Not since the Asian financial crisis has Southeast Asia had to contend with the combination of political and economic challenges that it now faces. Uncertainty in the major western markets and China are leading to currency weakness, anemic export growth and plunging commodity prices are hitting the region’s economies almost simultaneously, reducing growth expectations measurably for the next few years.
In the meantime, politics is complicating the region’s ability – whether at the country or multilateral level – to respond quickly and cohesively to these emergent economic problems. Governments in Bangkok and Kuala Lumpur are distracted by domestic controversies that could turn into potential instability; a possibly disruptive political transition will take place in Manila next year; and Indonesia’s president is attempting to regain his reformist footing after an underwhelming first year in office. Even in Myanmar, which only two years ago seemed to be on the verge of a breakout, questions about the pace and direction of reform have surfaced.
As a result, Southeast Asia’s investors have over the past year fled to greener – and often Western – shores. Even normally resilient foreign direct investors are being noticeably cautious, worrying that the combination of financial turmoil and weaker growth outlook compromise the region’s economic future, at least for the next few years. This has fueled speculation of further economic shocks down the road as higher interest rates and weaker demand could lead to widespread firm closures, especially in the small and medium enterprises that are at the core of job creation and growth in many of these countries.
Two regional currencies, the Indonesian ringgit and the Malaysian rupiah, have weakened to levels unseen since the peak of the 1990s crisis. The fear, unspoken but palpable among many who lived through the Asian financial crisis, is that this can cause social unrest to again erupt, particularly in the form of ethnic tensions in Indonesia or Malaysia, where the Chinese, while a minority, hold a significant portion of the wealth, or in urban versus rural constituencies in Thailand, where the latter continue to support former and self-exiled Prime Minister Thaksin Shinawatra.
However, while it is tempting to see parallels to the Asian financial crisis, 2016-2017 are unlikely to be 1997-1998. First, Southeast Asia does not have the deep macroeconomic imbalances that existed in the 1990s. Although companies have increased their borrowing over the past few years, including in foreign currency, and some major defaults are possible, the sense of local banks and companies being grossly exposed to weaker currencies and foreign investors calling in their money is low. In many cases, central banks in several countries have also tried to limit bank exposure to traditionally problematic sectors such as real estate to limit overall systemic risk, and warned firms against over-borrowing abroad while earning in the local currency.
Second, the decline has been gradual and not acute, helping avert a similar social shock. When the crisis hit Southeast Asia in the 1990s, the economic shock was so severe that frustrated citizens, many of them having only recently attained middle class status, vented their frustration at long-standing regimes, particularly in Suharto’s Indonesia and Mahathir Mohamad’s Malaysia.
Third, even assuming that an economic crisis does recur, political systems are more robust than the 1990s. Again, this is particularly evident in Indonesia, where elections since then have consistently and credibly yielded democratically elected governments at both the national and local government levels, and while citizens can be frustrated by the incompetence of their elected officials, the fact that they did vote them in (and can vote them out) provides outlet for public frustration. In the Philippines, elections in 2016 will help provide a similar safety valve, although the economy is more insulated from a crisis because of the still high level of foreign worker remittances.
In fact, it is both Thailand and Malaysia – the two countries where democratic systems since the crisis have developed the least or even regressed – that face the most difficult combination of political and economic environments today. Malaysia is still run by the United Malays National Organization (UMNO), which is now in danger of being split by a fight between Prime Minister Najib Razak and its long-time iconic leader, former Prime Minister Mahathir Mohamad. UMNO’s share of the popular vote has been declining since 2008, down to a minority based on the 2013 general elections, and it only maintains control of parliament through effective gerrymandering of election districts and because of an infirm political opposition.
In Thailand, at least two military coups have undone the political changes since the 1990s, as political elites have attempted to roll back the electoral and political power of former Prime Minister Thaksin Shinawatra. Order today is being maintained by the firm hand of the military and nothing else. A draft constitution was rejected in September by the military and the return to democratic government is unlikely until 2017. Although both countries have among the most competitive industrial and manufacturing sectors in the region, their political systems are proving to be liabilities at times of crisis, rather than sources of strength.
