Part 1 The global slowdown and developing Asia

Introduction

Developing Asia's economy is expected to expand by 7.6% in 2008 (Figure 1.1.1), picking up a shade to 7.8% in 2009. These projections suggest a slowdown from 2007's outcome, now estimated at 8.7%, the highest in 19 years. Still, growth projections for the next 2 years are only slightly below the recent historical trend (Figure 1.1.2) and would constitute a solid performance in an unsteady global economy.

Growth is expected to decelerate in most of developing Asia's economies in 2008, with only a few likely to match or better 2007's performance. Both the People's Republic of China (PRC) and India are projected to cool. In the PRC, growth of net exports is set to fall in 2008 and this will check expansion. In India, where domestic demand accounts for most output growth, a modest slowdown is seen. But growth is expected to ease in many other countries, too. Projected growth rates for Central Asia and for Southeast Asia are below those of 2007. Only the Pacific Islands is forecast to do better than last year.

Rising food and fuel prices are stoking headline inflation, but economic speed limits have also been tested, with recent output growth straining capacity. On the demand side, sustained balance-of-payments surpluses have seeped into domestic liquidity and credit expansion. The expected moderation of growth in 2008 and narrowing of current account surpluses may provide some respite. Nevertheless, trend inflation is rising (Figure 1.1.3) and the projected headline rate is expected to be the highest in a decade.

Risks to the baseline growth forecasts outlined in Asian Development Outlook 2008 (ADO 2008) are firmly to the downside. A coincident slowdown of output growth in the G3 economies—United States (US), European Union (EU), and Japan—now looks set for 2008, with only a moderate and highly uncertain pickup forecast in 2009. As new data are released, G3 growth forecasts are being cut. If the global slowdown is concentrated in sectors such as electronics, textiles and garments, and toys, as recent data appear to suggest, this would hurt Asian exporters. Although developing Asia is now exporting more to other emerging economies—the Middle East, Russian Federation, and elsewhere—this is unlikely to compensate fully for losses in the much larger, more established markets.

There are other important uncertainties. Rising food and fuel prices could probe developing Asia's resilience. Countries that are net fuel and food importers are likely to be squeezed by adverse movements in their terms of trade; more so, when unit values of important export products are weakening, as they now are for garments and textiles. In some countries such as Pakistan, adverse terms of trade movements threaten to widen further already substantial current account deficits.

As highlighted in ADO 2007 Update of September last year, fuel subsidies and other methods of restraining retail prices are already costing developing Asia dearly. Though some recent hikes in administered prices have been made, for example in Bangladesh and India, these are trailing international price increases with the result that the gap between border and domestic prices is again widening. Such open-ended fiscal commitments have high social opportunity costs and, in the absence of "exit strategies," could eventually threaten macroeconomic balances. Recently introduced food subsidies, intended to soothe social pressures, are now adding to fiscal worries. If there is a respite from rising prices, as the ADO 2008 baseline assumes, payments and fiscal risks should recede. But if food and fuel prices soar further—a possibility that cannot be ruled out—some governments may be faced with tough structural adjustments.

More general inflation risks also lurk and could limit policy options (if the deceleration of growth gives cause for concern). In the PRC, the consumer price index (CPI) climbed by 8.7% in February, the steepest rise in 11 years. In Central Asia, inflation is running in double digits, and in many other countries it is expected to accelerate this year. Monetary policy responses have been mixed (Figure 1.1.4) and occasionally lag price developments. The authorities in some economies are anxious that rising interest rates may attract capital inflows and put further upward pressure on nominal exchange rates. But if central banks attempt to resist (rather than manage) nominal currency appreciation, they will eventually court elevated inflation expectations as pressures build for the real exchange rate to appreciate. Sharp cuts in US interest rates are exacerbating pressures and will raise sterilization costs. If inflation expectations are allowed to ratchet up, this will risk long-term damage to productivity growth and to the credibility of central banks.

A key message of ADO 2008 is that, although problems will spread from the global economy to developing Asia—a process that is already visible in high-frequency trade and financial data—the region's growth in 2008 is much more likely to moderate than to lurch down. Developing Asia is not immune to global developments, but neither is it hostage to them. In the near term, Asia's structural transformation, robust productivity growth, and favorable policy climate will continue to support healthy growth. The outlook for credit may well tighten, but the regional financial system—which is still mainly built around bank credit—should be largely insulated from the huge deleveraging now under way in the US.

