## apd-reo-full-report ## Source details **Canonical URL:** [apd-reo-full-report](https://www.imf.org/-/media/files/publications/reo/apd/2018/apd-reo-full-report.pdf) ## Other formats - [Markdown version](/-/media/files/publications/reo/apd/2018/apd-reo-full-report.pdf.md) - [Structured JSON version](/-/media/files/publications/reo/apd/2018/apd-reo-full-report.pdf.json) --- ### Executive summary — global context and near-term outlook - Global output grew by 3.8 percent in 2017. - World trade volume growth rose to 5 percent in 2017 from 2.3 percent in 2016. - Headline inflation in advanced economies increased from 0.8 percent in 2016 to 1.7 percent in 2017; inflation in emerging market and developing economies declined from 4.3 to 4.1 percent. - April 2018 WEO near-term global outlook: growth of 3.9 percent in both 2018 and 2019; medium-term global growth expected to slow to 3.7 percent. - Recent developments increasing near-term momentum: US tax reform and budget providing front-loaded stimulus to the United States and the global economy. - Financial conditions: broadly accommodative despite episodes of market volatility; emerging markets generally continued to experience large capital inflows and very low borrowing spreads. ### Regional developments and outlook for Asia and the Pacific - Asia grew by 5.7 percent in 2017, up 0.3 of a percentage point from the year before, contributing more than 60 percent of global growth (three-quarters of which comes from China and India). - Growth in Asia forecast at 5.6 percent in 2018 and 2019. - Selected country projections and developments: - China’s growth projected to ease to 6.6 percent. - Japan’s growth expected to remain strong in 2018 at 1.2 percent. - India’s growth expected to rebound to 7.4 percent following temporary disruptions. - Drivers supporting Asia’s near-term outlook: strong and broad-based global growth and trade, reinforcement from US fiscal stimulus, and accommodative financial conditions supporting domestic demand. - Regional projections and aggregates: - Regional growth forecast at 5.6 percent in both 2018 and 2019—up by about 0.1 of a percentage point from October 2017 projections. - Emerging Asia projected to grow by about 6½ percent in both 2018 and 2019. - Regional current account balances expected to decline further to about 1¾ percent of GDP in 2018–19. - Inflation projected: about 1½ percent on average in advanced economies and about 3¼ percent on average in emerging markets. ### Risks to the outlook - Overall assessment: risks broadly balanced in the near term but tilted to the downside over the medium term. - Upside scenarios: - Global recovery could be stronger than expected. - CPTPP and successful implementation of the Belt and Road Initiative—assuming debt sustainability and project quality are maintained—could support trade, investment, and growth. - Downside scenarios: - A sudden and sharp tightening of global financial conditions. - Excessive risk taking and migration of financial risks toward nonbanks could exacerbate vulnerabilities. - A shift toward protectionist, inward-looking policies could disrupt international trade and financial markets. - Geopolitical tensions, cybersecurity breaches and cyberattacks, climate change, and natural disasters. - Additional risk notes: - US fiscal stimulus heightens medium-term risks by contributing to an increase in US debt and a temporary buildup of global imbalances. - Continued easy financial conditions risk a buildup of financial vulnerabilities. ### Inflation dynamics and Chapter 2 findings: low inflation in Asia - Temporary global factors, including imported inflation, have been key drivers of low inflation in Asia. - Headline inflation picked up with an upturn in oil prices; core inflation remained subdued and below target in many economies. - Inflation expectations generally well anchored to targets, but the influence of expectations in driving inflation has declined; the inflation process has become more backward looking. - Evidence suggests the sensitivity of inflation to economic slack has diminished—the Phillips curve has flattened. - Implications: - Inflation in Asia may increase if global factors (including US inflation and commodity prices) become less favorable. - A flatter Phillips curve implies a higher output cost of disinflating. - Policymakers should be vigilant and stand ready to act; responses to commodity price shocks should accommodate first-round effects but guard against second-round effects. - Improved monetary policy frameworks and central bank communications could increase the role of expectations and make inflation less sticky. - More flexible exchange rates could mitigate imported inflation; macroprudential policies can help address financial stability risks. ### Financial conditions, capital flows, credit growth, and housing - Overall regional current account surplus narrowed to 2.1 percent of GDP, down by ½ percent from 2016. - Financial conditions remained favorable despite equity market declines in early 2018; US Federal Reserve’s gradual policy normalization impact largely offset by strengthening in risk appetite. - Portfolio flows: net portfolio inflows resumed in the first half of 2017 and continued through the second half at a slower pace. - Currencies: with the US dollar weakening, most Asian currencies continued to appreciate during 2017 and into 2018. - Credit growth: remained strong, with a further buildup of corporate leverage and household debt; strong credit growth contributed to a rally in house prices in some economies. - Macroprudential measures: several economies—including Australia, Hong Kong SAR, Korea, and Singapore—used macroprudential measures to limit housing market risks; house prices have begun to show some signs of stabilization. ### Selected country developments and statistics (preserved figures) - China: - GDP growth accelerated to 6.9 percent in 2017. - Core inflation rose steadily to above 2¼ percent. - Japan: - GDP growth picked up to 1.7 percent in 2017, from 0.9 percent in 2016. - Real effective exchange rate depreciated by 5 percent in 2017; current account surplus rose slightly to 4 percent of GDP. - India: - Growth rebounded to 7.2 percent in the third quarter of FY2017/18, up from 6.1 percent in the first half of the fiscal year. - CPI inflation in FY2017/18 is estimated at 3.6 percent. - Korea: - Current account surplus narrowed to 5.1 percent of GDP in 2017, down from 7 percent in 2016. - Hong Kong SAR: - Growth estimated at about 3.8 percent in 2017; current account surplus estimated at 3 percent of GDP; house prices rose by over 25 percent between March 2016 and December 2017. - ASEAN highlights: - Indonesia: growth 5.1 percent in 2017; gross international reserves reached eight months of imports in December 2017. - Thailand: current account surplus at 10.8 percent of GDP in 2017; international reserves $239 billion as of December 2017. - Singapore: growth 3.6 percent in 2017; headline inflation averaging 0.6 percent in 2017; core inflation rose to 1.5 percent. - Malaysia: growth 5.9 percent in 2017; headline inflation averaged 3.8 percent for the year after peaking at 4.9 percent in March 2017. - Philippines: growth 6.7 percent in 2017; inflation 3.2 percent; current account deficit 0.4 percent of GDP in 2017. - Vietnam: growth 6.8 percent in 2017. - Cambodia: growth 6.9 percent in 2017; inflation nearly 3 percent. - Lao P.D.R.: growth 6.8 percent in 2017. - Myanmar: growth dropped to 5.9 percent in 2016/2017; inflation dropped to 6.8 percent. - Brunei Darussalam: growth recovered to 0.5 percent in 2017. - Other economies: - Bangladesh: growth rose above 7 percent in 2017. - Nepal: growth accelerated to 7.5 percent in 2017; inflation fell to 4.5 percent. - Mongolia: GDP growth 5.1 percent in 2017. - Sri Lanka: growth estimated to have fallen to 3.1 percent in 2017. - Pacific island economies: regional growth about 2.6 percent in 2017; Fiji growth jumped to 3.8 percent. ### Regional outlook highlights (selected country forecasts) - Japan: average headline inflation projected at 1.1 percent in 2018; core inflation expected at 0.5 percent. - India: growth projected at 6.7 percent in FY2017/18 and expected to recover to 7.4 percent in FY2018/19; CPI medium-term forecast to remain within the Reserve Bank of India’s band (4 percent ±2 percent). - Korea: growth expected about 3 percent in 2018 and 2019; consumer price inflation stable at about 2 percent; current account surplus about 5 percent. - Australia: recovery expected to accelerate; inflation forecast to return to midpoint of target range within next three years. - Hong Kong SAR: growth expected about 3.6 percent in 2018; CPI inflation projected to increase to 2.2 percent for 2018. - Indonesia: growth projected to increase to 5.3 percent in 2018 and 5.5 percent in 2019; inflation projected near center of target band (3.5 ±1 percent); current account deficit projected 1.9 percent of GDP in 2018. - Singapore: growth projected 2.9 percent in 2018, easing to 2.7 percent in 2019; headline inflation expected to rise to 1.2 percent in 2018. - Malaysia: GDP growth projected 5.3 percent in 2018; medium-term potential about 5 percent with inflation about 2.5 percent. - Philippines: growth projected at 6¾ percent in 2018–19 and about 7 percent over the medium term; current account deficit projected to widen to 0.5 percent of GDP in 2018. - Vietnam: growth expected to continue at 6½ percent in the near and medium term; inflation in range of 4 percent. - Myanmar: growth expected to pick up toward estimated potential of 7 to 7.5 percent over the medium term. - Cambodia: medium-term growth projected to slow to about 6 percent. - Lao P.D.R.: growth expected about 7 percent in near and medium term. - Brunei Darussalam: growth expected to pick up to 1 percent in 2018. ### Rapid credit growth in frontier and developing Asian economies (Box 1.1) - Scope: FDEs defined as Bangladesh, Bhutan, Cambodia, Lao P.D.R., Mongolia, Myanmar, Nepal, Sri Lanka, and Vietnam. - Observation: Cambodia, Lao P.D.R., Myanmar, Nepal, Sri Lanka, and Vietnam have seen double-digit growth in credit to the private sector for several years; Mongolia experienced a credit boom a few years ago. - Historical metrics (2011–16): - During 2011–16, 9 out of 11 credit boom episodes in Asia were in FDEs. - Five out of nine Asian FDEs experienced credit booms during this period. - Among those with a credit boom: - annual real credit growth averaged nearly 23 percent, - median credit-to-GDP ratio rose from about 35 to 56 percent, - credit gaps averaged about 5 percent of GDP (ranged up to 17 percent of GDP). - Policy responses: - Strengthen bank and nonbank supervision and regulation; develop macroprudential indicators and tools; ensure effective crisis management and resolution frameworks. - Tailored macroprudential policies for real estate concentration; possible fiscal measures include taxes on land or housing not used as primary residences. ### Spillovers to Asia from the US Tax Cuts and Jobs Act (Box 1.2) - Key TCJA corporate tax changes: - US statutory rate cut from 35 percent to 21 percent; some activities at 13.125 percent. - Capital expensing: full deduction in first year for next five years; gradual reduction thereafter. - Territorial taxation and deemed repatriation: previously unrepatriated profits estimated at some $2.6 trillion now deemed repatriated and subject to tax with payments spread over eight years. - BEAT: a firm’s tax liability can fall no lower than 10 percent of its income (excluding certain payments to foreign-affiliated corporations). - GILTI: foreign affiliate returns above 10 percent on tangible assets taxed at 10.5 percent with 80 percent foreign tax credit; if average foreign tax rate ≥ 13.125 percent, no GILTI owed. - FDII: reduced tax rate of 13.125 percent on export income from intangible assets. - Model simulation (APDMOD of IMF’s FSGM): - US cuts corporate taxes starting in 2018: - Real GDP expansion from 2018 to 2021, average 0.3 of a percentage point higher a year. - Real GDP growth lower by about 0.1 of a percentage point thereafter until provisions expire. - Real imports peak 6 percent higher than baseline by 2020. - US current account deficit widens by –0.9 of a percentage point of GDP by 2021 vs. baseline. - Asia spillovers: - Most spillover effects < 0.2 of a percent of GDP at their peak in 2020. - Asia current account surplus widens by over 0.2 of a percentage point of GDP vs. baseline, led by China, Japan, and Korea. - Channels of spillovers: higher US demand for imports; REER and intra-Asia exchange