Persistent disinflation due to lower oil and food prices, together with a deteriorating growth outlook, has prompted a number of Asian central banks to resume monetary easing in 2015. With a very low base of price levels, however, there is some worry in financial markets that escalating geopolitical tensions in Syria could trigger a rebound in oil prices and that the El Niño effect could disrupt food supplies, rekindling inflation and derailing Asia’s nascent monetary easing cycle in 2016.

In our view, though, slackening domestic demand in most economies suggests that there wouldn’t be much second-round transmission of inflation, even if oil and food prices were to rise. Central banks are likely to look beyond any noises in the consumer price index (CPI) and view the slowdown in economic growth as a more pressing issue in the coming quarters.

Oil Is Not the Dominant Factor

Of the two potential inflation-igniting factors, crude oil may be more prone to higher volatility in the months ahead owing to the geopolitical uncertainties in eastern Europe and the Middle East. However, oil prices, on their own, are unlikely to reverse the disinflation trend.

Looking into the components of inflation in Asia, oil prices—more broadly categorized as “transportation costs” in the CPI basket—have not been the main driver of headline inflation in the past (Display 1).

In fact, oil has contributed less than one percentage point to CPI inflation since the global financial crisis, although its weakness in recent months has trimmed about 0.5 percentage point from CPI inflation. A simple scenario analysis shows that even if Brent crude oil rebounds to US$76 per barrel—the top end of the market’s expectation—its inflationary impact would only be similar to that in 2011, when it added about 0.7 percentage point to the headline CPI (Display 2).

Meanwhile, if Brent stayed at US$56—the median forecast in the market—its impact on the CPI would be marginal. If Brent stays at the current level of around US$46, it will remain a drag on the CPI for most of 2016. Overall, the net effect of oil prices on the CPI is likely to be modest in the months ahead.

El Niño Effect

Food inflation could have a greater impact on Asia’s CPI inflation owing to the composition of the price index in most countries.

The market has been wary of El Niño—a meteorological condition caused by oscillations in ocean surface temperatures—since the second quarter. Indeed, the El Niño/Southern Oscillation (ENSO) index has hovered at elevated levels.

But, as we discussed earlier in the year, any impact on food inflation depends on the microclimate of the crop growing regions. There is no direct relationship between the ENSO index level and the severity of food inflation. Moreover, crop inventory is more abundant than during the past episodes of food inflation (see “Too Early to Worry About El Niño as Downside Risks to Growth Persists,” Asian Perspectives, July 17, 2015).

The potential impact of warm and dry weather on food costs is worth continued monitoring. But in recent months, prices of key crops such as rice, corn and wheat have drifted lower, reflecting the receding risks to supplies. Also, food prices in Thailand have declined again, dragging down CPI inflation, after a brief rise due to a drought over the summer.

Weak Demand in Focus

The big difference between now and 2011—when a jump in food and oil prices prompted a monetary policy response—is the trajectory of domestic demand, as the economies today are in a very different growth-cycle stage. With a debt overhang and fiscal conservatism prevailing in a number of Asian countries, domestic demand growth has continued to taper off in recent years. Many countries are also seeing their manufacturing sectors come under pressure from slower exports (Display 3).

From the monetary authorities’ perspective, core inflation remains at cyclical lows (Display 4), and the negative output gap has been widening—implying that their economies are running below their potential growth levels. Therefore, central banks are likely to look beyond any short-term noises in the headline CPI and keep growth their priority.

Bottom Line

All in all, slackening growth and subdued core inflation should remain supportive of local-currency bond markets. We believe that the monetary easing cycle in Asia has more room to run, especially in Thailand and Indonesia (Display 5). The key uncertainty is the potential currency market volatility that may result from an interest-rate increase by the US Federal Reserve, which could dampen foreign investors’ appetite for exposure to Asia’s local-bond markets.

By Vincent Tsui, Economist, Global Economic Research and Anthony Chan, Asian Sovereign Strategist, Global Economic Research, AB

———-

The information contained herein reflects the views of AllianceBernstein L.P. or its affiliates and sources it believes are reliable as of the date of this publication. AllianceBernstein L.P. makes no representations or warranties concerning the accuracy of any data. There is no guarantee that any projection, forecast or opinion in this material will be realized. Past performance does not guarantee future results. The views expressed herein may change at any time after the date of this publication. This document is for informational purposes only and does not constitute investment advice. AllianceBernstein L.P. does not provide tax, legal or accounting advice. It does not take an investor’s personal investment objectives or financial situation into account; investors should discuss their individual circumstances with appropriate professionals before making any decisions. This information should not be construed as sales or marketing material or an offer or solicitation for the purchase or sale of any financial instrument, product or service sponsored by AllianceBernstein or its affiliates. This document has been issued by AllianceBernstein Australia Limited (ABN 53 095 022 718 and AFSL 230698). Information in this document is intended only for persons who qualify as “wholesale clients,” as defined in the Corporations Act 2001 (Cth of Australia) or the Financial Advisers Act 2008 (New Zealand), and should not be construed as advice.

