asia economic monitor - december 2006

8/14/2019 Asia Economic Monitor - December 2006

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Highlights

Recent Economic Performance East Asias GDP likely grew 5.2% in the rst three quarters of 2006,

spurred by strong and steady demand for the regions exports andan expansion in domestic demand that peaked in several economiesin the rst half.

The export recovery, which started in the second half of 2005,extended well into the second half of this year for most of theregions economies, markedly boosting the contribution of externaldemand to the economic expansion.

Growth in domestic demand began to weaken in the second halfof 2006 in the NIEs and ASEAN-4, re ecting a drop-off in already

low investment growth and, more generally, slightly softer but stillstrong growth in consumption.

In the PRC, growth of investment in xed assets peaked in June2006 before slowing markedly as a result of the cumulative policymeasures introduced to curb excessive investment in key sectorssuch as real estate.

With the moderation in world economic expansion and softeningglobal oil prices, in ationary pressures have eased across most ofEast Asia.

Strong export growth and subdued import growth sustained current

account surpluses through the rst half of 2006, while net overallforeign in ows into the region continued into the second half of2006, resulting in continued reserve accumulation.

As in ationary pressures subsided, and with US policy ratesunchanged since late June 2006, policy interest rates remainedstable across much of East Asia in the second half of 2006, aftersubstantial tightening in the previous six months.

Financial sector indicators in East Asia generally remained strong,but progress in nancial sector reform and restructuring has beenuneven and vulnerabilities remain, such as growing exposure ofbanks to real estate.

Outlook, Risks, and Policy Issues With economic growth in the US and euro zone slowing to a more

tempered pace, the external environment facing East Asia in 2007is likely to be somewhat less supportive of economic growth, butmore conducive to containing in ation.

Continued overleaf

The Asia Economic Monitor (AEM) is asemiannual review of East Asias growth,

nancial vulnerability, and emerging policy

issues. It covers the 10 members of theAssociation of Southeast Asian Nations;Peoples Republic of China; Hong Kong,China; Japan; Republic of Korea; andTaipei,China.

Asia Economic Monitor 2006

December 2006 aric.adb.org

Asian Development BankOf ce of Regional Economic Integration

6 ADB Avenue, Mandaluyong City1550 Metro Manila, Philippines

Telephone+63 2 632 6239+63 2 632 4444

Facsimile+63 2 636 2183

[email protected]

How to reach us

ContentsRecent Economic Performance 3

GDP Growth 3

In ation 7

Balance of Payments 8

Financial and Exchange Markets 14

Monetary and Fiscal Policy 16

Assessment of FinancialVulnerability 21

Prudential Indicators 21

Activity Indicators 26

Market Indicators 27

Outlook, Risks, and Policy Issues 35

External Economic Environment 35

Regional Economic Outlookfor 2007 38

Risks to the Outlook 39

Policy Issues 43

Outlook for Individual Economies 46

Boxes1. Measures to Cool Investment in the

PRC: Are They Effective? 5

2. Of cial Foreign Exchange Reserves: How Much is Enough? 12

3. Monetary Conditions in East Asia:The Relative Importance of Interest and Exchange Rates 18

4. Indicator for Assessing FinancialSector Vulnerability 22


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Acronyms, Abbreviations, and Notes

ADB Asian Development BankAEM Asia Economic MonitorAMA advanced management approachARIC Asia Regional Integration CenterASEAN Association of Southeast Asian

NationsASEAN-4 Indonesia, Malaysia, Philippines,

Thailand

bbl barrelbp basis pointBOK Bank of KoreaCAR capital adequacy ratioCBC Central Bank of China (Taipei,China)CLI composite leading indicatorEAD exposure at defaultEU European UnionGDP gross domestic productIMF International Monetary FundIRB internal ratings basedIT information technologyJCI Jakarta Composite IndexKLCI Kuala Lumpur Composite IndexKOSPI Korean Stock Price IndexLao PDR Lao Peoples Democratic RepublicLGD loss given defaultLGU local government unitM effective maturityM2 broad moneyMCI monetary conditions indexMMR money market rateMSCI Morgan Stanley Capital

International Inc.NBC National Bank of CambodiaNEER nominal effective exchange rateNIE newly industrialized economyNPL nonperforming loanNYMEX New York Mercantile ExchangeOECD Organisation for Economic Co-

operation and DevelopmentOPEC Organization of the Petroleum

Exporting CountriesOREI Of ce of Regional Economic

Integration

PBC Peoples Bank of ChinaPCOMP Philippine Composite IndexPD probability of defaultpp percentage pointPRC Peoples Republic of Chinarepo repurchaseROA return on assetsROE return on equityROPOA real and other properties owned

and acquiredS&P Standard & PoorsSAFE State Administration of Foreign

ExchangeSET Stock Exchange of ThailandSOE state-owned enterpriseSTI Straits Times IndexTWSE Taiwan Stock Exchange IndexUS United States

WTO World Trade Organization

q-o-q quarter-on-quartery-o-y year-on-year

Coupled with an expected slowdown in growth in Japan and thePRC, the somewhat less favorable external environment shouldlead to a moderation of average GDP growth in East Asia from apostcrisis peak of 4.9% in 2006 to 4.4% in 2007.

Slowing growth is expected to ease in ationary pressures across theregion in 2007, continuing the trend of recent months, while currentaccount surpluses are expected to remain relatively strong.

Several risks could upset the above outlook: (i) a sharper-than-expected slowdown in the US economy, (ii) a disorderlyadjustment of global payments imbalances, (iii) signi cant global

nancial market turbulence, (iv) a sudden oil supply shock, (v) aninsuf cient slowdown of the PRC economy, and (vi) disruptionsstemming from non-economic shocks such as geopolitical tensionsand an avian u pandemic.

While the threat of persistently high in ation in the US has notfaded completely, the near-term risk of a sharper-than-expectedslowdowneven the possibility of a recessionis higher now thanin early 2006.

East Asia remains vulnerable to a disorderly adjustment of thestill-growing global payments imbalance, especially because manyeconomies in the region have signi cant exposure to the US throughtrade, investment, and nance.

There is a possibility of signi cant global nancial market turbulence.Markets are increasingly jittery over the risk of a US recession, asliding US dollar, and an uncertain path of US monetary policy.

Although international oil prices have fallen from the August 2006peak, a sudden reversal could further slow growth in economiesworldwide and reignite in ationary pressures.

Despite the recent easing of investment growth in the PRC, thereremains the risk that growth may not slow smoothly to a moresustainable pace.

Given the outlook for slower growth and reduced in ationarypressures, the case for additional increases in policy interest ratesis less clear in most East Asian economies.

The economic outlook offers limited rationale for aggressive scalexpansion in the near term, although additional public spendingon priority infrastructure may be desirable.

Structural vulnerabilities remain, however, and policy adjustmentscould focus on (i) alleviating constraints on productive investmentsin some economies and improving the quality of investment inothers, (ii) applying greater exchange rate exibility, (iii) increasingenergy ef ciency, and (iv) developing rapid-response systems tominimize damage from exogenous shocks.

Although there are many constraints on domestic market-orientedinvestment, policies that rebalance the sources of growth away fromexports toward domestic demand are of particular importance.

The Asia Economic Monitor December 2006was prepared by the Office of RegionalEconomic In t eg ra t ion o f t he As ianDevelopment Bank and does not necessarilyre ect the views of ADBs Board of Governorsor the countries they represent.

Note: $ denotes US dollars unless otherwise

speci ed.


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3

East AsiaA Regional Economic Update 1Recent Economic Performance

GDP Growth

East Asias gross domestic product (GDP) likely grew 5.2% inthe rst three quarters of 2006, spurred by strong and steadydemand for the regions exports, and an expansion in domesticdemand that peaked in several economies in the rst half. InJapan, year-on-year (y-o-y) GDP growth 2 crested at nearly 4.0%in the rst quarter of 2006 before easing slightly over the next twoquarters (Figure 1). The newly industrialized economies (NIEs)and to a much lesser extent the four middle-income countries ofthe Association of Southeast Asian Nations (ASEAN-4), mirroredthis trend. 3 In contrast, GDP growth soared to 11.3% in thesecond quarter in the People's Republic of China (PRC) and then

began to ebb as policies to curb booming investment took hold.Notwithstanding recent slower growth, in the rst three quartersof 2006 East Asian GDP growth rates were higher than in 2005(Figure 2).

GDP growth slowed after the rst quarter of 2006 as domesticdemand weakened. Among the NIEs and ASEAN-4, this mainlyre ected a drop-off in already low investment growth and,more generally, slightly easier consumption growth (Figure 3).The external sector partially cushioned the effect of slowinginvestment on growth as (i) export volume sustained a relatively

rapid pace of growth, and (ii) ongoing adjustments to highcommodity prices and a drawdown on inventories restrainedimport volume growth.

Consumption growth eased in the second half of 2006 yetremained strong in several East Asian economies. In Japan,for example, temporary factors, such as an exceptionally hotsummer, sharply curtailed private consumer spending in the third

0

2

4

6

8

10

2003Q1 2003Q3 2004Q1 2004Q3 2005Q1 2005Q3 2006Q1 2006Q3e

11.3

East Asia

PRC 2

ASEAN-4

NIEs

Japan

10.4

8.4

6.5

8.0

5.2

6.2

5.7

4.8

5.75.0

0.4

3.92.7

5.1

Figure 1: Regional GDP Growth 1

e=estimate1 Weighted by gross national income (atlas method,current $). Aggregates do not include Brunei Darussalam,Cambodia, Lao PDR, Myanmar, or Viet Nam.2 PRC estimates based on OREI staff calculations.Sources: OREI staff calculations based on national sources.

10.2

2.7

5.1

4.7

10.7

3.1

5.4

5.7

0 2 4 6 8 10 12

PRC 2

Japan

ASEAN-4

NIEs

2006Q1-Q3e2005

Figure 2: Regional GDP Growth 1 (y-o-y, %)

e=estimate1Weighted by gross national income (atlas method, current $).2 PRC estimates based on OREI staff calculations.Sources: OREI staff calculations based on national sources.

