Daniel Lian of Morgan Stanley: Navigating Long Macro Voyage for Southeast Asia

Navigating Long Macro Voyage for Southeast Asia
Daniel Lian (Singapore)

Morgan Stanley

Navigating Southeast Asia’s Structural Investment Themes and Avoiding Cyclical Noise and Rhetoric

International investors are clearly excited about the prospects for Southeast Asia, especially Singapore, Malaysia, Indonesia, and the Philippines. All sorts of cyclical and structural reasons are being advocated to justify reweighting of the region. Last week, we highlighted to investors that despite an improved macro environment, a favorable shift in economic restructuring strategy, and momentum in political economy reform, Southeast Asia remains quite heterogeneous. Different Southeast Asian countries have made different degrees of progress in each of the positive areas highlighted by international investors.

Favorable cyclical factors are often fickle. We believe Southeast Asia must navigate a long macro voyage. On this voyage, investors must carefully analyze and appraise structural developments, and eliminate unsustainable cyclical noise and rhetoric. Last week, we began our voyage by discussing the common favorable factors cited by international investors, on a country-by-country basis, and analyzing their merits and demerits (Macro Cherry-Picking Southeast Asia, November 24, 2004). This week, we examine the “investment theses” advocated by various quarters of the investment community.

Political-Economy Reform and Domestic Security — Geopolitical Risks

A large number of international investors are clearly excited by the prospect of political economy reform and the probability of some containment of domestic security and geopolitical risk. The emergence of new leaders (Malaysia and Indonesia) and stronger mandates on second terms (in the Philippines and possibly Thailand) are key factors in such excitement.

We do share the excitement to some degree. There are clearly some prospects of political economy reform concentrating on elimination of or substantial reduction in the rent-seeking complex (Malaysia, Indonesia, the Philippines) that, in turn, would substantially improve the distribution of economic fruits and the multiplier impact on growth, as well as probably reduce domestic security and geopolitical risk (Thailand, Indonesia, the Philippines). However, both efforts require a favorable political climate where the politicians who drive the present reform stay in power. One cannot rule out probable “offenses” and “responses” by vested interest groups and local separatist or extremist elements where they will fight to retain their rents and their goals. It is probably fair to price in some positive development, but, in our view, the market risks substantial mispricing on both. For example, over the past year or so, the market has been fairly optimistic on Malaysia, Indonesia, and the Philippines, but pessimistic and punitive on Thailand. It remains somewhat uncertain whether investors are correctly pricing the risk premium linked to political-economy reform and domestic security in Southeast Asia.

The “Natural Complementary Economic Relationship” with China

One of the strongest reasons that investors cite for investing in Southeast Asia is that the four bigger Southeast Asian countries (Malaysia, Thailand, Indonesia, and the Philippines) are well positioned to continue “exploiting” the “natural complementary economic relationship” — China manufactures for the world, and Southeast Asia supplies agriculture and resources to China as its manufacturing dwindles with the rise of China.

We have been strongly advocating the deployment of a dual-track strategy to develop the vast but underdeveloped non-manufacturing second-track sectors. Our argument is that this would reduce Southeast Asia’s dependence on manufacturing, multinational corporations, and their foreign direct investment. Pricing power would be improved by securing economic niches not “threatened” by China. Nonetheless, I am skeptical that the region is now fully ready to effectively exploit the complementary relationship opportunity with China.

There is indeed an elementary complementary economic relationship between China and Southeast Asia. China is single-mindedly pursuing industrialization, whereas Southeast Asia has the endowments and the development niche to be an even bigger agriculture, agro-business, tourism, and other soft-hard commodity supplier to China. However, the Southeast Asia niche in this aspect is relatively underdeveloped. Without proactive development of such a basic complementary niche through comprehensive economic strategy shifts, Southeast Asian nations cannot expect to make a good living out of the basic complementary economic relationship. We believe that a well thought out “dual-track strategy” emphasizing the development of the “second-track” sectors — agriculture, agro-business, rural and grassroots, small and medium enterprises, resources encompassing both soft and hard commodity development — and complementing the “first track” that emphasizes only mass manufacturing and urban-centric service infrastructure development is a critical strategy shift required by Southeast Asia in order to prosper together with China.

