Prepared by Merrill Lynch & Co.

International Fixed Income Research

In our opinion, Southeast Asian currencies have overshot, but the return to long- run equilibrium may not occur for a long time, at least not in 1998. The currencies will likely remain weak over the next two years, which is consistent with their cyclical positions.

The currency contagion has not only been moving north, but has taken on global implications as well, adding considerably to bearish sentiment on Asian currencies. In addition, the crisis has taken on a political dimension in Thailand, and Malaysia looks vulnerable to monetary-policy slippage.

The costs of borrowing will especially go up in Thailand. Thai debt has fallen from “A” category, and some foreign investors are prohibited from purchasing debt rated lower than “A”.

The trend in spread widening will likely continue, because Asian economies are likely to undergo further downgrades in 1998. Major ratings agencies have put on a negative sovereign outlook for all ASEAN economies except Singapore. In Northeast Asia, South Korea appears particularly vulnerable to further spread widening, while Hong Kong's banks have been put on negative credit watch.

It was only a little more than a decade ago that Asia faced its last serious economic challenge. Thailand adopted a basket system for determining the value of the baht in late 1983. This move followed devaluations of the currency in 1981 and 1983. The vibrant economies of Malaysia and Singapore encountered turbulent waters in 1985 with the global downturn in the electronics industry. Malaysia allowed the ringgit to depreciate by about 20% from 1984 to 1990 as the Malaysian economy contracted by 1% in 1985. In the same year, Singapore also recorded negative growth, and encountered severe currency turmoil. However, the Monetary Authority of Singapore successfully defended the currency against speculative attack, and adopted measures to make it more difficult to speculate against the local unit. As the oil price tumbled toward $10 per barrel, Indonesia devalued the rupiah by 40% in early 1986, to diversify its economy away from its overdependence on oil exports, and to support government expenditures and the economy's foreign-exchange requirements.

For the remainder of the 1980's, Asian central bankers were able to do what the macroeconomics textbooks said was virtually impossible. Policymakers could simultaneously pursue fairly precise and seemingly inconsistent targets for the exchange rate, interest rates, international reserves and money supply, and on average hit them in accordance with their annual economic plan. However, this ability was to be compromised by the rise in capital flows, and the increasing integration of these countries into global capital markets. The ever-increasing speed and rising level of international financial flows forced changes to take effect, and regional central banks had to choose between vying targets: interest rates, the exchange rate, and monetary/liquidity targets.

Exchange-rate policy has been the common thread and most visible component of the development strategies that resulted in the Asian economic miracle. In Korea and Taiwan, rapid development eventually led to the abandonment of a weak currency policy in the late 1980's as cheap labor became exhausted; wages and inflation rose, sparking the process of industrial upgrading. A strong currency was needed to contain inflation, to reduce costs of imported capital goods required for industrial upgrading and restructuring, and to lower domestic interest rates.

With the exception of Singapore, the nations of Southeast Asia were following an opposite path to that described here. The undervaluation of the Thai Baht, the Malaysian Ringgit and the Indonesian Rupiah in the 1980's was the linchpin supporting the broad-based economic reforms designed to spark growth in trade and investment. Rapid economic growth ensued. Fiscal policy remained tight, and in many instances became tighter to contain the sustained boom in demand. Incomes rose and poverty levels fell, as these countries marched up the ranks of the developing countries and climbed up the technology ladder. The rating agencies accorded these countries investment-grade status as well as several upgrades between them.

The strategy worked. Savings and investment rates rose dramatically, and the economies developed and diversified their production bases. The paradigm was well-executed, but fortuitous events helped the process. The dollar's decline against the yen and Deutschemark following the 1985 Plaza Accord provided a continuous boost to external demand for the region. If the dollar had appreciated against the other major currencies, the Asian miracle would have proceeded at a slower pace. As for the effectiveness of the paradigm in cyclical-demand management, external events beyond the control of policymakers have played an important role, intervening regularly to relieve the pressure on monetary authorities while fiscal policy aided the adjustment.

The strategy, however, was not without its weaknesses. The fixed exchange-rate regime and other controls hindered the development of the financial sector. Bank finance remained the dominant source of funding for economic growth. External funding was overly dependent on the short-term currency swap market and portfolio inflows to finance the external deficit since there were no long-term domestic capital markets. As these economies gained access to cheaper dollar financing offshore, borrowing rose rapidly, and found its way increasingly into nontradeable activities such as real estate. Lax supervision and regulation of the financial system, coupled with uninterrupted access to foreign capital, made delaying tactics, such as growing out of the problem, viable. It also allowed the bubbles to grow. Furthermore, the availability of offshore funds, which began in earnest in the early 1990's, allowed the countries to fall seriously behind in deregulating the real sector, developing the financial sector, and upgrading physical and human infrastructure.

In fact, the genesis of Asia's latest currency turmoil can be traced as far back as 1993, when a global stock-market boom and aggressive monetary easing by the U.S. Federal Reserve led to a sharp rise in the pool of global liquidity made available to both portfolio flows and foreign direct investment. At the same time, Southeast Asian countries were just beginning to liberalize and to develop their nascent capital markets, and together with their perceived economic virtues–investment and export-led GDP growth, high savings rates, and favorable demographic profiles–Asia became the natural destination for such capital. Indeed, debt, foreign direct investment, and equity inflows into the Asia/Pacific area grew exponentially from U.S.$ 25 billion in 1990 to U.S.$ 110 billion in 1996.

