Churchouse Letter
January 2012          by Peter Churchouse

Democracy, Debt and the Positive Potential of the Euro Crisis

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“Indeed, it has been said that democracy is the worst form of government except all those other forms that have been tried from time to time.”

……….so said Winston Churchill in a quotation so oft cited that it has almost become a cliché. But it is hard to disagree too much with its ultimate message.

The point I wish to make in this newsletter is how democracy almost inevitably, by its very philosophical underpinnings, destines its adherents to high taxes, big debt, big government, societies built on a culture of dependency, and the inevitability of the sorts of financial meltdowns that we have been witnessing in recent years.

However in the rubble of the financial shambles that we are witnessing at present there may be an outcome that preserves the good things we enjoy in our democracies, but at the same time reducing the financial risks of the fiscal profligacy that blights democracy in our lifetime. In so doing we will try to provide our own, perhaps naïve, unraveling some of the many tentacles of cause and effect in this mess, and the likely potential impacts for markets in Asia.

Having suffered through probably the worst ravages of contagion during the Asian financial crisis of the late 1990’s, we are ever mindful of trying to understand and prepare for the web of cause and effect, unintended consequences and “unknown unknowns”.

Democracies Breed Excess Debt, Excess Government, a Culture of Dependency

It is, in essence, quite simple. The democratic process almost in every form, involves politicians promising electorates all sorts of “goodies” as the bait for the citizen’s vote. He who offers the biggest bait, wins. But then comes the delivery of the electoral promises. This invariably costs money, paid for almost inevitably by the very taxpayers who got suckered in the first place. It is rare to see a government pay for its promised goodies by cutting goodies bestowed by previous incumbents.

Figure 1: Asian Real Estate Stock Indices Performance

Symbol Name Country Last % Price Change Year to Date 52 Week High Price 52 Week Low Price % Down from 52 Week Hi % Up from 52 Wee Low % Price Change 1 yr
.BSEREAL BSE Realty India 1,696 19.07 2,555 1,348 33.63% 25.83% -33.75
.FTFSTAS8600 FT ST RE ESTATE IDX Singapore 564 5.10 736 525 23.35% 7.57% -24.70
.FTFSTA8670 FT ST RE ES IN Singapore 594 4.51 699 567 15.05% 4.78% -13.32
.HSNP HSI-PROPERTIES Hong Kong 25,730 7.97 31,998 19,363 19.59% 32.88% -23.11
.HSREIT HS REIT Index Hong Kong 4,259 3.48 4,934 3,541 13.67% 20.28% -13.25
.NZPR PROPERTY GROUP New Zealand 824 1.48 842 764 2.16% 7.86% 5.84
.AXPJ SP/ASX200 A-REIT Australia 811 6.03 890 697 8.83% 16.46% -4.83
.SSEP PROPERTY SUBINDEX China 2,875 1.84 3,908 2,623 26.43% 9.61% -16.81
.TCOI CONSTRUC INDEX Taiwan 244 6.78 363 203 32.75% 20.06% -31.33
.IRLTY.T REAL ESTATE JAPAN 644 2.17 944 610 31.76% 5.63% -29.97
.TREIT REIT, general Japan 836 -1.79 1,128 805 25.87% 3.86% -26.67

Source: Thomson Reuters Eikon

It’s always more not less – more healthcare, more education, more infrastructure, more welfare, more pensions, more, more, more.

And more of what government provides involves more government departments, quangos and publicly funded organizations of every hue. The government sector at every level becomes bloated and inefficiency becomes endemic. It is no coincidence that the only major sector of the US economy to have expanded its headcount in the past four years is the federal government. And we should not be surprised that the average annual compensation of the federal workforce is around US$75,000 while that of the average employee in the private sector is paid closer to US$46,000, and this excludes the generous health care and pension benefits that public employees receive, while those in the private sector typically are much less well provided for, if they are provided for at all. This is not to mention the great comfort of job security that public sector employment typically brings compared to the private sector.

While the bankers cop a lot of flak on the pay front, perhaps deservedly in some instances, maybe the “compensation Nazis” might turn an eye towards the pampered public sector.

How many governments in major democracies around the world have actually cut public sector headcount in the past 5 years? Some may be about to do so. How many have actually cut public sector expenditure? Probably none, or at most, very few. Even if one juggles the numbers measured in real terms, or in relation to GDP growth, in relation to overall employment growth, I hazard that metrics of government employment and/or expenditure in major democracies will still look rather more friendly in the public sector than the private sector.

This creeping invasion of governments in democracies and the tendency in democracies for growing public spending financed increasingly by debt is a core underlying cause of the current global crisis which really come to a head in the US in 2007/2008.

In the US case, it was politicians who garnered votes by the promise that every American family who wanted to own his/her own home, should be able to do so, even if they could not afford to pay for it. Fannie Mae and Freddie Mac were installed as instruments of the state to underwrite this outcome. The whole world is paying for the consequences of this folly.

The Euro Crisis has Public Sector Rather Than Private Sector Debt at its Core

The Euro situation is very similar. While all eyes have been on Greece, which perhaps may have been the worst perpetrator of “pamper the voters” policies, pretty much all of the other European countries have been guilty to a greater or lesser degree of such trends. Even Germany and France have transgressed in respect of the outline Maastricht Treaty “rule” that members of the Euro zone must not breach a limit on government spending of 3% of GDP. France has not had a budget surplus since the mid 70s. Euro members have continued to spend and borrow happily as if this rule never ever existed. There are no teeth to the possibly quite sensible strictures that were enunciated at the time of the Euro’s birth. There is no body that has the authority to monitor and govern and ensure adherence to such limits. Governments have felt totally free to stomp all over these rules with impunity.

