Cablegate: Analysts Uncertain About Effect of Market

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RR RUEHCHI RUEHDT RUEHHM RUEHNH
DE RUEHGP #1517/01 2290835
ZNR UUUUU ZZH
R 170835Z AUG 07
FM AMEMBASSY SINGAPORE
TO RUEHC/SECSTATE WASHDC 3789
INFO RUCNASE/ASEAN MEMBER COLLECTIVE
RUEHBJ/AMEMBASSY BEIJING 2592
RUEHBY/AMEMBASSY CANBERRA 1947
RUEHUL/AMEMBASSY SEOUL 4069
RUEHKO/AMEMBASSY TOKYO 5666
RUEHHK/AMCONSUL HONG KONG 6237
RUEHDN/AMCONSUL SYDNEY 0746
RUEHIN/AIT TAIPEI 6414
RUEATRS/DEPT OF TREASURY WASHDC
RUCPDOC/DEPT OF COMMERCE WASHDC

UNCLAS SECTION 01 OF 03 SINGAPORE 001517

SIPDIS

SENSITIVE
SIPDIS

STATE PASS TO TREASURY SSEARLS
STATE PASS TO SF FEDERAL RESERVE TCURRAN
BEIJING FOR DLOEVINGER
TOKYO FOR MGREWE

E.O. 12958: N/A
TAGS: EFIN ECON ETRD EINV PGOV SN
SUBJECT: ANALYSTS UNCERTAIN ABOUT EFFECT OF MARKET
VOLATILITY FOR REGIONAL ECONOMIES

REF: JAKARTA 2234

1. (SBU) Summary: Singapore-based financial analysts
believe market volatility could have real economic effects on
Asia even though the region has limited exposure to the
subprime mortgage and credit derivatives problems afflicting
the United States and Europe. Central banks across the
region this week have been intervening to shore up
depreciating currencies as Asian equity and foreign exchange
markets remain volatile. Analysts foresee the possibility
that more indirect exposures could come to light and
inflation caused by currency depreciations could lead to
monetary tightening in some Asian countries, particularly
Indonesia. Many traders and investors are hoping for a
dramatic response by the U.S. Federal Reserve to stem the
market decline, but most Asian-based economists are more
sanguine due to Asia's strong economic fundamentals. If the
volatility leads to a slowdown in U.S. demand for Asian
exports, however, Asia may be in for more economic pain. End
Summary.

Market Turmoil Hits Asia
--------------------------

2. (SBU) Asian markets finally blinked this week. Their
bout of nerves stemmed from the dramatic volatility in the
U.S. and European money markets caused by liquidity problems
in the subprime mortgage and corporate paper markets that
began around August 9. The results in Asia were not pretty:
equity markets in Asia were off sharply on August 16, with
Indonesia falling as much as 8 percent during the day and
developed markets such as Singapore losing more than 4
percent of their value. Overall, the Morgan Stanley Capital
Index of the market capitalization for stock markets in Asia
excluding Japan dropped 18 percent from its July 24 peak
through August 16, although it remains up year-to-date by 5.2
percent. The fact that Asian stocks have shown positive gain
for the year has led some analysts to believe that hedge
funds are selling Asian stocks to help make up for losses
elsewhere in the world.

3. (SBU) Foreign exchange markets also took large hits, with
many analysts noting that the sharp appreciation of the yen
(reaching 3 percent in 3 days) reduces incentives for
so-called "carry trade" investments in high-yielding
currencies such as the Indonesian rupiah. (Note: The yen
carry trade involves funding investments in currencies
earning high interest rates using the yen-denominated assets
which have a low interest rate. While commentators often
assume that these types of trades are mostly undertaken by
hedge funds, in fact, Japanese households in search of better
returns on their investments make up a significant portion of
these trades. See Reftel Jakarta 2234. End note.)

