Asia’s Frontier Markets Stand Out In A Slowing World

Asia’s Frontier Markets Stand Out In A Slowing World
December 17 01:37 2014 Print This Article

In this report on Asia’s frontier economies, we take stock of the recent developments and outlook of Bangladesh, Cambodia, Lao P.D.R., Mongolia, Myanmar, Pakistan, Sri Lanka, and Vietnam.

We continue to see this cohort delivering relatively better performance than EM (emerging markets), subject to only marginally higher risk. The countries in this study have seen strong growth and impressive gains in income in recent years. Indeed, latest projections made by the International Monetary Fund suggest considerable upside going forward for most of these economies. If the present trend continues, we think that by the end of this decade a majority of these countries could well be represented in EM bond and equity indices, with a few of them with investment or close-to-investment grade sovereign ratings.

The transformation of Asia’s frontier economies has been recent but striking. While much more progress is needed before investors can find an array of investment opportunities in these countries, some are already fairly investor and business friendly, and others have begun to realize their rich potential.

At a time when global growth is uneven, financial market uncertainties continue to linger, and headwinds from aging and debt overhang are acting as brakes to industrial country growth, frontier economies are relatively unburdened by debt and are aided by favorable demographics, rising incomes, expanding middle class, and aspirational entrepreneurs. They are also potential beneficiaries of regional trade integration and China’s economic recalibration.

With per capita income steadily moving up from the bottom of the global income spectrum, Mongolia, Vietnam, and Sri Lanka are already in the same income bracket as EM economies like India (USD1600) and Indonesia (USD3400), with Bangladesh, Cambodia, Lao, Myanmar, and Pakistan fairly closely behind.

Combined with rising income, many frontier economies offer scale. Populations of Bangladesh (156 million), Myanmar (51 million), Pakistan (183 million), and Vietnam (90 million) are large enough to offer tens of millions of middle income class consumers both presently and in the coming years. There will be considerable purchasing capacity in this group of countries in the coming years, we are sure.

Multinational companies have already experienced impressive gains in sales in frontier markets. Considering that in ppp (purchasing power parity) terms the per capita GDP of a number of such economies is heading toward the middle-income category, such strong demand should be of no surprise and one should expect the trend to persist.

Recent revision of ppp weights and methodology by the World Bank has in fact raised the income figures for most frontier economies by 20-30%.

One of the reasons behind the appeal for frontier economies is their rising growth rates. The chart below shows that with the exception of Pakistan, all countries in our coverage have been growing on average by 5% or more over the past decade. IMF forecasts are broadly optimistic, expecting the trend to persist in the coming years, with Cambodia, Lao, Mongolia, Myanmar, and Sri Lanka projected to grow by over 7%.

The region’s frontier economies range from very small (Lao) to rather large. If present trend continues, Bangladesh, Pakistan, and Vietnam could be in the USD300 billion GDP range by the end of this decade, while the GDP of Myanmar and Sri Lanka could exceed USD100 billion. At such scale, these economies become serious contenders for a wide range and volume of consumption and high-return investment.

Another advantage of reaching a certain threshold of population and income (say 50 million and USD100 billion) is that the domestic economy reaches, to some extent, a self sustaining domestic demand momentum. While external shocks still matter, a large economy is capable of having wider range of activities and shock absorbing capacity than smaller ones. Also, scale allows certain industries (auto assembly, for example) to form that are simply not feasible or cost effective in smaller economies. With the exceptions of Cambodia, Lao, and Mongolia, all economies in this study are on track to reach such a scale, in our view.

Countries at the low end of the income spectrum tend to have poor institutions, as well as a poor macro policy framework. Typically, when growth picks up, so do excess lending and public spending, which lead to inflation and other macroeconomic slippages. The chart below however shows that with the exception of Pakistan, all countries in this study have seen inflation either steady or declining in the last five years.

There are several reasons to be constructive about the inflation outlook in the frontier economies. First, we see the ongoing correction in global commodity prices marking the beginning of a multi-year trend which will keep a major source of inflation, energy prices, at bay. Second, the decline in commodity prices could spread to broader prices and keep inflation expectations well anchored. Finally, after a few years of alarm, global rice and soybean supplies have stabilized as well, bringing relief. These developments are however, helpful, but not a guarantee of reduction in inflation. The onus will remain on the policy makers to keep subsidies under control, push for reforms to improve the supply side, and pursue monetary and exchange rate policies that are consistent with low and stable inflation.

The macro figures may be impressive, but if the frontier economies are going to capitalize on global investor interest, they have they work cut out to improve the business environment. Their track record in attracting FDI has been poor so far, although the investor interest in Myanmar and Vietnam remain substantial. With the exception of Mongolia, the frontier economies rank poorly in the “ease of doing business” survey. Clearly there is substantial room for improvement.

With only Mongolia, Sri Lanka, and Vietnam offering access to their sovereign bond markets, the space for fixed income investors in the frontier markets is limited. With global interest rates low, it is likely that corporate credit issuance will pick up, as has already been the case with a landmark issuance in Bangladesh. The major area of access remains the equity market, with Bangladesh, Pakistan, Sri Lanka, and Vietnam’s market capitalization combining to about USD175 billion.

In addition to building a stable macroeconomic environment that is conducive to investors, Asia’s frontier countries need to build on recent progress made in ensuring health, education, and overall quality of life. Without improving human living standards, frontier markets will not succeed in delivering outperformance regardless of their potential.

Summary of country views

Bangladesh

Recent moderation of exports and some weakening of remittances have slowed the economy’s upward momentum. Still, the overall macro picture is positive with inflation easing, fiscal deficit under control, public debt declining, and international reserves rising. Unless political unrest returns or global demand contracts in a disorderly manner, Bangladesh is primed for 6%+ growth for the rest of the decade.

Cambodia

High dependency on foreign capital makes the economy perennially vulnerable to external shocks. Still, GDP growth has been strong, and continued diversification of the exports market is a source of emerging strength.

Lao P.D.R.

Investment in mining and power sectors continues to fuel growth, which has averaged a remarkable 8% in recent years. But fiscal challenges may force a modest slowdown in years ahead.

Mongolia

Over-exuberance about mining prospects and poor governance have become drags to the economy. Highly expansionary policies in recent years have resulted to economic imbalances, compromising macroeconomic and financial stability. There is pressing need to re-orient policies towards safeguarding buffers to external shocks.

Myanmar

A newly-opened economy which is enjoying low-hanging fruits of first generation reforms, Myanmar’s potential is substantial but so too are risks to the outlook. Surging capital flows are supporting much needed infrastructure investment, but there is a clear need for further improvement in its institutional capacity to manage those flows. Among the various forthcoming markers of the economy’s integration to the global economy are attaining socio-political stability, improving governance, and strengthening fiscal, financial, and regulatory institutions.

Pakistan

Reasonable economic progress has been achieved lately despite political unrest. A critical IMF program is in place and is supporting near-term prospects. Political uncertainty however remains a key impediment, which could undermine efforts to reinvigorate the country’s economic potential.

Sri Lanka

A major beneficiary of peace dividend and political stability since the end of the civil war in 2009, Sri Lanka has soared to a 7.5% average growth rate in the last five years. Given the present macro situation, an average of 7.0% real GDP growth rate till the end of this decade looks achievable.

Vietnam

We see Vietnam achieving its impressive macro mix target of 6.2% growth and below 5% inflation in 2015. However, debt overhang remains a risk to its growth and stability, while exports are subject to downside risks from China’s slowdown.

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