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Speeches and Papers

Asia's Recovery and Macroeconomic Policy Challenges

by Jong-Wha Lee, Asian Development Bank

Prepared remarks delivered at the release event for the Asian Development Outlook 2010
April 19, 2010

I. Introduction

Good afternoon. I am very happy to be here today at the Peterson Institute for International Economics to launch the Asian Development Outlook (ADO) 2010. As a major annual Asian Development Bank (ADB) publication, the ADO provides a comprehensive economic analysis of 45 economies in developing Asia and the Pacific and offers forecasts of key economic variables for 2010 and 2011.

In my presentation today, I would like to focus first on the economic prospects for developing Asian economies, briefly present our views on the global recovery, and give you a snapshot of the factors that led to Asia's quick recovery. I will then discuss the risks that could derail this rebound.

In the second part of my talk, I will look at postcrisis macroeconomic policy challenges, the special theme of this year's ADO. Asia's rapid economic revival poses key challenges in macroeconomic management, particularly in ensuring that growth is sustainable.

Let me begin with a summary of key messages. Developing Asia's recovery has taken firm hold, with growth projected at 7.5 percent this year. Inflation pressures are growing, but these are likely to be manageable in most of the region. Nevertheless, global uncertainty and volatile capital flows present risks to the outlook.

The region weathered the harsh global environment of 2008–09 quite well. A return to robust and sustainable growth is now in sight if domestic demand can be strengthened. But now as it strives for sustained recovery, Asia faces the challenge of shifting the sources of growth away from temporary monetary and fiscal policy support and onto robust private demand. Authorities must adjust their monetary, fiscal, and exchange rate policies to prepare their economies for the changing environment in the postcrisis period. This implies reaffirming their commitment to prudent macroeconomic policies in the medium to long term.

II. Economic Prospects

Let me now turn to the global and regional outlook.

We expect only a mild recovery in global conditions this year. In particular, we project GDP in the United States, Japan, and eurozone to expand by an average of 1.7 percent in 2010, accelerating slightly to 2.0 percent next year. But, as emergency policy measures are gradually withdrawn, it is not clear whether the strength of broader demand components, especially from the private sector, will be robust enough to take over.

For the United States, our projections are for a moderately paced recovery, with GDP expanding by 2.4 percent in 2010 and 2.6 percent in 2011. For Japan, the outlook remains sluggish. Growth is forecast at 1.3 percent in 2010 and 1.4 percent in 2011. For the eurozone, GDP growth is expected to remain weak at 1.1 percent in 2010 and 1.6 percent in 2011.

A mild recovery in world trade is projected for 2010 and 2011, ranging between 7 percent and 8 percent. Inflation in the G3 economies is expected to be subdued at below 1.5 percent.

By contrast, we are optimistic that developing Asia's economic revival will be robust, supported by improving global prospects and the sustained impact of the large-scale fiscal and monetary stimulus. In 2010, we project growth to rebound to 7.5 percent, a strong acceleration from 5.2 percent in 2009, though still below the record 9.6 percent growth of 2007. But this region also faces the challenge of maintaining momentum as expansionary measures are gradually unwound and as external demand picks up only slowly. We project 2011 growth to edge back to 7.3 percent as the effects of the stimulus measures fade.

This figure shows the sources of GDP growth in 2009 in eight economies in Asia. The varied performance highlights the importance of resilient domestic demand—both consumption and investment—when hit by large external shocks coming from the global economy. The yellow block represents investment, which fell sharply in many countries, such as Singapore, Malaysia, Thailand, and Korea. This was the main factor behind a weak 2009. The impact was particularly severe for the more open economies, driven as it was by the collapse in exports, when export-oriented industries cut investment.

Contributors to GDP growth

But in Asia's three large countries—the People's Republic of China (PRC), India, and Indonesia—investment showed resilience. As seen in the yellow blocks, investment contributed positively to GDP growth, especially in the PRC. Large fiscal stimulus packages and generally upbeat business sentiment supported their corporate sectors.

Private consumption, as represented by the green blocks, was also notably steady in the three large economies. In the Philippines, private consumption was resilient, buoyed by strong remittances from overseas workers.

I mentioned that government fiscal stimulus provided significant support to GDP growth in 2009. Governments across the region responded decisively, boosting spending and cutting taxes to support demand and growth. The effects will still be felt this year. But fiscal balances deteriorated sharply as a result of these packages. In Thailand, for example, the fiscal balance as a percent of GDP in 2009 worsened 4 percentage points from the average in 2004–08.