There should be no room for complacency. Asia's growth is neither preordained nor guaranteed, and if economic vigor is to last, countries must address a raft of challenges. Today, weaknesses limit policy options and are mere bumps along the road to progress. However, left unattended, they could become inescapable road blocks along that path and a serious source of vulnerability.

Part 2 of this 20th anniversary issue of ADO 2008, Workers in Asia, looks beyond Asia's immediate issues and investigates the different challenges related to the creation of productive work and jobs in Asia. The first of three chapters, Young Asians: A squandered talent, analyzes developing Asia's capacity to fully redeem the demographic dividend of its many young people now moving into the labor force. Asia's skills crisis discusses the skills gap between what workers have acquired and the skills they need in economies that aim to move up the "value ladder." The last chapter, Asian workers on the move, analyzes the benefits to countries of the recent tectonic shifts in migration within Asia. All three chapters offer policy suggestions on what developing Asia can do to maximize the dynamism of its economies, and its people.

Part 3 presents, in a country context, overviews of recent economic performance, forecasts for the next 2 years, and the development challenges facing each country. Part 4 presents a brief analysis of the "errors and omissions" line in Asia's national accounts data.

In the following section of this chapter, Global outlook explains the wider backdrop for developing Asia's prospects. Economic conditions in the major industrial countries are reviewed with the spotlight on the possible implications of the still-unfolding credit crisis in the US. The evolution of the crisis affecting US credit markets is assessed and the policy challenges are identified. Prospects are then briefly reviewed for the US, eurozone, and Japan. This sets the scene for an examination of how a global downturn might be transmitted to developing Asia.

In the section, The uncoupling myth: The G3 slowdown and developing Asia, ties between developing Asia and the wider global economy are scrutinized at different levels. Macroeconomic models that capture historical linkages suggest that a combination of adverse shocks to output growth in the G3 and real exchange rate appreciation in developing Asia would register in slower growth, but that the effects are modest relative to potential output growth. Trade channels account for most of the spillover to Asia, though domestic demand could also be crimped by higher real interest rates. A more disaggregated look at the impact of slower consumption spending in the G3 suggests a fast-working—and in some cases substantial—drag on Asian exports. Drilling down further, patterns in recent manufacturing trade statistics show that developing Asia is already feeling the pinch from a slowdown in Japanese and US demand, particularly for cyclically sensitive consumer products.

Looking inside Asia, trade data still reveal strong economic complementarities between the PRC and other economies of East and Southeast Asia. The notion that cross-border linkages are being weakened as the PRC substitutes local for external suppliers finds little support. Vertically integrated supply chains that crisscross East and Southeast Asia remain an important mechanism that disperses and propagates the impacts of external shocks. Virtually all the increase that has occurred in intraregional trade in manufactured goods in recent years has been in parts and components. Final goods demand in the PRC still accounts for only a small share of exports from other Asian countries—though that share may be climbing.

Asia's financial markets are becoming more closely meshed with global markets. Most measures of financial integration, and thus potential contagion, have greatly strengthened over the past decade. Through these channels Asian borrowers will feel the pinch in international credit markets and Asia's bourses are likely to experience heightened volatility. But as Asia's banks are still the main originators of domestic credit, and their leverage and exposure to unsafe securities are low, the possibility of the credit crunch washing onto Asia's economic shores seems remote. Most Asian economies also have ample foreign reserves in the event of an unexpected rush to sell domestic currency.

In the final section, Reasons to be nervous: Commodity prices and inflation, the role of rising fuel and food prices in stoking inflation is considered. Net fuel and food importers are at particular risk of adverse terms of trade movements, and countries that choose to try and cushion the effects of rising border prices on consumers face a potentially large fiscal bill. A jump in long-run inflation—and fuel and food are major components of most household budgets in Asia—is perhaps a clearer short-run danger to developing Asia than moderating growth.

Global developments complicate the current picture. Although the slowdown in global demand should ease inflation pressures, deep cuts in US interest rates would add to them if Asian economies do not allow greater flexibility in nominal exchange rates. Lower interest rates also tend to make commodities more attractive as assets and so may support high prices (Figure 1.1.5), though the effects on inflation should be transitory. Any passive acceptance by Asia of an upward drift in inflation could deal a hard blow to long-run productivity growth. Even moderate inflation typically proves costly to get rid off. Conversely, price controls and extensive price subsidies, though they may temporarily corral inflation expectations, are not the answer and would stymie market adjustment processes.