June 02, 2010

Economics Group

Special Commentary

Jay H. Bryson, Global Economist

jay.bryson@wellsfargo.com ! 704-383-3518
Yasmine Kamaruddin, Economic Analyst
yasmine.kamaruddin@wellsfargo.com ! 704-374-2992

Will Europe Pull Down Asia?

Executive Summary
Volatility has crept back into financial markets due to concerns that the sovereign debt crisis in
the Euro-zone may lead to another recession there. At a minimum, fiscal tightening over the next
few years will create powerful headwinds on growth in many individual economies in the Euro-
zone. If another downturn occurs in the euro area, would it pull Asia under as well? What about
the global economy?
High export-to-GDP ratios across Asia tend to overstate the export dependence of the region.
Although the region is clearly more dependent on exports than are most western economies, the
percentage of total value added for which manufacturing exports account is much smaller than
gross export-to-GDP ratios. Moreover, domestic demand has been growing very rapidly in Asia,
and that should continue for the foreseeable future. In addition, we believe most Asian
governments have the financial wherewithal to turn to fiscal stimulus again should the need arise.
We conclude that a garden-variety recession in the Euro-zone would certainly slow growth in
Asia, but it probably would not pull the region, let alone the global economy, under again. If,
however, banks continue to eye one another wearily and another financial crisis comes to pass à la
the aftermath of the Lehman Brothers bankruptcy, then the outlook for Asia, as well as for the
entire global economy, could darken considerably.
How Big Is Asia Economically?
Financial markets have encountered a patch of volatility recently due to concerns about sovereign
debt levels in Europe. Even if a full-blown financial crisis à la Lehman Brothers is averted,
economic growth in most Euro-zone economies will likely be weak for the foreseeable future as
fiscal policies are tightened.1 In the United States, an incipient recovery appears to have taken
hold, but we project that the pace of expansion will remain subdued as consumers continue to
delever. Among the major regions of the world Asia has led the pack recently in terms of
economic growth. However, would a renewed downturn in Europe, if indeed one takes hold, pull
the global economy down with it or would Asia be able to pick up the slack?
We begin our discussion by comparing the size of respective economies. U.S. nominal GDP GDP in non-Japan
totaled $14.3 trillion in 2009, which represented a 1.3 percent decline from the record high Asia is smaller than
registered during the preceding year (Figure 1). At $12.5 trillion the Euro-zone economy was in the United States
12 percent smaller than the American economy last year. Taken in aggregate, nominal GDP in and the Euro-zone.
31 Asian economies was a bit greater than U.S. GDP last year. However, Japan has endured two
decades of disappointing economic growth, so many analysts consider it separately from the more
dynamic economies of the region, a practice that we follow in this report. Thus, nominal GDP in
non-Japan Asia (NJA) totaled $9.4 trillion last year, 90 percent of which was accounted for by
China, Hong Kong, India, Indonesia, Korea, Taiwan and Thailand (Figure 2). At first glance, it

1 For further reading on the effects of the sovereign debt crisis in Europe see The Long Road Ahead of Greece (and
Others) (February 5, 2010) and Is Greece the Tip of the Iceberg? (February 22, 2010), which are posted on
www.wellsfargo.com/economics.

This report is available on wellsfargo.com/research and on Bloomberg WFEC

 Will Europe Pull Down Asia? WELLS FARGO SECURITIES, LLC
June 02, 2010 ECONOMICS GROUP

would not appear that NJA would be able to replace the Euro-zone should the economy of the
latter falter again.
Figure 1 Figure 2
Nominal GDP in 2009 Asian GDP
In Trillions of Dollars 2009
$16 $16 Hong Kong
2%
Taiwan Thailand Other
$14 $14 3%
4% 11%

