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IT HAS BEEN a grim few weeks for financial markets. European sovereign-debt tremors, rising political risks in the Korean peninsula and worries about policy tightening in China have depressed investors. The financial press has taken on a decidedly downbeat tone, with some columnists sketching out extreme scenarios such as the collapse of the euro. In this context, it might be worth thinking through what the risks for Asia specifically are.
There appear to be four main risks that investors in Asia need to focus on — financial and political risks in the eurozone, risks of conflict in Korea and how global demand for Asian exports will fare as the global economic recovery wanes. Our view is that it is going to be a bumpy ride, but those Asian economies with strong fundamentals are likely to withstand the stresses reasonably well.
Eurozone: Two key risks
Despite, the Eurozone’s massive €750 billion ($1.3 trillion) package, financial markets remain nervous because of two separate issues: the financial risks of sovereign default and banking-sector stress and the political risks that will rise as eurozone economies are forced into restructuring.
- Financial risks: The massive eurozone package reduces the risks of default for the next three years, but it requires severe cutbacks in fiscal spending in countries such as Greece, Portugal and Spain. As reduced fiscal spending cuts domestic demand even further and produces deflation in consumer prices and real-estate values, borrowers in these countries will face a higher burden of debt just as their wage and job prospects are weakened. It is inevitable that loan delinquencies will rise, placing commercial banks under stress. Where non-performing loans hit particularly hard, banks may have to be bailed out, adding further to an already unsustainable fiscal burden. Since the other troubled economies are relatively small, the core question is: Will Spanish banks need substantial re-capitalisation? We take a positive stance — the Spanish central bank had the foresight to require substantial increases in banks’ capital adequacy during the Spanish economic boom and has been proactive in pushing the smaller financial institutions to merge in recent weeks; and
- Political risks: Unless economic growth revives in the troubled economies, they will not be able to keep refinancing maturing debt once the massive eurozone package is used up. With a single currency eliminating the option of currency devaluation to boost export competitiveness, economic growth can be revived only if there are structural reforms that unleash supply-side efficiency gains. This probably means removing social protections to make the labour and product markets a lot more flexible. In the short term, such reforms usually mean more pain than gain, as companies cut bloated workforces and streamline supply chains. The benefits of such reforms will be very powerful over time, but the high social costs in the short term will create political risks. The key question is whether the political leaderships in European countries of some size such as Spain can withstand the political backlash long enough to sustain economic reforms to the point where they can achieve their aims. We believe that this is possible — but at a cost: Governments will have to share the burden around by raising taxes and imposing stricter regulations on companies to buy the political support needed for economic reforms. They may also have to resort to some forms of protectionism to show workers that they are trying to protect them.
In short, Europe faces a few years of financial and political stress but will probably avoid the more extreme scenarios of euro collapse while its core economies such as Germany will continue to grow.
Should we fear conflict in the Korean peninsula?
The North Korean regime is often caricatured in the media as irrational, perhaps crazy enough to start a war. It is probably more accurate to describe its leaders as highly rational risk-takers who usually play a fundamentally weak hand with extraordinary skill. This is not the kind of government that will deliberately start a war. If there is a risk of conflict, it is that an accident or a miscalculation sparks off a conflict. When the North Koreans sank a South Korean naval vessel in late March, they probably thought they would get away with it: The South Korean use of advanced technology to prove North Korean involvement surprised them. Fortunately, the South Korean government has handled the crisis with considerable skill — calibrating its responses (mainly economic sanctions and restrictions on North Korean use of South Korean waters) carefully and leaving enough room for a political solution. With the even more isolated North Koreans now more dependent than ever on Chinese support, China probably has enough leverage to broker a compromise. In our view, therefore, there is little risk of imminent conflict. In the longer term, of course, it is unlikely that North Korea can continue in its current mismanaged and decrepit state. Its inevitable demise may well be accompanied by considerable turmoil — but our best guess is that that is unlikely in the next year or so.
China’s tightening does raise risks
While Chinese financial markets have shown their concerns over policy tightening by weakening almost 10% in May, investors still believe that the Chinese policymakers’ record of fairly deft economic management limits the risks and that policymakers will ease restrictive policies as soon as economic growth slows. We suspect, however, that this is an overly complacent reading of policy intentions. A close reading of recent official statements in China suggests that Chinese leaders believe it is better to risk economic growth in the short term by decisively cooling the bubbly real-estate market than to allow the bubble to grow to such proportions that the eventual risks to the economy are so much greater. In other words, they are prepared to tolerate a lot more economic pain in the short term than the market thinks. As a member of the central bank’s monetary policy committee put it last week, China’s housing bubble carries more severe risks than those in the US before the latter’s financial crisis because China’s bubble comes with potentially serious risks of social discontent. With local government officials being pressed by the central authorities to bring down housing prices and with the central authorities also bringing in progressively tougher measures to curtail the property market (such as taxes and restrictions on mortgage lending), the housing sector is certain to cool rapidly and bring economic growth down with it over time. After all, a large part of Chinese fixed-asset investment is said to be either directly or indirectly linked to the real-estate sector. Our estimate is that, after a blow-out performance in 1H2010, the Chinese economy will slow sharply in late 2010 or early 2011.
What about risks to Asian export growth?
This is the risk that financial markets have yet to focus on sufficiently. From late 2010, fiscal policy in most developed economies will turn more restrictive: Stimulus programmes are rapidly giving way to increasingly rigorous tightening of fiscal policy. The initial jump in demand, as inventories were rebuilt and some of the panic-induced reactions of late 2008 and early 2009 were reversed, will soon end. The easy part of recovery in global demand for Asian exports is over. The most likely scenario is that global demand will continue to grow but at a mediocre pace and subject to occasional bouts of weakness.
Implications for Asia
This assessment of risks suggests that catastrophic financial and political shocks are unlikely. The real risk is weaker prospects for Asian exports on account of weaker-than-expected Chinese and G3 economic growth.
- The economies that are likely to perform relatively better in such a scenario will be those with relatively less exposure to G3 and Chinese demand and that are enjoying structural factors that help buffer their economies: India and Indonesia fit into this category; and
- Another set of economies includes those that are export-dependent but have considerable leeway for policy response and enjoy some special or supply-side factors in their favour: South Korea, Taiwan and Singapore will probably take an initial hit from slower exports but can rebound reasonably well because of these positive factors.
In other words, it will be a rough ride for financial markets for quite a while.
