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Geopolitical turbulence ahead in Asia as local powers compete for influence

We expect Asia’s political scene to be dominated over the forecast period (2018-22) by China’s president, Xi Jinping, Japan’s prime minister, Shinzo Abe, and India’s prime minister, Narendra Modi. The three men are the most dominant leaders of their countries in decades and will retain power throughout the next five years. We expect Mr Abe to secure a third term as president of the Liberal Democratic Party (LDP) following its strong performance in the election for the House of Representatives (the lower house of parliament) in October 2017. This will enable him to lead the government until the next lower house election in 2021. Mr Xi’s position was further strengthened in the 19th national congress of the ruling Chinese Communist Party (CCP), in October 2017. At this point he has no obvious successor.

The 19th congress also marked a watershed in terms of China’s overt declaration of its pursuit of great-power status. China’s new global ambition will be enabled to some degree by US foreign policy changes under Mr Trump’s administration. The US president’s “America First” foreign policy has signalled a partial abdication of US leadership of global affairs, which will embolden China in exerting its political influence more forcefully in the Asia region. However, concerns about how China intends to deploy its expanding hard-power capabilities in support of its territorial and maritime claims in the South China Sea and East China Sea will encourage other countries to hedge against it, despite its economic heft. At the recent Asia Pacific Economic Co-operation meeting, in November 2017, the informal “Quad” alliance of Australia, India, Japan and the US met for the first time since 2007, seemingly out of concern over China’s regional ambitions. China’s use of soft power has also generated controversy. A year-long spat with South Korea showed China’s willingness to deploy economic levers aggressively, and an apparent campaign to build influence in Australia’s political, media and academic circles has led to a backlash. The Australian prime minister, Malcolm Turnbull, placed the recent introduction of legislation to counter foreign interference in domestic politics in the context of expanded Chinese activities.

 

Unpredictability in US foreign policy is a major threat

The Trump administration’s approach to North Korea has been aggressive and unco-ordinated. This has unnerved the country’s local allies and is likely to lead to rising militarisation in the region. Countries directly threatened by North Korea’s rising missile and nuclear capabilities, such as Japan and South Korea, will increase their defensive capabilities. Although we continue to assign a low probability to an open military conflict, we do not expect North Korea to give up its nuclear pursuits. This means that tensions are likely to flare up again, despite the South’s efforts to re-engage with the rogue regime. The diplomatic talks between the two Koreas that took place in January do not change this view.

The diplomatic tensions likely to result from the unpredictability of US foreign policy in Asia pose the biggest threat to economic growth and stability in Asia. However, growing US protectionism is an additional risk. The threat of tit-for-tat measures on trade has dogged the US-China relationship since the beginning of the Trump administration. Although Mr Trump was largely restrained in 2017 by the hope of enlisting China’s help on North Korea, we do not expect this to continue in 2018, as illustrated by the hardening US stance adopted in late 2017. In November 2017 the US suspended its main bilateral economic dialogue with China, launched a “self-initiated” investigation into Chinese aluminium sheet alloys (the first such investigation against any country in 25 years) and formally declared its opposition to China gaining market economy status under the World Trade Organisation (WTO). In December the US administration also linked unfair Chinese trade practices to national security. China is unlikely to sit idly by, however, and maintains an important arsenal of reciprocal and proportionate actions, which it would probably use against US companies, such as delaying required licences, increasing routine inspections and tightening market access based on national security. The empowerment of China hawks in the US administration will lead to some sort of hardline action in 2018. Unless cautiously navigated, this could spell trouble not just for the US and China but could also have global repercussions by disrupting trans-Pacific supply chains.

 

The region will nevertheless experience steady growth in 2018-22

Despite the uncertainty generated by US foreign policy, our core forecast is that the external economic and financial environment will remain supportive of growth in Asia. In 2017 Asian trade figures rose sharply, buoyed by improving global demand. We now expect these conditions to be broadly maintained throughout 2018-19. This is a departure from our previously more pessimistic outlook, and is driven by a change in our expectations for near-term economic expansion in China. We had expected the Chinese authorities to pursue a concerted, aggressive deleveraging in 2018, causing a significant economic slowdown. Amid signs that they will instead prioritise continued growth, we have revised up our growth outlook for this year, from 5.8% to 6.4%. As a result, we expect real GDP growth in Asia and Australasia to achieve an average of 4.2% a year in 2018-22, compared with 4.3% in 2013-17. Solid growth rates in China will continue to benefit economies closely involved in the country’s global supply chain, such as Australia, which supplies China with raw commodities, and South Korea, which provides it with industrial inputs.

Solid growth in 2018-19 will allow countries to absorb higher interest rates. This, combined with pressure from the monetary tightening cycle accelerating in the US, will lead some local central banks to embark on rising interest rates. This has already been the case in South Korea and could take place in the first half of 2018 in Singapore and Taiwan. In countries with floating exchange rates, moves to tighten monetary policy will result in an appreciation in their exchange rates. Energy prices will continue to rise, but will remain low compared with the peak of 2014, which will benefit at the margin a number of Asian economies such as the Philippines and Indonesia, which are net oil importers.

