CONTENTS East Asia and Pacific Regional Update ...................................................... 1. Summary ........................................................................................................ 1 2. East Asia regional outlook ............................................................................ 5 Growth ­ the cyclical outlook...................................................................... 5 Poverty reduction and human development ............................................8 3. The international and regional environment ........................................... 11 Developed country growth ........................................................................ 11 China.......................................................................................................... 12 Commodity markets................................................................................... 14 Trade policy developments........................................................................ 18 4. Domestic trends and policy challenges....................................................... 20 Balance of payments and financial markets .............................................. 20 Financial sector trends and issues.............................................................. 25 5. East Asia: 10 years after the crisis ............................................................. 25 Growth ­ facing a middle income challenge? ........................................... 26 Poverty and Inequality ­ a 10 year perspective ......................................... 32 Managing vulnerability.............................................................................. 33 Some policy perspectives........................................................................... 37 Country Sections.................................................... ..............................39 Appendix Tables......................................................................52 Special Focus: Sustainable development in East Asia's Urban Fringe ....... 61 Key Indicators Tables........................................................................................ 70 This Regional Update was prepared by Milan Brahmbhatt, Lead Economist, East Asia PREM, with the assistance of Antonio Ollero and Taranaki Mailei, drawing on inputs and comments from country economists and sector specialists throughout the East Asia and Pacific Region of the World Bank. The report was prepared under the general guidance of Deepak Bhattasali, Acting Chief Economist, and James Adams, Regional Vice President, East Asia and Pacific Region. East Asia Update 1 EAST ASIA AND PACIFIC REGIONAL UPDATE Summary years of sustained and accelerating expansion, with the US economy slowing and a global tightening of monetary Growth in Emerging East Asia accelerated to policies still underway. The base outlook remains for a reach 8.1 percent in 2006 1 (Table 1). This was the `soft landing' and continued expansion, but one that is strongest pace of economic expansion in the last ten years weighted with more uncertainties and with greater and a fitting commemoration of the decade that has volatility. The next two sections of the report explore the passed since the start of the Asian financial crisis in 1997. implications for East Asia. The region's accomplishments in grappling with and overcoming the crisis and in returning to solid growth are East Asia Regional Outlook varied and impressive ­ a doubling in the dollar value of regional output from pre-crisis levels, the emergence of · Growth. The strong overall regional outcome for China into the front rank of global economic powers, a 2006 was dominated by China, which now comprises halving in poverty rates, accumulation of over $2 trillion over half of Emerging East Asian GDP and where in foreign reserves. But even as the region celebrates growth reached 10.7 percent, a fourth year of over 10 recovery, new challenges are arising, which could slow or percent growth, driven by buoyant exports and even derail growth if not properly handled. The report investment. Activity also expanded at energetic 8-10 looks at these issues in a section on "Ten years after the percent rates in low income economies such as crisis." Cambodia, Lao PDR, Mongolia and Vietnam. In Another challenge of staggering proportions that Vietnam, across-the-board strength in exports, lies ahead is East Asian urbanization: The region's consumption and investment was buttressed by a surge in population will rise by around 17 percent between 2000 foreign direct investment before the economy's and 2025 but its urban population will jump by 65 percent accession to the WTO this January. The larger middle or 500 million. The Special Focus in this report on and high income economies of the region also continued "Sustainable Development in East Asia's Urban Fringe" to expand at more moderate but still healthy rates of 4-6 looks at the issues. percent. Some slowing in regional activity became apparent in the latter part of the year, with growth easing to 7.6 percent (y-o-y) in the fourth quarter. In China this Table 1. East Asia Economic Growth mainly reflected a moderation of investment spending 2005 2006 2007 2008 following policy tightening by the authorities. Emerging East Asia 7.6 8.1 7.3 7.0 Elsewhere, though, the slowing trend reflected lower Develop. E. Asia 9.0 9.5 8.7 8.1 export growth, especially to the US. And the emerging S.E. Asia 5.1 5.4 5.5 5.7 US downturn and slowing export growth are also the Indonesia 5.7 5.5 6.3 6.5 main factors behind the forecast easing in Emerging East Malaysia 5.2 5.9 5.6 5.8 Asian growth to 7.3 percent in 2007. The extent of the Philippines 5.0 5.4 5.6 6.0 US slowdown is one important risk in the outlook, but Thailand 4.5 5.0 4.3 4.5 continued growth in Japan and Europe should provide Transition Econ. some balance, together with continued growth in China's China 10.2 10.7 9.6 8.7 imports of components and other inputs from the rest of Vietnam 8.5 8.2 8.0 8.0 Asia (although recent trends suggest growing Small Economies 7.6 7.2 5.9 4.9 competition in the China import market as the country Newly Ind. Econ. 4.8 5.4 4.5 4.9 deepens its domestic supply chain for export goods). Korea 4.0 5.0 4.4 4.9 Another area of uncertainty is the extent to which 3 other NIEs 5.5 5.8 4.6 4.9 domestic demand in the East Asian economies outside Japan 2.6 2.2 2.3 2.4 China will be able to pick up slack from slowing exports. World Bank East Asia Region; March 2007. Consensus · Poverty. We estimate that the number of poor people Forecasts for NIEs.. in East Asia at the $2 a day level fell to some 552 million in 2006 (or 29 percent of the region's population). This year is also likely to be memorable for another Looking back, it is likely that the last five years of reason, as the turning point in the global cycle, after 5 economic recovery and expansion have been among the most productive for poverty reduction in the history of East Asia. Since 2001 the number of people living 1 Emerging East Asia comprises Developing East Asia (China, below the $2 a day line has been reduced by some 228 Indonesia, Malaysia, Philippines, Thailand, Vietnam and some million, an even bigger reduction in poverty than in the smaller economies) and four Newly Industrialized Economies or previous extended `boom' of 1991-96. Those earlier NIEs (Hong Kong, Korea, Singapore and Taiwan, China). East Asia Update 2 poverty reduction gains were also partially squandered in the latter part of 2006 was partly offset by a further during the subsequent 1997-98 financial crisis. If the increase in the contribution of net trade to growth ­ region's policy reform efforts succeed in reducing export growth accelerated (at a time when US demand macroeconomic and financial vulnerability while and other East Asian exports were waning), while import maintaining high growth, the payoffs for sustained growth decelerated. Rising net trade also contributed to poverty reduction would be large indeed. The Poverty a surge in China's current account surplus to an section of the report also looks at new policy approaches estimated $230 billion in 2006, or a striking 8.7 percent that governments are taking to tackle poverty in a more of GDP, up from $161 billion in 2005. The large comprehensive way. Thus China recently announced external surplus is complicating the authorities' efforts to plans for a nationwide rural safety net or `di bao' to establish an appropriately tight monetary policy by tackle vulnerability to poverty (i.e. the fact that many tending to feed more rapid growth in domestic credit. more people are vulnerable to falling into poverty as a These circumstances point towards a continued focus on result of adverse shocks than are actually poor at a given the authorities' policy of rebalancing the pattern of time). Indonesia announced plans to scale up spending economic growth, orienting growth more towards on poverty reduction through a National Community domestic demand and consumption, towards more even Empowerment Program that builds on the success of distribution of the benefits of growth, and towards less existing community development programs. These intensive use of energy and natural resources. They also programs focus on improving local governance and point to a continued focus on the role of greater service delivery through participatory planning, exchange rate flexibility and a stronger exchange rate as providing community block grants for productive assets instruments to bring about desirable expenditure such as rural infrastructure, education, and health. switching and laying the basis for a more independent and flexible monetary policy. The international and regional environment · Commodity markets. Oil prices remain extremely · Developed economies. After reaching 4 percent in volatile and subject to political risks. Having fallen 2006 (5.3 percent in PPP terms), global growth is at sharply from their peak of over $70 last August, crude oil something of a turning point, projected to fall to 3.4 prices averaged around $58 through much of the last six percent in 2007, led by a more than one percentage point months, although they were moving sharply higher to the fall in US growth to 2.1 percent. Growth in Japan and mid sixty dollar range by the end of March as a result of Europe has tended to surprise to the upside over the past escalating political tensions in the Gulf. The report year, however, and is expected to continue at rates assumes a mild decline in oil prices from $64 in 2006 to similar to 2006. The rotation in the balance of growth $56 in 2007 as whole, which would provide a modest from the US to the rest of the world should help stabilize terms of trade based income gain for the region. Among and begin a gradual adjustment in global macroeconomic fundamental factors favoring this stable to gradually imbalances. Another key aspect of the turn in the global declining price scenario is evidence that consumers in cycle is the continued gradual tightening of monetary many places are adjusting to high prevailing prices by policies in the developed world, most recently in Europe improving efficiency and cutting demand. Thus, even and Japan, which is bringing to an end an extended while demand from China continued strong in 2006, it period of negative real interest rates. Tighter monetary fell in the OECD. On the supply side high prices are policies are helping curb an incipient upturn in inflation finally inducing significant increases in production in developed economies, and are also providing a check capacity and output in non-OPEC suppliers. Given the to the danger of bubbles in financial and other asset significant fall in prices in the second half of 2006, markets, a healthy development. Higher developed OPEC has moved to stabilize prices by restricting output. country interest rates are also likely to slow or partially That has also increased its margin of spare production reverse the surge in `yield seeking' private capital flows capacity to the highest level in several years, which to emerging markets underway since 2003. This should be helpful in case of serious political disruptions development may actually ease macroeconomic to the market. Still, while it is hard to predict, a large management in many East Asian economies, which have politically driven spike in oil prices is well within the been grappling with the exchange rate and monetary bounds of possibility. And that would constitute another consequences of not only large current account significant risk in the East Asian outlook. surpluses, but also of significant capital inflows. · Balance of payments and financial market · China. Growth in China decelerated mildly in the developments. Emerging East Asian economies saw a second half of 2006, easing from almost 11 percent in the record increase in their foreign exchange reserves (i.e. an first half of the year to around 10.5 percent in the second, overall balance of payments surplus) of $357 billion ­ the result mainly of policy tightening aimed at curbing worth 7 percent of GDP - in 2006. This was the fourth excessive investment growth. Slower investment growth year when the increase in regional reserves exceeded East Asia Update 3 $200 billion. Foreign reserves for the region exceeded $2 if not properly handled ­ economies could find trillion by the end of 2006, of which $1.06 trillion was themselves in a `middle income trap' and struggle to held by China. Reserve accumulation was almost climb onwards to higher income levels. History shows entirely driven by East Asia's current account surplus, an that while many economies can reach middle income estimated $362 billion in 2006, another record. Almost status ­ often quite quickly ­ few pass through it because two thirds of the regional imbalance occurred in China, the policy and institutional changes needed are more where the current account surplus rose to an estimated complex and more challenging technically, politically and $230 billion or 8.6 percent of GDP, both records by a socially. Ten years after confronting the reforms needed significant margin. The other main economies in the to rebound from the financial crisis, East Asia is region also ran current account surpluses in 2006, which confronting reform challenges at least as complex. The in the majority of cases were also higher than in 2005. fact that other economies in the region like Japan, Hong Wary of letting surpluses push up their exchange rates Kong (China), Korea, Singapore and Taiwan (China) too far, for fear of hurting exports and employment, most have already escaped the `middle income trap' shows that governments have intervened, accumulated foreign it is possible. But the task will not be simple. We look at reserves and then mopped up the resulting increases in three key challenges: facing East Asia 10 years after the domestic liquidity with fairly hefty bond issues. But the crisis, and at some policy perspectives that can help growing costliness and other inconveniences of this address them. procedure have also led governments to consider other options. Thailand introduced controls on capital inflows · Maintaining High Growth, Sustainably. While in December, but rescinded a significant part of them overall East Asian per-capita income growth in the post following heightened uncertainty among investors. crisis period 2002-06 has been as strong as pre-crisis Overall though, the extraordinary scale of balance of trends, this conceals two distinct stories. In China per payments inflows over the last 4-5 years is leading policy capita growth of near 9 percent is somewhat faster than makers to put more emphasis on exchange rate pre-crisis. But many other middle (and high) income flexibility. This is evidenced by China and Malaysia's economies in the region are growing at about 2 adoption of a more flexible exchange rate framework in percentage points less than pre-crisis. There are thus at mid 2005, and an increased pace of appreciation among least two middle income growth challenges in East Asia. several other economies. In China rapid growth has led to an accumulation A sudden sell-off on the Shanghai stock market of stresses and imbalances that could affect China's at the end of February set off a correction in stock onward development if left unchecked. Environmental markets around the world. While there was no single stresses are the most apparent. China today contains 20 cause for the sell-off at the global level, the event does of the world's 30 most polluted cities. Industry is large provide evidence for a heightened appreciation of risk relative to services, which adds to environmental among investors, more uncertainty about the outlook, for pressure. On the demand side, the share of investment is example about prospects for the US economy, as well as large relative to consumption, raising concerns about the impact of tightening global monetary policies. Asset inefficient use of capital and a potential build up of markets in East Asia as elsewhere are likely to be more overcapacity in specific sectors. Rural-urban income gaps volatile in the coming period. have widened. To address these problems the government is developing policies aimed at `rebalancing Ten years after the crisis the economy' and `striving for a harmonious society'. While maintaining fast growth, the aim is to achieve a A decade after the financial crisis that devastated shift in production from industry towards services, more East Asia in 1997-98, the region is far wealthier, has reliance on domestic demand, and growth that is more fewer poor people and a larger global role than ever equally shared and more environmentally sustainable. before. Led by continued strong growth in China, Emerging East Asia now has an aggregate output of over Among other middle economies in the region, $5 trillion, double the dollar value just before the crisis. In however, growth has been less than pre-crisis, with per-capita terms real incomes are some 75 percent higher. investment somewhat weak and erratic. Their overall The poverty rate at the $2 a day level has fallen from 50 shares in world trade have also been under pressure as percent of the population to 29 percent today. When they have adjusted to the rapid emergence of China on the Vietnam reaches middle income status (defined as annual world trade scene. China's emergence, while it is pr capita income of about $900), which could happen as generating tremendous welfare gains for consumers soon as 2010, more than 9 out of ten East Asians will live around the world, is also creating intense competitive in a middle income economy. pressures for other East Asian economies in global But even as the region celebrates recovery, new markets (especially in the last 5 years). But China has challenges loom, which could slow or even derail growth also provided a fast growing market for components and East Asia Update 4 other inputs from other East Asian economies. The result equity and bond markets have grown. Prudential is a new division of labor, with pan-Asian production regulation and supervision to strengthen the stability of networks centered on China as a final integrator of the banking system have improved, but this is a work in products for export to the outside world, and a rapid rise progress and several areas still need to converge to in intra-regional trade in production inputs. World Bank international standards. To strengthen securities markets Investment Climate Surveys find East Asian firms rating the focus needs to be on factors that help increase market uncertainty as the biggest constraint on their operations. liquidity and efficiency. These include improving the That is hardly surprising, given the wrenching availability of information to price securities accurately, competitive challenges and structural adjustments they are reducing transactions costs, and fostering growth in the undergoing. Global competition is not going away. size and heterogeneity of the investor base. Efforts to strengthen the investment climate are key to creating an environment in which firms are able to more · Policy perspectives. The report highlights a number effectively seek out efficient investments and areas of of policy areas in which progress could have multiple global comparative advantage. benefits across the three highlighted areas of concern. · Poverty and Inequality. At the same time as East Investment climate reforms that reduce policy Asian poverty has been falling, inequality of income and uncertainty and needless and costly regulations can help consumption has increased in many economies of the strengthen the competitiveness of not only formal sector region, in some cases sharply. This matters. Inequality firms but also entrepreneurial activity among the poor. can hamper growth, as poor people without access to Deeper, more diversified capital markets lessen credit may be unable to exploit investment opportunities. vulnerability and enhance growth by offering more It can be a source of political and social unrest. Research specialized modes of resource mobilization and suggests that many of the same forces that are allocation, for example by supporting investment in new, contributing to rapid growth and more global integration more uncertain and innovative projects. Improving are also the forces that are shaping unevenness in credit access for the poor removes a key impediment to growth. Among other factors, increased globalization their pursuing profitable investment opportunities. has increased relative demand for skilled labor, pushing up wage premiums for education and skills, one of the Services trade liberalization, where East Asia key factors behind the rise in inequality. Spatial has lagged, would provide a boost to the productivity and disparities between urban and rural areas are exacerbated competitiveness of services consuming sectors. by location and agglomeration effects that reward coastal High quality infrastructure is an increasingly areas and cities with good transport links to global important element of competitiveness. It is estimated markets, and firms and workers in cities who benefit that East Asia has infrastructure needs of approximately from their closeness to each other in various ways. How $200 billion annually over the next five years, might inequality be mitigated without killing the golden goose of productivity growth and wealth creation? Meeting skilled labor shortages, which are an important constraint on firm operations in the region's · Managing Vulnerability. The financial crises of middle income economies. Education and other forms of 1997-98 highlighted the potential costs of mismanaging human capital development are a fundamental vulnerability. Economies in the region have pursued two underpinning for both domestic innovation activity and broad strategies to reduce the risk of crisis. First, they the capacity of the economy to absorb knowledge from have run current account surpluses and built up large abroad. Strengthening quality and enrollment in foreign exchange reserves as an insurance policy against secondary and tertiary education, improving labor force crises. Research suggests that reserves now far exceed training capabilities and fostering development of optimal levels for precautionary purposes. Instead they national innovation systems are an increasingly can create unwanted side-effects of their own, for important part of the region's policy agenda. Policies that example by fueling excessive expansion of credit, improve access to higher education will also promote a economic overheating, higher inflation or speculative more equitable distribution of the benefits of growth. bubbles in asset markets, potentially compromising the central bank's ability to pursue an independent monetary The importance of prudent macroeconomic policy. Second, economies have sought to strengthen policies cannot be overestimated. Continued movements fundamentals, in particular the financial sector. Progress towards greater flexibility would improve the ability of in this area has been significant. Banks in the previously economies to adjust to external shocks more smoothly crisis-affected East Asian countries have improved and would also allow central banks greater independence capital adequacy, asset quality and profitability. in the conduct of monetary policy. Financial systems have become more diversified as East Asia Update 5 EAST ASIA AND PACIFIC REGIONAL UPDATE East Asia Regional Outlook for a third year running, fueled by garment exports, tourism, Growth construction and agricultural expansion, and growth also ran Growth in Emerging East Asia reached 8.1 percent at 7 ½ -8 ½ percent in Lao PDR and Mongolia. Growth also in 2006, which was, fittingly, the strongest pace in the ten came in at a relatively healthy 5 - 6 percent in the middle years that have elapsed since the start of the Asian financial income economies of South East Asia, picking up from crisis in 1997 (Table 1). Among the developing economies 2005 in Malaysia, Philippines and Thailand, while easing of the region growth came in at 9.5 percent, also the highest only modestly in Indonesia. Coming down one more notch, in ten years. A moderate slowing in regional activity became apparent in the latter part of the year, however, with Exhibit 1 regional GDP growth easing to a year on year pace of 7.6 percent in the fourth quarter, close to the 7.3 percent pace East Asia - Quarterly GDP Growth we forecast for 2007 as a whole, primarily reflecting slower (% Change Year Ago) growth in the US economy and in East Asian exports. 12.0 The strong overall regional outcome for 2006 was dominated by China, which now comprises over half of 9.0 regional GDP and where growth reached 10.7 percent, a fourth year of over 10 percent growth, driven by buoyant exports and investment. The pace of activity in China 6.0 slowed marginally from 11 percent in the first half of 2006 to around 10.5 percent in the second, following a range of policy tightening measures implemented from April 3.0 onwards, although monthly data on industrial production and exports indicate that growth remained very strong in the 0.0 first quarter of 2007. Growth also continued to run at energetic rates in several of the low income transition economies of the region like Vietnam, Cambodia, Lao PDR -3.0 99911Q 99913Q 00021Q 00023Q 00121Q 00123Q 00221Q 00223Q 00321Q 00323Q 00421Q 00423Q 00521Q 00523Q 00621Q 00623Q and Mongolia. Growth topped 8 percent in Vietnam, E. Asia NIEs supported by across-the-board strength in exports, SE Asia China consumption and investment, the latter boosted by a surge in -6.0 foreign direct investment before the economy's accession to the WTO this January. Cambodia grew by over 10 percent Table 2. Growth in Real GDP and Components of Aggregate Demand (% change year ago) Indonesia Malaysia Philippines Thailand Hong Kong Korea Singapore Taiwan, S.E. NIEs China Asia GDP 2005 5.7 5.2 5.0 4.5 7.5 4.0 6.6 4.0 5.1 4.8 2006 5.5 5.9 5.4 5.0 6.8 5.0 7.9 4.6 5.4 5.4 2006 H1 5.0 6.1 5.8 5.6 6.8 5.7 9.0 4.7 5.5 5.9 2006 H2 6.0 5.7 5.0 4.4 6.9 4.4 6.8 4.5 5.3 5.0 Consumption 2005 4.0 9.2 4.9 4.3 3.3 3.2 3.1 2.7 5.2 3.1 2006 3.2 7.0 5.5 3.2 5.1 4.2 2.5 1.5 4.3 3.4 2006 H1 3.0 7.4 5.5 3.6 5.1 4.6 2.4 1.7 4.4 3.7 2006 H2 3.4 6.7 5.4 2.7 5.1 3.8 2.6 1.3 4.5 3.2 Investment 2005 10.9 4.7 -3.9 11.1 4.6 2.3 -1.9 1.2 7.3 2.0 2006 2.9 7.9 0.6 4.0 7.9 3.2 13.9 0.3 3.8 4.1 2006 H1 1.1 9.4 0.0 5.3 5.9 2.2 8.9 -4.5 3.7 1.5 2006 H2 4.6 6.5 1.1 2.8 9.9 4.2 13.8 4.7 3.9 6.1 Exports 2005 16.4 8.6 4.2 4.3 11.2 8.5 14.2 7.3 9.5 9.1 2006 9.2 6.3 12.1 8.6 9.9 12.6 10.4 10.1 8.9 11.3 2006 H1 11.4 5.4 16.6 11.7 9.9 13.7 23.4 13.0 11.1 13.8 2006 H2 7.1 7.2 8.3 5.9 10.0 11.6 0.3 7.5 7.0 9.3 Source: Haver Analytics, national data sources and World Bank staff estimates. Regional averages are 2000 US$ GDP weighted. East Asia Update 6 growth in the larger Newly Industrialized Economies (NIEs) US import growth slowed to 5.8 percent for 2006 as a whole like Korea and Taiwan, China continued to run in a 4-5 and was negative 2.2 percent (quarter on quarter seasonally percent range. Smaller economies like Papua New Guinea adjusted annual rate) in the fourth quarter of the year. US and a number of the Pacific islands have also seen a pick up GDP growth is forecast to fall to just over 2 percent in 2007 in growth over the last 2-3 years, in part due to higher and US import sluggishness may persist even in the commodity prices. However political instability and various consensus soft-landing scenario. social tensions continue to undermine the outlook in a number of cases. Second, there have been signs of some slowing in the global high tech cycle, although the picture remains Exhibit 2 mixed. Available monthly data indicated that East Asian high tech export growth among the NIEs and the South East East Asia - Export Growth Asian economies slowed sharply from a hefty seasonally (US$ 3Mo. Mov. Averages - % Change Year Ago) adjusted quarter on quarter pace of 24 percent in the third E. Asia SE Asia quarter to almost zero in the fourth. While world China NIEs semiconductor sales are continuing to grow at a healthy 9- 40 10 percent rate in dollar terms, a drawdown of excess inventories that had built up in the global chip supply chain is a likely contributor to the recent slowing in East Asian tech exports. To that extent it should be a temporary event. How underlying global high tech demand fares with a 20 slowing US and world economy remains to be seen. Third, the contrast between accelerating export growth in China and decelerating export growth in the rest of the region suggests that competition for international 0 market share among East Asian exporters may also be 01 01 01 02 02 02 03 03 03 04 04 04 05 05 05 06 06 06 07 intensifying. For example, China's exports to the sluggish 20 n-aJ 20-ya US market were still growing at 25-30 percent in year on M 20-peS 20 20 20 20 20 20 n-aJ 20-ya M 20-peS n-aJ 20-ya M 20-peS n-aJ 20-ya M 20-peS n-aJ 20-ya M 20-peS n-aJ 20-ya M 20-peS n-aJ year dollar terms in the latter part of 2006 and early 2007, a time when Korea, Taiwan (China) and Malaysia's exports to -20 this market had slowed to around 5 percent. Fourth, China's own import growth has been slowing over the course of 2006, which partly reflects some Slowing exports by year end (for some) slowing in the pace of investment spending, but also as China deepens its domestic supply chain for export goods. As noted, year on year growth eased over the In recent years China has been by far the most dynamic and course of the year in much of the region, with second half fast growing market for exporters in the rest of East Asia. growth lower than in the first in 7 of the 9 main economies Producers in the rest of East Asia have rapidly expanded of the region, and with only Indonesia and Hong Kong exports of parts, components and capital equipment to bucking the trend. One of the main common factors in China, in particular for use in China's export industries. moderating growth was a downturn in export growth in the Thus these economies' loss of direct market share in third second half of the year in the NIEs and in middle income markets has been offset by their growing role as suppliers to South East Asia, especially in the fourth quarter. As Table 2 China's own export sector. During 2006, though, growth in indicates, while real export growth in these economies China's imports from the rest of East Asia has slowed in averaged a solid 9-10 percent for 2006 as a whole, it fell line with its overall import growth, falling from 25-30 from 11-15 percent year on year in the first half to around 7- percent at the start of the year to 10-15 percent at its end. 9 percent in the second. On a seasonally adjusted basis, real exports actually contracted between the third and fourth Domestic demand trends continue to diverge quarters in several economies. Exhibit 2 displays the same slowing trend affecting South East Asia and NIE exports in Domestic demand trends around the region dollar terms, while also showing that export growth in continue to diverge and are harder to classify as neatly as China was moving in precisely the opposite direction in the exports. Consumption and investment continue to grow at second half, accelerating strongly, and reaching a dizzying strong rates in China, Vietnam and some of the other small, 42 percent year on year pace in the first two months of low-income transition economies. In China urban fixed 2007. asset investment was growing at 19 percent in the fourth quarter, even after policy tightening measures had brought There are several factors that may help explain growth down from 31 percent in the first half of 2006. these recent trends and also provide a window into the outlook for 2007. First, the long anticipated slowdown in The picture was much more mixed among the four US demand and imports does seem to be underway. Overall middle income South East Asian economies. Taken in East Asia Update 7 aggregate, consumer spending in these economies slowed expected to increase slightly to 5.5 percent in 2007, from 5.2 percent in 2005 to 4.3 percent in 2006, while however, the result in part of the present buoyant domestic investment slowed from 7.3 percent to 3.8 percent (Table 2). demand led recovery in Indonesia. Consumption and investment in several of these economies was adversely affected by the impact of higher oil prices Whether these projections turn out to be over- since 2004, the reduction of fuel subsidies in Indonesia and optimistic or conservative will depend to a significant Thailand, and the general tightening of monetary policy in degree on the outcome for the world economy and on the these economies through 2005 and into the first half of performance of East Asian exports. As noted, exports had 2006. But there is a good deal of diversity at country level. slowed significantly by late 2006 in most of the economies In Thailand domestic demand was adversely affected by other than China. However the broad macro trends for the political uncertainty in addition to the factors mentioned world economy in 2007 still look reasonably sound. While above, leading to a loss of momentum over the course of the down from an exceptional pace close to 10 percent in 2006, year, with both consumer and investment spending slowing overall world trade volume growth is still forecast at a solid from the first half of the year to the second. Indonesia saw 7.7 percent in 2007. And although US growth had slowed precisely the opposite pattern, though. Domestic demand to only around 2 percent in the second half of 2006, growth was weak in the first half of the year as consumers and in Japan and the EU surprised to the upside in the fourth businesses adjusted to the impact of the higher interest rates quarter ­ and these two economies together take close to 30 and the removal of fuel subsidies in 2005, but was then percent of East Asian exports, more than the 20 percent accelerating in the second half as lower inflation allowed the currently going to the US. Intra-East Asian trade takes close central bank to begin reducing interest rates. Domestic to another one third of regional exports. The central engine demand growth was also buoyant in Malaysia, with both in intra-East Asian trade is China's imports from the rest of consumption and investment growing at 7-8 percent. the region, which are primarily driven by China's exports to Consumers in the Philippines also increased real the world outside East Asia, as well as, to a lesser extent, expenditures by 5-6 percent, supported in part by a 20 China's domestic demand. We currently see China's percent rise in remittances from abroad. exports growing by around 19 percent in real terms in 2007, which while it may generate competitive pressures for other Table 3. Inflation (% change year ago) East Asian economies in third markets, will also continue to 2004 2005 2006 2006 2006 Latest provide a robustly growing Chinese market for components Year Year Year Q3 Q4 Month and other inputs from these other economies. As noted above, there has been a worrying slowdown in the pace "Headline" Consumer Price Inflation China's imports from East Asia in 2006, possibly related to China 3.9 1.8 1.5 1.7 1.9 2.7 competitive substitution from imports to local production. Indonesia 6.1 10.5 13.1 14.9 6.1 6.3 This is one of the risks in the forecast that will need to be Korea 3.6 2.8 2.2 2.5 2.1 2.2 monitored in coming months. Malaysia 1.5 3.1 3.6 3.6 3.0 3.1 The other main area of uncertainty is the extent to Philippines 6 7.6 6.3 6.1 4.8 2.6 which domestic demand in the East Asian economies Thailand 2.8 4.5 4.6 3.6 3.3 2.3 outside China will be able to pick up slack from slowing "Core" Inflation exports. During the 2001 global slowdown and high tech China 0.4 0.9 1.0 0.8 0.9 recession, domestic demand in these other economies Indonesia 8.7 9.6 6.3 6.0 proved highly sensitive to exports, so that overall GDP Korea 2.9 2.4 1.8 2.1 2.1 2.3 growth fell to only 1-2 percent. However there are a Philippines 4.9 7 5.6 5.2 4.8 3.0 number of factors that may provide greater resiliency now. Thailand 0.4 1.6 2.3 2 1.7 1.4 Capacity utilization is at much higher levels now than it was in 2001 and profitability and balance sheets in the region's corporations are also much stronger, providing a more favorable footing for investment. A particularly uncertain Outlook for 2007 factor impacting domestic demand is the outlook for oil prices. Our current central projection is for oil prices to Growth in Emerging East Asia is expected to slow average $56.5 in 2007, down from $64.3 in 2006, which by close to one percentage point in 2007, from 8.1 percent would provide a nice income boost for consumers and in 2006 to 7.3 percent in 2007. With China comprising businesses in the non-oil sectors of the region. But the over half of Emerging East Asian GDP, much of the decline surge in oil prices to well over $60 in mid March due to in regional growth is accounted for by the projected political tensions in the Gulf is a reminder of just how moderation in China's GDP growth from 10.7 percent in volatile this aspect of the outlook is. 2006 to 9.6 percent in 2007, the result principally of some easing in exports (which, however, would still continue to On the policy side, East Asian central banks have