Asia is a vital and vibrant part of the world economy. In terms of purchasing power parity, it includes three (China, Japan, and India) of the world's four largest economies, accounting for one-fourth of global output. And its importance is increasing, because Asia also boasts two of the world's fastest-growing countries: China, which has averaged 10 percent annual growth in the past decade, and India, where annual growth has been running above 7 percent since 2003. This article examines the region's economic outlook for 2006 and the policy challenges ahead. Specifically, it weighs the implications of growing competition in electronics.
        This year is expected to be another good one for Asia, with growth remaining robust and inflation generally subdued, though the outlook is clouded by risks and policy challenges. Projected growth for the region in 2006 is expected to be revised upward when the Fund's World Economic Outlook is released in May. This bright outlook derives in large part from the momentum that Asia has gathered in recent quarters, notably from the entrenchment of Japan's recovery and a stronger and lengthier upswing in the global electronics export cycle than had be expected.
        Prospects for growth have improved in nearly all parts of the region. Better growth is expected in the industrial countries, mainly because Japan's recovery (led by buoyant domestic demand) is proving to be unexpectedly vigorous. In fact, Japan's growth in the fourth quarter of 2005 - at 5 1/2 percent (seasonally adjusted annual rate) - was the strongest since 1991. Meanwhile, emerging Asia should continue to grow rapidly, led as before by China and India.
        The external environment also appears set to remain strong. The U.S. economy may be slowing somewhat, but this slowdown should be offset by more rapid growth elsewhere, notably in Europe. Meanwhile, global capital expenditure is accelerating, boding well for the electronics sector, which accounts for about one-third of the region's exports. Shifts within the electronics sector, however, could have implications for growth within the region.
        Emerging Asia's exports will also be affected by several major developments within Asia. Regional trade, spurred by a resurgence in the rapid growth of China's imports, is picking up. At the same time, regional currencies have appreciated in real terms against the yen, by some 20 percent over the course of 2005. The impact of this appreciation may be muted, however. Few Asian countries other than Korea compete directly with Japan, and any effect on export prices may be offset by reduced costs, especially for imports of Japanese capital equipment.

Test for Monetary Policy

        Despite this generally bright outlook, the region faces a number of policy challenges. In particular, the doubling of world oil prices since December 2003 has posed a dilemma for some countries whose domestic fuel prices have long been controlled. Recently, each of the ASEAN-4 countries raised domestic oil prices - most sharply in Indonesia, where gasoline prices increased by nearly 90 percent on October 1. Oil prices were also significantly increased in Malaysia and fully liberalized in Thailand (they have long been free in the Philippines).
        These bold price adjustments, however, now complicate monetary policy. For some time, the authorities in many Asian countries have maintained interest rates at historically low levels to spur generally weak domestic demand. This stance - made possible by low inflation - is now facing mounting pressure. Although inflation in Asia as a whole is expected to remain subdued, reduced oil subsidies in the ASEAN-4 countries have propelled average headline inflation to 10 percent and underlying inflation to nearly 6 percent. Central banks in these countries have responded aggressively, raising policy rates by 170 basis points between May 2004 and January 2006.
        These actions are already paying significant dividends. For example, in Indonesia, the reduction in oil subsidies, coupled with an aggressive rise in interest rates, has led to a sharp improvement in investor confidence, with the exchange rate appreciating by 10 percent against the U.S. dollar since September 2005 and the stock market rising by 18 percent. Similarly, in the Philippines, monetary tightening - together with strenuous revenue efforts, including an extension and rate increase in the value-added tax - has caused spreads on the country's U.S. dollar bonds to fall below 300 basis points for the first time in years.
        As this monetary tightening takes hold, however, Asian countries will face the renewed challenge of reviving weak domestic demand - an important source of the region's $350 billion current account surplus. This surplus has been stable in dollar terms in recent years and is expected to remain so in 2006 but with significant changes in composition. In most of the region, surpluses have been shrinking as oil imports bills have increased - notably in Japan and India, where domestic demand has also strengthened considerably. At the same time, China's surplus doubled, to about $160 billion (7 percent of GDP) in 2005, as exports boomed while imports stagnated for a time. This year, however, these trends should halt; in fact, China's surplus has already started to stabilize.
        Faced with rising prices and generally weak domestic demand, many countries have scaled back foreign exchange intervention, allowing their currencies to appreciate to help reduce upward price pressures and boost real household incomes. During the second half of 2005, reserve accumulation outside China amounted to just $5 billion, compared with about $40 billion in the first half. And between end-November and end-January, when there was a renewed surge in capital inflows, the region's flexible currencies (apart from those of China, Hong Kong SAR, and Malaysia) appreciated by 5 percent against the U.S. dollar. In contrast, in China, reserve growth remained approximately unchanged at about $100 billion in the second half of 2005, with a decline in capital inflows offsetting the widening of the current account surplus.
        In the months to come, the region faces several risks. First, oil prices could surge again, because the margin of excess oil production capacity is low and is likely to remain so for some time. Also, with the U.S. labor market tightening, inflationary pressures in the United States could rise, leading the Federal Reserve to raise interest rates by more than expected, dampening U.S. growth and triggering a widening of emerging market spreads. In addition, there is the threat of an avian flu pandemic, which could adversely affect global growth and financial conditions. Finally, there remains a danger of a disorderly adjustment to global current account imbalances.
        Source: IMF Asia and Pacific Dept.