international analysis and commentary

Southeast Asia can hedge its China risk

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Economic and market turmoil in China presents significant risk for Southeast Asia in 2016, but on the whole the region will muddle through with strong growth rates compared to developed and many other emerging markets. The Asian Development Bank recently held 4.6% in 2015 and to 4.9% from 5.1% in 2016 for the entire Southeast Asia region.

The downward revisions are attributable to the slowdown in the Chinese economy and subdued demand in advanced industrial economies, as well as concerns about agricultural output given an unusually bad year for both droughts and floods. For the five large economies in the Association of Southeast Asian Nations (ASEAN), the growth forecast for this year is lowered to 4.8%, still a slight improvement on 2014. The one exception to the downward revision has come in Vietnam, where growth expectations were recently revised up for 2015 due to high, sustained FDI that anticipates strong growth derived from the TPP. Planned infrastructure investment has fallen behind schedule in Indonesia and the Philippines, and Thailand’s recovery from a year of economic mismanagement that owes in large part to political turmoil has to date been meagre.

China is ASEAN’s largest trading partner with a growth in trade in recent years reflecting the integration of ASEAN economies into a China-centric production ecosystem. Two-way trade reached $350 billion in 2013 and was expected to hit close to $500 billion by the end of 2015, a number that will only increase as further gains are made with the newly upgraded 2015 ASEAN-China Free Trade Agreement (FTA) and once the ASEAN+6 FTA, the Regional Comprehensive Economic Partnership (RCEP), is realized.

China’s landing, whether hard or soft, reflects a structural shift from export manufacturing to service economy that has contributed to a growth slowdown that will continue to demand for ASEAN exports—particularly in raw commodities. While this is likely to have only a limited downside impact on ASEAN’s strong rate of growth in 2016 and 2017, uncertainty about the Chinese economy will heighten political anxieties in Southeast Asia given the breadth and depth of China-ASEAN commercial and economic ties.

These anxieties will be compounded by China’s strategic assertiveness on maritime disputes in the South China Sea, and heighten pressure to hedge against economic overdependence. As a result, regional economies will ramp-up efforts to develop strong trade, investment, political, and even security ties with countries other than China in the rest of Asia and elsewhere. The main focus will be on bi-lateral and multi-party trade agreements, the most ambitious of which is the 12-country TPP. Similarly, several key countries in the region see the ASEAN Economic Community (AEC) as a potential framework for Southeast Asia to create a single market with stronger bargaining power.

In the short-term, these trade deals will be less impactful on Southeast Asian economies than increased currency volatility due to lower interest rates and capital outflows, based on the assumption of slower growth in China and a rate hike by the US Federal Reserve.

Whether this is a problem that leads to capital controls is going to be determined by: (a) the extent to which debt is denominated in a foreign currency; (b) the degree to which the inflation pass-through is a serious enough source of social tension that it leads politicians to intervene; (c) the extent of any economic disruption caused by capital movements on the balance of payments account.

ASEAN nations are not facing anything near the scale of the 1997-98 Asian financial crisis, having built-up foreign exchange reserves and given the deepening of multilateral currency-swap mechanisms such as the Chiang Mai Initiative launched in 2010 with $120 billion, and doubled in 2012. Moreover, unlike the financial crisis of the late 1990s, nations in the region no longer need to defend fixed exchange rates regimes, a key source of vulnerability at that time.

For these reasons, explicit capital controls are unlikely given the influence of Washington Consensus-style economic policymaking in the region. But modest measures to reduce portfolio outflows given depreciation across the region under the banner of macroprudential policy are possible, especially in Malaysia and Indonesia.

In Malaysia the government may consider introducing the measures for the simple reason of the scale in reserve losses that has come with defending a ringgit that has declined to its lowest value since the Asian financial crisis. Nevertheless, we note that Malaysia’s central bank governor, Zeti Akhtar – well-respected in markets – has several times reiterated her views that such controls were undesirable, and otherwise remained above the political fray. Her retirement in April 2016 may increase the risk that the central bank is subject to political influence, and in turn raise the risk of both capital flight (if Najib were to appoint a ‘political’ successor) as well as capital controls to offset the impact of that flight.

In Indonesia, by contrast, the bigger worry than political influence is the exchange rate pass-through on inflation, given that the local population is more sensitive to price increases. Elsewhere, whether Thailand or The Philippines, there is more political tolerance for depreciation.

China will still help Southeast Asia close the infrastructure gap

China risk notwithstanding, regional trends and external geopolitical and economic pressures ultimately point toward a positive long-term outlook for ASEAN. Economic integration among ASEAN members by way of new multi-country trade deals will continue to help coordinate technical standards, create increasingly mobile labor markets, and unify policies toward foreign investors through 2030.

But one area in which ASEAN still sorely needs China is investment and expertise to close its substantial infrastructure gap. And China will deliver. Indeed, this substantial upgrade and expansion of infrastructure unifies ASEAN policy needs. While almost every ASEAN country has or will implement policies aimed at boosting the effectiveness of public-private partnerships in the infrastructure sector, performance will be inconsistent across the region owing to differing standards in relation to legal regimes, as well as local political dynamics.

Fortunately for Southeast Asia, the current sources of tension in China relations should not negatively affect Beijing’s plans to expand investment in Southeast Asia through its One Belt/One Road Initiative, particularly given the launch of the Asian Infrastructure Investment Bank and a stand-alone fund to finance Silk Road projects