Clearing the clouds of the Asian outlook

By Cheranka Mendis

Even if the status of the world economy seems to have found a rather fragile equilibrium with Europe over the past six weeks, the world is no closer to being immune from the risks that have cropped up as a result of the European and USA led recession and changes in world oil prices.

Standard & Poor’s Rating Service South East Asia Managing Director Surinder Kathpalia speaking at a forum titled ‘Rising Global Risks Cloud Asian Outlook’ on Tuesday noted that even with the expectation of recession calming down with the Greek bail out and orderly default of Greece bonds, Asia will continue to feel the tremor from the events in the world market.

Issues of the world

Starting with the second half of the year, Asia has had implications thanks to storms brewing in other parts of the world. This was indicated by the capital flows and trade flows slowing down in the Asia Pacific region. Sitting on such a situation where risk appetites are running high and liquidity drying up, even countries like China, India and Indonesia where domestic demand can be strong has begun to feel some of the pains as a result of the coming down and.

With the recent emergence of the rising oil prices which currently stands in the US$ 130 range and the Chinese dragon economy reducing its speed and continuing at a dawdling pace, things do not look like it is going to smoothen out very soon.

Kathpalia admitted that even though the situations in the past weeks might pose a feeling that the worse might be over, researchers at S&P believe that in the case of the euro situation, it is not in fact the ‘calm situation’ but is the ‘calm before the storm.’ If things do get rough in the Western world, the implications on US and the rest of the world will be staggering.

“While we feel that things are turning to the better, at different points of time within the last 12 months, the forecast for Europe and US had a declining situation even with the bailout and LTR package of little over US$ 1 trillion providing liquidity,” he said. However in the US, the job recovery situation is improving its stature while the manufacturing output sector increasing, Kathpalia admitted. “S&P’s expectation is that USA will be in the 2.5% reach in 2012.”

 The Asian context

“Europe still remains a risk,” Kathpalia said. “Implications of what is happening globally can affect Asian growth as well, despite positive news of Europe and the orderly default of Greek bonds, bailout, trillion dollar financing and the market confidence returning for Europe with sovereign yields compressing and markets believing that the situation may have been managed and handled in an orderly manner.”

Asia is vulnerable to Europe in several areas. Trade, especially in Hong Kong, Singapore and Malaysia, has extensive linkages in terms of exports and trade flows with Europe. There is also a deleveraging taking place where banks are looking to sell assets or cut back on credit lines.

The US GDP is approximately US$ 14 trillion, which is also the rough calculation of assets of the US banks. However in Europe, size of the region is also close to US$ 14 trillion but the assets in the banking sector are US$ 40 trillion. “If you have to see shrinking or deleveraging taking place, you are talking of fairly large numbers. The impact on that on the rest of the world is going to be quite significant with credit lines being dropped down or selling lines of assets.”

Asia is also highly dependent on cross border lending. Europe’s exposure to Asia remains at a position where 40% of all trade finances in Asia are financed by European banks. If the banks start pulling back, like they did in the second half of 2011, the question remains if Asian banks and financial markets will be able to fill that gap.

The other implication is that funding costs may go up posing problems for organisations and profitability, etc. Geopolitical risks such as the events in the Middle East and its impact on prices will also have its repercussions.

“By and large, except for Thailand and Japan, most of the countries have had growth slowing down quarter on quarter. In the case of Thailand, the situation is a cause of the floods while Japan has the earthquake to blame it on.” This means Asia had had a sluggish growth in the past year.

Exports from Asia have also suffered under the current state of affairs. Most countries have had fairly sharp declines in exports, particularly in Q3 and Q4. Inflation, which acts as an indicator on how policy makers manage interest rates, has been at a 3-6% range for most of Asia Pacific except for India and Vietnam which has had several rounds of interest rates increases and adjustments.

With the expectation that growth in 2012 is going to be more modest than 2011, the region could expect interest rates movements. “Rises of interest rates are likely to be a thing of the past in 2012,” Kathpalia said. “Some changes might be seen depending on how bad the situation in Europe is and how it affects economies in inflation in this part of the world.”

