September 2006, No. 41

Management

Asia Building on Success

The integration of capital markets has helped to allocate savings and investment more efficiently, but it has also increased the risks from volatile capital flows and financial contagion.

Asia, the world's largest continent with nearly three-fifths of its population, has undergone a remarkable transformation over the past 50 years. After the Second World War, Asia was a mix of poor and backward countries, possessing few natural resources and located far from most industrial countries. Since then, after embarking on an ambitious drive to open their economies to international trade and investment, many Asian countries experienced a remarkable period of sustained economic growth that has helped to lift millions out of poverty and improve living standards. Now, Asia is an important driving force in the global economy, featuring 4 of the world's 12 largest economies—Japan, China, India, and Korea—as well as several of the fastest-growing ones. Although Asia suffered a temporary setback from the financial crisis of the late 1990s, its quick recovery and dynamism suggest that its role in the global economy will continue to grow.

With Asia's growing importance in the world economy, it must play a role—together with other regions—in helping to address the large global current account imbalances.

As Asia looks to the future, the most important challenge it faces is how to adapt to globalization, with its wide-ranging impact on trade patterns, production processes, employment opportunities, and financial linkages. Globalization, of course, is not new to Asia, a region that has benefited greatly from its close engagement with the world. But the accelerating pace of globalization is bringing new issues to the fore.

• The integration of capital markets has helped to allocate savings and investment more efficiently, but it has also increased the risks from volatile capital flows and financial contagion. How to reduce domestic vulnerabilities, prevent future crises, and create international and regional safety nets for insurance against large and volatile capital flows remains a key challenge.

• The globalization of production—especially with the rapid emergence of China and India—has created tremendous opportunities, but major efforts will be needed to make the region's economies flexible enough to reap the benefits while minimizing the associated dislocations. Adjustment costs are already evident in growing income disparities, as some countries, and groups and regions within countries, are increasingly being left behind.

• With Asia's growing importance in the world economy, it must play a role—together with other regions—in helping to address the large global current account imbalances. Reforms will be needed to rebalance growth away from exports toward domestic demand. Such a rebalancing would not only be in Asia's interest but would also have positive spillovers to the rest of the world.

In this issue we review some of the key factors behind Asia's transformation and the challenges Asia faces in adapting to the rapid pace of globalization.

Staggered start: Asian countries began their rapid growth phase at different times. Japan, after the Second World War, was the first country to take off, followed by the group of so-called Asian tigers—Hong Kong SAR, Korea, Singapore, and Taiwan Province of China—which embarked in the 1960s on an ambitious outward-oriented strategy for growth. Other countries in the region soon followed, including Indonesia, Malaysia, and Thailand. More recently, China and India, pursuing their different paths of liberalization, have experienced rapid growth.

Overall, the results have been impressive. From 1950 to 1997, Asian countries grew by nearly 6 percent a year on average, nearly twice as fast as the rest of the world and more than 1½ times faster than the United States. Asian countries now account for about one-fourth of the global economy, in terms of both size and recent economic growth.

Trade was critical to success. During 1960–2005, Asia's share in global trade increased from 11 percent to 26 percent. Trade encouraged industrialization based on the dynamics of comparative advantage, shifting from agriculture to labor-intensive manufacturing and, more recently, to more capital-intensive, high-skilled industries. This pattern of industrialization helped foster growth with equity by creating new jobs and raising real wages. It also enhanced domestic competition and facilitated the transfer of advanced technologies.

Asian policymakers also pursued sound macroeconomic policies that allowed economic activity to flourish. These policies contributed to low and stable inflation, low levels of public debt, and high savings and investment, especially in human capital and economic infrastructure. Policymakers also demonstrated flexibility in responding quickly to changes in the external environment, such as the oil shocks of the 1970s and 1980s, and in abandoning failed industrial policies in favor of market-led growth.

From miracle to crisis to recovery: But in the late 1990s, Asia suffered a painful setback as a financial crisis hit Thailand and spread quickly through the region. The immediate trigger was the sudden sharp reversal of capital flows—net capital flows to Asian crisis countries swung from an inflow of over 6 percent of GDP in 1995 to an outflow of 2 percent of GDP in 1997 and rose above 5 percent of GDP the following year. But an underlying cause was structural weakness that left many economies vulnerable to the sharp withdrawal of capital.

A weak financial sector saddled with large nonperforming loans; a heavily indebted corporate sector that overinvested in some sectors, such as real estate; and doubtful corporate governance practices undermined investor confidence and exacerbated the crisis. In addition, many Asian countries, such as Korea and Thailand, relied on a rigidly managed exchange rate regime that was prone to misalignment and speculative attack.

Policymakers in the region responded by addressing these structural weaknesses to restore investor confidence and economic growth. Because Asian countries moved aggressively to restructure their financial and corporate sectors and liberalize their economies, investor confidence was quickly restored, allowing capital to return to the region. This, in turn, helped Asian countries reduce their external vulnerabilities by replenishing foreign reserves and repaying foreign debt. In the end, the financial crisis proved to be only a temporary setback, as many countries quickly realized the benefits of their extensive reforms and resumed their rapid pace of growth.

