The first cloud hovering over Southeast Asia is the prospect of increased economic uncertainty generated by the macroeconomic difficulties of advanced countries (particularly Europe, but also the United States and Japan) as well as the likelihood of a further slowdown in China. Not only are the Southeast Asian economies among the most open to trade and financial flows in the world, they are also tightly integrated through production networks with China, and via China with U.S. and European markets. Openness to trade and finance has brought immeasurable benefits to Southeast Asia over the last four decades—but by the same token, that openness now makes these economies vulnerable to the actions or, as some would argue, inaction of others.

 

Southeast Asian leaders should be worried. There is a significant probability that Europe, Southeast Asia’s largest trading partner, will go into recession in 2012—and that is if things go relatively well. The trade implications are well known, but may be underestimated (especially if a European recession snuffs out the tentative recovery in the United States). The financial repercussions, on the other hand, are more difficult to anticipate. Global financial markets have become so tightly integrated that a sudden increase in the demand for liquidity following any unpleasant shock or surprise in Europe could easily translate into a capital reversal on the other side of the world. Over the course of the last two years, the liquidity injected into the global financial system by the European Central Bank and the Federal Reserve quickly found its way to the shores of Southeast Asia in search of higher returns. These flows could just as easily reverse direction. This is a movie Southeast Asia has seen three times in recent memory—prior to the Asian financial crisis, then following the collapse of Lehman in 2008, and more recently (to a smaller extent) toward the end of last year. If it were to happen again, the shock to liquidity, interest rates, and exchange rates—and ultimately investment and growth—could prove difficult to manage.  Indonesia has always been the most vulnerable in this regard, given the large share of short-term financial assets owned by nonresidents, although this time around Thailand and Malaysia are also exposed.

 

China’s slowdown, and its rebalancing away from export and toward domestic sources of growth, adds another layer of uncertainty for Southeast Asia. China’s GDP is two and half times that of Southeast Asia and it is now the world’s second largest importer. A misstep by Chinese policymakers as they seek to engineer a soft landing, or unanticipated consequences as the gradual real appreciation of the renminbi works its way through relative prices into balance sheets of enterprises and banks, will have consequences that could easily spill over into Southeast Asia. 

 

Most Southeast Asian economies are less well positioned to handle the economic uncertainties and surprises of 2012 than they were when the global financial crisis hit in 2008. True, inflation is on the wane, external reserves are plentiful, and growth is resilient (despite the knock-on effects of Japan’s Tohoku earthquake and tsunami, Thailand’s devastating floods, and tepid demand in the advanced countries). But most Southeast Asian countries are running out of fiscal space, and this will limit public policy options to boost domestic demand in the event of yet another global slowdown. Moreover, there are serious doubts that China will once again come to the rescue with an outsized stimulus package, given that the government there is still cleaning up the mess left behind from the last one. Finally, with the honorable exception of Singapore, Southeast Asian economies are dependent to varying degrees on commodity and natural resource exports, and commodity prices are likely to be particularly volatile this coming year. 

 

Of course, each country in Southeast Asia is positioned differently. At one extreme is Indonesia, which has the most policy options available, given strong growth (6.4 percent in 2011), low government and external debt burdens, and a small fiscal deficit. At the other extreme is Vietnam, which suffers from periodic bouts of macroeconomic instability (inflation exceeded 18 percent in 2011), continues to run high external current account and fiscal deficits, has a large state enterprise sector in desperate need of reform, and is now suffering from a rising number of unofficial labor strikes. In between are arrayed the remaining economies of Southeast Asia, each with its own strengths and vulnerabilities: Thailand, where growth is going to climb from its nadir in 2011 as the economy rebuilds after last year’s devastating floods that inundated 66 of the country’s 77 provinces; Malaysia, where an expansionary budget in anticipation of an election year is expected to maintain growth at close to last year’s rate; Cambodia and Laos, which continue to be propelled by their abundance of natural resources (including hydro-power) and rapidly growing markets in their neighborhood, notably China and Vietnam; and finally, Singapore and Brunei, Southeast Asia’s small but wealthy states, the former driven by the power of trade, innovation, and high-end services, the latter by the power of oil.¹

There is also reason for concern over growing tensions in Malaysia in the run up to the elections that are expected to be held this year. National elections have to take place by March 2013, but Prime Minister Najib himself indicated that it is likely to be sooner.² Casting a shadow over the whole political process has been the ongoing sodomy case against the leader of the opposition, Anwar Ibrahim. The case against him was thrown out of court on January 9, 2012, but a mere ten days later the attorney general announced that the prosecution had lodged an appeal, thus ensuring the case will continue to cast a pall over the country’s political proceedings, generate increased tensions, and tarnish the prime minister’s efforts to be seen as a reformer.