grow at close to 20 percent in real terms). Growth among generally tightened monetary policies from mid 2004 to the the NIEs is also expected to ease by close to a percentage early part of 2006 to curb potential acceleration of inflation. point. In middle income South East Asia growth is Inflation rates have indeed been stabilizing and turning East Asia Update 8 lower over the course of this year (Table 3), allowing central Economic growth having reached close to 11 percent, banks to keep policy rates stable, and in the case of poverty at the $2 a day level is estimated to have fallen to a Indonesia and Thailand, to begin easing. In the event of an little over 340 million people or 26 percent of the population unexpectedly severe export slowdown, central banks should in 2006. Poverty reduction is also occurring at rapid rates in have room to begin or continue easing monetary policy in Vietnam, where poverty at the $2 a day level is estimated to 2007, to help bolster domestic demand. The move towards have fallen to around 36 percent in 2006, down from over greater exchange rate flexibility in the region in the years 62 percent only five years ago. Poverty rates in Vietnam are since the financial crisis should also give central banks more estimated to have now fallen below those in Indonesia and freedom to use monetary policy in support of domestic Philippines. The November 2006 East Asia Update, policy targets rather than to maintain a given fixed exchange discussed Vietnam's exceptional poverty reduction rate target. Fiscal balances have improved and government debt has generally declined over the course of the decade in performance in more detail, pointing to the contribution of most of the larger East Asian economies, thanks to fiscal rapid productivity gains in agriculture, diversification to consolidation efforts, relatively low interest rates and new crops and non-agricultural activities, income gains sustained economic growth since 2001. Except for the from higher international prices for key exported crops, Philippines, central government debt levels are now more resources for targeted poverty reduction programs and generally less than 50 percent of GDP, leaving room for a more pro-poor focus in public investment and other fiscal greater public spending, should circumstances require expenditure programs. Poverty reduction and economic growth have also accelerated in low income economies like Cambodia and Lao PDR in recent years, although poverty Poverty reduction and human development levels still remain high ­ over 50 percent of the population at the $2 a day level. Aggregate economic growth of 9.5 percent in The pace of poverty reduction in the region in the Developing East Asia ­ the most rapid since before the year was however a little below that in other recent years, in financial crises a decade ago ­ contributed to a further part because of an up tick in poverty in Indonesia. Much of significant reduction in poverty in 2006. Our current the increase resulted from significant increases in domestic estimates suggest that the number of East Asian poor at the rice prices in both 2005 and 2006, in part due to climatic $2 a day level fell to some 552 million (or 29.4 percent of conditions as well as to a ban on rice imports introduced in the population) in 2006, a drop of some 24.5 million (or 1 ½ January 2004, which has contributed to an environment of percentage points) from 2005. (Exhibit 3). low domestic stocks of rice. In response the government's decision to import additional rice is helping to stabilize Exhibit 3 prices. Growth in Indonesia also picked up in the latter part Poverty - Headcount Index of 2006 and is expected to reach 6.3 percent in 2007, up ($2 a day poverty line; Percent) from 5.5 percent in 2006. Our current forecast suggests that higher growth in 2007 should help offset the adverse impact Vietnam S.E.Asia 4 of higher rice prices, allowing some reduction in poverty rates for the year. But this projection is subject to much 80 Other Small * East Asia uncertainty, depending to a large degree on the future course China of rice prices. Cambodia 65 In Cambodia, a variety of indicators suggest continued progress on poverty reduction and human 50 development, but also a significant increase in inequality over recent years. The proportion of the population under the national poverty line fell from an estimated 47 percent in 1993/4 to 35 percent in 2004. Trends in housing and asset 35 indicators also confirm rising living standards. Education * Cambodia, Lao PDR, Papua New participation rates have increased considerably (although Guinea they suffered a small reversal in 2006), with rates rising 20 faster amongst girls than boys. Information from the 2005 1990 1996 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 Demographic and Health Survey suggests significant progress in expanding health service coverage and in improving health outcomes, notably a 30 percent decline in China, which contains the largest absolute number infant and under-five mortality rates since 2000, as well as a of poor, some 62 percent at the $2 a day level, remains at significant fall in HIV prevalence. The maternal mortality the center of the region's poverty reduction performance. East Asia Update 9 rate, however, has remained effectively unchanged at 472 landslides and earthquakes appear to be the most common deaths per 100,000 live births. causes of households falling into poverty. The National Bureau of Statistics reported that in the 592 poor counties in Rising living standards and falling poverty 2004, over forty percent of the households who fell into rates have been made possible by strong rates of economic poverty suffered a severe loss of income associated with growth, which averaged 8.4 percent between 1994 and natural disasters while over a quarter of the households 2006. However, the benefits of growth have been spread experienced a major health shock. rather unevenly. Average per capita consumption increased by 45 percent in the top quintile but only 8 percent in the The government is responding by scaling up rural bottom quintile between 1993/4 and 2004. The urban-rural social protection programs. Apart from a longstanding divide also remains great, with 91 percent of the poor living disaster reduction and disaster relief effort, China has not in the countryside. Inequality is also rising within the rural had a national (centrally-funded) rural safety net. That, population as more accessible villages get connected to however, is changing. In his report to the National People's urban-based growth and pull ahead of more remote villages, Congress in mid-March, Premier Wen Jiabao announced and as households with better endowments of assets and several new national social protection initiatives. Perhaps skills (and better access to capital) diversify into off-farm the most important is decision to set up a nationwide rural production and trading activities. safety net--a di bao or minimum subsistence allowance scheme--financed at least in part by the central budget. A Achieving high and more widely distributed similar scheme has been in place in urban China since the growth in agriculture and the off-farm rural economy late 1990s and in 2005 provided income support to over 22 requires investment in rural roads to better connect the poor million urban residents. In rural areas, however, only some with markets and reduce production risk, efforts to tackle provinces and counties had such a scheme, with generally complex land management challenges and improvements in very low and widely varying benefit levels. Under the new the quality and coverage of basic services. Meeting these initiative, the aim will be to establish a uniform di bao challenges in turn requires governance reforms on a number system across all of China's rural areas, and to scale up of fronts, including civil service reform, improved coverage from the 8 million who were covered in 2005 to accountability and better delivery of justice. nearly 30 million within the next year. Importantly, the China central government appears committed to providing the necessary financial assistance to poorer jurisdictions. The latest official estimate of rural poverty in China puts the number of rural poor--those with per-capita A related initiative is the decision to scale up the annual incomes less than the official poverty line of 693 National Cooperative Medical Scheme in rural areas. The yuan--at 21.5 million at the end of 2006, 2.2 million less NCMS is a new voluntary rural health insurance scheme than at the end of 2005. Because poverty in China is almost that was introduced on a pilot basis in 2003, operated by exclusively rural, these estimates suggest that less than 2 counties and subsidized by the local and central percent of China's population is currently poor, by official governments. Premiums paid by households are low, but count. The official poverty line is however a particularly reimbursement rates also appear to be low. Premier Wen stringent one. First established in the mid-1980s, it is meant indicated that in the coming year the NCMS pilot will be primarily to capture the minimum income needed to meet expanded to cover 80 percent of counties and that the basic subsistence needs such as food and clothing. Using the allocation from the central government budget to subsidize World Bank's international poverty standard of a dollar-a- the scheme will nearly double, from 5.8 billion yuan to 10.1 day per-capita consumption, we estimate that at the end of billion yuan. 2006 China still had about 105 million people--roughly 8 Indonesia percent of the population--consuming less than a dollar a day. That is the second largest number of poor in the world As noted, recent poverty developments in after India and is one reason why poverty reduction remains Indonesia have been significantly affected by large recent an important priority for China. increases in the price of rice. Poverty in Indonesia is quite sensitive to the price of rice, since it makes up about 25 Another reason is that vulnerability to poverty percent of the consumption basket of the poor, and since remains widespread. World Bank estimates indicate that three-fourths of the poor are net consumers of rice. Rice nearly a third of China's rural population was consumption prices increased by over 40 percent over the course of 2005 poor (by the dollar-a-day standard) at least once between and by over one third over the course of 2006, with further 2001 and 2004. This vulnerability to poverty reflects the increases in January and February 2007. In part, this was exposure of rural households to a variety of shocks--high because a moderate El Nino delayed the planting season by profile aggregate shocks such as the SARS epidemic, as over a month, but the situation was exacerbated by the rice well as a myriad of more localized and idiosyncratic shocks, import ban introduced in January 2004, which contributed ranging from the ill health of the primary income-earner and to an environment of low domestic stocks. The job loss, to crop-yield variability, adverse commodity price government's decision to import additional rice and movements and area-specific natural hazards. Health- BULOG's implementation of Operasi Pasar is helping to related shocks and natural disasters such as floods, droughts, stabilize prices but prices are only likely to move towards East Asia Update 10 the level of a year ago when the delayed main harvest percent in 2002/03 relative to a national poverty line. arrives in March/April. In addition, the unconditional cash Thanks to robust growth and a reduction in income transfer (UCT) put in place to compensate the poor for the inequality in the more recent half decade, the share of fuel price increases in late-2005 ended in late-2006. On the poverty was reduced by almost a third, lifting one eighth of other hand economic growth in Indonesia picked up to the 6 the population out of poverty. Projections suggest that the percent range and is projected to exceed 6 percent in 2007. poverty headcount fell further to 31 percent in 2005. Our current estimate is that higher growth will tend to offset other factors and start bringing poverty down in 2007. There are important changes in the character of However this estimate is subject to much uncertainty. poverty reduction between the two five year periods. The focus of poverty reduction shifted from areas with low The Government of Indonesia recently announced poverty in the first half of the decade to areas with high several major new poverty reduction initiatives. The poverty in the second half of the decade, from valleys to government plans to scale up spending on poverty reduction hilltops, and from the just poor to the very poor. As a result, through a National Community Empowerment Program the Gini coefficient of inequality first increased from 30.5 to (PNPM). In 2007, PNPM will be expanded to some 2,800 34.9, and then decreased from 34.9 to 32.6 in the more rural and urban sub-districts, with full national coverage of recent period. However, poverty still retains strong 5,360 sub-districts by 2009. The program builds upon geographic features: it is higher in rural areas, in priority Kecamatan Development Program (KDP) and Urban districts and in ethnic minority areas. Poverty Program (UPP), which focus on improving local There have also been significant improvements in governance and service delivery to communities at the sub- non-monetary indicators of human development, although district and village levels through participatory planning and regional disparities persist. The proportion of persons 6 community block grants. Funds are generally used for years or older with at least primary education increased productive assets, such as rural infrastructure, education, from one in four in 1995 to around two in four by 2002/03. and health. Previous evaluations of these community-driven Birth deliveries at health care centers doubled from 12 development (CDD) programs reveal positive results. They percent in 1992/93 to 25 percent in 2002/03. The proportion have proven successful in the targeting of poor Kecamatan was however much lower among ethnic minority women and have had a demonstrable impact on poverty. than among Lao-Tai women. Investments produce high economic internal rates of return ranging from 39 to 68 percent, and the costs for Mongolia infrastructure projects were estimated to be 20 to 25 percent New survey data for 2006 show that poverty in less than other government-sponsored public works of the Mongolia has continued to fall in recent years. The same quality. The programs also provide much needed national poverty headcount fell from 36 percent in 2002 (the employment to the poor, especially during the agricultural date of the previous comparable household income and off-season, or when there is drought, flood, and other expenditure survey) to 32.6 percent in the first 9 months of natural or economic catastrophes. 2006. Urban poverty incidence fell from 30.3 percent to Indonesia's unconditional cash transfer (UCT) 27.7 percent while rural poverty incidence dropped from program, which was introduced in 2005 to mitigate the 43.4 percent to 38 percent during this period. Poverty impact of the removal of fuel subsidies, is to be replaced by incidence declined most markedly in the Western region and a conditional cash transfer (CCT) program. CCT approaches in Ulaanbaatar, falling from 51 percent to 40 percent, while will be piloted in seven provinces in 2007 and are designed it remained unchanged in the Highland, Central and Eastern to address Indonesia's relatively high maternal and child regions. The poverty decline in recent years continues a mortality rates, and low progression to junior secondary longer term trend ­ the national poverty headcount is school among children of poor families. Based on the estimated to have fallen by 10 percentage points between experience of about 40 other countries with household CCT 1998 and 2002. programs, cash transfers will be given to mothers of 500,000 very poor and poor households on the condition Philippines that the family fulfills the relevant health and education According to the most recent available Family conditions. Impact evaluations of CCTs in other countries Income and Expenditure Survey (FIES), poverty incidence show impressive results in terms of reduced poverty, in the Philippines (using a national poverty line) was 30 increased school enrolment and attendance, usage of percent in 2003 compared to 33 percent in 2000. With preventive health services, and improved nutritional status. stronger economic growth in the interim period (an average The CCT will be rigorously evaluated two years after of 5.5 percent versus a historical trend of 3.5 percent), implementation poverty incidence should have declined further and faster, Lao PDR but final official estimates using the 2006 FIES will not be available until 2008 at the earliest. A recent Poverty Assessment for Lao PDR finds that poverty has fallen sharply since the early 1990s, from Increasing social spending could help accelerate 46 percent in 1992/93 to 39 percent in 1997/98 and 33 the decline in poverty, and this is now more feasible, given East Asia Update 11 recent improvements in tax collection. In the recently economies became more competitive with those in concluded 2007 Philippine Development Forum (a meeting developing economies. These flows may remain somewhat of government and development partners), the Philippine flat in the coming year.2 This development may actually government declared its intention to implement a national ease macroeconomic management in many East Asian social protection strategy, including a pilot conditional cash economies, which have been grappling with the exchange transfer program to address human capital shortfalls and rate and monetary consequences of not only large current protect the poor by supplementing their income. Its account surpluses, but also of significant capital inflows. efficiency would, however, depend on the reliability of the Commodity prices also show signs of having reached a targeting system in use. Currently, there is a multitude of cyclical peak, with substantial declines in oil and some national and local targeting systems and there is scope for a metals prices after the middle of 2006. Although oil prices more comprehensive, national system of targeting. Further are forecast to remain relatively stable in 2007-08, the developing disaggregated poverty data down to the forecast $50-60 range would be less than the $64 average in municipal level from the current regional level will also 2006, which would be a net boost for a region which is help. There is also a consensus among stakeholders that overall an oil importing one. The rapid surge in oil prices in poverty statistics ought to be released in a more timely mid to late March due to political tension in the Gulf fashion if they are to be more useful. nevertheless underlines the high volatility and uncertainty surrounding oil prices in the present climate. The international and regional environment Table 4. International Economic Environment 2005 2006 2007 2008 After reaching 4 percent in 2006 (5.3 percent in % Change from previous year, except interest rates PPP terms), global growth is at something of a turning GDP Growth point, projected to fall to 3.4 percent in 2007, led by a more World 3.5 4.0 3.4 3.6 than one percentage point fall in US growth (Table 4). World (PPP Weights) 4.7 5.3 4.7 4.7 Growth in Japan and Europe has tended to surprise to the OECD 2.5 3.0 2.4 2.7 upside over the past year, however, and is expected to United States 3.2 3.4 2.1 3.0 continue at rates similar to 2006. The rotation in the balance Euro Area 1.3 2.7 2.5 2.2 of growth from the US to the rest of the world should help Japan 2.6 2.2 2.3 2.4 stabilize and begin a gradual adjustment in global Developing Econ. 6.6 7.2 6.5 6.1 macroeconomic imbalances, that is, in the US current World Trade(Volume) 7.6 10.2 7.7 8.1 account deficit, which showed a significant fall in the fourth CPI Inflation - G7 a/ 2.5 2.6 1.6 1.7 quarter of 2006. For East Asia this means a weakening in Oil Price - $/bbl 53.4 64.3 56.5 54.4 its important US export market. - % Change 41.5 20.4 -12.2 -3.6 Another key aspect of the turn in the global cycle is Non-oil Commodity the continued gradual tightening of monetary policies in the Prices 13.4 24.7 1.5 -8.2 developed world, bringing to an end an extended period of LIBOR - US$. 6 Mo. 3.6 5.2 5.4 4.8 negative real interest rates. Although tightening is most -Euro 6 Mo. 2.2 3.1 3.8 4.3 advanced in the US, where policy rates have been stable Source: World Bank DEC Prospects Group March 2007. a/ In local since early 2006, after increasing 425 basis points over the currency aggregated using 2000 weight. .. previous two years, it is still continuing in Europe and Japan. The Bank of Japan raised its policy rate by 25 basis points to 0.5 percent on February 21, followed by a 25 basis Developed country trends points increase in the ECB policy rate to 3.75 percent in The United States economy grew 3.4 percent in early March. Tighter monetary policies appear to be 2006, about the same as in 2005, although quarter on quarter succeeding in curbing the incipient upturn in inflation in (q-o-q) growth slowed sharply after the first quarter of the developed economies, and also to be providing some check year. Output growth slowed from a strong 5.6 percent q-o-q to the danger of excessive euphoria or bubbles in financial seasonally adjusted annual rate in the first quarter to only 2 and other asset markets. Apart from the bursting of the percent in the third quarter and 2.2 percent in the fourth. bubble in the US housing market, higher rates also Reflecting the recession in the housing market, residential contributed to the correction in global stock markets in the investment fell 12.6 percent over the four quarters of the spring of 2006 and to the declines in stock markets at the year. While non-residential investment had grown at robust end of February and in March 2007, which may reflect a partial normalization in the pricing of risk. 2 Higher short term interest rates also have a bearing The Institute of International Finance forecasts private capital flows to emerging economies declining from $502 billion in 2006 on two other aspects of the global economy. Capital flows to $469 billion in 2007, with nearly all of the fall in bank lending to developing countries rose once again in 2006, but their and portfolio debt flows. "Capital Flows to Emerging Markets", rate of growth slowed as interest rates in developed January 18, 2007. East Asia Update 12 rates during the first three quarters of the year, it too fell at a housing-sector activity, which has already cut into 2.4 percent annualized rate in the fourth, suggesting that investment in other sectors, is expected to gradually shallow reduced construction sector activity was beginning to have out over the course of the year. As a result, even though knock-on effects elsewhere in the economy. In the latter knock-on effects in the construction and manufacturing part of the year, growth had become increasingly dependent sectors may continue to be felt, the overall negative impact on private consumption growth, which was underpinned by of the adjustment in the sector on GDP should weaken. healthy growth in employment and wages. In the last quarter Overall, GDP in the United States is projected to increase overall growth was also boosted by a 1.5 percentage point 2.1 percent in 2007, picking up to 3 percent in 2008. contribution from net trade, as export volumes rose at a 10.5 Weaker domestic demand will continue to be reflected in percent annual rate, buoyed by strong growth in foreign slower import growth and a decline in the trade and current- markets and the decline in the dollar since 2002, while account deficits of the United States, with the latter coming imports fell 2.2 percent, reflecting weaker domestic in around 4.5 percent of GDP by 2009, down from 6.5 investment spending and de-stocking. For 2006 as a whole percent in 2006. exports growth accelerated to 8.9 percent while import growth slowed to 5.8 percent in 2006. The turnaround in Growth in Japan was unexpectedly volatile over real trade flows, combined with lower oil prices, helped the the course of 2006 (Exhibit 4). Solid growth rates of 3-4 US current account deficit drop from 6.9 percent of GDP in percent (saar) in the last quarter of 2005 and first quarter of the third quarter to 5.8 percent in the fourth. 2006 were followed by a an unexpected downturn to rates of only 1.4 and 0.3 percent in the second and third quarters respectively, pulled down by lower public investment Exhibit 4 (reflecting longer term efforts at fiscal consolidation), OECD Real GDP Growth destocking, a slowing in export growth and a weakening in (% Change on previous quarter, SAAR) consumer spending that occurred despite the best labor 8 market conditions in more than a decade. In the fourth United States quarter the economy mounted an even more unexpected 7 Japan rebound, however, increasing 5.5 percent at annual rates, led Euro Area by strong growth in business investment and consumer 6 G3 spending, which increased by 13.2 and 4.2 percent 5 respectively. The robust growth in the quarter bolstered confidence that the economy could withstand monetary 4 tightening, allowing the Bank of Japan to increase its policy interest rate by 25 basis points to 0.5 percent. Growth for 3 2006 as a whole came in at 2.2 percent and is expected to grow at almost the same pace, 2.3 percent, in 2007. 2 Growth in the Euro Area was also generally robust 1 in 2006, growing at quarter on quarter rates of over 3 0 percent in three of the four quarters of the year. Fourth quarter GDP growth came in at 3.5 percent, led by healthy growth in exports, business investment and consumption, 200 200 200 200 200 200 2004200 200 200 200 200 200 200 200 200 -13 Q13 Q23 Q33 Q44 Q14 Q2 Q34 Q45 Q15 Q25 Q35 Q46 Q16 Q26 Q36 Q4 the latter boosted by a pick up in German consumer -2 spending in advance of a 3 percentage point hike in the value-added-tax rate in Germany. Growth in the Euro Area Monthly data for the first quarter of 2007 was in 2006 as a whole picked up to 2.7 percent from 1.3 percent mixed but showed continued weakness in many sectors. in 2005. Euro Area growth is likely to moderate in the first Housing starts tumbled 14.3 percent in January (month on quarter of 2007, in part as consumers in Germany adjust to month annual rate) to stand 28 percent below year earlier the higher VAT - German retail spending fell an levels. New factory orders for durable goods fell 7.8 unexpectedly steep 5.1 percent month on month in January. percent in January. Retail sales were stagnant for a second The outlook for the year remains broadly positive however. month in February 2007. This was partly due to Business and consumer sentiment were at unexpectedly high unexpectedly cold weather, but was still a worrying levels in February. Unemployment continued to fall, development in an economy where demand growth has reaching 7.4 percent in January. Euro Area growth is lately become increasingly dependent on the consumer. On projected to moderate only slightly in 2007, reaching 2.5 a more positive note the unemployment rate fell to a near 5 percent for the year. year low of 4.5 percent in February. Consumer confidence in February also increased to its strongest reading in five China years, on the back of good wage gains and ample job opportunities. Growth in China decelerated mildly in the second Overall, the consensus view continues to be for a half of 2006, easing from almost 11 percent in the first half `soft landing' in the economy. The sharp decline in of the year, to 10.6 and 10.4 percent in the third and fourth East Asia Update 13 quarters respectively. Growth for the year as a whole credit and monetary aggregates could stimulate a further amounted to 10.7 percent, the fourth year in succession of resurgence of investment. Early 2007 data show that over 10 percent growth. The modest slowing in the second investment has remained strong, with FAI growth reaching half of the year followed tightening measures that have been 23 percent in January-February. Industrial production implemented from last April onwards, aimed at curbing numbers were indicative of the continued strength in the real excessive investment growth, which, together with exports, economy, accelerating to 18.5 percent in January-February was one of the principal drivers of growth in the year. 2007, up from 14-15 percent in the last quarter of 2006. Recent monthly data on industrial production, exports and monetary aggregates however indicates that growth has The slowdown in investment growth in the latter remained strong in the first quarter of 2007. As in other part of 2006 was partly offset by a further increase in the countries, volatility in the stock market has increased contribution of net trade to growth. Export growth has in substantially, with steep price declines in late January/early fact been picking up over the course of the year, rising from February and late February being followed by significant around 22 percent in nominal US dollar terms in the last rebounds in equity prices. quarter of 2005 to 29 percent in the fourth quarter of 2006. Export growth further accelerated to 42 percent in January- Growth in nominal urban fixed asset investment February 2007. Export strength partly reflects new (FAI)3 did slow from about 31 percent in the first half of production capacity put in place by the heavy investment of 2006 to 22 percent in the third quarter and 19 percent in the recent years, as well as continued gains in productivity. fourth. The slower pace of investment growth followed Import growth, on the other hand, decelerated from a 25 imposition of administrative controls to limit speculative percent year on year pace in the first quarter of 2006 to 15.5 investment in real estate, reinforcement of controls and percent in the last quarter of the year, before picking up to a regulations on investment projects, including a re-evaluation little over 20 percent in January-February 2007. Slower of all large investment projects under implementation; and import growth in recent years is partly related to the loosening controls on capital outflows. For the year as a government's efforts to slow investment growth, but also to whole gross fixed investment (on the national account the expansion of industrial capacity and increasing definition) increased 25 percent in nominal terms, a fourth technological sophistication, which is allowing producers to year of annual increases in the 25-30 percent range. substitute towards local production and deepen their supply Investment is estimated to have reached over 42 percent of chains within the country. (Exhibit 5). GDP in 2006, up from 36 percent in 2002. The tightening measures also included a range of Exhibit 5 monetary policy measures to curb increases in liquidity, East Asia - Import Growth credit and monetary growth, which are linked to burgeoning (US$ 3Mo. Mov. Averages - % Change Year Ago) balance of payments inflows and which raise concerns that 60 accelerating monetary growth could fuel excessive E. Asia investment as well as the emergence of speculative SE Asia `bubbles' in asset markets such as real estate and equities. China These measures have included open market operations to 40 NIEs mop up liquidity in the inter-bank markets through greater issuance of Central Bank bills, increases in interest rates and increases in reserve requirement ratios. Issues of Central Bank bills increased to 3.65 trillion yuan in 2005, up 860 20 billion yuan or 31 percent from 2005. In March 2007 the People's Bank of China raised one year lending rates and deposit rates by 27 basis points to 6.4 and 2.8 percent respectively, the third increase in a year. In February the 0 - 01 -p - 02 -p - 03 -p - 04 -p - 05 -p - 06 -p 07 PBC also raised the reserve requirement for depositary May Se May Se May Se May Se May Se May Se financial institutions by 50 basis points to 10 percent, the 20-naJ 20-naJ 20-naJ 20-naJ 20-naJ 20-naJ 20-naJ fifth increase in a year. Despite these efforts, the year on -20 year rate of bank lending picked up to 17-18 percent in January-February 2007 from 13-14 percent in the same period a year earlier, while M1 money growth accelerated to With rising export growth outpacing imports by a 20-21 percent from 12-13 percent between the same periods. growing margin, the contribution of net trade to GDP While the recent interest rate increase is in large part a growth increased to 3.3 percentage points in the second half response to a pick up in inflation, it is also consistent with of 2006, up from close to 2 percentage points in the first the authorities' concern that continued buoyancy in the half. The trade surplus surged to $177.5 billion in 2006 and to $204.9 billion in the 12 months to February 2007, compared to $102 billion in 2005 and a mere $32 billion in 3 FAI is an imperfect measure of fixed investment and differs 2004. (Exhibit 6). The current account surplus increased to significantly from the national accounts measure. It is, however, available in a monthly data series. East Asia Update 14 an estimated $230 billion in 2006, or a striking 8.7 percent areas. The recently completed National People's Congress of GDP, up from $161 billion in 2005. in March made important advances in several of these directions. Current circumstances also point to a continued Exhibit 6 focus on the role of greater exchange rate flexibility and a China - Trade Balance stronger exchange rate as a means of bringing about (Bill US$ - 12 Mo. Moving Sum) desirable expenditure switching and laying the basis for a more independent and flexible monetary policy. 200.0 In recent years China's rapid growth has provided an important locomotive for trade and growth in the region as a whole, although, more or less in line with overall 150.0 imports, growth in imports from the rest of emerging East Asia slowed modestly in 2006, easing modestly from 20.5 percent in 2005 to 18 percent last year. (Exhibit 7). As with overall imports, there was a slowing in import growth from 100.0 the rest of Emerging East Asia over the course of the year, falling from 24 percent in the first quarter to about 13 percent in the fourth. Exports to China (and Hong Kong) 50.0 now make up over one fifth of the exports of other Emerging East Asian economies. If the slower pace of import growth in China persists through 2007, it could pose 0.0 a concern for these other economies, which are generally 1995- highly export dependent and which are also likely to be facing a slowdown in exports to the slower growing US Dec 1996-tcO 1997 1998 ug-A un-J 1999-rpA 2000 2000- eb-F Dec 2001-tcO 2002 2003 ug-A un-J 2004-rpA 2005 2005- eb-F Dec 2006-tcO economy. Exhibit 7 The surge in the trade and current account surpluses (discussed further in the later section on balance China: Imports from East Asia of payments issues) is one of the main short term (% Change Year Ago) macroeconomic imbalances of concern to the authorities.4 60 As noted, the authorities have aimed to cool the rapid 2004 growth in investment, so as to reduce the risk of 2005 overcapacity and resources being wasted in inefficient investment projects, which could also contribute to bad debt 2006 problems in the banking system. However there is a policy 40 dilemma here, since lower investment growth is also likely to slow imports and aggravate the rise in the external imbalance, unless offset by stronger consumption growth and a greater switching of domestic demand growth towards imports. The large external surplus in turns tends to feed 20 more rapid growth in domestic credit and money supply, complicating the authorities' efforts to establish an appropriately tight monetary policy. These circumstances therefore point towards a 0 continued focus on rebalancing the pattern of economic growth, which entails orienting growth more towards Korea Taiwan, Indonesia Philippines Thailand domestic demand and consumption, towards more even China distribution of the benefits of growth, and towards less intensive use of energy and natural resources. Such measures can include, among other, expansion of the social Commodity markets safety net, in particular expansion of rural health insurance High tech cycle and establishment of rural pensions, as well more public financing of education and health care, especially in rural Recent indicators provide a mixed picture of demand trends in global high tech markets, a key export 4 sector for most middle and high income East Asian Minister of Commerce Bo Xilai noted in January that "China's economies. Growing inventories in some segments of the excessive trade surplus is detrimental to both domestic economic development and foreign trade relations" and that reducing the market appear to have already led to some slowdown in trade surplus was the "top priority" of trade policy this year. exports and high tech production and exports from several East Asian economies. East Asia Update 15 On the more positive side world semiconductor 2006. Market researchers also reported increases in global sales in January 2007 were up close to 10 percent from year semiconductor inventories in the global electronics supply earlier levels and were also growing at a similar rate on a chain in the second, third and fourth quarters of 2006.5 seasonally adjusted month to month basis (Exhibit 8). For Producers and exporters in East Asia appear to have felt 2006 as a whole sales rose by 8.9 percent, up from 6.8 some of the impact as more of demand is met by drawing percent in 2005, and the Semiconductor Industry down of excess inventories. Exhibit 9 indicates that both Association is looking forward to a 10 percent increase in high tech industrial production and exports in several East global sales in 2007. Asia middle and high income economies (excluding China) slowed quite sharply in the last quarter of 2006. 6 However, Exhibit 8 so long as underlying final demand keeps growing at reasonably solid rates in line with a continuing global World Semiconductor Billings expansion, the inventory correction affecting East Asian (US$ Billion, 3 Mo. Mov. Averages, 7/95 - 1/07) exporters should be a temporary affair. 