"To the great benefit of most people, Asia and the West remain linked both by trade in goods, by capital flows and by cross-border travel and immigration."
Redefining Decoupling
by Robert Horrocks, CIO, Portfolio Manager, Matthews Asia
September 2010
During the latter half of 2007, market commentators engaged in a discussion about "decoupling." While valuations in Asia were on the rise, those in the U.S. and Europe were seeing a steady decline. Judging at least by valuations at the time, the markets had seemed to accept the decoupling theory as valid. Yet it was never quite obvious what decoupling really was. On the one hand, this idea that the world would have less and less to do with each other in terms of trade and money flows seemed outlandish as it contradicted all the evidence of 30 years of globalization. On the other hand, it seemed to make perfect sense that Asia's economies would see increases in domestic demand, and particularly consumer demand, that would outpace the rate of growth in export sectors. But decoupling, as an argument that Asia would be immune to the vicissitudes of the Western economic cycle, was dealt a blow during the global financial meltdown in late 2008.
Markets are now worried about fading momentum in the developed world recovery. What can we say about "decoupling" in the current economic environment? There seem to be clear differences emerging between the East and West in at least two areas of the economy. In economic stabilization policy, Western governments appear to be "pushing on a string," as their policies seem to be having minimal effect; in Asia, however, governments are pulling on the reins, trying to bring overstimulated economies back to a canter. And whereas confidence in Western economies has collapsed along with interest rates, Asian economies are still showing the vitality in demand and investment that is driven by expectations of future consumption growth.
In such an environment, the decoupling debate is resurfacing. What should investors care about in terms of decoupling? In the short term, they should care about the financial links between countries and whether Asia's markets can truly resist short-term shocks to other parts of the global financial system. Investors should consider to what extent overseas markets track their home market or plot a more independent course over a period of several years and in less volatile times. They should also care about the uniqueness of long-term investment opportunities in the target market, do they offer distinct choices that enhance your portfolio? Or are they just a derivative of growth elsewhere? Let us focus on these three aspects of decoupling and call them: "resilience," "independence," and "uniqueness." And let us look at Asia through the prism of each of these categories to see how the region stands now and how it may likely develop.
Crash Resistance
The West has always seemed resilient to events in the East, due to the strength of its domestic demand. In theory, Asia's relatively buoyant domestic demand should help their resilience. However, part of the West's strength has been the economic policy tools it uses to manage economic shocks, the effectiveness of which depends partly on the institutions built and partly on confidence in the policymakers. Asia has a mixed reputation in economic policy, capital controls are always a risk (see Asia Weekly July 2, 2010), and have been used in the past by several countries. Price controls are used extensively in places like India and China. And Asia had its own credit bubble-driven financial crisis in 1997-98. However, there seems little doubt, too, that the stimulus enacted by Asian governments in the face of the recent crisis were effective to an extent that the U.S. and European stimulus plans were not. The Asian Development Bank (ADB) projects growth for emerging East Asia this year at 8.1% and believes that most economies in the region are assured of a sharp V-shaped recovery this year.
But Asian equities were not "crash proof" in the immediate aftermath of the Greek debt crisis. After Greece's debt was downgraded to "junk" in April, the S&P 500 Index declined 12% toward the end of May; major Asian markets fell by between 8% (Japan) and 22% (Korea). India fell 16% and Hong Kong 11%. These are not particularly resilient results. Nor should we expect them to be, weak Western economies not only dampen global demand, they also affect capital flows. These flows into Asia have been strong, July alone saw US$3 billion of net flows into Asia ex Japan (twice the monthly average of 2005ā2007). These inflows can be volatile; we should not expect the region's markets to be immune from shocks to their source.
The resilience of Asia's economies depends on the stand-alone strength of their financial systems. But in one example we saw in late 2008 much trade finance in the region is run by Western banks. As credit seized up, goods were left standing on the docks on both sides of the Pacific Ocean, unable to move until the credit markets in the U.S. unfroze. The Korean banking system, reliant on overseas funding, would have suffered a severe setback were it not for a US$35 billion line of credit from the U.S. Federal Reserve. The pegging of the region's currencies, and particularly the Chinese renminbi, to the U.S. dollar remains a transmission mechanism for external shocks. Steps are underway to change some of these links. A China-linked, Hong Kong bank has won approval as a renminbi clearing bank in Taiwan, and even McDonald's will be issuing a renminbi bond in Hong Kong. Everything points to a widening of the sphere of influence of the Chinese currency and a deepening of the renminbi capital markets.
