Yellen risks exposing old vulnerabilities in emerging Asia

[HONG KONG] The populist leaders of India, Indonesia and the Philippines won office with promises of massive spending to upgrade their nation's roads, railways and ports. Doing so, the thinking goes, would supercharge economic growth and emulate China's success.

India's Prime Minister Narendra Modi intends to spend a record US$60 billion on infrastructure this fiscal year. Philippine President Rodrigo Duterte set an infrastructure spending goal of 7 per cent of gross domestic product, while Indonesian leader Joko Widodo has added 7,000 kilometres of new roads and four new airports and last week vowed more.

In a global landscape starved of yield, foreign investment has poured in to help fund the ambitions, lured by young populations and some of the world's fastest rates of economic growth. As a sign of their resilience, the trio have even shaken off interest rate hikes by the Federal Reserve, something that has tripped up many a developing nation in the past.

But now the Fed is set to embark into uncharted territory by shrinking its US$4.5 trillion balance sheet and old vulnerabilities are starting to resurface. The problem the three nations face is that, unlike China, they lack the industrial, export and domestic savings bases needed to fund their plans.

To dig foundations and pour cement, heavy equipment must be imported, weakening current accounts just as faster growth is also swelling imports. And the cost of the projects is pressuring budget deficits, leaving the governments heavily reliant on foreign cash.

"Stepping up infrastructure investments in these large Asian emerging markets will likely widen the current account deficit and increase external debt," said Chua Hak Bin, a Singapore-based senior economist with Maybank Kim Eng Research.

"Depending on the form of external financing, some emerging markets could become more sensitive to volatile foreign capital flows and currency mismatch risks."

Policy Risk

There are already signs of that strain in foreign-exchange markets. The Philippine peso is Asia's worst performer against a lacklustre greenback this year, down more than 3 per cent. Indonesia's rupiah is the third-worst, while India's rupee is in the middle of the Asian pack.

With the world's top central bankers gathering at the Jackson Hole mountain retreat in Wyoming this week, any comments signaling a faster-than-anticipated normalisation in developed-world policies could sharpen investors' minds on the potential fallout.

When compared to other major emerging markets like Brazil, South Africa, Turkey and Russia, the economies of India, Indonesia and the Philippines look in relatively good shape, said Rob Subbaraman, chief economist for Asia ex-Japan at Nomura Holdings Inc.

"Policymakers are aware of the risks of capital outflows, which helps explain their continued build-up of foreign exchange reserves," he said. And not all deficits are bad - if the financing is for productive purposes, that should lure more investment and boost growth, he said.

The Asian Development Bank estimates emerging economies in the region need to invest as much as US$26 trillion through 2030 to build transport networks, boost power supplies and upgrade water and sanitation facilities.

And overall debt levels remain low by global standards. So for now at least, foreign investors continue to underpin expectations for growth rates above 5 per cent.

Much will hinge on what happens with the US dollar. If it remains weak, there may be no cause for concern, said Alicia Garcia Herrero, Hong Kong-based chief economist at Natixis. Even if the greenback strengthens, the three have room to increase interest rates to keep foreign capital from leaving, she said.

Lingering problems with its banking system and a stronger currency make India the most exposed to global tightening among the three, she said, followed by Indonesia.

A weaker peso has already helped the Philippines adjust. While the risk of serious disruption appears low, "balance sheet reduction is new and it is hard to foresee the consequences," she said.

'Uncertain' Outlook

India's general government debt level is "significantly" higher compared with similarly rated countries, Moody's Investor Service has warned. While the federal government aims to narrow Asia's widest budget gap to 3.2 per cent of GDP in the current fiscal year, from 3.5 per cent, its top economic adviser said the outlook is "uncertain" given risks from slower growth and policy uncertainty.

Then there's the risk of a blowout in India's current account deficit, which the International Monetary Fund projects to be at its widest since 2013, when the Fed first signaled tightening after years of unprecedented stimulus. Defaults on bonds and syndicated loans by Indian companies are at a record of almost US$2 billion so far this year, compared with US$494 million for all of 2016, according to data compiled by Bloomberg.

"We expect the balance sheet reduction program of the Fed to potentially impact the flow dynamic in EM countries, to which India may not remain immune," said Kaushik Das, Mumbai-based chief economist at Deutsche Bank AG.

In Jakarta, President Widodo, known as Jokowi, has made infrastructure a foundation of his first term in office, vowing a year ago to develop "every inch" of an archipelago that would stretch almost from New York to London.

That comes at a cost: Indonesia's government projects the 2017 budget deficit will widen to 2.9 per cent of GDP, just short of a legal limit of 3 per cent.

Having increased government spending on infrastructure to more than 60 per cent of the annual budget since taking office in 2014, Jokowi's chances of re-election in 2019 are tied to his nation-building agenda. Problem is, the current account deficit has widened too, hitting US$5 billion or 1.96 per cent of GDP in the second quarter of this year.

Indonesia's economy is projected to grow next year by 5.4 per cent - which would be the fastest pace since 2013. But that remains well short of the 7 per cent target Jokowi set when he came to power three years ago.

"I think it is difficult to expect that Indonesia will achieve the relatively high growth this year, next year and in the next couple of years," former finance minister Chatib Basri said in an interview in Jakarta.

He said Indonesia must embrace "bold reform" if it wants more foreign investment and higher growth, but that doing so is extremely difficult when nationalist sentiments tend to dominate elections. He points out that while the next presidential election is not until 2019, the campaigning will begin much sooner with candidates finalised in September next year.

Similar pressures are being felt in the Philippines, where the central bank expects the nation's first current account deficit in 15 years in 2017. Mr Duterte's plan to raise taxes to help fund the infrastructure programme faces significant delays as lawmakers worry about a backlash from voters. Slower growth and a credit-rating downgrade are risks if lawmakers water down the government's tax-reform plan, the finance department has warned.

"The Philippines is quite vulnerable to Fed balance-sheet consolidation as its current account position is deteriorating, said Sanjay Mathur, chief economist for Asean and India at Australia & New Zealand Banking Group Ltd in Singapore.

The risks for the three nations haven't gone unnoticed by the International Monetary Fund, which warned in May that tighter financial conditions could trigger volatility in Asia's capital flows.

Whereas China's steady stream of export earnings and huge pile of domestic savings meant it could and still can fund its infrastructure plans, the underlying fragility for India, Indonesia and the Philippines leaves them more exposed should global markets seize.

"We are weary of the argument that large current account deficits are justifiable so long as the deficit is driven by infrastructure investments," said Maybank's Mr Chua.

BLOOMBERG