## Regional Economic Outlook — Asia and Pacific, October 2025

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---

### Executive Summary: Outlook and Key Projections
- The Asia and the Pacific region is projected to contribute about 60 percent of global growth in 2025.
- Regional GDP growth:
  - 4.5 percent in 2025 (steady relative to 2024).
  - 4.1 percent in 2026 (projected decrease).
- 2025H1 outcomes:
  - Growth in the first half of 2025 was stronger than expected, supported by strong exports (partly frontloaded ahead of higher tariffs), a buoyant tech cycle, and monetary and fiscal policy easing amid globally accommodative financial conditions and US dollar depreciation.
  - The 2025 deceleration is smaller than predicted in April 2025, largely because of a lower increase in US effective tariff rates compared to announcements at the time.

### Recent Developments: Resilience amid Uncertainty
- Trade shocks and trade policy uncertainty (TPU):
  - Sweeping US tariff increases announced on April 2, 2025, underpin the highest effective US tariff rate in a century and sharply raised trade policy uncertainty.
  - TPU rose substantially with tariff announcements and contributed to heightened external pressures on the region.
  - Some tariff increases were paused or reduced amid negotiations; tariffs for some other countries increased markedly in August; TPU remains high.
- Domestic constraints and demand:
  - Consumption remains below pre-pandemic trends in many countries; service sector weaknesses, property downturns, and sluggish consumer sentiment weigh on job and income recovery.
  - Institutional constraints limiting domestic demand recovery include limited scope for fiscal support because of high debt; inadequate social safety nets; and inefficiencies in the financial structure.
- Financial conditions and capital flows:
  - Financial conditions broadly eased in 2025 after brief tightening in April, reflecting lower corporate spreads, buoyant equity markets, and a weaker US dollar.
  - In Asian emerging markets, easing reflected declines in 10-year government bond yields and decreasing term premia (term premia decrease began in 2023 driven primarily by soft inflation).
  - Portfolio inflows to Asian emerging markets have resumed in recent months with the weaker dollar, recovering some early-2025 losses.

### Key Country and Regional Projections (selected)
- Asia: around 60 percent of global growth in 2025 and 2026.
- Advanced Asia: 1.6 percent in 2025.
- Japan:
  - 2025 growth: 1.1 percent (from 0.1 percent in 2024).
  - 2026 growth: 0.6 percent.
  - 2025 inflation: 3.3 percent; 2026: 2.1 percent.
- Australia: GDP growth 1.8 percent in 2025 (up from 1.0 percent in 2024).
- New Zealand: GDP growth 0.8 percent in 2025 (up from −0.6 percent in 2024).
- Korea: GDP growth 0.9 percent in 2025 (down from 2.0 percent in 2024).
- Emerging Asia: growth projected to slow to 5.2 percent in 2025 (from 5.3 percent in 2024).
- China: growth expected to moderate to 4.8 percent in 2025 (from 5.0 percent in 2024); projected 4.2 percent in 2026. Inflation: 0 percent in 2025 (down from 0.2 in 2024); 0.7 in 2026.
- India: projected to expand at 6.6 percent in 2025 (up from 6.5 percent in 2024); 6.2 percent in 2026.
- ASEAN: projected to slow to 4.3 percent in 2025 from 4.8 percent in 2024.
- Frontier and small states: Bangladesh FY2025 growth 3.8 percent; Mongolia 2025 GDP growth 5.5 percent; Nepal 2025:H1 GDP growth 4.3 percent.
- Pacific Island Countries (simple average) 2025 GDP growth projected to moderate to 2.9 percent from 3.6 percent in 2024.

### Inflation outlook (selected)
- Advanced Asia inflation: 2.5 percent in 2025 (down from 2.6 percent in 2024); 2.1 percent in 2026.
- Emerging Asia disinflation: 1.6 percent in 2025 (down from 2 percent in 2024); expected to return to 2 percent in 2026.

### Risks to the Outlook
- Downside risks (tilted):
  - Full negative effect of the tariff increases remains uncertain; intensifying trade tensions remain a major downside risk.
  - High TPU could weigh on investment and sentiment more than expected.
  - Tighter financial conditions due to domestic or global developments could amplify trade shocks and compound vulnerabilities.
  - Economic vulnerabilities could amplify social tensions.
- Upside risks:
  - AI-driven investment boom could deliver a stronger-than-expected boost to exports, investment, and productivity.
  - Further policy support could cushion shocks and lift growth prospects.
  - Reduction in geopolitical tensions would reduce uncertainties and lift investment and productivity.

### Structural Challenges and Productivity
- Broad-based productivity gains have stalled; capital misallocation has risen.
- Trade openness supported manufacturing growth, but domestic demand shortcomings and institutional/financial limitations hindered balanced recoveries.
- Reinvigorating productivity growth is essential to address medium-term headwinds to potential growth.

### Policy Recommendations (near-term and medium-term)
- Near-term:
  - Use targeted fiscal and monetary policy to smooth the impact of trade shocks and provide temporary support.
- Medium-term structural reforms:
  - Boost domestic demand, particularly consumption.
  - Support the services sector to address persistent underperformance.
  - Strengthen the efficiency of financial intermediation.
  - Reduce incentives for capital misallocation.
  - Mitigate the economic impact of population aging.
  - Promote greater intraregional trade and financial integration to enhance growth resilience and support financial development.
- Policy framework upgrades:
  - Fiscal reforms to manage large spending pressures and prepare for future shocks.
  - Monitor emerging challenges and opportunities in artificial intelligence (AI) and refine regulatory frameworks as needed.

---

### 2. Youth Unemployment: Emerging and Developing — Trade shocks, Growth, and Domestic Demand
- Geoeconomic shifts are redefining global trade and FDI patterns; Asia Pacific is "particularly vulnerable" due to deep integration into global value chains and rising exposure to United States demand.
- 2025H1 resilience:
  - Growth outturns in the first half of 2025 exceeded expectations relative to the April 2025 WEO.
  - Exports surged early in 2025, in part due to front-loading ahead of higher US tariffs; net exports remained a key growth driver.
- Exports and intraregional shifts:
  - Asian exports to the United States lost momentum in Q2 after accelerating from 2024 through early 2025; exports to the region and elsewhere remain robust.
  - China’s exports to the United States as a share of its total exports continued to decline; share to Asian partners increased, reflecting redirection of intermediate goods to ASEAN.
  - FDI into ASEAN economies has stayed strong; announcements suggest ongoing supply chain diversification.
- Domestic demand weakness:
  - 2025H1 contributions from domestic demand steady or declining across most countries (except Japan).
  - Retail sales growth generally remains below pre-pandemic average.
  - Negative output gaps and soft domestic demand contributed to inflation being below target in many Asian emerging markets.
  - Policy actions: China, Korea, Indonesia introduced fiscal stimulus measures; most countries’ 2025 fiscal impulse more expansionary than in 2024; most Asian economies eased monetary policy in response to low inflation; BOJ gradually raising policy rate (most recent hike in January).
- Cyclical and structural headwinds:
  - Private consumption in large emerging markets remains firmly below pre-pandemic trends.
  - Service-sector weaknesses (trade, transport, accommodation) remain headwinds to jobs and income growth.
  - Tourist arrivals recovered more slowly than in other regions and are persistently below the 2015–19 trend.
  - High household debt and housing cycle downturns damp consumer demand and construction in Thailand, New Zealand, China, Cambodia.
  - Institutional and structural challenges: limited fiscal scope, inadequate social safety nets, and inefficiencies in financial intermediation.

