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Economic and Political Review of Selected Asian
This series of country and regional reports is prepared by Mr. William
Thomson, a former Senior Vice President of the Asian Development Bank. Mr.
Thomson is an economist and investment banker specializing in Asia. He is Chairman and Managing Partner of PEDCA LLC, an affiliate firm of
The Aries Group Ltd., specializing in providing consulting services in
pension and insurance reform. The views expressed in these reports are
those of Mr. Thomson and do not necessarily represent those of PEDCA, The Aries
Group or their consultants.
As we look backwards to the closing of the year 2000 and the beginning of 2001 we find our thoughts at an even more difficult crossroads than normal. On the one hand, Asia, generally, continues its recovery from the 1997-8 traumas. We say generally since Japan's progress is far from sustained and others - such as Indonesia and the Philippines - have their own "little local difficulties", borrowing Harold MacMillan's felicitous phrase. North East Asia will not grow as fast as this year. But India and China look programmed for solid 6-8 percent growth, largely independent of what happens elsewhere.
It is the smaller, open economies that seem hostage to two external variables: the first is oil prices that act as a tax on these oil importing economies; the other, probably greater, uncertainty is the US economy and the depth and extent of its slowdown. Oil prices give some indication of having hit a cyclical peak, although that is a risky call given the volatility of politics in the Middle East. And the explosion of natural gas prices in California and elsewhere also give cause for concern about energy prices. However, the California situation appears to be the result of mismanaged deregulation and investment priorities rather than continuing uncontrollable demand. However, the knock-on effects could be considerable: both major utilities are threatened with bankruptcy and Bank of America, a lender to them, is rumoured to have problems with its derivatives book associated with these companies.
Both higher oil and gas prices can be blamed on under-investment in refineries and power generation facilities in the US in general - and California in particular - during the 1990s. A generous round of applause, please, for the environmental lobby and the loony cheerleaders and charlatans of the so-called "new economy" that balanced investment programs are still required.
The US slowdown
Since the machinations in the US economy will be so critical to the global economy, we will diverge from our discussion on Asian prospects to provide some comments on the possibilities confronting the US. We have to confess that we have been more sceptical than the consensus on the medium term prospects for the US although the consensus has been daily becoming more bearish. However, we have not allowed these concerns to colour unduly our view of Asian prospects. We freely admit that there is an inconsistency there and, consequently, Asian prospects later in the year may be less rosy than we are presently projecting.
The 1980s were the decade when Japan was the engine of growth for Asia and during 1990-2000 the United States filled that role magnificently. If, as we fear, the US slowdown turns out to be more secular than cyclical, what will fill the critical consumer of last resort for Asia in the immediate years ahead? Europe and internal Asian demand should replace a portion. Japan may even play a larger part; there are some promising straws in the wind there after the lost decade. But the US economy is still ultimately critical to the overall health of the Asian economy.
The times when US Administration's change political parties are often points of inflection in the US economy with consequent global implications. We can think back to the Nixon Administration in 1969 faced with handling the exploding costs of the Vietnam War and increased social expenditures. Similarly, the Reagan Administration in 1981 trying to deregulate and stimulate an over-regulated economy, reign in double digit (and rising) inflation - all whilst cutting taxes and increasing defence expenditures. In these and other cases, the US economy had a recession in the first year of the new administration and the markets had a difficult time.
Now - at least until this week -many will argue that the incoming Bush Administration faces relatively minor challenges compared to past changeovers. The Panglossians of Wall Street (Abbey Cohen etc.) will point to the "new economy", low unemployment, rising productivity, budget surpluses as strengths that are likely to persist as the Dow makes its climb to ever more ludicrous goals - 12,000, 20,000, 36,000 even 100,000. We say, Bah humbug!
As paid up contrarians we fear the US glass is half empty - and headed south - rather than half full. We are hard landers. As we said earlier, this complicates our views on where Asia is headed.
Regular readers will know that we have been long-term sceptics of the US boom believing that it was based ultimately on an unsustainable credit boom. It is our fear that Alan Greenspan was correct when he talked about irrational exuberance in early 1996 but backed away fearful of the consequences when the Dow Jones averages fell by 10 percent in the wake of the speech. Instead of hewing to those legitimate concerns, he rationalised the "productivity miracle" of the new economy with larger and larger doses of easy credit, fearing the systemic consequences of the Asian, Russian and LTCM crises and, all the while, delaying the ultimate day of reckoning.
He was aided in his endeavours by the accountancy and investment banking professions, which allowed corporate financial statements - for instance, through their treatment of options - to become a perversion of reality. The bankers and analysts broadcasting their new era mantras persuaded the gullible babbittry that earnings did not matter, only revenues counted - and it did not matter how you created those revenues - double counting and barter were just fine.
