Region better off to ride through tapering of QE.
FOR much of the past five years, emerging Asia (EA) has been host to cheap money inflows.
This came about as a result of quantitative easing (QE) measures by the US Fed, augmented by ECB’s (European Central Bank) own QE actions and, lately, sustained through Japan’s unique QE programme following “Abenomic” thrusts to un-deflate its 20-year period of deep sleep. Most of these monies reflected deliberate moves by global institutional investors, leery of low yields in Western markets, as they poured cheap borrowed funds into the region. While the going was good, EA was in the midst of shifting to a more precarious phase of evolution as its pace of growth slackens, certainly in China and India, not unlike their non-Asian BRICS partners (Brazil, Russia and South Africa). China could still hit its official target 7.5% growth in 2013 (7.7% in the first quarter and 7.5% in the second quarter of 2013). Growth in India has slipped to 4.4% in the second quarter (against below 5% for fiscal ended March 2013 and at one-half its annual rate between 2005 and 2008). Russia and Brazil (each at 2%-3%) are barely expanding against what they did in boom times, while South Africa has surely slipped away – less than 3% in 2013.
Collectively, BRICS will still grow 4%-4.5% in 2013, while Asean-5 (Indonesia, Malaysia, the Philippines, Thailand and Vietnam) will also decelerate to 5.6% this year (6.1% in 2012). EA is now expected to grow at about the same pace (6.9%) as it did in 2012 (against 8% in 2011 when it helped pull the global economy forward in the face of financial crisis). To be fair, that still sounds fast compared with what’s going on in the rich West; but it is nevertheless the slowest rate of expansion in a decade. The focus of concern is whether it’s a temporary loss of form or has EA permanently lost its mojo.
Take a deep breath
As I see it, the year marks the beginning of EA’s second phase of transformation when emerging markets as a group already accounts for just over ½ of world GDP (in terms of purchasing power parity - PPP - i.e. as reflected in real local purchasing power), against less than 1/3 in 1990. To me, this represents one of the greatest economic transformations in modern history. In the first phase, industrialisation and globalisation changed the world. Resource rich nations (including Australia) flourished as they satisfied the growing appetite of the likes of China which flooded the world with low-priced manufactures, hallowing out job markets worldwide. In the process, they helped to hold down inflation by making readily available a wide range of consumer goods at affordable prices around the world. Benefitting from the knock-on effects, 6 of the world’s 10 fastest growing economies are now found in Africa. The up-shot: incomes rose significantly all round. Ten years ago, China’s per capita income (in PPP terms) was only 8% of United State’s; today it’s 18% and rising. Catching-up will go on but the pace will decelerate, because its (i) workforce is falling (ii) population is ageing (iii) currency is up and stabilised (iv) wages are higher and (v) its total debt (as a ratio of GDP) is rising.
The current second phase is more transformative: involving hard structural reforms. For China, this means re-basing the growth model to one that’s more balanced and inclusive – pushing consumption on to assume the front row-seat ahead of investment and exports (which together propelled the economy for the past 40 years), and developing the services sector while industry shrinks. Indeed, resource-based mass production processes dependent on cheap labour will give way to greener, cleaner and technology-savvy ways to produce goods and services.
Value added is expected to come through a better educated, more productive but increasingly smaller workforce, harnessing new and innovative IT methods that will be hopefully home grown. That’s the plan any way – away from the old-style borrow-and-build policies, emblematic of China’s penchant for over-building. But these overhauls will be tough. Resistance is already building.
As long as money is cheap and plentiful, vested interests will push to slow down the reform process – so the need for restructuring change becomes less pressing. This is happening because EA on the whole is now better positioned than they were at the time of the last crisis in 1997-1998. China today has fiscal strength both to absorb losses from undue “knocks” and to stimulate, if needed. With the rich economies still feeble, chances are low that global monetary conditions will suddenly tighten. Even if they did, EA now has better defences based on flexible exchange rates, larger stashes of forex reserves, and relatively less debt in foreign currencies; their banking system is also stronger and relatively more stable after having been restructured at the last crisis.
