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For Asia, First Reform Then Growth 

Raymond Chan 

Asia-Pacific Outlook 


A path to economic success in China and Japan starts with sweeping economic reforms, says CIO Equity Asia Pacific Raymond Chan.
Asia amidst a strengthening US dollar After a decade of excess global liquidity inflows, largely a symptom of monetary easing measures within developed market during recent years, Asian economies are now likely facing a reversal of the catalysts for these flows. Growing concerns that a retreat from quantitative easing (QE) and rising yields would lead to contagion and a systemic financial crisis in the emerging markets have begun to weigh on equity, fixed income and currency markets in Asia. These concerns have been exacerbated by the recent less-than-robust growth momentum in Asia. However, for the most part, these indicators of economic stress do not warrant the same degree of concern as those heading into the 1997/98 Asian financial crisis, nor the Lehman liquidity crunch 10 years later, as vulnerability indicators, such as current account profiles, debt-to-GDP ratios and inflation, still reflect resilience.

For the time being, it appears that emerging market and Asian currencies and markets will be subject to a variety of capital flow-related headwinds over coming quarters, as witnessed by the recent capital flight from local equity and bond markets. Should this be a reversal, however, Asia is likely to fare much better than it has in the past, and is also likely to be better positioned than its emerging market counterparts – Asian emerging markets are not representative of the region’s emerging markets of old. Moreover, considering it is a resumption of growth in the US that is a key catalyst to the recent phenomenon, Asian economies are still well-positioned to benefit from a resurgence of US economic activity.

Following concerns over the introduction of capital controls in late April, the Thai baht has continued to fall relative to the US dollar through the middle of the second quarter. However, Thailand’s relatively conservative banking environment and economic fundamentals means it is well-placed to weather increased volatility in capital markets. Within Indonesia and India, on the other hand, economic fundamentals are not so well-placed, as witnessed by the recent weakness in their respective currencies. However, falling energy prices should help alleviate the pain of weakening currencies, while the strong monsoon rains in India should also help to keep food price inflation in check, thereby providing the central banks with some degree of flexibility.

The renminbi has appeared relatively strong through the recent market malaise, but a stable currency and strong economic growth profile look more difficult to maintain going forward. Premier Li indicated in mid- May that the government could not rely on expansionary policies to achieve its growth target, as room for policy easing is limited. The China Banking Regulatory Commission also issued new guidelines to strengthen the regulation of bill financing, which is a rapidly expanding shadow banking channel. These regulatory movements, together with recent soft macroeconomic data, have reinforced our view that China should go through a mild economic recovery over the long term. We expect this to be driven by economic and financial reforms, as policymakers have been sending consistent signals that they will focus on containing systemic financial risks, rather than actively promoting growth through stimulus packages.

On the currency side, we hold a constructive longterm view on the renminbi, supported by its internationalization process and China’s economic and financial reforms. That being said, given the recent rapid appreciation of the currency, as evidenced by offshore renminbi strengthening against the US dollar by 1.2% during the first five months in 2013, we expect the pace of appreciation to slow down. Market concerns about the tapering of QE by the US Federal Reserve may also dampen investor sentiment towards emerging currencies, including the renminbi. In addition, we expect further widening of the currency’s trading band, which should translate into more two-way movement for the renminbi going forward.

China's reform agenda: "No Pain, No Gain"

In mid-May, the State Council of China endorsed the Key Tasks of Economic Reform for 2013 measures submitted by the National Development and Reform Commission (NDRC). This State Council-endorsed paper identifies seven major areas of economic reform: 1) administrative structure and procedures; 2) fiscal budget and taxation; 3) capital markets; 4) capital investment in financing; 5) commodity pricing mechanism; 6) social welfare and safety nets; and 7) urbanization and rural-urban coordination.

Through these reforms, the Chinese government aims to transform the country's economy into one with a more balanced and sustainable growth model. Sacrificing economic growth for reform and transition has gradually become the party line. As long as economic growth stays above the minimum acceptable level (approximately 7.5% p.a.), it seems like the Chinese government will refrain from stimulating the economy in the old way. China will have to bear short-term pain before enjoying any long-term gain.

Structural concerns are becoming pressing problems that the current leadership understands cannot be ignored for another 10 years. The country's most senior leaders are well aware that, if they do not start taking actions to tackle these structural problems now, it is almost certain that there could be a serious social and economic crisis under their regime (within the next 10 years).

The key tasks set out in the paper are "for 2013", so there has to be some progress at least by end of this year. In fact, the endorsed paper was distributed to all relevant ministries and departments responsible for these key tasks, which means they will be held accountable for the results of their respective areas of reforms. In addition, many of the reform areas and key tasks identified in this paper are interrelated. It is, therefore, good to see a comprehensive high-level reform plan like this one to address China’s structural problems, which include local government fiscal constraints, social inequality, government-controlled capital markets and state-owned enterprise/public sector dominance.

