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p. 6 of 8 BACK | NEXT I. Developing Asia and the world Developing Asia: Economic highlights of 2004 and prospects for 2005-2007 Prospects for the world economy in 2005-2007 World trade and commodity prices Financial market developments Risks to the outlook, and challenges for developing Asia II. Developing Asia: Subregional trends and prospects III. Promoting competition for long-term development

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

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Risks to the outlook, and challenges for developing Asia

While developing Asia continues to add a strong impetus to the world economic expansion, the risk of global imbalances looms greater than ever. As discussed in ADO 2004, developing Asia has been an intrinsic part of the global imbalances, by producing large current account surpluses and financing a significant share of the US twin deficits mainly through large purchases of US securities. Ongoing weakness in the US dollar suggests that the adjusting forces for such imbalances might already be at work. As Asia is increasingly expected to share the burden in the adjustment process, Asian currencies may experience proportionately larger appreciation over the forecast period.

The other risks identified in ADO 2004 and ADO 2004 Update are still very relevant: the risk of epidemics, the threat of terrorism, the growing interdependence of regional economies, and sustained high oil prices. As evidenced by the recent resurgence of avian flu in Viet Nam and Cambodia, the risk of broader and more life-threatening epidemics remains a very serious concern to the region. In addition, the disastrous tsunami that struck the countries bordering the Indian ocean and its impacts—including the huge loss of human life and a sharp increase in poverty in the affected areas—underscore the need to reinforce regional cooperation in Asia to effectively deal not only with the aftermath of such natural disasters but also the continuing threat of terrorism—and all the more so in the context of increasing economic linkages across the region.

Global Economic Risks

Forces of global rebalancing unfold. The risk of global disruption stemming from large external imbalances in the US has been on the radar for some time, but the timing and impact of the inevitable adjustment process remain uncertain. Prior periods of adjustment and resultant weakness in the dollar have proved quite painful for the world economy. In the early 1970s, following the collapse of the Bretton Woods system, exchange rate volatility, inflation, and oil price shocks presented major economic challenges to policy makers around the world. In the late 1980s, the dollar’s decline contributed to the stock market crash in the US and financial turbulence. Moreover, overinvestment in Japan led to a decade of recession there, limiting that country’s contribution to global growth, while structural problems in the EU have played a similar role with regard to global growth.

With US growth outpacing that of other major industrial economies, its current account deficit is expected to rise further. On the back of robust domestic demand and considerable fiscal outlays, the US current account posted another deficit of $665.9 billion, or about 5.7% of GDP, in 2004, up from $530.7 billion in the previous year. Although the budget deficit came in smaller than expected at $412.1 billion in 2004, as a result of ongoing efforts by the US government to curb fiscal spending, the deficit is still up by $34.5 billion from $377.6 billion reported in the previous year. Behind the sustained increase in the US twin deficits has been strong reserves accumulation by Asian central banks. At the end of 2004, developing Asia’s foreign exchange reserves were about $1.6 trillion, with the majority held in dollar assets; including Japan, the figure is estimated to amount to more than $2.4 trillion. According to estimates by the Bank for International Settlements, the reserves accumulation of Asian central banks financed more than 70% of the US current account deficit in 2003. However, the increasing exposure to a weaker dollar may prompt Asian central banks to consider rebalancing their reserves portfolios. Corroborating this view, a recent survey of central bank reserve managers published by Central Banking Publications—a London-based private think-tank—indicated a tendency of shifting reserves away from dollar assets into euro assets.

Two main implications for developing Asia flow from this. First, the dollar could depreciate faster and more sharply than assumed in the baseline scenario, deeply eroding the value of dollar reserves, while constraining Asia’s exports before its domestic demand reaches firmer ground. Second, US interest rates could rise rapidly to break the dollar’s fall and ensure the financing of the US budget deficit, thus triggering a major adjustment in international financial flows. Combined, these two factors pose a significant risk to the regional outlook.