Aside from the politics and economics of crises, the other factor that will define the region in the long term, or at least perceptions of stability in the near term, is the geopolitical balancing act that its individual countries will attempt to play with the U.S., China, and to some extent Japan, Russia and even the European Union. Although it is and will be convenient to view Southeast Asia in terms of spheres of influence, the reality is more complicated – while countries will remain wary of Beijing’s regional intentions, they will also recognize that actual conflict over any territorial dispute is not only unrealistic given the differences in military capability between China and the other Southeast Asian countries, but damaging to both regional and individual country economies. Signals from Washington are also likely to temper even the countries seemingly most opposed to China, such as the Philippines and Vietnam – while the U.S. has cautioned Beijing against expansion of its facilities in the area and emphasized the need to respect freedom of navigation, it has also been similarly cautious in discouraging more risky behavior from Manila.
While all accept the reality of China’s rise (and hope to profit from it), they all share concerns about Chinese leadership. As such, although the ASEAN countries will resist being drawn into a U.S.-led bloc, they will still seek to leverage the U.S. military and economic presence as a hedge against regional domination by China. Some countries such as the Philippines will hew more closely to the U.S. position, since taking a more antagonistic stance vis-à-vis China on territorial disputes plays well domestically. Countries on the Southeast Asian landmass – such as Thailand, Cambodia and Singapore – will play a more sophisticated game of balancing economic and security relationships. Indonesia, which has its own goals of regional leadership in ASEAN will also attempt a more nuanced relationship.
The recent financial market turmoil in China will not significantly affect perceptions or attitudes in the region towards the country’s role in Southeast Asia. Despite its recent problems, China’s role in Southeast Asia will only grow – in fact, the relationship is deepening from trade to investment and financial flows.
Differentiation Will Be the Key
Therefore, while Southeast Asia will grab the occasional headline, the actual risk within the region is more manageable. Investors that paint the whole region, therefore, in the broad brush of emerging market withdrawal and heightened economic or geostrategic risk, will miss opportunities that the current currency and asset price weakness could provide for longer term investment. The key will be in differentiating the individual countries, as some countries will continue to experience sustained volatility, driven by both their political and economic vulnerabilities. Others will, however, prove to be more robust.
Where Risk Exists
Arguably the most politically and economically vulnerable country is Malaysia, where Prime Minister Najib Razak is under attack for supposedly mismanaging state development fund 1MDB, including allegations that he siphoned off USD 700mn into his personal accounts. Allegations of missing payments run over USD 1bn. The controversy has severely damaged Najib’s popularity and led to an open political battle with the iconic Mahathir. However, UMNO’s leadership has sided with the current prime minister against its former leader to avoid an open split within the party and to deny the opposition, which is suffering its own internal battles, any additional leverage. The party may also be reluctant to remove Najib while it has not yet chosen a successor who can lead UMNO through the crisis and to the next general elections in 2018. Najib, therefore, retains his position mainly by default, rather than by any successful effort at resolving the 1MDB fund controversy. This will create and sustain overall perceptions that the threats to his leadership have not been removed and that heightened political noise and a weak and distracted government will be the norm for Kuala Lumpur for the foreseeable future.
UMNO’s more precarious position has caused the party’s leadership to become more conservative as it tries to consolidate its support among majority Malays. Reform that targets affirmative-action pro-Malay policies have become more unlikely. However, this more conservative shift has further alienated ethnic Chinese and Indians, who make up roughly one third of the population. The late August pro-reform Clean (“Bersih”) rally, which was the largest of its kind since the movement was launched in 2007, was made up predominantly of ethnic Chinese Malaysians. Throup has been abandoning UMNO since 2008 because of the party’s seeming unwillingness to reform the pro-Malay affirmative action policies that have stunted industrial and economic growth. The risk is that the more UMNO attempts to circle the wagons, the more these ethnic divisions and tensions manifest.
Indonesia also faces serious economic challenges, as nationalist and consumption oriented policies and the lack of reform in the natural and industrial sectors have eroded its competitiveness. Among the Southeast Asian countries, Indonesia is the most vulnerable to an external shock triggered by U.S. Federal Reserve action. Foreigners hold a large amount of domestic debt, which, when combined with the amount of corporate USD debt, can generate volatility during times of high outflows. The current account has worsened over the past year, while foreign exchange reserves are not as high as those of Indonesia’s peers in Southeast Asia. Tax collection is also suffering as the economy weakens.
