Catalog

	Table of Contents
p. 3 of 25 BACK | NEXT Foreword, Acronyms and Abbreviations, Definitions I. Developing Asia and the world Prospects for developing Asia, 2005 and 2006 Prospects for the world economy Risks Subregional trends and prospects II. Economic trends and prospects in developing Asia III. The challenge of higher oil prices Statistical appendix

Asian Development Outlook 2005 Update : I. Developing Asia and the world

---

Prospects for developing Asia, 2005 and 2006

Developing Asia's gross domestic product (GDP) is now expected to grow at 6.6% in 2005, a very small upward revision on the Asian Development Outlook 2005 (ADO 2005) projection made in April. Growth in 2006 is also expected to be about that level. The solid regional performance masks some important revisions at country and subregional levels. This Update revises up growth projections for the People's Republic of China (PRC), which carries a large weight in the regional aggregate, for both 2005 and 2006.

Likewise, the ADO 2005 growth projection for India, another large economy, has been revised higher for 2006. But slower growth is now expected in a number of countries, particularly in Southeast Asia, partly as a consequence of higher oil prices. A key message of this Update is that developing Asia must begin to adjust to the possibility that higher oil prices will persist for some time. Prospects for 2006 and beyond are contingent not just on the evolution of oil prices, but also on policy responses to them (Box 1.1). The risks associated with the ADO 2005 projections are not new, but appear more tilted to the downside in this Update.

Resilience to higher oil prices has been a notable feature in developing Asia over the past few years. Growth averaged 6.7% between 2002 and 2004, despite a doubling in oil prices to $40 per barrel (/bbl). In this period, surging demand helped drive oil prices much higher. A buoyant global economic climate, including continued strong demand for Asian exports from the United States (US), low inflation, and strong external payments positions modulated the potentially harmful impacts of elevated petroleum prices. Gains from underlying structural improvements may also have partly offset negative impacts coming through from higher oil prices. Drawing on fiscal resources, governments in some countries took concerted measures to shield consumers from these higher prices, and the pass-through of higher costs to final goods prices was limited.

Looking ahead, oil prices are now being driven as much by cost and supply considerations as by demand, and prospects for a reversion of oil prices to lower, historical levels appear to be fading. Pressures that have been pent up over the past few years are now beginning to surface. Across developing Asia, import bills are rising sharply. In some countries, inflation is inching up (despite extensive oil price subsidization). Localized oil shortages are also on the increase. In a few countries, currency reserves are beginning to fall. If oil prices continue rising, there is a risk that an inflexion point could be reached at which investor and consumer confidence, not just in developing Asia but in the global economy, could begin to ebb quickly. In these circumstances, the drag on economic growth would be more pronounced than in the recent past. Structurally higher oil prices call for policy responses both to facilitate needed macroeconomic adjustments and to promote longer-run energy efficiency.

Against this, several positive developments should help sustain growth in developing Asia. Global economic conditions remain largely benign. In particular, the global electronics cycle should soon bottom out and more favorable conditions can be expected in 2006. In South Asia, the momentum of reform is continuing and important structural changes are being made that will help propel growth over the medium term. In the PRC, steps taken by the Government to cool investment growth have met with some success, and reforms continue to move forward. The new exchange rate regimes introduced in the PRC and Malaysia on 21 July offer the potential for future efficiency gains and greater scope for domestic monetary control. In Southeast Asia, particularly in Thailand, an early phasing out of oil subsidies will help protect fiscal integrity and, over the long run, will promote more efficient energy use. Finally, higher oil revenues, if managed wisely, should help accelerate development for net oil-exporting countries in the region.

Growth

In the first half of 2005, developing Asia continued to grow at a robust pace. Net oil exporters in Central Asia have benefited from higher oil prices and new production capacity, and subregional growth in 2005 is now expected to be over 9% (Table 1.1). Growth projections have also been revised up for East Asia for 2005. Propelled by fast investment growth and surging net exports, economic momentum in the PRC was faster than expected in the first half. Full-year growth of 9.2% is now anticipated, an upward revision of 0.7 percentage point on ADO 2005. Elsewhere in East Asia (other than Mongolia), slower than anticipated export growth is taking its toll on GDP. For East Asia outside the PRC, projected growth is now 3.8%, a significant downward revision from 4.4% in ADO 2005.

In South Asia, too, growth has surprised on the upside. Pakistan, in fiscal year 2005 (which ended on 30 June 2005), posted its fastest growth in over two decades: an expansive macroeconomic reform program of recent years is beginning to bear economic fruit, and improvements are now being seen in a variety of indicators of social and human development. Over the first 5 months of 2005, Bangladesh, contrary to expectations, continued its rapid growth in the garment industry, despite the ending of Multifibre Arrangement quotas. India continues to expand at a brisk but manageable pace.

