Asia Economic Review

Our readers know that we have a strong focus on Asia, a region where we have worked and invested since 1984.

In this post, and a times of recurring worries about China’s economic slowdown, in this article we shall review the main macroeconomic drivers of the largest economies of the region for the remainder of the year.

The largest economic region of the world

The economy of Asia comprises more than 4.5 billion people or 60% of the world population living in 49 different nation states.

In 2017, Asia’s GDP represented USD 56.6 Trillion in PPP terms and USD 28.3 trillion in nominal terms and is the largest economic zone of the world with 33.8 % of the total.

The largest economies in Asia in terms of nominal GDP are China, Japan, India, South Korea, Russia, Indonesia, Turkey, Philippines, Taiwan, United Arab Emirates, Thailand, Iran, Malaysia, Bangladesh and Singapore.

According to the World Bank, China surpassed the United States and the European Union to become the world’s largest economy in PPP terms in early 2015, followed by India. Both countries are expected to rank in the same positions between 2020 and 2040.

Moreover, based on Hurun Report, for the first time in 2012 Asia surpassed North America in amount of billionaires. More than 40 percent or 608 billionaires came from Asia, where as North America had 440 billionaires and Europe with 324 billionaires.

The fastest growing region of the world

Asia is also the fastest growing economic region of the world with an average growth rate of 5.3 % in 2017. It also has three of the fastest growing economies of the world at moment, which, incidentally, are also the most populated countries of the world, India at 7.70 %, China at 6.70 % and Indonesia at 5.7 %.

Over the past 50 years, Asia was the theatre of some of the world’s longest modern economic booms, starting from the Japanese economic miracle (1950–1990), the miracle of the Han River (1961–1996) in South Korea, the Taiwanese Miracle (1962–2012), the spectacular rise of China from the poorest economy of the world in 1978 to becoming the largest economy of the world in 2015 and the current economic boom in India (1991-present).

Interestingly enough, none of the above is reflected in the current market capitalization and valuation of their respective stock markets

The US equity market still represents 40 % of the world aggregate equity portfolios, against less than 20 % for the whole of Asia and barely 5 % for China.

As our readers know, and contrary to the consensus, our model portfolio asset allocation has a 77 % allocation to Asia as a whole, 18 % to Europe and is net short the USA ( tech in particular ) based on valuation and earnings growth potential criteria.

The following chart shows the CYCLICALLY-ADJUSTED P/E of the world equity markets based on the Case-Schiller methodology, clearly showing the undervaluation of China ( 8x ) and the overvaluation of the USA (24 x)

It is worth noting that India and Japan are also high on the valuation scale.

Equity markets ultimately reflect the health of an economy and their valuation is driven by the liquidity induced by monetary policies

Assessing the future course of the various equity markets therefore implies a clear vision of where the underlying economies are heading and where interest rates are heading.

China

China’s economic growth edged down in Q2 to 6.7% y/y after holding steady at 6.8% in the previous three quarters. Activity picked up in April and May after the government’s pollution controls were lifted.

Nearly all components weakened in year-on-year terms with the only exception of property construction, which has accelerated recently as signs of a recovery in demand seem to have encouraged developers to start more projects.

Growth in freight volumes and passenger traffic edged down in July. Electricity output growth continued to weaken and the volume of cargo moving through China’s ports slowed, likely reflecting a weakening in economic momentum in advanced economies.

Property Sector

The property sector reported a further acceleration in sales and prices last month but the rise is not due to lower borrowing costs or looser property controls.

While interbank rates and bond yields have declined significantly since the start of the year, mortgage rates have continued to rise thanks to increased regulatory scrutiny.

Down- payment requirements have also been tightened recently illustrating the fact that property controls are still intensifying. These controls have been fairly effective at preventing further price rises in tier 1 cities.

However, prices in smaller cities have picked up recently, defying the curbs as demand in smaller cities has been propped up by China’s shantytown redevelopment scheme.

Launched in 2005, the scheme initially involved relocating residents from soon-to-be-demolished shantytowns into newly-built social housing. More recently, however, local governments have started to provide cash compensation to dislocated residents in lieu of actually building more social housing.

As a result, many lower-income households that would previously have struggled to meet the steep down-payments required to buy new private properties have been able to do so. This appears to have pushed up demand and prices in the lower tier cities where shantytown redevelopments are more prevalent.

