## 1. Overview

## Source details

**Canonical URL:** [1. Overview](https://www.imf.org/-/media/files/publications/reo/apd/2019/oct/english/text.pdf)

## Other formats

- [Markdown version](/-/media/files/publications/reo/apd/2019/oct/english/text.pdf.md)
- [Structured JSON version](/-/media/files/publications/reo/apd/2019/oct/english/text.pdf.json)

---

### Key findings
- Asia remains the world’s fastest growing major region and is contributing more than two-thirds to global growth.
- Near-term prospects have deteriorated noticeably since the April 2019 World Economic Outlook, with risks skewed to the downside.
- Growth in Asia is expected to moderate to 5.0 percent in 2019 and 5.1 percent in 2020 (0.4 and 0.3 percentage point lower than projected last April, respectively).
- Global growth is projected to be 3.0 percent in 2019, improving to 3.4 percent in 2020 (0.3 percentage point lower for 2019 and 0.2 percentage point lower for 2020 than the April 2019 WEO forecast).
- For advanced economies, growth is projected to be 1.7 percent in 2019 and 2020 (the report later notes advanced economies projected at 1.3 percent in 2019 and 2020 in a regional context, reflecting broad-based downward revisions).
- Emerging market and developing economies are expected to grow by 3.9 percent in 2019, rising to 4.6 percent in 2020 (forecasts for 2019 and 2020 are 0.5 and 0.2 percentage point lower, respectively, than in April, reflecting downward revisions in all major regions).

### Recent regional developments and statistics
- Global manufacturing activity continued to weaken; trade volume growth decelerated to about 1 percent in the first half of 2019—the slowest pace since 2012.
- Exports in Asian emerging markets have been shrinking since late 2018, largely dragged down by weak intraregional trade, especially with China.
- China: GDP growth slowed to 6.2 percent year over year in the second quarter; high-frequency indicators point to continued weak activity in July and August. Growth is expected to decline moderately to 6.1 and 5.8 percent in 2019 and 2020, respectively (revised down since April by 0.1 percentage point for 2019 and 0.3 percentage point for 2020).
- Japan: recorded strong GDP growth in the second quarter; projected growth is 0.9 percent in 2019 and likely 0.5 percent in 2020.
- India: growth slipped to 5.8 percent year over year in the first quarter of 2019 and decelerated further to 5 percent in the quarter through June 2019; India is set to grow by 6.1 percent in 2019 and 7 percent in 2020 (down 1.2 percentage points for 2019 as reported).
- Korea: GDP grew by 2.1 percent year over year in the second quarter; exports have been falling due to lower global demand for semiconductors and slowdown in China.
- ASEAN-5 economies: growth lost momentum in the first half of 2019 amid weak exports.
- Headline inflation remained subdued in most economies, prompting many Asian central banks to cut policy rates.
- Financial conditions for Asian emerging market economies eased since April, and capital flows to the region have been generally robust following shifts toward more accommodative policy in the US Federal Reserve and the European Central Bank.
- Compressed spreads, higher house prices, and lower interest rates accounted for a relaxation of financial conditions in the region.

### Risks to the outlook
- External downside risks:
  - Possible further deepening of US-China trade tensions.
  - Weaker-than-expected growth of key trading partners.
  - Higher oil prices.
  - A disorderly Brexit.
- Risks within the region:
  - A faster-than-expected slowdown in China.
  - A deepening of regional tensions such as Japan’s and Korea’s bilateral relationship.
  - Rising geopolitical risks.
  - Increased incidence of natural disasters.
- Loosening monetary policy in key advanced economies and easing financial conditions could add to financial vulnerabilities in the region.

### Policy recommendations and priorities
- Use existing fiscal and monetary policy space to smooth domestic demand where warranted, given the expected deceleration in growth.
- Adjust financial sector policies proactively to ensure loosening financial conditions do not fuel a further buildup of financial stability risks.
- Prioritize reducing firm and household leverage where exposures are of concern.
- Structural reform priorities:
  - Further trade liberalization, including reducing nontariff barriers to services trade, and relaxing investment restrictions.
  - Sustained investment in people by upgrading human capital while empowering women and youth.
  - Policies to stimulate labor supply, including higher female labor force participation.
  - Reducing infrastructure gaps and enhancing regulatory frameworks.
  - More ambitious measures to mitigate drivers of climate change while building fiscal buffers to adapt to increasing incidence of natural disasters.

