Asia 2007: Robust Growth, Rising Risks

S&P Ratings says the region's economies and financial markets should remain solid, but an overheated M&A market could boost investor concerns

From Standard & Poor's RatingsDirect

Asia-Pacific financial markets will remain strong in 2007, but higher financing costs and more muted economic growth make a repeat of this year's stellar performance unlikely. Economic growth in Asia-Pacific is expected to again exceed most other regions in 2007, underpinned by strong domestic demand and intraregional trade, which will largely offset the impact of a slowdown in the U.S. economy.

These overall favorable economic and market conditions are likely to cause investors to minimize credit risk concerns and add fuel to an already overheated mergers and acquisitions (M&A) market. Indeed, the continued boom in M&A in the region has increased the volatility of share prices and the credit profiles of potential acquirers and target companies, raising new uncertainties for debt and equity investors.

Market Cycles

Nevertheless, investors are unlikely to curtail their very high tolerance for debt leverage, nor are corporates likely to ready themselves for an inevitable turn of the cycle. This should lead to the continuing deepening of the region's high-yield market, but at the cost of a number of companies slipping below investment grade, as well as a likely slight increase in the number of corporate defaults from what is now a cyclically low level.

Moreover, there is less upside potential for Asian equity markets in 2007 after such a spectacular performance in the second half of 2006. Tighter liquidity will have a dampening effect on regional stock markets, and earnings growth in 2007 and beyond will feel the pinch from rising input costs, wages growth, a heavier debt burden, and higher interest rates.

Looming Labor Constraints

Labor constraints also loom as a threat. Wage pressures are expected to build in Asia because of higher cost of living, increased pension and health-care costs, skills shortages, rising employment levels, and slower growth in the labor pool. The potential for a housing-bubble burst remains, but property prices should continue to be supported by urbanization and rising middle-class incomes.

On a positive note, the region's financial markets should continue to broaden and deepen in the year ahead. Rapid development of both the commercial and residential property markets will lead to greater issuance of real estate investment trusts (REITs) and mortgage-backed securities, while growth in infrastructure investment will rely increasingly on financing in the capital markets.

Furthermore, ongoing regulatory developments that are improving transparency, strengthening the local financial sector, and spurring foreign investment throughout the region, are encouraging growth in local financial markets. It is expected that governments across Asia-Pacific will continue to support the integration of local markets into the international capital markets. This process is bringing real and lasting benefits to local economies and international investors.

GROWTH: China still the key driver for the region

The outlook for economic growth in the Asia-Pacific region remains supportive, with growth rates expected to exceed most other regions in 2007, as strong domestic demand and interregional trade flows largely offset any potential export reductions stemming from an economic slowdown in the U.S. The region benefits from the three significant subregional economies of China, India, and Japan.

China, in particular, continues to be a key driver of regional growth, with the economic slowdown in the U.S. expected to dampen China's growth momentum only marginally. Consumer spending is expected to remain a supportive feature, underpinned by rising income levels and the wealth effect of higher residential property prices. Household indebtedness has risen to historical highs, although in many markets, debt levels have risen from a relatively low base.

Property markets are expected to remain active throughout 2007. Associated with the prevailing economic prosperity throughout the region has been strong demand for office space in most major commercial centers in Asia.