Such inflows, in the absence of central-bank foreign- exchange intervention, would have caused a sharp nominal appreciation in the exchange rate and depressed exports, an unpalatable outcome given the central role of the external sector in Asian growth. Central banks across the region, especially those running inflexible currency regimes such as Thailand, bought up U.S. Dollars to prevent their currencies from rising. But the simultaneous net sale of domestic currency that foreign-exchange intervention entails had the effect of expanding liquidity, an outcome that had to be avoided, since the region's booming economies were already creating incipient inflationary pressures. Thus, central banks were compelled to “sterilize” their foreign-exchange intervention by mopping up the liquidity created by their sales of domestic currency into the interbank market–either by outright interbank borrowing or by bond issuance. This was the core of Southeast Asia's policy dilemma for most of the early nineties; central-bank balance sheets show a sharp jump in domestic credit (as central banks withdrew liquidity out of the system) in response to the rising net foreign-asset portion as capital inflows picked up in pace in the early nineties.

But sterilization was an expensive option, because it involved central banks borrowing money at high domestic interest rates, then parking it in reserve currencies earning substantially lower returns. Worse, the process was self-defeating, because the maintenance of high domestic rates, whilst correct from a macro- stabilization perspective, only succeeded in attracting more foreign portfolio flows seeking higher returns. For example, the Thai Baht basket trade and the long Indonesian Rupiah trade proved to be extremely profitable in the last two years, as they provided an attractive carry and little exchange-rate risk. The upshot was that sterilization was oftentimes incomplete, and money-supply growth in Southeast Asia grew well above nominal GDP growth, even after adjusting for a lower velocity of money to take into account financial-sector deepening. In sum, the situation faced by the region was essentially untenable, and many expected exchange-rate regimes to shift over time towards greater flexibility. But the speed and the path taken towards that end took even the most hard- core Asia skeptics by surprise.

So what caused events to play out with such intensity and force? We would divide the causes of Asia's currency crisis into four broad factors:

–Nature of foreign inflows resulted in banks' funding mismatch: Inadequate bank supervision and lax internal criteria allowed over-reliance on sentiment-sensitive short-term foreign funding, which was used to on-lend long term, typically to construction. This weakness was evident in both Thailand and Indonesia, countries that ultimately had to turn to the IMF once the source of foreign funding was at risk of drying up. The house of cards first showed signs of collapsing upon defaults among property developers (e.g., Thailand's Somprasong Land) as the property cycle showed signs of maturing. This ultimately had knock-on effects on the asset quality and collateral value of the financial sector, especially for Thai finance companies, which typically had 25% exposure to property.

–Yield-curve inversion upon foreign-exchange intervention by central banks: As the signals began to unnerve foreign investors, capital outflows ensued, putting downward pressure on currency. Central banks' first response was to intervene in foreign-exchange markets, but the spending of foreign reserves proved untenable, as the hemorrhage proved to be less than temporary. Their second response was to jack up short-term rates sharply, creating an even greater squeeze on banks with funding mismatches. The fragility of Southeast Asia's banking systems was shown up by the latter chain of events; 58 finance companies in Thailand and 16 banks in Indonesia have thus far been suspended from operations.

–Misallocation of resources: Much of the investment in Southeast Asia was geared towards construction, which fueled growth for a prolonged period but posed a risk once the sector reached an overbuilt state.

–Little attention paid to soft infrastructure led to loss in export competitiveness: Asia's rapid growth led to a dire shortage of labor supply, as wages were bid up well beyond productivity advances. Exchange rates in trade- weighted terms also appreciated when the U.S.$ moved from 80 to 120 against the yen from mid-1995 to date. Competitiveness on both fronts was lost vis-a-vis the north, especially in the light of the 50% fall in the Chinese RMB in 1994. In addition, Vietnam and South Asia may apply further pressure on export competitiveness.

A multiple-equilibria analysis is interesting. The idea is that there is a short-run equilibrium determined by the financial market for the Asian currencies, and a long-run equilibrium determined by the real economy. Clearly we have overshot the long-run equilibrium exchange rates. The regional currencies were not more than 20% overvalued on a fundamental basis. However, the short-run financial equilibrium is determined by the overhang of dollar demand for debt, which is exacerbated by a current lack of confidence.

The longer this situation continues, the greater the damage to long-run fundamentals will be, and the more likely the short-term equilibrium will become the new long-term equilibrium.

The underdeveloped nature of the domestic market, coupled with the free flow of capital, exacerbates the ability of policymakers to determine the short-run equilibrium. Thus, better supervision and regulation of domestic capital markets is absolutely required as soon as possible. There is also an argument for limiting the scope of capital-account transactions between offshore and onshore parties, an approach that has already been taken in most of the SE Asian economies.

(Reprinted by permission. Copyright © 1997 Merrill Lynch, Pierce, Fenner & Smith Incorporated

November 6, 1997William Belchere

ML Fixed Income Research, Singapore

Merrill Lynch & Co.

International Fixed Income Research

North Tower 21st Floor

World Financial Center, New York, New York

Consensus National Futures and Financial On Line Index

Added to the WWW 11-07-97
Last updated on 11-07-97

Hosted by:
One Crossroads Place
610 West Maple Ave, Suite WWW
Independence, MO 64050
(816) 252-4080
sysop@kcmo.com

wmeubank@ocp.kcmo.com