The State Council and NDRC did not touch on the area of political reform, which should be the responsibility of the Communist Party. Unfortunately we have not yet seen any progress in political reform except on the anti-corruption front. This confirms our view that the new leaders are economically liberal but still politically conservative. Therefore, we should expect to see increased news flow on more specific reform measures over the coming few weeks.

Abe’s three arrows for Japan’s economic recovery

Japanese real gross domestic product (GDP) grew by 4.1% annualized on a quarter-on-quarter basis over the first quarter of 2013 (1.0% on a non-annualized basis), driven mainly by growth in consumption and exports. Consumption was boosted by the wealth effect with rallying equity markets, while exports increased due to the weakening yen. Despite a slow recovery in capital expenditure and the corporate sector in general, Japan's GDP growth beat consensus and was the highest among developed economies (Figure 1), demonstrating that "Abenomics" (economic policies of the Abe administration) has influenced sentiment and appears to be gaining traction in the real economy.

Abe’s dramatic fiscal expansion and bold monetary easing, referred to as the first two "arrows" of Abenomics, respectively, have already affected equity markets and sentiment significantly. While consumer price inflation growth is still negative, inflation expectations have been increasing, as evidenced by a widening spread between inflation-indexed Japanese Government Bonds and regular Japanese Government Bond yields (Figure 2). This has boosted the equity market and driven the yen downwards. A sustained trend toward inflation, from deflation, should dramatically alter investment and spending behaviours of both the household and corporate sectors.

Abe has also proposed structural reforms, his third "arrow", which is essential to increasing Japan's growth potential. Through deregulation and enhanced competitiveness, Abe aims to achieve 3% nominal growth by 2020. Specific targets include free trade agreements, special economic zones, promotion of domestic agriculture to double agricultural income, as well as measures to increase the female labour participation rate.

However, the market response towards the announced reform targets was not entirely positive, since it was marred by concern that the measures were far from adequate. Investors expected aggressive measures to stimulate corporate activity, such as the lowering of corporate tax rates and relaxation of labour regulations. While it was argued that stringent labour laws have hindered the adjustment of corporate cost structures, contributing to the country's longstanding deflation, it may be politically difficult for Abe to propose such changes at this point in time. If Abe’s Liberal Democratic Party wins the upper house elections in July, a likely scenario given that its current approval ratings are greater than 60%, he will have a free hand to push through even very difficult reform measures.

Despite the labour situation, Japanese corporates have somewhat streamlined their fixed-cost structures throughout the years. With recovering revenues, due to Abe's policies and the continued trend of recovery in the US, as long as the yen stays near its current (1USD=100JPY) level (Figure 3), companies are likely to post record earnings this year. Given the solid earnings outlook, we believe that the current market correction is only temporary, and expect the market to regain momentum after the upper house elections.


Growing concerns that a retreat from QE and rising yields could lead to contagion and a systemic financial crisis in the emerging markets are likely to increase volatility in Asian equity, fixed income and currency markets in Asia, though the traditional indicators of economic stress still reflect resilience. We continue to expect a mild economic recovery in China, with little room for any substantial economic stimulus. The nature and pace of reforms will be key economic catalysts going forward. The rest of the region will likely continue to face various degrees of liquidity pressure, though with few areas of potential calamity. Like China, success in Japan now rests on the introduction and implementation of reform measures, but enacting tangible, credible reforms will not be easy.

Figure 1: Global economic growth: Q1 2013

Q1 2013: USA + 2.5% Eurozone -0.95 Japan +3.5% China +6.6% Korea +3.5%
Equities Outlook

Source: Bloomberg, Daiwa Securities,
Allianz Global Investors, as at June 2013

Figure 2: Japan: expected rate of inflation
( 5-year breakeven inflation rate)

Equities Outlook

Source: Bloomberg, Daiwa Securities,
Allianz Global Investors, as at June 2013

Figure 3: Topix index - EPS and forex-adjusted EPS

Equities Outlook

Source: Bloomberg, Allianz Global Investors, as at June 2013
Past performance is not a reliable indicator of future results.

The material contains the current opinions of the author, which are subject to change without notice. Statements concerning financial market trends are based on current market conditions, which will fluctuate. References to specific securities and issuers are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Forecasts and estimates have certain inherent limitations, and are not intended to be relied upon as advice or interpreted as a recommendation.


Allianz Global Investors Distributors LLC, 1633 Broadway, New York NY, 10019-7585,, 1-800-926-4456.


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