Weakest link

Asia’s burgeoning economies – buttressed by strong export demand from Europe and massive foreign exchange reserves – protect it from slowdown in the West. Sunil Jagtiani reports from Hong Kong on the region’s partial decoupling from America.

When America stumbles, how hard will Asia fall? This question hangs over Asia’s economic and stockmarket prospects as evidence builds that America could be heading towards a slowdown after a financial crisis. Experts mostly agree the region is dynamic and confident enough to weather American economic woe, but they doubt it can emerge unscathed.

Last year saw generally high economic growth and sharp stockmarket gains in Asia, even though the American financial crisis dominated headlines from the summer onwards. The International Monetary Fund (IMF) reckons the newly industrialised Asian economies grew by 4.9% and that a large grouping known as developing Asia expanded by almost 10%. It forecasts 2008 growth of 4.4% and 8.8% respectively.

Asia’s stockmarket, though volatile, rose 12% over 2007 as measured by the MSCI Asia-Pacific index, about two percentage points higher than the World index. The overall figure masks major regional disparities: mainland Chinese shares, for instance, rocketed 93% and India’s bourse soared 47%, but Japan wilted to an 11% loss.

Analysts say Asia is emerging as an important driver of world economic growth after recovering from its debilitating financial crisis a decade or so ago (see box, page 21). Moreover, the region’s stockmarket is an indispensable asset class for many investors. The Japanese, for example, are known to borrow cheaply in yen to invest elsewhere in Asia.

But with America, which is a key buyer of Asian exports, apparently heading for a steep slowdown, investors are nervously asking whether America’s problems threaten Asia’s dynamism.

A mortgage default crisis in its subprime sector, which comprises riskier borrowers, has walloped America. The crisis has led to billions of dollars in losses, a credit crunch, a substantial housing market downturn and major stockmarket volatility.

Earlier this month America published some of the poorest jobs data since 2003 as its unemployment rate rose to 5%, raising the fear that the toll from the subprime crisis was mounting. Some analysts say America will suffer a recession this year, with most expecting global economic growth to slow.

Capital Economics, a consultancy, outlined in a recent research note how problems in America could affect Asia. It said that: “a US-led slowdown would be transmitted to Asia along three principal channels: the direct impact on trade, the impact on financial markets and asset prices and the indirect impact on consumer and business sentiment.”

The firm’s view is that Asia should continue to do well as long as America avoids an outright recession (see box, page 23). “The US remains a key export market for Asia as a whole, even though Europe is now a larger market for some countries,” it said.

“But there are important differences within the region. Total exports account for more than half the GDP of many of the smaller countries. However, in most cases, trade with the US is a fairly small proportion of the total, even allowing for indirect exports where intermediate goods are sent to third countries (notably China) for processing and onward shipping to the US.”

Asian exports to America fell when America slowed during 2001 and 2002 after the bubble in technology and internet stocks burst, the consultancy adds, and yet regional economic growth held up well despite that.

However, some analysts took Singaporean economic growth data released in early January as a challenge to this more sanguine stance about the likely impact on Asia of an American-led global economic slowdown. Singapore’s economy contracted by 3.2% over the fourth quarter of 2007 compared with the previous three-month period. The seasonally adjusted, annualised data greatly surprised analysts, who expected South-East Asia’s most advanced economy to expand healthily.

The data raises concerns because Singapore is one of Asia’s most open economies. Some pessimists say the figures portend what lies ahead for the rest of the region, but others feel the data are insufficient grounds to write off Asia’s 2008 economic prospects.

“Recent data, while still quite strong, are showing increasing signs of an export-led slowdown in Asia ex-Japan,” says Mingchun Sun, a Lehman Brothers economist. “Our baseline forecast for Asia ex-Japan is that, provided the global economy avoids a hard landing, regional gross domestic product growth should slow in 2008 from 8.7% in 2007 to a still strong 7.6%.”

“Although the decline in Singapore’s fourth quarter GDP raises the spectre of other Asian economies following suit, we do not expect this to be the case. As the most open economy in the region – exports account for 260% of its GDP – Singapore is most exposed to a global slowdown.

“It is also one of the smallest economies in the region … and has the most volatile growth pattern. Therefore, it is natural that Singapore would feel the pinch of a global slowdown earlier, and probably more drastically, than other Asian economies.”

For some experts, one of the key reasons why Asia may partially decouple from America in 2008 lies in the region’s infrastructure spending and trillions of dollars of foreign exchange reserves. The latter are seen as a buffer, which can be tapped to keep growth on track if export growth shudders to a halt. China’s reserves alone amount to more than $1.4 trillion (£700 trillion).

GaveKal, a Hong Kong-based consultancy, has estimated that Asia spent $800 billion on infrastructure last year, according to a report from Agence France-Presse, a newswire. GaveKal added that the infrastructure spending contributed more to Asia’s expansion than the American consumer. In the event of a slowdown in China, for instance, it can simply tap its reserves to fund its infrastructure programmes.

