As the picture of a US economy in decline has emerged with ever more shocking clarity over the past two years, talk among many observers has remained one of almost resolute confidence for emerging Asia: the region will escape relatively unscathed, the story went, thanks largely to its own drivers of growth – robust intra-regional trade and booming domestic demand.
“Domestic demand in developing Asia is still very strong,’ ADB president Haruhiko Kuroda told Emerging Markets in March, while Deutsche Bank chairman Joseph Ackermann noted in the same month that “the resilience evident in emerging markets will help to underpin broader global growth this year.”
But then came an IMF report in April which torpedoed the consensus view with startling force. “Asia has not de-linked and spillovers [from turmoil and recession elsewhere] could be significant,” the IMF declared in its latest report on the Regional Economic Outlook for Asia and the Pacific. The paper urged financial and monetary authorities in the region to make contingency plans for dealing with the fallout ahead.
For emerging Asia, “growth prospects remain dependent on how resilient the region’s financial systems and economies are to the ongoing financial market dislocation and the associated slowdown in the advanced economies,” the IMF said.
While forecasting a 1.25% drop in overall Asian growth to 6.2% in 2008, the IMF says that risks to the outlook remain firmly on the downside. Chief among these is a further credit market-led deterioration of global financial conditions, the Fund said. “While foreign demand for Asian exports would be lower in such a scenario, it is likely that the financial channel would be more virulent and complicated.”
Moreover, in the past decades correlations between Asia and the G3 have, if anything, strengthened, and the potential effects of developed market shocks have become more pronounced, according to an Asian Development Bank study. A 1% fall in US output for two years coupled with a 10% drop in the US dollar against Asian currencies would mean a 2% drop in growth for Asia for two years. Factor in a more severe US recession and the picture gets steadily worse.
“The risks as I see them are very much on the downside,” Bill Rhodes, senior vice chairman at Citi tells Emerging Markets. “This is not just because of US developments, but also because of the range of uncertainties on the international economic landscape, from potential geopolitical developments that could, for example, push oil prices higher, to further concerns in the financial sector.”
Even though economic activity across Asia Pacific remains fairly buoyant and domestic demand is still holding up, exports and other key activity indicators in recent months suggest that momentum is easing. Confidence indicators also point to a slowing pace of activity. One reason why Asian economies have remained buoyant so far despite a slowdown in US demand has been their increased focus on non-traditional export markets in Latin America, eastern Europe and the Middle East. But the IMF believes these regions to have still to feel the full impact of the slowdown in the US and in Europe.
The China factor
The other reason Asia’s economies are holding up is China – its key intra-regional trading partner and, according to the World Bank, the “independent growth pole” for the region. Yet for optimists’ faith in the world economy to be born out, offsetting any slowdown in US demand requires fast growth in demand in the rest of the world. Countries – most significantly China – will have to consume more, and fast.
In an interview with Emerging Markets, China’s central bank governor Zhou Xiaochuan says that while it’s too early to tell what the full impact of a US downturn will be on China, domestic consumption could help act as a buffer against waning Western demand and declining exports.
“Over the past three years China has seen an expansion of internal demand, especially consumption, which has made Chinese economic growth depend less on exports and more on internal demand,” Zhou says.
China has yet to register a decline in exports to the US, although the rate export is beginning to slow, he points out. “Up to now the reality of the negative impact on Chinese exports has been less than predicted. So if we look at exports to the US from China we could see them still growing, though at a low rate. We haven’t yet found it declining,” Zhou says.
Spillovers into Asia from previous slowdowns in the US economy have been moderate. But there are reasons to believe that the current US slowdown could have a significantly larger impact. The IMF suggests there is evidence that spillovers from the US, in particular to China, have risen in recent years and that financial contagion and global confidence effects could raise significantly the impact of such overruns.
Zhou acknowledges that – in terms of the global fallout of a US recession - the impact on Chinese exports is key. “Certainly we are following closely this very important factor which will have an impact on the Chinese economy, especially in external trade.
