How to make sense of the emerging-market sell-off

In tumultuous times such as these, we must look at the economic fundamentals to discern the “signal” from the “noise”. The key question today is, are the emerging markets fundamentally broken, or is this a brief phase where investors readjust their portfolios in light of the US recovery becoming more sustainable?

In Asia, the downward reassessment of trend growth in China has been singled out as a potential trigger for a region-wide downturn. Rising debt levels among Asian governments, companies and consumers following the 2008-09 global financial crisis, encouraged by unusually low interest rates, have also raised concerns. Let us examine these factors to assess how worried we should really be.

In China, the government is overseeing an economic soft-landing because one of its strategic objectives is to restructure the economy from one driven by high levels of investment and exports to one driven by local consumption. The current model of growth has long been recognised as unbalanced, uncoordinated and unsustainable.

It should not come as a surprise that economic reform, rather than economic stimulus, is the rage in Beijing today. Policymakers have now set a 7-per-cent medium-term yearly growth target for the economy, and unless there is a significant deterioration in the economy, they are likely to focus on broader issues including promoting urbanisation, fostering a level playing field for the private sector and upgrading social services such as education and healthcare. 

The recent central bank move to tighten short-term funding for banks is also part of the transformation process, weaning the economy off ultra-loose liquidity. The authorities are coaxing banks and businesses to be more aware of risks in making borrowing and lending decisions. This is encouraging news.

This leads to the rising concerns about debt levels across Asia. Our recent study shows that an analysis of this issue needs to be carefully nuanced. Differentiation is vital. Painting all of Asia with the same brush could lead to wrong conclusions. 

After years of rapid economic growth, Asia ex-Japan’s debt-to-GDP ratio has just reached the world average. However, on a more granular scale, our study of debt and solvency across corporate, household and government sectors in Asia concluded that current leverage levels are broadly manageable, with areas of concern and pockets of opportunity – areas where leverage can still rise to generate faster growth.

China’s leverage is the most worrisome in the region, as widely understood. However, the concern arises not from its overall credit-to-GDP ratio of 214 per cent, which places it only fifth among the Asian countries in our study. Rather, the concern is that debt is concentrated in the non-financial corporate sector. This is true even after we classify local government investment vehicle debt as government debt. 

The pace of credit growth is a concern. Credit has grown 22 per cent per year in the past five years – 6 percentage points faster than China’s nominal GDP growth, which is Asia’s highest.

The redeeming feature here is that the government has started to tackle this issue by slowing growth and curbing lending to industries facing overcapacity. In the event of a significant deterioration in the economy, problem loans are likely to surface and some banks may have to be recapitalised. But unlike most other major economies today, China has sufficient financial means to inject capital and restructure its problem lenders. 

Aside from China’s corporate sector, South Korea’s high leverage spans the economy and continues to be a drag on growth. But this problem should not be seen as a tail-risk that could threaten financial stability. South Korea has managed to avoid a hard landing since 2003 and has proactively used macro-prudential measures to limit overall leverage, particularly its external debt vulnerability.

There is also a longer-term positive story that receives little attention, but will help the global economy to rebalance. Household leverage across most of Asia – particularly in China, India and Indonesia – remains low and has the potential for growth. Indonesia’s credit expansion has recently accelerated, but it still has a relatively low level of aggregate debt to GDP, giving it room to use leverage to boost growth. 

While India’s high government debt is a concern, household debt is low. 

Taiwan’s total leverage is relatively benign – its household debt-service ratio is low and a legally mandated ceiling on government debt-to-GDP ratio enforces discipline. In Asean, stresses are confined to household credit in some economies. Malaysia’s household leverage is high, as is Singapore’s on some metrics. However, both countries’ household sectors have accumulated high liquid assets through mandatory savings. 

In Thailand, relatively fast credit growth has led to a rise in solvency stress indicators. However, levels of debt and debt-service indicators provide comfort. 

The Philippine economy has plenty of room to expand its private-sector leverage to boost domestic consumption and sustain growth. There is also ample scope for the private sector to partner with the government in financing ambitious infrastructure projects. 

While there are pockets of emerging concern, Asia’s fundamentals remain robust. Strong government and household balance sheets and still-high economic growth rates across most of the region provide sufficient flexibility to counter inevitable bumps as the economic cycle turns. 

Learning from Asia’s crisis in 1997-98, governments have been using macro-prudential policies since before they were considered to be best practice. Hong Kong and Singapore are prime examples of how such measures have been used to curb property prices. We see scope for several Asian economies to increase borrowing to maximise their growth potential.

In light of this, the turmoil in emerging markets should prove transitory for Asia. It does provide a timely opportunity for cleaning up stressed balance sheets in parts of the region, but it also sets the stage for the next phase of more durable and sustainable growth.

The recovery in the US, which has triggered the latest round of soul-searching, combined with Japan’s revival, should be seen as an added bonus, not detraction, for emerging markets and the global economy.

 

David Mann is head of research for Asia at Standard Chartered Bank.