened somewhat in recent months, the effect has been offset by loose domestic conditions. External financial conditions have generally tightened in Asia in 2010 relative to end-2009, reflecting real exchange rate appreciation and a moderation in capital inflows that contributed to a stabilization of equity valuations. On the other hand, domestic financial conditions have eased as real interest rates have declined, bank credit growth has picked up, and lending spreads have narrowed.
The FCI is a single summary measure of the overall stance of financial conditions. It is constructed as a weighted average of several financial indicators, with the weights determined by empirical measures of the relative contribution of each of these financial variables to economic activity.
Staff estimates of the FCIs for Asian economies consider four major financial variables:
growth of credit to the private sector (and, where available, lending standards of banks);
interest rates (real lending rates and interest rate spreads);
change in equity prices;
change in real effective exchange rates.
The weights assigned to each of these variables were derived from estimates of their impact on GDP growth within unrestricted vector-autoregression models (VARs), and were normalized to prevent the more volatile financial variables from dominating the broad index. These weights were found to reflect well the most obvious differences in the economic and financial structure of Asian economies. For instance, movements in real exchange rates were found to be relatively more important in export-dependent economies (Korea, Singapore, Taiwan Province of China, and Thailand) and were thus assigned proportionally higher weights for these economies. Stock prices were assigned relatively higher weights in economies with deeper stock markets (such as Japan and Hong Kong SAR).
This methodology allowed FCIs to measure exogenous changes in financial conditions that may affect economic activity with a lag. Indeed, changes in FCIs across Asian economies were found to significantly affect economic growth over a two-quarter period. Hence, the FCI summarizes the information on the future state of the economy contained in the current financial variables.
Recent movements in the FCI provide the following indications regarding overall financial conditions in Asia:
Financial conditions eased significantly during 2009 across the region, thanks to the strong recovery in equity markets and substantial monetary policy easing.
However, financial conditions have generally started to tighten since the beginning of 2010, following the stabilization of stock markets (particularly in Hong Kong SAR) and real exchange rate appreciation (Malaysia, Singapore, and Taiwan Province of China).
Despite the recent tightening, financial conditions generally remain accommodative in many emerging Asian economies compared with before the crisis (especially in China, the Philippines, and Thailand), as the policy easing of 2009 has not been completely unwound, equity valuations remain elevated, and bank credit continues to recover. However, overall financial conditions in mid-2010 were generally closer to the precrisis stance in industrial Asia (Japan, Australia, and New Zealand), owing to weak credit growth and the strong appreciation of exchange rates.
House prices in several economies (China, Hong Kong SAR, and Singapore) are growing at double-digit rates (Figure 1.21). In China, a property bubble appears to be inflating in some of the larger cities, although it does not seem as if property prices are significantly above fundamentals for the country as a whole (see Box 1.4). Starting in October 2009 some economies (China, Hong Kong SAR, Korea, and Singapore) have introduced measures to rein in real estate markets, such as more stringent limits on mortgage loan-to-value ratios and higher stamp duties and sales taxes on resale transactions. These measures have contributed to a moderation in some real estate markets. In Korea, property markets in Seoul declined sufficiently that in August the authorities eased the ceilings on loan-to-value and annual household debt-to-income ratios.
B. Economic Outlook
The economic outlook for Asia depends on the prospects for regional exports after the end of the inventory cycle, and on the strength of private domestic demand in the face of less policy stimulus and more volatile external conditions. This section addresses both prospects, discussing first the main forces shaping the outlook and then presenting the forecasts for 2010 and 2011.
Are House Prices Rising Too Fast in China?
China’s residential property market prices turned around and began to grow rapidly during 2009, especially in several large and medium-sized cities. Meanwhile, mortgage loans grew at nearly 50 percent in 2009, raising mortgage debt from 10 to about 15 percent of nominal GDP in one year. The sharp increase in prices, coupled with unprecedented lending growth, has led many to question whether there is a bubble building up in China’s property sector. In addition, improvement in housing affordability has stopped since mid-2009, making housing affordability a prominent issue.
This box measures how far residential property prices may have deviated from the levels consistent with medium-term fundamentals in different Chinese cities, both in the mass-market and luxury segments.1 It then characterizes price deviation in comparator countries, discusses similarities and differences with China’s experience as well as policy to contain financial imbalances in China in the future.
Judgments on the level of house prices are difficult to make, especially in markets that only formed into less than a decade and a half ago. But it is possible to compare house prices with benchmarks suggested by asset pricing relationships. The basis for assessing whether the level of house prices is “too high” or “too low” according to this framework is as follows: in a housing market with well-functioning rental and credit markets, the cost of owning a house (in nominal terms), or imputed rent, should be the same as the cost of renting a similar house for the same time period.2 If ownership cost is higher than market rent for some time, then buyers may be overpaying for that property and should switch to renting a similar property instead. Such deviations would induce arbitrage through changes in rents as well as changes in investment plans, which ultimately move the price toward its equilibrium.
The approximate annual cost of ownership consists of (i) the cost of foregone interest the homeowner could earn by investing elsewhere; (ii) the annual property tax, which in China is currently nonexistent; (iii) the tax benefit of owning when the owner deducts mortgage interest and property tax payments from income tax payment (if they are allowed to do so); (iv) maintenance cost; (v) expected annualized house price appreciation; and (vi) the additional risk premium to compensate homeowners for the higher risk of owning instead of renting.
The main findings from applying this methodology are:
House prices were not significantly overvalued in China as a whole during the first half of 2010. However, mass-market residential markets in Shanghai and Shenzhen and luxury residential markets in Beijing and Nanjing may be in the early stages of excessive price growth. Recent policy measures to cool down the markets unveiled by the government in April 2010 appear to have already had some impact on price growth. The gaps between market and fundamentals-implied prices have become smaller in a few cities.
During the past decade, house prices have corrected frequently in China, much like in Hong Kong SAR and Singapore, and in contrast to the trend increase experienced by advanced economies before 2008. Only recently have residential apartment prices in Singapore begun to deviate from benchmark by more than 10 percent for two consecutive quarters.
Systemwide mortgage loan-to-value movements tended to precede house price movements in China during 2007 to 2009. Measures to dampen leverage in 2007 led to a fall in house prices toward the benchmark price without persistent undershooting, while measures to ease leverage restrictions and extraordinarily loose monetary conditions in 2009 were followed by a surge in house prices.
Given the awareness of China’s authorities of the risks posed by excessive property price growth, and their experience in containing them, the threat of a housing price bust and consequent financial instability is not immediate. However, with structurally low real interest rates in the face of rapid income growth, no property taxes, lack of alternative investment possibilities, and the surging mortgage-to-GDP ratio, rapid property price growth in China is likely to continue. While we do not see evidence of significant and broad-based over-valuation in China’s residential property today, financial imbalances take time to build. As home ownership rises in this financial environment, policymakers are facing an ever growing challenge to financial stability.Note: The main author of this box is Ashvin Ahuja.1 Owing to a limited number of well-functioning rental markets in China and limitation in rent data, this box focuses on mass-market housing prices in Beijing, Guangzhou, Shanghai, Shenzhen, and Tianjin and luxury housing prices in Beijing, Hangzhou, Nanjing, and Shanghai.2 See Poterba (1984) and Himmelberg, Mayer, and Sinai (2005).
