Recent large equity sell-offs across Asia and safe haven flows into Japan illustrate perfectly the region’s vulnerabilities to further global shocks. While the region’s fundamentals—built up over the past decade—remain relatively strong, economic uncertainties in Europe and the United States pose large downside risks.

The world economy has entered a dangerous new phase and, as the IMF’s Managing Director stated recently, “what makes the situation all the more urgent is that it has implications for every country.”

Our Regional Economic Outlook for Asia and the Pacific emphasizes these risks, and stresses the need for policymakers to remain vigilant and nimble in this extraordinarily uncertain climate. The view from here in Tokyo—looking out at the region—may be more serene than the view from other advanced country capitals, but there are storm clouds on the horizon.

Policy balancing act

Asian policymakers are faced with an unusually delicate balancing act. On the one hand, domestic demand in Asia has been rather resilient, in contrast to most advanced countries. Factories are working at near full capacity and unemployment is low. Rather than the prospect of falling back into recession, overheating is the main concern in a number of economies, with credit growing strongly and inflation remaining stubbornly high. On the other hand, growth in Asia is slowing, mainly due to weakening external demand. So policies need to contend with softening exports, which act as a drag on growth, even as they seek to contain inflation and asset bubbles.

Guarding against spillovers

An intensification of turmoil in the euro zone could affect Asia through several channels. Foreign investors could withdraw abruptly (to some extent this is already happening, but things could get much worse). Stressed European banks could withdraw funding from their local branches and cut back on cross-border lending. And key derivatives markets—on which some local banks have become reliant—could be impaired. This would affect many regions, including markets in Asia where European banks have been important providers of dollar liquidity.

How should policymakers in the region react to domestic challenges amid such an unsettled external environment? In a word, flexibly.

• In overheating economies where monetary conditions are still loose, policies should be geared towards returning inflation to the target range. But policymakers should be willing to change direction quickly should downside risks materialize.
• In economies where inflation is under control and global financial linkages are greater, a pause in monetary tightening is warranted.

Asia’s fundamentals are good, and the scope for policy adjustments is much greater than in other regions of the world.

Asian low-income and Pacific Island economies face similar challenges, but often in a more acute form. In low-income countries, the fight against inflation is complicated by strong second-round effects and less well anchored inflation expectations. Pacific Island economies need to undertake further structural reforms to lift their potential growth.

Longer-term rebalancing

The weakness in global demand today only confirms that Asia would greatly benefit from rebalancing growth towards domestic sources of demand. Naturally, this will take time. But efforts should start now. Re-prioritizing fiscal spending could be an important component of this effort. Directing public spending toward critical infrastructure investments would help with rebalancing. It could also help foster more inclusive growth—this is one area in which the region could do much better—and I will write more about that in coming days.

This post originally appeared at iMFdirect and is reproduced with permission.