Asia: Bending, But Not Breaking

22 October 2019

The global economy is slowing. During previous bouts of world-wide economic weakness, Asia has been relied upon as an engine of growth. This time, however, Asian economic activity is also cooling, as the region (and individual countries within the area) confronts both external and domestic challenges. The deepening trade war, of course, poses risks for all countries, but the trade-oriented Asian economies that are deeply entrenched in global manufacturing supply chains are particularly exposed. The Chart below illustrates the US-China dispute is hitting the region’s export performance more than other areas, including the USA so far.

The good news, however, is that Asian economies are bending, but not yet breaking. However, the region’s growth outlook confronts additional headwinds. And, unlike the limber yogis depicted above, this is not a time for calm. Can Asian policymakers skillfully implement monetary and fiscal policies to offset the impact of the tradewar, as they have successfully done in 2019? What will be the impact on the region’s exchange rates, especially vital for trade-oriented economies? What can be done about the looming demographic challenge? We will discover that a multi-speed Asia lies ahead.

Bending, Not Breaking: Multi-Speed Asia

The Chart below illustrates that GDP growth has slowed in virtually all Asian countries. An examination of the components of GDP highlights the central role the trade war has played, as export volumes have declined sharply in most countries (Vietnam and the Philippines have been more resilient). Likewise, reflecting the decline in business confidence, capital spending has contracted in several countries (quite dramatically in Hong Kong, perhaps impacted by the on-going demonstrations). Fortunately, however, business investment has continued to expand in many nations, albiet at a slower pace, a sign of underlying soundness.

On the other hand, resilient consumption — in both the household and government sectors — have helped offset the weakness in the business sector. But, again, the performance of individual nations varies widely. Consumer spending has been weak throughout the more advanced economies of North East Asia, e.g. Korea, Taiwan, Singapore, and Hong Kong. Likewise, Chinese households continued to spend, albiet at a slower pace. In much of South East Asia, meanwhile, private consumption has recorded healthy gains, e.g. Malaysia, Vietnam, Indonesia, and the Philippines. India has been a surprising exception, as household outlays have slowed considerably.

Robust expansion in government spending throughout the region also helped boost cushion the impact of weak manufacturing activity. The Chart highlights the sharp rise in public sector outlays, especially in Korea, China, India, and throughout most of Southeast Asia.

Of particular interest, the Chart also illustrates that a multi-speed Asia is emerging. Specifically, economic activity has been considerably weaker in the more advanced economies of North East Asia. To be sure, these nations are especially integrated into global supply chains, and more vulnerable to the trade war. However, this does not explain the persistent weakness in household spending in these countries. In the next section, we will explore the roots of this evolving growth divergence.

As the Sino-US trade dispute is unlikely to be resolved quickly, Asian growth will decelerate further in 2020. With inflation remaining low throughout the region, will Asian policymakers step in again to support spending next year? The short answer is yes. The region’s overall low public sector debt levels provide ample opportunity to stimulate fiscal policy. In 2019, for example, region-wide fiscal policy expanded by roughly 1% of GDP, led by China, Korea, and India. The Chart above indicates, however, the boost from budgetary policies in 2020 will only be around 0.5%. Importantly, rising debt levels may make China and India more cautious. And the baton will be passed to the other nations of the region.

Slowing economies will continue to keep inflationary pressures at bay. Arguably, price increases remain uncomfortably modest in Korea, Taiwan, Singapore, and Thailand. With fiscal policy less expansive, central banks are likely ease already accommodative monetary conditions. Even though the Chart above shows real yields are low, inflation-adjusted rates are higher than the rest of the world. Thus, interest rates are likely to decline up to 50bp during the next 12 months.

Getting Old Is Not Easy!

To be sure, the trade war has contributed to slower and multi-speed growth in Asia. Arguably, however, domestic factors are playing an equally important role. In particular, the Chart above illustrates the signifcant consequences of the aging of Asia’s population during the coming decade. However, the impact is not uniform. The share of population above 60 years of age will rise especially sharply in North East Asia. Indeed, in Korea, Singapore, Hong Kong, and Taiwan, this group will account for a larger share of the population than even in Germany! China and Thailand are not far behind. By contrast, the population will remain comparatively younger in South East Asia and the Indian sub-continent. As the population ages, slower growth in the workforce will reduce the long-term growth potential of NE Asia compared to their more youthful neighbours.