This prop to the property market may soon start to fade, however, as the Government is now clamping down on local Governments shantytown re-developments.

Credit Curbs and lending policies

Growth in bank lending picked up in July to the fastest pace this year. However, a further slowdown in other forms of credit, including shadow financing, mean that broad credit growth continued to weaken to a fresh multi-year low.

Chinese banks extended RMB1450bn in net new local currency loans last month, down slightly from RMB1840bn in June, but above the consensus expectation of RMB1275bn.

In y/y terms though, growth in outstanding bank loans actually picked up from 12.7% y/y to 13.2%, the fastest pace this year. Lending to households continued to edge down, but this was outweighed by faster borrowing by corporations.

The PBOC’s favoured measure of broad credit — aggregate financing to the real economy (AFRE) — came in at RMB1040bn, down from RMB1180bn.

But unlike lending, growth in AFRE weakened in July, from 10.5% in June to 10.3% in July. The decline was the result of a slowdown in non-bank credit. In particular, shadow financing continued to weaken last month, reflecting a tightening in financial regulations.

Another measure of broad credit that adds government bond issuance to the AFRE data, also shows a further slowdown in July to 11.4% y/y from 11.7% in the previous month, the slowest pace since 2005.

Commercial banks’ non-performing loans (NPL) rose by RMB183bn in Q2, the biggest increase in over a decade. On paper, bad loans now make up just under 2% of all loans, the highest ratio since the Global Financial Crisis.

The official NPL ratio still looks low but the latest rise does suggest, alongside a recent jump in corporate bond defaults, that slowing growth is putting strain on corporate balance sheets.

One of the reason the NPL ratio remains a low level is that banks have stepped up their efforts to offload their bad loans.

NPL securitisation has led to a jump in banks’ issuance of asset-backed securities recently and new data made available by the People’s Bank last week show that banks have written-off RMB1.2tn worth of NPLs since the start of 2017, more than 1.1% of current outstanding loans.

As we have argued many times in the past, China’s transition from a bank financed economy to a capital markets financed economy has left the banking system with a large stock of non-performing loans on its book.

For more than a decade now, through high provisioning levels ( 150 % of NPLs ) and securitization of the legacy NPLs, bank balance sheets are gradually being cleaned up and this should translate ultimately in a rise in banks margins and net profits in the years to come.

US Trade War and the Currency

The tariffs imposed by the US so far and those that are due to come into effect this month should only cause limited damage.

However, the main effect of Donald Trump’s Trade War has been to send the Chinese RenMinBi into a tailspin as hedge funds shorted the currency and individual investors rushed to buy US dollars, interpreting that china would use a currency depreciation to counter the effects of the Trade war.

Data shows that Private firms and individuals have pulled capital out of China since the launch of the Trade War in response to concerns about the trade tensions.

But intervention by state banks and firms has been enough to more than offset this, without the PBOC needing to step in with direct FX sales.

China’s currency and capital flows were both fairly stable in the first quarter of 2018 but this calm ended in the middle of April, when the US administration announced the list of goods targeted by the first round of tariffs.

Capital outflows accelerated to US$7bn in June in seasonally-adjusted terms, the highest in almost a year.

The renminbi has continued to slide in July, losing a further 3% in both trade-weighted terms and against the US currency, the sharpest falls since the depreciation panic in 2016.

Yet, surprisingly, the July capital flow data suggest that China actually saw net capital inflows last month of US$3bn. Given that the last time the renminbi fell that sharply outflows jumped to more than US$50bn a month, it seems unlikely that there was no rise in outflow pressures last month.

A likely explanation — as highlighted in our post CHINA DRAWS THE LINE IN THE SAND — is that a pick-up in state-driven inflows in July outweighed outflows via other channels.

The PBOC has so far held off from deploying its own reserves to support the currency, but officials can intervene in other ways. Indeed, there have been widespread reports recently that officials have been leaning on state banks and firms to manage their cross-border flows in order to counter outflows from elsewhere.

There may have been other measures introduced too, which were not leaked. Evidence is inevitably circumstantial, but outbound portfolio flows from China have eased sharply over the past few weeks and were the lowest in nearly a year in July.

