How Vulnerable Are Asian Markets?

Posted October 14, 2008

It is likely that world stock markets will reach at least some interim low this month, if they have not already done so. This would set the markets up for a year-end counter trend rally before the growing awareness of the nasty consequences of the credit crunch on real economic growth next year causes stock markets to head back down again.

Such a turn of events is likely because investors, being human beings, will still want to believe again that government policy can solve the credit problem. This writer does not share that conviction. But what government policy can probably do is to prevent the trauma of an immediate Asian-style V-shaped downturn at the considerable cost of a much more protracted period of slow to zero growth. This looks increasingly like the path the West has chosen to follow as taxpayer-funded bank recapitalizations and other forms of fiscal guarantees increasingly proliferate.

Financial markets desperately want to see the kind of cross-border coordination now taking place in Europe, which accounts for the Dow’s rebound on Monday. Still, the lack of coordination between America and Europe in particular has been extraordinary given the extremely dire circumstances. But that will now surely change, as last week’s coordinated rate cuts suggest.

Last week provided ample evidence of the intensifying financial rot in Europe with the growing resort, from Ireland to Germany, of blanket government guarantees of bank deposits. This clearly raises hard questions abut Euroland’s ability to maintain fiscal rectitude to the undoubted consternation of Brussels and Berlin.

As for the Paulson debt buy-back package, it’s initial approach was deeply flawed for two reasons. First, in its original incarnation it did not recapitalize financial institutions directly, unlike Britain’s much more sensible partial nationalization of its banking system announced last week. On Tuesday, however, the Bush administration is expected to announce efforts to restore confidence in the U.S. banking system, following similar moves in Europe, which will include Treasury taking some $250 billion in equity stakes in hundreds if not thousands of banks.

Second, if taxpayer money is going to be spent to help lenders, it makes sense both politically and economically to come up with taxpayer funded schemes designed to help deserving borrowers. Policy in Washington is likely to evolve in both these directions next year whoever is president. There will also be another fiscal stimulus but this time focused on upgrading or replacing America’s worn-out physical infrastructure.

What about Asia? This export-driven region remains in the midst of a stress test as it will not become clear until the middle of next year whether Asia’s leading emerging economies, China and India, can achieve forecast 2009 real GDP growth rates of 8% and 6.5% in the context of American and European economies which will be lucky to grow at all.

Perhaps the key issue here is the Beijing policy response. The Chinese economy is clearly slowing fast, which is why an increasingly aggressive policy response is now expected and why the People’s Bank of China joined the monetary easing efforts last week. The PRC certainly has the tools available:

First, China is a monolithic state which means the PRC can effectively do what it wants while it also has the protection of a mostly closed capital account. Second, the country has remarkably clean fiscal accounts. Third, there are lots of things the Chinese can do beyond conventional monetary and fiscal easing. One obvious example is a U-turn on the current restrictive policy towards the residential property market, which is not only hitting the secondary market but also squeezing local governments in terms of sharply declining revenues from land sales.

There is clearly a risk in investing too much faith in Beijing policy makers in what remains to a significant extent a command economy. Still, the Beijing policy response worked both in the fallout from the Asian Crisis and after the tech bust earlier this decade. However, on this occasion the stakes are vastly higher, and it is to be hoped that the PRC leadership understands this. First, China is much more integrated into the global economy. Second, this is a consumption driven slowdown in the West. Indeed it is the first real slowdown in U.S. consumption in nearly 20 years. As such it represents a direct challenge to Asia and principally China’s mercantilist model.

It is important that Asian policy makers—and most particularly Beijing—respond to the shock of the slowdown in U.S. consumption in a constructive way. This means increasing efforts to move their economies away from excessive reliance on export-led growth. If they react in the opposite way, and engage in competitive devaluations as they see their foreign-exchange reserves decline, they will only succeed in delaying the long-overdue rebalancing of their export-driven economies and could spark a global trade war.

This raises the issue of psychology. Fundamentally, Asia should be dramatically less exposed to the financial fallout than America or Europe. This is because of the region’s lack of private-sector debt, be it corporate or consumer, or for that matter public-sector debt. Still, if risk averse psychology takes over, Asia can certainly worry itself into more of a problem than the fundamentals would warrant.

Christopher Wood, equity strategist for CLSA Ltd. in Hong Kong, is the author of “The Bubble Economy: Japan’s Extraordinary Speculative Boom of the ’80s and the Dramatic Bust of the ’90s” (Solstice Publishing, 2005).