Asia: Ten Years On—Taking Stock and Looking ForwardDavid Burton, Director, Asia and Pacific Department
International Monetary Fund
At the Singapore Press Club, Singapore
June 5, 2007
As Prepared for Delivery
Ten years ago, almost to the day, the Asian Financial Crisis started unfolding through South East Asia. Few countries in the region were left untouched and after-effects reverberated across the global economy. The 10-year anniversary of the crisis provides an opportunity to reflect on how Asia has fared since—and to consider the challenges that may lie ahead. And let me say what a pleasure it is to be back at the Singapore Press Club, and to discuss these issues with such a knowledgeable and distinguished group.
The Asia crisis
The central feature of the Asian crisis was a sudden reversal of investor sentiment and international capital flows. The roots of the crisis, however, were in financial and corporate sector weaknesses not fully apparent at the time. Other ingredients included pegged exchange rates that encouraged unhedged foreign borrowing; inadequate reserve levels; and a lack of transparency, not least about true levels of usable reserves. With the exception of Thailand, traditional macroeconomic imbalances were not evident beforehand and did not play a major role. As an aside, I would add that from my own experience in the crisis, lack of information was a serious obstacle to understanding what was happening at key moments and to formulating appropriate policy actions.
In this setting, doubts about the soundness of financial institutions and corporates spread quickly across national borders, creating a vicious circle of capital outflows, plummeting exchange rates, and crippling balance-sheet effects in the crisis-struck countries. Private demand collapsed and output in the most affected economies contracted quickly and sharply. Previously strong fiscal positions started to deteriorate. And the underdevelopment of social safety nets to protect those most exposed to economic disruptions exacerbated the social and economic impact of the slumps.
As private creditors were stampeding for the exits, the international community, working through the Fund, provided substantial financing. At the same time, governments in the region adjusted policies, increasingly taking strong and appropriate actions. Also, steps were taken to involve the private sector in providing financing. After some initial adjustments, the approach turned the tide; confidence began to recover and capital to return, though not before substantial damage had been done by the crisis. In fact, output recovered quite quickly with the most determined reformers performing the strongest.
The region today
Ten years on, Asia is again the most dynamic region in the global economy. Rather than withdrawing from globalization, Asia has continued to embrace it. Learning the right lessons from the crisis, Asia has undertaken a wide range of reforms over the last decade. These have been geared to equip the region to benefit more from globalization and to cope better with its attendant risks, especially those associated with mobile international capital.
At the national level, the key to today's success has been stronger macroeconomic policy frameworks, comprehensive reforms in the financial and corporate sectors, and greater transparency. More flexible exchange rates regimes in many countries have provided a cushion against external shocks, and substantial official reserves have been built up; inflation targeting has provided a monetary anchor in many cases; and fiscal policies have taken on a longer-term perspective to safeguard debt sustainability.
As for structural reforms, measures to deal with the immediate strains in the financial system have been complemented by steps to address the underlying weaknesses. More work lies ahead, but financial institutions and corporates in South East Asia have, on the whole, regained a solid footing. This has been well demonstrated over the past year as Asia has coped well with two bouts of global financial turbulence—albeit quite modest ones.
Significant reforms have also been undertaken at the regional level. Policy cooperation is gaining traction, with the crisis perhaps creating a stronger sense of regional identity. Initiatives like the Chiang Mai network of bilateral swap lines among Asian central banks, which is now to be turned into a reserve pooling arrangement, have provided a measure of regional self-insurance and commonality of purpose.
The IMF for its part has worked closely with economies in the region on their reform programs over the past decade. Increasingly this has been done as part of the Fund's normal policy dialogue with countries, including under new transparency and financial sector initiatives. Also, the IMF supports the various regional initiatives underway.
Looking ahead, the immediate outlook for the region is for continued strong economic growth, supported by continued above trend global expansion. As ever, there are risks to the near-term outlook, but with the reforms taken over the past decade, Asia is well placed to weather these.
Nevertheless, the region must tackle a number of challenges to assure itself of a bright future over the longer run. Priorities differ across countries, but a common theme stands out—coping with globalization and harnessing the benefits it can deliver. Here I will focus on four issues: rebalancing growth; coping with volatile capital inflows; adjusting to changing patterns of production and trade; and responding to increasing inequality.
Let me start with the need to rebalance growth. Asia continues to rely heavily on net exports as an engine of economic expansion. This is reflected in high rates of export growth and a continued large current account surplus for the region as a whole. Over time, greater reliance on domestic demand will be needed to assure a more balanced and sustainable pattern of growth—as Asia's share of global exports rises, sustaining high rates of export growth will become increasingly difficult.
For the region excluding China, continued relatively weak investment following the sharp decline after the Asia crisis lies behind the continued large current account surplus. While pre-crisis levels of investment were certainly excessive, the limited recovery is puzzling. It is, of course, difficult to say what is the appropriate level of investment. But investment does seem to be lower than macroeconomic fundamentals would suggest. A decade after the crisis, this can no longer largely be attributed to transitional difficulties, such as the need for banks and corporations to restructure—though there is some evidence that companies in the non-traded goods sector still find it difficult to obtain financing. Another explanation sometimes offered is that China is diverting investment away from other Asian countries. However, formal studies have been unable to find systematic evidence of this. We have found some evidence that investment has been affected by the perception of increased risk, even if in many ways actual risk has been reduced. Also, some shift from manufacturing toward less capital intensive service sector activities may be a factor.
While the causes of the weakness in investment are not fully clear, additional actions to strengthen the investment climate are certainly desirable. These include further improving corporate governance and legal frameworks, broadening and deepening financial systems, and enhancing macroeconomic policy frameworks. Further progress in these areas should serve to bolster investment, and thereby rebalance and sustain growth.
