Asia: Reforms, politics and tapering

by: Maritza Cabezas

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The year 2014 has started with increasing concerns that emerging Asia’s economic activity could be cooling down. We think that on the domestic front, the larger economies will be correcting their imbalances over the coming period, while elections in a number of countries have also increased the political rumblings. On the external front, there is the fear that the Fed could scale back the asset purchases faster than assumed if the US economy performs better than expected. Although Asia is now better prepared for the journey towards neutral monetary policy, volatility cannot be ruled out. We expect stable growth in Asia, but the divergence in growth forecasts remains an issue for the region. China will continue to be the fastest growing economy, with Thailand likely to be one of the slowest. Emerging Asia’s GDP forecast will remain steady at around 6% in 2014 and 2015.

Two-speed recovery in the region

The largest economies, China and South Korea, ended the year with steady growth. China’s GDP growth was slightly lower at 7.7% in Q4, compared to 7.8% the previous quarter. This resulted in a growth rate of 7.7% for 2013 as a whole, edging down from 7.8% in 2012. Meanwhile, South Korea’s GDP rose to 3.9% yoy in Q4, up from 3.3% in Q3. In both cases, domestic demand helped sustain the recovery, amid a favourable global environment. Taiwan also showed a strong growth momentum towards the end of the year, with GDP increasing to 2.9% in the last quarter from 1.7% in Q3.

 

The picture is somewhat different for the countries, including India and Indonesia, that have undergone a meaningful adjustment process. In the case of India, the sturdy steps to reduce the current account deficit and improve the fiscal balance have been accompanied by a slowdown in economic activity. This is also helping to correct the imbalances and resulted in the country’s current account deficit narrowing to 1.2% of GDP in July-September, compared with 4.9% in the previous quarter. Meanwhile wholesale price inflation finally declined in December, after six consecutive months of gradual increases, to 6.2%. Indonesia has been slightly less successful as its inflation has hovered around 8% in the past six months, with few signs of a turnaround in the current account deficit on the horizon, not least because of developments in the country’s policy on banning exports of unprocessed mineral ore. To make matters worse its credit growth in excess of GDP growth is one of the highest in the region (12%). The markets’ response has been more positive towards India, suggesting increasing expectations that measures will eventually translate into higher growth. Lastly, there are countries where reforms are needed, but have been put on hold. These include Thailand and Bangladesh, where the fundamentals have been deteriorating, but where no near-term solution seems available.

Inflation remains broadly low

Inflation across the region is at present generally benign. Average inflation in the region in 2013 was 4.4%, which is lower than in other emerging economic regions. Only India and Indonesia, however, have actively been fighting inflationary pressures, with the former taking the battle particularly seriously. Indeed, the Reserve Bank of India is considering the option of CPI-based inflation targeting. Over the next two years this could reduce inflation to 6%, compared with 9.9% in 2013. This would be a very significant commitment from the central bank since in the past it has faced the growth-inflation dilemma. The above suggests that, this year, India and Indonesia are expected to tighten monetary policy via rate hikes, while China is likely to see tighter liquidity conditions as a result of its struggle to rein in high credit growth.

 

Balancing the positives and negatives in 2014

In the current context it is important to look closely at the most important issues for Asia’s economic outlook over the coming year. Although some risks will be tilted to the downside, our scenario considers that the global recovery will be sufficiently strong to overcome some of these challenges.

Exports looking on the bright side

Our scenario for world growth in 2014 is somewhat more positive than the consensus. As the fiscal drag in the US and eurozone begins to fade, we expect to see firmer growth, particularly in the US. This should stimulate investment and improve consumer spending. Asia’s export performance over the past two years has largely been driven by fluctuations in demand from its two major trading partners: the US and eurozone. Looking forward, given the mixed picture for the recovery of Asian domestic demand, economic growth will need support from exports. Obviously, not all countries will benefit equally from stronger external demand. Taiwan and South Korea are already taking the lead, while India and China both reported export growth accelerating towards the end of 2013. Although commodity exporters such as Indonesia and Malaysia will not see a sharp increase in exports, commodity demand is still expected to do well over the coming months.

 

Asia’s mixed picture in the battle for funding

The Fed’s announcement on 18 December that it will be reducing the pace of asset purchases was cautious enough to avoid the risks of a renewed sell-off. In fact, the Asian countries that were most affected and that had come under severe pressure earlier in 2013, including India and Indonesia, have fared well from the Fed’s announcement. If the US economy surpasses the Fed’s expectations, countries in the region that have weaker fundamentals will face more uncertainty given the fear of unexpected market pressure. Past episodes suggest that the pace of tightening is fundamental for emerging markets, with rapid tightening previously having had the most adverse impact. Under such a scenario, the battle for funding could get tougher. Countries where interest rates will remain high, including China, which is in a process of deleveraging the financial system, are likely to remain attractive for investors as a result of the stronger fundamentals. China has already witnessed increasing capital inflows in the fourth quarter of 2013. In any case, Asia is better placed than other emerging markets, given that total debt/GDP ratios have declined in most Asian countries and foreign debt ratios have also improved. The group of countries in a stronger position are Korea, Taiwan, Singapore and the Philippines, while Indonesia, followed by Malaysia, has been the largest recipient of portfolio flows since quantitative easing started. Time will tell how successful countries with current-account deficits are in reducing their imbalances.

Elections a source of uncertainty

The Asian electoral process started this year in Bangladesh, where there has been a lot of unrest caused by the two leading women fighting for power. However, this political unrest has left key activities practically untouched, with average export growth in 2013 of over 20%. The economic effects that have been felt relate to the postponement of new investment projects as a result of the political instability, and this is capping the potential for growth. Meanwhile, elections in Thailand have been accompanied by protests, and the course of democracy in the country remains uncertain. Thailand’s government has announced a state of emergency in Bangkok and surrounding areas, and compromise between the political groups now seems further away than ever. Indonesia’s parliamentary elections in April 2014 and presidential elections in July 2014 are likely to be more peaceful. The mayor of Jakarta is a strong favourite, and there is a good chance that he may be able to push through the necessary reforms. India’s elections in May 2014 could be a game changer. Markets are likely to react positively to a stable coalition, but the risk of a divided parliament is high. This could exacerbate political instability and reduce the chance of structural changes. For some, a Modi victory and a replication of his success as Governor of Gujarat, particularly his efforts to improve the business environment, could be an asset for India.

China another source of uncertainty

In China, the announcements made since the Third Plenum in November last year are gradually translating into action. The measures issued so far support a more market-driven economy. Rather than a roadmap, it is more a case of experimenting with measures. Policies designed to reduce the risks of excessive credit growth from the shadow banking sector, including the various episodes of tightening the interbank market and the stricter stance towards the bailout of trust funds, have created uncertainty. Given the trade and financial interlinkages, the pace at which China implements these reforms will also affect the region as a whole. It is becoming increasingly obvious that China’s communication strategy has become essential to the success of the reforms. The lack of detail is causing stress throughout the region and beyond. We believe that China has sufficient scope to guide its economy through the transformation process in an orderly way and, in the medium term, its structural transformation will open a window of opportunities.

This publication is part of the Quarterly publication “Emerging Markets Outlook 2014Q1”

Deze publicatie is onderdeel van de kwartaal publicatie “Emerging Markets Visie 1e kwartaal 2014”