As SG releases its global economic outlook for the fourth quarter, Steven Xu, the bank's head of Asian economic research, talks to FinanceAsia about the prospects for the region. While the recovery in consumption is driving growth in most countries, particularly China and Korea, the story is not so bright for Hong Kong.
What is your current economic outlook for non-Japan Asia?
I'm generally positive about the region, firstly because we have seen a reversal of the investment-savings gap due to a significant improvement in balance of payments for most economies. In the last five years, savings have consistently outstripped investment, which has laid the foundations for some kind of consumption recovery. I am reluctant to use the word 'boom'; it's more like a revival, particularly in some Asean economies. Secondly, Asian equity markets are still undervalued in comparison to OECD ones, but not all, while most of the Asian currencies are also undervalued. The final factor is that the policy makers are under more pressure to inflate economies.
What is the story coming out of China?
Once the leadership transition is over in China, you are going to see greater clarity on the policy front. Politicians will be more inclined to cater to the driving force of the economy, which is the private sector. We will be looking for some breakthrough in capital market reforms and interest rate deregulation. China definitely has the most positive story to tell in the region.
Hong Kong is the most negative story. I look for 1% GDP growth this year and next year, with inflation of negative 2% in 2003. This year we think negative inflation will hover around 3%. If you look at the nine economies we cover - China, HK, Indonesia, Korea, Malaysia, Philippines, Singapore, Taiwan, Thailand - they have experienced economic acceleration in the last 16 months, while Hong Kong is the only one stagnating, which is unfortunate.
The Hong Kong economy has been depressed for well over a year. What are the main factors behind this?
Firstly, Hong Kong consumers are very sophisticated and rational: they look beyond this year's income to the future as well. If you want to discount future income, you have to take into account the tax regime or possible changes to that regime. The question of whether the low tax regime is going to be maintained has become a very serious issue. So possible changes - whether it is to consumption tax, corporate tax or salary tax - you are looking at some very hard numbers to reduce fiscal deficit.
The financial secretary has said the deficit is going to be HK$60 billion for 2002, which is a lot more realistic than the HK$45 billion he predicted during the Budget in March. The admission of fiscal deficit is a positive sign because it is shows recognition of the problem. With civil servant salaries accounting for 70% of fiscal expenditure, one way or another you need to address this issue (civil servants' further pay cuts), but at the present time I do not see any meaningful initiatives on that front. Without a significant cut in civil servant salaries, it is extremely unlikely that fiscal deficit can be brought under control. It is because of this nagging issue that consumers will continue to discount future reduced after-tax income. Naturally, investors will also be less bullish on the future rate of return on HKD assets.
I am not trying to be sensational about this - there is an economic theory underpinning this, which is called the Ricardian Equivalence. This basically says that consumers are going to be affected by deficit financing in such a way that they will reduce consumption in order to prepare for future tax liabilities. I think we have already seen that in Hong Kong since late 1997: retail sales numbers have continued to decline by around 4-5% year-on-year in recent months. If you look at investment, in some months we have actually seen double-digit decline. Credit growth is negative or flat, which suggests that private investment is not coming through.
Domestic consumption accounts for 60% of GDP so if this continues to be a drag, it will be very difficult for the whole economy to recover.
What kind of policies would you like to see to try and tackle these issues?
I don't want to be too pessimistic about Hong Kong because there are remedies to these problems. The main objective must be to cut fiscal deficit. To achieve this, you have to do two things. One - you have to carefully screen government investment projects. I am glad the financial secretary has said that the government will suspend projects that are 'unproductive'. This is important because unproductive government investment can have a crowding out effect on private investment.
The second factor is civil servant salaries. If you look at most private sector workers, generally they have taken a pretty pragmatic view on reduced bonuses and headcount in the past few years. I am not sure that public sector workers hold the same view. Fiscal prudence is vital to uphold Hong Kong's status as a major financial centre.
Housing policy is also very important. If you are to have a meaningful discussion about asset valuation, you have to take into consideration the tax regime. Property has been a vehicle to redistribute wealth in Hong Kong. In other words, high property valuation goes hand in hand with a low tax regime. The restoration of fiscal prudence must be the absolute priority and once we see this, confidence will easily come back.
