INDEPENDENCE DAY
For the first time, Asia will prove its economy can fly on its own.
By Abe De Ramos

Terry Ho believes that the Chinese economy is headed for a soft landing in 2007. The CFO of GST Holdings, the mainland’s largest maker of fire-alarm systems, agrees that new property projects are likely to slow rather than grind to a halt following a series of steps taken this year to rein in investments. Commercial and residential developments, which made up a third of GST’s revenues of 280m renminbi (US$35m) in the first half of the year, are likely to be affected. To prepare for the certain slowdown, Ho is looking to sustain revenue growth, which has been on target at 17% so far this year, by going overseas. “The export market is one of our key growth drivers going forward,” says the Hong Kong-born CFO. GST is eyeing Southeast Asia, and possibly India over time. “There are many new malls being constructed all around, and we think there is enough demand (in Asia) to generate long-term business.”

Ho is far from alone in his optimism; the prospect of a long-term boom in Asia is now almost a unanimous consensus. Never mind the tide of political turbulence from Thailand to North Korea – Asians seem to have grown insensitive to unscheduled leadership changes and arrogant saber rattling among neighbors. Never mind their continued dependence on imported oil that perennially threatens to stoke inflation and grab business focus away from investments – oil prices are going down and are likely to stabilize in the foreseeable future. And as no one would have imagined five years ago, never mind, too, a slowdown in the United States, the region’s most important trading partner, a relationship so strong and intertwined it has spawned the conventional wisdom that if America sneezes, Asia catches a cold. “That’s a misconception, and that adage is no longer true,” says Glenn Maguire, chief economist for Asia Pacific at Société Generale in Hong Kong.

It might be more than a coincidence that on the tenth anniversary of the Asian financial crisis, when foreign-capital flight rendered some governments and countless companies bankrupt, the regional economy, both as a whole and as individual parts, is fundamentally stronger than it has ever been. Asia’s financial systems and fiscal balances are in good shape, and domestic consumption and investments are strong. Its economies have gotten so better linked that they may no longer rely on the fortunes of the West to determine their own. This prosperity is even creating a new business class in companies like GST. Export-oriented Asian businesses are no longer polarized between foreign-invested ventures and cottage industries making goods that eventually end up in Japan, the US, or Europe – you can be medium-sized and trade solely with your neighbors. It might be too soon to declare Asian economic independence, but if there ever was a time for the region to prove that it has decoupled from the West – 2007 is it.

Le Divorce

“Next year will be a testing time for Asia,” says Nicholas Kwan, head of economic research for Northeast Asia at Standard Chartered Bank in Hong Kong. Kwan names two schools of thought in the decoupling theory: those who believe it is already happening, and those who think that it will never really happen, given that Asia’s ties with the West go beyond trading; the West is also a source of capital and direct investments. At least, the case for the former can be built up in the next couple of years, as the US economy heads for a slowdown.

While it remains unclear just how much America will decelerate – some argue that GDP growth will only be muted, while others predict a recession – there is no disagreement that US house prices are bound for collapse, and will pull down domestic demand as a result. Merrill Lynch predicts US GDP growth to slow to 1.9% next year from 3.4% this year, and bring consumer spending down to 1.6% from 3%, and capital expenditure to 5.5% from 7.2% over the same period. “A US-led global slowdown is in train,” echoes John Shin, economist at Lehman Brothers in New York. Merrill Lynch predicts 2007 global GDP growth to come down to 4.4% from 5.2% this year.

Asia will slow too – slightly. Société Generale sees regional GDP growth sliding to 7% from 8% this year, but not because Americans will be buying fewer DVD players and plasma TV sets made in Asia. “The main reasons are the administrative measures to cool the Chinese economy,” says Maguire. As China adjusts its growth, trade with neighbors – increasingly absorbed by its own domestic consumption (see box) – is likely to be affected. Rob Subbaraman, Asia economist at Lehman Brothers in Tokyo, also argues that the region is already in the midst of a slowdown, driven by weaker domestic demand and higher household debt-service costs, which in turn were due to high oil prices experienced recently. In other words, this blip is cyclical; Asians are adjusting their seats, but their growth momentum has not been broken. “While the risk is that the region’s economic slowdown will continue into next year, chances of a severe slump are slim,” says Subbaraman.

Indeed, Sun Bae Kim, chief economist for Asia at Goldman Sachs in Hong Kong, argues that the decoupling thesis “has been put to a real-time test” in the third quarter of this year. Kim describes the test as “a matter of whether Asia becomes a magnified version of whatever happens to the US, or have the ability to dampen whatever happens in the US and generate more growth domestically.” He points out that in the third quarter, the ISM indicator, which measures US manufacturing activity and inventory levels, diverged starkly from Asian industrial production (see chart, above). Previously, the two indicators had moved in sync, suggesting that the goods Asia produces are exported to the United States. That trend has finally reversed. Where did the manufactured goods go? Mainly within the region, says Kim. “Export growth has accelerated, with intra-regional trade continuing to lead the charge,” says Kim. “So far, Asia has met the decoupling challenge with flying colors.”