What Lies Ahead?
Asian real export growth is expected to moderate from precrisis trends, but will remain robust, in line with the expected continuation of the global recovery. Gains in market shares and increased final intraregional trade are unlikely to offset the weakness of final demand from advanced economies (see also October 2009 Asia and Pacific Regional Economic Outlook). Based on the October 2010 World Economic Outlook, final domestic demand from the United States and the euro area is projected to grow at about 1¾ percent (year-on-year) in 2011, down from about 2½ percent on average during 2004—07. Applying an estimated average income elasticity of Asia’s export to the United States and euro area of 3, this may subtract about 2½ percentage points from Asia’s real export growth in 2011 relative to the precrisis period average of about 14½ percent. The impact across regional economies will vary, however, based on how much export gowth in each economy depends on final demand from the United States and euro area.
Capital inflows to Asia are likely to remain strong. These inflows will be driven both by cyclical and structural factors. Interest rates in the advanced countries will likely remain low for a prolonged period and sustain flows to emerging markets (EMs), provided global financial market conditions remain relatively stable. Structurally, the higher medium-term growth prospects for the region, stronger policy fundamentals (including sound fiscal positions) and expanding local capital markets are leading fund managers and institutions to increase their allocations to emerging Asia (see IMF, 2010e). Given the long lead time required to change investment mandates and benchmarks, and the limited supply of assets available to foreign investors, this portfolio shift could take years to implement, implying persistent flows to the region.
The withdrawal of fiscal stimulus is expected to be very gradual. In all subregions of Asia, fiscal policy is expected to be less accommodative in 2010 than in 2009, as reflected in a negative fiscal impulse for 2010 (Figure 1.22). But fiscal stances remain accommodative, as cyclically adjusted government fiscal deficits are still relatively high (Figure 1.23). In a few cases (Hong Kong SAR, New Zealand, the Philippines, Singapore, and Thailand) stimulus is projected to continue in 2010, with a withdrawal starting only in 2011. The accommodative fiscal positions in the region mainly reflect the introduction of medium-term measures to support growth, rather than the extension of measures taken in response to the crisis. Some governments have extended stimulus measures, or phased in new measures, in response to special circumstances. For instance, in China, the reduction in taxes on automobile purchases and tax incentives for purchases of home electrical appliances has been extended until end-2010. In Japan, the eco-point program will remain in place until late 2010, and the government began a child support system in June.
Asia’s autonomous private consumption growth should remain robust. The rebound in asset prices and improved labor market conditions, which have been important contributors to the rebound of private consumption in emerging Asia, should continue to sustain consumption prospects in the future:
Continued foreign equity inflows will support equity valuations. Although wealth effects of equity prices on private consumption are generally relatively low in Asia, reflecting limited share ownership among Asian households, equity prices may affect consumption in the region through confidence effects. IMF staff estimates suggest that private consumption in Asia does indeed tend to react strongly to large foreign equity inflows (see Box 1.5).
Labor market conditions continue to improve across emerging Asia. With a few exceptions, including Japan, unemployment rates have returned to precrisis levels (Figure 1.24). Real wage increases have, however, been relatively muted, perhaps reflecting renewed uncertainties over the strength of external demand (Figure 1.25). Employment and wages seem closely linked to exports in many Asian economies, suggesting a firm growth in exports, in line with the unfolding global recovery, could contribute to a sustained improvement in labor market conditions in the region (Figure 1.26).
Capital Flows and Domestic Demand in Emerging Asia
Across emerging Asia, the recovery in domestic demand since the global financial crisis has been positively correlated with the volume of foreign capital inflows. This box examines empirically the relationship between capital inflows and domestic demand in a selected number of Asian emerging economies (India, Indonesia, Korea, Malaysia, the Philippines, Taiwan Province of China, and Thailand) over the last decade, using a vector autoregression (VAR) framework.1 The results suggest that, during this period, private consumption and investment in emerging Asia have tended to react strongly to shocks to foreign equity and debt inflows, and that the response appears to be tempered by exchange rate flexibility and less procyclical fiscal policy.
How does private domestic demand respond following a shock to capital flows?
Over the past decade, Asian private consumption and investment have responded for several quarters after a shock to capital flows. At its peak, the acceleration in private domestic demand following a 1 percentage point of GDP increase in portfolio equity flows is equivalent to 0.4 percentage points of quarter-on-quarter annualized growth in the case of consumption, and nearly twice that amount for investment. Both components of private domestic demand also grow more rapidly following a shock to other investment flows. Investment growth increases following a shock to portfolio debt flows and other investment flows, although the effect wears off relatively quickly.
Several possible links between capital flows and private domestic demand can account for the observed patterns.
Credit to the private sector responds favorably to other investment flows, suggesting that a link between other investment flows and private domestic demand is through the channel of credit. The link is seen more clearly for countries in the region (such as Korea) that rely on wholesale bank funding from overseas. Easier external financial conditions enhance the lending capacity of domestic banks and expand the volume of bank resources available. Even in a situation where banks do not rely on wholesale external funding, there may be a tendency to relax lending standards with the easing of external financial conditions.
The real cost of equity declines following a positive shock to equity inflows.2 The magnitude of decline is large compared with the size of typical fluctuations in this variable in advanced economies and is particularly strong in the case of the ASEAN-4 economies. The effect persists even six quarters after the initial shock and helps explain why investment growth increases in response to a large inflow of equity capital.
Capital inflows, private domestic demand, and policy stances
The strength of the linkages between private domestic demand and capital flows may also depend on the exchange rate regime and the fiscal policy stance.
Exchange rate flexibility offers an important buffer. The response of private domestic demand to a shock to capital flows is generally lower in absolute terms for countries with more flexible exchange rates.3 Not surprisingly, these are also the same countries where reserve accumulation is relatively weakly correlated with fluctuations in capital flows.4 The insulating effects of exchange rate flexibility arise from several possible factors. Greater exchange rate flexibility could translate into less sustained inflow pressure in anticipation of eventual appreciation, and therefore a smaller cumulative impact of capital flows on consumption and investment. With flexible exchange rates there would be less need for intervention which, if imperfectly sterilized, could fuel domestic consumption and investment via a buildup of liquidity and a credit boom. Even if the interventions are fully sterilized, the links between capital flows and domestic demand may remain strong if banks and firms anticipate that easy access to external finance will continue.
Countercyclicalfiscal policy can also weaken the ties between capital flows and the domestic cycle.5 Over the past decade in emerging Asia, countercyclical public spending has contributed to a lower sensitivity of private domestic demand to capital flows. The response of consumption growth to equity, debt, and other investment flows is lower in the case of counter-cyclical fiscal regimes. Countercyclicality of public spending also appears to contribute to a lower sensitivity of private investment in response to a shock to debt and other investment flows. By contrast, if public expenditure is procyclical, the spending on the upswing of the cycle could contribute to an increase in interest rates and greater appreciation pressures, which will attract additional inflows and lead to a further acceleration of private domestic demand.