Chinese firms and households also unusually reduced their holdings of foreign currency last month, having largely accumulated foreign exchange over the past few years.

Moreover, China’s policymakers still have plenty of tools left at their disposal, including direct FX sales and a tightening of capital controls to prevent further depreciation of the Yuan.

The sharp fall in Chinese equities was primarily caused by the sudden depreciation of the Yuan.

Markets wrongly interpreted that China would use a currency devaluation as a counter weapon in the trade war.

We actually see the trade war as the catalyst that will finally end the structural undervaluation of the Chinese currency

see our post CURRENCY WARS : ONE TARGET IN SIGHT: THE YUAN

Low level trade talks have started this week in the US after having been delayed for two months by Donald Trump’s inadequate tweets. We expect them to come to a resolution of the Trade war by a commitment form China to allow a structural revaluation of its currency over time.

For the remainder of the year, we expect the Chinese economy to slow down marginally

China is becoming a mature economy and its transition from an export-led model to a consumer-driven economy is in full swing.

A sequential decrease in GDP growth rates is perfectly normal at this stage of China’s development and far form being a cause for concern, it is actually a sign that China’s economy is becoming self-sustainable and less dependent on the outside world.

Moreover, a marginally slowing economy, and therefore lower inflation, opens the way for more stimulative monetary policies, a clear positive for equity markets.

Hong Kong

Hong Kong’s economy slowed last quarter after expanding in Q1 at the fastest pace since 2011.

GDP contracted 0.2% last quarter, a weaker number than expected and a sharp swing from the 2.1% expansion seen in Q1. It is not unusual though for the economy to contract slightly after a strong performance in the previous quarter.

In year on year terms, growth slowed from 4.6% to 3.5%, still a fairly rapid growth pace.

The breakdown of the Q2 data showed that growth in household spending contracted 0.6% while Government expenditure accelerated slightly to 1.6% from 1.2%. Capital spending growth slowed to 0.4% last quarter from 4.2%.

Exports contracted 0.4% in Q2 after a 3.1% rise in the first quarter. Year-on year, exports growth slowed to 4.6% from 5.2%.

Hong Kong’s economic should slow further over the rest of this year and into 2019. Hong Kong stands to lose if the trade conflict between the US and China were to escalate further.

The city is not directly affected by the US tariffs and, unlikely other countries in Asia, it does not supply many intermediate goods to China that are then assembled before being shipped to the US.

Nevertheless, Hong Kong is a conduit for trade between the US and China and a slowdown in trade growth would inevitably hurt the city’s economy.

Interest rates have risen recently as the Fed has continued to tighten policy. The 3- month interbank rate in Hong Kong is now close to multi-year highs and we expect it to rise further over the quarters ahead as the US Fed looks set to continue raising rates.

Hong Kong is framed by its 1986 peg to the US Dollar and is bound to follow US monetary policy as a consequence.

Higher interest rates will weigh on consumption and investment and will act as a drag on the local real estate market.

The tightening in monetary conditions will put Hong Kong’s overheated property market under strain. Home prices in the city have surged over the past decade and are much higher now relative to incomes than before the previous property crash in 1997.

We see Hong Kong GDP growth to average 3.5% this year before slowing to 1.5% in 2019.

Japan

The Japanese economy advanced 0.5 percent on quarter in the three months to June of 2018, after a 0.2 percent contraction in the previous period and beating market consensus of a 0.3 percent growth.

Positive contribution to GDP growth came from private demand (0.5 percentage points), of which private consumption (0.4 percentage points) and capital expenditure (0.2 percent). Exports had a negative contribution of 0.1 percentage points.

Private demand increased by 0.7 percent in the second quarter, reversing from a 0.4 percent fall in the first quarter, driven by a rebound in private consumption which was way above expectations of a 0.2 percent rise.

Capital expenditure expanded by 1.3 percent, much faster than a 0.5 percent growth in Q1 and far above forecasts of a 0.6 percent gain. It was the steepest increase in business spending since the first quarter 2015

Manufacturing sector powering ahead with the manufacturing PMI edging up from 52.3 in July to 52.5 in August. Industrial output rose by around 2% per quarter, faster than the 1.3% increase in the second quarter.

The export climate index, a weighted average of the PMIs of Japan’s main trading partners, fell to a four- month low in July, but still points to export volumes rising by around 5% per annum.

