(CPV)- The subsection traces the impacts of the economic slump in industrial countries on Asia’s regional economies in 2008 and 2009, based on the Oxford Economics (OE) global model. The OE updates projections for key economic variables for selected industrial and developing economies on a monthly basis. For purpose of analyzing the impacts of a more severe global slowdown, the October 2008 model release was used.
The model includes 10 developing Asian economies, namely, PRC; Hong Kong, China; India; Indonesia; Korea; Malaysia; Philippines; Singapore; Taipei, China; and Thailand. The key assumptions in the analysis are the central bank adopts an inflation targeting framework so that the short-term policy interest rate will be adjusted in response to inflationary pressure; the exchange rate is flexible; and the real wage is rigid in the short run, so that involuntary unemployment is possible when output falls. Simulations are conducted by assuming that economic growth in France, Germany, Italy, Japan, Spain, UK, and US would be lower than the baseline projections provided by the OE global model. Three scenarios of GDP growth in these countries are considered GDP growth in these countries would decline from the baseline projection by one-half of a percentage point in the second half of 2008 through the end of 2009; by one percentage point; and by two percentage points.
A moderates slowdown in the industrial world reduces growth in developing Asia by one-tenth of a percentage point in 2008 and four-tenths of a percentage point in 2009. The region’s heavy reliance on exports to support growth is largely responsible for the adverse impact.
Reduced import demand from developing Asia. Export growth in the region falls by an average of six-tenths of a percentage point in 2008 and nine-tenths of a percentage point in 2009. This negative impact is amplified by the fact that weaker final demand for the region’s exports translates into slower intraregional exports, which is largely driven by trade in parts and components within the region’s vertical supply chains. As a result, growth in imports of Asia is weakened.
Singapore suffers the heaviest economic blow, with GDP growth easing by two-tenths and eight-tenths of a percentage point in 2008 and 2009, respectively, on account of sluggishness in exports and private consumption. The PRC sustains the largest cutback in its exports, as growth is clipped by seven-tenths of percentage point in the first year and 1.0 percentage point in the second, slashing economic expansion by two-tenths and six-tenths of a percentage point, respectively, in 2008 and 2009. The PRC’s massive dependence on external demand accounts for the hefty decline in GDP growth.
Slower demand for the region’s export reduces the region’s current account surplus and damps investment spending and industrial production. As a result, unemployment rises and income fall. Personal spending and import demand drop. Slumping demand then eases price pressures and reduces inflation.
A sharp slowdown in Japan, UK, US, and major eurozone economies results in more adverse effects on developing Asian economies. Regional expansion slows by three-tenths and nine-tenths of a percentage point 2008 and 2009, respectively. Export growth tumbles, leading to a deterioration of the region’s current account balance. Industrial production slackens and unemployment increases. Regional incomes decline.
A deeper downturn in industrial countries dents developing Asia’s growth by a still larger magnitude. Regional GDP growth slips by six-tenths of a percentage point and 1.7 percentage points in the 2 years under consideration. The stimulations show that in 2009, Singapore’s expansion will be knocked down by 3 percentage points as exports plunge. The PRC’s growth will likewise be slashed further as its export sector takes a beating from lower industrial country demand.
The results of these three scenarios are based on the assumption that interest and exchange rates are not allowed to adjust. However, if a real depreciation in developing Asian currencies occurs in tandem with the global slowdown, the negative impacts on regional economies will be mitigated. Depreciating currencies effectively lower the price of developing Asia’s exports, boosting demand from other trading partners, and limiting the adverse effects on export growth.
Local currency depreciations also accelerate price pressures, lifting inflation rates across the region. If nominal interest rates are held fixed at baseline, levels, rising prices reduce real interest rates, encouraging investment and consumption. The overall impact on the region is therefore positive.
However, if in addition to the real depreciation of Asia currencies, interest rates are allowed to adjust, intensifying price stresses call for nominal interest rate hikes. With interest rates generally rising by more than the increase in prices, positive real interest rate change ensue, crimping domestic demand. The positive GDP outcome thus turns out to be smaller under the flexible interest rate scenario than in the fixed.
Recent development, however, indicate a tendency for central banks to be more accommodative in their monetary policies than suggested in the OE global model, particularly since inflationary pressures from high food and fuel prices have eased in some countries.
In early October, the central banks of Canada, Switzerland, Sweden, UK, US, and eurozone cut policy rates by 50 bps; of Australia by 100 bps; Hong Kong, China by 150 bps; of the PRC by 27 bps; and of Korea and Taipei, China by 25 bps.
