Emerging markets (EM) have been hit by the ebb and flow of tapering concerns. For Asia, in particular, the spectre of currency weakness and declining asset prices has reawakened fears of another 1997-style crisis. We think that is stretching it too far as the region has built sizable defences over the years. Countries such as India and Indonesia can, nonetheless, do more to bolster confidence – and capitalise on the extra time that the Federal Reserve (Fed) has given them – unwittingly or otherwise – by deciding not to taper QE.
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Emerging markets – previously favoured for their structural growth promise – have come under considerable pressure over recent months (with some arguing that there’s a noticeable sinking feeling about the region).
Even Asia, which had been the most compelling story within the EM block, has not been spared. Why has such a stark reversal of fortune come so seemingly out of the blue?
While the relative softness in economic data from China during the summer did not help sentiment towards Asia, the immediate fall in sentiment appears to have been triggered by the May Congressional testimony by Federal Reserve (Fed) chairman Ben Bernanke. Since he first floated the idea of tapering, there has been an increasing fear that global liquidity would dry up. As the thinking goes: the reduction in the pace of asset purchases by the US central bank would make life difficult for the economies that have been the recipients of such liquidity flows.
One of the clearest indications of such an impact is on the currency front (Figure 1). As shown in Figure 1, a number of Asian currencies have borne the brunt of subsequent risk aversion. Since late May, the Indian rupee had fallen close to 20%, at one point, against the US dollar. The Indonesian rupiah suffered a similar fate over the period. Of course, not all Asian currencies declined as sharply as those mentioned above. Although the currencies of Thailand, Malaysia and the Philippines have seen their values drop against the greenback, they have been more resilient. The Korean won and Singaporean dollar actually strengthened through the period.
Supply and demand
The differing degree to which the various economies have reacted to tapering fears is driven largely by their current account status.
To illustrate, a country with a negative current account balance will typically be running a trade deficit. That means it imports more goods and services than it exports, and therefore sees a net outflow of foreign exchange through the trade channels. This makes the economy more dependent on capital inflows from abroad to plug the gap in its foreign-exchange needs.
In good times, when global liquidity is flush and money pours in to purchase financial assets, a country’s current account deficit is not a big issue. Stylistically speaking, for every dollar that an importer needs – to pay for the purchase of, say, electronic goods from abroad – there might be an offsetting dollar that fund managers brought in to buy its equity or bond assets.
Such supply and demand dynamics of local currencies vis-à-vis foreign ones play a role in determining the country’s exchange rate at the end of the day. When global risk sentiment shifts – as we have witnessed lately – supply and demand dynamics could reverse rather quickly. In particular, in the case of India and Indonesia, their current account-deficit issues have become a point of contention for investors worried about how the economies can plug the shortfall in foreign-currency supply. This was exacerbated by fears that there would be less global liquidity.
Echoes of an eerie past
The overall aversion towards the region – and the extent to which some of the currencies have depreciated – has raised fears that the Asian Financial Crisis (AFC) of 1997 could repeat itself.
In our view, the probability of the region suffering a crisis of that scale remains remote.
Most countries in Asia are now running outright current account surpluses; we are a far cry from the days when most of them were deep in the red (Figure 2).Thailand – which was one of the countries worst hit by the AFC – ran a current account deficit of nearly 8% of its GDP in the years leading to 1997. While, year to date, its current account has indeed fallen below zero, it is by no means large enough to raise significant concern, especially given how its exports would be helped by exposure to a resurgent Japan. Meanwhile, other AFC-hit economies, such as Malaysia and Korea, have managed to turn their current accounts into outright surpluses over the period.
The comparisons, however, look less favourable for India and Indonesia. The former had a current account gap of around 5% of GDP in the first half of this year, which looks rather worse than the 2% gap it had in the years prior to the AFC (even though India was not hit by the crisis directly). Meanwhile, Indonesia’s current account appears to be at the same deficit level as it was before the crisis hit.