---

### 2. Financial Conditions across the World — Channels of Vulnerability and AI Cycle
- Financial Conditions Index (FCI) decomposition includes FX, corporate bond spread, equity price, and 10-year yield across regions (2010–2025 coverage).
- US dollar and portfolio flows:
  - Charts show portfolio flows (USD millions) and DXY index monthly Jan-24 through Aug-25 (portfolio flows axis −80,000 to 80,000).
- Vulnerability channels:
  - A one-standard-deviation increase in US trade policy uncertainty reduces investment in Asia by about 1 percent in the near term; effects about twice as large in emerging market economies.
  - Effective US tariffs on Asian economies are lower than initially announced; some agreements remain under negotiation with the possibility of higher tariffs.
  - High share of Chinese value added embedded in regional exports creates exposure to potential “transshipment” tariffs.
  - Decline in China’s export prices may risk negative spillovers to regional economies, especially in ASEAN.
- Corporate and external debt vulnerabilities:
  - Corporate debt-at-risk in Asian emerging markets has climbed; “zombie firms” noted.
  - Several ASEAN countries face increased external debt exposure; rollover risks and balance sheet distress may arise from external tightening.
  - Rapid population aging adds to long-term fiscal pressures.
  - Debt-at-risk metric: share of total debt held by firms with an Interest Coverage Ratio (ICR) below 1; firm-level ICR calculated using four-quarter average; underlying variables winsorized at 5%.
- Technology (AI) cycle:
  - AI-driven investment boom expected to continue in 2025 and 2026, partly offsetting tariff drags.
  - Upside: stronger-than-expected AI cycle could raise investment, exports, and productivity; region shows above average AI preparedness.
  - Downside: stretched AI asset valuations pose financial risks; an investor correction on AI optimism could tighten financial conditions.

### Policy recommendations (macro-financial)
- Monetary policy:
  - Monetary policy easing is appropriate in countries with inflation below target; additional easing may be expected in many countries to bring inflation back to target and anchor expectations.
  - Weakening US dollar has reduced capital outflow pressures and provided room for policy rate cuts where needed.
  - Japan: gradual normalization of monetary policy can support convergence toward the 2 percent target if the baseline materializes.
  - Exchange rate flexibility should be the first line of defense; judicious FX intervention could be used in line with the Fund’s integrated policy framework.
- Fiscal policy:
  - Temporary and targeted fiscal measures could support demand and vulnerable groups affected by the tariff shock; near-term stance should be calibrated to country circumstances.
  - China, Korea, and Vietnam introduced sizable fiscal packages to support demand and fund priority programs announced before the tariff shock.
  - Countries with high public debt should balance expansionary fiscal policy with medium-term consolidation to preserve debt sustainability.
  - Improve adequacy and coverage of social safety nets, especially for the bottom 20 percent of the income distribution.
- Structural reforms:
  - Productivity-enhancing reforms, further trade and financial integration, and additional macroeconomic policy support and structural reforms can help navigate challenging global environment.

---

### Fiscal Impulse over Time: Structural and Financial Reforms
- Structural reforms to support growth and rebalancing:
  - Address structural impediments promptly to accelerate reforms that address imbalances, boost productivity, and enhance resilience.
  - Support continued expansion of the service sector; reforms to improve financial intermediation and capital market development are essential to channel credit into productive service sectors.
- Financial reforms:
  - Rising capital misallocation associated with decline in productivity growth; diversify financial structure through capital market development to relax constraints and support productive firms and innovation.
  - Use macroprudential intervention in real estate and other high-risk credit segments; strategies needed to reduce risks from high debt morphing into debt overhangs.
  - Country examples: Thailand and Korea measures to tackle household debt; Chinese steps to refinance developer and LGFV debt but more restructuring needed for non-viable entities.
- Fiscal reforms and public balance sheet management:
  - Upgrade medium-term frameworks, expand fiscal coverage to include public banks, SOEs, and subnational governments, and develop a broader view of the public balance sheet.
  - Small and low-income states: mobilize domestic revenues and reprioritize spending where needed amid potential declines in international aid flows.
- Labor market and demographic policies:
  - Rapidly diminishing labor supply due to aging in China, Japan, Korea will dampen potential growth.
  - Policies: increase labor force participation, enhance employee training, integrate foreign workers.
- AI adoption:
  - AI can lift potential growth and offset aging impacts but could increase inequality, exacerbate productivity gaps between large firms and SMEs, and displace workers.
  - Policy responses: support AI integration and adoption in SMEs, reskilling, and strengthen social safety nets.
- Regional trade and financial integration:
  - Removing intra-regional barriers—even unilaterally—would positively affect competition, productivity, and growth.
  - Lowering FDI restrictions and enhancing competitiveness can attract shifting supply chains.
  - Deeper regional financial integration could reduce vulnerabilities to global shocks; reforms should be carefully sequenced.

### Effects of Trade Policy Uncertainty (key numeric findings)
- TPU surged to historical highs in 2025, peaking in April after US tariff announcements.
- Bilateral TPU index: recent TPU shock averaged five standard deviations across the region.
- Empirical panel (Jan 1995–Apr 2025): a one standard deviation increase in TPU leads to a 1 percent decline in investment within the same quarter; a five standard deviation shock implies a temporary 5 percent decline in investment.
- Investment effect stronger in emerging markets—about twice as large as in advanced economies.
- Short-term effects on exports limited; over about 40 months, investment decline translates into weaker export capacity.
- No evidence of trade frontloading in response to TPU spikes; no systematic impact on the US dollar around TPU episodes.

### Financial spillovers (selected indicators)
- Empirical analysis covers eight countries (Australia, China, India, Indonesia, Korea, Malaysia, New Zealand, Thailand) over August 2005–April 2025 in some specifications.
- On average across regional EMs, local-currency government debt increased from 26.5 to 44 percent of GDP over the past decade.
- Foreign holdings of local-currency government bonds dropped from around 20 percent in 2011 to around 10 percent now.

---

### Box 1.3 — Risk Assessment: Scenario Analysis for Asia (GIMF model)
- Methodology:
  - Uses the Fund’s Global Integrated Monetary and Fiscal (GIMF) model to simulate Scenario A (downside) and Scenario B (upside). Monetary policy reacts endogenously; most regions assumed to have flexible exchange rates; in Scenario A China’s exchange rate is managed through capital flow measures.
- Scenario A (Downside) assumptions and impacts:
  - Assumptions:
    - Additional permanent increase of US tariffs—by 10 percentage points on average, and by 30 percentage points on imports from China—without retaliation.
    - Global supply chains temporarily disrupted, lowering world TFP by about 1 percent in 2026–27.
    - Sovereign yields rise by 100 basis points through higher term premia (except in China).
    - Corporate spreads widen, more markedly in emerging markets.
    - Reduced foreign demand for US assets raises US risk premia.
  - Regional GDP impacts (percent deviation from baseline):
    - China: output drops by −1.3 percentage points relative to baseline after one year.
    - Rest of Asia: output declines by −0.3 percent in 2026, troughing at −0.8 percent in 2029.
    - World ex. Asia: output declines by up to −0.6 percent, on average, over the 2028–2030 period.
    - With global tighter financial conditions amplifying effects:
      - GDP in the Rest of Asia declines by up to 1.7 percent in 2027–28.
      - China’s contraction reaches 1.6 percent in 2026.
  - Dynamic: US dollar depreciation tends to benefit EM Asia as their currencies are generally less flexible against the dollar, supporting external demand and partially offsetting drag from higher real interest rates.
- Scenario B (Upside) assumptions and impacts:
  - Assumptions:
    - Tariffs imposed since January 2025 are permanently removed.
    - Imports from China see the largest decrease in effective tariff rates (about 22 percentage points), followed by Japan, Europe, and emerging Asia (10–20 percentage points).
    - Trade policy uncertainty declines.
    - AI provides higher-than-expected boost to productivity (TFP +0.8 percent over 10 years).
  - Regional GDP impacts (percent deviation from baseline):
    - China and the Rest of Asia see a GDP increase of 0.5 percentage points above the baseline.
    - Rest of Asia: GDP rises by 1.1 percentage points above the baseline in 2026 (driven by reduced TPU and a more favorable environment for investment).
    - With faster AI-driven productivity growth:
      - Output in China increases by 1.2 percent in 2026 (effect peaks after four years).
      - Output in the Rest of Asia is boosted by 1.3 percent in 2026 before gradually waning.
    - Outside Asia: output remains steadily above +1.1 percent, on average, over the 2027–2030 period.
- Key quantitative assumptions reiterated:
  - US tariffs increase in Scenario A: 10 percentage points on average; 30 percentage points on imports from China.
  - World TFP hit in Scenario A: about 1 percent in 2026–27.
  - Sovereign yields shock in Scenario A: rise by 100 basis points (except in China).
  - Tariff reductions in Scenario B: about 22 percentage points for imports from China; 10–20 percentage points for Japan, Europe, and emerging Asia.
  - AI productivity boost in Scenario B: TFP +0.8 percent over 10 years.

