Asia Risks Overheating, Bubbles on Capital Inflows, IMF Says

April 29 (Bloomberg) -- Asia’s economic recovery that’s outpacing the rest of the world is attracting capital inflows that may cause the region to overheat and lead to the formation of asset bubbles, the International Monetary Fund said.

Expectations of Asian exchange-rate appreciation may be boosting carry trade flows, where investors borrow cheaply in one currency and use the funds to invest in others, the Washington-based lender said in a report today. More flexible currencies and some capital controls can help limit the impact of investment flows, it said.

The World Bank predicts as much as $800 billion in global capital flows this year, compared with about an annualized $450 billion to developing economies in the second half of 2009, it said in a report this month. Emerging markets need to take “urgent action” on the surge of liquidity and capital flowing into their economies because they could spur inflation and trigger another crisis, according to Standard Chartered Plc.

“Brighter economic growth prospects and widening interest rate differentials with advanced economies are likely to attract more capital into the region,” the fund said. “Policy makers will need to be attentive to safeguarding the macro economy and financial system against the build-up of imbalances in local asset and housing markets.”

The IMF expects emerging Asia, which excludes Japan, Australia and New Zealand, to expand 8.5 percent this year and 8.4 percent in 2011. Including those countries, the region may expand 7.1 percent this year and next, it said.

Greek Tragedy

Bonds and stocks plunged across Europe in the past week as Greece’s budget turmoil forced it to seek a bailout from the European Union and the IMF, and Standard & Poor’s downgraded Greece, Portugal and Spain.

“While Greece’s sovereign debt situation has not had a major impact on flows to the region, the main risk scenario is one of worsening global risk aversion, should the jitters spill over to some of the larger European economies,” the report said. “Problems in Europe could force a further retrenchment of European banks from the region, possibly reigniting some dollar and euro funding pressures in Asian markets.”

China, India and Indonesia are countries with “stronger growth prospects” and they have received more capital inflows than other Asian peers, the IMF said.

“Inflows are likely to persist, with European and U.S. managers getting larger mandates to invest in Asia, as the region is expected to outperform advanced economies, where monetary policies are set to remain more accommodative,” the IMF said.

Interest Rates

Some Asian central banks including India and Malaysia are already raising interest rates or taking steps to remove excess cash in their banking systems to fend off inflation risks as the region leads the world recovery. Asian governments pumped more than $950 billion into their economies through increased investment, tax cuts and cash handouts to boost growth.

About a third of the fiscal stimulus injected into Asian economies may be withdrawn this year, the IMF predicts, adding that such policies are still expected to remain accommodative.

“The main near-term policy challenge for policy makers is judging the appropriate pace for normalizing monetary and fiscal policy,” the IMF said. “Policy makers will have to weigh the strength of Asia’s recovery against the fragility of the global recovery, which argues for a cautious and gradual withdrawal of stimulus. Most economies in Asia are fortunate to have some fiscal and monetary space to respond flexibly to external shocks.”

‘Remains Encouraging’

China’s economy grew at the fastest pace in almost three years in the first quarter, supporting Asia’s commodity- exporters including Australia, Indonesia and Malaysia, the IMF said. China is forecast to expand 10 percent this year and 9.9 percent in 2011, according to the report.

Demand for Asian goods “remains encouraging” this year as manufacturers replenish their inventories, boosting the region’s output for most of 2010, the IMF said. Exports will probably grow at “more moderate pace” in 2011 amid “sluggish” domestic demand in advanced economies over the next two years, it said. “The global crisis has highlighted the importance for Asia of a second, domestic ‘engine of growth’ that can substitute for lost demand from the industrialized world,” the report said.

Inflationary pressures will remain “generally contained” in the Asian region this year, the IMF said, adding that China’s price gains maybe “subdued” due to excess capacity. India, Indonesia and Vietnam will see less inflationary pressure in 2011 as commodity prices stabilize and amid tighter monetary policies, the report said.

One of the risks to the region may be commodity prices remaining stronger than expected, adding pressure on food costs, the IMF said.

“Greater-than-expected inflationary pressures may in turn induce more aggressive monetary tightening and weaken the virtuous cycle between strong economic activity, buoyant financial markets, and ample consumer confidence, which thus far has sustained private domestic demand in the region,” it said.