The post Benign inflation to keep Asian central banks focused on growth risks appeared first on AdviserVoice.

Quantitative easing (QE) by major central banks after the Global Financial Crisis led to significant portfolio investment flows into Asia. The flip side of this is that the prospect of a monetary tightening by the Federal Reserve has investors fretting about an abrupt reversal of such capital flows and a potential repeat of the 1997–1998 Asian Financial Crisis.

From a fundamental standpoint, however, external positions of most Asian economies today are much more robust than they were in the 1990s, and the underlying external debt dynamics are quite different as well.

A greater risk, in our view, stems from the opening up of capital accounts across the region in recent years, because swings in foreign investors’ money in Asian onshore markets could cause greater volatility in external balances. Overall, we don’t see the risk of a 1990s-style systemic crisis, but currency and asset markets could see a sizable correction if risk aversion escalates. Ultimately, the currencies need to be supported by economic growth.

More Sustainable External Positions

First of all, external accounts of Asian economies are now much more solid than 20 years ago. Back then, overheating domestic economic activity kept current account balances persistently in the red (Display 1). In recent years, by contrast, moderate domestic demand and a prudent monetary and fiscal policy mix have allowed most Asian economies to maintain current account surpluses—no overheating despite favorable funding conditions. This suggests that both external accounts and the investment cycle are sustainable.

Furthermore, Asia has also significantly reduced its reliance on external debt over the past decade (Display 2). Back in the 1990s, the largest source of external liabilities was foreign currency borrowings by corporations. There were also significant asset-liability mismatches. These imbalances made Asian currencies vulnerable to the speculative attacks that triggered a systemic crisis.

Since then, the corporate segment has deleveraged noticeably. Asian economies’ total external debt, relative to gross domestic product (GDP), has been on a sustained downtrend over the past decade and has not seen much of a rebound even under the QE policy regime.

In fact, leverage across Asia in recent years has been driven by the household and public sectors, which are primarily funded domestically in local currencies.

For now, the vulnerability is not in the foreign currency borrowings, unlike the 1990s. It is mainly the swings in foreign investors’ holdings of onshore local-currency bonds, their deposits with local banks, and credit extended by foreign banks’ local subsidiaries.

The increased influence of such factors is a natural consequence of the capital account liberalization that has taken place in many countries in recent years. Asian economies’ external accounts, therefore, cannot entirely escape the whims of the global financial market.

Buffer Against External Shocks

Given the risk of increased volatility in their external accounts, it is essential for Asian economies to maintain a sufficient level of reserves to weather any reversal in capital flows and to anchor investor confidence. Policymakers also need to tolerate foreign exchange flexibility as a shock absorber and automatic stabilizer.

A key difference between now and the late 1990s is the level of foreign reserves. Reserves are now at comfortable levels in most regional economies (Display 3). Back in the 1990s, reserves in South Korea, the Philippines and Malaysia were below the critical threshold—an amount equivalent to three months of imports—but many Asian central banks continued to intervene relentlessly in the currency market in an attempt to keep currencies at their overvalued precrisis levels. In retrospect, that’s a recipe for a hard landing.

The sufficiency of foreign reserves can be evaluated by comparing the reserves with net external financing requirements, which take into account maturing short-term external debt, amortization of medium-term external liabilities, current account financing requirements and foreign direct investments.

By this measure, current reserve levels of almost all Asian economies are sufficient, except for Malaysia (Display 4). And even in Malaysia’s case, about half of the shortterm external debt is the result of Malaysian banks repatriating excess deposits from overseas subsidiaries to their headquarters for liquidity management. It also includes equity injection and retained earnings of foreign banks operating in Malaysia. These are part of normal banking operations and should not be of much concern. Deducting such elements, which amount to more than 40% of foreign reserves, Malaysia’s reserve coverage is not as alarming as the headline ratio may suggest.

Protracted Slowdown a Key Risk

All in all, external positions of Asian economies are much more sustainable than in the late 1990s in view of the current account equilibrium, currency flexibility (which acts as a shock absorber) and foreign reserve coverage.

The real concern is the risk of a protracted period of economic slowdown. Back in the late 1990s, strong export demand in the developed markets, particularly before the technology bubble burst, greatly helped Asia to recover from the crisis and accumulate foreign reserves.

The problem now is that global demand has remained so weak for so long. Exports from many Asian countries experienced a further drop in August, while increases in public debt over the past few years imply that there is not much room for fiscal support (Display 5), and interest rates are already at historical lows. Ultimately, a strong economy will be Asian currencies’ best friend, but we cannot see the light at the end of the tunnel yet.

