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Euro Zone Woes Cannot Sink Asia: Expert

The recent weakness in asset markets in Asia shows that investors now believe Europe’s woes will put the region at risk. But whether this fear is justified depends on two possible scenarios – a breakup of the euro zone or a European recession.

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Those who believe in the first scenario have reason to be worried. A euro zone breakup involving any of the major economies would have an impact worse than the one seen after the Lehman collapse. We would see a domino effect on sovereign debt defaults and foreign exchange markets would be plunged into chaos by the sudden disappearanceof the world’s second most important reserve currency.

But how likely is this scenario? Very unlikely. Recent moves towards establishing a stronger fiscal union in Europe, unprecedented and massive provisioning of liquidity through both the European Central Bank (ECB) and national central banks, the massive additional balance sheet capacity of the ECB, fiscal and structural reforms in Italy, and the prohibitive costs of an exit from the euro for any major member of the European Monetary Union, including Germany, should ensure that the first scenario does not materialize.

However, the second scenario of a painful deleveraging in many European banks and anemically weak European growth is possible. This outcome would be bad for Europe, but not bad enough to undermine the outlook for stronger parts of the global economy, especially emerging Asia.

Here’s why. Europe was not the main engine of the global economy to start off with, and it remains a relatively closed economy. A European recession, especially if deeper and more protracted, would dampen world trade, including Asian exports, but nothing on the scale seen in 2008.

But trade only provides part of the linkage. The more important linkages come via the capital markets. The European Banking Authority’s requirement for banks to reach a tier 1 capital ratio of 9 percent by June of this year will require broad based deleveraging. As raising fresh capital is extremely difficult, one other avenue could be to shed assets, including assets abroad. Asia and other emerging markets, however, should not suffer unduly.

Banks Can’t Afford to Exit Asia

Most foreign banks are present in Asia via wholly owned subsidiaries, which cannot simply take capital back to their parent companies. Many of these subsidiaries are some of the most profitable parts of their businesses, and growing profits provides one important way to recapitalize.

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Shutting down all business lines in emerging markets would leave these banks without this important source of profits and force an even greater reliance on a weak domestic banking market in Europe.

Furthermore, a plan to temporarily exit and re-enter may not be possible, as a foreign company that leaves town during hard times would not be quickly welcomed or permitted back.

Indeed, even at the height of the post-Lehman financial crisis Asia did not see a wholesale pulling out of assets. But this deleveraging by many European banks is only part of the capital flow story.

Fund Flow to Asia Will Continue

Meanwhile, the ECB has launched its version of quantitative easing, which now augments the extraordinarily loose monetary policy of the U.S., Japan and U.K. We now see the most aggressive printing of money in modern times. While this aims to address domestic conditions, capital cannot be contained within national borders. Abundant global liquidity will continue to flow into Asian markets blessed with strong macro fundamentals—particularly as the region’s currencies still appear largely undervalued.

Short-term volatility excluded, monetary policy in these four major economies will ultimately facilitate net capital inflows into Asia and many other asset markets and thus avoid the risk of a recession-induced credit crunch in Asia.

Also, strong economic and political fundamentals support Asia. Unlike Europe or the U.S., Asia has built up plenty of room to provide fiscal stimulus and to lower interest rates in response to a worsening external environment. For example, the South Korean government’s debt levels have been slashed over the last decade and international reserves now well exceed levels seen before the global financial crisis.

And the largest countries like China, India and Indonesia can count on a robust and resilient domestic demand to counter external demand weakness.

A euro zone disintegration would be as calamitous as it is unlikely. On the other hand, the far more probable scenario of painful deleveraging by European banks and weak European growth, while a serious setback for Europe, will likely have far more modest and manageable global spillovers.

The world economy is used to powering ahead without much help from European demand. It will do so this time as well. And Asian markets, with their strong market fundamentals and unparalleled future growth prospects, will continue to lead the charge.

Dr Michael Hasenstab is Portfolio Manager and Co-Director of the International Bond Department for Franklin Templeton Fixed Income Group.