The hard economic indicators suggest that there are enough bright spots in the world economy to justify guarded optimism about prospects in our region for the rest of this year. Against this, however, there are several potential perils around us which, if realised, would cause us grief. Regional economies need to develop sufficient buffers to absorb possible shocks and if they can do so, they could better navigate themselves through the storms ahead.
US economy in the right spot
Economic indicators paint a better picture of the world economy than what nervous financial markets indicate: the major drivers of global growth are in relatively decent conditions.
Take the US economy to begin with. There, economic activity is cooling just the way we want — from a pace that generated high inflation to a more sedate pace, without tipping over into a recession. The US manufacturing sector is weakening but the much larger services sector still appears in fine fettle. Businesses are only cautiously cutting back on hiring but are not laying off workers. That allows the labour market to cool without producing the surges in unemployment that produce recessions.
Consumers are also throttling back on their spending without cutting spending outright. Firms continue to grow capital spending — core capital goods orders rose by 1.3% in April over the previous year. If businesses are confident enough to continue hiring workers, albeit at a slower pace, and to invest in new capacity, that must be a good sign.
Although inflation has not slowed as much as desired, the cooler labour market and slower activity should give the Federal Reserve Bank the opportunity to start cutting rates later this year. That should help to ease the burden of higher interest costs on consumers and businesses.
China gradually recovering
China is the other big growth engine over which there has been a lot of concern. China’s outlook is a harder call to make because it is in uncharted territory. There is no past precedent in China of how a sharp slowdown in real estate will pan out. It is also unclear how bad the financial fallout from the property sector’s travails will be.
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Still, we believe that the worst is over now that the authorities are expanding policy support more aggressively. Most big cities have drastically eased restrictions that were brought in several years ago to cool the sector. The government is offering to buy unsold homes and convert them into social housing. Greater financial support is also being offered to the better-managed property development firms. Local governments have been told to ramp up infrastructure spending and to expand programmes to replace slums with better quality housing.
As policy support improves, economic momentum is perking up. Purchasing manager surveys report that firms are more upbeat about prospects, especially firms in the private sector. The pipeline of new orders is steadying and Chinese exports are recovering. A recent survey showed Chinese consumers getting ready to spend more on both domestic and foreign tourism — a sign of brightening consumer confidence. China should be able to meet its growth target of around 5% this year.
Other indicators also positive
East and Southeast Asian economies that are heavily exposed to the technology sector will welcome the uptick in the tech cycle. South Korean exports of semiconductors are surging again. Taiwan’s export orders similarly show a broad improvement. As the inventory correction in the sector is completed and as the AI boom generates huge demand for semiconductors and associated electronics components, other economies that are exposed to the electronics sector such as Malaysia and Singapore should also revive.
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It is worth highlighting the secular trends in the tech sector. Progress in AI is persuading more companies to appreciate the immense potential in the sector. There is a boom in data centres as a result as well as a massive ramp-up in semiconductor demand. The large technology companies are each spending billions to seize the new opportunities offered by AI. That wave of capital spending will itself raise global economic growth.
More importantly, our view is that advances in AI will help to accelerate technological progress in other areas. For example, the immense computing power of AI is helping to prodigiously boost the biomedical sector’s capacity to discover new proteins. Such new proteins will help generate new drugs and therapies for a whole range of diseases. Similarly, AI helps scientists discover new crystalline structures, and so helps speed up progress in material sciences as well. All these new discoveries will open up new business opportunities and spur even more capital spending.
Overall, quite apart from the tech sector, global trade volumes are forecast to be rising again. The World Trade Organisation (WTO) as well as the International Monetary Fund and the OECD forecast stronger growth in exports this year. For example, the WTO expects trade in goods to expand by 2.6% this year, a big improvement on last year’s contraction of 1.2%. That is good news for this region.
The risk of a trade war
The world economy will have to navigate some potential pitfalls in the near future, the most worrying of which is the rising risk of a trade war.
The US has substantially increased tariffs on Chinese goods —for example, quadrupled tariffs on Chinese-made electric vehicles. Europe is not keen on getting into a trade war with China but it is also unhappy about Chinese-made goods like electric vehicles and batteries displacing its home-grown companies. At the end of May, at the finance ministers’ meeting of the G7 group of developed economies, the Europeans joined the US in warning that the “entire world economy is at risk from a glut of cheap Chinese exports”. China has warned that it would retaliate with trade measures of its own if the G7 economies targeted Chinese exports.