By contrast, “new export orders” is more downbeat. The index weakened from 50.0 to 49.3 and suggests that export volumes will barely rise at all in the third quarter.

Inflation is catching up again with “Input prices” climbing from 61.0 to 61.4, the highest it has been since March 2011. “Output prices” rose from 52.7 to 53.2, the strongest reading in almost a decade.

The index suggests that consumer prices will soon be rising by around 1.5% y/y, compared to 0.7% in June.

Trade War

Even if it escalates, the trade dispute between the US and China shouldn’t do significant damage to Japan’s economy. Japan is not directly involved in the trade war but its economy would be affected if tariffs resulted in reduced trade between the US and China.

The most direct impact would be through lower demand for Japanese-made intermediate goods. China-bound intermediate goods exports that eventually end up in exports to the US are equivalent to 0.3% of Japan’s GDP, while exports to China via the US are a smaller 0.1% of GDP.

The tariffs announced so far would therefore reduce Japan’s GDP by no more than 0.2% in the highly unlikely scenario that trade between the US and China in the affected goods came to a standstill.

In reality, US firms and US consumers have few alternative suppliers for many of the goods they buy from China. For this reason, the impact on trade flows and on Japan’s economy is likely to be far smaller, and remain small even if tariffs were expanded to cover all trade between the US and China.

A bigger threat is the ongoing Article 232 investigation by the US administration into car and truck imports, which may result in the introduction of a tariff on Japanese vehicles.

Japan’s exports of cars and other transport equipment account for 40% of US-bound shipments. The domestic value-added embedded in them contributes around 1% of GDP.

US tariffs on Japanese vehicles would shave off 0.2 % of GDP growth while a blanket US tariff on all Japanese imports would definitely push the economy into recession.

LMC Automotive estimates that a 25% on US car imports, if passed on in full to consumers, would lower overall US vehicle sales by around two million. That would be equivalent to a 20% drop in the number of imported vehicles. As such, a 25% tariff on Japanese cars could plausibly reduce Japan’s GDP by 0.2%.

What if the US imposed tariffs on all imports from Japan, including machinery and electronics.

US-bound exports from Japan generate 2.6% of GDP. A 25 % tariff of Japanese made goods sold in the US would probably push Japan’s economy into recession. We do not see any of the above happening.

Politics

Mr Abe will almost certainly win the LDP’s leadership elections on September 20th, allowing him to stay Prime Minister for another three years.

Mr Abe can count on the support of around three quarters of LDP members in the Diet. What’s more, 54% of rank and file LDP members think that Mr Abe is the most suitable candidate. Mr Ishiba, who will probably be the only other candidate after the withdrawal of Fumio Kishida, has only secured the twenty votes of his own Diet faction.

Fiscal policy will probably be tightened during his third term, but the impact on economic activity will be dampened by continued loose monetary policy. Meanwhile, those pinning their hopes on structural reform will remain disappointed.

Reform momentum has long since stalled and Mr Abe’s main project for his third term is the revision of the pacifist constitution. There are no plans to reduce excessive employment protection laws for regular employees, which would encourage job mobility and increase productivity.

The government has already delayed a planned increase in the sales tax from 8% to 10% twice, but it looks likely that it will press ahead with the hike currently scheduled for October next year.

Apart from the tax hike though, the government has indicated that it will keep fiscal policy broadly neutral.

Monetary policy will remain loose for much longer. The government appointed BoJ Governor Kuroda for a second term in April, opting for the continuation of aggressive monetary easing.

The introduction of the Bank of Japan’s 2% inflation target was the result of a joint agreement between the government and the Bank. As such, the Bank is unlikely to respond to the continued failure of hitting the 2% target by lowering its sight.

Japan’s inflation is ticking up but it will take years of continued monetary stimulus before it reaches the 3 to 4 % needed to deflate Japan’s 220 % of GDP stock of debt.

We see economic momentum picking up in the second half of the year, filed by a weaker Yen and monetary stimulus. Only an aggressive trade stance by the US would question this scenario,

Korea

The South Korean economy advanced 0.7 percent quarter-on-quarter in the three months to June 2018 after a 1 percent expansion in the previous period. The slowdown was explained by softer expansions in manufacturing and services and contractions in primary activity and construction, more than offsetting a sharp rebound in utilities.