China plans to spend about $2 trillion on infrastructure in its eleventh five-year plan, according to research by CSFB, an investment bank, and India intends to spend $1 trillion on railways alone by 2020. Asian economies also have scope to resort to fiscal policy in the event of a sharp slowdown, the firm says.

“Emerging economies have built up massive foreign exchange reserves,” says Andy Xie, an independent economist based in Shanghai who used to work for Morgan Stanley. “Those reserves provide a cushion.”

Xie takes the view that the forthcoming America economic slowdown could forge a changed global trading system, with China playing a more central role. “The US economy is in big, big trouble,” he says. “People are gradually realising that. The US economy is built on the debt, and the credit market has shut down. So money is not flowing as easily into the pockets of consumers.

“If the US stays down, which is quite possible, and China continues self-sustained growth, and brings other emerging economies together, then we have a different trading system. That means the end of the US-centric global trading system. The China-centric global trading system is unfolding now.”

Growing domestic consumption in Asia is part of this picture, other experts argue. Peter Alexander, the founder of Z-Ben Advisors, a Shanghai-based financial consultancy, says China should be viewed as a “continental economy” with growing domestic demand.

“There is an argument to be made that there is a decoupling going on especially compared with, say, 10 years ago,” he says. “Exports have been helping to drive growth but we don’t look at China as being dependent on exports like other Asian countries. You have a growing middle class and a lot of consumption in the major cities, which could mitigate some of the effects of a US downturn on the Chinese economy.”

Alexander says that booms in China’s share and property markets has created an “enormous” amount of wealth. “The Chinese economy is going to become more driven by domestic demand and less by exports,” he says. “A US slowdown would definitely have an impact, it’s just a matter of degrees.”

However, although experts argue that a case can be made for some degree of economic decoupling between Asia and America, the correlation between their stockmarkets appears more of a concern. For instance, Wall Street weakness at the start of 2008 contributed to sharp falls in some key Asian stockmarkets, continuing a period of poor performance that began in November.

Chetan Ahya, an analyst with Morgan Stanley in Singapore, argues that substantial volatility in American share prices could pose a risk to Asia if it spread to the region. “In the past few years, globalisation of financial markets has meant that we cannot ignore the possible transmission of growth shocks through financial market linkages,” he writes in a research note. “Not surprisingly, Asian financial markets have remained coupled with the US financial markets so far. During 2000-06, the average correlation between MSCI Asia Pacific Ex-Japan and MSCI US was 72.6%.”

Some analysts are also concerned that Asian shares are too expensive after a long and impressive boom, particularly in mainland China, where price-to-earnings ratios are stratospheric. India, meanwhile, lured a record $17 billion of foreign investment into its stockmarket last year, but is thought vulnerable to any future spike in risk aversion.

Xie says Asian share prices could fall for a few months before recovering later in 2008. Bourses featuring firms whose fortunes are most closely tied to the American economy, for example Taiwan’s, are likely to have the toughest time, he argues.

Matt Robinson, a Sydney-based economist at Moody’s Economy.com, says that the decoupling thesis is likely to be tested in 2008, but adds there are reasons for cautious optimism about Asian stockmarkets.

“Solid fundamentals in the Asia-Pacific region, robust household consumption and continuing strong export growth to China and Europe portray a sound outlook for local businesses in the year ahead,” he says.

“Without doubt, the subprime-related credit crunch has had global ramifications. However, the extent to which it has directly affected Asian businesses has been relatively marginal. While US demand for Asian products has shown signs of weakening, exports continue to grow on the back of strong demand from European consumers and a rising Chinese middle class.”

Japan could be one black spot in this otherwise generally upbeat outlook for Asia. Some analysts think its economy could be set for a period of weak expansion. Investors appear to be discounting trouble ahead. At the time of writing the Nikkei 225 index had fallen about 5% since the start of 2008, following on from its double-digit percentage slide in 2007.

Overall, then, most experts think Asia is better placed than in the past to cope with an American slowdown, but they still expect American woe to curb regional economic and stockmarket growth somewhat.

Diamond Lee, the manager of Resolution Asset Management’s Pacific Growth fund, says he was on alert for opportunities to pick up shares hit by short-term knee-jerk reactions.

“Looking forward from here, the key theme will be earnings momentum,” he says. “This in turn will be driven by events in the US, as well as the economic outlook arising from China, India and the Middle East. Overall, we believe these emerging economies will continue to grow at a robust pace in the medium to long term. Short-termism in investors’ behaviour will create opportunities for believers in secular trends: this includes domestic demand, which is increasingly driving economic growth in Asia.”

But for at least one expert, robust Asian economic performance despite an American slump may not necessarily be an altogether good thing.

“While it would be unreasonable to assume that Asian growth will be untouched by the US slowdown, the underlying point is that Chinese and other emerging economy growth rates continue to be propelled by extremely stimulative policy settings,” says Tim Bond, the head of global asset allocation at Barclays Capital.