However, it is in this area of resilience, financial market reform, that Asia has made perhaps the least progress since the global financial crisis and its own crisis in the late 1990s. Broader and deeper capital markets are surely a prerequisite for true resilience. The region has some liquid markets but the markets of its two giant and fast-growing economies, India and China, are still relatively illiquid and thinly supported by nascent domestic wealth management industries. Asia is perhaps still as dependent on the short-term stabilization policies of the U.S. Federal Reserve as it is the People's Bank of China.
Running on Different Tracks
Domestic demand will be another important way to generate increased economic independence. We believe domestic demand in Asia will continue to strengthen. In particular, domestic consumption will continue to increase as a portion of GDP. Crucially for the decoupling debate, this trend is likely to be significantly influenced by increased government spending on health care and welfare payments, and also, (as we highlight in our 2010 issue of AsiaNow) by increased spending on services in general. These activities tend to be less tradable than goods. Thus, the International Monetary Fund, along with other international institutions such as the ADB, World Bank and OECD, is forecasting relatively robust rates of growth for Asia (7%ā8%) even in light of weak growth in the G7 of a little above 2%. Even if Asia's economies do not achieve the growth rates of the recent past, the growth expected by most forecasters should support strong profit growth in domestic businesses.
But how unique are the investment opportunities in Asia? Asia was perhaps never as reliant on exports as commentators made out. But it is hard to deny that they have been an important part of the region's growth. For it was the commercial and technological knowledge, derived from foreign goods and competition, that allowed Asia to transform its economies. In the initial phase, this made many Asian companies "derivatives" of Western growth as they became low-margin manufacturers of Western branded goods for sale in the U.S. and Europe. More recently, however, Asian companies have started to compete with their own brands. In terms of research and development, and innovation, much progress has been made in the past through Asia's links with the West. Innovation has come "embedded" in imported machinery or through the commercial contacts with foreign countries. More recently, patents and innovation have been spurred by homegrown initiative. As the region grows in wealth, R&D spending should become a larger part of GDP. Currently, it lags economies such as the U.S. in terms of overall spend but not necessarily in terms of activity: China spends 1.5% of GDP on R&D, about half the ratio in the U.S., but China applied for about 194,600 patents in 2008, compared to about 231,600 for the U.S. Japan applied for more than 330,000 patents and Korea, with one of the best-educated populations in the OECD, applied for just over 127,000.
Just as the U.S. has its iconic brands, Asia will likely develop its own brands as well. Yes, there has been a tendency to mimic the U.S. lifestyle. But the U.S. is surely a less enticing model these days. Asia has, and will continue to, develop its own brands. Growth in domestic demand is not just about the quantity of dollars spent, or the size of the market, it is also about the changes in tastes and preferences that are going to take place in the market and the price signals that these send to entrepreneurs. For sure, I would expect multinational companies to enjoy some of this growth. But I think they will be at a disadvantage to local entrepreneurs in, for example, innovation in bean curd, rice wine and herbal remedies. Moreover, where brands are a statement of regional or national differences, foreign companies lack the credibility to build them. We have also seen how Asian consumers use the Internet for networking and communication through playful online identities, perhaps an oddity to many in the West, but no doubt valuable in countries where media has been more tightly controlled. Nuances like this can be hard for large Western-based multinationals to capture. Asian companies have also been expanding overseas; there will, I am sure, come a day when the phrase "multinational" is no longer almost exclusively connected in our minds with the idea of Western companies.
Coming Off the Rails
To the great benefit of most people, Asia and the West remain linked both by trade in goods, by capital flows and by cross-border travel and immigration. Trade war, capital controls, border closings or breakdowns in international relations could all lead to "decoupling" and are all risks that we must face. However, the clearest danger perhaps comes from capital controls. Much of what we have been discussing is the relationship between capital markets and the demand in Western and Asian economies. It is not difficult to envisage a situation in which the U.S., with a chronically moribund economy and gridlocked politics, resorts to increasingly aggressive monetary stimulus, even attempting to drive down the value of the U.S. dollar. In defending their fixed currency regimes, Asia's governments would be pushed into monetary easing that would threaten the stability of their asset markets and potentially the distribution of wealth in society. At this point, Asia's policymakers may well consider capital controls again.
So, Asia still remains susceptible to shocks and economic policy changes in the West. However, over longer time periods, it seems to be laying down its own economic track. Let me leave you with one last (mischievous) thought: if the ability to "decouple" is seen as the ability to cause a crisis elsewhere, then Asia has perhaps made greater strides. For, even if the relationship between Asia and the U.S. is still a lopsided one, we pay a lot more attention to the state of demand in China than we used to, and that has to be a sign of change in the relationship between East and West.
Roundtable: Redefining Decoupling
This month's Asia Insight focuses on the topic of Development of Asia's Financial Markets in a conversation with the following Matthews Investment Team members:
- Andrew Foster, Portfolio Manager
- Teresa Kong, CFA, Portfolio Manager
Q: What are your thoughts on the correlation between Asia's markets and those of the West?
