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With liquidity tightening and likely slowdown in the US, Asian economies are yet not resilient enough to sustain themselves
Rohit Chawdhry

The latest issue of World Economic Outlook by IMF can best be termed as hopelessly optimistic. The apex institution is forecasting a world growth of 4.9 per cent for 2006 after two back-to-back years of strong growth (see table 1, IMF Hopelessly Optimistic)
With likely events (or financial crisis) such as a sharp slowdown in US housing, an emerging market or a combination of both, it is likely that the world growth for 2006 is likely to be closer to four per cent than five per cent, which is what the IMF is forecasting. Correspondingly, the economic growth for developing Asia is likely to be closer to 6.5 per cent than eight per cent for the same period. Also, economic growth rates for 2007 are likely to centre around 3.5 per cent and 5.5 per cent for the world and Asia.

Discerning readers would find the argument difficult to digest without any evidence. To tackle this problem let us first analyse why there could be a financial crisis in the first place. Our model shows the following. Historically, all significant interest rate tightening cycles by the US Federal Reserve (of 150 basis points (bps) or more) have been accompanied by market dislocations or financial crisis (See Table 2, As Fed tightens, Financial Crisis lights (up))

But what could be the event risk or financial crisis? The biggest one of them all is the sharp slowdown in US housing, an event which has already started to unfold. This is the most important as it has kept the US consumer going and hence Asian exports buoyant for the last ten years. American incomes have been insufficient to finance consumers’ robust spending, so they have relied on the equity in their houses to support higher borrowing and lower saving – the wealth effect. The S&P Home Builders’ Index is down close to 40 per cent from the peak levels seen in Oct-Nov’06. Financial markets which usually lead the economic activity by six-nine months are sniffing weakness in the months ahead.

Any signs of stress in this key sector implies a capitulation of the US consumer (not to forget that high energy prices have already punched a hole in his pocket) and also significant setback for Asian exports. The key point is that trade links are important in transmitting from the US to the rest of the world, including Asia, and more importantly, China.

How serious is the slide in the US housing market? Consider the following. US home builders were even more pessimistic in June, with the NAHB survey (US National Association of Homebuilders) continuing its eight-month slide. Housing demand is drying up as mortgage rates climb and speculators are retreating as price expectations have crested. It is taking longer to sell a house these days. Inventory – the number of homes for sale – spiked 37 per cent for the 12 months through April 30, the most recent data available. Homes are staying on the shelf longer. At the same time, the rate of sales has slowed, so that there is now six months worth of supply, up from 4.1 months a year ago.

Finally, late payment on mortgages have risen by 29 per cent. Housing sector is a lea-ding indicator for the US economy and does so by three quarters ahead. This sector peaked in Oct-Nov of 2006. This implies that US growth for the second quarter is likely to be around 2.5 per cent rather three per cent expected by most economists (first quarter was around 5.6 per cent).

Further, the financial markets, or more specifically the US dynamic yield curve. A flat or slightly inverted yield curve shows an 88 per cent probability of a recession sometime between now and the end of next year. Of the past ten tightening cycles by the Fed, only two resulted in a soft landing (without recession). What about Asian growth rates?

Is US housing the only risk to the world and Asian growth rate? Possibly no. There are risks to the Eastern European economies of Hungary, Poland and Turkey, all of which are showing signs similar to Asian economies prior to the crisis period of 1997. Take for instance Hungary and Turkey, with current account deficits to GDP in the region of eight per cent and 6.5 per cent respectively. The current turmoil in Iceland and New Zealand could soon transfer to a much wider set of countries with large current account deficits and at risk of a sudden stop, e.g Turkey, Hungary, Australia, New Zealand, Spain and the US.

Indeed, with the exception of Russia that did not have a current account deficit in 1997-98, every financial crisis in the emerging market economies in the last decade (Mexico, Thailand, Indonesia, Malaysia, Korea, Brazil, Argentina, Ecuador, Turkey, Uruguay, Domi-nican Republic) had been associated – among several other vulnerabilities – with a large current account deficit that led to a sudden stop when a combination of domestic and external shocks hit the economy.

But surely, Iceland or Hungary aren’t important to Asian growth or its financial markets? Think again. In a globalised world, where all the economies are locked in, risk appetite is also locked and an event impacting distant Iceland could have an impact globally as the event becomes a contagion. Some suggest that since Asia is running current account surpluses and not deficits, financial events cannot impact these economies.

But consider the following: In 1997, when the Asian crisis hit Thailand, Singapore and Taiwan were two countries in the region which were running current account surplus. Yet, their currencies and economic growth took a hit. Singapore, as matter of fact, was running a current account surplus close to 16 per cent, yet its dollar got singed. It depreciated by seven per cent in sympathy with its Asian brothers. The point is, in an era of globa-lisation, boom-bust cycles have become more synchronous and events unfolding elsewhere in the world do have an immediate impact on both financial markets, consumption and economic growth as the wealth effect kicks in.

And why won’t we see a repeat of the 1997-1998 debacle among the Asian Tigers? They are more export-dependent now than in 1996. Short-attention-span hedge funds are now more involved in their markets. And, if things start to somehow unravel, foreign investors will recall their big 1997-1998 losses and want to beat the crowd out of the door. Does this imply that the structural theme of Asia is long gone? No. On the contrary, the strength of a region is determined by the crisis it goes through and the speed by which it is able to come out of it (refer to Asia’s Gold By Marc Faber – a classic and a must read). Make no mistake, this is Asia’s century, but like the US, which suffered enormous setbacks while getting industrialised in the 1900s, Asia will have its share of problems. But it is more likely to recover fast. So expect V-shaped recoveries after crisis periods.

Can India and China avert such a scenario? Unlikely. Contrary to the views of many, developing countries, including China and India, have not yet gained a big enough middle class to spawn domestically driven – as opposed to export-driven – economies. The middle class kingdoms of both the countries have seen significant growth over the last decade (see Chart Middle Class Kingdoms – India & China).

While more than half the population in China falls under the middle class definition, for India it is about a quarter. However, accor-ding to estimates, this is likely to rise to 84 per cent and 47 per cent by 2015. That’s a significant jump. But, as of now, the threshold level for cushioning the impact of a recession caused by global event risk is unlikely in these two economies and the rest of Asia. With the next global recession, probably initiated by a US house price collapse and fall in American consumer spending and imports, we will see who is right on the Chinese domestic-led growth argument. Bottomline: Asia is not yet ready to take over from the US as the main source of economic growth.

Further, China itself is trying to slowdown economy and property market at its end. China could raise its deposit interest rate by 27 bps before August and another 27 bps before year-end. The Fed is raising interest rates fast and high enough to create room for China to raise its interest rate, despite the expectation that the renminbi will appreciate. That’s not growth supportive for Asia in the short-run. In the next few months, it is unlikely that we will get clarity on the US trio of rates/growth/ inflation, and certainly worries will persist regarding the eventual consequences of a weaker US economy on Asia.

The author is portfolio manager, Oxus investments, new delhi, india.
Tel: +091 9899048845 Email: rchawdhry@gmail.com