Economic Research:

Despite Our Steady Growth Forecasts In Asia-Pacific, China's Financial Risks May Be A Wrench In The Works
Credit Market Services: Paul F Gruenwald, Asia-Pacific Chief Economist, Singapore (65) 6216 1084; paul.gruenwald@standardandpoors.com Secondary Contact: Vincent R Conti, Singapore (65) 6216 1188; vincent.conti@standardandpoors.com

Table Of Contents
Steady Asian Growth Masks A Shift In Composition Inflation Worries And Monetary Policy Action Still On The Back Burner Moral Hazard In China: Exit Financial Repression, Enter Financial Risks Can The Japanese Economy Weather Its Consumption Tax Hike? Political And Geopolitical Risks: Take Your Pick As The U.S. Fed Normalizes Its Monetary Policy, What Are The Real Risks Facing Asia-Pacific? Developments In China Make For A Shakier Baseline Appendix: Inflation And Policy Rate Forecasts Related Research

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Economic Research:

Despite Our Steady Growth Forecasts In Asia-Pacific, China's Financial Risks May Be A Wrench In The Works
Two major growth engines of Asia-Pacific are set to shift to lower gears. But our Asia-Pacific baseline growth scenario looks almost the same. For the region as a whole, we forecast 2014 and 2015 GDP growth at 5.4%. This is identical to 2013's actual growth and broadly unchanged from our previous forecast made in December. Growth in the two largest economies--China and Japan--is set to moderate, albeit for different reasons. However, we expect growth in the more open and trade-dependent Tiger economies of Hong Kong, Korea, Taiwan, and Singapore to improve this year and next as the U.S. and Europe gain steam. In contrast, our views on risk scenarios have changed materially since our last round of forecasts. Specifically, Standard & Poor's now believes China's financial sector risks have moved into our forecast horizon as the authorities appear to be laying the groundwork for addressing widespread moral hazard problems in the credit market. We also continue to see risks from U.S. monetary policy normalization as well as politics in South and Southeast Asia. As a result, we now view the risks to our baseline forecasts as tilted to the downside. Overview We forecast growth for Asia-Pacific to remain steady in the 5.25%-5.5% range over the next two years, although this masks decelerating growth in the two largest economies--China and Japan. With our improved outlooks on the U.S. and, to a lesser extent, Europe, Asia-Pacific's trade-dependent Tiger economies should outperform others. We expect India's growth to rebound as well. We have raised the probability of our downside scenario, reflecting the rising financial sector risks in China. Further ahead, we think the effects of U.S. interest rate normalization bear watching.

Steady Asian Growth Masks A Shift In Composition

We expect GDP growth in Asia-Pacific as a whole this year to be broadly unchanged--below trend but reasonably solid. However, the growth paths of China and Japan (which together account for 60% of regional GDP) are deviating from that of the rest of the region.
Table 1

Standard & Poor's Baseline GDP Growth Forecasts

2014f Australia China India* 2.6 7.4 6.0 2015f 3.0 7.2 6.3 2016f 3.1 7.0 6.5

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Economic Research: Despite Our Steady Growth Forecasts In Asia-Pacific, China's Financial Risks May Be A Wrench In The Works

Table 1

Standard & Poor's Baseline GDP Growth Forecasts (cont.)

Japan South Korea Hong Kong Indonesia Malaysia Philippines Singapore Taiwan Thailand Vietnam New Zealand Asia-Pacific Emerging Asia Newly Industrialized Economies ASEAN 1.3 3.5 3.6 5.6 5.2 6.6 3.7 3.7 2.7 5.5 3.1 5.4 6.3 3.6 5.1 1.2 3.8 4.1 5.8 5.6 6.0 3.9 3.9 5.1 6.0 2.5 5.4 6.4 3.9 5.7 1.2 3.8 3.6 6.0 5.7 6.1 3.5 3.8 4.4 6.3 2.5 5.4 6.3 3.7 5.7

* Fiscal year ending March. Regional aggregates are calculated as a weighted average using 2012 GDP measured in purchasing power parity terms.

