Economists mindful of contagion effect from currency crisis

THE currency crisis engulfing a number of countries has the makings of a larger problem for emerging markets, but any similarity to the Asian Financial Crisis (AFC) that had wrecked economies in SouthEast Asia is very far off the mark.

With the rupiah hitting levels last seen in the economic darkness some 20 years ago in the region, the risk of contagion has been spoken about in a growing number of circles.

The reason is that the trigger for the current problem afflicting Turkey, India, Argentina, South Africa and Indonesia is a structural economic problem, much like what had happened 20 years ago in South-East Asia.

Back then, it was overheating economies, large external debt, weak amount of foreign-exchange reserves and overvalued currencies that caused a meltdown in this part of the world.

Now, the trigger is the twin deficits, where the countries that have currency account deficits together with fiscal deficits have made them targets for funds that have taken advantage of the current global environment of the strong dollar, along with rising interest rates.

An uneasy eye has now been cast on the developments of this latest crisis, but for Malaysia, the risk of the country catching the “flu” from countries that are hurting is low.

“This is somehow similar to the AFC, as emerging markets suffered from gradual currency depreciation for a period of time before the AFC hit in 1997. However, back then, global capital flows were not as liquid as today.

“Therefore, it would take a shorter duration of time for it to evolve into a possible crisis, unless the right capital controls are implemented in time to prevent further possible damage to the affected emerging-market currency,” says Alliance Bank Malaysia Bhd chief economist Manokaran Mottain.

He says the risk of Malaysia being dragged into the emerging-market currency crisis at the moment remains muted, as the ringgit has only depreciated year-to-date by around 2.4% compared to other emerging-market currencies such as the Argentine peso (-50.2%), Turkish lira (-41.9%), Brazilian real (-18.5%) and South African rand (-18.6%) against the dollar.

“This is because the economic fundamentals in Malaysia remain sound, which is mainly driven by private consumption and private investment growth. However, we should remain cautious on a possible rapid meltdown as compared to the AFC period due to the instant availability of information now which will hasten the ‘contagion’ effect, which increases the fear sentiment among foreign investors and causes faster-than-expected capital flight from emerging markets such as Malaysia,” he says.

“Furthermore, the uncertainties arising from the ongoing trade wars between the United States and its major trading partners will weigh on sentiment further.”

AmBank Research chief economist Anthony Dass says the emerging markets are not in a very exciting position now, with the MSCI EM Index of stocks down by about 18% since peaking in January. The MSCI’s index of EM currencies is down about 8% since April.

“If the situation in Turkey and Argentina remains very volatile, it can spread to other countries like Brazil, India, Indonesia, Malaysia and the Philippines,” he says.

One thing going in Malaysia’s favour is the current account surplus. Since the AFC, Malaysia has always maintained a current account surplus and that is something the country intends to do no matter what.

Government officials have maintained that no matter how small or large the surplus is, the country must always see that as a credit to national accounts. In fact, there is a committee that looks into ensuring a surplus is always reached.

“Malaysia, though, sits on a current account surplus and comfortable reserves of around US$104bil. The risk remains on issues related to high gross financing, huge public debt and the challenge to balance the fiscal books owing to large leakages exposed thus far.

“Hence, it can limit the role of monetary and fiscal policies at a time when economic growth has been lowered. What can be expected will be a strong hit on the asset classes,” says Dass.

He says the challenge will be to contain capital outflow.

“The focus will be on the kind of policy measures that can be instituted, given the strong challenges the new government is experiencing from the leakages it has to endure after taking over the administration of the country. Will there be possibilities of some form of unorthodox measures being introduced to contain capital outflow?” asks Dass.

No one can be sure that the risks do not cascade onto other countries, like how the current emerging currency crisis has spread.

Dass points out that on the face of it, the emerging markets’ current financial crisis bears a striking similarity to the collapse of Thailand’s currency in 1997, which ultimately led to a financial meltdown across Asia.

“So far in 2018, the Turkish lira has fallen around 40% against the US dollar. Inflation has topped 16%, and concerns are that interest rates are still low compared to Argentina and Brazil held through President Recep Tayyip Erdogan’s intimidation of the central bank. Erdogan lacks a clear plan to restore fiscal discipline and has yet to convince markets that his economic policies can assure a soft landing,” he says.

What makes Turkey particularly vulnerable is its level of external debt, he says, adding that Turkey is significantly reliant on foreign capital with 70% of its debt denominated in US dollars and euros.

“This compares to 35% for the average emerging-market peer. Its current account deficit is close to 6% of gross domestic product (GDP) – one of the largest amongst emerging-market countries – making it vulnerable to a shock if foreign investors pull back.”

Dass points out that emerging markets have evolved over the past two decades, and economies have become more insulated from the risk of contagion.

“As Turkey’s risk of default rises, it is unlikely to cause a repeat of the crisis that spread through emerging markets in the late 90s.

“So, if we are looking at a wildfire of the scale of the AFC in 1997 – which can be defined as the old school having caused a wildfire which spread into a global crisis that threatened the economy and financial system by catching a few key hedge funds napping – that may not happen.

“The interbank-funding markets will tell the story. Demand for dollar funding among financial institutions would have skyrocketed if they thought that one – or more – were in trouble. The cost to convert foreign cash flows into dollars with cross-currency basis swaps would have jumped up alarmingly. Thus far, nothing like this has happened. So, it’s more like assets taking a beating,” he explains.

The lessons learnt from past crises have also seen the impact muted in some countries. SouthEast Asian nations by large know that reliance on external debt is a risk, and in Malaysia’s case, the external debt remains manageable.

Standard Chartered in a recent report says Malaysia’s external debt remains manageable, and it, excluding the financial sector, fell to 42% of GDP as of the fourth quarter of 2017 from 49% a year earlier, on repayments of maturing interbank borrowings and a strengthening ringgit.

The foreign-currency share of external debt at 66% is lower than that of other economies in the region. This implies that around 34% of external debt is insulated from currency fluctuations. It says that 66% of external debt denominated in foreign currency is subject to prudential liquidity management practices and hedging requirements, according to Bank Negara.

“Bank Negara added that the bulk of foreign currency-denominated borrowings were to expand productive capacity offshore. Meanwhile, the short-term share of external debt (on a remaining maturity basis) has eased to 66% of GDP from 69% in 2013. Despite the high level, we estimate that about 62% of short-term external debt is trade credit and interbank exposure,” it says.