### Thematic studies covered in the report
- Study 1: Management of international capital flows in Asia
  - Capital flows can be large, volatile, and disruptive.
  - Policymakers have extensively used foreign exchange interventions to cushion volatile capital flows, particularly where balance sheet mismatches are prevalent and financial markets are shallow.
  - Monetary policy has been deployed in response to inflation and growth shocks and in reaction to US interest rates, the exchange rate, and credit growth.
  - Macroprudential and capital flow management measures have responded to external, domestic macro, and domestic financial stability considerations.
  - Evidence suggests Asian countries deploy their toolkits to achieve a multiplicity of objectives when faced with external financial shocks.
- Study 2: Strengthening economic growth in South Asia
  - South Asia accounts for one-fifth of the world’s population and contributes more than 15 percent to global growth.
  - With 150 million new labor market entrants expected through 2030, a high-quality, job-rich growth strategy is needed.
  - Policy priorities include strengthening agricultural productivity, promoting sustainable expansion of manufacturing and higher-skilled services, greater domestic revenue mobilization to allow priority spending and fiscal consolidation, further trade and FDI liberalization, and investment in people.

*International Monetary Fund | October 2019*

---

### Growth outlook and drivers

### Revisions and drivers
- Growth in Asia has been revised down by 0.5 percentage point for 2020 since the April forecast.
- Growth will be supported by:
  - the lagged effects of monetary policy easing,
  - a reduction in corporate income tax rates,
  - recent measures to address corporate and environmental regulatory uncertainty,
  - government programs to support rural consumption.
- South Asia will remain an important driver of regional and global growth, leveraging a young and rising labor force.

### Inflation and current accounts
- Inflation across Asia is projected to be subdued at about 2.4 percent in 2019 and 2.6 percent in 2020, reflecting softening demand, and will remain below target in several economies.
- Large current account surpluses tend to be concentrated in advanced economies.

### Key risks (expanded)
- The outlook is clouded by a likely prolonged period of heightened global policy uncertainty.
- Major downside risks include:
  - Further adoption of distortionary trade measures between the United States and China. The baseline forecast assumes continuation of the status quo in US-China bilateral tariffs (continuation of all previously imposed or announced tariffs and retaliation, including the 10 percent tariffs, subsequently increased to 15 percent, on $300 billion of imports from China announced in August with imposition in September and December and the announced increase in tariffs from 25 to 30 percent on the $250 billion basket from October 15) and announced US policy vis-à-vis Chinese technology companies.
  - Tighter financial conditions, including potential reversal of capital flows and higher cost of dollar financing, affecting countries through balance sheet channels.
  - Faster-than-expected slowdown in China, which could weaken external demand, disrupt supply chains, depress confidence and investment, and generate significant negative spillovers across the region.
  - Higher oil prices (for example, following the September 2019 supply shock from attacks on Saudi Arabian production facilities).
  - Trade tensions between Japan and Korea that could affect the technology sector supply chains.
  - Materialization of sociopolitical risks (for example, in Hong Kong SAR or Kashmir) with regional spillovers.
  - High household and corporate debt vulnerabilities and potential property price corrections.
  - Climate change and natural disasters, especially affecting small and low-income economies with fewer buffers.

### Quantified impact of trade policy uncertainty (TPU) scenarios
- Local projections based on a news-based TPU measure suggest:
  - Investment-to-GDP ratio could be about 1½–2 percent lower for two years if the TPU measure remained at peak levels (such as those observed in May 2019).
  - Corporate spreads could increase by 35–50 basis points for one year across Asia if TPU remained at peak levels.
- Model simulations combining shocks imply:
  - The escalation scenario would lower real GDP by about 0.5 percent in China and about 0.3–0.4 percent in countries across the region depending on sensitivity to TPU, exposure to China, and policy credibility.
  - The truce scenario (uncertainty falling to levels observed during the “truce” in March 2019) would provide a boost to GDP, albeit smaller in magnitude than the losses from escalation.

