By Ron Rimkus, CFA
From the moment U.S. Federal Reserve Chairman Ben Bernanke mentioned the word “taper” in May, markets the world over have begun to embrace a new reality. With expectations that the U.S. Federal Reserve will soon begin to tighten monetary conditions, the Treasury Yield Curve has shifted upward by more than 100 basis points, the U.S. dollar is appreciating after years of decline, and emerging markets — particularly those in Asia — are grappling with renewed volatility. Growth has begun slowing, interest rates have been rising, capital is fleeing, and in countries such as India and Indonesia, currencies are dropping sharply. All of which raises the question: Is a second Asian Contagion, like the one in 1997, in the offing?
History may not repeat itself, but it sure does rhyme. Once again, as in the mid-1990s, easy money has inflated Asian economies, particularly over the past five years. And once again, an imminent shift in U.S. monetary policy is the pin bursting the bubble.
To really understand where emerging markets are today, and what might be in store, it is instructive to look at the root causes of the 1997 Asian financial crisis. The seeds of that crisis were planted in the late 1980s and early 1990s, when many Southeast Asian nations, including Thailand, Indonesia, Malaysia, and the Philippines, experienced a long period of prosperity dubbed the “Asian Miracle.” Many of these countries achieved sustained, strong growth by employing some variant of the infrastructure growth model, a term used to describe growth fueled by investments in manufacturing, exports, technology, and infrastructure, coupled with abundant cheap labor. This combination enabled Asia’s emerging economies to produce goods for export at competitive prices. It was a formula further supported by exchange rates that were fixed to the U.S. dollar, the currency of their largest export market. But the boom was fueled by credit, much of it denominated in U.S. dollars, as foreign capital sought out higher interest rates coupled with limited currency risk. In short, the Asian Tigers had hitched their wagon to the U.S. economy.
Unfortunately, things began to sour in 1995, when the United States adopted the Reverse Plaza Accord, whereby the U.S. Federal Reserve reversed its previous efforts to reduce the value of the U.S. dollar and coordinated monetary policy with Japan and Germany to increase the value of the dollar relative to those countries’ currencies. The rising dollar was a pivotal moment for the Asian Contagion: Over the 1995–1997 time frame, the Japanese yen fell approximately 60% against the U.S. dollar, making Japanese exports much cheaper on the international export market — and naturally, much more competitive against exports from Asian Tiger countries that were still pegged to the now rapidly appreciating U.S. dollar. As the dollar appreciated, currency markets smelled a problem and began selling Asian currencies, homing in first on the Thai baht, which authorities were forced to devalue in July 1997. Once Thailand broke its peg, currency traders swooped in on the remaining Asian Tigers, forcing each of them to break their own pegs. Ultimately, the International Monetary Fund was called in to provide financial support and help arrest the capital flight.
Once again, emerging market economies are suffering from capital flight. Yet some things have changed. As a recent article in the Wall Street Journal points out, Asian economies, for the most part, no longer maintain currency pegs to the U.S. dollar; instead, their currencies float freely. In addition, Asian central banks’ foreign reserves are substantially larger. Even so, dependence on foreign capital still runs high: In India, where the rupee has dropped 13% in three months to an all-time low against the U.S. dollar, external debt clocks in at more than $400 billion, of which roughly 80% is denominated in foreign currencies. India’s current account deficit is equal to about 5% of GDP.
For these countries to correct their deficits, their currencies must fall materially. Markets have already responded to the Bernanke taper meme, so even though the choice has been made for them by global investors, they now find themselves stuck between a rock and a hard place: Do nothing and watch their external debt skyrocket if their currencies continue to fall in value — or defend their currencies and keep rates low to spur their economies.
This dilemma points out a key lesson from the 1997 Asian financial crisis that is just as valid today: Government economic policies — whether it is setting non-market interest rates, pegging currencies, or whatever the case may be — inherently force markets to depart from the equilibrium that would be achieved by citizens freely choosing the supply and demand of anything, including currencies and credit. The resulting imbalances ultimately and inherently destabilize markets. The only unknown is where the imbalance will manifest itself. Well, now we know.
What about the free flow of capital? A common and often-repeated explanation for the 1997 crisis is that the Asian Tigers had too strongly embraced free trade and money flows, which led to serious gyrations that destabilized their economies. Nobel Prize–winning Columbia University economist Joseph Stiglitz has famously contended that “too much liberalization” was a root cause of the Asian crisis and had subjected these countries to “the will of speculators.” Perhaps, as Stiglitz and others argue, there should be a more measured approach governing capital inflows — a subject that is already receiving renewed focus from scholars and policymakers alike. But to highlight a country’s openness to foreign capital as a problem without also highlighting the abrogation of free market interest rates and exchange rates strikes me as shortsighted.
Yet here we are. Unfortunately for emerging markets like India and Indonesia (not to mention Turkey and Brazil), easy money in the developed world has likely created yet another credit-induced bubble that appears ready to pop. Or to switch up analogies: Money is like water. It always flows somewhere, and it’s never quite clear exactly where it will go. The resulting, inevitable malinvestment that follows in its wake is revealed only after calamity strikes.
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