Highlights of the Book

Asia and Policymaking for the Global Economy

Edited by Kemal Dervi, Masahiro Kawai, and Domenico Lombardi Published by the Asian Development Bank Institute and the Brookings Institution Press

s the global economy consolidates its recovery, leaving behind the worst recession in almost a century, emerging Asia leads the pack with growth projected at 9.6 percent for the Peoples Republic of China (PRC) and 8.2 percent for India in 2011.1 Building on the resilience of their aggregate demand, the soundness of their policy fundamentals and their swift response to the crisis, emerging Asian economies have been able to weather the global crisis that sent other countries to the brink of a severe economic depression. In the global financial crisis of 2007-09, the choice of the Group of Twenty (G-20) as the primary forum for international policymaking was meant to promptly engage rising economic powers, mainly from Asia, in containing potentially devastating spillovers and to include these emerging economies in decision-making processes (see Box 1). In fact, the financial crisis highlighted a fundamental change in the structure of the world economy, by making very apparent the unprecedented convergence in income of many emerging economies. Asia is at the heart of this change. While the early Asian tigers (Hong Kong, China; Republic of Korea henceforth Korea; Singapore; and Taipei,China)2 had already reached high levels of growth in the 1960s, the increased dynamism of the PRC from the 1970s
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onward and of India in the 1980s gave Asia enough weight in relative GDP by 1990 to begin the process of narrowing the aggregate income gap between advanced and emerging/developing economies. This convergence continues into the current century, after only a brief interruption in 1997 and 1998 at the time of the Asian crisis. The differences in per capita income between traditionally rich countries and the developing world will persist for decades, though these differences will steadily diminish as the overall size of the rich economies is soon to be surpassed by the aggregate size of developing country economies, even when measured at market prices. At purchasing power parity, emerging and developing economies have in fact already caught up, in terms of aggregate size. This volume examines the growth dynamics in Asia comparatively and historically (Ch. 2); appraises the scope for policy coordination among systemically important economies from an Asian perspective (Ch. 3); reviews financial stability in emerging Asia in the context of the current G20-led process (Ch. 4); and, lastly, evaluates the implications of Asias rise in the global economic governance by addressing the reform of the international monetary system (Ch. 5).

IMF World Economic Outlook, April 2011. Asian Development Bank naming conventions for its member economies are used throughout the Highlights. The Brookings Institution takes no position on Taipei,Chinas legal status.

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Box 1. The G-20

The G-20 currently comprises the European Union and 19 countries: Argentina, Australia, Brazil, Canada, France, Germany, India, Indonesia, Italy, Japan, Mexico, Peoples Republic of China, Russia, Saudi Arabia, South Africa, Republic of Korea, Turkey, the United Kingdom and the United States, collectively, representing about 85 percent of global output and two-thirds of the worlds population. Unlike many formal intergovernmental institutions, the G-20 has no permanent secretariat, while its size and structure are meant to encourage informal exchanges of views and the formation of consensus on international economic and financial issues. There are no formal votes or resolutions, and the G-20 chair rotates between members each year. Based on an agreed agenda, working groups and expert groups of deputies and senior public officials are formed to conduct research and case studies that provide background and analysis for G-20 leaders, finance ministers, and central bank governors. In the late 1990s, the Asian financial crisis of 1997-98 not only exposed key vulnerabilities in the global financial architecture, but also brought to light the importance of emerging economies in the stability and sustainability of economic growth in an increasingly globalized financial system. In the past, the Group of Seven (G-7) had been the key forum for economic coordination and informal dialogue on international economic and financial issues. The lack of representation from emerging economies in the G-7 limited the ability of the G-7 to deal with crucial issues in an increasingly international economy and financial system. In June 1999, the G-7 released a report to the Kln Economic Summit in Cologne, Germany, outlining the need for, and the benefits of, involving a broad range of countries in discussions on how to adapt the international financial system to a changing global environment. As a result, the G-20 was formally created at the September 25, 1999 G-7 Finance Ministers meeting in Washington, D.C., as a new forum for informal dialogue on key economic and financial policy issues among the finance ministers and central bank governors of systemically significant economies. Months later, finance ministers and central bank governors from 19 systemically significant economies and the European Union convened in Berlin on December 1516, 1999 to launch the first meeting of the G-20. The managing director of the International Monetary Fund (IMF) and the president of the World Bank, along with the chairs of the International Monetary and Financial Committee (IMFC) and the Development Committee (DC), have also participated in G-20 meetings of finance ministers and central bank governors. Following the eruption of the global financial crisis, the G-20 Finance Ministers Meeting was upgraded to the G-20 Summit, where heads of state of the group discuss major global financial and economic issues and agree on certain decisions and policies to be taken.