China faces a different problem. Investment has grown rapidly, but savings, especially in the corporate sector, have grown even faster. The need in China, therefore, is to reduce reliance on rapid investment growth as well as net exports, and to encourage consumption. Here, reforms to strengthen social safety nets, reorient public spending toward social areas, and improve financial intermediation are urgently needed to help strengthen consumption. Greater exchange rate flexibility is also needed to give monetary policy scope to reign in rapid credit growth and constrain excessive investment. Further reforms of the financial and corporate sectors will also be important. This will help to improve the quality of investment as the quantity is reduced.
The process of rebalancing growth in the region is likely to be accompanied by an appreciation of real exchange rates. This will be facilitated by the increased exchange rate flexibility around the region. However, the still limited flexibility in China makes it more difficult for other countries to allow their exchange rates to strengthen. And this has been reflected in continued substantial reserve buildups in some cases. This can be both expensive, and also create difficulties for monetary management.
Responding to shifting patterns of production and trade
Turning to the second challenge, Asia needs to continue to adapt to shifting patterns of production and exports around the region and globally. The development of complex supply chains in the region centered on China is a familiar story. China has often been described as the assembly line of the region, combining high-tech imported inputs with cheap domestic labor to assemble final goods that are exported to the rest of the world. As part of this process, production in other countries in the region has moved up the valued added chain.
There is growing evidence that this situation is further evolving. China appears to be increasingly using domestically sourced rather than imported intermediate inputs, reflecting its increased production capacity and technological capability. This has been spurred by the high investment in recent years. A related development is that while China's trade surplus with the United States and the European Union has continued to grow, its trade deficit with the rest of Asia has begun to shrink over the last two years.
Asia is already adapting well to this challenge and to similar challenges from elsewhere, including India. Singapore is a striking example of how this can be done successfully. For the region, the key to continued adaptation to this type of challenge will be to increase the flexibility of economies, so that they remain competitive and responsive. Further development of capital markets, greater labor market flexibility, measures to improve the business climate and education policies all have a role to play.
Coping with volatile capital flows
A third challenge is coping with volatile capital flows. Increasing financial integration at the regional and global levels brings many potential benefits, including diversification of sources of finance and risk sharing. However, one issue that officials in many countries are currently grappling with again is how to deal with surges in capital inflows. While net inflows have been relatively constant in recent years, gross inflows and outflows have both risen sharply. The increase in outflows is particularly noteworthy. It reflects a growing desire of residents in Asian to invest outside their home countries, which is a natural part of Asia's growing financial integration with the global economy.
As well as increasing in scale, gross capital flows in the region have also become more volatile. Particular concerns here are that surges in inflows can put strong upward pressure on currencies; can provide additional—sometimes unwanted—loanable funds in the financial sector, potentially contributing to asset price bubbles; and, perhaps most importantly, can create a risk that funds might flow out more quickly than they came in.
A temptation may be to address these concerns by imposing some form of capital controls to discourage speculative inflows. While the use of capital controls cannot be entirely ruled out, it can be very difficult to do in practice. And such controls in these situations can be counterproductive. There is evidence to suggest that capital controls tend to be particularly easily circumvented when they are re-imposed on previously liberalized systems. Also, in those circumstances, controls can create doubts about the future direction of policy, potentially discouraging foreign direct investment.
Surges in capital inflows seem for the time being to be a feature of financial globalization. And there is no "magic bullet" for dealing with them. The best short-run policy response appears to be a combination of exchange rate flexibility, and limited sterilized intervention to smooth exchange rate movements. Over the longer term, further steps to develop and deepen financial markets, including in the context of regional financial integration, can also help. Further liberalization of restrictions on outflows, as warranted by the pace of financial market reform, can also support deeper integration and potentially offset swings in capital inflows.
A fourth challenge is responding to inequality, which has been rising steadily across the region. For example, China displays now a more skewed income distribution than the United States or Russia. In fact, widely used measures of income dispersion such as the Gini coefficient (shown in the chart) or the degree of polarization, all point in the same direction—more unequal sharing of income (including along a rural/urban divide). This, of course, is not a phenomenon unique to Asia.
The causes of the growing disparities are complex. Several factors may be at play in Asia, but skilled-bias technical progress in the more advanced economies and the transition from agriculture to industry in developing ones appear to be the main forces shaping income distribution in the region. Globalization is, of course, providing the broader context for the changes in technology and patterns of production that are at the root of differential wage and sectoral developments. Besides ethical or social implications, worsening inequality is a concern for economic policymakers. If unattended, growing disparities could strain social cohesion and undermine the support for further engagement in the global economy, in spite of the great potential benefits from doing so.
Asian policymakers are looking for ways to stem the trend. Specific measures depend on individual country circumstances, but in all cases need to be supported by sound macroeconomic management, which is necessary for sustainable growth. This holds out the greatest promise to lift the poor from poverty and provide better opportunities to the disadvantaged. But policies are also needed to address inequality more directly. These include greater and more effective spending on education and infrastructure, especially in poorer areas. But they also include many of the reforms already mentioned, including strengthening social safety nets, labor market reforms that facilitate hiring, and greater access to financial markets to empower the poor and improve economic efficiency. Since the old tend to be poorer, steps to better prepare for the fiscal impact of rapid population ageing will also help redress income inequalities in several countries.
To conclude, ten years after a major financial crisis, Asia is looking at the future with renewed confidence. It has good reason to do so. Ground has been regained where it had been lost and Asia is well positioned to be an ever greater force in the world economy. Encouragingly, policies are increasingly attuned to the quickening pace of globalization. Although the challenges remain large, reform must be a continuous process in today's fast-paced global economy. For its part, the IMF will continue to work closely with economies in the region to help them move forward with this reform process.