The 2008 Financial Crisis and Potential Output in Asia: Impact and Policy Implications

Park, Cyn-Young; Majuca, Ruperto; Yap, Josef Working Paper The 2008 Financial Crisis and Potential Output in Asia: Impact and Policy Implications ADB Working Paper Series on Regional Economic Integration, No. 45 Provided in Cooperation with: Asian Development Bank (ADB), Manila Suggested Citation: Park, Cyn-Young; Majuca, Ruperto; Yap, Josef (2010) : The 2008 Financial Crisis and Potential Output in Asia: Impact and Policy Implications, ADB Working Paper Series on Regional Economic Integration, No. 45, Asian Development Bank (ADB), Manila, https://hdl.handle.net/11540/1957 This Version is available at: https://hdl.handle.net/10419/109556 Standard-Nutzungsbedingungen: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden. Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen. 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If the documents have been made available under an Open Content Licence (especially Creative Commons Licences), you may exercise further usage rights as specified in the indicated licence. http://creativecommons.org/licenses/by/3.0/igo The 2008 Financial Crisis and Potential Output in Asia: Impact and Policy Implications Cyn-Young Park, Ruperto Majuca, and Josef Yap No. 45 | April 2010 ADB Working Paper Series on Regional Economic Integration Cyn-Young Park,+ Ruperto Majuca,++ and Josef Yap+++ The 2008 Financial Crisis and Potential Output in Asia: Impact and Policy Implications ADB Working Paper Series on Regional Economic Integration No. 45 April 2010 Submitted in partial fulfillment of requirements under Asian Development Bank Contract No. S20318 under TA-6459 (REG): The Asia Regional Integration Center (ARIC), Phase II. The authors acknowledge the contributions of Dr. Jose Ramon G. Albert, Senior Research Fellow at PIDS who did the econometric estimates for the growth model using STATA software; and Michael Angelo A. Cokee, who did the Markov switching estimates of potential output using GAUSS software. The excellent research assistance of Fatima Lourdes E. Del Prado and Maureen Ane D. Rosellon, Research Specialists at PIDS, and Rogelio Mercado and Theresa Robles of OREI, is also acknowledged. The usual disclaimer applies. +Cyn-Young Park is Principal Economist, Office of Regional Economic Integration, Asian Development Bank, 6 ADB Avenue, Mandaluyong City, 1550 Metro Manila, Philippines. Tel +63 2 632 5473, Fax +63 2 636 2342, [email protected] ++Ruperto Majuca is Research Fellow of Philippine Institute for Development Studies (PIDS), National Economic Development Authority (NEDA) Bldg., 106 Amorsolo St., Legaspi Village, Makati, Philippines. Tel. +63 2 893 9585-92, Fax +63 2 810 6261, [email protected].ph +++Josef Yap is the President of Philippine Institute for Development Studies (PIDS), National Economic Development Authority (NEDA) Bldg., 106 Amorsolo St., Legaspi Village, Makati, Philippines. Tel +63 2 893 9591, 893 9592, Fax +63 2 810 6261, [email protected].ph The ADB Working Paper Series on Regional Economic Integration focuses on topics relating to regional cooperation and integration in the areas of infrastructure and software, trade and investment, money and finance, and regional public goods. The Series is a quick-disseminating, informal publication that seeks to provide information, generate discussion, and elicit comments. Working papers published under this Series may subsequently be published elsewhere. Disclaimer: The views expressed in this paper are those of the author and do not necessarily reflect the views and policies of the Asian Development Bank or its Board of Governors or the governments they represent. The Asian Development Bank does not guarantee the accuracy of the data included in this publication and accepts no responsibility for any consequence of their use. Use of the term ―country‖ does not imply any judgment by the authors or the Asian Development Bank as to the legal or other status of any territorial entity. Unless otherwise noted, $ refers to US dollars. © 2010 by Asian Development Bank April 2010 Publication Stock No. Contents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Abstract v 1. Introduction 1 2. Estimating Potential Output 2 2.1 Atheoretical Approach 2 2.2 Accounting for Structural Breaks 4 3. Impact of Financial Crises on Potential Output in Asia 6 3.1 Theory and Policy Responses 6 3.2 Evidence from Earlier Crises 7 4. Empirical Results 9 4.1 Results from Atheoretical Methods 9 4.2 Accounting for Structural Breaks Using Markov Switching 9 5. Post-Crisis Trends in Potential Output 10 5.1 Explaining Behavior of Potential Output 10 5.2 Econometric Evidence 13 6. Implications for Responses to the 2008/09 Crisis 13 6.1 Output Gap, Exit Strategies and Medium-Term Policies 13 6.2 Regional Rebalancing 15 7. Appendix 16 Appendix 1: Econometric Model and Empirical Results 16 References 30 ADB Working Paper Series on Regional Economic Integration 33 Figures 1. Possible Impacts of a Crisis on Outputs 20 2. Potential Output 23 3. Output Gap 25 4. Linking Regional and Domestic Rebalancing 27 Tables 1. Potential Output Growth Rates (using HP filter) 21 2. Potential Output Growth Rates (using BN decomposition) 21 3. Potential Output Growth Rates (using Band Pass– Christian, Fitzgerald method) 22 4. Technological Activity Index 27 A.1. Regression with Driscoll–Kraay Standard Errors 28 A.2. Cross-sectional Time-Series FGLS Regression, Random Effects 29 Abstract Monitoring the behavior of potential output helps policymakers implement appropriate policies in response to an economic crisis. In the short-run, estimates of the output gap can guide the timing of the implementation and withdrawal of stimulus measures. In the medium- to long-term, these estimates can also provide the basis for gauging productive potential and, hence, guide policies to support sustainable, non-inflationary output growth. In this paper, we investigate the post-crisis behavior of potential output in emerging East Asian economies by employing the Markov-switching model to account for structural breaks. Results show that after the 1997/98 Asian financial crisis, potential output in Hong Kong, China; the