---

### 2. Reshaping Value Chains: The Case for Deeper Asia-Pacific Trade Integration
- Current patterns and gaps:
  - Asia-Pacific is highly integrated in intermediate goods trade but has lower intra-regional trade in final goods relative to Europe and North America.
  - Trade agreements are predominantly bilateral or bilateral with a regional bloc (ASEAN), contributing to overlapping rules and inconsistent standards.
- Depth of trade agreements and NTBs:
  - Depth index: number of legally enforceable provisions out of 52; Asia-Pacific depth scores tend to be lower than Europe and North America, especially beyond WTO mandate areas (competition policy, environmental protection, e-commerce).
  - NTBs prevalent in South Asia and parts of ASEAN (index 0―20); NTBs affect both intermediate and final goods trade and may hinder final goods trade.
- Quantifying gains from deeper integration (model based on Cuñat and Zymek (2024)):
  - Scenario: move from current depth to maximum depth (complete coverage of legally enforceable provisions).
  - Long-term gains average about 1.8 percent of GDP for the whole region.
  - Most gains come from unilateral action reducing own NTBs; gains are amplified when all Asia-Pacific economies lower barriers.
  - Heterogeneity:
    - Smaller economies gain more than larger economies.
    - Countries exporting with higher shares of intermediates (e.g., Korea) obtain larger benefits.
    - Gains increase with the gap between starting depth and target depth (important for South Asia and economies with uneven integration).
  - Additional gains possible even if the rest of the world does not reciprocate.
  - Partial integration steps still deliver significant gains.
- Policy implications:
  - Continue openness to trade and investment; deepen regional agreements and improve coherence across overlapping arrangements.
  - Lower NTBs and broaden legally enforceable provisions beyond WTO mandates.
  - Support adjustment via social protection and active labor market policies.
  - Complementary policies: enhance cost competitiveness, liberalize FDI restrictions, improve macro stability and investment efficiency.

---

### Investment Efficiency and Capital Allocation: Key Findings and Policy Priorities
- Investment trends and efficiency:
  - Investment has stayed robust, but investment efficiency declined after the global financial crisis; ICOR rose over time (Asia levels generally higher; efficient considered less than 3–4).
  - Average return on assets (ROA) for listed firms (ex-financial sector) dropped significantly across the region compared to pre-global financial crisis period.
  - Misallocation:
    - Dispersion in marginal revenue product of capital (MRPK) across firms within sectors increased by about 25 percent between pre- and post-global financial crisis periods, lowering TFP.
    - Services sectors show higher MRPK dispersion—services account for a higher proportion of allocative inefficiency.
  - Zombie firms:
    - Share of firms classified as zombie firms in total debt almost tripled for the Asia-Pacific region after the global financial crisis, while marginally declining in the RoW.
  - Financing structure:
    - Listed Asian firms’ reliance on external financing has fallen since the global financial crisis, while net savings increased—suggesting financing constraints or instrument mismatch.
    - Within industries and countries, leverage increased for larger firms, indicating a shift of financial resources from smaller toward larger, less productive firms.
    - Debt finance through banks dominates; nonbank private sector financing remains small.
- Drivers and mechanisms:
  - Financial intermediation contributed to declining investment efficiency through financing constraints for smaller, productive firms; allocation toward larger, less productive firms; and lack of market-based instruments.
  - Evergreening increased, supported by implicit state support, weak insolvency laws, and easy financing.
- Empirical evidence and implications:
  - Financing constraints curtailed growth by limiting small and young firms’ expansion; impact larger in Asia.
  - Rising financial misallocation plausibly contributed to rising capital misallocation.
  - Improvements in financial intermediation and capital efficiency expected to boost jobs, income, and domestic demand.
- Policy recommendations:
  - Improve financial intermediation to meet scale and mix of financing needs; diversify away from bank debt toward market-based instruments (equity financing) suited to innovative firms.
  - Reform listing procedures, expand bond market access for SMEs, build domestic institutional investor base to mobilize long-term capital.
  - Strengthen insolvency frameworks and implement strategies to restructure nonviable debt to limit evergreening and resolve zombie firms.
  - Consider trade-offs of interest rate controls and financial repression; monitor prevalence of interest rate controls given recent reversals in some economies.
  - Tailor policies by development stage: access to finance dominant constraint in lower-income countries; mix of financing increasingly important with development.
- Gazelles and growth dynamics:
  - Gazelles underrepresented and underfinanced in Asia (under 2 percent of new entrants); support via venture capital and nonbank alternatives recommended.
- Country example — Vietnam:
  - Misallocation sizable and rising; capital misallocation main source since COVID-19, especially in services (real estate services).
  - Preferential credit policies (SOE preferential access, land allocation as collateral) contributed to misallocation.
  - Potential gains from removing misallocation: moving to efficiency frontier could raise aggregate TFP by over 50 percent (IMF 2025, forthcoming).
- Conclusion:
  - Priorities: broaden financial access, develop capital markets, restructure nonviable debt, strengthen financial oversight, and sequence reforms to mobilize long-term financing to support rebalancing and resilience.

*International Monetary Fund, Regional Economic Outlook — Asia and Pacific (data and text as of September 29, 2025).*

### Executive Summary.....................................................................................................vi

### Executive Summary

### Outlook and Key Projections
- The Asia and the Pacific region is projected to contribute about 60 percent of global growth in 2025.
- Regional GDP growth is projected at 4.5 percent in 2025 (steady relative to 2024), and to decrease to 4.1 percent in 2026.
- The December 2024–2025 outcomes: regional growth in the first half of 2025 was stronger than expected, supported by strong exports (partly frontloaded in expectation of higher tariffs), a buoyant tech cycle, and monetary and fiscal policy easing amid globally accommodative financial conditions and US dollar depreciation.
- The 2025 deceleration is smaller than predicted in April 2025, largely because of a lower increase in US effective tariff rates compared to announcements at the time.

### Recent Developments: Resilience amid Uncertainty
- External shock: sweeping US tariff increases announced on April 2, 2025—described as underpinning the highest effective US tariff rate in a century, with some of the steepest increases aimed at Asia—have sharply raised trade policy uncertainty.
- Trade policy uncertainty (TPU) rose substantially with tariff announcements and contributed to heightened external pressures on the region.
- Domestic constraints: consumption remains below pre-pandemic trends in many countries, with persistent weaknesses in the service sector, property sector downturns, and sluggish consumer sentiment weighing on post-pandemic recovery in jobs and income growth.
- Institutional constraints limiting domestic demand recovery include:
  - limited scope for fiscal support because of high debt;
  - inadequate social safety nets; and
  - inefficiencies stemming from the financial structure.

### Risks to the Outlook
- Risks are tilted to the downside:
  - The full negative effect of the tariff increases remains uncertain and the intensification of trade tensions continues to be a major downside risk.
  - Trade policy uncertainty, while lower than in April, remains high and could weigh on investment and sentiment more than expected.
  - Tighter financial conditions due to domestic or global developments could amplify trade shocks and compound vulnerabilities.
  - Economic vulnerabilities could amplify social tensions.
- Upside risks:
  - The current AI-driven investment boom could deliver a stronger-than-expected boost to exports, investment, and productivity.
  - Further policy support could cushion shocks more than expected and lift growth prospects.
  - A reduction in geopolitical tensions would help reduce uncertainties and lift investment and productivity.

### Structural Challenges and Productivity
- Broad-based productivity gains have stalled in recent years in the region, alongside a rise in capital misallocation.
- While trade openness supported manufacturing growth, domestic demand shortcomings and institutional/financial limitations have hindered more balanced recoveries.
- Reinvigorating productivity growth is essential to address medium-term headwinds to potential growth.

### Policy Recommendations
- Near-term policy stance:
  - Use targeted fiscal and monetary policy to smooth the impact of trade shocks and provide temporary support.
- Medium-term structural reforms to bolster resilient and sustainable growth:
  - Boost domestic demand, particularly consumption.
  - Support the services sector to address persistent underperformance.
  - Strengthen the efficiency of financial intermediation.
  - Reduce incentives for capital misallocation.
  - Mitigate the economic impact of population aging.
  - Promote greater intraregional trade and financial integration to enhance growth resilience and support financial development.
- Policy framework upgrades:
  - Fiscal reforms to manage large spending pressures and prepare for future shocks.
  - Monitor emerging challenges and opportunities in artificial intelligence (AI) and refine regulatory frameworks as needed.

