The resurgence of uncertainty in Europe and growing concerns about U.S. unemployment have led to a risk-off environment. These challenges have exposed cracks in the otherwise largely resilient economic stories of Asia, as witnessed through the recent volatility of equity and currency markets. Despite Asian economies still having a significant susceptibility to exogenous factors, the long-term secular trends in most Asian economies are still intact. With adequate room for monetary, fiscal and structural stimuli to accommodate a slowing of exogenous demand, most Asian economies are also well poised to benefit from a resurgence of a risk-on environment should Europe and/or the U.S. come up with substantial, credible fixes for their ailing economic situations. India remains the lone outlier in the region, as it faces a political paralysis that is bringing it closer to crisis conditions. Luck and significant structural reform are among India’s few remaining levers left to improve economic conditions in the current environment.
It is possible that Chinese policymakers have been behind the curve with their recent responses to economic slowing. However, we maintain the view that the bottom of economic activity has been reached in the second quarter , with a likely rebound of economic activity into the fourth quarter. Our view of a scenario of no hard landing is corroborated by an assortment of recent policy measures aimed at supporting growth, President Hu Jintao recently stated that China will “maintain steady and robust growth,” and there is an increased likelihood for additional measures to further stimulate economic activity. China has conversely indicated that it will not embrace the scale of the record stimulus unleashed in 2008, yet stabilizing its expansion rate at the very least would avert a greater drag on a global rebound hurt by Europe’s crisis and elevated U.S. unemployment.
While visiting Mexico for the G20 meeting in June, President Hu said in an interview with Mexican newspaper Reforma that China has taken “targeted measures to strengthen and improve macroeconomic regulation, accelerate the shift of the growth model, adjust economic structure and build long-term mechanisms to boost domestic demand.”
Besides the first reduction in interest rates since 2008 that was announced on June 7, China has in recent weeks accelerated approvals for projects ranging from clean energy incentives and lower-polluting steel mills to aid for first-time home buyers. While China remains an emerging market requiring substantial new investment, with estimates that the Chinese economy is at the equivalent stage of economic evolution as 1960s Japan or 1980s South Korea, fixed asset investments still represent more than 50% of economic activity and, though incrementally lower, is likely to remain elevated for years to come. If a sustainable path for economic growth is to be achieved, we should look for more concrete measures being instituted by the China’s government to improve the structure of the economy by boosting drivers of domestic demand. Another path toward a sustainable direction for economic growth includes the deregulation of the financial sector. Looking retrospectively at the past few decades, Chinese leaders have demonstrated both the ability and willingness to deregulate, reform and otherwise free up productive forces in the economy every time it has hit a snag. This has not changed, as was recently demonstrated by the implied path towards financial deregulation implicit in the June 7 interest-rate-cut announcement. The rate cut was symmetric: -25 basis points both to lending and deposit rates; however, for the first time, banks were also granted the flexibility to offer loans 20% below benchmark and deposits 10% above benchmark. While likely to compress banks’ net interest margins, this is a clear and welcome step toward interest rate liberalization and a strong signal of a loosening stance.
India is facing the most stressed macro backdrop in Asia, all while real credit growth has remained strong (suggesting unproductive lending) in the face of sharply slowing GDP growth, weak industrial production, soft gross fixed-capital formation, persistent inflation and a massive trade deficit. India’s woes center on quadruple deficits (current account, fiscal, governance and liquidity) which prevent monetary policymakers from taking any substantial options until many of these problems are addressed. Currently, the biggest source of problems in India comes from the lack of political purpose and unity to embrace long-standing structural reforms on the supply side of the economy, as at present there is little slack in the economy. The Reserve Bank of India recently, and wisely, held off on a rate cut at its late-June meeting, as at this juncture it would have had little, if any, impact on lending rates due, ultimately, to political paralysis on structural reforms. In addition, a rate cut is likely to have exacerbated the inflation risks, given fiscal and current account deficits and the lack of slack on the supply side of the economy. In the absence of progress toward any major reforms, the one virtuous cycle one can see evolving in India derives from a decline of oil prices and a recovery of capital flows, for now, placing the direction of India’s economy in the hands of fate amidst political dysfunction.
Japan’s current macro numbers, in particular the sequential production and export data, show the softening recovery of Japan’s business conditions, despite the strong year-on-year rebound following reconstruction efforts and a large base effect. In a risk-off environment generally characterized by dwindling global growth, the yen tends to be sought as a safe-haven currency. Therefore, Japan’s corporate earnings are largely affected by both the global economy and the exchange rate. In this sense, therefore, the monetary policy of the Bank of Japan (BoJ) will play a critical role in the equity market as well as the real economy.