Developing Asia will have to play a key role in bringing about a smooth adjustment without incurring too steep an economic cost, both for the region and the rest of the world. Reducing the US current account deficit requires faster growth in US savings. While the US Government must take the necessary steps to contain an unsustainable rise in the fiscal deficit, US income growth should also exceed growth in private consumption. The only way this will occur without a major slowdown in consumption and investment spending is with increased net exports. Such an outcome can be attained only if domestic demand in the rest of the world—particularly Japan, EU, and developing Asia—grows much faster. An orderly adjustment in Asian currencies along with strengthening regional demand could help achieve this result. Thus a major agreement among the key players would be needed to ensure a smooth and orderly adjustment of global imbalances.

A sharp increase in US interest rates could have negative impacts. The ongoing weakness of the dollar, the gradual working off of slack in the labor market, and sustained high oil prices all point in one direction—a bout of inflation in the US. With inflationary pressures building up, US interest rates could rise significantly higher in 2005. A sharp acceleration in these rates can exert significant influence on both the US and global financial markets. Over the past few years, a low interest rate and high liquidity environment have nurtured investors’ risk appetite, thus tightening credit spreads for both sub-investment grade and emerging market corporate and sovereign borrowers. Increasing carry trades have been also undertaken, reflecting a significant flow of funds into risk assets. A weakening of such international capital flows, in the event of a steep rise in US interest rates, could jeopardize generally heightened prices of risk assets around the world. Housing prices may also come under pressure in some industrial countries, including the US and the United Kingdom. More importantly, abrupt changes in financing conditions might expose emerging market economies in the region to some disruption. The wave of unwinding speculative positions and rising cost of international borrowing could also have negative impacts on emerging economies with large fiscal deficits and external debts.

High oil prices pose an added threat to the financial risks. While the economy of developing Asia appears to have gained considerable growth momentum to avoid a major slowdown from currently high oil prices, another steep rise in oil prices in combination with inflation and high interest rates could add significant strains on the regional as well as global outlook. Brent crude is projected to average $41 per barrel in 2005, much higher than its post-1990 long-term average of $20–25. However, as of 16 March, the Brent crude price surged again to $53.8 per barrel, exceeding last year’s peak of $51.4. This current price run-up beyond $50 per barrel is a vivid reminder that high oil prices remain a major risk for the region, given Asia’s high dependence on oil imports. (As reported in ADO 2004 Update, a $10 increase in oil prices for 1 year could shave an estimated 0.8 percentage point off growth in Asia excluding Japan.)

Regional Risks

Greater regional exchange rate coordination is necessary. The rapid depreciation of the US dollar has put Asian foreign exchange policies in the spotlight. With increasing risks of global imbalances, pressure on the region’s currencies is rising. Equally important is the increasing cost of maintaining a dollar peg, due to a rapid accumulation of foreign exchange reserves across the region and upward pressure on inflation. Reflecting these factors, some Asian currencies—including the baht, New Taiwan dollar, Singapore dollar, won, and yen—have already appreciated in the last quarter of 2004.

As de facto US dollar pegs become more difficult to maintain, varying degrees of exchange rate flexibility across the regional economies pose a risk to currency and financial stability. Regional economies currently exhibit a wide range of foreign exchange policies, from fixed exchange rate regimes to managed floats and flexible exchange rates. Nevertheless, by keeping local currencies relatively stable against the dollar, these economies have been able to achieve stable cross-currency exchange rates within the region. However, without concerted efforts among regional economies to maintain intraregional currency stability while introducing more flexibility vis-à-vis the US dollar, the recent divergence in exchange rates may lead to greater volatility of regional currencies against each other. Contrary to popular belief, the US economy is no longer developing Asia’s largest trading partner—developing Asia itself is. Increasing regional integration implies that greater volatility in cross-currency exchange rates could widen trade and financing gaps within the region, putting undue pressure on certain countries during the course of international currency adjustments. The challenge lies in further strengthening regional cooperation to address and contain such volatility while extending support to an agreement for the orderly adjustment of global imbalances (as noted in the section “Global economic risks”).