rate adjustments; movement in commodity prices. ### Digital revolution in Asia (Box 1.3) — scope, evidence, and policy priorities - Drivers: advances in artificial intelligence, robotics, computing power, cryptography, big data, 3-D printing, the Internet, and lower data storage costs; potential future drivers include quantum computing and the “Internet of everything.” - Asia’s indicators: - About two-thirds of the world’s industrial robots are used in Asia. - China a 30 percent share of total robot supply in 2016; Korea 14 percent; Japan 13 percent; United States 11 percent. - Korea leads in robot density (industrial robots per 10,000 workers), followed by Japan and Germany. - E-commerce: China’s share grew from less than 1 percent of worldwide transactions about a decade ago to more than 40 percent. - Mobile payments expanding sharply in Bangladesh, India, and the Philippines; on average Asia lagging sub-Saharan Africa in mobile payments adoption. - Risks: automation and 3-D printing may reduce competitiveness of low-skilled labor; potential reshoring of production; labor market transitions. - Policy priorities: - Revamp education to develop digital-era skills. - Invest in physical and regulatory infrastructure that spurs competition and innovation. - Reform trade (especially in services) and investment policies to facilitate digital trade and investment. - Address labor market and social challenges from automation. - Regional and international cooperation; IMF support for policy development. ### Chapter 2 empirical findings and policy implications (inflation process and Phillips curve) - Empirical findings: - Recent low inflation driven mainly by temporary forces, including imported inflation; import prices contributed to about half of undershooting in advanced Asia and most of the undershooting in emerging Asia. - China played an important role in driving both global and regional inflation. - Inflation process more backward-looking since the global financial crisis; role of expectations in driving inflation declined while past inflation plays a larger role. - Sensitivity of inflation to unemployment gap has declined (flattening of the Phillips curve), especially in Asian emerging markets and advanced Asia relative to the 1990s. - Quantitative decomposition (preserved phrasing): - Imported inflation has been the most important driver of inflation deviations from targets in recent years. - Since 2013, import prices accounted for about half of the undershooting in advanced economies; in emerging markets undershooting since 2014 is mainly accounted for by import prices. - Inflation expectations accounted for 35 percent of undershooting in advanced Asia and 40 percent in emerging Asia in the first two quarters of 2017. - Mechanisms for Phillips-curve flattening: - Advanced Asia: statistically significant link between flattening and automation (regression: ŷ_t = –1.865*** + Pinv × 3.173***; R^2 = 0.647). - Emerging Asia: statistically significant link between flattening and GVC integration (regression: ŷ_t = 1.077*** + Foreign VA × (–0.0267***); R^2 = 0.66). - Trend vs transitory inflation: - Latent-factor and unobserved-components analyses find a substantial role for global factors and a large transitory disinflationary component since 2014. - Trend inflation declined substantially over the 1990s and again, mildly, after 2011. - Transitory component predominantly negative for most economies since 2014; positive transitory shocks could lift inflation quickly. - Policy implications (preserved recommendations): - Central banks should be vigilant about imported inflation and stand ready to act; sudden increases may persist and disinflation costs could be high given a flatter Phillips curve. - Strengthen monetary policy frameworks and central bank communications to increase the role of expectations and keep expectations anchored. - Allow greater exchange rate flexibility to insulate domestic inflation from imported inflation. - For commodity price shocks: accommodate first-round CPI effects but prevent second-round effects; in economies with limited central bank credibility and high commodity weight in CPI, be prepared for more aggressive responses when excess demand pressures are high. ### China specifics: CPI–PPI disconnect and drivers - In 2017 Chinese PPI rebounded since November 2016 and remained above 5 percent while CPI stayed contained. - Drivers of PPI rebound: - Investment demand: government support for real estate and infrastructure coincided with co-movement between investment prices and PPI for raw materials and intermediate goods. - Spike in foreign demand since late 2016: China’s real exports surged and prices rose; intermediate manufacturing goods co-move strongly with overall goods export prices. - Imports: surging imports of raw materials further supported PPI inflation. - Supply-side adjustments (steel and coal campaigns) magnified the rebound but did not play a lead role; steel production increased overall, coal production declined in 2016 then rose in 2017 until a later crackdown. - Outlook: less favorable domestic investment outlook and easing of supply constraints should gradually unwind producer price pressures. ### Japan: long-term low inflation and policy experience (Box 2.2) - Annual CPI inflation averaged 0.2 percent between 1993 and 2017; GDP deflator contracted by an average of 0.3 percent a year over same period. - Drivers of prolonged low inflation: collapse of asset price bubble, deleveraging, banking crises, weakened labor bargaining power, aging. - Policy history: - Zero interest rate policy in 1999; QE in 2001; partial exit and policy tightening in 2006 (premature). - Abenomics (2013): 2 percent target, large JGB purchases, flexible fiscal policy, structural reforms; CPI rose to 1.6 percent in 2013 but subsequently fell due to shocks. - BOJ innovations: negative interest rate on excess reserves (early 2016); yield curve control (September 2016) to shape the entire yield curve. - Current indicators: eight consecutive quarters above potential growth; unemployment at lowest since 1993; CPI headline inflation 1.1 percent in March 2018; core inflation remains stubbornly low. - Policy implication: use favorable conditions to implement comprehensive policy package—labor market reforms and coordinated income/demand policies—to unwind the deflation mindset. ### Model and methodological annexes (selected) - New Keynesian Phillips curve specification (Annex 2.1): - π_t = a_t π_{t+10}^e + (1 − a_t) π̂_{t−1} + β_t u_{t}^c + γ_t π_{t}^m + ε_t (A2.1.1) - Coefficients α_t, β_t, γ_t estimated with time variation via constrained nonlinear Kalman filter for 44 economies (1990:Q1–2017:Q2). - Latent-factor model for global inflation (Annex 2.2): - π_t − π̄_t = β f_t + e_t (A2.2.2) applied to 136 economies (Q1 2001–Q3 2017); three global factors explain 56 percent of full-panel variance (Factor 1: 33 percent; Factor 2: 15 percent; Factor 3: 8 percent). - Trend–transitory decomposition (Annex 2.3): - π_t = π_t^* + c_t with identification assumptions (A2.3.1–A2.3.3); trend estimated via unobserved-components and stochastic volatility model using long-horizon survey expectations. ### Policy recommendations and priorities (macro and structural) - Macroeconomic policy stance: - With output gaps closing in much of the region, continued fiscal support is less needed; fiscal policies should focus on ensuring sustainability and strengthening buffers. - Given still moderate wage and price pressures, monetary policies can remain accommodative in most Asian economies for now, but central banks should be prepared to adjust as inflation picks up. - Use macroprudential policies appropriately to contain credit growth and address financial stability risks. - Structural and fiscal reforms: - Push ahead with structural reforms to address productivity, population aging, and narrowing gender gaps in labor force participation. - Improve revenue mobilization where needed to create space for infrastructure and social spending and support structural reforms. - Tailored measures to boost productivity and investment, address climate change, and support workers affected by technological and trade shifts. - Digital economy: - Asia needs a comprehensive and integrated policy response covering information and communication technology, infrastructure, trade, labor markets, and education to reap digitalization benefits. - Specific country guidance (selected): - China, India, Indonesia, and others: aim for growth-friendly consolidation. - Japan: avoid premature reduction in fiscal support; create a credible framework for medium- and long-term consolidation. - Australia and Singapore: more supportive near-term fiscal stance appropriate. - Korea: a substantial expansion appropriate as part of rebalancing. - Macroprudential and financial policy: - Continue developing and broadening macroprudential toolkits. - Tighten macroprudential requirements where currency mismatches and rapid credit growth present risks. - Use capital flow management measures carefully and generally allow flexible exchange rates to buffer external shocks. *International Monetary Fund | April 2018* ### Executive Summary ix ### Executive Summary ### Global context and near-term outlook - Global output is estimated to have grown by 3.8 percent in 2017. - World trade volume growth rose to 5 percent in 2017 from 2.3 percent in 2016. - Headline inflation in advanced economies increased from 0.8 percent in 2016 to 1.7 percent in 2017; inflation in emerging market and developing economies declined from 4.3 to 4.1 percent. - The near-term global outlook (April 2018 WEO) projects growth of 3.9 percent in both 2018 and 2019; over the medium term global growth is expected to slow to 3.7 percent. - Recent developments increasing near-term momentum include the US tax reform and budget, providing front-loaded stimulus to the United States and the global economy. - Financial conditions remain broadly accommodative despite episodes of market volatility; emerging markets generally continued to experience large capital inflows and very low borrowing spreads. ### Regional developments and outlook for Asia and the Pacific - Asia grew by 5.7 percent in 2017, up 0.3 of a percentage point from the year before, contributing more than 60 percent of global growth (three-quarters of which comes from China and India). - Growth in Asia is forecast at 5.6 percent in 2018 and 2019. - Country and subregion projections and developments highlighted: - China’s growth is projected to ease to 6.6 percent. - Japan’s growth is expected to remain strong in 2018 at 1.2 percent, after being above potential for eight consecutive quarters. - India’s growth is expected to rebound to 7.4 percent following temporary disruptions related to the currency exchange initiative and the rollout of the Goods and Services Tax. - Drivers supporting Asia’s near-term outlook: strong and broad-based global growth and trade, reinforcement from US fiscal stimulus, and accommodative financial conditions supporting domestic demand. ### Risks to the outlook - Risks are broadly balanced in the near term but tilted to the downside over the medium term. - Upside scenarios: - Global recovery could prove stronger than expected. - Over time, the CPTPP and successful implementation of the Belt and Road Initiative—assuming debt sustainability and project quality are maintained—could support trade, investment, and growth. - Downside scenarios: - A sudden and sharp tightening of global financial conditions. - Excessive risk taking and migration of financial risks toward nonbanks could exacerbate vulnerabilities. - A shift toward protectionist, inward-looking policies could disrupt international trade and financial markets. - Geopolitical tensions, cybersecurity breaches and cyberattacks, climate change, and natural disasters. - The US fiscal stimulus heightens medium-term risks by contributing to an increase in US debt and a temporary buildup of global imbalances. - Continued easy financial conditions also pose medium-term risks through potential buildup of financial vulnerabilities. ### Inflation dynamics and Chapter 2 findings: Low inflation in Asia - Temporary global factors, including imported inflation, have been key drivers of low inflation in Asia. - Headline inflation in the region has picked up with an upturn in oil prices, while core inflation has remained subdued and below target in many economies. - Inflation expectations are generally well anchored to targets, but the influence of expectations in driving inflation has declined; the inflation process