I am in Asia this week to launch our October 2010 Regional Economic Outlook: Asia and Pacific (REO) in Jakarta and Singapore. As I have inevitably found during visits to Asia over so many years, the mood here is confident about future economic prospects. Yet it is also watchful for risks that may be lurking over the horizon. This mood matches closely the main messages of our current assessment of the outlook for the region.
Skillful policy management
A self-sustaining recovery is now under way across Asia, with policymakers in the region having skillfully and effectively managed their response to the global downturn. Almost all regional economies grew above trend in the first half of 2010—even those that suffered the most pronounced downturns. Three factors helped the recovery: a rebound in global manufacturing and trade; policy stimulus; and, importantly, a recovery in private domestic demand.
The recovery in private domestic demand should help to sustain strong growth in Asia even after the global inventory cycle has run its course. We expect gross domestic product in Asia to grow by about 8 percent in 2010, nearly a full percentage point higher than we expected six months ago. Growth should then moderate to a more sustainable, but still healthy, 7 percent in 2011.
External risk factors
The external environment appears to be the main risk for Asia. If the recovery, and hence demand, in advanced economies were to falter, this could once again reverberate through the supply chain in Asia. A financial shock in advanced economies, such as funding shortfalls at a systemic institution or further concerns about sovereign creditworthiness, could spread quickly through financial markets and into the real economy. It would also cause capital flows to be more volatile, which tends to have a negative impact on domestic demand in Asia.
Managing capital inflows
But, for now, the pressing issue for Asian policymakers is how to manage the tide of large capital inflows. For example, here in Indonesia, inflows over the past year have been extremely large, especially relative to the size of the local financial markets. And Indonesia is not alone. Capital is flowing to economies all over Asia in large part because of the favorable growth prospects here. And Asia’s appeal will remain very strong as long as advanced economies remain sluggish, and their interest rates low and monetary conditions accommodative.
How, then, to react to what some have called a “wall of money” that could be heading Asia’s way?
Managing capital inflows is a difficult challenge. These inflows present many opportunities, but they can also pose potential risks. To limit the buildup of financial vulnerabilities, several Asian economies have taken macro-prudential measures—that is, measures that ensure not just the safety and soundness of individual financial institutions, the entire financial system and its macroeconomic impact. But ultimately, capital inflows will likely prove persistent and our sense is that broader actions will be needed.
Time to normalize policies
Indeed, the time has come to normalize fiscal and monetary stances, particularly as Asia’s recovery is now well established. Although many central banks have raised policy rates, monetary policy in the region generally remains accommodative. With output gaps closing rapidly, core inflationary pressures have begun to assert themselves. While capital inflows can be a complicating factor, monetary tightening has an important role to play in managing the influx of liquidity associated with those inflows, particularly given prospects for monetary easing in advanced economies and the limited flexibility of exchange rates here. The withdrawal of fiscal stimulus also remains gradual for the most part, and it is appropriate now to accelerate the pace of consolidation. Stronger currencies will be needed as part of the policy tightening. As I have argued before, currency appreciation is also needed in many economies as part of the policy package for rebalancing growth.
Even as we marvel at Asia’s success in bouncing back from the worst global recession in seven decades, it is always too early to say “mission accomplished” when it comes to economic policy. Now is the time to push ahead further with measures that will help economies to rebalance and sustain strong growth in the future.
I will write more in the coming days about these and other issues affecting the region.
Originally published at iMFdirect and reproduced here with the author’s permission.