But it’s clear the back-breaking speed of development is over. EA has come a long way. Still a long way to go. It’s being realised that room for catch-up is now less – but it’ll go on, only at a slower clip; only its quality gets better. For EA and BRICS, slowdown has become a reality. This simply means EA can no longer make up for any weakness in the rich West. Without stronger recovery in US, Europe and Japan (whose outlook as a whole, in my view, still remains dire), the global economy is unlikely to grow any faster than today’s lacklustre pace in the region of 3%. So, things will remain and even feel, sluggish.
My Sept 7 column: “QE3 Exit and Asia’s Policy Trilemma” talks of the trauma for EA of the impending Fed’s QE3 tapering. Of course, it didn’t happen as was widely anticipated. But the damage is done. Interest rates have risen (already up 100 basis points and rising). Bond yields have risen faster. Indeed, analysts and markets have since June highlighted concern over the stability and volatility of particular markets. So much so Morgan Stanley (a major Wall Street investment bank) has since identified Brazil, India, Indonesia, Turkey and South Africa (2 in Asia and 3 among BRICS) as the “Fragile Five.” They share one thing in common: all experienced excessive short-term capital inflows (StCI) in the face of growing current balance of payments (BOP) deficits for too long. Such easy financing has made governments tolerant of high growth rates even as their exchange rates appreciated making them less competitive.
With the recent reversal of fortune, their growth rates and exchange rates tumbled. EA as a whole is in trouble because (i) credit and commodity booms which led to high growth rates are not sustainable (ii) StCI has become too large and their reversal too unpredictable, with negative effects on stability (iii) surge in inflation becomes inevitable. Some even tried to defend falling exchange rates but at a high cost on reserves. Like it or not, governments have to reform to deal with the impending end to StCI sooner than they think. Further, the world has to cope with two approaching down cycles, viz. the 15-20 year credit cycle and the even longer, commodity cycle. EA benefitted from both that have now peaked. Its long decline has started. Most vulnerable are economies with persistent BOP deficits, high foreign debt, and stubborn budget deficits, which are the first to suffer. Similarly with large commodity exporters. That’s why Russia, Brazil, South Africa and Indonesia are particularly vulnerable. Many who ignored the needed structural change during boom times are likely to now experience low growth for prolonged periods.
In the circumstance, those who allowed state and crony capitalism to thrive in the process have locked themselves in the middle-income trap. Those that paused and committed to reforms (e.g. South Korea, Chile, Mexico) are likely to do better. Next round of reform will be hard and difficult. There’s no other way out and it has to be done.
Coping with cheap money’s end
Travelling around Asia, I gathered few realise the full implications (not to talk of even being aware) of the strengthening US dollar against EA’s currencies. Indeed, few Asian companies even bother about it, let alone hedge against it. The combination of China’s slackening growth in the face of transforming its investment-heavy strategy, and the prospect of imminent Fed “tapering” is taking its toll on EA. India and Indonesia have been the hardest hit. The rupee is down 20% since May and the rupiah, 13%. As the “Great Unwind” (Morgan Stanley) proceeds, it brings in its wake higher capital costs.
But the Chinese yuan is holding stable, despite pressure from a dramatically weaker yen (down 30% from its high). Hedge funds tell me how profitable it was for them this year – just borrowing yen and investing in yuan short-bonds and CDs (certificates of deposit), picking up gains from yuan appreciation and from attractive interest differentials. But, it’s possible yuan can weaken to put pressure on regional competitors. More volatility is likely.
Uncertainty still looms. EA also faces sobering and tightening alternative funding options as deposit growth slackens and bank lending tightens. With outflows from emerging market equity and bond funds rising further (more than US$60bil in the past three months), EA is bound to face more market volatility and increasingly more expensive capital costs. Swings in global bond markets this year have been violent: until May, bond yields hit record lows; from May to September, the sell-off pushed yields to 2-year highs.
