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p. 5 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

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Risks

The relevance of the global and regional risks identified in ADO 2005 in April are undiminished. Indeed, the assessment of this Update is that the overall outlook for developing Asia is more uncertain than earlier in the year, with some risks now being more accentuated. In particular, rising oil prices and the possible ramifications of increasing US interest rates on the region now merit closer attention. Other risks could also flare up. There is still little indication that global payments imbalances are receding. At a domestic level, structural vulnerabilities are still present in many countries in the region. Finally, there are risks to the outlook that are inherently more difficult to assess, and to respond to. For example, previous ADOs have drawn attention to the potentially devastating consequences of the spread of virulent diseases. Terrorist attacks also have the potential to seriously disrupt economic prospects.

Oil prices

Oil prices breached $70/bbl on 29 August reflecting concerns about Hurricane Katrina's impact on petroleum supplies from the Gulf of Mexico. In nominal terms, oil prices in late August are now over three times as high as they were in 2002 and are about 75% above ADO 2005's projection for average prices in 2005 and 2006. Oil prices sustained at current levels over a protracted period would have the potential to cut developing Asia's growth and would pose challenges for economic management (Part 3). The longer oil prices remain elevated, the more likely it becomes that consumers and producers will adjust their spending plans in anticipation of a lasting reduction in their potential income (relative to a situation of lower oil prices).

As developing Asia is a large net oil importer, sustained high oil prices would inevitably restrain output growth. Asia's major industrial trading partners would also suffer, amplifying direct negative effects through indirect trade channels. But the magnitude, incidence, and timing of these effects are not easy to predict. Impacts can only be detected indirectly--other changes are occurring at the same time--and they depend both on underlying structural characteristics of an economy and induced policy responses. The risks posed by sustained prices of $70/bbl are significant, but with appropriate policy responses should be contained in size and duration. But at a country level pressure points and room for policy maneuver will vary depending on underlying structure, financial strength, and policy credibility. Policy inertia and delays in adjusting to higher prices would certainly raise costs.

If real oil prices continue to ramp up and were to approach levels of over $80/bbl--the highest annual average price ever attained was $83/bbl (in first-half 2005 prices) in 1979--consumer and investor confidence could begin to ebb quickly, and the consequences for the global economy and for developing Asia would be more severe. Inflationary impacts would be felt first, but negative output effects would quickly follow. Asia would not only have to contend with the direct impacts on costs and demands but would also feel a sizable "aftershock" as negative effects are transmitted from major industrial trading partners. However, even in these difficult circumstances, significant and long-lasting reversals would be unlikely. Although developing Asia's energy consumption remains highly oil intensive, energy consumption per unit of GDP has fallen steadily over the past 25 years. In most countries, fiscal and foreign exchange positions are also stronger, and central banks would move quickly to avert the threat of a cost-push inflationary spiral.

For net oil exporters, high oil prices provide valuable foreign exchange resources that, if wisely managed, can be used to expand and accelerate development opportunities. The risk for these countries is that the oil bonus is not managed prudently and, instead, encourages unsustainable consumption or wasteful investment. Net oil exporters must also take care to ensure that activity in the non-oil, traded goods sector is not smothered either by domestic cost pressures, or by excessive appreciation of the real exchange rate.

United States interest rates

For a number of years, strong demand in the US economy, particularly private consumption demand, has been critical in sustaining rapid expansion of developing Asia's exports which, in turn, have primed the region's growth. Consumption demand in the US has been supported by historically low interest rates, tax cuts, and a booming housing market that has allowed households to cash in some of the equity value of their property to support spending.

Although the outlook for US growth remains generally bright, uncertainties loom. The Federal Reserve now looks likely to respond to ongoing inflationary pressures by continuing to tighten more and over a longer period than had been expected by markets in April. The US housing market boom also looks increasingly unsustainable and is raising concern over mounting household debt, and associated financial risks. Even a "soft landing", in which prices stabilize rather than fall, removes the stimulus that capital gains give to consumption. Consumer confidence is also weighed down by rapidly escalating gasoline prices and may be adversely affected by disruptions to supply caused by Hurricane Katrina. For many households, sharp price increases will create budgetary difficulties as they have little or no saving and are already highly indebted.

Taken together, these factors cast a shadow over prospects for continued robust growth of US consumption and, by extension, demand for Asia's exports.

