9th ASEAN Central Bank Governors' Meeting, Presentation by Naoyuki Shinohara,Deputy Managing Director, International Monetary Fund
April 3, 2013Presentation by Naoyuki Shinohara
Deputy Managing Director
April 3, 2013
As prepared for delivery
1. Good morning. It is a real pleasure for me to address central bank colleagues from ASEAN this morning and to be among so many friends.
2. In my presentation today, I would like to cover briefly the global economic setting and then review implications for the economic outlook and risks of the Asia region and ASEAN. In doing so, I would like to pay special attention to the potential risk of financial imbalances, before offering our views on the key policy challenges at the current juncture. Allow me to briefly highlight the key points of my presentation:
- As global tail risks have receded, economic activity in Asia shows signs of improving.
- Nevertheless, relatively easy global and regional financial conditions, rapid credit growth and the prospect of continued strong capital inflows warrant a closer look at potential financial stability risks.
- As policy makers manage the transition to rebuilding monetary and fiscal policy space, and may need to respond early and decisively to the further buildup of financial imbalances and potential overheating pressures, macroprudential tools will likely also play an important role in safeguarding financial stability.
3. The global economy entered 2013 with receding tail risks, thanks to policy actions that averted the U.S. fiscal cliff and an escalation of the euro area crisis. In the United States, activity, balance sheets, house prices, and credit are improving. Major emerging economies are also seeing strengthening activity. Meanwhile, financial conditions have markedly ameliorated across the board for the last half year or so, with equity prices rising to multiyear highs, volatilities declining, and credit spreads compressing. Downside risks remain significant, as recent market jitters have reminded us, but risks are now more balanced than they were six months ago.
4. Nevertheless, the global economic outlook remains subdued by a sluggish recovery in advanced economies. In particular in the euro area, weak activity has now extended to some core countries, and forward looking indicators such as the manufacturing purchasing managers’ index (PMI) remain in contractionary territory. As we work to finalize our growth forecasts in the coming weeks, we see only small revisions from our January 2013 Update. This envisaged a modest recovery of growth in the United States to about 2 percent in 2013 and 3 percent in 2014, as consumption firms up in response to the slow turnaround in the housing market and supportive financial markets, while the euro area would remain in recession in 2013, with a mild contraction of – ¼ percent, followed by a modest recovery to 1 percent in 2014. While we expect continued fiscal consolidation in both the euro area and the United States, monetary policy will likely remain highly accommodative in light of the weak outlook and substantial remaining slack.
5. In Asia, aided by easier financial conditions and stabilizing external demand, growth gained momentum in the first quarter of 2013, after slowing across the region through most of 2012 due to a broad-based weakening of exports. Led by China, export growth has begun to pick up, reflecting a combination of supply-chain links and strengthening demand within Asia and from advanced economies, notably the United States. At the same time, private domestic demand has remained robust with easy financial and favorable labor market conditions supporting consumer confidence, buoyant investment, and robust retail sales notably in China and to a lesser extent major ASEAN economies.
6. Headline inflation fell markedly across Asia through 2012, in many cases by some 2 percentage points, with India, Indonesia and to a lesser extent Thailand as the exceptions. Declines were generally driven by moderating food and commodity prices, and in several cases also weaker growth. Core inflation in early 2013 was low and stable, at or below 2 percent in a number of regional economies including China, Korea, Malaysia, and Thailand.
7. Consistent with a broad range of recent high-frequency activity indicators, we expect a further small pickup of growth in Asia in the near term, underpinned by continued robust domestic demand and some modest strengthening in external demand. Growth for Asia as a whole is forecast to increase to over 5¾ percent in 2013 and 6 percent in 2014. ASEAN economies as a group are expected to record similar growth rates, but this is subject to significant variation between countries. Some of the low-income economies such as Cambodia, Lao PDR, and Myanmar, are expected to grow faster than the average thanks to ongoing structural reform, investment in critical infrastructure, and improved political stability.
8. What underpins the robust outlook for domestic demand? Relatively easy financial conditions will help, as well as the favorable labor market conditions, as unemployment is at multiyear lows in several economies. The former reflects a combination of accommodative monetary policies, rapid credit growth in some ASEAN economies, and continued robust capital inflows, which in 2012 helped push up stock prices across most of the region by 10–20 percent. In particular, we estimate that portfolio equity flows boost private consumption and investment in Asia, mainly by lowering long-term interest rates and boosting credit growth, as well as by reducing the cost of equity.
