Eurozone breakup occupies thoughts of Asian managers

In the second of a three-part series on Asian expectations for the crisis, we hear Harvest call for a controlled eurozone breakup and the ADB evaluate policymakers' position in the region.
Eurozone breakup occupies thoughts of Asian managers

The effects of the eurozone crisis on Asia could be severe, but policymakers in the region are well placed to do something about it, says the Asian Development Bank (ADB).

In its analysis of the potential spillover effects of Europe’s sovereign debt crisis and US economic slowdown on Asia, the ADB modelled three scenarios: eurozone recession; US and eurozone recessions; and global economic crisis.

The worst-case global crisis resulted in a 1.8 percentage point cut in the ADB’s base 2012 forecast of 7.2% growth for East Asia (Asean plus China, Korea, Hong Kong and Taiwan) to 5.4%. The number to be subtracted for a eurozone recession was 1.1 percentage points (6.1%).

But speaking at the Foreign Correspondents Club in Hong Kong this week, Dr Iwan Azis, head of the ADB’s office of regional economic integration, admitted that this model was limited since it is based on averages and does not take into account confidence and expectation factors (meaning  it could be worse than 5.4%).

Nor does it take into account potential policy response. “This is why we use the wording that the effect of the external environment on Asia can be severe but is manageable because we believe policymakers will do something about it in the event of a severe scenario.”

The ADB did not assign probabilities to its scenarios (nor did it run a scenario for the potential collapse of the euro), because as Azis admits: “We are really uncertain about which scenario will happen.”

But he pointed to figures that indicate what policymakers in East Asia are focused on, even as the major threat to regional growth has swung over the past six months from inflation to how to stimulate the economy in the face of a global slowdown.

Data shows that while the share of East Asia’s exports to the US over the past decade has sunk from 22% to 14%, and from 11% to 10% for the eurozone, its share of exports to other emerging markets and developed economies has almost doubled from 9.8% to 17.3%.

Azis says that over the short-term policymakers will concentrate on strengthening domestic demand and further facilitating intra-regional trade, as well as striving to act collectively by working on standardisation and harmonisation across markets.

In the long-run, the focus on structural reform will centre on how Asian economies can utilise excess savings to finance badly needed infrastructure, both physical and non-physical.

In terms of the financial sector, Asian countries most affected by eurozone uncertainties have been those in which foreign players are most dominant, including Korea, Indonesia and Asean.

Clearly evidence is growing of an economic slowdown in emerging markets, with Brazil’s GDP having flattened in the third quarter and China reporting a manufacturing slowdown last month.

Emerging market funds have suffered close to $50 billion in outflows this year, notes Mark Konyn, Asia-Pacific chief executive of RCM. But he points out that while retail investors have retreated, institutional investors have generally stayed put.

With Asian credits having generally held up well despite the crisis, Konyn expects investors in this region to stay local and continue to own familiar names.

Similarly, Adam McCabe, senior portfolio manager for Asian fixed income at Aberdeen Asset Management, says Asian investors will be more inclined to repatriate money and explore investment opportunities in Asia.

“Asian balance sheets are less encumbered and as a result policymakers have significantly more flexibility than their developed market counterparts,” he says.

McCabe notes there is no mechanism for an orderly breakup of the eurozone, which is one reason he expects policymakers to pursue solidarity. “But it requires fiscal austerity and some fiscal union,” he states.

“Announcements can be made swiftly, but execution will take time and be frustrating for markets. As there is no means for the currencies of uncompetitive European countries to devalue, they must undertake an austerity-led restructuring.”

Politicians are due to convene today and tomorrow in Brussels for a pivotal European summit that could see closer fiscal integration rubberstamped as soon as next March.

Konyn suggests the euro cannot survive in its present form and ascribes a 70% possibility of a controlled breakup of the eurozone, including rule changes and restructuring, with a 30% chance of a messy breakup.

RCM is overweight German bunds at the long end of the curve and prefers to own high-grade spread products at the short end of the euro curve.

Investment director Michael Jiang of Harvest Global Investments lists three steps for the eurozone to dig its way out of this crisis: restructuring its membership mechanism; imposing a meaningful cutback in social welfare and living standards in Europe; and quantitative easing.

“But these three things cannot happen until the situation deteriorates far enough to trigger enough political will, namely huge capital loss, bank bankruptcy, bank deleveraging and recession, all of which are deflationary in nature,” Jiang says.

In other words, he expects the sequence of events to unfold in a similar way to 2008: crisis, followed by bank failures ­­and deleveraging, asset price collapse and recession, deflation, quantitative easing and finally inflation.

Harvest has no exposure to European sovereign debt, including German bunds. Asked his view on what constitutes a safe haven, Jiang says in terms of systemic risk to the eurozone sovereign debt/banking crisis, “the safest asset in our view is cash and US/China treasury bonds denominated in safe currencies such as US dollar, Hong Kong dollar and renminbi”.

While he notes that Harvest’s clients are all cautious, he says the actions they are taking varies greatly. “Some are avoiding emerging markets as a leveraged play on non-existent global growth, while others suspect there will be a degree of decoupling as China and other emerging markets weather the storm through resilient domestic demand and forceful government policy.”

Jiang expresses the hope that there will be a controlled breakup of the eurozone, with core countries remaining while others drop out, and gives 2012 as a timeline.

Asked what these scenarios imply for Asian debt, he says the worst case would see the US dollar appreciate due to a flight to safety. “Local currency will be under stress, not including the HKD/USD peg. It will be interesting to see how well the offshore RMB can stand the test versus the US dollar.”

McCabe believes there would be no escape if the eurozone was to break up and says uncertainty will continue to drive volatility in Asian currencies and credit markets. “But as the uncertainty is resolved, fundamentals will likely prevail over the medium term with Asian currencies and credit likely to benefit,” he adds.

Asked if he had confidence in credit default swaps as a risk management tool, he says: “If you are buying to protect against default, then no, nothing can beat selling the bonds. But if you are looking to manage your exposure to credit risk, then maybe, particularly in challenging liquidity conditions.”

He argues that a messy breakup of the eurozone would recast the die in terms of the impact it would have on counterparty risk. “Non-European entities may benefit, but trustees will need to reassess custody, mandate and execution standards.”

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