Asia's Economic Challenge

Yiping Huang, Citigroup, Hong Kong.
This article appeared in the June 2008 issue of Current Economics with permission of the author.

Key Concepts: Inflation | CPI | Monetary Policy |
Key Economies: Asia | China | India | Indonesia

China’s Earthquake

The earthquake, measured at 8.0 in magnitude on the richter scale, in Wenchuan county of Sichuan province on Buddha’s birthday in May was China’s most devastating human tragedy in decades. The confirmed death toll has already exceeded 65,000 and is still growing. While it will take years to rebuild the damaged homes, factories and infrastructure, the broken hearts from the sudden loss of loved ones might never heal.

The authorities’ swift response, however, has already commanded wide applause around the world. This contrasts sharply with previous disasters. Thirty-two years ago, China suffered a major earthquake in the Tangshan prefecture of Hebei province that killed nearly 250,000 people. At that time, local authorities blocked the news. It took three days for a local district chief to get to Beijing and break the news to the top leaders. This time, within two hours of the earthquake, Premier Wen Jiabao was already on his way to the epicenter. The quick response also confirms that the Chinese authorities can be very decisive and effective in crisis situations.

The earthquake is likely to impact the economy and policy, but at the national level its magnitude should be modest. Natural disasters such as earthquakes often cause three kinds of direct economic impacts — damage of assets, loss of production and consumption, and increased investment for reconstruction.

The hard-hit areas are mainly located in Sichuan, Chongqing and Gansu in west China, none of which are economic centers. The three provinces combined account for about 7% of national GDP. If we assume that half of these regional economies halt for an average of one month as a result of the earthquake, the total loss of economic output could be close to 0.3% of the national GDP, or about Rmb75bn. As most of the losses will likely occur during May or June, second quarter GDP growth could slow by as much as 1 percentage point.

In the aftermath of the earthquake, however, investment is likely to accelerate. The government has already estimated the total damage to 14,207 industrial firms in Sichuan, Chongqing and Gansu at Rmb67bn. The total damaged assets, including infrastructure, housing and farm properties, could be Rmb750bn, or 3% of GDP in 2007. If reconstruction starts immediately, then the net impact of the earthquake on GDP growth in 2008 is likely to be small. But investment is likely to play an even more important role in driving China’s growth in the next year or two.

The earthquake may also have some temporary impact on inflation and macroeconomic policies. Due to production disruption and transportation damage, inflation rates, especially food prices, are likely to stay at elevated levels for relatively longer. For instance, Sichuan normally supplies 11% of pork for the national market. This implies that the authorities will have to continue to fight inflation. But on the margin, the tragedy could make policymakers more reluctant to adopt aggressive tightening measures. In fact, the People’s Bank of China already delayed the implementation of an announced hike in the reserve requirement for commercial banks in the hardest hit regions.

In summary, the earthquake will have some negative impact on economic activity in the near term. Industrial production in the earthquake-affected areas may suffer, while consumption may see a broad softening. Tourism is likely to experience the most visible slowdown. Beyond these immediate effects, strong economic growth will probably continue. Investment momentum may pick up again due to reconstruction efforts and this should provide further support for commodity markets.

Asian Central Banks’ Dilemma

Policymakers continue to face a growth-and-inflation dilemma in Asia. While economic activities have shown more evidence of moderation, inflation rates have climbed higher in recent months. Most central banks are torn between the need to tighten monetary policy to fight inflation and the urge to ease policy to limit growth slowdowns.

According to the latest monthly economic data, the pace of industrial production eased in China, India, South Korea, Malaysia, Taiwan and Vietnam, while growth of exports moderated in China, Malaysia, the Philippines, Singapore, Taiwan and Vietnam (see Figure 1, below). So far, the slowdown has been modest in magnitude in general, but the trend may be worrisome for authorities, especially as the US economy continues to weaken. In China, for instance, export growth fell to 21.8% in April, down from 30.6% in March, while production growth edged down to 15.7% from 17.8% during the same period.

Figure 1. Directions of Latest Changes in the Growth of Production, Exports and Inflation Figure 2. GDP Growth in Asia: Current Versus Potential (% y-o-y)
Growth of Production, Exports and Inflation in Asia GDP Growth in Asia
Note: ↑ means acceleration while ↓ implies deceleration according
to the latest monthly data.
Source: CEIC Data Company Limited and Citi estimates
Source: CEIC Data Company and Citi

Rising inflation has become even more uniform in the region, evidenced by recent data from China, India, Indonesia, South Korea, Malaysia, the Philippines, Thailand and Vietnam (see Figure 1). China’s CPI rebounded to 8.5% in April, up from 8.3% in March, and Vietnam’s escalated to 21.4% from 19.4% during the same period. In all of these economies, except Thailand and Malaysia, actual inflation rates are already way above official targets.