Year-on-year, the economy advanced 2.9 percent in the second quarter of 2018, slightly above the 2.8 percent in the previous quarter but below the 3 percent expansion expected by consensus.

The softer overall growth was explained by a sharp 2.7 percent decline in gross fixed capital formation (vs +2.0 percent), with facilities falling 6.6 percent (vs +3.4 percent); construction 1.3 percent (vs +1.8 percent); and intellectual property rights 0.7 percent (vs +0.3 percent).

Final consumption expenditure expanded less (0.3 percent after a 1.1 percent expansion in the first quarter), with both private and public spending rising 0.3 percent. Meantime, exports grew only 0.8 percent (vs +4.4 percent) and imports declined 2.6 percent (vs +4.9 percent).

South Korea’s inflation stood at 1.5 percent year-on-year in July of 2018, the same as in the previous two months and below market expectations of 1.7 percent. Food inflation slowed to a four-month low while cost rose at a faster pace for housing & utilities and transport.

The headwinds of household debt

Household debt in Korea has surged in recent years, raising fears of a messy unwinding. Household debt in Korea is equivalent to around 95% of GDP, which is one of the highest in the world.

Economic history tells us that rapid increases in debt can lead to problems further down the line as was the case in the USA in the 2000s, leading to the 2008 financial crisis.

On the positive side, the vast majority of household borrowing has been in domestic, rather than foreign currency. Another comforting sign is that the rate of growth in household debt has slowed over the past year.

Mortgages account for most of the increase in household debt, raising worrying comparisons with the US on the eve of the global financial crisis, but there has not been a big increase in Korean property prices.

Korea’s banking sector is well-managed and should be able to cope in the event of a big increase in bad debts. Its capital buffers high, with the capital adequacy ratio (CAR) and tier 1 CAR well above the Basel III regulatory minimums of 8% and 6%, respectively.

Nonperforming loans accounted for just 1% of total loans in the first quarter of Q1. It would take a rise in the NPL ratio to 7% before banks’ capital ratios fell below the Basel III requirements.

However, not everything is positive. Despite very low interest rates, the debt service ratio in Korea has risen steadily in recent years, in line with the increase in the stock of debt.

Without a rapid increase in income growth, which is unlikely in the absence of a strong increase in productivity growth, the high household debt burden should weigh on private consumption over the medium term.

The increase in household debt puts the BoK in a difficult position. On one hand, keeping interest rates close to record lows could encourage households to take on even more debt, leading to a further build-up of risks in the financial sector. On the other hand, raising rates could make it more difficult for households to service debts and therefore derail the economic recovery.

For these reasons, we see Korea’s economy slow down in the years ahead and GDP growth to average just 2.5% in 2019–2020.

The concern is that we do not really see how Korea can reduce the overall level of Household debt to GDP apart from introducing more stringent lending criteria, and therefore impacting the banking sectors’ growth.

Any monetary policy tightening is likely to be very gradual.

Indonesia

Lat week’s rate hike by Bank Indonesia came against a backdrop of weakening economic growth and subdued inflation, and highlighted the commitment of the central Bank to defend its currency in the turmoil created by Turkey.

BI has now raised interest rates by a cumulative 125 basis points since late May and further rate hikes are likely before the end of the year.

The authorities are worried about currency weakness because of the relatively high level of foreign currency debt in the country which is equivalent to around 30% of GDP.

The Central bank did not seem too concerned about the impact of the rate hikes on the economy and left its growth forecasts at 5.0%-5.4% for this year, and 5.1–5.5% for 2019.

It also expressed its support for the government’s recent policy moves aimed at reducing the current account deficit, which recent figures show widened to 3.1% of GDP in the second quarter, up from 2.2% of GDP previously.

On the political front, Indonesia’s budget for next year envisages a big increase in cash handouts, and is clearly aimed at boosting support for President Joko Widodo ahead of general elections due in April. The poll is likely to be a repeat of the 2014 contest that saw Jokowi narrowly edge past former general, Prabowo Subianto.

Indonesia’s draft budget, which was published last Thursday, targets a small reduction in the budget deficit next year to 1.8% of GDP, from 2.1% this year.