Figure 2: Government, Corporate and Household Debt to GDP for Selected OECD Countries, 2010

Country % GDP
Total Government Corporate Household
US 268 97 76 95
Japan 456 213 161 82
Germany 241 77 100 64
UK 322 89 126 106
France 321 97 155 69
Italy 310 129 128 53
Canada 313 113 107 94
Australia 235 41 80 113
Austria 238 82 99 57
Belgium 356 115 185 56
Denmark 336 65 119 152
Finland 270 57 145 67
Greece 262 132 65 65
Netherlands 327 76 121 130
Norway 334 65 174 94
Portugal 366 107 153 106
Spain 355 72 193 91
Sweden 340 58 196 87
Average of the Selected Countries 314 93 128 93

Source: BIS working paper – The Real Effects of Debt (September 2011)

The evidence is all too clear. The major democracies of the world have continued to expand governments, expand public sector spending and public sector debt in the interests of feeding a voting public on the consumption that it has promised, without undue reference to an ability to afford. This has meant an ever-expanding and ever more intrusive and creative forms of taxation to fund such consumerism.

This house of debt is about to crumble (Fig. 3), and Greece is nothing more than a harbinger of things to come.

Figure 3: Euro Area Sovereign Debt as % of GDP

Euro Area Government Debt as percentage % of GDP risese from above 70% in 2000 Q1 to 86.94% in 2011 Q2.

There will likely be a growing group of countries that not only find their ability to fund themselves becoming more expensive but in increasing cases may become impossible to do, promising widespread defaults on sovereign debt and collapsing economies. Markets have shown that they are reluctant to fund sovereign issues given the risk that the market perceives, as best illustrated by the increase in the CDS pricing.

Europe’s credit crisis is a structural problem of enjoying a monetary system where less than creditworthy nations are able to access credit at the same price as much more creditworthy nations such as Germany and Holland. This is all very familiar and has more than an echo of the US sub-prime crisis in which millions of less than creditworthy households were able to access loans that they were not going to be able to service. Difference is that the borrower in Europe is sovereign states, while in the US it was households. While Greece and Italy are heavily indebted, their households have been as conservative or even more so than the Germany or Dutch households (See Fig 3).

Markets are Looking for the Quick Bernanke Fix – Print Money – Lots of it!

The signals are clear. The financial markets are clamouring right now for a quick fix:

Essentially the markets are baying for central banks to print more money – the Bernanke solution. Pour lots of cash into the system and all will be well! This is perhaps no surprise since the massive roll of the printing presses that the US launched in 2009 brought the US back from the precipice of financial disaster. So the markets are calling for a similar shot of steroids to “fix” the Euro crisis. There is little doubt that if the ECB were directly mandated to open the printing presses, the European banking system (and indeed that of most parts of the world) would stagger out of the danger zone, and happily carry on as before.

Manic for the Moment……

The pressure to actually fix the underlying causes is not what the markets really care about right now – they are manic for the moment, looking almost solely for the shot of cortisone to the system that would underpin immediate liquidity, make the problems disappear overnight, at least to allow their portfolios to show some positive colour. Politicians and central bankers need to take a longer term view, irrespective of the impetuousness of markets, to set in place a regime in which such a mess has a much lower probability of occurring again. But what is the probability that they will do so?

Europe has the Potential to Show the World a New Way, and the Crisis May Give it the Mandate

There is a core of policy makers looking a bit further than the current disaster and baulking at providing a blank cheque to politicians and banks, who will almost inevitably go out and do it all again. Just look at the USA. President Obama has passed a massively expensive healthcare program at a time of huge financial distress, with a rapidly rising budget deficit and massive rises in public sector debt. Politicians cannot resist the temptation to hand out the freebies. This was not done in the name of job creation/fiscal stimulus!

They need to be brought into check if we are not to see democracies continually tread these dangerous paths.

And funnily enough, Europe may, just may, show the way. It has the potential to do so given the collective will to affect structural change.

Removing Monetary Policy from the Hands of Politicians Has Given the World Almost 30 Years of Low/Moderate Inflation

First, let’s step back. The west has experienced about 25 – 30 years of moderate inflation (see Fig 4). This follows a period of very high inflation of the 1960’s and 1970’s. We won’t go into the underlying causes of this but suffice to say that our period of modest inflation coincides with a period when monetary policy has been handed over to central banks, whose almost sole mandate has been to keep inflation in check, in many cases within prescribed levels. This has taken control of money largely out of the hands of politicians. And it has worked well to a very large extent. We can argue that central banks may not have taken a wide enough view of inflation, tending to under rate assets prices, particularly real estate in the inflation equation. I suspect that going forward, following the recent real estate generated financial crisis, central bankers may take a slightly wider view of their inflation mandate.

But at least it has kept the politicians out of the mix! And we have enjoyed almost three decades of modest inflation.

Figure 4: Western Nations’ Historical Inflation from 1965 – 2010

Western Nations' Historical Inflation from 1965 - 2010, including Australia, the USA, the UK, Germany and France.

