Crunch time for Malaysia on economic reform


November 15, 2018

Crunch time for Malaysia on economic reform

by Stewart Nixon

http://www.eastasiaforum.org/2018/11/04/crunch-time-for-malaysia-on-economic-reform/

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Prime Minister Mahathir Mohamad’s honeymoon period after he swept to power in Malaysia may now be facing an economic reality test. Mahathir’s recent admission that his pre-election promises exceeded what can possibly be delivered is just the start. Analysts and investors alike are now hanging on further details of the government’s economic policy priorities.

In the six months since Pakatan Harapan (Alliance of Hope) under Mahathir ended more than six decades of one-party rule in Malaysia, the new government has taken a measured approach to policy development, allowing inexperienced ministers to get on top of their portfolios while it enjoyed electoral grace.

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“Under-investment in human capital is perhaps the single biggest drag on Malaysia’s economic development. It is therefore a positive that human capital remains a high policy priority in Malaysia — commanding its own pillar in the Mid-Term Review and the highest share of budget expenditure. Some of the worthwhile measures include policies to address immediate skills mismatches, invest in school infrastructure and raise the quality of education.”– Stewart Nixon

The release of the Mid-Term Review of the Eleventh Malaysia Plan, as well as the government’s first budget, throws some light on where the government might head on economic policy. Stronger governance and alleviating cost of living pressures are underlined as priority areas, along with greater regional development, entrepreneurship and digitalisation. These priorities represent positive investment in government effectiveness and inclusiveness. But there are questions about economic policy direction.

The Mid-Term Review provides a blueprint loaded with high-level aspirations that would represent an impressive reform agenda if translated into successful policies. But aspects of the Review raise questions about the government’s real capacity to navigate medium-term risks. The 2020 balanced budget target has been abandoned and the budget deficit has widened to 3.7 per cent of GDP (with an aim to reduce this to 3 per cent of GDP by 2020), while public investment — most notably in major rail and pipeline projects — is set to contract.

The cancellation and postponement of mega rail and pipeline projects has rightly been applauded on governance grounds, but the fallout presents some economic risks. Debate about future infrastructure needs has been sidelined by fear mongering about debt. Investors also now face higher levels of uncertainty and risk. While Chinese investors have been hit hardest by the cancellations, both governments appear to have so far handled the diplomacy of recontracting deftly.

The Review also foreshadows a host of new expenditure in healthcare, social protection, rural infrastructure and the environment that will need to be financed by either undeclared budget cuts in other areas or additional revenues.

Revenue raising — or the failure to address the need for it — is a serious weakness in government plans. Tax revenue has fallen to around 13 per cent of GDP — compared to the OECD average of over 34 per cent — and the government’s decision to dump the goods and services tax (GST) for a narrower ‘sales and service’ tax will accelerate the decline. The budget estimates tax revenue at just 11.5 per cent of GDP in 2019.

The Mid-Term Review hints at plans to diversify indirect taxes and increase non-tax revenue. Increasing indirect taxes appears ambitious after the noisily populist anti-GST campaign, while non-tax revenue is code for increasing dependence on revenues from state-owned enterprises (SOEs). The budget highlights this, reporting a 33 per cent drop in indirect tax revenue in 2018 and dividend hikes on PETRONAS in particular amounting to a doubling of non-tax revenue by 2019.

The budget hits some easy targets with higher taxes on property gains, sugar beverages, casinos, imports and online services. However it ignores potential reforms to wealth and property taxes or to the income tax system that currently covers only 15 per cent of workers and transfers very little from rich to poor households.

While the Malaysian government’s footprint may be low in taxation and expenditure, its participation in the economy is pervasive. The highly centralised top-down federation (that cripples local government initiative) and government ownership of more than half the local stock market ensure that the vast majority of economic activity is directly affected by the state.

