Needless to say, the past 24 hours have done nothing to dispel worries that we’re spiraling towards a repeat of the Asian Financial Crisis.
Asia ex-Japan currencies have been battered along with their EM counterparts worldwide on the back of China’s move to devalue the yuan which seemed to telegraph Beijing’s concern about the true state of the country’s flagging economy.
This has driven commodities to their lowest levels of the 21st century (yes, you read that correctly), pressuring EM FX from LatAm to Asia-Pac and sparking worries that emerging economies - even those armed with far higher FX reserves than they held two decades ago - may be ill-equipped to cope with accelerating outflows.
Indeed the similarities between the current crisis and that which unfolded in 1997/98 were so readily apparent that many analysts began to draw comparisons and that may have added fuel to fire over the past week.
Now, there seems to be a concerted effort to calm the market by explaining that while there are similarities, there are also differences. Of course this goes without saying. No two crises are identical and as the old saying goes, "history doesn’t repeat, but it does rhyme," and to the extent some of the imperiled economies are in better shape to defend themselves this time around (e.g. because they are in a better position from an FX reserve and capital account perspective) that’s a positive, but when attempting to cope with a meltdown, it may be more important to look at where things are similar and on that note, here’s some color from Morgan Stanley and BofAML.
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As highlighted in our answer to the question on “What is wrong with Asia’s macro story”, the region today has a number of similarities with the 1990s cycle in terms of a misallocation led by a low real rate environment led and then an adjustment cycle triggered by reversal in US Fed monetary policy.
- A low real rates environment – aided by starting point of high excess saving and easy monetary policy in the US.
- Domestic misallocation – in both cycles, there has been trailing misallocation of resources into unproductive areas. This is best seen in the rise in the region’s ICOR in both cycles.
- Debt build-up – Since 2008, the region’s debt to GDP has risen by 52ppt, to 206% in 2014. Similarly in the 1990s, there had been a buildup of debt in the run-up to the Asian Financial Crisis.
- External trigger – the adjustment phase in both cycles had been triggered by the rise in US real rates and appreciation of the US dollar (though in this cycle, the slowdown in China has been an additional factor in driving the adjustment).
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Can Asia escape the ghost of 1997?
The aftermath of CNY devaluation
Asian financial markets are seeing an intensification of selling pressure in the aftermath of the recent CNY devaluation. Investors are now asking if this is a repeat of the 1997 Asian financial crisis that was preceded by China’s 1994 devaluation. Our Asia Chief Economist, Hak Bin Chua, touched upon the similarities last week (see Tremors from China’s devaluation), but in light of the impending sense of crisis it is worthwhile exploring the issue further and asking whether Asia can escape history repeating itself.
Revisionist history and the blame game
The CNY’s recent depreciation and subsequent sell-off in global markets naturally prompts investors to put the blame on China’s doorstep and revisit its 1994 depreciation as the cause of the 1997 Asia financial crisis. The difficulty in blaming China for the 1997 crisis is that its economy was much smaller at the time, and not integrated into the WTO trade system. Its “devaluation” resulted from a merging of two exchange rates (one for trade and another for investments) producing a net devaluation of 7-8% (according to World Bank estimates) as the bulk of Chinese exports were already sold at the swap market exchange rate. This measure is much lower compared to the nominal 33% devaluation.
However, there are two alternative explanations for Asia’s 1997 crisis. The first is the “crony capitalism” narrative, in which Asia undertook unsustainable short-term FX borrowing to finance unsustainable current account deficits. This FX borrowing was guaranteed against implicit FX pegs that funded questionable investments. These investments were premised on the thesis of an Asian Miracle that proved unfounded and resulted in capital outflows and a collapse of Asian currency pegs.
The second explanation is that the seeds of the Asian financial crisis were sown by the 1985 Plaza Accord, which was aimed at halting USD strength and reversing JPY weakness. Ultimately, the subsequent JPY appreciation deflated Japan’s economic bubble in the early 1990s. Asia then faced a triple whammy of slower Japanese growth, ensuing JPY depreciation and a Fed tightening cycle initiated in 1994.
Japan vs China this time
No doubt the truth lies somewhere in between these three narratives. But it is worth exploring the similarity between China and Japan. Indeed, the CNY has embarked on a sustained appreciation since its managed float in July 2005 under pressure from G7 countries to “rebalance” its economy.
Chart 1 shows the similarity of the JPY REER appreciation since the Plaza Accord with the CNY appreciation since 2005 and the call from congressmen Graham and Schumer for a 30% appreciation. Another stylized feature of both economies was their sustained property market appreciation and asset bubble risk – this is illustrated in Chart 2. In nominal terms, the JPY appreciated 65% versus the USD in the decade following the Plaza Accord. Meanwhile, the CNY appreciated 22% since the 2005 de-peg from the USD.
The final key commonality between the Asia crisis and now is the transmission through falling commodity prices and its aftershocks for EM commodity producers, especially those with pegged exchange rates and a negative terms of trade shock. Kazakhstan’s FX shift from peg to float and risk premium being built into GCC FX forwards for the Saudi rial and Omani rial illustrate this fragility now.