Strength from within and demand from outside: Asia’s continuing growth opportunity Voice of Asia, March 2018

2017 has been quite the year! One year ago, when we launched the first edition of Voice of Asia, 2016 had given us an unexpected outcome in the US elections and the Brexit vote. At the beginning of the year, we were heading into unknown territory, unsure of the impact of this geopolitical upheaval and uncertainty on global trade. The headlines were gloomy, and commentators were cautious, making forecasts for 2017 somewhat lacklustre.

When considering the year ahead, we looked beyond the headlines and saw some cause for optimism. We predicted that Asia would outperform the lacklustre economic forecasts of the moment. Now, one year on, we know that a pickup in both domestic demand and export performance in 2017 helped deliver stronger-than-expected growth in the region. In fact, the protectionist rhetoric outside of Asia had a muted impact, as intra-Asian trade increased across the board, with commodity and technology-based exports in particular benefitting from improved global demand.

Now, looking at 2018 politically, uncertainty and caution remain. In fact, we now know the extent of the complexities that Brexit will bring, and have witnessed the tendencies of the US administration to make quick and far-reaching policy decisions. However, we have also had a year where the global economy has thrived, money is cheap, and markets are confident.

Some of the largest economies in Asia have made progress in addressing what have been serious causes for concern. China has taken steps to move away from such a heavy reliance on construction, while actively managing risks in its financial sector, and India has put some key tax reforms in place that will yield long-term gains. Japan has also slowly been addressing fiscal issues and is now well placed to implement real structural reforms. Other Asian economies, to varying degrees, are diversifying, implementing business-friendly policies, and investing in capital deepening. This is due to a combination of domestic factors, low rates, and a strong external environment.

Following this upside surprise of higher growth in Asia in 2017, growth could be expected to moderate over the next year. However, we believe the economies in Asia will enjoy another year of faster growth in 2018. There are three main reasons why:

• Domestic conditions, with many economies increasingly benefiting from both their structural reforms and greater stability. Two of the major economies in the region, China and India, successfully navigated some of their key challenges last year and have come out on top.
• Infrastructure spending, which remains a key priority in the region and will support both near-term activity and longer-term productivity.
• Ongoing recovery in global demand is likely to provide even more impetus to the trade-driven economies of the region.

Factor 1: Domestic conditions are well placed to deliver growth

A number of economies in Asia, such as India, the Philippines, and Thailand, are experiencing a pick-up in domestic demand in the form of consumption.¹ In others, external demand has been a significant contributor to growth, especially in China, Indonesia, and Singapore. Intra-Asian trade continues to be the major driver of export growth, with over half of exports by Asian countries and territories being sold within Asia.² At the same time, inflation has been stable for a sustained period, which will allow monetary policy to continue to support the recovery.

There are two developments in Asian economies that will support growth in the near future:

• Temporary drags which had short-term negative implications for business and consumer sentiment, such as adverse weather conditions and the implementation of economically sensible measures, are dissipating across Southeast Asia.
• Reforms to improve the business climate are already helping to produce a leap in the ease of doing business rankings around the region.

The region is shrugging off past negatives

In recent years, governments across Asia initiated fiscal consolidation programmes to place their long-term fiscal trajectories on a sounder footing. The initially negative effects on consumer confidence hurt growth in the near term, but these effects are now dissipating:

• India’s decision to demonetise in November 2016 had a disruptive impact on growth, and cash shortages are likely to still be depressing activity among cash-dependent small businesses and poorer citizens. Nonetheless, the economy may have recovered somewhat from the shock of the suddenly announced initiative, as currency circulation has returned to pre-demonetisation levels. Furthermore, the long-term impacts of moving more of the economy into the financial and tax system will be positive. In the past year, the government implemented the unified Goods and Services Tax (GST), which aimed to provide a fillip to the economy. The short-term impact was marked by a slowdown in growth and supressed consumer demand. However, market disruptions now seem to be reversing.
• Malaysia implemented a bold new goods and services tax in April 2015 to offset declining oil revenues. It also rationalised fuel and other subsidies, initially giving households a shock. Recent data shows that the Malaysian consumer has now mostly overcome these ill-effects.³
• In Indonesia, lower oil prices afforded the Jokowi administration an opportunity to rationalise fuel subsidies in early 2015. The early impact was to drive up inflation and depress consumer confidence. However, as government revenues were freed and channelled toward such productive activities as infrastructure development and targeted cash handouts, the downside impact has been reversed.⁴

Moreover, between 2013 and 2015, central banks in many parts of the region had also implemented macro-prudential measures to rein in excessive growth in household debt as well as real estate booms that they feared might threaten financial stability over time.⁵ As with the fiscal reforms above, such measures restrained domestic demand for a while, but no longer.