Private investment growth in Asia should also remain rapid. The most important drivers of the recovery in private investment since 2009 have been the turnaround in exports and rising capacity utilization (Figure 1.27).1 Capacity utilization and export growth together account for nearly half of the rebound in investment since the first quarter of 2009 in selected Asian economies. The decline in the cost of capital (Figure 1.28) has also contributed to the investment rebound, although to a lesser extent, as the strong balance sheet positions of Asian firms have enabled them to rely more on internal resources to finance investment during the early stages of the recovery. Looking forward, these underlying fundamentals are likely to continue to sustain private investment growth:
Capacity utilization rates outside Japan remain high (Figure 1.29).
Low and decreasing loan-to-deposit ratios in many Asian economies suggest that ample liquidity is available to fund a more decisive bank credit expansion (Figure 1.30). Indeed, bank credit growth to the corporate sector has started to pick up in the region in 2010. Moreover, Asian banks are unlikely to be greatly affected by the regulatory changes to strengthen the capital and liquidity of banks that are currently being contemplated in the global discussion (see Box 1.6).2
Steady inflows of foreign capital to Asia will also provide an important source of funding for corporate investment. Empirical evidence suggests that Asia’s private investment tends to react strongly to changes in capital flows, which tend to drive up domestic credit (Box 1.5). Domestic credit tends to respond particularly strongly to cross-border bank flows, especially in economies, such as Korea, where wholesale bank funding from overseas is important. Foreign equity inflows could also contribute to further reducing the real cost of equity.
Projections for 2010-11
GDP growth for Asia as a whole is projected to rise to about 8 percent in 2010 before moderating to a more sustainable rate of about 7 percent in 2011. The projections represent an upward revision of nearly 1 percentage point for 2010 compared with the April 2010 Asia and Pacific Regional Economic Outlook, mainly reflecting the much stronger-than-expected outturns across the region so far in 2010, and a slight reduction for 2011 (Table 1.1). For emerging Asia, growth is projected at about 9⅓ percent in 2010 and 8 percent in 2011, although with substantial variation across the region. A notable aspect of the outlook is that the large, domestic-demand-driven economies—China, India, and Indonesia—are set to grow particularly rapidly and lead the Asian recovery. Some specific features of the projections are as follows:
Asia and Global Financial Reforms
Asia’s financial systems have been remarkably resilient during the current crisis. This strong performance owes much to significant structural changes following the Asian crisis, and demonstrates that traditional virtues—maintaining adequate capital, avoiding excessive reliance on short-term funding, ensuring proper loan underwriting, and following sound risk management—remain critical. Appropriately, these principles are prominent in ongoing reform debates and Asia’s important role in institutions like the G-20, Financial Stability Board, and Basel Committee provides the region a platform to help build a stronger global financial system.
Looking ahead, however, reforms will be important to ensure that the risk of systemic crises remains contained as well as to support rebalancing. Encouragingly, the region has so far drawn the right lesson from the crisis—that financial development can bring great benefits if managed adequately and does not inevitably cause crises. Maintaining a strong supervisory regime, including by building up risk assessment capabilities and adopting a macroprudential approach, is essential in this regard. With capital flows likely to remain large in coming years, moving ahead with the development of Asia’s financial markets will become even more important to contain potential risks to stability as well make the best use of the region’s significant savings in support of domestic demand.
In this context, Asia will need to adapt to new global regulatory proposals. There is broad agreement on the key principles of reform in response to the crisis—widening the regulatory perimeter to include all systemically important financial institutions (SIFIs), bolstering supervision, improving the measurement and regulation of systemic risk, and strengthening crisis resolution mechanisms, particularly for “too-big-to-fail” institutions. Asia is helping to shape new international standards on these fronts. In addition, there is recognition that risk-taking needs to be curbed, notably through regulations designed to make financial institutions hold more and better quality capital, build buffers during good times, improve liquidity management, and curb excessive leverage. In this regard, enhancements to the Basel framework were recently announced, including:
Minimum capital ratios will be raised effectively to 7, 8½, and 10½ percent for common equity, Tier 1 and total capital (including a 2½ percent capital conservation buffer). An additional countercyclical buffer of 2½ percent may also be applied by national regulators during periods of excessive credit growth. These changes will be phased in over several stages from January 2013, with full implementation by January 2019 and existing capital instruments grandfathered for 10 years.
A leverage ratio will become a new Pillar 1 requirement. The precise metric is yet to be finalized, but capping total assets at 33 times Tier 1 will first be tested. Metrics based on total capital and tangible common equity are also candidates, with full implementation envisaged from January 2018.
New global standardsfor funding liquidity are to be introduced in the form of a 30-day liquidity coverage ratio (January 2015) and a net stable funding ratio to reduce banks’ dependence on short-term funding (January 2018).
As a whole, Asia is likely to be relatively less affected by these measures than the United States and Europe, because its banks already tend to operate under tight liquidity and capital rules, with regulators adopting a conservative approach in the implementation of Basel II requirements. The new capital standards, for instance, may not be binding as average ratios in many Asian banking systems are already above the minimum thresholds that will apply in 2019. In addition, curbs on risky behavior may also have less of an impact, given that Asian banks typically have a different business model—one that relies on relatively more stable sources of funding and revenue, that is, deposits and interest income. That said, there could still be some impact, although it should be largely manageable. Reforms to the quality of capital would have implications for some Japanese and Malaysian banks that hold sizable deferred tax assets and hybrid instruments. In addition, new liquidity standards could affect some banks in Australia, Korea, and New Zealand with a relatively high reliance on short-term wholesale funding, and some banks in Japan and India could be impacted if leverage limits include government securities on the asset side. More broadly, the cost of business could rise globally and there could also be some indirect effect if European and U.S. banks reduce lending to the region in response to these changes. However, the Basel Committee estimates that the potential impact on global lending conditions and growth would be relatively limited, with the benefits from reducing the probability of financial crises and their associated output losses outweighing the costs.
The phase-in period and grandfathering provisions provide further cushioning to implement these reforms, which would ultimately help sustain the region’s growth. The generally strong balance sheets and liquidity position of Asian banks should allow them to adapt quickly to the new regulatory requirements, perhaps even developing a competitive advantage over banks in other jurisdictions. Indeed, banks and regulators have already grasped the benefits of some reforms—for instance, Japanese banks have bolstered their capital positions through share issuances over the last year, New Zealand has introduced a core funding ratio, and Korean regulators are encouraging banks to move to longer-term funding maturities. In addition, a number of Asian authorities have indicated that they could implement stricter regulations on a faster timetable and tailored to contain systemic risks in the region, such as those from procyclicality, regulatory arbitrage, and the real estate sector. In this regard, some may adopt the higher capital standards for SIFIs (being developed by the Financial Stability Board for the G-20) as an add-on to the new Basel standards. Such a proactive strategy toward reforms could have significant payoffs: some analysts estimate that Asia could create the most value added in the banking industry over the next decade, with revenues in China and India potentially growing 10 percentage points faster than in the United States (McKinsey, 2010).Note: The main author of this box is Murtaza Syed.
