economic Insight

South East Asia

Quarterly briefing Q2 2013

Global slowdown is catching up with emerging markets

Welcome to the ICAEW Economic Insight: South East Asia, a quarterly forecast for the region prepared specifically for the finance profession. Produced by Cebr, ICAEWs partner and acknowledged experts in global economic forecasting, it provides a unique perspective on the prospects for South East Asia over the coming years. We focus on the largest economies of the Association of South East Asian Nations (ASEAN) namely Indonesia, Malaysia, the Philippines, Singapore and Thailand. The world economy remains fragile. The eurozone is unable to shake off its recession and many of its members are suffering extensive declines in national output as economies adjust to the strictures of fixed exchange rates. Public spending is being sequestrated in the US, slowing a labour market recovery that now depends heavily on the housing market for momentum. Monetary policy has been the weapon of governments choice in combatting the spectre of deflation and recession. Now, emerging markets are starting to show signs of slowing as well. China has eased off its super-charged growth trajectory, Brazil struggles to control inflation and to raise industrial output, and even oil and gasfuelled Russia appears to lack the energy for further growth. The deceleration of emerging markets in conjunction with the travails of Western economies has begun to pull commodity prices off their elevated levels. The prices of energy, mineral commodities and agricultural produce all appear set to lose ground, affecting export earnings for their producers and raising the possibility of a slump in some emerging

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markets. In summary, demand appears to be flagging in most quarters of the global economy. In this report we consider the impact that loose monetary policy abroad may have on the stability of ASEANs growth and the regions asset markets.

Global thirst for yield has boosted regional stock markets

In financial theory, stock prices are solely determined by the expectation of discounted future profits of the firms in question. However, many practitioners recognise that stock values are heavily influenced by the mood of the market and that expectations of the future can often be exaggerated both on the upside and the downside as the dotcom bubble and financial crisis have vividly illustrated. Investor perceptions of the promise of different asset classes plays a big role in determining prices, affecting demand for shares irrespective of an individual firms business prospects. The malaise of industrialised economies since the financial crisis, combined with low interest rates on offer, has increased the attractiveness of emerging market equities, making them a major beneficiary of investment inflows. ASEAN stock markets have ridden the wave of capital flowing in. The experiences of the different countries have diverged considerably, but an overall upwards trend in stock prices is clear. Figure 2 shows the rise in stock prices over the past decade. Despite the financial crisis, the ASEAN nations have achieved strong compound annual growth rates since 2003: 28.6% for Indonesia, 20.7% for the Philippines, 15.8% for Thailand and 12.9% for Vietnam. Though rising less quickly than the others, stock markets in Singapore with 10.1% and Malaysia with 10.2% still easily outpaced the 4.5% compound annual growth rate of Japan (Nikkei 250) or the 4.8% of Europe (FTSE Eurofirst 300) or the US S&P 500s 6.3%. Country fundamentals and corporate earnings prospects determined by these are the main driver of stock prices, but low earnings prospects and unattractive fixed income alternatives in industrialised countries are likely to have pushed up ASEAN asset prices. As well as gaining investment grade public debt ratings over the past year, Indonesia and the Philippines have become stock investors darlings, pushing stocks up 19.9% in the former and 34.1% in the latter in the 12 months to March 2013. Such growth rates are unsustainable and they may be seen as evidence of a bubble. We consider whether other indicators also point in this direction in the next section. Figure 2: Stock market indices (March 2003=100)
1,400 1,200 1,000 800 600 400 200

The return on safe assets has fallen to historical lows

During the Great Moderation from the late 1980s to the financial crisis, inflation targeting became the orthodox policy approach among central banks across major markets. The policy largely succeeded in driving down consumer price inflation and contributed to a steady decline in nominal interest rates. Figure 1 shows how the return on long-term government debt fell since the late 1980s to the present day. The long slump of Japan accelerated the decline compared with the US and Germany, but the joint direction of travel in all three countries is evident. The yields discussed here are in non-inflation-adjusted terms, but in the run-up to the financial crisis commodity prices and inflation rose and price rises have remained high since, mainly driven by the elevated cost of raw materials. However, the return on government debt, which varies inversely with demand, has continued to fall despite the higher inflation rates. Essentially, loose monetary policy is the key reason for this. The US Federal Reserve and the European Central Bank have dropped their benchmark interest rates to historic lows. When this policy tool was exhausted, quantitative easing was used to further reduce interest rates in an attempt to kick-start activity and avoid deflation after the financial crisis. The result has been a further decline in rates to unprecedented lows. Very low interest rates mean that investors in this major asset class are receiving meagre returns. The low return on public debt in the run-up to the financial crisis pushed capital into higher yielding assets, including sub-prime mortgages and junk bonds. The current lows in asset returns in government debt are again fuelling a hunt for yield. Emerging market assets have been a beneficiary and in the following section we look at the experience of ASEAN stocks as an indicator of this. Figure 1: 10-year government bond yields, %
% 12 10 8 6 4 2 0 86 88 90 92 94 96 98 00 02 04 06 08 10 12 United States
Source: Macrobond