In exchange rates there have been a significant amount of volatility relative to the US Dollar. The region, also vulnerable to oil price changes could pose bigger challenges to the likes of S. Korea, Thailand and India, which are relatively major consumers of oil but have issues dealing with it. The governments of such countries will find themselves in a difficult position if their balance sheets are not strong enough to provide the subsidies.

 Slowdown of the dragon

When it comes to the slowdown of China and the question of whether it will be a hard or soft landing for the country, even a hard landing would mean 6%, he said. Official figures from China indicate that GDP growth in 2012 is going to be 7.5%, which is likely to end on a higher number.

“What are affecting their growth are the exports to US and Europe coming down, sharp corrections in property markets and the flows coming out of Europe.” S&P expects an interest rate change if the growth slips further in China and inflation is under control as expected. A key challenge is that it is a heavily export-oriented economy and the biggest test is to get domestic demand to go up to match the softness in its exports.

Standard & Poor’s Rating Service South East Asia Managing Director Surinder Kathpalia – Pic by Daminda Harsha Perera

“Our economists in S&P say that GDP growth across Asia Pacific is going to be lower in 2012 relative to 2011. The ones to watch out are China with a growth close to 8%, India which is likely to be at a 7% mark or lower and Indonesia, which is rapidly coming up with a population of almost 300 billion, natural resources and significant amount of reforms done. Indonesia is expected to have a fairly steady GDP growth.”

Sovereign ratings and downgrades

Kathpalia identified sovereign ratings as a figure of a country’s ability and willingness to meet its obligations. He noted that it is essentially a view of the balance sheet of the government, not the economy.

In June 2011 S&P revised its criteria on sovereign ratings and put in place five pillars which form the base of sovereign ratings. “The factors we look at is the monetary policy, balance of payments, fiscal deficits and overall macroeconomic indicators such as GDP growth, etc., from the government’s ‘ability to pay’ side and the analysis of the typical risks such as political stability, and institution that lead to that etc is focused on from the ‘willingness’ side.”

He noted that during the last few years S&P has had more downgrades than upgrades. “We have also had more negative outlooks. At the moments the negatives are largely in Europe as against Asia Pacific.” In January this year S&P revised economies of 16 European countries which were placed under negative watch in December 2011. He also noted that downgrades for countries in trouble such as Greece and Italy started in 2004. “When the transaction is complete Greece is likely to be upgraded to CCC category. The situation in Europe on the sovereign side is still grim. If markets confidence is also lost, things will get worse.”

 For better times for Asia

S&P has had 22 sovereign ratings for Asia Pacific of which, 16 were stable, three (Indonesia, Philippines and Mongolia) were positive and another three (Japan, Vietnam and Papua New Guinea) received a negative outlook.

“We think Asia should be fairly resilient in being able to manage some of the risks emanating from the Western world. Key risks still remains if a deeper recession happens in Europe.” The changes taking place in the banking systems in Europe can have an impact on the funding and capital flows available to this part of the world.

In terms of domestic factors there are two that could affect Asia: politics and inflation. A leadership change is expected in China in Q4 which is likely to be orderly. The political issues in the regional countries including India and the geo political and social tension in S. Korea and N. Korea with the change in leadership in N. Korea and the 100 politicians coming back from a five-year ban in Thailand could cause problems for the region.

Noting risks that could have implications on Sri Lanka as well, Kathpalia stated that financial sector reforms must be produced which can create long-term stability, global imbalances need to be rectified and new areas of growth needs to be looked at as traditional areas such as US and Europe is unlikely to be the growth engines for the world. “As risks taken up by policy makers there are a variety of ways they can stimulate it. They could bring down interest rates, provide subsidies, etc. and stimulus measures to grow consumption.”

Risks are getting larger. “We believe that a full recession of major financial crisis in Europe is unlikely and think there will be a soft landing in China. As a result the outlook for most sovereign ratings in Asia will be benign. That is largely because there is resilience both at domestic level and most countries across Asia has built up reserves and implemented whole range of measures to strengthen their economies.”

Having said that, with the risks getting intense, challenges for policy makers are growing, which could lead to them making mistakes, he warned.

In conclusion, he remarked: “By and large our expectation is that most of Asia should continue to grow. I think we are in a situation where most countries are fairly resilient and are able to face shocks. Like most things, if these shocks are fairly severe, then Asia will be put to test.”