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Asian Development Outlook 2001 : I. Developing Asia and the World - Economic Developments and Prospects

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Risks and Uncertainties

The above projections are subject to a number of risks and uncertainties. The main external risks for DMCs in 2001 and 2002 relate to the prospects for the US economy. For some time, a key question has been the manner in which the US would make the transition from very rapid growth rates toward more moderate rates of expansion, often cast in terms of a “hard” or “soft” landing, and what a hard landing would imply. This question was central during 1998 and 1999 when the US economy was the main locomotive of global growth, given weakness in much of Europe, Japan, and the developing world. A sharp US slowdown at that time risked plunging the world into recession with adverse implications for many countries, including DMCs struggling to grow out of the 1997/98 financial crisis. In view of the broadening of the global recovery in 2000, the risks in this area have clearly receded, but have not entirely disappeared given the size and importance of the US economy and some fragilities in the rest of the world.

As noted earlier, key assumptions underlying the projections are that the current slowdown in the US will not be very severe—and that the other major industrial economies have sufficient momentum to keep the world economy growing at a satisfactory pace in 2001 and 2002 as the US recovers from its current weakness. Each of these assumptions can be considered in turn.

The expectation that the US slowdown will not be very severe or long-lived is based on the judgment that the macroeconomic fundamentals in the US are strong and that the economy has very flexible product and factor markets. Moreover, according to some observers, recent high levels of investment in high technology there have permanently and significantly boosted the economy’s potential growth rate. In an extreme version of this view, the current slowdown is essentially a modest “hiccup” and relatively rapid rates of growth will return quickly once current small inventory imbalances have been worked off and confidence returns.

There is some merit to this view. But there is also considerable uncertainty about the size of the “new economy” effects and the extent to which US productivity growth has been permanently raised. In addition, questions remain about the sustainability of continued very high valuations in the US stock market and the prospects for the dollar (in light of the large US current account deficit). It is possible that imbalances in these areas are small and could be reduced gradually, especially if new economy effects are very important. But the argument might also be plausibly made, based on historical experience, that the necessary adjustments could be large and disorderly with significant adverse effects on growth.

Partly in response to these uncertainties, the projections for the near-term outlook for the US economy have been made from the middle ground. On the one hand, it is assumed that the slowdown will be sharper and longer-lived than the hiccup assumed by new economy advocates. In addition, although the US growth rate over the medium term has been marked up to reflect new economy effects, a return to the relatively rapid growth rates of recent years is seen as unlikely. On the other hand, the projections assume no deep or long recession, such as might occur if the US economy faced a significant further stock market correction or if the dollar came under severe pressure. In the event of a more severe downturn, the US authorities have indicated their intention to apply monetary and fiscal measures to stimulate recovery. This might help provide a floor to US growth in 2001.

The other key assumption—that the other major industrial economies have sufficient momentum to keep the world economy growing—is based on the judgment that growth in Europe, and especially the euro area, has become sufficiently self-sustaining to withstand a slowdown in US imports. Various reasons for optimism can be put forward. Most important, the euro area is considerably more dependent on domestic demand than exports as a driver of growth, given the relatively low ratio of exports to GDP. In addition, reflecting significant structural reforms in recent years, the region has been enjoying an expansion led mainly by domestic demand, with generally impressive growth in consumption and investment and large reductions in unemployment rates. Beyond this, planned tax reductions in 2001 in the euro area, worth a little more than a net 0.5 percent of GDP, should help sustain domestic demand.

An important concern for the euro area, however, would be a sharp correction in the euro/dollar exchange rate due, for example, to unwillingness of investors to continue to finance the US current account deficit. Were the resulting appreciation of the euro to be very large and rapid, this could harm export competitiveness and growth. Although this is an important risk, it should not be exaggerated as some of the funds that previously financed the US deficit would no doubt move to the euro area. This would help boost European financial markets, offsetting somewhat the adverse implications of euro strength for external competitiveness. In addition, a stronger euro would provide the European Central Bank with additional room to lower short-term interest rates without compromising inflation objectives.

