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Asian Development Outlook 2003 : I. Developing Asia and the World : Overview of Economic Trends and Prospects
Developing Asia: Risks and UncertaintiesTwo broad kinds of risk underlie the forecast for the next 2 years. The first set concerns threats to the macroeconomic assumptions underpinning the forecast. The second set is related to geopolitical uncertainties associated with the possibility of terrorism and its impact on tourism, a major source of revenue for the region. Among these risks, the possible consequences of the conflict in Iraq on oil prices, trade, and remittances remain highly uncertain. In addition to these two risks, very recently the outbreak of what could become a major epidemic of SARS in several areas in Asia might have a substantial negative impact on several economies of the region by further discouraging tourism and slowing trade and business activity. Global Economic UncertaintiesFailure of Global Investment to Revive. Investment in the OECD could remain weak given the weight of low equity prices, geopolitical uncertainties, and higher oil prices. In previous recoveries in the US, for example, equity prices rebounded quite strongly following the end of the recession as measured by the bottom of the trough. In the current recovery, however, this trend has been strongly reversed. Equity prices fell by 19.4% (to 31 March 2003) from the end of the recession (i.e., 31 January 2002). The conflict in Iraq appears to be the main reason for possibly low stock prices in the next year according to a survey of European retail investors conducted by Gallup and the Swiss bank, UBS. However, investor uncertainty has also increased because of the series of accounting and other examples of corporate malfeasance, as well as concerns about oil prices and the growth potential of industrial countries. Should these developments, plus low capacity utilization and weakening consumption demand, lead the industrial countries to put off capital spending, it would have a depressing effect on economic growth in these countries with knock-on effects for developing Asia. Deflation. There has been growing concern in several countries about the problem of deflation a general fall in the price level for some sustained period of time (Box 1.4 discusses additional aspects of deflation). Among industrial countries, Japan has been in such a situation on and off for the past few years and both Hong Kong, China and the PRC have experienced deflationary pressure. There are several possible negative effects of deflation. Some of them are psychological while others have real effects on the economy. From the psychological point of view, if lower prices are anticipated in the future, consumers may hold off consuming until a later date. That will have a depressing effect on aggregate demand and contribute to a possible acceleration in a downward spiral of decreasing prices. In a country with a large debt overhang, deflation increases the cost of servicing as well as the real value of debt. It makes fiscal consolidation difficult and jeopardizes the loan portfolios of the financial system as corporations experience difficulty in servicing debt. The burden of addressing the problem of deflation is complicated when normal policy options such as devaluing the currency, increasing the money supply, lowering interest rates, and undertaking fiscal stimulus are limited. This could occur in circumstances where the banking system is already burdened with a large volume of nonperforming loans, where government deficits and existing debt are already high or legally constrained, and where the exchange rate is fixed. 
Rapid Adjustment in the US Current Account Balance and Dollar Exchange Rate. The problem of the so-called "twin deficits" of the US fiscal and current account balances has been cited as a risk in previous ADO forecasts as well as by the World Bank, IMF, and others. However, these risks have not materialized. In 2002, the value of the dollar fell by 2.6% against a trade-weighted basket of currencies which should, other things equal, result in a tendency for the US current account deficit to narrow. After posting a surplus in the last years of the Clinton administration, the fiscal position of the US has recently deteriorated substantially following the onset of the recession at the end of 2000 and in the early months of 2001, as a result of higher spending following the events of September 11, 2001, and more recently the conflict in Iraq. Has the twin deficit challenge reemerged as a significant risk? First, the chances of a downward spiraling of the dollar following capital flight are low. This scenario is unlikely because it would create a situation from which none of the major regions of the world economy would benefit, in particular Europe and Japan. Flight from the dollar would require a major reassessment of the risk-return trade off in holding US assets. This appears unlikely, as US assets seem an even stronger safe haven in a period of increasing global uncertainty, even factoring in the threat of international terrorism. A flight from the dollar would help make US manufacturing more competitive in international markets and that would promote US exports. However, it would have strong negative domestic effects, putting upward pressure on prices and interest rates and possibly discouraging investment. It would also hurt the exports of Japan and the EU and their stock markets, and thus their growth prospects. Developing countries would also be adversely affected. Particularly in Asia, exchange rates of several currencies could come under severe pressure. For these reasons it is unlikely that the required adjustments in external and domestic imbalances in the US will take place sharply. A more likely outcome is that the recent downward adjustment in equity prices will have a dampening effect on consumption, leading to a greater balance between the forces of investment and consumption sustaining growth. However, if very large unexpected fiscal deficits, partly resulting from tax cuts, add to the already high US federal debt held by the public ($3,711 billion, as of 31 March 2003), upward pressure on interest rates will intensify, possibly affecting a revival in investment and pulling down growth. Geopolitical UncertaintiesTerrorism and Shortfall in Tourism. As the attack on the Indonesian island of Bali showed, terrorism can have a significant impact on tourism in Asia. For many DMCs, tourism is a major source of external revenue and economic growth. Tourism accounts for about 9% of developing Asia's GDP and 7% of employment (see Box 1.1 Tourism Trends in Developing Asia, ADO 2002). In Southeast Asia, tourism accounts for nearly 11% of GDP (9.9% in Indonesia, 11.5% in Malaysia, 10.8% in Singapore, and 13.0% in Thailand). In South Asia, over 50% of the Maldives' GDP depends on tourism while for the Pacific it averages 22.2% of GDP. Similarly, employment in the tourism industry is sizable in many DMCs. Terrorist activities could thus significantly impact many economies in the Asia-Pacific region, with GDP, employment, and the balance of payments directly affected. In the case of Indonesia, estimates of the impact of the Bali bombing on the economy range from 0.5% of GDP in 2002 to 0.5-2% of GDP in 2003, depending on the effectiveness of the government response to the security threat and the repercussions on consumer and investment confidence.