Let's not mention the conflicts of interest or the phrase crony capitalism, please. We know that doesn't happen in the democratic, transparent Western markets, don't we? The whole of society became agents in a monumental con game of historic proportions to drive share prices too ever more ludicrous values. Historians will study this period for aeons and shake their heads in disbelief at the collective madness of the crowds. Mais, plus ca change! The reductio ad absurdum was when a certain well-known internet shill collected a $ 15 million bonus for recommending Amazon at over $ 100 per share (today below $ 15). Her other recommendations are off more than 90 percent. (An analyst we know recommended shorting Amazon in 1999 and early 2000 at $ 90 believing it had the potential to go to $ 20-$30. Nobody wanted to know and he did not get one percent of one percent of the shill's fees!)
The wealth that has been destroyed to date is comparable to that lost by the Asian crisis countries and the US is not yet formally in recession. The NASDAQ alone has, to date, lost about USD 4 trillion since its March peak approximately 40 percent of GDP. That does not include the huge junk bond losses expected in 2001 as their default rate rises to 10 percent from 6 percent in 2000 or the losses of the telecoms companies globally that have over invested in future technology of doubtful profitability - at least in the short/medium term. We can also expect real estate losses as the bubble deflates, with knock-on effects on the banking system. The main difference to previous downturns is that the losses so far are concentrated in the capital markets rather than the banking system.
However, we cannot expect the banking system to escape unscathed. Deflation of the credit bubble will have enormous consequences on the industry. It might be noted that the growth area on Wall Street is for bankruptcy lawyers with the big law firms. Then there are the little noted derivatives exposures of the banking sector. The LTCM bailout seems to have energised the use of these instruments and the potential exposures are many times the leading banks capital bases. But all off balance sheet! What you see is not what you get!
There are systemic issues here of capital losses on a gigantic scale that cannot be solved simply by reducing interest rates by a percent of two. In any case, the US is so dependent on foreign capital that the scope for reducing interest rates without creating a run on the dollar is limited. A run on the dollar, which is certainly a possibility, will only stimulate inflationary forces lurking below the surface of the economy. We, therefore, fear that Clinton has had the last laugh passing on to George Bush a tainted chalice as an inheritance. We expect the US slowdown to be more serious and extended than the consensus.
However, and this is an important caveat, whilst sceptics we are not inveterate gloom-mongers. We do not expect the US to enter the kind of meltdown that affected Thailand and others in 1997 but only because it is using its own currency. (Its Malaysia not Thailand!) The difficulties are more likely to evolve and become apparent over time. US policy responses should be more coherent and timely compared with the sluggish, often irrelevant, even counter-productive, policies exhibited by Japanese policymakers over the past decade. Also, we should not confuse the markets with the economy. Even if the markets as a whole go nowhere, there will be rotation within the markets and the economy, as a whole will probably ratchet down to lower and sustainable growth rates, perhaps after a brief recession.
The "Greenspan put", which was put into play on 3 January, will relieve the symptoms, at least for a while. Further reductions in interest rates are inevitable as the Fed attempts to pump money into the deflating bubble faster than it is leaking out in credit losses. If that is the case, Asia will have more time to adjust to the more challenging international environment.
It is now essential that George Bush can get his tax cuts through the Congress in some form during 2001. Both the US fiscal and monetary policy would then be primed for a modest recovery in late 2001. But we would not expect it to be the 1990s again.
What to look for in 2001
- Lower interest rates (it's already started)
- A lower dollar
- Volatile equity markets with still more water to be squeezed out of the tech sector and a return to "value" investing
- A stronger second half than first half (if confidence can be created by the new Administration)
The first half of 2000 saw the vigorous economic recovery of 1999 continue strongly, but there was some easing of the pace in the second half as higher oil prices took their toll along with a slowdown in the market for electronics exports. Reform fatigue and political uncertainties have contributed to reduced confidence on the part of foreign investors, particularly portfolio managers. Indeed, perhaps the most surprising observation was the close correlation that had developed between the US tech heavy NASDAQ and many Asian markets. This meant that when the NASDAQ went into meltdown the Asian markets also suffered. However, since November 2000 the Asian markets and the NASDAQ have largely de-coupled. They have resisted declining along with the latest NASDAQ gyrations.
The incoming Bush Administration is thought likely to place relations with Asia (economic and political) on a higher plane than the departing Administration. Within that, the priorities could shift. Relations with Japan are likely to improve in conjunction with a more sceptical attitude to China's geopolitical and longer-term military intentions. Asian nations, especially Japan, are likely to be encouraged to take a greater role in their own defence, meaning larger defence budgets. Relations with India could be beneficiaries of these moves. These moves, whilst strategic long term moves, could nevertheless increase uncertainty and thereby affect short-term confidence in the region.