Despite enabling the corruption scandals that brought down the former government, SOE dominance is not earmarked for meaningful reform in the near future. The budget speech declares that stakes in ‘non-strategic’ government businesses are to be reduced, yet if anything the Mid-Term Review is a blueprint for reinforcing paternalistic control of local governments and enhancing the primacy of SOEs. This is moving the Malaysian economy in the wrong direction. Rather, the government needs to focus on decentralising local governance and diluting SOE market concentration.

The large program of policies favouring Malays and other indigenous groups (Bumiputera) in the Mid-Term Review is another possible economic destabiliser. There was much hope that Mahathir’s more representative government would bring an end to the country’s long-running and ill-targeted affirmative action program. Yet the Review simply reaffirms the government’s commitment to continuing it. Outdated and divisive policies serve to perpetuate negative perceptions of the majority Malays, deter investment and encourage the brain drain of discriminated-against minorities.

Underinvestment in human capital is perhaps the single biggest drag on Malaysia’s economic development. It is therefore a positive that human capital remains a high policy priority in Malaysia — commanding its own pillar in the Mid-Term Review and the highest share of budget expenditure. Some of the worthwhile measures include policies to address immediate skills mismatches, invest in school infrastructure and raise the quality of education.

Still, the perpetuation of myths that low-skilled foreign workers are a drag on the economy and misguided plans to curb migrant inflows through increased levies and by further outsourcing responsibility to businesses with a vested interest in increasing numbers raise doubts about whether the government understands the extent and causes of Malaysia’s human capital deficiencies.

In the face of headwinds from global economic crises and trade wars, ambitious reforms are a must for Malaysia’s new government. Replacing current unproductive and populist measures with a medium-term policy platform that tackles distortions and disadvantage would not only enhance the country’s economy but also give needed weight to the government’s economic credentials.

Stewart Nixon is a Research Scholar in the Crawford School of Public Policy, The Australian National University. He is lead author of a new report from the Asian Bureau of Economic Research in the Crawford School on the Malaysian economy and was co-author of the OECD’s inaugural Economic Assessment of Malaysia.

Malaysians still count on bolder economic reform


November 13, 2018

Malaysians still count on bolder economic reform

Author: Editorial Board, ANU

ww.eastasiaforum.org

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READ ON: http://news.iium.edu.my/2016/04/10/book-review-a-new-malaysia-by-joaquim-huang/

The widely unanticipated ousting of Malaysia’s government in May not only left political analysts scrambling for explanations. It also had economists wondering what was in store for the economy.

The Najib Razak government had presided over relatively strong growth (5.9 per cent in 2017), low unemployment (around 3.5 per cent) and sound macroeconomic fundamentals. The eclectic group that gathered around former prime minister Mahathir and Pakatan Harapan (Alliance of Hope) to send the former government on its way had a less than stellar economic resume. Its campaign was mobilised around restoring good governance and unabashedly populist economics.

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Finance Minister Lim Guan Eng –Emulate Tun Tan Siew Sin-Take Care of our money and please don’t sleep on the Job

The promise of a sounder revenue base was abandoned with the scrapping of the goods and services tax (GST). The future of economic reform and sound economic management looked distinctly uncertain. The government’s first move on the economic front saw it outsource consideration of pressing economic and other national issues to a Council of Eminent Persons. The Council consulted widely with key academic, business and government stakeholders in developing an agenda for economic reform and delivered a report to government in August.

Despite the promise of transparent governance, the contents of the Council’s report have remained confidential. Meanwhile Finance Minister Lim Guan Eng focused his early efforts on exposing the former government’s accumulation of debt and corrupt contracting, alongside abolishing the GST and reintroducing petrol subsidies — prudent if poorly sold policies of the Najib government. While there has been silence on economic reform, there’s been a hive of activity from the new government on the governance front.

Mahathir sent a clear message to ministers that elected officials and civil servants are expected to act in the people’s interests. The pursuit of former prime minister Najib and his associates on corruption charges, the separation of powers for key agencies, push back on the empire that had developed around the Prime Minister’s Department and promises to end the most egregious political appointments are among the promising early signs of large-scale governance reform. Economic governance is also set to benefit under the recently updated Eleventh Malaysia Plan priorities. It affirms commitments to improve fiscal frameworks, tackle corruption-affected tender processes, strengthen the competition regulator and enhance frontline service delivery. The 2019 Budget released on 2 November supports these reforms with specific measures and resources. Action and optimism surrounding getting institutions fixed has staved off criticism about the lack of action on economic reform.