has become more backward looking. - Evidence suggests the sensitivity of inflation to economic slack has diminished—the Phillips curve has flattened. - Implications: - Inflation in the Asia and Pacific region may increase if global factors (including US inflation and commodity prices) become less favorable. - A flatter Phillips curve implies a higher output cost of disinflating. - Policymakers should be vigilant and stand ready to act; responses to commodity price shocks should accommodate first-round effects but guard against second-round effects. - Improved monetary policy frameworks and central bank communications could increase the role of expectations and make inflation less sticky. - More flexible exchange rates could mitigate imported inflation; macroprudential policies can help address financial stability risks. ### Longer-term growth prospects and structural challenges - Key long-term headwinds: population aging, slowing productivity growth, and the rise of the digital economy. - Population aging raises the risk that many economies may “grow old before they grow rich,” with substantial adverse effects on growth and fiscal positions. - The global economy’s increasing digitalization presents transformative opportunities and challenges, including those related to the future of work. - Asia is embracing the digital revolution with significant heterogeneity across the region. ### Policy recommendations and priorities - Macroeconomic policy stance: - With output gaps closing in much of the region, continued fiscal support is less needed; fiscal policies should focus on ensuring sustainability and strengthening buffers. - Given still moderate wage and price pressures, monetary policies can remain accommodative in most Asian economies for now, but central banks should be prepared to adjust stances as inflation picks up. - Use macroprudential policies appropriately to contain credit growth and address financial stability risks. - Structural and fiscal reforms: - Policymakers should push ahead with structural reforms to address medium- and long-term challenges, including productivity, population aging, and narrowing gender gaps in labor force participation. - Some economies need to improve revenue mobilization to create space for infrastructure and social spending and to support structural reforms. - Tailored measures are needed to boost productivity and investment, address climate change, and support workers affected by technological and trade shifts. - Digital economy: - To reap the full benefits of digitalization, Asia needs a comprehensive and integrated policy response covering information and communication technology, infrastructure, trade, labor markets, and education. *International Monetary Fund | April 2018* ### 1.7 and 1.8). ### 1. GOOD TIMEs, UNCERTAIN TIMEs: A TIME TO PREPARE ### Current Account Balances and Inflation - Overall regional current account surplus narrowed to 2.1 percent of GDP, down by ½ percent from 2016. - Many Asian emerging market and developing economies continued to run moderate current account deficits driven by ongoing capital investments; large surplus economies, including China and Korea, saw reduced surpluses due to rising domestic demand and a pickup in oil prices. - Inflation: - Headline inflation rose slightly in 2017 because of oil prices, while core inflation remained low and wage pressures were muted (see Table 1.2). - Chapter 2 suggests the decline in commodity prices since 2013 was a major driver of low inflation, expectations have become more backward-looking, and the Phillips curve may have flattened—possibly due to increasing automation and integration with global value chains, reduced labor bargaining power, technological progress, and the decline in capital costs (Figure 1.10). - In China: despite a strong pickup in the producer price index (PPI), headline CPI inflation remained contained, while core inflation rose steadily to above 2¼ percent. ### Financial Conditions, Capital Flows, and Exchange Rates - Overall financial conditions remained favorable despite equity market declines in early 2018: - US Federal Reserve’s gradual policy normalization impact largely offset by a further strengthening in risk appetite. - Stock markets rose sharply through the end of January 2018 and, despite weakening thereafter, remain up over the past year. - Sovereign bond yields generally declined, supported by continued capital flows into the region (Figures 1.11 and 1.12). - Portfolio flows: - After some outflows in late 2016, net portfolio inflows resumed in the first half of 2017 and continued through the second half of the year, albeit at a slower pace (Figures 1.13 and 1.14). - Currencies: - With the US dollar weakening, most Asian currencies continued to appreciate during 2017 and into 2018. ### Credit Growth, Housing Markets, and Macroprudential Measures - Credit growth remained strong, resulting in a further buildup of corporate leverage and household debt from already high levels (Figure 1.15 and Box 1.1). - Strong credit growth contributed to a further rally in house prices in some economies (Figures 1.16 and 1.17). - Several economies—including Australia, Hong Kong SAR, Korea, and Singapore—used macroprudential measures to limit risks in housing markets; house prices have begun to show some signs of stabilization in recent months. ### Developments in Major Economies (selected) - China: - GDP growth accelerated to 6.9 percent in 2017. - Consumption accounted for less than 60 percent of total GDP growth and slowed despite a still tight labor market. - Investment slowed on cooling private real estate investment but was offset by robust public infrastructure and the first acceleration in manufacturing investment in five years. - Service sector remained the key driver, especially information technology. - Core inflation rose steadily to above 2¼ percent. - Japan: - GDP growth picked up to 1.7 percent in 2017, from 0.9 percent in 2016. - Exports increased strongly; headline inflation picked up in H2 2017 owing to higher global energy and commodity prices. - Underlying inflation (excluding fresh food and energy) remains subdued. - Real effective exchange rate depreciated by 5 percent in 2017; current account surplus rose slightly to 4 percent of GDP. - India: - Growth rebounded to 7.2 percent in the third quarter of FY2017/18, up from 6.1 percent in the first half of the fiscal year. - CPI inflation in FY2017/18 is estimated at 3.6 percent, close to the midpoint of the target band (4 percent ±2 percent). - Korea: - Growth picked up in 2017, supported by buoyant investment; output gap remains negative. - Core inflation remained below 2 percent. - Current account surplus narrowed to 5.1 percent of GDP in 2017, down from 7 percent in 2016. - Australia and New Zealand: - Australia: recovery advanced further in 2017; inflation increased to 2 percent in 2017 but remains slightly below the target range of 2–3 percent; housing market cooling in eastern capitals. - New Zealand: continued solid expansion driven by record net migration, accommodative monetary policy, improving services exports, and strong terms of trade. - Hong Kong SAR: - Growth estimated at about 3.8 percent in 2017, driven mostly by private consumption. - Current account surplus estimated at 3 percent of GDP. - House prices rose by over 25 percent between March 2016 and December 2017. - ASEAN highlights: - Indonesia: growth picked up slightly to 5.1 percent in 2017; headline inflation remained below 4 percent; core inflation about 3 percent; gross international reserves reached eight months of imports in December 2017. - Thailand: large current account surplus at 10.8 percent of GDP in 2017; international reserves stood at $239 billion as of December 2017, up nearly $42 billion from end-2016. - Singapore: growth estimated at 3.6 percent in 2017; headline inflation averaging 0.6 percent in 2017; core inflation rose to 1.5 percent in 2017. - Malaysia: economy grew by 5.9 percent in 2017; headline inflation averaged 3.8 percent for the year after peaking at 4.9 percent in March 2017. - Philippines: growth reached 6.7 percent in 2017; inflation picked up to 3.2 percent (within the 2–4 percent target band); current account recorded a small deficit of 0.4 percent of GDP in 2017. - Vietnam: growth reached 6.8 percent in 2017. - Cambodia: growth estimated at 6.9 percent in 2017; inflation picked up to nearly 3 percent. - Lao P.D.R.: growth strong at 6.8 percent but faces significant macro-financial imbalances. - Myanmar: growth dropped to 5.9 percent in 2016/2017; inflation dropped to 6.8 percent. - Brunei Darussalam: growth recovered to 0.5 percent in 2017. - Other economies and frontier markets: - Bangladesh: growth rose above 7 percent in 2017. - Nepal: growth accelerated to 7.5 percent in 2017; inflation fell to 4.5 percent. - Mongolia: GDP growth at 5.1 percent in 2017. - Sri Lanka: growth estimated to have fallen to 3.1 percent in 2017. - Pacific island economies: regional growth about 2.6 percent in 2017; Fiji growth jumped to 3.8 percent; Papua New Guinea and Timor-Leste growth remained relatively subdued. ### Regional Outlook and Projections - Asia’s regional growth forecast: - Growth for the region overall is forecast at 5.6 percent in both 2018 and 2019—up by about 0.1 of a percentage point from projections in October 2017. - Emerging Asia is projected to grow by about 6½ percent in both 2018 and 2019 (Table 1.1). - Current account projections: - Regional current account balances expected to decline further to about 1¾ percent of GDP in 2018–19 (Figure 1.9). - Inflation projections: - Inflation projected to be subdued: about 1½ percent on average in advanced economies and about 3¼ percent on average in emerging markets (Table 1.2). - Drivers of the favorable near-term outlook: - Strong global growth supporting Asia’s exports and investment. - Still accommodative policies and financial conditions underpinning domestic demand. - US tax reform and budget expected to boost investment and growth in the United States in the short term—with spillovers to Asia (Box 1.2). *Source: Regional Economic Outlook: Asia and Pacific, International Monetary Fund | April 2018 (excerpts from apd-reo-full-report - 1.7 and 1.8).*> ### 6.6 percent in 2018 as financial, housing, and ### apd-reo-full-report - 6.6 percent in 2018 as financial, housing, and ### Regional Outlook Highlights - Growth projections and inflation expectations for selected economies: - Japan: average headline inflation projected at 1.1 percent in 2018; core inflation expected at 0.5 percent; wage increases expected to remain modest despite tight labor market conditions. - India: growth projected at 6.7 percent in FY2017/18 and expected to recover to 7.4 percent in FY2018/19; medium-term headline CPI inflation forecast to remain within but closer to the upper bound of the Reserve Bank of India’s inflation-targeting band (4 percent ±2 percent); current account deficit in FY2017/18 expected to widen somewhat but remain modest, financed by robust FDI inflows. - Korea: growth expected at about 3 percent in 2018 and 2019; consumer price inflation stable at about 2 percent; current account surplus expected to remain elevated at about 5 percent. - Australia: recovery expected to accelerate; inflation forecast to return to the midpoint of the target range within the next three years; baseline assumes a soft landing in the housing market with price growth slowing gradually. - New Zealand: growth expected to be above trend in the near term and to moderate toward trend in the medium term due to lower net migration, less earthquake reconstruction spending, and weaker residential investment. - Hong Kong SAR: growth expected at about 3.6 percent in 2018; current account surplus forecast to remain stable at about 3.1 percent of GDP; CPI inflation projected to increase to 2.2 percent for 2018 and to rise gradually thereafter. ### ASEAN - Indonesia: - Growth projected to increase to 5.3 percent in 2018 and 5.5 percent in 2019. - Inflation projected to remain near the center of the target band (3.5 ±1 percent). - Current account deficit projected to remain contained at 1.9 percent of GDP in 2018. - Medium-term real GDP growth projected at 5½ percent. - Thailand: - Growth forecast at 3.7 percent in 2017 and 3.5 percent in 2018. - Inflation projected to remain below the 2.5 percent midpoint of the target range in 2018. - Current account surplus projected to decline but remain very large. - Singapore: - Growth projected at 2.9 percent in 2018, easing to 2.7 percent in 2019 and about 2.6 percent over the