This year will likely see the first contraction of global economic activity in the post–World War II era. As financial firms in advanced countries have come under severe stress, credit has dried up, household wealth has shrunk, and uncertainty has increased. These developments, in turn, have triggered a sharp and synchronized collapse in global demand, setting off a corrosive feedback loop between the financial and corporate sectors that is posing major challenges to policymakers around the world. In the fourth quarter of last year, global GDP fell at an unprecedented 5 percent annualized rate, and has likely fallen by a similar amount in the first quarter of this year.
This year will likely see the first contraction of global economic activity in the post–World War II era. As financial firms in advanced countries have come under severe stress, credit has dried up, household wealth has shrunk, and uncertainty has increased. These developments, in turn, have triggered a sharp and synchronized collapse in global demand, setting off a corrosive feedback loop between the financial and corporate sectors that is posing major challenges to policymakers around the world. In the fourth quarter of last year, global GDP fell at an unprecedented 5 percent annualized rate, and has likely fallen by a similar amount in the first quarter of this year.
The spillovers from the global crisis have impacted Asia with unexpected speed and force. The intensity of the downswing has outstripped what could have been anticipated based on the historical correlation between business cycles in the G-2 (the euro area and the United States) and Asia (Figure 1.1). Indeed, the downswing has been even larger than in other regions, and sharper than at the epicenter of the global crisis. In the fourth quarter of 2008, GDP in Asia excluding China and India plummeted by close to 15 percent on a seasonally adjusted annualized basis (Figure 1.2).
More recently, some signs of stabilization have emerged. The slide in exports has eased off in recent months in several Asian economies, and forward-looking indicators for industrial production–in both advanced economies and Asia–have seen some improvement. In addition, pressures in credit markets have abated somewhat since March, with credit default swap (CDS) spreads easing and the global bond market reopening to a few highly rated companies in the region.
Even if these nascent trends continue, stabilization is far from recovery. Prospects for an imminent rebound of economic activity in the region are weak. Global financial stress remains exceptionally high and demand extremely low, which will continue to weigh on one of the world’s most highly integrated regions—only partially offset by the aggressive policy response. At the same time, downside risks abound. The longer the recession continues, the greater the cumulative pressure on Asian corporates and banks, potentially trapping Asia in a feedback loop where the weakness of each sector imperils the other.
This chapter reviews recent economic developments in Asia, analyzes the reasons why Asia has been hit so hard by the crisis, and examines the channels through which the global demand and financial shocks have been transmitted to the real economy. It then presents the outlook in 2009 and 2010, and discusses policy options to limit the risks of a further deterioration and prepare the stage for a recovery.
Why Has Asia Been So Hard Hit?
The Other Side of Integration: The Trade Channel
Why has Asia been hit so hard? In broad terms, the answer lies in the nature of Asia’s exceptional integration with the global economy. The rapid expansion of intraregional trade over the past decades led many to suggest that Asia could decouple from the business cycle of advanced economies. In reality, a large fraction of trade within the region reflects intra-industry processing and assembly through vertically integrated production chains. Virtually all growth in intraregional trade in recent years can be attributed to parts and components. As emphasized in the April 2008 Regional Economic Outlook, correcting for intra-industry trade reveals that the bulk of Asian exports are eventually consumed outside the region, and that the total trade exposure of the region to advanced economies has actually increased over time (Figure 1.3). Indeed, the correlation between U.S. import growth and Asian intraregional export growth has gradually become stronger (Figure 1.4).
The spillover has been amplified by Asia’s product mix, because the region is specialized in sectors particularly affected by the global credit crunch. Much of Asia relies for its growth on high-and medium-technology manufacturing exports—in particular, motor vehicles, electronic goods, and capital machinery (Figure 1.5). These sectors generally tend to exhibit a stronger cyclical response, owing to the big-ticket size of the products and their heavy reliance on financing. All these features contributed to make these sectors more susceptible to the sharp swings in perceived uncertainty and the availability of credit that has occurred since late 2008. The demand for advanced manufacturing has collapsed—Japanese auto exports, for example, have fallen by nearly 70 percent between September 2008 and March 2009. A comparison of Q4 GDP outturns across advanced and emerging market economies shows that those with a larger share of advanced manufacturing in their GDP have experienced sharper output declines (Figure 1.6). Interestingly, the strength of the correlation decreases if one uses the share of total manufacturing in GDP, confirming that advanced manufacturing is the key dimension.
Asia’s tightly integrated supply chain propagated the external demand shock rapidly across the region. The collapse in demand from advanced economies has been transmitted through the integrated supply chain, with dramatic effects on intraregional trade. Between September 2008 and February 2009, merchandise exports fell at an annualized rate of about 70 percent in emerging Asia—about one and a half times more than during the information technology (IT) sector bust in the early 2000s and almost three times more than during the Asian crisis in the late 1990s.
Exports to China from the rest of emerging Asia were particularly affected, declining at the rate of 80 percent over the same period (Figure 1.7)—though they have shown signs of stabilizing more recently. This is consistent with the large role of China as an assembly hub for final products in the Asian production networks—as shown by the steady increase of parts and components in China’s imports from emerging Asia during the recent past (Figure 1.8). The collapse of exports to China helps explain why economies like Hong Kong SAR and Taiwan Province of China have been broadsided—exports to China account for about 20 percent and 45 percent of their total exports, respectively, compared with 10 percent on average for the other economies in the region.
Meanwhile, other Asian economies not so tightly linked to the global supply chain, such as the commodity exporters and low-income countries (see Box 1.1), initially held up better but have been also affected by the collapse in resource prices and the resulting terms of trade shock.
How Did the Crisis Affect Low-Income Countries in Asia?
Little Initial Impact . . .
While Asian emerging markets were clearly feeling the pinch in the last quarter of 2008, growth in Asian low-income countries (LICs) came in broadly as expected, and the external positions of many countries actually improved as fuel prices tumbled and food prices stabilized.1 The delayed impact was mostly due to the indirect nature of the transmission of the financial crisis. Growth was initially sheltered by LICs’ lower trade integration and their export of lower-value-added products. Moreover, LICs were less vulnerable to the initial impact of the global financial shock—reflecting the limited size, depth, and overall development of LIC financial markets as well as lack of market access. Moreover, official financing of LICs—largely concessional—held up, and in some cases increased, in sharp contrast to the severe reduction in private inflows to emerging and developed economies.
…But the Crisis Is Now Hitting
After showing initial resilience, LICs are starting to feel the impact of the global economic crisis.
Commodity exporters were first to take the hit, as the fall in export prices weakened external and fiscal positions (Lao P.D.R., Mongolia, and Papua New Guinea);
Slowing growth in more advanced countries is beginning to show up in lower tourist arrivals and spending (particularly in Cambodia);
Plunging retail sales in the United States are leading to a reduction of garment export orders (Bangladesh and Cambodia) and severe compression of profit margins through aggressive price reductions (Bangladesh, Cambodia, Mongolia, and Sri Lanka);
Slowing regional growth is reducing low-skilled employment opportunities in emerging markets and developed countries, with detrimental effects on remittances;
Falling agricultural prices are lowering rural incomes—which still account for a sizable share of GDP in LICs—leading many households back into subsistence agriculture, which does not produce cash income;
Moderating capital inflows or even reversals of flows back to cash-strapped parent banks is significantly reducing local liquidity in those LICs whose banking systems are dominated by branches of foreign banks; and
Multinationals are delaying, and in some cases curtailing, sizable investment plans in LICs, which depend heavily on foreign direct investment (FDI) for growth and employment (notably in mining and power generation sectors), weighing on growth not only this year but also for years to come (particularly in Lao P.D.R. and Mongolia).