25 Asia ex Japan as % of World Sales: Asia excl Japan December 1995: 19.3% Japan Non oil commodity markets December 1998: 23.5% Europe 20 December 2001: 33.5% Americas Taken as a group, non-oil commodity prices have January 2007: 47.4% been relatively stable over the past 6-9 months, remaining around the high levels reached after more than four years of 15 strong price increases. The World Bank's index of non-oil commodity prices in nominal US dollar terms had increased about 85 percent between the beginning of 2002 ­ roughly 10 the start of the current boom in commodity prices ­ and May 2006. However, between last May and February 2007 5 the non-oil index rose only another 2 percent, although, as will be seen, there was much divergence in the performance of individual commodities. (Exhibit 10). The more stable 0 trend in prices recently is consistent with both moderately 59-l 69-l 79-l 89-l 99-l 00-l 10-l 20-l 30-l 40-l 50-l 60-l slowing world growth and tighter monetary policies around the world. Ju Ju Ju Ju Ju Ju Ju Ju Ju Ju Ju Ju Exhibit 10 Exhibit 9 Non-oil Commodity Prices. U.S. Dollar Indexes (Jan.2002=1) 3.4 East Asia: High Tech Production and Exports All non-oil commodities (3 Mo/3 Mo. % ch. saar) Food 2.9 Agricultural raw materials Exports 25.0 Metals & Minerals Production 2.4 1.9 15.0 1.4 5.0 0.9 00-n 00-l 10-n 10-l 20-n 20-l 30-n 30-l 40-n 40-l 50-n 50-l 60-n 60-l 70-n Ja Ju Ja Ju Ja Ju Ja Ju Ja Ju Ja Ju Ja Ju Ja Jan-05 Apr-05 Jul-05 Oct-05 Jan-06 Apr-06 Jul-06 Oct-06 Jan-07 -5.0 Of more concern, US business investment spending 5 Ann Steffora Mutschler. "Chip Inventories Still on Rise, but on high tech tailed off during 2006 (although US consumers won't derail market growth." Electronic News, 1/10/2007 kept spending), and tech orders from the G-3 countries also 6Exports include Hong Kong, Korea, Malaysia, Philippines, showed month to month declines in the latter months of Singapore, Taiwan (China) and Thailand. Production includes the same economies, except Hong Kong and Philippines. East Asia Update 16 Taking a longer view, the current boom in non-oil current cycle. As Exhibit 12 indicates, real short term commodity prices has been both longer lasting and bigger interest rates in the U.S. and Europe have now risen to a 2-3 than most cyclical commodity price upturns over the last 50 percent range, about the same range as in the mid-late years. (Exhibit 11). In real terms (relative to world 1990s, when real non-oil commodity prices were on average manufactured export unit values) non-oil commodity prices 35-40 percent lower than today. Slowing global growth in have reversed their declines over two decades and have now 2007 will also tend to dampen demand growth, although returned to their levels of the early 1980s. Metals and with China expected to continue strong growth in the 8-10 minerals prices in particular have reached levels in real percent range, the slowing should be moderate rather than terms that are higher than at any time since 1960 (the start dramatic. In line with these trends the Bank's commodity of this data series). projections look for non-oil prices in nominal US dollar Demand for commodities has been bolstered by the terms to dip 1 percent in 2007 and perhaps 7.5 percent in sustained period of strong global growth since 2002, 2008. including robust growth in developing economies, in Among commodities of interest to East Asian particular fast growing large economies like China, with a economies as exporters or as industrial importers, metals voracious demand for industrial raw materials. Another and minerals prices have on average remained near the factor supporting high commodity prices has been the low exceptionally high levels reached by early last year, dipping or negative level of real interest rates from 2001 through by only around 3 percent between May 2006 and February 2005. (Exhibit 12). Low interest rates could boost the 2007. Copper prices, in particular, have fallen about 30 demand for primary commodities or reduce their supply percent since May 2006, sapped by the steep downturn in through several channels. On the demand side, low interest the US housing construction sector and by a period of rates reduce the cost to firms of carrying larger inventories. destocking in China, induced by the previous exceptionally On the supply side, low interest rates reduce the incentive high price levels. However other base metals such as for extracting primary commodities today rather than nickel, lead and tin have seen further large gains of 45-95 tomorrow (for example the rate at which minerals are mined percent over the last 6-9 months, boosted by continued or forests cut down and the proceeds put on deposit to earn healthy industrial demand, very low stocks and occasional interest). Frankel (2006) finds significant empirical supply difficulties. Looking forward, base metal prices are evidence for the positive impact of low real interest rates on expected to be on a modestly declining trend in 2007-08. commodity prices and inventory levels.7 Apart from the broad growth and interest rate factors noted above, supplies are also likely to be increasing in response Exhibit 11 to prevailing high price levels. Mineral sector analysts note that it generally takes around four years for a significant Real Non-oil Commodity Prices supply response to higher prices to come through in this (1960-2006) Constant 1980 Prices* (1980=1) 2.0 sector. With prices having started to pick up from their All non-oil commodities previous trough in 2002, past experience suggests new Food supplies will start to enter the market in 2007 and 2008. Agricultural raw materials These considerations sound a note of caution for some of Metals & Minerals 1.6 the smaller, low-income mineral exporting economies in East Asia such as Mongolia and Papua New Guinea, which have enjoyed huge windfall income gains from high export prices in recent years. 1.2 Agricultural exporters in South East Asia have continued to enjoy further gains across a wide range of commodities in recent months though. Rubber prices had fallen sharply in the middle part of 2006, reflecting the fall 0.8 in world oil prices, and hence in the cost of synthetic rubber, but rebounded in recent months due to supply problems * Deflated by global manufactured exports unit value. (drought in Thailand, floods in Indonesia). In real terms prices remain at 25 year highs. Prices for fats and oils such 0.4 as coconut oil and palm oil also remain buoyant, at 10 year 1960 1963 1966 1969 1972 1975 1978 1981 1984 1987 1990 1993 1996 1999 2002 2005 highs in real terms, due to continued strong world wide demand. The tightening of monetary policies around the world over the past two years is one reason to expect that commodity prices may now be reaching their peaks in the 7Jeffrey Frankel: (2006). "The Effect of Monetary Policy on Real Commodity Prices". In John Campbell. (Ed.) Asset Prices and Monetary Policy. Chicago. (Forthcoming). East Asia Update 17 Exhibit 12 demand in OECD, in particular, actually contracted in 2006, falling to an estimated 49.2 million barrels per day from Real Short Term Interest Rates * 49.6 mbd in 2005. Demand contracted in all major OECD 5.0 regions, including North America, Europe and the Pacific. USA Adjustment to higher prices also curbed demand growth in 4.0 Germany developing Asia (other than China). Demand growth was more robust in China, however, driven by strong overall Japan 3.0 output and income growth and reflected, in particular, in surging demand for transport fuels. Oil consumption increased by a healthy 6.4 percent to reach an estimated 2.0 7.12 mbd in 2006. Strikingly, the increase in demand in China was over 50 percent of the overall increase in world 1.0 demand in 2006. Over 2002-06, China contributed just over one third of world oil demand growth. Developing Asia as 0.0 a whole contributed about half of world demand growth naJ peS ya over this period. M naJ peS ya M naJ peS ya M naJ peS ya M naJ peS ya M naJ peS -1.0 Exhibit 13 1996 1996 1997 1998 1998 1999 2000 2000 2001 2002 2002 2003 2004 2004 2005 2006 2006 -2.0 Monthly Average Crude Oil Price ($/bbl) * Three month interest rates, deflated by year on year percent (Jan 1990 - Feb 2007) change in CPI. -3.0 70 Oil markets Having fallen sharply from their peak of over $70 last August, crude oil prices in the last quarter of 2006 and 50 Average Sept. 1999 - the first quarter of 2007 have averaged around $58 per Average Jan. 1990 - Sept 2003 - $26.2 barrel, falling to a little over $50 in January 2007 but Aug 1999 - $18 rebounding to over $60 by early March, and then, with escalating political tension in the Gulf, towards the mid sixty dollar range by the end of the month8 (Exhibit 13). In 30 nominal terms prices in the $50-$60 range remain well above anything seen before the beginning of the current run- up in oil prices in early 2003. In real terms (relative to US consumer price inflation), crude oil prices over the last six 10 months were comparable to those in the mid 1980s. (Exhibit 14). Overall, developments over the last six Jan-1990Oct-1990 Jul-1991 Apr-1992Jan-1993Oct-1993 Jul-1994 Apr-1995Jan-1996Oct-1996 Jul-1997 Apr-1998Jan-1999Oct-1999 Jul-2000 Apr-2001Jan-2002Oct-2002 Jul-2003 Apr-2004Jan-2005Oct-2005 Jul-2006 months continue to provide evidence for the consensus view that - barring major political shocks that lead to large supply disruptions or an unexpectedly severe recession in the world On the supply side the high prices of recent years economy - oil prices have seen their peak in the current are also finally inducing significant increases in production cycle, but are unlikely to see dramatic declines in the near capacity and output. Non-OPEC supply (excluding Angola, term, trading instead in a more stable range, with only which recently joined OPEC) increased by an estimated 0.5 modest declines over the next 2-3 years. mbd in 2006, with gains in Russia and other FSU Among the factors contributing to the decline in oil economies, North America and Africa. Given the significant prices from their August 2006 peaks, growth in world oil fall in prices in the second half of 2006, OPEC has moved demand slowed to its lowest rate in several years in 2006 to stabilize prices by restricting output, with OPEC (an estimated increase of 0.8 million barrels per day production (excluding Angola, which is not subject to according to IEA statistics), as firms and other consumers production restrictions this year) falling by more than 1.5 around the world began responding to the prevailing high mb/d in the last six months. Reflecting the somewhat easier prices by improving efficiency of oil energy use and by conditions in the market, the level of spare production switching to other energy sources. Unusually warm weather capacity in OPEC has rise to around 3.9 mb/d. Granted, in major markets also contributed to the slowing in demand about 1.5 mb/d of that is in Iraq, Venezuela and some other growth by reducing demand for heating. (Exhibit 15). Oil economies where there are significant impediments to converting capacity into actual production. Nevertheless, the effective spare capacity in OPEC of about 2.5 mb/d, 8 while still low by historical standards, is at its highest level This reference price is an average of Brent, Dubai and West since December 2002. Texas Intermediate (WTI) crudes. East Asia Update 18 Exhibit 14 leaving prices vulnerable to unexpected supply disruptions and fears of disruptions. Average Real Oil Price (1970 Q1 - 2007 Q1. Real is Constant 2004 Dollars) 100 Trade Policy Developments Real oil price - constant 2004 dollars per barrel Doha Round ­ Another Try 80 3 year average of real Following a six month suspension, WTO Members oil price agreed to formally resume negotiations on the Doha Round lerr of multilateral trade negotiations in February 2007. The key 60 Barep to reaching a deal remains greater cuts by the US on trade- distorting agricultural support, greater agricultural market $ access by the EU and further market opening in 40 US manufactures and services by developing countries such as Brazil and India. EU and US trade negotiators have been meeting intensively, and there have also been a number of 20 high level meetings with other influential WTO members such as India and Brazil. Many of the proposals reportedly under discussion, when combined with progress already 0 made (such as offers to eliminate agricultural export Q1-1970 Q4-1971 Q3-1973 Q2-1975 Q1-1977 Q4-1978 Q3-1980 Q2-1982 Q1-1984 Q4-1985 Q3-1987 Q2-1989 Q1-1991 Q4-1992 Q3-1994 Q2-1996 Q1-1998 Q4-1999 Q3-2001 Q2-2003 Q1-2005 Q4-2006 subsidies by 2013 and to provide duty- and quota-free market access for at least 97 percent of exports from least developed countries), are sufficiently substantive to make a deal worthwhile. Significant gains for developing countries Exhibit 15 would also flow from services liberalization and trade World Oil Demand Growth facilitation, and from aid for trade accompanying the Doha (Million Barrels per Day) Round. According to a study by the WTO Secretariat, a 3.5 successful Doha round would compare favorably with the Uruguay Round. Studies of the impact of the Round have 3 Others generally suggested that East Asian economies would be N.America among the more significant beneficiaries from a new 2.5 Other Asia agreement. China The alternative to concluding a Doha deal at this stage is likely to be - at best - several years of drift, with an 2 accompanying cost in terms of a potential weakening of the rules-based multilateral system, a possible surge in 1.5 protectionist sentiment in developed and developing countries, increased stress on the WTO's dispute settlement 1 system and increased scope for trade diversion from proliferation of preferential trade agreements (PTAs). 0.5 According to WTO Director-General Pascal Lamy, it would "not be a major political shock that would precipitate any particular market crisis ... but rather a slowly developing 0 disease that would progressively sap the strength of the 2000 2001 2002 2003 2004 2005 2006 2007 multilateral trading system built up over the last 50 years, -0.5 Source: IEA Oil Market Report. Various issues. damaging its economic lungs, its political heart and its systemic bone structure." As one of the principal Looking forward, oil prices are currently projected beneficiaries of the multilateral trading system over the last to ease from $64 in 2006 to $56 in 2007 and $54 in 2008, 50 years, and as one of regions most deeply integrated into contributing to modest terms of trade based income gains in world trade ­ the region now generates over 20 percent of East Asia, a net oil importing region overall. On the supply world trade, with exports averaging over 50 percent of GDP side, the relatively still high level of oil prices should - East Asia would also be among the significant losers from continue to contribute to new investments in capacity and a weakening of the rules-based system. further gains in non-OPEC production, which is projected by the IEA to increase by 1 mb/d in 2007. On the other Vietnam Joins the WTO hand, continued world economic growth at relatively robust Vietnam's National Assembly ratified its accession rates over 3 percent is expected to induce stronger demand to the WTO in November, 2006 and the country was gains than in 2005 or 2006. Thus the margin of spare admitted in January 2007. Apart from reduction of border production capacity is expected to widen only gradually, trade barriers, the accession agreement intersects with many East Asia Update 19 aspects of Vietnam's development agenda, including legal adapted for post WTO conditions. The most vulnerable development, private sector development, the regulation of sectors are those where SOEs have been dominant players. utilities, public financial management and public A social safety net for redundant SOE workers has been in administration reform. Unlike other developing countries operation for more than three years and has assisted more that have become WTO members in recent years, Vietnam than 120,000 people who lost their jobs in the process of is to comply with the bulk of its commitments upon SOE transformation. Another option is to focus assistance accession on provinces, if they suffer disproportionately from adverse The average tariff will decline from a current level shocks, for example due to a concentration of certain crops. of about 17.4 percent to an average final bound of about Vietnam already has in place an effective mechanism to 13.4 percent, with most cuts occurring within five years. transfer budget resources from richer provinces to poorer (Exhibit 16). Going forward, Vietnam will have to rely on ones. WTO-consistent instruments as regards subsidies and industrial incentives. Compliance with the Agreement on Regional Arrangements and Rules of Origin Subsidies and Countervailing Measures and the Agreement Interest in regional trade agreements (RTAs) has on Trade-related Investment Measures mean that Vietnam continued to grow over the past year in developing and will no longer be able to offer investment incentives that are developed countries alike. While East Asian economies contingent upon exporting or localization ratios. With some remain committed to a successful Doha deal, many of them exceptions special treatment for state owned enterprises will also consider RTAs to be a useful complement, and a means be phased out. All foreign firms and individuals will be of maintaining trade-liberalizing momentum. permitted to import and export, except some items that remain subject to state trading. Vietnam has passed a WTO- At their latest annual summit in Vietnam in compatible law on Intellectual Property, and focus will now November 2006, the leaders of the 21 members of the Asia shift to its implementing guidelines. Vietnam has further Pacific Economic Cooperation (APEC) forum agreed to made commitments on a range of services, including in "seriously consider" negotiating a Free Trade Area of the distribution, telecommunication, and financial services. Asia Pacific (FTAAP) and instructed officials to "undertake Further, liberalization commitments have been made in further studies on ways and means to promote" the initiative several other services with varying degrees of foreign so that they could address it at their next summit in participation. Australia in September 2007. Since becoming a WTO member in 2001, China has also launched a flurry of Exhibit 16 regional trade negotiations with more than 30 economies Vietnam: Average tariff cut under WTO commitment around the world, counting both those completed or under negotiation. The EU is also seeking new bilateral free-trade agreements negotiations with countries such as India, South Korea and the ten ASEAN states. While some have expressed concern that such initiatives could be detrimental to the Doha negotiations, the European Commission has stressed that these new generation of bilateral trade agreements "will ultimately drive forward the multilateral trade agenda", as they are designed to complement the WTO system by tackling areas such as investment, intellectual property and public procurement, not currently covered by WTO rules. Properly designed RTAs can benefit their members, especially if combined with a nondiscriminatory reduction in external barriers. But if designed badly, the cost of such agreements in terms of trade diversion, high information costs and demands on limited administrative capacity may well exceed the benefits. For example, as many as half of all RTAs may divert more trade than they create. 9 It is notable that, despite the rise of regional agreements, the majority of trade in East Asia continues to take place on a Most Favored Nation (MFN) basis. One The most direct consequence of accession will be reason for this may be the costliness of rules of origin. Such greater competition of domestic production with imports, rules are a necessary feature of any form of RTA since they resulting, in some decline in internationally less competitive are required to ensure trade preferences are available only to sectors, offset by growth in more competitive ones. The government already has a number of effective instruments 9 to assist workers in adversely affected sectors, which can be Global Economic Prospects "Trade, Regionalism, and Development", World Bank, 2006 East Asia Update 20 the signatories to the agreement. The sheer number of exceptionally strong domestic investment. Elsewhere, RTAs has resulted in a complex web of multiple preferential especially among the economies affected by the 1997-98 tariff rates being applied to various trading partners, financial crisis, the current account swung into large frequently with varying timelines for reducing tariffs. surpluses as investment fell steeply after the crisis. In some Complex and inconsistent rules of origin--which often of these economies (for example Indonesia, Korea and govern eligibility criteria of RTAs--have the potential to Thailand), surpluses have generally trended lower since the restrict effective market access and can prevent many of the immediate aftermath of the crisis, partly as savings rates RTA benefits from being realized. have trended lower and as investment rates have gradually (if somewhat erratically) picked up. In other economies (Hong Kong, Malaysia, Taiwan (China) and Singapore), Domestic trends and policy challenges surpluses remain substantial and without much of a trend, largely because of persistent weakness in investment. Balance of payments and financial markets Exhibit 17 East Asia - Foreign Reserves Hefty BOP Inflows and Reserve Accumulation (US$ Bill. 1/1997 - 12/2006) Emerging East Asian economies recorded an 2,000 China Indonesia Malaysia aggregate increase in foreign exchange reserves (an overall 1,800 Philippines Korea Taiwan (China) balance of payments surplus) of $357 billion in 2006, up Singapore Thailand Hong Kong from $241 billion in 2005. Foreign reserves for the region 1,600 % Increase in reserves: exceeded $2.05 trillion by the end of 2006, of which $1.06 1,400 2000: 7.6% trillion was held by China. (Exhibit 17). Reserve levels 2001: 10.4% increased in all the main economies of the region, and did 1,200 2002: 21.1% so, moreover, at a more rapid pace than in 2005. As Table 5 2003: 26.4% 1,000 indicates the increase in reserves or overall balance of 2004: 30.0% 2005 16.6% payments surplus amounted to 7 percent of regional GDP, 800 2006: 21.2% much of that concentrated in China, the region's largest 600 economy, where overall net balance of payments inflows were over 9 percent of GDP. Although overall inflows were 400 not so large in most other economies, the median for these 9 200 largest economies still amounted to a hefty 4.7 percent of 0 GDP, ranging from a little over 2 percent in Indonesia to 97 97 98 99 99 00 01 02 03 04 04 05 06 06 near 16 percent in Singapore. Overall inflows to the region 19 899 19 20 200 20 20 500 20 have been running at over 5 percent of GDP since 2002. As an-J g- r-1a 19-tc g- r-2a 20-tc 20-ya Au M O 19-ya M 19-ceD 20-luJ eb-F 2001-peS r-2pA 20-voN un-J an-J Au M O M 20-ceD the discussion of longer run trends in the later section on "10 Years after the Financial Crisis" suggests, sustained Net capital inflows (inclusive of errors and overall inflows of this magnitude are unprecedented in the omissions) made little contribution to the region's overall economic history of East Asia, posing new challenges for balance of payments in either 2005 or 2006, although they macroeconomic management. were significant in individual economies, for example Korea and Thailand. (Table 5). This does not mean such flows As in 2005, Emerging East Asia's reserve were economically unimportant. On the contrary, both accumulation was almost entirely driven by its current capital inflows to and outflows from East Asia remain account surplus, which reached another record in nominal buoyant, reflecting the growing integration of capital dollar terms in 2006, an estimated $362 billion, up from markets within the region, as well as growing integration of $255 billion in 2005. The regional current account reached the region into global financial markets. It is just that, while 7.1 percent of GDP in 2006, also a record. Almost two both growing, they are balancing each other out. thirds of the regional imbalance occurred in China, where the current account surplus rose to an estimated $230 billion Among the major classes of capital flows, or 8.6 percent of GDP, both records by a significant margin. Emerging East Asia continues to receive strong net inflows All the other main economies in the region also ran current of foreign direct investment, an estimated $95 billion in account surpluses in 2006, which in the majority of cases 2006, about the same as $98 billion in 2005. The equivalent were also higher than in 2005. figures for China were an estimated $67 billion and $68 billion respectively. Exhibit 18 shows that gross FDI There are two distinct stories here. In China the inflows to the main South East Asian economies, Korea and exceptionally large surpluses are relatively recent, emerging Taiwan (China) revived strongly from 2004 to reach around only in 2005-06 (having run at less than 2 percent of GDP in $30 billion on an annualized basis by the latter part of 2005, the 1990s and 2-4 percent in 2000-04). Here it is a case of before leveling out in 2006. FDI gross inflows to Indonesia an extraordinary recent increase in domestic savings and the Philippines have seen particularly fast growth, more (especially in the business enterprise sector) outpacing than tripling between 2004 and 2006, while gross inflows to East Asia Update 21 Table 5 - East Asia - Balance of Payments 2003-06 - Percent of GDP * Overall Balance** Current Account Capital Account*** 2003 2004 2005 2006 2003 2004 2005 2006 2003 2004 2005 2006 East Asia 7.0 8.8 5.5 7.0 4.6 4.5 5.8 7.1 2.4 4.2 -0.3 -0.1 China 7.1 10.7 9.1 9.2 2.8 3.5 7.1 8.6 4.3 7.1 2.0 0.6 S.E. Asia 3.2 4.7 1.0 4.6 4.9 3.4 2.1 5.3 -1.7 1.2 -1.1 -0.7 Indonesia 1.8 0.0 -0.6 2.2 3.4 0.6 0.1 2.6 -1.6 -0.6 -0.7 -0.5 Malaysia 10.0 18.4 2.9 8.0 12.8 12.6 15.3 17.3 -2.8 5.9 -12.4 -9.3 Philippines 0.4 -0.6 2.9 3.5 1.6 2.4 2.0 4.7 -1.2 -3.0 0.9 -1.2 Thailand 2.1 4.7 1.2 7.1 3.3 1.7 -4.5 1.6 -1.2 3.0 5.6 5.5 NIEs 8.5 7.9 1.9 4.5 6.9 6.6 5.6 5.6 1.6 1.3 -3.7 -1.1 Hong Kong 4.1 3.1 0.4 4.7 10.4 9.5 11.4 10.7 -6.3 -6.4 -11.0 -6.0 Korea 5.6 6.4 1.4 3.2 1.8 4.1 1.9 0.6 3.8 2.3 -0.5 2.6 Singapore 14.9 15.3 3.1 15.8 24.2 20.1 24.5 27.5 -9.3 -4.7 -21.4 -11.7 Taiwan, China 15.0 10.9 3.3 3.6 9.7 5.8 4.6 7.0 5.2 5.1 -1.3 -3.4 * 2006 includes estimates for some economies.** Equals change in foreign reserves..***Includes errors and omissions. Thailand almost doubled. These trends should alleviate inflows of such capital of about $100 billion. Again, net previous concerns that the large volumes of FDI flowing to flows of these kinds of capital are the result of the balance China in recent years would preclude significant flows to between gross inflows and outflows, both of which are other parts of East Asia. At the same time gross FDI rising. Exhibit 19 shows that gross portfolio inflows to the outflows from the region have also been growing quickly in four main South East Asian economies, Korea and Taiwan the last 2-3 years, as East Asian corporations implement (China) rose substantially to reach near $80 billion in 2003, their own cross-border investment and production strategies. in line with the global upturn in flows to emerging markets Such outflows are now running at $6-8 billion a year in by investors which began at that time. Since then gross Korea and Taiwan (China), and have also picked up to $3-5 portfolio inflows to these six economies have run at a billion in Indonesia and Malaysia. somewhat lower level averaging around $50 billion per year while gross portfolio outflows have accelerated to a $60-70 Exhibit 18 billion annual rate. FDI Flows - Six Economies Exhibit 19 50 (4 quarter moving totals, US$ Bill.) Net Portfolio Flows - Six Economies * Inflows (4 quarter moving totals, US$ Bill.) 100 Outflows Net 30 Inflow Outflow 50 10 0 -10-2001 2001 2002 2002 2003 2003 2004 2004 2005 2005 2006 2006 - - - - - - - - - - - Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1-2001Q3-2001Q1-2002Q3-2002Q1-2003Q3-2003Q1-2004Q3-2004Q1-2005Q3-2005Q1-2006Q3-2006 -50 Indonesia, Korea, Malaysia, Philippines, Taiwan (China), Thailand * Indonesia, Korea, Malaysia, Philippines, -30 Taiwan (China), Thailand -100 Net FDI inflows to East Asian in the $90-100 billion range in 2005 and 2006 have been largely offset by net outflows of portfolio and other capital (chiefly bank Among the factors that are likely to have lending), a sharp swing from 2004, when there were net contributed to this turnaround is the reversal of interest rate East Asia Update 22 margins: as a result of monetary policy tightening, interest dependent in recent years. The large build up of reserves in rates in the United States now exceed the average level of the decade since the 1997-98 crisis has also provided an rates in East Asia. (Exhibit 20). Policy changes in the insurance policy against future capital market crises and direction of greater exchange rate flexibility and capital large unexpected outflows of capital, or other external account openness are also likely to have contributed. A shocks. large volume of speculative short term capital flows were attracted to East Asia in 2004 by the prospect of capital Exhibit 21 gains to be made from exchange rate revaluation in Exchange Rates vs. US$ countries with pegged exchange rates, such as China and (Rise=appreciation, Jan 2002=1) Malaysia. However both China and Malaysia undertook 1.6 Indonesia small revaluations of their currencies in mid 2005, followed Korea by a gradual or `crawling' appreciation at variable rates. 1.5 Philippines This has introduced a modicum of uncertainty about the Thailand future course of these exchange rates, tending to dissipate 1.4 Yen earlier speculative pressures. Euro Taiwan .Exhibit 20 1.3 China Overnight Interest Rates (%) 1.2 6.0 East Asia overnight interbank rates* 1.1 US Federal Funds Rate 5.0 1.0 4.0 0.9 02 02 02 03 03 03 04 04 04 005 005 05 006 006 6 3.0 Jan-20May-20Sep-20Jan-20May-20Sep-20Jan-20May-20Sep-20Jan-2May-2 Sep-20Jan-2May-2Sep-200Jan-2007 2.0 On the other hand efforts to temper the extent of currency appreciation can also create unwanted side-effects, including a diminution in the central bank's ability to pursue 1.0 an independent monetary policy. In the context of large * Median of China, Hong Kong, Indonesia, Malaysia, Korea, Philippines, Singapore, Thailand and Taiwan (China). balance of payments inflows, such efforts can contribute to 0.0 an expansion in the domestic monetary base and a broader 2 02 03 expansion of credit and aggregate demand. If the economy 03 4 04 5 05 6 06 Jan-2Ma 002 y-200p-20Jan-2May-2Sep-20Jan-2May-200p-20Jan-2May-200p-20Jan-2May-200p-20Jan-2007 0 003 004 005 006 is near full capacity this can contribute to economic Se Se Se Se overheating, higher inflation and unwarranted euphoria or bubbles in asset markets. Governments have then attempted to address these side-effects with one or other from a tool Managing Balance of Payments Inflows box of other offsetting policies, for example bond issues to Large balance of payments inflows are having a mop up excessive liquidity (`sterilization'), increases in variety of macroeconomic effects, and are posing policy bank reserve requirements, controls on balance of payments challenges for governments that are seeking the most capital inflows and relaxation of controls on capital effective means of adjustment. There is no single right outflows. answer here, but instead a variety of mechanisms through More exchange rate flexibility which adjustment can occur, with different costs and benefits that make them more or less appropriate according While many governments in Emerging East Asia to the different characteristics of the economies in question. remain cautious about the excessive exchange rate In the first instance large balance of payments flexibility, the extraordinary size of balance of payments inflows have increased demand for local currencies and inflows over the last five years is clearly bringing them to created pressure for exchange rate appreciation. To varying place more weight on the exchange rate as a means of degrees most economies have attempted to offset this adjustment. Thus China and Malaysia adopted a more demand by intervening to buy foreign currency, resulting in flexible exchange rate framework in mid 2005, which has the rapid build up of foreign reserves in recent years. On been followed by appreciations of around 7-8 percent the one hand, governments have been concerned about the against the US dollar. As Exhibit 21 indicates, this is more adverse impact of a rising currency on exports, and hence on than in Taiwan (China) or Indonesia over the same period. employment and growth. These concerns have particular As Exhibit 22 below indicates, appreciation against the US bite as many economies have become more export dollar has not led to a significant appreciation in the real East Asia Update 23 trade-weighted exchange rate of the Chinese yuan. Studies indicate that while there is some evidence However it has stabilized the real exchange rate of the yuan, that sterilization policies in developing countries can be even as the dollar has continued to gradually depreciate in effective in the short term, their effectiveness tends to erode trade weighted terms, instead of depreciating alongside the over time and they can also have unwanted side effects. 10 dollar, as occurred in 2002-2004. The pace of appreciation Sterilization tends to keep domestic rates (and spreads with since mid/late 2005 has also accelerated in the Philippines international rates) higher than otherwise, attracting yet and Thailand. Thailand's bilateral rate with the dollar more capital inflows.11 It can also entail quasi-fiscal costs surged over 20 percent between mid 2005 and March 2007. for the central bank, because assets held as foreign reserves Korea has perhaps placed the greatest reliance on the can earn less than the interest on liabilities issued to sterilize exchange rate for adjustment, with the won appreciating inflows. The central bank balance sheet is also subject to some 27 percent against the dollar between the end of 2001 increased exchange rate risk on its foreign reserve holdings. and mid 2005, with further gains of 8 percent since then. (Central bank income did move into loss in 2004 and 2005 in Korea, and in 2005 in Thailand). Sterilization through Exhibit 22 higher bank reserve requirements can also have Real Effective Exchange Rate Indexes (Jan unpredictable consequences, acting as a tax on the banking system, which banks pass on through higher lending rates 2002=1) 1.40 and lower deposit rates. This can, among other things, China Korea contribute to disintermediation from the banking system and Thailand Japan a shift of deposits into the non-bank financial sector, which 1.30 USA is harder to supervise and regulate. 1.20 Table 6. Reserves and Sterilization Foreign Base Money Sterilization 1.10 Reserves Growth (%) Indicator Growth (%) (% of GDP) 2004 2006 2004 2006 2004 2006 1.00 -05* -05* -05* China 42.9 35.2 10.4 20.8 6.0 4.2 0.90 Indonesia 5.1 12.1 16.3 28.5 -0.5 -1.0 Korea 9.0 8.9 3.3 19.9 2.1 1.4 Malaysia 26.9 9.1 7.5 10.6 9.8 3.4 0.80 1 5 9 1 5 9 1 5 9 1 5 9 1 5 9 Philippines 2.5 14.8 9.5 61.0 -0.4 -2.3 Thailand 20.0 6.7 8.7 2.2 4.5 1.9 2002M 2002M 2002M 2003M 2003M 2003M 2004M 2004M 2004M 2005M 2005M 2005M 2006M 2006M 2006M (1) Sterilization measured as change in foreign reserves less change in base money (as % of GDP). * Annual average in 2004- 05. Mopping up liquidity Central banks have also increased efforts to mop up or sterilize the potential expansionary impact on rising Some economies have also modified capital reserves on domestic money and credit, mainly through account regulations--either imposing controls on some sales of central bank securities (open market operations) or inflows or further liberalizing outflows. On December 19, increases in commercial bank reserve requirements. In 2006, Thailand announced an Unremunerated Reserve effect central banks have tried to get "the best of both Requirement (URR) scheme which required that 30 percent worlds", to manage exchange rates while also retaining of inflows into the stock market, bond market, mutual funds, control of monetary policy. Such sterilized intervention was property funds and warrants, and foreign loans be held on also the most widely used policy response during the deposit at the central bank interest-free for a year. Inflows emerging markets capital inflows of the early/mid 1990s. held for less than one year would, in effect, be taxed at 10 percent. However the stock market was then quickly Table 6 provides a broad indicator of sterilization, excluded from the scheme, which has also been relaxed in measured as the change in foreign reserves less the change various other ways since then. in base money (as a percentage of GDP). By this indicator several economies have relied on sterilization quite heavily Although it is difficult to draw firm conclusions in recent years, including China, Malaysia, Thailand and, to from empirical work on the efficacy of capital controls, a lesser extent, Korea. In China the concern that excessive some lessons can be drawn. If they are to be effective, such balance-of-payments induced growth in domestic liquidity could spur overheating has been particularly acute, given the 10Carmen M. Reinhart and Vincent R. Rienhart. (1998). Some prevailing high levels of economic growth and the Lessons for Policy Makers Dealing with the Mixed Blessing of investment boom in the economy. Capital Inflows. 