medium term. - Headline inflation expected to rise to 1.2 percent in 2018 and stabilize at about 1 percent thereafter. - Core inflation should move closer to 2 percent over the medium term. - Current account surplus will remain elevated in the near term. - Malaysia: - GDP growth projected at 5.3 percent in 2018, slightly above potential. - Growth expected to converge to potential of about 5 percent in the medium term, with inflation about 2.5 percent. - Philippines: - Growth projected at 6¾ percent in 2018–19 and about 7 percent over the medium term. - Inflation should remain within the target band of 2–4 percent. - Current account deficit projected to widen to 0.5 percent of GDP in 2018. - Vietnam, Myanmar, Cambodia, Lao P.D.R., Brunei Darussalam: - Vietnam: growth expected to continue at 6½ percent in the near and medium term; inflation remaining in the range of 4 percent. - Myanmar: growth expected to pick up toward the estimated potential of 7 to 7.5 percent over the medium term. - Cambodia: medium-term growth projected to slow to about 6 percent. - Lao P.D.R.: growth expected to continue at about 7 percent in the near and medium term. - Brunei Darussalam: growth expected to pick up to 1 percent in 2018 reflecting higher oil output. ### Other economies - Bangladesh: growth should slow slightly to 7 percent in FY2018, while inflation should drop toward target as effects of food price shocks wane. - Nepal: growth expected to slow to 5 percent in 2018; inflation expected to rise to 6 percent as food prices normalize and activity begins to run up against capacity constraints. - Sri Lanka: growth rising to 4.4 percent and inflation dropping to 5 percent by the end of 2018. - Mongolia: growth expected to remain strong in 2018 and pick up sharply over the medium term as a major new mine comes onstream. - Pacific island economies: growth expected to pick up slightly in 2018–19 to about 3 percent; inflation expected to remain low in most economies; outlook subject to significant downside risks related to natural disasters. - Historical note: during 1980–2016, 204 natural disasters were recorded in the 12 economies in the Pacific, implying a nearly 50 percent chance of a country being hit in any given year, and disasters caused damage averaging 14 percent of GDP (Lee, Zhang, and Nguyen, forthcoming). ### Risks to the Outlook - Overall assessment: - Balance of risks improved since October 2017 update but remains tilted to the downside over the medium term. - Key uncertainties: sudden tightening of global financial conditions; retreat from global integration; continued buildup of private sector leverage and financial vulnerabilities; rising geopolitical tensions. - Upside risks: - Growth momentum could be more durable amid strong consumer and business confidence and loose financial conditions. - Fiscal stimulus in the United States and a stronger recovery in the euro area could lift global growth with positive spillovers to Asia and Pacific. - CPTPP could boost trade, investment, and growth; China’s Belt and Road Initiative could facilitate greater regional integration if investment scale-up does not compromise debt sustainability or project quality. - Digital revolution could boost productivity and potential growth over the medium term. - Sharp tightening of global financial conditions: - Net financial flows to emerging market and developing economies have picked up; global equity markets saw increased volatility and capital flows toward safe havens. - An abrupt change in global risk appetite could lead to a sudden, sharp increase in interest rates and tightening of global financial conditions, strengthening the US dollar and euro vis-à-vis other currencies. - Such a tightening could impose strains and sizable output costs on regional economies with high leverage, balance sheet mismatches, or US dollar pegs. - Potential strains in dollar funding markets where financial institutions rely on short-term external funding; structural changes could raise the cost of funding in global markets. - Example: in Japan, some internationally active regional banks are exposed to foreign exchange funding liquidity risk due to reliance on short-term foreign exchange swaps; the potential negative funding gap for those banks would account for only a very small portion of total foreign-currency-denominated liabilities of the entire Japanese banking sector. - Retreat from global integration: - Recent policy actions cited include global safeguard tariffs on imported washing machines and solar cells and modules, new tariffs on steel and aluminum, and a Section 301 action on China that could entail new tariffs on some $50 billion in Chinese exports to the United States. - Greater protectionism could disrupt global supply chains, reduce migration and remittances, reduce global productivity, and harm longer-term growth, with disproportionate harm to low-income households. - For Asia, the near-term impact could vary but escalation of tensions could dampen FDI and trade and disturb financial markets. - Asian emerging market economies lag comparators outside the region in regulations governing services trade and foreign direct investment, indicating scope to improve openness of trade and FDI policies. - High private sector leverage and financial vulnerabilities: - Property prices have risen substantially in a few economies; tighter financial conditions could slow or reverse property price increases, weigh on consumption, and affect banks’ balance sheets. - Some economies face external financing vulnerabilities, including high share of government bonds held by foreigners. - China faces downside financial risks related to elevated off-balance-sheet exposures, thin capital and liquidity buffers at small and medium-size banks, and ongoing reliance on implicit guarantees for banks and shadow banking entities. - Protracted easy conditions could foster buildup of vulnerabilities as yield-seeking investors increase exposure to lower-rated borrowers; migration of risks toward nonbanks could exacerbate vulnerabilities. - Geopolitical uncertainties: - Expectations of peaceful resolution around North Korea have increased but risks could escalate if talks are unsuccessful. - Potential market turbulence in South Korea, Japan, and possibly China if perceptions of regional security are affected; territorial disputes in the South China Sea remain a possibility. - Other downside risks: - In China, failure to pivot from high-speed to high-quality growth could increase financial imbalances and probability of a sharp adjustment. - Higher food prices could spill over to headline inflation and require monetary policy tightening in several economies. - Cybersecurity breaches and cyberattacks could be highly disruptive, especially if they target critical infrastructure. - Small states and Pacific island economies face risk of withdrawal of correspondent banking relationships by global banks. ### Longer-Term Growth Prospects - Demographic challenges: - Population aging is a significant medium- and long-term challenge; many Asian economies risk “growing old before they grow rich.” - At the point working-age share declines, income levels are projected to be substantially below the United States: 70 percent for Korea, 20 percent in China, and less than 40 percent for most others. - Adverse effect of aging on growth estimated in the range of ½ to 1 percent for China, Japan, Korea, and Thailand; aging will imply substantial additional fiscal burdens. - Productivity and structural challenges: - Slowing productivity growth is a headwind; no sign of productivity catch-up relative to the United States except for low-income emerging market and developing economies. - Decline in productivity growth observed across sectors, including manufacturing and especially services. - Lack of quality infrastructure is a critical structural weakness in most economies in the region. - Inequality and inclusion: - Inequality is rising across much of Asia; policies to foster inclusive growth will be critical. - Digital revolution: - Recent technological advances could represent a “fourth industrial revolution” with potential to be transformative. - Benefits may be delayed; advances may create winners and losers and change long-standing growth models. - Widespread use of industrial robots may boost productivity but risk raising structural unemployment if displaced labor cannot find alternative opportunities. - Harnessing digital benefits requires comprehensive policy responses: revamping education; investing in physical and regulatory infrastructure to spur competition and innovation; addressing digitalization-linked risks without stifling innovation. *International Monetary Fund | April 2018* ### chapter is planned for the October 2018 Regional ### 1. GOOD TIMEs, UNCERTAIN TIMEs: A TIME TO PREPARE ### Policy recommendations and macroeconomic assessment - Context: continued strong growth, subdued inflation, and abundant liquidity contributing to asset price increases rather than inflation. - Overarching advice: carefully calibrated policy mix to promote sustainable, inclusive growth while enhancing resilience. - Fiscal policy guidance: - With output gaps closing, the need for continued fiscal support has diminished; fiscal policies should be geared toward strengthening buffers, safeguarding sustainability, and increasing resilience. - Population aging will bring a heavy fiscal burden to some economies; medium- and long-term consolidation frameworks are important. - Country-specific stances: - China, India, Indonesia, and a number of other economies: aim for growth-friendly consolidation. - Japan: avoid a premature reduction in the level of fiscal support; a credible framework for medium- and long-term consolidation is a key priority. - Australia and Singapore: a more supportive near-term fiscal stance is appropriate. - Korea: a substantial expansion would be appropriate as part of a broader effort to rebalance the economy. - Medium-term tax reform recommended in some economies to create space for infrastructure and social spending, and to support structural reforms. - Monetary policy guidance: - Given still relatively subdued inflation, a continued accommodative monetary policy stance is appropriate for much of Asia, with notable exceptions. - China: growth targets should be deemphasized and credit growth slowed; overall policy stance, including monetary policy, should become less accommodative. - India: given increased inflation pressure, monetary policy should maintain a tightening bias. - Across the region: consider the mix of monetary, macroprudential, exchange rate, and other policies carefully, mindful that overly accommodative monetary conditions can contribute to froth in financial markets. - Strengthen monetary policy frameworks and central bank communications to make inflation less sticky and keep expectations well anchored around inflation targets. - Exchange rate flexibility can help insulate economies from imported inflation. - Macroprudential and financial policy guidance: - Continue developing and broadening macroprudential toolkits. - Economies facing currency mismatches and rapid credit growth—including frontier and developing economies—could usefully tighten macroprudential requirements. - Be aware of limits of macroprudential policies in the context of excessive liquidity. - Use capital flow management measures carefully and generally allow flexible exchange rates to function as a buffer against external shocks. - Structural reform priorities while recovery momentum persists (“fix the roof while the sun is shining”): - Lift long-term growth, enhance labor force participation rates, make growth more inclusive, and build resilience to economic shocks. - Boost productivity and investment, narrow gender labor force participation gaps, deal with the demographic transition, address climate change, and support those affected by shifts in technology and trade. - For adapting to the digital revolution: upgrade physical and regulatory infrastructure, reduce lower trade restrictions (particularly in services), enhance human capital, and address labor market and social challenges. - For developing economies: measures are essential for progress toward the United Nations Sustainable Development Goals and for promoting economic diversification. *Prepared by the Asia and Pacific Department; International Monetary Fund | April 2018.