A troubled international environment

East Asia Update Philippines (36 million) and Thailand (19 million).2 Poverty rates surged after the 1997 financial crisis in Indonesia and Thailand, reaching 65 percent and 33 percent respectively by 1999 at the $2 a day level, but have fallen back substantially since then. Poverty in 2002 is estimated to have finally fallen back to the 1996 pre-crisis level in Thailand, reflecting unexpectedly strong growth and a modest fall in income inequality. Thailand’s North-East, the area of the country with the highest concentration of rural poor, also appears to have shared in the recent fall in poverty rates. Using the national poverty line, poverty in the North East fell to 18 percent in the first half of 2002 from 27 percent in 2000. The rural poor benefited from an 11 percent rise in farm incomes (and farm output prices) during the year, reflecting a recovery in rice and other commodity prices in world markets. Poverty also continued to fall in Indonesia, reaching 53.5 percent in 2002, only about 3 percentage points higher than in 1996, before the financial crisis. The Philippines shows a different pattern. Not being as hard hit by the financial crisis, poverty also rose much less in the wake of the regional crisis. But poverty reduction has also been more sluggish than in other countries. At the $2 a day level poverty rates peaked at an estimated 47 percent in 2000, but have only drifted down to an estimated 45 percent in 2002. The next sections of this report take up the implications of the current global environment and geopolitical events for the East Asia region, followed by an assessment of the recent upsurge in intra-regional trade, in particular the challenges and opportunities created by China’s rapid growth and emergence as a center for regional production and trade. Subsequent sections take up some key domestic trends and policy developments. 7 exports to the U.S. in 2002 rose 18 percent, contributing about 46 percent of the increase in the region’s total exports. Exports to the US were particularly strong in China, Malaysia, Philippines and Vietnam.3 Rising US demand helped offset weakness in regional exports to Japan, which fell 3 percent in 2002. Exhibit 5 Merchandise Export Growth (US$ - % Change Year Ago) 30 S.E. Asia (4) China Korea Other NIEs (3) 15 0 2000 2000 2001 2001 2001 2001 2002 2002 2002 2002 2003 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 -15 -30 A troubled international environment Rebounding export growth made a crucial contribution in the regional recovery in 2002. By the fourth quarter regional exports in US dollar terms were up 18 percent from a year earlier, and were especially strong in China and Korea, where they were rising at 25-30 percent by the last quarter. (Exhibit 5). Monthly data indicates that dollar export growth continued strong in the early months of 2003. To some extent these exceptionally strong year on year growth rates for dollar exports are boosted by technical factors such as the ‘easy comparison’ to very depressed export levels in late 2001/early 2002, and the decline in the exchange rate of the US dollar against other main currencies. Apart from these technical factors, however, three substantial factors stand out. The most important, the surge in intra-regional trade and exports to China, is considered in more detail in the next section. Another was economic recovery and reviving import demand in the US. East Asian Excluding North Korea and Myanmar, about which detailed information is lacking, but which undoubtedly contain a great many more poor. 2 The third principal factor was the bottoming out in the unprecedented recession in the global high tech industry, benefiting East Asian countries with significant electronics or high tech exports – Korea, Taiwan (China), Singapore, Malaysia, Thailand, Philippines and China. Worldwide billings for silicon wafers (the basic building material for semiconductors) increased about 6 percent in 2002, after falling 31 percent in 2001. World semiconductor sales, which had also slumped 31 percent in 2001, inched forward by about 1 percent in dollar terms for 2002 as a whole, the net result of continued weakness in prices being offset by rising sales volumes. However, although the year total figures were barely up on 2001, world semiconductor sales did rebound strongly on a quarter-to-quarter basis during much of 2002. Most remarkably, semiconductor sales within Asia (excluding Japan) surged by 30 percent in 2002, making it the largest regional semiconductor market in the world. (Exhibit 6). These data are consistent with suggestions that a major restructuring and relocation of the global electronics industry towards East Asia is underway because of severe competitive