Asia's emerging markets are out of sync with the global economy. This has so far been a good thing, given inflation levels and punishing rate hikes elsewhere in the world. S&P Global Ratings expects that India and Southeast Asia's GDP growth will markedly outpace the global trend.

Yet spillover risks and contagion could surface. Beyond being caught in the crosswinds of a desynchronized global economy, Asia EMs are also exposed to geopolitical tensions, climate pressures, and technology disruption. China's recovery is dragging and will not offset weakness elsewhere, as in past phases.

There is, in short, a lot to talk about for this region, and S&P Global Ratings did just that at a virtual conference held last week. Our economists and analytical leaders debated the broad risks on policy rates and inflation, and how these are filtering into the outlooks for Asia EM households, companies, banks, and economies in general.

Those interested can replay the event by registering here. In this report, we summarize some highlights from the wide-ranging discussions. Please see our appendix below for more details on the speakers and topics covered.

A Diversity Of Drivers In Emerging Asia Ex-China

We see diverse drivers in Asia EM markets ex-China. Trade and manufacturing will propel growth in Vietnam, Malaysia, and Thailand, while domestic demand is key for India. Demographics are a plus for nearly all these countries, with the exception of a slightly grayer Thailand.

"India and Indonesia have the two largest and youngest pools of workers in Asia," said Christopher Lee, chief analytical officer for Asia-Pacific. "They will continue to benefit from an expanding labor force in years to come."

Better control over inflation than other emerging markets

Central banks in India and Southeast Asia have, by and large, been able to keep inflation within their targets. And they been able to do this without matching the Federal Reserve's cycle. As rate differentials and a strong dollar hurt external funding, domestic markets and banks have increasingly stepped up.

One small demonstration of this is in the recent pricing of a Malaysia local-currency medium- to long-term issuance with a weighted average cost of 4.5%, as noted by Richard Timbs, the sector lead for Pacific Corporate and Infrastructure Ratings.

"Issuers are also replacing U.S.-dollar funding with domestic sources, including one case of refinancing expiring U.S-dollar obligations with domestic funding, then swapping the fresh funding back into U.S. dollars," added Mr. Timbs. "Some banks are offering that service."

No doubt, funding gaps are still large relative to spending needed to improve infrastructure, including transport bottlenecks and logistics efficiency--as well as paying for energy transition.

Countries with shallow domestic funding markets (e.g., Vietnam) or a higher dependency on U.S.-dollar borrowing (e.g., Indonesia) could struggle to finance some of these needed investments. Restrictive market or financing policies could add constraints. That said, emerging Asia remains attractive to global capital.

"Investors tell us that they are keen to deploy capital in infrastructure projects with good cash flow visibility, inflation hedge, robust structure and strong sponsors," said Abhishek Dangra, the analytical manager for infrastructure and utilities ratings in South and Southeast Asia and Pacific.

Mr. Dangra also noted that investors are actively looking to find the replacement for China real estate developers in the Asian bond market.

Globally High Leverage Casts A Big Shadow

The "lower for longer" decade of stability after the global financial crisis (GFC) has allowed borrowers to push debt leverage up to record levels. Governments and nonfinancial corporates borrowed the most.

"It is obvious that with inflation, higher interest rates and geopolitical tensions, the operating environment is now less stable," said Terence Chan, a senior research fellow at S&P Global Ratings.

For example, we expect the U.S. speculative-grade default rate to climb to 4.25% by March 2024 from 2.5% at March 2023.

Most Asian countries have not fully matched the Fed's rate hikes, and some haven't moved at all. Yet with risk aversion elevated, speculative-grade issuers in the region are facing tougher refinancing conditions. We highlight China's local-government financing vehicles (LGFVs) as one segment where nonpayment risk could get worse rather than better. A "flight to quality" is driving a wedge between LGFVs owned by richer versus weaker governments (see "Skewed Funding Amplifies Default Risks For China LGFVs," published on RatingsDirect on July 6, 2023).

In Asia, tighter financing conditions and China's property downturn contributed to a doubling of the corporate default rate last year to 1.3% for our rated entities. The 18 defaulted issuers were predominantly in low speculative-grade ratings.

If Contained So Far, External Risks Loom

Asian financial companies so far avoided upheaval due to rising interest rates, as seen a few pockets globally. For example, crisis in regional banks in the U.S., and the Credit Suisse write-downs in Europe, did spill over to Asia. We have a stable outlook for the sector for a number of reasons, including solid deposit bases, sufficient economic growth, and the likelihood of rapid government support under distress scenarios.

Chart 1

We see strains on real estate sectors as one of the larger risks for banks in the region.

"The property market turmoil in China and Vietnam will have some spillover to the banking sectors, but we expect it to be manageable given their moderate exposure to property and our expectations of government intervention," said Geeta Chugh, sector lead for financial institutions ratings, South and Southeast Asia.

Geopolitical Risks Bring Shifts And Unknowns

Rising geopolitical risks make it harder for companies, investors and governments to plan. Particularly, the risk to disrupting supply chains. While we think China will remain a major manufacturing base, even domestic companies are increasingly adopting a "China plus one" strategy.