*Source: Regional Economic Outlook—Asia and Pacific, Executive Summary (data and text as of September 29, 2025).*

### 2. Youth Unemployment: Emerging and Developing

### 2. Youth Unemployment: Emerging and Developing

### Trade shocks, geoeconomic shifts, and regional vulnerability
- Actions and ensuing negotiations are "redefining the geoeconomic landscape and reshaping patterns in global trade and foreign direct investment (FDI)."
- Asia Pacific is "particularly vulnerable" due to deep integration into global value chains and "rising exposure to United States demand."
- Some tariff shocks were "smaller than expected in April" as "some tariff increases were paused or reduced amid negotiations," while "tariffs for some other countries increased markedly in August."
- Trade policy uncertainty "continues to be high."

### Growth performance and 2025H1 resilience
- Economic growth in the current decade so far is about "1.8 percentage points below that of average in the 2010s—0.9 in advanced Asia and 2.3 in emerging Asia."
- "Asia has remained the fastest growth region in the world, contributing about 60 percent of global growth in 2024."
- Growth in "2025H1 was more resilient than expected," supported by:
  - "strong exports, in part reflecting front-loading ahead of higher US tariffs,"
  - and "policy easing."
- Across most countries, "growth outturns in the first half of 2025 exceeded expectations relative to the April 2025 World Economic Outlook."
- Anticipation of US tariffs "spurred a surge in exports early this year" and "kept net exports a key driver of growth."

### Exports, front-loading, and intraregional trade shifts
- Asian exports to the United States "lost momentum in Q2" after accelerating from 2024 through early 2025, but "exports to the region and elsewhere remain robust."
- "Export prices—excluding China—have largely stayed firm," with sector exceptions such as "Japanese car exporters."
- Purchasing Manager’s Index (PMI) new export orders "mostly remain subdued since April."
- China’s exports to the United States, "as a share of its total exports, have continued to decline," while the share to Asian trade partners has increased, reflecting redirection of intermediate goods to ASEAN.
- The increase in intraregional trade has also been supported by Asian advanced economies—particularly "Korea, Japan, and Taiwan POC"—benefiting from the "AI-related global investment boom."
- "FDI into ASEAN economies has stayed strong" and announcements of future investment "suggest that companies continue to pursue supply chain diversification in the region."

### Domestic demand weakness despite macro policy support
- "Domestic demand has remained soft in many Asian economies" despite policy easing.
- Contributions to growth in "2025H1 from domestic demand have been steady or declining, with the exception of Japan."
- Retail sales growth "generally remains below pre-pandemic average."
- Negative output gaps and soft domestic demand have contributed to inflation "being below target in many Asian emerging markets."
- Monetary and fiscal policy actions:
  - Some countries (for example "China, Korea, Indonesia") "introduced fiscal stimulus measures."
  - "For most countries, the 2025 fiscal impulse is more expansionary than in 2024."
  - "Most Asian economies have also eased monetary policy in response to low inflation."
  - The Bank of Japan (BOJ) is "gradually raising its policy rate, with the most recent hike in January."

### Cyclical and structural headwinds to recovery
- Private consumption in "large emerging markets in Asia" remains "firmly below the pre-pandemic trends."
- Persistent weaknesses in the service sector—particularly "trade, transport and accommodation"—have been "a headwind to job and income growth."
- Tourist arrivals in Asian economies "have recovered more slowly than in other regions and are still persistently below the 2015–19 trend."
- Recovery has been held back by factors including "fewer Chinese tourists" and "country-specific shocks" (examples: earthquake and liquidation of the national airline in Vanuatu).
- High household debt and a downturn in the housing cycle have dampened consumer demand and construction activity in some countries (examples: "Thailand, New Zealand, China, Cambodia").
- Institutional and structural challenges: "limited scope for fiscal support because of high public debt, inadequate social safety nets, and inefficiencies in financial intermediation" have contributed to the slow post-pandemic recovery of domestic demand.

### Financial conditions, exchange rates, and capital flows
- Financial conditions "have broadly eased" in 2025 after brief tightening in April.
- Easing reflected "lower corporate spreads," "buoyant equity markets," and "a weaker US dollar."
- In Asian emerging markets, easing also reflected "declines in 10-year government bond yields" and "decreasing term premia."
- The decrease in term premia "started in 2023, driven primarily by domestic factors such as soft inflation."
- Asian equities show mixed performance, with "pockets of somewhat stretched asset valuations" and "pockets of potential undervaluation."
- Currencies: while generally appreciating against the US dollar, "real exchange rate performance in Asia diverged in 2025."
  - Currencies in advanced Asia "generally appreciated against the dollar" but, except for the Japanese yen, "remained broadly stable in real effective terms."
  - Some emerging market currencies appreciated against the dollar but "depreciated in nominal and real effective terms," reflecting "soft domestic cyclical conditions and a relatively more accommodative domestic monetary policy stance."
  - "Portfolio inflows to Asian emerging markets have resumed in recent months with the weaker dollar, recovering some of the losses in early 2025."

*Source: text - 2. Youth Unemployment: Emerging and Developing (October 2025) — INTERNATIONAL MONETARY FUND*

### 2. Financial Conditions across the World

### 2. Financial Conditions across the World

### Financial conditions decomposition and recent dynamics
- Financial Conditions Index (FCI) components highlighted: FX, Corporate bond spread, Equity price, 10 year yield, FCI (aggregate).
- Regional and country group labels shown: Advanced economy Asia, Emerging market Asia excluding China, China, Advanced economy Europe, United States.
- Time series coverage shown from 2010 through 2025 for FCIs and component indices.

### US dollar and capital flows to Emerging Market Asia
- Charts indicate portfolio flows (USD millions) and DXY index (right scale) tracked monthly from Jan-24 through Aug-25.
- Portfolio flows range shown on vertical axis from -80,000 to 80,000 (USD millions).
- DXY index and regional portfolio flows displayed together for Jan-24 to Aug-25.

### Recent intra-2025 flow and risk windows
- Period categorizations in 2025:
  - Jan 1, 2025 - Apr 2, 2025
  - Apr 2 - June 30, 2025
  - June 30, 2025 to date
  - Jan 1, 2025 to date
- Country ticker list shown: NZL KOR JPN AUS SGP VNM IND CHN PHL IDN THA MYS
- Regional group averages presented: Asia AE, Asia EM.

### Outlook and macro-financial risks for Asia and the Pacific
- Growth projections and key forecasts:
  - Asia projected to contribute around 60 percent of global growth in 2025 and 2026.
  - Growth in advanced Asia forecast at 1.6 percent in 2025, broadly unchanged from 2024.
  - Japan: growth projected to increase to 1.1 percent in 2025 (from 0.1 percent in 2024); 2025 forecast is 0.5 percentage points higher than April 2025 WEO; growth in 2026 projected to moderate to 0.6 percent.
  - Australia GDP growth projected at 1.8 percent in 2025 (up from 1.0 percent in 2024).
  - New Zealand GDP growth projected at 0.8 percent in 2025 (up from −0.6 percent in 2024).
  - Korea GDP expected to grow at 0.9 percent in 2025 (down from 2.0 percent in 2024).
  - Emerging Asia growth projected to slow to 5.2 percent in 2025 (from 5.3 percent in 2024).
  - China growth expected to moderate to 4.8 percent in 2025 (from 5.0 percent in 2024); projected to moderate to 4.2 percent in 2026.
  - India projected to expand at 6.6 percent in 2025 (up from 6.5 percent in 2024); growth expected to moderate to 6.2 percent in 2026.
  - ASEAN countries projected to slow to 4.3 percent in 2025 from 4.8 percent in 2024.
  - Frontier and small states: Bangladesh FY2025 growth projected at 3.8 percent; Mongolia 2025 GDP growth forecast at 5.5 percent; Nepal 2025:H1 GDP growth projected at 4.3 percent.
  - Pacific Island Countries 2025 GDP growth (simple average) projected to moderate to 2.9 percent from 3.6 percent in 2024.

- Inflation projections:
  - Advanced Asia inflation forecast at 2.5 percent in 2025 (down from 2.6 percent in 2024); projected at 2.1 percent in 2026.
  - Japan inflation projected at 3.3 percent in 2025; decline to 2.1 percent in 2026 expected.
  - Emerging Asia disinflation expected: forecast of 1.6 percent in 2025 (down from 2 percent in 2024); inflation expected to return to 2 percent in 2026.
  - China inflation forecast at 0 percent in 2025 (down from 0.2 in 2024); projected at 0.7 in 2026.