11Peter Montiel and Carmen M. Reinhart. (1999). "The Dynamics of Capital Movements to Emerging Economies During the 1990s." East Asia Update 24 controls need to be comprehensive and forcefully in Japan may have been a factor by providing a reminder implemented, and may need to be often strengthened and that on average monetary policies globally are still being extended, as markets find loopholes and ways around them. tightened and that the period of negative real interest rates The effectiveness of controls also seems to be limited in and easy liquidity of recent years is drawing to an end. Oil sophisticated financial markets since these markets can offer prices also became much volatile during March than during instruments that reduce the cost of circumvention relative to the previous six months. Overall, then, perceptions of risk the incentives.12 are on the rise and this suggests that financial markets may Some economies are also looking to ease problems remain in a more volatile mode for some time to come. arising from balance of payments inflows by promoting or Such volatility may have a beneficial effect in so far as relaxing regulations on capital outflows. In January 2007, realistic risk perceptions reduce speculative fervor and Korea exempted investors for three years from capital gains induce a more prudent, long term mindset among investors. tax on earnings from equity funds abroad. Pension funds Exhibit 23 will be allowed to invest in overseas securities, and local investors can now buy unlisted or unregistered stocks. The Stock Market Indices (Jan 2003 = 1) ceiling on property investments abroad was also raised. 3.2 Given adequate supervisory, regulatory and market infrastructure institutions, an approach of liberalizing capital Philippines Singapore outflows would have the additional structural benefit of 2.7 Hong Kong China fostering greater regional and international financial integration. 2.2 Renewed stock market volatility Sharp 9 percent falls on China's Shanghai A and 1.7 Shenzhen A stock markets on February 27 set off corrections around the world, in both developed and emerging stock markets. The sell off in China was not 1.2 triggered by any specific economic or other news, beyond rumors about possible government actions to stem the boom in stock prices, which had surged by almost 150 percent 0.7 between the end of 2005 and February 2007. Indeed, after a week, the Chinese market began climbing again, to end March close to 5 percent higher than just before the sell off Jan-2001 May-2001 Jan-2002 May-2002 Jan-2003 May-2003 Jan-2004 May-2004 Jan-2005 May-2005 Jan-2006 Ma y-2006 Jan-2007 (Exhibit 23). Sep-2001 Sep-2002 Sep-2003 Sep-2004 Sep-2005 Sep-2006 The February 27 event in China provoked sell offs of varying size in other East Asian markets, as around the Exhibit 24 world. Within the next several days markets were down by 7-13 percent in Malaysia, Philippines and Taiwan (China) Stock Market Indices (Jan 2003 = 1) and by 1-4 percent in Indonesia, Korea and Thailand. As in 5.6 China, markets made up some ground in the rest of March, although had not recovered pre-ell off levels by month end. As in China, most other East Asian markets had also seen 4.6 Indonesia Malaysia substantial increases over the previous year, rising 30-50 Thailand Korea percent since the end of 2005 in Indonesia, Malaysia, Philippines, Hong Kong and Singapore (Exhibits 23 and 3.6 24). And stock markets had also risen quite well in most parts of the world since the middle of 2006. Thus there was likely a large element of simple profit taking in the world 2.6 wide decline that began in China. At the broader global level, however, other background factors are also likely to have contributed to the 1.6 recent volatility, and to continue playing a role going forward. In the US, for example, a reference to the risk of a US recession by former Fed chief Alan Greenspan added to 0.6 investor concerns. The beginning of interest rate tightening 12 Jan-2001 May-2001 Sep-2001 Jan-2002 May-2002 Sep-2002 Jan-2003 May-2003 Sep-2003 Jan-2004 May-2004 Sep-2004 Jan-2005 May-2005 Sep-2005 Jan-2006 May-2006 Sep-2006 Jan-2007 IMF. "Capital Controls: Country Experiences with their Use and Liberalization" (IMF Occasional Paper 190 (2000)). East Asia Update 25 Financial sector trends and issues 2005. The capital adequacy ratio rose of the credit card companies roseto 24.5 percent at end-September. Commercial banks in the larger economies of the region generally closed 2006 with further improvements in Exhibit 25 asset quality, including lower non performing loan ratios Commercial Bank Non-performing Loans and rising or stable capital adequacy ratios (Exhibit 25). (% of Total Loans) Economies continue to implement significant financial 20 sector reforms, as the following country notes indicate. Indonesia Korea In China the third national financial work Malaysia conference held in January set out directions for major 15 Philippines financial sector reform. Key reforms discussed were in rural finance, foreign exchange management, and policy banks. Thailand On rural finance, it was decided to reduce the access China thresholds for financial institutions to attract a more diverse 10 set of providers and to continue the reforms of the Agricultural Bank of China. Looking ahead, rural finance would also benefit from interest rate liberalization and further reforms in existing providers. On foreign exchange 5 reserve management, the meeting decided to explore ways to more actively manage the country's foreign exchange reserves. Banking indicators for Indonesia generally 0 improved in 2006. The capital adequacy ratio rose to over 2000 2001 2002 2003 2004 2005 2006 20 percent with net interest margins remaining close to 6 percent. However, the return on equity (ROE) fell to a little over 17 percent from 18 percent in 2005, reflecting charges In the Philippines the banking sector has continued to cover an increase in non-performing loans in the earlier to reduce balance sheet vulnerabilities. The NPL ratio for part of the year (due in part to a change in rules for loan Universal and Commercial banks fell from 8.2 percent at classification). However the NPL ratio fell sharply in late end 2006 to 6 percent at end 2006. Improvements in asset 2006 due to a pick up in intermediation and total loans quality are due in part to enactment of the Special Purpose outstanding, as well as a regulatory change by which state- Vehicle (SPV) Act, which was an important catalyst in owned banks could write-down NPLs according to the same reducing banking sector vulnerabilities via the take out of procedures as private banks. The government's financial non-performing loans and assets from commercial bank sector reform package issued in early July 2006 however balance sheets. About P97 billion worth of non performing strengthened regulatory powers to resolve problem debts at assets (NPAs) were sold through transactions under the SPV state banks more speedily. More broadly, the July reform Act by end 2005, reducing by about 19 percent the stock of package covers key areas such as financial stability, the NPAs in the banking system. In early 2006, the SPV Act banking sector, non bank financial institutions (NBFI), was extended by a period of another two years. This capital market development, export financing and enabled (mainly) universal and commercial banks to reduce privatization of SOEs. Implementation of the package is their stock of NPAs by another 18 percent in 2006. continuing. Bank Indonesia announced eight initiatives in January 2007 with a focus on improving banking intermediation, not only for large firms but also for SMEs and micro enterprises. East Asia: Ten years after the crisis In Korea the average non-performing loan ratio of A decade after the financial crisis that devastated the commercial banks fell to a record low of 0.8 percent at East Asia in 1997-98, the region is far wealthier, has fewer the end of 2006. In the non-bank sector, the six credit card poor people and a larger global role than ever before. Led companies have continued to improve financial health, with by continued strong growth in China, Emerging East Asia asset quality and capital ratios improving significantly. The now has an aggregate output of over $5 trillion, double the companies have recorded positive net income for six dollar value just before the crisis. Real per capita incomes consecutive quarters since the second quarter of 2005. A in the previously crisis affected economies13 have continuous drop in bad loans drove up their net income in significantly exceeded pre-crisis levels. For Emerging East the first three quarter of 2006 by 12.5 percent over the Asia as a whole they are some 75 percent higher. The previous three quarters. Average credit card delinquency poverty rate at the $2 a day level has fallen from 50 percent ratios have continued to fall, reaching 7.1 percent at end- September 2006, down from 10.1 percent at the end of 13Indonesia, Korea, Malaysia, Philippines and Thailand. East Asia Update 26 of the population to 29 percent today. When Vietnam Growth ­ facing a middle income challenge? reaches middle income status (defined as annual pr capita income of about $900), which could happen as soon as Emerging East Asia has come a long way since the 2010, more than 9 out of ten East Asians will live in a financial crises of 1997-98. By 2006 real per capita income middle income economy. for the region as a whole had increased by over 75 percent compared to 1996, the last pre-crisis year. As Exhibit 26 But even as the region celebrates recovery, new indicates, the region's real per capita income (measured in challenges loom, which could slow or even derail growth if purchasing power parity terms) continued to increase not properly handled ­ economies could find themselves in relative to incomes in high income OECD economies, rising a `middle income trap' and struggle to climb onwards to from a little under 14 percent in 1996 to over 19 percent in higher income levels. A recent World Bank report notes the 2005. Further, this increase in relative per-capita income strategies that economies need to make the transition from levels was the same as in the previous decade, 1986-96, low income to middle income are different from those showing no diminution in the pace of `catch-up' to high needed to transition from middle income to high income income country levels. status.14 Among other things, countries that are successfully making a transition towards high income status Exhibit 26 begin to specialize in selected areas where they are able to Per capita GDP (PPP) as % of OECD achieve economies of scale and technological leadership. Accompanying this change are a whole host of complex 40 (1975-2006) transitions, for example, substantial increases in the proportion of people with tertiary education and specialized skills, the transition from economies that largely absorb 1997 - 2001 knowledge from abroad to ones that are also a source of 30 innovation, the development of deep financial systems that provide a diverse range of services, the movement of much Emerging East Asia of the population into livable cities, among many others. At the socio-political level, successfully transitioning countries 20 Europe & Central Asia are able to maintain a certain level of social cohesion, Latin America avoiding the emergence of deep inequities of the kind that South Asia fuel social conflict and political instability and stall growth. Clean government and rule of law become the norm, while 10 corruption becomes the exception. Economic history has many examples of economies that succeeded in getting to middle income status 0 ­ often quite quickly ­ but have then stalled, unable to manage all of the complex economic, social cohesion and 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 political challenges needed to make the high income transition. Many economies in Latin America and the Middle East have remained at middle income level for It of course true that a large part of the region's decades, for example. Ten years after confronting the strong performance over the last decade is due to China, reforms needed to rebound from the financial crisis, East where real per capita income growth averaged 8.1 percent. Asia is confronting reform challenges at least as complex. Growth in several low income economies like Vietnam, The fact that other economies in the region like Japan, Hong Cambodia and Lao PDR has also accelerated to rates above Kong (China), Korea, Singapore and Taiwan (China) have pre-crisis performance. Nevertheless the crisis affected already escaped the `middle income trap' shows that it is economies have also displayed a robust performance in possible. But the task will not be simple. many respects. For one thing, all returned to positive growth quite quickly after the severe recessions of late 1997 This section does not attempt to survey all of the and 1998. Korea, Malaysia and Philippines promptly challenges facing East Asia in transitioning from middle regained or exceeded their pre-crisis level of per-capita income towards high income status. Instead it looks at the income in 1999, while this took longer, till 2003, in region's experience and some lessons learnt over the decade Indonesia and Thailand. Taking 2002-06 as the period of since the crisis in three key areas: maintaining high growth sustained post-crisis expansion15, economies such as in a sustainable way, addressing the problem of growing inequality and managing economic and financial vulnerability, to reduce the risk of future crises. 15 It is not straightforward to assess the underlying growth performance of the crisis affected countries in the period after the crisis, because, for one thing, these economies were also soon hit 14 Indermit Gill and Homi Kharas. "An East Asian Renaissance: by a second shock, the severe recession in the global high tech Ideas for Economic Growth", The World Bank, 2007 forthcoming. industry in 2001, which led sharp downturns in exports and output growth in much of East Asia. Thus for the purpose of this East Asia Update 27 Indonesia, Malaysia and Philippines have achieved real per their recovery from the crisis and boost growth to higher capita income growth of 3-3.5 percent, with per-capita rates. In the rest of this section we first look briefly at the growth in Korea and Thailand averaging 4-4.5 percent. challenges facing China. We next consider the dramatic Per-capita growth rates in the 3-4.5 percent range changes in international trade patterns that have affected the are certainly healthy enough compared to the per capita region over the last decade, in particular the rapid increase growth rate of the world as a whole over (say) the last in economic integration between China and the rest of the quarter century, which was 1.8 percent. But there are also region. Lastly we look at growth challenges in middle less flattering comparisons. First, recent growth in most of income East Asia outside of China, focusing in particular on the post-crisis economies is running at around 2 percentage investment. points less than in the two decades before the crisis. (The Economic Rebalancing in China only exception is the Philippines, whose recent per capita growth of 2.9 percent is much higher than its negligible 0.5 China's rapid growth over the last 20 years has percent performance in 1976-96.) Second, other emerging reduced poverty and improved living standards on a scale regions are growing substantially faster in recent years, so and at a pace unequalled in history. Inevitably growth at that the bar for comparison is now higher than in the past. such a rate has also led to an accumulation of interlinked For example the Europe and Central Asia region and the stresses and imbalances that could affect China's onward South Asia region experienced aggregate per-capita growth development if left unchecked. Environmental stresses are of 5-6 percent in 2002-06. Third, at their current growth the most apparent. China today contains 20 of the world's rates it will take longer for the East Asian post-crisis 30 most polluted cities, due largely to high use of coal and economies to close the gap with the developed world. cars. Serious erosion, acid rain and polluted waterways also Exhibit 27 shows how the previous rise in East Asian per- affect the lives of millions.16 On the supply side, the growth capita incomes relative to the developed economies has rate and share of industry is unusually high relative to tended to flatten out among post-crisis economies in recent services, which also contributes to pollution and high years compared to previous decades. energy and natural resources consumption. On the demand side, investment (and saving) is high and rising relative to Exhibit 27 consumption, raising concerns about inefficient use of capital and a potential build up of overcapacity in specific Per Capita GDP (PPP) as % of OECD sectors, which could also contribute to bad debts in the 1975-2006 banking system. A rising rural-urban income gap, in part Per Capita GDP Growth 1997 - driven by the capital intensive, manufacturing-led pattern of 40 1976-96 2002-06 2001 growth, has contributed to a sharp rise in overall income OECD 2.3 1.8 inequality. China 8.0 8.9 Indonesia 5.2 3.5 The broad long-term challenge of improving the Malaysia 5.0 3.0 30 quality of economic growth, rebalancing the pattern of Philippines 0.4 2.9 growth and striving for a harmonious society was put firmly Thailand 6.3 4.6 on the government's agenda with the approval of the 11th five year plan in March last year and reconfirmed during the 20 sixth plenum of the Communist Party of China (CPC) central committee in October 2006. It means a relative shift in production from industry towards services, more reliance 10 on domestic demand, more equally shared growth and more environmentally sustainable growth. Besides being desirable China Indonesia in their own right, measures that support rebalancing are Malaysia Philippines Thailand 0 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 16 A forthcoming multi-year multi-sector study estimates the physical and economic cost of air and water pollution in China as Evidently there is not one but at least two sets of reflected in the pollution-related disease burden, pollution- "middle income country challenges" facing economies in exacerbated water scarcity, wastewater irrigation, fisheries loss, the region today. In China this means new strategies to crop loss, and material damage. Building upon willingness-to-pay tackle the severe environmental and other stresses and surveys for reducing health risks from pollution among imbalances that have arisen during the last 20 years of very households in Shanghai and Chongqing municipalities, the study rapid growth. finds that the health costs of air and water pollution amount to Elsewhere, among the formerly crisis about 4.3 percent of GDP in China. By adding the non-health affected economies, the challenge is different, to build on impacts of pollution, which are estimated to be about 1.5 percent of GDP, the study indicates that the total cost of air and water pollution in China is about 5.8 percent of GDP. ("Call for a Green discussion we take the 2002-2006 as the representing the period of China"). sustained post-crisis expansion. East Asia Update 28 also likely to address the surging trade surplus, China's Exhibit 28 main short term macro challenge. A shift towards services relative to industry and, on East Asia Exports - as % of GDP the demand side, a larger role for consumption relative to investment and exports would address many concerns. It Taiwan (China) would make growth less intensive in energy, raw materials, and resources and less tough on the environment. It would Singapore also make growth less capital intensive, allowing China to grow with lower saving. Moreover, it would mean more Korea labor intensive growth, with more urban employment creation. Urban job creation is the key to reducing excess Thailand labor in agriculture and the related poverty and urban-rural 2005 inequality. Finally, it would ameliorate the pressures for Philippines 1995 overproduction of goods and current account surpluses. The World Bank's November 2006 China Malaysia Quarterly discusses policies that will help economic rebalancing, many of which are already in the pipeline.17 Indonesia Several macroeconomic measures can help stimulate consumption, reduce saving and encourage services growth. China+HK These include shifting public spending from investment to education, health and social security, speeding up financial 0 30 60 90 120 150 180 sector opening and reform to improve the efficiency of the allocation of capital, and establishing a dividend policy for State Owned Enterprises (SOEs) and improving corporate Exhibit 29 governance, to remove an over-investment bias. Several price and tax based measures would help East Asia Exports - as % of World Exports adjust the attractiveness of manufacturing (tradables) production relative to services (non tradables). These Taiwan (China) include allowing the exchange rate to move more closely in response to underlying pressures, which at moment imply Singapore 2005 an appreciation and an increase in the profitability of non 1995 tradables. They also include adjusting the price of inputs Korea into manufacturing--including land, energy, water, utilities, natural resources, and the environment--to better reflect Thailand relative scarcities and social preferences. In the area of energy, China has in recent decades had major success with Philippines using price increases to improve energy efficiency. Looking ahead, the resolution of the October plenum notes that Malaysia "industrial policies, fiscal and taxation policies and pricing policies shall be amended to encourage environmental Indonesia protection." The 11th Five Year Plan (2006-11) also sets a target of reducing energy consumption per unit of GDP by China+HK 20 percent and the total discharge of major pollutants by 10 percent. 0.0 2.0 4.0 6.0 8.0 Dramatic Changes in International Trade Patterns Emerging East Asian economies have continued to become more exposed to international trade over the last Integration with international trade ­ exploiting the decade, with merchandise exports increasing from 34 opportunities offered by global markets - has for decades percent of GDP in 1995 to 42 percent in 2005. As Exhibit been a key element of the `East Asian miracle'. The last 28 shows, trade to GDP ratios have risen in all of the major decade has seen further expansion and striking structural economies of the region. Emerging East Asia's overall changes in the pattern of East Asian integration, associated share of world exports also continued to rise, picking up in particular with the dramatic emergence of China as both a from 15.5 percent in 1995 to 17.9 percent in 2005. Here, major competitor and a source of opportunities for the other though, we see more of the new trends that have emerged in economies of the region. the last 10 years. All of the increase in East Asia's world trade share came from China (taken together with Hong 17World Bank China Quarterly. November 2006. Kong because of the intense trade links between the two East Asia Update 29 economies), which increased from 4.5 to 7.7 percent of country markets. Viewed by the impact on exporters, the world trade. Exhibit 29 shows that world trade shares most significant impacts have been in Korea, Taiwan among the other main economies in the region either fell or (China) and Singapore. 20 increased only slightly over the last decade. This leveling out or decline in world trade shares among other East Asian Exhibit 30 economies represents a significant change from previous Shares of Emerging East Asian Exports to USA - decades when these economies' trade shares also Computers, Peripherals and Semiconductors * experienced steady increases. 80 China There is little doubt that the emergence of China as an international trading power has had a major impact on NIEs the trade opportunities of other economies in the region, ASEAN-4 60 both as a competitor in world markets and as itself a new Source: Ahearne, Fernald et al and dynamic market for these economies. Studies of the (2006). long run general equilibrium impact of the rapid growth of * As percent of overall East China on the rest of East Asia and the world stress the 40 Asian exports to USA. welfare gains that most economies are likely to derive from a growing China. 18 But to exploit the new comparative advantages and secure the welfare gains created by the emergence of China is not an automatic process but will 20 require significant restructuring and adaptation by firms in the other East Asian economies. Ahearne, Fernald et al (2006) study the impact of China on trading patterns in the US market across 47 0 industry sectors between 1989 and 2005. China increased its 1989 1993 1997 2001 2005 market share in 41 of these sectors over this period, while, on the other hand, the market share of the East Asian NIEs fell in most sectors.19 Importantly, the pace of increase in China's market share in the US market increased dramatically in the most recent period 2001-05. Of Table 7. Export Markets particular note, the four middle income economies in South (As % of Own Total Export) East Asia ("ASEAN 4") had also been increasing their China Other 7 EA market shares in many sectors through 2001. But in 2001-05 & Hong Kong Economies the ASEAN 4 economies also lost markets shares. Thus the 1995 2005 1995 2005 post-crisis period 2001-05 appears to be the period when To competitive pressure from China has increased most USA 27.4 26.3 19.8 14.7 sharply. Exhibit 30 below illustrates how these trends Japan 17.1 12.5 13.1 9.9 played out in the largest sector of US-East Asian trade, EU 25 20.5 23.3 14.1 13.4 computers, peripherals and semiconductors. More formally, China & HK 13.3 22.5 Freund (2006) reports on an econometric investigation using bilateral trade data at the 4-digit SITC level from 1985 to Other 7 EA 16.3 16.0 22.5 21.3 2004 to test how China's exports to a particular third Rest of World 18.7 21.9 17.1 18.1 country in a given product category affect East Asian exports, controlling for overall exporter supply growth. The Not coincidentally, the increase in competitive study finds that on average other East Asian export growth pressures in third markets in recent years has also been to third markets in industrial products tends to be lower associated with rapid growth in other East Asian exports to when Chinese exports in these same products are large and China, frequently in the very industry sectors that have felt growing, with this effect being strongest in the most recent the most competitive pressure in the US and other markets, period, 2000-2004. The competitive impact has been for example in the computer, other office machinery and strongest in North America, Japan and many developing electronics sectors. However the character of this trade has changed ­ instead of exports of finished goods, exports from 18 See for example World Bank. (2006) "Dancing with Giants. the other East Asian economies to China have been China, India and the Global Economy". (Eds. L. Alan Winters and increasingly driven by exports of parts, components, capital Shahid Yusuf). equipment and other kinds of industrial inputs which are 19 Alan Ahearne, John Fernald, Prakash Loungani and John assembled or manufactured into finished goods in China for Schindler. (2006). "Flying Geese or Sitting Ducks: China's Impact on the Trading Fortunes of other Asian Economies." Board of Governors of the Federal Reserve System. International Finance 20Caroline Freund. (2006). "The Effect of China's Exports on Discussion Paper Number 667. (December). East Asian Trade with the World." Mimeo. World Bank.. East Asia Update 30 export to the outside world. This kind of intra-industry financial development, financial openness, legal trade has been closely associated with flows of FDI and the development, trade openness, terms of trade volatility, GDP establishment of regional production networks. It is also at growth, interest rates and credit flows.21 Up to a point, the the heart of the rapid increase in intra-regional trade in the cyclical "boom and bust" aspects of investment performance region in the decade since the crisis. As Table 7 indicates, in the region can go some distance towards providing a the rise in intra-regional trade has been entirely due to an useful explanation for the weakness of investment. In increase in the share of other East Asian economies' exports particular one can point to the high levels of spare capacity going to China (and Hong Kong), which surged from 13.3 that were built up in the investment boom before the crisis, percent in 1995 to 22.5 percent in 2005, reflecting the rise in the huge negative demand shock released by the financial exports of components and other inputs. (The share of these crisis and the further negative demand shock from the 2001 economies' exports to each other remained relatively flat, as global high tech recession. Ballooning corporate sector did the share of China's exports to these other East Asian debt, bad debt in the financial system and the need for economies). painful corporate and financial sector restructuring also magnified and protracted the economic shock. Investment weakness in other middle and high income Asia Nevertheless, these kinds of cyclical explanations The slower pace of output growth in several East become less plausible as the time elapsed since the crisis Asian economies has been accompanied by much more increases. For example, capacity utilization has been rising pronounced differences in investment spending across in most economies and is now near conventional definitions economies. While investment spending growth in China of full capacity in some. Corporate indebtedness has now has continued running at double digit rates, in many of the fallen to levels similar to those in industrialized economies other middle and high income economies of the region the and should not be a constraint going forward. Over the last recovery of investment after the 1997-98 crisis and the 2001 5-6 years banks in the previously crisis-affected East Asian slowdown has often been weak and erratic. This has lead to countries have also achieved substantial improvements in very different policy concerns around the region. Unlike capital adequacy, asset quality and profitability. Although policy makers in China, who are concerned to ensure that bank lending has remained sluggish in a number of the present investment boom there does not lead to over- economies, this now appears to be mainly a question of heating, policy makers in many of the NIEs and middle sluggishness in corporate demand for loans rather than in income South East Asian economies are concerned about the capacity of banks to supply credit. the causes of continued relative weak investment. Table 8 indicates investment growth has averaged only around 3 Other analysts have emphasized the role of percent or less in the four NIEs, Malaysia and Philippines in uncertainty in checking new investment. They point for the post crisis recovery period 2002-06. example to the high volatility of export earnings in a region that has become increasingly dependent on often highly Table 8. East Asia cyclical electronics and high tech exports.22 One can add Real Fixed Investment Growth the possibility that uncertainty may also have increased 1980 1990 1997 2002 because of the large and rapid changes in export market -89 -96 -01 -06 opportunities and comparative advantage experienced by East Asian firms over the past decade, and especially in the China 8.2 15.2 9.9 12.4 past five years, due in part to the rapid growth and South East Asia intensification of competition from China (as discussed in Indonesia 8.9 11.5 -5.9 6.3 the previous section). As a result many East Asian firms and economies are going through a period of structural Malaysia 7.0 17.7 -6.6 3.3 adjustment, pulling back in a range of sectors and markets Philippines 0.4 5.3 0.2 1.0 where they were previously competitive (an impact which Thailand 8.5 12.3 -14.5 7.7 may be felt immediately), while also having to invest time NIEs and resources (sunk costs) in seeking out the new sectors Hong Kong, China 5.3 9.3 -0.2 2.5 and market channels where there are investment opportunities created by the rise of China. Such a structural Korea 8.6 11.5 -1.8 2.1 adjustment process may generate significant uncertainty, Singapore 6.3 13.1 0.6 3.0 which may lead to new investment being delayed during an Taiwan (China) 7.4 9.2 1.7 1.4 interim adjustment period during which firms try to learn Source: World Bank. Compound annual average growth. 21For example, M.D. Chinn and Hiro Ito. (2005). "Current There is not yet a consensus about the causes of Account Balances, Financial Development and Institutions: slower growth in investment among East Asian economies Assaying the World `Savings Glut'". NBER Working Paper (ex-China) in the post-crisis period. Systematic 11761. November 2005. 22IMF. (2006). Asia and Pacific Regional Outlook. May 2006. econometric studies find it is not explained by economic Chapter V. "Asia's Investment Decline." fundamentals such as the fiscal balance, demographics, East Asia Update 31 more about the new environment, although later it may also and implementation of rules and policies by government stimulate stronger investment, as firms become more officials and in the courts. Some 50 percent of firms were familiar with new patterns of comparative advantage and concerned about this sort of policy uncertainty and market opportunities. arbitrariness in Indonesia in 2003, but it was also a concern for close to 30 percent of firms in China, Philippines and Exhibit 31 Thailand. On a related theme, concerns about corruption and crime are also particularly important for firms in the Constraints on Firm Operations Philippines. In this connection, IMF (2006) also notes some (% of Firms Answering 'Major or Severe') deterioration in the World Bank's indicators of governance for East Asia over the last decade (Kaufman, Kraay and Mastruzzi, 2006), which may also suggest an increase in Business licensing Thailand policy uncertainty. Infrastructure Philippines Among other investment climate issues, concerns Indonesia about the cost of and access to credit are prominent in Corruption, Crime Indonesia and, to a lesser extent, China (31 and 23 percent China of firms respectively). Infrastructure, especially unreliable Credit power supply, is flagged as a particular concern in the Philippines and China. Some 30 percent of firms in Labor Skills Thailand find the inadequate skills and education level of available workers to be a major constraint on their Taxes and customs operations. The proportion is also relatively high in China, where over a quarter of firms find this to be a major Economic Policy Uncertainty constraint. Macroeconomic Instability How important are investment climate variables for the operations of firms? To take just one example, 0 10 20 30 40 50 60 econometric analysis shows that adverse investment climate variables in Indonesia have had a large and significant negative impact on firm level total factor productivity (TFP) The quality of the investment climate in the region and investment (measured here as the probability of is also likely to play an important role. Regular firm-level undertaking a new investment). Total factor productivity is investment climate surveys conducted by the World Bank in adversely affected by a wide range of investment climate recent years provide a useful `firm's eye view'. Exhibit 31 conditions such as regulatory burden, policy uncertainty, shows the proportion of firms in various economies that felt poor financial market development, excessive labor that a particular issue was a major constraint on their disputes, and poor infrastructure. Since TFP is an important operations. In most economies shown the issues that determinant of the return to capital, these factors can also be concerned the largest number of firms as a major constraint seen as having an indirect negative impact on investment. on their operations are to do with uncertainty: concerns Among the factors having the largest direct negative about macroeconomic instability and about economic policy impacts on investment are poor functioning of the judiciary uncertainty. For example, even though macroeconomic (which has obvious negative implications for the security of conditions have greatly improved since the 1997-98 property rights, for example), corruption, lack of security financial crisis, some 42 percent of Indonesian firms in 2005 and lack of financial sector development. A one standard still cited concerns about macroeconomic instability as a deviation improvement in security or financial development major concern, although this proportion is down from 50 would increase the probability of a firm undertaking anew percent in 2003. These continued concerns may relate to investment by almost one third, for example. 