Dynamic performance in East and South Asia, largely driven by Chinese economic expansion

Following a moderate slowdown in 2001, East and South Asia have returned to an impressive growth performance since 2002. Regional GDP, which grew by about 6 percent in 2003 as a result of strong domestic and external demand, is forecast to accelerate in 2004.

The booming economies in East and South Asia, the recovery in the United States and the stability of exchange rates within the region have spurred rapid growth of exports and imports. Together with strong investment dynamics, this has favored a high degree of specialization, thereby promoting intra-regional trade.

Although the developed countries remain the largest market for developing Asia, during the 1990s and early 2000s there was a major change in Asia's trade patterns. A growing share of intra-regional trade has improved the export performance of all the major economies in the region, despite recent overall weakness in the world economy.

China has been playing a central role in these transformations. In 2003 and the beginning of 2004, China was a major engine of growth for most of the economies in the region.

The country's imports accelerated even more than its exports, with a large proportion coming from the rest of Asia. China's exploding import demand value, which registered a 40 percent increase in 2003, provided a substantial impetus to important trading partners in Asia, notably Japan and the Republic of Korea.

After a decade of stagnation, the Japanese economy finally achieved considerable recovery of output growth in 2003. Although there has been a rebound in corporate investment, the recovery was largely based on higher external demand. While exports to the United States fell in 2003, the export drive was mainly due to continued strong demand from China, suggesting a change in trade patterns within Asia and between Asia and the United States.

The main driving force of growth in the Republic of Korea in 2003 and 2004 was exports. These are highly oriented to China, Japan and the United States, which accounted for nearly 50 percent of the increase in that country's export revenues in 2003.

In China, GDP grew by more than 9 percent in 2003, driven mainly by the industrial sector. With policy eager to avoid a sharp turnaround, the momentum of that output surge is expected to be maintained in 2004 and well into 2005.

Private consumption increased a rate of nearly 8 percent, based on the rapidly rising disposable income of households, and reached almost 45 percent of GDP in 2003. However, a booming investment in fixed capital is at present the main engine of growth. The 26 percent increase in fixed investment in real terms last year was encouraged by easy access to credit. In 2003, there was rapid capacity expansion in some industries, especially steel, aluminium and cement, partly as a result of rocketing domestic demand for private housing. In order to prevent overinvestment, the Chinese Government, in April 2004, resolved to freeze new investment in those sectors.

With a growth rate of about 30 percent for the second consecutive year, Chinese exports were a major source of growth in 2003. Part of this expansion was the result of a rush to benefit from export tax rebates, which expired at the end of 2003. Nevertheless, the growth of imports outpaced that of exports, thereby reducing the trade surplus for the second consecutive year, as well as the contribution of net exports to economic growth. In the first half of 2004, the trade balance has turned negative.

Prospects for 2004 indicate continued strong growth in East and South Asia. The two largest countries, namely China and India, will continue growing at a fairly rapid pace thanks to dynamic domestic and foreign demand. There might be a slight deceleration of growth in China, owing to recently adopted restrictive measures.

Global trade recovery: Developing and transitional economies play a major role

Between 1990 and 2000, developed countries accounted for most of the world's export growth. This was not due to exports rising faster in developed than in developing countries, but to the fact that, on average, 70 percent of total exports originated in developed countries, and only 25 percent in developing countries during the 1990s.

By contrast, the recovery of world trade in 2002 and 2003 was propelled mainly by developing countries: developed countries accounted for about 21 percent of the increase in the volume of exports in 2003, developing countries for 66 percent, and transitional economies for 12 percent.

This shift is attributable not only to sluggish exports in most developed countries and regions but also to rapid expansion of export volumes in developing regions and in the transition economies of Central and Eastern Europe and the Commonwealth of Independent States (CIS).

The contribution of developed and developing countries to growth of world imports by volume was more balanced, at around 40 percent and 50 percent, respectively, in 2002-03; transitional economies accounted for the remaining 10 percent.

Imports in developed countries remained more dynamic than exports, due to the persistent growth of United States' imports. Even with a lower growth rate of imports, extra imports by developed countries have had a significant impact on world trade.

For instance, even though the United States imports increased by 8.8 percent in 2003, compared to 40 percent for Chinese imports, the expansion of imports in absolute value terms was almost the same for the two countries: US$105 billion in the United States compared to US$118 billion in China.

Weak export dynamism in developed countries in recent years has been partly the result of weak GDP growth. In Western Europe, faltering domestic demand within the region explains the low growth of export volumes between 2001 and 2003, since intra-regional trade accounts for approximately two-thirds of the region's exports.

In the United States, the economic downturn in 2001, together with the global slowdown of growth, affected both imports and exports. In 2002 and 2003, that country's imports recovered much faster than exports, fuelled by an expansionary economic policy and a strengthening of the dollar until 2002.

During the recent recovery, the geographical structure of the United States imports changed significantly: imports from China continued to grow by 52 percent in current value between 2001 and 2003 while those from Japan and the ASEAN countries contracted, leaving total imports from Asia almost unchanged.

The share of Canada and Mexico in US' imports decreased, while that of the EU increased. As for exports, these began to recover in the last quarter of 2003, favoured by the real depreciation of the United States widening trade deficit, equivalent to 5 percentage points of GDP in 2003, up from 2.4 points in 1997 and 4.6 in 2000.

Japan's trade surplus continued to grow in 2003, but at a much slower pace than in 2002. Imports volumes picked up following an appreciation of the yen and improved domestic economic conditions.

