Emerging Asia in a Post-Lehman World

OPINION: EMERGING Asian economies have proven surprisingly resilient to the credit crisis that began in the summer of 2007. This despite the fallout from the US housing decline being longer and stronger than anyone had predicted.

Direct contagion to the region has been largely limited to the financial markets, while real activity, which has been affected by indirect channels, has generally remained strong.

Headline growth has declined, but outside of the NIEs (Hong Kong, Korea, Singapore, and Taiwan) this decline has been modest. Indeed, growth in the region’s largest economies (China and India) as well as the ASEAN-5 (Indonesia, Malaysia, the Philippines, Thailand, and Vietnam) has moderated but remains above trend. Exports have performed particularly well, benefiting from growing intra-regional trade as well as demand from other emerging market countries buoyed by high global commodity prices.

This note takes a first look at the post-Lehman growth landscape in emerging Asia. Our preliminary view is that the “Asian split” we have seen to date will, if anything, intensify. While our soon-to-be-released growth forecasts will show lower growth for the region as a whole, the NIEs will take a relatively bigger hit.

Post-Lehman Fallout
The fallout from the bankruptcy of Lehman, the takeover of Merrill Lynch, and concerns over AIG has sent the region’s equity markets into yet another tumble, with bourses largely taking their cue from Wall Street. The decline has been felt relatively heavily in financial sector stocks, reflecting concerns about exposure to the latest group of troubled US financial institutions. The text table shows these declines for the NIEs, where financial systems are most developed and arguably have stronger linkages with both corporate and household balance sheets, and thus potentially larger effects on the real economy. Declines in the rest of the indices across emerging Asia were broadly similar.

Credit markets have also taken a sizeable hit following the latest round of turbulence. The iTraxx Asia ex-Japan indices both blew out and closed substantially wider in post-Lehman trading. Spreads on investment grade credit rose 32bps (to 197bps) while high level spreads rose 71bps (to 678bps).

In contrast, fallout in the region’s currency markets has been relatively muted. Since Friday’s close, our composite USD­AXJ index is little changed at -0.03%. This compares with a slightly weaker EUR (0.2%), a much weaker AUD (2.4%) and a much stronger JPY (1.4%) against the US currency. Within emerging Asia, the biggest movers have been the usual suspects—the Korean won and Indian rupee. Since Friday, the won has shed another 3.2% versus the US dollar (-23% ytd) and is down 1.9% versus AXJ (­14% ytd). The rupee has dropped 2.7% versus the US dollar (16% ytd) and is down -2.6% versus AXJ (-12% ytd).

Despite the trauma related to a large US investment bank going into bankruptcy and another being take over, trading has been orderly for the most part and markets are beginning to show some signs of stabilization.

The most recent equity performance has been mixed but, on balance, has at least partly rebounded in a number of economies. Spreads across the spectrum have generally tightened, and currencies are trading within a fairly narrow range.

But can emerging Asia hang on? US growth appears to be heading for another down leg and the question again is how shocks that begin outside the region could be transmitted to the region, both in substance and size.

Doin’ the Asian Split
While the region overall has weathered the credit crisis well so far, is the combination of the Lehman bankruptcy, the Merrill takeover, and the AIG downgrade going to prove to be too much? Our first impression is that we will see an intensified version of the “Asian split.” To illustrate this split we have constructed a, two-dimensional qualitative vulnerability map for the region.

The top axis shows the leading driver of GDP growth on an expenditure basis. Countries are grouped in relative terms. We would underscore that GDP is a value added concept, so countries with a large trade-to-GDP ratio (such as Malaysia) may not necessarily be heavily reliant on net exports in terms of value added. On this measure, China and India, as well as the ASEAN-5 countries are currently more reliant on domestic demand for growth. (In the ASEAN-5, this reflects a recovery of investment in recent years.)

In contrast, the NIE’s are all relatively more reliant on net exports for growth. The implication is that growth in the NIEs would be more affected by a slowdown in foreign demand than the rest of the region.

The left axis shows the current account position of each economy. Not surprisingly, most of the region has a current account surplus. This means that domestic savings are sufficient—on a net basis—to finance investment. (The current account can be defined in two, equivalent ways: exports of goods and services minus imports of good and services, or savings minus investment).

From a markets perspective, having a surplus means that, on a net basis, capital inflows are not necessary to finance domestic investment. So a current account surplus economy is less subject to the vagarities of the international capital flows, including from sometimes large swings in risk appetite. On this measure, only India and Vietnam are deficit countries (we view Korea’s deficit as transitory).

The implication is that current account deficit economies are by definition not able to self-fund their investment and, as such, are reliant on the sentiment of foreign investors—and global risk reduction therefore translates to slower investment and growth.

Putting these two metrics together gives us a (granted, simplified) vulnerability map of emerging Asia. Economies in the northwest quadrant—China and most ASEAN countries—are domestic demand-led and able to finance their own investment (given their current account surplus) and in our view are less vulnerable at the current juncture. Economies in the southeast quadrant—India and Vietnam—are domestic demand-led, but relatively reliant on foreign savings to finance growth; these are seen as moderately vulnerable economies.

Similarly, economies in the northeast quadrant are also vulnerable given that growth is more reliant on foreign demand, which looks to face increasingly large downside risks. Importantly, we see no countries as being located in the southwest quadrant, which would suggest the highest degree of vulnerability.

Of course, this two-dimensional map could be augmented to capture other relevant variables. A case could be made for including the contribution of the financial sector to the economy, and here the region’s money centres—Hong Kong and Singapore—could arguably be marked down further as a result of direct contagion from the Lehman bankruptcy. One could also include political risk, where Thailand and Malaysia are candidates for a mark-down given recent events. And so on. But we think the two dimensional map does a good job of capturing the basics.

Conclusion
With developments in the global financial system once again unfolding in unprecedented ways, forecasting the path of emerging Asia has become increasingly challenging. This note has taken a first pass at the issue, and concluded that the Asian split we have seen to date is likely to intensify. But with the possibility of the landscape changing dramatically in a short period of time, one should take these views with the appropriate amount of caution. This is especially true given that the origin of the crisis lies outside the region, meaning that understanding second-round and indirect transmission channels, which are inherently difficult to forecast, takes on critical importance.

Of course, emerging Asia should be relieved that, unlike the 2001 tech bubble burst and the 1997-98 financial crisis, the “action” has started elsewhere for a change. As a result, the region seems likely to pass through the current credit crisis relatively well.

By Paul Gruenwald, head of economics and research markets Asia, ANZ Bank.*

Australian Property Journal