Markets: Have Asian and Emerging Markets really turned the corner?
BT's Paul Durham looks at what's happening in Asian and South American investment markets.rk
Tuesday, August 3rd 1999, 12:00AM
More than two years have passed since the emerging markets crisis began, when a seemingly minor event in Thailand resulted in the near-collapse of Asian financial markets and a subsequent crisis in Russia and Latin America. Yet looking at the current state of financial markets and the growing global economy, it now seems remarkable that some experts were predicting a global recession. Now we are in the midst of a V-shaped recovery in Asia, with evidence suggesting that Russia and Latin America are also set for a strong rebound.
How Asia Bounced
The fundamental basis for Asia’s recovery is an improvement in the region’s net liquidity position. This improvement can be attributed to four factors - the support of the IMF and the World Bank, the turnaround in the region’s external accounts, an increased amount of direct foreign investment, and returning flows to the region’s sharemarkets.
The IMF, the World Bank, and various other agencies can take much of the credit for the turnaround in Asia. The $100 billion (plus) rescue package they injected into the region immediately improved the liquidity situation, and was quite literally "the oil for the wheel".
The second phase to improved liquidity has been the turnaround in the region's external accounts. This occurred because weakness in the economies caused imports to virtually collapse, while exports were supported as currencies weakened significantly. In effect the region moved from a massive deficit to a massive surplus - with a swing in their international position over the last two years in the order of $150 –175 billion.
Direct foreign investment picked up - that is, corporations started to buy cheap assets. This is particularly important, because large corporations have a higher risk tolerance and a longer time perspective than portfolio investors, and they believe in the long-term Asian growth story.
Portfolio investors also contributed somewhat, and net redemptions from the region are being replaced by net inflows. This trend is expected to accelerate in coming months.
Lower Interest Rates
The net result of these funds coming into the region is that interest rates tumbled. For example, in Korea during Christmas of 1997, interest rates were over 40 per cent. Today they are around 8 per cent.
At its heart, Asia’s problem was a private banking problem - the banks lent money some of which they will never get back, and they lent against collateral. With 40 per cent interest rates the collateral value is worthless, but at 8 per cent the collateral has some positive value. There existed a vicious circle - higher and higher interest rates forced more and more people into bankruptcy and lowered the value of collateral assets. But this circle has now become a virtuous circle - where lower and lower interest rates mean more and more borrowers become viable, and the collateral value backing the loan goes up in value - so the extent of the underperforming or non-performing loans starts to diminish.
Lower interest rates also lead to an asset allocation shift among local investors. Today significant domestic funds are being injected into financial markets - larger sums than from offshore. For instance in Korea, foreign flows have amounted to less than $100 million a month on average during the recovery period, whereas in June alone, local investors put in just under $7 billion into equity markets.
The next stage of recovery will be improved domestic consumption. There is massive pent up demand in this region - for the last 18 months consumers have almost been too afraid to consume due to the economic uncertainties facing the region.
The Asian Parallel in other Emergers
The Asian crisis was paralleled in other emerging markets. The disequilibrium in Asia and the financial stresses it caused led financial markets to downgrade any country where economic or political fundamentals were less than solid. In Russia for instance, where there was an unstable government, a large deficit and poor debt position, a build up in pressure meant it became incapable of funding outstanding debt. This led to Russia defaulting, and in doing so, devaluing its currency.
But the fundamental improvements we have seen in Asia are also occurring in Russia. The realignment of its currency has seen trade balances turn positive, the economy has stabilised and is starting to turn around. In June, industrial production grew 9 per cent year-on-year, versus a May figure of 6 per cent. Once again this is a very sharp recovery, and is an example of the extreme adjustment that can take place.
It is well documented that the problems in Russia - in itself a fairly insignificant economy accounting for less that 2 per cent of world GDP - caused severe financial problems in other markets due to the nature of gearing in markets at that time. A lot of large financial companies lost money at this time, and were forced to liquidate other investments causing prices to fall in otherwise stable markets. One casualty was Latin America and Brazil in particular. The Russian crisis of the third quarter 1998 became the Brazilian crises in the fourth quarter 1998 and first quarter of this year.
Brazil was similar to Russia in that it had an unstable mix of debt and deficit problems, an overvalued currency, and political problems. Today Brazil also looks to be on the path to recovery, although it is too early to say whether or not it will be entirely successful.
Risks
One remaining hurdle is developments in China. While China wasn’t a "crisis" country, it has been delaying vital reform due to the unstable environment in the rest of Asia. Now that Asia has turned the corner, now might be time for China to do some restructuring. The types of restructuring we are looking for include a devaluation of its currency - for which the odds are rising quite rapidly. This is likely to affect Hong Kong at least in the short term.
Another potential risk is a shock from the US. The primary risk here is a situation where growth becomes too strong in the short-term, and the US Federal Reserve is too slow to act in lifting rates. This could result in a re-emergence of inflation fears and lead to a more aggressive increase in interest rates down the track. We would stress however that this is by no means our central case.
Other risks are political, with elections in India and in Argentina this year, and in Mexico, Thailand, Taiwan and Korea next year. Elections are important because they influence policy, especially when they are closely contested. In this situation, politicians will be making more populist announcements and less fiscally or economically prudent comments, potentially destabilising markets.
Expectations
Economic recovery is expected to continue on Asia, where on average growth should rise to 5 to 5.5 per cent this year and next year. The crisis countries should accelerate and China should decelerate. Latin America should basically stay stagnate this year, but ought to accelerate in the year 2000, up to 3-4 per cent in 2000, with similar growth profiles expected for Eastern Europe.
Paul Durham is head of emerging markets at BT Funds Management in Sydney
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