Malaysia’s main challenge in 2009 will not be the global financial meltdown. Rather, it will be continued grandstanding between the ruling coalition and, since March 8th 2008, a much stronger opposition. The aftermath of March 8th, 2008 produced a lame duck Prime Minister with a lame duck government. The Prime Minister, Ahmad Badawi, instead of gracefully resigning for leading the United Front (Barisan Nasional) to its worst ever electoral results, stubbornly held on to the party presidency and Prime Ministership of the country.

However, members from within his party (United Malay National Organisation – UMNO) and the United Front were calling for his resignation. Simultaneously, the newly constituted opposition coalition – The Peoples Coalition (Pakatan Rakyat) led by the charismatic Anwar Ibrahim, was threatening to overthrow the ruling government through mass defection.

The lame duck Prime Minister, after intense pressure has agreed to step down in March 2009 as part of a transition plan. The current Deputy Prime Minister, Najib Tun Razak will then take over as the next Prime Minister when he is voted in at the next UMNO general assembly. Although, this plan was supposed to have improved confidence in the ruling government, the reverse has actually taken place as there exist serious doubts on the credibility of Mr. Najib as he has too many skeletons in his closet. Meanwhile, Anwar Ibrahim and the Peoples Coalition continue to threaten to topple the government.

The above situation has shifted the politicians and bureaucrats focus away from managing the country to gaining political mileage. Debates in parliaments have focused on scoring political points and not on critical issues, save a few. Policymaking has been reduced to blackmailing the citizens. A case in point was the presentation of the economic recovery plan by the Deputy Prime Minister who is also Finance Minister. The oppositions staged a walk-out of Parliament when the Finance Minister refused to answer their questions. The Deputy Prime Minister has since come under heavy criticism for providing a weak fiscal stimulus plan amounting to RM7 billion (approximately US2 billion) that is deemed to be insufficient and insinuations that it would only benefit the ruling parties cronies. However, the opposition’s proposal of RM50 billion (approximately US14.3 billion), led by the Democratic Action Party (DAP) is clearly a populist strategy. Among the recommendations were:

• RM 6,000 annual oil bonus to all families earning less than RM 6,000 a month or RM 3,000 annual bonus to bachelors earning less than RM 3,000 a month;
• Progressive reduction of corporate tax rate from the present 25per cent to 17per cent;
• Daily revision of petrol prices to take into account of changes in the international price of oil;
• Immediate reduction in gas prices as well as electricity tariffs, which was increased by 26per cent for businesses when the price of oil was USD 124 per barrel to reflect in the drop to around USD 50 per barrel; and
• An additional RM 2 billion wireless project to make all the major towns and cities in Malaysia wifi so that as many Malaysians as possible can be connected to the Internet.

While expansionary policies are a necessary response to the financial meltdown, the recommendations seem to focus on pleasing the public rather than sound economic deliberation. It is important to note that Malaysia has been running a fiscal deficit since 1998.

Sound policymaking in Malaysia may still be an illusion as Mr. Najib deals with the fallout from the by-election on January 17th, which threw serious doubt over his bid to be crowned Prime Minister. He also has to demonstrate to UMNO that he is not weak and will not give in to the demands of the non-Malay political parties in the National Front who now are themselves fighting for their political survival. At the same time, Najib must attempt to restore the peoples confidence in him in the light of serious allegations of foul-play and corruption. It is therefore unlikely, that the global financial crisis will be a priority for politicians in Malaysia for the year 2009.

–

Gregore Lopez is currently pursuing a PhD in Economics at Australian National University and blogs at greglopez.wordpress.com. He also volunteers as the Editor of the Malaysia section of New Mandala.

This is part of the special feature: Reflections on developments in Asia in 2008 and the year ahead

1. Malaysia: the political tide runs out
2. Return to higher principles in Malaysian politics
3. Malaysia: a year of economic and political reversals

The Paris-based International Energy Agency’s (IEA) recent report includes revised forecasts for world oil demand in 2009. IEA’s shocking estimate is that global demand for oil in 2009 will decline by half a million barrels per day (bpd) than in 2008! This is based on the IEA’s estimates that global economic growth will be a mere 1.2 per cent for all economies after being revised downwards from the nearly 3 per cent forecast earlier.

This implies that OECD economies will post a negative growth in 2009 and emerging economies are also likely to achieve only moderate GDP growth. China is expected to grow only at 6.5 per cent, the lowest rate in eight years, despite the massive stimulus that the authorities announced at the end of last year. Given the weakness in Chinese and US demand¸ global oil prices are likely to remain extremely soft this year.

What are the implications for India?

First, the reality of an unprecedented global economic downturn and absence of any recovery in 2009 should now be recognized. The impact on India’s economic prospects for this year and the next should be carefully and urgently worked out.  There is currently lack of real appreciation amongst Indian policy and opinion makers of the severity of the global economic downturn. Some, like Surjit Bhalla, continue to insist that India’s economic performance in 2009 will be better than in 2008. This is dangerous because it diverts attention from the measures that need to be taken to try and mitigate the impact of the global downturn and prevent domestic demand plummeting. The implementation of public sector infrastructure projects needs to be put on a mission mode. If the previous home minister can held accountable for the Mumbai debacle, those in charge of infrastructure and economic ministries should also be held accountable for their poor performance and compromising the country’s economic security Better to take action now, rather than wait for the young, educated and unemployed taking to the streets. It does not take long for demographic dividend to be converted to a demographic crisis.

The second implication is that the government needs to use this window of low global oil prices to take the much needed step of decontrolling the prices of petroleum products. This will remove, once for all, this vexed issue from the realm of partisan politics. There is a cabinet decision of May 2003 to dismantle the administered oil price mechanism. This was held in abeyance first by the NDA government and thus by the present government. It is disingenuous to argue that dismantling oil price controls will harm the poor. Deserving beneficiaries, who do not by any stretch of imagination include motorcycle and car owners, can be easily protected by properly targeting the subsidy through either cash transfers or a system of smart ration cards. These will permit them to secure their supplies of kerosene and LPG at lower prices from all designated outlets that would be directly subsidized by the government. Price decontrol, along with the assurance that it will never be brought back, will attract domestic and foreign investment in all the segments of the petroleum sector. Getting rid of oil price controls will contribute to improving the investment climate directly and also boost business confidence in general. So this should be announced now, along with a further price cut.

