Asia-Pacific Economic Outlook: Risks Abound, Led by China's Financial Sector

Asia-Pacific Economic Outlook: Risks Abound, Led By China's Financial Sector
Credit Market Services: Paul F Gruenwald, Asia-Pacific Chief Economist, Singapore, Singapore (65) 6216 1084; paul.gruenwald@standardandpoors.com Secondary Contact: Vincent R Conti, Singapore (65) 6216 1188; vincent.conti@standardandpoors.com
Table Of Contents
Growth Momentum Moves Toward The Smaller, Open Economies Too Early To Worry About Inflation And Monetary Policy Action Moral Hazard In China: Exit Financial Repression, Enter Financial Risks Japan Post-Consumption Tax Hike: So Far, So Good Politics Front and Center In Two "Fragile" Economies Can A More Leveraged Asia Digest Fed Rate Rises? A Relatively Shaky Baseline Appendix: Country GDP Growth
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Our baseline scenario for Asia-Pacific economic growth is boring. It remains on a steady track, at least at the aggregate level. For the region as a whole, real GDP is likely to grow at 5.4% in 2014 and 2015, in our view, identical to the outturn in 2013 and broadly unchanged from our forecast in November last year. Of course, there is some variation. Growth in the two largest economies--China and Japan--is set to moderate, albeit for differing reasons. And we see growth in the more open and trade-dependent "Tiger" economies (Hong Kong, Korea, Singapore, Taiwan) rising this year and next as global trade flows improve on the back of stronger U.S. and European performance. We are also forecasting a bounce in India's growth, assuming that a strong mandate emerges from the ongoing elections. In contrast, our thinking on risk scenarios has changed quite a lot over the past few quarters. Specifically, we have moved the timing of our Chinese financial sector risk scenario, which used to be in the medium term (and beyond our forecast horizon) into the next one-to-two years. This is because the authorities appear to be laying the groundwork for addressing widespread moral hazard problems in the credit market. We also continue to see risks from U.S. monetary policy normalization as well as politics in South and Southeast Asia. Putting this all together, we now see the balance of risks to our baselines as tilted to the downside. OVERVIEW We forecast growth for Asia-Pacific region to remain steady at 5.25%-5.5% over the next 1-2 years. although this masks moderating growth for the two largest economies: China and Japan. The outlook has improved for the U.S. and, to a lesser extent, Europe, suggesting Asia-Pacific's more trade-dependent Tiger economies should outperform; we see a bounce in growth for India as well. We have raised the probability of our downside scenario, reflecting rising financial sector risks in China; further ahead we think the effects on Asia of U.S. interest rate normalization bear watching.
Growth Momentum Moves Toward The Smaller, Open Economies

Our baseline macroeconomic scenario for Asia-Pacific has not changed much since late 2013. We see GDP growth this year as being broadly unchanged from last year--below trend but reasonably solid. However, the steady overall pace masks a divergence between the growth paths of China and Japan (which together account for 60% of regional GDP) from that of the rest of the region. Our detailed forecasts appear in the Appendix.
Table 1
Standard & Poor's Baseline GDP Growth Forecasts

2014f Australia China India* 2.6 7.4 6.0 2015f 3.0 7.2 6.3 2016f 3.1 7.0 6.5
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Table 1
Standard & Poor's Baseline GDP Growth Forecasts (cont.)

Japan South Korea Hong Kong Indonesia Malaysia Philippines Singapore Taiwan Thailand Vietnam New Zealand Asia-Pacific Emerging Asia Newly Industrialized Economies ASEAN 1.3 3.5 3.6 5.6 5.2 6.6 3.7 3.7 2.7 5.5 3.1 5.4 6.3 3.6 5.1 1.2 3.8 4.1 5.8 5.6 6.0 3.9 3.9 5.1 6.0 2.5 5.4 6.4 3.9 5.7 1.2 3.8 3.6 6.0 5.7 6.1 3.5 3.8 4.4 6.3 2.5 5.4 6.3 3.7 5.7
*Fiscal year ending March. Regional aggregates are calculated as a weighted average using 2012 GDP measured in purchasing power parity terms.
China is likely to continue on its more moderate growth trajectory as policymakers attempt to steer the economy onto a more sustainable path; indeed the 7.4% growth in the first quarter was in line with this view, as well as the market consensus. In Japan, the effects of the increase in consumption tax appear manageable so far, but in our view continue to pose the largest risk to growth--and especially the fight against deflation. Australia has passed the peak of its investment boom, but exports should be able to provide decent growth in the short term as previous years' mining investments come online. India is in the midst of a period of sub-par growth, driven not only by structural rigidities but also by tighter policies implemented to combat inflation and capital outflows stemming from the market turbulence in mid-2013. The more export-dependent Tiger economies will likely see a pick-up in growth this year, given the improvements in the U.S. economy and global trade, as well as a modest improvement in Europe. Finally, the Southeast Asian economies' growth outlooks are increasingly driven by country-specific factors.
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Chart 1
Thailand is the one exception where we have significantly lowered our baseline forecasts. The political turmoil has gone on longer than expected, and there is little indication of what the end game might be. As such, we have lowered our growth forecast by 1.7 percentage points for 2014 to 2.7%, given the disruptions that the political situation is causing within the economy, and the negative effect it is having on confidence and investment.
Too Early To Worry About Inflation And Monetary Policy Action