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cHAPter 2. Structural Transformation in Asia and the World Economy

Kemal Dervi and Karim Foda examine the sources of the greatest structural transformation that the world economy has ever experienced in a 30-year period. Emerging Asia (EA), led by PRC in terms of size and rate of growth, will likely reach almost one-quarter of world GDP at market prices by 2020, compared to 6.6 percent in 1990 and 16 percent in 2010. Its rise is somewhat similar to that of Japan during the postwar period. While the Japanese story only involved about 120 million people, the EA story involves nearly 3 billionapproximately 40 percent of world population. Growth performance in EA is fundamentally transforming the overall structure of the world economy and shifting its center of gravity. Dervi and Foda pinpoint two distinctive characteristics of the EA group, namely, GDP growth rates and ratios of investment to GDP. From 1999 to 2008, the rate of growth in EA was about three times that in advanced economies, and about twice the rate of growth in other emerging and developing economies. During the same period, investment rates were high in EA countries, increasing from about 29 percent of aggregate GDP in 1999 to about 38 percent in 2008, much higher than in any other part of the world. EA has accomplished this by combining rapid capital accumulation, driven by sustained high investment rates, and fairly rapid technological progress as measured by the growth of to-

tal factor productivity. This differs from what happened in the Soviet Union, where investment rates were very high but there was not much total factor productivity growth generated. The supply-side factors will remain in play over the next decade, at least enough to allow a growth rate similar to that of the recent past. Future growth sustainability will also depend on the demand side. Because EA is a region with higher savings than investment and thus with a current account surplus, it has demonstrated that, in the aggregate, it does not need foreign capital inflows to finance its high investment rates. Rather, EA requires net foreign demand to ensure that potential growth is realized. The debate over whether EA can sustain growth from the demand side hinges mainly on global imbalancescurrent account surpluses or deficits. EA countries have run surpluses in their accounts on the order of 9 percent of GDP for the PRC, and 17 to 19 percent of GDP for Malaysia and Singapore. Across the Pacific, the United States has run a large deficit in the order of 5 to 6 percent of GDP in its peak, although it has now decreased to 3 percent. It is generally agreed that EA can no more run its precrisis current account surpluses than the United States can continue with its pre-crisis deficit. However, too drastic a decline in the Chinese structural surplus might not be feasible in the short run without triggering a decline in the Chinese growth rate, which would hurt not only the PRC but also overall world growth. In fact, the rebalancing has become an important agenda item for the G-20 (see Box 2).

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Box 2. The G-20s Mutual Assessment Process