For now, the government is focused on some administrative tweaks that would reduce pressure on the currency. A more adequate response by the government would be strong structural reforms that raise FDI inflows, improve the implementation of long-delayed infrastructure projects, reduce structural rigidities in the economy and mitigate recent distortions introduced by nationalistic policies.
However, with President Joko Widodo unable to assert political control for much of his first year in office – his administration coalition was a minority until September this year and the president himself is occupied by a political feud with his party leader – the probability of significant and far-reaching reform in the near term, while gradually increasing, is still low. Meanwhile, the weak and sometimes confusing political and policy signals from Indonesia through the end of the year are likely to create some volatility on their own, making it difficult for the government to respond quickly to shocks.
In comparison, Widodo does not face any significant leadership challenge, either from inside or outside his party. There is no sense of an overhang of political instability in Jakarta, unlike in Kuala Lumpur. The difference between Indonesia and Malaysia is that Widodo has more political capital than Najib, which is the result of Indonesia having a more democratic system and credible elections. Economic outcomes are still important for leaders’ popularity in both countries, and the weakness of the currency and decline in growth are taking their political toll, but what differentiates both leaders’ political fate is that voters in Indonesia ultimately see elections as a valid way of removing erring leaders, unlike in Malaysia.
And Where Risk is Less
Neither Thailand, the Philippines nor Vietnam has the potential for a political or economic shock similar to Indonesia and Malaysia. The risks are more in the long term, should they fail to implement structural reforms that keep their economies competitive. Foreign investors will likely see these three countries as the most favorable destination for investment in the near term.
In Manila, it will soon be clear who the main contenders will be for the 2016 presidential election and this will be the variable that will drive the political outlook. Should the surveys show Vice-President Jejomar Binay as the favorite, then risk perceptions are likely to go up, not only on concerns about the potential for corruption and patronage under his administration, but on the apprehension that he will likely have an uneasy and potentially destabilizing relationship with the powerful business and middle class elites in Manila. On the other hand, if an alternative candidate, either Grace Poe or Mar Roxas, gains the upper hand, then risk perceptions will recede as neither candidate is burdened by the same corruption allegations as Binay. Regardless of whoever succeeds Aquino, however, the challenge will be the same – the country needs serious upgrades to its creaky infrastructure, improve rule of law and business regulation and licensing, and reduce corruption.
In Thailand, the military continues to maintain control and is unlikely to allow any form of dissent that could morph into wider and more dangerous forms of protest or mobilization. Although the factions that ousted the government allied with former Prime Minister Thaksin Shinawatra are still broadly in alignment, this transition is now fully associated with the military and coup leader and Prime Minister Prayuth Chan-ocha. The institution’s full weight is now being used to assure that the political quiet is maintained. Therefore, while there are important markers and risk triggers ahead such as the drafting of a new constitution and the criminal trial of former Prime Minister Yingluck Shinawatra, the probability of this risk manifesting is low in the near term.
But long-term uncertainty still persists, especially if the negative political environment continues to drag down both consumer and investor sentiment, and impedes important infrastructure upgrades needed to keep the economy competitive. Thailand’s industrial capabilities are among the best in the region, especially in auto and consumer goods manufacturing, but while the country may avoid both political and economic shocks, a longer-term downgrade of its once rapidly industrializing economy cannot be fully discounted.
Vietnam continues to make only very slow progress in resolving the bad debts in the banking system and reforming its inefficient state enterprise system. Yet Prime Minister Nguyen Tan Dung is arguably in his best political position in 6-7 years; the probability is increasing that he will win the position of General Secretary next year, the most powerful post in the Communist Party of Vietnam, and that an ally will succeed him as prime minister. While Dung is mindful of how large capital flows led to the asset bubbles and inflation that undermined his leadership from 2009 to 2011, he still likely sees private capital as being an important component of Vietnam’s future growth – which makes a consolidated and wizened Dung a favorable scenario for foreign investors.
Similar to other emerging markets, Southeast Asia’s currency and asset markets are experiencing the negative effects of the uncertainty generated by the imminent interest rate rise in the United States and China’s volatility and potential economic weakness. There is even speculation of a 1990s-style crisis. However, political and economic systems have evolved and systems where the governments have become more accountable have also become more robust, enhancing stability. Investors would, therefore, be better served by not painting the region with such as broad brush, and looking at where governments, accountable to their constituencies, are now putting in place the measures needed for longer term reform and growth.