23 firms' long memories of the crisis and also to occasional episodes of renewed volatility in exchange rates, interest These results suggest that, although they are rates and inflation that have occurred in the post crisis sometimes politically difficult and time consuming to period, in particular in 2000/01 and in 2005. Firm concerns implement, investment climate and governance reforms to about macroeconomic instability have also been high in the reduce the scope for uncertainty about policies and laws and Philippines, where the government's efforts to reduce a improve other aspects of the business climate can have large fiscal deficit and high public debt have been at the significant payoffs for investment and growth. Such efforts center of attention. These examples underline the continued are at the core of the agenda for revitalizing growth in the central importance of macroeconomic stability in firms' post crisis middle income economies. perception of the investment climate. The investment climate surveys also highlight the importance of uncertainty about the content, interpretation 23World Bank Indonesia Investment Climate Assessment 2003. East Asia Update 32 Poverty and Inequality - a 10 year perspective 24 the region, though, the revival of poverty reduction has been uneven and corresponds to differences in the pace of One of the distinctive features of the `East Asian economic growth. In low income economies like Vietnam, Miracle' of recent decades has been its ability to combine Cambodia and Lao PDR economic growth and poverty rapid growth with a relatively equitable distribution of the reduction have both accelerated to exceed pre-crisis rates. benefits of growth, reflected particularly in a rapid pace of In the previously crisis-affected middle income economies poverty reduction. We find that for the region as a whole, in South East Asia, though, both growth and the pace of the pace of poverty reduction in the period after the poverty reduction have been somewhat lower than in the financial crisis has been just as rapid as before it. However pre-crisis period. the pace of poverty reduction is not equally robust everywhere. A still fairly large proportion of the region's Exhibit 33 population continues to subsist at fairly low living standards. And inequality in income and consumption has Thiel Index of Consumption Inequality risen significantly since the 1990s. 1990 and 2002 40 Exhibit 32 1990 The Pace of Poverty Reduction 2002 (Average Reduction in the Poverty Headcount Rate* ) 6 30 East Asia China Vietnam S.E.Asia 4 4 Other Small 20 2 10 China R laysia Thailand Vietnam 0 Indonesia KoreaLao PD Ma Philippines 1990-96 1997-2001 2002-06 While East Asian poverty continues to fall, a * $2 a day Poverty Headcount Rate potentially more disquieting trend is that inequality of -2 income and consumption has increased in most economies of the region. Exhibit 33 shows that the Thiel Index of As Exhibit 32 indicates, the $2-a-day poverty rate within-country inequality increased markedly between 1990 in East Asia was falling on average by close to 3 percentage and 2002 in China, Indonesia, Lao PDR, Philippines and points a year in the pre-crisis boom period 1990-96. The Vietnam, and fell only in Thailand. A closer look at the number of poor below this income line fell from 1.07 billion increase in inequality in China finds that the largest part of (two thirds of the population) in 1990 to 851 million (half the increase was contributed by an increased in inequality the population) in 1996. The rate of poverty reduction between urban and rural areas, with additional significant slowed all over the region during the financial crisis. contributions from increased inequality within rural areas Poverty rates increased sharply in the crisis-affected middle and within urban areas. Indeed the rural-urban divide is income economies such as Indonesia, Philippines and emerging as a key focal point of inequality in the region, Thailand. There was also a slowdown in the pace of with 75-80 percent or more of poverty at the $1-a-day level poverty reduction elsewhere, even in economies that had not being concentrated in rural areas. themselves fallen into crisis. A recent analysis of rising inequality in East Asia In the post-crisis period 2002-06, though, the pace argues that many of the same forces that are contributing to of poverty reduction has once more picked up to close to 3 rapid growth and more global integration are also the forces percentage points a year, bringing the $2-a-day poverty that are shaping unevenness in growth.25 headcount down further, from 43 percent in 2001 to 29 · A key factor underlying the rise in inequality percent in 2006 (an estimated 552 million people). Within within the region has been an expansion in wage inequality. In particular, as in many countries around the 24 Recent developments in poverty reduction and human development are discussed on pages XX of this World Bank East Asia Update, while Appendix Tables 7 and 8 below provide 25The discussion of inequality in this section follows Gill and detailed historical and forecast data on poverty. Kharas (2007) op.cit, Chapter 6: `Cohesion.' East Asia Update 33 world, there has been a large increase in the wage disparities in the region. Current inequalities may become premium paid to education and skills. For example the entrenched through inequality of opportunity across wage premium for college graduates over senior high generations. There is also growing evidence that inequality school graduates in China increased from 12 percent in may hamper productive investments and growth: poor 1988 to 37 percent in 2001. people without access to credit may be unable to exploit · Increased global integration has increased the investment opportunities that would benefit society. relative demand for skilled labor, in particular as foreign Excessive disparities may also be a source of political direct investment (FDI) has concentrated in skill-intense instability and social unrest. The last section of this sectors and has introduced new technologies. Relative discussion looks at approaches that may be helpful in wages for skilled labor have also tended to increase addressing inequality. because of the less elastic supply of such labor. · Enterprise reforms and downsizing of the state Managing Vulnerability owned enterprise sector in economies like China and Are East Asian economies still vulnerable to Vietnam has reduced the proportion of employment in the capital market and financial crises? In many respects it is public sector. As workers move into private sector fair to say that they are much less vulnerable to the specific employment, their wages become more closely related to kind of crisis that hit these economies in the second half of their skills, leading to more wage dispersion. Some 1997 and in 1998. But that is not to say that they are not former SOE workers drop out of the job market, accept subject to any risks. lower wages (especially if they are older) or become employed in the urban informal sector. Here it may be worth briefly summarizing how East Asia got into trouble in the 1997-98 crisis. The lead up · Spatial disparities between dynamic urban areas to the crisis involved growing private capital flows to and lagging rural areas are exacerbated by so-called emerging markets - an emerging markets boom - location and agglomeration effects. Coastal areas and encouraged in part by the prevailing low interest rates in the cities with other good transport links to global markets developed world In many instances governments had attract the lion's share of FDI. Firms and workers in recently liberalized financial institutions, although without urban agglomerations benefit from their closeness to each building up a sufficiently strong financial supervisory and other in various ways, enhancing their productivity and regulatory capacity. These poorly regulated financial incomes and further attracting modern firms and FDI. institutions took on excessive external debt, especially short About 80 percent of FDI in China in 1989-2003 was term, foreign currency debt, which they intermediated to concentrated in the coastal provinces, which also enjoyed local borrowers (who also borrowed abroad directly), faster income growth than the rest of the country. stimulating a surge in domestic credit, investment and asset · The trend towards fiscal decentralization in much prices. Strong asset prices and growth in turn attracted more of East Asia during the 1990s has tended to increase foreign capital inflows. Vibrant domestic demand growth disparities in the fiscal resources available to local also led to the emergence of significant deficits on the governments and in their ability to provide public balance of payments current account. The crisis began services of importance to the poor such as health and when a sharp change in foreign investor sentiment in mid education services. 1997 led to a sudden stop in capital inflows, a severe liquidity squeeze, the emergence of massive bad debts, a · Massive internal migration from rural areas to fast collapse in investment and severe recession. growing urban areas has been a powerful equalizing force through its effect on reducing wage and income Economies in the region have pursued two broad differentials across regions and sectors. However strategies to manage vulnerability and reduce the risk of workers may lack the minimum levels of assets, crisis. First, they have generally run current account education, skills and information needed to migrate. surpluses and built up large foreign exchange reserves as a Migration may also be impeded by policies that deny buffer or insurance policy against crises. Second, they have them access to public services in the cities they want to sought to strengthen fundamentals, for example by migrate to. maintaining prudent macroeconomic policies and, in particular, by strengthening the financial sector.26 Among Should people in East Asia care about rising the kinds of risks that might persist or new risks that might disparities? After all, some of the factors that have been emerge are potential unwanted side-effects from the mix of responsible for rising disparities are also the ones policies used to support recovery after the crisis, or risks contributing to growth. Arguably, as the modern sector associated with only incomplete implementation of reforms. continues to grow and absorb ever larger proportions of low-productivity labor from other sectors, the disparities will eventually decline. Values surveys show there is a fair 26 degree of support among East Asians for disparities that IMF (2006) "Country Insurance: The Role of Country Policies" provide incentives for effort. Nevertheless there are still presents a framework for analyzing the kinds of policies that reasons for concern about the growth of excessive countries can implement to protect themselves from adverse economic shocks. East Asia Update 34 Exhibit 34 shows the distinctive evolution of East different in China compared to the post-crisis economies of Asia's overall balance of payment in the recent post crisis the region. In China the current account has surged despite period, with large current surpluses being joined by very high levels of investment, due to a sharp increase in significant capital account inflows, especially in 2002-04. domestic savings. The largest part of the savings increase in (See the detailed discussion of recent balance of payments China has derived from an increase in business profits and trends on pages 18-22 above). The Exhibit highlights the savings. Among the post-crisis economies, on the other contrast with the period of the pre-crisis boom in the early- hand, saving has been relatively stable but the current mid 1990s just described, when large net capital inflows to account surplus has surged due to the large decline in the middle income South East Asian economies and Korea investment after the crisis. were partly offset by significant current account deficits.27 Exhibit 34 Reserve Accumulation as Crisis Defense As the earlier discussion of recent balance of East Asia* Balance of Payments: Overall Balance payments argued, most economies in the region have (% of GDP) resisted upward pressure on the exchange rate caused by 10 large balance of payments surpluses by intervening in the foreign exchange market, resulting in the rapid build up of 8 foreign reserves in recent years. For one thing, governments have been concerned about the potential adverse impact of Current account exchange rate appreciation on competitiveness, exports and 6 employment. 4 The build up of record foreign reserves in East Asia can also be viewed as a form of precautionary saving, buffer or self-insurance against the risk of balance of 2 payments crises. Exhibit 37 shows the large increase in the ratio of foreign reserves to short term foreign debt among 0 the five crisis economies in the decade since the crisis. In 1990 1992 1994 1996 1998 2000 2002 2004 2006 all cases reserves stand well above the 100 percent ratio recommended by the so-called Greenspan-Guidotti rule of -2 Capital account thumb for reserve management, in most cases 2 ½ to 5 times * excludes Hong Kong above it. Jeanne and Ranciere (2006) present evidence that -4 developing economies typically use reserves to smooth domestic demand and growth during a balance of payments crisis.28 In addition to mitigating the impact of a crisis, high Exhibits 35 and 36 below show that the underlying reserve levels might also serve to prevent crisis. Jeane and forces driving large current account surpluses are very Exhibit 35 Exhibit 36 China: Gross Domestic Investment and 6 Other Economies: Gross Domestic Investment and Savings (as % of GDP) * Savings (as % of GDP) 50.0 35 Investment Savings 45.0 30 40.0 25 35.0 20 * Simple average of Indonesia, Korea, Malaysia, Philippines, Investment Taiwan (China), Thailand Saving 30.0 28 15 Level5 of 7 Reserves for Emerging Market Countries: Formulas and Olivier Jeanne and Romain Ranciere.5 (2006). "The Optimal 9 1 3 5 7 9 1 3 7 9 1 3 5 27The capital account is stated inclusive of errors and omissions. 9801 9821 9841 9861 9881 9901 9921 9941 9961 9981 0002 0022 0042 0062 Applications." IMF 198Working Paper199 WP/06/229. (October). 197 197 197 198 198 198 198 199 199 199 199 200 200 200 East Asia Update 35 Ranciere develop a formal model to determine the optimal an appreciation of 7-8 percent since then. The Korean, level of reserves. The optimal level increases with the Philippines and Thai currencies have also seen appreciable probability of a `sudden stop' in capital flows, which, in increases over this period. Continued movements towards turn is found empirically to increase with the extent of greater flexibility would improve the ability of economies to financial integration, the ratio of public debt to GDP and the adjust to external shocks more smoothly and would also extent of real exchange rate appreciation. They find that the allow central banks greater independence in the conduct of optimal level of reserves in Emerging Asia has indeed monetary policy. increased substantially over the last decade, principally due to the region's growing financial integration, and is Financial Sector Strengthening estimated to be about 25 percent of GDP in 2005. However, East Asian reserves actually averaged around 46 percent of The decade since the crisis has seen substantial GDP, exceeding the proposed optimal level by a wide changes in the size, diversity, efficiency and stability of margin. financial systems in East Asia. If prior to the crisis the focus of attention was on mobilizing finance, now the it has Exhibit 37 shifted to the efficiency of resource allocation, diversification of supply, and improving the robustness of Foreign Reserves as % of Short Term financial systems to withstand a range of shocks External Debt 700 The assets of East Asian financial systems reached Indonesia $9.6 trillion in 2005, over one fifth the size of US markets 29 Malaysia and almost half the size of Japan's. Financial markets Philippines have also become more diversified. The importance of a more diversified financial system is that, given sufficient 500 Thailand market depth, it can serve to enhance efficiency, since Korea financial intermediaries and securities markets perform the core functions of resource mobilization, resource allocation and risk management in different specialized ways. By 300 offering a wider array of risk-sharing mechanisms, diversification can also increase the overall risk-bearing capacity of the economy. Reflecting increased diversification, equity markets 100 in the region have tripled since the crisis--from a market capitalization of US $0.8 trillion in 1997 to almost US$ 2.9 trillion in 2005. The region's bond markets have also seen sizable growth over the past nine years, albeit with -1001996 1997 1998 1999 2000 2001 2002 2003 2004 2005 considerable variation across countries. For the region as a whole, bonds outstanding amounted to US$1.5 trillion in 2005--up from US$ 0.4 trillion in 1997. Despite the The large build up of reserves can however create impressive (300 percent) growth in the securities markets unwanted vulnerabilities or side-effects. Purchases of over the past nine years, the banking sector, with US$5.5 foreign exchange with local currency lead to an increase in trillion in assets, still dominates. On average the banking domestic base money, which, if left untreated, can underpin sector accounts for almost 60 percent of total financial a broader expansion of credit and aggregate demand, sector assets. contributing to economic overheating, higher inflation and Significant structural changes have taken place in unwarranted euphoria or bubbles in asset markets, the banking sectors of crisis affected countries, as a result of potentially compromising the central bank's ability to policy efforts to address issues of capitalization, pursue an independent monetary policy. To avert these governance, risk management and operational efficiency. consequences many East Asian governments have tried to Banking sectors have generally become more consolidated, mop up excessive liquidity ("sterilization)" through large with a fall in the number of banks in most middle income bond issues, sometimes amounting to several percentage countries, as well as an increase in their median size. points of GDP, as well as increases in commercial bank Although banks have yet to reap the benefits of scale and reserve requirements. But these expedients can also have scope, efficiency measures such as the ratio of operating undesirable side effects (discussed in more detail in section costs to assets have improved and compare favorably to on recent balance of payments developments earlier in the banks in other regions. As the earlier section in this report report). on recent financial sector trends discusses in more detail, Faced with these complications, policy makers in banks in the previously crisis-affected East Asian countries the region have been gradually moving towards greater exchange rate flexibility. China and Malaysia widened the 29 Swati Ghosh: (2006). "East Asian Finance: The Road to band for their currencies in the middle of 2005, followed by Robust Markets." World Bank. East Asia Update 36 Exhibit X. Compliance with Basel Core Principles for Banking Supervision have achieved substantial improvements in capital · Cross-border banking. which requires supervisors adequacy, asset quality and profitability. Average NPLs in to apply global consolidated supervision over the five crisis countries fell from close to 30 percent in 1998 internationally active banks. to only about 6 percent in 2006, although this remains higher than in some other developed and developing In terms of strengthening securities markets, the regions. key constraints that need to be addressed in East Asian securities markets are limited liquidity and low efficiency. The region has undertaken significant efforts to Three key factors affect liquidity and efficiency--and improve prudential regulations and supervision to ultimately the role that securities markets play in the region, strengthen the stability of the banking system, but this is a namely: the availability of information to price securities work in progress and several areas still need to converge to accurately, transactions costs, and the size and heterogeneity international standards. Based on a review of the of the investor base implementation of the Basel Core Principles for Banking Supervision (BCP), there are several areas in which fewer · The availability of good information to price than 60 percent of the countries are compliant or largely securities accurately is affected by corporate governance compliant. Such areas, where more focus and policy effort and the degree and quality of disclosure. Countries in the is needed include: region have made considerable progress in strengthening the legal and regulatory framework for corporate · The independence, powers, and resources of governance and disclosure requirements, and in banking supervisors; strengthening accounting and auditing standards. But a · Criteria and processes for licensing banks; stronger focus on implementation and enforcement are needed; · Prudential regulations and requirements, including rules for evaluating asset quality and the adequacy of · Factors affecting transactions costs include loan-loss provisions and reserves; and systems to withholding taxes and fees, the efficiency of monitor, and control country risks and all other material intermediaries, market infrastructure and institutional risks; arrangements. While the region fares quite well in market infrastructure with fairly advanced clearance and · Remedial measures and exit which requires settlements systems, strengthening of the intermediaries supervisors to have and promptly apply remedial and further development of the supporting markets and measures when banks do not meet prudential institutional arrangements such as repo markets, requirements. securities lending, and derivatives markets, is needed; · A broader and more diversified investor base, will depend on further developing the domestic institutional East Asia Update 37 investor base--pension funds, insurance and mutual markets. Such a development would not only reduce funds--as well as fostering greater regional financial vulnerability to crises but would also enhance the integration. Securities markets have become more efficiency, capacity for specialization and growth integrated both globally and within region over the past potential of the economy. Since financial 10 years. However, in several economies, a sizable intermediaries and markets perform the core functions proportion of shares remains inaccessible to cross border of resource mobilization, resource allocation and risk investors. This, coupled with the fact that a significant management in different ways, they may each be better proportion of shares is closely held, means that in some at certain aspects of these functions. A more economies only a relatively small percentage of shares is diversified financial sector and capital market are freely available to potential investors. In turn this can especially important to support investment not just in significantly dampen liquidity and efficiency in the stock well-known old lines of business, but especially markets. investment in new, more uncertain, more innovative and long term projects. At the same time, the financial constraints faced by poor households are a key Some Policy Perspectives impediment to their taking advantage of income- generating opportunities. Improving access to credit The preceding discussion has touched on a variety and other financial services for the poor may be a of policies and ideas that may assist economies in East Asia major step in promoting a more equitable distribution maintain robust growth in a sustainable way, reduce of the benefits of economic growth poverty, strengthen equity and manage vulnerability. Bringing some of these points together: · Availability of high quality infrastructure services is · The importance of prudent monetary and fiscal increasingly important as a competitive element determining firms' investment decisions. It is policies to maintain or improve macroeconomic estimated that East Asia has infrastructure needs of stability cannot be underestimated. Investment climate approximately $200 billion annually over the next five surveys show macro instability to be one of chief years, 65 percent in new investment, with the constraints on operations perceived by firms, and it is remaining 35 percent channeled toward maintenance as well one of the chief sources of vulnerability to of existing assets. Government has a critical role to crises. play in developing the long range vision for · Governance reforms to reduce arbitrariness and infrastructure, coordination between key players uncertainty in the formulation and implementation of (public-private partnerships, central versus local policies and laws would also help address one of the government levels etc), developing the fiscal space for major concerns of firms in the region. Grouped with the appropriate public sector roles, enhancing this is the need for continued progress in combating competition and strengthening the quality of corruption and crime, as well as regulatory reforms to regulation. reduce, simplify or eliminate needlessly burdensome · Skilled labor shortages are an increasingly important and complex regulations, which add unnecessarily to constraint on firm operations, especially in the region's the costs of doing business and are also important middle income economies. While East Asia has made sources of uncertainty for firms. But reforms that big strides in primary education over the last two reduce arbitrariness, corruption and needless red tape decades, enrollments at the secondary and tertiary would perhaps be of even greater importance in levels remain relatively low in many countries and accelerating poverty reduction and improving equity, there are large disparities within countries. Education for example by helping improve delivery of basic and other forms of human capital development are a services for the poor, or in fostering entrepreneurial fundamental underpinning for both domestic activity among the poor. innovation activity and the capacity of the economy to · Financial sector and capital market development. absorb knowledge from abroad. Strengthening quality Economies in the region have made substantial and enrollment in secondary and tertiary education, progress in restoring the capital adequacy, asset quality improving labor force training capabilities and, more and profitability of their banking sectors. The generally fostering development of national innovation challenge now is to strengthen the corporate systems are an increasingly important part of the governance of financial institutions and further bring region's policy agenda. Because imperfect access to the quality of prudential regulation and supervision up credit and other impediments may prevent poor people to advanced standards. This will become increasingly from improving themselves through higher education, important in ensuring that risk transfer among financial policies that improve access to higher education will institutions through new financial instruments--which also promote a more equitable distribution of the has been a major innovation globally--takes place benefits of growth. appropriately. Also important is to continue to foster · Facilitating internal migration has the potential to the development of deeper, more diversified capital become a major force for greater equity within East Asia Update 38 countries, in addition to its contribution to a more flexible business environment and to growth Impediments that hamper migration include the low human capital base of potential migrants, de facto restrictions on the movement of people cross regions, and the poor access to basic services (education of children, housing, and health) for migrants in destination areas. · The development of social protection systems. Greater economic integration has tied the fate of people in East Asia to changes in the world and regional economies, thus exposing populations to new sources of vulnerability. The coverage of formal social protection systems is limited in most countries, while the demands on the systems have risen because of expanding urbanization and migration and the aging populations in several countries. Improving the coverage and performance of unemployment insurance, health insurance, and pension systems, as well as targeted income-transfer programs, is likely to assume more importance in the future. East Asia Update 39 COUNTRY SECTIONS Major Economies 30 government temporarily halted approval for new mutual funds in December and banned banks from extending loans China for buying stocks in January. The end-February sell off of Chinese stocks seemingly triggered, for the first time, a Economic growth eased slightly in the second half global sell off. Chinese equity markets remain volatile, as do of 2006, as strong external trade offset much of the impact markets in other countries. of slower investment. Real GDP growth was 10.5 percent (yoy) in the second half of 2006, which brought growth for Near term economic prospects remain favorable. 2006 as a whole to 10.7 percent, compared to an upwardly Chinese exporters and manufacturers have been affected by revised 10.4 percent in 2005. Preliminary data suggests several recent policy measures to rebalance the economy, growth remained very strong in early 2007. Investment including tax measures and appreciation, and more such cooled in the second half of 2006 in response to tightening measures are likely to follow. However, continued measures introduced mid-2006. Consumption has continued productivity growth and a resilient world economy promise to grow robustly, but still slower than overall GDP. only a minor export slowdown. Indeed, export growth remained very strong in early 2007. Domestically, the Exports continued to outpace imports by a wide fundamental drivers of investment growth remain in place, margin through February 2007, and in the second half of and investment is therefore unlikely to slow drastically in 2006 external demand largely offset the growth impact of 2007, while boosting consumption will remain challenging, the investment slowdown. The external surplus reached particularly in rural areas. In all, our projection for GDP new highs: we estimate that China's current account surplus growth in 2007 remains unchanged at 9.6 percent. The has overtaken Japan's in 2006 to be the world's largest. external imbalance is unlikely to shrink much in the near Processing export growth, which is predominantly done by term, and a significant surge in inflation seems unlikely. foreign-invested firms, trended down in 2006 following Measures to rebalance the economy as announced by slower global trade, but processing import growth declined government could temporarily slow growth further in 2008. even more. As a result, the processing surplus increased and now accounts for all of the trade surplus. China's deficit in China's internal macro challenges remain non-processing trade declined from US$ 73 billion in 2004 manageable, but the external imbalance is on the rise. Thus, to US$8 billion in 2006, as non-processing exports powered the preferred policy measures to address domestic concerns ahead. In addition to the current account surplus, inward are those that also reduce the external imbalance. The FDI also provided a steady stream of inflows, and foreign government has already decided on a dividend policy for exchange reserve accumulation continued apace. Surging SOEs and a more rapid increase in spending on health and stock prices prompted government measures to slow the education, and stepped up the pace of currency appreciation. amount of new funds moving in the stock market. These measures tend to reduce investment and increase consumption, and are thus steps in the right direction. Consumer price inflation has picked up recently, Meanwhile, containing investment growth and inefficiency led by higher food prices, especially grain. Since WTO on a more sustainable basis calls for structural policies that accession, grain prices in China have been moving more in address the underlying causes of inefficiency and excess line with international prices, which rose sharply in late investment. 2006. Chinese grain prices have recently risen less than international prices, though, in part because the government At the annual session of the National People's released grain on the market from its grain reserves. Non- Congress in March, the government presented its Work Plan food consumer price inflation remains modest at around 1 for 2007, which includes several initiatives to rebalance the percent. pattern of economic growth. Rebalancing aims to make growth less intensive in resources and energy, less China's stock markets have risen sharply since damaging for the environment, more evenly distributed and mid-2006, although a correction took place end February. more led by domestic demand and domestic consumption. Besides continued strong profit growth, progress in equity market reform, notably the reduction in the overhang of In terms of the overall economic strategy, non-tradable shares, has boosted stock prices. The rapid rebalancing involves a shift in the pattern of growth. This stock price increases have re-ignited the public's enthusiasm shift means more growth of the services sector instead of for investment on the stock market, and the amount of funds industry and a larger role for consumption instead of flowing into mutual funds increased rapidly. The investment and exports. This would meet the aim to make growth less intensive in energy, raw materials, and resources, and less tough on the environment. It would also 30 More detailed individual Country Briefs for the major make growth less capital intensive, allowing China to grow economies can be found at the World Bank website: with lower saving, and more consumption. Moreover, it http://www.worldbank.org/eapupdate/ would mean more labor intensive urban growth, and thus East Asia Update 40 less excess labor in agriculture and the related poverty and exports increased 10 percent. High international commodity urban-rural inequality. Finally, it would ameliorate the prices contributed to strong growth in non-oil primary pressures for overproduction of goods and current account commodity exports (e.g. rubber, palm oil and coal). The surpluses. current account surplus rose to US$9.6 billion in 2006, Several rebalancing policies were discussed at the much higher than 2004 (US$1.6 billion) and 2005 (US$0.3 March meetings. They include unification of the corporate billion). International reserves rose from US$35 billion in income tax (between foreign and domestic enterprises); a 2005 to US$43 billion in 2006. property law; significant increases in government spending Markets are increasingly confident. The rupiah on education, health, and agriculture, farmers, and rural exchange rate has traded in a stable range between areas.31 Rp.9,000-9,200 against the US dollar for some time. Yields The third national financial work conference held for government bonds continued to fall at all maturities in in January set out directions for major financial sector early 2007, reflecting a positive outlook for inflation and reform. Key reforms discussed were in rural finance, foreign further cuts in interest rates. The Jakarta Stock exchange exchange management, and policy banks. On rural finance, continues to trade near all time highs. Inflation fell to 6.6 it was decided to reduce the access thresholds for financial percent at the end of 2006, lower than Bank Indonesia's institutions to attract a more diverse set of providers and to target of 7-9 percent but higher than expected due to recent continue the reforms of the Agricultural Bank of China. increases in food and especially rice prices. These pressures Looking ahead, rural finance would also benefit from spilled into January and February when inflation remained interest rate liberalization and further reforms in existing at worryingly high 1.2 and 0.6 percent rates over the providers. On foreign exchange reserve management, the previous month. As the base effect of higher year on year meeting decided to explore ways to more actively manage inflation created by the fuel price in 2005 has worked its part of the country's foreign exchange reserves. way out of comparisons, Bank Indonesia lowered policy rates by 375 basis points from a high of 12.75 percent to 9.0 percent by March 2006. However, the rise and fall in Indonesia administered rates was not reflected in a proportional Economic indicators are signaling a strong pickup changes in lending rates. in economic growth at the end of 2006 and into 2007, Government spending continued to run below although recent natural disasters may dampen the upturn in budget and the debt to GDP ratio fell dramatically. The the near term. Flooding in the greater Jakarta area in preliminary 2006 results show a budget deficit at 1.1 percent February forced more than 300,000 people from their homes of GDP, lower than the earlier estimates at 1.3 percent of and caused widespread economic disruption. The GDP. The government debt to GDP ratio dropped to 41 government estimates losses of 0.1-0.2 percent of GDP. percent from 45 percent in 2005. The lower deficit sent a Other incidents included flooding in Flores, more positive signal to markets but unfortunately also reflects earthquakes in Sumatra and a series of air and sea transport below-budget government capital spending. While central accidents. government capital spending rose to 1.9 percent of GDP, Growth is recovering from a slowdown in the last significantly higher than 2005's 1.2 percent, it was still quarter of 2005 and the first half of 2006 caused by the below target by 0.3 percent of GDP. Regional government removal of fuel subsidies and the accompanying increase in spending is also likely to undershoot budgets by an even fuel prices (an average of 114 percent) and interest rates (up greater amount. 