Macro

Asian Economics
abc
Global Research

Blowing bubbles  Excess liquidity in Asia raises the spectre

of asset bubbles, especially in property
Money’s too loose in Asia
 The bubble will grow for several years
to come if policy-makers don’t step up

 But lingering growth risks will reinforce

caution, pushing asset prices up further

Here we go, again

We’ve been here before. A crisis erupts, markets panic, and
policy-makers, reading the news along with everyone else,
slash interest rates to pump up growth. In principle, this is
perfectly all right. The trouble is, however, that if policy stays
too loose for too long, it will blow bubbles. In Asia, liquidity
is far too abundant to keep interest rates this low. Yet, it
appears unlikely that the region will strike out on its own
and tighten while everyone else is stuck in the emergency
room. In short, the seeds are being sown for Asia’s next
bubble. The world has not changed, it just moved places.

Chapter 1: Still standing

Two points to note. First, liquidity is extremely abundant in
Asian financial systems. There is no credit crunch to speak
of. Sure, banks have become more cautious since the crisis,
15 July 2009 but this is a cyclical response and does not reflect a breakdown
in the financial transmission mechanism. Second, Asia, unlike
Frederic Neumann*
Economist other parts of the world, does not suffer from a balance sheet
The Hongkong and Shanghai Banking Corporation Limited (HK) crisis, allowing leverage to build quickly if rates stay low.
+852 2822 4556 fredericneumann@hsbc.com.hk
Chapter 2: Bubble economics
Monetary policy is far more powerful than a fiscal stimulus,
but develops more gradually over time. Low growth and
lingering uncertainties are preconditions for bubbles to
emerge, as they force officials stay accommodative. Asset price
increases can occur even if growth fundamentals appear
unsupportive. In fact, the divergence of asset values from their
View HSBC Global Research at: http://www.research.hsbc.com
fundamentals is precisely why the thing is called a “bubble”.
*Employed by a non-US affiliate of HSBC Securities (USA) Inc,
and is not registered/qualified pursuant to NYSE and/or NASD Chapter 3: The trilemma, again
regulations
Issuer of report: The Hongkong and Shanghai Banking For Asia to tighten independently, it needs to let go of the
Corporation Limited idea of exchange rate competitiveness. But such beliefs are
Disclaimer & Disclosures so deeply ingrained after decades of export-led development
This report must be read with the that aggressive, independent action appears unlikely.
disclosures and the analyst certifications
in the Disclosure appendix, and with the
Disclaimer, which forms part of it
 Macro
Asian Economics abc
15 July 2009

Still standing
 Credit growth has slowed in most Asian markets, but liquidity is
still flush across the region, and capital markets have stabilized
 There are few signs of balance sheet stress in Asia, either in the
business or in the financial sector, allowing leverage to rebuild
 Low policy rates will ultimately feed into cheaper funding costs as
well, likely stoking another boom in credit creation in coming years

Hardly crunched including re-intermediation due to the temporary

shutdown of credit and equity markets. Still, the
The idea of a “global credit crunch” appears a
overall point is not so much what is causing credit
little misplaced when viewed from Asia. The
growth to hold up so well, but the fact that banks
recent turmoil certainly engulfed much of the
were in a position to accommodate the demand
world’s banking system, but the region has so far
for lending by firms when capital markets froze.
been spared a full-blown lending crisis. As we
argued elsewhere (see Is Asia facing a credit 1. Credit growth across Asia remains strong (avg, % y-o-y)
crunch?, 18 September 2008), the region was 25
always likely to feel more of a credit “pinch”, 20
rather than an all-out “crunch”. In the event, this 15
is what occurred: bank lending, the dominant
10
conveyor of corporate financing in Asia, slowed
5
temporarily from a previous red-hot pace, but it
0
hardly went into free fall.
-5
Take a look at the latest data. Chart 1 shows credit 97 98 99 00 01 02 03 04 05 06 07 08 09
growth for Asia ex Japan. On a weighted basis, Asia ex. JP simple w eighted

credit growth accelerated recently. This evidently Source: CEIC, HSBC; NB: data through April 2009

reflects soaring bank activity in China. On a non-

weighted basis, lending did indeed slow in the last
few months, but at more than 15% can hardly be
labelled an outright collapse. In fact, taking into
account the fall in economic activity, the
slowdown in lending is hardly surprising. There
are, of course, factors that may have artificially
sustained credit growth over the past six months,
But the story goes further than this. Not only has
credit growth held up well, but banks are, at least
for the most part, able to sustain their current pace
for quite some time. There are two factors at work
here, which are worth investigating. First, few
financial institutions in the region suffer from a
structural impairment of their balance sheet, at
least nowhere near the same extent as their

2
 Macro
Asian Economics abc
15 July 2009

2. Credit growth varies among countries (% y-o-y) 5. Provisions mostly adequate against non performing loans

30.0 6
150
25.0 5
20.0 4
100
15.0 3
10.0
50 2
5.0
1
0.0 n/a
0 0
-5.0
CH HK IN ID SK MY PH SG TH
CH HK IN ID SK MY PH SG SL TW TH
Credit grow th, latest Provisions % of NPLs NPL ratio % (RHS)

Source: CEIC, HSBC Source: IMF, CEIC, BSP, HSBC; NB: data is latest available

Western peers. The table below shows the share
of global write-offs among banks that are related
in the broadest sense to the US subprime fiasco.
Asia, including Japan, accounts for a mere fraction
of such crippling exposure. To put this into
perspective, it is also worth keeping in mind that
the banking system in Asia is considerably larger
than in the Americas, although both are smaller
than Europe’s by a substantial margin. Note
further that the amount of capital raised in Asia is
far higher relative to write-offs than elsewhere.
leverage up in the recent go-go years, leaving
corporate and household balance sheets relatively
fit and lean – a topic to which we will return
below. This is now paying off: banks’ balance
sheets, from a systemic view, remain quite robust,
especially considering the scale of the collapse of
activity, and we do not expect any nasty surprises
in the pipeline.
6. Loans as a share of deposits mostly well below 100%
150.0