Weak Linkages to Subprime Problems
----------------------------------------

4. (SBU) Regional banking analysts have told us that
Southeast Asian financial systems have "very little" exposure
to the U.S. subprime mortgage sector. They note that most
regional banks are not sophisticated enough to "dabble in
complex credit derivatives." Exposure in Indonesia,
according to one official source, is non-existent among the
major banks, although it is impossible to rule out
inappropriate investments by smaller, private banks. Only
one smaller bank admitted exposure in Thailand. Singaporean
banks have the largest exposure in the region, with a total
of S$2.3billion (US$1.5 billion) in total exposure to
collateralized debt obligations (CDOs), the vast majority of
which are still highly rated by credit rating agencies.
Moreover, only S$0.6 billion (US$0.4 billion) of the
Singaporean banks' CDO portfolio is related to mortgages --
the section of the market under pressure in the U.S. and
Europe. One analyst estimated that writing off half of the
mortgage related CDOs would only reduce the banks' estimated
profit for 2007 by 5 percent.

SINGAPORE 00001517 002 OF 003

5. (SBU) Singaporean banks admit that their asset management
companies have approximately S$81.5 billion (US$53.6 billion)
in third-party assets that are invested in CDOs, of which
S$4.8 billion (US$3.2 billion) are mortgage-related products.
While banks do not disclose who holds these investments,
analysts presume these assets are widely dispersed and mostly
highly rated, diminishing the risks for systemic problems.

6. (SBU) Sources speculate that non-bank financial
companies may face more problems from the market turmoil than
banks due to their higher subprime and credit market
exposure. Insurance companies, for example, may have
purchased these products. However, insurance companies would
likely have purchased more highly rated tranches of credit
derivatives and would typically hold these investments for
the long term, thereby mitigating short term volatility risk.
The closure of the corporate paper markets may affect
finance companies that rely on debt (rather than deposits) to
fund their lending activities. However, these finance
companies could present some risk to financial stability to
the extent that many of them are owned by banks. Whether
this would have a systemic effect would depend on how large
the finance companies were relative to the banks and how long
the credit markets stayed closed, according to analysts.

Currency Moves Could Mean Inflation
-------------------------------------

7. (SBU) Media reports and market participants observed that
many central banks in the region were intervening to defend
their currencies. Most notably, Bank Indonesia, Bank Negara
(Malaysia), and the Monetary Authority of Singapore (MAS)
were cited in the press as selling their U.S. dollar reserves
to prevent further depreciation. Rapid depreciation, if
sustained, could lead to a surge in inflation. Analysts
cited Indonesia as particularly at risk for inflation, and
noted that the rise in the exchange rate to 9,500 rupiah per
dollar significantly reduced the likelihood of further
interest rate cuts for the rest of the year, something the
central bank had been planning to implement. Only Thailand,
which faces increasing political pressure due to a rapidly
appreciating currency over the last year, appears to welcome
the devaluation pressures.

Money Market Stability
----------------------

8. (SBU) In contrast to the foreign exchange markets,
Southeast Asian interbank lending markets have not seen much
volatility. Analysts noted, for example, that neither
Singapore nor Indonesia had seen volatility in overnight
interbank lending rates, suggesting that the excess liquidity
in the banking sectors and lack of direct exposure to the
U.S. subprime issues has translated into little if any
increased risk in lending to Asian banks.

The Way Forward?
----------------

9. (SBU) Several analysts mentioned that investors were
"praying for a Fed rate cut" to stem the slide and bail them
out. They noted that the futures market was now pricing in a
rate cut in the United States. Most Asian-based economists,
however, contend that an interest rate cut -- especially an
emergency cut by the U.S. Federal Reserve -- is unnecessary
to stop the turmoil in Asian markets. They compare the
current situation to previous bouts of instability in the
emerging markets, in particular those that lasted 5 to 6
weeks in April, 2006 and February - March, 2005. Most
analysts observed that it was probably good that investors
were reconsidering the relative risk of their investments. In
fact, as a result of the current turmoil, global risk
appetite has had its largest shift in ten years, according to
Merrill Lynch.

SINGAPORE 00001517 003 OF 003

Comment
-------

10. (SBU) Fundamentals in Asia are strong: most countries
are running current account surpluses; banks are well
capitalized and highly liquid; companies are not highly
leveraged; central banks have the power to limit currency
instability thanks to large FX reserves; growth is generally
solid; and direct exposure to subprime issues appears low
across the region. However, should the U.S. economy --
especially U.S. personal consumption -- weaken dramatically,
there will likely be spillover affects on the real economy in
Asia. The United States is, after all, the largest market
for Asian exports.

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HERBOLD

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