While the outlook for the region remains reasonably favourable, there are downside risks

THIS past weekend, at the IMF-World Bank Spring meetings, finance ministers and central bank governors from around the world met amid serious financial market turmoil which began in the US sub-prime market and continues to spread across asset classes and regions.

Less vulnerable: Asian economies are well-positioned to implement macroeconomic policies needed to protect themselves against risks from the financial market turmoil

Yet for many in Asia, the discussions surrounding this turmoil may have seemed remote. After all, Asia continues to grow robustly, while financial institutions in the region have largely escaped the problems confronting their counterparts in the United States and Europe.

Moreover, improved macroeconomic frameworks and financial oversight – not to mention the accumulation of vast reserves – mean that Asia is generally far less vulnerable than a decade ago and better placed to implement needed policies to deal with a global slowdown.

Nevertheless, 2008 is likely to be a challenging year for the region. Already there are signs that exports to the United States and European Union, and electronics exports in general, are slowing, as are retail sales. While Asian financial institutions appear to have limited exposure to sub-prime and related assets, and there is no sign of a credit squeeze, the region has not been immune to contagion – equity markets have fallen, spreads have risen, and corporate debt issuance has declined sharply.

The IMF projects that growth in emerging Asia will decline by about 1.5 percentage points but, at 7.5 per cent, would still lead global growth. At the same time, inflation is rising across the region. This initially reflected spikes in food and commodity prices pushing up headline inflation, but pressures are recently showing signs of broadening, with core inflation moving upward as well.

While the central outlook for the region remains reasonably favourable, there are downside risks. The IMF’s World Economic Outlook projects a 1.25 percentage point decline in the global growth, to 3.7 per cent in 2008, led by a mild recession in the United States.

But with the financial crisis spreading – and notwithstanding dramatic and helpful actions by major central banks – a significant possibility of a deeper slowdown in the US and globally remains.

How big an impact might such a sharper slowdown have on Asia?

In our April 2008 Asia and Pacific Regional Economic Outlook we find that, while over the last 15 years, spillovers from US growth to Asian growth have been modest – with a one percentage point US slowdown leading to a 0.25 to 0.5 percentage fall in Asian growth – the impact today could be significantly larger.

Despite Asia’s success in diversifying its exports, both trade exposure to, and financial integration with, the United States have actually increased over this period, and Asia’s business cycles are increasingly aligned with US cycles.

To date, a slowing of exports to the United States has been partly offset by strong exports to non-traditional markets, notably in the Middle East and Latin America. But this reflects the positive impact of high global commodity prices on these two regions, and in a global slowdown both commodity prices and the positive impact on Asia’s exports could moderate.

Moreover, while Asian financial markets have held up well, a further deterioration in the global financial environment could affect the region, by raising funding costs, reducing confidence or increasing the volatility of capital flows.

In a worst-case scenario, a US credit crunch could spill over to Asia, lowering growth in the region.

On the positive side, Asia is well-positioned to implement macroeconomic policies needed to protect against these risks.

For now, central banks in much of Asia should focus on rising inflation pressures. For some countries, notably China, more flexible exchange rates would allow for a more effective monetary policy, while stronger currencies would dampen inflation.

In the face of a sharp slowdown, however, inflation could ease, and many countries would have scope for a more accommodative monetary stance. Fiscal policy could also play a role – prudent policies in much of Asia have created ‘fiscal space’ which can be effectively used if needed.

Given the prominence of financial risks, additional steps may be required. First, monetary and supervisory authorities should be focused on monitoring risks related to ongoing questions about exposure to potentially impaired assets. Regulators also need to ensure that risk management – including of liquidity risk – remains appropriate.

Second, the authorities should review contingency plans to ensure they are prepared for any worsening in the financial environment. Central banks should clarify conditions under which liquidity facilities might be activated, while the authorities also should formulate plans to handle potential calls for bank recapitalisation.

Over the last decade, Asia has become increasingly integrated into the global economy, and has benefited with a period of sustained and rapid growth. On the flip side, it now finds itself unable to escape fully the impact of global financial and economic turmoil. But timely and appropriate policy responses can mitigate the impact of this turmoil and help ensure that the region continues its strong economic performance this year and beyond.

DAVID BURTON, director of the Asia and Pacific Department of the International Monetary Fund

Source : Business Times – 16 Apr 2008