Asia’s Economic Silver Lining

It is nearly certain that the US is headed for a recession and that Asia cannot escape the pain.

When exports to North America slide it will not be easy. But just because Asian de-coupling from the US market will likely prove a myth, it does not mean that Asian stocks need to nose-dive in unison.

In the short term, of course, investors are taking flight. When US markets fell 3 percent on February 5, the Hang Seng Index promptly fell 5.8 percent on opening, the Nikkei by 4.1 percent and the Straits Times Index was down 3.6 percent. Foreign investors in particular have been quick to assume that weakness in US demand, plus a weak dollar, immediately slashes earnings prospects in Japan and elsewhere. Of course, that is partly true, particularly for the likes of Toyota with its still-huge dependence on the US market. Ditto for Taiwanese and South Korean makers of laptops and plasma screens.

It is true, also, that the sudden contraction in new credit in the west is mirrored by a slowdown in China as government efforts to restrain lending finally begin to bite – helped along by the weather and perceptions of slowing foreign demand. Any slowdown in China’s growth would naturally affect all the Asian countries for which China has become a principal market.

But investors sooner or later will look beyond the immediate and see what is actually happening, or likely to happen, longer-term. The US-originated credit boom was largely concentrated in finance and property. There is a lot of unwinding still to do, perhaps as much as Japan faced in the 1990s. It remains to be seen whether that happens quickly, whether budget deficits, dodgy accounting or changes in laws slow it down, as in Japan, rather than enabling the catharsis to be sharp but short as in the 1997 Asian crisis.

But even in the US it is possible to imagine that the pain will be concentrated in those sectors where the binge was most apparent – finance, property and private equity/leveraged buyouts.

For sure, manufacturing and retailing will suffer as demand slows but the pain of bringing the profit percentage of GDP back from a near record high to average or less will be focused elsewhere. The reason is rather obvious. Many companies in these sectors are cash-rich, under-leveraged and they have been quite cautious in making new investments since the brief 2001 recession.

And what applies to much of the non-financial, non-property sector in the US applies in far greater measure to most of East Asia, except China. As Michael Taylor of Coldwater Economics points out in a recent commentary, the growth in Japan’s capital stock slowed from 1.5 percent in 1997 to minus 0.5 percent last year. In Korea capital stock growth has slowed from 13.9 percent in 1997 to 5.4 percent a decade later and in Taiwan from 9 percent to 3.9 percent.

The situation in Southeast Asia has been similar. Indeed, countries such as Malaysia, Thailand and Indonesia have been fretting about inadequate investments in new plant and equipment and even Singapore’s once-manic growth in capital stock has slowed dramatically.

In other words, the natural slowdown in more developed countries has been supplemented by the salutary impact of the Asian crisis, with humility taking over from hubris (except in latecomer India), and profitability gaining ground over size and market share. Where there has been a return to fast credit growth under the impact of the global liquidity deluge, it has been in property and consumer lending.

For sure, rising exchange rates will damage some profits. But generally there is little sign, at least in manufacturing and even financial services, of the crippling over-expansion of the past. Domestic markets may be slack but they still yield steady profits and while it will doubtless slow, China remains a growth story. It is also a story from which East Asian companies, with their large manufacturing bases in China, will continue to profit, a trend that offsets losses to their domestic economies of weaker industries moved to China.

China is of course the exception to slow facility investment in East Asia. But even there, much has been focused on infrastructure and heavy industries like aluminum smelting that do not compete with their neighbors. The potential now for China’s consumption to outstrip export growth by a substantial margin makes it likely that overall the country is not about to suffer major indigestion from over-investment in manufacturing.

Speculative housing, yes. Waste of resources on grandiose public buildings, yes. Unreformed lending standards by banks, yes.

But overall, East Asia is not significantly over-invested in manufacturing capacity, particularly as its global market share continues to grow. So though rising commodity prices, rising exchange rates and faltering export markets in the west will crimp profits, the blow will be muted.

In short, in Asia (as in the US) investors are wise to buy manufacturers and retailers and to avoid financial institutions and property, which even in Asia will be wounded by the sharp slowing of global credit growth.