The Outlook for Asia Pacific: Sustaining the Unsustainable
Perhaps it is simply equity bear market fatigue or a naïve faith in the
omnipotence of US policy makers faced with presidential elections but investors
have decided that cyclical recovery is now in the pipeline. Certainly, relief
over a quick end to the Iraq conflict has provided a trigger and, in Asia, the
defeat of the SARS (Severe Acute Respiratory Syndrome) virus adds to the impression
that the worst must be over.
Of course, no decent bear market rally would be possible without some fig leaf
of fundamental support. In this case, the ongoing US housing debt mania has
combined with a post-war snap-back in confidence to produce a rise in leading
indicators. Corporate sector refinancing activity and a compression in risk
premia allow investors to believe that the adjustment process is well in hand
and that self-sustaining growth will return in a matter of months.
Such hopes are magnified in Asia. For all the talk of shrugging off the export
yoke and harnessing gross domestic product (GDP) to domestic spending and intra-regional
trade, the unsavoury truth is that Asian countries have never been so externally
dependent. As Figure 1 illustrates, the share of total exports in regional GDP
has risen inexorably over the past two decades and was only briefly higher than
today back in 2000 at the height of the electronics folly. Even China has a
substantially larger trade sector relative to GDP than does the US and this
is accentuated by its reliance on flows of inward direct investment amounting
to some 4.5% of GDP.
The upshot is that the global trade cycle remains of critical importance to
the region. Is there really a recovery around the corner?
Cognoscenti of the Japanese experience will be struck by the similarity between
what has occurred in the US economy and financial markets over the past six
to nine months and what happened in Japan in 1992-93. Three years into a bear
market, the Japanese authorities were taking more proactive steps to halt economic
decline: interest rates were coming down quickly and the government was enacting
fiscal stimulus packages. The Nikkei 225 index reached a trough in August 1992
and enjoyed a sharp rally in the early part of 1993 accompanied by a backing
up in bond yields. Housing activity was relatively strong and leading indicators
went back above the boom/bust 50 mark. (See Figure 2.)
The point is not to draw a direct parallel between US economic conditions now
and those in Japan then, though capital investment and asset price bubbles are
similar, but to warn against over-confidence in the efficacy of policy measures
when underlying structural adjustments are incomplete. Ian Morris, HSBC’s US
economist, points out that excess capacity in the US economy cannot be explained
merely by reference to a deficiency of demand and neither is it limited to the
high-tech or manufacturing sectors of the economy.
Crucially, he states: “If excess supply that is independent of deficient
demand exists, the implication is that investment and employment will be weak.
This then raises the odds of demand remaining weak too, which acts to retard
the labour market’s path towards full employment, despite the apparent looseness
of monetary and fiscal policies.”[1]
Far from being an irrelevant, lagging economic indicator – as it is conventionally
viewed – the unemployment rate then becomes central to the economic outlook.
Instead of consumer spending remaining stable while the corporate sector adjusts,
the very adjustment of the corporate sector ultimately tips consumer demand
over, as jobs are lost (Figure 3).
This is again reminiscent of the Japanese experience where unemployment began
to rise significantly during the course of 1993 as the corporate adjustment
was far from over. Bond yields renewed their descent and the equity market rally
petered out. It was a false dawn.
So much for history, are there any current indicators that would corroborate
market optimism in a recovery this year or is this another false dawn? In particular,
from an Asian perspective, what is happening to the global industrial cycle
that correlates most closely with trade?
Figure 4 shows the ratio of manufacturing shipments to inventories for the
US and Japanese economies. This ratio normally reaches a turning point some
three to six months ahead of changes in industrial output (linked to Asian exports).
While the absolute level of inventories is low, shipments have been falling
in both countries. It is simply too early to expect a turnaround in industrial
activity this year. The contrast with other troughs in the industrial cycle
(e.g. early-1996, end-1998, late-2001) is clear. Neither would the picture be
altered by inclusion of Europe where survey data is generally weaker than in
the US or Japan.