Among all Asia's subregions, economic growth will pick up in 2010, but performance will not be uniform.

In the hardest hit region, Southeast Asia, growth is forecast to rebound sharply to 5.1 percent in 2010, from 1.2 percent in 2009. This was its weakest result since the Asian financial crisis of 1997–98. The five economies of the subregion that shrank in 2009 will return to growth in 2010.

East Asia, meanwhile, will be the best performer of 2010, with GDP expected to accelerate to 8.3 percent in 2010. This will be supported by resilient growth in the PRC and strong recoveries in the three economies that contracted last year, that is, Hong Kong, China; Mongolia; and Taipei, China.

For South Asia, because major countries report figures in fiscal year terms, growth in 2009 actually inched up to 6.5 percent from 6.4 percent in 2008. But only India and Afghanistan saw gains. Growth is expected to pick up in most South Asian countries in 2010.

Central Asia also suffered last year, as growth slowed to 2.7 percent from 6.1 percent in 2008, with all countries putting in a weaker performance. Recovery is slow, but the subregion is expected to grow faster as the Russian economy recovers on higher oil prices.

Aggregate growth in the Pacific region pulled back to 2.3 percent in 2009 but is also expected to see recovery this year.

    2008 2009 2010 2011  
  Central Asia 6.1 2.7 4.7 5.9  
  Azerbaijan 10.8 9.3 9.5 9.7  
  Kazakhstan 3.3 1.2 2.5 3.5  
  East Asia 7.3 5.9 8.3 7.7  
  China, People's Republic of 9.6 8.7 9.6 9.1  
  Hong Kong, China 2.1 -2.7 5.2 4.3  
  Korea, Republic of 2.3 0.2 5.2 4.6  
  Taipei, China 0.7 -1.9 4.9 4.0  
  South Asia 6.4 6.5 7.4 8.0  
  Bangladesh 6.2 5.9 5.5 6.3  
  India 6.7 7.2 8.2 8.7  
  Pakistan 4.1 2.0 3.0 4.0  
  Sri Lanka 6.0 3.5 6.0 7.0  
  Southeast Asia 4.3 1.2 5.1 5.3  
  Indonesia 6.0 4.5 5.5 6.0  
  Malaysia 4.6 -1.7 5.3 5.0  
  Philippines 3.8 0.9 3.8 4.6  
  Singapore 1.4 -2.0 6.3 5.0  
  Thailand 2.5 -2.3 4.0 4.5  
  Vietnam 6.2 5.3 6.5 6.8  
  The Pacific 5.4 2.3 3.7 5.0  
  Fiji Islands -0.1 -2.5 -0.5 0.5  
  Papua New Guinea 6.7 4.5 5.5 7.7  
  Vanuatu 6.3 3.8 4.6 4.0  
  Developing Asia 6.6 5.2 7.5 7.3  
This table shows our forecasts for subregions and selected economies in Asia. Let me just pick up on a few countries for discussion. The PRC's economy is forecast to expand 9.6 percent in 2010, up by close to one percentage point from 2009. Aggressive fiscal and monetary stimulus is being adjusted, but will continue contributing to strong growth. And buoyant domestic demand will be backed by firmer external demand this year. The trade surplus will resume its upward trend. But as the stimulus policies are phased out, economic growth should ease to about 9.1 percent in 2011.

India will lead the South Asian subregion with projected growth of 8.2 percent this year. Its rebound a year earlier and continued strong expansion stem largely from domestic demand conditions.

Continued modest growth of 3.0 percent is expected in Pakistan this year. Macroeconomic imbalances have narrowed and economic fundamentals have improved, but the security environment and an ongoing power crisis are both a fiscal burden and obstructing a growth revival.

In Viet Nam, GDP growth is projected to accelerate to 6.5 percent in 2010 and 6.8 percent in 2011, although not to the rapid rates seen in 2001–07. Devaluation and inflation pressures built up in late 2009, in part because of economic stimulus policies. The authorities face a challenge in ratcheting up economic growth while safeguarding macroeconomic stability.

Economic activity in Indonesia is forecast to quicken this year to 5.5 percent and return to prerecession levels in 2011, based on strengthening domestic demand and supportive macroeconomic policies.

In Thailand, the pace of recovery is expected to be moderate in 2010, in light of political tensions that will likely cause some delays in a government infrastructure program.

