Asian policy makers must be ready to respond “early and decisively” to overheating risks in their economies stemming from rapid credit growth and rising asset prices, the International Monetary Fund said.

Growth is set to pick up gradually during the year and inflation is expected to stay within central banks’ comfort zones, the Washington-based lender said in a report Monday. Greater exchange-rate flexibility in the region would play a “useful role” in curbing overheating pressures and coping with speculative capital inflows.

Asian economic growth that the IMF estimates will be almost five times faster than advanced nations this year, and increasing investor appetite for risk have spurred capital inflows into the region. The Bank of Japan this month joined counterparts in the U.S. and Europe in unleashing monetary stimulus, which may fuel further currency gains in developing markets such as the Philippines, where policy makers have stepped up efforts to cool appreciation. 

“Financial imbalances and rising asset prices, fueled by strong credit growth and easy financing conditions, are building in several Asian economies,” the IMF said. “Policy makers in the region face a delicate balancing act in the near term: guarding against the potential buildup of financial imbalances while delivering appropriate support for growth.”

The IMF’s Regional Economic Outlook for Asia and Pacific echoes concerns in an April 15 World Bank report that emerging economies in the region should consider reining in monetary stimulus. Japan needs to have a credible strategy to lower debt, while China’s challenge is to unwind past credit stimulus and curb the growth of shadow banking, the lender said Monday.

Asia will lead a three-speed global recovery, with domestic demand supported by “strong” labor market conditions, “robust” consumer confidence and household disposable income, falling unemployment rates and rising real wages, the IMF said. Economies may also benefit from China’s growth momentum and Japan’s stimulus measures, it said.

China’s economy will expand 8 percent this year and 8.2 percent next year, while India’s gross domestic product will rise 5.7 percent in 2013 and 6.2 percent in 2014, the IMF said.

Still, the threat of external risks such as the euro-area crisis remains substantial, and while capital inflows can provide an impetus, they can also be disruptive, the IMF said.

“In the event of a severe global slowdown, capital flow reversals and falling external demand would exert a powerful drag on Asia’s most open economies,” including lower investment and employment in export-dependent sectors and possibly lower remittances by overseas labor, it said.

Risks within the region include disruption to trade from natural disasters or geopolitical tensions, it said. An economic slowdown in China led by sharply lower investment, and a rise in sovereign risk in Japan in the absence of a credible medium-term fiscal and growth strategy also pose threats.

China, Asia’s biggest economy, faces a debt overhang from previous credit-led stimulus, according to the IMF. It remains vulnerable to a renewed growth slowdown that could be triggered by financial stress or uneven progress in reforms, it said.

In India, monetary policy can best support growth by putting inflation on a clear downward trend, the IMF said. In Indonesia, where price gains are close to the upper end of a target band and the current account deficit is widening, there may be a case for higher policy rates, it said.

Some nations must address fiscal deficits, especially where the gap is larger than before the financial crisis, the IMF said. At the same time, most Asian governments also need to increase public spending on education and health, while food and energy subsidies in countries such as China, Indonesia and Malaysia, should be eliminated and replaced by programs such as cash transfers, it said.

“To sustain high rates of per capita income growth, the policy agenda will have to vary across a range of priorities, including economic rebalancing, strengthening infrastructure investment, reforms in goods and labor markets, and meeting the challenges from rapid demographic change,” the IMF said.
 

(Bloomberg)