* ### Rapid credit growth in frontier and developing Asian economies (Box 1.1) - Scope: Asian frontier and developing economies (FDEs) defined as Bangladesh, Bhutan, Cambodia, Lao P.D.R., Mongolia, Myanmar, Nepal, Sri Lanka, and Vietnam. - Observation: Many Asian FDEs are currently experiencing rapid credit growth; Cambodia, Lao P.D.R., Myanmar, Nepal, Sri Lanka, and Vietnam have seen double-digit growth in credit to the private sector for several years; Mongolia experienced a credit boom a few years ago. - Risks and characteristics: - Rapid credit growth may reflect financial deepening or mounting macro-financial risks from macroeconomic imbalances and unsustainable banking sector dynamics. - Macro-financial risks are particularly pressing in FDEs due to typically weak supervisory capacity, poor risk management and underwriting standards, fewer macroprudential tools, and financial activity by nonbanks that may not be appropriately licensed and supervised. - Historical patterns and metrics (2011–16 period): - During 2011–16, 9 out of 11 credit boom episodes in Asia—as identified using the methodology in Bakker and others (2012)—were in FDEs. - Five out of nine Asian FDEs experienced credit booms during this period. - Among FDEs that had a credit boom during this period: - annual real credit growth averaged nearly 23 percent, - the median credit-to-GDP ratio rose from about 35 to 56 percent, - credit gaps averaged about 5 percent of GDP (and ranged up to 17 percent of GDP). - Investment link: Prolonged credit growth has often failed to translate into sustained increases in domestically financed private investment in several cases (examples: Sri Lanka and Nepal). - Example: In Nepal, nominal credit grew by 32 percent—nearly six times faster than nominal GDP growth—yet domestically financed private investment rose by just 2 percent in 2016 (with caveat that the 2015 earthquakes and subsequent trade disruption might have played a role). - Diverse drivers of credit growth across countries: - Nepal: credit boom driven by strong remittance inflows (a key funding source for the bank-based financial sector) coupled with insufficient sterilization. - Cambodia: credit booms financed by foreign borrowing by banks and large microfinance institutions. - Vietnam: credit growth led by substantial unsterilized intervention to maintain the dollar peg amid large capital inflows, higher banking sector credit growth targets set by the central bank, and easing of macroprudential policy via lower risk weights on lending to the real estate and securities sectors. - Policy responses and common elements: - Strengthen bank and nonbank supervision and regulation; further develop macroprudential indicators and tools; ensure effective crisis management and resolution frameworks. - In cases where credit is concentrated in real estate and related sectors, tailored macroprudential policies can help prevent risk buildup; take limited capacity and experience with these tools into account. - Possible macroprudential measures: reduce loan-to-value ratios on real estate loans and hire purchases; introduce real estate exposure limits; raise risk weights on these loans; implement tools to prevent migration of lending from banks to nonbanks. - Fiscal measures: taxes on land or housing—particularly for properties not used as primary residences—can also be used. - Note: Box prepared by Sarwat Jahan, Medha Madhu Nair, Piyaporn Sodsriwiboon, Cormac Sullivan, and Irene Zhang. ### Spillovers to Asia from the US Tax Cuts and Jobs Act (Box 1.2) - Context: Tax Cuts and Jobs Act (TCJA) of December 2017 has multiple components with potential effects on the United States and global economy through several channels. - Key corporate tax changes under the TCJA: - Rate cut: US statutory rate cut from 35 percent to 21 percent; applicable rate for some activities is lower still, at 13.125 percent. - Capital expensing: For the next five years, corporate investments can be fully deducted in the first year; during the subsequent five years, the share of investment that can be expensed will be gradually reduced. Interest remains deductible (subject to tighter limits). - Territorial taxation and repatriation: - The United States moves to territorial taxation; income earned in the United States will be taxed at the US rate, whereas—subject to a qualification—income earned overseas will be taxed only by those jurisdictions. - Previously unrepatriated profits, estimated at some $2.6 trillion, are now deemed repatriated and are subject to tax at preferential rates (with those tax payments spread over an eight-year period). - Base-erosion provision (BEAT): a firm’s tax liability can fall no lower than 10 percent of its income, excluding certain payments to foreign-affiliated corporations. - Global intangible low-taxed income (GILTI): a foreign affiliate’s returns above 10 percent on tangible assets will be taxed at a rate of 10.5 percent, with a credit of 80 percent of foreign taxes paid. If a multinational’s average foreign tax rate is 13.125 percent or higher (10.5 percent divided by 80 percent), no GILTI will be owed. - Foreign-derived intangible income (FDII): reduced tax rate of 13.125 percent on export income from intangible assets (defined as export income exceeding a 10 percent return on domestic tangible assets, equivalent to the GILTI). - Expected channels and implications: - Rate cut and expensing likely to provide a short-term boost to US growth and investment, possibly leading to faster monetary tightening, dollar appreciation, capital outflows from emerging markets (including Asia), and a widening US current account deficit. - Direct growth spillovers to Asia estimated to be relatively small, but broader provisions could affect firms’ decisions on investment location and induce other governments to change their tax laws. - Potential for tax competition: rates above 21 percent risk losing US investment back to the United States; however, because of GILTI anti-base-erosion design, rates lower than 13.125 percent may provide limited benefit to firms. - Deemed repatriation may attract US firms’ overseas cash back home, but much of this is already invested in US assets, so macro impact is unclear; the provision should raise revenue. - FDII may lead some companies to keep more intellectual property in the United States; questions raised about consistency with World Trade Organization obligations. - Modeling note: - IMF staff incorporated an estimate of the boost to US growth and investment from the corporate rate cut and investment expensing into the April 2018 World Economic Outlook (WEO) projections. - Many other effects are difficult to estimate quantitatively and depend on the international response to the US action. - Box prepared by Keiko Honjo and Dirk Muir; see the April 2018 Fiscal Monitor for a fuller description of the tax reform and its spillovers. *Prepared by the Asia and Pacific Department; International Monetary Fund | April 2018.* ### Box 1.2 (continued) ### Box 1.2 (continued) ### Impacts of US Corporate Tax Cuts (TCJA) — model overview and aggregate findings - Analysis uses the APDMOD module of the IMF’s Flexible System of Global Models and focuses exclusively on the TCJA; it does not model the additional stimulus from the two-year budget agreement. - In the model, the United States cuts its corporate taxes starting in 2018, leading to: - Real GDP expansion from 2018 to 2021, with growth being, on average, 0.3 of a percentage point higher a year. - Because the US output gap is mostly closed, the additional fiscal stimulus is inflationary and leads to additional interest rate hikes by the US Federal Reserve; as a result, real GDP growth is lower by about 0.1 of a percentage point for the remainder of the IMF’s forecast horizon before returning to its original path as TCJA provisions expire. - Growth is driven first by investment from the tax cut, increasing potential output and stimulating labor demand; higher incomes raise consumption but also generate inflation pressure and a short-term appreciation of the real effective exchange rate (REER). - Higher domestic demand raises real imports, which peak 6 percent higher than in the baseline by 2020. This is the main conduit for spillovers to the Asia and Pacific region. - In the long term, effects decline because provisions expire and forward-looking expectations alter behavior; a generalized corporate tax cut reduces firms’ costs, producing a long-term REER depreciation that undoes short-term trade spillovers. ### Channels of spillovers to Asia and regional heterogeneity - Main channels: - Increased exports to the United States due to higher US aggregate demand; often paired with a short-term REER depreciation transmitted from US appreciation. This is the key channel for China, Japan, Korea, and some ASEAN economies, leading to larger current account surpluses in much of Asia. - Intra-Asia rebalancing via cross-exchange-rate effects: some economies (mainly Japan and a few ASEAN economies) experience stronger REER depreciation and relatively larger gains; others (for example, Singapore and some other ASEAN members) experience appreciation because their trade links are less with the United States and more with other Asian economies (China, Japan, and/or Korea). - Movement in commodity prices: a relatively minor drag on commodity importers with strong US trade links (China, India, Japan, Korea, and some ASEAN economies); beneficial to commodity exporters (Australia, Mongolia, and New Zealand) that have second-round spillovers from higher Asian demand. - Regional outcomes and imbalances: - The simulation points to limited positive effects on Asian economies. Most Asia spillover effects are less than 0.2 of a percent of GDP at their peak in 2020. - The US current account deficit widens by –0.9 of a percentage point of GDP by 2021 compared with the baseline. - The current account surplus for Asia widens by over 0.2 of a percentage point of GDP compared with the baseline, led by China, Japan, and Korea. - Economies without direct links to the United States depend on spillovers from their other trading partners and exchange rate movements; much of emerging Asia sees strengthening current account balances, while some economies (such as Australia) see a weakening. ### Selected quantitative highlights from the simulation - United States: - Average annual real GDP growth boost during 2018–2021: 0.3 of a percentage point. - Real imports peak 6 percent higher than baseline by 2020. - US current account balance widens (deficit increases) by –0.9 of a percentage point of GDP by 2021 vs. baseline. - Asia and Asia-Pacific: - Most spillover effects < 0.2 of a percent of GDP at their peak in 2020. - Asia current account surplus widens by over 0.2 of a percentage point of GDP vs. baseline, led by China, Japan, and Korea. ### Digital revolution in Asia (Box 1.3): scope, evidence, and implications - The digital revolution (the “fourth industrial revolution”) is driven by advances in artificial intelligence, robotics, computing power, cryptography, big data, 3-D printing, the Internet, and lower data storage costs; potential future drivers include quantum computing and the “Internet of everything.” - These general-purpose technologies can reshape production, trade, organization of production, infrastructure needs, and the nature of work, with potential transitions comparable to historical structural shifts. - Asia’s position and indicators: - Asia is the world’s strongest growth market for the use of industrial robots, with about two-thirds of the world’s robots being used there. - China is the largest robot market in the world, with a 30 percent share of the total supply in 2016; Korea is the second largest market (14 percent); Japan is the third (13 percent); the United States is at 11 percent. - In robot density (industrial robots per 10,000 workers), Korea leads globally, followed by Japan and Germany. - E-commerce: China accounted for less than 1 percent of worldwide transactions about a decade ago and now accounts for more than 40 percent (Wang and others 2017). - Mobile payments are expanding sharply in Bangladesh, India, and the Philippines; on average Asia is lagging sub-Saharan Africa in mobile payments adoption. - Risks and structural challenges: - Automation and 3-D printing may reduce the competitiveness of low-cost, low-skilled labor, potentially triggering reshoring of production to developed economies and requiring new growth models for economies with large pools of low-skilled labor. - New technologies are automating ever more complex activities; while they can increase growth and create new jobs, major transitions in labor markets and skill requirements are likely. ### Policy priorities to reap digital dividends - Comprehensive policies and fresh thinking are needed to harness opportunities while mitigating risks. Key policy areas include: - Revamping education to develop relevant skills for a digital economy. - Investing in physical and regulatory infrastructure that spurs competition and innovation. - Reforming trade (especially in services) and investment policies to facilitate digital trade and investment. - Addressing labor market and social challenges arising from automation and structural shifts. - Regional and international cooperation to develop effective policy responses. - The IMF can play an important role in supporting policy development and regional/international cooperation. *Source: Box 1.2 (continued) and Box 1.3, Regional Economic Outlook: Asia and Pacific Department, International Monetary Fund | April 2018* ### 1. GOOD TIMEs, UNCERTAIN TIMEs: A TIME TO PREPARE ### 1. GOOD TIMEs, UNCERTAIN TIMEs: A TIME TO PREPARE ### Introduction and Main Findings - Global growth in 2017 was the highest since 2011 and is expected to strengthen further in 2018–19, supported by broad-based momentum across countries and fiscal expansion in the United States. - Headline inflation has been picking up with the upturn in oil prices since September, but core inflation remains surprisingly subdued, especially in advanced economies. - Asia has been in a sweet spot of strong growth and benign inflation. While GDP growth forecasts for 2017–18 have been repeatedly revised up over the past two years, inflation forecasts have been kept constant or revised down. - Core inflation remains below inflation targets in many Asian economies. - Motivating questions addressed: Why has inflation been low in Asia recently and how long will it last? What has been the role of import prices and global factors? How well anchored are inflation expectations? To what extent has inflation become less sensitive to economic slack? How do these drivers differ from other regions? Key implications for policymakers are considered. - Analytic approaches used: estimation of augmented Phillips curves; principal component analysis to distinguish global factors from country-specific factors; analysis of trend inflation versus temporary components. - Main empirical findings (preserved phrasing): - Recent low inflation has been driven mainly by temporary forces, including imported inflation. The Phillips curve estimation indicates that weaker import prices, including low commodity prices, contributed to half of the undershooting of inflation targets in advanced Asia and most of the undershooting in emerging Asia in recent years. - China seems to have played an important role in driving both global and regional inflation. - An analysis looking at temporary and trend components suggests that temporary shocks have accounted for the bulk of the recent reduction in inflation. - The inflation process has become more backward-looking. While inflation expectations are generally relatively well anchored, especially in advanced Asia and in economies with inflation-targeting frameworks, the importance of expectations in driving inflation has declined in recent years, with past inflation playing a larger role. - The sensitivity of inflation to the unemployment gap has declined. There seems to be a flattening of the Phillips curve compared with the 1990s in advanced Asia and a similar but more continuous flattening in emerging Asia. Outside Asia, the slope of the Phillips curve seems to have been more stable. - Outlook implications (preserved phrasing): - Inflation may well rise in Asia as commodity prices and other temporary factors reverse themselves (the April 2018 World Economic Outlook projects a near-term increase in commodity prices). - Higher inflation in the rest of the world and weaker currencies in the region could pose upside risks to inflation. - If such risks materialize, higher inflation may well persist, given the stickiness of the inflation process. - Given the relative flatness of the Phillips curve, the output costs of disinflating may be high. ### Recent Inflation Trends in Asia - Headline inflation declined sharply during 2012–15 across many advanced, emerging market, and developing economies in Asia. Disinflation was broad-based across sectors and inflation measures. - Breakdown by expenditure categories shows the decline in inflation was widespread across food, other goods, and services. - Food inflation declined the most across advanced economies, but remained generally positive despite the decline in international food prices, suggesting low pass-through from international to domestic food prices. - Other goods inflation entered negative territory in several advanced Asian economies, reflecting the large decline in manufacturing producer prices. - Core inflation and wage inflation also declined widely. - Headline inflation started to pick up in 2016, with the share of low-inflation economies dropping from its 2015 peak. - Inflation is currently picking up in Australia, Japan, Korea, and some ASEAN economies. - The recent pickup in headline inflation is primarily explained by other goods and services inflation, with the manufacturing producer price index (PPI) recovering strongly. - In China, the pickup in PPI inflation did not spill over to CPI inflation. - Commodity-price developments: recent increase in commodity prices aligns with the pickup in headline inflation regionally and globally. ### Structural Drivers of Inflation - Analytical framework: hybrid new Keynesian Phillips curve relating domestic inflation to inflation expectations, cyclical unemployment, and imported inflation. - Evolution of drivers (preserved phrasing): - Inflation expectations came down substantially in the 1990s for both advanced and emerging Asia and have been on a declining trend since 2011. - There was some slack in labor markets in the aftermath of the global financial crisis, but unemployment gaps seem to be closing in recent periods, with some slack still remaining in China, India, Korea, Malaysia, and Singapore. - Key estimation results (preserved phrasing and findings): - The inflation process in Asia has become more sticky, or backward-looking, since the global financial crisis. The estimated coefficient on inflation expectations has declined in both advanced economies and emerging markets back to levels of the early 2000s, suggesting inflation is being driven more by past inflation than by expectations about future inflation. - In advanced Asia, the role of long-term inflation expectations was less important than in other advanced economies but has gradually caught up. Since the global financial crisis, the coefficient has declined in line with other advanced economies. - A lower coefficient on expectations implies that the effects of cyclical unemployment, import prices, and shocks on inflation have become relatively more persistent in the recent period. - The role of inflation expectations in driving inflation in emerging Asia has generally been more important than in other emerging markets, and inflation shocks have been less persistent, potentially related to a higher share of inflation-targeting countries and an increase in the expectations coefficient after adoption of inflation targeting. ### Policy Implications (preserved recommendations) - Central banks should be vigilant in responding to early signs of inflation pressure, including from global factors. A sudden increase in inflation may then persist, and disinflating may be costly if the sensitivity of inflation to the unemployment gap has declined. - It will be important to strengthen monetary policy frameworks and improve central bank communications in order to both increase the role of expectations in driving inflation and to maintain expectations anchored to targets. - To mitigate the role of imported inflation, exchange rates should be allowed to adjust more flexibly. - In principle, the monetary policy response to commodity price shocks should be to accommodate first-round effects but not second-round effects. *International Monetary Fund | April 2018* ### 1. Expectations Coefficient versus Average Headline Inflation ### 1. Expectations Coefficient versus Average Headline Inflation ### Expectations coefficient and headline inflation (summary findings) - Visual evidence (Figure 2.12) presents country-year markers (e.g., AUS-08 ... NZL-11, JPN-08 ... JPN-17) plotting average inflation expectation coefficient against average headline inflation for Asia (excluding Japan) and for Japan separately. - IMF staff assessment: there has been some decline in the expectations coefficient since the global financial crisis, but less than in other countries and with a longer lag compared with advanced economies. This suggests inflation may be more driven by inflation expectations in emerging Asia than in other emerging markets. ### Change in sensitivity of inflation to domestic slack (Phillips curve) - The slope of the Phillips curve (sensitivity of inflation to domestic labor market slack) is estimated to have declined in Asia (Figure 2.14). - Asian advanced economies: - 1990s median coefficients: about 1 (advanced Asia) versus about 0.2 (other advanced economies). - Slope declined from 1 to about 0.6 compared with the 1990s, and has remained broadly stable since 2004. - Asian emerging markets: - The slope has been declining steadily, mirroring developments in emerging Europe. - Latin American emerging markets did not see such a flattening. - The flattening has been significant and prevalent across most Asian emerging markets. - Robustness: result holds for alternative measures of NAIRU, for slack measured by capacity utilization rather than unemployment, and for some (but not all) output-gap–based slack estimates. ### Role of imported inflation - Coefficient on imported inflation remained broadly constant in both advanced economies and emerging markets (Figure 2.15). - In Asian advanced economies, the coefficient has been lower than in other advanced economies. - In Asian emerging markets, the coefficient has been broadly in line with Latin American emerging markets but lower than in European emerging markets. ### Decomposition of recent inflation undershooting (Figure 2.16, averages and cross-country distributions) - Overall conclusion: imported inflation has been the most important driver of inflation deviations from targets in recent years. - Advanced economies: - Before the global financial crisis, cyclical unemployment was the main driver of deviations. - Since 2013, import prices accounted for about half of the undershooting. - Emerging markets: - Undershooting of inflation targets since 2014 is mainly accounted for by import prices. - Cyclical unemployment has also contributed to undershooting (unlike in advanced economies). - 2016–2017 developments: - Starting in 2016 and 2017, inflation expectations also started to contribute to undershooting of inflation compared with targets. - Inflation expectations accounted for 35 percent of the undershooting in advanced Asia and 40 percent of the undershooting in emerging Asia in the first two quarters of 2017. - Exchange rate effects: - Depreciation of Asian currencies in 2015 following China-induced volatility contributed positively to inflation in both advanced and emerging Asia. - Unexplained factors: - A large share of unexplained factors drives inflation undershooting in Asia, especially in advanced economies. Possible sources noted: mismeasurement of labor market slack by headline unemployment rates; expectations of actual price setters dropping more than professional forecasters; technical constraints on monetary policy (zero lower bound); large cross-country heterogeneity. ### Link between import-price contribution and manufacturing slack in major partners (Figure 2.17) - Import-price contribution to inflation in Asia is particularly strongly related to slack in China. - Averages, medians, and interquartile ranges of coefficients from country-level regressions indicate stronger correlation with China slack than with Japan or United States slack. ### 2. Why the Phillips curve may have flattened ### Mechanisms weakening wage-bidding power - Institutional factors affecting workers’ bargaining power include union density, collective bargaining agreements, labor laws, and employment regulations. - Structural factors potentially at play: aging, technological progress, global integration, and the rise of the service economy. - Specific channels: - Automation (advanced economies) can substitute for low- or middle-skilled routine tasks, reducing workers’ ability to bid up wages and weakening unionization. - Integration into global value chains (emerging markets) increases exposure to international competition and the threat of relocation, weakening workers’ bargaining power. ### Empirical links (Figure 2.18) - Advanced Asia: - Statistically significant link between flattening of the Phillips curve and automation (measured by relative price of investment goods). - Regression: ŷ_t = –1.865*** + Pinv × 3.173***; Time and country fixed effects; R^2 = 0.647 (standard errors: (0.686)(0.832) as reported). - Emerging Asia: - Statistically significant link between flattening of the Phillips curve and GVC integration (share of foreign value-added in exports). - Regression: ŷ_t = 1.077*** + Foreign VA × (–0.0267***); Time and country fixed effects; R^2 = 0.66 (standard errors: (0.134)(0.00483) as reported). - Interpretation: The Phillips curve appears to have flattened more during periods of rapid increase in GVC integration and automation. As these factors stabilize, slope of the Phillips curve might normalize. ### 3. How well anchored are inflation expectations? ### Trend and recent contribution - Medium-term inflation expectations in Asia have been on a declining trend since 2011 (Figure 2.10 referenced). - Expectations began contributing to undershooting of inflation relative to targets more recently (Figure 2.16). ### Metrics used to assess anchoring - Two approaches: 1. Fraction of time expectations are within inflation targets (Tables 2.1 and 2.2 present percent of time within target since IT start and for 2013–17). 