Republic of Korea (Korea); Singapore; and Malaysia reverted to levels consistent with trends prior to the crisis. While there were permanent drops in potential output for both Thailand and Indonesia, growth rates returned to precrisis trends. The People’s Republic of China (PRC); Taipei,China; and the Philippines are special cases as explained in the report. Econometric estimates of a simple growth model show that the differences among the patterns of post-crisis recovery can be attributed to the investment-to-gross-domestic-product (GDP) ratio; macroeconomic policies; exchange rate behavior; and productivity, which is proxied by the level of technological activity. These results can be used to guide policy in the aftermath of the 2008 global financial crisis. Keywords: Potential output, Markov-switching model, structural break, global crisis, East Asia JEL Classification: C3, E32 The 2008 Financial Crisis and Potential Output in Asia: Impact and Policy Implications | 7 in the 1990s, eventually achieved and even exceeded the levels of output that pre-crisis growth trends had suggested (Haugh et al., 2009). A priori, the impact of a crisis on potential output is uncertain. Hence, it is important to investigate the sources of a decline in output following a crisis. It is very difficult to determine the path of potential output in the event of a crisis. However, identifying the sources of the output loss—for example, a temporary rise in the unemployment rate or a decline in productivity—has important implications for the output gap and the appropriate policy responses. If the output loss is largely associated with the output gap—a temporary deviation from potential output—stabilization policies would be sufficient. However, if the loss is induced from a change in potential output, the appropriate policy response would require more fundamental reforms that can address structural problems (Cerra and Saxena, 2005). In addition, a financial crisis can change potential output through indirect effects. Indeed, crises usually trigger policy responses from public authorities to cushion against the economic downturn. Stabilization policies can sometimes have long-term effects. On the one hand, investment in infrastructure is likely to boost potential output. On the other hand, some policies can be detrimental to long-term growth when they introduce distortions or encourage excessive risk-taking. At the same time, temporary fiscal measures can lead to a permanent increase in government size and debt levels, which in turn will have negative effects on growth. Finally, the impact of policies depends on the nature and design of the specific measures. Financial crises can also foster the implementation of structural reforms that can enhance potential output by moderating political opposition to reforms. 3.2 Evidence from Earlier Crises Many studies looked into the impact of financial crises, including the effect of the 1997/98 financial crisis on potential output in Asia. Past experience shows that financial crises tend to cause substantial and persistent output losses, although there are significant country variations. The patterns of medium-term output performance following financial crisis have attracted much attention recently. Several studies have examined the medium-term behavior of output in the crisis-affected countries. Some stylized facts about crisis-driven recessions have emerged.  Financial crises, especially those involving a banking crisis, tend to have a negative and persistent effect on potential output. Furceri and Mourougane (2009) estimate that financial crises lower potential output by between 1.5% and 2.4% on average for the economies of the Organisation for Economic Cooperation and Development (OECD). The magnitude of the effect increases with the severity of the crisis. Abiad, Balakrishnan, Brooks, Leigh, and Tytell (2009) also found that output tends to be depressed substantially and persistently following banking crises after investigating 88 banking crises that occurred over the past 4 decades across a wide range of economies. Their finding was based 8 | Working Paper Series on Regional Economic Integration No. 45 on a comparison in each economy between the medium-term level of output8 and the level it would have reached if it had adhered to the pre-crisis trend.  Following financial crises, output does not return to its original trend path over the medium-term on average. Growth does, however, eventually return to its precrisis rate for most economies, suggesting that the pattern of medium-term output performance following a financial crisis is best described by Scenario 2 in Figure 1.  The depressed output path tends to result from long-lasting reductions of roughly equal proportion to the employment rate, the capital-to-labor ratio, and total factor productivity (Abiad et al., 2009).  Initial conditions and policy responses have a strong influence on the size of the output loss. What happens to short-term output is also a good predictor of the medium-term outcome. Interestingly, post-crisis output losses are not significantly related with the level of income. In Asia, one of the first cross-country estimates of the output gap in the aftermath of the 1997/98 crisis was undertaken by Bautista (2003). By applying the generalized Hamilton model as modified by Lam (1990) and Kim (1994), he addressed the problem created by structural breaks. One interesting result was that the stochastic output gap estimates obtained from the modified Hamilton model were on average smaller than estimates of the linear–quadratic output gap. The reason is that shocks to potential output partly account for the fluctuations in GDP. This is clear evidence that the 1997/98 crisis had an adverse impact on potential output. The downturn in the Philippines and Thailand, however, could not be classified as recessions and instead appeared as slowdowns. Rather, the different experiences of each country could likely be attributed to different policy responses as well as their initial conditions. A similar approach was applied by Cerra and Saxena (2005), but with the asymmetry also applied to the output gap. They used a two-common-factor model