How Asean become the world’s economic bright spot

Institutional Investor, September 2012

The Asean region stands out in the world economy for one reason above all others: it’s not in a mess. While the US struggles to revive, Europe wrestles with sovereign debt, India battles the deficit and Chinese growth slows, the Asean economies have largely stayed strong, underpinned by low debt, healthy banking sectors, high reserves and a demographic sweet spot.

“The region’s growth has held up reasonably well,” says Edward Teather, senior southeast Asia economist at UBS. “There’s obviously been ups and downs in the region; Thailand had its disastrous floods, but has bounced back pretty strongly.” And others have not faltered. “The Malaysian economy is holding up well, Indonesia has barely even slowed yet, and the Philippines keeps surprising on the upside. Singapore hasn’t seen much GDP growth but when you look around, it feels pretty good on the ground.” And alongside those established mainstays, other more frontier economies – from Vietnam to newly emerging Burma/Myanmar – offer the potential for explosive growth.

On top of that, Asean is in the middle of a long-term integration among its member states, in terms of trade, labour and capital flows. At a time when European harmony is disintegrating, the reverse is happening in southeast Asia, and it ought to be to the collective good. “Through liberalisation, you make it easier to do business,” explains Teather. “The more business gets done, the more value is added, and the higher incomes grow.”

Despite these positives, many markets in the region are trading at a considerable discount to long-term price earnings ratios and price-book values, which potentially creates a good long term opportunity for investors. According to Nomura, Asia Pacific ex-Japan is trading at a 17.8% discount to long-term P/E ratios, and 24% to price/book. There are exceptions – Indonesia, the world’s market darling, is at a 22.4% premium to long term price earnings and 22% to price book, while Thailand and the Philippines are in positive territory – but by and large the region doesn’t look expensive despite its better economic fundamentals. Little surprise, then, that Nomura has a heavy overweight allocation on emerging Asia (recommending a 12% weighting to the region, compared to 8% in the benchmark). “We expect these markets to be supported by improvement from fairly depressed sentiment levels, looser policy in key regional economies, and a second-half growth pickup in China,” writes analyst Michael Kurtz in Hong Kong.

So what’s so special about Asean? The first point is growing resilience to external shocks. Despite the miserable state of the rest of the world, the region can still be expected to grow on its own steam. Nomura has set out two cases for the world economy: one in which the euro area has a 0.6% decline in GDP growth in 2012 (its base case), and one in which it plunges to a 2% decline. In the base case scenario, it expects Indonesia to grow GDP by 5.8% in 2012, Malaysia 4.4%, the Philippines 4.6%, Singapore 2.7% and Thailand 5.5%. But even in the worst case scenario, only one of those economies – trade-heavy Singapore – would decline; Thailand and Indonesia would hardly be dented at all, such is the strength of their domestic economies. Economists also seem to be expecting a relatively rapid bounce back from any declines; Deutsche Bank’s 2013 GDP growth forecasts are 6.5% Indonesia, 5.3% Malaysia, 6% Philippines, 3.5% Singapore, 4.2% Thailand, 5.5% Vietnam and 6.9% for emerging Asia as a whole.

“Asean economies have shown a great deal of resilience in two ways,” says Tai Hui, regional head of research, Asia, at Standard Chartered. “One, governments and central banks have been able to mobilise policies to limit the amount of pain on households and corporates. They’ve been quite proactive in supporting the job market as much as they can. The second part is the financial sector: although stock markets are incredibly choppy, if you look at the bond market and banking sector, they have in most cases been resilient.”

Secondly, although Asean economies are enormously divergent in terms of economy, culture, language and politics, their underpinning demographics have a lot of common. “In relative terms, Asean economies look good as a bloc,” says Taimur Baig, chief economist for India and Asean countries at Deutsche Bank. “Generally there is a great deal of confidence here compared to what you see in the G3 economies: large sources of domestic demand, strong investor interest, robust consumer sentiment.” Asean populations tend to be young, with the bulk within the working age, and with a growing middle class.

A third point is the marked difference between Asean and the West in terms of the health of the financial services sector and access to capital. “A key part of the region’s strength is the availability of credit,” says Teather. “That has allowed firms to keep their factories open, to keep their employees on if orders dip; and if they do that, there’s the ability to bounce back quickly. Credit growth is in double digits in the region, which isn’t the case elsewhere in the world.”

There’s also little reason for that to change no matter how bad Europe gets. “Credit growth should remain pretty strong,” Teather says. “When you look at the various indicators on how much leverage and risk banks are taking, such as loan to deposit ratios in the banking sector, they are still at reasonable levels.” It is commonly argued that banks in Asia are far healthier than those in the west because they already went through a painful, decade-long period of restructuring and deleveraging after the Asian financial crisis in 1997-8. Additionally, countries themselves are comfortable enough in their fiscal positions to be able to keep money flowing. “When you look at current account balances, spending is rising compared to income,” Teather adds. “Most big Asean countries have still got healthy surpluses. So that source of spending hasn’t dried up either.” Credit growth does depend on the place; Baig says that in countries substantially exposed to the trade cycle, like Singapore, credit growth is slowing, while in more domestically driven economies like Indonesia there is “exceptionally high credit growth.”

