Since July, when the Philippines devalued its currency, Asian currencies have endured a brutal pounding, exacerbated by the Hong Kong stock-market bloodbath of October 28 and mounting evidence of Japan’s banking-sector problems. Fearful of the risk of contagion, investors have been retreating from such places as Russia and Brazil where risks are particularly apparent. This has put stiff pressure on these countries’ currencies.
“We’re entering a risk-aversion phase with the focus on safety,” says Avinash Persaud, chief currency strategist at JP Morgan in London. “This has been initiated by Asia and by the year-end wish to protect savings. As for the force of contagion, the greatest risk is now. We would tell investors to reduce exposure.” He thinks it could be a year before investors in emerging markets feel courageous enough to return in force. For now, investors are still reeling from heavy declines in Asian currencies. Since the middle of last year, Indonesia’s rupiah has fallen by 87%, the Korean won by 85%, the Thai baht by 63%, the Philippine peso by 34% and Malaysia’s ringgit by 32%.
“Generally, many investors were lured to the emerging markets because they saw it as a good diversification, a little patch of nirvana,” Persaud observes. “As ever, foreign-exchange markets like to punish the complacent.”
Some emerging-market investors, including Baring Asset Management and Foreign and Colonial, have already cut exposure to places such as Russia, where an estimated $5 billion has left the country’s government bond (GKO) market and where a further $4 billion to $5 billion is also at risk of leaving. The government has so far spent around $2.5 billion, or a tenth of its foreign-currency reserves, to support the rouble since October 28. In all, foreign investors own 30% of Russia’s $58 billion rouble-denominated GKOs.
The bleeding of foreign-investor capital has compounded nervousness about the potential for fresh volatility when the government reverts to a new foreign-exchange system on January 1. The central bank will then re-denominate the rouble to 6.100 to the dollar with a 15% band on either side of that rate.
“Right now there is a sliding band until the end of this year,” says an official with the EBRD. “If the rouble significantly devalues between now and the end of the year, it would slide out of this band. This would be a big problem. It would dent the credibility of the central bank, which has been the most credible policy maker [in the region]. The pressure is there, and it’s very significant.”
Currency traders say that if the rouble falls below 6,350 to the dollar – the central bank’s so-called “line in the sand” – the risk of devaluation would dramatically increase. “People think that’s a long way off,” says a currency trader at Citibank. “But we’ve seen big currency moves, and you can’t rule it out.” For much of December, the rouble was trading at around 5,950 to the dollar.
Regional concerns
For the moment, investors and other currency specialists will be watching closely. Attention will also be trained on some of Russia’s neighbours. “We’re concerned about Russia, Czechoslovakia and Poland, and the exit of money via Russia’s GKO market,” says Stephen Hannah, IBJ International’s chief economist in London. “There are worries about the impact on the rouble. That could trigger a ripple effect on former Soviet Union countries.”
Many big investors are loath to take any chances for the moment. Although the rouble fell only just over 6% last year, compared with 19% in 1996, there are fears that the currency could yet take a big spill.
“We’ve reduced our Russian exposure, and we’ll be closely studying what’s going on there,” says Jim Valone, portfolio manager for Baring Asset Management’s $700 million emerging-market debt fund. “The main impact on the rouble is pressure to convert into dollars as foreigners exit the GKO market. The central bank will have to defend currency by spending reserves or they’ll need to raise interest rates. If they keep raising interest rates, that will impact the economy and hinder their recovery.”
Although most investors and economists believe Russia will weather this period of Asia-inspired crisis, some admit it’s still one of the toughest times the rouble has faced since the government embarked on its programme of serious economic reform. Confidence has been shaken by the scandal-prompted resignation of finance minister Anatoly Chubais (who remains deputy prime minister) and the worrying state of public finances. The IMF has suspended a $700 million tranche of its $10 billion support loan because of poor tax collection. Russia’s inability to gather taxes has meant the country is still heavily dependent on domestic and foreign borrowing to finance its budget deficit. These anxieties are keeping pressure on the rouble.
“I would say this is one of the biggest tests of the rouble since it was devalued in 1994, and since Russia has been on a more reform-oriented path the past two to three years,” says David Simmonds, an emerging-market economist with Citibank in London. “I think they’ve taken a bold measure in terms of liberalizing their foreign-exchange regime, but to some extent they’re dependent on international sentiment. It would be helpful if they could come out like Brazil with strong, decisive measures,” he adds.
Within days of the Hong Kong collapse on October 28, Brazil raised interest rates from 21% to 43% to stem a flight of capital over worries about the country’s currency, the real. In contrast, Russia waited until November 10 to announce a seven percentage point rise in its refinancing rate to 28% in its own concerted effort to defend the currency and quash speculation in roubles.
Despite Brazil’s quicker and more aggressive response, the government was still forced to spend some $8 billion, or 13% of its foreign-exchange reserves, to underpin the currency. Brazil has taken these steps at a time when GDP is expected at best to grow 1% to 1.5% next year. Many in the market, including foreign-currency speculators, have taken these measures as a clear sign that Brazil means business about protecting its real. That said, the currency is by no means out of the woods yet.
“The government is really backing the currency,” says Amalia Estenssoro, an economist with HSBC James Capel in London. “And up to now they’ve been successful. But we have to see if capital flows return. Flows haven’t been stabilized yet and we have to see what happens when Eurobonds are rolled over in the first quarter [up to $5 billion of Eurobonds are due to be redeemed by the end of December]. That’s the big test.”
