International > Economics

13 April 2012

Asian Tigers Economic Update

Growth slowed considerably in the Asian Tiger economies late last year and remains relatively sluggish in 2012. However, some partial indicators suggest that conditions have improved modestly more recently, bolstered by improvements in the US economy, and an apparent v-shape recovery in Thailand from last years floods. However, demand for exports from advanced economies is likely to remain soft, at least in the near term, and will continue to be a headwind for domestic activity. Indonesia has been a big exception to the slowdown its economy is much less export driven and it has maintained very solid growth. Overall, however, our 2012/13 Asian growth forecasts are largely unchanged. Persistent inflationary risks present a difficult situation for policy makers, facing the potential for stagflation in an uncertain global environment. Inflationary pressures have generally eased across the region, although to varying degrees, but risks from elevated commodity prices (particularly oil) may limit the potential for policy easing if needed. In this edition, we continue our examination of the Asian Tigers international financial linkages and the potential risks from a sudden capital withdrawal. The most immediate risks stem from European bank deleveraging, but the more remote risk of a sudden confidence shock escalating into a destabilising withdrawal of hot money would be more of a problem were it to occur. Overall, Asian Tiger economies should experience less financial disruption from deleveraging than other emerging economies, particularly emerging Europe. However, European bank participation is still large enough in most countries to cause significant disruption to Asian credit markets. More broadly, Asian economies remain vulnerable to capital fluctuations, albeit less so post Asian Financial Crisis thanks to improved capital management policies.

Commodity price pressures could become a concern

Key components of demand in Tiger economies % yoy

Asian Tiger Economies Regional GDP

Table: Growth Forecasts

Average annual GDP growth (%) 2012 2011 Hong Kong 3.5 5.0 Korea 3.1 3.6 Singapore 3.3 4.9 Taiwan 2.5 4.0 Indonesia 6.4 6.5 Malaysia 4.1 5.1 Philippines 4.0 3.7 Thailand 4.9 0.1 Asian Tigers 4.2 4.0 Memo: World 3.7 3.2 China 9.2 8.0 Source: Thomson Reuters, NAB 2013 3.6 3.5 4.1 3.6 5.9 4.5 4.1 4.5 4.2 3.7 8.2

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How vulnerable are Asian Tiger financial systems to another global crisis?
Since the start of last decade, emerging Asian economies have become an increasingly attractive destination for foreign investors. Strong growth in the region resulting in a large interest rate differential and significant improvements in financial stability since the Asian Financial Crisis have supported a shift in investor perceptions of the region particularly relative to more developed economies (Graph). Significant amounts of quantitative easing in developed economies over recent years have also helped to bolster the steady flow of capital into emerging Asian economies. While the availability of foreign funds has generally been beneficial to domestic economic growth, one of the drawbacks to large inflows can be the increased susceptibility to financial crises. The most immediate risk in this regard stems from Europes ongoing problems with sovereign debt which have disrupted financial markets and placed significant funding pressure on banks in the region. These factors combined with more stringent capital requirements have resulted in European banks undertaking a process of deleveraging that has sapped funds from other regions as foreign assets are sold off and overseas banking activities are suspended. Emerging Asian economies have generally experienced credit growth in recent years that has outpaced their economic performance (Graph). Although a continuation of this trend could create difficulties down the line, it also means that a disruption to funding availability could constrain economic growth in the nearterm. We started to see a reduction of foreign lending into the region over 2011, but precisely how vulnerable Asian economies are to foreign bank deleveraging is difficult to gauge. Simple and commonly used metrics of external vulnerabilities suggests the region is relatively well placed compared to other emerging economies, but a renewed global financial crisis would still cause significant disruption. Excluding China, foreign bank participation in Asian Tiger economies has remained relatively unchanged at around 50 per cent of outstanding domestic credit. Of this, euro-zone bank participation is currently at 7 per cent, down from over 10 per cent in 2008. This is broadly on par with the relative exposures in Australia and the United States, and well below that of the UK and Germany (Graph). Using this metric, emerging Asia is also relatively less exposed to euro-zone banks than other emerging economies. In their December Quarterly Review, the BIS reported euro bank participation in emerging Europe, Latin America and AME (Africa & Middle East) at 47.3 per cent, 17.1 per cent, and 13.7 per cent respectively. Unsurprisingly, Hong Kong and Singapore, the regions largest financial centres outside of Tokyo, have the largest exposure to European banks, although the majority of liabilities lie with countries outside the euro-zone (particularly the UK). Aside from foreign bank penetration, the BIS suggest a number of other metrics to gauge the vulnerability of an economy to a withdrawal of bank lenders. The first is the proportion of foreign bank claims that are in the form of cross-border loans (as opposed to local lending of banks with foreign affiliates) since this type of lending tends to be most volatile. On this measure, China, Indonesia and the Philippines are most at risk with cross-border lending accounting for more than half of total foreign claims. However, the proportion held by euro-zone banks is likely to be small. Exposure to short-term debt liabilities can also be a concern in the current environment if there is a risk that these loans will not be renewed. All of the Asian Tiger economies have a very high

