Lessons learnt

IFR Review of the Year 2012
14 min read

A lot of water has passed under the bridge since the Asian financial crisis 15 years ago, and although there is still plenty of work to be done, the region has made spectacular progress. The current turmoil in Europe has left Asia looking like a safe bet.

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Fortress Asia has held fast since the global financial crisis struck in 2008, but there is certainly no room for complacency. While another full-blown crisis seems unlikely, a less severe shock is certainly possible.

Somewhat bizarrely, Asia’s resilience has made it both a haven from the turmoil in more developed markets and a destination for investors looking for decent returns and a credible growth story. Huge amounts of money have flowed into the region over the past 12−18 months.

This is a positive story, but this inflow of foreign capital is also eerily reminiscent of the “hot money” that poured into Asia in the run-up to the region’s financial crisis. Likewise, 2012 has been a record year for US dollar bond sales in Asia, but short-term foreign debt − both sovereign and corporate − was a major contributing factor to the devastation of 1997. Poor corporate governance was also a feature of the Asian turmoil 15 years ago, and from events surrounding companies from Sino-Forest in China to the Bakrie Group in Indonesia, scandals are also back.

Could a repeat of the Asian crisis befall the region again? There are some disturbing similarities – and some reassuring differences – between Asia today and 15 years ago.

In fact, much of the region’s present-day strength can be directly attributed to the lessons learnt and reforms undertaken in the wake of the 1997 turmoil.

Asian governments, for one, learnt a great deal. Many have since adopted floating exchange rates, so their central banks would not be forced to spend huge chunks of their foreign reserves trying to maintain pegged exchange rates (Thailand spent all of its reserves during the Asian crisis). And if Asia’s central banks did look to shore up their currencies, they each have far more foreign reserves at their disposal today, while the Chiang Mai Initiative promises to provide a regional alternative to IMF assistance.

Asia’s banks, even after considerable balance sheet expansion in recent years, are very well capitalised – in part because the Asian crisis forced the region to adopt the kind of banking reforms and consolidation that Europe and the US are undertaking at the moment.

Local liquidity

Another major difference is that Asia has worked very hard, and with considerable success, to develop its local currency debt markets so as to reduce their dependency on offshore debt. Local currency bonds have come so far that Thailand now plans to turn all of its sovereign debt into baht. Given that Thailand is where the Asian financial crisis began in June 1997, it is quite an achievement that the Kingdom has built a baht bond market that now matches its Bt8trn (US$268bn) bank market.

Likewise, the Philippines, although not a major victim of the Asian crisis (due to it being an underachiever before the crisis rather than prudential fiscal management), has clearly learnt the value of liquid local currency markets. It has embarked on several liability management exercises aimed at turning dollar liabilities into peso debt, and has been a pioneer in selling local currency bonds to global investors.

Indonesia, Malaysia and South Korea have, equally, worked hard to develop their local currency bond markets.

Deeper local capital markets reduce the likelihood of a repeat of the Asian crisis because companies that have borrowed in their local currencies are sheltered from exchange rate movements. This also limits contagion, because one of nastiest effects of falling exchange rates is the way they can quickly turn good companies into bad ones even if they hold only modest levels of foreign debt.

In addition to local bond markets, individual wealth is also changing the Asian liquidity landscape.

“Singapore has emerged as a major private banking and investment management centre. So now more Asian money stays in Asia and is managed in Asia. Private banks are now providers of liquidity. There is now a way of channelling Asian investors’ savings to Asian issuers,” said Surinder Kathpalia, managing director, ASEAN, at Standard & Poor’s and a veteran of the Asian crisis.

Private banking might represent the very upper end of Asian wealth, but less visible changes in demographics and urbanisation are also fundamentally increasing intra-Asian liquidity and building social safety nets.

“Many South-East Asians are now asset-rich, but not cash rich, so are selling their fixed assets and diversifying into financial investments,” said Herald van der Linde, head of Asia equity strategy at HSBC and also a veteran of the Asian crisis. “Asian companies and governments are also building healthcare and pension systems so money is flowing into pension funds and the like and this is building up increasingly large pools of local liquidity. This may not be as visible as other changes but it is transforming Asia and will keep doing so.”

The final difference is in Asia’s entire geo-political landscape. As hard as it may be to fathom today, China was a bit-part player during the Asian crisis. It is now the world’s second-biggest economy and a political heavyweight. India, likewise, was more a kitten than the tiger it is today.

Stress points

These reforms are impressive − and these differences reassuring − but many reforms remain dangerously incomplete.

“The recovery almost came too fast for Asia, and with the good times there is always a risk that policymakers may take the foot off the pedal for reforms. Much has been done, but there is still some unfinished agenda,” said S&P’s Kathpalia.

Despite these huge improvements, there are some worrying stress points. Flexible exchange rates are not immune from devaluation. Significant capital flight from Asia would still devalue currencies – not to mention other asset prices – even if it would not send them into freefall this time around. And, given the huge flows of foreign money into Asia in recent years, a fair chunk of that money may not stick around if the Chinese and Indian economies keep slowing, or if interest rates (and therefore yields) start to rise in western markets.