Until now, the government has been able to avert a crisis, as it did in October. Estenssoro reckons the government has enough ammunition to withstand another currency assault by speculators. Reserves currently stand at $52.9 billion. She says the country could afford to run those reserves down to $40 billion. “Below that, you’re talking about the IMF coming in to help,” she says.
Worries about US exposure
Right now it’s hard to say where emerging-market investors feel safe to go. With Asia looking off-limits for months or more to come, some argue that a good chunk of that money will have to go somewhere else, such as Latin America. As much as Brazil would like to be a home to those funds, however, emerging-market investors may feel it’s too soon to take that chance – at least until it becomes more clear what effect the Asian crisis will have on the US economy. Brazil and Argentina are among the most sensitive of the Latin American countries to the US economy, which means they’re particularly vulnerable if economic growth in the US slows significantly.
“Our estimates are that US growth will be hit by around 0.3% over the course of next year; Europe by 0.1%; and Japan by 0.6%,” says Nick Parsons, currency analyst at Paribas Capital Markets in London. “The US isn’t the biggest casualty, but 0.3% is starting to be a significant number.” He believes that equity markets will remain unsettled through next year, with major exchanges shedding another 5% in value. One worry is that further serious losses on the US stock exchange could prompt a repatriation of dollars elsewhere. Others, meanwhile, say Asia’s deepening credit problems in the finance sector could also have serious repercussions in the US.
Stephen Lewis, chief economist of London Bond Broking, a division of Monument Derivatives, says the market is currently of two minds about the credit crisis in Japan. One view, he says, is that the Japanese authorities are biting the bullet at long last and will stem the financial problems which have burst to the surface. The other is that this is the first stage in a progressive breakdown of the financial markets in Japan.
“This is dominating sentiment, and it’s giving rise to some of the major capital flows out of the yen and into the Deutschmark and other European currencies, on the view that the US financial system could be more exposed to a breakdown in the Asia Pacific region,” says Lewis. “Europe is seen, wrongly, as insulated from that area.”
Lewis argues that Japanese banks are primary lenders in Asia Pacific, including parts of the US, making this whole region especially vulnerable if Japan’s banks go into free fall. In California, he says, some 30% of bank deposits are owned by Japanese institutions. There’s a danger, however remote, that these institutions could start calling in loans.
IBJ’s Hannah agrees that fear of a US slowdown has been the primary cause of the dollar’s relative underperformance compared with the Deutschmark. In late August, when the Dow Jones index fell 1,000 points in just four days, the dollar fell to Dm1.7120 from Dm1.7700. The dollar has yet to recover fully, having so far retraced 77% of those losses through the end of December. But Hannah believes that fears of looming US economic and financial woes are overblown. “There’s a big debate about what impact Asia will have on the US,” he says. “But as far as fears about bank deposits and the wholesale selling of US treasuries go, I think that’s an overdone worry. The Bank of Japan has made it clear it’s going to make available large liquidity, so panic selling of US dollar assets is not a likely scenario.”
If market strategists think it unlikely that the US will fall victim to a wholesale exodus of investors, many think it even less likely that the Asia crisis will stop European monetary union from going forward on schedule. This is partly because Europe has so much at stake in the run-up to Emu, and partly because the currency markets are one of the few areas where central banks can exert some real control. Many traders believe there’s still upside for continental European currencies which have been overshadowed by the Deutschmark and the dollar, but that trading ranges will probably remain limited for quite a while. Continental European currencies could get a boost from global bond investors that have been underweight in Europe, but those gains will probably be conservative given the uncertainties about the practicalities of Emu. Europe’s central banks, meanwhile, have their own agenda for keeping currency ranges as quiet and predictable as possible.
“Central banks have an incentive to keep currencies in recent ranges,” Paribas’ Parsons says. “They can’t control equities, but they can control short-term interest rates and currencies.” As he sees it, “the major preoccupation of policymakers is to prevent a meltdown”.
Credit quality matters
In the meantime, market-makers and investors will be digesting lessons learnt from the Asian currency crisis – and attempting to anticipate other possible crises in the process. Stuart Brown, an emerging-market economist with Paribas Capital Markets, says the markets are already digesting one now-obvious lesson: the microeconomic issues such as asset quality and credit exposure in Asia.
“This whole thing with Asia has reached a proportion which has surprised many of us,” says Brown. “It is a part of the world which was characterized by solid fundamentals, and now is characterized as a toxic wastehill. There are factors which we haven’t given enough attention to, micro-underpinnings like banking supervision, the quality of lending to enterprises and the amount of investment in real-estate.”
David Beers, managing director of sovereign debt at Standard & Poor’s in London, thinks government authorities in Asia remain in shock and so haven’t absorbed all the economic-policy implications of the crisis as yet. “The story is going to linger for some time” he warns. “Next year, there will continue to be currency [turbulence] because of uncertainty about government policies. There are probably a handful of systems which could still get in trouble. They’re mostly in Asia, but there are some in eastern Europe.”
Beers suggests the next currency crisis could take the form of a sovereign default on speculative-grade debt, should credit problems surface abruptly as they did in Asia. He draws a parallel between the mass defaults that tore through the US high-yield debt markets in the late 1980s, when nobody had any such default experience, and the possibility of future defaults among unsuspecting investors of emerging-market sovereigns.
“Investors keep thinking these countries have been around a long time. But I keep reminding people that five years ago Hungary and Mexico were the first sovereign issuers of speculative-grade debt. This is a market still struggling with that key concern: what does a sovereign default look like?”