This geopolitical uncertainty comes at a time that weakness has spread from the South East Asian countries to North East Asia that had been stronger until now. Domestic political changes and the US slowdown have combined with the slow progress in attacking the ills of the region's banking systems to the weakening of the recovery. This has been a factor in the slowing the Korean and Thai recoveries and can also be seen quite markedly in Taiwan, a country thought largely to be outside the severely affected Asian economies.
North East Asia
Taiwan had a stock market bubble in the late 1980s at the same time as Japan's bubble. The market collapsed 80 percent from 12,000 to 2,600 in 1990 recovering to over 10,000 in early 2000. Along with the stock market collapse was a real estate recession and bad debts in the banking system. But this was largely papered over for several years and even today NPLs are only officially 5 percent of portfolios.
However, the change of Administration in April to the first non-KMT President has affected confidence more severely than might have been expected. By upsetting the uneasy compact with the Mainland over independence and following that with blatant populist economic measures, his old-line KMT opponents have had a field day that has upset investor confidence. President Chen now faces impeachment hearing over a relatively trivial issue of an old nuclear power plant.
In the meantime, the Government is showing some of the same maladroitness shown by the Japanese over the past decade: trying to prop-up the stock market directly with Government funds, forcing banks to lend to favoured near bankrupt to avoid layoffs etc. Coupled with Taiwan's close economic linkages to the US electronics cycle, the Taiwanese stock market is the first Asian market to fall below the post Russian crisis lows.
The incoming Bush Administration is expected to be more sceptical of Chinese geopolitical aims and, as a consequence, more willing to assist Taiwan, possibly by incorporating them into a regional anti-ballistic missile defence plan. Whether this will be achievable in terms of realpolitick and how it will play in terms of confidence we will have to see. Confidence, we recently observed, has plummeted far below its normal ebullience. However, internal policies and the US economic cycle will largely determine Taiwan's performance next year. Relations with the Mainland have improved slightly with the establishment of very limited direct trade and travel links. We expect sub par growth of 5-5.5 percent at best in 2001.
Korea also has reform fatigue and faces presidential elections later in the year. Nevertheless, halting progress is being forced on the heavily indebted chaebols as major subsidiaries are shed, albeit reluctantly. Again, banking system reform is progressing slowly. On the other hand, momentous events could possibly be unfolding at the 38th parallel. Time again will tell and the Bush Administration people are more sceptical about North Korean intentions. Bringing North Korea into the family of nations is likely to be a very expensive proposition for South Korea but would provide rebuilding and construction opportunities for some of the large corporations. Growth in 2001 is expected to be about 5.5 percent down from 8 percent in 2000. Estimates, however, are exceptionally volatile at present.
The Korean market lost over 50 percent of its value in 2000 and the KSE index was then selling at half the levels of 1988, although it has rebounded slightly in January in the wake of drops in US interest rates. Prices are exceptionally low and values good for the patient investor.
South East Asia
Foreign analysts now often place Thailand, Indonesia and the Philippines in a so-called TIP basket. This is somehow intended to indicate that the economies are too troubled or too small to be of interest to the foreign investing community. We object to the deprecatory term partly on atheistic grounds but more on the fact that it confuses rather than clarifies the different challenges these economies are facing and, indeed, the different progress they are making.
These are small markets in global terms and even within Asian portfolios. Their market capitalisation has been downgraded first by the Asian crisis, then by international investors insane infatuation with the "new era" phenomena and finally by Morgan Stanley reducing their weightings within global and regional indices, thereby forcing index managers and closet indexers also to dump them.
With all this bad news, how much more can there be? We suspect very little. These are bombed-out, unloved markets providing very interesting value in an area still growing much faster than the OECD countries can ever dream about. Market cap/ GDP has generally fallen by more than 80 percent since the glory days of the mid-1990s and now languish around 20 percent. Thailand's market capitalisation, for instance, is now around USD 25 billion. Intel, by way of example for one typical technology company, lost about USD 35 billion of market capitalisation on one day in September.
The total mutual fund exposure to emerging markets world-wide is about USD 30 billion (bonds and equity) whereas US market capitalisation is about USD 10,000 billion. We will leave the arithmetic to the reader to imagine what could occur if investors decided to redirect a miserly fraction of one percent of their portfolios to emerging markets. At the peak, we estimate foreign investment in emerging markets was in excess of USD 150 billion.
We have written extensively recently about the Philippines recently and the challenges it faces. We will not repeat them here in detail. Suffice to say at this point that the country is wrestling with a toxic mixture of political instability, urban and rural violence, upcoming elections for Congress, high oil prices, weakened demand for its primary export - electronics.