with regime switching in each of the factors. Real GDP, investment, and private consumption were used to identify the common transitory and stochastic trends. Their results indicate some amount of permanent output loss in all six economies that were part of the study. The recovery phase is predominantly characterized by a return to the normal growth rate of an expansion, rather than a higher-than-normal growth rate. This is akin to Scenario 2 of Figure 1. Thus, the level of output is permanently lower than its initial trend path. Cerra and Saxena also determined that the impact of the 1997/98 crisis was milder in the Philippines, a result that is consistent with Bautista. The cumulative output loss in the Philippines for the period 1997–1999 was only 1.5%, compared to 22.3% in Indonesia, 10.3% in the Republic of Korea (Korea), and 19.0% in Malaysia. Unfortunately, Thailand was not included in the study due to lack of data. 8 The medium-term is defined as 7 years after the crisis in this paper. The 2008 Financial Crisis and Potential Output in Asia: Impact and Policy Implications | 9 4. Empirical Results 4.1 Results from Atheoretical Methods Three relatively simple atheoretical methods were initially applied to determine the variation in the empirical results. The economies that were included in the estimation are the People's Republic of China (PRC); Hong Kong, China; India; Indonesia; Japan; Korea; Malaysia; Philippines; Singapore; Taipei,China; and Thailand. In addition, estimates were applied to the US and aggregate Europe.9 The data used are described in the appendix. The end-point problem of the HP filter is addressed by extending the data up to the fourth quarter of 2010 by applying ADB forecasts. The results are summarized in Tables 1-3. All three methods—HP, band pass (BP)–CF, and BN—suggest a noticeable drop in the potential output growth for (i) the countries affected by the 1997/98 Asian financial countries (e.g., Malaysia, Indonesia, Thailand); and (ii) all regions and countries (with the possible exception of the PRC, Indonesia, and India) for the 2008/09 global crisis. In general, among the three methods used, the BN decomposition registers the largest reduction in potential GDP growth during both crisis periods. This result is expected because, as previously explained, the BN methodology results in a decomposition in which much of the GDP variation is in the trend and stochastic component. For the 1997/98 crisis, all three methods suggest a large and substantial reduction in potential output growth for Indonesia and Thailand; a relatively large potential output growth reduction for Malaysia; Korea; and Hong Kong, China; and a relatively small but noticeable potential output growth decline for Singapore; Taipei,China; and Japan. The results are not surprising given that Indonesia and Thailand are known to have suffered the most from the 1997/98 crisis. For the 2008/09 crisis, Singapore registers the largest potential output growth reduction using the HP filter and BN decompositions methods, and second largest potential output growth reduction using the BP–CF method. This can be explained by Singapore’s large dependence on exports and foreign capital flows. All three methods likewise registered no (or negligible) potential growth reductions for the PRC, Indonesia, and India. The reasons behind the results for the PRC and India include the PRC’s injection of a large fiscal stimulus package into the economy and India’s lower level of export dependency compared to the East Asian economies. 4.2 Accounting for Structural Breaks Using Markov Switching To account for structural breaks, the Markov switching model as a generalized Hamilton model and modified by Lam (1990) and Kim (1994) was applied to nine East Asian 9 Includes Austria, Belgium, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Netherlands, Norway, Portugal, Spain, Sweden, Switzerland, and United Kingdom. 10 | Working Paper Series on Regional Economic Integration No. 45 economies.10 The resulting level of potential output is then compared to the estimates obtained from the HP filter. This is shown in Figures 2a–2i. Generally the results from the MS regime methodology and the HP filter do not deviate significantly from each other. However, there are distinct differences. The MS results are more jagged, which is to be expected since the methodology is sensitive to breaks in the data and the HP is a smoothing procedure. In only one economy is the difference between the two estimates relatively large: Malaysia. The authors unfortunately cannot offer a credible reason for this. Figure 2d shows that from 1984 to 1991 the HP estimates were consistently below the MS estimates, while the reverse is true from 1991 to 2007. The difference between the two methodologies shows up more clearly in the estimates of the output gap in Figures 3a to 3i. Except for Malaysia and Singapore, the output gap estimates for MS are smaller than those from the HP filter. This is to be expected since in the MS methodology the switch in regimes is loaded into the potential component of output. Another consequence of this bias in loading is that the output gap for the MS methodology becomes positive after the 1997/98 crisis for many key economies including Indonesia, Malaysia, Singapore, Thailand, and Korea. This counterintuitive result implies that the crisis caused a fall in potential output that was larger than the fall in actual output. The weakness in the original MS methodology was supposed to have been addressed by the algorithm of Kim and Piger (2002), and Kim and Murray (2002). 5. Post-Crisis Trends in Potential Output 5.1 Explaining Behavior of Potential Output For the purposes of this study, it is important to determine whether or not estimated potential outputs—using both the MS and HP methods—for the nine economies will follow the same general pattern after the 1997/98 crisis. To determine the applicable scenario among Scenarios 1, 2, and 3, the trend of potential output immediately prior to the 1997/98 crisis was estimated from data obtained from the MS method. A simple linear trend was estimated—mostly based on the period from the first quarter of 1990 to the second quarter of 1997—and extended. This is shown as a black dashed line in the graphs.11 While it is still too early to tell how the 2008/09 crisis will affect medium-term output performance, the path of potential output following the 1997/98 crisis can provide valuable insights. Output declined for most economies in emerging East Asia12 in the wake of the 1997/98 crisis. While the causes and impacts of the crisis are well 10 We are grateful to Carlos C. Bautista for providing us a copy of the GAUSS algorithm to estimate potential output using this method. The algorithm can be provided upon request. 