Emerging markets seen to withstand capital flow reversal

US Currency. AP FILE PHOTO

MANILA, Philippines—Asian emerging markets appear in a much better position to withstand the ongoing reversal of capital flows than during the Asian currency crisis of 1997, according to British bank Barclays.

But external vulnerability is seen higher for India and Indonesia, both under challenge to fund current-account deficits amid increasing market stress, Barclays said in a commentary titled “Different from 1997” dated Aug. 30.

With the selloff in emerging market assets intensifying over the past week, investors are increasingly scrutinizing the vulnerability of these economies to a further selloff and the potential for liquidity or funding problems in the scale of the 1997-98 Asian financial crisis. At that time, the devaluation of Asian currencies and the consequent surge in interest rates caused banks’ bad loans to pile up, depressing economic output in the region.

“While exaggerated market reactions may reinforce these concerns, the underlying positions of Asian economies generally look healthy to us,” Barclays said.

Looking across a number of key metrics, Barclays argued that most emerging markets in Asia were much better placed to withstand market volatility and outflows than was the case in 1997, noting that foreign exchange reserves—the most basic gauge of the external balance—and coverage of short-term debt and imports were much higher, while current accounts remained mostly in surplus, though shrinking in recent years in contrast to the deficits preceding the 1997 crisis. The bank further noted that the overall savings/investment balance in Asia remained heavily skewed in favor of savings, even though household debt had risen in the past five years.

Barclays noted that foreign exchange reserve coverage ratios of imports were well beyond the generally accepted healthy level of six months, with Korea and the Philippines four to five times better covered than in 1997, while coverage in Malaysia and Taiwan had doubled.

“Short-term debt coverage by forex reserves—a key vulnerability in the 1997-98 crisis—has also increased considerably. In 1997, many countries in [emerging market] Asia could barely cover their short-term debt with forex reserves, whereas reserves cover now ranges from 2x to 8x,” the bank said.

The exceptions are Indonesia and India since despite considerable increases in their foreign exchange reserves, these have barely kept pace with the growth in imports, Barclays said. It noted that coverage of short-term debt had risen for Indonesia versus 1997 level, though it remained a laggard in the region. On the other hand, it said India’s coverage ratios for imports and short-term debt have actually fallen, the former driven by a sharp rise in trade credits on the back of its increased trade openness.

That said, India’s coverage was still much better than was the case for Thailand and Korea in the run-up to the 1997 crisis, Barclays said.

“Arguably, a bigger problem for India and Indonesia, and the key driver of the recent sharp depreciation of their currencies, is their current account deficit. These are essentially being funded by portfolio inflows, plus some debt-creating inflows. This means their vulnerability to a reversal of capital flows has increased significantly, which could trigger large moves in currency markets if the money stops coming in,” the research said.

On the other hand, Barclays noted that economies like South Korea, which were hit in 2008 by high short-term external debt levels, have performed well in recent market conditions. In Korea’s case, Barclays said this were mainly reflected in a rising current-account surplus, increasing demand from the United States and a sharp improvement in its ratio of foreign exchange reserves to short-term debt coverage. With short-term liabilities falling, the Korean won has outperformed its emerging-market peers, despite Korea being one of the largest and most open economies in the world.