How today's turmoil will shape tomorrow's markets

Intra-regional integration cushions Asia-Pacific economies from the global turmoil, while falling inflation rates open the way for monetary stimulus.
No region's financial markets are the same, but few are as varied as those in the Asia-Pacific region. And the geographic size of the countries in this region is not always in direct proportion to the size of the respective economies.

Standard & Poor's Ratings Services covers 14 markets here, ranging from Vietnam, with its per capita GDP of about $4,000, to Hong Kong at $44,000 and China at about $2,400. The state of the region's financial sectors reflects the range, depth, and capabilities of the financial institutions and markets, and the status and efficiency of their regulatory frameworks.

Despite these differences, we believe there is strong justification for thinking about Asia-Pacific as a single region with financial and economic strategies that share several common elements. Many of the economies, particularly the less affluent ones, are expanding quickly. Among them are China and India, the two fastest-growing economies in the world.

Domestic factors are the primary growth drivers in Asia-Pacific, giving the region a substantial cushion against global turbulence and reinforcing the fact that its economies are integrating at a steady pace. The eagerness of virtually all the countries in the region to exploit the opportunities provided by their fast-growing neighbours is leading to harmonised trading practices, which we expect will evolve into greater access to a variety of services operating within an increasingly coordinated regulatory system.

In short, a regional financial strategy must take into account the forces bringing the region together, as well as the significant differences in the economic conditions that will persist, even at the end of the next decade.

A two-year perspective

The economic slump in the US will have a definite effect on the Asia-Pacific region, mainly by slowing export growth. But two factors ù decreasing inflation and growing integration ù are likely to offset this, at least in part.

Domestically, more or less across the region, the recent abatement of inflationary pressures has created the opportunity for monetary stimulus. The surge in inflation early this year was the result of a confluence of oil, commodity and food prices. All three have since dropped, the latter two as a result of more enduring forces than the first. Oil prices have come down considerably from their peak, but current levels reflect global growth pessimism, and prices could climb again. Production restraints by OPEC could add to the pressure. However, prices are unlikely to rise again to the levels reached earlier this year if the current global economic conditions persist.

Inflation is slowing sharply and will remain relatively moderate next year and beyond. Many countries in the region are already cutting their benchmark interest rates in addition to infusing large amounts of liquidity into their financial systems to support the overall economy as well as specific institutions or segments. These central banks will continue to ease monetary policy as inflation drops, and those that have not yet cut rates will almost certainly do so in the next quarter. We recognise that there are risks involved in this approach, but given the global situation, we feel that in most countries these risks are smaller than the risks of inaction.

Big and broad monetary stimulus, accompanied in some countries by fiscal stimulus, will keep growth from slipping too sharply. Although we expect expansion to slow a bit in 2009, monetary measures will likely stimulate a recovery in the second half of the year and keep it on track for 2010 ù reinforced by the recovery of the US economy that we expect by then. Macroeconomic indicators in 2010 should resemble those of the boom years of 2006 and 2007, although with slightly lower growth rates.

Growing regional integration, which at the moment emphasises commodity trade, is reinforcing the cyclical effects of monetary stimulus. Recent trade data show that exports to the US from most Asian countries have slowed, but exports to neighbouring countries have remained steady. The significance of the US market for exports from most of these countries, although still high, has declined.

The short-term implication of this is that the increase in regional trade will offset the effects of the slowdown in the rest of the world. In Asia, growth in China and India are the biggest factors. Because monetary stimuli in both countries will likely provide a boost, this should spill over into the performance of other economies, which are beginning to send increasingly larger volumes of goods to these two countries.

Although our baseline scenario indicates decelerating expansion in the region through 2009, growth rates will probably remain relatively stable by global standards. However, there are risks, mainly related to the state of the global financial sector. Virtually all Asia-Pacific countries have seen significant capital inflows in the past few years. But portfolio flows have slowed drastically, contributing to falling equity prices and depreciating currencies as funds are repatriated. As conditions stabilise, there may be some reversal of this trend, but it will take time for flows to return to the levels of 2006 and 2007, if they ever do.

