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For Southeast Asia, the Recent Turmoil Is Anything but 1997 Again

Asean countries are resisting today’s turbulence in emerging markets thanks to reforms taken in the wake of the late ‘90s crisis.

When a key indicator of Chinese manufacturing fell to a six-month low in January, many emerging-markets investors feared that Southeast Asian countries would be hit again by the kind of financial contagion that roiled the region in 1997. Many countries had already experienced capital outflows sparked by the U.S. Federal Reserve Board’s tapering of its bond-buying program. A slowdown in China, the most important export market for most of these economies, might send investors stampeding to the exits.

The doomsayers turned out to be wrong. Although some emerging markets, notably those with large dollar-denominated debts, such as Argentina, Hungary, India and Turkey, faced strong pressure, countries in the Association of Southeast Asian Nations — Brunei, Cambodia, Indonesia, Laos, Malaysia, Myanmar, the Philippines, Singapore, Thailand and Vietnam — emerged unscathed and seemed downright ebullient in comparison.

Consider Indonesia. Although the country was included in Morgan Stanley’s so-called Fragile Five bloc of emerging-markets nations, Indonesia’s stock market had the best-performing equity index in Asia in January and was up 13.68 percent for the year as of March 17, while the rupiah had climbed 7.3 percent against the dollar. Similarly, the Philippines’ PSEi stock index had gained 9.46 percent this year as of March 17. Even the Thai baht, which was the canary in the coal mine back in 1997 and dropped in value recently because of a political impasse in the country, has managed to post a modest gain against the dollar of 1.8 percent since the start of the year.

“Markets aren’t in panic mode anymore,” says Benoit Anne, head of emerging-markets strategy at Société Générale in London. “Southeast Asia is moving from doom to bloom. Although I have not called the start of the bloom phase yet, I can smell the blossoms.”

Rodolfo Martell, portfolio manager of the $630 million BlackRock Emerging Markets Long/Short Equity Fund, says Southeast Asia “is going to be a nice jewel” for investors. The region is “relatively isolated from the negative sentiment affecting other emerging markets, such as Eastern Europe and Turkey, and that is a good thing,” he adds.

What explains the resilience? Asean countries have avoided serious trouble so far because they learned the lessons of 1997 and took appropriate countermeasures, says Eswar Prasad, professor of trade policy at Cornell University, former head of the International Monetary Fund’s China division and co-author of Emerging Markets: Resilience and Growth Amid Global Turmoil. Those measures include reducing foreign currency debt, moving from fixed to floating exchange rates and building vast stockpiles of foreign currency reserves to call upon if their own currencies come under attack. The 1997 crisis began when Thailand ran out of foreign exchange reserves and could no longer maintain the peg between the baht and the dollar.

“Almost across the board Asean countries have much lower levels of foreign currency debt than they had during the Asian financial crisis,” Prasad tells Institutional Investor. “They have flexible exchange rates, and they have large FX stocks in reserve. Even those economies that got hit hard during the announcement of the Fed taper and thereafter suffered a rough patch are not really vulnerable to the sort of crises that they would have been vulnerable to in the past.”

Foreign investors seem much more discriminating these days, Prasad adds, so a crisis in one emerging-markets country does not necessarily lead to a sell-off across the entire sector, as happened in 1997.

To be sure, the region does face some serious challenges. A major slowdown in China and continuing weakness in Europe would hurt the region’s exports. Rising household debt poses risks to domestic demand in many Asean countries. Growth has slowed sharply in Thailand, and domestic political uncertainty clouds the outlook there and in Indonesia.

Yet most investors believe the positives outweigh the potential negatives across most of the region. One measure of investor confidence is Japanese foreign direct investment. According to Singapore’s DBS Bank, Japan increased its FDI in Asia by $40 billion in 2013, and fully 42 percent of the country’s FDI is now in Southeast Asia — considerably more than in China.

FDI has made all the difference in a country like Indonesia, which had a current-account deficit of 3.3 percent of gross domestic product in 2013, according to Société Générale’s Anne. The country received $22.5 billion in FDI last year, an increase of 22.4 percent over 2012, according to Indonesia’s Investment Coordinating Board. “The deficit is almost fully covered by sustainable foreign direct investment,” Anne says. “The macro picture is much stronger than perceived by the markets.”

Investors did punish Indonesia during the first wave of taper scares, between May and September of last year, selling shares and dumping the rupiah. Morgan Stanley analysts included Indonesia in the Fragile Five — alongside Brazil, India, South Africa and Turkey — because of the country’s current-account deficit.

