The Importance of Local Factors

It’s not all about Europe

While it is difficult to discuss the region’s economic outlook without taking into account Europe’s sovereign and banking stress and potential massive fiscal consolidation in late 2012， it is also crucial to take into account local factors in Asia. Asian policy makers， both central banks and governments， are guided primarily by domestic developments. Understanding domestic dynamics is also critical to establishing relative value trade ideas within the region.

There are three key areas to highlight. First， Asia’s export slowdown in H1-2012 is expected to put pressure on consumption growth in H2， especially in export-oriented economies. This could hold back overall growth momentum(Figure 1). Second， China’s latest stimulus programme is expected to be positive for North East Asia and ASEAN， but the impact is likely to be felt only in late 2012. Third， despite the shortterm slowdown in consumption， mediumterm inflation concerns–especially arising from strong lending growth in some economies–could persuade Asian central banks to keep monetary policy on hold instead of loosening in anticipation of fallout from the West.

Consumption growth moderates

Consumption growth has been an important growth driver for Asia since the global financial crisis， although it is not sufficient to fully offset the negative effects of a weak US and Europe on export-dependent economies. Asia’s strong labour markets， in terms of both employment and income growth， have been crucial to maintaining consumption growth in the region. Then there is the positive wealth effect from local residential real-estate and equity markets. Some markets， such as Hong Kong and Singapore， have seen material property price increases， creating a positive wealth effect for homeowners. Equities had a positive wealth effect on consumer spending across Asia in Q1-2012， particularly benefiting high-income economies such as Hong Kong， Singapore， Taiwan and South Korea， where household ownership of equities is more widespread.

Looking ahead， we expect consumption growth to stay positive but to decelerate somewhat. Job growth is holding up， but weaker external demand is likely to temper income growth in the region. The Q2 equity-market correction could also dampen consumer spending in highincome economies. As Figure 2 shows， retail sales have already slowed in Hong Kong (where they also serve as a proxy for consumption by wealthy tourists from mainland China)， Singapore and Korea.

China is doing the heavy lifting again

With the US and Europe failing to help Asian exporters， China is widely expected to come to the rescue once again. Beijing’s desire to avoid another fiscal stimulus on the scale of its 2008-09 package， which was blamed for contributing to asset bubbles and inflation， suggests that this one will be smaller and more disciplined. In the absence of an explicit announcement on a new fiscal stimulus， we are tracking the fiscal impulse， long-term loan data and project starts to gauge the impact of the spending programme on the economy.

We see this as modestly positive for Asian exporters， although we do not believe China can completely offset weak demand from Europe and the US. In 2008-09， two groups –North East Asian economies and commodity-exporting economies – benefited the most from China’s stimulus programme， and we expect the same this time. North East Asian economies – Hong Kong， Taiwan and Korea – stand to gain from strong Chinese demand given that exports to China make up 25-52% of their total exports(Figure 3).

Commodity exporters – including Indonesia， Malaysia and， to a lesser extent， Thailand –also stand to benefit. China is likely to step up its commodity imports when the stimulus kicks in， providing a direct boost. These producers， which have suffered from negative terms of trade in commodity prices so far in 2012， will also benefit indirectly from the positive price impact of China’s increased demand for commodities. Given that we expect the effects of China’s stimulus to become visible in late Q3， the impact on Asian growth is likely to be felt only in late Q3 to early Q4. Hence， the additional boost to 2012 growth is likely to be modest.

The long and short of Asian central banks

Monetary policy is appropriate for now

Based on our discussions with Asian central bank officials， we make two observations on the regional economic outlook: (1) Asia’s H1 growth slowdown is manageable， and was largely the result of policy tightening in 2010 and 2011. In fact， some officials welcome the deceleration because it mitigates overheating risk. (2) Europe remains the biggest source of external risk given Asia’s exposure to the region via trade， financing and capital flows. However， given the high degree of uncertainty surrounding political and economic events in Europe， it is difficult for Asian policy makers to set policy based on a particular outcome in Europe.