pressures in the present relatively weak global market conditions. Still, a sustained export recovery in East Asia would be more secure in the context of a sustained upturn in overall global high tech demand – and that still remains in some doubt. Global 3 On the other hand, Singapore exports to the US were down 1-2 percent, heightening concerns about competitiveness, especially in the high tech sector. East Asia Update semiconductor sales peaked in the three months to November 2002, and have trended lower in December, January and February. Bookings and billings for US semiconductor equipment also trended lower in the fourth quarter of 2002 and early 2003. Exhibit 6 Semiconductor Billings by Region 6.00 8 Text Table 2. International Economic Environment 2001 2002 2003 2004 (Bill. US$/month; 3 mo.moving averages; Feb'95-Feb'03) Americas Asia ex.Japan % Change from previous year, except interest rates GDP Growth World 1.2 1.7 2.3 3.2 OECD 0.9 1.5 1.8 2.8 United States 0.3 2.4 2.5 3.5 Japan 0.4 0.3 0.6 1.6 Euro Area 1.5 0.8 1.4 2.6 World Trade (Volume) 0.4 3.0 6.2 8.1 CPI Inflation - G7 a/ 1.5 1.0 1.4 1.3 Oil Price - $/bbl 24.4 24.9 26 21 - % Change -13.7 2.4 4.4 -19.2 Non-oil Commodity -9.1 5.1 8.2 2.3 Prices LIBOR (US$. 6 Mo.) 3.5 1.8 1.7 3.2 Source: World Bank DEC Prospects Group March 15, 2003. a/ In local currency, aggregated using 1995 weights. 3.50 Japan Exhibit 7 Europe OECD: Industrial Production (2000 Q3=1) 1.00 Source: Semiconductor Industry Association Feb-95 Feb-96 Feb-97 Feb-98 Feb-99 Feb-00 Feb-01 Feb-02 Aug-95 Aug-96 Aug-97 Aug-98 Aug-99 Aug-00 Aug-01 Aug-02 Feb-03 1.00 A soft patch in the developed world recovery OECD economic growth in 2003 is expected to reach 1.8 percent in 2003, the second year of the global recovery – mildly higher than the 1.5 percent pace achieved last year and still well below the 2.5 percent OECD trend growth rate over the last two decades. (Text Table 2). The growth outlook for the year is expected to be restrained by the impact of the Iraq crisis on oil prices and general uncertainty in late 2002 and early 2003, as well as by significant financial and economic imbalances and vulnerabilities that were built up in the boom economy of the late 1990s, and which have not yet been resolved. Having got off to a strong start in the first half of 2002, the global recovery then lost momentum, especially in the fourth quarter, when growth rates in the US, Europe and Japan all slowed significantly. A variety of monthly indicators suggested some continued softness in the early months of 2003. (Exhibit 7) In the United States strength in consumer spending and residential construction had helped ease the 2001 recession and spur the 2002 recovery, supported by low interest rates. However consumer spending growth decelerated and consumer confidence fell sharply in the fourth quarter of 2002 and early 2003. Retail sales continued weak in the first quarter of 2003. Going forward, the concern is that consumption may be restrained by high levels of household debt and sharp losses in US household net worth, amounting to about $5 trillion in 2001 and 2002, due mainly to hefty declines in equity prices. 0.95 USA Japan Eurozone 0.90 Note: Partial monthly data for 2003:1 0.85 20 00 :3 20 00 :4 20 01 :1 20 01 :2 20 01 :3 20 01 :4 20 02 :1 20 02 :2 20 02 :3 20 02 :4 20 03 :1 Household balance sheets are in better shape in Europe and Japan, where, however, consumer confidence is being dampened by worries about rising unemployment. In Europe the EU’s economic sentiment index remained at a low level in February, with continued declines in consumer and industrial confidence. Consumer confidence was at its lowest level since 1996, while industrial production was barely higher on year earlier levels (Exhibit 7). Industrial production in Japan had rebounded during 2002, fueled by strong export growth, especially to the rest of East Asia. After a slowdown in the fourth quarter of 2002, both exports and industrial production appeared to be recovering in early 2003, raising hopes that the Japanese economy could surprise to the upside in 2003. But a range of indicators suggests such optimism could be premature. Worsening wage and employment conditions contributed to weak household spending in early 2003. A sharp fall in the index East Asia Update of leading indicators in January raised the possibility that the economy could slip back into recession. Stock market prices fell to a twenty-year low, worsening the financial condition of banks, many of which will have had to write off large losses on stock holdings and on bad debts at the end of the first quarter. The 2002 recovery in the developed countries was fueled in part by strong fiscal stimulus. The aggregate fiscal deficit of OECD countries