Surging East Asian Capital Inflows a Big Concern, Says ADB Report

News Release | 26 July 2007

HONG KONG, CHINA - Continued strong growth in the People's Republic of China and only slightly moderating expansions in the newly industrialized economies and most of ASEAN should lead emerging East Asia to robust 8.1% GDP growth in 2007 and 7.9% in 2008, says a new report issued by the Asian Development Bank (ADB).

As the region steams along, however, surging capital inflows - which reached a record $269 billion in 2006 - brought with them increasing pressures for currency appreciation and fast-rising asset prices, leaving authorities with a new set of macroeconomic challenges to manage, says the July issue of the Asia Economic Monitor.

"Already this year the Thai baht (offshore) is up over 17.6% and the Philippines peso over 9%, while equity markets have been rising fast and showing increasing signs of volatility," says Jong-Wha Lee, Head of ADB's Office of Regional Economic Integration (OREI).

"Authorities in the region are faced with a serious challenge as they look for the right policy choices to manage these capital flows and keep the economic expansion on a steady course," he says.

The danger of capital inflows, although they can also benefit an economy, lies in the potential for a sudden reversal, with huge implications for asset prices and overall macroeconomic conditions.

Nonetheless, the region is in a far better position to manage potential financial shocks than they were before the Asian financial crisis a decade ago - most of these economies are running big current account surpluses and central banks are largely sterilizing the capital inflows, resulting in huge foreign exchange reserves.

The policy response to the challenge will vary, but in general authorities should consider a package that includes greater currency flexibility, monetary policy that strikes a balance between domestic and external objectives, limiting the role of fiscal policy, further liberalizing capital outflows, and developing more efficient financial market regulation and supervision.

Overall in emerging East Asia, economic health was underpinned by a strong external sector, as resilient consumption in the United States and a strong recovery in Europe fed into robust demand for the region's exports. That environment should remain supportive in 2007, with still strong, if somewhat easier global growth.

The importance of the external environment was particularly true in the PRC, where merchandise exports remained a key driver of economic growth, with second-quarter GDP coming in at 11.9%, the highest level in 12 years.

Domestic demand through much of the region has also remained solid - although it weakened slightly due to somewhat slower investment - with private consumption stronger than in 2006. In Korea, private consumption continued to recover steadily from the household debt-related contraction of 2003.

The potential risks to the economic outlook include greater than expected inflation; increased financial market volatility; a sharper US economic slowdown; a disorderly adjustment of global payments imbalances; and noneconomic events, such as geopolitical disruptions or further outbreaks of avian flu.

Inflation continued to fall in most Association of Southeast Asian Nation economies, but has started to rise in PRC, where it increased rapidly in the first half, and in the Republic of Korea, and Singapore.

In meeting the risks, authorities may consider policy options including cautious monetary policies, measures to deepen financial markets and improve investment climates, and allowing market signals to encourage energy conservation policies.

The July AEM also includes a theme chapter looking at the region's banking sector 10 years after the financial crisis, which notes that across much of the region significant progress has been made returning banks to robust health. Impaired assets have been cleaned up and risk management systems have been strengthened.

Yet, progress has been uneven and the challenges faced by banking systems continue to differ sharply. While financial systems in the region are now less exposed to changes in debt-related capital flows than a few years ago, new risks have emerged as banks have moved into activities such as household lending, securities, and property.

Banks also need to continue the rehabilitation and restructuring process and should accelerate the upgrading of governance and disclosure standards, particularly as the adoption of the Basel II framework begins, while authorities should encourage greater bank lending to business investment across the region (with the exception of the PRC).

AEM analyzes emerging East Asia's economic growth, financial and corporate sector restructuring, and emerging policy issues. AEM is available on OREI's Asia Regional Information Center (ARIC) website.