As a result, growth forecasts for Asian LICs have been marked down relative to the April 2008 Regional Economic Outlook, albeit less so than for emerging markets, reflecting the lower degree of sophistication of exports in LICs. Among Asian LICs, the magnitude of the markdown is correlated with the share of FDI in GDP (e.g., into the capital-intensive mining sector, which has undergone sharp price reductions) and the share of exports destined for U.S. retail-based industries, such as garments.
Somewhat surprisingly, more vulnerable Asian LICs—those with comparatively large fiscal and/or current account deficits, low reserves, and generally higher risk of external debt distress—are not necessarily experiencing the weakest near-term growth prospects, as commodity exporters had reduced vulnerabilities over recent years.2 However, these factors may affect governments’ ability to address the crisis with countercyclical measures.
What Room for Policies?
Policymakers in LICs face a difficult tradeoff between supporting growth and employment and safeguarding macroeconomic stability—in particular, the presence of highly vulnerable groups and large development needs must be weighed against stubbornly high vulnerability. Asian LICs face equal challenges, and strides toward reducing poverty made during the global boom are now clearly at risk.3 High vulnerability together with weak public expenditure management, ineffective monetary transmission mechanisms, and other policy constraints may reduce the scope and effectiveness of countercyclical policies. Moreover, currency depreciation may have little effect in boosting exports when trading partners are contracting.
Fiscal policy. Government revenues are coming under strain. The low and narrow revenue base faced by most LIC governments leaves them vulnerable to a reduction in trade and turnover taxes, and in some cases lower tax payments by a few large multinationals operating in their countries.4 In the absence of additional sources of finance, domestically financed public investment programs are coming under pressure—in cases where adjustment is not being made, the pressure risks spilling over onto international reserves. In Asia, the substantially weaker revenue outlook (as in Mongolia, Lao P.D.R. and Papua New Guinea) together with concerns about the quality of additional spending and about debt sustainability (Bangladesh, Lao P.D.R., Nepal, and Sri Lanka) would indicate that there is little scope for further fiscal stimulus by governments. In most cases, a reprioritization of spending toward strengthening the social safety net is the most viable response. However, countries that have built cash buffers during the recent upcycle (such as Cambodia) may have somewhat more space for expanding overall spending.
Monetary policy. In LICs the role of financial markets in providing credit in support of growth is limited by a lack of market development and financial depth. Moreover, ineffective (and in some cases nonexistent) policy instruments and weak institutions limit the capacity of the central bank to conduct monetary operations. In Asia, the limited scope for countercyclical easing is also because of dollarization, weak financial institutions, and exchange rate pegs. That said, the decline in food and fuel prices have reduced inflationary pressures in many LICs and liquidity conditions have tightened (owing to both lower foreign inflows and slowing deposit growth) at the same time that official domestic financing requirements are rising, potentially crowding out the private sector. Cautious easing in some cases may therefore be warranted, provided macroeconomic stability is not placed at risk.
Note: The main author of this box is Carol Baker.1 Low-income Asia comprises nine nations eligible for the IMF’s Poverty Reduction and Growth Facility (PRGF) not included in the REO sample (i.e., excluding India and Vietnam): Bangladesh, Bhutan, Cambodia, Lao P.D.R., Mongolia, Myanmar, Nepal, Papua New Guinea, and Sri Lanka. GDP data are preliminary estimates and subject to revision.2 While external debt ratios have come down—much of this due to multilateral efforts such as the Heavily Indebted Poor Country (HIPC) initiative and Multilateral Debt Relief Initiative (MDRI) debt relief—they remain high. According to the most recent Debt Sustainability Assessments, only one Asian LIC is assessed to be at low risk of external debt distress, while four are at moderate risk and three either high risk or in debt distress.3 In terms of gross national income, Asian LICs as a group fall at the mean of non-Asian LICs, while they are still far from catching up with emerging Asia—in purchasing power parity (PPP) terms, Asian LICs’ per capita GDP remains about 15 percent of that of Asian emerging economies, roughly unchanged from the early 1990s.4 Indeed, forecasts for 2009 fiscal deficits in LICs globally have been marked down from the slight surplus (driven mostly by commodity-producing Africa) envisioned in April 2008 to a deficit of more than 3 percent of GDP in March 2009, generally excluding discretionary measures. Most LIC governments have yet to develop or implement discretionary fiscal measures.
The Other Side of Integration: The Financial Channel
Asia was also expected to be insulated on the financial side. Financial institutions in Asia were believed to be well capitalized, with only limited exposure to U.S. subprime securities and little involvement in high-risk mortgage lending practices despite the property market boom in some economies in the region. In the end, all of this proved true. The subprime crisis did not pose any direct threat to Asian banking systems, nor did the recent decline in house prices in these economies. However, the indirect effects of global financial turmoil have proved exceedingly strong.
This is because Asia’s financial ties with the rest of the world have deepened over the past decade, exposing the region to the forces of global deleveraging. In particular, cross-border bank flows to the region and corporate borrowing on international bond markets increased significantly; Asian banks have generally expanded their reliance on wholesale funding; and the share of foreign equity securities held by Asian residents and of Asian securities held by foreigners has soared (see Regional Economic Outlook, April 2008). Asia’s greater participation in international financial markets has played a key role in fostering growth in the region. However, the earlier trends are now working in reverse, leading to a substantial tightening of external financing conditions. In particular:
International bank flows to Asia turned negative, as escalating losses are pushing advanced economies’ banks to reduce their exposure to emerging markets, either directly or through their foreign affiliates (Figure 1.9).
Access to external bond financing has become much more difficult. Only sovereigns and the highest-rated companies are able to borrow and even then only at high spreads, though a spurt of such borrowing took place in the first quarter of 2009. For example, the Philippines, Indonesia, and Korea have successfully issued sovereign bonds, and Australian and New Zealand banks have issued government-guaranteed bonds. (Figure 1.10).
Regional markets experienced net equity outflows through mid March 2009, as global institutional investors and hedge funds tried to reduce exposure to emerging markets in general.1 As a result, equity prices have been under pressure—despite a modest rebound from the lows reached in February 2009, the Morgan Stanley Capital International (MSCI) emerging Asia index remains about 40 percent below its level at the beginning of 2008, broadly in line with other world regions (Figure 1.11). The notable exception is the Chinese stock market, which has been supported by early signs that fiscal stimulus measures are beginning to gain traction.
Reduced global risk appetite has also caused regional currencies to depreciate (Figure 1.12). In particular, the Korean won and the Indonesian rupiah have depreciated about 20 and 10 percent in nominal effective terms between September 2008 and March 2009, respectively, thereby supporting exporters’ profits and current account balances. The Australian and New Zealand dollars have also been severely hit by the decline in commodity prices. By contrast, the Japanese yen has appreciated by about 25 percent in nominal effective terms during the same period, following the unwinding of carry trade positions and narrower interest rate differentials against key currencies—and contributing to the sharp turnaround in Japan’s trade balance, back into negative territory after about 30 years of uninterrupted surpluses.