### Channels of vulnerability: trade, financial tightening, and debt
- Trade policy and uncertainty:
  - One-standard-deviation increase in US trade policy uncertainty reduces investment in Asia by about 1 percent in the near term, with effects about twice as large in emerging market economies.
  - Effective US tariffs on Asian economies are lower than initially announced; some US agreements with Asian countries remain under negotiation with possibility of higher tariffs.
  - High share of Chinese value added embedded in regional exports creates exposure to potential “transshipment” tariffs.
  - Decline in China’s export prices may risk negative spillovers to regional economies, especially in ASEAN.

- Financial conditions and amplification of shocks:
  - Financial conditions in Asia remain accommodative but could reverse if trade policy uncertainty or geopolitical tensions intensify, or if investor optimism about AI corrects.
  - A sharp global risk-off could raise external borrowing costs, especially for frontier economies, and put pressure on weaker currencies.
  - In emerging market economies, reversal of recent term-premium declines or repricing of inflation expectations could raise yields and worsen debt dynamics.

- Corporate and external debt vulnerabilities:
  - Corporate debt-at-risk in Asian emerging markets has climbed, driven by weak demand and property sector issues; “zombie firms” noted.
  - Several ASEAN countries face increased external debt exposure; rollover risks and balance sheet distress may arise from external tightening.
  - Rapid population aging adds to long-term fiscal pressures across much of the region.
  - Debt-at-risk metric: share of total debt held by firms with an Interest Coverage Ratio (ICR) below 1; firm-level ICR calculated using four-quarter average; underlying variables winsorized at 5%.
  - External debt of non-government and non-bank sectors presented as percent of GDP across 2019 and 2024 comparisons for Advanced Economies (AE) and Emerging Economies (EM).

### Technology (AI) cycle: upside potential and financial risks
- AI-driven investment boom expected to continue in 2025 and 2026, partly offsetting tariff-related drags.
- Upside scenarios:
  - Stronger-than-expected AI cycle could lead to higher investment and exports, particularly in countries with strong exposure to the tech cycle.
  - Adoption of AI could raise productivity more than projected; region demonstrates above average AI preparedness.
- Downside financial risks:
  - Stretched AI asset valuations pose downside risks.
  - A correction in investor optimism about AI could contribute to tighter financial conditions.

### Policy recommendations and priorities
- Macro policies to absorb shocks and reduce uncertainty:
  - Monetary policy easing is appropriate in countries with inflation below target; additional easing may be expected in many countries to bring inflation back to target and anchor expectations.
  - Weakening US dollar has reduced capital outflow pressures and provided additional room for policy rate cuts where needed.
  - In Japan, gradual normalization of monetary policy can support convergence toward the 2 percent target if the baseline materializes.
  - Exchange rate flexibility should be the first line of defense in case of shocks; judicious FX intervention could be used to maintain stability in line with the Fund’s integrated policy framework.
- Fiscal policy options:
  - Temporary and targeted fiscal measures could support demand and help vulnerable groups affected by the tariff shock; near-term fiscal stance should be calibrated to country circumstances.
  - China, Korea, and Vietnam have introduced sizable fiscal packages to support demand and fund priority programs announced before the tariff shock.
  - In countries with high public debt, expansionary fiscal policy needs to be balanced with medium-term consolidation to preserve debt sustainability.
  - Improving adequacy and coverage of social safety nets, especially for the bottom 20 percent of the income distribution, could help support domestic demand.
- Structural reforms:
  - Productivity-enhancing structural reforms, including further trade and financial integration, could boost regional growth.
  - Additional macroeconomic policy support and structural reforms can help navigate the challenging global environment.

### Scenario analysis and modelling
- Box 1.3 uses the Fund’s Global Integrated Monetary and Fiscal (GIMF) model to quantify impact of selected risks around the baseline, illustrating potential downside and upside scenarios—including higher or lower tariffs and higher productivity growth due to faster AI adoption.

*International Monetary Fund, Regional Economic Outlook — Asia and Pacific, October 2025.*

### 2. Fiscal Impulse over Time

### 2. Fiscal Impulse over Time

### Structural reforms to support growth and rebalancing
- Countries in Asia should promptly address structural impediments to growth to accelerate reforms that address economic imbalances, boost productivity, and enhance resilience.
- Structural policies to support continued expansion of the service sector are essential for economic rebalancing:
  - The structural transformation towards services has slowed in recent years, partly due to the COVID-19 pandemic, limiting job and income recovery.
  - Continued international integration could boost tradable services, such as education and training, important for labor to adapt to new technologies (November 2024 Regional Economic Outlook: Asia and the Pacific).
  - Reforms to improve financial intermediation and capital market development are essential to channel credit into more productive service sectors because credit allocation historically favored manufacturing and real estate.

### Financial reforms to raise investment returns and productivity
- Rising capital misallocation has been associated with the decline in productivity growth in recent years; diversifying the financial structure, including through capital market development, would help relax financial constraints and support productive firms and innovation (see Chapter 3).
- Both private and public debts have risen since the pandemic and evergreening corporate borrowing has increased, weighing on growth and productivity.
- Macroprudential intervention in real estate and other high-risk credit segments should be used to contain systemic risks, while dedicated strategies are needed to reduce risks from high debt morphing into debt overhangs.
- Country examples:
  - Thailand and Korea have introduced measures to tackle household debt.
  - The Chinese authorities have taken steps to refinance developer and Local Government Financing Vehicles (LGFV) debt, but more is needed to restructure non-viable entities.

### Fiscal reforms and public balance sheet management
- Fiscal reforms are essential to manage large spending pressures and prepare for future shocks:
  - Upgrade medium-term frameworks to anchor budgets, build transparency, and allow more gradual fiscal adjustment in some countries.
  - Expand fiscal coverage to include public banks, SOEs, and subnational governments, given substantial policy support delivered through these entities in Asia.
  - Develop a broader view of the public balance sheet to better design policies and assess and manage vulnerabilities (IMF 2024).
- In small and low-income states, potential declines in international aid flows call for renewed efforts to mobilize domestic revenues, and where needed, reprioritize spending.

### Labor market policies to address demographic pressures
- Projections indicate rapidly diminishing labor supply over the medium to long term because of aging in major Asian economies such as China, Japan, and Korea, which will dampen potential growth (October 2024 Regional Economic Outlook: Asia and the Pacific, Analytical Note).
- On the demand side, ageing and population decline are expected to curb consumption and shift consumption composition toward more old-age services (for example, health) and away from young-age services (for example, education).
- Recommended policies: increase labor force participation, enhance employee training, and integrate foreign workers to help manage the gradual transition.

### AI adoption: opportunities and challenges
- Advances in AI can lift potential growth and offset the negative impact from aging in Asia, but also pose socio-economic challenges:
  - AI adoption could increase inequality, exacerbate productivity gaps between large firms and SMEs, and displace workers (IMF 2025).
  - Policy responses should support AI integration and adoption in SMEs, increase labor market capacity to adapt to AI via reskilling and job switching, and strengthen social safety nets.

### Regional trade and financial integration
- Further regional trade integration through lower barriers to trade and investments could yield substantial dividends:
  - Removing intra-regional barriers to trade—even unilaterally—would have positive effects on competition, productivity, and growth (see Chapter 2).
  - Coupled with stronger regional demand, it would enable economies to diversify export markets and reduce costs, offsetting some headwinds from tariff shocks.
  - Lowering FDI restrictions and enhancing competitiveness can help attract shifting supply chains.
- Deeper regional financial integration could reduce vulnerabilities to global financial shocks and support financial development:
  - Advanced economies in Asia are well integrated into global financial markets; Asian emerging markets are mostly integrated through cross-border banking and could benefit from further linkages, including FDI and capital markets (see Figure 1.9).
  - Reforms should be carefully sequenced to minimize potential amplification of common shocks.

