March 2012

Asia Pacific Economic Outlook

In thIs Issue:

AustraliaChinaIndiaIndonesiaThailand

Asia Pacific Economic Outlook — March 2012 2

The looming threat of a Chinese slowdown is weighing on Australia’s economic outlook. Australia’s export sector is heavily dependent on Chinese demand, which is showing signs of cooling off. The mining industry, Australia’s main breadwinner, is expected to be particularly affected by a slump in China’s housing market, which absorbs most of its exported resources. The quarter-over-quarter pace of expansion slowed down to just 0.4 percent during the December quarter, half of what was recorded during the previous quarter. Annual growth through 2011 was 2.3 percent.

Exports are not the only source of vulnerability in the Australian economy. Housing prices have been falling while unemployment has shown little improvement in recent months. While this has dampened domestic demand, the bigger risk lies in the banking sector’s exposure to the housing sector. Much of the last decade saw a consistent increase in home prices supported by loose credit conditions and government subsidies. Even during the 2008 crisis, prices stumbled slightly but regained momentum on the back of the government’s generous First Home Owner Boost. However, since last year, home

prices have been cooling down, falling as much as 4.8 percent year-over-year at the end of February 2012.Going forward, a steep fall in home prices could potentially shake up the banking sector; four of the country’s largest banks hold almost 80 percent of domestic mortgages on their books. The banking sector’s reliance on external financing for short-term borrowing poses an additional risk. Thus, potential disruptions in global markets could test the domestic banking sector’s ability to withstand shocks. Banks are already facing the pinch of tighter credit conditions abroad, which has been weighing on their profit margins. In February, the country’s four main banks responded by raising mortgage rates by 6–10 basis points in order to cope with higher costs of wholesale funding. This could exert further downward pressure on households’ ability to borrow.

Australian households remain highly indebted with loans equivalent to about 150 percent of their disposable income. Thus, tighter credit conditions and stagnancy in the job market have weighed on consumer spending. Retail sales were almost flat during the last few months of 2011 in spite of the holiday season. This is also reflected

Australia

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in the Westpac-Melbourne Institute Survey of consumer sentiment, which remained subdued and increased only marginally in January 2012.

Business sentiment was also below trend levels at the start of 2012, but it improved slightly as the central bank loosened policy rates last year. During the last quarter of 2011, manufacturing dwindled while construction activity contracted by 4.6 percent quarter-over-quarter, further highlighting weak business conditions. In order to stimulate demand, the central bank cut interest rates twice in a row during its monthly policy meetings in November and December. Despite the interest rate relaxation, inflation eased to 3.1 percent at the end of the December quarter, leaving room for additional loosening in case worsening global conditions compromise the Australian growth outlook.

During 2011–2012, the Australian economy will likely expand at a modest pace of 2.5–3.0 percent. The biggest downside risk to this estimate comes from a greater-than-expected slowdown in China as authorities try to tame inflation. Developments in the Eurozone and the United States will also likely influence foreign investment, commodity export prices, and overall demand from Australia’s trading partners. Even as the economy undergoes structural changes and copes with global headwinds, the mining sector has stayed its course; a $34 billion LNG project was recently approved and will likely boost investments and exports. Thus, Australia’s mining sector — its star performer — is expected to bolster the economy in the face of external headwinds.

During 2011–2012, the Australian economy will likely expand at a modest pace of 2.5–3.0 percent. The biggest downside risk to this estimate comes from a greater-than-expected slowdown in China as authorities try to tame inflation.

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Perhaps the best word to describe China’s economic situation is “gradual.” The economy is experiencing gradually slower growth; the government is gradually easing monetary policy; the property market bubble is gradually deflating; and the headwinds from Europe are gradually having a negative impact on China’s economic performance. Certainly, the Chinese authorities are comfortable with the term “gradual.” After all, one Chinese economist described the momentous changes in economic policy over the past thirty years as the “gradual revolution.” In a country whose history is strewn with words such as “disruptive,” “dramatic,” and “abrupt,” the word “gradual” is relatively reassuring.