The deficit target is based on the assumption of a 13% increase in government revenue. However, revenue collection typically falls short of target. Last year the government brought in only 90% of its target.

By Indonesian law, the combined budget deficit of the central and regional governments is not allowed to exceed 3% of GDP. With government debt less than 30% of GDP, Indonesia’s fiscal position is one of the healthiest in the region.

The budget is also targeting a 10% increase in government spending next year. Most of the increase will go on cash handouts, including a big rise in pay for civil servants and a doubling of benefits to poor households.

The budget also sees a big increase in spending on energy subsidies next year, with spending set to go up by 66%.

On the negative side, spending on infrastructure is scheduled to increase by just 2.4% next year. This is the smallest increase since Jokowi took office. Between 2014 and 2018, spending on infrastructure increased by an annual average of 30%.

The low priority given to infrastructure is a worry given Indonesia’s woeful infrastructure, which is rated as one of the worst in the region. Poor road, rail and port links act as a significant drag on the country’s economic potential.

Indonesia’s gross domestic product grew 4.21 percent quarter-on-quarter in the three months to June of 2018, the strongest growth rate since the series began in 2005, supported by government spending and fixed investment and a faster increase in private consumption.

Indonesia’s annual inflation increased to 3.18 percent in July of 2018 from 3.12 percent in the previous month, but below market expectations of 3.24 percent.

Indonesia’s economy has been well-managed over the past few years and the Central bank decision to defend its currency is the right one.

The country has plenty of budgetary ammunition to boost growth in case of a slowdown, which we see unlikely considering the boost to consumption that the coming budget will trigger.

India

India is on track to hold its position as one of the world’s fastest-growing economies as reforms start to pay off, according to the International Monetary Fund.

The $2.6 trillion economy was described by Ranil Salgado, the IMF’s mission chief for India, as an elephant starting to run, with growth forecast at 7.3 percent in the fiscal year through March 2019 and 7.5 percent in 2020.

The nation accounts for about 15 percent of global growth, according
to the Washington-based fund.

Key risks flagged by the IMF include higher oil prices, tightening
global financial conditions and tax revenue shortfalls.

Authorities should take advantage of stronger growth to bring
down debt levels, simplify the consumption tax system and
continue to gradually tighten monetary policy, according to the IMF.

After the cash ban in late 2016 and a disruptive nationwide sales tax last year, India’s economy is once again gaining momentum.

Growth reached the fastest pace in seven quarters in January through March, and high frequency indicators from purchasing managers’ surveys to auto sales data show the economy is likely to gain momentum.

Risks are mounting though. The rupee has plunged 7 percent against the dollar this year, the worst performer among major Asian currencies, threatening the inflation outlook.

The Reserve Bank of India delivered its second straight interest rate hike
at the beginning of August as policy makers seek to maintain economic stability against a global backdrop of trade tensions and currency turmoil.

Continuing structural reforms are key to high growth and Modi’s administration has already demonstrated its ability to move boldly.

Further rationalization of the goods and services tax and labor reforms are high on the agenda.

Indian equities have been star performers this year, making new highs after new highs. Valuations are high which explains our relative underweighting when compared to China.

We remain positive on India, particularly on the internal consumption sectors.

Malaysia

Last week’s figures show that Malaysia’s growth slowed sharply in Q2, partly reflecting the political transition following the May election.

GDP growth in Malaysia slowed sharply in Q2, to 4.5% y/y from 5.4% in Q1. The outturn was weaker than expected and marked the slowest pace of growth in six quarters.

The breakdown of the data showed that the political transition following May’s shock election result appeared to have played a role, with public sector investment contracting by 9.8% y/y.

Weaker export growth due in part to unplanned supply outages in the mining sector and production constraints in the agriculture sector also contributed to the slowdown.

These more than offset a pick-up in private consumption and investment growth.

Looking ahead, growth should recover some momentum in the near term as the temporary drag on export growth stemming from the mining and agriculture sectors fades. Meanwhile, the scrapping of the Goods and Services Tax (GST) from June should continue to provide a boost to consumers’ spending power.

However, a sharp rebound is unlikely. For one, the hole in government revenue caused by abolishing GST and the revelation that Malaysia’s government debt burden could be as high as 74% of GDP (compared to the previous estimate of 54%) will keep a lid on government spending.

