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net
Asia ASEAN Indonesia

6 January 2012
Macro

Asia Economics Special Economics

2012 Country Risk Watch

Research Team
Taimur Baig, Ph.D
Global Markets Research

Chief Economist
(+65) 64238681
taimur.baig@db.com

Juliana Lee
Senior Economist
(+852) 2203 8312
juliana.lee@db.com

In this note we highlight what we believe are the major risk factors in 2012 Michael Spencer, Ph.D
for the Asian EM economies under our coverage. We exclude risks stemming Chief Economist
from external demand and global financial market stress as those risks are (+852) 2203 8305
michael.spencer@db.com
present by and large everywhere. Instead, this is a summary of domestic
macro risk factors.

We see China facing major financial reform and restructuring challenges this
year. India has a plethora of risks to deal with but we think that the fiscal
situation and the financial sector are the ones to watch out. In Indonesia, we
see another year of strong growth but there could be some overheating
risks. Malaysia might see a slower pace of structural reforms. In the
Philippines, a rise in political tension could be a distraction.

South Korea should continue its much-needed restructuring of the

household balance sheet while trying to contain negative economic and
financial spillovers. Both Hong Kong and Singapore will deal property market
corrections as growth slows, while Taiwan will hold early elections. Thailand
will count the fiscal cost of flood related restructuring.
Economics

Deutsche Bank AG/Hong Kong

All prices are those current at the end of the previous trading session unless otherwise indicated. Prices are sourced from local
exchanges via Reuters, Bloomberg and other vendors. Data is sourced from Deutsche Bank and subject companies. Deutsche
Bank does and seeks to do business with companies covered in its research reports. Thus, investors should be aware that the
firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a
single factor in making their investment decision. DISCLOSURES AND ANALYST CERTIFICATIONS ARE LOCATED IN
APPENDIX 1. MICA(P) 146/04/2011.
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6 January 2012 Asia Economics Special

2012 Country Risk Watch

In this note we highlight what we believe are the major risk factors in 2012 for the
Asian EM economies under our coverage. We exclude risks stemming from external
demand and global financial market stress as those risks are present by and large
everywhere. Instead, this is a summary of domestic macro risk factors.

China—impact of financial reform

Concerns stem from two related issues, both a legacy of the 2009 stimulus. First, after
property prices rose by more than 30% in the year after the crisis and with growing concerns
of speculative excess, policymakers embarked on a sustained policy of curtailing residential
investment. By the end of 2010 these policies had succeeded in cooling off the market
somewhat and as the tightening policy continued by the end of 2011, prices had clearly
begun to fall. The private Soufun index indicated a 13% decline in prices between
September and November, while the NDRC’s index showed a much more modest decline.
Falling prices and lower transaction volumes discourage new construction and hence a likely
decline over the next couple of quarters in “commodity housing” fixed assets investment
which accounts for about 15% of overall investment. As home ownership grows, the
negative wealth effect from house price declines likely increases. Neither effect can be easily
quantified, but a drag on GDP this year of 1% - 1.5% at least seems likely.

The 2009 stimulus also saw an growth of local government debt. By end-2010 local
governments owed more than the central government and it was estimated that more than
20% of these loans were nonperforming. While we are inclined to think most commentators
exaggerate this risk to financial stability – we expect NPLs from this source to be mostly
absorbed by different levels of government over the next three or four years leaving very little
losses on banks’ books – uncertainty over the strategy for dealing with these loans continues
to weight at least on sentiment if not actually on banks’ willingness to extent credit.

Looking further ahead, financial sector reforms pose significant risks to China’s investment-
led growth strategy. While this may be deliberate – the official policy is, after all, one of
shifting the source of growth to the consumer away from investment – we note it
undoubtedly poses significant risks. The anomaly of an economy with a real growth rate in
excess of 10% over the past year but real borrowing costs less than half that is likely to be
corrected by markets if liberalization is genuine. The growth of the informal lending market in
recent years shows how eager households are to earn a “reasonable” rate of return on their
savings, with consequent upward pressure on firms’ borrowing costs. Capital account
liberalization adds to this pressure by potentially giving households the ability to invest
abroad, which as the CNY nears equilibrium, will be viewed as increasingly attractive.

