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ViewpointSeptember 3 2012

Building on Asia's economic success

Asia has been a bastion of growth during the global financial crisis, but there are a number of key issues that must be addressed if the region is to continue being a major contributor to global economic growth.
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Building on Asia's economic success

Since the global financial crisis, Asia has served as a bulwark of economic and financial stability. Over the next couple of years the region is expected to continue to be one of the world’s primary engines of growth, amid the continuing weakening of a number of advanced economies. And although the region is exposed to considerable downside risks should the crisis in Europe deepen, many countries have ample policy space, and fundamentals are strong.

Nonetheless, Asia faces several medium-term challenges. Surmounting these successfully will be crucial to ensuring that the continent continues to be a world growth leader, thereby increasing its contribution to global economic activity. Of course, in a region as geographically vast and diverse as Asia, different countries face different circumstances and challenges. Nonetheless, some broad issues of significance to the whole region – and beyond – may be identified.

Progress has already been made in several of these areas, such as external rebalancing, regional integration and safeguarding financial stability. That said, a substantial reform agenda lies ahead.

Rebalancing act

Led by China, Asia’s current account surplus has declined considerably since its pre-crisis peak. This reflects many factors, such as the appreciation of Asian currencies, the robust import growth to satisfy strong domestic demand, and weak demand in advanced economy trading partners. Because global economic weakness has coincided with exchange rate appreciation, especially in China, it is difficult to assess to what extent the narrowing of current account surpluses represents a sustained shift, and hence an amelioration of structural global imbalances.

Moreover, in China, internal rebalancing has suffered a setback as excessively low consumption has weakened further since the beginning of the global financial crisis. Instead, domestic demand has been driven by strong investment, raising concerns about excess supply capacity, including in the export sector, and the quality of banks’ credit portfolios. To sustain the recent moderation in the current account surplus will require further flexibility of the renminbi to be accompanied by structural reforms to redress domestic imbalances.

The authorities have identified a broad range of measures in China's 12th Five-Year Plan, including enhancing and strengthening social safety nets, accelerating progress towards financial liberalisation, expanding the service sector and increasing household income. In the Association of South-east Asian Nation (Asean) economies, reductions of current account surpluses have also coincided with an increase in investment ratios, but this appears more sustainable in light of the negative investment gap separating them from other emerging markets.

Continuing to increase regional trade integration is essential to sustaining growth in Asia. Recent growth in intra-regional trade has been striking. While global trade and Asia’s trade with economies outside the region have both doubled since 2000, intra-Asian trade has tripled. Asian economies have formed a supply network, with China taking the role of an assembly hub for final goods exports, notably consumer goods.

The most immediate benefit of this increased trade integration in the region is the buffer it creates vis-à-vis a shock from Europe or the US. But, given the importance of vertical supply chain links with China, exports of other Asian countries to China will suffer if China’s exports continue to slow. By contrast, increasing direct and indirect access to Chinese consumer good markets could offer lasting benefits for Asian trading partners. So the benefits of regional trade integration are complementary to China’s success in internal rebalancing.

Increasing inflows

Foreign direct investment (FDI) is not only a relatively stable source of external financing, it also offers the most direct growth benefits. Asia’s record of attracting FDI has been patchy. In the run-up to the global financial crisis, FDI as a share of global domestic product expanded less quickly than portfolio and bank inflows, and it remains relatively low. This represents an untapped opportunity.

Greater FDI inflows – including intra-regional flows – could help reduce some of the persistent investment shortages in parts of the region, such as the Asean countries. In countries which urgently need infrastructure upgrades, in transport networks, power generation and myriad other areas, public-private partnerships could provide one avenue to attract FDI. Also, FDI could transfer valuable expertise and bring countries closer to the international technology frontier.

During recent episodes of global financial tension, capital has tended to flow into several advanced countries’ government securities. But the intervening periods of financial calm have typically been accompanied by strong portfolio flows to emerging markets, including Asian emerging market economies (EMEs). While these recent flows have been driven at least in part by the very low interest rate environment in advanced economies, from a long-run structural perspective, higher growth and better macroeconomic fundamentals in Asian EMEs relative to advanced countries are likely to continue to drive strong 'downhill' capital flows.

Strengthening regulatory defences

In principle, capital flows are beneficial to investors and recipients alike, reallocating capital to those areas and projects where the marginal product of capital is highest, and facilitating consumption smoothing and diversification of shocks. Nonetheless, there is ample recent evidence that some types of capital flows can exacerbate financial fragilities and boom-bust cycles, and Asian policy-makers should strive to minimise these risks. Greater exchange rate flexibility would help with managing inflows, by reducing investor perceptions of a one-way bet.

In addition, Asian economies should continue to strengthen their macro-prudential frameworks. Many of the prudential measures adopted in Asia since 2010 have been designed to reduce risks to financial stability, including from large capital inflows.

International experience suggests that strengthening the regulatory framework can play an important role in limiting adverse spillovers from an international liquidity crunch or other shock.

For example, in South Korea, a ceiling on the loan-to-deposit ratio has significantly reduced banks’ wholesale funding, while more stringent liquidity requirements and limits on foreign exchange exposures have prevented short-term debt from returning to 2008 levels. In New Zealand, the introduction of a core funding ratio has helped reduce banks’ reliance on short-term external funds. Australian banks have also reduced their short-term external borrowing, and early adoption of a requirement along the lines of the Basel III net stable funding ratio could reduce vulnerabilities further.

Naoyuki Shinohara is the deputy managing director of the International Monetary Fund

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