### Effects of trade policy uncertainty (Box 1.1)
- Trade policy uncertainty (TPU) surged to historical highs in 2025 and remains elevated, peaking in April after the announcement of new US tariffs on strategic sectors.
- TPU measurement and empirical findings:
  - A new bilateral TPU index based on text analysis of news reports focuses on trade with the United States and captures country-level variation; the recent TPU shock averaged five standard deviations across the region.
  - Based on a panel of Asia-Pacific economies from January 1995 to April 2025, a one standard deviation increase in TPU leads to a 1 percent decline in investment within the same quarter; the effect is statistically significant for up to three quarters.
  - Applying the recent shock size of five standard deviations implies a temporary 5 percent decline in investment.
  - The investment effect is stronger in emerging markets—about twice as large as in advanced economies.
- Other TPU findings:
  - Short-term effects on exports are limited; over longer horizons—about 40 months—the decline in investment translates into weaker export capacity.
  - There is no evidence of trade frontloading in response to TPU spikes.
  - No systematic impact on the US dollar—bilateral and effective exchange rate measures show no material movement around TPU episodes.
- Policy implication: Policymakers should remain alert to TPU risks; timely macroeconomic support and structural policies can help offset some of the drag, and tailored policy responses are needed across countries and sectors.

### Financial spillovers to Asia-Pacific (Box 1.2)
- Global long-term yields have trended upwards since the pandemic; decomposition shows changes reflect both expected policy path and increases in term premia.
- Main findings:
  - Global rates affect Asia’s long-term rates; heightened global term premia have put upward pressure on regional term premia, while lower expected external policy rates—particularly in the US—and country-specific conditions have provided offsetting forces.
  - On equities and FX markets:
    - When global investors mark up the expected path of policy rates (risk-neutral long rates), Asian equities often rise and currencies strengthen.
    - When global investors demand more compensation for holding duration (a higher term premium), equities soften and currencies tend to weaken.
  - Spillovers into real activity and inflation are modest over the studied horizons, suggesting recent waves have been absorbed mainly within financial markets.
- Regional resilience and policy guidance:
  - The region has been mostly shielded from global financial spillovers recently, supported by domestic cyclical conditions, deeper local-currency bond markets, and stronger domestic policy frameworks.
  - Policy recommendations: keep domestic anchors strong, continue building market depth so shocks are absorbed rather than amplified, and maintain FX/liquidity buffers to manage bouts of volatility.
- Selected numeric indicators cited:
  - The empirical analysis covers eight countries (Australia, China, India, Indonesia, Korea, Malaysia, New Zealand, Thailand) over August 2005-April 2025 in some specifications.
  - On average across regional EMs, local-currency government debt increased from 26.5 to 44 percent of GDP over the past decade.
  - Foreign holdings of local-currency government bonds dropped from a peak of around 20 percent in 2011 to around 10 percent now.

_International Monetary Fund, Regional Economic Outlook—Asia and Pacific, October 2025._

### Box 1.3. Risk Assessment: A Scenario Analysis for Asia

### Box 1.3. Risk Assessment: A Scenario Analysis for Asia

### Methodology
- Uses the Fund’s Global Integrated Monetary and Fiscal (GIMF) model to simulate two multi-layered scenarios—a downside (Scenario A) and an upside (Scenario B)—drawing on the global analysis in Box 1.2 of the October 2025 World Economic Outlook.
- Monetary policy reacts endogenously; most regions assumed to have flexible exchange rates, while in Scenario A China’s exchange rate is managed through capital flow measures.
- Scenarios are cumulative; each layer builds on the previous one.

### Scenario A (Downside)
- Assumptions:
  - Additional permanent increase of US tariffs—by 10 percentage points on average, and by 30 percentage points on imports from China—without retaliation.
  - Global supply chains are temporarily disrupted, lowering world total factor productivity by about 1 percent in 2026–27.
  - Sovereign yields rise by 100 basis points through higher term premia (except in China).
  - Corporate spreads widen, more markedly in emerging markets.
  - Reduced foreign demand for US assets raises US risk premia.
- Regional GDP impacts (percent deviation from baseline):
  - China: output drops by −1.3 percentage points relative to baseline after one year.
  - Rest of Asia: output declines by −0.3 percent in 2026, troughing at −0.8 percent in 2029.
  - World ex. Asia: output declines by up to −0.6 percent, on average, over the 2028–2030 period.
  - With global tighter financial conditions amplifying effects:
    - GDP in the Rest of Asia declines by up to 1.7 percent in 2027–28.
    - China’s contraction reaches 1.6 percent in 2026.
- Additional dynamic:
  - A depreciation of the US dollar tends to benefit EM Asia as their currencies are generally less flexible against the dollar than other EM currencies, and, thus, would depreciate against other regions, supporting external demand and partially offsetting the drag from higher interest real rates.

### Scenario B (Upside)
- Assumptions:
  - Tariffs imposed since January 2025 are permanently removed.
  - Imports from China see the largest decrease in effective tariff rates (about 22 percentage points), followed by Japan, Europe, and emerging Asia (10–20 percentage points).
  - Trade policy uncertainty declines.
  - AI provides higher-than-expected boost to productivity (TFP +0.8 percent over 10 years).
- Regional GDP impacts (percent deviation from baseline):
  - China and the Rest of Asia see a GDP increase of 0.5 percentage points above the baseline.
  - Rest of Asia: GDP rises by 1.1 percentage points above the baseline in 2026 (driven by reduced trade policy uncertainty and a more favorable environment for investment).
  - When compounded with faster AI-driven productivity growth:
    - Output in China increases by 1.2 percent in 2026, with the effect peaking after four years.
    - Output in the Rest of Asia is boosted by 1.3 percent in 2026, before the impact gradually wanes.
  - Outside Asia: output remains steadily above +1.1 percent, on average, over the 2027–2030 period.

### Key quantitative assumptions and figures
- US tariffs increase in Scenario A: 10 percentage points on average; 30 percentage points on imports from China.
- World TFP hit in Scenario A: about 1 percent in 2026–27.
- Sovereign yields shock in Scenario A: rise by 100 basis points (except in China).
- Tariff reductions in Scenario B: about 22 percentage points for imports from China; 10–20 percentage points for Japan, Europe, and emerging Asia.
- AI productivity boost in Scenario B: TFP +0.8 percent over 10 years.
- Scenario A peak regional contractions:
  - China: −1.3 percentage points (after one year); −1.6 percent (in 2026, with financial amplification).
  - Rest of Asia: −0.3 percent (2026), −0.8 percent (2029), up to −1.7 percent (2027–28 with financial amplification).
- Scenario B peak regional gains:
  - China: +0.5 percentage points above baseline; +1.2 percent with AI in 2026.
  - Rest of Asia: +0.5 percentage points above baseline; +1.1 percent in 2026 (policy uncertainty channel); +1.3 percent with AI in 2026.
  - World ex. Asia: output > +1.1 percent on average over 2027–2030.

### Lessons from past tariff shocks and supply-chain reconfiguration
- Evidence from the US–China tariff episode (2018–19) indicates heterogeneous tariff differentials across countries can divert trade flows and reshape supply chains.
- Empirical findings:
  - Tariff-targeted sectors in several Asia-Pacific countries experienced higher growth in exports to the US and intermediate goods imports from China compared to unaffected sectors (notably Cambodia, Bangladesh, Vietnam, and Sri Lanka).
  - Intermediate goods exports within the region rose to nearly 60 percent of total intermediate goods exports by 2019 (up from a pre-2017 average of 53 percent).
  - China’s increased trade share with the region is concentrated in intermediate goods and does not extend to final goods.
  - Supply-chain reconfiguration involved partial relocation of production by firms in China; countries that expanded value-added exports to the US often experienced more FDI from China (measured by announced or completed greenfield FDI projects).
- Not all economies or sectors benefited; mechanisms limiting gains include sector composition effects, timing effects, long-term trends, and competition effects.

### Factors correlated with relative gains from tariff-induced reallocation
- Regression analysis identifies characteristics associated with larger relative gains in value-added exports to the US in tariff-targeted sectors:
  - Lower labor cost (proxied by lower nominal GDP per working-age population).
  - Greater openness to FDI.
  - Stronger pre-existing trade linkages with both China and the US (backward GVC linkage with China).
  - Political stability and geopolitical alignment with China show expected signs.
- Interpretation: cheaper labor, openness to FDI, and established trade relationships are pivotal for attracting relocated production and increasing value-added exports in response to global tariff shocks.