Bank Indonesia, the central bank, began intervening in the foreign exchange market last year, dealers and analysts say, driving the rupiah down more than 20 percent, from 9,700 to the dollar in May to 12,165 at the end of the year. “I think that was engineered with the policy aim of stanching the red ink in their current account,” says Tim Condon, Singapore-based head of Asian financial markets research for Dutch bank ING. By making imports more expensive and exports cheaper, the current account should improve — and it did. The country posted a trade surplus in each month of the fourth quarter. As a result, the annualized current-account deficit declined to 1.98 percent of GDP in that quarter from 3.85 percent in the third quarter.

At the same time it was steering the rupiah lower, Bank Indonesia began a series of hikes in its short-term policy rate, raising it a total of 175 basis points between June and November, to 7.50 percent, in a bid to keep a lid on inflation.

“Recent developments indicate that the rate of inflation is under control and the current account deficit is shrinking,” the central bank said in a statement after its latest policy meeting, on March 13. It predicted that household consumption would slow and that investment growth, including nonconstruction investment, would rebound in the second semester of 2014.

The bank said it would maintain a tight monetary policy for the remainder of this year, forecasting that inflation would decline from 7.75 percent in February to 4.9 percent by the end of the year, within its target range of 3.5 to 5.5 percent.

“Frankly, I think Indonesia has taken the tough position that was much needed to allow for some macroeconomic adjustment with regard to the current-account deficit, raising interest rates and allowing the currency to depreciate, and showing a willingness to sacrifice domestic growth,” says Herald van der Linde, head of Asia-Pacific equity strategy at HSBC Holdings in Hong Kong. “Indonesia shouldn’t be part of the Fragile Five people were talking about last year.”

Bank lending slowed slightly in December but is still growing at a rate of more than 21 percent a year. ING’s Condon believes that tighter money will result in a hit to growth this year, but Indonesian authorities predict the effect will be slight. The central bank forecasts that growth will range between 5.5 and 5.9 percent this year, compared with 5.8 percent in 2013.

Lewis Kaufman, manager of Santa Fe, New Mexico–based Thornburg Investment Management’s $2.8 billion Developing World Fund, says that the long-term outlook for Indonesia is attractive but that macro risks cloud the short-term horizon. Nonetheless, he has invested 2.3 percent of his fund, a long-term holding, in Indonesia’s Bank Mandiri, the nation’s largest lender, which was created through the merger of four state-owned banks after the late-’90s crisis. “Even if interest rates rise a lot, which will hurt net interest margins for banks, Mandiri is well positioned to protect margins and take market share,” Kaufman says. He also likes Matahari Department Store, a chain that takes merchandise on consignment.

Higher mortgage rates might help rein in the booming property market in Indonesia, where real estate prices grew by an estimated 14 percent last year, according to a Bank Indonesia survey. The central bank moved in September to curb the real estate boom by imposing a 60 percent loan-to-value ceiling on second-home mortgages and a 50 percent limit on third homes.

The government has been pressing companies, both foreign and domestic, to increase production in Indonesia rather than bringing in imports or exporting commodities. In response, companies like General Motors Co. have ramped up production in the country. Last year GM invested $115 million to retool a plant at Bekasi, near Jakarta, to produce small cars for the global market.

“The government is encouraging companies to have local operations if they want to import some other-model cars into Indonesia,” says Gustavo Colossi, vice president for sales at GM Southeast Asia. The Chevrolet Spin, a small sedan produced in Bekasi, is now being exported to other Southeast Asian markets, as well as to Latin America and Africa, Colossi says.

In January the government banned exports of some commodity minerals, such as bauxite, in hopes of spurring production of aluminum in Indonesia rather than exporting the commodity to China. But the authorities exempted copper, one of the country’s largest exports, from the ban after lobbying by producers.

Eric Sugandi, Jakarta-based economist at Standard Chartered, says Indonesia’s two biggest challenges are bringing its current-account deficit under control and improving its antiquated infrastructure. Fuel makes up about a quarter of the country’s imports, and the rupiah’s decline has increased the cost of the fuel bill. The government subsidizes fuel for Indonesia’s growing ranks of automobile and motorcycle owners; cutting those subsidies could cause a huge political backlash.

Fixing the nation’s infrastructure bottlenecks could add 2 percentage points a year to economic growth, Sugandi estimates. Efforts to improve infrastructure may get some new impetus after parliamentary elections in April and presidential elections in July, Sugandi says, but he notes that local officials play a significant role in getting infrastructure projects under way and that there is little coordination between central authorities and local governments.

