Malaysia ETF Should Benefit from Asia Free-Trade Agreement

| About: iShares MSCI (EWM)

Risk Factor: Medium to high, suggest 8% trailing stop loss

Catalyst: China-ASEAN Free Trade Agreement begins January 1st 2010

Tip: Pair with Singapore (NYSEARCA:EWS)

Overview and Rationale
On January 1st, 2010, China and ASEAN’s 10 Southeast Asian nations (combined GDP of over $1 trillion) will launch the world’s third-largest free trade area. Trade between China and the 10 states that make up the Association of Southeast Asian Nations has soared in recent years, to $192.5 billion in 2008, from $59.6 billion in 2003. The new free trade zone, which will remove tariffs on 90 percent of traded goods, is expected to increase that number but there will be losers and winners as China applies even more economic pressure on ASEAN manufacturers.

The zone will rank behind only the European Economic Area and the North American Free Trade Area in trade volume. It will affect 1.9 billion people. The free trade area is expected to help Asian countries increase exports, particularly those with commodities that resource-hungry China badly needs.

This brings us to Malaysia which is likely one of the countries that will benefit most from this agreement. The Malaysia ETF (NYSEARCA:EWM) has long been a favorite of mine, though like most emerging markets, appears to be a bit on the expensive side. It is a solid middle-income country with a good demographic profile and a nicely balanced economy. Its 28 million citizens are a diverse lot: 54% Malay, 25% Chinese, 8% Indian and 11% Bumiputra.

  • Malaysian banks were for the most part not affected by the global credit crisis last year since May Bank, Public Bank, CIMB and Malayan Banking were not very involved in derivatives. Due to progress in manufacturing and services, Malaysia in incrementally garnering a Singapore like reputation as a high quality and investor-friendly place to do business. I referred to this trend as Malaysiapore in a recent Forbes Asia column.

  • Importantly, Malaysia is the world’s largest producer of palm oil - a cheaper substitute for vegetable or sunflower oil which are used in cooking. In addition to palm oil and rubber, Malaysia is blessed with an abundance of forestry, fertile agricultural land and minerals like copper and iron-ore. Crude oil and Natural gas were discovered offshore in the 1970s and today Malaysia subsidizes gasoline for domestic consumers and is a net exporter of crude oil.

  • Malaysia is Asia’s third most trade-dependent economy, after Singapore and Hong Kong. Prime Minister Najib Razak, has said that the downturn has exposed Malaysia’s over-dependence on exports. He wants services to account for 70% of GDP in the future, up from 54% now.

  • In 2008, Foreign Direct Investment (FDI) into Malaysia increased by 38% from the previous year. Australia was the largest investor followed by US, Japan and Germany. However this year, FDI plunged to just $13 B from January thru May before rebounding nicely.

  • Since Islam is the largest and official religion in Malaysia, the financial sector follows the principles of Islamic finance and takes a conservative approach compared to banks in other countries. Since Independence from the British, the country has been a Parliamentary democracy with a stable government in most years. Corruption is lower in Malaysia relative to other ASEAN countries such as Indonesia or Thailand.

  • Malaysia has had limited success in innovation based industries like IT, biotechnology, semiconductors. It has been able to excel in the agricultural and commodity sector and more recently is heavily encouraging the growth of tourism, healthcare and education sectors.

Going forward, a recently released World Bank report opined that Malaysia will remain in a “middle-income trap” and fail in its longstanding goal of joining the developed world by 2020 unless it can add value to its economy.

In a comprehensive overview of Malaysia’s economic prospects and policies, the bank said the country had recovered well from the global financial crisis and would grow 4.1% in 2010, after a contraction of 2.3% in 2009.

The report said the medium-term outlook was also promising, forecasting growth of 5.6% in 2011 and 5.9% in 2012, assuming a sustained global recovery from the crisis.

But the report warned that Malaysia’s growth performance was lagging behind its neighbors because of its continuing inability to decisively generate added value to its economy.

The report said, “The economy seems to be caught in a middle income trap — unable to remain competitive as a high-volume, low-cost producer, yet unable to move up the value chain and achieve rapid growth by breaking into fast-growing markets for knowledge and innovation-based products and services.”

Perhaps the competition spurred by this trade zone will take Malaysia to the next level.

Disclosure: None