The third implication is that the economy needs to be closely monitored so there is advance action rather than a reactive response to worsening conditions. In the unfortunate absence of a full-time finance minister, a mechanism should be established under the Prime Minister to monitor the implementation of the stimulus package and also to undertake some much needed reforms. Such monitoring would for example have revealed that non-food credit has actually contracted both in November and December. The contraction has been of the order of Rs 30000 crore compared to October levels. On Friday 16 January, commercial banks parked nearly Rs 39 000, under the reverse repo window, which is more than seven times the amount (Rs 5035 crore) borrowed from the RBI at repo rates. This amply demonstrates commercial banks inability or unwillingness to advance credit. It is important at this stage for the RBI and the government to discuss with the banks the reasons that are preventing banks from advancing credit despite the liquidity that is now at their disposal. Simply ordering the banks to lend more will only increase the share of directed lending which inevitably results in rising levels of non-performing assets. RBI needs to explain the reasons for which it still pays a 4 per cent interest on funds parked with it when it wants the banks to lend more. And the government should immediately consider lowering the guaranteed returns on small savings and employees provident fund so that the cost of deposits can be brought down. There will hardly be any recovery without bringing down the cost of capital for the large body of investors, especially small and medium enterprises.

This is part of the special feature: Reflections on developments in Asia in 2008 and the year ahead

1. India faces an ugly environment in 2009
2. The old ghosts of India show their faces again
3. India: Confronting the Global Financial Crisis

The recession now present in advanced economies seems set to continue for a while yet.

The annual Neemrana conferences on the Indian economy provide a valuable opportunity to take stock of the state of the US and world economies, and the implications of global developments for the Indian economy.

The conferences are held annually at the Neemrana Fort Palace hotel in Rajasthan. They are co-hosted by NCAER and ICRIER. International (primarily US) participation is organised by the NBER, arguably America’s most respected network of academics engaged in research on issues of economic policy. The format is designed to encourage informal, off-the-record discussion on a range of current issues in economic policy.

This year marked the tenth anniversary of the conference, amidst the most challenging environment the global economy has faced in that decade. Despite the roaring boom of the past few years, past conferences had repeatedly warned of the unsustainability of two structural trends, namely the size of the US current account deficit and the decline in the US household savings rate that lay behind it. However, the depth of the crisis in the US financial system and economy, and its global impact was difficult to anticipate even as recently as a year ago.

Prior to the conference, my initial assumption was that the worst was probably behind us as far as the slowdown in the major economies was concerned. The discussion at the conference, particularly with regard to the US and European economies, suggested that this was no more than wishful thinking, and that considerable pain lies ahead. (There was relatively little discussion of the prospects for the Japanese and Chinese economies, but these are unlikely to improve the picture.)

Quite apart from the overall assessment of the short-term outlook, however, was the nature of the analysis that led to these sombre conclusions. In the case of the US, the underlying mechanism at work is a massive re-pricing of risk by financial institutions following the unexpectedly high default rates on sub-prime mortgages that began to be evident some two years ago.

This repricing of risk has led to the destruction of household financial wealth in the two principal assets held by American households, residential real estate and equities. Between these two, the estimated reduction in overall household wealth is of the order of ten trillion dollars.

Historical estimates suggest that this would lead households to cut back their consumption by around 4 per cent of their reduced wealth, just as the past enhancement of this wealth led to major increases in consumption during the boom. The estimated cutback in consumption alone represents a negative ‘demand shock’ of approximately 2.5 per cent of US GDP, or $400 billion.

Compounding this withdrawal of demand is the slowdown in housing construction: a million fewer housing starts represents a further withdrawal of some $200 billion in demand. So the ‘demand gap’ that needs to be filled just to replace these two sources is in the order of $600 billion on an annual basis, without taking into account other destruction from demand either in terms of (net) exports or reduced corporate investment, both of which are likely under present conditions. The only silver lining is the relief household budgets will receive as a result of lower fuel prices.

Under normal circumstances, both monetary and fiscal policy would be available to offset such sharp ‘autonomous’ decreases in final demand. Unfortunately, despite Herculean efforts by the Federal Reserve, monetary policy is not generating any traction because of the seizure in the credit markets, itself largely related to uncertainties on the valuation of housing-related securities.

No effective floor has so far been placed under house prices, despite several proposals to do so. The impact of house price declines on the balance sheets of financial institutions is enhanced in the case of the US by the fact that, in most states (and unlike the situation in other advanced countries), mortgage loans are ‘non-recourse’: that is to say, they are only secured by the value of the house, and are not secured by other assets of the borrower. Approximately 25 per cent of all houses with mortgages are now worth less than the value of the mortgage that they bear, encouraging homeowners to surrender their homes and walk away from the loan. This additional supply further depresses prices. So there is no immediate reason to see a return to normality in US credit markets, at least not until a floor is found, or is placed, under housing and equity markets.

The past and likely future inefficacy of monetary policy therefore puts the entire burden for replacing the ‘missing demand’ on fiscal policy. Yet the prospective design of the Obama fiscal stimulus package came in for criticism both as to its scale and as to its composition. If the advertised figure of $775 billion over two years is accurate, then on an annual basis the injection of demand is only half as large as is needed. To the extent that a portion of the relief is in the form of temporary cuts in income taxes, recent evidence suggests that such cuts tend to be saved rather than spent, particularly in an environment where households are busy rebuilding their balance sheets. If the demand ‘hole’ is not adequately plugged, then second-round multiplier effects could worsen the downturn.

The US remains central to the global recovery. The story from Europe is gloomy for many of the same reasons but also for two additional ones. Several of the smaller countries have very high levels of debt already and are likely to be penalised by the markets for expansionary fiscal policy. And members of the Eurozone lack the instrument of exchange rate adjustment. There is the additional factor that the leading European economy, Germany, which does have fiscal space, remains unconvinced of the efficacy of fiscal stimulus.

Finally, despite G-20 protestations to the contrary, there is considerable expectation that protectionist tendencies are likely to intensify in this global climate. All in all it is an an ugly environment for India to face as it struggles with its own issues of internal security, corporate governance and general elections. Welcome to 2009!

–

Suman Bery is the Director General of the National Council of Applied Economic Research, New Delhi. He serves on the Central Board of the State Bank of India, India’s largest bank and has been a member of several government committees and task forces.