Jakarta Governor Joko Widodo and former army chief Pramono Edhie Wibowo are two of the leading candidates in a wide-open race to succeed incumbent President Susilo Bambang Yudhoyono, who is prohibited under the constitution from seeking a new term. Widodo, the front-runner in recent polls, is a populist politician who raised the minimum wage in the capital region by more than 40 percent last year and gave poor city dwellers access to free education and health care. Perhaps most importantly, in a country where corruption is rampant, he is seen as incorruptible. He is the candidate of the Indonesian Democratic Party of Struggle, which was founded by late independence leader Sukarno and is now led by his daughter Megawati Sukarnoputri, who served as president from 2001 to 2004. Wibowo, Yudhoyono’s brother-in-law, is seen as a supporter of the pro-business policies of the current president. Yet most political analysts believe economic policy will remain broadly the same regardless of who wins.

The same can’t be said of Thailand, where a political stalemate has seriously undermined growth. Since December, Bangkok has seen a series of violent protests against the government of Yingluck Shinawatra, who took over as prime minister in 2011 after her brother, former prime minister Thaksin Shinawatra, went into exile in Dubai following a conviction for corruption. Yingluck called new elections for February, but antigovernment protesters blockaded polling stations, and the results were never finalized.

The social and political unrest has virtually paralyzed the government. Yingluck had planned to borrow 2 trillion baht ($62 billion) to finance major infrastructure projects in Thailand, but because the government is only a caretaker —the prime minister dissolved Parliament in December — it cannot legally take on new debts. In March the country’s supreme court declared the infrastructure spending unconstitutional, leaving it in limbo. The government also hasn’t been able to pay farmers crop price supports for nearly six months because of its inability to borrow.

The instability carries a steep cost: Since the turmoil began investors have withdrawn everything they invested in the country between 2009 and 2012, according to Christopher Wood, chief equity strategist at brokerage CLSA in Hong Kong.

The capital outflow contributed to a sharp decline in growth, to 0.6 percent in the fourth quarter from 1.4 percent in the third. The decrease reflected a sharp contraction in domestic demand: Consumer, investment and government spending were all down. In all, growth in 2013 was 2.9 percent, a steep drop from 6.9 percent in 2012.

Sethaput Suthiwart-Narueput, a Yale University–educated economist who heads the Thailand Future Foundation, a Bangkok think tank, says Thai investment never fully recovered from the Asian financial crisis 17 years ago. One reason is that Thailand now has many more competitors for investor dollars. Vietnam, for example, didn’t exist as a destination for foreign capital in 1997, but it now gets more FDI than Thailand ­­— $11 billion last year, compared with Thailand’s $8 billion. “If we had a strong and effective government that could embark on infrastructure investment, that would typically bring in a lot of private investment, but strong and effective government is not something we’ve had for quite some time,” says Sethaput.

Benjarong Suwankiri, chief economist at TMB Bank in Bangkok, points out that household debt in Thailand has been rising dramatically since 2011, when a major flood caused widespread damage and prompted consumers to go on a credit-fueled spending spree the following year. The government later offered citizens tax breaks to buy cars, causing household debt to increase further, rising 18 percentage points to 68 percent of GDP, a level approaching Malaysia’s 80 percent. Thailand’s per capita GDP is a little more than half that of Malaysia, and many analysts question the economy’s ability to sustain such debt levels.

All of these factors have weighed down the economy. The National Economic and Social Development Board, the government’s planning agency, expects the economy to grow by 3 to 4 percent this year, down from earlier estimates of 4 to 5 percent.

On March 12 the Thai central bank cut its policy rate by 25 basis points, to 2 percent. The bank’s monetary policy committee said that “downside risks to growth have risen in the wake of the prolonged political situation.” But economists like Benjarong say a rate cut won’t have much effect on growth while the political stalemate continues.

In contrast to Thailand, the Philippines under President Benigno Aquino III has managed to shed its reputation as the perennial sick man of Asia to become an investor favorite in the past few years. The economy grew at a robust 7.2 percent rate in 2013, up from 6.8 percent in 2012, making the Philippines the fastest-growing economy in Southeast Asia.

CLSA’s Wood says his model portfolio gives the Philippines’ equities the biggest overweight in 11 years because of two factors: foreign remittances from Filipinos working abroad and the country’s business processing outsourcing industry. The sector, which provides services such as call centers to multinational companies, has expanded rapidly in recent years and become a potent rival to competitors in India.

