Progress towards the integration of the economic community of the Association of South-east Asian Nations in 2015 has been impressive, but challenges remain as member countries attempt to bring together very different values.
The integration of the economic community of the Association of South-east Asian Nations (Asean) is the largest regional consolidation undertaken since the European Economic Community was established in 1957. Its task is arguably trickier. Incorporating countries as politically, economically and socially diverse as Singapore and Myanmar in the same business group is no easy task.
That explains in part why many observers doubt that the Asean Economic Community (AEC) will be formalised by the end of 2015, as scheduled. But this is no testament to failure. The AEC has made impressive progress in trade liberalisation and, to some extent, political reconciliation – as exemplified by Myanmar’s re-engagement with the international community two years ago. The events of 2015 will hardly be an arrival point.
Services liberalisation is proving harder to implement due to some countries’ protectionist tendencies. But co-operation via finance – such as a region-backed natural disaster bond – could have enormous social benefits.
The AEC’s challenges will be manifold, and include overcoming significant infrastructure shortcomings and ensuring less developed markets catch up with advanced peers, while avoiding unwise liberalisation and the low-income trap.
Trade galore
Since the 1980s, Asean’s gross domestic product (GDP) has been growing at an average of 4.5% annually. The region’s positive growth fundamentals, stellar demographics and huge base of small and medium-sized enterprises (SMEs), which constitute 70% to 80% of regional industry, make AEC an enticing trading partner.
The value of merchandise trade is higher than the combined GDP of Asean countries, accounting for 104% of the region’s GDP. The region’s key trade partners are the US, the EU, Japan and China, according to Standard Chartered.
Important steps were made in tariff reduction when taxes among the relatively more advanced Asean-6 countries (Brunei, Indonesia, Malaysia, the Philippines, Singapore and Thailand) were dropped to zero in 2010.
“AEC’s scorecard remained at 77% of its March 2013 [policy] targets. But the progress in tariff reduction is remarkable. Less than 5% of intra-Asean trade is subject to tariffs over 10% and 99% of goods traded in the Asean-6 have 0% tariffs,” says Takehiko Nakao, the president of the Asian Development Bank (ADB).
Newer Asean members Cambodia, Laos, Myanmar and Vietnam are developing quickly thanks to a growing inter-Asean supply chain. There is an economic zone in the Cambodian capital of Phnom Penh, for instance, producing components needed in Thailand for final products in China.
“Even among components, there is a supply chain,” says Iwan Azis, head of the ADB’s regional economic integration office. “China needs to follow the global market, meaning it needs to have high-quality standards. That in turn raises the quality of intermediate inputs from Thailand, which puts pressure on Cambodia.”
FDI boom
Foreign direct investment (FDI) continues to be a key driver of the AEC’s development. With huge untapped consumer pools, liberalising economies and the newer Asean member countries offering especially cheap labour, FDI in the region has thrived.
Some argue geography is also on AEC’s side. “China's expansionist policy threatening many of its neighbouring countries is allowing us to show ourselves as a valid alternative destination,” says Roberto Dispo, president of Philippines-headquartered First Metro Investment Corporation.
Mr Nakao sees foreign investment as essential. “FDI does not prevent growth, it promotes it. Blocking FDI in this globalised economy is impossible and harmful,” he says.
The Asean-5 (Indonesia, Malaysia, the Philippines, Singapore and Thailand) received more FDI than China in 2013, according to Bank of America Merrill Lynch. Annual volumes grew by 7% to $128.4bn, while FDI into China dropped by 3% to $117.6bn in the same period.
Shifting focus
Asean FDI has also changed. While Japanese multinational corporations flooded the region after the yen’s 1984 appreciation, foreign investors now focus on SMEs. “SMEs generally account for more than 90% of the secondary sector in any country in the world – even more so in the Asean region,” says Sothea Oum, economist at the Economic Research Institute for Asean and East Asia (Eria).
Mr Azis predicts FDI will focus on AEC domestic markets rather than the export sector. “Asean’s middle class and personal income are increasing. Investors are targeting consumers,” he says. This could help decrease dependence on foreign products.
If prospective revenue streams will be in local currencies then FDI will follow suit. This will reduce foreign exchange instability in a region where some countries have adopted dollarisation, which in a way means importing monetary policy.
Foreign investment in local currencies will avoid situations such as what happened in mid-2013, when the US Federal Reserve’s mixed messages on the future of quantitative easing (QE) sent shocks through markets worldwide. Mr Azis says: “During the QE tantrum of May 2013, Asean started realising dependence on major currencies tied its hands. The maximum it could do was to ask the US to be informed of future plans”.
Under-reported EU
There is a misconception that FDI into Asean is led by China, Japan and South Korea competing for commercial relations and soft power. “We entertain three to four Japanese missions in the Philippines every week. They are trying to relocate firms, to look for equity partners, companies they can work with on a joint-venture basis,” says Mr Dispo, who is based in Manila.
