Speech

50th SEACEN Governors’ Conference, Address by Naoyuki Shinohara, Deputy Managing Director, International Monetary Fund

November 20, 2014

Good morning! It is a pleasure to be here today to address my colleagues from Asia. I would like to express my gratitude to the organizers, particularly to Governor Bakani of Bank of Papua New Guinea, and to all who have contributed to the excellent organization of this conference. This 50th gathering of the SEACEN Governors is an important milestone for a region that has seen so much success over the past generation. The IMF is very pleased to be your partner in this ongoing endeavor.

In my intervention this morning, I will first discuss the global and regional economic outlook, highlighting the policy actions needed to shift the global economy to a stronger growth path. For Asia, I will emphasize the need to rebuild buffers and press ahead with structural reforms and infrastructure development. I will then underscore the key role that regional initiatives can play in strengthening resilience.

Global outlook

As discussed in our latest World Economic Outlook, the global recovery in 2014 remains uneven and is proving weaker than expected. Largely due to weaker-than- expected global activity in the first half of 2014, we project that the world economy will grow by only 3.3 percent this year, picking up modestly next year to 3.8 percent. That said, there are significant risks to this scenario that I will address in a moment.

The outlook differs significantly across countries and regions. Among advanced economies, the recovery is expected to be strongest in the United States, where activity has gathered momentum following a weak first quarter. The recovery is anticipated to be modest in Japan—a point I will return to shortly—and weakest in the Euro Area. The European Central Bank is implementing actions to revive credit growth and tackle low inflation, but deflationary pressures persist. Overall, six years after the global financial crisis, we see advanced countries still confronting the legacies of high debt and unemployment.

Emerging market and developing economies will continue to be a major driver of global growth, but their growth is likely to be slower than in the recent past. That is partly because weaker medium-term prospects are affecting today’s investment decisions.

We believe that the downside risks facing the global economy have increased.

Our recent Global Financial Stability Report expressed concern that markets may be under-pricing risk. We also are concerned that markets are not fully internalizing the uncertainties surrounding the macroeconomic outlook and their implications for the pace of withdrawal of U.S. monetary stimulus. The recent increase in financial market volatility is a reminder of these risks and of potential further corrections.

In this context, a faster normalization of U.S. monetary policy could lead to a spike in global interest rates, sharp reversals in capital inflows, declines in local asset prices, increases in long-term interest rates, and elevated asset price volatility. This risk is particularly relevant to emerging economies that have been the recipients of sizable portfolio inflows. This is a topic that I will return to later today at the session on capital flows.

Geopolitical risks also could have adverse effects on the global economy. An escalation of the tensions in Ukraine or the Middle East could disrupt global commodity prices, financial markets and trade. The spread of the Ebola outbreak in Africa, if not promptly and appropriately addressed, is a risk that could undermine growth prospects in that part of the world. So it is crucial that the international community maintain its commitment to contain this pandemic.

At the same time, the impact of the recent decline in oil prices remains uncertain. It is not fully clear whether the trend has been driven by supply or demand shocks. Lower oil prices should provide some relief to consumers, especially if it is sustained.

Looking beyond the near term, there is a risk that global growth will remain disappointing. This could result from mutually reinforcing declines in potential growth and persistently weak aggregate demand, particularly investment. While this risk is mostly prevalent for advanced economies, emerging economies have also experienced a decline in potential growth.

Actions are needed on two fronts: continued support to domestic demand, and the implementation of reforms that can boost supply. In advanced economies, raising growth will require continued support from monetary policy, and, where feasible, fiscal policy. Emerging markets have to address underlying structural problems by carrying out overdue structural reforms. They also need to prepare for U.S. monetary policy normalization and shifts in financial market sentiment.

Asia’s Outlook

Let me now turn to the outlook for the Asia Pacific region. Although first-half growth was disappointing, the economic outlook for the region remains solid. GDP growth is projected at 5.5 percent in 2014, inching up to 5.6 percent in 2015.

The region is expected to benefit from the ongoing, although modest, global recovery. This will help sustain Asia’s exports, while relatively low interest rates, strong credit growth, and high asset prices will continue to support domestic demand.

In China, GDP growth in 2014 should remain at around 7.4 percent, and is expected to moderate further to 7.1 percent in 2015. This forecast assumes continued efforts to rein in vulnerabilities and the steady implementation of reforms.

Japan’s growth is projected to slow to 0.9 percent in 2014, and remain broadly stable in 2015. However, some uncertainty surrounds this projection, as domestic demand remains sluggish.

In India, GDP growth is forecast to rise to 5.6 percent in 2014, accelerating in 2015 despite headwinds from fiscal consolidation and a tighter monetary stance. Meanwhile, Korea, Australia, and New Zealand are set to continue growing at a relatively solid pace, while Indonesia and Thailand will slow down in 2014. That will be followed by a rebound in 2015 as the global economy recovers and domestic policy uncertainty subsides. Stronger trade, remittances, and tourism revenue should benefit frontier both and developing economies.

Asia’s Policy Challenges

However, downside risks are significant and important medium-term challenges remain for Asia.

As I have already discussed, a disorderly reaction to the normalization of U.S. monetary policy remains an important risk—as we saw last year. Geopolitical tensions could also disrupt trade and capital flows, although Asia is less exposed to tensions in Eastern Europe and the Middle East.

