Five years on from the onset of the global financial crisis, and Asia’s economic model is beginning to tarnish.
Billions of US dollars of foreign investor capital has exited the region over the past three months, seeking investment prospects in the US or Europe instead. The flows are in large part in response to indications by the US Federal Reserve (Fed) that the times of easy money are drawing to an end as the US economy recovers. But they also indicate increasing investor unease with Asia’s largest economies.
It marks a startling change in conviction. For most of the past five years Asia’s economic vitality was the envy of Europe and the US alike. While the latter two economic blocs were mired in the legacy of a global financial crisis that began in September 2008, most of Asia’s major economies thrived, courtesy of rapid monetary-policy loosening and, in particular, a Rmb4 trillion (US$586 billion) lending-based stimulus programme introduced by China on November 9, 2008.
In the following years it seemed as if the world’s economic clout was tipping eastwards. In some ways it has. The region now accounts for 30% of global trade and 18% of gross domestic product (GDP), compared to 22% and 8% respectively before the global financial crisis. And there is potential for more, given that China, India and Indonesia are among the most populous nations in the world. The International Monetary Fund (IMF) expects that Asia’s share of world GDP will rise to 22.2% in 2017 and China alone will account for 14.3%, which will match the entire euro bloc.
But the weapons that helped Asia execute its swift economic comeback have begun to backfire.
Countries have kept their monetary policies too loose for too long, with low interest rates and the easy availability of capital leading households and companies to leverage up to concerning levels in some cases.
At the same time, the efficacy of these ultra-loose policies is decreasing. Asia’s average productivity growth rate has been dropping since 2010, according to HSBC and CEIC figures. Falling local productivity has impacted on Asia’s once-enviable current account surplus levels. Surpluses in China, Hong Kong, India, Indonesia, Japan, Korea, Malaysia, the Philippines, Singapore, Thailand and Taiwan nearly halved from US$726 billion in the third quarter of 2007 to US$327 billion in the fourth quarter of 2012, according to a June 28 Nomura report.
“Slowing productivity growth amid rising leverage is not a terribly sustainable proposition,” says Frederic Neumann, an Asia economist for HSBC. “Asia is in a credit trap of sorts: a lot more debt is needed to generate GDP.”
Asia isn’t in trouble – yet. China’s economy is still expanding by more than 7%, Indonesia is aiming for as much as 6.5% GDP growth for this year and even India’s labouring economy should wheeze its way past 4% in 2013. But these economies cannot sustain themselves indefinitely through ultra-loose monetary policy and footloose foreign capital, particularly with their debt levels on the rise.
The region needs to begin deleveraging, control its asset bubbles and execute structural reforms. Meet these requirements and the countries can maintain their economic progress; fail and they risk another regional economic crisis.
Too good for too long
The seeds of Asia’s current debt difficulties were sown back in 2009 – in response to the global financial crisis that began in the US with the collapse of Lehman Brothers on September 15 and swiftly spread worldwide.
US and UK banks, in particular, were exposed to billions of US dollars of losses on mortgage-backed securities and collaterised debt obligations (CDOs). Lenders across the world panicked about counterparty risk and stopped lending, to each other and to companies, causing trade financing and interbank lending to collapse. Tight liquidity risked crippling Asia’s export-dependent countries.
China led the fight back. After its economic output collapsed in the fourth quarter of 2008, a fearful Communist Party leadership introduced a Rmb4 trillion lending-based stimulus programme. The package focused on local banks lending ultra-cheap money to local governments and state-owned enterprises for infrastructure projects. It proved so atomic that it almost immediately lifted depressed global financial markets, helping to replenish lost confidence.
Meanwhile, other Asian nations implemented countercyclical fiscal and monetary policies that granted them more independence from their traditional export-led growth models.
The policies were designed to encourage borrowing to prop up economic growth. They worked a treat. Households and corporates were encouraged to borrow by the low interest rates and relatively stagnant equity markets. This helped Asia’s GDP growth rate average 8.5% during 2009, 2010 and 2011, at a time when the US and Europe were labouring at around 0.3% and -0.2%, respectively.
But debt levels have trended upwards as a result. Between the third quarter of 2007 and the fourth quarter of 2012, the ratio of private domestic debt to GDP in Asia ex-Japan increased by more than 50 percentage points of GDP in Hong Kong and Singapore and up to 40 percentage points in Malaysia, Korea, China and Thailand. The region’s combined public and private debt rose from 133% of GDP in 2008 to 155% in mid-2012, according to the McKinsey Global Institute.
The rising debt levels have caused asset bubbles, especially in property markets, while leaving countries more vulnerable to interest-rate volatility. They have also undermined the financial strength of some countries, including China, India and Indonesia – the region’s three largest emerging economies.
Fitch Ratings found China’s overall debt-to-GDP ratio of 198% to be concerning enough to drop its credit rating from ‘AA-’ to ‘A+’ on April 9, 2013. Both Standard & Poor’s and Moody’s cut India’s credit rating outlook to stable from negative on April 25, 2012 as a result of increased debts, weakening growth prospects and a lack of critical reforms needed to take control of the country’s deteriorating current account deficit.