The revised Plan and the government’s first Budget were expected to provide clarity about the new government’s medium-term economic reform agenda. Despite the short-term fiscal bind, the hope was that ambitions for economic reform would match those for governance.

As this week’s lead article by Stewart Nixon notes, the commitment to reform in key areas is underwhelming.

‘The Mid-Term Review provides a blueprint loaded with high-level aspirations that would represent an impressive reform agenda if translated into successful policies,’ says Nixon. ‘But aspects of the Review raise questions about the government’s real capacity to navigate medium-term risks. The 2020 balanced budget target has been abandoned and the budget deficit has widened to 3.7 per cent of GDP (with an aim to reduce this to 3 per cent of GDP by 2020), while public investment — most notably in major rail and pipeline projects — is set to contract.’

Malaysia has a low level of taxation revenue and public expenditure, but the government’s role in the economy is still pervasive. As Nixon observes, ‘The highly centralised top-down federation (that cripples local government initiative) and government ownership of more than half the local stock market ensure that the vast majority of economic activity is directly affected by the state.’ There is a worrying disconnect between government rhetoric recognising the need to act in these areas and policies under the Review and Budget that would achieve the opposite.

Perhaps the biggest drag on Malaysia’s economic performance and handicap to its breaking through the middle-income trap is flailing human capital development. Nixon writes, ‘It is therefore a positive that human capital retains high policy priority in Malaysia — commanding its own pillar in the Mid-Term Review and the highest share of budget expenditure.’ But while the government is pursuing worthwhile measures to address immediate skills mismatches, invest in school infrastructure and raise the quality of education, it still lacks a plan to address key shortcomings, including an outdated learning culture, centralised decision-making and politicisation.

As Nixon identifies, ‘The large program of policies favouring Malays and other indigenous groups (Bumiputera) in the Mid-Term Review is another possible economic destabiliser.’ The hope that Mahathir’s more representative government would bring an end to the country’s long-running and ill-targeted affirmative action program is still just a hope. The Review simply reaffirms the government’s commitment to continuing it while the budget extends discrimination into the digital arena. ‘Outdated and divisive policies serve to perpetuate negative perceptions of the majority Malays, deter investment and encourage the brain drain of discriminated-against minorities,’ says Nixon.

The challenge over time will be to build the tax base and put in place a transfer system that targets need and addresses universal problems of inclusiveness. Reforms that reduce pervasive federal government presence across the economy and influence in local governance are a high priority. Without these changes, tackling corruption-riddled systems of political patronage will be a job that’s never properly done.

The continuation and extension of pro-Bumiputera policies represents a disappointing failure to promote a more inclusive approach to ethnic relations. Fixing Malaysia’s floundering education system is also now a top priority.

If ever a government had the mandate and popularity to progress a bold reformist economic agenda in Malaysia it is now. Taking the leap to developed economy status rests on challenging reforms in areas of well-publicised and politicised weakness. Instead, the government’s first major economic policy announcements delivered mixed messages on debt reduction, unproductive handouts, minimalist tax tinkering and increased dependence on SOEs and their dividends.

Post-election uncertainties affecting investor confidence, the looming global trade wars and emerging-economy financial risks all call for more determined fiscal re-prioritisation and bolder structural reform to send a strong signal that the new government has the nous and determination to meet the people’s economic expectations.

The EAF Editorial Board is located in the Crawford School of Public Policy, College of Asia and the Pacific, The Australian National University.