rose by 3 percentage points of GDP in 2001-02. But it is difficult to foresee them continuing to rise at the same pace, so that the degree of fiscal stimulus is likely to fall going forward. The US federal deficit is expected to rise about 1 percentage point of GDP in 2003, less than half of the increase in 2002. Japanese fiscal policy is hampered by already large deficits and very high and rising levels of public debt, while existing policy rules also constrain fiscal policy in the Euro zone. Given this fading in the forces that have carried the recovery thus far, a continued strengthening in developed country growth over time will increasingly rely on business investment, usually a buoyant source of demand at this stage in a normal recovery. There are indeed conditions in place that should favor some recovery of investment in 2003. As noted, monetary policy is supportive, corporate profits began picking up in the US and Japan, and spreads on corporate debt, which had surged earlier in 2002 reflecting growing risk aversion, began falling back. US business investment rose in the fourth quarter of 2002, for the first time since the recession began. However business investment in OECD countries more generally had continued to fall through much of 2002, and it remains to be seen if the recent upturn in US investment is indicative of a broader trend. Companies continue to grapple with the excess capacity and high corporate debt built up in high tech bubble economy of the late 1990s, and, in this still fragile environment, spending decisions may continue to be delayed until the geo-political stress and uncertainty created by the Iraq crisis are dissipated. Overall then, the soft patch in developed country growth that began in the last quarter of 2002 may extend through the first part of 2003, which will tend to constrain quarter to quarter growth in East Asia’s exports, although, as noted, technical factors may continue to boost year on year growth rates for a while. A more robust trend in global growth and exports is however expected to take hold in the latter part of 2003, going into 2004. Impact of the Iraq war … and what about SARS? The prospect of war in Iraq threw an increasingly thick pall of uncertainty and stress over world economic and political events in the last quarter of 2002 and the first quarter of 2003. The crisis affected world activity through a variety of real and potential or feared effects – surging oil prices; concern about heightened domestic political tensions in the Middle East, South Asia and parts of East Asia, including the possibility of renewed terrorist attacks; a 9 pullback in world tourism and a feared disruption of migrant worker employment in the Middle East; and worsened political tensions among major developed countries; all of which fostered an unsettling of business and consumer confidence, as economic actors waited uneasily to see how things turn out. The Iraq crisis The most obvious index of the intensifying Iraq crisis has been volatility in the price of crude oil – world oil prices rose from an average of $23 in the first half of 2002 to $27-28 in the second half, then soared to $36 in early March 2003, before collapsing back to around $26-27 when the military action in Iraq actually began.4 (Exhibit 8). The oil price has been elevated by concerns over the possible loss of Iraqi production (2 million barrels per day (mb/d)) as well as the risk that other key exporters in the region (Kuwait, Saudi Arabia) could experience supply interruptions—either due to disruption to transport networks or damage to oil production and shipping facilities. These tensions were exacerbated by persistent strikes in Venezuela, which reduced cumulative world oil supply by 100 million barrels (the equivalent of 50 days of Iraqi supply), a number of other supply factors and an exceptionally cold winter in North America, which resulted in exceptionally low commercial oil stocks. Exhibit 8 Oil Price ($/bbl) and World Stockmarket Index ($) 1.05 40 Stock Market Index Left hand side 0.96 Oil - Right hand side 35 0.87 30 0.78 25 0.69 0.60 Jan- Mar- Jun- Sep- Dec- Feb- May- Aug- Nov- Jan01 01 01 01 01 02 02 02 02 03 Source: Datastream. Oil is West Texas Intermediate 20 15 The global and regional East Asian forecasts presented here incorporated the assumption of a ‘short war’ in Iraq, which, in the event turned out to last less than a month. In this scenario, after having surged to average around $32 per barrel in the first quarter of 2003, oil prices fall sharply during the remainder of the year because the war ends quickly, dissipating the risk premium in the price of oil, significant damage to regional oil production facilities is averted, and other countries stand ready to raise production 4 