Sovereign credit rating on LT debt more attractive

Increased dependence on credit growth

Foreign bank participation

Vulnerability to capital flight (BIS indicators) foreign bank claims

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proportion of short-term foreign bank credit; Thailand is the only economy with long-term liabilities of more than 50 per cent. There are signs that bank deleveraging, combined with the weaker growth outlook and investor uncertainty, are weighing on credit conditions in Asia. While we can take some comfort in the generally healthy financial position of banks in the region, the IIF emerging markets lending conditions survey indicates that banks in emerging Asia (15 banks included in the survey) have experienced a deterioration of funding conditions over 2011. Most of this deterioration stems from international markets, although the ECBs LTRO has helped to stabilise conditions more recently. Although a number of factors have contributed to the tightening of credit standards, the December survey asked senior loan officers additional questions on the contribution of financial strains in the euro area. Of the Asian banks surveyed, 67 per cent said that euro area strains contributed significantly to the deterioration. Nevertheless, foreign bank lending forms only part of Asias financial risks. A significant shock to confidence whether emanating from Europe or elsewhere could easily spark a sudden and disruptive withdrawal of other debt or equity capital; speculative short-term investments are likely to be the most sensitive to these events. Late last year we started to see signs of risk aversion driving hot money outflows from emerging Asian economies, including China, despite relatively high-yields and robust long-term growth outlook. The ASEAN 4 economies experienced a sharp reversal in portfolio flows in the September quarter, with the largest swings occurring in Indonesia and Malaysia. This followed a period of volatile, but persistent, inflows of portfolio investment since the global financial crisis. The outflows in the September quarter corresponded with a noticeable decline in equity values, while foreign holdings of central bank debt (and to a lesser degree government debt) have also fallen. It makes sense that these securities would be sensitive to foreign flows since the limited depth of financial markets encourages portfolio investment to shift primarily into government and central bank debt, as well as equity markets. In contrast, much of the capital flow volatility in the newly industrialised economies has stemmed from bank related and other flows (especially in the financial hubs of Hong Kong and Singapore), although net portfolio outflows have gradually picked up since late 2009 adding headwinds to equity markets. Although the degree of capital withdrawal has not quite reached GFC levels, and has started to ease, the impact of potentially disruptive flows in the future can be managed via a variety of policy tools. Most of the Asian Tiger economies have become more proactive in managing capital flows in the years following the Asian Financial Crisis, although the approach taken differs somewhat between countries. The first line of defence is a flexible exchange rate, as deviations from fair value can create market expectations that trigger disruptive speculative flows. In the event of a rapid withdrawal of hot money, lingering inflationary pressures could limit the potential for exchange rate depreciation, despite an apparent moderation in economic activity. This may facilitate a market perception of currency overvaluation, although large run-ups in foreign reserves suggest this is unlikely. While East Asian currencies have become more flexible, there has been a strong tendency towards the preservation of international competitiveness. In the post-GFC period, Thailand, Indonesia, Korea and Malaysia all experienced gradual FX appreciation, but accumulations of FX reserves might suggest that currencies remain undervalued. Most of the Tiger economies (excluding Hong Kong which employs a currency peg to the USD) experienced currency depreciation in the second half of 2011, although it was a fairly minor adjustment for most when compared to 2008.