4. Bank write-offs and capital raised since 3Q07 (USDbn, %) 100.0

(1) Write- (1) as % of (2) Capital (1) as % of
offs total raised (2)
50.0
Asia 38.8 2.6 83.3 46.6
Americas 978.4 66.5 738.6 132.5
Europe 458.0 31.1 447.1 102.4
0.0
Total 1,471.6 100 1,268.9 116.0
Source: Bloomberg, HSBC CH HK IN ID SK MY PH SG SL TA TH
Loan to deposit ratios, latest
For Asia, of course, there is still a residual risk to Source: CEIC, HSBC; NB: definitions vary slightly, data through April and May 2009
balance sheets from rising non-performing loans.
But there are reasons to be relatively sanguine: for The second big factor helping to sustain financial
one, Asia is suffering from something more akin solvency of the region’s banking systems is the
to a cyclical rise in NPLs for which banks should comfortable level of liquidity. With the possible
have provisioned in fatter years. This contrasts exception of Korea, wholesale funding plays a
with the structural breakdown of financial relatively minor role throughout Asia. Moreover,
markets in the West, where an entire class of already going into the crisis, lenders were struggling
recently prominent assets has gone up in smoke, to recycle all the cash coming in their door: deposit
and the relevant funding model along with it. In growth was strong over the last couple of years,
addition, there is evidence that Asia did not and continuously so during the crisis. As a result,

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 Macro
Asian Economics abc
15 July 2009

loan-to-deposit ratios remain rather conservative
in most Asian markets. Only Korea and Thailand
have ratios over or near 100% although, in both
cases, certificates of deposit, which are not
included in deposits because they are tradable
securities, play a prominent role. Loan-to-deposit
ratios are also quite low historically. The chart
below makes the point clear: in recent months, the
ratio has again fallen, boosting the overall level of
available liquidity. Taking a longer-term view, the
ratio is higher than during the deleveraging years
of 1998 to 2007, when the region was recovering
from the Asian Financial Crisis. Still, we regard
this period as somewhat of an aberration, given
the long recovery process following the bust, and
the ratio still remains well below the more
“normal” period of the early to mid-1990s.
7. Falling, and still well below pre-Asian Crisis levels
110
financial system: this is beginning to change, for
sure, but most local corporate bond markets, as
well as equity issuance, are relatively small
compared with the size of bank lending. A closer
look, of course, reveals some nuances: Korea,
Hong Kong, Singapore, India, and Malaysia, for
instance, have more market-based systems. But
we contend that banks in all these cases are large
enough to accommodate corporate financing in
the face of capital market jitters.
Here, we offer two reasons for the historically low
loan-to-deposit ratios in Asia. First, as already
alluded to, bank credit expanded at a pace roughly
in line with nominal GDP growth. As a result,
deposits grew at an almost equally rapid clip. And
this remains the case: as the chart below shows,
deposit growth reaccelerated in recent months,
depressing the loan-to-deposit ratio and leaving
banks with excess cash to deploy.

100 8. Deposit growth has reaccelerated (% y-o-y, average)

25
90
20
80

15
70
Jan-94 Jan-97 Jan-00 Jan-03 Jan-06 Jan-09
10
Loan to deposit ratios (Asia ex Jap, simple avg)
5
Source: CEIC, HSBC
97 98 99 00 01 02 03 04 05 06 07 08 09
Asia ex. JP simple weighted
One relevant question is why loan-to-deposit
Source: CEIC, HSBC
ratios have remained so low. One might surmise
that the growing prominence of capital markets in
The second reason is also of interest, especially
Asia has displaced bank lending and thus limited
when put in a broader context. Base money grew
the scope for credit expansion. But we doubt that
robustly in recent years, reflecting a relatively
this explanation holds much water: the essential
accommodative monetary stance. This reflects, for
character of financial systems, whether they are
the most part, aggressive central bank intervention
bank or market based, remains relatively static
in the foreign exchange market, with the build-up
over time, something that is exemplified by both
in dollar reserves not being fully sterilized. This
Germany and Japan, two countries where, after
matters for gauging the outlook for monetary
decades of capital markets development, banks
conditions, too – a subject to which we will return
remain at the centre of corporate financing. In
in the last chapter. Suffice it to say here that,
Asia, most countries retain a bank-centric

4
 Macro
Asian Economics
15 July 2009
should central banks once more intervene in
foreign exchange markets and purchase dollars,
and there is evidence that they recently have, then
base money growth is likely to pick up speed,
helping to sustain deposit growth.
9. Base money growth: An accelerating trend (% y-o-y, avg)
21
19
17
15
13
11
9 1200
7
5
97 98 99 00 01 02 03 04 05 06 07 08
Asia x CH& JP (sim ave) Weighted
Source: CEIC, HSBC
As elsewhere in the world, of course, the region’s
credit markets remain under stress. For example,
bond spreads based on HSBC’s Asia Dollar Bond
Index remain elevated, although nowhere near
levels seen during the peak of the crisis. This is to
be expected: traded credit, unlike bank credit, is
closely linked to the global financial system, and
Asia is not immune to spillover of stress from
other parts of the world. Still, taking bond market
spreads as a sign of fundamental financial market
dislocation is misleading: as mentioned, Asia’s
economies are overwhelmingly dependent on
bank financing, and this more localized channel of
intermediation remains in far better shape than in
virtually all developed markets.
In fact, even though the global credit crunch is
often seen as a quintessential banking crisis, this
is incorrect. Fundamentally, the subprime bust
was a capital markets crisis where credit
intermediation via securities became the source of
instability. Banks were certainly drawn into this
crisis, but this was largely as a result of their
engagement with capital markets. In Asia, as
elsewhere in the world, capital market activity
abc
also boomed in recent years. But the difference is
that commercial banks had far less direct exposure
to financial markets. This is crucial, since it leaves
Asian banks in a relatively robust position to take
the slack from slowing financial intermediation
via capital markets. As a result, the region has not
been drawn into a full-blown credit crunch and
should emerge from the lingering effects of
financial constraints far more rapidly.
10. Spread of HSBC’s Asia Dollar Bond Index (bp)
1400
1000
800
600
400
200
0
Nov-04 Oct-05 Sep-06 Aug-07 Jul-08 Jun-09
high grade high yield
Source: CEIC, HSBC
We spare the reader a more detailed discussion of
financial market systems in various economies
across the region. Korea, and possibly India, are the
only two markets were the banking system remains
arguably incapable of generating strong credit
growth in years to come. In the case of Korea, this
may dampen the speed of the domestic recovery –
although, even here, it needs to be pointed out, we
are not expecting a systemic banking crisis to
emerge. Rather, the country’s banks are likely to
undergo a period of consolidation, with relatively
restrained credit growth, but certainly not the
outright aggressive deleveraging that is required in
the West; which renders a sharp recession, or at
least a prolonged recovery process with enduring
sub-trend growth, virtually inevitable.
It’ll make a difference
Evidently, banks remain in relatively robust
shape. This has powerful implications: with
monetary policy extraordinarily loose currently,
5
 Macro
Asian Economics abc
15 July 2009