Impact of Conflict in Iraq. The conflict could affect DMCs in a number of ways. Certainly, one is the risk of terrorism and its impact as discussed above. In addition, the economic impact could be felt through three other channels: (i) a significant oil price increase; (ii) a fall in overseas worker remittances; and (iii) a sharp fall in export demand from industrial countries, the US in particular, as well as from Middle Eastern countries. While the Asia-Pacific region includes several oil exporters (Azerbaijan, Indonesia, Kazakhstan, Malaysia, Turkmenistan), most of the DMCs are oil importers—PRC, India, and Korea particularly so. Hence, a significantly higher oil price lasting several quarters would have a substantial direct impact on the DMCs' oil importers, in terms of higher imports and inflation. For instance, a $2.50 average increase in oil prices would cost Korea—the world's fourth largest importer of oil—over $2 billion a year in higher imports. Model simulations based on the Oxford Economic Forecasting World Macroeconomic model indicate that an oil price increase of about 20% over the 2003 baseline would cost, depending on the economies concerned, 0.2-0.3% in terms of GDP growth in 2003, and 0.3-0.5% GDP growth in 2004, even if prices returned to an average of $26/bbl by 2004. However, while somewhat higher oil prices are already factored into the baseline forecast, it appears that with the conflict unwinding, the oil market situation is such that neither significant supply disturbances nor high oil prices are expected. But high volatility might remain in the oil market. The conflict might significantly affect the remittances of DMC workers in the Middle East. About half of Pakistan's overseas worker remittances originate in the Middle East, and so does a significant proportion of remittances to Bangladesh and Sri Lanka (India's remittances are more diversified). Remittances from the Middle East to the Philippines are also substantial (about 10% of total remittances, or about $700 million). The conflict and its aftermath might seriously impact many of the DMCs' economies the greatest risk appears to be that beyond a certain length of time, it will adversely impact consumer (and mainly investor) confidence in industrial economies, thus further retarding a recovery that by all measures is already anticipated to be weak. Also, the conflict will have a direct impact on the exports of DMCs to the Middle East. Some DMCs depend on the Middle Eastern markets, and on Iraq in particular, for a significant share of their exports. For instance, Iraq alone absorbs about one third of Viet Nam's exports of rice and tea (which are among Viet Nam's leading primary exports). It is noteworthy that estimates of the impact on the overall balance of payments from the first Gulf crisis (August 1990-February 1991) point to relatively modest losses of 1-2% of GDP for Bangladesh, India, Pakistan, and Philippines; the loss was over 4% for Sri Lanka, resulting from a combination of a fall in tourist arrivals, loss of remittances, and higher oil prices. Uncertainties Related to SARSIncreasingly, a major risk to economic growth in developing Asia, particularly East and Southeast Asia, relates to the spread of SARS. Already, the epidemic is significantly affecting travel and tourism in several countries of the region, as well as several other services subsectors, such as hotels and restaurants, retail trade, and transport—particularly air transport within the region. While it is too early to evaluate the impact of the epidemic on regional economic activity, since much will depend on how long it lasts, certain economies— PRC; Hong Kong, China; Indonesia; Malaysia; and Singapore—will be affected, even if the impact is of short duration (2-3 months). Hence GDP growth forecasts for these economies for 2003 have already been lowered. However, if the epidemic is not brought under control by about mid-May, the economic impact on developing Asia will be much broader and deeper, for two main reasons. First, bookings for the major tourism season associated with summer holidays in Europe and elsewhere in the northern hemisphere will be lost. Second, the reduction in business travel and other transport-related cutbacks could start to affect manufacturing export orders, such that the impact of the epidemic would be felt across a broader swathe of the economies affected. In response to these uncertainties, several governments in Southeast Asia, e.g., those of Singapore and Thailand, are considering support packages for those sectors of their economies most affected by the epidemic.
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