Asia’s outlook a tale of cautious optimism: IFR Asia

IFR Asia, Feb 2010

Asia’s economic outlook is a story of cautious optimism. All the signs are good, but the process of withdrawing stimulus, avoiding asset bubbles without derailing the recovery, will be delicate.

It’s hard to start a look at Asia’s outlook anywhere other than China. “I’m in the ‘China saves the world’ camp,” says Tin Condon, chief economist for Asia at ING. “In late 2008 China’s policies, particularly the fiscal stimulus early on, saw domestic demand and investment almost immediately accelerate.” That started to suck in imports, visible in the stabilizing of Asian export markets early in 2009, and one by one other economies are recovering in line with their exposure to Chinese demand. “It’s just a question of where they are in the cycle,” he says. “The North Asian economies are ahead of the Southeast Asians, and they are ahead of the US; the winners in terms of growth are going to be the ones most exposed to China.”

China’s influence, and that of emerging markets generally, has become a widespread view; HSBC’s group chief economist Stephen King and global head of emerging markets research Phil Poole wrote in January that “we have reached a tipping point in global economic affairs….2009 will surely go down as the year when we both uncovered the scale of the crisis in the developed world and celebrated the resilience of much of the emerging world in the face of what appeared to be a perfect economic storm.” They, too, pinned this on China, now “able to stand on its own two feet, capable of delivering rapid economic growth even while its export engine was badly misfiring.”

But the scale of China’s influence has been clear in a less welcome way recently, with its efforts to withdraw stimulus having a pronounced negative effect on world markets. “It’s been an awful two weeks and a lot of that is China bubble angst, and worries about the removal of stimulus,” says Condon.

Certainly, getting this process right is – for China and all world economies – going to be tricky, and hugely important. “It’s all about fine tuning,” says Mike Rees, CEO for wholesale banking at Standard Chartered. “It’s a very delicate balance. The differences between overreacting and under-reacting are quite profound. Many local banks are flush with liquidity and trying to use that liquidity. The problem is how you withdraw it in a certain way so you don’t go cold turkey.”

It’s already happening: India has raised its statutory reserve requirements for banks by 75 basis points, to 5.75%, and is expected to increase policy interest rates at the next opportunity. China has introduced curbs on bank lending. “It’s about pulling gently on each of the levers to find the right balance,” says Rees. “The real question is whether they accept a lower level of growth to reduce the risk. And I don’t think that debate has started yet.”

Economists vary on their opinions of where China goes next in withdrawing stimulus, but Jun Ma, the chief economist at Deutsche Bank, has a representative view: a desired level of new lending at RMB7.5 trillion for the year, compared to RMB9.6 trillion in 2009; a rise in reserve requirement ratios in the first few months of 2010 [this has since happened]; raised interest rates from the People’s Bank of China from the second quarter; and gradual appreciation in the RMB. Regulators have already said they want an increase in capital adequacy ratios at the big banks to 11% in 2010.

Ma says China will also undertake significant structural reforms, to remedy over-reliance of growth on investments and exports; the external imbalance, illustrated by a large trade surplus and the rise in FX reserves; overcapacity in low-end energy intensive manufacturing sectors; and the environmental impact of the current growth model. He suggests stimulating consumption, promoting urbanization in second and third tier cities, accelerating health care reform and promoting new (greener) energies as possible policy shifts.

China’s cooling measures are not proving especially popular with markets so far, but most economists are pleased to see them happen. “In China’s case it’s difficult to bet against the track record of the authorities in soft landing their economies,” says Condon. “Eventually investors will get comfortable that these measures in China are positive, and will sustain growth not derail it, and this bubble angst will fade.” But it’s going to take a while. “This removal from stimulus question will be a serious overhang for risk assets in the first quarter of the year and it’s already proving to be.”

Nobody is expecting Chinese growth to go backwards as the stimulus comes out though, and projections on its numbers still look dramatically different to anywhere in the developed world. Qu Hongbin, HSBC’s chief economist for China, is calling GDP growth to accelerate to 9.5% in 2010 from 8.7% last year, with an infrastructure-led recovery sustained well into 2010.

India has similar prospects and equally robust challenges, just without quite the same global scrutiny that China attracts. India’s own official GDP target for 2010 is now 7.5%, revised upwards from 6%, and once again the question has turned from how to recover to how to keep things calm. Barclays Capital economist Prakriti Sofat calculates that India’s recent cash reserve ratio hike will withdraw Rs360 billion from the system, but that “even after a full pass-through of the hike, we think there is roughly Rs350 billion of excess liquidity in the system.” Sofat adds: “The RBI has clearly indicated that liquidity management and controlling inflation were its key policy goals ahead of its next meeting in April.”

Elsewhere in Asia, the picture varies from place to place. Some countries look far removed from the Indian and Chinese success stories: Philippines GDP growth in 2009 was just 0.9%, and government forecasts for 2010 are a modest 2.6 to 3.6%, hostage to food prices and El Nino conditions. In Malaysia, where prime minister Najib Razak has predicted 3.5% growth, there is the potential impact of political change and social unrest, something Malaysia has not had to think about for 40 years. In Thailand, the timetable for stimulus withdrawal looks positively American: Barclays Capital doesn’t expect a rate rise until the third quarter of 2010 and expects interest rates to reach 1.75% by year end. Generally speaking, it’s the bigger economies that engender optimism, with Indonesia another standout, buoyed by the political stability that came from last year’s presidential re-election.

Generally, few economists are predicting unbridled joy for emerging market economies, with most expecting some kind of scare or distraction in the course of the year without necessarily reaching consensus on what it will be. Bank of America Merrill Lynch analyst Daniel Tenengauzer has been describing this as “Thanksgiving before Halloween”, with a market feast in the first six months of 2010 followed by some kinds of market scare. This premise calls for strong performance in emerging markets assets in the first part of the year, driven by appetite and a rebound in inflows, with some volatility. Merrill points to forecasts from the Institute of International Finance, which recently revised up its projection for net private capital flows into emerging markets for 2010 to US$722 billion, from US$672 billion. This would be a 65% increase on 2009, and would also be up on 2008.

The second part of this scenario (the scare bit) could be prompted by further tightening of monetary policy – including the European Central Bank, which Merrill expects to see raise rates in September – and a correction in foreign investor positioning if they have overstretched their emerging markets exposure in the first half of the year.  

For years, economists have been debating the strength of intra-Asian trade and its resilience when export markets are down; the crisis has provided some illustration of how much Asia has grown in that regard. Asia may not have been strong enough to miss out on the world’s stock market collapses, but economically, it does look reasonably well differentiated. “Internal Asian trade is one of the main drivers of export recovery,” notes Qu at HSBC. “With demand elsewhere in the world stabilising following earlier declines, exports should continue to underpin Asia’s rebound over the next several quarters.” But he is keen to note it’s not all about exports, and Asia’s recovery is not entirely dependent on them. “To date, domestic demand has provided the main lift to Asian growth, a theme that will continue over the coming years.” He says surveys show hiring intentions near record highs in most markets, with car sales soaring across the region, particularly in China, Vietnam, Taiwan and India.

And so the big questions all come back to central bank policy. “We expect central banks in all Asian markets, with the exception of Japan, to raise interest rates, even before their peers in the west have embarked on a tightening course,” Ho says. “In essence, the trajectory of monetary policy between the East and the West will have to diverge, putting ever growing pressure on the region’s exchange rates to appreciate.”

But none of this is easy, and Rees has a cautionary, practical reminder. “Not everyone is going to get this right,” he says. “The chances of every country getting it right first time are virtually nil.”