Asia’s local debt markets are undoubtedly a major achievement, but they are not yet in their full glory. As much as they have developed, they are still not big enough to meet corporate Asia’s funding needs. A particular problem is that local markets cannot accommodate lower-rated issuers; there is just no local appetite for anything but the best-known brands or state-linked credits. This is why the Chinese and Indonesian companies are such frequent high-yield dollar issuers. This contributes to an ugly dynamic in which the borrowers most likely to default are the ones that have borrowed offshore.

There may also be a darker side to the rise of Asia’s private banks, in that it enables unrated bonds to get done more easily – and that has been particularly evident in the Singapore bond market. The lack of a rating reduces transparency and stokes concerns about corporate governance, an area where Asia’s deficiencies are well known.

Indonesia’s Bakrie Group is a prime example. The conglomerate survived the Asian financial crisis despite defaulting and is back to business as usual. The group’s reverse listing of its coal assets on the LSE and the subsequent collapse of its relationship with its UK partners – amid an investigation into alleged irregularities at the Indonesian units – shows that corporate governance concerns remain alive and kicking. The Bakries may even go as far as paying more to buy back shares from Bumi PLC chairman Samin Tan that it will offer other shareholders.

Investors, for their part, have shown what short memories they have. During the Asian crisis Indonesia’s Asia Pulp & Paper became the biggest defaulter in emerging market corporate history and even ring-fenced its prime Chinese operation so creditors could not get their hands on it during the restructuring.APP China and other Chinese units can now freely tap the renminbi bond market, as if investors are unaware of this history or are happy to take the risk of not being repaid.

This boldness may be partly down to the fact that not many of today’s investors were in the game 15 years ago. Without the experience of a meltdown in Asia’s markets, they associate the region only with strong growth rates.

Equally, investors operate in a very different world today. In 1997–98 Asia was in crisis but the rest of the world was doing well, so fund managers had plenty of options. Today, not only is there almost no growth in Europe or in the US, but interest rates are at historical lows.

“Investors today are operating in a very low interest-rate environment. They have a huge pool of money to invest and need to generate a return for their investors, and there isn’t really anywhere else outside Asia to invest it for such returns, notwithstanding the risk,” said Kathpalia.

Opportunities outside emerging markets might be few today, but when they do return investors may well take a different view of some of the Asian risk they are willing to book now.

Recent corporate governance scandals also hide a more nuanced picture. Corporate governance across Asia clearly needs to improve, so there will always be headline cases, but in many parts of the region the treatment of creditors remains untested.

“In South-East Asia many companies’ views are still very much informed by the Asian financial crisis, but in places like China there is no such reference point. The corporate thinking in China is much more short term, and they are far less scared of debt,” said HSBC’s van der Linde.

China’s pre-eminence

Geo-politically, Asia is unrecognisable from the days of the region’s own crisis. So far, the rise of China has been positive, because Asia’s deeper intra-regional trade links have helped protect the region from the slump in demand from Europe and the US. China’s ability to launch a huge stimulus package at the height of the global credit crisis in 2008–09 also helped keep Asian economies on track.

Now, however, China also poses its own threat to the region’s financial stability.

The build-up of debt was one of the major precursors to the Asian crisis, and that looks truer of China today than it does of South-East Asia.

China’s economy has been slowing month on month, and that will slow growth right across Asia. Much of the hot money that has flowed into Asia has gone into China, and as China’s prospects have dimmed, so have investors withdrawn their money. If enough money is pulled out of China to spook financial markets, then investors could quickly do the same to many Asian economies, and the region could be in for a sharp correction.

It has been a record year for bond issuance in Asia, and the distinctly bubble-like characteristics have left that market looking especially vulnerable to such capital flight. Spreads on Asian credits have ground relentlessly tighter and have compressed to a level that makes little sense.

US dollar bonds due 2021 from the Republic of the Philippines have traded as tightly as Treasuries plus 41bp – a good example of pricing that it is way too low to reflect the risk. It would not take much for foreign investors to decide the same thing and pull their money out.

Asia has come a long way in the 15 years since the Asian crisis, and its economies are fundamentally better now than they were then.

Foreign reserves are higher, banks are better capitalised, exchange rates are freer, companies can now borrow money in their local currencies and the region is less dependent on US and European demand.

A repeat of the horrors of 1997 is unlikely – barring, of course, any mammoth external shock such as the break-up of the eurozone.

However, there are still plenty of worrying stress points that mean something very painful, but less than a full-blown crisis is certainly possible, especially given the fragile state of the global economy. Asia’s governments, regulators and central banks have the arsenal to manage the fallout from any large-scale capital flight, but that does not mean it is immune from a nasty shock. Although the region has come a long way in 15 years, there is still plenty of work still to be done.

Asian foreign reserves 1997 and 2012