With news souring in the G-3, it is becoming increasingly questionable whether improving liquidity conditions are sufficient to place a solid floor under asset prices until an improvement in fundamentals begins to take shape. Over the next six months, cracks could appear in the floor.

Until recently, many global strategists were recommending overweight positions in emerging markets assets. The formula, the argument goes, is as follows: G-3 yield curves steepen as monetary policy eases and global monetary easing becomes fully coordinated when the ECB cuts rates in April on account of more signs of weakness in Europe. These easings, in turn, signal a bottom in OECD coincident and leading indicators. The strategy call would be: buy emerging markets assets and ride the wave to stardom and high-octane investment performance. Liquidity stories, however, usually work well when the earnings and profits cycles are bottoming. But the reality is that both cycles are turning down across Asia and will likely continue to do so at least in the next three months. At the same time, we are perhaps as much as nine months away from a bottom in the economic cycle. Thus, the liquidity story can be read as a short-term tactical trading story that can be overwhelmed at any time by news of deteriorating fundamentals.

What is behind this liquidity argument? If there is growth in financial system liquidity, which is defined as a measure of transactions demand for money, in excess of nominal GDP growth, then this excess money has to go somewhere; that is, deposits, fixed income instruments or equities. But where does the liquidity come from? In the case of Asia, where exports of goods and services comprise 50% of GDP, a virtuous liquidity cycle has almost always been sparked by an upturn in exports. Businesses tied to the export sector experience a surge in earnings and profits and this impacts positively on the financial sector. Banks and corporates are flush with cash. The central bank buys foreign exchange and sells local currency to the banks, adding liquidity to the system. Foreign exchange rates remain stable, interest rates fall and credit expansion greases the wheels of commerce and a surge in economic activity.

The sharp rise in Asian exports that began in late 1998 and ran through most of 1999 had, in retrospect, the makings of a genuine liquidity-driven rally. To be sure, such a confluence of simultaneous forces generated so much liquidity that asset prices rallied and FX reserves rose sharply during Asia's post-crisis healing period. Moreover, the export cycle and capital flows generally moved together rather than apart during this cycle. In fact, Asian central banks had to undertake massive sterilization programs to prevent overheating.

So what is different about present liquidity conditions? Let's start with the monetary forces at play. Fed rate cuts have and will continue to increase the dollar supply in international financial markets. The Bank of Japan will follow suit, while the ECB is likely to ease before mid- year. Fed easing has provided Asian central banks with room to ease as well, evidenced by the recent rate cuts seen in South Korea, Taiwan and the Philippines. But what is different this time is that demand from the G-3 countries for Asian exports will not only be absent, but is likely to contract. Thus, the increase in global liquidity could find its way into Asian asset markets, in short sporadic episodes. But these are unlikely to remain enduring in nature until the export cycle picks up. In essence, foreigners drove Asia's January rally, but these inflows have since reversed. Thus, there is yet another critical difference between now and 1999. This time, the liquidity is not coming through the balance-of-payments channel (i.e., a pick up in exports and capital inflows). Rather, domestic liquidity has been accumulating through two main channels. First, banks' loan-to-deposit ratios continue to fall across Asia in the absence of credit demand and meaningful bank restructuring. Second, countries such as Taiwan have begun to return the liquidity sterilized in the healing period back into the banking systems. Indeed, the potential pool of liquidity for Asia through this route, absent credit demand and given flush liquidity conditions, Asia appears to be caught in a classic liquidity trap for now. Under such conditions, a liquidity rally can occur without the fundamental leg in place, but only for a brief period. Ultimately, the credit multiplier determines the extent of liquidity creation and it is heavily influenced by economic fundamentals. The additional liquidity being provided by Asian policy makers is winding up in risk-averse assets such as dollar-denominated sovereign bonds (where buyers have been predominantly Asian banks and insurance companies). Lending activity of financial institutions in the crisis countries of Asia remains impaired by the backlog of unrestructured or uneconomically restructured loans. The makings of a liquidity-driven rally thus appear extremely tenuous for now.