In September 2009, leaders at the G-20 summit in Pittsburgh agreed to the Framework for Strong, Sustainable, and Balanced Growth, proposed by the United States. Through this framework, they pledged to devise a method for setting objectives, to develop policies to support such objectives, and to assess outcomes through mutual evaluation. The end goal is strong, sustainable, and balanced growth in which the improvement of living standards in emerging and developing countries is supposed to be a critical element. To accomplish this, the G-20 has also devised a standard template for national policy frameworks that will allow countries to indicate key forward-looking elements of their policy plans and to outline the expected impact of policies both on their domestic economy and, more broadly, on their national forecasts for key economic variables for the subsequent three to five years. From its inception, the G-20 envisioned the IMF playing a substantial role in the Mutual Assessment Process (MAP). As a first step, the IMF was tasked with analyzing how national and regional frameworks fit together and if national policies are collectively consistent with their shared broader goals for a strong, balanced and sustainable global economy. Because the G-20 initiated the MAP and requested IMF assistance, it is considered a voluntary upon request service members of the Fund, which falls under Article V, Section 2 of the Articles of Agreement. To facilitate this work, G-20 members agreed to submit policy frameworks (with a consistent template) to the Fund for staff analysis. This is also an important distinction for the Funds traditional bilateral and multilateral surveillance analyses, which are based on Fund staffs independent projections, analyses and assessments; whereas the MAP is based entirely on voluntary inputs and projections provided by the G-20 member. In February 2011 in Paris, the G-20 agreed to a set of indicators for persistently large global imbalances: 1) internal indicators of public debt, fiscal deficits, private savings rates and private debt; and 2) external indicators in the form of external imbalances of the trade balance and net investment income flows and transfers. In April 2011, the G-20 finance ministers and central bank governors met again in Washington DC amidst the annual IMF/WB Spring Meetings with the goal of finalizing the choice of indicative indicators so that the MAP process could move forward. An agreement was reached on how to proceed with these indicators, based on a two-pronged approach: 1) The agreed upon indicators will be run to determine if, in the case of a given G-20 country, they are out of line with historical trends. 2) Those countries that emerge, based on at least 2 of the 4 indicators, to have persistently large imbalances will be assessed in-depth by the IMF to determine the root causes of their imbalances and to identify challenges to adjustment. The G-20 also agreed a selection rule in which individual countries whose GDP accounted for more than 5 percent of the combined GDP total (that is, France, Germany, India, Japan, PRC, UK and the US) will be subjected to more stringent indicator tests, making it less likely that those countries can avoid a more in-depth assessment. For this purpose, the IMF will conduct consultations with such countries and will report its assessment to the G-20. Findings will be discussed at the next G-20 summit in Cannes.

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cHAPter 3. The Rise of Asia and Implications for International Economic Coordination
Following the analysis in Chapter 2 focusing on the supply-side sources of growth, Rajiv Kumar and Dony Alex look into the demand side in Asia, highlighting the role that the economies in the region can play in achieving a more balanced and sustainable economic growth and greater coordination of macroeconomic policies. The authors argue that there are three possible ways to increase aggregate demand in Asia. The first is to increase domestic private consumption, especially in the PRC and Japan, as well as in the ASEAN region. Doing so would allow other countries, such as the United States, to take greater advantage of external demand and to rebalance their economies. Although this would have a positive impact, especially in reducing the PRCs dependence on external demand to sustain its very rapid GDP growth, it would be difficult for a country-by-country process of internal rebalancing alone to compensate for the weak and demand-slowing growth in some advanced economies. The second way would be for oil-exporting economies to reduce their current account surpluses to push up aggregate world demand. Oil-exporting countries could be expected to spend more of their savings from sudden surges in oil prices, if they were assured of stable future income streams. This could be accomplished by reforming the financial sectors both in Asia and in oil-producing countries to ensure that such savings could be suitably invested and would generate stable earning flows from Asia to oil producers. The implementation of these financial sector reforms, however, can come about in the medium to long term. The third way to increase aggregate demand in Asia would be to further boost economic activity in the region, including in the lower-income Asian economies, by accelerating the process of
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pan-Asian economic integration and establishing institutional mechanisms for designing and financing regional infrastructure projects. One way to shore up regional demand would be to complete the process of trade and economic integration among the ASEAN + 4that is, the ASEAN member states, PRC, India, Japan, and Koreain order to strengthen their contribution to greater dynamism in regional economic activity. Another option would be the establishment of an Asian Investment Bank (AIB), which would supplement the efforts of the Asian Development Bank (ADB) and other national development banks to finance infrastructure and connectivity in Asia at levels comparable to those in Europe and the United States. Kumar and Alex conclude that the strengthening of regional economic activity in Asia could contribute to external demand stimulus for the U.S. economy and help both Asia and the United States to achieve higher economic growth and employment through sustainable rebalancing. In the context of Asia-Pacific rebalancing, it is crucial that intra-regional economic activity in Asia be bolstered through higher demand for regional public goods, and supplemented by increased domestic demand in economies with a current account surplus.