Hence， most Asian central banks are likely to adopt a wait-and-see approach. Most see their current monetary policy stance as appropriate for the level of economic activity， which has moderated since a year ago. While most monetary authorities fear downside risks from Europe (as highlighted in monetary policy statements from around the region in recent months)， they are also watchful of medium-term inflation risks at home.

One eye on inflation risk

Inflation has been less of a concern in recent months. The spike in oil prices in Q1 triggered by geopolitical tensions in the Middle East and expectations of an economic recovery in the US gave way to a sharp correction in Q2 on renewed concerns about a global recession. Falling energy prices， combined with stable food prices， have helped to moderate headline inflation in low- to middle-income economies including China， Indonesia， Malaysia， the Philippines and Thailand(Figure 4). Headline inflation has returned to the level seen in 2010， before the food-led surge in consumer prices.

However， inflation momentum persists in Hong Kong and Singapore due to the lagged effect of housing cost increases. Singapore’s rising transport costs， the result of price increases for vehicle Certificates of Entitlement (CoEs， or ownership permits)， have also contributed to high inflation there. In India， stubborn inflation forced the Reserve Bank of India to keep its policy rate and reserve ratio unchanged on 18 June， despite market expectations of easing.

Some central banks in the region are also watching strong lending growth， even as deleveraging forces continental European banks to reduce exposure to the region. In particular， loan growth in Indonesia， the Philippines， Malaysia and Singapore is still high (Figure 5)， implying that their central banks will be unable to loosen monetary policy significantly from current levels for fear of fuelling medium-term inflation risks. This convinces us that unless there is a credible and sizeable threat to the growth outlook， most Asian central bankers should be content with their current monetary positions for the remainder of 2012.

In search of relative value via local factors

The global environment is critical to Asia given the region’s high exposure to exports. However， we believe domestic factors are crucial in determining relative economic performance –which is critical for investors seeking relative value opportunities， and for corporates faced with investment and resource allocation decisions.

China and India both have sizeable domestic demand bases and should therefore be relatively insulated from global economic challenges. This is particularly true for India， whose exports-to-GDP ratio is among the lowest in Asia.

While growth in both economies moderated in Q1-2012， the policy reactions were markedly different. China has loosened liquidity and cut interest rates， and we believe fiscal stimulus is imminent. Although the scale of this stimulus is unlikely to match the spending seen in 2008-09， it is important to reinforcing confidence in China and across the region.

Meanwhile， India’s large fiscal deficit will constrain fresh spending or tax cuts. Stubbornly high inflation， which we believe is the result of structural issues such as poor infrastructure， has prevented the Reserve Bank of India from loosening monetary policy and boosting growth.

Another pair of countries worth watching is Indonesia and the Philippines. Indonesia’s economic fundamentals are robust， with firm consumption and investment supporting headline growth. Less favourable terms of trade due to falling commodity prices are likely to be a temporary setback. Of greater concern is the government’s U-turn in late March on hiking subsidised fuel prices， which raised concerns about policy credibility. In addition， the temporary shortage of USD liquidity in late May has prompted investors to review Indonesia’s medium-term political and policy prospects. We remain positive on the Indonesia story， but it will take a concerted effort by the government and central bank to re-establish the credibility that has attracted international investors for the past two to three years.

In contrast， the Philippines is returning to the radar screens of corporate and portfolio investors. Its relatively low exports-to-GDP ratio implies that the economy is resilient to global uncertainty. Overseas worker remittance flows were remarkably stable during the global financial crisis， supporting the current account and domestic consumption. Meanwhile， the Aquino administration has been pushing ahead with government and economic reform programmes.

Rating agencies have recognised such efforts. SP and Moody’s upgraded their sovereign rating outlooks on the Philippines to positive from stable in December 2011 and May 2012， respectively. We believe the Philippines could achieve investment grade in 2014 at the earliest by pushing ahead with fiscal reform and boosting investment. International investors are embracing the Philippines – foreign net purchase of local equities continued to rise in Q2， despite global concerns. This compares favourably with the rest of the region， including Indonesia， which saw foreign net selling of equities across the board in Q2-2012 (Figure 6).