Can East Asia Endure Another Global Economic Crisis?

Emerging East Asia was severely affected during the 2008/09 global economic crisis; but the region rebounded rapidly and robustly. Much of this rebound has been due to the decisive and large fiscal and monetary stimulus measures that were implemented by all countries in the region. The economic resilience is partly due to rebalancing sources of growth from external to domestic demand and the diversification of export markets.

Growth is still strong but continuing sovereign debt problems in Europe and an anemic US economy will moderate economic growth rates in emerging East Asia next year.

A deep and prolonged recession in both Europe and the US could impact emerging East Asia seriously, says ADB in its latest Asia Economic Monitor.

“The turmoil emanating from Europe poses a growing danger to the trade and financial systems of emerging East Asia so Asian’s policymakers must be prepared to act promptly, decisively, and collectively to counter what could be an extended global economic slowdown followed by a slow recovery,” said Iwan J. Azis, Head of ADB’s Office of Regional Economic Integration.

The report, published biannually, has cut the forecast for the region's growth in 2012 to 7.2% from the 7.5% ADB forecast in September. Growth is seen at 7.5% for 2011, down from the previous 7.6% forecast.

New global economic crisis

According the report, financial institutions in the Eurozone and US would likely roll back lending to emerging East Asia in the event of a new global financial crisis. The Eurozone and US  are major markets for the region’s exports and significant sources of financial capital. Hence, any shock to both will have strong repercussions on the region.

The report asks a critical question whether emerging East Asia has the means to withstand another global shock.

There are 3 possible scenarios in 2012:

  • A recession confined to the Eurozone, with the economy contracting 3.9% for 2012 (4.4 percentage points below the ADB forecast). This would bring output to its 2009 level. Under this scenario the US economic growth would slow to 1.6% in 2012 (down 0.5 percentage point from the base forecast);
  • A deep recession in the Eurozone and US—as the nascent US recovery is disrupted by the Eurozone debt crisis. Under this scenario, the US economy would contract 0.1% in 2012, 2.2 percentage points below the baseline. A growth of slightly below zero implies the US would be in technical recession.
  •  A new global crisis where both the Eurozone and US output falls to the 2009 troughs.

In the worst case scenario with the Eurozone and the US contracting as much as they did in 2009, the economy of emerging East Asia would grow by only 5.4% next year, 1.8 percentage point below the 7.2% currently forecast. The East Asia economy – which also includes Japan - would grow by 4.2%, 1.2 percentage points below the current forecast. That would be a smaller impact than the region felt following the 2008-2009 global crisis, in part because the region  now depends less on exports to US and European markets.

Short-term

To cope with a potentially prolonged global crisis and a slow subsequent recovery, Asia’s policymakers must consider financial, monetary, and fiscal tools. These include contingencies to safeguard financial stability and ensure sufficient credit is available locally. Monetary policy must remain flexible while exchange rate coordination would avoid competitive devaluations. And the region should look to apply fiscal stimuli gradually and judiciously where needed while avoiding strain on their budgets.

Long-term

Regardless of short-term adjustments, the report recommends emerging East Asia needs to continue its structural reforms and supply-side policies to sustain long-term growth. With demand from the Eurozone and US expected to remain weak over the coming decade, emerging East Asia should continue to work toward increasing intraregional trade and financial cooperation, expanding links with other emerging economies. Strengthening institutions related to investment business climate is another important reform that will allow the region to make use of excess savings for productive use and for the financing of badly needed economic and social infrastructure.

Risks

The region’s banking systems remain sound; yet its  economies are vulnerable to tightening global liquidity. In general, the region is less exposed to the global crisis via the trade channels but on the financial side, remains just as vulnerable as in 2008.

Trade channel

The impact of the 2008/09 global financial crisis was transmitted mostly through trade. The trade collapse in 2008 was also exacerbated by the lack of trade financing. Since then, the region has become less dependent on export markets in the Eurozone and US. However, the threat of drying up trade financing due to a possible credit crunch caused by the Eurozone crisis may put a serious strain on trading activities, on which many countries in Emerging East Asia depend on.

Financial channel

The report notes that heightened risk aversion would see investors slash holdings of Asian financial assets while highly leveraged European banks would cut lending, leading to tighter credit conditions in Asia and a destabilization in the financial system.

What can policymakers do?

The report recommends that authorities in emerging East Asia need to respond promptly, decisively, and collectively should downside risks from the Eurozone and US materialize and the current problems morph into a full-blown global financial and economic crisis.

The region’s policymakers will need to ensure adequate and timely provisioning for liquidity. This is to ensure that systemically important financial institutions are not pressured and credit is available for key economic activities, including trade.

Critically important are institutional arrangements for providing emergency liquidity—their scope and effectiveness must be adequate to deal with potentially troubled institutions.

Policymakers should also encourage and help banks raise necessary capital to strengthen capital ratios, if needed, and provide full or partial guarantees to new lending.
Monetary authorities will need to strike a careful balance to keep inflation under control, even though it limits room to respond to a slowing economy. In particular, the implications of inflation on the poor are important as much of the burden of heightened food and fuel prices disproportionately falls on the most vulnerable.

The report warns that while extreme volatility (and over- or under-shooting) may warrant foreign exchange market intervention, excessive exchange rate support or foreign exchange reserve drawdowns could overly weaken macroeconomic fundamentals.

Regional cooperation

According to the report, policymakers should collaborate closely to prevent financial contagion from spreading further and maximize the positive impact of national policies on other economies in the region.

The region must prepare for a prolonged crisis and weak post-crisis recovery by implementing appropriate short-term macroeconomic responses and pursuing necessary long-term structural reforms.

Efforts to deepen regional integration through existing regional initiatives can boost regional trade and demand and help establish the East Asia and Pacific region’s new role in leading the global economy.

Outlook

Slow global growth presents an opportunity for emerging East Asian governments to refocus on reforms that will enhance growth in the medium- and long-term. Once volatility in global financial markets recedes, capital flows are likely to return to emerging East Asia.

When that happens, a concerted effort to maintain exchange rate competitiveness and to “translate” the augmented capital into domestic productive use becomes important.