A Brief History of Decoupling

Some economists have been observing the decoupling trend for as long as the integration of Asian trade became evident. In the last 15 years, there have been two dramatic US economic slowdowns. The most recent lasted from 2000 to 2001, driven by the technology bubble that led to an investment contraction in the country. That dealt a heavy blow to Asia. “A lot of Asia’s recovery from the regional crisis was on the back of very strong demand for IT goods in the lead-up to Y2K from the US,” says Maguire of Société Generale. “The bursting of the bubble created excess capacity and impacted Asia very heavily.” Prior to that was the consumer-led slowdown from 1990 to 1991, which Asia weathered relatively well; growth across the region slowed only to 8% from 10%. That, however, was cushioned by strong demand from Europe and Japan. “Europe was booming on the back of the German reunification, and Japan was enjoying the tail-end of its asset-price boom,” says Maguire.

This time, Europe is not in the picture, although Japan is in the frame, cementing the argument for a more united Asia. “The rule of thumb is half of Asia’s trade these days is among themselves, and half to the US and Europe,” says Kwan. “So if worse comes to worst, in a simplistic sense, if you lose half, you still have half the engine running.” But to what extent can the region truly pick up the slack left by the West? “Japan is finally waking up after 15 years of sleep. The second driver is China, and third is India,” says Kwan. “There is debate on how big these giant economies are in purchasing-power parity or current exchange-rate terms, but the conclusion is they are bigger than what you see in numbers.” Citigroup estimates that China’s GDP will grow 9.2% in 2007, and India’s 9%.

Asia’s formula for decoupling rests on a number of factors, the most celebrated of which is domestic demand, a measure of both consumer spending and investments, whether led by the private sector or pump-primed by the government. Of the two, consumer spending is the more heralded. As the region has become more prosperous, young and upwardly mobile Asians proudly demonstrated their propensity to spend, and China and India are the clear leaders by value. According to Japanese research firm Nomura, private consumption expenditure grew 50% in China to US$712 bn in 2004 from US$475 bn in 1999, and 48% in India to US$437 bn from US$294 bn over the same period.

Meanwhile, the size of the population with annual income above US$3,000 – considered to be the middle class in those countries – will soar to 180m in 2009 from 44m in 2004 in China, and to 53m from 6m in India over the same period. “From a fear of big countries picking up and having some sort of catastrophic slowdown or policy tightening, we’re now becoming much more relaxed with the liquidity trends in China and the durability of the Indian upturn,” says William Belchere, chief economist for Asia Pacific at Macquarie Research in Hong Kong. “These economies are just beginning to converge in a sustained path, which makes Asia a very powerful growth story.”

Well Oiled

No doubt, the decline in oil prices will help Asia weather whatever weakness in their exports would arise out of sluggish consumption in the US. “Oil could suck out the liquidity and reinforce the downturn, but then prices are backing up,” says Belchere. The Organization of Petroleum-Exporting Countries estimates that until 2010, oil supply coming online will be equivalent to 13m to 14m barrels a day, whereas demand would increase only 7m to 8m barrels a day. Again, this is positive for Asian demand. “This will be an offsetting adjustment to a slowdown in the US, and central banks in Asia can potentially ease monetary policy now,” agrees Maguire. “Banks can ease policy to support domestic demand.”

Indeed, since the Asian crisis, central banks in the region have become shrewder financial managers. While they accumulated foreign-exchange reserves to keep exports competitive (US$2 trn as of 2005 from US$600 bn in 1996), this liquidity, coupled with high savings rates, gave them the flexibility to decouple their interest rates from that of the United States. Asia’s central banks have not raised interest rates in lock-step with the US Federal Reserve as they had in previous cycles, suggesting that they were, in fact, comfortable allowing their currencies to appreciate – yet another boost to domestic consumption. This is most obvious in China, India, Japan, and South Korea, which by themselves account for the bulk of Asian economic growth.

“Previously, if the Fed had raised interest rates by 425 basis points as it has, Asia would have had to follow,” says Kim of Goldman Sachs. “But it didn’t, so that gives Asia the flexibility to focus on monetary policy that allows them to help the domestic economy.” All these while regional economies are running current-account surpluses, which should amount to US$300 bn, or 5% of total GDP next year. “We don’t have the vulnerability we had in the past cycles, when Asia was running current-account deficits and reserves were not rising,” says Belchere. “This is a much more resilient Asia than we’ve ever seen before.”