“The Philippines has a unique export: They export their people, who speak English well,” Wood says. The inflow of dollars helps drive domestic consumption, prompting healthy returns on a range of equities, from retailers to banks, he notes.

According to Bangko Sentral ng Pilipinas, the country’s central bank, remittances helped generate a current-account surplus of $11 billion, or 4.3 percent of GDP, in 2013. The bank projects that remittances will rise by 6 to 7 percent this year. The current-­account surplus will ease slightly, to $10.4 billion in 2014, central bank governor Amando Tetangco announced in December.

“While the global economy has become more challenging because of heightened financial market uncertainty following monetary policy adjustments in the U.S. and generalized concerns about the sustainability of growth in emerging economies, domestic economic activity is likely to stay firm,” the central bank said in its latest policy statement, in February. “Sound fundamentals such as buoyant demand, strong fiscal and external positions as well as favorable consumer and business sentiment would support economic activity going forward.”

The central bank has kept its key policy rates steady since October 2012, with the overnight borrowing rate at 3.5 percent and the reverse repurchase facility rate at 5.5 percent. The stance appears aimed at deterring foreign speculators from using the peso as a carry trade, according to ING’s Condon. The central bank cut rates by 100 basis points during 2012, encouraging carry trade activity. The peso declined by about 9 percent last year, to 44.26 to the dollar, but has steadied lately, trading at 44.68 in mid-March.

Some analysts believe the central bank will be forced to raise rates this year because of inflation concerns stemming from the increased spending required to help the Philippines recover from Typhoon Haiyan, which hit in November, killing 5,280 people and devastating a wide swath of the country. The government has said an estimated $8 billion will be needed to help the stricken area recover. The Philippines’ inflation rate rose to 4.1 percent in 2013 from 2.9 percent a year earlier. The central bank has an inflation target of 4 percent plus or minus 1 percentage point.

Maarten-Jan Bakkum, an Amsterdam-based strategist who advises the $243 million ING Emerging Markets High Dividend Equity Fund, says the Philippines is the only country in Southeast Asia in which his fund is overweight. The fund focuses on stocks in the banking, consumer and telecommunications sectors because they offer the greatest liquidity in an otherwise illiquid market.

Equity valuations in the Philippines look much better now thanks to last year’s sell-off, says HSBC’s van der Linde. The PSEi dropped 20.9 percent between May, when former Fed chairman Ben Bernanke first hinted at a tapering of the U.S. central bank’s bond purchases, and the end of December.

“The underlying economic story there is very strong, if not the strongest in Asia,” contends van der Linde, noting that the Philippines at present faces no political concerns like those in Indonesia and Thailand. Another plus is that the Philippines has no major government subsidies, unlike Indonesia, Malaysia and Thailand, where subsidies are causing economic distortions and posing difficult political challenges for governments.

The Malaysian government has begun to rein in subsidies as part of a broader package of reforms intended to contain the budget deficit and reinvigorate the economy. Those moves, combined with expectations of a recovery in key export markets in the West, have buoyed investor confidence.

“Given that 10 percent of Malaysia’s exports go to Europe, we think that Europe flipping from negative to positive growth is significant,” says David Mann, head of Asian research for Standard Chartered in Singapore. “On top of that, we’re expecting to see an acceleration in U.S. growth.”

Malaysia’s economy expanded by 4.7 percent last year, down from 5.6 percent in 2012, but growth picked up in the fourth quarter to a 5.1 percent rate, the fastest pace in a year, thanks to a surge in exports. Manufacturing exports rose 10.2 percent in the fourth quarter, compared with a flat performance in the first nine months.

Mann estimates that the slowdown in exports earlier in 2013 cut 3 percentage points from the growth rate last year. “We think this year that negative is going to evaporate,” he says. “It’s a similar sort of story, to a slightly smaller degree, in Singapore.”

A weaker currency has also given a boost to Malaysia’s exports. The ringgit fell nearly 12 percent against the dollar between May and September of last year. It has stabilized since then, trading at about 3.27 to the dollar in mid-March.

Thanks to the improvement in exports, Malaysia’s current-account surplus grew to $4.93 billion in the fourth quarter of 2013 from $3.06 billion in the third. For the full year the surplus was $11.36 billion, or 3.8 percent of GDP, down from $18 billion the year before. In 2013 the ringgit came under pressure and depreciated 8 percent — making it the worst-performing Asian currency in the last quarter of the year.

