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This Regional Update was prepared by Milan Brahmbhatt, Lead Economist, East Asia PREM, with the assistance of Antonio Ollero,and Nancy Mensah, drawing on inputs and comments from country economists and sector specialists throughout the East Asia andPacific Region of the World Bank. The report was prepared under the general guidance of Homi Kharas, Chief Economist, andJemal-ud-din Kassum, Regional Vice President, East Asia and Pacific Region.

CONTENTS

East Asia and Pacific regional overview................................................ 1

1. Introduction.........................................................................................................1

2. East Asia – at the peak of the cycle?................................................................. 6Growth – securing the path to sustained expansion ........................................ 6

Poverty – down by 250 million in five years................................................... 8

3. The international and regional environment ............................................... 11

Developed country growth – the pause that refreshes?................................. 12China – what kind of landing?. ...................................................................... 13Commodity cycles and the oil price shock .................................................... 16

Box 1. Managing commodity windfall gains ........................................ 21

Trade policy developments .......................................................................... 22Box 2. The end of quotas on garment and textiles trade.......................23

Capital markets and global imbalances ........................................................ 23

4. Domestic trends and policy challenges........................................................... 27

Fiscal policy…...............................................................................................28

Corporate sector - trends and reforms........................................................... 29Financial sector...............................................................................................30

Country Sections ............................................... …………………………33

Appendix Tables…………………………………...…..…… .... …………46Special Focus: Strengthening the investment climate in East Asia ................. 54

Key Indicators Tables ............................................................................................. 63



EAST ASIA AND PACIFIC R EGIONAL OVERVIEW

Introduction

2004 has turned out to be a remarkable year for

East Asia on several dimensions.1 Economic growth isexpected to top 7 percent for the region overall, while

among its developing economies it should reach near 8

percent, the strongest since the regional financial crisis,and more than one percentage point higher than we had

expected at this time a year ago. Exports have been buoyant since late 2002, supported by unexpectedly

strong recovery in the developed world, cyclical rebound

in the global high tech industry and a surge in intra-

regional trade, led by booming exports from the rest of

East Asia to China. Uncertainties about the future of the

multilateral trading system - from which East Asia has

profited perhaps more than any other developing region – appeared to diminish as WTO members agreed a

negotiating framework for the Doha Round. Importantly,

the driving forces of the recovery have also been

evolving, as late 2003 and early 2004 saw the first robustand really widespread rebound in East Asian fixedinvestment spending since the crisis, underpinned by

continued gradual improvements in the profitability and

balance sheets of corporations and financial institutions.

At some point this year or next, we estimate that

the number of people living on less than $2 a day in East

Asia will fall below one third of the population. Asrecently as 1999 that proportion was 50 percent. That is,

around 300 million people will have escaped from

poverty in the years of recovery since the financial crisis.

Perhaps most strikingly, this is a time not only of

economic and social progress in East Asia, but also of

remarkable political advances. This year saw a sweep of legislative and presidential elections right across the

region, including in Cambodia, Indonesia, Malaysia,Korea, Philippines and Taiwan (China). Most recently

some 155 million voters – more than 80 percent of the

electorate – participated in Indonesia’s first ever direct

presidential elections, resulting in the peaceful transitionof authority from sitting president Megawati Sukarnoputri

to the winner, president-elect Susilo Bambang

Yudhoyono.

The Indonesian elections cap what has been in

essence a genuine political revolution over the last five

years, albeit – thankfully – a largely peaceful one,

bringing about a transition from a highly centralized

political system with autocratic powers concentrated in

the hands of the president, to a representative andsubstantially decentralized one. Political accountability –

1 East Asia comprises Developing East Asia (China,

Indonesia, Malaysia, Philippines, Thailand, Vietnam and

some smaller economies) and four Newly Industrialized

Economies or NIEs (Hong Kong, Korea, Singapore and

Taiwan, China).

the accountability of politicians to citizens - has beentremendously strengthened through genuinely competitive

elections for the presidency, the legislature and regional

governments, contested by political parties that seem – by

East Asian standards - relatively cohesive and based on

differentiated political programs and ideas. A free press

and a vigorous civil society have emerged, providinggreater scrutiny and transparency over government

actions. At the global level Indonesia emerges as the

world’s third largest democracy and – not less important – its largest Muslim majority democracy.

Yet, amid these triumphs, recent data alsosuggest that the cyclical recovery in East Asia has peakedand that activity is shifting or has already shifted intolower gear, while a number of cross-currents and risks

noted in earlier editions of the World Bank’s East Asia

Update have intensified, some without and some within

the region. In a word, the environment facing East Asia is

more uncertain.Some of these risks are discussed in more detail

later in the report. Perhaps the one of most concern is the

steep spike in world oil prices, which will reduce incomes

among the majority of economies in the region that are

net energy importers, as well as among the developednations which comprise Emerging East Asia’s major

extra-regional export markets – the United States, Japan

and Europe. Affected by oil prices, as well as by a variety

of domestic factors, growth in the developed world shiftedto a lower pace in the second quarter of 2004, most

notably in Japan, and to a lesser extent in the U.S., while

monthly indicators suggested softening activity in Europe

in the third quarter. Overlaid on the growth pause in thedeveloped world is the likelihood of another cyclical

downturn in the global high tech industry, a concern for

East Asia which is now the leading location for

manufacturing and assembly in this industry. East Asiandecision makers are also giving much attention to the

outlook for China. While efforts to slow China’s

investment boom have had some success, a re-

acceleration could increase the likelihood of a later, moresevere ‘hard-landing’ that could knock away a key source

of new export demand in the region over the next few

years. Even with a ‘soft landing,’ the growth of East

Asian exports to China will decline from their recent

soaring pace, a change that seems to have already begun.

The consensus view remains that the recent

slackening of activity in the developed world will prove atemporary pause in a more sustained expansion, while

China will continue to expand at rates that – while lower

than recently – will remain high by world standards.

Nevertheless, the apparently remorseless rise in oil prices

has heightened worries about a more serious downturn.

These concerns are exacerbated by worries about large

global macroeconomic imbalances, in particular record

sized and growing U.S. current account deficits and the



East Asia and Pacific Regional Overview 2

foreign financing they require, notably from the current

account surplus economies of Japan and Emerging EastAsia. Unpredictable changes in investor sentiment and

risk appetite could result at some point in interest rate

hikes, exchange rate swings and a sharp adjustment in

U.S. aggregate demand and imports – a recession. That

would be a costly outcome for all.

What should the focus of policy makers be inthis sort of uncertain and potentially volatile

environment? Rather than fretting too much about a

cyclical slowdown that is inevitable to some extent, the

focus is better placed on nurturing the emerging recovery

in private investment. This would enhance the supply

capacity of the economy and also has advantages from a

near-term demand perspective. So far the regional

recovery has been driven by exports and consumer demand. Going forward, however, export growth may be

crimped by the cyclical factors and imbalances noted

above. Consumption has been boosted in part by rapidgrowth in credit to households, but, as recent experience

in Korea and Hong Kong (China) shows, this has itsdangers too. A key issue for policy makers, then, is to

nurture the recent investment recovery in the region by

strengthening the investment climate, so that the recovery

is sustained through the present period of global

uncertainties and cyclical slowdown.

A recent series of Investment Climate Surveys

undertaken by the World Bank helps document the key

constraints and problems faced by firms and other businesses in East Asia. One key finding is that in manyeconomies uncertainty about domestic macroeconomicconditions or government policies is an important

problem for firms, and more global uncertainty further

raises the premium on credible, transparent and predictable domestic policies. For those East Asian

countries with high public debt levels, like the

Philippines, an example would be a pre-announced

program to reduce debt, thereby bringing down the

sovereign risk premium and borrowing rates for all

private investors. Many specific actions can be taken

immediately to both cut the costs of doing business and toreduce corruption and arbitrariness by simplifying

business regulation, cutting red tape and improving thetransparency of procedures. There are likely to be high

dividends from reforms to improve cost effective delivery

of infrastructure and logistics services, as well as to

improve labor market outcomes through greater flexibilityand better institutions for upgrading worker skills.

Continued efforts to address remaining private sector

balance sheet vulnerabilities through financial and

corporate restructuring remain worthwhile. Efforts are

also needed to strengthen prudential regulation of thefinancial sector, and further develop capital markets,which will help diversify risk more broadly within the

economy, for example through leasing and factoring,more institutional investment, pension funds, insurance

companies and mutual funds. More broadly, judicial

reform and faster third-party arbitration can help establish

sounder rules-of-the-game.

The priorities vary by country, but the potential

for policy reform to assist in the investment recoveryseems very real in most countries. An overview of the

Bank’s recent surveys and analysis in this area is

presented in the Special Focus section at the end of this

report, entitled “Strengthening the Investment Climate in East Asia”. Developments at the country level are also

discussed in the “Country Sections” towards the back of

the report, while fuller Country Briefs are available at the

website associated with this report.2

East Asia - at the peak of the cycle?

• Economic growthin East Asia is expected to reach

7.1 percent in 2004, over one percentage point higher

than in 2003. (Table 1). The strength in activity has beenwidespread, encompassing most of the diverse

economies in the region. Fixed investment spending has

also picked up in recent quarters, not only in fast

growing economies like China and Vietnam, where it has been strong for some time, but also in the middle and

high income economies, where it has been erratic and

weak in the wake of the 1997-98 financial crisis and the

2001 high tech crash. Annualized quarter-on-quarter

growth in the second quarter of 2004 dipped to an

average of only 3-4 percent among the 8 South East

Asian and Newly Industrialized Economies. Regional

growth is expected to decelerate in 2005, althoughreaching a relatively robust pace near 6 percent.

Table 1. East Asia Economic Growth

2002 2003 2004 2005

East Asia 6.0 5.9 7.1 5.9

Develop. E. Asia 6.9 7.8 7.9 7.0S.E. Asia 4.6 5.3 5.8 5.5Indonesia 4.3 4.5 4.9 5.4Malaysia 4.1 5.3 7.0 6.0Philippines 4.4 4.5 5.4 4.5Thailand 5.4 6.8 6.4 5.8

Transition Econ.China 8.3 9.3 9.2 7.8Vietnam 7.0 7.2 7.2 7.5

Small Economies 2.6 4.2 4.1 3.4Newly Ind. Econ. 4.7 3.0 5.9 4.4

Korea 7.0 3.1 4.9 4.43 other NIEs 2.8 2.9 6.9 4.4

Japan -0.3 2.5 4.3 1.8World Bank East Asia Region; Oct. 2004. Consensus Forecasts

for NIEs

• Poverty. The number of East Asians living below $2a day is estimated to have fallen to around 34 percent in

2004, amounting to some 636 million people. As

recently as 1999 that proportion was 50 percent,

2 http://www.worldbank.org/eapupdate/ .




representing some 890 million people. With per-capita

real GDP growth in Developing East Asia havingaveraged around 6 percent a year in the years since 1999,

there could hardly be more striking evidence as to the

power of sustained economic growth to reduce poverty.

Developments in China, which contains two thirds of the

poor in East Asia – some 418 million -naturally dominatethe regional picture. Poverty at the $2 a day in China is

estimated to have fallen to about 32 percent in 2004,

driven by significant recent gains in rural income. Rural

income gains in 2004 were mainly due to increased

agricultural output, a more than 30 percent increase in

grain prices, the introduction of direct subsidies to

farmers, and a reduction in agricultural taxes. Outside of China, the bulk of recent poverty reduction in terms of

absolute numbers of poor has occurred in three other

economies, Indonesia, Thailand and Vietnam.

The international and regional environment

• A ‘growth pause’ in the developed world. Growth in

the OECD economies is expected to reach 3.5 percent in

2004, about one percentage point stronger than had been

expected a year ago. Growth in the United States and

Japan, is expected to reach over 4 percent in 2004, before

slowing in 2005 to a little over 3 percent and a little

under 2 percent respectively. In the U.S. consumer

spending had already shifted to a lower pace in mid

2004, likely reflecting the impact of higher oil prices,

lower tax rebates and a reduced pace of mortgagerefinancing. In Japan business investment, hitherto one

the strongest elements in the recovery, took a breather inthe second quarter, perhaps reflecting concerns about

higher oil prices, indications of a slowdown in global

high tech and slowing growth in exports to China and the

rest of Asia. During the third quarter downside surpriseswere the largest in Europe, where industrial production

actually contracted. OECD growth is forecast to ease

significantly to 2.6 percent in 2005, although that would

still be well above the OECD growth pace in 2001-03,

the period of the last major global slowdown andsubsequent upturn.

• China – what kind of landing? In China the

authorities have used a growing array of instruments to

try and slow potentially excessive growth in investment

spending, including credit restrictions, administrativecontrols on investment, and finally, in late October,

higher interest rates, with some success. Fixed asset

investment growth (in current prices) did indeed fall to23 percent in the second quarter, although it recovered

somewhat in the third, after the completion of

administrative inspections, and several other demandindicators remained strong. However, the quality of

adjustment in China might improve now that interest rate

caps have been removed. That will give much needed

support to SME lending and to the development of the

secondary market in mortgages. GDP growth slowedfrom 9.6 percent in the second quarter to 9.1 in the third.

Some impact is being felt on China’s imports from East

Asia, which grew less quickly in July-August than in the

first half of 2004 or 2003, although in most cases stillrunning at 25 percent or more Beyond these cyclical

developments, however, trade between China and the

rest of East Asia is likely to be sustained by the growing

industrial integration of the region, and the continued

expansion of cross-border production networks and tiesamong multinational companies, their suppliers and

customers. In the economic boom of the last two years

(2002 and 2003) China’s worldwide imports grew by 69

percent, led by an 80 percent increase in imports of

machinery and transport equipment. Imports of

machinery and transport equipment from other East

Asian economies (excluding Japan) however jumped 117 percent, implying a gain in market share of over 6

percentage points in just these two years.

• High tech cycle turning over? Concerns about

slowing OECD and China growth are amplified by

evidence of slowing demand growth in the highlycyclical global high tech industry. East Asian tech

production growth slowed in the third quarter ascustomers ran down unwanted inventories. New orders

for tech output in the G-3 countries slowed, as did

momentum in global semiconductor sales.

• Commodity markets and the new oil shock. Perhaps

the most alarming recent global development is the rise

in average crude oil prices over the past year from

around $27 a barrel in September 2003 to $46.7 in the

first three weeks of October 2004 (and to $50-55 for specific crudes like WTI), although in real terms pricesstill remain about half their peak level in the 1979-80second oil shock. Prices have surged because of

unexpectedly strong and coordinated global demand

growth, led at the margin by rapid growth in China, lowspare production capacity due to a lack of investment in

the 1990s and a series of natural and political

disruptions. Oil prices are currently expected to average

$39 in 2004 and $36 in 2005, thanks to the growing

production and fall in price of crudes from the Persian

Gulf.. Strong world growth has also contributed to a

surge in metals and other non-oil commodity prices.Studies of the impact of the oil shock suggest it could

knock 0.5 percent off world GDP growth, with a 0.8 percent impact in Asia. Impacts within the region will be

highly differentiated, with substantial net oil importers

like Korea, Philippines and Thailand suffering the largest

income losses. At the other extreme small net exportersof both oil and non-oil commodities like Papua New

Guinea are expected to enjoy very large windfall gains.

Proper macroeconomic management and use of such

gains will be a major challenge in such economies.

• Trade policy developments. The July 31 WTO

General Council agreement on a negotiating framework for the Doha Round of multilateral trade talks is good

news for East Asia, which is expected to be one of the

main beneficiaries of the Round. The agreement laid out

a road map for progress in four areas: agricultural trade




liberalization, non-agricultural market access, services

and trade facilitation. Most of the hard work of arrivingat specific detailed agreements still lies ahead, however.

East Asian economies, having much to gain, need to be

active in the negotiations, pushing for a speedy

conclusion.

• International capital markets and flows. After last

year’s return of large scale private capital flows toemerging markets, 2004 has seen something of a pause,

with flows continuing at the levels reached in the second

half of 2003, but not growing as rapidly as before. The

pause is likely the result of the heightened uncertainties

affecting the global outlook, as well as the shift towards

higher interest rates in the U.S. That emerging capital

markets were taking a fairly relaxed view of these

developments was suggested by a number of other indicators. Spreads on East Asian Eurobonds, which fell

sharply in 2002 and 2003, have been largely stable in

2004. Stock prices surged in 2003, peaked in January-February this year, pulled back by 5-10 percent in the

second quarter, before starting to move higher once morein the third quarter.

• East Asia and Global Rebalancing. If Emerging

East Asia is a recipient of private capital inflows, it,

together with Japan, is also one of the major suppliers of

finance for the main macroeconomic imbalance in the

world at present, the U.S. current account deficit, which

amounted to $568 billion in the year to the second

quarter of 2004. The Emerging East Asian economiesalone had current account surpluses of about $138 billionover this period, which, combined with net capitalinflows, allowed them to accumulated over $250 billion

of official foreign exchange reserves, a significant

proportion being invested in U.S. financing instruments.There is now a consensus that these imbalances cannot

continue in this fashion for too much longer, and that

policy makers need to find a means of achieving a

‘global rebalancing’ that is not disruptive of global

growth. A part of this obviously depends on U.S. policy

efforts to boost national savings by reducing the U.S.

budget deficit. But global imbalances have alsoincreased because of the sharp fall in domestic

investment in many emerging East Asian economiesafter the regional financial crisis – averaging about 11

percentage points of GDP between 1997 and 2003.

Within the region, the major surplus economies are Japan

and the NIEs, but even developing Asian economies willneed to play a part. The best outcome is for East Asia’s

contribution to global rebalancing to center on fostering

much stronger domestic private investment, which would

also position these economies for sustained long run

growth. Continued adjustment in exchange rates canalso play a role, as can sustained trade liberalizationefforts, in particular in services sectors, where East Asia

has tended to lag other developing regions.

Domestic trends and policy challenges

• Strengthening fiscal positions. Governments in the

region continue to grapple with the burden of substantial public sector debt built up after the 1997-98 financial

crisis as a result of governments shouldering the cost of

recapitalizing and restructuring insolvent financial

institutions, the calling of other contingent claims on

government, wider public sector deficits and realdepreciation of currencies. In light of the weakness of

the fiscal position, the most pressing challenge is in the

Philippines, where gross public debt has reached over

100 percent of GDP. President Macapagal-Arroyo

submitted a package of fiscal measures for approval to

Congress that, if fully implemented, would help stave off

a fiscal crisis. In Indonesia several years of prudentfiscal management have helped nudge debt-GDP ratios

steadily lower in recent years, although significant

challenges remain, including reducing costly fuel

subsidies so as to free up resources for more

economically efficient and equitable uses (such asinfrastructure, development spending and debt

reduction). Malaysia also is focusing on significant

fiscal consolidation in its latest budget. In Thailand,where budgets moved into surplus a couple of years ago,

the government has boosted public investment and is

pondering a five year program of large scaleinfrastructure projects.

• Recent corporate sector trends and issues. The profitability and balance sheet position of East Asian

firms have continued to strengthen, providing a more

secure foundation for the recent upswing in investmentspending observed around the region. Ordinary income

to sales ratios for listed non-financial firms have risen

substantially from their low points in 1998, while debt-

equity ratios have fallen, and are now broadly in line

with international norms. Countries continue to make

efforts to resolve the situation of weak firms and deal

with the remaining stock of distressed assets. Since the

special debt workout frameworks that were established in

the aftermath of the crisis have mostly been wounddown, progress on corporate restructuring increasingly

depends on the effective functioning of the legal and judicial system, and, in particular of effectively

functioning bankruptcy systems and market-based asset

disposition. More generally, policy makers are

increasingly focusing on measures to strengthen the

broader investment climate, the subject of the ‘Special

Focus’ in this report.

• Recent financial sector trends and issues. Banks

have also benefited from the acceleration of economic

activity over the past one and a half years. The

profitability of commercial banks—as measured by the

rates of return to assets and equity—has improvedsizably in Indonesia and Thailand, and marginally in thePhilippines and Korea, and remains comfortable in

Malaysia. Average risk-weighted Capital AdequacyRatios (CAR) have also been above the 8 percent BIS

norm in all five countries for several years now, while




Non Performing Loan (NPL) ratios have continued to

decline, reflecting, to varying degrees, continuedrestructuring efforts, improved capacity of borrowers to

repay, and new loan growth. Some caveats should be

noted. First, despite progress, NPL ratios remain in

double digits in Thailand and the Philippines. Second,

aggregate numbers on profitability and loan quality cansometimes mask considerable differences across groups

of banks; some segments remain vulnerable. One trend

and potential vulnerability across countries in the region

has been rising household debt and with it, increases in

the share of NPLs from household lending. In Korea

household debt grew quickly between 2000 and 2002,

and subsequent problem with credit card delinquencieshave had a serious macroeconomic effect in slowing

consumer spending. Household debt has also grown in

Malaysia and Thailand, without so far running into

serious difficulties. Countries are also continuing to

make progress on various aspects of strengthening thefinancial system in terms of regulation and supervision.



East Asia Update 6

Exhibit 1

East Asia - Quarterly GDP Gro

(% Change Year Ago)

-6.0

-3.0

0.0

3.0

6.0

9.0

12.0

Q

1 - 1 9 9 9

Q

3 - 1 9 9 9

Q

1 - 2 0 0 0

Q

3 - 2 0 0 0

Q

1 - 2 0 0 1

Q

3 - 2 0 0 1

Q

1 - 2 0 0 2

Q

3 - 2 0 0 2

Q

1 - 2 0 0 3

Q

3 - 2 0 0 3

Q

1 - 2 0 0 4

China NIEs

SE Asia E. Asia

EAST ASIA AND PACIFIC R EGIONAL OVERVIEW

East Asia – at the peak of the cycle?

Growth in the East Asia region is expected torise to a little over 7 percent in 2004, more than a percentage point higher than in the preceding two years,

and more than three percentage points higher than in

2001, the trough of the last global economic slowdown.

(Table 1 above). Growth has been especially robust

among the Developing East Asian economies, running atnear 8 percent for a second year, led by plus 9 percent

growth rates in China. Among these economies the last

two years have been the strongest period of growth since

before the 1997-98 financial crisis. As Exhibit 1 shows,

the year on year growth rate of quarterly regional GDP in

East Asia has accelerated almost continuously since the

middle of 2001 – interrupted briefly only by last year’s

SARS crisis – to reach around 7.5 percent in the firstquarter of 2004 and just over 8 percent in the second.

Growth – securing the path to sustained expansion

Yet, even as the recovery has flourished –

fostering the first widespread recovery in investment

spending since the financial crisis more than 6 years ago –

a number of cross-currents and risks have emerged or intensified, mostly, though not entirely, associated with

the external environment. Policy makers in the regionnow must carefully ponder the mix of policy efforts andreforms needed to steer the regional economy from sharp

cyclical recovery of the last 2 years onto the path of

sustained medium term expansion.

Several features of the recent surge in growth

deserve attention. First, the acceleration or continuing

strength in activity has been geographically widespread ,

encompassing many if not most of the diverse economies

in the region, ranging from a continent sized economy

like China to small island economies like the Solomons,

from high income economies like Singapore and Taiwan(China) through middle income economies like Malaysia

and Thailand to low income economies like Lao PDR,

Vietnam, Papua New Guinea and Mongolia.

Second, recent quarters have seen a widespread

strengthening of fixed investment spending around theregion. Of course investment has already been rapidly

expanding for some years now in fast growing economies

like China and Vietnam, in the former case to such an

extent that curbing excessive investment has this year

become a central preoccupation for the authorities. In

many other economies, however, investment has beenmuch more erratic and weak over the last 5-6 years.

These include economies affected by the 1997-98

financial crisis such as Indonesia, Malaysia, the

Philippines, Thailand and Korea, as well as economies

such as Hong Kong, Singapore and Taiwan (China) that –

while less directly affected by the financial crisis – experienced more serious effects from the deep recession

in the global high tech industry in 2001, as well as from

adjustments to changing comparative advantage and other competitive challenges Annual average growth in fixed

investment among these economies averaged only 0.3

percent in 2001-03. Aggregate demand growth during

this period has instead been more dependent on privateconsumption, which has been most robust in the South

East Asian economies, as well as on exports.

It is in this group of 8 middle and high income

economies that investment spending has rebounded in late2003 and early 2004. Investment, which had made a

negligible or negative contribution to growth in most

economies in 2003, made the largest positive contribution

in many in the first half of 2004. (Exhibits 2 and 3). The

average year on year pace of GDP growth among these

economies increased from 4 percent in 2003 to 7.2

percent in the first half of 2004, while the contribution of fixed investment increased from 0 percent in 2003 to 3.6

percentage points in the 2004 first half. In other wordsfixed investment contributed half of the growth in

expenditures on GDP in the first half, with especiallystrong outcomes in Malaysia, Thailand, Hong Kong,

Singapore and Taiwan (China).

A number of positive trends have helped foster

the investment revival in the region, some of which are

explored at greater length in this report. Exports

accelerated and have remained strong since late 2002,



East Asia Update 7

Exhibit 2

Contributions to GDP Growth in S.E.(% change year ago)

-6.0

-4.0

-2.0

0.0

2.0

4.0

6.0

8.0

10.0

12.0

2003 2004

H1

2003 2004

H1

2003 2004

H1

2003 2004

H1

Indonesia Malaysia Philippines Thailand

Net Exports

Investment

Pub. Consump

Priv. Consump

GDP Growth:

4.5 4.7 5.3 7.8 4.7 6.3 6.8Contributions may not sum to growth due to statistical discrepancies in

Exhibit 3

Contributions to GDP Growth in(% change year ago)

-10.0

-5.0

0.0

5.0

10.0

15.0

2003 2004

H1

2003 2004

H1

2003 2004

H1

2003 2004

H1

Hong Kong Korea Singapore Taiwan

(China)

Priv. Consump. Pub. Consum

Investment Net Exports

GDP Growth

3.2 9.5 3.1 5.4 1.1 10.0 3.

Contributions may not sum to growth due to statistical discrepancies in

supported by the recovery in the developed world, astrong cyclical rebound in the global high tech industry

and a surge in intra-regional trade, led by booming

exports from the rest of East Asia to China. Regional

export growth has run at 25-30 percent on a year earlier in

dollar terms through much of 2004. Especially in South

East Asia, firms’ cash flow has also been bolstered by

robust growth in consumer spending. (Exhibit 2).

Macroeconomic conditions have been benign in most

economies, an important factor in reducing businessuncertainty. High current account surpluses and rising

foreign reserves have bolstered confidence and allowed

lower interest rates in many economies. Public sector debthas also trended lower or at least been stable in most –

though not all – economies, the Philippines being an

exception here. Policy efforts to foster financial and

corporate sector restructuring and reform have continued

at various rates. Portfolio capital flows returned to the

region in large volume in 2003. As the review of corporate sector trends later indicates, firms around the

region have used this exceptionally favorable climate to

reduce excessive debt and improve profitability. Theimproved financial health of corporates has put in place

perhaps the final precondition for the present recovery in

investment.

The third important observation about therecovery is that East Asian growth is expected to peak in

2004, indeed may already have done so in the first part of

the year. While year on year growth in the first half of

2004 reached the relatively high rates displayed in Exhibit

1 above, seasonally adjusted rates of growth from one

quarter to the next were also turning down in severaleconomies at this time. As Exhibit 4 below shows, the

seasonally adjusted annualized growth in output in the

second quarter of 2004 as compared to the first fell onaverage to only 3-4 percent among the 8 South East Asianand Newly Industrialized Economies. On a technicalnote, the apparent contradiction between the two types of

growth rates is explained by the fact that quarter on

quarter increases in GDP were extremely strong in the

third and fourth quarters of 2003, pushing up the year on

year comparisons in the first half of 2004, even as quarter

on quarter growth rates were starting to fall by this latter

point. The slower trend in growth will likely be reflected

in yearly growth rates for the second half of 2004, whenthere will be a much tougher comparison to high levels of

output in the second half of last year. The flash estimatefor third quarter growth in Singapore indicated that GDPactually contracted from the second quarter, while theyear on year pace dipped to 7.7 percent, down from 12.5

percent in the second.

