Emerging Asia: Positive Outlook Despite Pitfalls

Source : The Business Times, October 23, 2007

Beware uncertain global economy and riskier financial environment, says DAVID BURTON

EMERGING Asia's economies have been among the most dynamic in the world in the last decade. Today, the region accounts for almost half of global economic growth. Much of this success stems from broad reforms by these countries in the last 10 years.

Encouraging picture: During the recent turbulence over the US sub-prime crisis, emerging Asia's equity markets initially fell along with other emerging markets, Asian currencies experienced downward pressure and financial conditions tightened. But what is striking is the speed with which emerging Asia recovered from this initial shock.

These reforms have led to healthier financial and corporate sectors and more robust macroeconomic policy across the region. But the recent financial turbulence, still playing out across the globe, highlights the question of just how vulnerable the region remains to developments in the United States and other industrialised countries.

What, therefore, are the key strengths and vulnerabilities for the region today? And what challenges are Asia's policymakers likely to face in the period ahead?

The International Monetary Fund's (IMF) Asia and Pacific Department addresses these issues in detail in its Fall 2007 Regional Economic Outlook (www.imf.org).

The year 2007 has been another good one for the region so far. Economic growth has exceeded expectations. China and India have led the way, with growth rates in the first half of the year of 11.5 and 9.25 per cent respectively. The trend has been positive for others as well. Exports remain buoyant and growth is becoming somewhat better balanced in many countries, with private consumption and investment making an increasing contribution.

For the year as a whole, we project that emerging Asia will achieve economic growth of nearly 9.5 per cent. Moreover, inflation continues to remain in check. While a recent modest pick-up in headline inflation in the region requires close monitoring, this rise mainly reflects higher food prices, especially in China, and is not expected to generate large second-round effects.

The region weathered well the recent global financial turbulence, when concerns over rising defaults in the US sub-prime market led to increased volatility in equity and credit markets worldwide.

Emerging Asia's equity markets did initially decline along with other emerging markets, Asian currencies did experience downward pressure, and financial conditions did tighten. However, what is striking is the speed with which emerging Asia recovered from this initial shock.

Capital inflows to the region have returned, and its equity markets are now about 10 per cent higher than before the summer's turbulence. Reflecting this resilience, the IMF foresees only a modest slowdown in 2008, to about 8.5 per cent, resulting from lower external demand for Asia's exports, and an assumed effective policy tightening in China.

The sub-prime crisis has, however, increased uncertainty about the outlook for the global economy - and for emerging Asia. First, it remains uncertain whether we have seen the worst of the global financial turbulence or if there are additional shocks ahead. The region's apparently small exposure to sub-prime mortgages and structured products more generally has helped moderate the impact of the sub-prime crisis on Asia. This in itself reflects the relatively unsophisticated nature of the financial sector in much of the region.

But another bout of global financial volatility could have significant spillovers for the region. It could reverse recent inflows and make financing more difficult for a number of sovereign and corporate borrowers.

But perhaps the main risk to the region is that of a sharp slowdown in the US and the euro area, resulting from the persistent US housing doldrums and associated global financial problems.

Despite the view being expressed that Asia has 'delinked' from the US and other industrialised countries, the truth is that the region remains significantly dependent on exports to the rest of the world. While an increasing share of exports are within the region, much of this still reflects the integrated production processes within Asia, with much of the final demand still in the industrialised world.

So, how big an impact would a US or global slowdown have on Asia? It would likely not be as big as during the dotcom bust of 2001-02. Then, the decline centred on information technology products, which are of particular importance for emerging Asia.

Nevertheless, IMF staff estimates that a one percentage point decline in US economic growth could reduce growth in emerging Asia, through lower exports, by up to 0.4 percentage point. While sizeable, this would, however, not have a dramatic impact on emerging Asia's economies.

Overall, then, the outlook for emerging Asia remains positive, but the economic environment will, as always, present a number of policy challenges.

First, policymakers need to be ready to respond to a slowdown in the global economy including - in countries where inflation expectations are low and well-anchored - through more accommodative monetary policy.

Second, the volatile global environment has raised uncertainty regarding capital flows to the region. Countries will need to continue to be pragmatic and allow for greater exchange rate flexibility to create two-way risk in foreign currency markets and promote a rebalancing of growth where necessary. This is especially pertinent in China, where the current account surplus has continued to grow and the currency remains considerably undervalued relative to medium-term fundamentals.

Finally, the sub-prime crisis, while so far largely skirting the region, will provide a number of lessons for Asia, as its financial systems become more sophisticated. This is likely to include the need for enhanced financial supervision.

At the same time, countries will also likely need to strengthen reporting and disclosure requirements, and pricing and provisioning rules to deal effectively with complex financial products, and the cascading system of risks they imply.

The author is director of the International Monetary Fund's Asia and Pacific Department