Meanwhile, look out for speculation. Speculation on regional currency appreciation has already triggered substantial private capital inflows to the region. Relatively short-term flows, such as portfolio equity investment and commercial bank lending, were particularly high in the last quarter of 2004. With the majority of such capital flows destined for the PRC, the increasing volatility of capital flows compounds the difficulties of sterilization, exacerbating the overinvestment problem. The speculative capital flows also increase the risk of a sharp unwinding, if US interest rate increases accelerate as inflation takes off or if investors simply change their expectations. Although ample official foreign reserves and strong macroeconomic fundamentals limit the risk of a financial crisis recurring, sound management of capital flows is particularly important for these countries to arrest excess volatility in their currency and financial markets. To this end, regional diversification and specialization can help underpin the efficient allocation of financial resources for more productive uses across the region. Alleviation of financial risks may result from enhanced dynamic competitiveness of individual countries in the region and from intraregional trade—through greater diversification and specialization in goods and services—which will not only broaden the use of increasing capital inflows across the region, but also reinforce regional economic growth and integration.

Overheating in the PRC is still a possibility. ADO 2004 warned against the risk of overinvestment in some sectors and the related increase in nonperforming loans in the banking sector. The PRC Government has taken a series of steps to slow investment and credit growth in some sectors, which include tightening liquidity and employing administrative measures to contain overheating in the concerned sectors. Despite such measures to engineer a soft landing, the PRC economy is still performing strongly, growing by 9.5% in 2004. Fixed asset investment rose by 25.8% that year, only 1.9 percentage points lower than in the previous. Although there are signs that government policies have been effective in reining in inflationary pressures and generating more balanced growth, the latest growth figures suggest that more austere measures of tightening may be necessary to curb overinvestment and achieve a soft landing. Failure to do so in the near future may increase the risk of a hard landing at a later date.

Epidemic outbreaks remain a very significant risk. Strong regional cooperation is absolutely vital in mitigating the risk of various epidemics. The tsunami that devastated coastal areas of the Indian Ocean left these areas vulnerable to epidemics. While the immediate economic consequences remain under control in many affected countries, poor sanitary conditions alongside the lack of sound health systems are risk factors for epidemic outbreaks of typhoid, hepatitis, diarrhea, and cholera across the region. The outbreaks of avian flu in 2004 reportedly killed 29 people out of 37 affected in Viet Nam and have affected some parts of Asia. The risk of an avian flu pandemic cannot be ignored, as the persistent fear that the virus could mutate into a form that can spread efficiently from human to human remains. The threat of diseases is significant, and the region still remembers the grim impacts of severe acute respiratory syndrome on overall economic activity, let alone the loss of human life. In order to avert another disease-related disaster, strong regional cooperation, together with help from international aid agencies, is needed to ensure early detection of outbreaks, effective treatment of the affected, protection of the public against contagion, and minimization of the spread across borders.

Challenges to Developing Asia’s Policy Makers

Developing Asia and the Pacific has exhibited remarkable resilience while continuing to adjust to the emergence of the PRC as a major economic power, and more recently to the rise of India. Taking advantage of enormous opportunities that these potential economic powerhouses should bring to the region, developing Asia is expected to continue rapid and robust growth in 2005–2007 and beyond. Nevertheless, Asian policy makers face significant challenges to maintain sound macroeconomic fundamentals while nurturing domestic demand conditions to sustain strong growth momentum. Overall, the downside risks are considerable, particularly as some external factors—such as the moderation of the world expansion, the downturn of global information technology industries, and sustained high oil prices—weigh on the regional outlook over the forecast period.