China is likely to continue its gradual moderation in growth as policymakers attempt to steer the economy onto a more sustainable path. In Japan, the consumption tax increase continues to pose the largest risk to growth and the fight against deflation, as the initial boost from Abenomics begins to fade. Australia has passed the peak of its investment boom, but exports should be able to provide decent growth in the short term as previous years' mining investments come online. India is in a period of sub-par growth, hampered not only by structural rigidities but also by tighter policies implemented to combat inflation and capital outflows stemming from the market turbulence in mid-2013. As mentioned, growth in the Tiger economies will likely pick up this year, in step with global trade improvements driven by the U.S. and Europe (see chart 1). In Southeast Asia, country-specific factors increasingly influence growth outlooks. Thailand is the exception, where we have significantly lowered our baseline forecasts. The political turmoil has gone on longer than expected, and there is little indication of the ultimate outcome. We have therefore cut our 2014 growth forecast by 1.7 percentage points to 2.7%, given the disruptions that the political situation is causing within the economy, and the negative effect it is having on confidence and investment.

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Economic Research: Despite Our Steady Growth Forecasts In Asia-Pacific, China's Financial Risks May Be A Wrench In The Works

Chart 1

Inflation Worries And Monetary Policy Action Still On The Back Burner
We continue to expect inflation to remain under control across most of the Asia-Pacific region. Although improving external growth prospects will likely cause output gaps to narrow somewhat and inflation to edge up, especially in the Tiger economies, the sub-par growth performance of the past few years suggests that most economies are still operating below capacity. The Philippines may be the exception, having grown rapidly, propelled by the business process outsourcing sector and the benefits it has had on the rest of the economy. Inflation in Japan and Malaysia will likely rise because of consumption taxes. In India and Indonesia, tighter monetary policy enacted during the previous round of financial market stress will help to rein in inflation. On the monetary policy front, we expect very little impulse for central banks to adjust interest rates over the year. Interest rates are still quite accommodative, with growth steady or improving, and inflation largely benign. The exception remains the Reserve Bank of New Zealand, which is likely to tighten settings steadily because of concerns about the possible overheating of the housing and construction market; indeed, the RBNZ raised its policy rate in March 2014. The Philippine central bank may also need to cool the economy after consecutive years of above-trend growth.

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Economic Research: Despite Our Steady Growth Forecasts In Asia-Pacific, China's Financial Risks May Be A Wrench In The Works

Meanwhile, the Bank of Thailand will likely ease monetary conditions further to support an economy that is being hindered by political gridlock; the bank cut its policy rate last November and again in March. In the rest of the region, India and Indonesia have tightened ahead of their neighbors, reducing the need to raise policy rates much further. The People's Bank of China will likely hold its main policy rate steady while increasing the relative importance of its open market operations. It has already extended its liquidity facilities to include small and medium banks. Finally, the Bank of Japan may increase its rate of asset purchases to counter the effects of the consumption tax hike on disposable incomes and confidence if growth slows and prices start to fall again.

Moral Hazard In China: Exit Financial Repression, Enter Financial Risks

The warning flares are up. We now see an increased likelihood that the Chinese authorities may address the financial sector risks sooner rather than later, with a potential for a disorderly adjustment (see "Credit FAQ: Can China Come To Grips With Soaring Public Debts And Moral Hazard In The Financial System?" published March 3, 2014, on RatingsDirect). In contrast, we previously saw these risks as occurring in the medium term, outside our forecast horizon. Although our base case scenario assumes any fallout from such an event to be largely contained, our increasing concern lies with a fast-growing class of credits outside of the banking sector: most notably, wealth management products (WMPs) issued by non-bank entities such as local government financing vehicles, property developers, and trust companies. The assets underlying these claims can essentially be anything. These products are sold through the state-guaranteed banks and promise returns that are much higher than WMPs issued by the banks themselves, making them very attractive to investors. Crucially, there is widespread belief in China that the state guarantee of the banks that distribute WMPs extends to these non-bank initiated products as well. This leads to a moral hazard in the form of risks not being correctly monitored and priced. The result is an oversupply and underpricing of such risky products, as well as excessive investment. Under our risk scenario, a credit event in the non-bank portion of the financial sector leads to market instability as perceptions of state guarantees unravel following a series of government-sanctioned defaults. This would initiate a turbulent period, in which funding could dry up as the domestic market struggles to re-price risk across a spectrum of credit products. Even viable investments could struggle to get financing in such an environment. As a result, China's growth could fall sharply for at least a few quarters, led by investment. However, we note that (1) China's fiscal and monetary authorities will almost certainly step in strongly to try to mitigate the fallout from such an event; and (2) the self-financed nature of the system rules out a full-blown external or fiscal crisis. The effectiveness of the policy response would be crucial in determining the length and severity of such a credit event. The above scenario in China would have a significant impact on the rest of the region. Economies that are highly exposed to China's investment demand could experience the largest slowdowns (see chart 2). Specifically, in Hong Kong, Australia, and most likely Taiwan (where data are not available), capital and raw material exports to China account for large percentages of total exports--close to 40% for Hong Kong and about 25% for Australia. Korea, Japan, and the Philippines form the next tier, with China-bound capital and raw material shipments making up 10% or more of total exports. India is the least vulnerable at 2.5%.