World oil price calculated as an average of West Texas Intermediate, Brent and Dubai crudes. East Asia Update or release strategic reserves as needed. In this base case scenario the oil price averages $26 in 2003, only 5 percent higher than in 2002, before falling to an average $21 in 2004. Despite the uncertainties of the post-war outlook in Iraq, this remains the most likely scenario. As noted, oil prices plunged by around $10 as the US led coalition forces advanced and entered Baghdad in less than three weeks. The Iraqi oil fields were captured with very little damage and war related disruption of oil production in other Middle Eastern countries was also avoided. Commercial oil stocks in the US, which had fallen to unprecedented lows, began rising sharply in early April. Refugee flows out of Iraq have been negligible, especially compared to the vast numbers in the 1991 Gulf War, while the status of migrant workers in other Gulf countries is also comparatively unaffected. This will relieve concerns about a serious disruption to migrant worker remittances in countries where these flows are a significant source of foreign exchange earnings, for example the Philippines. Public discontent about the war has certainly run high in other Middle Eastern countries, and, to a less significant degree, in some South East Asian countries. But, at least in East Asia, this has not become a major source of political tension, and should not do so if the post-war scenario in Iraq is reasonably peaceful. However, even in this relatively benign base case scenario, it is estimated that the initial run up in oil prices and the impact of high geo-political stress and uncertainty on business and consumer confidence may reduce developed country GDP growth in 2003 by around 0.2 percentage points relative to a ‘no-war’ scenario. This would affect East Asian exports and might have an adverse impact effect on East Asian GDP growth of 0.1-0.2 percent. The full multiplier effects could be twice as large as the impact effect. It is worth underlining, however, that this scenario still sees developed country growth picking up to 1.8 percent in 2003, with world trade growth doubling to around 6 percent from 3 percent in 2002. Higher oil prices would also have a direct income effect on East Asia. The region’s aggregate net oil imports have averaged 1.5-2 percent of GDP in recent years. The impact effect of a 5 percent rise in oil prices would be to reduce the region’s external current account balance by less than 0.1 percentage point of GDP. The position of individual countries can of course be quite different from that of the region as a whole. As Exhibit 9 below indicates, countries like Malaysia, Indonesia and Vietnam are net oil exporters, which will benefit from higher oil prices. On the other hand countries like Korea, Philippines and Thailand have net oil imports of 4-5 percent of GDP, where a 5 percent oil price rise would represent an impact income loss of around 0.2-0.3 percentage point of GDP. Other more extreme ‘long war’ scenarios involving severe political turmoil, disruption of oil production in other Middle East countries and oil prices averaging $35-40 in 2003 have now become very unlikely. Just as well, since, 10 obviously, the export dependent, oil importing East Asia region would have been hard hit in such a dire scenario. More relevant scenarios now focus on post-war developments in Iraq. A downside post-war scenario could entail persistent instability and civil conflict within Iraq, serious tensions with neighboring countries, inflamed political tensions among the Middle Eastern publics in general - all keeping oil prices under upward pressure. The serious political rifts among developed countries that were exposed by the Iraq crisis might become worse in such a scenario, which might tend to hinder multilateral cooperation more generally, for example on global trade and development aid issues. An upside scenario would entail the gradual consolidation of peace in Iraq, the emergence of a credible domestic Iraqi political authority and the start of economic development. The removal of sanctions would likely have immediate large benefits for the Iraqi public, followed by a buildup of Iraqi oil production and the start of a large multi-year reconstruction boom in Iraq. Traditional political tensions between state and non-state actors in this part of the Middle East could moderate because of the radically changed security balance in the region, while world oil prices would be lower than otherwise. Both of these developments would tend to benefit East Asia. East Asian construction companies and skilled service providers find lucrative markets in Iraq in this scenario. The rebuilding of Iraq’s health services might