The ICAEW Economic Insight: South East Asia, is a quarterly forecast for the region prepared directly for the finance profession.
Positive 2019 outlook despite US-China trade spat
Economic growth continued to moderate across most South-East Asia (SEA) economies in Q3. Average GDP growth as a whole slowed to 4.8% year-on-year, from 5.2% in Q2. Vietnam was the exception with GDP growth accelerating 6.9% on the year, up from 6.7% in Q2 as FDI inflows continued to support growth in manufacturing activity and exports.
Domestic demand has held up well this year, although export growth has moderated. We expect the knock-on impact of the US-China trade war against a challenging global backdrop will be felt more strongly in 2019.
Many of the region’s economies are small open economies heavily dependent on exports, with a high level of exports to China. In particular Malaysia and Vietnam are both highly exposed to China with total exports to China in value added terms accounting for 10.7% and 10.3% of GDP respectively in 2017. Of this more than half were to meet Chinese domestic demand. Hence the expected slowdown in China’s domestic economy next year will weigh significantly on growth in the region.
Moreover, we expect Asian economies with the closest ties to China to be hardest hit in a trade war. Looking across the SEA region, Singapore and Malaysia would see the biggest impact on GDP, with GDP 1% points lower in Singapore by 2020 and Malaysian GDP is 0.4% lower. Meanwhile Indonesia and the Philippines are relatively unscathed.
Eventually, some economies may benefit from the relocation of supply chains and South-East Asia could be a preferred destination. But it is not an easy decision to uproot large parts of an electronics or car supply chain. We view this as a medium-term structural change rather than a short-term remedy.
We expect domestic demand will provide some relief amid the more challenging outlook for exports. Fiscal spending is expected to be strong in Indonesia, Thailand and the Philippines ahead of upcoming elections in H1 2019 and we expect many governments in the region, including Indonesia and Malaysia, to miss their ambitious fiscal consolidation targets for 2019. In the case of Vietnam, while the government’s fiscal position has improved, we see limited space for any expansionary fiscal policy next year.
However, domestic demand growth is unlikely to reach the stellar pace achieved in 2018, in part because of lower monetary policy support. Indonesia and Philippines have been more aggressive than their peers with policy rates raised 175bp a piece, in a bid to support their respective currencies. Looking ahead, we expect central banks to continue tightening over 2019. However, in general our interest rate projections are not due to rapidly rising inflationary pressures but financial stability considerations, whether arising from higher US interest rates or internal developments.
In Indonesia, persistent capital flight pressures and risks of renewed weakening in the rupiah are likely to keep the central bank hawkish. This is true for the Philippines as well, along with still-elevated inflation. In Thailand, rising concerns about the implications of accomodative policy amid high debt levels have tilted the scale in favour of hikes and we expect Thailand to begin tightening in Q1 2019. Similarly, Singapore are expected to maintain a tightening bias to discourage further debt build-up and cool property markets.
Overall, we expect GDP growth across all of the SEA economies to moderate next year. As a small open economy heavily dependent on exports, we expect Singapore to experience the sharpest slowdown with GDP growth set to moderate from an expected 3.3% in 2018 to 2.5% in 2019. Meanwhile, although growth is set to ease in Vietnam, Indonesia and the Philippines next year we still see them as among the top ten fastest growing economies globally. This should reinforce investor faith in Indonesia and the Philippines and lead to FX gains next year, despite rising rates in most advanced economies. Overall, we forecast GDP for the region as a whole at 5% in 2019 (down from the 5.3% expected in 2018).
The robust momentum in the economy in Q2 has likely strengthened the central bank’s commitment to prioritising currency stability in the short term. Indeed, the 8% depreciation in the Indonesia rupiah this year versus the US$ has already led Bank Indonesia (BI) to raise interest rates a total of 125 basis points since May, bringing the policy rate to 5.5% at end-August. We expect BI to raise the policy rate a further 25bp in the coming months to provide further support to the currency. Indeed, we believe the currency will remain under depreciation pressure as the widening current account deficit (no longer fully covered by net FDI inflows like in 2017), means Indonesia is increasingly reliant on capital inflows. This and the high non-resident ownership of local bonds (close to 40%) also means the currency is vulnerable to swings in investor sentiment. This is especially worrisome as US Fed rate rises and global trade tensions are weighing on EM currencies in general. Although we expect only one more rate hike this year, we acknowledge that risks remain tilted towards additional near-term BI rate rises.