In addition to their demand effects, rising US interest rates could spell an end to the unusually favorable financing conditions that borrowers in Asia, and other emerging markets, have enjoyed. In 2005, emerging market debt has traded at very low spreads to historical norms. If long-term rates were to rise, countries with high levels of external debt would, in particular, face increasing debt servicing burdens and would have their scope for fiscal maneuver constrained. The prospect of capital outflows in search of higher, safer yields could also put pressure on some Asian currencies and, at a time of rising oil costs, aggravate inflationary pressures.

Global payments imbalances

Divergent growth, savings, and investment across the major regions of the world are unlikely to correct themselves quickly. There is general agreement that the resolution of these imbalances will require coordinated global actions. In Asia, domestic demand needs to play a larger role in supporting growth. Outside the PRC, investment demand is still anemic. In the PRC, consumption demand remains subdued. Responses are needed across a broad front to ensure that future growth in developing Asia is better balanced in terms of its domestic and external components. If these adjustments are not made, the efficiency costs, and the risks to future growth, could be high.

There is also general agreement that the resolution of imbalances would be aided by a fall in the real value of the US dollar. Indeed, such a fall is needed to help persuade international investors to digest an increasing supply of dollar assets, and to encourage a shift of resources toward the traded goods sector in the US, and out of the traded goods sector of other countries. But views vary about the extent of the required depreciation and its timing, and about whether adjustments are likely to be smooth or abrupt. The longer the real sector has to adjust, the smaller the required depreciation and the smoother adjustments might be. The risk is that financial markets, which have so far accommodated widening imbalances, could yet become impatient and force abrupt and painful changes.

One possible, but still unlikely, scenario is that there is a sudden dip in international investor demand for US dollar assets. This would likely precipitate a sharp fall in the value of the US dollar, requiring an increase in US interest rates to combat attendant inflationary pressures. But if sharp monetary tightening and an effort to shift out of a wide class of US dollar assets were to spill over into US house prices, this could smother US consumption demand and economic growth. With anemic growth in both Japan and the euro zone, such a turn of events would have serious repercussions for growth prospects in developing Asia.

Other developments that could trigger disorderly and costly adjustments would include an escalation of trade sanctions. These would be to the detriment of global consumers and would limit scope for beneficial specialization of production across countries.

Structural reforms

Concerted reform efforts are continuing in many countries in developing Asia, and economic structures are being strengthened. Despite this, weaknesses remain, with the sources of vulnerability varying across countries.

In South Asia, large fiscal deficits and difficulties in mobilizing revenues may constrain the public investments that will be needed to support broad-based advances in productivity and growth. In the PRC, the investment boom has been highly concentrated and has cloaked inefficiencies. If excess capacity and falling profits cut into investment demand, this would remove an important driver of growth, and would weaken a fragile financial system. In Southeast Asia, a variety of indicators suggests that financial sectors are now much stronger than they were at the time of the Asian crisis in 1997. But there is no room for complacency. Some countries still have high debt levels and although bank balance sheets have strengthened considerably, asset quality remains vulnerable to changes in interest rates and economic buoyancy. There remains scope for improving banking regulation and supervision and, over the longer run, the deepening of domestic bond markets will be important in promoting the efficiency and safety of domestic financial systems.

Avian flu

A final risk relates to health. Experts continue to warn of the possibility that some virulent diseases, particularly avian flu, could become endemic among humans. The possibility of the virus being transmitted from human to human is still regarded as small, but nonetheless sufficiently large to warrant concerted preventive measures. In 2003, severe acute respiratory syndrome (SARS) is estimated to have cost the region about $18 billion in lost income, or the equivalent of 0.6% of regional GDP (ADO 2003 Update). In Hong Kong, China it has been estimated that SARS cut growth by 2.6 percentage points. The sizable impacts occurred despite quick containment and the low incidence of SARS in the general population. By contrast, if avian flu were to pass easily from person to person, it might afflict millions, if not hundreds of millions, of people.

Besides the direct costs of loss of life and treatment of the sick, productivity would be seriously affected. Even healthy workers would likely stay at home, and global supply chains would be seriously disrupted. Consumer sentiment and investment confidence would nosedive as would asset and commodity prices. The associated costs would be colossal and their incidence would be felt globally. By comparison, the costs of providing antiviral drugs, inoculating fowl, and educating farmers about the risks and compensating them for losses, estimated at about $100 million, appear modest.

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