This is part of the special feature: Reflections on developments in Asia in 2008 and the year ahead

1. India faces the harsh reality
2. The old ghosts of India show their faces again
3. Malaysia’s progress in a gloomy global economy and contested political environment

Vietnam began the year 2008 with high expectations. There was exuberance at the admission to the WTO and record growth of 8.5 per cent was recorded in 2007. The government set an even higher target in 2008, aiming for growth at 8.5-9 per cent.

Events took a seemingly unexpected turn. Signs of overheating, already evident at the end of 2007 amidst the asset bubble and rising inflation, became more and more visible towards the end of the first quarter.

The VN index lost almost 45 per cent of its value in just the first three months. The CPI was already running at 9.2 per cent for the first quarter, corresponding to a year-on-year rate of nearly 20 per cent, much higher than in neighbouring countries. Inflation rose from month to month and peaked in August, when the year-on-year rate reached 28.3 per cent.

To some extent, the price hike resulted from the surge of world prices, especially food and fuel prices. With a very open economy and a stable exchange rate, price rises in international markets were transmitted directly to domestic prices. Vietnam still maintains controls over prices of some essential goods and services, but the evidence shows that there were close correlations between the movements of international and domestic prices in controlled commodities.

The overall increase of world prices aside, the macro turbulence in Vietnam in the fist half of 2008 was essentially home-made. Policy responses were slow and not directed at the factors behind the price hike in 2007. Of particular concern were the large inflows of foreign indirect investment and the extraordinary (and related) high rate of credit growth.

In March 2008, the year-on-year rate of credit growth reached 63 per cent, driven largely by excess liquidity and speculative investment in the stock market and the real estate sector. Massive capital inflows caused upward pressure on the Vietnamese Dong, which threatened to reduce the competitiveness of exports. In response, the State Bank of Vietnam (SBV) bought more than 10 billion U.S. dollars in a single year and consequently injected large amount of cash into the economy.

Vietnam was thus confronted with the ‘impossible trinity’ of simultaneously trying to maintain a virtually fixed exchange rate, an open capital account, and an independent monetary policy. Attempts to sterilize interventions in the foreign exchange market did not succeed and the accumulation of reserves led to an expansion in the monetary base.

A potential adverse impact of high inflation in the presence of stable nominal exchange rate is the loss of competitiveness for the Vietnamese economy against its trading partners. As inflation in Vietnam was much higher than in its main trading partners, there was a significant appreciation the Vietnamese Dong in real terms. There was also the threat of a widening trade deficit, already at 15 per cent of GDP in 2007, and weaker export growth.

High inflation and the resulting instability prompted the government of Vietnam to act and, in March 2008, a stabilization package was launched. The package saw a switch in priority from high growth to stability and included credit tightening, spending cuts and above all, a reduction in the growth target to 7 per cent, much lower than the initial figure set at the end of 2007. Credit growth was to be brought down to 30 per cent in 2008 by a number of measures, notably the sharp increase in the benchmark interest rate, from 8.75 to 12 per cent in May, then 14 per cent in early June. Greater flexibility was also imposed on the exchange rate.

The package also included contractionary fiscal policy measures such as cutting government spending, cancelling inefficient public investment projects and postponing new projects. By May 28, ministries, provinces and the state economic groups had reportedly decided to postpone, delay or stop nearly 1000 projects, equivalent to 7.8 per cent of the total investment budget.

The stabilization package seemingly worked well in dampening the overheated economy. Credit growth was brought under control. The three month moving average of CPI declined rapidly after May and the consumer price index declined after October.

Yet as Vietnam barely struggled out of the home-made turbulence, the world financial crisis caused the broader economic environment to deteriorate dramatically. Like many other open developing economies, Vietnam was inexorably engulfed by the crisis. The adverse effects of the global downturn were visible in the last few months of 2008. Exports declined in 3 consecutive months after September 2008, and only increased slightly in December. Although FDI commitments reached a record of US$ 64 billion, three times those of 2007, FDI disbursement has slowed in recent months. Perhaps the most visible effect has been seen in manufacturing employment. Reports from a sample of 461 firms in Ho Chi Minh City showed that more than 20 per cent of the workers of these firms have already lost their jobs. Nonetheless, the number of reported strikes increased rapidly in 2008.

Against the backdrop of a global recession, an expansionary package was introduced at the end of 2008. Loosening monetary policy saw interest rates cut to 8.5 per cent over a short period of time. A stimulus package of US$6 billion was proposed that includes substantial tax reductions and investment in infrastructure. Important social protection measures, including introduction of unemployment benefits and a 50 per cent increase in the poverty line, were part of the package. The consensus, however, was that appropriate intervention should have economic stability as the first priority. Inflation remained high at 23 per cent in 2008, and the stimulus package should avoid causing another wave of price surges.

Overall, Vietnam performed relatively well in 2008. GDP grew at 6.23 per cent and registered FDI reached a record high. Exports grew much better than those of neighbouring countries, at nearly 30 per cent, even though the increase in world prices played an important role in this achievement.

This year will be more challenging for Vietnam.

The crisis in 2008 revealed serious structural weaknesses in the economy. Vietnam is an economy in which growth is still highly dependent on external demand and external financing. With high levels of current budget deficits, trade deficit and inflation, and decreasing oil revenues, the room for manoeuvring aggregate demand is likely to be limited. The hotly debated stimulus package barely touches upon these structural weaknesses, and is likely to foster inefficiency and waste public resources if not properly designed and implemented. Above all, the delayed and ad-hoc responses to overheating and price overshooting, and conflicting stimulus package proposals are all evidence that Vietnam still lacks an effective mechanism for informed and systematic policy-making.

–

Quang Doan is Senior Economist at the World Bank and was formerly Senior Research Fellow at the Vietnam Academy of Social Sciences, Hanoi.

This is part of the special feature: Reflections on developments in Asia in 2008 and the year ahead

1. Vietnam: Balancing growth and stability in a more market-oriented economy
2. Vietnam sails through the crisis but needs reform to sustain the growth
3. Managing the risk of inflation during economic recovery – the case of Vietnam

Against a backdrop of quarter-by-quarter falls in the country’s economic growth rate, 2008 was more about rare economic highlights than milestones.

In early 2008, Malaysia’s last two economic corridors, the Sabah Development Corridor and the Sarawak Corridor of Renewable Energy were launched to bring further social and economic development to the economically backward states of Sabah and Sarawak in East Malaysia. These economic corridors, including the three launched earlier in Peninsular Malaysia – Iskandar Malaysia, the Northern Corridor Economic Region and the East Coast Economic Region – aim to ensure a more regionally balanced socio-economic development of the nation. There are, however, criticisms of the speed of implementating projects.

