Asia-Pacific Regional Outlook

Looking ahead, prospects are relatively bright. Regional growth is expected to amount to 6 percent both this year and next, propelled by vigorous exports and strong domestic demand in China and India. Meanwhile, headline inflation is expected to remain around 3—3½ percent, as lower food prices offset the impact of higher oil prices. At the same time, the region’s current account balance is forecast to remain around 3 percent of GDP, albeit with large changes in its distribution.


Looking ahead, prospects are relatively bright. Regional growth is expected to amount to 6 percent both this year and next, propelled by vigorous exports and strong domestic demand in China and India. Meanwhile, headline inflation is expected to remain around 3—3½ percent, as lower food prices offset the impact of higher oil prices. At the same time, the region’s current account balance is forecast to remain around 3 percent of GDP, albeit with large changes in its distribution.

Executive Summary

Asia’s economic performance in recent years has been impressive. Despite considerable obstacles, including the legacy of the 1997–98 crisis and more recently surging oil prices, Asia’s economic growth has been the fastest amongst the major regions in the world. Since 1999, growth in the region as a whole has averaged 5½ percent per year, with growth in emerging Asia averaging 6¾ percent per annum. As a result, Asia accounted for nearly half of world economic growth over this period. Meanwhile, inflation in the region has remained low and the external position strong.


Real GDP Growth Comparisons

(Annual percentage change)

Citation: Policy Papers 2005, 075; 10.5089/9781498330961.007.A001

Sources: IMF, WEO database; and staff estimates.

Looking ahead, prospects are relatively bright (Chapter I). Regional growth is expected to amount to 6 percent both this year and next, propelled by vigorous exports and strong domestic demand in China and India. Meanwhile, headline inflation is expected to remain around 3—3½ percent, as lower food prices offset the impact of higher oil prices.

At the same time, the region’s current account balance is forecast to remain around 3 percent of GDP, albeit with large changes in its distribution. In most countries, external imbalances are expected to diminish. The current account surplus of emerging Asia excluding China is expected to fall by more than half to 1 percent of GDP in 2005, then narrow further to ¾ percent in 2006, the result of sharp increases in oil import costs. And with capital inflows to most countries shrinking, reserve accumulation is forecast to slow dramatically in most countries. But in China the current account surplus is expected to increase by 2 percentage points to 6 percent of GDP in 2005, before falling back to 5½ percent of GDP in 2006.

This favorable outlook, however, is not without risks:

  • The major risk comes from high petroleum prices, a particular danger in Asia because many of its economies are manufacturing-intensive and thus highly oil-dependent. So far, the region has been able to cope with the global price increases, largely because the surge in export earnings has until recently been enough to offset higher oil import bills. However, with oil prices continuing to climb, the toll on income and demand is mounting. Meanwhile, monetary policy will need to limit any second-round impact of higher oil prices and keep inflation expectations well anchored—a task that will require vigilance since real interest rates in the region are currently at historically low levels.

  • In some countries, governments have shielded consumers from higher costs, by passing on only a portion of the world increases onto domestic prices. But as world prices continue to rise the costs of subsidizing domestic prices is proving increasingly unsustainable. Domestic prices in these countries will need to increase, with inevitable effects on demand.

  • A second major risk comes from potential weaknesses in external demand. According to WEO projections, growth in advanced countries will remain robust, while leading indicators suggest that the electronics sector, which accounts for a third of the region’s exports, is set for a cyclical upswing. However, there are downside risks, again mainly from higher oil prices.

  • A third risk comes from the rise in protectionist sentiment, driven by global imbalances and growing fears of emerging market competition. Already, the removal of quotas on textiles and clothing has triggered safeguard actions, and there are pressures for further restrictive measures.

Notwithstanding the generally bright outlook, some aspects of the region’s economic performance create concern and pose policy challenges.

  • For all of Asia's impressive economic performance, the region remains highly dependent on economic developments in the rest of the world. Exports of emerging Asia have grown by 10½ percent per year on average over the past decade, reaching 18 percent per annum during 2002–04, and now account for 45 percent of emerging Asia’s GDP. But autonomous domestic demand has remained subdued in most countries, with the notable exceptions of China and India (Chapter II). And partly for this reason, growing regional integration has not diminished Asia’s dependence on the outside world; although the production of goods has become dispersed across borders, their ultimate destination typically continues to be OECD countries (Chapter V). Reviving domestic demand and developing broader regional integration are consequently major policy objectives.

  • Second, the central role of external demand has been reflected in a sustained current account surplus for the region, contributing to global imbalances. Economies experiencing rapid economic growth typically experience a deterioration in their current account balances. However, since Asia’s growth has been exportled, its current account surplus has been large and relatively stable in recent years, at around 3 percent of GDP. The mirror image of the strong current account has been a large savings-investment gap. In 1998, investment fell sharply and has not recovered significantly since (except in China, and more recently, India), partly reflecting a necessary adjustment after the unsustainable boom of the mid-1990s, but also reflecting structural weaknesses that still linger—with implications for the unfinished reform agenda (Chapter III).

  • Third, central banks have generally responded to large foreign exchange inflows by intervening, fueling a rapid rise in Asia’s foreign exchange reserves. Since 2001, Asian reserves have doubled, reaching $2.6 trillion in mid-2005, an ample level by any standard measure of reserve requirements. Partly as a consequence, regional authorities—including Japan and Korea—have scaled back their foreign exchange intervention, allowing greater flexibility in exchange rates. Moreover, on July 21 China also moved in this direction, revaluing the exchange rate by 2 percent against the U.S. dollar and announcing that the rate would henceforth be set with reference to a basket of currencies. At the same time, the Malaysian authorities abandoned their dollar peg in favor of a tightly managed float.

  • As emphasized in recent WEOs, a further appreciation of Asian currencies will ultimately need to be part of the resolution of global imbalances. However, studies suggest that appreciation, on its own, will only have a limited effect on current account positions (Chapter IV). For a significant and orderly adjustment to take place, domestic demand will also need to be strengthened. And this will need to be driven by structural reform; there is little room for activist macroeconomic policy, as government debt remains high (around 40 percent of GDP in emerging Asia) while real interest rates are already exceptionally low.


Emerging Asia: Exports and GDP Growth

(Year-on-year percent change)

Citation: Policy Papers 2005, 075; 10.5089/9781498330961.007.A001

Sources: IMF, APDCORE database; and staff estimates.1 Excludes India and Singapore.

Emerging Asia: Current Account, Saving and Investment1

(In percent of GDP)

Citation: Policy Papers 2005, 075; 10.5089/9781498330961.007.A001

Sources: IMF, WEO database; and staff estimates.1 Excludes China.

Emerging Asia: General Government Debt1

(In percent of GDP)

Citation: Policy Papers 2005, 075; 10.5089/9781498330961.007.A001

Sources: IMF, APDWEO database; and staff estimates.1 Excludes Singapore.

I. Economic Developments and Outlook


Over the past several years, a number of factors have combined to lift growth in Asia. Starting in 2003, the OECD economies began to recover, spurring demand for Asia’s exports. In particular, demand for electronics exports boomed as the sector finally recovered from its post-2000 slump (Box 1). Meanwhile, China’s growth, together with its continuing development as a processing hub for regional exports, began to generate a growing demand for the region’s products, with exports to China from the rest of emerging Asia rising by 45 percent y/y in 2004 alone. As a result, growth in Asia began to accelerate reaching 6 percent in 2003 and 6¾ percent in 2004—its highest level in almost a decade (Box 2).

Electronics Exports

  • Electronics have been a key component of external trade in emerging Asia. In the last three years, exports of electronics from emerging Asia have grown rapidly—more than 20 percent on average annually—and, by 2004, comprised 30 percent of total exports. In a number of countries, this share exceeded 50 percent. While intra-regional export growth has been strong, advanced economies remained the final destination for most of these exports (about two-thirds), as companies based in emerging Asia continued to penetrate these markets.

  • Underneath this strong performance, a fundamental change in the production chain has been taking place. Historically, production of semiconductors and final assembly of electronics destined in large part for advanced economies was concentrated in a number of newly industrialized and ASEAN economies. But in recent years China has become a major player in this chain, as its manufacturing and assembly capacity increased rapidly. Other economies in the region have adjusted by increasing their exports of higher-value added products to China, and China, after final assembly, has increasingly exported these to advanced economies. As a result, China’s share in total electronics exports of emerging Asia to the rest of the world has doubled in the last four years to more than 35 percent in 2004. So far, not all types of production have moved to China and, while the number of foundries (factories that produce chips designed by others) have increased, leading edge production has remained mostly outside China, and high-end chip design has remained mostly in the hands of advanced economies.

