How a war in Iraq will affect Asia - China and Hong Kong are relatively well placed to weather the storm.

www.financeasia.com By Jame DiBiasio 17 February 2003

Even a swift, successful war in Iraq will have negative consequences for Asia, although China and Hong Kong have a better capacity to absorb a shock, according to analysts speaking at a panel sponsored by the Asia Society in Hong Kong.

A war will lead to some degree of economic slowdown in the West, which will hurt foreign direct investment in China. But companies everywhere, although investing less overall, will also look to cut costs and shift production to China, says Don Hanna, head of economic and market analysis at Citigroup/Salomon Smith Barney. So while FDI reductions are expected, they will be less than global falls in investment. Moreover China's internal consumer story is sheltered from the global economy.

Beyond that, however, most of the analysis is disturbing.

Peter Best, head of oil and gas equity research at CSFB, outlined several themes, not so much to predict oil prices as to assess the drivers behind them.

First, he notes the world already faces an oil problem, even without a war. OPEC has become an effective cartel, while developed countries have experienced lower inventories than they had in 1991. As a result, prices have risen. Moreover big petroleum companies such as Shell and BP have been unable for various reasons to increase production. Crude prices are now $36 a barrel, and a war will spike them to $40. The question is what follows: a price decline with lower demand and new production - or a sustained shortage? He also notes Venezuela may remain offline for some time to come.

Second, he says Asia is the world's biggest net importing region. Over 60% of its oil supplies as a region are imported, and most of that comes from the Middle East.

Third, this is not a short-term problem, but one that will worsen over the next 10 years. This is the flip side to Asia's (and especially China's) high growth rates. China is now around the eighth largest consumer of oil; Best expects it to become the second, after the United States. Meanwhile Asia's home-grown supply of oil is dwindling. As a result Asia's imports of oil will double by 2010 - requiring more oil than the Middle East currently produces.

Best says exposures to oil price rises vary across the region. Japan, despite its dependence on imports, is energy efficient and has a large stockpile, so he says it can ride out volatility. Australia, Indonesia and Malaysia are cushioned because they are also oil producers. China, also a producer, is vulnerable, as it has no reserve, and its growth means exports will grow 400% by 2010, making it as big an importer as Japan.

Taiwan, Korea and Thailand are all importers and have no stockpiles and are inefficient users.

Richard Hancock, Singapore country manager at security and risk management specialist Hill & Associates, says a war is likely to increase the prospects for terrorism in Asia. The length of the conflict, and its portrayal in the media, will shape the extent to which extremists will garner active support among the general population. “Any terrorist group requires a support base,” he observes. A prolonged war with civilian casualties increases the likelihood terrorists can find succour - shelter, information, supplies - in the region.

He also predicts an upsurge in anti-Western demonstrations that could get ugly. “During the Jakarta riots in 1998, Westerners felt they were spectators to events - but the next time they could find themselves the focus.”

Southeast Asia will get rocky. Both the Philippines and Indonesia, as well as Pakistan, have groups capable of getting weapons and making bombs, as well as anti-Western movements beyond the law. Many countries in Southeast Asia suffer from weak anti-terror laws or infrastructure: the ability of Singapore to nip attempts by extremists to bomb US and other Western targets is not universal.

Hanna said most evaluations assumed the war will be a general repeat of the 1991 conflict: short and sweet. This would mean a six-week firefight accompanied by oil at $40 a barrel for three months. But he says there is a possibility that these outlooks are too rosy.

The extent of an oil price spike and its duration depends on whether Iraqi and regional oil refineries are destroyed, as well as the willingness of OPEC members such as Saudi Arabia to increase production. Asia is particularly vulnerable: while US imports of oil equate to 1% of its GDP, Asian imports range from 3-5% of GDP. The Philippines, Korea, Taiwan and India are particularly exposed.

Should oil facilities be destroyed, in a worst case, Hanna sees oil priced at $80 a barrel through 2004, which will cut importers' GDP growth by 2-3%. So in the worst case, US economic growth would not be 2.5% but -0.5%. The benign scenario would have US GDP growth fall to 2.0% for a few months, and then rise on the back of fiscal stimulus and improved sentiment.

It would be worse for Asia, however, as it is dependent on US economic activity. Malaysia, Singapore and Hong Kong are open economies: trade accounts for more than 100% of their GDP. Other Asian countries' trade accounts for up to 50% of GDP. This is quite different to Japan or America, where trade is around 10% of GDP. Hanna notes, however, that Hong Kong is less vulnerable, despite its open economy, because so much of its trade flow is based on China. “Hong Kong is left with a cushion,” he says.

It's not all doom and gloom, either. Hanna notes that Indonesia and to an extent Malaysia, for all their weaknesses, would gain from higher oil prices. He reckons each dollar rise in the price of oil equates to $150 million more in exports. This would result in a strong fiscal improvement for Indonesia. But Hanna frets the offset would not compensate for trade losses for Malaysia. The Philippines, he adds, loses on all counts.

Moreover, all countries will suffer from changes to capital flows, Hanna says. Already risk premiums are rising, which leads to higher interest rates on sovereign bonds, which makes capital-raising expensive and stymies growth. Stock markets will also suffer - a really big problem for the US, where so many people own equities, but also for markets such as Malaysia's which have relatively higher valuations.

He also warns tourism's service flows will decline throughout Southeast Asia, particularly in Malaysia and Thailand.

Governments do have ways to counter these effects, Hanna says, by pursuing fiscal stimulus programmes. This is easier in North Asia: he notes Korea and China already are running fiscal surpluses. Hong Kong has been worried of late of deficits but has room to spend its way out of trouble, as have Singapore and Thailand. Indonesia cannot afford this option, but has the higher oil price. The Philippines' deficit is too far out of hand, however.

Lastly, Hanna foresees weaker exchange rates across the region. Even if higher oil prices spark inflation, he doubts central banks will tighten policy and raise interest rates. Such a move wouldn't take care of the problem of an oil shortage, and besides, inflation rates are already so low that it's not seen as a problem, for now.

Note that many of these observations are accounting for a middle-of-the-road outcome to the war. A best-case scenario would mean a short-lived spike in oil prices, followed by high growth in the US.

But to realize this requires a short war; the discovery of a ‘smoking gun' involving a weapon of mass destruction that is targeted at a neighbouring Muslim country; a stable post-Saddam Hussein Iraq; European investment in the new Middle East and participation in peacekeeping; and a focus on resolving the Israel-Palestine conflict. The extent to which these outcomes are not realized will determine how badly Asian economies suffer.