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ASIA: Systemic distress is not inevitable

By John Caparusso, Global Head of Banks Research at Standard Chartered Bank

 

As emerging economies endure another episode of financial-market stress and volatility, it is appropriate to consider whether and how they might foster more stable conditions. External factors such as global growth and Fed policy matter and are beyond developing countries’ control; but this is not new. The interesting question is, are emerging economies now unusually vulnerable to global forces because their structural resilience has weakened?

Our recent research has focused on a central aspect of this question: what factors lead to borrowers’ default? The classic answer – excessive financial leverage – points in the right direction but lacks nuance. Singapore’s aggregate leverage is nearly level with Spain’s. Does anyone believe the two countries are equally vulnerable? Japan’s total credit relative to GDP is about twice China’s. Does this adequately capture their relative levels of financial system strain?

These comparisons highlight the fallacy of aggregating debt across entire economies. Individual borrowers repay their own obligations from their own cash flow. It is impractical to aggregate a country’s repayment difficulties from the cash-flow solvency of individual borrowers; at the other extreme, is it inappropriate to think of solvency as the repayment of a country’s aggregate debt from its aggregate GDP. Fortunately, recently improved databases from the Bank for International Settlements offer a happy medium. Matching borrowings by governments, households and non-financial corporates against cash flows yields meaningful sector-level debt service ratios.

Within Asia (excluding Japan), our region of focus, leverage and debt repayment strain is most acute in China’s corporate sector. Korea’s aggregate leverage is higher, but two considerations offset this: borrowings are more evenly distributed across corporates and households, and high leverage is a long-established condition to which borrowers are acclimated. India’s solvency stress, much in the news, is acute but surprisingly narrow. Farmers, households and small businesses have very low borrowings; leverage is highly concentrated among listed firms, particularly among a small subset of large companies with high borrowings in both domestic and offshore markets. Most Southeast Asian economies have quite modest corporate leverage; their strains are less acute and reside mainly in the household sector.

While financial leverage is obviously fundamental, we believe full consideration of default risk should also consider business risks, including the level of operating leverage and the extent to which the underlying business is cyclical. To illustrate, memory chip production is a risky business, with highly cyclical volume and volatile prices combined with a production process dominated by fixed costs. One would not expect a DRAM maker to operate with the financial leverage of a stable consumer-products manufacturer. A similar trade-off between business risk and financial leverage extends from individual borrowers to industries and the broader economy.

We think neglecting operating leverage as a source of systemic risk can lead policy makers and investors to overlook useful insights. Over the past ten years, listed companies across Asia have reduced their degree of fixed asset intensity, and have evolved toward more flexible cost structures – even in China, where rising fixed asset investment relative to GDP suggests a shift toward higher capital intensity and cost rigidity. (We suspect the investment has been skewed toward public infrastructure.) Conversely, neglecting operating leverage arguably under-emphasises the risks in Hong Kong, a market with a large sector of high-fixed cost property developers in an economy highly correlated to frothy asset prices.

Balancing financial and operating leverage, we think structural risks in Asia are potentially most severe in China, closely followed by Hong Kong and, at a distance, by India. Structural solvency risk in Korea is surprisingly benign, and it is low in ASEAN.

Even for China, the probability and timing of any worst-case outcome are uncertain – classic ‘tail risk’ conditions. India’s worst-case scenario is much less severe but, under current circumstances, more likely. The delay of Fed tapering does not alter this opinion; it simply

defers it, hopefully for long enough to permit remedial measures. As we scan countries, we find it useful to distinguish between structural risk (which affects the worst-case depth of a problem, but not its probability or timing) and ‘cyclical’ risk (which highlights periods of maximum vulnerability).

Systemic distress is not inevitable anywhere in Asia. However, we believe that certain conditions – particularly the build-up of financial leverage in some countries and sectors, and the (usually related) property-market froth – are incipient risks that policy makers should continue to manage and investors should monitor vigorously.

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