In early June the government announced that it would remove controls on the price of petrol and allow fluctuating prices; a move that was unprecedented, given that the surge in global oil prices resulted in a ballooning fuel subsidies bill. Petrol subsidies were not totally removed, only decreased, and petrol pump prices were revised from time to time to reflect market price movements.

In December, the government announced that it would set a ceiling price at RM2.70 a litre, and give a subsidy of 30 sen per litre if the market price moved above RM1.90 a litre. Any fall in the market price to below RM1.90 a litre will result in the imposition of a tax, the quantum of which is still being discussed.

The central bank’s Overnight Policy Rate was kept at 3.50 per cent over the first three quarters of 2008, even though GDP quarterly growth had been moderating successively, from 7.1 per cent to 6.7 per cent to 4.7 per cent. In November, the central bank finally reduced its OPR by 25 basis points to 3.25 per cent.

Recently published third quarter data indicate that the country’s overall balance of payments recorded a deficit of RM31.5 billion, as compared to a surplus of RM26.2 billion in the previous quarter. This deficit was due largely to a significant drop of RM61.5 billion in the capital and financial account. In the previous quarter, the drop had been just RM12.3 billion. The current account balance, on the other hand, remained positive with a surplus of RM38.7 billion, a slight increase from the surplus of RM37 billion recorded in the previous quarter.

The fuel subsidy cut in June resulted in inflation soaring to 7.7 per cent in that month, compared to 3.8 per cent in the previous month. Compounded by escalating food prices, the inflation rate rose further to 8.5 per cent in July. By November, the inflation rate eased to 5.7 per cent.

In November, Malaysia finally announced a 7 billion-ringgit economic stimulus package to avert recession in 2009. The package has been criticized by some quarters as too late, and too little to adequately contain the impact of the global economic crisis on Malaysia. Criticism has also been leveled at how the 7 billion ringgit will be spent, as the package will go mostly to towards the construction and upgrading of low-cost housing units, schools, roads and public amenities.

Political tsunami

The results of Malaysia’s 12th general election on 8th March 2008, which has been hailed as a ‘political tsunami,’ a ‘political near-revolution’, and one that its citizens will be talking about for years, revealed an immense groundswell of public opinion against the ruling government and/or a rejection of race-based politics. Liberals regard it as a new dawn for democracy in Malaysia, a positive move towards constructive political development, and good for the nation’s long-term future.

For the first time since Malaysia gained its independence in 1957, the ruling coalition government lost its crucial two-thirds supermajority, which for a long time had enabled it to amend the constitution at will to its own advantage. On top of that, the government lost five of 13 state legislatures, as compared to only one in the 2004 election.

For the quiet Malaysian, the political change had been long in coming. There have been persistent complaints that the government has not done enough to tackle massive institutionalized corruption, issues of poor governance, non-tranparency, ethnicised politicking, and religious and ethnic insensitivities. Many share the view that the government has lost touch with the very people who voted them in.

The message of the loose coalition of opposition parties was loud and clear: that they are a viable alternative, and would tackle the issues uppermost in people’s minds. The success of the opposition alliance can be attributed to its ability to use new technologies such as blogs, mobile phone text messages and YouTube during the 2008 election, a milestone in Malaysian politics, to circumvent tight media control by the government.

Malaysia appears to have been forced by the success of the opposition parties in the 2008 election to embark on a bout of democracy. Already there are signs of change within the ruling coalition, as change will be necessary to its continued political survival.

But after a half century in power, it is hard to change, and there is much internal resistance to it, so UMNO’s days may at last be numbered.

–

Quah Boon Huat is a research fellow at the Malaysian Institute of Economic Research (MIER). Prior to joining MIER, he worked in the banking and stockbroking industry.

This is part of the special feature: Reflections on developments in Asia in 2008 and the year ahead

1. Economic and political developments in Malaysia: new players new game?
2. Malaysia: the political tide runs out
3. Politics without priorities in Malaysia

China enters 2009 in a vastly different situation from what it was in a year ago. At the beginning of 2008, the biggest macroeconomic challenges were overheating and inflation. Now, they are a slump in growth and deflation.

This sea change within a matter of 12 months had no single cause. The People’s Bank of China (PBOC) continued to tighten monetary policy aggressively during the first half of 2008, including significant rate hikes and rapid currency appreciation, in order to control inflation. But global recession was probably a far more important contributor to the reversal of China’s macroeconomic trend. Since mid-2008, industrial production has decelerated sharply, power generation has collapsed, and even the growth of exports turned negative in recent months. The Purchasing Managers’ Index (PMI) already pointed towards a deep manufacturing recession in China.

The latest data have prompted many market economists to revise down significantly their 2009 GDP forecasts. This is probably an overreaction. First, current headline production and GDP data overstate the slowdown in underlying demand. Growth of fixed asset investment has only moderated slightly, growth of retail sales held up quite well, and trade surpluses actually surged. According to the Deputy Governor of PBOC, Yi Gang, the difference is explained by inventory adjustment. Given the collapse of commodity prices and the darkening clouds surrounding the economic outlook, companies began to slash their material inventories, leading to faster slowdown in production than in demand. Once inventory adjustment ends, probably during the first quarter of this year, according to Yi Gang’s estimation, production could rebound sharply.

More importantly, the government still has the will and capability of supporting growth at around 8 per cent. Some economists have argued recently that the Chinese government won’t be as successful as 10 years ago because now 37 per cent of the economy is directed to exports and 60 per cent of the economy is accounted for by the private sectors. It is true that the Chinese economy is a lot more market-oriented today. But that by no means implies that the state’s ability to influence economic activities has diminished significantly. The state still controls 43 per cent of fixed asset investment and 60 per cent of banking assets. Fiscal revenues as share of GDP increased from 11 per cent in 1997 to 21 per cent 2007. In early November, the State Council announced a package of RMB4 trillion to stimulate domestic demand in 2009-2010. In the following months, provincial governments proposed investment plans totaling Rmb25 trillion, which is equivalent to 100 per cent of 2007 GDP.

All recent official statements confirm that maintaining 8 per cent growth has become a political as well as economic policy priority. And we can be confident that the government can achieve this goal, at least for the next year or two.

