Despite the increasing momentum of the global recovery, financial stability risks are growing as equity markets decouple from broader economic prospects. Phyllis Papadavid, Head of Research and Advisory at Asia House, assesses the risk of market corrections for Asia’s COVID recovery.
– The risk of multiple market corrections, typically a decline of more than 10 per cent, is growing. A resurgence in COVID19, trade tensions and the global semiconductor shortage have been key catalysts.
– Economically, emerging markets look vulnerable with risks stemming from slower private consumption, weaker trade momentum and lower inward investment as home bias could rise.
– In Asia, rapid household debt growth has typically been followed by sharp market corrections in the past; this makes financial market developments key for regional economic recovery.
Global equity markets are now largely considered to have decoupled from broader economic prospects in a number of economies. A resurgence in COVID19 cases, increased trade tensions and developments such as the global semiconductor shortage, have been dominant catalysts. Asian equity markets tend to be disproportionately affected by the latter two in particular, with US-China trade tensions having a sizeable impact on the region’s equity markets, as well as the IT sector.
This raises financial stability risks at a time when the global recovery is showing momentum. Economies that have either struggled to contain the pandemic or are particularly exposed to its economic impact look to be at risk. Thailand, with its large tourism sector, or India and the Philippines, struggling to contain the latest COVID19 waves, are illustrative of this. Some of the associated financial and economic risks are beginning to build with equity and currency markets showing more pronounced deterioration.
The risk of multiple market corrections, typically a decline of more than 10 per cent, is growing. As an illustration, India’s Sensex, the Shanghai Composite Index and Taiwan’s TAIEX index are up by a respective 50 per cent, 22 per cent and 66 per cent relative to a year ago – with China and India’s markets down six per cent since around mid-February. The Shanghai Shenzhen CSI 300 index is already in correction territory given its 12 per cent decline since February. A sharper market correction could exacerbate economic losses.
Economically, emerging markets look vulnerable. The average annual loss in per capita GDP over from 2020 to 2024, relative to pre-pandemic forecasts, is projected to be 5.7 per cent in low-income countries, 4.7 per cent in emerging markets, with a comparatively lower loss of 2.3 per cent in advanced economies. The magnitude of any further correction depends in part on its catalyst. For example, higher interest rates might not be as negative a shock if they reflect higher growth expectations. And yet, in a scenario of a more pronounced financial market decline, these could be key pathways to consider for Asia:
Slower private sector growth and consumption
Equity market wealth effects on consumption could be significant. This impact could also be mediated through the interest rate channel; higher rates at a time of slower employment growth amid COVID19 could exacerbate challenging household debt dynamics in Asia, which are particularly notable in South Korea and China. A loss of purchasing power is important at a time when inequality within countries is high, and is in part, fuelling trade tensions with partner economies. In the past, a 10 per cent increase in stock markets has typically led to an increase in private consumption of between 0.29 per cent to 0.35 per cent. However, the impact is asymmetric in that a negative shock would have an even larger downside impact on consumption than a positive one.
A loss of purchasing power and in trade momentum
Intermittent and more recent exchange rate depreciations have been evident in countries where there is a growth deterioration. The sharp depreciation of the Indian Rupee has been of note. Exchange rate depreciations are frequently welcomed – or even prompted – by policymakers in the expectation of gaining export competitiveness. And yet, for smaller open economies, the more likely outcome is a loss of import purchasing power. Furthermore, the price of imported goods remains significantly more volatile compared to consumer goods. Currency depreciations also sometimes lead to stagflation – both high inflation and low growth. Given this, measures of inflation expectations will be important to watch. This risk is concerning given reports that the pandemic has also significantly increased inequality in the region.
Weaker inward investment
If a financial market correction occurs alongside a protracted increase in risk aversion, this could lead to a more permanent retraction in investment flows into the region’s economies in favour of safe-haven assets and investments (such as the US dollar). This is because, typically, home bias in making investments dominates during times of uncertainty. And this could extend beyond portfolio investment flows in bonds and equity markets, into long-term real investments through foreign direct investment (FDI). We have already seen a decline in FDI owing to COVID19 and this could lead to a further retraction. South East Asia’s largest recipients of FDI (Singapore, Indonesia and Vietnam) have all seen sizeable annual declines of 28 per cent, 24 per cent and 16 per cent respectively.
It could be that the global economic recovery accelerates, driven by unprecedented policy responses and vaccination programmes. Any financial market weakness would be limited to specific regions and markets. However, the 2021 global upturn is likely to be a multi-speed recovery. A sharper financial market correction is significant to watch for given that its associated economic pathways tend to be more powerful in emerging economies where there is higher financial vulnerability – such as high indebtedness and low foreign exchange reserves. Quick policy reaction functions are important at a time when multiple economies are already contending with multiple economic and financial shocks stemming from the COVID19 pandemic. Where over-indebtedness does exist, it is important to have efficient and low-cost resolution strategies that restructure and reignite productive activity. In Asia, periods of rapid household debt growth have been followed by sharp market corrections, such as in South Korea, Taiwan, and Thailand. This makes financial market developments particularly important for the region’s recovery.
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Disclaimer: All the information in this note is correct, to our knowledge, at the time of writing. Asia House notes are for information purposes only and do not constitute a recommendation.