On the other hand, things are gradually moving in the wrong direction. In January, for example, there was a decline in exports; a decline in the flow of foreign direct investment into China; a decline in manufacturing activity, according to a survey of purchasing managers conducted by the private sector (a government survey suggested that manufacturing activity expanded); and an increase in the rate of inflation. Aside from the inflation data, all of this was due largely to the slowing of economic activity outside of China, principally in Europe. In response to this slowing, China’s central bank has twice lowered the required reserve

ratio for commercial banks with the intention of boosting liquidity and credit market activity. Still, the combined drop in the reserve ratio of 100 basis points does not come close to offsetting the 600 basis point increase that took place over the past two years in order to fight inflation. Despite the small increase in inflation in January, the fight against inflation has largely been a success. That is why the central bank is now comfortable engaging in a gradual easing of monetary policy. More is expected.

The successful easing of monetary policy is evident by the gradual nature of the slowdown — often known as a “soft landing.” Indeed, the Conference Board’s index of leading economic indicators for China actually rose in January, suggesting that prospects in the months ahead are fairly good. Equity market participants evidently agree, having boosted equity prices in the past few months. Market participants are also confident that the trajectory of policy will be accommodative in the months ahead. Moreover, the president of the World Bank agrees; Bob Zoellick recently said that China is headed for a soft landing and indicated confidence that China would avoid a more onerous slowdown.

China

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Offsetting actionsFinally, government policymakers have signaled a willingness to take new action to offset the negative headwinds facing China. For example, the government is endeavoring to boost first-time home ownership. It is providing first-time buyers with incentives in the form of low interest rates and small down payments. This is at a time when the government continues its efforts to puncture the housing bubble and discourage speculative activity in the housing market.

In addition, recent government actions have been designed to boost consumer purchasing power and alleviate income inequality. In Beijing, Shenzhen, and Shanghai, the minimum wage has been substantially increased. In the last week of February, the minimum wage in Shanghai rose 13 percent. This follows an average 22 percent increase in the minimum wage in 2011 in 24 major cities. The idea is to boost consumer spending, enable factory workers to improve their standard of living, reduce income inequality, and reduce the risk of social unrest.

Putting things offIn a year when political power will be transferred, the government is keen to avoid major disruption to the economy. As such, it is likely that the government will utilize fiscal tools to boost economic activity in case the economy faces even more severe headwinds from abroad.

In addition, the government is showing a desire to avoid, or at least postpone, the turmoil that might come from the unwinding of imbalances. Specifically, local governments have accumulated about $1.7 trillion in debts that many analysts deem unsustainable. Moreover, a loss of revenue from weak land sales has exacerbated the problem of servicing this debt. Many analysts were recently concerned about the possibility of an imminent crisis if banks were forced to write down these debts. Instead, the government has instructed banks to roll over the local government debt, thereby postponing the day of reckoning.

As such, the threat of an imminent financial crisis is now gone, but the issue has not disappeared. The World Bank president, Bob Zoellick, recently predicted a soft landing and suggested that China will have to make a number of changes if it is to avoid problems stemming from long-simmering imbalances. He was in China to introduce a new World Bank report entitled “China 2030.” The report says that China’s current economic model is not sustainable and must be changed. It calls for more privatization, more reliance on market forces, the elimination of restrictions on internal migration, a boost to the social safety net, more transparent capital markets, and better fiscal controls for local governments, which are currently laden with debt. It will be interesting to see whether China’s new leaders will heed this call.

In a year when political power will be transferred, the government is keen to avoid major disruption to the economy.

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For the last several months, the Indian economy has been torn between controlling inflation and maintaining robust economic growth. In order to control skyrocketing inflation, the central bank chose to sacrifice growth in order to rein in inflation. A 20-month period of rising interest rates, which lasted until October 2011, has slowly but surely put the brakes on economic growth. And although inflation dropped to a 26-month low in January, it remains to be seen if inflation will stabilize at the current level, casting doubts on whether the central bank can really afford to reduce interest rates at this point in time. With industry increasingly worried about the high cost of capital and the manufacturing sector showing signs of stagnation, the central bank must quickly decide which of its limited options it must deploy in order to the economy keep chugging along.

