Asia can han­dle a strong dol­lar

Financial Mirror (Cyprus) - - FRONT PAGE - Mar­cuard’s Mar­ket up­date by GaveKal Drago­nomics

Can emerg­ing mar­kets han­dle a strong US dol­lar? This is a cru­cial ques­tion for in­vestors in emerg­ing Asia since an ap­pre­ci­at­ing dol­lar has of­ten spelt trou­ble for the re­gion’s mar­kets. The worry is that the dol­lar now looks to be on a sec­u­lar strength­en­ing trend with the DXY up 6% since July 1. For its part, the MSCI Asia ex-Ja­pan in­dex has lost 3% in less than two weeks.

An ap­pre­ci­at­ing dol­lar is a threat to Asian eq­ui­ties as it amounts to an ef­fec­tive mon­e­tary tight­en­ing, via in­creased debt ser­vice costs. As cen­tral banks in the re­gion have sought to keep their cur­ren­cies weak rel­a­tive to the dol­lar, es­pe­cially since the early 2000s, they have also been forced to follow the di­rec­tion of US rates (the ‘im­pos­si­ble trin­ity’ re­sult of ac­cept­ing free cap­i­tal move­ment, but tar­get­ing the ex­ter­nal value of the cur­rency). This re­la­tion­ship has weak­ened lately as Asian pol­i­cy­mak­ers have mod­er­ated their mer­can­tilist lean­ings. Nev­er­the­less, it still holds.

There tend to be three broad sit­u­a­tions when a strong dol­lar spells trou­ble for Asian eq­uity mar­kets:

- The Asian growth cy­cle is out of sync with that in the US. We last saw this in 2004 when the Fed­eral Re­serve started to hike rates at a time when de­mand was soft­en­ing within Asia, in part due to China rein­ing back de­mand in its prop­erty sec­tor. Although this proved to be a mid-cy­cle cor­rec­tion, Asian eq­uity mar­kets saw a pro­nounced pull-back.

- Global risk-off ig­nites cap­i­tal flight. Dur­ing the 2008 cri­sis, cap­i­tal fled emerg­ing Asia and moved into trea­suries. Asian banks saw their fund­ing costs rise and also ex­pe­ri­enced re­duced ac­cess to fund­ing.

- Do­mes­tic bal­ance sheet prob­lems. In the late 1990s, Asian economies faced an acute sol­vency cri­sis as a re­sult of their high lev­els of for­eign bor­row­ings and over-val­ued cur­rency ex­change rates. In this case, Asian economies did not have the op­tion to weaken their cur­ren­cies as a pres­sure re­lief since they had a very large stock of dol­lar debt. So where are we to­day? For the most part, pol­i­cy­mak­ers learnt the les­son of the 1997-98 Asian cri­sis and they have care­fully man­aged their ex­ter­nal bal­ance sheets While Asian cor­po­rates may have in­creased their for­eign bor­row­ings, ag­gre­gate debt lev­els re­main man­age­able and are not of a scale to threaten sol­vency prob­lems (In­done­sia is the one pos­si­ble ex­cep­tion, be­cause of its rel­a­tively weak for­eign re­serves). Hence, we do not see a dis­rup­tion.

Last sum­mer’s “ta­per tantrum” hit emerg­ing Asia hard be­cause global bond yields rose steeply with­out a pickup in the growth out­look. Also, the shake-out was fo­cused on those weak link economies such as In­dia, Turkey, In­done­sia and South Africa which were run­ning big twin deficits, and were in the late stage of their credit cy­cles. Our con­tention is that the cor­rec­tion process is pretty much done and Asia is ready to start a new growth phase linked to a US re­cov­ery.

Prob­a­bly the big­gest risk to a be­nign US tight­en­ing cy­cle in Asia would be a sharp slow­down in China. Asian cor­po­rates can prob­a­bly suck up a slow­down in fi­nal de­mand growth from China. What they What they would not be able to re­sist is a de­fla­tion­ary mar­gin squeeze stem­ming from Chi­nese com­pa­nies liq­ui­dat­ing their inventory. Still, for now our cen­tral sce­nario is that China’s slow­down re­mains a con­trolled af­fair, with growth tick­ing down to the 7% re­gion.

For th­ese rea­sons, we are rea­son­ably con­fi­dent that Asia is locked into a rel­a­tively be­nign growth cy­cle where an ap­pre­ci­at­ing US dol­lar and very slowly ris­ing US rates her­ald a pos­i­tive mes­sage of growth. His­tory would sug­gest that the as­so­ci­ated vo­latil­ity with such a cy­cle will pro­vide ben­e­fi­cial buy­ing op­por­tu­ni­ties.

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