The Asian growth story: can it continue?

May 2013

The 19^th EuroFinance in Singapore, held from 15^th-17^th May with more than 450 delegates, kicked off with an economic overview of the Asian situation. The market dynamism is attracting investment and corporate development in the region, but are there dangers lurking beneath the surface?

Any corporate operating in the emerging Asian markets – whether global multinational or domestic dynamo – is well aware of the complexity that comes with the territory, but the region’s rapid growth story over the past seven years has been hard to ignore. However, in the past few weeks doubt has begun to creep in, with talk of economic data turning sour, the risk of a hard landing in China and a downturn in exports.

“Don’t worry too much about this in the near term,” says Frederic Neumann, Co-Head of Asia Economic Research and Managing Director, HSBC, Hong Kong, speaking at the opening plenary of the EuroFinance Singapore conference. His attitude is that this negative talk is “all noise” and the region remains in an upward trajectory.

Having said that, Neumann is not blind to potential upcoming risks. “There are some parallels in Asia with what we see in the West, such as increasing household debt. Although not an immediate concern, it is something we need to keep an eye on.”

Starting from the global economic situation, one important area to look at is the level of industrial production: emerging Asia has reached a level 47.1% above its pre-crisis peak, whereas the level of industrial production in the US is -1.7% and Europe is -13.4% compared with previous peaks. This shows that some form of decoupling is happening, according to Neumann, as the increase in Asian output has occurred despite the West not reaching its previous levels.

The other important area to consider is the Western central banks’ response to the global financial crisis. There is a rule of thumb amongst economists that after a recession central banks only start to tighten monetary policy when output is 10% above the previous peak, mainly because only at that point will unemployment rates start to drop and inflation re-emerge. “Continuing with the current recovery rate in the US, to reach 10% above the previous peak will take another two years or so,” says Neumann. “Therefore, there is no need to worry about the Federal Reserve withdrawing quantitative easing (QE) despite the recent media hype.”

In Europe, the European Central Bank (ECB) should do much more to support economic growth, believes Neumann. The ECB cut interest rates but it will have to turn to QE to arrest the decline. This response is important for Asia because the monetary easing policies in the West are partly responsible for the increase in the East’s output. This is where the decoupling story goes awry. “In the real sense, in terms of trade flows, we have decoupling – growth in Asia is not dependent on exports to the West. However, financially the Asian recovery is closely linked to the stimulus coming from the West, and its continuance will allow Asia to grow for another two years,” he states.

 

China: engine of growth

Despite Neumann’s positive outlook, the talk of a hard landing in China is still a worrying development, as the driving force in the region’s economic growth. The country displayed disappointing growth figures in 1Q13 and most economists lowered the growth projections for 2013 as a result. However, looking at leading indicators, he argues, the Chinese economy should accelerate into the year-end. The key driver of this growth within China is infrastructure spending.

After last summer’s scare, when many thought the Chinese economy was about to fall off the cliff, the Chinese government “very quietly” unleashed a fiscal stimulus that allowed local government entities to reinvest in infrastructure. “If you tally up the projects announced in the second half of last year, most will start to hit the ground now and in the third quarter, and that alone will add 1.5 percentage points to GDP in China, so there is a big lift still to come,” says Neumann.

Another reason to be optimistic about the growth in China is the record amount of liquidity being injected into the economy. “We refer to this as total social financing (SF), which is a combination of bank lending, bond issuance and other types of lending that is made available. This was a record high injection, so we expect some pick up in infrastructure investment over the coming two quarters. In addition, consumer spending is not dramatically slowing down and retail sales in real terms are accelerating.”

Neumann explained how Chinese policy makers truly think about investment. “When you talk to incoming Chinese officials, they always stress one thing: China is not even halfway through its urbanisation process. In order to cover the inflows from the countryside to the city they have to continue to invest.” About 400 million people are expected to move to the urban centres during the next 10 years. As of last year, the majority of Chinese people now live in urban areas. “The urbanisation rate jumped from 40% to 51% last year and we can expected that they will reach urbanisation rates of up to 70-80%,” he says.

 

Emerging risks: a replay of 1997?

The large injections of liquidity into the Asian markets has generated many questions about the effects and sustainability of the stimulus packages, East and West, raising the spectre of the Asian crisis in 1997.

When interest rates in the US and Japan fell in the early 1990s, investors looked for higher yields elsewhere and began lending into emerging Asian economies. This led to an increase in the region’s leverage and the bank credit to GDP ratio started to rise until 1997. During those seven years, growth in Asia was not export led but domestic demand led. In fact many of these countries had trade deficits and growth was entirely driven by loose liquidity. This is very similar to what is seen today, according to Neumann.

In late 1996 when Japan started to slide into recession, Japanese banks realised that they had non-performing assets at home and start withdrawing money from the rest of the region to protect their balance sheet. “That was the first sign of a liquidity squeeze in the rest of Asia,” says Neumann. “Quickly other banks started to cut their credit lines into Asia, liquidity dried up and the Asian crisis ensued. This triggered a vicious deleveraging process, during which the bank credit to GDP ratio in Asia fell, growth slumped and it was a terrible time for anyone who lived through that period.”

From 2001 to 2006, Asian banks repaired their balance sheets and the region’s growth was driven by exports to West, not domestic demand. “Once their balance sheets were repaired and the region regained financial confidence, it started to leverage up again and bank credit to GDP started to rise up until the global financial crisis. But the crisis barely registered in Asia – only in two quarters is there a blip in the bank credit to GDP ratio and after that it shoots up again, driven by the liquidity pouring in and record low interest rates. Since 2006, Asia’s growth has again been driven by domestic demand, investment and consumption. We don’t need the Western consumer necessarily because we can use leverage to pump up growth.”

Neumann is quick to point out that just because the region is above the previous peak doesn’t mean that it is as vulnerable as before. “For example, we are mostly local currency financed, not US dollar like in 1997. We have current account surpluses today and the richer a country is in per capita terms, the more debt it can carry, etc,” he explains.

But he warns that there are imbalances building up. What can be a trigger for this whole process to unravel? Neumann came up with three possible scenarios that would prick the Asian debt bubble:

1. Higher global interest rates.
   
2. Exploding local inflation that undermines financial confidence.
   
3. Some sort of financial scandal or crisis that again undermines financial confidence, such as a Ponzi scheme, a European bank getting into trouble at the level of a Lehman Brothers or a “Chinese Bernie Madoff” appearing.
   

He believes that neither Europe nor the US will raise interest rates soon, at least for another 12-18 months. In addition, Bank of Japan (BoJ) recently announced one of the most aggressive monetary easing programmes in recent history, pumping $1.5 trillion into the economy over next two years.

“There will be even more money flowing out of Japan and where will it go? Into emerging Asia, which will add further fuel to the fire. You will see Japanese banks increase lending into the region, liquidity will rise and there will be a low interest rate environment for even longer,” says Neumann. “The liquidity train has just left Tokyo station, is at Yokohama right now and will be in Bangkok by the end of the year.”

This insight was first published on www.treasurytoday.com