The external environment has soured for Asia-Pacific economies. China's outlook is subdued and growth prospects have worsened in the U.S. and Europe, pointing to weaker export demand. At the same time, global energy and commodity prices have eased. But with U.S. core inflation still high, the Federal Reserve is likely to keep raising its policy rate. S&P Global Ratings believes higher global interest rates and the associated capital flow strains, together with varying degrees of domestic inflation, will pressure Asia-Pacific central banks to lift rates, even as economies slow.

We see constructive signs. Recovering domestic demand will support economic expansion as the impact of COVID-19 and restrictions abates. We generally expect significant overall growth in the second half of 2022 and a slowdown in 2023 due to weaker global demand and higher interest rates. Pressure to tighten monetary policy because of inflation is generally lower in this region than in the U.S. While the resulting policy divergence could potentially invite capital outflows and depreciation, it helps contain the hit that higher interest rates have on growth.

Amid weak confidence and housing activity, we expect a shallow sequential recovery in China in the second half of 2022 and 2.7% GDP growth for 2022 as a whole, compared with our previous forecast of 3.3%. We project 4.7% GDP growth next year, from 5.2% earlier, even as we downgrade 2022 growth. We have also nudged down our forecast for growth in 2024, to 4.8%.

We have trimmed our GDP growth forecast for Asia-Pacific ex-China in 2022 by 0.1 percentage point compared with our June outlook, to 4.8%, and expect growth in this region to slow to 4.3% in 2023, compared with 4.6% in June. The slowdown notwithstanding, Asia-Pacific is set to remain the world's fastest-growing major region.

China's Prospects Remain Subdued

In China, economic momentum weakened again in the third quarter amid an unchanged COVID-19 stance. New outbreaks mean new restrictions in various cities, hurting economic activity; and COVID-19 caution has combined with morose sentiment to further depress spending. The weak sentiment manifests in very low consumer and business confidence, a high household saving rate, and an acceleration in deposits (chart 1). As we stressed, consumption and services are suffering more from COVID-19 restrictions than investment and industrial production.

Very poor real estate activity and sentiment also inhibit growth. Property developers are grappling with tight rules on their finances. Worries among potential homebuyers about the ability of property developers to deliver purchased apartments have sapped confidence and led to a "mortgage strike" by homebuyers in parts of the country. Housing sales and starts have languished around 25% and 45% down on a year ago, respectively, for much of the third quarter. With sentiment low, the property market is likely to hinder the overall economy into 2023.

The government has lowered its growth ambitions as it prioritizes its COVID-19 strategy for now, while policy support remains modest. China's Politburo in late July ruled out a significant change in the COVID-19 stance and played down the need to meet the 2022 growth target of "around 5.5%" set in March. In August, the People's Bank of China cut its key interest rates, and the government announced measures to facilitate further financing for infrastructure development and for property developers, to ease their liquidity problems. Senior officials have called on local governments to support growth, but the central government has so far refrained from pursuing major stimulus.

China's economic weakness has lowered demand for other countries' exports. The impact of China's COVID-19 controls on its supply chains has been much smaller than often realized internationally (see chart 2). Rather, from an international perspective, the problem in China is weak demand. Indeed, the country's imports have withered, in part because of the impact of the property downturn on commodity imports. Combined with the resilience of China's exports, this has boosted the trade surplus in 2022 despite a large worsening of the terms of trade amid high energy and commodity prices.

Chart 1

Chart 2

Looking ahead, the recent policy easing should support growth in the second half. But we have scaled back our expectation for growth in the rest of the 2022 following signs of renewed weakness. This includes the property market, and new obstacles such as a heatwave and power cuts in the southwest of the country in August and renewed lockdowns in several large cities in September.

The growth outlook for 2023 is also subdued. Growth in 2023 will benefit somewhat from the support in the pipeline. It is hard to predict when the government will start to adjust its overall COVID-19 stance and meaningfully lift restrictions. Our baseline forecast assumes it happens in 2023, likely after the first quarter. This should eventually support domestic demand. But the easing will most likely be gradual; in the meantime the lack of visibility on an exit from the COVID-19 stance will weigh on consumption and investment.

Meanwhile, we believe the property sector is unlikely to recover swiftly, and slower external demand will bite. Moreover, geopolitical considerations and economic decoupling (by the U.S. and other countries) weigh on growth prospects. Some investment decisions are being postponed, and some foreign companies are seeking to expand production in other countries.

We think the risks to our forecast for 2022-2023 are broadly evenly balanced. The key domestic downside risk is that "organic" demand--consumption and non-government investment--disappoints. This could be because of prolonged pursuit of the government's current COVID-19 stance or another hit to activity and confidence in the real estate sector.