### Policy recommendations to build resilience
- Fiscal policy:
  - Support domestic demand where needed and where there is fiscal space (example countries: Korea, Thailand).
  - Rebuild buffers via fiscal consolidation over the medium term where fiscal space is at risk (example: India).
  - In China, some stimulus could be appropriate to stabilize growth in 2019 and 2020 given the recent round of tariff increases.
- Monetary policy:
  - Generally accommodative and calibrated to local circumstances.
  - Where inflation pressures are subdued and growth is slowing, accommodative monetary policy is desirable (example countries: India, Korea, Philippines, Thailand).
  - Improved market communications and strengthening of the monetary policy framework could help lift inflation expectations (example: Japan).
  - Monetary policy should remain neutral as long as domestic imbalances are small (example: Malaysia).
- Financial sector policies:
  - Strengthen policies to ensure accommodative monetary conditions do not fuel buildup of financial stability risks (example: Japan).
  - Revive bank credit by accelerating cleanup of bank and corporate balance sheets and improving governance of public sector banks (example: India).
  - Closely monitor real estate markets and implement appropriate macroprudential measures where high household debt entails risks (examples: Australia, China, Korea, Malaysia, New Zealand).
  - Deepen financial markets, including more liquid markets for longer-term corporate bonds and currency hedging, to mitigate corporate vulnerabilities and allow the exchange rate to act as a shock absorber.
  - Fiscal policies could also limit the bias toward debt finance.
- Structural policies:
  - Further trade integration, including in services, and product and labor market reforms to offset demand shocks and facilitate adjustment to realigning global supply chains.
  - Upgrade human capital (South Asia) and stimulate labor supply (Japan, Korea, Thailand) through measures such as broadening access to education and vocational training, promoting participation of women and the elderly (for example, expanding childcare facilities and raising the retirement age).
  - Revamp infrastructure, enhance regulatory frameworks, and further open the services sector to private investment (example: ASEAN) to raise potential growth.
  - Implement policies that incentivize lower greenhouse gas emissions (for example, carbon taxes or emission trading systems).
  - Build fiscal buffers for meeting growing financial needs to adapt to climate change and increasing incidence of natural disasters (especially small states).

*International Monetary Fund | October 2019*

---

### 3. Facing the Tides: Managing Capital Flows in Asia

### Key findings on capital flows and macro-financial risks
- Large and volatile capital flows pose a central economic challenge for Asian emerging market economies because they can trigger disruptive swings in exchange rates and financial conditions.
- Capital flows are typically expansionary for the domestic economy and can raise financial system vulnerabilities.
- Capital flows have been—at times—large compared to the size of domestic economies.
- Capital flows associated with the global financial cycle can weaken the effectiveness of monetary policy as a stabilization tool.

### Exchange rate: shock absorber or shock amplifier
- Currency depreciations have two opposing effects:
  - Support activity by improving competitiveness of exporters and import-competing industries.
  - Depress activity by increasing the debt burden of firms with foreign exchange liabilities.
- Firm-level evidence across Asia:
  - A 30 percent currency depreciation shifts 7 percent of firms into a high probability of default category, with stronger effects when the share of foreign exchange debt is high.
  - Depreciation increases firm-level investment on average, but contracts investment in firms with foreign exchange liabilities that are more than 20 percent of their debt.
- Financial development matters:
  - Higher foreign exchange liabilities tend to hurt balance sheets of companies operating in countries with relatively less-developed financial markets.
  - Where markets are shallow, hedging opportunities are fewer or costlier.
- Macro effects:
  - A 1 percent real depreciation lowers the investment ratio by ½ percent when markets are shallow (effect not statistically significant in countries with well-developed markets).
  - A similar effect is observed for GDP growth, although the impact is more short-lived.
- Exchange rate volatility and growth-at-risk:
  - Adverse exchange rate shocks (depreciation or higher exchange rate volatility) can shift the entire GDP growth distribution to the left in less financially developed economies, increasing tail risks.
  - Favorable near-term external shocks (appreciation, lower volatility, easing domestic financial conditions) can pose significant tail risks to growth over the medium term.

### Policy responses: multifaceted and instrument-intensive
- Policy frameworks:
  - Many Asian emerging market economies operate as de facto flexible inflation targeters with quasi-managed floats and pursue multiple objectives of price, growth, and financial stability using a variety of instruments.
- Foreign exchange intervention (FXI):
  - Asian emerging market economies on average absorb about 70 percent of net capital flows through FXI.
  - FXI is used more actively in response to volatile flows such as portfolio flows.
  - FXI in response to outflows (to mitigate depreciation pressures) is more pronounced where corporate foreign exchange liabilities are larger, indicating balance sheet mismatches drive intervention decisions.
  - Countries with greater financial depth rely less on FXI.
- Monetary policy reaction:
  - Monetary policy responds to inflation as expected, but also reacts to:
    - US interest rates, reflecting the global financial cycle,
    - The exchange rate, particularly when financial markets are less developed,
    - Credit growth, reflecting financial stability considerations.
- Macroprudential measures (MPMs):
  - MPMs respond to domestic macro-financial risks and global factors.
  - MPMs are often tightened in periods of strong capital inflows.
  - Reaction estimates indicate MPMs tend to be tightened in periods of lower US policy rates and higher domestic inflation and growth.
  - An increase in credit growth raises the probability of MPM tightening.
- Capital flow management measures (CFMs):
  - CFMs are less frequently used than MPMs.
  - When employed, CFMs are often applied outside of capital flow surge episodes and mostly to address risks in property markets.
  - CFMs have generally been applied more frequently to address inflows than outflows, often through stamp duties and taxes on nonresident property purchases.
  - CFMs and MPMs targeting property markets have generally been tightened in combination.