By Vincent Tsui, Economist, Global Economic Research and Anthony Chan, Asian Sovereign Strategist, Global Economic Research, AB

——–

The information contained herein reflects the views of AllianceBernstein L.P. or its affiliates and sources it believes are reliable as of the date of this publication. AllianceBernstein L.P. makes no representations or warranties concerning the accuracy of any data. There is no guarantee that any projection, forecast or opinion in this material will be realized. Past performance does not guarantee future results. The views expressed herein may change at any time after the date of this publication. This document is for informational purposes only and does not constitute investment advice. AllianceBernstein L.P. does not provide tax, legal or accounting advice. It does not take an investor’s personal investment objectives or financial situation into account; investors should discuss their individual circumstances with appropriate professionals before making any decisions. This information should not be construed as sales or marketing material or an offer or solicitation for the purchase or sale of any financial instrument, product or service sponsored by AllianceBernstein or its affiliates. This document has been issued by AllianceBernstein Australia Limited (ABN 53 095 022 718 and AFSL 230698). Information in this document is intended only for persons who qualify as “wholesale clients,” as defined in the Corporations Act 2001 (Cth of Australia) or the Financial Advisers Act 2008 (New Zealand), and should not be construed as advice.

The post Asia: Sound fundamentals suggest no repeat 1997–1998 crisis appeared first on AdviserVoice.

Reliance on External Borrowing

Asia’s frontier-market economies such as Mongolia, Pakistan and Sri Lanka have been frequent issuers in the international bond market. They rely primarily on external borrowings to finance their current account deficits and replenish their foreign reserves (Display 1). Nonetheless, in the current risk-averse market environment and unfavorable funding conditions, these frontier economies are now exposed to refinancing risks.

Of those Asian frontier issuers, we think Mongolia will be the most vulnerable in the coming months. Given that the adverse market conditions may linger for some time, we believe that central banks should lay their hands off their currencies and tolerate market adjustments so as to prevent a further depletion of their limited reserves.

Fundamentals Remain Intact

Purely on fundamental grounds, macroeconomic stability risks for these frontier markets are not too concerning in the near term. In Mongolia, previous tightening efforts are now bearing fruit, while the expanded export capacity thanks to foreign investment-driven mining projects has helped to improve the non-oil trade balance (Display 2). In Pakistan an International Monetary Fund (IMF) program for an Extended Fund Facility (EFF) arrangement remains on track—with budget consolidation, monetary tightening and a foreign reserves rebuild all making progress—even though a decline in exports has kept the non-oil trade deficit elevated.

In contrast, a procyclical policy mix in Sri Lanka deserves attention. A strong rebound in private sector credit growth, together with a populist budget, has buoyed domestic demand and kept the trade deficit wide. Still, despite the rising risks of overheating, subdued oil prices are providing a cushion for Sri Lanka’s external account.

Upcoming Refinancing Stress Points

For now, refinancing external liabilities in these tough market conditions will be a daunting task for these Asian frontier economies.

The good news is that the three countries issued sovereign bonds and acquired foreign currency liquidity to strengthen their reserves in late 2014 and early 2015—before market sentiment turned sour. The import coverage ratios of their foreign reserves remain comfortably above the critical threshold of three months (Display 3).

However, maturing foreign currency debt in the coming quarters will be sizable. The funding requirement is particularly worrying in Mongolia—equivalent to 28% of total foreign reserves in the second half of 2015 and another 13% in the first half of 2016 (Display 4).

Pakistan’s refinancing needs in the coming 12 months are more manageable, at 5% of foreign reserves. Although Sri Lanka’s refinancing needs amount to 17% of foreign reserves in the first half of 2016, the administration can still wait till the end of the year to see if there is any improvement in market conditions.

Mongolia Vulnerable

So, of the three frontier markets, Mongolia faces the greatest urgency to secure foreign currency funding by the end of September. Unfortunately, timing is less than ideal, both in terms of the global market and the economic cycle. A commodity exporter, the country not only suffers from collapsing commodity prices but also from a slowdown in the Chinese market—a dominant export destination. And political uncertainty ahead of a June 2016 election will also keep investors wary in any upcoming sovereign bond issues.

There are limited policy options: the government can approach the IMF as the central bank’s tightening efforts have already met most of the criteria for the IMF program. However, that would be politically tricky ahead of the election, as it implies a failure of economic policies. A more likely outcome would be for Mongolia to tap the market, even at relatively high costs, when the market stabilizes.

Monitoring Sovereign Risks

So, how should investors monitor sovereign risks ahead of likely bond issuances by the frontier-market countries?

For Mongolia, which enters an election cycle, investors should focus on the commitment to prudent policies: Will there be a supplementary budget to cut fiscal expenditure in response to a revenue shortfall when the parliamentary session starts? Will the 2016 budget reflect prudent revenue projections? Will the central bank steer clear of any premature monetary easing?

