Southeast Asia, so long a byway of the world economy, has become a well-worn path for foreign investors seeking refuge from the continuing after-effects of the global financial crisis. They have come because the region has been surging ahead over the last few years, even as the West slumped, China readjusted and India stuttered.
As confidence grew in Southeast Asia’s newfound ability to realize its potential, success followed success: Indonesia is on the cusp of becoming the region’s first trillion-dollar economy, and achieved an investment-grade credit rating for the first time in 14 years in late 2011, something the Philippines also attained for the first time ever earlier this year; manufacturing has been booming in Malaysia and Thailand; and the Philippines began to challenge India as the top destination for offshore services, while posting first-quarter GDP growth of 7.8%, Asia’s best performance.
However, just when everything seemed to be going so well, cracks have begun to emerge in the foundations of the Southeast Asian boom. A bust is still avoidable, economists believe, but the fate of the regional economy over the next couple of years probably depends more on events in Europe and other turbulent sectors of the global system than on the decisions of local governments and central banks.
Too much of a good thing
The Catch-22 for Southeast Asia is that, while economic success is welcome, too much of it can be dangerous.
As the optimism about Southeast Asia became contagious, foreign capital – desperately short of promising avenues elsewhere in the world – began to flood the region. But before long, this was looking like too much of a good thing. Real estate prices rose quickly and stock markets spiked: asset bubbles, in other words, were starting to form. The Philippine stock market, for example, has risen 20 percent in the first half of this year after growing strongly in 2012, making it one of the world’s hottest exchanges. The abundance of money has also fuelled a glut of domestic consumption, with ordinary Southeast Asians making the most of easy access to credit, and accumulating household debt.
Meanwhile, national economies, despite posting impressive growth, began showing signs of stress as it became clear that Southeast Asia could not simply forge ahead irrespective of the tough global conditions. As a result of the recession in the West and China’s ongoing economic readjustment, Southeast Asia has been exporting less; market weakness reduces the value of the commodities it sells. Even strong South-South trade, which had helped insulate the region’s economies from the Western crash, has begun to cool, with Brazil and other major developing countries now experiencing slowdowns of their own.
In the first half of 2013, things have started to come to a head. Rajiv Biswas, Senior Director and Asia-Pacific Chief Economist at IHS, points in particular to the “destabilizing impact” of the quantitative easing programs launched by the U.S. Federal Reserve and the Bank of Japan; these have released additional money into the system, much of which has flowed straight into Southeast Asia. The problem is that these flows can quickly go into reverse – and investors could very rapidly pull their money out if the sentiment surrounding Southeast Asia cools. This has left Southeast Asia’s currencies and stock markets vulnerable, says Biswas.
There are grounds for optimism, however, according to Jayant Menon, Lead Economist at the Asian Development Bank’s Office of Regional Economic Integration. Despite concerns about Southeast Asia’s near-term prospects, capital is not yet fleeing the region wholesale because it doesn’t really have anywhere more attractive to go in the current climate. “Things are still looking good in this region, comparatively speaking,” Menon explains. He also dismisses concerns that we have another Asian Financial Crisis in the making: regional governments are better organized now, Menon says, and have the foreign exchange reserves which they lacked in 1997 to act as a buffer against currency collapses.
Nonetheless, he identifies a “wave of uncertainty creeping in, almost as if someone’s worried the party could end soon.” Foreign investors who once rushed into the region with blind optimism are now aware that “the vulnerabilities have been increased, and the risk factor is exposed,” Menon continues. “That could be a self-fulfilling prophecy. There will be a correction. The only question is when and how – will it be slow and gradual, or sudden and painful?” If foreign investors decide that major losses could be around the corner, then a huge amount of capital could exit the region very suddenly and painfully, he warns.
Even then, Menon believes that the implications for the region might not be too severe. Private investors themselves stand to lose most from the bursting of the asset bubbles they have helped to inflate. Unlike in the West, where real estate bubbles were fuelled by debts that could never be repaid, the overvaluation of Southeast Asian stocks and real estate has been driven by private finance. So while privately owned assets could lose a lot of their value, governments and banks will not be exposed.
“But debt-driven private consumption is the bigger concern,” Menon says. “That’s not sustainable – and I’m talking about Thailand and Malaysia here, as well as Indonesia and the Philippines.” The risk is that ordinary citizens, now burdened with cheap debt, suddenly find that borrowing has just become a lot more expensive, as central banks tighten their monetary policies in order to cool their economies and, in doing so, hike interest rates.