So how far off is an uptick in fundamentals? GDP forecasts for 2001 have progressively been lowered. US, Euroland and Japan economic growth forecasts have been cut at least once already this year. World growth will slow to 2.4% from 4.1% in 2000. Risks continue to be on the downside. With respect to the US outlook, GDP growth forecast for 2001 has been lowered to 2.1%. The main reason for the downgrade is that capital spending, and in particular tech-related capital spending (3% in 2001 vs. 25% in 2000), will likely be softer than originally assumed. With profits being slashed, capex could slump badly this year. A drop in employment will likely dampen any hopes of a recovery in consumer demand until late 2001. As a result, the US Fed will cut rates to 4.5% by mid-2001 in response to the slowdown. In fact, all major economies are decelerating. 2001 Euroland GDP growth rate will be 2.2% down from 3.4% in 2000. The narrowing of the growth differential between the US and Euroland should underpin a rise in the euro to US$0.97 by year-end. Coupled with declines in inflation, the ECB is likely to cut the repo rate from 4.75% now to 4.00% by year-end. The first of three 25-bp cuts could occur in April and then again in October and December.

The forecast for Japan has also been trimmed. But once again the slowdown is modest, with real GDP growth expected to slow from 1.7% in 2000 to 0.7% in 2001.Investment spending should remain strong at about 4%, but the strength of consumer demand remains less certain. Industrial production is likely to contract through the H1 2001. As growth slows, the yen could continue to weaken toward Y130/US$ over the next six months. Although the government may opt for yet another aggressive stimulus package, it is unlikely to be successful without microeconomic reforms. If these do not follow, the yen and Asia will probably suffer. The prospects for Asia's economic fortunes are less favourable, with an increase in risks. While it is expected to avoid recession, growth could be revised downward further into the 2-3% range if global growth drops below 2%. The direct impact of the revisions to the global outlook impacts Asian growth through a softening in the contribution of net exports to growth. The indirect effects are transmitted via an associated decline in domestic capex and consumer spending as external demand fades. Asian growth may slow only modestly to the 4-5% range in 2001 from 7% in 2000. Weaker growth reinforces our benign inflation forecast for Asia. With respect to the liquidity story, net balance-of-payments inflows through the current account will narrow markedly this year. The projected slowdown in export growth to 5.6% in 2001 from nearly 21% in 2000 suggests that growth will tail off sharply. If investor confidence weakens, then net balance-of-payments outflows could occur on the capital account. If they swamp the smaller net inflows on the current account, then the liquidity argument for Asian assets dries up with it. Moreover, attempts to reflate the economy through monetary or fiscal policy may be ineffective even if liquidity stays onshore, as it will provide little boost to growth. At worst, policy easing could destabilize domestic financial markets against the backdrop of a falling yen.

It is clear that Asia will face a fairly sharp externally induced slowdown this year. Besides a slowing US economy, the region continues to face considerable challenges from slowing IT-related demand. Growth rates in global semiconductor sales appear to have peaked, as have new orders for telecommunications, computers and peripherals. In particular, the dramatic fall in orders of telecommunication products and electronic components from the US, products that feature significantly in Asia's export profiles, provides an ominous warning for the direction of Asian exports going forward. South Korea and Malaysia, where the shares of these two products are especially high, will likely be the worst hit. This, in turn, has currency implications both for the won and the ringgit going forward.

If OECD central banks ease, it may place a floor under Asian asset prices and improve investor sentiment toward Asia and emerging markets in general. But it will do little to cushion the slowdown over the near term. Add dearer oil or a weaker yen to the mix and the fact that Asian equity prices tend to underperform when the global profit cycle turns downward, and a bearish picture emerges for at least the initial phase of 2001.

A word on the impact of Japan's woes on asia: Japan has come full circle once again. The sharp drop in the yen that accompanied the downturn in Japanese economic activity in 1997/1998 helped usher in and then deepened the Asian crisis that ensued. The upturn in Japanese activity and the recovery of the yen in 1999 and the initial phase of 2000 greatly aided Asia's export-led recovery. But the yen is slipping again, industrial production is contracting and private demand remains weak. What are the implications for Asia? The major avenues through which Japan would directly impact Asia's economic fortunes are as follows: 1) Trade impact: not only a reduction in Japanese import demand mainly via outsourcing, but also an impact on export competitiveness, particularly South Korea; 2) Capital account impact: through the potential withdrawal of Japanese bank finance to Asia as well as portfolio flows and a drop in Japanese foreign direct investments to Asia. With respect to the trade impact, Asian exports to Japan are generally smaller as a percentage of GDP than those destined for either the US or EU. Malaysia and Thailand would likely be the hardest hit, but this would be unlikely to substantially dent the current account surpluses projected for 2001.