In China, GDP growth is projected to be 10½ percent in 2010, based on strong domestic demand, while net exports are likely to remain a drag on growth. In 2011, growth is expected to moderate to about 9½ percent, but to be driven more by private-sector demand as the stimulus winds down (Figure 1.31). In particular, consumption growth should remain robust and increase as a share of GDP, underpinned by strong labor market conditions and continued policy efforts to raise household disposable income.
In India, GDP growth is expected to reach about 9¾ percent in 2010 before moderating slightly to 8½ percent in 2011. Private domestic demand is expected to remain strong (Figure 1.31), with investment supported by rising corporate profits, credit growth, and capital market issuance, and consumption supported by strong labor market conditions and rising disposable income.
Growth in the NIEs is expected to moderate from 7¾ percent in 2010 to 4½ percent in 2011 (roughly in line with potential), reflecting a smaller contribution from inventory accumulation and net exports, owing to lower demand from both advanced economies and China. The drivers of growth are expected increasingly to shift from public to private demand (Figure 1.32).
Growth in the ASEAN-5 economies is projected to reach about 6½ percent in 2010 before moderating to about 5½ percent in 2011 (Figure 1.32). Indonesia is likely to experience robust growth in both 2010 and 2011 from broad-based strength in consumption and investment, and with additional support from planned infrastructure development. In the Philippines, above-trend growth in 2010 reflects a recovery in exports, strong consumption supported by robust remittance inflows, and a pickup in investment. In 2011, as the recovery matures, growth is expected to return to trend. In Malaysia, private consumption will be the main driver of growth in 2010, in line with improvements in employment conditions and rural incomes. Growth is expected to moderate slightly in 2011 owing to weaker external demand, although private investment is likely to advance in response to structural reforms to boost medium-term growth. In Thailand, robust and broad-based growth in 2010 will move to a more sustainable pace in 2011, as stimulus policies are rolled back and export growth moderates.
In Japan, growth is projected to reach 2¾ percent in 2010 before slowing to 1½ percent in 2011. With a softening external environment, business investment plans are expected to pick up only gradually, particularly in export-related sectors. Private consumption should slow over the next few quarters as fiscal stimulus measures expire, before picking up later in 2011 as labor market conditions gradually improve (Figure 1.33).
Growth in Australia and New Zealand is projected to remain strong through 2010 and 2011 (Figure 1.33). In Australia, real GDP growth is projected at 3-3½ percent in 2010—11, with private investment in mining and commodity exports taking over from public demand as the main driver of growth. Despite rising mortgage rates, household consumption should be supported by the recent rebound in employment that has buoyed real income growth. In New Zealand, GDP is expected to grow at about 3 percent in 2010 and 2011, as commodity exports remain robust.
Asia: Real GDP Growth
(Year-on-year; in percent)
Asia: Real GDP Growth
(Year-on-year; in percent)
|Hong Kong SAR||-2.8||6.0||4.7|
|Taiwan Province of China||-1.9||9.3||4.4|
|Emerging Asia excl. China||2.5||8.2||6.4|
|Emerging Asia excl. China and India||0.4||7.2||4.9|
Asia: Real GDP Growth
(Year-on-year; in percent)
|Hong Kong SAR||-2.8||6.0||4.7|
|Taiwan Province of China||-1.9||9.3||4.4|
|Emerging Asia excl. China||2.5||8.2||6.4|
|Emerging Asia excl. China and India||0.4||7.2||4.9|
Inflation is expected to increase across most of the region (Figure 1.34). In China, inflation is expected to remain moderate in the near term, reflecting a further expansion of capacity as a result of the large investment program in response to the global financial crisis, significant productivity growth, and abundant labor supply. In India, although food prices are expected to ease after 2009’s drought and headline inflation is projected to slow gradually to about 7 percent by March 2011, underlying inflationary pressures are expected to remain elevated, given little or no slack in the economy and still accommodative monetary conditions. In Indonesia, inflation is expected to approach the upper end of the 4-6 percent target range in 2011, on the back of a narrowing output gap, recovering credit growth, and administered price hikes. In Korea, with the output gap closing in the second half of 2010 and monetary policy still highly accommodative, headline inflation is expected to reach 3½ percent in 2011. In Japan, deflation has continued to recede and, with a narrowing of the output gap, headline inflation is expected to turn positive in early 2012.
Asia’s current account surplus as a proportion of the region’s GDP should continue to narrow in the near term. The surplus is expected to decline from about 3½ percent in 2009 to about 3 percent in 2011, reflecting contributions from most major economies in the region (Figure 1.35). China’s current account surplus is projected to fall by nearly 1½ percent of GDP in 2010 relative to 2009, but to start increasing again in 2011. Excluding China, the current account surplus for the rest of the region is expected to fall to under 2 percent of GDP in 2011, from 2⅔ percent in 2010, as higher regional growth translates into a faster pickup in imports than in exports, and as income from investment outside the region falls with lower growth in the rest of the world. The decline in the external surplus is expected to be more pronounced in the ASEAN-5, consistent with government initiatives to boost infrastructure spending and to induce more private investment. In India, the current account deficit is projected to rise to 3 percent of GDP in 2010/11, as domestic demand remains strong.
The main risks to the growth projections arise from the external environment, and particularly the downside risks to global growth (Figure 1.36). As the October 2010 World Economic Outlook notes, a sustained and healthy global recovery depends both on stronger private demand in advanced economies that facilitates a shift away from fiscal support, as well as on higher net exports from current account deficit countries and lower net exports from surplus countries. But strong policies to foster these changes are not yet in place. As a result, the global recovery is expected to be both sluggish—the current World Economic Outlook projection for global growth of 4-4¾ percent in 2010 and 2011 is sluggish considering that advanced economies are emerging from their deepest recession in the past 60 years—and vulnerable to downside risks.
A key downside risk for Asia is a scenario in which advanced economies are hit by renewed financial turbulence that disrupts their private domestic demand. Renewed turbulence in sovereign debt markets in advanced countries could cause renewed damage to their financial sectors, and spill over to the real economy through higher bank funding costs and tighter lending conditions. Although Asia’s economic fundamentals are generally strong, the region would feel the impact of fresh turmoil and a renewed slowdown in the rest of the world in light of its close trade and financial linkages with advanced economies.
Trade linkages remain an important spillover channel for Asian economies, which rely heavily on external demand to drive growth.3 Over the past two decades, emerging Asia has experienced a boom in intraregional trade, particularly since China’s accession to the World Trade Organization. During the recovery from the global recession, intra-Asian exports, notably to China, rose about twice as fast as Asian exports to the United States and the European Union. For many regional economies, China is now the single largest direct export destination, accounting for about 20 percent of the exports of other Asian economies. However, to a large extent, the boom of intraregional trade reflects growing vertical integration and thus trade in intermediate inputs. Indeed, two-thirds of the final demand for Asian exports still comes from outside the region, and non-Asian final demand accounts for an estimated 20 percent of the total value added produced in the region. The dependence on non-Asian demand is higher (up to 50 percent) in the region’s smaller and more export-reliant economies, such as Malaysia, Singapore, Taiwan Province of China, and Thailand (Figure 1.37). A 1 percent decline in U.S. and euro area domestic demand could subtract an estimated ½ percentage points from GDP growth on average across Asia, with estimates ranging from about 0.1 percentage points for Indonesia to about 0.6 percentage points for Malaysia (Figure 1.38). In addition to direct effects, a more pronounced slowdown in external demand would also hamper the transition to private domestic demand in Asia by weakening labor market conditions as well as the investment recovery. However, the region’s “growth leaders”—particularly China, India, and Indonesia—are relatively less vulnerable to external demand shocks than some of the smaller economies because of their large domestic demand bases, which are playing a larger role in their growth.