Looking forward, however, economists at our investment bank expect the situation to improve for both countries. A combination of narrower trade deficits, as well as an uptick in services exports and remittances, could help India narrow its current account gap to 3.7% of
GDP in the 2014 fiscal year. On the other hand, slower import growth would help Indonesia narrow its current account deficit to 3.1% of GDP next year. While both economies would, indeed, still have current account gaps, it appears that they will, at least, be narrower.
Defences stronger than in 1997
Apart from the more favourable current account situation, the regional economies are also in better shape in terms of the foreign exchange reserves that they have built up over the years (Figure 3).
Take Indonesia, for instance. While the level of its foreign reserves have dipped recently due to currency intervention, at US$93bn (as of the last available data of August), it is more than five times what it had in 1998. Indeed, in a dramatic turn of events, Indonesia actually contributed $1bn to the International Monetary Fund in 2012, 15 years after having to accept harsh measures in return for a $40bn bailout.
Other AFC-hit countries, such as Korea, Malaysia and Thailand, have similarly ramped up their foreign exchange reserves. In times of volatile global capital flows, having a buffer of this nature gives regional policymakers the flexibility to intervene in the exchange rate markets to smooth out the ride. No less importantly, it also helps to bolster domestic confidence and prevent the kind of panic expatriation of funds that occurred during the AFC.
To that end, it helps too that there is a greater degree of cross-border cooperation between the regional policymakers. For instance, apart from the potential to utilise its own foreign exchange reserves, Indonesia’s central bank extended a $12bn swap line with Japan recently and is reportedly in talks with two other regional counterparts for similar agreement (Bloomberg Sep 24, 2013).
In good times, capital inflows mask the presence of current account deficits
Bernanke bought them time
In spite of the above, the greatest help for Asia’s policymakers might have come from a rather unexpected central-bank counterpart – the Fed.
Even though it was the Fed’s tapering talk that kick-started the most-recent concerns about the health of the emerging markets, the postponement of the action has been inadvertently helpful. Since the Fed’s announcement on 18 September, capital outflow concerns – which built up alongside expectations of tapering – have eased. This has won a reprieve for EM Asia overall, but particularly for economies that suffered the most on the back of their current account shortfalls.
The Indonesian equity markets jumped 7% and its beleaguered currency strengthened past the 11,000 level, at one point, on the day after the Fed’s announcement.
The way ahead for these markets might not be as straightforward, however. The postponement of tapering merely buys the policymakers time to sort out the underlying macroeconomic issues – it does not get rid of those issues.
To that end, the surprise rate hike by India’s central bank (on 20 September) is laudable (Figure 4). After all, the 25bps hike came unexpectedly, and at a time when the need to anchor the Indian rupee had been lessened.
While the initial market reaction was negative, from a longer-term perspective, the hike would go a long way towards breaking the entrenched inflation expectations of the Indian economy.
After all, what better way to boost their inflation-fighting credentials – and battle one of India’s most entrenched macroeconomic issues – than to raise rates when least expected. What a debut by India’s new central bank chief, Raghuram Rajan, having led his first monetary policy meeting.
It will take time for such measures to have an effect. And, even if tapering does not take place until December, fear of the event may resurface if US data strengthens significantly in the interim, for instance.
Hence – outside of our overweight call on developed market equities – we prefer to gain exposure to Asian equities by focusing our positioning on north Asia.
Specifically, we continue to see a recovery in sentiment towards the Chinese market. While growth rates may seem soft by China’s lofty historical standards, the overt pessimism will continue to be negated as the economy shows signs of strength.
Elsewhere, we have a favourable outlook on the Korean and Taiwanese markets, given the stronger macro fundamentals of these countries and their solid exposure to the recovery in the global-trade cycle.
That said, our highest convection medium-term trade remains long USD/CHF, which we see as a leveraged version of EUR/USD. With EUR/CHF trading close to its floor, CHF’s upside is limited. In contrast, its downside is meaningful, particularly in the context of an improving euro area economic outlook and dissipating EUR risk premium. We, therefore, see more material upside in selling CHF (rather than EUR) against USD.