That said, much of the recent increase in Japan's import demand from Asia is simply outsourcing to cut costs for Japanese export companies. Final demand still resides in the US and thus the impact of a Japanese downturn may be underestimated especially for countries such as Taiwan that have benefited from a H2 2000 surge in Japanese demand. As US demand slows, Japanese demand could wane and deepen the decline in the Asia export cycle. Regional FX rates will likely weaken to offset the loss of competitiveness due to the decline in the yen. A Japanese slowdown could clip 2-3% off Asian export growth in 2001 in the absence of a strong policy response. This would leave Asian exports nearly flat from their 2000 level. Indeed, Chart 4 could be interpreted as Asian central banks holding FX rates too strong given the outflow of capital, and thus a sharp correction in regional FX rates may be ahead. Indeed, this might be the most important impact of Japan's current woes.

The impact on trade flows is slow moving and would not likely be felt full force until mid-2001. This is not the end of the story, however, because faster moving capital outflows that might accompany a weaker Japan could exert a lot more pressure on domestic financial markets. The stock of Japanese bank claims on Asia was US$112 billion as of September 2000. The reduction in Japanese banks' Asian exposure from mid-1997 through mid-1999 amounted to almost 5% of the region's GDP. This dwarfed the change in Japanese imports from Asia (US$10 billion p.a. decline from 1996-1998). Japanese banks' ability to cause future strains on liquidity has thus been greatly reduced. Outside of the money centres, Japan's banks are most heavily exposed to China, Thailand, Indonesia and South Korea. But Hong Kong looks the most exposed to disruptive shifts in interbank flows due to the peg.

Finally, Japanese FDI in Asia has stabilized and had begun to recover, albeit gradually, which in the past has laid the foundation for Asia's export-led growth. Although small in value terms, this is the channel through which Asia has moved up the manufacturing value-added ladder. Indeed, export growth and technology transfers are closely associated with this flow. Japan's FDI flows into Asia only amount to about 0.5% of regional GDP in FY1998, but have dropped since then. These flows are unlikely to pick up over the next several quarters with the weakening of the yen. South Korea and Southeast Asia would appear to have the most to lose through lost asset sales helping to clear the backlog leftover from the crisis. Outsourcing has been substituted for FDI in the case of Taiwan.

Everything is relative, so who are the relative winners? From a macroeconomic vantage point, the gap between improving liquidity and better fundamentals remains a couple of quarters away. At this juncture, there is no sign of a drop in external demand so sharp that it would imperil currencies in a way that would offset attempts to ease policy across the region. A shift in investor sentiment could thus spark a rally in the interim, particularly in South Korea, Taiwan and Thailand. In fact, these are the markets still up on the year due to their oversold levels coming into 2001. However, without the fundamental leg to underpin the markets, equity rallies will likely be short-lived. Where are the fundamentals most likely to brighten first? The estimate of the bottom of the growth and export cycle for each country uses an assumption of firming of US GDP by the third quarter, moving up to 3.5% in the fourth quarter, and growing by about 4% in 2002. The bottom of Asia's growth and export cycle occurs mostly in Q3 2001 under such a scenario. However, South Korea and Taiwan will likely be the first out in either scenario. South Korea's export slowdown started as early as mid-2000 (well ahead of Southeast Asia), while Taiwan's recent sharp run-down in inventories provides a hopeful beacon of imminent export recovery. Of course, all bets are off under a more prolonged global downturn, in which case Asia's trough gets pushed into 2002, and worse, growth after the bottom is reached comes in much more subdued. In contrast to the rest of the region, China and India remain stronger for longer and never really slow sharply due to their relative independence from the global cycle. Malaysia and the Philippines are interesting cases. Malaysia is expected to encounter difficulties in early 2002 regardless of the global cycle. The fixed FX rate will make exports uncompetitive vis-à-vis other economies where floating rates can adjust downward to cushion slower external demand elsewhere. An ultimate policy move would, on balance, be reactive rather than proactive.

While the economic cycle points to recovery in H2 2001 for Thailand and the Philippines, the political environment could spoil the broth. At this point, both appear to be taking a turn for the better. Finally, Indonesia remains a challenge, at least until political clouds begin to lift, hopefully by August this year.