Asia in a bubble — what bubble?

Written by HSBC Global Research

Monday, 19 October 2009 11:04

IS ASIA already in a bubble? Reading the papers, you might think so. However, although bubble talk is all the rage, at this point the region isn’t actually in one.

Of course, if left unaddressed, the current monetary set-up in Asia might ultimately blow a bubble of mind-boggling size. But, so far, the train hasn’t left the station.

This means two things. One, policymakers still have time to correct the course, tightening monetary policy even without the Fed.

Two, it isn’t too late to purchase your ticket if you believe officials will prove slow to respond. We’ll leave detailed investment calls to our respective strategists. For now, we consider from an economic perspective whether Asia has already entered bubble territory.

The evidence suggests not. But the journey appears rapidly headed in that direction.

A bubble, your trusted textbook will tell you, occurs when asset values deviate from their fundamentals. This definition, of course, is as ubiquitous as it is useless.

In practice, it’s virtually impossible to call a bubble when it occurs: only in hindsight does it reveal itself as such. But, this doesn’t mean that we cannot define circumstances in which bubbles are more likely to evolve than not. And economists have tried.

The literature offers a number of guidelines that help in their detection. The starting point is the following: bubbles are extraordinary events and are therefore associated with a significant deviation from trend of various indicators.

Take stock prices. Charts 1 and 2 show the percentage deviation of Asian equity prices from their long-term trend. The critical thing, of course, is to define the exact deviation that constitutes a bubble. Various studies suggest different thresholds.

But for highly volatile assets, such as equities, 40% has been suggested as a rule of thumb. We have indicated that level with a black line in charts 1 and 2. According to this criterion, Asia ex-Japan entered bubble territory in 1993, came close to one during the tech boom in 2000, and again hit the stratosphere in 2007.

Currently, however, we are nowhere near the bubble threshold. In fact, the trend gap for stocks is still deeply negative. Equity investors, of course, may quibble with this view based on all types of arguments, including P/E ratios and the like.

But, the point here is to show that from an economic perspective and one likely to be more prevalent in the halls of central banks than investment firms, we cannot unequivocally talk of an equity bubble at this stage.

Let’s move to property. Charts 3 and 4 show the deviation gap for residential property price indices for China and Hong Kong. This time, we simply define bubble territory at the point where the property price gap exceeds its long-term trend by one standard deviation (a definition we shall apply for the remainder of the indicators in this text).

According to our measure, China had two real estate bubbles: one between 2004 and 2005 and one in 2007/08. But, flashy headlines notwithstanding, our measure does not suggest that the country is currently in the grip of a fully-fledged bubble.

It is the same for Hong Kong: Over the last two decades the territory has seen three property bubbles, but isn’t witnessing one just yet. Where, then, does this idea come from that property is running wild in Greater China and elsewhere in Asia?

Two reasons. First, the quick snap-back of prices from their crisis lows has taken most, including us, by surprise, defying more rational explanations and therefore fuelling “bubble” talk.

Second, the breathtaking jump in property prices has so far occurred only in pockets: Beijing and Shanghai in China, for instance, and those coveted Peak mansions in Hong Kong. However, the mass market in both cases hasn’t exactly soared yet. In time, of course, it may, but that is another story.

Bubble hawks are pointing to one indicator, however, which is seemingly flashing red. Trends in the credit to GDP (gross domestic product) ratio are often taken as a reliable sign of asset price trouble.

Conceptually this may be correct: After all, if credit expands faster than GDP over time, money appears to be too loose and investors may start to do silly things with their funds.

Charts 5 and 6 show the credit to GDP trend gap (again, the percentage deviation of the credit to GDP ratio from its long-term trend): This indicator is now well above its one standard deviation threshold. Should we worry? Not quite. Upon closer inspection, it turns out that the ratio has risen largely due to the sudden collapse in nominal GDP (China excepted, of course) and not a surge in bank lending.

In fact, on that measure, the Asian financial crisis itself, running from 1997 to 1999, may be described as a bubble as well, which is hardly the case. In short: this indicator isn’t what it is often cracked out to be.

No bubble without leverage
But should we dismiss lending trends entirely? No. Asset bubbles require fuel and this comes generally in the form of rapid credit expansion. Chart 7 shows real bank lending growth in Asia. On a weighted basis, this has evidently soared of late. But, this almost entirely reflects the credit boom in China.

Looking at a simple average for the region, which places greater weight on other countries, this has actually come down since the crisis. To be sure, the absolute level of credit growth still remains quite high, especially considering the traumatic recessions these markets have just been through.

Still, as of this moment, for the region overall, lending trends are not suggestive of a bubble, which would presumably require accelerating, not slowing, credit growth.

And there is another point to consider. One feature of an asset bubble, though certainly not a requirement, is that leverage begins to build in the financial system.

If not, then rising asset prices may perhaps be described as rallies or booms, but not as bubbles, as the latter implies a painful deleveraging process once you hear the “pop”.

So what’s the state of financial leverage in Asia at the moment? Answer: Low and falling. Take a quick look at chart 8. Our regular readers will recognise the chart from previous reports, but we thought it worthwhile reproducing it here since we cannot think of any single chart that sums up Asia’s current financial condition best.

What we refer to is the loan to deposit ratio in the region’s banking systems.

As you can see, this has fallen of late, implying deleveraging among financial institutions (at least of the deposit-taking kind). But, this is not the whole story: consider also the level of the loan to deposit ratio. This is well below 100 and thus suggestive of excess liquidity in the banking system.

Before the Asian financial crisis, when the region was undoubtedly sailing the blissful world of a financial bubble, this ratio was well above the 100 mark.

The good news: We aren’t there yet. The bad news (depending on your point of view) is that we may get back there. With rates this low, this is more likely than not.

Hard assets, not just soft
One last point. Asset bubbles are usually associated with an investment boom. Only think of the fibreoptic craze during the tech episode or construction during the housing rage.

In fact, it is commonly held that asset bubbles are purely a financial phenomenon when in reality they are accompanied by soaring expenditure on physical assets as well.

Therefore, one useful indicator for the detection of bubbles is the investment to GDP ratio. Again, we look at the percentage deviation of this ratio from trend and define the bubble threshold as one standard deviation.

For Asia, excluding Japan and China, it is difficult to speak of a bubble at this moment, with investment spending as a share of GDP being so depressed relative to trend. Certainly, in the final years before the Asian financial crisis, and again during the tech boom, the investment trend gap was above, or at least closer to, our defined bubble level.

As for China, a similar conclusion holds: Even though investment here is stronger, reflecting in part the massive fiscal stimulus effort that the government has implemented, in relative terms it hasn’t deviated so far from underlying trend that one would have to raise the flag and call this a bubble.

Put aside your newspaper. Asia ain’t in a bubble yet. This may happen or it might not — but it’s still up to the policymakers to decide.

This report was dated Oct 16, 2009.

This article appeared in The Edge Financial Daily, October 19, 2009.

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