9. Regional economies are also expected to benefit from growing internal demand spillovers. For some of the more advanced open economies, such as Korea and Taiwan Province of China, direct and indirect exposure to demand from China and Japan is as important as demand from the United States and Europe. They should therefore benefit from the ongoing recovery in China, where we see growth recovering to about 8 percent, and stimulus measures adopted by the new government in Japan, which will help to sustain growth in 2013 at about 1½ percent. Recent exchange rate movements are unlikely to materially affect this outlook as they have been generally moderate in real effective terms, and supply-chain links tend to dampen their impact on external competitiveness. From a historical perspective, export market shares of Asian economies remained close to trend despite large swings in real effective exchange rates in the aftermath of the global financial crisis.
10. In the case of ASEAN economies, growing integration in final consumer goods trade may also contribute to favorable intraregional demand dynamics. Indeed, ASEAN economies have not just successfully integrated in regional supply chains. As will be discussed in greater detail in the forthcoming Asia Pacific Regional Economic Outlook, trade in final consumption goods between the larger, more advanced ASEAN economies—that is, Indonesia, Malaysia, the Philippines, Singapore, and Thailand—has seen a remarkable uptrend, accounting for nearly one third of their total consumer goods exports in 2011. There is also empirical evidence that intra-regional demand is becoming an important driver of growth for these ASEAN economies. Together with a growing and large domestic market greater trade integration is providing the region with a source of resilience against global demand shocks.
11. We expect inflation to remain generally within central banks’ explicit or implicit comfort zones, with the notable exception of India. Consistent with the moderate pickup in growth and a stable outlook for global food and commodity prices, headline inflation would average 3.3 percent in 2013, only slightly higher than the 2012 average of 3.2 percent and would rise to 3.6 percent in 2014.
12. Risks to this forecast have become more balanced over the last six months. In particular global tail risks have receded, as I mentioned before. Nevertheless, the potential impact of external risks on Asia remains considerable. In the event of a severe global slowdown, falling external demand would exert a powerful drag on Asia’s most open economies, directly and through the second-round impact of lower investment and employment in export-oriented sectors. For example, a scenario in the forthcoming World Economic Outlook shows that if a reassessment of sovereign risks in the euro area and other systemic advanced economies prompted further fiscal tightening and lower growth, and growth was lower say by some 2 percentage points relative to the baseline, growth in emerging Asia would be reduced by about 1 percentage point on average in each of the next two years.
13. But there are also risks and challenges from within the region that are now coming into focus. One risk, in particular in Emerging Asia and a number of ASEAN economies, stems from the gradual buildup of financial imbalances related to rapid credit growth and rising asset prices. In fact, credit growth across a number of economies in the region has continued to exceed nominal GDP growth, and even longer term trends in a number of cases, including in China, Korea, Vietnam, Singapore and Indonesia. With global financial conditions easing markedly since mid-2012 amid further loosening of monetary stances in major advanced economies, risk capital has began returning to Emerging Asia. Net portfolio flows gained strength after turning positive in the third quarter of 2012. The turnaround has been led by ASEAN economies, where the swing in net portfolio flows amounted to about 3¼ percent of GDP. At the same time, the impact of European bank deleveraging on Asian financial systems continued to be relatively small.
14. However, and with some variation across countries, financial stability risks do not appear to be imminent at this stage. First, a set of new financial heat maps suggest that while risks of price bubbles are forming in the housing, equity and credit markets in selected markets and economies, they generally still appear to be moderate by historical standards. The heatmap shown here illustrates price-dynamics in the credit, equity and housing markets relative to historical norms, as measured by the number of standard deviations a price may deviate from its median over the last decade. The colors turning yellow, orange or red indicate that prices are rising significantly above their historical norms and that the momentum of excessive increases is gaining strength. By this measure, selected ASEAN economies face growing financial imbalances in the credit and equity markets, while the housing markets still look relatively stable, although, by definition, the heatmaps do not necessarily detect pressures in subsegments such as large cities. For ASEAN low-income countries, financial stability risks mainly arise from rapid credit growth, notably in Cambodia and Laos, and structural changes in the financial system, including the creation of new stock markets, requiring financial supervision to become more comprehensive, forward-looking, and risk based.
