Asia leading the global recovery

DURING the first half of this year, Asia was in the lead of the global economic recovery. As analysed in the International Monetary Fund's (IMF) latest Regional Economic Outlook for Asia and the Pacific (REO), this strength in activity was fuelled by both strong exports and robust domestic demand.

As anticipated, export growth for the region has moderated in the second half, reflecting the sluggish recovery in the United States and western Europe, as well as the maturing of the global inventory cycle.

In line with regional trends, Malaysia too has rebounded impressively from the impact of the global financial crisis. Growth in the first half of the year was 9.5%. While export growth in Malaysia has moderated, domestic demand - in particular from the private sector - remains robust and a broad-based expansion is under way.

The outlook for Malaysia is strong

For Asia as a whole, still accommodative macroeconomic policies, robust consumer confidence, improving labour markets, and higher asset values are all expected to help sustain consumption. In line with this, we project that Asia will grow at 8% in 2010 and a more sustainable 7% in 2011 as the recovery matures further.

The near-term outlook for Malaysia also remains strong. Domestic demand, led by consumption, is expected to continue to make a substantial contribution to growth. Macroeconomic policy settings have been normalised to reflect the transition to private sector-led growth.

The resumption of fiscal consolidation is welcome, while the monetary policy stance has become less accommodative but still remains appropriately supportive of growth. Moreover, the ringgit has appreciated markedly, providing further support to domestic demand as the driver of growth over the near term. In line with the above, we expect Malaysia's GDP growth to be close to 7% this year and 5.5% in 2011.

The region still faces risks

Despite the overall favourable outlook for the region, some important risks continue to cloud the horizon. The fragility and unevenness of the global economic recovery remains a concern. An unanticipated weakening in activity in the advanced economies would spill onto the Asian economies through weaker export growth. Asia as a whole has also attracted large capital inflows since the middle of 2009, reflecting ample global liquidity and favourable growth prospects for the region.

While asset markets in the region generally do not appear to be overvalued as of now, further capital inflows could pose vulnerabilities if they result in unsustainable asset valuations or excessive expansion of domestic liquidity. Inflation has already bottomed out in many countries across the region, and house price pressures have emerged in some economies.

This constellation of risks calls for a continued and cautious normalisation of macroeconomic policy settings, and careful monitoring of the financial sector. Macroprudential measures that have been implemented in some economies remain an important element of the toolkit to guard against financial sector risks.

Finally, should the downside risks to global growth materialise, Asian policymakers have ample room to readjust macroeconomic policies to counter any adverse effects on economic activity in their own economies.

In Malaysia, the financial sector has weathered the global crisis well and corporate balance sheets remain strong. The authorities have demonstrated an impressive track record in proactive financial supervision and sustained efforts to develop financial markets both in the conventional and Islamic finance areas. Nevertheless, there are some risks that need to be closely watched. For example, Malaysia too could be vulnerable to large capital inflows and excessive asset price rises. Household debt is also high, although this is mitigated somewhat by substantial asset holdings. We are confident that the authorities have the tools to address these risks, should they materialise.

The challenges for Asia over the medium term

What are the challenges for Asia over the medium term? The global financial crisis demonstrated the need for the region to rely more on a "second engine of growth" - namely domestic demand. Rebalancing towards domestic demand requires sustained steps to increase domestic consumption and investment, including through fiscal measures, structural reforms in labour, product and financial markets, as well as greater exchange rate flexibility.

Fewer motives for precautionary saving and greater incentives for businesses to increase investment in domestically-oriented sectors should be among the outcomes of such reforms. In the REO, we demonstrate that improving access to credit for small and medium enterprises operating in domestic markets, including services, as well as to increase investment in infrastructure, could help ignite the second engine of growth in Asia. Indeed, the development of SMEs and access to financing is an area Malaysia has emphasised and made progress on in recent years.

There are significant challenges for Malaysia too over the medium term. The growth momentum which propelled the country from low to middle income by the early 1990s stalled after the Asian crisis.

As a result, Malaysia continues to remain a middle income country while some of its peers that started from similar initial positions have achieved higher per capita incomes. As rightly recognised in the authorities' Economic Transformation Programme and the 10th Malaysia Plan, rekindling the growth momentum requires deep structural and fiscal reforms to unlock Malaysia's growth potential.

The key to success will be implementation. The reform process should proceed at a measured pace and take into account the need to protect vulnerable groups. At the same time it needs to be steady and sustained.

Key reforms under way must be pushed forward. In particular, poorly designed subsidies - especially fuel subsidies - should be phased out and replaced with targeted assistance. Improving the business environment by levelling the playing field through reform of government-linked companies and further labour market liberalisation will also pay dividends.

The IMF stands ready to contribute its international perspective and global expertise to the ambitious goals that the Malaysian authorities have set for themselves. We are looking forward to continuing a mutually beneficial engagement.

- The Star Online