With the exception of China, Asia-Pacific is breathing easier than the rest of the world. Global obstacles have altered the outlook since the Credit Conditions Committee convened three months ago. These include a longer-than-expected Russia-Ukraine conflict; higher energy and commodity prices; higher and more sticky inflation, especially in the U.S.; faster monetary policy normalization in the U.S. and Europe; and economic damage from COVID-19 lockdowns and restrictions in China.

These hurdles led us to downgrade our 2022 global growth forecast in our interim update in May (see "Global Macro Update: Growth Forecasts Lowered On Longer Russia-Ukraine Conflict And Rising Inflation," published on May 18, 2022). We cut our GDP growth projections for the U.S., China, and Europe by 0.7-0.8 percentage points and raised consumer price index (CPI) inflation forecasts for the U.S., Europe, and some Asia-Pacific economies. In our current global forecast round we have further reduced our growth projections for the U.S., Europe, and China and raised our inflation projections for a range of economies.

For Asia-Pacific, the two key changes to the global outlook are the weaker growth in China due to stringent COVID restrictions and the higher projected U.S. interest rates. Considering the slower-than-expected easing of COVID restrictions and shallow recovery of domestic demand in China, we have further lowered our baseline 2022 growth forecast for the country to 3.3%.

Despite the headwinds, Asia-Pacific growth prospects remain broadly favorable. Outside China, the post-COVID domestic recovery is mostly continuing. We expect solid economic growth in 2022-2023, especially in economies relatively led by domestic demand such as India, Indonesia, and the Philippines.

However, rising inflation has been a key factor behind the start of the monetary policy normalization in many economies: all but four central banks have started raising their policy rates. The other key motivation is staving off external pressure amid rising global interest rates. Capital outflows and currency depreciation against the U.S. dollar have so far been contained. But we expect most central banks to continue to raise their policy rates to anchor inflation expectations and guard against external vulnerability.

China's COVID Weakness

In China, lockdowns in Shanghai and elsewhere have hindered the economy since end-March. Consumption and the service sector have particularly suffered (chart 1), and more so than investment and industrial production. Nonetheless, because of the intricate supply chains in and around Shanghai industrial production has been substantially disrupted.

Since May, restrictions and their economic impact have started to ease, but the recovery is shallow. Conditions in industry and exports improved significantly in May. And, as has been the case throughout the COVID period, the effects of China's restrictions on global supply chains should remain manageable. However, consumption and service sector activity remained weak and the recovery is slower than in 2020. This is because the easing of restrictions on movement has been gradual, new restrictions have been imposed in other areas, and overall sentiment remains poor. In all, the economy is on track for a very weak second quarter, with little or no year-on-year growth.

Policy makers are taking modest steps to support growth. On the monetary side, concerns about capital outflows amid rising U.S. interest rates prevent the People's Bank of China (PBOC) from slashing interest rates. But the PBOC is using quantitative levers to support credit growth. On the fiscal side, China is advancing its infrastructure development and has implemented some tax cuts, while a cut in the mortgage rate provides some support to the property market.

A Tepid Recovery In China

Given China's weak second quarter and with its COVID stance unlikely to change soon, we expect the country's growth to fall well short of the "around 5.5%" target. In our new baseline, we project full-year GDP at 3.3%. This is based on the impact of lockdowns and restrictions easing in the second half and some stimulus kicking in. The lack of visibility on the COVID situation has started to affect medium-term prospects, as investment decisions change and some foreign companies look at moving production to other economies. As a result, we have tempered our expectation as to how much the economy can recover in 2023 following the current weakness.

The key downside risk in China is new COVID lockdowns in one or more large, relatively developed cities with economic heft and connectivity. GDP growth in 2022 would be lower still, with the relative strain on consumption, investment, industrial production and service sector activity to resemble that of the recent episode.

China's lockdown weakness has lowered demand for other countries' exports. The fact that consumer spending is hit harder by the lockdowns than investment and industrial production mitigates the stress on other economies, as China's consumption is less import-reliant. Nonetheless, China's imports have weakened severely, in part because of the impact of the property downturn on commodity imports (chart 2).

