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Asian Development Outlook 2004 : I. Developing Asia and the World
Risks to the Outlook for Developing Asia ADO 2003 and ADO 2003 Update identified three sets of risks for developing Asia: geopolitical, SARS related, and global economic. The geopolitical risks associated with the threat of terrorism remain, unfortunately, very much a reality for developing Asia, while the end-2003 and early-2004 outbreak of an avian flu epidemic has been a clear reminder that epidemics will continue to be a major risk for Asian economies. Enhanced regional cooperation is of paramount importance in containing the human and economic impact of such epidemics. Global economic risks have not abated, and they essentially pertain to the sustainability of the economic recovery in major industrial countries and to world economic imbalances. While developing Asia is increasingly playing a major role in the global economic context, developments in major industrial countries remain very important to the regional outlook. Imbalances in the recovery of industrial countries hold significant risks for Asian economies. ADO 2004 adds a new set of economic risks that are more specifically regional. They are linked to rapidly increasing regional economic interdependence itself. The surge in intraregional trade has been a major positive development for the region, but it also carries with it these new risks. Global Economic Risks By the first quarter of 2004, and for the first time since 2000, a broad and robust economic recovery appears to be under way globally, led mainly by the US and developing Asia. In Japan, the economic pickup was deepening while in the euro zone some signs of improvements were also apparent. In spite of rising oil and commodity prices, inflationary pressures remained generally subdued. In major industrial countries, generally expansionary fiscal policies-and a huge fiscal stimulus in the US in particular-together with accommodative monetary policies have fueled the recovery. As a result, since mid-2003, interest rates have all been at historical lows across all maturity ranges while fiscal deficits have been widening particularly in the US. Room for further macroeconomic stimulus appears to have hit its limits. Behind this upbeat picture of the world economy, there are however significant imbalances and risks, which could threaten economic performance over the forecast period. In the nearer term, the major concern is the uncertain employment situation in the US. While employment data released in March 2004 appear to indicate a revival in the labor market, uncertainties remain. If the improved job market outlook is not confirmed over the next few months, consumer spending could be negatively impacted, and US growth would slow. The strengthening of labor markets in industrial countries, and with it the broadening of the expansion, is particularly crucial as the current stances of macroeconomic policies are not sustainable over the medium and longer term, especially in the US. Monetary policy will have to be tightened within the next year, first in the US and later probably in the EU. The current extremely low interest rate environment cannot be maintained for several reasons. First, rising oil and commodity prices together with a prolonged period of production growth in the world economy will put upward pressure on inflation. Second, low interest rates have led to a ballooning of household debt-at over 100% of disposable income in the US-and the possible emergence of asset bubbles. Finally, the increasing burden of financing the US fiscal deficit will put upward pressure on interest rates, particularly if Asian central banks scale back their purchases of US debt (as is likely over the forecast horizon). While the timing remains very uncertain and looks still some time off, the rate increases will have a very significant impact on bond markets, financial markets, and asset prices. The severity of the impact will crucially depend on the quality and depth of the recovery at the time, particularly in terms of employment and income generation. Investor and consumer perception of the depth of the recovery will determine the financial markets' responses to rate increases. Weak sentiment could create significant volatility in financial markets, and in fixed income markets in particular-as seen in June-July 2003-pushing long-term interest rates substantially higher. Costlier debt repayments would directly impact highly leveraged households and corporations. Real estate markets would be affected across industrial countries, and government borrowing costs would jump. The upshot is that the circumstances and imbalances characterizing the current economic recovery make the necessary adjustments to tighter macroeconomic policy particularly delicate and uncertain. A period of low growth in industrial countries with inflation and real interest rates both higher is a definite possibility. Two major imbalances that do not appear to overly concern the markets so far could exacerbate the above outcome over the forecast horizon: the US fiscal and current account deficits. First, under present policies, projections indicate that the US will be running a very large fiscal deficit for a long time. Over the longer term, the burden of financing the needs of aging populations in industrial countries will also put pressure on national budgets. As interest rates rise, markets might start factoring in more strongly the prospect of financing widening fiscal deficits. This would tend to push up further long-term interest rates. Second, while financial markets have not shown much concern about the US current account deficit so far, this situation may change. As monetary policies are tightened, greater volatility in financial markets amid rising interest rates could spill over into greater dollar exchange rate volatility. Markets could start evaluating more closely whether a visible correction of the US current account is under way. A number of outcomes are possible. A very large depreciation of the dollar itself will not suffice to narrow the US current account deficit. A compression of US demand will be needed to reduce imports, and hence the likelihood of a low growth period with higher interest rates. However, the negative impact of this outcome could be substantially mitigated if global growth is more broadly dispersed across countries. The implications are that growth needs to accelerate in industrial countries other than the US, and that more flexible exchange rate policies need to be followed, particularly in Asia. A worst-case scenario would be for governments to seek adjustments through a sharp rise in trade protectionism. It is obvious from the above analysis that there is a large degree of uncertainty associated with the adjustment process that the global economy needs to go through over the next 2 years. For developing countries in Asia, it is important to evaluate what this negative outcome could be. It is also important to realize that, increasingly, developing Asia is an intrinsic part of the adjustment process. A smooth adjustment in the global economy will greatly benefit from continued strong growth and the pursuit of pragmatic economic policies in the region. Regional Economic Risks While, as mentioned, developing Asia is an increasingly important element in shaping global developments, there are a number of risks in the outlook that relate more specifically to the region. In most cases, risks can also be viewed as opportunities-opportunities to cooperate and reform. In