If there's one thing which stands out about the West since 2008, it's this: there's been almost no substantive economic reform. There's been a lot of money printed, talking up of prospects (forward guidance in central banker parlance), huge subsidies to save certain sectors, but little restructuring of economies to put them on a more sustainable footing. Where the financial crisis showed the dangers of relying on ever-expanding debt to fund consumption, that reliance has only increased since.
Asia isn't immune from criticism on the reform front either. Much of the region has been busy congratulating itself for avoiding the worst of 2008, while ignoring the growing problems at home. China has fallen into the western-style trap of relying on more debt to produce enough economic growth to ward off a serious downturn. India's in trouble after backtracking on the broad-ranging reforms of the early 1990s which fuelled an average 6% GDP growth over the past two decades. Meanwhile, Indonesia - considered the rising star of Asian economies only a short time ago - has slowed quickly after keeping interest rates too low for too long and failing to sufficiently cut spending on the likes of energy subsidies.
Unlike the West though, the problems in Asia - barring Japan - appear soluble. But the time for reform is now if Asia's to take the next leap forward in its economic development. Today we're going to look at what Asia needs to do to get back on track.
Easy gains are over
If you'd told someone just 20 years ago that emerging markets - of which Asia is by far the largest - would account for more than 50% of global GDP or that China would be the world's second-largest economy, they'd have probably laughed at you or recommended that you visit the nearest psychiatrist. Such has been the rapid rise of the East.
Asia's astonishing progress can be put down to a mix of good management and good luck. The former includes:
- Bold reform. Think Deng Xiapao's dramatic opening up of China's economy from 1978, India's 1991 balance of payments crisis resulting in broad-ranging economic deregulation, the 1997 Asian crisis and subsequent political, economic and social overhaul of Indonesia, Malaysia, Thailand, South Korea and the Philippines.
- Relatively stable politics, particularly during the past five years. For instance, Indonesia has had a stable, albeit minority-ruling, government for almost a decade. Even Thailand and the Philippines - both notorious for throwing out leaders through violent and non-violent means - now have well-entrenched governments.
- Regional integration. Intra-Asia trade has flourished as barriers have come down. The formation of associations such as Asean has helped (though Asean has suffered setbacks of late).
Luck has also played a part, including:
- The fall of the West from 2008 resulted in investors looking to park their cash in a better, higher-yielding growth story and Asia fit the bill.
- The commodities boom from 2000 disproportionately benefited the region, particularly China and South-East Asia.
- Most of Asia has benefited from positive demographics with young populations driving increased economic productivity.
But many of the trends mentioned above are now turning around. Reform has stalled across the region. While politics remains relatively stable, that could change with key elections in India and Indonesia next year. Regional integration has taken a step backward as U.S.-China rivalry in Asia heats up. Potential QE tapering in the U.S. has already led to investors cashing out of Asia. That hasn't been helped by faltering growth as the commodities boom fades. Finally, demographics have turned negative in the likes of China where the working age population is now in decline.
That doesn't mean the Asian growth story is over. It just means that the easy gains of yesteryear are over. And the region needs to adapt quickly. Kick-starting economic reform to drive growth should be a key priority.
Asia is a large, diverse region though and its countries are at different stages of development and have different issues which need to be tackled. Today, we're going to explore the plight of four Asian countries - China, India, Indonesia and Japan.
Will Xi be the next Deng?
Many people forget how far China has come in a relatively short period of time and yet how poor it remains. In 1978, GDP per capita in China was just US$228. That figure has risen 26x to today's US$6,000. Amazing work. But to put it into context, Chinese GDP per capita is only 12% of the U.S. equivalent of close to US$50,000. China still has a long way to go.
What's got China to this point though has been an aggressive reform zeal. In 1977, the National Congress of the Communist Party chose Deng Xiaoping as Mao Zedong's replacement after the chaos and disastrous social experiments of the Mao years. Deng quickly freed rural households to farm their own plots and keep the earnings. That led to a huge acceleration in farm profits and productivity. Deng also allowed farmers to sell their produce in the city, opening the way for the vast migration of people from country to city, which has transformed China.
From 1982, Deng also proceeded to promote a younger generation of like-minded leaders. These leaders extended many of the reforms into the cities and loosened control of government enterprises and regulations.
And in 1992, Deng kick-started the reform process again by endorsing market experiments of export manufacturing zones on the southern coast. This paved the way for China to become the exporting powerhouse that it is today.
