asia economic monitor 2007 - regional integration · asean-4 indonesia, malaysia, philippines,...

Highlights

Recent Economic Performance•Economic growth in emerging East Asia remained strong in

the second half of 2007, in many cases performing better-than-expected—supported by healthy growth in consumption,investment,andcontinuedsolidexports.

•Inflationarypressureshavebeenincreasingacrosstheregionoverthepastseveralmonths,withheadlineinflationreachingmulti-yearhighsinseveraleconomiesonhigherfoodandenergyprices.

•Current account surpluses continued to grow, and with capitalinflows remaining strong through the first 9months of 2007,balanceofpaymentspositionsstrengthenedacrossmuchoftheregion.

•Currencyappreciationagainst theUSdollar gainedmomentumthroughoutmuchof2007,withexchangeratesupnearly5%onaveragesincethebeginningoftheyear.

•Monetarypoliciesacrosstheregionhavebecomemorecautioussince the July global financial turbulence—given the increasedvolatilityoftheregion’sfinancialmarkets,inflationarypressures,andtheuncertainoutlookformajorindustrializedeconomies.

•Despite limited spillover into emerging East Asia from the USsubprimeturmoil,thereareseveralsignsoffinancialvulnerabilityrelatedtosharpgainsinequityandrealestateprices.

Outlook, Risks, and Policy Issues•The external environment for emerging East Asian economiesisexpected toweakensomewhat in2008,aseconomicgrowthin industrial countries moderates, oil and commodity pricesremainelevated,andglobalfinancialmarketscontinuetoexhibitheightenedvolatility.

•With the external environmentweakening somewhat—and thePRC,theregion’slargesteconomy,expectedtosoftennextyear—aggregateGDPgrowthinemergingEastAsiaisforecasttoslowto8.0%in2008fromalikely8.5%thisyear.

•The region’s economic outlook is subject to greater downsiderisksnowthanjustafewmonthsago—includingthepossibilityofaUShardlanding,furthertighteningofglobalcredit,anabruptadjustment in exchange rates, and a continued rise in oil andcommodityprices.

Continued overleaf

The Asia Economic Monitor (AEM) is asemiannual review of emerging EastAsia’s growth, financial vulnerability,and emerging policy issues. It coversthe 10members of the Association ofSoutheastAsianNations;People’sRepublicofChina;HongKong,China;RepublicofKorea;andTaipei,China.

Asia Economic Monitor 2007 December 2007 aric.adb.org

Asian Development Bank Office of Regional Economic Integration

6ADBAvenue,MandaluyongCity1550MetroManila,Philippines

Telephone+6326326265+6326324444

Facsimile+6326362183

[email protected]

How to reach us

ContentsRecentEconomicPerformance 3

GDPGrowth 3Inflation 6BalanceofPayments 7FinancialMarketsandExchangeRates 10MonetaryandFiscalPolicy 12

AssessmentofFinancialVulnerability 15

EconomicOutlookfor2008,Risks,andPolicyIssues 21

ExternalEconomicEnvironment21RegionalEconomicOutlookfor2008 27RiskstotheOutlook 30PolicyIssues 34

Special Section

CanEmergingEastAsiaWeatherGlobalFinancialInstability? 42

Boxes

1.FedRateCutsandPolicyDilemmas 35

2.MeasuringMonetaryIndependenceinEmergingEastAsia 37

3.AssetMarketsandtheRealEconomy 51

4.IsEmergingEastAsiaDecouplingfromtheUS? 55

ADB AsianDevelopmentBankAEM AsiaEconomicMonitorASEAN AssociationofSoutheastAsian

NationsASEAN-4 Indonesia,Malaysia,Philippines,

ThailandBIS BankforInternational

SettlementsCLI compositeleadingindicatorCPI consumerpriceindexECB EuropeanCentralBankEU EuropeanUnionFDI foreigndirectinvestmentFed FederalReserveG3 GroupofThreeGDP grossdomesticproductH1 firsthalfH2 secondhalfHKMA HongKongMonetaryAuthorityIMF InternationalMonetaryFundIT informationtechnologyJCI JakartaCompositeIndexKLCI KualaLumpurCompositeIndexKOSPI KoreanStockPriceIndexLaoPDR LaoPeople’sDemocraticRepublicM2 broadmoneyMSCI MorganStanleyCapital

InternationalInc.m-o-m monthonmonthNEER nominaleffectiveexchangerateNIE newlyindustrializedeconomyNPL nonperformingloanOECD OrganisationforEconomicCo-

operationandDevelopmentOREI OfficeofRegionalEconomic

IntegrationPCOMP PhilippineCompositeIndexPRC People’sRepublicofChinaQ1 firstquarterQ2 secondquarterq-o-q quarteronquarterRMB renminbiROA returnonassetsROE returnonequityROPOA realandotherpropertiesowned

andacquiredROW restofworldS&P Standard&Poor’sSET StockExchangeofThailandSTI StraitsTimesIndexTWSE TaiwanStockExchangeIndexUK UnitedKingdomUS UnitedStatesy-o-y yearonyearWTO WorldTradeOrganization

Acronyms, Abbreviations, and Notes

TheAsia Economic Monitor December2007was prepared by theOffice of RegionalEconomic Integration of the AsianDevelopment Bank and does notnecessarily reflect the views of ADB’sBoardofGovernorsorthecountriestheyrepresent.

Note:“$”denotesUSdollarsunlessotherwise

specified.

•Givenspecificdomesticconditionsfacingtheregion’seconomies,monetary authorities will need great care in designing policyresponsestothechangingexternalenvironment:

—ineconomiesthatusegreaterexchangeratecontrol,increasingcurrencyflexibilitycouldaddusefulmonetaryleverage;and

—East Asian economies may wish to explore ways to bettermaintainstabilityamongintraregionalexchangerates.

•Otherpolicyprioritiesmayfocuson(i)managingtheconsequencesofrapidlyincreasingcapitalinflows,(ii)improvingtheinvestmentclimatetostrengthendomesticdemand,(iii)continuingtodevelopefficientanddeeperfinancialmarkets,and(iv)promotingenergyefficiencyandconservation.

Can Emerging East Asia Weather Global Financial Instability?Despitestrongresiliencetotheweakeningexternalenvironment,vulnerabilities in the region’s financial systems should not beunderestimated,asresurgentcapitalinflowsandexcessliquiditymaycomplicateatrueassessmentofrisk.

Theregion’slargelybank-dominatedfinancialsystems—withweaksystemicsupportforeffectiveriskmanagement—leavedoorsopento potential spillovers if conditions in global financialmarketsworsenorinvestorsentimentshifts.

Recenttrendsintheglobalfinancialsystem—notablythegrowing

presenceofnonbankfinancialinstitutionsandproliferationofnew

instrumentsforrisktransfer—willalsobecomeincreasinglyrelevant

intheregionalcontext.

Greaterfinanciallinkageswithglobalmarketsincreasestheregion’sexposuretorisksarisingfromglobalfinancialinstability.

Similarly,strongtradetiestomajorindustrializedcountriessuggestthat the risk to the regionmightbegreater ifgrowth in thoseeconomiesslowssharply.

Monetarypolicyanchoredoninflationtargeting,aprudentfiscalapproach, and greater exchange rate flexibility could limit anyspilloverofcontinuedglobalfinancialinstability.

Policymakers will need to concentrate on enhancing riskmanagement systems, strengthening disclosure requirements,andupgradingsupervisoryframeworkstobetterassesspotentialvulnerabilities.

Economieswith less-developed financial systemsmay not faceimmediatefinancialtransmissionfromthesubprimeturmoil,butnonethelesscouldfocusonlonger-termdevelopmentissuessuchasinstitutionbuilding,financialsectorreforms,andcapitalmarketdevelopment.

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Emerging East Asia—A Regional EconomicUpdateRecentEconomicPerformance

GDP Growth

Economic growth in emerging East Asia remained strong in the second half of 2007, in many cases performing better-than-expected—supported by healthy growth in consumption, investment, and continued solid exports.

EconomicgrowthinemergingEastAsiainthesecondhalfof2007

likelysustainedthemomentumofthebriskfirsthalf.Combined

gross domestic product (GDP) of the nine largest economies

inemergingEastAsia1grew8.9%(year-on-year) inthethird

quarter of 2007—or 6.1% excluding the People’s Republic of

China (PRC)—the highest in recent years (Figure 1). In the

PRC,GDPgrew11.5%inthethirdquarter,thesameasinthe

firsthalf.Thefourmiddle-incomecountriesoftheAssociationof

SoutheastAsianNations(ASEAN-4)grew6.2%,higherthanthe

5.7%recordedinthefirsthalf.GDPgrowthinthefournewly-

industrializedeconomies(NIEs)—HongKong,China;Republicof

Korea(Korea);Singapore;andTaipei,China—acceleratedto6.0%

inthethirdquarterfrom5.0%inthefirsthalf.

Excluding the PRC, robust growth was supported by strong

consumptiondemandandsolidexports(Figure 2).Theexternal

sectorcontributedstronglytotheoverallexpansiondespitethe

slowdownintheUnitedStates(US)economy,drivenbyrelatively

healthygrowthintheeurozoneandongoingrecoveryinJapan.

Privateconsumptionintheregionalsostrengthenedmarkedly

over the past 3 quarters of 2007. Private consumption grew

5.2%inthethirdquarter,upfrom4.6%inthepreviousquarter

(Figure �).

1TheninelargestemergingEastAsianeconomiesarePeople’sRepublicofChina(PRC); Hong Kong, China; Indonesia; Republic of Korea (Korea); Malaysia;Philippines;Singapore;Taipei,China;andThailand.

7.1

5.7

4.14.24.7

4.03.44.0

4.64.9

2.9

4.7

0

1

2

3

4

5

6

7

8

2004Q1 2004Q3 2005Q1 2005Q3 2006Q1 2006Q3 2007Q1 2007Q3

ASEAN-4Emerging East Asiaex. PRC

NIEs

6.2

5.2

Figure3: Consumption Growth (y-o-y,%)

Source:OREIstaffcalculationsbasedonCEICdata.

China, People’s Rep. of

7.3

8.5 8.9

11.5

11.911.5

9.1

6.05.0

6.26.7

6.2

8.1

6.6

3.2

0

2

4

6

8

10

12

2004Q1 2004Q3 2005Q1 2005Q3 2006Q1 2006Q3 2007Q1 2007Q3

Emerging East Asia2

ASEAN-4

NIEs

Figure1:GDP1 Growth—Emerging East Asia2

1Weightedbygrossnationalincome(atlasmethod,current$).2IncludesASEAN-4,NIEs,andPeople’sRepublicofChina(PRC).Aggregates do not include Brunei Darussalam, Cambodia,LaoPDR,Myanmar,andVietNamforwhichquarterlyGDPdataarenotavailable.Source:OREIstaffcalculationsbasedonnationalsources.

2.6 2.1 2.3 3.1 2.3

1.4

1.7

1.6

1.31.0

2.9

-0.5

0.91.6

2.1

1.53.3

-0.4

0.35.7

4.9

6.35.4

4.8

7.4

6.5

-1

0

1

2

3

4

5

6

7

8

2004Q1 2004Q3 2005Q1 2005Q3 2006Q1 2006Q3 2007Q1 2007Q3

Statistical discrepancyNet exportsInvestmentConsumptionGDP

6.1

1.8

0.9

3.3

Figure2:Contributions to GDP Growth—Emerging East Asia ex. PRC (y-o-y,%)


R E G I O N A L U P D A T E

�

Earlyindicatorssuggeststronggrowthintheregionwill likely

continue in the fourthquarter,althoughata somewhatmore

moderatepace.Industrialproductionremainedgenerallyhealthy

acrosstheregion,exceptinthePhilippines,whereitcontinued

tocontract(Figure �a, �b).Butindustrialproductiongrowth

mayhavepeakedinseveraleconomies,includingthePRC,Korea,

andSingapore,andremainedmodestinIndonesiaandMalaysia.

Retail salesalsopoint toa relatively strongsecondhalf,with

growth in thePRC;HongKong,China;Korea;andSingapore

generallyhigherinthethirdquarterthaninthefirst6months

oftheyear(Figure 5).

InthePRC,stronginvestment,solidconsumption,andresilient

exports supported high GDP growth. The investment boom

regainedstrengthin2007aftereasingsomewhatinthesecond

halfof2006,withfixed-assetinvestmentedgingupto25.7%

(year-on-year)inthethirdquarter,from24%in2006(Figure 6).

Consumerspendinggrewsteadily,withretailsalesgrowthonan

upwardtrend—reachingarecord18.1%inOctober.Theexternal

sectoralsoremainedstronginthePRC,despitemeasurestocool

exportgrowth,suchasadownwardadjustmenttotheexporttax

rebatesystem,andevenamidconcernaboutproductqualityand

safety.Exportswereup27.1%inthefirst3quartersoftheyear,

justunderthe27.2%growthrateforallof2006.

Astrongrecovery indomesticdemandboostedgrowth in the

ASEAN-4economies(Figure 7).ButThailandwasanexception

as lingering political uncertainty ahead of the 23 December

electionsaffectedprivateconsumptionandinvestmentdemand.

Consumption growthwas the weakest in 6 years and fixed

investmentfellby0.7%inthefirsthalf.Butprivateconsumption

generally increasedintheotherASEAN-4countries,fueledby

publicsectorsalaryhikes,healthylabormarkets,andstronger

overseasremittances,whichproppeduphouseholdincomeand

spending.FixedinvestmentalsopickedupstronglyintheASEAN-4

countries,contributingabout1.7percentagepointstototalGDP

growthof6.2%inthethirdquarter(Figure 8).Election-related

government spending in the Philippines and infrastructure

programdisbursementsintheotherASEAN-4economiesprovided

anadditionalboosttoconsumptionandinvestment.Meanwhile,

intheASEAN-4countries,thecontributionofnetexportstoGDP

growthfell to0.6percentagepoint inthethirdquarter,down

from3.4percentagepointsinthesecondquarter(Figure 9).

Themainfactorsincludetheweakeningexternalenvironmentand

Singapore

Korea, Rep. of

Hong Kong, China

China, People's Rep. of

15.8

28.6

18.115.5

3.6

-4.3-2.8

6.5

-3.6 -5.0-10

-5

0

5

10

15

20

25

30

Jan-05

Apr-05

Jul-05

Oct-05

Jan-06

Apr-06

Jul-06

Oct-06

Jan-07

Apr-07

Jul-07

Oct-07

Figure5:Retail Sales Growth (y-o-y,%)

Source:CEIC.

Figure4a:Industrial Production Growth1 (y-o-y,%)

13-monthmovingaverage.Source:OREIstaffcalculationsbasedonCEICdata.

Philippines

Thailand

Malaysia

Indonesia

2.0

-9.3

-4.8

-14.2

-2.6

12.6 12.5

17.6

9.012.4

-3.5

11.1

4.4

-20

-15

-10

-5

0

5

10

15

20

Jan-04

Jun-04

Nov-04

Apr-05

Sep-05

Feb-06

Jul-06

Dec-06

May-07

Oct-07

Singapore

Korea, Rep. of

Taipei,China

9.6

18.1

3.5

-5

0

5

10

15

20

25

Jan-04

Jun-04

Nov-04

Apr-05

Sep-05

Feb-06

Jul-06

Dec-06

May-07

Oct-07


11.5

Figure4b:Industrial Production Growth1(y-o-y,%)

13-monthmovingaverage.Source:OREIstaffcalculationsbasedonCEICdata.


5

strengtheningcurrencies,butstrengtheningdomesticdemand

hasalsobeguntohelpnarrowtradesurpluses.InthePhilippines,

forexample,theappreciationofthepesoinrealterms—mainly

duetostrongcapitalinflowscombinedwithasurgeinoverseas

workerremittances—hashurttheexportcompetitivenessofthe

manufacturing sector and seen exports slowing. Remittances

havebolsteredprivateconsumption,however,andtheservices

sectorhasbecomethemaindriverofstronggrowththisyearin

thePhilippines,contributing3.6percentagepointstothe6.6%

third-quarterexpansion.

PrivateconsumptionalsostrengthenedintheNIEs(seeFigure3).

InHongKong,China,privateconsumptionpickedupasincome

andwealthincreasedamidstrongemploymentandhealthygains

intheequitymarkets.InKorea,theon-and-offrecoveryfrom

2003’s household debt-related contraction has steadied, with

supportfromatighterlabormarketandboomingequitymarkets.

And in Singapore and Taipei,China, private consumption was

boostedbytightlaborandstrongerpropertymarkets.Investment

intheNIEseconomiesalsoremainsbuoyant,althoughiteased

inthethirdquarterfromstronggrowthinthepreviousquarter:

itscontributiondeclinedto0.6percentagepoints,from2.5in

thesecondquarter(Figure 10).Fixedinvestment,specificallyin

plantandfacilities,pickedupinTaipei,Chinaoncapitalexpansion

in the semiconductor sector. Private investment remained

stronginSingaporeandHongKong,China,supportedbyrapid

constructionsectorgrowth.Korea’sfixedinvestmentheldupas

well, despite slowing construction demand. Non-construction

business investment, in particular,made a strong showing in

recentquartersonthebackofrecoveryindomesticdemand.

InVietNam,third-quarterGDPgrowthof8.7%wasthehighestin

adecade,aidedbycontinuedexpansioninindustry,construction,

and services. GDP in Brunei Darussalam contracted 1.7% in

thefirsthalfof2007,afterstronggrowthin2006,largelyona

dropinoilproduction.InCambodia,agradualdecelerationin

GDPgrowthcontinuedasexternaldemandsoftenedandprivate

consumptioneased,although thepace likely remainedstrong

atanestimated9.2%thisyear.IntheLaoPeople’sDemocratic

Republic (LaoPDR),GDP likelygrew6.8%in2007as foreign

investment drove robust expansion of the industrial sector,

especially in mining and energy. In Myanmar, independent

projectionsputGDPgrowthinarangeofabout3–6%forthe

2007fiscalyear.

10.5

9.9

5.64.9

6.45.4

6.7

4.53.9

3.8

-2

0

2

4

6

8

10

12

2004Q1 2004Q3 2005Q1 2005Q3 2006Q1 2006Q3 2007Q1 2007Q3

Fixed investmentPrivate consumptionDomestic demand

8.1

6.1

6.4

Figure7:ASEAN-� Domestic Demand Growth (y-o-y,%)


2.0 2.3

0.51.2

0.8

-1.7

0.3

-1.4-1.6

2.2

-1.1-0.2

3.1

0.3

-3

-2

-1

0

1

2

3

4

2004Q1 2004Q3 2005Q1 2005Q3 2006Q1 2006Q3 2007Q1

Fixed assetsChanges in inventoryTotal domestic investment

1.7

1.6

-0.1

2007Q3

Figure8:Investment Contributions to GDP Growth: ASEAN-�(y-o-y,%)


10.5

5.62.6

11.6

3.4

8.7

3.5

11.2

7.7

1.2

5.7

43.0

29.8

25.7

0

2

4

6

8

10

12

14

2004Q1 2004Q3 2005Q1 2005Q3 2006Q1 2006Q3 2007Q1 2007Q305101520253035404550

ASEAN-4

Emerging East Asia,ex. PRC

NIEs


China, People's Rep. of1

Others

5.0

8.1

Figure6:Fixed Assets Growth(y-o-y,%)

1PRC figures are based on nominal fixed-asset investmentgrowth(year-to-date).Source:OREIstaffcalculationsbasedonCEICdata.

-1.4

3.4

0.60.4

-1.7

2.43.1

0.61.2

1.62.2

1.7 1.51.00.5

1.6

-3

-2

-1

0

1

2

3

4

5

6

2004Q1 2004Q3 2005Q1 2005Q3 2006Q1 2006Q3 2007Q1 2007Q3

ASEAN-4 net exportsNIEs net exportsEmerging East Asia ex. PRC net exports

1.8

0.6

Figure9:Contributions of Net Exports to GDP Growth (y-o-y,%)



6

Inflation

Inflationary pressures have been increasing across the region over the past several months, with headline inflation reaching multi-year highs in several economies on higher food and energy prices.

WhileheadlineinflationstartedtoriseintheASEAN-4economies,

it reached a 16-year high in Singapore, 12-year highs in the

PRCandTaipei,China,anda9-yearhighinHongKong,China.

Inrecentmonths,itwasalsoatitshighestsince2005inKorea

andinVietNam.Onaverage,theregion’sinflationwasup5.2%

inOctober2007; fromarecent lowof1.9%inOctober2006

(Figure 11).Theriseinheadlineinflationismainlyattributedto

rapidandpersistentincreasesinfoodandenergypricesresulting

fromrealcapacityconstraints—notsimplyone-offeventssuchas

poorweather.Coreinflationisalsoincreasinginsomeeconomies

(Figure 12). Persistent high growth inmonetary aggregates

may have also contributed to rising inflationary pressures

(Figure 1�).

InthePRC,theconsumerpriceindexhita12-yearhighof6.5%

inAugustandagaininOctober—fromalowof1%inJuly2006—

puttingpressureonthecentralbanktofurthertightenmonetary

policy.Surgingfoodprices(up17.6%overtheyeartoOctober)

havedrivenheadlineinflationinrecentmonths.Theunderlying

factor,however,isampleliquidityintheeconomyasaresultof

persistently largecapital inflowsandstrongmoneygrowth in

recentyearsdueto incompletesterilization.Rapidassetprice

inflationhasalreadybeenasignificantmacroeconomicproblem

inthePRC.Andnow,headlineinflationalsoexceedsreturnson

bankdeposits,encouragingmorehouseholdstoputtheirmoney

inthealreadyoverheatingstockmarkets—whichtheauthorities

havebeentryingtocool.

InflationinASEANcountrieshasincreasedinrecentmonthsas

stronggrowthcontinuestoclosetheoutputgapandenergyand

foodpricesrise.InIndonesia,exemplifyingtheASEAN-4trend,

inflationwasbackupto6.7%inNovember,afterfallingto5.8%

inJune2007.Inthepast6months,inflationalsodriftedhigher

inMalaysia(fromabout1.5%tocloseto2%),thePhilippines

(fromaround2.3%to2.7%),andinThailand(frombelow2%to

3.0%) (Figure 1�).Andwiththepossibleremovalofremaining

fuelsubsidiesintheretailmarket,inflationmayhaverisenstill

Fixed assetsChanges in inventoryTotal domestic investment

1.6

0.81.4

0.81

-0.2-0.2-0.8

0.80.7

-0.2

0.6

2.3

2.52.4

1.5

0.6

-4

-3

-2

-1

1

2

3

4

2004Q1 2004Q3 2005Q1 2005Q3 2006Q1 2006Q3 2007Q1 2007Q3

Figure10:Investment Contributions to GDP Growth: NIEs(y-o-y,%)


China, People’s Rep. of

NIEs

Emerging East Asia

6.55.3

3.9

6.2

10.7

4.24.8

3.63.4

5.2

2.8

-1

1

3

5

7

9

11

Jan-04

Jun-04

Nov-04

Apr-05

Sep-05

Feb-06

Jul-06

Dec-06

May-07

Oct-07

ASEAN-4

Figure11:Regional Inflation—Headline Rates (y-o-y,%)


Philippines

Korea, Rep. of

Thailand

Malaysia

Singapore

Indonesia

2.4

5.0

7.1

0.7 1.5

2.9

-1.4

3.9

-0.1 1.0

6.3

10.2

-2-10123456789

1011

Jan-04

Jun-04

Nov-04

Apr-05

Sep-05

Feb-06

Jul-06

Dec-06

May-07

Nov-07

Figure12:Core Inflation Rates (y-o-y,%)

Note:Officialfigures,exceptMalaysia(ex.food,fuel,utilities)andSingapore(ex.food,privatetransport).Sources:OREIstaffcalculationsbasedonCEICdata.

