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Economic Research: Asia-Pacific Recession Guaranteed


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Economic Research: Asia-Pacific Recession Guaranteed

A recession across Asia-Pacific is now guaranteed due to a deep first-quarter shock in China and the shutdown of activities across G7 economies. S&P Global Ratings believe this, together with a loss of household and business confidence in these economies, will translate into severe and more persistent supply and demand shocks across the region. Unemployment rates will rise.

The global policy response, including the Federal Reserve's policy-rate cut to zero and the Bank of Japan's scaled-up asset purchases, will help cushion but not quickly reverse, these shocks. Local measures aiming to support vulnerable sectors and workers, such as a payroll tax cut in China, may help but their effect will wane the longer the crisis lasts.

Domestic demand will be hit almost everywhere by restrictions on movement and risk aversion. External spillovers will be felt through four channels:

• People flows--travel, tourism, and education

• Trade--demand for the region's exports

• Supply chains--disruptions to production

• Commodity prices

The amplifier, which has taken an outsized role, is tightening financial conditions. This could tip an economic recession into a regional financial crisis.

We lower our forecasts for China, India, and Japan for 2020 to 2.9%, 5.2% and -1.2% (from 4.8%, 5.7%, and -0.4% previously). Our U.S. colleagues have revised their 2020 forecast to a range of 0% to -0.5%. We will flesh out forecasts for the region soon but we should expect downward revisions of about 0.5-1.0 percentage point across the board.

Our estimate of permanent income losses is likely to at least double to about $400 billion. For credit markets, a key question is how these losses are distributed across sovereigns, firms, banks, and households.

The scars that will be left by these shocks on balance sheets and in labor markets threaten a more drawn out U-shaped recovery. The timing of a recovery depends, most of all, on progress in containing viral spread. Even if major progress is made during the second quarter, after a sustained period of stressed cash flow many firms will be in no position to resume investing quickly. Households that have either lost their jobs or have worked fewer hours will spend less. Banks will be managing the deterioration in asset quality. There will be pent-up demand but the longer the crisis drags on, the weaker it will be.

Risks are still on the downside. Aside from failure of virus containment, the key risk is that tighter financial conditions trigger destabilization in more vulnerable pockets of the region's financial system. Emerging markets, for now, remain most vulnerable to these skew risks.

China's Enormous First-Quarter Hit

China is recovering gradually from an economic blow that was much harder than most expected. February data confirm a huge shock to activity in the first quarter. Investment accounts for about 45% of China's economy--and fixed asset investment in January and February combined plunged by almost 25% compared with a year ago. Over the same period, industrial production and retail sales fell by 14% and 21%. These are unprecedented numbers. This not only confirms a hard hit to growth but indicates that the authorities are not smoothing the data.

For 2020 as a whole, we now forecast 2.9% growth from 4.8% previously. We now expect China's economy to shrink by 10% during the first quarter over the same period a year ago. Our forecast assumes that year-on-year growth rates turn positive in the third quarter at about 8% and peak well into double-digits in the first quarter of 2021. In turn, we forecast growth in 2021 at 8.6%.

Our forecast assumes progress in containing the virus and a gradual normalization. However, external headwinds from the U.S. and Europe will impede manufacturing and trade. In response, policymakers may launch more domestic stimulus with the aim of restoring some sense of normalcy to labor markets. While infrastructure investment is an option, this will not help the labor market that much. The service sector now accounts for almost half of all employment. More important, services is the engine of job creation, accounting for all of the jobs growth in China over the last decade. Support for small and midsize firms and the service sector, which could absorb excess labor from manufacturing, may be more effective.

As activity picks up, Chinese demand for imports from Asia-Pacific should begin to recover slowly. This will help to partially offset the shock from the U.S. and Europe. A big-bang stimulus from China, especially if it is targeted at the housing market, would change this cautious view. While we still expect only moderate easing, the risk of a larger policy impulse is rising.