Growth painsGDP growth in the third quarter of the current fiscal came in at a woeful 6.1 percent, marking a sharp drop from 7.7 percent in the first quarter and 6.9 percent growth in the second quarter. Manufacturing growth slipped to 0.4 percent compared to 7.2 percent and 2.7 percent in the first and second quarters, respectively. The seventh successive quarterly slowdown — and the slowest growth in three years — has not only triggered fears that the economy will slow down further in the last quarter of

the current fiscal (January–March 2012), but also that overall growth for the fiscal year could fall short of the downwardly revised target of about 7 percent.

Furthermore, growth in the next fiscal year could stagnate at a “new normal” of about 6 percent, and employment generation could be significantly dented unless significant efforts are made toward improving credit conditions and resurrecting investments in the coming months. The central bank, in a recent announcement, affirmed that Indian corporate houses were not optimistic about an improvement in their financial performance in the first quarter of calendar year 2012. It should, however, be noted that no significant slowdown in domestic demand and consumption is expected. Private consumption expenditure rose 6.2 percent in the fourth quarter of calendar year 2011 compared to a year ago. Demand, although robust, is unlikely to positively affect the books of companies given the current interest rate regime and rising input costs.

Growth data from India’s eight core infrastructure sectors paint a gloomy picture as well. The core sectors grew only half a percent in January, signaling that companies are hesitating to make investments. Output improved only in four infrastructure industries, indicating that a broad industrial slowdown could be in the cards. Industrial output

India

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growth dropped to 1.8 percent in December from 5.9 percent in November.

Exports grew at 10 percent in January, following a declining trend in the previous months. Although cumulative exports from April until January grew 23 percent, weak demand from Western markets and global political developments are likely to exert a drag on exports in 2012. On the other hand, rising imports are exerting a negative pressure on the trade deficit.

Few positives, policy challengesInflation, the barb that threatened to derail India’s growth for several months, has been on the decline over the last several weeks. Inflation dropped to a 26-month low of 6.6 percent in January after remaining above 9 percent for much of 2011. The fall in inflation reflects a drop in food prices, but the impact of high input prices, which makes its way into inflation through the cost of manufactured goods, shows no sign of dropping in the near future. Although the drop in inflation has been latched on as a rallying point for industry to call on the central bank to drop interest rates, the central bank can far from afford to conclude that the recent dip in inflation signals a long-term trend. In fact, the central bank has announced that it would be premature to start reducing interest rates without seeing any abatement of inflationary threats exerted by the high fiscal deficit and global energy prices.

India’s fiscal deficit between April and January came in at 4.4 trillion rupees, or 105 percent of the full-year target. During the same period last year, the deficit stood at 58

percent of the budgeted target. The central government admitted that meeting the fiscal deficit target of 4.6 percent of the GDP would be a “great challenge.” The government’s pledge that it would try to keep the deficit below 5 percent of GDP seems unlikely to be met. The central bank, in recent months, has blamed the fiscal deficit for constraining monetary policy and causing inflation.

Analysts ascribe part of the blame for the current economic situation to a retreat in foreign capital, a weak rupee, and uncertainty over government reforms in certain key areas like Foreign Direct Investment (FDI). How India will fare this year depends heavily on the steps the central bank takes in order to spur growth, the upcoming union budget, and the government’s will to push through important economic reforms.

Thus far in 2012, the central bank has already eased the reserve requirements for banks, infusing liquidity into the economy. It is likely that further liquidity could be infused into the economy after the central bank’s review meeting in March. Although it might be too early to expect a drop in interest rates, the central bank may be compelled to reduce interest rates sooner rather than later. The upcoming union budget could go a long way in making the central bank’s job easier as well. If policy decisions to support infrastructure, social initiatives, and agriculture come through, and if reform-related policies are given an impetus, we could quickly see positive sentiment returning to the economy, allowing the central bank some more time before it can ease interest rates.

How India will fare this year depends heavily on the steps the central bank takes in order to spur growth, the upcoming union budget, and the government’s will to push through important economic reforms.