and expected to remain so for quite some time, 1997. This is easily documented by looking at
credit growth should reaccelerate and support debt-to-equity ratios for non-financial listed
economic growth. This is, in fact, what occurs in corporations in the region. To be sure, debt-to-
virtually every cyclical recession, and we still equity ratios rose again in 2008, but this in part
characterize Asia’s slump as such, even if it reflects the sudden gyrations in the stock market.
proved far more severe than usual, given that Also, the overall level of the debt-to-equity ratio
there is no evidence of a fundamental dislocation remains well below the peak years of the 1990s.
in the region’s financial systems.
12. Debt to equity ratios have come down over time
11. Bank lending spread over policy rate (%) 80%
12.0
60%
10.0
8.0 40%
6.0
20%
4.0
2.0 0%
0.0 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008
J an-9 5 Jan-98 J an-01 Jan-04 Jan -07 Asia ex Japan
A SE AN N IEs
Source: Bloomberg, HSBC; NB: for listed companies ex financial institutions
Source: CEIC, HSBC; NB: data through May 2009

Here, the biggest progress has been achieved by

To be sure, so far, there is still relatively little
countries hardest hit by the 1997 crisis: Korea,
evidence that bankers are passing on record-low
Thailand, and Indonesia; while Taiwan, China,
policy rates to their customers. During the recent
and the Philippines have also made progress.
bust, financial institutions across Asia, with the
Admittedly, there are a few countries where debt-
notable exception of China, maintained a cautious
to-equity ratios increased over the years; still,
stance, charging relatively high spreads for new
even in these cases, they remain moderate.
loans and tightening credit standards. But, again,
this is a typical, cyclical reaction to any slump, 13. Debt to equity ratios in selected Asian markets

and we expect lending standards to loosen rapidly 1 80%

in the coming months and quarters as memories of 1 30%

the global crisis fade. Already, in Korea, Hong
80%
Kong, Singapore, and Taiwan (the NIEs), lending
spreads have receded. But even in ASEAN, where 30%
they have not moved much of late, they are not
-20%
overly high in historical comparison. A U C H HK IN ID J P S K M Y N Z PH SG TW TH Ax J
199 6 20 08
It is well worth highlighting another aspect of this
Source: Bloomberg, HSBC; NB: for listed companies ex financial institutions
particular crisis: corporate balance sheets are now
in much better shape than during the run-up to the
What matters for financial stability, however, is
Asian Financial Crisis, which in turn reduces the
not only the amount of debt a company carries
risk to banks. There are two main reasons for this.
relative to its equity, but also its ability to service
First, firms underwent a lengthy deleveraging
these obligations, especially when financial
process for several years following the bust in
conditions suddenly tighten. On this measure, too,

6
 Macro
Asian Economics abc
15 July 2009

Asian firms went into the recent crisis in better 2002 to 2008, return on assets averaged 6.4%, a
shape than into the previous bust. Consider the full percentage point higher than during the earlier
quick ratio, which is defined as current assets (net pre-crisis episode. Better profitability has given
of inventories) as a share of current liabilities. For firms in Asia a little more buffer to weather the
most of this decade, the ratio gradually rose, sudden drop-off in demand and even provided room
leaving companies in a fairly robust position when to keep on staff during the downturn – something
the credit crunch suddenly struck. To be fair, in that is now paying off as demand rebounds.
2008, the quick ratio declined again, reflecting in
15. Return on Assets structural higher in recent years
part the need to draw on current assets to make
8.0%
ends meet in such extraordinary times. But, even
7.0%
now, the ratio is still at reasonably healthy levels. 6.0%
5.0%
14. Quick ratio increased in recent years 4.0%
3.0%
1.10
2.0%
1.0%
1.00
0.0%
0.90 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008

Asia Ex Japan
0.80
Source: Bloomberg, HSBC; NB: for listed companies ex financial institutions
0.70
1990 1993 1996 1999 2002 2005 2008 Engine’s still running
Asia Ex Japan
Asia’s financial systems remain in robust shape.
Source: Bloomberg, HSBC; NB: for listed companies ex financial institutions; quick ratio
defined as current assets, net of inventories, as a share of current liabilities
Balance sheets contained little direct exposure to
Western toxic assets, while Asian corporations are
The second reason why corporate Asia is in more nowadays far less vulnerable to a financing crunch
robust shape today is that profitability has increased than during the bust of 1997. The region still
over the years. In fact, macroeconomic data grapples with excess liquidity, which banks will
suggests that productivity growth has accelerated ultimately look to deploy. Contrary to other regions
since about 2005, allowing firms to churn out in the world, Asia remains in a strong position to
more goods per unit of input, thus raising their leverage up again and push up lending growth.
profitability and making them more immune to a With monetary conditions extremely loose, there is
sudden tightening of financial conditions, as well little reason to expect the traditional response of
as swings in end demand. financial institutions to low policy rates to fail.
Asia’s financial engine, in short, is still running.
The next chart shows the return on assets for
listed, non-financial companies in Asia ex Japan
over time. This series, of course, is rather volatile
from year to year but, when viewed over a longer
time horizon, one can detect a structural increase
in the profitability of Asian firms. Between 1990
and 1996, return on assets averaged 5.4% in the
region, dropping sharply thereafter as the Asian
Financial Crisis took its toll. For the period from