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Economic Research: Despite Our Steady Growth Forecasts In Asia-Pacific, China's Financial Risks May Be A Wrench In The Works

Chart 2

Can The Japanese Economy Weather Its Consumption Tax Hike?

Abenomics faces its first big test in April 2014 when the consumption tax rises to 8% from 5%. Prime Minister Shinzo Abe's revitalization program for Japan has so far brought good results. GDP growth has picked up in the past two years, and although the pace of activity slowed to just 1% on an annual basis in the fourth quarter of 2013, domestic momentum remains fairly solid. Importantly, inflation as measured by a number of metrics has turned positive and continues to rise, suggesting an opportunity to end two decades of nearly constant deflation. We believe the consumption tax is necessary but might be coming too soon. It risks putting a damper on growth and reigniting deflationary pressure in the economy. If this happens, then the Bank of Japan may need to take decisive action through expanding its balance sheet faster in order to further loosen monetary conditions. This would be necessary to keep inflation on an upward path as well as to break the well-entrenched deflation mindset and anchor inflation expectations at about 2%.

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Economic Research: Despite Our Steady Growth Forecasts In Asia-Pacific, China's Financial Risks May Be A Wrench In The Works

Political And Geopolitical Risks: Take Your Pick

Politics and geopolitics loom large in Asia-Pacific this year. These are inherently difficult to quantify, and can be seen as "known unknowns." Elections take place in two important countries in the first half of the year: India and Indonesia. Financial market turbulence hit both countries hard in the middle of 2013. Their currencies weakened substantially and growth fell. However, their large current account deficits--the proximate cause of the sell-off--have narrowed and their currencies actually strengthened in the recent emerging market selloff. The issue in India and Indonesia is the political will to tackle: (1) various fiscal subsidies that contributed to budget concerns as well as current account deficits, and (2) the bottlenecks in policies regarding foreign direct investment, given that more stable investment flows are needed in the longer term to credibly finance ongoing current account deficits. We believe significant progress on the policy front is unlikely until the election results are clear. Elsewhere, the political stalemate in Thailand drags on. An escalation of the violence remains a risk, although both the government and the opposition continue to mainly posture for now. A longer-term risk is that foreign direct investors start to have a dimmer view of Thailand's attractiveness for doing business, but there are few indications of this so far. Recent political developments in the Ukraine also bear watching. While the effects on Asian markets to date have been indiscernible, the situation has not fully stabilized and ripple effects cannot be ruled out.

As The U.S. Fed Normalizes Its Monetary Policy, What Are The Real Risks Facing Asia-Pacific?
As far as risks to Asia go, has the market's focus on the U.S. Federal Reserve's "tapering" been correct? We believe the Fed's policy adjustments need to be defined more broadly to include not just the reduction of asset purchases, known as tapering, but eventual increases in short-term policy rates. The tapering, and expectations around tapering, has caused some market turbulence in Asia. But the effects have been limited in both scope--India and Indonesia--and duration; the selloff in mid-2013 was much more pronounced than in early 2014 (see chart 3). We believe the region is reasonably well insulated to withstand further taper-related selloffs because the current account imbalances that drove the initial funds outflows have narrowed substantially.