400 basis points). Growth dipped to 5 percent through mid In August the President announced major new 2006, but then recovered to 5.9 percent and 6.1 percent poverty initiatives including: a program to provide block respectively in the third and fourth quarters of 2006, leaving grants to every village in Indonesia by 2009 (PNPM); and a growth for 2006 as a whole at 5.5 percent. Growth in the pilot conditional cash transfer program (PKH). The PNPM second half of 2006 was led by a pickup in private initiative is designed to create employment, stimulate the consumption and investment, while exports also remained local economy and build community participation. The PKH strong. Imports picked up rapidly in response to reviving pilot should support demand through conditional cash domestic demand. Rebounding automobile and motorbike transfers designed to improve health and education sales, capital goods imports and consumer confidence all outcomes. Research has shown that poverty outcomes are suggest that growth is continuing to accelerating. very sensitive to rice prices. Recent increases in rice prices, Exports exceeded US$100 billion in 2006 for the as well as the termination of the unconditional cash transfer first time, growing 18 percent over 2005 in US dollar terms. program could slow poverty reduction or even lead to an Non-oil and gas exports grew 20 percent while oil and gas increase in poverty in 2007 despite higher growth. However the government's decision to undertake some imports of rice appears to be stabilizing prices. Unemployment appears to 31 A package of potential rebalancing policies can be found have stabilized at a little over 10 percent (10.4 percent in in the World Bank's November 2006 China Quarterly February 2006 and 10.3 percent in August 2006). Update (pp 15-17). East Asia Update 41 The government continued to push forward on its the factors likely to determine the direction of monetary economic policy packages. After much debate Parliament policy. Concerns about housing prices have led the has passed a new investment law providing, among other government to speed up housing supply and to propose a things, equal treatment between domestic and foreign housing bill that requires builders to disclose housing investors, binding international arbitration, the elimination construction costs and to put price ceilings on new housing. of forced divestiture, land use rights up to 95 years (from 35 Given the sluggish economy, the government has years previously), and extended residency permits for frontloaded government expenditure in the first half of foreign investors. However, important tax laws remain 2007. The fiscal balance excluding the social security fund under discussion in Parliament. The latest package on the will continue to run a deficit of around 1 percent of GDP in financial sector includes a decree to allow state-banks to 2007. write-off non-performing loans, which should accelerate lending from this source. Infrastructure achievements Even with robust exports and lower oil prices, the include a Risk Management Unit in the Ministry of Finance current account stayed at near balance, running a surplus of that is assessing limited public guarantees for projects and US$ 150 million in December 2006 and a deficit of US$ an agreement to develop 10 model projects for Public 500 million in January 2007, the latter due to increased Private Partnerships. But there are still relatively few large consumer goods imports and a widening travel account infrastructure projects actually getting underway. deficit. This balanced current account trend is likely to continue through 2007. The capital account registered a Growth is expected to pick up to 6.3 percent in surplus of US$ 18.6 billion in 2006 due to the increase in 2007. Externally, while a slowdown in world growth is short-term borrowings by banks, despite net outflow of expected, consensus projections are for it to be relatively foreign portfolio investment and more overseas securities modest. Indonesia is also less export dependent than other investment by domestic investors. Large net inflows of East Asian economies. Domestically there may be some capital could serve to further strengthen the won and to further room for interest rate declines, especially in lending further expand foreign exchange reserves, which reached rates which have remained high. Central and regional US$ 242.8 billion as of February 2007. To mitigate the government fiscal policy should be more supportive as pressure, the government encouraged capital outflows by spending catches up to budgeted levels. easing regulations on overseas direct and real estate investment, and by expanding tax incentives for overseas Korea equity funds. The Korean economy expanded by 5 percent in Moderating domestic and export demand is 2006. Growth was supported mainly by stronger private expected to result in slower GDP growth of 4.4 percent in consumption (4.2 percent), growth in facility investment 2007, a little lower than in 2006. The North Korean nuclear (7.5 percent) and strong exports (13.0 percent). In the past issue, volatile housing prices, won appreciation and higher few months, however, the economy has slowed, easing to oil prices could still pose a downside risk to the economy 4.0 percent growth in the final quarter from 4.8 percent and although recently those risks have been mitigated 5.3 percent in the third and second quarter, respectively, somewhat. The possibility of a sharper slowdown in the US principally due to weaker domestic demand. Private economy and Presidential elections in December also could consumption moderated in the final quarter from recovery at pose uncertainties to the economy. a faster pace than household income since 2005. Slow growth in employment and income is likely to restrain Malaysia private consumption growth in the near future. Fixed investment growth remained sluggish in 2006 with negative The Malaysian economy achieved robust 5.9 growth in construction investment, partly affected by percent GDP growth in 2006, up from 5.2 percent in 2005. government measures to curb speculation in real estate, Manufacturing expanded 7 percent (5.1 percent in 2005), although construction investment did begin to pick up with the fastest-growing products being electronic and slightly in the fourth quarter. Exports continued robust electrical (E&E), petroleum, rubber, and metal products, growth averaging 16 percent in the first two months of although there was some slowing in the second half (H2), 2007, but is expected to slow with a slowing overall export resulting from high stocks and weaker external, especially environment. US, demand,. Agricultural output increased 6.4 percent (2.5 percent in 2005), reflecting higher natural rubber and crude Inflation has been subdued partly thanks to lower palm oil production. The services sector expanded 6.5 oil prices and the strengthening of the won. Headline percent, supported by growth in government, finance, and inflation was 2.2 percent in February 2007, below the lower business services. Spurred by higher household disposable range of the central bank's medium term target of 2.5-3.5 income and commodity prices, private consumption rose by percent. The Bank of Korea kept its target for the 7.0 percent. Public consumption also expanded at a similar benchmark call money interest rate at 4.5 percent over the rate, accelerating to a 40 percent increase in the second half. last seven months, after an earlier increase in rates by a Gross fixed capital formation expanded by 7.9 percent (4.7 cumulative 125 basis points. More subdued inflation, percent in 2005). moderation in growth and high real estate prices are among East Asia Update 42 Gross exports in 2006 rose 10.3 percent to RM 589 return on assets was sustained at about 1.4 percent. The billion. E&E exports, which accounted for about half of capital position of banking system (including Islamic banks) total exports, increased by 6.4 percent. Natural rubber and remained strong in 2006. The risk-weighted capital ratio of palm oil exports were also strong as a result of increases in the banking system fell modestly to 13.0 percent (14.4 both volumes and prices. Crude oil and liquid natural gas percent in 2005) due to a large increase in total asset value. also strengthened mining exports. Gross imports increased The core capital ratio also dropped slightly from 11.4 by a similar magnitude as exports, leaving the trade balance percent to 10.3 percent. at RM 108 billion, an 8.7 percent increase from 2005. Despite strong full-year performance, gross exports fell Underpinned by stable inflation rate, robust slightly in Q4 (E&E exports dropped by 4.7 percent). In Q1- corporate earnings, and large equity investment inflows, the Q3 2006, the current account surplus reached RM 65.3 stock market was bullish in 2006, especially in H2. At end- billion (11 percent higher than the same period in 2005), 2006, the Kuala Lumpur Composite Index (KLCI) reached while the balance on capital and financial accounts swung to 1,096, a 21.8 percent increase from end-2005 and is the a deficit of RM 23.5 billion from a surplus of RM 9.7 billion highest level since 1996. The daily average turnover also in 2005. Gross foreign direct investment inflows increased recorded a 41.2 percent increase. The index continued to steadily in 2006, reaching RM 18.1 billion at the year-end. rise in early 2007 until the late February worldwide Despite higher FDI inflows, the swing to deficit on the turbulence on stock markets, when stock prices pulled back overall capital account arose from a significant increase in sharply, although as of mid-March they still remained the short-term loans extended by non-resident controlled higher than end 2006 levels. companies to their related companies aboard (as part of Looking forward, real GDP growth in 2007 is centralized treasury operations). The overall balance of expected to moderate to 5.6 percent, largely due to lower payments in the first three quarters of 2006 registered a growth in US demand for E&E products. The prospect for surplus of RM 27.9 billion, a 44.0 percent decline from the 2008 remains healthy with 5.8 percent growth. While the same period in 2005. Net international reserves at end-2006 external sector will slow, growth should be sustained by reached RM 290.4 billion, up 9.5 percent from 2005. domestic demand. Strong consumer spending is likely, Meanwhile external debt dropped 8.3 percent from 2005, underpinned by lower inflation, high commodity prices, mainly attributed to a significant decrease in banking sector stable interest rates, robust equity market, and rising wages. debt and debt repayment by the public sector. An accommodative fiscal policy, as part of the Ninth Fueled by higher petroleum-related revenues and Malaysia Plan, should also help to strengthen demand. As individual income taxes, federal government revenue rose inflationary pressure from higher fuel prices subsides and 20.2 percent in the first three quarters of 2006. On the external demand softens, the central bank will likely expenditure side, while operating expenditure grew maintain the OPR at 3.50 percent for the coming months to moderately, development expenditure expanded by nearly boost domestic demand. It is expected that the Malaysian 26 percent, reflecting larger spending on trade and industry Ringgit will continue to appreciate against the US dollar, and public utilities. Overall, the government recorded a reflecting the weaker US dollar and sustained large current budget surplus of 2.7 percent of GDP compared with a account surpluses. deficit of 0.4 percent of GDP in Q1-Q3 2005. Meanwhile, federal government debt reached RM 245.8 billion, an 8.0 Philippines percent increase from 2005. Market sentiment towards the Philippines Consumer price inflation in 2006 picked up slightly improved during 2006, aided by the major fiscal adjustment to 3.6 percent (3.0 percent in 2005). Following lower oil during 2005-06 and abundant global liquidity. Equity prices prices and easing price levels in Malaysia's trading partners, and the peso rose significantly (until the global correction in inflation moderated in H2. The Malaysian ringgit continued late February 2007), as did foreign direct investment, to appreciate modestly against the US dollar. At end-2006, portfolio inflows and international reserves, while interest the exchange rate was RM 3.53 from RM 3.78 per US dollar rates and inflation fell. Real GDP grew by 5.4 percent in at end-2005. Monetary policy has been tight but stable. The 2006 and real GNP by 6.2 percent, marking the first time Overnight Policy Rate (OPR) has remained at 3.50 percent that three consecutive years of growth of 5 or more percent since its last change in April 2006. The average overnight was recorded since the 1970s. Higher growth was inter-bank rate rose from 2.72 percent in 2005 to 3.38 underpinned by strong growth in business process percent in 2006, while the average lending rate of outsourcing, electronics exports, remittances and commercial banks increased slightly. consumption. Asset quality in the banking sector continued to Public consumption also expanded in 2006, despite improve. Based on the 3-month definition, the NPLs ratio a reenacted budget, due mainly to first quarter pump declined from 5.8 percent in 2005 to 4.8 percent in 2006. priming and fourth quarter supplemental budget spending. Supported by higher incomes from fees, trading and Investment grew marginally in 2006, but continued its investment, the banking sector enjoyed a 12.7 percent decline as a share of GDP to below 15 percent. Moreover increase in its pre-tax profits, while the annualized rate of the slight increase in investment was tilted towards public East Asia Update 43 construction, while private construction and acquisition of increase as a share of GDP after continuous compression durable equipment contracted. On the supply side, since 2002. agriculture grew by 4.1 percent in spite of two severe typhoons in the fourth quarter of 2006. Service sector Falling GOCC (Government Owned and growth of 6.3 percent was led by the financial sector and Controlled Corporations) deficits, continued surpluses in the private services. Manufacturing output continued to grow two major pension funds, and a rising surplus for local on pace with GDP but, in contrast to recent years, mining governments also contributed to the consolidated deficit witnessed a contraction. reduction. In particular, the deficit of the National Power Corporation, traditionally the largest GOCC deficit Inflation fell to 4.3 percent by end-2006 and to 2.6 contributor was held in check, reflecting tariff increases in percent by February 2007, aided by the stronger peso and 2004-05 and aided by recent peso appreciation (given its relatively stable food and oil prices. Average inflation in large external debt). By contrast, the National Food 2006 fell to 6.2 percent from 7.6 percent in 2005. The Authority's deficit increased to be the largest single central bank (BSP) did not explicitly lower its overnight contributor to the GOCC deficit (about 0.4 percent of GDP). rates but instead reintroduced a "tiering scheme" in The non-financial public debt/GDP ratio fell from 87 November, whereby bank deposits placed at the BSP percent in 2005 to an estimated 77 percent in 2006 receive progressively lower rates on balances above P5 reflecting both real growth and real appreciation of the peso. billion and P10 billion than the 7½ basic rate. The strong performance of electronics exports and Employment growth in 2006 slowed to 2 percent, remittances far outweighed the impact of higher imported less than growth of the working age population. The growth oil prices on the current account--the current account of wage and salaried workers was higher, at 2.9 percent, but surplus in 2006 jumped to $5 billion from $2 billion in their share of total employment is still only about 50 2005--while rising foreign direct and equity investment percent, and fell relative to 2004. By contrast, the also contributed to gross reserve accumulation to $24.4 proportion of unpaid family workers, prevalent in billion by February 2007, from $18.5 billion in 2005. Net agriculture and private households, increased. Under the old FDI inflow rose to $2.35 billion in 2006, nearly double the definition, unemployment had dropped slightly to 11 2005 level, and net portfolio inflows also accelerated percent as of October 2006, in part due to a decline in the following the May-June sell-off. A 20 percent increase in labor force participation rate. Underemployment, however, remittances to $12.8 billion in 2006 underscores the vital grew to 22.7 percent from 17.6 percent two years ago. role of remittances and transfers for the balance of About 1.1 million Filipino workers are estimated to have payments: through these flows, which together account for left the country in 2006 for employment overseas, which in over 13 percent of GDP, large trade deficits have been part reflects the lack of domestic employment opportunities, transformed into current account surpluses, which in 2006 as well as higher wages abroad. grew to over 4 percent of GDP. The consolidated public sector deficit (CPSD) is Boosted by foreign capital inflow, the Philippine estimated to have fallen to about 0.7 percent of GDP in stock market was among the top East Asian performers in 2006 from 1.8 percent in 2005 and 4.9 percent in 2005, 2006, and continued to ascend towards pre-Asian crisis implying a primary public sector surplus in 2006 of over 5 highs--prior to the global correction of equity prices that percent of GDP. The reduction of the CPSD was essentially began in the last week of February 2007 which saw the due to a larger cut in the National Government deficit. The stock market index lose more than 12 percent of its value in NG deficit, targeted for balance by 2008, was reduced to 1 one week. However equities had recovered 6-7 percent of percent of GDP in 2006 from 2.7 percent in 2005. In their post-correction losses by the latter part of March. The contrast to the 2002-05 period, when NG deficit reduction peso appreciated by about 7½ percent against the U.S. dollar was driven primarily by expenditure compression, in 2006, in 2006, and strengthened further in early 2007 even as the the bulk of the adjustment was due to implementation of the BSP continued to build reserves as a net buyer of foreign VAT reforms which raised tax revenue by 22 percent, currency. Interest rates in the peso market and Philippine increasing the tax/GDP ratio from 13 percent in 2005 to spreads in the global market fell substantially, with the about 14.3 percent in 2006--marking the first significant former prompting more investment into equities. The increase in tax effort since the post-Asian crisis collapse of benchmark 91-day Treasury bill averaged 5.4 percent in tax revenue. In the first two months of 2007, the budget 2006 and fell below 3 percent in February 2007. Sovereign deficit fell to P18.6 billion, versus P40.4 billion through spreads declined by 100 basis points in 2006 reflecting both February 2006. Revenue in February was boosted by lower public deficits and the falling spreads for emerging proceeds from the P25.2 billion sale of the Government's markets in general. In January 2007, the national stake in Philippines Telecommunications Investment Corp. government issued a $1 billion 25-year bond at a yield of However, tax revenue through February was 0.5 percent 6.55 percent. This completed the national government's below collections in 2006 as opposed to the targeted 14 intended commercial borrowing for 2007. percent increase. With Congressional approval in January of the 2007 budget, non-interest spending is slated to Gradual strengthening of the banking sector has continued. Regulations are in closer alignment with East Asia Update 44 international standards and regulatory policies are more Public investment growth is unlikely to offset this responsive to the growing sophistication and globalization significantly, as good governance is a key policy plank of of the banking industry. The extension of the Special the Government, which will slow public funds Purpose Vehicle Act enabled universal and commercial disbursement. Several measures are being put in place to banks to reduce their stock of NPLs by another 18 percent in make public procurement more transparent and accountable, 2006. BSP expects an additional P100 billion worth of which is commendable. The Ministry of Finance NPLs/NPAs would be taken out from bank balance sheets nevertheless plans to make every effort to raise public during 2007. Capital adequacy requirements are also being investment, especially in appropriate infrastructure thereby brought in line with international norms. increasing aggregate domestic demand and catalyzing additional private investment. However, public investment Thailand is projected to rise by 5 percent in 2007, given the additional scrutiny and the transition to better procurement practices. Thailand grew by 5 percent in 2006, slightly better than 4.5 percent in 2005, on the back of strong export The challenge going forward is to improve private growth and a sound macro and fiscal situation. This means investor confidence in Thailand through quick policy that average annual GDP growth rate in the last two years actions. Unless the Government adopts measures to address was 1.3 percentage points below the average for the the sources of the policy uncertainty, it is likely to linger in previous three years. This is in part because the easy gains 2007. The signing of the Japan-Thailand FTA (following from increased utilization of excess capacity were exhausted recent approval by National Legislative Assembly) will no and in part because investor and consumer confidence doubt contribute to improving investor perceptions, remains depressed. Exports grew by 8.5 percent (4.3 percent especially the Japanese. The approval of a modified FBA in 2005) while imports grew by only 1.6 percent (9 percent amendment, that not only rationalizes the law but also in 2005), contributing to most of the growth last year, as includes liberalization of some key services sub-sectors total domestic demand grew by only 1 percent. Inflation is critical to Thailand's development strategy, will also expected to fall by more than 2.5 percentage points this remove many of the misgivings of foreign investors. In year. GDP growth is forecast at 4.3 percent in 2007. addition, if the Government takes actions to reduce the regulatory burden ­ actions that were highlighted in the Growth in private investment was only 4 percent, NESDB-World Bank investment climate assessment ­ down from 11 percent in 2005, and is projected to be not investor confidence will improve. much better in 2007. Even this low growth was owed mainly to foreign investment expanding at a real rate of 25 Addressing the continuing pressures for real bhat percent in 2006 ­ continuing the momentum it has shown in appreciation in a manner that maintains market confidence the post-recovery period ­ as private domestic investment would also help to improve business sentiments. The current experienced negative growth. Domestic Thai investors, in account surplus is projected to continue in 2007 (1.3 percent both tradable and non-tradable sectors, have remained of GDP instead of 1.6 percent in 2006) together with falling skittish throughout the recovery period because of structural debt-service obligations. The Government will thus have to factors -- in part greater market uncertainty arising from signal the use of other measures to support agricultural and China's WTO accession and in part investment climate labor-intensive manufactures ­ exporters who employ a constraints like high regulatory burden, inadequate large share of labor force and remain most vulnerable to availability of right skills and a growing deficit in appreciation ­ in the transition period, to enhance market infrastructure that kept investors costs in Thailand high confidence. Measures targeted at those sub-sectors will relative to competitors. permit them to adjust gradually, either by enhancing productivity or by transferring employees to other sectors. Shorter-term factors have worsened investor In addition, increasing domestic demand to reduce the confidence, especially the perception of heightened policy current account surplus can lower the pace of real uncertainty resulting from recent changes. Higher oil prices appreciation (e.g. lowering nominal interest-rates; raising from 2004 onwards have imposed adjustment costs on public investment, etc). investors. The increased political uncertainty -- political disturbances in 2005, followed by coup in 2006 and The Government has taken several actions recently, impending transition in 2007 ­ is contributing to the wait- in respect of the energy and financial sector which needs to and-see attitude of investors. In the last four months be implemented. The recent energy sector reforms are investors' perception of greater policy uncertainty has been contributing to rationalization of that important sector. added to the above list, which is likely to affect private Similarly, the financial sector would benefit from the investment in 2007 adversely. This was due mainly to the impending approval of several Acts: the recent cabinet- December 2006 capital controls to stem the real bhat approved Central Bank Act, the Securities Exchange appreciation - even though most of these controls have now Commission Act and the Currency Act would have to be been relaxed -- and the January 2007 Cabinet approval of passed by the National Legislative Assembly and the amendments to the Foreign Business Act (viewed as making Deposit Insurance Act and the Secured Transactions Act foreign investment more restrictive than before). would have to be approved by both the cabinet and the assembly. This is expected to be followed by many of the East Asia Update 45 actions cited above, in order to strengthen investor and 12 billion dollars (11 weeks of next year's imports) consumer confidence. compared with 8.6 billion dollars at end-2005. The National Assembly ratified Vietnam's Vietnam accession to the WTO in November, 2006 and the country Two events dominated the economic landscape in was admitted in January 2007. In December, Vietnam was the last six months, namely Vietnam's accession to the also accorded permanent normal trading relations (PNTR) WTO and a dramatic boom in the stock market. Both or unconditional MFN by the US. Vietnam's tariff structure events pose policy challenges for the government in the will witness major changes. The average tariff will decline short- and medium-term, with the stock market already from a current level of 17.4 percent to an average final having attracted substantial short-term attention. GDP grew bound of 13.4 percent. Average agricultural tariffs are to by 8.2 percent in 2006 with industrial value added decline from 23.5 percent before accession to a final bound increasing by 9.8 percent and services 8.3 percent. Within of 21 percent while industrial tariffs will fall from 16.6 to the industrial sector, the turnover of the domestic private 12.6 percent. Tariff cuts are to be phased-in over periods sector expanded 23.9 percent while that of state-owned ranging from 3 to 12 years, with most occurring within five enterprises (SOEs) grew 9.1 percent. years. On the services side, Vietnam will grant full trading and wide ranging distribution rights to foreign firms; it will The retail sales index grew by 20.9 percent in 2006 allow 100 percent foreign owned banks; and will also about the same as 2005. Implemented investment, which is significantly open up telecommunication services. different from the national accounts measure, is estimated at nearly 41 percent of GDP, growing 22.4 percent over 2005 Fiscal revenues grew by 20 percent compared with in nominal terms. The investment share of the domestic 2005 and exceeded budgeted levels. Revenues from crude private sector has risen from 23 percent in 2001 to 34 oil exports were buoyed by high international prices. Tax percent in 2006. FDI commitments, boosted by imminent revenues from the private sector continue to rise, reaching WTO accession, surged to 10.2 billion dollars well above its 50 percent of non-oil revenues in 2006, up from 36 percent 2005 level of 6.2 billion and surpassing the peak level of 9 in 2001. On the expenditure side, minimum wage hikes billion in 1996. FDI commitments for 2007 have already have become an important contributor to the increase in reached 1.9 billion dollars. recurrent outlays in the last three years. Minimum wages for state employees have been raised by a cumulative 214 Inflation trended down through most of 2006 percent since January 2003, the latest increase in October reaching 6.6 percent in December, and 6.5 percent in 2006. The minimum wage hike is also a basis for the February 2007. The moderation in prices resulted from both adjustment of government pensions and other social security food and non-food components. The government has payments. The adjustments are designed to eliminate the announced its intention to move towards market based minimum wage gap between domestic and foreign invested pricing for petroleum products, steel, cement, coal, paper, sectors by 2010 as part of international commitments. The and fertilizer. For gasoline such price adjustments have budget deficit is estimated to have declined from 1.2 percent already become more market based. Electricity prices were of GDP in 2005 to 0.7 percent in 2006. On-lending of ODA raised by an average of 7.6 percent in January 2007, though receipts to project implementing enterprises or agencies is low income households were shielded. Looking ahead, price expected to have attained 1.2 percent of GDP in 2006. Other pressures remain, as evidenced by the recent rise in steel and items which contribute to public or publicly guaranteed cement prices. debt, but are not included in the definition of the budget Export growth in 2006 stood at 22.8 percent about deficit amounted to 2.8 percent of GDP in 2006. Including the same level as in the previous year. Exports of seafood, these items, public debt is estimated around 44 percent of garments, and footwear were particularly strong, the latter GDP at end-2006, a level considered to be within despite of an antidumping suit in the EU. Import growth manageable limits. picked up in 2006 largely due to capital goods, in particular Stock market capitalization surged from under 0.5 machinery and equipment for the Dung Quat oil refinery billion dollars in December 2005 to 13.8 billion (22.7 and industrial zone. The net result of these trends was a percent of GDP) by December 2006, and then to a current small trade surplus. With tourism and remittances remaining level of 24.4 billion. The number of listed firms rose from buoyant the current account is expected to have recorded a about 40 to nearly 200 at present. December alone surplus of 1 to1.5 percent of GDP. Inflows of FDI and witnessed more than 100 new listings as firms rushed to ODA were also robust. ODA inflows reached 1.8 billion avail of tax incentives to be withdrawn in 2007. The stock dollars while inflows of FDI, as recorded in the balance of price index shot up 144 percent in 2006 and has already payments, are estimated to have surpassed 2 billion dollars. seen an additional increase of 50 percent in the first two Portfolio inflows also picked up in line with investment months of 2007. The market is set to expand further with opportunities being offered by the growing domestic capital 20 large state owned enterprises scheduled to list in 2007. market. As a result foreign exchange reserves have seen a The boom has inevitably led to concerns that stocks are rapid rise: by end-December reserves had increased to over being overvalued by inexperienced investors. The median price-earnings ratio stood at 21 in early 2007, with about a East Asia Update 46 quarter of the firms over 30. It is estimated that foreign unpredictable. The new oil sector will also pose challenges stock holding is of the order of 4 billion dollars. The for macroeconomic and fiscal management. authorities have for now put to rest rumors that capital controls would be imposed in a bid to slow down foreign External developments were also positive. Despite inflows or outflows. However measures have been pressure from high world oil prices, the current account announced to enhance disclosure by companies, clamp deficit (excluding transfers) declined to -7.7 percent in 2006 down on insider trading, and to limit bank lending against (from -9.6 percent in 2005) and gross international reserves stocks. expanded by 20 percent to US$ 1.1 billion. FDI continued its upward trend reaching a record high of US$ 475 million. Credit growth slowed from around 32 percent at Consumer price inflation declined to 2.8 percent (from 6.7 end 2005 to 21 percent by mid-2006, but ticked-up percent in 2005), due to an easing of oil prices and a somewhat to 25 percent by November 2006. The slower growth in 2006 was mainly attributable to more cautious significant drop in food and clothing prices. The consumer lending by state owned banks as they adhered to stricter price index is expected to remain low (below 5 percent) for prudential standards. Lending from joint stock banks 2007 and the riel (local currency) to remain stable both in (JSBs) on the other hand grew by nearly 40 percent. Base terms of dollars and partner country currencies. money growth in 2006 was driven almost entirely by The fiscal front saw some improvement in 2006. foreign inflows which were incompletely sterilized by the Tax revenue grew modestly from 7.6 percent of GDP in SBV. On the policy front, a new regulation stipulates that 2005 to an estimated 8.0 percent in 2006. Non-tax revenue all joint stock, joint venture and foreign invested banks need remained constant at 2.3 percent of GDP. Expenditure is to have a chartered capital of 1 trillion dong by 2008 and 3 estimated to have fallen slightly to 13.1 percent of GDP in trillion dong by 2010. For SOCBs a minimum chartered 2006 (down from 13.6 percent of GDP in 2005) but greater capital of 3 trillion dong is required by 2008. After nearly emphasis continued to be put on the social sectors with a 15 months since the PM's decision to equitize Vietcombank and Mekong Housing Bank, the consultants to advise on the significant increase in nominal spending, though total process have been hired. Under current plans the banks will capital spending declined in real terms. In the medium term, conduct initial public offerings in the fourth quarter of 2007. the overall budget balance is anticipated to be stable at around -3.7 percent of GDP (excluding grants). Smaller Economies Similarly, the financial sector saw some improvement in 2006. Combined deposits (in riel and Cambodia foreign currency) of banks rose by 43 percent and the lending-to-deposit ratio has continued to trend upward, Cambodia's robust economic performance reaching 68 percent in 2006 (from 64 percent in 2005), continued in 2006. Real GDP growth is estimated at about reflecting growing business activities in 2006 (business 10.5 percent, a third consecutive year of double-digit registration grew by nearly 50 percent over 2005, for growth. Growth continues to be underpinned by garment example). There are now 20 banks operating in Cambodia, exports, tourism, construction, and agricultural expansion. up from 18 in 2005. Cambodia, however, remains a highly- The garment sector, which employs 10 percent of the labor dollarized economy with nearly 75 percent of broad money force and which accounts for 14 percent of GDP, expanded (M2) and 97 percent of banking deposits in US dollars. The further, with exports rising by 20 percent in 2006. At the commercial interest rate is still high at around 16 percent same time 20 percent growth in tourist arrivals resulted in a per annum. 