The Boao Forum for Asia 2016: Pre-Conference Reflections

ASEAN economic impact: Action and reaction reflections

Despite many challenges, the ASEAN economies are likely to do modestly better in 2016 compared to 2015.

First, global demand is likely to improve boosted by two factors in particular. One is the decline in oil prices. The other is that the large developed economies of the US, Europe, and Japan are set to expand with increased vigor this year. As their economies revive, companies are also likely to step up wage increases and spending on capital goods. The result is that their growth could generate more imports from Asia.

Second, negative global factors should dissipate to some extent. In particular, the worst of the decline in commodity prices which depressed rural incomes across Southeast Asia should be over.

Third, domestic headwinds are likely to ease.

While the baseline scenario for ASEAN is indeed better, some risks remain in the environment: First, the US Fed will be raising interest rates, which will have considerable impact on currencies and capital flows. Ensuing financial risk may have consequences. Second, a slower Chinese economy would pose some risks to economic growth as well as financial markets in ASEAN. Third, geo-political risks, particularly in the Middle East, could affect ASEAN by impacting oil prices or increasing threats of terrorism.

The global context for ASEAN economies is improving

We believe that the Group of Three (G3) economic growth will recover with greater vigor, led by the US in particular.

There are several reasons for our upbeat view.

First, we see the US recovery gathering momentum.

• Gradual improvements in labor markets, housing, bank lending and business confidence will feed on each other, reinforcing each other and producing much stronger growth than expected.
• This will allow one missing ingredient in the recovery to emerge — wage growth. Falling unemployment, reduced slack in the labor market will support this.
• The second missing ingredient, business spending on plants and equipment, is less certain but important for Asia, as this is highly correlated with ASEAN manufactured export growth. If firms do gain more confidence about economic recovery and that Europe and Japan are also recovering, then business capital spending should also recover and that will drive growth in ASEAN’s manufacturing sector, especially for Singapore, Malaysia, and Thailand.
• The third missing ingredient has been demand from its major trading partners: the Eurozone and Japan. We expect this to return as well.

Pending a shake up in financial imbalances such as high yield corporate debt, the US economy should surprise positively — above trend growth will raise inflation estimates, but the current account deficit will widen.

The Eurozone, is likely to do modestly better than in 2015.

• The composite lead indicators for the region are flashing positively, indicating above trend growth.
• The drag from fiscal austerity is diminishing.
• The region is also benefitting from setting multiple promoters of growth with the weaker Euro strengthening export competitiveness, while easy monetary conditions are helping demand. More controversially, the large inflow of immigrants, while creating political pressure, is also raising government spending, especially in Germany. Finally, lower oil prices will also raise real incomes and spending.
• Although there are still challenges in the area, financial conditions are slowly improving. Surveys of credit officers show that they are no longer tightening lending conditions, with some marginal easing evident in some regions.

Japan, too, is likely to perform somewhat better in 2016:

As with Europe, the composite lead indicator is rising. Moreover, the labor market is tight, causing wages to rise. In addition, the government’s policies on minimum wage increases will also raise consumption. Finally, low oil prices will help Japan as well.

The implications are positive for the ASEAN region. Given its high exposure to export demand, a revival of demand for manufactured goods in the G3 economies, which still account for close to half of the world economy, can only help exports.

Some of the negative factors in the global economy in 2015 are likely to ease.

Commodity prices have already fallen sharply in 2015. The commodity prices most relevant to ASEAN are unlikely to fall significantly in 2016. Note that ASEAN economies are principally affected by prices for soft commodities such as rice, crude palm oil, coffee, cocoa, and tapioca pallets. We believe that the worst is over for these items, which means that, unlike in 2015, falling prices will not drag down growth.

Energy prices are important to some extent for Indonesia and Malaysia but their effect is often exaggerated. As it has been a major coal exporter, coal prices are important to Indonesia, but as far as oil prices are concerned, Indonesia today is a net oil importer. Oil prices matter for Malaysia but as 80% of its exports are manufactured goods, the impact of oil prices on economic growth is limited. Oil prices do affect fiscal revenues, however, and as a result Malaysia is likely to have to adjust its planned fiscal spending downwards in 2016.

Domestic headwinds are likely to ease

While ASEAN dealt with a weaker global economic environment, it also struggled with domestic headwinds of many kinds. The good news is that many of these negative headwinds are likely to subside.

• Several ASEAN nations rationalized fuel and other subsidies, led by Malaysia and Indonesia. The initial effect was depressed consumer confidence as the cost of living rose but this negative effect should diminish in 2016. Malaysia also introduced a goods and services tax which further damaged consumer confidence. As some of the fiscal savings are being recycled back into the household sector through direct cash transfers to lower income people, consumer spending is likely to recover.
• Domestic demand was also hurt by macro-prudential measures introduced since 2012 to cool overheating property sectors as well as to rein in a worrying build-up in household debt. While household debt levels remain a concern, they have stopped growing rapidly, while property markets have cooled noticeably across the region, allowing room for easing of these restrictive measures.
• Bad weather as a result of the worst El Nino in almost 20 years hurt agricultural production while also causing damage such as the trans-boundary haze problem — when extensive smoke from burning peatlands in Indonesia led to widespread disruption in parts of Indonesia, Malaysia, and Singapore. This is unlikely to be repeated in 2016.

What are the major risk factors?

