Love it or hate it, Asia is inextricably linked with the US and however much China has grown in importance, it is still the US that will be the key driver of Asia’s fortunes in the next few years. The good news is that the American economy appears set for a strong pick-up, one that will give Asian economies a nice boost. But beyond that cyclical bounce, several things could go wrong — financial turbulence caused by the strong dollar and rising interest rates in the US, a slide into protectionism and a change in strategic approach to Asia, all of which could worsen uncertainty in the region.
US economy poised for strong run
Taking together the data of recent weeks and despite the occasional setback, there is growing evidence that the US economy is not only gaining momentum but also that the acceleration is likely to be sustained for a while:
• Activity indicators signalling strength. Both the manufacturing and non-manufacturing purchasing manager indices have gained strength with new orders growing at an energetic rate, which points to expanding economic activity in the coming months.
• The US Federal Reserve Bank’s Beige Book survey reveals rising wages and growing demand for workers. The past two months have seen a further tightening of labour markets, resulting in more instances of manpower shortages, not just in high-skilled engineering and technology-related professions but also in blue-collar construction and manufacturing. As a result, moderate increases in wages have been seen in most districts.
• Bullish consumers likely to boost retail sales and housing. The improvement in job and wage prospects probably explains why consumers are increasingly more optimistic. The Conference Board’s Consumer Confidence Index reached a 15-year high last month. This ebullience in consumers should also translate into further strength in US housing. After all, American homeownership rates are still at multi-decade lows, so more confidence about jobs and further wage growth is likely to translate into stronger housing demand, giving a welcome fillip to domestic demand.
• American business confidence also at decade-high. Surveys by J.P. Morgan of middle-market business leaders and a separate survey of small firms have shown heady levels of business optimism not seen for a decade. The ongoing economic recovery helps but so does the expectation that the Trump administration and its Republican allies will deliver higher fiscal spending, lower taxes and more deregulation that will improve sales and profits. President Donald Trump’s inaugural budget proposal envisaged a colossal US$54 billion rise in military spending. That could translate into a huge boost for the high-technology sector, given the technological intensity of New Age defence strategy. The multiplier effects of such defence expansion could be substantial.
• Recovery in the US, eurozone and Japan mutually reinforcing. Robust demand in the US will spill over into the other large economies that are its main trading partners, helping their economic recovery to take off. Recent economic data in both the eurozone and Japan surprised positively, even before the full effect of the American acceleration was felt, which tells us that these large economies are putting much of their recent weakness behind. That could also explain the surge in new orders for American service companies — most likely reflecting the spillover from the Japanese and European recovery.
All this bodes well for Asian economies, whose exports are already reviving in line with a growing rebound in world trade. And this improvement in trade prospects is also flowing through to industrial production. In addition, improving global demand is pushing up the prices of oil, coal and metal, which, in turn, is creating faster income growth in Asia and increasing government revenue.
But get ready for financial turbulence
Fed officials, including chair Janet Yellen, vice-chair Stanley Fischer and the dovish Lael Brainard, recently made it clear that the Fed will be raising rates faster than expected. Although this precipitated a sharp change in market expectation of a rate hike — and unlike what happened in the past when there were such changes in expectation of monetary tightening, for example during the May 2013 taper tantrums — Asian financial markets did not suffer much. There was none of the surges in capital outflow or abrupt currency depreciation.
However, investors would be injudicious if they thought that a rising US dollar and interest rates would not cause turbulence in Asia over time.
First, the markets seem to be assuming for now that the two to three rate hikes they had been expecting this year are simply happening a little earlier. But the upward trajectory in US economic activity will, we think, force the Fed into at least three or four hikes this year and even more aggressive tightening next year. As the markets price these in, the pressure on Asian asset markets and currencies will mount.
Second, the recent bullish moves in equities were probably fuelled by investors moving cash into financial assets rather than reallocating existing funds out of emerging market assets. In time, the latter is more likely, which will hurt Asian asset prices and currencies.
The potential damage goes beyond just declines in equity valuations or currencies. At a time when US dollar-denominated debt in emerging economies has surged, a stronger dollar and higher dollar interest rates will increase the repayment burdens on companies in such markets. As it is, about 10% of such debt owed by companies in emerging economies is due for repayment this year, which will give rise to a lot of stress.
