10th ASEAN Central Bank Governors' Meeting (ACGM), Presentation by Naoyuki Shinohara, IMF Deputy Managing Director
April 4, 2014Presentation by Naoyuki Shinohara
IMF Deputy Managing Director
Nay Pyi Taw, Myanmar
April 4, 2014
As prepared for delivery
1. Good morning. It is an honor for me to have this opportunity to address central bank colleagues from ASEAN. Today, my presentation will cover the global economic setting, and review the outlook, risks, and main policy priorities for the Asia region and ASEAN. I will also briefly discuss some major policy themes in Asia, along with their implications for the region and ASEAN. Let me highlight at the outset that our April WEO is being finalized, so some of the numbers that I will refer to are preliminary and still subject to change.
2. Let me briefly highlight the key points of my presentation:
- Overall global growth has been firming up on account of the recovery gathering momentum in advanced economies, but the pickup in growth was more modest in emerging markets in the second half of 2013. Some large emerging market economies are experiencing subdued growth, owing in part to domestic policy weaknesses and uncertainty. Global activity picked up and world trade gained momentum in the second half of 2013. This is expected to continue, assuming financial volatility continues to subside. Growth should rise from 3.0 percent in 2013 to 3.6 percent in 2014, with the main impetus coming from advanced economies. Growth in emerging market economies is expected to increase to 4.9 percent in 2014 from 4.7 in 2013.
- The outlook for Asia is one of steady growth. GDP growth is forecast to improve slightly in 2014–15 to 5.5 percent, helped by stronger growth in advanced economies, healthy labor markets, and robust credit growth. For the ASEAN region, growth is expected to be broadly stable at 5.0 percent in 2014.
- An unexpected tightening of global liquidity remains the main external risk, particularly for emerging economies. Nevertheless, recent policy actions to address vulnerabilities (e.g., in India and Indonesia) have started to bear fruit, as evidenced by more muted reaction of regional financial markets to the bout of global volatility in early 2014.
- Domestic vulnerabilities in emerging economies in Asia could magnify the external risk. As interest rates rise, vulnerabilities stemming from pockets of high corporate leverage and household indebtedness will come to the fore. If economic conditions deteriorate, corporate defaults may occur and investment by highly-leveraged firms could take a hit. However, given the relatively small size of debt owed by distressed firms, corporate sector risks do not appear systemic at this juncture.
- Asia is also facing various risks originating from within the region. These include a sharper-than-envisaged slowdown and financial sector vulnerabilities in China, less effective Abenomics, and political tensions and uncertainty.
- With respect to strengthening Asia’s resilience to risks and the growth outcomes, a continuation of recent macroeconomic policies appears to be the right recipe in most economies. This would involve a gradual fiscal consolidation, maintaining monetary policies at their current supportive stance while inflation pressures in most of the region remain subdued, and normalizing gradually as economic slack diminishes and risks recede. In some cases, interest rate hikes will be needed to ensure that inflation is firmly on a downward path. Any volatility in capital flows should be met with exchange rate adjustment and sparing use of foreign exchange intervention. Macroprudential tools could continue to be used as a complement to mitigate the volatile capital flows. Finally, there is also ample scope in Asia to tackle structural impediments to growth by pressing ahead with a new wave of fiscal and structural reforms.
3. Global growth has been firming up on account of the recovery in advanced economies. Global activity picked up and world trade gained momentum in the second half of 2013. This is expected to continue, assuming financial volatility continues to subside. Growth should rise from about 3 percent in 2013 to 3¾ percent in 2014, with the main impetus coming from advanced economies.
4. The U.S. economy grew by a faster-than-anticipated 1.9 percent in 2013, led by domestic demand, despite an estimated fiscal drag of about 1¼ percent. The housing recovery continued and consumer spending picked up, with increases in house and stock prices, and a further decline in household debt relative to disposable income, raising household net worth above its long-term average. This momentum is expected to continue and GDP could increase by 2.9 percent in 2014 and 3.0 percent in 2015, also supported by a smaller fiscal drag and a pickup in nonresidential fixed-investment growth as consumer and business confidence improve.
