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Economy

George Magnus: Asia looks vulnerable as Fed prepares to change its tune

Asia-Pacific equity markets have recovered by about 8% from their nadir in February, according to the MSCI Emerging Markets Asia Index. That mirrors a global trend in which equity markets have risen strongly, especially in the U.S., while bond yields have remained low and market volatility measures have dropped to levels last seen in 2007. Such buoyancy in financial markets was scarcely imaginable earlier this year, when investors worldwide feared the consequences of moves by the U.S. Federal Reserve to scale back its quantitative easing program.

     The Fed has continued to taper QE at a rate of $10 billion a month, meaning it is on course to unwind its asset-purchase program completely by the fourth quarter of this year. As things stand today, it seems unlikely that market optimism will be punctured anytime soon.

     We should be wary, however, of extrapolating too much, because the foundations of the "feel-good factor" in global finance are becoming increasingly shaky. Above all, while the Fed is behaving like a fairy godmother toward asset prices now, it is bound to turn into a wicked stepmother before too long. When it does, U.S. bond yields will rise, reflecting a changing view about short-term interest rates. This will have a marked impact on Asia, where shadows over medium-term growth prospects are already darkening. Financing costs for banks and for heavily indebted nonfinancial corporations will rise. Capital will be drawn out of local currency fixed-income and credit markets, where foreigners have built up significant positions. U.S. dollar commodity prices may rise if higher policy rates strengthen the currency, but that may not apply in industrial and metals-based commodity markets.

Don't fight the Fed, but watch it like a hawk

For now, in spite of a slow, steady reduction in the volume of asset purchases, the Fed has continued to assure the world not only that U.S. policy rates will stay at the so-called zero lower bound for a long time, but also that when they do increase, their "equilibrium" level will be materially lower than we have experienced in the past. Financial markets expect the Fed to raise interest rates around mid-2015 but the supposed timing oscillates, depending on how the economy is expected to perform.

     Currently the Fed is pondering how to ensure interest rates stay low enough to lend support to continued economic recovery, but not so low as to jeopardize financial stability. The economic arguments are themselves bifurcated. On one hand, the U.S. economy is staging a good rebound after a near 3% annualized fall in gross domestic product in the first quarter. Nonfarm employment growth picked up to a robust 288,000 in June, from 224,000 in May, and unemployment has fallen steadily to 6.1%. On the other hand, the structure of employment and the labor market in general is still weak, and annual increases in wages and salaries have barely budged from a feeble 2%, which means real take-home pay is still lower than a year ago.

     Market views come thick and fast, and often change, but they always return to the utterances of Janet Yellen, the Fed's chair. Shortly before the June employment data were released, she said she did not see a need at present for monetary policy to "deviate from a primary focus on attaining price stability and maximum employment, in order to address financial stability concerns." In other words, policy isn't going to change. As if to emphasize the point, she went on to say that she saw pockets of increased risk-taking across the financial system, but that the Fed would most likely adopt "a more robust macroprudential approach," otherwise known as regulation, to deal with any anxiety about financial instability.

     U.S. stock markets took their cue from these remarks, rising to record levels before the July 4 Independence Day holiday weekend, with global markets for the most part sustaining recent gains or advancing. This bias is unlikely to change significantly, as long as the Fed articulates its intentions in this way. But we should watch for the first signs of change, which will arise because of continued economic growth momentum, and possibly from lagging wage and inflation developments. There is no guarantee the current judgment of the Fed and the futures markets -- that policy rates will not rise for more than a year -- will not change abruptly.

Trouble at home

Political and economic risks in Asia sit uncomfortably with a generic rise in equity markets, and what market participants call "skinny spreads," or narrow credit- and interest-rate risk premiums over local benchmark or U.S. government bonds. The principal reason they all go hand-in-hand is because of the liquidity impulse emanating from the Fed, and the institution's assurances that it is, in effect, safe to go on accumulating risk.

     Asian markets, for example, have moved on from or ignored several risky developments. There was an unequivocally positive reaction to the stunning electoral victory of Narendra Modi's Bharatiya Janata Party in India, which has given the country hope for reform and renewal after the previous government's economic and political funk. But markets have not stopped for long to recognize, for example, the coup in Thailand; Indonesia's fiercely contested election; fears over China's property market downturn, which looks serious this time; new uncertainties over the next phase of Abenomics in Japan; and rumbling tensions in the South and East China seas.

     The recent democracy protests in Hong Kong may have been written off in financial markets as a local disturbance of little consequence outside the territory, but they deserve a special mention on anyone's watch list. No one expected Beijing not to exert its influence over Hong Kong, and it is clearly doing so in the media, business practices, commerce, tourism, and real estate. But amid stagnant wages, faltering public services such as education, and growing concerns over judicial independence, Hong Kong could change from Asia's premier financial and trade center into just another large Chinese city. It is not so much that it is experiencing unmanageable stress, but that China may choose not to address it in ways that sit well with the city's more educated groups. Potentially, then, Hong Kong could also become a more troublesome issue for the Asian investment climate.

Word to the wise

Now set these political troubles against a medium-term growth outlook that continues to deteriorate. The International Monetary Fund still expects developing Asia to grow by about 4.5% over the next few years, after nearly 6% average growth between 2003 and 2012, but the underlying picture is better described in a different way. A lot of economic catch-up has already been done. Growth derived from the deployment of physical labor and capital is slowing, and structural reforms are being promoted as an urgent alternative to reliance on rising debt. Indeed, balance sheet problems loom for Asia as the burden of debt rises relentlessly. In developing Asia, private-sector debt has risen to almost 160% of GDP, which is 45% higher than in 2008. This is about the same as the U.S., but the Asian figure is rising and the American one declining.

     The highest debt levels and the fastest rises have occurred in China. But Taiwan, South Korea, Malaysia, and Thailand all face similar problems. Even less leveraged countries such as India, Indonesia and the Philippines need to avoid this trap. And while there is broad regional recognition of the need for structural economic and policy reforms as a substitute for credit expansion, in reality it often takes a crisis before governments feel compelled and able to formulate and implement them.

     It took the Asian financial crisis of 1997-1998, for example, to trigger comprehensive economic and political reforms in the region. The main risk from now into 2015 is that reform inertia or reluctance will tempt Asian governments, perhaps including China, to advocate exchange-rate depreciation as a counterbalance to constraints on credit expansion, and to sustain export and labor-cost competitiveness. This might be all too tempting away if higher U.S. bond yields, reacting to changing expectations about the Fed, push the dollar up.

     The combination of slow monetary policy regime change in the U.S., looming limits to credit and debt creation in Asia and the growing likelihood of Asian currency depreciations -- including for the yen -- is likely to result in a renewed outbreak of financial and economic turbulence, even if that seems a distant prospect right now. It is against this backdrop that the region's political uncertainties appear especially unsettling. As the former chief executive of Citigroup, Chuck Prince, opined famously in 2007: "As long as the music keeps playing, you've got to get up and dance." Investors should be smarter and leave the dance floor before the Fed changes its tune.

George Magnus is a former chief economist at UBS and author of "Uprising: Will Emerging Markets Shape or Shake the World Economy?"

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