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17 Jul 2013

Asia’s bitter medicine

Frederic Neumann

by Frederic Neumann

Co-Head of Asian Economic Research, HSBC

Asia's bitter medicine

Change in China is having an impact on trade patterns around the world

The data coming out of Asia isn’t very pretty. Slowing exports reflect the dip in US capital spending and the recession in Europe. Optimists suggest slowly recovering demand in the West, plus a more vigorous Japan, will spur a rebound in Asian shipments but our economists expect only a very tepid recovery and think Japanese demand will fizzle again after the country’s generous fiscal and monetary boost.

More fundamentally, a pick-up in Western demand may not lift Asian growth as it has previously. In fact, if stronger US growth leads to tighter monetary policy, Asia might be disproportionately harmed given that it has come to rely on cheap cash and leverage.

Productivity growth has slowed over several years across Asia. High and rising debt mean that if funding costs climb a painful
shake-out might ensue

Exports to the West are thus unlikely to lift Asia out of its funk and risks to local demand have grown sharply. China casts a shadow over the region: our Chief China Economist has cut his forecast of growth from 8.2 per cent for 2013 and 8.6 per cent for 2104 to just 7.4 per cent for each year.

Given China’s recent role as Asia’s growth engine, the slowdown is being felt throughout the region. Korea, Taiwan, and Hong Kong are among the most exposed. In Australia, the turn in commodity prices and declining confidence in the “China story” hit just as mining investment is peaking.

In other economies, the impact is occurring directly through slowing shipments to China and indirectly via deteriorating confidence in the region’s growth outlook, causing companies to curtail investment and slowing job growth. India and Indonesia have, over past years, shown the lowest sensitivity to Chinese growth, but even there, investment has slowed.

But not only slowing demand from mainland China is tripping up Asia. The region’s growth has long largely reflected a powerful re-leveraging cycle, fuelled by record low interest rates and liquidity pouring in from the West. With financial volatility increasing, this process is increasingly at risk.

However, even this doesn’t tell the whole story. China’s soaring debt market and shadow banking system imply that overall lending there has risen much more than the simple bank-credit ratios suggest.

Households account for a sizeable chunk of total debt in several markets, including Taiwan, Malaysia, Hong Kong, Singapore and Korea. This reflects soaring house prices and attendant mortgage financing plus, increasingly, other consumer finance such as credit cards. An interruption in the credit process would thus hurt growth in these economies especially.

Productivity growth has slowed over several years across Asia. High and rising debt mean that if funding costs climb – because of a cash crunch in China or tapering by the US Fed – a painful shake-out might ensue.

The broader policy setting should still be sufficiently supportive, at least in the near term, to avoid an all-out bust. China’s government maintains considerable controls over the financial systems plus ample fiscal buffers to avoid a hard landing. And in the rest of Asia, Japanese easing and gradual withdrawal of the Fed’s stimulus should allow things to tick along, even if growth continues to slow.

But what’s urgently needed are far-reaching structural reforms. Chinese officials face tough policy decisions stretching from liberalising financial controls and pruning the privileges of state enterprises to beefing up land and migration rights. In India, the reform agenda includes encouraging further foreign investment, streamlining the tax system, accelerating infrastructure approvals and cutting costly subsidies.

And Japan needs to follow fiscal and monetary stimulus with an agenda that ranges from raising the participation of women in the workforce to liberalising employment legislation and healthcare, cracking down on trade barriers and disincentives for inward foreign direct investment.

Even Asia’s smaller markets have work to do. Indonesia and Malaysia must cut costly subsidies further. In fact, most of emerging Asia, outside of China, must do more to improve infrastructure. The trick will be to do this without sharply raising government debt. And that will be politically painful.

This research was first published on 9 July 2013.

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