### Potential costs and trade-offs of the policy mix
- Implementing and communicating a policy framework that uses multiple instruments jointly to achieve multiple objectives is more challenging than single-objective frameworks.
- Potential costs of FXI:
  - Frequent FXI might de-anchor inflation expectations (evidence for this in Asia is weak).
  - FXI may give rise to significant sterilization costs.
  - FXI could hamper development of foreign exchange derivative markets.

### Conclusion: implications for policy
- Managing capital flows while internalizing multiple macroeconomic and financial stability objectives is difficult for emerging market economies in Asia.
- Capital flows are generally beneficial but can be large and volatile, often driven by sentiment shifts in large advanced economies, and tend to be expansionary—fueling domestic credit growth and amplifying financial vulnerabilities.
- Capital flows can induce large exchange rate swings that amplify rather than absorb shocks, exacerbating macro-financial risks.
- Asian economies use multiple instruments (FXI, monetary policy, MPMs, CFMs) to pursue an array of macro-financial objectives, reflecting the complex policy challenges they face when confronted with large and volatile capital flows.
- The data-driven analysis in this section aims to inform ongoing reflection on managing volatile capital flows and exchange rates in Asian emerging market economies.

*International Monetary Fund | October 2019*

### 1.   Overview   1

### 1. Overview

### Key findings
- Asia remains the world’s fastest growing major region and is contributing more than two-thirds to global growth.
- Near-term prospects have deteriorated noticeably since the April 2019 World Economic Outlook, with risks skewed to the downside.
- Growth in Asia is expected to moderate to 5.0 percent in 2019 and 5.1 percent in 2020 (0.4 and 0.3 percentage point lower than projected last April, respectively).
- Global growth is projected to be 3.0 percent in 2019, improving to 3.4 percent in 2020 (0.3 percentage point lower for 2019 and 0.2 percentage point lower for 2020 than the April 2019 WEO forecast).
- For advanced economies, growth is projected to be 1.7 percent in 2019 and 2020 (the report later notes advanced economies projected at 1.3 percent in 2019 and 2020 in a regional context, reflecting broad-based downward revisions).
- Emerging market and developing economies are expected to grow by 3.9 percent in 2019, rising to 4.6 percent in 2020 (forecasts for 2019 and 2020 are 0.5 and 0.2 percentage point lower, respectively, than in April, reflecting downward revisions in all major regions).

### Recent regional developments and statistics
- Global manufacturing activity continued to weaken; trade volume growth decelerated to about 1 percent in the first half of 2019—the slowest pace since 2012.
- Exports in Asian emerging markets have been shrinking since late 2018, largely dragged down by weak intraregional trade, especially with China.
- China: GDP growth slowed to 6.2 percent year over year in the second quarter; high-frequency indicators point to continued weak activity in July and August. Growth is expected to decline moderately to 6.1 and 5.8 percent in 2019 and 2020, respectively (revised down since April by 0.1 percentage point for 2019 and 0.3 percentage point for 2020).
- Japan: recorded strong GDP growth in the second quarter; projected growth is 0.9 percent in 2019 and likely 0.5 percent in 2020.
- India: growth slipped to 5.8 percent year over year in the first quarter of 2019 and decelerated further to 5 percent in the quarter through June 2019; India is set to grow by 6.1 percent in 2019 and 7 percent in 2020 (down 1.2 percentage points for 2019 as reported).
- Korea: GDP grew by 2.1 percent year over year in the second quarter; exports have been falling due to lower global demand for semiconductors and slowdown in China.
- ASEAN-5 economies: growth lost momentum in the first half of 2019 amid weak exports.
- Headline inflation remained subdued in most economies, prompting many Asian central banks to cut policy rates.
- Financial conditions for Asian emerging market economies eased since April, and capital flows to the region have been generally robust following shifts toward more accommodative policy in the US Federal Reserve and the European Central Bank.
- Compressed spreads, higher house prices, and lower interest rates accounted for a relaxation of financial conditions in the region.

### Risks to the outlook
- External downside risks:
  - Possible further deepening of US-China trade tensions.
  - Weaker-than-expected growth of key trading partners.
  - Higher oil prices.
  - A disorderly Brexit.
- Risks within the region:
  - A faster-than-expected slowdown in China.
  - A deepening of regional tensions such as Japan’s and Korea’s bilateral relationship.
  - Rising geopolitical risks.
  - Increased incidence of natural disasters.
- Loosening monetary policy in key advanced economies and easing financial conditions could add to financial vulnerabilities in the region.