The suspension of a number of large Chinese-backed infrastructure projects, including the East Coast Rail Link, will also weigh on construction activity and investment growth.

Another drag on growth is likely to be the less favourable external environment. There are likely spill-overs from the US-China trade war, given that Malaysian exporters are heavily integrated into Chinese supply chains.

On the political side, since his surprise victory in the May elections, 93-year-old Prime Minister Mahathir Mohamad has wasted no time in carrying out his main campaign promises.

With his first 100 days in office now almost up, Mahathir has already scrapped an unpopular Goods and Service Tax (GST), suspended several large-scale infrastructure projects and is in the middle of a huge anti-corruption campaign.

The decision to axe the GST, which has caused a sharp drop inflation, should lead to an increase in consumer’s real spending power and provide a short-term boost to growth.

However, scrapping the GST will lead to a deterioration in Malaysia’s fiscal position. Despite a replacement tax being implemented in September and higher oil prices providing a boost to revenues from the oil sector, the budget deficit will probably widen from 3.0% of GDP in 2017 to 3.5% this year.

Given Malaysia has one of the highest levels of public debt in the region, sooner or later the government is likely to come under pressure from financial markets to get fiscal consolidation back on track. This would imply a tightening of fiscal policy later in the years ahead.

The government’s decision to suspended a number of large Chinese-backed infrastructure projects, including the East Coast Rail Link and a high-speed rail line to Singapore will hold back growth in the short term.

However, the projects would have left Malaysia saddled with bad debts, making its poor fiscal position even worse. Many of these projects were considered to be of dubious economic value considering Malaysia’s good infrastructure.

The corruption crackdown has progressed at a rapid pace. Since the election, the previous prime minister, Najib Razak, has been charged with embezzlement, while the attorney general, the head of the anti-graft commission and the entire board of the state’s sovereign wealth fund, have all been replaced. There has also been change at the top of the central bank.

Tackling corruption should improve the economy’s long-term prospects.

The government hasn’t yet taken any steps to reform the system of affirmative action that provides preferential opportunities to ethnic Malays. Dismantling the out-of-date system would help to boost Malaysia’s productivity and raise its trend rate of growth.

Over the next couple of years Mahathir is expected to cede power to his one-time fierce rival, but now political ally, Anwar Ibrahim, a staunch reformer.

The political changes are making us more positive on Malaysia than we have been in a long time and we expect growth to remain at 5 % plus in the next two years.

Thailand

This week’s data showed Thailand’s GDP growth in Q2 easing slightly to 4.6% y/y, down from a record 4.9% the quarter before but higher than expectations.

The breakdown of the data showed a pullback in government consumption growth, which was partially offset by a pick-up in private consumption and investment growth as well as a smaller drag from net exports.

On the negative side, the tourism sector is unlikely to match its recent strong showing in the quarters ahead. The sharp pick-up in tourist arrivals since Q4 2017 partly reflected a rebound following the end of a year-long mourning period for King Bhumibol. These favourable base effects are unwinding.

The slowdown in Chinese tourist arrivals in July suggests a recent ferry disaster on the island of Phuket, which led to the deaths of 47 Chinese tourists, will drag on the tourism sector at least in the near term.

On the positive side, infrastructure spending will be a key driver of the economy. The government’s transport infrastructure investment program, which is worth more than 2 trillion baht (14% of GDP) from FY2015 to FY2024, is expected to gather pace.

In addition, rising capacity utilisation also bodes well for the ongoing recovery in private investment.

Thailand’s inflation remains subdued with a CPI that rose to 1.46 percent in July 2018 from 1.38 percent in the previous month and in line with market expectations.

On the political side, the military government has continued to push back the date for a general election, with the latest promise to hold the election by May 2019.

While there have been no outbreaks of significant unrest so far, the risk remains that if the electorate feels the military government is backtracking on its commitment to return the country to civilian rule, tensions will flare up again.

Another outbreak of protests and violent conflict would deal a significant blow to the economy. The important tourism sector would be among the hardest hit. Business and consumer sentiment would also be hurt.

We remain positive on Thailand’s economy with an expected growth rate of 4 % this year and 3.5 % next year.

The political situation mjts be watched carefully though.

Originally published at Mechelany Advisors.