1.3

3.4

-1

0

1

2

3

4

5

6

7

8

2003Q1 2003Q3 2004Q1 2004Q3 2005Q1 2005Q3 2006Q1 2006Q3e

Consumption

InvestmentNet Exports

Statistical DiscrepancyGDP

4.2

-0.9-0.7

2.3

5.3

7.4

5.5

3.8

6.1

5.1

1.4

1.9

3.4 3.1 2.2

1.93.1

2.1 2.9 2.8 2.6

0.9

3.1

2.2 0.7 1.2

0.5

Figure 3: Contributions to Regional 1 GDPGrowth (y-o-y, %)

1East Asia includes the 10 members of the Association of Southeast Asian Nations(Brunei Darussalam, Cambodia, Indonesia, Lao Peoples Democratic Republic,Malaysia, Myanmar, Philippines, Singapore, Thailand, and Viet Nam), plus PeoplesRepublic of China; Hong Kong, China; Japan; Republic of Korea; and Taipei,China.2Unless otherwise noted, all growth gures are y-o-y.3The newly industrialized economies are Hong Kong, China; Republic of Korea; Singapore; and Taipei,China. The ASEAN-4 economies are Indonesia, Malaysia,Philippines, and Thailand.

e=estimate1Regional = ASEAN-4 + NIEs.Source: OREI staff calculations based on CEIC data.


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R E G I O N A L U P D A T E

4

quarter of 2006. This interrupted a vigorous period of expansionsupported by higher labor income and rmer prices, whichboosted consumer and business con dence. In the PRC, private

consumption remained healthy, although it contributed less thaninvestment to overall economic growth. Nominal monthly retailsales growth averaged 13.5% through September 2006, pointingto a third consecutive year of double-digit gains. Among the NIEs,despite softening, private consumption contributed signi cantlyto GDP growth (Figure 4). In the Republic of Korea (Korea),however, the recovery in private consumption from a householddebt-related contraction in 2003 seemed to be winding down inthe third quarter of 2006. And in Taipei,China a large credit debtoverhang constrained consumer spending.

In ASEAN-4 economies, more stable GDP growth partly re ectsthe larger contribution from private consumption than in the NIEs,even if growth performance in these countries was uneven. Forexample, in the Philippines, large overseas workers remittancescontinued to allow for strong and stable growth in privateconsumption. In contrast, faltering private consumption growthwas most evident in the high-in ation Indonesian environment,although it was offset by very strong public consumptiongrowth.

Investment generally slowed in 2006. In Japan, a contraction in

public investment more than offset stronger private investmentgrowth, driven by rising capacity utilization and improved businesscon dence. In the PRC, growth of investment in xed assetspeaked at 33% in June 2006 before dropping to 16% in October,as a result of the cumulative policy measures introduced to curbexcessive investment in key sectors such as real estate (Box 1).Elsewhere, persistently weak or uneven investment contributedlittle to economic growth. In the NIEs, a light rebound in domesticinvestment faded after the rst quarter of 2006 as inventorieswere drawn down (Figure 5a). Over the rst three quarters of2006 in Hong Kong, China and Singapore, xed investment growth

rebounded somewhat from exceptional weakness in 2005, but wasstill weak in Korea and contracting in Taipei,China. The ASEAN-4economies underwent sharper inventory corrections and a morepronounced overall deterioration in investment (Figure 5b). Overthe rst three quarters of 2006, xed investment reboundedsomewhat in Malaysia, but dropped off sharply in Indonesia andThailand, and continued to contract in the Philippines.

Figure 4: Private ConsumptionContributions to GDP Growth: NIEs andASEAN-4 (y-o-y, %)

e=estimateSource: OREI staff calculations based on CEIC data.

2003Q1 2003Q3 2004Q1 2004Q3 2005Q1 2005Q3 2006Q1 2006Q3

Fixed AssetsChanges in InventoryTotal Domestic Investment

0.4

2.4

1.20.7

-4

-3

-2

-1

1

2

3

4

1.1

3.2

1.0

1.7

0.9

-1.3-1.0

-0.3

-1.5

-0.3

0.8

-0.5

Figure 5a: Investment Contributions toGDP Growth: NIEs (y-o-y, %)

Source: OREI staff calculations based on CEIC data.

-4

-3

-2

-1

1

2

3

4

2003Q1 2003Q3 2004Q1 2004Q3 2005Q1 2005Q3 2006Q12006Q3e

-0.8

3.2 3.1

1.9

-1.3

0.1

-0.3

Fixed AssetsChanges in InventoryTotal Domestic Investment

0.91.2 2.3

0.51.0

0.5

2.4

-1.7

2.1

-1.4

0.8

0.1

-0.4

-1.8

-0.8

Figure 5b: Investment Contributions toGDP Growth: ASEAN-4 (y-o-y, %)

e=estimateNote: 2006Q3 for Indonesia and Thailand are OREI staffestimates.Source: OREI staff calculations based on CEIC data.

2.1 2.11.6

-1.2

2.4

4.0

-2

-1

0

1

2

3

4

2003Q1 2003Q3 2004Q1 2004Q3 2005Q1 2005Q3 2006Q1 2006Q3e

NIES ASEAN-4


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5


Oil prices began to climb in mid-2003 after remaining below $25 per barrel (bbl)apart from spikesfor

17 years. Prices rose by 33% in 2004, 42% in 2005, and 20% in the rst half of 2006. These are historichighs in nominal terms, altho ugh abou t 16%below the highs of 1979 1980 in rea l terms(F ig ur e B1 .1 ). Du ri ng much of this ascent, 6-month futures were priced higher than 12-monthfutures, suggesting that oil prices were expectedto decline (Figure B1.2). However, in late 2005,near-term prices fell below lo ng er -t er m pr ic es ,me an in g th e ma rk et expects a longer periodof elevated oil prices. Since then , the dif ferentia lhas stayed near zero.

Rapidly growing demand, limited spare capacity,geopolitical uncertainties in oil-producing regions,supply disruptions, and in cr ea se d in te re stfrom portfolio investors in global oil marketshave worked in tandem to generate both high andvolatile oil prices.

From the demand side, wo rl d GD P gr ow thhist ori cal ly out pace d energy consumptiongrowth (Figure B1.3). The gap was widest in theearly 1990s and the late 1990s. However, growthin energy consumption accelerated with therecovery from the global sl ow do wn in 20 01 ,surpassing world GDP growth in 2002. Onaverage, while globa l oil demand grew atabout 1 million bbl per day (mbd) in the 1990s, itgrew by 1.5 mbd between 2002 and 2005. Muchof this came from rapid econ omi c gro wth ofthe PRC and other large emerging economies.PRC demand increased from 2 mbd in 1990to 7 mbd in 2005. With emerg ing economiesnow accounting for a larger share of theworld economy, energy dem and is gr owi ngfa st er re la ti ve to th e global economy.

However, although growth in global oil consumption

slowed from 4% in 2004 to 1.3% in 2005andis expec ted to rem ain somewhat subdued at1.5% in 2006oil prices have continued to rise.This suggests that other factors besides energy demand are also at work in keeping energy prices high.

1Emerging East Asias consumption of world energy more than doubled from 8.4% in 1980 to 21.2% in 2005. Energy consumption in non-Organisation for Economic Co-operation and Development (OECD) economies is expected to account for 75% of the growth in world energyconsumption and, in 2015, to surpass that of OECD economies. International Energy Outlook 2006 , Energy Information Administration, US

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Jan-71

Jan-76

Jan-81

Jan-86

Jan-91

Jan-96

Jan-01

Jun-06

68.9

54.4Real Price

Nominal price

4045505560657075

Jun-06Jan-06Sep-05May-05

Nominal price

Real Price

65.1

Note: Real Brent price de ated using producers price in dex of allcommodities with Dec 2001 as base year.Sources: International Financial Statistics Online (International MonetaryFund), Bloomberg, and US Bureau of Labor Statistics.

Figure B1.2: 6-month Minus 12-month Futures Oil Price,NYMEX ($/bbl)

Source: Bloomberg.

01-Jan-02

-2

-1

0

1

2

3

4

5

30-Jul-02 25-Feb-03 23-Sep-03 21-Apr-04 19-Nov-04 29-Jun-05 07-Jul-06

3.9

-0.1

-1.7


Box 1: Measures to Cool Investment in the PRC: Are They Effective?

The recent drop in the growth

of xed asset investment in thePeoples Republic of China (PRC)comes after a long period when,despite numerous measuresto restrain the investmentboom, investment grew almostunabated (Figure B1). Thisraised concerns that measurestaken to cool investment werenot effective. Many analysts hadpreviously suggested that theproblem was primarily one ofexcess growth of the monetarybase (liquidity), stemming in

part from foreign exchangemarket intervention, whichcontributed to excessive banklending to nance projectsof perhaps questionablequality. A secondary problemwas continuing investmentpromotion by local governments,for example, through theextensive use of credit lines(called package loans) to nancelocal investment projects.

Accordingly, many policies in2005 focused on graduallyreducing overseas sources ofexcess liquidity. This approachcontinued into 2006 but wascomplemented in mid-year by(i) non-market measures suchas decrees to curb packageloanstargeting domesticsources of excess liquidityandby (ii) direct measures to curbinvestment in speci c sectors,such as higher downpaymentson mortgage loans. In thesecond half of the year, however,authorities increasingly usedmore market-based measuressuch as hiking interest ratesand reserve requirements. Allof these policy actions were

1World Bank, China Quarterly Update , August 2006, Box 2.2World Bank, China Of ce Research Working Paper No. 5: How Will Chinas Savings-Investment Balance Evolve?, p. 24,www.worldbank.org.cn.3See, for example, the exchange of views between Weijan Shan of TPG Newbridge and Bert Hofman and Louis Kuijs of the World Bank in the September, October, and November issues of the Far Eastern Economic Review .

designed to cool investment

by reducing liquidity and creditgrowth.