Decimated People Flows Mean Job Losses

The new dimension to the shock hitting Asia-Pacific is external to the region. People flows from the U.S. and Europe will be decimated for at least two quarters, heaping more pressure on the tourism industry. At this point, the entire year looks set to be a write-off for airlines, hotels, and the many small businesses in Asia-Pacific that cater to tourists. Even though reported COVID-19 cases in China look to have peaked, the country will prioritize getting back to work rather than taking a vacation. American and European tourists are no longer in a position to fill the hole. Even domestic tourists in many economies are set to stay indoors.

This implies a huge economic hit. Consider Thailand, where tourism accounts for 11% of GDP (the value-added part may be a little less). In February, foreign arrivals in Thailand fell 44% compared with a year earlier, with arrivals from China plummeting by more than 85%. A second shockwave from the U.S. and Europe will now knock arrivals over the coming months. Assuming a 20% decline in tourism arrivals for the full year, this alone would shave over 2% off the level of GDP, pushing Thailand into its deepest recession since the Asian financial crisis in 1997-1998.

The longer that people flows dwindle, the harder it becomes for firms to avoid shedding jobs. Airlines are furloughing staff. Other firms are likely to follow, helped by employment models in service sector industries that rely on easy-to-fire part-time and casual workers. We estimate that, on average across Asia-Pacific, accommodation and catering accounts for about 7% of total employment. Other services account for another 53%.

Labor Markets Already Weaker Than They Looked

Australia is an example of an economy vulnerable to labor market shocks. While the headline unemployment rate is low, the underemployment rate--that is the proportion of workers that have a job but would like to work longer hours--has remained stubbornly high at over 8%. The underemployment problem is likely more acute in the accommodation and catering sectors, which account for over 7% of total employment. Of these jobs, over 60% are part time. While this give employers flexibility in reducing hours, the impact on workers can be brutally swift. In turn, this will hit consumer confidence and household income and spending.

Japan is another example where the labor market is less than meets the eye. Over the last decade, about 5.5 million new jobs has been created, helping to push the unemployment rate very low. However, almost two-thirds of these jobs are temporary and the majority of those are part time with fewer protections. During a service sector downturn, these are jobs where it is easy for firms to scale back hours or let people go. Again, while helpful for firms it will have an immediate effect on household incomes and confidence, already shaken by the spread of the virus.

A Final Demand Shockwave From The U.S. And Europe

Asia's export engine will stall. Few economies in our region will be spared by weaker demand in the U.S. and Europe. The best way to assess how big this could be is by looking at the contribution of Asia-Pacific economies to total final demand. This is often called value-added exports and includes services such as tourism. While these comprehensive data are lagging--we only have the 2015 results--they tend to be sticky over time and likely provide a fair reflection of current exposures. Exposures may be somewhat smaller now, reflecting the rising importance of demand from China--but still in the ballpark.

Unsurprisingly, the trade-oriented economies of Singapore, Thailand, Vietnam, Malaysia, and Korea are most exposed. In all of these cases, the value-added contribution to final demand in the U.S. and Europe is either close to or well into double digits.

Share of Economy Exposed To Final Demand In The U.S. and Europe
(% of GDP)
U.S. E.U. Total
Singapore 10.3 7 17.3
Vietnam 5.7 9.5 15.2
Thailand 4.9 6.1 11.1
Malaysia 4.4 5.5 9.9
Korea 3 5.1 8.2
Hong Kong 4.3 3 7.3
Philippines 2.6 4.7 7.3
India 2.8 4.2 6.9
China 2.6 3.9 6.5
New Zealand 2.5 3.1 5.5
Japan 1.7 3.2 4.9
Indonesia 1.8 2.4 4.2
Australia 1.4 1.7 3.1
Note: Data for 2015. Source: OECD and S&P Global Economics.

Again, a thought experiment helps conceptualize the problem. If final demand in the U.S. and Europe, which usually grows at about 1.5%-2%, shrinks by the same amount for the full year, the effect on demand for Asia-Pacific exports is likely to be larger (trade is more volatile than GDP). Assuming that final demand falls instead of growing by 2% (a 4ppt shock) and trade exhibits an elasticity to demand of 1.5x, the direct hit to the level of GDP could be as large as 1% in Singapore and Vietnam. These are economies where growth had already been marked down due to the China shock.