Chart 1

Chart 2

Growth Outlook For Asia-Pacific Ex China Remains Solid

Economic growth generally eased in early 2022 after the rebound in 2021. With quarter-on-quarter growth falling to 0.7% in Asia-Pacific ex China, year-on-year growth slowed to 3.3%, compared with 5.4% in 2021. The slowdown was most pronounced in Hong Kong and least visible in Malaysia.

Export momentum has softened. This is in line with the slowdown in global trade we have been expecting for 2022 and a likely slowdown in major economies including the U.S. This will especially weigh on growth in relatively trade-sensitive economies such as South Korea, Taiwan, Thailand, and Singapore.

However, the recovery in domestic demand from COVID is largely intact, so overall growth has softened only modestly. This is especially so in Australia, India, Japan, Indonesia, and the Philippines where growth is more domestic demand-oriented.

We expect India's GDP to grow by 7.3% in fiscal year 2023 compared with 7.8% three months ago. The causes of this downward pressure on growth are high oil prices, slowing global demand for India's exports, and high inflation. The latter is curbing the purchasing power of the poor because energy and food, key drivers of current inflation, account for a chunk of their consumption basket. But there are also factors supporting growth. A normal monsoon is forecast for 2022. This will support agriculture production and help control food inflation. A rebound in contact-based services--as vaccination penetration improves and people learn to live with the virus--will also boost growth.

Overall, we revised down our GDP growth forecast for Asia-Pacific ex China in 2022 by a modest 0.1 percentage point compared with our May interim update to 4.9%; compared to the outlook of three months ago the new forecast implies a downward revision of 0.3 percentage point.

Output will remain below its pre-COVID trend for a long time in several Asia-Pacific economies. We currently expect that as of 2022 this "scarring" will be the largest in the Philippines, India, Malaysia, and Thailand (chart 3). Nonetheless, our forecast for Asia-Pacific GDP growth of about 4.8% in 2023-2025 would mean the region will resume its status as the world's fastest growing.

Table 1

Inflation And External Pressure Demand Central Banks' Attention

Inflation has risen and is likely to increase further. We have raised our projections for inflation in several economies, especially in Australia, India, Indonesia, New Zealand, Singapore, South Korea, and Thailand. Driving these revisions are higher energy and commodity prices and, in a few cases, larger pass-through as economies recover and core inflation picks up amid decreasing slack.

Government policy matters. While energy price inflation generally remains high, that is not so in Malaysia and Indonesia. The two economies are net energy exporters and are not passing on some of the energy commodity cost increases to consumers. In Asian emerging markets food price inflation is generally not as serious as in other emerging market regions, but it is rising (see chart 4).

Chart 3

Chart 4

Among the economies we cover, CPI inflation is the highest in India, where a relatively unresponsive supply side has kept inflation elevated. High fuel and commodity prices triggered the initial rise in inflation, but it has become broad-based and persistent. Despite relatively weak consumer demand in many pockets, core inflation remains elevated as companies protect margins by passing on the rising input costs to consumers. The rebound in contact-based services is also contributing to inflation. We expect consumer inflation of 6.8% this fiscal year, and 5.8% for the last quarter January-March 2023.

Consumer inflation is rising across the region. By May, inflation was exceeding the upper bound of central bank targets in Australia, India, New Zealand, the Philippines, South Korea, and Thailand (see chart 5). The rise in inflation has led central banks in Australia, India, Malaysia, and the Philippines to join others in starting to normalize monetary policy.

Still, consumer inflation has generally not risen as much as in the U.S. and Europe. Core CPI pressures have only started picking up recently since the post-COVID recovery in domestic demand has been more muted. Moreover, in many economies, a relatively responsive supply side helps to absorb demand increases. In China, Japan and Indonesia, inflation prospects remain contained.

In China, consumer inflation remains low amid weak demand, and it is unlikely to significantly exceed the PBOC's 3% target. Japan's headline inflation reached 2.5% because of the higher energy and commodity prices. So-called "core core" inflation, which excludes volatile components such as energy and food, was 0.8% in April. With wage growth in Japan's large service sector unlikely to spike, we agree with the Bank of Japan (BOJ) that headline inflation will fall again in 2023.

Indonesia used to be a relatively high inflation economy. But reforms, including those in the logistics sector, have reduced structural inflation. This reform, combined with the impact of some administrative measures to contain energy prices, has kept CPI inflation below the upper band of the central bank's target.