Because of that, the withdrawal of credit that has come with the deleveraging by continental European banks has not been as debilitating as it might have been in earlier years. “The local and regional banks are clearly plugging a lot of the gaps,” says Hui. “And in niche markets like shipping finance, where there has been an impact from banks withdrawing, institutions like private equity have stepped up. We are not seeing the kind of liquidity freeze we experienced in 2008 and 2009.”

It’s notable  that capital is beginning to flow within the region as well. “One interesting thing we’re seeing is that regional pension funds and insurance companies are looking more and more within Asia for investment opportunities,” says Baig. “Now you see Thai asset management companies owning Korean debt issuances, or Singaporean asset management companies creating Asian bond funds and finding client interest. Regional central banks are diversifying their ample holdings of reserves into Asian assets. This is a significant development.” Additionally, interest rates have remained higher in Asia than in the west, as central banks have sought to keep inflation under control; that has made them very attractive sources of potential yield. These days Asian asset managers, as well as multinationals, see the benefits of investing in higher yielding credit in Asia.

This brings us to the other strong selling point of Asean: regional integration and its knock-on effects.

Asean was founded in 1967, against the backdrop of the Vietnam war, in Bangkok. Its mandate initially was to accelerate economic growth, social progress, cultural development and stability through the region, in the spirit of cooperation and mutual assistance. Its five original member states were Singapore, Malaysia, Indonesia, Thailand and the Philippines; although it has since been joined by Laos, Cambodia, Vietnam, Brunei and Myanmar, the original five are still the core. Largely, it has been about a broader idea than a practical reality, but some big moments have come along the way, such as the signing of a free trade agreement in 1992 and the so-called Chiang Mai initiative which created a network of bilateral swap agreements in 2000.

Since 2010, this has been followed by more free trade agreements, within Asean and with China, and the target now is the creation of the Asean Economic Community in 2015. By then, it is hoped that there will be free movement of goods, services, investment, skilled labour and capital between all the member states.

It’s already happening. “The 2015 goal is a bit of a red herring, because you can already see from the Asean scorecard [a measure of liberalisation in member states] and from the FTAs being negotiated that it is an ongoing project,” says Teather. “The impact is already being felt, will continue to be felt up to 2015, and will be felt beyond that. The 2015 date is just a figurehead.” What’s actually happening is slow but steady progress in a host of bilateral deals which eventually, over time, add up to something approaching unification on tariffs and flows. “A characteristic of the Asean way of doing things is, instead of trying to move everyone forward together, it’s more a track of possibilities,” Asean says. “Different countries will find themselves at different places along that line, moving at their own speed but influenced by where their peers are. It’s easier to liberalise if everyone else is liberalising as well.”

Not everyone thinks rapid progress is being made. “I would be a little more cautious on progress,” says Hui. “If you’re looking at a free trade area similar to the European Union of Nafta, that’s going to take longer than 2015 to accomplish.” He points to the difficult global environment – “never constructive for integration efforts” – as well as the political cycle in the region, with elections probably within six months in Malaysia, two years in Indonesia, and with frequent change in Thailand. “There is not a synchronised political cycle where the leaders of these 10 countries can get together to discuss regional issues.” That said, he feels that even if momentum on FTAs has slowed, there is an opportunity for progress on physical integration – road and rail networks, IT, power.

Partly because of liberalisation, and partly because this is what tends to happen as countries develop anyway, trade patterns are changing in the region. Historically, Asean has had better trade relationships with the rest of the world than with itself; even today, only about 25% of total Asean economy trade is with fellow Asean economies, which is far lower than in, say, the European Union of Nafta.

This is gradually changing. “From basic economic theory, we know you tend to trade more with your geographic neighbours,” says Baig. “As Asean economies removed trade barriers and eased the movement of people within the region in recent decades, more intra-regional movement of goods, capital and labour has taken place. This trend will only strengthen in the period ahead.”

Economists in the region have long struggled to get a handle on just what this means, though, because one pattern is that goods are exported to China – which looks like an intra-regional trade – but there are assembled into something else that is ultimately sold to the US or Europe. This matters because if the trade is really intra-regional, then Asia is better insulated against global shocks; if it isn’t, then Asia will still be hit by slowdowns in the west because that’s where the end buyer still is. “We still can’t tell clearly if the pick-up in intra-regional trade is just a function of the deepening regional supply chain,” Baig says. “But I think we are likely to see more final demand in Asia: country A producing something and it stays in country B instead of going to the US or Europe. It would make the entire region more resilient.”

Teather notes that, even if overall numbers haven’t changed all that rapidly, “what you are seeing is trade in Asia becoming less hub-and-spoke than it used to be [with Singapore as the hub] and more like a web between Asean nations, rather than everything going to and from Singapore.”