But Politicians Still Control The Fiscal Mix

So what next? The politicians still control fiscal policy, and most importantly spending, taxation and the provision of freebies to a voting population that is more than happy to feed at the trough of government handouts. To some extent the central banks can act as a bit of a brake on politicians’ generosity insofar as the extent to which the inflationary impacts of public sector spending may be dulled by independent monetary policy. Watch any election anywhere, and politicians will pander to special interest groups with the promise of policies that will make their lives easier, more comfortable, all of which ultimately has to be paid for by the voters through increases in taxes.

There is no doubt that there are huge areas of our lives and activities that do probably need to be provided by government. There will always be people who are disadvantaged, poor, sick, need help of some kind. The mark of success of 20th Century democracy is that it has recognized this and taken humanity beyond the dark satanic mills of 19th Century Europe and America. We live in a rather more humane and caring society that that of our forefathers.

Social Safety Net Becomes a Hammock

The danger has become that politicians have taken this several steps further to where there is tendency for the social safety net to become a hammock. Naturally enough people are happy to accept the benefits but I am less than convinced that the connection between access to public sector provided benefits and the payment of these through taxes of various types is understood very clearly. And of course it is not in the interests of politicians to make it their business to improve this understanding.

While the UK and Germany have about the same government spend as a percent of GDP (see Fig 5), Germany is renowned for its infrastructure, general education levels and level of healthcare. The UK’s public healthcare system is a constant source of complaint and much urban infrastructure appears under-invested and obsolete.

Figure 5: Government Expenditure as % of GDP 2011

Government Expenditure as % of GDP 2011. Includes China, Japan, Indonesia, Thailand, India, Singapore Hong Kong, Vietnam, Germany, France, US, UK and Canada.

Herein lies a potential positive outcome of the Euro crisis. A great many observers can see that many countries in Europe are too heavily indebted with bloated governments and highly generous welfare and benefit systems. This is an unsustainable situation. Hence the call for dramatic changes to the Euro pact that will bring greater discipline to fiscal regimes.

A Call to Arms – in the Form of Providing a More Unified Euro Fiscal Regime

I have always been skeptical of the sustainability of an economic regime where a group of nations enjoys a common currency and interest rate regime under very divergent fiscal regimes. So the profligate big spenders of the olive belt can borrow at the same rate of interest as their more abstemious neighbours to the north. That was never going to work.

There seems to be building serious momentum to deepen the Euro pact to provide a much more unified set of fiscal policies within the partners of this grand experiment. This was conspicuously absent from the initial common currency agreement. The current crisis may well provide the impetus for this to happen. If markets do not see a clear and credible program to move to this outcome, with a timetable, there may continue to be reluctance to fund government debt needs over the medium term, with sustained periods of high bond yields which do not make recovery from the current recessionary conditions easy.

If such a regime can be credibly put in place it may just take at least some of the profligate tendencies of politicians out of the domestic political arena. If governments can be brought to book for breaching the fiscal “rules”, and punished for it, then there is perhaps a much reduced risk of governments getting themselves into the parlous state of finances that we see so often and which are the root cause of the current Euro crisis.

This would force politicians to much more seriously consider their fiscal options, and weigh up the consequences of their policies in budgetary terms, if they knew that they would be potentially named and shamed by a “Eurozone Budget Oversight Commission”. And politicians would have a perfectly positioned “blame taker” to lay before their voters.

Such a framework would in effect be similar to the establishment of independent central banks that have largely removed the temptations of monetary indulgence from politicians. The Euro zone may possibly succeed in creating a mechanism that removes a lot of the fiscal policy temptations away from the political arena. Such a system would likely encourage politicians to much more carefully analyse their spending and competing policy imperatives.

A model of democracy that removes much of the temptations of monetary and fiscal profligacy from the politicians, or at least tempers it significantly, may present a longer term, more sustainable, and more and more acceptable form of democracy.

The Euro Crisis – A Blueprint

A blueprint of the Euro Zone's current Economic Crisis.

Sir Winston Churchill’s famous remark would be given a new relevance.

My nagging, underlying concern about such an outcome is that it possibly creates more levels of government, more bureaucracy (the existing EU is widely criticized as a bureaucratic quagmire), and that deeply disturbing notion of “Big Brother” directing our lives.

Such an Outcome Might Give Democracy a Better Name

This may all be the ravings of a delusional optimist, but weirder things have happened. Such an outcome might end up giving democracy a better name. It is not a great advertisement as a role model for emerging economies right now. In fact, the current financial shambles that the western world has got itself into has probably done more to cause countries like China to edge back from more market opening and democratic reforms. They are justified in asking themselves if this is the type of world and outcome they want for themselves.

The Tangled Web of Cause and Effect

Over the past couple of months we have been bombarded with many thousands of column inches in our newspapers and probably even more thousands of column inches of research from anyone who cares to write about the Euro crisis. Many (or most) pieces one sees address only one or two aspects of the great puzzle, leaving quite large parts of the problem untouched.

If Europe and the west generally were able to engineer an outcome that reduces the probability of the sorts of financial disasters that we have seen in the past few years, then democracy might just prove to be a better option than the alternatives to many countries grappling to shake off the shackles of autocratic and bigot ridden regimes.

To help us frame our own thinking we have been developing a schematic to internally understand the multi layers and directions of these issues (see Fig 6). We thought it might be worth sharing these with our readers, in the full knowledge that this does not cover all the bases, and to the very well informed may seem a little simplistic. This chart has drawn on our own observations and many articles, research notes and publications from many others.