0 03 04 05 06 07 08 09 10 11 12 13

Vietnam Indonesia Japan

Philippines Thailand Eurozone

Malaysia Singapore US

Germany

Japan

Source: SGX STI, IDX JSE Composite, SET SET50, MYX KLCI, PSE PSEi, HOSE VNI, Cebr

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Singapore productivity
Singapore has been a remarkable economic success story since independence in 1965 as it managed to sustain high, if somewhat volatile, output growth even after its industrialisation. Looking ahead, the growth outlook has diminished so that a slower pace of expansion is expected. In terms of underlying causes, growth theory suggests that the amount of factors of production labour, land and capital as well as their respective productivities will determine output in the long run. To understand Singapores prospects therefore requires an understanding of these elements. A glance at Figure 3 showing labour productivity (ie, how much is produced per hour worked) by sector reveals interesting trends. Looking at the three main sectors construction, manufacturing and services we can see a decline of labour productivity that is evident across the economy. The fall is sharpest in the manufacturing sector, which had exceedingly high annual labour productivity growth rates in 2010. However, this was a fundamentally cyclical event as output had plunged during the financial crisis and the subsequent recovery boosted output per worker. In construction the pattern is less clear, but rates of -3.5% in Q4 2012 are well below the series average of +2.0%. Services have also seen erosion of labour productivity and for the economy as a whole output per hour worked was down 3.5% year on year in Q4 2012. Does this mean that Singapore has lost its edge and is doomed to gradual decline? Given the long-term nature of the productivity concept, such an interpretation would be premature. Figure 3 shows that the numbers are volatile in the short term and owe more to the business cycle than to fundamental shifts that can only be discerned over a longer time frame. Productivity will determine Singapores prosperity in future years, but its best looked at as an outcome of the economys structural transformation than a determinant itself. If Singapore manages to grow productive sectors with high value added then its overall productivity will rise. The latest figures offer a positive indication of this: the biggest improvement in Q4 came in finance and ICT, both sectors that promise to add substantially to the island nations productive capacity if they keep growing. Figure 3: Annual labour productivity growth in Singapores sectors
% 55 45 35 25 15 5 -5 -15 -25 09 Q1 Q4 Q1 10 Q4 Q1 Total Services 11 Q4 Q1 12 Q4

The ASEAN private sector is leveraging up again

Strong returns in the equity markets are a sign of investor confidence. For households and firms, a similar gauge of confidence is the amount of credit that they take on. In the run-up to the Asian financial crisis, credit growth was running fast, both in domestic and foreign loans. The market turmoil in the late 1990s led to an extended period of deleveraging within the affected countries, especially among firms which cut back their financial obligations to protect themselves from the prospect of another sharp downturn. Figure 4 shows that the amount of credit for the four countries with the largest credit markets Singapore, Thailand, Indonesia and Malaysia expanded faster than their output until 1998 and then dropped sharply. The leverage, or ratio of debt to income, largely declined until 2010 (with a short exception in 2008/09). With optimism rife, deleveraging ended in 2011 and the private sector has been raising its debt exposure again, a trend likely to continue while the positive outlook persists. Due to a low debt burden of about 34% (in 2012) in Indonesia, the biggest ASEAN economies as a group have a moderate debt ratio of roughly 76%. Due to limited data, the Philippines are not included, but its private sector debt burden is similar to that of Indonesia, while that of Singapore, Thailand and Malaysia is in the region of 120130% of GDP not low, but manageable if the good growth prospect becomes reality. A strong increase in credit is a warning sign as it often results in inefficient investment in the hope of a rosy future that turns out less bright than expected. For now, the debt burden in relation to income stands slightly above half of that reached during the pre-Asian crisis peak. However, if credit continues to significantly outpace nominal GDP then this may indicate trouble ahead. Figure 4: Aggregate nominal USD credit to households and non-financial firms and GDP growth at market exchange rates for Singapore, Thailand, Indonesia & Malaysia
% 30 20 10 0 -10 -20 -30 -40 92 96 Credit
Source: IMF, BIS, Macrobond, Cebr