This sounds like a very positive story. But that’s not the end of it. The government should be able to support growth, but it won’t be able to support profits or income. In fact, deflation is likely to return and haunt China again in 2009. During the past 10 years, China suffered from a deflation problem twice – first during the 1998 Asian financial crisis and second following a mild recession in the U.S. in 2001. During both episodes, deflation was directly caused by collapse of export growth and emergence of overcapacity. If the same causation still exists, then we are likely too see much more serious deflation in 2009 — not only are exports a much greater component of GDP, but the collapse of external demand will be more severe and broad-based.

Deflation can create room for more aggressive policy easing. But it’s bad for profits, investment and, therefore, employment and income. In other words, we are likely to see a soft landing in headline growth but a hard landing in corporate earnings. It will be tough for investors, who will likely need to focus on those GDP proxies (such as utilities), low-income elasticity items (such as consumer staples) and beneficiaries of stimulus packages (such as commodities).

Unfortunately, the biggest challenge will probably occur after 2010. Essentially this is because the current stimulus packages are likely to be effective in supporting growth, but are probably sub-optimal in improving growth quality. For years, the government has been trying to rebalance the growth model, reducing reliance on exports and investment. But of the RMB4 trillion announced by the State Council, at least three quarters of the package are for investment projects (RMB1,800 billion on railways, highway, airports and power grid, RMB1,000 billion for post-earthquake reconstruction Rmb280 billion for low-rental housing). The RMB25 trillion projects proposed by provincial governments are almost exclusively for investment expenditures.

The massive spending will surely ensure the government’s 8 per cent growth target will be met. But it may bring its own problems. First of all, the massive increase in investment is likely to make China’s growth model even more unbalanced. Of course China still needs more infrastructure, but imagine what happens if it invests an amount equivalent to the size of 2007 GDP within two years, not to mention the inefficiency, waste, bad planning and even corruption problems. More importantly, this kind of stimulus package is not sustainable. So the ideal scenario is that the world economy recovers before the stimulus packages end. Then the export engines can operate at full speed again. And GDP growth can return to high gear.

There is one small problem. After this crisis,  import demand from the US is likely to fall. As Citigroup forecasts, the US household saving rate is expected to rise from around 1 per cent last year to 5-6 per cent over the next two years, while the US current account deficit may fall from 4.5 per cent of GDP to around 2 per cent. This could mean that China may not be able to export as much as it used to before the crisis. And in order to maintain rapid growth, China will again be forced to turn to boosting domestic demand. China and other Asian economies were able to export their way out of recession after the 1998 Asian crisis, but they won’t be able to do the same this time around. For all these reasons, the government needs to focus more on boosting consumption than on promoting investment during the current round of stimulation.

A minimum 8 per cent growth has become the universally accepted target in China. It has almost become a religion – everybody believes it, but nobody can explain exactly why. The most authoritative answer is social stability. In order to maintain social stability, China needs to create 10 million jobs (inclusive of 8 million new labor market entrants) every year, and that translates into 8 per cent growth.

This argument has a number of problems. Firstly, the correlation between job creation and GDP growth is clearly non-linear, depending on the structure of economic growth. Building railways and highways do not really create many urban jobs, and certainly not sustainable urban jobs. And during the 1990s, new job market entrants were about 8 million a year. New entrants fell to about 5 million during the current decade and may fall into the negative during the next decade. So perhaps the growth rate necessary to sustain full employment will also fall over time?

If social stability is the primary policy objective, perhaps it would be more effective to attack the problem directly? For instance, spending most of the RMB4 trillion or even RMB25 trillion on social security, tax cuts or even giving out consumption coupons would be more effective for maintaining social stability. If low-income households receive better income support and migrant workers become entitled to unemployment benefits, then it wouldn’t be that devastating even if growth dropped below 8 per cent. In fact, because that would improve social security and income distribution, it should also boost consumption over time.

To be fair, the government has been making efforts to improve social security and income support. The RMB4 trillion package contains spending items such as rural social security and healthcare. Policymakers have also been designing new measures to improve pensions and minimum income support, to increase farmers’ income, and to improve healthcare and other social welfare systems. But the spending committed to these items looks tiny compared to investment expenditure. One reason for this bias is because the impact of infrastructure spending on growth is felt much faster. Yet it may also be related to the political system – in a democratic system politicians may be more willing to cut taxes since it helps election prospects, whilst in an authoritarian system big image projects are much more effective in facilitating promotion.

China is likely to maintain 8 per cent growth over the next year or two. But deflation is also likely to return and corporate earnings could suffer greatly. The biggest challenge will be after 2010. Even if the global economy recovers by then, China may still be forced to adjust toward domestic demand when stimulus measures run their course.

Policymakers are already aware of the structural problem. Hopefully they will make efforts to optimize sources of growth over the next two years, while lifting rates of growth, and that could make the post-2010 transition smoother. But so far this outcome remains only a hope.

–

Dr Yiping Huang is Chief Economist Asia for Citigroup and Professor of Economics, Crawford School of Economics and Government at the ANU.

This is part of the special feature: Reflections on developments in Asia in 2008 and the year ahead

1. Is the pessimism about the Chinese economy warranted?
2. US-China economic imbalance: Alternatives to appreciating the Chinese yuan
3. China needs to adjust its monetary policy now

PNG had another interesting year in 2008. The first half of the year saw economic growth remain strong as the country continued to benefit from yet another boom in the price of its commodity exports. High resource prices underpinned a significant expansion in the manufacturing, construction and agriculture sectors. Towards the middle of the year, however, poor monetary responses to a prolonged growth in domestic liquidity, coupled with a continued strong external sector, meant that inflationary pressures began to increase, with inflation rising to 13.5 per cent in September 2008.

September, of course, also marked the onset of global financial crisis. Barring a couple of jitters on the PoMEX, PNG’s economy weathered the direct impacts of the crisis relatively unscathed. In large part this was because of the healthy supply of foreign exchange reserves and domestic bank liquidity built up over previous years which gave the financial sector sufficient flexibility to cope with any adjustment costs.