15. Corporate and household sector balance sheets also appear generally robust. Corporate sector leverage has generally picked up recently, but it has remained moderate by historical standards. Debt-to-equity ratios remain below their median level recorded during 2002–07, reflecting deleveraging in the aftermath of the global financial crisis. Moreover, debt-to-equity ratios for corporate sectors in Asian economies are generally below levels observed in the United States, the euro area, and to a lesser extent emerging economies in Latin America. Asian firms also tend to have stronger liquidity positions than those in other regions, and the share of foreign currency debt is generally moderate, although there has been some rapid growth in issuance of private foreign currency debt in Indonesia. Finally, profitability ratios for Asia’s corporate sector also remain rather solid and stable, in part reflecting the more favorable growth environment relative to other world regions. For the household sector, leverage has also picked up, and in a few economies lending by banks to households at close to or above 60 percent of GDP is relatively high, but household debt-to-income ratios remain broadly in line with historical averages.
16. Although the picture does not look alarming for now, financial imbalances can worsen relatively quickly and are often difficult to unwind. Therefore continued vigilance is required in monitoring risks. As shown here, banks in the region have built up buffers—tier 1 capital in excess of regulatory levels plus loan-loss reserves minus bad loans—which should help contain the impact of potential imbalances. However, in a number of Asian economies, buffers remain somewhat below those in the United States and the emerging economies in Latin America.
17. This brings me to the last section of my presentation today, which is about policies. Despite progress in rebuilding the global financial system, the process has gone on too long, and helps prolong uncertainty. The ultimate goal is a stronger financial sector that supports growth and the real economy—one that behaves differently from before the crisis, and further action is needed. First, while U.S. and European banks have substantially increased their capital ratios, lower sovereign spreads and improved bank liquidity in the euro area have not resulted in better private borrowing conditions—continued financial fragmentation and elevated bank lending rates and tight credit standards indicate that further repair of their balance sheets is needed. Second, major steps forward have been taken on global regulatory reform, including, agreements on global bank capital and liquidity regimes, and FSB standards on Effective Banking Supervision and Resolution Regimes. However, there have been delays, such as on implementing Basel III in major jurisdictions, national and across-borders frameworks for orderly resolution of big banks, regulation of shadow banking, etc. Third, progress is needed towards a more complete banking union in Europe, comprising of an integrated regulatory and supervisory framework, a single resolution mechanism and resolution authority, and a common safety net.
18. On other policies, adjustment efforts in the euro area periphery countries need to be sustained and must be supported by the center, including through full deployment of European firewalls—the European Financial Stability Facility (EFSF), and the European Stability Mechanism (ESM). In the United States, the priority remains avoiding excessive fiscal consolidation in the short term, promptly raising the debt ceiling, and agreeing on a credible medium-term fiscal consolidation plan, focused on entitlement and tax reform. In Japan, although the stimulus is expected to boost growth in the near term, the priority is to underpin the renewed emphasis on raising growth and inflation with more ambitious monetary policy easing, adopt a credible medium-term fiscal consolidation plan anchored by the consumption tax increases in 2014–15, and raise potential growth through structural reforms.
19. Closer home, the key near-term challenge in Asia consists of a delicate balancing act: guarding against potential further build-up of financial imbalances, and calibrating the support to growth while external demand and growth prospects are still subdued, at least for 2013. As policy makers manage the transition to rebuilding monetary and fiscal policy space, macroprudential and capital flow measures will continue to play a role where conventional monetary management proves insufficient to address specific financial stability issues.
20. As you can see, many Asian economies have resorted to a broad range of prudential measures in recent years, which have often been focused on the stability risks arising from overheating property markets, such as loan-to-value (LTV) caps for mortgages. When prudential measures took the form of capital flow measures, they were aimed at safeguarding financial system stability in the face of surging capital inflows, often with a view to affecting the composition and duration of flows.
21. While macroprudential and capital flow measures can be a useful addition to the authorities’ toolkit, their effectiveness has varied across countries, in part reflecting the degree of economic and financial development, exchange rate regime, vulnerability to certain shocks, and the accompanying macroeconomic policies. Depending on circumstances they are also considered a complement to more conventional monetary tools and can offset undesirable side effects. Take, for example, the case of Singapore where monetary tightening through faster future exchange rate appreciation may induce domestic interest rates to fall today and thus have the undesirable side effect of stimulating interest-sensitive demand for real estate assets. Another case is China where stimulus in response to the global financial crisis led to rapid credit growth, prompting the authorities to use macroprudential measures to contain house price increases. In addition, empirical estimates across a broad country sample suggest that some prudential measures may also help dampen business cycle fluctuations.
