While Asian currencies have been quite unstable in recent months, comparisons with the Asian Financial Crisis are over the top, in our view. External positions of the region’s economies are in a much healthier state today. A big problem, however, is that global export demand has remained sluggish for so long, depriving the currencies of a key source of strength.
Quantitative easing (QE) by major central banks after the Global Financial Crisis led to significant portfolio investment flows into Asia. The flip side of this is that the prospect of a monetary tightening by the Federal Reserve has investors fretting about an abrupt reversal of such capital flows and a potential repeat of the 1997–1998 Asian Financial Crisis.
From a fundamental standpoint, however, external positions of most Asian economies today are much more robust than they were in the 1990s, and the underlying external debt dynamics are quite different as well.
A greater risk, in our view, stems from the opening up of capital accounts across the region in recent years, because swings in foreign investors’ money in Asian onshore markets could cause greater volatility in external balances. Overall, we don’t see the risk of a 1990s-style systemic crisis, but currency and asset markets could see a sizable correction if risk aversion escalates. Ultimately, the currencies need to be supported by economic growth.
More Sustainable External Positions
First of all, external accounts of Asian economies are now much more solid than 20 years ago. Back then, overheating domestic economic activity kept current account balances persistently in the red (Display 1). In recent years, by contrast, moderate domestic demand and a prudent monetary and fiscal policy mix have allowed most Asian economies to maintain current account surpluses—no overheating despite favorable funding conditions. This suggests that both external accounts and the investment cycle are sustainable.
Furthermore, Asia has also significantly reduced its reliance on external debt over the past decade (Display 2). Back in the 1990s, the largest source of external liabilities was foreign currency borrowings by corporations. There were also significant asset-liability mismatches. These imbalances made Asian currencies vulnerable to the speculative attacks that triggered a systemic crisis.
Since then, the corporate segment has deleveraged noticeably. Asian economies’ total external debt, relative to gross domestic product (GDP), has been on a sustained downtrend over the past decade and has not seen much of a rebound even under the QE policy regime.
In fact, leverage across Asia in recent years has been driven by the household and public sectors, which are primarily funded domestically in local currencies.
For now, the vulnerability is not in the foreign currency borrowings, unlike the 1990s. It is mainly the swings in foreign investors’ holdings of onshore local-currency bonds, their deposits with local banks, and credit extended by foreign banks’ local subsidiaries.
The increased influence of such factors is a natural consequence of the capital account liberalization that has taken place in many countries in recent years. Asian economies’ external accounts, therefore, cannot entirely escape the whims of the global financial market.
Buffer Against External Shocks
Given the risk of increased volatility in their external accounts, it is essential for Asian economies to maintain a sufficient level of reserves to weather any reversal in capital flows and to anchor investor confidence. Policymakers also need to tolerate foreign exchange flexibility as a shock absorber and automatic stabilizer.
A key difference between now and the late 1990s is the level of foreign reserves. Reserves are now at comfortable levels in most regional economies (Display 3). Back in the 1990s, reserves in South Korea, the Philippines and Malaysia were below the critical threshold—an amount equivalent to three months of imports—but many Asian central banks continued to intervene relentlessly in the currency market in an attempt to keep currencies at their overvalued precrisis levels. In retrospect, that’s a recipe for a hard landing.
The sufficiency of foreign reserves can be evaluated by comparing the reserves with net external financing requirements, which take into account maturing short-term external debt, amortization of medium-term external liabilities, current account financing requirements and foreign direct investments.
By this measure, current reserve levels of almost all Asian economies are sufficient, except for Malaysia (Display 4). And even in Malaysia’s case, about half of the shortterm external debt is the result of Malaysian banks repatriating excess deposits from overseas subsidiaries to their headquarters for liquidity management. It also includes equity injection and retained earnings of foreign banks operating in Malaysia. These are part of normal banking operations and should not be of much concern. Deducting such elements, which amount to more than 40% of foreign reserves, Malaysia’s reserve coverage is not as alarming as the headline ratio may suggest.
Protracted Slowdown a Key Risk
All in all, external positions of Asian economies are much more sustainable than in the late 1990s in view of the current account equilibrium, currency flexibility (which acts as a shock absorber) and foreign reserve coverage.
The real concern is the risk of a protracted period of economic slowdown. Back in the late 1990s, strong export demand in the developed markets, particularly before the technology bubble burst, greatly helped Asia to recover from the crisis and accumulate foreign reserves.
The problem now is that global demand has remained so weak for so long. Exports from many Asian countries experienced a further drop in August, while increases in public debt over the past few years imply that there is not much room for fiscal support (Display 5), and interest rates are already at historical lows. Ultimately, a strong economy will be Asian currencies’ best friend, but we cannot see the light at the end of the tunnel yet.
By Vincent Tsui, Economist, Global Economic Research and Anthony Chan, Asian Sovereign Strategist, Global Economic Research, AB
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