India—fiscal and financial

After a year when there was widespread stress due to high inflation, tightening monetary
policy, anemic investment, challenges to reform initiatives, governance scandals, capital
outflows, and pressure on the exchange rate, India steps into 2012 with lingering concerns
about the reform environment and spillover stress from the previous year's growth
slowdown. While growth will likely remain under pressure for the time being, inflation could
see a respite only for a few months, and one would have to be optimistic to expect a major
positive turnaround in reform initiatives or the legislative process, we are focused on two
other risks. First, fiscal slippage in FY11/12, anticipated by us the moment the budget was
passed last spring, has unfortunately become all but certain, with the central government
announcing substantial additional borrowing. We expect close to a 1% of GDP worsening of
the fiscal deficit relative to the budgeted 4.6% of GDP target for this fiscal year. We are

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6 January 2012 Asia Economics Special

equally, if not more, concerned about the fiscal situation in FY12/13, when weak revenue
generation, a challenging privatization environment, and rising spending pressure on social
areas and subsidies could cause the deficit to worsen or at best remain in the 5.5% of GDP
range. If this turns out to be the case, public sector borrowing requirement will remain high,
crowding out the private sector, and keeping sustained pressure on long term interest rates
precisely at a time when growth needs to be bolstered through a more enabling set of
liquidity and credit conditions.

We expect the financial sector to face quite a bit of stress in 2012. Lower growth could affect
credit quality and debt servicing, a sharply depreciated rupee could create external debt
repayment difficulties (although our calculations suggest that even under a sudden stop of
capital flow scenario there will not be any systemic manifestation of repayment risks as
reserves coverage is ample), and liquidity conditions could remain challenging if the fiscal
situation continues to weaken. India's financial sector benefitted from considerable public
sector intervention and regulatory forbearance during the 2008 global financial crisis, but
there are fewer avenues to carry out such measures this time, and hence greater risk exists
for the associated stress to spread further.

Indonesia—overheating.
We have been a supporter of Indonesia for years, repeatedly arguing that its rich natural
resource base, increasingly stable macro-economy, deepening democratic institutions,
vibrant civil society, strong fiscal position, and favorable demographics have combined to set
the ground for strong growth for years to come. We have however noted lately that our
concern is for the economy to overheat along the way as consumer and business confidence
and sentiments are not adequately anchored by policy makers, who appear to be eager to
propel the economy to a higher plane.

This concern primarily stems from our discomfort with the central bank's policy stance,
which appears to be pushing for higher credit growth through aggressive lowering of
borrowing costs. This is taking place at a time when credit and liquidity conditions are already
ample, and therefore the risk of over-consumption and investment is rising, along with the
possibility of overshooting asset prices (especially real estate). We also find the central
bank's bond market intervention strategy susceptible to causing distortion in the market
through excessive reductions in bond yield (which reduces the incentive for domestic
pension funds and insurance companies to invest in government securities). We believe that
the right way to reduce financing cost is through a pro-active anti-inflationary policy stance,
but right now inflation is being kept low through administrative measures (administrative
control of energy prices is a key, but not the only, channel in this context), while the
monetary policy approach is clearly not helping anchor inflation expectations.

Since in 2012 the economy could once again be one of the fastest growing in the region,
benefitting from ratings upgrades as well, it may seem odd to single out the risk of
overheating, especially when the global economy is likely to slow. We are however not keen
on ignoring risks just because they seem at odds with global developments. With consumer
confidence close to an all time high, the traditional phenomena of excessive exuberance
causing excessive consumption and mis-allocated investment appears well within the realms
of possibility in Indonesia.