However, the EU is the leading source of FDI into Asean, investing $74.76bn in the region between 2011 and 2013. The EU has finalised one free-trade agreement (FTA) with Singapore and could sign one with Vietnam at some point in 2015. “This is a major change. Vietnam has stepped up its engagement in FTA negotiations since mid-2013 and we are making very rapid progress,” says one EU official.
The EU has been negotiating FTAs with Thailand and Malaysia, although it stopped talks with Thailand due to its military coup, while Malaysia has suspended negotiations in light of its recent elections. Progress in both cases is slow, says the EU official.
The EU's negotiations with the newer Asean members remain tricky. “They require elaborate rules on services, procurement investment, sanitary measures, technical barriers to trade, competition law and sustainable development to engage in FTA talks, and their capacity is not sufficient right now,” says the EU official.
The best-case scenario would be an Asean-wide FTA, but it remains impossible for the time being. “Asean countries are too diverse and trade is still not integrated enough. When they do conclude the AEC, create an internal market with an external tariff structure like the European Economic Community in the 1970s, and they can trade as a bloc, we will consider an Asean-wide FTA,” says the EU official.
The low-income trap
If used in the recipient country’s best interest, FDI can create jobs, transfer knowledge and managerial skills, provide technology and help domestic firms grow. The risk is that less developed countries will keep wages low and labour unskilled to continue attracting FDI and enter a low-income trap.
Mr Oum at Eria says foreign investors are starting to face difficulties in finding skilled labour for higher value-added industries in countries such as Cambodia, Laos and to a lesser extent Indonesia and Myanmar. Mr Azis is more optimistic, however, and sees inter-regional supply chain networks already counteracting low-income trap risks.
FDI intrinsically averts these threats, according to Mr Nakao. “FDI will raise wages over time. It is happening in China now. Chinese growth has been promoted by FDI. It brought in money, technology and managerial skills. This has had many spillover effects and promoted many start-ups in the country. Chinese wages started growing too. The challenge is whether China can upgrade its economy and become competitive. Investing more in human capital is necessary,” he says.
But according to Yoshifumi Fukunaga, senior policy coordinator at Eria, increasing wages is not enough. “The problem is not whether labour is cheap or not," he says. "The problem is if labour productivity meets the standard of the minimum wage. That demands good levels of education and human resource development.”
Indonesia, for instance, has an education problem. According to the Organisation for Economic Co-operation and Development, about 50% of Indonesia’s workforce has a primary school education only, while a mere 8% holds a formal qualification.
Deregulation obstacles
Achieving a free flow of financial services in the AEC is also taking longer than expected. “Banking and retail sector deregulation lags tariff progress but countries are keen to improve,” says Mr Nakao. “There are obstacles such as labour issues and banking sector regulations trying to protect certain segments of society or to promote financial inclusion. Some countries don’t want foreign financial institutions wiping out domestic banks that they believe play an important role in the local market.”
Indonesia, for instance, passed a law limiting foreign bank ownership to 40% in 2013. “There are different nationalistic interests at play within Asean,” says Mr Dispo.
Indonesia’s new law stopped Singapore’s largest bank, DBS, from purchasing a controlling stake in Danamon. Despite some accusations that the new law was designed to stop the transaction, Danamon’s president, Henry Ho, says the transaction could have happened anyway.
“If a bank which has 40% ownership demonstrates good governance for 18 months, it will be allowed to buy more. Also, DBS has operations in Indonesia. The moment it bought 40%, it could have integrated DBS Indonesia into Danamon to give [DBS more than] 40% ownership,” says Mr Ho.
Lack of reciprocity
Simultaneously, Bank Mandiri allegedly lamented Singapore’s lack of reciprocity (for example, if five Singapore banks enter Indonesia's market, five Indonesian banks should be able to do the same in Singapore). This complicated the matter further. Mr Ho thinks this issue could have been negotiated separately.
In contrast, the Philippines allows foreign banks to freely enter the market, open an unlimited number of branches and retain 100% ownership. “We feel insecure and threatened by the entry of foreign banks. Our capital sizes are small compared to regional and global banks. The combined asset size of our three largest banks – BPI [Bank of the Philippine Islands], BDO [Unibank] and Metrobank – equals that of CIMB, the fifth largest bank in Malaysia,” says Mr Dispo.
Though healthy and already Basel III-compliant, smaller institutions have started consolidating in the run up to banking liberalisation. But the Philippines’ banks will retain competitive advantage in market knowledge and culture. Foreign banks could add a different set of skills, however. “Strategic alliances will be forged whereby our familiarity with the market will be complemented by technology and new products coming from bigger banks,” says Mr Dispo.
In any case, there are enormous opportunities for banks servicing AEC’s booming trade. “Trade within Asean will continue to grow as long as countries keep their borders open. Our trade finance business grows 20% a year,” says Mr Ho.
No over-arching rule
To counteract the slow pace of services liberalisation, the AEC has introduced the concept of reciprocity. As with all AEC initiatives, it is not enforceable. It is based on trust, which leaves room for loopholes and unmatched promises. “That is the difference between the EU and AEC. In the EU, once everything is passed via plebiscite, there is no turning back. The AEC is all based on a voluntary basis. Things could happen in their own sweet time,” says Mr Dispo.
