Asia’s biggest economy is slowing, the Federal Reserve is about to kick off an interest rate tightening cycle, and China has just devalued its currency.
That chain of events back in 1994 eventually touched off a round of competitive currency devaluations that helped trigger the Asian financial crisis, featuring bank and corporate failures and recessions across much of the region.
Is the current market turmoil foreshadowing yet another region-wide bust? There are certainly parallels, but important differences as well. This time around, Asian economies have stronger current account balances, fiscal positions and foreign exchange reserves that provide a thicker buffer against turbulence.
Risks are building nonetheless as China’s surprise yuan policy U-turn on Aug. 11 sends ripples across the globe from Vietnam to Kazakhstan and threatens vulnerable emerging market economies from Brazil to Turkey. The global selloff deepened Monday, with U.S. index futures signaling more losses.
China’s yuan devaluation comes on top of a steep slowdown in the world’s second-biggest economy and Asia’s biggest (Japan was No. 1 back in 1994) and a commodities slump that is hurting nations from Brazil to Australia, Malaysia and South Africa. Chinese companies now threaten to displace exports from Asian and emerging market competitors just as the U.S. Federal Reserve prepares to raise interest rates for the first time since the global financial crisis.
“A nasty storm is probable, not just possible” in countries like Brazil and South Africa, said Stephen Jen, co-founder of London-based hedge fund SLJ Macro Partners LLP. “But I do not anticipate a crisis or even very tense moments in Asia. The main reason is that the Asian Crisis of 1997 already cleansed Asia’s financial system and Asia’s resilience ought to be higher.”
Before 1994, Asia was the darling of the investment world and viewed by some as a late-20th century growth miracle. That euphoria didn’t last long.
China’s devaluation 21 years ago is often cited as a proximate cause to the subsequent emerging markets crisis, while the Fed rate rise the same year was the trigger, according to Lombard Street Research.
This year, China’s surprise currency move has prompted Vietnam to devalue the dong. Kazakhstan’s currency tumbled more than 20 percent against the dollar last Thursday when the country relinquished control of its exchange rate. The South African rand and Turkey’s lira have extended losses.
“A downward adjustment cycle in Asia began in 2013 -– this cycle has been and will remain painful,” Morgan Stanley economists including Chetan Ahya in Hong Kong, wrote in a report Monday. While the downturn is likely to persist, “we believe a 1997-98 scenario is unlikely.”
A more domestic debt profile, the presence of persistent disinflationary pressures, current account surpluses, flexible exchange rates, and adequate FX reserves give policy makers in the region better control over liquidity conditions, they wrote.
The Asian crisis was about indefensible currency pegs to the dollar, inadequate foreign exchange reserves, and heavy exposure to hot money inflows, says Stephen Roach, a senior fellow at Yale University.
Today’s circumstances are different on the first two counts. Yet there’s one disturbing similarity: China’s exposure to about $1 trillion of dollar-denominated bank debt as the yuan carry trade starts to unwind after the People’s Bank of China’s devaluation, said Roach, who was chief global economist for Morgan Stanley during Asia’s financial crisis.
A weaker local currency adds to the debt burden for China’s already pressured companies, who’ll now have to pay more yuan for their U.S. dollar repayments.
Asia also faces a new vulnerability, the sheer dependence of regional economies on a China that is decelerating, said Roach. In the mid-1990s, the robust U.S. economy was the main buyer of products from the region.
“That means as Chinese exports sag —- and they are falling quite significantly now (minus 8.3 percent year-on-year in July) —- it spells trouble for the rest of China-dependent Asia,” said Roach.
The yuan will fall to 6.5 against the dollar by the end of this year and 6.9 at the end of 2016, bringing it close to a 10 percent depreciation, according to Bank of America Merrill Lynch.
Jen estimates that a 10 percent depreciation in the yuan will create 5 to 20 percent moves in the rest of Asia.
In Asia, Vietnam, Thailand, South Korea and Malaysia are more vulnerable to the devaluation, while in Europe Hungary and Poland are at risk and Turkey may suffer the most, according to Lombard Street Research economist Shweta Singh in London.
Not everyone agrees Asia is primed for another crisis. The idea the yuan devaluation then triggered a sequence of events that culminated in a crisis is “the old canard that just won’t be slaughtered,” said David Loevinger, a former China specialist at the U.S. Treasury who is now an analyst at fund manager TCW Group Inc. in Los Angeles.
The yuan devaluation of a generation ago was more symptomatic of other problems facing the region at the time and not a causal trigger of the ensuing crisis, said Glenn Maguire, a Singapore-based economist at Australia & New Zealand Banking Group Ltd. Because Asian currencies are no longer rigidly pegged to the dollar, as many nations hit hardest in the last crisis were, the region now has a greater ability to adjust to changing circumstances, he said.
The outlook for U.S. monetary policy is also very different. While the Fed raised rates aggressively in 1994, a worsening outlook for global growth and an appreciating dollar means the probability of an increase in interest rates next month has fallen below 50 percent, Credit Suisse Group AG says.
The parallels with this year include vulnerabilities in “a bunch of the emerging world countries,” including the whole of Latin America, Turkey and South Africa, said Shane Oliver, head of investment strategy at fund manager AMP Capital Investors Ltd. in Sydney, which oversees about $114 billion.
“China has set the cat among the pigeons,” he said.