Malaysia –pace of structural reforms

While parliamentary elections are not required until 2013, it is widely believed that the
government will call an early election this year. With the government having lost their two-
thirds majority in the last election, the next election takes on particular political significance.
But we think the economic consequences could be important. This government has
embarked on an energetic transformation of governance and of the economic model.
Broadly, this involves reducing the role of government in the economy and expanding the

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6 January 2012 Asia Economics Special

scope of the private sector and market mechanisms. The government’s role is to be that of a
rule-setter and facilitator, investment rules including for foreigners are being liberalized and
subsidies on key food and energy items reduced. While a temporary suspension of the more
politically difficult elements of the transformation program should be expected if the election
result were to reduce the enthusiasm for the reform programs altogether we note this would
be a lost opportunity to improve Malaysia’s competitiveness.

Philippines—politics and reform initiatives.

Typically, given its strong trade linkages, the Philippines economy tends to experience a
slowing of growth whenever there is a slowdown in industrial economies. While this year is
no exception, we are expecting the economy to be somewhat supported by strong
remittance, a comfortable external financing position, and fairly robust consumption and
business sentiments.

One wrinkle in this picture is an uncomfortable rise in political tension, which we fear could
get in the way of reforms. The government has ambitious plans to boost spending on
infrastructure, tourism, and human capital, but we are worried that many of these initiatives
would be slowed down by rising political tension between the President and his political
opponents. We look forward to seeing a reduction in such tensions.

Hong Kong and Singapore—property market correction

For both Hong Kong and Singapore, the biggest risks are clearly external given their roles as
international financial centers and merchandise trade entrepots. But in this cycle we are
faced with an additional risk – a correction in the property market. Both governments have,
over the past year, introduced measures to dampen property price inflation, including by
increasing stamp duties and tightening investors’ access to bank credit. Some of these
measures have been aimed directly at foreign buyers (who have been driving a large part of
market activity).

We see these measures as prudential approaches to ensuring macroeconomic stability and

social cohesion. Sharply rising real estate prices impact residents’ aspiration to own non-
public housing, exposes banks to higher sectoral risk, and encourages speculation that could
ultimately impact both retail and institutional investors, and by extension the financial system.

The risk however is that with investor sentiment already weakening the price adjustment
process could become disorderly, adversely impacting the financial system in any case.
Prices have already begun falling modestly in Hong Kong although evidently not yet in
Singapore. A key challenge for both governments will be to engineer a market correction
while keeping at bay destabilizing spillovers.

South Korea—household debt

Like their counterparts in the US and UK, the South Korean authorities face the tough
challenge of supporting overall economic growth while encouraging households to reduce
debt. The household debt burden continues to rise and indeed borrowing has grown faster
over the past two years leaving households even more vulnerable to higher interest rates or
tighter credit conditions. Concerns are exacerbated by the deleveraging by European financial
institutions, which could provoke the same in South Korea as funding lines are withdrawn and
result in a sharp downturn in economic activity. Fortunately, the authorities have not only
built-up stronger defenses against a sudden, large capital outflow and prompted restructuring
of FX loans of South Korean financial institutions, but also promoted restructuring of
domestic loans, including conversion of bullet loans into amortizing loans, and limited their
growth. While the authorities have done well in managing risks with respect to commercial
banks, they have only begun with non-bank financial institutions, which have historically dealt
with more vulnerable borrowers. Meanwhile, sustained weakness in mortgage loan growth
points to continued weakness in the private housing market. One bright spot may be the

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6 January 2012 Asia Economics Special

government’s drive to provide more affordable housing for the public, which we expect to
provide some support for the construction sector, which has suffered four consecutive
quarters of decline since Q4 2010.

