There's been a depressing sense of déjà vu about the world economy over the past week. Once again, we are worrying about policymakers in the core developed economies failing to get to grips with a financial crisis; and once again we are fretting about the adverse spillover effects to the key emerging markets that have helped support Australian growth.
We know that our region will not be immune from developments in Europe. In this regard, it's important to remember that the key lesson from the previous global financial crisis was not that the emerging markets of Asia and elsewhere were safe from a downturn in the developed world: in fact, when the crisis went critical after the collapse of Lehman Brothers, both economic activity and financial markets crashed right across the world.
Rather, it was that the affected emerging markets were nevertheless able to aggressively use fiscal and monetary policies to offset the worst effects of the downturn, and had the policies and institutions in place that were able to deliver an impressive degree of resilience in the face of a severe external shock.
As the crisis in the Eurozone deepens, that resilience is now facing another major test. According to the World Bank's latest regional assessment for East Asia and the Pacific, weaker growth in the EU (and the US) will once again have a significant impact on the region, given continued high direct trade exposures to developed markets:
The same report shows how regional financial markets are increasingly correlated with their global counterparts, leaving the region vulnerable to financial contagion effects:
But just how vulnerable? In its October 2011 regional economic outlook for the Asia and Pacific, the IMF looked at the impact of a major global downturn scenario under which growth in the EU would fall by 3.5% below baseline for two years, leading to a 1% fall in US growth over the same period. According to the Fund's estimates, in this kind of scenario GDP growth in the Asia and Pacific region could fall by 1.5-4 percentage points relative to baseline:
Note that those numbers do not take into account the effect of any offsetting policy changes: the IMF also found that additional fiscal stimulus measures by China (by some 2-3% of GDP) would offset about one-fifth of the impact of this negative shock on output in the region.
So once again, the critical questions are likely to revolve around the nature and quality of the region's policy response to an external shock. The good news is that, when compared to much of the developed world, the region still has a reasonable amount of policy space left. The not-so good news is that the room for policy manoeuvre is less than it was when the GFC hit.
This is especially true in the critical case of China, where the authorities had until quite recently been busy trying to manage the adverse consequences of their last round of growth-saving intervention: a property bubble, deteriorating asset quality on bank balance sheets, and other predictable legacies of any orgy of directed lending.
