As the emerging market meltdown accelerates, plunging half of EM equity bourses into bear market territory and wreaking unspeakable havoc on currencies from LatAm to Asia-Pac, analysts and commentators alike have scrambled to find historical analogs that can serve as a guidepost when assessing the damage and, more importantly, predicting where things go from here.
One historical episode that’s received quite a bit of attention in the wake of the yuan deval is the Asian Financial Crisis of 1997/1998 and indeed, FX strategists from across the bulge bracket have done their best to catalogue the similarities (e.g. low real rates, increasing debt, exogenous shock factor, commodity transmission mechanism, similarities between Japanese and Chinese REER appreciation in the lead up, etc.) and point out the differences.
For commentary from Morgan Stanley and BofAML, see "The Ghost Of 1997 Beckons, Can Asia Escape? [11]."
Below, find excerpts from Goldman’s take.
* * *
From Goldman
Asian FX weakness is stirring memories of the Asian Financial Crisis (AFC) and raising questions on how Asia’s fundamentals look now, compared with the mid-1990s.
Given that Asia’s current account positions are in much better shape now than the mid-1990s – and indeed since the 'taper tantrum' period in 2013, given the notable improvement in the current account deficits of India and Indonesia – focus is on the challenges to Asia’s external balances that may emerge from portfolio outflows.
Foreigners also hold substantial proportions of outstanding debt in some markets – around 40% in Malaysia and Indonesia.
Given the size of foreign holdings of Asian equity and debt, should foreigners reduce their portfolio holdings by 2-3% over the course of a month, it would broadly offset the region’s current account surpluses, leaving their external balances in a shakier position. During the 'taper tantrum' period, foreigners sold markedly more than 3% of their portfolio holdings through June and July 2013, highlighting the risk that portfolio outflows could cause further Asian currency weakness. The small current account deficits in India and Indonesia make their respective currencies most vulnerable. The high concentration of foreign holdings of Malaysian and Indonesian debt suggests that the MYR and IDR could be vulnerable to notable foreign selling of local currency debt.
Recent Asian currency weakness has increased the focus on Asia’s external debt levels given that currency depreciation raises the cost of servicing the debt. Post the Global Financial Crisis (GFC), external debt has risen in India, Indonesia, Malaysia, Thailand and Taiwan, but has fallen in the Philippines and Korea. Malaysia has the highest level of external debt in the region at over 60% of GDP.
External debt is above the levels recorded prior to the AFC in Malaysia, Taiwan and Korea, but below AFC levels elsewhere. Indeed, Malaysia’s external debt is equivalent to the peaks reached in Indonesia and the Philippines prior to the AFC.
Across the region, foreign currency denominated debt makes up at least 50% of external debt, rising to close to 100% in the Philippines. However, maturity also matters: the level of short-term external debt is judged to be the most vulnerable part of external debt given that it may need to be rolled over in a period of market tension. Short-term external debt makes up around 50% of external debt in Malaysia and China, but less than one-third elsewhere.
The ability of a central bank to lean against FX volatility depends on whether or not the country in question has an adequate amount of FX reserves. FX reserves have fallen across the region due to valuation losses on the non-Dollar holdings and/or for intervention purposes. In some cases, this drop has been notable – by 31% in Malaysia, since the middle of 2013 and by 17% in Thailand since early 2011. Indonesian FX reserves have fallen by 7% since February. We examine the adequacy of Asia’s FX reserves on several typical metrics:
Import cover is defined as the number of months imports can be sustained should all inflows cease. The IMF uses three months’ import coverage as the benchmark for reserves. FX reserves across Asia more than satisfy this criterion. Regional import coverage tends to be between 6 and 10 months, with a high of 22 months for China and a low of 6 months for Malaysia.
The ratio of reserves to short-term debt: the most widely used metric for reserve adequacy is the Greenspan-Guidotti rule of 100% coverage of short-term debt. The rationale is that countries should have enough reserves to resist a significant withdrawal of short-term foreign capital. The level of Malaysia’s short-term debt is equivalent to the level of FX reserves.
The ratio of reserves to broad money is less frequently used a measure of adequate FX reserves. This metric is designed to capture the risk of capital flight, in particular outflows of deposits of domestic residents. The upper limit of a prudent range for reserve holdings is 20%. Reserves in China and Korea do not cover 20% of broad money (they only cover 18% of broad money), but everywhere else the coverage is well above 20%.
Broadly, Asian FX reserves can be judged to be adequate, with the exception of Malaysia, where FX reserves now barely cover short-term debt.
In comparison to their status prior to the Asian Financial Crisis, Asia’s fundamentals are (broadly) in better shape. Consequently, we are unlikely to see explosive FX weakness. But other factors are at play, including large debt overhangs in some countries, the sharp decline in commodity prices and political uncertainty in some countries. On the other side of the FX equation, we expect US Dollar strength to continue on the back of solid US growth and the prospect of Fed tightening in coming months. We therefore expect Asian currencies to continue to depreciate.
