Despite the market rout, a repeat of the 1997 Asian crisis is unlikely
The intensity of this week's sell-off in global financial markets was led, largely, by emerging market assets. Since the renminbi depreciation on August 11, the MSCI emerging markets index has declined by 12 per cent in US dollar terms. The depreciation bore down on commodity prices, raised concerns about weakening growth in China and the potential loss of a currency anchor in Asia, while triggering a sell-off across global emerging markets. Woes were compounded by data showing that China's manufacturing sector has recently been shrinking at its fastest pace since 2009.
The plummet of emerging market currencies, equities and credits has prompted observers to draw parallels with previous market convulsions, most notably the Asian financial crisis, in which emerging markets bore the brunt of the pain. While emerging markets are unlikely to be similarly slammed by the current bout of volatility, the macroeconomic cycle means they remain fragile. But the more important question is, why have emerging market assets reacted so negatively?
Growth in emerging market countries has been driven by an environment of low real interest rates, reinforced by easy monetary policy and China's push to stimulate domestic demand. But with both factors now perceived to be unwinding, emerging markets have been forced into a process of adjustment.
Adding to the overhang, the collapse in commodity prices combined with a slowdown in growth in China - the world's largest consumer of commodities - leave at risk economies dependent on exports to China.
Renminbi depreciation will also affect major exporters - in Asia this means virtually all countries. The sole exception, India, is relatively sheltered.
However, it would be foolish to assume the effect is uniform. Countries in north Asia are potential beneficiaries of increased consumption in developed markets while Malaysia and Indonesia are particularly vulnerable to foreign exchange volatility and potential capital outflows in the region, in advance of the US Federal Reserve raising interest rates. Indeed, the recent dramatic fall in the value of the Malaysian ringgit was a primary catalyst in sparking fears that the region might be heading for another crisis. With a rate hike from the Fed looming, it is little wonder that parallels are now being drawn with the cataclysmic events of 1997. But are things really that dire for Asia?
There are shared catalysts with 1997: household debt levels are high in some Asian countries; the value of currencies across the region is plummeting; and Malaysia is currently weathering a political crisis.
But this is where the similarities end. Asia's external debt versus foreign exchange reserves is relatively small and balance sheets across the region are less susceptible to currency devaluation than they were 18 years ago. In 2015, falling currencies have acted as shock absorbers, cushioning the real economy as the US dollar strengthens while, at the same time, helping local industry and manufacturers.
Much of the current weakness in Asian currencies is due to broad-based US dollar strength. Furthermore, unlike during the crisis in 1997, Asian central banks have welcomed currency weakness as a valve to reduce pressure on economic growth and to rectify their current account imbalances. With exchange rate levels fairly aligned with the region's macro fundamentals, and foreign exchange reserves and current account balances on a much stronger footing than in the late 1990s, a repeat of a 1997-style Asian crisis is unlikely.
No impending catastrophe then, but that doesn't mean all is rosy. Uncertainty about the scale of the Chinese slowdown, the shadow cast by imminent tightening by the Fed and a collapse in commodity prices is a toxic mix not just for Asia - but for all emerging markets. The return on equity for emerging market equities remains low, industrial production has slowed and exports across the region have contracted. For these reasons, the outlook for Asia's emerging markets is cloudy.
Kelvin Tay is regional chief investment officer, Southern APAC, at UBS Wealth Management