Asia: The square root of V

Written by DBS Group Research
Friday, 30 October 2009 10:44

Asia’s V-shaped recovery continues and may be the sharpest on record. Industrial output in the Asia-9 has now surpassed pre-crisis levels and shows little evidence of slowing. The rebound in the Asia-8, which excludes China, is even sharper, though that’s mainly because the fall in the Asia-8 was sharper too.

There are two important points to remember when considering this V-shaped recovery. First, Asia managed this with zero help from the US. By July, Asia’s industrial output had returned to pre-crisis levels but import demand from the US had turned up only in June.

Second, it’s not the first time this has happened. Asia beat the US out of the 2000/01 downturn by a good four months. This fact and the reasons behind it are what allowed us to say, all the way back in December 2008, that Asia would pull the same trick this time — even more forcefully — when everyone else was saying that the region would have to wait for the US to recover before it could.

Times change, and the biggest change under way in the global economy today is how much Asia contributes each year to global growth relative to how much the US does, or used to. More than anything else, this shift explains why Asia was able to pull off the V-shaped recovery that it did with no help from the US.


What next?
The V-shaped recovery has manifested itself in double-digit GDP growth since 2Q09. Virtually all of Asia, save for Taiwan and Indonesia, recorded growth rates in the teens in 2Q09 — Singapore 19% (quarter-on-quarter, saar), China (14%), Hong Kong, Malaysia, India and Korea, all 11%-13%.

So far into 3Q, the race continues. Three countries have reported 3Q growth and all remain in double-digit territory. Singapore came first with a 15% showing, followed by China at 10% and Korea at 12%. Korea’s growth was an acceleration from an already high 11% in 2Q09.







The square root of V
The question is, can this continue? The answer is, of course not, for any of a thousand reasons (three are discussed below).

Double-digit growth will soon give way to sideways movement in output levels. Asia’s V-shaped recovery will turn into a square-root-shaped recovery. That is, a sharp drop, a sharp rise, and then a palpable turn sideways.

When will Asia hit the kink in the square-root sign? Probably by the end of this year or early-2010. In terms of GDP growth, Asia will experience a second quarter of double-digit growth in 3Q09 that should drop to high single digits (6%-8%) in the fourth quarter.

By 1Q10, growth should be back to “normal” for most of the countries in the region.


What will slow things down?
Three things will constrain growth very soon: demand, supply and policy. On the demand side, growth is running at double-digit rates only because it fell at double-digit rates earlier on.

What Asia is experiencing now is the ‘snapback’ from a series of 4-5 events in late-2008 that included, perhaps most notably, the shell shock from the collapse of Lehman Bros in September 2008. The sharp collapse had a bottom.

The equally sharp rebound will have a top. With speeds on both sides of the trough about the same, the upswing should last for about as long as the downswing did: two quarters. And only as long as the downturn — for the upswing is no less and no more than its flip side.

And if demand did surge for considerably longer, there’s the supply side to contend with. Output can grow as fast as demand does so long as there is excess capacity, as is the case now. But with demand and supply soaring back, excess capacity will soon vanish. And once demand hits the brick wall of capacity constraints, output can expand only as fast as those walls can be moved.


Policy tightening on the way
Finally, policy will start to rein in demand and growth too, and probably sooner than most have been imagining. Two quarters of double-digit demand and output growth is marvellous but once excess capacity is exhausted — and at current rates it will be by year-end — double-digit demand growth implies double-digit inflation in most countries. That’s too high. Policies will change.

In some countries, policies will tighten “automatically” as expansionary fiscal policies run their course and are not renewed. In some, planned spending may even be clawed back as the need diminishes and the weight of deficits grows on the minds of authorities.

In all countries, monetary tightening will be a key feature of 2010. In general, we have been expecting monetary tightening to begin in earnest around 2Q10, with a few exceptions.

On the tighter side, we have been looking for India to start hiking rates in January and that remains very much on the cards after yesterday’s hike in the SLR by the RBI. We have also been expecting Korea to start hiking rates in 1Q and with the acceleration in GDP there in 3Q09 (to 12% from 11%) the risk is surely that hikes come sooner rather than later.

For Asia overall, much will depend on China, where we expect rate hikes and currency appreciation to begin in 2Q10. We look for gradually higher interest rates with the benchmark 1Y lending rate rising by 81bps (to 6.12%) by the end of the year.

We also expect the authorities to allow the currency to resume its appreciation vis-a-vis the US dollar in 2Q10 and to strengthen to 6.61 per dollar by year-end.

Currency appreciation in China will set the stage for appreciation elsewhere in Asia. With China’s yuan headed north, other countries will be able to follow suit more comfortably than if they went solo.

Asia-10 currencies have already risen 5.5% on average against the dollar since December 2008 and we expect another 6%-7% rise from current levels in 2010.


Inflows at the gate: bolt it shut?
Other things equal, currency appreciation and higher interest rates would help cool regional economies and keep a lid on imported inflation as well. The trouble is, higher interest rates and the prospect of currency gains have the tendency to attract foreign capital.

And such inflows have the tendency to wreak havoc with the best laid monetary plans. Inflows drive interest rates back down and push currencies further north than officials wanted. Hike rates again and you just get another round of inflow: Asia-vu.

There’s no easy “exit strategy” for loose monetary policies when capital accounts are open and inflows are pounding on the gate. Central banks can target interest rates or they can target the currency. But so long as capital accounts are open, they can’t target both. It’s one of those tough facts of life for central bankers.

The solution, if it can be called such, is to control inflows. The trouble is, everyone hates controls and for good reason. They are clumsy and messy and partly for this reason have the awful tendency to change from day to day.

But they do give central banks a stronger hand in controlling interest rates and exchange rates. And for this reason the control option always comes back to the fore when inflows are pounding on the door.

We have little doubt central banks will be trying to raise interest rates in 2010. We have even less doubt that strong capital inflows into the region will be a key feature of 2010 and that currencies will be under a lot of upward pressure. Better prepare for yet another controls debate in 2010 too.


This article appeared in The Edge Financial Daily, October 30, 2009.