 

By lodging the appeal, the attorney general has given a new fillip to Pakatan Rakyat—a loose coalition of three parties headed by Anwar Ibrahim that, at the 2008 election, surprised the pundits by garnering a third of the national vote and gaining control of five of Malaysia’s thirteen state legislatures.³ In the absence of the government’s appeal against Anwar Ibrahim’s acquittal, Pakatan’s diverse coalition member parties would have been required to present a common front on the issues most worrying Malaysians today—the economy, inequality, crime, inflation, immigrant workers, and corruption. Instead they have been offered a stick with which to beat the government. It also puts Prime Minister Najib and his incumbent party, Barisan National, on the backfoot, as many Malaysians and most international observers saw the original case against Anwar, and now the appeal, as politically motivated. It also partially negates some of the good press that Najib had been receiving as a result of the acquittal, as well as for the range of reforms he had introduced last year including the repeal of the Internal Security Act that allowed for detention without trial.

 

The dramatic events surrounding the Anwar trial, the as-yet-incomplete process of electoral reforms, together with the inevitability of increasingly confrontational rhetoric, will only fuel simmering tensions that have been building in Malaysia over the past few years. Barisan Nasional, including in its earlier incarnation of Partai Perikatan, has been in power continuously in Malaysia for over 50 years and there is a serious likelihood that if an election were held tomorrow, its majority in the national assembly will diminish. The worry is, however, that if the election proves to be close, it may escalate tensions—and a misstep by either side could lead to violence. Indeed, the country is no stranger to civil unrest—there was a major riot as recently as July 2011 triggered by demands for electoral reforms; and, in recent years, there have been periodic eruptions of ethnic and religious riots, reflecting deep fault lines in Malaysian society. It is critical that matters do not reach such a point in the build-up or immediate aftermath of the election; the alternative will be catastrophic for Malaysia as well as for the rest of Southeast Asia.

The prospect of additional instability, and perhaps even unrest, sweeping Thailand is another potential issue for the region in 2012. Many factors point to this. The first is uncertainty surrounding the monarchic succession. The health of Thailand’s revered 84-year old King Bhumibhol Adulyadej, the world’s longest-serving monarch, is deteriorating.⁴ The prospect of the king’s son, Crown Prince Vajiralongkorn, ascending the throne is deeply worrying to many Thais, including some senior members of the armed forces, who do not view him with the same respect as they do his father, and also see him as being close to former prime minister Thaksin Shinawatra. And then there is also the advancing age of General Prem Tinsulanonda (91 years old and counting), the head of the Privy Council and the most trusted adviser to the king for decades, who has been instrumental in ensuring the monarchy’s central position in Thai society and as an anchor of stability in the country. The second is the return of 111 politicians to active political life on May 31, 2012, after serving a court ban on the now-defunct Thai Rak Thai Party (the predecessor to the Pheu Thai party) that was headed by the former prime minister. Thaksin—a polarizing figure in Thai politics—was Thailand’s prime minister from 2001 until he was overthrown in a military coup in 2006 and currently lives in exile (in Dubai) to avoid serving his sentence on conflict of interest charges handed down in 2008. Several of the 111 politicians banned from active political life are senior and powerful members of Thaksin’s old party—and no doubt expect to to be appointed to key positions in the government—which is now led by his younger sister, Prime Minister Yingluck Shinawatra. And third, there may be government efforts to either amend the 2007 constitution or prepare a reconciliation law either of which would pave the way for Thaksin’s return.

 

Thaksin’s return to Thailand in the foreseeable future is virtually certain. The question is whether it will happen this year or next. It is well known that he already plays an active role in running the country from afar, but he and the Pheu Thai party know this is a poor substitute for being a legitimate presence inside the country to assume day-to-day leadership of the party and the government. But without adequate groundwork, his return will galvanize opposition—not least from the military. Thaksin’s ability to orchestrate his peaceful return will thus require a national compact in which all stakeholders will be protected from legal prosecution for political actions over the past six years, but fashioning such a compact will unlikely be completed in the near future.

A final cloud hovering over Southeast Asia in 2012 is rising tension in the South China Sea following the Obama Administration’s “pivot” toward Asia late last year. The U.S. foreign policy “pivot” could be attributed to a multitude of reasons, but one of them was to protect the freedom of navigation in the Malacca Straits and the South China Sea. The issue was discussed at the East Asia Summit held in Bali on November 19, although the chairman’s statement of the proceedings is silent on the issue. Just days after that meeting, the Philippines protested to China that three Chinese naval vessels had intruded into its waters near the Sabina Shoal in the South China Sea; the Philippines navy subsequently sent its new acquisition from the United States, the Gregorio Del Pilar—a 46-year old coast guard cutter—to protect its interests in that area. And early in 2012, the Indian company Oil and Natural Gas Commission Videsh announced that it was resuming drilling in a hydrocarbon block in Vietnamese territorial waters disputed by China, while at the same time China’s National Offshore Oil Corporation announced that it will send out its first deep water survey vessel to search for oil and gas prospects in the South China Sea.