Canada and Sweden have reduced policy rates further and a few other countries such as India, New Zealand, and Vietnam have joined the interest-cutting bandwagon. These decisions aim to unfreeze money markets and restore credit access to the financial sector and to the real economy.
Indonesia, meantime, raised its policy rate by 25 bps as domestic inflation seemed to be accelerating in September. A few other regional economies are still suffering from double-digit inflation rates. Where inflation remain high, monetary policy should be kept tight. If current interest rates are fixed until end-2008, or cuts are implemented through 2009, prospects for developing Asia are set to improve.
However, if inflationary pressures persist as high production costs are passed on to consumers, growth prospects for the region could deterioration further.
Note, however, that the results presented above have not considered government responses that have recently been announced to boost growth and ease liquidity and credit constraints. This is because there is incomplete information as to how these stimulus packages would actually be implemented .
A major implication of this shortcoming is that the resulting impacts of the various scenarios on developing Asia could be based downward, and that outcomes could turn out better for the region.
Nonetheless, forecasts of growth in developing Asia in 2008 and 2009 have been sharply downgraded as the severity of the recession in the industrial economies has worsened. Hence, we are more concerned that growth could weaken even more than is implied in these scenarios and could remain well below recent growth rates for a prolonged period.
As the global financial crisis continues to unfold, there is increasing uncertainty about the eventual duration of the global slowdown. The 3 scenarios presented earlier assumed the global downturn would last for 18 months.
However, there is a possibility that the slump may extend to 24 months. Under such a scenario, Asia’s growth prospects would be hammered through 2010. A slowdown in industrial countries that would stretch through the first half of 2010 would further batter regional exports, reduce growth, and clip domestic demand. On the whole, a deep and prolonged global downturn would have severe ramifications for developing Asia’s growth prospects.
To sum up, impacts of the global financial turmoil, is affecting the real economy in Asia. However, the evidence of a significant decline in equity and offshore bond markets, and a reduction of net capital inflows in many Asian countries points to additional risks to the real economy that could occur from prolonged global financial turmoil.
Consumption and investment began to deteriorate from illiquidity of the banking sector, an increase in the cost of capital, and a reduction in household wealth. This situation needs to be watched closely, especially in countries with high current account and government budget deficits a tightening credit conditions.
Under such circumstances, a country faces the risk of sudden reversal of capital flows and a limited capacity of government in implementing expansionary fiscal and monetary policy in order to neutralize the contraction in aggregate demand.
Key lessons for Asia:
A number of key lessons for developing Asia emerge from our analysis. Some of those pertain to the short term while others pertain to the medium and long term. In the short term, given the fragile state of public confidence in the region’s financial system, it is critical for the monetary authorities to do everything within their power to support their financial institutions.
In the current environment of tension and uncertainty, the fall of one bank could easily entail domino effects that would bring down the whole banking system. Injecting liquidity into the financial system, relaxing the terms of access to the discount window, and expanding deposit insurance are some specific measures the region’s monetary authorities can take to bolster public confidence.
In fact, many of them have already begun to take such policies. Since lack of confidence in the financial system is in no small part due to lack of information, authorities should also encourage their financial institutions to become more transparent.
In the short run, it is also important for the region’s governments to support their real economies through expansionary monetary and fiscal policies. Encouragingly, many of them have already begun to cut interest rates and boost public spending in an effort to lessen the severity of the slowdown and speed up the recovery of their economies.
In addition, maintaining an open international trading system is crucially important for developing Asia. Strong efforts to resist calls for increased protection and to move ahead with global trade negotiations in the World Trade Organisation will help in this vein.
In the medium and long term, the US subprime crisis highlights the need for Asian countries to continue and build upon the postcrisis structural reforms of their financial sectors, including further strengthening of their regulatory infrastructures.
While those reforms have helped to protect the region from the global financial meltdown this time, the more general lesson for Asia is that even financially advanced economies are susceptible to risks arising from lax regulation and reckless lending. It is also important that the region’s policymakers do not draw the wrong lessons from the current crisis.
In particular, it is not financial innovation per se that precipitated the crisis but rather the failure of prudential regulation to stay on top of innovation.
Finally, in the long term, the unsustainable nature of the global current account imbalances that have contributed to this crisis has some implications about Asia’s economic growth strategy. In particular, it suggests that Asia may have an enlightened self-interest in modifying its growth strategy toward a greater reliance on domestic demand.