A similar story is told by the behaviour of industrial commodity prices that
typically rise when global activity is improving – there is no such trend at
present. In recent months the picture has been somewhat distorted by the fall
in the US dollar (USD), which has the effect of boosting dollar-based prices
and gives the misleading impression of slight recovery. To strip this out, Figure
5 shows industrial commodity prices expressed in SDR (special drawing right)
terms.
Of course, investors might be forgiven for supposing that, while global industrial
activity might be sluggish for a few more months, the downside is limited and
it may be time to take a more constructive view of Asia’s export prospects.
Unfortunately, rather the opposite condition applies. Regional exports saw a
strong upturn in 2002 and are only now losing momentum. As Figure 6 illustrates,
export growth has outstripped the modest upturn predicted by our model and has
just started to come back to earth. Why has the trade cycle been so vigorous?
The answer is twofold. First, as we have discussed before[2], there has been
a change in the regional division of production that has helped to lift China’s
global export market share as an increasing proportion of Asian manufactured
goods are processed and assembled in the mainland. To some extent, therefore,
there is double-counting in the aggregate export growth data since part-finished
goods sent to China from other Asian countries are counted again as Chinese
exports on their way to the rest of the world. This is not to deny that China
has seen a genuine increase in market share but to remember that the lift to
overall Asian export growth and to value added is exaggerated.
Second, Chinese domestic demand itself has raised Asian exports. This is not
fully captured in our export model in which it is assumed that a key variable
– global industrial production – is mirrored by the weighted output of the US,
Europe, Japan and a selection of newly-industrialised Asian economies. This
is becoming less accurate as industrial activity in China expands.
Figure 7 gives an illustration of how important Chinese industrial activity
has become. Since close to 45% of Chinese GDP is manufacturing and since, on
a purchasing power parity (PPP) basis, China’s economy is some 55% of the US
economy, then in volume terms China is the largest manufacturing country in
the world! A word of caution is appropriate: GDP-based PPP weights should not
strictly be applied to the value of manufactured goods output, but the point
of the exercise is to show that Chinese industrial activity – as a source of
demand – should not be lightly overlooked.
As Figure 8 shows, if global manufacturing activity is re-weighted to include
China then it makes a substantial difference to the growth rate. Perhaps more
important than the absolute levels of growth, including and excluding China,
is the difference between the two that has widened in recent years. In short,
China’s rapid industrialisation – both domestically and externally driven –
has an influence on Asian exports that we had not previously taken into account.
Should we therefore be optimistic that any slowdown in regional trade will
be modest? Again, the problem is that the good news for Asian exports is already
behind us. China’s manufacturing activity has just started to slow down in keeping
with what is occurring in the rest of the world. Moreover, while reliable inventory
data are not available, the ratio of sales to output in manufacturing (which
can be used as a proxy) has been dropping in recent months (Figure 9) suggesting
that industrial activity will moderate further over the summer months. To the
extent that the SARS virus has depressed final demand and caused some marginal
loss in export orders then this will accentuate the downward trend.
So, notwithstanding the current financial market optimism that a cyclical recovery
is about to begin, we find precious little corroborative evidence for it. On
the contrary, aside from short-term noise and gyrations, it still appears to
us that the loss of momentum in manufacturing activity, which pre-dated the
Iraq War, is continuing. For Asian countries, the lift from China is starting
to ebb and regional exports are likely to drop in the second half of 2003.
Little wonder in these uncertain times that Asia’s central banks, with the
notable inclusion of the Japanese, have been vigorously resisting the upward
pressure on their currencies caused by the relative easiness of US monetary
policy. Private investors see little incentive to hold low-yielding US assets
so the authorities have stepped into the breach. In May 2003 alone, regional
foreign exchange reserves increased by a phenomenal USD75bn taking the aggregate
close to USD1.6tr, the bulk of which is held in USD-based securities.