7
 Macro
Asian Economics abc
15 July 2009

Bubble economics
 Policy rates have hit a record low while monetary transmission is
still intact: a potent mix that has fuelled asset bubbles in the past
 Lingering growth risks are not prohibitive of bubbles, but may in fact
fuel these as monetary policy remains overly loose for a long time
 Loose financial conditions should push up especially property prices
over time, with a powerful wealth effect finally supporting growth

Where it shows
What ultimately concerns us here is the economic
impact of loose monetary conditions. Providing
that their balance sheets are not fundamentally
asset prices lead banks to take on more risk, thus
further stoking financial leverage – a process that
eventually begins to feed on itself.
1. Asian policy rates (%, simple averages)

impaired, banks will eventually respond to lower 10

policy rates, and credit growth should rise, 8
stimulating the economy. Despite its importance 6
in driving growth, the effect of monetary policy is
4
often misunderstood.
2
First, it is a far more potent tool for economic
0
management than fiscal policy. Additional public
Jan-00 Jan-03 Jan-06 Jan-09
expenditure or tax cuts tend to have only a short-
Asia x JP ASEAN NIEs
lived effect on aggregate demand. Moreover, the
Source: CEIC, HSBC
effectiveness of a fiscal stimulus crucially hinges
on the capacity of the financial sector to respond
The potency of monetary policy is easily revealed
to the growing demand for credit, including lower
by a quick look at past cycles. Take Asia: when
funding costs. As such, prospects for a policy-
the Federal Reserve slashed interest rates in the
driven economic “reflation” remain far more
early 1990s, the region saw a head-spinning run-
promising in Asia than in many Western markets.
up in asset prices that gathered steam until about
Second, the impact of a monetary stimulus lasts 1996 and led eventually to an equally head-
much longer: the initial impulse reverberates over spinning bust. The recent sub-prime crisis in the
time via the multiplier process of credit creation, United States arguably had its source in ultra-low
which allows banks to expand lending over time policy rates following the Fed’s rate cuts in the
on the back of a growing deposit base. Third, the wake of the tech slump. This particular bubble ran
so-called “financial accelerator” helps sustain the all the way through 2006, triggering the lingering
potency of the initial monetary impulse: rising recession about a year later.

8
 Macro
Asian Economics abc
15 July 2009

The remarkable thing about such liquidity-driven
asset bubbles is their long-cycles, underlining the
eventual potency of loose monetary policy. Also,
successive monetary tightening over the course of
the bubble has apparently little impact: once the
financial accelerator goes into full throttle, it takes
aggressive tightening to pop the bubble – and,
more often than not, policy-makers are reluctant
to step up for fear of bringing down the house.
In a world of globalized financial markets, there is
an added complication, to which we shall return in
more detail below. Suffice it to say that monetary
conditions are today determined globally, not
locally, as capital is mobile and exchange rates are
far stickier due to intervention than a neat, orthodox
model of the world would prescribe. In the 1990s,
Asia was to some extent hostage to Fed policy and,
during this decade, the Fed was to some extent
hostage to Asian purchases of dollars, which kept
monetary conditions looser than the nominal rise in
the federal funds rate would otherwise suggest. Now
we are risking a repeat of the 1990s: with the world’s
major central banks holding rates near zero, Asia
is facing extremely loose monetary conditions and
arguably has limited room to tighten independently.
What is the likely effect of such loose monetary
conditions on Asia? The liquidity available will
ultimately require an outlet somewhere. There are
three principal avenues: public investment, private
investment, or asset purchases. This to be sure, is
an extremely stylized view of an economy, but it
makes the essential point clear: savings will have
to be deployed somewhere, especially since they
remain in ample supply. Currently, the public
sector is drawing on a big chunk of available
capital. This is most evident in China, where the
recent surge in bank lending is mostly tied to
publicly sponsored infrastructure projects.
Elsewhere, the public sector finances itself more
via capital markets, but the overall impact on
financial conditions is essentially the same.
Still, public sector borrowing requirements are not
sufficient to absorb the excess savings available,
with budget deficits across the region forecast to
stay well below levels currently seen in the West,
even as local savings rates are far higher. In addition,
there appears little urgency for a drive to expand the
capital base of private industry given that the slump
leaves many sectors with excess capacity. As a
result, the financing conditions for assets remain
conducive for further price gains in years to come:
excess capital, after all, eventually finds an outlet.
To underline, however: this is a multi-year process
rather than a short-term call on the direction of
financial markets. As history shows, bubbles

2. Simplified time-line: Asian asset markets and the US Federal Funds rate (%)

9 US recession and S&L crisis prompts Russian and LTCM

Asia bull run takes off
Fed to cut, Asian bull run starts crisis, Fed cuts
8 tech bust, Fed cuts global sell-off post
Asian Crisis
7 Lehman
deflation fears, Fed
6 keeps rates low
5 Asian
bubble?
4
3
2
Fed starts tightening, Asia's property Asia rebounds US housing
1
Asian equities sell off bull market fades with tech bubble bubble bursts
0
Jan-90 Jan-93 Jan-96 Jan-99 Jan-02 Jan-05 Jan-08

