Confidence is running high that Asia’s rapid growth will protect the region from the worst of the turmoil in Europe. Yet global bank exposure to Asia, at US$2.3trn at the end of June, means the threat of capital flight is ever-present. Is Asia guilty of complacency?

The theme of Asian decoupling is as old as the hills. For years, economists and analysts have argued over whether or not Asia is a sufficiently powerful and independent economic bloc to be able to come through the macro shocks relatively unscathed. It is always hoped for, but never quite achieved. With Europe in crisis and the US flirting with recession and unresolved debt, the question is being asked again.

The simple truth is that, no matter how much more robust Asian economies look than those in the west, regardless of how much better their fiscal positions and demographics, capital continues to fly from these places whenever there are global (or western) worries. Illogical though it may be, Asian capital markets remain a risk-on bet. “We saw trickles in September, but the risk is we may start to see serious net capital outflows from Asia, which can be very destabilising,” said Rob Subbaraman, Nomura’s chief Asia economist.

A look at capital flows over the last five years is illuminating. According to Subbaraman, in the 10 quarters before the global financial crisis from the first quarter of 2006 to the second of 2008, Asia ex-Japan attracted US$265bn of net capital inflows – a broad measure, including net portfolio debt and equity, FDI, international bank lending and balance of payments. In the following two quarters, in the eye of the credit crisis, US$118bn departed. “A reasonable chunk left,” he said. “However, what’s interesting is that in the next 10 quarters, from the first quarter of 2009 to the second quarter of 2011, net capital inflows totalled US$684bn.”

That vast increase has been down to Asia’s better fundamentals relative to the rest of the world, the higher interest rates available, and the easing policies in advanced economies that pushed capital towards Asia. Still, should we expect, as happened last time, for half of it to leave again when things turn sour? “There is a lot of room for foreign capital to leave Asia if we start to move towards anything starting to resemble the global financial crisis,” Subbaraman said.

This is a more alarming prospect in some markets than others. Indonesia, in particular, has been watching closely for signs of capital flight, since, at its peak, foreigners accounted for 35% of all rupiah government bonds, with a similarly high representation in the stock market. “We have the capacity to withstand reversals,” said Rahmat Waluyanto, in the debt management office of Indonesia’s Ministry of Finance. “We have relatively large forex reserves, a widening domestic investor base, and a bond stabilisation framework.”

However, money is leaving. The rupiah, having gained more than 5% against the US dollar in the first eight months of 2011, has slid by more than 6% since the start of September as overseas investors sold stocks and bonds. Foreign ownership of government bonds fell 1.1% in a single week in late November. Indonesia is a market darling: a domestic consumption story, a model new democracy, a fiscally sound nation and one capable of borrowing US$1bn of seven-year money at just 4% in November at a time when Italy was paying almost 7% on its own debt. A move up to investment-grade status within the next six months is considered a formality. However, none of that is enough to stop foreign capital leaving when there are difficulties in Europe and the US.

“The Global Financial Crisis Part II is spreading to Asia a little faster than we had anticipated,” said John Woods, Citi Private Bank’s chief investment officer for Asia Pacific. Speaking on November 22, he noted that every currency and every equity market in Asia had declined month to date, with India, Australia, Korea and Taiwan hardest hit.

According to Woods, this is partly a function of weak levels of risk appetite, and partly capital outflows as continental European banks reduce their cross-border lending to shore up their capital positions at home. BIS data says that, of Asia’s US$2.3trn loan exposure to global banks, 21% of it is extended by eurozone financial institutions. “Fears are growing that as French, Italian and Spanish banks exit the region, a credit crunch could escalate in scale similar to the global financial crisis of 2008–09,” he says.

Lessons learned

Leaving aside capital flows, it is inevitable that growth will slow as a consequence of problems in the US and eurozone, but, from this economic viewpoint, concerns are not so high. “These are challenging times, but, in many emerging economies, such as Malaysia, we did our reforms and strengthened our economy and our financial system [after the Asian financial crisis] and there is a tremendous payoff now,” said Dr Zeti Akhtar Aziz, Governor of Bank Negara Malaysia. “These measures placed us with a greater degree of resilience in coping with not only the economic implications, but the surges and reversals of capital flows, which are better intermediated into our financial system.”

She added: “With all the developments in Europe, the impact is in volatile financial markets, which impacts our money and foreign exchange markets. However, aside from that, the domestic economy is particularly strong.”

Many of her Asian peers share similar views, as do some economists. “Asia ex-Japan is becoming more resilient to economic conditions in the major advanced economies,” said Subbaraman. “One big reason is China: not only do we have the world’s second biggest economy in our backyard, but nearly all its growth is domestic-led. And several indicators suggest that more and more of Asia’s exports to China are staying in China, rather than being assembled and shipped out.”

This is a crucial point in the decoupling argument: economists have argued for years that growing intra-Asian trade has bolstered Asia’s independence from macro shocks, while just as many have countered that most of that intra-Asian trade comes from goods to be assembled in China and then ultimately exported to the West, undermining that independence.

There is a “tipping point” though, for Subbaraman, at which point Asia does start to get hit by slowing growth or recessions in the West. “When exports are cooling moderately like they are now, firms just accept that. But if the downturn really starts to deepen, firms have to face more difficult decisions on cutting back on jobs, expansion plans and capex, which has multiplier effects on domestic demand.” Then, there’s the effect of negative wealth and falling asset prices from equity to property on confidence.

For central banks in Asia, there are considerable challenges. “It’s really tough to be an Asian central banker,” said Subbaraman. “I think they should get paid more. They’re stuck between a rock and a hard place at the moment.” There are obvious threats to growth, and already some central banks, with Australia and Indonesia at the forefront, are cutting rates, with many others expected to follow, such as Malaysia and Korea. “But, on the other hand, you can see a number of other reasons not to ease right now,” said Subbaraman. Although headline inflation is easing, core inflation is still quite high in most countries; loan growth in many Asian nations is still at double digits; and it’s still possible that capital flows could come back in very quickly. “It could prove to be a mistake if Asian central banks are aggressively pre-emptive right now. It might be better to wait.”