5. In order to minimize risks to this positive US outlook, it will be critical to address medium-term fiscal risks, and also to continue to manage carefully the withdrawal of monetary support. QE tapering has proceeded relatively smoothly so far, helped by Federal Reserve forward guidance that has kept expected future short-term rates at low levels. The FOMC recently changed its forward guidance, dropping the previous quantitative thresholds and moving to more general, qualitative guidance linked to the degree of progress toward maximum employment and 2 percent inflation. This shift marks a reasonable evolution in communication and will help provide the Federal Reserve with greater flexibility. In order to make sure that such flexibility does not come at the expense of wider dispersion of market expectations and greater policy uncertainty, clear communication by the FOMC regarding how it assesses progress towards achieving its employment and inflation goals will be key.
6. In the euro area, a modest recovery is taking hold—stronger in the core countries, but weaker in the periphery. Activity shrank by about ½ percent in 2013, but growth has been positive since the second quarter, helped by stronger domestic demand on the back of slower fiscal consolidation. Budding growth and lower tail risks have buoyed financial markets, with marked compression in sovereign spreads in stressed economies (although these spreads have increased modestly with recent financial market volatility). The euro area recovery is expected to continue in 2014, with growth expected to be 1.2 percent, reflecting a smaller fiscal drag, expectations of improving credit conditions, and stronger external demand. Progress on banking union and repair of bank balance sheets is still required to ensure a durable recovery.
7. Activity in emerging market and developing economies picked up slightly in the latter part of 2013—from 4.6 percent in the first half to 5 percent in the second—driven by stronger external demand from advanced economies. Tighter external financial conditions, however, will be a drag on domestic demand. Indeed, yields have gone up and are expected to rise further. The recent bout of financial volatility in early 2014 highlights the challenges for emerging economies posed by the changing external environment. Many emerging economies came under renewed pressure in late January—equities fell, risk premiums rose, and currencies depreciated. While pressures were felt widely, economies with weaker fundamentals were more impacted, including South Africa and Turkey.
8. Overall, even as global prospects slowly strengthen, the specters of some old risks remain (incomplete financial sector reform, large debt burdens) and we see some new risks appearing. Let me mention two in particular:
- First, in the advanced economies—particularly in the euro area—the risk of prolonged low inflation is looming and needs to be appropriately addressed, including through unconventional monetary policies as needed. Persistently large output gaps—with the exception of Germany—are expected to moderate inflation to about 1.1 percent in 2014–15, well below the ECB’s objective of close to 2 percent. Low inflation also complicates the task in the stressed economies in the euro area, where the real burden of debt would rise if real interest rates increased. The Japanese experience with deflation shows that early action is warranted. High unemployment could also lead to reform fatigue, political uncertainty and reversals, jeopardizing the recovery.
- Second, in emerging market economies, there is a risk of heightened market volatility associated with the tapering of monetary policy in the U.S. Given that countries with larger domestic and external imbalances are likely to be more affected, strong macroeconomic policy responses on their part will be key—as will continued clear communication and cooperation among all countries concerned. New geopolitical risks could also threaten financial stability in some emerging economies, particularly in Central Europe and Middle East regions.
9. Let me now turn to Asia. Portfolio flows into Asia, which reached record highs in early 2013, saw a persistent reversal in the wake of the May 2013 “tapering episode”. During this period, the exchange rate has remained an important shock absorber across most of the region. Most economies made only limited use of their reserves to counter the currency pressures, and reserves are now higher than they were a year ago, with the main exceptions of Indonesia and Thailand. Along with other emerging markets, emerging Asian economies also faced large capital outflows in January 2014, although they proved more resilient to this latest bout in global volatility, reflecting in part policy actions taken in 2013 to address external and domestic imbalances (e.g., interest rate hikes in India and Indonesia, fuel subsidies cuts in Indonesia, fiscal reforms in Malaysia).
10. While the financial environment for emerging markets has been challenging, financial conditions across ASEAN+3 have remained broadly conducive. Domestic credit growth and corporate bond issuance have been strong. Equity markets rebounded from their spring 2013 lows as global and regional economic prospects improved. Foreign bank lending to emerging Asia, on the other hand, did lose some of its momentum during the course of the year.