11 A similar analysis will result if the trend is based on the HP estimate of potential output. 12 Throughout this paper, emerging East Asia refers to nine selected economies of developing Asia: the PRC; Hong Kong, China; Indonesia; Korea; Malaysia; the Philippines; Singapore; Taipei,China; and Thailand. The 2008 Financial Crisis and Potential Output in Asia: Impact and Policy Implications | 11 documented, an extensive analysis of the recovery process is still limited. In particular, the behavior of potential output over an extended period of time has not been adequately studied for emerging East Asian economies. Of particular interest is which scenario in Figure 1—Scenario 1, Scenario 2, or Scenario 3—materialized for each economy. The different outcomes can be traced to the set of policies implemented to cope with the crisis. The patterns of post-1997/98 crisis recoveries differ significantly across borders, particularly between three groups of economies. The first group comprises Singapore; Hong Kong, China; Korea; and Malaysia. The second group includes Indonesia and Thailand; and the third group covers the PRC; Philippines; and Taipei,China. The first group generally follows Scenario 1 and the second and third groups follow Scenario 2. Among the third group, potential output did not seem to be affected by the 1997/98 crisis and eventually exceeded levels consistent with pre-crisis trends. In Hong Kong, China; Korea; Singapore; and Malaysia, the levels of potential output reverted to levels consistent with pre-crisis trends after an initial drop in the wake of the crisis. Hong Kong, China experienced the largest fall and longest recovery period at about 10 years. The absence of currency flexibility may have contributed to this situation. Unlike the other economies, Hong Kong, China saw the Hong Kong dollar appreciate in real effective terms in 1997 and 1998. The real effective exchange rate of the Hong Kong dollar did not return to its 1996 level until 2003. Greater openness seemed to be one of the major factors that allowed this group to ride out the crisis. According to some studies,13 sharp currency depreciations were one of the main contributors to the quick recovery of economies in the region as the resulting increase in exports helped economies to emerge from the crisis. This export orientation also helped maintain the pace of technological progress as measured by total factor productivity (TFP). Estimates confirm that TFP growth collapsed during the crisis, but has since reverted to earlier trends. Other estimates show that Korea; Singapore; and Taipei,China had a higher level of TFP than the ASEAN-4 economies14 did many years after the 1997/98 crisis.15 Data from the United Nations Conference on Trade and Development (UNCTAD) show that the first group of economies referenced above—plus Taipei,China—have a higher index of technological activity (Table 4). This technological advantage helped the newly industrialized economies (NIEs)16 and Malaysia to return to a level of potential output that is consistent with their pre-crisis trend. In the case of Indonesia and Thailand, the 1997/98 crisis shifted the potential output path downward from the pre-crisis trend level, although growth eventually recovered to the pre-crisis rate. The impact of financial crises on the level of potential output tends to be long-lasting for these two countries. Abiad et al. (2009) find that the path of output 13 Park and Lee (2002). 14 ASEAN-4 comprises Indonesia, Malaysia, Philippines, and Thailand. 15 APO (2004) as cited by ADB (2007) reports estimated TFP growth until 2000. Kidsom (2008) shows that in 2004 the level of TFP of the NIEs was higher than that of ASEAN-4. 16 NIEs includes Hong Kong, China; Republic of Korea; Singapore; and Taipei,China. 12 | Working Paper Series on Regional Economic Integration No. 45 tends to be depressed substantially and persistently following the crisis as a result of reductions in the employment rate, capital-to-labor ratio, and TFP in roughly equal proportions after analyzing 88 cases of financial crises over the past 4 decades. They also argue that "capital and employment tend to suffer enduring losses relative to the pre-crisis trends." In emerging East Asia, Park and Lee (2002) and ADB (2007) find that the main cause of the decline in potential output was the sharp contraction in investment and lower capital accumulation afterwards. Some argue that the drop in investment and capital stock in the pre-crisis period might be overestimated if an investment boom preceded the crisis and as a result investment was at unsustainable levels prior to the crisis. Nevertheless, the crisis seems to have reduced incentives to invest in capital and thus slowed capital accumulation.17 The output path in the PRC; Taipei,China; and the Philippines seem fairly unaffected by the 1997/98 crisis, albeit for the reasons that are completely different. The PRC's strong growth momentum continued with its relatively closed economic and financial systems unaffected by the crisis. Prior to the 1997/98 crisis, the PRC boasted huge foreign reserves, low external debt, and sound economic fundamentals, which allowed it to ride out and counter speculative attacks against its currency. Also, the slow pace of financial liberalization meant there was little opportunity for foreign speculators to tap the domestic capital market. This lessened the magnitude of uncontrolled capital movement. In the Philippines, potential output languished in the 1980s and the momentum of its economic recovery in the 1990s seems to have overcome the adverse impacts