What is peculiar is that some groups in the US and elsewhere should regard
this action as harmful to US interests on the narrow pretext that competitively-priced
Asian currencies will draw away investment and jobs. Of course, in some manufacturing
sectors this is undoubtedly the case, but the bigger picture is quite different.
Without the flow of official funds from Asia would US long-term rates have been
able to fall as far as they have done over the past year? How easy would it
have been to finance the burgeoning US current account deficit at a time when
private sector investment from Europe and elsewhere was on the wane? As Figure
10 shows, Asian central banks have played a pivotal financing role that has
sustained the US housing sector and consumer demand.
It is hard to imagine that the US Government is not aware of the importance
of attracting overseas finance when the current account deficit is approaching
5% of GDP. While it may be politics to pay lip service to the vested domestic
interests that call for a dramatic change in Asian exchange rate policy, the
authorities will know that they cannot risk any curtailment of capital inflows
or they will end up suffering an Asian-style balance of payments crisis.
Ahead of US elections, the administration’s priority is to keep domestic bond
yields low (to help support consumer demand) and to encourage overseas governments
to stimulate their economies (to lift exports). While a gradual decline in the
USD may serve a useful purpose, now would not be a good moment to have a trade
fight with creditor nations.
This is not to say that what governments want is what they get. A USD crisis
may still occur but it will not be because of table thumping by American policy-makers
over Asian exchange rate levels.
The real issue is for how long the flow of funds from Asia can help to sustain
US growth as jobs are gradually being lost. A withdrawal of overseas capital
is not the only mechanism by which the balance of payments can be adjusted.
While less spectacular, the same end can be achieved via the attrition of job
losses on the propensity to spend – so closing the savings-investment gap.
Of course, it is not merely concern over the outlook for the US economy that
is motivating Asian central banks to resist currency appreciation but, specifically,
fear over possible loss of business to China. While the evidence for “hollowing
out” of Asian economies is patchy, there has been a decline in global market
share in Japan, Taiwan, Hong Kong and Singapore. China, by contrast, is increasing
its share by some 0.5% per annum and is now the world’s largest recipient of
foreign direct investment. On a real effective basis, the renminbi (RMB) is
among the cheapest of the currencies in the region, as Figure 11 shows.
With the Chinese economy growing at close to 10% year-on-year (y-o-y) in January
to March and by an estimated 8% in the first-half of 2003, despite the SARS
virus, perhaps the mainland authorities will decide to tolerate a gradual appreciation
of their currency, if not an immediate upward revaluation. After all, consumer
prices are now rising again and there does appear to be some official concern
about overheating in some sectors of the economy. Moreover, with World Trade
Organization (WTO) entry set to liberalise trade, the authorities might wish
for a more flexible exchange rate regime.
Yet, convenient as it would be, we do not buy the arguments for voluntary RMB
revaluation in the near-term (i.e. over the next 18 months) for a number of
reasons:
Qu Hongbin, HSBC’s China economist, has gone through these arguments at some
length in recent publications[3]. However, it is worth reiterating the central
point, namely that the Chinese economy is far from facing any generalised problem
of overheating.
As Figure 12 illustrates, core inflation (consumer price index [CPI] less food
and fuel) has been dropping in y-o-y terms for more than a year and has been
in and out of negative territory since late-1999. China is no different from
most other countries in seeing a temporary up-tick in fuel costs over the past
six months that is now subsiding.
Judging by the continued negative output gap (Figure 13), headline inflation
is likely to remain extremely muted in the coming months. As mentioned earlier,
there has been an unintended build-up of inventories exacerbated by the SARS
outbreak, retail sales growth has dipped and exports are unlikely to buck the
global downward trend in the second half of the year.