Sound macroeconomic policy is integral to sustaining high growth. There are growing concerns that the basis of sound macroeconomic conditions needs to be reinforced. First, headline inflation has picked up across the region. Higher food and energy prices have been mainly responsible for the rise in CPI inflation. Although supply-side pressures have yet to trigger a full-blown price effect through a wage-price spiral, a pickup in CPI inflation complicates the monetary policy decisions of Asian central banks. Some countries, including the PRC where strong consumption and investment growth is already stoking inflationary pressures, have taken tightening measures. In other countries where domestic demand remains a concern, monetary policy remains flexible, providing necessary support to underpin a nascent recovery in domestic consumption and investment demand. However, the monetary authorities face increasingly limited room to maneuver, as the region has been flush with liquidity due to strong private capital inflows, thus building greater external reserves and further exacerbating the difficulties of sterilized interventions. In these countries, the central banks need to closely monitor monetary and financial conditions over the rest of this year. As the domestic demand recovery reaches a firmer footing, the eased monetary policy should gradually reverse to keep price stability.

Second, behind the modest inflation (despite Asia’s high dependence on oil imports) have been policy efforts to contain the price pass-through of high oil prices. Many Asian governments have increased oil subsidies, strengthened price controls, or cut import duties on oil during the price run-up. While protecting consumers from higher global oil prices, the incomplete pass-through has led to a deterioration in the fiscal position in these countries, particularly in India and Indonesia where budget conditions have been an ongoing problem. As noted in ADO 2004 Update, heavy debt burdens—which will become heavier if international financing costs rise—continue to be a threat to the medium-term outlook for many countries in the region. Large fiscal deficits have been a persistent problem in South Asia and the Pacific for many years. Many countries in Central Asia and some in Southeast Asia also run high levels of external debt. With the cost of international borrowing rising and inflation picking up, these economies are vulnerable to rising debt-servicing burdens. Taking stock of ongoing economic strength, these regional governments should continue their efforts to enhance their fiscal position by consolidating the budget deficit and promoting effective public debt management. Phasing out oil subsidies, along with deregulation in energy prices, also needs to be considered as part of the fiscal reforms.

Successful implementation of structural reforms remains a priority. Looking ahead, Asia’s growth strategy needs to focus on balancing domestic growth and enhancing resilience to external shocks for long-term sustainability. To this end, policy priority should be given to creating a positive investment climate for enhancing competitiveness (see ADO 2003, Part 3: “Competitiveness in developing Asia”), to generating sustainable increases in domestic demand across the region, and to further strengthening regional economic cooperation to improve the region’s resilience against adverse external conditions. The following are worth noting in this respect.

First, broadening intraregional trade and investment underpins strong regional dynamics to allow extra resilience against adverse shocks from the rest of the world. Along these lines, recent initiatives to increase regional economic integration through Asian bond market development and regional trade agreements are welcome, to the extent that these efforts help strengthen regional cooperation as well as broaden its economic linkage to the rest of the world economy.

Second, Asian economies should continue to strengthen their financial systems to underpin the efficient use of financial resources. Financial sector weaknesses coupled with lack of prudential oversight have often led to credit and asset price booms during the era of liquidity in Asia, only to be followed by painful corrections. In order to strengthen its financial sector, developing Asia needs to enhance risk management, strengthen prudential oversight, establish healthy credit systems, and improve governance. Continuous progress in financial sector reforms combined with sound macroeconomic management will be key to ensuring currency and financial stability in the region, as some large economies such as the PRC and Korea are experiencing increasing capital inflows. To channel such resources to productive uses, the sound management of private capital flows is crucial, to be achieved by broadening financial markets, strengthening market infrastructure, building a sound legal and regulatory framework, and enhancing market transparency.

Third, it is imperative for the region to increase domestic absorption by nurturing local investment conditions (see Part 3: “Promoting competition for long-term development”). In line with the above financial sector reforms, further comprehensive structural reforms should follow to improve overall economic efficiency and competitiveness. Such reforms include the successful implementation of corporate and financial sector restructuring through strengthening the balance sheets of companies in these sectors while creating an investment-friendly environment through minimizing unnecessary regulatory barriers in business activities, encouraging private incentives toward more dynamic market economies, opening domestic markets to international competition, and creating a level playing field across all sectors. Over the forecast period, strong growth in Asian demand is not only important for more balanced and resilient regional growth, but is also essential for alleviating the pressure of global imbalances.

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