On average, we anticipate that consumer inflation in Asia-Pacific will reach 3.6% in 2022. This relatively modest pace of price increases helps mitigate the interest rate increases central banks must pursue at a time when growth faces possible resistance.

Table 2

The Specter Of Capital Outflows

Meanwhile, the U.S. Federal Reserve's policy tightening raises the potential for capital outflows from Asia's economies--especially its emerging markets. We now expect the Fed to raise the federal funds rate above 3.5% by mid-2023. As some capital is attracted by higher U.S. interest rates, Asia-Pacific currencies and asset markets are affected.

Capital outflow pressures have so far remained moderate. In China, "net financial flows" have been large in the first five months of 2022, but they don't point to a major shift compared with 2021. There have been appreciable equity outflows out of India and the Philippines, but other portfolio outflows are limited.

Exchange rate movements suggest that markets have so far generally focused more on the divergence of monetary policy and energy price increases than on potential emerging market vulnerability. Where the monetary policy outlook remained accommodative, currencies have depreciated against the U.S. dollar, with the Japanese yen the starkest example. In response to the energy price increases, markets have also favored the currencies of net energy exporters such as Australia and Indonesia. But up until June 20, 2022, the Asian emerging markets currencies had on average weakened 5.0%, a modest amount compared with the Asia-Pacific developed markets' average of 7.2% (excluding the pegged Hong Kong dollar) and 8.0% for the euro (see chart 6).

Chart 5

Chart 6

The Chinese renminbi has weakened significantly against the U.S. dollar since early April. But so far this year depreciation has remained modest; and it remains quite strong in effective (trade-weighted) terms. The weakening since early April was mainly because of the impact of the lockdowns and possibly geopolitical factors. Another factor is the relatively easy monetary policy in China and the fact that bond yields there are now broadly in line with those in the U.S. Further lockdowns would trigger more renminbi depreciation.

Notwithstanding the absence of major pressure so far, rising U.S. interest rates could force capital outflow--emerging market central banks will want to guard against this.

Central Banks Face A Balancing Act

Against this backdrop, Asia-Pacific central banks are weighing the desire to support growth against the need to tighten policy to anchor inflation expectations or to head off financial instability.

Many central banks are on course to tighten substantially because of higher inflation. Where CPI inflation is already exceeding targets significantly and is bound to rise further, central banks will seek to tighten monetary policy and maintain their credibility.

Central bankers in emerging markets that are vulnerable to capital outflow in the context of an increasingly hawkish U.S. Fed have little policy room. They will likely need to tighten. This is especially the case for net energy-importing emerging markets without a current account surplus to start with. The reason is that their current accounts will turn into significant deficits in 2022 due to higher energy prices. This points to India, the Philippines, and Thailand.

Where neither inflation nor external pressure is a major constraint on monetary policy, central banks will focus on supporting growth, in our view. Where possible, central banks will want to tighten policy as little as possible, or not at all.

• In China, quantitative channels and capital controls provide leeway to ease monetary policy without necessarily seeing sharp currency deprecation. Amid economic weakness, the PBOC is combining small interest rate cuts with quantitative instruments to support credit growth.
• The BOJ reaffirmed its commitment to very easy monetary policy despite a more hawkish U.S. Fed. With underlying inflation pressure subdued, the BOJ won't raise its policy rate any time soon, we believe. While the ensuing weakening in the yen worried some government officials, there is little sign it will affect the BOJ's policy stance for now.
• We expect some policy rate increases in in Indonesia, but to levels that remain modest.

While the higher inflation and more hawkish U.S. Fed stance affect all Asia-Pacific central banks, how they respond to it varies in line with local conditions and leeway.

Table 3

Table 4

Table 5

Related Research

• Higher Interest Rates Will Cool Some Red-Hot Residential Markets In Asia, June 16, 2022
• Economic Research: Global Macro Update: Growth Forecasts Lowered On Longer Russia-Ukraine Conflict And Rising Inflation, May 18, 2022
• China's COVID Policy To Further Weigh On Economy, Credit, May 16, 2022
• Economic Research: Interest Rates To Rise Across Asia-Pacific, April 13, 2022
• Economic Research: Asia-Pacific Economic Risks, Thy Name Is Inflation, March 28, 2022

Editor: Lex Hall, Design: Halie Mustow