Woods notes that the market is pricing in interest rate cuts across the region, but notes that although inflation is peaking, “price pressures are proving surprisingly stubborn.” He added: “Sticky inflation complicates Asia’s growth-versus-inflation trade off.”

All eyes are on China, which more and more people (Woods included) think is ready to move towards easing monetary policy. “For all sorts of reasons, China rightly fears a global recession,” Woods said. “Still highly dependent on external demand, China has been attempting to transition towards higher private consumption, but reforming your economy in the teeth of slumping global demand is challenging to say the least.”

It is a queasy sort of a day when Asiamoney meets Zeti Akhtar Aziz, Governor of Bank Negara Malaysia, at Washington DC’s Four Seasons Hotel in September, and not just because of the jetlag and the changeable weather. We meet during a period of miserable uncertainty in world markets: the eurozone in crisis, the US staring at a double-dip recession, and markets looking hopefully to the IMF/World Bank annual meeting to provide some direction, which they utterly fail to do.

For Zeti, the mood is not as bad as it is for some others: Malaysia is basically doing fine, and while it will clearly slow as a result of global problems, it would be a surprise if its growth rates dipped below 4% at any point in the next 12 months. But what’s striking about this meeting is that the normally reticent and softly-spoken Zeti has some unusually strong opinions about problems in the west – and how to fix them.

That’s because, having worked through the Asian financial crisis – she was rising through the Bank Negara ranks at the time and became governor in its aftermath, in May 2000 – she believes there are clear lessons about the process of recovery that the west has not yet shown much sign of taking on board.

“While we need to deal with the financial sector and bring about regulatory reform, it has to be accompanied by pro-growth policies,” Zeti says. “That is what we did in the Asian crisis. We had to do the financial and debt restructuring, but for a chance for those policies to be successful we needed to have growth.” She’s quite specific about what she means – which also stands out, in a week dominated by broad and grand statements and an absolute minimum of practical detail: she  highlights policies to support SMEs, households, access to finance, credit enhancements, infrastructure development and private sector incentives. “We had a V shaped recovery,” she says. “Many parts of the developed world, and the IMF, said we would have a lost decade. We didn’t.”

The west, she says, just hasn’t been doing what it needs to. “Only now are we seeing some of these measures being implemented in the US,” she says. “They needed to have been implemented three years ago.” She also calls for policy that is “more anticipatory rather than reactive. When we were managing the crisis in Asia we looked at what was the worst yet to come and what did we need to do to deal with it, rather than just implementing policies to prevent a collapse and thinking that was it.”

Malaysia is not a member of the innumerable groupings and federations in world finance – the G7, the G20, the G24 – instead making its presence felt more in Asean and in Islamic finance initiatives around the world. Lacking a voice on the world stage, it is perhaps not surprising that she is not a fan of the IMF, nor of representation of emerging economies within it. “The IMF has to become neutral,” she says. “This neutrality and credibility would be enhanced if there was greater representation of emerging markets in the role of the IMF and in its governance process. Crises don’t just happen in emerging markets; this is something the IMF didn’t highlight to the world until quite late.” She says while the IMF has sought to increase that representation, it has done so “in a very incremental manner.”

She goes further and doubts the leadership the IMF has shown; Asiamoney’s interview takes place directly before the formal start of the meetings, but it’s unlikely her opinion was changed by any of the statements of the following days. “The IMF doesn’t seem to have a significant role in this,” she says. “We have looked for the IMF to have a greater role in recognizing what the issues are in their surveillance, and we look for it to provide solutions to many of these problems. Their solutions have not been forthcoming.”

So how does all this affect Malaysia and Asean? “In emerging markets we are doing better [than in the west] but we are going to see moderation in our growth as well, because we are very much part of the global economy and most of us are highly open. But we are still going to see growth, and are still on a growth path.”

Across Asia, central bank governors are having to deal with shifting priorities. For much of the last year, most of them have had to fight off inflation, and have correspondingly been rising interest rates through the year. There are markets where inflation remains a challenge – Vietnam, India, China – but across most of Southeast Asia it’s all but stopped being an issue.

Take the Bank of Thailand, which has raised rates on seven separate occasions since December, reaching 3.5%. “I think we were on the right direction so far, but if you ask the question from now on, we do think the slowdown in the world economy will mollify somewhat the inflation pressure,” says Prasarn Traitvorakul, Governor. “The job is to take a proper balance, but the balance lately has tilted towards the risk of growth becoming more apparent than inflation pressure.” When the bank next meets to discuss rates, on October 19, it would now be a major surprise to see another hike.

In places like Thailand, where domestic consumption is strong and the outlook good, the global problems have arguably been helpful. “We hope that some slowdown in the world economy will lower the pressure from the supply side,” says Prasarn. (A wild card, though, is a new government policy offering to buy local rice at heavily subsidized rates; HSBC has warned that, with Thailand being the world’s biggest rice producer, this could put inflation back on the agenda in rice-importing countries.) Like many Asian nations, Thailand has sought to boost intra-regional trade’s proportion of the overall national trade balance sheet, reducing reliance on the west, and this should prove helpful. “The feeling is not too pessimistic or optimistic,” he says. “There are threats from what’s happening in the euro zone and the US, but there are also encouraging factors like regional integration in trade and financial flows.”

Zeti, in Malaysia, has been viewing the world with similar interest. From late 2010 Bank Negara raised rates four times in seven months, from 2% to 3%, and then stopped in July, “given the increased uncertainties and the significantly heightened risks to growth,” says Zeti. From her perspective, in a country with palm oil and rubber at the heart of the national economy, commodities were the most important thing to watch. “As commodity prices stabilized, which was a major factor from the supply side producing higher inflation, demand has slowed globally,” she says. “This will limit inflation, so most central banks have paused their increases in interest rates.” Official estimates of full-year growth in Malaysia are 5-6%, but it dropped to just 4% year on year in the second quarter of 2011.