cHAPter 4. G-20 Financial Reforms and Emerging Asias Challenges

In this chapter, Masahiro Kawai assesses recent progress in financial sector reform in EA achieved through the G-20 process, focusing on the following issues: building stronger capital, liquidity, and leverage standards; addressing too-big-to-fail problems; designing macroprudential supervisory and regulatory frameworks; and strengthening international coordination of financial supervision and regulation. Although these reforms are expected to strengthen the financial systems of Europe and the United States, where the crisis originated in 2007, it is also in Asias best interest to pursue them.
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A significant part of the G-20 process has been its endorsement of the Basel III capital and liquidity requirements. The objective is to introduce a fair amount of counter-cyclicality to the bank capital rules while increasing the provisioning against maturity mismatches that give rise to funding liquidity risks. Banks in EA will be less affected by the new supervisory framework, largely because of reforms already enacted. However, EA banks will benefit from the implementation of the framework in the United States and Europe. Likewise, since most EA banks are small internationallythough some may be considered large in their domestic markets they are unlikely to be affected by the emerging international regulation of systemically important financial institutions (SIFIs). Still, there is merit in identifying and appropriately overseeing national SIFIs. The crisis of 2007-2009 taught a key lesson, namely that authorities in the United States and Europe failed to assess the ability of their respective financial systems to withstand systemic shocks, in part because of their traditional bottom-up approach to microprudential regulation and supervision of individual firms. On the contrary, the objective of macroprudential regulation and supervision is to provide a topdown framework for identifying risks in the financial system as a whole. In Asia, in fact, many authorities have actively intervened in their respective financial systems in a macroprudential way, even though they do not have a formal framework. Hence, there is an urgent need to establish a full-fledged macroprudential supervisory framework that focuses on systemic risks across the global economy. Similarly, another important lesson from the global financial crisis is that monetary and macroprudential policies should play complementary roles in addressing systemic risks. For this reason, a mechanism should be devised to allow central bankers, financial regulators, and finance ministry officials to share information about systemic risk and

to coordinate policies to prevent the buildup of excessive risk. A systemic stability regulator whether a single entity or a councilshould be established at the national level for this purpose. Foreign capital flows into EA resumed in 2010, fueled by the expansion of liquidity in advanced economies. These flows will test the macroeconomic management capacities, exchange rate policies, and financial supervision frameworks in Asia. Up until now, sterilized intervention has been the instrument of choice for many EA economies to prevent nominal appreciation of their exchange rates. Given that interventions in foreign exchange markets have been mostly unidirectional, sterilization is becoming an increasingly costly method to prevent the economy from overheating, while the accumulation of net foreign reserves cannot be sustained indefinitely. Another option for addressing the current surge in capital flows would be to impose capital controls reminiscent of the Chilean experience, but evidence of their overall effectiveness is mixed. Where no definitive measures exist at the national level to effectively manage capital flows, Kawai concludes that an attractive alternative is regional collective action, insofar as it expands the menu of options available to individual countries. By stepping up regional financial market surveillance, policymakers can mitigate the impact of investor herd behavior and financial contagion. A countrys adoption of tighter prudential policies and capital inflow controls could push capital towards other countries. The establishment of a new high-level Asian Financial Stability Dialogue would bring together all the responsible authoritiesincluding finance ministry officials, central bankers, and financial supervisorsto address regional financial market vulnerabilities and make efforts at regional financial integration through greater harmonization of standards and market practices (see Box 3).

