Anniversaries are always a tempting time to reflect on past achievements. This summer will mark 10 years since the start of the Asian financial crisis that started with the run on the Thai baht and spread rapidly across the region’s currencies and economies, wreaking havoc. A decade on and, with the possible exception of Thailand, Asian economies have much to celebrate.
In 1998, the economies of Indonesia, Malaysia, the Philippines, South Korea and Thailand, the countries worst affected by the crisis, shrank by almost 8% on average. The same economies grew at a respectable 5.4% in 2006. Government finances have been strengthened and capital controls mostly removed. The capitalization and regulation of local banks have improved significantly and Asian stock markets are more accessible to foreigners.
Although the picture for Asia seems unremittingly positive, it might be premature to open the champagne. There are several alarming similarities between Asia 10 years ago and now. In the decade before the crisis, the economies of Indonesia, Malaysia, the Philippines, Singapore and Thailand grew on average by 8% a year, according to the IMF.
Rob Subbaraman, regional economist at Lehman Brothers in Hong Kong, estimates that the GDP of Asia ex-Japan will grow by 8% in 2007 and 2008.
The inflation outlook 10 years ago, as now, was muted and most Asian economies were running healthy budget surpluses, as is the case today. Foreign capital inflows were also extremely strong, with almost $100 billion of capital inflows in 1996, another similarity (see chart).
"Capital inflows for the region are bigger now than at any time than before the crisis," says Subbaraman. "This can become too much of a good thing. It’s one of the reasons you had the Asian financial crisis 10 years ago."
Crises have a habit of emerging from unexpected places, so now would seem an apposite moment to consider where a problem might emerge. Garry Evans, Asia equity strategist at HSBC identifies what are generally perceived to be the key "known" risks facing Asia’s economic progress, including a slowdown in the US, monetary tightening in China, and a return of strong inflation. He then considers what he deems the "unknown" risks, or "black swans", in a reference to the book of the same name by trader-turned-author Nassim Nicholas Taleb – unpredictable events that upset perceptions of the ordinary course of things.
According to Evans, certain Asian markets have displayed unusually high interest rate and currency volatility despite a generally benign outlook for financial markets. This could spell trouble ahead as central banks worry over an excessive build-up of foreign borrowings, inflationary pressures from overheating economies and excessive market speculation or a lack of export competitiveness because of currency appreciation.
However, both Evans and Subbaraman find the greatest risk for a market upset at the very heart of what is fuelling Asia’s markets. Global liquidity, the flow of capital into Asia and its corresponding effects on currencies, interest rates and ultimately, markets is "probably the most likely hatching area for black swans," says Evans.
The effects of globalization on Asian economies – labour arbitrage that absorbs inflationary pressures and growing trade surpluses recycled into local bond markets – are pouring money into the economic system. Increasingly, that money is finding its way into markets, leading to asset inflation and, inevitably, to bubbles.
Loose monetary conditions coupled with the benign inflation environment produce low real interest rates, and that is attracting foreign capital. Lehman Brothers estimates that capital inflows to Asia ex-Japan averaged 6.1% of GDP in 2005 and 2006, similar to the levels in the two years before the crisis. More capital means more competition for assets, reducing returns and raising risk appetite.
"With risk-free rates everywhere low," says Evans, "investors have been forced to take risk to pick up yield... Huge amounts of capital have flowed into emerging markets and bonds."
Capital flows
Compare that statement with comments made on the origins of Asia’s financial crisis by Stanley Fischer, then first deputy director of the IMF, in a speech in Washington DC in January 1998. "Large private capital flows to emerging markets, including the so-called ‘carry trade’, were driven by... an imprudent search for high yields by international investors without due regard to potential risks," he said.
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Asia ex-Japan’s total capital inflows and outflows |
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Note: includes China, India, Philippines, Singapore, South Korea, Taiwan and Thailand |
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Source: CEIC and Lehman Brothers |
Although capital flows are the driver of current market conditions just as before the Asia financial crisis, the nature of the capital is different. Ten years ago, much of the capital that flowed into Asia comprised short-term bank loans, which were withdrawn rapidly as the crisis hit. Most of the capital flowing to the region today is in the form of equity, either direct or portfolio investment.
The nature of the capital is different but the effects are the same. Risk appetite has grown as cost of capital has shrunk. Asset inflation has set in and bubbles are clearly forming. Domestic equity markets in China and Vietnam are the clearest examples. Several Asian real estate markets also look overvalued.
Although the predominance of equity in capital flows will render a financial crisis on the scale of 1997 less likely, if a sharp correction does arrive in Asia foreign capital will be harder to withdraw, making the inevitable adjustment possibly more painful for investors than for companies.
Despite the risks behind Asia’s latest decade of growth, known or unknown, no one is predicting an end to the party in the near future, although everyone agrees that current conditions cannot continue indefinitely. What does seem clear is that the longer Asia’s markets party continues, the less likely it is that the next 10-year anniversary will be nearly as rosy as the present one.