Zeti says that for central bank governors in Asia, “the biggest challenge is to have price stability in an environment of sustainable growth. You have rising prices, and at the same time you also have risks to growth, and those risks have become higher because of what is happening around the world.”

One area Asia cannot escape is capital flows. In recent years foreign money has flooded into Asia, particularly Asian bonds, in search of yield backed by strong fiscal stories. But as always, when markets get really bad, capital instead is withdrawn from these supposedly riskier asset classes, despite the fact that the risks appear far bigger in the developed world. In some cases, this isn’t a judgment on risk at all, but a need to liquidate capital in order to pay down other exposures.

Indonesia is the market that has most to lose in this respect; by the end of August foreign ownership of rupiah-denominated government bonds stood at over 35%. That money has been chasing the Indonesia story: a transformed fiscal position over the course of the last decade, a growth model predicated on commodities and domestic consumption, and an apparently successful and stable democracy. But for some time, investors both local and foreign have worried: what if it all leaves again?

Rahmat Waluyanto, in the debt management office of the Ministry of Finance, says that a modest reversal has started to happen. In the space of a week in September, foreign ownership dropped from 35.4% to 33.6%. But he is at pains to point out that foreign ownership in the government bond market is still heavily net positive, at around US$5.5 billion year to date. The withdrawal, he says, “has nothing to do with domestic economic fundamentals but FX movements due to jitters caused by the worsening euro debt crisis.” Not all fixed income is fully hedged in terms of FX exposure, hence the withdrawal, he says, although in fact non-deliverable forwards on the rupiah have been moving up, not down. “There’s no reversal yet; the real money accounts still stay,” Waluyanto says. “Indonesia has the capacity to withstand,” he adds, citing relatively large foreign exchange reserves (which crossed US$100 billion for the first time earlier this year), a widening domestic investor base (including retail investors, pension funds and insurers), and a bond stabilization framework.

Indonesia has mentioned this framework before, but it’s not always been clear what’s involved. Waluyanto says there are four strategies to negate a negative impact of a sudden reversal: the debt management office will use funds from the annual budget to buy back government securities; state-owned companies will buy in; so will be Treasury Unit and Government Investment Unit of the finance ministry; and if necessary, parliament can approve the use of accumulated cash surpluses to buy government securities.

Zeti, too, notes a change in the threat of capital flows. “We are seeing very significant surges in capital outflows and reversals,” she says. “Previously it destabilized us quite significantly. But in the current environment we are seeing these flows are better intermediated by emerging economies.” In 2009, she says, Malaysia’s reserves declined by $25 to $30 billion, with a major depreciation in the currency. “But we could take it in our stride.” She says that, in contrast to the Asian financial crisis, Malaysia has more resilient financial institutions, more developed financial markets, higher reserve levels, a more flexible exchange rate, and more instruments to sterilize inflows than before. Today, around 20% of Malaysian government bonds are foreign-held.

Whatever else happens, southeast Asia is surely the only part of the world where you can still find people barracking for sovereign upgrades at a time when the rest of the world is falling apart. In the Philippines and Indonesia, expectations are high of improved ratings from international rating agencies. Both countries can provide long lists of improvements, from budget deficits to domestic market depth and government responsibility. With Turkey having been upgraded in early September, its Asean peers are not about to stop waving the flag now. Indonesia, Waluyanto points out, has credit default swaps trading considerably tighter than Turkey’s; proof, he says, that if the story is bright there, then it’s brighter still in Indonesia. “So Indonesia should now be in the investment grade category,” he says. It’s good that somewhere in an uncertain world, there are people looking up and not down.

Smart Money was in Washington DC last week for the IMF/World Bank annual meetings. We could describe the mood as toxic, miserable, scared, grim and hopeless. But that would be putting too positive a spin on it.

If the world had been hoping for leadership, and a clear sense of direction out of crisis, then they didn’t get it. There is no shortage of gatherings, groups and institutions in the world today – the G7, the G20, the World Bank, the IMF, the various European bodies, plus of course all of the national sovereigns – but none of them gives any impression of being in charge. Markets, lacking any roadmap they can rely upon to fix the world economy’s many problems, are panicking and falling.

One moment encapsulated the meeting. With the mood at its worst, late on Friday night the G20 – led by France – hosted a press conference. It was packed, as the world’s media waited to hear a message of reassurance and the concrete steps the group would set out for recovery. France’s finance minister and development minister took to the stage and started talking. They talked about a new financial transactions tax; about infrastructure development in the emerging world; about transparency. After half an hour they stopped; they hadn’t mentioned the growing financial crisis once, and became visibly irritated when anybody asked about it. It was like watching an ostrich bury its head in the sand. If the sand was on the Titanic. And the Titanic was on a different planet.

It summed up the sense that the world economy is a car going downhill on a steep mountain road with no driver.

But what does all of this mean for investments? Several themes came out of the meeting, and of market behavior around them:

1. Not only could Greece default, the euro really could collapse. It probably won’t, but the possibility can no longer be ignored. The precise consequences of this are unclear, but anybody thinking of buying into European equities because they look good long-term value might want to wait a little longer for some certainty – and maybe a lot longer.
2. Just because emerging markets have better economic fundamentals than the developed world, it doesn’t mean their markets are invulnerable to global shocks. This perverse logic applied in the 2008 financial crisis and it is happening again: the Singapore dollar, for example, having fallen 8% against the US dollar in about a week having previously soared; and the Indonesian stock market plunging despite the fact that Indonesia has one of the world’s most vibrant economies, built almost entirely on domestic consumption. The US dollar, for all its troubles, remains a safe haven asset and money is returning there during difficult times.
3. Traditional safe havens are not behaving like they used to. Gold fell with all other asset classes, presumably because people have had to liquidate their holdings just to get cash.
4. On its own, the US economy probably wouldn’t go into recession; there’s nothing happening there to suggest the economy would shrink, just grow sluggishly. But the crisis in the eurozone on top of America’s other problems – unemployment, fiscal deficit – may be enough to create the so-called double dip, with the US returning to recession barely two years after coming out of the last one.
5. Remember what happened to the Aussie dollar in 2008? As the world economy floundered, demand for commodities suffered, and assets moved to US dollars for safety, causing the Australian dollar to decline. It’s already starting to do so again, dropping below parity last week, and if we do go back into global recession there will likely be further to go. That said, this time around Australia is a higher rated sovereign credit than the United States, and the case for it as a safe haven is better than ever. If the world investment community does decide the Australian dollar is a safe haven, that should push the currency up, not down.
6. In the medium term, fund managers tend to see good prospects for Asian bonds. Some say Asian equities too, but there’s also a fear that things are going to get worse before they get better.
7. In the meantime, cash is looking rather attractive.
8. And how about Australian equities? Investors will have fresh memories of the market halving over 2007 and 2008. Just like last time, the crisis has very little to do with Australia – arguably even less so. The last crisis was about the banking system, and Australia did have some problems in that area. But the current crisis is about sovereign debt, and Australia has no problem at all in that respect: it is one of the most robust economies in the world. But as we learned last time, when a global stock rout takes place, pretty much everyone suffers, fairly or otherwise. Analysts are already pointing to the good long term value in the Aussie market: Aussie shares now carry a grossed up dividend yield of 7.3%, which looks attractive. But the mood is very much buyer beware.

Asian central bank governors are shifting their focus from inflation to growth in the wake of problems in the world economy.

The Bank of Thailand has raised rates on seven consecutive occasions since December, to 3.5%, in an attempt to combat inflation pressures, but that process appears to be over for the time being. “I think we were on the right direction so far, but if you ask the question from now on, we do think the slowdown in the world economy will mollify somewhat the inflation pressure,” Prasarn Trairatvorakul, Governor, told Emerging Markets. “The job is to take a proper balance, but the balance lately has tilted towards the risk of growth becoming more apparent than inflation pressure.” Bank of Thailand’s next meeting on interest rates takes place on October 19.

In some respects, the global slowdown makes life easier for Asian central bank governors, who in many cases – most notably India and Vietnam – have wrestled with limited success with inflation this year. “We hope that some slowdown in the world economy will lower the pressure from the supply side,” Prasarn said. He added that domestic consumption in Thailand remained very strong.

Zeti Akhtar Aziz, Governor of Bank Negara Malaysia, agreed that inflation had largely ceased to be a pressing issue for Asian central banks. “As commodity prices stabilized, which was a major factor from the supply side producing higher inflation, demand has slowed globally,” she said. “This will limit inflation, so most central banks have paused their increases in interest rates.” Bank Negara hiked rates in four steps from 2% to 3% from late 2010, “to normalize interest rates and adjust the degree of monetary accommodation,” but ceased in July “given the increased uncertainties and the significantly heightened risks to growth.”

Zeti said she expected emerging markets to continue to grow, but at a slower rate due to the global economy. “In emerging markets we are doing better [than the west] but we are going to see moderation in our growth,” she said. Malaysia’s economic growth was just 4% year on year in the second quarter of 2011, though Zeti has said she expects full year growth of at least 5%.

For central bank governors in Asia, “the biggest challenge is to have price stability in an environment of sustainable growth,” Zeti said. “You have rising prices, and at the same time you also have risks to growth, and those risks have become higher because of what is happening around the world.”

Prasarn noted that Thailand’s international trade had been shifting towards an intra-regional focus, and less from the USA and the eurozone, so from his perspective “the feeling is not too pessimistic or optimistic. There are threats from what’s happening in the euro zone and the US, but there are also encouraging factors like regional integration in trade and financial flows.”

Prasarn said that international investors appeared to have responded well to Thailand’s new government. “On the positive side, the winning is quite clear, rather than a political system which is split,” he said, noting the stock market had risen after the election. “Longer term it very much depends on the results: the outcome of the work produced by the government.” He did, however, appear cautious about a controversial new rice policy that pledges to buy rice at inflated rates and has pushed rice prices up globally. “That’s also our concern,” he said. “We hope that whatever the plan, it will be executed efficiently.”

The architect of the Doha development round has said it would “break the heart of the world” if the Doha agenda is not implemented.

Mike Moore, who was Director-General of the World Trade Organization when the Doha round was launched, and is the former prime minister of New Zealand, said “it would be a great folly to declare the Doha round dead. You’ll never get it up again.” He said that the scope of the Doha round should be increased, without abandoning the original agenda. “We have to keep Doha, and widen it to represent the new realities of the economy,” he said. “We must face 21^st century issues, but not at the expense of 20^th century issues.”

Others backed his claim. “We will literally be crying because we didn’t complete Doha,” said Ernesto Zedillo, Director of the Yale Center for the Study of Globalization, and former President of Mexico. “We will regret that the Doha agenda, which is not only about agricultural and non-agricultural products but about discipline in other aspects of international trade, has not been fulfilled.” But he agreed the agenda needed to be modified.

But Arvind Subramanian, senior fellow at the Peterson Institute for International Economics, said what was needed was a new agenda reflecting the influence of China on the world economy. “No emerging country wants to take down its tariffs when China has its undervalued exchange rate,” he said. “The big development in the trading system is the rise of China, and it’s potentially a threat, which I think we have to respond to. Essentially we need a new China round of trade negotiations that can take on board the Doha round.”

Zedillo said that any trade agenda had to focus on agriculture, which was a driving element of the Doha round. “Agriculture today is more important than 10 years ago because we are creating new middle classes in the world that want to be fed better, and we face demand for food that we have not faced before in history,” he said. “We need the market economy to provide solutions to that.” He bemoaned the “rich countries [that] complain and accuse developing countries for demanding special and differential treatment,” arguing that the rich countries had in fact invented preferential treatment, for themselves, on agriculture in the past. “We will not be able to feed the millions of people that will be living in the next years if we don’t get serious about agriculture,” he said.

Zedillo also called for greater discipline on preferential trade agreements – or “discriminatory trade agreements”, as he called them. “I want a rule-based, reciprocal, universal, zero-tariffs system. That’s the best system for humanity,” he said.