- Against the background of stronger external demand and still accommodative financial conditions, activity across Asia picked up in 2013 and is expected to remain solid in 2014. GDP growth is forecast at around 5.5 percent in both 2014 and 2015, helped by stronger exports and domestic demand. Exports have gained momentum, as trading partners’ demand, especially from the U.S. and Europe, has picked up. Domestic demand is expected to continue to be underpinned by healthy labor markets and, particularly in ASEAN, solid credit growth. And recent high-frequency indicators, while somewhat mixed, point to a continuation of these trends into 2014.
- In China, the unveiling of the government’s reform agenda in 2013 has boosted sentiment but progress on economic rebalancing remains incomplete and investment continues to be a major growth driver. Growth is expected to decelerate slightly to a more sustainable path, 7.5 percent in 2014 and 7.3 percent in 2015. While the inflation outlook is expected to remain benign (with inflation averaging 3 percent in 2014–15), the steady withdrawal of monetary support for the economy should continue, given concerns about overinvestment and credit quality.
- ● Japan’s GDP growth picked up to 1.7 percent in 2013 and industrial production, retail sales and consumer confidence have been strong – a testament to the initial success of Abenomics. While wage growth has remained low, asset prices and expanding credit have helped underpin domestic demand. A weaker yen has benefited exports, albeit less than expected so far. Going forward, fiscal consolidation will be a growing headwind and supportive measures (including higher public investment and corporate tax cuts) will partly offset the impact of the consumption tax hike and the phasing out of past stimulus. Overall, GDP growth is expected to be 1.4 percent in 2014 (above potential) but would slow to 1 percent in 2015. Headline inflation will rise to 2.8 percent this year (around 1.7 percentage points of which is due to the consumption tax hike) and moderate to 1.7 percent in 2015. Underlying measures of inflation, such as core inflation and inflation expectations from surveys and from indexed government securities, are expected to stay in the 1–2 percent range.
11. In contrast with broader developments in the region, ASEAN economies decelerated more recently, and trends within ASEAN have diverged. After staging an impressive recovery following the global crisis, growth in the ASEAN-5 economies (Indonesia, Malaysia, Philippines, Singapore, and Thailand) dropped by an average of nearly one percentage point in 2013 compared with the 2010–12 period, with the exceptions of the Philippines and Indonesia. The decline in real GDP growth was driven mainly by the lower contribution of investment and private consumption, particularly in Thailand and Malaysia, but weak exports were also a drag on growth. In the forthcoming Asia Pacific Regional Economic Outlook we find that the recent growth slowdown in ASEAN-5 has been more cyclical than structural as trend growth has largely held up while the credit cycle (which had boosted cyclical growth) has moderated. In addition, the slowdown has reflected domestic factors more than external factors. Reflecting this and the more supportive role of global demand going forward, we remain optimistic about ASEAN growth prospects going forward.
12. Inflation is expected to remain contained across much of the region. Output gaps are expected to close only gradually across Asia and commodity prices are forecast to remain soft in the near term. Indeed, in Korea, Thailand, and New Zealand, inflation is expected to remain well below the official central bank target. As in 2013, India and Indonesia are likely to confront relatively high inflation rates, but price pressures have already receded and are expected to remain on a downward path, in part due to the recent tightening of monetary policy.
13. Risks to the outlook have become more balanced, but are still tilted to the downside. While the external environment is uncertain, particularly for emerging markets, Asia is also facing various idiosyncratic risks.
- The main external risk relates to the continued tightening of global liquidity. As growth in the United States improves, global interest rates will rise and Asia will face a further tightening in financial conditions. In addition, unexpected tightening of financial conditions in the U.S. and elsewhere could lead to further bouts of capital flow and asset price volatility. As seen last year and in last January, economies with weaker fundamentals and a greater reliance on global finance and trade are likely to be the most affected. In the case of ASEAN economies, as global conditions tighten, the domestic credit cycle is likely to moderate and borrowing costs go up, which could adversely affect domestic demand as recent growth has been supported by strong credit, which has led to increasing household debt and corporate leverage. Declining asset and house prices, if significant, could create adverse feedback loops, further impacting domestic demand.
- A sharper-than-envisaged slowdown and financial sector vulnerabilities in China could also adversely affect growth in the region; strains have already been seen in the corporate bond market and some trust products. As in recent months, this could spark adverse financial market reaction both in China and globally.
- Less effective Abenomics would mean lower inflation and lower growth in Japan, which would likely spill over into economies that have strong trade and FDI linkages with Japan, such as Korea and Thailand.