26 percent jump in tourism receipts. Agriculture continued to expand (4.4 percent) while construction slowed slightly. On the structural reform agenda, the Government's Public Financial Management Reform Program continues to International and domestic conditions bode well for yield results. Following achievements in 2005 and 2006, a economic prospects in 2007. The four growth pillars-- second wave of reforms started in January 2007, including: garments, tourism, construction, and agriculture--are a streamlining of budget execution procedures to speed expected to continue to thrive in 2007 with real GDP growth disbursements to spending agencies, the introduction of projected at about 9.0 percent and expected to remain strong program budgeting to better align spending with priority in the medium term. Growing FDI and the discovery of National Strategic Development Plan objectives, and offshore oil and gas reserves will likely bring about even adoption of a new chart of accounts to improve expenditure higher growth (production is expected to start in 2009 or reporting. These measures should improve the efficiency of 2010). However, the garments sector is now facing stiffer the PFM system as well as reduce fiduciary risk by reducing competition from Vietnam's accession to the WTO and the the threat of corruption. From January 2007 import tariff possibility of greater competition from China in 2008. rates have been reduced to reflect the ASEAN Harmonized Agricultural growth in Cambodia has been particularly System and the World Customs Organization Protocol volatile in recent years, and is therefore somewhat Requirement. Though much remains to be done, banking reform has also shown progress. The Financial Sector East Asia Update 47 Development Strategy (FSDS) 2006-2015 will focus on a gold production contracted by 50 percent and 1800 job number of key challenges in the medium term, including losses are expected as a result. Sugar production in 2006 improving financial institution operations, increasing registered growth of 2 percent. In light of recent political intermediation, and strengthening the links between banking developments, the European Union is however re-evaluating and microfinance. the nature of its F$350 million (US$208 million) adjustment support to the sugar industry. Inflation of about 3 percent Despite progress in many areas, Cambodia still has been well contained through tight monetary policy. faces difficult challenges in light of the Millennium Development Goals. The challenges include a high rural The fiscal deficit narrowed slightly to just below 4 poverty rate, achieving high survival rates at all levels of the percent of GDP in 2006, as targeted. The revised 2007 educational system, and improving access to quality health Budget, presented by the interim administration in early services, especially in terms of child and maternal health. March, aims to reduce the fiscal deficit below 2 percent of However, a recently released demographic and health GDP in 2007 (as was the target of the original 2007 Budget). The main measures to reduce public expenditure survey shows some progress. The infant mortality rate (per include a 5 percent civil service wage cut as well as 1,000 live births) fell from 95 in 2000 to 66 in 2005 and reductions in capital expenditure, operating grants and child (under 5) mortality (per 1,000 live births) decreased transfers, and grants to the Fiji Visitors' Bureau. The VAT from 124 in 2000 to 83 in 2005. HIV prevalence also rate is maintained at its current level of 12.5 percent while appeared to have fallen remarkably. The notable lagging customs tariff have been raised. indicator is the maternal mortality rate, which likely remains unchanged over the past five years. The revised budget aims to reduce the public debt level from 53 percent of GDP in 2006 to 45 percent of GDP Fiji in the medium-term, with most debt sourced domestically. Public external debt and debt service were below 5 percent A bloodless military coup ousted the elected Prime of GDP and 2 percent of exports in 2006, respectively. Minister and cabinet on December 5, 2006. A month later, However, interest payments on a US$150 million Fiji's military commander who led the coup, was sworn-in international bond issue in September 2006--expected to as interim PM and has since installed a 16 member interim mature in 2011--will increase debt servicing requirements. cabinet. The main priorities of the interim government include reforming the electoral process before holding the The current account deficit widened through the next general elections and establishing an anti-corruption year to November 2006. Merchandise exports (excluding unit to investigate alleged corrupt practices. In mid- mineral fuel re-exports) fell by 3 percent mainly due to February, the interim PM announced a `roadmap' to lower earnings from sugar, while imports climbed by 17 democracy which could see the return to democratic rule in percent owing to stronger consumption demand and higher 2010. The roadmap includes plans for a review of Fiji's cost of oil. This led to a downward slide in foreign exchange 1997 Constitution and an examination of electoral reserves, now estimated to stand at US$457 million boundaries which will include a population census. (equivalent to just over 3 months of imports) at end-January 2007. These events have drawn condemnation from A tight monetary stance is being maintained, with several countries, some of whom have imposed sanctions on measures including interest rates hikes, credit ceilings on Fiji, such as suspension of part of their aid, and travel bans individual banks, exchange controls mainly on current on the interim government officials. The Council of the account transactions, and the repatriation of the National Commonwealth suspended Fiji's membership, and the U.S. Provident Fund's foreign assets. Overall, these measures withdrew its support for the Fijian military's participation in appear to have safeguarded the reserves from further new peace operations (although Fijian troops currently in erosion. Iraq are not affected). The interim government's 3-year roadmap has also been criticized with calls for speedier Lao PDR progress in restoring democracy. Lao PDR continues to enjoy rapid economic Vigorous expansion in the services sectors, growth and impressive poverty reduction. Growth increased especially construction, led to a doubling of real GDP to 7.0 percent in 2005, up from 6.4 percent in 2004, and is growth to 3.4 percent in 2006, notwithstanding a downturn estimated at about 7.5 percent in 2006. It is expected to in tourism and gold production that occurred later in the remain at above 7 percent in the next few years - 7.1 percent year. The tourist sector, Fiji's main foreign exchange earner, for 2007 and 9.0 percent for 2008. Growth is being driven was adversely affected by the coup and the extended period by FDI inflows in mining and hydro-power, by agriculture of uncertainty that preceded it. Tourist visitor arrivals fell and processing industries as well as growing mineral from 576,000 in 2005 to 545,000 in 2006. The closure of exports. Non-hydro/mining sectors (agriculture, the Emperor Gold Mining Company's mining operations in manufacturing and services/tourism) are expected to sustain early December 2006 occurred for commercial reasons-- growth and pick-up pace, due to rising FDI in those sectors. East Asia Update 48 The share of agriculture in GDP has been falling and is Table Meeting between the government and its development expected to drop further from 45 percent in 2005 to about 38 partners on November 28-29, it was decided that the Plan percent by 2008 while the contribution of industry should will be submitted as a Poverty Reduction Strategy (PRS). jump from 30 percent to 37 percent, with most of the growth Progress has been good on the Public Financial coming from the power and mining sectors. Consumer price Management reform agenda, with the Budget law drafted inflation continued to decline in 2006, falling to 6.8 percent ahead of schedule. The Public Financial Management on average (4.7 percent in December 2006) compared to 7.2 Strengthening Program (PEMSP) is gaining momentum. percent in 2005. It is expected to drop to around 4 percent Efforts to improve public financial management are in 2007 and 2008. occurring on time before the point when revenues from the Macroeconomic conditions remain relatively Nam Theun 2 project start coming on stream, in 2009/10. stable, reflecting improved monetary and fiscal discipline, The Government is also trying to strengthen oversight of the with inflation in single digits for the last a few years, and State Owned Enterprises (SOEs). Good progress has also public expenditures under control. Budget revenues rose been achieved on private sector and trade reform. The new from 11.4 to 12.1 percent of GDP (FY2005/06), well above Enterprise Law has been approved but awaits the issuing of the original target of 11.4 percent. The budget deficit shrunk implementing decrees. Lao PDR is working on WTO sharply, from 3.3 percent of GDP in FY2004/05 to 1.2 accession. The legislative action plan has been prepared percent in FY2005/06 ­ especially due to capital and initial offers on goods and services are being discussed expenditures below allocations. In FY2006/07, revenue is in Geneva. Progress continues on commitments to reduce expected to increase to about 12.4 percent of GDP with the tariffs under AFTA and to introduce single window under budget deficit at about 2 percent of GDP. The challenge for ASEAN. At the Round Table Meeting, the Government Lao PDR is to sustain this good revenue and fiscal presented a comprehensive strategy for private sector performance in the future. The government has also development and trade focusing on improving the continued to maintain a tight monetary policy stance and exchange rate stability in recent years. Reserves increased investment climate and including reduction in cumbersome above the 3 months of imports mark in 2006 and should stay regulations and procedures at and behind the border. at that level in the coming years because of expected Reform of state-owned banks has been slow, but increases in mining exports, tourism receipts, and FDI there are new initiatives that will contribute to leveling the inflows. However, the imports associated with large playing field in the banking sector. The SOE sector is projects continue to push up the external current account borrowing less from banks and receiving lower subsidies deficit as a percent of GDP. from the government, while large SOEs are undergoing Lao PDR's external public debt burden remains restructuring and adjustment in output prices. But the high, but the debt service burden should be manageable restructuring of state-owned commercial banks is not going with a prudent borrowing strategy. According to the latest well. The urgent priorities are to implement the modified joint Bank-Fund staff Debt Sustainability Analysis (DSA), Governance Agreements and make better use of the at end-2004, Lao PDR's stock of public and publicly International Banking Advisors, strengthen the oversight guaranteed external debt amounted to USD 2.1 billion in and supervision of banks and reduce NPLs. There is also nominal terms and USD 1.36 billion in net present value need to obtain private strategic partners. The government (NPV) terms. This was equivalent to about 83 percent of has already received several offers from international GDP, or 55 percent of GDP in NPV terms (with indicative investors. There is also a need to `level the playing field' for threshold of 30). The NPV of external debt comprised 199 all state-owned and private banks, but progress on this percent of exports (with indicative threshold of 100) and account has been slow. The government has prepared the 495 percent of fiscal revenues (with indicative threshold of new Financial Institutions Law which seeks to level the 200). All three debt indicators exceed the indicative playing field for all banks. sustainability thresholds for countries with comparable CPIA ratings, placing Lao PDR in IDA's "high risk of debt Some risks remain at the macro level: mainly fiscal distress" category. A prudent debt strategy would consist of pressures and upcoming boom in large projects. . It will be a borrowing on only concessional terms, supported by continuous challenge to sustain and improve revenue continuation of structural reforms, including SOE, banking performance. New exemptions introduced on imports of and public financial management reform, together with petroleum products will tend to erode the revenue base. stronger revenue collection and better prioritization of There is a need to widen the non-resource revenue base. public expenditures. There are also pressures to raise wages, albeit from a The Government disseminated the final draft of the relatively low base. Another potential risk is the upcoming 6th National Socio-Economic Development Plan. The Plan boom in mining and hydro-power investment which may presents a candid assessment of progress on structural bring some standard risks such as Dutch disease. In reform in the last five years, and lays out the strategy for the addition, the GOL is taking equity stakes in all new next five years based on lessons learnt. After the Round hydropower projects, in addition to royalties and taxation. Given the limited public resources available and the speed East Asia Update 49 of expansion in this sector, such policy may eventually has appreciated slightly against the US dollar (increasing by undermine Lao PDR's debt sustainability as well as 4.5 in 2006 to reach Tg1,164 per US$). financial sustainability of the state electricity company A fiscal surplus was recorded in 2006 for the (EDL, Electricité du Laos) through which these stakes are second consecutive year, reaching 9 percent of GDP. taken. The accumulation of arrears to utility companies General revenue and expenditure amounted respectively to should be kept under control. The government should 42.7 percent and 38.7 percent of GDP in 2006. The main consider using increased revenues to cover these factors contributing to this surplus were the exceptionally obligations. high level of copper and gold prices leading to an increase in foreign trade tax collection and dividend earnings, the Mongolia introduction of the windfall tax which in the short term lead In 2006 Mongolia's GDP grew by 8.4 percent in to increased revenue, an overall increase in tax collection real terms, of which 2.0 percentage points were contributed due to a higher level of economic activity, as well as by agriculture, another 2.0 points by industry and the improved budget expenditure control and strengthened remaining 4.4 percentage points from services, bringing government financial management. Overall budget Mongolia's GDP per capita up to $1,037 at the end of the expenditure increased by 37 percent in 2006. Main year. Good weather conditions benefited Mongolia's contributing factors were a 30 percent wage increase since livestock sector as well as agricultural production. As a February 1, 2006 and the extension of welfare transfers. result, livestock, which accounts for 21.7 percent of Following the adoption of anticorruption Mongolia's GDP, grew by 14.4 percent and crop production legislation, an anticorruption agency was established early increased by 63.4 percent in 2006. The mining sector 2007 and should gradually begin operations in the course of continues to benefit from high international gold and copper the year. The agency is responsible for corruption prices, which have led to new mine exploitation and prevention and public education, investigation of corruption increased production. Real growth in this sector reached 2.7 cases as well as the collection, review and disclosure of percent due in particular to a newly operating zinc mine as financial statements for high-ranked public officials. well as copper and gold extraction. The partnership agreement with the EU and the recovery of domestic food In 2006, 4 large state-owned enterprises were and cashmere industries contributed to a rise in privatized and bought by foreign investors: the Gobi manufacturing production. Trading sector real growth is cashmere factory, the State Circus and Saving Bank. The estimated at 6.9 percent in 2006, benefiting in particular largest commercial bank "TDB" changed ownership to a from strong real growth in hotel and restaurant services (30 domestic investors' group. percent percent) related to increased activity in tourism accompanying the 800 year Chinggis Khan Empire Papua New Guinea anniversary, and in telecommunications (14 percent) Papua New Guinea has experienced four following the entry of a new cell phone operator. consecutive years of moderate expansion, with real GDP Annual inflation reached 6 percent at the end of growth rising to an estimated 3.7 percent in 2006. Inflation 2006, down from 9.5 percent in 2005. Contributing factors and interest rates on government securities remain modest, to this moderate rate were a sustained meat supply, a stable employment increased significantly in 2006, government exchange rate leading to a moderate increase in the price of debt has fallen sharply as a share of GDP, and foreign imported goods and a decrease in communication prices by reserves have grown to more comfortable levels. High 13.4 percent. Compared to 2005, money supply (M2) world prices for key export commodities (oil, copper and increased by 34.8 percent, due to increased export revenue gold) have clearly helped economic performance, and and official and non official foreign inflows. Credit to contributed to significant fiscal and external current account private sector grew by 44.8 percent in 2006. Local currency surpluses in 2006. But prudent fiscal management has also commercial interest rate on loan declined to 24.5 percent in played an important role. The forthcoming elections in July December 2006 from 28.3 percent in 2005. 2007 will mark the first time in Papua New Guinea's history that the Government will have remained in office for its full Given the favorable conditions in the livestock and term. At the same time, poverty remains high, human mining sectors, total Mongolian exports increased by 43.6 development indicators weak, the quality of education and percent in 2006 while imports increased by 25.7 percent, health care delivery poor, and the incidence of HIV/AIDS leading to a trade surplus of $39.6 million or 1.4 percent of has increased sharply. GDP. This, combined with sustained remittances from overseas Mongolian workers as well as official transfers, led Growth of over 4 percent is forecast for 2007, to a current account surplus of $145 million at the end of reflecting an expansion in mineral production as new mines 2006. With sustained capital inflows, including private are opened, and a more expansionary fiscal stance. The non- investment and official capital inflows, net international mineral sector is expected to continue to grow by about 4 reserves increased by 130.6 percent (reaching $ 687mln) in percent. Employment rose sharply across most sectors in 2006. As a result, Mongolia's freely floating exchange rate 2006 with employment in non-mining and mining sectors up East Asia Update 50 by 8 and 6 percent, respectively--though urban Economic growth of about 5 percent in both 2005 unemployment remains very high. and 2006 has been aided by increased production of palm A budget surplus of 6.4 percent of GDP in 2006 is oil, higher (but unsustainable) rates of logging as well as attributable to increased mineral tax receipts and lower than expansion in the services sector, especially construction. budgeted development spending due in part to delayed The presence of RAMSI has also boosted demand for goods supplementary budgets. A smaller fiscal surplus is and services. Inflation of about 8 percent in 2006 reflected projected for 2007 owing to a decline in projected mineral robust growth in private credit and strong demand from the tax revenue and higher spending in the lead-up to the expatriate community. general elections. To maintain fiscal discipline, the 2006-07 A current account deficit of 16 percent of GDP in budgets allocate spending away from current expenditure to 2006 resulted from high oil prices and an increase in non-oil one-off development expenditure mostly in infrastructure imports used in investment projects. Foreign reserves stood and human capital. Restrained fiscal policy in recent at US$98 million at end-2006, equivalent to just over 5 years--spending/GDP declined even as revenue/GDP has months of import cover. While the current account deficit is grown--has facilitated a significant reduction of central expected to remain high in 2007, gross reserves are not government gross debt from over 60 percent of GDP in expected to be adversely impacted, given increased FDI 2003 to below 40 percent in 2006. linked to the palm oil and gold mine projects, as well as Average inflation increased somewhat in 2006 to continued strong official development assistance. 3.5 percent and may do so again in 2007 as higher A 25 percent increase in government revenue, government spending places upward pressure on prices. But aided by improved tax compliance and a growing economy, it will likely remain within the Central Bank's medium-term resulted in a budget surplus of 0.6 percent of GDP in 2006. inflation target range of 2.5 to 4.5 percent. Private credit However, further efforts will likely be needed to maintain growth remains strong while Treasury bill yields have fiscal discipline in the medium term. Fiscal risks include declined slightly to the 3-4 percent range as issuance of the impact of recent large public service wage increases, Treasury bills ceased after May, in light of the continuing declining logging tax receipts, lower import duties and aid cash surplus. flows, recurrent expenditure needs, the fragile financial The current account surplus nearly doubled as a situation of state-owned enterprises and provincial share of GDP to about 7½ percent in 2006, benefiting from governments and the potential impact of future fiscal high commodity prices, but also reflecting strong growth of decentralization. non-mineral exports. The kina remained broadly stable in Total public debt fell from 80 percent of GDP in 2006, appreciating by about 3 percent against the U.S. 2005 to 70 percent in 2006, while external debt declined dollar. International reserves rose by about 90 percent in from 54 to 50 percent of GDP in the same period. Factors 2006 to nearly US$1.5 billion, and amounted to over 8 contributing to the reduction in debt include some debt relief months of mineral imports (and nearly 4 months of total received through the Honiara Club negotiations, and the imports). agreement with the Central Bank of Solomon Islands to settle interest arrears and outstanding advances. Debt levels While the macroeconomic outlook remains favorable, are still high, however, as is the risk of debt distress. uncertainty has increased as a result of the looming general elections and the relatively frequent recent cabinet changes. Timor Leste The A$8 billion (K20 billion) PNG-Australia gas pipeline project, which was due to begin construction in late 2006, Timor-Leste slid into crisis in April 2006, after has been called off following a commercial reassessment by over 40 percent of the army went on strike to protest alleged foreign partners. discrimination, after which they were dismissed by the Government. The ensuing violence was centered in Dili and Solomon Islands left about 160,000 internally displaced, 35 dead and over 2,000 houses burnt. The violence exposed tensions within The formation of the new four-party Coalition for the military, between military and police, and between Change Government in May 2006 quelled the violent civil eastern and western parts of the country, and the country unrest that occurred in April 2006, following national was forced to call upon international forces to restore order. elections and announcement of the initial choice of Prime While the conflict subsided after the arrival of foreign Minister by the newly elected Parliament. The political troops, security conditions remain fragile and incidents of situation however, remains fluid. Concurrently, a series of violence, often gang related, have continued. diplomatic rows between the Solomon Island and Australian governments has raised the possibility that this may The security crisis led to a political crisis, forcing constrain the Australian-led Regional Assistance Mission to the resignation of former Prime Minister Alkatiri in mid- Solomon Islands (RAMSI) operation in the country. 2006, his replacement in July by former foreign minister Ramos-Horta, and the house-arrest of the former interior minister on charges of distributing arms. UN supervised East Asia Update 51 Presidential elections are scheduled for April 9, 2007, with have exacerbated the intensity of the recent conflict. A parliamentary elections to follow in June-July 2007. critical challenge therefore is to improve budget execution Amidst a fragile political environment, concerns of possible so that spending priorities can be better realized. violence during or after the elections however remain. There are still an estimated 30,000 people The fiscal and current account balances in 2006 displaced in camps in Dili. Government and international each recorded surpluses of over 100 percent of non-oil agencies are continuing to provide humanitarian assistance, GDP, and are projected to increase during 2007/08 but many of the displaced are fearful of going back to their reflecting large and growing revenue and royalties from homes amidst concerns of insecurity. offshore oil and gas fields. The FY2006/07 Budget provides for higher government spending, particularly for emergency The economy in 2006 was set back by the unrest assistance, wage bonuses for civil servants, and an increased with the closure of some government departments and subsidy to the state-owned electricity company (offsetting a disruption in private sector activity. Coffee production, the reduction in electricity prices). Capital spending, main non-oil export commodity, fell by about 20 percent, particularly for infrastructure projects, is budgeted to more although the offshore oil and gas sector was undisturbed. than triple, but actual spending is again expected to be well Real non-oil GDP is estimated to have declined by nearly 2 below budget reflecting the aforementioned constraints. percent in 2006, notwithstanding a year-end boost from Deposits accumulated in the Petroleum Fund had reached $1 higher public spending and international aid. CPI inflation billion by February 2007. spiked to nearly 7 percent by end-2006, reflecting supply disruptions and higher transportation costs. With the The country faces the challenge of rebuilding trust buildup of the new UN mission and higher government and addressing the security situation and the rule of law. spending, non-oil GDP growth is expected to increase in Adequate response to basic humanitarian needs and 2007. development requirements is also vital. In parallel, there is a need to jump-start the economy and respond to basic The implementation of Government's investment humanitarian needs and development requirements. Strong program has been hampered by delays in capital budget governance over the rapidly accumulating Petroleum Fund execution due to weak capacity. Private investment and job will need to be maintained, as will reforms to spur non-oil creation have also been weak. Unemployment in Dili, private sector activity. where about a quarter of the formal labor force resides, was estimated at 27 percent, and with 53 percent of the population under age 17, urban youth unemployment of 40 percent (aged 15-24) is a particular problem that appears to East Asia Update 52 APPENDIX TABLES Appendix Table 1. Quarterly Real GDP Growth - % Change Year Ago China Hong Indonesia Korea Malaysia Philippines Singapore Taiwan Thailand East Asia Kong (China) Q1 2001 9.1 2.4 3.9 3.5 2.9 1.3 4.6 0.6 1.7 5.5 Q2 2001 8.7 1.6 5.8 3.7 0.2 2.0 -0.7 -3.1 2.2 4.8 Q3 2001 8.1 -0.3 3.4 3.4 -1.2 1.4 -6.6 -4.6 2.1 3.8 Q4 2001 7.6 -1.0 1.6 4.6 -0.5 2.3 -6.2 -1.5 2.7 4.1 Q1 2002 8.8 -1.0 3.5 6.5 1.3 4.2 -0.5 1.3 4.5 5.8 Q2 2002 9.2 0.4 4.2 7.0 4.2 4.6 4.9 4.2 5.0 6.8 Q3 2002 9.3 2.9 5.6 6.8 6.0 3.3 6.5 6.1 5.8 7.3 Q4 2002 9.1 4.8 4.7 7.5 5.8 5.5 5.9 5.3 6.0 7.4 Q1 2003 10.8 4.4 4.9 3.8 5.0 4.8 3.1 3.4 6.9 7.2 Q2 2003 8.4 -0.7 5.0 2.2 4.7 4.3 -2.2 0.1 6.6 5.1 Q3 2003 10.1 4.0 4.6 2.3 5.3 5.4 3.7 4.2 6.7 6.7 Q4 2003 10.4 4.8 4.6 4.1 6.8 5.1 7.8 5.9 8.3 7.6 Q1 2004 9.8 8.1 4.1 5.4 7.9 6.5 8.8 7.6 6.7 8.0 Q2 2004 9.6 12.4 4.4 5.7 8.5 6.9 12.5 9.0 6.6 8.5 Q3 2004 9.2 6.7 4.5 4.7 6.8 6.0 7.4 5.5 6.2 7.2 Q4 2004 9.5 7.6 7.2 3.3 5.9 5.5 6.9 2.5 5.7 6.9 Q1 2005 10.5 6.3 6.1 2.9 6.1 4.2 3.7 2.5 3.5 7.1 Q2 2005 10.5 7.5 5.9 3.4 4.1 5.4 6.1 2.9 4.7 7.3 Q3 2005 10.2 8.4 5.8 4.8 5.3 4.8 8.2 4.2 5.5 7.7 Q4 2005 10.4 7.8 5.0 5.5 5.2 5.3 8.3 6.4 4.3 8.0 Q1 2006 10.4 8.0 5.0 6.3 5.9 5.7 10.1 4.9 6.1 8.2 Q2 2006 11.5 5.5 5.0 5.1 6.2 5.8 8.0 4.6 5.0 8.3 Q3 2006 10.6 6.7 5.9 4.8 5.8 5.3 7.0 5.0 4.7 7.9 Q4 2006 10.4 7.0 6.1 4.0 5.7 4.8 6.6 4.0 4.2 7.6 Source: Haver Analytics and national sources. Quarterly data for China is estimated using new annual production side GDPdata. Appendix Table 2: East Asia: Merchandise Export Growth (US $; % change form a year ago) Q4 Q1 Q2 Q3 Q4 Oct- Nov- Dec- Jan- Feb- 2005 2006 2005 2006 2006 2006 2006 06 06 06 07 07 East Asia (9) 18.0 19.8 17.0 19.8 19.4 21.6 18.4 16.0 23.0 16.4 SE Asia 13.2 16.2 11.2 14.9 16.8 17.7 15.2 9.1 23.3 13.7 Indonesia 19.7 17.7 13.9 12.9 17.2 20.7 18.2 9.6 29.5 18.3 10.5 Malaysia 11.4 14.0 13.3 13.7 14.2 17.1 11.2 -0.8 22.9 13.0 16.5 Philippines 4.0 13.9 3.5 13.4 19.5 15.9 7.4 15.5 10.7 -3.6 21.8 Thailand 14.5 18.8 9.5 18.6 18.9 16.8 21.0 19.9 24.0 19.0 China 28.4 27.2 21.7 26.6 24.0 28.7 28.9 29.5 32.7 24.8 33.0 51.7 NIEs 12.7 15.5 15.7 17.0 16.7 17.5 11.3 8.5 15.0 10.3 16.9 5.3 Hong Kong 11.6 9.4 10.4 12.8 5.6 8.2 11.5 7.5 13.8 13.4 8.5 10.8 Korea 12.0 14.6 11.4 10.5 16.9 16.4 14.4 10.7 18.7 13.8 20.9 11.3 Singapore 18.8 27.4 31.0 36.7 35.3 32.1 10.5 10.1 17.9 4.3 22.2 -0.6 Taiwan (China) 8.8 12.5 14.2 11.8 13.7 18.0 7.2 5.2 8.0 8.4 17.3 -3.8 East Asia Update 53 Appendix Table 3. East Asia and the Pacific: GDP Growth Projections Estimate Forecast Forecast 2000 2001 2002 2003 2004 2005 2006 2007 2008 East Asia 7.8 4.6 6.9 6.8 8.0 7.6 8.1 7.3 7.1 Developing East Asia 7.7 6.7 7.9 8.9 9.1 9.0 9.5 8.7 8.1 South East Asia 6.0 2.4 4.6 5.6 6.0 5.1 5.4 5.5 5.7 Indonesia 5.4 3.8 4.4 4.7 5.1 5.7 5.5 6.3 6.5 Malaysia 8.9 0.3 4.4 5.5 7.2 5.2 5.9 5.6 5.8 Philippines 6.0 1.8 4.3 5.0 6.2 5.0 5.4 5.6 6.0 Thailand 4.8 2.2 5.3 7.1 6.3 4.5 5.0 4.3 4.5 Transition China 8.4 8.3 9.1 10.0 10.1 10.2 10.7 9.6 8.7 Vietnam 6.8 6.9 7.1 7.3 7.7 8.5 8.2 8.0 8.0 Small Economies 3.2 3.9 3.6 5.1 6.6 7.8 7.2 6.0 5.8 Cambodia 8.4 7.7 6.2 8.6 10.0 13.4 10.5 9.0 6.8 Timor-Leste 15.4 16.6 -6.7 -6.2 0.3 2.3 -1.6 5.0 3.5 Lao PDR 5.8 5.8 5.9 6.1 6.4 7.0 7.5 7.1 9.0 Mongolia 1.1 1.0 4.0 5.6 10.7 6.2 8.4 7.0 7.0 Fiji -1.7 2.0 3.2 1.0 5.3 0.7 3.4 -2.5 2.0 Kiribati 1.9 1.8 -4.3 2.3 -1.4 0.3 0.8 0.8 .. Marshall Islands 0.9 5.5 4.0 1.8 0.4 3.5 4.0 3.5 3.0 Micronesia, Fed. Sts. 8.4 0.3 1.1 5.1 -3.8 0.3 1.0 1.0 .. Palau 0.3 1.3 -3.5 -1.3 4.9 5.5 5.7 5.5 4.8 Papua New Guinea -1.2 -0.1 -0.2 2.2 2.7 3.3 3.7 4.3 3.7 Samoa 7.0 7.1 4.4 1.6 3.2 5.4 2.3 3.1 3.5 Solomon Islands -14.3 -9.0 -1.6 6.4 8.0 5.0 5.3 6.2 3.3 Tonga 5.2 1.8 3.0 3.2 1.4 2.3 1.9 0.6 1.6 Vanuatu 2.7 -2.7 -4.9 2.4 5.0 6.1 3.0 2.4 2.4 East Asia NIEs 8.0 1.1 5.2 3.2 6.0 4.8 5.4 4.6 5.0 Hong Kong (SAR) 10.0 0.6 1.8 3.2 8.6 7.5 6.8 5.3 5.1 Korea 8.5 3.8 7.0 3.1 4.7 4.0 5.0 4.5 5.0 Singapore 10.1 -2.4 4.2 3.1 8.8 6.6 7.9 5.5 5.6 Taiwan (China) 5.8 -2.2 4.2 3.4 6.1 4.0 4.6 4.1 4.6 Japan 2.8 0.2 0.1 1.8 2.7 2.6 2.2 2.3 2.4 Source: World Bank data and staff estimates. East Asia is the sum of Developing East Asia and the Newly Industrialized Economies. East Asia Update 54 Appendix Table 4: Primary Commodity Prices (US Dollars - % change from a year ago) Actual Projections 1980- 1991- Commodity 90 98 2000 2001 2002 2003 2004 2005 2006 2007 2008 Crude oil average 0.0 -5.7 56.2 -13.7 2.4 15.9 30.6 41.5 70.4 -12.2 -3.6 Non-Energy Commodities -0.8 0.4 -1.4 -9.1 5.3 10.2 17.5 13.4 0.0 24.6 -1.0 Agriculture -1.9 0.8 -5.7 -9.1 8.6 9.6 10.5 7.9 24.6 12.0 0.0 Cocoa -7.3 4.0 -20.2 18.0 66.4 -1.5 -11.5 -0.8 2.7 0.5 -0.8 Coffee, arabica -3.6 12.6 -16.2 -28.5 -1.2 4.3 25.3 42.7 42.2 0.3 -1.7 Coconut oil -1.4 10.6 -38.9 -29.4 32.4 11.0 41.4 -6.6 -8.1 15.3 -1.9 Palm oil -3.0 12.3 -28.8 -7.9 36.6 13.6 6.3 -10.4 1.5 12.9 -2.3 Rice, Thai, 5% 0.8 2.1 -18.5 -14.6 11.0 3.0 20.3 20.4 28.3 5.0 -3.1 Sugar, world 16.4 -2.8 30.6 5.6 -20.3 3.0 1.1 37.8 106.3 -21.7 -2.0 Logs, Malaysia 1.9 3.4 1.5 -16.3 2.7 14.5 5.4 3.0 21.4 14.9 5.5 Sawnwood, Malaysia 4.1 -0.1 -1.0 -19.1 9.4 4.6 5.5 13.2 28.9 11.4 5.4 Rubber, RSS1, Singapore -1.7 0.5 6.2 -13.8 33.0 41.5 20.4 15.2 61.6 -14.6 -3.1 Metals and minerals 2.9 -2.6 12.6 -9.6 -3.1 12.7 37.1 26.7 0.0 50.9 -2.3 Tin -6.7 -0.7 0.6 -17.5 -9.5 20.5 73.9 -13.3 3.1 13.9 -15.0 Copper 4.3 -4.1 15.3 -13.0 -1.2 14.1 61.1 28.4 134.6 -10.7 -25.0 Source: World Bank DEC Prospects Group. East Asia Update 55 Appendix Table 5: East Asia: Exchange Rates (LCU/$) Taiwan, China Indonesia Korea Malaysia Philippines Singapore China Thailand Yen Apr-2006 8.02 8775.00 945.70 3.63 51.83 1.58 31.91 37.52 114.30 May-2006 8.02 9220.00 947.40 3.63 52.65 1.58 32.02 38.13 112.24 Jun-2006 8.00 9300.00 960.30 3.68 53.59 1.59 32.40 38.22 114.95 Jul-2006 7.97 9070.00 953.10 3.65 51.62 1.58 32.76 37.85 114.80 Aug-2006 7.96 9100.00 959.60 3.68 50.94 1.57 32.91 37.58 117.32 Sep-2006 7.91 9235.00 945.20 3.68 50.39 1.59 33.10 37.54 117.80 Oct-2006 7.88 9110.00 944.20 3.65 49.81 1.56 33.26 36.75 117.65 Nov-2006 7.84 9165.00 929.90 3.62 49.76 1.54 32.43 36.02 116.40 Dec-2006 7.81 9020.00 929.60 3.53 49.13 1.53 32.60 36.04 118.95 Jan-2007 7.78 9090.00 940.90 3.50 49.03 1.54 32.95 35.80 121.68 Feb-2007 7.74 9160.00 938.30 3.51 48.29 1.53 32.95 35.45 118.54 Mar 28- 2007 7.73 9150.00 940.78 3.46 48.12 1.52 44.30 32.11 116.92 Appendix Table 6: East Asia: Foreign Reserves Minus Gold (US$ Billion) Hong Kong Taiwan, China Indonesia Malaysia Philippines Thailand (SAR) Korea Singapore China Total Dec-1996 107.039 19.281 27.009 9.905 37.810 63.808 33.201 76.847 88.038 462.938 Dec-1997 142.762 17.396 20.788 7.178 26.254 92.804 20.369 71.289 83.502 482.341 Dec-1998 149.188 23.516 25.559 9.273 28.825 89.650 51.975 74.928 90.341 543.255 Dec-1999 157.728 27.257 30.588 13.282 34.063 96.236 73.987 76.843 106.200 616.185 Dec-2000 168.278 29.394 29.523 13.090 32.016 107.542 96.131 80.132 106.742 662.848 Dec-2001 215.605 28.016 30.474 13.476 32.363 111.155 102.753 75.375 122.211 731.428 Dec-2002 291.128 32.039 34.222 13.329 38.055 111.896 121.343 82.021 161.656 885.689 Dec-2003 408.151 36.296 44.607 13.655 41.077 118.360 155.282 95.746 206.632 1119.806 Dec-2004 614.500 36.320 66.418 13.116 48.665 123.540 198.994 112.232 241.738 1455.523 Dec-2005 821.514 34.724 70.203 15.926 50.692 124.244 210.317 115.794 253.290 1696.704 Oct-2006 1012.008 39.895 79.345 19.440 60.685 131.181 229.387 131.553 261.820 1965.314 Nov-2006 1040.926 41.579 79.500 19.658 62.756 132.661 234.183 134.308 265.140 2010.711 Dec-2006 1068.489 42.586 82.164 20.025 65.292 133.168 238.882 136.717 266.148 2053.471 Source: Haver Analytics, Datastream East Asia Update 56 Appendix Table 7: Regional Aggregates for Poverty Measures in East Asia $1 ­a-day $2-a-day Mean Consumption Headcount Number Headcount Number Population (1993 Index (%) of Poor Index (%) of Poor (mill.) PPP$/month) (mill.) (mill.) EAP 1990 68.03 28.8 456.9 66.9 1,060.8 1585.4 1996 99.84 14.7 252.1 49.6 851.2 1716.0 1999 101.93 15.5 274.8 49.9 884.8 1772.4 2000 113.40 13.9 247.9 45.8 820.0 1789.6 2001 121.50 12.9 233.7 43.2 780.1 1805.6 2003 139.67 10.5 192.9 37.3 686.3 1838.0 2004 149.78 9.4 173.2 34.1 631.3 1850.2 2005 162.39 8.1 151.4 30.9 576.8 1865.5 2006 175.19 7.6 142.9 29.4 552.4 1880.7 2007 188.56 6.9 131.3 27.5 521.6 1896.2 2008 200.81 6.3 119.4 25.8 490.9 1906.1 EAP less China 1990 96.44 21.8 96.3 59.1 261.2 442.1 1996 136.25 10.4 51.3 44.6 219.6 492.1 1999 123.58 11.0 56.4 50.8 261.2 514.5 2000 132.13 10.2 53.1 48.4 252.6 522.2 2001 135.59 9.6 50.8 47.3 250.5 529.3 2003 145.78 7.5 40.8 41.3 225.6 545.7 2004 150.14 7.3 40.0 39.0 214.9 550.4 2005 155.84 6.2 34.4 36.5 203.4 557.8 2006 158.90 6.7 38.1 37.3 210.6 565.4 2007 164.68 6.2 35.5 35.4 202.9 573.1 2008 167.25 5.5 31.5 33.4 191.9 575.3 S.E.Asia 4 1990 82.33 17.8 56.0 60.3 189.7 314.6 1996 111.23 7.9 27.5 43.6 152.7 350.2 1999 97.26 10.1 36.9 52.8 193.5 366.2 2000 102.89 9.2 34.4 49.9 185.5 372.0 2001 104.27 8.6 32.4 48.7 183.7 377.2 2003 114.10 6.7 26.2 42.2 164.3 389.2 2004 118.71 6.9 27.3 41.0 161.8 394.8 2005 124.03 6.0 23.9 38.5 154.1 400.4 2006 124.33 7.1 28.9 40.4 164.0 406.1 2007 128.65 6.6 27.2 38.6 158.8 411.8 Lower Income EA (Cambodia, Laos, PNG, Vietnam) 1990 45.21 47.7 40.3 84.6 71.6 84.6 1996 64.62 24.6 23.7 69.4 66.9 96.4 1999 68.68 19.1 19.5 66.5 67.6 101.6 2000 71.72 18.1 18.7 64.9 67.0 103.2 2001 74.40 17.5 18.3 63.7 66.7 104.8 2003 81.66 13.3 14.5 56.3 61.2 108.7 2004 89.39 11.7 12.6 49.4 53.1 107.5 2005 94.84 9.6 10.4 45.1 49.3 109.1 2006 99.98 8.2 9.1 42.0 46.6 110.8 2007 105.20 7.3 8.2 39.2 44.1 112.5 East Asia Update 57 Appendix Table 8: Poverty in East Asia - Country Estimates $1 ­a-day $2-a-day Mean Consumption Headcount Number Headcount Number Gini Population (1993 Index of Poor Index (%) of Poor Coefficient (mill.) PPP$/month) (%) (mill.) (mill.) Cambodia 1990 55.95 32.5 3.4 76.3 7.9 -- 10.3 1996 66.43 24.2 2.8 69.3 8.1 -- 11.7 1999 70.67 21.0 2.6 66.6 8.3 -- 12.5 2000 70.42 22.6 2.9 67.8 8.6 -- 12.7 2001 71.88 21.4 2.8 66.8 8.7 -- 13.0 2003 74.33 18.9 2.6 64.6 8.7 -- 13.5 2004 76.56 19.0 2.6 63.9 8.8 41.7 13.8 2005 86.02 12.4 1.7 56.2 7.9 -- 14.1 2006 90.88 10.9 1.6 53.6 7.7 -- 14.4 2007 95.03 10.0 1.5 52.0 7.6 -- 14.6 2008 99.38 9.4 1.4 50.3 7.5 -- 14.9 China 1990 57.05 31.5 360.6 69.9 799.6 36.0 1,143 1996 85.20 16.4 200.8 51.6 631.6 39.3 1,224 1999 93.07 17.4 218.4 49.6 623.6 42.6 1,258 2000 105.69 15.4 194.8 44.8 567.4 43.9 1,267 2001 115.65 14.3 183.0 41.5 529.6 44.9 1,276 2003 137.09 11.8 152.2 35.7 460.7 -- 1,292 2004 149.63 10.3 133.2 32.0 416.4 -- 1,300 2005 165.18 8.9 117.0 28.6 373.5 -- 1,308 2006 182.19 8.0 104.9 26.0 341.7 -- 1,315 2007 198.90 7.2 95.9 24.1 318.7 -- 1,323 2008 215.31 6.6 87.9 22.5 299.0 -- 1,331 Indonesia 1990 61.58 20.6 36.7 71.1 126.7 28.9 178.2 1996 86.62 7.8 15.4 50.5 99.6 36.5 197.2 1999 66.80 12.0 24.9 65.1 135.0 31.0 207.4 2000 72.53 9.9 20.9 59.5 125.3 -- 210.5 2001 73.44 9.2 19.7 58.7 125.2 -- 213.2 2003 83.98 6.6 14.5 50.1 110.0 34.1 219.4 2004 85.58 7.4 16.5 49.0 109.1 34.7 222.7 2005 90.21 6.0 13.6 45.2 102.1 34.9 226.1 2006 85.65 8.5 19.5 49.6 113.8 35.4 229.5 2007 87.96 8.2 19.0 47.9 111.5 -- 232.9 2008 92.05 7.2 17.1 45.1 106.7 -- 236.4 Laos 1990 39.16 53.0 2.2 89.6 3.7 -- 4.2 1996 48.27 41.3 2.0 83.1 4.1 -- 4.9 1999 51.56 36.6 1.9 80.5 4.2 -- 5.3 2000 53.31 33.9 1.8 79.4 4.3 -- 5.4 2001 55.48 31.3 1.7 77.4 4.3 -- 5.5 2003 59.03 25.5 1.5 73.1 4.2 -- 5.8 2004 61.40 22.9 1.4 71.1 4.2 -- 5.9 2005 64.24 20.0 1.2 68.6 4.2 -- 6.1 2006 67.40 17.5 1.1 65.9 4.1 -- 6.2 2007 70.24 15.1 1.0 63.4 4.0 -- 6.4 2008 74.89 12.1 0.8 58.7 3.8 -- 6.5 East Asia Update 58 Appendix Table 8: Poverty in East Asia - Country Estimates (Continued) $1 ­a-day $2-a-day Mean Consumption Headcount Number Headcount Number Gini Population (1993 Index of Poor Index (%) of Poor Coefficient (mill.) PPP$/month) (%) (mill.) (mill.) Malaysia 1990 195.32 2.0 0.4 18.5 3.4 -- 18.2 1996 261.87 0.8 0.2 13.1 2.8 -- 21.1 1999 271.70 < 0.5 -- 12.6 2.9 -- 22.7 2000 304.27 < 0.5 -- 9.7 2.3 -- 23.3 2001 304.09 < 0.5 -- 9.7 2.3 -- 23.8 2003 325.57 < 0.5 -- 8.1 2.0 -- 24.7 2004 353.60 < 0.5 -- 6.3 1.6 -- 25.1 2005 379.36 < 0.5 -- 4.8 1.2 -- 25.5 2006 399.58 < 0.5 -- 3.8 1.0 -- 25.9 2007 416.24 < 0.5 -- 3.0 0.8 -- 26.2 2008 434.43 < 0.5 -- 2.3 0.6 -- 26.6 PNG 1990 82.18 29.7 1.2 59.4 2.3 -- 3.9 1996 93.15 24.6 1.1 54.4 2.5 48.4 4.6 1999 78.35 30.7 1.5 61.6 3.1 -- 5.0 2000 71.87 35.3 1.8 65.0 3.3 -- 5.1 2001 66.43 38.0 2.0 69.2 3.6 -- 5.3 2003 63.35 39.2 2.2 70.8 3.9 -- 5.6 2004 63.78 38.8 2.2 70.6 4.0 -- 5.7 2005 63.68 39.0 2.3 70.6 4.1 -- 5.9 2006 64.24 39.2 2.4 70.1 4.2 -- 6.0 2007 65.25 38.6 2.4 69.0 4.3 -- 6.2 2008 65.90 38.1 2.4 68.0 4.3 -- 6.3 Philippines 1990 90.32 19.1 12.0 53.5 33.5 -- 62.6 1996 107.15 14.8 10.6 46.5 33.4 -- 71.9 1999 107.20 13.5 10.0 46.9 34.9 -- 74.4 2000 106.93 13.5 10.3 47.2 36.0 46.2 76.3 2001 106.10 13.5 10.5 46.7 36.3 -- 77.9 2003 106.35 13.1 10.6 45.6 36.9 44.5 81.1 2004 110.88 11.7 9.6 43.4 35.8 -- 82.4 2005 113.87 10.8 9.1 42.1 35.3 -- 83.7 2006 118.60 9.6 8.1 39.9 34.0 -- 85.1 2007 123.30 8.4 7.3 38.0 32.9 -- 86.5 2008 128.20 7.4 6.5 36.1 31.7 -- 87.9 Korea 1990 301.09 < 0.5 -- < 0.5 -- 29.88 42.87 1996 480.46 < 0.5 -- < 0.5 -- 29.71 45.52 1999 450.06 < 0.5 -- < 0.5 -- 30.00 46.62 2000 496.18 < 0.5 -- < 0.5 -- -- 47.01 2001 520.51 < 0.5 -- < 0.5 -- -- 47.35 2003 549.12 < 0.5 -- < 0.5 -- -- 47.85 2004 544.02 < 0.5 -- < 0.5 -- -- 48.08 2005 557.48 < 0.5 -- < 0.5 -- -- 48.29 2006 583.01 < 0.5 -- < 0.5 -- -- 48.50 2007 606.91 < 0.5 -- < 0.5 -- -- 48.69 East Asia Update 59 Appendix Table 8: Poverty in East Asia - Country Estimates $1 ­a-day $2-a-day Mean Consumption Headcount Number Headcount Number Gini Population (1993 Index (%) of Poor Index (%) of Poor Coefficient (mill.) PPP$/month) (mill.) (mill.) Thailand 1990 102.88 12.5 7.0 47.0 26.1 43.8 55.6 1996 143.92 2.2 1.3 28.2 16.9 43.4 60.0 1999 123.50 3.1 1.9 33.6 20.7 -- 61.7 2000 125.42 5.2 3.2 35.6 22.0 43.2 61.9 2001 131.21 3.6 2.2 32.0 19.9 -- 62.3 2003 145.46 1.6 1.1 24.0 15.3 -- 64.0 2004 151.53 1.8 1.2 23.8 15.4 42.5 64.6 2005 154.50 1.9 1.2 23.8 15.5 -- 65.1 2006 158.50 1.8 1.2 23.2 15.3 -- 65.7 2007 164.84 1.4 0.9 20.6 13.6 -- 66.2 2008 170.89 1.1 0.7 18.6 12.4 -- 66.8 Vietnam 1990 41.73 50.8 33.6 87.0 57.6 -- 66.2 1996 63.66 23.6 17.7 69.4 52.2 -- 75.2 1999 68.90 16.9 13.4 65.9 52.0 -- 78.9 2000 73.16 15.2 12.1 63.5 50.7 -- 79.9 2001 76.62 14.6 11.8 61.8 50.1 -- 81.0 2003 85.63 9.9 8.3 52.9 44.3 -- 83.8 2004 95.36 7.8 6.4 43.9 36.0 37.0 82.0 2005 100.77 6.2 5.2 39.7 33.0 -- 83.1 2006 106.50 4.9 4.1 36.3 30.6 -- 84.2 2007 112.45 4.0 3.4 33.0 28.2 -- 85.3 Notes for Appendix Tables 7 and 8 The poverty lines in Tables 7 and 8 are set at $1.08 and $2.15 per person per day (in 1993 PPP$) for all countries. For most countries, 1993 World Bank PPP estimates are used. The PPP for the Philippines is from the Penn World Tables, while that for PNG is the 1996 World Bank PPP. PPPs for Vietnam, Lao PDR and Cambodia have been further adjusted using a calorie price ratio between Indonesia and Vietnam. Projections are based on World Bank growth rate forecasts for 2003-2004. Wherever possible, the projections utilize information on sectoral GDP growth rates, changes in the food CPI relative to the general CPI, changes in the GDP deflator relative to the CPI, and changes in the consumption-income ratio. The projections assume that there is no change in relative inequalities within sectors. For China, the projections are done separately for rural and urban China, and then aggregated using population shares. Estimates for all countries except Malaysia and China are based on surveys of household consumption. The estimates for Malaysia and China use income surveys. For China, a survey-based estimate of mean consumption is used in conjunction with the income Lorenz curves to derive poverty estimates. These poverty estimates differ from those commonly found in national poverty assessments for two main reasons. First, country assessments use national poverty lines that differ from the uniform international poverty lines used here. Second, national poverty lines also typically allow for spatial cost of living differentials within countries, but such adjustments are omitted here to maintain a consistent methodology across countries. For instance, in the case of Thailand, these differences explain why the above estimates indicate a small increase in poverty between 1998 and 2000 (in spite of adjusting the CPI by the change in the national poverty lines over this period), while national poverty line-based estimates indicate a decline. Also for Thailand, the 2002 estimate is based on a longer consumption module, which could lead to a small overestimation of consumption relative to 2000. Poverty estimates for the Philippines for the years 2001 and 2002 are an average of a "forward" projection using survey data for 2000 and a "backward" projection using survey data for 2003. East Asia Update 60 Appendix Table 9: NPLs of Commercial Banks (% of total loans) 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 Dec Dec Dec Dec Dec Dec Dec Dec Dec Dec Indonesia a/ 7.2 48.6 32.9 18.8 12.1 7.5 6.8 4.5 7.6 6.1 Korea b/ 6.0 7.3 13.6 8.8 3.3 2.4 2.2 2.0 1.3 0.9 Malaysia c/ .. 