provide a great opportunity for a country like the Philippines, which is one of the world’s leading exporters of trained nursing personnel. The SARS Crisis Unfortunately Iraq is not the only the shock affecting East Asia. The World Health Organization’s March alert about Severe Acute Respiratory Syndrome (SARS) sparked extraordinary public concern throughout East Asia and more widely in the world. The WHO issued an international warning against travel to Hong Kong and neighboring Guangdong province in southern China, where the virus first emerged. Within the region, Singapore and Vietnam also had a significant number of cases. But economic activity in the region as a whole could be affected until the outbreak is brought under control. Already by early April US airlines were reporting an 80 percent drop in bookings to Asia. There are at least a couple of reasons why forecasting the economic impact of the SARs outbreak is difficult, if not impossible at this time. First, public health experts still do not have a full understanding about the nature of the SARS virus, its method of transmission, how to test for or treat it, although research on these questions is now rapidly moving ahead. This lack of knowledge makes it difficult to judge how many people might be affected by the outbreak, how long it will last or how far it will spread. The SARS virus appears to be similar to that associated with the common cold, and the symptoms are similar to those of influenza. Many infectious disease epidemics including influenza follow a cyclical ‘boom-bust’ pattern, with a East Asia Update beginning, a peak and an end (although there may be weaker repetitions of the cycle in a later endemic stage of the disease).5 But at this stage there is not sufficient information to gauge how large the cycle will be. To date (April 22) less than 250 deaths have been reported from SARS. On the other hand, even ordinary annual influenza epidemics are estimated to cause 250-500,000 deaths worldwide. 6 Exhibit 9 11 March were down 17 percent from the first half of the month. Tourism receipts represent a little under 3 percent of GDP for East Asia as a whole, (Exhibit 9 ) so that the impact effect of a 10 percent fall in tourist arrivals in 2003 because of SARS would be to reduce income and the current account balance by around 0.3 percentage point of GDP. Such a fall sustained over the whole year would be extraordinary, however, given the robust 7 percent annual trend growth in East Asian tourist arrivals over the last decade, and the fact that arrivals in South East Asia rose about 4 percent in 2002, despite concerns about terrorism after 9/11 and the Bali attack. Such a steep decline is probably more realistic for the worst affected areas, like Hong Kong and China, rather than for other less affected countries. Countries in the region also differ according to how important tourism is to their economy. Tourism receipts represents less than 3 percent of GDP in countries like China, Korea and the Philippines, while they represents 4 percent or more of GDP in economies like Hong Kong, Indonesia, Malaysia, Singapore and Thailand. A 10 percent fall in tourist arrivals would have an impact effect of less than 0.2 percentage points of GDP in China, but one of 0.5 percentage points in a more tourism dependent economy like Hong Kong. Transport services related to tourism, other personal travel, and business travel has suffered. The effect is most severe in the airline industry, which was fragile even before the onset of SARS. However, trucking and shipping have also been affected, although as yet this effect is much more localized. The feed-through effects from airline distress (both local and international carriers) to the banking system and to employment/social security is expected to be significant, with approximately 36,000 jobs at risk worldwide if airlines continue to maintain the present SARS-related route cuts for another month. In most-affected areas like Hong Kong, shopping malls and districts have emptied, so domestic retail sales could also be depressed for a period. Hong Kong's Retail Management Association said in early April that retail sales had plunged between 50 per cent and 80 per cent since the outbreak of SARS last month. Business travel has been curtailed. The International Security Management Association survey shows that 45.6% of firms have restricted travel to the AsiaPacific region, and another 12.7% have totally banned such travel. Many leading firms that consume components or purchase finished goods from Asia (e.g., Intel, WilliamsSonoma, Pier 1) are in this group. In recent years China has become the leading global location for export processing of highly differentiated light industrial manufactures, sectors in