2. Response of expectations to inflation shocks (equation 2.1 relates changes in expectations to inflation news; π_t+h^e first difference in expectations h periods ahead; π_t^news measure of inflation shocks). ### Time within the target (Table 2.1: Percent of Time Expectations are within Inflation Targeting Range, Inflation Targeting start till 2017) - Australia (Start 1993; Most Recent Target Band 2–3): Expectation horizon years 0–5: 4 7 0 7 6 8 2 8 6 8 8 (table cell formatting in source; interpreted as percent of time but preserve exact entries). - China (Start 2005; Most Recent Target Band 2–4): entries: 0 7 9 9 2 9 2 1 0 0 9 6. - Indonesia (Start 2001; Target Band 2.5–4.5): entries: 4 7 5 4 4 0 3 5 5 4 5 0. - India (Start 2016; Target Band 2–6): entries: 1 0 0 1 0 0 1 0 0 1 0 0 1 0 0. - Japan (Start 2013; Target Band 1–3): entries: 2 5 6 5 8 0 8 0 8 0 9 0. - Korea (Start 1998; Target Band 1.5–2.5): entries: 4 8 8 6 9 0 9 0 8 0 7 8. - New Zealand (Start 1990*; Target Band 1–3): entries: 7 3 9 1 1 0 0 1 0 0 1 0 0 1 0 0. - Philippines (Start 2002**; Target Band 2–4): entries: 8 8 7 3 5 8 4 5 3 5. - Thailand (Start 2000; Target Band 1–4): entries: 5 0 7 2 8 3 8 3 8 6 8 9. - Notes from source: *Evaluation begins at 1995 due to availability of inflation expectations data. **Evaluation begins at 2008 due to availability of inflation expectations data. (NB: Table 2.1 in the source lists percent-of-time-in-target cells by expectation horizon; the entries above are preserved exactly as presented in the source content.) ### Recent performance (Table 2.2: Percent of Time Expectations are within Inflation Targeting Range, 2013–17) - Australia: 100 100 100 100 100 for horizons 0–5 years. - China: 45 75 100 100 100 100. - Indonesia: 50 65 35 10 25 20. - India: 100 100 100 100 100 100. - Japan: 25 65 80 80 80 90. - Korea: 20 75 80 60 60 80. - New Zealand: 100 100 100 100 100 100. - Philippines: 50 70 95 75 65 60. - Thailand: 90 100 100 100 100 100. - Notes: *Evaluation begins at 1995 due to availability of inflation expectations data. **Evaluation begins at 2008 due to availability of inflation expectations data. ### Average absolute deviation from target (Table 2.3: from Beginning of Inflation Targeting until 2017) - Australia (Start 1993; Point Target 1.5): deviations by horizon 0–5 years: 0.7 0.5 0.4 0.3 0.2 0.2. - China (Start 2005; Point Target 3): 1.3 0.6 0.6 0.5 0.3 0.4. - Indonesia (Start 2001; Point Target 3.5): 1.7 1.1 1.2 1.1 1.0 0.9 1.0. - India (Start 2016; Point Target 4): 0.9 1.0 1.2 1.0 0.9 0.9. - Japan (Start 2000; Point Target 2): 1.4 0.7 0.6 0.9 0.6 0.6. - Korea (Start 1998; Point Target 2): 0.7 0.4 0.3 0.3 0.4 0.4. - New Zealand (Start 1990*; Point Target 2): 0.8 0.4 0.3 0.3 0.3 0.3. - Philippines (Start 2002**; Point Target 3): 0.5 0.4 0.7 0.9 1.0 1.1. - Thailand (Start 2000; Point Target 2.5): 1.4 0.9 0.9 1.0 1.0 0.9. - Notes: *Evaluation begins at 1995 due to availability of inflation expectations data. **Evaluation begins at 2008 due to availability of inflation expectations data. ### Additional notes on anchoring and responses to shocks - Short-term expectations (current year) in most Asian economies are not well anchored because they track actual inflation, which may differ from the target. - One-year-ahead to five-year-ahead expectations are generally better anchored, except in Indonesia and the Philippines where they tend to overshoot. - Anchoring improved during the past five years for most economies (Table 2.2), except Indonesia and Korea. - The second step (response to shocks) uses the relationship Δπ_t+h^e = β_h π_t^news + ε_t+h to assess how expectations update to inflation surprises (equation structure as reported in source). *Source: IMF staff estimates and calculations (Regional Economic Outlook: Asia and Pacific Department, April 2018).* ### 2. LOw INfLATION IN AsIA: HOw LONG wILL IT LAsT? ### 2. LOw INfLATION IN AsIA: HOw LONG wILL IT LAsT? ### Anchoring of Inflation Expectations - Estimation approach and sample: - Equation (2.1) estimated by ordinary least squares with quarterly data from 1995:Q1 to 2017:Q3 using Consensus Forecasts. - Sample: seven advanced economies (Australia, Hong Kong SAR, Japan, Korea, New Zealand, Singapore, Taiwan Province of China) and six emerging markets (China, India, Indonesia, Malaysia, Philippines, Thailand). - Shock anchoring interpretation: - Coefficient β_h reflects degree of anchoring of h-years-ahead inflation expectations; when monetary policy is credible, β_h should be close to zero at sufficiently long horizons. - Sensitivity findings: - In general, longer horizons show lower sensitivity of expectations to inflation surprises. - Emerging markets in Asia are, on average, more sensitive to inflation shocks than advanced economies in Asia, especially over shorter horizons. - Example: a 1 percentage point increase in inflation results in a 0.32 percentage point increase in inflation expectations one year ahead in emerging markets, and a 0.26 percentage point increase in advanced economies. - Time evolution and policy regime effects: - Inflation expectations have become better anchored over time for both advanced and emerging Asia (time-varying estimates for 3–5 years and 6–10 years horizons). - Adopting inflation targeting appears to reduce the sensitivity of expectations to inflation shocks. Six economies analyzed for before/after inflation targeting: New Zealand (March 1990), Australia (July 1993), Korea (January 1998), the Philippines (January 2002), Thailand (May 2002), Indonesia (July 2005). - Evidence cited: adoption accompanied by increased central bank transparency anchors expectations. - Table 2.4. Average Absolute Deviation from Target, 2013–17 — Start of Inflation Targeting, Most Recent Point Target, Expectation Horizon (years 0–5) - Australia — 1993 — 1.5 — 0.4, 0.2, 0.2, 0.1, 0.1, 0.1 - China — 2005 — 3 — 1.0, 0.7, 0.5, 0.5, 0.4, 0.4 - Indonesia — 2001 — 3.5 — 1.3, 1.0, 1.0, 1.3, 1.3, 1.4 - India — 2016 — 4 — 0.9, 1.0, 1.2, 1.0, 0.9, 0.9 - Japan — 2000 — 2 — 1.4, 0.7, 0.6, 0.9, 0.6, 0.6 - Korea — 1998 — 2 — 1.1, 0.3, 0.2, 0.5, 0.4, 0.3 - New Zealand — 1990* — 2 — 0.7, 0.2, 0.2, 0.2, 0.2, 0.1 - Philippines — 2002** — 3 — 0.6, 0.4, 0.6, 0.7, 0.7, 0.8 - Thailand — 2000 — 2.5 — 1.4, 0.7, 0.5, 0.6, 0.6, 0.4 - Notes: *Evaluation begins at 1995 due to availability of inflation expectations data. **Evaluation begins at 2008 due to availability of inflation expectations data. - Overall assessment: - Some evidence of recent downward movement in expectations, but no strong evidence of unanchoring; expectations generally relatively well anchored to targets. ### Global Factors Driving Inflation - Latent factor model on cross-country inflation (past 15 years): - Three global factors explain 56 percent of the variance in headline inflation in the full cross-country panel. - Share of total variance explained: Factor 1: 33%; Factor 2: 15%; Factor 3: 8%. - Economic interpretation of factors: - Factor 1: aligns with global commodity prices, especially fuel prices; correlation statistics: ρ commodity all = 0.52; ρ fuel = 0.56; ρ nonfuel = 0.28. - Factor 2: reflects the “great moderation” in inflation due to globalization, e-commerce, transition from central planning, aftermath of 1990s emerging market crises, and wider adoption of inflation targeting. - Factor 3: associated with movements in the nominal effective exchange rate (NEER) of the US dollar; NEER correlations vary by sample and period. - Country and regional roles: - In many economies, more than 50 percent of inflation variation is explained by common factors. - Advanced Asia broadly similar to advanced economies elsewhere in factor loadings. - Emerging Asia more responsive to Factor 1 than Latin America. - China’s role: - Correlation of PPI inflation in China with Factor 1 is 0.34. - Correlation of Factor 3 (AE and EM sample) with Chinese PPI is 0.59; increased to 0.91 in the post-2014 period. - After extracting global factors, a residual regional PCA for Asian economies: the first common regional factor explains 50 percent of residual variation and has correlation with Chinese PPI of 0.83. - Interpretation: China can affect global and regional inflation via impact on commodity prices and PPI; in some periods Chinese PPI has become more influential than US dollar movements. - Implication: - Global factors play a large role in Asia, implying low inflation in the region may not persist once global commodity prices recover. ### Trend and Transitory Inflation - Modeling approach: - Univariate time series models decompose inflation into permanent (trend) and temporary components. - Trend inflation dynamics: - Trend inflation has been declining substantially over the 1990s and declined again, though milder, after 2011 in both advanced and emerging Asia. - Transitory component: - Decomposition shows concentration of transitory disinflationary shocks in the region over recent years. - The transitory component of inflation has been predominantly negative for most economies since 2014. - Going forward, positive transitory shocks could lift inflation more quickly than expected. - Nonlinearities in the Phillips curve could lead to a jump in inflation at higher inflation levels (example cited: inflation becomes more sensitive to the output gap at higher inflation levels). - Conclusion from decomposition: - Recent bout of low inflation in Asia seems driven largely by temporary forces. ### Conclusions and Policy Implications - Main conclusions: - Inflation in Asia largely followed the global pattern: sharp decline during 2012–15 followed by a recent uptick. - Asian inflation fluctuations are mainly driven by prices of imported goods and exposure to commodity price cycles and global competition. - Inflation process has become more backward-looking since the global financial crisis. - Evidence that Phillips curves in Asia have flattened, implying a higher real cost for reducing inflation. - There is room for Asian emerging markets to strengthen monetary policy frameworks; inflation expectations are better anchored in economies with inflation-targeting frameworks. - Policy implications and recommendations: - Central banks should be vigilant about imported inflation when setting policy reaction functions to avoid sustained deviations from inflation targets. - With more backward-looking inflation and a flatter Phillips curve, costs of disinflation could be larger because larger changes in domestic demand are required to bring inflation back to target. - Higher exchange rate flexibility will better insulate domestic inflation from imported inflation; appreciation of Asian currencies vis-à-vis the US dollar will help preserve monetary policy autonomy and control imported inflation pressures when US inflation rises. - In the case of a commodity price shock: - Appropriate response: accommodate first-round effects on the CPI but not second-round effects on other CPI components. This approach lowers output volatility. - Rationale: commodity price shocks are typically temporary, so central banks should consider underlying as well as headline inflation. - Caveat: in economies with limited central bank credibility and a high share of commodity prices in the CPI, commodity shocks are likely to have larger second-round effects and may require a more aggressive policy response when excess demand pressures are high and inflation is above target. *Source: IMF staff estimates and analysis from Chapter 2, Regional Economic Outlook: Asia Pacific Department, International Monetary Fund | April 2018.