10.6 11.0 9.7 11.5 10.2 9.0 7.5 5.8 4.8 Philippines d/ 4.7 10.4 12.3 15.1 17.3 15.0 14.1 12.7 8.5 6.0 Thailand e/ .. 45.0 39.9 19.5 11.5 18.1 13.9 11.6 8.3 8.1 (a) Excludes IBRA's AMC; end-3Q 2006 data is as of Aug. (b) Excludes KAMCO/KDIC. The NPL ratio increased in 1999 due to the introduction of stricter asset classification criteria (forward looking criteria); (c) Excludes Danaharta. NPL series used by Bank Negara Malaysia, which is net of provisions and excludes interest in suspense; (d) From September 2002 onwards, the NPLs ratios are based on the new definition of NPLs (as per BSP Circular 351) which allows banks to deduct bad loans with 100 percent provisioning from the NPL computations; (e) Excludes transfers to AMCs. (Note that the jump in headline NPLs in December 2002 was a one-off increase, reflecting a change in definition and did not affect provisioning requirements). East Asia Update 61 Special Focus Sustainable Development in East Asia's Urban Fringe Introduction diminishing transaction costs, among others. Agglomeration economies help create internationally Two features that make East Asia's urbanization1 connected mega cities, concentrating production and notable in comparison with other regions are the overall generating economic growth. As elsewhere in the world, low urbanization level and the high population density of agglomeration economies are present in East Asian its mega cities. East Asia is remarkably under-urbanized countries, even if they are under-urbanized. In Vietnam, in comparison to regions such as the Americas and where only about 25 percent of the population is urban, Europe. Even if one takes into account income figures, towns and cities contribute 70 percent of the national several countries in East Asia are still relatively under- output. In China, 120 cities contribute 75 percent of the urbanized. For example, China has about 75 percent of country's GDP. In the more urbanized countries of the Brazil's real gross domestic product (GDP) per person in region, the same is true. In Korea, about half of the purchasing power parity (PPP) terms but while 84 percent country's GDP comes from the capital area of Seoul of the Brazilians live in cities, only around 40 percent of (Fujita and Thisse 2002), and Metro Manila and the Chinese do so. Even richer East Asian economies such surrounding areas account for about 60 percent of the as Korea, while having more than 2.5 times Brazil's per Philippines' economic growth (Webster 2004). capita real PPP GDP, is slightly less urbanized (81 percent).2 Yet, if one looks at the East Asian mega cities, A Snapshot of Urbanization in East Asia not only are they comparably large but they are also more densely packed. Average urban densities in East Asia Urbanization has been occurring at different range from 10,000 to around 15,000 persons per sq km -- degrees in East Asian countries throughout the last about double the urban densities of Latin America, triple century. Yet, as indicated in Figure 1, in 1960 most those of Europe, and ten times those of US cities. In other countries of the region were under-urbanized. By 2000, words, not many East Asians live in cities, but those who countries could be grouped into three categories: "high" do are crowded into a relatively small area. urbanization (over 50 percent of the total population in urban areas) -- Korea, Malaysia, the Philippines; and At the same time, policymakers in several East Mongolia; moderate urbanization (25 - 50 percent) -- Asian countries perceive that the path out of poverty is the Vietnam, Thailand, China, and Indonesia and low path of urbanization. There are several reasons for this urbanization (under 25 percent) -- Laos and Cambodia. view. Urbanization facilitates the provision of services such as health, education and infrastructure, increasing opportunities for knowledge sharing and learning, Figure 1: Urbanization Levels in East Asia, 1960-2000 (% of population in urban areas) Urbanization levels in East Asia, 1960-2000 (% of population in urban areas) 100 90 80 70 60 50 40 30 20 10 0 ai os ai s a h odb La nam andl ani aer etiV haiT Ch Cam onesdnI liaogno M nepipilihP ysiala outS Ko M Low urbanization Moderately urbanized Highly urbanized 1960 1980 2000 East Asia Update 62 While the pace of urbanization varies among Figure 2: Log real GDP per capita and countries, Figure 2 clearly shows that, as countries urbanization in 1960, 1980, and 2000 urbanize they also grow richer. One East Asian country however is an exception ­ although the Philippines 10 y = 0.0563x + 4.7391 witnessed most of its urbanization between 1980 and R2 = 0.7685 2000, the country's real GDP per capita changed little South Korea over the period. It is unlikely that a single factor can fully 9 explain this phenomenon, but the highly concentrated nature of the country's urbanization, coupled with the Malaysia haphazard fashion in which it has been occurring (and atipacr 8 Thailand perhaps the fragmentation of its geography ­ a pe characteristic also shared by Indonesia), may offer some clues. Perhaps public "bads" associated with unmanaged 7 China Philippines urbanization such as congestion and pollution, among PDGlaer Indonesia others, are neutralizing many of the benefits of gol agglomeration. 6 East Asia's under-urbanization is likely to change significantly and at an increasing pace over the 5 two coming decades. Between 2000-2025, according to the United Nations Population Division, the total population of East Asia is expected to increase by about 4 0 20 40 60 80 100 17 percent,while its urban population is expected to urbanization (%) increase by around 65 percent, or by 500 million people. As Table 1 indicates, by 2030, over 60 percent of China's Most of this growth will be happening on the population will be urbanized. In the Philippines, almost urban fringe. In China, according to Webster (2004), peri- 80 percent of the population will be living in cities. By urban areas alone are expected to grow by approximately 2030, in East Asia as a whole, most people will be 250 million persons over the next three decades. The urbanized. social, environmental and economic consequences and implications of this trend region-wide are likely to outweigh most other major development issues in the coming decades. This note provides a special focus on development in East Asia's urban fringe, which will play a central role in the region's efforts to grow through middle-income levels. Table 1: Projected Urban Population Growth in East Asia, 2000-2030 Urban Population Increase 2000- (1,000) Geographical 2030 Average Annual Urbanization Country Distribution increase level 2030 2000 2030 2030 (%) (1,000) (%) 2000-30 (1,000) (%) China 456,527 877,565 60 421,038 92 14,035 61 Indonesia 88,855 187,913 13 99,058 111 3,302 68 Philippines 44,291 86,598 6 42,307 96 1,410 76 Vietnam 18,987 45,954 3 26,966 142 899 43 Korea 37,281 43,136 3 5,856 16 195 86 Thailand 18,948 35,449 2 16,502 87 550 47 Malaysia 14,215 27,308 2 13,094 92 436 78 Cambodia 2,222 8,692 1 6,470 291 216 37 Lao PDR 1,019 3,546 0 2,527 248 84 38 Mongolia 1,415 2,335 0 920 65 31 67 E Asia 804,641 1,471,101 100 666,460 83 22,215 62 Source: UN (2004) East Asia Update 63 The Urban Fringe this note, the urban fringe is defined as areas subject to urban expansion on the edge of cities (often called "rural- What is it? urban" areas or "peri-urban" areas), and environmentally fragile urban areas (e.g. river banks, canal edges and There are several definitions of urban fringe. floodplains) which are unstable and unfit for occupation One of the first definitions to appear in the literature dates and should be protected to provide ecological services to back to the Second World War period and focuses on the cities." Broadly speaking, this definition encompasses conflict between urban and rural uses that is often primarily marginal land (unstable and unfit for pervasive in the urban fringe: "areas of transition between occupation) and land in the periphery of urban areas. well recognized urban land uses and the area devoted to agriculture" (Wehrwein 1942). Other definitions take a Why is it important? more urban-centric view. For example, Chicoine (1981) defines urban fringe as areas that "generally include those The urban fringe is frequently ignored as a areas bordering central cities, surrounding close-in specific area within the studies of urbanization. As stated suburbs and noncontiguous nearby towns, and extending by Stren (1994), it is symptomatic that "urban studies" into the adjacent, open countryside." The urban-centric and "rural and regional studies prevail over `fringe view can be associated with geographical distance as in studies.'" One potential difficulty is that the urban fringe Webster (2002), where peri-urban areas are usually is conceptualized and defined in many ways in the considered to start just beyond the contiguous built-up literature, as seen above. urban area and extend as far as 150 km from the core city center, or as in the Chinese case as far as 300 km. The Nonetheless there are several factors that suggest geographical focus is also present in some definitions of the importance of the urban fringe as deserving greater government agencies as in the case of the US Census attention on the part of policy makers. In most developed Bureau, for which "the urban fringe generally consists of countries, increases in, household incomes, urban contiguous territory having a density of at least 1,000 subdivision codes, infrastructure investment patterns, persons per square mile. (c. 400 persons per sq. km). The open space undervaluation, and commuting under-pricing, urban fringe also includes outlying territory of such among other factors, translate into urban expansion on the density if it was connected to the core of the contiguous urban fringe. Some of these factors are present in the area by road and is within 1 ½ road miles of that core, or urban expansion taking place in East Asia as well. In within 5 road miles of the core but separated by water or addition, as illustrated by Table 2, it is important to factor other undevelopable territory. Other territory with a in rural-urban migration, whose impact on urban population density of fewer than 1,000 people per square expansion will tend to increase in future years as a result mile is included in the urban fringe if it eliminates an of continuing urbanization linked to substantial declines enclave or closes an indentation in the boundary of the in the overall rate of natural increase of the population. In urbanized area."3 Korea and China, for example, by 2030, the rate of natural increase will be negligible, meaning that virtually The above definitions fail to provide insights on all urbanization will result from migration. But there are the social and economic forces in place in the process of exceptions, as in the case of Malaysia and the Philippines, urban fringe occupation. More helpful perhaps in where higher rates of natural increase are associated with understanding the processes at work is a simple economic already high urbanization levels. definition where the urban fringe is defined as: "...the frontier in space where the returns to land from traditional Occupation of these peripheral or marginal areas and customary urban land uses are roughly equal to the generates substantial demands for shelter and services, returns from traditional and customary rural land uses. In including environmental ones. In Vietnam, between 2004 theory, such a frontier should always exist, although its and 2010, the generation of urban solid waste is expected exact location on the ground may not be easily fixed (Hite to increase from 6 million tons to 12.6 million tons 1998).4 This definition, however, does not take into (World Bank 2004). In China, without increased account the existence of market failures.5 This is provision of low cost housing and social services, important if policymakers aim at designing instruments to migrants are considered to be at risk of descending into adequately mitigate problems associated with the poverty.6 In addition, the urban fringe is frequently the processes at work on the urban fringe. The definition of dumping ground for industrial enterprises forced out from the urban fringe should thus go beyond equating rates of the city centers either through laws and regulations or due return between urban and rural uses to include at least to economic factors such as rising land prices. some sources of market failures. Thus, for the purpose of East Asia Update 64 Table 2: Contribution of Migration/Reclassification to Urban Growth in East Asia, 1950-2030 (%) Country 1950s 1960s 1970s 1980s 1990s 2000s 2010s 2020s Cambodia 23 35 33 24 40 53 57 59 China 45 39 45 65 72 76 80 86 Indonesia 44 46 53 62 67 66 63 61 Malaysia 46 46 45 44 44 41 35 34 Philippines 24 26 35 46 48 43 38 37 Korea 55 59 65 65 54 48 61 85 Thailand 28 32 41 40 34 47 67 75 Vietnam 50 44 29 28 44 57 65 72 East Asia 46 42 45 58 64 68 72 76 Source: Derived from UN (2004) While many already occupy the urban fringe and Over 30 percent of the East Asian urban will do so in the future, it should be noted that not all population already lives in slums (approximately 270 slum areas are in the urban fringe according to the million people)7, and even if the rate of slum formation is definition used in this note. As Table 3 indicates, the halved, by 2030 this number will increase by 80-90 situation is heterogeneous, with slum areas located both million. on public and private land, and in diverse types of building structures, in the four cities chosen below. Table 3: Slum Areas in Four East Asian Cities (% of urban population living in slums) City Slum Areas Comment Bangkok Shanties located on public land along river Major reduction in slums in recent years due to relocation and tenure (2%) channels regularization policies. Chengdu Traditional one storey housing. Major programs to relocate river side housing now completed; current (38%) Old co-operative-walk up tenements. programs to remove old-style housing and 1950s tenements. This is a common Migrant accommodation in peripheral areas. feature of cities throughout China. Main `problems' are over-crowding and lack of in house sanitation. Water and electricity provision is almost universal. Over 1 million migrants are estimated to reside in peripheral areas. Manila `Buildings or areas that are deteriorated, Largely found in inner city, and in many different locations; not so prevalent in (44%) hazardous, unsanitary or lacking in standard peripheral areas. conveniences' and overcrowded / poorly- Many but not all slums will be on illegally occupied land. Some slum areas serviced areas. have been in existence for many years. Over 60% of slums are not located in environmentally fragile areas. Major relocation programs for Pasig River and some railway alignments. 25% of residents of slums are not poor. Phnom Housing located on marginal public land Private ownership of land abolished in 1974 hence virtually all are squatters Penh (e.g. railway tracks, wide roads, riversides), although some distinction between `squatter' and `urban poor'. (72%) private land or houses, rooftops in central Some have `purchased' peripheral plots. areas, peripheral areas (some on floodplains Located throughout city. Many but not all in environmentally fragile areas. and some not on both public and quasi- private land). Relocation (and some land sharing) programs for city centre squatters from marginal and non-marginal areas. East Asia Update 65 A Bird's­eye View of East Asia's Urban Figure 4. The Variety of Development on the Fringe Urban Fringe in East Asia ­ Bangkok Figure 3 provides a simplified schematic representation of the development pressures on the urban fringe. This is illustrated in Figure 4, an aerial photograph of Bangkok's urban fringe, where well planned areas mix with parks, agriculture, and unplanned settlements, resulting in a complex and diverse land use pattern even in the absence of major natural obstacles such as mountains or large water bodies. Both figures, however, are unable to provide an adequate depiction of the potential social and environmental problems that may arise as a result, since pollution and slums are hardly visible. Figure 5, however, clearly displays the dismal living conditions of slums in Ho Chi Minh City and Manila, where poor housing is densely packed in environmentally sensitive areas such as canals. Cities in East Asia will increasingly face trade- offs with respect to ensuring clean growth today versus cleaning up tomorrow. Avoiding road congestion and the Figure 5. Encroachment into Water Areas - associated local health (and global climate) impacts of air Manila and Ho Chi Minh City pollution are usually less costly than addressing the consequences in the future. Protecting natural systems that provide ecological services such as clean water sources and flood control are further examples where inter-temporal implications need to be taken into account by policy makers, as they affect the level of risk to which the urban population is subject and the likely costs of public services and infrastructure. Figure 3: Development Pressures on the Urban Fringe Source: Belgian Technical Cooperation, 2003, downloaded from www2.btcctb.org/thlg/en/canal.htm. A Conceptual Framework to Address the Sustainable Development of the Urban Fringe Urban expansion in East Asia's urban fringe is already a reality. Yet, in order to take full advantage of the benefits of urbanization discussed above and achieve a sustainable Rural Area occupation of the urban fringe, it is important to design policies that address the sources of economic, environmental, and social pressures in a balanced way. East Asia Update 66 As with other development problems, and as failures thus also play an important role in explaining the recently recognized in the literature8, the balance is sub-optimal development of the urban fringe. achieved at both the local and central levels and should be sensitive to the innate conditions of specific cities. Figure 6: A conceptual framework for the Examples from different countries and regions serve to Sustainable Development on the Urban Fringe illustrate these ideas. Microeconomic Figure 6 provides a schematic depiction of a Factors Source: conceptual framework to address sustainable development of the urban fringe.9 The outer ellipse contains key Public Central Governments Monopoly factors that influence the development of the urban fringe. Goods/Bads They are all interrelated, hence the continuous line connecting them. For example, urban expansion is closely linked to financial markets liquidity and credit availability. This in turn may impact growth and Urban Fringe Civil Economic individual preferences to move or migrate to the urban Markets Society Social fringe. The inner rectangle connects the four key sources Environmental of market failures, which are prime targets for public policy and the use of instruments both for mitigating or stimulating their occurrence.10 The inner diamond Externalities Information connects the main actors influencing the economic, (+,-) environmental and social issues in the urban fringe. They Local Governments both influence and are influenced by the factors described in the outer ellipse. For example, while central Macroeconomic Growth Factors governments may have greater (though not full) control over macroeconomic factors, their power over individual Author based in part on OECD 2002 preferences is somewhat limited. Local governments and civil society through non governmental organizations (NGOs), on the other hand, have little control over Comparing Urban Fringe Policy Issues macroeconomic factors, but may influence preferences across East Asian Countries through local infrastructure supply and local regulations to address pollution, among other instruments. These This note focuses on the land conversion as an actors are potential regulators and social drivers in the over-arching process indicative of the complexity and broad sense, taking advantage of available instruments diversity of the issues affecting the urban fringe in the including policy ones to achieve the sustainable East Asia region. It illustrates this process through four development of the urban fringe. country examples, chosen based on different levels of urbanization (and incomes). Figure 7 provides a The unbalanced development of the urban fringe schematic representation of the land conversion process cannot be solely explained by market failures. and its potential consequences. Land conversion in the Governments are often aware of these and design and region follows a spectrum that ranges from state implement policies and related instruments to alleviate monopoly over the process to unregulated private sector market failures. Yet, some public sector responses may occupation. Variations along this spectrum for Korea, lead to unintended consequences which lead to a new set China, Vietnam and the Philippines are indicated. . of problems; or the original instruments may be overly Figure 7: Land Conversion Process ambitious and fail to take into account institutional weakness to enforce them. The phenomenon of the slums in many countries can be at least partially explained by State Private overly restrictive zoning, unrealistic infrastructure service Monopoly Private Sector Regulated Sector standards and building codes, among others. The same is Unregulated true for environmental policy instruments, such as Vietnam China Korea Philippines Philippines sewerage treatment requirements, among others. These Da Nang Hanoi urban fringe are all instruments often used by governments in the Land Conversion Marketability hopes of improving living conditions. In a worse case scenario, the instruments may also generate rent-seeking behavior,11 which in turn makes changing them more Shifting the Public bads to terms of trade cities difficult due to non-transparent political influences, Optimality = Regulated from rural to Private Sector mitigating corruption and broad governance problems. Policy urban areas public bads and addressing regressivity East Asia Update 67 The conversion process in China and Korea Vietnam is attempting to take a path between follows roughly a monopoly model. China differentiates China / Korea and the Philippines. Even within Vietnam, between rural land ("owned" by village collectives) and municipalities have taken different approaches to land urban land ("owned" by the state). The conversion from conversion and urban expansion on the urban fringe, rural to urban land happens through requisition, which is a implying a greater degree of autonomy from the central monopoly of the state.12 Land requisitioning both authority. This is in part due to the initiative of municipal provides land for development and increases municipal administrations but it is also due to policy instruments and revenues through the sale of land concessions at market laws set at the central level. Land in Vietnam belongs to values under the new land use following its purchase at the state but, in accordance with the recent land law, land current use values under the previous land use. While use rights are set at the household level and are starting to Korea allows for private ownership of land, land use be well established, traded and enforced. As in China, conversion is also based on a compulsory approach Vietnam adopted a pro-active and interventionist compensating farmlands according to existing use value, approach to urban expansion involving a strong planning as in China. On the one hand, the strict planning process system and the use of land requisitioning as a revenue in both countries has generated some positive results -- source in the absence of an alternative municipal tax base relatively better infrastructure standards and services, (such as the property tax systems typical of most other avoidance of some environmental degradation as they countries). While a differential is still observed between become apparent, securing the provision of some urban the value at which land is requisitioned by government public goods, among other things. At the same time, the and that at which it is later made available to the market process has taken place, at least in part, at the cost of the after conversion to an urban land use, over time this is rural sector, and has prompted the over-conversion of likely to change, as markets for land use rights become land and its urban under­utilization. This is the case better established especially in China, where municipalities depend significantly on this source of revenue. In Korea, In Vietnam, the path followed by Da Nang municipalities benefit to a greater extent from central municipality is more comparable to the Chinese approach, government transfers and thus need to rely less on land with its use of large-scale land requisitioning, due both to conversion revenues. the dynamism of its city authorities and the availability of surplus state-owned enterprises and military land. It also In Korea, after the urban sprawl problem became exhibits similar problems to many Chinese cities ­ such recognized in the 1970s, regulation of land conversion as over-requisitioning and premature provision of became so strict (with the creation of. greenbelts, for infrastructure (including luxury housing) which reflect the instance) that it ended up generating a land shortage in non-market responsiveness of the interventions. However, Seoul. The continued population growth in the capital uncontrolled low-income residential development is also region led to the revision of land conversion regulations occurring in some Vietnamese cities -- a phenomenon in the early 1990s. The development of `semi-agricultural largely absent in China, as the collective ownership of zones' was allowed, leading once again to urban sprawl in land precludes farmers developing on their leased the 1990s, this time led by private sector, small-scale, agricultural plots in an extensive way. Ha Noi's residential development without proper infrastructure expansion has often been achieved by taking land only, provision. These developments became known in Korean keeping the villages. This avoids the need for relocation. as "reckless development" due to the lack of social and The compensation that would otherwise have to be paid transportation infrastructure.13 can be used for construction of new housing units, and their location adjacent to the expanding urban area and The Philippines, where 65 percent of the urban construction sites, increases the likelihood of new population lives in slums, lie on the other side of the employment. There is, however, a danger that these spectrum. Land conversion occurs primarily via an villages in the Ha Noi area could develop into slums unregulated or weakly regulated private sector. The unless infrastructure is upgraded, and appropriate controls absence of planning -- or its weak implementation -- are imposed. Ho Chi Minh City, on the other hand, is translates into a number of public "bads" for the country's clearly developing in a more unplanned way and exhibits major cities. Metro Manila for example is heavily several of the characteristics of other fast growing Asian congested and polluted, has limited infrastructure cities ­ a variety of land uses, high and low income services, and around 40 percent of slum occupation in residential areas, informal settlements, ribbon environmentally fragile areas. This has led to slum development, a patchwork of developed and undeveloped removal in major problem areas, as in the case of the plots. Pasig River. Ultimately, interventions are ex-post, focusing on tenure regularization and upgrading, often The Way Forward involving a very active civil society. East Asia is at a turning point of a major development phenomenon -- urbanization. If well East Asia Update 68 managed, urbanization can provide significant gains in myriad of instruments being used around the world that terms of prosperity and poverty alleviation without the can assist the East Asian policymakers in their quest to environmental and social costs that some countries are achieve urban expansion in a balanced and sustainable already facing. The phenomenon is likely to soon way. Some are already in use but may need to take into encompass even East Asian countries which are still account new issues and objectives as the urbanization largely rural, but are likely to rapidly urbanize over the process unfolds. Important questions for policy makers in next 25 years. In fact, Laos and Cambodia are expected to East Asia, as they consider new approaches, will be: How be the countries where urbanization will occur fastest in well has the menu of policy instruments worked? What the future, simply because their base is currently very did it take to design and implement them ­ in terms of low. resources, cost, time, technical capacity, and leadership? What are the basic pre-conditions (such as regulatory and Managing the urban transition effectively will institutional frameworks) for their effective launch and call for significant policy reforms, the use of new implementation? Relevance of the menu will vary instruments and processes, and the enhanced involvement according to the circumstances of specific countries and of the private sector and civil society. Table 4 provides a will need to be clarified. However, failure to act now and concise view of the urbanization problems and some of thus missing the opportunity to effectively manage the the potential policy responses referred to in this note. It is urban transition may be a costly proposition. a simplified menu and actual instruments need to be designed for local and national conditions. There are a Table 4: Urbanization Problems and Policy Responses Problems Policy responses Economic 1. Economic enterprises are inappropriately located Land use planning and financial incentives 2. Agricultural land is lost to less valuable urban Land use planning, land conversion policies, and uses or is retained despite more valuable urban uses financial incentives 3. Excessive service and transportation costs due to Land use policies to increase densities and inadequate infrastructure concentrate development Imposition of development impact fees to obtain developer contributions for offsite infrastructure Social 4. Development leaves existing residents less well Improvements in compensation rates, employment off measures, and financial stake in ensuing development 5. Unserviced informal settlements Tenure regularization, upgrading, relocation Low-cost housing construction, land management, land pooling Appropriate land subdivision and construction standards Direct and indirect subsidies Improved municipal finances for provision of infrastructure in low-income areas Requirements that developers provide quotas of affordable housing Environmental 6. Excessive pollution Regulatory measures, including standards for pollution discharges and market-based instruments Licensing procedures Effective monitoring and enforcement 7. Encroachment on land that is better left Land use planning and environmental controls undeveloped Source: Adapted from Chapter 5 ("Cities") in Gill, Kharas, and others (2007). East Asia Update 69 Stren, Richard ed. 1994. Urban Research in the This Special Focus was prepared by Dan Biller. Developing World, Vol. I Asia. Toronto: University of Comments from Maria Teresa Serra, Milan Brahmbhatt Toronto Press. and Indermit Gill (the World Bank's East Asia and Pacific Region), and discussions with Antonio Bento (University of Maryland), and Joe Wood (Halcrow 1 Urbanization refers to increased number of urban Group Limited) are gratefully acknowledged. The dwellers. This comes about through natural growth of author is also thankful for Ceren Ozer's research urban populations, migration, and the reclassification of assistance and suggestions. Except where noted, this rural to urban areas. Urban expansion refers to the shift in piece is based on the mimeo "EAP Sustainable land use from rural to urban. Development on the Urban Fringe" produced by 2World Bank data. Halcrow Group Limited for the World Bank under Dan 3US Census Bureau 1995 at: Biller's supervision. Unless stated, all photographs are http://www.census.gov/population/censusdata/urdef.txt from Google Earth. 4In most developing country cities, the urban fringe now will not be the urban fringe in several years. 5 Failure of market forces to allocate the socially optimal level of urban fringe occupation and use among References conflicting demands. The four main sources of market failures are: (1) public good / public bad, (2) externality, Chicoine, David L. 1981. "Farmland Values at the Urban (3) imperfect information, and (4) monopoly. These will Fringe: An Analysis of Sale Prices" Land Economics, be defined as needed in the text. 6 57(3): 353-362. According to Taylor (2004), the poverty rate among urban immigrants (after remittances) was 50 percent Franco, S. (2005), Sprawl in developed and developing higher than among permanent urban residents in 2001. 7 countries, mimeo. The definition of slum is based on the absence of one or more of the following: durable housing construction, less Fujita, Masahisa and Thisse, Jacques-François. 2002. than 3 persons per room, access to safe water, adequate Economics of Agglomeration: Cities, Industrial Location, sanitation, and tenure security. It embraces a wide variety and Regional Growth. Cambridge University Press. of settlements, from shacks of non-permanent materials located in `danger areas' which would be classified as Gill, Indermit, Homi Kharas and others. 2007. An East `unfit for human habitation' to areas of more robust Asian Renaissance: Ideas for Economic Growth. housing on non-marginal land where improved Washington, D.C.: World Bank. Forthcoming. infrastructure would provide an acceptable level of shelter. UN Habitat (2006). 8 Hite Jim. 1998. "Land Use Conflicts on the Urban Rodrik (2006) 9 Fringe" Strom Thurmond Institute, Clemson University, It should be noted that a detailed discussion of this South Carolina. Available at: conceptual framework is beyond the scope of this paper http://www.strom.clemson.edu/publications/hite/landuse- due to its page limits. The examples provided in this hite.pdf paragraph are mainly focused on illustrating how the conceptual framework works in practice. 10 Korea Research Institute for Human Settlements (KRIHS) Take the example of a public bad such as pollution or a forthcoming. Sustainable Development on the Urban public good such as watershed protection. A public good Fringe: Korean Case Study. [bad] or service is neither rival in consumption nor excludable in use. Society needs to find alternate ways of OECD. 2002. Towards More Sustainable Consumption: ensuring its socially optimal supply (in case of a public An Economic Conceptual Framework. Paris. Available at: good) or mitigation (in case of a public bad). 11 www.oecd.org/env/consumption. Rent-seeking behavior can be defined as "expenditure of resources to bring about an uncompensated transfer of OECD, 2003. Harnessing Markets for Biodiversity: goods or services from another person or persons to one's Towards Conservation and Sustainable Use, Paris. self as the result of a `favorable' decision on some public policy." (OECD 2003) 12 Rodrik, Dani. 2006. "Goodbye Washington Consensus, It should be noted that village collectives also engage in Hello Washington Confusion? A Review of the World land conversion from rural to urban use, but the legality Bank's Economic Growth in the 1990s: Learning from a of this action is ambiguous. 13 Decade of Reform"Journal of Economic Literature, 44 KRIHS (forthcoming). (4): 973-987. December.