World Bank evidence suggestsone reason these measureshad limited success was that ahigh proportion of investmentprojects were nanced by retainedearnings of unusually pro tableprivate enterprises. 1 In fact,the World Bank estimates thatenterprise savings in 2005 were20.0% of GDP, as comparedwith, for example, 4.8% for India

in 2004 and 14.8% for Koreain 2002. 2 Given that enterpriseinvestments totaled an estimated31% of GDP, this means thatroughly two-thirds of investmentswere nanced by enterprisesavings. This does not necessarilymean that retained earnings are

nancing investment, howeverpro ts from rms with surplussavings relative to investmentplans are still channeled throughthe banking system (together withhousehold savings) to other rmswith savings de cits relative totheir investment plans. However,the World Bank also suggests thatsectors with the most pro tableprivate sector rms are also thosewith the highest investment rates,implying that retained earningsmay be playing an important role.

If retained earnings are fundinga large share of investment thenmacroeconomic managementbecomes more dif cult because(i) investment will be procyclical,accentuating business cycles,(ii) it will be less subject to marketdiscipline, and (iii) monetarypolicy will be less effective. Thus,the World Bank concludes that

an important policy would

be one that discouragesexcessive retention of earnings.For example, state-ownedenterprises (SOEs) might berequired to distribute dividends.

However, the conclusion thatretained earnings are nancingthe bulk of investment has beenchallenged by other analysts,who argue that enterprisepro tability in the PRC is muchlower than suggested by theWorld Bank, and that the

confusion arises, in part, becauseof statistics that are eithermismeasured, misinterpreted,or both. Some have pointedout that the National Bureauof Statistics data show that23% of all industrial rms andone-third of SOEs are losingmoney, concluding that true

rm pro tability is lowin partbecause of declining prices for

nished products. 3 Thus, banksnance the bulk of investment

and this low-pro t model ofrapid growth is risky for the PRCbecause of the threat to banksfrom a signi cant nonperformingloan overhang. The implicationis that the policy priority shouldbe to improve bank supervisionand banking practices as acomplement to reducing liquidityin the system.

At rst glance, these views areirreconcilable. Either the bulk of

investment is funded by retainedearnings or by banks. Bothcant be true. However, in termsof policy, these two views arenot as incompatible as at rst


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Box 1: High and Volatile Oil Prices: A Need for Improving Energy Ef ciency

Oil prices began to climb in mid-2003 after remaining below $25 per barrel (bbl)apart from spikesfor

17 years. Prices rose by 33% in 2004, 42% in 2005, and 20% in the rst half of 2006. These are historichighs in nominal terms, altho ugh abou t 16%below the highs of 1979 1980 in rea l terms(F ig ur e B1 .1 ). Du ri ng much of this ascent, 6-month futures were priced higher than 12-monthfutures, suggesting that oil prices were expectedto decline (Figure B1.2). However, in late 2005,near-term prices fell below lo ng er -t er m pr ic es ,me an in g th e ma rk et expects a longer periodof elevated oil prices. Since then , the dif ferentia lhas stayed near zero.

Rapidly growing demand, limited spare capacity,geopolitical uncertainties in oil-producing regions,supply disruptions, and in cr ea se d in te re stfrom portfolio investors in global oil marketshave worked in tandem to generate both high andvolatile oil prices.

From the demand side, wo rl d GD P gr ow thhist ori cal ly out pace d energy consumptiongrowth (Figure B1.3). The gap was widest in theearly 1990s and the late 1990s. However, growthin energy consumption accelerated with therecovery from the global sl ow do wn in 20 01 ,surpassing world GDP growth in 2002. Onaverage, while globa l oil demand grew atabout 1 million bbl per day (mbd) in the 1990s, itgrew by 1.5 mbd between 2002 and 2005. Muchof this came from rapid econ omi c gro wth ofthe PRC and other large emerging economies.PRC demand increased from 2 mbd in 1990to 7 mbd in 2005. With emerg ing economiesnow accounting for a larger share of theworld economy, energy dem and is gr owi ngfa st er re la ti ve to th e global economy.

However, although growth in global oil consumption

slowed from 4% in 2004 to 1.3% in 2005andis expec ted to rem ain somewhat subdued at1.5% in 2006oil prices have continued to rise.This suggests that other factors besides energy demand are also at work in keeping energy prices high.

1Emerging East Asias consumption of world energy more than doubled from 8.4% in 1980 to 21.2% in 2005. Energy consumption in non-Organisation for Economic Co-operation and Development (OECD) economies is expected to account for 75% of the growth in world energyconsumption and, in 2015, to surpass that of OECD economies. International Energy Outlook 2006 , Energy Information Administration, US

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Jan-71

Jan-76

Jan-81

Jan-86

Jan-91

Jan-96

Jan-01

Jun-06

68.9

54.4Real Price

Nominal price

4045505560657075

Jun-06Jan-06Sep-05May-05

Nominal price

Real Price

65.1

Note: Real Brent price de ated using producers price in dex of allcommodities with Dec 2001 as base year.Sources: International Financial Statistics Online (International MonetaryFund), Bloomberg, and US Bureau of Labor Statistics.

Figure B1.2: 6-month Minus 12-month Futures Oil Price,NYMEX ($/bbl)

Source: Bloomberg.

01-Jan-02

-2

-1

0

1

2

3

4

5

30-Jul-02 25-Feb-03 23-Sep-03 21-Apr-04 19-Nov-04 29-Jun-05 07-Jul-06

3.9

-0.1

-1.7


16.2

0

5

10

15

20

25

30

35

40

45

Jun-04

Sep-04

Dec-04

Mar-05

Jun-05

Sep-05

Dec-05

Mar-06

Jun-06

Oct-06

3

1

6 8 10

12

14

4 5 7 9 11 13

15

2

16.5

32.5

16

appears. The exact ratio mightbe in question but it is possiblethat there are large numbersof rms nancing their owninvestments and signi cantnumbers of less pro table

rms borrowing from banks.Thus, (i) encouraging accuratereporting and measurementof pro ts, (ii) implementing asensible dividend policy for SOEs,(iii) improving bank performance,

and (iv) using more directmarket measures to drain excessliquidity from nancial marketsare all important policies thatcan reduce risks and improvemacroeconomic management.

Oct 2004: Peoples Bank of China (PBC)removed ceiling on most commerical banklending rates; raised benchmark one-yearlending rate and one-year benchmark depositrate by 0.27 percentage point to 5.58% and2.25%, respectively.

1

Dec 2004: PBC issued central bank bills with3-year maturity for the rst time.2

May 2005: Authorities announced property-related measures to curb speculation in

residential and commercial markets, includingsales tax on residential ats sold within 2 years ofinitial purchase, and a tax penalty on developersfor land undeveloped within a year of purchase,among others.

4

Mar 2005: Downpayment for consumerhousing loans was raised from 20% to 30%for cities and areas believed to have rapidlyincreasing real-estate prices.

3

Jul 2005: PBC adopted market-basedmanaged oating foreign exchange regime.5

Sep 2005: State Administration of ForeignExchange (SAFE) enhanced overseas investmentsupport of domestic foreign-exchange designatedbanks providing guarantees to PRC enterprises andquali ed domestic institutions foreign investmententerprises.

6

Oct 2005: PBC sterilized liquidity throughissuance of 3- and 6-month bills.7

Nov 2005: PBC conducted rst-ever currencyswap worth $6 billion, for a year.8

Mar 2006: SAFE announced further liberalizationof capital account including liberalization of domesticcompanies overseas investments.

9

April 2006: Several ministries jointly issued a

decree to stop providing package loans or creditcooperation agreements with local government units(LGUs). PBC convened window guidance meetingto control rapid credit expansion and improve loanstructure. PBC raised benchmark one-year lendingrate by 0.27 percentage point to 5.85%.

10

May 2006: Real estate investments by foreign-ers were restricted. PBC adjusted downpaymentratio for mortgage loans by commercial banks to beno less than 30%.

11

Jun 2006: PBC (i) tightened liquidity by issu-ing central bank bills to commercial banks thathave created excessive loans, (ii) establishedforeign exchange primary dealer system, and(iii) convened window guidance meeting tocontrol rapid credit expansion. Restrictions onreal estate investment were imposed.

12

Jul 2006: PBC further adjusted policiesgoverning overseas investments: removingforeign exchange quotas and allowing domesticinvestors to make overseas payments on pre-investment expenditures with their own foreignexchange. Reserve requirement ratio rose by0.5% to 8.0%.

13

Aug 2006: PBC raised (i) reserve

requirement ratio by 0.5 percentage point to8.5%; (ii) benchmark one-year lending rateand one-year deposit rate by 0.27 percentagepoint to 6.12% and 2.52%, respectively; and(iii) individual mortgage rate by 5 percentagepoints to 15%.

14

Sep 2006: PBC raised reserve requirementthat banks must hold against foreign currencyfrom 3% to 4%.

15

Nov 2006: PBC raised reserve requirementratio by 0.5 percentage point to 9.0%.

16

Figure B1: PRCs Fixed Asset Investment (y-o-y, %) and Related Policies

Sources: OREI staff calculation from CEIC data, Asian Development Outlook 2006 (ADB), JP Morgan, and World Economic Outlook, 2006 (World Bank).

Note: January and February growth rates are equal because the cumulative levels of the rst 2 months are not separately available.

1616


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7

The export recovery that began in the second half of 2005,extended well into the second half of 2006, markedly boostingthe contribution of external demand to the regional economic

expansion. In late 2006, neither the housing-led slowing of GDPgrowth in the United States (US), nor weaker global industrialproduction had a signi cant impact on external demand for theregions goods. In Japan, a relatively weak yen supported astrong rebound in export demand. In the PRC, export growthreaccelerated in the third quarter of 2006. In the NIEs andASEAN-4 economies, robust gross exports and positive netexports contributed to GDP growth (Figure 6). External demandcontinued to expand at a healthy pace in 2006 in Hong Kong,China and Singapore, and strengthened noticeably in Korea andTaipei,China. Among the ASEAN-4 economies, only in Malaysia

was export demand growth mildly weaker, following very stronggrowth in 200405. In contrast, exports improved noticeably inIndonesia, and especially in the Philippines.

In ation

By the third quarter of 2006, the world economic expansionhad moderated, contributing to lower global commodity pricesand reducing in ationary pressures across East Asia, with thenotable exception of Japan (Figure 7). For several economies inthe region, headline in ation began to ease well before energy

prices peaked in early August 2006. In Japan, however, headlinein ation moved into positive territory after mid-2006. In thePRC, despite rapid consumption growth, consumer price in ationeased slightly over the course of 2006 to 1.4% in October 2006,from an average 1.8% in December 2005. Limited adjustmentsto administered energy prices, erce competition, abundantsupply of manufactured goods, and a bountiful harvest helpedkeep in ation low.

