Asia Won't Get Away Clean

If you want a sense of how events in the US financial markets and economy will impact Asia, do not look at the trade numbers so much as money supply. It is easy to make the argument that Asia has at least to some extent decoupled from the US and hence will be only moderately impacted by a US recession, just as the US, and indeed the west in general, was itself only mildly impacted by the Asian crisis a decade ago.

Take China. Its exports may seem vulnerable as they amount to 40 percent of gross domestic product. Yet only 20 percent goes to North America. The value-added in Chinese exports probably amounts to around only 40 percent so its contribution to demand is only around 16 percent of GDP. Exports are thus small compared with both domestic consumption and investment. So in theory at least there is little reason why they should not continue to grow at the 8-10 percent rate of recent years and which continues to be the mainstream forecast for the short to medium term. That’s probably faster than exports can keep growing but given the size of China’s trade surplus, domestic demand-led growth is no problem – indeed, it will help re-balance global trade.

Japan’s exports have a much higher value-added but its gross exports to GDP are much lower than China’s so the net impact is about the same.

Of other Asian exporters of manufactures, Korea will likely suffer somewhat more from a US recession, but against that it has been continuing to gain global market share in many products. Taiwan will be hurt more because of its higher dependence on the US – both directly and via its assembly operations on the mainland. Again however, its focus on leading-edge products in the IT and electronics fields – including mobile phones and low-cost laptops – will be an offset.

Southeast Asian countries in theory look vulnerable because of their very high trade-to-GDP ratios. However they remain far more reliant on commodity exports and tourism – and remittances in the case of the Philippines -- than on manufactured exports, which look large in gross terms but which in many cases have value added lower even than those of China. (Only 15-20 percent in the case of many Malaysian and Thai electronics products and Vietnamese shoe exports).

Unless the US recession triggers a collapse of buoyant commodity prices, the region’s exports should continue strong enough to support continued domestic demand growth. Base metal prices could suffer but energy and food prices look to remain firm because the production response to recent high prices takes a long time to materialize.

India is generally viewed as being more immune than most from a US recession and a global slowdown because of its low exports-to-GDP ratio and the importance of remittances, supposedly less impacted than goods, in its foreign earnings. The dramatic rise in its growth rate has been due to much-improved savings and investment as well as the impact of its services exports and even its goods export growth has been dominated by new markets such as China.

However, the good news ends there. In particular it ends for those Asian countries, headed by India and China, that have been most touched by the surge in global money and credit creation. This surge has had two causes. First and most important is the size of the US current account deficit – approximately $700 billion in 2007. In the case of China, with a surplus of roughly half that amount, the impact has been to swell domestic money supply. The efforts of the People’s Bank of China to sterilize the impact have been largely unsuccessful.

Meanwhile Chinese currency appreciation has been too slow to have any significant impact on the trade balance. Indeed the tiny steps in revaluation have merely encouraged the inflow of speculative capital, sure that the gradual appreciation against the dollar would continue.

In the case of India, the impact of global liquidity has been even more marked. India has continued to record a current account deficit and inflow of FDI remains quite low. But the flood into rupee deposits and the stock market has helped finance 20 percent-plus growth in credit to the private sector even while the public sector remains in deep deficit. The global flood of money (and attendant hubris) has enabled Indian companies like Tata to buy themselves a place on the world stage rather than earning it through export success or technological advance.

The money flooding into the fashionable emerging economies – mainly the BRICs plus Vietnam and Turkey but generally excluding the now more sober economies hit by the Asian crisis of a decade ago – has been further boosted by capital outflow from the other two big northeast Asian surplus economies, Japan and Taiwan. Their ultra low interest rates have done little to spur domestic demand but have ensured a flow into emerging markets as well as back into the US to sustain its consumption binge.

On top of this global money supply surge came the expansion of derivative financial instruments. In practice these have now been found to disguise credit risk and hence inflate credit growth. Their impact was mainly on the western economies, particularly those with large savings deficits. But they have spilled over into global markets, in particular helping to fund cross-border acquisitions, often by highly leveraged private equity funds.

The issue for all of Asia now is: are these conditions about the change and if so what will be their impact?

The direct impact of the western financial crisis will be limited, mostly to the losses of Asian institutions which had bought dodgy dollar instruments. However, it is already apparent that the deal flow which had been driving some emerging as well as developed markets has dried up in the wake of the credit crisis and hence will have a sustained impact on asset prices and expectations even if it has not impact on profits.

Even without a slowdown in the rate of growth of global foreign exchange reserves – largely a function of the US deficit – global credit growth thus looks likely to slow significantly.

But the bigger issue is the impact of a US recession on that US current account deficit and hence of its flow through to domestic money growth in the countries, headed by China and India, which are supposed to keep spearheading Asian GDP growth.

For sure, the US government and the Federal Reserve are burying their heads in the sand, cutting interest rates and providing fiscal stimulus to try to keep the US consumer gorging. The Fed has cuts rates to zero in real terms even though the latest private savings ratio in the US was a negative 0.5 percent! The administration, with full support from all presidential candidates, is to deliver a $150 billion present to consumers at the cost of an even bigger government deficit.

All this may slow the improvement in the US external deficit and hence slow the rate of decline in global money growth. But it is unlikely to keep the US out of recession. The mix of slowing US external deficit with rising Asian currency rates will slow Asian base money and credit growth. In turn, that will feed through to asset prices – particularly India and China with their obvious bubbles – and from there to investment.

FDI will also be affected because even companies flush with cash after a prolonged period of strong profits – will hold back from new investments as they see demand growth declining. The cash-rich will also hold on to their cash until they see enough carnage to start buying distressed assets – particularly in the US. (Not a few Asian companies would love to get their own back on the US which was able to buy assets, particularly in Korea, for almost nothing in the wake of the Asian crisis).

Of the major Asian economies, only China has the very obvious ability to try to offset slower domestic growth caused by declining exports. Its budget deficit is tiny and the needs of its central and western regions vast. It also has the capacity to bail out (again) its still mostly state-owned banks. But China’s policy responses tend to be very slow and may be far too late to prevent a sharp decline in its rate of growth.

India has zero capacity to offset a decline in liquidity. Its current account and budget deficits – not to mention its oil import dependence – are already too high for comfort. It could even get into serious trouble if much of the short-term money which has flooded in over the past two years and driven foreign reserves to $275 billion decides to exit, driving down asset prices and squeezing credit in a manner reminiscent of Southeast Asia a decade ago.

The financial sectors in both India and China also face the added danger that local bad debts will start to escalate, next year if not this. Rates of credit growth have been far too high even for buoyant economies so expect a very sharp reversal in non-performing loan ratios, which had fallen under the stimulus of new credit.

Japan has the theoretical potential for increased domestic demand, but years of efforts to stimulate it with fiscal deficits and near-zero interest rates have failed.

For different reasons, Korea, Taiwan and Southeast Asia may be able to boost domestic demand. Capital may return to Taiwan as the KMT returns to power and the economy is boosted by hopes of closer cross-strait links. Korea’s new government may find its domestic stimulus works. Malaysia’s massive trade surplus provides plenty of scope for growth if political hurdles can be overcome, and Indonesia, with strong exports and looking to an election in 2009, will probably continue to expand relatively fast. But even combined these cannot offset any sharp reduction in China and India.

In short, it is the financial sector, local and global, which is the worry for Asia, not the US recession per se. It is the coming end of the money and credit binge which has ensured that asset prices and investment have far exceeded several economies’ ability to generate adequate returns.

No one’s problems are as bad as those of the US, but the only safe havens could be those with the lowest expectations – now Japan, Taiwan and Thailand.