Taiwan – politics
Taiwan has enjoyed relatively resilient domestic demand, supported by credit growth not
seen since 2005 and a surge (admittedly from a low base) in Mainland tourist arrivals. As
elsewhere, the low interest rate environment has encouraged property price inflation and in
response, the authorities have tightened monetary policy and adopted administrative
measures to discourage mortgage loan growth. These restrictive policy trends have all but
come to an end, as risks to global growth rose sharply in 2H 2011. However, credit growth
appears to have peaked, deterred by the weak economic outlook, and property price inflation
has been easing since early 2010. So Taiwan appears to have avoided the excesses of China
and Hong Kong property bubbles. But political risk is important in the very near term, with the
presidential election looming in less than 10 days. While we do not expect a significant
change in the direction of economic policy regardless of the result of the election, the
possibility of a change in the relationship with the Mainland is a worry.

Thailand—government finance
The flood’s impact intensified in November and disruption to economic activities has been far
worse than expected. The worst of the impact will be felt in 2011Q4 with a drop in GDP likely
of more than 6%QoQ(sa). While we expect a notable rebound in economic activities in 1H
2012, this view relies heavily on a timely, effective implementation of reconstruction efforts.
But what lies ahead is a possibly costly reconstruction bill and a possibly significant increase
in government deficits and debt. To make room for that, the Finance Ministry has proposed
to transfer THB1.4tn (about 13% of GDP) of legacy FIDF debt (stemming from the 1997
crisis) to the Bank of Thailand (BoT). Since the central bank does not apparently have
sufficient income to service this debt without incurring losses, the risk of inflationary debt
monetization is a legitimate one, in our opinion.

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6 January 2012 Asia Economics Special

Appendix 1
Important Disclosures
Additional information available upon request
For disclosures pertaining to recommendations or estimates made on a security mentioned in this report, please see
the most recently published company report or visit our global disclosure look-up page on our website at
http://gm.db.com/ger/disclosure/DisclosureDirectory.eqsr.

Analyst Certification
The views expressed in this report accurately reflect the personal views of the undersigned lead analyst(s). In addition, the
undersigned lead analyst(s) has not and will not receive any compensation for providing a specific recommendation or view in
this report. Taimur Baig/Juliana Lee/Michael Spencer

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6 January 2012 Asia Economics Special

Regulatory Disclosures
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Risks to Fixed Income Positions

Macroeconomic fluctuations often account for most of the risks associated with exposures to instruments that promise to pay
fixed or variable interest rates. For an investor that is long fixed rate instruments (thus receiving these cash flows), increases in
interest rates naturally lift the discount factors applied to the expected cash flows and thus cause a loss. The longer the
maturity of a certain cash flow and the higher the move in the discount factor, the higher will be the loss. Upside surprises in
inflation, fiscal funding needs, and FX depreciation rates are among the most common adverse macroeconomic shocks to
receivers. But counterparty exposure, issuer creditworthiness, client segmentation, regulation (including changes in assets
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conversion, repatriation of profits and/or the liquidation of positions), and settlement issues related to local clearing houses are
also important risk factors to be considered. The sensitivity of fixed income instruments to macroeconomic shocks may be
mitigated by indexing the contracted cash flows to inflation, to FX depreciation, or to specified interest rates – these are
common in emerging markets. It is important to note that the index fixings may -- by construction -- lag or mis-measure the
actual move in the underlying variables they are intended to track. The choice of the proper fixing (or metric) is particularly
important in swaps markets, where floating coupon rates (i.e., coupons indexed to a typically short-dated interest rate
reference index) are exchanged for fixed coupons. It is also important to acknowledge that funding in a currency that differs
from the currency in which the coupons to be received are denominated carries FX risk. Naturally, options on swaps
(swaptions) also bear the risks typical to options in addition to the risks related to rates movements.

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David Folkerts-Landau
Managing Director
Global Head of Research

Guy Ashton Marcel Cassard Stuart Parkinson

Head Global Head Associate Director
Global Research Product Fixed Income Research Company Research

Asia-Pacific Germany Americas Europe

Fergus Lynch Andreas Neubauer Steve Pollard Richard Smith
Regional Head Regional Head Regional Head Regional Head

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