Philippines

Malaysia

Thailand

18.5

26.0

11.3

32.3

12.2

3.6

6.2

2.76.9

10.3

0

5

10

15

20

25

30

35

Jan-04

Jun-04

Nov-04

Apr-05

Sep-05

Feb-06

Jul-06

Dec-06

May-07

Oct-07


Korea, Rep. of

Figure13:Money Growth1 (y-o-y,%)

1M2.Source:CEIC.


7

furtherinMalaysiaduringthecourseoftheyear.Astrongpeso

inthePhilippinesandweakerdemandinThailandshouldhelp

ease inflation in both countries.Meanwhile, fast growth also

contributedtoinflationinsmallercountries:Novemberconsumer

pricesinVietNamwereup10.0%overayearearlier,thehighest

innearly3years.

TheNIEshaveseeninflationrisingquicklyinrecentmonths—most

significantlyinTaipei,China(5.3%inOctober),andinSingapore

(3.6%inOctober),whereinflationwasbelow1%inthefirsthalf

of2007.Whilehigheroil pricespushedupheadline inflation,

abouthalfoftheincreaseinSingaporewasduetothehikeinthe

goodsandservicetaxes.Higherfood,oil,andothercommodity

prices,alongsiderisingwagesduetorelativelytightlabormarkets

andthepass-throughofincreasingbusinesscosts,havefueled

inflationarypressuresintheNIEs.

Balance of Payments

Current account surpluses continued to grow, and with capital inflows remaining strong through the first 9 months of 2007, balance of payments positions strengthened across much of the region.

Third-quarterexportgrowth(invalueterms)inemergingEast

Asia softened, although it was still robust. However, import

growthslowedmoreandthecombinedtradesurpluswidened

asa result, comparedwith thesameperiod in2006.Exports

slowed largely because of a cyclical downswing in the global

information technology industry,while importseasedbecause

ofrelatedinventoryadjustmentsintheindustryoverthepast

fewquarters.Despitestrengtheningdomesticdemand,current

accountsurplusesacrosstheregionweresustainedgoinginto

thesecondhalfof2007.Capitalinflowsalsoremainedstrongin

thefirst9months,contributingtoasignificantlystrongerbalance

ofpayments.Internationalreservescontinuedtobuildascentral

banksintervenedinforeignexchangemarketstocurbtherapid

paceofcurrencyappreciation.

InthePRC,exportsgrewablistering26.2%inthethirdquarter

of2007,thoughmarginallyslowerthanthe27.6%ofthefirst

half. Import growth accelerated to 21% in the same period,

abovethe18%ofthefirsthalf.Thetradesurplusreachedmore

Indonesia

Philippines

Viet Nam

Malaysia

Thailand 2.7

7.6

4.5

6.7

18.4

14.5

8.810.0

9.110.3

1.93.02.8

5.3

02468

101214161820

Jan-04

Jun-04

Nov-04

Apr-05

Sep-05

Feb-06

Jul-06

Dec-06

May-07

Nov-07

Figure14:Inflation in Selected ASEAN Economies—Headline Rates (y-o-y,%)

Sources: OREI staff calculations based on data from CEICandInternational Financial Statistics,InternationalMonetaryFund.


8

than$212billioninthefirst10monthsoftheyear,already20%

abovetheentire2006total.That ispartiallyduetoarushto

movegoodsbeforecertainexport taxrebateswereabolished

orreducedon1July.Thebiggertradesurplusmayalsoderive

fromacceleratedexport receipts or delayed import payments

astheprivatesectorisexpectingafurtherappreciationofthe

renminbi(Table 1a).

TheaggregateASEAN-4tradesurplusremainedhighinthefirst

halfof2007,despiteaslowdown inexports(Table 1b).The

currentaccountbalanceimproveddramaticallyby79%year-on-

yearduetoastrongtradesurplus,maintainingahealthyoverall

balanceofpaymentspositionwithanadditionalsmallsurpluson

thefinancialaccount.AstrongcurrentaccountsurplusinThailand

wasfueledbyrapidexportgrowthinelectronics,vehicles,and

ironproducts.ExportgrowtheasedsomewhatinMalaysia,but

remainedrobustinrecentmonthsinIndonesia.ThePhilippines

hasbeenrunningtradedeficits,butithaspostedcurrentaccount

Table1b:Balance of Payments—ASEAN-�(%ofGDP)

2004H1 2004H2 2005H1 2005H2 2006H1 2006H2 2007H1

CurrentAccount 2.2 4.5 1.2 2.9 3.9 6.3 5.9

NetGoodsBalance 7.4 9.5 5.2 7.9 7.7 9.7 7.3

NetServices -2.6 -2.8 -2.5 -3.2 -2.5 -2.4 -0.7

NetIncome -3.9 -3.6 -3.5 -4.1 -3.3 -3.0 -2.6

NetTransfers 1.4 1.4 1.9 2.3 2.0 2.0 2.0

CapitalAccount 0.0 0.0 0.0 0.1 0.1 0.1 0.0

FinancialAccount 0.4 1.7 3.2 -2.5 1.2 -2.5 1.1

NetDirectInvestment 0.9 1.3 2.9 1.9 2.1 1.5 0.7

NetPortfolioInvestment 1.9 3.0 2.3 0.5 1.9 1.8 4.3

NetOtherInvestment -2.4 -2.7 -1.9 -4.9 -2.8 -5.8 -4.0

NetErrors&Omissions 0.7 -1.3 -1.6 -0.7 0.1 -0.6 -0.6

OverallBalance 3.3 4.8 2.8 -0.3 5.3 3.2 6.4

Sources:International Financial Statistics Online,InternationalMonetaryFund;andCEIC.

Table1a:Balance of Payments—PRC(%ofGDP)

2004H1 2004H2 2005H1 2005H2 2006H1 2006H2 2007H1

CurrentAccount 1.1 7.3 7.0 12.7 8.0 16.7 11.8


NetServices -0.8 -1.0 -0.4 -0.7 -0.5 -0.6 -0.2

NetIncome -0.3 -0.4 0.5 0.8 0.3 0.8 0.9

NetTransfers 1.4 2.4 1.3 2.0 1.2 2.0 1.3

CapitalAccount 0.0 0.0 0.2 0.3 0.2 0.3 0.1

FinancialAccount 9.4 11.8 3.7 4.7 3.2 0.4 6.4

NetDirectInvestment 4.3 5.7 2.3 5.4 2.7 4.0 3.7

NetPortfolioInvestment 3.9 2.1 -0.1 -0.4 -2.6 -4.5 -0.3

NetOtherInvestment 1.2 4.0 1.5 -0.3 3.1 0.9 3.1

NetErrors&Omissions -1.0 2.9 -0.5 -1.3 -0.7 -0.9 0.9

OverallBalance 9.4 22.0 10.4 16.4 10.7 16.6 19.2



9

surpluses because of the strong inflow of remittances from

overseasFilipinoworkers—amountingtoabout10%ofGDPinthe

firsthalfof2007.Inaggregate,theASEAN-4financialaccount

showedasmallsurplusinthefirsthalfof2007—incontrasttoa

largedeficitinthesecondhalfoflastyear—resultinginanoverall

balanceofpaymentssurplusofabout$30billion.Foreigndirect

investment remained robust, but it was portfolio investment

flowswhich rose sharply to about $20billion in thefirst half

fromthe$15billionin2006.Partlyduetodebtrepayments,the

“otherinvestment”accounthasbeenpersistentlydeepindeficit

inrecentyears.

ThethreesmallerNIEshadlargecurrentaccountsurplusesin

thefirsthalf,butKorearanasmalldeficit.ThereversalinKorea

waslargelyduetoahugedeficit in itsservicestrade,caused

bypersistentgrowthinoutboundtourism.HongKong,China’s

strongservicestradeandincomereceiptsonitsassetsabroadled

toahealthycurrentaccount,inspiteofadeficitingoodstrade.

Inthethirdquarter,exportgrowthremainedgenerallyrobust

intheNIEs,withamodestdropinimportgrowth,pointingtoa

continuedsurplus intheaggregatecurrentaccount.TheNIEs

financialaccountperformancewasquitevaried(Table 1c).In

thefirsthalf,whilecapitalflowedintoKorea(mainlyintheform

ofotherinvestmentstohelphedgingactivitiesofitsshipbuilding

industry),itflowedoutofTaipei,China(mainlyportfoliooutflows),

andoutofSingaporeandHongKong,China(intheformofother

investmentoutflows).InKorea,netinflowsinotherinvestments

werealmostthreetimesnetoutflowsinportfolioinvestments.

Thishasbeenthetrendoverthepastyearorso,reflectingthe

sharpriseinhedgingbyKoreanshipbuildersforsurgingexport

orders.Butrecently,domesticbanks’on-shorelendingactivities

Table1c:Balance of Payments—NIEs(%ofGDP)

2004H1 2004H2 2005H1 2005H2 2006H1 2006H2 2007H1

CurrentAccount 5.8 7.2 5.2 5.9 4.5 6.5 5.8


NetServices 0.7 0.5 0.3 0.6 0.4 0.9 0.3

NetIncome 0.3 1.0 0.7 -0.2 0.3 0.4 1.3

NetTransfers -0.8 -0.7 -0.7 -0.7 -0.8 -0.7 -0.7

CapitalAccount -0.2 -0.2 -0.3 -0.2 -0.2 -0.2 -0.2

FinancialAccount 1.7 -3.1 0.3 -4.4 -1.9 -2.9 -3.5

NetDirectInvestment -0.3 0.2 1.8 0.2 1.1 0.4 0.9

NetPortfolioInvestment -6.7 -0.2 -5.0 -1.3 -5.5 -5.8 -4.0

NetOtherInvestment 8.7 -3.2 3.5 -3.3 2.5 2.4 -0.4

NetErrors&Omissions 0.5 1.0 0.6 0.6 0.8 -0.1 0.2

OverallBalance 7.8 4.9 5.8 1.8 3.2 3.3 2.3



10

inforeigncurrencyhavebecomestronger,someofwhichwere

madeinyen,suggestingthatborrowingfromforeignbanksmight

havebeenincreasingpartlytotakeadvantageofwideningyield

differentialsbetweendomesticandforeigncurrencies.

Financial Markets and Exchange Rates

Financial markets across the region quickly recovered from the expansive wave of US subprime turmoil in July and August—many reaching record highs fueled by large portfolio inflows—raising concern among policy makers about the risk of an equity market bubble.

Afterasharpsell-offinlate-Julyandearly-Augustamidconcerns

aboutUSsubprimemortgagesandtheimplicationsforUSgrowth,

mostequitymarkets inemergingEastAsia recoveredquickly

(Figures 15a, 15b).BoomingequitymarketsinthePRCwere

barelyaffectedbytheglobalfinancialturmoil,althoughtheyhave

beenlosingsteaminrecentmonths.Therestofregionalequity

markets also retreated somewhat inNovember amid concern

aboutafurtherslowdownintheglobaleconomy.Currenciesin

theregionfellbrieflyattheheightoftheturbulenceascapitalfled

andpushedtheUSdollarhigher.ButsincelateAugust,currencies

intheregionhaveappreciatedsignificantlyagainstthedollaron

furtherevidenceofaslowingUSeconomyandthreesubsequent

USFederalReservepolicyratecuts,totaling100basispoints.

(Figures 16a, 16b).

ExcludingthePRC,gainsinequitypricesovertheyear—through

theendofNovember—rangedfrom10%inTaipei,Chinato49%

inIndonesia.InthePRC,equitypriceshavebeenrisingeven

faster,withthestockpriceindexinShanghaigaining130%by

mid-Octoberfortheyear,ontopofa148%risein2006.Since

then(throughend-November),however,theShanghaiComposite

Indexhasfallenbyalmost20%astheauthoritiescontinuedto

tightenmonetarypolicy.

Nowpolicymakersinsomeeconomiesarebecomingincreasingly

anxious about the risk of an equitymarket bubble driven by

strong capital inflows and ample liquidity. Across the region,

equitymarketshavebeenonaquickrise,puttingauthoritiesin

abindbecauseraisingpolicyratesmayattractfurtherportfolio

Philippines

Thailand

Malaysia

Indonesia 230

133

157

204

153154

132123 118

105

87

171162

80

100

120

140

160

180

200

220

240

2-Jan-06

30-Mar-06

25-Jun-06

20-Sep-06

16-Dec-06

13-Mar-07

8-Jun-07

3-Sep-07

29-Nov-07

Figure15a:Composite Stock Price Indexes1—ASEAN-� (lastpricedaily,2January2006=100,localindex)

1DailystockpriceindexesofJCI(Indonesia),KLCI(Malaysia),PCOMP(Philippines),andSET(Thailand)Source:OREIstaffcalculationsbasedonBloombergdata.

Singapore

Korea, Rep. of


Taipei,China94118

99

137120

485

155

277

399

85

115

145

175

205

235

265

295

2-Jan-06

30-Mar-06

25-Jun-06

20-Sep-06

16-Dec-06

13-Mar-07

8-Jun-07

3-Sep-07

29-Nov-07

60120180240300360420480540600

Hong Kong, China

China, People's Rep.ofOthers

191

148135

Figure15b:Composite Stock Price Indexes1—NIEs and PRC(lastpricedaily,2January2006=100,localindex)

1DailystockpriceindexesofHangSeng(HongKong,China),KOSPI (Korea), STI (Singapore), TWSE (Taipei,China), andcombinedShanghaiandShenzhenComposite(PRC),weightedbytheirrespectivemarketcapitalization.Source:OREIstaffcalculationsbasedonBloombergdata.


11

inflows, which are already strong.Meanwhile, an unwinding

ofcarrytradesontheyen(andotherlow-yieldingcurrencies)

remainsaworrygivenheightenedfinancialuncertainty.Apartial

unwindingoccurredbrieflyduringtherecentmarketturmoilasa

partofre-pricingofrisks.Ifinvestors,whopreviouslyborrowed

low-yieldingcurrenciestoinvestinhigh-yieldingemergingmarket

assetsandcurrencies,choosetoclosetheirpositions,itcould

significantlyexacerbatevolatilityinfinancialmarkets.

Currency appreciation against the US dollar gained momentum throughout much of 2007, with exchange rates up nearly 5% on average since the beginning of the year.

Strongbalanceofpaymentspositionsfromcurrentandcapital

account surpluses continued toputupwardpressureonmost

currencies in the region. In the first 11months of 2007, the

region’scurrenciesappreciated4.8%againsttheUSdollaron

average,andby4.1%sincemid-August.Centralbankscontinued

tointerveneinforeignexchangemarketstocurbtheappreciation

(particularlysinceAugust),asindicatedbyrisingforeignexchange

reserves.Intheyeartodate,thePhilippinepesoandtheThai

baht (both up 15%) outperformed other currencies, largely

supportedbygrowingcurrentaccountsurpluses.TheMalaysian

ringgit,Singaporedollar,andthePRCrenminbihaveappreciated

by5–6%sofarin2007,withothercurrenciesintheregionfairly

steady,thoughvolatileinrecentmonths.ThePeople’sBankof

Chinaallowedtherenminbitoappreciate0.5%inthelastweek

ofOctober,thebiggestweeklyrisesinceitmovedtoamanaged

floatinJuly2005.Thissuggestsitmayhavedecidedtoaccelerate

thepaceofappreciation.

Sovereign bond spreads over US Treasuries widened in July

and August as the financial turmoil intensified, particularly

in Indonesia and the Philippines. After narrowing somewhat

during September and October, these spreads widened even

furtherinNovember,asthespecterofasharperUSslowdown

increasedandinvestors’riskappetitedecreased(Figure 17).

Andbyend-August,yieldcurveshadshiftedupinmostemerging

Asian economies compared with the second quarter—again,

particularlyinIndonesiaandthePhilippines.InthePRC;Korea;

and Taipei,China; the upward shift may also have been the

outcomeofcontinuedmonetarytighteningintheseeconomies

inthethirdquarter.InterestratesinthePRCwereontherise

Singapore

Korea, Rep. of


109

102

115

109

110109

Taipei,China95

100

105

110

115

120

125

130

135

140

02-Jan-06

30-Mar-06

25-Jun-06

20-Sep-06

16-Dec-06

13-Mar-07

08-Jun-07

03-Sep-07

29-Nov-07

99

Figure16b:Exchange Rate Indexes—NIEs1 and PRC (2Jan2006=100)

1Rep.ofKorea;Singapore;andTaipei,China.Source:Bloomberg.

Philippines

Thailand

Malaysia

Indonesia

105103

113

124

110

118

99

123

100

105

110

115

120

125

130

135

140

145

9502-Jan-

0630-Mar-

0625-Jun-

0620-Sep-

0616-Dec-

0613-Mar-

0708-Jun-

0703-Sep-

0729-Nov-

07

133128

117

142

112111

Figure16a:Exchange Rate Indexes—ASEAN-� (2Jan2006=100)

Source:OREIstaffcalculationsbasedonBloombergdata.

Philippines

Malaysia


280

237

Indonesia

Viet Nam121

262

198

180

309

286

116

246

134

0

40

80

120

160

200

240

280

320

3-Jan-06

31-Mar-06

26-Jun-06

21-Sep-06

17-Dec-06

14-Mar-07

9-Jun-07

4-Sep-07

3-Dec-07

204

Figure17:JP Morgan EMBI Sovereign Stripped Spreads (basispoints)

Source:Bloomberg.


12

in2007,comparedwithend-2006,asauthoritiestriedtocool

anoverheatingeconomy.Yieldcurvesinmosteconomiesalso

steepened thisyear,mirroring the trend inworldmarkets. In

Indonesia,Philippines,andThailand,curvessteepenedasloose

monetarypolicypusheddownyieldsonshortermaturities,while

rising inflationpushed theyieldshigheronbondswith longer

maturities(Figures 18a, 18b, 18c).

Monetary and Fiscal Policy

Monetary policies across the region have become more cautious since the July global financial turbulence—given the increased volatility of the region’s financial markets, inflationary pressures, and the uncertain outlook for major industrialized economies.

EastAsia’smonetaryauthoritieshavebeencautioussinceJuly

2007,witheconomiesbuoyant,inflationontherise,yetwithan

uncertainoutlookfortheexternalenvironmentandforfinancial

volatility.ThailandhaskeptpolicyratesunchangedsinceJuly,

whenitloweredrates.Malaysiahasnotchangeditspolicyrate

sinceApril2006—thelasttimeitraisedtherate.Koreatightened

policyinJulyandinAugustbuthaskepttheratesteadysince

then.ButthePRCandTaipei,Chinacontinuedtotightenduring

September.Amongtheregion’sbiggereconomies,onlyIndonesia

andthePhilippineshaveloweredpolicyrates(Figure 19).

Sofarthisyear,thePRCcentralbankhasraiseditsbenchmark

rate five times (1.17 percentage points) and the reserve

requirementratio10times(5.5percentagepoints)initseffortto

containanincreasinglyoverheatingeconomyandsurgingstock

markets.Themostrecentincreaseofthereserverequirement

ratioof1percentagepointwilltakeeffecton25December.Real

interestratesremainverylow,however,andthereisgrowing

concernthatthisisfuelingresurgentinvestmentandasset-price

inflation. The authorities have also restricted loans for stock

purchases and raised the stamp duty on share trading. The

centralbankwidenedtherenminbitradingbandagainsttheUS

dollarfrom0.3%to0.5%inMay.Moneysupply(M2)inrecent

months, however, has continued to grow above 18%, higher

thanthecentralbank’stargetof16%.Giventhattheinvestment

surgecontinuesunabatedandthestockindexesremainonthe

Figure18b:Indonesia Benchmark Yields (%perannum)

Source:Bloomberg.

8.95

9.33

10.29

8.45

9.62

9.88

10.43

7.5

8.0

8.5

9.0

9.5

10.0

10.5

11.0

2 4 6 8 10 12 14 16 18 20

12-Nov-200729-Aug-200728-May-200729-Dec-2006

15

Year of Maturity

4.15

4.58

3.79

4.43

2.89

3.36

2.68

3.22

2.0

2.5

3.0

3.5

4.0

4.5

5.0

2 3 4 5 6 7 8 9 10

12-Nov-200729-Aug-200729-May-200729-Dec-2006

Year of Maturity

Figure18a:PRC Benchmark Yields (%perannum)

Source:Bloomberg.

5.5

6.6

7.4

9.6

6.1

8.8

8.3

6.0

6.5

7.0

7.5

8.0

8.5

9.0

9.5

10.0

2 4 6 8 10 12 14 16 18 20 22 24

12-Nov-200729-Aug-200728-May-200729-Dec-2006

157 25

Year of Maturity

9.5

Figure18c:Philippines Benchmark Yields (%perannum)

Source:Bloomberg.


1�

rise,furthermonetarytighteningiswidelyexpectedbeforethe

endoftheyear.

IndonesiapauseditseasingcyclefromJulythrough6December,

whenitlowereditspolicyrateto8.0%.InitsDecemberstatement,

BankIndonesiasaiditremainsconfidentthatinflationisonalong-

termdecliningtrenddespiteloominginflationarypressures.The

PhilippinesalsocutpolicyratessinceJuly,loweringitsdiscount

rate three timesandbringing it to5.5%byNovember. Itdid

so, however, in tandem with liquidity management measures

tocontainhighmoneygrowthinthefirsthalfoftheyear.The

BankofThailandmaintaineditspolicyinterestrateat3.25%in

October,afterinflationrosetoa9-monthhighof2.5%inthe

samemonth—duetorisingfuelcosts.Malaysiahaskeptitspolicy

unchangedsinceApril2006.

AmongtheNIEs,therehasbeensomeconvergenceinmonetary

policydirection.Citingrobustgrowthandincreasinginflation,the

BankofKorearaiseditspolicyrateinJulyandAugust(byatotal

of50basispoints).ButitpausedfromSeptembertoNovember,

pointingtostablegrowthandpricesamidampleandincreasing

liquidity,evenasoilpricesroseandfinancialmarketsweathered

highervolatility.Taipei,Chinahascontinuedtohikeitspolicyrate,

whichreacheda6-yearhighof3.25%inSeptember,bringingits

monetarystancetoamoreneutrallevel.Taipei,China’sinterest

ratesare lower than inotheremergingmarkets,encouraging

capitaloutflowsputtingdownwardpressureonitscurrency.Due

to rising inflation, the SingaporeMonetary Authority slightly

increasedtheslopeofitsnominaleffectiveexchangeratepolicy

bandinOctoberinordertocapinflationarypressuresandensure

pricestabilityoverthemediumterm.

Governments in the region have maintained fiscal prudence, but budgetary trends diverged slightly as varied economic and social situations warranted different fiscal strategies.

On fiscal policy,most governments in the region have been

prudent, although trends have varied (Table 2). The PRC’s

fiscal position remains healthywith amodest deficit due to

strongrevenuegrowth,butauthoritiesseeaneedfor further

improvementinthestandardsoffiscalmanagementandpractices.

Thegovernmentcontinuestoadjusttheemphasisandstructure

ofexpenditures,addressingweaklinksineconomicandsocial

Philippines

Malaysia

Thailand2China, People's Rep. of

8.00

12.75

5.003.503.503.00

5.50

7.507.50

2.752.25 3.253.25

7.29

0

2

4

6

8

10

12

14

01-Jul-04

27-Dec-04

24-Jun-05

20-Dec-05

17-Jun-06

13-Dec-06

10-Jun-07

06-Dec-07

Indonesia

Korea, Rep. of

Taipei,China

Figure19:Policy Rates1 (%perannum)

Notes:1BankIndonesiarate,(Indonesia);overnightcallrate(Korea);overnight policy rate (Malaysia); reverse repurchase rate(Philippines); official discount rate (Taipei,China); 1-yearlendingrate(PRC).2BankofThailandswitcheditsbenchmarkfromthe14-dayto1-dayreverserepurchaserateon17January2007.Source:Bloomberg.


