East to East
Japanese firms are set to ramp up investments in emerging Asia in response to monetary easing at home. While increased foreign investment is good news for the region, economists are already drawing parallels with the bubble that Japan helped inflate in the run-up to the Asian financial crisis in 1997.
Source: Reuters/Sukree Sukplang
Anyone who witnessed the turmoil of the 1997 Asian financial crisis will be well aware of Asia’s vulnerability to global capital flows. Having weathered the storm in the US dollar markets 11 years later, the region may now be facing a new threat.
The Bank of Japan, under the leadership of former Asian Development Bank president Haruhiko Kuroda, announced an unprecedented monetary-easing experiment on April 4, pledging to double the country’s monetary base in a bid to achieve a 2% annual inflation target within two years and lift the country out of a prolonged economic slump.
The move has already weakened the yen and boosted asset prices at home. Economists, however, are warning that its impact may extend much further afield as Japanese investors are forced to look for higher returns.
“We are expecting sizable spill-over effects from what is happening in Japan, but it will take some time before these show up in other markets,” said Rob Subbaraman, chief economist for Asia ex-Japan at Nomura. “Semi-core European bonds, US Treasuries and emerging markets, such as Mexico and Poland, stand to benefit. In Asia, the money will flow to Australia and the more liquid bond markets of Malaysia, Thailand and South Korea. REITs could also benefit.”
HSBC analysts estimate that US$700bn–$1trn could flow out of Japan in the next 12 months, a number they term “conservative”. Government bonds from France to the US rallied in the days after the announcement, especially at the long end, on expectations that the BoJ’s increased purchases of long-dated Japanese Government bonds would push investors into similar alternatives.
An enthusiastic response to Shinzo Abe’s fiscal and monetary easing has stoked risk appetite in Tokyo, sending equities up as much as 50% in the six months since the prime minister first set out his plans last November. That, together with the rally in JGBs, may keep domestic investors from sending their money overseas for the next few months. Foreign investment, however, is an inevitable consequence, according to Frederic Neumann, co-head of Asian economics research at HSBC.
“It takes time – it could be two quarters before the wall of money shows up, but it will come,” said Neumann.
Retail investors are already stepping up their overseas investments through toshin mutual funds, and analysts expect institutional investors to follow as confidence grows that the unprecedented policy is working. Investors may also wait for the upper house elections in July to reinforce the political support for Kuroda’s programme before they step up their risk appetite.
Quantitative easing in the US, dubbed QE, lifted global markets and helped Asia rebound from the turmoil that followed the collapse of Lehman Brothers in 2008, but the situation this time around is very different.
“QE, especially QE1, contributed a lot to Asian capital flows. What we worry about more is the future,” said Changyong Rhee, chief economist at the Asian Development Bank. “In crisis time, using short-term monetary expansion makes sense, but, from now on, it’s not a crisis period, and the ongoing benefit is not so clear.”
The impact on fast-growing Asia could be especially pronounced.
“It is surprising how much reluctance there is to impose capital controls, but you have to wonder how long Asia can afford to take that stance”
The BoJ is not the only central bank pursuing aggressive monetary easing, but purchases equal to as much as 15% of GDP make its programme three times as big as the US Federal Reserve’s QE. The Japanese also have a long record of investing in emerging Asia.
“Now, there is a competition with expansive monetary policy all over the world, and that will be quite a scary thing,” said Rhee. “Eventually, this QE has to slow down or end, and we have to look at how an unwinding of this policy is going to affect Asia.”
Additional investment, while welcome, adds to the risks of asset price bubbles that will eventually burst.
“Investing in Asia is no longer as safe as it used to be. The risk premium is rising,” said Subbaraman. “Symptoms of overheating are becoming more obvious across the region. House prices have risen substantially and debt levels are increasing very rapidly.”
Domestic private credit, combining institutional lending to households and outstanding corporate debt, has increased by 30 percentage points of GDP since 2008 in Thailand, China, South Korea, Malaysia, Singapore and Hong Kong, according to Subbaraman. Increases of that magnitude within five years have led to crises in the past, Nomura has shown.
