The global investment community continues to deliberate about the impact of quantitative easing stemming from Europe, and more recently from Japan, as a means to revive domestic demand. Meanwhile, several Asian economies are embarking on a different kind of stimulus, aimed at boosting long-term productivity and investment spending, through structural changes to the underlying economies. Last month’s Asia Insight focused on “Asia’s Deepening Capital Markets,” in which we highlighted that growth is being supported by financial market reforms designed to both deepen the markets and broaden its participant base. This month’s Asia Insight provides some context around wider economic reforms, how the imperatives may differ from the past and how Matthews Asia seeks to participate in these changes through our portfolios.
Countries in Asia are no strangers to reforms and many of us who have watched these markets for decades recall the solid recovery posted by these economies in the aftermath of the 1997 Asian Financial Crisis (AFC). In hindsight, the AFC proved to be short, albeit deep, because the regulators were forced to adopt tough measures, mainly prescribed by the International Monetary Fund (IMF). The intention was to rectify policy missteps and to clean up major faults in the financial system; and the results were very positive over the long-term. Two important factors helped Asia recover quickly. First, there had already been significant productivity gains within the agricultural and manufacturing sectors, leading into the AFC—particularly in North Asia. Second, the IMF's rescue led to relatively groundbreaking reforms prompted by a financial shock.
This kind of radical change rarely occurs in the absence of a crisis. On the back of these reforms, Asia posted multiple years of impressive growth. More recently, progress has stemmed from better terms of trade or increasing leverage. But these factors are not sustainable, and slowing growth is strengthening the resolve of today’s policymakers to embark on much-needed reforms. But what distinguishes Asia from the West is that reforms are targeting the economy at its foundation—at the corporate and consumer level. This is contradictory to common practices that use fiscal spending or monetary policy to affect temporary improvements in top-line GDP growth. What we are seeing today is an effort to mobilize capital in parts of South Asia, and at the same time, an effort to better allocate capital and build an innovation-led economy in parts of North Asia. Reforms implemented during the post-AFC era were prompted from outside of Asia, while current reforms are being driven by local governments.
Capital Accumulation: Still an Important Step for Parts of Asia
In the book, “The Mystery of Capital: Why Capitalism Triumphs in the West and Fails Everywhere Else,” Peruvian economist Hernando de Soto Polar describes capital as "that part of a country's assets that initiates surplus production and increases productivity." Capital is not to be confused with money, which is one of the many forms in which it travels. Instead, capital is an asset that generates money when invested.
In the initial stages of economic development in North Asia, countries gained ground by using all available labor in agriculture to build economies of scale and push output to the highest possible level. As yields increased, economic surpluses also increased, leading to capital accumulation. In the next stage, the surpluses in human capital and other resources were directed toward manufacturing. In this phase, a small number of entrepreneurs and technicians made an outsized impact on economic development by focusing on innovative-mechanized production by employing large cohorts of unskilled and semi-skilled labor.
In North Asia, agricultural industrialization led to productivity gains and allowed surplus labor to be absorbed into other parts of the economy. But in many other parts of Asia, the agricultural sector’s share of overall employment is still where Japan was in the 1950s and 1960s—where agriculture still accounts for 30% to 50% of all employment—including China, Indonesia, the Philippines, Thailand and Vietnam.
South Korea and Taiwan, and more recently China, have demonstrated a ruthless and uncompromising focus on competition and productivity, and this has been crucial to developing robust manufacturing. Asia’s policy initiatives toward accumulating and mobilizing capital have included a host of measures to support economic development including deregulation in labor to provide more flexible cost structures; deregulation in ownership structures that can provide a greater role for the private sector; deregulation in natural resources; as well as liberalization of the financial markets.
The pace and sequencing of these initiatives can be critical; when changes occur too slowly, there is a risk of weak job creation and technological obsolescence, as there has been in India and Indonesia. When changes happen too quickly, countries run the risk of experiencing a speculative frenzy that can be counter-productive to long-term development.
“Make in India”: A Push for Manufacturing
India's challenges in the manufacturing sector illustrate the complexities of implementation in real (versus theoretical) political and economic systems. Ownership barriers, rigid labor laws, complex land acquisition rules and weak infrastructure have conspired to stunt manufacturing growth. But whenever these barriers have been lifted, the response from the entrepreneurial community has been encouraging. The automobile industry, liberalized in 1991, was among the first segments of manufacturing to open up to private sector participation. Since then, output has grown 15-fold and, India is increasingly considered a destination for manufacturing and an export base for auto parts and automotive vehicles.
India's newly elected Prime Minister Narendra Modi has made manufacturing a key agenda point. Specifically, his administration plans on building a globally competitive industrial sector that can steadily increase market share in exports. To support this, authorities have progressively lowered ownership barriers to foreign firms within manufacturing. Most recently, in the defense and railways sectors, it has increased the level of ownership permitted by foreigners to 49% and 100%, respectively.
Labor laws in India are more vexing because they are legislated concurrently by both the central and state governments. The Northwestern state of Rajasthan has taken the lead in labor deregulation by reducing government-approval restrictions on hiring/firing workers. Other proposed measures aim to provide greater flexibility in running factories, and in complying with existing labor laws. If the efforts in Rajasthan lead to greater job creation, it will be difficult for other states not to follow suit.
Formal job creation is surely a goal of Mr. Modi’s and the kinds of changes sought by the state of Rajasthan are certain to challenge some vested interests. But the recent elections have given a broad mandate of growth and governance over welfare entitlements to the incoming government.