Financial spillovers from advanced countries to Asian banks, firms, and sovereigns are also a source of concern, although they appear to be generally manageable.
Banks: Asian banks are unlikely to face significant fallout from credit or liquidity shocks that may occur in advanced countries, due to their relatively small overseas exposure (20-30 percent of total assets), particularly to Europe (7—10 percent of total assets) where financial stress was particularly acute earlier in 2010 (Figure 1.39). Indeed, Asian bank credit default swaps (CDS) spreads have remained well below their 2008-09 levels. Banks’ funding exposures to advanced economies could be a potentially larger source of concern for some economies, particularly those that rely more on foreign wholesale funding, as the bulk of cross-border claims on Asian economies are held by European banks (notably French, German, Swiss, and U.K. banks) (Figure 1.40).
Firms: Corporate foreign currency-denominated rollover needs over the next few quarters appear sizable in dollar terms, particularly for Australia, Korea and, to some extent, India. On the other hand, such needs are generally small relative to potential shock absorbers, such as gross official reserves (Figure 1.41).4 Local currency-denominated rollover needs are modest in comparison with the depths of local banking systems (Figure 1.42).
Sovereign: Asian sovereign CDS spreads have remained broadly stable in recent months, suggesting that investors’ perceptions of sovereign default risks continue to be low. This reflects relatively strong fiscal positions, and, in the few cases where public debt levels are elevated by regional standards, such as India and Japan, relatively low levels of external debt (Figure 1.43). However, an escalation of debt sustainability concerns in advanced economies and a jump in global risk premiums would raise financing costs for Asian governments (see Box 1.7).
Further increases in volatility and risk aversion in global financial markets could weaken private domestic demand in Asia. The experience during the 2008-09 crisis and 2010 financial turbulence suggests that Asian debt and equity markets are highly correlated with global markets (Figure 1.44). A jump in global risk aversion that led to a reversal of foreign capital inflows to the region would hurt private consumption and investment by negatively affecting confidence, increasing the real cost of equity, and reducing credit to the private sector. At the same time, a few economies (Hong Kong SAR, Japan, and Singapore) could experience capital inflows in search of safe havens. In Japan, a further real appreciation of the yen could weaken the export-led recovery, exacerbate deflationary pressures, and, via lower share prices, hurt banks’ stock portfolios. In Hong Kong SAR and Singapore, on the other hand, further capital inflows may exacerbate overheating pressures in the property sector.
Sovereign Spreads and the Risk of Contagion for Asia
Since the beginning of the global financial crisis in late 2008, sovereign spreads in Asia (defined as the difference between 10-year sovereign bond yields and the yield on 10-year swap)1 have gone through three distinct phases:
Phase I (October 2008–March 2009): Following the collapse of Lehman Brothers, sovereign bond yields increased well above swap rates across Asia, particularly in emerging Asia.
Phase II (March 2009–September 2009): Most Asian sovereign spreads fell back to precrisis levels, as systemic risk decreased.
Phase III (October 2009–July 2010): Increasing idiosyncratic risks caused greater differentiation among economies, but sovereign spreads in the region have generally remained contained regardless of the sovereign debt turmoil in the euro area.
What determines these fluctuations? Does the risk of contagion from advanced country sovereign risks to sovereign spreads in Asia depend on the type of the financial shock, in particular its global nature? And what is the role played by country-specific factors?
To address these questions, this box uses a model developed by Caceres, Guzzo, and Segoviano (2010), that allows assessing the relative contribution to Asia’s sovereign spreads from three different factors:2
Changes in global risk aversion as captured using an index of global risk aversion, as in Espinoza and Segoviano (forthcoming).
Changes in sovereign risk or contagion, or in the degree to which risks originating from other sovereigns spill over to Asian sovereigns. Contagion is measured as the probability of distress of a country given that distress has occurred in other countries, as in Segoviano and Goodhart (2009).
Changes in country-specific fiscal fundamentals, defined here as public debt-to-GDP ratio and fiscal deficitto-GDP ratio.
The results of the model suggest that spillovers from sovereign risk were the main driver of the changes in Asian sovereign spreads since the financial crisis outbreak. In Phase I, contagion contributed to the spike of Asia’s sovereign spreads, as higher probability of distress outside the region affected market confidence in Asia. This effect reversed in Phase II, where positive spillovers (or negative contagion) drove the rapid normalization of Asian sovereign spreads. Within Asia, the impact of contagion in driving swap spreads appears relatively limited only in Japan, presumably reflecting the limited foreign ownership of Japanese government debt. In Phase III, the spillover from sovereign risk elsewhere to Asian economies was more limited, possibly reflecting the smaller and more “local” nature of the most recent financial turmoil relative to the post-Lehman episode.
At the same time, changes in fiscal fundamentals have played a much smaller role in driving Asian sovereign spreads, relative to euro area economies. On average in Asia and over the three phases, the contribution from fundamentals to changes in sovereign spreads was estimated at 5 percent of total changes, compared with 27 percent for the euro area. This partly reflects the relatively more solid fiscal position of Asian economies in general over the three periods. Nevertheless, the contribution from contagion to swap spreads tends to be higher for Asian economies with relatively higher overall public debt ratios, and relatively higher external debt ratios.Note: The main authors of this box are Carlos Caceres and D. Filiz Unsal.1 For China, Indonesia, Malaysia, and the Philippines, we use the difference between 5-year sovereign bond yields to the yield on 5-year swap.2 The model is estimated with GARCH (1,1) specification. Our data set spans from the beginning of 2005 through mid-2010, encompassing ten Asian economies.
Within Asia, a more abrupt slowdown of economic activity in China than expected is a tail risk. If such an abrupt slowdown were to occur, it would have implications across the region given the linkages of many regional economies with China through the vertical integration of trade, imports by China of commodities and capital goods from other Asian economies, financial flows, and other channels.
D. Policy Challenges
Managing the Exit from Stimulus
The main short-term policy challenge for Asian policymakers is to manage the exit from policy stimulus now that the recovery is well under way across the region. Closing output gaps and emerging pressures in goods and asset prices suggest that the time has come to normalize fiscal and monetary policy stances.
Monetary policy stances remain generally accommodative, although many economies have started taking steps to normalize them (Figure 1.45). “Excess liquidity” (the difference between broad money growth and nominal output growth) has come down from its peak in late 2009, but it remains above precrisis levels (Figure 1.46). Real policy rates are still well below their precrisis levels in most economies despite the rapid recovery and, with a few exceptions (such as Australia and Malaysia) they are also well below estimated levels that are consistent with stable inflation and zero output gaps (Figure 1.47).
An early move to normalize monetary policy stances is needed to head off pressures in goods and asset prices.