GDP surprised on the downside in Q2 slowing to 4.5% year-on-year, down from 5.4% in the previous quarter. Imports grew at a much faster pace than anticipated, rising 2.1% year-on-year and outpacing exports of 2%. Underpinning the strong growth in imports was a pick-up in domestic demand, which rose 4.7% year-on-year from 0.4% in Q1. In particular, household spending surged to a multi-year high of 8% year-on-year reflecting a boost to consumer sentiment after the new government abolished the Good and Services Tax and the re-introduced fuel subsidies.
We expect household spending will remain the key driver of GDP growth through to 2019. However, most other domestic demand components are forecast to cool. We look for public spending to moderate as the new government reviews major infrastructure projects and undertakes plans to prune government expenditure. That said, there exists a number of uncertainties surrounding the government’s fiscal decisions.
The government is committed to improving the fiscal deficit, however, the reinstated Sales and Service tax (from September) will only apply to ‘selected services at 6%’ and will cover a smaller range of goods and services compared to GST. As such we do not think it will be sufficient to fill the revenue gap caused by the removal of the GST (which accounted for around 18% of revenues in 2018).
In the short term the new government does have some fiscal space as oil tax revenues are likely to be higher than previously projected. We forecast oil prices of around US$75pb on average in 2018, compared with the previous government’s expectation of US$52pb. The announcement of the disbandment of several ‘politically-linked’ departments will also help ease some of the fiscal pressures.
However, if the government remains committed to lowering the fiscal deficit beyond this year, further expenditure cuts and/or a new source of revenue generation will be needed. Our base case is that government will tolerate some fiscal slippage to support domestic demand amid moderating export growth. Overall given the weaker than expected Q2 GDP outcome we have downgraded our 2018 GDP growth forecast to 4.9% previously with GDP expected to grow by 4.7% in 2019.
We also expect the pace of government infrastructure spending growth to slow into 2019. With the next general election set for April 2019, the government is prioritising keeping fuel prices stable, raising public sector pay and boosting social assistance benefits.
However, fuel price freezes could lead to a deterioration in SOE balance sheets. And given the widening current account deficit over H1 (where it averaged 2.6% of GDP compared to 1.7% in 2017), the government is concerned about the downward pressure strong import growth is having on the IDR. Importantly, recently announced delays to certain government and SOE investment projects and to capital imports pose downside risks for investment.
This coupled with some delays to infrastructure projects, is likely to more than offset any boost from higher pre-election public spending. We maintain our view that GDP will grow 5.1% in 2018 and 2019.
Bank Indonesia (BI) has raised its policy interest rate by a cumulative 175bps this year. This is despite inflationary pressures remaining benign as the central bank is prioritising financial stability and is trying to support the Indonesia rupiah (IDR). USD strength amid higher US interest rates has been the catalyst for much of the change in sentiment towards EM currencies as a whole this year, with US-China trade tensions, less synchronised global activity and geopolitical risks also supporting the USD. The stronger dollar has also highlighted the vulnerability of some EM currencies. In the case of Indonesia, its current account and fiscal deficits alongside high foreign ownership of Indonesian bonds (close to 40%) has left the IDR vulnerable to swings in investor sentiment and the IDR has dropped by around 10% against the USD between end of Q1 and late November.
Going forward, we expect BI to raise rates by a further 50bp next year to try to stabilize the IDR against the risk of rising US interest rates, although we acknowledge that risks remain tilted towards additional near-term rate rises. In addition, the finance ministry has started efforts to control pressure from the current account deficit by encouraging import substitution with local goods as well as delaying big ticket energy imports. We forecast USD/IDR at 14,980 by end-2018. In the absence of another liquidity shock, we expect the greenback to come under renewed pressure in 2019. Coupled with a more stable CNY we expect the IDR to appreciate modestly against the USD to 14,800 by end-2019.
