Remain cautious in East Asia

by Levi Folk | February 26, 2007

Far East equity markets have been riding high since 2003 in step with the global economic boom. Economic prospects are very compelling, driven by the rapid industrialization of China, making these markets tremendous long-term investment opportunities. However, suggestions that they are immune to global economic disruption and could sustain themselves are premature. Investors should expect markets to correct in the event of a concerted economic downturn in the developed world.

The economies of emerging East Asia grew about 8% in 2006, and with the strong growth of recent years, economic fundamentals have improved. Gone is the massive dollar-denominated public debt that hung over regional economies leading to the Asian financial market “crisis” in 1997. Central government debt is below 50% of GDP, with the exception of the Philippines, according to the World Bank.

Fiscal accounts are well within the limits of acceptable borrowing and inflation is mostly under control. Interest rates were raised, generally, since mid-2004 and have stabilized in sympathy with slowing inflation.

Governments have been rewarded in lower borrowing costs—only 200 basis points over developed-market debt, versus the 1,000-basis-point-plus premium of the 1990s—and in higher equity market valuations and strong returns.

A popular argument making the rounds is that the economies, and hence the stock markets, of emerging East Asia are now less reliant on global trade, thus making them less exposed to a global economic slowdown. Statistical support is provided by the World Bank: 44% of exports in East Asia that are interregional.

Furthermore, in the event of an export-led economic slowdown, governments of emerging East Asia now have policy tools at their disposal to boost domestic demand. Lower inflation means central bankers could cut interest rates and near-balanced budgets means finance ministers could boost spending to increase growth and maintain corporate profitability.

This has not been the case in past economic downturns in the developed world: When the U.S. economy sneezed, Asian financial markets developed a bad case of flu. The U.S. economy slowed considerably in 2000, and its trade balance temporarily improved in the ensuing two years due to slowing imports. Not surprisingly, the economies of East Asia slowed, to less than 2%, excluding China, and equity markets weakened, suggesting the diversification benefits of emerging markets are overstated.

There are good reasons to expect a severe hangover, not a lighter one, for Far East equity markets should the economies of the developed world slow.

Firstly, the increase in interregional trade is deceiving, even misleading, if one concludes the region is shielded from changes in developing countries’ economic growth.

The increase in trade between countries in the Far East is a result of—not incidental to—strong trade flows between China and the United States. World Bank data bears this out: Nearly two thirds of intra-Asian exports find their way to outside markets, 14% go to Japan, 25% to the United States and 22% to Europe.

Cheap labour has led China to establish itself as the regional assembler of manufactured goods destined for the U.S. market. The inputs to the manufacturing process are now shipped to China from other countries in the region. Computer components may be produced in Malaysia, for example, and then shipped to China with the ultimate destination being the United States.

So a slowdown in the United States would affect trade and financial markets in the Far East, much as they did in 2000.

The second and perhaps bigger problem for financial markets in the emerging world is that a U.S. slowdown would cut imports and the flow of dollars overseas. The U.S. trade deficit has been a major source of cheap credit globally as U.S. dollars shipped to China are reinvested in the U.S. bond market by the Peoples Bank of China (foreign exchange reserves top US$1-trillion in China alone and exceed US$2-trillion regionally).

Low rates have stimulated borrowing in low-risk securities and the destination of those funds are such less liquid markets as emerging Asia. Hedge funds are undoubtedly feeding at this trough, but data suggests ordinary investors are investing in riskier emerging market equities, too.

U.S. investors put US$14-billion on a net basis in emerging markets in 2006, increasing the total invested to a record US$102.7-billion by year-end, according to the Investment Company Institute.

As a side note, foreign exchange reserve accumulation in the interests of stemming currency appreciation is inflationary and partially explains the stock market bubble that appears to be inflating in China.

A slowing U.S. economy and an improving U.S. trade deficit would also likely coincide with a contraction in global liquidity, which means the riskiest money would come off the table first, undoubtedly affecting East Asian stock markets.

With rising regional valuations and equity gains partially based on increased market leverage, the risks of investing in the emerging markets of Asia are still pronounced for equity investors. Economic fundamentals are generally improved, but developed markets still affect outcomes in the region perhaps as they did in the past.