1�

Table2: Fiscal Balance of Central Government(%ofGDP)

2003 2004 2005 2006 20071 20081

Cambodia -6.0 -4.7 -3.4 -1.5 -4.1 -3.2

China,People’sRep.of -2.2 -1.3 -1.2 -0.5 -0.9 -1.2

HongKong,China -3.3 1.7 1.0 1.6 1.9 2.3

Indonesia -1.7 -1.0 -0.5 -1.0 -1.5 -1.7

Korea,Rep.of 0.1 -0.5 -1.0 -1.3 -1.5 -1.2

Malaysia -5.3 -4.3 -3.8 -3.3 -3.2 -3.1

Philippines -4.6 -3.8 -2.7 -1.1 -0.1 0.1

Singapore2 4.1 5.5 8.3 6.6 4.4 …

Taipei,China2 -3.0 -2.1 -1.7 -0.7 -1.9 …

Thailand2 0.6 0.3 0.2 0.1 -1.7 …

VietNam -1.2 0.9 -1.2 -5.0 … …

…=notavailable1Budget.2Fiscalyear.Sources:Nationalsources;Asian Development Outlook 2007,AsianDevelopmentBank;EconomistIntelligenceUnit;andWorldBank.

developmentandimprovingruralpublicservices,whichwillhelp

promotebalancedgrowthbetweenruralandurbanareas.

TheNIEshaverelativelystrongfiscalpositions.Singaporeand

HongKong,Chinawereinsurplusin2006,whichlikelycontinued

into2007.AlthoughKoreahasrunaprimaryfiscalsurplus,its

adjustedfiscalbalance—whichexcludessocialsecurityfundsand

iscloselymonitoredbythegovernment—wasindeficit.Whileits

fiscalpositionremainsgenerallysound,thegrowingcostsofsocial

securityandwelfareprogramscontinuetoconstrainbudgetary

room.Taipei,Chinahasreduceditsbudgetdeficitoverthepast

fewyears,thoughithasbudgetedabiggerdeficitin2007than

in2006.Overall,theNIEsaremovingtowardfiscalconsolidation,

with ongoing efforts to improve revenue collection, broaden

taxbases,rationalize incentives,andmanageexpendituresto

efficientlyaddresskeypublicconcerns.Revenuesareexpected

torisewitheconomicgrowth,whileexpendituresandreforms

arefocusedonmovingtowardamoreequitablesystem.Amajor

concernistheadequacyofsocialsafetynets,inparticularfor

anageingworkforce.TheNIEsalsoneedtoresolvestructural

issues tomaintain their competitiveedge in the regional and

globalmarkets.

InIndonesia,thefiscaldeficithasbeenkeptatgenerallymodest

levels following the successful consolidation of recent years.

The challenge remains in keeping the deficit around 1.0%of

GDPandreducinggovernmentdebt to30%ofGDPby2009,

whilepromotingabetterinvestmentclimateandinfrastructure

development.Malaysia’sfiscalpositionhas improvedrecently,


15

possibly due to stronger-than-expected oil-related revenues.

Butfurtherspendingisexpectedinrelationtonewinvestment

projects and development programsplannedunder theNinth

MalaysianPlan.InThailand,lingeringpoliticaluncertaintyand

tightenedgovernanceruleshavedelayeddisbursementofthe

plannedfiscalexpenditures,whichlimiteditseffortstoaccelerate

infrastructurespendinginkeyutilitiesandservices.ThePhilippine

government,meanwhile,targetedadeficitofP63billionin2007

fromP64.8billion (1.1%ofGDP) in2006and is expected to

surpassitsgoalduetostrongrevenuesandlargeprivatization

receipts. To ensure a balanced budget by 2008, stronger tax

administration and continued restraint in expenditures are

needed.PublicsectordebtintheASEAN-4economieshasdeclined

since2003.

AssessmentofFinancialVulnerability

Despite limited spillover into emerging East Asia from the US subprime turmoil, there are several signs of financial vulnerability related to sharp gains in equity and real estate prices.

Recentturbulenceininternationalfinancialmarketshassofar

hadonlylimitedeffectontheregion’sfinancialmarkets.Following

sharpdeclinesinthethirdquarter,regionalequitymarketshave

generally advanced—albeit amid higher volatility—and there

hasbeen sufficient liquidity in the region’s short-termmoney

markets.Theresiliencehasbeentheresultofthestrengthening

ofmacroeconomic and financial fundamentals in the region

togetherwith limiteddirectexposuretosubprimeandrelated

financialproducts.Thepotentialforspilloverremains,however,

assegmentsofthemajorinternationalfinancialmarketshave

notyetreturnedtonormalcy,additionallossesfromsubprime

relatedproductscontinuetoappear,andawiderre-pricingof

creditriskcannotberuledout.Inaddition,elevatedequityand

realestatepricesinanumberofregionaleconomiesareatrisk

of correction in the event of further international turbulence.

Reported large capital positions in regional banking systems,

generallylowernonperformingloan(NPL)ratios,andimproved

cushionsagainstmarketriskaregroundsforguardedoptimism,

butnotcomplacency.


16

Prudential Indicators

Prudential indicators for regional banking systems generally remain strong, with a sizable build up of capital cushions.

Favorableeconomicandfinancialconditionsinrecentyearshave

playedakeyroleinhelpingregionalbankingsystemsbuildup

largecapitalcushionsandreturntoprofitability.Supported in

manycasesbyofficialassetmanagementcompanies,manybanks

havealsosubstantiallyreducedtheirNPLratiosandstrengthened

assetquality.Reductionsinpublicandexternaldebtburdensto

relativelylowlevels(Table �)andupgradesinsovereignrisk

ratingshavealsoplayedakeycontributingrole(Figures 20a,

20b, 20c, 20d).Exposure toglobalmarket risk,however, is

higherthaninthepastandanyfurtherworseningininternational

financialmarket conditions could prove challenging. Banking

systems in the region entered the current period of financial

turbulencewithconsiderablestrength.Mostnotably,NPLratios

havegenerallyremainedloworhavefallenfurther(Table �a).

In addition, regulatory capital cushions have generally been

sustained at high levels (Table �b). Profitability in regional

bankingsystemscontinuedtobestrongthroughthemiddleof

theyearasreflectedinhighratesofreturnonassetsandequity

(Tables �c, �d).Thehighlevelsofprofitabilityhavereflected

notonly improvements incore lendingactivities,butalsothe

recentfavorablefinancialconditionsthathaveboostedreturns

onbanks’securitiesholdings.

Activity Indicators

Recent improvements in banking sector strength and soundness, sustained by strong macroeconomic fundamentals, reflect the improved risk profiles of regional banking systems, but they are now more closely linked to financial market conditions and thus more sensitive to movements in asset prices and returns.

Subduedlendingtothebusinesssectorhasmadedebtandequity

investmentsanincreasingshareofbankassets,whilebanksalso

havemovedaggressivelyintonewareassuchashouseholdand

realestatelending.Althoughbanks’newbusinessoperationshave

helpedprofitability,theyhavealsolefttheriskprofilesofbanking

Malaysia

Thailand

Philippines

Indonesia

Viet Nam

B-BB+

BB-

CCCCCC+

BB

BBB-BB+

AA-

BBB+BBB

2-Jan-03

30-Dec-03

27-Dec-04

21-Dec-05

15-Dec-06

27-Nov-07

Figure20a:S&P Sovereign Ratings (Long-termforeigncurrency)

Source:Bloomberg.

Singapore

Korea, Rep. of

Hong Kong, China

China, People's Rep. ofBBB+

A-

A

A+

BBB-

BBB

AA-

AA+

AA

AAA

2-Jan-03

30-Dec-03

27-Dec-04

21-Dec-05

15-Dec-06

27-Nov-07

Taipei,China

Figure20b:S&P Sovereign Ratings (Long-termforeigncurrency)

Source:Bloomberg.

B2B1

Ba3Ba2

Caa1B3

Ba1

Baa2Baa3

A2A3

Baa1

Malaysia

Thailand

Philippines

Indonesia

Viet Nam

2-Jan-03

30-Dec-03

27-Dec-04

21-Dec-05

15-Dec-06

27-Nov-07

Figure20c:Moody’s Sovereign Ratings (Long-termforeigncurrency)

Source:Bloomberg.

Baa1A3

A2

A1

Baa3-

Baa2

Aa3

Aa1-

Aa2

AaaSingapore

Korea, Rep. of

Hong Kong, China


2-Jan-03

30-Dec-03

27-Dec-04

21-Dec-05

15-Dec-06

27-Nov-07

Taipei,China

Figure20d:Moody’s Sovereign Ratings (Long-termforeigncurrency)

Source:Bloomberg.


17

Table3: Public and External Debt(%ofGDP)

200� 200� 2005 2006 2007

Public Sector Debt

China,People’sRep.of 19.2 18.5 17.9 17.3p …

Indonesia1 58.3 55.2 45.6 38.6 35.7p

Korea,Rep.of1 22.0 25.2 29.5 32.2 33.3p

Malaysia 68.8 66.7 62.5 56.5p 55.6p

Philippines2 100.8 95.4 86.3e 77.4p 72.7p

Thailand 50.7 49.5 47.4 42.3p 39.2p

VietNam 40.8 42.7 43.7 45.5p …

External Debt

China,People’sRep.of 12.7 12.8 12.6 12.7p …

Indonesia 57.7 53.5 46.6 36.6 31.2p

Korea,Rep.of 25.9 25.3 23.7 29.7 35.8p

Malaysia 47.3 44.6 39.6e 35.2p 33.5p

Philippines 78.8 70.5 62.6e 51.5p 46.7p

Thailand 36.2 31.7 29.5 27.5p 25.8p

VietNam 33.8 33.9 32.5p 32.6p …

p=projection,e=estimate,…=notavailable.1Centralgovernmentdebt.2Nonfinancialpublicsectordebt.Source:ArticleIVConsultations,InternationalMonetaryFund.

Table4a: Nonperforming Loans (%ofcommercialbankloans)

2001 2002 200� 200� 2005 2006 20071

China,People’sRep.of … 21.6 17.8 13.2 8.6 7.1 6.2

HongKong,China2 6.5 5.0 3.9 2.3 1.4 1.1 1.0

Indonesia 12.1 8.1 8.2 5.7 8.3 7.0 5.8

Korea,Rep.of 2.9 1.9 2.2 1.7 1.1 0.8 0.7

Malaysia2 10.5 9.3 8.3 6.8 5.6 4.8 3.5

Philippines2 17.3 15.0 14.1 12.7 8.2 6.0 5.3

Singapore … … 5.4 4.0 3.0 2.43 …

Taipei,China 7.5 6.1 4.3 2.8 2.2 2.1 2.3

Thailand 10.5 15.7 12.8 10.9 8.3 4.2 4.4

Memoitems:compromisedassetsratio(Indonesia)andnonperformingassetsratio(Philippines)

Indonesia 31.9 24.0 19.4 14.2 15.6 16.03 …

Philippines 27.7 26.5 26.1 24.7 19.7 18.64 ……=notavailable1DataforHongKong,ChinaasofMar2007;KoreaandTaipei,ChinaasofJun2007;PhilippinesasofAug2007;Indonesia,Malaysia,PRC,andThailandasofSep2007.2Reportednonperformingloansaregrossclassifiedloanratioofretailbanks.3AsofSep2006.4AsofJun2006.Notes:1.Thetableexcludesnonperformingloanstransferredfrombankbalancesheetstoassetmanagementcompanies.2.ThemeasurementofNPLsfollowsofficialdefinitionsanddiffersacrosseconomiesdependingonloanclassification(forexample,whethera3–monthor6–monthruleisused),thetreatmentofaccruedinterest,andwhetherspecificprovisioningisdeductedfromtheNPLmeasure.3.ForMalaysiaandthePhilippines,reportedNPLsarenetofspecificprovisioning.4.CompromisedassetsratioincludesreportedNPLs,restructuredloans,andforeclosedassetsforthe16largestbanksinIndonesia;distressedassetratioreferstotheratioofNPL+realandotherpropertiesownedandacquired(ROPOA)+restructuredloans,currenttototalloanportfolio,gross+ROPOA.Sources:Nationalsources;CEIC;andGlobal Financial Stability Report,InternationalMonetaryFund.


18

Table4d: Rate of Return on Commercial Bank Equity(%perannum,endofperiod)

200� 200� 2005 2006 2007H1

China,People’sRep.of … 13.7 12.4 14.1 …

HongKong,China 16.9 18.7 18.4 18.9 …

Indonesia1 25.3 37.1 32.3 33.2 35.52

Korea,Rep.of 3.4 15.2 18.4 14.6 …

Malaysia 15.3 16.0 16.5 16.1 …

Philippines 9.3 7.6 9.5 11.5 9.9

Singapore 10.3 11.8 11.1 12.43 …

Taipei,China 6.5 8.8 4.4 -7.3 5.1

Thailand 15.7 15.7 14.2 8.5 5.7

…=notavailable.12005figureonadomesticconsolidationbasis;notstrictlycomparablewithpreviousyears.2AsofMar2007.3AsofSep2006.Sources:CEIC,nationalsources,andIMFGlobal Financial Stability Report, InternationalMonetaryFund(PRCandIndonesia).

Table4c: Rate of Return on Commercial Bank Assets (%perannum)

200� 200� 2005 2006 2007H1

China,People’sRep.of … 0.8 0.8 0.9 …

HongKong,China 1.4 1.5 1.6 1.5 1.72

Indonesia 2.6 3.5 2.6 2.6 2.9

Korea,Rep.of 0.2 0.9 1.3 1.1 …

Malaysia 1.3 1.4 1.3 1.3 …

Philippines 1.2 1.0 1.1 1.3 1.1

Singapore 1.1 1.3 1.2 1.31 …

Taipei,China 0.5 0.6 0.3 -0.4 0.3

Thailand 0.7 1.3 1.4 0.8 0.3

…=notavailable.1AsofSep2006.2AsofMar2007.Sources:CEIC,nationalsources,andGlobal Financial Stability Report, InternationalMonetaryFund(PRCandIndonesia).

Table4b: Risk-Weighted Capital Adequacy Ratios (%ofrisk-weightedassets)

200� 200� 2005 2006 20071

HongKong,China 15.3 15.4 14.8 14.9 13.63

Indonesia 19.4 19.4 19.5 20.5 21.3

Korea,Rep.of 11.2 12.1 13.0 12.8 12.9

Malaysia 14.0 14.3 13.6 13.1 12.6

Philippines 17.4 18.7 17.7 18.5 …

Singapore 16.0 16.2 15.8 15.42 …

Taipei,China 10.1 10.7 10.3 10.1 9.5

Thailand 14.0 13.0 14.2 14.5 15.4

…=notavailable.Note:Basedonofficiallyreportedrisk-adjustedcapitaladequacyratiosunderBaselIandappliedto commercialbanks (exceptRepublicofKorea,wheredata includesnationwide commercialbanks, regionalbanks,andspecializedbanks).Data for thePhilippines isonaconsolidated,notsolo,basis.1DataforHongKong,ChinaasofMar2007;KoreaandTaipei,ChinaasofJun2007;Indonesia,Malaysia,andThailandasofSep2007.2DataforSingaporeasofSep2006.3BasedonBaselIIcalculations.Thepreviousyears’calculationswerebasedonBaselI.Source:Nationalsources.


19

systems more susceptible to movements in bond and equity

prices,realestateprices,andconsumercredit-worthiness.

AspartofthepreparationfortheadoptionofBaselII,banksinthe

regionhaveincreasinglybeenrequiredtoholdmoreregulatory

capital in relation tomarket risk,which should help increase

resilience to adversemarket developments. Debt and equity

securitiescurrentlyrepresentasignificantshareofbankassets

intheregion,withthesharesinIndonesiaandthePhilippines,for

example,reachingaboutonethirdoftotalbankassets (Table 5).

Holdingsofofficialdebtsecuritiesgenerallyimplylowlevelsof

creditrisk,butthesesecuritiesarestillsubjecttomarketrisk,

asareprivatedebtandequitysecurities.

Awareoftheserisks,supervisoryandregulatorybodiesinthe

regionhavebeenincreasinglyusingstressteststoassessthe

robustnessofbankingsystemstoworseningmarketconditions

and to determine appropriate cushions. Both secured and

unsecuredhouseholdlendingarebecomingincreasinglyimportant

tobankactivitiesintheregion(Tables 6a, 6b, 6c).Household

indebtednessinrelationtoGDPisover40%inseveraleconomies,

but remains low in Indonesia and the Philippines. Generally,

householdindebtednesshasnotrisentothelevelsthatwould

warrantconcern.However,givenrecentrapidgrowth,thelack

oflong-establishedcreditregistriesinseveralcountriesand,in

somecases,alackofinformationaboutthedistributionofcredit

acrosshouseholds, thesituationneedsclosemonitoring.Real

estate loans(asclassifiedbynationalauthorities)account for

anincreasingshareofoverallfinancialsectorlendinginseveral

Table5: Securities Investment to Total Bank Assets of Commercial Banks (%)

200� 200� 2005 2006 20071

HongKong,China 19.0 19.2 19.6 20.2 17.3

Indonesia 19.2 20.2 18.0 24.8 29.6

Korea,Rep.of 21.3 20.8 22.1 20.2 20.2

Malaysia 14.1 10.6 9.6 9.3 13.2

Philippines 28.6 31.6 32.0 30.0 35.9

Singapore 17.7 17.1 16.5 15.9 16.8

Taipei,China 15.2 14.2 12.1 12.0 11.5

Thailand 17.8 16.0 16.0 15.8 16.4

…=notavailable.Note:ForPRCandIndonesia,claimsratherthansecuritiesdataareused.1DataforHongKong,China;Singapore;Malaysia;andTaipei,ChinaasofSep2007;IndonesiaandThailanddataareasofAug2007;PhilippinesasofJul2007;andRepublicofKoreaasofJun2007.Sources: CEIC, Hong Kong Monetary Authority, Bank Indonesia, and Bangko Sentral ngPilipinas.


20

Table6a: Household Indebtedness (%ofGDP)

2002 200� 200� 2005 2006 2007Q�1

Indonesia 5.4 6.7 8.2 9.1 8.5 8.3

HongKong,China 62.0 60.9 58.2 55.5 52.1 54.0

Korea,Rep.of 32.5 34.9 35.3 37.6 40.8 41.0

Malaysia2 47.2 49.2 50.0 52.5 53.1 53.7

Philippines 5.3 4.8 5.2 4.7 4.2 4.2

Singapore3 … … 51.0 49.4 46.4 47.4

Taipei,China 43.2 47.2 53.0 58.3 56.7 56.8

Thailand … … 24.5 24.7 23.7 23.5

Table6b: Household Non-mortgage Indebtedness (%ofGDP)

2002 200� 200� 2005 2006 2007Q�1

Indonesia 4.2 5.2 6.4 7.1 6.3 6.1

HongKong,China 10.3 10.3 10.9 11.0 11.7 13.2

Korea,Rep.of 13.2 13.8 13.6 14.2 15.2 15.5

Malaysia2 21.0 21.3 21.9 23.7 24.8 24.9

Philippines 4.5 4.1 4.5 4.1 3.6 3.6

Singapore3 … … 18.0 16.7 15.4 15.2

Taipei,China 16.3 18.4 21.5 23.5 19.5 18.3

Thailand … … 8.4 7.6 6.5 6.1

Table6c: Household Mortgage Indebtedness (%ofGDP)

2002 200� 200� 2005 2006 2007Q�1

PRC 6.9 8.7 10.6 10.0 10.7 11.6

Indonesia 1.2 1.5 1.8 2.0 2.2 2.2

HongKong,China 50.3 49.9 47.3 44.4 40.3 40.8

Korea,Rep.of 19.3 21.1 21.8 23.4 25.6 25.5

Malaysia2 26.2 27.8 28.0 28.7 28.4 28.8

Philippines 0.8 0.7 0.7 0.6 0.6 0.6

Singapore3 29.3 32.9 33.0 32.7 31.0 32.2

Taipei,China 26.9 28.9 31.5 34.8 37.2 38.5

Thailand 13.9 14.6 16.1 17.1 17.2 17.4

…=notavailable.1Asof30Jun2007forIndonesiaandKorea;31Mar2007forthePhilippines.2Sumofloansforpersonaluse,creditcards,purchaseofconsumerdurablegoods,andpurchaseofpassengercarsforcommercialbanks,merchantbanks,andfinancecompanies.2006and2007datafromcommercialbanksandmerchantbanksonly.3Referstoconsumerloansfromcommercialbanksandfinancecompanies.Sources:CEIC;Monthly Statistical Bulletin,BankNegaraMalaysia;Monthly Statistical Bulletin,MonetaryAuthorityofSingapore;People’sBankofChinaandHongKongMonetaryAuthority.

regional economies (Figure 21). As a result, the financial

system’s exposure to real estate has increased, as have the

possibleadverseeffectsofanycorrectioninrealestateprices.

National authorities in several countries—including the PRC,

Korea, andVietNam—have recently taken steps tohelp cool

thesemarkets.

0 10 20 30 40 50

Hong Kong, China

Indonesia

Korea, Rep. of

Malaysia

Philippines

Singapore

Taipei,China

Thailand

Dec-04Dec-05Dec-06Sep-071

China, People's Rep. of 15

20

15

8

36

46

38

19

18

11

47

1236

16

9

17

40

20

Figure21:Real Estate Loans (%oftotalloans)

Sources:People’sBankofChina,Bank Indonesia, FinancialSupervisoryService(Korea),BankNegaraMalaysia,BangkoSentralngPilipinas(Philippines),BankofThailand,HongKongMonetaryAuthority,andCEIC.1KoreaasofJun2007.


21

Market Indicators

While the share prices of listed financial corporations in the region have largely avoided the sharp downward corrections of their US and European counterparts, they have generally underperformed the stock market indexes on which they are listed.

Regional banking systems have avoided the sharp downward

adjustments in share prices evident inmany of themature

financialmarkets during the recent turbulence. For themost

part, this has reflected relatively low direct exposure to the

creditandliquidityproblemsintheUSsubprimemarket,along

withlessconcernonthepartofinvestorsaboutthepossibility

of unreported off-balance sheet losses. To date, several

economies in the region—including PRC; Hong Kong, China;

Korea; Singapore; and Taipei,China—have reported exposure

totheUSsubprimemarket,butthesehavegenerallybeenvery

small,andprovisioningchargeshavehadonlyalimitedimpact

onprofitability.Acontinuedbenignoutcomeisnotnecessarily

guaranteed, however, in the event that international financial

turbulenceresumesand there isamoregeneral re-pricingof

creditrisk.

EconomicOutlookfor2008,Risks,andPolicyIssues

External Economic Environment

The moderation in economic growth among the world’s major industrial economies that started this year is likely to continue in 2008.

LedbyaslowdownintheUSeconomy,economicgrowthinthe

OrganisationforEconomicCo-operationandDevelopment(OECD)

is projected tomoderate further to 2.3% in 2008, following

estimatedgrowthof2.7%in2007.Butgrowthdecelerationin

thenon-USOECDeconomiesisexpectedtoremainreasonably

modestin2007–08,withdomesticdemandintheeurozoneand

Japanmakingagradualrecovery.Andwhilefinancialturbulence

inrecentmonthshasyettohaveanymajorimpactonthereal


22

economy, stockmarkets around theworld continue to show

significant volatility. Tighter credit conditions persist in some

segmentsofmoneyandlendingmarkets,andmoresignificant

economicrepercussionscannotberuledout.