Source: CEIC, HSBC

9
 Macro
Asian Economics
15 July 2009
develop only gradually and include occasional
corrections (which actually make it possible for
the run-up to be sustained for quite a long period).
Bubble economics
An often-heard objection is that loose monetary
policy cannot stoke bubbles if the underlying
economic fundamentals are not supportive of
growth. This is misleading for three reasons. First,
the seeds of bubbles are laid by excessively loose
monetary policy. This, in turn, occurs, when
growth fundamentals are weak, justifying various
“emergency” measures by central bankers. In fact,
economic uncertainty is almost a precondition for
a bubble as it ensures that policy remains loose for
a certain amount of time, allowing the credit
multiplier and financial accelerator a long enough
period to gather steam. Note that the ongoing risk
of “deflation” was often cited in the United States
as justification for why interest rates had to be
held low for a long time following the tech bust.
The argument that loose monetary policy amid an
economic slump can engender bubble conditions
is obviously not valid if the financial transmission
mechanism is impaired. This, in fact, requires even
greater monetary accommodation for even longer
periods, simply to heal the financial sector and
bring the economy back to trend growth. This is
currently the case in the West. But, in Asia, where
monetary conditions are still to a large extent
influenced by the West, the transmission
mechanism is, we contend, far from impaired.
The second point is that asset bubbles can have a
positive impact on economic growth. Again, take
the United States: the recent expansion was arguably
driven in large part by the run-up in house-prices.
This in turn fired up the construction industry and
led to a boom in equity extraction from rising
housing wealth, which itself fuelled growth in
consumption. Of course, other factors were at
play, too, but surely the housing price bubble goes
a long way to explaining the recent economic
expansion. More broadly, what we have in mind
10
abc
is the “wealth effect”, the notion that rising asset
prices, primarily for property and stocks, raises
the net worth of households and corporations,
spurring spending and investment.
3. Marginal propensity to consume out of housing wealth
Emerging Asia United States United
Kingdom
short-run 0.03-0.04 0.02-0.12 0.06
elasticities
long-run 0.08-0.14 0.09-0.14 0.07
elasticities
Source: IMF
The common view that wealth effects are limited
in emerging Asia is misplaced. Certainly, in the
short term, the marginal impact of rising asset
prices on private consumption is lower than for
instance in the United States and the United
Kingdom, which can in part be explained by the
greater volatility of Asian asset prices and therefore
a more cautious response on behalf of households.
Over the long run, however, the wealth effect is
equally, if not more, powerful, suggesting that a
strong and lasting run-up in asset prices in the
region will indeed encourage private spending.
A comprehensive recent study confirms that long-
run wealth effects are relatively large in a number
Asian markets. Overall, a 10% rise in housing
wealth raises private consumption by 0.25-0.49%,
an effect that is especially pronounced in Hong
Kong, Thailand, and Singapore. Meanwhile, a
10% gain in stock prices lifts household spending
by 0.29-0.49%, with Korea and Singapore leading
the way, but also significant effects in China,
Hong Kong, Taiwan, and Thailand.1 Admittedly,
wealth effects tend to be asymmetric, depressing
consumption more on the way down than on the
way up. But wealth effects are also highly
persistent, leaving consumption spending
relatively immune to short-term fluctuations in
1
Peltonen, T., Sousa, R, and Vansteenkiste, I., Wealth effects
in Emerging Market economies, ECB Working Paper No.
1000, January 2009.
 Macro
Asian Economics
15 July 2009
asset prices. With the relatively swift return of
both property and stock prices in the region to last
year’s highs, it is reasonable to expect no lasting
negative impact from the nine-month sell-off
through March of this year.
The third point relates to the definition of bubbles.
Essentially, these mark a sustained divergence of
asset prices from their fundamental value – a
process that is violently corrected when the bubble
bursts. The view, therefore, that Asia could not
possibly experience an asset bubble in the coming
years because growth may initially remain sub-
trend is misleading: it is precisely because
fundamentals do not justify massive asset
inflation that we regard this as a “bubble” rather
than a sustained “bull run”. As history shows,
however, bubbles can run for quite some time,
making them in the process hard to distinguish
from bull runs – another precondition, in fact, for
the emergence of a bubble in the first place.
It’s happening
In the strictest sense, monetary conditions are not
purely a function of policy rates. In small, open
economies, as most of the region’s markets are,
the level of the exchange rate plays an equally
important role. An effective depreciation has
roughly the same impact as a cut in the interest
rate: raising aggregate demand. This occurs via a
boost to exports and a reduction of imports. At the
same time, depreciation also spurs price pressures
as the higher price of foreign purchases trickles
through the economy. It is common, therefore, to
express monetary conditions as a function of both
the interest rate and the exchange rate. We employ
indices for each of the Asian markets to underline
the basic message: monetary conditions have
loosened substantially, reflecting not only record-
low interest rates, but also weak exchange rates.
abc
4. Monetary conditions index (% change from 2005)
15
loosening
5 5
-5
-5
-15 tightening
-25 -15
99 00 01 02 03 04 05 06 07 08 09
Asia ex CN & JN (RHS) Asia ex. JN
Source: CEIC, HSBC
But monetary conditions indices, despite their
popularity, provide only a partial picture. What
matters on the ground is whether financial, as
opposed to monetary, conditions are easing as
well. After all, low policy rates in themselves do
not guarantee that a monetary stimulus is being
pushed into the economy. To assess the current
state of financial conditions, we have therefore
constructed a financial conditions index for four
Asian markets. This takes into account not only
the level of the exchange rate (here in real effective
terms), but also short-term money market rates,
credit growth, and house and stock prices.
Including credit growth is intuitive enough, since
financial conditions are greatly dependent on the
pace of bank lending, especially in bank-centred
financial systems. Equity and property prices also
affect financial conditions: a rise in asset values
amounts to an effective easing for the economy,
not least because it raises the net asset position of
households and firms and boosts the value of
collateral for bank loans.2 Often, this impact of
rising asset values on local financial conditions is
not sufficiently appreciated among policy-makers,
2
The weights of our financial conditions index were
determined via a reduced form output equation, where the
explanatory variables, with the exception of the interest rate,
enter in deviation form from time-varying trend.
11
 Macro
Asian Economics
15 July 2009
making them slow to respond to incipient asset
bubbles with interest rate hikes.
What is striking is that financial conditions in our
four markets can barely be described as tight, despite
the massive sell-off in asset prices and slowdown
in credit growth (the latter with the exception of
China). The reason is that market interest rates
remain low, and the decline in stock and property
prices has not been all too damaging. Overall,
financial conditions do not appear prohibitive for
a quick resumption of growth, at least judging
from the historical relationship between our
financial conditions index and GDP growth.
5. Korea: financial conditions remain benign
15
loos ening
10
5
0 -6
-5 tightening
-10
1994Q1 1996Q3 1999Q1 2001Q3 2004Q1 2006Q3 2009Q1
real GDP % Yr FCI (RHS)
Source: CEIC, HSBC; NB: data extends through 2Q
There is already evidence that loose monetary,
and increasingly loose financial, conditions are
stoking asset prices. Barely a few months after the
biggest collapse in industrial production that the
region has seen, which includes the traumatic
episode of the Asian Financial crisis, asset markets
are surging back. The rise in equity prices is
sufficiently well documented that we will confine
our discussion to property, which may ultimately
be the biggest beneficiary of persistently loose
monetary, as well as financial, conditions.
12
abc
6. China financial conditions changing gradually
16 4
loosening
14 3
12 2
10 1
8 0
6 -1
4 tightening -2
2 -3
0 -4
1999Q1 2001Q1 2003Q1 2005Q1 2007Q1 2009Q1
real GDP % Yr FCI
Source: CEIC, HSBC
But it warrants noting that even capital markets
across Asia may exhibit decoupling, both from
fundamentals but also from their traditional
4 correlation with markets in the West, as excess
2
liquidity, intermediated more and more by local
0
-2 financial institutions, increasingly underpins the
-4 local rally. In fact, the current crisis may have
contributed to a greater “home bias” among local
-8
investors who have now come to discount the
-10
-12 supposedly safe investment opportunities that
developed markets once appeared to offer. With
sufficient savings available, and thin local markets to
begin with, Asian capital markets may come to enter
bubble territory, even as other markets tread water.
Hong Kong is arguably the most susceptible
economy to a property price rally, if not a bubble.
The territory’s monetary conditions are effectively
determined by the Federal Reserve. Moreover,
strong lending growth in China may ultimately
spill over into Hong Kong as well, adding an extra
dimension to the territory’s monetary drivers that
was never so pronounced in the past. Already,
prices for real estate have had a strong run: an
official index has risen 21% annualized in the
three months through April, with anecdotal
evidence pointing to further strong gains in May
and June as well, which could put the index near
the top reached during the middle of last year.
 Macro
Asian Economics abc
15 July 2009

