Asian Growth Faces Headwinds From Global Uncertainty

European financial turbulence, U.S. slowdown could spill over to Asia

Policymakers face delicate balancing act with lingering overheating pressures

Rebalancing would reduce vulnerability, help promote inclusive growth

GDP growth across Asia is forecast to average 6¼ percent in 2011, rising to 6¾ percent next year, moderately lower than envisaged 6 months ago, and in line with the weaker global outlook.

“Risks for Asia are decidedly tilted to the downside,” suggest the authors of the twice-annual report released in Tokyo.

Although far from the epicenter of the crisis, Asia remains vulnerable to further trade and financial shocks given its high degree of integration.

In addition to a drop in global demand for Asian exports, foreign investors could retrench from the region, reversing their large positions. European banks could reduce cross border lending, causing credit flows to dry up.

Nevertheless, given the financial, corporate, and public sector balance sheet strengths built over the last decade, Asia has buffers which should help it navigate this global environment.

The region has also accumulated large foreign reserves. Many countries still have policy space to support economic activity in the event the risks materialize.

Policymaking more complex as overheating risks remain

The IMF expects inflation to recede after peaking in 2011, as food and energy prices moderate, but cautions that inflation remains elevated in many countries.

In countries where overheating pressure remains high, and monetary conditions continue to be accommodative, the report suggests that the ongoing return to a more neutral monetary stance is appropriate.

“Elevated inflation risks in many countries call for a continuation of macro-policy normalization. However, against the backdrop of unusual uncertainty, a pause in tightening is warranted, particularly in countries where inflation pressures have been contained and that are highly sensitive to a global slowdown,” says the report.

Many Asian countries have also been normalizing their fiscal stances following the stimulus implemented in response to the global downturn. If the recovery in the region continues, the report says this normalization should be allowed to run its course.

Given the combination of heightened downside risks and lingering overheating pressures, policymakers confront...