“But there is also some uncertainty – you have to use probabilities to describe the different scenarios,” he says. “[We call for] policy coordination globally to help the world economy get rid of too many troubles.”
Yet as economists such as Harvard’s Ken Rogoff have pointed out, there are plenty of reasons to be concerned about medium term prospects for China’s economy. Rogoff reckons the chances of a major recession in China “at least one year of sub-6% growth – during the next couple of years are 50:50.”
“If China were to slow dramatically, while growth in Europe and the US was still weak, recent low global interest rates, high commodity prices and strong global growth would be history,” he wrote recently.
Inflation’s reprise
Falling export demand combined with spiking inflation and “notable backpedalling on market reforms” could mix to form a lethal cocktail for the Chinese economy, this year and beyond, Rogoff said.
Inflation is fast becoming the primary concern for policy-makers not just in China but across the region. Increased domestic demand, combined with rising food and energy prices, has piled on price pressures while undervalued currencies have caused a massive build-up of reserves which has in turn poured fuel on an inflationary spiral that is already gripping many emerging economies, including China. On top of this, rising commodity, energy and food prices and a falling dollar - to which many emerging market currencies are effectively pegged – have all opened the door to inflation’s sinister return.
“The external environment has changed very significantly,” Thailand’s central bank governor Tarisa Watanagase tells Emerging Markets in an interview. “A couple of years ago [people] were saying inflation is history, largely because of China. But now it’s back.”
China, like much of Asia, is balancing the threat of a slump caused by weaker global demand for exports against the risk of spiraling prices stoking public discontent.
Although a slower US economy may ease some of the price pressures due to lower external demand, but expensive food and fuel looks increasingly like a structural phenomenon.
ADB president Kuroda tells Emerging Markets: “I am more concerned about inflationary pressures in some countries in Asia.” And as ADB chief economist Ifzal Ali puts it: “This is a far more important issue than the threat of recession.”
Food and other commodity price inflation is seen not just as a threat to economic growth in Asia and other developing regions but also as a possible cause of social instability. Surging food prices could provoke ‘major incidents’ in the developing world unless the problem is tackled quickly and effectively, France’s development minister Alain Joyandet warned in Tokyo during a meeting of G8 development ministers in April.
“What I think we have to be very careful about is not to dismiss the increase in food and primary commodity prices as just a flash in the pan,” the ADB’s Ali tells Emerging Markets. “A major structural shift is taking place. Owing to global warming, the growing season in developing countries has probably shrunk. Canadian and American farmers are probably the biggest beneficiaries” but the developing world is a net loser, he says.
“All the work that we have done suggests that if food prices keep growing at 5-6% a year, that will reduce the mean incomes of the bottom 40% of households” in Asia. “It will increase inequality and the incidence of poverty will go up. Rising inflation - food prices in particular - represent the most regressive impact in incomes because top income groups spend much less on food relatively than do lower income groups . This is already beginning to have major social and political ramifications,” says Ali.
Asia’s ‘inflation spiral’ is being brought about not just by food and fuel prices but by multiple upward pressures on prices compounded by supply constraints, the ADB says. Infrastructure bottlenecks and skill shortages arising from rapid growth are forcing up prices and wages. At the same time, money supply is expanding beyond central bank targets in some countries because of burgeoning current account surpluses and the accumulation of foreign reserves.
Despite administrative measures and subsidies designed to rein in prices, inflation is expected to spike in 2008 and could hit a decade-long regional high. Region-wide, inflation is expected to rise to 5.1% on average in 2008 and subside to 4.6%t in 2009. Price increases will be highest in Central Asia, where they will remain in double digits, the ADB predicted. Inflation is running at an 11-year high in China and is also a threat to other countries, such as Vietnam.
Warnings on inflation were sounded also by the World Bank. Headline inflation is now running at more than 15% a year in Vietnam and has reached 9% in China and 11% in Cambodia, it notes.