A few Asia EM countries will benefit from the "China plus one" trend--Vietnam and India stand out here. Yet in general, technology-import bans on China are a negative for the region as a whole. This is because they would curb productivity gains and thus growth potential for the region's biggest economy.

Bottom Up: How Are Asian Corporates Dealing With Elevated Inflation And Funding Costs?

Elevated prices are hitting corporate margin in sector- and country-specific ways, said Xavier Jean, the Southeast Asia country lead for corporate ratings. He anticipates that affected companies will have been able to pass through about 50% of recent cost increases by the end of 2023, though this number varies significantly from sector to sector.

If the pain proves short-lived, some upside might follow. This is so if higher end prices stick even after input costs normalize. "Will companies reduce their prices once input prices start to fall? Probably not if they don't have to. So you could end up having a protracted period of margin expansion," said Mr. Jean.

In terms of rates sensitivity, the most vulnerable niches remain asset and capital intensive sectors with high debt levels. These include real estate developers, REITs, some conglomerates and state-owned enterprises (see chart 2). Companies we rate in those sectors have ratios of debt to EBITDA above 5x on average.

Chart 2

Many companies, however, proactively raised financing when it was cheaper. On the whole, we think more downside rating actions would be driven by margin compression, than from higher funding costs.

No China Backstop This Time Around

"External conditions will stay tough," said Jose Perez-Gorozpe, head of credit research, emerging markets.

In wrapping up the conference, Mr. Perez-Gorozpe noted that policy rates look set to stay higher for longer in major economies like the U.S. That will make it harder for EM economies to ease. And some emerging markets, such as in Latin America and the Middle East, are also struggling with inflation and below-trend growth.

Asia EMs are in relatively better shape. But if external conditions worsen, this time around we won't have a major stimulus from China to save the day.

Writer: Cathy Holcombe

Digital design: Halie Mustow, Evy Cheung

Appendix

Global Emerging Markets Conference 2023: Spotlight On Asia-Pacific, July 14, 2023

Opening Address 

• Vera Chaplin, Managing Director - Asia-Pacific Regional Practice Lead

Keynote Address: Developed Markets 

• Paul Gruenwald, Global Chief Economist, on "Can developed markets manage inflation and economic slowdown?"

Session 1: Regional Outlooks

Peak China Or Not? 

• Q&A with Louis Kuijs, Chief Economist, Asia-Pacific, and Vera Chaplin on whether China's rebound is for real.

Asia EMs ex-China: The Risks And The Rise 

• Christopher Lee, Chief Analytical Officer, Asia-Pacific, and Vera Chaplin looks at the drivers, drags and demographics for India and Southeast Asia.

Session 2: Debt Leverage

Will Rising Global Leverage Spill Over To Asia? 

• Terry Chan, Senior Research Fellow, Credit Research & Insights, Asia-Pacific, and Eunice Tan, Head of Credit Research, Asia-Pacific and Senior Director & Sector Lead, Insurance Ratings, Asia-Pacific, discuss "Minsky moments" as they review some of the eye-popping leverage ratios the world over.

High Costs & Financing 

• Richard Timbs, Sector Lead, Pacific Corporate & Infrastructure Ratings, with Ryan Tsang, Managing Director, Analytical Manager, Financial Services, Sovereign & International Public Finance Ratings, Greater China, discuss funding and liquidity in the region. And whether wage inflation the next shoe to drop?

Geopolitics & Supply Chain 

• Eunice Tan and Terry Chan debate the ramifications of China Plus One on supply chains. And how increased controls might affect the semiconductors industry?

Session 3: Sectors

How Are Corporates Managing The Pressure Of Rising Costs And Interest Rates? 

• Xavier Jean, Country Lead, Corporate Ratings, Southeast Asia, and Christopher Lee, drill down on how rising costs and interest rates are hitting bottom lines for rated corporates.

Financial Services: Where Are The Risks? 

• Gavin Gunning, Sector Lead, Global and Asia-Pacific, Financial Institutions Ratings, with Geeta Chugh, Sector Lead, Financial Institutions Ratings, South & Southeast Asia, focus their discussion on contagion from upheavals elsewhere; property strains; and the outlook for insurers.

What Are The Implications For Sovereign & International Public Finance? 

• Kim Eng Tan, Sector Lead, Sovereign Ratings, Asia-Pacific, Susan Chu, Sector Lead, International Public Finance Ratings, discuss which sovereigns are winners and losers in this higher interest rate environment? And is the relationship changing between China's central and local governments?

Infrastructure: A Crucial Sector 

• Abhishek Dangra, Analytical Manager, Infrastructure & Utilities Ratings, South & Southeast Asia and Pacific, and Christopher Lee, discuss what is holding back emerging Asia's energy transition? And how are global manufacturers coping with the rising frequency of extreme weather events?

Closing Address 

• Jose Perez-Gorozpe, Head of Credit Research, Emerging Markets

Related Research

• Skewed Funding Amplifies Default Risks For China LGFVs, July 6, 2023
• Asia-Pacific Q3 2023: Domestic Demand, Inflation Relief Support Asia's Outlook, June 25, 2023
• Asia's Central Banks Are Right To Be Tough On Inflation, Too, June 22, 2023