In general, exchange market pressures in the region have been met with only a limited degree of foreign exchange intervention, which in most cases has aimed at smoothing volatility. Consequently, after the sharp decline observed during the peak of the global financial turmoil late last year, foreign reserves have stabilized so far in 2009 (Figure 1.13).
Shortages in dollar funding led to tensions in regional money markets in late 2008, requiring massive injections of liquidity by monetary authorities—including by extending the range of collateral accepted for central bank facilities, expanding access to central bank discount windows, and establishing foreign currency swaps lines with local banks. These policies have generally succeeded in alleviating local liquidity pressures, as shown in a decline in TED spreads from the peak last year. Still, long-term dollar funding remains scarce, as banks are still wary of taking on longer term credit risk.
Domestic financing has also come under stress, as risk aversion and the desire to preserve capital have induced banks to tighten lending standards. Bank credit to the private sector has continued to grow but at a lower pace than before, with the notable exception of China, where quantity restrictions on credit growth have been loosened. In addition, lending rates remain high despite aggressive cuts in policy rates (Figure 1.14). Many small and medium-sized enterprises (SMEs), which borrowed heavily during the previous decade to expand their activities as suppliers to the larger manufacturing enterprises, are facing a financing squeeze, as banks have started to rein in their lending to these firms just as the earlier loans are falling due. Trade finance was also initially affected, as more aggressive demand for up-front deposits and credit guarantees from importers hampered export activities in the last quarter of 2008. Since then, however, the situation seems to have improved with firms reporting less difficulty in obtaining trade credit. Nonetheless, this segment of the credit market remains a channel through which renewed banking strains could further undermine trade and production (see Box 1.2).
The Global Financial Crisis and Trade Finance in Asia
The dramatic fall in both exports and imports across the region has raised the question of the role played by the contraction in trade finance. Although less risky than other forms of cross-border lending, the short-term nature of trade financing makes it vulnerable to shifts in risk aversion. For example, sharp declines in trade finance were reported in Russia, the Philippines, Thailand, and Korea in 1997–98, and in Turkey in 2000–01. Bank-financed trade credits also declined by as much as 50 percent in Brazil and Argentina in 2002. Is a trade finance crunch behind the recent collapse of Asia’s trade?
Searching for Evidence
Answering this question is difficult. There are no comprehensive data on trade finance. Lack of systematic information in part reflects the nature of the business (relationship banking) and in part the wide diversity of financing instruments (ranging from business-to-business credits, to bank loans and letters of credit, which are off-balance-sheet items).1 An additional complication is that these instruments are often close substitutes, so that partial information may not be representative of broader sectoral trends. For example, a fall in the reported issuance of letters of credit may be associated with greater recourse to alternative forms of finance or cash-in-advance arrangements, with little impact on trading activities.2
Recent industry surveys have tried to fill the information gap. A survey of some 40 banks done jointly by the IMF and the Bankers Association for Finance and Trade in early 2009 suggests a worldwide decline in the value of trade finance (intermediated through letters of credit, export credit insurance, and short-term export working capital) between January 2008 and October 2008, as well as an increase in the cost of trade credit. The impact appears to have been broadly similar across regions. Comparable results were captured by a March 2009 survey of the International Chamber of Commerce. Both surveys are, however, short on quantitative details and suffer from low response rates and limited country coverage.
Some available economy-specific data, although fragmented, throws more light on developments in Asia. The volume of letters of credit in both Korea and Taiwan Province of China has collapsed; balance of payments data on trade credit for Japan and Korea (which encompasses both bank-intermediated and business-to-business credit) point to a sharp fall in foreign financing to local firms; and in Hong Kong SAR, bank loans for trade finance have recorded the steepest decline since the Asian financial crisis. For emerging Asia as a whole, syndicated loans for trade finance—a segment where large international banks play a key role—have contracted at the fastest pace on record and more than the world average. Overall, Asia appears to have experienced a significant reduction in trade financing.
Supply or Demand?
Reduced lending, however, may be the result rather than the cause of less international trade. For example, a drop in the G-3’s demand for Asia exports would naturally lead to less demand for trade credit, directly and along the intraregional supply chain.3 So would significantly lower commodity prices, which not only reduce the value of required import financing but could also trigger strategic behavior by importers keen on forcing contract renegotiations.
In fact, there are reasons to believe that the bulk of the decline in trade finance can be explained by shifts in the demand for credit rather than in its supply:
First, according to industry sources, banks in the region continue to lend to established customers and have reportedly maintained broadly the same credit limits as in the first half of 2008, except for smaller high-risk customers.
Second, a recent survey of 500 firms by the Hong Kong Trade and Development Council shows that a key concern among respondents is the lack of foreign demand, while the availability of trade credit is one of the lesser worries.
Third, if Asia could not meet G-3 demand for goods owing to financing constraints, shortages would have developed and prices of imported goods in the G-3 would have gone up. There seems to be no evidence, however, that this is happening.
Tellingly, the ratio of trade credit to total trade has increased in recent months in Hong Kong SAR and Taiwan Province of China, while it has remained broadly stable in Korea. Although not conclusive, this evidence supports the view that the availability of trade credit has not been the main driver of collapsing trade flows.
This said, Asia is far from being in a business-as-usual environment. Many small and medium-sized enterprises (SMEs) are struggling with the (globally) higher cost of funds. Conditions on working capital and overdraft loans have tightened, further reducing the availability of resources to finance trade. The cost of verifying letters of credit has risen considerably for a number of countries, including India and Korea. So have the fees charged by banks to exporters for insurance against nonpayment by importers. Reportedly, these increases reflect increased counterparty risk as well as capital constraints within banks.4
In response, governments in several economies in the region have announced supporting measures. In China, Hong Kong SAR, India, Indonesia, Korea, Thailand, and Singapore, governments have increased funds and guarantees for export finance, including through programs targeted at SMEs. Early signs suggest these programs are helping companies maintain access to trade credit.
Note: The main authors of this box are Olaf Unteroberdoerster and Harm Zebregs.1 Moreover, there are variations in periodicity and timeliness of reporting among various data sources.2 In fact, in recent years, the use of relatively costly letters of credit has steadily declined. According to various industry sources, about 80 percent or more of all international trade is financed through working capital loans, overdrafts, and business-to-business credit, for which a breakdown by their different uses does not exist.3 Another factor that is likely to have reduced the demand for trade financing is the steep drop in commodity prices since the second half of 2008.4 Financing charges have reportedly increased because banks that are adopting Basel II have to apply higher risk weights to trade loans in the absence of internal risk data that would justify lower weights.
External Shocks Have Rapidly Fed through to Domestic Demand
Asian corporates have reacted to the slump in global demand by cutting production and reducing inventories. For example, in the first two months of 2009 industrial production in Japan and the newly industrialized economies (NIEs) declined at rates above 50 percent on a three month’s annualized rate basis—a record decline. While the cutbacks in production have managed to bring inventories down, the drop in shipments has been so severe that excess inventories (relative to sales) have jumped to unprecedented levels in some economies, like Japan and Taiwan Province of China. More recently, these ratios have started to come down, particularly in Korea, where the reduction of inventories has been accompanied by an increase in shipments, helped by the very weak currency (Figure 1.15). Nevertheless, despite the aggressive pace of inventory reduction, the size of the adjustment needed to return to precrisis inventory to shipments ratios is such that, absent a sharp rebound of global demand, inventory de-stocking will likely depress GDP growth over the next few quarters.