“Until that basic condition changes – which will eventually happen when the relevant authorities finally start to fear the increase in inflation pressures – we should expect to see Asian and Western economy growth rates diverge.”

But he says the implications of this situation are “wholly and perhaps counter-intuitively negative”, because strong Asian growth will help keep commodity prices high, stoking American and European inflation and curtailing central banks’ freedom to cut borrowing costs to ease the credit crunch triggered by the subprime crisis. The result, Bond says, could be a deeper global slowdown in 2009 than would otherwise have been the case.

Capital Economics on decoupling

Experts at Capital Economics pose the question as to what would happen to emerging Asia if the rich economies of the West slow amid heated debate about whether Asia’s economy has decoupled from that of America.

“The strong performance of emerging Asian economies is likely to be severely tested by a US-led global slowdown in the next year or two,” Capital Economics argues.

“However, provided the US avoids an outright recession (as we expect), Asian growth should still be buoyant and Asian assets continue to do well,” it says.

The consultancy says Asia’s gross domestic product “held up remarkably well” when the world’s advanced economies last experienced a downturn, over 2001 and 2002, despite a slump in exports to America.

Moreover, the expected downturn in the West in 2008 is likely to be less severe than the one seven years ago, it adds.

“The prospect of further dollar weakness – and hence increasingly unwelcome strength in Asian currencies – is an additional threat to regional growth,” Capital Economics says.

“Lingering inflation concerns mean that Asian central banks may be reluctant to cut interest rates as far as they might otherwise have done to offset the damage to competitiveness from rising currencies,” it adds.

But it says the prospect of gradual appreciation in Asian currencies, led by the renminbi, ought to make Asian assets attractive for international investors and help the global economy to rebalance.

The consultancy expects China to grow at about 10% even if export growth stalls.

“The sustainable growth rate is not quite as high in India – perhaps 8.5% – and the risks of overheating are greater. Indian equities have risen even further than Chinese equities since 2003. This suggests that there is greater downside for Indian equities too, especially if reform momentum stalls as the global environment deteriorates,” it says.

Capital Economics says high oil prices should boost Indonesia, South East Asia’s biggest economy, although subsidies to keep “retail fuel prices down are offsetting much of the benefit”.

“The economies of Singapore and Malaysia are among the most exposed to the US, with US-bound exports accounting for more than 20% of national gross domestic product,” the consultancy warns.

But Malaysia stands to benefit from high infrastructure spending and measures to develop the property market, it says, adding that infrastructure spending is key to Philippine economic expansion too.

Capital Economics forecasts American economic growth of about 1.7% in 2008. It says the American economy probably grew about 2% in 2007, below the 3.3% achieved in 2006.

It concludes that “the ongoing slowdown in America and tempering of growth elsewhere will hurt some exporters in Asia, but the region as a whole should continue to register solid growth”.

Asia after the financial crisis

Asia is set to emerge as a third pillar of the global economy behind America and Europe over the next decade after recovering from its 1997 financial crisis, but it must still embrace change, according to Dominic Barton, a director of the Shanghai office of McKinsey, a consultancy.

Last year marked the tenth anniversary of the beginning of the Asian financial crisis, which was caused by macroeconomic imbalances that exposed fundamental weaknesses in Asia’s corporate and financial sectors, Barton wrote recently in the McKinsey Quarterly.

“The sequence of events that began with the Thai baht’s collapse in July 1997 ultimately cost the region tens of billions of dollars and led many observers to speculate about an impending ‘lost decade’ in Asia,” he says.

But after a “remarkable” transformative decade, Asia’s financial system is “substantially deeper and more robust than it was in 1997”, he argues.

“Sitting atop an enormous rising economic tide, it is poised to benefit from a host of factors,” Barton says.

These include the rise of China and India, the re-emergence of Japan after its decade of economic torpor in the 1990s, robust trade within Asia, vast infrastructure spending and opportunities presented by increasingly powerful Asian sources of capital.

“Asia appears set to play an important role in the world’s financial system over the coming decade – a true third partner in the global triad, along with Europe and the United States,” Barton says.

However, he adds that it would be foolish to think Asia had been “immunised against imbalances, shocks, and dislocations” since the region’s breakneck pace of a economic growth and financial development made such problems inevitable.

“Asian regulators and chief executive officers of financial services companies have concerns about the co-ordination of central banks, regulators and government ministries – both within and among the region’s countries,” he says.

There were “worrying signs of asset bubbles” emerging in China, Hong Kong, Indonesia, Singapore, and Vietnam, Barton says.

He says Asia’s financial system has to make “critical improvements and initiatives” to achieve truly global presence and to put the region “on a stable path for the next decade”.

The changes included such things as better risk management at financial institutions.

Barton warns that Asia has to guard against arrogance or over-confidence after a period of great success over the past few years.

“Over-confidence was evident in Asia during the early part of 1997, as it was recently on Wall Street and in London – and in the run-up to all the financial crises of the past century,” he says.