Friendly Neighbors

This confidence, says Yiping Huang, chief Asia Pacific economist at Citigroup in Hong Kong, has allowed most markets in the region to gain immunity from the perennial problem of unpredictable politics. Asian markets, he says, have become “politics-proof” thanks to improved macroeconomic stability and policy continuity. The Thai stock market, for example, dropped nearly 3% in the two days following the military coup on September 19, only to surpass pre-coup levels within three weeks. South Korean stock and money markets, meanwhile, were back to normal within a week of North Korea’s nuclear missile test. “It’s not true that investors are no longer sensitive to political risks,” says Huang. “But the improved fundamentals and increased probability of policy continuity suggest that the risks associated with political change can be, most times, minimized or controlled.”

That, says Kim, could be an unintended consequence of reforms made during the the Asian crisis, which exposed corruption in governments to the extent that banks were at their beck and call. “In Korea, whoever occupied the Blue House ten to 15 years ago happened to matter because the government controlled the banks, and the banks in turn controlled the ability of the corporate sector to grow and expand,” he says. That has changed since the banks were recapitalized, consolidated, and in a number of cases partially sold to foreign investors. “Now the banks have more money than they know what to do with in terms of cash flow. They’re not held hostage to the purse strings of the government anymore.”

Individual Asian economies are poised for sustained growth going forward. Hong Kong is a slam-dunk beneficiary of Chinese liquidity, as a good amount of capital from the mainland finds its way back to the city’s retail and financial markets. Singapore is undergoing a structural boost with its recent embrace of casinos and redevelopment of the main shopping district of Orchard Road. South Korea will be buoyed by consumer and construction spending. Malaysia’s consumer spending has remained solid and will be supported by the government’s pump-priming activities. While domestic-demand growth in the Philippines has stalled, an expected cut in interest rates should perk it back in 2007, echoing similar themes in Thailand and Indonesia. Economists are least positive about Taiwan, which is heavily reliant on exports to the US, and whose consumers remain trapped in a cash-card debacle.

A trend to watch out for, says Belchere, is the cross-border spillover of liquidity in terms of intra-regional foreign direct investments. “China is beginning to invest in parts of the region,” he says. “With all this cash, Asia is going to begin integrating more rapidly with M&A activity, which again is enormously bullish.” Maguire agrees, adding that intra-regional FDI is also being driven by the same cost-arbitrage opportunities that brought companies to China – a future phenomenon he describes as yet another wave of globalization. Companies that invested in China are now shifting their production to Vietnam, while those that invested in India are shifting their attention to Bangladesh. “FDI, rather than being a US or Europe dynamic, is becoming an intra-Asian dynamic, and with that we’ve seen expansion of employment,” says Maguire. “We’re seeing economies continually pursuing profits via lowering production cost. That’s not something that’s going to end, even if you see a slowdown and lower domestic demand in the US.”

But will direct investment from the West ever lose its importance to Asia? Not at all, says Kwan. While they account for less than 15% of total investments in the region, their quality is often superior. “Generally, FDIs are at the higher end of the investment ladder, with better technology, efficiency and income generation,” he says.

Going forward, the next piece of the foundation that will establish a more independent Asia will be less reliance on foreign capital for corporate funding. “As you start to see the bond market in Asia develop and deepen, you’ll increasingly see money for FDI raised in Asian debt markets rather than US debt markets, and that makes common sense given that the bulk of trade is intra-Asia,” adds Maguire. But Kwan of Standard Chartered says that is an ideal that is not likely to happen overnight. In fact, the lack of avenues for domestic debt-market funding exposes one of the remaining weaknesses of the Asian region – its financial-sector reform has only been half-baked. “The capital-adequacy ratios of banks are better, non-performing loans are lower, but they are still very much in the traditional banking business,” says Kwan. “When you go to the more exotic or high-risk financing such as derivatives, most of these banks are still very weak, so their capabilities are way [beneath] the demands of the real economy.”

The problem doesn’t end there. Unlike the West, Asian banks have yet to gain expertise in allocating capital efficiently. “To fix that problem, you need capable financial intermediaries to channel your own savings, and do it in a safe and prudent way so you can absorb shocks,” says Kwan. “We still haven’t really done it yet.” Belchere of Macquarie argues that efficient allocation of capital is a challenge Asian governments themselves face, creating a risk of wasting the liquidity they have been working so hard to build. “The biggest thing we don’t have is a proactive policy to be able to use the money a bit better,” he says. “Parts of the region still need significant upgrading in terms of physical infrastructure, and in terms of social infrastructure. Cash is coming so fast it can hardly be used, but we’re still looking for positive [projects] to come up.” Among the factors that hinder this is corruption – still a dark spot in most Asian governments.

To be sure, these are long-term challenges that need to be addressed. In the meantime, companies like GST can bask in the warm fuzz of being in the right place, at the right time.