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Economic Research: Despite Our Steady Growth Forecasts In Asia-Pacific, China's Financial Risks May Be A Wrench In The Works

Chart 3

The larger risk, in our view, is the effects of interest rate normalization on Asia-Pacific, where debt levels have been climbing. As noted in our previous quarterly update, debt growth has accelerated in the period after the financial crisis in five economies in the region: China, Hong Kong, Malaysia, Singapore, and Thailand. Many borrowers have loans with short-term floating interest rates and will therefore see their debt-servicing costs rise, perhaps substantially, when the U.S. Fed eventually increases its short-term policy rate to 4% from around zero currently. Based on current market pricing, the markets expect this increase to take place over two years from mid-2015 through mid-2017. The question is whether borrowers are anticipating this rate hike; if they have not been expecting this, then spending (since disposable income after debt service would fall more than expected) and asset prices (a higher interest or discount rate would imply lower valuations) would be negatively affected, with repercussions on the real economy.

Developments In China Make For A Shakier Baseline

All told, 2014 is shaping up as a good but not great year for Asia-Pacific. Although the global economic backdrop--growth in the U.S. and Europe as well as global trade--is set to improve, the risks have moved closer to home. China, which has been the key source of growth and a rock of stability for many years, has now moved front and center in our risk scenario analysis. The Chinese authorities have managed to use their "late-mover" status deftly

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Economic Research: Despite Our Steady Growth Forecasts In Asia-Pacific, China's Financial Risks May Be A Wrench In The Works

to avoid the kinds of monetary, fiscal, and external pitfalls that have plagued other emerging market economies. The region is watching if China can again maneuver safely through the choppy waters of its ongoing financial sector risks.

Appendix: Inflation And Policy Rate Forecasts

Table 2

Standard & Poor's Baseline CPI Inflation Forecasts (12-month average)

2014f Australia China India* Japan South Korea Hong Kong Indonesia Malaysia Philippines Singapore Taiwan Thailand Vietnam New Zealand * Fiscal year ending March. 2.7 3.0 8.0 2.4 2.2 4.0 6.3 3.2 4.1 2.7 1.4 2.4 6.9 2.0 2015f 2.7 3.0 7.5 1.5 3.0 4.1 5.3 3.6 3.5 2.9 1.6 2.7 6.5 2.1 2016f 2.8 2.7 7.0 1.9 2.9 4.1 5.5 3.1 3.7 2.6 1.5 2.7 6.1 2.1

Table 3

Standard & Poor's Baseline Policy Rate Forecasts, end of year

2014f Australia China India* Japan South Korea Hong Kong Indonesia Malaysia Philippines Singapore Taiwan Thailand Vietnam New Zealand 2.50 6.00 8.00 0.10 2.50 N/A 7.75 3.50 3.75 N/A 2.00 1.75 6.50 3.50 2015f 3.50 6.00 8.00 0.10 2.50 N/A 7.50 4.00 4.25 N/A 2.50 2.25 6.50 4.50 2016f 4.00 6.00 8.00 0.10 3.00 N/A 7.50 4.00 4.25 N/A 2.50 2.25 6.50 5.00

* Fiscal year ending March. N/A--not applicable.

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Economic Research: Despite Our Steady Growth Forecasts In Asia-Pacific, China's Financial Risks May Be A Wrench In The Works

Related Research
Credit Conditions Asia-Pacific: Largely Stable With A Dash Of Negative, With A Key Focus On China's Shadow Banking Environment, March 26, 2014 Cracks In The Fortress? Challenges Rise Within China's Financial Sector, March 3, 2014 Credit FAQ: Can China Come To Grips With Soaring Public Debts And Moral Hazard In The Financial System? March 3, 2014 Economic Research: Asia-Pacific 2014: Risks Narrow As Growth Grinds Higher, Dec. 10, 2013 Under Standard & Poor's policies, only a Rating Committee can determine a Credit Rating Action (including a Credit Rating change, affirmation or withdrawal, Rating Outlook change, or CreditWatch action). This commentary and its subject matter have not been the subject of Rating Committee action and should not be interpreted as a change to, or affirmation of, a Credit Rating or Rating Outlook.

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