Post-2008 global financial crisis (GFC) resulted in the introduction of quantitative easing (QE) by the US in 2008 and thereafter Europe saw huge funds pouring into Asia in search of higher yields, thus boosting Asian GDP growth. The huge inflow of funds could lead to asset bubbles in house prices and the stock markets. We saw a new vulnerability in the strong build-up of external debt in the form of bonds denominated in the local currency. This report aims to examine and explain the importance of REER, domestic interest rates and inflation and their impact on the GDP growth of the Asean-5 (Indonesia, Malaysia, the Philippines, Singapore and Thailand) using “cointegration” to determine shocks caused by the variables that result in short-run deviation from long-run equilibrium. The variables will become policy targets to ease the shocks back to the long-run equilibrium. From our analysis, we found that real effective exchange rate (REER) and domestic interest rates play a key role in influencing the Asean-5 countries GDP while the importance of inflation is evident for Malaysia, the Philippines and Thailand. Thus, the policy targeting is evident on these variables to ensure the misalignment with GDP is corrected, which also means investors should observe these policy targeting variables in tandem with their portfolio strategy. Also, the observation found that Indonesia and Malaysia displayed an undervalued REER while the Philippines, Singapore and Thailand presented an overvalued REER.

A. Background

• The 1997 Asian Financial crisis (AFC) saw countries like ASEAN-5 (Indonesia, Malaysia, the Philippines, Singapore and Thailand) registering strong GDP contraction. These countries’ GDP was dragged by a chaotic financial sector as well as the real economy. Amongst the reasons for a strong beating on their GDP growth was due to their currency management.

• Post-2008 global financial crisis (GFC), which erupted from the US added with Europe on the verge of recession, resulted in the introduction of quantitative easing (QE) by the US in 2008 and thereafter Europe. Huge funds poured into Asia in search of higher yields. These massive capital inflows boosted Asian GDP growth, but could cause problems.

• Underpinned by the huge inflow of funds, the underlying fear is that it could lead to asset bubbles in house prices and the stock markets. The risk of a potential bubble burst remains. We saw a new vulnerability in the strong build-up of external debt in the form of bonds denominated in the local currency. If the bonds held by foreigners are large in value, it raises the vulnerability to the effects of a withdrawal. Besides, the short-term portfolio investors who came searching for good returns could exit should conditions turn unfavourable.

• So, the ASEAN-5 countries which benefitted from capital inflows can become vulnerable to financial volatility and economic instability. But the severity remains unclear. The reason being, after the 1997 AFC, their level of foreign reserves improved strongly with current account surplus, thus able to cushion external debt problems and keep speculators at bay. But their GDP hardly reached the 7%–10% pre-crisis growth rates.

• This report aims to examine and explain the importance of real effective exchange rate (REER), domestic interest rates and inflation and its impact on the GDP growth of Asean-5 countries (Indonesia, Malaysia, the Philippines, Singapore and Thailand) using “co-integration” to determine shocks caused by the variables that result in short-run deviation from long-run equilibrium. The variables will become policy targets to ease the shocks back to the long-run equilibrium.

B. GDP targeting

1. Indonesia

• We found domestic interest rates (+0.003%) have impacted the GDP growth during the quarter under review while the influence from real effective exchange rate (REER: +0.10%) was felt after a one-quarter lag in the short run.

• Following the short-run shocks that caused misalignment with the long-run equilibrium, our analysis showed the speed of reverting to the long run equilibrium was at 4.4%.

• Meanwhile, our analysis suggested both the domestic interest rates (+0.06%) and REER (+2.27%) played a significant role in influencing the GDP in the long run.

• Hence, we expect the policy targeting would focus on REER given its large coefficient and supported by domestic interest rates in a move to support the GDP growth.

2. Malaysia

• Our analysis showed a significant impact from inflation (+1.81%), domestic interest rates (+0.03%), and the real effective exchange rate (REER: +0.24%) during the quarter under review in the short run.

• Following the short-run shocks that caused misalignment with the long-run equilibrium, we found the pace of adjusting to the long-run GDP equilibrium was 69.8%.