For Sri Lanka, the central bank’s decision in early September to cease quoting the reference rate and effectively float the currency was a welcome move. A marketdriven exchange rate would act as an automatic stabilizer for import demand. Investors should monitor whether this is a one-off adjustment, and how actively the central bank intervenes in the foreign exchange market going forward.

Meanwhile, with parliamentary elections just finished, the market should focus on whether fiscal consolidation will be back on the agenda. Also, will the administration be friendlier to foreign investors? Will the central bank tighten monetary policy to curb credit growth?

For Pakistan, steady progress in macroeconomic adjustments required by the IMF program will be key. Bond investors should also monitor the execution of a Sino-Pakistani foreign direct investment pact signed in April totaling 20% of Pakistan’s gross domestic product. This holds the key to strengthening the country’s external account, pulling the economy out of prolonged lethargy, and lowering the cost of bond issuance.

Currency as Shock Absorber

For now, central banks should refrain from foreign exchange intervention. Attempts to stabilize exchange rates have already sharply drained reserves over the past several months (Display 5). Given the uncertainty over how long the risk-off market conditions will persist, the central banks should preserve their ammunition and wait for the window of opportunity for a bond issuance to reopen, in our view.

By Vincent Tsui, Economist, Global Economic Research, and Anthony Chan, Asian Sovereign Strategist,Global Economic Research, AB

The post Asian frontier economies face refinancing risks appeared first on AdviserVoice.

Victim of Renminbi Devaluation

The Malaysian ringgit (MYR) has been a major victim of the Chinese renminbi’s surprise devaluation, which has triggered a broad sell-off in Asian currencies. The renminbi shock came at a particularly inopportune time for Malaysia, as Bank Negara Malaysia (BNM) had been trying to defend the MYR, draining 8% of its foreign reserves in July alone to US$96.7 billion.

The sharp fall in the MYR and the aggressive intervention by BNM has led to concerns in the market that draconian capital controls and a currency repegging, similar to the measures introduced in 1998, might be back on the table. In our view, such attempts to wrestle with the market will only induce more turbulence in Malaysian financial markets, given the hefty positions of foreign investors.

The differences between today’s economic fundamentals and those of 1998 suggest that such capital controls would be costly and yield no benefit from an economic standpoint. Be that as it may, we believe that investors should remain vigilant about the risk of such a policy misstep, as the deteriorating political situation could result in various nationalist or populist moves.

Different Policy Considerations

So what are the differences in today’s economic environment from that of 1998?

First, foreign exchange asset/liability mismatches in the late 1990s were severer, both in the private sector and in the banking system. The foreign exchange loan-to-deposit ratio was as high as 200% back then (Display 1)—in other words, private sector companies’ foreign currency borrowings from banks were double their foreign currency deposits. The net foreign exchange liabilities of banks themselves also stood at nearly 7% of the banking system’s balance sheet (Display 2). Any sharp MYR depreciation could have resulted in a significant balance-sheet crunch. Now, however, both private sector businesses and banks have positive net foreign asset positions, which means that there is not as much need to stabilize the MYR at all costs.

Second, foreign reserves had dwindled to more alarming levels before the 1998 capital controls. The reserves covered only three months of imports, and short-term external debt rose to 60% of the reserve levels. Now, the need to protect reserves is less urgent. Even though BNM has been draining reserves, the reserve level still stands at six months of imports, which is a more comfortable level than those of many other emerging-market countries outside Asia.

Third, even if BNM were to impose capital controls, such measures would not be very effective in rebuilding foreign reserves at present owing to underlying external payment dynamics. Back in the late 1990s, external demand was healthier and net foreign direct investment (FDI) inflows were more sizable. Moreover, an import compression pushed the current account balance back into a surplus—offsetting the capital outflows and keeping the net external position in a surplus.

But now, Malaysia is suffering from a structural decline in the current account surplus that is exacerbated by deteriorating terms of trade and sluggish export demand—and there is no positive driver for improvement in sight (Display 3). Even if BNM reintroduced capital controls, foreign investors would merely unwind their positions after the holding periods expired, and BNM might remain under pressure from the risk of a portfolio outflow for years to come.

Disastrous Outcome of Capital Controls

The key argument for capital controls is that they would help to restore monetary policy autonomy. By imposing capital controls in 1998, BNM was able to cut its policy rate by 300 basis points to mitigate the economic shock from the Asian Financial Crisis.

At present, we are not seeing any liquidity stress in the domestic financial system. However, if BNM opts to impose capital controls, foreign investors are likely to promptly unwind their huge positions in Malaysian debt securities in a knee-jerk reaction. Foreign investors hold a staggering 46% of outstanding Malaysian Government Securities (MGS), the highest foreign ownership in Asia, and this will be the key to the vulnerability of the country’s external position. The amount of foreign holdings is greater than the excess cash holdings of pension funds, insurance companies and the banking system—the major investors that hold the other half of outstanding MGSs (Display 4). There is not enough onshore liquidity to digest an abrupt unwinding of foreigners’ MGS holdings.

