Until September 2008, the Asia-Pacific region was showing reasonable, if moderating growth even as concerns about the global financial problem and its spill-over into macroeconomic performance intensified. During this period, there was some hope that regional momentum would continue, driven by domestic and intra-regional trade.
The two charts below display growth in exports and industrial production respectively in January-September 2008 over the corresponding period of 2007. The growth levels vary across countries but, for the most part, are positive. The charts also display the growth rates for these two monthly indicators over the subsequent period of, typically, two months. Keeping in mind the difficulties in comparing growth over periods of differing length,
the contrast between the two is quite striking.
In several countries, growth has turned negative during the latter period and in virtually all countries, it has decelerated sharply.
|Exhibit: Growth in Exports in 4Q08 compared with 1Q-3Q08 (y-o-y%)|
|Exhibit: Growth in Industrial Production in 4Q08 compared with 1Q-3Q08 (y-o-y%)|
For the Philippines and Thailand, the data point refers to the Value of Production index; for China it refers to the Value Added by Production index
September 2008 is viewed by many observers as a significant discontinuity in the evolving global scenario, mainly as a result of the collapse of Lehman Brothers and the impact that this had on both financial markets and consumer and investor expectations. This could well be the reason why the US and Europe decelerated sharply at this time and along with them, the Asia-Pacific region. However, when we look back at the dynamics in the region over the past several months, there is another possible explanation for the sharp dip in the fourth quarter of 2008.
Inflation has receded so sharply in recent months that the focus has now shifted to the potential for deflation. But, barely a few months ago, from about March to July 2008, inflation rates in the region were soaring to very uncomfortable levels. Although this was driven by commodity prices - food, minerals and energy - central banks responded by tightening monetary policy. This was due to concerns about the persistence of price shocks and the inflationary spiral that they could trigger. For about five months, policy rates and liquidity ratios were steadily increased, even as news about the global financial system became more and more negative. Inflation was seen as a more significant risk than recession.
It is widely perceived that monetary tightening has a lagging effect on the real economy. The lags may vary depending on circumstances, but a period of about six months is not unreasonable. By this measure, everything else remaining the same, we should have seen the first signs of the impact around September. Since the tightening continued until July or a bit after, we should expect its impact to persist until at least the first quarter of 2009. Therefore, even if we completely ignore the impact of the global situation, the region should have seen slower growth in the last quarter of 2008 and the first quarter of 2009 purely as a result of the monetary actions in the first half of 2008.
Now, add to this the impact of significant deceleration in the US and European economies and the sharp reversal in capital flows. These instantaneously reduce export activity as well as financial intermediation. Related activities, like logistics, also suffer.
In short, the sharp deceleration seen in the fourth quarter reflects a combination of the lag effect of earlier monetary tightening and the contemporaneous effect of a slowdown in exports and capital flows. The combined effect can, with high likelihood, be expected to persist into the next couple of quarters. After this, the massive monetary reversal outside and inside the region should begin to have its own lagging impact. This is the basis of the expectation that growth will begin to turn around in the second half of 2009.
Fiscal measures initiated by several governments across the region will reinforce the stimulus provided by central banks. Given that both these sets of policy instruments tend to favour domestic demand (for example construction activity), we would expect the relatively larger economies in the region to show earlier signs of a turnaround than those which are more significantly dependent on exports. These early signs will be reinforced by recoveries in the key export markets, as they begin to turn around in 2010 and beyond.
However, we should not ignore or underestimate the risks to this outlook. The entire turnaround scenario is based on the resumption of normal levels of credit flow. By this measure, Asia's financial systems are perhaps better placed than those in the west, as they are still dominated by banks, which, on the whole, have not seen the degree of erosion of capital that western banks have experienced. The capacity of Asian banks to resume lending is therefore reasonably intact.
However, rising uncertainties about performance, particularly of the export sectors, and declining consumer confidence, stemming from threats to incomes and jobs, put pressure on both the supply of and demand for credit. Until things change on this front, monetary stimuli will not be transmitted through the system, thereby proving ineffective in spurring a recovery. To increase their impact, governments have to find ways of both increasing confidence among borrowers and mitigating (implicitly or explicitly) the risks of lending. Loan guarantees is one way of doing this, provided they are accompanied by tight monitoring of borrowers. For many governments, though, the capabilities needed to manage these somewhat unconventional instruments effectively will be a constraint.
A second factor that needs to be kept in mind is that, even as macroeconomic indicators provide advance notice of a turnaround, various sectors and companies have been badly hurt by the developments of the past few months; the longer the negative momentum persists, the more damage will be done. A recovery needs businesses to expand production and capacity. However, if the damage has been extensive, their ability to take advantage of opportunities provided by low input prices, interest rates and favourable policy measures may be limited. The ability of an economy to recover will depend on its flexibility to quickly move resources across sectors and to companies that have the best chance of succeeding. The efficiency of domestic capital and labour markets will thus play a significant role in facilitating a recovery.
Third, it must be recognised that the combination of macroeconomic and financial shocks have used up much or all of the shock absorption capacity that economies have. Central banks can only bring their policy rates down so far and governments can only spend so much money. Foreign exchange reserves will help stave off balance of payment pressures, but do not contribute directly to growth. Our outlook for a turnaround in the second half of 2009 is, therefore, contingent on no further shocks hitting the global economy. Escalation of military conflict, a bad harvest, rising protectionism and worsening financial conditions are factors that could hinder the effectiveness of recent policy responses. If this happens, there is hardly any capacity left for further actions.
In sum, 2009 promises to be a mixed year, combining a very weak first half with a somewhat better second half. Strong policy actions, which take advantage of the benign inflationary scenario, are the main source of optimism. However, after several months of distress, the capacity of financial systems, companies and consumers to respond to the stimulus is going to be a key factor in initiating a turnaround. Also, most economies are simply not in a position to counter any further shocks.
Subir Gokarn is the chief economist for Asia-Pacific at Standard & Poor's.