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Asian Development Outlook 2005 Publication Highlights : I. Developing Asia and the world
Financial market developments
Buoyed by generally strong economic growth and a continued low interest rate environment around the globe, international financial markets remained vibrant in 2004. Investor confidence, which was hurt amid surging oil prices and a softening global rebound between July and early August last year, has since recovered. The prospect of continuing global recovery led by still robust economic expansion in much of Asia (including the PRC) and the US—though at a slower pace than in 2004—together with relatively muted inflationary pressures, appears to be underpinning the turnaround in global investment activity. By the end of 2004, both equity and corporate bond prices had climbed higher, recovering most of their earlier losses. The return of investor confidence was reflected in the rebound of global equity prices (Figure 1.8). Shedding concerns about tight oil supplies, which sent the price of Brent crude beyond $50 per barrel during October last year, international investors quickly resumed the mid-August rally. The focus of investment decisions has been gradually shifted to the resilient growth outlook, as the much-feared inflationary risk from rising oil prices remained largely under control. Strong corporate earnings, despite the sustained high oil prices, also contributed to the revaluation of the international equity markets. In the US, the Dow Jones Industrial Average index rose by 9.9% between its low for the year on 12 August and end-December. The Dow Jones Euro Stoxx 50 index for the European market and the MSCI Asia Pacific index for Asia excluding Japan followed suit by gaining 14.0% and 23.6%, respectively, over the same period. Meanwhile, the faltering economic outlook weighed on Japan’s Nikkei 225 stock market index, which remained relatively flat, increasing by only 4.2%. 
Credit spreads have also been held tight on both investment grade and high-yield corporate bonds since late August. While the credit market remains flush with liquidity from the historically low interest rates of the past few years, the corporate sector, which emerged from credit excesses in the late 1990s with enhanced corporate discipline, has been slow to expand business activities or take new credits in many parts of the world. Overall, such a supply/demand imbalance has kept bond prices high even as the US policy rate has increased. A strengthening of corporate balance sheets on solid profit gains and still soft capital spending have also contributed to improvements in credit ratings of corporate borrowers, thus underpinning the price rally in the corporate bond market. The gradual increase in optimism regarding the global economic outlook and the pace of ongoing rate movements in the US helped lift investors’ risk appetite, which had retrenched significantly during the heavy sell-off of risk assets between April and May prior to the initial Fed decision to raise interest rates on 30 June 2004. Between then and March 2005, the Fed raised the policy rate by a total of 175 basis points. The measured pace of the rate hikes by the Fed (now expected as an increase of 25 basis points at each monetary policy meeting) anchored market expectations, contributing to a significant decline in volatility in the US bond market. At the same time, effective communication by the Fed with the market has nurtured some complacency among investors, as they have perceived the ongoing rate movements as a return to a neutral stance in monetary policy, rather than a tightening. Although the range of a perceived neutral rate differs among investors, there appears to be an increasing consensus that the target Federal Funds rate will not rise higher than 4.0%, which is much lower than the end results of previous tightenings, for example, 6.0% in February 1995 and 6.5% in May 2000. 
Underpinning the expectation of relatively low, if rising, interest rates, inflation has remained contained in spite of sustained high oil prices. Given the slack in the labor market, the Fed should be able to continue its measured pace of tightening for the first half of 2005, before gradually settling at a “neutral” rate. The target Federal Funds rate is expected to reach 3.75% by end-2005, with an average of 3.1% for the year as a whole. A considerable upside risk remains, as inflation could significantly pick up on the closing output gap as well as rising input costs. The ADO 2005 baseline assumptions for the Federal Funds rate are an average 4.2% for 2006 and 4.4% for 2007. The 6-month London interbank offered rate ended last year at 2.78% and is projected to rise to close to 4.0% by end-2005. In the euro zone, the faltering economic outlook has lowered expectations of a rate increase by ECB in the first half of 2005. However, the September futures for 3-month Euribor are priced at a discount rate of 2.4% as of 28 February, suggesting that ECB is expected to raise its policy rates in the last quarter of the year in response to persistent inflation and credit growth. The Bank of Japan is unlikely to shift away from its zero interest rate policy. Deflationary pressures, though easing, remain a sizable threat to the fragile recovery. The subdued inflation rate has kept long-term bond yields low around the world, with the exception of Japan where easing deflationary pressures have kept long-term interest rates marginally up (Figure 1.9). Even in the face of the Fed rate hikes, yields on the 10-year US treasury note have drifted down since the middle of last year. Falling bond yields at the long end, though mainly attributable to the well-anchored inflationary expectations, have partly reflected the bearish sentiment among investors since mid-2004, weighed down by the prospect of moderating growth in the world economy in the coming years. The yield curves have significantly flattened across major industrial countries since mid-2004. The trend of global flattening was underpinned by the demand for bonds with longer duration, which kept the prices up, thus limiting the yield increase at the long end. The revival of carry trades—investing in long-term securities with higher returns by taking on short-term liabilities with low interest rates—also contributed to the demand. Ongoing demand excess will likely continue to put a lid on long-term bond yields until the middle of 2005. However, with increasing inflationary pressures and solid growth prospects in the US, yields on the 10-year treasury note are expected to rise higher in the second half of the year. 
