Price pressure: Asian inflation to reach 4.5% in 2011

As expected, Asia’s growth momentum moderated in the second quarter due to headwinds from higher commodity prices and disruptions to supply chains from the March 11 earthquake in Japan. The slowdown followed very strong growth through the first quarter, fueled by both domestic and external demand, which had led to overheating risks. In particular, industrial production and exports have eased across the region, with incoming second quarter GDP outturns now confirming the slowdown.

In addition to the usual concerns about Asia’s cyclical growth position and inflationary pressures, market focus has been dominated in the past quarter by external events. In particular, concerns have risen about the impact on global growth and financial stability of ongoing European sovereign debt tensions, the US debt debate, and the outlook for US growth and monetary policy. As elsewhere in the world, these issues have weighed on regional stock markets, although sentiment has generally remained buoyant given the region’s strong underlying fundamentals and growth prospects.

Despite downside risks, we expect growth to rebound during the remainder of the year. Stabilizing commodity prices, a recovery in Japan, and strong underlying fundamentals set the stage for a pick up in growth. Continued strong demand from China and India should offset sluggish demand from the US and Europe. More broadly, domestic demand in the region is expected to remain robust on strong income growth and sustained credit expansion.

With the second quarter slowdown largely in line with our previous forecasts, we have made relatively minor adjustments to our 2011 and 2012 projections. For Asia ex-China, we have lowered our 2011 full-year growth projection from 4.3% to 4.1%, mainly due to downward revisions in Japan and Australia on weaker-than-expected outturns to date. We have maintained our growth projection for China at 9.4%. Our 2012 projections remain broadly unchanged, at 5.2% and 9.1%, respectively for Asia ex-China and China.

Inflation remains a challenge, despite some easing from stabilizing commodity prices and the moderation in second quarter growth. Underlying price pressures are still present, as evidenced by rising core inflation. We are revising up our 2011 inflation projection to 4.5% for Asia ex-China (from 4.1% previously), and to 5.3% for China (from 4.9% previously). 

We continue to expect further gradual monetary policy tightening, but with the magnitude and pace constrained by concerns about the growth outlook and external environment. Some central banks have begun signaling a softer stance, and we are scaling back our previous interest rate calls for Australia, Indonesia, and Korea. We expect further modest currency appreciation in most currencies as capital inflows resume due to the region’s strong growth prospects and rising yield differentials. 

Risks have become more balanced since our last quarterly update. While overheating risks remain, they have eased due to the second quarter slowdown. At the same time, downside risks to the growth outlook have risen. There is a possibility that the slowdown of the second quarter may prove more enduring than in our baseline, especially if the external environment were to weaken due to slowing growth in the US and continued financial tensions in Europe.