Southeast Asia has had its fair share of ups and downs over the last fifteen years. First it went through the traumatic events of the Asian financial crisis in 1997-98. No sooner had it regained some economic momentum, than the region was hit by the global financial crisis. Now, Southeast Asia faces the European crisis and its impact threatens to dwarf the previous two.
Southeast Asia can’t be blamed if it is experiencing “adjustment fatigue.” But complacency would be unforgiveable. The region may have weathered the global financial crisis enviably well, but it may not be so lucky next time. In any event, even as Southeast Asian policymakers may hope for the best, they should be preparing for the worst.
There is some confidence that Southeast Asian economies can weather a “muddling through” scenario in which Greece remains in the eurozone and is supported by a combination of austerity measures, structural reforms, bank bailouts, and continued quantitative easing by the European Central Bank (ECB). That’s the most optimistic scenario out there, but it’s increasingly less probable.
The second scenario—an orderly Grexit—would add macroeconomic turbulence in the near term as European banks deal with the damage to their balance sheets, and seek to recapitalize and deleverage. Although Greece is a relatively small economy compared to the rest of the eurozone, the macroeconomic fallout from its euro exit could still be severe. And the ECB will likely need to pump in more liquidity to counterbalance shortages.
The third and worst-case scenario is that Greece not only exits the eurozone, but the firewalls of the European Financial Stability Facility (EFSF) and the ECB prove ineffective in containing a contagion that spreads to other economies in and out of Europe. If this happens, all bets are off.
The global economy will be in a place it has likely never been before—certainly not in the last eight decades. The crisis will not only hit the stronger European economies hard, but spread to the United States where the current recovery is anemic and the banks are still in the process of repairing the damage to their balance sheets caused by the Great Recession.
Southeast Asian economies are particularly vulnerable to a global slowdown given their direct and indirect trade links with Europe and the United States. Not only will direct exports to Europe take a hit, but component and commodity exports immediately headed to China will also suffer if Chinese exports to the advanced economies are affected, as they almost certainly will be. And a slowing global economy will mean lower commodity prices, leading to still lower export revenues for Southeast Asia.
Indeed, most Southeast Asian economies are already showing signs of slowing export and GDP growth in the first quarter of 2012. Export earnings are not increasing at the same pace and the stimulus packages introduced in 2009 and 2010 have now run their course. Thailand and the Philippines are the notable exceptions to this as Thailand is still recovering from the devastating floods of late 2011 and the Philippines continues to be buoyed by strong remittance inflows.
Greece’s exit from the eurozone will not only lead to a further deterioration in export and GDP growth for Southeast Asia, it will also have repercussions for financial flows.
In fact, Southeast Asia should expect a replay of late 2008 and early 2009. This will include an initial withdrawal of liquidity as banks in advanced countries seek to deleverage, recapitalize, and reduce lending, followed by significant injections of liquidity by the ECB and the U.S. Federal Reserve that will push capital flows into emerging markets, including Southeast Asian economies, in search of high returns a few quarters later.
Most Southeast Asian economies are fairly resilient to volatility in capital flows. Thanks to prudent policies over the past decade, the majority of banks in the region are well capitalized, the corporate sector holds relatively low debts, and the debt burden of sovereigns remains within prudent limits. But there is little doubt that volatile capital flows will complicate macroeconomic management, lead to pressures on exchange rates, interest rates, and inflation rates, and require deft handling by central banks to ensure that stability is maintained.
Financial flows are likely to be most volatile in Indonesia, because a relatively large proportion of the country’s traded stocks and short-term domestic debt instruments are owned by non-residents who can sell their holdings at the slightest sign of trouble. As a result, the exchange rate for the rupiah tends to be the most unstable in Southeast Asia, and domestic liquidity management during crises is always a challenge. Indeed, the rupiah has predictably weakened in the last few weeks and the government now needs to consider an appropriate monetary policy response.
Although the Southeast Asian economies are in reasonably good shape heading into the impending European crisis, they are not as well positioned today as they were three years ago when the global financial crisis first erupted. Their sovereign debt burdens are heavier, budget deficits larger, inflation rates higher, and growth rates slower. What is more, this time around China is less likely to respond with the same oversized economic stimulus package that it used in 2009 amid a global slowdown.
So what should the Southeast Asian economies do in the short term? The answer, interestingly enough, is the same irrespective of which scenario ultimately unfolds in Europe. Southeast Asia must build shock absorbers while it increases international competitiveness, and put contingency mechanisms in place that can be drawn upon if, and when, the crisis breaks.
Economies can absorb the shock of a sudden slowdown with countercyclical fiscal policies, but freedom to do so depends on existing sovereign debt burdens and fiscal deficits. Indonesia, for example, has the most room among Southeast Asian economies to run countercyclical fiscal policies thanks to its low sovereign debt burden, small primary deficit, and large external reserves.
Malaysia, on the other hand, has arguably the least room to maneuver. Indeed, while other Southeast Asian economies were reigning in their fiscal spending this year, Malaysia introduced an expansionary budget with populist measures in anticipation of an upcoming general election. As a result, from a macroeconomic perspective, Malaysia is somewhat more vulnerable than its neighbors to a sudden deterioration in Europe.
Much can also be done to improve competitiveness through an adjustment in the composition of government spending. With this in mind, Malaysia and Indonesia should reduce their fuel subsidies and apply the savings either toward deficit reduction or infrastructure and education development. In a similar vein, Thailand needs to stem the hemorrhaging of public funds through its new rice policy and apply the savings toward higher priority programs to boost international competitiveness.
The economies of Southeast Asia should also be testing the efficacy of contingency mechanisms in the event of a European debacle. Most important among these is the multilateral Chiang Mai Initiative that would activate swap arrangements among the Association of Southeast Asian Nations and China, Japan, and South Korea. This mechanism has never been used—not even when South Korea was in dire straits in late 2008—so it remains an open question whether it will respond as expected in the heat of a crisis.
Southeast Asian economies also need to put in place other bilateral swap arrangements, such as with the U.S. Federal Reserve. This is a mechanism that proved effective during the Asian financial crisis and during the global financial crisis. And yes, Southeast Asia should put aside its aversion to the International Monetary Fund and employ precautionary credit lines that can act as a final insurance against liquidity shortages if all other arrangements fail.
Southeast Asian economies can see the storm approaching even if its severity is difficult to predict. There is no excuse for inaction. Now is the time to check the ballast, clear the decks, and make ready for the heavy weather that lies ahead. Even if the storm doesn’t materialize, a trimmer economy will be more competitive. But if the storm does strike, the economy will be better positioned to withstand the shocks that are likely to come its way.
The Carnegie Asia Program in Beijing and Washington provides clear and precise analysis to policy makers on the complex economic, security, and political developments in the Asia-Pacific region.
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