 

 

Brexit is bringing the UK back to Southeast Asia


November 11, 2018

Brexit is bringing the UK back to Southeast Asia

by Jürgen Haacke and John Harley Breen, LSE

http://www.eastasiaforum.org/2018/11/09/brexit-is-bringing-the-uk-back-to-southeast-asia/

As the United Kingdom proceeds to leave the European Union, the Conservative Party government is busy promoting an international identity for itself under the banner of ‘Global Britain’. It is enunciating an ‘All of Asia’ policy — ostensibly to signal that London is keen to engage all countries in the wider East Asia region, big and small. Emboldened by the belief that it already has strong bilateral relations with many Southeast Asian countries, London envisions a future in which the United Kingdom makes a meaningful contribution to regional security, prosperity and development. The problem is that Southeast Asia does not yet seem to care much.

The UK government has several objectives in Southeast Asia. For starters, the United Kingdom needs to strengthen its trade relationships in Southeast Asia to help offset the challenges it may face in its future economic and trade relationship with Europe. It also wants to be taken seriously as a status quo power that is prepared to defend the rules-based international order. Further objectives flow naturally from the United Kingdom’s exit from the European Union, such as establishing a formal relationship with ASEAN.

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The debate within Southeast Asia on London’s role in the region is still in the early stages. Southeast Asian signatories to the Comprehensive and Progressive Agreement for Trans-Pacific Partnership have not articulated a collective position on the United Kingdom’s possible membership. Meanwhile ASEAN has not clarified what position, if any, members hold regarding the possibility of dialogue partnership status. And while Western analysts offer both critical and supportive arguments in relation to the United Kingdom’s possible return to Southeast Asia as a military power, the region has yet to embark on a discussion of whether such a return to ‘East of Suez’ would be welcome.

ome Southeast Asian governments seem set to welcome a stronger UK commitment to the region. Singapore is looking forward to signing a trade deal with the United Kingdom once it leaves the European Union, after signing a UK–Singapore Defence Cooperation Memorandum of Understanding in June 2018.

Other ASEAN countries still look at their relations with the United Kingdom through the prism of the European Union. The United Kingdom is an important market for ASEAN imports within the EU-28, ranking third for goods and second for services. But UK market share in ASEAN-4 (Singapore, Malaysia, Thailand and Vietnam) is only around 1 per cent, and there is little expectation that this will change soon.

London’s willingness to re-engage militarily in Southeast Asia, and the maintenance of a near-permanent naval presence in the Asia Pacific in 2018 with the deployment of HMS Sutherland, HMS Albion and HMS Argyll, have been duly noted. But this greater military commitment follows a period of relative absence from the region, notwithstanding the United Kingdom’s role in the Five Power Defence Arrangements (FPDA). ASEAN government officials seem unsure as to why London is considering a return as a military power and what it would hope to achieve, while also pondering whether the United Kingdom’s newly demonstrated interest in a continuous naval presence is sustainable.

Developing a formal dialogue partnership between ASEAN and the United Kingdom is also not straightforward. ASEAN states would need to be persuaded that it is in their best interest to allow the United Kingdom to submit an application despite a moratorium in place, and to bypass other applicants at some political and reputational cost. ASEAN members would also need to agree by consensus on the United Kingdom becoming a dialogue partner, which is an outcome that cannot be taken for granted.

International Trade Secretary Dr Liam Fox MP and HM Trade Commissioner for Asia Pacific Natalie Black

International Trade Secretary Dr Liam Fox MP and HM Trade Commissioner for Asia Pacific Natalie Black

The United Kingdom should consider whether its relations with ASEAN countries have adequate coherence. Espousing an ‘All of Asia’ policy suggests that Southeast Asian states will be taken seriously. But it remains only a label of inclusivity rather than shorthand for meaningful substance. At the moment, the United Kingdom seems to have different priorities for individual states in the region. These may reflect UK values and interests, but it is not clear that there is an overarching narrative under which specific policies towards individual ASEAN states are convincingly subsumed.

While London has gone to some lengths to strengthen trade relations and engage the UK private sector in its interests in Southeast Asia, it may want to extend greater support to regional embassies and high commissions to identify opportunities of interest with their Southeast Asian counterparts. Bilateral joint trade commissions would help to communicate London’s trade policy with greater clarity, while facilitating dialogue on future trade arrangements and identifying areas of investment that are of interest to ASEAN governments. Such moves would be welcomed by governments in the region and complement the June 2018 appointment of the UK Trade Commissioner for Asia Pacific.