which meetings between producers and foreign customers to determine product designs, specifications and timetables play a crucial role. The Guangdong Trade Fair (April 15-30) is one of the most significant events worldwide for purchases of apparel, household goods, electronic components and electronic and electrical systems. A disruption of these key business events and links could have Mapping Potential Impacts - Oil Exports/Imports (+/-) vs. Tourism Receipts 4.00 Net Oil Exports (+) as % GDP Indonesia 2.00 Oil exporter / Low tourism 0.00 0.0 -2.00 Oil importer / Low Tourism Philippines -6.00 Korea 1.0 2.0 China 3.0 4.0 Oil exporter / High tourism 5.0 6.0 7.0 8.0 Malaysia East Asia aggregate Oil importer High tourism Thailand -4.00 Tourism Receipts as % of GDP. (Source: WTO; 2001) A second reason for uncertainty about impacts is that in the short run the economic consequences arise for the most part from public perceptions and fears about the disease, and from precautions the public is taking against it, rather than from the disease itself. It is difficult to foresee how such perceptions will evolve, how they will respond to the information and views made available by government, media and other sources, or how intense or durable such perceptions and fears will turn out to be. Given these uncertainties, it is not possible to do more than outline possible channels of economic impact and calculate some illustrative scenarios. The principal way SARS appears to spread is through droplet transmission i.e. face to face interactions.7 The worst affected industries in the short run are therefore service industries based on face to face interaction between service providers and customers, for example tourism, transportation and retail sales, which face a sharp fall in demand from a risk-averse public. Early estimates – mostly of the period since late February – indicate that tourism receipts around the region are down by a little over 10 percent. Total arrivals in Hong Kong in the second half of 5 R.M. Anderson and R.M. May. Infectious Diseases of Humans: Dynamics and Control. Oxford. 1991. 6 World Health Organization. Influenza. EB111/10. November 2002. 7 Centers for Disease Control. Http://www.cdc.gov/ncidod/sars/faq.htm. East Asia Update a significant impact not only on China but also on other countries of the region. Not only do other countries compete in some of the same light industrial sectors, but, as the next section discusses, they are increasingly becoming suppliers of inputs and components to Chinese producers and exporters. The whole increasingly dense network of intraregional trade ties in East Asia could therefore be affected for a time. Finally, passing from the impact of perceptions to the impact of the disease itself, most governments in affected countries are struggling with how to provide adequate health care for SARS patients, particularly care in the hospital system, which has come under significant pressure in some of the affected cities. The infection rate among health providers is also a matter of concern. 8 What are the policy implications over and above the obvious need for stringent public health measures to control the spread of the disease? Since the short run economic impacts are almost entirely based on public fears, information policy will play a critical role. Any perception that governments are hiding information will lead people to assume the worst, magnifying the adverse effects. A frank, fully transparent information policy is ultimately likely to be far less costly. Finally, it is important to note that the shocks hitting East Asia this year are most likely temporary ones. The higher oil prices and the other effects of the Iraq crisis are temporary because they are driven by fears surrounding a temporary event, the Iraq war. While there is important uncertainty about how big the SARS crisis will turn out, in principal it too is a temporary shock. In general the appropriate response to a temporary shock is to mainly finance it by running down foreign assets, or by more foreign borrowing, rather than by cutting back on domestic consumption, as would be appropriate if the shock was a permanent one. The region as a whole has run large current account surpluses and built up huge foreign exchange reserves in recent years. Regional foreign reserves total near $800 billion dollars, about 30 percent of regional GDP. Most of the larger economies should therefore have little difficulty in financing the adverse shocks of 2003. However countries with significant fiscal financing needs may need to strengthen adjustment efforts as a result of the more troubled international climate of 2003. A fading boost from non-oil commodity prices? In several South East Asian countries exports have