Why Asia should suck up Tantrum II
Asian currencies took a hit last week as the ongoing global bond market sell-off forced capital outflow. Yet unlike the “taper tantrum” of two years ago, the region has navigated this sell-off with limited collateral damage—emerging Asia’s benchmark bond index has fallen by -3% in the last two weeks compared with a -19% peak-to-trough slump in 2013. A fair question is whether heavily leveraged Asia is the next shoe to drop. So long as current ructions do not turn into a rout, sparking a global risk-off, Asia remains a good bet as the macro backdrop is far better than two years ago.
This may seem counterintuitive since aggregate Asian debt levels are back to those seen just before the 1997/98 Asian crisis, while in Northeast Asia, deflationary winds are blowing hard. The difference with past crisis periods can be seen across a range of macro settings: (i) Asian economies mostly run flexible exchange rate systems and have tended to suppress their currencies’ value to allow the build-up of reserves, (ii) Indonesia and India were overheated in 2013 but have acted to crimp demand, which has helped external balances to sharply improve, and (iii) economies with external surpluses such as South Korea have forced banks to address a maturity mismatch problem where they have borrowed short and lent long.
Another difference this time is the positive impact of the fall in the price of oil and other commodities. Disinflation and even outright deflation in several Asian economies, causing real interest rates to swing positive, has granted policymakers space to ease rates, which should mean that a 2013 policyinduced slow-down can be avoided.
For investors, comfort can be taken from the macrooutlook, but also the fact that nominal yields on benchmark Asian debt, despite recent ructions, remain significantly higher than on developed market equivalents.
To be sure, problems may emerge if the dollar resumes its appreciation track due to the Federal Reserve moving to normalise policy, while Asia shifts toward easing. Since most Asian currencies to some degree are dollar-linked, the standard Asian response would be to engender a depreciation that boosts exports and crimps imports. However, such a mercantilist approach may be less effective than usual as both Europe and Japan are playing the same game, hence lessening Asia’s scope to devalue its way out of trouble. Also, the last 18 months have seen a general collapse in Asian currency volatility, and so any disruption to these calm seas could produce unforeseen events, with a self-reinforcing cycle of capital outflow, currency depreciation and falling asset prices. Still, the move to a general risk-off is not our central scenario and we advise investors to switch into US dollar denominated, high-grade Asian debt which still pays an approximate 200bp premium over treasuries.