Emerging Asia: policy risks in focus in 2012

Any Asia outlook piece is sure to address the sustainability of China as the proverbial Atlas carrying the world on his shoulders. The consensus is for slower growth next year, but for every note claiming a manageable reduction in growth there is another foretelling a crash to the bottom.

I will not attempt to add my own views to the rabble because I do not think the closed system of accounting in the country allows for a legitimate forecast of a crisis event.

Is this meteoric pace of Chinese growth sustainable? The answer is “not likely.”

Will the house of cards come crashing down within the next few years? With foreign reserves of approximately 50% of nominal GDP and strict control of the lending environment, I would say the answer is also “not likely.”  

China will eventually need to change its growth model from an export-driven focus to internally sustainable growth. The country has risen to economic power through the traditional method of subsidized production and a policy of cheap exchange rates.

Without nurturing the consumer class, this creates a huge production/consumption imbalance and the country can sell excess production as exports.

Chinese exports to developed countries still account for close to 70% of total exports, making the economy particularly susceptible to euro zone and U.S. weakness. China’s size and per capita economic disparity means it may be able to continue this model for longer than other countries in the past, but will eventually need to adjust growth to consumption.

As for the rest of the region, the most significant risk is that of increased inflation in the face of lowered growth as pointed out in a recent article by Bloomberg.

European weakness is slowing exports for economies in the region, especially export-driven South Korea and Vietnam. Central banks are taking a more accommodative stance to support growth but are also stoking inflationary pressures. The Asian Development Bank is forecasting 7.2% growth for the next year while Fitch has raised their regional inflation estimate to 5.9% for 2012.

Malaysia and the Philippines have already presented stimulus plans to support their economies. China has recently reversed a two-year policy of tightening with softer requirements on bank reserves. As inflationary pressures heat up from accommodative policy across the globe, investors may look to agricultural commodities and assets with inflation protection. 

Risks

Though risks exist in heightened inflation due to monetary policy, the region is in a much better position than during past crises. The dependence on credit markets and relative debt position of the region has improved significantly from 1997 and the Asian financial crisis.

Short-term debt still remains high in some countries and could be a risk in those smaller markets dependent on exports, i.e.Vietnam.

Political risk should be fairly subdued with the possible exception of Malaysia, where risks are relatively small as well.

As interest rates are cut to spur economic growth and investors shun risky assets, currency values could fall further. This could further drive losses to foreign investors through translation loss. Hedging investments with a short on the country’s currency or related currencies could help to offset losses.

Country by Country

China: China’s massive program of economic stimulus during the height of the 2008-9 credit crisis showed the political will to keep the economy growing. 

India:  Unlike China, the country has limited options for stimulus due to an already high budget deficit and one of the highest rates of inflation in the region.

South Korea: South Korea is more dependent on exports than others in Asia and runs a current account surplus of about 2% of GDP. Meanwhile, global investors have pondered the implications of regime change across the North Korean border.

Indonesia: Jakarta’s gain of 3.2% and return to investment grade makes Indonesia the standout among Asian peers for 2011. An accommodative monetary policy and strengthening credit environment should drive the economy into2012 and warrant an overweight position.

Malaysia: The central bank of Malaysia has been less accommodative than others in the region, which has contributed to one of the lowest rates of inflation among peers. Despite restrictive monetary policy, the economy has held up well.

 

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