Speed wobbles hit Asian giants

In the holiday-season euphoria, analysts appear to have become excessively upbeat about Asia's economic prospects for 2006.

Credit Suisse First Boston's latest forecast says the 10 biggest economies in Asia outside Japan will expand at a weighted average rate of 7.5 per cent next year. Three months ago, the prediction was just 6.4 per cent.

China and India are expected to race ahead, expanding 10.1 per cent and 8.5 per cent respectively.

While an optimistic outlook for Asia is plausible, it's important to recognise there are risks.

China and India face daunting challenges to economic stability in 2006 and the nature of the risks is well-known. Over-investment is the Achilles heel of the Chinese economy; India's flaw is too little investment put into rapidly increasing consumption.

"China's investment demand is based on excessive optimism about the future," says Andy Xie, Morgan Stanley's chief economist for Asia. "India depends on capital inflow to fund its consumption-led growth, like a poorer version of the US."

Domestic demand in China's red-hot economy hasn't kept up with the country's growing exporting prowess. The result is a persistent trade surplus, expected to triple this year to more than US$100 billion ($149 billion).

Making things worse, a state-dominated banking system wastes export earnings and foreign capital by pumping money into state-owned enterprises in industries where there's overcapacity, such as cement, steel and property.

Xie estimates that China needs to shift as much as US$250 billion of its economy from investment to consumption just to prevent new bad loans in the banking system.

India's situation is the reverse. Merchandise exports are constrained by shortages in basic infrastructure, such as power, ports, roads and airports. Computer software and back-office services, in which the country is the world leader, are still a small part of the Indian economy.

Amid surging domestic consumption, exports are nowhere close to their potential. That's forcing India to pay for its spending with US dollars sent home by overseas Indians or by selling domestic equity to foreigners.

Neither country's strategy is indefinitely sustainable.

In 2006, China will face a real threat of trade retaliation in the US.

If the US Treasury finds China guilty of currency "manipulation" and Congress slaps a proposed 27.5 per cent punitive tariff on toys, textiles, shoes and electronics imported from China, it will be a crushing blow for Beijing's export-led economic growth strategy.

Unless domestic demand in China rises quickly, providing a solution to the trade surplus and the overcapacity problems, rapid economic growth may be hard to sustain in 2006.

India's ballooning trade deficit is becoming a source of concern for overseas investors.

The trade gap soared to US$27 billion in the first six months of 2005, almost equalling the entire US$28 billion deficit of 2004.

Having poured a net US$10.6 billion into Indian equities this year, compared with US$8.5 billion in 2004, investors are looking closely at the trade deficit and feeling uneasy.

Consequently, the Indian rupee has weakened 2.6 per cent against the US dollar this quarter.

India's profligacy - public debt equals 90 per cent of GDP - makes investors jittery about financing even a modest current-account deficit.

"This macro pressure point [of rupee weakness]," say Merrill's Asia strategists, "has the ability to feed through the equity market, as we saw with Indonesia."

The Chinese and Indian economies may be tested next year even without an oil shock, a sudden collapse of the US dollar or a bird-flu pandemic.

"China and India," Xie says, "look the most vulnerable."

- BLOOMBERG