By definition, a shock always originates where you least expect it. Early in 1997, as the global economic boom continued, the nature and timing of the next downturn were far from most people's minds. Then came economic turmoil in the region where experts least expected it - Asia. Now, Asia's economic woes are threatening to turn many of our basic market assumptions upside down.
During the second half of 1997, Asia has endured plummeting currencies and stock markets, and large mark-downs in economists' growth forecasts for the region. The promise of perpetual Asian growth no longer appears assured.
Considering the admiration and worldwide respect which the region and its Tiger economies have rightfully enjoyed over the past 15 years, these recent events have a certain poignancy, and they seem less a disappointment and more a betrayal. Much more than mere momentary uncertainty, they could provoke loss of faith. It has become legitimate to ask whether we should now test our faith or discard it.
Then there is another question: if Asian economies are tumbling along with their currencies and stock markets, can the region's aviation sector be far behind? Will the sector experience serious, irreversible damage?
The answer to both questions ought to be no. True, Asia's aviation markets are facing a downturn, with lower traffic, lower load factors, lower profits, lower cash flow and, most significantly, lower liquidity. A painful period of adjustment will follow. But fundamentally and in the longer term, Asia's aviation markets are sound. Over time, they will regain much of their former charm.
NOT INVULNERABLE
Asia still represents the highest market growth potential over the coming two decades. Its markets are simply not invulnerable any more. Although humans are inclined to react viscerally in these situations, a measured analysis of the facts can overcome raw instinct.
The world, however, does need to sit up and take notice. There are still some individuals who have failed to recognise the significance of the currency crises and worldwide stock market turmoil of late 1997. They heard the words but missed their meaning.
The aviation industry is experiencing its first real global business cycle. In previous industry cycles, geographical linkages were not so well established. In the past, there were economies capable of maintaining a degree of insulation from events outside their own sphere. Asia itself emerged from the last recession relatively unscathed.
But the insulation does not work any more. Whether we like it or not, we're all in this together now. Globalisation of markets means that economic shocks reverberate, and they do so in ways that are not always entirely familiar or predictable. The effects of factors like overcapacity, massive currency depreciation and liquidity problems in any region ripple outward.
As long ago as late 1996, there were some warning signs for Asia's airline industry. While making a speech in Geneva, a CIBC partner had the temerity to suggest that Asia would experience a downturn in the first or in the second quarter of 1998.
CRUCIAL ASSUMPTIONS
Underlying the analysis by the CIBC partner were several crucial assumptions. The first was that Asian capacity could probably grow faster than traffic, and much faster than revenues in dollar terms. This was based on the anticipated relationship between the relative size of the aircraft order book and the number of aircraft in service. He reasoned that yields, and therefore revenues, would come under pressure as a result.
The second assumption was that the downturn might reverberate beyond Asia by impacting liquidity: lower cash flows would translate into increased external capital requirements and reduced liquidity. Since the previous aviation cycle of 1989-1995, aviation capital markets have become much more dependent on each other. Under conditions where the overall capital requirements were growing as the result of a much higher rate of deliveries of new aircraft, the effect of any reduction in cash flow would be magnified.
So 1998 would mark the beginning of a period of overcapacity in some parts of Asia. This would be followed by a period of illiquidity in other markets, on the assumption that Asia's greater needs and strong international standing would divert investment from other markets which were perceived to be weaker.
Not surprisingly, these were not popular views at the time. Recently, though, they have gained some currency.
At that time, overcapacity was the chief concern. The CIBC estimates of future deliveries of new aircraft to Asian carriers, based on announced and anticipated orders, totalled roughly one-third of the fleet in service. A more recent analysis, which includes options as well as orders, indicates a worsening trend: the current Asia-Pacific order book shows that total seats on order have reached 47 per cent of seats in service. This ratio seems much too high.
In the 1996 analysis, CIBC estimated sales and retirements of existing fleet, the rate at which incremental capacity would come on line, and the rate at which Asian markets might absorb this new capacity. It would have been better to focus on traffic growth rates. To anticipate dislocations in other parts of the world in the event that external capital requirements expanded, CIBC analysed liquidity in what were seen to be apparently vulnerable markets in Latin America and Eastern Europe. The focus should have been on liquidity in Asia.
Above all CIBC, like most analysts, failed to predict this year's economic downdraft. The velocity of the downdraft was breathtaking. Its magnitude is no better evident than in the year-to-date results of Asian stock markets. Few observers will admit to a belief that markets are infallible oracles. However, conclusions to be drawn from this data are very likely to be directionally correct. And it is, after all, the market results which have become the central symbol of Asia's economic malaise.
The charts demonstrate the dramatic change which has taken place. In the first 11 months of 1997, share prices fell between 20 and 60 per cent in US dollar terms in all but one of the principal Tiger stock markets (Chart 1). Expressing the prices in US dollar terms captures the combined impact of the decline in securities values and currency values. Six of the eight major Tiger currencies have slumped against the US dollar, with the Malaysian ringgit, Thai baht and Indonesian rupiah the worst affected (Chart 2).
Clearly the stock-market data serve as an index of misery and a measure of wealth-destruction for Asian investors, but they also suggest the direction of investment flows in the region - outwards, for the major part. They may also suggest the course of future flows as well - they can hardly be expected to reverse in the near future.
One of the features of emerging markets in the 1990s has been the prominence of foreign investment. There has also been a great deal of rational, and some emotional, debate about the relative contribution of foreign investment to the success of emerging market economies, especially those in Asia. It is difficult to imagine sustaining high single-digit or low double-digit economic growth rates in such an investment climate over the near term. This helps to explain why so many forecasters have reduced, some of them by half, their near-term expectations of economic growth rates for the region.
For the aviation sector, of course, economic growth and traffic growth are closely linked. So Asian aviation markets will feature overcapacity and the prospect of declining economic growth rates over the next few years - an unfortunate confluence of two events. Alone, either would be unpleasant: taken together, they are reminiscent of the US markets in 1991. Added to this is the currency crisis exacerbating what might merely have been a mild liquidity problem in the aviation sector. This makes it a triple whammy.
In order to contain the damage, there are a number of obstacles to overcome. These include the understandable reluctance of financiers to finance, and the hesitation of governments to assist in a meaningful way.
New financing must be undertaken carefully, if reluctantly. Existing financing may be restructured. Marriages will be arranged.
RELUCTANCE TO ACT
Many people in the financial community recognise two critical contentions. First, Asia has attractive long term prospects. Second, Asia's most formidable obstacle to containing the collateral damage and achieving its long term prospects may be a reluctance to admit the possibility of a serious problem existing in the first place. This leads to the second obstacle: reluctance to take decisive, responsive action.
Not too long ago, the western economies received a lecture which they did not enjoy. The West benefited enormously from those insightful but chafing homilies on cooperation, the sublimation of the individual for the common goal, total quality management, and the value of hard work.
Asia's business and political leaders would do well to be reminded of some western values: rigorous self-appraisal, full disclosure, willingness to champion an unpopular view, and courageous and decisive individual initiative.
With leadership, almost anything is possible. Faith, somewhat akin to liquidity, is belief in the possible.
Source: Airline Business