In February, the BoJ set the goal of a 1% annual increase of the Consumer Price Index to get out of a deflationary spiral. The current price level and the expectation of the prices as of the end of 2012 are far below that goal which suggests that the BoJ would accelerate easing to achieve this goal in the near future. The BoJ has not made any additional, drastic easing policies since February, and some expected that proactive action would have been announced at the meeting in June. However, it is difficult for the BoJ to implement a new policy before more progress is made in Europe, alongside the G20 meeting and the EU summit as both could shape decisions that will affect the framework and financial stability of Europe. The government is currently discussing a hike in the consumption tax. Prime Minister Noda is eager to raise the tax rate to address the rapidly ballooning deficit and has, therefore, compromised with the opposition parties in various other areas in order to pass the bill. Although the possibility of a general election cannot be denied, the bill for the tax hike could pass legislative approval by this summer at the earliest. Since the BoJ wants the government to maintain a disciplined budget, the enactment of the tax hike could make them more willing to implement the additional accommodative policies.
Indonesia’s long-term structural story has been one of the most compelling secular stories in the region. It has been led by a relatively strong fiscal position, a historically resilient balance of payment positions, and a strong consumption and commodity linkage story (energy and soft and hard commodities.) However, Indonesia currently faces cyclical pressures from a combination of global risk aversion, external funding linkages and a current account that is now falling sharply into deficit. Softening commodity prices, slowing global demand and resilient domestic demand from investments have contributed to a widening current account deficit, whereas high foreign ownership of government bonds (28.8% of sovereign government bonds) as well as a high external debt-to-foreign exchange reserve ratio (>200%) leave the Indonesian rupiah vulnerable to a reversal of capital flows in a risk-off environment. In the current risk-off environment, policymakers recently have started rationing onshore U.S. dollar liquidity in an effort to protect foreign exchange (FX) reserves; however, amidst the shortage of U.S. dollar liquidity, widening bid/offer spreads have been placing further depreciation pressure on the rupiah. Should the risk-averse environment be prolonged, the rupiah could face continued pressure from a balance-of-payments perspective, so events in Europe and the U.S. in the coming weeks and months could have significant bearing on the direction of the rupiah and the potential for severe capital outflow.
While a rapid depreciation of the rupiah would destabilize the economy, we believe the Bank of Indonesia will have enough ammunition this time around to combat the situation if it materializes. Foreign reserves stood at $113 billion at the end of May. Furthermore, the economy is strong fundamentally (GDP expanded at 6.3% in the first quarter of 2012) with core inflation holding steady at 4% year-over-year. We believe, therefore, that with what looks like an increasing likelihood of resolution in Europe, the rupiah should find stability going forward.
Recent events in Europe and growing concerns in the U.S. have led to a risk-off environment that has exposed cracks in the otherwise largely resilient economic stories of Asia, as witnessed through recent volatility of currency markets. In addition to Indonesia, other currencies susceptible to weakness should there be a prolonged risk-off environment include the Indian rupee and South Korean won due largely to significant exposure to external financing. Despite the inherent economic risks that accompany a significant weakening of currencies, the export-oriented industrial productivity in South Korea and the substantial commodity export potential endemic to Indonesia provide significant buffers to ameliorate currency weakness. Whereas failed political direction in India has left the economy too dependent on domestic consumption without any significant export base, leaving the economy dramatically susceptible to substantial currency weakness.
Interestingly, a potential stopgap to augment FX reserves and mitigate capital outflow from Indonesia could be the renewal of a renminbi swap line with China that expired in March of this year, which policymakers appear to currently be in the process of renewing. As this swap line itself represents a minor policy tool, the ramifications for the expedition of the renminbi internationalization process could be quite profound: the potential catalyst for a rapid transition to the adoption of the renminbi could be through a transition to renminbi financing in markets with significant export potential to China and susceptibility to a dearth of U.S. dollar liquidity, such as we are now witnessing in Indonesia. If the risk-off, dollar-constrained environment continues, Indonesia may well be the most likely candidate to test an expedited transition toward the rapid adoption of the renminbi trade settlement.
Specific to renminbi appreciation, we continue to see expectations for moderate, but slightly less stable, renminbi appreciation as the key catalyst supporting global stability. We expect that further easing expectations in China will allow further convergence between the onshore renminbi and offshore renminbi interest rate markets, which should bode well for the offshore renminbi bonds market. We believe the internationalization of the renminbi will be the key important driving factor to support renminbi appreciation in the long term (and vice versa), although we expect the pace of appreciation likely will be slower this year owing to the uncertainties in the global economic environment. We continue to believe that stability in the pace of currency appreciation would be the preferred scenario as China rebalances its economy from mainly export driven to a more domestic-led economy, and a gradual renminbi appreciation trend should help shift the resources and capital from the production of tradable goods to services and non-tradable goods.
The European debt crisis will continue to be the central factor driving market sentiment into midsummer. However, we maintain our base-case view that the euro zone is not going to collapse and that adequate liquidity will be provided to the financial system by the European Central Bank and quite possibly by the U.S. Federal Reserve. Although Asia’s equity and currency markets have been negatively affected as the European sovereign debt crisis intensified, the fundamentals of Asian economies are still largely intact. Lower oil prices are also quite positive for economies due to high energy import dependence. Inflation has been retreating, which should allow Asian central banks more flexibility in the event of worsening external demand. Outside of aggressive monetary policy action from developed markets, we would expect the economic activity of emerging economies of Asia to continue to be key drivers of incremental global growth through the rest of the year.