Our scepticism about the economic prospects in 2000 has been borne out. Our timing on the removal of President Estrada was over optimistic. However, we still believe it is only a matter of time and our view remains that the country is likely to go into recession in 2001 unless there is a relatively speedy resolution of the impeachment crisis. Even if he goes speedily, the macro negatives from overseas will remain and the best the country can probably expect is less than the population growth rate of around 2.3 percent. On the other hand, a new Administration will undoubtedly give a boost to confidence, domestic and foreign, and there would then be the possibility of several years of a more technocratic administration with an increased commitment to reform. This should provide room for improvements in 2002 and beyond.
As we have written elsewhere, we believe the stock market and Philippine Government debt paper are likely to get big boosts from a change in Administration. Foreign investors are sharply underweight this market - albeit a relatively unimportant one for global investors. But there are some real values around for the patient. The currency, which has declined 20 percent more than the Thai Baht should stabilise and even recover some of these excess declines if and when confidence can return.
Nowhere in Asia is more frustrating to attempt to analyse at the present time than Indonesia. The country is attempting to effect a transformation of its politics and economic structures under an adverse external environment. President Wahid is seen as ineffective and erratic. Calls for independence from the yoke of Jakarta are being heard throughout the land and communal violence is increasing. Radical autonomy legislation is due to go into effect momentarily. This will place more funds and power in the hands of local officials, who may well be unprepared for this responsibility.
Little or no progress has been made on corruption or banking sector or corporate reform. The Governor of the Central Bank has been accused of malfeasance, albeit not in his present duties, but cannot be removed from office.
And yet, despite the category of woes, the country continues to defy the gloom-mongers. The military is still in its barracks. The President has not been impeached and the country's economy grew by 5 percent in 2000, helped by firm commodity prices for oil, gas and palm oil.
More of the same can be expected in 2001. President Wahid may never look comfortably in control. The provinces will be restless, even violent, there will be little progress on substantive issues but the economy will stagger along in positive territory. We do not see new foreign investors coming here any time soon. That includes the local Chinese. However, those already there in the oil and gas business may be willing to increase their exposure.
Thailand is by far the most politically stable of the South East Asian developing countries, although it had a military government as recently as 1992. In the past year the Chuan administration that has governed since soon after the onset of the 1997 crisis has been in consolidation mode waiting for the elections on 6 January. After taking many difficult policy decisions in the aftermath of the crisis a certain reform fatigue set in as the election countdown - the first under a new democratic constitution passed in 1997 - drew nearer.
Thai governments previously tended to revolving doors, somewhat akin to Italy, as coalitions reconstituted themselves with a given cast of characters. The Chuan government broke that mould and was the first in Thai history to serve its full term of office. Nevertheless, as a result of reform fatigue on the part of the electorate and impatience with the pace of growth and its narrow base since the crisis, it appears as if the opposition led by Thaksin Shinawatra and his Thai Rak Thai Party has won a significant victory and will lead the next government. His support comes mainly from the rural areas whilst Bangkok with its large volume of middle class voters has traditionally supported Chuan and the Democrats.
The Thaksin platform is populist to the core. It has promised faster growth through debt relief to farmers and pork barrel funds for each village to attract the rural voters. But it has also proposed reduced corporate tax rates, income tax cuts, faster privatisation, an SME bank for business start-ups and an Asset Management Company (AMC) to buy the commercial banks bad debts.
The problem about the platform is that the budgetary arithmetic simply does not add up. Public debt has grown to 50 percent of GDP since the crisis. If the economy has stable growth potential of 5-6 percent then there is room for some budget deficit but it must be well under the growth rate. With a savings rate in excess of 30 percent a small budget deficit is not, in our view, an insurmountable problem. But it must be constrained. Fortunately, Thailand has a responsible financial history and we would expect the actual programme eventually implemented to be in accordance with Thai tradition.
The choice of Finance Minister will be an important factor in how the country proceeds. None has been announced as this is written.
The prospective Prime Minister also faces corruption charges from the independent anti-corruption commission, which is eager to earn its spurs. It is impossible to say how the case will be resolved but we note the charges date back about eight years and do not appear to have broken the law at that time. We would not bet against Thaksin's survival at this time given the extent of his popular mandate.
Thailand faces a more difficult trading environment with the US slowdown. Responsible tax cuts and movement towards removing the dead weight of bad loans from the banks are likely to increase confidence and animal spirits. Growth, initially, may be lower than last year but should pick up as new money is put into the economy. We therefore see the possibility of a significant rally in the Thai markets from their present incredibly depressed levels. The sustainability of any gains will be dependent on events in the global markets and responsible moves by the new government.
The market as measured by the SET is trading at about 290. It was 550 in January of 2000 and July of 1999. It has the potential to more than double over the next year or so, if foreign capital begins to trickle back and domestic confidence is revived. It is a small, unloved market and we favour it as a contrarian bet.
Country updates for China, India and a brief review of the possibilities for emerging markets will follow at in few days times.
William R. Thomson 8 January 2000
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