For the NIEs, in ation trends varied across countries, althoughthey remained generally low and, in aggregate, fell over 2006.In Taipei,China, price pressures faded sharply: in ation beganto ease by mid-year, turned negative in August, and deepenedinto 1.2% de ation in October, as energy and food prices fellagainst the backdrop of weakening domestic demand. In Koreaand Hong Kong, China, the adjustment was relatively mild, inpart because of stronger underlying domestic demand. In bothcases in ation dropped after peaking in August. In Singapore,after drifting mildly upward until January 2006, in ation easedbelow 1.0% by August.

6.1 5.64.5 4.5

9.7

19.2

11.9

2.2

-2.5

2.1

-3

0

3

6

9

1215

18

2003Q1 2003Q3 2004Q1 2004Q3 2005Q1 2005Q3 2006Q12006Q3e

ASEAN-4 exportsNIEs exportsASEAN-4 net exportsNIEs net exports

Figure 6: External Contributions to GDPGrowth (y-o-y, %)

e=estimateSource: OREI staff calculations based on CEIC data.

1.61.4

10.0

8.0

2.2

1.2

-0.40.6

-1

1

3

5

7

9

11

Jan-03

Jun-03

Nov-03

Apr-04

Sep-04

Feb-05

Jul-05

Dec-05

May-06

Oct-06

PRC

ASEAN-4

NIEs

Japan

4.7

Figure 7: Regional In ationHeadlineRates (y-o-y, %)

Sources: OREI staff calculations based on CEIC data,Hong Kong Monetary Authority, and Central Bank of China(Taipei,China).


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8

Among the ASEAN economies, which generally have higherin ation, the 2005 upswing associated with rising energy priceswas generally more pronouncedas was the downward trend

when those pressures subsided. The aggregate trend depicted inFigure 7 largely re ects Indonesia, the largest ASEAN economy.After the 127% upward adjustment to fuel prices in October2005, monthly in ationwhich remained at double digit levelsuntil October 2006dropped sharply to 6.3%. In ation trendeddecisively down elsewhere in ASEAN as well, particularly in thoseeconomies where the pass-through of energy prices occurredquickly (Figure 8). In Thailand, in ation dropped from above 6.0%in May 2006 to under 3.0% in September as fuel prices declined.In contrast, Malaysian in ation remained relatively high for alonger period, with the adjustment to higher global energy prices

started but incomplete. In Cambodia, Philippines, and Viet Nam,bumper harvests erased the effects of the 2005 drought, pushingagriculture prices down and, with them, overall in ation.

Accompanying the drop in headline consumer in ation wasa general decline in core in ation. When volatile energy andfood prices are stripped out, core in ation shows the slowingpass-through of higher energy costs into the general price level(Figure 9). In Malaysia, in particular, the effect on in ation of therise in transportation rates early in 2006 dissipated quickly. Thereis renewed weakness in core prices in Singapore, meanwhile,

and in Japan, core in ation is negative or near zero, despite theupward trend in headline in ation.

Balance of Payments

Even as global industrial production cooled in the second halfof 2006, a resurgent electronics sector helped to boost exportsacross the region. In Japan, strong capital goods exports toJapanese rms operating in the PRC, and robust US demand forfuel-ef cient cars, drove export growth into double digits in thethird quarter of 2006 (Figure 10A). PRC export growth reboundedto 30.9% in October 2006 as textile and electronics manufacturerscontinued to gain global market share, especially in Europe, whereaccelerating growth in domestic demand stimulated imports.ASEAN exports accelerated on strong demand from the PRC, thefastest growing market for many ASEAN productsespeciallyintermediate goods for the electronics sector (Figure 10B). Forthe NIEs, special factors moderated the boost from favorableglobal demand. In Korea, for example, a strong won constrained

4.4

10.3

8.9

3.5

012345678

91011

Jan-03

Jun-03

Nov-03

Apr-04

Sep-04

Feb-05

Jul-05

Dec-05

May-06

Oct-06

CambodiaPhilippines

Viet Nam

Malaysia

Thailand

6.75.4

5.8

3.1

2.8

6.77.5

Figure 8: In ation in Selected ASEANEconomiesHeadline Rates (y-o-y, %)

Sources: OREI staff calculations based on data from CEIC andInternational Financial Statistics (IMF).

3.4

2.23.7

8.1

5.95.1

-1.4

0.9

-0.6

2.6

1.8-0.5

-2-1012345678

Jan-03

Jun-03

Nov-03

Apr-04

Sep-04

Feb-05

Jul-05

Dec-05

May-06

Oct-06

Philippines

Korea Thailand

Malaysia

Singapore

Japan

4.4

1.9

Figure 9: Core In ation Rates (y-o-y,%)

Note: Of cial gures, except Malaysia (ex. food, fuel,utilities) and Singapore (ex. food, private transport).Sources: OREI staff calculations based on Bloomberg data,CEIC, Bank of Thailand, and Bangko Sentral ng Pilipinas.

10.6

0.6

24.6

12.6

6.9

0

5

10

15

20

25

Jan-03

Jun-03

Nov-03

Apr-04

Sep-04

Feb-05

Jul-05

Dec-05

May-06

Oct-06

Exports

Imports

Figure 10A: Japan Merchandise Export &Import Growth 1 ($ value, y-o-y, %)

1 3-month moving average.Source: CEIC.


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9

electronics exports even as robust US and PRC demand for capitalgoods and cars drove export growth to 21.3% in September 2006.In Hong Kong, China, slightly slower growth in the US and PRC,

and increased use of direct shipments from PRC factories, slowedre-export growth, with total export growth falling to 8.6% in thethird quarter of 2006 from 12.8% in the rst quarter.

Import trends varied across the region: energy prices pushedup import bills in some cases, whereas in others, import growthwas constrained by inventory drawdown. For example, higherenergy prices and resurgent domestic demand reacceleratedimport growth in Japan, which had slowed sharply in late 2005.In the NIEs, stronger demand in 2006 had import growth up to13.9% by October, from 11.3% in December 2005 (Figure 10C).

In the PRC as investment slowed, import growth fell to 20.5%in October, from 22.0% in September 2006. In the ASEAN-4economies, import growth was subdued compared with thestrong acceleration in export growth. This was partly the resultof a large inventory correction, which began to fade in the secondhalf of the year.

Driven by strong exports and the varied import picture, mosteconomies posted strong trade surpluses in the rst threequarters of 2006. The PRC stands out, with a large rise in thetrade surplus to $19.3 billion in October 2006, from $11.2 billion

in December 2005 (Figure 11). In the ASEAN-4 economies risingtrade balances, sustaining a trend begun in late 2005, should seehigher surpluses (or a lower de cit in the case of the Philippines).In the NIEs, by contrast, the aggregate surplus fell, primarilythe result of a weakening trade surplus in Korea and a wideningde cit in Hong Kong, China.

Positive trade balances mostly translated into sustained currentaccount surpluses through the rst half of 2006. The currentaccount surplus was stable at 3.8% of GDP in Japan, rose to8.0% in PRC and to 4.7% in ASEAN-4, and dipped to 4.9% inthe NIEs (Table 1a1d). These net in ows were matched bygenerally stronger capital accounts in the rst half of 2006. Evenin Japan, where net capital out ows in the rst three quarters of2006 amounted to 2.5% of GDP the overall balance of paymentssurplus improved marginally to 0.7% of GDP. Elsewhere in theregion, strong net capital in ows complemented current accountsurpluses in contributing to a signi cantly stronger balance ofpayments. As a result, balance of payments surpluses reboundedsubstantially from those in the second half of 2005.

27.6

6.7

12.9

24.7

11.6

30.9

39.8

0

5

10

15

20

2530

35

40

Jan-03

Jun-03

Nov-03

Apr-04

Sep-04

Feb-05

Jul-05

Dec-05

May-06

Oct-06

NIEs

ASEAN-4

PRC

21.7

13.1

17.3

Figure 10B: Merchandise Export Growth 1($ value, y-o-y, %)


11.3

51.5

0

10

20

30

40

50

Jan-03

Jun-03

Nov-03

Apr-04

Sep-04

Feb-05

Jul-05

Dec-05

May-06

Oct-06

NIEs

ASEAN-4

PRC

22.1

7.7

31.2

12.3 13.9

12.3

20.5

Figure 10C: Merchandise Import Growth 1 ($ value, y-o-y, %)


4.9

5.9

-3.6-5

0

5

10

15

20

Jan-03

Jun-03

Nov-03

Apr-04

Sep-04

Feb-05

Jul-05

Dec-05

May-06

Oct-06

NIEs

ASEAN-4

Japan

PRC11.1 11.2

7.0

5.1

5.8

19.3

Figure 11: Trade Balance 1 ($ billions)

13-month moving average.Source: CEIC.


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10

Table 1a: Balance of PaymentsASEAN-4 (% of GDP)

2004H1 2004H2 2005H1 2005H2 2006H1

Current Account 2.8 5.1 2.0 3.5 4.7

Capital Account 0.0 0.0 0.0 0.1 0.0

Financial Account -0.1 1.5 2.0 -2.8 0.1

Net Direct Investment 0.2 0.6 1.8 0.8 0.9

Net Portfolio Investment 1.5 2.7 1.8 0.8 2.1

Net Other Investment -1.9 -1.8 -1.6 -4.5 -2.8

Net Errors & Omissions 0.8 -1.2 -0.9 -0.4 0.9

Overall Balance 3.5 5.4 3.2 0.4 5.7

Sources: Bank Indonesia, Bangko Sentral ng Pilipinas, International Financial Statistics Online(IMF), and CEIC.

Table 1b: Balance of PaymentsNIEs (% of GDP)

2004H1 2004H2 2005H1 2005H2 2006H1


Capital Account -0.2 -0.2 -0.3 -0.2 -0.2

Financial Account 0.5 -3.7 0.7 -5.4 -2.2

Net Direct Investment -0.6 -0.3 0.8 1.1 1.4

Net Portfolio Investment -7.4 -0.4 -4.7 -1.1 -5.5

Net Other Investment 8.5 -3.0 4.6 -5.4 1.9

Net Errors & Omissions 1.3 1.2 -0.0 0.8 0.7


Sources: International Financial Statistics Online (IMF), and CEIC.