 

Tackling high debt levels takes the back seat in China’s economic policy

Our previous forecast that China’s economic growth would slow sharply in 2018 was informed by the view that the government would take the opportunity to tackle decisively the debt overhang that poses the main risk to China’s long-term economic stability. Emboldened by a reshuffle of the Chinese Communist Party (CCP) at its 19th national congress in October 2017, we expected the president, Xi Jinping, to back policies to reduce credit supply and to harden budget constraints on profligate state-owned enterprises and local governments. He would take such an approach, we argued, partly because of his long-term political ambitions: better to tackle the issue earlier, rather than risk financial instability in the latter years of his presidency.

The main reason why we now consider this unlikely concerns the annual Central Economic Work Conference (CEWC) held in December 2017. The meeting sets the tone and priorities for economic policy in the coming 12 months. The statement released after the meeting did not refer explicitly to the deleveraging campaign, which featured prominently in the CEWCs held in 2016 and 2015 under the banner of supply-side structural reform (SSSR). The omission appears to have been deliberate. In a similar vein, a meeting of the CCP politburo prior to the CEWC discussed not deleveraging, but “controlling the leverage ratio”, a formulation that gives room for the ratio to rise further-albeit not at the same rapid rate seen in the past. The economy-wide debt ratio, as measured by the Bank for International Settlements, stabilised at around 255% in 2017, helped by double-digit nominal GDP growth.

 

Multiple “tough battles” will be pursued simultaneously in 2018

The CEWC statement gave prominence to the need to reduce financial risk, but it also identified two other “tough battles” for policy in 2018 (eliminating rural poverty and reducing pollution). This means that the drive to enhance regulation of opaque parts of the financial sector is best understood as an effort distinct from (albeit related to) the deleveraging programme, which is aimed at reducing the large corporate debt burden via initiatives such as debt-for-equity swaps.

 

Mounting risks for the “moderately prosperous society” beyond 2020

We view recent developments as indicating that the authorities remain committed to the “moderately prosperous society” target of doubling real GDP from the 2010 level by 2020, which means delivering average growth of 6.3% a year in 2018-20. Indeed, there have been leaks to the media from the CEWC that the government will retain an annual real GDP growth target for 2018, fixing it at around 6.5%, the same level as in 2017.

However, we believe that from 2021 there will be more political space to move to a slower growth rate. Mr Xi has decided not to define his goal of delivering “basic socialist modernisation” by 2035 in terms of GDP growth. We take this as a signal that the government intends to move away from numerical GDP targeting over the long term. Reflecting this, we expect growth to fall below 6% in 2020-21. Nonetheless, the decision not to pursue aggressive deleveraging in the near term increases the risks attached to the long-term outlook for economic growth. The risk of an uncontrolled slowdown in economic activity will increase dangerously if tough measures to curb debt issuance continue to be delayed after 2020.

 

Shinzo Abe’s position will be strong after his election gamble paid off

Following the renewed landslide secured by the ruling LDP and its coalition partner, Komeito, in the October 2017 general election, Japan will enjoy continued political stability in 2018-22. The election victory will enable Mr Abe to secure a third term as president of the LDP in a party leadership poll scheduled for September 2018. Assuming that approval ratings for the government remain high, we expect Mr Abe to lead the government until the next lower house election in 2021. However, we believe that the LDP will be reluctant to confer an unprecedented fourth term on Mr Abe, paving the way for a leadership contest before the 2021 election. A weak opposition will struggle to exert influence over the administration’s legislative programme. Mr Abe will continue to pursue his eponymous economic agenda, Abenomics, focused on reflating the economy. Mr Abe will also push ahead with his timetable for constitutional change. He will encourage debate on the issue in 2018 with a view to holding a referendum as early as mid-2019, which would leave sufficient time to make the necessary legislative amendments by 2020. However, significant obstacles remain, not least the differences of opinion with-in the ruling coalition and among its allies in the upper house. Gaining public support for the move in a referendum will be the toughest part of this effort.

 

Modest growth prospects for Japan with 1.1% a year in 2018-22

Abenomics has contributed to a mild recovery that has now spanned six years. By the end of 2022 we expect the Japanese economy to complete its longest span of expansion since the 1980s. Even so, growth is likely to slow, averaging just 1.1% a year in 2018-22, compared with an estimated 1.8% in 2017. One reason for this is the constraints on Japan’s ultra-loose monetary policy. The QE strategy adopted by the Bank of Japan (BOJ, the central bank) will face problems in the next few years, as the BOJ now owns so much of the government’s debt that this is reducing liquidity and distorting the market. We believe that, as a result, the BOJ will make preparations to “normalise” its policy settings by end-2018, when we expect it to announce plans to taper its asset purchases slowly from 2019.