### Policy recommendations and priorities
- Use existing fiscal and monetary policy space to smooth domestic demand where warranted, given the expected deceleration in growth.
- Adjust financial sector policies proactively to ensure loosening financial conditions do not fuel a further buildup of financial stability risks.
- Prioritize reducing firm and household leverage where exposures are of concern.
- The cyclical slowdown highlights urgency of structural reforms to lay a foundation for high, inclusive, and environmentally sustainable medium-term growth, including:
  - Further trade liberalization, including reducing nontariff barriers to services trade, and relaxing investment restrictions.
  - Sustained investment in people by upgrading human capital while empowering women and youth.
  - Policies to stimulate labor supply, including higher female labor force participation.
  - Reducing infrastructure gaps and enhancing regulatory frameworks.
  - More ambitious measures to mitigate drivers of climate change while building fiscal buffers to adapt to increasing incidence of natural disasters.

### Thematic studies covered in the report
- Study 1: Management of international capital flows in Asia
  - Finds capital flows can be large, volatile, and disruptive.
  - Policymakers have extensively used foreign exchange interventions to cushion volatile capital flows, particularly where balance sheet mismatches are prevalent and financial markets are shallow.
  - Monetary policy has been deployed in response to inflation and growth shocks and in reaction to US interest rates, the exchange rate, and credit growth.
  - Macroprudential and capital flow management measures have responded to external, domestic macro, and domestic financial stability considerations.
  - Evidence suggests Asian countries deploy their toolkits to achieve a multiplicity of objectives when faced with external financial shocks.
- Study 2: Strengthening economic growth in South Asia
  - South Asia accounts for one-fifth of the world’s population and contributes more than 15 percent to global growth.
  - With 150 million new labor market entrants expected through 2030, a high-quality, job-rich growth strategy is needed.
  - Policy priorities include strengthening agricultural productivity, promoting sustainable expansion of manufacturing and higher-skilled services, greater domestic revenue mobilization to allow priority spending and fiscal consolidation, further trade and FDI liberalization, and investment in people.

*International Monetary Fund | October 2019*

### 0.5 percentage point for 2020 since the April

### 0.5 percentage point for 2020 since the April forecast

### Growth outlook and drivers
- Growth in Asia has been revised down by 0.5 percentage point for 2020 since the April forecast.
- Growth will be supported by:
  - the lagged effects of monetary policy easing,
  - a reduction in corporate income tax rates,
  - recent measures to address corporate and environmental regulatory uncertainty,
  - government programs to support rural consumption.
- South Asia will remain an important driver of regional and global growth, leveraging a young and rising labor force.

### Inflation and current accounts
- Inflation across Asia is projected to be subdued at about 2.4 percent in 2019 and 2.6 percent in 2020, reflecting softening demand, and will remain below target in several economies.
- Large current account surpluses tend to be concentrated in advanced economies.

### Key risks
- The outlook is clouded by a likely prolonged period of heightened global policy uncertainty.
- Major downside risks include:
  - Further adoption of distortionary trade measures between the United States and China. The baseline forecast assumes continuation of the status quo in US-China bilateral tariffs (continuation of all previously imposed or announced tariffs and retaliation, including the 10 percent tariffs, subsequently increased to 15 percent, on $300 billion of imports from China announced in August with imposition in September and December and the announced increase in tariffs from 25 to 30 percent on the $250 billion basket from October 15) and announced US policy vis-à-vis Chinese technology companies.
  - Tighter financial conditions, including potential reversal of capital flows and higher cost of dollar financing, affecting countries through balance sheet channels.
  - Faster-than-expected slowdown in China, which could weaken external demand, disrupt supply chains, depress confidence and investment, and generate significant negative spillovers across the region.
  - Higher oil prices (for example, following the September 2019 supply shock from attacks on Saudi Arabian production facilities).
  - Trade tensions between Japan and Korea that could affect the technology sector supply chains.
  - Materialization of sociopolitical risks (for example, in Hong Kong SAR or Kashmir) with regional spillovers.
  - High household and corporate debt vulnerabilities and potential property price corrections.
  - Climate change and natural disasters, especially affecting small and low-income economies with fewer buffers.

### Quantified impact of trade policy uncertainty (TPU) scenarios
- Local projections based on a news-based TPU measure suggest:
  - Investment-to-GDP ratio could be about 1½–2 percent lower for two years if the TPU measure remained at peak levels (such as those observed in May 2019).
  - Corporate spreads could increase by 35–50 basis points for one year across Asia if TPU remained at peak levels.
- Model simulations combining shocks imply:
  - The escalation scenario would lower real GDP by about 0.5 percent in China and about 0.3–0.4 percent in countries across the region depending on sensitivity to TPU, exposure to China, and policy credibility.
  - The truce scenario (uncertainty falling to levels observed during the “truce” in March 2019) would provide a boost to GDP, albeit smaller in magnitude than the losses from escalation.