US economic growth—down from 2.9% last year to a likely 2.2% this year—is expected to slow further in 2008, driven by the housing market correction and related financial market volatility.

Third-quarterUSGDPgrowthcameinstrongat4.9%,unexpectedly

acceleratingoverthesecondquarter’s3.8%(quarter-on-quarter,

seasonally adjusted annualized rate) (Figure 22). Although

consumerswilllikelyfeelthedowndraftfromthesubprimeturmoil

inthemonthsahead,recentconsumptionandemploymentdata

showmuchresilience.Relativelyrobustconsumerspending is

supportedbyahealthyjobmarket.InAugustthroughOctober,

non-farm payrolls were up an average of nearly 120,000.

Average hourly earnings are also edging up and an increase

in real disposable personal income has supported consumer

spending.Butthepersistenthousingslumpposesasignificant

threattogrowth.Homesalesarestillfallingand,withtheglut

of home supply, house prices are expected to drop further

(Figure 2�).Theeffectonconstructionfromthehousingmarket

correctionisalsolikelytocontinuetoconstraingrowthinto2008.

Meanwhile,thehousingmarketdownturnhasspilledoverintothe

manufacturingandserviceindustries.Retailsaleshaveslowed

inrecentmonths,hitbyasharpdeclineinconsumerconfidence.

RecentsurveysofbusinessactivityfromtheInstituteforSupply

Managementalsoshowalossofmomentumamidsluggishnew

ordersandrisinginventories(Figure 2�).Inresponsetothe

downside risks to economic growth, the US Federal Reserve

(Fed) cut its official rate again on 11December by 25basis

points(bp),addingtothe31October25bpcutandthe50bpcut

on18September.Whileslowingeconomicactivityhashelped

keeppricepressuresatbay,resurgentglobaloilandcommodity

pricesarereignitinginflationconcerns.Headlineinflationdrifted

higherto3.5%(y-o-y) inOctober, fromthefirst-halfaverage

of2.5%,althoughcoreinflationremainsstablewithintheFed’s

comfortzone.TherecentdeclineintheUSdollarisalsoraising

concerns,althoughitishelpingimproveexportperformance.The

UScurrentaccountdeficitispersistentlylarge,butaweakerUS

dollarwillallowforanothermoderateimprovementinthetrade

balancein2008.

Figure22:Contributions to Growth—US (seasonallyadjusted,annualized,q-o-q,%change)

Source:USBureauofEconomicAnalysis.

2.1

0.6

2.7 33.5 3.6

2.5

3.1

2.8

4.5

1.2

7.5

3.5

1.2

4.8

1.1

2.4

4.93.8

-4

-2

0

2

4

6

8

10

2003Q1

2003Q3

2004Q1

2004Q3

2005Q1

2005Q3

2006Q1

2006Q3

2007Q1

2007Q3

Personal consumptionGovernment consumptionPrivate domestic investmentNet exportsGDP

Real GDP growth

4.97

6.927.12

255.5

184.3

215

4

5

6

7

8

Jan-01

Oct-01

Jul-02

Apr-03

Jan-04

Oct-04

Jul-05

Apr-06

Jan-07

Oct-07

150

200

250

300

Sales (million units)

Prices(Mean, $ '000)

Prices

Sales

Figure23:Existing Home Sales1 and Prices—US

1Seasonallyadjusted;annualized.Source:CEIC.

5249 51

65

56

61

65

43464952555861646770

Jan-04

Jun-04

Nov-04

Apr-05

Sep-05

Feb-06

Jul-06

Dec-06

May-07

Oct-07

Non-manufacturing

Manufacturing

Figure24:US Business Activity Survey Indexes1

1Data survey from the Institute for Supply Management.Theindexesareasummarymeasureshowingtheprevailingdirectionandscopeofchange.Anindexabove50%indicatesthat the manufacturing or non-manufacturing economy isgenerallyexpanding;below50%indicatesthatitisgenerallydeclining.Source:Bloomberg.


2�

Growth momentum in the euro zone is likely to slow from an estimated 2.6% this year to 2.1% in 2008 amid heightened financial volatility and a substantial appreciation of the euro.

In2007,theeurozoneeconomyheldfirmonthebackofrobust

investmentandGermanindustrialstrength(Figure 25).However,

thatpaceisunlikelytocontinueasaslowingUSeconomyand

astrongereurostarttocrimpexportgrowthandtightercredit

damps investment. Euro zone financialmarketswere visibly

shakenbytheUSsubprimeturmoil.Indeed,severalEuropean

bankswithdirectexposuretoUSsubprimemortgagesandrelated

mortgagederivativeswerecaughtinthemeltdown.Notably,IKB

DeutscheIndustriebankreportedlargelossesandBNPParibas

made headlines by suspending withdrawals from $2.2billion

worth of funds invested in asset-backed securities.Worries

aboutthefinancialturbulenceinturnunderminedconsumerand

investorsentiment(Figure 26).Astrongeuro—whichsurgedto

recordhighsagainsttheUSdollar—andtherecentriseinmoney-

market interestratesabovetheEuropeanCentralBank(ECB)

reference rate suggest thatmonetary conditions arede facto

tightening,whichmightallowtheECBtorelaxitstighteningbias

forthetimebeing.Nonetheless,inflationarypressuresarerising,

witheurozoneinflationpickingupto3.0%inNovemberdueto

risingenergyandfoodprices.Tightenedproductioncapacityand

labormarketconditionsarealsotranslatingintohigherpricesand

wages.Onabrighternote,externalperformancesofarexhibits

relativebuoyancydespitethestrongeuro.Remarkableresilience

in emergingmarket economies coupled with their currency

strengthagainsttheUSdollar’sslidehashelpedsustainexport

growth,especiallyinGermany.Theeurozonecurrentaccountis

expectedtobeinbalancein2008.

In Japan, GDP likely grew 1.9% this year but the momentum has weakened visibly, with GDP growth projected to slow to 1.7% in 2008.

Third-quarter growth rebounded to an annualized 1.5% from

a1.8%declineinthesecondquarteronstrongexportsanda

pickupininvestment(Figure 27).ButaslowingUSeconomyand

recentstrengtheningintheyencastashadowoverexport-driven

growthnextyear.Arecoveryinprivateconsumptionalsostilllags,

reflectingsluggishgrowthinhouseholdincomedespiteagradual

tighteninginthelabormarket.However,theinvestmentoutlook

95.4

112.1

104.8100.8

85

90

95

100

105

110

115

Jan-04

Oct-04

Jul-05

Apr-06

Jan-06

Nov-07

Figure26:Economic Sentiment Indicator1

—euro zone

1The economic sentiment indicator is a composite indexof business and consumer confidence indicators based onsurveysofoveralleconomicassessmentandexpectationsintheeurozone.Source:Bloomberg.

4.35.9

4.3

8.4

0.80

2

4

6

8

10

Jan-04

Jun-04

Nov-04

Apr-05

Sep-05

Feb-06

Jul-06

Dec-06

May-07

Oct-07

Figure25:German Industrial Production (y-o-y,seasonallyadjusted)

Source:Bloomberg.

2.6

4.6

1.4

3.1

1.8

-1.8

1.5

3.2

1.2

-0.4-1.7

2.1

3.0 4.4

6.6

-0.8 -0.3

3.3

5.3

-4

-2

0

2

4

6

8

2003Q1

2003Q3

2004Q1

2004Q3

2005Q1

2005Q3

2006Q1

2006Q3

2007Q1

2007Q3

Private consumptionGovernment consumptionInvestmentNet exportsStatistical discrepancyGDP Growth

Real GDP growth

Figure27:Contributions to Growth—Japan(seasonallyadjusted,annualized,q-o-q,%change)

Source:CabinetOffice,GovernmentofJapan.


2�

remainsgenerallypositivegivenhealthycorporateprofits,tight

capacitylevels,andstillbenignfundingconditions.Butconcernis

rifethattherecentfinancialturmoilmaydepressconsumerand

investorsentimentfurther,particularlyiftheUSeconomyslows

moresignificantly.Headlineinflationhasagainbeenbelowzero

formostoftheyear,whilecoreinflation—whichexcludesfood

andenergyprices—hasbeenfurtherdippingintothenegative

(Figure 28). TheBankof Japanhaskept rates steadysince

February, reflecting amore cautious stance in light of softer

economicactivityandtherecentfinancialmarketvolatility.

Continued strong growth in most emerging market economies is likely to partially compensate for the easing demand in developed countries; yet growth in world trade volume is projected to slow to 7.6%, after growing about 9% this year.

Worldtradevolumegrowtheasedin2007asdemandfrommajor

industrial countries slackened. But brisk demand elsewhere,

particularlyinthedevelopingworld,ishelpingsustainrelatively

healthymomentum. After someweakness aroundmidyear,

industrial production in key industrial countries is slowly

recovering, but not to previous levels. And while unable to

compensate fully for the moderation in demand from OECD

economies,healthymomentuminmanufacturingoutputamong

developingcountriesisexpectedtoprovidesupportforcontinued

robust world trade in 2008, albeit at amoderated pace. In

emerging East Asia, for example, industrial production grew

morethan13%inthesecondquarterof2007.2ThePRCleads

thegroup,withindustrialproductionup18.1%.Butsolidgains

havebeenachievedacrosstheregion.

Anotherfactorinexpectationsformoremoderatebutstillhealthy

world trade growth is the recovery in the global information

technology(IT)industry.Earlysignsindicatethatglobaldemand

for IT products—amajor source of export earnings formany

emergingEastAsianeconomies—is likelytoreboundin2008.

Therewasacyclical ITdownturnthroughmostof2007,with

weakeningequipment investment in theUSearly in theyear,

fallingchipprices,andsluggishinventoryadjustments.However,

itnowappearsthatarecoverymaybeunderway,whichmayhelp

theregion’s industrialproductionandtradefurther into2008.

Thedecelerationinnewordersisslowingandthesemiconductor

2ExcludingBruneiDarussalam,Cambodia,LaoPDR,andVietNam.

0.3

-1.0

0.3

0.8 0.9

-0.3

-0.2

-1.5

-1.0

-0.5

0.0

0.5

1.0

Jan-04

Apr-04

Jul-04

Oct-04

Jan-05

Apr-05

Jul-05

Oct-05

Jan-06

Apr-06

Jul-06

Oct-06

Jan-07

Apr-07

Jul-07

Oct-07

Headline inflation

Core inflation

Figure28:Inflation—Japan (y-o-y)



25

book-to-billratio,whichslidto0.79inSeptember,isalsoheading

upward(Table 7).

High energy and commodity prices are expected to continue into 2008 due to a combination of strong demand—especially from emerging markets—and consistent worries over supply conditions.

InNovember,crudeoilpricessetanewrecordhighnear$100a

barrel.Globaldemandisstrongdespitesofteninggrowth,while

supply conditions remain precarious. Persistent geopolitical

tensionsandsupplyconcernscoupledwithlimitedsparecapacity

giverisetosignificantpricevolatility.Foodpricesandsomemetals

pricesalsocontinuedtogainsignificantlyin2007(Figure 29).

Althoughamoderation in theupward trend is expected, it is

likelythatenergyandseveralcommoditypriceswillremainat

historicallyhighlevelsinto2008.

Recent shifts in monetary stances of major central banks suggest global monetary conditions may remain accommodative a bit longer.

In response to ade facto tightening inmajormoneymarket

conditionsduringthesubprimeturmoil,theUSFederalReserve

decisivelylowereditsovernightrate,whileothermajorcentral

bankshavepausedintheirtighteningcycles.Flighttoqualityand

liquidityduringtheAugust2007marketsell-offpushedyields

on 10-year US, United Kingdom (UK), and euro government

bondslower(Figure �0).Andageneralre-pricingofcreditrisks

haswidenedcreditspreads forcorporatebonds(Figure �1).

Emergingmarket sovereign bond spreads also widened as

Table7: Semiconductor Shipments, Bookings, and Book-to-Bill Ratio

Date Shipments Bookings Book-To-Bill

y-o-y, % m-o-m, % y-o-y, % m-o-m, % Value y-o-y, % m-o-m, %

31-Jan-07 14.98 -2.31 17.94 -3.43 1.00 3.09 -0.99

28-Feb-07 10.89 -1.73 8.11 -3.30 0.98 -2.97 -2.00

31-Mar-07 7.30 0.94 2.48 1.54 0.99 -3.88 1.02

30-Apr-07 10.64 11.02 -2.30 10.42 0.98 -11.71 -1.01

31-May-07 14.98 4.73 1.41 4.75 0.98 -11.71 0.00

30-Jun-07 13.53 5.86 -9.80 -2.09 0.91 -20.18 -7.14

31-Jul-07 2.92 -4.65 -18.93 -12.52 0.83 -21.70 -8.79

31-Aug-07 -3.47 -0.21 -20.73 -2.50 0.82 -17.17 -1.20

30-Sep-07 -6.90 -7.42 -24.66 -9.93 0.79 -19.39 -3.66

31-Oct-07 -4.79 -4.45 -16.14 -0.28 0.83 -11.70 5.06

Source:OREIstaffcalculationsbasedonBloombergdata.

All PrimaryCommodities

Metals2

Food & Beverage3

AgricultureMaterials4

50

100

150

200

250

300

Jan-04

Jun-04

Nov-04

Apr-05

Sep-05

Feb-06

Jul-06

Dec-06

May-07

Oct-07

222

163165

141

107

287

251

134

Energy1

230

Figure29:Primary Commodity Price Indexes (Jan2004=100)

1Crudeoil,naturalgas,coal.2Copper,aluminum,ironore,tin,nickel,zinc,lead,uranium.3 Cereal, vegetable oils, meat, seafood, sugar, bananas,oranges,coffee,tea,cocoa.4Timber,cotton,wool,rubber,hides.Source:OREIstaffcalculationsbasedondatafromtheIMF Primary Commodity Prices,InternationalMonetaryFund.

1.94

3.95

5.19

4.44

5.55

4.594.67

4.04

3.69

1.0

1.5

2.0

2.5

3.0

3.5

4.0

2-Jan-06

20-Mar-06

5-Jun-06

21-Aug-06

6-Nov-06

22-Jan-07

9-Apr-07

25-Jun-07

10-Sep-07

26-Nov-07

3.0

3.5

4.0

4.5

5.0

5.5

6.0

Japan

euro zone

UKUS

euro zone, UK, USJapan

Figure30:10-year Government Bond Yields (%perannum)

Note:Theshadedareaindicatestheperiod15Julto20Sept2007.Source:Bloomberg.


26

investors fled risky assets. There is now concern that tighter

global creditmayaffectoveralleconomicactivityby reducing

loanstobusinessesandhouseholds.Thereisalsoevidencethat

lending standards are already becoming more strict in some

maturecreditmarkets.

Despite significant injections of liquidity into the financial system by the world’s major central banks, financial volatility in global markets remains high, with heightened investor sensitivity to risk likely to persist into 2008.

StockmarketsralliedaftertheFed’sratecutsinSeptemberand

October.TheworldMorganStanleyCapitalInternational(MSCI)

BarraIndexisnowhigherthanbeforethemarketcorrectionin

AugustandSeptember(Figure �2).3Butglobalequitymarkets

remain sensitive to new data releases on the US economy,

reflectingheightenedriskperception.There-pricingofcreditrisks

hasalsobeenorderlyinmostcreditmarkets.Butsomesegments

ofthemoneymarketsarestillstrainedbyalackofliquidityand

increasedcounterpartyrisk.Despitegenerallytightercreditand

heightened financial volatility, however, external funding for

emergingEastAsianeconomiesremainsadequate.

In sum, the external environment for emerging East Asian economies is expected to weaken somewhat in 2008, as economic growth in industrial countries moderates, oil and commodity prices remain elevated, and global financial markets continue to exhibit heightened volatility.

Althoughrecentfinancialinstabilityhashadonlylimitedimpacton

theglobaleconomy,furthersignificantspillovercannotberuled

out.WorldGDPgrowthisexpectedtoslow,althoughwiththe

globalITmarketslowlyrecoveringfromitsrecentslump,external

demandforregionalproductsmayremaingenerallysupportive

nextyear.Andinflationarypressuresareresurfacingasglobaloil

andcommoditypricessurge,complicatingmonetarydecisions

into2008.AfterabriefretreatinAugustandSeptember,capital

flowstoemergingmarketeconomieshaveresumed,againadding

topressureonassetpricesandcurrenciesinthesemarkets.Amid

increasedvolatilityinpriceandvolume,financialconditionswill

warrantclosemonitoring.

3 TheMSCIBarraindexesarewidelyusedasperformancebenchmarksbyassetmanagers.TheMSCIAllCountryWorldIndexcovers23developedand26emergingequitymarkets.Sources:WallStreetJournalandMSCIBarra.

Japan

US

euro zone

142131

32

72

195

150

124

105 100

676458

370

25

50

75

100

125

150

175

200

02-Jan-06

30-Mar-06

25-Jun-06

20-Sep-06

16-Dec-06

13-Mar-07

08-Jun-07

03-Sep-07

29-Nov-07

basis points

Figure31:Corporate Bond Spreads1

Note: The shaded area indicates the period 15 Jul to 20Sep2007.1 Refers to the difference between yields of 5-year bondsissuedbyBBB-ratedfinancecompaniesandyieldsofsovereignbenchmarkbondsofthesametenor.Source:Bloomberg.

130

120115

174

197190

214

162

80

100

120

140

160

180

200

220

02-Jan-06

20-Mar-06

05-Jun-06

21-Aug-06

06-Nov-06

22-Jan-07

09-Apr-07

25-Jun-07

10-Sep-07

26-Nov-07

Emerging Latin America

Emerging Europe

Emerging Asia

World

Figure32:MSCI Indexes(2Jan2006=100)

Note:Shadedareaindicatestheperiod15Julto20Sep2007.Source:MorganStanleyCapitalInternational(MSCI)Barra.


27

Regional Economic Outlook for 2008

With the external environment weakening somewhat—and the PRC, the region’s largest economy, expected to soften next year—aggregate GDP growth in emerging East Asia is forecast to slow to 8.0% in 2008 from a likely 8.5% this year.

While much of the region will be affected by the expected

slowdownineconomicexpansionin industrialcountries,there

remain several mitigating factors that will allow emerging

EastAsianeconomies tosustain lowerbutstill robustgrowth

(Table 8). Despite attempts to cool its economy, the PRC is

likelytocontinueitsdouble-digitexpansion.Atthesametime,

growthintherestoftheregionhasbecomemorebroad-based,

withstronggainsinsomelargereconomies—includingIndonesia

and thePhilippines—andsmall economiescontinuing to catch

up.GDPgrowthintheNIEsisexpectedtoeaseonlymodestlyin

2008,whileGDPgrowthinASEAN-4islikelytobe,ifanything,

higher. Also, despite softer external demand and the cyclical

downswingintheglobalITindustry,exportsperformedstrongly

andmosteconomiesintheregionpostedsolidcurrentaccount

surplusesin2007(Figure ��).Asrobustgrowthpersistsinthe

regionandtheglobalITindustryisexpectedtorecoveroverthe

courseof2008,exportgrowthisexpectedtorecover.Butrapid

economicgrowthandstrengtheningdomesticdemandarelikely

tocompresscurrentaccountsurplusesacrosstheregion.

The PRC economy is expected to continue double-digit growth in 2008, but the pace may soften—off its current peak—if measures to cool the economy begin to take hold.

Growthinthefirst3quartershitarecord11.5%,andisprojected

tosustaindouble-digitlevelsfortheremainderofthisyearand

next,althoughthepace isexpectedtomoderateto10.5%in

2008.Aseriesoftighteningmeasureshasbeenintroducedto

curb rapid investment growth and asset-price inflation since

mid-2006,butthefulleffecthasyettobeseen.Strongexports

continuetobolsterinvestment,especiallyinmanufacturingand

mining.Increasingly,privateconsumptiongrowthiscontributing

toeconomicstrength.Risingincomesandimprovementstothe

social security system underpin rapid consumption growth. A

planned increase in fiscal spending should also supportmore

2.6

16.711.8

2.7

31.0

8.0

7.4

27.9

14.0

1.4

18.5

4.2

13.9

14.7

12.0

-0.3

-5 0 5 10 15 20 25 30 35

2007H12006H22006H1China, People's Rep. of

Hong Kong, China

Indonesia

Korea, Rep. of

Malaysia

Philippines

Singapore

Thailand

Taipei,China

5.5

7.87.5

4.55.4

Figure33:Current Account Balance (%ofGDP)

Source:International Financial Statistics,InternationalMonetaryFund.


28

broad-basedexpansion in2008,withmorepublic investment

slatedforeducation,healthcare,andruraldevelopment.

GDP growth in the NIEs is forecast to average 5.1% next year, just slightly below an estimated 5.3% in 2007.

InKorea,growth isgatheringpaceasstrongexportearnings

andcorporatesectorbalancesheetssupportreasonablyhealthy

investmentgrowth.Inaddition,asteadytighteninginthelabor

marketisdrivingagradualrecoveryinconsumption.InSingapore,

despitebuoyantindustrialactivity—drivenbythemanufacturing

Table8: Annual GDP Growth Rates (%)

Average ADB Forecasts

1996–2006 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

Emerging East Asia 1,2 6.5 6.7 7.7 �.6 7.0 6.9 8.0 7.8 8.� 8.5 8.0

ASEAN 1,2 �.2 �.� 6.7 1.9 �.9 5.� 6.� 5.6 6.0 6.� 6.1

BruneiDarussalam 2.0 3.1 2.9 2.7 3.9 2.9 0.5 0.4 5.1 1.9 2.3

Cambodia 8.6 12.6 8.4 7.7 6.9 8.5 10.0 13.5 10.8 9.2 8.0

Indonesia3 3.1 0.8 4.9 3.6 4.5 4.8 5.0 5.7 5.5 6.2 6.4

LaoPDR 6.3 7.3 5.8 5.8 5.9 5.8 6.9 7.2 7.3 6.8 7.9

Malaysia4 4.9 6.1 8.9 0.5 5.4 5.8 6.8 5.0 5.9 5.9 5.9

Myanmar5 10.7 10.9 13.7 11.3 12.0 13.8 13.6 13.2 ... ... ...

Philippines6 4.3 3.4 6.0 1.8 4.4 4.9 6.4 4.9 5.4 7.0 6.4

Thailand 3.1 4.4 4.8 2.2 5.3 7.1 6.3 4.5 5.0 4.3 4.8

VietNam 7.3 4.8 6.8 6.9 7.1 7.3 7.8 8.4 8.2 8.3 8.5

Newly Industrialized Economies1 �.5 6.9 7.7 1.0 5.� �.2 6.0 �.8 5.5 5.� 5.1

HongKong,China 3.8 2.6 8.0 0.5 1.8 3.0 8.5 7.1 6.8 6.1 5.4

Korea,Rep.of 4.6 9.5 8.5 3.8 7.0 3.1 4.7 4.2 5.0 4.8 5.0

Singapore 5.5 7.2 10.1 -2.4 4.2 3.1 8.8 6.6 7.9 8.1 6.3

Taipei,China 4.6 5.7 5.8 -2.2 4.6 3.5 6.2 4.2 4.9 5.0 4.8

China,People’sRep.of 9.3 7.6 8.4 8.3 9.1 10.0 10.1 10.4 11.1 11.4 10.5

Japan 1.2 -0.1 2.9 0.2 0.3 1.4 2.7 1.9 2.2 1.9 1.7

US 3.2 4.5 3.7 0.8 1.6 2.5 3.6 3.1 2.9 2.2 1.9

Eurozone 2.1 3.0 3.8 1.9 0.9 0.8 2.0 1.5 2.8 2.6 2.1

...=notavailable1Aggregatesareweightedaccordingtogrossnationalincomelevels(atlasmethod,currentUS$)fromWorld Development Indicators(WorldBank).2ExcludesBruneiDarussalamandMyanmarforallyearsasweightsareunavailable.3GDPgrowthratesfrom1999–2000arebasedon1993prices,whilegrowthratesfrom2001onwardarebasedon2000prices.4Growthratesfrom1999–2000arebasedon1987prices,whilegrowthratesfrom2001onwardarebasedon2000prices.5ForfiscalyearApril–March.6Figuresfor2004–2006arenotlinkedtotheGDPfigures2003backwardsduetoNationalStatisticsOfficerevisionsofsectoralestimates.Sources:ADB;governmentestimates(BruneiDarussalam);Eurostatwebsite(eurozone)EconomicandSocialResearchInstitute(Japan);BureauofEconomicAnalysis(US).


