Downside Risks to AXJ Growth Reducing but Not Totally Out of the Way

AXJ growth outlook has been influenced by three key factors – (a) domestic demand and policy environment; (b) exports; and (c) the global funding environment. Our base case GDP growth forecast for 2012 considering the outlook for these three factors was at 6.9% compared with 7.5% in 2011. While domestic demand growth has been stabilising post the moderation due to policy tightening in line with our expectations, over the past few months we have been concerned about the downside risks due to external factors. In particular, we have been worried about the risk of the region’s exports growth decelerating faster than our base case due to weaker DM growth and that a potential aggressive deleveraging in Europe’s banking sector could result in the escalation of funding risks for the region. Recent developments have pointed towards an improvement on both these fronts and may have reduced those downside risks to some extent, in our view.

Downside Risk Factor #1: External Demand

Why were we worried?

The region typically operates on a dual engine growth model of exports and domestic demand, with the relative importance of the two engines varying across the region. The region’s openness to trade flows and its cross-border production networks have meant that the slowdown in final demand in the developed world would likely be reflected in weaker exports growth in the region.

Indeed, the period of weakness in the region’s export growth since 2Q11 was one of the key warning signals to us that the growth outlook was weakening for the region (see Asia Pacific Economics: 2H2011- Growth Concerns to Outweigh Inflation Risks, July 25, 2011). Moreover, in 3Q11, concerns about fiscal tightening and deleveraging in the European banking system increased the downside risks regarding export growth.

Under our base case outlook for 2012, our economics team expects export growth for the region to decelerate to 11%Y, down from the estimated 20%Y growth we saw in 2011. However, from April 2011 to December 2011, seasonally adjusted exports for the region excluding Hong Kong, Indonesia and Malaysia (for which December 2011 data are not available yet) had grown by only 2.7% cumulatively (seasonally adjusted non-annualised). If the seasonally adjusted exports trend were to remain flat in the coming months, by March 2012 year-on-year exports growth for the region excluding Hong Kong, Indonesia and Malaysia would have decelerated to -0.7% from 8.8% in December 2011.

What has changed?

Some of the key indicators of the region’s exports trend, such as the US ISM new orders index and manufacturing PMI in Europe, have also bounced off lows, suggesting that economic activity in the manufacturing/export sectors may have stabilised.

Improvement in Exports Trend Required to Achieve Our Base Case Forecasts

While incoming economic news over the past few months has been mostly better than expected, our US economics team still sees US GDP growth running at a sluggish, trend-like 2.25% this year as its base case. Similarly, our European economics team forecasts GDP in the euro area to contract by 0.3% in 2012 (compared with growth of 1.6% in 2011).  While the recent improvement in leading indicators has been encouraging, we believe that there needs to be a sustained sequential growth in exports for it to be on track to achieve our 2012 growth forecasts. Indeed, if the exports trend does not improve further on sequential basis, we could get export growth of close to zero on a year-on-year basis from March 2012 onwards.

Downside Risk Factor #2: Funding Risks

Why were we worried?

Our base case view on the funding environment has been that deleveraging in Europe’s banking sector, if it proceeds in a orderly fashion, will be a manageable challenge for Asia ex Japan (for more details, see Cross-Asset Research Asia Insight: The Challenge to Asia of European Deleveraging, November 13, 2011). We have built the impact of deleveraging in Europe in the form of slowdown in capital flows, resulting in cost of risk capital remaining higher for longer even as GDP growth would moderate in 2012.

However, during November and December, some of the countries in the region started to see capital outflows resulting in net FX outflows. Indeed, the region has seen net foreign exchange (FX) outflows since August 2011. From August to December 2011, China’s FX reserves declined by 2.5% (US$81 billion). FX reserves for the region excluding China fell by 4.0% (US$80 billion) over the same period. Within the region, Indonesia and India’s FX reserves have declined by the largest magnitude, falling by 11.6% and 7.0%, respectively. The decline in net FX inflows (outflows) is causing deceleration in reserve money growth across the region and varying degrees of tightness in inter-bank liquidity conditions.

What has changed?

Policy action by the ECB appears to have helped to reduce the funding risks. Indeed, our colleagues in Europe believe that the Long-Term Refinancing Operations (LTRO) have significantly reduced the risk of a systemic banking crisis (for more details, see Don’t Underestimate the Impact of the LTROs, January 18, 2012). LTRO is emerging as some kind of a backdoor indirect quantitative easing (QE), as per our European economics team. Spreads of Italian and Spanish two-year government bonds over German two-year government bonds have declined to 338bp and 297bp, respectively, down from 602bp and 448bp as of December 1, 2011. This stabilisation in the funding risks has also been manifested in a narrowing of the LIBOR-OIS spreads, which had been rising until recently.

Is this improvement sustainable?

The recent policy action by ECB has stabilised the funding environment for the European banking system and helped to reduce the tail risks. However, our European banks team still believes that ECB measures may make deleveraging slower and more orderly, but won’t stop it.

Bottom Line: Downside Risks Reducing but Not Totally Out of the Way

We believe that the domestic demand outlook will remain stable and are building in for a very gradual and limited easing across the region. The improvement of leading indicators for exports and reduced systemic risks in the funding environment have given us some comfort that the probability of the downside risks to region’s growth have been reduced.

However, the risks have not fully receded, in our view, as various swing factors could lead to yet another twist and turn in the macro environment.  Particularly, on the funding risks, our European banks and economics teams highlight that “The market and banks will continue to be concerned by the risks of Greek restructuring without adequate backstops; the risk of restructurings in Portugal and beyond depending on back-stops; potential knock-on effects of sovereign downgrades; pro-cyclical fiscal policies; and the lack of a coherent long-term plan for eurozone”. Lingering concerns over the sovereign debt situation in Europe meant that the downside risks of a tougher funding environment will likely remain with us for some time.

In the context of systemic risks and recession risks, our global economics team believes that the ECB, Bank of England and the Fed could implement broad-based QE eventually. Our Co-Head of Global Economics team, Joachim Fels refers to this as Great Monetary Easing Part Two (for more details, see Sunday Start, What Next in the Global Economy, January 22, 2012).

What Real-Time Indicators to Track for AXJ?

For the exports outlook, we would continue to watch the incoming data points such as the new orders component of PMIs in the US and Europe. On actual data, we track exports for Korea and Taiwan as they tend to lead the region’s trend. Indeed, Korea’s export data are released as soon as the month ends, making them a timely indicator for actual trends for exports in the region. On funding risks for the region, we track indicators such as LIBOR-OIS spreads, CDS spreads around the region and the trend in FX reserves (in the absence of an accurate up-to-date source of comprehensive data for capital inflows).


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