The flip side: Being aware of what could go wrong in 2018 Voice of Asia, March 2018

Our outlook for the Asia Pacific region over the next year is positive. Asian countries and territories enjoyed a stronger-than-expected year of economic growth in 2017, and this is set to continue into 2018.

The first article in this edition of Voice of Asia, “Strength from within and demand from outside: Asia’s continuing growth opportunity,” outlines the supporting roles played by steady recovery in global demand and accommodative financial conditions in this positive story. But it is the heavy lifting by the Asia Pacific economies themselves that has positioned them to make the most of the upswing.

Many economies in the Asia Pacific region have embarked on journeys of domestic structural reform. In some of these economies the pain of adjustment has now faded, and they are well placed to reap the benefits.

So there are reasons to be positive about the outlook for 2018. However, it is important to also acknowledge the downside risks on the horizon. We believe these are the areas to look out for in 2018:

• A major vulnerability in growing private sector indebtedness, with:
  • Particular risk from highly leveraged household balance sheets in Australia and South Korea
  • Some potential fallout from Chinese corporate debt and shadow banking (a Minsky moment)¹
• The outside possibility of a major shock if geopolitical tensions intensify

In examining these, we are not predicting these risks as likely outcomes. In fact, we believe that the economies in Asia Pacific are better placed to deal with an external shock than in the past. But not all risks are external, and it will be important for authorities to manage these challenges carefully.

Growing private sector indebtedness

At the top of our list of the challenges facing the region is the build-up of debt from the post-2008 financial crisis period of excess global liquidity. The increase in government debt is attributed in part to the post-crisis economic downturn and the policy efforts by governments to support demand and stabilise financial markets (figure 2.1). In the ensuing decade, fiscal sustainability issues have received significant attention.

While achieving a sound fiscal position continues to be a priority for most governments, including Japan and Australia, we see the growing indebtedness of the non-financial private sector (the non-government sector excluding the financial sector) as a near-term source of vulnerability. Highly leveraged corporate and household balance sheets have left this sector vulnerable to shocks. How vulnerable the broader economies might be will depend on where the debt has accumulated as well as the strength of their financial systems.² In some instances, this debt has been channelled into housing markets, for example, in Australia, China, and Korea, raising concerns of asset price bubbles. We take a closer look at some of these below.

In the near term, the catalyst which tests these vulnerabilities may be related to intensifying geopolitical tensions, including greater levels of protectionism. While there is no cause to believe that tensions will suddenly escalate, the nature of these risks is that they can be unpredictable.

Amid easy financing conditions following the 2008 financial crisis, a number of the large Asia Pacific economies have seen a large increase in debt use by both households (figure 2.2) and non-financial corporations (figure 2.3).

The increase in household debt has been particularly prominent in Australia, China, and South Korea. Debt accumulation on its own is not necessarily a problem. The level of indebtedness matters, but it is not all that matters. It is important to understand what the debt is used for. For example, whether or not the funds are used productively and help generate future income streams. Generally, the increase in leverage has helped support aggregate demand following the downturn after the 2008 financial crisis.

Nonetheless, higher debt levels increase borrowers’ sensitivity to interest rates. While interest rates are low at present, as they gradually normalise, borrowers will face greater debt servicing pressure. Debt servicing problems can lead to greater credit risk in the financial system, which in turn could have implications for the real economy. The debt service ratio (DSR) for the private non-financial sector in China nearly doubled immediately prior to the 2008 financial crisis (figure 2.4). The DSR in Australia and Korea has increased since the early 2000s, but remained broadly unchanged over the past decade despite debt use increasing significantly over this period.

Highly leveraged household balance sheets in Australia and South Korea

The recent increase in household debt is generally associated with historically low borrowing costs, contributing to demand for housing. The latter has coincided with the return of households’ risk appetite. Greater demand for housing contributes to higher house prices, leading to more collateral being available to property owners for additional borrowing. The concern is that these purchases are driving ”irrational exuberance,” and are creating asset price bubbles, thereby putting highly exposed household balance sheets at risk of a sudden price drop. If household balance sheets are funded by banks, a sharp price correction can lead to serious consequences for the banking system and for the real economy.

Along these lines, housing markets in Australia and China have experienced significant price growth (figure 2.5). However, the risk of a sharp price correction in these markets depends on whether the fundamentals of supply and demand are supportive of the market.

In Australia, house prices have risen for the past four years, mainly driven by strong demand and supported by population growth as well as domestic and overseas investment. At the same time, in key markets such as Sydney, supply has not kept up. In addition, lending standards have been strong and the prudential regulator continues to keep an eye on risks and has sought to manage them using its macro-prudential toolkit. The sector is well capitalised and loan quality is sound (figures 2.6 and 2.7).

While Australian banks are highly exposed to residential mortgages, the major banks’ stress tests demonstrate that they are resilient to significant shocks. On balance, while prices in Sydney, and to a lesser degree Melbourne, have eased a little in recent months, we don’t believe that a sharp price correction is likely in the near term, although highly leveraged household balance sheets remain a source of concern.