29

andconstructionsectors—moderationisexpectedduetoaslowing

infinancialservices.TheoutlookforHongKong,China,whichis

heavilyinfluencedbythePRC,remainssolid.However,therapidly

closingoutputgapandmoresubduedfinancialmarketconditions

implysomeeasingofgrowthin2008.

The four largest ASEAN economies—currently in the upswing phase of their business cycles—are forecast to maintain strong growth in 2008, with Indonesia and Thailand accelerating, Malaysia maintaining this year’s pace, and the Philippines slowing somewhat from a strong 2007.

Strong domestic demand and resilient exports are likely to

keepthefourmiddle-incomeASEANcountriesingoodstead.In

Indonesia,GDPgrowthcontinuestoaccelerate,afterexceeding

6%in2007forthefirsttimesincethe1997/98Asianfinancial

crisis.Buoyantconsumptionandstronginvestmentonthebackof

easiermonetarypolicyunderpintherobustoutlook.InMalaysia,

improvingelectronicsexportswillsupportrelativelystronggrowth

whiletheimpactoffiscalstimulusondomesticdemandgradually

fades.InthePhilippines,GDPgrowthwillremainhighatabout

6.4% in 2008—although off the post-crisis peak reached this

year—onstronggainsinnetexports,privateconsumption,and

governmentspending.Thailand’seconomycontinuestostruggle

amid ongoing political and policy uncertainties. But there is

substantial scope for expansionary policies—which can boost

GDPgrowthin2008—oncetheDecembernationalelectionshave

reducedpoliticaluncertainty.

The smaller ASEAN economies—Cambodia, Lao People's

Democratic Republic (Lao PDR), and Viet Nam—continue to

post impressiveeconomicgrowth,althoughGDP inCambodia

isexpectedtoslowabitin2008.Thepaceofeconomicgrowth

in2008isexpectedtoquickenfurtherinVietNam,drivenby

vigorousindustrialactivityandstronginvestmentfollowingits

January2007accessiontotheWorldTradeOrganization(WTO).

Cambodia is working to consolidate output performance by

promotingamorebalancedexpansionamongkeyindustries—

includingagriculture,construction,garments,andtourism.But

GDPgrowthremainsnarrowlybasedongarmentsandtourism.

Intheshortterm,increasinglyuncertainprospectforgarments

ishamperingtheeconomy.TheLaoPDRisbenefitingfromlofty

globalenergyandcommodityprices,asstronginvestmentand


�0

growthinminingandhydropowersectorssupporttheexpansion.

GDPisforecasttogrowsignificantlyat7.9%in2008from6.8%

in2007.

Even as growth slows somewhat, inflation is generally picking up in many emerging East Asian economies, largely due to resurgent oil and other commodity prices.

InthePRC,inflationwasbackupto6.5%inOctober2007,with

particularlyacuteinflationriskridingthebackofrapiddemand

growthandwageincreases(see Figure 11).Plannedpricing

reforms of state-controlled sectors—an increase in the prices

of public utilities, including power and water, for example—if

implemented,mayadd toexisting inflationarypressuresnext

year. In general, for the rest of the region, robust growth,

relatively tight labormarkets, and higher energy prices are

expectedtogenerallyincreaseinflationarypressuresin2008.

Currentaccountsareexpectedtocontinuetoshowlargesurpluses

inthePRC;HongKong,China;Malaysia;andSingapore,butwill

likelybeclosetobalanceinIndonesia,Korea,andThailand.After

abriefwithdrawalofforeigncapitalduringtherecentfinancial

turbulence,capitalinflowstotheregionhaveresumedtheupward

trendwithavengeance.Persistentcurrentaccountsurplusesand

netcapitalinflowswillcontinuetoplaceappreciationpressures

onregionalcurrenciesin2008.Andasauthoritiesintervenein

foreignexchangemarketstocurbthepace, foreignexchange

reserveswillriseacrosstheregion(Table 9).Withheightened

volatilitythreateningfinancialstability,authoritiesshouldclosely

monitorfinancialmarketdevelopmentsandremainvigilantfor

anymis-pricingofrisk.

Risks to the Outlook

The region’s economic outlook is subject to greater downside risks now than just a few months ago—including the possibility of a US recession, further tightening of global credit, an abrupt adjustment in exchange rates, and a continued rise in oil and commodity prices.

ThepossibilityofaUSrecessionremainsariskgivenunderlying

housingmarketweaknessandgrowingconcernaboutaspillover


�1

onto consumer spending and business activity in general.

The persistent housing slump already dragged down private

residentialinvestmentfortheseventhconsecutivequarterduring

July–September2007.Businessandinvestmentactivityarealso

slowingastheoutlookbecomescloudierandfinancialmarket

uncertainty dampens business confidence. Consumersmay

also comeunder significantpressure if deterioratingbusiness

sentiment affects the labor market. Consumer confidence

droppedforathirdconsecutivemonthinOctober,toitslowest

level in a year, as housingmarketwoes andwidening credit

concernscompoundedworriesabouttheeconomyandfuturejob

prospects.EmergingEastAsia’stradelinkswithG3economies4

remainsubstantial,althoughingradualdecline(Figure ��).If

theUSeconomyslowssharply,itseffectonglobaltradewould

be significant—it remains an important source of demand for

manyEastAsianexporters,andforthePRCinparticular(21%

of totalexports in2006,andhigher if factoring in third-party

economies’ re-exports). The US subprime turmoil could also

spawnareassessmentofhousingpricesglobally.Othercountries

withsignificanthouse-priceinflationinthepastfewyears,such

assomeEuropeancountries—particularlytheUK—andAustralia,

alsoremainvulnerabletoahouse-pricebust.IftheUSeconomy

entersarecessionandtheglobaleconomysubstantiallyslows

4G3includestheeurozone,Japan,andUS.

Table9: Foreign Exchange Reserves (excludinggold)

Country/Region$ billion % change (y-o-y)

Dec-05 Dec-06 Mar-07 Jun-07 Sep-071 Dec-05 Dec-06 Jun-07 Sep-071

BruneiDarussalam 0.5 0.5 0.5 0.5 0.5 -2.2 5.9 2.6 3.1

Cambodia 1.0 1.2 1.2 1.4 1.4 1.0 21.4 36.4 32.4

China,People’sRep.of 821.5 1,068.5 1,204.0 1,334.6 1,435.6 33.7 30.1 41.4 44.9

HongKong,China 124.2 133.2 135.3 136.3 140.8 0.6 7.2 7.6 8.1

Indonesia 33.1 41.1 45.7 49.4 51.2 -5.2 24.0 28.4 25.3

Korea,Rep.of 210.3 238.9 243.8 250.6 257.2 5.7 13.6 11.1 12.7

LaoPDR 0.2 0.3 0.4 0.5 0.5 4.9 39.5 80.8 63.9

Malaysia 69.9 82.1 88.2 98.1 97.9 6.0 17.6 25.0 23.6

Myanmar 0.8 1.2 1.7 1.8 1.8 14.7 60.3 87.8 62.0

Philippines 15.9 20.0 21.7 23.5 27.9 21.4 25.7 28.7 47.9

Singapore 116.2 136.3 137.7 144.1 152.4 3.2 17.3 12.3 18.2

Taipei,China 253.3 266.1 267.5 266.1 262.9 4.8 5.1 2.2 0.5

Thailand 50.7 65.3 69.1 71.3 78.7 4.2 28.8 26.3 31.2

VietNam 9.1 13.4 18.3 20.3 20.3 28.5 47.9 79.5 70.2

EmergingEastAsia 1,706.6 2,068.1 2,235.3 2,398.2 2,529.1 16.6 21.2 26.9 29.5

1Ifdataisunavailableforreferencemonth,datareferstomostrecentmonthwheredataisavailable.Source:International Financial Statistics, InternationalMonetaryFund.

Figure34:Trade links (shareofG3inemergingEastAsian1exports)

1BruneiDarussalam;Cambodia;People’sRepublicofChina;HongKong,China; Indonesia;RepublicofKorea;LaoPDR;Malaysia; Myanmar; Philippines; Singapore; Thailand;Taipei,China;andVietNam.Source:Direction of Trade Statistics,InternationalMonetaryFund.

Japan

22.2 20.7 20.9 18.9 21.4 21.1 20.0 17.6 16.7

14.1 15.4 15.214.815.7

15.1 14.016.6 15.4

11.213.2 10.6 12.314.6

12.7 12.510.2

8.836.4 36.0

42.741.9

0

8

16

24

32

40

48

56

1990 1992 1994 1996 1998 2000 2002 2004 2006

EU

US

Intra-regional trade


�2

intandem,theimpactonemergingEastAsianeconomieswill

bepotent.

EveniftheUSavoidsarecession,globalfinancialmarketsseem

tobeenteringaperiodofincreasedvolatility,andtheresulting

marketadjustmentscouldinstigatefurtherboutsofturbulence.

Somemarketadjustmentsthatcorrectmis-pricingandreassess

riskexposuresoffinancial institutionsshouldbewelcome—as

theextendedperiodofeconomicandfinancialstabilityinstilled

asenseofcomplacencyanddeterioratedmarketdiscipline.But

initiallybenigncorrectionscouldrapidlyturndisruptive.Credit

risk re-pricingandretrenchment fromhigh-riskassets—taken

in the context of the complexity and illiquidity embedded

in new investment vehicles—have causedmajor clogging in

money/interbanklendingmarkets.Continuedstrainsinmoney

markets—andinsomecreditmarkets—willlikelytightengeneral

creditconditionsbyincreasingthecostandreducingtheamount

offunding.Inmajorindustrialcountries,suchastheUSandthe

eurozone,lendingstandardshavebeentightenedandthereare

signsthattheoverallcreditsupplytobusinessesandhouseholds

isbeingreduced.AfullblowncreditcrunchcouldslowGDPgrowth

substantiallyinG3economiesandhavemajorimplicationsfor

externaldemandforemergingEastAsianproducts.

Sudden swings in capital flows and abrupt adjustments in

exchange rates due to the large global payments imbalances

and a potential reversal in investors’ risk appetite is another

concernfortheregion’seconomies.Attheheightoftherecent

financialturbulence,globalinvestorsretreatedfromriskyassets,

includingthoseinemergingEastAsia.Mostregionalcurrencies

havealreadyappreciatedsubstantially(see Figures 16a, 16b),

buttheyremainvulnerabletogreatervolatilityintermsoffuture

directionsandmagnitudeofcapitalflows.Perceivedexchange-

ratemisalignmentsinemergingEastAsianeconomiescontinue

todrawcapital inflows,particularly in the formof short-term

portfolioinvestments,whichaddappreciationpressureandfuel

asset-priceinflationinmanyoftheseeconomies.Inparticular,

somecountriesintheregion—includingIndonesia,Korea,and

Philippines—have seen rapid increases in capital inflows for

portfolioinvestmentsoverthepastfewyearscoupledwithhigher

ratesofcreditgrowth.Foreignportfolioandotherinvestments

nowexceeddirectinvestmentsinemergingEastAsia(Figure �5)

andthispatternofincreasingshort-termcapitalflowsmakesthe

regionvulnerabletofinancialvolatilityandanunexpectedreversal

Direct investment inflows

Portfolio investment inflowsOther investment inflows

Total gross investment inflows

4.2

1.93.4

7.02.9

4.1

3.4 3.9 4.3

2.41.91.7

13.011.5 12.2 11.8

-113579111315

2004H1 2004H2 2005H1 2005H2 2006H1 2006H2 2007H12

10.1

7.09.2

Figure35:Emerging East Asia1 Financial Accounts (%ofGDP)

1IncludesPRC,ASEAN-4,andNIEs,LaoPDR,Myanmar,andVietNam.22007H1figuresdonotincludeMalaysia(dataunavailable).Sources: International Financial Statistics, InternationalMonetaryFundandcountrysources.


��

ofglobalfinancialflows.Recentswingsinglobalfinancialflows

andheightenedvolatilitycanbeexacerbatedbyvulnerabilities

stemmingfromthepersistentlylargeglobalpaymentsimbalances.

Somesignsofmoderationhaveemerged.TheUScurrentaccount

deficit this year is expected at 5.6% of GDP, down sharply

from6.2%lastyear.5Still,resultingglobalimbalancesremain

extremely large. To theextent that theongoing correction in

globalfinancialmarketsmayreflectthedynamicsofunderlying

marketforcestoreducethescaleofglobalimbalances—which

entails aUSdollar depreciation,USeconomic slowdown, and

reductionofUSdollarassetreturns—evenagradualandthus

protractedunwindingprocesswouldhavesignificantimpacton

emergingEastAsianmarkets.Atthesametime,slowerUSgrowth

couldreviveprotectionistsentiment.Takentogether,adisorderly

adjustmentinglobalpaymentsimbalancescoupledwithasharp

contractioninUSaggregatedemandandafreefalloftheUS

dollar,althoughveryunlikely,cannotberuledout.Thiswould

haveapotentiallyseriousimpactontheregion.

Freshboutsofinflationarypressuresduetosustainedincreases

in food and energy prices pose a threat to maintaining

macroeconomicstabilityinsomeemergingEastAsianeconomies,

withtherisksmorepronouncedinsomethanothers.Inparticular,

inthePRCandHongKong,China,inflationisbeingfuelledby

risingfoodprices,rapidlygrowingdomesticdemand,tightening

labormarkets,andstrongforeignexchangeinflows—exacerbated

byrigidexchangerateregimes.Intherestoftheregion,although

stillmanageable,inflationarypressuresarequicklyresurfacing

aswellduetonarrowingoutputgapsandrisinginputprices.The

sustainedriseinglobaloilpricesisamajorconcern(Figure �6),

asmarketsremaintightand,withlittlesparecapacity,anysupply

disruptionorheightenedgeopoliticalconcerncouldleadtoeven

higherprices.GiventalkofrecessionamongtheG3economies

andcurrentinflationarypressuresintheregion,anothermajoroil

priceshockcouldcontributetoaperiodofstagflation.Ifinflation—

especiallycoreinflation—headshigher,monetaryauthoritiesin

theregionwillhavelessflexibilitytodealwithpotentiallyslower

economicactivityarisingfromweakerexternaldemand.

5WiththeweakeningintheUSdollar,exportspickedupstronglyby16.2%(q-o-q,seasonallyadjusted,annualizedrate)inthethirdquarterof2007—from7.5%inthepreviousquarter—whileimportgrowthremainsmoderateduetoaslowingeconomy.Ifexportandimportgrowthcontinuesatthecurrentpace,allelseequal,theUScurrentaccountdeficitwillstabilizeatabout3%ofGDPby2011.

64.1

54.6

77.273.987.2

92.6

70.3

0102030405060708090100

May-05

Nov-05

May-06

Nov-06

May-07

Nov-07

May-08

Nov-08

Spot

Future prices (as of 19 Nov 2007)

Future prices (as of 14 Aug 2007)

Figure36:Brent Spot and Future Prices1 ($perbarrel)

1Historicalpricesaremonthlyaveragesofdailyspotprices.Source:Bloomberg.


��

Policy Issues

Slower economic growth coupled with a buildup of inflationary pressures—despite appreciating currencies—poses major challenges in macroeconomic management for emerging East Asian economies.

The region’s resilience to recent financial turmoil was in no

small part due to strongmarket confidence derived from a

robustgrowthoutlook,soundmacroeconomicindicators,current

accountsurpluses,andhealthyexternalpositions.Theremarkable

improvementsmadeinthedecadesincetheAsianfinancialcrisis

reflectstrongmacroeconomicprudence in termsofcontinued

fiscalconsolidationandmeasuredinflationrates.However,given

the uncertain global outlook, heightened financial volatility,

andsustainedhighoilandcommodityprices,macroeconomic

managementremainsamajorchallenge.Policydilemmasmay

be particularly acute in countries where rapid credit growth

andasset-priceinflation—associatedwithstrongforeigncapital

inflows—limit the scope formonetary responses to external

adversity(Box 1).

Given the specific domestic conditions among the region’s

economies,monetaryauthoritieswillneedgreatcareindesigning

policyresponsestothechangingexternalenvironment.Slowing

externaldemandandtheuncertaingrowthoutlook—butrising

inflationarypressures—raisetheriskofpolicymistakesinthose

economieswheremonetary policy needs to be fine-tuned to

meetbothgrowthandinflationobjectives. Becausetheworld’s

majorcentralbanks’keypolicyratesareexpectedtofallfurther

orleveloffamidbelow-potentialgrowthexpectations,monetary

authoritiesintheregionmayfeelpressuretokeepratesonhold

orevenlowertheminlinewiththeglobaltrend.

However, to the extent that some decoupling of the region’s

growthoutlook fromthatof theglobaleconomy isunderway,

monetarypolicies in the regionshouldalsodecouple.Despite

weakening growth in key industrial countries, the region’s

prospectsremainstrong,evenifslowingsomewhat—thePRC,

forexample,stillfacesoverheating.Incountrieswheredomestic

demandisstrongandinflationisrising—particularlythePRCand

VietNam—theremaybemeritincontinuingmonetarytightening.

Inmuchoftheregion,however,inflationremainslargelyincheck,

suggesting room forpolicydiscretion if thedownside risks to


�5

The potential for a stronger-than-expected slowingof theUSeconomypresentspolicychallengesforauthoritiesthroughoutemergingEastAsia.Butforthe fast-growing economies of thePeople’sRepublic ofChina (PRC)andHongKong,China—whichmaintainlimitedflexibilityorahardpegtothe US dollar—it creates seriouspolicydilemmas,amidsignsthatinflation isbecomingproblematicandassetpricesmorefrothy.

Rigid exchange rate regimesin both economies create policydilemmas because US monetarypolicyhasbeguneasing.AweakerUSeconomy—thedestination forabout 20% of PRC exports andabout16%ofHongKong,Chinaexports—and the correspondingUSFederalReserveratecuts,maypromptauthoritiestocutinterestrates to maintain exchange rateregimes and accelerate policiesthat could steer demand towarddomestic sources. Yet, in bothcases, r is ing asset prices—exacerbated by large inflows offoreigncapital—callforpoliciesthatinsteadreinindomesticdemand.

TheissuesareparticularlyacuteinthePRC,whereauthoritiesarestruggling to conduct policy thatwillsteeranoverheatingeconomyto a more sustainable growthpath.Macroeconomicstabilizationpolicy is further complicated bygrowthimbalancesacrossdifferentsectorsandprovinces,astill-fragilefinancialsystemawashinliquidity(largelyduetopersistentlyswellingtrade surpluses), and a currencysubject to strong appreciationpressures.Thedilemmaarises inpart from the fact that policiesto boost domestic sectors to balancegrowthcould feed fast-rising inflation(Figure B1.1). A persistent risein headline inflation could in turnweakenprivateconsumption,insteadofshiftingthegrowthbalancetodomesticsources.

Conversely,atightermonetarypolicyalso carries risks for the economy.1Asset price appreciation has beenveryrapidinthepastfewyears,withmarked increases in price-earningsratiosinlocalstockindexes.Aparticular

concern is the increasingly largenumberofhouseholdinvestorsplayingthestockmarket,somewithborrowed

1Withinflationhigh,realinterestratesarestillverylow.The1-yearbenchmarklendingrate,adjustedfor inflationof6.5%,is just0.79%,whicharguablymakesforthecasethat the currentmonetarypolicy stance isstillexpansionary.

money.Correctionsmaybesharpandswift, with adverse repercussions forits fragile banking system and thebroader economy. More importantly,newhikes in interest rates combinedwithunabatedanticipationofcurrency

appreciation will attract capitalflows further, aggravating theliquidity overhang and fuelingassetpricerises.

Faced with this dilemma,authoritieshaveuseddirectinstru-ments, including administrative“windowandcreditpolicyguidance”controls to rein in the speedof credit growth. Under these,banksmaybesanctionedthroughliquiditypenaltiesorevenpersonnelchargesifexcessivelendingisnotcurtailed.Giventhelimitedpolicyoptions, such targetedmeasuresmight be more effective than amonetarytightening,whichcouldhaveaneconomy-wideeffect.Thedilemmanowfacingpolicymakersalso strengthens the case forgreater exchange rate flexibility.Astrongercurrencyshouldcontainthe excessive trade surplus,moderate investment in tradablesectors,andmitigate inflation.Itwouldalsohelptightenmonetaryand credit conditions withoutinterestrateincreases.Thatsaid,thegovernment’spolicyofgradualappreciationcontinuestoblunttheeffectiveness of monetary policyand entices capital inflows inanticipationofhigherreturnsfromthe yuan’s revaluations, addingfueltoassetmarkets.LikewiseinHongKong,China,

theimportanceoftheUSmarketpresentspolicychallengesbecauseofthehardcurrencypeg.Cutsto

theUSfederalfundsratearematchedlocally through the Linked ExchangeRateSystemthatpegstheHongKongdollartotheUSdollar(Figure B1.2).Yet, given the strong economy andrecentinflationat9-yearhighs,lowerinterestratesarenotcalledfor.

Box1: Fed Rate Cuts and Policy Dilemmas

Nominal Effective Exchange Rate (increase = appreciation)

Nominal Interest Rate

Inflation Rate

104.9

95.4

5.5

6.8 6.3

3.8

0.4

3.2

92

95

98

101

104

107

Jan-05

May-05

Sep-05

Jan-06

May-06

Sep-06

Jan-07

May-07

Sep-07

-1.0

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

%NEER Index

Interest rateInflation rate

1Baserate.2Jan2005=100.Sources:BankforInternationalSettlementsandHongKongMonetaryAuthority.

FigureB1.2:Nominal Interest Rate,1 CPI Inflation, and Nominal Effective Exchange Rate (NEER)2—Hong Kong, China

FigureB1.1:Nominal Interest Rate,1 CPI Inflation, and Nominal Effective Exchange Rate (NEER)2—PRC

1Benchmark1-yearlendingrate.2Jan2005=100.Sources:BankforInternationalSettlements,CEIC,andNationalBureauofStatisticsofChina.

103.7

106.7

107.05.6

7.3

6.5

3.3

0.998

100

102

104

106

108

110

Jan-05

May-05

Sep-05

Jan-06

May-06

Sep-06

Jan-07

May-07

Sep-07

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

8.0

%NEER IndexNominal Effective Exchange Rate (increase = appreciation)

Nominal Interest Rate

Inflation Rate

Interest rateInflation rate


�6

Domesticdemandgetssupportfromrising incomes, strong employment,the buoyant stockmarket, renewedbusiness confidence, and a recoveryinconstruction.Andinthenearterm,thedomesticeconomyshouldbeableto shoulder some export weakness.But,theparallelratecutsbuiltintothepegcomewithundesirablechallenges,particularlyincontaininginflation,whichinOctober hit 9-year highs at 3.2%.Inflationarypressuresarehighduetorobustdomesticdemandandsustainedhighoilandfoodprices.Butwithapeg,aweakerUSdollarandtheFed’seasingpolicy are readily transmitted to thelocalcurrencyandinterestrates,fuelinginflationconcerns.