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Infrastructure development is paving the way for optimism in Indonesia. A longstanding lack of infrastructure has been a significant roadblock in the country’s attempts to achieve its full economic potential, but the Parliament has finally passed a land acquisition bill that will allow the government to expedite infrastructure development. Although the bill is pending the president’s approval and the timeliness of implementation is widely speculated, it is likely a step in the right direction. The new legislation ensures speedier land acquisition for infrastructure projects and a fair sale price to landowners, and it will likely boost private sector involvement, which has been kept at bay by bureaucratic inefficiencies.

Earlier this year, the country regained its investment grade rating for the first time since the 1997 Asian crisis. This will allow Indonesia to borrow cheaply and attract more foreign investment into the economy. In fact, recent data released by the Investment Coordination Board indicates that despite global risk aversion, foreign investment in Indonesia stayed its course in 2011. During the fourth quarter of 2011, total investment realization increased 19.2 percent from a year ago. Foreign investment surged 25.2 percent year-over-year to over $5 billion during the fourth quarter, taking the cumulative foreign

investment to about $19 billion for the entire year. Foreign investors — especially from Singapore and regional economies — continue to pour money into Indonesia with transportation, communication, and storage garnering the largest share of foreign inflows.

Foreign investment is expected to play a critical role in bridging Indonesia’s investment gap, as the government has been conservative with infrastructure spending in a bid to limit its fiscal deficit. Indonesia’s infrastructure spending is equivalent to about 4 percent of GDP and is expected to rise gradually over the next few years. This is still far less than India and China, which currently spend 8–10 percent. In 2012, the Indonesian government plans to boost its spending by 19 percent to $18 billion in an attempt to improve roads, airports, and railways, which will likely enhance the outlook for private investment as well.

The government is also thinking about reducing fuel subsidies and redirecting the resulting fiscal savings toward infrastructure development. Energy subsidies are currently estimated to account for nearly 20 percent of the government’s spending, compared to just 3 percent attributed to infrastructure. The Parliament has not approved such a plan yet, but government officials say that

Indonesia

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the hikes will be in place by April. It is widely speculated that if energy subsidies are removed, oil prices may climb by as much as 33 percent, thus exerting inflationary pressures.

Inflation has been continuing its downward trend in the past few months, supporting the central bank’s recent monetary policy cuts. In February, inflation eased to 3.6 percent, which is well within the central bank’s target range of 3.5–5.5 percent for 2012. The central bank, which seems dovish in its outlook, expects inflation to decline further through the year. However, a policy-led hike in energy prices could threaten price stability in the broader economy.

Despite the risk of inflationary pressures, Indonesia’s economic outlook is favorable. The economy expanded by 6.5 percent in 2011, driven primarily by investment and domestic consumption. The country’s 240 million consumers and an abundance of natural resources are expected to continue to attract investment in 2012. Its limited reliance on exports may keep the economy relatively insulated from external developments, but volatile portfolio investments will remain at risk. Nevertheless, its newly acquired investment grade rating and a favorable

domestic economic environment will likely ensure a steady flow of foreign direct investment during the year.

According to consensus estimates, the Indonesian economy is expected to grow at a pace of 6.5 percent in 2012; the government is chasing a target of 6.7 percent growth during the year. While this target may seem ambitious, it is not entirely unattainable. Many believe that Indonesia — Asia’s largest economy after China and India — has come of age. In spite of the global economic turmoil that stalled some of its regional peers, Indonesia’s 2011 economic expansion was the fastest since the 1990s, further highlighting the economy’s resilience.

Indonesia is a fast-emerging economy whose true potential remains to be unlocked. The biggest challenge in achieving full potential is posed by the lack of adequate infrastructure, which is more often the result of red tape rather than a lack of funds. Of late, the government has taken symbolic steps to remove bureaucratic delays and incentivize investment, underlining its commitment to improving infrastructure. However, actual implementation of the proposed legislations is itself entangled in bureaucracy, and it remains to be seen how far the government can go in achieving its economic targets.

Despite the risk of inflationary pressures, Indonesia’s economic outlook is favorable. The economy expanded by 6.5 percent in 2011, driven primarily by investment and domestic consumption.

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Thailand

The most devastating flood in over five decades inundated over two-thirds of Thailand, claimed more than 700 lives, and caused economic damages in excess of 328 billion baht. As a result, the Thai economy contracted for the first time since 2009 and shrank 9 percent year-over-year in the fourth quarter of 2011. Manufacturing and exports were severely hampered, and Thailand’s GDP grew by a modest 0.1 percent in 2011.