Importantly, however, though Deng died in 1997, the like-minded leaders he groomed carried on his legacy. Deng handpicked his successor, Jiang Zemin, and was also a mentor to Jiang's successor, Hu Jintao.
In 2001, China pushed to enter the World Trade Organisation and was eventually accepted. To join the organisation, China had to roll back trade barriers. In effect, the country opened itself up to foreign trade. This had an enormous impact in subsequent years.
What's clear though is that the economic reform which propelled China's rise stalled under regime of Hu Jintao. Since 2009, the country has instead relied on increasing amounts of debt to sustain its growth. That's led to significant distortions in the economy (real estate and alternative lending bubbles, for instance). And the debt seems to be achieving less and less, with GDP growth decreasing from the 10% average of 1980-2010 to the current 7.5%.
China needs a fresh bout of economic reform to increase productivity and reduce the reliance on debt to fuel growth. Here are some of the things that it needs to do:
- Decrease the influence of state-owned enterprises (SOEs). These SOEs number close to 114,000 and account for anywhere from 33-50% of economic output. All academic literature shows government agencies are much less productive than private businesses. Moreover, the more influence they have, the more they crowd out entrepreneurial activity. In China, SOEs control all the key industries, such as banking and resources. That needs to change to unleash growth.
- Deregulate the finance sector. China has an immature financial system. It regulates interest rates and deposit rates. It continues the yuan currency peg to the U.S. dollar. Its bond market is still relatively new. Further deregulation will allow capital to flow more freely and to be allocated more effectively.
- Clean up the banking sector. China has a bad debt problem that it hasn't owned up to. The stimulus of 2009 was financed via state-owned banks and many of the investments have undoubtedly gone bad. Everyone knows it. Better to acknowledge it now, otherwise it will be a drag on banks and the economy for several years to come.
- Boost the services sector. Clearly China's economy has become too reliant on investment spending at the expense of consumption. To increase consumption, it needs to boost the services sector. Doing this will provide more jobs (services are more labour-intensive than manufacturing), a key positive amid a slowing economy.
- Increase the social safety net. China's retirement system has assets of US$30 billion compared with the country's foreign exchange reserves totalling more than US$3 trillion. Given the rapidly ageing population, social programs need to be ramped up.
- Reduce corruption. There have been well publicised moves against Bo Xilai and, more recently, against the head of the commission which oversees state-owned enterprises. The question is whether these moves are politically motivated or a genuine attempt to reduce corruption. The truth is probably a bit of both but time will tell. Rampant corruption is not only costing the economy (some estimates suggest costs of up to 10% of GDP) but is a direct threat to the legitimacy of the Communist Party (where most of the corruption occurs).
The Communist Party holds a key economic meeting in November where the announcement of wide-ranging economic reforms is expected. I remain cautiously optimistic that Xi Jinping can deliver the necessary reforms but their impact will only be felt in the long-term. In the meantime, China may slow further as it deals with the unwinding of the recent credit bubble.
The move against India seems overdone
Unlike China, India seems to need a large crisis for change to happen. In 1991, a balance of payments crisis precipitated widespread economic deregulation which is credited for driving the rapid economic growth of the past two decades. Another crisis in the early 2000s led to further deregulation and privatisation of key industries. Like clockwork, a decade later, another crisis beckons. And the calls for reform grow stronger.
Unlike many commentators though, I believe the current crisis has been less about India's current account deficit (which essentially means you're investing more than you're spending) and more about capital flows and confidence. The fact is that India's trade deficit (a key component of the current account) has been decreasing since May and is likely to continue to decrease. And there's no correlation between the fall in the currencies of emerging markets and their respective current account deficits. If this view is right, the substantial depreciation in the rupee seems overdone.
The best way to stabilise the rupee would be to raise interest rates but this would impact the economy which has already slowed markedly. Not to mention that increasing rates in the lead-up to a general election is never favoured by incumbent governments.
Alternative options to stabilise the situation include measures to reduce the large budget deficit - at close to 5% of GDP-, the phasing out of energy subsidies - accounting for 2.3% of GDP - and the issuing of international sovereign bonds, denominated in rupee, to bring in capital to fund the current account deficit.
In the long-term, the subsidy issue is crucial. Growing subsidies from a government intent on bribing rural voters has been a central cause of the high inflation. Fertiliser subsidies have increased almost three-fold over the past five years, while petrol subsidies have grown by more than 20x!
India's legendary bureaucracy and corruption will also need to be addressed. The country ranks 94th out of 176 countries in Transparency International's Corruption Perception Index. The likes of China and Sri Lanka, not exactly doyens of clean government, rank higher than India (ie. are perceived as less corrupt). There are some estimates that suggest corruption has cost India more than US$120 billion over the past ten years.