The Insolvency Bucket

Figure 6, Part 1


Our first aim is to separate out what is an insolvency issue and what countries are experiencing a liquidity problem. Greece clearly falls into the solvency buckets, and Ireland, Belgium and Portugal also probably fall into the same category. Italy Spain, and more recently France do not have an outright solvency problem, but more a problem obtaining funds to roll over debt, or to issue new debt. Liquidity problems could conceivably morph into solvency problems if liquidity dries up for an extended period for large borrowers (banks) and sovereigns, and/or the cost of borrowing rises to such an extent that debt is unsustainable.

For the countries in the insolvency bucket, three key solutions are being pushed by various policy groups and outside financial market pundits. We should perhaps be a little wary of the prognostications of many market participants – their vested interests lie in short sharp policy moves that may provide short sharp movements in markets, policy moves that might not provide the longer term structural fixes that are necessary.

Figure 6, part 3

A Possible Solutions to Europe's Solvency Problems? Budgetary/Fiscal Austerity may work, but there is not enough time. External financial aid/support. And Debt Restructuring both through debt monetisation, which has inflationary potential and private sector involvement, where sovereign debt holders would take haircuts, meaning a hit to Banks' capital ratios. Alternatively they could leave the monetary union, which would cause a deep recession and potential bank collapse.

  1. Budgetary and fiscal austerity – Forcing this on insolvent countries is likely to be hugely deflationary and worsen near term economic prospects. But is necessary longer term. Such moves are also too late to avert the near term crisis anyway.
  2. Debt restructuring: (i) Monetisation of debt – essentially involves third parties (e.g. ECB, IMF, or others) standing in the market buying up whatever sovereign debt that the market wants to throw at it. Roll the printing presses through the backdoor! This is basically the approach adopted by the Federal Reserve and is favoured by many market participants as it bails them out of potentially dangerous financial positions. A quick fix to stabilise markets!
  3. Debt restructuring: (ii) Private sector involvement (PSI) – Private holders of sovereign bonds in this camp take a sizable haircut on their holdings. Clearly banks are not in favour of this, and certain governments have also been against this as it may portend very negative outcomes for some of their own major banks (e.g. France). Haircuts mean banks may take a hit to capital ratios, and may need to raise capital to restore these to required levels.
  4. External financial support for sovereigns – This essentially involves external organizations providing direct financial support such as providing new loans to sovereigns, underwriting or backstopping/guaranteeing new or existing sovereign debt. The European Financial Stability Fund (EFSF), European Central Bank, IMF, other central banks around the world, sovereign wealth funds are the main sources of such support being mooted.

Bank Capital Adequacy Ratios Need Restoring – Difficult, Painful, Expensive

Figure 6, part 4

Ways to restore capital ratios include: issuing new shares which may be difficult in the current market; Retaining profits through withheld dividends and possibly alienating shareholders; Selling Assets, likely at low prices; changing how existing assets are managed, which takes time to restructure; Reducing Lending and Deleveraging, which may hurt profits and dampen economic recovery.

A direct outcome of the financial crisis and most particularly arising from solvency problems, is the need for banks to boost capital adequacy ratios. There are several paths to this end – (i) issue new shares – expensive and difficult in the present depressed investment climate for banks generally. (ii) Retain profits, reduce dividends, and run the risk of alienating shareholders. (iii) sell assets, possibly at low prices, even if buyers can be found. (iv) Manage existing assets differently – but can take time to affect such changes. (v) Reduce lending, deleverage, which may hurt profits and can be a dampener on economic recovery.

The Liquidity Bucket

Figure 6, part 2

The Liquidity Problem for Euro Countries like Italy, Spain and France, which may become a solvency problem later. Do they cut public sector spending which could stall the recovery or look for both short term & long term support such as direct purchasing of sovereign bonds and recapitalizing banks through loans?

Countries such as Italy, Spain and France are facing a liquidity problem, and not a solvency problem. They are not bust, but markets have proven reluctant to lend to banks and governments in these countries, with the result that cost of borrowing has risen substantially, to levels that if maintained for a long period of time, would potentially shift the problem from a liquidity problem to one of solvency. Hence the urgent need to bring liquidity back to something approaching normal for these countries, and bring interest rates down to sustainable levels.

The same shortlist of organizations are in the firing line to provide the short and long term financial support for countries in this group. The types of support being promoted and increasingly implemented include:

  • Direct purchase of sovereign bonds.
  • Provision of guarantees for sovereigns and banks.
  • Provision of cheap capital for immediate bank funding needs.
  • Provision of longer term loan capital for banks.
  • Provision of loans to support bank recapitalizations.
  • Broadening the types of security that can be accepted by lending institutions. The ECB has already started down this path.

Figure 7: Government Debt (at Face Value) as % of GDP

Government Debt (at Face Value) as % of GDP from 2006-Q2 2011. Left hand chart includes Italy at 125.26%, Canada at 109.01%, the Euro Area at 91.76%, France at 82.38 in Q4 2010, Germany at 83.47% in Q1 2011, and Spain at 71.96%. The right hand chart includes the US at 95.20% and the UK at 81.70%.

As we write this, some of these measures have been put in place over the past couple of weeks and have had the effect of bringing down bond yields, increasing funding sources for banks and generally lowering the risk temperature somewhat, at least for the near term.

But the structural challenges have not gone away.