  • Following more than two years of exceptional growth, emerging Asia’s electronics exports began to decelerate in mid-2004 and, by the first quarter of 2005, shrunk 14 percent (q/q, saar) as orders from the United States and Europe slowed down. Semiconductor production capacity utilization declined to 85 percent from 93 percent in the first quarter of 2004, as capacity expansion outpaced increases in production. Foundries in particular experienced a sharp decline in capacity utilization, while leading edge production remained close to full capacity. More recent figures suggest, however, the beginning of a turnaround, as U.S. new orders growth turned positive in mid-2005, and electronics exports of a number of economies—notably Korea, Singapore, and Taiwan Province of China—started to pick up.

  • Looking ahead, there are reasons to be cautiously optimistic. While it is unreasonable to expect the return of strong growth rates observed in the past couple of years, the leading indicators remain relatively healthy. In particular, U.S. order books suggest that U.S. tech demand is rebounding, especially with new products coming to the market and the cyclical replacement of technology initially purchased during the Y2K scare. Also, inventories in the semiconductor industry are relatively lean, capacity utilization rates are increasing at the foundries, and pricing across the component sectors have been stable. Moreover, Asian firms may benefit from a shift in the locus of production out of the United States and Europe. However, competition in the market remains strong, with brand names taking market share from some Asian suppliers.


Electronic Exports in 2004

(In percent of total exports)

Citation: Policy Papers 2005, 075; 10.5089/9781498330961.007.A001

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

Industrial Countries: Developments and Outlook


  • Japan's economy has regained momentum after a pause during the latter part of 2004. Exports seem to be accelerating again and recent data—including the national accounts for the first half of 2005—point to a revival of domestic demand. These conjunctural developments, together with significant underlying progress in bank and corporate restructuring, have positioned Japan to embark on a period of sustained growth.

  • With the economy now more resilient, fiscal consolidation has become a policy priority. Achieving the authorities' objective of primary balance excluding social security by early in the next decade will require strong efforts, and an even more substantial adjustment may be needed to stabilize the debt.

  • The priority for monetary policy remains conquering deflation. Staff has recommended sustaining the BoJ's quantitative easing framework until deflation—and deflation expectations—is eliminated.

  • Meanwhile, further structural reforms are needed to raise the economy's trend growth rate and deal with the pressures associated with population ageing.


  • After a brief pause, Australia’s economy looks set to accelerate again. Growth was 2¾ percent (q/q, saar) in the first quarter, a pace which is expected to continue for the remainder of the year. But with exports rising rapidly, growth is expected to quicken to about 3½ percent in coming years. Prospects are underpinned by high investment, particularly in the resource export sector, responding to an historically high terms of trade. Export commodity prices are up almost 50 percent in the past 18 months, with strong Chinese demand for iron ore and coal being a key factor.

  • Meanwhile, the housing market seems to be staging a “soft landing”, diminishing a major threat to growth. House prices were flat in the year to March 2005 after rising by 17½ percent annually in the three preceding years.

  • Macroeconomic policies are well placed. The monetary stance is broadly neutral, with the target cash rate at 5½ percent compared with CPI inflation of 2½ percent. The fiscal surplus is projected to average almost 1 percent of GDP in the medium term, even after allowing for increases in income tax thresholds and for a significant decline in export commodity prices in the next few years.

New Zealand

  • New Zealand’s economy has also slowed, but for different reasons than in its trans-Tasman neighbor. In New Zealand, house prices are rising, supporting solid growth in domestic demand. But net exports are declining, partly reflecting the influence of the high level of the New Zealand dollar. Accordingly, growth is expected to slow to about 2½ percent in 2005 and 2006, from almost 5 percent in 2004.

  • Despite the slowdown, the economy is still operating close to potential, stoking inflationary pressures. With CPI inflation rising to 2¾ percent (y/y) in June 2005, the central bank has raised interest rates by 175 basis points since early 2004 to 6¾ percent, aiming to moderate domestic demand and thereby assure that inflation remains in line with the 1–3 percent medium-term objective.

  • The fiscal surplus has soared, sparking debate ahead of the September 17 election. Buoyant revenues have increased the underlying operating surplus to an estimated 5¼ percent of GDP in 2004/05, prompting the Government to propose tax relief targeted to families, coupled with higher social spending. The main opposition party has proposed general increases in personal income tax thresholds and a reduction in the company tax rate.

Real GDP Growth

(Year-on-year percent change)

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Sources: IMF, APDCORE database; and staff estimates.

By late 2003, however, the underlying impetus behind Asia’s growth had already begun to weaken. In some regions of the global economy, notably the euro area, the recovery was starting to falter. The electronics boom gradually faded, as the expansion of capacity outstripped demand in advanced economies, saddling producers with unsold inventories and triggering sizeable declines in semiconductor prices. In addition, China’s imports decelerated sharply following the policy tightening in the second quarter of 2004, which curbed investment in a number of overheated sectors, such as steel and chemicals. Meanwhile, global oil prices were surging, with the price of Dubai oil—Asia’s main type of crude oil import—increasing by 23 percent in 2004 and a further 65 percent in the first eight months of 2005, swelling the region’s import bills (Box 3).

The Impact of World Oil Price Increases

  • Asia’s dependence on oil is similar to that of other regions, although oil intensity varies quite significantly from country to country. The NIEs are particularly oil-dependent, mainly because their manufacturing is concentrated in energy-intensive industries, such as petrochemicals, steel, and cement. And while the rest of Asia is more oil-efficient, most of these countries are still oil-dependent in another sense: they rely on imports to satisfy the bulk of their petroleum needs.

  • The sharp increase in oil prices over the past two years has consequently resulted in a large increase in Asia’s oil import bill. Initially, the region was spared the full brunt of the world market increase, as the price of Dubai oil—its main type of import—was slower to rise than that of other types of crude. But this year the reverse has been true, and now the cumulative increase for all types is now around the same, some 105 percent between end-2003 and August 2005. This increase is expected to raise the cost of emerging Asia’s net oil imports from 2 percent of GDP in 2003 to 4 percent of GDP in 2005.

  • In principle, the oil price increase should have had a significant impact on regional growth. According to staff estimates, a sustained $10 per barrel increase in oil prices ceteris paribus reduces full-year Asian GDP growth by an average ¾ percentage point, and by an average of 1¼ percentage points once feedback effects from lower growth in the rest of the world take hold. With the cumulative increase in prices having reached $25 per barrel by mid-2005, even the first-round estimates would imply a nearly 2 percentage points reduction in Asia’s growth rate.

  • The apparent impact, however, has been much more modest. One reason is that strong growth in demand for Asia’s exports has until recently been sufficient to offset the negative impact of higher oil prices. Another reason is that from end-2003 through June 2005 domestic petroleum product prices had only risen by less than one-third of the increase in crude oil prices.

  • In many instances, the limited pass-through reflects state intervention in petroleum product price setting. About one-half of the countries in the region have some degree of state controls, which have limited the average domestic price increases in these countries to about 34 percent (in dollar terms) on average from end-2003 through August 2005. In so doing, some countries have incurred significant fiscal costs, notably India and Malaysia, where subsidies are expected to amount to 2¼ percent of GDP this year assuming domestic fuel prices and international oil prices stay at current levels for the rest of the year; and Indonesia, where they are expected to reach 4½ percent of GDP.

  • Even among the economies with freely-determined prices, however, domestic petroleum product prices have risen by much less than world crude prices. A key reason is that taxes, as well as refining and distribution costs, have remained relatively stable—and they make up a substantial fraction of prices at the pump, up to two-thirds of the total in some countries. In some cases, domestic prices have also been held down by the appreciation of local currencies against the U.S. dollar.

  • There have also been factors cushioning the impact at the next stage of the pass-through—from higher oil prices onto CPI inflation. The direct impact has been relatively small, since the weight of gasoline in regional CPIs is only 3 percent on average; and even once transport and electricity prices are added, the weight only reaches 10 percent. Meanwhile, the indirect impact has also been limited because strong competition, especially from China, has forced many firms to absorb the higher oil costs rather than raise output prices.

  • That having been said, high world prices may yet put pressure on inflation rates, because substantial price increases are still required in those countries with administered prices. Since many of these countries had subsidized petroleum products even before the recent run-up in world prices, they would need to raise domestic prices by an additional 43 percent on average to bring them up to end-August world price levels, according to staff calculations (Annex I). Particularly large increases are needed in India and Indonesia, exceeding 60 percent and 120 percent respectively.


Oil Intensity, 1998-2000

(Kgs per $ of PPP GDP)

Citation: Policy Papers 2005, 075; 10.5089/9781498330961.007.A001

Source: IMF staff estimates.1 Emerging Asia includes China, India, NIEs (except Singapore and Taiwan POC), and ASEAN countries.