Hong Kong still has a lot of advantages compared to Singapore, for example, as an offshore centre for Rmb in the not-so-distant future. Affordability of property is also at an all-time low, which is particularly favorable, so recovery is very much related to confidence. The SAR government must act quickly on the fiscal prudence issue to meet or even exceed investor's expectations.
You are bullish on China. How important a factor is China in driving growth in non-Japan Asia?
China is increasingly becoming a driver for regional growth. For example, if you look at this year's cross-Straits trade, it is probably around US$35 billion. There has been a massive imbalance with Taiwan running a huge trade surplus with China. That surplus could be roughly equal to $25 billion this year. Taiwan's economic growth would have been flat or even negative in 2002 without this. The same phenomenon, although not quite as acute as the cross-Strait trade, is emerging between Korea and China.
Some people look at the trade surplus between China and the US and are alarmed by its seeming sustainability. I don't have the same fears because if you examine the trade imbalance between the US and China, you have to take into account the trade imbalances between China and Korea and Taiwan. Otherwise, it would be misleading to focus on rising trade imbalance between China and the US.
Obviously, it would be unrealistic to say that China will replace the US as the main driver of the region's economy, because its nominal GDP is still smaller than that of France. So China is not going to offset the vacuum left by the reduced US capital expenditure and a potential fallout of the US consumers.
What effect is the continuing uncertainty in the global political environment having on Asia?
Investors have become increasingly skeptical about the sustainability of US consumption growth, which is why when you look at the stock market performance between July and September, Asia has been under-performing the S&P and Dow Jones indices even accounting for the recent export data coming through. Asian stocks are basically discounting some sort of cyclical peak in the region - the question is whether the dichotomy between real economies and financial variables would narrow. So if trade continues to hold up, the regional bourses should rally.
Confidence in Korea remains high: is this sustainable?
One of the stories in Korea is that credit is being allocated more efficiently - distortions in the economy are gradually being removed, which is also the case in China. Since 1998, we have seen interest rates fall from 13% to between 7% and 8% in real terms, but inflation remains below 3%, below the Bank of Korea's target. The Central Bank has gained much credibility.
We are aware of the sizzling property market in Seoul and the build-up of consumer credit, but if you look at broader money supply measurements in Korea, we haven't seen excessive credit growth yet. This is very different to what happened in Korea in the mid-1990's or Malaysia in 1984-85, so it is far too simplistic to talk about a bubble in Korea. In short, Korea is the only country in the region experiencing a real estate boom but at least inflation is still under control.
Another positive is that we are continuing to see foreign competition in the banking sector and people have more consumption choices due to proliferation of financial products for consumers.
If you look at Southeast Asia, it seems to me that consumption is pretty neutral. The low interest rate environment has actually imposed restrictions on the currencies. That is why the Bank of Thailand has to tolerate the weakening of the Thai Baht, because you cannot maintain low interest rates and a stable Thai Baht simultaneously over a long period. I am also sure at some stage that the ringgit peg will be an issue again.
Some people have taken a fairly positive view on the growth stories in Thailand and Malaysia. What is your view on that?
You need to differentiate Malaysia and Thailand. I can see why people are turning more positive on Malaysia because it really didn't take that much of a hit during the Asian financial crisis. Secondly, the banking sector was not severely damaged during that period. However, I think it is premature to say that there will be a consumption boom based on positive anecdotes such as car sales.
In the case of Thailand, there is still unfinished work in the banking sector. In Malaysia, interest rates may be low but while the ringgit peg remains at 3.8 to the dollar, this only undermines the effectiveness of monetary policy. Consumers and investors will naturally question whether it will be a permanent scenario for the local interest rates to remain low in real terms. It is difficult to recognize in both countries the secular changes that have taken place in Korea. That is why I would say that we might be seeing a consumption revival in both Thailand and Malaysia: not a boom.
What about the Philippines?
Fiscal deficit in the Philippines is a chronic situation. This year, once investors realized that there had been a fiscal slippage, you started to see a reduced capital inflow. Overseas workers are hoarding hard currencies and the Peso will remain undervalued. This restricts the Central Bank, because it isn't able to cut interest rates even though inflation does not seem to be a problem. We previously thought that Philippines' sovereign credit story was compelling, however, we no longer take that view.