With the Fed not yet ready to “taper,” yields have since moved lower. Eventually, they will head higher again. The risks and maths get more daunting. It is said the biases and rigidities of capital markets pose once again the paradox of thrift. As capital withdraws from emerging markets, some EA nations will be forced soon to adopt austerity measures and run BOP surpluses. But who will then be able – and willing – to run deficits? It’s either China (yuan wants to be a reserve currency) or eurozone (its euro is already a reserve currency). Unfortunately, they both also want to continue to run surpluses. Since it’s a zero sum game, this simply means US must resume its role as the consumer of last resort, i.e. run deficits. So we are back to square one, with imbalances threatening the system’s stability once again.
Rising cost of capital
Not surprisingly the Asian Development Bank (ADB) recently expressed concern that money would be harder and more expensive to tap. It’s a pity since this is happening at a time when EA investment needs are huge and when European banks have significantly withdrawn from lending to the region. Indeed, ADB estimated EA needs to invest some US$8 trillion in transport, communication and energy infrastructure by 2020. This is critical for the region as its poor state of infrastructure hampers future productivity growth prospects and poverty eradication efforts.
“A slower growth outlook for the region has also contributed to capital flowing out with the withdrawal of funds, leading to rising bond yields and depreciating currencies. The turmoil in global financial markets has made it harder and more expensive for companies to issue foreign currency bonds; it has also made it harder and more expensive for EA companies – particularly lower-rated firms – to borrow in key foreign currencies such as US dollar, euros and yen,” according to the ADB.
In the first five months of 2013, US$81bil were issued but in June and July, only US$7.5bil were raised. ADB is right to be worried about EA’s rising interest rates (by Indonesia in mid-September) in an effort to stem capital outflows (and fight inflation as India just did recently) resulting from feared monetary “tapering” by the US Fed; bond yields will also rise causing the value of bond portfolios of banks and businesses to fall. These constraints the growth of bond markets which, at the same time, cause the cost of capital to rise. To soften the blow, I agree with ADB that EA clearly needs to (i) develop more stable sources of funding, including foreign direct investment; and (ii) widen the range of bond investors, including pension funds.
What then, are we to do?
It is easy to conclude that EA now has hit a wall, undermined by China’s slackening growth; end of the commodities super cycle; and the ongoing US government shutdown and the potential debt default by Oct 17, so that short-term outlook for interest rates (while trending upwards) is decidedly murky. Despite the recent continuing sell-off in markets across Asia and Latin America, it will be unfortunate to write off EA. In my view, EA is now better placed to resume its vital role in global growth over the long term. While growth is bound to be more measured, ongoing efforts at reform (especially in China) to shift to a more consumer-driven economy and towards deeper and market-oriented financial markets, provide a more reliable base from which to meet challenges ahead. What’s making the difference is its rising middle class.
Indeed, it will include people who had managed to get out of poverty, taking better care of their health, enjoying a better living standard and seeking better education and social amenities for their young. EA has come a long way and is now better prepared. There has been a sea of change from the past. Observed Nobel Laureate Paul Krugman: “The good news in Asia now is that the levels of external debt are much lower than the 1997 levels and Asian countries are not as financially vulnerable.”
Still many worry about China. True enough, China is now experiencing a tough transition in serious reforms, including allowing banks to set interest rates to reflect market forces and allowing free flow of investment into and out of China. I regard this more as a sign of maturity than of weakness. Indeed, more pressure being placed on getting on with structural overhauls would lead to a higher likelihood of tough social reforms happening.
So far, signs are economic slowdown has stabilised. People should not unduly over-react to China’s changing condition. All’s well that ends well.
Former banker, TAN SRI LIN SEE-YAN is a Harvard educated economist and a British chartered scientist who speaks, writes and consults on economic and financial issues. Feedback is most welcome; email: email@example.com.
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