Subir Gokarn: Asian alternatives

Countries in the region appear to have realised the potential benefits of being in a fast-growing neighbourhood.

Uncertainty about the prospects for the global economy in the coming year or two persists. While the housing sector in the US has slowed down, it is not yet clear whether, or when, this will escalate into a broad-based recession. Macroeconomic indicators are still sending out mixed signals. While many baseline forecasts still suggest positive growth rates for 2008, they still indicate relatively high probabilities of the economy going into recession, commonly in the 30-40 per cent range. The impact of the housing sector slowdown and the problems in the financial sector will undoubtedly be aggravated by the high oil prices, which seem set to stay at or close to current levels in the coming months.

Asia has been the global engine of growth over the past few years. In 2006, China accounted for about 30 per cent of incremental global GDP (in purchasing power parity terms). The US and India accounted for 12 and 11 per cent, respectively. Asian growth has thus been driven by a combination of high growth rates in two large economies in the region and the buoyancy of exports, particularly to the US. This second contributor is clearly under threat in the event of a significant US slowdown, more so if it precipitates into a recession. The question is: will this have a significant impact on the region's growth performance?

There are a number of reasons to believe that the impact of a moderate slowdown in the US on overall Asian growth will be relatively mild. First, the fact that the two fastest-growing economies in the world are in the region provides substantial ballast to regional growth. Both China and India are undoubtedly highly integrated with the US, the former through manufacturing exports, the latter through a more diversified goods-and-services basket. However, it is also fair to say that, in recent years, the high growth rates of both economies have been significantly driven by domestic forces, both consumption and investment. Even if exports have large domestic multiplier effects, any weakness in them is unlikely to offset the combination of favourable demographics, rising affluence and capacity expansion driven by positive medium-to-long term prospects.

Of course, the region as a whole can benefit from the strong performance of these two economies only if there is a high level of integration between the Asian economies. The smaller economies, which export a much larger share of their GDP, are potentially far more vulnerable to a US slowdown, even a mild one. There is evidence of increasing economic integration amongst Asian economies. From a strategic perspective, the strongest indicator of this is the large number of trade agreements that countries in the region have entered into, or are in the process of doing, between themselves. More than half of the 60 or so agreements that the major economies in the Asia-Pacific region are signatories to exclusively involve other countries in the region.

There are signs that intra-regional trade is growing quite rapidly. While the US remains the biggest single importer from virtually all the Asian economies, their exports to countries within the region exceed their sales to the US. Some of this trade is undoubtedly providing intermediate inputs for final export to the US, so it is vulnerable to a US slowdown, but a lot of it is destined to meet rising domestic demand in these economies. The collective impact of the current and future trade agreements will only reinforce this trend, giving the countries in the region greater ability to benefit from their being in a fast-growing neighbourhood. The uncertainty about progress in the global trade framework is clearly not deterring these countries from trying to set up a regional system that potentially benefits them all.

From a shorter-term perspective, these economies are generally in a similar situation to the US with respect to their interest rate cycles. Central banks in virtually all of them were raising policy rates during 2005 and 2006. As a consequence, inflationary pressures moderated, which now gives them a choice of either holding course or reducing rates in order to stimulate domestic demand. If most of the countries in the region follow this course, there will be a broad-based regional stimulus, which, given the increasing trade integration, should provide a collective offset to slowing demand for imports from the US.

The one exception to the moderate inflationary scenario is, of course, China, which has seen a spurt in consumer prices in recent weeks, particularly food staples. The Chinese government has announced its commitment to dealing with this, but intends to rely on supply-side measures, at least for the time being. It does not seem likely that China will initiate a significant domestic demand contraction in order to counter inflationary pressures. Neither does it give any indication of letting the yuan appreciate faster than envisaged in the 2005 plan, which would be an obvious component of a demand contraction policy.

There are, of course, significant risks to this relatively comfortable scenario. If the US were to go into a recession, there is no guarantee that a regional domestic demand stimulus, combined with increasing integration will offset lost business in the short term. This risk is itself aggravated by the oil price situation. Both China and India are seeing their demand for petroleum products grow very rapidly. Both have resisted passing through current prices to domestic consumers, who, as a result, have not responded by cutting down on their fuel consumption. As the pass-through inevitably takes place, it is likely to take some toll on the growth rates in both economies. A slowdown in these two economies could then spill over into the other economies in the region.

Further, the opportunity that central banks now have to stimulate domestic demand by lowering interest rates is because inflation rates are moderate. Higher oil prices, to the extent that they translate into rising inflation rates, will constrain their ability to use this instrument. This, in fact, is a global concern. The inflationary consequences of oil prices could hinder the use of monetary policy to counter a recession.

In sum, while the persistence of the growth momentum in Asia is not seriously under threat even if the US economic growth were to slow down, there are visible threats to it, in particular, oil prices. But, countries in the region appear to have realised the potential benefits of being in a fast-growing neighbourhood and most are taking tangible steps to realise these.

The writer is Chief Economist, Standard & Poor's Asia-Pacific. The views are personal