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Box 3. The Asian Financial Stability Dialogue

To deepen regional financial integration while maintaining regional financial stability, the Asian Development Bank proposed in 2008 the creation of an Asian Financial Stability Dialogue (AFSD). This would be a regional forum that would bring together all responsible authorities finance ministries, central banks, and financial supervisors and regulatorsto address financial market vulnerabilities and strengthen financial supervision and regulation, while promoting financial market development and introducing initiatives for regional financial integration. The global financial crisis underscored the importance of establishing an effective framework for sound financial supervision and regulation to improve market governance at the national level. An important challenge for Asias emerging economies would be to strike the right balance between pursuing national financial market development and regional financial integration on the one hand and maintaining national and regional financial stability on the other. Regional financial integration would require continued liberalization of domestic financial regulations and crossborder restrictions of financial services and financial flows in many emerging and developing economies. To address these challenges, concerted efforts are needed at the regional level. The AFSD could help Asian financial authorities coordinate their efforts to promote regional financial stability through information exchange, the mutual recognition of market practices, and the harmonization of minimum supervisory standards. The AFSD could promote regional surveillance of macroeconomic and financial links, including capital flows and asset price movements, so as to spot emerging systemic risksthrough early warning mechanismsand act on them collectively. It could identify systemically important financial firms at the regional level and strengthen monitoring of them. To maximize its effectiveness, it should complement and coordinate with other regional institutions such as the ASEAN + 3 Macroeconomic Research Office that focus mainly on macroeconomic surveillance and policies, as well as monitoring policy implementation. Given that not all Asian economies are members of the Financial Stability Board (FSB) or the Basel Committee on Banking Supervision (BCSB), the AFSD would need to consolidate Asias views and positions and make sure that these are heard at the FSB and other global organizations such as the Bank for International Settlements.

Regional collective action would also be necessary with regard to exchange rate policies. In fact, if the fear of losing international price competitiveness prevents a country from allowing its currency to appreciate, the country could cooperate with its regional competitors to take action simultaneously. Collective currency appreciation would not only contribute to financial and macroeconomic stability in the region, but would also minimize the loss of price competitiveness.

