How will Asia stay resilient amid the devastating market turmoil?

It remains too premature to conclude that the next move in policy rates for Non-Japan Asia (NJA) is down. Naturally, amid the market turmoil – and the risk this poses to real economic activity – Asian central bankers will stay prudent. However for most economies in the region we believe this will at most result in a temporary pause in the policy cycle, which should be emphasized remains in 'normalization' rather than 'tightening' mode.

As our US economists note, although they do not believe that renewed recession is the most likely outcome, the odds of a double-dip in the US have increased "given the risk of negative psychology feeding on itself, and with the economy already looking more fragile." How Asia might fare in this worst-case scenario of a double-dip will drive the monetary policy path in the coming days/weeks/months. Our prognosis is not as dire as equity market movements over the past two sessions suggest.

For a start, since the Lehman crisis the region has made some genuine headway in leaning more on domestic rather than external demand to drive growth. In 2008 even as the daisy-chain slide in global external demand hit, domestic demand offered a significant buffer. There was an inevitable squeeze in domestic demand the following year as real investment suffered, but by 2010 domestic demand had rebounded strongly again.

Much of this owed to the massive monetary and fiscal response from regional policymakers, but as the region recovered, upward pressures on employment and wages also started to form, in turn resulting in record-high levels of consumer confidence in many parts of the region.

Drilling a little deeper, it is also worth nothing that, where exports have driven the NJA recovery, the demand has not come so much from the US or even G3 economies, but from within the region itself. Since the Jan09 trough in regional exports, shipments to China have surged 250% to-date; by contrast shipments to the EU and the US are up by around 50%.

These numbers should not surprise. The slow but steady structural shift with respect to exports over the past decade must by now be familiar to readers – today NJA buys nearly 54% of its own exports, up 10%-pts from 2003.

Chinese demand explains some of this rise – China currently buys 19% of NJA exports, more than double the share in 2000. The US' share of exports, by contrast, has gone from nearly 23% in 2000 to around 12% in 2010 (Figure 3).

Of course then the next question to ask is how China might hold up in all of this. If the 9.5%yoy expansion in Q2 GDP did not put your fears to rest (an above-trend 1.7%qoq sa, according to quick calculations), then it is perhaps worth noting the disproportionately large downward fixing in USD/CNY the PBOC delivered at the open relative to the EUR/USD rally – down 146pips to an all-time low of 6.4305.

Arguably this may have been a signal to the US that its pace of dollar accumulation (which occurs whenever they intervene to weaken the CNY) need not carry on as rapidly as before, particularly now that its debt has become dis-pleasurably of a lower rating.

Regardless of the true motive, allowing significant currency appreciation at such a tumultuous juncture says something about the level of confidence Chinese authorities have over the outlook.

Last but not least there are three other positives to consider when assessing how resilient NJA might be through a double-dip scenario:

1. the fact that monetary conditions in some countries remain accommodative, with rate hikes since Lehman nowhere nearly matching the cuts made in response and/or currency appreciation having largely taken place against the USD rather than on a real trade-weighted basis;
2. the fact that fiscal policy in the region today remains significantly more accommodative than pre-Lehman, and
3. that oil prices have slid about 11% in recent days (Brent), and are almost 30% lower than the peak seen pre-Lehman. With regards to (1), key economies like Indonesia and Korea come to mind (they have hiked only 25bps and 50bps respectively over the recovery).

Meanwhile we will continue to see budget deficits generally in excess of 3% of GDP over this year and the next, from sub-3% in 2007 for most governments in the region fiscal consolidation has not been high on the agenda since Lehman.

The implications of (3) are clear – budget deficits, corporate margins and trade balances will all stand to benefit from declining oil prices, with the region (except for Malaysia) being a net oil importer.