Emerging Asia - credit conditions

Hot money flows appeared to reverse during 2011

Equity markets still holding up reasonably well

Real exchange rate indices 2007=100

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The accumulation of FX reserves in the region over the past decade provides a useful buffer to capital volatility. All of the Asian Tiger economies are thought to have accumulated enough foreign reserves to call upon if required to stabilise currencies and satisfy foreign debt obligations. In fact, traditional metrics used by the IMF suggest that reserves of ASEAN economies may be excessively large (Chart) this can create other problems in terms of inflation and the cost of sterilization. In contrast to long-term trends, over H2 2011 both Thailand and Indonesia experienced declines in reserves larger than those recorded during the GFC. During that period some Asian central banks intervened in USD markets to support local currencies that had come under pressure from an investor flight to quality. The most notable interventions came from Bank of Korea and Bank of Indonesia. Nevertheless, with market confidence improving since the start of the year, Asian currencies are appreciating once again, and reserve accumulation looks set to recommence. Finally, prudent monetary and fiscal policies can further help to contain capital volatility, although elevated interest rate spreads in the region and slowing activity will limit the interest rate response to hot money flows. As an alternative, capital controls and macroprudential policies have been used extensively by Asian Tiger economies to limit the risks. Although evidence supporting the effectiveness of macro prudential policies is mixed, the ability to target specific parts of the economy (eg asset prices) makes them an attractive alternative to traditional policy measures (see East Asian Update June 2011 for an examination of the use of these policies). Overall, Asian Tiger economies should experience less financial disruption from European bank deleveraging than other emerging economies, particularly emerging Europe. However, European bank participation is still large enough in most countries to cause significant disruption to Asian credit markets. In the event that contagion leads to an acceleration of capital withdrawal more broadly, swings in capital flows will have significant impacts on Asian financial markets, increasing volatility and causing fluctuations in exchange rates that could be detrimental to trade, domestic demand and inflation. That said, large savings (especially in China) means that Asian banks are generally well positioned to inject funding if necessary; capital adequacy ratios are high, returns are healthy and non-performing loans have declined. Similarly, large foreign reserves will provide some buffer, while any quantitative easing by developed economies would likely renew capital inflows to Asia.

Forex reserves can provide a buffer for capital withdrawal

But reserve buffers of EA economies are more than adequate

Overnight money market rate differentials

Central banks will remain cautious

Significant policy stimulus implemented during the GFC led to a period of rapid economic growth and surging inflationary pressures across Asia. In response to overheating concerns most central banks across the region shifted to a relatively tight monetary policy stance to rein in economic growth and normalise interest rates. However, this sequence of policy tightening appeared to take a u-turn toward the end of last year as slowing advanced economies weighed on exports and industrial activity. Regional supply chains were also disrupted towards the end of the year following severe flooding in Thailand, which further contributed to the slowing rates of production and uncertainty across the region. The upshot of weaker global demand has been a moderation in the inflationary pressures and some easing in the flow of hot money that had been such a concern for central banks. Inflationary pressures have eased since mid-2011 with headline CPI growth dropping to almost 3% yoy by February, which is well below both the pre and post-GFC peaks (around 8% yoy and 4% yoy respectively). Most of the easing in inflationary pressures

Asian Tigers CPI inflation

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stemmed from lower soft commodity prices, although we have also started to see some modest pass through of disinflation to the broader economy; core inflation has eased to around 2% yoy from a peak of slightly over 3% yoy in July 2011. Despite an easing CPI inflation across most of the Asian Tiger economies, the degree of easing varies significantly between countries. Indonesia has experience the most notable softening of inflationary pressures, with headline rates falling to around 3% yoy in February from a peak of around 7% yoy early last year. However, proposed changes to fuel subsidies had raised concerns over the potential impact on prices in the broader economy; the most recent BOI consumer survey suggested that the anticipated subsidy change had boosted consumer price expectations across the board. Other central banks in the region remain cautious of ongoing elevated inflation expectations. Inflation in Singapore has been particularly sticky, with headline inflation merely levelling out to be amongst one of the highest in the group (4.6% yoy in February). With disinflation largely restricted to housing and commodities, Singapores core inflation has continued to track higher thanks to tight labour market conditions. One significant concern to the inflation outlook is the effect of very high energy costs. Supply-side concerns stemming from geopolitical tensions and production outages, as well as robust demand from non-OECD economies, have combined to prop up global seaborne oil prices. While higher oil prices may benefit net exporters such as Malaysia, consumers are likely to continue feeling the pinch with oil prices remaining at very elevated levels since the start of the year. Even in Asian countries where prices are subsidised by the government (such as Indonesia), strains on public finances and/or refiners profit margins have increased the necessity for oil price hikes. Indonesias plan to raise subsidised fuel prices in April was met by significant public protest, and has been postponed for the time being. Persistent inflationary risks present a difficult situation for policy makers, facing the potential for stagflation in an uncertain global environment. Industrial production, which had come under significant pressure from soft demand in advanced economies and supply disruptions (due to the Thailand floods) has improved recently but remains quite subdued. The recovery in Thailand has progressed relatively nicely with private consumption and investment surpassing pre-flood levels. Recovery has been particularly pronounced in the autos sector, which has benefited from significant pent up demand both domestically and abroad (continuing on from the disruptions following Japanese disasters earlier in 2011). Similarly, the more open economies of Korea and Taiwan have started to see their manufacturing sectors stabilise. The HSBC/Markit PMIs for both Taiwan and Korea improved in March to 54.1 and 52.0 respectively (up from 52.7 and 50.7 the previous month). Outcomes greater than 50 point to an expansion in manufacturing activity in the near-term. Hong Kongs economy wide PMI was also positive at 52 for March, the third successive month. The prevailing headwinds to growth and inflation late last year halted the tightening cycle in most Asian Tiger economies, while Indonesia and Thailand made a number of cuts to policy rates. With Thailands reconstruction underway and supply disruptions slowly being resolved, the need for dramatic policy cuts may have been reduced in the expectation that domestic demand conditions should improve, or at least stabilise. Nevertheless, most central banks remain cautious about the growth outlook, and continue to acknowledge the host of downside risks. The Thai central bank has cut its policy rate by 25 bps twice since October, but at 3% it is still very low and close to zero in real terms. Part of the reason for accepting such a low rate has been the need to mitigate the

