Asia vs Europe: The US$2.3 trillion question

IFR Asia, December 2011

Confidence is running high that Asia’s rapid growth will protect the region from the worst of the turmoil in Europe. Yet global bank exposure to Asia, at US$2.3trn at the end of June, means the threat of capital flight is ever-present. Is Asia guilty of complacency?

The theme of Asian decoupling is as old as the hills. For years, economists and analysts have argued over whether or not Asia is a sufficiently powerful and independent economic bloc to be able to come through the macro shocks relatively unscathed. It is always hoped for, but never quite achieved. With Europe in crisis and the US flirting with recession and unresolved debt, the question is being asked again.

The simple truth is that, no matter how much more robust Asian economies look than those in the west, regardless of how much better their fiscal positions and demographics, capital continues to fly from these places whenever there are global (or western) worries. Illogical though it may be, Asian capital markets remain a risk-on bet. “We saw trickles in September, but the risk is we may start to see serious net capital outflows from Asia, which can be very destabilising,” said Rob Subbaraman, Nomura’s chief Asia economist.

A look at capital flows over the last five years is illuminating. According to Subbaraman, in the 10 quarters before the global financial crisis from the first quarter of 2006 to the second of 2008, Asia ex-Japan attracted US$265bn of net capital inflows – a broad measure, including net portfolio debt and equity, FDI, international bank lending and balance of payments. In the following two quarters, in the eye of the credit crisis, US$118bn departed. “A reasonable chunk left,” he said. “However, what’s interesting is that in the next 10 quarters, from the first quarter of 2009 to the second quarter of 2011, net capital inflows totalled US$684bn.”

That vast increase has been down to Asia’s better fundamentals relative to the rest of the world, the higher interest rates available, and the easing policies in advanced economies that pushed capital towards Asia. Still, should we expect, as happened last time, for half of it to leave again when things turn sour? “There is a lot of room for foreign capital to leave Asia if we start to move towards anything starting to resemble the global financial crisis,” Subbaraman said.

This is a more alarming prospect in some markets than others. Indonesia, in particular, has been watching closely for signs of capital flight, since, at its peak, foreigners accounted for 35% of all rupiah government bonds, with a similarly high representation in the stock market. “We have the capacity to withstand reversals,” said Rahmat Waluyanto, in the debt management office of Indonesia’s Ministry of Finance. “We have relatively large forex reserves, a widening domestic investor base, and a bond stabilisation framework.”

However, money is leaving. The rupiah, having gained more than 5% against the US dollar in the first eight months of 2011, has slid by more than 6% since the start of September as overseas investors sold stocks and bonds. Foreign ownership of government bonds fell 1.1% in a single week in late November. Indonesia is a market darling: a domestic consumption story, a model new democracy, a fiscally sound nation and one capable of borrowing US$1bn of seven-year money at just 4% in November at a time when Italy was paying almost 7% on its own debt. A move up to investment-grade status within the next six months is considered a formality. However, none of that is enough to stop foreign capital leaving when there are difficulties in Europe and the US.

“The Global Financial Crisis Part II is spreading to Asia a little faster than we had anticipated,” said John Woods, Citi Private Bank’s chief investment officer for Asia Pacific. Speaking on November 22, he noted that every currency and every equity market in Asia had declined month to date, with India, Australia, Korea and Taiwan hardest hit.

According to Woods, this is partly a function of weak levels of risk appetite, and partly capital outflows as continental European banks reduce their cross-border lending to shore up their capital positions at home. BIS data says that, of Asia’s US$2.3trn loan exposure to global banks, 21% of it is extended by eurozone financial institutions. “Fears are growing that as French, Italian and Spanish banks exit the region, a credit crunch could escalate in scale similar to the global financial crisis of 2008–09,” he says.

Lessons learned

Leaving aside capital flows, it is inevitable that growth will slow as a consequence of problems in the US and eurozone, but, from this economic viewpoint, concerns are not so high. “These are challenging times, but, in many emerging economies, such as Malaysia, we did our reforms and strengthened our economy and our financial system [after the Asian financial crisis] and there is a tremendous payoff now,” said Dr Zeti Akhtar Aziz, Governor of Bank Negara Malaysia. “These measures placed us with a greater degree of resilience in coping with not only the economic implications, but the surges and reversals of capital flows, which are better intermediated into our financial system.”

She added: “With all the developments in Europe, the impact is in volatile financial markets, which impacts our money and foreign exchange markets. However, aside from that, the domestic economy is particularly strong.”

Many of her Asian peers share similar views, as do some economists. “Asia ex-Japan is becoming more resilient to economic conditions in the major advanced economies,” said Subbaraman. “One big reason is China: not only do we have the world’s second biggest economy in our backyard, but nearly all its growth is domestic-led. And several indicators suggest that more and more of Asia’s exports to China are staying in China, rather than being assembled and shipped out.”

This is a crucial point in the decoupling argument: economists have argued for years that growing intra-Asian trade has bolstered Asia’s independence from macro shocks, while just as many have countered that most of that intra-Asian trade comes from goods to be assembled in China and then ultimately exported to the West, undermining that independence.

There is a “tipping point” though, for Subbaraman, at which point Asia does start to get hit by slowing growth or recessions in the West. “When exports are cooling moderately like they are now, firms just accept that. But if the downturn really starts to deepen, firms have to face more difficult decisions on cutting back on jobs, expansion plans and capex, which has multiplier effects on domestic demand.” Then, there’s the effect of negative wealth and falling asset prices from equity to property on confidence.

For central banks in Asia, there are considerable challenges. “It’s really tough to be an Asian central banker,” said Subbaraman. “I think they should get paid more. They’re stuck between a rock and a hard place at the moment.” There are obvious threats to growth, and already some central banks, with Australia and Indonesia at the forefront, are cutting rates, with many others expected to follow, such as Malaysia and Korea. “But, on the other hand, you can see a number of other reasons not to ease right now,” said Subbaraman. Although headline inflation is easing, core inflation is still quite high in most countries; loan growth in many Asian nations is still at double digits; and it’s still possible that capital flows could come back in very quickly. “It could prove to be a mistake if Asian central banks are aggressively pre-emptive right now. It might be better to wait.”

Woods notes that the market is pricing in interest rate cuts across the region, but notes that although inflation is peaking, “price pressures are proving surprisingly stubborn.” He added: “Sticky inflation complicates Asia’s growth-versus-inflation trade off.”

All eyes are on China, which more and more people (Woods included) think is ready to move towards easing monetary policy. “For all sorts of reasons, China rightly fears a global recession,” Woods said. “Still highly dependent on external demand, China has been attempting to transition towards higher private consumption, but reforming your economy in the teeth of slumping global demand is challenging to say the least.”