By Kevin Plumberg, Asia Asset Allocation Correspondent

HONG KONG (Reuters) – A crash in Asian exports has led to a rise in bad loans and a slump in credit growth in the region’s economies, trends that will crucially prevent them from becoming more independent of developed world demand.

Exports have plunged nearly 40 percent in the last six months in the Asia Pacific outside Japan, after severe recessions in the developed world killed demand. Just this week China, Taiwan and the Philippines all reported significant falls in exports.

The shock is forcing quick and profound change on economies throughout the region, with capital expected eventually to flow to companies driven by domestic consumption rather than exports.

However, rising unemployment, failed businesses and climbing rates of non-performing loans, defined as loans either in or close to default, have all made banks less willing to lend at precisely the time it is needed to fund new businesses and encourage big purchases of things such as property.

This has created the danger that the downturn in Asia will start to feed on itself.

“That’s the pincer we are in right now. Banks need to lend to get the recovery going but they are reluctant to do so because businesses are in distress,” said Subir Gokarn, Asia-Pacific chief economist with Standard & Poor’s in Mumbai.

China and India are clearly exceptions, with credit growth accelerating despite slumps in industrial output. The dominant presence of the government in those banking systems has helped to ensure the flow of credit, although concerns are rising about the quality of loans being doled out.

For the rest of the region, the slump in exports that started in the second quarter of 2008 quickened rapidly at the end of the year, taking credit along with it.

Credit has been slowing the most in Hong Kong, Singapore and South Korea — some of the richest countries in non-Japan Asia that are the most open to trade and capital flows.

In Hong Kong, total loan growth slowed to 8 percent in December on a three-month rolling basis compared with a year earlier, down from 22 percent at the end of June.

Singapore’s loan growth rate was halved in the same period, while credit in Korea shrank a whopping 20 percent in November.

NEGATIVE FEEDBACK

Of course, Asia’s banks are healthier compared with many institutions in Europe and the United States, where the value of toxic assets remains uncertain 18 months after the crisis began.

However, the severity of the global recession and the upheaval in the financial system have kept banks reluctant to lend, despite falling policy rates, forcing governments to step up with debt guarantees and rescue packages.

Slower credit growth increases the risk of what’s called a negative feedback loop.

“What this means is that consumers don’t get cash as easily, so they buy less. So there is less demand for businesses that sell less and they invest less. If they invest less then there’s concern that as sales slow, they will lay people off and there’s a negative cycle between consumption and investment,” said Matt Hildebrandt, an economist with JPMorgan in Singapore.

The longer an economy remains in such a cycle, the greater the chance that potential growth, or the lowest growth rate before inflation rises, will fall. While emerging Asia is not there yet, the risk is increasing, Hildebrandt said.

Hopes for the entire region lie in China and India.

Loan growth there has reportedly been resilient, with small companies hit hard by the export collapse getting a large share of the new money. However, this has raised concerns about the ability of these companies to repay debt and the growing amount of bad loans on the balance sheets of local banks.

Fund managers at JPMorgan Asset Management are overweight China in their regional portfolios, with an emphasis on consumption-related sectors, but are steering clear of smaller banks that have big exposure to the small and medium-sized companies that have been devastated by disappearing global demand, fearing a rash of bad debts.

BEWARE

The ghost of non-performing loans has already begun to haunt Asian banks’ balance sheets. After the Asian financial crisis of 1997-1998, many banks cleaned up their act by restructuring bad debt covenants or transferring assets to other entities.

Though only six years ago, a financial stability forum convened in Beijing found that deflationary pressures were making it a challenge for economies in the region to dispose of NPLs.

Ted Osborn, business recovery services leader with PricewaterhouseCoopers in Hong Kong, works with companies in China and Hong Kong that are having trouble paying their debts.

He said he expected a “substantial” increase in NPLs in China in the first quarter alone, as factories bleed jobs and losses.

“You will have a number of companies that have relied on their loans being refinanced not being able to refinance them as easily. They will have more difficulties in repaying the loans because of the export nature of many of these companies,” he said.

Alistair Scarff, an analyst with Merrill Lynch in Hong Kong, expects the ratio of NPLs to loans to rise gradually in Asia Pacific to 2 percent in 2009 and 2.1 percent in 2010 from 1.7 percent in 2008. Chinese, Indian and Malaysian banks will see the biggest increase in bad loans, and loan loss provisions will likely increase as well.

He recommended investors focus on bank stocks with higher asset quality in addition to valuation. He likes Australia’s Westpac Bank and Malaysia’s Bumiputra-Commerce Holdings.

With the risk increasing that a bank’s next loan will become a non-performing one, lenders have been cutting back. But they are also foregoing an ingredient of sustainable growth in Asia.

“The flow of credit is the critical link that needs to fall into place if we are going to see a recovery,” S&P’s Gokarn said.

source: yahoo finance.

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