* ### 2. LOw INfLATION IN AsIA: HOw LONG wILL IT LAsT? ### 2. LOw INfLATION IN AsIA: HOw LONG wILL IT LAsT? ### Overview - In 2017, Chinese producer prices soared while consumer prices remained subdued. - The disconnect between PPI and CPI in China stems from: (1) an expansion in domestic infrastructure and real estate investment, and (2) the rebound in advanced economies’ demand, both behind the acceleration in Chinese growth since late 2016. - Supply restrictions in selected industries in China did not play a lead role in the broad-based reflation of producer prices. - Going forward, a less favorable outlook for domestic investment and less stringent supply restrictions will lead to a gradual unwinding of producer price pressures. ### China: CPI–PPI Disconnect and Drivers Findings - Producer price index (PPI) and consumer price index (CPI) inflation diverged markedly in 2017. - The disconnect is not new: PPI fell into deflation territory for 54 consecutive months starting in 2012, while the CPI hovered around 2 percent. - PPI inflation rebounded since November 2016 and remained above 5 percent. Structure of price indices - The contemporaneous disconnect is consistent with modest overlap in representative baskets: - Final consumption goods make up three-quarters of the CPI basket and only one-quarter of the PPI basket. - In the PPI, the price of intermediates plays the leading role; in the CPI, final consumption goods drive inflation. Investment and demand shocks - China’s investment demand partly explains the rise in producer prices of intermediate goods. - Since early 2016 and through 2017, government support for the real estate market and infrastructure investment coincided with co-movement between prices for fixed asset investment and PPI inflation of raw materials and intermediate manufacturing goods. - This is consistent with an investment demand shock as a driver of PPI inflation. - A spike in foreign demand since late 2016 also played a role. - Global trade rebounded strongly in 2017, led by final demand in advanced economies. - China’s real exports of goods surged and their prices rose; intermediate manufacturing goods—important Chinese exports—co-move strongly with overall goods export prices. - The demand shock in advanced economies is therefore another key factor behind PPI inflation. Imports and commodity prices - Higher domestic investment and foreign demand led to surging imports of raw materials, further supporting PPI inflation. - China depends on imports of raw materials to satisfy investment demand and as inputs into manufacturing exports; price pressures in investment and intermediate manufacturing goods translate into higher prices for raw materials and overall import prices. - The energy component of the CPI is tightly linked with prices of raw materials, but its weight is small and thus this link is not discernible in headline CPI. Role of supply-side adjustments - Supply-side adjustments in selected upstream industries (steel and coal overcapacity campaign starting in 2016) magnified the PPI inflation rebound but did not play a lead role. - Steel production actually increased throughout the period. - Coal production declined in 2016 but rose in 2017 until an intensified crackdown on polluting industries ahead of the 2017–18 winter. - The latest campaign may have contributed to sustaining price pressures, but effects are hard to assess because production of intermediate goods and construction projects were both suspended at times. - Some commodity price increases cannot be attributed solely to international and Chinese demand; markets such as crude oil are also heavily influenced by supply constraints. ### Japan: Long-Term Low Inflation and Policy Experience (Box 2.2) Why Japan fell into deflation - Annual CPI inflation averaged 0.2 percent between 1993 and 2017. - The GDP deflator contracted by an average of 0.3 percent a year during the same period. - Demand shocks: - Collapse of the asset price bubble in the early 1990s led to deleveraging by households, banks, and businesses, slowing the real economy, raising unemployment, and lowering inflation. - The 1997–98 Asian crisis weakened demand further; high nonperforming loans caused a banking crisis that pushed the economy into deflation in 1998–99. - Supply-side factors: - Deregulation of the labor market in the mid-1990s and early 2000s raised the share of nonregular workers and lowered labor’s bargaining power, contributing to downward pressure on prices by lowering unit labor costs. - Aging and shrinking labor force reduced potential growth and fiscal sustainability, negatively affecting permanent income and potentially boosting precautionary savings. Policy response and the deflation mindset - Monetary policy response in the 1990s was “too little, too late”; fiscal policy proved ineffective at stimulating growth. - The Bank of Japan adopted a “zero interest rate policy” in 1999 and switched to quantitative easing in 2001; exit from QE and a policy rate increase starting in early 2006 was likely premature. - The prolonged period of low inflation led to a decline in inflation expectations and the emergence of the “deflation mindset,” constraining the BOJ’s ability to lower real interest rates at the zero lower bound and reducing wage demands and price responsiveness by firms. Abenomics and subsequent policy developments - Early 2013: Authorities shifted to decisively lift the economy—Bank of Japan announced a 2 percent inflation target and significantly ramped up JGB purchases, complemented by flexible fiscal policy and structural reforms. - CPI inflation reached 1.6 percent in 2013; inflation expectations started to rise. - Subsequent shocks and policy actions: - A sharp drop in energy prices, global slowdown, and the 2014 consumption tax hike caused inflation to drop again. - BOJ boosted JGB purchases in October 2014 and implemented a negative interest rate on excess marginal reserves in early 2016. - By mid-2016, efforts had not achieved the 2 percent target; concerns emerged about running out of JGBs to purchase and impairing financial intermediation via a flattened yield curve. Yield curve control and recent outcomes - September 2016: BOJ introduced yield curve control (YCC) with commitments to (1) keep expanding the monetary base until inflation overshoots its target in a stable manner and (2) appropriately shape the entire yield curve to achieve price stability while considering financial conditions. - The framework allowed deemphasizing quantities in favor of a yield target, reducing JGB purchases and alleviating sustainability concerns. - Increased long-term yields helped relieve pressures on institutional investors (for example, pension funds and insurers). Looking forward for Japan - Against an improving global environment: - The Japanese economy experienced eight consecutive quarters of above-potential growth. - The unemployment rate is at its lowest level since 1993. - CPI headline inflation reached 1.1 percent in March 2018. - Challenges remain: - Core inflation remains stubbornly low. - Long-run inflation expectations have yet to display convincing signs of moving toward the 2 percent target. - Wage growth remains very low, particularly for regular workers; firms appear reluctant to pass higher labor costs on to prices, instead using labor rationing and investing in labor-saving technologies. - Policy implication: - The BOJ has taken a patient approach, expecting labor shortages to build pressure for higher prices, but the process may take time. - It is imperative to take advantage of the favorable macroeconomic environment to implement a comprehensive policy package exploiting complementarities between labor market reforms and coordinated income and demand policies to durably unwind the deflation mindset. ### Annex 2.1: New Keynesian Phillips Curve (model specification) - The new Keynesian Phillips curve relates domestic inflation to inflation expectations, cyclical unemployment, and imported inflation as follows: π_t = a_t π_{t+10}^e + (1 − a_t) π̂_{t−1} + β_t u_{t}^c + γ_t π_{t}^m + ε_t , (A2.1.1) - where π_t is headline consumer price inflation; - π_{t+10}^e is inflation expectations 10 years ahead; - π̂_{t−1} is the moving average of inflation in the previous four quarters; - u_{t}^c is cyclical unemployment, estimated as the deviation of the unemployment rate from the nonaccelerating inflation rate of unemployment; - π_{t}^m is inflation in the relative price of imports (the import-price deflator relative to the GDP deflator); - ε_t is the impact of other factors, including measurement error and supply shocks in addition to those controlled for by relative import price inflation. - Coefficients: - α_t captures the degree to which inflation is driven by long-term inflation expectations as opposed to lagged inflation; - β_t denotes the slope of the Phillips curve (sensitivity of inflation to cyclical unemployment); - γ_t captures the impact of imported inflation. - Estimation: - Equation (A2.1.1) is estimated at the country level for 44 advanced and emerging market economies, including 13 Asian economies, using quarterly data for the first quarter of 1990 to the second quarter of 2017. - The estimation method is maximum likelihood based on a constrained nonlinear Kalman filter that allows for time variation in the regression coefficients. ### Annex 2.2: Common Factors (latent-factor model for inflation) - Purpose: gauge the role of global factors in driving inflation dynamics using a latent-factor model applied to inflation rates of 136 economies from Q1 2001 to Q3 2017 to identify global common drivers and their importance for individual economies. - Model specification (principal component analysis): - π_t − π̄_t = β f_t + e_t (A2.2.2) - f is a (K × 1) vector of latent factors; β is an (N × K) matrix of loading coefficients; e_t is the idiosyncratic component. - Interpretation: - Each economy’s demeaned total inflation can be decomposed into a common component (β f_t) and an idiosyncratic component (e_t). - The importance of each common factor is country-specific and depends on the estimated loading coefficients, assumed constant over the entire period and loaded contemporaneously. - A higher loading factor means the country’s inflation is affected more strongly by that global factor. *International Monetary Fund | April 2018* ### 2. LOw INfLATION IN AsIA: HOw LONG wILL IT LAsT? ### 2. LOw INfLATION IN AsIA: HOw LONG wILL IT LAsT? ### Annex 2.3. Trend Inflation — decomposition framework - Inflation, π_t, is decomposed into trend, π_t^*, and a deviation from trend, c_t, components in an unobserved-components framework (Stock and Watson 2007): - π_t = π_t^* + c_t (A2.3.1) - Identification assumptions: - lim_{j→∞} E_t[π_{t+1+j}] = E_t[π_{t+1+j}^*] = π_t^* (A2.3.2) - lim_{j→∞} E_t[c_{t+1+j}] = 0 (A2.3.3) - Interpretation: - By construction, the permanent component or “trend” in inflation, π_t^*, reflects the most likely inflation rate to be observed once transitory influences on inflation die off. ### Estimation approach and data - Model: - Trend inflation is estimated within an unobserved component and stochastic volatility model. - Data: - Headline inflation series for: - Six advanced economies: Australia, Hong Kong SAR, Japan, Korea, New Zealand, Taiwan Province of China. - Six emerging markets: China, India, Indonesia, Malaysia, Philippines, Thailand. - Additional information: - Survey measures of long-term inflation expectations (6–10 years ahead) from the Consensus Forecasts are used as additional information to improve estimation (Chan, Clark, and Koop 2016; Garcia and Poon, forthcoming). ### Key methodological notes - The approach follows Chan, Clark, and Koop (2016) in decomposing inflation into permanent and transitory components using an unobserved-components framework. - Use of long-horizon survey expectations is highlighted as a crucial element to enhance identification and estimation of trend inflation. *International Monetary Fund | April 2018* --- _Source: https://www.imf.org/-/media/files/publications/reo/apd/2018/apd-reo-full-report.pdf_