A slower trend in East Asian growth would have

been expected to some extent in any case, the pace of

economic activity in the region making a normal

transition from sharp upswing in the recovery phase of the

economic cycle to somewhat lower but sustained growth

in an expansion phase. However, 2004 has also seen the

emergence of several key risks or actual trends that arealready tending to offset the positive factors underpinningthe recovery in East Asia so far, or may do so in the

foreseeable future.

Among these factors, several of which are

discussed in greater detail later in the report, perhaps the

most immediately of concern has been the steep spike in

world oil prices, from late 2003 onwards which is directlyimposing significant income losses among the majority of

economies in the region that are net energy importers, as

well as among the major developed nations which



East Asia Update 8

Exhibit 4

East Asia - Quarterly GDP Gro(% Change Quarter Ago, SAAR)

-6.0

-2.0

2.0

6.0

10.0

14.0

Q 1 2 0 0 1

Q 2 2 0 0 1

Q 3 2 0 0 1

Q 4 2 0 0 1

Q 1 2 0 0 2

Q 2 2 0 0 2

Q 3 2 0 0 2

Q 4 2 0 0 2

Q 1 2 0 0 3

Q 2 2 0 0 3

Q 3 2 0 0 3

Q 4 2 0 0 3

Q 1 2 0 0 4

Q 2 2 0 0 4

NIEs SE Asia

comprise Emerging East Asia’s major extra-regional

export markets – the United States, Japan and Europe.Affected by higher oil prices as well as by a variety of

specific domestic factors, growth in the developed world

had already shifted to a lower pace in the second quarter

of 2004, most notably in Japan, and to a lesser extent in

the U.S., while monthly indicators suggested a softening

pace of activity in Europe in the third quarter. Inaddition, overlaid on the growth pause in the developed

world is the likelihood of another cyclical downturn in the

global high tech industry, a concern for a region like EastAsia which is now the leading location for manufacturing

and assembly in this industry.

As if all this were not enough, East Asiandecision makers are likely devoting as much if not more

attention to the outlook for China – in particular the

efforts of the authorities to slow the investment boom in

that economy while averting a ‘hard-landing’ that could

knock away a key source of new export demand in the

region over the next few years. Even with a ‘soft landing’

however, the growth of East Asian exports to China will

decline from their recent soaring pace, a change thatseems to have already begun.

The consensus view remains that the recent

slackening of activity in the developed world will prove a

temporary pause in a more sustained expansion, while

China will continue to expand at rates that – while lower than during the current boom – will remain very high by

world standards. But it must be admitted that the

apparently remorseless rise in oil prices has heightened

worries about the risk of a more serious downturn. These

concerns are exacerbated by the fact that the oil price

shock is occurring in a context of already large global

macroeconomic imbalances, notably the record andgrowing U.S. current account deficits. These deficits, it

must be said, were a help during the last global

slowdown, when they injected a substantial demand

stimulus into the world economy and helped avert a worse

recession, but have required a growing flow of foreign

financing, most notably from the current account surpluseconomies of Japan and Emerging East Asia. A sharp

disruption of these critical financing flows would likely

result in increases in dollar interest rates, swings inexchange rates and a steep adjustment in U.S. aggregate

demand and imports – a recession in short. These would

be costly outcomes for all concerned. Finding economic policies to defuse the mounting imbalances in a

cooperative and less costly way will be an increasing

preoccupation not just of one economy and government

but - necessarily – for all the economies and governments

that participate in this relationship.

Poverty – down by 250 million in five years

At some point in the latter part of this year or in

early 2005 we estimate that the number of people living

on less than $2 a day in East Asia will fall below one thirdof the population. As recently as 1999 that proportion

was 50 percent. (Exhibit 5). Put another way, the number

of poor in East Asia (by the $2 a day definition) will have

fallen from around 890 million in 1999 to around 636

million just 5 years later, a fall of 29 percent during a

period in which the total population of the region

increased by about 4 percent (to around 1.85 billion).

With per-capita real GDP growth in DevelopingEast Asia having averaged around 6 percent a year in the

years since 1999, there could hardly be more strikingevidence as to the power of sustained economic growth toreduce poverty. Looking back over the last 15 years, the period since 1999 is the second of two in which fast

economic growth has yielded major reductions in poverty.

The first was the economic boom of the early-mid 1990s,

when per-capita growth averaged close to 9 percent and

the poverty headcount rate was reduced from two thirds

(67 percent) in 1990 to 50 percent in 1996. In between

was the period of slow growth associated with the East

Asian financial crisis, when per-capita growth fell to

around 3 percent a year and the regional poverty rateremained flat at 50 percent.

Looking more closely at the recent gains inregional poverty reduction, developments in China

naturally dominate the regional picture. The number of

poor in China comprised three quarters of the poor in EastAsia in 1990, and even today, after years of faster than

average poverty reduction, there are still an estimated 418

million Chinese poor – mostly in the rural areas –

comprising two thirds of the regional total. Relative to

China’s own population, poverty at the $2 a day level is



East Asia Update 9

Exhibit 5

Poverty - Headcount Index($2 a day poverty line. Percent)

25

50

75

1990 1996 1999 2000 2001 2002 2003 2004 2005

Other small * VietnamS.E. Asia (4) East AsiaChina

* Cambodia, Lao PDR, Papua New Guinea

estimated to have fallen to about 32 percent in 2004.

About 90 percent of China’s poor live in rural areas, andrural developments indeed continue to exercise a

predominant influence on poverty reductions trends.

A recent detailed World Bank study of poverty

reduction in China by Ravallion and Chen calculates that

75-80 percent of national poverty reduction over the

period 1980-2001 is accounted for by poverty reduction

within the rural sector, with most of the remainder accounted for by migration from rural to urban areas.3

The study finds that poverty reduction has been veryresponsive to economic growth - in general a one percentincrease in average incomes has led to a 2.5-3.5 percentfall in the poverty rate – but that the benefits of growth for

poverty reduction have been partly offset by widening

income inequality. As might be expected, the sectoral

composition of growth is also crucially important for

poverty reduction; growth in rural incomes is far more

important than urban, as is growth in the primary sector

(mainly agriculture) as compared to secondary or tertiary

sector growth. Policies affecting agricultural and rural

sector growth are therefore the most powerful from a poverty reduction perspective. Ravallion and Chen arguethat China’s agrarian reforms of the early 1980s were

responsible for over half of all the poverty reduction inthe period 1980-2001. Agricultural pricing policies have

3 Martin Ravallion and Shaohua Chen. “ China’s (Uneven)

Progress Against Poverty”. World Bank Working Paper 3408.

September 2004. The study uses a poverty line of 850 yuan for rural areas and 1200 yuan for urban, which are significantlylower than the $2 a day benchmark .http://econ.worldbank.org/working_papers/38741/

also had an important effect. Until recently the

government operated an extensive food grain procurementsystem that effectively taxed farmers by setting quotasand fixing procurement prices below market levels.Increases in procurement prices had a strong positiveeffect on agricultural output and incomes and served as a powerful short term policy against poverty. FinallyRavallion and Chen also find that periods of low inflationhad a beneficial effect on poverty reduction in China.

Rural living standards in China have indeed

shown significant recent improvements. Rural residents’

cash income increased by 11.4 percent year-on-year in thefirst 9 months of 2004, compared to only about 2 percent

per year in 2002-2003. Rural incomes grew faster than

urban for the first time in 6 years. As a result, rural

poverty rates are estimated to have come down

significantly. Rural income gains were mainly due to

increased agricultural output, a more than 30 percentincrease in grain prices, the introduction of direct

subsidies to farmers, and a reduction in agricultural taxes.

While the fiscal costs of agricultural subsidies arecurrently modest, experience in developed countries

shows the potential for such subsidies to become a

concern in the longer run. The government is also movingto develop a coherent policy and legislative framework

for social assistance, on which it issued a white paper in

September. This would help ameliorate the disparities in

the social protection system between urban and rural

areas, and could benefit migrant workers, who often “fall between the cracks” of urban and rural systems. Recently

a growing number of provinces have been implementing

rural safety net schemes modeled on the urban dibao

system, which is a cash transfer system based on income

and asset testing.

Efforts to improve social safety net programs arealso afoot in Mongolia. The government’s social securitymaster plan aims to move from a system that targetssocial categories or groups to one based directly on theactual income and consumption situation of households.

The system’s ability to target support to those most in

need will be enhanced by the 2002-3 Living Standards

Measurement Survey, the first nationally representativehousehold-level survey for Mongolia. The results of the

survey, which will be available shortly, will establish

baseline poverty information and help in monitoring

implementation and results from the country's Economic

Growth Support and Poverty Reduction Strategy.

Outside of China, the bulk of recent povertyreduction in terms of absolute numbers of poor has

occurred in three other economies, Indonesia, Thailand

and Vietnam. In Indonesia, economic growth rates have

gradually strengthened after the 1997-98 financial crisis,

reaching 4.5 percent in 2003 and near 5 percent in 2004.

The latest Susenas data show poverty using the national

poverty line down to 15.1 percent in 2003, finally below

pre-crisis levels. However, while economic managementhas generally been sound during this critical election year,



East Asia Update 10

Exhibit 6

there are some specific areas where policy reforms could

enhance the pace of poverty reduction. AlthoughIndonesia adheres to a generally liberal trade policy

regime, some recent moves in a more protectionist

direction could raise the cost of subsistence for the poor,

in particular the seasonal import ban on rice, which will

tend to raise retail prices for rice, to the detriment of poor

households who are largely net consumers of rice.

4

Increased minimum wages in recent years are

also having a negative impact on formal sector

employment in Indonesia. Minimum wages increased in

real terms by 13 percent a year between 2000 and 2004.

Widening differentials between formal and informalsector wages have discouraged formal sector employment. Formal sector employment has fallen from31.8 million in 2000 to 26.5 million in 2003. Open

unemployment, which increased to 9.5 percent in 2003,

will be a major issue facing the new administration.

Finally, fuel subsidies, which now eat up 16 percent of the

government’s budget, are sometimes justified as being

pro-poor. Such subsidies are regressive, however, benefiting the better off more than they do the poor. A

gradual reduction in the subsidy with compensation for

poorer households would allow the new administration togenerate significant budgetary savings that could be usedfor development spending that actually benefits the poor,while also allowing further fiscal consolidation.

Between 1998 and 2002 Vietnam saw eight percent of its 80 million population move out of poverty,

using a poverty line based on a consumption basket that

provides 2100 calories per day and a set of non-food

items. However, progress was uneven, with little or no

poverty reduction in three out of the country’s eight

regions. The regional rate of poverty reduction appearsclosely correlated with the proportion of ethnic minorities

among the population (the correlation coefficient is -

0.85). The persistent high poverty rate among ethnicminorities at a national level (69 percent) is caused by a

series of factors including geographic isolation, low

human capital, lack of secure access to land, and poor governance. The depth of poverty for ethnic minorities

(represented by the poverty gap) suggests that sustained

economic growth alone will be unlikely to lift these

groups out of poverty.

A recent calculation of the change in provincial

poverty rates between 1999 and 2002 shows a large

4 The import ban on rice was introduced in January 2004

and was only supposed to last till 2 months after the

harvest, but has since been extended twice. Modeling

work suggests that the ban is equivalent to about a 100 percent ad valorem tariff. Its initial impact on rice prices

was not very noticeable because of this year’s extremely

good harvest, but this could change in the off-season

period, and over time, as harvests return to more normal

levels..

variation across the country. Spectacular progress (30

percent of the population moving out of poverty) has beenmade in some parts of the country such as Quang Ninh in

the northeastern corner of Vietnam. (Exhibit 6). This area

has seen the development of a vibrant tourism industry

and lies on an important trading route with China. It may

also be benefiting from spillover effects of rapid

economic growth in neighboring provinces. There aresimilarly spectacular reductions in poverty in Binh Thuan

province, which neighbors very rapidly-growing

provinces in the south east of the country. In other parts of the country the proportion of poor people barely changed.

These data were constructed using poverty mapping

techniques (for 1998) and household survey data (for 2002). New data on living standards will become

available in mid 2005.

In Thailand poverty at the $2 a day level has

fallen from 22 percent in 2000 to an estimated 14 percentin 2004, benefiting from stronger economic growth and,since 2002, from the boost to rural incomes given by

higher world prices for Thailand’s principal export crops.While poverty at the $2 level is still estimated at over 70

percent in Lao PDR, at the $1 level it has fallen from 34

percent in 2000 to an estimated 24 percent in 2004,

supported by growth in a 5-6 percent range. Recent data

published by the National Statistical Center provide some

evidence of rising living standards. The share of food in

household expenditures fell from 64 percent in 1992/3 to

55 percent in 2002/3, suggesting that people were able to



East Asia Update 11

Exhibit 7

Lao PDR: Possession of Durable G

(% of Households)

0 10 20 30 40 50

Motorbike

TV

Refrigerator

Electric Rice

Cooker 2002/0

1997/9

Source: NSC. The Household of Lao PDR. March 200

devote more of their growing incomes to non-food items.

As Exhibit 7 indicates the possession of durable consumer goods is also increasing.

Progress on poverty reduction may have been

less robust elsewhere in the region. In the Philippines

preliminary data from the 2003 Family Income and

Expenditure Survey (FIES) released by the National

Statistical Office in August 2004 indicate that average

family expenditures and incomes both decreased in real

terms between 2000 and 2003. Real average familyexpenditures declined by about 7 percent during this

period. In 12 out of the 17 total regions, real averagefamily expenditures in 2003 declined relative to their level in 2000. The decline was largest in the NationalCapital Region, where real average family expenditures

fell over 17 percent during this period. National income

inequality decreased slightly, with a decline in the Gini

coefficient to 0.47 in 2003 from 0.48 in 2000, but income

inequality remains high, with average incomes in the top

decile over 20 times that of the bottom decile. It should

be noted that there is a significant discrepancy between

the preliminary FIES data, which indicate lower total and

average family incomes and expenditures, and thenational income accounts data which indicate increasing per capita GDP over the same period. Resolving these

data inconsistencies will be important to obtain a clearer picture of what has actually happened to poverty in the

Philippines during this period. Poverty incidence

estimates based on the FIES data are expected to be

released by the government shortly.

Progress on poverty reduction has also been

more limited in some of the smaller low income

economies of the region. In Cambodia, the latest Socio-

Economic Survey is still in the field and due to be

completed at the end of December 2004, but estimates based on earlier household level data suggest that poverty

at the $1 a day level has been flat in a 40-45 percent range

in recent years. Even though overall economic growth has

run in a 5-6 percent range in recent years, growth in the

agricultural sector has been less robust. Poverty in its

non-income dimensions shows a bleak picture. Childmortality rates are high at 138 per 1000 live births in

2002, almost three times the level for East Asia and

higher than the average for low income countries.Maternal mortality rates at 450 per 100,000 are also three

times higher than the East Asia region. In Papua New

Guinea poverty at the $1 level is estimated to have driftedhigher from 35 percent in 2000 closer to 40 percent now.

The international and regional environment

The year on year pace of Emerging East Asian

export growth in dollar terms accelerated through much of 2004, picking up from the low 20 percent range early in

the year, to near 30 percent in the three months to August.

(Exhibit 8). The strongest performance overall was fromChina and Korea where exports in the middle part of the

year were running at a year on year pace of 35-40 percent,

while, at the lower end, exports in Indonesia and the

Philippines were quite sluggish, growing at less than 10 percent rates. Most other countries experienced export

growth in a 20-30 percent range.

By the end of the third quarter there were

however signs of a deceleration in export growth In both

Korea and Taiwan (China) the year on year pace of dollar

exports in the three months to September was lower byabout 10 percentage points than the year on year growth

rate in the three months to July. (Exhibit 9). An even

sharper deceleration is apparent when these economies’seasonally adjusted growth from one quarter to the next is

considered. China’s year on year export growth also

dipped about 5 percentage points in the three months toSeptember as compared to the three months to August.

Other economies, for whom export data were available

only through August at the time of writing, did not yet

show much indication of a slowdown.

Nevertheless there are at least three reasons why

a significant slowdown in East Asian export growth may

now be underway. First, there are indications that growthin East Asia’s major developed economy markets slowed

in the second and third quarters of the year. The depth

and duration of this ‘slow patch’ in the developed world is

uncertain, but it is likely to have some effect on EastAsian exports. Second, there are indications that the

soaring pace of East Asian export growth to China over the last two years is slowing this year. Partly this may

just reflect the fact that some East Asian economies

achieved very high growth rates from a very small initial

volume of exports to China, which was bound to decline.



East Asia Update 12

Table 2. International Economic Environment

2002 2003 2004 2005

% Change from previous year, except interest rates

GDP Growth

World 1.7 2.7 4.0 3.2

OECD 1.3 2.0 3.5 2.6United States 1.9 3.0 4.3 3.2

Japan -0.3 2.5 4.3 1.8

Euro Area 0.9 0.5 1.8 2.1

World Trade (Volume) 3.6 6.7 11.1 8.7

CPI Inflation - G7 a/ 1.0 1.5 1.8 1.4

Oil Price - $/bbl 24.9 28.9 39.0 36.0- % Change 2.4 15.9 35.0 -7.7

Non-oil Commodity

Prices 5.1 10.0 17.1 -3.3

LIBOR (US$. 6 Mo.) 1.9 1.2 1.6 3.5

Source: World Bank DEC Prospects Group update Oct. 2004.a/ In local currency, aggregated using 1995 weights.

However, although the overall GDP growth rates for

China remained as high as 9.1 percent in the third quarter of 2004, there was already a ‘soft landing’ underway in its

imports, whose growth rate decelerated quite significantly

at this time. Third, after two years of strong upswing,

growth in global demand for high tech products appears

to be decelerating, and this cannot but impact the region

which is now the leading assembler and manufacturer of high tech products.

Exhibit 8

East Asia - Export Growth

(US$ 3Mo. Mov. Averages - % Change Year

-20

-10

0

10

20

30

40

50

J a n - 2 0

0 1

A p r - 2

0 0 1

J u l - 2

0 0 1

O c t

- 2 0 0

1

J a n - 2 0

0 2

A p r - 2

0 0 2

J u l - 2

0 0 2

O c t

- 2 0 0

2

J a n - 2 0

0 3

A p r - 2

0 0 3

J u l - 2

0 0 3

O c t

- 2 0 0

3

J a n - 2 0

0 4

A p r - 2

0 0 4

J u l - 2

0 0 4

E. Asia SE Asia

China NIEs

Exhibit 9

East Asia - Export Growth

(US$ 3Mo. Mov. Averages - % Change Year

-30

-20

-10

0

10

20

30

40

50

J a n - 2 0

0 1

A p r - 2

0 0 1

J u l - 2

0 0 1

O c t

- 2 0 0

1

J a n - 2 0

0 2

A p r - 2

0 0 2

J u l - 2

0 0 2

O c t

- 2 0 0

2

J a n - 2 0

0 3

A p r - 2

0 0 3

J u l - 2

0 0 3

O c t

- 2 0 0

3

J a n - 2 0

0 4

A p r - 2

0 0 4

J u l - 2

0 0 4

Indonesia Philippines

Korea Taiwan (China

Developed country growth

Growth in the OECD economies is expected toreach 3.5 percent in 2004, the second highest since the

late 1980s (the highest being in 2000, the climax of the

global high tech boom) and about one percentage point

stronger than had been expected a year ago. (Table 2).

OECD growth is led by the United States and Japan,

where it is expected to reach over 4 percent in 2004. Asindicated in Exhibit 10, growth in both countries was

especially strong in the second half of 2003 and early

2004, with quarter on quarter seasonally adjustedannualized rates (SAAR) occasionally reaching over 6

percent, before slowing in the second quarter of 2004.However, one consequence of this pattern of strong

growth late last year and early this year is that in these

two countries growth for the year 2004 as a whole will be

high as compared to 2003 under most circumstances, even

though growth from one quarter to the next during the

year may run at lower rates – as indeed occurred in the

second quarter, and as monthly data suggest was also the

case in the third quarter of 2004.

Recovery in the United States has been

underpinned over the last two years by exceptional

growth in productivity, recovering corporate profits, very

low interest rates, wealth gains due to higher equity andhouse prices and the final doses of fiscal stimulus from

lower taxes. Growth eased in the second quarter of 2004,

however, falling to 3.3 percent (SAAR), down from 4.5

percent in the first, the net result of a number of off-

setting factors. The biggest contributor to the downturn

was lower consumer spending growth, likely reflectingthe impact of higher oil prices, lower tax rebates and a

reduced pace of house refinancing. Lower net exports also

contributed to the slowdown, and were reflected in the

second quarter current account deficit of $166 billion, or

5.7 percent of GDP, both record figures. On the other



East Asia Update 13

Exhibit 10

OECD Real GDP Growth

(% change on previous quarter; SAAR

-2

0

2

4

6

8

2003 Q1 2003 Q2 2003 Q3 2003 Q4 2004 Q1 2004 Q2

USA

Japan

Euro area

hand, residential and business investments, which have

made a major contribution to the recovery over the pastyear, accelerated further in the second quarter, helping

offset the downdraft from consumption and next exports.

A variety of monthly data in the third quarter appeared to

confirm that growth was likely to consolidate in a more

modest 3-4 percent range, including slower growth in

retail sales and industrial production, a downturn inconsumer confidence and a lower pace of job creation. In

line with this data, the flash estimate for third quarter

growth was 3.7 percent.

Growth in Japan was especially strong in late2003 and early 2004, reaching quarter on quarter annualrates of 7.6 percent and 6.4 percent respectively, spurred by exports, most notably to China, and a recovery in

corporate profits and business investment. But second

quarter 2004 growth fell to an unexpectedly low 1.3

percent (q-on-q annualized), pulled down by lower public

spending and a fall in the growth of business investment.

Monthly indicators in the third quarter also did not give a

clear signal as to trend, seeming to indicate that the

economy was sailing in a region of cross-currents.

Exports remained the strongest demand impetus, althoughrates of growth – including those of exports to China andthe rest of East Asia - were easing. Consumption

spending has been modest in this recovery, sincehouseholds remain concerned about slow employment

growth and stagnant or falling wages - a trend confirmed

by a continuing weakness in third quarter retail sales.

Business sector activity also appeared to be restrained,

perhaps by concerns about rising oil prices, indications of

a slowdown in global high tech and the potential for a

sharp slowdown in China, although, on the other hand,

profits continued strong, boding well for an eventual

rebound in investment. Reflecting the ambivalence,

orders for machinery and industrial production continuedto weaken in the third quarter, while, on the other hand

the September Tankan survey indicated that the ratio of

corporate profits to sales had risen to match previous

highs. Business sentiment was also rising. Overall, the

Cabinet office concluded in October that there were signs

of a pause in the economy. Still, consensus views do notso far project a return to stagnation, looking instead for

2005 growth in the region of 2 percent.

China – what kind of landing?

Other East Asian economies may perhaps be

watching the evolution of the Chinese economy even

more anxiously than they are economies in the developed

world. The reason of course is that in the last two yearsChina has been much the largest source of export market

growth for many of the other regional economies. In

2003, for example, growth in exports to China and Hong

Kong contributed 50-60 percent of the overall exportgrowth enjoyed by Korea and Taiwan, and about 25

percent in economies like Malaysia and Thailand. The

Chinese authorities, however, are concerned about the

rapid pace of domestic demand growth in the Chinese

economy, in particular potentially excessive investment

spending, which could lead to or worsen excess capacity

in various sectors of the economy, as well as add to the

bad debt problems of the banking system. Fixed capitalformation reached 43 percent of GDP in 2003, while

Fixed Asset Investment, a somewhat different measure of

investment, expanded by over 40 percent in nominal

terms in the first quarter of 2004.5 An unexpectedly sharp

deceleration in the economy, it is feared, could pull downChina’s imports and so remove an important source of

export market growth for the rest of the region.

The authorities have taken a variety of policy

measures to cool the economy. Monetary policy has been

tightened through increases in bank reserve requirements

and ‘window guidance’ from the central bank, the

People’s Bank of China (PBC). These measures seem to

have been effective in slowing growth in creditoutstanding from a peak of 25 percent in the first quarter

of 2003 to 7 percent in the second quarter of 2004.Policy interest rates have recently been slightly increased.

However, with higher producer price inflation, real

interest rates remain negative, which may tend toencourage further investment in areas like real estate.

This could be offset if banks take advantage of the greater

flexibility they now have to set interest rates at levels that

reflect underlying market conditions and risk. It is to be

hoped that this will provide a better market-based

5 Statistics on fixed capital formation are only available

on an annual basis, while data on fixed asset investment

(fixed capital formation plus sales of land) are published

on a higher frequency basis.



East Asia Update 14

mechanism through which monetary policy can operate,

balancing the administrative measures which have so far been the crux of the effort to slow demand. In April the

National Development and Reform Commission (NDRC)

issued an order prohibiting investment projects in 359

sub-industries, while discouraging new projects in another

175 sub-industries, with construction, steel, and

aluminum the main targets. These sub-industries becamesubject to credit rationing and restrictions on land use.

Exhibit 11

East Asia - Import Growth(US$ 3Mo. Mov. Averages - % Change Year

-20

0

20

40

60

J a n - 2 0

0 1

A p r - 2

0 0 1

J u l - 2

0 0 1

O c t

- 2 0 0

1

J a n - 2 0

0 2

A p r - 2

0 0 2

J u l - 2

0 0 2

O c t

- 2 0 0

2

J a n - 2 0

0 3

A p r - 2

0 0 3

J u l - 2

0 0 3

O c t

- 2 0 0

3

J a n - 2 0

0 4

A p r - 2

0 0 4

J u l - 2

0 0 4

E. Asia

SE Asia

China

NIEs

Exhibit 12

China: Imports from East Asia(US$ - % change year ago)

0

25

50

75

100

I n d o

n e s i a

K o r e a

P h i l i p

p i n e

s

S i n g

a p o r e

T a i w

a n , C h i

n a

T h a i l a

n d

2003

2004 1-3

2004 4-6

2004 7-8

These measures have had some success. The

most obvious impact has been on fixed asset investment

(FAI) growth, which fell to 23 percent in the second

quarter, although it recovered somewhat to 29 percent in

the third, after the completion of administrativeinspections. Unfortunately, most of the impact on FAI

growth was concentrated in the private sector. Overall

GDP growth is easing gradually – growth was 9.1 percent

in the third quarter, down from 9.7 in the first half of 2004

and 9.9 percent in the last quarter of 2003. Retail sales

remained buoyant, increasing 10 percent year on year inthe January-August period. Industrial production at the

end of the third quarter continued to run at about 16

percent above year earlier levels, only mildly less thanearlier in the year. As noted above, export growth has

generally remained strong.

The most accurate overall assessment might bethat the Chinese economy is slowing but that, on currentevidence, the slowdown is likely to be gradual and fairly

mild. While inflation has accelerated this year, with CPI

inflation reaching 5.2 percent in September, much of the

increase is attributed to increases in volatile food prices,

as well as higher raw material and fuel prices. The non-

food CPI was however only 1 percent higher in August.Thus, so long as inflation is perceived to remain in check

and the problem of excessive investment is seen to be

easing, drastic measures to slow the economy are unlikelyto be imminent.

Given this sort of backdrop China’s import

demand growth is likely to fall from the heady 40 percent

plus rates in the first part of the year, but should continueto grow at a relatively health pace so long as China’s

domestic growth does not stall, and so long as China’s

own exports to the world maintain their relatively high

trend growth. The last point is relevant because a

substantial proportion of China’s imports are demanded

as inputs and components for China’s own exports – up tohalf on some estimates. As Exhibit 11 indicates, the

slowing may already have begun with import growth in

the third quarter falling to 30 percent, compared to 43 percent in the second. Import growth from other East

Asian economies has also slowed. As Exhibit 12 indicates

import growth from East Asia in July-August wasgenerally lower than in the first half of 2004 or in 2003,

although in most cases still running at 25 percent or more.

A last point is that many East Asian economies

have been gaining market share in China’s imports over

time. The growing complementarity between the East

Asian economies may help sustain growth in their exports

to China even if China’s overall imports slow in the

aggregate. The last two years have seen a remarkable jump in this process. Table 3 shows the growth in

China’s imports between 2001 and 2003, broken down

between broad commodity categories and the economies

from which they were imported.6 Table 4 shows the

6 Here ‘Raw materials’ comprise SITCs 0,1,2,and 4: food

and live animals, beverages and tobacco, crude materials

(inedible except fuel) and animal and vegetable oils.