Excess liquiditycouldalsocauseabubbleinlocalstockmarketsandfuelarealestateboom.TheHangSengIndexhas been hitting new record highs,

althoughprice-earningsratiosarenotyetexorbitant.Andthelistingofseveralpopular mainland Chinese companieson the localmarket has also led toa surge in capital inflows. Combinedwithcurrentaccountsurpluses,thesehave boosted domestic liquidity andcredit growth. Asset prices may risefurtherasdepositholdersswitchfromlower returns earned on savings intothe higher-yielding asset markets.Propertypricesarerisingaswell:thedomesticpropertypriceindexinJunebroke a level last achieved in 1999,andallothersegmentsofthepropertymarkethavebeenbullish,reachingorsurpassing peaks attained before the1997/98Asiancrisis.Whiletheseareallingredientsforrisinginflationandassetbubbles,thelackofshort-termcountermeasuresduetothepegraiseconcernsaboutsustainabilityofmacroeconomic

andpricestability.Thelackofmonetarypolicyoptions

means the onus for maintainingeconomic stability falls on fiscalpolicyandotherstructuralpolicies.Inparticular,iftheexchangeratecannotadjust to external shocks, domesticwages and prices will have to. Thismeansthatlaborandproductmarketswill have to be even more flexible.However,anymeasurestomakethemso,mostlystructuralinnature,canonlybearfruitinthemediumtolongterm.Inthetradablesector,theseeconomies’competitiveness iscommendable,butmuch room for improvement is leftin the domestic sector. In the labormarket, an aging population andshortageofskilledlaborpresentlonger-termchallengestopolicymakers.

growthmaterialize.Nevertheless,inflationaryconcernslingerin

severalcountries—includingIndonesia,Korea,andPhilippines—

wheretheoutputgapisclosingonrobustgrowthwhilerising

global oil and commodity prices threaten to push input costs

higher.Clearly,thereisno“one-size-fits-all”solutionforthese

countries,but thesituation requiresheightenedvigilanceand

carefulmonitoringofinflationarydevelopments.

Ineconomiesthatusegreaterexchangeratecontrol,increasing

currency flexibility could add useful monetary leverage

domesticallyinanenvironmentofheightenedexternaluncertainty

(Box 2).Continuedlargecurrentaccountsurplusesandforeign

capital inflows remain destabilizingmacroeconomic forces in

many parts of the region. Associated with this, rapid credit

growthandasset-priceinflationgenerallynarrowthescopefor

monetaryeasingagainstasharpeconomicslowdown.Acurrency

appreciationcanbolstermonetarydiscretionby tighteningde

factomonetaryconditions.However,despiteincreasingcurrency

flexibility over the past few years,many regional economies

continuetointerveneinforeignexchangemarkets.Theseefforts

tomaintaincurrencystabilityareoftenineffectivebeyondthe

shortterm,wheneconomicfundamentalscontinuetoputupward

pressureonthecurrency.Ineffectivesterilizationalsocontributes

toexcessliquiditygrowthandasset-pricebooms,whilefuelling


�7

In an environment where capitalmovesfreely,simultaneouslytargetingan exchange rate and maintainingan independent monetary policyis impossible. This is the so called“impossibletrinity”.1Twoofthesethreeobjectivescanbeachievedatthesametime,butnotallthree.Ifacountrypegsits currency to another’s, the UnitedStates(US)dollar,say,itcannotdeviatesignificantlyfromthe ‘host’monetarypolicy.Ifbusinesscyclesarein tandem, then that maycreate no problems—theUSFederalReserve’spolicymaybeappropriateforthepeggingeconomy.Butifcyclesdiverge,what’sgoodfortheUSmaynotbegoodfortheother.

Some countries, especially small,open ones with underdevelopedfinancialsystems,electtohavedollarpegs. They are willing to sacrificemonetary independence in order topromotetradeandeconomicgrowthbyminimizingexchangeratefluctuations.That said, an oft-cited cause of theAsianfinancialcrisiswasthede factopegging of the region’s currencies totheUSdollar.Afewyearsbeforethecrisis, those currencies strengthenedalongsidetheUSdollar,leavingexportsless competitive and causing rapiddeterioration of current accounts.AfterThailandmovedtofloatthebaht,concernaboutthesituationturnedtofear and massive amounts of capitaltookflight,triggeringachainofeventsthataffectedmuchoftheregion.

Sincethen,thelessonsofthecrisishaveledmanyeconomiesintheregiontoadoptflexibleexchangerates.Thislikely also allowedmore independentmonetary policies in the region, assuggestedinKimandLee(2004)2and

1A formal model for this hypothesis wasdeveloped by Robert Mundell and MarcusFleminginthe1960s.2Kim,C.J., and J.W.Lee,2004.ExchangeRateRegimeandMonetaryIndependenceinthePost-CrisisEastAsia:AnApplicationofRegime Switching Model with EndogenousExplanatoryVariables.Economics Department Working Paper,KoreaUniversity.

Kawai(2007).3This box examines empirically

whether the economies of emergingEast Asia have indeed pursued moreindependent monetary policies sincethe financial crisis. In the spirit ofFrankel,SchmulkerandServen(2002)4andShambaugh(2004),5thefollowingerror-correction formulation can beused to examine monetary policyindependence:

where ∆ denotes first difference, forexample,∆rt

lc=rtlc-r lc

;rlcthelocalcurrencyinterestrate;r*theforeigncurrencyinterestrate;ut the error term, α1p and α2p thecoefficients of short-run dynamics oflagged domestic interest rates andforeigninterestraterespectively;δthespeedofadjustmenttothelong-runrelationship;andβ the long-run sensitivity of thedomestic interest rate to the foreigninterestrate.

The error correction model iscommonlyusedtoempiricallyanalyzethe dynamic behavior of time-seriesvariables. Intuitively, the equationtakes a set of variables—here theyarelocalandforeigncurrencyinterestrates—thathasalong-runequilibriumrelationship,andtracestheirdynamicbehaviors to converge towards theequilibrium condition. Given an opencapitalaccount,acountrythatincreasesinterest rateswill attract capital, andthis will cause the exchange rate toappreciate. If a central bank wants

3Kawai, M. 2007. Toward a RegionalExchange Rate Regime in East Asia. ADB Institute Discussion Paper No.68.4Shambaugh,J.C.,2004.TheEffectofFixedExchangeRatesonMonetaryPolicy.Quarterly Journal of Economics 119,301–352.5 Frankel, J.A., S.L. Schmulker, and L.Serven, 2002. Global Transmission ofInterest Rates: Monetary IndependenceandCurrencyRegime.NBER Working Paper Series WP8828.

tofix itscurrencytoahostcountry’scurrency, its domestic interest rateswillhavetoadjustaccordinglytothehost country’s interest rate changes.Thislong-runequilibriumrelationshipiscapturedintheequationbythetermsinthesquarebracket,whereδmeasureshow fast localcurrency interest ratesreturn to equilibrium, and β showshowmuchlocalcurrencyinterestratesshouldmoveinresponsetothechanges

in foreigncurrency interestrates. Ifacountrypegs itsexchangerate,itsmonetarypolicyshouldmirrorthatofthehostcountryinthelong-

run:β will be close to one,while itsspeedofadjustment,δ,willbegreaterthanzero.Incontrast,whenacountryadopts a fully floating exchange rateregime,δwillbeclosetozeroandβbecomesinconsequential.Monthlymoneymarketrates6from

January1990toJuly2007areobtainedfor Indonesia; theRepublicofKorea;Malaysia;thePhilippines;andThailand,aswellastheeffectiveovernightfederalfunds rate for the US. The pre-crisissamplespans1990:1to1997:5,justbeforethefloatingoftheThaibaht.Thepost-crisissamplegoesfrom1998:10onwardssoastoreducetheeffectsofunnecessaryvolatilityassociatedwiththecrisis.7The results generally confirm that

thedomesticmonetarypoliciesoftheregionaleconomieshavegainedgreaterindependence from the Fed’s policysincethecrisis.Figure B2.1showsthatthespeedofadjustments(δs)ofmostcountrieshasvisiblydeclinedsincethecrisis,except forMalaysia,wheretheresult is statistically insignificant forthepre-crisisperiod.Figure B2.2alsoreportsthegenerallyaffirmativeresultsin terms of the long-run sensitivity

6 TakenfromtheInternationalMonetaryFundIFSandcentralbankwebsites.7 For Malaysia, it starts from July 2005aftertheunpeggingoftheringgittotheUSdollar.Theidentifiedcrisisperiod(1997:6to1998:10)isalsolargelyalignedwithKimandLee’s(2004)datingofstructuralbreaksfortheirsimilarsetofcountries.

Box2: Measuring Monetary Independence in Emerging East Asia

ΣΔrtlc = δ β[Δrt

lc -p1p

P

p=1+Σ

P

p=0Δrt

* -p2p

- rtlc -1-

0- rt

* -1 [+ut

t-1


�8

coefficient,β.Sincethecrisis,β hasfalleningeneral,suggestingthatthelong-runrelationshiphasbecomeweaker.Thatis,thereislessevidenceofaone-to-one relationship between domesticinterestratesandtheUSfederalfundsrateafterthecrisis,exceptinIndonesiaand the Philippines. For Indonesia, itis statistically insignificant to rejectthat there is one-to-one relationship,but β has declined nonetheless. Forthe Philippines, other circumstantialevidence suggests that the larger β after the crisis should be interpretedwithcautionanddoesnotnecessarily

reflectalossofmonetaryindependence.Prior to the establishment of BangkoSentralngPilipinasin1993,whichgavethecentralbankitslegalindependence,thePhilippineswasexperiencingvariousfiscalanddebtproblemsandmonetarypolicywaspreoccupiedwithresolvingthem.Takentogether,theseresultssupport

the idea that a move towards moreflexible exchange ratemanagementafter the financial crisis has allowedgreatermonetarypolicyindependenceinmanyemergingEastAsianeconomies.Inthecontextofrecentfinancialmarket

developments and the likely impactonregionalandglobaleconomies,thelesson from this empirical analysis isclear.Theregion’sbusinesscyclesareheading in a different direction thanthe US, which is directly affected bythefinancialturmoil.Totheextentthatthe region’s business cycles divergefrom that of the US, autonomousmonetarypolicyisalsoneeded.Allowingcurrencies to move more freely mayhelptheregionattaingreatermonetarypolicy lever in the face of increasingeconomicandfinancialuncertainty.

0.24*

0.12*

0.10*

0.07*

0.39**

0.34*

0.17*

0.46*

0.03

0.70*

0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8

Indonesia

Korea, Rep. of

Philippines

Thailand

Malaysia Pre-CrisisPost-Crisis

FigureB2.1:Speed of Adjustment Coefficient (δ)

Notes:*and**denotesignificanceatthe1%and5%levelsrespectively.δmeasureshowquicklythelong-runequilibriumbetweendomesticinterestratesandtheUSinterestratesisrestored.

Pre-CrisisPost-Crisis

0.46

0.27*

0.65

0.21*

0.25*

1.34

0.74

1.40

0.95

0.04*

0 0.2 0.4 0.6 0.8 1 1.2 1.4 1.6

Indonesia

Korea, Rep. of

Philippines

Thailand

Malaysia

FigureB2.2:Long-run Sensitivity Coefficient (ß)

Notes:*denotessignificanceatthe1%level,meaningtherejectionofthehypothesisß=1.ß measuresthelong-runsensitivityofdomesticinterestratestotheUSinterestrates.


�9

expectations for futureappreciationand thus attractingmore

capitalinflows.Ineconomieswithrigidexchangerates,itwillbe

increasinglydifficulttomeetbothinternalandexternalobjectives

usingmonetarypolicyalone.

There may be merit in emerging East Asian economies cooperating to maintain relative stability in intraregional exchange rates, considering the increase in intraregional trade and other economic cooperation within the region.

With strong current and capital account surpluses, some

economiesintheregionwithmoreflexibleexchangerateshave

experiencedveryrapidcurrencyappreciation.Theseeconomies

maybetemptedtointroducesomeformofcapitalcontrolsoruse

administrativemeasurestocurbstrongshort-termcapitalinflows

and portfolio investments. Hurried administrative measures,

however, are potentially disruptive and may only temporarily

alleviatethesymptomsofunderlyingstructuralproblems,and

they should be used with caution. When any type of capital

controlshavetobeusedasalastresort,theseshouldbecarefully

definedandpreciselytargetedtominimizecreatingdistortions.

Butthetrendofintraregionaltradeandinvestmentflowsisvisibly

risingandcontinuestosupporttheregion’seconomicgrowth.

Wherepossible,drawingupamorecoordinatedregionalapproach

toexchange ratepolicymightbeabetteralternative to take

advantageofgrowingintraregionaltradedynamicwhilehelping

alleviatetheburdenofsharp,unilateralappreciationpressures.

Even as economies design the right mix of macroeconomic

responses,theywillcontinuetobenefitfromundertakingdeeper

andmorecomprehensive structural reforms.Withheightened

financial volatility and its potential spillover on the global

economy,theregion’sgrowthstrategyshouldreinforceeffortsto

rebalancesourcesofgrowthwhileretainingresiliencetoexternal

shocks.Inthisrespect,areasoffocuscouldincludeimprovement

oftheinvestmentclimateandbusinessenvironment,advancing

post-crisisfinancialsectorreformagendas,developingdeeper

financialmarketsintheregion,andpromotingenergyefficiency

andconservation.


�0

For several ASEAN economies, a better investment climate could strengthen domestic demand—which could help offset lower external demand—and help ensure that strong capital inflows are put to better use.

The post-crisis recovery in investment remains incomplete in

manyof the region’seconomies,morespecificallyamong the

crisis-affected economies themselves. Key areas ofweakness

are policy uncertainties, governance, the quality of legal and

institutional frameworks, and regulatory capacity. Addressing

these problems will require more comprehensive structural

reforms to improve efficiency and competitiveness through

minimizing unnecessary regulatory barriers for businesses,

encouragingprivateincentivesandmarketdiscipline,creatinga

levelplayingfieldacrossallsectors,andfosteringcompetition

toupgradeinstitutionalcapacity.

Measures to develop efficient and deeper financial markets in the region can help enhance the resilience of the region’s financial systems against heightened global market volatility.

Advancingpost-crisisfinancialsectorreformagendasremainkey

toensuringfinancialstabilityinthecrisis-affectedcountriesinthe

faceoflargeswingsincapitalflows.Financialsectorweakness—

coupledwithalackofprudentialoversight—oftenledtobooming

credit and surging asset prices during past eras of liquidity,

onlytobefollowedbypainfulcorrections.Althoughtheregion’s

bankingandfinancialsectorshavemaderemarkableprogress,

rapidfinancialglobalizationrequiresstepped-upeffortstokeep

upwiththeevolvingfinancialenvironmentandinnovation.These

effortsshouldincludeupgradingriskmanagement,revamping

information disclosure policies and transparency, enhancing

governance,andstrengtheningprudentialoversight.Thesound

managementofprivatecapitalflowsisalsocrucial,possiblyby

deepeningfinancialmarkets,strengtheningmarketinfrastructure,

buildingasoundlegalandregulatoryframework,andheightening

markettransparency.

Regionalpolicymakersarewellawareoftheproblemposedbythe

shallownessoffinancialmarketsintheregionrelativetodeeper

marketsintheUS,eurozone,andevenmoredevelopedregional

peers.Indeed,theAsianBondMarketsInitiativerepresentsa


�1

cleardesiretodevelopefficientandliquidbondmarketsinthe

regiontodiversifyfundingoptionsandenhancetheefficiencyof

financialresourceallocation.Recentglobalturbulencereinforces

theimportanceofmorediverseandresilientfinancialsystemsin

thefaceofpotentialmarketvolatility.

Finally, measures to promote energy efficiency and conservation remain imperative, given record oil prices and the region’s high dependency on oil imports.

Althoughsignificanteffortshavebeenmadetobringlocalprices

closertogloballevels,manycountriesintheregioncontinueto

subsidizeenergypricesorinfluencedomesticprices.Theincomplete

pass-throughcouldcomplicatemacroeconomicmanagementby

weakening fiscal positions. The agenda for domestic energy

marketreformmayinclude(i)reducingsubsidiesandaligning

thelocalpriceswithglobalprices;(ii)removingupstreamand

downstreampricecontrolsandavoidingadministrativemarket

distortions; (iii) promoting energy conservation and energy

efficiency;and (iv)fostering competitiveenergymarkets that

rewardprivatesectorinnovation.

SPECIALSECTION

�2

CanEmergingEastAsiaWeatherGlobalFinancialInstability?

Introduction

EmergingEastAsiaexhibitedremarkableresilienceduringrecent

boutsofglobalfinancialturbulence.Theregion’sfinancialmarkets

tumbledinAugust2007amidconcernsoverUnitedStates(US)

subprimemortgages and spreading global credit fears. But a

relativelyquickrecoveryfollowedbymid-September.Emerging

East Asian share prices rebounded to record levels while the

region’s currencies resumed their upward trend against the

weakeningUSdollar.Sovereignbondspreadsinlocalmarkets

remainsignificantlyhighercomparedwiththestartoftheyear—in

linewithglobalmarketdevelopments.Butthisreflectsgeneral

creditriskre-pricingandaratherhealthymarketcorrectionafter

anextendedperiodofheightenedriskappetites.

Severalimportantfactorscanhelpexplainthisresilience.First,

the region’s financial institutions have relatively small direct

exposure to US subprime mortgages and structured credit

products.Second,stronggrowthprospectsandsoundexternal

positionshavecontinuedtosupportinvestors’confidenceinthe

region’seconomies.Andthird,improvedandprudentpoliciesin

mostemergingEastAsianeconomieshelpmitigatetheimpact

ofexternalshocks.

This, however, does not imply that the region will remain

shieldedfromglobalfinancialmarketdevelopments.Theexternal

environmentisincreasinglyuncertainandthecurrentperiodof

financialturbulencewilllikelycontinue.Therearesomeimportant

channels throughwhich further instability can be transmitted

totheregion’sfinancialmarkets—withsignificantimpacttothe

regionaleconomyasawhole.Heightenedriskperceptionand

erodinginvestorconfidenceisone.Aswinginmarketsentiment

and a sudden change in liquidity conditions is another. The

contagioneffectscouldbecomemoreseriousiftighteningcredit

conditions and financial instability dampen broad economic

activitiesbothatglobalandregionallevels.

Thissectionexaminestheregion’sstrengthandvulnerabilitiesin

thecontextofcurrentfinancialmarketsituationstoshedlighton

thechallengesfacedbytheregion’spolicymakers.Afterbriefly

summarizingrecenteventssurroundingtheUSsubprimeturmoil

SPECIALSECTION

��

anditsimplicationstotheregionalbankingandfinancialmarkets,

thesectionexaminesthevariouschannelsofcontagiontothe

region’seconomiesinlightofongoingdevelopmentsinregional

financialmarketsandinstitutions.Implicationsforfuturepolicy

decisionsareevaluated.

How Did Emerging East Asia Survive the Recent Turmoil?

Ridingthehousingpriceboomduring2001–2005,USresidential

mortgage lendingsawrapidgrowth—with increasingamounts

goingtoborrowerswithshakycredithistories.AstheUSFederal

Reserve(Fed)beganraisinginterestratesinJuly2004,these

subprime mortgage holders naturally faced larger interest

payments.Thesubsequentcoolinginthehousingmarketalso

madeitmoredifficulttorefinancemortgagesintoloanswithbetter

terms—orpayoffmortgagesbysellinghomes.Consequently,

delinquencies on subprimemortgages rose significantly from

mid-2005(Figure �7).

Proliferationofstructuredcreditproducts—whichhelpedbundle,

repackage,andsellsubprimemortgagestoabroadspectrumof

globalinvestorgroups—providedthelinkforfinancialcontagion.6

Thesenewcreditrisktransferproductsandmechanismshave

gainedpopularityinmaturemarketsasawayofboostingprofits

inanenvironmentofrelativelylowinterestrates,whilehelping

manageriskexposuresoffinancialinstitutions.Butasdefaults

onUSsubprimemortgagesspilledoverontothebalancesheets

ofhedgefundsandotherinvestmentfunds,anumberofbanks

havebeenaffectedthroughoff-balancesheetfinancial“conduits,”

whichinvestedheavilyinrelatedmortgagederivativesandcredit

products.

Theuncertaintyaboutwhoholdshowmuchofthesemortgage-

related products—and where—generated widespread distrust

amongfinancialinstitutionsworldwide.Addfinancialinnovation

andglobalization,andtherisksbecamedispersedonabroader

basisthroughouttheglobalfinancialsystem.Also,whilefinancial

innovation has increased banks’ ability tomove risk off their

balancesheets,ithasnoteliminatedthepossibilitythatthissame

riskcouldreturnunexpectedly,andsuddenly.Asconcernsabout

6 Foramoredetaileddiscussion,seeAsia Bond Monitor,November2007,athttp://asianbondsonline.adb.org/documents/abm_nov2007.pdf,pg33.

0

2

4

6

8

10

12

14

16

1 11 21 31 41 51 61 71 81

2000200120022003200420052006

2006

Months after origination

Figure37:Nonprime Mortgages Delinquencies (60-DayDelinquenciesbyVintageYear,inpercent)

Source: Update on the Global and Regional Outlook, InternationalMonetaryFundpresentation,29Nov2007.

SPECIALSECTION

��

creditandcounterpartyrisksspread,banksbecamedefensive

and scrambled for liquidity. Key short-term rates in mature

marketssoaredinearlyAugust(Figure �8),promptingmajor

centralbankstoinjectlargeamountsofliquidityintheinterbank

moneymarket.

Heightenedriskaversionledglobalinvestorstoretreatfromrisky

assetsduringtheAugustsell-off,includingthoseinemergingEast

Asianmarkets.Stockpricesplummetedacrosstheregionand

regionalcurrenciestookatumble.High-yield,high-riskemerging

marketsovereignbondspreadsalsowidenedsharply,asinvestors

begantorequirehighercompensationforassumingrisk.

Because the region’s banks—which continue to dominate emerging East Asian financial systems—were little affected by the US subprime problem, the impact on local financial systems was largely contained.

DisclosedexposuresofemergingEastAsia’sbankinginstitutions

havebeenlimitedthusfarandrelativelysmallagainsttotalbank

assets.7BanksinIndonesiaandMalaysiahavevirtuallynodirect

exposure.AndwhilebanksinthePhilippinesandThailanddeal

withstructuredcreditproducts,theyarelargelydispersedrather

thansystemic,andsmall insize.Somebanks in thePeople’s

RepublicofChina(PRC);HongKong,China;RepublicofKorea

(Korea);Singapore;andTaipei,Chinareportedmoresignificant

exposurestotheUSsubprimemarket—throughstructuredcredit

productssuchascollateralizeddebtobligationsandasset-backed

securities.Buthereagain,theexposureislessthan5%oftotal

assetsformost.Therearesomereportsoflossesfromnonbank

financialinstitutionssuchasinsurancecompaniesinTaipei,China

andbanks’off-balancesheet investment funds inHongKong,

China;butthegeneralpictureremainsbenign.