Asian Tigers Headline CPI inflation

Asian Tiger industrial output and exports

Policy interest rates in the Tigers

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economic damage caused by the Thai floods. However, the continuous improvement in the Thai economy over February suggests little need for further loosening, and the BoT judge the overall economic stability in Thailand to be sound. Indonesia cut its policy rates several times from 6% last September to 5% in February, but has held it unchanged in recent months. The Bank of Indonesia have stated that the balance of risk shows the growth trend to be downward bias due to the impact of the global economy and government policy. However, solid growth in domestic demand, combined with the economic growth in the US and renewed (albeit wavering) confidence in the European handling of sovereign debt issues, have helped remove some of the downward bias. Nevertheless, the central bank are confident that CPI inflation will remain within the target band of 4% +/- 1% -- looking through potential distortions from fuel subsidies suggesting interest rates are likely to remain on hold. In contrast to our Taylor rules, the central bank is unlikely to commence aggressive interest rate normalisation any time soon. Elsewhere, central banks in South Korea, Taiwan and Malaysia have sat on their hands to see if global financial markets settle and the world economic outlook improves (as we expect it to). Although this is exactly what they started to see early this year, they remain mindful of the downside risks, and markets uncertainty has come creeping back more recently. The Malaysian central bank remains worried about subdued growth in advanced economies, despite recent improvements, but are confident that the domestic economy remains strong enough to drive the expansion of the Malaysian economy. They also note a number of potential upside risks to inflation stemming from supply disruptions and high commodity prices. Overall, this suggests that it may maintain the currently low 3% policy rate in the near-term, although our Taylor rule suggests the need for a slight policy tightening to address the potential lack of spare capacity. South Koreas central bank is also monitoring events very closely, but felt that the economy had started to stabilise in February. However, despite an improved PMI in March, trade outcomes were soft for the month, and CPI inflation eased below the central banks 3% mid-range target (although probably due to temporary factors). Although inflation expectations are persistently high, for now this is offset by the downside risks to the economy stemming from soft external demand. Consequently, policy rates will remain on hold in the near-term. Currency movements are the other mechanism through which regional central banks operate monetary policy. The Singapore central bank actually targets a trade weighted exchange rate index. The Indonesian central bank does have a policy interest rate but it also puts a lot of emphasis on the role currency movements can play in getting inflation into its target range. As the chart opposite shows, there has been quite a lot of variation between the Tiger economies when it comes to movements in the broadest measure of their currencies the trade weighted index. Most had experienced a general downward trend in exchange rates in H2 2011, partly driven by portfolio adjustment by foreign investors. While this trend has continued in some countries, such as Indonesia, improving economic data in Asia and the US in recent months, and the stabilising measures taken in Europe, helped bolstered investor optimism and exchange rates in Taiwan, Singapore and Malaysia. Singapore is likely to continue with its current pace of currency appreciation in the near-term, but concerns over persistent inflation may encourage a shift to more rapid appreciation (steeper slope) in coming months.

Taylor rules point to further tightening

Real policy interest rates and economic growth - average

Nominal exchange rate indices Jan 2007=100

Overall, recent policy announcements suggest many central banks consider the international economic environment to have improved marginally of late. However, we do not expect to see the regions central banks resume their process of interest rate normalisation until the global economic recovery becomes more entrenched and there is more certainty over how events will unfold in Europe. While there is a risk of renewed inflationary pressures, these are more than offset by the downside risks to the global outlook.

For more information, please contact James Glenn 0392088129

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Supplementary Charts
Growth in Outstanding Credit Capital Goods Import Values

House Price Indices

Construction Indicators

Asian Tigers Retail Sales Volumes

East Asia Producer Prices

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