Table 1c: Balance of PaymentsJapan (% of GDP)

2004H1 2004H2 2005H1 2005H2 2006H1


Capital Account -0.1 -0.1 -0.1 -0.1 -0.2

Financial Account 3.3 -2.2 -2.8 -2.6 -2.5

Net Direct Investment -0.4 -0.6 -0.6 -1.3 -1.4

Net Portfolio Investment 0.6 0.4 0.1 -0.7 4.7

Net Other Investment 3.0 -2.0 -2.4 -0.6 -5.8

Net Errors & Omissions -0.4 -0.8 -0.2 -0.5 -0.4



Table 1d: Balance of PaymentsPRC (% of GDP)

2004H1 2004H2 2005H1 2005H2 2006H1


Capital Account -0.0 -0.0 0.2 0.2 0.2Financial Account 9.4 3.6 3.7 1.8 3.2

Net Direct Investment 4.3 1.9 2.3 3.6 2.7

Net Portfolio Investment 3.9 -0.7 -0.1 -0.3 -2.6

Net Other Investment 1.2 2.4 1.5 -1.5 3.1

Net Errors & Omissions -1.0 2.8 -0.5 -0.9 -0.7

Overall Balance 9.4 11.4 10.4 8.4 10.7



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11

The improvements in balance of payments, coupled with centralbank intervention in the foreign exchange markets, have led tocontinued reserve accumulation, adding nearly $280 billion in

9 months to the regions reserveswhich exceeded $2.8 trillionby end-September 2006 (Table 2). Although 60% of thisaccumulation was in the PRC, where reserves topped $1 trillion inOctober 2006, most other economies in the region also added totheir reserves in 2006. High reserves are increasingly attractingpublic attention, in part because they are generally perceived assubstantially higher than normal reserve requirements (Box 2).

Table 2: Foreign Exchange Reserves (excluding gold)

Country/RegionValue ($ billion) % change (y-o-y) % change from Dec 2005

Dec 05 Mar 06 Jun 06 Sep 06 Dec 04 Dec 05 Mar 06 Jun 06 Sep 06

Brunei Darussalam 0.5 0.5 0.5 4.9 -2.2 0.1 2.7

Cambodia 1.0 1.0 1.0 15.7 1.0 5.7 8.6

China, Peoples Rep. of 821.5 877.6 943.6 990.5 50.6 33.7 6.8 14.9 20.6

Hong Kong, China 124.2 125.8 126.6 130.3 4.4 0.6 1.3 1.9 4.9

Indonesia 33.0 38.2 38.3 40.5 -0.0 -5.6 15.7 16.2 22.7

Korea, Rep. Of 210.3 217.3 225.6 228.2 28.2 5.7 3.3 7.3 8.5

Lao PDR 0.2 0.2 0.3 7.0 4.9 6.5 7.8

Malaysia 69.9 73.1 78.4 79.2 49.1 5.2 4.6 12.3 13.4

Myanmar 0.8 0.9 0.9 22.2 14.7 15.5 21.8

Philippines 15.9 17.8 18.2 18.8 -3.9 21.4 12.1 14.4 18.3

Singapore 115.8 121.4 127.3 129.2 17.2 3.2 4.9 9.9 11.6

Taipei,China 253.3 257.1 260.4 261.6 17.0 4.8 1.5 2.8 3.3

Thailand 50.7 53.7 56.4 60.0 18.5 4.2 6.0 11.3 18.4

Viet Nam 9.1 10.7 10.7 13.1 28.5 18.7 18.7

Emerging East Asia 1,706.1 1,795.4 1,888.3 1,951.7 29.9 16.6 5.2 10.7 14.4

Japan 834.3 837.7 849.8 866.5 25.7 0.0 0.4 1.9 3.9East Asia 2,540.4 2,633.1 2,738.1 2,818.2 28.3 10.6 3.6 7.8 10.9

. . . = not availableSources: International Financial Statistics Online (IMF), Institute of International Finance, Inc., and Ministry of Finance (Japan).


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12


Box 2: Of cial Foreign Exchange Reserves: How Much is Enough?

After a period of rapid reserve

accumulation, many emergingmarket economies in EastAsia and elsewhere now holdvery large stocks of foreignexchange reserves, strainingtraditional reserve managementpractices and creating pressureto enhance return on reserveassets. Increasingly, countriesare employing independentagencies and external managersto cope with more sophisticatedmanagement of reserve tranches

invested in less liquid assets withhigher return, but also higherrisk. Moreover, in many emergingeconomies, the once obscurepractice of reserve managementis now a subject of public debateand scrutiny, with frequent callsfor novel uses. Some of thesemight have macroeconomic policyimplicationssuch as proposalsto invest some portion of reservesin domestic assets. Behind thisdesire to put reserves to moreproductive use is an implicitperception that reserves aremore than adequate. This leadsnaturally to the question: Whatis an adequate level of reserves?

Traditionally, as part of an overallpolicy to promote macroeconomicstability, an adequate level ofreserves is held to maintainforeign currency liquidity andreduce vulnerability to external

shocks. For the open economiesof emerging East Asia, end-2005

1 ADB. 2005. Early Warning Systems for Financial Crises: Applications to East Asia , p. 59. In that study, for the sample period 19701995, the thresholdminimum levels for reserves to short-term debt were 0.51 for Indonesia, 0.23 for Korea, 1.82 for Malaysia, 0.8 for the Philippines, 0.16 for Singapore, and 0.54for Thailand. Reserves below these minimum levels suggest a heightened crisis probability.2See IMF. 2000. Debt- and Reserve-Related Indicators of External Vulnerability , pp.1415.3See Kim et al. 2005. Reserve Adequacy in Asia Revisited: New Benchmarks Based on Size and Composition of Capital Flows , Table 9. Such a range isnot necessarily optimal as (i) those out ows were mainly related to short-term debtnow much lower in most emerging markets, (ii) the risk of such severecrises is not uniform across emerging markets, and (iii) such reserve levels may be costly to hold or problematic to accumulate if theyand the associatedinterventionsbecome high relative to the monetary base or level of public debt.

reserves in months of imports are

given in column (3) of Table B2.In recognition of the greater roleof capital ows in triggering thecurrency crises of the 1990s,reserve adequacy measuresevolved beyond the 3-months-of-imports benchmark associatedwith xed exchange rate regimesand closed capital accounts in the1970s and 1980s. For the openeconomies of emerging East Asia,end-2005 reserves in months ofimports are given in column (3)

of Table B2.

There are two basic alternativeconcepts for reserve adequacy.The rst concept focuses on theneed for precautionary reservesas insurance against the externaldrain of anticipated capital out owsin the event of a temporary loss ofinternational capital market access.Empirical work supports the ratioof reserves to short-term externaldebt, by residual maturity, as themost signi cant reserves-relatedleading indicator of currency crises,although estimated critical valuescan differ from the general rule-of-thumb value of 1.0. 1 Actual reservesto short-term debtcolumn (4)exceed this level by a largemargin for the regions economies,in part because reserves haveclimbed, but also because short-term external debt has shrunk.

An alternative concept of adequacyfor potential internal drain or

domestic capital ight is reserves

as a percent of broad money(M2). This measure is less widelyused, enjoys less empiricalsupport, 2 and lacks a rule-of-thumb minimum ratio. Still, thethree hardest hit economiesduring the Asian nancial crisisof 1997/98 (Indonesia, Korea,and Thailand) had out ows of1828% of M2. Reserves of theemerging market economies ofEast Asia generally lie withinor exceed this range as wellcolumn (5). 3 Remarkably, de-spite the perception of EastAsian economies as outliersin their tendency to hold largeexcess reserves, only Malaysiaand Korea exceed the medianvalue for 53 emerging economiesfor all three rules of thumb. In addition to these simplemeasures, which emphasizedifferent vulnerabilities, thereare more comprehensivemeasures such as a liquidity-at-risk indicator of reserveadequacy that combinesmeasures of expected externaland potential internal sources ofdrain on reserves. To the desiredcoverage of short-term externaldebt is added a potential capital

ight measure constructed asM2 multiplied by (i) a factorthat gauges vulnerability by theexchange rate regime and (ii) a

country risk factor re ectingmacroeconomic fundamentals.


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13


1

Table B2: 2005 Indicators of Reserve Adequacy for Emerging East Asia

Economy byExchange Rate Regime 1

Risk 2 Actual Reserves Adequate Reserves Indicator 3

(1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (11)

0 to 1,1=high

risk($ billion)

monthsof

imports(GSI)

/short-term

externaldebt

% M2 ($ billion)

monthsof

imports(GSI)

/short-term

externaldebt

% M2Excess

reserves($ billion)

% Excess

Currency Board

Brunei Darussalam 4 0.5 1.8 9.0

Hong Kong, China 0.24 124.2 3.8 1.8 27.2 80.7 2.5 1.2 17.6 43.6 35.1

Peg or Tight Band

PRC 0.32 821.5 13.3 13.4 22.6 408.5 6.6 6.7 11.2 413.0 50.3

Malaysia 0.31 69.9 6.5 4.5 41.5 31.1 2.9 2.0 18.5 38.8 55.5

Managed Float/Low Access

Cambodia 0.79 1.0 2.3 25.1 79.4 0.0 0.1 1.0 3.2 0.9 96.0

Lao PDR 0.75 0.2 3.5 4.1 46.9 0.1 0.8 1.0 11.4 0.2 75.7

Myanmar 0.86 0.8 2.3 1.1 55.3 0.7 2.2 1.0 52.4 0.0 5.2

Managed Float/Higher Access

Indonesia 0.60 33.0 3.8 1.9 26.6 32.5 3.8 1.8 26.2 0.5 1.6

Singapore 0.11 115.8 6.2 1.5 87.7 80.2 4.3 1.0 60.8 35.6 30.7

Taipei,China 0.22 253.3 18.4 7.5 33.3 68.0 5.0 2.0 8.9 185.3 73.2

Thailand 0.37 50.7 4.3 4.6 26.6 25.2 2.2 2.3 13.2 25.5 50.3

Viet Nam 0.60 9.1 3.1 4.3 22.1 7.0 2.4 3.3 17.2 2.0 22.4

Independent Float

Korea 0.27 210.3 7.8 4.0 38.0 67.4 2.5 1.3 12.2 142.9 68.0

Philippines 0.57 15.9 3.3 1.6 30.6 13.2 2.7 1.3 25.3 2.8 17.3

Total/Median(Emerging East Asia)