Oil Intensity, 1998-2000

(Kgs per $ of PPP GDP)

Citation: Policy Papers 2005, 075; 10.5089/9781498330961.007.A001

Source: IMF staff estimates.1 NIEs exclude Taiwan POC, for which data are not available, and Singapore, which imports oil for re-export.

Asia and Comparators: Size of Manufacturing

(In percent of GDP)

Citation: Policy Papers 2005, 075; 10.5089/9781498330961.007.A001

Sources: World Bank, WDI database; and US Bureau of Economic Analysis.

Emerging Asia: Oil Imports1

(In percent of GDP)

Citation: Policy Papers 2005, 075; 10.5089/9781498330961.007.A001

Sources: IMF, WEO database; and staff estimates.1 Net import of crude oil and oil products, except for Korea (crude oil only).

Gross Fiscal and Quasi-Fiscal Costs of Price Subsidies123

(In percent of GDP)

Citation: Policy Papers 2005, 075; 10.5089/9781498330961.007.A001

Sources: Country authorities; and IMF staff estimates.1 For oil exporters, the net costs are smaller. For example, net fiscal and quasi-fiscal costs in India are 0.5 percent of GDP both in 2004 and 2005.2 Data for China and Taiwan POC are not available.3 Estimates based on an assumption that oil prices average — 70/bl for August -December 2005.

Components of Petroleum Product Retail Price, June 20051

(In percent of total)

Citation: Policy Papers 2005, 075; 10.5089/9781498330961.007.A001

Sources: Country authorities; and IMF staff estimates.1 Countries with market determined prices.2 Includes customs, excises, VAT, and sales tax as applied in each country.

Emerging Asia: Exports

(Q/Q percent change, 3mma, SAAR)

Citation: Policy Papers 2005, 075; 10.5089/9781498330961.007.A001

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

Emerging Asia: Direction of Exports

(In billions of U.S. dollars, 3mma)

Citation: Policy Papers 2005, 075; 10.5089/9781498330961.007.A001

Sources: IMF, Direction of Trade Statistics; and staff estimates.

As all this occurred, emerging Asia’s economies began to slow down. GDP growth in emerging Asia eased to 8¼ percent (q/q, SAAR) in the first quarter of 2005 from a peak of nearly 12 percent in the third quarter of 2003, with export growth essentially ceasing (q/q) in the first quarter of 2005. The slowdown was felt throughout the region, with the notable exception of China, where growth was sustained by still-robust domestic demand. In the rest of emerging Asia, growth declined much more markedly, to 3¼ percent from 11¼ percent (q/q, SAAR) over the same period. The deceleration was particularly steep for the NIEs, reflecting their dependence on electronics exports.


Emerging Asia: Real GDP Growth

(Percent change)

Citation: Policy Papers 2005, 075; 10.5089/9781498330961.007.A001

Sources: IMF, APDCORE database; and staff estimates.

As growth decelerated, domestic demand in emerging Asia moderated in the latter half of 2004 and the beginning of 2005. In particular, investment growth fell sharply to 2¾ percent on average (q/q, SAAR) in the first quarter of 2005, from a peak of 17¼ percent in late 2003. The decline was again particularly pronounced in the NIEs, where the contribution of domestic demand to growth actually turned negative in the first quarter of 2005. In China, investment moderated somewhat in response to a tightening of administrative controls, and net exports became the leading contributor to output growth.


Emerging Asia: Domestic Demand and Export Growth1

(Q/Q percent change, SAAR)

Citation: Policy Papers 2005, 075; 10.5089/9781498330961.007.A001

Sources: IMF, APDCORE database; and staff estimates.1 Excludes India and Singapore.

Emerging Asia: Consumption and Investment Growth1

(Q/Q percent change, SAAR)

Citation: Policy Papers 2005, 075; 10.5089/9781498330961.007.A001

Sources: IMF, APDCORE database; and staff estimates.1 Excludes China and India, for which expenditure-based national accounts data are not available.

Inflation and Oil Prices

In recent years, headline inflation in Asia has remained relatively modest, despite robust economic growth and a significant run-up in global oil prices since mid-2004. During 2004, headline inflation in emerging Asia rose by 3 percentage points to 5½ percent in the third quarter, primarily on account of high food price inflation, driven to a large extent by demand from China following a drought and the consequent reduction in harvest. By contrast, the impact of higher oil prices was much more limited, partly because pass-through was moderate in most countries and partly because the weight of energy in the region’s price indexes was much smaller. Stiff competition—including from China—has also discouraged firms from passing on higher energy costs into output prices, cushioning the impact on CPI inflation (see Annex I).


Emerging Asia: Consumer and Producer Prices

(12-month percent change)

Citation: Policy Papers 2005, 075; 10.5089/9781498330961.007.A001

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

CPI Inflation

(Year-on-year percent change, average)

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Sources: IMF, APDCORE database; and staff estimates.

Wholesale prices for India.

So far this year, CPI inflation has subsided to 2½ percent for Asia as a whole, and 3¼ percent for emerging Asia. Food prices have declined significantly as the drought in China ended, more than offsetting the continued rise in oil prices. With respect to the latter, Asia has been more exposed than other regions this year because Dubai oil prices have risen by roughly 65 percent in the first eight months of this year, more than average world prices, the reverse of last year’s pattern when Dubai prices increased by only 23 percent. About half of the countries in the region have continued to limit the pass-through to domestic prices, helping to contain the impact on headline inflation.

External Developments

Asia’s current account surplus increased marginally last year, despite a rising oil import bill, but this reflected a significant increase in surpluses of just two countries. Japan’s current account surplus rose by ½ percentage point to 3¾ percent of GDP, on the back of robust export growth1 and buoyant investment income, and China’s current account surplus rose by 1 percentage point to about 4¼ percent of GDP, not only because Chinese exports continued to gain market share, but also because import growth slowed suddenly and sharply. The decline was particularly pronounced for imports of machinery and equipment, due to the moderation in investment growth, and also because the coming on stream of new manufacturing capacity enabled China to reduce its dependence on imports. Private transfers also rose, possibly reflecting expectations of a renminbi revaluation.

Current Account Balances

(Percent of GDP)

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Sources: IMF, APDCORE database; and staff estimates.

Excluding China, emerging Asia’s current account surplus declined last year by 1 percentage point to 2¾ percent of GDP, on the back of a higher oil import bill and a marginal decline in the non-oil current account surplus. In some countries, such as Thailand and India, current accounts actually shifted into deficit, reflecting soaring import demand and rising oil prices.

So far this year, current account balances in emerging Asian economies have generally deteriorated again, with the exception of China and India. In China, the trade balance swung into a large surplus during the first seven months of 2005, as soaring textile and clothing exports following the removal of MFA quotas in January 2005 helped buoy otherwise slowing exports, and continued import substitution led to slower import growth; in steel for example, the country shifted from being a net importer to being a net exporter. In India, the current account returned to a small surplus as invisibles earnings (including from outsourcing) increased sharply, more than offsetting an acceleration in imports to 40 percent y/y. In the rest of Asia, current account surpluses mostly narrowed, with export growth slowing and surging oil prices driving up the oil import bill.

Since late 2001, emerging Asia’s foreign reserves have risen faster than the current account surplus, because of the contribution of capital inflows into the region (Annex II). The surge in inflows that started in 2003 has fuelled a $765 billion rise in emerging Asia’s international reserves over the past two and a half years.2 Starting in early 2005, however, capital inflows have slowed considerably, the result of a strengthening in the U.S. dollar. Consequently, reserve accumulation in Asia excluding China came to a virtual standstill in May and June.


Emerging Asia: Sources of Reserve Accumulation

(In billions of U.S. dollars)

Citation: Policy Papers 2005, 075; 10.5089/9781498330961.007.A001

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

Gross International Reserves

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Sources: IMF, APDCORE database; and staff estimates.

Residual maturity.

Throughout most of 2003 and 2004, Asian authorities responded to these inflows primarily with broad-based sterilized intervention. Most countries were still then in an early stage of economic recovery. With domestic demand remaining weak, and deflation a threat in some countries, authorities were unwilling to allow a sizeable appreciation that could slow down the one vibrant motor of their economies – exports. This was reflected in the very large build-up in official reserves mentioned above, and a modest growth of base money.