cHAPter 5. Reforming the International Monetary System through the Lens of Emerging Asia
In chapter 5 Domenico Lombardi examines asymmetries between the sustained integration of emerging economiesmany located in Asiainto the global economy and the resilience of the international monetary system (IMS) to adapt accordingly. The first source of structural asymmetry has to do with the pressure to adjust
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external accounts, which is much stronger for deficit countries than it is for those in surplus, as was noted by Lord Keynes long before the Bretton Woods Conference in 1944. However, the lack of an authentic multilateral forum to discuss and formulate policy responses had left emerging and developing economies more vulnerable in an increasingly interdependent world. With its recent elevation to the leaders level, the G-20 may finally be able to serve as a relevant forum where emerging economies can voice their concerns and constructively channel their criticism. In September 2009, leaders at the G-20 Summit in Pittsburgh agreed to the Framework for Strong, Sustainable, and Balanced Growth. This is the first relevant multilateral surveillance exercise on a global scale in recent history, although so far it has been mainly geared towards making national authorities aware of the international spillover effects of their policies and providing a context in which policymakers can exercise mutual pressure. This is not the same thing as national authorities committing to quantitative policy targets to which they can be held accountable in a multilateral forum, although recent progress on that front is encouraging (see Box 2). The central role that domestic currencies, especially the U.S. dollar, play as a global reserve asset is the second source of asymmetry. Because of the reliance on the domestic currency of a single country as the principal international reserve asset, it makes it difficult for U.S. policymakers to reconcile, in the long run, their domestic macroeconomic goals with the (increasing) need for a net supply of dollardenominated international assets. This leaves the IMS vulnerable to unilateral adjustment in the economic policies of the reserve currency country. In this regard, Special Drawing Rights (SDR) have played only a marginal role, despite the provision in Article VIII of the IMF
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Charter about making the special drawing right the principal reserve asset in the international monetary system. After the last general allocation of $250 billion in 2009, which was endorsed by G-20 leaders at the height of the crisis in 2009, many experts have called for an expanded role of the SDR in managing risks associated with countries that do not issue hard currencies. Since the SDR is an artificial unit of account with limited scope for use within existing parameters, the head of the Chinese central bank has proposed a significant overhaul in the IMS to increase the role of the SDR. The proposal envisages a political bargain between structural reforms of the IMS and the restoration of the IMFs centrality in it. In the meantime, the managing director of the IMF and its governance bodies have expressed an interest in proposals for strengthening the role of the SDR, and the 2011 French presidency for the G-20 has made it an important agenda item. The third element of asymmetry in the IMS relates to the governance of the institution charged with the task of overseeing it, the IMF. The distribution of voting power has been heavily biased towards Western countries. Because many emerging Asian countries have carried inadequate weight in the IMFs decision-making, their positions were less likely to be incorporated into the funds policies and programs. A case in point is the IMFs intervention in Asia in the late 1990s. A further example of how the IMFs governance affects the asymmetries of the IMS is the fact that, against the need for increased reserves, the issuance of SDRs requires approval of 85 percent of the voting power of the IMF membership. Besides the potential veto power that such a large supermajority affords to a few countries or groupings, the governance arrangements underpinning the issuance of SDRs reduces the IMFs ability to be responsive to the liquidity needs experienced by some segments of its membership. At the same time, it embeds a tension in the institutional mandate to
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pursue systemic stability, as it leaves decisions on regulating global liquidity in the hands of those countries issuing the hard currencies used as international reserve assets. After the endorsement by the G-20 last fall, the IMF membership is working on a governance reform package to be finalized by the time of the next annual meetings in 2012. The package will feature a shift in voting power of 6 percent in favor of emerging and underrepresented economies. This means that the PRC should become the third largest shareholder, while Western Europe will eventually have to forfeit two seats on the executive board. These recent developments would not have been possible without the political impetus provided by the G-20, with the presence of the large Asian economies. In order for the IMF to garner the support of the emerging Asian countries, IMF reforms must be linked to structural changes in the IMS so as to reaffirm its role as the central institution in a reformed and global monetary system.

arguing that intra-regional economic activity in the region can be bolstered through higher demand for regional public goods and supplemented by increased domestic demand in economies with a current account surplus. Their analysis highlights the contribution that EA can thus provide to external demand stimulus for the U.S. economy, helping both the United States and Asia achieve a more sustained growth through rebalancing. Kawai reviews financial sector issues in EA in the framework of the G-20 process. While reforms endorsed in such context are expected to strengthen the financial systems of Europe and of the United States, where the crisis originated in 2007, it is also in the regions best interest to pursue them. In discussing pros and cons of various policy options, Kawai points out the need for Asia to step up regional collective action, for instance, through the establishment of a new high-level Asian Financial Stability Dialogue to help address market vulnerabilities and to support financial integration by promoting greater harmonization of standards and market practices. Finally, Lombardi examines the role of EA countries in the international monetary system highlighting the fundamental asymmetry between their sustained integration into the global economy and the resilience of the IMS to adapt accordingly. In his analysis, he argues that EA is mainly interested in pursuing structural reforms of the IMS and that, as a result, institutional changes at the IMF disconnected from the latter objectives are likely to be of limited interest to the region. Only by linking IMF reforms to structural changes in the IMS will the IMF gain strong support from EA as the central institution of a reformed and truly global monetary system.

Concluding Remarks
In this collaborative research project between the Asian Development Bank Institute and the Brookings Institution, Dervi and Foda examine the dynamics of growth in Asia, which has represented the source of the greatest structural transformation in the global economy in the last 30 years. Their analysis shows that growth in EA sustained by supply-side factors such as high investment rates and fairly rapid technological progressis likely to continue for the next decade at rates not far from those observed so far. Building on the analysis in the previous chapter, Kumar and Alex focus on the demand side,

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