0.37 1,706.1 3.8 4.1 32.0 814.5 2.6 1.3 17.2 891.1 49.5

Total/Median(53 emerging markets) 5

0.44 2,783.8 5.1 3.5 33.6 1,416.6 3.0 1.6 20.8 1,366.7 42.5

Total/Median(Selected OECD) 6

0.08 1,116.0 1.8 0.3 7.5

. . . = not available1Classi cations as of 31 Dec 2005, based on actual, de facto arrangements as determined by IMF staff. 2On a scale of 0 to 1, with higher scores indicating greater risk of sovereign default. Derived from the September 2005 Institutional Investor Country Credit Ratings,pp. 143148.3Equals short-term external debt + a fraction of M2. The fraction is a % of M2 (30% for pegs and bands, 0% for managed oat with low capital market access, 10%for managed oats with higher access, 10% for independent oats and currency boards) multiplied by the country risk rating factor in column (1).4Risk rating and 2005 import data are unavailable.5The 14 economies of emerging East Asia plus 39 other emerging market economies that were among those holding the largest levels of reserves at end-2005.6Selected OECD economies include the following non-euro zone developed economies with exchange rates classi ed as independent oats: Australia, Canada, Japan,New Zealand, Norway, Sweden, Switzerland, United Kingdom, United States. Excluding Japan, reserves were $282 billion at end-2005.Source: www.imf.org/external/np/mfd/er/2005/eng/1205.htm


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Financial and Exchange Markets

Uncertainty about the path of US policy and long-term ratesgenerated signi cant nancial market volatility in 2006, especiallyin MayJune when increased in ation expectations nudgedup long-term US interest rates. This trend was evident in keyequity markets in the region (Figures 12a12b). Despite sharpcorrections over that 2-month period, the Indonesian and thePhilippine stock market indexes gained 43% and 35% respectivelythrough 15 Novemberon top of already respectable gains in

2005. Only PRC stock indexes gained moreclose to 70%over the same period, in part because the government lifted amoratorium on new stock issuance. Gains were more limited onKorean stock markets, but were strong in 2005.

Emerging East Asian local currency bond markets were similarlystrong and bonds outstanding continued to grow rapidlyto$2.4 trillion by mid-2006 from $2.0 trillion at end-2005. Growth

14


1

The less exible the exchangerate, and the more likely iscapital ight, the larger the levelof reserves required to instill

con dence in its stability anddeter capital ight in a crisis.Column (6) provides theresulting calculations of adequatereserves. By this indicator, amajority of these economieshold reserves well in excess ofthat deemed adequate to meetliquidity needs in the event of acapital account crisis.

These results are indicativeonly and other factors may playimportant roles in determiningdesired reserve levels. However,levels of reserves held bymany monetary authorities,regionally and globally, appearsubstantially larger than actualforeign currency liquidity needs.This tendency seems greater

among economies with less exibleexchange rates, although it maysometimes re ect recently largeand temporary current account

in ows or greater risk aversion asa result of past crises. Whateverthe reason, the notion thatmany monetary authorities areholding excess reservesbeyondprecautionary needsis a widelyheld view, giving rise to questionsabout what to do with the excessreserves.

Because precautionary reservesare generally held in safe, liquidassets, and many emergingmarket economies have largeunaddressed needs for publicgoods, calls are inevitable for moreproductive investment of excessreserves in higher-return foreignassets or, more controversially, inhigh-quality domestic investmentprojects.

Increasingly, countries areadopting the rst option underreserve management strategies,although not without costs,

including, higher operationalrisks. The second strategy wouldrequire converting reserves tolocal currencyreducing foreigncurrency reserves by the amountof the desired investment. Thereare, potentially, many bene tsto such schemes. However,if excess reserves arise outof a policy of intervention tomanage exchange rates, thenreconverting the excess reservesto local currency will tend toundermine that policy. Thus,decisions to redeploy portions ofreserves should be made in thecontext of a total macroeconomicpolicy framework, including theneed for changes, if any, in theexchange rate regime.

4 De Beaufort, Wijnholds, and Arend Kapteyn. 2001. Reserve Adequacy in Emerging Market Economies , IMF WP/01/143, www.imf.org.

Figure 12a: Composite Stock PriceIndexes 1NIEs and PRC(weekly average, rst week ofJanuary 2004 = 100, local index)

1 Weekly averages of Hang Seng (Hong Kong, China), PCOMP(Philippines), KOSPI (Korea), STI (Singapore). The PRCIndex is based on the Shanghai and Shenzhen compositeindexes, weighted by their respective market capitalization.Source: OREI staff calculations based on Bloomberg data.

129

77

174170

151

119 122111

157

133

60

80

100

120

140

160

180

2-Jan- 04

12-May- 04

20-Sep- 04

29-Jan- 05

9-Jun- 05

18-Oct- 05

26-Feb- 06

7-Jul- 06

15-Nov- 06

Korea

PRC

Taipei,ChinaHK,

China

Singapore


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15

was strongest in the PRC, at 22% over the 6 months, because ofrapid issuance of central bank bonds to absorb excess liquidity.There was also large public issuance in Thailand and Viet Nam

to nance infrastructure projects and in Korea to nance defenseprojects. In the Philippines, in contrast, local currency governmentbonds outstanding fell as very successful foreign currency issuescombined with better-than-expected revenue collection to reducelocal public nancing needs. Corporate bond issuance across theregion also expanded robustly, aided in some cases by marketreforms. Issues were frequently oversubscribed, and buoyantinvestor demand (including demand for Islamic bonds) generallylifted bond prices. As a result, in the third quarter of 2006, yieldcurves shifted down from levels reached in response to May-June2006 volatility, and attened once again. Although speci c country

trends vary, the yield curve for Malaysia illustrates the generaltendency (Figure 13). 4

Strong capital in ows, meanwhile, put strong upward pressureon regional currencies in 2006although reserve accumulationpartially mitigated these pressuresand most appreciatedagainst the US dollar. Exceptions included the Japanese yen andVietnamese dong, which remained broadly stable. The Indonesianrupiah, Korean won, Philippine peso, and Thai baht rose most, inboth nominal and in real effective terms (Figures 14a, 14b). Theseeconomies also saw faster reserve accumulation than in 2005,

an indication of substantial in ows and appreciation pressures.Despite a large current account surplus and net capital in ows,the yuan rose only 2.4% from JanuaryOctober 2006.

167

225

114

130

93 96

144

195

75

100

125

150

175

200

225

2-Jan- 04

12-May- 04

20-Sep- 04

29-Jan- 05

09-Jun- 05

18-Oct- 05

26-Feb- 06

7-Jul- 06

15-Nov- 06

Indonesia

Malaysia

Thailand

Philippines

Figure 12b: Composite Stock PriceIndexes 1 ASEAN-4 (weekly average, rstweek of January 2004 = 100, local index)

1 Weekly averages of JCI (Indonesia), KLCI (Malaysia), TWSE(Taipei,China), and SET (Thailand).Source: OREI staff calculations based on Bloomberg data.

4For more details about bond market trends and a theme chapter on bond marketliquidity, please see the November 2006 Asia Bond Monitor , available atasianbondsonline.adb.org.

3.88

4.78

4.15

2.5

3.0

3.5

4.0

4.5

5.0

2 3 4 5 6 7 8 9 10

15-Nov-200615-May-200615-Mar-2006

Figure 13: Malaysia Benchmark Yields (%per annum)

Source: Bloomberg.

9286

108

96

127118

111

105

70

85

100

115

130

Jan-04

Apr-04

Jul-04

Oct-04

Jan-05

Apr-05

Jul-05

Oct-05

Jan-06

Apr-06

Jul-06

Nov-06

Indonesian rupiah

Thai baht

Korean won

Philippine peso

Figure 14a: Exchange Rate Indexes(weekly average, rst week ofJan 2004 = 100, $/local currency 1)

1An increase is an appreciation.Source: OREI staff calculations based on Bloomberg data.

Indonesian rupiah

108.9

103.2 108.0

100.7

120.5114.0

848892

96100104108112116120124128

Jan-04

May-04

Sep-04

Jan-05

May-05

Sep-05

Jan-06

May-06

Sep-06

Korean won

Thai baht

Philippine peso

122.0

115.8

Figure 14b: Real Effective Exchange Rate(Jan 2004 = 100, $/local currency 1)

1 An increase is an appreciation.Source: OREI staff calculations based on Bloomberg data.


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Monetary and Fiscal Policy

As in ationary pressures subsided and with US policy ratesunchanged since late June 2006, increases in regional policyinterest rates slowed considerably in the second half of 2006, aftersubstantial tightening in the rst. Japan lifted its zero interestrate policy and raised its overnight call rate 25 basis points inJuly 2006, while Korea in August hiked rates amid persistentin ationary pressures and Taipei,China moved to bring ratescloser to neutral despite some weakening in domestic demand(Figure 15).

The exception to this trend was the PRC, where authoritiesstepped up efforts to reduce liquidity amid signs of acceleratinginvestment growth in the second quarter. Lending rates wereraised for a second time in the yearby 27 basis points in August2006deposit rates were put up, and reserve requirements wereraised several times. Elsewhere in the region, rates generally heldsteady, although Indonesian authorities, since May, continued togradually reduce rates. And in the Philippines, although of cialrates were unchanged, authorities loosened monetary policy byre-introducing tiered interest rates for banks deposits with thecentral bank, a move aimed at stimulating bank lending.

Despite the slowdown in policy adjustments, monetary conditionscontinued to tighten in much of the region as a result of sustainedexchange rate appreciation. The effect on in ation tended tobe more signi cant in economies that have larger trade sectorsrelative to the size of the economy. In some cases, such asSingapore, the exchange rate has had a more important effectthan the interest rate (Box 3). Liquidity growth, as measured bythe growth in money supply, also tapered off in several economies,although more so in some than others (Figure 16) . This mirroredthe tightening in terms of the price of currency (interest andexchange rates).