 

The reality is that with rapidly rising energy demand in China, Japan, and Korea, not to mention the smaller economies of Southeast Asia, the passageway through the South China Sea for energy shipments from the Middle East is increasing in global strategic importance with each passing day. Moreover, the South China Sea itself holds gas and oil reserves of anywhere between 20-200 billion barrels of oil equivalent (in comparison, Saudi reserves are about 260 billion). But there are three other reasons why the South China Sea has become a source of international tension. The first is competing claims between China on the one hand and Vietnam, Brunei, Philippines, Malaysia, and Taiwan on the other over the 200-odd Spratly and Paracel Islands (there is also a competing claim between China and Indonesia regarding an area just north of the Natuna Islands). For the parties concerned, there is little alternative but to arrive at a negotiated settlement, and therein lies the rub—China wants bilateral negotiations, but the countries would prefer multilateral discussions through ASEAN. The second is that China’s interpretation of the rights of international navigation in the extended economic zone would not permit the passage of foreign military vessels conducting surveillance, reconnaissance, and intelligence gathering—an interpretation that is not shared by the overwhelming majority of nations, including the United States.⁵ And the third is overlapping claims to the continental shelf made by China, Vietnam, and the Philippines in response to a call to register such claims by the UN Commission on Limits to the Continental Shelf. 

 

The history of dispute in the South China Sea goes back a long way—certainly back to 1973 and perhaps even earlier. The 2002 Declaration of the Conduct of Parties in the South China Sea (signed between ASEAN and China) imposed a freeze on claims that has by and large stuck, although over the years there has been an escalation in actions to defend rights in the waters surrounding those claims, especially by China. To defuse tension, the parties started negotiating a code of conduct in late 2010—reflecting a change in China’s stance that heretofore had objected to any procedures that reflected a multilateral approach.

 

Nevertheless, there are three developments that suggest that tensions in the South China Sea will only rise: increased technical capability of the China’s armed forces to protect the country’s claims assertively; a rising level of nationalism and self-confidence within China articulated by an increasingly vocal press; and now the foreign policy pivot of the United States, which—with the 60-70 ships and 200-300 aircraft deployed by the United States Seventh Fleet in the Pacific—has the capability of intervening if coercion or conflict erupts. All the indications are that this area of the world could become a flashpoint as the region seeks to arrive at a new equilibrium in the balance of power—an equilibrium that has been upset by the rise of China.

Southeast Asia’s silver lining in 2012 will be the withdrawal of international sanctions against Myanmar and its reentry into the family of nations. Already, the release of over 600 political prisoners and other economic and political reforms (including the re-registration of the National League for Democracy—Aung San Suu Kyi’s party—for the April 1 by-election) have paved the way for the restoration of diplomatic relations with the United States and other western countries. The Myanmar government also recently signed cease-fire agreements with the Karen and Shan armed factions, and although no resolution has been reached with the Kachin Independence Army, the government has pulled back from its offensive. An IMF-World Bank team is in Myanmar and wrapping up its work to assess the state of the economy and the need for international financial support and priority reforms, including the process of unifying the official and unofficial exchange rates.⁶ If President Thein Sein maintains the trend of opening Myanmar economically and politically—and there is reason to believe he will—then, in due course, Myanmar could experience an economic boom as labor productivity and living standards catch up with its Southeast Asian neighbors.

 

While the reasons behind the timing of Myanmar’s political opening up will be debated and studied for years, three factors probably played a key role. The first was China’s large and growing economic presence in the country, which must have worried Myanmar’s generals who had earned their spurs fighting communism and also rubbed up against the country’s fiercely independent streak. The proximate reason for the earlier postponement of the Myitsone Dam was primarily on environmental grounds, an issue that had gained momentum with Aung San Suu Kyi’s support, but it was also seen as an exertion of sovereign authority. The second was the leadership of ASEAN in channeling global aid to Myanmar following Cyclone Nargis in 2008, pointing to a constructive approach through which Myanmar could interact with the world and opening a policy space in which initial, small reform steps could be implemented. And the third was the clear message from the United States that human rights and democracy were important.

 

Going forward, however, it will be important to keep in check expectations about the future speed of economic and political reforms and to be mindful of limits to the government’s institutional and implementation capacity. Economic reforms should be introduced slowly and deliberately, with careful attention to sequencing. Once donor funds start flowing, they should be directed through the budget, subjected to parliamentary oversight, and aligned with country, not donor, priorities. The initial focus will need to be on maintaining macroeconomic stability, increasing rural infrastructure to support agriculture, gradually liberalizing agricultural prices, and developing a governance framework for natural resource management.  Trying to do too much too fast would be wasteful, potentially trigger macroeconomic instability, and perhaps even retard long-term growth. It will be important to recognize that Myanmar’s abundance of natural resources requires a development path that uses this wealth prudently to build sustained and inclusive development for generations to come—a strategy that requires institutional change, sound macroeconomic management, and a long-term vision for the country’s development that is supported by most stakeholders. At the same time, the outside world will need to be patient and realistic in its demands for more political freedoms. In this, the appropriate approach would be constructive engagement, not to foist a foreign political or institutional framework, but to help fashion one that is tailored to Myanmar’s history and culture. And finally, Myanmar’s ethnic problem cannot be overemphasized and will require prolonged internal negotiations that will inevitably have its ups and downs. After all, the ethnic minorities account for a third of the population and half of Myanmar’s states (seven of fourteen). Without a durable subnational framework for its ethnic minorities, appropriate political representation, and adequate voice in national policy formulation, Myanmar’s internal political reforms will count for naught.