Decoupling
From the region
Singapore aggressively develop its external economy. By 2010, its external economy will hit $500 billion, three times GDP and make up 30 % of national income.
July 2, 2001

By Joe Quinlan and Rebecca McCaughrin in New York
and Daniel Lian in Singapore

Investors should not judge a country by its neighborhood. To that end, while the news from Southeast Asia has been anything but rosy lately, we think Singapore is in far better shape to carve out a new niche.

The city-state has adopted a new model of growth centered on an aggressive outward expansion via M&A, supplanting the old East Asian model that relied on high savings, regional consolidation, and inward FDI investment.

Against this backdrop, we think an exclusively regional focus in Southeast Asia overlooks emerging investment opportunities in Singapore.

Once among the fastest growing regions of the global economy, Southeast Asia confronts a number of structural headwinds to long-term growth, including a more competitive China, a digital/technology divide that separates Northeast Asia from Southeast Asia, and simmering political instability in such nations as Indonesia and the Philippines.

For these reasons and others, investor confidence in Southeast Asia remains tenuous at best. In light of these developments, a consensus has begun to form that a partition within developing Asia has emerged.

On one side are the dynamic economies of Northeast Asia, led by China and the technologically-adept economies of South Korea and Taiwan.

On the other side is Southeast Asia, outmatched by the north in human and financial endowments, as well as technological skills. Not surprisingly, capital flows-both FDI and portfolio flows-have gravitated north at the expense of the south, thereby amplifying Asia's divide.

Straddling this divide, however, is Singapore. Given its first-world amenities and advanced economic capabilities, Singapore has always been an anomaly in Southeast Asia.

Singapore, for instance, weathered the Asian financial crisis rather well, while its neighbours suffered.

In 1998, Southeast Asia excluding Singapore experienced a 9% plunge in real growth. Growth in Singapore was basically flat in the same year.

In 1999 and 2000, Singapore grew by 5.9% and 9.9%, respectively, among the fastest levels of growth in the world. By contrast, the rest of the region grew by only 3.1% in 1999 and 5.1% in 2000, well below pre-crisis levels.

Given this divergence in growth, we think the post-crisis backdrop has only served to accentuate the differences between Singapore and the rest of Southeast Asia.

More importantly, we believe Singapore is well ahead of its neighbours in pursuing an alternative development strategy.

An economic development model that hinged on multinational-led inward investment served Singapore and most of Southeast Asia well in the past.

But, looking forward, we expect Singapore to pursue a strategy that emphasises investment in its more competitive services sector, combined with a policy of globalisation through greater direct investment abroad.

In the process, we believe Singapore could effectively de-couple from the challenges facing Southeast Asia.

Developing a new model of economic development is of critical importance since we doubt the status quo or the models of the past will sustain long-term growth.

At best, continuing with the FDI-MNC development model will only guarantee economic survival for a select few in the region.

Other than a small quantity of FDI focused on basic resources extraction or other resources-based development, we do not believe MNCs will direct much FDI to Southeast Asia.

Rather, we expect Greater China to occupy many layers of the value chain, propelled by its diverse and rich factor endowment and disproportionately large FDI flows.

While we expect the region as a whole to face deteriorating terms of trade given global imbalances, the impact of worsening terms of trade should tilt decisively against Southeast Asia.

Moreover, we do not think the economic development cycle will swing back in favour of Southeast Asia any time soon. That runs counter to the belief that economic development works in cycles.

In our view, economic development is a dynamic, not a cyclical, process. It does not follow the same patterns observed in the business or inventory cycles.

As a case in point, in the 1950s, New Zealand was one of the wealthiest developed countries, Argentina was a success story among middle-income nations, and the Philippines was an aspiring star among the developing nations.

In the last 50 years, the development cycle has turned against these nations. Likewise, ceteris paribus, we believe China's economic advantages will prevent the development cycle from swinging back in favour of Southeast Asia.

We also do not expect Southeast Asia to be propped up by commercial and investment ties to Japan and the US.

While it might make political sense for the US and Japan to ensure that the region becomes a balancing and complementary economic entity to China, we do not see this strategy likely to be executed over the medium-term.

The chief reasons motivating FDI from western MNCs are business opportunities and eventual profits rather than political considerations.

Japan's intensifying outsourcing and the gradual shift of its FDI and trade ties toward China probably mark the beginning of a protracted period of stronger economic ties with China at the expense of Southeast Asia.

Against this backdrop, Southeast Asia stands at a critical juncture.

Just as Singapore provided its neighbours with a successful model for stimulating growth in the 1990s, again, the tiny city-state is at the forefront in crafting a new strategy for responding to the challenges afflicting the region a decade later.

In the first part on Singapore De-coupled s Forum, we dwelled on the failure of the old East Asian model to alleviate the challenges that Southeast Asia as a whole and Singapore in particular face in achieving sustainable growth.

We argued that as a nation with limited resources, constrained by political instability in the surrounding region, and at risk of losing market share to lower-cost-producing Chinese stalwarts, Singapore must aggressively pursue a new model of growth.

