On firmer Ground

IFR Asia Awards 2013
10 min read
John Noonan

On firmer Ground

On firmer Ground

Emerging Asia’s foreign exchange markets will bid 2013 goodbye without too many tears. Forex markets across the world and, notably, in emerging Asia, went from multi-year highs to a deep slump from mid-year on premature suggestions from the US Federal Reserve that it would begin to rein in its massive five-year stimulus programme.

Prices have since recovered ground, but the path ahead continues to depend on US monetary policy, which could again whipsaw the region with unanticipated results. Some analysts even see worrying similarities to the period before the Asian financial crisis of the mid-1990s, when the Fed normalised policy with successive rate hikes as the US recovered from an early 1990s recession.

There are key differences in emerging Asia today that make the crisis unlikely to be repeated. Among them are stronger economic and policy fundamentals in many economies, Japan’s aggressive efforts to lift its economy and its promises to invest in emerging Asia, and the Fed’s more transparent approach to monetary policy.

Indeed, the ADB has said that fears of a 1997-like meltdown are misplaced as the region can weather the financial storm expected when the US begins to wind back its stimulus.

“Many countries in Asia learned the hard lessons of 1997 and have rightly strengthened macroeconomic management, financial regulation, and corporate governance,” the bank said in its October outlook report.

The wild card remains the Fed. It was Chairman Ben Bernanke’s comments indicating the Fed was getting ready to trim its US$85bn-a-month bond purchases that led to a spike in yields across the globe, a drop in equity markets and an outflow of money from bonds and stocks across Asia ex-Japan. It is no wonder market participants are on tenterhooks awaiting word of when the Fed will actually begin scaling back.

Asian EM currencies began solidifying after the Fed announced in September that it was not quite ready to start scaling back. Also, markets region-wide received a further boost from Chinese data showing a mini-stimulus programme, begun in July, was helping to restore growth, as well as central bank moves in Indonesia and India designed to tame elevated inflation and narrow their bloated current account deficits.

Bank Indonesia hiked rates 175bp in the six months to November, even surprising markets on June 11 with a near-midnight hike to its deposit facility rate. Raghuram Rajan, India’s new central bank chief, lifted interest rates twice after taking office on September 4.

The Indonesian rupiah deteriorated to a new four-year trough in November, but was still about 8% above its 2008-09 lows and around 30% higher than the depths of 1998. Meanwhile, the Indian rupee rebounded around 9% from its August record low.

These positive moves, based on strengthening fundamentals in two of the worst-hit emerging economies, offer an encouraging sign that Asia’s developing economies are resilient, and have the wherewithal to withstand shocks to the global economy.

Still, the IMF has noted some parallels today to the 13 months leading up to February 1995, a period when the Fed tightened monetary policy by an aggressive 300bp. The 10-year Treasury yield soared more than 200bp higher as of the end of 1994.

As then, the world has experienced heavy capital inflows into EM economies, and there are cyclical divergences between the US and EM economies with increases in long-term bond yields.

Today’s difference

Yet, there are several positive developments that make things different this time. Policy frameworks in EM countries are stronger and forex reserves are deeper. Forex reserves relative to GDP have doubled in most Asian economies since the end of the 1997 crisis, and the ratio of short-term debt to reserves is consistently below 1 across developing Asian economies, according to the Dallas Federal Reserve.

Other differences include greater exchange-rate flexibility today and the fact the Fed now provides clearer forward guidance on monetary policy. That transparency has bought some time for policymakers in the region to bolster economic fundamentals and investor confidence.

The sharp divergence between developed and EM manufacturing activity, which had soared to a very wide level earlier this year, closed further in October, JP Morgan noted in a client note on November 4.

Despite headwinds from tighter credit conditions and weak corporate profit margins, exports from EM to developed markets had accelerated and the inventory cycle had turned positive, promoting a modest acceleration in EM industrial output, JP Morgan said.

Another big plus is that funds are unlikely to flow out as much from emerging Asia, compared with other parts of the emerging world, given its better relative fundamentals, according to ANZ analysts Richard Yetsenga, Khoon Goh and Irene Cheung.