There are also upside risks. It is possible we underestimate the buoyancy of domestic demand after the adjustment of the COVID-19 stance. As in the U.S. and Europe, both households and corporates in China have relatively high saving balances (deposits), which they could deploy if confidence returns.

Asia-Pacific Ex-China Economies: A Slowdown After Robust Growth In 2022

Growth largely remained robust in the second quarter. Weighted average year-on-year growth in Asia-Pacific was 4.0%, unchanged from the first quarter. A pronounced slowdown in China was offset by a strong rebound in India as consumption--especially of services--continued to recover and investment grew robustly (chart 3). Japan's economy also grew strongly.

The widely expected slowdown in global demand is a big test for Asia-Pacific. Real export growth and manufacturing purchasing managers' index surveys have already deteriorated in Northeast Asia, especially in the global trade bellwether economies of South Korea and Taiwan.

The recovery of domestic demand from the effects of COVID-19 should support growth. Outside of China, governments and people have largely moved to a "living with COVID-19" stance, although in some economies (such as Japan) new COVID-19 waves are affecting mobility and spending.

Following a mostly solid 2022, we expect the slowdown in 2023 to vary across the region, depending on several factors (chart 4). These include:

• More domestic demand-oriented economies are less exposed to the global slowdown. We expect a larger slowdown in 2023 in South Korea and Taiwan than in India, Indonesia, and the Philippines. Indeed, we have retained our India growth outlook at 7.3% for the fiscal year 2022-2023 and 6.5% for the next fiscal year, although we see the risks titled to the downside.
• In some countries the domestic demand recovery from COVID-19 has further to go. This should support growth next year in India, Malaysia, the Philippines, and Thailand. The latter three should also further benefit from improving tourism.
• In some economies the impact of higher interests on growth will be pronounced, either because policy interest rates climb strongly or the effect of the increases is profound. Policy interest rate increases hit harder in case of high debt or heavy borrowing on variable terms. Notably, higher interest rates will weigh on growth where mortgage-financing has expanded strongly.

Chart 3

Chart 4

While our forecast incorporates the subdued growth outlook for the U.S., Europe and China, downside risks remain substantial, especially from the U.S. and Europe.

Table 1

The Approach To Inflation Will Shape The Trajectory

The recent fall in energy and food prices has eased the pressure on inflation. However, as we previously argued, what happens to core inflation--underlying inflation excluding energy and food--is key for understanding the trajectory (see in "Asia-Pacific: Varying Core Inflation Paths Drive Monetary Policy Divergence," July 25, 2022).

Core inflation has shot up in some Asia-Pacific economies, less so in others. It has soared in Australia, South Korea, and New Zealand and has remained high in India. On the other hand, it has stayed low in China and Japan and modest in Hong Kong, Indonesia, Malaysia, Taiwan, and Thailand (see chart 5).

On a sequential (month-on-month) basis, core inflation seems to have plateaued in some Asia-Pacific economies and declined in India. But in some economies it is too early to conclude that a downward trend has started. For instance, in India headline Consumer Price Inflation (CPI) is likely to remain outside the Reserve Bank of India's upper tolerance limit of 6% until the end of 2022. That's amid substantial weather-induced wheat and rice price increases as well as sticky core inflation. And food inflation may rise again.

Table 2

How much central banks will need to raise policy rates to bring down core inflation in line with their targets depends on several factors. These include the current rate of core inflation, the amount of slack in the economy, and pressure from wage costs. We noted recently that unit labor costs are rising in Hong Kong, New Zealand, Singapore, and South Korea; and labor markets in these economies could squeeze consumer prices (see "Wage Hikes Are An Inflationary Risk For Parts of Asia-Pacific," Sept. 1, 2022).

Malaysia and Indonesia seem to see similar trends, although we do not have visibility on higher frequency unit labor costs in most emerging markets. On the other hand, unit labor costs are yet to rise much in Australia, Japan, Thailand, and Taiwan.

In some countries the reduction of energy subsidies will complicate central banks' efforts to rein in inflation. Persistently high energy prices call into question the sustainability of high subsidies. Indonesia's decision to slash overall energy subsidies--while providing targeted income support to 20 million households--will raise inflation by 2-2.5 percentage points, in our estimate, and will require Bank Indonesia to increase interest rates much more than it has done so far.

But the subsidy cut will also provide incentives to reduce fuel consumption and decrease the country's fiscal deficit, thus strengthening macroeconomic sustainability. With energy prices unlikely to fall significantly soon, pressure could mount for other governments with large untargeted energy subsidies or energy and electricity price caps to pass on more of the price and cost increases to consumers.