While the movement of trade away from the west has been a good thing for Asean nations, it has left it more exposed to a slowdown in China, where GDP has already slowed from double digit levels to 7.6%. Economists vary in their views on what this means for Asean. “It’s still going to be strong growth and a strong source of demand,” says Teather. “But we do see moderation, and perhaps that takes the edge off southeast Asian growth at the margin.” Baig agrees. “If there’s no further deterioration in the US, euro-area or China, Asean economies could remain fairly robust,” he says. “China is important for regional demand, but not only to the extent that its slowing growth is a function of the US and EU economies getting worse.” Hui, however, notes: “Since the global financial crisis, China has typically been responsible for one fifth to one third of export growth in the Asean region. China slowing down is the deciding factor when it comes to slower export performance in Asean.”

While trade and labour movement is clearly increasing, movement of capital may prove to be the hardest part of the process. After the Asian financial crisis, it became very clear that Asia needed bigger, stronger and more sophisticated local currency bond markets, and this has been achieved with great success. But the problem is these markets are not at all integrated. If an investor in Malaysia decides to invest outside their domestic market, they don’t go across the border to Thailand or Singapore, but all the way to US dollars. This infuriates local practitioners, who would much prefer to see capital remain in the region.

The Asian Development Bank in particular has been working for years on this problem, with a host of initiatives, study groups and working parties. They are gradually seeking to harmonize issuance, investment and regulatory standards among the member states in Asean in order to keep liquidity in the region, create greater fund-raising opportunities for local companies, and a wider range of local investment alternatives for investors both individual and institutional. “The effort is not to try to force Asian savings in the region, but to provide avenues for them to do so,” says Teather.

Asean economies are so diverse it is worth looking at some in more detail. Nowhere is quite so beloved as Indonesia, which was an absolute basket case of an investment story in the wake of the financial crisis. Today, it is a model emerging democracy, politically stable, anchored on domestic consumption, with growing foreign exchange reserves and a host of positive economic ratios to point to. But has it had too much adulation?

“There have been some slippages that have raised investor concerns,” says Baig. “Fundamentally the country looks strong, but there has been indecision on the fuel price increase, recent rulings by courts that suggest greater economic nationalism with respect to mining, and the current account has worsened due to weak exports and sticky imports. This has reduced some of the enthusiasm of investors. But when one travels to Indonesia, one realizes that if there is one country in Asia where there is hardly any sense of an impending slowdown, it’s Indonesia. Confidence is still sky high.”

And in future, we’re all likely to be looking much more closely at Myanmar/Burma, which as it moves along the path towards democracy and liberalization will see more investor interest from the west as embargoes are gradually lifted. This is a long, long-term story – there is barely a functioning stock market right now – but the same was said about Vietnam a decade ago.

Overall, what really stands out about Asean is that it is a partnership where people seem to like each other, rather than the cut-throat carnage elsewhere in the world where unity has been attempted. “Integration is not plain sailing; there are obviously disagreements and hiccups,” says Teather. “But was is interesting is that Asean is still talking about and moving towards liberalization and integration. That’s very different to what  you see in the rest of the world, where the trend is away from liberalization and towards protectionism.”

And progress should be good for the region. “It is very hard to argue against integration from a macro-economic perspective,” says Hui. “It means you are able to make better and more efficient use of the 600 million population you have here.” It also brings together a useful range of skill sets, he says: Singapore as the financial centre, commodity producers feeding emerging market demand, robust industrial bases in Thailand and Malaysia, abundant labour throughout, and business outsourcing expertise in the Philippines. “It’s a very complementary region. But it is still very diversified in income, political systems and culture. How do you integrate 10 countries into a closer-knitted economic unit? That’s still the key challenge.”

BOX: The investor perspective

Fund managers in the region tend to favor Asean economies, but with a sense of concern that too much money has already flowed their way.

Matthew Vaight, a portfolio manager at M&G Investments who specializes in emerging markets and Asian equities, says there is a strong economic growth story in Asean economies with consumer-driven economies and attractive demographics. “These markets, however, are garnering a lot of attention, and investors have arguably become overly enamored with them,” he says. “From our point of view valuations are now looking expensive.” M&G is now underweight Asean.

Part of the reason for this is that, despite the power of the economies themselves, they lack obvious national champions for international investors to buy. “The Asean region as a whole does disappoint us,” says Vaight. “There is a lack of exciting, innovative companies with an international footprint. Most markets are dominated by domestically focused companies such as banks and utilities; there are very few global leaders.”

The clear exception to this rule is Singapore, which Vaight says is the market he is most attracted to because of its maturity, its corporate governance standards, and the fact that valuations are now attractive. As a regional hub, it attracts wealth from its neighbors, which Vaight says makes it an Asian equivalent of Switzerland. “From an investment perspective, this attraction of overseas funds has positive ramifications for the Singaporean banks and companies with property exposure in the country, such as Fraser & Neave and Jardine Matheson.”

At Threadneedle Investments, chief investment officer Mark Burgess notes that the main Asean economies are slowing in response to weaker Chinese and global growth, but that Thailand and the Philippines have impressed with their robustness. “With inflationary pressures continuing to abate across the region, ASEAN central banks have scope to ease monetary policy and help support growth,” he says.