Not another Asian crisis, but watch the Fed

Chi Lo, regional head of research (NE Asia), Standard Chartered Bank Global Markets, Hong Kong, explains why Asia will escape another financial crisis.

Investors are now more aware of the differences between emerging markets than before. Hence, the effect of the recent Argentine financial woes has been confined, with Asian markets showing only measured response in terms of rising bond spreads and falling stock prices and currencies. Cross-border hedge funds are not as powerful now as they were four years ago. Crucially, Asian external accounts have improved to absorb external shocks. Asia's current accounts have turned into surplus since the Asian crisis. Foreign debts have been pared and foreign exchange reserves have risen sharply.

Nevertheless, a global shock of falling external -- especially electronics -- demand has also hit Asia's export-oriented economies, many of which are flirting with domestic recessions again. Though it is unlikely that Asia would fall into another financial crisis like in 1997/98, those Asian economies that have large fiscal deficit and/or high debt may feel more of the financial pains and emerging markets contagion than the others.

Is the worst over?

Two of Asia's dragon economies are suffering from sharp economic deceleration. Singapore is seeing the worst manufacturing sector contraction in more than ten years, and Taiwan is not far from a recession. Meanwhile, Hong Kong, another dragon economy, is still stuck with deflation after 32 months of falling prices. Its GDP growth is threatening to fall below 3% year-on-year this year after surging 10.5% last year. Most Asian currencies have been weakening since last year, reflecting the economic woes.

The fall in Asian share prices over the past 20 months is comparable to the 1997/98 decline, suggesting that Asian markets had been expecting a regional economic downturn much earlier than the US markets. The extent and duration of the decline also suggest that many Asian markets might be passing through the maximum stress point, unless another bad external shock, such as a collapse in the global economy, hits. 

With flexible currency regimes, Asian authorities now have more leeway to boost domestic growth than before the Asian crisis. Many regional governments, notably in Northeast Asia, are firing monetary and fiscal cylinders to salvage their economies. Both Korea and Taiwan are relaxing their monetary policies more aggressively recently, and are planning to increase fiscal stimulus in the coming months.

The stabilising Chinese economy is another positive for Asia. As a percentage of GDP, China absorbs as much imports from Asia as Japan. Meanwhile, the rest of Asia's exports to China are still running at double-digit rates, while their overall exports are contracting.

Signs of wakening

The short-term outlook of a weakening yen and Latin American crisis could still drag down most Asian currencies. But further decline in the regional currencies in an orderly fashion may not necessarily be bearish for Asian equities because currency depreciation could offer an escape route for profit squeeze by boosting export competitiveness and inflating profits in local currency terms.

Some Asian economies are showing signs of bottoming out. Korean wholesale growth and consumer durable goods and public confidence have picked up recently. Korea could well be the first Asian economy to emerge from the current economic slump. China's growth has recovered since Q4 last year, with GDP growth remaining at close to 8% in the first half of this year, despite slumping external demand.

The closed nature of the Chinese economy should help limit the impact of the global slump on the Middle Kingdom. With Beijing determined to halt any economic slide by expansionary demand management policies and Chinese consumption reviving, Chinese growth will be able to buck the declining global trend. Steady, amid slow, reform progress and political stability also make China an attractive investment destination in Asia.

Looking across the region, a north-south divide prevails. Northeast Asia, with more stable politics, stronger fundamentals, lesser debts and higher foreign exchange reserves, will provide the authorities there with more leeway to react to negative global shocks. On the other hand, Southeast Asian economies' less benign fundamentals will mean more downside risk for their market and growth outlook than the north counterpart in the coming quarters.

Watch the Fed

A key issue for Asia's growth outlook is the global, notably the US, economy due to the region's open economic systems and the importance of the US market for Asian exports. Despite six interest rate cuts, even Federal chairman Greenspan is not sure if a sustained US economic recovery is achievable yet. Thus, he has left opened the door for more interest rate cuts if needed. Further, the weakening trend of the world economy is far from over.

Europe seems to be heading for stagflation and Japan is mired in deflation. If left unattended, these two sick economies could drag the global system into a deep recession. With monetary policy immobilised in both Euroland and Japan, the burden of policy adjustment has fallen on the US, which is the only major economic power that has the ability to sustain global liquidity.

Europe's stagflation

Rising inflation, due to high energy costs, a rigid labour market and a lack of productivity growth (especially relative to the US), and falling onshore public confidence have highlighted the risk of stagflation in Euroland. The sharp decline in global manufacturing activity is adversely affecting the European economies, which are still dominated by the manufacturing sector. Meanwhile, prices are unable to fall to reflect the economic weakness, due to economic rigidities in the European system.

Stagflation is the worst nightmare for the ECB. It is unwilling and, given its anti-inflation mandate, unable to cut rates aggressively at a time when inflation is creeping up. But growth is on the edge of a sharp decline. As a result, the Euro has suffered chronic weakness, a trend that is unlikely to change until the stagflation dilemma disappears.

Japan's mistake

By targeting fiscal restraint just as the economy is sliding into a recession, the Japanese government is making a policy mistake. While the country's fiscal problems need to be addressed, this is not the right time. Under recessionary pressures, a Keynesian approach of expansionary demand management policies is needed to facilitate economic retrenchment. The fiscal restraint under the current circumstances is risking an economic implosion, which will in turn make reform implausible.

Relative to Euroland and Japan, the US growth outlook still looks better. The US Fed also enjoys much more policy credibility than both the European and Japanese central banks. All this will continue to underpin the USD in the medium-term.

Downward bias for US rates

A strong USD and faltering growth in Japan and Europe will continue to crimp US profits. Mired in excess capacity, US capital spending will fall further. With US consumers expected to retrench their balance sheets in the coming months, it is unlikely that the US economy would sustain an economic recovery so soon. Hence, there remains a downward bias for US interest rates. In the previous recession in the early 1990s, the real Fed fund rate was pushed down to negative levels for half a year. Today, the real Fed fund rate is still hovering around 1%.

The good news is that Fed chairman Greenspan is vigilant against recession and will likely do whatever he can to prevent one from happening. This reduces the odds of a policy mistake that could worsen the US and global economies further. So no need to cry for Argentina, but pray for the Fed to work its magic.


Chi Lo, is regional head of research (NE Asia), Standard Chartered Bank Global Markets, Hong Kong.

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