News analysis

Confidence crisis, but repeat of 1997 unlikely

A steel factory in China. In the writer's analysis, while investors should steel themselves for market jitters, the confidence crisis stemming from China is likely overdone.
A steel factory in China. In the writer's analysis, while investors should steel themselves for market jitters, the confidence crisis stemming from China is likely overdone.PHOTO: REUTERS

Trend devaluation of yuan will not affect resilient Asian currencies as much

China's shift to greater exchange-rate flexibility has received applause from free-market advocates such as the International Monetary Fund. For Asian economies and investors, the timing could not have been worse.

Many have read the move as a sign of deeper woes in the Chinese economy, while some consider it the removal of an anchor for Asian currencies. A trend devaluation of the yuan could weigh on neighbours' currencies, potentially sparking capital flight from the region.

In short, China has created a confidence crisis. Its US$11 trillion (S$15.6 trillion) economy, equivalent to 44 per cent of Asian gross domestic product , has too much gravity for its neighbours not to be affected by stalling Chinese demand. Indeed, across Asia, economic growth has sharply disappointed and currencies are falling. Some countries, including Singapore, have uncomfortably high household debt levels. Others, like Malaysia, are witnessing political uncertainty.

But the similarities with the 1997 Asian financial crisis end there. Stark contrasts exist between then and now that point to the resilience of the region as a whole.

Importantly, levels of hard currency external debt relative to total foreign exchange reserves are now much smaller, rendering Asian balance sheets less vulnerable to currency depreciation.

Stark contrasts exist between then and now that point to the resilience of the region as a whole. Importantly, levels of hard currency external debt relative to total foreign exchange reserves are now much smaller, rendering Asian balance sheets less vulnerable to currency depreciation.

With flexible exchange rates, regional central banks are no longer compelled to defend any "line in the sand" - these were moves that sent regional interest rates spiralling upwards during the 1997 crisis.

Indeed, much of the recent weakness in Asian currencies has been due to the US dollar's broad-based strength in anticipation of a rate hike cycle, rather than a reflection of severe fundamental weakness in the region. Asian central banks have in fact acquiesced to currency weakness as a valve to lessen pressure on economic growth and rectify current account imbalances.

Also, we are not convinced that China's move was designed to significantly weaken the yuan, or a sign of rapid deterioration of the Chinese economy.

With deep pockets for fiscal stimulus and monetary policy leeway, the authorities are proactive in supporting growth. A week after the People's Bank of China changed its exchange rate regime, it cut interest rates for a fourth time this year and eased requirements on how much capital banks should keep in reserve.

But the yuan's depreciation does remove an anchor for Asian currencies. A more freely floating yuan would mean corresponding adjustments to currencies of Asian countries, especially those that count China as an export competitor. In this light, some Asian currencies will weaken more than others.

Taiwan, South Korea and Thailand have relatively large trade links and similarities with China in terms of their exports.

Hence, they are more likely to weaken their currencies in tandem with further yuan depreciation.

Singapore is similarly exposed to trade with China, but because it manages its currency on a trade-weighted basis, its reaction will reflect not just the yuan, but also how major currencies like the euro and yen track its movements.

Meanwhile, the Indian rupee and the Philippine peso are likely to weaken less than their peers. India has limited trade exposure with China, while the Philippines' domestically oriented economy makes it less vulnerable to a slowdown in Chinese imports.

Indonesia and Malaysia both rely on China as a key importer of their commodity products, but their vulnerability lies more in the fact that foreigners own nearly 40 per cent and 50 per cent, respectively, of their local-currency government bonds. This makes the rupiah and the ringgit susceptible to foreign selling when the Federal Reserve does raise interest rates for the first time since 2006, if not in September, then potentially in December.

Globally, the occasional shockwaves from China can still send jitters across international markets, especially the emerging market complex. In global equity, we are of the view that the euro zone and Japan remain the most attractive markets globally, as they benefit from improving corporate earnings and ultra-easy monetary policy.

Within Asia, choosing the more defensive markets is likely to pay off, given the region's still-weak economies and potentially weaker currencies. These include India, where earnings growth is above regional average; Singapore, which has a good representation of defensive sectors; and Taiwan, which is especially leveraged to the US recovery cycle.

Likewise, a global bond portfolio is likely better off, with preference for corporate high-yield issuers in the US and Europe, which offer attractive yield pick-up relative to government bonds.

Within Asia, high-yield bonds are also relatively attractive. While many of the issuers in this segment are from China, their borrowing costs should be manageable, as ample domestic liquidity helps mitigate some of the yuan headwinds. In essence, the confidence crisis stemming from China is likely overdone.

While Asian economic growth will likely stay muted, the chances of succumbing to a 1997-style crisis are likely distant.

•Tan Min Lan is Head, Asia Pacific Investment Office, UBS CIO Wealth Management

A version of this article appeared in the print edition of The Straits Times on September 07, 2015, with the headline 'Confidence crisis, but repeat of 1997 unlikely'. Print Edition | Subscribe