This article first appeared in Forum, The Edge Malaysia Weekly on May 18, 2020 - May 24, 2020
After two months of turmoil, financial markets in Asia have stabilised. The region’s currencies weakened sharply against the US dollar in the early days of the Covid-19 crisis. But they have now bounced up, even though many are trading at levels that are generally weaker than where they were pre-crisis. Still, there is no room for complacency. Asian currencies continue to be at risk as global investors remain nervous. The unsettled global economy, continuing virus risks and geo-political tensions could easily trigger another bout of financial turbulence during which our region’s currencies could again come under severe stress.
As the volatility of the past few days in global markets has shown, investors are still nervous and ready to pull capital out of Asian markets at a moment’s notice. The US and China are engaged in ill-tempered exchanges over all manner of issues while American legislators and officials threaten new regulations or policies that could hurt China. The Covid-19 virus continues its deadly march across the world. True, several countries seem to be finally coming to grips with containing the virus and are gingerly easing the restrictions that crushed their economies. But fears abound that a second wave of infections could erupt and bring the tentative hopes for a recovery to a swift and inglorious end.
Given this investor nervousness, there is one factor in particular that could spell trouble for regional currencies, and that is the darkening outlook for several emerging economy currencies. The economic fundamentals in many emerging economies have weakened. Especially concerning has been the surge in indebtedness. Emerging markets as a whole have foreign debts of around US$71 trillion (RM308.5 trillion). Of this amount, an estimated US$6 trillion will mature this year — meaning emerging economies will have to find the money to repay these debts in the current unfavourable circumstances.
Still, the largest emerging economies outside Asia are facing immense challenges. Brazil, Turkey, Russia, Mexico and South Africa are all facing one kind of pressure or other. The virus is spreading in Brazil and President Jair Bolsonaro’s erratic policies have raised fears that he may be impeached. Turkey, too, is suffering a widening public health crisis — investor concerns have been compounded by declining foreign exchange reserves, aggressive monetary easing and impending large debt repayments. Turkey also has the misfortune to live in a dangerous neighbourhood where political risks are rife. In Russia, virus infections are growing at a frightening rate and the economic consequences could be dire.
In addition, there is a class of emerging economies called the frontier economies that are under substantial stress. In the heady days of ultra-easy money, investors rushed to buy bonds issued by these riskier developing economies whose debt burdens have leapt from not quite US$1 trillion in 2005 to US$3.2 trillion currently, or 114% of their GDP, according to the Institute of International Finance. In recent weeks, several of these frontier economies, including Zambia, Ecuador and Rwanda, have revealed that they may be unable to repay their debts. Lebanon has already defaulted on its debts while Argentina is in tense negotiations with creditors and may default soon.
More can be said about other emerging economies but the picture is clear — the chances of a sudden loss of confidence in emerging markets is real.
Where are the vulnerabilities in Asia?
Asia’s emerging economies are generally in better shape but they will not be immune to such a shock. Despite these better fundamentals, the movements of several Asian currencies seem to be correlated with troubled emerging economy currencies such as the Turkish lira — this applies in particular to the Indian rupee, Vietnamese dong, Indonesia rupiah and Philippine peso.
One reason for this high sensitivity to emerging currencies is the surge in foreign debt across Asia. The total debt in non-financial corporations in Asia has grown substantially since the global financial crisis 12 years ago, and a large portion of this is denominated in foreign currency. This year, an estimated US$900 billion of debt is maturing, and of this, US$150 billion is denominated in US dollars — at a time when the greenback is very strong and the deep recession has depleted the cash flows of indebted corporations. Should investors’ risk appetites take a plunge because of multiple stresses in emerging economies across the world, it will become difficult for the Asian emerging countries to refinance their debts.
Another challenge in Asia is the high foreign ownership of financial assets. This means that when there is an abrupt fall in risk appetites, the exodus of capital can produce very damaging consequences — local currencies fall sharply, potentially triggering a loss of confidence. Foreign ownership of bonds and equities remains relatively high in both Indonesia and Malaysia, even though it has edged down of late.
How concerned should we be?
The risks are high and they are growing. However, there are also some offsetting factors. After all, during the extreme turbulence in financial markets in March, we saw massive capital outflows from Asia, dwarfing even the huge exodus during the global financial crisis in 2008. In March, Emerging Asia alone endured US$19.5 billion of outflows from debt markets and US$35.9 billion of outflows from equity markets.