of the 1997/98 crisis (Figure 2h). In fact, the level of potential output at a certain point during the 1997/98 crisis is estimated to have exceeded the level consistent with the pre-crisis trend. Moreover, the Philippines did not benefit as much from pre-crisis capital inflows compared with other East Asian economies and therefore was not as severely affected by the abrupt withdrawal of capital from the region. Apart from its technological advantage, Taipei,China’s relatively good performance immediately after the 1997/98 crisis is attributed to several factors similar to those present in the PRC at the time of the crisis. For one, the Taipei,China’s huge foreign reserves, low external debt, and sound economic fundamentals allowed it to withstand speculative attacks against its currency. Also as in the PRC, the slow pace of financial liberalization meant there was little opportunity for foreign speculators to tap the domestic capital market. This lessened the magnitude of uncontrolled capital movement. In addition, Taipei,China adopted a moderately loose monetary policy that kept the price range within reasonable levels. Strictly speaking, Taipei,China belongs to the first group since the economy experienced a recession in 2001 and Figure 2i depicts a Scenario 1 pattern. The recession was brought about by the downturn in the global electronics market, increase in the number of bad loans in the financial sector, and continued migration of Taipei,China’s manufacturers to the PRC to take advantage of cheaper costs for land and labor. However, since the fall in potential output was mild and not related to the 1997/98 crisis, Taipei,China is included in the third group. 17 Furceri and Mourougane (2009). The 2008 Financial Crisis and Potential Output in Asia: Impact and Policy Implications | 13 Differences in initial conditions, country-specific reasons, and policy responses exerted significant influence on the patterns of post-crisis recovery. The cross-country comparison of post-crisis recoveries suggests three important elements contribute to a healthy recovery. First are the initial conditions. Economies with relatively sound economic fundamentals stand a better chance in dealing with a shock. Second, continued openness and currency flexibility allowed some economies to tap external demand when domestic demand slackened. Luckily, a favorable external environment during the 1997/98 crisis helped the region in the recovery process. Third, swift policy responses to mitigate the initial crisis impact proved beneficial not only in the short-term, but also later in the medium- to long-term, by minimizing disruptions in asset allocation, such as a rise in unemployment and a deterioration in capital stock. Finally, the crisis prompted corporate restructuring and structural reforms in many emerging East Asian economies. Their medium-term output performances reflect the success of these reforms. 5.2 Econometric Evidence A simple growth model was estimated to provide econometric evidence for the arguments in the previous section (Appendix 1). The results indicate that the investment- to-GDP ratio exerts a positive and significant impact on per capita growth of potential output. Policy variables represented by government consumption and money supply also affect the dependent variable significantly. The significant impact of the growth rate of major industrialized economies implies that greater openness and a favorable global economy support the expansion of potential output. However, the impact of the real effective exchange rate is ambiguous as explained in Appendix 1. The econometric results, however, do not refute the need for a depreciation that will restore external balance. An interesting result is the positive and significant impact of the level of technological activity in the random-effects version of the econometric results. While the variable is insignificant in the fixed-effects model, the study presents enough evidence to support policies that enhance an economy’s technological capability. 6. Implications for Responses to the 2008/09 Crisis 6.1 Output Gap, Exit Strategies, and Medium-Term Policies Output losses associated with crises are significant, but appropriate policy responses can shape the post-crisis recovery and help contain medium-term output losses. The forecast-adjusted simple HP filtered estimates and the MS estimates suggest a drop in potential output growth for emerging East Asian economies.18 Consistent with earlier 18 The output gaps derived from HP estimates are used for the analysis in this section. The MS output gaps are relatively small and have a counterintuitive sign particularly after the 1997/98 crisis. As explained earlier, this is because the switch in regimes is loaded into the potential component of output. 14 | Working Paper Series on Regional Economic Integration No. 45 studies, potential output is likely to have been reduced by the 2008/09 crisis. However, the drop was generally milder during this crisis compared to the 1997/98 crisis. The previous crisis experience also shows large variations in the post-crisis recovery patterns of individual economies. The key challenge for policymakers is therefore to implement policies that will close the output gap and at the same time stem the decline in potential output. Policy adjustments at the macroeconomic level are an integral part of the recovery process. A critical difference between the 1997/98 crisis and the 2008/09 crisis is the size and promptness of monetary and fiscal responses. Short-run monetary and fiscal policy stimuli proved effective in dealing with immediate crisis effects in 2008/09.19 Output gaps (Figures 3a to 3i) show that many economies reached their troughs in the first quarter of 2009, only one quarter after the crisis created negative output gaps. This can be attributed to timely and sizeable policy support. In contrast, during the 1997/98 crisis, the output gaps were largely negative for nearly 2 years from the first quarter of 1998. Recent studies also find that short-run expansionary macroeconomic policies are positively correlated with smaller output and growth losses (Abiad et al., 2009). While expansionary macroeconomic