MARKETS are having the jitters again as the flow of news has turned almost unrelentingly bad. Investor expectations that the Greeks would vote for the bailout were dashed, and it now looks like Greece could well be on track for a disorderly exit from the eurozone. Chinese markets have cracked despite massive policy intervention. Closer to home, controversies in Malaysia remind investors of how unpredictable politics can be, and yet how damaging to investor confidence.
Our take is that there certainly are risks, but markets may not be giving sufficient weight to those that really matter.
China is the big risk to Asian emerging markets, not Greece
Despite policymakers mobilising a plethora of supportive actions over the last weekend, the Shanghai stock market continues to be volatile and under downward pressure. The fact that the combination of mobilising billions of dollars to buy stocks, cancelling IPOs, cutting interest rates, easing lending conditions for margin financing and threatening short sellers with penalties could not restore market confidence, is a bad sign.
This means that margin debt — which grew explosively as the market rose — remains a major risk to financial stability. Official margin lending surged fivefold to RMB2.2 trillion by end-June, from just RMB403 billion in June 2014. However, some media reports suggest there has also been a huge amount of informal institutions which have lent on margin to equity investors.
Unfortunately, the risks go well beyond just the equity market. Few of the well-informed Chinese we speak to believe that growth is anywhere near 7%, as official data shows. Most believe it to be in the 4% to 5% range, with increasing downside risks. One of our contacts has observed massive amounts of finished goods piling up in retailers’ warehouses. For example, stocks of air conditioners are said to amount to six times their normal levels. The huge excess capacity in manufactured goods means that nominal industrial sales are barely growing, so companies are struggling to find the cash to repay their debts. Not surprisingly then, non-performing loans are growing sharply, albeit off a low base.
This does not necessarily mean that China will tumble into a full-fledged crisis, but it does mean that the risks in China will not end once they sort out the mess in stock markets, as they eventually will. Clearly, we should expect more financial stresses. And the economy will remain wobbly despite efforts to stimulate demand. Industrial profits are falling, undermining companies’ willingness to invest in an economy where almost half of demand comes from investing activity. Electricity demand is barely growing, and the central bank’s index of loan demand is at a record low, substantially lower than its worst reading during the global financial crisis. Consumer confidence has been hurt, with car sales falling for the first time in two years.
So, while China can probably avoid a crisis, its economy will remain under pressure and the impact the country has on the outside world will be a troubled one:
• Anyone who doubts that should look at the plight of the Australian dollar, which slumped in response to China’s struggles to stabilise its equity markets, as did currencies such as the Brazilian real. The reason is that China’s travails are causing cyclically sensitive commodities such as oil, copper and iron ore to tumble in price, hurting commodity exporters all over the world — but helping manufacturers and net importers of raw materials, such as India.
• Risk appetites have also been hurt badly, resulting in a withdrawal of capital from emerging markets. And that is causing emerging economy currencies to fall as well. But as foreign currency-denominated debt in many of these countries has risen, this currency depreciation could aggravate their economic woes as companies struggle to repay much more expensive foreign debt.
However, China’s difficulties may not materially reduce global demand if ongoing recoveries in the US, Europe and Japan can be sustained — which we believe is still possible, as we argue below.
Greece is certainly a problem, but less of a threat
Clearly, the situation in Greece is untenable. At best, the planned European Union summit could find a short-term Band-Aid to keep talks going and buy time for a solution to emerge. But even if that were to happen, there is a high probability that things will unravel. First, months of increasingly bitter wrangling between Greece and its eurozone partners has led to a fundamental breakdown in trust between the two parties: A compromise is still possible, but it is difficult to imagine. Second, Greece’s economy and financial conditions have worsened during the past few months of uncertainty, meaning that a conventional solution would require the injection of a huge amount of new funding into Greece and a haircut on its debt. One wonders whether the eurozone creditors have the appetite to meet these needs.
So, even with the usual ups and downs of eurozone diplomacy, the most likely scenario is that Greece eventually exits the eurozone and plunges into crisis. When this happens, financial markets will take another hit, but probably not a disastrous one. Greece is a tiny part of the eurozone economy, so the direct impact on the eurozone’s growth prospects should not be dire. Eurozone leaders have been preparing for such a crisis for months, as Jean-Claude Juncker, president of the European Commission explained. The European Central Bank will pull out all the stops to limit contagion and ensure that other crisis-hit economies such as Spain and Portugal will not be at risk. Larger eurozone countries such as Germany and France will also step in to provide support. If confidence can be maintained, the eurozone recovery will continue, albeit at a slower pace.
Markets could be underestimating the risk of Fed tightening
We think the other big risk is that markets might abruptly recalibrate their expectations of monetary tightening by the US Federal Reserve. Investors have formed a strong consensus that Fed tightening is less likely and that even if there is a rate hike, the trajectory of tightening will be shallow. They see the Greek crisis and China-related risks deterring the Fed. Moreover, low inflation and less-than-exuberant growth in the US economy appears to give the Fed few reasons to tighten. In fact, the International Monetary Fund has added to this entrenched view by bluntly telling the US not to raise rates until 2016.
However, there are reasons why this complacent consensus could be wrong:
• While US growth is not torrid, it is pretty decent. The second quarter probably saw a strong rebound of above 3% from the weakness in the first quarter. Forward-looking indicators are good: New orders for both manufacturing and services are rising at a decent pace. The recovery in housing is progressing well enough to boost construction spending, which will provide strong multiplier effects going forward. Consumer confidence is back at post-crisis highs.
• Moreover, the recovery in labour markets continues to reduce unemployment to close to full-employment levels. While jobs growth is not as strong as in late 2014, it is running at roughly double the pace needed to absorb new entrants into the work force. Indeed, the survey of job openings shows they are continuing to expand at a healthy pace. There are also early signs of wage growth beginning to accelerate.
• We also see Japan’s recovery continuing to gain traction, as indicated by the recent Bank of Japan Tankan survey. And, as discussed above, we see the eurozone continuing its modest rebound, even with the drama in Greece. Thus, external demand for US exports is likely to recover ahead of expectations.
• In the end, the Fed has to decide whether the risks of delaying monetary normalisation (creating asset bubbles and other distortions, which could create future crises) exceed the risks of premature tightening (hurting a modest economic recovery). As the Greek situation stabilises and economic growth and falling unemployment continue in the US, our bet is that the Fed’s concerns will shift to favour rate increases.
What does this scenario mean for Asia?
In short, we see the developed economies recovering ahead of expectations, while China disappoints, hurting commodity exporters and causing emerging economy currencies generally to weaken. The implications for Asia will be varied:
• This combination will be positive for Asian exporters of manufactured goods — especially if capital spending recovers in the US and Japan, as we expect. South Korea, Taiwan and Singapore should benefit, as should Malaysia and Thailand.
• However, global investors’ risk aversion will probably increase, to the detriment of countries where political concerns are high, or where external vulnerabilities such as current account deficits remain uncomfortably high. In this context, political uncertainty in Malaysia may not help. Indonesia’s current account deficit has improved slowly, but not enough to reduce concerns over its external vulnerability.
• On the other hand, global investors will favour those emerging economies where the economy is recovering and the structural prospects are improving, even if they are not immediate beneficiaries of a stronger US economy. India, the Philippines and Vietnam look relatively good on this score.
The bottom line: There certainly are risks on the global scene, but there are also bright spots which provide opportunities.
Manu Bhaskaran is a partner and head of economic research at Centennial Group Inc, an economics consultancy
This article first appeared in Forum, The Edge Malaysia Weekly, on July 13 - 19, 2015.