Finally, the collapse in global commodity prices in 2014–2015 also hurt household incomes in the rural sectors in countries such as Indonesia, Thailand, and Malaysia. Bad weather (for example El Nino) in 2016 had also decimated agricultural exports in Malaysia, with palm oil being the main casualty as plantations were scorched.⁶ Elsewhere, Thailand had to contend with rural droughts over the past few years which had an adverse impact on crop yields.⁷ In India, overproduction and demonetisation also hurt farm incomes. Now, we find commodity prices stabilising and farm incomes in particular bouncing back, giving a boost to domestic demand.

Reforms are adding up, improving the business climate and thus boosting investment

In China, businesses have increased leverage as government encouraged spending and investment in heavy industry to boost economic growth. However, this resulted in significant overcapacity in the industrial sectors and increased financial sector risks. Chinese authorities have been progressing domestic reform to reduce this overcapacity, and so far the tightening measures in credit markets have had a generally muted impact on economic activity.⁸

Meanwhile, the Indian government has made huge strides towards financial inclusion by implementing the JAM trinity (Jan-Dhan Yojana, Aadhaar linkage and Mobile Subscription), which facilitates the delivery of services and transfer of government benefits to more than one billion citizens. Coupled with the demonetisation in late 2016 and Goods and Services Tax reforms over the last year, India is steadily moving towards a greater formalisation of the informal economy. More broadly, there was a significant improvement in the local business climate, with India jumping 30 places in one year to No. 100 in the World Bank’s “Doing Business” ranking.⁹

There has also been progress on the fiscal front as governments take advantage of stronger economic conditions to implement difficult reforms:

• In Japan, there has been a refocus on the fiscal arrows of Abenomics to lift the Japanese economy from a decade of tepid growth and the threat of deflation. On the agenda is a rise in the consumption tax rate from 8 percent to 10 percent in October 2019. Previously, a rise in the consumption tax has driven the economy into recession. But with conditions proving upbeat, it is likely that the 2019 rise will go ahead. Proceeds from the rise will be funnelled into policies aimed at boosting productivity in the ageing economy, including improved childcare facilities to support women’s participation in the workforce.
• To ensure fiscal prudence, the Philippines government is stitching together tax reforms to raise revenues for an infrastructure programme and to keep government finances on solid footing. Personal income tax rates will be slashed (except for high income earners), corporate taxes will be lowered, and other tax provisions will be simplified to improve taxpayer compliance. To offset revenue loss on these fronts, the value-added tax base will be expanded by reducing exemptions. Excise taxes on fuel and levies on sweets will be restructured. The government is also contemplating a tax amnesty programme in 2018 to broaden the tax base and raise tax rates further.

On the other hand, some governments are taking advantage of improved budget positions to boost spending plans and attract foreign investment, a key policy goal across the region to boost economic growth and longer-term productivity gains. Policy can focus on streamlining government processes, reducing corruption and red tape, as well as changing foreign ownership rules.

• A KRW 11 trillion supplementary budget—aimed at boosting job creation, social welfare expansion, and other income-boosting measures for the South Korean people—was approved in early 2017. Ramped-up fiscal spending will lead to increased investment in social infrastructure as well as support for real estate investment as incomes rise.
• The Singapore government aims to attract investment by leveraging its hub status and openness to trade and commerce. In 2017, the Committee on the Future Economy (CFE) unveiled seven strategies to boost competition and ensure the country stays relevant.¹⁰ To support this goal, the government has announced a flurry of measures and initiatives focussed on innovation and digitisation.¹¹
• The Thai government hopes to woo foreign investors to set up manufacturing bases in the region by offering significant external economies of scale for foreign firms to exploit. To complement the manufacturing push, the government has developed Thailand 4.0, a comprehensive plan for the country to pivot towards a knowledge-based economy with emphasis placed on R&D and innovation.¹² To this end, the Thai government has identified 10 target industries for the nation to prioritise which will be the new engines of growth.
• In Indonesia the reformist Jokowi administration has pushed ahead in its efforts to improve the business climate to attract foreign investment. Since the start of 2015, Indonesia has been implementing 16 deregulation policy packages to address Indonesia's business environment.¹³ In 2016, President Jokowi signed a regulation on the negative investment list which lists fields of businesses that are open and closed to foreign investment with varying percentages of ownership.¹⁴ These have correspondingly resulted in marked improvements in the macroeconomic environment, financial market development, and innovation, leading to record foreign direct investment (FDI) in the third quarter of 2017 and boosting Indonesia 19 places in the World Bank’s “Doing Business” ranking.¹⁵
• The Duterte administration in the Philippines recently instructed the National Economic and Development Authority to relax restrictions on foreign investments in eight areas, including retail trade and maintenance of domestic infrastructure amongst others. A revision to the Foreign Investment Negative List is in the works as the government attempts to open up sectors previously closed to foreign competition and ownership.¹⁶ There are also plans to lower the capital requirement for foreign investors to do business in the country.