policies have been moderately successful in narrowing the negative output gap, careful monitoring of the output gaps is important to avoid risks of mistimed exits. In the wake of the recent crisis, the first order of business was to design and implement fiscal stimulus packages, and to loosen monetary policy. The swift policy responses have been moderately successful as GDP growth for East Asian economies was generally higher in the second and third quarters of 2009 compared with the first quarter. However, fiscal policy has to be consolidated and monetary policy has to be tightened in due time otherwise the recovery will be snuffed by inflationary pressures. Output gaps can be a useful guide in timing an exit strategy. For the majority of the region's economies, the forecast-adjusted, simple HP-filtered estimates suggest that output gaps remain negative. Although a declining trend is detected, the negative output gap suggests that any talk of exit strategies is still premature. The exceptions to this are the PRC and Indonesia, where output gaps are turning positive. The region's policymakers need to look into instituting more structural measures designed to counter the permanent effects of a crisis on output. It is important for policymakers to be able to determine whether the downturn in GDP during crisis years is associated more with the cyclical components or a reduction in the potential output. Cyclical downturns might be countered with fiscal and monetary countercyclical policy. On the other hand, a permanent reduction in potential output growth is better addressed with more structural changes (such as policies to reduce the structural rate of unemployment). The estimated results using the forecast-adjusted, simple HP-filter and the MS methodology suggest that for some countries and regions, both the 1997/98 and 2008/09 crises reduced potential output growth. Therefore, future crises are likely to once again lead either to Scenario 2 or Scenario 3, rather than Scenario 1. For economies that did experience a Scenario-1-type pattern, the importance of productivityretaining measures was underscored. This again makes further structural reforms a 19 This is also supported by the econometric evidence presented in Appendix 1. The 2008 Financial Crisis and Potential Output in Asia: Impact and Policy Implications | 15 priority. An exit strategy from the stimulus measures and a shift to policies that focus more on medium-term economic growth is, therefore, very important. A major policy consideration is how to lift potential output to minimize medium-term output losses while sustaining a recovery’s momentum. A crisis provides incentives and catalysts for structural reforms. Economies that have seized the opportunity were often able to grow faster and achieve higher potential output even after a crisis. Although necessary structural reforms are country-specific, many of these structural policies are medium-term in nature (e.g., education and R&D). Hence, there should be investment programs in the pipeline as the stimulus measures are withdrawn. Additional key actions that can contribute to national economic recovery include the strengthening of the banking sector and financial markets, control of inflation, and timely provision of fiscal stimuli. Measures to reduce unemployment have also been largely successful, although larger numbers of workers are employed in the informal sector in many developing countries. 6.2 Regional Rebalancing Since a favorable external environment is crucial to the full recovery of potential output and the timing of recovery of industrialized economies is uncertain, rebalancing the sources of growth toward greater domestic and regional demand is important. In this context, it is important to distinguish between rebalancing at the regional level and rebalancing at the national level (or domestic level) and how these two processes relate to each other. A framework as shown in Figure 4 should be developed as the basis for appropriate policies. Some experts have noted that Asia’s outward-oriented development model does not need to be overhauled. Rather, what will be required is an adjustment in net exports and some shift toward production for Asian demand. In other words, the main thrust of regional rebalancing should be an increase in intra-regional trade and investment among East Asian economies, but with more of the final exports going to economies in the region instead of the US and Western Europe. In order to facilitate this transition, some economies have to import more from their neighbors, which implies increasing their domestic spending (consumption and investment). Hence, rebalancing will lead to an increase in the level of potential output. The strategy of coordinating regional and domestic rebalancing will allow the economies of East Asia to retain their outward orientation and overcome the threat of protectionism. As indicated earlier, openness was crucial for the NIEs in maintaining their technological edge. The relatively stable real effective exchange rates of the nine economies of emerging East Asia, largely due to the absence of disruptions in the balance sheets of the financial and corporate sectors, will also contribute to maintaining an outward orientation. 16 | Working Paper Series on Regional Economic Integration No. 45 7. Appendix Appendix 1: Econometric Model and Empirical Results Model To guide policymakers and provide econometric evidence for the arguments laid out in the text, a simple growth model is estimated. Instead of actual gross domestic product (GDP) growth being the dependent variable, the per capita growth rate of potential output is used. The estimated model is as follows: is per capita growth rate of economy i at time t, is the investment-GDP ratio of economy i lagged k periods; is government consumption growth y-o-y in real terms for economy i lagged l periods; is the year-on-year (y-o-y) percentage in the real effective exchange rate for economy i lagged m periods, with positive value indicating an appreciation; is y-o-y money supply growth in real terms for economy i lagged n periods; is the weighted average of the y-o-y real GDP growth rate of the United States (US), Japan, and Europe, with weights fixed at 42%, 14%, and 44%, respectively; is the per capita income of economy i in 1990 in PPP$; and is the level of technological activity for economy i as reported in Table 4, with the 1995 figure being applied to 1990–1999 and the 2001 figure being applied to 2000–2009. The growth model is patterned after Park and Lee (2002) since the economy’s behavior after the 1997/98 crisis is of interest in this study. The investment-to-GDP ratio indicates the rate at which the capital stock is augmented. Data on the latter variable is not available for all economies hence GDPI / is used instead. Differences in initial conditions could affect future growth rates and also the pattern of adjustment to a crisis. In growth theory, an economy with a lower initial per capita GDP is in a more favorable position for future growth. The fundamental idea is that the gap in existing capital and technology between the current and steady-state levels provides an opportunity for ―catching up‖ via high rates of capital accumulation as well as diffusion of technology from more advanced economies. This is the rationale for the variable . Meanwhile, macroeconomic and structural reform policies implemented by the government for crisis management can influence the behavior of both actual and potential output. Fiscal policy can shore up domestic demand while monetary policy usually plays a crucial role in determining consumption and investment. While the major concern of policymakers would be short-term output growth, implementing appropriate stimulus measures has repercussions on medium- and long-term output growth. For The 2008 Financial Crisis and Potential Output in Asia: Impact and Policy Implications | 23 Figure 2: Potential Output (local currency, billion) Figure 2: Potential Output (local currency, billion) Source: Authors calculations using gross domestic product (GDP) data sourced from Oxford Economics and forecast GDP growth rates from the Asian Development Outlook 2009 Update. Markov Switching HP Potential Output Trend immediately prior to 1997 crisis 100 140 180 220 260 300 340 380 420 460 Mar- 80 Jun- 82 Sep- 84 Dec- 86 Mar- 89 Jun- 91 Sep- 93 Dec- 95 Mar- 98 Jun- 00 Sep- 02 Dec- 04 Mar- 07 Jun- 09 a. Hong Kong, China Dec- 10 40000 80000 120000 160000 200000 240000 280000 Mar- 80 Jun- 82 Sep- 84 Dec- 86 Mar- 89 Jun- 91 Sep- 93 Dec- 95 Mar- 98 Jun- 00 Sep- 02 Dec- 04 Mar- 07 Jun- 09 b. Republic of Korea Dec- 10 5 15 25 35 45 55 65 Mar- 80 Jun- 82 Sep- 84 Dec- 86 Mar- 89 Jun- 91 Sep- 93 Dec- 95 Mar- 98 Jun- 00 Sep- 02 Dec- 04 Mar- 07 Jun- 09 c. Singapore Dec- 10 20 40 60 80 100 120 140 Mar- 80 Jun- 82 Sep- 84 Dec- 86 Mar- 89 Jun- 91 Sep- 93 Dec- 95 Mar- 98 Jun- 00 Sep- 02 Dec- 04 Mar- 07 Jun- 09 Dec- 10 d. Malaysia 100000 200000 300000 400000 500000 600000 Mar- 80 Jun- 82 Sep- 84 Dec- 86 Mar- 89 Jun- 91 Sep- 93 Dec- 95 Mar- 98 Jun- 00 Sep- 02 Dec- 04 Mar- 07 Jun- 09 e. Indonesia Dec- 10 200 400 600 800 1000 1200 1400 Mar- 80 Jun- 82 Sep- 84 Dec- 86 Mar- 89 Jun- 91 Sep- 93 Dec- 95 Mar- 98 Jun- 00 Sep- 02 Dec- 04 Mar- 07 Jun- 09 f. Thailand Dec- 10 24 | Working Paper Series on Regional Economic Integration No. 45 Figure 2: continued Figure 2: continued Source: Authors calculations using gross domestic product (GDP) data sourced from Oxford Economics and forecast GDP growth rates from the Asian Development Outlook 2009 Update. Markov Switching HP Potential Output Trend immediately prior to 1997 crisis 800 1800 2800 3800 4800 5800 6800 7800 Dec- 88 Jun- 90 Dec- 91 Jun- 93 Dec- 94 Jun- 96 Dec- 97 Jun- 99 Dec- 00 Jun- 02 Dec- 03 Jun- 05 Dec- 06 Jun- 08 Dec- 09 Dec- 10 g. People's Republic of China 100 150 200 250 300 350 400 Mar- 80 Jun- 82 Sep- 84 Dec- 86 Mar- 89 Jun- 91 Sep- 93 Dec- 95 Mar- 98 Jun- 00 Sep- 02 Dec- 04 Mar- 07 Jun- 09 h. Philippines Dec- 10 500 1000 1500 2000 2500 3000 3500 Mar- 80 Jun- 82 Sep- 84 Dec- 86 Mar- 89 Jun- 91 Sep- 93 Dec- 95 Mar- 98 Jun- 00 Sep- 02 Dec- 04 Mar- 07 Jun- 09 Dec- 10 i. Taipei,China The 2008 Financial Crisis and Potential Output in Asia: Impact and Policy Implications | 25 Figure 3: Output Gap Figure 3: Output Gap -10 -8 -6 -4 -2 0 2 4 6 8 Mar- 90 Dec- 91 Sep- 93 Jun- 95 Mar- 97 Dec- 98 Sep- 00 Jun- 02 Mar- 04 Dec- 05 Sep- 07 Jun- 09 -2.5 -2 -1.5 -1 -0.5 0 0.5 1 1.5 2 Output Gap, HP (Left Axis) Output Gap, MS (Right Axis) Dec- 10 a. Hong Kong, China -10 -8 -6 -4 -2 0 2 4 6 8 10 12 Mar- 90 Dec- 91 Sep- 93 Jun- 95 Mar- 97 Dec- 98 Sep- 00 Jun- 02 Mar- 04 Dec- 05 Sep- 07 Jun- 09 -0.012 -0.008 -0.004 0 0.004 0.008 0.012 0.016 Output Gap, HP (Left Axis) Output Gap, MS (Right Axis) Dec- 10 b. Republic of Korea -12 -8 -4 0 4 8 12 16 Mar- 90 Dec- 91 Sep- 93 Jun- 95 Mar- 97 Dec- 98 Sep- 00 Jun- 02 Mar- 04 Dec- 05 Sep- 07 Jun- 09 Output Gap, MS Output Gap, HP Dec- 10 c. Singapore -9 -6 -3 0 3 6 9 12 Mar- 90 Dec- 91 Sep- 93 Jun- 95 Mar- 97 Dec- 98 Sep- 00 Jun- 02 Mar- 04 Dec- 05 Sep- 07 Jun- 09 Output Gap, MS Output Gap, HP Dec- 10 d. Malaysia -15 -10 -5 0 5 10 15 Mar- 90 Dec- 91 Sep- 93 Jun- 95 Mar- 97 Dec- 98 Sep- 00 Jun- 02 Mar- 04 Dec- 05 Sep- 07 Jun- 09 -0.003 -0.002 -0.001 0 0.001 0.002 0.003 Output Gap, HP (Left Axis) Output Gap, MS (Right Axis) Dec- 10 e. Indonesia -10 -8 -6 -4 -2 0 2 4 6 8 10 12 Mar- 90 Dec- 91 Sep- 93 Jun- 95 Mar- 97 Dec- 98 Sep- 00 Jun- 02 Mar- 04 Dec- 05 Sep- 07 Jun- 09 -2 -1.5 -1 -0.5 0 0.5 1 1.5 2 2.5 Output Gap, HP (Left Axis) Output Gap, MS (Right Axis) Dec- 10 f. Thailand 26 | Working Paper Series on Regional Economic Integration No. 45 Figure 3: continued -8 -6 -4 -2 0 2 4 Mar- 90 Dec- 91 Sep- 93 Jun- 95 Mar- 97 Dec- 98 Sep- 00 Jun- 02 Mar- 04 Dec- 05 Sep- 07 Jun- 09 -7 -6 -5 -4 -3 -2 -1 0 1 2 3 Output Gap, HP (Left Axis) Output Gap, MS (Right Axis) Dec- 10 g. People's Republic of China -4 -3 -2 -1 0 1 2 3 4 5 Mar- 90 Dec- 91 Sep- 93 Jun- 95 Mar- 97 Dec- 98 Sep- 00 Jun- 02 Mar- 04 Dec- 05 Sep- 07 Jun- 09 -1 -0.75 -0.5 -0.25 0 0.25 0.5 0.75 1 1.25 1.5 Output Gap, HP (Left Axis) Output Gap, MS (Right Axis) Dec- 10 h. Philippines -7 -5 -3 -1 1 3 5 7 Mar- 90 Dec- 91 Sep- 93 Jun- 95 Mar- 97 Dec- 98 Sep- 00 Jun- 02 Mar- 04 Dec- 05 Sep- 07 Jun- 09 -1 -0.8 -0.6 -0.4 -0.2 0 0.2 0.4 0.6 0.8 1 Output Gap, HP (Left Axis) Output Gap, MS (Right Axis) Dec- 10 