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Asia: A Bright Outlook, with Some Clouds on the Horizon

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
March 2006
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Asia is a vital and vibrant part of the world economy. In terms of purchasing power parity, it includes three (China, Japan, and India) of the world’s four largest economies, accounting for one-fourth of global output. And its importance is increasing, because Asia also boasts two of the world’s fastest-growing countries: China, which has averaged 10 percent annual growth in the past decade, and India, where annual growth has been running above 7 percent since 2003. This article examines the region’s economic outlook for 2006 and the policy challenges ahead. Specifically, it weighs the implications of growing competition in electronics.

This year is expected to be another good one for Asia, with growth remaining robust and inflation generally subdued, though the outlook is clouded by risks and policy challenges. Projected growth for the region in 2006 is expected to be revised upward when the Fund’s World Economic Outlook is released in mid-April. This bright outlook derives in large part from the momentum that Asia has gathered in recent quarters, notably from the entrenchment of Japan’s recovery and a stronger and lengthier upswing in the global electronics export cycle than had been expected.

Prospects for growth have improved in nearly all parts of the region. Better growth is expected in the industrial countries, mainly because Japan’s recovery (led by buoyant domestic demand) is proving to be unexpectedly vigorous. In fact, Japan’s growth in the fourth quarter of 2005—at 5½ percent (seasonally adjusted annual rate)—was the strongest since 1991. Meanwhile, emerging Asia should continue to grow rapidly, led as before by China and India.

The external environment also appears set to remain strong. The U.S. economy may be slowing somewhat, but this slowdown should be offset by more rapid growth elsewhere, notably in Europe. Meanwhile, global capital expenditure is accelerating, boding well for the electronics sector, which accounts for about one-third of the region’s exports. Shifts within the electronics sector, however, could have implications for growth within the region (see box, page 71).

Emerging Asia’s exports will also be affected by several major developments within Asia. Regional trade, spurred by a resurgence in the rapid growth of China’s imports, is picking up. At the same time, regional currencies have appreciated in real terms against the yen, by some 20 percent over the course of 2005. The impact of this appreciation may be muted, however. Few Asian countries other than Korea compete directly with Japan, and any effect on export prices may be offset by reduced costs, especially for imports of Japanese capital equipment.

Emerging Asia refers to China, India, the newly industrialized economies (Hong Kong SAR, Korea, Singapore, and Taiwan Province of China), and the ASEAN-4 (Indonesia, Malaysia, the Philippines, and Thailand). Industrial Asia refers to Japan, Australia, and New Zealand.

Test for monetary policy

Despite this generally bright outlook, the region faces a number of policy challenges. In particular, the doubling of world oil prices since December 2003 has posed a dilemma for some countries whose domestic fuel prices have long been controlled. Recently, each of the ASEAN-4 countries raised domestic oil prices—most sharply in Indonesia, where gasoline prices increased by nearly 90 percent on October 1. Oil prices were also significantly increased in Malaysia and fully liberalized in Thailand (they have long been free in the Philippines).

These bold price adjustments, however, now complicate monetary policy. For some time, the authorities in many Asian countries have maintained interest rates at historically low levels to spur generally weak domestic demand. This stance—made possible by low inflation—is now facing mounting pressure. Although inflation in Asia as a whole is expected to remain subdued, reduced oil subsidies in the ASEAN-4 countries have propelled average headline inflation to 10 percent and underlying inflation to nearly 6 percent. Central banks in these countries have responded aggressively, raising policy rates by 170 basis points between May 2004 and January 2006.

These actions are already paying significant dividends. For example, in Indonesia, the reduction in oil subsidies, coupled with an aggressive rise in interest rates, has led to a sharp improvement in investor confidence, with the exchange rate appreciating by 10 percent against the U.S. dollar since September 2005 and the stock market rising by 18 percent. Similarly, in the Philippines, monetary tightening—together with strenuous revenue efforts, including an extension and rate increase in the value-added tax—has caused spreads on the country’s U.S. dollar bonds to fall below 300 basis points for the first time in years.