The underlying issue has been and remains an overhang of excess industrial
capacity, compounded by an extraordinary surfeit of labour in the rural areas
that has been migrating to the towns. While expansion of the service sector
– both formal and informal – continues apace, it is estimated that some 10 million
jobs must be created every year just to keep the unemployment rate from rising.
WTO entry, beneficial from the point of view of productivity and hence long-term
growth potential, is nonetheless likely to cost China some 18 million jobs in
the first five years, according to the Development Research Centre of the State
Council.
The reality of a competitive labour market and the erosion of housing, health
and other guarantees for state employees is not lost on ordinary urban householders.
Though a minority of the population is seeing rapidly rising income and is broadening
its pattern of expenditure, the average propensity to consume has fallen since
the Asian crisis and remains at a low level despite booming exports and investment
(Figure 14).
The Chinese authorities are keenly aware of the challenge of maintaining economic
and social stability at a time of structural change. They have stimulated investment
spending both directly and indirectly through the banking system and have been
successful in generating top-line growth. The concern now is that some of the
investment may have been misdirected in recent years and there is a need to
curtail lending to the more speculative hot spots.
Rather than re-valuing the currency to achieve this objective, it is much more
likely that the authorities will simply clamp down on the those areas of bank
lending that most concern them. This is already happening.
Moreover, in so far as a strong balance of payments has contributed to easy
monetary conditions, the authorities have developed the necessary tools to sterilise
this inflow. As Figure 15 shows, base money growth has dropped back into single
digits in the early part of 2003 despite nearly 30% growth in the central bank’s
net foreign exchange reserves.
The bottom line is that money supply growth is set to decline as export growth
starts to flag and speculative domestic investment is curtailed. In the meantime,
there is plenty of excess capacity in the economy that will preclude inflation.
The Chinese authorities have no incentive to alter the current exchange rate
regime with all the attendant risks of restructuring and given the importance
of the external sector in generating high-quality jobs and investment. Therefore,
without heavy international pressure, which we would judge to be foolhardy from
the point of view of the Americans who are reliant on a steady inflow of Asian
capital, regional currencies will not appreciate significantly.
The symbiotic relationship between the cash-strapped, over-consuming US economy
and the surplus savings nations of Asia is embedded. Yet, all of economic history
tells us that there are limits to debt-financed growth and that countries that
depend on ever-increasing flows of foreign capital cannot expect to reward investors
with ever lower returns. The most likely outcome is that US growth will be constrained,
as companies must keep a check on income and employment. Asian central banks
have sustained the unsustainable but, short of a smart recovery in Asian and
European domestic demand, there will be a day of reckoning.
To the extent that Asian capital outflows have contributed to a “muddling through”
of global demand thus far and raised hopes for an imminent economic recovery,
they have obscured the fact that central banks have not been nearly as generous
in their money market operations as some commentators suggest.
Stephen King, HSBC’s Chief Economist, reckons that the US Federal Reserve is
still only in Stage 3 of a five-stage strategy to ward off deflation[4]. Stages
1 and 2 have involved lowering short-term interest rates and acquiescing in
an easing of fiscal policy, in an entirely conventional manner. Stage 3 involves
manipulating the yield curve such that long-term interest rates are kept in
check. While it is certainly the case that the Federal Reserve has been successful
in lowering inflation expectations and “talking down” bond yields, there has
been no hard action taken so far to purchase longer-dated treasury securities.
As it stands at the moment, base money growth is running at around 7% y-o-y
(well within historical ranges) and broader aggregates such as M2 or MZM are
up less than 8% y-o-y, significantly slower than a year ago.
In Japan, base money is up more than 16% y-o-y but this still represents a
deceleration over the past year from over 30% growth and the Bank of Japan has
not been increasing its outright purchases of government bonds. As for the mooted
purchase of asset-backed securities, this remains a relatively small market
and so will have little macro impact. Peter Morgan, HSBC’s Japan economist,
continues to point out that central bank policy is having no impact on bank
lending, which is demand determined. Indeed, broad liquidity growth dropped
into negative territory for the first time ever in May.
