Dark clouds over the drivers of Asian economic dynamism

Ifzal Ali, Jakarta

The economies of developing Asia are expected to grow 7 percent this year equaling their performance in 2000, which saw their fastest growth since the Asian financial crisis. Growth has been strong in all subregions, and particularly solid in East and Southeast Asia. Is this pace sustainable?

Three factors drive Asia's growth: Exports to industrial countries, growing intraregional trade, and, increasingly, consumer demand. Major clouds are forming over each of these drivers.

At the global, regional, and domestic levels serious risks are emerging. These risks, which are likely to strengthen over the next two years, pose a clear and present danger to developing Asia's economic dynamism. The era of high GDP growth rates, low interest and inflation rates, and strictly managed exchange rates could be ending.

The first risk lies in key macroeconomic imbalances, in particular, the unresolved budget and current account deficits in the United States. The persistence of these deficits could trigger sharp increases in interest rates and a considerable depreciation of the U.S. dollar.

Growth in industrial countries would slow significantly, leading to a drop in exports from Asian economies. Interest rates in developing Asia would respond to short-term U.S. interest rates in a sharply positive manner. Rising rates would hurt domestic demand across the region.

The second risk lies in China. In the past two years, China has emerged as a major engine of intraregional trade. Developing Asia's exports to China have soared at an average annual rate of 30 percent.

Economies in East and Southeast Asia have been prime beneficiaries. A pronounced slowdown in China would affect countries differently depending on the nature of the slowdown, the characteristics of each trading partner, and its trade relationship with China.

If efforts to halve growth in fixed asset investment result in a slowdown in China's growth rate of two percentage points, GDP growth rates in developing Asian economies would fall 0.2-0.5 percentage point. Hong Kong would slow about one percentage point.

Pair softer growth in China with a simultaneous slowdown of two percentage points in the U.S. and one percentage point in Japan, and developing Asian economies, excluding Hong Kong, could see growth drop a significant 0.5-1.0 percentage point.

These possible outcomes highlight the need in many developing Asian countries to consider medium-term policies aimed at expanding the role of consumer demand in sustaining growth.

Consumer demand is increasingly important across Asia. Its rising profile has been supported in most countries by expansionary fiscal policies and a low interest rate environment associated with accommodative monetary policies.

Some danger signals are emerging. In the past two years, a sharp increase in household debt and a consumer debt crisis in South Korea have eroded consumer confidence significantly. In 2004, the Bank of Thailand tightened credit card regulations to preclude a Korea-style crisis.

Consumer demand in developing Asia remains vulnerable to higher interest rates. The continuation of macroeconomic imbalances in the U.S., the likelihood of much higher U.S. interest rates and the responsiveness of local interest rates in Asia require close attention. Inflationary pressures aggravated by the spike in oil prices have also emerged in the first three quarters of 2004 and central banks are tightening monetary policy.

Imaginative and bold policy responses will be needed to maintain growth amid a pick-up in inflation, weaker external trade prospects, and the need for some tightening of macroeconomic policies.

At the macro level, action is possible in three areasfiscal, monetary, and exchange rate policy. Given the burgeoning fiscal deficits in many Asian countries, expansionary fiscal policy is not feasible. Growing inflationary pressures preclude further accommodation in monetary policy. In many economies, exchange rate policy is ripe for change.

Policy makers in developing Asia have limited their access to macroeconomic instruments through their decision to limit exchange rate movements within narrow or no bounds. In the context of rapidly growing international reserves, this policy could lead to asset price bubbles, abruptly rising interest rates and sharp macro adjustments.

In addition, the balance sheets of central banks are carrying low-yielding U.S. treasuries and high-yielding domestic debt sold to the public resulting in significant financial and opportunity costs. A sharp depreciation of the U.S. dollar would magnify losses manifold.

Developing Asian governments hold about US$1.5 trillion in international reserves. These need to be put to better use. More flexible exchange rates would insulate the economies of developing Asia from imported cost push inflation from factors like higher oil prices, dampen increases in local interest rates, and contribute to alleviating global macroeconomic imbalances. Firms in developing Asia should secure their competitiveness through improvements in productivity and innovation, rather than relying on weak currencies.

As clouds gather over Asian economies, policy makers must consider new policy instruments -- including new exchange rate policies -- that would enable Asia to hold its place as the world's most dynamic region.

The writer is Chief Economist at the Manila-based Asian Development Bank. This is his personal view.