Asian central banks’ responses to this macroeconomic challenge have been somewhat different across the region. China, India and Taiwan, for instance, have maintained modest tightening steps. The People’s Bank of China and Reserve Bank of India have repeatedly adjusted reserve requirements in order to control liquidity conditions. The State Bank of Vietnam recently stepped up tightening efforts by hiking the policy rate to 12% from 8.5% previously, as the inflation problem was clearly getting out of hand.

In Indonesia, Bank Indonesia (BI) also hiked the policy rate by 25 basis points (bps) in May and June to 8.50%, as headline CPI, at 8.9% in April, was already way above its 4-6% target range. The fuel price adjustment in June, by 20-30%, will likely push CPI to the 10-11% range during the third quarter. We now expect BI to hike the policy rate by at least another 100bps before year-end. Meanwhile, Bank of Thailand (BOT) recently shifted to more hawkish tones, and it will probably begin to tighten in the coming months.

Meanwhile, South Korea and the Philippines have resisted calls to tighten monetary policy. Bangko Sentral ng Pilipinas emphasized the supply-side nature of the current inflation problem and reasoned that rate hikes would not be effective in bringing down energy or food price increases. Bank of Korea (BOK) appears to face increasing constraints from the new president’s pro-growth policy. The Korean government now forecasts 6% GDP growth in 2008, compared with our forecast of 4.2% and last year’s 5%. If the government’s influences come through the Monetary Policy Committee (MPC), then BOK might cut the policy rate before the end of the year.

Reluctance to tighten in face of rising inflation could lead to either forced aggressive policy actions later or an overshooting of inflation expectations. While we share some sympathy over the argument of supply-driven inflation, a lack of decisive monetary policy action could also yield at least two types of consequences. First, the central banks’ monetary policy credibility would suffer, especially for India, Indonesia, South Korea, the Philippines and Thailand, which adopt inflation targeting mechanisms. And, second, supply-driven inflation could spread quickly, as long as monetary conditions are loose. In some economies, including China, Korea and Thailand, core inflation has already begun to show an uptrend.

Supply-Driven Inflation

So far, energy and food are still the two most important contributors to Asia’s high inflation. This at least partially confirms the popular perception of supply-driven inflation. A comparison of growth potentials and current growth rates, however, provides a slightly different picture. Quite a few economies, such as Hong Kong, Indonesia, Korea, Malaysia, Singapore and Taiwan, all recorded above-potential growth rates during the first quarter of this year (see Figure 2, above). This suggests that demand might not be entirely innocent. But our 2008 GDP forecasts are below their growth potentials for every economy, implying possibly limited roles for demand in driving future inflation.

Therefore, gauging the future paths of commodity prices and their likely impacts on macroeconomic conditions becomes critical. In a recent report, we analyzed the long-term and short-term factors influencing food prices. Our key conclusion was that, while food markets would probably regain balance in the long run when technologies respond, food prices were likely to stay at elevated levels in the coming year.

The story for energy costs is probably even more complicated. The average West Texas Intermediate (crude oil) spot price rose from US$58.3/barrel in the first quarter of 2007 to US$97.9/barrel in first quarter of 2008. In fact, the rapidly rising oil price alongside the steady weakening of the global economy is one of the biggest puzzles this year. There are several hypotheses that try to explain the recent extraordinary surge of oil prices. One relates to increased financial investment as a result of hedging US dollar weakness. Another points to rising marginal costs of oil production. In any case, it might be safe to conclude that the good days of cheap oil may be gone for a long time, even if oil prices do correct in the near term.

Figure 3. OEF Simulation: Impacts of a US$10 Increase in Oil Prices Figure 4. China and Korea: Oil Expenditures as Shares of Nominal GDP (%)
Impact of a US$10 Increase in Oil Prices China and Korea Oil Expenditures
Source: OEF model simulation Source: BP, CEIC Data Company and Citi

What are the macroeconomic consequences of high oil prices? As a first step, we apply the Oxford Economic Forecasting (OEF) model to simulate a US$10 increase in oil prices. The simulation results may not reflect accurately what would happen in the real economy. Yet, they are useful for guiding and organizing our thoughts. According to the model, a US$10 increase in oil prices reduces GDP growth by an average of 0.4ppt, raises CPI by 0.5ppt, reduces current account balances by 0.6ppt of GDP and lowers fiscal balances by 0.1ppt of GDP (see Figure 3, above).

Recent experience suggests that these estimates, especially those for growth and inflation, are probably too large. A key reason is that the simulation results are based on historical correlations. But the coefficients have probably shifted significantly over time, particularly during the last decade or two. One possible reason is that the recent surges in oil prices have been steady, rather than abrupt, which provides time for the economies to adjust and adapt. Another possible factor is the declining proportion of energy in production. For example, China’s oil intensity of GDP (measured by oil consumed in tons divided by GDP in constant prices) dropped by 71% between 1978 and 2007. Similar changes can be observed in all other economies in the region.