As such, the consequence of a reintroduction of capital controls would be a sell-off in the domestic fixed-income market, which pushes up interest rates and threatens the highly leveraged economy (Display 5). This would defeat the original purpose of capital controls.

BNM’s Policy Options

All in all, BNM has limited policy options in responding to currency attacks. First, a rate hike to support the currency is not feasible—incremental adjustments would not be effective, while a significant monetary tightening would badly hurt the leveraged economy.

Second, intervention to facilitate an orderly exchange rate adjustment would not be sustainable, as BNM is running out of ammunition. With less than US$100 billion in foreign reserves, BNM would be fair game for currency speculators. The more actively BNM intervenes, the more incentive for speculators to further sell the ringgit.

A more likely outcome is for BNM to introduce macro prudential measures such as limits on short selling of the MYR or on banks’ foreign exchange derivatives exposure—similar to ones imposed by Indonesian and South Korean authorities before. Still, there’s a limit to how far BNM can go with this approach as it seeks to slow down the MYR weakness but not overreact and scare off foreign investors. BNM may be able to mitigate the downward pressure on the MYR but not reverse the currency’s trend. It will eventually need to allow the market to make adjustments on its own.

All in all, we believe that a reintroduction of capital controls will yield no benefit and only cause a spike in domestic interest rates, risking significant economic disruption. In the tail-risk scenario, where politics dictate, we think that investors should be alert not just for MYR volatility but also for a potential spillover to other Asian markets.

By Vincent Tsui, Economist, Global Economic Research, and Anthony Chan, Asian Sovereign Strategist, Global Economic Research, AB

———-

The information contained herein reflects the views of AllianceBernstein L.P. or its affiliates and sources it believes are reliable as of the date of this publication. AllianceBernstein L.P. makes no representations or warranties concerning the accuracy of any data. There is no guarantee that any projection, forecast or opinion in this material will be realized. Past performance does not guarantee future results. The views expressed herein may change at any time after the date of this publication. This document is for informational purposes only and does not constitute investment advice. AllianceBernstein L.P. does not provide tax, legal or accounting advice. It does not take an investor’s personal investment objectives or financial situation into account; investors should discuss their individual circumstances with appropriate professionals before making any decisions. This information should not be construed as sales or marketing material or an offer or solicitation for the purchase or sale of any financial instrument, product or service sponsored by AllianceBernstein or its affiliates. This document has been issued by AllianceBernstein Australia Limited (ABN 53 095 022 718 and AFSL 230698). Information in this document is only intended for persons that qualify as “wholesale clients,” as defined in the Corporations Act 2001 (Cth of Australia), and should not be construed as advice.

The post Malaysia: capital controls to support ringgit would be disruptive appeared first on AdviserVoice.

El Niño and food inflation

Over the past year, lower oil prices highlighted disinflation risks and helped bond market performance across Asia. Now, however, investors are turning their attention to the risk of a rebound in food prices due to El Niño, a meteorological condition caused by oscillations in ocean surface temperatures.

During its previous bouts, in 2008 and 2011, El Niño exacerbated the inflationary pressure in Asia and prompted policy responses. A rebound in the headline consumer price index (CPI) now risks limiting policy options for central banks— particularly those that have inflation targets—at a time when the downside risk to growth is intensifying, as evidenced by the weaker manufacturing activity indicators in recent months.

An uptick in the El Niño/Southern Oscillation (ENSO) index in May this year drew the market’s attention to the risk of the El Niño effect, as the phenomenon is often associated with warmer and drier weather that could disrupt food supply.

However, a closer look at the ENSO index and food inflation in past cycles suggests that not all episodes of El Niño—or, elevated readings in the ENSO index—have resulted in food inflation, 1998–1999 being a prime example (Display 1).

Moreover, the El Niño effect must continue for some time before it results in food inflation. As of now, we have just two consecutive months of an uptick in the ENSO index for the Asia-Pacific region, and it’s also still one level below the highest reading. In our view, it’s still too early to conclude that El Niño and food inflation are returning.

Investors should also be aware that there is no direct relationship between the level of the ENSO index and the severity of food inflation. In some of the past episodes of El Niño, such as those in 2008 and 2010–2011, food inflation was significant and became a dominant driver of CPI inflation. But there are also cases in which food inflation stayed benign even during a significant El Niño. In addition, food prices respond to an ENSO index spike with some time lag, which means that even if El Niño were to disrupt food supply, it might only start to affect the CPI six to 12 months down the road.

Game changer?

In the absence of a broad-based commodity price inflation due to a lackluster global demand outlook, a rebound in food prices alone is unlikely to change the overall inflation picture of the region. In the past two episodes of El Niño and significant food inflation, the food component accounted for just 1.5–1.6 percentage points of Asia’s CPI inflation (Display 2).