And he warned of the perils of neglecting trade imbalances. “Fundamentally, trade is about international peace and security,” he said. “Economic incompetence can destroy geopolitics and but at risk that international peace and security,” he said.

A senior Indian policy official has denied that a new definition of the poverty line in India will penalize millions of the country’s poor.

On Tuesday India’s planning commission filed an affidavit with the country’s Supreme Court to re-set the level at which people are considered to be poor: those in rural areas living on more than 26 rupees (around 50 US cents) per day, and more than 32 rupees in cities, will not be considered poor – and therefore ineligible for government assistance such as food subsidies. The figure is starkly lower than the World Bank’s definition of the poverty line, at $1.25 per day.

But Kaushik Basu, chief economic adviser to the government of India, told Emerging Markets that the government had not yet decided which definition of poverty to use, and that the final definition would allow assistance to as many individuals as possible. “We are inclined to use the most generous definition,” he said, “by which I mean a definition where more people will qualify as poor.” Asked if the definition would impact who would qualify for food subsidies, he said: “Who will qualify as poor will certainly depend on this.”

The move has been widely derided as an attempt to make India appear to have less people in poverty than it does, but Basu said it was instead related specifically to a new food security program. “There are three competing definitions of poverty that are used in India,” he said. “When we switch from one to another, we don’t want to the mistake of… having poverty going down just by changing the definition: of course we don’t want to do that. But now we are going into a new food security program where we are going to try to reach out to a very substantial portion of the poorer population, we have data on the new definition so we can do that job better.” Previously the main definition of poverty in India has been based on calorie intake rather than income or spending.

Amar Bhattacharya, Director of the G24 Secretariat – and an Indian national who was previously a senior adviser on poverty reduction at the World Bank – also defended the move. “As long as you are consistent in the measure, I think that makes absolute sense,” he told Emerging Markets.

India’s opposition has pilloried the move. At a press conference in New Delhi yesterday, the BJP party spokesman Prakash Javadekar said the new criteria were “like rubbing salt in the wounds of the poor.”

“Estimating the numbers of people in poverty is an exercise which often ends in number crunching for the sake of justifying the government’s miserly investment in food and services for people living in poverty,” said Avinash Kumar of Oxfam India. “This seems to be the case here. This will exclude a vast number of people from essential services, when what is needed is universal access to basic needs like food, healthcare and education.”

Kumar added: ”In the past few years, four different commissions set up by the government of India have come up four different estimates of the number of people living in poverty. This confusion within the government itself is a testimony to the government’s shoddy and often self-serving attempt to shy away from its real responsibilities.”

Basu also claimed that poverty was declining in India. “From 2005 to 2009, we know that poverty has gone down quite substantially no matter which definition you use.” Even based on the new definition, India would have more than 400 million poor, or around one third of the population.

Former Federal Reserve Chairman Alan Greenspan has called upon the US to prioritize reducing debt over stimulus, calling the debt position “the most extraordinarily difficult fiscal problem the US has ever had.”

“There has never been a question about the quality of American sovereign debt since we started in 1791,” he said. “If we had the luxury of waiting, I would say we could probably find a theoretical construction in which we would stimulate today and pay off the debt later.” But he said waiting was not an option.

“My view is, when confronted with an issue like this, you have to ask yourself in a policy sense what are the consequences if you are wrong?” If the US were to pay down debt and to find it wasn’t necessary, he said, “that is relatively easy to readjust. If, however, we assume we have time to counter this problem and we are wrong, then it is very dangerous.”

“I don’t think we can take the risk of not coming to grips with our debt problem fairly quickly,” he said.

Dr Greenspan said that if the US were to return to recession, it would be a consequence of problems in Europe. “If it weren’t for the existence of the euro problem, I would say it would be very unlikely. Though the American economy is confronted with a high degree of uncertainty, it isn’t the type of uncertainty that creates economic declines: it just suppresses growth.”

He described Europe as “the major problem” in the world economy, and appeared to question whether the euro’s existence had been sensible. “It turns out that 1999 [when the euro was formed] was one of those very rare periods in a boom when everything is working, including the euro,” he said. “I recall when the euro was about to go into play, I said: I don’t believe it, they made it work.” But it was predicated, he said, “on the conventional wisdom that Italians would henceforth behave like Germans. And here, I think, was a gross underestimation.”

“What we’re seeing now is a pulling apart of northern and southern Europe,” he said. “Northern Europe is essentially lending to southern Europe, and the question is, either there is fiscal consolidation – which implies political consolidation – or something breaks.

“Markets are telling us they are fearful that something will break, and Greece is weeks away from default unless there is a new tranche of funding.”

In light of problems with the euro, Dr Greenspan said there were lessons for emerging economies. “I would say it’s essential that they maintain flexible exchange rates,” he says. “If your exchange rate is weakening because investment policy is not good, then adjust that, but don’t try to artificially lock yourself into a stronger currency in expectation that the benefits of the stronger currency will flow to you without cost.”

In other remarks, Dr Greenspan criticized Obama administration policies based around job creation. “I have a problem defining a goal of government policy as jobs in the private sector,” he said.  “Corporations try to keep their workforces as slim as they know how. They work very hard not to create jobs, but to destroy them.” Government should instead create economic conditions in which businesses have to hire people to meet demand.

Asked about the internationalization of the renminbi, he said “I think it’s many years in the future… At this stage I don’t see the Chinese will perceive it to their advantage to do what is required for the RMB to become an international currency.”

India’s finance minister, Pranab Mukherjee, has warned there is a danger of currency wars as emerging market countries seek to avoid the pressures that come with their climbing currencies.

“If the crisis deepens further and there is greater volatility in financial flows, there is an increased risk of this happening,” he said.

“Our view is, if such tensions arise, they should be eased through dialogue, not through competitive devaluations.”

Mr Mukherjee argued that the rising level of emerging market currencies ought to be reflected in the mechanisms used to build special drawing rights, the international reserve assets created by the IMF.

