Think Tank

China, Asia and the World: Rebalancing

Richard Martin, Managing Director, IMA Asia

As Asia emerges from the shadow of Covid-19, there will be disparity in economic performance across the region. Some markets will count out stronger, others weaker. Over time, there will also be an economic and geopolitical ‘rebalancing’, not just within Asia, but between the region and the world at large. While it is difficult to look too far ahead at this stage, there are significant downside risks on the horizon. At recent all-India sessions of the India CEO Forum, Richard Martin, Managing Director of IMA Asia, shared his outlook for the regional and global economies, and the implications this has for business.

An Imperial College report spurred governments into action…

Shaping the debate on Covid-19…
Two recent reports – one by Imperial College London, the other by Yale University – have shaped the global policy response to Covid-19. The one by Imperial College made Donald Trump and Boris Johnson change course and take much sterner action. It also guided the Indian government to impose a full nationwide lockdown. In a nutshell, its projections indicate that, without strict containment, even the best healthcare systems would quickly get overwhelmed. Each stage of suppression lowers the case load, pushes it out further and gives countries a better chance of coping. The report also predicts a second wave later this year or in early 2021 – which many countries are now preparing for.

…and another by Yale has shifted the debate on the costs and benefits of suppression

The Yale study focuses on the expected mortality rate and VSL (value of statistical life) losses in each country under different stages of response. It find that the same policies have different outcomes in each country. With strict suppression, richer, older nations will see a dramatic reduction in both mortality rates and VSL losses. On the other hand, emerging markets like India have poor health systems and younger populations that need to keep working to survive. In such places, the gains from suppression are lower, so it is important to ‘get them open’ quickly.

Forecasters everywhere use the IMF WEO as a starting point for projections…

…and its economic impact
The IMF’s bi-annual World Economic Outlook report is the bedrock for economic forecasters. Not only does the IMF have a good understanding of countries and regions, it also uses common assumptions and a single model to arrive at forecasts. This makes it easier to compare across countries. Yet, while these numbers are a good starting point for GDP estimates, there are a range of local factors at play that affect the actual growth trajectory, but are hard to capture in a formal model. IMA Asia, for example, will factor in the more recent information it has access to, as well as local market dynamics (including competition and regulation), national leadership capacity, and a country’s capacity for reforms. Its estimates thus often vary from those of the IMF.

…but also add in their own variables and assumptions

Too many unknowns to allow a long view…

…but 2021 will be a ‘90% world’

…and its economic impact
What is striking about the IMF’s April 2020 update is that, for the first time in 30 years, it does not give 5-year growth projections, but stops at 2021. It acknowledges that with Covid-19, there are too many new and unknown variables at play. The report also presents three alternative growth scenarios, but all are on the downside. The first accounts for a longer-than-expected outbreak this year, the second for a second wave in 2021, and the third, worst-case scenario factors in both risks playing out. In the base case, the IMF expects world growth to slow from a 20-year average of 3.8% to 1.4% in 2020 and 2021. Advanced economies are likely to de-grow, while India will slow to an average of 4.6% and China to 5.2% (see table below). However, since the report’s release, IMA Asia’s outlook has become more pessimistic, and assumes that a worse or worst-case scenario will unfold.

Taiwan is poised to surprise on the upside, buoyed by an upturn in the electronics cycle…

A regional snapshot: Taiwan
Within Asia, the major economies will follow divergent growth paths over the next two years. Taiwan is likely to surprise on the upside in comparison to the IMF forecasts. It continues to see robust growth, booming investment, low unemployment, rising bank credit, and strong exports and industrial production. Driving this is an upturn in the global electronics cycle, which benefits Taiwan’s world-leading semiconductor manufacturers. Last year, TSMC invested over USD 15 billion in capex, and it plans to plough in another USD 17 billion this year. With people working from home, and companies making the transition to digital virtually overnight, Covid-19 has ramped up the global demand for new consumer and business electronics.

…and a rebalancing away from China

The other side of the Taiwan growth story is its rebalancing away from China, both politically and in terms of supply chains. In January, President Tsai Ing-Wen was re-elected by a landslide, partly on the back of a campaign promise to pay Taiwanese firms to reshore. This is death-knell for the once-dominant KMT and its policies of closer integration with the ‘mainland’. China is integral to Taiwanese supply chains, with over 50% of the value-add in a typical ‘Taiwanese’ product originating overseas, mainly in China. Going forward, this ratio is expected to drop sharply. Foxconn, the largest export manufacturer and private-sector employer in China, is Taiwanese. It has over a million workers and 15 factories. Were even 2 of these to be re-shored to Taiwan, they would soak up what little unemployment that currently exists there.