7. Hong Kong financial conditions have loosened again 8. Singapore financial conditions loosening as well

15 20 6
loosening 4
15
10
10 2
5 0
5
-2
0 0
-4
-5 -6
-5 tightening -10 -8
-10 -15 -10
1994Q1 1996Q3 1999Q1 2001Q3 2004Q1 2006Q3 2009Q 1994Q1 1996Q3 1999Q1 2001Q3 2004Q1 2006Q3 2009Q1
FCI real GDP % Yr real GDP % Yr FCI

Source: CEIC, HSBC Source: CEIC, HSBC

Elsewhere, prices have stabilized as well and have financial environment is conducive to the
started to move upward, rather than down, which emergence of asset bubbles. We want to
is, given the scale of economic collapse over the underline, however, that this is a multi-year
prior nine months, a rather extraordinary trend. process, with ups and downs along the way.
Take Korea, which only in the first quarter was
9. Property prices indices are pointing up again
gripped by panic about a balance-of-payments
190 50
squeeze. Property prices in Seoul have risen 3%
170
annualized in the three months to June, with the 40
150
prices in the more upscale Gangnam area jumping 130
more than 7% according to the official index, 30
110
which may well understate the true extent of 90 20
property reflation in Korea. 70
50 10
Singapore, too, is a case in point. The city-state Jan-94 Jan-97 Jan-00 Jan-03 Jan-06 Jan-09
was gripped by the most severe recession in Hong Kong Singapore (RHS)
decades, if not the entire history of the country.
Source: CEIC, HSBC; NB: HK to April (1999 = 100), SG to June (1998 = 100)
And yet, property prices are again moving up. The
resale index for Housing Development Board In fact, from a broader perspective, the recent sell-
flats, reflecting genuine local buying conditions off may be regarded as a temporary setback in a
more than other such measures, rose 5% longer bubble run that started in the second half of
annualized over the second quarter and reached an 2006 across Asia. The post-Lehman plunge in
all-time high. China, evidently, is also feeling asset markets, from this perspective, helped to
buoyant, with both equity and property benefiting prolong the bubble that was already under way:
from increasingly benign financial conditions. first by correcting asset values for a short while
Where it all leads and thus reshuffling investor participation, and
second because it loosened monetary policy
Taken together, monetary conditions for Asia
across the globe, re-energizing Asia’s bubble.
remain far too loose compared with the underlying
fundamentals, including the relative stability of
the region’s financial systems. With excess
savings to deploy, and no evident outlet, the

13
 Macro
Asian Economics abc
15 July 2009

The trilemma, again

 Lingering growth risks will reinforce a bias towards loose monetary
policy in Asia, including a preference for competitive exchange rates
 Attempts at squaring the circle and tightening with controlled
exchange rates will founder as sterilization proves ineffective
 What Asia requires is monetary policy decoupling from the
Western world and a new targeting framework for central banks

The big picture rather loose domestically, further stoking the

appreciation of asset prices already under way.
Our worry is this. Policy rates among the major
This, in the short term, even makes economic
central banks are likely to stay low for quite some
sense: a reflation of asset prices is part and parcel
time. Even if the Federal Reserve, the Bank of
of boosting domestic demand, which is the only
England, the European Central Bank, and the Bank
avenue open currently to revive growth as exports
of Japan were to hike rates over the coming year,
linger. The risk, however, is that, over the long
we doubt that these would be aggressive moves,
term, asset values diverge progressively from
with policy rates unlikely to hit levels seen during
fundamentals: bubbles emerge. This, to be sure, is
the peak of the last cycle for several years to come.
not inevitable, but it does represent a risk, and
At the same time, sub-trend growth in these history provides precedents that Asia is liable to
economies will dampen the outlook for the such developments.
region’s exporters, capping any significant upside,
1. HSBC G4 policy rate forecasts (%, end period)
even if we allow for shipments to other emerging
2008 2009f 2010f
markets bouncing back at some stage. The
US 0 to 0.25 0 to 0.25 0 to 0.25
struggling export sector will exert a powerful Eurozone 2.50 1.00 1.00
Japan 0.10 0.10 0.10
political and psychological impact on policy- UK 2.00 0.5 2.00
makers: after decades of export-led growth, both Source: CEIC, HSBC
the institutional and ideological framework of
officials across the region favours exchange rate In short, monetary tightening will be a decidedly
weakness to preserve competitiveness, especially slow process in Asia – too slow, in fact, to amount
at a time when the sector is bleeding. to a sufficient transformation of local monetary
conditions. For one, asset price reflation is still
To prevent exchange rates from appreciating,
required to help Asian economies, which are
central banks will either be slow to raise interest
rather exposed to the export downturn, to bridge
rates or aggressively intervene in FX markets. In
the shortfall in external demand. In addition, the
either case, monetary conditions will remain