$12 $12 Indonesia

6%

$10 $10

Korea
$8 $8
9%

$6 $6
India
13%
$4 $4
China
$2 $2 52%

$0 $0
United States Euro-zone Asia non-Japan Asia

Source: International Monetary Fund and Wells Fargo Securities, LLC

Non-Japan Asia is
However, the economic effect that a country has on other economies should be measured by its
comparable in size
imports rather than by the sheer size of its economy. And in that regard, NJA is nearly as big as
to the United States
the Euro-zone and it slightly exceeds the United States (Figure 3) 2 . How can a region that is
and the Euro-zone
25 percent smaller than the euro area in terms of nominal GDP have roughly the same amount of
in terms of imports.
imports? The answer is that NJA is generally more open to international trade than is the Euro-
zone. For example, the imports-to-GDP ratio of China is about 30 percent, and comparable ratios
in some countries, most notably Singapore and Hong Kong easily exceed 100 percent. In contrast,
imports from external countries are equivalent to only 15 percent of GDP in the euro area, and a
similar ratio characterizes the U.S. economy.
An insightful reader could claim that Figure 3 overstates the economic impact that NJA has on
the rest of the world. The large number of imports for NJA that is shown in Figure 3 simply
reflects an even larger number of exports. That is, NJA turns imports of raw materials and
intermediate inputs into exports of finished goods, and the overall current account surplus of NJA
totaled $460 billion in 2009, about 5 percent of the region’s GDP. A downturn in the rest of the
world would hurt Asian exports, which would weaken economic growth in NJA. By this reasoning,
economic activity in NJA, which has an export-to-GDP ratio that has ranged between 30 and
40 percent in recent years, may appear to be ultimately dependent on the rest of the world.
Gross exports-to- However, exports-to-GDP ratios overstate the effect that exports have on an economy. Take the
GDP ratios very open economy of Singapore for example. In 2008, the export-to-GDP ratio of the city-state
overstate the effect was nearly 180 percent of GDP. How can an economy possibly export 180 percent of its GDP? The
that exports have answer is that the import-to-GDP ratio is very high as well, roughly 170 percent. In other words,
on an economy. Singapore imports significant quantities of goods, adds value via the production process, and then
exports significant quantities of finished goods. The “true” effect of exports on the Singaporean
economy should be measured by the value added created in the production process rather than by
the raw exports-to-GDP ratio.
Unfortunately, the data we need to calculate the value-added effect of exports in the overall NJA
region are not readily available. However, China, for which the necessary data exist, is instructive.
The manufacturing sector currently accounts for 42 percent of value added in the Chinese
economy, and roughly 25 percent of Chinese industrial production is exported. Therefore, the
value-added effect of manufacturing exports on the Chinese economy is about 10 percent (0.42

2 In order to estimate the economic effect that NJA has on the rest of the world, we exclude intra-NJA trade. If all imports
were counted, NJA imports would total nearly $3 trillion.

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Will Europe Pull Down Asia? WELLS FARGO SECURITIES, LLC
June 02, 2010 ECONOMICS GROUP

times 0.25) of Chinese gross national income rather than 35 percent of GDP. 3 And China is at the
high end of the range of manufacturing value added (as a percent of total value added) in the
region.
Figure 3 Figure 4
Value of Imports in 2009 Household Spending as a Percent of GDP
In Trillions of Dollars Percent
$2.0 $2.0 70% 70%
2000
2008
60% 60%
$1.6 $1.6

50% 50%

$1.2 $1.2
40% 40%

30% 30%
$0.8 $0.8

20% 20%

$0.4 $0.4
10% 10%

$0.0 $0.0 0% 0%
United States Euro-zone non-Japan Asia China India Indonesia Korea Hong Kong Thailand

Source: International Monetary Fund, United Nations and Wells Fargo Securities, LLC

That said, exports are clearly more important for most Asian countries than for most western
economies. For example, manufacturing exports account for roughly 4 percent of U.S. gross
national income, significantly less than the comparable figure for China. 4 Moreover, a downturn
in the Euro-zone clearly would have a slowing effect on NJA. Exports to the Euro-zone total
roughly $400 billion, which represents about one-third of the total exports that NJA sends
outside of the region. The bigger question is whether a downturn in the euro area would pull NJA
into recession. Or could NJA help to support growth in the rest of the world should the Euro-zone
fall back into recession? Answers to these questions ultimately depend upon the state of domestic
demand in NJA, a subject to which we now turn.
Domestic Demand Is Stronger Than Commonly Perceived
A common perception among investors is that consumer spending in NJA is weak, which is given
some empirical justification by Figure 4 and Figure 5. The consumption expenditures-to-GDP
ratio in many Asian economies is below the 60 to 70 percent range that characterizes many
Western economies (Figure 4). In China, this ratio is abysmally low at only 36 percent. Moreover,
the ratio for NJA has trended lower over the past two decades (Figure 5). 5
Although up-to-date data on real consumption expenditures for the entire NJA region are not Growth in real
readily available, the observations that we do have are not particularly weak. For example, the consumer spending
year-over-year growth rate in the value of Chinese retail sales is running around 18 percent at in non-Japan Asia
present, and real consumption expenditures in both Hong Kong and Korea rose more than has been strong.
6 percent in the first quarter of this year relative to the same quarter in 2009. Moreover, annual
data show that growth in consumer spending in NJA has been strong since the Asian economic
crisis of 1997-98. Real consumption expenditures in NJA grew roughly 6 percent per annum
between 2000 and 2008, well in excess of the 2.8 percent annual growth rate achieved by
American consumers, once considered to be the world’s most prolific shoppers, over that same

3 Analysts tend to focus on the expenditure components of GDP, such as consumption expenditures and fixed investment
spending. An equivalent way of looking at an economy, however, is via income because the act of production produces
income. Gross national income is simply gross national product (GNP) less depreciation expenses.
4 A bit more than 20 percent of U.S. manufacturing output is exported and manufacturing accounts for 18 percent of
value-added in the United States.
5 In Figure 5 we proxy NJA by only China, Hong Kong, India, Indonesia, Korea and Thailand. However, we doubt that the
lines in Figure 5 would change significantly if all 30 countries were included because the six economies mentioned above
account for 85 percent of NJA GDP.