Let me now move on to our inflation forecasts. As economic activity recovers, inflation will increase but will remain manageable. In the coming two years, we see the region's average inflation returning to the historical average of around 4 percent. Although consumer price inflation pressures are expected to be manageable, sharp increases in asset prices need to be monitored. Unusually easy monetary policies throughout the region cannot be kept for too long and there is a need to revert to a normal stance.

The region's current account surplus narrowed, for a second consecutive year in 2009, to an average 4.9 percent of GDP—a significant decline from the record peak of 6.5 percent in 2007. It is forecast to narrow further to 4.1 percent in 2010 and 3.6 percent in 2011, on the back of a slow pick up in external demand and strong domestic demand, particularly in the PRC.

While we are optimistic about the region's prospects, several downside risks could still derail the economic revival. The weakness in the US mortgage market continues to be a concern, particularly since the US recovery is still weak at this point. The withdrawal of monetary and fiscal stimulus in industrial countries may be mistimed, and this can disrupt the recovery in the region. As the Dubai and Greek crises highlight, rapidly deteriorating fiscal positions, if repeated in the industrialized countries, could have dire consequences for global financial stability.

A jump in commodity prices, meanwhile, could decelerate the impetus for growth. As the experience of the 2008 price spike demonstrates, rising food prices could lead commodity producers to halt exports in the name of food security, which would only exacerbate the problem.

The risk from global imbalances could also persist in the midterm, and this may be the harbinger of the next crisis. Coordinated policies are important for regulations to be effective, particularly among the G-20 group of countries so as to avoid "regulatory arbitrage." Multilateral cooperation is the key to protect global stability, and this is crucial to avoiding bilateral conflicts over exchange rate and trade issues. Overall, multilateral cooperation is more important than bilateral negotiations.

In addition, developing Asia's stronger recovery and higher interest rates relative to those in the major industrial countries are already attracting potentially volatile capital flows, which may trigger asset price bubbles and complicate macroeconomic policy management.

Let me briefly elaborate on a few of these risks. Delinquency rates on residential mortgages as well as on commercial real estate in the United States remain elevated. Bank balance sheets are suffering as a consequence. US residential property prices rebounded, but have picked up slowly from their 2009 trough. Nearly one-quarter of mortgaged properties in the United States still have loan balances that exceed their market values. The high unemployment rate also suggests that mortgage defaults may continue to rise. Under these circumstances, financial institutions may be hesitant to restart lending to businesses. Such an incomplete resumption of credit flows could further disrupt the real economy, weakening the prospects for recovery.

Capital flows in emerging Asian economies

Global current account imbalances narrowed during the crisis, but sustainability is uncertain. The US current account deficit narrowed significantly, matched by adjustments in surplus countries such as Japan, the Middle East, and the Russian Federation. But permanently reducing the current account imbalances requires structural adjustments, especially in saving and investment. This is a big challenge for Asian countries because a disruptive unwinding of global imbalances will create volatile capital flows and will hurt the region.

Another key challenge for developing Asia is how to deal with rising asset prices. On the back of expectations for robust economic recovery, asset prices, particularly of real estate, are showing a surge in some countries. There must be some speculative investments in the real estate sectors. We now see the big surge in the real estate markets of some Asian economies, such as the PRC and Hong Kong, China. House prices in Hong Kong have returned to precrisis levels. The PRC's house prices are showing an increasing trend over time, but recently there has been a big surge. For some regions, prices have increased more significantly, especially in coastal areas. Central banks in the region need to keep a close watch on developments in macroeconomic indicators and implement regulatory measures as soon as signs of a bubble emerge.

Behind this surge in asset prices are increasing capital flows into the region. The chart shows net inflows starting to rise again in the second half of 2009. Economies that have rebounded firmly are attracting investors with a rising risk appetite. In addition, continued low policy rates in the major industrial countries and greater market liquidity have prompted arbitrage flows due to large interest rate differentials and a resumption of some carry trades.

Of course, countries would prefer long-term, stable capital flows, because volatile short-term inflows can disrupt economic activity. Policy measures are therefore needed to guard against disruptive surges in capital inflows. Strengthening regulatory measures is one option. Greater exchange rate flexibility is another, as this will help mitigate the negative impact coming from huge capital inflows. Too much intervention in the foreign exchange market will lead to excessive liquidity in the domestic financial markets and create exchange rate misalignments. There is also room for applying macroprudential policies to deter the formation of asset and price bubbles. The possibility of carefully designed capital control measures to deter short-term disruptive inflows may also be considered by governments in the region.