been boosted by higher prices for agricultural primary commodity exports like rice, rubber, palm oil, coconut products and lumber. Dollar prices for these five 8 12 commodities rose 41 percent on average from the last quarter of 2001 to the first quarter of 2003, although this rise still did not fully offset the large price declines and terms of trade losses experienced by many countries in the region from 1998 through mid-2001. (Exhibit 10). The rise in dollar prices for commodities has been partly underpinned by the recent fall in the US dollar against other major currencies, and also by the start of recovery in the world economy, albeit a modestly paced one. However, the especially strong increase in prices for agricultural products over the past year is mainly attributed to poor supply conditions in various sectors. Prices should ease as these conditions improve, and, indeed, prices for rice, coconut oil and palm oil peaked in January 2003 and fell in February and March. Rubber however continued to strengthen sharply during the first quarter of 2003, as a result of still adverse weather conditions and aggressive supply management by the three dominant natural rubber producers, Malaysia, Thailand and Indonesia. Minerals prices, which are more sensitive to industrial demand conditions, have risen much less over the past year. Exhibit 10 East Asia: Commodity Prices 1.40 (US$ - Index 2000 Q1=1) LogsMeranti Rice Coconut Oil Palm Oil Rubber Crude Oil 1.20 1.00 0.80 0.60 0.40 00 00 00 00 01 01 01 01 02 02 02 02 03 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 As noted, most of short run effects are based on precautions taken by a risk averse public. A serious epidemic can also have long run, supply based effects if the disease leads to many deaths and increased illness. These include reduced labor supply, lower labor productivity, lower savings and increased diversion of resources into healthcare. See for example Maureen Lewis: The Economics of Epidemics. Georgetown Journal of International Affairs. Summer/Fall 2001. The rise in agricultural commodity prices has had a significant impact on particular sectors and groups, boosting rural incomes and contributing to rural poverty reduction in Thailand and other South Eastern countries. The impact on national income in middle income South East Asian nations is likely to be more limited, however, since such exports generally make up less than 20 percent of their merchandise exports. In addition income gains in oil-importing countries like Thailand and Philippines will tend to be offset by the rise in oil prices over recent months. The largest gains will be in countries like Indonesia, Malaysia and Vietnam, which are both oil and non-oil commodity exporters. East Asia Update International Capital Markets World financial markets presented a picture of contrasts in late 2002 and early 2003. Markets were afflicted by high levels of volatility and risk aversion through much of 2002, but showed intriguing signs of stabilization and better sentiment in the latter part of the year. Net private capital flows to developing countries ran at 2.5 percent of GDP in 2002, still about half the level before the East Asian financial crisis. (Exhibit 11). Capital market flows in particular remained negligible in net terms for the year as a whole, while gross capital market flows, at about $150 billion, were flat on the previous year.9 However gross flows to developing countries began rebounding in the last couple of months of 2002 and in January-February 2003. Emerging market bond issuance in January was the highest in three years. Capital flows into emerging market mutual funds also rose strongly from the turn of the fourth quarter of 2002 onwards, with flows into emerging market debt funds especially strong in the new year. Exhibit 11 13 economic risk arising from the war seems not to have been a factor in investors’ thinking. Exhibit 12 East Asia - Foreign Reserves 800 (Jan.1990-Dec.2002. US$ Bill.) Philippines Indonesia Malaysia Thailand Singapore Korea Taiw an, China China 600 400 200 0 Ja n1 J a 990 n1 J a 991 n1 J a 992 n1 J a 99 n- 3 1 J a 994 n1 J a 995 n1 J a 996 n19 J a 97 n1 J a 998 n19 Ja 9 n- 9 2 J a 000 n2 J a 001 n20 02 Private Capital Flows to Developing Countries (% of GDP) 5.0 Exhibit 13 Eurobond Spreads 1/99 - 4/03 350 China Thailand Malaysia Korea 2.5 0.0 19 90 19 91 19 92 19 93 19 94 19 95 19 96 19 97 19 98 19 99 20 00 20 01 20 02 250 -2.5 All Dev.-Net FDI All Dev.-Capital Market flow s E.Asia-Net FDI E.Asia-Capital Market flow s 150 -5.0 Source: World Bank Global Development Finance. 