The flow on effects of the crisis have led to a large downturn in the price of many of PNG’s key commodity items which had been driving revenue and output growth. This has had an immediate impact on the Government’s fiscal position with the 2009 Budget predicting a 25 per cent overall decline in domestic tax revenue.
In last year’s PNG economic update, Bob Warner and Eric Omuru warned that PNG would one day face this situation, highlighting the need for commodity boom revenues to be invested in productivity enhancing sectors which can generate long term economic benefits for the country. The global financial crisis appears to have brought that day to the present. The question is, however, has PNG made the requisite reforms and investments in human and physical capital to withstand a global economic downturn? Or will this commodity boom follow the path of previous decades and be followed by an economic bust?

Unlike previous booms, the Government has a large supply of unspent windfall revenues which it will be able to use to maintain expenditure levels at commodity boom levels for a number of years. Indeed, this will be the case in 2009 with the Budget foreshadowing a K600 million drawdown from Trust. Perhaps the most important difference between this and past bust cycles is the prospect of the ExxonMobil LNG Project. In the event that this project comes on-stream, and this is looking increasingly likely, the nature and structure of the PNG economy will fundamentally change. Although weaknesses in these calculations exist, ExxonMobil modelling predicts that the size of the PNG economy will more than double over the medium term, rising in real terms from K8.65 billion in 2006 to K18.2 billion. Oil and gas exports would increase more than four-fold, with the LNG project contributing an additional K11.4 billion, compared to total PNG oil and gas exports of K2.6 billion in 2006.

Significant reforms have been made this year to the system of intergovernmental financing. Following reforms to the Organic Law on Provincial Governments and Local-level Governments in July, new measures were introduced in the 2009 Budget to reduce the difference between each provincial government’s service delivery costs and the amount of revenue which they receive. This is a positive step forward as continued progress on this front, combined with improved accountability mechanisms, will bring provinces to a similar level of fiscal capacity to meet the costs of delivering a comparable set of basic services.

This optimism does mask some important challenges facing the country over coming years. The onset of the LNG project will create classic Dutch disease effects and put further pressure on the rural sector, which creates wealth and livelihoods for the vast majority of Papua New Guineans. The massive growth in output is also likely to spur on more growth in domestic liquidity and inflation. Again, this will disproportionately impact on the welfare of the poor.

More fundamentally, the LNG Project is likely to perpetuate what is already a highly commodity dependent economy. This has diverted, and is likely to continue to divert, much needed attention and focus away from more important economic challenges such as lowering the costs of the PNG’s pervasively expensive business and investment environment. Some progress was made in the airlines sector this year with the entrance of a Virgin Blue/Airlines PNG partnership dramatically lowering the cost of international flights. Nevertheless, national investment policies continue to be dominated by subsidies, concessions and monopoly trading rights. As a result, PNG fell back another 9 places in the 2009 World Bank Cost of Doing Business survey, now ranking 91st out of 121 developing countries.

Further microeconomic reform is needed if PNG is to set itself on a long term sustainable growth path.

–

Aaron Batten is PhD candidate in Economics the Australian National University. He is currently based at the National Research Institute in Port Moresby, Papua New Guinea.

This is part of the special feature: Reflections on developments in Asia in 2008 and the year ahead

1. Managing the boom in mineral revenue in Papua New Guinea
2. Papua New Guinea: The informal economy and the resource boom
3. On the brink of success – Papua New Guinea’s economic revival

‘The magic is over.’

So said French Foreign Minister, Bernard Kouchner, referring to the financial crisis that originated in Wall Street and the battered global standing of the United States.

Under a formula of low interest rates and financial leverage, the US government and investment banks choreographed an asset-inflated housing-bubble boom, enabling Americans to go on a spending free-for-all on the strength of debt.

That alchemy no longer works.

The credit crunch spread from the financial arena to the automotive sector, along with discount stores and government, eventually hitting family finances hard and dragging the global economy into recession.

Against this backdrop, Americans elected Barack Obama, a Democratic Senator from Illinois, as the country’s first black president.

‘America is a country where everything is possible again,’ said former British Prime Minister Tony Blair of Obama’s victory.

In this historic outcome, Blair surely must have glimpsed the magic of democracy through ‘choice’ by the people.

Turbulent changes have confronted the United States and elsewhere throughout 2008.

Iceland was part of the story. The crisis facing the Big Three U.S. automakers shows that the very foundation on which the auto industry stands, not only in the United States but elsewhere in the world, has been drastically shaken.

Global climate change and the deepening energy crisis are prodding the world to shift from a petroleum-dependent, automobile-based civilization to low-carbon societies: we see the stirrings of this change through efforts like those to promote solar power generation.

In our neighbourhood, China is on a path to becoming a global power, while burdened by its infringements of human rights, media control, income gaps and environmental degradation. Symbolically, a man dubbed ‘the Olympics prisoner’, a former factory worker, was charged with inciting subversion of state power after protesting alleged medical malpractice and calling for ‘human rights, rather than the Olympics’. The Chinese authorities are also working to control and even formulate ‘public opinion’ on the Internet.

Japan and the rest of the world are becoming inseparably and intricately linked. People’s lives and jobs are affected by developments not just in Wall Street, the City of London or Shanghai but in Dubai, Mumbai, Peshawar, Lagos and even in the Arctic.

The global financial crisis will likely further drive Japanese workers, who are increasingly shifting to non-regular positions, as the traditional Japanese employment system flounders, into a situation where workers become little more than drifting, discrete sand particles.

The reality of the ever-liquefying workplace and the condition of the new working poor is exemplified, for example, by a 39-year-old man who asked an NPO for help with only 100 yen in his pocket after having to hop from one piecemeal job to another. A day in the life of a middle-aged freight trucker involves spending 12 straight nights in the vehicle delivering goods for a lower-echelon subcontractor.

What lies at the root of these problems are the fraying ‘public’ systems.

Public infrastructure is coming apart at the seams as we see the many problems in medical care, pension, education and public safety.

Rebuilding the ‘public sector’ is indispensable to reviving capitalism, even though there is no alternative to capitalism but capitalism itself. Making up for deficiencies in the market requires imposing rules of fairness in the market, maintaining jobs for workers and providing stability for societies.

Robust public systems are essential for that purpose.

The first step to realize it is to give the nation an opportunity to choose a clear policy platform and an administration.

The open seams in public systems can also be seen in the weakening functions of debate (analysis, commentary and proposal) on public policies, despite a flood of information.

The challenge in 2009 is to contribute to the debate on the choices that now have to be made.

–

Yoichi Funabashi is Editor-in-Chief of the Asahi Shimbun, a leading Japanese daily, and one of Japan’s foremost commentators on foreign affairs and public policy.

