Volatility in some of Asia’s emerging economies is set to continue until structural reforms are undertaken.
Volatility in some of Asia's emerging economies is set to continue until structural reforms are undertaken.
There has been pressure on emerging market assets, notably currencies, during the past week.
India, Indonesia and Brazil have been particularly hard hit, with the Indian rupee down 19 per cent and the Indonesian rupiah and Brazilian real both down around 14 per cent.
The problems we are now seeing in these and other emerging countries are indicative of an unfavourable turn in their longer term or secular cycle.
In the mid 1990s there was much talk of an ‘Asian miracle’. Growth in the ‘Asian tiger’ economies was galloping along at over 7 per cent per annum and their share markets were dramatically outperforming.
However a reliance on foreign capital, current account deficits, excessive debt levels and overvalued fixed exchange rates led to doubts among foreign investors.
Capital outflows starting in Thailand led to the ‘Asian contagion’, which spread across the emerging world.
By the early 2000s, Asian and emerging countries generally got their act together thanks to a range of productivity enhancing reforms, less reliance on foreign capital, low and floating exchange rates and high foreign exchange reserves and this along with the industrialisation of China and a related surge in commodity prices.
The slump in the traditional advanced economies of the US, Europe and Japan increased interest in the emerging economies among investors, which reached a crescendo after the GFC.
Then followed a surge in the value of Asian currencies versus the $US during the past decade as a result of strong capital inflows.
How much like 1997?
Several factors are driving the current rout in Asian and emerging markets:
• possible reduction in monetary stimulus (QE) by US Federal Reserve;
• evidence that some emerging countries, such as Brazil, India and Indonesia, used the capital inflows that occurred as a result of QE in the US to finance budget and current account deficits;
• subdued growth in China has taken its toll on the emerging world generally by putting downwards pressure on commodity prices and dragging on the demand for imports from the Asian region; and
• the boom years of the past decade allowed several emerging countries to go easy on necessary structural reforms. Poor infrastructure, excessive regulation and restrictive labour laws are key problems.
The end result has been inflation and trade imbalances and reduced potential growth rates – a sharp increase in capital outflows from emerging to advanced countries, which in turn has resulted in falling asset prices and currency values for much of Asia and the emerging world.
Put simply, there is no easy way out for countries with current account deficits when foreign investors start to withdraw their capital. Domestic spending must fall and interest rates must rise and exchange rates fall to bring this about. The only way out is to reform their economies.
This is particularly the case in Brazil, India and Indonesia, which have persistent budget deficits and current accounts heavily in deficit (indicating a now heavy reliance on foreign capital inflows).
China, South Korea, Taiwan and Russia with large current account surpluses, are far less vulnerable.
In the better-performing emerging economies the central banks have much higher foreign exchange reserves, exchange rates are floating rather than fixed and not as high as they were before the Asian crisis and inflation is lower.
For investors, while emerging market shares are relatively cheap it’s too early to reweight towards them.
It’s not 1997 again, but the risks have increased.
Shane Oliver is head of investment strategy and chief economist at AMP Capital