Inflationary risks: high headline inflation, due to spikes in food and energy prices, could spill over into inflation expectations and then into core inflation. These risks are all the more real in the context of increasingly tight resource utilization in many Asian economies. Chapter II shows that rapidly closing output gaps tend to amplify the second-round effects of higher commodity prices on inflation in Asia. The chapter also suggests that the role of demand factors in driving inflation in Asia has increased over the last decade.
Asset bubble risks: history suggests that Asia can be susceptible to asset boom-bust cycles during periods of “excess liquidity” (see April 2010 Asia and Pacific Regional Economic Outlook). Maintaining accommodative monetary conditions in the context of rapid economic growth could lead to asset price inflation. Some monetary policy tightening may be justified even in the absence of strong and visible CPI inflation pressures, particularly in economies where household debt is relatively high and credit growth rapid (Figure 1.48).
Greater exchange rate flexibility will be an important component of policy tightening. Foreign inflows to Asia in recent quarters have been reflected mainly in international reserve accumulation and less so in exchange rate appreciation (Figure 1.49). Reserve accumulation has accelerated in most of emerging Asia since May 2010, and has contributed to excess liquidity in many countries. Allowing the exchange rate to appreciate in response to inflows would be more conducive to normalizing the policy stance, and (as discussed below) would also help in managing effectively the volatility associated with capital inflows.
In Japan, however, given the yen’s appreciation and sluggish domestic demand, the central bank should continue to stand ready to ease policy further to address possible downside risk to the outlook. The Bank of Japan (BoJ) has already taken further measures to expand liquidity, such as extending the size and maturity of a fund-supplying facility aimed at reducing term premiums and introducing a facility to help finance bank lending to private sector projects in new growth sectors. In October 2010, the BoJ announced a new “comprehensive monetary easing” policy, aimed at driving longer-term interest rates and risk premiums lower. The policy (i) maintains the uncollateralized overnight call rate at between 0 and 0.1 percent; (ii) commits to maintaining the virtually zero interest rate policy until medium- to long-term “price stability is in sight;”5 and (iii) establishes a program to purchase various financial assets (up to ¥5 trillion in one year), including government securities, corporate bonds, exchange-traded funds, and real estate investment trusts.
Fiscal policy stimulus in the region should be withdrawn further, now that the recovery is under way. A withdrawal of fiscal policy stimulus would allow governments to reconstruct the fiscal space that they need to cope with adverse shocks in the future. Countercyclical fiscal policy can also help to cushion domestic demand against the impact of large capital flows (Box 1.5). The extent and type of fiscal adjustment that is appropriate for each country will depend on individual circumstances, particularly the pace of the recovery and the surrounding risks, as well as the fiscal space available (Figure 1.50). Fiscal consolidation could be accompanied by moves to strengthen medium-term fiscal frameworks, which can help to better anchor fiscal policy. Several governments in Asia are already moving in this direction (Table 1.2). For commodity exporters, in particular, fiscal rules could reduce the procyclical bias imparted by volatile fiscal revenues, as well as ensure that the benefits from these resources are shared across generations (see Box 1.8).
Selected Asia: Medium-Term Fiscal Objectives
Selected Asia: Medium-Term Fiscal Objectives
|Japan||Halve primary deficit (in percent of GDP) by FY2015, and achieve stable reduction in the public debt ratio from FY2021.|
|Korea||Balance central government budget (excluding social security funds) by 2013—14.|
|China||Move toward balanced budget.|
|India||Central government deficit of 3 percent of GDP by FY2013/14 and debt ratio of 45 percent of GDP by FY2014/15.|
|Philippines||Deficit target of 2 percent of GDP by 2013.|
|Thailand||Balanced budget by FY2014.|
Selected Asia: Medium-Term Fiscal Objectives
|Japan||Halve primary deficit (in percent of GDP) by FY2015, and achieve stable reduction in the public debt ratio from FY2021.|
|Korea||Balance central government budget (excluding social security funds) by 2013—14.|
|China||Move toward balanced budget.|
|India||Central government deficit of 3 percent of GDP by FY2013/14 and debt ratio of 45 percent of GDP by FY2014/15.|
|Philippines||Deficit target of 2 percent of GDP by 2013.|
|Thailand||Balanced budget by FY2014.|
Many Asian economies could reorient spending within available fiscal envelopes to further support investment in infrastructure. Chapter III suggests that, in economies where private investment is particularly low, infrastructure investment can increase competitiveness and crowd in private investment. Several governments across the region have stepped up their allocations to infrastructure over the last two years (China, Hong Kong SAR, Indonesia, and Thailand). Nonetheless, infrastructure gaps appear sizable in several economies, including India and most of the ASEAN. In these economies, greater use of public-private partnerships, if well managed, could usefully complement direct public financing and potentially allow the public sector to take advantage of private sector efficiencies.
Asian low-income countries (LICs) and Pacific Island countries (PICs) face significant fiscal adjustment and reform challenges in the coming years. The situation of Asian LICs and PICs is discussed in more detail in Chapter IV. Fiscal positions in these economies have deteriorated significantly during the global crisis, raising some debt sustainability concerns. Their fiscal challenges, however, go beyond the need for fiscal consolidation, as there are also large financing needs for development spending. Creating the fiscal space to step up public investment programs will require LICs to implement fiscal reforms. For many PICs the need for significant fiscal adjustment and reform challenges in the coming years mainly derive from progress in trade liberalization and declining overseas assistance.
Policy Responses to Large Capital Inflows
Fiscal Policy in Commodity-Exporting Countries
The increase of commodity prices in recent years has raised two concerns over fiscal policy in commodity-exporting countries:
Excessive volatility of fiscal revenues: changes in the terms of trade impact revenue directly, as a substantial share of revenues is resource-related, or more broadly, because GDP is sensitive to the commodity cycle. In the short term, this volatility could foster policy procyclicality. A sharp increase in revenues, for example, could lead to a rise in expenditure, and vice versa. Indeed, fiscal policy appears to have been more procyclical in commodity exporters in recent years, compared with noncommodity exporters.
Intergenerational distribution of the benefits from nonrenewable resources: if commodities are nonrenewable, their exports decrease national wealth. Some of this wealth could be saved, both to help achieve long-term fiscal sustainability and for intergenerational equity. Without a compensating accumulation of assets (physical or financial), the welfare of future generations would be permanently harmed.
Fiscal frameworks in Asia-Pacific commodity exporters
How are these issues dealt within Asia-Pacific commodity exporters?
In Australia, the framework laid out in the Charter of Budget Honesty requires fiscal policy to contribute to moderating cyclical fluctuations in economic activity, and maintain Commonwealth Government debt at prudent levels. The current government’s strategy is to achieve budget surpluses on average over the medium term, to help moderate the procyclical impact from the terms of trade. The framework allows for swings in the fiscal balance over the cycle and yet maintains the flexibility that allowed the large fiscal stimulus during the crisis, without the need for abandoning its fiscal rules (IMF, 2009b). Another objective of this framework is to improve the financial net worth of the government over the medium term, which de facto helps achieve an equitable allocation of the benefits from nonrenewable resources across different generations.1
In New Zealand, the 1994 Fiscal Responsibility Act introduced principles of fiscal management, as opposed to mandatory targets. Governments are required to reduce total Crown debt to prudent levels, to spell out policies to reach that target, and to explain temporary departures. It is left to the government to interpret the relevant fiscal terms. The framework is flexible enough to take into account excessive volatility of commodity prices.