Offsetting the impact of this demographic timebomb will require sharply higher labour productivity. Unfortunately, recent efficiency trends reenforce the emergence of a multi-speed Asia. As in the G7 countries, efficiency gains have slowed in recent decades (and years) in the more advanced NE Asian nations (see Chart above). On the other hand, productivity growth has remained healthy in most of SE Asia. Indeed, successful reform efforts in Vietnam, India, the Philippines, and Indonesia have produced accelerating gains in output per hour in recent decades (and years). China’s productivity improvements remain healthy, but are now slowing. The policy implications are numerous: to boost productivity governments must improve education, upgrade infrastructure, raise the retirement age (requiring pension reform and adult re-training), and much more.

CMVLB: Coming to the Rescue?

CMLVB is the new Asian acronym: short for Cambodia, Myanmar, Laos, Vietnam, and Bangladesh! Such trendy abbreviations usually emerge for a reason. Indeed, optimists hope these countries can play a larger role in global supply chains, especially if the trade war and rising Chinese wages lead manunfacturers to look for new regional production hubs. Also, can these countries contribute more to lifting regional growth, especially as the maturing NE Asian economies slow?

Of course, a full discussion is well beyond the scope of the this blog, but do see my earlier piece “Vietnam: Asia’s Rising Star”. However, there is reason for qualified optimism. The combination of relatively favourable demographics and reform-induced productivity gains have lifted the long-term growth potential for these nations. In fact, the Chart above points to three speeds for Asia’s long-term growth potential: 7-8% for India and CMLVB (subject to numerous caveats!), 5-6% for China, Indonesia, Philippines, and Malaysia, and 2.5-3.5% for Korea, HK, Thailand, Singapore, and Taiwan.

The increasing interest in foreign direct investment in some of these countries also appears promising (Chart above). But, the amounts are tiny: FDI into CMLB totalled only $10 billion last year — Vietnam was an additional $16 billion. Also, these countries and their economies are still quite small. Indeed, the overall GDP of Cambodia, Myanmar, and Laos is only the same size as the Slovak Republic. In terms of population, the three together are similar in scale to Thailand. Certainly not enough to move the dial on regional GDP growth in the near term, and too small to ever attract large-scale absolute amounts of FDI (although they may remain chunky as a percent of local GDP). Interestingly, however, these nations have benefited from higher exports to the USA during the trade war: US imports from CMLVB are up 35% in 2019, while purchases from China have declined 13!

Strategic Implications

  • Asian GDP growth will slow further in 2020. All countries are likely to expand below their long-term trend potential.
  • India’s GDP growth slowed to 5% in Q2 2019. I expect India’s current weakness to be short-lived, and expect output to advance 6.4% next year. India will be Asia’s top performer during the coming decade.
  • On the other hand, China’s slowdown will be longer and deeper than expected, as the nation copes with both the trade war and domestic adjustments (deleveraging and transitioning to consumer-led growth). Long-term GDP could slow towards 5%.
  • Vietnam will be the top performer of the CMLVB group. Successful reform and the size of its domestic market will attract the most FDI, as manufacturers look to diversify their regional supply chains.
  • Central banks will lower interest rates 50bp or more. Indonesia offers an attractive opportunity.
  • With a trade war, persistent weakness in China, and below-trend regional and global growth, it’s hard to get excited about equities during the next 12-months. But, as US rates decline and the USD eventually weakens, the environment will eventually become attractive.
  • Despite the adverse impact of the trade war, Asian FX has held up relatively well. The Chart above suggests the region’s exchange rates are broadly in line with LT fundamentals, perhaps with the exception of the Thai baht. In addition, the Chart below illustrates Asia’s external balance sheet is far healthier than other EM areas. As the US Federal Reserve reduces interest rates, the TWD and THB could appreciate modestly near term, unless the trade war escalates dramatically (which I do not expect). MYR and IDR could be vulnerable if the Fed does not deliver expected rate cuts (as both have relatively large external borrowing needs).
  • China and India are the wildcards. If near term growth continues to disappoint, policymakers may allow further FX weakness. I expect both CNY and IND to depreciate more than implied by current interest rate differentials in the period ahead.