The fact of the matter is that European countries of almost every political persuasion have grown fat on government spending, social policies that countries cannot afford, big government – in fact all the things that politicians in democracies promise endlessly and then borrow to pay for. There is a clear and present need for many European countries to reshape their services provisions and public sector spending. This is going to be painful and the spending addicted public are not going to willingly give up their perks without some major battles. But of course, the Keynesians of the economic world suggest that in a recession is not the time to reduce the role of the public sector – it is the time to boost it to ensure quicker economic recovery.

But what are the markets telling us? Britain, whose economy is in just as dire straits as others in the Eurozone, has gone public with a program of austerity and a package of reasonably clear policies. It is seeing its bond yields being well supported (at least so far) and its currency has been one of the better performers. Britain has taken on something of a “safe haven” status, despite its weak economy.

Support Mechanisms Do Little for the Real Economy

While feeding Europe’s banks with a diet of cheap funding may help them limp out of a near term crisis, its impacts on the broader economy are unlikely to be hugely beneficial in the short term. The banks receiving cheap money will probably simply place it with the ECB earning a good spread in what is effectively a subsidized carry trade. As we saw in the US, very little of the improved balance sheet of banks found its way into the real economy in the form of loans to businesses and companies producing jobs. The money was effectively sterilised from the real economy, and will likely be the same in Europe.

Job creation and business will be the inevitable victim of this state of affairs.

European Banks’ Funding Crisis…..Straddling the Solvency and Liquidity Buckets

Figure 6, part 5

European Banks have both a solvency and liquidity problem. Sources of Financial Support for European Banks include: European Financial Stability Facility (EFSF), European Central Bank (ECB), International Monetary Fund (IMF), Other central banks outside Euro Zone, Sovereign Wealth Funds.

Until recently most European banks tapped institutional sources such as American money market funds for around 70% of their day to day funding, with the balance largely from retail deposits, typically from their home country.

Since the European debt crisis lurched onto radar screens with a vengeance in 2011, these funds have steadily reduced exposure to Europe. In addition U.S. regulators have tightened the rules on what these funds can hold, which means that they are likely to be less significant sources of capital for European banks in the future.

Fitch Ratings data suggests that US funds’ exposure to European banks dropped sharply by the end of October to 35%of assets from as much as 50% at the end of June. Exposure to French banks, for example, fell from 15.5% of assets in May to 5.5% in assets at the end of October, contributing to rumors of troubles at some of France’s largest institutions. This fall in external funding sources has been compensated by higher borrowings from the ECB, to the tune of about €834 billion. This activity by the ECB has not been greeted with universal approval by Eurozone leaders.

In mid December the ECB initiated the largest refinancing operation in its history, supplying a 3 year liquidity facility to European banks. Even though the operation was a success with banks oversubscribing there is little evidence of this liquidity finding its way into supporting lending to businesses and consumers. Much has been deposited back at the ECB with. ECB deposits are now at the highest level since the financial crisis in 2008.

While the funding from the money markets is drying up, funding from retail deposits is also coming under pressure especially for the countries in the insolvency bucket In October, Greek and Irish deposits fell by 15% and almost 11% respectively year on year. Depositors are seeking safer havens to park their cash.

Taking a Stab at the Implications for Asia. Let’s Start With What Appears to be the Simple Consensus.

Figure 6, Part 6

Asia Specific Impacts of the Euro Debt Crisis. It provides cheap capital for short term bank markets. Slower exports to Europe mean slower economic growth, reduced lending from US/Euro to banks in Asia will mean tighet lending markets in Asia. Asia will resume domestic fiscal/monetary stimulus to support growth. There will be reduced demand for

  1. Most obviously, European growth is going to stumble badly in the coming months, most likely with the Euro zone (and near neighbours) likely sliding back into outright recession.
  2. The US, while possibly avoiding outright recession, will also likely see growth curtailed to below its long term run rate.
  3. Asian growth, dependent as it is on exports to these major blocs, is likely to slip by a couple of percentage points at least for the region as a whole. But growth still the same.
  4. Europe is Asia’s largest export market, so recession there will likely produce a sharp slowdown in growth of Asian exports, if not an outright decline, as occurred during the Asian financial crisis.
  5. Hong Kong and Singapore report very high levels of exports (see Fig 8) as a percentage of GDP, but a great deal of this is re-exports from neigbouring countries and is not manufactures of the domestic economy. However, re-exports are a significant fillip to the local economy, and a fall in these may have a disproportionate impact on these small economies.
  6. The US, while possibly avoiding recession, will also likely see growth curtailed to below its long term run rate. While the US$ is showing some strength in the short term as a “safe haven” currency, the medium to longer term prospects for the dollar are less clear. A weaker dollar will make the US a more attractive manufacturing destination again, potentially placing even further strain on Asia’s exports.

Financial System Risks are Greater and Less Predictable

This is all pretty much consensus thinking as we come into 2012.

Figure 8: Exports of Goods and Services as % of GDP

Exports of Goods and Services as a percentage % of GDP. Chart includes China (30%), Japan (15%), Indonesia (25%), Thailand (75%), India (22%), Vietnam (78%), Singapore (211%), Hong Kong (233%), Germany (47%), US (13%), UK (29%), and Canada (29%).

Impacts of recession in Europe and slow growth in the US in terms of trade flows and economic output are clear and potentially reasonably predictable. Much less so, and of greater concern is the impacts from distress and uncertainties in the financial system. The tail risks for the financial system outcomes are potentially large. It is fair to say that even on fairly optimistic assumptions, liquidity in the Asian financial system is likely to be under pressure. European banks have been significant players in Asian banking and funding markets.