Diminishing Subsidies: Is this a Sign of Deepening Resolve?
In Indonesia, one of the first steps taken by the incoming administration of President Joko Widodo was to reduce energy subsidies in order to allow gasoline prices to move closer to market-determined rates. Subsidies often have unexpected consequences and lead to crowding out. In this case, the fiscal costs associated with energy subsidies had been twice as high as expenditures on infrastructure and three times as high as spending on health care. They had also been harmful because they disproportionately benefited the top 20% of Indonesians, adding to already-high tensions surrounding class and wealth in the country.
India and Malaysia have taken similar steps to cut energy subsidies, which now account for 2.5% and 1.7% of GDP, respectively. If these policies continue to hold in an environment of rising oil prices, it will be a sure sign of leaderships’ determination to push ahead with structural reforms that may sacrifice the short term for the sake of the long term.
The new governments in India and Indonesia are working to reduce dependence on individuals, and to strengthen the role of institutions by improving public service performance and coordination across ministries. Technological systems are also helping to improve work flow and reduce corruption through increased transparency. As an example, India’s public services administration’s transition to an e-governance platform has been credited with helping to launch an astonishing 33% of previously stalled investment projects, amounting to as much as 5% of GDP. These types of efficiency improvements are occurring behind the scenes, and are less controversial than bolder efforts to reduce subsidies and deregulate industries.
Capital Allocation: A Growing Priority
The macroeconomic policy settings in the capital allocation phase of development are often characterized by an environment of low interest rates, strict capital controls and low exchange rates. In recent times, China has been exemplary in its use of policies to promote capital accumulation. China has also been successful in directing savings and surpluses toward accelerated technological learning.
Some have argued that the hectic pace of infrastructure creation in China is more indicative of capital misallocation. While we acknowledge that the rapid pace has its risks, it is also entirely possible that the massive infrastructure spend has been a key enabler of the Internet/e-commerce revolution now engulfing the country. Rapid capital mobilization may be a normal step in economic development, but perhaps the government realizes that the impetus has to shift toward better allocation of capital. As such, there has been a resolute commitment toward freeing-up interest rates, liberalizing exchange rates and slowly lifting the controls on the capital account.
China’s authorities are embracing financial sector reform, but on their own terms. The steps toward internationalization of the renminbi (RMB) are at the leading edge of those efforts. At the national level, this gives China additional trade-settlement options and reduces dependence on the U.S. dollar; but that is only a part of the multi-year story. By using the RMB as a financing mechanism in international trade, Chinese exporters may gain share in higher value-added items, such as telecommunication routing equipment, capital goods and personal computers, et al.
For financial reform to be successful, it needs to promote competition from both private and foreign players. One of the key thrusts of Chinese authorities has been to provide private firms with access to a broader range of sectors. In support of this, there has been an attempt to improve access to funding for small- and medium-sized enterprises (SMEs). Many of these companies in China, and other parts of Asia, still have to rely on internally generated funds since capital availability remains constrained.
Most notable has been a general effort to deregulate parts of the services economy previously controlled by state-owned enterprises. One clear example is health care, where increasing competition is gearing up to meet the changing needs of average consumers. One perverse outcome of accelerating prosperity has been increased incidents of lifestyle diseases, such as diabetes and heart disease. In order to provide higher-quality health care, the government has allowed private companies to enter the hospital sector.
In general, building a higher-quality services economy will test the mettle of authorities. Steps to level the playing field, between conglomerates and SMEs, can help. South Korean policymakers have picked up the gauntlet in this regard. Recent actions to encourage dividends, improve the use of cash and to refine ownership structures within conglomerates are steps in that direction. The development of the services sector can lead to greater balance and more inclusive growth in Asian economies, which is another step in the direction toward increasingly efficient economic structures.
Sentiment can be Unpredictable over the Short Term
We have not seen a near-synchronous effort toward structural changes within Asian economies in quite a while. China has taken the lead and has been the most rapid and most consistent in its execution. By withdrawing from its role as director of a planned economy, the Chinese government is embracing a regulatory role in a more market-oriented economy. The government’s near single-mindedness comes with the realization that while the current reforms can be painful, the cost of missing out on greater global stature that will come from further growth will be even more painful. Yet the investment community seems to shrug off these developments in China, while the mere possibility of change in India is enough to send spasms of excitement across the capital markets.
Arguably, the task at hand in India is different. Like many parts of South Asia, it focuses on overall growth prospects from a better supply-side response to freeing-up factors like land and labor. China, much like other parts of Asia, has to focus on a more rational organization of talent and push for greater quality of growth. The success in either of these endeavors is not guaranteed. And as history has shown, the path to future development has been traversed in multiple ways by Asian economies.
How do we Capture Opportunities in our Portfolios?
One thing is increasingly clear—in the stages of economic development across Asia, greater diversity means there are greater numbers of businesses from which to choose. One way to participate in this dynamic is to stay nimble within the confines of a disciplined investment process. The other important goal is to remain focused on the long-term evolution of these economies, rather than getting drawn into short-term predictions. We analyze the financial information of companies, but it is sometimes useful to use a long-range lens to understand the intentions behind some of the initiatives affecting companies in Asia. Of all the above reform initiatives, two are crucial—to improve the quality of life for the household, and to boost economic productivity. If we can identify those businesses that are doing so, we believe this will be a powerful force for our shareholders.
Sharat Shroff, CFA
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