It’s all just a drop in the ocean


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Still convinced that their ailing currencies are sick because of the attentions of speculators, Asean finance ministers have agreed a fund for mutual defence through forex market intervention. Most bankers reckon the $1 billion put in the pot is a derisory amount to cope with what is anyway a misdiagnosed condition. Beyond that there’s disagreement on whether Asean currencies have bottomed out or have further to fall.

Singapore: stands out from the general
gloom about southeast Asian economies
With the region's currencies crashing down around them early last month, the finance ministers of the 10 member states of the Association of Southeast Asian Nations (Asean) sat in a room in Kuala Lumpur, Malaysia, that must have seemed more like a bunker. They asked themselves, as their currencies fell, how it all seemed to be going horribly wrong - again. After all they were still making the right noises about reform. How could they have been found out so quickly? The truth is, investors haven't believed the spiel for some time.

The fact that many of the region's economies had seemingly recovered so dramatically had led to complacency. It meant that they didn't bother to finish the prescribed course of antibiotics. And unlike the last time their currencies dropped to similar levels, the US economy is not going to pull them out of the quagmire quite so rapidly.

Before the Asean ministers got together it was pretty clear what topic would dominate their discussions: the Asean swap arrangement. The member states, with Japan, Korea and China standing alongside, felt it necessary to give a signal to boost confidence in their sagging currencies: to tell the world that, if the worst came to the worst, they would defend their currencies against what seems an inevitable downward trend. To back up such a bold statement Asean plus 3 decided to dig out, dust off and present to the global investors an old defunct plan that didn't work the last time their currencies headed south.

The Asean swap arrangement (ASA) is a network of swap agreements between member states set up in an attempt to stop raids on the region's currencies. The central pool of $1 billion - increased from $200 million - in theory would quickly be made available to member states faced with a short-term liquidity crisis as a consequence of defending a currency against the onslaught of speculators. In addition, it was proudly announced, Asean members are negotiating bilateral agreements with China, Japan and Korea that will also allow them to get their hands on the foreign reserves of the north Asian states if the need should arise.

The IMF has sniffed around the plan, seeming to feign some interest, and made grunts about pulling it under its umbrella of influence. It would seem to be done mainly to aggravate Malaysia. Japan, much to the annoyance of Malaysia, believes too that only 10% of the total amount of bilateral swaps agreed should be free from constraints - the remaining 90% should be tied to the reforms overseen by the IMF. That seems a reasonable idea considering certain members' penchant for throwing good money down big black holes.

Malaysia, which did have other plans, made it perfectly clear that the whole region could well do without any more interference from the IMF, claiming that its states' sovereignty was threatened. This culminated in an outburst and stamping of feet by Malaysian finance minister Daim Zainuddin, who declared: "We are not under the IMF. Why should they impose their conditions on us?"

But while Malaysia is getting hot under the collar about the arrangement, most international bankers are unsure what all the fuss is actually about. Although many of the details and arrangements are being kept under wraps until the Asian Development Bank meeting in Hawaii later this month, it's tough to find a banker who doesn't openly laugh when ASA is mentioned.

An economist based in Hong Kong describes ASA as no more than a red herring. A currency strategist based in Singapore says: "It's a total non-starter. I am totally cynical about it and unless I am missing the point it's a pile of garbage." Credibility is the major problem. But it's not the bankers that have missed the point. With the reappearance of ASA with such a fanfare it appears that Asean itself has missed the point.

The region suffers from a psychological overhang from the 1997-98 crisis. The speculative raids that caused currency values to plummet over a 12-week period are burnt into the minds of politicians and decision-makers of the time, many of whom are still clinging to power. Several states remain deluded, blaming evil external forces. They find it hard to believe that this time their currencies are not on the slide only because of speculators and hedge funds.

"Speculators may have benefited from it but they are not the fundamental cause," says Julian Jessop, economist, global markets at Standard Chartered Bank in London. "It's a combination of fundamental domestic economic and political problems and a global slowdown that has seen flight to the dollar." Salomon Smith Barney/Citigroup's Clifford Tan, director for Asian economic and market analysis in Singapore, agrees. "There is a belief that ASA is set up against hedge funds, but if you take the other side of the coin, you have to have slippage on a number of fronts to make such attacks possible. Speculation doesn't occur in a vacuum."

"Look," says Geoffrey Barker, HSBC's chief economist in Hong Kong, "if central banks believe that this is a speculative problem then they are barking up the wrong tree."

The number of hedge funds has actually fallen since the crisis. And as Rebecca Patterson, vice-president and currency strategist at JP Morgan, points out you don't see one or two investors coming in and doing the monster trades that move the markets any more.