Factor 2: A strong pipeline of infrastructure spending initiatives

Governments across the region have embarked on a burst of infrastructure initiatives. Not only will infrastructure projects boost the near-term outlook for economies in the region through higher investment activity, they will also support longer-term growth through an increase in productivity.

The largest infrastructure effort in the Asia Pacific region is China’s Belt and Road Initiative. The ambitious project aims to boost productivity and efficiency gains in Asia by improving trade links between Asia and Europe. The project is still in the early stages, but a number of infrastructure deals have already been signed under the initiative. The reach of these initiatives is illustrated by the agreement that the Papua New Guinean government has signed with China, which will deliver infrastructure projects aimed at enhancing agriculture, road, and water supply to rural parts of the country.¹⁷

But it isn’t just China that has an ambitious infrastructure program. Various governments across the region have committed large swathes of cash to infrastructure projects, predominantly in the transport space.

• Many state governments in Australia are awash in cash as revenues from stamp duty soared, with house prices rising rapidly over the past year or so, supporting the budget bottom line. This has manifested in a flurry of investment activity, including a number of large transport projects planned in the major eastern states.
• The Indian government has acknowledged the need to bridge the country’s infrastructure deficit with greater emphasis on public investment. The Modi government gave the greenlight to an INR 7 trillion infrastructure program in late 2017, with the aim to pave more than 80,000 km of road by March 2022. India has also taken steps to collaborate with international partners to speed up the process of infrastructure building. Specifically, India and Japan have been cooperating on infrastructure development in India's north-eastern states.
• In Indonesia President Jokowi has accelerated government investment in infrastructure—spanning the construction of roads, ports, power plants, and rail transport amongst others—with 37 projects currently in the infrastructure priority list and slated to be completed by 2019.¹⁸ To address the shortfall of funds, given the cap on government spending plans, the Jokowi administration is inviting private-sector involvement from both domestic and foreign investors.
• Further upgrades to pre-existing transport infrastructure are in the works in Singapore, with new and expanded metro lines due to commence operations in the coming years. There is also the Kuala Lumpur-Singapore high-speed rail project,¹⁹ a bilateral initiative between the Singapore and Malaysia governments.

And it’s not only transport receiving government funding, with both the Korean and Taiwanese governments expanding their fiscal stimulus packages to include investment in new technology, such as green energy and the adoption of artificial intelligence.

Although public investment is a major driver of growth in 2018, there are also signs that private investment is picking up. In Australia, private capital expenditure grew in year-on-year terms in the third quarter of 2017 for the first time since the end of 2012. Furthermore, the outlook is also positive, with planned capital expenditure picking up in the 2017–18 financial year.

The abundance of public and private investment will create jobs and business opportunities across the region in the short term. Looking longer term, improved connectivity will ease the movement of goods across each economy and support business productivity.

Factor 3: Continued recovery in global demand providing greater impetus to the trade-driven economies of the region

The global economy has turned a corner, with demand rising robustly since late 2016, and we believe that it will likely accelerate (figure 1.1). This cyclical upswing in the world economy has supported the broad-based lift in activity in Asia Pacific. More than 75 percent of the world economy is now enjoying an upswing, with forecasts anticipating global growth to rise to 3.6 percent in 2017 and 3.7 percent in 2018 from 3.2 percent in 2016.²⁰ Growth in advanced economies is at its fastest in three years, with OECD lead indicators pointing to slightly above trend growth (figure 1.2).

We believe there are three major forces at play that will power a modest acceleration in global demand, to the benefit of exporting nations in the Asia Pacific region.

The global economy is entering a cyclical upswing after close to a decade of crises and challenges

Simultaneous growth in most parts of the world produces an interesting dynamic where growth in some countries spills over into other groups of countries, reinforcing their recoveries which then spill back into the first set of countries, thus producing an upward spiral. The initial gradual rebound in activity in the United States boosted demand in other advanced economies such as the Eurozone and Japan. As the mutually reinforcing virtuous circles of economic expansion garnered greater momentum, trade-oriented East Asian economies joined in the economic upswing and gave an additional boost to the recovery in global demand, trade, and investment flows.

Underpinning this dynamic is the return to normal health of key motors of activity in the economies that were hit by the global financial crisis. In particular, business confidence is on an upward trend, which will support greater levels of investment activity as businesses become more comfortable taking on risk again (figure 1.3).