Teresa Kong:
First, let's take a look at the underlying fundamental picture of the U.S. fixed income market. Traditionally, it has been composed of four major asset classes: Treasuries, agencies, mortgages, and corporates. Fannie Mae and Freddie Mac are now under conservatorship, so their credit is now basically that of the U.S. Treasury. The U.S. government has also become the buyer of last resort in mortgages. Regarding correlation, the formerly four unique asset classes have collapsed into basically just two: U.S. Treasuries and corporates.
Barring another financial crisis, Asia's local fixed income markets should be less correlated to the West. Even though the macroeconomic cycles are still linked to the U.S., there is enough domestic growth that several of the region's central banks have stronger tightening biases as they are worried about too much growth.
Andrew Foster:
The challenge for U.S.-based investors is that, even when measured over fairly long cycles, the correlation between Asian and U.S. equities is high, and trending higher. Unfortunately, this means that investors in the region don't receive a material diversification benefit.
Asia's rising correlation is a byproduct of the fact that the region's markets have grown more integrated with the rest of the world. The important upside to this is that they have seen consistent gains in depth and liquidity. Though Asian stock markets have certainly felt severe shocks, we can look back on every past year for improved breadth and liquidity in the markets.
So while this integration has had a notable downside, rising correlations, the positives nonetheless outweigh the negatives. Prior to this integration, Asia's capital markets were small, isolated, illiquid, and excessively volatile. When risk aversion rises, the tide goes out everywhere, including Asia. Yet at the same time, the market's improved depth and breadth means that it plays a much more central role in the economic landscape.
This has important and practical implications for Asian business. Previously, stock markets were too small and shaky to comprise a major source of funding for most companies. Most corporations generally ignored the price of their public stock. Now, companies are capable of raising billions of dollars from Asian stock markets. Some of the biggest IPOs in the history of the world have taken place in China over the past few years. Consequently, companies have changed their orientation: they are beginning to treat the public markets, and the investors behind them, with much greater care.
Q: What is happening in terms of currency policies in the region?
Andrew Foster:
If we talk about prerequisites for further economic independence, we need to see the emergence of independent and capable policies to manage money supply and credit growth. Asia's central banks are tightening as they look at their own domestic conditions; they are doing so well ahead of the U.S. Federal Reserve, and probably set for more. To me, this suggests that the outsized role that the U.S. dollar has had as a de-facto currency standard within the region is waning. The challenge that Asia faces is that until there is a strong surrogate that can stand in for the dollar, or perhaps a new reserve currency, there will be a lot of small nations that will struggle to conduct capable monetary policy on their own. There's been talk of some sort of regional currency like the euro. I tend to think that won't come to pass.
Teresa Kong:
We're seeing the Chinese government instituting policies in exactly that direction, positioning the renminbi to be more of a global currency. They're doing it in thoughtful, gradual steps. One of those steps is the fact that they are encouraging corporates to invoice in renminbi. As the terms of trade, or "center of gravity" moves away from the U.S. and more towards Asia, it increasingly makes sense for the corporates to move toward a currency that reflects those underlying fundamentals.
Another step that China has taken is to allow certain multinationals to issue bonds denominated in renminbi as Robert highlighted in his commentary. This has, in effect, enabled Hong Kong banks with renminbi deposits to diversify away from just local Chinese entities to multinationals like McDonald's.
Andrew Foster:
It's a pretty profound step. By issuing bonds in the renminbi these companies get a cheap source of capital becauseĀ offshore interest rates on renminbi bank accounts are near zero. The problem is that when a company earns renminbi by trading with a Chinese counterpart, there's very little it can do with the currency it receives.
Teresa Kong:
Developing local capital markets is very important in many Asian countries where larger corporates have always been dependent on the international market for long-term funding. A corporate would always want to lock up cheap funding for as long as possible. Most of these local markets haven't offered term and haven't offered size. Most banks offer floating rates, and often for only up to three years. So governments are keen to push out the yield curve and establish benchmarks so that corporates can tap a longer and deeper market.
Q: What else needs to happen?
Andrew Foster:
There is a lot that has to happen, including continued banking reforms. There has to be a broad and deep perception in the global marketplace that there is credible monetary policy within China on a domestic basis, and the jury is still out there. What we also should see is a liberalization of the interest rate regimes in the banking sector where there's both a ceiling and a floor on deposit rates.
I still firmly believe that the Chinese are on a solid path to the opening of the capital account but it will happen on their own time schedule, even if that means defying the expectations of policymakers around the world.
Matthews Asia Funds holds no positions in securities issued by McDonald's Corporation, Fannie Mae or Freddie Mac.
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