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DEVELOPMENTS IN THE eurozone are looking more fragile by the day. Although it is not the case that another major global crisis is definitely on the cards, the risks have now grown to a point where the prudent investor should start thinking through what such a crisis could mean for Asia.
What has changed in the eurozone to raise concerns?
The essential change in the past week is that financial markets now fear a near-term Greek default that could undermine the balance sheets of major financial institutions in Europe and elsewhere. Previously, investors assumed that even if Greece were to default, this would only happen in the future, giving European banks exposed to Greece and other risky credits the time to build up capital buffers so that the impact of defaults could be mitigated. Credible reports suggesting that key officials in Germany were preparing contingency plans in the event of a Greek default coincided with news that Greece was struggling to meet the conditions of its bailout to change perceptions.
Rising fears that European banks would suffer major ratings downgrades by rating agencies further upset markets. Consequently, as worries about European banks rose, these banks are finding it more difficult to raise funds in wholesale financial markets, putting a strain on their liquidity positions. Bank shares have plummeted in value, making it difficult for them to restore confidence by raising more equity. Major indebted eurozone nations such as Italy are now forced to pay much higher interest rates in their latest bond issues — rates that simply cannot be sustained in the long term.
It cannot be emphasised enough, though, that the key issue is not simply a market perception of Greek default risks. Underlying this perception is the hard reality that the heavily indebted eurozone countries are now in an impossible position. First, efforts to cut fiscal spending hurt economic growth and reduce tax receipts: This means fiscal deficits remain high despite the spending cuts. Second, fears about how eurozone banks’ exposure to Greece is becoming a self-fulfilling prophecy — denied access to liquidity, these banks could go into a downward spiral.
Neither should investors comfort themselves by thinking this is simply a eurozone problem. The US has also not been spared. While US banks may not have huge direct exposure to Greece, some fear that the indirect exposure might be fairly painful. In the meantime, the spike in concerns about the eurozone has caused the US dollar to appreciate against most currencies as safe haven demand for US dollar assets has surged. This will not help the US economy — at a time when consumer and business spending is weakening, the last thing the US needs is a strong currency that weakens its export competitiveness.
What are the likely scenarios?
It is really difficult to sustain an optimistic scenario in such circumstances. The only question is how bad it might get. The most likely scenario is a fairly difficult one for Asia, as described below.
First, there is no doubt that global economic activity will decelerate markedly. The latest Organisation for Economic Co-operation and Development (OECD) composite lead indicators for July were dismal, foreshadowing an acrossthe- board global deceleration. Even emerging economies such as China, India and Brazil are set to slow down. With the sharp deterioration
since August, it is likely that the economic trajectory will now be even more downbeat than the July lead indicators suggest.
Second, financial turbulence is likely to worsen. It is difficult to rebuild the confidence in the highly indebted countries and in the eurozone banks that has been weakened unless there is a far-reaching policy response in the eurozone that addresses the roots of the problem. We cannot rule this out but, given the political disagreements in the eurozone and its track record so far, a confidence-building policy reaction seems unlikely.
Thus, the key factors that determine the outlook for Asia are likely to deteriorate:
- First, global demand for Asian exports will almost certainly weaken;
- Second, aggravating this will be a fall in the prices of commodities that are sensitive to the economic cycle such as coal, base metals and rubber;
- Third, falls in equity markets and the constant drumbeat of bad news will hurt business confidence in Asian economies. Foreign investors will prefer to defer or downscale commitments to emerging economies. Domestic businesses in Asia will also like to watch and wait rather than continue hiring and expanding capacity; and
- Fourth, as economic and financial conditions worsen, global investors are likely to become more risk-averse and pull funds out of riskier emerging-market equities. Capital outflows will increase and push down Asian currencies relative to the US dollar. This could cause inflation to rise a tad more than it would have.