And "because of market volatility, investors take profits earlier", she notes. "They'd sooner take the 3% profit rather than risk waiting for the 15%."

The size of ASA points to its being no more than a symbolic stance. Some might say shambolic. As all of the strategists and economists point out, $1billion is a drop in the ocean. If any speculator were to make a concerted effort to knock a currency out the amount on offer would not last very long. "It is like giving 10 people on the Titanic one life jacket," says Jessop. "It's practically irrelevant. Even if you gave $1 billion to each country, that is only a few days' trading."

Deutsche Bank's Peter Chen, managing director and head of FX sales Asia, doesn't go so far as to describe it as irrelevant. He feels that, leaving aside the amount agreed, ASA creates a sense of security in a market that requires confidence. "People need to know that the leaders are serious and that there is hope out there. This is as much about human psyche as market mechanics."

Mansoor Modi-Udin, currency strategist for UBS Warburg in Singapore, agrees. He believes that if the policymakers are so determined to continue blaming outsiders for their woes they have to be seen to be doing something. Just saying they will stand up to speculators is not enough for a politically excitable and fickle populace.

Peter Chen
The reality, however, is that if Asean really wants to impress the market it should be talking about a common reserve in the region of $75 billion. Further credibility could also be added if the arrangement were automatic.

So, if a currency were to come under pressure, the Asean central banks with their large excess reserves would readily jump to its defence. "However," says Peter Redward, a currency strategist in Deutsche's Singapore office, "the key to a system like this, is that it needs a large country that has stability and can act as an anchor. But in Asia we don't have that. Japan is not big enough now to be able to provide such stability and it has a volatile currency too, moving 25% in the last 12 months. China? That's at least 10 years away from being in such a position."

The bilateral agreements are an important part of the strategy of weaker countries such as Thailand and Indonesia. But again the markets are sceptical. Thai officials, for example, are confident that an agreement with Japan will be signed in Honolulu. Against a romantic and tranquil setting of palm trees and white beaches, Thailand and Japan will reach agreement that will allow them to borrow up to $3 billion from each other to prop up their respective currencies.

But what's confusing is the lack of rationale. Thailand already has $32.2 billion in foreign reserves. And Japan won't go, and has no need to go, cap in hand to Thailand asking it to chuck Japan some loose change.

"I met with some Korean government officials last week," says one banker, peppering the conversation with names of the region's political heavyweights he has met and apparently advised. "And I asked them if they would be willing to lend to southeast Asia.

They just laughed at me because, as they said, nobody is going to give carte blanche over their reserves. That's the main problem."

Desmond Supple, managing director and head of research, Asia, at Barclays Capital, doesn't confine his laughter to ASA - he also can't contain his mirth when these ever so slightly more sensible bilateral arrangements are mentioned. "Korea, Japan and China are not going to lend to southeast Asia. Korea needs all of its reserves," he says. "The Korean government is building up liabilities so fast that it will need those forex reserves. And who is going to lend to Thailand? It has $32 billion in forex reserves but almost half of them are loans that have to be paid back over three years. It's just not going to happen. There is just a total lack of reality."

Citibank's Tan adds another element to an already depressing equation. "The problem is that if you put too much money on the table and your country's economic fundamentals are out of whack you could then potentially introduce some element of speculation," he says. "It's also a potential land mine risking your reserves for another country. They need to be extremely cautious about how these funds are used if at all. I believe they are still putting the cart before the horse. They should be looking at prevention rather than cure. No region can solve this by itself."

Other more desperate measures have been introduced by such countries as Thailand and Indonesia in an attempt to tie down the phantom speculators. To nobody's surprise their currencies remain very weak and continue on their southerly course. In January Indonesia's central bank decided to tighten forex trading restrictions in an attempt to stabilize matters. Then in March it decided it would cast an ever more watchful eye over banks dealing in foreign exchange. All banks involved in forex deals have to provide a monthly transaction report.

Bank Indonesia has also effectively stamped out offshore banks from trading the Indonesian rupiah. "Indonesia basically won't guarantee delivery of its currency offshore," says UBS Warburg's Modi-Udin. "This means that if we trade offshore, where for example UBS Singapore tries to buy rupiah from Bank B in Singapore, there's no guarantee that if Bank B doesn't pay that we can have the settlement of this debt taken to court." Because of this, he says, the offshore market has virtually dried up. But it has come at a cost to Indonesia itself. Since liquidity has been sucked out of the market the rupiah has become more vulnerable to movement. "There are not many parties trading so any time anyone comes in to demand the US dollar the currency weakens very rapidly since there is no-one to pass the buck to in the offshore market."