Still,thespilloverfromthefinancialturmoilemanatingfromG3

financialmarkets could be potentially large. Generally sound

macroeconomicfundamentalsandgrowthprospectshelpedlimit

the initial losses in emergingEastAsianequities, bonds, and

currencies.However,somerecenttrendsintheregion’sfinancial

systemswarrantclosemonitoring.Assetpricesareboomingin

severalemergingEastAsianmarkets,withheightenedrisksof

mis-pricing.Bankingsystemsareextendingnewbusinesslines,

7 The estimates are based on the surveys of Fitch ratings, Moody’s Investors’Service,andStandard&Poor’s.

UK

64.6

83.8

16.1

32.5

88.4

91.3

114.3115.3

0

20

40

60

80

100

120

06-Jul-07

20-Jul-07

03-Aug-07

17-Aug-07

31-Aug-07

14-Sep-07

28-Sep-07

12-Oct-07

26-Oct-07

09-Nov-07

23-Nov-07

07-Dec-07

US

euro zone

Figure38:Key Short-term Money Market Rates (inspreadsoverpolicyrate,basispoints)

Source:Bloomberg.

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bringing new exposure to new territories and types of risk.

Foreigncapitalinflowstotheregioncontinuetorise—insome

casessharply—contributingtorapidgrowthinmoneysupplyand

credit,thusfuellinginflation.Againstthisbackdrop,heightened

uncertaintyoverthedurationandmagnitudeofcapitalinflows

and increased financial volatility pose a significant threat to

macroeconomicandfinancialstability.

Where Are the Lurking Vulnerabilities in Emerging East Asia’s financial systems?

The region’s largely bank-dominated financial systems—with weak systemic support for effective risk management—leave doors open to potential spillovers if conditions in global financial markets worsen or investor sentiment shifts.

In the aftermath of the Asian financial crisis, large-scale

restructuringandreformswereundertakentobringtheregion’s

bank balance sheets back to health—and to revamp highly-

leveraged firms. Prudential regulationswere also reinforced.8

Ongoingeffortstodevelopcapitalmarketshelpbroadensources

forcorporatefinancing,yetbanksstilldominateastheprimary

sourceforeconomicactivity(Table 10).Tosupportcurrencyand

financialstability,macroeconomicmanagementingeneralhas

becomemuchmoreprudent,withinflationtargetingintroduced

inseveraleconomies,fiscalbudgetsconsolidated,andexchange

rateregimesmoreflexible.However,somepocketsofweakness

remainintheregion’sbankingandfinancialsystems,whilenew

challengesareemerging.

On balance sheets, the region’s banks appear healthy, with

virtuallynoexposuretothetypeofexternalcreditrisksthatthe

current turmoil involves.Nonperforming assets have declined

dramatically across the region since the crisis. Risk-weighted

capital adequacy ratios are higher. And banks have reduced

short-termexternalborrowings—whichhadpreviouslyexposed

themtorisksstemmingfromcurrencyandmaturitymismatches.

Meanwhile, bank income sources have been broadened by

diversifyingintohouseholdlending,offeringnewtypesoffinancial

services,andstrengtheningfeestructures.8 Foramoredetaileddiscussion,seeAsia Economic Monitor,July2007,athttp://www.aric.adb.org/pdf/aem/jul07/July%20AEM%20complete%20250707.pdf,page54.

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Thelimitedexposuresoftheregion’sbankingsystemstotheUS

subprimefalloutmaybemoreareflectionoftheregion’srelatively

less-developedfinancialmarketsandinstitutions,whichremain

largelyunsophisticatedintermsofthearrayofproductsoffered.9

Indeed, bank lending generally fell in the post-crisis period

(Figure �9).Conservativelendingpracticesandstrengthened

prudentialregulationsfollowingthe1997crisishavekeptbank

investmentsinrelativelysafeassets,suchaslocalgovernment

securities(Figure �0).

Andrisksmayarisefromthebroadeningscopeofbankingbusiness

andtheirexposurestonewtypesofmarketrisks(Table 11).

Withtherecenthousingboomsacrosstheregion,forexample,

mortgage-related lending has increased sharply. Elevated

levelsofhouseholdindebtednessalsoshowsignsofstress(see

AssessmentofFinancialVulnerability,pages15–21).

Securities holdings have increased as a share of total bank

investments. Alongwith the rise in investment banking-type

activities,thisindicatesexposuretogreatermarketrisks.Regional

banks are participating in securities-related transactions—

underwriting,dealing,andbrokerage,forexample—andinforeign

exchange,leasing,andinsuranceactivities.Bankshavealsobeen

encouragedtotakepartinlocalbondmarketdevelopment—as

issuers, underwriters, investors, and guarantors. This also

exposesbankstonewrisks.

9Banksinthenewlyindustrializedeconomies(NIEs),however,arebeginningtooffermoresophisticatedproducts,rapidlynarrowingthegapwiththeircounterpartsintheG3.

Table10: Sources of Finance in Emerging East Asia (percentageofGDP)

Commercial bank loans1 Domestic debt securities outstanding Stock market capitalization

2001 Sep 20072 1996 2006 2001 Oct 2007

China,People’sRep.of 102.1 111.0 7.2 44.4 40.0 121.7

HongKong,China 168.2 192.0 22.5 34.8 299.4 1021.9

Indonesia 18.7 24.1 3.0 24.0 14.5 49.5

Korea,Rep.of 57.4 88.0 50.8 113.8 41.1 116.5

Malaysia 97.2 109.4 72.5 98.6 131.9 187.3

Philippines 44.7 29.6 33.6 38.4 59.0 124.8

Singapore 106.2 93.7 26.5 65.5 216.5 348.2

Taipei,China 142.3 144.2 34.6 56.5 103.9 195.5

Thailand 83.0 74.6 10.1 54.0 31.3 86.1

1PRCdatareferstototalloans.2PhilippinesasofAug2007.Source:OREIstaffcalculationsbasedondatafromCEIC,Bloomberg,andPeople’sBankofChina.

1987 1989 1991 1993 1995 1997 1999 2001 2003 2005

160

120

80

40

0

160

120

80

40

0

IndonesiaKorea, Rep. of

Malaysia

Philippines

Thailand

Figure39:Bank credit to the private sector before and after banking crises1

Source:Turner,Philip(September2007)Are Banking Systems in East Asia Stronger?BankforInternationalSettlements.

0 5 10 15 20 25 30 35 40

Thailand

Singapore

Malaysia

Korea, Rep. of3

Indonesia2

Hong Kong, ChinaEnd-1994Mid-2005

Figure40:Government securities held by commercial banks (%ofdomesticcredit1)

1Ofcommercialbanks.2Firstbarreferstoend-1996.3Secondbarreferstoend-2004.Source:Mohanty,etal(2006),Banksandaggregatecredit:whatisnew?,BIS Papers No 28,August2006.

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Recent trends in the global financial system—notably the growing presence of nonbank financial institutions and proliferation of new instruments for risk transfer—will also become increasingly relevant in the regional context.

In regionaleconomieswithmoreadvancedfinancial systems,

technologicalprogressandcompetitionarerapidlymodifyingthe

overallriskprofileofbankingandthefinancialindustry.Nonbank

financialinstitutionssuchasinsurancecompanies,pensionand

mutualfunds,andleasing,factoringandventurecapitalfirms,

whilestillunderdeveloped,havegrownrapidlyinrecentyears.

Althoughsmallasashareoftotalfinancialsystemassets,the

sizeofthemanagedassetsisrisingrapidlyat25.4%onaverage10

overthepast5yearsinNIEs.

Despite generally conservative banking activity in the region,

largely unregulated nonbank financial institutions are already

taking on increasingly risky investments for higher returns.

Localinstitutionalinvestorshavealsostartedtoincreasetheir

overseas investments and diversify their holdings into riskier

andmoresophisticatedequity,credit,andcurrencyderivatives.

Overthepastfewyears,sharpincreasesinportfolioinvestment

outflows(mainlydebtsecuritiesfromPRCandKorea)suggestthat

exposuresinsomeemergingEastAsianeconomiestomortgage-

relatedsecurities—althoughthemajorityarelikelytobeprime

ratherthansubprimemortgages—mightbebiggerthancurrently

estimated(Figure �1).

10 TheestimatedgrowthisbasedonthesizeofmanagedassetsofmutualfundsandprivatepensionfundsinNIEsreportedbytheOrganisationforEconomicCo-operationandDevelopmentandtheInvestmentCompanyInstitute.

4.5 5.33.4 4.7

5.19.5

6.5

12.1

-0.4-3.8

10.1

11.1

2.26.8

4.2

19.0

27.9

20.0

5.2

14.6

9.2

-3

2

7

12

17

22

27

2000H1 2001H1 2002H1 2003H1 2004H1 2005H1 2006H1 2007H1

Direct investment outflows

Portfolio investment outflowsOther investment outflows

Total Gross investment outflows

Figure41:Investment Outflows—NIEs(%ofGDP)

Note:Negativevaluesindicatethatproceedsfromredemptionofearlierinvestmentoutflowsexceedinvestmentoutflowsfortheperiod.

Sources: OREI staff calculations based on data from International Financial Statistics,InternationalMonetaryFund,andcountrysources.

Table11: Composition of bank lending1

Housing loans Consumer loans Business credit

199� 1999 200� 199� 1999 200� 199� 1999 200�

HongKong,China 7 15 15 2 3 3 86 76 73

Singapore 14 20 26 13 12 15 60 51 39

Indonesia 5 6 7 18 60 37

Korea,Rep.of 9 33 18 17 69 47

Malaysia 10 18 28 8 16 64 45

Thailand 9 7 10 4 3 6 64 71 68

1Ofcommercialbanks.Aspercentageoftotaldomesticcredit.Source:Mohanty,M.etal(2006),Banksandaggregatecredit:what’snew?”BIS Papers No. 28.

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Atthesametime,abroadeninginvestorbasehasledtoincreasing

demandfornewdebtproductsandservices,whichisspawning

increasinglycomplexnewinstruments.Taketheregion’sbond

markets,forexample.Sincethe1997financialcrisis,developing

localcurrencybondmarketsintheregionhasbecomeapriority—

inparttoofferalternativestobankfinance.Theexpansionof

globalliquidityandincreasingdemandforhigh-yieldingassets

alsoresultedinasharpriseinshort-terminvestmentinflows,

whichpouredintolocalcurrencydebtmarkets.Thesizeoflocal

bondmarketsroseto56.8%ofGDPinthefirsthalfof2007,up

from19.1%in1997.

Furthermore, ongoing development of derivativesmarkets in

some economies—and increasing off-balance sheet financial

transactions in connectionwith rising local fundmanagement

activities—implyfundamentalchanges intheregion’sfinancial

systembalancesheetstructures,inparticular,thetypesofrisks

towhichbanksareexposed,andtheirmagnitude.Thesefinancial

marketdevelopmentsmaycontributetoalackoftransparencyin

bankingoperationsandcompoundtheopacityofriskexposures

withinbroadfinancialsystems.

Thecomplexityofnewfinancialproductsandservicespresent

bothchallengesandopportunitiesintermsofriskmanagement.

Ononehand,theavailabilityofnewfinancialinstrumentsand

marketssuchascredit-risk-transferinstrumentsandderivatives

markets allows banks to broaden the scope of their risk

managementcapabilities.Butasbusinessoperationsgrowmore

complexandsophisticated,keepingriskmanagementsystems

up-to-datewillpresentincreasingchallengestobothbanksand

bankregulators.

Despite the resurgent capital inflows to the region following the August turmoil, a sharp reversal in risk appetite and financial flows remains a possibility in a climate of heightened volatility and uncertainty, due to a re-pricing of risk and the potential unwinding of the so-called “carry trade.”

Effects from growing capital movement—and short-term

investments—associated with increased financial market

integrationandcapitalaccountliberalizationalsoposeasignificant

risktotheregion’seconomiesshouldanexogenousshockoccur.

Thisposesapotentiallygreaterrisktothecountriesthathave

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experiencedrapidgrowthinportfolioinvestmentflowsandasset

priceinflationinrecentyears.

Capital flows to and from the region reached record highs in

recent years (Figure �2). With the volume of cross-border

capitalflowsontherise,sotoohavecross-borderholdingsof

financialassetsincreasedsharply (Figure ��).Grossexternal

assetsandliabilitiesasashareofGDPreached131%in2004,

upfrom51%in1990.11

Moreworryingisthechangingstructureofcapitalinflows,with

short-termcapitalnowaccountingformorethan60%oftotal

inflows.Substantialrisesinthe“otherinvestment”inflowsmay

alsoreflectincreased“carrytrade”activitiesand“hotmoney”—

drivenbyinterestratedifferentials.12Againstthisbackdrop,a

suddenshiftinthedirectionandmagnitudeoffinancialflowsisa

significantconcern.Thesharpincreaseinshort-terminvestments

inthemid-1990shasbeenoftenblamedasamajorreasonfor

the1997Asianfinancial crisis—as these instantly turned into

significantcapitaloutflowsattheonsetofthecrisis.Totheextent

that thisparticularcomponentofshort-termcapital inflows is

extremelyvolatileandhighlyinterest-ratesensitive,theregion’s

financialmarketsaresubjecttothevagaryofforeigninvestor

sentiment. This also places regional authorities in a difficult

positionwhenpursuingautonomousmonetarypolicies.

Large capital inflows, strong credit expansion, and adverse

macroeconomic consequences are not new to emerging East

Asia.Robusteconomicgrowthinrecentyearshasunderpinned

surgingassetpricesbyboostingtheregion’sincomeandfueling

marketexpectationsforhigherfuturereturns.Keyregionalstock

marketindexessoaredandpropertypricesarerisingrapidlyin

manyregionaleconomies.Thejumpinmoneysupplyandfalling

domesticinterestrateshasbeenbehindthesharpriseinasset

prices.Butaprolongedperiodofmacroeconomicstabilityalso

seemstohavebredabiggerriskappetiteandsomecomplacency

amonginvestors.

11 Lane,PRandGMMilesi-Ferretti(2006):TheexternalwealthofnationsmarkII:revisedandextendedestimatesofforeignassetsandliabilities,1970–2004,IMF Working Papers, no 06/69,March.

12 These non-foreign direct investments (FDI) and non-portfolio inflows oftenrepresentshort-termborrowingsoftheregion’sbankingsystemsandtradecredits.Althoughsomecountry-specificfactorscanaccountfortherecentincreases—suchasasharpriseinoverseasborrowingbybanksinKoreatohelplocalshipbuildershedgetheirfutureUSdollarreceipts—thiscannotbethefullregion-wideexplanation.

-2,500

-2,000

-1,500

-1,000

-500

0

500

1,000

1,500

2,000

2,500

1990 1992 1994 1996 1998 2000 2002 2004

Gross financial derivatives Gross portfolio equity Gross debt Net financial assets

Assets

Liabilities

Figure43:Cross border financial assets and liabilities of Emerging East Asia1 ($billion)

1ASEAN+PRC+NIEs.Source:OREIstaffcalculationsbasedondatafromLane,P.andG.Milesi-Ferretti(2006),TheExternalWealthofNationsMarkII:RevisedandExtendedEstimatesofForeignAssetsandLiabilities,1970-2004,IMF Working Paper 06/69.

5.05.0 4.7 4.3

3.3 2.4 2.7 2.9 3.4

2.7 3.9 4.6 4.1

-1.7 -2.1 -2.0-2.6 -0.9

-3.2-6.8

-4.6

-3.2

3.9

-3.8

-5.8-4.4

-2.4

-15.0

-10.0

-5.0

0.0

5.0

10.0

15.0

2003H2

2004H1

2004H2

2005H1

2005H2

2006H1

2006H2

2007H1

Other investmentsPortfolio investmentsDirect investmentsNet flows

Inflows

Outflows

Figure42:Financial account—Emerging East Asia (%ofGDP)1

1FiguresincludeChina,People’sRep.of;HongKong,China;Indonesia;Korea,Rep.of;Malaysia;Philippines;Singapore;Taipei,China;andThailand.22007H1figuresdonotincludeMalaysiabecausedataareunavailable.Source:OREIstaffcalculationsbasedondatasourcedfromtheInternational Financial Statistics,InternationalMonetaryFund,andcountrysources.

2

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Theassetpriceboomhasalsobeengenerallybroad—covering

local equity, bond, and property markets. Rapid liquidity

growth,fueledbyhighofficialexchangereserves,hasincreased

demandforvariousassets.Theappearanceofmoreinstitutional

investorsand theirassetmanagementactivities in the region

alsoincreasedtheshareoffinancialassetsinindividualinvestor

portfolios.Growingsizeofassetmarketsvis-à-vistheeconomy

has naturally led to increased exposures of various sectors—

household,corporate,andfinancial—tochangesinassetprices

(Box �).Againstthisbackdrop,ifassetpricesareaffectedas

macroeconomicconditionsworsen,theoveralleconomicimpact

ontheregion’seconomiescouldbesignificant.

Could These Vulnerabilities Combine to Become “the Perfect Storm?”

Uncertaintiesabouttheevolutionoftherecentturmoilpersist,

especiallyonheightenedvolatilityinfinancialmarkets,re-pricing

of risks globally, and the increased odds of a US recession.

EmergingEastAsiaboastsstrongeconomicfundamentalsand,

asofnow, thereare fewsignsoffinancialmarket turbulence

derailingtheregion’srobustgrowth.Butsomeoftherecenttrends

haveincreasedtheregion’svulnerabilitiestoprolongedfinancial

instability and its continuing influence on themacroeconomic

stability.

As equity prices rose sharply, price-earning ratios shot up

(Figure ��).With their new business lines, banks entered

new territories of exposure and risks; exposure to consumer

credit, housing loans, and securities investments could incur

losses should macroeconomic conditions worsen with rising

household indebtedness and falling asset prices. Inadequate

information—andinmanycaseslimitedsupervisorycapacity—on

off-balancesheetexposuressuchasderivativesisalsoaconcern.

Inaddition,theincreasedactivityofnonbankfinancialinstitutions

and growing complexity of available financial products (and

services)contributetotheopacityoffinancialsystemsandtheir

riskexposures.

PhilippinesThailand


Indonesia

Korea, Rep. of

Taipei,China

12.9

44.7

15.419.8

Singapore

Hong Kong, China

Malaysia

0

5

10

15

20

25

30

35

40

45

50

Jan-05

Apr-05

Jul-05

Oct-05

Jan-06

Apr-06

Jul-06

Oct-06

Jan-07

Apr-07

Jul-07

Oct-07

Figure44:Price Earnings Ratio

Source:Bloomberg.

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Asset markets (equity andproperty) in the nine biggereconomiesinemergingEastAsiahave been booming in recentyears.1Since2001,stockpriceshaverisenover100%onaverage,and property values have alsosoared(FiguresB3.1a,B3.1b,andB3.1c).Policymakersacrosstheregion have expressed concernabout surging asset prices andthepotentialimpactoneconomicactivity of amajor correction inthesemarkets.As asset markets grow in

size, the regional economy isincreasinglyexposedtoswingsinassetprices.Inthepastsixyears,stockmarketcapitalization,asaratio to gross domestic product(GDP),hasdoubledortripled inmostofemergingEastAsia,exceptforMalaysiaandSingapore,whereithasgoneup lesssignificantly.BytheendofOctober,theaveragemarket capitalization for sevenoftheninelargeremergingEastAsian economies—except HongKong, China and Singapore,whosemarket capitalization ismuch higher—was about 126%ofGDP(FigureB3.2),morethandoubletheaverageattheendof2001.Propertypricesare risingfastaswell.Althoughofficialdatasuggestpropertypricesremaininlinewitheconomicgrowth,datalimitations may have resultedin underestimation of propertyprice increases in many of theregion’s economies, particularlythe People’s Republic of China(PRC). Data from the privatesector, such as Jones Lang LaSalle Research, suggest thatpropertypricesare rising fasterin the region than official dataindicate.Thewaveoffinancialdeepeninghas

1 The economies covered in this box areIndonesia,Malaysia,Philippines,andThailand(ASEAN-4), the People’s Republic of China(PRC), and the four newly industrializedeconomies(NIEs):HongKong,China;RepublicofKorea;Singapore;andTaipei,China.

also accompanied the expanded sizeoffinancialassetholdingsofindividualinvestors.Fastrisingstockpricesandincreasingnewissuance—reflectedinthedramaticriseinmarketcapitalization—attracted ever growing participationof individual investors in local stockmarkets. In the PRC, the number of

investor accounts doubledto133millionbyNovember2007,from66millionin2001.Indirectly through mutualfunds, the value of stockmarket investments roseto RMB3.3trillion by end-October fromRMB80billionat the end of 2001. Withgrowing income, housingownership is also rising. Insome large countries in theregion, policymakers havealreadybeenconcernedaboutthe rapid rise in householdmortgagedebt.

Changes in asset pricescouldaffecttherealeconomyby the wealth effect andchangesinthecostofcapital.Higherassetpricesincreasethe wealth of consumers,boostingconsumerconfidenceand encouraging higherspending. Stronger assetvalues would also improvefirms’ and banks’ balancesheetsandthusinducebanksto charge lower premiumsorincreasethesizeofloansby the so-called ‘financialaccelerator’ effect. At thesame time, booming stockmarkets would encouragecorporate investment byloweringthecostoffunding.

Empiricalresearchshowsthat the wealth effect ofassetprices,thoughsmall,issignificant in emergingEastAsia.Kuralbayeva,Karlygash,and N’Diaye (2006) findsthat in Malaysia; HongKong, China; Indonesia;and Korea, a 10% rise inreal stock prices increasesprivateconsumptionbyabout

0.2–0.3%, similar in magnitude toestimatesforindustrializedcountries.2Althoughresultsarenotavailable for

2Kuralbayeva,Karlygash,andPapaN’Diaye,2006,DeterminantsofPrivateConsumptioninASelectedNumberofAsianCountries,IMFWorkingPaper(forthcoming).

Box3: Asset Markets and the Real Economy

78.0

220.5

95.4

125.3

50

70

90

110

130

150

170

190

210

230

Real stock price

Real property price

Real GDP

2001Q1

2001Q4

2002Q3

2003Q2

2004Q1

2004Q4

2005Q3

2006Q2

2007Q1

2007Q3

FigureB3.1b:ASEAN-�: Asset Prices and Real GDP(2003=100)

Source:OREIstaffcalculationsbasedonCEICandBloombergdata.

69.1

332.1

116.9

141.0

50

100

150

200

250

300

350

2001Q1

2001Q4

2002Q3

2003Q2

2004Q1

2004Q4

2005Q3

2006Q2

2007Q1

Real stock price

Real property price

Real GDP

2007Q3

FigureB3.1a:People’s Republic of China: Asset Prices and Real GDP(2003=100)


82.8

214.1

112.5

124.5

70

90

110

130

150

170

190

210

230

Real stock price

Real property price

Real GDP

2001Q1

2001Q4

2002Q3

2003Q2

2004Q1

2004Q4

2005Q3

2006Q2

2007Q1

2007Q3

FigureB3.1c:NIEs: Asset Prices and Real GDP (2003=100)


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52

the region, changes inasset prices have beenfound to have significanteffect on investment aswell in most industrialcountries.3The1997Asianfinancialcrisiswasavividexamplethatsoaringassetprices, pushed by largecapital inflows, increasedtheleverageofborrowersandexpandedinvestmentthrough the f inancialacce lerator channe l ,contributing to financialandeconomicvolatility.4

Withsurgingassetpricesand increasingly sizableassetmarkets,themainchallengeformacroeconomicpolicyinemergingEast

3See,forexample,RobertBarro,TheStockMarketandInvestment,Review of Financial Studies, Vol. 3, No. 1 (1990),pp.115–131,forUSevidence.4 Edison, Hali, Pongsak Luangaram, andMarcusMiller,2000,“AssetBubbles,Leverageand‘Lifeboats’:ElementsoftheEastAsianCrisis,”Economic Journal,Vol.110,No.460,pp.309–34.