We still expect inflation to remain under control across most of Asia-Pacific. Although improving external growth prospects will likely cause output gaps to narrow somewhat and inflation to tick up, especially in the Tiger economies, the sub-par growth of the past few years suggests that most economies are still operating below capacity. The Philippines may be the exception, having experienced rapid growth, driven by the business process outsourcing sector and the significant spillovers it has had on the rest of the economy. Japan and Malaysia will likely see higher inflation from consumption taxes. For India and Indonesia, tighter monetary policy enacted during the previous round of financial market stress will cause consumer price index (CPI) inflation to moderate. On the monetary policy front, we see very little impulse for policy makers to move interest rates in either direction
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over the year. Policy rates are still quite accommodative, growth is steady or improving, and inflation remains largely benign. The exceptions are the Reserve Bank of New Zealand, which raised its policy rate in March and April 2014, and the central bank of the Philippines, which raised the required reserve ratio of the banks in order to drain additional liquidity from the system. Meanwhile, the Bank of Thailand recently cut rates to provide support to the economy, which is hindered by political gridlock. In the rest of the region, India and Indonesia have tightened ahead of their neighbors, reducing the need to raise policy rates much further moving forward. The People's Bank of China will likely hold its main policy rate steady while increasing the relative importance of its open market operations within its policy toolkit. Already, it has extended its liquidity facilities to include small and medium banks, and lowered the reserve requirements for rural banks. Finally, we would not rule out the Bank of Japan increasing its rate of asset purchases to try to counter the effects of the consumption tax hike on disposable incomes and confidence should growth slow and prices start to fall again.
Moral Hazard In China: Exit Financial Repression, Enter Financial Risks

Our view on the timing of risks to Chinese growth has shifted. We now see an increased likelihood that the Chinese authorities may address the financial sector risks sooner rather than later. Under our baseline scenario, the fallout from such an event will be contained; but in a downside scenario the transition to a more risk-based financial system, including the reduction in moral hazard, could be disorderly. A source of the risk lies with the fast-growing class of credits outside of the banking sector: most notably, wealth management products (WMPs) issued by non-bank entities such as local government financing vehicles, property developers, and trust companies. The assets underlying these claims can essentially be anything. These products are sold through the state-guaranteed banks and promise returns that are much higher than WMPs issued by the banks themselves, making them very attractive to investors. Crucially, there is widespread belief in China that the state guarantee for the banks that distribute WMPs extends to these non-bank initiated products as well. This leads to moral hazard in the form of risks not being correctly monitored and priced. The result is an oversupply and underpricing of such risky products, as well as excess investment. Under our risk scenario, a credit event in the non-bank portion of the financial sector leads to market instability as perceptions of state guarantees unravel following a series of government-sanctioned defaults. This would initiate a turbulent period in which funding could dry up as the domestic market struggles to re-price risk across a spectrum of credit products. Even viable investments could struggle to be financed in such an environment. As a result, China's growth could fall sharply for at least a few quarters, led by investment. We note, however, that: (a) China's fiscal and monetary authorities will almost certainly step in strongly to try to mitigate the fallout from such an event; and (b) the self-financed nature of the system rules out a full-blown external or fiscal crisis. The effectiveness of the policy response would be crucial in determining the length and severity of such a credit event.
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Chart 2
This scenario will have significant spillover effects into the rest of the region as well. Economies that are highly exposed to China's investment demand stand to see the largest slowdowns. Specifically, in Hong Kong, Australia and most likely Taiwan (data are not available), capital or raw material exports to China account for large percentages of total exports--close to 40% for Hong Kong and around 25% for Australia. Korea, Japan, and the Philippines form the next tier, with China-bound capital or raw material shipments making up 10% or more of total exports. India is the least vulnerable, at 2.5%.
Japan Post-Consumption Tax Hike: So Far, So Good