“In the BRIC countries, as their contribution to world output and economy is increasing substantially, therefore the currencies used in these countries should have to be widely appreciated.” That, he said, “should have been taking into account while determining the ingredients of the SDRs.” He added, though, that India was not calling for that today because other factors, such as free convertibility of currencies, need to be taken into consideration. “But the importance of these currencies has increased.”

Reserve Bank of India governor Duvvuri Subbarao said that India was able to absorb the high levels of capital flows it has been receiving, and had no immediate intention of imposing controls upon them. “At the moment we have a current account deficit and are able to absorb the flows that are coming in,” he said. “We are quite unlike other emerging economies which are having a problem of excess capital lows.” He said the RBI would continue to use a range of “quantity and price instruments” to manage capital flows, “so that they bring foreign savings necessary for our development.” He said that using taxation to manage capital flows was “clearly not off the table,” but added: “the question of foreign controls is clearly outside any policy consideration at the moment.”

One of India’s most central challenges today is inflation, which logged a 9.8% (headline) and 7.6% (core) year-on-year increase in August, above consensus expectations. “The high inflationary environment is clearly not going away anytime soon, with underlying inflation pressures firmly in place,” said Leif Eskesen, chief economist for India at HSBC. “Moreover, there are further upside risks to the inflation outlook.”

The Reserve Bank of India has acted aggressively to combat inflation, raising interest rates 12 times and 500 basis points in (WILL CHECK), slowing growth as a consequence, without managing to bring about a decline in the headline inflation rate. But World Bank chief economist for South Asia, Kalpana Kocchar, said that momentum inflation is starting to come down. “The RBI has done a good job trying to put a lid on demand pressure,” she said. “A lot of these pressures are coming from a big increase in rural demand as a result of the push for inclusive growth,” such as a national rural guarantee scheme. “On one hand that’s a good story, putting more money in the hands of the poor, but it’s straining the resources of the economy and that’s causing inflation.”

She said India faces pressure as the only South Asian nation to be fully globally integrated, both on trade and finance, and noted that India’s main stock market index has fallen as much as or further than most developed countries, and more than emerging market composites. She noted “some home-grown problems with regulatory uncertainty and some policy paralysis in India,” and highlighted the need for investment.

Malaysia has big ambitions. In 2010 Prime Minister Najib Razak announced the Economic Transformation Programme: a vast, enterprising plan with the overall goal of turning Malaysia into a high-income fully developed nation by 2020.

Perhaps spurred by the arrival of credible opposition in Malaysia for the first time in its modern history, Najib’s reforms go further than broad macroeconomic goals. They include political and social change as well as capital market development and a revamp of corporate governance among Malaysia’s companies. The prize, in economic terms, is a targeted growth rate of 7% annually over the next 30 years, and Malaysian citizens who are four times wealthier in real terms in 2020 than they were in 1990.

[Subhead] Malaysia and world turmoil

In the short term, though, Malaysians are looking at yet another sequence of ructions in the developed world and wondering how it will affect them. The good news: Asean nations are, in the main, in far stronger fiscal positions than most other parts of the world and therefore better equipped to deal with the problems; while Malaysia doesn’t have quite the almost debt-free fiscal position of some peers, it looks dramatically healthier than any western nation you could name. The bad news: Malaysia’s still a major exporter, and can’t be completely immune from problems elsewhere.

“Malaysia is a relatively low-volatility country,” says Dato’ Lee Kok Kwan, Deputy CEO of CIMB. “During downturns it tends to perform much better [than peers] because of that lower volatility. The GDP growth rate for 2011 may be below 5%, but it’s still decent growth.” And to look on the bright side, the flagging world economy has dampened concerns that had been rising about inflation in Malaysia, fuelled by commodity price rises.

Analysts are broadly positive about Malaysia’s outlook. “We rule out a double-dip in the Malaysian economy,” says Manokaran Mottain at AmInvestment Bank. “Robust levels of domestic demand, along with ample liquidity and the government’s ETP, will provide support at the tail end of this year.” He acknowledges, though, that the unstable global economy is certainly a negative for Malaysia, hitting both overall trade and external demand. He expects a 5% growth rate to be achieved, provided there is not a very large drop in crude oil prices or major delays to ETP projects. “As a net exporter of oil, Malaysia still relies heavily on crude oil in terms of generating income for the country,” he says.

Much like Indonesia, there has certainly been no shortage of foreign capital wanting to engage with Malaysia. “We are awash with liquidity,” says Lee. “We’re at the highest level of excess liquidity ever: the central bank needs to sterilize the system.” FDI has increased, after a period of stagnation around 2009. And portfolio flows, which were negative for about three years up to the end of 2009, have become consistently positive, attracted to Malaysia’s commodities and defensive characteristics. Foreign ownership of bonds, too, continues to rise. “The fundamentals are almost zero foreign currency debt, high FX reserves, and significant surpluses in the current account and trade account. The country, structurally, is in very good shape to absorb shocks.”

Internationally, there is a similar view. “Whenever regional markets take a dip, Malaysia outperforms every time,” says Chris Oh, analyst at UBS. “Our view remains that Malaysia will still outperform, although the reality is it will go down.” The Malaysian market, he says, has long been a story underpinned by two themes. “One, it is a relatively under-owned market: foreigners who had not been in Malaysia will come to put money here. Two, on a relative basis, Malaysia has a more stable source of funding from domestic investors.”

[Subhead] Power in banking

Malaysia’s relative strength is probably most clearly illustrated in its banking sector. 14 years on from the financial crisis, it is a powerful industry, with RM1.6 trillion in assets, healthy coverage ratios and low problems with loan impairment. “If you compare the banking sector today versus 1998, the system is significantly different, and stronger,” says Lee. “Delinquencies are low, profitability is decent, structurally it is in good shape, and the reliance on foreign currency is low. 2008 was a severe, multi-standard deviation downturn, but Malaysian banks went through that crisis completely unscathed. Nearly all remained profitable.”