Private investment has also slowed significantly. The decline in fixed capital formation subtracted about 1½ percentage points from GDP growth in emerging Asia (excluding China) during the last quarter of 2008, compared to 2½ percentage points subtracted by the decline in net exports (Figure 1.16). The fall was particularly sharp in Japan and the NIEs, as plunging external demand created large excess capacity in manufacturing sectors and caused corporate profitability and confidence to plummet. As a result, business fixed investment declined by about 15 percent (year-on-year) in the last quarter of 2008 on average in Japan and the NIEs— close to the peak declines during the Asian crisis and the IT-related recession. Business investment has even suffered in countries less affected by the global demand shock, such as India, because external financing has dried up and banks have became more conservative in their lending standards. At the same time, a downturn in property markets in a number of countries has contributed to a severe drop in residential investment (Figure 1.17).
Private consumption has been relatively more resilient. The decline in private consumption subtracted only about an average of ½ percentage point from regional GDP growth in the last quarter of 2008. That is because private consumption has been supported by real income gains from lower commodity prices, notably oil and food. Moreover, households have been able to draw down on their high stock of savings in the banking system, which dwarfs investment in the stock market. In countries where this buffer has been less effective—for example, where relatively highly leveraged households have been hit by tighter access to credit and falling house prices, as in Korea—cutbacks in household spending have been more severe.
The impact on household consumption from the crisis has also been moderated by the delayed adjustment of employment levels. While Asian firms have reduced their investment plans and slashed production, they have so far attempted to preserve employment and limited redundancies to part-time workers. However, the longer the demand shock persists, the fewer alternatives firms will have but to restructure, and the region could see a wave of consolidation through mergers and acquisitions. Looking at the historical relationships between industrial output and employment growth in selected emerging Asian economies suggests that the current downturn might push employment growth down by up to 4 percentage points over the next six months, implying rates of employment contraction close to those during the Asian crisis (Figure 1.18). Indeed, unemployment has already started to climb across the region (Figure 1.19).
Domestic demand has remained resilient in China, but with little benefit to other economies in the region, as shown by the sharp decline in Chinese imports from the rest of Asia. This is largely because policy efforts taken to shield the Chinese economy from the global crisis have shifted the composition of demand away from manufacturing investment, which largely uses imported machinery and equipment, and toward public investment, which relies mostly on domestic inputs. Moreover, the resilience of household consumption has not had a large trade impact, as consumer goods account for only a small share of imports.
A Long Recovery Ahead
The synchronized nature of the global downturn and Asia’s strong reliance on external demand weigh against the prospects of a speedy turnaround of economic activity in the region. The current crisis vividly illustrates that, far from having “decoupled” from the global economy, Asia has experienced accelerator effects at work. Hence, despite governments’ efforts to invigorate domestic demand, the prospects of a recovery at this stage hinge critically on a rebound in global activity.
The April 2009 World Economic Outlook expects global growth to gradually recover in early 2010, but to remain well below potential until the end of that year. The timing of the recovery depends on progress in stabilizing financial market conditions in mature markets. It will take some time to deal with bad assets and restore confidence in bank balance sheets, especially against the background of a deepening downturn that is expanding losses on a wide range of bank assets. Nevertheless, comprehensive policy steps to improve credit conditions, together with sizable fiscal and monetary support, will eventually create the conditions for a recovery in advanced economies next year. The key question for Asia is: will the region need to wait for this to happen before returning to precrisis growth rates?
Historical experience shows that Asia will need improved demand from advanced economies to escape the crisis. Chapter 2 of this Regional Economic Outlook looks more in detail at previous recession episodes in the Asia and Pacific region since 1980 and finds that the path to recovery in Asia tends to be led by a strong rebound of exports. In particular, strong global demand and currency depreciation allowed a rapid, V-shaped rebound of the region from both the financial crisis of the late 1990s and the IT bust episode of early 2000. This time around, though, there is no economic momentum elsewhere in the world to create demand for Asia’s products. Hence, net exports’ contribution to GDP growth is expected to cease over the next two years (Figures 1.20 and 1.21).
Private domestic demand will also remain generally subdued, as the external shocks continue to spill over onto private investment and consumption. Private gross fixed investment will remain depressed under the pressure of financing constraints and excess capacity accumulated over the recent past in key tradable sectors. Indeed, econometric evidence linking exports to domestic demand in selected Asian economies shows that it may take up to about a year and half for investment growth to return to its precrisis rate in countries with a large trade exposure to advanced economies (such as Korea, Malaysia, Singapore, and Thailand). Meanwhile, private consumption is expected to remain subdued as long as rising unemployment, weak confidence, and low asset prices (including house prices, see Box 1.3) weigh on households’ spending plans. In general, the monetary easing and large fiscal transfers already approved will help limit the damage to the economies, and are expected in some cases (e.g., Japan and Malaysia) to bring growth into positive territory for a few quarters. However, they will not be enough to generate sustained growth in the region.
Housing Prices: Could Further Declines Threaten Growth?
Asia has experienced substantial housing price runups in recent years. Now, prices have begun to slide again. Could these price declines threaten consumption and growth? The answer varies by country. Led by India, New Zealand, and Australia, several Asian economies have seen large real appreciations in their housing markets over the past 10 years. Run-ups in local markets have been even stronger than suggested by average national prices as shown here. Examples include cities like Shanghai or Beijing, or the high-end segments in Hong Kong SAR, Korea, and Singapore, all of which have rushed ahead of their respective national averages. At the same time, some countries in Asia have shown little movement in real house prices, including Japan and Thailand, where real estate markets were still reeling in the early 2000s from the bursting of previous bubbles. Moreover, Asia as a whole has not witnessed the kind of housing bubbles seen in other regions, such as the United States and Western and Eastern Europe (see IMF, 2008b).
Some of the recent price appreciation cannot be explained by fundamentals. While strong income and population growth in the region account for part of the real appreciation, it is likely that another part can be traced back to the excessive liquidity and risk-taking that characterized the global economy up to 2007. Hence, it may not be sustainable. In order to assess how much of the increase in regional house prices is not explained by fundamentals, house price growth in selected Asian economies was modeled as a function of an affordability ratio (the lagged ratio of house prices to disposable incomes), growth in disposable income per capita, short-term interest rates, long-term interest rates, credit growth, and changes in equity prices and working age population. The unexplained increase in house prices (house price gaps) is interpreted as a measure of “overvaluation” and, therefore, identifies which countries may be particularly prone to a correction in house prices. Econometric estimates of the house price gap show that five economies in the region had gaps of about 10 percent or more at recent peaks.1
Recent price declines have helped narrow the gap, though in some cases not fully. Prices have come down substantially over the last year and a half, notably (but not exclusively) in Hong Kong SAR, New Zealand, and Taiwan Province of China, where real prices are 20 percent, 15 percent, and 11 percent lower than the peak, respectively. Following these declines, there is little evidence that real house prices are “overvalued” relative to fundamentals in Asian economies.
