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September 2011
Asia ex-Japan index fell 23% alongside a sell down in global equity markets since 27th July. The widening EU sovereign crisis, S&P downgrade of US government debt and subsequent brokers’ downgrade of global GDP series have taken its toll on all emerging markets. Asian CDS spreads have been comparatively well-behaved until the last couple of weeks. Massive foreign capital outflows drove up spreads leading to a collapse in all Asian currencies.
It is believed that an awful lot of bad news is now in the price. The equity risk premium (ERP) for Asia ex-Japan now stands at 7.9% which is more than 2 standard deviations above its long-term average of 4.2. During the recent global financial crisis, Asia ex-Japan's ERP exceeded current levels for only five weeks between October and December 2008.
While Asia has not decoupled from the developed economies, it is gradually becoming less reliant on the G3 economies. Emerging markets account for 50% of the global nominal GDP. Since 2008, Asian policymakers have been focussing on promoting internal demand-driven growth. This is particularly so in China. The Chinese nominal GDP is close to USD$7trn this year as compared to USD$4.5trn in 2008. During H1 of this year, Chinese domestic demand contributed fully to GDP growth (negative net exports). This has quickly become an important driver of growth for the rest of Asia as China is no longer just an assembly hub for the region. The sharp decline in commodity prices is a major cushion for the region, helping to widen profit margins and tame high inflation. Food and energy-related items account for over 40% of the CPI basket in most Asian countries.
Weaker growth in the developed world, if materialised, will bring further downside risk to external demand. The most vulnerable economies under this scenario are Singapore, Hong Kong and Taiwan. Seasonally-adjusted exports for Korea and Taiwan (which leads the rest of the region) have been flat on a sequential basis since March 2011.
Some countries appear to have more room for measured fiscal expansion to boost growth. While China still has fiscal room to contain the downside risk to growth, India may not be able to respond given its high fiscal deficit. The latter is likely to focus more on boosting private sector confidence through policy reform. In Malaysia, stimulus spending is financed by the private sector.
The liquidity situation in China is still very tight, as indicated by the chart below, using M1 growth minus industrial production, the liquidity indicator favoured by the central bank PBoC.
The initial response from China to the current global crisis is encouraging. The State Council released a circular on August 9 following a meeting on global financial market conditions, stating that Chinese macroeconomic policies have gradually begun to take effect, with price control being effective overall and structural rebalancing in progress. More importantly, it allowed RMB to appreciate at an accelerated rate to the USD as well as a basket of currencies, in contrast to pegging the currency to USD in July 2008. This is positive for global rebalancing. It was interesting to note that PBoC maintained a relatively stable currency during the major sell down in all other Asian currencies last week.
While an appreciating RMB is indeed a tightening in policy, there are a number of reasons why China has decided to pursue it now. The overriding concern is, as always, domestic politics. In the past the trigger for social unrest was unemployment. Now social dissatisfaction is more likely to result from rising prices. While high interest rate is not favoured by debt ridden local governments, strong exchange rate has the support of politically powerful state owned enterprises (SOEs) who are net importers. The second concern is the insecurity of its US$3trn US treasuries. The likelihood of more capital inflows against a global low interest rate environment is another reason for keeping RMB strong now. The added benefit of this policy is to boost domestic consumption as well as to contain inflation. The National People’s Congress passed the final version of the Amendments to Personal Income Tax Law on 20th June 2011, effective from 1st September 2011 to lower income tax threshold to boost consumption.
China’s affluent urban middle and upper classes have the ability to increase their support for the local as well as global economy significantly, if the recent trend of RMB appreciation continues. The total urban household incomes at end 2011 are estimated at approximately US$4.5trn. This could be a gross underestimate as it is impossible to gauge the true size of China’s underground economy. However, it is apparent that a 2008/09 style of stimulus package from China is not likely as the economy still faces inflationary pressure and high loan to GDP ratio of 128%. The local government debt, or LGFV, while remaining risky, is manageable. According to the Chinese Constitution, all local government power is granted by the central government and the central government should take ultimate responsibilities. Hence, here lies the bottom line: the central government will not allow local governments to go bankrupt. It will strive to avert systemic risks in the banking industry.
Selective easing is the most likely policy going forward, focussing mainly in building social housing and boosting consumption. Premier Wen Jiabao’s comments were carefully analysed. However, he has been swinging from proclaiming victory over inflation, to saying that price stability is still the priority, and then back to underplaying the risk of rising inflation. This underlines two observations. Firstly, China is facing a dilemma in its policy making, involving a trade off in balancing growth and prices. Secondly, with the tempo for political transition gathering pace, the ongoing power struggle within the higher echelon continues to send out mixed and conflicting signals. A case in point is the widening of reserve requirement ratio (RRR) to include margin deposits announced by PBoC. This is equivalent to 2-3 RRR hike, suggesting more tightening.
While Chinese policies are likely to remain murky, the economic fundamental outlook for ASEAN remains robust with transparent policies. The equity markets in Asia are very oversold, trading at 8.8 x PER, 1.2x PBV. The markets are likely to be volatile as sentiment will continue to be driven by external events. However, with the stronger economic fundamentals, Asian markets have the ability to bounce back stronger and faster than the other regions.
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