In all, considering economies other than Indonesia, we expect elevated core inflation to drive up policy rates materially further in Australia, India, New Zealand, the Philippines, and South Korea. In other Asia-Pacific economies we generally expect more moderate core inflation and policy rate increases (table 3).

Table 3

Higher interest rates will especially affect housing markets. Although concerns over the stability of the financial sector are still largely manageable, rising rates will slow down housing activity and weigh on housing prices and consumer confidence. The effects will be greatest where housing debt is the highest and where a large share of it is on variable terms.

We believe that residential markets in Australia, New Zealand, and South Korea are the most vulnerable to rising interest rates (see "Higher Interest Rates Will Cool Some Red-Hot Residential Markets In Asia," June 15, 2022). In these markets house prices are declining and housing activity has slowed.

Housing markets in the region's emerging market economies are less vulnerable to interest rate swings, in our view, possibly because of lower financial access for households, and urbanization pressures.

Outflows Strain Foreign Exchange Markets

Rising global interest rates have triggered capital outflows and depreciation against the U.S. dollar. We note that net capital outflows have generally risen in 2022 (see "Foreign Reserves in Asia's Emerging Markets are Strained," Aug. 22, 2022). Net financial flows have been particularly large in China and South Korea lately, although they have eased somewhat since a peak in May.

Combined with the impact from higher energy and commodity prices on current accounts, the outflows have strained foreign exchange markets. Exchange rate depreciation has absorbed a large part of this pressure, especially in Japan, New Zealand, the Philippines, South Korea, and Taiwan (chart 6). But foreign reserves have nonetheless fallen in Asian emerging market economies, even after adjusting for large valuation changes.

Chart 5

Chart 6

With the U.S. Fed set to keep raising its policy rate to rein in inflation, pressure on Asia-Pacific foreign exchange markets will persist. Given reasonable reserve adequacy and the general willingness to let the exchange rate absorb much of the pressure, we don't expect foreign reserves to decline to dangerously low levels any time soon. But we expect the Fed to continue raising its policy rate through the first half of 2023, implying further pressure ahead.

External strain is most likely to flare in Asia-Pacific economies where inflation is relatively low and where central banks seek to keep monetary policy accommodative.

In China, the reduction in policy rates alongside a rise in the U.S. was a key factor in the recent depreciation of the renminbi (RMB) beyond 7 RMB to the U.S. dollar. Indeed, the authorities feel the relaxation of monetary policy to support growth is constrained by concerns about capital outflows and further deprecation against the U.S. dollar.

Thus, even as China's currency remains relatively strong in effective (trade-weighted) terms, policy makers have acted to dampen the depreciation. But, given the further rise in U.S. policy rates in store and our expectation China's monetary policy will remain accommodative, we expect the renminbi to weaken further in the coming months.

The Bank of Japan's determination to maintain its highly accommodative monetary policy amid the shift to higher rates elsewhere has led to a sharp depreciation of the yen this year. On Sept. 22, 2022, the government intervened in the currency market to support the yen for the first time since 1998.

However, in our view, worries about the exchange rate are unlikely to change the monetary policy stance, especially not before April 2023, when Governor Haruhiko Kuroda is scheduled to step down. As we said earlier this month, powerful structural forces are curbing spikes in Japan's consumer prices (see "Why Japan's Consumer Inflation Will Drop Back Below 2%," Sept. 7, 2022). We expect headline CPI inflation to fall below 2% again in 2023, making monetary tightening unlikely any time soon.

More generally, the responses of central banks and the currency implications will vary. Some Asia-Pacific central banks will raise their policy rates to reduce the pressure on foreign exchange markets. Others will err on the side of tightening less if that is justified in terms of domestic inflation. That could leave their foreign exchange markets exposed to the impact of additional U.S. Fed hikes. But some central banks may be willing to accept that for the sake of protecting growth at a time of a global slowdown.

Table 4

Table 5

Related Research

• Why Japan's Consumer Inflation Will Drop Back Below 2%, Sept. 7, 2022
• Wage Hikes Are An Inflationary Risk For Parts of Asia-Pacific, Sept. 1, 2022
• Foreign Reserves in Asia's Emerging Markets are Strained, Aug. 22, 2022
• Asia-Pacific: Varying Core Inflation Paths Drive Monetary Policy Divergence, July 25, 2022
• Higher Interest Rates Will Cool Some Red-Hot Residential Markets In Asia, June 15, 2022

Editor: Lex Hall

Designer: Halie Mustow