Emerging Asia: Cumulative Increases in Base Money, NFA, and NDA

(In billions of U.S. dollars)

Citation: Policy Papers 2005, 075; 10.5089/9781498330961.007.A001

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

As recovery took hold and reserves swelled to ample levels, some countries reduced their foreign exchange intervention. Starting in March 2004, Japan completely ceased intervening in the foreign exchange market, allowing the yen to appreciate by 4¼ percent against the U.S. dollar by January 2005. Similarly, Korea has scaled back its intervention, leading the won to appreciate by nearly 16 percent against the U.S. dollar between end-2003 and mid-August 2005. Appreciations of other currencies against the U.S. dollar since August 2004 have also been significant, including for India (6 percent). In real effective terms, however, only Korea’s and India’s exchange rates have appreciated significantly since late 2004.


Exchange Rates Against the U.S. Dollar1

(January 2004=100)

Citation: Policy Papers 2005, 075; 10.5089/9781498330961.007.A001

Source: Bloomberg LP.1 Value below 100 indicates appreciation.

Real Effective Exchange Rates

(January 2003=100)

Citation: Policy Papers 2005, 075; 10.5089/9781498330961.007.A001

Source: IMF, APDCORE database.

The most recent market developments appear consistent with a greater degree of flexibility for regional exchange rates. On July 21, the People’s Bank of China (PBC) announced that the renminbi would be revalued upward by 2 percent against the U.S. dollar and its value set with reference to a basket of currencies. Since then, the renminbi has traded in a tight range against the dollar. But in the non-deliverable forward (NDF) market, investors assume that the July revaluation is the first step toward greater exchange rate flexibility: premia in mid-August 2005 suggested that the renminbi would appreciate by around 5 percent within 12 months.

China’s move had ripple effects across the region. Malaysia’s central bank announced on July 21 that it would immediately move from its U.S. dollar peg to a managed float for the ringgit with reference to a currency basket; by mid-August the ringgit had appreciated by around 1 percent against the U.S. dollar. In addition, the yen, the won, and the Thai baht all gained more than two percent against the U.S. dollar.

Exchange Rate Developments Since July 21

(July 21, 2005 to August 12, 2005)

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Source: Bloomberg LP.

In terms of U.S. dollar per national currency.

Exchange rate change from July 20 to August 22, 2005.

Outlook for 2005 and 20063

Asia’s growth is forecast to slow to about 6 percent in 2005, down ¾ percentage point from 2004, the result of decelerating exports. For emerging Asia, growth is forecast at 7½ percent, also slower than last year. Still, the current forecasts are ¼ percentage point higher than in the April WEO, reflecting upgraded forecasts for three key countries.

  • The growth outlook for Japan in particular has improved considerably—to 2 percent, from only ¾ percent in the April WEO—as domestic demand is regaining forward momentum, following a soft patch during the latter part of 2004. Private consumption was up 4.9 percent q/q annualized in the first quarter, and recent indicators such as industrial production, retail sales, and foreign machinery orders all point to a continued expansion in private investment and consumption going forward.

  • Growth in China is now forecast to slow only modestly to 9 percent, with accelerating private consumption offsetting slower investment and export growth. Private consumption should be supported by rising rural incomes following a good harvest, strong job creation, and an expansion of credit to households. Investment is now expected to decelerate less than earlier anticipated, supported by high profitability, as productivity has soared while labor costs have remained relatively stable. And even export growth, while slowing, is expected to remain stronger than elsewhere because China has a more diversified export base and depends less on electronics.4

  • Growth in India is projected to hold up at 7 percent on the back of a better-than-expected outcome for agriculture in the first quarter and continued buoyancy in the industrial and services sector.

At the same time, significant decelerations in growth are foreseen for most other countries in emerging Asia, as export growth is expected to halve in both the ASEAN4 and the NIEs while domestic demand is expected to decelerate. Korea is the main exception, with domestic demand growth projected to rise by 1¾ percentage point to about 3½ percent, primarily because households are now finally in a position to increase their spending, after two years during which they focused on reducing excessive debt accumulated during a 2000-02 credit boom.

Growth for 2006 should remain steady at 6 percent. Japan’s growth is expected to hold steady in 2006, at 2 percent, with domestic demand growth remaining at 2 percent and net exports accelerating. Emerging Asia’s growth has been revised up by about ¼ percentage point, to about 7 percent, also about the same as last year.

But there could be a shift in the distribution of growth. In most economies in the region, growth is expected to pick up in 2006, led by a recovery in external demand. The latest economic releases are consistent with this projected pick-up, with some electronics leading indicators (such as the U.S. book-to-bill ratio) showing signs of recovery and exports rebounding in several countries (e.g., Taiwan Province of China, Malaysia and Singapore). At the same time, the forecast also incorporates a further half-a-percentage point slowdown in growth in China to around 8¼ percent, as investment is expected to continue to decelerate to more sustainable levels. A slight reduction in growth is also projected for India (to 6¼ percent), resulting from higher oil prices and a possible tightening in short-term interest rates.


Tech Sector Indicators1

Citation: Policy Papers 2005, 075; 10.5089/9781498330961.007.A001

Source: CEIC Data Company Ltd.1 Three-month moving average.

With governments increasingly deciding to pass on higher world oil prices as they try to limit the costs of oil subsidies, inflation is set to rise, albeit modestly. In economies with controlled petroleum product prices, staff estimates suggest that domestic prices need to be raised by an additional 43 percent on average to bring domestic prices (in dollar terms) up to world market levels. Headline inflation in 2005 and 2006 for Asia as a whole is nonetheless expected to remain relatively flat at 3—3½ percent y/y, thanks to the offsetting impact of lower food prices. For emerging Asia, inflation is projected at 4 percent, about the same as in 2004, but about ¾ percentage point higher than in the April WEO.

Meanwhile, the region’s current account surplus is forecast to remain around 3 percent of GDP in both 2005 and 2006, but with a marked change in the distribution around the region. China’s current account surplus is forecast to increase by 2 percentage points to 6 percent of GDP in 2005, and remain high at 5½ percent of GDP in 2006, as the rapid expansion in manufacturing capacity should translate into greater exports, while allowing domestic production to substitute increasingly for imports. In contrast, the current account surplus for emerging Asia excluding China is projected to more than halve to roughly 1 percent of GDP in 2005 and to narrow further to ¾ percent of GDP in 2006, the result of growing oil deficits.


Current Account Balance

(In billions of U.S. dollars)

Citation: Policy Papers 2005, 075; 10.5089/9781498330961.007.A001

Sources: IMF, WEO database; and staff estimates.

Risks to this mostly bright outlook stem mainly from rising energy prices at this stage.

  • Oil prices (Dubai) have increased by 65 percent this year (through end-August) and, based on futures prices, are expected to remain high over the near term, hurting regional incomes and putting upward pressure on inflation. The latest WEO assumptions have revised oil prices up sharply, yet by end-August world prices were already above the 2006 forecast of $61.8 per barrel. Asia’s economies are quite vulnerable to oil price increases, as they are highly dependent on oil compared to countries in other regions. So far, incomplete pass-through has muted the impact on output, but rising fiscal and quasi-fiscal costs are likely to make this approach increasingly unsustainable, especially if energy prices keep rising. In countries with high public indebtedness and large gross financing requirements, higher oil prices could also increase short-term external vulnerability, especially if they lead to higher global interest rates, or if the rising costs of maintaining fuel subsidies have a negative impact on market sentiment.

  • The near-term risks to growth in the advanced economies outside Asia, and therefore the risks to demand for Asian exports, are slanted to the downside, as rising energy prices could begin to weigh on advanced country growth. Already, leading indicators for the OECD economies have deteriorated for much of this year—even before the further surge in world oil prices in August. In the event of a global slowdown, risks to Asia’s outlook also stem from the limited scope for counter-cyclical policy, given the high levels of public debt.

  • The tech sector shows some upside potential. The Semiconductor Industry Association has revised its forecast of worldwide semiconductor sales growth to 6 percent in 2005, up from a zero growth forecast at end-2004 and several recent leading indicators, including U.S. new electronics orders, the U.S. Purchasing Managers’ Index, the PMI for Singapore for July, and the U.S. book-to-bill ratio, point to early signs of a recovery.

  • Another risk arises from the increase in protectionist sentiment in advanced countries---a potentially serious threat for Asia, given its dependence on exports. Already, the expiry of multilateral quotas has led to safeguard actions on China’s textile exports, and there are pressures for further restrictive measures (Box 4).

  • Finally, an outbreak of the avian flu could have a serious economic impact on Asia, as the experience of SARS in 2003 has amply demonstrated (Box 5). If a pandemic were to develop, the impact on the region could be significant.