East Asia Update 15

dollar value in 2003 of China’s imports of these broad

commodity categories, as well as the market shares inthese categories achieved by the economies that export to

China.

Table 3. China – Growth in Imports between 2001

and 2003 (Percent Change)

TotalRaw

Materials FuelsManuf-actures MTE*

World 69.5 55.2 67.2 63.2 80.3

USA 29.5 70.2 123.2 50.9 3.7

EU 50.0 22.3 -3.3 56.7 49.9

Japan 73.3 27.6 69.2 59.6 85.5

East Asia 81.1 51.3 47.2 58.3 116.8

Korea 84.5 20.9 1.4 61.3 148.9

Taiwan, China 80.6 40.4 80.3 64.5 102.3

Singapore 104.5 102.1 98.6 108.5 107.4

Hong Kong 18.0 44.3 10.8 5.5 30.3

Indonesia 47.8 23.2 77.8 43.1 82.6

Malaysia 125.4 135.0 114.2 77.1 140.8

Philippines 224.2 35.2 10.1 105.3 263.6

Thailand 87.3 36.8 113.5 74.0 119.4

Vietnam 44.1 70.9 18.3 190.7 263.4

Cambodia -25.3 47.5 .. -51.1 -93.4

PNG 88.8 107.9 14.6 -70.7 ..

* Machinery and Transport Equipment. Source: Comtrade

China’s overall merchandise imports grew 69.5

percent in these two years to reach $413 billion in 2003,

led by an 80 percent increase in what is now the largestcategory, machinery and transport equipment, which

includes all manner of high technology electronics, parts

and components (as well as consumer electronics and

passenger vehicles). China’s overall imports fromEmerging East Asian economies gained even more

rapidly, increasing 81 percent, led by a more than

doubling (116.8 percent) in imports of machinery and

transport equipment from East Asia. East Asia’s share inChina’s machinery and transport equipment imports

reached 38 percent, which in fact represented a

remarkable gain in market share of over 6 percentage

points in just two years. Japan also slightly increased its

market share in this category to 23 percent in 2003. ThusChina now sources over 60 percent of its crucial

industrial, high tech and transport machinery, equipmentand components from the wider East Asia region, a mark

of the growing industrial integration of the region, and the

continued expansion of cross-border production networks

‘Manufactures’ comprise SITCs 5,6 and 8: chemicals,

manufactured goods and miscellaneous manufactures.

MTE is SITC 7: Machinery and Transport Equipment.

and ties among multinational companies, their suppliers

and customers.

Table 4. Market Shares in China’s Imports 2003 (As

% of import category)

Total

Raw

Materials Fuels

Manuf-

actures MTE*

World (US$ Bill.) 413 43 29 146 193

Market Shares (%)

USA 8.2 17.5 0.9 8.0 7.4

EU 13.2 5.9 0.9 11.8 17.8

Japan 18.0 4.1 1.9 18.6 23.2

East Asia 36.5 18.3 26.6 41.7 38.3

Korea 10.4 1.6 6.7 14.6 9.9

Taiwan, China 12.0 1.9 1.2 16.5 12.5

Singapore 2.5 0.2 5.3 2.2 2.9

Hong Kong 2.7 1.5 0.6 3.4 2.8

Indonesia 1.4 3.7 3.9 1.3 0.5

Malaysia 3.4 4.5 3.2 1.5 4.6

Philippines 1.5 0.4 0.2 0.3 2.9

Thailand 2.1 3.3 2.4 1.7 2.2

Vietnam 0.35 0.74 2.96 0.13 0.04

Cambodia 0.01 0.03 0.00 0.01 0.00

PNG 0.06 0.48 0.07 0.00 0.00

* Machinery and Transport Equipment. Source: Comtrade

As would be expected, the newly industrialized

high income economies in the region such as Korea,

Taiwan, China and Singapore were among the principal

beneficiaries of China’s investment boom, expanding

their share of China’s machinery and transport equipmentimports to a full 25 percent. However China’s imports of

equipment from middle income economies in South East

Asia like Malaysia, the Philippines and Thailand, while

smaller in absolute value than those from the NIEs, also

enjoyed some of the strongest rates of growth – more than

tripling in the case of the Philippines (although of course

this was from a low starting point). Even Indonesia,whose non-oil exports have struggled with problems of

declining competitiveness in recent years, achieved an 80

percent increase in this category.

China’s imports of other categories of raw

materials and manufactures also expanded at a relativelyhealthy pace, in a 50-70 percent range. As the later

discussion of commodity and oil markets indicates, rising

demand from China has been an important contributor at

the margin to the surge in oil and non-oil commodity

prices over the past 1-2 years. Higher commodity prices

have been an additional channel through which China’s

growth has contributed to windfall income gains among

commodity exporters in East Asia and elsewhere (whilegenerating income losses for net commodity importers

like Korea and the Philippines). It is noticeable, though,



East Asia Update 16

Exhibit 13

East Asian Exports and World

Semiconductor Sales

(Dec 1994-Aug 2004; % change year

-60

-40

-20

0

20

40

60

D e c - 1 9 9

4

J u n - 1 9 9 5

D e c - 1 9 9

5

J u n - 1 9 9 6

D e c - 1 9 9

6

J u n - 1 9 9 7

D e c - 1 9 9

7

J u n - 1 9 9 8

D e c - 1 9 9

8

J u n - 1 9 9 9

D e c - 1 9 9

9

J u n - 2 0

0 0

D e c - 2 0 0

0

J u n - 2 0

0 1

D e c - 2 0 0

1

J u n - 2 0

0 2

D e c - 2 0 0

2

J u n - 2 0

0 3

D e c - 2 0 0

3

J u n - 2 0

0 4

orld semiconduct

sales

East Asian

export growt

that growth in China’s imports of these categories was

less than that in machinery and transport equipment.Formal studies confirm that China’s income elasticity of

demand for imports is significantly lower for intermediate

products, raw materials and consumer goods than it is for

capital goods. A recent analysis by Eichengreen, Rhee

and Tong (2004) estimates that China’s income elasticity

for imports from Asia in 1990-2002 averaged about 0.6for intermediates, 1.5 for consumer goods and 2.2 for

capital goods.7 Thus growth in China’s imports of raw

materials and consumer goods, especially manufactures produced by low wage unskilled labor, is likely to

generally remain less dynamic than its demand for capital

equipment.

As Table 3 broadly suggests, East Asia’s overallshare in these more slow growing markets is also tending

to gradually decline as the region’s overall comparative

advantage shifts towards more sophisticated products.

East Asian economies that still tend to specialize in raw

materials and low wage manufactures are also likely to

face intense competition in the Chinese market fromdomestic producers and exporters in other developing

regions. Nevertheless, East Asian economies that succeed

in seeking out and sharpening competitiveness insegments of unique comparative advantage, as well as inmaintaining a favorable low cost business environment,should still be able to do well. Examples of fast growing

East Asian exports to China among natural resource based

products include crude rubber from Malaysia and

Vietnam, cork and wood from Malaysia and Papua New

Guinea, vegetable oils from Malaysia, and vegetables and

fruits from Vietnam. Examples of fast growing

manufactured exports (other than machinery and transport

equipment) include professional and scientificinstruments from the Philippines and Malaysia, non-

ferrous metals from the Philippines, organic chemicalsand iron and steel from Malaysia and Thailand, andrubber manufactures, textile yarns and footwear fromVietnam.

Commodity Cycles and the Oil Shock

High tech

A variety of recent information including global

semiconductor sales, inventories, industry warnings on

demand, and weak new orders suggests that there has

been a downshift in momentum in the global high techindustry in recent months. World semiconductor sales

have been on a rising trend since the recession lows of

mid 2001 and averaged $18.2 billion in the three months

to August 2004, not much less than previous global peak

sales of $18.7 billion in October 2000, at the height of the

7 Barry Eichengreen, Yeogseop Rhee and Hui Tong.

“The Impact of China on the Exports of Other Asian

Countries”. NBER Working Paper 10768. September

2004.

global high tech boom. The year on year rate of sales

growth in August had however dipped to 34 percent,down from 40 percent in June. As Exhibit 13 indicates

sales in this industry are highly volatile and, as would be

expected, are also closely correlated with exports from

East Asia, the leading region for production, assembly

and exports of electronic and other high tech products. A

more sensitive measure of momentum such as growth inseasonally adjusted sales from the previous three month

period has also dipped in recent months.

Industry reports also suggested a build up of

excess component inventories during the second quarter.J.P Morgan estimates that inventories of semiconductorsat PC component suppliers rose to 84 days in the secondquarter of 2004, even higher than a previous peak of 78

days in the first quarter of 2001. According to the

Semiconductor Industry Association (SIA), producers

have taken swift action to correct the overbuild by

trimming capacity utilization rates in the third quarter.8 In

line with these industry reports of inventory correction,

tech output among East Asian producers has dropped

(from 22 percent annualized month-on-month growth in

June to 3.7 percent in July.). Beyond the recentinventory correction, industry participants appear togenerally expect that a cyclical peak in 2004 will be

followed by a significant slowing in the growth pace of global semiconductor sales and in other market segments

8 J.P. Morgan North America Equity Research.

“Semiconductor 3Q04 Preview”. 07 October 2004.

Semiconductor Industry Association Press Release

“Industry Reacts Quickly to Reports of Excess

Inventories”. September 30, 2004.



East Asia Update 17

Exhibit 14

Non-oil Commodity P(Dollar indexes. Jan.199

0.50

0.70

0.90

1.10

1.30

J a n - 9 6

J u l - 9 6

J a n - 9 7

J u l - 9 7

J a n - 9 8

J u l - 9 8

J a n - 9 9

J u l - 9 9

J a n - 0 0

J u l - 0 0

J a n - 0 1

J u l - 0 1

J a n - 0 2

J u l - 0 2

J a n - 0 3

J u l - 0 3

J a n - 0 4

J u l - 0 4

Non-energy

Food

Raw Materi

Metals

in 2005. Recent data also indicate some slowing in new

technology orders in the main developed economies.High tech exports from East Asia are therefore likely to

slow in coming months, although it remains to be seen

how deep or protracted such a downswing will be.

Primary commodity demands

After significant increases between late 2001 andearly 2004, non-oil commodity prices have been generally

flat or have trended somewhat lower since the spring. It

remains to be seen whether this represents only a

temporary pause or marks the beginning of a more

sustained retreat. Dollar prices for non-oil-commodity

prices had risen about 45 percent on average between the

end of 2001 and March 2004 – that is, between the end of the last global economic slowdown and what is likely to

have been expected to be the peak of the current global

cycle. Prices for metals and minerals and agricultural rawmaterials were especially strong, rising 50 –60 percent in

this period. (Exhibit 14). The rebound in commodities

has been underpinned by unexpectedly strong global

demand for industrial raw materials, driven by robust

growth in China, other developing economies, the United

States and Japan, as well as by capacity constraints

resulting from low prices and low investment in various

sectors in earlier years. Prices in dollar terms were alsosupported by the fall in the U.S. currency against other

major currencies, as well as by the extended period of low

interest rates and easy monetary policy with whichgovernments sought to counter the bursting of the global

stock market bubble and economic slowdown of 2000-01.

Several of these underlying forces appear to have

at least shifted gear. Global demand growth has eased,

with some slowing in the U.S. and Japan in the secondquarter of 2004, as well as policy efforts to curb the

overly rapid pace of growth in China. After falling

through 2002 and 2003, the U.S. dollar also reversed

course and managed a mild appreciation in 2004. At themargin the start of a moderate tightening in U.S.

monetary policy may also have contributed to restraining

further increases in commodity prices in 2004.

The overall non-oil index fell 4 percent between

March and September 2004, led by declines in various

food commodities. Fats and oils prices in particular fell

25 percent, led by a 37 percent fall in soybean prices, onreduced demand from China and improving supply

prospects in the U.S. Prices for South East Asian edibleoil exports such as palm and coconut oil were also down

after the spring. Although prices for various grains suchas wheat, maize and sorghum have also fallen back on

higher global supply prospects, the price of rice – an

export product for farmers in Thailand and Vietnam, and

a staple in household consumer budgets throughout the

region – has not. Dollar prices have risen about 40

percent from $168/mt in mid 2001 to a range of $230-

240/mt in 2004.

Metals and agricultural raw material prices,

which are more closely tied to industrial demand thanfood prices, have tended to remain more resilient this

year. Metals prices have been fairly flat since January,

following their 50 percent surge in 2003. Imports and

apparent consumption of metals in China have eased

substantially in recent months, due mainly to a slowdown

in the construction sector and tightened credit, making itmore difficult to finance imports. Apparent consumption

of the major metals fell to 4 percent growth in July

(3mma), from 28 percent in April. Nevertheless lowstocks and market deficits for most metals continue to

underpin prices, which could move higher if demand

growth and imports to China accelerate once more. Pricesfor agricultural raw materials exported from South East

Asia such as rubber and timber have also been fairly

resilient, not falling much from recent peaks at the start of

the year. The impact of non-oil commodity price

movements on economies in East Asia is considered at

the end of the next section, together with the impact of

higher oil prices.

The Oil Price Shock

Perhaps the most alarming recent developmentderiving from the global economy is the relentless rise in

crude oil prices over the past year. The average price of anumber of different qualities of crude oil has risen from

around $27 a barrel in September 2003 – which was also

the average price of oil over the preceding three years – to

$42 in September 2004 and $46.7 in the first three weeks



East Asia Update 18

Exhibit 15

Monthly Average Crude Oil Price ($/bb(Jan 1990-Oct. 2004)

10.0

20.0

30.0

40.0

50.0

J a

n - 1 9 9 0

N o

v - 1 9 9 0

S e

p - 1 9 9 1

J u l - 1 9 9 2

M a

y - 1 9 9 3

M a r - 1 9 9 4

J a

n - 1 9 9 5

N o

v - 1 9 9 5

S e

p - 1 9 9 6

J u l - 1 9 9 7

M a

y - 1 9 9 8

M a r - 1 9 9 9

J a

n - 2 0 0 0

N o

v - 2 0 0 0

S e

p - 2 0 0 1

J u l - 2 0 0 2

M a

y - 2 0 0 3

M a r - 2 0 0 4

Average Sept. 199

Sept 2003 - $26.2

Average Jan. 1990

Aug 1999 - $18

Exhibit 16

Average Real Oil Price(1970 Q1-2004 Q4. Real is Constant 2004 Dollar

0

20

40

60

80

100

Q 1 - 1 9 7 0

Q 1 - 1 9 7 2

Q 1 - 1 9 7 4

Q 1 - 1 9 7 6

Q 1 - 1 9 7 8

Q 1 - 1 9 8 0

Q 1 - 1 9 8 2

Q 1 - 1 9 8 4

Q 1 - 1 9 8 6

Q 1 - 1 9 8 8

Q 1 - 1 9 9 0

Q 1 - 1 9 9 2

Q 1 - 1 9 9 4

Q 1 - 1 9 9 6

Q 1 - 1 9 9 8

Q 1 - 2 0 0 0

Q 1 - 2 0 0 2

Q 1 - 2 0 0 4

U S $ p e r B a r r e l

Real oil price - constant

2004 dollars per barrel

3 year average of realoil price

October 2004

of October 2004.9 As Exhibit 15 suggests, even before

the latest hike, oil prices have generally averaged $8-9 a barrel higher during the 2000s than the $18 average of the

1990s. Although in nominal terms recent prices

significantly exceed those before the 1991 Gulf War or

those during the second oil shock of 1980, the comparison

is somewhat less alarming in real or inflation-adjusted

terms. Oil prices deflated by the U.S. consumer priceindex are only slightly higher than before the first Gulf

War and still slightly under half those at the peak of the

1980 shock, when prices were over $90 a barrel in today’s prices. (Exhibit 16).

Reasons for the oil price increase

There appear to be three main sets of reasons for this

year’s oil spike. First, the unexpectedly strong and

coordinated global recovery across most of the world has

fueled sharply higher demand for oil. World consumption

averaged 81.8 million barrels per day (mbd) in the first

half of 2004, about 3mbd (or 3.9 percent) higher than the

same period of 2003, and well above the expectedincrease of around 1-1.5 mbd. At the center of the

unexpected strength in demand has been China, where

apparent consumption increased from year earlier levels

by 1 mbd (or 19 percent) in the first quarter of 2004 and

9 This is the average of West Texas Intermediate (WTI), Brent

and a Dubai crude oil price, which is rather lower than thewidely reported WTI price, recently near $55. Demand and

prices for light crudes like WTI have risen much more stronglythis year than those for heavier crudes. The premium of WTIover the heavier Dubai, usually around $3-4, has recently spikedup to $12-14.

1.3 mbd (or 25 percent) in the second, far higher than the

7 percent annual average growth in the country’s oildemand over the past decade. Demand growth in China

has been highest for transport fuels like gasoline and

diesel, but was strong across all segments, including fuel

for power generation, naptha as feedstock for new

petrochemical capacity and LPG and kerosene for

household and commercial use. Commercial stockingalso often has a large impact on demand in China,

although it is unknown what role it played in the first half

of 2004. There were also large demand increases in therest of Asia and North America.

Second, while OPEC and non-OPEC sources

have pushed production higher to meet rising demand, the

cushion of available spare oil production capacity has

become very thin. OPEC crude oil production in the third

quarter is estimated to have reached 29.4 mbd, nearly 3

mbd more than a year earlier, while non-OPEC

production was also up by perhaps 1mbd. However

OPEC spare capacity is now down to some 1.5 mbd, as

compared to 6-7 mbd in 2002, so that, in the near term,

OPEC’s capacity to manage prices has been weakened or lost, and demand increases are increasingly having to berationed by higher prices. The present low capacity is

generally held to reflect low investment in developing oil

production capacity over the past decade, itself a

reflection of low oil prices in the 1990s. The number of

new oil wells drilled in OPEC countries in 2003 fell by

6.5 percent, for example.

Lastly oil prices have been pushed higher by a

series of political tensions and natural shocks that have

either directly disrupted production in different locations,



East Asia Update 19

or have increased the probability of such disruptions in

the future. These have included terrorist attacks in Iraqand Saudi Arabia, the dispute between the Russian

government and the Yukos oil company, political strife in

Venezuela, strikes and violence in Nigeria, the simmering

dispute with Iran over its nuclear program, the disruption

of production in the Gulf of Mexico by Hurricane Ivan

and, most recently, power outages in Kuwait.Oil price outlooks

Where now for oil prices? Differences of

opinion on the market outlook have widened, with some

analysts arguing that prices could reach $60 or even

higher over the next year, and could be sustained at over

$40 in the longer term. The view that the market hasundergone a fundamental structural change is given some

support by oil futures prices, which have moved higher

much more closely in line with spot prices than hasgenerally been the case in the past. In mid-October the

spot price for WTI was around $55 a barrel while the two

year forward price was around $44. Indeed even the

longest dated NYMEX contract for delivery of oil in 2010

was trading as high as $39, although this in particular is a

very thinly traded market.

On the other hand the majority or consensus of

oil market forecasts continue to look for prices togradually trend lower from current peaks, although likely

staying above $30 for at least the next two years. While

not underestimating the strength of demand and the reality

of limited capacity, it can be noted that world production

has in fact recently risen somewhat faster than demandand that OECD crude stocks are in the middle of their

historic range. An additional 1.4 mbd of non-OPEC

supply and 0.4 mbd of OPEC supply are expected to enter the market in the fourth quarter, with further capacity

increases expected in 2005. Indeed Iraq surprised the

market with an 0.5mbd production increase in September.

Demand pressures have been highest for light sweetcrudes, but these should abate with the end of the U.S.

driving season.10 More generally demand pressures

should also ease as consumers adjust behavior and

conserve in response to higher prices. It is notable that

China’s oil imports after increasing 39 percent in the firsteight months of 2004, and by 37 percent in August, grew

by only 5.7 percent in September.

The Bank’s current outlook is in line with the

general consensus view; it looks for prices to average $39a barrel in 2004 and $36 in 2005, before falling to $32 in

2006 and $26 in the longer term. But it is almost needlessto add that in the present environment all oil projections

are even more than normally subject to major

uncertainties.

10 International Energy Agency. Oil Market Report . September

and October 2004.

Oil shock impacts and policy responses

It should be said that since this year’s oil priceincrease is principally the result of rising demand, it is asign of global economic strength rather than weakness.

Nevertheless, with demand running up closer to oil supply

constraints, rising prices will serve as a mechanism to

slow world growth from its heated pace in 2004. For the

East Asia region higher prices will directly curb incomesin the majority of larger economies because they are net

oil importers. East Asian economies will also be affected

by the impact of higher oil prices on the main export

markets in the developed world or OECD countries,

which overall is an oil importing region.

An analysis of the impact of high oil prices bythe International Energy Agency (IEA) estimates world

output would fall by 0.5 percent in a scenario in which oil

prices average $35 a barrel over the whole period 2004-08, as compared to a base case scenario of $25 a barrel.11

Under this scenario higher oil prices lead to a transfer of

$150 billion a year from oil importing to oil exporting

economies. (The increase in the oil import bill for

Emerging East Asian economies will be around $20-25

billion a year in 2004-05). This is likely to have a net

negative effect on world aggregate demand and income,

because, while oil importers suffer an income loss and areexpected to cut domestic demand, oil exporters are

expected, as in earlier oil shocks, to save a significant

fraction of their increased income, at least initially. Inimporting countries, on the other hand, the adverse impact

effect of the income loss may be exacerbated by structural

rigidities that lead to adjustment costs in the form of

temporarily higher unemployment of labor and other

resources. Inflation will rise, although the extent and

duration of the rise will depend on the extent to whichlabor market rigidities and macroeconomic conditions

lead to a price-nominal wage spiral. The real exchange

rate of oil importers would typically depreciate.

As regards the impact on OECD economies, one

mitigating factor is that these economies have become

more energy efficient since the oil shocks of the 1970s

and early 1980s. The amount of oil used to produce a unit

of real GDP in the OECD halved between 1973 and 2002,while these countries’ net oil imports fell by 14 percent.

Nevertheless as a group OECD economies still import

over half their oil needs, with net oil imports amounting

to $260 billion or about 1 percent of GDP in 2003. The

IEA study estimates aggregate OECD output would fall

by 0.4 percent relative to the base case in the first twoyears of the scenario, with the impact somewhat less in

the U.S. and somewhat higher in the Euro zone.

The impact of the oil shock is expected to be

higher among developing countries, due to their generally

greater dependence on oil imports and higher

11 IEA. Analysis of the Impact of High Oil Prices on the Global

Economy. May 2004.



East Asia Update 20

Exhibit 17

East Asia - CPI Inflati

(2001 Q1 to 2004 Q3)

-2

2

6

10

14

2001 Q1 2001 Q3 2002 Q1 2002 Q3 2003 Q1 2003 Q3 2004 Q1 2004 Q3

China

Indonesia

Malaysia

Philippines

Korea

Thailand

consumption of oil per unit of GDP. As indicated in

Table 5, net oil imports amounted to 4-5 percent of GDPeven before the recent price increases in economies such

as Korea. Philippines and Thailand. Energy intensity

among East Asian economies (measured here as BTUs

per 1995 dollar of GDP at market prices) is generally

higher than among the developed economies because the

share of industry in GDP is higher while that of servicesis lower. Energy intensity among the larger Asian

economies shown in Table 5, for example, is about twice

the average among the G7 economies, and in most caseshas been rising over the last decade.

Table 5. Energy Imports and Consumption

Net Oil Exports2002

Energy Consumption(per dollar of 1995 GDP)

Mtoe*As %

of GDP

BTU per

dollar 2002

Avg. % Ch.

1990-02

China -61.7 -0.9 35764 -5.2

Indonesia 8.6 4.2 20331 2.1

Korea -109.0 -4.7 12340 0.8

Malaysia 11.9 4.5 20897 1.6

Philippines -13.1 -3.9 12560 1.2

Thailand -33.1 -5.1 16701 3.3

Japan -204.3 -1.6 3876 0.4

Source: IEA Energy Balances, World Bank, U.S. Energy

Information Administration. * Mtoe - Million Tons of Oil

Equivalent.

Output in the Asian region as a whole (includingIndia) is estimated to be reduced by 0.8 percent in the IEA

study, while inflation increases by 1.4 percent. Theestimated decline for China is also estimated at 0.8

percent, with somewhat larger output losses in the more

oil dependent economies of the region. As Exhibit 16

indicates, East Asian CPI inflation rates did indeed pick

up markedly in the second and third quarters of 2004. Themedian inflation rate in the 9 largest economies rose from

1.6 percent in the last quarter of 2003 to just over 3

percent in the third quarter of 2004. Prices were boosted

not only by higher oil but also by higher food prices,

reflecting recent substantial increases in international

agricultural commodity prices, and in some cases by poor domestic harvests.

For policy makers in oil importing economies

the oil price shock has consequences for which there arefew easy or straightforward policy responses. The oil

price increase will tend to both increase inflation as wellas reduce real income and create more unemployment. At

one extreme, policy makers could focus policy

instruments, in particular monetary policy, on trying to

neutralize the demand reducing effect of higher oil prices,

thereby stabilizing unemployment. This would risk the

rise in inflation caused by higher oil prices being passed

into further wage and price increases, leading to a permanent or longer term rise in inflation. At the other

extreme policy makers could focus exclusively on

neutralizing the inflationary impact of the oil shock, for

example by trying to stabilize overall or core inflation

rates. That could generate significant increases in

unemployment.

In practice policy makers will be concerned

about both inflation and unemployment, and so will haveto weigh the gains from policy actions that move one of

these variables closer to its target against the losses from

the other variable moving away from target. This means policy makers may have to accept some temporary

increase in both inflation and unemployment while

keeping close watch that neither diverges too far from itsdesired target value. The particular weight policy makers

attach to the inflation or unemployment target is likely to

be affected by the cyclical position of the economy before

the oil shock. In several East Asian economies the strong

growth of the last 1-2 years, the resulting reduction in

excess capacity and the low prevailing level of real

interest rates all suggested the need for tighter monetary policies, a process that has already begun in China, andmore recently in Thailand. With this kind of background

of strong aggregate demand pressures, policy makers

might initially be more concerned about the inflationary

impact of the oil price rise, and so may wish to retain a bias towards further tightening of monetary policy, while

keeping a close eye on the evolution of output and

employment. Macroeconomic adjustment among the oil

importers will also be assisted by some depreciation of

the real exchange rate (relative to where it would have



East Asia Update 21

Exhibit 18

Income gains/losses due to select

commodity price changes(As % of GD

-2.0

0.0

2.0

4.0

6.0

8.0

10.0

P N G

M o n g o l i a

M a l a y s i a

V i e t n a m

I n d o n e

s i a

C h i n a

T h a i l a n d

P h i l i p

p i n e

s

L a o P D

R

C a m b o

d i a

K o r e

a

2004

2005

Assumed Price Changes2004 2005

Oil 34.9 -7.7

Rice 16.4 -4.3

Edible Oils 14.4 -10.8

Iron Ore 18.6 8.2

Copper 58.8 -6.2Rubber 18.1 -10.4

been without the oil price increase), something that will

be easier to accomplish in economies with a flexibleexchange rate regime.

Policy makers in the oil and non-oil commodity

exporting economies of the region will face a somewhat

different set of problems in dealing with the windfall

gains generated by high oil and non-oil commodity prices.

Exhibit 18 estimates the initial impact effect of both theoil and non-oil commodity price increases on several

economies in the region. A small economy such as Papua

New Guinea, a net exporter of both oil and non-oil

commodities, could experience a windfall income gain

around 10 percent of GDP, while larger net exporters of both types of commodity like Indonesia, Malaysia andVietnam could see windfall gains of perhaps 2-3 percentof GDP. An economy like Mongolia which is a net oil

importer could also experience a large net income again

because the price of its main mineral export, copper, is

expected to have risen almost 60 percent for 2004 as a

whole. As Box 1 explains, if improperly managed, such

large windfall gains can have a variety of unexpectedeconomic ill effects.

Box 1. Managing commodity windfall gains

It is hard to imagine that when rising commodity

prices sharply boost the income of a poor economy – giving it a large windfall gain - that could turn out to be a bad thing. If the gain is well managed it should not. Atdifferent periods economies like Indonesia, Malaysia,

Chile, Botswana and Norway have in fact been able to

manage their natural resource wealth to foster

development and broad welfare gains for the population.