### Policy implications and recommendations
- “Policies to promote openness in trade and foreign direct investment, supported by reforms to enhance competitiveness, are key to maintaining trade as an engine of growth.”
- Deeper intra-Asia integration can offer resilience and opportunities; complementary policies would be needed to assist workers through the transition to ensure inclusive outcomes.
- The chapter underscores that lowering trade barriers—both within the region and globally—can yield sizable economic gains, but heterogenous tariff differentials, high uncertainty around tariff levels, and stricter rules of origin make supply-chain reconfiguration more challenging.

*Authors of the box: Sofia Felici and Andrea Pescatori.*

### 2. Reshaping Value Chains: The Case for Deeper Asia-Pacific Trade Integration

### 2. Reshaping Value Chains: The Case for Deeper Asia-Pacific Trade Integration

### Regional integration: current patterns and gaps
- Asia-Pacific is highly integrated in intermediate goods trade but has lower intra-regional trade in final goods relative to Europe and North America.
- Divergence reflects prevalence of regional supply chain trade oriented to overseas final demand and signals untapped potential for deeper intra-Asia-Pacific final goods trade.
- Trade agreements in Asia-Pacific are predominantly bilateral or bilateral with a regional trade bloc (that is, ASEAN), contrasting with broad-based, legally binding agreements in areas such as the EU or USMCA. This patchwork may contribute to overlapping rules, inconsistent standards, and a lack of institutional coherence.

### Depth and content of trade agreements; non-tariff barriers
- Depth of trade agreement integration is measured by the share of provisions that are legally enforceable between country pairs (index: number of legally enforceable provisions out of 52).
- Compared to Europe and North America, Asia-Pacific depth scores tend to be lower, especially in areas beyond the WTO’s mandate (for example, competition policy, environmental protection, e-commerce).
- Sub-regional disparities:
  - ASEAN is relatively integrated.
  - South Asia has particularly shallow coverage.
  - Some sub-groups (for example, ASEAN, members of CPTPP) have internal depth but limited coverage with other major regional economies.
- Non-tariff barriers (NTBs) prevalence:
  - NTBs are especially notable in South Asia and parts of ASEAN (index, 0―20).
  - NTBs affect both intermediate and final goods trade; some instruments (for example, standards and technical regulations) and certain rationales may particularly affect final goods trade.
  - NTBs may be a factor holding back final goods trade in the region.
- Recently enacted regional agreements could reduce NTBs (for example, through harmonizing standards) and boost trade integration—conditional on broadening membership.

### Quantifying gains from deeper integration: model and scenarios
- Model framework:
  - Multi-country, multi-sector quantitative trade model building on Cuñat and Zymek (2024).
  - Capital responds endogenously to trade liberalization; depth scores are translated into trade costs (“iceberg costs”) to capture NTBs.
  - Depth score proxy: extent of legally enforceable provisions between country-pairs (out of 52).
- Scenario: Asia-Pacific economies move from current depth to maximum depth (corresponding to 1 in Figure 2.12) — complete coverage of legally enforceable provisions within and beyond the WTO’s mandate.
- Key simulated outcomes:
  - Long-term gains average about 1.8 percent of GDP for the whole region.
  - Most gains come from unilateral action—economies reducing their own NTBs to imports from regional partners.
  - Unilateral gains are amplified when all Asia-Pacific economies lower their trade barriers, creating an additional “external demand channel.”
- Heterogeneity in gains:
  - Smaller economies (even those with relatively low tariffs, for example, some members of ASEAN) gain more than larger economies from shifts in relative prices and cheaper access to inputs.
  - Countries exporting output with higher shares of intermediates (for example, Korea) obtain larger benefits.
  - Gains rise with the size of the gap between starting depth and the target depth—important for regions such as South Asia and for economies with uneven integration across partners (for example, AEs and ASEAN).
- Gains when reducing NTBs vis-à-vis the rest of the world:
  - Substantial additional gains are possible even if the rest of the world does not reciprocate, owing to spillovers and the non-excludable nature of some provisions.
- Partial steps matter:
  - Given constraints to full removal of NTBs, smaller steps to integration can still deliver significant gains; gains vary by the degree of ambition feasible in the region.

### Policy implications and recommendations
- Primary policy imperatives:
  - Continue openness to trade and investment, complemented by policies to mitigate distributional impacts.
  - Deepen regional trade agreements: expand participation in newer and deeper agreements (for example, CPTPP) and improve coherence across overlapping arrangements to harmonize rules and lower compliance costs.
  - Lower NTBs and broaden the coverage and legal enforceability of trade provisions, including areas beyond the WTO’s mandate (for example, competition policy, public procurement, investment policy, environmental protection, digital trade).
- Support for adjustment and distributional mitigation:
  - Enhanced social protection and active labor market policies to support reskilling and job transition.
  - Well-designed efforts to build stakeholder support to address politically sensitive reforms.
- Complementary policies to boost competitiveness and resilience:
  - Enhance cost competitiveness to facilitate production relocation where appropriate.
  - Liberalize restrictions on foreign firm entry and facilitate their operations—Asia-Pacific economies are relatively more restrictive in FDI.
  - Improve macroeconomic stability and investment efficiency to unlock long-term growth opportunities and support external rebalancing via diversified export destinations.

### Institutional and recent agreement context (Box 2.1)
- WTO remains a cornerstone but faces limitations for new policy areas (digital trade, investment, sustainability) and challenges in multilateral rulemaking and enforcement.
- Two major regional trade agreements in Asia-Pacific:
  - Regional Comprehensive Economic Partnership (RCEP): Signed in 2020; brings together ASEAN and five major economies—China, Japan, Korea, Australia, and New Zealand; focuses on trade in goods, tariff liberalization, and strengthening regional production networks; legal framework emphasizes inclusiveness and accommodates diverse levels of development.
  - Comprehensive and Progressive Agreement for Trans-Pacific Partnership (CPTPP): Comprises 12 countries; more comprehensive and legally binding than RCEP, covering labor standards, environmental protection, digital trade, and investment with an enforceable dispute settlement mechanism; accession can entail politically sensitive and costly reforms (for example, agriculture, labor, environment, state-owned enterprise regulation).

*International Monetary Fund • October 2025*

### 2. Reshaping Value Chains: The Case for Deeper Asia-Pacific Trade Integration

### 2. Reshaping Value Chains: The Case for Deeper Asia-Pacific Trade Integration

### Investment efficiency and capital allocation: key findings
- Investment has stayed robust in Asia but investment efficiency declined after the global financial crisis, reflected in a high and rising incremental capital–output ratio (ICOR).
- ICOR for most Asian economies has risen over time, especially after the global financial crisis when output growth slowed; although rising ICOR is visible in the rest of the world (RoW), the level of ICOR is generally much higher in Asia (less than 3–4 is considered efficient).
- Average return on assets (ROA) for listed firms, excluding the financial sector, has dropped significantly across the region compared to the period before the global financial crisis; this drop is sharper than in other regions and not concentrated in a few sectors.
- Misallocation of capital, measured by the dispersion in the marginal revenue product of capital (MRPK) across firms within sectors, increased by about 25 percent between the periods before and after the global financial crisis, lowering total factor productivity (TFP).
- Services sectors show higher dispersion in MRPK, suggesting services account for a higher proportion of allocative inefficiency.
- The share of firms classified as zombie firms (firms older than 10 years that during three consecutive years could not cover interest payments with operating income) in total debt has almost tripled for the Asia-Pacific region after the global financial crisis, while it has marginally declined in the RoW.
- Listed Asian firms’ reliance on external financing has fallen since the global financial crisis, whereas net savings have increased, suggesting rising financing constraints or a mismatch in available instruments.
- Within industries and countries, there has been a relative increase in leverage for larger firms, indicating a shift of financial resources from smaller toward larger firms that tend to be less productive.
- Debt finance, typically through banks, is more dominant in Asia compared to Europe and the United States; nonbank-based private sector financing remains small in most Asian economies.
- Interest rate controls reversed their long-run liberalization trend since the global financial crisis in some Asian emerging markets and low-income developing countries; data on interest rate controls are reported through 2017 with the indicator described.