Growth turned negative in Q1, but China is still able to dial up the economy at will

In Q1 (Jan-Mar) China reported negative GDP growth for the first time in decades, and clearly, the Middle Kingdom faces major problems. However, with its authoritarian government, it does have huge advantage: the ability to dial growth up or down at the turn of a key. (In February, its PMI index collapsed, but bounced right back up the next month. No other country can replicate this.) For several years, China has struggled to rebalance growth away from fixed investment (currently ~45% of GDP), and towards consumer spending. With consumption slowing, it is now ramping up infrastructure and residential-construction spending to prop up growth. Restrictions on property ownership are being lifted, and old buildings are being torn down and rebuilt. Currently, IMA Asia forecasts that China will grow at ~5% in 2021, much lower than the IMF’s 9% estimate. Without the additional capex, growth would have been even lower, at around 3.5%.

It will struggle to shift from capex-led to consumer-led growth…

…and will pay a heavy price as it decouples from America

In the years ahead, China’s rebalancing will have profound implications for the rest of the world. In line with its China 2025 policy, the ‘world’s factory’ will produce fewer low-value items – which will move to countries like Vietnam, Bangladesh and hopefully India – but more hi-tech goods. However, an even bigger ‘rebalancing’ is also underway: a decoupling from America. Superficially, this pulling apart of the world’s two biggest markets is about trade; substantially it is about IP; but at root, it is really about power. At the very top of the US establishment, across nearly all departments/agencies, the backlash against China is extraordinary. This animosity will spill over into corporate decision-making – perhaps to the advantage of countries like India – and it is unlikely to recede even if Joe Biden wins the White House. Moreover, anti-China sentiment has spread to other countries, including Australia, the UK and Europe. This may eventually create a ‘wall’ that corporates will find hard to scale.

Northern Asia is badly in need of a policy re-think

Japan and South Korea
Both Japan and South Korea desperately need a shift in policy direction. Japan’s manufacturing GDP fell at a compounded -0.5% over 2015-20 and is expected to continue shrinking (by 0.3% a year) through 2025. South Korea will do slightly better, with its industrial economy likely to grow at 2% annually over the next five years, compared to 1.3% in the last five. However, in both countries, markets are either stagnant or shrinking, and industry needs to move offshore. Prime Minister Abe has been unable to push through the growth-boosting reforms he had promised. Meanwhile, President Moon, who came to power on a left-leaning agenda of higher minimum wages, greater strictures on the chaebol, and better relations with North Korea, has met with little success.

Singapore stands to gain from Hong Kong’s misfortune, but has constraints of its own

Hong Kong and Singapore
Singapore stands to gain from Hong Kong’s misfortune, but has constraints of its own For the last 100 years, Asia has had two hubs, but one of them is now slowly being dismantled. The ‘one country, two systems’ mechanism is collapsing, and many Hong-Kongers and MNCs are leaving as social unrest spreads and political repression deepens. Singapore, with its relative abundance of land, stands to gain. IMA Asia projects that it will grow faster than Hong Kong (3.2%, compared to 1.9%) through 2025, though Hong Kong might be able to spur growth by doubling down on property development. A possible road-block for Singapore is its small labour pool. Recently, the government – which faces an election next year, and does not want to appear too friendly to outsiders – has imposed stricter controls on foreign workers. This will impact growth.

Vietnam is steadily replacing Thailand as the manufacturing hub of South East Asia

Thailand and Vietnam
Thailand was once c the ‘Detroit of South East Asia’ – a hub for vehicles and electronics. However, it has lost this crown to Vietnam, which – from being an eighth of Thailand’s size a decade ago – now has a bigger industrial sector and a rising consumer class. In Thailand, a fragile coalition has replaced the more stable (but also military-backed) regime that came before it. Consumers and investors are unhappy and are holding back on spending. In contrast, Vietnam’s President Trong is firmly in control as head of state, the communist party and the military. He is mildly pro-market and broadly follows the China growth model. Investors have easy access to land, power and roads, and anchor investors like Samsung have put huge amounts into their supply chains. Political stability, a labour force similar to China’s – 90% of working age women are in the workforce, most people have basic education and there is a large pool of semi-skilled workers – have drawn in huge foreign investment in recent years, spurring growth.