The more serious threat comes from a potential slowdown in foreign direct investment, which has contributed to a considerable expansion of production capacity in these economies. Nearly all of them will see major reductions in their investment levels if foreign direct investment dries up as a result of financial constraints in the developed economies. For infrastructure-starved economies, notably India, these constraints could severely dampen growth prospects by shutting off the flow of resources into increasingly viable infrastructure projects. This will limit growth in both the short and long terms.

Looking farther out

The development of Asia-Pacific's financial sector and the business opportunities it provides can be viewed as the outcome of three mutually reinforcing factors: economic growth, demographic changes, and the initial conditions of the financial sector.

We expect China and India to contribute about 70% of the region's incremental GDP in the next 10 years, at a steady rate, and no other country to add more than 10% to the aggregate in that time. (We expect Japan to contribute about 11% between 2010 and 2015, but its contribution will likely decline in subsequent years.)

Meanwhile, transitions in the demographics of working-age people (ages 15 to 64) and senior citizens (65 and older) will have significant implications for financial requirements. It is clear that the bulk û about 62% û of the region's working-age population will come from India. Pakistan will be the next-highest contributor with about 11%, so the subcontinent will be the overwhelming source of working-age people in the region. But the distribution of senior citizens will be different: China will account for more than half of this group, while India will contribute 25%.

Based on the World Economic Forum's recently published "Financial Development Report 2008," which scored countries on multiple indicators of financial development, there is a great deal of difference across the region in the extent of financial sector development. Notably, about 95% of incremental economic activity will take place in countries with less-developed financial centres, and only 5% in economies at the higher end of the rankings. In short, the overwhelming proportion of the new opportunities emerging in the next decade will be in economies that have relatively less developed financial systems today.Virtually every country on the continent is entering into an increasing number of regional agreements, both within Asia-Pacific and outside. This reflects the shared perception that gaining preferential access to a rapidly growing market is worth the price of reciprocity.

In a fast-growing region, the relative ease of negotiating agreements with a small number of countries makes it even more tempting to do so. The concerns about regional agreements diluting the benefits from free trade are valid at one level. However, the difficulties in negotiating a global agreement, which became evident during the latest round of the Doha Development Agenda talks earlier this year, make smaller, regional agreements a more practical option.

The dominant form of regional agreement is the free trade agreement, which typically provides preferential access to commodities and manufactured products. However, there is an increasing tendency to enter into comprehensive economic cooperation agreements or economic partnerships, both of which widen the scope of preferential access to services and investments. As this network of agreements expands and the latter two categories become more prevalent, opportunities to provide cross-border financial services will increase. We must point out that the experience with these has typically been that the fine print can neutralise the larger intent of greater access, but from the long-term perspective, this trend represents a significant opportunity to locate resources strategically to maximise market access.

When will regional markets recover?

The short-term economic outlook for the region suggests a recovery by 2010 with the help of the monetary and fiscal stimuli in many countries and the ongoing benefits of greater integration. Growth in China and India will help keep the entire region growing at a relatively fast pace, even as other parts of the world experience stagnation or declines in GDP next year.

However, parts of the financial sectors in these countries have been particularly hurt by the global turbulence. The sudden, sharp reversal of capital flows, especially from equity markets, has affected a variety of activities, from intermediation to asset management to research, all of which gained significantly during the boom years of 2006 and 2007. We believe these segments will be forced to consolidate during the recovery to achieve higher efficiency.

Declining investment levels may also lead to lower debt issuance. Consumption expenditure will likely be the biggest factor in the recovery, while traditional capacity-expansion investment will wait until the economy stabilises. In the absence of further significant shocks, this should happen toward the end of 2010, a year or so into the recovery.

The effects of the turbulence on foreign investment will also have implications for business. Infrastructure, for example, is becoming increasingly attractive to foreign investors, as policies and regulations combine to create a hospitable environment for private money. However, if foreign investors are constrained for funds or otherwise wary of entering into somewhat uncharted waters, this source of financing will be weak for a while. In some countries, governments have the fiscal capacity to fill the gap, but a move back to public investment would represent a diminished business opportunity.