Trends in scal policy varied across East Asia in 2006, with someeconomies adopting tighter measures, while others expandedde cits (Table 3). However, most governments were prudent. Inthe PRC, strong revenue growth matched expenditure growth,keeping the scal de cit low. Indonesia maintained a small, butmildly expansionary de cit, as did Korea, and Viet Nam ran asomewhat larger de cit. In contrast, Cambodia, Malaysia, andPhilippines continued efforts to reduce de cits, while Hong Kong,China's scal performance has improved signi cantly since 2003.

Korea

Malaysia

Taipei,China

Indonesia

Japan

10.25

0

2

4

6

8

10

12

14

04-Jul-04

08-Oct-04

12-Jan-05

18-Apr-05

23-Jul-05

27-Oct-05

31-Jan-06

07-May-06

11-Aug-06

15-Nov-06

12.75

Philippines7.50

Thailand

4.005.004.50

3.75 3.503.002.25

2.625

7.50

0.265

Figure 15: Policy Rates 1 (% per annum)

1Overnight call rate (Korea); overnight policy rate (Malaysia);reverse repurchase (repo) rate (Philippines); of cial discountrate (Taipei,China); 14-day repo rate (Thailand).Sources: Bloomberg and CEIC.

Thailand

16.3 17.114.1

15.412.28.28.4

0

5

10

15

20

25

3035

Jan-03

Jun-03

Nov-03

Apr-04

Sep-04

Feb-05

Jul-05

Dec-05

May-06

Oct-06

Malaysia

PRC

Philippines

Figure 16: Liquidity Growth 1 (y-o-y,%)

1Liquidity = M2.Sources: Bloomberg and CEIC.


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Table 3: Fiscal Balance of Central Government (% of GDP)

2003 2004 2005 2006 2007

Cambodia -6.0 -4.7 -3.4 -3.0 ...

China, Peoples Rep. of -2.2 -1.3 -1.2 -1.0 ...Indonesia -1.7 -1.3 -0.9 -1.3 1 -1.1 3

Korea, Rep. of 0.2 -0.5 -0.6 -1.4 ...

Malaysia -5.3 -4.3 -3.8 -3.5 2 -3.4 3

Philippines -4.6 -3.8 -2.7 -1.2 4 -0.9

Singapore 5 6.5 5.5 6.5 4.3 ...

Taipei,China 5 -3.0 -2.1 -1.8 -2.5 -2.0

Thailand 5 0.6 0.3 0.2 0.1 2 ...

Viet Nam -4.3 -2.0 -2.3 -2.6 .... . . = not available1revised budget, 2revised estimate, 3budgeted, 4JanuarySeptember 2006, 5 scal year.Sources: National sources; Asian Development Outlook 2006 (ADB); Economist IntelligenceUnit; International Monetary Fund; and World Bank.

Thailandwhere expenditure was held back for part of the yeardue to the political impasseis expected to have a balancedbudget for 2006.

In most East Asian economies, public nances are relativelystrong, and several governments have reduced public debt since2004 (Table 4), partly as a result of reducing scal de cits.Nonetheless, Indonesia (which has markedly reduced its publicdebt) and the Philippines remain scally vulnerable to nancialturbulence because of its still-high levels of public debt andweaker nancial systems. Japan's high domestic debt levels also

leave it vulnerable to rising interest rates. Moreover, in othereconomies, such as the PRC (where of cial public debt is below20% of GDP) there are signi cant contingent liabilities. TheInternational Monetary Fund (IMF) estimates, for example, thatnonperforming loans (NPLs) and pension fund liabilities couldadd more than 30% to PRCs public debt over the next severalyearswith external borrowings of state enterprises an additionalpotential public liability. That said, the region's public sectors stillenjoy relatively strong sovereign ratings and exceptionally lowsovereign risk premiums on internationally traded governmentbonds. In some cases, such as Malaysia, there are signi cant

government assets that partially mitigate the vulnerabilitiesposed by high levels of gross debt.

Table 4: Public Sector Debt (% of GDP)

2003 2004 2005 2006

China,Peoples Rep.of

19.2 18.5 17.9 17.3 p

Indonesia 1 58.3 55.7 46.5 40.9 p

Korea,Rep. of 1

22.0 25.2 29.6 32.3 p

Malaysia 68.9 66.7 59.2e

57.8p

Philippines 2 101.3 96.1 90.0 e 83.7 p

Taipei,China 1 30.3 31.3 31.9 . . .

Thailand 49.4 47.5 p 45.9 p . . .

Viet Nam 40.8 42.7 43.7 45.5 p

. . . = not available, p = preliminary, e = estimate

Notes:1 Central government debt.2 Non nancial public sector debt.Sources: IMF Article IV Consultations (various issues),Bank of Thailand, National Statistics (Taipei,China),Department of Statistics (Singapore).


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The July 2006 Asia Economic Monitor (AEM) explored

the use of a monetary conditions index (MCI) toassess the effects of interest rate and exchangerate changes on domestic monetary conditions inthe region. 1 In large open economieswhere tradeis small relative to overall outputthe interest rateis the primary determinant of monetary conditions.In smaller open economies, however, exchangerates are as important because of their impact on(i) domestic in ation, given the pass-through fromimported prices, and on (ii) output, given the impacton net exports. An MCI tracks monetary conditionsby combining both interest rate changes and theeffect of exchange rate movements computed inpercentage points. 2

Figures B3aB3i compute trends in monetaryconditions since June 2004, when the US FederalReserve began its most recent tightening cycle. 2 Each

gure tracks deviations in (i) the money market ratefor its level in June 2004, (ii) the nominal effectiveexchange rate (NEER) from its June 2004 level,and (iii) the MCI, calculated using CLSA Asia Paci cestimates.

The gures reveal signi cant variation in the extentof monetary tightening across the region and therelative importance of interest and exchange rates.This variation arises from differences in economicstructure, economic conditions, and monetarypolicy objectives. For most economies in the region,appreciating exchange rates mean that monetaryconditions are tighter than implied by adjustmentsin interest rates alone.

In East Asia, economies can be roughly divided intothree groups based on the extent of movementin the MCI. In the rst group of three economies,there were almost no changes in nominal interestrates or overall monetary conditions. In Japan, alarge developed economy, signi cant depreciation

Box 3: Monetary Conditions in East Asia: The Relative Importance of Interest and Exchange Rates

1 Box 3: Monetary Policy Options for Emerging East Asia, AsiaEconomic Monitor , July 2006.2 An MCI is constructed by estimating the effect on in ation of botha 1 percentage point (pp) change in the interest rate and a 1 ppchange in the exchange rate. The ratio of these two estimates givesthe interest rate equivalent of a 1 pp change in the exchange rate.A table of these estimates, computed for East Asian economiesby CLSA Asia Paci c ( The Ifofax, 10 July 2006, www.clsa.com.) , wasincluded in the July 2006 Asia Economic Monitor .

Figure B3b: Malaysia A 1% change in NEER has the sameeffect on prices as a 68 bp change in the interest rate.

Figure B3: Monetary Conditions Indexes

for Selected East Asian Economies

Figure B3a: Japan A 1% change in NEER has the sameeffect on prices as a 3 basis points (bp) change in theinterest rate.

0.3

-0.1

-12.9

-7.2

-15

-10

-5

0

5

10

15

20

Jun-04

Oct-04

Feb-05

Jun-05

Oct-05

Feb-06

Jun-06

Oct-06

MMR

MCI

NEER

0.81.2

0.5

-15

-10-5

0

5

10

15

20

Jun-04

Oct-04

Feb-05

Jun-05

Oct-05

Feb-06

Jun-06

Oct-06

MMR MCI

NEER

Figure B3c: Taipei,China A 1% change in NEER has thesame effect on prices as a 48 bp change in the interestrate.

-0.2

5.33.1

-1.6

-15

-10

-5

0

5

10

15

20

Jun-04

Oct-04

Feb-05

Jun-05

Oct-05

Feb-06

Jun-06

Oct-06

MMR MCI

NEER 0.6


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3In the US, as in Japan, monetary conditions are little in uencedby exchange rate movements. In this context, monetaryconditions refer to the effects of money on the aggregateeconomy. For large economies, the external sector tends tobe relatively small and the effect of domestic interest rateson aggregate demand tends to be dominant. In contrast, forsmaller economies such as Canada or New Zealand, in whichexternal demand plays a more important role, exchange ratemovements can more signi cantly impact domestic in ation.

Figure B3d: Hong Kong, China A 1% change in NEER

has the same effect on prices as a 45 bp change in theinterest rate.

3.7

2.2

-3.3

-15

-10

-5

0

5

10

15

20

Jun-04

Oct-04

Feb-05

Jun-05

Oct-05

Feb-06

Jun-06

Oct-06

MMR

MCI

NEER

Figure B3e: Philippines A 1% change in NEER has thesame effect on prices as a 42 bp change in the interestrate.

0.8

4.8

8.3 9.6

-15

-10

-5

0

5

10

15

20

Jun-04

Oct-04

Feb-05

Jun-05

Oct-05

Feb-06

Jun-06

Oct06

MMR

MCI

NEER

Figure B3f: Indonesia A 1% change in NEER has thesame effect on prices as a 160 bp change in the interestrate.

3.4

-14.1

10.0

2.1

-0.8

-15

-10

-5

0

5

10

15

20

Jun-04

Oct-04

Feb-05

Jun-05

Oct-05

Feb-06

Jun-06

Oct-06

SBI MCI

NEER

of the NEER had little effect on actual monetary

conditions. In the smaller, more trade-dependenteconomies of Malaysia and Taipei,China, theMCI is more in uenced by the NEER, which itselfshowed little change from June 2004. For Japanand Taipei,China, very low in ation permitteda relatively more accommodative stance. ForMalaysia, with elevated in ation stemming from, atleast in part, the pass-through of energy costs toadministered prices, an accommodative monetarystance mitigated the impact of the gradualreduction of the scal de cit.