But, on the other hand, windfall gains have quite often

been squandered, with few lasting gains for the public,and could even lead to countries being worse off in the

long run. In oil rich Nigeria, for example, real per-capita

GDP in 2003 was no higher than in 1970, while the

economy was saddled with high debt. Policy makers in

the small low-income East Asian economies like

Mongolia, Papua New Guinea and Timor-Leste that arereceiving large windfall gains this year may therefore find

it useful to look at the experience of other countries in this

area.

A good starting point is that commodity prices

are very volatile, so most commodity based windfall gainsare only temporary – boom will likely be followed by bust. However policy makers in developing countriesoften mistakenly act on the assumption that a temporary

income gain is permanent, consuming it immediately,

allowing it to be misappropriated through corruption, or

spent on domestic investments with low rates of return.

Even worse, it is sometimes used to underpin more

foreign borrowing, which is then used for these purposeson an even wider scale. The real exchange rate often

appreciates, squeezing profitability in the non-natural

resource export sector or the import competing sector of the economy. When commodity prices fall and the bustarrives, however, the country is left with heavy debts butfew offsetting assets, weaker and more corrupt

institutions, an overvalued exchange rate and

uncompetitive industries that may never fully recover.

Severe macroeconomic adjustment with sharp falls in

living standards and growth then follow.

The general rule for temporary windfall gains is

that welfare over time can be improved by saving most of

the gain and using the returns on this investment to enjoya smoother and somewhat higher level of consumption

over many years. Since the government is commonly the

‘trustee’ for the country’s resources, it is primarilythrough fiscal policy that this rule can be implemented,

with the government smoothing expenditures over time to

avoid the need for large disruptive adjustments.

A variety of fiscal approaches to managing

booms have been attempted. Before getting to specifics,it is worth stressing that the success of any policy will

depend on the incentives for its politicians and

bureaucrats to actually implement it, rather than to find a

way around it, as well as on the quality of its budgetary

and other institutions. Some degree of public financial

accountability is needed simply to know what has come inand where it is going. Decomposing the fiscal accounts

into a natural resource and a non-resource balance is also

important for designing good policies. Broad institutional

reforms to strengthen the quality and transparency of

fiscal decision-making are thus an essential foundation.

Many countries have found the simplest

expedient to boost savings (after paying off any foreign

commercial debt) is to establish some form of



East Asia Update 22

stabilization or savings fund . Commodity revenues are

paid into the fund when commodity prices exceeds acertain reference level (as with Chile’s Copper

Stabilization Fund), or according to a fixed proportion (50

percent of oil revenues for the Alaska Permanent Fund),

with the funds being used to accumulate a portfolio of

long term financial assets. Of course all this will only

matter if the government actually constrains its spendingwithin the limits implied by the rule (rather than ‘saving’

revenues in the fund, on the one hand, and continuing

high spending and foreign borrowing on the other!)

Julia Devlin and Michael Lewin. “Managing Oil Booms

and Busts in Developing Countries”. In World Bank (2004). Managing Volatility and Crises: A Practitioner’s

Guide.

Trade Policy Developments

This has been a banner year for world trade. It is

estimated that world trade volumes will increase by over 11 percent in 2004, almost twice the trend rate of growth

in 1990-2003. East Asia has played a central role in this

year’s trade boom, not only as a key supplier of import

demands elsewhere in the world, but as itself a new major

source of import demand. This year China alone is

estimated to have contributed around 15 percent of theoverall increase in world imports volumes, whileEmerging East Asia as a whole is estimated to havecontributed somewhere between one third and 40 percent

of world trade growth.

Yet, even as trade itself has boomed, there has

been a nagging worry that the multilateral system of rules

upon which the expansion of trade ultimately rests isunder pressure, and might erode if progress fails to be

made on the present Doha round of global trade talks.

Such concerns were heightened by the failure to reach

agreement at last year’s Cancun meeting of the WTO, but

they may be relieved by the WTO General Council’sadoption of a negotiating framework for the talks at its

meeting of 27-31 July. This is of general importance for

East Asia, which studies find to be among the principal

beneficiaries of a successful new global trade round. Thestart of 2005 will also see another important trade policy

development, the end of the Multifiber Agreement system

of quotas on trade in garments. Box 2 below considers

the consequences.The WTO Framework Agreement

The WTO General Council meeting agreed on a

negotiating framework for the Doha trade negotiations; its

importance lies in getting the talks back on the road,though it must be admitted that most of the hard work of

arriving at specific detailed agreements still lies ahead.

There were four principal points:

• Agricultural trade. The agreement lays out a road

map for the elimination of agricultural export

subsidies, better disciplines on export credits and state

trading enterprises, and introduction of newcommitments to reduce trade-distorting farm subsidies,

with deeper cuts in countries with higher subsidies and

significant cuts early on. The impact on East Asia of

this part of the agreement may be limited because most

of the region is not a major exporter or importer of

some of the commodities most heavily subsidized inthe developed world, such as beef, dairy, wheat or

corn. On the other hand there was no specific

agreement on rice, the most important agriculturalcommodity in the region. Even though it would

generate large welfare gains for their own consumers,

there seems little likelihood that East Asian countriesthat heavily protect their domestic rice producers will

allow improved access to domestic markets. One issue

of concern for East Asian economies is tariff escalation

in developed economies, whereby higher tariffs are

imposed on more highly processed products, thereby

constraining diversification into food processing by

developing economies. Another is the use by

developed economies of high and non-transparentspecific duties on agricultural and agro-processed

products. Even though the framework agreement

contains no specific plan for these issues, it would be toEast Asian countries’ advantage to push for progress

on them.

• Non-agricultural market access. The framework

agreement sets the stage for the pursuit of tariff cuts

according to a non-linear formula and the reduction or

elimination of non-tariff barriers. Although many

issues are still open concerning the next steps in the

NAMA negotiations, there is clear understanding about

the importance of achieving progress in this area,which accounts for more than 60 per cent of

international trade.

• Services. WTO members agreed to intensify effortsto increase market access for services. Revised offers

must be tabled by May 2005. East Asia has lagged

behind other developing regions in opening its servicesmarkets, even though evidence suggests that the

productivity gains associated with more efficient

services are particularly high. International trade

agreements in services can offer East Asia several

benefits: increasing the credibility of reforms as the

result of binding international commitments, and

facilitating regulatory cooperation. Improved access tomarkets abroad can also be important.

• Trade facilitation. There was also agreement to

initiate negotiations in this area, The agreement calls

for less red tape, more efficiency in the movement of

goods across borders, and clarification and

improvement of WTO rules governing customs

procedures to expedite the movement, release, andclearance of goods. In East Asia port and

infrastructure bottlenecks are one of the most

significant factors raising costs for potential exports.



East Asia Update 23

Red tape and an antiquated approach to customs

procedures in some countries can equal a 5-15 percenttariff.12 Logistics improvements, essential for moving

up the value chain, have very high payoffs in East

Asia. High-value agriculture (flowers, fruits, seafood)

and manufacturing (electronics) demand sophistication

not only in production by also in logistics handling.

Timeliness matters, and a fast, reliable, supply chain isessential. In East Asia, the key logistical bottlenecks

seem to be high internal land transport costs and port

logistics. This is in sharp contrast to the highefficiency of external transport, with trans-Pacific

shipping costs declining sharply over the past decade.

The WTO framework agreement, which focusesmainly on border issues, is narrower than the broader

trade facilitation agenda that East Asian countries are

concerned about. Yet, it can serve as an impetus to

foster their broader reform agenda.

Box 2. The End of Quotas on Garment and TextilesTrade

New Year’s day 2005 will see the final phasing

out of the 30 year old system of quotas on world garment

and textiles trade (first under the 1974 Multifiber

Agreement and then under the transitional 1995

Agreement on Textiles and Clothing). East Asian

economies, which exported over $100 billion of the total

$226 billion world trade in garments in 2003, will be

among those most affected by the change.

China, whose exports are the most tightly restricted by

the present quota system, will be a principal gainer, due to

low unit labor costs, economies of scale (which are

especially important in textiles production), the

established finance and marketing networks of HongKong-based parent companies, and vertical integration

between its garment, textiles and cotton growing sectors.

A recent study estimates that China will increase its share

of U.S. garment imports from 16 to 50 percent as a result

of quota removal, and from 20 to 29 percent in the EU

import market. (Nordas, 2004).

Vietnam is a potential winner. Its garment exports have

recently grown at a 30-40 percent annual pace to exceed

$3.5 billion in 2003. With labor costs among the lowest

in the region and productivity levels quickly rising to

those of China, Vietnam is very competitive in garments.However, since it is not yet a member of the WTO, it may

continue to face continued volume restrictions in the US,

EU and Canadian markets while restraints are lifted onothers. If Vietnam achieves its planned accession to the

WTO in 2005 or 2006, this will be a temporary setback .

Cambodia, however, could be quite adversely affected.

Garments contribute 76 percent of exports and all of

12 K. Krumm and H. Kharas (eds.). “East Asia Integrates”.

Oxford University Press and the World Bank, 2004.

manufacturing employment, but are closely correlated

with those sub-categories where China is presently mostquota constrained. Productivity levels are less than in

China, offsetting lower wage levels. The industry is also

hampered by longer lead times and a limited domestic

textiles production capacity. One potential comparative

advantage however is Cambodia’s adherence to ILO-

monitored Core Labor Standards, which are viewedfavorably by some classes of buyers. Cambodia and a

number of other Least Developed Countries have also

asked for preferential duty-free access to the U.S. market,which otherwise imposes a 15 percent duty on garment

imports from WTO members.

Even after the end of the ATC, however,exporters are still likely to face various types of protection, including ordinary import tariffs and so-called

safeguard or anti-dumping measures. The U.S, has

already applied one year restraints on three Chinese

knitted products, with more likely to follow, while the

E.U. is studying measures against synthetic clothing from

China.

On the whole, however, there will be a much

more fiercely competitive market place for garments and

textiles. Given the importance of economies of scale,

vertical integration and low labor costs, some speculatethat the textile and garment industry will evolve to a two-

tier structure – one, occupied by China and India, will

produce the vast majority of low-cost garments, andanother tier will be occupied by a number of producers

which serve niche markets and help firms diversify the

risk of concentration on China and India. Such niches

may be defined by brand characteristics, corporate social

responsibility, rapid turnaround or other features. Firm

location decisions will in part be determined by the paceat which countries establish the right investment climate

for a more flexible, technology-driven sector. Success

will depend on good infrastructure and logistics, quick turnaround times, openness to trade, efficient trade

facilitation services, low regulatory burdens, flexible

labor markets and creating a risk environment thatencourages firms to invest in skill development and

technology upgrading.

H. Nordas. (2004) The Global Textile and Clothing

Industry post the Agreement on Textiles and Clothing.

W.T.O. (September).

Capital markets and global imbalances

The second half of 2003 saw a large reflow of private capital flows to emerging markets for the first

time since the financial crises of the late 1990s, led by

flows of portfolio and equity bond flows. International

investor demand for emerging market securities appears

to have been bolstered by growing confidence about the

global recovery and the improving environment for



East Asia Update 24

developing economies, improved perceptions of the

general quality of policies in these economies, and by thelow level of interest rates in the developed world. Partial

data for 2004 suggest that flows to emerging markets

have taken a pause this year – continuing at roughly the

same levels reached in the second half of 2003, but not

growing as they did last year. Exhibit 19 below shows the

total of gross bond and equity issues and commercial bank borrowings by emerging markets as a group and by

Asian emerging markets in particular. Gross flows on this

definition reached an annualized pace of about $250 billion in the second half of 2003 and remained at about

that level in the first three quarters of 2004. Flows to

Asian markets followed roughly the same pattern.

Exhibit 19

Gross Capital Flows to Emerging Markets(US$ Bill. at annual rates)

0

100

200

300

2002 2003 H1 2003 H2 2004 H1 2004 Q3

Emerging

MarketsAsia

Source: World Bank DECPG Finance Team

The leveling out or pause in emerging market

flows this year is consistent with other trends in the

international economy. As noted earlier in this report,

uncertainties about the outlook for the global economy

have tended to multiply this year. In addition, U.S.

monetary policy began tightening at mid year, with thefederal funds rate rising from 1 percent to 1.75 percent at

present, while the 6 month US dollar LIBOR, the most

commonly used benchmark for pricing commercial bank loans, has increased by about 100 basis points. The yield

on the 10 year U.S. Treasury Note – the benchmark for

pricing bonds – also rose in the second quarter, before

falling back over the rest of the year, as concerns

increased about a slower pace of growth in the U.S.

economy going forward. (Exhibit 20. Note also the

falling spread between long and short term interest rates,

which is often viewed as a predictor of slower growthahead).

Exhibit 20

U.S. $ Interest Rates - Short and Long Term

1

2

3

4

5

1 / 1 / 0 4

1 / 1 6

/ 0 4

1 / 3 1

/ 0 4

2 / 1 5

/ 0 4

3 / 1 / 0 4

3 / 1 6

/ 0 4

3 / 3 1

/ 0 4

4 / 1 5

/ 0 4

4 / 3 0

/ 0 4

5 / 1 5

/ 0 4

5 / 3 0

/ 0 4

6 / 1 4

/ 0 4

6 / 2 9

/ 0 4

7 / 1 4

/ 0 4

7 / 2 9

/ 0 4

8 / 1 3

/ 0 4

8 / 2 8

/ 0 4

9 / 1 2

/ 0 4

9 / 2 7

/ 0 4

1 0 / 1 2 / 0 4

10-Yr Treasury Note

LIBOR

Spread

Higher U.S. interest rates can be expected to

have some dampening effect on flows to emerging

markets, while, on the other hand, the relative mildness of

the increase is consistent with the level of flows onlyflattening out rather than falling this year. Indeed,

consistent with the pullback in longer term interest rates

during the third quarter, emerging market flows appeared

to be strengthening once more towards the end of the

year. Gross emerging market flows in September were

estimated to have jumped to $31 billion, up from $14

billion in August, those to Asia increasing from $3 to 7

billion, including significant bond issues by Malaysia andthe Philippines.

Other indicators confirm that emerging capitalmarkets have so far taken a relatively relaxed view of

increased global uncertainties and the tightening in U.S.monetary policy. Spreads on some sectors of emerging

market debt – Latin America for example – did indeed

rise modestly in the first half of the year, but have fallen

back since then. Spreads on East Asian eurobonds, which

fell sharply in 2002 and 2003, have been largely stable in

2004, or seem to have been driven mainly by domestic

policy or political developments. (Exhibits 21 and 22).

Spreads for China, Korea, Malaysia and Thailand fell

below 100 basis points in mid-late 2003, and have stayed below that level in 2004. In the Philippines spreads fell

by about 100 basis points after Mrs. Macapagal-Arroyowon re-election in the May presidential elections. In

Indonesia spreads also spiked briefly by about 100 basis

points in July because of uncertainties about the

presidential elections there, but have fallen back since

then.

Exhibit 21



East Asia Update 25

Eurobond Spreads 1/2001 - 11/2004

0

300

600

900

2 0 0 1 M 0 1

2 0 0 1 M 0 5

2 0 0 1 M 0 9

2 0 0 2 M 0 1

2 0 0 2 M 0 5

2 0 0 2 M 0 9

2 0 0 3 M 0 1

2 0 0 3 M 0 5

2 0 0 3 M 0 9

2 0 0 4 M 0 1

2 0 0 4 M 0 5

2 0 0 4 M 0 9

Korea

Indonesia

Philippines

Exhibit 22

Eurobond Spreads 1/2001 - 11/2004

0

50

100

150

200

250

300

2 0 0 1 M 0 1

2 0 0 1 M 0 5

2 0 0 1 M 0 9

2 0 0 2 M 0 1

2 0 0 2 M 0 5

2 0 0 2 M 0 9

2 0 0 3 M 0 1

2 0 0 3 M 0 5

2 0 0 3 M 0 9

2 0 0 4 M 0 1

2 0 0 4 M 0 5

2 0 0 4 M 0 9

China

Malaysia

(left)

Thailand

The recent movement of East Asian stock market

prices is also consistent with a mild pause in privatecapital flows. Stock prices surged in 2003 with

strengthening growth, the improving financial health of corporations in the region, and the return of foreign

portfolio capital inflows. Stock market prices in Thailand

doubled over the course of 2003, rose 60-70 percent in

Indonesia and by 30-40 percent in most other economies

(Exhibits 23 and 24). Prices generally peaked in January-

February this year, then pulled back by 5-10 percent in

the second quarter, before starting to move higher once

more in the third quarter.

Exhibit 23

Stock Market Indices (Jan 2003 = 1)

0.9

1.1

1.3

1.5

1.7

J a n - 2 0 0

1

M a y

- 2 0 0

1

S e p - 2 0 0

1

J a n - 2 0 0 2

M a y

- 2 0 0

2

S e p - 2 0 0

2

J a n - 2 0 0

3

M a y

- 2 0 0

3

S e p - 2 0 0

3

J a n - 2 0 0

4

M a y

- 2 0 0

4

S e p - 2 0 0

4

Philippines

Singapore

Hong Kong

Exhibit 24

Stock Market Indices (Jan 2003 = 1)

0.7

0.9

1.1

1.3

1.5

1.7

1.9

2.1

J a n - 2 0

0 1

M a y

- 2 0 0

1

S e p - 2 0

0 1

J a n - 2 0

0 2

M a y

- 2 0 0

2

S e p - 2 0

0 2

J a n - 2 0

0 3

M a y

- 2 0 0

3

S e p - 2 0

0 3

J a n - 2 0

0 4

M a y

- 2 0 0

4

S e p - 2 0

0 4

Indonesia Malaysia

Thailand Korea

East Asia and Global ImbalancesAs was discussed in more detail in the April

2004 World Bank East Asia Regional Update, Emerging

East Asia has tended to run large overall balance of

payments surpluses in recent years, as a result of its

substantial current account surpluses since the 1997-98

financial crisis, as well as the more recent resurgence of

private capital inflows.



East Asia Update 26

Annual Four-Quarter Sum

2001 2002 2003

2003

Q3

2003

Q4

2004

Q1

2004

Q2

USA -386 -474 -531 -530 -531 -537 -568

Japan 88 112 136 124 136 154 163

Euro Area -15 52 29 26 29 42 46

East Asia 1/. 91 125 164 .. .. .. ..

East Asia 2/. 96 120 144 131 144 138 135

South East Asia 22 27 32 33 32 31 29

Indonesia 7 8 7 7 7 5 4

Malaysia 7 8 13 13 13 14 14

Philippines 1 4 3 4 3 4 5

Thailand 6 7 8 8 8 8 7

East Asia NIEs 52 63 86 79 86 90 92

Hong Kong 10 13 17 17 17 15 14

Korea 8 5 12 7 12 20 25

Singapore 16 19 28 27 28 27 28Taiwan, China 18 26 29 29 29 27 26

China 17 35 46 .. .. .. ..

China trade bal 23 30 25 19 25 18 14

Table 6. Current Account Balances (US$ Bill.)

Note 1/. Inclusive of China current account. 2/. Inclusive of China

trade balance.

Indeed, as Table 6 indicates, Emerging East Asia

(and Japan) are among the major suppliers of financing

for the main macroeconomic imbalance in the world

economy at present, the U.S. current account deficit. The

U.S. deficit amounted to $568 billion in the year to the

second quarter of 2004, the largest part of the counterpart

to which were surpluses of around $300 billion in EastAsia and Japan. The Emerging East Asian economies

alone had current account surpluses of about $138 billion

in the year to the second quarter of 2004. Combined with

net inflows on the capital account, these economies

accumulated over $250 billion of official foreignexchange reserves in the year to July 2004. Total reserves

of the 9 economies reached over $1.2 trillion, including

significant holdings of U.S. government debt. (Exhibit

25). According to the U.S. Treasury Department, six

Asian economies (China, Hong Kong (China), Korea,

Singapore, Taiwan (China) and Thailand) held $381 billion of U.S. government securities in August 2004,

while Japan held $722 billion. These Asian economies

thus held $1.1 trillion out of a total $1.8 trillion U.S.official debt held by non U.S. residents, which in turn was

about one quarter of the total $7.3 trillion U.S. federal public debt outstanding.

The recent sharp deterioration in the U.S. currentaccount deficit has drawn renewed attention to the need

for adjustment of global macroeconomic imbalances.

Studies suggest that on unchanged policies and with no

further dollar depreciation, the U.S. deficit wouldcontinue to increase, reaching perhaps over $1 trillion per

year or 13 percent of GDP by 2010.13 Non-U.S. residents

would of course become unwilling to hold ever growingvolumes of U.S. debt long before then. Unpredictable

changes in investor sentiment and risk appetite could then

result at some point in a very large dollar devaluation,

steep U.S. dollar interest rate hikes and a sharp

adjustment in U.S. aggregate demand and imports, a

severe recession in short.Exhibit 25

East Asia - Foreign Reserves(US$ Bill.)

0

200

400

600

800

1,000

1,200

J a n - 1 9

9 6

J u l - 1

9 9 6

J a n - 1 9

9 7

J u l - 1

9 9 7

J a n - 1 9

9 8

J u l - 1

9 9 8

J a n - 1 9

9 9

J u l - 1

9 9 9

J a n - 2 0

0 0

J u l - 2

0 0 0

J a n - 2 0

0 1

J u l - 2

0 0 1

J a n - 2 0

0 2

J u l - 2

0 0 2

J a n - 2 0

0 3

J u l - 2

0 0 3

J a n - 2 0

0 4

J u l - 2

0 0 4

China IndonesiaMalaysia PhilippinesKorea Taiwan (China)Singapore ThailandHong Kong

Change in reserves from year

ago (US$ bill.)

2000: 47 2002: 154

2001: 69 2003 234

2004:7 251

To adjust global imbalances, policy makers

around the world – and, given the nature of theimbalances, policy makers around the Pacific Rim in the

first instance – need to consider the means of achieving a

less disruptive ‘global rebalancing’ of macroeconomic

imbalances. A part of this obviously depends on U.S.

policy efforts to boost U.S. national savings by reducing

its budget deficit. But global imbalances have alsoincreased in recent years because of the sharp fall in

domestic investment in many East Asian economies after

the regional financial crisis, especially in the NIEs. As

Exhibit 26 shows, the ratio of investment to GDP

increased between 1997 and 2003 in only one economy,China. It fell in every one of the other main economies of

the region, ranging from a fall of 6 percentage points of

GDP in the Philippines to one of 26 percent of GDP inSingapore. The average change across the 9 economies

was an 11 percent fall in investment to GDP ratios.

Savings ratios also declined, but by much less, on average

falling by about 3 percent points of GDP. There was

13 Catherine L. Mann. “Managing Exchange Rates:

Achievement of Global Re-balancing or Evidence of

Global Co-dependency?” Business Economics. July

2004.

http://www.iie.com/publications/papers/mann0704.pdf



East Asia Update 27

therefore a net swing towards surplus on the external

current account balance of about 8 percentage points of GDP, primarily due to lower investment.

Exhibit 26

Changes in Savings and Investment

(1997-2003; % of GDP)

-35 -25 -15 -5 5

China

Hong Kong

Indonesia

Korea

Malaysia

Philippines

Singapore

Taiwan, China

Thailand

Savings

Investment

The recent upswing in East Asian investmenttherefore makes a contribution towards the global

adjustment process. As Table 6 above shows, the East

Asian current account surplus has started to fall in 2004

(although the change is disguised to some extent by the

recent sluggishness in the Korean economy, which has ledto a sharp increase in Korea’s current account surplus).

China, which has already made a contribution to

adjustment as a result of its strong recent investment and

import boom, may make less of a contribution for sometime, as it attempts to reduce the over-heated pace of investment in the country. The issue will then becomefostering more robust and sustained investment spending

in the other Asian economies. Continued adjustment in

exchange rates is also likely to play a role in the overall

macroeconomic adjustment of the region (though not

perhaps in every individual case). While in a number of

cases such as China, Hong Kong and Malaysia, nominal

exchange rates have remained constant against the dollar

as a result of formal pegs or tight bands, in most other

cases exchange rates have generally appreciated against

the dollar over the last 2-3 years, rising by 5-10 percent inThailand and Taiwan, China, and 10-20 percent in

Indonesia, Korea and Japan. A third significant

contribution to adjustment can come from further trade

liberalization in the region, especially in the area of services, where liberalization in East Asia has tended to

lag other regions.

Exhibit 27

Exchange Rates vs.

(Rise=appreciation, Jan 2002=1)

0.900

1.000

1.100

1.200

1.300

1.400

1.500

J a n - 2 0

0 2

A p r - 2

0 0 2

J u l - 2

0 0 2

O c t

- 2 0 0

2

J a n - 2 0

0 3

A p r - 2

0 0 3

J u l - 2

0 0 3

O c t

- 2 0 0

3

J a n - 2 0

0 4

A p r - 2

0 0 4

J u l - 2

0 0 4

Indonesia

Korea

Philippines

Thailand

Yen

Euro

Taiwan, China

Domestic trends and policy challenges

The preceding discussion suggests that most East

Asian economies have enjoyed an excellent economic

recovery over the past two years, supported both by thestrength of cyclical factors in the external environment, aswell as improving macroeconomic, financial and

corporate sector developments at home. This sectionlooks at some of the domestic trends more closely. In

addition, since the preceding discussion also suggests that

East Asian economies are slowing from their recent

cyclical peaks and external conditions are becoming more

uncertain, it also considers the policy efforts and reforms

that may be helpful to policy makers in the region as they

seek to negotiate the uncertainties and cautiously steer

economies from the sharp cyclical upswing of the last 2

years onto the path of sustained medium term expansion.

One useful focus may be to remedy domestic policyweaknesses that are themselves sources of uncertainty,

while strengthening policies and institutions that helpalleviate risk and uncertainty.



East Asia Update 28

Exhibit 28

Public Sector Debt(As % of GDP)

10

30

50

70

90

110

2001 2004 2001 2004 2001 2004 2001 2004

Thailand Malaysia Indonesia Philippines

Gross Debt

Net of Reserves

Source: National sources, IMF, World Bank. Note: Indonesia is

central government.

Fiscal Policy

The years after the 1997-98 regional financial

crisis saw substantial increases in the levels of gross

public sector debt among the five crisis affected countries,

-Indonesia, Korea, Malaysia, Philippines and Thailand.

Public debt rose as a result of governments shouldering

the cost of recapitalizing and restructuring insolvent

financial institutions, the calling of other contingentclaims on government, wider public sector deficits and

real depreciation of currencies (although, of course, the

specific contributions of these individual causes varied

widely across countries). The average of gross public

sector debt in these economies rose from about 30 percentof GDP in 1996 – which was rather less than the average

level of public debt among all emerging market

economies at that time - to about 60 percent in 2001,

about the same as the emerging market average.

As Exhibit 28 indicates, gross public debt levels

in Malaysia have been stable in recent years at a littleover 60 percent of GDP, while falling recently to around

45 percent in Thailand and a little over 50 percent inIndonesia.14 In recent years most East Asian economies

have also run current account surpluses and accumulated

large official foreign exchange reserves. Viewed net of

official reserves, public debt levels are estimated at a little

14 Public debt to GDP in Indonesia was previously

reported at around 70 percent. However, a recent revision

of the national income accounts has raised estimates of

GDP, reducing estimates of debt to GDP ratios.

less than 20 percent of GDP in Malaysia and Thailand,

and around 40 percent in Indonesia.

In Indonesia the lower trend in public debt toGDP ratios over recent years has been supported by

generally cautious fiscal policies; the central government

overall deficit has generally been held at less than 2

percent of GDP (Exhibit 29 below), with the primary

balance running a surplus. The overall deficit for 2004 isestimated at 1.3 percent of GDP, although both revenues

and expenditures have been boosted by higher oil prices.