More of this recovery in demand and output is manifesting itself in the form of export demand; the under performance of global exports relative to world output is reversing.

This is a huge benefit for Asian exporters of manufactured goods. The components of the WTO lead indicators for world trade—air freight, container throughput, electronics trade, and export orders—are all rising, suggesting that this rebound in global exports has further to go. The volume of world trade flows continues firmly on an upward trajectory, with the CPB World Trade Monitor rising 5.1 percent year over year in September 2017, up from 4.5 percent in August 2017 and extending a run of accelerating increases since February 2016. The broader trend is that of sustained growth since late 2016—a marked shift from growth that was below 2 percent, or sometimes even negative, in the period 2015–16.

The uplift in trade has been supportive of the strongest improvement in business conditions in over half a decade, with the Global Manufacturing Purchasing Managers’ Index (PMI) clocking in at 53.5 for October 2017, its highest level since May 2011 (figure 1.4). The sub-index for new export orders—a lead indicator for future Global Manufacturing PMI performance—is also around its recent high.

Regional economies are gathering momentum, with the more trade-oriented ones such as Malaysia, Vietnam, Singapore, South Korea, Taiwan, and Thailand standing to benefit most. Export demand has filtered into manufacturing activity and then generated demand in ancillary areas such as port and airport activity, logistics, and trade-supporting services such as trade finance. Even for countries and territories that are not very export-oriented, outward shipments have seen some stability over the previous year. This has largely been true for India, where exports revived in 2017 and further from April to October 2018, after two consecutive years of weak growth .²¹ Much of this increase in exports was generated in engineering goods, textiles, pharmaceuticals, and chemical products rather than traditional commodities.

Extremely accommodative global financial conditions continue to support the global recovery

Generally, global financial conditions remain accommodative, in large part because signs of inflationary pressures remain remote. Equity markets have strengthened and volatility is low. Credit availability is generally not an issue as interest rates remain low (with the exception of China). Asset markets in many countries have benefited from this liquidity, helping to support household and business balance sheets. At the same time, capital flows into the emerging market and developing economies (EMDE) have returned (figure 1.5) and non-resident capital inflows to the region remain resilient (figure 1.6).

Despite stronger activity, price pressures remain subdued, giving space for central banks to maintain accommodative monetary policy to support the economic recovery.

There are tantalising signs of a further strengthening in private capital expenditure

Investment spending has been the missing ingredient in the global recovery; yet there are signs that it could return. What’s more, Asian exports of manufactured goods are quite sensitive to capital spending—a recovery here would add substantially to global demand for Asian exports.

We have seen core capital goods orders rise in the United States (figure 1.7), and the Tankan survey²² shows capacity utilisation in Japan at its tightest since 1991 (figure 1.8).

Indeed, for the first time since the bursting of its stock market bubble in 1990, the Tankan survey indicated that demand exceeded capacity for large Japanese companies.

In the Eurozone, easing credit conditions will provide more support for companies’ investment plans in the world’s largest import market.²³ Just as banks are becoming more willing to lend, rising business confidence suggests that firms will be more willing to borrow to expand. This is seen in the economic confidence index for the Eurozone, which recently rose to 114.2, its highest level since January 2001.²⁴

In particular, indicators of demand for technology goods such as semiconductor billings and the Fed’s Tech Pulse index are also at multiyear highs (figure 1.9). This is a new structural driver of growth: new and proliferating technologies such as data analytics, artificial intelligence, and the Internet of Things are taking off, producing sharp increases in the demand for a variety of electronics components manufactured in East Asia. A rise in global demand for technology could also positively impact foreign flows to India, especially with government initiatives such as “Make in India” and “Digital India” gaining increasing visibility.

Additionally, there are also underlying forces at work in the global economy that strengthen the case for a material uptick in investment.

• The tax bill approved in the United States in December should support an increase in investment given the emphasis on a large tax cut for American corporations.
• With the successful conclusion of the 19th Party Congress in China, the firmly ensconced President Xi Jinping will continue to progress his hallmark Belt and Road Initiative. This will drive a massive injection of infrastructure-induced demand into Southeast Asian and Central Asian economies. China’s infrastructure initiatives will support the launch of mega infrastructure projects in the region.

The global economy is set for a new investment cycle that will bolster the rebound. Investment spending has high multiplier effects in the short term and, by boosting production capacity, generates long-term growth as well. Finally, the trade effects of growth driven by capital spending are more significant than growth driven mostly by consumer demand.

There is a lot to be positive about when considering the outlook for 2018. Yet if the unpredictability of the last few years has taught us anything, it is the importance of looking at the flip side—examining and being aware of what might happen, as well as what we think is likely to happen. This is what we look at in our second article “The flip side: Being aware of what could go wrong in 2018.”