Is this enough to exclude sizeable effects of house price drops on consumption and GDP growth in the region? House price declines can affect consumption both because households feel poorer but also because the collateral they can pledge against credit is smaller. Although there is a large body of literature about the effect of house price changes on private consumption in advanced economies, such studies are scarce for emerging market economies. Previous cross-country studies (IMF, 2008c) suggest that elasticities tend to be higher, at least in the short run, in countries with more developed housing finance systems that make it easier for households to access housing-related credit, for example by allowing them to use houses as collateral. Consistent with these findings, some recent studies (Peltonen, Sousa, and Vansteenkiste, 2009) found that housing wealth effects have increased in emerging Asia over the recent past, reflecting increased innovations in many regional housing finance markets.2 As a result, elasticities of private consumption growth to house prices in emerging Asian economies are estimated to be relatively close to those in advanced economies with flexible housing mortgage markets, such as the United States and the United Kingdom. In the case of New Zealand and Taiwan Province of China, remaining gaps and short-run elasticities from the table would suggest a decline in consumption by between ¼ and ½ percentage points. In other emerging Asian economies, both lower gaps and short-run elasticities would imply smaller effects on consumption, of about ¼ percentage point or less.
While these are relatively modest effects, two types of consideration would suggest prudence in downplaying risks to growth from house price declines in Asia. First, long-run elasticities of housing wealth are generally estimated to be larger than short-run elasticities, suggesting that the effect of price declines in recent quarters may have yet to fully play out. Second, historical experience suggests that property prices can fall well below levels consistent with fundamentals, and that the burst of property valuation bubbles can have important knock-on effects on consumption.
Marginal Propensity to Consume out of Housing Wealth
Includes China, Hong Kong SAR, Indonesia, Korea, Malaysia, Singapore, Taiwan Province of China, and Thailand.
Note: The main authors of this box are Jacques Miniane and Dan Nyberg.1 House price gaps are not reported for India, China, and Singapore, due to the small samples available for the estimation for these countries. Gaps are estimated through separate regressions for each economy. For Australia, immigration growth and mortgage rates are included among the regressors.2 For estimates of housing wealth elasticities in Asia, see Edelstein and Lum (2004), Cheng and Fung (2008), and Peltonen, Sousa, and Vansteenkiste (2009).
Overall, we expect growth for Asia to decelerate to 1.3 percent in 2009 from 5.1 percent in 2008, and to return to 4.2 percent—still below potential—in 2010. In particular:
In industrial Asia, Japan is expected to suffer a severe recession throughout 2009, experiencing its worst annual performance on record (Table 1.1). The strong fiscal response to the crisis will bring quarterly GDP growth back to positive territory in the second half of this year, but underlying growth will remain weak as the export collapse spills over to private domestic demand. Sustained positive growth will reemerge only in late 2010, after the external environment improves. Meanwhile, large excess capacity in key manufacturing and export sectors, such as cars and electronics, means the production adjustment will be particularly difficult, especially since Japan’s financial conditions have become tighter than during the banking crisis of the 1990s (see Box 1.4). Australia and New Zealand will also see negative output growth on average in 2009, but are expected to return to positive growth toward the end of this year, thanks to their strong policy response, healthy financial sectors, and exchange rate depreciation.
Like Japan, the NIEs are expected to experience a long and severe recession, owing to their high exposure to the global advanced-manufacturing cycle and their extensive global financial links. Among these economies, Korea is expected to rebound earlier and more strongly, as exports will benefit from the sharply depreciated exchange rate and domestic demand will be supported by the forceful policy stimulus.
Among the ASEAN-5, Thailand, Malaysia, and the Philippines are going to be hit more severely by the global crisis, owing to their higher dependence on advanced manufacturing exports and large spillovers from the external sector to domestic demand, affecting consumers and investor confidence. In Thailand and Malaysia, growth will be negative on average in 2009 and will resume firmly only next year, as the effect of strong fiscal efforts eventually complement the improvement in global conditions. Growth is expected to be zero in 2009 in the Philippines, as waning remittances—an important driver of consumption—will dampen domestic demand. By contrast, growth in Indonesia and Vietnam will remain positive over the next two years, reflecting the relatively lower share of advanced manufacturing in these economies and the higher contribution to growth from domestic demand. However, these economies, too, are forecast to see a substantial deceleration in growth from 2008 and output gaps over the next two years.
For India, we expect growth to slow markedly in 2009 before starting to rebound toward year end. Although its still relatively low dependence on exports will contain the transmission of the global demand shock, India will be particularly affected by the financial shock, because the strong investment growth in recent years owed much to favorable credit conditions. With external financing having tightened and the domestic credit cycle having turned, investment growth is expected to be severely curtailed, and so is GDP growth.
In China, GDP growth will also slow down notably from the average pace of the recent past. Still, the aggressive policy response is expected to support domestic demand and maintain growth at rates close to the level authorities consider necessary to generate jobs consistent with social stability. In particular, the massive program of public investment initiated late last year is expected to compensate for the decline in private investment and absorb productive resources no longer utilized in the tradable sector.
Under normal circumstances, financial conditions faced by households and corporations can be assessed well on the basis of the central bank policy rate and the exchange rate. However, such an approach would seem inappropriate at the current juncture as the global financial turmoil has often been accompanied by marked increases in risk premium, declines in asset prices, and tighter access to credit. Indeed, while all Asian economies have been hit considerably by the collapse in external demand, the spillovers to domestic financial conditions have differed markedly across the region reflecting different degrees of financial openness, financial sector vulnerabilities, and monetary policy responses.
To assess the recent evolution of financial conditions in an analytical framework, this box constructs a Financial Conditions Index (FCI) for four major Asian economies: Australia, China, Japan, and Korea.1 The index is calculated from country-specific models which link GDP growth to a number of financial indicators such as interest rates, credit growth, lending attitudes of banks, exchange rate, and stock market prices, while controlling for relevant external factors such as oil prices, global growth and global financial conditions.2
Based on these FCIs, the figures confirm that the net effect of global financial turmoil and policy responses on domestic financial conditions has differed widely across Asia:
In Japan, despite a reduction of the policy rate to 0.1 percent, financial conditions have become tighter than they were during the banking crisis of the 1990s, amplifying the impact of lower external demand on the local economy. Tightening financial conditions have reflected a variety of factors: stricter lending attitudes of banks—in part due to banks’ losses on their equity holdings; rapid real exchange rate appreciation; low equity prices; and elevated credit spreads.3 Japan’s monetary policy options to deal with these developments have been limited by the low level of policy rate at the onset of the global financial turmoil (0.5 percent). The authorities have taken steps to improve availability of credit by providing funds to boost banks’ capital and extending guarantees on small and medium-sized enterprise (SME) lending, and have also taken unconventional monetary policy steps aimed at easing corporate lending spreads, such as in the commercial paper market. In recent weeks, financial conditions have eased, with a narrowing of some credit spreads, yen depreciation, and rising stock prices. On balance, however, financial conditions remain tight and will likely remain a drag on growth for some time.
In China, financial conditions have loosened significantly since last fall as monetary policy responded aggressively to slowing growth. The policy measures have included interest rate cuts, relaxation of credit quotas and mortgage lending conditions, and greater support for SME lending. Loan growth jumped to 24.2 percent (year-on-year) in February, although real interest rates have increased as consumer price inflation has fallen at a faster pace than policy and lending rates. On balance, the financial conditions have turned accommodative and will—together with sizeable fiscal stimulus—support economic activity.