Adapted from a column in the Asahi Shimbun on 31 December 2008

This is part of the special feature: Reflections on developments in Asia in 2008 and the year ahead

1. The financial crisis – and loansharks in Japan and NZ
2. Lessons from Japan for the US financial crisis
3. The impact of the global financial crisis on China’s migrant workers

The Australian Labor government’s first full year in office became a momentous political and economic challenge as it moved to deal with the impact of the deepening global financial crisis while seeking to advance national foreign policy and security interests.  By year’s end it seemed inevitable that Kevin Rudd’s government would be judged primarily by its economic management over 2009-10.

But Rudd remained committed to expanding Australia’s role as an activist, if largely conformist, middle-power. Despite changes of emphasis, and new multilateralist initiatives, he left little doubt that there would be more continuity than change in Australian foreign and defence policies while the government’s economic management would be cautious, orthodox but consistent with giving a nudge to global big spending stimulatory economic policies.

A clear mark of Rudd’s caution was the minimal greenhouse gas reduction targets announced towards the end of the year. The decision pleased Australian business, but it seemed at odds with the fanfare and the bloated rhetoric that surrounded Rudd’s early prime ministerial decision to sign the Kyoto accord.

In broad strategic terms Rudd Labor in 2008 was trying to balance and to respond to the short-term and long-term challenges facing Australia.  The major short-term challenges were economic:  the financial crisis, falling employment, and concerns within Australia’s ageing population over superannuation and savings losses.  The long-term challenges were geo-political: historic demographic and economic shifts that could diminish Australia’s regional and global relevance, the rise of China and India as major regional powers, and the global impact of climate change.

These short-term and long-term challenges were connected.  The geo-political implications of the financial crisis were coming into focus by the end of the year, although questions were clearer than answers.  What would be the security consequences of a major collapse of Chinese economic growth? Would the world economy be able to avoid devastating protectionism? Would Australia face more markedly authoritarian, ambitious and expansionary regional states and leaders if the world economy did not recover reasonably quickly? And how would climate change impact on global security and security relationships.

The Rudd government’s response to the economic crisis, like that of most countries, was to introduce stimulatory economic packages to encourage spending. At the end of the year the packages totalled some A$22 billion with promises of more to come if necessary.   At the same time interest rates tumbled as the Reserve bank moved to ease the economic pain of home-buyers with mortgages.  The government claimed Australia could still avoid recession and a deficit budget, but it was going to be a close-run thing if it did.

Rudd proved an inveterate traveller in the pursuit of Australian diplomatic and security interests.  His efforts were perhaps most dramatically focused when he attended the G20 meeting on the economic crisis in Washington in November, but his travels took him to the US, Britain, China, Japan, Malaysia, South Korea, Singapore, Indonesia, New Zealand, Romania, Belgium, Peru, and Afghanistan.

In multilateral mode Rudd proposed, with little promise of immediate success, the establishment of an Asia-Pacific security community; he established a commission under former Labor foreign affairs minister Gareth Evans to pursue the eventual elimination of nuclear weapons; he launched a new bid for an Australian seat on the United Nations security council.

In bilateral mode he stressed the importance of Australia’s relationship with the US and was delighted by Barak Obama’s election. He also sought to use his knowledge of China and its language to advance Australian interests in the middle kingdom. Rudd responded quickly to criticism that he had ignored the importance of Japan, and made a hastily organised visit to Tokyo.

Rudd made it clear that he would not modify the massive rearmament program put in place by the former government –although it remains to be seen how the demands of the financial crisis will affect Australian plans to spend tens of billions of dollars on new fighter aircraft, surface ships and submarines.  Canberra defence orthodoxy maintains that Australia has to maintain a technological edge over regional powers because the country has a relatively small population from which to draw its military forces.  How successfully it can continue to do is still unclear.

A national security policy statement released late in the year was received with faint and generally damning praise and a definitive statement of long-term national security policy is expected in a new defence white paper due around March 2009. A major issue for Rudd will be how to respond to expected US pressure to commit more troops to Afghanistan.

The future of the Rudd Labor government already looks like being determined by how successfully it can balance the inter-connected demands of economic crisis management with the demands of defence and security management in a dynamic and uncertain regional security environment. This will not be an easy job.

–

Geoffrey Barker was formerly senior security and defence columnist with the Australian Financial Review.

This is part of the special feature: Reflections on developments in Asia in 2008 and the year ahead

1. Australia has a valuable role in the “great balancing act”
2. Australia: not spared but prepared to manage the worst
3. Australia: a country racked by division and drift

The Chinese people had high expectations for smooth and fruitful year at the beginning of 2008 – the year of the Beijing Olympics, the 30th anniversary of China’s reform, and a number in Chinese culture signifying good luck and good fortune.

As it turned out, 2008 was a year in which there was as much bad luck as good. In February, southern China was lashed by a severe snow storm; in March, social turmoil in Tibet; in May, the devastating earthquake hit Sichuan; and the Olympic torch was met by protests in some Western countries.

The Olympics in August were a stand-out and government and land reforms were welcomed. But after the Olympics, the world was thrown into economic crisis, and China had to turn to fighting the rapid onset of economic recession.  The poisoned milk scandal also took place.

These were no trivial tests of the achievements of 30 years of reform. The scale of China’s growth and its speed is without precedent in world history. But the question remains: how resilient to natural and social disasters is the new China ? And what further reforms are needed to assure a harmonious role in the world?

Natural disasters

The two natural disasters that preceded the Olympics revealed China as a big economy, but not a strong one. The snow storm left millions of travelers and families shivering and stranded; and a large part of the country in shambles, its people exposed to the vagaries of nature.

The deadly 8.0 M Sichuan earthquake on 12 May, claiming almost 100,000 lives, also exposed the fragility of Chinese infrastructure – despite the worldwide admiration of China’s rescue efforts and the formidable courage and compassion of the Chinese people at its epicentre. During the first couple of days, no contact was possible with the outside world from the earthquake zone and many lives were lost because of poor rescue equipment and the collapse of low-quality buildings.

Milk scandal

The melamine milk scandal broke in July and by November China reported an estimated 300,000 victims: many infants died from kidney stones and other kidney damage. The World Health Organization referred to the event as one of the largest food safety events it has had to deal with in recent years.