Trade policy changes a real risk for Asia
It is clear that the Trump administration and US Congress are planning major changes that could cause much disruption in trade-dependent Asian economies.
For example, a border adjustment tax would be decidedly bad for Asia. The Republican Party leadership in the US Congress is advocating a border adjustment tax (BAT), which, in effect, subsidises US exports, while imposing a tax penalty on imported goods. Because it is such a controversial proposal that could raise the cost of living for Americans, Trump has stopped short of endorsing it while well-funded lobbyists are mobilising public opinion against it. Still, we believe some form of BAT will prove too attractive for the president and Congress — BAT is the only reform option they have that promises the massive bounty of tax revenue they will need to bring coherence to conflicting goals of a large rise in defence and infrastructure spending, huge tax cuts and no major worsening of the fiscal deficit. After all, Trump continues to rail against the alleged asymmetry in the treatment of American exports and has called for a level playing field for American exports. More than that, BAT will disrupt existing supply chains in which Asian exporters have thrived and will almost certainly provoke retaliation by major trading partners, thus risking the continued expansion of trade that is so vital to Asia’s growth.
Worse still, Trump’s approach could disrupt the existing trade order. A leaked report suggests that the Trump administration is prepared to ignore any World Trade Organization rulings they do not agree with and promise to “aggressively defend American sovereignty over matters of trade policy”. Trump’s disdain for the WTO, which he dismissed as a “disaster” during his election campaign, could lead to a more aggressive use of laws like the old Section 301 Trade Act of 1974, which allowed the president to determine if practices unjustifiably restricted US commerce. Such measures were last used against Japan in the 1980s during a dark time for world trade and their reappearance in this age would send a chill down Asia’s spine.
US’ strategic approach may not help Asia
The new American administration plans to substantially raise the country’s defence spending, funding this expansion through a huge cut in the budget for US aid and diplomacy. In addition, the administration is adopting a stridently nationalistic tone in its economic relations with Asian allies. Despite the best efforts of his Defence Secretary and Secretary of State, Trump seems to be shifting American strategy away from soft power and towards hard power and appears to place less value on longstanding strategic relations with Asian allies.
Whether an approach that makes allies nervous and relies so much on a large increase in military assets — which will only become available in several years’ time — is the best way to deal with current security challenges in Asia is a moot question. All this is happening as the strategic position in East Asia has changed decisively for the worse. China has already established a military position in the South China Sea that puts the US on the back foot and makes it almost impossible for other nations with territorial claims to protect their positions. And North Korea, having made progress in developing a deterrent based on nuclear weapons and missiles that could, in time, threaten the US, feels it can engage in ever-more brazen acts in countries that never thought they could become victims of the regime’s extraordinary behaviour, as Malaysia has learnt. Nothing in the new American approach will help it deal with North Korea.
Moreover, the Trump administration is aggressively pushing through a radical policy agenda on the basis of a weak electoral mandate, almost guaranteeing a large political backlash and endless controversies that will sap its energies, leaving little bandwidth for foreign policy. Many Asian nations are looking at the increasingly gridlocked and fractious American political system — which is also more aggressively nationalistic — and contrasting it with the Chinese system, which seems to deliver more coherent policies and which is extending its soft power through well-funded overtures to Asians, such as the One Belt One Road initiative. Some of them may well choose to realign themselves with the rising Chinese power rather than an American system in which they have less and less confidence.
Some may argue that the Trump administration is still taking shape and that it is premature to be pessimistic. However, the intent of the president and his key advisers is quite clear and is unlikely to change.
Conclusion
We think that in the near term, the US recovery will give Asian economic prospects a larger boost than expected. But we also see monetary policy normalisation proceeding in a more disruptive manner than many may think. However, the greater concerns are first, trade policy, and second, geopolitical risks to Asia. These risks may seem far away for some of us but we should not grow complacent. Asia is in for a rough ride.
Manu Bhaskaran is CEO of Centennial Asia Advisors
Save by subscribing to us for your print and/or digital copy.
P/S: The Edge is also available on Apple's AppStore and Androids' Google Play.