Asia has reduced its exposure to short-term capital flows since the 1997-8 crisis. Many countries run current account surpluses and the region has accumulated vast currency reserves.
July 2 marked the 10th anniversary of the devaluation of the Thai baht that ushered in the Asian currency crisis. The period that followed saw an huge decline in activity and buying power in the region, bursting the bubble on the growth of the “Asian tigers”. Yet from the end of 1998 to July 2, 2007, the MSCI Asia ex Japan index has produced a return of 217% in dollar terms, outperforming the MSCI World index in every year except 2000 (including a return of 18% from the end of 2006 to July 2, 2007 compared with a 10% return for the MSCI World). The cumulative excess return from investing in the region since the end of 1998 has been 151%. Yet as the chart (top) shows, despite this relative outperformance the region has only just recouped 50% of the relative losses of 1997.
Unlike the mid-1990s when financial stresses were evident, the Asian economies and markets remain robust. In the 1990s these economies ran large current account deficits, but it is no longer the case. According to the International Monetary Fund, India ran a current account deficit of 2.2% of gross domestic product (GDP) at the end of 2006, though this is an exception. As a group the newly industrialised Asian Economies ran surpluses of 5.6% of GDP.
As a consequence, these countries are now not as vulnerable to the whims of short-term investment flows. That many economies now run current account surpluses shows that those in the domestic economy are being conservative. Few businesses are highly leveraged, many operate with net cash on their balance sheets, preferring to hoard cash rather than build new productive capacity, reflecting lessons learned in the crisis period.
In some ways this conservatism creates vulnerability, as it implies reliance on external demand. The accumulation of vast foreign exchange reserves shows the region has not yet forgone its mercantilist ways, as the reserves reflect an unwillingness to let local currencies appreciate. While this would increase residents’ buying power, it would also undermine export competitiveness.
This dependence on an export-orientated model could see growth slow were the world economy to slow down. The most likely source of such a downturn would seem to be the American housing market, where the implosion caused by the collapse of the subprime lending sector shows no signs of abating.
The latest release of the National Association of Home Builders (NAHB) survey showed confidence fall to the lowest level since January 1991, as the index has sharply reversed the signs of stabilisation seen over the turn of the year. The NAHB survey has only been lower than the latest reading in December 1990 and January 1991, yet this earlier occurrence happened in the midst of the first Gulf War and 18 months after the Federal Reserve had first cut interest rates (rates had been reduced from 9.75% in May 1989 to 7% in November 1990.
If anything, recent weeks have shown that the effects of the housing downturn are becoming more widespread as the extra premium on corporate bonds and related derivative structures have started to widen after a prolonged period of decline. Furthermore, where debt issues were got away easily earlier in the year and “cov-lite” deals were common, deal sizes are now being reduced or pulled as investors tighten the conditions under which they are willing to invest.
With some large debt issues due to hit the market over the summer, including $62 billion (30 billion) to be raised by Cerberus to complete their Chrysler purchase, the repercussions for equity markets underpinned by the “leverage buyout” bid could be significant if private equity fails to finance these take-outs.
Yet were there to be a knock-on hit to Asian equities if risk appetites diminished, it is likely this would present an opportunity to buy greater exposure to the domestic Asian economies. While there is doubt whether Ben Bernanke, the Fed’s chairman, will enact his version of the “Greenspan put”, the likely response to any seizing up of American credit markets would be to cut interest rates in an effort to underpin the American housing market and restore confidence.
As was the case following the post-2000 downturn, such a move would further undermine the value of the dollar. Where the post-2000 problems centred on corporate finances, this time it is homeowners who are likely to be shut out from markets. Under such a scenario, rate reductions from the Fed would persist.
With no evident inflation problems, Asian economies could be expected to mirror these interest rate reductions, in part to prevent their currencies from rising too rapidly in value versus the dollar. Minus the debt overhang faced by America, this monetary easing would see domestic activity in Asia respond relatively rapidly. As the chart (bottom) shows, American equities underperformed the world and Japanese equity markets in 1993/1994, as improving global growth to the middle of the decade even lifted growth rates in post-bubble Japan. Yet the correct decision was not to return to the 1980s trend of chasing Japanese outperformance; it simply provided another opportunity to add to American positions.
Any America-led down cycle in global activity would offer a similar opportunity in Asia. So while it may be difficult to argue that Asian economies and markets would be immune from a serious downturn in America, the lower levels of debt and stronger position of these nations suggests the medium-term risk reward remains attractive.