Leaky currency controls
The currency controls will make no difference unless Indonesia forces exporters to repatriate dollars. There have been some attempts. "But compliance is only partial, which is actually a euphemism for saying there are 17,000 islands there," reckons one banker. "And if you know the right people you can get away with anything,".

JP Morgan's Patterson continues the theme and echoes the thoughts of every foreign banker in Singapore, thoughts that for some reason Indonesia hasn't quite grasped. "Yes they have stopped speculators to a degree, but speculators are not the root of this country's problems," she says. "The rupiah is going down because Indonesia is a mess." What's making things worse is that the longer it tries to stabilize the currency by blocking and restricting movement of capital the longer the international investor will shy away from Indonesia.

One currency that has been attracting a lot of attention is the Malaysian ringgit. As others slide, the ringgit stays pegged. The debate surrounding ponders whether or not it should be re-pegged. For now Malaysia and prime minister Mahatir Mohammad are adamant that there is absolutely no need to. This in the face of the ringgit's appreciating against all currencies in the region save the Philippine peso and the Taiwanese dollar. There is also a fear that the country's declining foreign reserves and the outflows of foreign portfolio capital are adding to the pressure.

View graph.

"We think they should re-peg," says Deutsche's Redward. "It's just a matter of how they do it. The biggest danger is that if they don't re-peg by a large enough amount then people will simply get scared about another re-peg and instead of capital flight decreasing it will increase."

Supple at Barclays Capital reckons Malaysia doesn't need to re-peg: it should get rid of the peg all together. "There is no economic rationale to keep the peg. It's purely political. Malaysia has a small open economy with a fixed exchange rate. It has got no control of monetary policy and you have to be concerned about balance of payments. Now there are large capital outflows and it's getting quite worrying."

Those who believe that Mahatir needs to loosen his grip think he should just go in one morning, bite the bullet and re-peg from 3.8 to 4.5, which would effectively snuff out the speculative pressures and expectations that are now building.

But there are just as many that feel that Mahatir should hold his ground, pointing out that with $27 billion of foreign reserves and with low external debt there is no real pressure. Mahatir himself has said that short of a 20% shift in valuation Malaysia will not even entertain the thought. And this makes some sense. Why devalue the currency when it's suffering from a lack of global demand rather than just a Malaysian problem.

"This is not a valuation issue," exclaims Barker at HSBC. "The Malaysians are taking just as much market share as all the other countries. There has to be a big change for it to become an issue. Their exports are going to slow down whether they devalue by 20% or don't devalue by 20%. It will not stop external factors from damaging the economy and even if they took another 1% market share that just won't do it in a global slowdown."

Jessop at Standard Chartered mentions a dark cloud on the horizon that could force Mahatir's hand. What happens if the Argentine peg goes? That's something that Jessop believes is extremely likely. "If the Argentine peg collapses there may well be concerns about the Malaysian peg and speculative pressure on neighbouring currencies. This could lead to unacceptably high interest rates. It's the contagion effect. You just have to look at what happened last time."

By devaluing, many bankers feel that Mahatir would be admitting failure. "But you never know what a politician is going to think next," says Eddie Tan, Citibank's financial markets head, and country treasurer for Hong Kong and China.

Geoffrey Barker
The question that most observers are now trying to answer is when the slide is going to stop. Market consensus, as is to be expected, is split. But two things are generally acknowledged. First, the dollar/yen rate is a key determinant. And second, even those banks that churn out positive spin about the future prospects of the region know they are going to have a tough time coaxing investors back into it in the short term - no matter how sophisticated bankers claim their stockpicking has become.

As one banker based in Hong Kong says: "If you are a fund manager sitting 6,000 miles away, Asia just looks terrible. OK, amongst all this you have Singapore and Hong Kong, which are, to be honest, fundamentally nice houses situated in a shitty neighbourhood." He tries to qualify his harsh opinion. "Take the Philippines and you have stories of corruption. Indonesia you have ethnic tensions and potential political instability. Will nothing ever settle there? Thailand has a new administration and investors are nervous there could be a new wave of patriotic government.

And then there's Malaysia with its fixed exchange rate that it can't maintain for ever." His stance is all too clear but he adds, almost ironically: "I sense on the currency front we may not have seen the worse."

Modi-Udin, based in the fundamentally nice house of Singapore, agrees: "It's a long term downward trend and people who try to catch the bottom keep getting hit by it. We have been telling investors that they shouldn't jump back in. Keep short in these currencies and be long in the dollar. And that seems to have worked out very well."