However, there are signs that even emerging economies are also troubled by surges in exports of Chinese goods such as steel. Note how Mexico, Chile and Brazil have imposed higher duties on steel products from China over the past several weeks. Other Latin American economies such as Colombo are reported to be planning similar moves.
The fundamental problem lies in a few key trends which are simply not tenable from a political perspective: China’s share of world exports is rising but its share of world imports is not rising — in fact it is edging down. China’s share of global manufacturing output is already very high but it is investing in yet more capacity, even though there are signs of excess capacity in China. China’s share of world exports of new emerging industries is rising while its share of low-value activities has stopped falling and is rising again.
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China’s case is that it cannot be blamed if its domestic firms have become so competitive that they can displace imports in the Chinese market while increasing their share of global markets. Unfortunately, this does not wash with the majority of countries any more — political leaders are under pressure from voters not to allow even more of their manufacturing sectors to be pummelled by imports. There is also more scrutiny of how China developed such competitiveness in the first place, with many countries feeling that China has used state subsidies and other forms of help to “unfairly” out-compete other countries.
There does not seem to be any solution in sight to this challenge. The WTO is no longer able to undertake its arbitration role any more due to the US vetoing new members to the appellate body because of its unhappiness with the WTO. Geopolitical frictions are so high that a negotiated settlement of these trade disputes look difficult.
The next few months will probably see a ramping up of trade tensions. Southeast Asia, and other emerging regions, will be caught in between.
Risks around the USD
There are several pressure points in global finance. One is the impact of much higher interest rates. Several emerging economies are already in default but differences among creditor countries is making resolution of such debt crises more challenging. More broadly, the sudden eruption of the regional banks’ crisis in the US last year told us that there are financial imbalances in many countries that could take us by surprise. Whether it is commercial real estate in the US or further defaults by large emerging economies, these risks remain high.
However, the area which could prove much more problematic is the fiscal position of the US and how it could undermine confidence in the USD, the global reserve currency. Right now, this seems unlikely. The USD reigns supreme — it has strengthened against virtually all other currencies and remains the safe haven of choice for global investors in a time of great global uncertainty. Efforts by China, Russia and the Brics countries to find alternatives to the USD have proven futile despite claims to the contrary. Because the dollar’s dominance has confounded the pessimists, financial markets have become complacent about its downside risks.
However, a recent report by the OECD carries a clear warning that the US fiscal position is increasingly untenable. It described how pensions and health expenses could add 25 percentage points of GDP to gross debt by 2040 given the ageing dynamics in the US. Worse still, ageing means a lower potential growth in the US economy just as interest rates are rising there. As lower growth juxtaposed against higher interest rates is a toxic combination that makes growing debt unsustainable in the long term. The OECD calculates that this factor could add another 30 percentage points of GDP to gross debt by 2040. So, even before the unavoidable additional expenses related to managing climate change are included, the US fiscal position is looking rather unhealthy.
These risks are not theoretical and nor are they far away in the distant future. At the end of May, bond prices and yields spiked in the USD slide as it turned out that three auctions of US debt had met with muted demand. As the US presidential campaign heats up in coming months and it becomes clear that both sides of the American partisan divide could drive up deficits and debt levels even higher, more questions will be asked about the fundamentals underpinning the USD. Then, what?
What can our region do to contain these risks?
Thus, while the economic cycle may well perk up and bring higher growth, there are serious risks to that scenario. Southeast Asian governments must assume that there is a reasonable chance that ructions in global trade and finance will pose a danger to their economies. They have to re-double efforts to boost their resilience to the shocks that could emerge. This requires action on a number of fronts:
Further strengthen the ability to withstand financial shocks. This means building up foreign exchange reserves, and working together to strengthen the Chiang Mai Initiative so that the region can help each other better in a crisis.
Boost measures to insulate the region against protectionism. The region has to cooperate more to leverage off the two large trade agreements — the CPTPP and RCEP — so that these agreements can provide some shelter from protectionist measures such as tariff increases and the like.
Strengthen policy buffers so that monetary, fiscal and other policy supports can be implemented quickly and efficiently if a crisis hits.
Overall, the region’s resilience has improved in the past decade. Unlike the “taper tantrums” of 2013 when the mere hint of a rise in US rates destabilised currencies such as the rupiah, our region has weathered an actual sharp rise in US rates fairly well. If we can build on that improved resilience, we should be able to better manage the growing risks that confront us.
Manu Bhaskaran is CEO of Centennial Asia Advisors