### Drivers and mechanisms identified
- Financial intermediation contributed to the decline in investment efficiency through:
  - Financing constraints faced by smaller and more productive firms, limiting their ability to expand.
  - Allocation of financing toward larger, less productive firms.
  - A lack of an optimal mix of financing instruments (market-based instruments such as equity financing being underdeveloped).
  - Rising evergreening (provision of financing to firms that exhibit persistent inability to service their debt).
- Structural features highlighted:
  - Bank-dominated financial systems favor size and collateral over growth, constraining access for riskier, small, and young firms and for firms with intangible assets.
  - Underdeveloped capital markets, limited listing procedures, constrained bond market access for SMEs, and a lack of a domestic institutional investor base reduce availability of long-term risk capital.
  - Historical banking weaknesses and policy factors (implicit state support, weak insolvency laws) have underpinned evergreening episodes.

### Empirical evidence and implications
- Financing constraints curtailed growth by making it difficult for small and young firms to expand; the impact is more significant for Asia.
- Rising financial misallocation plausibly contributed, at least in part, to rising capital misallocation in Asia.
- Improvements in financial intermediation and capital efficiency are expected to:
  - Boost job and income growth.
  - Strengthen domestic demand.
  - Facilitate more balanced growth and economic rebalancing.

### Policy recommendations and salient reforms
- Improve financial intermediation to meet demand for both scale and mix of financing for a broader set of firms.
- Diversify the financial structure away from an overreliance on bank debt by developing market-based financing instruments, especially equity financing, which better suit riskier, innovative, and fast-growing companies and attract long-term investors and risk capital.
- Reform listing procedures, expand bond market access for SMEs, and build a domestic institutional investor base to provide more stable long-term capital.
- Implement reforms to support timely restructuring of nonviable debt and strengthen insolvency frameworks to limit evergreening and enable resolution of zombie firms.
- Consider the trade-offs of interest rate controls and financial repression, as these can distort market incentives and reinforce rent seeking and efficiency losses; monitor prevalence of interest rate controls given their recent reversal in liberalization in some Asian economies.
- Tailor policies to country development levels: the saliency of developing alternative financing instruments rises with the level of development.

*International Monetary Fund. October 2025. Regional Economic Outlook — Asia and Pacific (chapter excerpt).*

### 3. Investment Efficiency and Capital Allocation: The Role of Financial Structure

### 3. Investment Efficiency and Capital Allocation: The Role of Financial Structure

### Evidence of financing constraints in Asia
- Strong evidence of financing constraints in Asia: a statistically significant positive interaction between external finance dependence and the level of financial development (following Rajan and Zingales (1998) and Li (2020)); financial constraints are more pronounced in Asia than for the global sample.
- Financing constraints are concentrated among small (low asset) and young firms.
- Similar patterns hold for capital expenditure (see online Annex Table 3.2).
- Empirical relationship across firm size and performance:
  - A 1 percent larger firm size before the global financial crisis (net worth) is associated with 2 percent more investment and 0.1 percent more leverage during the period after the global financial crisis.
  - The increase in MRPK dispersion after the global financial crisis stems from greater deterioration in MRPK of larger firms.
- Mechanism consistent with Gopinath and others (2017): constrained smaller firms accumulate internal savings and cannot expand capital, leading to higher MRPK for constrained small firms relative to unconstrained larger firms; leverage and firm size are positively correlated, MRPK and firm size are inversely correlated.

### Misallocation, evergreening, and zombie firms
- Evergreening facilitated by easy financing and contributes to capital misallocation by crowding out more productive investment.
- Empirical findings on zombies:
  - The share of zombie firms has risen faster in sectors with high reliance on external sources of financing.
  - Lower costs of financing (proxied by policy rates) during the periods after the global financial crisis and COVID-19 were associated with an increase in the share of zombie firms in these sectors, by about 0.4 percent for a 1 percent decline in interest rates (see online Annex Table 3.4).
- Lower cost of capital reduces creditors’ pressure to clean up balance sheets and encourages loan evergreening.
- Spillovers from zombies to non-zombies include dampening of investment, productivity, and employment (Albuquerque and Iyer 2024).
- Policy implication: developing a strategy to restructure unviable debt is key to improving capital efficiency.

### Scale versus mix of financing and financial structure
- The scale of financing is the dominant constraint in Asia; the importance of the mix of financing (debt versus equity) rises with the level of development.
- Methodology (Whited and Zhao 2021): treat financial liabilities—debt and equity—as primitive inputs into production and allow debt and equity to be either perfect or imperfect substitutes; deviations in debt-to-equity ratios across firms are departures from the first-best.
- Figure 3.10 (results summarized):
  - Estimates show scale dominates in Asia, but the share of aggregate TFP gains attributable to the mix of financing increases with development.
  - Chart reports counterfactual aggregate TFP gains under empirically estimated elasticity of substitution between debt and equity and under perfect substitutability, averaged over 2010-2022, expressed as shares of the aggregate TFP gain.

### Gazelles (young high-growth firms)
- Gazelles are underrepresented and underfinanced in Asia, limiting their contribution to productivity and growth.
- Characteristics and empirical findings:
  - Gazelles make up under 2 percent of Asia’s new entrants.
  - Defined (literature definition): between formation and age 10, (1) a three-year period of annualized growth in deflated sales of 20 percent or more, (2) at least 100 employees, and (3) sales of at least 100,000 in 2015 US$ terms.
  - In Asian advanced economies, gazelles carry higher leverage than other firms from a young age; after controlling for leverage, gazelles face higher borrowing costs than other firms: on average by 63 bps in Asian advanced economies, up to 80 bps for those with more intangible assets.
  - In Asian emerging markets, gazelles show no excess leverage or excess interest costs; their share of new entrants is just one percent.
- Policy implication: broadening financing options, including nonbank alternatives such as venture capital, could support the emergence and growth of gazelles—particularly for firms with high intangible assets lacking traditional collateral.

### Vietnam: preferential credit policies and rising misallocation (Box 3.1)
- Misallocation in Vietnam is sizable and rising—capital misallocation is the main source of rising aggregate misallocation, especially since COVID-19; misallocation is relatively low in manufacturing but high in services, notably real estate services.
- Potential gains from removing misallocation: moving to the efficiency frontier could potentially raise aggregate TFP by over 50 percent (IMF 2025, forthcoming).
- Evidence linking misallocation to preferential credit policies:
  - Preferential access to credit for SOEs from development and state-owned banks and allocation of prime land at below-market prices used as collateral contributed to capital misallocation (Le 2022).
  - Even after a significant reduction in the number of SOEs, Tu (2019) reports SOEs accounted for 0.5 percent of the total number of firms, employed 9 percent of the labor force, and held 29 percent of total assets in the economy.
  - IMF (2017) found credit misallocation between SOEs and non-SOEs among listed firms; SOEs’ borrowing costs have been significantly lower than those of domestic private firms (see Figure 3.1.1), helping less-productive SOEs stay competitive and gain market share—depressing overall productivity.

### Conclusion and policy recommendations
- Diagnosis:
  - Asia-Pacific’s growth slowdown has been accompanied by a decline in efficiency of investment and a rise in capital misallocation.
  - Inefficiencies in financial intermediation have contributed to lower returns on investment and misallocation.
- Policy priorities:
  - Broaden financial access for firms and address evergreening.
  - Develop a more diversified financial structure with a larger role for capital markets to mobilize long-term financing and improve access for services and innovation-intensive firms with larger intangible assets.
  - Areas of focus: streamline listing procedures, broaden the investor base, foster long-term financing, and implement regulatory reforms to lower barriers to nonbank financing.
  - Tailor priorities by development stage: access to financing is the bigger constraint in lower income countries; the importance of mix of financing rises with development, underscoring the need to develop markets for alternative financing instruments in higher income countries.
  - Restructure nonviable debt to achieve allocative efficiency gains.
  - Review and strengthen financial oversight and risk management to prevent evergreening.
- Broader macroeconomic effects:
  - Improvements in financial intermediation and capital efficiency will support job and income growth, particularly in services and smaller firms facing financing constraints, enabling stronger domestic demand growth.
  - Better financial intermediation reduces firms’ precautionary saving motives and encourages better dividend payout, contributing to stronger consumption and more balanced growth without excessive reliance on external demand.

*Source: 3. Investment Efficiency and Capital Allocation: The Role of Financial Structure, October 2025 • INTERNATIONAL MONETARY FUND*

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_Source: https://www.imf.org/-/media/files/publications/reo/apd/2025/october/english/text.pdf_