Although in most markets lending by European banks is well under 10% of total lending, it is nevertheless significant, particularly if it is withdrawn and no new lending is forthcoming from these sources.

There will be considerable pressure on European and even US banks to reduce loan exposure to Asian (and other) markets.

Some European banks are exiting businesses in Asian markets now, and will continue to do so, possibly at an accelerated pace.

Asian financial organizations buying European portfolios will reduce their ability to grant new financing in the region. Unless governments in the region step in to fill the gap, there is likely to be an environment of tighter lending conditions and higher borrowing costs for companies and households in the region.

The Following is a List of the Core Outcomes We Think are Likely with an Asia Focus and that Shape Our Investment Thinking

  • Major commodity prices particularly non-agricultural are likely to be well off the boil in the short term, with a pull back in investment in commodity based ventures in Asia Pacific.
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    Figure 9: Asia Current Account Balance as a % of GDP

    Asia Current Account Balance as a % of GDP from 1975-2010. Includes China at 5.19%, Japan at 3.56%, Korea at 2.78% and India at -2.99%.

  • China may well slow its recent commodity investment spree with implications for Australian, African and Latin American commodity sectors and its implications for M&A activity in the space, as well as company valuations in this space.
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  • Commodity driven currencies such as the A$ and NZ$ will likely settle below recent highs. This may help the domestic export sectors of these markets but may slow domestic consumer spending, further delaying a recovery in these sectors. Lower commodity prices and a somber domestic consumer will likely push growth to the downside.
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  • FDI flows to slow. Foreign direct investment in China from the EU, which was historically one of the largest contributors to Chinese FDI, is also likely to significantly decrease. India which has only recently been a significant recipient of FDI is also likely to experience a pullback, with perhaps important negative implications for this country which has a significant current account deficit, and for whom FDI is an important part of the country’s drive to upgrade its infrastructure.
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  • Given the climate of uncertainty in markets such as China and India, we can expect to see a net outflow of domestic funds from these countries with investors seeking “safe haven” investments elsewhere. Recent “cooling” policy initiatives by governments and central banks accelerate these flows.
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  • Sovereign bond yields in Europe will come down as the immediate crisis fades and liquidity is injected into the European financial system through a variety of channels, including those noted above. Events of the past couple of weeks confirm this trend.
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    Figure 10: South East Asia Current Account Balance as % of GDP

    South East Asia Current Account Balance as % of GDP from 1974-2010. Includes Malaysia at 17.54%, Thailand at 4.63%, Philippines at 4.2%, and Indonesia at 0.80%.

  • Asian banks will also be affected by the paralysis in interbank markets in Europe, limiting their ability to tap these markets in the short term. This may limit their ability to lend to domestic customers. Lending to Asian companies by European and US banks will likely contract, leaving gaps in the lending market. Credit may be more difficult to source in Asian bank markets for many companies, particularly smaller companies.
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  • Tighter bank lending conditions for Asian companies is likely to lead to an increase in issue of higher yield corporate bonds, and demands for equity issuance.
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  • Relatively speaking Asian consumers are not highly leveraged (markets such as Korea, Australia, New Zealand being the main exceptions), with mortgage lending at the core of consumer borrowing. This has already been curtailed in many markets in recent months, and shows signs of remaining tight at least in the very short term. Loan to value ratios are normally quite low in Asia, giving a solid cushion against falls in asset prices.
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  • Private equity players in Asia will find a more ready market for acquisitions than may have been the case in the past year or so when credit was easy and fewer companies needed to turn to PE sources for funding.
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  • Asian banks are likely to be in the market to buy assets from European banks (and also US banks) needing to offload assets and boost balance sheet security. This is already happening, and may accelerate.
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  • Many banks in markets such as Hong Kong and China effectively turned off the lending taps in the past three months or so as loan quotas had been filled. New lending quotas for 2012 are likely to be initiated in Q1 and that will likely free up loan markets somewhat. This is particularly likely to be the case in China.
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  • The strong tightening bias that has been part and parcel of most Asian markets in the past 12 – 15 months, aimed at curbing asset prices (i.e. real estate and land prices in particular) and rising inflation is likely to soften as the global economy slows and regional exports slow, with potential employment and social problems emerging. Korea, Taiwan, China, Hong Kong, Singapore, Malaysia, India have all been engaged in varying amounts of tightening and fiscal/administrative controls in the past 18 months.
  •  

  • This is particularly the case in China, and to some extent also in India. Signs of inflation easing as well as definite sharp pull-back of property markets will provide added impetus for the possible roll-back of some tightening measures put in place over the past year or so.
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  • China in particular has the potential to witness a systemic lending problem given that more than US$3 trillion of new lending has entered the market over the past 3 years. Some estimates suggest about 25% of that lending may have gone to real estate in various forms. I would be surprised if the actual figure is not substantially higher. With real estate prices falling, inventories building, and sales slowing, there is good reason to be concerned about a sharp rise in non-performing loans in China in particular. It is just a matter of how much, and what the policy responses will be. Banks are positioned to raise significant new capital to lift capital adequacy ratios.
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  • Unemployment will rise in most Asian economies, probably not to the levels seen in the Asian financial crisis of the late 1990’s, but bring with it the risks of social unrest and political instability in some countries. For some countries (e.g. China) curbing the potential for unrest will be at the very core of economic and social policy, to the exclusion of almost all else.
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  • Many countries will embark on policies aimed at stimulating domestic consumption—again! But this is unlikely to be as aggressively pursued as was the case in 2009 in the immediate aftermath of the Lehman collapse.
  •  

  • Most countries have the firepower to implement such measures, but the effectiveness of domestic investment is increasingly questionable and inefficient. Current account balances can be expected to worsen in many parts of the region. Currencies may also weaken against the US$, especially in H1 of 2012.