14
 Macro
Asian Economics
15 July 2009
deeply established focus on competitiveness is
hard to shake off; but it is difficult to see the
region tightening independently if exchange rates
do not move: the notion that a country can choose
its monetary stance freely as well as manage its
exchange rate has been proved mistaken, time and
time again. What is required for this to work is
watertight capital controls, but these have yet to
be invented.
2. FX reserves have again risen in recent months (USDm)
3500
3400
3300
3200
3100
3000
Oct Jan Apr
Asia x J Asia x J C (RHS)
Source: CEIC, HSBC
Back to school
It has become a well-rehearsed economic concept,
taught ad nauseam and appearing in all basic
economics and management courses. We refer
here to the “trilemma”, or “unholy trinity”: the
economic impossibility of policy-makers to
pursue an independent monetary policy and
manage their exchange rate, all the while the
currency is freely convertible. One of these has
ultimately to give – either officials ignore
movements in the exchange rate, or stop setting
interest rates independently, or prevent capital
from rushing across the border. We will spare you
a repeat of that dreaded lecture; suffice it to note
that this classroom concept holds real-world
lessons for officials.
The point is this: with currencies convertible –
and virtually all are, over time, even if capital
controls exist, because of the numerous ways of
circumventing official rules – Asian officials will
abc
have to choose between setting interest rates
independently and letting the exchange rate go, or
managing the exchange rate and learning to live
with arbitrary monetary conditions. Historically,
Asian policy-makers have effectively chosen the
latter, living in the shadow of the Federal
Reserve and buying and selling dollars to manage
their competitiveness.
Supposedly, there is one short cut that officials
claim allows them to square the circle of the
1450 trilemma: sterilization. This involves buying and
selling local currencies to match FX intervention,
1400 insulating management of the monetary base (or,
effectively, monetary policy) from management
of the exchange rate. In reality, however, this type
1350
of short cut does not work terribly well, especially
1300 when the requirements of domestic monetary policy
begin to diverge drastically from those found
elsewhere. This underlines our earlier point that
monetary – though not financial – conditions are
nowadays a global phenomenon.
There are, in fact, three reasons why sterilization
does not work. First, maintaining interest rate
differentials between domestic and foreign
interest rates involves an indefinite commitment
to the absorption, or issuance, of local currency.
When central banks purchase dollars, which is the
more common case in Asia, they tend to issue
local securities, thus reabsorbing excess local
currency that was put in circulation via the
intervention in the FX market. The trouble is that
the stock of saleable securities that the central
bank holds in finite. Once these run out, officials
have to resort to other sterilization measures, such
as raising reserve requirements for the banking
system. But, progressively, these measures
become ever more distortive and hamper the
smooth functioning of the financial system.
The second problem with sterilization is more
technical. While in theory it is possible to exactly
offset the initial expansion of the monetary base
15
 Macro
Asian Economics
15 July 2009
with a subsequent contraction, in practice the
issue is not quite so straight-forward: the monetary
base itself needs to vary along with fluctuating
output, and it is difficult to determine what precise
expansion or contraction of the monetary base is
required irrespective of FX intervention.
The third problem is a little more subtle, but is the
most important and involves market psychology.
Liquidity, whether defined as broad money growth
or, more narrowly, as capital market depth, is
essentially “a state of mind”. Suppose that capital
rushes into a country because of brighter economic
prospects. The authorities intervene in the FX
market to hold the currency stable and succeed in
sterilizing the impact on the monetary base. But,
the rush of capital inflow most likely reflects a
vote of confidence of foreign investors in the
economy and thus boosts confidence that growth
will hold up. This, in turn, encourages the
expansion of broad money and deepens capital
markets: “liquidity” thus expands autonomously
despite the attempt by the central bank to run an
independent monetary policy.
Altogether, there is a temptation to resolve the
trilemma and use sterilization to preserve monetary
policy independence and control over the exchange
rate. But, over time, this policy is extremely
difficult to sustain. Moreover, it is bound to be
harder to sustain the greater the different
requirements for local monetary conditions across
the globe become: sterilization may be feasible if
there is little opportunity for return arbitrage, but
the more varied return prospects are between
individual economies, the more capital will rush
across borders and the harder it is to implement
sterilization policies successfully.
What Asia needs
In the current environment, global return prospects
are already starting to diverge considerably. This
will make it harder for local Asian officials to
insulate domestic monetary conditions from
16
abc
conditions elsewhere. Consider, for example,
equity flows. The chart below shows net equity
inflows into Asia on a monthly basis. Evidently,
the crisis led to a rush for the exits, with equity
portfolio capital leaving in a hurry. In recent
months, however, the tide has turned as Asia’s
economic prospects have brightened. In May, equity
inflows into Asia were the highest on record, while
April saw the third-highest net inflows on record.
3. Net equity flows into Asia ex Japan
10
5
0
$ bn
-5
-10
-15
Asia ex -Japan
-20
00 01 02 03 04 05 06 07 08 09
Source: Bloomberg, HSBC
Of course, this may all be a temporary snap-back
after a deep sell-off, and does not necessarily
herald a sustained inflow into Asian markets in
the coming months. Indeed, our strategists caution
that Asian financial markets may feel far from
bouncy in the near term. Still, from an economic
perspective, the potential for capital inflows raises
the risk of a self-sustaining process: if policy-
makers opt to blunt the effect of inflows on the
exchange rate by purchasing dollars, and fail to
sterilize fully the impact on the domestic money
supply, they’ll simply pour oil on the fire and
allow asset markets to swell, attracting further
inflows into Asia. And the story continues.
No, you can’t
Where does all this leave us in terms of Asian
monetary policy? As discussed, we fear that the
current framework is too centred on exchange rate
competitiveness and insufficiently focused on
risks of domestic asset bubbles. In the current
 Macro
Asian Economics abc
15 July 2009