Points of weakness
Worryingly, it is the region’s biggest economy, Indonesia, which is the source of the most anxiety. Vietnam is arguably in much greater difficulty, but it is less critical to the region’s economic wellbeing. “Indonesia is the economy in Southeast Asia that matters the most,” says Menon. “Vietnam could go through a major adjustment without much regional impact, but not Indonesia – if Indonesia suffers, the whole world will notice.”
As one of the world’s most promising emerging markets, Indonesia had been enjoying large volumes of foreign investment and capital inflows. But the country has lately been running a trade deficit, as exports have declined – especially the sale of coal to China, a key income stream – even as imports have continued to rise. That trade deficit wasn’t so serious while foreign investment was pouring in, but now that foreign interest has started to wane – and indeed some foreign capital is already being withdrawn – Jakarta is having to dig into its own currency reserves in order to balance the books. The Indonesian government currently has over $100 billion in reserves, but is spending $2-3 billion a month propping up its currency – an activity which cannot continue indefinitely.
Malaysia finds itself in similar difficulties, with its currency weak and possible capital flight a cause for concern. But Indonesia is more vulnerable, explains Biswas, because out of all the Southeast Asian countries its stock market and debt markets have the highest proportion of foreign ownership. Now, he warns, “sustained portfolio capital outflows from the Indonesian equity and local government debt markets could put further downward pressure on the rupiah,” which has already fallen from around 9,400 to the dollar a year ago to 9,900 today. Last week, the Central Bank raised interest rates – an opening salvo in what could become a broader campaign to prevent a further weakening of the rupiah – while the government this week made the unpopular decision to cut fuel subsidies, which should reduce its budget deficit.
This may be enough to stabilize Indonesia’s weakening currency, and stem capital outflows. “Overall I’m still positive about Indonesia – it will be the next BRIC economy in Asia,” Biswas says. “A moderate further decline [in the rupiah’s value] can be absorbed. But if it’s a significant further decline, it creates inflation and affects asset prices. And then it becomes a snowball effect – investors withdraw money in a panicky way, and then you have questions about the stability of the markets.”
Biswas adds that political risk is also tarnishing the Indonesian story. With President Yudhoyono due to step down in 2014, foreign investors are beginning to worry about what might follow – and may hold back from committing funds to Indonesia until these issues are clarified.
The Philippines is likely to experience a similar crisis in investor confidence as the end of President Aquino’s tenure approaches in 2016, given Aquino’s perceived centrality to the country’s reform process. But for now, the Philippines looks robust, in Menon’s opinion: growth is strong, and only private investors stand to lose from real estate and stock market bubbles. “The Philippines is finally having its turn after decades of being the ugly spot in Southeast Asia,” he says. “They finally have things that really justify that, notably huge improvements in governance and tax collection. So their basic fundamentals look good and are improving.”
The outlook for Vietnam is altogether more grim: its debt-laden banks are in crisis, and Hanoi does not have the money to recapitalize them. "Vietnam faces a long period of macroeconomic adjustment,” says Biswas. Fortunately for the rest of the region Vietnam only accounts for 6 percent of ASEAN GDP, and its troubles are unlikely to damage the others’ prospects.
There are further grounds for feeling confident about Southeast Asia’s chances of avoiding a bust, with huge investments in new infrastructure offsetting the fall in exports. Thailand and Malaysia are already spending billions upgrading their transport networks, and Indonesia and the Philippines are likely to follow suit. Once in place, this new infrastructure will then significantly boost productivity in the long term, removing some of the bottlenecks that have always stunted growth in the region.
As things stand, the ASEAN region is still anticipating growth of around 5 percent in 2013, despite the structural concerns. “These countries are also rebalancing away from external sources of demand,” adds Menon. “The rebalancing is being engineered – it’s something they want.” With future levels of demand from China, Europe, Japan and the U.S. far from clear, this is a wise strategy, Menon argues, so long as the shift to domestic demand is not fuelled unsustainably by the accumulation of too much household debt.
But until such time as that structural transition occurs, Southeast Asia finds itself in the uncomfortable position of being hostage, to some extent, to the economic fate of those other regions. “The region’s adjustment should be gradual,” Menon says, “but it’s a question of what happens in Europe more than anything else, with China and Japan also possible factors. If there’s an external trigger, like another eurozone crisis, then there could be a major correction, which could be sudden and painful.
“The next few weeks are very important,” Menon concludes. The region’s governments and central banks can certainly strengthen their positions by making smart decisions about their monetary and fiscal policies. But they will be watching Europe and China, nervously, for the sort of external shock that might truly burst Southeast Asia’s bubble.