Parallels with 1997
One worrying precedent for those who remember Asia’s financial crisis more than 15 years ago is the role that Japanese institutions played in inflating the bubble. In the run-up to the Thai devaluation, Japanese banks were the biggest suppliers of credit in Asia, holding more than 50% of all foreign bank loans in Thailand, 39% in Indonesia and 36% in Malaysia, according to BIS figures.
Fuelled by the BoJ’s loose monetary policy, easy Japanese credit helped Asia continue to expand even after the US Fed began tightening in 1994, ending a rally in the dollar market. That suggests Japan’s recent actions may offset any mild tightening that comes should the US begin to unwind QE later this year.
“Japanese banks have, historically, played an important role in transmitting the central bank’s financial impulse to the rest of the region,” said Neumann, pointing to the mid-1990s. “It was also the sudden withdrawal of these institutions in the run-up to Japan’s recession in 1997 that starved Asia of desperately needed liquidity and, hence, contributed to the ultimate bust.”
“Investing in Asia is no longer as safe as it used to be”
Others reject that argument, blaming inadequate foreign reserves and volatile portfolio investments for the crash that started in Thailand. The view that Asia is less at risk today, however, is unanimous.
Thailand, Indonesia and Korea, all heavily indebted in 1997, have become both contributors and recipients of capital. Reserves are stronger and bank supervision is better.
“We learned a lot in 1997,” said Rhee. “One of the main reasons why Asian economies are more resilient compared to 1997 is thanks to the hard lessons – we paid a lot. Outflows out of Japan will continue, but risk management is much better in Asia.”
Even without the BoJ’s programme, preventing Asia’s economies from overheating is becoming a more pressing challenge for the region’s policymakers.
Soaring house prices have become a hot topic – from Singapore to Jakarta – and booming bond markets are adding to rising debt levels across the region. The Philippines and Thailand are struggling to absorb the negative carry costs that come from absorbing foreign exchange reserves.
Policy options, however, are limited: fiscal constraints are politically unpopular, while raising interest-rate hikes risk attracting more capital flows.
The answer for some may be a version of capital controls – a sensitive topic in Asia’s emerging markets, but one that the IMF and other development banks concede may be necessary in certain circumstances.
“It is surprising how much reluctance there is to impose capital controls, but you have to wonder how long Asia can afford to take that stance,” said Neumann. “Some kind of capital-flow management, like a Tobin tax or ceilings for asset purchases by foreigners, or a minimum holding period for investments, could be useful.”
Subbaraman at Nomura argues that other measures will have a bigger impact.
“Asia should be letting its currencies appreciate more. Fiscal tightening can also be useful in dampening capital inflows,” he said. “Rate cuts from here would be a mistake.”
Worth the risk
Now in charge of the BoJ, Kuroda has pledged to be flexible with the easing programme and to guard against unintended consequences. It would be a cruel twist if the man tasked with championing Asia’s development for the past eight years were ultimately to sow the seeds for another Asian crisis, but few expect that to happen.
“South Korea stands out as having more similar exports to Japan than any other Asian country, but we haven’t revised down our growth forecasts for any Asian country because of the BoJ. The direct effect from cheaper Japanese exports will not be so big, and a growing Japan will be supportive for the rest of the region,” said Subbaraman.
Rhee at the ADB is keen to emphasise the positives.
“Japan has a very tight supply chain in Asia. So, when they are looking to increase investment abroad, that could have a very positive impact on some countries – like Myanmar and others who receive FDI from Japan or host Japanese factories.”
If Kuroda’s experiment does reinvigorate Japan’s economy, the increased demand for imports resulting from higher domestic growth will offset the short-term volatility.
That goal, for Rhee, is worth looking beyond the risks.
“Japan has an aging society and recycling of Japanese capital within the region has been one of the major reasons for the dynamism in Asia,” said Rhee. “Many other Asian economies need the money.”
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