The picture over the first half of 2005 has been less upbeat in Southeast Asia. A variety of factors conspired to slow growth, including poor harvests (Philippines and Thailand), a cyclical downturn in the global electronics sector (Malaysia and Philippines), and higher oil prices (Philippines and Thailand). Against this, a successful political transition and an improving investment climate are likely to lift growth in Indonesia in 2005, and robust growth in Viet Nam is expected to continue. Overall, the ADO 2005 projection for 2005 growth in Southeast Asia has been revised down to 5.0% from 5.4% in April.

In the Pacific, the picture is mixed. As net oil exporters, Papua New Guinea and Timor-Leste have benefited from higher oil prices, but the other Pacific countries are totally reliant on imported oil, and use oil intensively in energy production. The end of quota access under the Multifibre Arrangement has had a negative effect on the Fiji Islands, the Pacific's second-largest economy.

Looking to 2006, this Update projects GDP growth of 6.6% for developing Asia, unchanged from the April projection made in ADO 2005. This stable regional average camouflages changing circumstances at country and subregional levels. It also masks negative oil impacts, as a variety of positive factors is expected to help pull up growth from the earlier ADO 2005 projections.

In East Asia, the growth projection for 2006 is now marginally down on the earlier ADO 2005 forecast. A small upward revision for the PRC is more than offset by downward revisions for the Republic of Korea and Taipei,China. Nevertheless, both these economies should enjoy faster expansion in 2006 than in 2005.

The Update projection for Indian growth for 2006 has been revised up and this lifts the subregional average for South Asia. The more bullish projection reflects strengthening fundamentals, important structural changes, and the expected impact of large infrastructure investments. These positive elements will partly offset and possibly outweigh any negative effect from high oil prices. Decelerating, though solid, growth in Pakistan in 2006 reflects both the transitory nature of some of the factors that spurred the economy in 2005 (such as the favorable harvest), and the higher base from which 2006's performance is now being measured.

Economic growth in Southeast Asia is expected to accelerate in 2006, but the pickup may be slower than predicted in ADO 2005. In Thailand, the temporary factors that held expansion in check in 2005 (including the December 2004 tsunami, see Box 1.3 below) should recede and new infrastructure spending programs will likely help lift growth. The global electronics sector should also bottom out and by 2006 begin a new expansionary phase. This will help lift exports and growth in Malaysia and the Philippines. In Indonesia, growth is expected to continue at about its current pace, but budgetary and other difficulties present downside risks.

Inflation

Prospects for inflation vary. In some countries, favorable agricultural harvests, for example in the PRC and India, have lowered food prices and have helped keep inflation in check. But in Bangladesh, Philippines, Thailand, and Viet Nam poor harvests have added to inflation. Higher oil prices are now percolating through to final goods prices. In some countries, this is because of significant reductions in oil subsidies. As profit margins are squeezed by higher oil prices, firms can also be expected to begin to pass on cost increases to customers. In Central Asia, strong demand, primed by oil export income, is putting pressure on prices. Across developing Asia, to minimize the risks of a cost-push inflationary spiral and heightened inflationary expectations, a number of central banks have already raised interest rates, but in many countries, real policy rates remain low and in some places negative. Further monetary tightening can be expected through 2005 and into 2006. In addition, domestic pressures for monetary tightening are likely to be reinforced by rising US dollar interest rates.

External payments balances

Developing Asia's current account surplus with the rest of the world is expected to narrow a little in 2005, and some more in 2006, from the 2004 level. Current account surpluses are expected to gradually diminish in Southeast Asia, and deficits to widen in South Asia. A substantial increase in the cost of oil is being felt in many countries. In East Asia, a smaller surplus is expected in both 2005 and 2006. However, the PRC's current account surplus is likely to widen in 2005 on the basis of strong export growth, before coming down somewhat in 2006. Central Asia, which is a net exporter of oil, is likely to run a smaller current account deficit in 2005 and may move into surplus in 2006.

Capital inflows have continued at a brisk pace in 2005. Developing Asia remains a favored destination for foreign direct investment. The PRC still attracts the lion's share of such investment, but other countries are benefiting, too. Long-term investment has been encouraged by prospects of continued strong growth and improvements in the business investment climate. Portfolio capital inflows have also been strong in 2005, though lending by private creditors has shrunk. Expectations of an appreciation of regional currencies buoyed short-term inflows in the first half of 2005, and these inflows may continue for the rest of the year.

A combination of current and capital account surpluses will feed further accumulation of currency reserves in 2005 and through 2006. In the PRC, reserves had climbed to $711 billion by end-June 2005. Despite a current account deficit, capital inflows have supported reserves accumulation in India. However, trends in reserves positions are not uniform and in some countries the accumulation of reserves is tapering off, or reserves are even edging down (Box 1.2). The path taken by foreign exchange reserves will depend on the extent of regional currency appreciation, international interest rate movements, investor appetite for risk, current account balances, foreign direct investment inflows, and any measures that countries take to limit currency speculation. The recent moves toward more flexible currency regimes by the PRC and Malaysia have so far resulted in only small appreciations of their currencies, but pave the way for more significant adjustments over the medium term and provide a basis for greater leverage over domestic monetary policy.