In this second part, we explore how Singapore has reinvented its development model via an aggressive outward M&A strategy, combined with investment in its more competitive services sector and a seismic shift in the corporate landscape.

Long at the receiving end of FDI inflows, Singapore firms have recently become more proactive in pursuing cross-border acquisitions and partnerships.

In contrast to other countries in the region, Singapore has experienced a surge in outward announcements and completions.

Gross outward completions hit a record $9.4 billion in 2000, and announcements in the first five months of this year are already nearly twice as high as record announced outflows seen in 1999 and 2000.

This sets Singapore apart from the region, and more broadly, from most emerging markets, where the direction of flows remains decidedly inward.

While emerging markets have been involved in a few high-profile deals this year, they have generally been the targets, not acquirers in those transactions (i.e., Mexico's Banacci, South Africa's De Beers, Hong Kong's Dao Heng Bank).

Most striking about the rise in M&A activity seen in Singapore is the gloomy backdrop against which it is occurring.

Global cross-border M&A announcements in the first five months of this year declined over 40% relative to the same period last year, while Singapore's outward announcements have increased five-fold compared to last year (which was itself a record-high level).

While no other emerging market year to date has proposed a cross-border acquisition over $5 billion, Singapore has two.

In March, Singapore Telecommunications bid $8.5 billion to acquire Australia's Cable & Wireless Optus. If completed, the combined company would see half its revenue originating from outside Singapore, turning the city-state's largest company into a major global firm.

In April, DBS Bank announced its $5.4 billion bid to purchase Hong Kong's Dao Heng Bank.

Moreover, in an effort to establish more competitive firms outside its regional reach, Singapore has begun to seek out targets beyond its traditional destinations (i.e., Malaysia, Thailand, Hong Kong, Taiwan).

Some of the larger transactions this year have involved targets in Australia, UK, Belgium, and Switzerland. Historically, M&A activity has softened when share prices decline and economic growth turns sluggish.

Singaporean firms, however, have not been dissuaded by the expectation of a slowdown in growth to 4.1% this year, down from the rapid clip in 2000 of 9.9%, nor by the 20% drop the SGX (All Sing-Equities Index) has experienced since the beginning of the year.

Part and parcel of dismantling of the East Asian model, the Singapore government recently undertook reforms that liberalised the financial services, telecom, and transport and utilities sectors, which has in turn spurred Singapore's cash-rich firms to reinvent the way they do business.

Prior to 1998, most family-controlled businesses dismissed the prospect of merging, viewing it as a loss of ownership rather than a means to expanding.

Deregulation spawned a number of smaller, but equally competitive firms that drove Singapore's most conservative family-controlled firms to venture into partnerships with one-time rivals in order to compete.

As testament to the changing corporate landscape, domestic consolidation, which is often a precursor to cross-border acquisitions, rose steadily from 1990 to 2000.

On an annualised basis, domestic consolidation has since slowed, perhaps as combined firms have exhausted resources in the city-state and now seek them abroad. Cross-border M&A data corroborate this conclusion.

While the absolute level of outward M&A is still nominal compared to global flows, as a share of GDP, Singapore's outward completions hit 10.2% last year, far more than developing (0.7%) and developed (4.6%) economies alike.

Empirical research deems takeover activity above 2-3% of GDP as unusual and anything in the range of 10% of GDP extraordinary (see Golbe and White, 1988).

With this year's outward announcements running at an annualised rate of $37 billion-nearly equal to the level of outflows the economy has seen in the last 10 years combined-2001 could turn out to be Singapore's Age of the Deal.

Southeast Asia is clearly at a crossroad. Beyond the cyclical weakness of the global economy, the region confronts a number of structural variables that could temper growth and development in the years ahead.

Although hardly immune to the simmering problems of the region, the divide that separates the city-state from its regional neighbors has deepened over the past few years.

We expect this trend to continue, which means investors should use greater care when speaking of "Southeast Asia." Singapore will never be completely de-coupled from the region, but the city-state no doubt functions as if its future lies elsewhere.

In the short term, the international investment community has adopted a skeptical attitude on Singapore's push overseas as they believe Singaporean companies have paid too much for their overseas assets, and that the returns on the external economy have not been commensurate.

However, we believe such skepticism is based on rather short-term valuation models that miss the longer-term growth potential offered by the vast external economy Singapore is rapidly building.

International portfolio funds destined for the Singapore market are increasingly invested in companies that derive a significant share of their earnings from abroad.

By the end of 2010, we estimate that the external economy of Singapore will grow to approximately $500-550 billion, or three times nominal GDP.

If Singapore can achieve a nominal annual return of 10% from its external economy, the net factor income from abroad could contribute as much as 30-35% to national income.

Investors exposed to the Singapore market could then potentially achieve global returns and diversification in a prudently managed local macroeconomic and regulatory environment.

(The article is distributed by Morgan Grenfell (Asia) Limited on June 28.)