• Our analysis suggested inflation (+2.59%), domestic interest rate (+0.04%) and REER (+0.34%) played a significant role in influencing the GDP in the long run.

• We discovered that for policy targeting, the focus will be on inflation given its large coefficient and supported by REER and domestic interest rates in a move to support the GDP growth.

3. Philippines

• Our assessment showed inflation (+0.63%), domestic interest rates (+0.02%) and REER (-0.17%) influenced the GDP after a onequarter lag in the short run.

• From the short-run shocks that caused misalignment with the long-run equilibrium, we found the speed of reverting to the long run GDP equilibrium was 12.4%.

• We discovered inflation (+5.11%), domestic interest rate (+0.13%) and REER (-1.40%) influenced the GDP in the long run.

• For policy targeting, we believe the focus will be on inflation and followed by REER given their large coefficient and supported by domestic interest rates in a move to support the GDP growth.

4. Singapore

• We found domestic interest rates (+0.03%) have impacted the GDP during the quarter under review while the REER (-0.65%) effect was felt after a one-quarter lag in the short run.

• Due to the short-run shocks that caused misalignment with the long-run equilibrium, we found the speed of reverting to the long-run GDP equilibrium was 40.5%.

• In our analysis, we discovered domestic interest rate (+0.08%) and REER (-1.60%) influenced the GDP in the long run.

• Meanwhile, we are of the view that for policy targeting, the focus will be on REER given its large coefficient and supported by money supply and domestic interest rates in a move to support the GDP growth.

5. Thailand

• The analysis showed inflation (+5.46%), domestic interest rates (+0.03%), money supply (-0.93%) and REER (-0.68%) tend to affect the GDP growth after a one-quarter lag in the short run.

• As a result of the short-run shocks that caused misalignment with the long-run equilibrium, we found the speed of adjustment reverting back to the long-run GDP equilibrium was 84.8%.

• We discovered domestic interest rate (+0.04%), inflation (+6.44%) and REER (-0.81%) influenced the GDP in the long run.

• We are of the view that for policy targeting, the focus will be on inflation given its large coefficient and supported by money supply and REER with domestic interest rates acting as a complement in a move to support the GDP growth.

C. Conclusion

• We believe that the undervalued REER is a powerful cyclical instrument as it supports exports and domestic demand. Thus it is able to create more job opportunities and spur GDP growth. But this strategy must be employed with precautions. This explains why Indonesia and Malaysia maintained an undervalued REER with the aim of supporting their respective GDP growth through export competitiveness.

• Thus in terms of policy targeting, we noticed Indonesia’s focus is on REER given its large coefficient and supported by domestic interest rates while for Malaysia, it is on inflation given its large coefficient and supported by REER and domestic interest rates in a move to support the GDP growth.

• But the risk of employing undervalued REER as a strategy to drive the GDP growth is the potential reversal of the GDP growth trend. Relying on undervalued REER will eventually raise the import costs that will start to kick in and add pressure on inflation, business margins and living cost as interest rate hikes start to emerge. It may not augur well for the economy if the adverse knock-on effect becomes too glaring.

• Meanwhile, an overvalued REER will help check inflationary pressure with imported goods becoming cheaper while the high value of currency will force domestic producers to improve efficiency to become more competitive in the global market.

• In this study, we found the Philippines, Singapore and Thailand displayed an overvalued REER. The emphasis on REER is more visible in Singapore, which is not surprising given their focus on monetary targeting to promote the GDP growth. Meanwhile, for Malaysia and Thailand, the focus is more on inflation targeting to ensure inflationary pressure is well maintained while promoting GDP growth with the REER being supportive.

• The danger of depending on overvalued currency is that it will eventually hurt export competitiveness in the global market, which in turn weighs on the export industries, domestic demand, labour market, current account position and GDP.

• Looking at the equity market, it tend to view the undervalued REER positively, especially for an export-dominated country. Exported products become cheaper, which in turn bring in higher cash flows, profits and hence raise the stock prices of the domestic companies. The opposite holds true.

Source: AmInvest Research - 5 Dec 2017