The Impact of the Removal of Textiles Quotas

  • China has been the major beneficiary of the removal of textiles and clothing quotas in January 2005, but many low-income countries in Asia (LIAs) have also fared reasonably well.1

  • The expiry of textiles and clothing quotas has allowed China to gain substantial market share. During the first five months of this year, China’s textile exports to the United States expanded by around 60 percent according to U.S. data, with exports in the newly liberalized product lines tripling. Similarly, exports to the EU rose by nearly 40 percent, and by around 80 percent in the liberalized categories. As a result, China now accounts for about 25 percent of both the U.S. and EU textile imports, up from 17 percent a year ago.

  • India has also benefited significantly. India’s textile exports increased by 30 percent to the United States and 10 percent to the EU during the first five months of this year, as liberalization enabled India to take advantage of its relatively low labor costs, niche markets, abundant supply of cotton, and strong textile and apparel base. In addition, the country continues to benefit from trade preferences: although the EU will remove preferential market access for textile exports beginning in January 2006, it has maintained access for clothing exports, which account for three-quarters of India’s total textile and clothing exports. India’s market share of the U.S. and EU textile imports remains modest, however, at only 7 percent. Moreover, India does not have preferential access to the U.S. market, and its exports still face many constraints including poor infrastructure, lack of scale economies, a ban on foreign direct investment in the retail sector, and an unsupportive tax regime.

  • Meanwhile, exports in some LIAs have held up relatively well. During the first five months of this year, Bangladesh, Cambodia and Sri Lanka all recorded double-digit growth in textile exports to the United States, a marked improvement from 2004. Bangladesh has gained from its exports of knitwear, which are priced lower than those of China. Export performance in Cambodia has been supported by its relatively high labor standards, while Sri Lanka has relied on long-established relationships with certain large U.S. buyers.

  • Other LIAs, however, have experienced sharp declines in exports. During the first five months of this year, Lao P.D.R., Mongolia and Nepal all witnessed steep downturns in textile exports, as production shifted to neighboring countries with greater comparative advantage. And looking ahead, there are further ominous signs. Prices have fallen, by 18 percent on imports of liberalized textile products from China into the EU and by 13 percent on imports of apparel products from China into the United States. Over time, this will squeeze the profit margins of LIA exporters and erode their overseas orders.

  • Prospects for LIAs will also be affected by the recent re-imposition of quantitative restrictions on selected Chinese textile products. In mid-year, the United States and the EU responded to the surge in China’s exports by invoking safeguard clauses, with the United States capping annual growth in seven textile categories at 7½ percent and the EU limiting growth in 10 categories to 8–12½ percent. Since these restraints affect one-quarter of the U.S. and EU imports of Chinese textiles, they will have a significant impact on the market. As a consequence, distortions in global textile trade would be maintained and potential savings to the world’s consumers would not be fully realized.

  • The implications for LIAs, however, are unclear. On the one hand, the restraints may aid LIAs by encouraging industrial country importers to diversify their sources of textile suppliers. However, they could also hurt LIAs by forcing Chinese exporters to divert production into the remaining liberalized product categories or into other countries which have not imposed quotas, thereby intensifying competition in these markets.

  • LIAs have responded to these challenges by taking steps to bolster their competitiveness. These have included encouraging textile firms to shift to high value-added or more specialized products; implementing measures to increase labor market flexibility; and adopting programs to improve infrastructure, such as roads and energy supplies to factories. In addition, LIAs have lobbied for preferential access to the U.S. and EU markets. So far, the United States has reduced import tariffs by granting normal trade relations status to Vietnam in 2001 and Lao P.D.R. in 2004. Meanwhile, since 2001, the EU has eliminated duties and quotas for nearly all products originating from least developed countries, which include several LIAs.3

  • During this adjustment period, the Fund stands ready to provide assistance through its Trade Integration Mechanism (TIM), as has already been done for Bangladesh.

1 Low-income countries in Asia (LIAs) include Bangladesh, Cambodia, Lao P.D.R., Mongolia, Nepal, Sri Lanka, and Vietnam.2 Unless otherwise indicated, all references to “textiles” include both textiles and clothing.3 Including Bangladesh, Cambodia, Lao P.D.R., and Nepal.

Value of Textiles and Clothing (T&C) Exports

(Percentage change year-to-date)

article image
Sources: United States International Trade Commission; Eurostat; and IMF staff estimates.

Data are for January through May 2005.

Data are for January through April for Mongolia, January through May for Bangladesh and Sri Lanka, and January through June for Cambodia, China, Nepal and Vietnam.

Data for Lao P.D.R. are highly sensitive to fluctuations in export orders given the low export base to the U.S.

Data for Mongolia are highly sensitive to fluctuations in export orders given the low export base to the EU.

Avian Influenza: Is It A Serious Threat?

  • Avian influenza viruses normally affect only birds and pigs. However, in 1997 an epidemic of the highly pathogenic H5N1 strain jumped to humans in Hong Kong SAR, inflicting severe respiratory disease on 18 people, of whom 6 subsequently died. In response, the authorities destroyed the territory’s entire poultry population of 1½ million within three days, thereby helping to prevent a pandemic.

  • Nevertheless, the disease continued to spread. In late 2003/early 2004, there was a major regional outbreak, affecting livestock in Cambodia, China, Indonesia, Japan, Korea, Lao P.D.R., Thailand, and Vietnam. More than 120 million chickens died or were culled, and in Thailand and Vietnam humans deaths were reported as well.

  • In December 2004 a third wave began, and it continues to date, mainly in Cambodia and Vietnam. The number of human cases increased, exceeding those infected in the first and second waves.

  • Experts believe that eventually a pandemic will occur. The World Health Organization notes that many farmers in the region live in close proximity to their poultry, making it easy for infected animals to transmit their flu to humans. Moreover, since avian flu virus mutates easily it may eventually become readily transmissible from human to human, greatly amplifying its scope for propagation among people. Preventing a pandemic would thus require major changes in livestock management, as well as improvements in the monitoring and reporting of outbreaks.

  • The economic consequences of a pandemic are difficult to predict. Nevertheless, the main channels through which an economy could be affected are clear and numerous. They include: poultry production, export and consumption; tourism; and industrial production, since factories could be forced to stop operation to slow the outbreak of the flu. Within Asia, the largest poultry sectors are found in China, Indonesia, and India, while tourism is important for countries such as Cambodia, Malaysia, Thailand, and Hong Kong SAR, all of which have earnings equivalent to 5½ percent or more of GDP.

  • A comparison with the SARS outbreak is instructive. SARS is not as contagious as avian flu, and its outbreak in 2003 was confined to a relatively small geographical area. Nonetheless, its effect on economic activity in the afflicted countries was dramatic and immediate. GDP fell in the second quarter of 2003 at an annualized rate of around 5 percent in Taiwan Province of China, 8½ percent in Singapore, and 10 percent in Hong Kong SAR (q/q, seasonally adjusted). As the outbreak subsided, however, production rebounded sharply in all of these economies.


OECD Leading Indicators

(6-month percent change, annualized)

Citation: Policy Papers 2005, 075; 10.5089/9781498330961.007.A001

Source: OECD.

II. Policy Developments and Issues

Since the late 1990s, a main policy focus of regional authorities has been to restore robust growth and reduce vulnerabilities. This has involved reforms to strengthen banking and corporate sectors, improve fiscal positions, and build up international reserve cushions. Over this period, and with the exception of China and India, external demand has been the main driver of growth. Domestic demand growth has been held down by weak investment, which dropped sharply during the financial crisis in many countries and has regained only limited ground since.


Asia: GDP Growth and Domestic Demand1

(Four-quarter percent change)

Citation: Policy Papers 2005, 075; 10.5089/9781498330961.007.A001

Sources: IMF, APDCORE database; and staff estimates.1 Excludes China and India.

Looking forward, a challenge for much of the region is to further rekindle domestic demand, thereby reducing reliance on net exports. This must be done in a way that preserves strong macroeconomic positions, and is consistent with progress in reducing vulnerabilities. The room for maneuver on macroeconomic policies is limited, given that in many economies public debt levels are still quite high and interest rates remain near record lows. In addition, domestic policy decisions must now be weighed against the background of emerging external risks, including rising oil prices, global current account imbalances and higher U.S. interest rates, which have implications for inflation as well as growth. Much of the burden in strengthening domestic demand in Asia must therefore rest on further progress with structural reforms, including those that may support strengthening consumption as well as improving the investment climate.

Need for Fiscal Consolidation Rules Out Stimulus

In the late 1990s, fiscal positions deteriorated sharply in emerging Asia. In many cases, authorities incurred large financial sector restructuring costs as a result of the financial crisis and then had to cushion demand during the economic downturn that followed. The result was a large build-up in public sector debt, with the debt to GDP ratio in emerging Asia rising by 9¾ percentage points between 1996 and 1999, to 36½ percent of GDP.

