As emerging Asia slowly moves away from the post-Asian currency crisis norm of maintaining hefty current account surpluses, the region will likely see greater foreign exchange volatility, debt financing as well as increased tolerance among policymakers to foreign inflows and local currency appreciation.
This is according to Claudio Piron, a Singapore-based emerging Asia fixed income strategist at Merrill Lynch, who also predicted that Asia’s emerging markets may increasingly rely more on fiscal spending rather than monetary policy stimulus to make up for the slack in the global economy.
In an August 2 research note titled “Asia’s Strategic Bond Shift,” Piron noted that current account balances in the region would shrink as a natural consequence of declining demand in the West. This deficiency will take years to repair as Western economies embark on structural reforms, while simultaneously prompting Asian economies to compensate for this deficiency in demand by engaging in more government spending.
“We also argue that monetary policy stimulus also has its limits, given that Asia is intrinsically a price-taker and not a setter by virtue of its export growth dependency,” he said.
“It is increasingly likely that Asia will have to engage looser fiscal policy to compensate for the limitations on effective countercyclical monetary policy and structural shortfall in G7 [countries’] demand for Asian exports. Moreover, it will also take considerable time to reorient Asia’s economies toward private, domestic-led demand,” it said.
If this outlook of declining current account surpluses unfolds in the coming years, Piron said there will be direct implications for asset markets in the region, namely: foreign exchange volatility, debt growth and intra-regional flows.
Piron said a structural decline in current account surpluses meant a reversal of the capital account outflows and the implied future Asia foreign exchange appreciation would be more reliant on capital inflows. Given the monetary easing backdrop in the West, it was argued that the likelihood was that these capital flows will be portfolio-driven and more volatile, resulting in higher Asian foreign exchange volatility.
One key impediment to local government debt markets in Asia has been the lack of depth and supply, but the need for greater fiscal deficit financing to support growth may help to alleviate this shortage of bonds, the research said. “Note, too, that Asian policy makers may be willing to tolerate more foreign inflows and currency appreciation to keep yields low amid rising bond supply,” the report said.
“Despite diminished current account surpluses and more portfolio flow dependency, the bad days of sudden-stop capital reversals should be over,” the report said.
It noted that Asia, excluding Japan, was investing 24 percent of its global long-term bond portfolio within its own region—a trend that is rising as home bias declines. This compares with Asia ex-Japan accounting for only 1.5 percent of the West’s global long-term bond portfolio. “Asia’s own demand for gross external assets likely will rise due to rising per capita incomes and a rising demographic cohort of workers that will save,” it said.
The Philippines gets about 7 percent of all long-term bond inflows into emerging Asia from the US and Europe, based on Merrill Lynch estimates.
On the other hand, it said Asia’s top three recipients of Western flows are Korea (36 percent), Malaysia (13 percent) and Indonesia (11 percent), which are also favored by investors from Asia-Pacific. These three countries account for $120 billion, or 61 percent, of the $198 billion invested in the region by the US and Europe.