### Policy recommendations to build resilience
- Fiscal policy:
  - Support domestic demand where needed and where there is fiscal space (example countries: Korea, Thailand).
  - Rebuild buffers via fiscal consolidation over the medium term where fiscal space is at risk (example: India).
  - In China, some stimulus could be appropriate to stabilize growth in 2019 and 2020 given the recent round of tariff increases.
- Monetary policy:
  - Generally accommodative and calibrated to local circumstances.
  - Where inflation pressures are subdued and growth is slowing, accommodative monetary policy is desirable (example countries: India, Korea, Philippines, Thailand).
  - Improved market communications and strengthening of the monetary policy framework could help lift inflation expectations (example: Japan).
  - Monetary policy should remain neutral as long as domestic imbalances are small (example: Malaysia).
- Financial sector policies:
  - Strengthen policies to ensure accommodative monetary conditions do not fuel buildup of financial stability risks (example: Japan).
  - Revive bank credit by accelerating cleanup of bank and corporate balance sheets and improving governance of public sector banks (example: India).
  - Closely monitor real estate markets and implement appropriate macroprudential measures where high household debt entails risks (examples: Australia, China, Korea, Malaysia, New Zealand).
  - Deepen financial markets, including more liquid markets for longer-term corporate bonds and currency hedging, to mitigate corporate vulnerabilities and allow the exchange rate to act as a shock absorber.
  - Fiscal policies could also limit the bias toward debt finance.
- Structural policies:
  - Further trade integration, including in services, and product and labor market reforms to offset demand shocks and facilitate adjustment to realigning global supply chains.
  - Upgrade human capital (South Asia) and stimulate labor supply (Japan, Korea, Thailand) through measures such as broadening access to education and vocational training, promoting participation of women and the elderly (for example, expanding childcare facilities and raising the retirement age).
  - Revamp infrastructure, enhance regulatory frameworks, and further open the services sector to private investment (example: ASEAN) to raise potential growth.
  - Implement policies that incentivize lower greenhouse gas emissions (for example, carbon taxes or emission trading systems).
  - Build fiscal buffers for meeting growing financial needs to adapt to climate change and increasing incidence of natural disasters (especially small states).

*International Monetary Fund | October 2019*

### 3. Facing the Tides: Managing

### 3. Facing the Tides: Managing Capital Flows in Asia

### Key findings on capital flows and macro-financial risks
- Large and volatile capital flows pose a central economic challenge for Asian emerging market economies because they can trigger disruptive swings in exchange rates and financial conditions.
- Capital flows are typically expansionary for the domestic economy and can raise financial system vulnerabilities.
- Capital flows have been—at times—large compared to the size of domestic economies.
- Capital flows associated with the global financial cycle can weaken the effectiveness of monetary policy as a stabilization tool.

### Exchange rate: shock absorber or shock amplifier
- Currency depreciations have two opposing effects:
  - Support activity by improving competitiveness of exporters and import-competing industries.
  - Depress activity by increasing the debt burden of firms with foreign exchange liabilities.
- Firm-level evidence across Asia:
  - A 30 percent currency depreciation shifts 7 percent of firms into a high probability of default category, with stronger effects when the share of foreign exchange debt is high.
  - Depreciation increases firm-level investment on average, but contracts investment in firms with foreign exchange liabilities that are more than 20 percent of their debt.
- Financial development matters:
  - Higher foreign exchange liabilities tend to hurt balance sheets of companies operating in countries with relatively less-developed financial markets.
  - Where markets are shallow, hedging opportunities are fewer or costlier.
- Macro effects:
  - A 1 percent real depreciation lowers the investment ratio by ½ percent when markets are shallow (effect not statistically significant in countries with well-developed markets).
  - A similar effect is observed for GDP growth, although the impact is more short-lived.
- Exchange rate volatility and growth-at-risk:
  - Adverse exchange rate shocks (depreciation or higher exchange rate volatility) can shift the entire GDP growth distribution to the left in less financially developed economies, increasing tail risks.
  - Favorable near-term external shocks (appreciation, lower volatility, easing domestic financial conditions) can pose significant tail risks to growth over the medium term.