“We like the fact that Malaysia has a current-­account surplus, unlike other emerging-markets nations,” says BlackRock’s Martell. “The country has a stable outlook. Boring is good.”

Investor confidence in Malaysia got a boost when the government reported that its fiscal deficit declined to 3.9 percent last year from 4.5 percent in 2012. A reduction in government fuel subsidies in September contributed to the improvement. More subsidy cuts are looming: The government has announced that electricity prices will rise by 15 percent this year. Analysts welcome the moves. Energy subsidies had climbed from 9.8 percent of government spending in 2009 to 17.5 percent in 2012, an increase the government realized was unsustainable.

Rising energy prices are expected to lead to a small uptick in inflation, as shown in January, when inflation reached 3.4 percent — a two-year high. But Standard Chartered’s Mann says it’s unlikely that the Bank Negara Malaysia, the country’s central bank, will raise its policy interest rate from the current 3 percent level, where it has been since May 2011, until the final quarter of this year.

In October, when Malaysia was nearing its self-imposed debt ceiling of 55 percent of GDP — the highest in Asia — the government of Prime Minister Najib Razak announced plans to replace the current sales tax regime, which omits numerous items, with a broad-based goods and services tax of 6 percent in 2015. Some analysts believe the change could boost domestic consumption this year as consumers seek to make purchases before the change comes into effect.

Growing political tensions could cloud the outlook, however. The reduction in subsidies and consequent price increases for food and energy have ratcheted up opposition to Najib’s United Malays National Organization, the coalition that has ruled Malaysia since it gained independence from the U.K. in 1957. The coalition narrowly defeated the opposition People’s Alliance in parliamentary elections last year. The political climate heated up in March with the reopening of a controversial criminal case against opposition leader Anwar Ibrahim. An appeals court overturned a 2012 acquittal of Anwar on sodomy charges and sentenced him to five years in prison. Anwar was sacked as Finance minister after a policy split with then–prime minister Mahathir Mohamad during the Asian crisis and then prosecuted for sodomy a year later, in a case he has condemned as politically motivated.

Malaysia’s rising household debt — which has climbed by 20 percent of GDP in the past five years — also worries some analysts.

Debt also has been increasing in neighboring Singapore, hitting 77 percent of GDP, but most analysts believe it poses little threat to the economy. Output expanded by 4.1 percent in 2013, and although the government is forecasting growth of between 2 and 4 percent this year, analysts at Standard Chartered predict a rate of 4.4 percent.

In many respects, the city-state stands apart from the rest of Asean. Singapore has long since escaped the so-called middle-income trap that slows many emerging-markets countries: It made the leap to high-tech manufacturing and a buoyant services industry. Per capita income stands at a lofty $60,000, one of the highest rates in the world, compared with $16,000 for Malaysia and $9,500 for Thailand. Whereas manufacturing output grew by 1.7 percent last year, services expanded by 5.3 percent thanks largely to increases in financial services and retail sales.

“Singapore’s probably the most transformed economy in Asia,” says ING’s Condon. “There are some strains as a result of that within the society here, but through its policy actions Singapore put itself among the most desirable cities in the world for both business and pleasure.” Condon cites the 2010 opening of casinos in the Lion City, which bring an estimated $7 billion a year into the economy.

Among Asean’s frontier economies, a group that includes Cambodia, Laos, Myanmar and Vietnam, only the last gets much attention from portfolio investors. The outlook there remains bright, analysts say.

Vietnam’s $170 billion economy grew 5.4 percent in 2013 as a result of a 15 percent surge in exports. Manufacturing exports are booming because of low wages and a disciplined workforce, which make Vietnam attractive to companies looking for low-cost production alternatives to China. Economists at Crédit Agricole expect the economy to grow by 5.7 percent this year, mainly because of recovery in developed markets.

Vietnam does face major problems in its banks and state-owned enterprises, which still account for about half the economy. Last year the government set up state-owned Vietnam Asset Management Co. to buy nonperforming loans at every bank with an NPL rate of more than 3 percent. Following a real estate boom and bust in Vietnam, the banking system as a whole has an NPL rate of almost 8 percent of outstanding loans.

Yet in Vietnam, and across the wider region, investors are increasingly seeing more opportunity than risk.

“Southeast Asia has a combination of cheap valuations and technical positions that are much better” thanks to a decline in volatile short-term capital flows, says Société Générale’s Anne. “Let’s not panic over China. I think everybody has had time to prepare for a China slowdown for some time. I would argue it’s in the price already.” • •

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