Global Policy Forum

By John Mulcahy

Asia's economies have made the transition from victim to villain without passing through the hero phase. Five years ago the Asian currency crisis produced a seismic shift in capital as investors ran for cover, slashing 80 percent off the Indonesian rupiah's value, for instance, in less than six months. Now the money is flowing back into Asia, forcing massive intervention by the Bank of Japan (BOJ) to curb the yen's strength, while China dismisses pressure to revalue or float the yuan.

So what is different this time? ABN AMRO's chief Asian strategist, Eddie Wong, argues that the appreciation of Asian currencies "will be a long and gradual process, as will the trend of capital flow to Asia". ABN AMRO's view is that the evidence of private-sector funds flowing back into Asia suggests that economic growth is shifting "back from the West to the East".

Capital has no conscience, of course, and the funds flowing into Asia are far more concerned with expectations of above-average returns than with US Treasury Secretary John Snow's aggressive lobbying for a realignment of Asian currencies. It is no secret that Asia's domination of global foreign-currency reserves rankles in certain quarters, prompting Snow's strident posture on the issue. Japan and China together account for more than 50 percent of global foreign-currency reserves, and by some lights the yen and the yuan should be allowed to find their own level.

The perceived undervaluation of the yuan has other effects as well, not least the claim that China is competing unfairly with US manufacturers of clothing and toys. While the claim of unfair competition may or may not be true, it is by no means certain that a floating yuan would actually rise. The instability of China's banking system and pent-up "hot money" outflows could well swamp the beneficial effects for the currency of China's massive trade surplus. In any case, this is a moot point, as there is little prospect of Beijing succumbing to pressure from the United States or anywhere else to revalue or float its currency.

In a recent report, HSBC economist Geoffrey Barker notes that "the Chinese authorities have critical domestic challenges that are likely to take priority over altering their exchange rate. They need to dampen the surge of investment spending that threatens to lead to a fresh round of NPLs [non-performing loans] for the banking system."

Japan's dilemma is that it is still in the throes of deflation, and it desires a weak currency to tackle that problem. Ideally, the yen should fall to 150-200 to the US dollar. However, in the wake of the Group of Seven (G7) joint statement on September 20 calling for more flexible exchange rates, the yen strengthened to 110 against the dollar as capital surged into Japanese assets. The BOJ poured money into the dollar as its intervention reached a monthly record of US$40.6 billion, taking the Japanese central bank's intervention to $121 billion for the year to date.

Asia has a quality problem for the first time in years. It is attracting huge interest again, marked by an estimated 1,000 institutional investors attending stockbroker CLSA's investor forum in Hong Kong and China last month, and by a pronounced increase in market liquidity across the region. "People who didn't want to know about Asia three months ago are desperate to participate in placements," says David Williamson of Daiwa Securities in Hong Kong. And, according to HSBC economist Barker, "the flow of funds is shifting away from financing overseas (especially US) growth and consumption, in favor of financing growth in the region". He says the appreciation of Asia's floating currencies, led by the yen, is partly in response to political pressure and partly a function of a cyclical improvement in the Japanese economy.

It is this latter point that will produce sustained capital flows. It is true that short-term capital flows resulting from currency speculation precipitated the Asian currency crisis in 1997, but it was economic growth in the 1990s that required substantial capital, and a faltering of this growth that led to the flight of investment capital from 1997 onward. South Korea's foreign debt rose from about $44 billion in 1993 to $157 billion in 1997, while over the same period Thailand's foreign debt doubled to $96 billion, and Malaysia's foreign debt also doubled between 1992 and 1997, to $43 billion.

While investors in Asia have been reading the runes to establish the timing of a reflationary cycle that would underpin the domestic asset markets, the prospect of rising prices is far more ominous for the United States. Concerns about inflation tipped the bond market over the edge in July, although it has since stabilized. However, any evidence pointing to a pickup in China's inflation would be seen as a precursor to another round of US inflation. Any real evidence of renewed inflation would be accompanied by a shift in monetary policy by central banks, which have almost universally adopted an easing stance in recent times. At the moment the movements in capital have been modest, and there is no immediate threat of inflation accelerating in Japan or China, but it is likely to be a concern by 2004 and beyond.

In its world economic outlook, published ahead of the annual meetings in Dubai last month, the International Monetary Fund (IMF) said Asian currency intervention was helping to push the world economic recovery off balance. The IMF's chief economist, Kenneth Rogoff, said the world recovery was "dangerously dependent on domestic demand in the US, driving the US current-account deficit up to unsustainable levels". Rogoff added that the growing US deficit would induce a sharp decline in the dollar at some point. "If the euro has to bear the lion's share of the adjustment in the dollar, that is going to create a lot more difficulties than if all the Asian currencies also allow themselves to appreciate significantly against the dollar."

And so the debate rages, but the capital continues to ignore the sophistry as it seeks returns. CLSA strategist Christopher Wood notes in his Greed & Fear report that the MSCI Asia ex-Japan index has risen 39 percent from its bottom in May, while the Standard & Poor's 500 is up 24 percent from its March low. "The stellar performance of both Japan and the rest of the Asian region during the past six months is without doubt generating renewed interest in the Asian equity investment story among global investors and asset allocators," Wood argues.

The question is whether the flows will be orderly or whether the momentum will again drive values so far and so fast that investors will soon be paying too much for assets, sowing the seeds of the next Asian crisis. The availability of unlimited cheap capital during the 1990s fueled the classic boom and bust during that decade. In 2003, though, the wounds are still fresh, and while portfolio investors may be paying too much for capital, there is no compelling evidence to suggest that managers of businesses are misallocating capital in the way they did during the 1990s.

It is true that the concentration of foreign equity investment into Asia tends to distort capital allocation. Individuals in Paris, Texas, or in Graz, Austria, are unlikely to invest directly in Thailand, Indonesia or the Philippines. Instead, they will channel their investments through banks or mutual funds, which in turn bundle the funds and transfer them to specialist fund managers. History suggests that many of these institutional fund managers think and act alike, producing a herd mentality that is currently producing huge flows into Asian markets, but which can similarly reverse as the "herd leaders" change their views.

Asian equity placements, few and far between from 1998 until very recently (except for the dot-com period), are now a daily occurrence. The owners of businesses are happily selling equity at current prices to investors from Europe and, especially, the United States. Do these businesses actually need the capital, or are they simply taking advantage of liquidity and raising capital because it is there? A bit of both is the most probable answer, as investment banks and stockbrokers, starved of business for several years, rush to mop up as much of the incoming capital as possible before the liquidity dries up again. "The first few placements will do very well, but eventually the appetite will be satisfied, and investors will realize that they will need to see some performance before putting more money into these markets," says Daiwa's Williamson in Hong Kong.

There is no doubt that Asia has rebooted itself since the cataclysmic crisis of the late 1990s. According to the World Bank, Asia ex-Japan's average savings rate for the period 1997-2001 was 37 percent of gross domestic product (GDP), compared with 20 percent for Europe and 15 percent for the United States. The creation of its own capital base has been East Asia's persistent attraction for international equity investors, and this time really is no different. The question, though, is whether the returns on this capital will be any better than during the last period of capital shift from the West to the East.

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