Although the United States remains Japan's largest trading partner, bilateral trade between these two countries declined. As Japan's manufacturing has been steadily moving to China, many of the goods previously exported directly from Japan to the United States are now finalized and shipped to the United States by Japanese subsidiaries based in China.

This would also explain why Japanese exports of capital and intermediate goods to other Asian countries, especially to China, have grown dramatically.

In 2003, Japanese exports to China grew by 44 percent in current dollar terms, much of the increase being driven by demand of intermediate products from Japanese subsidiaries that produce goods destined for both the Chinese market and for exports.

In developing economies, trade volume recovered in 2003, albeit with varying intensity in different regions. East and South Asia experienced the most rapid growth of both imports and exports, continuing their strong growth trend of recent years, except for a slight contraction in 2001. Intra-regional trade expanded at an even higher rate, growing more than sixfold over the last three decades. At present, 35 percent of East Asian exports go to other economies in the region, compared to less than 24 percent in 1985.

This massive increase in intra-regional trade has been partly due to higher import demand from within the region, notably from China, but also to a reorganization of production processes into regional production networks, which have resulted in increased trade flows of industrial supplies and intermediate goods. These are produced in the more industrialized countries in the region such as the Republic of Korea and Singapore, and are finalized in countries with low-cost labour, mostly China.

The expansion of East Asian trade has occurred together with a substantial change in the destinations of exports. Deeper production-sharing practices within the region have contributed substantially to the rise of intra-regional trade flows.

In particular, China's emergence as a major production site for labour-intensive stages of production and assembly has exerted a huge impact on such flows, both within Asia and between Asia and the rest of the world. Goods that were previously processed and exported by other Asian countries are now finalized in China for export.

This phenomenon explains, in large part, the increasing bilateral trade imbalances between China and its major trading partners; China has recorded growing trade surplus with North America and Europe, while widening its trade deficit with the rest of Asia.

At the same time, the rapid growth of industrial activity in China is increasing its demand for energy and industrial raw materials, which it imports from other developing countries and transition economies.

Consequently, China is playing a fundamental role in the international commodity market.

Overinvestment and policy constraints in China

China's policy objective of keeping the exchange rate of yuan stable had to be put in the context of the objective of controlling domestic credit and investment boom. While the rapid growth of investment normally has called for a significant tightening of momentary conditions, speculations about an imminent appreciation of the yuan has induced huge private capital inflows fuelling a liquidity balloon and relaxed credit conditions.

The growth of investment in fixed assets, by 26 percent in 2003, and even further acceleration in early 2004, has become a major concern for policy makers. Easy availability of credit, together with local government officials' zeal to deliver economic growth, triggered another wave of fixed capacity formation in private and increasingly, in public investment.

The danger of such a development is that much of the investment undertaken at present could eventually turn out to be unprofitable, as prices for the goods produced in the new plants might fall well below the prices now obtained in global and Chinese markets. This would lead to new non-performing loans and exacerbate the problems in the banking sector a well-known phenomenon of credit-led economy. Chinese officials are especially cautious, in light of their experience of similar overinvestment from 1992 to 1994. Even though the investment bubble then was smaller than the current one, it ended with several years of deflation and left a legacy of non-performing loans. Thus, cooling the overheating economy so as to contain financial losses from a future bursting of the bubble has become top priority for the government.

However, attempts to subdue the credit boom have been complicated by the de facto fixed exchange rate regime. With United States' interest rates having fallen to historic lows in 2003, investors have grown increasingly interested in Chinese assets. This has resulted in intense gross inflows of private portfolio capital, based on investors' speculation on an imminent appreciation of the yuan.

According to Standard & Poor's estimates, US$40 to US$50 billion of "hot money" flowed into China in 2003. Conversion of domestically held foreign currency deposits into yuan dominated deposits also intensified.

As the monetary authorities were determined to defend the exchange rate, they were forced to buy a large proportion of this capital and to emit yuan in exchange. This policy increased liquidity in the banking sector and made it possible for commercial banks to hand out more new loans than the central bank would have wanted.

So far, the central bank has been reluctant to raise interest rates in order to cool down the economy, for many reasons. First, this might accelerate the inflow of hot money, as higher interest rates in China would make yuan-dominated deposits even more attractive relative to United States assets. Second, it could make house purchase more costly, thus triggering a sudden fall in real estate prices, which would increase the risk of a hard-landing economy. Third, as lending rates and distribution of loans are not yet fully market-determined, part of the credit boom seems to be very inelastic to changes in the interest rate. This is especially true for loans handed out at the request of local governments in an attempt to stimulate growth in their region.

Abandoning the fixed exchange rate and letting the currency appreciate in order to bring liquidity under control does not seem to be an attractive option for the Chinese authorities either, even though they have long considered a possible floating of the yuan. One fear is that a small revaluation at the juncture could attract more hot money to China, owing to speculation of further appreciations to come. A large appreciation, on the other hand, might substantially hurt Chinese competitiveness in international markets, and it probably would not succeed in curtailing the build-up of capacities aimed at the domestic market, especially overcapacity in steel, aluminium and office space.

With the trade surplus turning into a deficit, and domestic inflation increasing, pressure for an appreciation of the yuan is abating. In the mid-1990s, China's central bank managed to slow down the economy, without drastic interest rate hikes, by reducing credit growth through other channels such as higher reserve requirement ratios. Even though the increasing openness of the Chinese capital markets has made this task more complicated over the past decade, there is still a good chance that China will be able to manage a soft landing.

(China Daily September 17, 2004)