Indonesia: that sinking feeling
Of course, Indonesia is the other country whose currency is under attack. Only 18 months ago, Indonesia was the darling of the investment community. Now, it's become a pariah.
Investors have focused on Indonesia's large current account deficit, which is 3% and growing, versus the 0.7% average of 2008-2011. Clearly the economy has overheated as interest rates were kept too low for far too long (which should have been obvious to the investors who piled into the country's bonds in 2011-2012). To stabilise the currency, the government has hiked rates by 150bps this year. Further rate rises are likely until the trade deficit improves.
A key issue remains reducing fuel subsidies. The government has taken some positive steps on this front, but needs to do more. It raised petrol prices by 44% this year. But the budget deficit is still expected to swell to 3.8% of GDP this year, with fuel subsidies expected to cost 200 trillion rupiah, equivalent to 13% of government revenue.
Like India, Indonesia has a huge corruption problem. The government has long promised to address the problem but few results have been achieved. Indonesia ranks 118 out of 176 countries in Transparency International's Corruption Perception Index. India ranks much better on this index, as noted above, which shows you how much work that Indonesia has to do to tackle corruption.
Decentralisation of government probably hasn't helped the corruption issue. Decentralisation has been lauded for redistributed economic gains from the capital, Jakarta, to regional cities. On the flipside though, corruption has spread with decentralisation, making it harder to detect and fix.
Savings from cutting subsidies and corruption should be used to bolster infrastructure. Anyone who's spent time in Jakarta traffic (the worst of any capital city in Asia if not the world?) knows the extent of the infrastructure problem. To put it into context, Indonesia spends less than 5% of GDP on infrastructure compared with China's 9%. Granted, China has probably overspent on infrastructure, but that shouldn't detract from Indonesia having a much greater need than China for better roads and transport systems and yet it's spending less.
Yes, Indonesia has its problems but let's not forget how far the country has come since 1997 when it was on its knees. Now it's a flourishing democracy, with a relatively strong economy and low debt. Indonesia's issues should prove temporary if a new government can provide fresh impetus to economic reform.
Japan's third arrow may come too late
Japan is very different from the rest of Asia as it's been a developed country for more than 20 years. It's so different that the geniuses in finance developed an Asia ex Japan stock market index, which spawned many Asia ex-Japan funds. This was recognition that Japan was indeed different, but for all the wrong reasons as the country's growth stalled while the rest of Asia boomed. Better to cut Japan off to bring in investor money, the financial world thought.
How things have changed. Japan has attracted droves of investors of late, drawn to the world's biggest turnaround story (at least in their eyes). These investors have followed a simple equation: more stimulus equals a higher stock market. Recent history has taught them as much as the correlation between U.S. stimulus and the stock market there sits at more than 90% since 2009.
The bulls on Japan certainly outnumber the bears at present. They argue the massive stimulus being undertaken, unprecedented in scope, is the best for the country to move its way out of deflation. And promised economic reforms will provide the necessary tonic for sustainable, long-term growth. These reforms, the so-called third arrow of "Abenomics", may include the following:
- Labour reform. It's been long recognised that Japan is a tough place to fire people, which makes for a rigid workforce and reduced economic flexibility. That's held back productivity and needs to change for Japan to move forward.
- Streamlined regulations. Japanese bureaucracy is entrenched and holds immense power. Too much power, from the perspective of most outsiders. Cutting bureaucracy and regulation would prove positive steps.
- Cutting corporate taxes. At 38%, Japan's corporate tax is among the highest in the industrialised world. Economic studies are relatively unanimous in concluding that higher taxes stunt growth.
- Increased immigration to address labour shortages. This is highly unlikely given the political sensitivities involved. But Japan's ageing population is a huge issue. Remember that GDP growth equals population growth plus productivity growth, which means a declining working age population provides a significant drag to GDP.
The bears on Japan, of which I am one (see this post for more), argue that the country debt burden is so huge that the country is cornered, whatever it does. If inflation rises to the government's target of 2%, interest rates will rise too and so will the interest burden on government debt. At 2%, this interest burden would be the equivalent of 80% of government revenue. If the stimulus strategy fails, the government will be forced to print more and more money to stay solvent. Either way, the bond market will revolt at some point. And the impact from any reforms is likely to come too late.
This post was originally published at Asia Confidential: http://asiaconf.com/2013/09/15/a-wake-up-call-for-asia/