As this monetary tightening takes hold, however, Asian countries will face the renewed challenge of reviving weak domestic demand—an important source of the region’s $350 billion current account surplus. This surplus has been stable in dollar terms in recent years and is expected to remain so in 2006 but with significant changes in composition. In most of the region, surpluses have been shrinking as oil import bills have increased—notably in Japan and India, where domestic demand has also strengthened considerably. At the same time, China’s surplus doubled, to about $160 billion (7 percent of GDP) in 2005, as exports boomed while imports stagnated for a time. This year, however, these trends should halt; in fact, China’s surplus has already started to stabilize.

ASEAN-4’s electronics exports face growing competition

Electronics exports are a mainstay of ASEAN-4 economies. In the recent upturn of the electronics cycle, however, exports from some of these countries have lagged behind the regional export recovery. In 2005, this was especially evident in Indonesia (where electronics exports contracted toward the end of the year) and the Philippines (where they remained flat). Has the electronics sector in both countries become less competitive? The situation is of particular concern in the Philippines, where electronics account for over two-thirds of total exports.

These developments, by themselves, are not conclusive evidence of an emerging problem. Electronics exports from the Philippines, and to a lesser extent from Indonesia, have not always been closely linked with the global electronics cycle. Indeed, there are early signs that the Philippines’ electronics exports may finally be accelerating.

Other indicators, however, suggest that regional and technological factors are, indeed, posing a challenge for the ASEAN-4. At the regional level, the emergence of China as a location for electronics manufacturing has diverted investment in new capacity from Southeast Asia. Investment in new fabrication plants in China shot up to $16 billion over the period 2001-04, whereas investment in Southeast Asia fell to just $5 billion, with an even sharper decline in Taiwan Province of China.

This regional factor is compounded by the rapid pace of technological innovation. For example, the ASEAN-4 electronics sector tends to be heavily geared toward the production of hard drives, which, over the medium term, may be increasingly replaced with flash memory. Indeed, Apple Computer recently decided to replace hard drives in the latest generation of iPods with flash memory, a shift that will benefit primarily Japan, Korea, Taiwan Province of China, and the United States. As the capacity of flash memory evolves further, hard drives may become increasingly relegated to more mature products (such as servers), in which market growth will be slower.

Vital role

For a number of countries in emerging Asia, electronics make up a significant part of overall exports.

(percent of total exports1)

1Average of January 2003-September 2005.

2Newly industrialized economies.

Data: CEIC Data Company Ltd. and IMF staff calculations.

Over the medium term, each country could address these challenges by building on its competitive advantages. Thailand is an important producer of hard drives, for which demand may gradually wane. But it will benefit from the emergence of its automotive sector, which produces mainly Japanese cars for export to the rest of ASEAN. Meanwhile, Malaysia’s competitive edge lies in the shorter delivery times that its infrastructure allows. This advantage may erode over time as China’s infrastructure continues to improve. Indonesia benefits from low wage costs, but weak investment in the export sector since the Asian crisis may signal a longer-term structural problem. Finally, the Philippines benefits from its English-speaking labor force, but investment has been weak, and three electronics multinationals announced last year that they were moving production elsewhere in the region.

Faced with rising prices and generally weak domestic demand, many countries have scaled back foreign exchange intervention, allowing their currencies to appreciate to help reduce upward price pressures and boost real household incomes. During the second half of 2005, reserve accumulation outside China amounted to just $5 billion, compared with about $40 billion in the first half. And, between end-November and end-January, when there was a renewed surge in capital inflows, the region’s flexible currencies (apart from those of China, Hong Kong SAR, and Malaysia) appreciated by 5 percent against the U.S. dollar. In contrast, in China, reserve growth remained approximately unchanged at about $100 billion in the second half of 2005, with a decline in capital inflows offsetting the widening of the current account surplus.

In the months to come, the region faces several risks. First, oil prices could surge again, because the margin of excess oil production capacity is low and is likely to remain so for some time. Also, with the U.S. labor market tightening, inflationary pressures in the United States could rise, leading the Federal Reserve to raise interest rates by more than expected, dampening U.S. growth and triggering a widening of emerging market spreads. In addition, there is the threat of an avian flu pandemic, which could adversely affect global growth and financial conditions. Finally, there remains a danger of a disorderly adjustment to global current account imbalances.

IMF Asia and Pacific Department

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