Starting in 2000, authorities began rectifying their fiscal imbalances. The deceleration in growth in emerging Asia from early 2000 to mid-2001 was actually met by a very modest tightening, as authorities were becoming concerned about debt sustainability. The growth pick-up in mid-2001 gave countries more room to tighten, even if this did not happen in earnest until 2003. Between 2000 and 2004, central government deficits in emerging Asia were reduced by 1¾ percentage points of GDP on average. Fiscal consolidation was achieved through increases in revenue, with the ratio of revenue to GDP increasing by 2½ percentage points over the period and more than compensating for the observed increase in expenditure. Higher revenue came through a combination of additional tax measures, improved collection, and a significant rebound in economic activity over the period. Oil exporters (e.g., Indonesia, Malaysia, and Vietnam) received an additional revenue lift from high oil prices, although this was partially offset by sharply higher fuel subsidies.

Recent fiscal consolidation has not been strong enough to prevent increases in debt stocks. The debt to GDP ratio for emerging Asia increased by 2 percentage points between 2000 and 2004, with double-digit increases in the Philippines and Taiwan Province of China. Indonesia is a notable exception to this trend, with its debt to GDP ratio falling by 33 percentage points over this period. Looking more in detail, one can see two distinct sub-periods. From 2000 to 2002 fiscal consolidation was timid and countries maintained substantial primary deficits, resulting in rising debt stocks. Consolidation then accelerated in 2003 and debt stocks relative to GDP started falling, but have yet to reach 2000 levels.

Unlike emerging Asia, industrial Asia did not go through this pattern of fiscal expansion followed by consolidation over the period. Japan has incurred steady deficits of 6¼ percent of GDP on average since 1997, with the economy mired in deflation and weak growth. At the opposite end, Australia has achieved relatively steady surpluses of 1 percent of GDP on average, while New Zealand significantly raised its surplus in 2003 and 2004 to 5¾ percent and 4¼ percent respectively. As a result, both countries have experienced a substantial reduction in their debt stocks.

Selected Fiscal Indicators

(In percent of GDP)

article image
Sources: IMF, APDWEO database; and staff estimates.

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

Central government only

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

Fiscal year ending March; excludes privatization receipts from revenues.

Non-financial public sector debt.

Fiscal year ending September.

For 2005, the general trend toward gradual fiscal consolidation is expected to continue in emerging Asia. Despite a slight deceleration in economic activity, staff expects modest improvements in the fiscal balance of almost all regional economies. The debt to GDP ratio in the region is expected to fall by ¾ of 1 percentage point in 2005.

However, more needs to be done to meet the challenge of medium-term fiscal sustainability throughout Asia. Average debt stocks remain high relative to GDP, and coming decades will bring the added pressure of ageing populations in several countries. Moreover, fiscal flexibility in regional economies may be further limited by uncertainties surrounding off-balance sheet or contingent liabilities faced by governments, such as non-performing loans at state-owned banks in China. Staff has argued that now is a good time to act, given strong growth in the region.

Monetary and Exchange Rate Policy: A Balancing Act between Growth and Inflation

As growth faltered in the late 1990’s and the need for consolidation limited the room for maneuver on fiscal policy, many authorities focused on monetary policy to stimulate the economy. Average nominal and real interest rates in emerging Asia fell by 5 percentage points between 1997 and 1999, as growth collapsed in the wake of the Asian crisis. What is perhaps surprising is that the monetary easing in emerging Asia continued through mid-2004 despite improving economic conditions, with real interest rates falling to zero or becoming negative. One key factor is that domestic demand remained weak in several countries even as output began to recover, with investment remaining low in much of the region. And partly for this reason, inflationary pressures remained very subdued, with some economies such as Japan, Hong Kong SAR, and Taiwan Province of China actually experiencing a period of deflation, on some price indices.


Emerging Asia: Short-term Interest Rates1

(In percent)

Citation: Policy Papers 2005, 075; 10.5089/9781498330961.007.A001

Source: IMF, APDCORE database; and staff estimates.1 Three-month interbank rates or nearest equivalent.2 Based on contemporaneous inflation.

Industrial Asia: Short-term Interest Rates1

(In percent)

Citation: Policy Papers 2005, 075; 10.5089/9781498330961.007.A001

Source: IMF, APDCORE database; and staff estimates.1 Three-month interbank rates or nearest equivalent.2 Based on contemporaneous inflation.

By 2004, the room for monetary stimulus to encourage stronger domestic demand was threatened by the rise in commodity prices. Fear of inflationary pressures began to emerge with higher world oil prices and domestic food prices, while interest rates in the U.S. were rising. In the event, authorities responded with only small increases in interest rates when they responded at all, judging that commodity price increases would not feed through to second round inflation, and that imported inflation pressures could be offset by allowing some exchange rate appreciation against the U.S. dollar. That judgment generally proved correct as inflation tailed off by the end of 2004. In 2005, economies are benefiting as food prices have dropped even as oil prices continue to increase, so that the net impact on overall inflation remains moderate.


Selected Countries I: Policy Interest Rates1

(Percent per annum)

Citation: Policy Papers 2005, 075; 10.5089/9781498330961.007.A001

Sources: IMF, APDCORE database, and staff estimates;1 Japan, Korea, Singapore, Philippines.

In those economies where domestic demand had successfully been reignited, monetary authorities initiated a policy tightening bias that continues today. Authorities began to raise interest rates gradually in small steps (Australia, India, Indonesia, Taiwan Province of China, and Thailand) or took other incremental steps to withdraw liquidity (China and Malaysia) as policy authorities sought at the same time to remain supportive of growth (the one exception was New Zealand, which has raised the official interest rate seven times since end-2003). Again, the reason authorities raised rates in small increments was the belief that economies would be able to absorb commodity price shocks with little lasting impact on headline inflation.


Selected Countries II: Policy Interest Rates1

(Percent per annum)

Citation: Policy Papers 2005, 075; 10.5089/9781498330961.007.A001

Sources: IMF, APDCORE database, and staff estimates.1 Australia, New Zealand, Taiwan POC, China, India, Indonesia, Malaysia, Thailand.

Given continued lackluster domestic demand growth and heavy reliance on net exports, countries were initially reluctant to allow exchange rates to appreciate in 2002–03 when capital inflows into the region were heavy. Also, deflation was a concern in some countries. But in 2004, as growth resumed and in many cases domestic demand improved, the authorities in the region began to allow more exchange rate appreciation, in part as it helped offset inflation pressures from higher oil prices, thus providing support to the incremental approach to monetary policy tightening. In addition, the decision by the Japanese authorities to refrain (since March 2004) from intervening in the foreign exchange market meant that other currencies could also be flexible without losing competitiveness against Japan.


Foreign Exchange Reserve Accumulation

(In billions of U.S. dollars)

Citation: Policy Papers 2005, 075; 10.5089/9781498330961.007.A001

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

Starting in early 2005, appreciation against the dollar slowed or even reversed as capital inflows tailed off. In effective terms, however, regional currencies continued to appreciate throughout the period. Moreover, on July 21 the Chinese authorities decided to revalue the renminbi by 2 percent against the U.S. dollar, and to set its value subsequently with reference to a basket of currencies. The Malaysian authorities abandoned their dollar peg in favor of a tightly managed float the same day.


Nominal Effective Exchange Rates

(Percent changes from June 2004 to June 2005)

Citation: Policy Papers 2005, 075; 10.5089/9781498330961.007.A001

Sources: IMF, APDCORE Database; and staff estimates.

Looking forward, there is a need for monetary authorities to remain vigilant. While the recent decline in inflation has led to an effective rise in real interest rates, these remain near historic lows. Moreover, regional rate increases have not matched rises in global rates, a fact made easier by increased exchange rate flexibility in the region. Given that further oil price increases cannot be ruled out and that capacity utilization ratios are rising - and finally approaching pre-crisis levels in some countries, - monetary authorities will need to stay on guard if low inflation in the region is to be preserved.

Supporting Growth Through A Reinvigorated Structural Reform Agenda

Reflecting the importance of structural reform in encouraging investment, boosting productivity and strengthening economic resilience following the Asia crisis, many countries in the region launched a reform agenda aimed at stimulating strong and sustained growth over time. Key elements of the agenda have generally included reforms in the financial and corporate sectors, labor market, and trade policy. Important successes have been achieved, particularly in banking and corporate reform. Looking ahead, an important challenge for the region will be to improve infrastructure while preserving fiscal sustainability.