This experience can help us evaluate the potential impact on the overall inflation picture. Regional inflation is now at cyclical lows, and there may not be much passthrough from El Niño, given the unimpressive growth rates. Even if there was a food inflation comparable to 2008 or 2010–2011, that should only bring the regional CPI back toward its long-term average of around 3%–4%. That is fairly benign, and swings in food prices per se typically do not have big monetary policy implications.

Better inventory levels on net basis

Looking at the supply/demand dynamics, there are also other factors that could mitigate the severity of any El Niño–driven inflation in the coming months. The current inventory levels for wheat and rice are similar to those in 2010–2011 and better than those in 2007–2008 (Display 3).

Wheat has a relatively small weight in the CPI basket across the region anyway because it’s not a staple in most Asian diets. And as for rice, the region has been largely self-sufficient, even during the previous droughts. Meanwhile, Asia is a net importer of coarse grains, mainly used for animal feeds. Global price fluctuations in coarse grains may have a more direct impact on domestic costs. In fact, during the previous two episodes of food inflation, surging meat prices were a key driver of the consumer price inflation. But the inventory of coarse grains is now at a much more comfortable level than before, offering some buffer against a global price rebound. Thus, in terms of the stockpile, the region is better positioned than before to withstand any El Niño effect.

Limited secondary effect

Lastly, the secondary effect on broader prices should also be a smaller concern than in the previous El Niño periods. Back in 2008 and 2011, the Asian economy was growing beyond its potential growth level, as estimated by the output gap using the Hodrick-Prescott (HP) filter. Core inflation had already been rising when food prices surged. By comparison, there is growing evidence of a greater economic slowdown across the region since the second quarter this year. Exports have been deteriorating, while lackluster domestic demand has kept the core CPI inflation benign. In such an environment, the secondary effect should not be a major concern (Display 4). While monetary tightening by Asian central banks in response to rising inflation in the previous cycles was justified from an economic fundamental perspective, a potential food inflation in the near future driven by external factors should not by itself result in policy responses. All in all, even though the risk of El Niño has increased, it is still too early to judge whether it will persist. There’s even more question about whether the effect would induce a food price inflation and whether that would affect broader consumer price inflation. So, for policymakers and bond investors, the downside risks to growth and other external uncertainties continue to be greater concerns, at least for now.

By Vincent Tsui, Economist, Global Economic Research and Anthony Chan, Asian Sovereign Strategist,Global Economic Research, AB

The post Asia: Too early to worry about El Niño as downside risks to growth persist appeared first on AdviserVoice.

Disinflation driven by a sharp decline in oil prices has resulted in a divergence in monetary policies across Asia over the past several months. India and Indonesia have been the front runners in the rate cut camp, followed by Singapore. The central banks of these countries have cited the increasing global economic uncertainty and the policy leeway created by low inflation as the bases of their policy actions. Meanwhile, central banks in Korea, Thailand, Malaysia and the Philippines remain reluctant to cut rates owning to concerns about causing financial instability.

However, the leverage cycle in most of the region has moderated noticeably over the past few quarters, and the instability concerns may be overdone, in our view. And in the countries where the balance of risk is unclear, we believe that policymakers should focus primarily on household leverage, as large corporations have become less dependent on debt financing in recent years.

Moderating Leverage Cycle

Even though most Asian central banks have maintained an easing bias since 2012, loan growth has been mediocre over the past three years, staying below the long-term average (Display 1). Credit growth has continued to decelerate in 2014, particularly in the countries of ASEAN (the Association of Southeast Asian Nations).

Weak credit demand is the result of a number of factors: household debt is already elevated, governments are consolidating their fiscal positions, and manufacturers see little need to boost capital expenditure amid disappointing export trends. South Korea and Taiwan were the only countries in the region that registered a modest recovery in credit growth in recent months, but even in those countries the pace of growth has been slower than in previous cycles.

The increase in banks’ leverage has been benign as well. The loan-to-deposit ratio has risen only modestly in most Asian economies since 2008 (Display 2). Banks have generally remained prudent in extending loans. The only exceptions to this trend are Singapore, Malaysia and Indonesia. Even so, the credit cycle should not be too much of a concern in Indonesia, where credit penetration remains low and its 36% credit-to-GDP ratio is among the lowest in the region. In Malaysia and Singapore, the increase in the loan-to-deposit ratios has accompanied an increase in household debt for real estate purchases, and the credit cycle deserves more attention from policymakers. But even here, the momentum has already moderated noticeably.