 

Hun Sen’s Power Paradox


November 9, 2018

Hun Sen’s Power Paradox

by Dr. Sorpong Peou, Ryerson University

http://www.eastasiaforum.org/2018/11/07/hun-sens-power-paradox/

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Cambodian Prime Minister Hun Sen is continuing to push the limits of personal power consolidation. While his strategies have been highly successful so far, they are likely to result in greater political insecurity in Cambodia.

Several concerning developments have emerged in 2018. Since the Supreme Court banned the main opposition party — the Cambodia National Rescue Party, or CNRP — in November 2017, Hun Sen has further consolidated his power by appointing family members to top government positions.

Some of these promotions were of his children. For instance, in late 2017 Hun Sen appointed his third son, Hun Manith, as General Director of the General Directorate of Intelligence, a new intelligence unit designed to train spies for combat against terrorists and any suspected threat from ‘revolutionary’ forces. Hun Sen also promoted his son-in-law, Dy Vichea — former head of the Ministry of Interior’s Central Security Department — to Deputy Chief of the National Police. Most importantly, Hun Sen elevated his eldest son Lieutenant General Hun Manet (pic below) as a General (four star) following his promotion to Deputy Commander in Chief of the Royal Cambodian Armed Forces (RCAF).

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These tactical moves are part of the Prime Minister’s long-term strategy to consolidate power, which has been in place since he removed his then co-prime minister, Norodom Ranariddh, from power in July 1997. Hun Sen has used coercive means to tighten political control over state institutions and co-opt loyal followers. Hun Sen now maintains tight control over the judiciary and electoral processes at both the local and national level and his party, the Cambodian People Party (CPP), dominates the bicameral legislature.

Why has Hun Sen carried out these tactical moves? For some commentators, they are simply a part of Cambodia’s entrenched political culture of authoritarianism, nepotism and patrimonialism.

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While there is some truth to this way of looking at Cambodian politics, it overlooks Cambodian leaders’ deep sense of insecurity, which drives them to weaken opposition forces by all means necessary. Hun Sen has been comparatively more successful than past Cambodian leaders in consolidating power, and is continuing to expand his domination of Cambodian politics after more than three decades.

Despite this success, Hun Sen still appears to feel insecure. His efforts to fill top government positions with family members are not simply about building a family business empire but rather about shutting down potential threats from within and without. This may explain why Hun Sen maintains a bodyguard unit of up to 6000 well-equipped and highly-paid troops.

Hun Sen’s sense of political vulnerability is also reflected in the words of Hun Manith, who reportedly said that the new General Directorate of Intelligence was designed to deal with ‘internal and external disturbance from a hostile and ill-intended group of people’ and that ‘the political and security situation and competition in the future will be more intense than in previous years’.

But Hun Sen is making the same mistake of the many Cambodian leaders before him: maximising political security by endlessly consolidating power. Hun Sen appears to believe that this strategy will continue to work for him. The problem with this strategy, though, may emerge from Cambodia’s external environment.

Hun Sen has taken advantage of the post-Cold War peace dividend and is also enjoying growing support from China. But he runs the risk of over-relying on Beijing’s support. The extent to which China is prepared to protect the CPP is difficult to determine, but what is clear is Chinese leaders’ long history of abandoning their allies when much was at stake. While Hun Sen may be aware of this possibility, his strategy to weaken domestic political challenges may increase his political insecurity.

Another problem with power consolidation through nepotism or patrimonialism is that it tends to invite resistance and opposition from both within the party and without. At some point, forces opposed to Hun Sen will grow stronger and nastier, especially if an economic downturn hits the country. And if Western democracies begin to impose sanctions on Cambodia, not only will ordinary Cambodians suffer, but the ruling elite will also face a legitimacy crisis. In this scenario, the CPP is likely to resort to even more repressive violence and may even end up self-imploding.