The most significant progress in structural reforms across the region has been in the financial sector. Authorities recognized that a well-developed financial system promotes growth, by mobilizing savings and channeling them to good business opportunities, in turn leading to more rapid accumulation of capital and faster technological progress. To that end, significant progress in bank restructuring has taken place across the region, as witnessed by the sharp declines in non-performing loan ratios. Foreign ownership of banks has increased in several countries, further aiding restructuring of distressed assets and bringing the potential to improve governance and accelerate the transfer of technology and management practices. However, for the region as a whole, there is still some catch up to do vis-à-vis other emerging markets in terms of bank profitability. Improvement in risk pricing and development of non-interest income activities are other important tasks for the future.


Emerging Asia: Non-Performing Loans

(In percent of total loans)

Citation: Policy Papers 2005, 075; 10.5089/9781498330961.007.A001

Sources: CEIC Data Company Ltd; and the World Bank.1 1998 WB estimate for Korea.

Corporate reforms have also advanced in several countries in the region. Trimmed labor costs and reduced excess capacity have led to a rise in profitability and corporate de-leveraging. In emerging Asia, debt-equity ratios have fallen from 204 percent in 1998 to 107 percent in 2003, while return on equity has gone from 4½ percent in 1999 to 6¾ percent in 2003. At the same time, new legislation was passed in several countries to improve corporate governance, notably strengthening the independence of supervisory boards and increasing shareholders’ rights. However, corporate governance still falls short of international best practice in most countries. Further privatization took place in the region. Yet in sectors such as energy more needs to be done if the region is to meet growing demand without unduly burdening government budgets.


Emerging Asia: Corporate Sector Debt-to-Equity Ratios

(In percent)

Citation: Policy Papers 2005, 075; 10.5089/9781498330961.007.A001

Source: IMF, Corporate Vulnerability Utility.

Asia faces a very large infrastructure gap as investment in infrastructure has lagged recent rapid growth rates. Addressing this gap will be key if the region is to maintain its growth momentum. According to a joint study by the World Bank, the Asia Development Bank, and the Japan Bank for International Cooperation, infrastructure needs in East Asia will total $200 billion a year for the next five years, 65 percent of which will be in the form of new investment and the remainder on maintenance of existing assets. Not surprisingly, a large share of this infrastructure demand will come from China. India also faces large infrastructure requirements, with needs estimated at $27–$45 billion per year over the next five years.

Some countries are increasingly resorting to public-private-partnership arrangements (PPPs) to finance infrastructure needs in times of limited fiscal resources. Korea, for instance, has recently announced a plan that would procure, through PPPs, infrastructure assets geared toward the delivery of social services, with the capital value of these assets amounting to 3 percent of GDP. PPPs present many potential opportunities, ranging from better value for money relative to standard public procurement, to private and financial sector development. However, staff has warned that the benefits of PPPs should not be oversold, in particular their ability to provide infrastructure without affecting the government’s balance sheet. PPPs can generate fiscal liabilities regardless of whether the financing of the asset entails gross borrowing by the government. As such, transparent reporting of the capital value of all PPPs and of the uncontingent and contingent liabilities associated with these projects is essential. Otherwise, PPPs may become an easy tool to bypass spending controls and to give the illusion of a larger fiscal envelope.

Proposals for more active investment of some foreign reserves in emerging Asia have suggested their use to finance public infrastructure. Official reserves can provide a new source of financing for domestic projects whose rate of return is likely to be considerably higher than that on foreign official assets. Beyond the financial rate of return, there are likely to be large social benefits to these projects. However, reserve-financed public investment is essentially just central bank credit to government, where the debt is in the form of liabilities issued by the central bank when purchasing the foreign reserves. This proposal also entails the risk that public investment decisions will take place outside the usual vetting framework. Potential transparency and governance problems would argue for keeping spending on such projects in the budget, rather than creating a separate entity capitalized by excess reserves. Last but not least, financing infrastructure through the use of reserves can impinge on the independence of the monetary authority.

While progress has been achieved in labor market reform, the agenda remains heavy. Australia, Japan and New Zealand have made significant progress, albeit to different extents, in easing labor market rigidities. Other countries have not been so successful, and would benefit from removing restrictions on layoffs and contract work and easing employment protection. At the same time, there is a need for retraining programs and targeted safety nets in countries where outsourcing has reduced demand for low-skilled workers.

Intra-regional trade and financial integration has progressed, but in many ways Asian countries remain better integrated with the non-Asia rest of the world than with each other.5 Intra-regional trade has grown rapidly in the last ten years, but the pattern of trade is consistent with the positioning of Asian countries at various stages of a global production chain whose final demand resides ultimately in the United States and Europe. Similarly, the region continues to rely on the intermediation of non-Asia mature markets for the allocation of capital.

Whether recent and prospective free trade agreements can deepen regional integration remains to be seen. The region has recently experienced a proliferation of bilateral and regional free trade agreements, and more are at the negotiation stage. A key question is whether this complex web of FTAs will deepen the “global production chain” model of intra-regional trade, lead to European-style “horizontal” intra-regional trade (where countries export final goods to each other), or on the contrary slow integration. As regards financial integration, regional bond markets are developing, particularly under the auspices of the Asian Bond Market Initiative, but further progress can be achieved in other areas of capital markets such as intra-regional banking activity.

III. Saving and Investment

Since the Asian crisis, the saving-investment balance in Asia has swung from a slight deficit to a significant surplus. This reflects mainly a sustained decline in investment, rather than an increase in saving. With the factors underlying the investment drought – notably excess capacity and corporate restructuring – ebbing, investment should pick up in coming years, and Asia’s saving-investment surplus should decline.


Current account balances of Asian countries have swung widely over the past decade. In the years prior to the Asian crisis of 1997–98, emerging Asian economies were running current account deficits equivalent to over 1 percent of GDP on average, with a number of countries exhibiting current account deficits in excess of 5 percent of GDP. Japan generally ran current account surpluses, and Asia’s overall current account was broadly in balance. After the crisis, current account balances in emerging economies swung to large and sustained surpluses, averaging 3 percent of GDP since 1998.

The counterpart to the adjustment in current account balances are movements in underlying saving and investment behavior:

Saving developments

  • Saving rates have been relatively stable in Asia, albeit at higher levels than in other regions. Over the past fifteen years, gross saving in Asia has averaged around 30 percent of GDP, about double the level in the United States, and 50 percent higher than in the euro area.

  • In emerging Asia excluding China, saving dipped slightly during the Asian crisis, reflecting a sharp and sustained decline in public sector saving, partly offset by an increase in private saving above precrisis levels.

  • In Japan, saving has declined steadily in the past decade owing to a fall in public saving and the impact of population aging on private saving. Given the economy’s size, developments in Japan have helped push overall saving in Asia excluding China (see below) to slightly below the pre-crisis level.


Gross National Saving

(In percent of GDP)

Citation: Policy Papers 2005, 075; 10.5089/9781498330961.007.A001

Sources: IMF, WEO database; and staff estimates.

Investment developments

  • Investment in Asia as a whole has been higher than in other regions, averaging above 30 percent of GDP over the past fifteen years. For Asia as a whole, investment dipped during the Asian crisis, but has since returned to pre-crisis levels.

  • Investment rates in emerging Asia excluding China, which had increased markedly in the years before the Asian crisis, collapsed sharply during the crisis (by 8 percentage points of GDP between 1996 and 1998). Investment rates have remained depressed since the crisis, having risen by only 2 percentage points of GDP from 1998 levels.

  • Both public and private investment declined, and are each still below precrisis levels. Domestically-financed investment has experienced the sharpest decline; after dipping slightly, FDI has returned to pre-crisis levels.

  • These developments point to the emergence of an “investment drought”, rather than a “saving glut” in emerging Asia excluding China. As noted above, the adjustment in investment in the immediate aftermath of the crisis dwarfed the move in saving. In a longer perspective, the decline in investment of 3 percentage points of GDP between the 1990–97 average and 2004 almost fully explains the increase in the saving-investment balance over this timeframe, with saving up only marginally. The private sector has borne the bulk of the adjustment, with a sharp fall in investment complemented by an increase in saving. By contrast, the saving-investment balance of the public sector has deteriorated, driven by the adoption of looser fiscal policies in response to the crisis and by one-off costs associated with recapitalizing financial systems.


Gross Capital Formation

(In percent of GDP)

Citation: Policy Papers 2005, 075; 10.5089/9781498330961.007.A001

Sources: IMF, WEO database; and staff estimates.

Emerging Asia: Saving-Investment Balances1

(In percent of GDP)

Citation: Policy Papers 2005, 075; 10.5089/9781498330961.007.A001

Sources: IMF, WEO database; and staff estimates.1 Excludes China.

Emerging Asia: Change in Savings-Investment Balance1

(In percent of GDP)

article image
Sources: IMF, WEO database; staff estimates.

Excludes China.