Although recent data for Japan suggest some faltering of the recovery in 2000, it is premature to conclude that the economy will slip back into recession. Indeed, the projections suggest that the recovery will remain largely on track in 2001—albeit at a slightly lower rate than in 2000—before picking up momentum again in 2002. There are, however, risks if the US economy makes a hard landing. Macroeconomic policies in Japan will need to remain accommodative and structural reform must be urgently accelerated.

Turning to the DMCs, the main external risks relate to the effects of slower growth in the US. Although the projections already take account of a US slowdown, the size of its effect is uncertain, given both the key role that the strong recent expansion in the US played in helping DMCs grow out of the 1997/98 financial crisis and the fragility of some of the recoveries in DMCs. In addition, there is uncertainty about the implications of the US slowdown for the terms and conditions of DMCs’ access to international capital markets. The possibility of an increase in risk aversion and tighter terms for external financing cannot be excluded, especially if major stock markets remain volatile. This would have negative spillover effects on Asian financial markets and net capital flows.

As background, the 1997/98 financial crisis gave an important lesson to many DMCs on the risks of financial integration. Not surprisingly, therefore, concerns have been raised as to whether such a crisis could happen again in the event of a sharp deterioration in the external environment. As currencies and stock markets in a number of DMCs tumbled in the latter half of 2000, many commentators wondered whether the region was seeing a repeat of the earlier crisis.

There are several reasons for believing that the current situation is fundamentally different from that of 1997/98, and that another crisis is, therefore, extremely unlikely.

• First, and most important, the external shock that the region faces this year is primarily a real rather than a financial shock, related to the slowing in one of the regions’ major export markets. Although export slowdowns played some role in triggering the 1997/98 crisis, the key factor at that time was a significant confidence-induced turnaround in the capital account following a period of strong capital inflows. Moreover, much of the turnaround in DMC capital accounts may already have taken place in 2000 as the effects on the region of the US slowdown started to become apparent.
• Second, reflecting policy reforms and adjustments since the financial crisis, many DMCs have considerably stronger external situations than a few years ago. In particular, in the case of the five economies most affected by the crisis, balance of payments on current account are in surplus, short-term external debt levels have been reduced in relation to international reserves, and international reserve positions are generally quite comfortable.
• Third, the structure of capital flows to many DMCs has changed since the mid-1990s with portfolio flows and relatively stable FDI largely replacing volatile short-term bank loans. Although portfolio flows also tend to be volatile, swings tend to be reflected to a significant degree in the prices of assets (equities and bonds) rather than in the capital flows themselves. They, therefore, generally have different implications to pullbacks of short-term bank credit that need to be repaid at face value.
• Fourth, many DMCs—including several with relatively open external capital accounts—have adopted more flexible exchange rate arrangements. In these cases, the exchange rate is able to play a larger role in adjusting the economy to external shocks. More flexible exchange rate arrangements also provide greater scope for monetary policy to moderate a growth slowdown.
• Fifth, many DMCs have embarked on comprehensive reform programs to enhance the safety and soundness of their financial systems and strengthen corporate sectors.
• Sixth, transparency has been improved considerably in many DMCs, making unlikely the reappearance of the kind of regionwide negative surprises that figured prominently in the 1997/98 crisis.
• Finally, the degree of leverage and the activities of investment hedge funds have been cut back in the last few years, making the intense speculative pressure that was evident in the earlier crisis less likely.

Against this background, the current situation appears quite different from that of 1997/98. Yet, this does not imply that DMCs should be complacent about the outlook for 2001. Even though the situation has improved considerably, some DMCs have new and different weaknesses from those in 1997/98 that might be important during any slowing of their recoveries. In this connection, it is useful to note some vulnerabilities that may have implications for how DMCs can be affected by the slowdown, such as:

• high dependence of recoveries in some DMCs on export growth (despite recent pickups in domestic demand);
• concentration of some DMCs’ exports in a relatively few product groups, such as technology goods that are currently slowing sharply as the US weakens;
• incomplete progress in financial sector restructuring as reflected in either continued relatively high levels of NPLs and/or inadequate provisioning for bad loans;
• inadequate progress in corporate restructuring as reflected in poor profitability and/or continued high leverage ratios;
• unbalanced recoveries in which some domestic sectors (such as construction) and certain demand components (such as investment spending) have remained relatively weak, even with rapid GDP growth; and
• political difficulties and uncertainties that may impair DMCs’ ability to deal effectively with the problems created by a growth slowdown, and that may hinder the pace of economic recovery and reform.