Obviously, oil and gas revenues are up, but higher market

prices for fuel have also pushed the cost of fuel subsidies

sharply higher, from 1.7 percent of GDP in 2003 to anestimated 3 percent of GDP in 2004, a hefty chunk of total government expenditures which are 21-22 percent of GDP. Restructuring the fuel subsidy mechanism is one of

the most important policy challenges facing the new

government. Fuel subsidies encourage inefficiently high-

energy consumption in several East Asian economies

including Indonesia, while having a regressive effect on

income distribution. A reduction in the subsidy combinedwith targeted compensation for the poor would free up

significant resources for pro-poor development spending

and for fiscal consolidation, while encouraging greater energy conservation and efficiency.

In Malaysia fiscal policy was mildly

expansionary in 2000-03 as the government sought to

counter adverse shocks and uncertainties in the externalenvironment. In 2003 an Economic Stimulus Package

sought to counteract adverse shocks emanating from the

SARS epidemic and the Iraq War. Central government

deficits ran at 5-6 percent of GDP in 2000-03, although

public sector deficits were much lower, about 1 percent of

GDP or less. (Exhibit 29). With the private economyrecovering strongly, the government has aimed to achieve

substantial fiscal consolidation. The central deficit is

likely to fall to 4.5 percent in 2004, although this would be over 1 percent larger than the original budget for 2004,

due to rising fuel subsidies. The deficit is budgeted to be

further reduced to 3 _ percent in 2005, through higher sintaxes and curbs on current and capital spending, although

not in fuel subsidies. In Thailand the central government

and public sector balances moved into surplus in 2002/03

(October-September) with higher revenues responding to

faster growth and more efficient tax administration.

Responding to higher than expected surpluses, the

government introduced a supplementary spending program in 2003/04, together with a temporary subsidy ondiesel and gasoline. Public investment spending will

grow for the first time since the financial crisis, and is

expected to rise significantly in 2005 and beyond, when

the government is considering a five year program of large scale public infrastructure projects.





East Asia Update 30

improved markedly (Exhibit 31), in most countries, about

10-15 percent of total corporate debt is held by firms withinterest coverage ratios of less than 1. (The exception is

Korea, where the weaker firms are now the SMEs, which

generally have lower absolute levels of debt.)

Exhibit 31

Interest Expense to Sales(% - Non-Financial Listed Companies)

0

2

4

6

8

10

12

14

Indonesia Korea Malaysia Philippines Thailand USA

1996

1998

2003

Source: Worldscope: Sample of Listed

Non-financial companies. 2003 for

Indonesia..

Continued efforts to resolve the situation of

weak firms and deal with the remaining stock of distressed assets can make a significant contribution to

sustaining the present economic recovery and the rebound

in investment. From the perspective of firms,

uncertainties about the conditions for resolution of their

distressed debt cast a pall over prospects for new

investment and financing. From the perspective of banks,

a relatively high continued level of Non Performing

Loans (NPLs) is costly and reduces bank profits. It can

also contribute to risk aversion, reducing banks’willingness to lend even if they are adequately

provisioned, restricting the scope for real sector growth17.

Since the special debt workout frameworks that wereestablished in the aftermath of the crisis have mostly been

wound down, progress on corporate restructuring will

increasingly depend on the effective functioning of the

legal and judicial system18. Indeed, most countries in the

region are taking measures to strengthen the legal

17 Some analysis done on banks in Thailand for example,

suggests a negative relationship between banks’ NPLs

and credit growth, even after controlling for banks’

capital positions.18

In Thailand, the CDRAC voluntary debt workout framework

closed in mid-2003, in Malaysia, the CDRC was wound

down in 2003, and in Indonesia, the JITF closed in

December 2003.

framework for bankruptcy, though further progress is

needed, particularly with regard to implementation.

In Korea , for instance, the unified insolvency bill,

submitted to the National Assembly in late 2002 is still

awaiting approval. In Thailand , an amendment to the

Bankruptcy Act aiming to improve the individual

bankruptcy framework was endorsed by the Cabinet, but aspecific time for submission to Parliament has not been

designated. Moreover the amendment does not cover the

corporate bankruptcy framework, which retainssignificant weaknesses and loopholes. Actions to lessen

the case backlog in the Civil Courts (such as providing

more budgetary resources and special hours for trials) arestill awaiting approval from the National Judicial

Committee.

In Indonesia, observers agree that the new

Bankruptcy Law adopted after the financial crisis is a

sound one. Amendments to help correct problems in

implementation (seeking, among other things, to better

control spurious bankruptcy petitions) have beenapproved in parliament. The Commercial Court was

another important innovation, set up as a special chamber

of the existing district courts to help deal with thecomplex issues raised in the implementation of the bankruptcy law. Delays in issuing and implementingregulations designed to insulate the commercial court

from the major problems affecting the judiciary have

meant that it too has acquired some of the same problems

as the wider judiciary, including weaknesses in

administration, and transparency and accountability, and

inadequate funding. However, an updated version of the

Commercial Court Blueprint and action plan for reform

were published in early 2004, covering administration,transparency, funding and enforcement of court decisions,

and a number of these reforms have recently beeninitiated.

In China a new draft Bankruptcy Law covering

private enterprises had its first reading in the National

People’s Congress in June. Creditors or debtors would beempowered to petition for bankruptcy without having to

seek government approval. In contrast to existing

arrangements, the new draft law gives priority to secured

creditors over workers. While the draft law’s requirement

that any reorganization plan achieve majority approval by

each group of claimants (i.e. secured creditors, workers

and unsecured creditors) could leave reorganization planshostage to worker demands, the draft includes a provisionfor the court to approve (“cram down”) a disputed plan as

long as specified absolute priorities are met. While

representing a major step forward, the draft law warrants

further review. One clear implication is that the newBankruptcy Law will require large increases in the

number and quality of insolvency judges, administrators

and other insolvency professionals.



East Asia Update 31

Financial Sector

Banks have also benefited from the accelerationof economic activity over the past one and a half years.

The profitability of commercial banks—as measured by

the rates of return to assets and equity—has improved

sizably in Indonesia and Thailand, and marginally in the

Philippines and Korea, and remains comfortable in

Malaysia. (Exhibit 32) Average risk-weighted CapitalAdequacy Ratios (CAR) have also been above the 8

percent BIS norm in all five countries for several years

now, while NPL ratios have continued to decline,reflecting, to varying degrees, continued restructuring

efforts, improved capacity of borrowers to repay, and newloan growth (Exhibit 33 and Appendix Tables 9).

Two caveats should be noted however. First,despite progress, NPL ratios remain in double digits in

Thailand and the Philippines. The BOT has taken several

measures to expedite NPL resolution by Thai banks,

including tightening provisioning requirements on long-

standing NPLs and amending laws to allow thegovernment assessment management company (AMC) to

acquire NPLs from private banks and AMCs. However,

the amendments have not yet been reviewed byParliament. In the Philippines the SPV Law provides tax

breaks and other incentives to encourage financial

institutions to clear their books of bad assets, but progress

in disposing of these assets has been minimal. So far, onlya handful of SPVs have been registered. There remains a

large gap between the valuations placed on these assets by

banks and investors, making banks reluctant to sell the

assets. Strengthening the effectiveness of the SPV Act

with supporting legislation such as the Corporate

Recovery Bill and the Securitization Bill is also essential

to provide the necessary environment for distressed assetresolution.

Second, these aggregate numbers mask

considerable differences across groups of banks, and

some segments remain vulnerable. In Indonesia for

instance, the financial position of state banks remains

considerably weaker. In Thailand, private banks continue

to be riddled with high NPLs.

Rising household debt

One trend and potential vulnerability across

countries in the region has been rising household debt and

with it, increases in the share of NPLs from householdlending.

Household debt has grown the fastest in Korea,

especially between 2000 and 2002. Since 2002, the

number of people in default on their debt has risen sharplyto reach 3.7 million. Delinquencies on credit cards are the

main factor, following a more than 5 fold expansion in

credit card debts during 2000-2002. While delinquencies

on bank loans remain below 2 percent, delinquencies on

credit card debt amounted to 14 percent. Efforts by

indebted households to repair their balance sheets have

led them to reduce consumption, which has fallen in every

one of the five quarters from the second quarter of 2003through the second quarter of 2004, sharply slowing GDP

growth.

Exhibit 32

Commercial Banks - Return on Asset

(%)

-0.5

0

0.5

1

1.5

2

2.5

3

Korea Indonesia Malaysia Philippines Thailand

2000

2002

2003

2004

Exhibit 33

Commercial Banks - Capital Adequac

Ratios (%)

0

5

10

15

20

25

Korea Indonesia Malaysia Philippines Thailand

2000

2002

2003

2004

Government policies aimed at stimulatingdomestic demand by providing tax deductions and

lotteries were a factor contributing to the growth in credit

card use. And weakness in supervision allowed credit

card companies to issue cards without requiring basic

information needed to assess credit risk, such as the

borrower’s income. Household credit extended by

commercial banks amounted to 35.8 percent of GDP at



East Asia Update 32

the end of 2003, under 60 percent of the total credit

extended to households. The financial institutions and thegovernment have established a number of channels for

resolving household debts, including establishing

Hanmaeum Finance (the bad bank) to restructure

individual debts, the Credit Counseling and Recovery

service (CCRS) to run an individual workout program for

personal delinquents, private workouts, a personal debtor recovery system, where the court system will implement a

new rehabilitation procedure, and personal bankruptcies.

Nine percent of the total number of delinquent borrowershave been resolved so far.

Household debt has also grown in Malaysia andThailand, without, so far running into serious difficulties.Starting from a relatively low base, Malaysian bank loansto households in the form of mortgages and consumer

loans almost doubled between 1998 and 2003, while

credit card use rose sharply. With the recent emergence

of alternative corporate financing instruments, and the

corresponding reduction in the corporate sector’s reliance

on bank financing, banking institutions have increasinglyfocused their lending on the household sector, especially

through the expansion of their credit card business.

Whereas the total stock of banking system NPLs hasdeclined in recent years, to RM 58.3 billion at end-2003,reflecting the successful asset recovery efforts of Danaharta and corporate restructuring, NPLs to

households have risen throughout the period, to RM 19.3

billion. In particular, while NPLs on consumer loans have

declined from their peak of RM 11.2 billion in 2001 to

RM 8.4 billion in 2003, mortgage-related NPLs have risen

by 46 percent since 2001, to RM 10.1 billion. Credit card-

related NPLs have also risen sharply, but their share in

total household NPLs still remains small (3 percent).In Thailand the share of household loans to total

credit rose to 34 percent in 2003 or by 10 percent over the

past three years, due both to strong growth in householdlending and low credit growth to corporates. This shift

towards household lending has taken place across all

institutions’ growth, although it has been particularlystrong for finance companies. Housing loans continue to

be the major component of household credit and

mortgages have the highest NPL ratio—with inflows into

the pool of NPLs in the personal consumption sector

amounting to B 34 billion in 2003, despite strong

economic growth. Credit card NPLs however, have

remained around 3 percent of credit card loans—muchlower than Korea (14 percent). The Bank of Thailand hasimplemented a series of measures to curb excessive

borrowing by individuals. Banks are now required to

disclose on a consolidated basis all penalty fees charged

on missed payments on personal loans. Credit cardregulation was tightened again in April 2004 to require

that the credit be limited to five times the card holder’s

income, increasing the minimum monthly debt servicing

on a credit card balance from 5 percent to 10 percent, and

requiring that credit cards which are in arrears for more

than three months be revoked.

Strengthening financial supervision and regulation

Countries are also making progress in

strengthening the financial system in terms of regulationand supervision. In Indonesia, the central bank and the

ministry of finance have signed a memorandum of understanding on how to handle banks in financial

difficulties, covering decision-making and coordination

between the two bodies, the provision of a financing

facility; and the source of financing through the issue of

government securities. The Parliament passed a

milestone law on deposit insurance in August 2003. The

new deposit insurance program replaced the existing blanket guarantee on all banks’ liabilities, and provided

for creating the Indonesian deposit guarantee corporation

(LPS), to insure deposits up to Rp 100 million. The MOUand the establishment of the LPS mean that the main

elements of a financial safety net are now in place.

Finally Bank Indonesia (BI) also announced a new

regulation to improve the assessment of commercial bank

health. BI will require each bank to conduct a self-

assessment every quarter and submit it to BI for review.

Should the bank score unsatisfactorily, BI will require

bank management to provide action plans for correctiveaction.

In the Philippines, legislative amendments to the

charter of PDIC – the deposit insurance agency - were

recently approved, which among other things, restored the

power of the PDIC to examine the books of member banks and also improved the legal protection for PDIC

staff to some degree. It is also important that the BSP

charter amendments recently filed with Congress should be enacted and put into effect promptly. The amendments

enhance the central bank BSP’s capacity to deal with

problem banks and facilitate a fast transition to

consolidated risk based supervision and internationalsupervision standards. The amendments are also expected

to provide better protection against lawsuits for bank

regulators. A MOU was also signed by the BSP, PDIC,

SEC and Insurance Commission (IC), creating a Financial

Sector Forum (FSF), which is expected to provide aninstitutionalized regulatory framework for core

supervision and regulation of the financial system.

Another positive development is the progress made

towards establishing a centralized credit bureau, which

the BSP is currently studying in consultation with

stakeholders. The new bureau would maintaininformation on both positive and negative aspects of

individual and corporate borrowers’ credit history, unlike

the existing data sharing facilities which records only

negative information.

In Thailand, the BOT has adopted a number

of measures in line with the New Basel Capital Accord,

the full implementation of which is planned for late 2008.

The supervision and examination process has shifted from



East Asia Update 33

transaction testing to reviewing a bank’s risk management

system and process. A policy statement on goodgovernance was issued in 2002, which requires greater

disclosure from banks, particularly with regard to their

risk profile.



East Asia Update 34

COUNTRY SECTIONS

Major Economies19

ChinaPolicy measures to cool down the economy

appear to have had some success, but it is too early to callthe end of the investment boom that has become known as

“overheating”. GDP growth eased to 9.7 percent year-on-

year (y-o-y) in the first half of 2004, slightly down from

the 9.9 percent recorded in the last quarter of 2004.Growth has still been mainly driven by investment,

although retail sales have also remained buoyant. Looking

ahead, we expect GDP growth to ease further, to 9.2

percent for 2004 as a whole, and 7.8 percent in 2005.

Debates continue on the extent and form of

“overheating”, the success of the measures to slow down

investment, as well as on the appropriateness of relying

on administrative measures instead of more market-

oriented tools. After peaking in the first quarter,

investment growth slowed down following administrativemeasures that seemed targeted at limiting investments in

specific sectors where the authorities saw excess capacityto be building up. Fiscal policy has also contributed to

limiting demand pressures, but monetary policy has

shown an ambiguous stance. Growth in monetary

aggregates and credit has slowed down considerably, in

part induced by “window guidance” of the central bank

and further tightening of reserve requirements. This

despite continued capital inflows, which the authorities

largely sterilized. On the other hand, real interest rateshave until recently continued to decline as a result of

increases in inflation. Indeed, low interest rates and thestrong incentives for local governments to boost growth intheir region, combined with their reliance on revenuesfrom real estate developments, continue to fuel

investment. Moreover, low or negative real deposits rates

have started to show their effects on households, who are

increasingly seeking alternative investments for deposits

in banks.

The new investment policy announced in July

aims to increase the role of the market in investment

decisions, but the key tool for this—the interest rate—is

yet to play its proper role. Banks are not yet using the

recently granted (moderate degree of) flexibility in setting

interest rates. In addition, the authorities have beenreluctant to increase interest rates significantly because of

concerns about the impact on financial fragility in the

corporate sector, banks’ balance sheets, and capital

19 More detailed individual Country Briefs for the major

economies can be found at the World Bank website:

http://www.worldbank.org/eapupdate/

inflows. At the same time, underlying inflation pressures

remain manageable, which provides support for the

authorities usage of measures that seemed targeted at

preventing future over-supply in certain sectors rather than at further significantly tightening overall

macroeconomic policies. Against this background, the

modest increase in interest rates effective October 29(around 25 basis points) serves mainly as a signal that the

authorities would be ready to use the interest rate

instrument more forcefully if required on the basis of developments on inflation or deposits.

Nonetheless, looking ahead, with underlying

inflationary pressures projected to remain limited, drastic

macroeconomic measures to cool down the economy are

unlikely to be imminent, and if the economy lands at all,

it is likely to be a soft landing this time around. The rapid

deceleration in credit in recent months, if continued, couldalready cause a larger than expected slowdown, although

it is too early to tell whether the credit growth decline is

largely due to lower demand because of the impact of theadministrative measures, or whether banks have becomemore reluctant to lend. Nonetheless, fears of a hardlanding remain limited in light of continued strong

demand indicators in recent months.

Growth in agricultural production has picked up

and rural incomes increased significantly—due to grain

price increases and, to some extent, the government’s

“pro-rural” policies. Plans announced to expand the social

security system more fully to rural areas may help to

reduce the remaining large gap between rural and urbanliving standards, although the feasibility of the plans at

this stage of China’s development remains to be seen.

External developments remained favorable.Production capacity has expanded significantly due to the

recent investment boom, and this allowed exports (in

US$) to grow by 35 percent (y-o-y) in the first 9 months

of 2004. Driven by the buoyant domestic demand, imports

grew 38 percent in this period. With a small currentaccount surplus and a significant surplus on the capital

account, China continued to increase its foreign exchange

reserves—by US$ 80 billion to US$ 483 billion in end-

July 2004.

Indonesia

The successful and peaceful election and

political transition represent an important step in the

consolidation of Indonesia’s democracy. In the run-off

election September 20th, Susilo Bambang Yudhoyono

(SBY), former coordinating minister for security and

political affairs, was elected as the next president, with his

term extending to 2009. The next few months are crucial

to Indonesia’s medium-term economic picture. A new



East Asia Update 35

economic policy package and early implementation steps

by the new government would draw attention frominvestors and markets. Currently there are signs of

investment recovery and the external economic

environment is supportive. Together with high capacity

utilization – serving as a proxy for investment demand - a

credible economic policy package and its implementation

are likely to be rewarded by an acceleration in investment.The World Bank’s forecast for GDP growth is now 4.9

percent in 2004 and 5.4 percent in 200520.

During the first half of 2004, the economy grew

by 4.7 percent (yoy). The good news is that investment

grew by 8.3 percent, much higher than 0.4 percent in thesecond half of 2003. Other indicators also signal arecovery in investment. Capital goods imports for the period January-September increased by 35.3 percent

(yoy) and the number of investment approvals is also on

the rise in 2004. However, these numbers start from a

low base in 2003 and sustained increase in investment

will require continued improvement in the investment

climate. Employment also rebounded. Recent quarterlydata indicate that the open unemployment rate declined

from 8.5 percent in August 2003 to 7.4 percent in May

2005, although a high 65 percent of the employed are inthe informal sector 21. Market sentiment is strong. The bombing at the Australian embassy in September had verylittle impact on markets. The stock and foreign exchange

markets recovered to the pre-bombing level on the

following day but renewed concerns about security.

Fiscal and external risk indicators continued to improve.

The government debt to GDP ratio declined from 81

percent at end-2000 to 53 percent in June 2004. The

external debt ratio also declined from 86 percent at end-

2000 to 53 percent by June 2004. These positive politicaland economic developments were reflected in rating

upgrades and Fitch recently upgraded their rating outlook from ‘stable’ to ‘positive’.

Despite these signs of investment recovery,

Indonesia’s investment climate remains weak, especially

as compared to regional competitors. The World Bank’sDoing Business Survey 2005 shows, for example, that it

takes 151 days in Indonesia to start a business, much

higher than regional competitors such as Thailand (33

days) and Malaysia (30 days).

On the fiscal front, the revised 2004 budget

(using 1993 base GDP) estimates that fuel subsidies will

20 Growth forecast is revised up from 4.5 percent to 4.9

percent for 2004 and 5 percent to 5.4 percent for 2005. In

addition to favorable recent political and economic

developments, change in the GDP base year affects therevision.21 Quarterly labor statistics are drawn from a much

smaller sample size than the annual labor force survey

and this trend will need to be confirmed from the annual

numbers from the August sample.

increase from a budgeted Rp.15 trillion (0.7 percent of

GDP) to Rp.59 trillion (3 percent of GDP) at $36/bbl. Atthis level of expenditure the fuel subsidy is close to total

development expenditures (Rp.72 trillion or 3.2 percent of

GDP). While increased revenues will hold the overall

deficit almost unchanged (up from 1.2 to 1.3 percent of

GDP) from an efficiency point of view, reducing the fuel

subsidy is among the most important challenges for thenew government.

The White Paper package of policy measures

announced in September 2003 combined with an adequate

implementation record and monitoring mechanism

contributed to bridging the “policy credibility gap” at theend of the IMF program. As of September 2004, thegovernment successfully completed most of itscommitments under the White Paper though performance

varies by area. In particular progress on ‘increasing

investment, exports and employment’ lagged behind

macroeconomic stability and financial sector

restructuring. The investment, export and employment

section included structural issues in legal reform andemployment that have proved difficult. However there

are a number of policy successes including: the enactment

of the State Audit Law and the amendment of theBankruptcy Law, Law No.22/1999 on decentralizationand No.25/1999 on fiscal decentralization. The newgovernment will need a new economic policy package

that should focus on consolidating the achievements to

date, and especially on improving the investment climate.

Korea

Buoyed by strong export demand, Korea's

economy grew 5.3 percent year-on-year in the firstquarter and 5.5 percent in the second quarter of 2004.The economy is clearly on a rebound from last year's

underperformance and is expected to grow 4.9 percent

this year and 4.4 percent next year. Exports has been

exceptionally strong, rising 23-27 percent in real terms in

each of the past three quarters. High-tech and IT-related

products, which now account for a third of the country’s

export receipts, have generated much of the trade surpluswith cell phones and flat-panel displays gaining in

importance ahead of semiconductors. Equally strong

were shipments of steel, metals and chemicals,

particularly to China, which last year outpaced the U.S. as

Korea's main export market.

Domestic demand however has been relatively

weak and policy-makers continue to ease macroeconomic

policies with the aim of generating broader-based growth.

In August, the central bank cut interest rates by 25 basis

points to a historic low of 3.5 percent in an attempt to

encourage domestic spending. The authorities also front-

loaded fiscal expenditures into the first half of the year,

enacting a supplemental budget amounting to about 0.5 percent of GDP. For next year, the authorities are

reportedly targeting a deficit of 1.25 percent of GDP,



East Asia Update 36

consisting of a package of tax cuts, including a one

percentage point reduction in all income tax rates andextra spending specially directed at social programs.

A recovery in domestic demand however will

clearly depend on whether household spending picks up.

Household spending has been depressed over the past one

and a half years, following a rapid expansion of credit

card lending during 2000-2002, which in turn resulted in a

substantial increase in household debt and household loan

delinquencies. To address the household debt problems,

the authorities and financial institutions have established a

number of channels that offer varying terms depending on

the size of debts and whether the debts are to single or

multiple creditors. The Ministry of Finance and Economy

has also announced plans to step up the financial

supervision of credit card issuers and to implement an

early warning system in the credit card loan sector.

Korea’s large corporations, which have so far

used their profits to further de-leverage their balance

sheets and to invest in abroad, particularly in China, nowappear to also be increasing their domestic investments.

Investment in machinery and equipment, which declined

for four consecutive quarters, picked up in the second

quarter. Overall, Korea’s non-financial corporate sector

remains in good health on average, having lowered

leverage ratios to international norms and strengthened

profit margins. The exception to the general pattern of

corporate health is in the SME sector. SME finances have

weakened after a period of strong credit growth, although

so far, there has been little increase in the SME

delinquency ratio.

Korea’s banking sector remains healthy. Indeed,with the recent economic rebound banks’ net income rose

four-fold in the first half of this year. Potential bank

losses on SME loans remain limited, both because half of

the loans are collateralized and government guarantees

cover one fifth of SME credits, and because most SMEs

deal with only one or two creditors which facilitates any

debt restructuring. Following capital infusions, the

average CAR of credit card companies has also improved,

from negative last year to 7 percent this year.

Based on our expectations of the externalenvironment—including higher oil prices, a cooling of the

global IT sector, and a slowdown in China’s growth--weare projecting a lower growth rate of 4.4 percent for

Korea next year. While lower than consensus forecast at

the beginning of this year, the projected growth rate is

still higher than those of most OECD countries. Over the

longer-run, initiatives to place the SME sector into a more

competitive footing will help sustain stronger growth, as

will continuing efforts to improve corporate governance particularly in Korea’s large corporations. Equallyimportant will be the initiatives announced recently toenhance productivity of the Korean economy by opening

up segments of the services sector to increased

international competition.

Malaysia

The Malaysian economy continued to strengthenthrough the first half of 2004, and real GDP is on course

to grow by 7 percent in 2004, and 6 percent in 2005. Real

GDP increased by 8 percent in Q2 2004, driven bysustained expansions in manufacturing output and

services, mirrored by a prolonged cyclical upswing in

both domestic private and external demand, and continued

prudent domestic financial management.

Domestic demand was driven by robust private

consumption and a sharp pick-up in private investment,

which the authorities estimate at 14_ percent. Public

consumption grew by 7.1 percent, while public

investment declined by 28 percent in line with the 2_

percentage points of GDP contraction budgeted for 2004.22

Foreign direct investment inflows were sustainedand channeled mainly to oil and gas, manufacturing, and

services sectors. External demand was boosted by the

synchronized economic recoveries in the U.S.A., Japan,

and Europe, stellar growth in China, expanding intra-regional trade, and robust international commodity prices.

The overall global outlook for 2004 remains favorable,

but the combined effects of some moderation in China’s

growth, higher oil prices on the global economy, and the

anticipated decline in the demand for electric and

electronic (E&E) products towards the end of the year

will act to moderate growth in the second half of 2004

and in 2005.

Strong export performance marks 2004. Exportsof chemical, metal, and rubber products performed wellfollowing higher volume sales in the region, while salesof agricultural commodities expanded strongly fromhigher earnings of palm oil and natural rubber. Crude

petroleum exports benefited from the rise in world prices,

while sales of liquefied natural gas increased sharply from

higher regional demand. Imports rose by 32 percent

through end-June, reflecting higher purchases of

intermediate and capital goods, and remained strong

through August, boosted by higher imports of consumer

goods stemming from stronger private consumption.

Tourist arrivals surged by 38.4 percent in Q1, but

declined slightly in Q2.The overall balance of payments remained in

surplus and net international reserves rose further, to

$56.9 billion by end-September, equivalent to 7_ months

of retained imports and 5 times short-term external debt.Total external debt rose slightly to $51 billion in Q2,

equivalent to 49 percent of GNP.

22 Gross development expenditure of the Federal Government.



East Asia Update 37

Consumer price inflation rose by 1.4 percent in

August, reflecting higher prices for beverages andtobacco, rent, fuel, and power, but the overall increase

was restrained by the limited increases in Government-

controlled prices. Core inflation remained subdued.

To bolster domestic private sector-led growth,

the Government is combining gradual fiscal consolidation

with a prudent but accommodative monetary policy. Theoverall budget deficit for 2004 is projected to decline to

4_ percent of GDP, from 5_ percent of GDP the year

before, and the 2005 Budget envisages a further decline to

3_ percent of GDP. The monetary stance of Bank Negara

Malaysia (BNM) remains accommodative but consistentwith the exchange rate peg to the U.S. dollar. In a further move to liberalize lending rates, in April the BNMintroduced a new overnight policy interest rate (OPR) to

replace the three-month intervention rate. With ample

liquidity, financial institutions have been able to lower

their lending rates, and this has helped fuel consumer

spending and business investment.

The financial sector continues to be

strengthened. Around 31 of the 119 policy

recommendations of the Financial Sector Master Plan

have been fully implemented, while another 24 are being

implemented on a continuous basis. Recent measuresinclude strengthening guidelines for corporate

governance, improving the prudential framework by

adopting new standards on asset-backed securities andincorporation of market risk, allowing intra-group

mergers of commercial banks and finance companies, and

improving consumer awareness and protection. The 2005

Budget also includes measures to open stock brokering

activities to foreigners, and allow the entry of global fund

managers and full foreign ownership of venture capitalcompanies.

The performance of commercial banks continued

to improve through mid-2004. Risk-weighted capital of banks increased to a healthy 13.8 percent of assets, while

net non-performing loans of commercial banks declined

to 7.7 percent of total loans. Returns on equity and assets

rose steadily to 18.7 percent and 1.6 percent, respectively,

while earnings per share have increased for most banks.The provision of Islamic banking services also continued

to expand.

