Corruption, Crony Capitalism and Growth

This is slowly making the rounds (excerpt):

Where Crony Capitalism Rose and Prosperity Fell (and Vice Versa)
By Matthew A. Winkler

With populists emulating autocrats from Azerbaijan to Zimbabwe, free markets are being forced to confront crony capitalism.

One response is visible in the reversal of fortunes of Malaysia and Indonesia. The two nations still wrestle with the politics of ethnicity and religion at odds with the capitalism of market competition….

…But the historic advantage that Malaysia, with just 30 million people, has enjoyed over its Southeast Asian neighbor of 250 million is disappearing amid a barrage of corruption allegations challenging Prime Minister Najib Razak….

…Global investors aren't waiting for a legal verdict. They're already making Indonesia the favored regional economy at Malaysia's expense: The relative value of every financial asset in the young democracy is increasing at an unprecedented rate after decades of authoritarian rulers….

…Indonesia's rupiah has strengthened 26 percent against the Malaysian ringgit since June 2014, the biggest rally so far in the new century, according to data compiled by Bloomberg.

During the past three years, the Indonesian economy also has been growing at a faster rate. As recently as the second quarter of 2014, Indonesia's gross domestic product expanded at an annual rate of 1.56 percentage points less than Malaysia's. Today, the trends are reversed, with Indonesia's GDP advancing 0.71 percent faster than the Malaysian economy.

The divergent growth rates are reflected in the stock market, where the 539 companies in the Jakarta Stock Exchange Composite Index gained 287 percent during the past 10 years, according to Bloomberg data. That's more than three times the 95 percent return during the same period for the 30 companies that make up the FTSE Bursa Malaysia Kuala Lumpur Index, and amounts to Indonesia outperforming Malaysia by 7.6 percent each year. The gap has grown more pronounced since 2014, as the Indonesia market has outperformed Malaysia's by 9.3 percent annually.

In the bond market, Indonesian government securities provided a total return (income plus appreciation) of 100 percent since 2010. That's 6.5 percent per year more than Malaysian government debt, which returned 30 percent over the same six years, according to Bloomberg data. Since 2014, Indonesia's advantage has widened to 7 percent.

The inferior performance of Malaysia's debt is reflected in the country's deteriorating fiscal outlook during the past two decades. Since 1997, when both countries saw their surpluses transformed into deficits, Indonesia kept its budget close to balanced with an average annual deficit of 1.32 percent of its GDP, according to data compiled by Bloomberg.

The creditworthiness of Malaysia worsened, with the deficit exploding to 4 percent of GDP. That's another way of saying that business and investment conflicts of interest don't pay.

The argument sounds plausible, and no doubt confirms a lot of people’s prior beliefs – that corruption and crony capitalism inhibit growth, and reducing one or the other (ideally, both), would result in faster economic progress.

Only problem is, all the evidence to back this up is pretty weak and can be pretty much explained by other factors. In other words, Mr Winkler is wrong. This is just another version of the “1MDB caused the Ringgit to weaken” story.

But lets take it step by step:

1. The MYR has weakened against the IDR

True, but…this ignores two things. Malaysia is a net energy exporter, while Indonesia (despite being an oil producer also) is a net energy importer. If you take away LNG exports, very nearly 2/3rds of Malaysia’s trade surplus would disappear. The 70% drop in energy prices from June 2014 onwards would therefore be massively negative for the Ringgit and positive for the Rupiah, and in fact that is exactly what we’ve seen. Cross reference with the currency of any other major energy exporter, and I think you’ll see the same.

The second point here is that, even with the large relative movement we’ve seen over the past couple of years, the Ringgit is still up 35% against the Rupiah since 2000. At the peak (October 2014), the Ringgit was up nearly 70% over the past decade and a half.

2. Indonesia is growing faster

This is the strangest argument, out of all the strange arguments used here. In economic theory, low income countries should “converge” on the living standards of high income countries. This implies that low income countries should have faster growth rates, and the bigger the gap in living standards, the faster the growth rates. To illustrate, say I have one apple and you have two apples. If I add one apple for me, that’s 100% growth, but the same apple for you would be 50% growth.

Based on the latest IMF WEO database, Malaysia had a GDP per capita level roughly 3x higher than Indonesia in 2014. Incremental growth is harder for Malaysia than it is for Indonesia – they’re coming from a lower base. In fact the correct question here is not why Indonesia has overtaken Malaysia in economic growth, but rather why was Indonesia growing so slowly in the first place? By rights, they should be growing consistently higher than Malaysia and well above 5%.

3. Stock market performance

This is pretty much identical to the argument above. Faster economic growth implies faster earnings growth, and even if you assume constant earnings multiples, stronger stock price performance. The only other thing I’d add here is valuation – Malaysia had one of the highest market PE ratios in the region, and still does (the Philippines has caught up). What this means is that Malaysian stocks are fairly “expensive” relative to their earnings level. That limits investment into the market, because the upside is likely to be more limited.

4. Bond market performance

This argument is fairly ridiculous – Indonesia’s bond market offers higher returns, because it’s higher risk. At BB+ (S&P rating), Indonesia is just below investment grade, and as a result, yields are higher than they are in Malaysia (at A-). I’d bet that the currency factor was a big contributor as well. If you’re using bond performance as a barometer, Germany (10yr bond yield at 0.2%) and Japan (10yr bond yield at 0%), must be hopelessly corrupt banana republics.

5. Government borrowing

This is pretty much the only argument here that I think might make sense…but there’s some nuance to this that people should really know. Indonesia managed to bring down their government debt to GDP ratio from an eye-watering 87% in 2000 to a low of 23% in 2012. Something to make fiscal conservatives proud, and maybe something Malaysia should emulate, right? Rein in government spending, balance the budget, everything should be hunky-dory, and investors should be rushing in because they are confident.

Except Indonesia’s government debt only went down in abosolute terms in 4 of the last 16 years. In fact, since 2010, debt has been rising steeply with a CAGR of 12.7%, compared to Malaysia’s debt rate of growth of only 8.7%. Similarly, while Malaysia’s budget deficit has been slowly declining since 2010, Indonesia’s has been increasing. That kind of undercuts Mr Winkler’s argument – Indonesia has not in fact been any more fiscally responsible than Malaysia has been.

Moreover, Indonesia’s success in bringing down the debt ratio can be boiled down to two things: growth and inflation. Strike that, that should read very high inflation. The average inflation rate in Indonesia since 2000 was over 7%, or nearly 3 times higher than Malaysia. While BI has done a great job in taming inflation in Indonesia, most of the debt “repaid” has largely been through the inflation “tax”.

Lastly, Indonesia doesn’t have the kind of local institutionalised funds that Malaysia has. As a result, a lot of government debt is denominated in USD, something which Malaysia and Malaysian companies have been careful to avoid since the Asian Financial Crisis. The Malaysian government in fact has a hard absolute limit on foreign borrowing since the 1980s. The Indonesian exposure to USD debt is a point of vulnerability, because of the currency mismatch between revenue (taxes in Rupiah) and obligations (debt in USD) – another reason why debt yields (and thus returns) are higher in Indonesia, to compensate investors for the higher risk of default.

6. Corruption, crony capitalism and growth

My final point is that it’s really very, very hard to show that corruption affects economic growth. I just can’t find any evidence of it globally (see here), despite the popular conception that it surely must have an impact. This article is a case in point – all the “evidence” gathered can be attributed to much larger, more fundamental factors that affect a complex RM1.5 trillion economy.