The milk scandal exposed a host of problems: poor governmental supervision, inadequate law enforcement, and the power of special interests amongst them. The milk scandal also exposed a more general problem of food safety in China, and China has moved to adopt stricter measures to ensure the food safety. After all, GDP is only part of the story of development: people’s lives, protection and living standards are the ultimate purpose of economic development.

Olympics, China and the world

With the Olympics, China moved to centre stage in living rooms around the world.

As China stepped up onto the international stage, the inevitable question was how should China seek to understand the world, and how should the world seek to understand China. The Beijing Olympics was a good first test in examining this question.

As the Chinese people were preparing to show their hospitality to the world, the torch relay was met by violent protests in some western countries about a range of political issues. Some western politicians even called for a boycott of the opening ceremony. This caused many Chinese people to rethink the relationship between China and the west.

Eventually, China hosted an ‘exceptional’ Olympics with a spectacular opening ceremony, and efficient organization, involving thousands of dedicated volunteers. The Olympics saw many western people change their view of China after experiencing the reality in China and seeing Chinese people up close. Thanks to the Olympics, China has also become a more open and tolerant, as well as a more tolerated, society.

Reforms in 2008

In 2008, China restructured government through the creation of ‘mega-departments’. The number of ministries was reduced from 31 to 27. The target is to establish a service-oriented government and improve governance efficiency through streamlining the overlapped functions of different government departments.

An important milestone event in 2008 was the land reform at the 3rd plenum of central committee of CPC. The duration of farmer’s land use right was extended from 30 years to ‘long term’, and farmer’s interests and rights are to be strictly protected under new laws. Though the transaction of land use rights is not the focus, the door is now open for transaction in land and for capitalist agriculture.

Other major reforms included: value-added tax reform to eliminate the overlapping taxes and encourage equipment investment, and fuel tax reform to abolish the road maintenance fees and other charges.

Tacking and jibing economic policy

This was a year to test the ability of China’s economic team in tackling new and complex economic problems. Though these tests were huge and are ongoing, 30 years of experience in policy development has created, it is fair to say, a considerable legacy in policy management skills within the leadership team.

At the beginning of last year, the priority of macroeconomic policy was to control inflation and prevent overheating of the economy (so-called two ‘prevents’). The Chinese boom was driven by export-oriented growth and related investment spending. Two interdependent steps were required: one to balance China’s trade surplus through RMB appreciation, reducing export-tax rebate, and other trade policies; the other to transform China’s economy from export-oriented to domestic market based growth. If it hadn’t been for the financial crisis, the expectation was that this might be achieved smoothly within 3 to 5 years.

Mid-year, there were already signs that overheating was no longer a serious problem, and China’s economic growth was about to slow. The central government promptly adjusted the policy from ‘two prevents’ to ‘ensure stable economic growth and control inflation’. Monetary and fiscal policies were relaxed accordingly.

In the fourth quarter, the world economic crisis deteriorated rapidly and China’s downturn was worse than expected. The central government initiated 4 trillion yuan economic stimulus package in November and introduced measures to stimulate consumption and exports.

The estimated 9 per cent growth in 2008 is not bad, but many investors suffered in the stock market collapse as the Shanghai Composite Index plummeted by 65.5 per cent. The ups and downs of international commodity market also had a negative impact on the Chinese economy and taught Chinese investors a serious lesson on market risk.

The challenges ahead

The most immediate challenge is to tackle the current economic crisis and hold growth up at around 8 per cent in 2009. The medium and long term challenge is how to improve China’s market system and political institutions.

This year is the 60th anniversary of the foundation of the People’s Republic of China. The economic blueprint for 2009 was outlined at the three-day Central Economic Work Conference at the end of 2008. The primary goals are ‘ensuring high growth, expanding domestic demand, and upgrading the economic structure’.

The growth target in 2009 is set at 8 per cent. Though 8 per cent would be the lowest growth rate in China since 1997, it would be a relatively high growth in the context world recession. The biggest uncertainty for China’s own performance is where the world crisis heads in 2009.

The inflation target is 4 per cent. If exports continue to drop, there could be deflation but the proposed reforms in resources sector could be inflationary. The acceleration in government spending could also translate into inflation.

Though China’s trade surplus in November 2008 reached a record high, the overall contribution of the trade surplus to its GDP growth is likely to have been negative or zero in 2008. Though the transformation of China’s economic growth pattern requires balanced trade, trying to achieve trade balance through the financial crisis would have a negative effect on the economy. In 2009, China will try every effort to stimulate its export.

The biggest challenge is employment. China needs to create about 10 million new jobs each year to absorb labor growth. A sizable proportion of the unemployed are migrant workers who have land in their hometowns. This is one reason why China is very cautious in dealing with the issue of land privatization. Access to land plays a role in security for migrant workers.

Chance for reform

The 4 trillion yuan stimulus package ushered in an ‘active fiscal policy and appropriately easy monetary policy’. Government and government-related investment is growing quickly, but private investment remains in the doldrums. A major problem for China’s economic growth is how to stimulate private investment (a core element in growth in the past) and private consumption.

The key will be further reform. The recession actually provides the chance to wind up the momentum of reform in 2009. Expanding the domestic market and upgrading industrial production requires reforms in line with ‘liberalization, deregulation and decentralization’. These reforms are necessary to make the market system work better.

To stimulate private investment, China needs to get rid of barriers to entry barriers in sectors that are monopolized (such as telecommunications, transport, urban utilities, financial sectors, healthcare, education), and reform its investment system. To expand domestic consumption, social security and healthcare system must be reformed. As inflationary pressure is alleviated, energy and resource price reforms can also be introduced.

Building soft power

If economic power can be called hard power, then what China most needs to improve is its ‘soft power’ through strengthening institutions and instigating a cultural renaissance. China is a country with 5,000 years of civilization. It was one of the most prosperous countries in the world until industrial revolution in the 18th century. The economic success in the past 30 years has imbued the Chinese people with a strong sense of optimism and confidence in the future. A civilization that has survived 5,000 years, can now build a culture compatible with the pillars of modern civilization in a globalised world: a strong market economic system and democracy.

–

Yongsheng Zhang is Senior Research Fellow at the Development Research Center of the State Council (DRC), PRC and Professor of Economics at Renmin University, Beijing.

This is part of the special feature: Reflections on developments in Asia in 2008 and the year ahead

1. Indonesia steps onto the world stage
2. China’s role in running the world economy
3. Does China really aim to take over the world?