Asia: Limited Re-coupling Ahead

AXJ growth trend has held up very well so far. Despite a slowdown in the US over the past few quarters, AXJ has maintained its strong growth trend until recently. During 3Q97, AXJ growth remained close to its highest levels seen since the Asian crisis, at 9.0%. China, India, and the ASEAN region have been supporting this accelerated growth trend, which, particularly in the past four quarters, has been driven by accelerating domestic demand even as external demand has slowed. However, we believe that AXJ will face the real test during the first quarter of 2008 as the US dips into recession. We believe that the market may first be surprised on the downside as the growth trend slows in AXJ in 2008 (limited re-coupling) before it builds the conviction for soft decoupling.

Limited re-coupling in 2008. Our US economics team expects US GDP growth to slow to 0.5% YoY in 2H08 from 2.6% YoY in 2H07. Our full 2008 estimates for the US now stand at 1.1% YoY compared with 1.8% YoY estimated earlier. Similarly, we have recently cut our 2008 growth forecast for Europe to 1.6% YoY from 2.0% YoY estimated earlier. For Japan, we now estimate 0.9% YoY growth in 2008 versus 1.9% YoY earlier. We believe that AXJ growth will slow significantly, to around 7% YoY in 2H08 from around 9.0% YoY in 3Q07. This would be significantly less severe than in the 2001 recession, when AXJ growth decelerated to 3.9% YoY in 2H01 from a peak of 8.1% YoY in 1H00.

Five Reasons Why AXJ Should Cope Better with a US Recession in the Current Cycle

First, major strengthening of AXJ’s balance sheet over the past few years. AXJ’s balance sheet is in very different shape now than it was in 1997-1998, as evident in the trend on FX reserves and external debt. While external debt to GDP has declined to 19.8% as of 4Q06 from 33.7% in 1Q99, foreign exchange reserves to GDP has increased to 42.3% as of Sep-07 (US$2.7 trillion) from 22% in 1Q99. As a result, AXJ’s surplus liquidity stock (stock of liquidity sterilized through issuance of bonds and cash reserve ratio hikes) has increased to about US$1,365 billion (23.9% of GDP) as of Aug-07 from US$544bn (13.5% of GDP) in Aug-04. This excess liquidity merely reflects relatively weak credit cycle, implying that the financial leveraging in the real economy is also manageable in this cycle. Most countries in the region have now cleared up the banking sector nonperforming loans (NPLs). Except for India, most of the countries in the region have seen a steady decline in their credit-deposit ratio to 74% as of Sep-07 compared with 85.2% in Sep-99.

Second, external slowdown may not be as severe because in the rest of the world (excluding US and Europe) export growth is not likely to slow very sharply. Indeed, while growth in AXJ exports to the US has slowed sharply, to 1.2% YoY in September 2007 (from 13.2% YoY in 4Q06), exports to the rest of the world (excluding US and Europe) have remained relatively stable, up 16% YoY (versus 20% YoY growth in 4Q06). While we expect a further slowdown in external demand as the US growth trend deteriorates, the downside may not be as severe as witnessed in 2001 with support from rest of the world.

Moreover, we believe that domestic demand growth will be relatively stronger in the current cycle. All three components of domestic demand – private consumption, investments, and government spending – are likely to fare better in 2007 than in 2001.

Third, private consumption growth has been relatively strong in the current cycle, even as external demand is slowing. Indeed, private consumption for the AXJ (ex-China) has accelerated to a 30-quarter high of 5.5% in 3Q07. While quarterly GDP expenditure data for China are not available, we believe that the consumption trend is similar in China.

Fourth, capital expenditure trend is decoupling from exports. In the past, AXJ capex was highly correlated with exports, and capex was the only driver of domestic demand. In the current cycle, capex growth will not decelerate as sharply due to demand for investments to feed improved private consumption growth and construction/infrastructure needs.

Fifth, fiscal policy has enough room to respond to a sharp external slowdown. Public debt to GDP for the region has also declined significantly from post-crisis highs. The fiscal deficit was just 1.5% of GDP in 2006, versus the peak of 3.2% in 2001. In the event of a sharper external slowdown, governments will likely increase public spending. Independently of the external environment, some countries are already witnessing a pick-up in government spending due to elections and/or changes in government.

Don’t Ignore the Risks of Financial Market Linkages

The key downside risk to our outlook is the potential for major turbulence in US equity markets. In the past few years, globalization of financial markets has meant that we cannot ignore the possible transmission of growth shocks through financial market linkages. This point has been well enunciated in the IMF’s World Economic Outlook Report, April 2007. The report highlights that since the 1970s, cross-border financial linkages have increased significantly, with gross external assets of industrial countries rising from 28% of GDP in 1970 to 155% in 2004. Over the same period, gross external assets of emerging market countries increased from 16% of emerging market countries’ GDP to 57%. Not surprisingly, Asian financial markets have remained coupled with the US financial markets so far. During 2000-06, the average correlation between MSCI Asia Pacific Ex-Japan and MSCI US was 72.6%.

We believe that the growth trend in AXJ will see limited re-coupling in 2008. While we concede that there are downside risks to our view, we believe that the AXJ economies are in much better position to face a US slowdown in the current cycle than they were in the 2001 cycle. The key risk to this outlook is the potential for significant turbulence in the US financial markets to spread to Asian financial markets.

By Chetan Ahya Singapore
Morgan Stanley
December 16, 2007