However, the fear of exclusion could be enough to motivate co-operation. “The AEC will be defined by a mathematical equation: ‘Asean minus’. If you're not in the AEC, you will be the minus. It incentivises countries to join,” says Mr Dispo.
For Mr Azis, slow financial services liberalisation is due to countries’ different starting points rather than lacking co-operation. Many banks want to tap into Indonesia’s huge unbanked market, for instance. Even if reciprocity were upheld, it would be far harder for Indonesian banks to enter a sophisticated and saturated market such as Singapore.
Though banking liberalisation remains an issue, the AEC could use finance to generate socially useful products such as a natural disaster bond, as proposed by Eria. Mr Oum’s research shows that a vast number of Asean households are very risk-tolerant and market-base mechanisms such as insurance to tackle natural disaster aftermath do not work. Even common insurance products are rare. People still rely on government intervention for all relief support after calamities have occurred.
“There is scope for a common reinsurance market or to issue a common catastrophic insurance bond, as experienced in the Caribbean,” says Mr Oum. Having insurance would encourage households to make longer term plans such as allocating resources for business or investing in children’s education. Talks on this project are ongoing.
Infrastructure hurdle
A hurdle to the AEC’s integration is infrastructure. While day-to-day traffic can cause huge problems in some large Asean cities, issues in commercial transport are even more serious.
“I hear stories of coal miners wanting to ship coal from Kalimantan to Java and it’s more expensive than shipping coal from Australia to China. It doesn’t make sense,” says Mr Ho when discussing Indonesia’s ports.
Poor Asean infrastructure is not a matter of the region's private sector lacking financial resources. Banking and corporate sectors have healthy balance sheets, and the AEC has an excess of savings and experienced massive capital inflows after the US’s and Europe’s low-rate environment began in 2005. Rather, the issues are poor spending allocation – infrastructure spending generally makes up about 5% of Asean countries’ GDP, and even as low as 2% in some areas – and operational constraints.
AEC public private partnerships (PPPs) are tackling another obstacle – identifying bankable infrastructure projects. According to Mr Ho, however, Indonesian banks are unlikely to finance infrastructure projects. “They are too long term. We need development banks to at least make the down-payment to get projects going. Our role is to make sure infrastructure contracting is generated. We will advise contractors on doing local work and will ensure a trickle-down effect to the people,” he says.
But in the Philippines, banks see value in investing in power and energy. The president and chief executive of one local bank says: “With the yield curve being relatively flat, you can go longer and hold on to longer assets and even finance projects traditionally with your deposits, though there are limits.”
One of First Metro’s projects involved building the power supply for the Philippine island of Boracay, while BPI invests in alternative energy such as solar projects. Elsewhere, the ADB is helping Vietnam write a PPP law and is collaborating with the ministries of finance in Indonesia and the Philippines. Legal and institutional obstacles in less developed markets such as Myanmar could make effective PPP usage harder for now.
Over-zealous governments could be a hurdle to PPP. Mr Nakao says: “There is the risk of governments promising companies excessively high income and having to compensate for their shortfalls with taxpayer money. Governments must use PPPs in a well-designed manner.”
Asia's development banks
It is estimated that the Asia-Pacific region will need $8000bn in infrastructure investment in the next 10 years.
Development banks have helped significantly as Association of South-east Asian Nations governments do not have enough capital to meet these needs. But even their funding capacity is limited.
“Infrastructure spending needs exceed the capacity of governments and the Asian Development Bank [ADB]. Even when new development banks arise, we probably still will not be able to meet these needs. Some countries that are joining these new players are telling us that we should still increase our size,” says Kazu Sakai, the director-general of ADB’s strategy and policy department.
ADB has a $3bn ADB Fund (ADF) based on donor money and raises $10bn annually in capital markets for its Ordinary Capital Resources (OCR) operation. “The size of ADF depends on our donors’ generosity and donors are becoming less generous because they have their own problems at home,” says Mr Sakai. OCR’s size is limited by equity. To maintain its AAA rating the ADB keeps its equity-to-loan ratio at 25%.
To increase capacity by at least 20%, the ADB has proposed adding $33bn of ADF-accumulated donor contributions to $17bn of OCR equity.
Meanwhile, the Asian Infrastructure Investment Bank (AIIB) – the first multilateral institution proposed by China – will start operating in 2015 with a $50bn base.
Allegedly tired of the Bretton Woods institutions’ slow pace of reform and the poor representation of some Asian countries, China proposed the AIIB in October 2013. The World Bank is largely interpreted as US-centric, the ADB as Japanese-centric and the International Monetary Fund as Europe-centric.
Enormous infrastructure needs in Asia make overlaps with the ADB unlikely. “The Chinese authorities said they will complement ADB’s role and not compete with us – and I believe this,” says Takehiko Nakao, president of the Asian Development Bank.
But some in the development community question the AIIB’s compliance with international best practices. “The AIIB’s advent is understandable because there is a huge need for infrastructure investment across Asia. At the same time, the new bank should adhere to international standards on procurement systems, and environmental and social protection, including compensation for resettlement,” says Mr Nakao.
