Asia is resilient amid global turbulence

Conflicting hypotheses of Asia's decoupling versus a severe negative impact on the region from a US slowdown will be put to the test over the next few quarters, argues Standard & Poor's.
As the turbulence in US financial markets took hold in 2007 and gave every indication of spilling over into a growth slowdown or even a recession, opinions about its impact on other parts of the world, particularly Asia, were divided. There was the ôdecouplingö school of thought, which argued that Asian growth momentum in recent years had diversified from the regionÆs dependence on exports to the US and that a US slowdown would not impact too badly. Others argued that while dependence on the US had certainly decreased, it was still very heavy for most of the regionÆs economies û particularly the smaller ones. So should a US slowdown occur, there would be a significant adverse impact in this region.

Now that expectations of a US recession have more or less been fulfilled, these conflicting hypotheses will be put to the test over the next few quarters. As the title of this article suggests, we are currently of the view that strong regional drivers will help to insulate Asia from the adverse impact of a moderate US recession. Here, we provide some evidence to support this view. However, this is not to say that the regional economies do not face significant risks to sustained growth and macroeconomic stability in the months ahead.

Asia-Pacific growth and inflation outlooks

Table 1 shows our growth and inflation outlooks for major economies in the region for 2008 and 2009. First, we see lower growth during 2008 and 2009 compared to the preceding two years û for all the countries. With reference to the point made above, virtually all these countries tightened monetary policy during 2005 and 2006 amid overheating concerns. Just as for the US, the outlook for these economies would, under normal circumstances, have been for slower growth during this year and next. However, the worsening outlook for the US in the wake of developments during 2007 has also contributed to lower growth expectations for the Asia-Pacific region.

Second, while Asia-Pacific growth rates will slow somewhat, the region will still grow at a relatively fast pace. Two of the three largest economies û China and India û are also the fastest growing and will continue to grow at about 8% (or above) over the next two years. This provides the region with enormous momentum. As will be demonstrated below, this momentum will help sustain a positive growth environment for Asia-Pacific as a whole. The ability of the regionÆs economies to insulate themselves against a US recession is enhanced by their ability to exploit the opportunities in the region through greater economic integration.

Third, the inflation outlooks for most of the regionÆs sovereigns are relatively benign in the baseline scenario. Inflation rates are expected to remain close to 2006 and 2007 levels. This is the expected outcome of the tight monetary policy stance that central banks in the region have typically maintained over the past two years. One factor in favour of the insulation view is that most of these economies now have the room to lower interest rates, thereby allowing rising domestic demand to substitute for slowing export growth. However, in recent weeks, the emergence of inflation as a significant threat across the region casts some doubt on this course of action. We will address this issue below.

An important factor in the regionÆs resilience is JapanÆs return to positive growth. Although JapanÆs growth is predicted to slow down compared with its 2%-plus rate of the last couple of years, the expectation is that growth will continue, even in a changed global scenario, reflecting the buoyancy that the faster-growing economies in the region brings to the neighbourhood. JapanÆs growth, in turn, reinforces the growth impulses in other countries in the region. The Asean countries, which are relatively more dependent on exports, are also expected to grow at respectable rates.A perspective on export diversification

Table 2 provides evidence in support of the view that the Asian economies ùthough still heavily export-oriented ù have diversified their exposures away from the US. The numbers show that growth in exports to the US slowed considerably during 2007 for virtually all the countries in the table. However, the picture for total exports was much more ambiguous.

For some countries, growth rates of aggregate exports during 2007 were reasonably close to the recent trend. For others, the slowdown in US imports adversely impacted aggregate performance. While the decomposition of exports to countries other than the US is not reported here, the evidence suggests that a significant proportion of the incremental export growth in the recent past comes from the neighbourhood.

There is a fairly obvious institutional context for the increasing integration in the neighbourhood. Asian countries have been extremely active in entering into trade and broader commercial agreements, both within and outside the region. By 2007, the countries listed in the table were signatories to more than 60 agreements, of which about 36 were with other countries on the list. And more are in the pipeline. Of course, some of these were essentially statements of intent, but the overall thrust of trade policy in the region is quite clear. The benefits of greater integration within the region are significant and cannot be subordinated to the larger, but far more elusive, objective of a global free-trade agreement. Fast-growing neighbours, particularly those whose growth is driven from within, offer enormous opportunities for all these countries and they are all trying their best to exploit those opportunities.

The risk
The above-mentioned evidence, and interpretations, was meant to justify the title of this article. Asia does have the ability to continue to grow quite strongly even when the rest of the global economy finds itself in some trouble. However, like all inferences, this one is also dependent on several crucial assumptions. If relatively benign assumptions turn sour, this could translate into a far worse outcome for the region than was suggested by the modest declines in growth rates noted in Table 1. Some of the key risks that the region faces are as follows:

A severe US recession
A prolonged slump in the US economy and the effect it will have on demand for imports, particularly of consumer goods from the region, will impact on wage incomes and investment activity in Asia. Producers can generally weather a short and shallow recession without either laying off too many people or drastically changing their medium-term capacity expansion plans. Both these stabilising influences will be vulnerable to a longer and deeper slump.

This has clearly emerged as the most significant threat to macroeconomic stability in the region. It is important to emphasise that the forces driving global inflation are not directly related to current US macroeconomic circumstances. Oil prices appear to have developed a dynamic of their own, becoming relatively insensitive to the global slowdown, which is a clear departure from past patterns. Commodity prices are surging for a number of reasons, not least the still-buoyant demand in Asia and particularly in China.

Food prices have been increasing over the past couple of years, driven by a wide range of factors. In fact, high energy prices have contributed to rising food prices in two very direct ways û diversion of consumable crops to bio-fuels and higher fertiliser prices resulting in lower utilisation and declining yields. Adverse weather conditions in some major food-producing regions are also contributing to the pressure.

Apart from the political implications of food-price inflation in many countries in the region, the immediate macroeconomic consequence is that it limits the central banks' ability to ease monetary policy. Since rate cuts have been cited as an important means of offsetting the potential decline in exports to the US, the inability to use them to the full will inevitably weaken the regionÆs capacity to insulate itself from the broader global downturn.

Asian economies are buoyed by the performance of the region. There has been a noticeable convergence in their macroeconomic and trade policies, as they all attempt to derive the full value of their neighboursÆ collective performance. From a short term perspective, growing integration is contributing to the regionÆs ability to insulate itself from macroeconomic turbulence in the US. Notwithstanding this, however, there are some visible threats to the region in the form of food and energy prices, which may adversely affect performance over the next couple of years. Managing these risks will be the most important challenge facing policymakers across the region as they try and sustain their own performance while moving towards greater integration.

This article was written by Subir Gokarn, chief economist at Standard & Poor's, Asia Pacific.
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