00 GDP

04

08 Difference

12

Manufacturing Construction
Source: Singapore Ministry of Manpower

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House prices are not booming (yet)

In many financial crises, such as in the US and in several European countries, house prices have played a significant role in fanning the flames of an unsustainable boom. It requires large increases in credit to enable households to keep purchasing expensive assets that are growing in price at a faster rate than incomes. The rise in household wealth in such a cycle generally leads to rising consumption, boosting the economy and further encouraging speculation. Those prices can therefore be an indicator of economic turmoil ahead so is a house price boom happening in South East Asia? The official indices presented in Figure 5 suggest that this is not the case. Since early 2008 prices have been rising steadily in Indonesia, Thailand and Malaysia. The latter has seen the biggest increases, though data are only available until the middle of 2012 when a plateau appears to have been reached. Singapore shows a more erratic pattern than the other countries as prices dropped considerably during the global financial crisis, but soon recovered to display an overall rise in line with other large economies in the region. These aggregate indices can be misleading, however, as they mask diverse market dynamics within countries. For instance, though restrictions on foreign buyers appear to have put a lid on apartment prices, land prices in Singapore have been rising sharply. In Indonesia, which is experiencing fast loan growth 23.7% in the year to Q3 2012, albeit from a low base there is anecdotal evidence of surging condominium prices. Below the surface there may thus be localised bubbles emerging that can have a destabilising impact. Rising house and equity prices often go hand in hand and if credit growth persists at a rate in excess of output growth then a bubble may develop in this area. For now, however, a look at residential property prices suggests that there is no overheating here and that the risk of a housing bubble has not emerged, though it may in future. Figure 5: Residential real estate price indices (March 2008=100)
140 130 120 110 100 90 80 70 08 Malaysia Indonesia 09 10 Singapore Thailand 11 12

Investment inflows and consumer demand to reduce trade surpluses

The current account is one part of the balance of payments and the capital account is the other. The capital account consists of various forms of investment, be they in securities such as equities, in the form of loans or direct investment in productive assets. The trade balance is the most important component of the current account that also includes factor income such as foreign dividends and transfers such as remittances or aid. A countrys trade balance is commonly thought of as reflecting the success of local producers of manufactured goods and commodities, with services playing a role for some countries such as those dependent on tourism, logistics or finance. On the demand side, household demand is a key determinant of the trade balance, but here, too, external factors play a big role. As the name suggests, the balance of payments should be zero overall. This means that investment inflows must lead to an offsetting rise in the current account, for instance through a rise in the trade deficit. As laid out above, record low interest rates in markets such as the US and Japan have resulted in a global hunt for yield which has driven increasing flows of capital into emerging markets. The stable growth performance of ASEAN has led to significant investor interest and the projected continuation of high GDP growth rates see next section should support additional inflows. At the same time, household consumption is rising as the middle class grows and consumer credit increases at a substantial rate. Taken together, it is likely that these factors will lead to higher imports and thus a deterioration in the trade balance for many countries of the region, as illustrated in Figure 6. Singapore should be an exception to this pattern as it stands to benefit from an uptick in global trade when the world economy begins picking up speed towards the end of the year and into 2014. Malaysia is projected to be more affected by falling energy and commodity prices than some of its neighbours and for Thailand a roughly stable trade balance is expected to continue. For the lower income countries, which are seeing strong rises in consumer spending and elevated business investment, we expect further falls in the trade balance that have already been evident over the past years. Figure 6: Trade balance, dotted line for forecasts
% 30 25 20 15 10 5 0 -5 -10 00 03 Singapore Thailand 06 09 Malaysia Philippines 12 Indonesia 15

Source: Valuation & Property Services Department of Malaysia, Bank of Indonesia, URA Singapore, Bank of Thailand, Cebr

Source: Singapore Department of Statistics, Bank of Thailand, BPS, Malaysia Department of Statistics, Philippines National Statistics Office, Cebr

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The growth outlook remains healthy despite some concerns