Manufacturing units, including textiles, automobiles, and electronics were forced to stall operations. Ebbing manufacturing output was accompanied by a significant decline in exports. Global supply chains, particularly in the automobile and electronics sectors, experienced major disruptions. In addition, household consumption and capital formation fell 3.0 and 3.6 percent, respectively in Q4 2011. Finally, declining tourism led to a lull in the restaurants and hotels sector.

However, the worst seems to be over. Several industries, including the auto sector, have staged a remarkable recovery. As the year progresses, reconstruction spending and improved domestic consumption will likely bolster the Thai economy. A weak external environment could present

a host of challenges, but Thailand’s economy is expected to bounce back in 2012.

The Thai Board of Investment (BOI) revealed that foreign direct investment increased in January by a staggering 60 percent compared to the previous year. The BOI received investment promotion requests from foreign investors for 80 projects valued at 25 billion baht, of which 37 were for new investments. As several auto sector manufacturers resumed operations, Thailand’s automobile production and sales rose sharply in January. While part of the increase can be attributed to base effects, the outlook for the sector is positive for the coming months.

In addition, industrial confidence and consumer confidence rose over the past two months as factory operations and domestic demand increased. With inflation expected to remain relatively benign, the Bank of Thailand may adopt an accommodative monetary policy. As a result, interest rates will likely be held at 3.0 percent, allowing businesses ample opportunity to kick-start the economy.

Thailand’s exports are also likely to rise in the first quarter of 2012 thanks to several Free Trade Agreements with Southeast Asian nations, which are becoming the country’s

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largest export market. However, the consequences of weak external economic conditions may be felt as early as the second quarter. A fragile U.S. economy and the debt crisis in Europe are casting a shadow on the Thai export sector’s growth prospects. Furthermore, mounting optimism around growth prospects in Thailand resulted in a surge of capital inflows. Thailand’s currency has strengthened to a two-month high after international investors increased their holdings of Thai assets. A stronger currency could compromise some growth in the export sector.

On the downside, rising oil prices and recent bombings could drag down GDP growth in Thailand. The tourism industry will likely be hit hardest, at least in the short run. Whether or not businesses will take a cautious stance and hold back investments in the coming months is unclear. The University of the Thai Chamber of Commerce (UTCC) projected that the bomb incident and rising oil prices will drag down GDP growth in the first quarter. However,

it maintained its annual growth projection for 2012 at 4.5–5.0 percent.

Thailand’s economy is getting back on its feet. As factories become fully operational, employment and industrial output will likely improve. Private consumption could drive growth when the minimum wage hike takes effect on April 1, 2012. The government is also likely to step up public expenditure on reconstruction and disaster relief. As a result, the Thai economy may experience higher inflation during the latter part of the year. Meanwhile, the volatile external environment remains a significant challenge. If the global economy stalls, developed countries along with many Asian economies may experience slower growth, in effect, lowering demand for Thai exports. On the other hand, improved external demand may bode well for growth.

A fragile U.S. economy and the debt crisis in Europe are casting a shadow on the Thai export sector’s growth prospects.

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About the Economistseditor

Dr. Ira KalishDeloitte Research Deloitte Services LP Tel: +1 213 688 4765 E-mail: ikalish@deloitte.com

Dr. Ira Kalish is Director of Global Economics at Deloitte Research.

He is an expert on global economic issues as well as the effects of economic, demographic and social trends on the global business environment.

Managing editorRyan AlvanosDeloitte Research Deloitte Services LP Tel: +1 617 437 3009 E-mail: ralvanos@deloitte.com

ContributorsPralhad BurliDeloitte Research Deloitte Services LP India Tel: +91 40 6670 1886 E-mail: pburli@deloitte.com

neha JainDeloitte Research Deloitte Services LP India Tel: +91 40 6670 3133 E-mail: nehajain59@deloitte.com

siddharth RamalingamDeloitte Research Deloitte Services LP India Tel : +91 40 6670 7584 E-mail: sramalingam@deloitte.com

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