What's next?: As Asia builds on this recovery, it faces a variety of fresh policy issues created by the accelerating pace of globalization. They include finding ways to prevent future crises, strengthening integration to enhance the region's broader participation in the global economy, seizing the opportunities created by the rapid emergence of China and India, ensuring that the benefits of growth are more evenly shared, and contributing to the resolution of global current account imbalances.

Preventing future crises:The time-tested importance of having a sound macroeconomic framework, including appropriate monetary and fiscal policies, to protect against financial crisis remains relevant for the future. Asian countries have made progress in this area, particularly by moving to more flexible exchange rate regimes where appropriate, such as in Korea and Thailand. Many countries have also built up foreign exchange reserves as a way of cushioning their economies from shocks.

Another key task is to reduce public debt burdens to more comfortable levels. Since the mid-1990s, the growth in public debt in emerging Asia has been particularly rapid, rising from about 40 percent of aggregate GDP in 1996 to about 55 percent in 2005. While there has been progress in reducing debt ratios, there is wide variation across the region. The current period of strong growth provides a golden opportunity to curb fiscal imbalances, not only to reduce vulnerabilities but also to prepare for the fiscal costs of Asia's aging population, especially in Japan and China.

In addition, many countries need to further strengthen their financial systems. A healthy and sound financial system would not only better serve increasingly sophisticated economies but would also help make markets more resilient by providing more financial instruments for a broader sharing of risks. To promote a sound financial sector, there is a need to further strengthen supervision to safeguard against systemic risk, improve risk-management skills, enhance corporate governance to strengthen market discipline, and put in place an efficient bankruptcy system for restructuring.

Strengthening regional integration: Since the crisis, Asian countries have taken steps to deepen regional integration and cooperation. On the trade front, Asia has experienced remarkable progress, with intraregional trade reaching over 40 percent of total trade in 2005, a level comparable to that reached in the North American Free Trade Agreement, up from 30 percent in 1990. Much of this expansion is being driven by market forces, especially the rapid integration of global production processes, particularly in China. There is also growing momentum for regional economic cooperation, including bilateral and regional trade arrangements (RTAs), most recently with the signing of an agreement between Korea and Singapore in 2005.

How to make regionalism work to strengthen trade, investment, and growth for Asian countries will be a challenge. There is the risk that the proliferation of RTAs could come at the expense of trade with nonmember countries, known as trade diversion. To be building blocks rather than stumbling blocks to multilateralism, RTAs should proceed in parallel with unilateral and multilateral liberalization. As tariff rates are lowered, the risk of trade diversion will be minimized.

Furthermore, Asian countries are increasingly being integrated into a regional supply chain, with final products destined in many cases for exports outside the region. RTAs can advance this integration, encouraging countries to specialize and trade more intermediate goods with each other. But this requires RTAs to be comprehensive in product coverage with few exemptions, featuring simple and transparent rules of origin to reduce the cost of compliance.

On the financial front, Asian governments have also worked to advance regional cooperation and integration, launching the Chiang Mai and regional bond market initiatives. Enhancing policy dialogue and expanding regional safety nets are welcome because they can assist in strengthening regional surveillance, reducing the risk and severity of liquidity crises, and complementing the role of the IMF in promoting global financial stability. But, despite progress in financial reforms, capital markets in many Asian countries are still relatively underdeveloped. Here, regional initiatives could spur reforms—such as the harmonizing of laws, regulations, tax treatments, and market infrastructure—that would help these markets develop.

A healthy and sound financial system would not only better serve increasingly sophisticated economies but would also help make markets more resilient by providing more financial instruments for a broader sharing of risks.

Building on the opportunities from China and India: The growth of China and India has contributed to improved prospects for Asia as a whole. China's emergence as both a production network and a final export market for the region has been a key factor in boosting intraregional trade and investment; meanwhile, India has also grown rapidly following reforms in the early 1990s and, more recently, has become a global leader in service exports, even though its impact on the regional and global economies has so far been more limited.

At the same time, the emergence of these giants has also raised concerns about heightened competition for foreign investment and exports. Are these worries justified? A recent IMF staff study contends that China's emergence has so far not crowded out foreign direct investment (FDI) to other Asian countries, including low-wage countries. Even so, the impact of China and India's rapid development on the rest of the region is likely to grow. For other countries in Asia, the key to seizing the opportunities created by China and India will be to increase the flexibility of their economies to remain competitive and responsive.

Here, further development of capital markets and greater labor market flexibility will encourage resources to move quickly to new growth industries based on a country's comparative advantage. Measures to improve the business environment, such as further deregulation and liberalization of closed sectors, will facilitate new investment and innovation. Education policies aimed at upgrading skills will also enable workers to shift into new industries, while enhancing the social safety net will ease the burden of adjustment for the most vulnerable.

