Asia faces test of faith as crisis deepens; The trouble with hidden leverage is that it doesn’t stay hidden forever

June 27, 2013 10:04 am

Markets Insight: Asia faces test of faith as crisis deepens

By Henny Sender

Fed tapering plans and China slowdown are already hurting

Brokerage houses are working full time to print charts showing that the emerging markets of Asia are in much better shape to withstand the end of the US Federal Reserve’s easy money policies than they were in 1997 when the Asian financial crisis was formally inaugurated with the devaluation of the Thai baht on July 2 of that year.

Their favourite shows that all the basket cases of 16 years ago now have foreign exchange reserves that are twice as large as their short-term debt.Because of that ample rainy day money, countries including Indonesia, Malaysia, the Philippines, South Korea, Thailand (and even perhaps hapless India) are less vulnerable – at least on the surface. But will the region really be that fortunate?

Signs of distress are beginning to surface already as the result of a combination of anticipated tightening from the Federal Reserve and slower growth in China. Asian currencies and both debt and equity markets in the region are dropping, bringing tighter financial conditions in their wake.

As they fall, they raise the cost of capital for households, companies and governments and test the quality of investment over the past few years.

At DBS, the Singapore-based bank which is increasing its reach as a regional Asian lender, risk managers are stress testing their loan books to see how their borrowers withstand these more challenging conditions, assuming at least a 10 per cent drop in local currencies. Some analysts think that is too optimistic. Stephen Jen of SLJ Macro is assuming at least 15 per cent falls in many local currencies as capital flows to emerging markets reverse.

Slower growth in China may be a good thing for China itself, but for its neighbours whose economies have benefited from Chinese demand, particularly for commodities, it will prove damaging. Among the worst hit sectors will be mining, which means the big coal and iron companies of Australia and Indonesia.

“Everyone there wants to have a mine,” says the head of one of the big international private equity firms in Asia. “It’s like the Great Leap Forward in China; a mine in every backyard.”

But that desire was born when China was growing 10 per cent a year. China will probably never grow at that rate again.

The first signs of distress are already surfacing in Australia, where the currency fall has been especially dramatic. Farallon, one of the big beneficiaries of the last financial crisis, has already swooped in to provide rescue finance to Whitehaven, a local mining company.

Officials in Australia speak bravely of a more balanced economy, where manufacturing will benefit from a weaker economy, but it only has 16m people and its labour is expensive, making those claims wishful.

Meanwhile, many hedge funds have short positions in Australia, either as a hedge because they are optimistic about China or because they are pessimistic about China and see Australia as a casualty of dimming prospects on the mainland.

“It is insurance against meltdown risk in China,” as one hedge fund manager in Singapore notes. Sure, Australia has reduced its dependence on foreign capital but not enough for today’s conditions. What is true for Australia is true for others, such asIndonesia, as well.

It would be wonderful to think that the region has learnt a lesson from the trauma of 1997. Korea, for example, (where the nightmare of that time is referred to still as the IMF crisis), has a big capital account surplus and has increased its foreign exchange reserves. Yet foreigners have been pulling money out of the equity market and the Korean Treasury market.

Is this because they are nervous about South Korea, which will be hurt both by the Japanese effort to drive the yen down against the won and the slowdown in China, South Korea’s largest market? Or is it because South Korea is far more liquid than the markets of Southeast Asia so that when foreigners wish to reduce their exposure to Asia, the South Korean market is the easiest to exit? And how much does the reason matter, given that the negative effects are the same either way?

One reason for the confidence that this time is different and better for Asia is the belief that the region has less dollar borrowings. But that faith may not be justified. In recent months, few people expected the Fed to muse publicly about reducing its provision of the elixir of easy money to the markets and fewer still expected to see dollar strength.

Some companies, especially private companies, in places like Indonesia and Indiabegan borrowing dollars to save on the interest payments, without bothering to hedge those dollar exposures, bankers and investors say. That is of course what got so many companies in trouble last time around.

That suggests there may be worse to come. The trouble with hidden leverage is that it doesn’t stay hidden forever.