My Say: Credible policymaking vital as financial shocks erupt

This article first appeared in Forum, The Edge Malaysia Weekly, on October 10, 2022 - October 16, 2022.
My Say: Credible policymaking vital as financial shocks erupt
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There is a growing risk that financial disruptions could hurt prospects for Southeast Asian economies.

The fragility of financial markets is seen in the outsized moves that occur in response to unexpected news such as the sharp crash and then rebound of the British pound. This fragility matters because there is a higher probability of bad news these days — whether due to the sharp rise in interest rates or geo­political tensions or the weakening global economy or climate change. Making these risks potentially more dangerous is the fact that central banks, which previously would step in to mitigate such risks, are today more conflicted: for example, they are focused on combating inflation, which restricts their ability to mount aggressive moves to maintain stability.

The implications for the regional economies are worrying. We can, however, take some comfort from the large foreign exchange buffers that countries in the region have built up and the resilience they have established. While it is true that some of these buffers are beginning to weaken after months of financial turbulence, we believe that, by and large, the regional economies can ride through the storms — so long as they maintain credible policies.

The markets are fragile and there is more likely to be bad news than not

Markets are making extreme moves of late and there are good reasons that this will continue.

First, when markets were flush with liquidity, they were priced to perfection. So, now, when liquidity is dwindling, it takes just a small disappointment or a mild bit of unexpected bad news to cause a sharp fall in asset prices. For example, when rumours spread that a large Swiss bank was in financial difficulties, its stock price tumbled and European financial markets took fright — even though these rumours were not backed by hard evidence.

Second, the recent convulsions in UK financial markets reflected not only nervous markets’ capacity for extreme moves but also how the policymakers that we investors depend on to stabilise confidence are losing credibility. Markets tumbled after the new government of UK Prime Minister Liz Truss presented a mini-budget whose radical tax cuts and large budget deficit alarmed investors.

Worse still, the incident also revealed how market participants had been engaging in investment strategies that were potentially destabilising. As a result of extremely sharp and totally unanticipated spikes in UK government bond yields, the UK pension fund industry teetered on the brink of crisis — owing to their strategy of using derivatives linked to bond yields to enhance returns.

Similar sharp market moves have been seen elsewhere. The yen has buckled as investors showed their discomfort with the Bank of Japan’s insistence on maintaining ultra-easy monetary conditions even as most central banks around the globe raised rates.

We think it is entirely likely that many other market participants have been engaging in risky strategies as well and will be exposed in coming weeks and months. It would not surprise us if we had more episodes of forced liquidations of assets or calls on collateral made by financial institutions on highly leveraged market players that then precipitate sharp market corrections.

The trouble is that not only do we have dry tinder on the ground in global financial markets, but there are many potential sparks that could trigger wildfires.

First, monetary tightening on the unprecedented scale and speed we are seeing could precipitate more stress episodes. For instance, there are signs that the global economy is now cooling rapidly. Slower growth in demand could trigger recessions in some economies, especially in Europe, which could then knock back onto their trading partners. As the experience of the UK pension fund industry showed, tight money could also be causing risky investment strategies to unravel in parts of the market no one thought vulnerable. Moreover, as the realisation dawns that we are in for a long period of tight money, asset pricing is likely to be re-evaluated. Thus, whether it is global real estate prices that have inflated so much over the past decade or the opaque valuations of private equity holdings or the cost of capital for start-ups and growth firms, be prepared for lots of shocks.

Second, the chances of more extreme and unpleasant developments in geopolitics have also grown:

•     Take the example of Ukraine. With Russian forces in Ukraine on the back foot, there are more fears that Russian President Vladimir Putin may resort to extreme actions to retrieve Russia’s position. There is even talk of tactical nuclear weapons being unleashed. Just last week, Russian officials reacted with angry threats after US President Joe Biden said the US would deliver yet more high-tech weaponry to Ukraine; and

•     There are also many risks closer to home. Taiwan has just said it would strike at Chinese fighter jets crossing into what it considers to be its sovereign territory as marked by the 12 nautical mile (22km) limit around Taiwan island. North Korea just tested a missile which, in an act of extreme provocation, flew over Japan. The US, Japan and South Korea are likely to react by stepping up defensive preparations against North Korea. In short, then, the risks of rising tensions or provocations in the region have increased.

Central banks may intervene to save markets but at a high price and with less effectiveness

The Bank of England had to mount a massive intervention involving huge and guaranteed purchases of bonds that partly contradicted its monetary policy stance: In other words, its efforts to maintain financial stability came at the expense of its credibility in fighting inflation. So, financial stability was finally restored — but at the expense of question marks over the Bank of England’s effectiveness in combating inflation.