### Policy responses: multifaceted and instrument-intensive
- Policy frameworks:
  - Many Asian emerging market economies operate as de facto flexible inflation targeters with quasi-managed floats and pursue multiple objectives of price, growth, and financial stability using a variety of instruments.
- Foreign exchange intervention (FXI):
  - Asian emerging market economies on average absorb about 70 percent of net capital flows through FXI.
  - FXI is used more actively in response to volatile flows such as portfolio flows.
  - FXI in response to outflows (to mitigate depreciation pressures) is more pronounced where corporate foreign exchange liabilities are larger, indicating balance sheet mismatches drive intervention decisions.
  - Countries with greater financial depth rely less on FXI.
- Monetary policy reaction:
  - Monetary policy responds to inflation as expected, but also reacts to:
    - US interest rates, reflecting the global financial cycle,
    - The exchange rate, particularly when financial markets are less developed,
    - Credit growth, reflecting financial stability considerations.
- Macroprudential measures (MPMs):
  - MPMs respond to domestic macro-financial risks and global factors.
  - MPMs are often tightened in periods of strong capital inflows.
  - Reaction estimates indicate MPMs tend to be tightened in periods of lower US policy rates and higher domestic inflation and growth.
  - An increase in credit growth raises the probability of MPM tightening.
- Capital flow management measures (CFMs):
  - CFMs are less frequently used than MPMs.
  - When employed, CFMs are often applied outside of capital flow surge episodes and mostly to address risks in property markets.
  - CFMs have generally been applied more frequently to address inflows than outflows, often through stamp duties and taxes on nonresident property purchases.
  - CFMs and MPMs targeting property markets have generally been tightened in combination.

### Potential costs and trade-offs of the policy mix
- Implementing and communicating a policy framework that uses multiple instruments jointly to achieve multiple objectives is more challenging than single-objective frameworks.
- Potential costs of FXI:
  - Frequent FXI might de-anchor inflation expectations (evidence for this in Asia is weak).
  - FXI may give rise to significant sterilization costs.
  - FXI could hamper development of foreign exchange derivative markets.

### Conclusion: implications for policy
- Managing capital flows while internalizing multiple macroeconomic and financial stability objectives is difficult for emerging market economies in Asia.
- Capital flows are generally beneficial but can be large and volatile, often driven by sentiment shifts in large advanced economies, and tend to be expansionary—fueling domestic credit growth and amplifying financial vulnerabilities.
- Capital flows can induce large exchange rate swings that amplify rather than absorb shocks, exacerbating macro-financial risks.
- Asian economies use multiple instruments (FXI, monetary policy, MPMs, CFMs) to pursue an array of macro-financial objectives, reflecting the complex policy challenges they face when confronted with large and volatile capital flows.
- The data-driven analysis in this section aims to inform ongoing reflection on managing volatile capital flows and exchange rates in Asian emerging market economies.

*International Monetary Fund | October 2019*

### 0.3 percentage point.

### 0.3 percentage point.

### Manufacturing
- If expanded sustainably, manufacturing could complement services in creating job-rich growth.
- Cross-country estimates of employment elasticities to gross exports suggest a more substantial boost to employment could come from increasing manufacturing exports, compared to services.
- South Asia has scope to climb the global quality ladder by producing more complex varieties of existing products to build on its comparative advantage.

### The Policy Agenda
- Core objective: create more and better jobs by investing in people, supporting private-sector-led investment, and improving resource allocation, anchored in sound macroeconomic management and financial stability.
- Secure debt sustainability:
  - Pressing need for fiscal consolidation given still elevated fiscal deficits and public debt levels in most economies in the region.
  - Make space for much-needed infrastructure investment and social spending.
  - In India and Bangladesh, fiscal consolidation would help reduce financial repression given reliance on the banking system for financing.
  - Since tax revenues remain low by international standards, notably in Bangladesh and Sri Lanka, greater revenue mobilization is recommended via:
    - a broader tax base,
    - greater tax efficiency,
    - streamlined tax exemptions,
    - stronger tax administration.
  - Transparent and prudent management of contingent liabilities from public investment projects, public-private partnerships, state-owned enterprises, and other off-budget expenditures is critical.
- Guarantee efficient credit provision and safeguard financial stability:
  - State-owned banks play an important role in financing private and public investment.
  - Empirical literature (World Bank 2013) shows state-owned banks tend to have weaker performance compared to private and foreign banks in India and Bangladesh.
  - A smaller state footprint in the financial sector could strengthen financial intermediation and resource allocation.
  - South Asia could gain from catching up with regional peers on financial inclusion, especially through greater use of fintech.
- Open further to trade and foreign direct investment and improve infrastructure:
  - Average tariff rate remains relatively high at 10 percent in 2016, with significant nontariff barriers (cumbersome trade documentation, long processing times).
  - Further trade liberalization would support economic activity and integration into global supply chains.
  - Investment constraints include caps in India, negative lists in Bhutan, and complex approval systems in Nepal.
  - Rapid development will require large investments in infrastructure across the region, including energy, transport, water, and urban services, facilitated by land reforms.
- Prepare the workforce for the challenges of the 21st century:
  - Invest in human capital and address the sizable informal sector.
  - Spending on education in South Asia is broadly in line with peers, but scope exists to improve coverage and quality.
  - India: tertiary education investment supported the high-skill service sector, but further efforts needed to broaden access to quality primary education and boost literacy.
  - Greater investment in research and development by public and private sectors could generate high returns given South Asia’s distance from the technological frontier.
  - Reducing significant gender gaps and further empowering women would benefit the main economies.