fact, the current strong underlying economic growth trends in the region create a unique occasion to turn these risks into opportunities. Two distinctive and very positive features of economic developments in the region over the past few years have been the emergence of intraregional trade as a major driver of growth and the increasing importance of domestic consumption demand in many countries. These features could become even more important if the recovery in major industrial countries were to falter. While these developments are positive elements in the medium-term outlook for developing Asia, they also inherently carry risks to regional growth as the interdependence among the economies of the region is becoming stronger (Table 1.3). Managing the concomitant risks is creating new challenges for policy makers as their national policy decisions are increasingly impacting on other countries in the region. Among the regional risks that also have substantial global implications, an overheating of investment in the PRC is probably the most important. The phenomenal growth of investment in that country could increasingly become inflationary, as prices of raw materials, land, and factors of production other than labor could soar. Already, many commodity prices and transportation rates are being boosted by demand from the PRC. The Government has indeed announced measures to contain overinvestment. However, the situation will have to be closely monitored as the impact of overheating in the PRC could have repercussions on export trade in many other economies in developing Asia. Over the longer term, overinvestment would result in a capacity overhang which would also adversely affect the region. Other major policy challenges in the PRC are well known, and include the need for fiscal consolidation and for financial sector-particularly banking-reforms and SOE reforms. The successful handling of these challenges is extremely important to regional growth. The shift toward progressively stronger domestic demand-led growth can be welcomed. Household debt levels must, though, be monitored and contained if financial systems, which have not fully recovered from the financial crisis, are not to face a new form of NPLs as well as a new crisis, if income growth slows. There is evidence that, in several Asian developing countries, continued accommodative monetary policies, and the proactive efforts of financial institutions to diversify their earnings base is fueling rapid growth in household debt. Improved regulation and supervision is called for, along with some tightening of monetary policies. The policy dilemma will be to mitigate the impact of higher interest rates on badly needed business investment, which has remained weak in a number of countries, particularly in Southeast Asia. It is clear that the deepening of financial sector reforms, including the further development of nonbanking financial institutions, remains central to the reform process and sustained high growth in all economies of the region. There is concern that financial sector reforms have been slowing or have stalled over the past 2 years in several countries in developing Asia, partly because stronger growth masks possible problems (such as lack of resolution of NPLs-see following section). High growth thus offers a unique opportunity for accelerated economic reforms; it should not be used as an excuse for complacency. The huge accumulation of foreign exchange reserves by many countries in Asia over the past 2 years is a striking phenomenon. Reserves are now estimated at $1.3 trillion. As pointed out in ADO 2003, reserves in most countries have significantly overtaken short-term debt. While originally the accumulation of reserves reflected the prudent behavior of policy makers, increasingly however, it appears to be fueled by speculative market behavior stemming from rigidities in many of the region's exchange rates. Such a development carries significant risks for the region. First, except for countries with closed capital accounts, capital flows could reverse briskly, sending negative signals about the economies affected, even though the economic fundamentals remained unchanged. Second, and more important, interventions to maintain stable exchange rates against the dollar could result in significant further increases in domestic liquidity, which if not sterilized-an increasingly difficult task-might lead to unbridled domestic credit expansion and possibly create the conditions for a new Asian financial crisis. Third, the reserves, which are held mainly in the form of US dollar deposits and US treasury bills, are vulnerable to a loss in value as the dollar depreciates. Hence, it might be an opportune time to reassess the policies underlying the large accumulation of foreign exchange reserves in the region. While countries in developing Asia all face major macroeconomic policy challenges and long reform agendas which, if not tackled, will become risks to their outlook, they all need also to maintain sustainable robust economic growth over the medium and long term in order to generate employment opportunities for large and fast-growing labor forces. In a sense, this is a key risk faced by the whole of developing Asia over the medium term. In this context, countries will need to implement structural reforms to improve their investment climate and competitiveness, and enhance productivity. These reforms will be particularly complex as they are needed at a time when the fiscal situation in many Asian countries needs consolidation. Ensuring greater efficiency of the public sector, competent public debt management, improved corporate governance, and enlightened public-private partnerships will be key policy challenges over the medium term. Again, greater regional integration has given a new dimension to the need for such policies. These issues will be particularly important in 2004 as many Asian economies are holding elections, including Hong Kong, China; India; Indonesia; Korea; Malaysia; Philippines; Sri Lanka; and Taipei,China. Finally, an issue to be looked at is how much fast-rising consumption demand in some countries reflects rapidly growing income inequalities. This could be a risk to the medium-term outlook, since not only income growth, but also employment generation for large and rapidly growing labor forces will be essential for economic growth to be sustainable. Labor market reforms and measures to lift the skills of the labor force will be critical to address these inequalities, as well as the inequalities between the countries of the region. Economic policies will thus need to emphasize how growth can be socially inclusive, benefiting progressively larger segments of the population. Increasingly, microreforms to foster the development of small and medium enterprises and the establishment of social safety nets will need to be a part of the core policy agenda. Also, in the context of greater participation of people in policy decision making in developing Asia in general, such inclusive growth will be important for people to feel any ownership of the continuing reform process. In conclusion, the opportunity provided by the next 2 years of robust growth must be used to initiate and sustain a wide-ranging raft of reforms in developing Asia. These reforms should aim to support socially inclusive development, which is essential to rapidly expand the constituency for reform. The sustainability of the reform process and high growth rates hinges on building and broadening this constituency.
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