But the big point is that even such eye-watering levels of outflows did not destabilise emerging Asia. This speaks to the considerable improvement in resilience in the region. Currencies did depreciate but not alarmingly. Also, these currency adjustments did not produce damaging spillovers to the rest of the economy — a stark contrast to previous crises such as in 1997/98 when an initially small currency shock was rapidly amplified into a crisis of historic proportions. Emerging Asia has been tested and has shown itself to be considerably more resilient than in the past.
There are several reasons for this greater resilience. First, the recent depreciation of Asian currencies has left them much more competitive than before. While their currencies have fallen in value, inflation rates have remained low — which means that the cost competitiveness gained from weaker currencies has been preserved. That, in turn, means that our currencies do not need to depreciate any further in order to boost exports.
Trade balances in this region have actually been improving despite the fall in exports. The extraordinary plunge in oil prices is a boon for virtually all the emerging Asian economies, except perhaps for Malaysia. Moreover, as the Covid-19 crisis has spread, businesses have become wearier of making large capital spending commitments. The resulting fall in investment has helped to compress imports.
Finally, Asian central banks have also established greater credibility in the eyes of financial investors over the years. They have improved the quality of their communications with investors, who have rewarded this greater transparency with more confidence in central banks. Central banks in the region have also won kudos from investors for steadily bringing inflation down — investors know that if a country’s inflation rate is not much higher than its trading partners’ inflation, then its costs are not rising faster than in its trading partners. That preserves the currency’s competitiveness and reduces the need for currency depreciation to support export prowess. Across the region, such inflation differentials have narrowed, which means that Asian currency risks have fallen in a very fundamental way.
What should we look out for now?
Even if there is renewed pressure on emerging economy currencies, Asian currencies remain well-positioned to withstand those pressures better than their peers. It would probably take a confluence of unfortunate developments to upset the currency equilibrium in Asia.
The critical risks to watch out for would be whatever might crystallise a destabilising loss of confidence in a country. We need to look out for the following:
• A political crisis that shakes confidence even among locals, prompting a flight of capital on a large scale: While there are concerns over political friction in some countries — such as Malaysia and Thailand — no one expects political unrest or disturbances of a serious kind.
• A failure to contain the spread of the Covid-19 virus, leading to a prolonged period of lockdown that would crush the local economy: Several countries in Southeast Asia have managed the crisis very well — Vietnam and Thailand, for instance — while Malaysia has also done reasonably well despite a political crisis. Singapore is on track to bring down the pace of new infections after the unfortunate setback with its large population of foreign workers. There are some question marks over Indonesia and the Philippines, though. In Indonesia, there is no sign of the rate of new infections abating. A recent spike in infections in the populous province of East Java has raised concerns. The traditional exodus of people from towns back to their home villages has been banned by the government so as to forestall the spread of the virus, but enforcement of this ban has been ineffectual. However, checks by independent sources of the number of burials and cremations suggest that while the disease is still spreading, the spread is not as alarming as feared. So, as far as we can tell currently, the likelihood is that the virus will continue spreading in Indonesia for longer than in other parts of the region but the damage caused is likely to be less than in the worst-affected countries.
• A large and unexpected deterioration in current account deficits: For example, should the supply and demand factors in the oil market improve significantly by the fourth quarter as some expect, we could see a strong rebound in oil prices. That would reverse some of the improvement in the external accounts that currently help Asian currencies. A second threat is if remittance incomes collapse. Remittances are quite important for the Philippines in particular while Indonesia is also a net recipient of remittances. The World Bank has warned of a threat to remittance inflow. Large numbers of migrant workers in the Middle East might be sent home as collapsing oil revenues sends countries in that region into a severe downturn.
• Worries about future central bank policies: As explained above, the increased credibility of central banks has been an important reason for currency resilience in Asia. Anything that dents that confidence would pose a risk to currencies. For instance, developed-country central banks have resorted to extreme forms of quantitative easing, bordering in some cases on outright printing of money. But these developed countries are generally given a lot more leeway by financial markets than developing economies. Currencies in the region would certainly be hurt if their central banks chose to experiment with far more aggressive forms of monetary easing than what markets are used to.
Conclusion: So far, so good
There is no room for complacency vis-à-vis the risk to Asian currencies. The global environment will remain fraught enough to keep investors nervous. Despite immense challenges, Asian currencies have held up relatively well, and for good reason. But we would not be surprised if emerging market currencies come under severe stress in the coming months. Policymakers in Asia — which means central banks and their political masters — must be careful not to risk recent gains through political or policy moves that undermine confidence.
Manu Bhaskaran is CEO at Centennial Asia Advisors
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