22. It is also worth emphasizing that the experience of Asian economies with macroprudential and capital flow measures has been an important factor shaping the evolving institutional view of the IMF. Whether these measures are appropriate mainly depends on the need and room for macroeconomic policy adjustment, the time it takes for policies to become effective, and the specific source of financial sector risks and their impact on the real economy. As such, these measures should be clearly targeted and communicated, and generally temporary, as they can buy time but cannot substitute for longer-term macroeconomic and financial sector policies.
23. The timely phasing in of Basle III requirements provides an opportunity to further strengthen the macroprudential toolkit, and the development of Asian financial markets. Asian banks are generally well positioned to comply with the new rules that make banks hold more and higher-quality capital and establish more robust funding structures. The limited supply of high-quality local bonds could pose a greater challenge to many Asian financial systems in meeting tighter liquidity-coverage ratios. But these ratios may also encourage the development of new instruments that constitute a reliably safe and liquid pool of assets for banks to hold.
24. As I said before, macroprudential and capital flow measures cannot be a substitute for, but will have to be coordinated with, any necessary adjustment in macroeconomic stances. So, let me conclude with our assessment on the latter.
25. Against the backdrop of uncertain growth prospects central banks in the region kept or brought down policy rates to low levels in 2012. To the extent that inflation remains low and stable, this accommodative stance has served them and the region well. Now, a transition to rebuilding monetary policy space would generally be warranted by the ongoing growth recovery under our baseline projection, as well as by the risks of a further buildup of financial imbalances, which otherwise could prove more difficult to unwind. However, the need and direction for future monetary policy action differs substantially across economies, mainly reflecting different exposures to shifting growth risks and risks to financial stability. For example, in Japan, additional monetary easing would be beneficial and can be part of a broader set of policies, which include ambitious medium-term fiscal consolidation and structural reform to raise growth in a sustainable way. By contrast, in China, past credit-led stimulus has led to an overhang. Social financing—a broad measure of credit in the Chinese economy—has remained buoyant and the share of nonbank financing has increased significantly. The challenge there will be to continue supporting the economy while unwinding past credit stimulus and curbing the growth of off-balance sheet and nonbank intermediation. For countries where inflationary pressures have been elevated, such as Indonesia, vigilance on inflation will pay dividends for long-term growth.
26. Greater exchange rate flexibility would also play a useful role in curbing future overheating pressures and speculative capital inflows. Most exchange rate movements since our last update in October 2012 have been consistent with fundamentals, with real effective exchange rates appreciating in many Emerging Asian economies amid narrowed current account surpluses. In Japan, the recent depreciation began from a moderately overvalued level and reflects a number of factors, including a widening trade deficit, lower global risk aversion and new monetary policy initiatives.
27. Turning to fiscal management, country circumstances—including the cyclical position and available fiscal space—will also determine the appropriate pace of fiscal consolidation. As shown on the right hand side, higher structural deficits than before the crisis imply the need for greater efforts to rebuild fiscal space in many Asian economies, including some ASEAN members, especially as projected improvements in structural fiscal balances remain small on current policies. Some fiscal consolidation could also help preempt potential overheating pressures from continued strong capital inflows. With risks more balanced than six months ago, letting automatic stabilizers play should be a sufficient first line of defense if growth were to disappoint somewhat.
28. Strengthening fiscal space and frameworks is also needed to achieve sustained and more inclusive growth over the medium term. As we will discuss in greater detail in our forthcoming Asia Pacific Regional Economic Outlook, fiscal management in Asia has become more effective over the past decade in responding to shocks in a timely manner, helping to smooth GDP fluctuations. However, there is ample scope to make both revenue and expenditure policies more growth-friendly and ensure that Asia’s growing prosperity is shared across all income groups.
29. In conclusion, let me say that near-term growth prospects for Asia have improved somewhat, mainly reflecting receding global tail risks. Even though the global recovery remains fragile and subdued, relatively easy global and domestic financial conditions, rapid credit growth and the prospect of continued strong capital inflows under our baseline require continued vigilance in monitoring the potential buildup of financial stability risks. Against this background, policymakers will have to manage the transition to rebuilding monetary and fiscal policy space, and macroprudential tools will continue to play an important role in safeguarding financial stability.