Fear and the Fed
Abenomics, Fed tightening and China’s worsening economy are fuelling currency volatility across Asia. However, despite slumping exchange rates, a repeat of the region’s 1997-98 financial crisis is not on the cards.
Asian currencies have been under pressure for the past three years since Japanese Prime Minister Shinzo Abe made yen devaluation an axis of his strategy to defeat deflation. More recently, the slowdown of the Chinese economy, the related slump in commodities prices and expectations of a coming rise in US interest rates have added to the strain.
Currencies such as the Indonesian rupiah have fallen to levels against the dollar last seen during the Asian financial crisis of 1997-98, raising fears of another cycle of devaluations and foreign debt-repayment problems. Back then, managed currency peg regimes collapsed across Asia and exposed the region’s reliance on short-tenor dollar funding, which became impossible to service with devalued currencies.
Fortunately, both the unfolding scenario and its likely consequences appear to be quite different this time.
“Emerging-market assets are under-owned by the global investment community rather than over-owned, and that will mitigate the risk of capital flight due to Fed rate normalisation.”
After decades of deflation and slow economic growth, “Abenomics” has set itself the task of pushing up Japan’s inflation rate to around 2.5% on the back of an orchestrated weakening of the yen, accompanied by a massive stimulus package rooted in quantitative easing via government purchases of bonds and other financial products.
The policy has succeeded in bringing down the yen by around 45% against the US dollar since inception, but it has also prompted a regional round of competitive devaluations, as Asian countries, deeply reliant on trade, feared losing out to Japanese exports.
In addition, Asia has been hit by weaker global trade and falling growth in China, which had been the region’s growth locomotive for the best part of three decades. At the same time, the US Federal Reserve is about to raise short-term interest rates after almost a decade of standing pat.
Sameer Goel, head of Asia macro strategy at Deutsche Bank in Singapore, acknowledges that Federal Reserve rate hikes have historically led to a cheapening of emerging-market currencies and credit, but sees little risk of another Asian financial crisis.
“There are some crucial differences versus the situation in 1998. In the first place, the external positions of Asian countries are in far better shape, particularly the current accounts and their reserves are far higher than they were prior to the Asian financial crisis,” said Goel.
“More importantly, back in the late 1990s, many Asian countries were running peg regimes to the US dollar. Of course, you could argue that, in Asia, most currencies are run on a managed floating basis and have been gradually cheapened to reflect cyclical economic weaknesses, but that is an entirely different regime from pegging.”
Another signal difference between now and the late 1990s in Asia is that the “double mismatch” of currency and tenor, largely blamed for the Asian financial crisis, has been significantly reduced as local debt markets have grown in size and global investors have moved into local currencies. While Asian governments found themselves struggling to service US dollar debt in the late 1990s, some 45% of Malaysian domestic currency debt is now in the hands of offshore investors, with the figure at around 35% for Indonesia.
These markets have benefited from the global hunt for yield in the face of historically low interest rates in the US, the eurozone and Japan. Moreover, they have proved able to offer competitive funding rates for regional companies versus US dollar or euro debt, while still delivering similar sizes.
Still, the popularity of Asia’s domestic markets has given rise to fears that Fed normalisation will lead to mass capital flight from the region as cash is repatriated to a US dollar market that finally begins to offer a decent yield return.
“It’s important to realise that there has been a secular trend towards diversification among international asset managers and that Asian equities and debt have been added to portfolios,” said Goel.
“Of course, there is a risk of capital flight when you have domestic bond markets held in large volume by international investors, but I would argue that emerging-market assets are under-owned by the global investment community rather than over-owned, and that will mitigate the risk of capital flight due to Fed rate normalisation.”
Another element that is crucial in gauging the vulnerability of Asia’s currencies is central bank policy. To take India as an example, back in 2013 during the “taper tantrum”, when Asian debt markets wobbled on of fears of a withdrawal of the Fed’s quantitative-easing programme, the Indian rupee took a major hit, losing around a quarter of its value against the US dollar in a matter of months.
That meltdown was ascribed to India’s current account deficit, and it was feared that prolonged weakness in the rupee would trigger mass default among Indian companies, which had offshore liabilities and a severely compromised domestic currency.
However, two years on, the rupee has recovered, together with the Indian economy, thanks to the Reserve Bank of India’s astute policy moves.
“The country has successfully calibrated the demand and supply of US dollars, accumulated over US$100bn of reserves and reduced the ratio of the current account deficit to around 1.5% of GDP, which is very manageable. Inflation is also under control, so I think they have eradicated the risk factors, which hit the rupee so hard in 2013,” said Goel.
A similar policy concentration is afoot in Indonesia and Malaysia, which have seen their currencies hit hard over the past few years, thanks in part to weak commodity prices, with both countries heavily reliant on commodities exports. This year, both the ringgit and the rupiah have hit lows not seen since the Asian financial crisis, but both countries continue to post strong economic growth, relatively benign debt-to-GDP levels (at around 27% in Indonesia and 51% in Malaysia) and ample forex reserves.
In response to the currency weakness, Indonesia and Malaysia have wheeled out economic packages to encourage domestic and foreign direct investment and staunch the bleeding.
In September, Indonesia announced a stimulus package aimed at accelerating FDI, including fast-tracking approval for industrial parks and offering tax discounts on forex earnings from exports. This will bolster the supply of dollars onshore and, hence, take some pressure off the rupiah.
In Malaysia, the government plans to inject billions of dollars into financial markets via ValueCap, a state firm aiming to invest M$20bn (US$4.6bn) in some of the country’s worst-hit stocks.
The country is reeling from a scandal surrounding state-owned investment company 1MDB, with claims made in local and international media that Prime Minister Najib Razak received funds totalling around US$700m into his personal bank accounts, something the leader staunchly denies, claiming the funds were a political donation.
This idiosyncratic input helps explain some of the ringgit’s weakness, but most regional investors see the currency’s malaise as part of the overall currency weakness now afflicting the region.
Perhaps, the bigger story overshadowing Fed rate normalisation is the outlook for China’s growth and the Beijing’s policy on the renminbi.
The shock devaluation of the renminbi over the summer again added to the woes of Asian currencies, but many market observers see that as a one-off move and believe China’s over-arching ambition is to see increasing internationalisation of its currency, beginning with inclusion in the International Monetary Fund’s Special Drawing Rights basket.
“China’s weakening GDP growth will be a factor, which drags down growth in Asia’s economies, particularly in countries that have over-leveraged into the commodities boom,” said a Singapore-based foreign exchange trader.
“In the long run, the Chinese want reserve currency status for the renminbi and, so, I don’t see secular weakness for the unit. You could argue that the worst is over for Asia’s currencies and that Fed rate normalisation and all that entails for asset prices is already factored in.”
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