- Finally, domestic and global political tensions could cause trade disruptions or weaken growth. Some countries in the region will have elections (India and Indonesia) while, in others, domestic political tensions have affected investment and activity (Thailand and Bangladesh). Strong intra-regional trade integration, which has contributed to greater business cycle synchronization and spillovers over the years, could transmit geopolitically-related disruptions along the regional supply chain.
14. The financial stability heat map suggests relatively moderate risks. Asset prices, for instance, do not appear greatly out of line with fundamentals. Corporate leverage has started to rise, but this rise is modest in comparison to the spike in leverage observed in the mid-1990s or (in magnitude) to the deleveraging that occurred in the 2000s.
15. There are, however, pockets of concern. First, rising leverage could potentially amplify risks, particularly the impact of higher interest rates and slower growth. In addition (as discussed in detail in the forthcoming Asia and Pacific Regional Economic Outlook), the concentration of leverage among weaker firms (such as those with lower profitability, lower liquidity, and higher debt service relative to profits) in India and Indonesia and the potential for greater corporate strains in China are concerns. And elevated housing prices in Hong Kong SAR, the Philippines, and Malaysia, and high credit growth in Malaysia and Singapore as well as in Frontier and Developing Economies such as Mongolia, Lao PDR, and Cambodia warrant special attention.
16. Household debt has increased, but also appears manageable. Credit to households has risen rapidly in Korea, Malaysia and Thailand, and household debt-to-GDP ratios now stand above 60 percent in these countries (as well as in Hong Kong SAR or Singapore). The strength of household balance sheets in these economies is dependent on house price prospects, and across most of Asia, housing valuation ratios do not appear to be out of line with historical levels. But there are important exceptions, including Hong Kong SAR, New Zealand, and the Philippines, as well as certain segments in the largest cities in ASEAN and China.
17. Importantly, banks in the region have continued to strengthen their balance sheets. Tier 1 capital levels have increased across many countries, although they remain below those in other regions, including Latin America. Banks’ profitability has improved as growth has boosted non-interest revenues (with the notable exception of Korean banks). Finally, non-performing loans have been declining across the region, but they tend to be a backward-looking indicator.
18. In light of the risks the region faces, and the pockets of vulnerabilities in corporate and households’ balance sheets, how should policies respond? I now turn to the main policy challenges facing the region. But before doing so, I would like to emphasize that while the region is resilient and policy frameworks are generally sound, the experience of recent months has shown that in the event of large shocks financial imbalances and the associated policy trade-offs can worsen relatively quickly. This puts a premium on transparent policy frameworks and swift actions aimed at bolstering fundamentals (including by tackling vulnerabilities head on). Partly as a result of policy actions taken in the aftermath of the May 2013 tapering episode, Asian markets have weathered the January 2014 spike in global risk aversion well, unlike other EMs that had delayed policy adjustments. However, these efforts need to be maintained.
19. In terms of policy requirements, first, across most of emerging Asia, given the relatively low inflation and the benign near-term inflation outlook, countries appear to have space to maintain the current supportive stance of monetary policy. Over time, a gradual normalization of monetary conditions would be warranted as economic prospects continue to improve and downside risks recede.
20. There are two notable exceptions. In India, given the current level of inflation and its notorious persistence, further increases in the policy rate will likely be needed to put headline inflation on a downward path. Within ASEAN, Bank of Indonesia should be ready to increase policy rates to fend off any potential inflationary pressures. In both countries, if balance of payments pressures re-intensify, a policy tightening would help reduce vulnerabilities and contain the inflationary impact of any exchange rate depreciation.
21. As shown more recently in the case of Thailand, if there were to be an abrupt tightening of global financial conditions, many of the region’s central banks could capitalize on low inflation and their policy credibility to loosen monetary policy and soften the adverse impact of tighter financial conditions on growth.
22. The two largest economies in the region are in significantly different situations. In Japan, re-inflating the economy should remain the main goal of monetary policy. The risk of an incomplete exit from deflation means that monetary policy actions will remain focused on raising inflation expectations. Boosting nominal wage growth remains a key way to achieve this. China, on the other hand, needs to slow the growth of credit, especially in the shadow banking sector. Chinese authorities should also minimize the buildup of risks in the financial sector without causing a steep deceleration in growth, which would call for continued interest rate liberalization and slower M2 growth, even if growth were to miss the official targets by modest margins.
