Asia's boom hides system fragility

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The recent global financial crisis has spurred Asian countries to accelerate regional trade liberalization and economic integration. One of the biggest promoters has been the Asian Development Bank which claims there are currently 88 free trade agreements, up from 25 ten years ago, and with a further 133 in the pipeline. For many enthusiasts the ultimate goal is a single currency, something akin to the Euro, which would reduce currency risk and constitute a third anchor for the world’s financial system.

 While an Asian Monetary Union may be a stretch too far, the region’s growing interdependence is undeniable and there are several cogent reasons for believing that the integration process has much further to run. The first is Asia’s noodle bowl of proliferating FTAs, including the high-profile China-ASEAN pact which came into force amid much fanfare on Jan 1 of 2010. This agreement is especially important to ASEAN given China’s growing regional preeminence.

 To illustrate, China’s exports to ASEAN have risen by 94% over the last five years and continue to grow at a blistering pace. During the most recent three months China’s exports to ASEAN are up 40.2% from the corresponding period a year earlier, while imports are up 76.5%. Beyond ASEAN countries, the growth in China’s trade flows with Japan and Korea are almost equally dramatic. For example, Korea’s exports to China have risen by 533% over the last decade (during this period, Korea’s exports to the US grew by 0.3%).

While growth in the quantity of exports has been spectacular, equally important is the progress in the quality of exports. For example, China’s export mix is rapidly moving up the value chain with its strongest growth, especially to the US and EU, being in “mechanical and electrical products” and “new and high tech products” (custom’s categories). Exports in both sectors have grown by more than 120% over the last five years, and now account for the lion’s share of China’s exports (dwarfing lower value-added products such as clothing and toys).

To accomplish this rapid transition to higher value exports, China has developed an extensive regional supply chain, importing sophisticated machinery and intermediate products from Japan, Korea, and ASEAN countries. A Jan 2010 ADB publication on regional production sharing demonstrates that the trade in parts and components of vertically integrated industries is much more important in Asian than the EU or NAFTA (especially in electronics and electrical industries; but less so in autos). The competitiveness of its intricate production networks makes Asia a powerful example of integration, with China reigning as the premier assembly hub.

Accordingly, China has actively encouraged inward foreign direct investment, and now ranks as the world’s #2 recipient (after the US). Last year’s $US 90 bn of FDI helped establish 23,435 ventures in China. The bulk of this FDI comes from Asia (the top six investors are HK, Japan, Singapore, Korea, the US, and Taiwan), with well over 50% invested in the manufacturing sector (by contrast, the banking sector’s share is a measly 0.5%). While FDI outflows from China have only been about 15% the value of inflows, they are destined to grow considerably over the medium-term, with most streaming into other Asian countries.

Another reason for being optimistic about accelerated integration is that, according to Professor Eichengreen at the University of California, Berkeley, Asia comes as close to satisfying the classic optimum currency area criteria as Europe did in the early 1990s. The main cost of joining a currency union is the loss of sovereignty over monetary and exchange rate policies, where such costs depend upon the nature of exogenous shocks affecting member countries (the more symmetrical the better) and the speed with which they adjust to them. The academic evidence is clear that the correlation of supply and demand shocks within Asia is similar to that among EU members (the evidence also demonstrates that correlations are endogenous, rising in response to monetary union). Further, the evidence suggests that, although the average size of shocks is larger, the speed of adjustment to shocks in Asia is much faster than in the EU region, because of its more flexible labour market and wage rates.

However, an incipient Asian currency union exhibits one fatal flaw relative to the EU. That is, the Asian the financial system remains under-developed, a failing that could take decades to rectify. This is particularly true of China, which requires dramatic liberalization of fixed income and FX markets, and the phasing out of its stringent capital controls.

Subsequently, Asian capital markets are more closely bound to global markets than to each other. According to a recent paper from the BIS titled “Why is there so little financial integration in Asia?”, Asians direct only one quarter of their foreign portfolio investment to other Asian countries. This stands in marked contrast to the pattern for trade flows (intra-regional flows account for over half of Asia’s trade), as well as the experience in Europe (where over half of the region’s portfolio investment is in other European countries). Further, a number of Asian countries need to move much further in the direction of greater central bank independence and policy transparency. As Professor Eichengreen emphasizes, this is true whether they opt for monetary union or not. Consequently, an Asian monetary union is likely decades away.

Regardless, the momentum appears unstoppable and the process of Asian integration keeps steamrolling along, especially in terms of trade and investment patterns, and to a lesser extent portfolio flows. Aside from some straightforward short-term trades (buy commodity, energy and agricultural sectors in Thailand, Indonesia and Malaysia), accelerated integration has three important medium-term implications for investors. First, and similar to the earlier European experience, cross-border valuation differentials are destined to narrow. This will, for example, benefit Korean equities (trading on a 10.1x PER, well below the regional mean) against Japanese equities (PER of 31.3x). It may also benefit several high-yielding sovereign bond markets, such as Indonesia and the Philippines, especially relative to Japan, Taiwan and Singapore.

Second, FX markets will be increasingly driven by fundamentals, which should favour the undervalued KRW and RMB, especially against the JPY and the other G4 currencies. Finally, deregulation will encourage the development of deeper and more sophisticated fixed income and FX markets, accompanied by a plethora of new products, including corporate bonds and derivative instruments, which will inaugurate a flood of new strategies and opportunities for investors.

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