GDP growth edged slightly lower in Q3 to 4.4% year-on-year from 4.5% in the previous quarter. Growth was weighed by ongoing supply side disruptions in the mining sector which saw overall export growth fall 0.8% on the year. As import growth also slowed sharply, up 0.1% year-on-year, net exports subtracted 0.7%pts to Q3 annual growth.
Offsetting the weak external sector was ongoing robust private demand. Household spending surged ahead in Q3, rising 9% on the year as spending was boosted by a tax holiday for two out of three months in the quarter. Fixed investment growth also accelerated to 3.2% year-on-year, driven by private sector investment (up 6.9% year-on-year). However, public investment fell 4.5% as the government continues to review major infrastructure projects. Inventories were also a large drag on growth, subtracting 1.4% points from the annual growth rate.
We expect GDP growth to continue to moderate into 2019. Notwithstanding any temporary boost to exports as mining production normalises, cooling Chinese import demand and trade protectionism will weigh on exports. Given ongoing fiscal consolidation, we expect GDP growth to ease from 4.8% this year to 4.5% in 2019.
The Pakatan Harapan government’s inaugural budget, released on 2 November, increases the estimated fiscal deficit in 2018 to 3.7% of GDP from 2.8% previously. This was based on higher expenditures due to debt liabilities related to the 1MDB state fund, the reclassification of off-balance sheet liabilities and paying GST refunds. The abolishment of the GST and reintroduction of fuel subsidies also weighed on revenues. The government has announced measures to reduce the fiscal shortfall to 3.4% in 2019 and 3% in 2020.
We believe that the fiscal position will improve because some of the fiscal slippage is due to one-off factors such as paying MYR34 billion in tax refunds. Nonetheless, we expect the deficit to come in slightly higher than the government’s targets, at 3.5% of GDP in 2019 and 3.3% in 2020. The government forecasts the economy to grow by 4.9% next year, after an estimated 4.8% in 2018. We think the government is underestimating the impact of slower Chinese import demand and increased protectionism on exports. Meanwhile, we expect higher inflation and rising interest rates to moderate domestic demand. We forecast GDP to grow by 4.5% next year, down from 4.8% in 2018, before moderating to 4.2% in 2020.
We are also more cautious on the potential boost to revenues from the new taxes, particularly next year, as there will likely be some delays in fully implementing them. Moreover, we think the forecast improvement in cost management for supplies and services may be too optimistic.
Despite the higher fiscal projections, we do not expect this to lead to credit rating downgrades. This reflects efforts to not only restore public finances in terms of the fiscal deficit over the medium term, but also public debt. Other factors supporting Malaysia’s positive credit ratings include: lower interest rate payments as a share of revenues following the announcement that Japan will guarantee JPY200 billion of 10-year Samurai bonds at an indicative coupon of 0.65%, which will be used to roll over maturing debt; and improved transparency and governance standards. That said, the tail risk of a downgrade has risen, given the government’s increased reliance on oil prices as well as implementation risks and revenue uncertainties.
Indeed, either a fall in oil prices or an external shock that leads to sharply lower economic growth could stymie fiscal consolidation efforts. Using Oxford Economics’ Global Economic Model, if Brent oil prices were to be $20pb lower than our average baseline forecast of $75pb over 2019-2020, we estimate that, in the absence of lower government expenditures, the fiscal deficit would widen to 3.8% of GDP in 2020, as oil and tax revenues fall. Coupled with a lower current account surplus, this could trigger an adverse feedback loop of higher interest rate costs and/or a run by foreign investors. We estimate that a higher risk premium on Malaysian sovereign bonds would lead the 10-year yield to increase by 30bps above our baseline by end-2020 and the MYR to be around 2% weaker against the USD. If the oil shock led to a credit rating downgrade, 10-year bond yields would end-2020 at around 5.2% (a 15-year high) versus our baseline of 4.7%.
Economic Insight reports are produced with ICAEW's partner Oxford Economics, one of the world’s foremost advisory firms. Their analytical tools provide unparalleled ability to forecast economic trends.