Current and future Cambodian leaders need to realise that security maximisation through unrestrained power consolidation is counterproductive and dangerous. Security does not necessarily result from others’ insecurity. But for this to happen would require CPP leaders to shift from a self-serving strategy to one that considers the security of others through effective dialogue and democratic power sharing.

Dr. Sorpong Peou is a Professor with the Department of Politics and Public Administration at Ryerson University, Toronto

China’s Foreign Policy under Xi Jinping


October 24, 2018

China’s Foreign Policy under Xi Jinping

by Neil Thomas, University of Chicago

http://www.eastasiaforum.org/2018/10/21/chinese-foreign-policy-under-xi-jinping/

  …”contrary to some recent commentary, it seems unlikely that ‘world power’ or ‘world domination’ are China’s priorities. The CCP observed the Soviet errors of external overreach and antagonism toward the US-led system during the Cold War. China now interacts with the international order like other major states: it complies with the order because to do so serves its interests and tries to influence this order where it does not”.–Neil Thomas

There is a risk of a ‘new Cold War’ between the United States and China. After decades of bilateral engagement and multilateral collaboration, the Trump administration’s first National Security Strategy (NSS) branded China a ‘revisionist power’ that seeks to ‘displace the United States in the Indo-Pacific region’ and ‘shape a world antithetical to [US] values and interests’ in an age of renewed ‘great power competition’.

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Rising powers like China rattle ruling powers like the United States because their ascendance creates tension within existing structures of global power. US power lies in its unmatched military capabilities and the ‘international order’ of multilateral institutions, interstate rules and global norms that promote economic openness and rules-based dispute resolution. The charges of ‘revisionism’ levelled in the NSS show that the Trump administration fears that China will replace the United States as global hegemon and threaten the basic tenets of international order.

China has indeed become a more active participant in global affairs under the leadership of Xi Jinping, who took office in November 2012. Signs of China’s rising power, though, are a natural result of its growth. More important is what China intends to do with its newfound capabilities. Does Xi want to revolutionise Chinese foreign policy? Stop opening China’s economy? Overturn the international order?

International policymakers must study Xi’s words because he, as the Chinese Communist Party’s (CCP) General-Secretary and head of the Central Foreign Affairs Commission, is pivotal in setting the overarching orientations and strategies of China’s foreign policy. The most authoritative articulation of Xi’s policy agenda is his ‘Report’ to the 19th CCP National Congress in October 2017.

An analysis of Xi’s foreign policy discourse suggests that there may exist more continuity than often assumed between the strategies of Xi and his predecessors. This intersection between past and present is captured neatly in the foreign policy section of Xi’s Report: ‘Following a path of peaceful development and working to build a community of common destiny for humankind’.

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What’s new is that Xi stamped his authority on CCP foreign policy under his signature formulation of ‘building a community of common destiny for humankind’ — although Hu Jintao had used the phrase previously. The ‘community of common destiny’ is basically an international system in which deeper economic integration and political dialogue eases conflict and bolsters security. Xi is proactively ‘building’ this future through an intense focus on the Belt and Road Initiative (BRI) and global governance.

What’s not new is that Xi retains the ‘peaceful development’ strategy articulated by Hu in the mid-2000s, which derives from the CCP’s ‘basic line’ of ‘peace and development’ in international relations that Deng Xiaoping introduced in 1985. In the Report, Xi framed the foreign policy achievements of his first five-year term, including the BRI and the Asian Infrastructure Investment Bank, as ‘new contributions to global peace and development’. He has told Party leaders that the ‘peace and development’ strategy is ‘aligned with the fundamental interest of the country’ and is a ‘fundamental foreign policy goal’.

This ‘peace and development’ strategy reflects the belief that China’s economic development requires a peaceful external environment and cooperative relations with major powers. It replaced the Maoist creed of inevitable conflict between the capitalist and socialist worlds as the CCP’s official ‘assessment of the international situation’. Deng believed this strategy would help China ‘exert a much greater influence’ in a global system that the CCP perceived as dominated by Western powers.