In the corporate sector, recent reforms under the

Capital Markets Master Plan include the requirement thatdirectors report on internal controls, mandatory disclosure

of compliance with the Malaysian Code on CorporateGovernance, and the adoption of international accounting

standards and best practices on internal audit functions.

Also, the Securities Commission now has more

supervisory and enforcement capabilities, including

greater power to impose civil penalties.

Meanwhile, leverage, cash flow, and profitability

indicators of the corporate sector have improved overall.

Debt-equity ratios have declined, as companies have

either restructured their debts or settled them in an

environment of declining interest rates. Interest coverageratios, and returns on equity and assets, have improved,

although not to their pre-crisis levels. However,

performance of the Malaysian stock exchange was

disappointing. Though the exchange continued to deepen

during 2004, with the number of listed companies rising

to 946 by early October, the gains of composite index in2003 and early 2004 were among the lowest in the

region’s top ten markets. Encouraged by the low interest

rate environment, higher funding from private debtsecurities more than offset the decline in equity finance.

With regard to Government-linked companies(GLC), thirty of the total 40 GLC are slated for restructuring. Also, the Government has launched KeyPerformance Indicators (KPI) and Performance-Linked

Compensation (PLC) programs, whereby management is

now fully accountable for performance and remunerated

accordingly. All GLC will be required to fully adopt KPI

and PLC programs by 2005, and the KPI concept is being

extended to public agencies. Further governance-relatedimprovements are to be implemented at the corporate

level of public agencies, including reducing the size of the

individual boards, removing regulators from the boardsand replacing them with independent directors, andintroducing new CEOs and professional management.

To guard against external vulnerabilities, the

Government is promoting domestic private sector-ledgrowth, while encouraging FDI in selected strategic

sectors. In addition to financial and corporate sector

reforms, and fiscal consolidation, the Government aims to

further bolster private sector development through fiscal

incentives, improved governance, sequenced

liberalization, and strengthening tertiary education toimprove educational outcomes and the technological

capacity of firms.

The Government’s reform agenda is expected to includemeasures to further improve the investment climate for

domestic and foreign investors in both manufacturing and

services sectors. This will include reductions in the

regulatory burden facing firms, the strengthening of

professional and managerial skills of its workers, promoting innovations in firms and opening up the

services sector to greater foreign investment. Greater

emphasis on total factor productivity growth is sought in

the rationalization and simplification of fiscal incentives.

Philippines

Economic growth strengthened in the first half of

2004, but the pace of growth is likely to slow given the

increase in oil prices, rising domestic interest rates and the

prospect of higher international interest rates, large public

sector deficits and external financing requirements amidst

uncertain prospects for fiscal adjustment. Risks to theexternal environment add to the urgency of fiscal

adjustment.



East Asia Update 38

Real GDP growth increased to 6.3 percent in the

first half of 2004 from 5.3 percent in calendar 2003,driven primarily by private consumption growth of 5.9

percent. Investment grew by 9.4 percent during the first

half, though its relatively low share in GDP (less than 20

percent) limited its contribution to overall GDP growth.

Inflation through September 2004 (y/y) jumped to 6.9

percent after averaging 3 percent in 2003 primarilyreflecting rising petroleum product prices.

Unemployment, while still high at 11.7 percent as of July

2004, fell by about a percentage point from July 2003 as1.2 million net new jobs were generated over the period.

Most of the new jobs created were in the farm and

services sectors, whereas manufacturing jobs barely grew.

Weaknesses in public finances remain of seriousconcern as public debt has grown rapidly in recent

years—nonfinancial public sector debt exceeds 100

percent of GDP and contingent liabilities are also

significant. The fiscal program for 2004 targeted the

consolidated public sector deficit (CPSD) to increase

from 5.5 percent of GDP in 2003 to 6.7 percent in 2004reflecting a rising deficit within state-owned enterprises

(GOCCs), and notwithstanding the targeted decline in the

national government deficit to 4.2 percent of GDP from4.6 percent in 2003. The increased GOCC deficit in turnwas expected to be driven by a sharply higher deficitwithin the National Power Corporation (NPC).

Developments to date indicate that CPSD/GDP ratio may

in fact remain relatively stable in 2004 with the national

government deficit reduction on target thus far and the

GOCC deficit below target as of early 2004.

Nevertheless, it remains vital to move expeditiously to

reduce the public sector deficit given the aforementioned

risks to the external environment and the prospect of further downgrades by international ratings agencies

absent a more vigorous effort to reduce the public sector deficit.

The Government of President Gloria Macapagal-

Arroyo—who was reelected as President in May for a six

year term beginning in July—has proposed a series of legislative measures to increase tax revenue, but the

extent to which these measures will be enacted, and at

what pace, remains uncertain. The Energy Regulatory

Commission (ERC) recently authorized power tariffs to

be raised by nearly one peso per kwh, which will reduce

but not eliminate the operational losses of the NPC,

whose debt and debt servicing burden remains excessive.

Philippine sovereign bond spreads haveremained relatively stable in 2004 (about 470 basis points

over ten year US Treasury bonds in mid-October); the $1

billion global bond issued by the Government on

September 9 was priced at nearly 500 basis points above

equivalent US Treasuries. Yield curves for domestic

government paper have also risen during theyear—though rate increases have lagged the rise in

inflation—and one-year T-bill rates as of mid-October

stood at nearly 10 percent. The peso depreciated in real

effective terms, falling to a low of P56.5/USD in mid-

October before recovering somewhat. Despite ongoingconcerns regarding the fiscal outlook, equity prices

increased by an average of about 23 percent since the

beginning of the year, underpinned by robust earnings

growth in the corporate sector through the first half of

2004. Growth in bank lending to the corporate sector

remains weak, however—loans grew by less than 1 percent in the first half of the year.

On the external front, the trade deficit narrowed

to $700 million and the current account surplus more than

doubled to $1.9 billion in the first half of 2004 as export

growth of nearly 10 percent outpaced import growth.Philippine export growth however lagged the performanceof other major economies in the region. Notwithstandingthe current account surplus and substantial foreign

borrowing through bond issues (primarily to service

maturing debt), gross international reserves fell by nearly

$900 million in 2004 through September to $15.9 billion

in part reflecting negative net portfolio and FDI flows in

the first half.

Preliminary data from the 2003 Family Income

and Expenditure Survey (FIES) indicate that total real

family incomes decreased by 4.4 percent between 2000

and 2003 while total real expenditure declined by 1.7 percent. Average incomes and expenditure declined by

even more. These declines occurred across the span of

income categories, indicting that that poverty may haverisen during this period. There are, however,

inconsistencies between the income and expenditure

figures from the FIES and the national account data which

indicate real GDP growth of about 11 percent during the

same period.

Thailand

The Thai economy continues to perform robustly

though estimated growth of 6.4 percent this year, is lower

than last year. Higher oil prices have reduced growth but

not as much as the actual rise in world prices would

suggest; the domestic retail price of diesel has not beenraised this year. Growth of private consumption is downrelative to last year due in part to higher retail prices of gasoline for cars, and in part to slower growth in rural

incomes. Growth of private investment has slowed too

relative to last year, especially foreign direct investment,

probably due to volatile oil prices and pre-electionuncertainties. Public investment, however, has risen

significantly this year, in sharp contrast to the previous

five years of continuous retrenchment in public capital

formation. Receipts from tourism are up strongly after

the slump last year due to Severe Acute RespiratorySyndrome (SARS). Export earnings are growingstrongly, though growth in export volumes is down

compared to 2003, and the terms of trade will improve byroughly 3.5 percent notwithstanding higher world oil

prices.



East Asia Update 39

GDP growth in 2005 is projected to be around

5.8 percent, slower than this year. This is in part due todeferred adjustment of retail prices of diesel and lower

world demand for exports. The Government has

announced its intention to float the retail price of diesel

early next year, which would raise diesel price by more

than a third of its current price; this will affect private

consumption and private investment. Also, worlddemand for exports will be lower than 2004 -- including

overall growth in import demand from China. Imports on

the other hand, are projected to continue growing morerapidly given Government’s plans for public investment

generally and infrastructure investment particularly.

The macroeconomic situation remains robust,though higher oil prices and rising interest rates are likelyto take their toll. Headline inflation will rise to 3 percent

in 2004, compared to 1.8 percent last year, largely due to

the increases in oil and electricity prices. Projections for

2005 indicate that inflation will rise further to around 4

percent as retail prices of diesel are adjusted fully to

reflect world prices. Real interest rates are at their lowestlevel. Total investment is strong as public investment is

increasing rapidly after five-years of retrenchment;

private consumption growth, while slower than last year,continues to be an important driver of growth.

External vulnerability to shocks has fallen

further. Total external debt has fallen to US$ 50 billion

by July this year (around 31 percent of GDP) – fallingfrom $52 billion in end-2003 - as the Government

continue to prepay loans, including some to the

international financial institutions. The current account

surplus, though falling will be around 4 percent of GDP in

2004, as trade surpluses narrow further with further pick-

up in import demand. External reserves now exceedUS$40 billion, around 4 times the level of short-term

external debt. Next year, the current account surplus is

expected to decline further given the projected increasesin both public and private investment and the resulting

rise in imports.

Exports earnings grew by 23 percent in the first

8 months of this year. This growth was made possible by

a 16 percent increase in world prices of exports, sinceexport volumes grew by only 6 percent, nearly half the

rate in 2003. Three export categories – electrical

machinery and parts, non-electrical machinery and parts,

vehicles and parts – comprised 44 percent of export

earnings this year. In terms of contribution to export

growth, the developed country markets (US, Europe &Japan) provided most to the growth in export-earnings,

followed by ASEAN; together they accounted for two-

thirds of this growth, with China contributing a tenth,

significantly lower than last year. Exports to ASEAN

grew by 31 percent, twice the rate of last year, while

exports to China grew by 24 percent, a third of last-year’srate.

However, export volumes grew slowly at only 6

percent, half the rate in 2003. Clearly negative growth involumes of agricultural and fishery exports contributed,

but most of it is accounted for by a slowdown in volume-

growth of manufactured exports. Within manufactures,

volume growth of resource-based products (including

processed foods) and high technology products (like

machinery and parts) have fallen relative to last year.With rising capacity-utilization, supply-side constraints

are becoming major influences on Thailand’s export

performance. Future private investment in manufacturingwill be a key determinant of Thailand’s ability to sustain

high export growth.

This performance should be viewed against theremarkable Thai export performance since 1999. Exportshave grown rapidly in every year except 2001, thereby

raising the export share in Thailand’s GDP significantly

(relative to pre-crisis years) and Thailand’s export share

in world market. This success has been accompanied by a

significant shift in the composition of exports towards

higher value-added items like electrical/non-electricalmachinery and parts as well as vehicle and parts. This has

been driven in part by higher foreign direct investment

inflows in the post-crisis period, encouraged no doubt bythe liberalization of foreign entry soon after the crisis, and by the further rationalization of the import regime.

Private investment grew by 16 percent in last 8

months, a slower rate than last year. Most of this is probably accounted for by little or no growth in foreign

direct investment flows. This maybe due to the

uncertainties arising from higher world oil prices, the

nature of adjustment in Thai retail prices of petroleum

products and of course, the impending elections.

However, two positive aspects of this year’s growth in private investment are worth noting. First, there is a

significant increase in Board of Investment (BOI)

approvals of private investment applications, includingFDI, suggesting that lack of FDI growth is likely to be a

‘blip” rather than a trend. Second, despite the above

uncertainties, private domestic investment growth remains particularly robust, a good sign for the future.

Nevertheless, some private investmentcharacteristics suggest fragility. First, while recovery

continues, private investment as a share of GDP is still

only 17 percent, significantly lower than the annual

average of the 1980s. Second, residential construction

investment continue is still contributing around a quarter

of the annual increase in private investment; additions tomanufacturing capacity supported in part by the low real

interest rates. Third, given that capacity in manufacturing

appears to be constraining export-volume growth, even a

temporary slowdown in private investment growth is

likely to slow export volumes next year.

Banks increased corporate lending is likely to

sustain increasing private investment. There is a rise in

banks lending to businesses this year relative to last year,



East Asia Update 40

growing at an annualized rate of 14 percent over last year.

These loans appear to be going mainly to tradable sectors,and relatively large firms.

Public investment will grow this year for the first

time since the crisis. After retrenchment for the past 5

years, public investment grew by more than 7 percent this

year. This growth has come mainly in the form of

investments by local governments, and to a smaller extent by the center. With the Cabinet approval of large

infrastructure projects, growth in public investment next

year is likely to be much higher than 2004. This

continuing rise in public investment will thus become an

important driver of growth in future.

The Government is considering a large five-year program of public infrastructure investments . The

financing mechanisms are still not clear. The final size of

the program will depend on how the financing constraintis addressed. Nevertheless, a large investment program

will have several macroeconomic implications, one of

which relate to the evolution of current account balance; it

is very likely that Thailand will generate a current account

deficit sooner than would happen on current trends.

But will these investments “crowd-in” private

investment and promote sustained growth. This will

depend on whether public infrastructure investments willenhance competitiveness of the Thai economy, thereby

raising rates of return on private investment. This can

happen if the Government addresses three issues. First,

public infrastructure investment program should be

embedded in an overarching strategy for delivering better quality and more cost-effective infrastructure services

aimed at improving competitiveness. Second, these

investments will have to be accompanied by policychanges that will promote inter-modal and logistics

efficiency and ensure better mix of public-private

investments in infrastructure and logistics. This means

that current restrictions on private entry and operation willhave to be relaxed. Third, public organizational

arrangements – in Bangkok and in the provinces – will

have to be developed in a way that increases operational

efficiency of public infrastructure investments.

Addressing the existing restrictions on the

services sector will be important in this context. In

particular this relates to the regulatory framework for telecommunication, ports, air-travel, financial services,

logistics services and so on. Modifications in theseregulatory frameworks that help to increase competition

and improve efficiency, but also promote growth in thesesectors and enhance competitiveness of Thailand.

The 2004 Global Competitiveness Report shows

that other countries are moving ahead in competitiveness.

Thailand’s rank in overall “Growth Competitiveness” has

slipped from 32 in 2003 to 34 in 2004. This is

notwithstanding the significant improvement in ranking

on macroeconomic environment. The largest declines in

ranking are in respect of public institutions (by 7 places)

and in technology (by 4 places), largely because other

countries have moved ahead.

Household consumption growth slowed relativeto last year, but continues to be an important growth

driver. Household consumption in the first half of this

year grew by 5.8 percent, a slow down from 6.2 percent in

the same period last year, and will likely slow down in the

second half when oil prices has rises sharply andconsumer confidence declines. Continued growths in

consumer credits and farm incomes this year and

supportive government measures, will support

consumption growth, helping to cushion some of the

adverse impacts of the oil price rise. Consumption of services accounts for more than half of consumptiongrowth, at least for the first half of the year, compared toonly a quarter last year. This is primarily because the

rebound of tourism-related services such as hotels and

restaurants and transportation services from their slump

last year.

While banks’ exposure to households have risen

further, household debts look manageable. Thailand’s

household debt to disposable income has been rising since

2002 and is close to 60 percent this year. This has been

accompanied by rising household debt for all income

groups; the lowest income group and the highest have thehighest debt as a share of household income, making them

vulnerable to a rise in interest rates.

Positive developments are seen in the financial

and corporate sector, though more remains to be done. In

the financial sector, bank supervision was strengthened bythe Bank of Thailand (BOT) and prudential regulation on

loan classification and enforcement has been tightened.

Aggressive loan expansion by a large state commercial bank has slowed down following the BOT’s intervention.

In the corporate sector, the Parliament has passed partial

amendments to the Bankruptcy Act, which are aimed at

ameliorating the legal framework for individual bankruptcies. Nevertheless, NPLs are still in double-digits

and measures to expedite NPL resolution has been

delayed and still awaits the enactment of amendment to

AMC law.

Implementation of reforms in 2004 continue, but at a

relatively slow pace. There has been further

rationalization of import tariffs and signing of FTAs thatare increasing competition for producers and opening up

better export opportunities. Similarly, changes in publicsector governance in respect of public financial

management and public administration streamliningcontinue. There have been fewer changes in respect of

private investment regulations while the changes in legal

framework formulated for the financial sector, secured

transactions, collateral and so on, still remain to be

enacted and implemented.



East Asia Update 41

Vietnam

GDP growth in the third quarter, at 8.0 percent,lifted the growth rate for the first nine months of 2004 to

7.4 percent year on year (y-o-y). Growth is expected to be

maintained at 7-7.5 percent for the rest of the year. The

main macroeconomic development in the last 9 months

has been the sharp rise in prices, generating considerable

debate among policy makers on response strategies. Thehigh international price of oil, which on the one hand has

been an important factor in the recent upsurge in inflation,

has on the other hand boosted export receipts andgovernment revenue.

The industrial sector grew by 10.6 percent in the

first 9 months of 2004 with manufacturing rising by 9.3

percent. The construction sector recorded a growth of 8.1 percent in the first nine months with a pick up in the

second and third quarters helped by demand injections

from the government’s investment program. Growth in

this sector has however been dampened by the high price

of steel. Agricultural growth stood at 2.3 percent in thefirst 9 months of 2004, representing a recovery in later

months. The poultry and livestock sub-sector, which

represents around 7 percent of GDP, was impacted by theavian influenza outbreak and witnessed a reduction in

value added of 6.1 percent y-o-y in the first quarter, and

2.2 percent y-o-y in the first six months. This represents

the net effect of a sharp reduction in poultry output beingcompensated to some extent by an increase in substitute

livestock products. The impact on the tourism sector,

other than in the month of March, has not been

significant. Tourist arrivals have increased by 45 percent

in 2004 compared with the first 9 months of 2003, partly a

rebound from the effects of SARS. In recent months there

have been some new but isolated outbreaks of avianinfluenza. While these have been marginal, this is an area

that would require a high level of vigilance by the

authorities.

Domestic consumption and investment have

been strong. The retail sales index rose by 18.3 percent y-

o-y in the first 9 months of 2004. Investment, in current

prices, rose 19 percent in the first 9 months of 2004representing 36.2 percent of GDP. On the external front,

exports grew by 27 percent y-o-y in value terms during

the first 9 months of the year. Crude oil exports,

benefiting largely from high international prices, rose 43

percent in value terms. Garment exports slowedconsiderably to under 18 percent (compared to 53 percent

in the same period of 2003) being constrained by quota

limits in the US market. Exports of shrimp were adversely

impacted by anti-dumping proceedings by the US. As a

result, in the first nine months, exports of sea products

remained flat overall, but declined by over 20 percent tothe US. An emerging export this year has been wood

furniture. These exports may in effect be substituting

exports from China which have been slapped with anti-

dumping proceedings. Faced with an uncertain market

situation in the US, exporters have looked to diversify

into the EU and Japanese markets with some initial

success. This trend will be aided by garment quotaincreases in the EU market and improved food safety

standards adopted by Vietnamese exporters.

With the expiration of the MFA in 2005,

Vietnam will likely face tougher competition in

international markets. This is because Vietnam, not

currently a WTO member, will continue to face importquotas. As a counter, the government is seeking to

negotiate garment quota increases in EU and US markets

while producers are starting to focus on non-quota

products. Another area where the government would need

to act relates to reducing the transaction costs in quotaallocation as exporters face stiffer competition fromquota-free countries. On the positive side, buyers appear keen to have diversified sources of supply and would

retain Vietnam as an established source. A key factor

would be the signals on WTO membership: if these

remain strong then it will be a solid incentive for buyers

to not re-source away from Vietnam.

Import growth at 21 percent in the first nine

months equaled the pace in the same period last year. The

trade deficit in the first nine months is estimated at 4.3

percent of GDP compared with 6.6 percent in the same

period of 2003. With a continuation of recent trends, thecurrent account deficit which stood at 4.7 of GDP in 2003

will likely narrow this year as remittances have remained

strong. On the financing side ODA disbursements willcontinue to be the main source. FDI disbursements,

according to official data which employ a definition

different from the balance-of-payments one, have risen 16

percent y-o-y in the first half of 2004. Gross foreign

exchange reserves stood at $6.3 billion (2.6 months of

imports of goods and services). During 2003 reserveswere boosted as commercial banks moved funds from off-

shore deposits on-shore. This trend has slowed in 2004.

Budgetary revenues remained robust in the first9 months of 2004 fulfilling 79 percent of the annual plan

and expenditures remained on target. Government

revenues have benefited from higher non-tax sources such

as the profits of oil-producing state owned enterprises.

However, import-export revenues are reported to have been lower than targeted. The lower than expected

collections from trade taxes can be explained in terms of

removal of tariffs on items such as oil products and steel

in order to cushion the price impact on consumers;

sharply lower imports of high tariff items such as

motorcars and their component parts; and only in part dueto the ongoing tariff reductions under the ASEAN Free

Trade Area (AFTA). The government’s target deficit of

2.2 percent of GDP for 2004 remains attainable.

By September, 2004 the CPI had increased by 10

percent y-o-y, a significant rise compared with the

January, 2004 figure of 3.4 percent. The price of food,

which accounts for nearly half the consumption basket

had risen by 19 percent y-o-y. The rise in the price of



East Asia Update 42

non-food items was lower, at 4 percent. This rise in

prices has been mainly supply-driven stemming from theavian influenza outbreak, and higher international prices

of key commodities such as oil, fertilizer and steel. The

avian influenza outbreak resulted in a rise in prices of

poultry products, with knock-on effects on prices of

substitute meat products. Meanwhile, the price of

fertilizer, a major input, has risen 46 percent. However,there are signs that a deceleration in inflation is already

underway. The average month-on-month rise in CPI

during June-September was 0.6 percent compared withover 1.5 percent in earlier months.

Credit growth rose sharply from 25 percent in2003 to around 35 percent y-o-y in June 2004, but thisshould not be seen as the factor behind inflation as themajor rise in credit occurred after inflation had shown

signs of abating. The State Bank of Vietnam (SBV)

expects credit growth to slow in the coming months and

anticipates meeting its target of 25 percent for 2004. In

order to control credit growth SBV has increased the

reserve requirement for banks from 2 to 5 percent(effective from July 1, 2004). Slowing credit growth at

this stage is better viewed as an attempt to control the

quality of lending rather than reducing aggregate demand.The credit growth from commercial banks has beensomewhat offset by slower disbursements by theDevelopment Assistance Fund (DAF) which, in the first

six months, is reported to have met only 20 percent of its

disbursement target for 2004. This is likely related to the

new government decree regulating policy lending which

introduced stricter criteria for loan approvals.

GDP growth is expected to remain around 7-7.5

percent in 2005, with domestic demand playing a more

important role than in 2004. Export growth is likely toslow as oil prices are expected to soften, and quota limits

constrain garment exports. Export growth would thus

depend on Vietnam’s success in negotiating quotaincreases for garment exports. Investment from all

sources, state, non-state, and the foreign invested sector is

expected to remain strong. The current account deficit isanticipated to be around 4.6 percent of GDP. Inflation is

expected to decline to 5-6 percent by the middle of next

year.

Smaller Economies

Cambodia

Cambodia’s economic growth has been slowingstarting last year. Real GDP grew by 5.2 percent in 2003,

compared to the annual average of around 7 percent in the

1999-2002 period, largely due to a jump in agricultural

growth resulting from favorable weather conditions. Real

GDP growth is projected to slow to 4.3 percent in 2004 as

agricultural slows relative to 2003 and structural

weaknesses constrain non-agricultural growth. Next year,

the termination of the Multi-Fiber Agreement (MFA) isexpected to lead to negative growth in the garments

sector; given the importance of garments to the

manufacturing sector, this decline will reduce real GDP

growth to around 2.4 percent in 2005. Growth in services

and construction are also expected to slow, but the impact

will likely be somewhat offset by the tourism sector,which is expected to grow by 15 percent. Reductions in

overall incidence of poverty remain limited.

Inflation is expected to rise somewhat relative to

the low rate of 0.5 percent in 2003, but it is projected to

remain well below 5 percent in 2004 and 2005 if currentmonetary and fiscal policies are maintained. Monetaryand fiscal policies have been broadly stable. Prudentfiscal policy has been key to ensuring price stability in

Cambodia’s highly dollarized economy. Fiscal revenue is

expected to recover in 2004 after falling in 2003. The

revenue-to-GDP ratio is expected to rise to 11.9 percent in

2004 from 10.4 percent in 2003, reflecting increases in

both tax and non-tax revenues. However, Cambodia’srevenue effort is one of the lowest in the region and

compares quite unfavorably to other low income

agricultural economies. With implementation of tax policy and administration reform in the Tax and Customsand Excise Departments, Cambodia’s medium term fiscal position looks to be favorable. Expenditure will be limited

to 18.0 percent of GDP in 2004, and is projected to rise

very slowly thereafter. The projected overall budget

deficit of 6.1 percent of GDP in 2004 is expected to

decline steadily over the medium term, with the deficit

continuing to be offset by external financing. External

developments have been on track with continued

expansion of trade, a stable exchange rate, and risinggross official reverses (equivalent to 3.0 months of

imports in 2004).

The ratification of membership to the WorldTrade Organization (WTO) membership was a major

achievement for Cambodia, though overall progress on

structural reform—in particular governance reform— remained lackluster in 2003 and in 2004, in part because

of the elections and the difficulty of forming a

government. The new government – formed in July 2004

– has announced a “Rectangular Strategy,” which puts

governance at the core and highlights the need for

creating a more favorable private sector environment.

This promising announcement has also been accompanied by a process for formulating a comprehensive publicfinancial management reform program and a private

sector action plan. It is hoped that these will translate into

the implementation of reform measures soon, that will

help to increase economic confidence and begin reversingthe decline in economic growth.

Fiji

Political tensions have persisted in Fiji with

ongoing discussions between the government and



East Asia Update 43

opposition about the composition of the Cabinet. In mid-

2003 the Fiji Supreme Court ordered the Prime Minister to include the Fiji Labour Party (FLP) in his Cabinet

under the power sharing provisions of the Constitution.

In response, the Prime Minister announced that Cabinet

would simply be expanded to accommodate the required

number of FLP representatives. However, disputes have

arisen as to the precise number of FLP representativesrequired under the Constitution, whether the leader of the

FLP is entitled to a position in Cabinet, and whether there

is any restriction on the significance of Cabinet postsoffered to members of the FLP. This issue may not be

fully resolved until the next election due in September

2006.

Court cases in 2004 relating to the 2000 coupresulted in Fiji’s Vice President, Ratu Jope Seniloli, along

with four other prominent Fijians, being found guilty of

taking an unlawful oath at the height of the May 2000

political uprising and sentenced to four years jail.

Agitation for pardons began almost immediately.

Despite these tensions, the economy is estimated

to have grown by 4.8 per cent in 2003; the 2004 forecast

of 4.7 per cent growth is due to continuing strength in

building and construction, wholesale and retail trade,

restaurant and hotel sectors. However, the severe floodsin April and June will have reduced output of sugar cane

and food crops. Inflation has risen marginally to 2.9 per

cent in the year to August 2004, and the year-end 2004forecast for inflation is 3.5 per cent.

Tourism, Fiji's main foreign exchange earner,continues to grow. Visitor arrivals rose by 17 per cent in

the year to August 2004. The garment industry, the

second biggest foreign-exchange earner, has seen amarginal decline in the past five months, although on a

positive note Australia has extended its preferential trade

agreement for another seven years. Sugar production

through August increased by 7 per cent in 2004 over thecomparable period last season. However, problems of

expiring land leases, poor mill performance, incidences of

cane burning and cane transportation problems will need

to be resolved to prevent expected declines in future

years. Moreover, the government-owned Fiji Sugar Corporation is alarmed about the possible ramifications of

a WTO ruling in August on the preferential treatment

given by the EU to Fiji and some other sugarcane

producing countries, but as yet it is unclear whether this

will affect Fiji’s preferential access to the EU sugar

market.

The fiscal deficit is estimated to be 6.4 per cent of GDP

for 2003, almost 1 percentage point higher than budgeted,

partly as a result of unanticipated spending pressures that

arose during the year from Cyclone Ami. The failure of

privatization receipts to materialize added to the

budgetary pressures. As a result of recent budget deficits,

total public sector debt increased to almost 50 per cent of

GDP in 2003, higher than the government’s medium-term

target of 40 per cent by 2005.