• There may be ill effects from US monetary tightening. In first half of 2016, there will be a recalibration of expectations of the steepness of the rate hiking trajectory by the Fed if the expectations for US economy discussed above materialize. This will probably spur a renewed round of capital outflows from emerging Asian markets, leading to currency gyrations and more financial stresses.
• The US Dollar is likely to strengthen against ASEAN currencies as these capital outflows cause external accounts to weaken. However, we do not expect the US Dollar to surge because by late 2016 it will be clearer that the Eurozone and Japan are doing reasonably well, thus supporting Euro and Japanese Yen against US Dollar.
• It is likely that China’s economy will stabilize in early 2016. Nevertheless, given the increased linkage between China and Southeast Asia through trade in goods and services such as tourism — both direct as well as portfolio investment by China — and likely increases in lending for infrastructure projects as a result of Chinese initiatives such as “Belt and Road Initiative”, worse than expected slowdowns or financial stresses in China would have damaging effects on ASEAN economies.
• Geo-political risks remain high: risks in the Middle East will tend to spill over into Southeast Asia through increased threats of terrorism, while clashes between Sunni and Shia Muslims in the Middle East could also lead to religious tensions in this region.

What are the likely policy responses within ASEAN?

Given this context, policy makers in ASEAN will have to tread a wary course to ensure growth without compromising financial stability.

• While some central banks may favor monetary easing, we believe that the scope is limited by financial turmoil and currency weakness.
• Fiscal spending on infrastructure is likely to rise. Several countries — Thailand and Indonesia in particular — are likely to see accelerated fiscal disbursements as large infrastructure projects finally take off.
• Supply side reforms, such as those by President Joko Widodo as he enters his second year in office, are shifting away from nationalism to being more open to foreign investment in selective ways.

Impact on ASEAN economies

Given these global and regional factors, the key factors determining how countries react will be:

• How much a country’s economy benefits from reviving G3 demand for manufactured goods exports;
• How credible the central bank is;
• Political risks and likely scenarios;
• Financial vulnerabilities;
• How the economic cycle is moving;

Using this framework, we now look at selected ASEAN economies.

Indonesia is certainly at risk and likely to be a net loser.

• G3 uplift is weak: Indonesia does not benefit so much from the G3 upside, given its export structure, so the key is the financial impact.
• Financial vulnerabilities: Indonesia continues to have too high a level of foreign ownership of equities and bonds. It has firms who have taken on foreign currency debts. Short term debt and reserves are uncomfortably low.
• Central bank: Its central bank has improved greatly but still does not have the same standing as banks such as Bank Negara Malaysia or Bangko Sentral ng Pilipinas. It has a history of sudden currency falls and rapid capital flight. Bank of Indonesia is itching to ease policy but lacks the credibility to do so. A mistimed move would send the Indonesia Rupiah (IDR) reeling and spur capital outflows.
• The economic cycle is turning. There is less drag from commodity price falls. Crude palm oil prices could rebound. Impact of fuel subsidy cuts fall out. Government spending is being ramped up.
• Political risks are manageable. The president is coming to grips with the levers of power.

Thailand is likely to be resilient if political shocks are avoided.

• G3 uplift can be sizeable: Exports have been weak through this year but it has a strong base of export-oriented manufacturing in automobiles, auto parts, electrical appliances, electronic components — much of which will benefit from G3.
• Financial vulnerabilities are contained: It has adequate reserves to fund external debt while years of political crisis have reduced foreign holdings. However, household debt has risen and so it is susceptible to rising rates, which the Bank of Thailand will have to manage. The banks are well capitalized and rigorously supervised.
• The central bank is credible and independent. The governor is trusted by the current government and King.
• Political risks are extremely high: there may be a nasty turn in political risk soon.
• However, the economic cycle is about to turn: Less drag from falling farm incomes, rectification moves and a strong impetus from fiscal disbursement. Commodity prices could increase.

Malaysia will probably be more resilient than given credit for.

• G3 uplift is very positive: Malaysia is one of the most open economies in the world.
• Financial vulnerabilities do exist: Household debt has risen but banks are well capitalized and rigorously supervised. Some of the external debt ratios look bad because its two banking giants are regional and book their debt in Kuala Lumpur.
• The Malaysian Ringgit (MYR) is probably hugely under-valued: Ringgit depreciation is not accompanied by a spike in inflation so it has preserved its competitiveness gains. This will become increasingly evident, as export orders have already been rising.
• The central bank is highly credible and well-prepared.
• The economic cycle is also turning up: Less drag from the negative impact of Goods and services tax (GST) and fuel subsidy cuts. The Economic Transformation Program public investments are strong and there is crowding in private investment as well. Commodity prices could bounce up.

Singapore’s uplift will be dominated by external demand.

• Big beneficiary from G3 demand: Its electronics sector is still important and will benefit greatly if G3 capital spending recovers.
• Financial vulnerabilities: High corporate and household debt and a deflating property bubble make Singapore susceptible to a spike in interest rates. Stress tests by both Monetary Authority of Singapore (MAS) and International Monetary Fund (IMF) suggest this is manageable from a financial stability perspective.
• The central bank is highly credible.
• The economic cycle is weighed down by domestic headwinds such as real estate deflation and corporate sector adjustments to lost competitiveness.
• Political risks are minimal.

The Philippines

• G3 uplift will not be so strong, with a low trade to GDP ratio and relatively small export-oriented manufacturing sector, but there could be a positive impact on overseas Filipino workers (OFWs) and Business Processing Outsourcing (BPO).
• Central bank is credible as it mostly gets policy right, and inflation is under control. The Philippine Peso (PHP) has been allowed to weaken more than needed.
• Financial vulnerabilities are not a major issue. There is no big imbalance or huge surge in debt levels.
• The economic cycle shows some signs that OFWs remittances are losing momentum and that BPO employment has stalled, so there are some warning signs though they could be temporary.
• Political risks are a tad high: The presidential election could be messy with Poe’s disqualification, etc.

Manu Bhaskaran
Founding Director and Chief Executive Officer
Centennial Asia Advisors