i. Taipei,China The 2008 Financial Crisis and Potential Output in Asia: Impact and Policy Implications | 27 Figure 4: Linking Regional and Domestic Rebalancing Table 4: Technological Activity Index REGIONAL REBALANCING DOMESTIC REBALANCING Table 4: Technological Activity Index Rank 1995 Rank 2001 (out of 117 countries) Index (out of 117 countries) Index High Innovation 3 Japan 0.949 5 Japan 0.935 10 Taipei,China 0.89 7 Taipei,China 0.902 18 Singapore 0.803 12 Singapore 0.875 24 Korea, Republic of 0.762 20 Korea, Republic of 0.812 Medium-high Innovation 37 Hong Kong, China 0.613 33 Hong Kong, China 0.632 61 Malaysia 0.401 55 Malaysia 0.446 63 China, People's Republic of 0.39 58 China, People's Republic of 0.417 67 Thailand 0.34 61 Thailand 0.361 76 Philippines 0.264 80 Philippines 0.265 85 Indonesia 0.203 Low Innovation 93 Indonesia 0.175 Source: UNCTAD. World Investment Report, 2005 Note: Each component of the Index has equal weights, the Index value being the simple average of the normalized value of the three variables: R&D manpower, patents in the United States and scientific journal articles. Country Country 28 | Working Paper Series on Regional Economic Integration No. 45 Table A.1: Regression with Driscoll–Kraay Standard Errors Table A.1 Regression with Driscoll-Kraay standard errors Pesaran's test of cross sectional independence = 8.664, Pr = 0.0000 Average absolute value of the off-diagonal elements = 0.223 Time period: 1990.1 to 2009.2 Number of obs = 702 Method: Fixed-effects regression Number of groups = 9 Group variable (i): country F( 16, 8) = 106.12 maximum lag: 3 Prob > F = 0.0000 within R-squared = 0.5020 gr_opc Coef. Std. Err. t P>|t| I/GDPi,t-1 44.30594 11.34307 3.91 0.005 18.14877 70.46311 I/GDPi,t-2 1.766473 13.11754 0.13 0.896 -28.48262 32.01557 I/GDPi,t-3 -11.73668 11.00396 -1.07 0.317 -37.11184 13.63849 I/GDPi,t-4 -35.71371 9.817551 -3.64 0.007 -58.35303 -13.0744 REER i,t-1 0.0493613 0.0185593 2.66 0.029 0.0065636 0.0921591 REER i,t-2 0.0566701 0.0151829 3.73 0.006 0.0216583 0.0916819 REER i,t-3 -0.0057716 0.0137737 -0.42 0.686 -0.0375339 0.0259906 REER i,t-4 -0.0312023 0.0091777 -3.40 0.009 -0.0523661 -0.0100386 MSi,t-1 0.0277273 0.0337377 0.82 0.435 -0.050072 0.1055266 MSi,t-2 0.1160739 0.0331892 3.50 0.008 0.0395395 0.1926083 GCi,t-1 0.0204435 0.0176002 1.16 0.279 -0.0201426 0.0610297 GCi,t-2 0.0430097 0.0188366 2.28 0.052 -0.0004276 0.086447 GR_US_JAP_EU 0.7960337 0.1319575 6.03 0.000 0.4917391 1.100328 TA it -1.138649 12.81787 -0.09 0.931 -30.6967 28.4194 GDPi,0 0.0004438 0.0014232 0.31 0.763 -0.0028381 0.0037257 crisis -4.0994 1.146849 -3.57 0.007 -6.744039 -1.45476 _cons (omitted) [95% Conf. Interval] The 2008 Financial Crisis and Potential Output in Asia: Impact and Policy Implications | 29 Table A.2: Cross-sectional Time-Series FGLS Regression, Random Effects Table A.2: Cross-sectional time-series FGLS regression, random effects Coefficients: generalized least squares Panels: heteroskedastic Correlation: no autocorrelation Pesaran's test of cross sectional independence = 10.209, Pr = 0.0000 Estimated covariances = 9 Number of obs = 702 Estimated autocorrelations = 0 Number of groups = 9 Estimated coefficients = 17 Time periods = 78 Wald chi2(16) = 965.06 Prob > chi2 = 0.0000 gr_opc Coef. Std. Err. t P>|t| I/GDPi,t-1 60.89181 9.454518 6.44 042.36129 79.42232 I/GDPi,t-2 3.132636 13.37797 0.23 0.815 -23.0877 29.35297 I/GDPi,t-3 -16.2035 13.39094 0.226 -42.44925 10.04225 I/GDPi,t-4 -39.66735 9.476735 -4.19 0 -58.24141 -21.09329 REER i,t-1 0.0527876 0.0142222 3.71 00.0249126 0.0806627 REER i,t-2 0.0505705 0.0175188 2.89 0.004 0.0162344 0.0849067 REER i,t-3 -0.0029573 0.0170837 -0.17 0.863 -0.0364407 0.0305262 REER i,t-4 -0.0319757 0.0141286 -2.26 0.024 -0.0596672 -0.0042842 MSi,t-1 0.0343035 0.0311144 1.1 0.27 -0.0266796 0.0952866 MSi,t-2 0.0914888 0.0314566 2.91 0.004 0.0298349 0.1531427 GCi,t-1 0.0383344 0.0164303 2.33 0.02 0.0061316 0.0705373 GCi,t-2 0.054322 0.0163228 3.33 0.001 0.0223298 0.0863142 GR_US_JAP_EU 0.7037246 0.0744424 9.45 00.5578202 0.8496289 TA it 3.414927 0.723703 4.72 01.996495 4.833358 GDPi,0 -0.0001203 0.0000401 -3 0.003 -0.0001989 -0.0000417 crisis -3.624811 0.3724092 -9.73 0 -4.35472 -2.894902 _cons -2.149762 0.4873421 -4.41 0 -3.104935 -1.194589 [95% Conf. 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Business Cycles, Indicators, and Forecasting. Chicago: University of Chicago. The 2008 Financial Crisis and Potential Output in Asia: Impact and Policy Implications In this paper, Cyn-Young Park, Ruperto Majuca, and Josef Yap investigate the post-crisis behavior of potential output in emerging East Asian economies by employing the Markovswitching model to account for structural breaks. Results show that after the 1997/98 Asian financial crisis, potential output in Hong Kong, China; the Republic of Korea (Korea); Singapore; and Malaysia reverted to levels consistent with trends prior to the crisis. Econometric estimates of a simple growth model show that the differences among the patterns of post-crisis recovery can be attributed to the investment-to-gross-domestic- product (GDP) ratio; macroeconomic policies; exchange rate behavior; and productivity. These results can be used to guide policy in the aftermath of the 2008 global financial crisis. About the Asian Development Bank ADB’s vision is an Asia and Pacific region free of poverty. Its mission is to help its developing member countries substantially reduce poverty and improve the quality of life of their people. Despite the region’s many successes, it remains home to two-thirds of the world’s poor: 1.8 billion people who live on less than $2 a day, with 903 million struggling on less than $1.25 a day. ADB is committed to reducing poverty through inclusive economic growth, environmentally sustainable growth, and regional integration. Based in Manila, ADB is owned by 67 members, including 48 from the region. Its main instruments for helping its developing member countries are policy dialogue, loans, equity investments, guarantees, grants, and technical assistance. Asian Development Bank 6 ADB Avenue, Mandaluyong City 1550 Metro Manila, Philippines www.adb.org/poverty Publication Stock No. Printed in the Philippines