Credit growth, capital inflows and strong imports lead to economic problems if the positive expectations that theyre based on fail to materialise. On the other hand, if judged correctly and avoiding excess these developments can grow the economy and lay the foundation for future prosperity. The analysis laid out above suggests that international factors have helped support markets and may have a role in supporting investment and consumption, but there is no clear evidence of a credit or house price bubble at this point. Provided that commodity prices that support export earnings and local currencies remain elevated, the economic outlook remains positive: ASEAN GDP is projected to expand by around 4.9% per annum between 2013 and 2015. The quick emergence of a trade deficit amid elevated commodity prices suggests that Indonesia may be most at risk of a further fall in its export revenues. If the global environment stays stable then low private sector leverage and the potential to develop domestic demand as well as abundant resources should further support growth in the country. That is the central scenario at present and for 2013 GDP growth of 5.7% is expected. The downward trend of mineral and agricultural commodities is projected to reduce the growth rate to 5.5% in 2014 and to 5.4% by the end of the forecast horizon in 2015. Malaysia has enjoyed a period of low inflation and strong growth, aided by elevated energy and other commodity prices as well as fast increases in domestic spending. A distinct slowing in the latter has been evident and tax rises should put additional pressure on the economy, resulting in growth in 2013 of a comparatively low 4.4%. Further ahead, growth is currently expected to decrease slightly to 4.2% in 2014 and 4.1% in 2015, as monetary policy is tightened to counter rising inflation. The island and trading nation of Singapore is feeling the effects of subdued global trade, manifesting itself in a drop in industrial production that is unlikely to be reversed very soon. This year output is predicted to grow by about 2.3%, with most of the positive impetus coming towards the end of the year. Unemployment remains low and provides a good basis for rising domestic demand alongside an expected revival of industrial production growth that should foster a return to faster growth next year. For 2014 GDP is expected to rise by 3.6% and by another 3.8% in 2015. Closely integrated into the global manufacturing value chain, the economy of Thailand was strongly affected by floods and recession in the eurozone. However, a minimum wage should support broad-based consumption growth, while buoyant business confidence is likely to provide another domestic boost, lifting GDP growth to 4.8% this year. Output expansion is predicted to moderate to 4.4% in 2014 and 4.5% in 2015. The Philippines looks to be doing exceptionally well as the government spends heavily on infrastructure and confidence about governance and business prospects abounds. Strong exports and booming household expenditure are adding to the positive picture, resulting in the prospect of a 5.1% growth in 2013, followed by 5.4% in 2014. Eventually, capacity constraints are likely to catch up with the success story, leading to higher inflation, tighter monetary policy and a fall in growth to about 4.5% in 2015. icaew.com/economicinsight cebr.com

Figure 7: Forecasts for annual gross domestic product growth rates, %

% 6 5 4 3 2 1 0 Indonesia 2013 Malaysia 2014 Thailand Singapore Philippines 2015 ASEAN

Source: Cebr

Unorthodox monetary policy could come to haunt investors

In terms of risk factors, the soft landing underway but not yet completed in China poses risks if it becomes less smooth. Excessive credit creation is likely to prove disruptive at some point and may lead to a slump if enthusiasm turns to fear. ASEAN would not escape the fallout. The perennial threat from the eurozone, where Cyprus once again demonstrated a lack of crisis management ability, could also hurt the region. Though this is widely known, its worth bearing in mind that this risk will persist for the period of restructuring in the common currency area, and another slump in the eurozone may still happen for another five or so years. Massive monetary stimulus in Japan points to another concern. The distortion of money markets that has pushed sovereign yields down but failed to revive activity may well lead to trouble down the road. Quantitative easing is distorting market signals and leads to the mispricing of risk, meaning that many investors will face unexpected losses when the next significant downturn comes. Commodity price inflation may be another sideeffect of the masses of cheap money available, hitting the purchasing power of households the world over. Though the latter may have reversed the money will flow to where returns are highest, further exacerbating the perilous allocation of capital. So far ASEAN has benefitted from this trend, but if it suddenly reverses the impact may be dire. In this light, high equity prices both in the region and further afield look premature.

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Cebr
The Centre for Economics and Business Research is an independent consultancy with a reputation for sound business advice based on thorough and insightful analysis. Since 1993 Cebr has been at the forefront of business and public interest research. They provide analysis, forecasts and strategic advice to major multinational companies, financial institutions, government departments and trade bodies.

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