Investment and saving

Large current account surpluses and associated reserves accumulation in developing Asia have been taken as evidence of a "savings glut" in the region. But, outside the PRC, it has been changes in investment rather than saving that have been most closely associated with external surpluses. Following the Asian currency and banking crisis of 1997, investment rates collapsed in many countries and still remain well below their precrisis peaks. Measured against longer-run averages, current investment rates are also low. On the other hand, gross domestic and private savings rates do not seem to vary much with short-run changes in economic growth, financial conditions, or the real exchange rate. Savings behavior appears to be driven more by slowly changing structural and institutional factors. In the PRC, for example, saving has climbed with long-run falls in fertility and a strengthening precautionary motive linked to the transition from state to market provision of jobs and social services. In helping redress external imbalances, a challenge for many countries remains to boost investment rates from their current low levels.

In India, Malaysia, Pakistan, and Thailand, as well as in some other countries, measures are now in place to scale up infrastructure investment. These programs have the potential to boost productivity growth over the medium term and to close gaps on unmet infrastructure needs. However, governments will need to take care to ensure that projects deliver durable benefits and can be financed at reasonable cost. Steps that are being taken across the region to strengthen the business investment climate and to promote a more efficient and safer financial system should help reduce debt, contain risks, and lift corporate profits. These measures should also eventually pave the way for stronger investment growth.

Box 1.2 Foreign exchange reserves in developing Asia Developing Asia's foreign exchange reserves rose by about $136 billion over the first half of 2005 to $1.74 trillion, according to preliminary available data (Box table). This aggregate increase is little different from the approximately $139 billion advance in the first half of 2004, though the pattern of gains and losses has changed somewhat: the PRC accounted for about 75% of the 2005 gain versus just less than 50% in the 2004 period; gains in other large reserves holders were more modest; and a few more countries have experienced some reserves losses. Timing and lumpiness of capital flows can influence reserves movements during the course of a year, but declines are often symptoms of emerging pressures in the external accounts. The second half of 2004 saw a much larger reserves gain ($231 billion) than the first half, marking the largest expansion achieved by the region to date. Developing Asia's foreign exchange reserves more than doubled in the 3 years between end-2001 and end-2004, for an increase of $815 billion to $1.6 trillion. These annual increments are very much larger than in previous years, as shown in Box figure 1. This surge has attracted great attention, especially in the context of growing global payments imbalances. Nearly one half of this increase in reserves in that 3-year period is accounted for by the PRC (raising its share in the regional total to about 40%, from 27% at end-2001). Three other economies--in descending order Taipei,China; Republic of Korea; and India--accounted for most of the rest, such that these four economies accounted for just over 85% of the reserves buildup in the period. For the PRC, the main balance-of-payments components since 1995 are traced out in Box figure 2, and indicate the changing pattern of factors that have shaped the evolution in reserves. As shown, moderate current account surpluses and large FDI inflows have been relatively stable over the period, while net non-FDI (including errors and omissions) turned to a large positive balance from 2002. This item has been an important contributor to recent reserves gains, accounting for just over 40% of the increase in reserves in 2004. The timing of this abrupt change suggests that it reflects speculative elements in ordinary transactions (i.e., avoidance of exchange controls) in anticipation of appreciation in the yuan exchange rate. FDI and other net capital flows accounted for just over 60% of the recent buildup in the country's external reserves. It is not yet clear what immediate impact the 21 July adjustment in the exchange system will have on net non-FDI capital inflows. In the case of Taipei,China; Republic of Korea; and India as a group, FDI was not a major factor in their aggregated net capital account, but even then net non-FDI (including errors and omissions) moved markedly higher after 2001 (see Box figure 3), contributing about 55% of the reserves increase in the 3 years. In India, the current account surplus was a small factor--one sixth--in reserves accumulation, partly reflecting the success of attracting capital through nonresident Indian deposit schemes, while in the other two economies it accounted for about one half. While greater exchange rate flexibility will aid global adjustment efforts and improve economic efficiency in developing Asia, a combination of current and capital account surpluses are expected to continue reserves accumulation in the period immediately ahead. Capital flows have played a major role in such accumulation recently and they will likely continue to be significant, since the region is expected to continue to be a preferred investment destination. For some, the recent rapid growth in regional foreign exchange reserves has come to be associated with the region's trade surplus with the US and that country's growing trade deficit. While bilateral balance is not to be expected in a multilateral trading system, Box figure 4 indicates that, while the region's share in the US merchandise trade deficit has stayed largely stable (at least since 2000), within that trend, the PRC has gained (reflecting its development as the global lowest-cost producer of many manufactured goods), in contrast to Southeast Asia.

Back I. Developing Asia and the world	Next Prospects for the world economy