In the near term, the region could also be adversely affected by a sharper growth slowdown in China, where the ongoing correction in the real estate sector could have an impact on real and financial activity. Financial sector links would amplify the impact of this correction, given the direct exposure of banks and shadow banks to real estate through credit to developers and household mortgages. There is also an indirect linkage through the use of real estate as collateral for other loans. More broadly, declines in house prices elsewhere in the region could also adversely affect activity and private consumption.

In Japan, delays in implementing structural reforms could lead to slower potential growth, leading, in turn, to an adverse impact on regional trade and growth prospects.

There are also growing medium-term risks. For the region as a whole, potential growth has already declined and could weaken further, particularly if reform implementation is delayed and the investment outlook remains subdued.

Against this background of risks, Asian economies need to rebuild buffers, move ahead with the structural reform agenda, and give emphasis to infrastructure development.

Further strengthening fundamentals and rebuilding policy space will help Asia weather future turbulence in global markets. The benefits are clear: when U.S. long-term rates rose last year, the economies that retained investor confidence were those with stronger fundamentals and those that took steps to lower inflation and reduce external imbalances.

Assuming that the global recovery firms up, regional policymakers need to pursue gradual fiscal consolidation. This is particularly important for economies where deficits and debt are large and/or where output is close to, or above, potential. They need stronger and faster fiscal consolidation.

Many economies in the region should also start, or continue, a gradual tightening of monetary conditions. But the recalibration of monetary policy should continue to depend on inflation and growth developments.

Growth-Enhancing Reforms

The structural reform agenda varies across the region. China needs to hold to its comprehensive blueprint to rebalance the economy and achieve sustainable growth. Many other emerging and frontier economies should prioritize reforms to boost productivity, including addressing long-standing supply-side bottlenecks. They also need to improve the efficiency of tax and public spending.

For Japan, there is has been progress with the structural reform element of Abenomics, but more needs to be done. In both Japan and Korea, the priority is to tackle inefficient services and address the distinction between secure permanent workers and vulnerable temporary workers.

Infrastructure development also can boost short-term demand and potential growth. As shown in our latest World Economic Outlook, the stock of infrastructure capital as a share of output has fallen considerably over the past thirty years across most economies. In emerging markets and low-income countries, infrastructure provision per capita remains a fraction of the advanced economies.

Where slack exists in economies and monetary policies are accommodative, the boost to aggregate demand from infrastructure can be bigger. Where countries have fiscal space, there is evidence that higher public investment financed by debt can have larger output effects than budget-neutral investments. But if the efficiency of public investment is constrained, the long-term gains from higher investment will be weaker.

All of this is germane to Asia’s development—as highlighted by APEC’s recent decision to make infrastructure a priority on its agenda.

Regional Integration

The domestic policy actions I have described can mitigate spillovers from global financial volatility. But one key question today’s seminar will seek to address is whether regional initiatives also matter. For instance, would greater financial development and integration mitigate increase cross-border transmission of shocks? Does the answer depend on whether these shocks originate from Asia or from the rest of the world?

In recent decades, trade integration within Asia has increased more than in other regions. In valued-added terms, intraregional trade grew on average by over 10 percent a year from 1990 to 2012, twice the pace seen outside of Asia. Meanwhile, financial integration has started to catch up, although it still lags trade integration.

The long-term gains are clear. Trade integration has unleashed major productivity gains across Asia, particularly through the build-up of regional supply-chain linkages. Further trade liberalization, particularly in services—and as part of the ASEAN Economic Community—could provide a further boost to productivity. Greater financial integration also holds the promise of higher productivity and living standards, not least by improving the allocation of saving and investment across the region.

But increasing trade and financial integration has strengthened the propagation of growth shocks. Business cycles in Asia have become more synchronized over the past two decades, with the correlation between ASEAN growth rates almost reaching the very high levels seen in the Euro Area.

The IMF’s April 2014 Regional Economic Outlook for Asia and the Pacific found that the trend increase in trade between Asian economies over the past 20 years has accounted for around one-quarter of the increase in business cycle synchronization. One driver that is likely to increase more in the future is the growth of final demand from China. Asian economies depending on China have generally experienced a greater increase in their co-movement with China over the past decade.

This suggests that some countries would be more affected by growth shocks originating from China. Based on our empirical results, a one percentage point decline in China’s growth lowers GDP growth in the median Asian economy by about 0.3 percentage point after a year. That is double the rate for the median non-Asian economy.

Financial integration has been a more ambivalent force. It has magnified the impact on business cycle synchronization of large global shocks like the global financial crisis. But in normal times, it has lowered synchronization somewhat, possibly by facilitating international reallocation of capital. However, this has been less of a factor in Asia, where cross-border financial claims and flows so far have been small.

Conclusion

Given the room for further regional trade liberalization and financial integration, future spillovers are likely to rise, particularly during crises. The main challenge for policymakers then will be to reap the major gains from increasing integration while minimizing the side effects from greater spillovers. International policy cooperation can play a role here.

Self-insurance through further reserve accumulation can help individual countries cushion the blow from such shocks. But this approach is costly and does not provide risk sharing between countries. This points to the potential stabilizing role provided by regional financial safety nets such as the enhanced Chiang Mai Initiative or bilateral swap lines between the region’s central banks. These initiatives can usefully complement swap lines with central banks outside the region and the global financial safety net provided by the IMF.

I am very interested to hear how this conference addresses these issues over the next two days. I trust this exchange of views will prove useful for all of us.

Thank you very much.