Indonesia and Malaysia do not have fiscal frameworks that allow responding to the commodity price cycle, or that target an “equitable” drawdown of oil wealth. But efforts have been made in recent years to decrease the dependence of the budget on oil revenues, by improving non-oil revenue compliance and by rationalizing fuel subsidies.
Fiscal rules in commodity-exporting economies
Various fiscal rules have been adopted around the world by commodity exporters to address both the excessive revenue volatility and intergenerational equity issues (Davis and others, 2001, and IMF, 2009b). In general, the difficulty of distinguishing between temporary and permanent terms-of-trade shocks could further complicate the design and implementation of fiscal rules for commodity exporters.
Cyclically adjusted, structural balance. By correcting for changes in commodity revenues, this rule allows insulation of the budget from the volatility of commodity prices and the effects of the business cycle. Revenue windfalls will be saved in good times to build a buffer against a fall in commodity prices. This rule is appropriate for commodity exporters that do not have large commodity revenues but are still subject to sharp swings in the terms of trade. One drawback is that it requires an estimation of the output gap, which is subject to considerable uncertainty and large ex post revisions. As such, this rule may not be easy to monitor and communicate to the public. Nonetheless, it has been extremely successful in Chile in avoiding procyclical fiscal policies during periods of terms-of-trade booms. In Mexico, consideration is being given to introducing a structural rule that reinforces savings at the peak of the cycle.
Noncommodity balance target rule. Setting a target on the noncommodity balance can insulate the budget from the volatility of commodity revenues, and let the authorities focus on a fiscal aggregate that can be controlled more than the overall balance. During periods of relatively high commodity prices or output, the overall budget might accumulate a surplus, and a deficit during periods of low prices or output, but expenditures would be unaffected. This rule is in effect in Norway, which uses the non-oil structural deficit as fiscal target. A general concern about this rule is that targeting a noncommodity balance could lead to excessive headline deficits in the case of a sharp drop in commodity prices or output, assuming that the drop is temporary. Moreover, this rule is not easy to implement when the share of each commodity in total revenues is small.
Commodity stabilization or savingfunds. Revenue volatility and intergenerational issues can also be achieved by establishing “stabilization” or “saving” funds. Stabilization funds are a mechanism that helps smooth government expenditure in view of volatile commodity revenue. They are designed to accumulate resources when the commodity revenue is above or below some preannounced thresholds. Saving funds convert resource wealth into financial wealth. These funds have mostly been used in oil and gas exporters such as Algeria, Azerbaijan, the Gulf countries, Libya, and Russia, and in a few cases their creation supplements other fiscal rules (Norway).
Managing capital inflows is another major policy challenge for Asia. With U.S. monetary conditions likely to remain supportive for an extended period and global interest rates likely to remain low for the foreseeable future, Asia may attract further capital inflows that could contribute to overheating pressures in goods or asset markets. This is especially the case for economies with tightly managed exchange rate policies, which may in effect import easy global monetary policy conditions unless they tighten capital controls. By depressing local long-term yields, large capital inflows may undermine efforts to tighten the monetary stance through policy rate increases. Large portfolio inflows may also swamp local financial markets, particularly local bond markets, which are relatively small in most of Asia (Figure 1.51). As discussed in the October 2010 Global Financial Stability Report, portfolio flows to emerging markets may result in “herding” behavior, where allocations are made simply on the basis of what other investors already do. In these circumstances, a self-reinforcing cycle can develop, whereby large portfolio inflows lead to a mispricing of risk that further reinforces the inflows to unsustainable levels and exacerbates the risk of a sudden and disruptive reversal. Policy responses to try and minimize the risks from large and destabilizing capital inflows can include exchange rate appreciation, macroprudential measures, and tighter fiscal policy.
Greater exchange rate flexibility offers an important buffer against the risk posed by large capital inflows. IMF staff analysis shows that domestic demand overheating in response to surges in capital inflows is less likely in economies that have more flexible exchange rates (Box 1.5). Greater exchange rate flexibility could also reduce expectations of a large step appreciation, and thus dampen the pressure on inflows and the associated impact on consumption and investment. Furthermore, exchange rate flexibility would reduce the challenges for domestic liquidity management, as it would lessen the need for reserve intervention and the resulting risk of excess liquidity and credit booms.
A stronger prudential framework can also help to mitigate the adverse consequences of sizable and potentially volatile capital inflows. Indeed, several Asian economies have implemented preemptive measures to limit a buildup of financial vulnerabilities. The measures, with respect to the effects of capital inflows, have mainly related to banking sector leverage, short-term foreign capital inflows, property price inflation, and foreign currency exposures.
In June 2010, Indonesia and Korea took steps to restrict the volatility of capital inflows and reduce short-term external exposures. In Indonesia, the central bank introduced a one-month holding period requirement on central bank bills, for both domestic and foreign investors. In Korea, limits on foreign currency derivative positions were introduced to discourage banks’ short-term foreign currency borrowing, and thus to minimize the systemic fallout from spikes in global risk aversion and sudden withdrawals of capital. These measures have been successful so far mainly in altering the nature of inflows rather than their size. In Indonesia, foreign appetite for central bank bills has remained strong after the introduction of the measures, but the holding period requirement could dampen the severity of outflows should risk appetite diminish. In Korea, the foreign currency hedging that was done by Korean branches of foreign banks has started being done by the foreign parent banks instead.
In Taiwan Province of China and Thailand, measures were taken to reduce currency appreciation pressures. In November 2009 Taiwan Province of China prohibited foreign investors’ access to time deposits as a way of curbing inflows and speculation, while in February and September 2010 Thailand eased controls on capital outflows.
In April 2010, the New Zealand authorities implemented new liquidity rules for banks aimed at reducing the risks that a sudden reversal of capital inflows may lead to bank funding strains as was seen during the global financial crisis (see Box 1.9). In Korea, to address vulnerabilities associated with wholesale funding, the loan-to-deposit ratio will be capped at 100 percent from 2013.
Policies for Rebalancing
While private domestic demand is expected to be the main driver of growth in Asia in 2010 and 2011, the prospects for sustained progress toward external rebalancing over the medium term are still unclear. Private consumption and investment are together projected to contribute about 3 and 2 percentage points to emerging Asia’s total GDP growth in 2010 and 2011, respectively. This rebalancing may prove to be mainly cyclical, however, as over the medium term external surpluses are expected to decrease only modestly. The relatively limited reduction in projected surpluses over the medium term would contribute to global imbalances remaining elevated, as discussed in the October 2010 World Economic Outlook (Figure 1.52).
