Two Challenges for Asia's Economy in 2011

Asia’s recovery is firm and the region is expected to continue to grow by 7.8 percent in 2011 and 7.7 percent in 2012, despite the modest and still uncertain recovery in the major industrial economies and the recent hardship in Japan.

However, maintaining high growth could be more difficult than Asia seems prepared to admit. In order to sustain its growth, the region needs to address two important challenges.

First, managing inflation pressures must be the first priority. Thanks in part to their faster recovery, some Asian economies are already showing signs of overheating. Moreover, ongoing tension in the Middle East and the nuclear anxieties in Japan have further heightened market expectations of higher oil prices.

Rising inflation, in particular of food prices, is proportionately more damaging to Asian economies, home to two thirds of the world’s poor. It could not only undermine the region’s recovery, but also aggravate income inequality, hamper political and social stability, and affect growth prospects in the long run. The recently announced Twelfth Five-Year Plan of the People’s Republic of China recognizes the importance of inclusive growth.

However, managing inflation in a two-speed world is not an easy task. Monetary tightening through hiking interest rates would attract even more volatile capital inflows, further compounding the problem. For example, foreign exchange intervention to maintain international competitiveness could be self-defeating as it inevitably increases domestic liquidity and subsequently inflation.

Maintaining a coherent policy mix is key to success. For countries with persistently large current account imbalances and misalignment between their exchange rate and fundamentals, more flexible exchange rates are a better policy. For countries without such symptoms, relying more on temporary policies, such as capital controls, may be an option. But it has to be executed in an internationally coordinated manner to avoid the risk of being protectionist.

Second, looking ahead, Asia has to find new sources of growth as it reduces reliance on the US as consumer of last resort. Industrial countries are unlikely to drive global demand and growth any time soon. In addition to increasing domestic consumption in Asia, strengthening South-South links through recycling of savings to investment in the less affluent South can take up the slack.

It is encouraging that this trend is already happening. South-South trade has expanded fast in the past two decades, from about 7 percent of world merchandise trade in 1990 to 17 percent in 2009. The South is also no longer just a recipient of foreign direct investment (FDI) from the North. Some of the high-saving economies of the South have become new sources of outward FDI.

However, this trend does not automatically guarantee new sources of future growth for Asia. Much of it has been the result of the rise of “Factory Asia”, where developing Asia sourced intermediate goods and parts mostly from the South for assembly into final goods that are exported to affluent markets in the North. Hence, growing South-South links do not necessarily translate into greater economic independence from the North.

To maximize its full growth potential, the South has to reduce barriers to trade in final goods and investment. Although tariffs in the South have fallen in the past two decades, they are still much higher than with the North. Applied tariffs in the South averaged 9.3 percent in 2005–2008, compared to 3.2 percent in the North.

Reducing these remaining bottlenecks will result in more industry migration from Asia to other less affluent developing countries. Hosting manufacturing industries, which the North previously exported to Asia, could be a new stimulus for African growth, for example. Using savings from the South for investment through industry migration rather than holding them in safe assets in the West will contribute to the stability of the global economy by promoting global rebalancing.