Demand for dollars
The increased debt levels are not particularly burdensome now, but they could drag on economies once interest rates begin rising or investor liquidity becomes less readily available.
The latter is already taking place, courtesy of the US Federal Reserve.
Fed chairman Ben Bernanke could begin reducing quantitative easing as early as the Federal Open Markets Committee (FOMC) meeting that takes place on September 17-18. Cutting the amount of globally available dollars would increase the value of the US dollar and raise the appeal of the US economy.
This foreseeable outcome is already causing a capital outflow from Asia, weakening regional currencies and forcing countries to consider rate hikes. The strengthening of the dollar would be particularly detrimental for Asian companies with foreign currency-denominated debts, as their debt-servicing costs would effectively rise unless hedged.
And there are a lot of them. Over the past two years nearly 1,000 private and publicly owned companies in Asia ex-Japan have taken advantage of plunging yield levels to borrow approximately US$280.4 billion in US dollar-denominated bonds and loans, according to data from Dealogic. US-dollar bond issuance from the region reached a record US$176.6 billion in 2012.
These appealing yield levels look likely to begin unwinding. An IMF Global Financial Stability report published in April 2013 estimated that a combined 300 basis points (bp) of effective tightening in US monetary policy would wipe out the spread-tightening gains of the past four years. That would affect the refinancing costs of many regional corporates.
Local currency debt markets could also suffer. According to the IMF report, local currency corporate bond yields could rise almost 100bp on average if foreign investors sell 20% of their Asian-currency bond holdings. That’s a worry for countries such as Malaysia, where foreign investors hold more than 40% of government bonds.
The rise in regional debt levels has left Asia’s banks – and hence its economies – more vulnerable to economic volatility. The IMF noted in its report that Asian banks enjoy relatively high levels of capital, but that this could come under strain if the region’s economic growth disappoints, or if additional capital is required to fund rapid balance-sheet expansion. And Moody’s said in July that the credit quality of banks in the Asia Pacific region has likely hit a cyclical peak and lenders may become more susceptible to asset-quality deterioration.
“With the potential risk of a turn in the interest-rate cycle, we view strong asset inflation and credit growth trends as vulnerabilities, as this combination would likely cause credit costs to rise from their current low base,” says Gene Fang, a Moody’s senior analyst.
The agency downgraded Singapore’s banking system from stable to negative because of rapid loan growth and rising real-estate prices, and cut its outlook on Hong Kong’s banking system to negative from stable because of increasing exposure to Chinese borrowers.
The likelihood is that the region’s banks will come under greater strain, courtesy of weaker economic growth and ongoing market adjustments to the reduction of quantitative easing and, eventually, rate hikes. The possibility of policy mishaps could also affect the strength of lenders if, for example, central banks raise rates too quickly or governments prefer to encourage more lending to offset weakening economies. Non-performing loans could well rise.
Biting the bullet
Despite the rise in the region’s debts, Asia doesn’t appear in immediate danger of another debt crisis. Unlike the region’s financial crisis of 1997, most governments and companies don’t owe large sums of foreign currency-denominated, short-term debt. Instead they have increasingly used their own developing bond markets to raise funds.
But the region’s countries are reaching a point where they need to implement some difficult but necessary structural reforms if they are to avoid future credit crises.
“Countries that start to focus on longer-term sustainable growth rather than getting it for the near term, even though it leads to bad side-effects, and … countries [with] more prudent long-term policies, are going to get rewarded,” says Rob Subbaraman, chief economist for Asia ex-Japan at Nomura. “So countries that preemptively raise interest rates or keep fiscal policy prudent, even though it might hurt growth, or countries that bite the bullet and do reforms will attract more interest from investors.”
China is already attempting to tackle its mounting problem of a systemic build-up of opaque, non-banking debts (see box on page 25). India and Indonesia are also facing a shortfall in investor confidence. Both run large current account deficits, and Bernanke’s hints about QE tapering has led to an outflow of capital from both (see box, right).
Malaysia needs to overcome social division and increase the diversification of the country’s revenues away from oil and gas. South Korea needs to improve the profitability of its small and medium enterprises, and Thailand needs to find ways to boost domestic demand.
Over the past five years, Asia’s vitality has helped propel the world during a time of fragility. And the region still has a lot going for it. Countries such as India, Indonesia, the Philippines and Vietnam continue to boast young and vibrant populations whose potential, if correctly harnessed, could ensure their economic vitality for years to come.
But the region’s debts have mounted and, if not addressed soon, these problems risk holding back further development.
With economic momentum slowing, many of the region’s countries need to better manage their credit expansion and embrace reform. Policymakers need to be extra careful in limiting growth in risky areas of credit, while maintaining liquidity for sectors that are crucial to strengthening the pillars of economic growth.
Countries like India and China must find ways to quickly identify bad loans instead of sitting on them, and implement standardised write-off and delinquency processes to enable their companies to plan ways to repay debt.
South Korea and Malaysia, which have high levels of household debt, must also be aware that although macroprudential measures are helpful, they also need to tackle the core reasons why debt is rising in these areas.
Implementing these tasks will be tricky and will require strong consensus and forward-looking acumen on the part of policymakers.
Asia has had an easy five years. Now comes the hard work.