The extent of these vulnerabilities as well as their implications vary significantly across and within country groups in the region. Perhaps the most vulnerable countries are among the five most severely affected by the 1997/98 crisis. To varying degrees, these five countries have been undergoing a sharp “V-shaped” rebound in the last three years and recording, in many cases, very impressive growth. Initially, the recovery was driven mainly by exports, as domestic demand remained very weak due to difficulties in domestic financial and corporate sectors. Subsequently, domestic demand has tended to pick up as recoveries have matured, especially in those DMCs that have made significant progress in financial and corporate restructuring. However, domestic demand has in some cases been largely driven by spillovers from the export sector, rather than autonomous factors.

Moreover, even though consumption spending has risen in some of the five DMCs, fixed investment has generally remained weak and, in many cases, is below precrisis levels. The ability of these five DMCs to sustain growth will depend on their capacity to strengthen domestic demand and increase exports to the faster-growing regions of the world. While there may be room for fiscal stimulus in some cases, that room has generally become more limited given the high budgetary costs of financial sector recapitalization. In these circumstances, it will be important for these five DMCs to move ahead with needed structural reforms to facilitate a “crowding in” of private domestic demand, including investment spending. Where appropriate, this can be supported by an easing of monetary conditions. Although there is some uncertainty about how some of these DMCs will cope with the slowdown, the situation is manageable in all five cases.

The other DMCs likely to be significantly affected by the US slowdown are Hong Kong, China; Singapore; and Taipei,China. For the most part, however, the situation in these economies is very different from that in the five crisis-affected countries. These three NIEs were less severely affected by the Asian financial crisis and thus are not undertaking the kinds of broad recovery programs adopted by the other five. Moreover, these three economies generally have much stronger and sounder financial systems, as they are not in the process of being nurtured back to good health. Like the five countries, however, recent growth has generally been heavily dependent on exports, including technology items, and their exports are generally expected to slow sharply in 2001, contributing to lower GDP growth that year before a rebound in 2002. In particular, in the cases of Hong Kong, China and Taipei,China, expected continued strong growth in the PRC will help moderate the slowdown.

Finally, the PRC and India will obviously be affected by the US slowdown given the importance of exports in their recent expansions. In addition, each economy, to varying degrees, has benefited from the technology boom. At the same time, however, each country has a substantial nontraded sector and domestic demand has been driven significantly by the implementation of economic reforms and supportive domestic macroeconomic policies. If exports slow rapidly, growth could be sustained in these countries through the implementation of domestic structural reforms and, to the extent that medium-term sustainability is not compromised, through continued supportive fiscal policies. In general, the ability of these two countries to sustain growth is likely to be much greater than in the case of the five crisis-affected countries. And indeed, by maintaining domestic demand growth, the PRC and India can help provide economic stability to the region.

The effects of the US slowdown on DMCs will depend heavily on the behavior of intraregional trade. This has grown significantly over the last decade and can play a role in reducing the region’s vulnerability to external factors, such as a slowdown in the US. Whether intraregional trade will, in practice, play such a role will depend on its composition and the factors driving its growth. Hence, for example, if it has been driven mainly by autonomous demand in the region, it might be expected to provide a significant buffer to an external slowdown. Conversely, if outsourcing of production for the region’s exports has driven its growth, then it may be less resilient. Based on available data, a sizable share of intraregional trade seems to involve intermediate inputs. Even though this implies that, if such trade will not necessarily be a major buffer to a US slowdown, it does not rule out a stabilizing influence, especially if the PRC and India show continued strong domestic demand growth.

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