Efforts by the Aquino government in the Philippines, together with improving economic indicators in Indonesia, have made the two countries prime hunting grounds for foreign direct investment (FDI) recently in Southeast Asia.
However, capital inflows, particularly to the more leveraged economies such as Malaysia and Thailand, may ease, leaving the region’s major economies more exposed to reversals, warns HSBC.
“We expect that capital inflow coming into the region to be more selective, favouring countries with stronger fundamentals and stable political conditions, leaving the Philippines least vulnerable and Thailand most vulnerable. This is likely to pose headwinds for credit growth in coming years,”
wrote Leif Eskesen, chief economist for India and Asean with HSBC, in a recent report.
However, Mr Eskesen does not expect capital reversals for sustained periods given that the Asean-5 economies (Singapore, Malaysia, Indonesia, the Philippines and Thailand) still have favourable growth and interest rate differentials. Even so, inflows are likely to be smaller than in recent years and more volatile.
He said policymakers in the five countries would have to walk the straight and narrow on monetary and fiscal policies to keep inflation, leverage and external imbalances in check. They should not just focus on policies that fuel growth in the short term, but on structural reforms that can help raise productivity growth.
Recent figures from Bank of America Merrill Lynch showed that FDI inflows to the Asean-5 economies in 2013 stood at US$128.4 billion, which was higher than the total to China of $128.4 billion. The figure represented a 7% year-on-year increase for the five Asean countries, while China faced a 3% drop.
Capital inflows are generally positive for an economy as they help support consumption and investment, and bring spillover benefits in terms of know-how and competition.
Among the big supporting drivers for the repositioning of FDI in Asia are regional demographic change and the China-Asean Free Trade Agreement (Cafta).
According to the Bank of America Merrill Lynch report, Cafta has reduced tariffs to practically zero on 90% of all goods traded between Asean member countries and China over the past five years or so.
These changes have significantly helped countries such as Indonesia, the Philippines, Malaysia and Thailand to become manufacturing destinations for the giant Chinese market.
Moreover, Vietnam recently stated that it would reduce corporate income tax to 20% by 2016, leading to a new expected boom in FDI into an economy that has been struggling, just as the Asean Economic Community (AEC) starts to become a reality.
On the demographic front, meanwhile, China is getting older; it has reached the stage of “age-dependency optimum” and has already started losing workers. Last year, 2.4 million workers retired from China’s labour force and were not replaced.
The number of elderly Chinese is expected to reach 30% of the population by 2030. However, the Philippines has a strong advantage in terms of a demographic dividend, with a median age at only 23 years in 2010.
On the other hand, with the US Federal Reserve scaling back its stimulus and emerging markets losing some of their shine as a result, if an extended period of capital inflows is followed by abrupt capital flow reversals, it could be a bumpy ride.
“If policymakers do not adequately disperse countermeasures by tightening domestic policies, FDI can also cause loose domestic financial conditions which can result in excessive credit expansion and asset price bubbles,”
said Mr Eskesen.
The HSBC report also indicated that after the global financial crisis of 2008, which followed a buoyant credit cycle, it is important to look at the extent to which capital flows helped drive credit growth. It is important to determine whether the credit cycle is vulnerable to capital outflows, or more likely to a decline in net inflows.
The report said monetary policy should focus on gradually moving from its current accommodative stance back to neutral to contain inflation and external imbalances, and ensure the credit cycle does not get over-extended.
“Among the five countries, the Philippines is in a relatively favourable situation, given the lower degree of leverage and its current account surplus which make its less vulnerable to a tightening in global financial conditions,” the report said.
“Whereas, Thailand’s case, much depends on how the political situation pans out. If a resolution is found in coming months and growth resumes in the second half, confidence can be restored.”
Malaysia and Vietnam, HSBC added, are better placed in terms of their external positions, but they have higher leverage ratios.
“If capital inflows, however, in a pessimistic scenario turn into significant outflows, there could potentially be a need to ease monetary policy, introduce emergency liquidity measures, and loosen the fiscal purse strings, if the knock-on effect on the economies is large enough. However, that is not the scenario that we see at this moment,” Mr Eskesen concluded.