In Australia, financial conditions tightened in the first half of last year owing to rising lending rates, falling equity prices, and the strong dollar. Although credit growth is slowing, overall financial conditions have since then loosened markedly because the authorities cut the policy rate by more than 4 percentage points since September 2008, lending rates came down faster than expected inflation, and the exchange rate depreciated.
Korea is the only case out of the four countries analyzed in which financial conditions have remained accommodative since the onset of the turmoil. This has mostly been due to the large depreciation of the won. The central bank has also contributed by cutting the policy rate by more than 3 percentage points since November 2008. Real lending interest rates have declined and credit growth has remained robust, though lending rates have fallen by a smaller degree than the policy rate and the lending spreads, while declining, remain elevated.
In summary, the global financial turmoil and policy responses have had vastly different implications for domestic financial conditions across these four countries. Calculations based on the FCI models suggest that, if allowed to persist, tight financial conditions could deduct about 2 percentage points from Japan’s GDP over the next 1½ years. In Australia, the positive contribution of financial conditions to growth could be about ¼ percentage point; moreover, Australia’s financial conditions have further scope for improvement going forward given the considerable monetary policy space. The accommodative financial conditions in Korea could support activity by about ½ percentage point, while the loosening financial conditions in China could boost growth by about 1 percentage point.4
These results suggest that, while all Asian economies have been hit hard by the global turmoil, different policy responses devised to affect financial conditions can lead to different paths of economic recovery in the region. Such policies could include not only changes to the policy rates, but also support to banks and measures to lower credit spreads.
Note: The main author of this box is Martin Sommer.1 The recent literature on the Financial Conditions index includes Gauthier, Graham, and Liu (2004), Lack (2003), English, Tsatsaronis, and Zoli (2005), Goodhart and Hofmann (2001), Guichard and Turner (2008), and Swiston (2008).2 The calculation of the FCI involves three steps. First, a country-specific VAR is estimated using quarterly inflation-adjusted data. Second, generalized impulse responses of Pesaran and Shin (1998) are calculated to assess the cumulative impact of the financial factors on GDP growth after 6 quarters. Third, the estimated elasticities are used as weights for the FCI. All variables are expressed as a deviation either from the sample mean or from the long-term trend. Global growth and financial conditions are proxied using the U.S. and Japan data as appropriate. Caution is needed in interpreting the FCI for China because the available data series are short and often available only on a year-on-year basis, and multiple administrative restrictions make gauging the true financial stance difficult.3 Lending attitudes of banks are seen as an important factor behind tightening financial conditions in the United States (Swiston, 2008) and elsewhere. Out of the four countries considered in this box, long-term time-series data on lending attitudes are only available for Japan. In the case of the other countries, changes in lending attitudes may be partly reflected in interest rate spreads and stock prices to the extent that these variables reflect deteriorating export revenues, corporate profitability, and creditworthiness. Conversely, the relatively large estimated impact of stock prices on financial conditions in some countries likely reflects not only the classical consumer wealth effect, but also expected corporate default probabilities, which in turn influence lending attitudes.4 The contributions to growth are calculated as the sum of contributions to growth from each variable contained in the FCI after 6 quarters, where variables are expressed as deviations from their trend or sample mean. The calculation assumes that financial conditions were on average neutral over period 1995–2008; the results should therefore be interpreted only as illustrative.
Under the projected growth profile, output gaps would continue to widen through the end of 2010 in most countries. To be sure, estimates of potential growth have been marked down in many Asian economies, to reflect the impact of the financial crisis on potential output—including through disruptions to supply chains, lower rates of capital accumulation, and loss of labor skills through prolonged unemployment. This is consistent with the evidence discussed in Chapter 2, that financial crises tend to lead to sizable and permanent declines in potential output in the region—after 10 years, output can be expected to be 10 percentage points below (and in some cases more) where it would have otherwise been barring the crisis, in contrast with no permanent losses after standard recessions. Despite the reduction in potential output, output gaps are expected to rise through the second half of 2010 in all Asian economies, as growth only gradually returns to potential (Figure 1.22). This would also imply an increase in unemployment rates, which will reach about 5 percent in the NIEs—a sharp increase (about 1½ percentage points) relative to 2008.
The combination of widening output gaps and the sharp drop in commodities prices since mid-2008 also implies downward pressure on inflation, and deflation in a few economies (Figure 1.23). In Japan and Taiwan Province of China, headline inflation is expected to be negative on average in 2009, under the pressure of overcapacity in the advanced manufacturing sector and weak inflation levels to start with. Headline inflation is expected to rise modestly in 2010 in the majority of Asian economies, as commodity prices increase modestly and the disinflationary effect from their collapse in the second half of 2008 unwinds. Nevertheless, core inflation is likely to remain subdued, helping to open space for monetary policy support.
Asia’s current account surplus is expected to decline only slightly in the next two years. For many economies in the region, trade surpluses are actually expected to increase, as the combined effects of weak imports and lower oil prices more than offset the collapse in exports. On the other hand, commodity exporters will see their current account balances worsen, while China and India’s balances are expected to remain relatively unchanged (Figure 1.24).
Net private capital inflows to the region are expected to become negative in 2009, driven by sharp retrenchments in bank lending and portfolio flows—though even the more resilient foreign direct investment (FDI) flows are also expected to take a hit—before rebounding in 2010 as deleveraging winds down and risk appetite returns. Overall, net private capital outflows from emerging Asia are expected to amount to ½ percent of GDP in 2009—about one-third of the outflows experienced during the Asian crisis in 1998 (Figure 1.25).
Key Risks to the Outlook
Risks to this outlook remain tilted to the downside. Projections are characterized by an exceptional degree of uncertainty, as shown by the unusually large confidence bands around our baseline forecast for the region (Figure 1.26). The downside risks are across several fronts:
First, there is the risk that the G-2 could take longer to recover. As pointed out in the April 2009 World Economic Outlook, the return to global growth in 2010 is predicated on the basis of a gradual stabilization of financial conditions and a pickup in production and trade, thanks to strong policy implementation in both advanced and emerging market economies. However, there are risks that financial strains will become deeper, and that macroeconomic policy support is withdrawn prematurely. In this case, the global downturn could continue to deepen. This would make it even more difficult for Asia to recover.
Second, the feedback loops between the real and financial sectors could become more insidious than anticipated. At present, our belief is that losses in the corporate sector will remain manageable (see Chapter 3 of this Regional Economic Outlook). However, many industries in Asia, including key sectors such as autos and electronics, have already seen a collapse in demand and profits, and a squeeze in foreign financing, at a time when domestic banks have tightened lending standards. The recent experience in developed countries suggests that, even for corporates that entered the current downturn with relatively strong balance sheets, financial distress should by no means be ruled out. Hence, there is a risk that continued weak demand and tighter financial conditions will lead to a surge in corporate bankruptcies in the region. In that case:
Corporate distress would feed back into Asian banks, making them even less able or willing to extend credit to the private sector. Using the stress test results of Chapter 3, if renewed risk aversion or falling corporate earnings lower equity prices in 2009 to the same amount as in 2008 corporate default would reduce bank Tier 1 capital ratios by up to 2 percentage points, prompting a further tightening of credit. Corporate default risk would rise by up to 4 percentage points—a similar increase to that experienced during the Asian crisis—with potential sizable effects on economic activity.