In Europe, unconventional policy measures are not even on the agenda and there
is concern that conventional steps have been too grudging.
The irony is that confidence in a “second-half, US-led economic recovery” may
have the effect of keeping monetary policy relatively conservative. This certainly
appears to be true in Asia where a similar lack of interest in unconventional
policy measures exists as in Europe though a much greater determination to maintain
currency stability. Yet the People’s Bank of China is not the only central bank
to be sterilising its foreign exchange intervention. Average base money growth
in the rest of the region is well under 7% y-o-y, in a narrow range for the
past two years (Figure 16).
Beyond a misplaced belief in global recovery, Asian central bank action also
stems from a view (with which we largely concur) that increases in liquidity
may do little to promote growth at a time when demand for funds, from the corporate
sector in particular, is lacklustre.
What is more difficult to justify in some countries is the political constraint
over allowing deposit rates to fall below inflation. Even if corporate demand
for funds may be sluggish, there is greater potential from the consumer. As
Figure 17 shows, real deposit rates in Asia are firmly in positive territory
in contrast to the negative returns available in USD accounts. Thailand represents
the exception though it is worth bearing in mind that the state of the banks
has made it difficult to pass these low costs on to all borrowers.
The upshot of such policies is that “excess liquidity” (the difference between
growth in money supply growth and nominal GDP) is steadily diminishing (Figure
18). Without a rapid change in policy direction, such a squeeze may soon bring
the rally in regional equity markets to a grinding halt just as was the case
in 1997 and 2000.
The countries with the best prospect of sustaining growth are those that are
not already in deflation and where money supply growth is relatively firm. These
include Thailand, the Philippines and Indonesia. Liquidity conditions are good
in Hong Kong, but without a lift from exports, it is hard to see where recovery
will come from.
Given all the discussion of deflation elsewhere in the world, it is surprising
that most Asian central banks seem little troubled by the prospect. Of course,
in Hong Kong there is not much that can be done and the authorities make the
valid point that domestic price declines carry fewer risks than in many countries
because of the strength of the banking system and the low gearing of the corporate
sector. A falling USD does not alleviate deflation since the majority of Hong
Kong’s trade is with dollar bloc countries (the US and China) and with other
Asian nations whose currencies are being held down.
Core consumer prices are now declining in China, Hong Kong, Singapore and Taiwan
and they are barely rising at all in Thailand and Malaysia. Even in the Philippines,
a chronically inflation-prone country, price rises are in low single digits.
As Figure 19 illustrates, despite a trade-driven rebound over the past year,
most countries still have negative output gaps so there is every prospect of
further falls in prices in the coming six to 12 months.
Not only are domestic prices falling but export prices (which had rebounded
following the electronics collapse in 2001) are now fading again in dollar terms
(Figure 20). Without an export recovery, earnings will be hit in both volume
and price terms.
In conclusion, we find it rather surprising to hear some commentators talk
about dramatic growth in liquidity underwriting asset prices in Asia and elsewhere.
While global funds have continued to flow to US consumers and the housing sector,
the policy settings are not as easy as they appear. Talk of deflation and the
need for unconventional policy measures has not yet been matched by action,
certainly in Asia ex-Japan. Neither should investors assume that the printing
press would necessarily be an effective antidote to excess capacity and debt
problems even if it were switched on.
We therefore continue to regard deflation as the most likely outcome, bear
market rallies in equity markets notwithstanding.
1. “The US Capital Overhang”, World Economic Watch, 11 April 2003.
2. “The Final Curtain”, Asian Economics, HSBC, Q2 2003.
3. “China: Revaluation still off the menu”, Asian Economic Insight, HSBC, 26 June
2003.
4. “Thinking the unthinkable”, Global Economics, HSBC, May 2003.
