Dark clouds over the drivers of Asian economic dynamism

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.