Who will survive?

Banks typically dominate Asia's financial systems, despite the rapid progress made in equity and other markets over the past few years. In the current environment, the general view is that bad assets have done less damage to Asian banking systems than to their peers in other parts of the world. This is partly because Asian banks did not have significant direct exposure to troubled assets, but also because they have been relatively prudent in their domestic lending practices. Although the slowdown in economic activity has hit banks in the region, the pattern is far more reflective of a business cycle downturn than of serious problems with their balance sheets.

The relative stability of the banking system will play an important role in providing financial support to the recovery. But it will also bring back into the spotlight concerns about a market-dominated financial system and the systemic risks, both internal and external, that it entails. Although the general direction of financial sector reforms in the region is to improve the balance between banks and markets, it is quite reasonable to expect the pace of movement in that direction to slow significantly after the turmoil.

There will be strong opinions expressed that the reason for Asia's coming out of the episode relatively unscathed is precisely that it had not moved so far down the road toward market domination. Whether this is a legitimate claim or not, it will heavily influence the debate on financial sector reforms and reduce the room for policymakers to manoeuvre.

This debate will be of the greatest significance in the countries that present the greatest opportunities and that have relatively little financial development. Different choices for financial sector reform and development will have different implications for business. While all of this plays out, we should view the "flight to banks" as the most likely direction of Asia's financial sector policy.

Where will the trading hubs be?

Domestic demand for financial services, as we see in Hong Kong and Singapore, will be important in determining where the next financial hubs will emerge. Economic activity in China and India points to centres in both locations, bringing Shanghai and Mumbai into prominence.

Hong Kong could take advantage of its position as an international centre to capitalise on the opportunities that domestic demand for services in China provides. Singapore, however, does not have the same domestic market or hinterland advantage. Only Indonesia will provide the Lion city with a significant incremental opportunity, and it will certainly not be anything as large as what China or India could provide.

Demand for international services by foreign and domestic investors looking for global portfolio diversification will also come into play. Here again, China and India will be at the top of the list, as both will have a significant edge in terms of incremental volumes in both directions. Hong Kong and Shanghai will compete for the Chinese business, and Hong Kong will again hold the edge because of its legacy. The Chinese government could expand Hong Kong's physical capacity by, for example, extending the geographic boundaries of the Special Administrative Region. Or, it could go the other way and level the playing field for Shanghai to take the leading role. Mumbai has a potential competitor in Dubai for some of the services investors will need, but the competition will be less intense than the rivalry between Hong Kong and Shanghai.

Finally, local conditions, both in terms of the regulatory frameworks and physical infrastructure, will matter. China and India score relatively low in this regard; they must implement substantial reforms before they can aspire to the status that Hong Kong and Singapore have today. Physical infrastructure would also clearly argue against Mumbai. In sum, the dominant hubs of today are likely to maintain their positions for some time.

Which instruments will dominate?

India, with its enormous working-age population, will feel the greatest need for instruments that finance productive assets. With the right set of policies in place, India could emerge as the dominant manufacturing location in the region, while China vacates this post because of its rapidly aging population. As this occurs, the need for instruments that finance capacity creation will grow rapidly. This will also be true in other countries with similar age profiles, such as Vietnam, and could provide a basis for standardised regional offerings.

A related trend will be the financing of infrastructure, which is critical for less affluent countries to sustain their growth rates. Both private and public entities will be looking for access to funds through markets if these prove to be cheaper than bank loans.

China's income-security requirements are likely to dominate its needs. Instruments that provide stable long-term yields will be necessary to take care of a population segment that will live mostly off its own savings. The state may provide social security, but this will be at a subsistence level. This need is also likely to become larger in India in the next decade, given that the country is expected to contribute about 25% of the incremental number of senior citizens in the region.

Overall, though, we have to keep the dominant position of banks in mind. Even if banks provide alternatives to these channels of finance that are less efficient than what markets provide, the fears about market instability may induce governments in the region to favour banks over markets.

This article was contributed by Subir V Gokarn, a primary credit analyst with Standard & Poor's in Mumbai.
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