Lao PDR

Real GDP grew by 5.3 percent in 2003, slightly

lower than in 2001 and 2002, but is expected to reach

nearly 6 percent in 2004. This strengthening of growth

performance is due to higher private and publicinvestment, some recovery in tourism, and robust export

performance fuelled by growth in China, Thailand and

Vietnam. Though world growth and regional growth is

projected to slow down in 2005 relative to 2004, GDP

growth in Lao PDR is likely to exceed that of 2004,

mainly due to a projected jump in foreign investments in

mining and hydro-power, with continued good export

performance and stable agricultural and manufacturing

growth. Poverty reduction is projected to continue.

Inflation is expected to fall from the high of 12.6 percent

at end-2003 to below 10 percent in 2004 and 2005, as

long as fiscal consolidation is continued.

The fiscal situation, though improving, remains

fragile. This is largely because the share of government

revenue in GDP has been stagnating for several years,

while the pressure for increased spending continues.

These are manifest in the pressures to increase the modest

salaries and benefits of public servants, as well as to raise

non-wage recurrent expenditures. The Government has

held the line on spending increases for the last three

quarters and achieved the higher tax-collection targets.

As a result inflation has continued to fall in 2004. The

challenge is to sustain fiscal prudence and maintain

inflation at single-digit levels.

Since 2001, the Government has been

implementing a program of structural reform, together

with relatively successful macro-stabilization. The latter

has focused mainly in the areas of public expenditures,

state owned enterprises (SOEs), the financial sector,

private sector development and regional trade. Theseefforts were sustained in 2004, though at an uneven pace.

On trade, annual reductions in AFTA tariffs and inexpansion of inclusion list have also continued. On SOE

reform, detailed time-bound programs of restructuring-

actions for Lao Airlines, Nam Papa Lao, Pharmaceutical

Factory No. 3 and Phudoi were adopted by the Prime

Minister in April 2004, and their implementation is

underway, albeit at a slower pace than planned. Onfinancial sector reform, amendments to the commercial

banking law and issuance of new regulations in respect of

concentration and foreign exchange exposure are in process. The restructuring efforts for BCEL (the Foreign

Trade Bank) and the Lao Development Bank (latter

formed from merger of two state commercial banks) havealso been continuing in 2004 with the help of

international banking advisors, but non-performing loans

in these two banks are coming down more slowly than

envisaged, largely due to provincial government’s



East Asia Update 44

continuing arrears to private contractors working on

government projects. On private sector development,incentives were recently rationalized and the process for

integrating the laws on foreign and on domestic

investment is being discussed.

Mongolia

In 2003, GDP growth in Mongolia was 5.6 percent, an increase of 1.7 percent from the 3.9 percent

growth rate in 2002. This good record resulted partly from

the strong expansion in the mining sector, and a favorable

external environment. For the first half year of 2004, thereal gross industrial output grew at 5,8 percent. This

robust growth originates mainly from the mining sector

expansion (8.8 percent growth over the first semester)

following the increase in copper and gold world market prices and the start of mining exploitation by new foreign

investors. Given this favorable environment, GDP is

projected to reach 6 percent this year.

During the first semester, signs of inflationary

pressure were perceived. As of June 2004, CPI increased by 5.3 percent from the corresponding period of previous

year, and by 7 percent from the beginning of the year,

respectively. This significant increase in inflation ismainly caused by the increase in the domestic oil price

(by 23 percent since the beginning of July) which in turn

is due to the increase of prices on the world market and to

the Yukos oil company financial crisis, Mongolia’s main

oil supplier. In addition, an accommodating monetary

policy has accompanied the increase in prices. As of June2004, M1 and M2 increased respectively by 21.9 percent

and 45.6 percent, a marked acceleration from the June

2003 figures (11.3 percent and 39 percent respectively).

At the end of 2003, public sector debt had reached 118.7 percent of GDP while external public debt was 103 percent of GDP. Most foreign loans (more than 98 percent) are concessional lending, implying a low risk and

cost on these liabilities for the Government. Overall,

Mongolia’s public debt remains manageable, despite a

significant increase following the settlement of the

Transferable Rubble Russian debt at the end of 2003.

During the first semester, export earnings

increased by 40 percent and imports by 33 percent, led by

a sustained external demand for copper, gold and textile.Mongolia signed a trade and investment framework

agreement with the United States earlier this year, as a

first step toward a free-trade agreement. This reflects theconcern among countries that have built thriving textile

export trade regimes upon a U.S. quota system that will

expire at the end of this year. The U.S. is Mongolia's third biggest export market, the bulk of that trade being

textiles, and textile exports contribute to 10 percent of

annual Mongolia’s GDP. Private remittances have

increased significantly over the last three years reaching

in 2003 10.8 percent of GDP. On the capital account side,FDI and foreign aid and loan remained sustained. Overall,

net international reserves in the end of 2003 were US$

129 millions, a drop from the 2002 figure of US$ 225.8

millions, reflecting the use of part of the reserves for thesettlement of the Russian debt. The floating exchange rate

remained stable at the end of June 2004, at 1174 togrog

per US dollar.

In 2003, total budget revenue amounted 40.7 percent of

GDP, a 4,8 percent increase from 2002, partly due to

strong increase in corporate income tax collection (5,1 percent in 2003 versus 3.7 percent of GDP in 2002). In

2003, total budget expenditure and net lending increased

to 45.4 percent of GDP from 44.2 percent of GDP in

2002. Government overall deficit decreased in 2003 to 4.7

percent of GDP from 6 percent in 2002 and is projected to be 4 percent in 2004. In end June 2004, total budgetrevenue collection reported an increase of 43.4 percentcompared to June 2003, as a result of a good tax effort.

The corporate income tax rate was reduced by 25 percent

(from 40 percent in 2003 to 30 percent in 2004) as a step

to reduce the tax burden on private sector activities and

toward a single income tax system. As of June,

government expenditure had increased by an extra 20.1 percent compared to the corresponding period of previous

year. Overall, there are indications of a loosening of

policies in the run-up of the 2004 elections, including asharp increase in wages (up to 25 percent) and pensions(up to 30 percent). The implementation of the publicexpenditure management reform program has shown

progress this year, with for instance the adoption in March

2004 of a resolution on the budget planning process in

order to make it more explicit and enforceable. However,

the impact of the settlement of Russian debt were

incorporated in the Medium-Term Budget Framework in

Spring 2004, but remains to be reflected in an amended

budget for 2004 in the Fall. Finally, the June 2004elections led to the unexpected result of no clear

parliamentary majority, opening the stage to a prolonged period of uncertainty regarding the continuity of thereform program, in particular in the domain of social policies and the overall macroeconomic framework.

Papua New Guinea

Political Developments. The governmentcontinued to face challenges in the first half of 2004,

through opposition efforts to bring about a motion of no-

confidence. In apparent response and to ward off further

challenges there have been a number of Cabinet

reshuffles. At mid-year, Parliament was adjourned untilearly November 2004.

Implementation of the Enhanced Cooperation

Program between Papua New Guinea and Australia

commenced in the second half of 2004, following

Parliamentary ratification of the underlying treaty. Under

this package Australia will support PNG to respond to the

long term deterioration in the law and order situation and

to strengthen economic management through deploymentof about three dozen Australian public servants mainly

into line positions in the PNG public service and over 200



East Asia Update 45

police and other legal/judicial personnel to underpin

improvements in law and order as well as in areas such as border control. Australia will provide new financing for

the police related portion of the program while the other

components will be financed out of the existing bilateral

aid program.

Economic Developments. The nascent

economic recovery of 2003, when real GDP expanded anestimated 2.7 percent, is continuing in 2004 and GDP

growth is expected to be around 3 percent. A key factor

which has contributed to the continued improvement is a

tight fiscal stance which has underpinned the restoration

of macroeconomic stability. Buoyant global commodity prices, particularly for a number of PNG’s keyexports—including oil, gold and some agriculturalcommodities—have also contributed to increases in

production as has an improvement in business confidence.

The coffee season has commenced early but it is expected

that the bumper harvest of 2003 will not be matched in

2004. The economic recovery remains fragile not the

least because of supply constraints and resource depletionin the mineral sector.

Expenditure control efforts have been intensified

in 2004, while an agenda for improved budget

management is being rolled out. As a result a budgetarysurplus estimated at 1.5 percent of GDP was achieved

over the first half of 2004. While the tight controls are

expected to be maintained it is expected that the overalloutcome for the year will be a deficit of around

1.5 percent of GDP, in line with the budget plan. This is

on account of seasonality in the PNG economy. In

addition to the improved expenditure controls, the budget

position has also been supported by sharply higher

revenues from the mineral sector—principally oil andgold—combined with a sharp reduction in debt servicing

costs. Government has taken advantage of the

opportunity offered by improved macroeconomicconditions to restructure its domestic debt obligations.

In line with these developments the current

account is expected to shift to surplus by year end. The

currency has remained stable in 2004, appreciating

slightly relative to the U.S. dollar over the first ninemonths of the year.

The easing of the monetary stance whichcommenced during the third quarter of 2003, has

continued through 2004 and has facilitated a reduction inTreasury bill yields from 16 percent in January 2004 to a

little under 5 percent in September 2004. Thesedevelopments have facilitated an easing of inflation,

which was running at an annualized rate of 2 percent at

mid year. External reserves have continued to accumulate

during 2003, with gross external reserves increasing by

about US$200 million during the year to September when

they stood at just over US$600 million, equivalent to

more than 6 months of non-mineral imports.

Solomon Islands

The restoration of law and order, underpinned bythe intervention of the Regional Assistance Mission to

Solomon Islands in July 2003 has been effectively

maintained and permitted the scaling back of the military

component. Technical support continues, however,

through advisors and placement in-line positions, in

economic and central agencies and the legal and judicialsystem. Improvements in security have boosted public

confidence and reinvigorated formal business activity,

particularly in Honiara.

The government is considering adoption of a

new constitution based on a federal system of

government, with a significant number of political,

financial and legal powers transferred to stategovernments. Although a bill may be ready to be tabled

in Parliament by end-2004 or early 2005, there are

concerns regarding the high costs of establishing such a

structure, even as central government finances remain

fragile. As well, effective systems to monitor the fiscaland economic performance of provinces are absent,

risking the sought after improvement in public service

delivery.

After four years of contraction, which saw a

cumulative decline in real GDP of 16.5 percent, the

economy expanded in the second half of 2003 due to

growth in primary production, construction and services.

Consequently GDP increased by an estimated 5.1 percent

in 2003, and is projected to expand by 4 percent in 2004.Inflation declined substantially in 2003, to 3.8 percent on

a year-end basis compared to 15.4 percent in 2002,

although it has picked up slightly to almost 7 percent in

the year to July 2004.The restoration of fiscal discipline was reflected

in the budget deficit of 1.4 percent of GDP in 2003, and a

surplus of 4 percent of GDP is projected for 2004.

Despite the recommencement of debt service payments,

total government debt, both domestic and external, has

only fallen marginally reflecting the large build up of

arrears. Significantly, the Government reached an

important settlement with its major domestic

bondholders—mainly the commercial banks and the

National Provident Fund—in the first half of 2004. Under the terms of this, 60 percent of interest arrears due to the

bondholders were written-off, and the restructured bonds

were replaced with a 14 year amortizing bond, carrying aninterest rate of 21/4 percent, compared to about 9 percent

on the previous bonds. Overall the Government saved

about SI$11.8 million on the interest arrears and an

estimated SI$130 million in interest costs through the

reduction in interest rates.

The balance of payments strengthened in 2003 as

a current account surplus of almost 1.5 percent of GDP

was recorded fuelled in part by timber exports with

reserves continuing to be rebuilt, buoyed by inflows of

foreign assistance. The level of reserves has almost



East Asia Update 46

doubled in the past year, reaching SI$538.1 million inSeptember 2004. As a result the Central Bank of theSolomon Islands lifted the foreign exchange controls that

had been in place since 2000.

Although the economic recovery is encouraging, the

structural reform agenda remains critical to sustaining that

recovery. This includes the cost, efficiency, reliability

and coverage of telecommunications and power service tounderpin private sector development and business

activities, as well as the resumption in inter-island

shipping services which are so important to rural

agricultural production.



East Asia Update 47

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 1999 8.3 -2.7 -6.1 5.9 -1.0 0.7 2.1 4.1 -0.2 4.1

Q2 1999 7.0 1.9 1.8 9.7 4.8 3.8 6.6 6.4 3.4 6.3

Q3 1999 7.0 4.6 2.8 11.1 9.1 3.8 8.4 4.7 8.4 7.1

Q4 1999 6.5 9.3 5.4 10.9 11.7 5.1 8.6 6.4 6.4 7.6

Q1 2000 8.1 13.6 4.1 13.1 11.7 5.3 9.6 7.9 6.5 9.1

Q2 2000 8.3 10.1 4.5 9.4 8.5 6.1 8.2 5.1 6.2 7.7

Q3 2000 8.2 10.3 5.3 8.2 8.4 7.2 10.0 6.7 2.4 7.6

Q4 2000 7.6 7.2 7.5 4.3 7.1 5.3 9.7 3.8 4.0 6.2

Q1 2001 8.4 2.2 4.4 3.5 2.9 1.3 4.1 0.6 1.6 4.8

Q2 2001 8.0 1.4 6.1 3.7 0.2 2.0 -1.3 -3.3 2.1 4.1

Q3 2001 7.1 -0.5 3.9 3.4 -1.2 1.4 -5.6 -4.4 2.1 3.0

Q4 2001 6.9 -1.1 1.0 4.6 -0.5 2.3 -6.1 -1.6 2.6 3.3

Q1 2002 8.0 -1.0 2.7 6.5 1.0 4.0 -0.4 0.9 4.4 4.9

Q2 2002 8.4 0.4 4.0 7.0 4.1 4.2 5.0 3.7 5.5 6.1

Q3 2002 8.5 3.0 5.4 6.8 5.8 3.3 4.7 5.2 5.8 6.6

Q4 2002 8.3 4.8 4.9 7.5 5.6 5.6 4.0 4.5 6.0 6.7

Q1 2003 9.9 4.4 5.5 3.7 4.6 4.8 1.7 3.5 6.7 6.4

Q2 2003 7.9 -0.6 4.8 2.2 4.6 4.2 -3.9 -0.2 5.8 4.2

Q3 2003 9.6 4.0 3.7 2.4 5.3 4.8 1.7 4.0 6.6 5.9

Q4 2003 9.9 4.9 4.1 3.9 6.6 5.0 4.9 5.7 7.8 6.9

Q1 2004 9.8 7.0 5.0 5.3 7.6 6.5 7.5 6.7 6.6 7.5

Q2 2004 9.6 12.1 4.3 5.5 8.0 6.2 12.5 7.7 6.3 8.1

Source: Haver Analytics and national sources

Appendix Table 2: East Asia: Merchandise Export Growth(US $; % change form a year ago)

2002 2003 Q3 2003 Q4 2003 Q1 2004 Q2 2004 Q3 2004 Apr-04 May-04 Jun-04 Jul-04 Aug-04 Sep-04

East Asia (9) 9.6 19.1 15.2 23.4 23.7 28.7 27.0 26.4 28.0 31.5 27.2 28.4 25.4

SE Asia 5.1 11.3 6.7 13.0 12.2 17.1 23.0 16.5 16.2 18.6 19.9 23.3 25.7

Indonesia 1.5 6.6 1.9 3.6 -0.9 7.1 24.7 2.9 10.8 7.5 7.7 25.6 41.4

Malaysia 5.9 12.7 7.9 15.2 17.3 22.0 26.9 23.1 20.3 22.6 28.1 23.7 28.8

Philippines 9.5 2.3 -0.8 4.8 6.3 10.8 8.4 8.9 15.3 8.2 3.2 13.7 8.4

Thailand 4.8 17.9 13.1 21.7 18.8 21.5 23.4 22.1 15.4 27.2 26.7 25.2 18.8

China 22.4 34.6 29.7 40.5 34.0 37.3 34.8 32.4 32.8 46.7 33.9 37.5 33.1

NIEs 5.7 14.2 10.6 18.0 22.9 28.0 23.5 26.4 30.0 27.7 25.8 24.7 20.2

Hong Kong 5.4 11.8 7.1 11.9 13.3 17.7 17.0 19.3 15.7 18.2 16.5 20.9 13.8

Korea 8.0 19.3 15.9 25.6 37.7 38.8 29.3 36.7 41.9 38.0 36.2 28.8 23.5

Singapore 2.8 15.2 10.9 18.9 18.7 29.0 28.5 26.6 28.5 31.9 28.2 30.5 27.0

Taiwan (China) 6.3 10.4 9.6 16.8 22.3 28.8 21.6 22.8 39.4 24.4 26.0 20.0 19.2



East Asia Update 48

Appendix Table 3. East Asia and the Pacific: GDP Growth Projections

Actual Forecast Forecast

1997 1998 1999 2000 2001 2002 2003 2004 2005

East Asia 6.4 -0.1 6.3 7.6 3.8 6.0 5.9 7.1 5.9

Developing East Asia 6.9 1.7 5.7 7.2 5.7 6.9 7.8 7.9 7.0

South East Asia 3.4 -9.3 3.3 5.9 2.5 4.6 5.3 5.8 5.5

Indonesia 4.7 -13.1 0.8 5.4 3.8 4.3 4.5 4.9 5.4Malaysia 7.3 -7.4 6.1 8.9 0.3 4.1 5.3 7.0 6.0

Philippines 5.2 -0.6 3.4 6.0 3.0 4.4 4.7 5.4 4.5

Thailand -1.4 -10.5 4.4 4.8 2.1 5.4 6.8 6.5 5.8

Transition

China 8.8 7.8 7.1 8.0 7.5 8.3 9.3 9.2 7.8

Vietnam 8.2 5.8 4.8 6.8 6.9 7.0 7.2 7.2 7.5

Small Economies 1.8 0.4 8.1 2.6 1.7 2.6 4.2 4.1 3.4

Cambodia 6.8 3.7 10.8 7.0 5.7 5.5 5.2 4.3 2.4

East Timor -35.0 15.0 15.0 3.0 -3.0 1.0

Lao PDR 6.9 4.0 7.3 5.8 5.8 5.8 5.3 6.0 7.0

Mongolia 4.0 3.5 3.3 1.1 1.1 3.9 5.6 6.0 6.0

Fiji -0.9 1.5 9.6 -2.8 2.7 4.3 4.8 4.7 3.0Kiribati 5.7 12.6 9.5 1.6 1.8 1.0 2.5 .. ..

Marshall Islands -9.4 2.5 0.6 0.9 -1.3 4.0 2.0 1.5 ..

Micronesia, Fed. Sts. -4.6 -2.8 0.2 4.4 1.1 0.8 2.4 2.0 ..

Palau 2.3 2.0 -5.4 0.3 4.5 1.1 1.5 2.0 ..

Papua New Guinea -3.9 -3.8 7.5 -1.2 -2.3 -0.8 2.7 2.8 2.1

Samoa 0.8 2.4 2.6 6.9 6.2 1.5 3.5 3.2 3.2

Solomon Islands -1.4 1.8 -0.5 -14.3 -9.0 -1.6 5.1 4.2 4.4

Tonga 0.1 2.4 3.1 6.6 0.3 1.6 2.5 1.0 2.0

Vanuatu 2.4 3.0 -2.1 2.5 -1.9 -0.3 2.0 2.8 3.3

East Asia NIEs 5.7 -2.7 7.1 8.1 1.0 4.7 3.0 5.9 4.4

Hong Kong (SAR) 5.1 -5.0 3.4 10.2 0.5 1.9 3.2 7.4 4.6

Korea 4.7 -6.9 9.5 8.5 3.8 7.0 3.1 4.9 4.4Singapore 8.5 -0.9 6.8 9.7 -1.9 2.2 1.1 8.3 4.5

Taiwan (China) 6.7 4.6 5.4 5.9 -2.2 3.6 3.3 5.8 4.3

Japan 1.8 -1.2 0.2 2.8 0.4 -0.3 2.7 4.3 1.8

Sources:

World Bank data and staff estimates. East Asia is sum of Developing East Asia and Newly Industrialized Economies.

Indonesia National Accounts use base your 1993 for 1997-2000 data and base year 2000 for 2001-05 data







East Asia Update 51

Appendix Table 8: Poverty in East Asia - Country Estimates

$1 –a-day $2-a-day

Mean

Consumption

(1993

PPP$/month)

Headcount

Index

(%)

Number

of Poor

(mill.)

Headcount

Index (%)

Number

of Poor

(mill.)

Gini

Coefficient

Population

(mill.)

Cambodia

1990 48.29 48.3 4.4 83.7 7.7 41.6 9.1

1996 57.77 36.7 4.0 76.9 8.4 41.6 10.5

1997 56.95 38.4 4.2 78.0 8.5 41.6 10.9

1998 55.97 39.4 4.4 78.6 8.8 41.4 11.2

1999 55.48 41.5 4.8 79.3 9.1 42.3 11.5

2000 55.72 43.4 5.1 79.4 9.3 43.9 11.8

2001 57.01 43.0 5.2 78.6 9.5 44.6 12.1

2002 56.68 45.5 5.6 79.0 9.8 46.2 12.4

2003 58.80 42.2 5.3 77.9 9.9 45.4 12.7

2004 59.37 42.6 5.5 77.6 10.1 46.3 13.0

2005 59.46 42.2 5.6 77.5 10.3 46.0 13.3

China1990 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

1998 91.32 16.1 201.2 49.8 620.8 41.0 1,248

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

2002 130.27 12.9 165.9 37.9 486.3 46.1 1,285

2003 142.85 11.7 150.6 34.8 449.3 46.7 1,292

2004 155.37 10.7 138.7 32.1 417.8 47.2 1,300

2005 166.76 9.8 127.7 29.9 391.1 47.4 1,308

Indonesia

1984 49.80 36.7 58.7 80.0 128.1 30.3 160.11990 61.58 20.6 36.7 71.1 126.7 28.9 178.2

1996 86.62 7.8 15.4 50.5 99.4 36.5 196.8

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 32.2 210.5

2001 73.44 9.2 19.7 58.7 125.2 32.1 213.2

2002 81.72 7.2 15.5 53.5 115.6 34.3 216.2

2003 87.26 5.7 12.5 48.8 107.1 34.8 219.4

2004 91.24 5.1 11.4 46.1 102.8 35.4 222.7

2005 95.12 4.7 10.6 43.8 99.1 36.1 226.1

Laos

1990 39.16 53.0 2.2 89.6 3.7 32.7 4.2

1996 48.27 41.3 2.0 83.1 4.1 36.5 4.91997 50.35 38.4 1.9 81.3 4.1 36.5 5.0

1998 49.45 39.8 2.0 81.9 4.2 36.5 5.1

1999 51.55 36.6 1.9 80.5 4.2 36.5 5.3

2000 53.30 33.9 1.8 79.4 4.3 36.5 5.4

2001 55.47 31.3 1.7 77.4 4.3 36.5 5.5

2002 57.35 29.0 1.6 76.1 4.3 36.5 5.7

2003 59.01 26.9 1.6 74.9 4.3 36.5 5.8

2004 61.16 24.5 1.5 73.1 4.3 36.5 5.9

2005 63.96 21.7 1.3 70.7 4.3 36.5 6.1



East Asia Update 52

Appendix Table 8: Poverty in East Asia (Continued)


Mean

Consumption

(1993

PPP$/month)

Headcount

Index

(%)

Number

of Poor

(mill.)

Headcount

Index

(%)

Number

of Poor

(mill.)

Gini

Coefficient

Population

(mill.)

Malaysia

1984 172.09 8.9 1.4 29.5 4.5 50.5 15.3

1987 170.88 4.8 0.8 25.0 4.2 47.0 16.6

1989 176.21 3.2 0.6 22.4 4.0 46.2 17.7

1990 195.32 2.0 0.4 18.5 3.4 46.2 18.2

1992 219.48 1.5 0.3 17.6 3.4 47.7 19.1

1995 253.64 1.0 0.2 14.0 2.9 48.5 20.6

1996 261.87 0.8 0.2 13.1 2.8 48.5 21.1

1997 315.95 < 0.5 -- 8.8 1.9 49.1 21.7

1998 269.00 < 0.5 -- 12.9 2.9 49.1 22.2

1999 271.54 < 0.5 -- 12.6 2.9 49.1 22.7

2000 304.47 < 0.5 -- 9.7 2.3 49.1 23.3

2001 303.83 < 0.5 -- 9.7 2.3 49.1 23.82002 301.26 < 0.5 -- 9.9 2.4 49.1 24.3

2003 315.69 < 0.5 -- 8.8 2.2 49.1 24.7

2004 332.61 < 0.5 -- 7.6 1.9 49.1 25.1

2005 347.64 < 0.5 -- 6.6 1.7 49.1 25.5

PNG

1990 72.95 35.4 1.4 64.3 2.5 48.4 3.9

1996 93.15 24.6 1.1 54.4 2.5 48.4 4.6

1997 88.62 25.6 1.2 56.0 2.7 47.5 4.7

1998 83.15 27.8 1.4 59.0 2.9 47.7 4.9

1999 78.37 30.7 1.5 61.6 3.1 47.8 5.0

2000 71.89 35.3 1.8 65.0 3.3 47.6 5.1

2001 66.41 38.0 2.0 69.2 3.6 47.8 5.32002 63.41 39.2 2.1 70.4 3.8 47.5 5.4

2003 63.36 39.4 2.2 70.3 3.9 47.5 5.6

2004 63.39 40.0 2.3 70.5 4.0 47.5 5.7

2005 62.99 40.4 2.4 70.6 4.1 47.5 5.9

Philippines (* See Footnotes)

1985 74.92 22.8 12.4 61.3 33.3 41.0 54.2

1988 82.77 18.3 10.7 55.6 32.4 40.7 58.3

1990 90.32 19.1 11.7 53.5 32.6 43.8 61.0

1991 87.75 19.8 12.3 55.0 34.3 43.8 62.4

1994 89.10 18.4 12.3 53.1 35.5 42.9 66.8

1996 107.15 14.8 10.4 46.5 32.5 46.2 69.9

1997 110.21 12.1 8.6 45.2 32.3 46.0 71.51998 108.77 13.7 10.0 46.6 34.1 46.7 73.1

1999 107.20 13.5 10.1 46.9 35.0 46.2 74.7

2000 106.93 13.5 10.3 47.2 36.0 46.2 76.3

2001 N/A N/A N/A N/A N/A N/A N/A







East Asia Update 53

Appendix Table 8: Poverty in East Asia (Continued)


Mean

Consumption

(1993

PPP$/month)

Headcount

Index

(%)

Number

of Poor

(mill.)

Headcount

Index

(%)

Number

of Poor

(mill.)

Gini

Coefficient

Population

(mill.)