 

From Hero to Zero!

Emerging market equities were big outperformers in global equity markets in the immediate aftermath of the Lehman meltdown, in the belief that such markets stood a better chance of maintaining growth and less systemic risk than many western markets. MSCI Emerging Market index produced a stellar 79% return in 2009 with MSCI EM Asia a little behind at 74%. That outperformance sagged in 2010 and gave way to big underperformance in the past year, with Asia Pacific ex Japan (APxJ) roughly on a par with the latest disaster poster child, Europe. The US safe haven status together with some better numbers emerging from the mess late in the day drove the US markets to post a very respectable performance given the circumstances earlier in the year.

Figure 11: Total Savings as % of GDP and Total Reserves

Total Savings as % of GDP and Total Reserves in billions of USD. Includes China (53% and 2,914 bn USD), Japan (24% and 1,096 bn USD), Indonesia (32% and 96 bn USD), Thailand (31% and 172 bn USD), India (34% and 300 bn USD), Singapore (46% and 226 bn USD), Hong Kong (30% and 269 bn USD), Vietnam (32% and 12 bn USD), Germany (23% and 216 bn USD), France (17% and 166 bn USD), US (11% and 489 bn USD), UK (12% and 82 bn USD) and Canada (18% and 57 bn USD).

Asia’s performance was not universally awful Southeast Asian countries did relatively well posting low single digit positive or negative performance (Indonesia, Thailand, Malaysia, Philippines). This was a far cry from the down 20% sort of averages of North Asian markets including Singapore.

Have Markets Thrown the Baby out with the Bathwater?

Despite Asian economies looking likely to experience some contagion from Europe in 2012, there is some argument for thinking that investors might have marked many of these markets down a little too aggressively in the past year. Many are now looking very cheap.

Figure 12: Comparison Indices – Asia ex-Japan and World

Comparing the Asia Pacific ex-Japan Index and the Dow Jones Global World Index from January 2011 to January 2012. Shows that Asia underperformed global stocks.

Asia ex-Japan:

  • Trailing P/E ratio of around 10.5 times vs. 10 year average of about 16 and a high of around 65 times in the past 12 years.
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  • Forward P/E ratio of around 9.7 times vs 10 year average of almost 13 times. This is now more than 1 standard deviation below the long term average.
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  • Price to book ratio (P/BV) of 1.5 times vs. 10 year average of close to 2 times.
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  • For emerging markets generally (not just Asia) the equity risk premium relative to US 10 year treasuries is now close to its record highs over the past 20 years, only a little bit lower than at the height of the global financial crisis in late 2008/early 2009, and higher even than during the peak of the Asian financial crisis in 1998/99. Surely Asia is not in as risky a position today as it was then!
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  • Emerging markets — including Asia — have seen very significant net outflows of investment funds in 2011, particularly in the second half.
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  • Growth stocks and higher risk stocks did particularly poorly in Asia in 2011 as investors entered risk aversion mode and earnings growth revisions trended downwards. Cyclicals and financials, including property stocks did particularly poorly, the latter largely as a result of almost universal initiation of measures by governments and central banks to cool rising property prices around the region. Those measures are working.
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  • At present, according to work by Marcus Rosgen a former colleague and now Asian strategist for Citigroup, Asian markets are pricing in an implied earnings growth of only 1.4% – in perpetuity! This is at the very low end of a 25 year range, and as Marcus points out well below even the rate of inflation that Asia has experienced over the past 25 years.
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  • Defensive stocks (usually strong balance sheets, strong earnings visibility, solid dividends etc) have proved to be the big outperformers in the region in the past year.
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  • When all is said and done, Asian markets today are trading at valuations similar to those at the peak of the Asian financial crisis of the late 1990’s when Asian economies really were heading into the tank, with distress in households, corporates and governments widely spread around the region. Currencies and earnings were in free fall, and bankruptcies were widespread in many markets, particularly in Southeast Asia. The underlying prospects for the consumer, and for corporates today is a far cry from that period. Yes, there is risk out there, but the likelihood of the sort of financial meltdown that we saw in Asia in 1997-1998 is low, even if there are problems in Europe and credit markets do suffer problems.

Figure 13: Comparison Stock Indices for Indonesia and China

Comparison Stock Indices for Indonesia and China Q1 2009 - Q4 2011. Indonesia: JSX Composite Index; .JKSE and China: Shanghai New Composite Index. South East Asia has outperformed North Asia.

Losers become winners? Mean Reversion to Kick In

Markets everywhere have a habit of mean reverting. For Asian markets, now priced by most valuation measures at least one standard deviation below the long term averages, I sense that there is likely to be a move back towards longer term averages at some point during 2012, maybe later than sooner, but the move will commence at some point during the year. The losers of 2011 are likely to become the winners of 2012.