23. Finally, in many of Asia’s Frontier and Developing Economies, particularly Mongolia, Lao PDR, and Cambodia, tightening monetary policy to curb domestic credit growth is key to address domestic imbalances such as overheating, as well as to help reduce external imbalances.
24. Regarding foreign exchange intervention, it is worth noting that over the past year countries have generally pursued flexible exchange rates and used intervention only sparingly in the face of significant capital flow volatility. This strategy should continue, with intervention aimed primarily at smoothing volatility, especially in countries with more than adequate reserves.
25. As I mentioned in previous occasions, macroprudential policies have been used more extensively in Asia than in other regions, both before and after the global financial crisis. This has resulted in a tight stance that has contributed to financial stability. In addition, the current stance across the economies in the region that used macroprudential tools appears broadly justified given the steady growth, continued strong credit growth in many countries, and pockets of elevated asset prices (particularly housing prices). If asset prices were to decline sharply, easing some of the measures that were taken in recent years to curb upward pressures in credit or asset prices should be considered. For instance, in the forthcoming Asia Pacific Regional Economic Outlook we find some of these macroprudential measures, particularly those related to the housing market such as debt-to-income ratios, loan-to-value ratios and housing taxes, appear to have had an effect on credit growth, house price inflation, and leverage. But more broadly, macroprudential tools could continue to be used as a complement to mitigate the effects of volatile capital flows.
26. Regarding fiscal policies, a gradual fiscal consolidation remains appropriate for most countries in Asia, alongside reforms to raise tax revenues and change the composition of spending so as to prioritize infrastructure and social spending. Such actions would rebuild fiscal space, thus enabling fiscal authorities to better cope with future shocks as well as creating the conditions for fiscal policy to be a more effective tool to promote inclusive growth. Indeed, structural fiscal positions are weaker than before the global financial crisis in a number of countries, and public debt is high in Japan, and to a lesser extent Malaysia.
27. As with monetary policy, country circumstances will shape the direction of policies. In Japan, recent fiscal consolidation measures are a welcome step but a concrete medium-term fiscal consolidation strategy is still needed. Central government debt in China is low, but there is a need to reverse the upward trajectory of local government debt, accompanied by reforms of intergovernmental fiscal relations. In ASEAN, Malaysia has embarked on significant fiscal reforms, encompassing, inter alia, the rationalization of subsidies and better targeting of transfers. These reforms are expected to increase resilience and bolster the fiscal framework, and the medium-term adjustment plan—which will also benefit from the introduction of a GST—will lessen Malaysia’s fiscal vulnerabilities. Vietnam should capitalize on its robust near-term growth outlook to address its fiscal deficit, which would in turn allow it to tackle bank and SOE reforms.
28. While adjustments to the macroeconomic policy mix are important, pushing ahead with structural reforms will also be critical to sustain the growth momentum going forward while addressing vulnerabilities and structural impediments. Potential growth in Asia is still higher than in other regions, and for many economies the quality of specialization and the sophistication of industry and exports bode well for medium-term growth. But new reforms are needed as productivity has decelerated in recent years, including in ASEAN as our research has shown.
29. The reform agenda varies considerably across economies in the region. Across most of ASEAN, it should focus on removing structural impediments to growth through regulatory policies and higher infrastructure investment. In China, reforms to liberalize the financial system and raise the cost of capital are key to improving resource allocation, reducing the dependence of the economy on credit, and rebalancing growth away from investment. In Japan, further product and labor market reform remains a priority. In Frontier and Developing Economies reforms should focus on improving the business environment, attracting FDI, and increasing integration with the rest of the Asia Pacific region.
30. Let me conclude by saying that Asia remains resilient and its growth momentum is set to continue. But policy makers in the region should avoid complacency and continue to tackle vulnerabilities, allowing Asia to continue to capitalize on the recovery in the rest of the global economy and to boost medium-term growth. The tightening of global financial conditions and the bouts of financial volatility (which are certain to come) will undeniably bring some of the challenges to the fore, but the region is well positioned to thrive as the necessary policy adjustments are tackled.
Thank you for your attention.