Asia/Pacific: Declining Profits Ahead
Andy Xie (Hong Kong)
Even though East Asia ex-Japan (‘EAXJ’) is unable to pass higher oil costs to its trading partners, high property prices and rising inflation are holding up business profits. When property bubbles deflate and inflation erodes consumer purchasing power, businesses will have to absorb the higher oil costs. Corporate earnings in 2005 could decline, in my view.
If oil prices do drop dramatically, it would imply a major burst in US consumption and Chinese investment demand. Corporate earnings would likely also decline in such a scenario.
Speculative unwinding has caused oil prices to decline by 13% from the peak on August 20. Demand may be slowing but probably not yet sufficiently to alleviate the tight supply-demand balance. The ultimate relief will come when property prices begin to adjust downwards around the world, especially in China.
Leveraged to Oil
About one-fifth of EAXJ’s GDP depends on trade directly. The higher oil prices have raised production costs for the region. The region, however, is facing difficulties passing the higher costs on to customers in richer economies like the US, Europe, or Japan.
The region (including Mainland China, Hong Kong, Taiwan, Korea, Indonesia, Malaysia, Philippines, Singapore and Thailand) is consuming about 14.5 million barrels per day (MBD). The Brent crude price has averaged $35.4/barrel, or $6.6 more than last year. The extra oil cost compared to last year is running at $96 million per day or $35 billion per annum (or 1% of 2004 GDP). The total oil consumption would amount to $185 billion for East Asia ex-Japan in 2004 or 5.3% of its GDP compared to 2.7% of GDP for the world as a whole.
Brent crude averaged $20/barrel in the previous 15 years. It is quite likely that the region’s economies are used to oil prices at such a level. Otherwise, it would not be twice as leveraged to oil as the rest of the world. If we use $20/barrel as the benchmark for measuring the impact of higher oil prices, the region is paying 2.3% of GDP more for oil.
Not Passing On the Higher Oil Prices
EAXJ is not passing the higher oil prices to its customers in richer economies like the US, Europe or Japan. The US import price has declined slightly for goods from newly industrialized Asian economies (or ‘NIC’s’) compared to a 3.3% rise for manufactured goods from industrialized economies in general.
Asian exporters do not have brands or proprietary technologies and often depend on brand owners or big distributors to sell their products. They are at the bottom of the global trading system and are the most vulnerable to price squeeze. The US import price for NIC’s has underperformed that for industrialized economies in general by 35% in the past ten years.
The concentration of IT goods among Asian exports could explain partly the weaker prices. However, we see prices declining for garments, shoes, toys and a broad range of products. The lack of pricing power for Asian exports is not just a product issue. It is due to excess labor supply and lack of brands and proprietary technologies.
The burden for absorbing higher oil prices is very heavy for the region. If EAXJ could raise export prices by 3.3% like other industrialized economies, it would amount to about $35 billion in extra income, sufficient to pay for the higher cost of oil.
Who Is Paying for Higher Oil Prices?
China stands out on vulnerability to high oil prices. Its consumption is running at 7 MBD, or up by 1 MBD from last year. Its production is probably still running at 3.5 MBD. The increased prices and the higher import volume are costing China $19 billion extra in 2004 compared to the likely growth of $200 billion in GDP. The marginal cost of oil to China is running at 10%, nearly four times the world’s average. China’s overall oil bill is running at $89 billion or 5.3% of GDP this year, twice as high as the global average.
While not passing high oil costs on to Western consumers, China is mostly passing them on to property buyers. China’s new property sales could reach 8% of GDP in 2004, of which one-third of the value could be from the price increase since the beginning of 2002. That price appreciation could amount to 2.7% of GDP. Relative to $20/barrel, China’s oil costs are higher by 2.3% of GDP at a total of 7 MBD. The higher property prices are paying for the higher oil costs.
Korea is passing the higher oil costs to its consumers. Its CPI was up 3.5% in the first eight months of 2004 compared to 3.4% for the whole 2003. Korea’s CPI inflation is likely to reach 4.5% for 2004. The extra 1% costs consumers about $4 billion. Korea’s oil consumption may be running at 2.4 MBD. The higher oil prices are likely to cost Korea $5.8 billion. The higher inflation could absorb 70% of that. In addition to the bursting credit bubble, the higher inflation is contributing to Korea’s consumption weakness.
China and Korea account for about 70% of the oil consumption in EAXJ. Other economies are obviously minor in the overall picture. Among these, I believe Thailand is the most vulnerable in Southeast Asia. It also appears to be passing higher oil costs to its consumers. Its CPI is up by 2.9% this year compared to 1.8% for the whole of last year. Taiwan’s CPI is already up 2.4% this year compared to zero last year.
The Profit Squeeze to Come
The profit squeeze is concentrated among exporters so far. The rest have escaped by passing the higher costs on to property investors or consumers; this is why corporate earnings have held up well.
The current mode of absorbing higher oil costs is not sustainable, in my view. Speculation is a major motivation in China’s property demand. As long as the expectation of price appreciation remains strong, China could sustain strong growth under high oil prices. As soon as the expectation for property prices reverses, China would not be able to grow fast and pay for oil prices at current levels.
The Chinese economy is at a turning point. Property prices are stalling everywhere in China. Most property experts believe that it is seasonal and that strong demand will return in autumn. I think that the weaknesses in the auto sector, stock, and property markets are related. Because China has expanded investment so much, there is not enough money to go around. Further, the Fed raising interest rates is slowing capital flow into China. This combination makes its property market vulnerable.
Higher inflation, unless accompanied by higher wages, will cause consumption to slow. But cyclical momentum is already turning down. I see it as quite unlikely that wages could accelerate from here. If labor unions force up wages, it would only lead to stagflation, while not reviving consumption.
The profit squeeze from higher oil prices will come, in my view. Unless consumers in the US, Europe and Japan are willing to pay higher prices for Asian exports, as soon as China’s property bubble begins to deflate, corporate earnings in EAXJ could decline.
The property bubble is also holding up US consumption power. As the Fed is raising interest rates, it is unlikely that American consumers would be willing to pay higher prices for Asian products. Thus, corporate earnings in EAXJ will likely decline in 2005, in my view.
morganstanley.com |