There is likely to be an increased appetite for growth and cyclical stocks at some point, perhaps triggered by Europe pulling back from the brink of financial disaster and some slow improvement in the macro environment in the US, together with the realization that Asian economies are still going to produce solid economic growth, albeit a bit lower than the recent past. The pattern of policy tightening that has characterized Asian economies in the past 12—18 months, will give way to gradual easing, providing a catalyst for better equity market performance and particularly better performance for financials, property stocks and cyclicals. Easing will likely be rather more modest and measure than the panic reactions we saw in early 2009 from global central banks and governments.

China financials in particular are priced for long term earnings declines, as are Hong Kong and China property stocks.

A Mean Reversion in Markets Will Likely See the Following:

The following are some thoughts on markets that I think have a decent chance of playing out over the coming year. The markets are positioned almost for Armageddon in Asia, and while there are very clear risks to growth and the global banking system, Armageddon is a low probability outcome.

A prudent strategy for Asian investors might be to slowly add to risk in the region, rotate into last years under-performing markets, while maintaining macro hedge positions, particularly in sectors that are most likely to suffer from a global growth slowdown.

  • North Asian markets (Korea, Taiwan, China, Hong Kong, and possibly Singapore) will outperform south east Asian markets such as Philippines, Thailand, Malaysia, Indonesia.
  •  

  • Risk appetite will increase, but volatility has not disappeared overnight.
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  • From being a source of funds in 2011, Asian equity markets will become a destination for funds flows in 2012 in response to weak economic outlook elsewhere.
  •  

  • Growth stocks and financials will see improved performance. Financials, particularly in China and Hong Kong are very much in value territory.
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  • Investors may do well to gradually shift the balance of portfolios along these lines over the course of coming months. Given the tail risks in financial markets generally, a swift portfolio rebalancing is probably not called for at this point.
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  • For China banks, the negatives are now well signaled—slower growth is likely, capital raising is likely, but directed lending quotas are likely to be strong in the near term as China aims to limit the damage to its economy from crisis in Europe. It is highly unlikely that the core policy banks will be allowed to become a systemic risk to China’s financial system. We do expect NPL’s to rise in China, particularly from the property development and infrastructure sectors. This is hardly new news to China’s regulators, who will ride to the rescue of the major banks if the NPL problem looks like becoming acute. Industrial and Commercial Bank of China—ICBC—(1398:HK) and China Construction Bank (0939:HK) are trading at around 6 times forward earnings, at a P/BV of around 1.2X and implied earnings growth of around –9% in perpetuity.
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    Figure 14: Shanghai Property Index vs Shanghai Stock Index

    Shanghai Property Index vs Shanghai SSE NEW COMP Stock Index from 2007 to 2012. The property index fell 53% since Q3 2009, while the SSE NEW COMP Index fell 33 % since Q3 2009.

    Figure 15: HK Property Index, HS REITs Index vs Hang Seng Index 2006 to 2012

    Comparing the performance of the Hong Kong Property Index, the Hang Seng REITs Index and the Hang Seng Index from Q1 2006 to Q1 2012.

    Figure 16: Singapore Real Estate Index vs Stock Index 2007 to 2012

    Comparing Singapore's Real Estate Indices against the Stock Index. FTSE ST ALL SHARE INDEX vs FTSE ST Real Estate Index vs FTSE ST Real Estate Investment Trust Index from 2007 to 2012.

  • The China government is walking a delicate balancing act between cooling down the effects of it over exuberant lending in 2009/2010, and preventing a socially and financially destabilising systemic problem.
  •  

  • Property stocks around the region have been savaged by a policy mix aimed at slowing asset price growth, and more “risk off” investor stance that has characterized financial markets over recent months. A visible shift in the regional policy mix to a more easing bias will see stock investors discounting better times for companies in the sector. Although prices in physical markets have not yet bottomed, stocks in this sector tend to move well in advance of the underlying asset class both on the upside and the downside, often at least 6 months, and sometimes even closer to 12 months.
  •  

  • In this regard, focus should initially be on larger cap developers focused on the residential market, the LIKELY BENEFICIARIES of cooling policy initiatives. In China, focus should initially be on China Overseas Land (688:HK), China Resources Land (1109:HK), China Vanke (000002:CH). In Hong Kong, Sun Hung Kai Properties (0016:HK) and Cheung Kong Holdings (0001:HK) will likely prove the bell-weather stocks in the sector.
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    Figure 17: Comparison of Property Stock Indices; Europe/USA/Asia

    Comparing Property Stock Indices in Europe, USA and Asia. Policy Initiatives have hurt Asia Property Stock Performance.

  • Basic material stocks such as cement stocks are likely to perform reasonably well in China as Government aims to build 10 million units of social housing to bridge the urban affordability gap and policy initiatives are likely to stimulate some areas of infrastructure spending in the face of a slowdown in export led growth.
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  • For Thailand rebuilding following the devastating floods of 2011 will provide a fillip to the sector. Cement stocks in both countries and industrial estate developers in Thailand will likely see decent earnings prospects in 2012.
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  • For Singapore property sector, there is probably time to wait as the underlying supply/demand picture for residential property points to a modest oversupply in the short term. Of the big developers, Keppel Land (KPLD:SP) is trading at the very low end of valuation and producing a very healthy 5% plus dividend yield. CapitaMalls Asia (CMA:SP) the Singapore listed retail REIT operating in China should benefit from any easing of policy in China. Watch for any pull back from property cooling measures.
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  • Consumer stocks will perform well in countries where policies aim to boost domestic demand to counter the effects of export slowdown. China is the key focus here, but also consumer stocks in Korea, Taiwan as well as Thailand and Indonesia stand to be in the outperforming category.

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