However, Southeast Asia ex-Singapore is far from fully exploiting its second-track potential. The whole region has become more manufacturing-dependent, in terms of both output and exports, over the past decade. Manufacturing output’s share of ASEAN 5 GDP rose from 25.2% in 1994 to 30.2% in 2003, and manufactured exports’ share of GDP went up from 35.5% to 49.3%. The growth in manufactured goods and merchandise (all goods) production and exports is the principal reason why Southeast Asia has survived the onslaught of China and recovered from the Asia Crisis over the past decade.

However, the intensified manufacturing dependence is not a bad development at all. It demonstrates that the “Sino Hollow” thesis is probably not valid (see our October 7, 2004, note of this title), and that Southeast Asia retains good manufacturing growth potential and can grow strongly and structurally if it further develops and exploits its complementary economic relationship with China.

Export- or Domestic Demand-Led Growth?

A large number of international investors believe that Southeast Asia will either have to export well, i.e., economies will have to stay extremely export-driven/outward-oriented, or successfully shift to a sustainable domestic demand strategy. They thus tend to build their investment case on either rising trade with a prosperous China or a stronger domestic demand thesis.

These investors are not wrong. However, Southeast Asia is likely to have to continue to count on both. We believe it is quite possible that the region will continue to enjoy both export and domestic demand growth. Positive GDP growth trends and output potential can accommodate both. Hence, the correct investment theme would be to appreciate that traditional exports — mass-manufactured or generic soft or hard commodity exports — will not generate enough income to see the region to prosperity. The larger Southeast Asian nations need a balanced strategy as outlined in the dual-track discussion above.

The balanced dual-track strategy is the key, because it provides the critical economic linkage between growth in the second-track sectors, with both second-track-driven exports and second-track-led structural resilience in domestic demand. Thai Prime Minister Thaksin’s dual-track experiment over the past four years has clearly demonstrated that properly stimulated second-track sectors create domestic demand resilience. Underdeveloped agricultural, rural, grassroots, and SME sectors are capable of generating better multipliers, as leakage to imports on income created is fairly small. At the same time, new entrepreneurs in the non-mass manufacturing sectors are carving out export niches that are not in direct competition with China or other generic manufacturers elsewhere.

Exports have consistently outgrown domestic demand in ASEAN over a long period. ASEAN can structurally underpin the export sectors through the development of export-oriented non-mass manufacturing in the second-track sectors. This would generate a great deal of domestic demand resilience as second-track sectors are stimulated. Every ASEAN economy has increased exports faster than domestic demand over the past decade — this is where the opportunity lies for sustainable second-track-driven domestic demand growth.

Private Consumption- or Investment-Led Growth?

International investors who subscribe to the domestic demand boom thesis tend to put their faith in Southeast Asian private consumption. They believe the region over-saved and over-invested in the 1980s and ’90s. Hence, they think a private consumption boom is both a “default” outcome — as investment gives way to private consumption — and a necessary one if Southeast Asia is to salvage its growth, given the rise of China and the Asia Crisis. I was a subscriber to such a consumption thesis until quite recently. However, I now disagree on the basis of the following observations:

First, with the exception of Indonesia, Southeast Asia has used exports rather than private consumption as the engine of growth over the past decade. The so-called structural boom in private consumption has taken place only in Indonesia. For the other four countries (Singapore, Malaysia, Thailand, and the Philippines), private consumption to GDP ratios in 2003 remain roughly the same as in 1994, as well as the average over the 1994–2003 period. In other words, there is no fundamental “macro” expansion in private consumption (however, the banking system’s orientation towards consumers and away from corporates in the region over the past decade may have contributed to expansion in household balance sheets). More significantly, in Indonesia, the structural lift in private consumption — from sub-60% in 1994 to almost 70% in 2003 — was hardly a sign of economic strength or economic prosperity but rather a “default” phenomenon of corporates and households massively scaling back their investments and contracting their balance sheets. Concomitantly, households trimmed their wealth or reduced their rate of savings in order to sustain living standards in the face of massive inflation, currency devaluation, and falling real income after the Asia Crisis.

Second, there are serious institutional barriers to raising private consumption. Young demography, institutionalized or forced saving social structures, the high price of property relative to income, unequal distribution of income and wealth, and undervalued exchange rates all contribute to excessive saving. In my view, these institutional barriers will remain for a long time, thus dimming the prospects for private consumption.