Sharing the benefits of growth: Although globalization has helped improve growth prospects in Asia, the benefits from this growth have not been evenly shared. Asia remains home to some of the poorest countries in the world, and even in the fastest-growing economies, such as China and India, vast areas remain poor and underdeveloped. In many countries, including the more developed ones, like Japan and Korea, income inequality is widening, and economies are becoming increasingly polarized, as some sectors and groups have surged ahead of others.

To ensure that the benefits from globalization are more evenly shared, Asian countries will need to pursue reforms that will expand opportunities for the poorest groups and regions to catch up.

These would include broadening financial systems to improve access to credit and insurance, particularly by small enterprises and the working poor; adopting labor reforms that strike the right balance between flexibility and protection of basic employee security; establishing social safety nets that encourage labor flexibility; and, in some countries, improving the functioning of land markets to unlock their productive potential. Policies to improve the poor's access to quality health care, education, and infrastructure will also assist in enhancing their economic contribution. Finally, prudent macroeconomic policies that promote financial stability can help protect the poorest groups, who, because of a lack of assets and instruments, are more vulnerable to financial crisis.

Helping resolve global imbalances: In recent years, the rise in global current account imbalances has cast a spotlight on Asia's external surplus, along with the large deficit in the United States. Although the current account surplus in parts of emerging Asia and in Japan has started to narrow in response to the rising cost of oil imports, the strengthening of domestic demand, and exchange rate appreciation in some countries, more needs to be done.

How to reduce the imbalances is a hot topic. The large U.S. current account deficit and the counterpart surpluses in Asia and elsewhere are a concern because of the risks that a disorderly adjustment could slow global growth, destabilize financial markets, and lead to the imposition of protectionist policies around the globe. With its reliance on exports, this would be particularly damaging for Asia. There is an agreed international cooperative strategy to address the imbalances, requiring policy actions by deficit and surplus countries to rebalance demand. For Asia, this involves structural reforms to boost domestic demand and allow exchange rates to adjust, although there are important differences in the policy requirements across the region. The needed policy adjustments in Asia will also help rebalance demand and put growth in the region on a more sustainable footing.

In emerging Asia (excluding China), the surplus largely reflects a collapse in investment rates in the aftermath of the Asian financial crisis, while saving rates have been relatively stable. Investment remains subdued despite the progress in corporate and financial restructuring since the crisis. According to work done by IMF staff, a reason for the "investment drought" appears to be a perceived increase in risk, which may reflect more realistic perceptions about risks than during the precrisis period.

What can be done to boost investment? On the macroeconomic front, sound policies that reduce uncertainty will remain critical. On the microeconomic front, improvements in corporate governance and regulations will reduce the costs of doing business, while further development of the financial sector will help transfer risk from the corporate sector to the wider investing public. It will also help create new financing structures to support startup enterprises, which will become increasingly important as Asian economies become more knowledge- and technology-intensive.

In Japan, since the early 1990s, the current account surplus has reflected a slower decline in the national saving rate relative to aggregate investment. Saving rates have fallen because of demographic factors and countercyclical fiscal policies to combat deflation, whereas investment has remained weak since the bursting of the asset-price bubble. Structural reforms to liberalize product markets, make the labor market more flexible, and encourage inward FDI will strengthen growth prospects and bolster private investment. They will also help mitigate the impact of population aging on potential growth.

In China, in stark contrast to the rest of Asia, the investment rate has been high and rising—reaching about 40 percent of GDP in 2005. But, because the saving rate has risen even faster—to about 47 percent of GDP in 2005—China's current account surplus has increased considerably. The steady rise in saving rates reflects increases in government, enterprise, and household savings, which now account for about 30 percent of disposable income.

If China hopes to stimulate a more permanent increase in consumption and make economic growth more balanced over the medium term, it will need to continue reforms on many fronts. Greater exchange rate flexibility, which, through an appreciation of the currency, will help boost consumption by raising household purchasing power, and a shift in budgetary spending toward education, health, and social safety nets (including reforming the pension system) are important macroeconomic policy measures. Further banking and financial market reforms will also prompt increased consumption by creating new savings, consumer lending, and insurance instruments that will help diversify risk and encourage households to spend more. In rural China, reforms to enable farmers to sell their land use rights at market prices and borrow against their land would also help meet the financing needs of rural households.

Building on success: The path that Asian countries have traveled to growth and prosperity in the past 50 years is nothing short of remarkable. Many ingredients of that success will remain relevant for the future—the embrace of openness, the commitment to macroeconomic stability, and the drive to adapt and reform in response to changing circumstances.

The rapid pace of globalization has brought new challenges. To meet them, Asia will need to continue to reform—to reduce vulnerabilities to crises; deepen regional integration while remaining open to multilateralism; strengthen financial systems and enhance the flexibility of its economies in order to benefit from the emergence of China and India; and rebalance demand to achieve more sustainable growth. With Asia continuing to reform and adapt, its prospects will remain bright, and its contributions to the global economy will be even greater over the next 50 years.                          

Source: Finance and Development Magazine