For most of the region, physical goods trade, especially in intermediate goods, remains most important. The charts below shows gross exports (not value added) of selected Asia-Pacific economies to the U.S., Europe, and China as a share of GDP in 2018. This does not look through the supply chain, so it likely under-represents the real exposure to the U.S. and Europe. Still, what it does show is the large proportion of intermediate goods in trade. Only Japan ships a large share of consumer and capital goods to these economies.

Lower Oil Prices Are A Double-Edged Sword

Lower oil prices are typically a boon to Asia-Pacific's many net importers; however, this time their impact on credit markets might be the more important channel. Over time, as credit markets have become more integrated, the relationship between high-yield credit spreads in Asia-Pacific and comparable benchmarks in the U.S. has increased. S&P Global Ratings, even before the global spread of the coronavirus, has expected the energy and natural resources sector, along with consumer services, to account for the majority of speculative-grade defaults in 2020 (see "The U.S. Speculative-Grade Corporate Default Rate Is Likely To Reach 3.5% By December 2020," published on RatingsDirect on Feb. 21, 2020). As default pressures ramp up from lower oil prices, U.S. spreads could widen further.

In turn, this could trigger a further widening of spreads and less access to external financing across our region. We should not discount the economic benefits of lower oil prices with a net oil deficit of about 2.5% on average across Asia-Pacific. The windfall gains from lower oil prices will be distributed among sovereigns, households, and firms, depending on energy price and subsidy policies. But it is too simplistic to think that a sharp fall in oil prices is unambiguous good news when investor risk aversion is already rising.

The U.S. Dollar Remains Key For Financial Conditions

Equity, credit markets, and exchange rates are likely to overshoot in response to high uncertainty. Asset prices will suffer, naturally as the effects of an economic sudden-stop are priced in. Still, risk aversion may add to the selling pressure as investors require a substantially higher risk premium to hold exposed assets when quantifying future risks is hard.

Risk premiums are now moving rapidly toward stress levels. Implied currency volatility in some of Asia's emerging markets (EMs) have exceeded trade-war peaks and are approaching levels last seen during the Eurozone sovereign debt crisis in 2011. Credit spreads have gapped wider (in part due to thin liquidity) and for speculative grade in Asia have almost doubled.

If lingering uncertainty results in a strong preference for U.S. dollars, policymakers in Asia's EMs may be forced into a damaging round of pro-cyclical policy tightening. We have touched on this before (see "COVID-19 Now Threatens More Damage To Asia-Pacific," March 6, 2020) but the basic story is that markets' preference for dollars and the requirement for a very high risk premium to hold local-currency assets may force these economies to run higher current account balances--that is, a narrower deficit or a higher surplus.

This could be solved by letting the currency weaken. However, if policymakers worry about the effects of very large currency declines, an external adjustment may require higher domestic interest rates and domestic demand compression. In turn, downward pressures on growth could intensify until markets find a level at which funding can resume. Vulnerable economies remain India, Indonesia, and the Philippines.

The Virus Remains The Wildcard

We have focused on economics here but of course the key uncertainty remains virus transmission. Our baseline global scenario, founded on expert scientific opinion and subject to high uncertainty, was that the world would come to grips with the coronavirus at some point during the second quarter of 2020. We will review that baseline before fleshing out a new round of forecasts.

Viral spread is particularly problematic in Asia's emerging markets where healthcare infrastructure is weak. Restrictions are now being imposed in some of these countries--for example, the lockdown of Metro Manila in the Philippines--reflecting that risks have increased. As household and business confidence in these economies erodes, we will start to see domestic demand suffer.


Related Research

  • COVID-19 Now Threatens More Damage To Asia-Pacific, March 6, 2020
  • The U.S. Speculative-Grade Corporate Default Rate Is Likely To Reach 3.5% By December 2020, Feb. 21, 2020

This report does not constitute a rating action.

Asia-Pacific Chief Economist:Shaun Roache, Singapore (65) 6597-6137;
Asia-Pacific Economist:Vishrut Rana, Singapore (65) 6216-1008;

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