Korea

1990 301.09 < 0.5 -- < 0.5 -- 29.88 42.87

1991 330.38 < 0.5 -- < 0.5 -- 29.85 43.27

1992 362.09 < 0.5 -- < 0.5 -- 29.85 43.66

1993 383.03 < 0.5 -- < 0.5 -- 29.36 44.06

1994 411.09 < 0.5 -- < 0.5 -- 29.36 44.45

1995 440.03 < 0.5 -- < 0.5 -- 29.11 45.00

1996 480.46 < 0.5 -- < 0.5 -- 29.71 45.55

1997 483.84 < 0.5 -- < 0.5 -- 28.97 45.99

1998 400.86 < 0.5 -- < 0.5 -- 29.42 46.43

1999 450.06 < 0.5 -- < 0.5 -- 30.00 46.86

2000 497.15 < 0.5 -- < 0.5 -- 30.00 47.28

2001 521.82 < 0.5 -- < 0.5 -- 30.00 47.642002 559.06 < 0.5 -- < 0.5 -- 30.00 47.97

2003 546.35 < 0.5 -- < 0.5 -- 30.00 48.24

2004 570.39 < 0.5 -- < 0.5 -- 30.00 48.48

2005 592.64 < 0.5 -- < 0.5 -- 30.00 48.72

Thailand

1988 90.42 17.9 9.6 54.1 29.0 43.8 53.7

1990 102.88 12.5 7.0 47.0 26.1 43.8 55.6

1992 129.75 6.0 3.5 37.5 21.7 46.2 57.8

1996 143.92 2.2 1.3 28.2 17.0 43.4 60.1

1998 121.73 3.3 2.0 34.1 21.0 40.6 61.5

1999 123.50 3.1 1.9 33.6 20.7 40.7 61.7

2000 125.42 5.2 3.2 35.6 22.0 43.2 61.92001 131.21 3.6 2.2 32.0 19.9 42.4 62.3

2002 139.40 2.4 1.5 27.7 17.4 42.2 62.8

2003 146.80 1.6 1.0 23.8 15.0 41.4 63.1

2004 153.87 1.3 0.8 21.4 13.6 41.4 63.4

2005 161.43 1.0 0.6 18.2 11.6 40.9 63.7

Vietnam

1990 41.73 50.8 33.6 87.0 57.6 35.0 66.2

1993 48.85 39.9 28.3 80.5 57.2 35.0 71.0

1996 63.66 23.6 17.7 69.4 52.2 36.3 75.2

1998 68.54 16.4 12.8 65.4 50.9 35.4 77.7

1999 68.90 16.9 13.4 65.9 52.0 35.4 78.9

2000 73.16 15.2 12.1 63.5 50.7 35.9 79.92001 76.62 14.6 11.8 61.8 50.1 36.8 81.0

2002 78.67 13.6 11.2 58.2 47.8 37.5 82.1

2003 84.06 10.9 9.0 54.3 45.1 37.5 83.2

2004 87.89 9.4 7.9 51.4 43.3 37.6 84.3

2005 92.06 8.0 6.9 48.2 41.1 37.7 85.4



East Asia Update 54

Notes for Tables 7 and 8

______________________________________________________________________________________

(1) The poverty lines in Tables 8 and 9 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 relativeto 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 exceptMalaysia 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 toderive 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.

* Pending. Poverty estimates for Philippines are to be released shortly by Government of the Philippines.

______________________________________________________________________________________

Appendix Table 9. NPLs in the commercial banking system of the crisis-affected countries

(percent of total loans)

1997 1998 1999 2000 2001 2002 2003 2004

Dec Dec Dec Dec Dec Mar Jun Sept Dec Mar Jun Sep Dec Mar Jun

Indonesia (a) -- -- 64.0 57.1 48.8 50.3 48.5 40.7 31.1 30.3 27.7 24.4 18.1 18.9 17.9excl. IBRA 7.2 48.6 32.9 18.8 12.1 12.8 11.8 10.5 7.5 7.6 7.1 6.7 6.8 6.3 6.2

Korea (b) 8.0 17.2 23.2 14.0 7.4 6.6 5.0 4.8 4.1 4.2 4.7 4.9 4.4

excl. KAMCO & KDIC 6.0 7.3 13.6 8.8 3.3 2.9 2.5 2.5 2.4 2.6 2.6 2.6 2.7 3.1 2.6

Malaysia - 21.1 23.4 22.5 24.4 24.6 23.7 23.1 22.4 22.1 21.9 21.1 21.2 21.0 20.1

excl. Danaharta -- 16.7 16.7 13.4 16.3 16.7 15.7 15.3 14.7 14.6 13.9 13.3 13.1 13.0 12.3

Philippines (c) 4.7 10.4 12.3 15.1 17.3 18.0 18.1 16.5 15.0 15.5 15.2 14.5 14.1 14.0 13.8

Thailand (d) -- 45.0 41.5 29.7 29.6 29.7 29.9 29.6 34.2 34.1 34.1 33.5 30.6 29.6 29.6

excl. AMCs -- 45.0 39.9 19.5 11.5 11.4 11.3 11.7 18.1 17.8 17.6 16.8 13.9 13.0 13.0

Memo: Malaysia (e)excl. Danaharta

-- 10.6 10.6 8.3 10.5 10.6 10.0 9.6 9.3 9.1 8.7 8.3 8.3 8.3 7.7

a) Only includes IBRA’s AMC; b) The NPL ratio increased in 1999 due to the introduction of stricter asset classification criteria (forwardlooking criteria) ; c) 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; d) Includes transfers to AMCs but

excludes write-offs. (Note that the jump in headline NPLs in December 2002 was a one-off increase, reflecting a change in definition anddid not affect provisioning requirements). The June 2003 figure is preliminary and was estimated using transfers to AMCs and lending toAMCs as of March 2003; e) NPL series used by Bank Negara Malaysia, which is net of provisions and excludes interest in suspense.



Special Focus: Strengthening the Investment Climate in the East Asia and Pacific Region

Reviving private investment is a critical challenge facing

countries in the East Asia and Pacific region. Growth in

physical capital per worker (capital intensity) contributed a

large part of East Asia’s extraordinary output growth

performance in the first part of the 1990s and before.23.

Since the 1997-98 East Asian financial crisis, however,

capital per worker growth has fallen in many countries of

the region, although not in China or Vietnam (Figure 1),

running at only 1-2 percent a year in several. Private

investment has been depressed, averaging 14 percent of

GDP in 2003 as compared to its pre-crisis average level of

25 percent.

This special focus paper looks at the investment climate in

East Asia, focusing in particular on those determinants of

private investment that are amenable to policy change. The

determinants of investment are wide-ranging, and a good

summary of international experience is given in the WorldBank’s World Development Report (WDR) 2005 “A Better

Investment Climate for Everyone”. This special focus

illustrates some of the global messages of the WDR with

information from Investment Climate Assessments (ICAs)

undertaken by the World Bank in five East Asian

economies, using data from over 6500 registered firms. 24 It

looks in particular at policies and institutional changes that

can affect the investment climate by (i) reducing policy-

related risks and uncertainties, (ii) reducing policy-related

costs of doing business, and (iii) raising investment returns.

II. Recent trends in Investment in East Asia

G rowth in physical capital per worker has slowed

dramatically since the 1997 financial crisis in the five

crisis-hit countries, Indonesia, Korea, Malaysia, Philippines,

Thailand (Figure 1). In the Philippines, investment has been

weak since the early 1990s and capital per worker has

grown at barely 1 percent per year. In the four other middle-

income countries of Southeast Asia, capital intensity growth

has fallen from 4-7 percent per year to less than half that

rate. One exception is Korea, where investment has

recovered somewhat more robustly after the crisis. The

third category of countries includes China and Vietnam,

which did not have crises and where physical capital per

worker has continued increasing very rapidly, in the case of China averaging around 10 percent since 1990. While a

detailed capital stock figure is not available for Vietnam,

23 Bosworth and Collins, 2003.24 Investment Climate Assessments have been completed for

Cambodia (2003), China (2002, 2003), Indonesia (2004),

Malaysia (2003) and the Philippines (2003). They are in

progress in Mongolia and Thailand and will soon be

launched in Lao PDR and Vietnam.

high investment rates suggest that capital intensity has

grown rapidly there as well. .

Figure 1: Growth in Physical Capital Per Worker (% per year)

0.0

3.0

6.0

9.0

12.0

Indonesia Thailand Korea Malaysia China Philippines

%

1990-97

1997-2003

Source: Bosworth and Collins (2003); World Bank calculations.

Aggregate investment patterns are mirrored by Foreign

Direct Investment (FDI) trends. FDI has played a

significant role in several East Asian economies, providing

resources and technology, both in the host industry andthrough linkages with the rest of the domestic private sector.

However, FDI has declined substantially in most countries

since 1997, except in China, following global trends. (Table

1). Excluding China, FDI inflows to the six largest

developing economies have been cut in half from an average

of around $16.5 billion a year in 1998-2000 to the recent

trend of around $7.5 billion in 2001-2003. Indonesia andthe Solomon Islands have even witnessed a consistent

outflow of FDI since 1997. One exception to this trend has

been in resource rich economies, where FDI in mining, oil

and other natural resources has followed improvements inlegislation in Mongolia, PNG, and Vietnam.

China of course has continued to be a magnet for FDI.

Indeed, China’s accession to the WTO, large domestic

market, strong growth, skilled workforce and the innovative

potential of its economy make it very attractive to FDI.

China received 85 percent of total FDI flows to the East

Asia region in 2003, and became the world’s largest

recipient, attracting around US$54 billion worth of FDI.



Special Focus: Strengthening the Investment Climate in East Asia 56

Table 1: Recent Trends in FDI in EAP: FDI Inflows as

% of GDP

1994-1997 1997-2001 2002-2003

Cambodia 5.4 5.7 2.8

China 5.3 4.2 4.0

Fiji 2.0 1.9 1.2

Indonesia 2.1 -1.7 -0.1

Korea, Rep. 0.4 1.5 0.6Lao PDR 5.7 2.6 1.2

Malaysia 6.5 3.4 2.9

Mongolia 1.7 3.7 9.0Papua New Guinea 3.1 4.1 1.9

Philippines 2.0 2.2 1.3

Solomon Islands 3.6 -2.3 -0.6

Tonga 1.2 1.6 1.6Thailand 1.4 4.4 1.1

Vietnam 9.1 4.9 3.6

Services are a new engine of FDI in East Asia. One new

phenomenon is the growing importance of services in FDIin the region. The share of services has increased from 43

percent of the region’s total inward FDI stock in 1995 to 50

percent in 2002. Growth was more pronounced in countries

like Thailand, Hong Kong (China) and Singapore, but even

in Malaysia, Philippines and Korea the share of services in

FDI is substantial (Table 2).

Table 2: Share of services in total inward FDI (Stock)

1990-2002 (Percentage)

Economy 1990 2000 2002

Cambodiaa

.. 39.7 36.4

China .. .. 31.4a

Hong Kong, China .. 92.0 93.0

Indonesia .. .. ..

Lao PDR .. .. ..

Malaysia 35.4 .. ..

Mongoliaa

100.0 37.0 41.3

Myanmar a

23.0 35.1 34.7

Papua New Guineaa

3.4 .. ..

Philippines b

23.5 45.2 43.9

Republic of Korea 37.8 34.9 42.0

Singaporec

58.5 63.3 ..

Thailand 47.6 62.2 56.8

Vanuatu .. .. ..Viet Nam

a20.6 .. ..

Source: UNCTAD, FDI database

(www.unctad.org/fdistatistics).

a Approval data.

b Data refer only to equity.

c Data for 1990-1996 refer only to equity

while data for 1997-2000 refer to total direct investment.

III. Improving the Investment Climate in East Asia

The East Asia and Pacific region generally fares well in

international comparisons of investment climate.

According to the A.T. Kearny 2003 ranking, 9 of the 25

most preferred destinations for FDI in the world were in

East Asia. Besides China, the front-runner since 2002, Japan

(15), Thailand (16), South Korea (18), Vietnam (21), andMalaysia (24) appear in the top 25 lists. However, results

from the five investment climate surveys completed in the

region suggest that serious impediments to private sector-led

growth still exist. These surveys summarize the views of

firm managers about constraints to investment and firm

performance, classified in terms of whether an issue is

considered to be “serious” or “very serious”. Figure 2

shows the most binding constraints reported in the five

countries. While the ranking is relative and may not be

comparable across countries, it does offer policymakers a

practical quantitative approach to prioritizing and

sequencing reform across a broad range of possible problem

areas. One clear result is that a single, one-size-fits-allapproach would not be sensible for the region. The range of

critical issues is as diverse as the countries themselves.

Fig. 2 Major investment climate constraints

0

10

20

30

40

50

60

Cambodia China Indonesia Malaysia Philippines

P e r c e n t

Macro Instability

Policy uncertainty

Corruption

Finance

Electricity

Skills

Regulation & tax admin.

Source: Investment Climate Assessments, World Bank.

Macroeconomic instability continues to be a concern for a

large proportion of firms in Cambodia, Indonesia and the

Philippines. Uncertainty about government policies or

regulations is also a concern for a substantial number of




firms in these economies, as it is in China.25. C orruption is

also an important concern in Cambodia, Indonesia and the

Philippines.. Corruption can often increase the uncertainty

of the business environment, it also has a major impact on

inflating the cost of doing business. Finally, firms in

Malaysia and, to a certain extent, China identified skills

shortages as an obstacle to their operations. Skills shortages

are a key barrier to higher innovation and investmentreturns.

a. Reducing Policy Uncertainty and Other Policy-

Related Risks.

Policy-related risks are risks stemming from policy

uncertainty, macroeconomic instability and capital markets,

and insecure property rights and arbitrary regulation.

Perhaps the most basic requirement for a strong investment

climate is to ensure a stable macroeconomic

environment . Even though macroeconomic conditions

have steadily improved since the shock of the 1997-98financial crisis, 50 percent of firms in Indonesia still report

concerns about macroeconomic instability as a major or

severe constraint, partly because of some further volatility in

inflation, interest rates and the exchange rate during the

post-crisis period. For example, the exchange rate fell quite

sharply and inflation rose in 2000 and early 2001, when the

credibility of the administration was damaged by financial

scandals and growing political tensions between the

legislature and the President. There is a growing body of

evidence documenting the powerful negative effects on

private investment and growth of high political and

economic instability26. In a sample of 79 countries over the

period 1960-2000 Hnatkovska and Loayza (2004) find that a

one standard deviation increase in volatility reduced annual

per-capita GDP growth by 0.7 percentage points. When the

fiscal or/and external balance is unsustainable, investors

anticipate higher implicit taxation or expropriation through

seignorage, default or banking crisis and adopt a “wait and

see” attitude. In addition, the country’s risk and interest

rates rise, further depressing private investment.

The firm level surveys report uncertainty about the

content and implementation of policies as one of the

leading investment climate constraints in several economies,

including Indonesia, China, Cambodia and Philippines. InIndonesia, 48 percent of firms are particularly concerned

about it, and in China one third of firms report the same

(although, as will be seen, they report fewer problems in

some specific areas that generate uncertainty in other

25 While the definition of policy-related risk does not

include political risk, it is important to note that political

stability is a pre-condition to a predictable policymaking.26 Economic instability is generally proxied by volatility in

various macroeconomic variables.

economies). Firms’ reluctance to invest under uncertainty

stems from irreversibility effects. Once an investment is

made, firms may get stuck with excess capital or low returns

if they misjudge demand, or if their very success makes

them a target for rent-seekers – i.e. for corrupt bureaucrats

and politicians. Drilling down, policy uncertainty is often

correlated with firms’ views about stable property rights and

about stable interpretation of government regulations.

Effective property rights will tend to increase productive

investment, as investors will anticipate being able to

appropriate the returns of their activity. Poorly defined or

ill-protected property rights, judicial manipulation or

outright crime amplify risks and dampen investment. As

shown in figure 3, countries with the lowest confidence in

the legal system are also those in which the investment rates

are lowest. Less than 60 percent of firms in Indonesia are

confident that their property rights can be protected. Foreign

investment has been particularly adversely affected by well-

publicized cases of highly arbitrary rulings in commercialcases before the courts. The rate is even lower in Cambodia

where less than 40 percent are. Importantly, even though

they report concerns about policy uncertainty in general, in

this specific area fewer Chinese firms lack confidence about

the protection of their property rights in practice. Property

rights, often used as proxy for institutions, have been shown

to be a “fundamental cause of long-run growth”(Acemoglu,

Johnson, and Robinson, 2004).

Fig. 3: Confidence that courts will uphold

property rights

(% of firms)

0 20 40 60 80 100

Cambodia

China

Indonesia

Malaysia

Philippines

Source: Investment Climate Assessments, World Bank

Consistent implementation of government regulations is

another source of policy uncertainty. In some countries, the

gap between formal policies and what happens in practice is




perceived to be large. As shown in figure 4, around 56

percent of firms surveyed in Indonesia do not believe the

interpretation of rules is predictable. This may to some

extent be an inevitable reflection of the great political

changes Indonesia has undergone in the last five years.

Policy making is now taking place in a brand new political

and institutional context, with powerful new players such as

the elected legislature and regional governments contestingthe previously almost unchecked power of the executive

over economic policy, with all players now also competing

for the favors of the electorate. The sooner policy making

and implementation settle down to predictable rules and

procedures, the better for business activity. In the

Philippines, another country where firms report high

concerns, studies often attribute policy uncertainty to

sudden changes in policies or regulations designed to

advantage a favored firm at the expense of its competitors,

as different branches or agencies of government vie for

access to bribes or to push the interests of different patrons,

or as firms seek special privileges and favors with respect to

large one-off concessions, infrastructure contracts or salesof public assets.27 Firms are more likely to start ma king

long-term investments when they are convinced that

government policy actions will follow predictable rules of

the game.

Figure 4: Firms that believe interpretation of

regulations is unpredictable (%)

0 10 20 30 40 50 60

Cambodia

China

Indonesia

Philippines


27 See, for example, Balisacan and Hill (2003) and

references therein.

Figure 5: Share of Management's time

spent dealing with officials (%)

0 5 10 15 20

Cambodia

China

Indonesia

Malaysia

Philippines


In China, implementation effectiveness and predictability is

less of a problem, and the main source of policy uncertainty

stems from the heavy regulatory burden. As shown in

figure 5, the representative manager spends nearly 19

percent of his/her total time dealing with red tape in China.

However, the burden does not appear to be shared equally

across regions. Firms in more advanced regions appear to

have lower regulatory burdens than less advanced ones. This

might create further divergence between rich and poor

provinces, and encourage the flow of capital to regions

where there is less red tape. In Cambodia, where this ratio is14 percent, the regulatory burden on firms is so heavy that it

overwhelms other visible deficiencies such as finance,

infrastructure, and human capital/skills.

Countries can mitigate some risks over the medium

term. Provisions to use foreign arbitration and special

commercial courts in case of conflict, for example, may

reassure a reluctant foreign investor to settle in a country

even if the efficiency of its overall judicial system is in

question. Also, developing better capital markets (bond

markets, leasing, credit rating agencies) could help diffuse

financial crisis risks. In high profile investments, such as in

infrastructure or mining, very detailed concession contracts

are one avenue to specify and allocate risk to the party best

able to mitigate it. But recent experience has shown that

even these types of contracts have their shortcomings and

are subject to re-contracting when conditions change

radically. New public-private approaches may be needed

for these types of projects.




Fig. 7: Bribe as Share of firm's sales (%)

0 2 4 6

Cambodia

China

Indonesia

Philippines

b. Reducing the cost of doing business

Costs associated with weak contract enforcement,

corruption, crime, unreliable infrastructure, and

burdensome regulations are powerful deterrents to

investment. The World Development Report 2005

estimates that these costs can amount to over 25 percent of a

typical firm’s sales ---or more than three times what it paysin taxes. For example, the cost of dispute resolution in thePhilippines is one of the highest in the world. In such legally

costly environments, firms prefer contracting and

partnership arrangements that restrict exposure and lower

the cost of exit. As a consequence there are lower levels of

technology transfer, lower supply of capital, and slower integration into production networks.

Reducing the cost of starting and operating businesses.

The cost of registering a business is prohibitive for some

countries, coming close to 500 percent of per capita income

in Cambodia or close to 150 percent in Indonesia. Also, as

shown in figure 6, the cost of registering a property can

exceed 5 percent of the value of the property in the

Philippines and Indonesia.

Curbing Corruption is also likely to be an important

element in improving the investment climate. While on a

world scale the region may not be the most corrupt ---East

Asian countries rank in the bottom half (least corrupt) of the

distribution across all countries studied by the World Bank,

the issue is serious enough to warrant analysis and scrutiny.

In Cambodia, around 55 percent of firms find corruption a

key problem, 41 percent in Indonesia, 35 percent in the

Philippines. Corruption is bad for investment and growth

because of the direct cost of bribes (Figure 7) and also because of the corrosive impact of corruption on

discriminatory rules and other forms of rent-seeking and

state capture.

Figure 6: Cost of registering a property as

% of property value

0 2 4 6 8 10 12

Cambodia

China

Indonesia

Korea, Rep

Lao PDR

Malaysia

Mongolia

PNG

Philippines

Thailand

Vietnam

AVERAGE

Source: Doing Business Database, World Bank

In Cambodia, firms report paying up to 6 percent of their

sales in bribes, over twice that of Bangladesh and by far the

highest among all Asian comparators28. Indonesia and the

Philippines also report rates higher that 4 percent. Given the

fact that the average operating income is only 5-10 percent

in most competitive environments, the impact of bribes can

be very substantial. One consequence of pervasive

corruption in Cambodia is little long-term investment in productive assets outside of protected sectors. Ultimately,

firms prefer to remain small and informal, denying the

government revenues, and reinforcing low civil service

salaries and poor public sector regulatory performance,

which in turn contributes to weaknesses in the investment

climate. There is a growing body of evidence documenting

the powerful negative effects of corruption on private

investment and growth. For example, Taduran (2000)

estimates that a reduction in corruption in the Philippines to

the low levels prevailing in Singapore would raise the ratio

of investment of GDP by 6.6 percent and the rate of annual

per-capita GDP growth by 1.65 percent. Also, results

obtained on firm-level data suggest that Chinese firms thatreport having to offer informal payments to obtain loans had

significantly lower productivity levels and labor growth

rates, see World Bank (2002, China ICA).


Better infrastructure, especially reliable power supply, is

perceived as a major issue in the Philippines and, to a lesser

degree in China and Indonesia. In the Philippines the costs

28 Of all countries surveyed by the World Bank, bribes

average more than six percent of sales only in Algeria and

Nicaragua.




associated with unreliable electricity supply alone amount to

around 10 percent of a typical firm’s sales (figure 8). This iscomparable to India and Kenya. Public investment in

infrastructure has been declining in the Philippines, and at

less than 3 percent of GNP is one of the lowest in the

region. The country ranks low for most infrastructure

indicators. The World Economic Forum ranked it 68 out of 75 countries in the overall quality and sufficiency of

infrastructure. With respect to its Asian neighbors, the

country’s rank in terms of service delivery is 8 out of 11 in

the quality of electric supply, 6 out of 12 in telephone

subscribers per 100 people, and 6 out of 12 in total road

network. Problems arising from exercise of monopoly

power also contribute to the high cost of inter-islandshipping. Increasing investments in the physical

infrastructure by revamping and rethinking Private

Participation in Infrastructure (PPI) should be considered.

Figure 8: Losses from electricity

outage as a % of sales

0 2 4 6 8 10

Cambodia

China

Indonesia

Malaysia

Philippines


High interest rates are a major concern in some of the

smaller countries in the region. There is ample empirical

evidence suggesting that inadequate access to finance, and

high real interest rates, are harmful for investment and

growth (Beck et al. 2004). In East Asia, Mongolia, Lao PDR

and Cambodia have the least buoyant private sectors and thehighest real domestic interest rates29 (Figure 9). Mongoliastill has the highest rate in the region, despite a noticeable

decline from 27.4 percent in 2002 to 18.4 percent in the firstseven months of 2004.

29 The interest rate is calculated from IFS (2004) as the

lending rate - CPI (inflation). The interest rate for 2004 is an

average of the first seven months of the year.

Three main reasons might explain the high lending rates in

Mongolia. First, the real funding cost is high. Comparedwith other East/Southeast Asian countries, Mongolia's

national savings rate is low (18 percent), and so is its

financial intermediation (financial sector assets total about

57 percent of GDP). In addition, the liberalization of the

banking system has resulted in a large number of financialinstitutions (16 commercial banks, more than 100 NBFIs,

and numerous credit cooperatives, etc.), fiercely competing

for the very limited pool of savings. Financial

intermediation is not efficient. The real level of non-

performing loans (NPLs) may be much higher than what is

reported, and operating expenses are rising rapidly. Weak

banks need a large margin to survive and cover their costs.Lending remains a high-risk business. The society's credit

culture is weak, and so is the legal and regulatory

framework that is supposed to encourage a strong credit

culture. Penalties for defaulting are low and not

systematically applied. Banks’ risk management capacity isalso weak, and the usual practice is to keep high liquidity.

In the Philippines, high public sector debt and deficits may be generating some crowding out of the private sector.

Access to external private finance is limited by country risk

factors. High spreads on sovereign bonds—the highest in

the region—make external borrowing difficult for all but a

handful of private firms. Domestic capital markets and

nonbank financial institutions are underdeveloped and

concerns about corporate governance and sanctity of

contracts inhibit risk capital and joint ventures.

Fig.9: Real Interest Rate (Lending Rate, %)

0.0

5.0

10.0

15.0

20.0

25.0

C a m

b o d i a

C h i n a

F i j i

I n d o n e s i a

L a o P D

R

K o r e a ,

R e p

M a l a y s i a

M o n g o l i a

P N

G

P h i l i p p i n e s

S a m

o a

S o l o m

o n s

T o n g a

T h a i l a n d

V i e t n a m

Average 2001-2004

Source: IFS (2004), IMF.




c. Reducing barriers to innovation and higher returns to

investing

In some cases, low investment rates can be explained by

policy distortions that limit the supply of complementary

production factors such as human capital or access to

technology and innovation, thereby driving down private

rates of returns on capital.

Ensuring the appropriate supply of skills that match an

employer’s desire to upgrade technology is critical to

increasing investment returns. In Malaysia one out of four

firms surveyed identify the skills and education level of

workers as a major obstacle to their activity. The ratio is

even higher at one in every three in China (Figure 10). The

complaints of firms about skills shortage are consistent with

analyses of the return to education, return to training, and

trends on unemployment (World Bank, 2003). Results

provide strong evidence that fast growing economies face

tensions at the high end of their labor markets, resulting in

high wage premiums to workers with tertiary education andto those who have received firm-specific training, leading

correspondingly to lower returns to capital. In Malaysia, the

return for tertiary education is nearly 18 percent versus 9.5

percent for secondary education and only 4.5 percent for

primary education. This reflects the extent of skills

shortages and the high value managers’ place on skilled

workers.

Fig. 10: Managers ranking labor regulation

and skills as major constraint (%)

0 10 20 30 40

Cambodia

China

Indonesia

Malaysia

Philippines

Labor

regulation

Skills


For fast growing economies, potential benefits from

relaxing the skill constraints are large. Relaxing the

skills constraints can provide large benefits. In the case of

Malaysia, it could raise the sales of most industries by an

average of 11 percent.

Fostering a country’s innovative capacity can boost

returns on investment. An alternative way to increase

returns is to encourage innovation. There are three key

ingredients that drive a nation’s innovative capacity: ideas,

clusters and networking, and national innovation systems. InMalaysia, while firms are technologically active in terms of

adopting and adapting new technologies, they are weak in

technology creation and innovation. Indeed, few firms

report activities to facilitate innovation. Only 20 percent of

manufacturing firms and 12 percent of services firms report

any R&D activity. Only 11 percent of manufacturing firms

file patents or copyright materials. An alternative way to

boost innovation is to encourage competition. High

competitive pressure on firms’ benefits consumers helps

drive productivity improvements, and can increase the

likelihood of innovation. The WDR 2005 estimates the

change in the likelihood of innovating at more than 50

percent. Given the complementarities between skills andtechnology, further improving the quality of the educational

output in EAP countries could help reducing skills shortage

and, to a large extent, weak innovative capacity.

IV. Conclusions

This paper asks what governments in the EAP region can do

to accelerate private investment growth. Results of the

investment climate assessments conducted in the region

suggest that in Indonesia and Philippines, policy-related

risks seem to be the most binding constraint to investment.

Upholding property rights, reducing the regulatory burden,keeping the commitment to the current rules of the game

and reducing macroeconomic instability would help. In

countries such as Philippines and Cambodia, the high cost

of doing business stemming from poor governance and

corruption, and poor physical and financial infrastructure

appear to be holding back investment. Revamping

investment growth would require curbing corruption,

ensuring a reliable supply of power, and better access to

finance. In Malaysia and, to a certain extent, in China, skills

shortages appear to be a key impediment to higher

innovation and investment returns. Further improving the

quality of the educational output could be critical in

boosting returns to investment and accelerating private

investment recovery.

These results indicate that “investment climate” issues are

diverse. Consequently, some prioritization is needed for

each country. A quantitative survey is one instrument that

can help sort out the priorities, but ultimately the quality of

a public-private dialogue is crucial to this process, and must

be followed up by a determined political commitment to

reform that might cut across several different government




agencies. Coordinating this change process to ensure

impact is a further challenge for governments across the

region.

This Special Focus was prepared by AlbertZeufack, World Bank East Asia PREM, drawing

on inputs from investment climate teamsthroughout the region, as well as from the WorldBank World Development Report 2005 team.




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