Published November 20, 2008

No way can Asia escape the financial fallout

Effective policy response critical both within the region and also for the global economy


THE global financial turmoil has intensified in recent weeks, and the world economy is entering a deep and protracted slowdown. Despite bold actions in the United States and Europe to tackle the crisis, credit is likely to remain constrained for some time, as financial institutions continue to reduce leverage, while growth in industrial countries is expected to be negative next year. What does this mean for Asia? And what can be done to limit the impact on the region?

Despite Emerging Asia's strong fundamentals - notably its substantial cushion in official reserves and robust corporate and banking sector balance sheets (and limited exposure to US sub-prime mortgages and structured credit products) - any hope that the region would escape the crisis largely unscathed has evaporated. Weak global growth will depress demand for Asia's exports; indeed, a significant export slowdown is already underway. And the global financial turmoil is making itself felt strongly in the region, including through much tighter funding conditions, more volatile capital flows, sharply depressed equity prices, weakening currencies, and higher sovereign and bank spreads.

Looking ahead, slowing domestic economies (and, in some cases, cooling housing markets) will likely increase pressure on corporates, contributing to a rise in bad loans and credit costs for banks, and risking an adverse cycle of a tightening of credit conditions and deteriorating economic growth.

The International Monetary Fund's (IMF) Asia and Pacific Regional Economic Outlook, forthcoming early next week (see, projects a significant slowdown across the region, with growth falling well below trend in almost all countries. While emerging Asia is expected to escape the sort of full-fledged recession now expected for the US, EU and Japan, risks - notably from the global environment - are large and clearly to the downside.

Policymakers in the region have responded to the worsening economic environment with a range of measures. Several governments have broadened or increased guarantees on bank deposits or other liabilities, while central banks have taken steps to provide both domestic and foreign currency liquidity on an emergency basis. The focus of monetary policy in the region has been shifted decisively to supporting growth, and a number of fiscal stimulus packages have been adopted or announced.

These efforts should all help limit the damage to the region, but going forward, more will need to be done, at both the global and national levels. At last weekend's G-20 Summit in Washington, Asian countries played a key role - in line with their growing economic power - in developing an international roadmap for containing the current crisis and avoiding future ones. And national policies will play a critical role in protecting core financial institutions and softening the economic slowdown.

First, Asian policymakers need to continue to focus on ensuring financial stability and the functioning of credit markets. Despite the financial stresses, conventional bank lending in the region has held up reasonably well so far and policymakers need to stand ready to minimise the tightening of overall credit conditions and its spillovers to the economy. Monetary authorities will need to continue to supply their banking systems with adequate domestic and foreign exchange liquidity; develop contingency plans to extend guarantees and recapitalise banks, if necessary; and consider steps to support trade credit, should serious difficulties emerge. In all this, transparency and communication will be key, to allow both citizens and global investors to understand what is being done and why.

Second, monetary policy in almost all countries in the region should maintain an accommodative bias. With weakening domestic demand and lower commodity prices contributing to sharply reduced inflation risks, monetary policy should now be aimed squarely at supporting growth. However, with inflation rates still above target in some countries, communication by central banks regarding the economic outlook and the expected path of inflation will play a key role in anchoring expectations.

Fiscal stimulus

Third, fiscal policy can play a key role. Given the progress with fiscal consolidation in the region, most countries have room to use fiscal policy to support growth, albeit to varying degrees. While the best approach will vary across countries, fiscal stimulus is most effective when it is timely, temporary, and targeted to purposes providing the biggest 'bang for the buck'. Infrastructure spending can be part of the mix, provided that projects are high quality and can begin to be implemented quickly.

Fourth, intervention in the foreign exchange markets should be limited. A number of regional currencies have weakened sharply since September. While some intervention may be warranted to smooth excess exchange rate volatility and to address possible overshooting, sustained one-sided intervention may backfire, resulting in larger and more disruptive adjustments later. Moreover, given the potential need for further foreign exchange liquidity provision in some countries, international reserves should be marshalled for their most critical purposes.

Finally, despite Asia's generally strong fundamentals and appropriate policy response so far, it cannot be ruled out, especially if the global financial crisis intensifies, that some Asian economies could experience liquidity difficulties. The international community needs to stand ready to provide large-scale and rapid financial assistance in those circumstances.

The IMF is ready to do just that, and has already moved quickly to help emerging market countries in other regions. Last month, the Fund introduced a new short-term liquidity facility for countries with sound policies but which are facing short-term balance of payments pressures, and is moving to increase the pool of resources available to it. Moreover, substantial foreign exchange swaps are already available to Asean+3 countries under the Chiang Mai Initiative, and there have been discussions to increase these amounts and step up regional policy coordination more broadly.

So, while the period ahead will undoubtedly be a difficult one, Asia's strong fundamentals, coupled with a focused and proactive policy stance should limit the damage. Given Asia's role in recent years as a global engine of growth - the region contributed more than half of global growth in recent years - an effective policy response will be critical both within the region and for the global economy.

The writer is director of Asia and Pacific Department of the International Monetary Fund