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Xi’s policy statements imply that the overarching concern of China’s foreign policy remains the creation of a ‘more enabling international environment’ for China’s continued development. As China’s interests continue to expand, so too does its desire to participate in global affairs.

But contrary to some recent commentary, it seems unlikely that ‘world power’ or ‘world domination’ are China’s priorities. The CCP observed the Soviet errors of external overreach and antagonism toward the US-led system during the Cold War. China now interacts with the international order like other major states: it complies with the order because to do so serves its interests and tries to influence this order where it does not.

Xi’s Report also reaffirmed Deng’s ‘opening to the outside world’ as a ‘basic national policy’. ‘Opening’ for Deng meant China would integrate into the global economy, enter international institutions and improve living standards in a manner that sustained CCP control.

Xi has insisted that China ‘absolutely must not waver’ from ‘reform and opening’ because it is the ‘propelling force’ behind China’s ‘international status’. He even framed his signature economic policy — a ‘new normal’ focused on consumption, services and markets — as a ‘new structure’ of reform and opening that ‘improves its quality and level’.

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Xi’s continuation of key strategies like ‘peace and development’ and ‘reform and opening’ suggest he may not have changed China’s objectives so much as the means by which the CCP pursues them. Xi’s China is ‘revisionist’ in the narrow sense of hoping for changes that reflect new realities but not in the existential sense of wanting to supplant the current order or global hegemon.

Until recently, White House views on China were quite consistent: the United States would ‘welcome the rise of a stable, peaceful, and prosperous China’ and ‘reject the inevitability’ of ‘confrontation’ if China acted within the international order. But the latest NSS said the ‘engagement’ strategy had ‘failed’.

The endurance of ‘reform and opening’ and of ‘peace and development’ in Xi’s foreign policy discourse imply that engagement is not such a failure. The continuance of these two key foreign policy concepts intimate that, while Xi’s CCP does want to project China’s power, it is still constrained by a belief in the benefit to China of global order and stability.

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US relative power in global affairs is declining, but this trend is mostly the result of other countries’ embrace of the international order built by the United States, which nonetheless retains significant advantages in military, diplomatic, commercial, technological and cultural power. It would best advance its national interests by accepting but proactively managing China’s rise within an improved iteration of this order. We should avoid a ‘new Cold War’.

Neil Thomas is Research Associate in the Think Tank of The Paulson Institute at the University of Chicago.

This article appeared in the most recent edition of East Asia Forum Quarterly, ‘Asian crisis, ready or not’.

Gearing Up for the next Financial Crisis


October 22,2018

Gearing Up for the next Financial Crisis

by Andrew Sheng

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http://www.eastasiaforum,org

In July 2018, the Bank for International Settlements (BIS) asked whether the world was heading towards a perfect financial storm, with the US stock market heading for record highs even as emerging markets like Argentina and Turkey were running into foreign exchange problems. Twenty years after the Asian financial crisis of 1997–98 and the global financial crisis of 2007–08, storm clouds are gathering once again.

Conventional economic models failed to predict the last two crises because the technical definition of financial risk is measured volatility. The global financial crises proved that current models of financial risk, largely used by banks and financial regulators, are totally blind to Black Swan or Grey Rhino events of unmeasurable uncertainty.

This time round, the consensus is that the Grey Rhino (an event with high probability and high impact, but where the trigger is uncertain) is the looming rise in US interest rates in response to a domestic economy that is running at nearly full capacity, with low unemployment levels and signs of creeping inflation. As the BIS has warned, non-financial borrowers outside the United States owe US$11.5 trillion dollars, of which US$3.7 trillion is owed by emerging markets.

Turkey’s recent currency woes are symptoms of domestic policies badly managed, aggravated by the US threat of economic sanctions. Turkey alone has US$467 billion of foreign debt. As global risks rise, capital is flowing back to the booming US stock market and potentially higher interest rate yields. Emerging markets have no alternative but either to allow exchange rate depreciation or defend themselves with higher interest rates that depress their own growth potential. Recently both Indonesia and Hong Kong had to defend their exchange rates through higher interest rates and intervention, respectively.