A surge in corporate bankruptcies would spill over to domestic demand, with a sharper-than-anticipated increase in unemployment rates putting a dent on consumption. Model simulations suggest that consumption growth would decline relative to our central forecast by about 1¾ percentage points on average in 2009 and 2010 in emerging Asia (excluding China and India)—which would bring the total decline in private consumption growth closer to the sharp (6 percent) decline experienced in 1998 during the Asian crisis. This would subtract about 1 percentage point from GDP growth in the region in each of the next two years (Figure 1.27).
A third risk is that global deleveraging could limit corporates and sovereigns access to external financing. Our baseline is based on the assumption that the large buffer of reserves will provide a cushion against the deterioration in external financing conditions. Reserve cover ratios for Asian economies are generally much larger than for other emerging markets—indeed, most of these economies have enough reserves to cover projected external financing requirements in 2009 (Figure 1.28). Still, one lesson from this crisis is that even countries with a large reserve cushion, a comfortable current account position, and a strong and responsible policy framework can be hit hard. Most vulnerable are those economies whose banks and corporates accumulated substantial short-term foreign currency debt in recent years: these countries could face further cuts in bank credit lines and problems in rolling over existing foreign liabilities. These risks could be accentuated by contagion from emerging European economies. With European banks significantly involved in Asia, further difficulties in Europe’s financial system could accentuate these risks as they may precipitate a further withdrawal of dollar and euro liquidity to the region. Econometric estimates by IMF staff suggest that, based on historical relationships, the sharp decline in GDP growth in the G-7 economies over the next two years would be consistent with a much stronger drop in private capital inflows to emerging Asian economies than anticipated in our baseline (Figure 1.29).2 While there are reasons to believe these forecasts may be too dire (see also Annex 1.2 in the April 2009 Global Financial Stability Report), they illustrate the scale of the tail risks to Asia from the global financial crisis.
Finally, over a longer horizon, Asian economies are exposed to the risk of a structural decline of demand from advanced economies. For many years, consumption in the West had grown rapidly, fueled by increasing debt. But households in advanced economies have started repairing their over-leveraged balance sheets, and the era of easy credit to finance purchases of consumer durables, such as automobiles and consumer electronics, could well be over in industrial countries. Indeed, experience of previous financial crises suggests that credit can drop very sharply during the crisis and stay at that lower level for years to come—something that would restrain consumption even after a recovery in the global economy takes hold. In that case, the growth rate of Asian manufacturing and exports could be structurally lower for many years, and Asia’s export-led growth strategy may no longer pay the same dividends as in the past.
What Role for Policy?
The one significant upside risk is a stronger-than-anticipated policy response (Figure 1.30). Forceful countercyclical policies would provide insurance against downside risks, or help Asia come out of the recession more quickly if the risks do not materialize. At the same time, the potential costs of this insurance policy are moderate: inflation pressures are absent and while some countries face concerns about fiscal sustainability, these can be assuaged by ensuring that the stimulus is temporary and put in a credible medium-term fiscal framework.
On monetary policy, many economies still have scope for additional interest rate reductions. The impact of the aggressive cuts in interest rates so far has been largely offset by declining inflation expectations, so that real interest rates have remained relatively constant, or have increased, in a number of countries (Figure 1.31). Indeed, overall financing conditions have in some countries actually tightened over the past year, threatening to put additional pressure on growth (Box 1.4).
In addition, Asian authorities may increasingly need to turn to unconventional measures to improve the availability and cost of credit. Traditional monetary tools have become less effective as policy rates have approached their zero bound in a number of economies, and as greater caution by banks and rising risk premiums have weakened the traditional monetary transmission mechanism in the region. For these reasons, Asian central banks may need to try and reduce risk premiums and unlock activity in credit markets by expanding their balance sheets, as done in the advanced countries and some economies in the region (Japan and Korea) (Figure 1.32). In particular, central banks may need to support credit to the private sector through various forms of “credit easing,” such as purchasing longer-term instruments (including corporate bonds) to drive down rates further out on the yield curve. Alternatively, or in addition to these measures, Asian governments may need to sustain the supply of credit by providing guarantees to bank lending, as done in few Asian economies over the recent months, particularly in support of credit to small businesses. Whatever the measures employed, it will be important to accompany them with a clear communication of the objectives and criteria of success of interventions.
This is also what emerges from looking at the experience of Japan’s banking crisis of the 1990s, as done in Chapter 4 of this Regional Economic Outlook. Faced with a systemic banking crisis and severe economic slowdown, Japan took some unprecedented measures at the time that are now being replicated in the United States and other parts of the world, including quantitative easing and conducting monetary operations through a broader range of securities. Such operations were taken to help stimulate activity by supporting asset prices, encouraging the expansion of bank balance sheets and influencing expectations. Japan’s experiences suggest that direct measures to jump-start dysfunctional credit markets may also be warranted, and that effective communication with markets and the public is vital when unconventional tools are being used. To minimize risks to the balance sheet and credibility of central banks, and to avoid disrupting markets once conditions normalize, a credible exit strategy also needs to be articulated early on. Finally, Japan’s experience suggests that unconventional policies are not a panacea. In fact, their costs in terms of disrupting monetary policy transmission and delaying restructuring rises over time, placing a premium on timely steps to address financial system stresses and restore debtor balance sheets.
On fiscal policies, it may be important to ensure that the stimulus injected in 2009 will not be withdrawn prematurely. Thanks to sound policies and a historical preference for conservative fiscal policies, many Asian economies entered the crisis with significant room for countercyclical fiscal support. This has enabled Asia as a whole to implement discretionary fiscal packages for 2009 that are slightly larger than the G-20 average (Figure 1.33), and higher than in past recessions (see Chapter 2).
Relative to the G-20 as a whole, stimulus packages in the Asian G-20 countries tend to be more heavily weighted toward spending (Figure 1.34), with particular emphasis on investment in infrastructure (China) and relatively less on social safety nets. By contrast, Indonesia’s 2009 stimulus package is almost exclusively focused on corporate and personal income tax relief.
However, only a few Asian countries have so far announced packages for 2010, creating the public perception that stimulus might be withdrawn at a time when economies are likely to remain very weak. Of course, countries have annual budget cycles, and it is likely that fiscal policy will be more supportive than the chart currently shows. But it would be even better to announce such measures now, to provide reassurance that governments will continue to support demand as long as necessary. This is particularly needed because most Asian economies, unlike some European countries, do not have extensive “automatic stabilizers,” such as unemployment insurance, that can provide support to demand without discretionary measures.
Not all economies in the region have the same space for additional fiscal measures, as fiscal policy intervention may be hampered by the lack of access to financing, excessive fiscal deficits or public debt, or institutional and capacity constraints (see Box 1.5).
The Case for Fiscal Stimulus
As elsewhere, Asian countries have been introducing fiscal packages to combat the recession. These packages are relatively large, imparting an average stimulus of about 2½ percent of GDP in 2009—with even higher amounts in China, Japan, and Korea—compared to 2 percent of GDP for the G-20 as a whole. So, is there any need or scope to do more?
The problem with current packages is that they are programmed to wind down next year, even as Asia’s economies are likely to remain very weak. Even with the stimulus already planned, output in the region is projected to remain well below potential for some time, yielding output gaps averaging 2½ percent this year and 3¾ percent in 2010. Moreover, this is under a baseline scenario with significant downside risks, suggesting a need to sustain stimulus in 2010.
