Asia: Calm after the storm

by: Maritza Cabezas

2013Q4-131121-05-Asia.pdf ()

During the first half of 2013 there was a sense of malaise surrounding Asia. The region’s economic activity had slowed down somewhat, while current account surpluses were deteriorating and the deficits in India and Indonesia were raising increasing concerns. Matters were made worse by expectations of Fed tapering, the consequences of which are well known. Meanwhile, the Fed’s announcement in September that it would delay tapering was a relief for emerging markets in general. Since then, foreign reserves have been steadily recovering in Asia, while currencies are gaining ground. Growth is expected to have slowed slightly in 2013. The outlook is brighter in 2014 based on expectations of a stronger global recovery. Then in 2015, the impact of China’s reforms will lead to slightly slower growth.

Asia’s diverging economic activity

Going into the third quarter, the uncertainty surrounding the Fed’s monetary policy and a slowdown in domestic demand resulted in a slight loss of growth momentum in several countries. India and Indonesia are the weaker economies, where higher policy rates and uncertainty around the policy stance are hurting economic activity. By contrast, China and Korea have been growing at a faster pace than expected. Recent GDP reports indicate that investment in these two countries has been an important driver of growth. At the same time, other countries in the region maintained relatively stable growth in the third quarter.


131121-EM Outlook-Asia-tabel

External demand gradually improving

Although Asia’s external position has improved considerably since the 1997 crisis, current account balances have been deteriorating in recent years. Markets saw the financing of high deficits as a major threat once expectations of the Fed tapering solidified. The deficit countries, India (-3.9% of GDP) and Indonesia (-3.3% of GDP), have had to take drastic measures in the past few months to promptly correct their current account positions. We are positive regarding the short-term impact of these measures, which include prohibitions on importing gold in India and less subsidies for oil-related imports in Indonesia. But there are already signs that import prohibitions are being curtailed. Meanwhile, export growth to the US has gradually been improving, although the most recent data points to some slowdown. Export growth rates to the eurozone are no longer negative, but growth remains low and volatile. Still, intraregional exports have yet to lift.


131121-EM Outlook-Asia-exports to the world

Capital inflows ticking up

Indonesia, India and Malaysia have become major recipients of capital flows in the past years (non-foreign direct investment). The Fed’s low interest rates have been a determinant “push” factor for capital flows to Asia. A major part of the capital inflows were in the form of cross-border loans, but the issuance of local currency bonds was also popular. Past experiences of Fed tightening have shown that the sensitivity to investor sentiment of these types of capital flows is substantial. This time was no exception. Indeed, between May and August the ASEAN block, together with India, saw around USD 19bn in outflows of local currency bonds held by foreigners. As a consequence of the abrupt capital outflows, currencies in these regions weakened considerably, while foreign reserves declined, partly as a result of interventions to defend the currencies. However, capital flows in the region have been recovering since September. The exception is India, where modest outflows from the local bond market continued. Meanwhile, the other countries saw an inflow of USD 3bn into the local currency bond market. International reserves have been gradually increasing. Hence, the impact of the summer turmoil appears to be manageable.


131121-EM Outlook-Asia-loss in foreign reserves

At the same time, China has been one of the region’s countries that managed to maintain its growing trend of capital inflows despite the summer turmoil. It appears that China’s exchange rate policy and capital controls were perceived as favourable in a context of instability. In fact the RMB and the Korean won appreciated, as these currencies were considered safe havens.

Monetary policy moving towards further tightening

In the past months, rate hikes have been on hold in most of Asia, with the exception of India and Indonesia where inflation is high. In China, inflation is still low, but has lately been trending upwards. We expect that India and Indonesia, together with China, will continue tightening in the coming quarters. India’s battle against inflation has resulted in two consecutive rate hikes in a period of only six weeks, while Indonesia has hiked interest rates five times in the past year. The Reserve Bank of India has taken a hawkish stance with the new governor Rajan. As a result, we now expect another rate hike before the end of the year. In the case of China, the more precautionary monetary policy is related to the risks surrounding high leverage rates of both corporates and local governments. Efforts to refrain from liquidity injections from the Central Bank of China have put upward pressure on interbank rates and forced central bank authorities to ease liquidity on two occasions. We expect authorities will continue to manage liquidity with prudence, while the financial system will have to be more cautious in its lending policy to reduce inflation risks and combat undesirably high property prices.

Outlook positive, but there’s work to be done

In the short term, Asia’s forward-looking PMI surveys suggest that manufacturing confidence is improving, even in the countries most affected by the summer turmoil. PMI readings in China and Korea have been leading the way, recording three consecutive months of gains. The readings in India and Indonesia seem to have bottomed out, but India’s PMI is still below the 50 mark, indicating contraction. However, given tighter monetary conditions, we don’t expect a rebound of economic activity in the region in the fourth quarter. Still, Asia remains the fastest growing region at around 5.9% in 2013.

The main concerns for 2014 centre around India and Indonesia. Both countries have implemented strong adjustment programmes, but there are some worries surrounding the continuity of these policies given the elections scheduled for next year. Moreover, both countries are at the lower limit of investment grade. A downgrade could be disruptive, but we expect the ratings of both countries to remain stable. On 7 November, S&P reaffirmed India’s BBB rating. Ample reserves and an increasingly credible monetary policy are the key anchors that will help maintain the rating until after the elections in 2014. Fitch also reaffirmed India’s rating during the summer. In general, we expect economic activity in the region to pick up next year, with the possible exception of India and Indonesia, mainly on the back of the recovery of advanced economies. China’s economy is already benefitting from the improved global environment, which should further support the region.

We think emerging Asia will continue with the reform agenda in 2015. As the Fed unwinds its monetary easing policy and investors discriminate more across countries, fundamentals will become increasingly important in the region. In China, leaders at that time will have consolidated their power after two years and the time will be ripe to initiate reforms that are now considered somewhat controversial. These include directed actions for state–owned enterprises and more in-depth financial sector reforms. This will weigh somewhat on economic growth in China, which we forecast at 7% in 2015. Spill-over effects from this slowdown are likely to consequently affect the region.

Risks to the outlook remain modest

We expect the Fed’s exit from quantitative easing and interest rate normalisation to unfold in an orderly way. However, a faster-than-expected tightening of global conditions could introduce stress to emerging markets. In this case, Asia will not be spared, mainly because many of the adjustment policies will take time to work through the economy. Indeed, India and Indonesia will continue to be vulnerable. In any case, we think that the region is sufficiently strong to avoid a full-blown crisis comparable to the 1997Asian crisis. Fiscal balances, reserves and real exchange rates are better now than they were then, but volatility in the coming period cannot be ruled out.