With this has come the development of a relatively deep and liquid capital market. The development of Malaysia’s local currency bond market in particular has been a vital prop to the growth of the financial system and broader economy. Where once Malaysian enterprises would have to seek dollar funding, and incur foreign exchange risk, now a wide range of issuers can tap ringgit funds at durations out as far as 25 or 30 years in some cases. That is a crucial support for long-term project financing, among other things, and as major institutional investors like the Employee Provident Fund continue to gain scale and sophistication, there is more and more reason to be positive about bond market strength.

This is one of the main sources of discussion today. Malaysia’s institutions are in the process of introducing their second Capital Market Masterplan, a document designed to govern the development of the markets over the next 10 years, alongside a corporate governance blueprint being launched simultaneously.

These programs are discussed in more detail in the roundtables within this report, but in essence they aspire to promote capital formation, expand the efficiency and scope of intermediation, deepen liquidity, build capacity, improve governance and help Malaysia become a more international centre. “There’s going to be a lot of work ahead of us for everyone involved,” says Tan Sri Zarinah Anwar, chair of the Securities Commission, Malaysia’s market regulator. “In the first capital market masterplan [which governed 2001-10), it was relatively easy to do because it was a very nascent market. In today’s very uncertain conditions, with so many diverse inputs coming from so many sources, we need flexible terms on how we implement the new plan.” Zarinah says that Malaysia has a “very robust infrastructure”, but notes it “needs to build a corporate governance culture: internalising the spirit and substance of corporate governance.”

[Subhead] Islamic leader

One of the mainstays of the development of Malaysia’s financial services industry and capital markets has been the evolution of Islamic finance in the country, creating what is unarguably the most sophisticated and mature market for Islamic banking anywhere in the world. While most countries are still trying to build a domestic industry, that job is clearly done in Malaysia; for the last few years, the priority has instead been to make Kuala Lumpur a hub to attract foreign capital into Islamic finance. The Malaysia International Islamic Finance Centre is the centrepiece of this initiative, and has already succeeded in attracting some of the world’s biggest name in funds management, such as Aberdeen to Nomura.

“The government has supported the market greatly, and the infrastructure and regulatory environment are already there,” says Encik Mohd Effendi Abdullah, Head of Islamic Markets at AmInvestment Bank. “It’s easy to operate in that system. The next step is, with the government having liberalized the industry, we need to attract foreign investment here into Islamic banking. The government has given several international licences.” For some time, an Islamic megabank licence has been under discussion, although meeting its onerous terms – such as US$1 billion of paid-up capital – has apparently been problematic for bidders. A licence is apparently going to be awarded in the third quarter.

The sense of going international is pervasive at Bank Negara Malaysia, the central bank, on both the conventional and the Islamic side. “The world is highly dynamic,” says Dr Zeti Akhtar Aziz, Governor. “The environment, both domestic and international, is rapidly changing. There is therefore further work to be done.” Partly, this is about product development. “As Malaysia moves up in the value chain and transitions to new areas of economic activity, new kinds of financing will be required.” She refers to urbanization, and an ageing population, as other spurs. But Zeti’s main enthusiasm these days, beyond the domestic duties she has fulfilled for more than a decade, is the sense of Malaysia’s role in a regional and world community. “Going forward, we will become even more interdependent,” she says. “Emerging economies will become more interlinked. Malaysia will be very much part of this process. In fact, our financial institutions are having great presence in other parts of the world while our own financial system will be more liberalized. We will become increasingly connected, especially with other emerging economies.” One of Bank Negara’s priorities today is positioning Malaysia’s financial system to be ready for that, and to be in front of it, in keeping with the national ambition to be a more developed economy.

Again, Islamic finance tends to underline these themes. Dr Zeti has, for example, been at the forefront of the development of the International Islamic Liquidity Management Corp (IILM), a collaborative effort between 12 central banks and two Islamic multilaterals. IILM will issue short-term multi-currency Shariah-compliant liquidity instruments in order to boost cross-border flows between financial centres, and to preserve liquidity among Islamic markets and financial institutions. Zeti personally was a spearhead in this initiative; not coincidentally, IILM’s global headquarters is in Kuala Lumpur.

Going international is not straightforward, though; while Kuala Lumpur has attracted some world-class names to set up in Islamic fund management, for example, it’s less clear that they’ve brought any money with them. With every passing year more people in the country talk about wanting internationals to commit to bringing capital in, rather than just creating an avenue for it to leave Malaysia.

Malaysia’s stock market has been in a period of innovation for several years, trying new initiatives such as launching derivatives, facilitating listed sukuk, launching real estate investment trusts and fostering an Islamic commodities exchange. It’s a significant presence: Dato’ Tajuddin Atan, CEO of Bursa Malaysia, points out that as well as the achievements in the bond market, the stock market is home to more companies than any other in the Asean region. The market needs more secondary liquidity – Atan discusses this in the roundtable elsewhere in this report – and would like a greater chunk of more government-linked companies to be listed (which is a stated ambition of Khazanah, the state entity tasked with improving the performance of those GLCs). But generally, it stands comparison with Asean peers very well.

The stock market also plays into the Islamic theme, with the vast majority of stocks (by number more than by market capitalisation, since most banks are not Islamic) being Shariah-compliant.

[Subhead] New politics

Malaysia is due a general election next year, and it will represent an interesting and potentially divisive time for the country. For most of its history Malaysia has had no credible opposition; the strong showing of Anwar Ibrahim’s coalition in the last election was a major shake-up for the country, and it is widely felt that Prime Minister Najib’s reformist efforts have in large part been prompted by the messages of that election. Najib has recognised the need to end affirmative action policies which have supported Bumiputras, or ethnic Malays, but which have arguably reduced competitiveness and ultimately caused the country to suffer. Ending these policies, while keeping the multi-racial country in some unity, is a major challenge, and the election will be something of a referendum on how he is doing. “There’s very little doubt that the Prime Minister is extremely committed to changing things, but with Malaysia it is a question of delivery and implementation. History suggests we should be cautious in that regard,” says Robert Prior-Wandesforde, head of India and South-east Asia economics at Credit Suisse.