Instead of private consumption, we see Southeast Asia embarking on a structural boom in domestic investment. The economic and policy rationale for a structural investment boom, the macro magnitude and economic implications of such a boom, and the “content” of such investment are critical to understanding the forthcoming investment boom.

Economic and policy rationale. While Japan and the four Asian Tigers (Singapore, Hong Kong, Taiwan, and South Korea) may have already passed the phase of rapid capital accumulation, the larger ASEAN four that are still low in per capita income must use new productive investment to boost future growth potential. (We believe Singapore has largely exhausted domestic investment opportunities and may not raise its domestic investment ratio further. That is why its external economy strategy centers on deploying excess saving in acquiring foreign assets.) Sources of productive investment would include appropriate infrastructure, upgrading the value chains of existing economic activities, and new second-track economic development.

Macro magnitude and economic implications. Among the larger ASEAN four, Thailand and Indonesia possess more certainty of generating a structural investment boom. Thailand’s average savings rate of 34% from 1994 to 2003 means there is considerable room for its gross investment rate to rise from the present 25% to perhaps 35–36% over the next few years. We believe that is exactly what Mr. Thaksin wants to do over the next few years. In the case of Indonesia, its gross investment ratio has fallen from 31% in 1994 to only 19% in 2003, while its gross savings ratio stood at 24% at the end of 2003. Its much higher average savings ratio of nearly 28% indicates room to lift the gross investment ratio by 10% of GDP. In our view, shrinking the present current account surplus to zero or even running a small deficit at 1–2% of GDP would not have a negative influence on the macro prudence and stability enjoyed by both economies.

Both Malaysia and the Philippines possess good scope for a lift in investment as well. Malaysia has consistently generated very high savings (44% of GDP), and the Philippines has considerable scope to raise its present savings rate to at least in the low 20% area, if the present round of revenue enhancement efforts coupled with structural fiscal reform results in a significant reversal in the government’s deficit trend. Raising the investment rate to the low 20% level could trigger a significant rise in investment in the Republic. However, in the case of Malaysia, some investment uncertainty emanates from the fact that the government is attempting to reduce its investment role. In the Philippines, the battle on the present round of revenue enhancement moves and structural fiscal reform is far from complete.

Content of investment boom. During the last phase of the investment boom, i.e., the late 1980s to mid-1990s, Southeast Asia splurged largely on unproductive investments (many high-end condominiums, golf courses, and white elephant infrastructure) that are wasteful and on generic mass manufacturing production capacity that is no longer relevant to the region’s new growth strategy. The new phase of investment will require the region to boost the productivity of second-track sectors such as services, agriculture, agro-businesses, SMEs, and grass-roots sectors. It should also focus on boosting the productivity of education and the government, as well as infrastructure to support these second-track activities.

Currency Revaluation — Boon or Boom?

Some quarters of international investors are advancing the idea that as the US Federal Reserve drives down the value of the dollar and China finally submits to outside pressure to revalue its currency or implement exchange rate flexibility, the unwinding and revaluation/appreciation of the ringgit peg as well as appreciation of other Southeast Asian currencies under their managed float/basket peg regimes would warrant rising optimism on Southeast Asian markets.

We think these investors would be proved right if the Fed succeeds and China succumbs. There would be short-term capital gain on Southeast Asia investment holdings. Also, currency revaluation/gains would render a domestic demand boom quite probable in Southeast Asia. However, there might be at least two opposing structural impacts — one positive and one negative — resulting from such a titanic currency move.

A positive structural development could take place as Southeast Asia exploits its currency gains to help fund its own investment boom, since foreign capital goods that are essential for capital formation would become cheaper. The currency gains would also favor domestic demand in general as imports become cheaper, and a typical monetary response to currency revaluation is to allow for some degree of domestic monetary expansion. More significantly, the currency gains would help sharpen the region’s focus on second-track development as its generic mass-manufactured exports become less competitive and less in demand in the global marketplace.

A negative structural development would occur if a domestic demand boom were not managed properly. The region might take the easy route of compensating stronger currency-induced export deterioration with a loose money-induced unproductive asset boom rather than the tough journey of restoring export competitiveness through productive investment. This has happened in Japan and, to varying degrees, in the four Asian Tigers since the Plaza Accord in 1985.