Continued structural reforms will be needed to sustain the outlook for private consumption in key Asian economies, particularly China. Recent developments are positive in this regard. Retail sales have been on an upward trend in recent years in China, and private consumption as a share of GDP stabilized in 2009 after years of decline. In addition to structural changes in the dynamics of consumption, as a result of urbanization and demographic changes, household consumption in China is also likely to continue benefiting from authorities’ efforts to expand pension and health care coverage, which should gradually lower the motivation for precautionary saving. However, given the relatively low share of household consumption in GDP, and the many economic forces that prevent it from rising more quickly, it is still a major challenge for China to raise the share of private consumption over the medium term.
Bank Funding and Liquidity Rules in Australia and New Zealand
The global financial crisis highlighted the need for banks to have adequate liquidity to safeguard financial stability and the Basel Committee proposed new liquidity rules in December 2009. Given that a key external vulnerability in Australia and New Zealand is their banks’ sizable short-term offshore funding, the authorities moved ahead of other countries to propose new liquidity policies.
In October 2009 the Reserve Bank of New Zealand (RBNZ) introduced new quantitative requirements to increase banks’ liquidity and reduce reliance on short-term offshore funding. Given its concern that market discipline approaches based on disclosure to address banks’ liquidity risk were insufficient, the RBNZ first floated plans for new liquidity rules in late 2007, and the following became effective from April 2010.1
Liquidity mismatch ratios set minimum “zero” requirements for one-week and one-month mismatch ratios each business day. The mismatch ratios compare a bank’s liquid assets and likely cash inflows with its likely cash outflows, expressing the difference as a ratio of total funding.
A minimum core funding ratio (CFR) aims to ensure that banks hold sufficient retail and longer-dated wholesale funding. The minimum CFR has been set at 65 percent of total loans and advances from April 2010, increasing to 70 percent from July 2011 and 75 percent from July 2012.
In September 2009, the Australian Prudential Regulation Authority (APRA) also proposed changes to its current prudential approach to banks’ liquidity risk management. The APRA proposals emphasize stress tests and define a three-month “market disruption” scenario that mainly targets banks’ resilience to a disruption in access to offshore wholesale funding. The proposals reflect the authorities’ views that existing regulatory arrangements have worked effectively over recent years in Australia and severe stress in the financial system was avoided during the recent financial crisis. Given the Basel Committee’s proposals in December 2009, APRA decided to delay the finalization of its revised liquidity rules.
Since the onset of the global financial crisis in 2008, Australian and New Zealand banks have improved their funding structures. They have significantly increased their liquid assets and retail and long-term wholesale funding. However, it is not clear whether this was because of the RBNZ’s plans to introduce liquidity requirements, the Basel Committee’s proposed liquidity standards, the uncertain and volatile environment, or rating agencies putting pressure to reduce their exposure to rollover risk. While only indicative, a cross country comparison suggests that New Zealand’s new liquidity policy may have played a role in reducing its external vulnerability: since end-2007 (precrisis), short-term external debt declined by 15 percent of GDP in New Zealand, whereas it rose for many other countries.2 During the same period, New Zealand banks’ dependence on short-term offshore funding also declined more than in Australia and Korea.
Changes in Short-Term External Debt
(In percent of GDP)
Changes up to June 2010.
At the same time, the shift to more stable funding in Australia and New Zealand seems to have increased bank funding costs. Both the experience of the crisis and new liquidity rules in New Zealand have made banks willing to pay more to attract retail deposits.3 In addition, funding costs increased as banks lengthened the maturity of their wholesale funding, given a positively sloped yield curve. Thus, bank funding costs relative to the policy rate have increased substantially, by an amount equivalent to tightening of policy rates of about 100 basis points. Banks in the two countries have generally responded to higher funding costs by increasing their lending rates relative to official benchmark rates and keeping their net interest margin at about 2-2½ percentage points.
The impact of New Zealand’s new liquidity policy is expected to be stronger in cyclical upturns, when banks tend to resort to short-term offshore funding markets to support credit expansion. To satisfy growing credit demand, banks will need to find funding mostly from customer deposits and longer-term markets. As a result, lending rates should automatically move higher during credit upswings, without the RBNZ needing to raise the policy rate to the same extent. Moreover, limited access to retail and longer-term funding could put a brake on procyclical lending. Through these channels, the CFR has the potential to play a role in assisting monetary policy.
Private investment in the region will likely benefit from more efforts to boost infrastructure. In several economies, notably China, Hong Kong SAR, India, Indonesia, Malaysia, the Philippines, and Thailand, governments are putting in place measures to boost infrastructure. This is already benefiting heavy equipment and steel manufacturers in the region (particularly in Korea), inducing them to expand capacity to meet these demands. In time, improvements in infrastructure will benefit end users, enhance connectivity, and draw in additional investment (see Chapter III).
In general, a successful shift in Asia’s pattern of growth toward private domestic demand would require the simultaneous implementation across the region of a package of measures.
Such a package would include (i) a continued strengthening of social safety nets, which should help to further reduce precautionary saving and thus boost consumption (especially in China); (ii) further advances in financial sector reforms, which can support private consumption as well as investment, both by smaller firms and by larger firms that seek financing for large projects; and (iii) more exchange rate flexibility, which will boost household disposable income and facilitate the shifting of resources to nontradable sectors. As emphasized in the April 2010 Asia and Pacific Regional Economic Outlook, in order for these measures to be most effective, they need to be undertaken widely across the region. If only a few countries implement reforms, then, although rebalancing may have some positive domestic and regional spillovers (especially if undertaken in larger economies such as China), it is unlikely to fill the void created by weaker external demand from advanced economies.
In sum, Asia’s situation is a positive one as it has emerged in the lead of the global recovery and policymakers have managed effectively the balance of macroeconomic risks. Now that the recovery is well established, it is time for policy stances to be normalized across the region. Should downside risks materialize, countries generally have ample room to ease policies in response. It is time also to look ahead to the medium term, when Asia will have to rely increasingly on domestic demand for its growth. A strong package of measures taken across the region to foster this medium-term reorientation will help Asia to sustain its robust growth, and it will also help to sustain growth in the rest of the world by contributing to a reduction in global imbalances.
This definition of Asia differs from the World Economic Outlook.
Note: The main author of this chapter is Roberto Cardarelli, with inputs from Leif Lybecker Eskesen, Souvik Gupta, Adil Mohommad, Malhar Nabar, Runchana Pongsaparn, D. Filiz Unsal, Olaf Unteroberdoerster, and Yiqun Wu.
This conclusion is based on results from an empirical model of private investment growth in selected emerging Asian economies (Indonesia, Korea, Malaysia, the Philippines, Taiwan Province of China, and Thailand) using available and estimated quarterly data on private investment. A standard specification for private investment growth was estimated using a panel generalized method of moments (GMM) approach, in which the explanatory variables included export growth, private consumption growth, capacity utilization, credit growth, a measure of uncertainty (the VIX index), and the lending rate.
Box 1.9 suggests that new banks’ liquidity standards adopted in New Zealand in 2010 may have led to an increase in banks’ funding costs and bank spreads.
See Chapter III of the April 2010 Asia and Pacific Regional Economic Outlook.
For Australia, the high ratio reflects the fact that it is the exchange rate that acts mainly as a shock absorber.
The Bank of Japan’s Policy Board members’ understanding of price stability is a change of the annual CPI rate in a positive range of 2 percent or lower with the midpoint at about 1 percent.