Developments in China stand out from the rest of emerging Asia. Gross saving in China has increased sharply since the Asian crisis, reaching almost 50 percent of GDP in 2004. This reflects increased saving by the government and enterprises, particularly in natural resource sectors, due to low dividend payout ratios and high retained earnings in the context of rising profits. High enterprise saving has been in turn channeled into investment, which has also expanded sharply in recent years; unlike the rest of emerging Asia, the saving-investment surplus of the private sector is significantly lower than before the Asian crisis. These developments could be consistent with a shift in production and investment to China from other emerging Asian economies, possibly reflecting developments in relative competitiveness. Indeed, private sector investment in emerging Asia as a whole has returned to near pre-crisis levels, with the increase in China offsetting the decline in the rest of emerging Asia.


Emerging Asia: Private Sector Saving-Investment Balances

(In percent of GDP)

Citation: Policy Papers 2005, 075; 10.5089/9781498330961.007.A001

Sources: IMF, WEO database; and staff estimates.

Emerging Asia: Private Investment

(In percent of GDP)

Citation: Policy Papers 2005, 075; 10.5089/9781498330961.007.A001

Sources: IMF, WEO database; and staff estimates

What Factors Account For These Developments?

Historically high rates of saving relative to other regions reflect largely institutional factors specific to Asia. Studies find that high household saving rates are largely a response to the lack of social safety nets, which leaves individuals dependent on their own saved resources to protect against negative shocks and old age expenditures. Underdeveloped financial systems reinforce these incentives, as the access to insurance and other risk-sharing products is limited. Demographic changes which have led to an expansion in working-age populations have further supported these trends. On the corporate side, high levels of zsaving reflect the nature of corporate financing in Asia. In contrast to other regions, corporate bond markets in Asia though growing are small, and corporations tend to rely on bank loans or retained earnings to finance their operations. The importance of retained earnings may have increased since the crisis as banks pared corporate lending and overgeared corporates sought to repair their balance sheets.

Recent movements in saving behavior have been broadly consistent with economic developments. Saving rates tend to rise with output growth and the extent of fiscal consolidation, and fall with the expansion of private sector credit and the rise in elderly dependency ratio. All told, as shown in the September 2005 WEO, a standard saving equation based on these elements predicts recent saving developments well.

However, it is difficult to account for the behavior of investment. In a standard model, the investment rate is related to output growth (through accelerator effects), credit availability, and the cost of capital. The WEO finds that applying such a framework would overpredict actual investment in emerging Asia by a significant margin. From this perspective, the stagnation of investment in emerging Asia since the crisis, despite a return to rapid growth and low real interest rates, is a puzzle.

While it is difficult to determine the equilibrium level of investment, it is likely to be somewhat above the current rate. A return to the peak pre-crisis level of investment is neither likely nor desirable, given the evidence of directed lending and overinvestment (discussed below). However, it may be difficult to sustain robust growth with the current low level of investment. For example, the average incremental capital-output ratio (ICOR) for emerging Asian economies (excluding China) was 4.7 for the period 1981–1996. A return to this level would imply that achieving an estimated potential growth of 6 percent per year would require an investment rate of 28 percent of GDP, 3½ percentage points below the 1996 level, but some 3 percentage points above the current level. Consideration of a number of special factors may be needed to shed light on the factors behind this ongoing investment shortfall.

Overinvestment in the early 1990s may have led to overcapacity which continued to act as a drag on investment well after the onset of the Asian crisis and the Japan bubble. In the run-up to the crisis, a number of countries and sectors – for example, construction in Thailand and Malaysia, manufacturing in Korea—saw the emergence of bubbles. Investment in these sectors expanded rapidly—in some cases doubling as a share of GDP within ten years—before collapsing sharply in the crisis. Analysis in the WEO also concludes that emerging Asia experienced overinvestment in the pre-crisis period, and underinvestment in recent years. The overhang of capacity created during the boom may have depressed new investment for years. In addition, the tight relationship between capacity utilization and investment appears to have broken down in the post-crisis period, with investment remaining stagnant despite tightening capacity. Even as the consequences of past overinvestment on capacity wear off, new investment remains hesitant.


Thailand: Investment

(Share of GDP; 1996=100)

Citation: Policy Papers 2005, 075; 10.5089/9781498330961.007.A001

Source: National Economic and Social Develpment Board.

Korea: Capacity Utilization and Investment

(Share of GDP; 1996=100)

Citation: Policy Papers 2005, 075; 10.5089/9781498330961.007.A001

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

Malaysia: Capacity Utilization and Investment

(In percent of GDP)

Citation: Policy Papers 2005, 075; 10.5089/9781498330961.007.A001

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

Corporate restructuring may also have depressed investment. The Asian crisis hit the corporate sector hard, leading to widespread bankruptcies, expanding debt burdens, and collapsing sales. The immediate priority for corporations was to restructure their finances and operations. This involved restructuring and paying down debts, revamping operations, and improving efficiency. In this situation, demand for new investment was reduced. Corporate restructuring has taken some time, but significant strides have been made in cutting debt levels and improving profitability. However, significant improvements were already apparent by 2003, and yet investment has remained depressed.

Indicators of Corporate Sector Health

(In percent)

article image
Source: IMF Corporate Vulnerability Utility.

Despite the improvement in the health of the larger corporate sector, other key sectors remain weak. The small-and medium-sized enterprise (SME) sector was hit especially hard by the crisis and, given the domestic focus of its operations, benefited little from exchange rate depreciations. Moreover, SMEs’ access to private financing dried up, as banks became particularly hesitant to lend to small-scale enterprises with relatively obscure balance sheets. For a number of reasons, including a squeeze on profits arising from reliance on domestic demand and competition from China, SMEs have made slower progress in restructuring than larger export-oriented corporations. Government programs to support the SME sector may also have inhibited restructuring (see Box). Lingering weaknesses in the SME sector may have depressed the aggregate investment rate despite the improvement in headline corporate indicators, which cover only listed firms and not SMEs.

How Will Saving and Investment Evolve?

Underlying trends point to a narrowing of the saving-investment balance, as saving declines and investment recovers. The sharp swing in the saving-investment balance came in response to forces unleashed by the Asian crisis. As these forces dissipate further, underlying influences are likely to lower saving and raise investment. The WEO projections anticipate that the saving-investment balance in emerging Asia excluding China will decline by 2¼ percentage points of GDP by 2010 (from 2¾ percent of GDP in 2004), despite the maintained assumption of constant real exchange rates. The saving-investment balance in China is projected to decline by 1½ percentage points from a peak of 6 percent of GDP in 2005.


Emerging Asia: Savings and Investment Projections1

(In percent of GDP)

Citation: Policy Papers 2005, 075; 10.5089/9781498330961.007.A001

Sources: IMF, WEO database; and staff estimates.1 Excludes China.

Private saving rates are projected to decline modestly. Household saving is projected to diminish as populations age, but these demographic changes may not hit in full force for many years. While the share of the workforce in the overall population is already past its peak in Japan and Korea, this share will peak in China between 2010 and 2015, and in India and the Philippines after 2035. Adding to the gradual drag from demographic changes, the continued expansion of consumer lending—from very low levels in many countries—should support private consumption at the expense of household saving. In all, WEO projections anticipate that private saving in emerging Asia will decline by 3½ percentage points of GDP by 2010.

Against this decline, public saving is expected to rise as fiscal policies tighten to deal with high debt levels. Japan offers a case in point, where an adjustment in the primary fiscal balance of some 7 percentage points of GDP is needed by the early 2010s to stabilize the debt ratio. Fiscal tightening is also needed in emerging Asia, with public saving projected to rise by almost 3 percentage points of GDP by 2010, although specific consolidation plans have not yet been elaborated in many countries. As individuals do not fully reduce their saving to offset increased public saving (i.e., full Ricardian equivalence does not apply), public sector developments in Asia will tend to support high saving rates.

With many of the inhibiting factors ebbing, investment should begin to pick up. Corporate restructuring appears well advanced with bankruptcy rates having fallen sharply and debt levels below pre-crisis levels in a number of countries. The process of operational restructuring is still ongoing, as firms seek to raise the return on assets and equity, but corporate balance sheets have been substantially rehabilitated. Ongoing problems in the SME sector remain a drag, but there is some evidence that the restructuring process is slowly reaching this sector as well. In addition, the overhang of excess capacity has narrowed, with capacity utilization rates approaching precrisis levels. Firms appear well placed to raise their investment levels; indeed, private investment increased in all emerging Asian economies in 2004. The WEO forecasts that investment in emerging Asia will rise an additional 1½ percentage points of GDP by 2010.

The potential role for macroeconomic policies to accelerate the process of adjustment in saving and investment may be