Housing price rises in South Korea tend to be limited to certain areas in big cities. For example, the average apartment price in Seoul has risen more than 20 percent over the past four years.³ South Korea’s household DSR ranks as one of the highest among G20 advanced countries.⁴ On the other hand, household balance sheets appear relatively sound.

At the same time, the South Korean government has now become serious about stabilising the city’s property markets by introducing tighter mortgage requirements and raising capital gains taxes. Authorities will also need to manage the implications of the large flows of household credit extended via less stringently regulated non-bank financial institutions—which has outpaced household loans made by the banking sector since 2011.⁵ In the past four years, total loans by non-bank financial institutions have grown at one and a half to two times the rate of household loans extended by the banks (figures 2.8 and 2.9).⁶

Chinese corporate debt and shadow banking

The rise in corporate debt has been driven by easy credit. Lower interest rates and low market volatility have allowed companies to borrow more affordably. Expansionary monetary policy following the 2008 financial crisis have sought to encourage greater investment by businesses. The rapid increase in debt levels of non-financial corporations in China has largely been driven by the state-owned enterprises (SOEs) (figure 10).

The characteristics of the rapid accumulation of debt are a cause for concern. The increased use of short-term wholesale funding, the significant role played by shadow banks, as well as small and medium-sized banks, in extending credit, have, according to the IMF, “increased the opacity of intermediation, increased the use of unstable short-term funding, and raised sensitivity to liquidity stress.” (Figure 2.11).⁷

Zhou Xiaochuan, governor of the People’s Bank of China, recently warned of a possible Minsky moment facing China. He stated that “if we are too optimistic when things go smoothly, tensions build up, which could lead to a sharp correction, what we call a ‘Minsky moment’. That’s what we should particularly defend against.”⁸

However, the situation in China today does appear to be quite different to that of Japan in the early 1990s—the time of the last classic Minsky moment in a major economy in the region—when the real estate and stock market bubbles burst. While there are concerns about house price inflation in major cities (figure 2.5) and debt levels, with the debt servicing burden raising rapidly (figure 2.4), Chinese authorities are very aware of the financial system risks and have been working to implement measures to reduce the current imbalances. At the same time, the government has large fiscal buffers, economic growth is solid, and the banking sector asset quality appears relatively sound (figures 2.6 and 2.7).

While Chinese authorities should remain cautious, there are no signs of a major correction in 2018. The successful mitigation of financial stability risks by Chinese authorities will mean managing the impact of tightening credit conditions becoming an excessive drag on economic activity. Deleveraging of the SOEs is an opportunity to clean up some of the underperforming enterprises that are weighing on competitiveness in the long term. At the same time, meaningful reforms to continue financial sector liberalisation and broaden the sources of growth in the economy will be important to longer-term sustainability.

Geopolitical tensions intensifying

The spread of global protectionist sentiment is a concern for the Asia Pacific economies. The United States has announced its intention to review all legacy free trade mechanisms through the lens of its “America First” trade policy. The US Trade Representative’s ongoing investigation of China’s intellectual property rights and technology transfer rules is another shot across the bow of the Sino-US trade relationship. While actual US movement to address its bilateral trade imbalances was rather limited in 2017, this is likely to intensify in 2018 before the midterm elections in November. On the other hand, it is difficult to see trading partners coming to the table, given the US administration’s unrealistic trade negotiation mandate. The intention is to eliminate the country’s bilateral trade deficits (which are simply a product of broader macroeconomic conditions and influences).

Nonetheless, the impact of the United States erecting trade barriers would be strongly felt, not only by countries and territories with huge bilateral trade surpluses with the United States (including China, Japan, and Korea), but also by Malaysia, Thailand, and Vietnam, where high manufacturing export levels to the United States are a large share of GDP. Reversing the decades of progress on trade liberalisation will be detrimental to both the United States and its trading partners, particularly if it leads to retaliatory measures.

While the October 2017 currency report of the US Treasury did not label China a currency manipulator, it kept China on a currency “monitoring list.” The risk of tensions in the Sino-US relationship escalating from rhetoric into counterproductive policy measures remains a concern. The implications of a currency war would be devastating for the ongoing global recovery. But further US aggravation of this issue may be unlikely in the near term. The US administration is looking to Beijing to align with their tough stance on North Korea, which could moderate their willingness to further put the Chinese government off side.

More broadly, rising military tensions over North Korea could be the trigger of world risk-averse sentiment and form the basis of the reversal of capital flows. Military engagement would entail huge human and physical damage to countries directly involved, potentially including not only South Korea, but also Japan and China. Now that the international and Chinese economic sanctions against North Korea have been further strengthened, chances of a breakthrough in the standoff may be receding.

An escalation of tensions could rock business and consumer confidence and be a source of economic instability. Indeed, given the high levels of debt in key parts of the Asian economies as outlined above, such an escalation could prove to be the catalyst for a sharp correction in investors’ willingness to support further growth and hit financial markets in the region. However, the various forces currently appear to be in balance, albeit a delicate one.