Asiaistopreventanyfinancialmarketexcessfromspillingovertogoodsandservices markets, thus threateningmacroeconomicstability.Policymakersshould also aim tominimize the riskof financial instability as a sustainedperiod of asset price inflation oftenunderminesfinancialsectorsoundness,even if those gains initially appearbroadlyjustifiedbyfundamentals.Thisrequiresauthoritiestoremainfocused

on containing inflationarypressuresandexpectations,andstrengtheningfinancialmarket regulation andsupervisiontoaddressrisksassociatedwithassetpricebooms.Prudentialmeasures,such as tightening lendingstandards and criteria,could limit the speculativeparticipationthatmayleadto misalignment of assetpricesand the consequentprice collapse. Tighteningsupervisory policies canalso be helpful, as theycantargetproblemsectorsmoreclosely,whilelimiting

theriskofderailingeconomicgrowthby using monetary policy that canhave long-lasting and much broadermacroeconomicconsequences.

0 30 60 90 120 150 180 210

Taipei,China

Malaysia

Philippines


Korea, Rep. of

Thailand

Indonesia

Latest *Dec 2001

103.9

59.0

41.1

14.5

195.5

187.3

124.8

121.7

116.5

86.1

49.5

40.0

31.3

131.9

150 300 450 600 750 900 1050 1200

Singapore

Hong Kong, China

216.5348.2

299.41021.9

Hong Kong, ChinaSingapore

Others

FigureB3.2:Stock Market Capitalization (%ofGDP)

*Asatend-Oct2007.Source:CEICdatabase.

Tightening financial linkages increase the region’s exposure to risks arising from global financial instability.

Booming assetmarkets in some regional economies also run

theriskofcorrectionshouldglobalfinancialinstabilityreverse

investmentsentiment.Theregion’sequitymarketstendtomove

intandemwithglobalequitymarkets.Since1997,greatermarket

openness has enticed greater foreign investor participation

directlyintoemergingEastAsia’sequitymarkets.Portfolioinflows

totheregionhavebeenparticularlystrong,especiallyinrecent

years.Sotheregion’sequitymarketsremainhighlysensitiveto

swingsinforeigninvestors’riskappetite.

Intheperiodsince1990,correlationbetweendailychangesin

stockpricesintheregionandthoseintheDowJonesIndustrial

Average ranged from20%to40%,with theexceptionof the

PRC,whichshowedalmostnocorrelation.Inthemorerecent

period from 2006, however, the correlation of emerging East

Asianmarketswith theUSmarket pickedup sharply to over

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5�

90%(Figure �5).Shouldtherebeasell-offinsay,USmarkets,

onecouldexpectasimilarmovewithintheregion.Ingeneral,the

correlationwithintheregionhasalsoincreasedinrecentyears,

reflectingthetighteningfinancialintegrationattheregionallevel

aswell.

Although the environment for external funding remains broadly positive, heightened financial volatility—together with elevated funding costs—are expected to narrow external funding opportunities for emerging East Asian borrowers.

Sovereigncreditspreadshavealreadywidenedinthewakeofthe

USsubprimeturmoilandhavedriftedhigherinrecentmonths.

Creditriskre-pricingtriggeredbytherecentfinancialfermentis

alsoexpectedtobroaden.

EmergingEastAsia’sdebtmarketshavebeengrowingstrongly,

attractingglobalinvestorsinsearchofyield—particularlyagainst

theclimateofgenerally lowinterestrates inmaturemarkets.

Butheightenedmarketvolatilitywill likelyslowgrowth in the

market on both the demand and supply side. On the supply

side,risingcostsoffinancingandelevateduncertaintyoverthe

economicoutlookmayleadcompaniestodelayplansforraising

newcapital.Acrosstheregion,offshore issuanceofcorporate

bondsfellsharplyinthewakeofthesubprimecrisis(Figure �6).

Simultaneously, investors’ heightened sensitivity to risk could

forcetheirretreatfromtheregion,reducingdemandforemerging

marketdebtaswell.

Ifthegrowingriskaversion—accompaniedbyare-pricingofrisk

andasuddenshiftintheglobalinvestmentclimate—leadstoa

creditcrunch,tougherfundingconditionscouldaffecttheregion’s

economicactivitiesmoreseriously.TheUSsubprimeproblemand

relatedglobal creditmarket turbulencehasalreadyadversely

affected credit conditions inmaturemarkets. Recent reports

confirmtighterlendingconditionsintheUSandtheeurozone,

whichisexpectedtoaffectbothhouseholdandcorporatefunding

decisions.13 If this global trend spreads to the region, tighter

credit conditions and increasingly uncertain economic outlook

coulddampeninvestorconfidenceandslowcorporatespending,

particularlyineconomiesthatarelessbusiness-friendly.

13SeeEuropeanCentralBank(2007),theNovemberissueofEUbankingsectorstability.TheFedquarterlyreportsalsoindicatedtighteninglendingcriteriaandrestrictions.

0

1

2

3

4

5

Singapore China, People's Rep. of

Hong Kong, China

Korea, Rep. of

JanFebMarAprMay

JunJulAugSepOct

Figure46:Foreign currency bond issuance (JantoOct2007,$billion)

Source:Bloomberg.

0

50

100

150

200

250

300

350

01-Jan-04

07-Oct-04

14-Jul-05

20-Apr-06

25-Jan-07

01-Nov-07

00.10.20.30.40.50.60.70.80.91

Emerging East Asia

US Dow Jones

Correlation for the period2004-2005 = 0.35

Correlation for the period2006-2007 = 0.93

Figure45:Correlations between US and Emerging East Asia stock markets (1Jan2004=100)

Source:OREIstaffcalculationsbasedonBlooombergdata.

SPECIALSECTION

5�

Strong trade ties to major industrialized countries suggest that the risk to the region might be greater if growth in those economies slows sharply.

The possibility of a slowdown in theUS economy is amajor

concern,withitsannualGDPgrowthprojectedtofallfurtherto

1.9%in2008—downfromthisyear’smoderationtoanestimated

2.2%.TheUSeconomyremainsthesingle largestmarketfor

emergingEastAsia’sexports(Figure �7).Shouldtheworld’s

largest economy stumble into recession, knock-on effects on

theregion’seconomiescouldbeconsiderable.Studiessuggest

thata1%reductioninUSGDPgrowthcouldshavetheregion’s

growthintherangeof0.3–0.5percentagepointthroughdirect

andindirectdemandeffects.14

Thereislittledoubtthatfavorableexternaltradeandfinancial

conditionsprovidedanimportantfoundationforrobustgrowthin

emergingEastAsiaoverthepast5years.Althoughtheregion’s

growthappearssettocontinue,asharpslowdownorrecession

intheUSeconomywouldcertainlyleaveitsmarkontheregion’s

economies(Box �).

First,accountingfornearly30%ofglobalGDP,theUSeconomy

couldtriggerasignificantreductioninworldincomeanddemand

for the region’s exports should it slow much sharper-than-

expected.Second,with theUSasglobalfinancial center,any

majordisturbanceinUSmarketscouldquicklytransmittoother

majorglobalfinancialmarkets,withrepercussionsfeltthroughout

emergingmarketsaswell.Astherecentsubprimemarketturmoil

showed, contagion through financial channels can be potent.

Heightenedfinancialvolatilitywillalsoinfluencecapitalflowsand

investorconfidence.Thereareotherchannelsof transmission

aswell—viacommoditypriceadjustmentsortermsoftrade,for

example.Changes inUSmonetarypolicyandexchangerates

mayalsohavesecond-roundpriceandwealtheffectsontrade

andglobalfinancialassetpositions.

PastepisodesofUSslowdownsandtheirimpactontheregion’s

economiescanprovidesomeroughestimatesofthepotential

effectshouldtheUSeconomyfallintorecession.Duringthefive

US recessionsbetween1974and2001, emergingEastAsia’s

growth fell by about 0.28 percentage points on average for

everypercentagepointdeclineinUSgrowth.Buttheaverage

maskssignificantvarianceintheextentofspilloversdepending

14SeeADB,2007,DevelopingAsiaandtheWorld,Asian Development Outlook.

1990

US 20.4Japan

14.6

EU16.2

ROW 19.4

Emerging East Asia 30.0

2006

Emerging East Asia 39.5

ROW 20.7

EU15.2

US 16.2

Japan8.4

Figure47:Composition ofEmerging East Asia’s Exports (%)

Note:ROW=restofworld.Source:StaffcalculationsbasedondatafromDirection of Trade Statistics,InternationalMonetaryFund.

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TheideathatemergingEastAsianeconomiesinaggregatearedecouplingfrom the US economy has becomea hot topic lately. The region’s GDPgrowth,forexample,hasnotfaltereddespiteavisibleslowinginUSgrowthinrecentquarters(Figure B�.1).Has emerging Asia becomebetterableto insulate itself fromeconomicfluctuationsinindustrialcountries—and, ifso,howandtowhatextent?

Theregion’sresilienteconomicperformance stems from bettereconomicpoliciesandstrengthenedinstitutionalframeworksasaresultof successful reforms in the 10years since the 1997/98 Asianfinancial crisis. Strong growthand economic development haveresumed in most crisis-affectedcountries. And, with increasinglyopen financial markets in theregion—andrelativelylowinterestratesinindustrialcountries—capitalinflowstoemergingEastAsiahavebeenstrongduringthepastseveralyears,boostingeconomicactivity.More efficient financial systemscoupledwithpositiveexpectationsaboutfuturegrowthprospectsandprofitabilityintheregioncontinuestoattractforeigncapital.

Improvedmacroeconomicpolicyframeworksandreformstoestablishefficientfinancialmarketswasanimportantelementofthepost-crisisrecovery. All five crisis-affectedeconomies1 have more flexibleexchangerate regimescomparedwith pre-crisis period. And fourout of the five also opted forinflationtargeting.Whileincreasedcurrency flexibility increased thedegreeofmonetarypolicyfreedom,the adoption of inflation targetinghas helped maintain macroeconomicstabilityagainstcyclicalfluctuationsandenhanced monetary policy credibility.Improved fiscal positions withmore

1 The five crisis-affected countries areIndonesia, Malaysia, Republic of Korea,Philippines,andThailand.

effectivepublicdebtmanagementalsohave allowed increased options forfiscal action when appropriate—withfurtherreformscurrentlyunderwaythatshouldcreatemoreeffectiveautomaticstabilizers.Whilereformshaveyetto

becompletedinsomeareas,significantprogresshasbeenalsomadeinbankingsupervision and regulatory reformin crisis-affected countries. Effortsare continuing to introduce greatermarketdisciplineintheoverallfinancialsystemthroughbettergovernanceandenhancedmarkettransparency.

Another l ikely reason for theregion’s continued economic strengthisthediversificationofemergingEastAsia’s export base—the geographiccompositionofitstradingpartnersalongwiththerapidgrowthin intraregional

trade. Trade is amajor channelthroughwhich economic shocksare transmitted across borders.The region’s export-to-GDPratio—nearly 32.5% of GDP in2006 compared with the worldaverageof24.9%—illustratestheregion’srelativelystrongexternaldependency. But emerging EastAsia’sincreasingtradeopennesshasbeen accompanied by significantprogress in the diversification ofits exportmarkets.Although theUS remains the region’s singlelargestmarket,itabsorbed16.7%of the region’s exports in 2006,downfrom23.2%in1985.Japanand theeurozonenowaccountsfor24.0%ofemergingEastAsia’stotal exportmarket, well abovetheUSmarketshare.Meanwhile,intraregionaltradeasaproportionof total exports also rose from26.2%in1985to42.7%in2006.This increased diversificationof the region’s export marketssuggeststhatanexternaldemandshock arising from idiosyncraticindividualmarketturbulencecouldbe mitigated to some extent bystronger growth in other exportmarkets.Indeed,therelationshipbetween US non-oil imports andemerging East Asian exportsloosened visibly in 2006-07(Figure B�.2).

However, changing demandconditions in the world’smajoreconomies—including the US—

represent still an important factorbehind emerging East Asia’s exportgrowth.Nearly41%oftheregion’stotalexportsaredestinedforG32markets.Althoughlooseningsomewhatinrecentyears, the relationship between US

2G3 includes the euro zone, Japan, andUS.

Box4: Is Emerging East Asia Decoupling from the US?

-2

0

2

4

6

8

10

12

2001 Q1

2001 Q3

2002 Q1

2002 Q3

2003 Q1

2003 Q3

2004 Q1

2004 Q3

2005 Q1

2005 Q3

2006 Q1

2006 Q3

2007 Q1

2007 Q3

-2

0

2

4

6

8

10

12

Emerging East Asia

US

FigureB4.1:GDP Growth in US and Emerging East Asia1(y-o-y,%)

1Weightedbygrossnationalincome(atlasmethod,current$).Aggregates include People’s Republic of China; Hong Kong,China; Indonesia; Republic of Korea; Malaysia; Philippines;Singapore;Taipei,China;andThailand.Source:OREIstaffcalculationsbasedonnationalsources.

0.46

0.63

0.52

-20

-10

0

10

20

30

40

Jan-91

Dec-93

Nov-96

Oct-99

Sep-02

Aug-05

%

0.0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

US non-oil importsEmerging Asian exportsAverage 1991-97 (rs)Average 1998-02 (rs)Average 2002-07 (rs)

Apr-07

FigureB4.2:Correlation between growth rates of US non-oil imports and emerging East Asian exports

Source:OREIstaffcalculationsbasedondatafromDirection of Trade Statistics,InternationalMonetaryFund.

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non-oilimportgrowthandthatoftheregion’s exports also remains tight—theircorrelationover2002–2007was0.52 (see Figure B4.2). Despite thegrowing share of intraregional trade,evidenceindicatesthatasubstantiallylargeportion of emergingEastAsia’sintraregionaltradestillcatersexternaldemand3. Indeed, when taking intoaccount the share of intraregionaltrade ultimately destined for the G3economies, the share of G3marketsin the region’s total exports rises toover60%insteadofthe42%.Totheextentthatintraregionaltradeisdrivenbytradeofintermediategoodsamongtheregionaleconomiesforfinalgoods

3ADB. 2007. Uncoupling Asia: Myth andReality.Asian Development Outlook 2007.

destinedoutsidetheregion,emergingEastAsia’sintraregionaltradedynamicsremains sensitive to the changes inexternaldemandconditions.

Clearly, with its unparalleledpresence inworld tradeandfinancialmarketscenes,theUSeconomyexertsbyfarthemostsignificantleverageontheglobalbusinesscycle.Ofteninthepast,aUSrecessionwasaccompaniedbyslowergrowthelsewheretovaryingdegrees.4 Evidence drawn from pastrecessionsandthedirectandindirecttradelinkagesfortheregion’sexportssuggest that a US slowdown wouldhavesignificantimpactontheregion’s

4 International Monetary Fund. 2007.DecouplingtheTrain?SpilloversandCyclesintheGlobalEconomy.Chapter4inWorld Economic Outlook(April).Washington,DC.

economies.TheimpactwouldbemuchgreatershouldtheUSeconomyenterarecessionwithothermajorindustrialeconomies slowing in tandem. Thereisalsoachancethatongoingmarketcorrectionsandre-pricingofcreditriskscould becomemuchmore disruptive,leadingtoprolongedfinancialinstabilityandasevereglobaleconomicslowdown.Policies will need to remain flexibleand readily accommodating againstradical financialmarketmovements,whilecontinuingtoimproveeconomicresilience through deeper and morecomprehensivereformefforts.

onthenatureoftheUSslowdown—spilloversweregreaterwhen

therecessionwastriggeredbyashockthatwasmoreglobalin

nature.Themostrecentrecessionin2001wastriggeredbythe

burstingofthedot-combubbleandanassociateddownturninthe

globalITindustry.Theregion’smedianquarterlygrowthfellby

1.1percentagepointsinconnectionwitha2.9percentagepoint

declineinUSgrowth.Despitegenerallyrobustmacroeconomic

fundamentals and large accumulated reserves as a cushion,

theregion’seconomiesneedtoplanincaseofsharpswingsin

externaldemandandfinancialconditions.

Where Policy Can Make a Difference

Monetary policy anchored on inflation targeting, a prudent fiscal approach, and greater exchange rate flexibility could limit any spillover of continued global financial instability.

Gains achieved in fiscal consolidation and the application of

prudentialpoliciesshouldbemaintainedtoensureappropriate

insulation.Althoughpost-crisisfiscalreformsandprudentpolicies

haveconsolidatedfiscalandexternaldebtpositionsinmanyofthe

region’seconomies,publicsectordebtratiosremainsubstantial,

ranging froma high of 72.7%ofGDP in the Philippines to a

lowof33.3%inKorea,reflectingthecostoffinancialsystem

restructuring.

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Monetarypolicyshouldcontinuetoreinininflationaryexpectations.

Inflation—gatheringsteamacrosstheregion—hasalreadypushed

thelong-termbondyieldshigherdespitelowershort-termrates,

steepeningtheyieldcurves.Theriseinlong-terminterestrates

couldraisetheburdenofinterestratepaymentsongovernments,

particularlythosewithlargepublicdebtpositions.Withincreased

holdings of long-term government securities by the region’s

banks, this increase in long-termbondyieldscouldalsopose

risksofcapitallossesifbondpricesdropandassetsarevalued

mark-to-market.

As the global financialmarkets enter a period of turbulence,

heightenedvolatilitycanbuildhigherriskpremiumsintoemerging

markets,bringingwithitahighercostoffundingthroughoutthe

system.Ifemergingmarketcreditriskspreadswidenfurtherand

externalfundingconditionsdeterioratesharply—associatedwith

changes in investors’riskperception—relatedhikes infunding

costsandtheshortageofavailablefundingcouldhaveharmful

effects on the economies of emerging East Asia particularly

thosethatstillrelyonexternalfundsforinfrastructureandother

developmentrequirements.

Againstthisbackdrop,it is imperativeformonetaryandfiscal

authoritiestoensuresoundmacroeconomicpoliciesremain in

placewithsufficientflexibilitytoadapttotheevolvingexternal

environment.

Policymakers will need to concentrate on enhancing risk management systems, strengthening disclosure requirements, and upgrading supervisory frameworks to better assess potential vulnerabilities.

Creditriskmanagersinemergingmarketshaveadifficulttime,

asnecessaryinformationoncreditratingsandtradedsecurity

prices,forexample,canbehardtocomeby.Inmanyeconomies

therearevery limiteddataondefaulthistories.Even if there

weredata—variablessuchasdefaultprobabilitiesandlossgiven

defaults—mightnotprovideagoodguidetothetruesituationin

arapidlyevolvingfinancialenvironment.

Thus,enhancedsupervisoryreviewiscriticalinmaintainingsound

riskmanagementandensuringminimumcapitalrequirements

aremet.Arobustsupervisoryreviewprocess,includingefforts

bybankstoassesscapitaladequacycanalsoallowbankersand

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regulatorstoengageindiscussionstobuildariskmanagement

system that is flexible, yet reinforces their risk assessment

capacity.

Enhancedbank transparency canbolstermarket discipline. It

shouldenablemarkets to rewardbanks that take responsible

approachestoriskmanagementandpenalizethosethatdonot.

This isagain theapproach takenby theBaselCommittee—to

encouragemarketdisciplinebyrequiringdisclosuresthatwillallow

marketparticipantstoassesskeypiecesofinformationabouta

bank’srisks.Onewayistofollowa“menuofoptions”approach,

wherebybankswouldberequiredtodiscloseinformationrelevant

totheapproach(es)usedinthemeasuringofcapitalrequirements

andonthebasisofmateriality.

The region’s banking systems have gone through major structural changes since the financial crisis, but further reforms are needed to enhance their flexibility and resiliency against heightened volatility.

Althoughtheregion’sbankingsystemssofarexhibitedresilience,

somenotablechangesintheregion’sbankingbusinessessuch

as increasing household lending and securities transactions

requirespecialattention.Rapidexpansionbyfinancialinstitutions

intounfamiliarareasinevitablyentailsnewtypesofrisks.The

growing involvementofnonbankfinancial institutionsand the

plethoraofnewinstrumentsforrisktransferarechangingthe

regionalfinanciallandscape.Butthevastlydifferentdevelopment

stagesoffinancialmarketsandsystemsacrossborderssuggest

immediate policy challenges and reform needs would differ

greatly,thusrequiringcarefultailoringofthereformeffortsto

countryspecifics.

Some economies in emerging East Asia with more advanced

financialsystemsneedtobettermanagetheirbankingsystem’s

risk exposures in light of the recent turmoil and continue to

guardagainstpotentialspillovers.Theycouldacceleratereform

efforts to keep abreastwith ongoing global financialmarket

trendsanddevelopments,particularlyinbuildingtowardBaselII

compliance—severalof theNIEsareplanning tobegin this in

2008.Strengtheninginformationdisclosurepolicies,upgrading

standards in accounting and auditing, enhancing corporate

governance,andenhancing institutional capacityareareas to

address.

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Economies with less-developed financial systems may not face immediate financial transmission from the subprime turmoil, but nonetheless could focus on longer-term development issues such as institution building, financial sector reforms, and capital market development.

ForemergingEastAsianeconomiesthatareintheprocessof

buildingthebasicsoftheirfinancialsystems,itisusefultopursue

abroadpolicyframeworkthatestablisheslegalandinstitutional

infrastructureforfinance.Thesecanincludeinsolvencyregimes,

creditorrights,andprudentialregulations.Earlyeffortstobuild

information and governance infrastructure—such as credit

information systems, accounting and disclosure rules, and

internalandexternalauditingsystems—arealsoprerequisites.

Strengthening systemic liquidity support through effective

monetaryoperations,efficientpaymentsandsettlementsystems,

andliquidmoneyandcreditmarketswillfollowsuit.Thistype

ofinstitutionalbuildingisanimportantpreconditionforfinancial

liberalizationwithoutunderminingfinancialstability,particularlyas

theseeconomiesmovetowardstructuresthatcantakeadvantage

ofthebenefitsofeconomicandfinancialglobalization.

Conclusion

Despite strong resilience to the weakening external environment, vulnerabilities in the region’s financial systems should not be underestimated, as resurgent capital inflows and excess liquidity may complicate a true assessment of risk.

Against a backdrop of continued uncertainty over the future

growthoutlookandglobalfinancialstability,deeperandmore

comprehensivefinancialsectorandmarketreformsarerequired

toenhanceflexibilityandresiliencyoftheregion’sbankingand

financial systems—whilemaintaining strongmacroeconomic

prudencetounderpineconomicandfinancialsoundness.

Therecentfinancialmarketturmoilhighlightstheimportanceof

transparencyandgovernanceinthefinancialsystems.Globalized

finance alongwith rapid innovation has complicated the task

of effectively regulating and supervising financial institutions.

Strengthening regulatory and supervisory frameworks is

particularly important for emerging East Asianmarkets that

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have relativelyweakfinancialmarket infrastructure for credit

riskassessmentandeffectiveriskmanagement.

Alackofinstitutionalcapacityamongbothfinancialinstitutions

andregulatorsisanotherfactorthatcanhampereffectiverisk

monitoring and control, let alone the onslaught of evolving

financial technology. Although country-specific requirements

varygreatlydependingonareasofimmediatedomesticpolicy

concern,formulatinganappropriatepolicyframeworktoprepare

forpossiblerisksfromcontinuedglobalfinancialinstabilitycan

help insulate emerging East Asia from anymajor deleterious

effects.

asia economic monitor 2007 - regional integration · asean-4 indonesia, malaysia, philippines,...

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