August 2008

RECESSION and ASIA: Seeds of Discontent

Recession may not be an immediate fear in Asia, but food prices are a major source of inflation in Asia. Fiona Rintoul asks if the growth story is over ... As recently as October last year, the Singapore-listed pan-Asian DBS Bank suggested that worries about inflation in Asia were overblown. “Asia’s inflation stands accused of disorderly conduct. Nothing could be further from the truth. Outside of food prices in China and Singapore – special cases both – inflation is far below average and falling,” the bank said.

Today, that looks a little like wishful thinking. Inflation has been showing its teeth in Asia for some time, threatening one of the most stunning economic growth stories of all time with its nasty sharp incisors, but recently it has really started to bite. Inflation in many parts of Asia is now at its highest levels for nearly a decade.

“Inflation has become a real problem this quarter,” says Jason Pidcock, manager of the Newton Oriental Fund, who believes the situation has been exacerbated by Asian governments’ attempts to hold their currencies down against the US dollar last year.

“The problem with that is that it increases the money supply and that overspills into inflation,” says Pidcock. “Unfortunately, it’s come at a time when there is also supply disruption in food and energy.”

At the recent Nomura Asia Equity Forum, which took place in Singapore in July, Teh Kok Peng, president of the hedge fund and private equity arm of the Government of Singapore Investment Corporation (GIC), the Singapore sovereign wealth fund, suggested that Asian central banks needed to tighten their monetary policy further to deal with inflation. But the problem with that, of course, is that in the context of global slowdown it is domestic consumption that is driving Asian economic growth.

“The export sector has been hit by a slowdown in demand from the US and Europe,” says Pidcock, “which governments ordinarily might offset by stimulating domestic consumption, but it’s hard to do that when you have high inflation.”

However, Asian governments have tended to prioritise maintaining growth over fighting inflation. Growth is more important in Asia than it is in the West. And, observes Kathryn Matthews, Asia CIO for Fidelity International, while Western governments might typically react to rising inflation by raising interest rates, that has seemed a less viable option in Asia.

“Concerns about growth have been greater than concerns about inflation, and my personal view is that that is probably right,” says Matthews. “Growth is essential for the future success of the region. You need growth levels in China of at least 7%, maybe 8%, to keep up the momentum.”

Another issue that has stopped governments tackling inflation is social unrest. There have already been food riots in, for example, the Philippines, and the president of the Asian Development Bank, Haruhiko Kuroda, warned that the explosion in food and energy prices poses a serious threat to political and economic stability in the region. As a result, Asian governments are very nervous of bringing the man on the street face to face with price hikes. They have therefore sought to weather this period of high inflation with subsidies rather than by tightening monetary policy.

Some of these attempts to cope with food inflation and protect vulnerable populations through subsidies have made matters worse, however. “Some countries have brought in restrictions on the export of some foodstuffs, such as rice,” says Pidcock. “But that makes it worse for other countries, such as the Philippines, which is a large net importer of rice.”

The downside of subsidies
Subsidies can also cause longer-term damage. “When there is government interference like that it messes things up long term,” says Pidcock. “It messes up the pricing signals and there is less incentive for producers to expand production.” Subsidies also mask the market reaction to price increases that would slow down demand. And some countries, such as Korea and India, are now starting to feel the impact of the subsidies on their budget deficits.

“A lot of these countries have been faced with quite a nasty dilemma,” says Mark Thirlwell, director of the International Economy Programme at Australia’s Lowry Institute. “One of the ways that they’ve been trying to limit the impact of rising food and energy prices is through government subsidies, but as prices have got higher and higher the budgetary burden of those subsidies has also started to get very high. And for economies, in particular India, which already has quite large budget deficits and a lot of public debt, the fiscal burden of doing that has got very difficult.”

It sounds like that leaves the Asian countries between a rock and a hard place. So is the fabulous growth story over? Not a bit of it.

“Growth levels across the region will come down, but they will still be higher than in the West,” says Pidcock. “Certain companies will still be able to do well, but you’ll have to be more careful about which companies you invest in.”

It’s a stockpicker’s market in other words, and at the moment, Pidcock particularly likes stocks in the energy and telecoms sectors. The telecoms sector will benefit from the cost of equipment coming down, he says. It will then be possible to raise talking costs at a rate that is lower than inflation, but that represents attractive margins for providers.