There is no doubt that macroeconomic policies, especially the decisive fiscal and monetary response to the crisis, helped the region recover from the global crisis. But as we enter the postcrisis period, the environment has changed and, as I have outlined, we face a wide range of macroeconomic challenges. So now we ask the question: What role can fiscal and monetary policies play in coping? This is the issue we address in the ADO 2010 theme chapter.

III. Macroeconomic Management Beyond the Crisis

The chapter is called Macroeconomic Management Beyond the Crisis. It explores the critical issue of whether Asia should pursue fiscal and monetary activism in the postcrisis period or whether the region would be better served by simply resuming its basic macroeconomic framework of monetary and fiscal prudence.

Let me briefly summarize the main messages of this chapter. Governments across developing Asia quickly rolled out large fiscal and monetary stimulus packages during the crisis to fight the sharp downturn in economic activity. As the global crisis recedes and normalcy returns, we argue that developing Asia should reaffirm its commitment to the sound and responsible fiscal and monetary policies that fostered macroeconomic stability and sustained growth.

There is, however, plenty of scope, as it does so, to improve and strengthen monetary, exchange rate, and fiscal policies to better prepare the region for the postcrisis world.

Traditionally, the region's monetary policy focused on maintaining price stability. Compared to the 1990s, the region's strong growth rates in the 2000s took place in a relatively lower and more stable inflation environment. This is largely consistent with the present general consensus that high and volatile inflation tends to be detrimental to economic growth.

Various exchange rate regimes are in place in the region. Some are pegged to the US dollar; others are managed floats; while some are freely floating. When the global crisis struck, many of the region's currencies depreciated initially, but eventually appreciated as a result of the faster economic turnaround. The exceptions are the PRC and Hong Kong, China, where the currency is pegged to the US dollar.

On the fiscal side, public debt to GDP in Asia on average remains significantly below the ratio of the industrialized countries. Ample fiscal space, the consequence of a history of responsible fiscal behavior, helped Asia respond aggressively to the global crisis.

However, the region should not just go back to its precrisis monetary, exchange rate, and fiscal policies. Instead, given the potentially more challenging postcrisis global environment, it would do well to adjust macroeconomic policies to better adapt.

In particular, five key macroeconomic policy recommendations emerge from our study:

First, the global crisis underlines the huge risks of unsound monetary policy and inadequate financial regulation. Financial supervision and regulation need to be strengthened and there has to be closer coordination between monetary policy and financial regulation. This will allow Asia to better monitor and prevent asset price bubbles while maintaining the primary focus on goods price inflation.

Second, exchange rate policy must shift away from an excessive focus on export competitiveness. More flexible exchange rates driven by fundamentals provide a mechanism to absorb shocks, result in a more efficient allocation of resources, and promote the region's rebalancing process. Closer intra-Asian coordination on exchange rate policy will help to mitigate the fear of losing export competitiveness vis-à-vis neighboring economies, which has been a major barrier against greater exchange rate flexibility for the region as a whole.

Third, the region should reaffirm its tradition of sound fiscal policy in the postcrisis period to secure adequate fiscal space for future shocks. While maintaining fiscal discipline and sustainability, strengthening automatic stabilizers through better design and implementation can contribute to output stability and social protection.

Fourth, jointly pursuing fiscal and exchange rate policy reforms will magnify their impact on rebalancing. The big challenge for Asian countries is to strengthen domestic sources of growth. Though this requires structural adjustments, macroeconomic policies could help as well because fiscal measures such as public spending on health care and pensions can mitigate household uncertainty and boost consumption. Greater exchange rate flexibility will boost household purchasing power and allocate resources toward domestic industries.

Finally, policy coordination is extremely important. Some countries are reluctant to initiate a large appreciation in their currencies because they fear losing competitiveness in major export markets in favor of their neighbors. A concerted appreciation of regional currencies will help them overcome this fear. There are other issues that require global cooperation, such as reforming the global financial architecture and strengthening global financial regulation. These issues are better addressed in multilateral venues and Asia should play an important role in making a contribution to the global discussion.

That concludes my presentation. Thank you very much.


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Policy Brief 10-24: The Central Banker's Case for Doing More October 2010

Policy Brief 10-26: Currency Wars? November 2010

Testimony: Correcting the Chinese Exchange Rate September 15, 2010

Book: Debating China's Exchange Rate Policy April 2008

Policy Brief 07-4: Global Imbalances: Time for Action March 2007

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Working Paper 11-14: Renminbi Rules: The Conditional Imminence of the Reserve Currency Transition September 2011

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