The credit-to-GDP ratios in Taiwan, India, Thailand and Indonesia have even declined over the past year. This suggests that banks are opting to strengthen their capital base instead of expanding their loan books. So the multiplier effect of any monetary easing should be modest. Even though credit growth has been decelerating over the past quarters, outstanding bank credit relative to GDP has continued to increase in China, South Korea, Singapore and Thailand (Display 3). Except for China, the increase was due to weaker GDP growth, however. And even in China, the government’s effort to improve the quality of credit in order to reduce excess capacity and local government debt is as important as—if not more important than—just the credit-to-GDP figures.

Policymakers in these countries are bound in a dilemma over whether to stimulate growth, or to refrain from easing to contain the risk of internal imbalances.

Household Debt Remains Key Concern

Sector-wise, leverage accumulation has been mainly confined to households, with most of the increase stemming from real estate activities. Still, in order to manage housing demand and curb speculative activities, targeted macroprudential measures, rather than monetary policy, should be more effective.

Large corporations in most of the region have reduced their reliance on debt financing over the past few years, despite the accommodative monetary conditions. The debt-to-equity ratio for listed companies across the region has fallen significantly (Display 4).

These companies account for a major share of banks’ corporate credit exposure, except in China, owning to the massive stimulus in 2009; the Philippines, where corporate leverage has increased only modestly; and South Korea, where the debt-to-equity ratio has already been declining for three years.

Monetary Policy Implications

The bottom line is, most of the region is already facing a credit downcycle, and sluggish credit demand, rather than excess liquidity conditions, should be the primarily consideration for policymakers, except in Singapore and Malaysia.

Singapore does not have an interest rate–based monetary policy, and its property prices have begun to consolidate anyway, but Bank Negara Malaysia should continue to refrain from easing because of the risk of a housing cycle overheating. For other central banks that have yet to start on a monetary easing cycle, the prescription is less clear cut.

Thailand’s debt has increased considerably in the past few years, but a lot of that is due to lending by state-owned institutions spurred by the government’s fiscal incentives. So, there is only a limited risk of housing overheating. In fact, Thailand’s commercial banking system has only seen a marginal increase in leverage, partly because corporations have been reducing their reliance on credit.

Likewise, the Philippines has also seen little increase in leverage, both in the private sector and the financial system. South Korea is now seeing a modest recovery in credit growth after some significant deleveraging in the financial system. But with a negative output gap, sluggish domestic demand and tepid nominal GDP growth, reflating growth should be the bigger priority for the South Korean authorities. In all these three countries—Thailand, the Philippines and South Korea—concerns about financial instability should not be a major constraint for monetary easing, and central banks have the flexibility if an easing is needed, in our view.

By Vincent Tsui, Economist, Global Economic Research and Anthony Chan, Asian Sovereign Strategist, Global Economic Research, AB.

———-

The information contained herein reflects the views of AllianceBernstein L.P. or its affiliates and sources it believes are reliable as of the date of this publication. AllianceBernstein L.P. makes no representations or warranties concerning the accuracy of any data. There is no guarantee that any projection, forecast or opinion in this material will be realized. Past performance does not guarantee future results. The views expressed herein may change at any time after the date of this publication. This document is for informational purposes only and does not constitute investment advice. AllianceBernstein L.P. does not provide tax, legal or accounting advice. It does not take an investor’s personal investment objectives or financial situation into account; investors should discuss their individual circumstances with appropriate professionals before making any decisions. This information should not be construed as sales or marketing material or an offer or solicitation for the purchase or sale of any financial instrument, product or service sponsored by AllianceBernstein or its affiliates. Note to Canadian Readers: AllianceBernstein provides its investment management services in Canada through its affiliates Sanford C. Bernstein & Co., LLC and AllianceBernstein Canada, Inc. This document has been issued by AllianceBernstein Australia Limited (ABN 53 095 022 718 and AFSL 230698). Information in this document is only intended for persons that qualify as “wholesale clients,” as defined in the Corporations Act 2001 (Cth of Australia), and should not be construed as advice.

The post Asia: are financial imbalances still a constraint for monetary easing? appeared first on AdviserVoice.

As 2015 business gets fully under way, bond investors face a major divergence in world central bank policies: the US Federal Reserve is moving closer to monetary tightening, while the European Central Bank (ECB) has just launched an aggressive asset purchase program with an open-ended commitment and the Bank of Japan (BoJ) continues to gobble up large chunks of Japanese government bonds.

A few months ago, the potential windfall for Asia from the global quantitative easing (QE) race appeared confined to some spillover portfolio flows from Japan. But the ECB’s aggressive easing has raised the prospect for a greater positive impact, given the dominance of European investors in many Asian bond markets. Moreover, Asia would also benefit from inflows through the bank credit channel, given European banks have been a key external funding provider in the region.

EU Bond Investors’ Presence Grows

Even prior to the ECB’s latest easing, European investors were expanding purchases of foreign debt securities, which accelerated in early 2014 (Display 1). In fact, the EU has surpassed the US as the largest bond investor in the region over the past few quarters. Overseas portfolio investments by US investors, which have mirrored the Fed’s balance sheet expansion over the past several years, have moderated after the Fed began tapering its QE3 program. while Japanese investors’ foreign-asset buying has remained modest despite the BoJ’s aggressive QE.