The tricky thing about US interest rates is that economies with high domestic and foreign debt are vulnerable to tighter liquidity and financial fragility, because their interest rates and credit-risk spreads rise non-linearly. Doomsayers of East Asia’s financial collapse argue that China’s debt of 250 per cent of GDP is the tipping point.

Financial risks are rising not just in China, but globally. Dun and Bradstreet’s Global Risk Matrix, published in May 2018, suggested that US interest rate rises could trigger a fresh debt crisis, sending the global economy into contraction. Echoing this sentiment, the International Monetary Fund’s July 2018 World Economic Outlook argued that rising trade tensions are threatening growth recovery in Europe, Japan and Britain more than predicted. Any overheating in the United States would trigger currency crises for some emerging markets.

In short, we cannot separate financial risks from geopolitical risks. Any unforeseen event arising from a geopolitical miscalculation, climate change disaster, war or cyber-induced disruption could trigger another round of financial crises.

Global financial fragility comes from two structural imbalances. First, the United States is the leading deficit country in terms of trade and debt, owing the world a net US$7.7 trillion, or 39.8 per cent of GDP. This amount is growing because of rising fiscal debt and the low level of national savings. Second, below-par global growth since 2008 has been underwritten almost completely by central bank unconventional monetary policies, which have brought interest rates to an unsustainably low level.

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Market fears that the large central banks will withdraw quantitative easing — QExit — threaten to jeopardise the current frail recovery, which is why US President Donald Trump is also against the Federal Reserve raising interest rates.

If geopolitical risks trump financial risks, what could go wrong in the coming months?

Western analysts think that the trigger will be a Chinese debt meltdown. But Chinese debt is internal debt, as China has foreign exchange reserves equivalent to 188 per cent of its foreign debt and still runs a current account surplus. China’s debt problem is an internal debt issue, very much like that of Japan. While Japanese debt is owed largely to Japanese households, Chinese debt is largely owed by state-owned enterprises and local governments to state-owned banks. In such a situation, China is well positioned to rewrite its national balance sheet, a privilege not possible for more privately dominated markets.

A possible Black Swan (a low probability but high impact event) is an unexpected sharp increase in the yen–dollar exchange rate. Japan is the third largest economy after the United States and China and has been increasing its overseas assets since the 1990s. Between 2007 and July 2018, the Bank of Japan has grown its assets the most among the major central banks (to US$4.9 trillion, or just over 100 per cent of GDP). By the end of 2017, Japan’s gross foreign and net assets grew to US$9 trillion and US$2.9 trillion respectively, equivalent to nearly one quarter of US growth in gross foreign liabilities during the same period.

US trade deficits have been sustained by foreign inflows (which had central bank origins) in which Japan is a major player. During the Asian financial crisis, sharp volatility in the yen–dollar exchange rate caused a dramatic withdrawal of Japanese bank loans from Asia, aggravating a regional liquidity crisis that was already spurred by speculative currency attacks.

What complicates today’s financial fragility is Trump’s attempt to control the US trade deficits. He assumes that bilateral negotiations can reverse the unsustainable growth of national debt, which tripled in the last decade and may grow to 100 per cent of GDP in another decade. But tariffs only increase inflation for the consumer, which would trigger higher interest rates and jeopardise the fragile financial stability achieved through unsustainable monetary policies.

The next global crisis will most likely be triggered by geo-political mistakes. In an age when politicians are proving fickle in their decisions, central bankers are perhaps the only professionals who appear able to do something about financial risks. But since Trump does not care much about professional advice, Asian markets worry less about measurable financial volatility than unmeasurable personality risks.

Andrew Sheng is Distinguished Fellow at the Asia Global Institute, University of Hong Kong. 

This article appeared in the most recent edition of East Asia Forum Quarterly, ‘Asian crisis, ready or not ’.