While EPFR data show bond and equity outflows from EM Asia totalling US$2.1bn in the week to November 13, after outflows of US$256m the week before, EM Asia bond flows have been less volatile than other EM markets, based on ANZ-compiled data.

Emerging Asia’s accumulation of foreign assets and the Bank of Japan’s aggressive reflationary policies should also help offset the impact of the eventual slowing of the US money-printing programme.

Helping emerging Asia is the EM private sector, which is piling up assets abroad through their globalised “multinationals” and pension funds that allow for foreign investments, say Nomura FX strategists. According to UN estimates, outward foreign direct investment from developing countries in 2012 amounted to US$4.4trn.

If a crisis does erupt, and EM currencies are devalued, local private investors will be able to bring their offshore investments back home at favourable exchange rates, the Nomura strategists say.

Those possible “two-way flows” will limit exchange-rate and asset-price volatility and provide for a smoother adjustment of balance of payments. Moreover, holding a stock of outward FDI and portfolio investment, rather than reserves at the central bank, brings higher returns on private-sector investments over the long run, they say.

That could be especially relevant in Indonesia, one of the most exposed to offshore portfolio investments. The private sector in Indonesia has now accumulated more offshore assets than the central bank’s reserves, partly, out of frustration with investing within Indonesia itself and, partly, to take advantage of potential opportunities in places like the Middle East and Africa, which could see a growth boom in minerals and raw materials markets.

Japanese support

One of the biggest supports to emerging Asia could come from Japan. Prime Minister Shinzo Abe’s efforts to lift his nation through fiscal and monetary stimulus is expected to lead to an economic and corporate profit resurgence that will push more stable liquidity into emerging Asia during 2014–15, according to Glenn Maguire and Weiwen Ng, ANZ’s Asia Pacific economists.

While profit recoveries in Japan had always led to strong outward FDI, ongoing tensions between Beijing and Tokyo, the growing importance of the Association of South-East Nations as a host to offshore Japanese production suggested ASEAN economies would grab a larger share of Japanese FDI in coming years, Maguire and Ng said in a research report

That could be significant. IMF statistics show growth in emerging Asian economies rising 0.5–0.7 percentage points for every 1% of GDP increase in inward Japanese FDI over 1985–2010.

One clear strategy of Abenomics is to boost outward FDI, the ANZ economists say. Japan’s External Trade Organisation, for instance, supports more than 1,000 small and medium enterprises in overseas business expansion and plans to double SME exports come 2020.

Japan is also ready to capture a huge share of Asia’s infrastructure boom, with Japanese consortiums having recently bagged a raft of major infrastructure deals in Myanmar and Indonesia. Infrastructure deals are seen tripling to ¥30trn per year come 2020.

Japan’s aggressive reflationary policies are still rumbling through the economy. Prices ex-food and energy stopped falling in September and jobs availability rose to the highest level in over five years, big manufacturing sentiment was at the most bullish in nearly six years in the September quarter and capex has been rising amid a strong upswing in the profitability of large Japanese enterprises.

While companies remain wary about boosting wages or investment and investors are unsure of Abe’s appetite for structural reforms, Japanese companies remain hopeful. A Reuters Corporate Survey conducted from October 25 to November 11 showed nearly 75% of the 247 companies that responded to a question on Abe’s growth strategy believed it was “commendable” or “very commendable”.

The diverging policy outlooks from the Fed and BoJ, meanwhile, are keeping downward pressure on the yen, which provides further support to Japan’s growth. While it is true that the BoJ’s 2.0% inflation target remains distant, policy members have signalled a willingness to expand stimulus if domestic and offshore risks impede progress towards the price goal.

Undeniably, the inevitable normalisation of US monetary policy will send shivers through emerging Asia with the currencies of countries with current-account deficits, namely India and Indonesia, the most vulnerable to downside risks.

However, with the region now better positioned to deal with adverse financial shocks, emerging Asia’s currencies are highly unlikely to suffer the fate they did during the Asian financial crisis.

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On firmer Ground