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'Asia needs a different plan to recover from crisis'

May 01, 2009

Asia’s excessive dependence on external demand for growth can affect its long-term sustainability, says M. Shahidul Islam, Research Associate at the Institute of South Asian Studies, National University of Singapore. Highlighting the uncertainty of fiscal packages, he insists on a constructive plan to stimulate growth.

As the recession in the US deepens, it is apparent that America’s traditional role as the world’s ‘consumer of last resort’ is now at stake. Consumer confidence in the US has plunged owing to the ‘wealth effect’ following the burst of the assets bubble.

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The McKinsey Quarterly reports that the two forces that until recently turbocharged US consumer spending – growing household debt and a falling saving rate – are now following a reversal trend.

American consumers have accounted for more than three-quarters of its GDP growth since 2000 and for over one-third of global growth in private consumption since 1990.

The crisis has clearly shown that Asia has not decoupled from US growth. The drop in Asia’s exports to the US is expected to continue. China and some other Asian countries risk the grind-down of their reserves invested in the US Treasury and other American assets.

Considering these scenarios, the key question is: where does Asia stand in terms of its growth potential? Though 2008 (and so far 2009 too?) has been an annus horribilis for growth forecasters such as the International Monetary Fund and Asian Development Bank, it is widely viewed that Asia’s growth prospects are not that bleak, owing to several positive signs.

These include fewer mismatches in external debt, lower imbalances in the government, better corporate and banking sector balance sheets, and ample foreign exchange reserves.

Better fundamentals

Although the fundamentals of emerging Asia’s banks and financial sectors are much better than the West, banks in the region have stopped lending to riskier borrowers. Regional equity markets have plunged and Asia’s access to external finance is severely hampered. All these factors are affecting bank lending, and consumers’ and investors’ confidence adversely. Consequently, fiscal policies are in the spotlight more than monetary measures — a general phenomenon during an economic downturn.

"The question, however, is whether fiscal stimulus is enough for Asia’s growth to rebound"

In line with Keynesian prescriptions, one of the major policy responses that several key Asian countries have adopted are fiscal stimulus plans aimed at stimulating aggregate demand. The question, however, is whether fiscal stimulus is enough for Asia’s growth to rebound. There is also a debate on the degree of effectiveness of the fiscal multiplier.

The old Keynesian multiplier, which captures the impact of government spending, is estimated to be in the range of 1.5 to 2. However, recent research, particularly following the publication of the Smets-Wouters model in the American Economic Review, suggests that the impact of government spending is much less in the new Keynesian multiplier, which is more forward-looking.

One size doesn’t fit all

The reason is that the effect on GDP diminishes as non-government components (consumption and private investment, in particular) are crowded out by government spending.

However, one should be more cautious in explaining the impact of the fiscal multiplier as one-size-does-not-fit-all. The impact of fiscal stimulus depends on leakages into savings and imports, and responses of monetary policy to the fiscal actions, among others.

According to a recent IMF Staff Position Note, for a relatively closed economy with few or no financing constraints for the government, it is plausible that the fiscal multiplier would exceed 1, especially when combined with an accommodative monetary policy.

"Compared to the current US fiscal measures, Asian economies have some leverage in terms of their effectiveness"

The size of the multiplier would be smaller for a small open economy that is usually prone to higher leakages into imports. Moreover, such economies are more susceptible to financial market constraints (owing to upward pressure on real interest rate) or could be subject to monetary policy that offsets the fiscal stimulus. However, compared to the current US fiscal measures, Asian economies have some leverage in terms of their effectiveness.

About half of the Washington package consists of transfer payments, as opposed to permanent increase in government spending. However, in most Asian economies, in the absence of programmes such as unemployment benefits, money can be spent for infrastructure or other similar sectors directly instead of transfer payments. Nevertheless, the effectiveness of government expenditure on infrastructure projects, particularly in terms of employment generation, depends on whether the projects favour capital or labour.

Moreover, Asia is home to the largest number of hand-to-mouth households that generally consume all their current income. This is yet another good sign that the money will be spent for consumption rather than savings, even if some fiscal stimulus comes as transfer payments.

Global recovery crucial

The IMF Staff Note shows that the size of the fiscal stimulus packages announced for 2009 by the US, Eurozone, Japan and emerging Asia are equivalent to 1.9, 0.9, 1.4 and 1.5% of these respective economies’ GDP, albeit the US’ fiscal package for 2010 is much bigger than that of the other regions. It also reveals that, of the two major types of stimulus plans – tax cuts and infrastructure – emerging Asia is banking much more on the latter.

Generally, the multipliers for tax cuts are much smaller, ranging from 0.5 to 1. The study projects that the growth effects of a fiscal stimulus could result in 2.1% growth in Asia, followed by the US (1.5%), Japan (1.1%) and the Euro area (0.9%) in 2009.

"Fiscal packages could drive Asian growth from as low as 0.5% for India to as high as 6.5% for Thailand"

Using its global macro model, the simulation run by Oxford Economics has also found that fiscal packages could drive Asian growth from as low as 0.5% for India to as high as 6.5% for Thailand, depending on the size of their packages as a share of GDP, among others.

Although the ultimate effects of government expenditures vary from country to country, the broad picture is that Asia can bank on fiscal packages in 2009 and perhaps in 2010 too. However, the governments’ fiscal imbalances cannot be sustained for an indefinite period.

If the current recession is no different than the previous ones, then one can expect Asia and rest of the world to rebound following the adjustments of a traditional boom-and-bust business cycle. However, if the rest of the world does not recover by 2010, particularly if the US and Europe go into a prolonged recession, then Asia’s decades-long high growth might come to a halt.

The simple reason is the region’s excessive dependence on external demand for growth, India being an exemption to some extent. To avert such a gloomy scenario, Asia requires another plan.

So, waiting for a US recovery, as in the past, could be a costly mistake for Asia. As the Black Swan logic says, the history of a process over a thousand days tells us nothing about what is to happen next. The best example is a turkey before and after Thanksgiving!

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