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 Will Europe Pull Down Asia? WELLS FARGO SECURITIES, LLC
June 02, 2010 ECONOMICS GROUP

period. So if growth in consumer spending in NJA has actually been strong, then why has the
personal consumption-to-GDP ratio for the region trended lower over the past two decades?
Real income The answer is that the investment-to-GDP ratio, which is also shown in Figure 5, has risen from
growth has been about 20 percent in the mid-1980s to 30 percent today, implying that investment spending has
very robust. grown even faster—nearly 10 percent per annum—than consumer spending over the past two
decades. This extraordinarily high growth rate in investment spending is financed by the high
savings rates that are prevalent in NJA. As paradoxical as it may sound, high saving rates lead
eventually to strong growth rates of consumer spending. High saving rates finance capital
investment, which is the wellspring of economic growth. Strong economic growth causes incomes
to rise rapidly, thereby leading to strong growth in consumer spending. For example, growth in
the value of China’s gross national income averaged 16 percent per annum between 1990 and
2008. Little wonder that growth in the value of Chinese household consumption expenditures
averaged about 14 percent per annum during that period. 6
Figure 5 Figure 6
Household Consumption and Fixed Investment Japan Household Consumption and Fixed Inv.
As a Percent of GDP As a Percent of GDP
80% 80% 70% 70%
Aggregate series for China, India,
Indonesia, Korea, Hong Kong and
70% Thailand 70% 60% 60%

60% 60%
50% 50%

50% 50%
40% 40%

40% 40%
30% 30%
30% 30%

20% 20%
20% 20%

10% 10% 10% 10%

Household Consumption: 2008 @ 44.1% Japan Household Consumption: 2008 @ 57.8%
Fixed Investment: 2008 @ 31.5% Japan Fixed Capital Formation: 2008 @ 23.1%
0% 0% 0% 0%
70 75 80 85 90 95 00 05 55 60 65 70 75 80 85 90 95 00 05

Source: United Nations and Wells Fargo Securities, LLC

Sooner or later, the trend decline in the consumption expenditures-to-GDP ratio in NJA will level
off as growth in investment spending slows. In that regard, Japan’s experience is illustrative. The
Japanese economy achieved its “take off” from the mid-1950s to the early 1970s, growing at an
annual average growth rate of 9.2 percent between 1956 and 1973. Like China today, this period of
very strong economic growth in Japan was achieved by robust growth in investment spending,
which accounted for more than 30 percent of GDP by the early 1970s (Figure 6). After 1973,
Japanese investment spending slowed significantly, which allowed the consumption
expenditures-to-GDP ratio in Japan to stabilize and edge a bit higher.
Auto sales in China The Japanese experience regarding the purchase of “big ticket” items is also illustrative. In 1955,
and India could Japan was still a very poor country and only one car was bought for every 1,000 people during
become impressive that year (Figure 7). As Japan moved up the income scale, automobiles became more affordable.
in the years ahead. By the late 1980s, the ratio had risen to approximately 60 auto sales per year per 1,000 people.
Although Indonesia has experienced very little increase in its ratio over the past two decades, both
China and India are exhibiting Japanese-like behavior with respect to car sales per capita. With
more than 1 billion inhabitants each, the number of auto sales in China and India could become
impressive in the years ahead. In the first four months of 2010, more than 6 million cars were
sold in China. If that pace continues through the end of the year, the 18.5 million units that would
be sold would exceed the best year for car sales ever recorded in the United States.

6 We do not have data on real income or real personal consumption expenditures in China. However, the GDP price
deflator rose at an annual average rate of nearly 6 percent between 1990 and 2008. Deflating the nominal growth rates by
the price deflator yields implied growth rates for real income and real consumption expenditures of 10 percent and 8
percent, respectively, which are incredibly strong for these real variables.