Taking advantage of still favorable external funding conditions, emerging market issuers continued to raise significant funds through equities and bonds in international capital markets in 2004. Total equity issuance by emerging Asian market countries amounted to $22 billion, about two thirds of which was offered by the PRC. Bond issuance was also active, with total corporate and sovereign bond issuance of $38 billion, up from $22 billion in 2003. The comparatively more resilient growth outlook for emerging Asian markets than mature markets, even as moderating growth is expected for the world economy, boosted capital inflows to regional capital markets as well, particularly in the latter half of 2004. Net private capital flows to the region amounted to $146.3 billion in 2004, up from an already high $116.3 billion in 2003, bolstered by continuing foreign direct investment flows into the PRC and a surge in syndicated loans (Figure 1.10). According to the Institute of International Finance, Asia-Pacific accounts for nearly 90% of net portfolio equity flows to emerging markets with an estimated total of $31.2 billion in 2004. Net private credit flows in the form of syndicated loans also jumped to $33.5 billion from $13.8 billion in 2003. Such relatively short-term capital flows were particularly strong in the last quarter, driven by increasing speculation on the potential appreciation of regional currencies. Heightened risk appetite, together with ample liquidity, has also contributed to a decline in emerging market spreads (Figure 1.11). Emerging market bond spreads, which experienced a surge prior to the much-anticipated Fed tightening, subsequently narrowed and ended the year at their lowest level since the 1997–98 financial crisis and subsequent emerging market crises. Falling from a peak of 301.8 basis points during the April–May sell-off, sovereign risk spreads of emerging Asian markets came down to 256.7 basis points by the end of January 2005. Robust, albeit moderating, economic growth, strong trade surpluses, and high levels of foreign exchange reserves, combined with relatively healthy fiscal positions across Asia, have enhanced credit quality and lowered default risk, thus supporting bond prices in the region. 
Strong capital inflows—led by significant PRC-bound foreign direct investment flows—will likely continue, based on the robust regional economic outlook over the forecast period. The prospect of strong earnings growth and attractive prices still makes emerging Asian equity markets a top destination for portfolio inflows among emerging markets, while a gradual increase in international interest rates is likely to moderate the pace of private credit flows through bond purchases and syndicated loans. The Institute of International Finance estimate of total net private capital inflows to developing Asia and the Pacific is $125.6 billion for 2005. Despite the improved outlook for growth in the US, the dollar resumed its decline, falling by more than 11.0% against the euro and 9.0% against the yen from their respective peaks to troughs during the last quarter of 2004 (Figure 1.12). A significant deterioration in the trade balance and the investor perception that the US Government’s measures may be inadequate to curb fiscal deficits exacerbated the dollar’s slide. However, widening interest rate differentials, as well as macroeconomic fundamentals in the US that remain considerably stronger than those in the euro zone, suggest that the euro/dollar rate may have reached bottom. Barring any sudden trigger to financial instability, such as higher inflation, another surge in global oil prices, or an unwinding of Asian central banks’ dollar assets, the dollar should be able to maintain its current strength vis-à-vis the euro. The pressure on developing Asian currencies to appreciate will likely intensify, on the basis of Asia’s relatively robust growth outlook and continuing capital inflows to the region. Against this background, more proactive and concerted regional efforts will be needed to ensure an orderly adjustment among regional currencies in the face of the ongoing global currency movements.
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