2003 50 Improving sentiment towards emerging markets was also apparent in the pattern of spreads. Earlier in 2002, turmoil in emerging debt markets had centered on crises in Argentina, Brazil and Turkey, and was reflected in large increases in spreads in the second and third quarters of 2002. However spreads on emerging market debt fell substantially in the last quarter of 2002 and early 2003. In part this was seen as a ‘relief rally’ after elections in Brazil and Turkey. But it was also part of a broader improvement in sentiment towards high risk assets, a more general fall in risk aversion, since high yield corporate debt in the US and other developed markets also rallied. Significantly, emerging market debt rally occurred at the very time that tensions over Iraq were soaring. The potential for increased political and 9 Defined as the sum of bank lending, portfolio equity and portfolio bond flows. East Asian economies have by and large been shielded from some of the volatility in international capital markets in the last 1-2 years, because of the large improvements in their external balance sheets, the result of running current account surpluses since the financial crisis, achieving a dramatic reduction in their net external liabilities. While most economies in the region have maintained market access on excellent terms, they have, as Exhibit 11 above indicates, taken the opportunity to pay down foreign debt, so that net capital market flows to the region have been negative for five years, although that process appears to be drawing to a close. As noted previously, regional foreign reserves have also doubled since East Asia Update the financial crisis to reach about $800 billion, or 30 percent of regional GDP. (Exhibit 12). Economies are likely to have built up such enormous reserves in part from precautionary motives, to avert the enormous economic costs that might result from any future cut off from access to international capital markets, such as occurred during the 1997 crisis. However, the precautionary motive cannot explain the acceleration in reserve accumulation during 2002. Instead, continued overall weakness in private investment and aggressive intervention in currency markets are likely to explain most of the recent increase in reserves. Given this strong macroeconomic background, few East Asian economies were not much affected by the steep rise in spreads on emerging market debt in the middle part of last year. Eurobond spreads on East Asian debt fell sharply in late 2001 and the first half of 2002, and though they backed up mildly in the second half of the year, they generally remained at their lowest levels in years. (Exhibits 13 and 14). Spreads are highest and most volatile in countries like Indonesia and the Philippines which are most affected by concerns over fundamentals such as political stress, fiscal deficits and public debt. Exhibit 14 Eurobond Spreads 1/99 - 4/03 1,200 14 (averaging only 1.5 percent over the last two years), as well as, more recently, the severe impact of SARS on the Hong Kong economy. (Exhibit 15). Singapore, where growth averaged close to zero in 2001-02, also saw a near 30 percent fall since the start of 2002, as did the Philippines. Other markets, however have done a lot better than the typical outcomes in the developed world over this period. Prices in Indonesia and Malaysia were roughly flat, while Thailand was up 25 percent. (Exhibit 16). The Korean stock market was the strongest in the region in the first part of 2002, but prices have been tending lower since then, especially in the last few months, affected by rising tensions with North Korea, concerns about corporate governance raised by the SK Group scandal and lowered expectations about export market growth. Exhibit 15 Stock Market Indices 1.2 (28 Dec.2001=1) Japan Philippines Singapore Hong Kong (SAR) USA 1.0 Indonesia Philippines 0.8 900 600 0.6 2 O ct -0 2 D ec -0 2 r-0 2 ec -0 1 n0 g0 Fe b Fe b Ap Au Ju Ap Ap r-0 3 300 D Exhibit 16 0 1.8 Stock Market Indices (28 Dec.2001=1) Indonesia Korea Thailand Malaysia World stock markets remained volatile and on a generally falling track over the last 15 months. US equities fell around 25 percent in the first three quarters of 2002, and have then stabilized near that level in the following six months, perhaps reflecting uncertainties about the direction and strength of the economic recovery going forward. Japanese stocks, on the hand, have continued to trend lower, falling around 35 percent in 2002 and another 6 percent in the first quarter of 2003. East Asian equity markets have seen a wide variety of outcomes over this period, mainly reflecting divergences in fundamental economic trends. Equity prices in Hong Kong fell almost as much as in Japan over the last 15 months, reflecting the general trend of weak growth 1.4 1.0 0.6 2 O ct -0 2 D ec -0 2 r-0 2 2 -0 2 Au g0 Ju n0 ec -0 Fe b Fe b -0 3 1 D Ap r-0 3 2 -0 2 -0 3