Alternative energy
On the energy side, the Newton Oriental Fund has a broad portfolio of investments covering traditional energy suppliers, such as oil and gas companies, as well as alternative energy companies. With energy use set to rise across Asia as countries develop and urbanise, and oil prices already extremely high, Pidcock sees particular potential in the alternative energy sector. The Newton Oriental Fund is invested in companies such as the Hong Kong-based Noble Group, a supplier of coal and ethanol; the Korean nuclear power plant builder Doosan; Silex, an Australian firm supplying advanced materials to the nuclear and solar power industries; and Suzlon, an Indian wind technology company.

“Alternative energy is definitely a more important sector,” says Pidcock. “Nuclear power will be bigger, and wind and solar energy will be too. There will be a technological breakthrough on the solar side soon, but you can’t put solar everywhere. You need the nuclear alternative too.”

There are also important economic positives in the region that will provide cross-section benefits when they come into play. One of these is the low indebtedness of the Asian countries. While people in the West are heavily indebted, national savings levels in Asia have increased five-fold in the last 20 years, says Matthews. At the same time, consumer debt levels have fallen dramatically and corporate debt levels are much lower than in the recent past.

“The good news for the region is that debt levels are quite low compared to the West,” agrees Pidcock. “This means the region will recover more quickly. Once the US and the UK have bottomed out and the decline in exports peaks, the recovery will be rapid from that point on.”

And even the global slowdown can bring benefits for some sectors. A weakening export market may have adversely affected some Asian technology companies, but in India, for example, there has also been a plus side.

“I’m currently overweight to stocks in the software and services sector, since many of them were trading at relatively reasonable valuations,” says Arun Mehra, manager of Fidelity’s India Focus Fund. “A global slowdown will also encourage companies to cut expenses by outsourcing to low-cost destinations, such as India.”

Overall, then, there is a feeling that, while the Asian growth story has been tarnished by the current high inflation levels, which have perhaps lasted longer than governments initially expected, it could be polished back up again fairly quickly. This is because the fundamental drivers of growth remain in place, particularly in the region’s key economy of China.

“I continue to see the long-term structural trends of industrialisation and urbanisation in China remaining intact,” says Wilson Wong, manager of Fidelity’s Greater China Fund. “These two trends will continue to support infrastructure spending and domestic consumption growth in China amid an uncertain external environment.”

There is also a feeling that inflation may now have peaked. “From where the high level is now, I don’t see it going up much higher,” the Singapore GIC’s Teh the told the Nomura Asia Equity Forum in July.

Sensible approach
Inflation is now also beginning to be tackled in a more sensible manner, suggests Fidelity’s Matthews. “There’s a general recognition in the region that subsidies cannot be a long-term solution to inflation,” she says. “We’re seeing subsidies reduced and a more developed-world response to inflation, more of a monetary response.”

Meanwhile, DBS Bank suggests that Asia’s continuing (albeit reduced) growth in the face of domestic inflation and collapsing global demand can also be attributed to a shift in the global economic axis of power. It’s a shift that’s fairly fundamental and that puts Asia in the driving seat.

“US demand growth has dropped to zero over a three-year period. Oil prices have tripled over the same time frame. Disaster planners could not have invented a more testing scenario. Yet growth in Asia remains stronger than it should be even on a clear day,” the bank says in its 2008 third-quarter report. “Demand, mostly Asian, explains both puzzles. Asian demand kept growth alive and demand ‘survived’ the rise in oil prices because it drove the rise in oil prices.”

That doesn’t mean the Asian story is going to be an unalloyed picnic, however. Inflation in some countries is at scary levels – in Vietnam it’s 26% – and the spectre of social unrest will remain as long as food needs cannot be met. There are other dangers ahead too. Pidcock points to one: water.

“There are going to be water shortages in many parts of the world,” he says. “Some countries will have to import water. Food production growth is limited because of that.”

Forget food inflation. What about water inflation for a scary thought?

This is where the land of no easy answers begins. DBS Bank figures show Asian domestic demand converging with that of the US. “In 2008 for every dollar of fresh demand the US puts on the global table, Asia will put out 93 cents,” the bank says. They’re pretty pleased with that figure and who can blame them, but it doesn’t just mean that Asia will finally be catching up on the West. It also means more and more people will be competing for a pool of resources that may not be able to expand enough to accommodate them all.

Traditionally, these kind of problems have been solved by things like war and pestilence. Otherwise, there’s another route, already tried out by China.

“Population control measures will be a future topic,” predicts Pidcock. ©  2008 funds europe

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