China's Economic Pain Will Power Southeast Asia's Gains

8 MINS READFeb 25, 2019 | 10:30 GMT
A Chinese worker checks wheels on Jan. 28, 2019, at a factory in Lianyungang, Jiangsu province.

A Chinese worker checks wheels on Jan. 28 at a factory in Lianyungang, Jiangsu province. Companies looking to relocate outside China have been expanding into Southeast Asia for the past several years.

(STR/AFP/Getty Images)
  • The U.S.-China trade war is speeding up the relocation of low-end manufacturing investment outside China into parts of Southeast Asia.
  • A highly effective tech supply chain makes it hard for companies to diversify their own beyond China's but political considerations could prompt some Asian tech giants, especially those from South Korea and Taiwan, to look elsewhere.
  • The U.S.-China trade war and China's weakened export sector will continue to place a drag on Southeast Asian economies, inflicting greater pain on countries highly dependent on trade or with high current account deficits.

Editor's Note: This assessment is part of a series of analyses supporting Stratfor's upcoming 2019 Second-Quarter Forecast. These assessments are designed to provide more context and in-depth analysis on key developments over the next quarter.

As the global trade and investment picture continues to evolve, Southeast Asia has gained momentum as a top destination for investors seeking lower-wage manufacturing labor, high returns on capital and infrastructural investments, and opportunities to profit from the region's sizable and fast-growing domestic markets. The ongoing trade battles between the United States and China are set to push even more manufacturing investment into the region. The surge will be unevenly distributed, with some countries gaining more than others in the long term. However, in the short term, Southeast Asia's emerging economies will all have to contend with the supply chain disruptions caused by the U.S.-Chinese trade war, an extended slowdown in the Chinese economy and weak global demand for Chinese manufactured goods — as well as their individual internal structural issues.

The Big Picture

Over the past five years, Southeast Asia has emerged as a magnet for foreign investment. Companies looking to relocate outside China have been expanding into the region for years, attracted by its low-wage labor force, export-oriented economies and infrastructural development needs. The U.S.-China trade war is accelerating the pace of change. Still, Southeast Asian countries contend with internal structural issues and the effects of changing global trade patterns.

Stratfor has long identified the economies of Southeast Asia as emerging magnets for global investors and manufacturers as China slowly moves away from a low-wage economy and its era of high growth fades. By 2017, annual foreign direct investment into Southeast Asia had nearly doubled from a decade earlier, to $137 billion. This exceeded the $135 billion in foreign direct investment into China in 2017 and accounted for one-fifth of the total global investment into developing economies. In 2018, foreign direct investment into Southeast Asia continued to outrank investment into China, rising to $145 billion. The increase occurred even as global FDI overall fell 19 percent from 2017 levels. The decline has been attributed in part to tax reform in the United States, which last year encouraged U.S. companies to repatriate billions of dollars in foreign earnings. It also has been attributed to the trade battles between China and the United States. FDI in Southeast Asia arguably rose as the threat of higher U.S. tariffs prompted companies with operations in China to look to nearby locations.

Charts showing the flow of foreign direct investment into Southeast Asian countries, 2010-17.

Foreign direct investment into Vietnam increased 9 percent in 2018, primarily into its manufacturing and processing sectors. Singapore and Indonesia led the region's tech-related investment. Singapore also draws financial investment into Southeast Asia and is the investment gateway into the rest of the region. Investment into Indonesia's e-commerce and digital economies made up 15 to 20 percent of its total foreign direct investment. Manufacturing investment into Thailand largely recovered from its fall in 2016 (a result of cyclic political instability) and also grew robustly in the Philippines and Malaysia. (China contributed to a third of Malaysia's manufacturing investments in the first nine months of 2018.) As in previous years, roughly 80 percent of FDI into Laos was in mining and hydropower. In Cambodia, investments into its garment sector, a traditional area of FDI into the country, declined while those into electronics and equipment manufacturing increased. Notably, financial and real estate investment into Cambodia rose by about 20 percent, with the majority of the investment coming from China. Together with Myanmar, these developing economies continued to experience an increase in overall investment into a wide range of manufacturing sectors, including garments, equipment, food processing and even automotive.

New Opportunities

The trend of increasing manufacturing investments into Southeast Asia has been underway for at least five years, driven in part by China's attempt to phase out its own low-end manufacturing. But the disagreements between China and the United States over trade, coupled with China's prolonged economic slowdown, have focused new attention on Southeast Asia. Anecdotally and according to business surveys, companies see Southeast Asian countries as top destinations for expansion, investment returns and supply-chain diversification beyond China. The trend will gain steam in the lower-end manufacturing value chain as China's economic transition continues.