Supple has an equally depressing outlook. He believes that all the Asian currencies, especially the Japanese yen, are on a long-term downward spiral. The yen, he reckons, will drop from its 123 to 125 level and reach the 140 level by the year-end. That's one of the most bearish forecasts around. But he goes further. Much further. Supple points out that since there is now an awareness in Japan that building bridges across rice fields doesn't do the trick, it is moving to a neutral fiscal policy, accompanied with gradual economic reforms and a very loose monetary policy. A weak yen will be the transmission vehicle to get things moving. He notes: "Our rolling 24-month prediction is 170 to 180. We don't see that Japan has any policy options. The government says they have no growth potential in the economy. The yen is the only tool they have."

It's a sentiment that's not shared. With a yen meltdown of these proportions, Chinese devaluation alarm bells start sounding in many bankers' heads. "Assuming the downward trend will continue," says Jessop at SCB, "you can draw a line of between 130 and 140. If that line is breached there's a good chance that China will devalue and that will take everyone down." Jessop points out the bellicose noises China started to make in 1998 when the yen was hitting 148 to the dollar. "Chinese threats to devalue were an important factor behind the coordinated intervention to stop the yen going further. The Chinese don't need to devalue but the threats are more credible this time around."

Policy makers are already intervening verbally. The People's Bank of China stated that it would be more than willing to join some sort of coordinated intervention. Japan has publicly acknowledged that if the yen were to disappear too far down the tubes it would in fact be damaging for the rest of Asia.

Perhaps it's a case of Japan admitting that if it catches the flu, the rest of north Asia will be hospitalized and southeast Asia will drop dead.

Inherent weakness
Supple disagrees with this, believing that it's important not to overstate the correlation between yen weakness and the rest of Asia. "Even with a strong yen, Asian currencies are going to be weak," he says. "We are not seeing the level of reforms across Asia that should have taken place. The region has to provide underlying levels of competitiveness because there is not enough domestic demand to offset this. The easing of exchange rates is the easiest way to boost aggregate demand and promote price stability which is a trend that will lead to weaker currencies." Tan at Citibank, although a lot less bearish than Supple, points out too that if the region's currencies do strengthen against the dollar "it looks as if the economies in the region will just tank".

Peter Redward
There are some bulls. Leading their charge is HSBC's Barker, who is convinced that the slide has finished. He states: "We are in the overshoot phase of the Asian currency devaluation. How could there be a further weakening in these currencies? Valuation-wise they are as screamingly cheap as you can get. We have a major overshoot on these currencies. Most are 20% to 30% undervalued."

Barker thinks that observers have focused too much on the weakness of Asia's export performance, which has led to caution over the currencies. He points out, however, that the currencies were falling at a time when export activity was at its peak. So it wasn't a case of weak exports meaning weak currencies. He explains his reasoning: "Last year US interest rates had risen so there was a big effort to repay US debt. This meant a large capital outflow. In addition when Nasdaq fell there was a knee-jerk reaction to sell out of emerging-market equities."

In short, Barker believes that because it was these capital flows that drove the currencies last year, now with portfolio investors already having fled the carnage there can't be another wave of selling.

Following this argument would suggest that the currencies must be at the bottom. Barker is then also quick to say that investors are now very underweight Asia and underweight Japan.

Deutsche's Redward believes that in the short term there will be some further weakening but he agrees with Barker to some degree and takes the argument onto a similarly positive tack. "Most of the mobile capital has already left the southeast Asia region. There is, however, still a lot of capital that could come out of north Asia. But most people are looking past the slowdown in Korea and Taiwan and banking on this part of the world turning around."

As soon as there is a belief that the end is in sight some intrepid investors will no doubt step back in. UBS's Modir-Udin says the firm is still not recommending early attempts to get back on the Asian merry-go-round. There are also too many conflicting signals. While one proclaims that Asia is entering another crisis period and has been for some time, another gives the all-clear.

On top of this the direction of the US economy is still unsure - JP Morgan gives it a 45% chance of slipping into recession. The yen continues to slide; questions surround changes in the region's growth prospects, which are being downgraded constantly; and confusion surrounds the future direction of the tech sector.

These are all factors that will continue to weigh heavily on the region's currencies. Until investors get answers to a few of them they will continue to stand on the outside looking carefully at where to put their money.

And unless the states that are guilty of taking their foot of the reform pedal put it back on they are unlikely to be at the front of the queue to receive it. As one banker jokes: "I think sometimes it may just be safer to put all the money under a mattress."