So far, portfolio outflows from Europe have been driven primarily by interest-rate differentials, especially after the ECB pushed its deposit rate into negative territory in June 2014. The euro area’s monetary base has remained largely flat over the past two years, but now the ECB’s balance-sheet expansion is likely to provide an additional impetus for portfolio outflows.

EU investors have always been among the largest players in Asia, even though the ECB has lagged well behind the Fed and the BoJ in recent years in terms of the scale of its quantitative easing (Display 2). Even after excluding a significant portion of the flows from Luxembourg—the country is a global hub for investment funds, and the ultimate holder of debt securities would be hard to track—the EU’s investment position in the Asian bond market was still larger than that of US investors and more than double that of the Japanese as of end of 2013. Accelerated foreign bond purchases by European investors over the past few months may have further widened their lead.

Potential Winners

Within Asia, bond markets that are likely to benefit the most from the policy divergence would be those with less reliance on US investors (and thus less exposed to a Fed tightening) and those in which European and Japanese investors have a greater presence.

Traditionally, European investors have had a large presence in Indonesia. Even after excluding Luxembourg, the EU accounts for one-third of foreign holdings in Indonesia’s bond market (Display 3). Bond markets in Thailand and Malaysia also enjoy a greater presence of European investors, although foreign participation in Thailand’s bond market is smaller than in Malaysia or Indonesia.

By contrast, the Philippines and South Korea have a greater exposure to US investors, while India has less exposure to investors from all these major economies.

While many factors may affect European investors’ asset allocations to individual markets, the pattern of current holdings at least indicates those investors’ traditional preference and should help to identify the markets with better prospects of receiving increased inflows. Markets with a greater participation of European and Japanese investors are also likely to face less rollover risk for maturing debt.

Benefits from Banks Credit Channel

Flows from Europe are not limited to portfolio investments. European banks have had the greatest share of external lending in Asia over the past few years (Display 4). Their total exposure has been little changed since the European sovereign-debt crisis, but now with the ECB expanding the monetary base more aggressively, more external leakage is likely. Japanese banks’ Asian loan books expanded significantly after the BoJ stepped up its monetary easing. The fresh European flows would help offset an otherwise decelerating credit cycle in the region.

Thailand and Malaysia may be the main beneficiaries of the current global monetary policy backdrop, given that these economies rely more on credit provided by European and Japanese banks and less on that from US banks (Display 5). Taiwan and South Korea are mixed cases, as they are also reliant on US lending and may be vulnerable to a Fed tightening.

Hong Kong and Singapore, Asia’s main financial centers, have seen a noticeable increase in European banks’ credit over the past two years. That may be reflecting European lenders’ preference for larger corporations that have regional headquarters in those cities or are more actively involved in capital-market transactions.

Bottom Line

All in all, given the strong presence of European investors in Asian bond markets, the impact of increased ECB liquidity is worth paying attention to in the coming months. Along with other positive factors— such as lower inflation expectations and increasing odds of more accommodative central bank policies in the region—it may provide additional impetus for local bond market performance. Because of a greater exposure to EU and Japanese investors and less reliance on US money, ASEAN markets—particularly Indonesia, Thailand and Malaysia—may be better positioned than their other regional counterparts, in our view.

By Vincent Tsui, Economist—Global Economic Research and Anthony Chan, Asian Sovereign Strategist—Global Economic Research, AllianceBernstein

———–

The information contained herein reflects the views of AllianceBernstein L.P. or its affiliates and sources it believes are reliable as of the date of this publication. AllianceBernstein L.P. makes no representations or warranties concerning the accuracy of any data. There is no guarantee that any projection, forecast or opinion in this material will be realized. Past performance does not guarantee future results. The views expressed herein may change at any time after the date of this publication. This document is for informational purposes only and does not constitute investment advice. AllianceBernstein L.P. does not provide tax, legal or accounting advice. It does not take an investor’s personal investment objectives or financial situation into account; investors should discuss their individual circumstances with appropriate professionals before making any decisions. This information should not be construed as sales or marketing material or an offer or solicitation for the purchase or sale of any financial instrument, product or service sponsored by AllianceBernstein or its affiliates. Note to Canadian Readers: AllianceBernstein provides its investment management services in Canada through its affiliates Sanford C. Bernstein & Co., LLC and AllianceBernstein Canada, Inc. This document has been issued by AllianceBernstein Australia Limited (ABN 53 095 022 718 and AFSL 230698). Information in this document is only intended for persons that qualify as “wholesale clients,” as defined in the Corporations Act 2001 (Cth of Australia), and should not be construed as advice.

The post European investors may hold key to Asian bond market performance appeared first on AdviserVoice.