environment, policy-makers will have to redirect in the face of asset bubbles in the future. For one,
their focus on domestic objectives to prevent the current cycle of asset reflation is needed to
bubbles from blowing ever larger. sustain growth, which arguably was not the case
previously, when booming exports held out the
Of course, at least notionally, officials across the
prospect of sustained growth. In addition, local
region have a more diverse set of targets than
monetary requirements are starting to diverge to
mere exchange rate competitiveness. On paper, a
the extreme from those needed elsewhere, and it is
number of central banks, including the authorities
difficult to see how the region could forcefully
in Korea, Thailand, the Philippines, and Malaysia,
tighten independently as the rest of the world
are inflation targeters. However, effectively, most
keeps monetary policy ultra-loose.
central banks tend to intervene in foreign
exchange markets as well, and not purely to What’ll happen
manage price pressures in the economy. This bias
In reality, of course, it is not quite as black and
has only been reinforced during the crisis, as
white as we have laid out in this text. At the
exports came under pressure, with the attendant
margin, policy-makers will try to contain the
risks for domestic economic and social stability.
bubble by rolling out various measures, including
Admittedly, there are already signs that Asian regulatory changes for banks, to take the froth out
officials are growing increasingly worried about of local asset markets. But there is a risk that this
the possibility of asset bubbles. The Bank of approach will prove insufficient over time to rein
Korea, for example, one the most hawkish central in the bubble, and we suspect that asset prices will
banks in the world when it comes to asset prices, therefore remain well supported for the coming
has already signalled its discomfort with excessive few years, especially with regard to property.
levels of local liquidity and the perk-up in local
Is this, then, an instance where you should place
property and stock prices. Meanwhile, the Chinese
all your hopes on flying asset prices? Not quite.
authorities are also signalling that asset prices
The path is strewn with risks, including that
movements are on their radar, and a gradual pick-
financial calamities in other parts of the world
up in money market rates at the time of writing
could snuff out risk appetite locally, too. Also,
was widely interpreted as an official warning shot
bubbles never expand smoothly. There are setbacks
for overly optimistic investors.
along the way that are well worth keeping in
In fact, both central banks have in the past shown mind. But the point is that we are entering a long
some tendency to target asset prices. The Bank of upcycle in Asia, underpinned by flush liquidity.
Korea, for example, hiked interest rates during the The most recent bubble, fortunately, will not be
last cycle more than the underlying inflation the last. Alas, neither was the recent bust.
outlook warranted, in part to take the steam out of
the local property rally. The authorities in China,
similarly, advised banks to curb lending last year
in order to cool down the economy and rein in a
fizzy real estate market.

Still, this should not be taken as a signal that

central bankers, whether in Korea, China, or
elsewhere, will adopt a sufficiently strong response

17
 Macro
Asian Economics abc
15 July 2009

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18
 Macro
Asian Economics abc
15 July 2009

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19
 abc

Global Economics Research Team

Global Emerging Europe, Middle East and Africa
Stephen King Juliet Sampson
Global Head of Economics +44 20 7991 5651 juliet.sampson@hsbcib.com
+44 20 7991 6700 stephen.king@hsbcib.com
Kubilay Ozturk
Stuart Green +44 20 7991 6045 kubilay.ozturk@hsbcib.com
+44 20 7991 6718 stuart1.green@hsbcib.com
Alexander Morozov
Europe +7 495 783 8855 alexander.morozov@hsbc.com

Janet Henry Murat Ulgen

Chief European Economist +90 21 2366 1625 muratulgen@hsbc.com.tr
+44 20 7991 6711 janet.henry@hsbcib.com Simon Williams
Astrid Schilo +971 4507 7614 simon.williams@hsbc.com
+44 20 7991 6708 astrid.schilo@hsbcib.com
Latin America
Germany
Jonathan Heath
Lothar Hessler
Chief Economist, Latin America
+49 21 1910 2906 lothar.hessler@hsbctrinkaus.de
+52 55 5721 2176 jonathan.heath@hsbc.com.mx
France
Argentina
Mathilde Lemoine
Javier Finkman
+33 1 4070 3266 mathilde.lemoine@hsbc.fr
Chief Economist, South America ex-Brazil
United Kingdom +54 11 4344 8144 javier.finkman@hsbc.com.ar
Karen Ward
Ramiro D Blazquez
+44 20 7991 3692 karen.ward@hsbcib.com
Senior Economist
North America +54 11 4348 5759 ramiro.blazquez@hsbc.com.ar

Ian Morris Brazil

+1 212 525 3115 ian.morris@us.hsbc.com Andre Loes
Chief Economist
Ryan Wang +55 11 3371 8184 andre.a.loes@hsbc.com.br
+1 212 525 3181 ryan.wang@us.hsbc.com
Tatiana G Gomes
Stewart Hall Senior Economist
+1 416 868 7523 stewart_hall@hsbc.ca +55 11 3371 8183 tatiana.g.gomes@hsbc.com.br
Global Emerging Markets Mexico
Sergio Martin
Philip Poole Chief Economist
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+44 20 7992 3680 wietse.nijenhuis@hsbcib.com Lorena Dominguez
Asia Pacific Economist
+52 55 5721 2172 lorena.dominguez@hsbc.com.mx
Qu Hongbin
+852 2822 2025 hongbinqu@hsbc.com.hk
Robert Prior-Wandesforde
+65 6239 0840 robert.prior-wandesforde@hsbc.com.sg
Frederic Neumann
+852 2822 4556 fredericneumann@hsbc.com.hk
Seiji Shiraishi
+81 3 5203 3802 seiji.shiraishi@hsbc.co.jp
Prakriti Sofat
+65 6230 2879 prakritisofat@hsbc.com.sg
Janus Chan
+852 2996 6975 januschan@hsbc.com.hk
Song Yi Kim
+852 2822 4870 songyikim@hsbc.com.hk
Christopher Wong
+852 2996 6917 christopherwong@hsbc.com.hk
Yukiko Tani
+81 3 5203 3827 yukiko.tani@hsbc.co.jp
Sophia Ma
Associate
Sun Junwei
Associate