Meanwhile, China remains an attractive investment destination thanks to its effective and integrated electronics and tech supply chains. China possesses more than half of the world's manufacturing capacity for electronics, with a supply chain sprawling across Asia. But China's domestic market for items such as automobiles and cellphones is peaking, and beyond their trade war, long-term economic competition between China and the United States will motivate global companies to look elsewhere to supplement their heavy presence in China. Apple Inc., for instance, announced in December that it will begin assembling its top-end iPhones in India; the decision coincides with an anticipated slowing of sales in China. Several Japanese motor suppliers such as Nidec and Panasonic have also shifted production from China to Thailand and other countries.

A chart showing the sale of goods to the United States through China as a percentage of GDP in 2017.

Further, China's long-term economic slowdown may give governments of strategic Chinese competitors such as South Korea and Taiwan additional motivation to lessen their supply chain exposure from China. For example, as its relations with Beijing deteriorate and the trade war affects its tech firms, Taiwan has both encouraged and aided its native technology companies to shift their production either back to its shores or to parts of Southeast Asia as part of its revived "Southbound Policy." Likewise grappling with China's slowing economy, South Korea recently renewed its effort to diversify its trade relationships. In part, Seoul aims to negotiate bilateral free trade deals with the Philippines, Indonesia and Malaysia.

Past efforts by Taiwan and South Korea to lessen their economic dependence on China have achieved underwhelming results. Nonetheless, there is gathering impetus to expand manufacturing into Southeast Asia. Some countries will benefit more than others, of course, but the expansion generally will be felt across the region.

Prospects and Vulnerabilities

With its stable political environment, favorable average labor costs and a supply chain relatively integrated with China's under the so-called China Plus One strategy, Vietnam has emerged as a key beneficiary of the increasing investment focus on Southeast Asia. In January, Vietnam's foreign investment had surged 52 percent from the year earlier. Notably, the month's increase in science and tech investment shows that Vietnam has upbeat prospects as it seeks value-added investment in high-tech, electronics, and information and communications technology. Still, Vietnam will have to aggressively update its supporting industries and labor force to keep its edge. Likewise, the quality of its infrastructure and its adaptive workforce puts Malaysia in a favorable position to reap the benefits of electronics and machinery companies relocating from China in the coming months, while the country looks to expedite the long-delayed process of upgrading its industrial value chain. Both Vietnam and Malaysia, however, are vulnerable to fallout from the ongoing trade war, tight global liquidity and other external volatilities, given their reliance on trade and — for Vietnam in particular — their limited fiscal and monetary policy buffers.

A chart showing Southeast Asian export destinations, 2017.

Thailand, Indonesia and the Philippines have reported sharp investment increases in a variety of manufacturing sectors over the past two years, but political uncertainties could stall their momentum in the short term. In Thailand, the restart of electoral politics for the first time since a military coup in 2014 has revealed deep divisions between the monarchy and military on one hand and the popular opposition on the other. While Thailand has weathered previous political storms and remains a regional auto and electronics manufacturing hub, the government will have to avoid tamping down business sentiment as competition from its neighbors intensifies. The task may be even more difficult for Indonesia as it heads toward general elections in April amid falling investment, a struggling export sector and a rising current account deficit. Presidential challenger Prabowo Subianto has criticized incumbent Joko "Jokowi" Widodo's investor-friendly reforms and preference for close trade and infrastructural cooperation with China. With a tight race likely giving more ambitious investors pause, Indonesia will face hedging against external shocks more difficult.

Despite generally favorable investor sentiment for Southeast Asia, China's economic slowdown and the weaker global demand for its goods will put a drag on most Asian economies. With the exception of Vietnam, which reported a 7 percent growth in its gross domestic product in 2018, most major and several emerging Asian economies such as Thailand's and Malaysia's have reported a relative slowdown in economic growth from a year earlier. The effect is particularly notable in countries with highly integrated supply chains, such as South Korea, Singapore, Taiwan and Malaysia. Coinciding with falling Chinese exports in December, emerging economies such as the Philippines, Thailand and Indonesia also reported a monthly decline in exports of 12.8 percent, 1.7 percent and 4.6 percent, respectively. Even Vietnam reported a 1.2 percent decline in exports in January 2019. Without a positive resolution to its trade war with the United States, China's deflating export sector and the slowdown in electronics trade — equivalent to 25 percent of the region's total exports in goods — will continue to burden Southeast Asia's economies. The burden will inflict greater pain on countries more dependent on exports and with higher current account deficits.

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