APAC: Domestic strengths counter policy uncertainty

The outlook for sovereign creditworthiness in Asia Pacific (APAC) in 2019 is stable overall, reflecting expectations for the fundamental credit conditions that will drive sovereign credit over the next 12-18 months. Solid domestic fundamentals, including rising incomes and competitiveness, generally ample foreign exchange reserves and often sizeable domestic savings, will continue to underpin government credit quality. However, tensions between the US and China could disincentivise investment and weigh on growth potential, while wider risk premia would weaken debt affordability and raise government liquidity risk, particularly for frontier markets.

Shifts in domestic priorities away from fiscal consolidation, or in political appetite to address weaknesses in the financial sector, pose a risk to some emerging and frontier market sovereigns' credit profiles. In some advanced economies, an increasing focus on social welfare and more inclusive growth, while conducive to social cohesion and policy effectiveness in the longer term, could hurt near-term profitability and investment.

Stable outlook

As of January 9, 21 of 24 rated APAC sovereigns have stable outlooks, while three have negative outlooks. Positive and negative rating actions were broadly balanced in 2018, and there were more upgrades than downgrades.

One downgrade in 2018, compared with two in 2017. The smaller number of downgrades is consistent with the largely stable credit environment predicted for 2018. More rating factors also strengthened in 2018 than in 2017. However, increasing external vulnerability and government liquidity risk drove a larger number of negative changes to susceptibility to event risk scores in 2018 relative to positive changes and compared to 2017. This reflected limited prospects for strengthening in liquidity and external buffers for some sovereigns ahead of tightening global financial conditions. This was the case for Sri Lanka (B2 stable), where a political crisis has exacerbated external vulnerability and government liquidity risk, and raises uncertainty over fiscal and macroeconomic reforms. We downgraded the rating in November.

Persistent US-China tensions will weigh on regional growth, despite robust domestic drivers. Relations between the US and China are expected to swing between conflict and compromise, involving trade, investment, technology and geopolitics. Tensions will weigh on exports and GDP growth in APAC in the near term.

Risks to the region's medium-term growth prospects have also increased, given trade exposure to China and integration of manufacturing supply chains within APAC. While still open in 2019, the window for addressing longstanding credit challenges, ranging from external to fiscal and banking vulnerabilities, is closing as the economic outlook dims.

GDP growth in APAC will slow with global trade, but monetary policy and domestic fundamentals remain supportive. The pace of economic expansion in APAC is likely to soften in 2019-20, with emerging and frontier market economies likely to experience the sharpest deceleration. Moody’s forecast median GDP growth rates of 5.5 per cent and 5.2 per cent in 2019 for APAC emerging and frontier market economies respectively, while growth in the advanced economies will likely slow to 2.5 per cent.

Generally benign prospects for inflation will nevertheless allow monetary policy to remain accommodative in the advanced economies. Longer term, rising incomes and a growing middle class, expanding working-age populations and infrastructure investment enhancing economic competitiveness will underscore output in the region's emerging and frontier markets.

Trade tensions pose policy trade-offs in China; risk that policy effectiveness diminishes. In China, GDP growth is forecast to slow to 6 per cent in 2019-20 as trade tensions weigh on exports and manufacturing activity, and exacerbate the tightening of domestic credit supply resulting from the government's deleveraging and derisking campaign. Since mid-2018, China's authorities have eased policy through targeted liquidity measures, taxation changes and infrastructure spending, which will shore up growth.

However, designing and implementing policy that simultaneously buffers the shock of the US trade tariffs and potential further restrictions, while continuing deleveraging and derisking without triggering too sharp a slowdown in growth, poses complex tradeoffs. The effectiveness of some of the policy tools that the government is turning to, particularly in fiscal policy, is untested and could prove lower than we currently assume.

Supply chain

Trade-oriented, supply chain economies are particularly vulnerable to lower export growth in China. Hong Kong is especially vulnerable: while goods exports to China are mainly transshipments with a limited value-added component, China accounts for around 90% of total services exports. The bulk of these are financial and trade-related services, demand for which would decline on lower trade flows. Japan, Korea, Malaysia, Singapore, Taiwan and Vietnam are also exposed, especially given the integration of their economies into the electronics supply chain through China, which is at the centre of the trade and technology dispute with the US.

These economies variously specialise in the production of computer and smartphone components, and semiconductor chips. Our baseline forecasts assume some limited negative impact on investment in these economies, commensurate with direct trade effects and in light of the decline in import intensity of Chinese electronic exports over the past two decades. A downside scenario involving the broad reevaluation of production and investment across the region's production chain would have a large, longer-term impact on these economies.

Commodity exporters would be exposed to a sharper-than-expected growth slowdown in China. Slower growth is unlikely in China to materially affect the country's demand for commodities and other raw materials, given a likely increase in infrastructure spending as the authorities aim to counter the trade shock. However, a sharper slowdown in China than currently projected by Moody’s would likely weigh on commodity exporters globally, whether through reduced demand for their exports or lower commodity prices.

Some APAC economies compete directly with China on exports of finished goods in and/or parts of electronics, electric machinery, automobiles and textiles, which are currently subject to US tariffs. Shifts in US demand could result in higher imports of electronics and automobiles from Japan and Korea, and electronics from Taiwan. Bangladesh and Vietnam could receive larger orders for readymade garments, given their ability to scale production. Even if there is some reshoring of production to the US, producers along the supply chain could also benefit from higher US demand for intermediate goods, given their manufacturing capabilities and competitive advantages ranging from lower production costs to production efficiencies.

However, supply chains do not evolve overnight, and commercial relationships depend on a wide range of factors. Any change would depend on the duration of the tariffs, and the intensity and scope of tensions between the US and China.

Bilateral trade pacts with the US would not shield APAC economies from the direct impact of global US tariffs. There remains a risk that the US will impose global tariffs, particularly on automobiles and parts given their contribution to the US trade deficit. Japan and Korea would be most directly exposed in such a scenario, given the size of their automobile sectors.

Source: Moody’s Investor Service