A second group of economies experienced atightening of monetary conditions roughly on theorder of magnitude of the US, which tightenedinterest rates by 425 basis points (bp). 3 InHong Kong, China, a weak NEER mitigated theeffect of increases in interest rates on monetaryconditions. In contrast, in the Philippines, with littlemovement in the interest rate, an appreciatingexchange rate tightened monetary conditions.In Indonesia, both interest rates and exchangerates were important to monetary conditions.In the lead-up to the August 2005 mini-crisis, adepreciating NEER loosened monetary conditionsuntil steep interest rate hikes reversed the NEER.The combined effect sharply tightened monetaryconditions, before they stabilized and then eased.

In the third group of economies, monetaryconditions tightened much more significantlyrelative to the US and other economies in theregion. In each case, increases in the interest rateand in the exchange rate contributed to a higherMCI. In Thailand, changes in monetary conditionssmoothly tracked rising interest rates until 2006,when a rising NEER pushed the MCI higher. In thevery open Singaporean economy, where exchange

rates have a more important impact on the economy


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Notes: The money market rate (MMR) is the interbank overnight rate (period average)Malaysia; Taipei,China; and Thailand; theuncollateralized overnight rate (period average)Japan; the weighted average rate on all maturities of uncollateralized call rates (periodaverage)Korea; the 3-month interbank rate (end of period)Singapore; the Hong Kong Interbank Offered Rate (the middle closing ratesquoted by Standard Chartered Bank for the interbank money market)Hong Kong, China; the weighted average (weighted by loan amount)of overnight rates on loans to banks and nonbank nancial institutionsPhilippines; and the 1-month rate of Bank Indonesia certi cate (endof period)Indonesia.

Sources: For MMRBangko Sentral ng Pilipinas, Bank Indonesia, Bank Negara Malaysia, Bank of Japan, Bank of Korea, Bank of Thailand,Central Bank of China (Taipei,China), Hong Kong Monetary Authority, Monetary Authority of Singapore; For NEERBank for InternationalSettlements; For MCIOREI staff calculations using CLSA Asia Paci c estimates.

Figure B3g: Thailand A 1% change in NEER has the sameeffect on prices as a 33 bp change in the interest rate.

3.96.3

5.8 7.1

-15

-10

-5

0

5

10

15

20

Jun-04

Oct-04

Feb-05

Jun-05

Oct-05

Feb-06

Jun-06

Oct-06

MMR

MCI

NEER

Figure B3h: Singapore A 1% change in NEER has thesame effect on prices as a 119 bp change in the interestrate.

2.7

8.85.1

-15

-10

-5

0

5

10

15

Jun-04

Oct-04

Feb-05

Jun-05

Oct-05

Feb-06

Jun-06

MMR

MCI

NEER

Sep-06

Figure B3i: Korea A 1% change in NEER has the same ef-fect on prices as a 38 bp change in the interest rate.

0.7

7.5

18.0

-15

-10

-5

0

5

10

15

20

Jun-04

Oct-04

Feb-05

Jun-05

Oct-05

Feb-06

Jun-06

Oct-06

MMR

MCI

NEER

than the interest rate, the effect of a rising NEERwas magni ed and monetary conditions havetightened by nearly 900 bp since June 2004. In

Korea, a larger, less export-leveraged economy,the effect of a sharp NEER appreciation contributedto a still-large increase of 750 bp in monetaryconditions from June 2004.The in ation-targetingBank of Thailand, which moved aggressively tocontain rising core in ation with rate hikes in the

rst half of 2006, held rates steady in the secondas domestic demand weakened and NEER-inducedtightening helped to lower in ation. Similarly, inKorea, the combination of imported in ation anda nascent domestic recovery made the exchangerate an effective means of tightening.


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Assessment of Financial Vulnerability 5

The array of indicators used to assess nancial sector performance(Box 4) have been grouped into three categories: (i) prudentialindicators help measure nancial system performance and banksability to withstand shocks; (ii) activity indicators illustrate thelevel of bank lending operations; and (ii i) market indicators showhow nancial market participants view asset values.

Prudential Indicators

Across much of the region, continued strong growth kept nancialmarket conditions quite favorable, despite modest monetary

tightening and short-lived market turbulence in MayJune 2006.NPL ratios continued to fall, rates of return on assets (ROA) andbank equity (ROE) were generally sustained at highly competitivelevels, provisioning ratios increased or remained high, and risk-weighted capital adequacy ratios (CARs) among banks remainedwell above the international 8% norm. 6 With the exception ofTaipei,China, nancial sector indicators were strong in early 2006,though economies differed with regard to remaining NPLs andrisk-weighted capital ratios.

The key factors driving these improvements were progress

in resolving impaired assets from the 1997/98 nancial crisis(Indonesia, Korea, Malaysia, Thailand); addressing problemsfrom large credit card receivables in the early 2000s (Korea); orresolving much earlier bank-related issues (Japan). With speci cprovisioning for losses largely completed, pro ts and returns havebounced back. Higher earnings have been used to strengthencapital cushions. In Taipei,China, however, the recent weakeningof these indicators emanated from large losses attributed to thesharp increase in credit card delinquencies.

5

In previous issues of the Asia Economic Monitor, this section focused on progress inthe regions nancial sector restructuring following the 1997/98 crisis. With nancialsector restructuring now largely complete, assessment of nancial vulnerabilitynow takes a broader perspective paying particular attention to issues related to

nancial stability, the challenges associated with ongoing nancial innovation andliberalization, and the adoption of new Basel II capital standards. The range ofindicators used in this section has also expanded to include measures of nancialstrength and soundness; in addition, use of market data has increased, includingviews of credit rating agencies, and equity market valuations.6 Economies whose banks are required to hold risk-weighted capital ratios of 8% arePRC; Hong Kong, China; Indonesia; Korea; Malaysia; and Taipei,China. In the caseof Philippines, Singapore, and Thailand, banks are required to hold risk-weightedcapital ratios of 10%, 10%, and 8.5%, respectively.


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Extending the previous AsiaEconomic Monitor analysis, a

wider set of nancial indicatorsare used to assess nancialsector vulnerability in East Asianeconomies. These indicators areclassi ed into three groupings:

prudential indicators: coveringthe core set of prudential andrelated indicators, 1 such asregulatory 2 CARs (Basel I Risk-Weighted Capital Ratios), 3 NPL(or asset) ratios, provisioningratios, rates of ROA and ROE,

and non-risk-weighted CARs;4

activity indicators: tracking thelevel and structure of nancialsector activity as re ected inloan activity, loan deposit ratios,securities investments, and thedivision of loan portfolios intomortgage and non-mortgagerelated household lending andbusiness lending; and

market indicators: giving themarkets assessment of nancialsystem strength as re ectedin the views of credit ratingagencies and the market value of

nancial sector stocks. Particular

1These indicators are similar tobut less comprehensive thanthe nancial stability indicators constructed by the International MonetaryFund and World Bank.2Regulatory capital is de ned as the capital recognized by the authorities for regulatory purposes, and in general will differ from the bookvalue of capital as de ned in nancial statements and the stock market value of a nancial institution.3A number of economies in the region further divide regulatory capital into Tier I, II, and Tier III capital, in l ine with the approach taken in the Basel Capital Adequacy framework.4In both the Basel I and II frameworks, the amount of regulatory capital an institution is required to hold is linked to the risk pro le of its assets, with some assets receiving a zero credit risk weight. The non-risk adjusted capital ratio is de ned as the ratio of regulatory capitalto total assets that are not weighted for risk.5Major rating agencies also rate nancial institutions local and foreign currency debt. Because such ratings provide the agencies assessmentof the risk of the particular debt issues, they do not represent an overall assessment of an institutions nancial strength and soundness.6Core pro tability typically refers to pro ts associated with an institutions core activities. In the case of several banking systems in th eregion, core pro tability refers to the regular income from lending operations (net of provisioning) and excludes certain fee-based incomeand exceptional returns from securities investments.7Not only whether a 3- or 6-month rule is used to classify a loan as nonperforming, but also more generally to speci c provisioning andthe treatment of accrued interest.

Box 4: Indicators for Assessing Financial Sector Vulnerability

attention, in this context, is paidto how major rating agencies rate

nancial institutions strength andto their qualitative assessments ofnancial system soundness. 5

Several observations can bemade about the three groups ofindicators:

Prudential indicators providethe key measure of nancialsystem strength and soundness.Generally, nancial systems withhigh regulatory capital ratios,

strong asset quality, high levels ofprovisioning, and high and stablecore 6 pro tability are seen as saferand sounder than those with lowervalues. However, the usefulness ofthese of cial measures criticallydepends on the strength ofaccounting systems and theeffectiveness of supervisory andregulatory regimes in ensuring theaccurate and timely identi cationofand provisioning forimpairedassets. Any shortcomings in theseareas (for example, in recognizingimpaired assets or the accrual ofnon-received interest) can lead tothe overstatement of returns andregulatory capital cushions.

Prudential indicators also do notdirectly provide information about

the strength and robustnessof risk management systems,which arguably are the keyunderlying factors contributingto the safety and soundnessof nancial institutions. Forthese, and other reasons, theindicators are supplemented bymarket indicators, which providemarket assessment of nancialsystem safety and soundness asgiven by credit rating agenciesand stock market valuations.

Any signi cant discrepancybetween prudential and marketindicatorssuch as betweenstock market valuations andreported returns, or betweenof cially reported impairedassets and credit rating agencyestimatesis a potential sourceof concern.

Although efforts are beingmade by international bodies toencourage standardization in thereporting of prudential indicators,countries differ signi cantly inthe criteria they use to classifyimpaired assets, 7 whethernonperforming asset data is


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provided in gross terms or isnet of speci c provisioning, andin the way in which regulatory

capital is measured. Moreover,some economies in recent yearshave made signi cant changesto the criterion used to assessasset quality and in the amountof regulatory capital to be held inrelation to market risk. In thesecircumstances, care is neededin comparing nancial indicatorsacross countries and over time.

Differences between reportedregulatory risk to weighted andunweighted assets in principleprovide information on the riskin a nancial institutions assetportfolio as well as its overallleverage. Re ecting the zerocredit risk weight attached toown-sovereign claims in theBasel I framework, nancialinstitut

asia economic monitor - december 2006

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