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Will Europe Pull Down Asia? WELLS FARGO SECURITIES, LLC
June 02, 2010 ECONOMICS GROUP

The bottom line is that another downturn in Europe need not pull NJA under as well. Economic
shocks in Europe are transmitted to Asia via exports, but the effects on overall GDP growth in the Another downturn
latter have not tended to be devastating. The slowdown in the euro area in 2001-2003 did not in Europe need not
appear to have a marked effect on NJA’s real GDP growth (Figure 8). Growth in Asia clearly pull non-Japan
slowed last year as continental Europe experienced its worst recession in decades, but the Asia under.
negative growth rates that some NJA economies experienced in late 2008/early 2009 had more
to do with a complete collapse in export finance than they did with the downturn in the Euro-zone
per se. Moreover, many Asian economies were able to support growth in 2008-2009 via
aggressive fiscal stimulus programs. Because most governments in the region are not heavily
indebted, unlike their European counterparts, another round of fiscal stimulus could be
undertaken in most NJA economies to offset the contractionary effect of reduced exports to the
euro area.
Figure 7 Figure 8
Motor Vehicle Sales Real GDP Growth
Motor Vehicle Sales per 1000 People Year-over-Year Percent Change
70 70 12% 12%
Aggregate Asia GDP is a weighted average of GDP
growth for China, India, Indonesia, Korea, Hong Kong
60 60 10% and Thailand 10%

8% 8%
50 50

6% 6%
40 40
4% 4%
30 30
2% 2%

20 Japan, 1955-2009 20
0% 0%
China, 1998-2009
10 India, 2002-2009 10 -2% -2%
Euro-zone GDP: 2009 @ -2.2%
Indonesia, 1989-2009 Aggregate Asia GDP: 2008 @ 7.1%
0 0 -4% -4%
0 5 10 15 20 25 30 35 40 45 50 96 98 00 02 04 06 08

Source: CEIC, United Nations and Wells Fargo Securities, LLC

Conclusions
Valued at current exchange rates, Euro-zone GDP represents about 20 percent of global GDP.
Moreover, the 16 economies that comprise the Euro-zone import $1.7 trillion worth of goods from
outside the common currency area. Therefore, a double-dip recession in the euro area, should one
occur, clearly would exert a slowing effect on the rest of the world. Although NJA could not
completely offset the negative effect on the rest of the world from another downturn in the euro
area, NJA would probably not be pulled under by a mild recession in the Euro-zone. Exports
account for a much smaller percentage of value-added in NJA economies than gross exports-to-
GDP ratios imply, and growth in NJA domestic demand has been, and likely will remain, rather
strong. In addition, most NJA governments have the financial wherewithal to implement further
fiscal stimulus measures should they prove necessary.
However, the effects on the rest of the world from a renewed downturn in the euro area may not
be limited simply to trade flows. Fearing losses that some financial institutions in the Euro-zone
may be forced to realize from potential restructuring of sovereign debt, banks have become
somewhat leery of lending to each other. Consequently, inter-bank lending rates have risen over
the past few weeks much like they did in the late summer of 2007 when the sub-prime mortgage
crisis was still in its infancy. Should credit markets completely shut down as they did in the
aftermath of Lehman’s failure, the outlook for the global economy, including NJA, would darken
considerably. Indeed, some economies in the region experienced deep, albeit short-lived,
downturns in the aftermath of the Lehman bankruptcy as export finance collapsed. Although a
mild, run-of-the-mill recession in the Euro-zone would probably not lead to a generalized global
recession, investors should not be complacent about the risks to global growth until the financial
fallout from the sovereign debt in Europe is better understood.

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Wells Fargo Securities, LLC Economics Group

Diane Schumaker-Krieg Global Head of Research (704) 715-8437 diane.schumaker@wellsfargo.com

& Economics (212) 214-5070

John E. Silvia, Ph.D. Chief Economist (704) 374-7034 john.silvia@wellsfargo.com

Mark Vitner Senior Economist (704) 383-5635 mark.vitner@wellsfargo.com
Jay Bryson, Ph.D. Global Economist (704) 383-3518 jay.bryson@wellsfargo.com
Scott Anderson, Ph.D. Senior Economist (612) 667-9281 scott.a.anderson@wellsfargo.com
Eugenio Aleman, Ph.D. Senior Economist (612) 667-0168 eugenio.j.aleman@wellsfargo.com
Sam Bullard Senior Economist (704) 383-7372 sam.bullard@wellsfargo.com
Anika Khan Economist (704) 715-0575 anika.khan@wellsfargo.com
Azhar Iqbal Econometrician (704) 383-6805 azhar.iqbal@wellsfargo.com
Ed Kashmarek Economist (612) 667-0479 ed.kashmarek@wellsfargo.com
Tim Quinlan Economist (704) 374-4407 tim.quinlan@wellsfargo.com
Kim Whelan Economic Analyst (704) 715-8457 kim.whelan@wellsfargo.com
Yasmine Kamaruddin Economic Analyst (704) 374-2992 yasmine.kamaruddin@wellsfargo.com

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