### Building the Reform Momentum
- Under a substantial liberalization scenario, supported by stepped-up infrastructure improvement and harnessing South Asia’s young and large workforce:
  - The region could contribute about one-third of global growth by 2040.
  - This is 5 percentage points higher than the expected contribution under the current baseline scenario.
- Growth scenarios for the region (long term, average):
  - Accelerated reform scenario: real GDP growth would surpass 6.5 percent.
  - Current baseline: nearly 6 percent.
  - Downside scenario (demographic dividend not secured): 5 percent.
- India-specific projections:
  - Real GDP could be boosted by 20 percent by 2040 under reform.
  - Per capita income could rise to about 50 percent of that in the United States by 2040.
- Policy implementation notes:
  - Clear communication on reform benefits and prioritization by expected macro-structural impact are key to building momentum.
  - Stronger social safety nets are important to support difficult structural reforms and minimize distributional impacts.
  - New policies must remain mindful of fiscal, financial, and environmental risks.

### Annex 1 — The Risks of Heightened Trade Policy Uncertainty (TPU)
- Context and methodology:
  - TPU measures are constructed using country-specific news-chatter algorithms counting articles that meet defined criteria within a database of over 650 million news articles.
  - Sample economies include: Australia, China, Hong Kong Special Administrative Region, India, Indonesia, Korea, Malaysia, New Zealand, the Philippines, Singapore, Taiwan Province of China, Thailand, and Vietnam.
  - TPU mapping to economic variables uses Jordà (2005) local projections with controls including fiscal and monetary policy uncertainty.
  - Two local projections models:
    1. Confidence shock: regress investment-to-GDP ratio on TPU and controls.
    2. Financial market shock: regress corporate spreads on TPU and controls.
- Empirical findings:
  - Increases in TPU are associated with declines in investment/GDP and higher corporate spreads.
  - The investment-to-GDP ratio drops and continues falling over a two-year period before dissipating.
    - Under robustness checks, magnitudes range from -0.5 to -1.0 percent and generally last for about two years.
  - Corporate spreads rise following an increase in TPU; the effect appears contained to one year.
- Scenario construction:
  - Escalation scenario: difference between 2017q4 and the maximum value of TPU between 2018q1 and 2019q2.
  - Truce scenario: difference between 2019q1 and the maximum TPU from 2018q1 to 2019q1.
- Scenario implications (Asia):
  - Under escalation:
    - Investment-to-GDP ratio could be about 1½-2 percent lower for two years in advanced and emerging Asia.
    - Corporate spreads could increase 35-50 basis points for one year.
  - Under truce:
    - Investment-to-GDP would get a significant boost and corporate spreads would shrink, but magnitudes are smaller than under escalation.
- GIMF model integration and macro effects:
  - Shocks to investment and corporate spreads are introduced into GIMF to capture interaction and spillovers.
  - Mechanism: lower investment → reduced productive capacity → depressed real GDP → lower wealth → reduced consumption → further GDP decline; real exchange rate depreciates, with heterogeneous impacts across economies.
  - Model results:
    - China: about 0.5 percent lower real GDP under escalation.
    - Emerging Asia: around 0.4 percent lower real GDP.
    - Advanced Asia: close to 0.3 percent lower real GDP.
    - Some economies could experience trade diversion gains; others could face larger losses from actual tariff implementations.
  - Truce scenario dynamics are similar but expansionary and smaller in magnitude.
- Comparison to prior estimates:
  - Relative to October 2019 WEO estimates, financial effects are smaller and confidence effects slightly larger for Asian economies.
  - The combined confidence and financial effects from the TPU methodology are around 10 to 20 percent smaller than those of the October 2019 WEO.
  - Impact of TPU on growth in Asia under escalation is broadly in line with Caldara and others (2019).

*Source: Regional Economic Outlook, Asia and Pacific, October 2019 — excerpt.*

---


_Source: https://www.imf.org/-/media/files/publications/reo/apd/2019/oct/english/text.pdf_