Abenomics entered a critical period on April 1 when the consumption tax was increased from to 8% from 5%. On a fortuitous note, the economy was on fairly solid footing going into the tax hike. GDP growth has picked up in the past two years, and although the pace of activity slowed to just 1% on an annual basis in the fourth quarter of 2013, domestic momentum remains fairly solid. Importantly, inflation as measured by a number of metrics has turned positive and continues to rise, suggesting an opportunity to end two decades of more or less constant deflation. The consumption tax is necessary for longer-term fiscal sustainability but is being implemented too soon, in our view.
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The risk is that it puts a dampner on growth and reignites deflationary pressure in the economy. If this were to pass, then the Bank of Japan would need to take decisive action through expanding its balance sheet faster in order to further loosen monetary conditions. This would be needed in order to continue to keep inflation on an upward path and to continue to break the well-entrenched deflation mindset and anchor inflation expectations at around 2%. The preliminary data that have come out following the tax hike look encouraging. Sales at convenience stores and chain restaurants have been steady. And travel reservations for the upcoming Golden Week appear reasonably solid as well. Sales of discretionary, higher-priced items have softened as expected, but overall consumption momentum in the mass market seems to be holding up so far.
Politics Front and Center In Two "Fragile" Economies

Politics and geopolitics loom large in Asia-Pacific this year. These are inherently difficult to quantify, and can be seen as "known unknowns." National elections take place in two important countries in the first half of the year: India and Indonesia. Both countries were hit hard by financial market turbulence last summer, and saw their currencies weaken substantially and growth fall. The proximate cause of the sell-off, the large current account deficits, has narrowed and currencies have strengthened in the latest tapering related sell-off. At issue in both economies is the political will to tackle: (a) various fiscal subsidies that contributed to budget concerns as well as current account deficits; and (b) the friendliness of the investment regime, given that longer term, more stable flows are needed to credibly finance ongoing current account deficits. Indonesia's April Parliamentary elections, which have implications for May's Presidential election, provided mixed results. No party was able to reach the threshold of 25% of the votes needed to nominate a stand-alone Presidential candidate. The offshoot is that coalitions need to be formed to nominate candidates, with the risk of diluting the ability for policy maneuver once in power. India's six-week long election process has begun, with the opposition BJP party polling ahead so far. Elsewhere, the political stalemate in Thailand drags on and an escalation of the violence remains in play. A longer-term risk is that foreign direct investors change their view regarding the attractiveness of Thailand to do business; but recent survey data suggest that such a shift is yet to take place. Ongoing political developments in the Ukraine also bear watching. While the effects on Asian markets to date have been negligible, the situation remains fluid and spillovers cannot be ruled out.
Can A More Leveraged Asia Digest Fed Rate Rises?

Has the focus on U.S. Fed "tapering" been correct? We think that the potential spillovers from Fed policies need to be defined more broadly to include not just the reduction of asset purchases (known as tapering), but eventual increases in short-term policy rates. Taken together, these actions can be termed the normalization of Fed policy.
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Tapering, and expectations around tapering, has caused some market turbulence in Asia to be sure. But the effects have been limited in both scope (to two economies, India and Indonesia) and persistence (the selloff in mid-2013 was much more pronounced than the early 2014 sellout); see chart 3. We think that the region is reasonably well insulated to withstand any further taper-related selloffs, given that the current account imbalances that drove the outflows have narrowed substantially.
Chart 3
The larger, though less immediate, risk in our view is the effects of U.S. Fed interest rate normalization on Asia-Pacific. This is a story about rising debt levels and the exposure to rising interest rates and its effects on debt service. Debt levels have accelerated following the global financial crisis in five economies in emerging Asia: China, Hong Kong, Malaysia, Singapore, and Thailand. The risk is that many borrowers have short-term floating interest rates and will therefore see their debt-servicing costs rise, perhaps substantially, as the Fed normalizes its short-term policy rate to 4% from around zero at present. Current market pricing has this rise starting in mid-2015. At issue is whether borrowers have fully factored in this rate rise. If it has not, then negative effects on both spending (since disposable income after debt service would fall more than expected) and asset prices (since a higher interest or discount rate would imply lower valuations) could be expected, with feedback loops to the real economy. Moreover, a faster than expected normalization of US short-term
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terms would increase the financial risks to highly indebted economies.
A Relatively Shaky Baseline

