Monday, April 18, 2011

Asian Perspectives from PIMCO Chia-Liang Lian

Asian Perspectives
  • Public finances in most emerging Asian countries have improved, supported by fiscal reforms and buoyant economic growth.
  • Monetary authorities in the region are focused on preserving price stability.
  • The resilience of emerging Asian countries leads us to be open to adding exposure as attractive opportunities arise.
The human calamities and economic costs of disaster-struck Japan continue to dominate headlines since the earthquake in March. As the world observes how the nation tries to cope with one of the most severe natural disasters in history, one attribute of the Japanese people stands out – resilience. In a recent issue of Time magazine, one university student has this to say: “After this earthquake, a lot of us feel energized for the first time. My friends... are saying, what can we do?” By most indications, Japan will turn things around and emerge stronger.
Asia’s Financial Tsunami in 1997–1998
Nearly 15 years ago, emerging Asian countries had to deal with a different kind of disaster. A financial tsunami sent economic tremors throughout the region’s hitherto fast-growing nations, beginning with Thailand. Initial policy reactions varied across countries, but denial was by far the most common. In the subsequent months, however, denial turned into acknowledgement, albeit begrudgingly.
The Asian crisis was fundamentally an external balance of payments crisis, and the impact on exchange rates was immediately observable. The Indonesia rupiah’s plunge from a pre-crisis average of 2,400 to a low of 16,650 to the U.S. dollar in mid-1998 brought its economy to near-paralysis. South Koreans suddenly found themselves having to adjust to a four-digit exchange rate against the U.S. dollar. Hong Kong successfully fended off intense speculation on its linked currency regime.
Today, emerging Asian economies face a radically different set of exogenous concerns. Nevertheless, the hard lessons learned from the financial crisis have served to place the region on a stronger footing. Healthy levels of foreign reserves underscore the need of “self-insurance” to hedge against contingencies, while policymakers target at achieving fiscal discipline and monetary prudence. Reinforcing the strong starting conditions are the region’s attributes of rising incomes, large populations and underdeveloped infrastructure. The upshot is that emerging Asian economies should continue to demonstrate resilience against global downturns, as they did since the Lehman shock in 2008.
Foreign Reserves as “Self-Insurance”
The harsh realities of the Asian crisis brought home the point of “self-insurance” through foreign reserve accumulation. South Korea presents the most striking turnaround story. From nearly exhausting its foreign exchange war chest in late 1997, its foreign reserves have risen to almost $300 billion (see Chart 1), an all-time high. While attention has been centered on the stratospheric rise of reserves in China ($3.0 trillion), new records are being set for several regional countries, including Taiwan ($393 billion), Hong Kong ($274 billion), Singapore ($233 billion), Thailand ($170 billion), Indonesia ($106 billion) and the Philippines ($66 billion).
Emphasis on Fiscal Discipline
In contrast to the current fiscal troubles in peripheral European Union (E.U.) countries, public finances in most emerging Asian countries have improved, supported by fiscal reforms and buoyant economic growth. China pulled through the 2008 Lehman crisis because it had the “will and wallet” to turn on the fiscal spigot. The impact was immediate if not dramatic, precisely because of years of under-spending due to overheating concerns. In the Philippines, the economic administration under President Benigno Aquino III has made fiscal consolidation a top policy priority. There are tentative signs of progress, with the Philippines’ 2010 GDP growth accelerating to 7.3%, the fastest pace in more than three decades.

Monetary Prudence and Inflation

In the post-Lehman period, Asian central banks were among the first to turn up the hawkish rhetoric. An easy monetary stance became increasingly incompatible with the region’s marked rebound in growth and, more importantly, a feverish housing market. Monetary authorities are particularly mindful of the lessons from the housing bubble experiences in Japan in the mid-1980s and more recently in the U.S. Importantly, the focus is on preserving price stability as a necessary condition for sustaining economic growth over the long term. To this end, we expect central banks to broaden policy tightening to include other monetary instruments, including the exchange rate.

Manageable Impact from Japan Quake

While the region is by no means immune to the impact of the Japan earthquake, we expect emerging Asia to manage well the near-term fallout from aggregate demand weakness. Indeed, the incident has not interrupted thus far the tightening cycle in emerging Asia. Instead, the policy vigilance has increased, given the threat of higher oil prices on account of evolving developments in the Middle East and North Africa. Over the past month, at least four central banks (China, India, Philippines and Taiwan) have lifted their respective rates, underscoring an ongoing theme of policy normalization.

Admittedly, manufacturing hubs in China and Southeast Asia may have to deal with the potential disruptions to the intra-regional supply chain. Visitor traffic from Japan to tourism-based countries will likely experience a drop-off. Nonetheless, we would characterize the drag as temporary over an expected bumpy course in the second quarter. Paradoxically, a few competing countries, notably South Korea, could benefit from a positive substitution effect in high-technology sectors.

We should note that Japan has become less important for emerging Asian exporters over the past two decades. Over this period, the share of Japanese demand has halved to 8% of total exports (see Chart 2). In comparison, China’s share has steadily risen to around 15% to match the U.S, although the E.U. share is the largest at 19%. In the longer term, the impact of infrastructure reconstruction in Japan should provide a boost to the region. Exporters of oil and coal, including Malaysia and Indonesia, stand to benefit.
Investment Implications

Our conviction of the resilience of emerging Asian countries leads us to be open to adding exposure as attractive opportunities arise. We continue to maintain exposure to emerging Asian currencies. We expect growing acquiescence to currency appreciation as an effective tool to keep imported sources of inflation in check. In this regard, the gradual appreciation trend in the Singapore dollar should remain intact. Despite recent gains, we believe the South Korean won and Chinese yuan remain fundamentally undervalued.
In external credits, select high grade, quasi-sovereign bonds in South Korea and India offer attractive reward opportunities for the risk. We look for avenues to “shake hands with governments” in countries where credit fundamentals are continuing on an upward trajectory. Specifically, Indonesia appears on track to potentially achieve investment grade status in the next twelve months. While the sovereign bonds have largely priced in the prospect of an upgrade, select higher-yielding corporate bonds offer an attractive risk-reward balance, particularly those that have demonstrated a consistent credit record. In the credit default swap market, we look to add, during periods of generalized market weakness, exposure to high quality sovereigns with strong credit metrics.  

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