This latter factor is very important in understanding the reduced impact of oil on the economy. Oil expenditure as a share of nominal GDP rose significantly during the past five years in Asian economies due to the surge of oil prices (see Figure 4, above). However, the current shares are still lower than the peaks reached in 1980, thanks to declines in oil intensity.

The US$200/Barrel Scenario

As a risk scenario, we examined the likely impact of oil prices reaching US$200/barrel by the end of this year. Based on this assumption, we calculate the average oil price to be US$141.7/barrel in 2008, compared with US$72.3 in 2007 and US$66.1 in 2006. The quarterly oil price profiles are likely to be US$98.0 (actual), US$123.4, US$156.3 and US$189.1, assuming smooth growth of oil prices during the rest of the year. If the average oil price is US$142, then the shares of oil expenditure in nominal GDP likely will reach 11.4% in China and 11.7% in Korea, exceeding their respective peaks in 2008. This would certainly present a very different picture.

By halving the growth elasticity estimates from the OEF model, we conclude that an increase in oil price by US$10/barrel would slow Asian economic growth by an average of 0.22ppt. And oil prices rising to US$200 before year-end (or an average US$142/barrel for 2008 from last year’s US$72/barrel) could result in a reduction of Asia’s GDP growth by another 1.5ppt. Our current GDP forecast is 7.5% on average for Asia in 2008, compared with 8.7% in 2007. Higher oil prices could mean greater downside risks for these economies.

Thailand, Taiwan, Malaysia, India, Indonesia and China all have high energy-intensity. These are also the economies that will likely be more affected by further increases in oil prices (see Figure 5, below). However, most of them, including Malaysia, India, Indonesia and China, all have domestic oil subsidies (see Figure 6, below). This could help reduce the short-term impact on growth but should add significant pressures on fiscal balances. The inflation impacts could be more direct and significant. Currently, we forecast an average CPI of 5.5% for Asia in 2008, compared with 4.0% in 2007. However, if oil prices reach US$200 this year, then this might add at least 3.5ppts to the average inflation rate, if we apply the inflation elasticity from Figure 3.

Most Asian economies are net oil importers, with Indonesia, Malaysia and Vietnam being the only exceptions (see Figure 6). In 2007, oil trade deficits accounted for 7.9% of GDP in Thailand, 5.9% in the Philippines and 6.7% in Korea.

Figure 5. Oil Intensity of GDP for Asian Economies, 2006 (Tons of Oil/US$mn GDP) Figure 6. Net Oil Imports and Oil Subsidies
in 2007
Oil Consumption and GDP for Asia Net Oil Imports and Oil Subsidies in Asia</td>
<td width=
Note: Oil consumption for Singapore excludes those for the refinery as most of the finished goods are exported in the end.
Source: BP and Citi
Source: CEIC Data Company and Citi
Figure 7. Asia's 2008 Current Accounts: Base Case and Risk Case with Oil Shock
Current Account Balances in Asia
Source: Citi estimates  

In 2007, when average oil prices were US$72/barrel, China’s net imports of oil were US$85.2bn, or equivalent to 2.5% of that year’s GDP. If oil prices rise to US$142/barrel this year, as we assume, then China’s trade balance and current account balance could deteriorate by roughly another 2.5ppts of GDP. Our base case forecast for the 2008 current account surplus is 8.5% of GDP for China. Oil prices rising to US$200 by year-end could reduce China’s current account surplus to 5.9% of GDP (see Figure 7, above). This would not pose any serious problem for China.

But for the Philippines, Taiwan and Thailand, the current account surpluses could turn to deficits of -3.5%, -5.0% and -4.1% of GDP, respectively. In India and Korea, their current account deficits could widen sharply to -6.0% and -8.0% of GDP, respectively. As a result, the peso, Taiwan dollar, baht, rupee and won could suffer from high oil prices.

Finally, spiking oil prices would also have negative impacts on economies with domestic oil subsidies, mainly China, India, Indonesia and Malaysia. However, Indonesia has already carried out fuel adjustment, by 20-30% in June. Malaysia also announced a possible price adjustment, possibly by 20%. Once these happen, the inflation rates in Indonesia and Malaysia will probably shoot up. The potential growth effects should become greater, but the fiscal pressures could ease. This leaves India, whose fiscal deficit is already close to 6% of GDP, as the only major economy to tangle with higher fiscal subsidies.

Home Download Sample Order Economic Forecasts Contact

Copyright © 2008-2013 Consensus Economics Inc Site Map