All told, 2014 is shaping up as a good but not great year for Asia-Pacific. Although the global backdrop--growth in the U.S. and Europe as well as global trade--is set to improve, the risks have moved closer to home. The new worry is that China, the source of growth as well as a rock of stability for many years, is entering a tricky period of moving to a more market- and risk-based financial sector. As a result, China has now moved front and center in our risk scenario analysis. Over the past few decades since opening up to the reset of the world, the Chinese authorities have managed to deftly use their "late mover" status to avoid the kinds of monetary, fiscal, and external pitfalls that have plagued other emerging market economies. Whether they can again maneuver safely through the choppy waters of their ongoing financial sector realignment is the main concern for the region in the near term.
Appendix: Country GDP Growth

Table 2
CPI Forecasts
Base (% average year-on-year) Australia China India* Japan South Korea Hong Kong Indonesia Malaysia Philippines Singapore Taiwan Thailand Vietnam New Zealand 2014f 2.7 3.0 8.0 2.4 2.2 4.0 6.3 3.2 4.1 2.7 1.4 2.4 6.9 2.0 2015f 2.7 3.0 7.5 1.5 3.0 4.1 5.3 3.6 3.5 2.9 1.6 2.7 6.5 2.1 2016f 2.8 2.7 7.0 1.9 2.9 4.1 5.5 3.1 3.7 2.6 1.5 2.7 6.1 2.1 2014f 2.5 2.6 7.5 2.0 1.6 3.5 5.8 2.9 3.9 2.4 1.1 2.0 6.6 1.3 Downside 2015f 2.0 2.2 7.0 0.8 2.0 2.9 4.2 2.6 2.9 2.5 0.9 1.9 5.8 1.5 2016f 2.1 2.0 6.0 1.4 2.3 3.4 5.0 2.4 3.3 2.5 1.1 2.3 5.4 1.7 2014f 2.9 3.2 10.0 2.8 2.4 4.3 6.5 3.3 4.4 3.0 1.7 2.4 7.0 2.7 Upside 2015f 3.0 3.3 10.0 2.4 3.4 4.7 5.8 4.0 3.9 3.4 2.1 2.9 6.9 2.5 2016f 3.2 2.8 10.0 2.6 3.2 4.7 6.0 3.2 3.9 3.1 1.6 3.0 6.5 2.2
*Fiscal year ended March. f--Forecast.
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Table 3
Policy Rate Forecasts

Base (%) Australia China India* Japan South Korea Indonesia Malaysia Philippines Taiwan Thailand Vietnam New Zealand 2014f 2.5 6.0 8.0 0.1 2.5 7.8 3.5 3.8 2.0 1.8 6.5 3.5 2015f 3.5 6.0 8.0 0.1 2.5 7.5 4.0 4.3 2.5 2.3 6.5 4.5 2016f 4.0 6.0 8.0 0.1 3.0 7.5 4.0 4.3 2.5 2.3 6.5 5.0 2014f 1.5 5.5 7.8 0.1 2.0 7.0 2.5 3.0 1.5 1.5 6.5 2.5 Downside 2015f 1.5 5.0 7.5 0.1 2.0 7.0 2.5 3.0 1.5 1.5 5.0 2.8 2016f 1.8 5.0 7.0 0.1 2.3 7.0 2.8 3.3 1.9 1.8 5.0 2.8 2014f 2.8 6.3 8.0 0.1 2.8 8.0 3.8 4.0 2.1 2.5 6.5 4.0 Upside 2015f 3.8 6.5 8.5 0.1 3.3 8.0 4.3 4.5 2.6 3.3 7.0 4.3 2016f 4.0 6.5 9.0 0.1 3.5 8.0 4.3 4.5 2.6 3.3 7.0 4.3
*Fiscal year ended March. f--Forecast.
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Asia-Pacific Economic Outlook: Risks Abound, Led by China's Financial Sector

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