With the first of the three “arrows” of Abenomics, loose monetary policy, losing its edge, the authorities will have to place greater reliance on the second arrow, fiscal stimulus measures, to support the economy. However, this policy tool is also facing constraints, ranging from unfavourable demographics and rising welfare costs to ambitious self-imposed fiscal targets. The government will therefore face greater pressure to make headway with the third arrow, structural reforms. The effects of these will, however, take time to feed through to the wider economy. Japan’s shrinking workforce is a more fundamental barrier to growth and investment. Abenomics has delivered some benefits in terms of boosting output per head, and female labour participation has increased. However, achieving the government’s growth target in the medium to long term would require an overhaul of social policies such as immigration, which neither the government nor the electorate is willing to consider. As a consequence, we do not expect the government to meet its ambitious target of expanding the economy to ¥600trn (US$5.4trn) by fiscal year 2020/21 (April-March).

 

Investment in India will pick up now that bad debts are being addressed

India will record Asia’s fastest growth rates over 2018-22. The economic outlook in India is broadly positive, as a high savings rate, rapid growth in the workforce, urbanisation, an expanding middle class and a further shift away from low-productivity agriculture towards manufacturing and services will support rapid economic growth. We forecast that India’s economy will grow by an annual average of 7.8% in fiscal years 2018/19-2022/23 (April-March), well above China’s rate of expansion. Crucially, one of the key conditions for our optimistic forecast was met when the government announced a major bank recapitalisation plan, worth over US$32bn, in October 2017. As bank and corporate balance sheets improve, this will provide the backdrop for stronger gross fixed investment growth and put economic expansion on a more sustainable footing.

On the production side, services will continue to account for the bulk of growth, but the manufacturing sector will benefit from an improving business environment. The share of agricultural production in GDP will shrink, but the rural economy will remain a source of volatility owing to the lack of sufficient contingencies in place to combat erratic weather.

The political environment will also be conducive to steady economic expansion. The National Democratic Alliance coalition, dominated by Mr Modi’s centre-right Bharatiya Janata Party (BJP), is well placed to win a second five-year term in office at the next parliamentary election, in 2019, as well as a majority in the upper house in that year. Both of these developments would give the BJP a much freer hand in advancing its economic agenda, but could also see it push more controversial cultural and social aspects of its so-called Hindutva (Hindu-nationalist) platform.

 

South-east Asian economic growth rates stay on track

Growth will also remain on track in the ASEAN member states, with an average annual expansion across the region of 4.8% in 2018-22, the same pace as in 2013-17. Vietnam, Cambodia and Myanmar, in particular, will continue to record growth rates of above 6%, owing to relatively low wage costs, advantageous geographical locations and comparatively stable governments. In Cambodia, the election scheduled for July 2018 is unlikely to be held in a free and fair environment, and the prime minister, Hun Sen, and the Cambodian People’s Party (CPP) will remain in power.

 

New political momentum for growth and distributive policies in South Korea

Support for the liberal South Korean president, Moon Jae-in, remains strong since his election in May 2017. Despite lacking a strong majority in the legislature, the ruling party, Minjoo, will manage to deliver on part of the president’s ambitious policy agenda ahead of the next legislative election, in 2020. These initiatives include job creation, corporate governance reform and re-engagement with North Korea. However, Moon Jae-in’s focus on fairer growth and redistributive policies largely neglects the required economic shift from an export-oriented economy towards an innovation- and creativity-driven model. With our improved global economic outlook in 2018-19, the performance of the South Korean economy will therefore remain steady in the first part of the forecast period. However, achieving policy objectives will become more challenging from 2020 amid a technical recession in the US and a faster deceleration in Chinese economic growth rates. Similarly, Moon Jae-in’s re-engagement effort with North Korea is likely to have limited results, as the North is set to complete its nuclear and missile programme within one or two years.

 

Asia and Australasia growth and inflation
(% change)
  2013 2014 2015 2016 2017 2018 2019 2020 2021 2022
Real GDP growth 4.6 4.1 4.2 4.1 4.5 4.3 4.4 4.0 4.2 4.2
 ASEAN 5.0 4.5 4.5 4.5 5.0 4.7 4.8 4.5 4.9 5.0
 China 7.8 7.3 6.9 6.7 6.8 6.4 6.3 6.2 5.5 5.2
 India 6.4 7.5 7.9 7.1 6.7 7.6 7.9 7.5 8.0 8.2
 Japan 2.0 0.3 1.1 1.0 1.8 1.5 1.6 0.4 1.1 1.1
Inflation 3.7 3.4 2.2 2.1 2.1 2.8 3.0 2.8 2.6 2.8
 ASEAN 4.4 4.3 3.1 2.3 3.0 3.3 3.5 2.9 3.3 3.6
 China 2.6 2.1 1.5 2.1 1.6 2.5 3.2 2.8 2.3 2.5
 India 9.9 6.6 4.9 4.9 3.8 4.7 4.8 4.2 4.3 4.4
 Japan 0.3 2.8 0.8 -0.1 0.5 1.1 1.4 1.6 0.9 1.1
Source: The Economist Intelligence Unit.

 

 

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