Politics has become a serious impediment to growth in both Malaysia and Indonesia

Malaysia and Indonesia
Malaysia and Indonesia are both capable of sustained 6%+ growth but politics gets in the way. Indonesia suffers from rampant economic nationalism and has no tolerance for the private sector. (As a share of the economy, SOEs play a bigger role there than in China.) Growth was just 3.2% a year over 2015-20 and is likely to stay below 5% over the next 5 years. In contrast, Malaysia suffers from deep ethnic and religious differences, and from entrenched corruption, which scares investors. Oil and gas revenues make up 60% of the budget, and have been recycled into consumer spending via handouts and a large public sector. However, with oil prices plunging, this will need to stop. Growth over 2020-25 is likely to average 5%, compared to 5.2% in 2015-20.

The ANZ siblings are on a similar path: stable politics, migrant- and resource led growth, and good government finances

Australia and New Zealand
Politically and economically, Australia and New Zealand are on similar paths. Both are led by prime ministers who were expected neither to win power nor to hold on to it. Yet Scott Morrison is likely to be the first Australian PM in 15 years to complete his term; Jacinda Ardern has carved out an image as a stand-out leader, and looks set to be re-elected. Both countries rely heavily on tourism and are big resource exporters: dairy in New Zealand’s case, and coal and iron ore in Australia’s. Similarly, in-migration is a huge driver of economic and population growth, with migrants accounting for 2 of every 3 ‘new people’ in each country. (New Zealand is currently seeing a housing-construction boom that is driven by migration.) With low debt-GDP ratios, they are comfortably placed to ramp up government spending if required. Finally, with two solid ‘growth engines’ in place – one domestic, the other export-led – they can continue to grow even if one of the engines stalls.

Four balance sheets determine the health of any economy

Emerging from this ‘balance sheet recession’
In any economy, demand is a function of the health of four types of balance sheets: government, corporate, household, and that of financial institutions. When all four are robust, consumer spending and investment tend to be, as well. Conversely, when one or more balance sheet is stressed, asset prices fall, and the impact ricochets through the system. Demand drops, bankruptcies, bond defaults and unemployment rise. This further weakens balance sheets and triggers a recession. In fact, roughly one in every three downturns, including the GFC is a ‘balance sheet recession’. In many ways, this describes what the world – and India – is going through today.

The fastest way out is for one balance sheet to expand, making space for the others to repair themselves

Emerging from this ‘balance sheet recession’
As China, America and Europe showed in 2009-10, the direct way out of a balance sheet recession is for the government to expand its spending by taking on debt. This provides space for the other three ‘actors’ to repair their balance sheets and deleverage. Going forward, many countries will lift public spending but India may not be able to follow the same path. It has a low public debt-GDP ratio but its capacity to borrow offshore is limited. Moreover, India’s sovereign risk rating is at the lowest investment grade, so even a one notch downgrade would take it into junk status. That, in turn, would cause the cost of renewing debt to sky-rocket. The only real option, therefore, is for India to undertake economic reforms that allow its four sets of balance sheets to self-repair. This will be a gradual process, and may take years.


How businesses will change post-Covid
The post-Covid world will be a ‘90% world’ – one where demand (nearly) everywhere is 10% lower than it would otherwise be. Corporates will have to adapt to this new reality, which will impact their operations in several, distinct ways:

Covid will reshape supply chains…

  • Supply chains will become less efficient but more resilient. In this age of rising industrial nationalism, global supply chains will fragment and companies will have to increasingly rely on domestic ones. They will also need to align themselves more closely with governments to ensure that they are not caught on the ‘wrong side’ of the fence politically.

…the route to market…

  • Increasingly, the route to market will be digital, including for B2Bs. Supply chains will need to become more visible and transparent and new skill-sets will be required. Covid has already forced many businesses to accelerate their digital transformation – some have made changes overnight that were years in the planning.

…how companies earn revenue…

  • All manufacturing companies will become services firms. Covid has highlighted the risks around tying one’s revenues to delivering a physical good at a point in time. Businesses that rely on annual service contracts are on safer ground in terms of both payments and margins. Just as airplane/engine manufacturers have made this shift in the last 10 years, so will other sectors, including automobiles.

…and will force businesses to become more flexible and agile

  • Flexibility will become a strategic imperative. Recognising and adapting to the reality of a decoupled world will be critical, and for most companies, BAU is not an option.
  • Leadership and team management will undergo a sea-change. Keeping employees engaged and mobilised will be difficult in a world where social media has completely shifted. (This is the first crisis in which an employee who has suffered a salary cut or job loss can complain about it the same day to the wider, online world.) Businesses will also need to move away from the pseudo-military hierarchies of the past to a hyper-networked world with no external walls around the organisation.