Asia can handle a strong dollar
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.