Similar dilemmas can be seen in China. It is clear that the economy is slowing and that financial stresses are growing there. Yet, the policy response to stimulate the economy has been hesitant and incremental — and there is a good reason for that. Previous stimulus packages have led to high debt and excess capacity in areas such as real estate. So, China’s policy­makers realise that traditional forms of policy intervention to maintain robust economic growth are not the way to go — but they have not developed new policy tools to replace the old approach. Moreover, with the yuan under depreciating pressure, they are hesitating to cut interest rates as that could lead to more capital outflows that would weaken the yuan even more.

The broad challenge globally is that until inflation is quelled, central banks everywhere will face this quandary if confronted by a financial shock: They have to calibrate stabilisation efforts very carefully or risk their credibility in bringing inflation down.

So, where does that leave Southeast Asia?

The good news is that regional economies have strengthened their buffers against external shocks. Lessons were learnt from the Asian financial crisis of 1997/98. The result is that the region has developed more shock absorbers that come in quite handy in the turbulent global environment we now face.

Broadly speaking, the regional economies bolstered their resilience through several means.

First, their macro­economic policies are more coherent and consistent than in the 1990s. There are none of the pegged exchange rates that invited speculative attacks. More rigorous mone­tary and fiscal policies have kept inflation and current account balances generally in line with trends elsewhere in the world as well. Central banks in the region now command a high level of credibility. This is seen in how our currencies have suffered less contagion from sharp falls in other emerging market currencies.

Second, financial institutions are much better regulated and are strongly capitalised. This helps reduce the risk that a small shock is amplified by a weak banking sector into a major crisis as happened in 1997.

Third, economies are also more diversified in terms of export markets and the products exported. Domestic demand also plays a bigger role so that a slowdown in global economic growth, while hurting, does not damage prospects as much as before.

Finally, the defences against external financial shocks have improved as well. A key element of this is foreign exchange reserves. One important metric is to look at the import-cover ratio, or the multiple of foreign exchange reserves over imports. Almost all economies in this region comfortably exceed the benchmark of an import coverage ratio of three, with 

Vietnam being the slight exception of just having slightly more than three months’ worth of foreign exchange reserves. It is true, however, that the import cover ratio has declined between 2021 and 2022 — as reserves were used to support their respective currencies but also because of a valuation effect due to the depreciation of non-US dollar currencies in their reserve currency portfolios.

Even if we use stricter metrics, it looks like most of the region is in good shape to weather a range of external shocks. For instance, under the International Monetary Fund’s Assessing Reserve Adequacy (ARA) metric, all regional economies, with the possible exception of South Korea, hold reserves that comfortably sit within or exceed the ARA safe limit of 100% to 150%. The reserves-over-broad-money ratios, used to reflect capital flight risks via an outflow of resident deposits, are also healthy for most economies, with 20% deemed the upper end of a prudent range, but with 5% being a typical threshold. 

Finally, the reserve-over-short-term-debt ratios for most Asian economies exceed the general rule of thumb that suggests a 100% coverage, with Malaysia being the slight exception.

Should we, then, worry that these buffers are eroding somewhat as foreign exchange reserves are being used to protect currencies against strong depreciation pressures? At one level, no — after all, the whole rationale for building up these reserves is to use them in the kind of troubled period we are currently enduring. Moreover, it is unlikely that the period of turbulence will last so long that the buffers are reduced to worrying levels.

Conclusion: What ultimately matters is credibility built on sound policies

Our view is that while these quantitative metrics are important, the nub of the issue is not so much numbers as something more intangible, namely the credibility of policymakers.

The past few years saw one crisis after another and were therefore a test of the systems in Southeast Asia. It is fair to say that throughout this challenging period, Southeast Asian countries gave financial markets good reasons to be confident in their policymaking prowess — at least insofar as macroeconomic policies were concerned. Monetary policies were carefully calibrated and, even where quantitative easing was used, this was done in a careful manner and communicated clearly to financial markets. Fiscal spending had to be expanded massively to cope with the Covid-19 pandemic but, even here, policymakers were quick to sketch out plans to return to fiscal rectitude in a reasonable period of time. Indonesia is a particularly good example of a country that has established itself as a credible player, but so were other regional economies.

In short, we are in for a tumultuous time in the global economy and in financial markets. So long as governments in the region remain rigorous in their policy approach, we believe the region can withstand the turbulence and come out in good shape.

Manu Bhaskaran is CEO of Centennial Asia Advisors

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