If that test is passed, though, Malaysia otherwise exhibits long-term thinking, and not just because of Najib’s 2020 vision. A great deal of long term infrastructure is approaching the development phase in Malaysia, providing a spur to the economy if the external situation deteriorates. Between October 2010 and June 2011, six rounds of projects – 87 initiatives within 65 projects (out of 131 identified in an initial roadmap document) – were announced, expected to bring in RM170 billion in investment and 362,000 jobs, according to UBS. They are wide ranging: the first round included an Asia e-University, a six-star St Regis hotel in Kuala Lumpur, a foundry plant in the Kulim High-Tech Park, a new low-cost carrier terminal at the airport in Sepang, and a bio-oil fuel plant in Sabah, for example. Numerous others have been announced since from petroleum and gas to education, healthcare, data, technology and mass transit.

Malaysia has a long track-record of wildly ambitious plans and has not always delivered on them. For this series, a group called the Performance Management and Delivery Unit (PEMANDU) is tasked with enabling the projects. “Investors have been sceptical about the pace of ETP implementation as BN [the ruling party]’s other government initiatives in the past are perceived to have disappointed,” says Oh. “The roll-out pace suggests a greater urgency on the part of PEMANDU and the government to roll out the private sector initiatives that will help recharge the domestic economy.” Oh says, though, that investors are really waiting for the roll out of the biggest infrastructure spending projects, such as the MRT (mass rail transit), high speed rail and Klang river revitalisation. One knock-on effect of the initiatives may be warmer relationships between Singapore and Malaysia: one of the biggest projects underway in Malaysia is in Iskander, just across the strait from Singapore. As part of this project, a one-stop customs immigration and quarantine terminal should be built at each of the two land crossings between Singapore and Malaysia, which should halve the time it takes to cross the border.

Not everyone is convinced that Malaysia can do quite what Najib asks in the next 10 years. “That would be a challenging task,” says Taimur Baig, a chief economist at Deutsche Bank. “The country is endowed with rich natural resources and is unburdened by its relatively small population, but in terms of graduating to that next level where you can unambiguously call it an economic powerhouse, the jury is very much still out.” But even if it doesn’t achieve as highly as it aims, there are positive developments underway in Malaysia; at a policy and a regulatory level, many of the ambitions look like international best practice. The big question for the country will be whether those big ideas can trickle down into thorough, effective implementation.

Southeast Asian nations are braced for volatile capital flows caused by problems in developed world economies, but insist they are now strong enough to deal with them.

“We are seeing very significant surges in capital outflows and reversals,” said Dr Zeti Akhtar Aziz, Governor of Bank Negara Malaysia. “Previously it destabilized us quite significantly. But in the current environment we are seeing these flows are better intermediated by emerging economies.”

In Indonesia, Rahmat Waluyanto, in the debt management office of the Ministry of Finance, said foreign ownership of bonds had fallen from 35.4% to 33.6% in the space of the last week, but said net inflows into the government bond market stood at $5.5 billion year to date. “There is no reversal yet: the real money accounts still stay,” he said. “We have the capacity to withstand flows.”

In 2009, deleveraging by international investors led to the withdrawal of large sums from Asian markets, particularly Korea and Malaysia. “Our currency depreciated to levels we haven’t seen for a long time, and our reserves declined by 25 to 30 billion dollars,” Zeti said. “But we could take it in our stride.” Around 20% of Malaysian government bonds are foreign-held. Emerging markets generally have been heavy recipients of foreign capital since the 2008 global financial crisis, but Asian nations worry about the impact of sudden reversals during times of macroeconomic stress.

Both policymakers said their countries had specific reasons for being more resilient to capital flight. Zeti in Malaysia cited more resilient financial institutions, more developed financial markets, higher reserve levels and a more flexible exchange rate. “The central bank also has a wider number of instruments to absorb them and to sterilize some inflows so they don’t lead to the formation of asset bubbles,” she said.

Waluyanto said Indonesia was protected by its large foreign exchange reserves (which passed US$100 billion for the first time earlier this year), a widening domestic investor base, including retail investors and the growth of pension funds and insurance, and a measure called the bond stabilization framework. He said this involves strategies to anticipate negative impacts of sudden reversals, including buybacks of government securities by his office, the coordinated purchase of government securities by state-owned corporations, and using cash surpluses with the approval of parliament to buy into the market.

However Zeti said Malaysia is still not ready for full currency liberalization. Although foreign exchange in Malaysia is much liberalized since the Asian financial crisis, with no restrictions on inflows or outflows by residents and non-residents, the ringgit has not been internationalized in a way that would allow access to the currency in offshore markets. “At this stage, our assessment is that the internationalization of the ringgit should not be hastened,” she said. “The benefits must outweigh the costs. In an environment of highly volatile global financial markets, opening the ringgit offshore market could increase the risk of significant disruptions in our domestic financial markets.”

She set out the pre-conditions to internationalizing the currency: a stronger domestic foreign exchange market, with enough market players and products to promote two-way flows; capacity among domestic companies and investors to manage foreign exchange exposures; and better risk management and corporate governance practices.

Zeti said inflation had largely ceased to be a pressing issue for Asian central banks. “As commodity prices stabilized, which was a major factor from the supply side producing higher inflation, demand has slowed globally. This will limit inflation, so most central banks have paused their increases in interest rates.” Bank Negara hiked rates in four steps from 2% to 3% from late 2010, “to normalize interest rates and adjust the degree of monetary accommodation,” but ceased in July “given the increased uncertainties and the significantly heightened risks to growth.”

Zeti said she expected emerging markets to continue to grow, but at a slower rate due to the global economy. “In emerging markets we are doing better [than the west] but we are going to see moderation in our growth.” Malaysia’s economic growth was just 4% year on year in the second quarter of 2011, though Zeti has said she expects full year growth of at least 5%.

For central bank governors in Asia, “the biggest challenge is to have price stability in an environment of sustainable growth. You have rising prices, and at the same time you also have risks to growth, and those risks have become higher because of what is happening around the world.”