The benefits of doing so can be assessed through a simulation using the IMF Global Integrated Monetary and Fiscal model (GIMF).1 The GIMF simulation assumes that all countries across the world sustain their 2009 fiscal stimulus in 2010. That is, economies that in the baseline scenario withdraw stimulus in 2010 are assumed to take additional measures that maintain it at the same level as in 2009. For Asia, this would imply providing additional fiscal stimulus of around ½ percentage point over the WEO baseline. In this case, average output growth in Asia would be between ⅓ and ¾ percentage point higher than in the baseline—with a relatively greater impact in industrial Asia reflecting a more expansionary stance there. This result depends on the assumption that countries retain fiscal credibility, so that interest rate risk premiums do not rise and undermine the benefits of the stimulus. Moreover, with coordinated action across countries, there is less “leakage” of fiscal stimulus through imports and thus additional fiscal measures have a greater impact than when taken in isolation.
This assumption—that Asian countries have scope for further stimulus—needs to be verified. To do this, an indicator of fiscal space was constructed for each major country, taking into account a number of possible constraints.2 For example, further stimulus could raise concerns about fiscal sustainability, particularly if debt levels are already high. Or it could lead to macroeconomic difficulties, such as inflation or balance of payments problems. Fiscal spending also could run into capacity constraints and efficiency concerns. And in some cases there are fiscal responsibility laws limiting the size of debts and deficit.
Graphing the fiscal space indicators against average projected output gaps during 2009–10 suggests that most countries have both the need and the fiscal space to provide additional stimulus (relatively large output gaps and high index measures). A few countries appear to have significant constraints on additional stimulus, but most of them also have less need. Only one country—Japan, in the southeast corner of the figure—appears to be facing a dilemma, where the need remains sizable (an output gap of about 8 percent) but the scope has diminished (the index of fiscal space is at its lowest value of 1).
In sum, most of Asia has both the need and the scope to sustain fiscal stimulus. But at the same time, countries will have to be careful to preserve credibility, by placing such measures within a robust medium-term fiscal framework that will eventually stabilize debt-to-GDP ratios at comfortable levels.
Note: The main authors of this box are Mark Horton, Anna Ivanova, and Papa N’Diaye.1 The model is well-suited for assessing the effects of fiscal policy because it has numerous non-Ricardian features, which make fiscal policy matter more than in other large macroeconomic models. In particular, households have a finite economic lifetime, are liquidity constrained, and have income streams that change during their lifecycle, while tax structures affect their labor and savings decisions. The version of the GIMF used comprises eight regions, of which five are Asian: Japan, Korea, China, Australia/New Zealand, and a group of emerging Asian economies (Hong Kong SAR, Singapore, Malaysia, Indonesia, the Philippines, and Thailand).2 The fiscal space index is a weighted average of seven indicators: (1) financing constraints, based largely on the size of savings-investment gaps; (2) sustainability constraints, based largely on the average projected debt-to-GDP ratio over 2009–14; (3) credibility constraints, based on the average overall ratio of fiscal balance to GDP projected in 2009–10; (4) macroeconomic constraints, based on inflation, current account deficits, reserve coverage, and an indicator of the potential crowding out of the private sector; (5) institutional constraints, based on fiscal rules or laws, earmarking provisions, and revenue-sharing arrangements; (6) capacity constraints, based on whether investment projects and social safety nets can be expanded quickly; and (7) efficiency constraints, based on perception of the efficiency of public spending, as well as structure of the tax base.
Especially in cases where fiscal space is narrow, it will be critical to clearly signal that such stimulus packages are extraordinary and will be unwound once the recovery is firmly established. The best way to do this would be to anchor fiscal plans in a credible medium-term fiscal strategy, to ensure that debt-to-GDP ratios will be stabilized at comfortable levels.
Further strengthening bank capital will also be needed to limit adverse feedback loops. Overall, the measures taken so far by Asian authorities to preserve financial stability have been effective in stabilizing confidence in the financial system and preventing a meltdown—as shown by stable deposit levels in the banking system and the absence of systemic bank runs. Despite this, credit quality is likely to deteriorate as the recession drags on and markets remain worried about the health of banks. To preempt concerns over the health of Asia’s banking system, efforts to shore up capital even further will be invaluable. This may require the use of public funds in certain cases.3 The alternative of relaxing loan provisioning requirements, so that banks simply do not recognize nonperforming loans or prospective losses to capital, could prove counterproductive. International experience has shown that this just raises uncertainty over the health of bank balance sheets, thereby further constraining credit availability.
In addition, it may be prudent to prepare, on a contingent basis, plans to address the growing risks of large-scale corporate failures. For example, legal frameworks may need to be put in place or modified to promote efficient and orderly corporate debt workouts. Regulatory measures that can facilitate creditor coordination would be particularly important, and if the bankruptcy system becomes overwhelmed then government-supported out-of-court mechanisms may be necessary.
It will also important to preserve open capital and trade flows. Some worrying signs of protectionism are also surfacing within Asia. For example, few economies have restricted the import of certain goods while others have increased tax rebates for exporters. To be sure, protectionist pressures have already intensified across the globe—and will continue to do so as more economies slip into recessions. But countries should avoid supporting demand for only domestically produced goods and services through higher tariffs or import quotas. The experience of the Great Depression shows all too clearly the catastrophic consequences of restrictive trade policies and “beggar-thy-neighbor” exchange rate management. Given their high integration with the rest of the world, Asian economies would be the most affected by these policies.
Finally, in the longer term, Asian economies may need to look more at their own domestic economies as an engine of growth. As noted above, Asia faces the risk of a protracted period of lower growth in the wake of the global crisis, as consumers in their main export markets gradually rebuild their balance sheets. Therefore, Asia may need to rebalance growth away from exports and toward domestic demand in order to return to precrisis growth rates. China is already trying to catalyze private consumption, which has been falling for a decade relative to GDP. In principle, there should be scope to do this in many Asian countries, particularly those where consumption forms a relatively low share of GDP (Figure 1.35). Building social safety nets would go in this direction, because a stronger social protection system will reduce the need for precautionary savings to meet necessities related to health, education, and retirement. At the same time, exchange rate appreciation might also help—by providing price incentives to shift resources toward production for domestic use and by raising real household income, thereby spurring consumption. Although exchange rate appreciation may not be a realistic strategy at present as most Asian currencies are under pressure to depreciate, it may become so over the longer term.
Note: The main authors of this chapter are Roberto Cardarelli, Romuald Semblat, Olaf Unteroberdoerster, and Harm Zebregs. Souvik Gupta and Shuda Li provided research assistance.
After turning in their worst performance on record, hedge funds are faced with record redemptions. At end 2008, more than 1,000 hedge funds based in Asia managed some US$130 billion, nearly a third less than in 2007. For Hong Kong SAR, industry reports suggest about 15 percent of locally incorporated hedge funds are closing each quarter.
These forecasts derive from a vector autoregression (VAR) model containing the following four variables: real GDP growth in the United States, real GDP growth, real private gross fixed capital formation growth and net private capital flows (as a percent of GDP) in emerging Asia (defined as average of China, India, Indonesia, Malaysia, the Philippines and Thailand). Data are annual from 1990 to 2007. The forecast for net private capital flows to emerging Asia shown in Figure 1.29 are obtained forcing the G-7 real GDP growth to follow the path envisaged in the April 2009 World Economic Outlook.