Having learned from the 1997 crisis, Asia’s currency defence is likely to be prudent and eclectic

Asian economies are in a much better state today, more able and willing to tolerate currency depreciation, which can act as a shock absorber
To slow it down, Asia could use an array of instruments, from interest rate increases and opportunistic currency interventions to piecemeal capital-flow management

Rob SubbaramanandSi Ying Toh

Published: 4:30pm, 23 Oct 2022

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While the US Federal Reserve’s aggressive monetary tightening and strong dollar look set to add pressure to the balance of payments and currency depreciation in Asia, fears of a full-blown Asian crisis appear overdone.

Indeed, the severity of the 1997 Asian financial crisis, starting with the devaluation of the Thai baht on July 2, was breathtaking: by June 1998, the Indonesian rupiah had lost 85 per cent of its value against the dollar. More astonishing was the volatility that saw the South Korean won fall by 28 per cent in December in 1997, with the sum of the daily percentage changes that month being five times as large, totalling 156 percentage points.

But this time, Asia is not the epicentre of the global economic downturn, nor is its inflation as severe as in the rest of the world. For most Asian countries, nominal trade-weighted exchange rates are not weak, highlighting that the Asian currency depreciation is more the result of an exceptionally strong dollar, and should not be regarded as a symptom of weak economic fundamentals.

Apart from Hong Kong, Asia’s exchange rates are much more flexible today. Fewer countries have large current account deficits, with most running surpluses, and Asian countries’ foreign-exchange reserve buffers, in terms of import cover or as a share of the gross domestic product, are healthier. There is also less room for large-scale capital flight as there has not been a large build-up of “hot money” net capital inflows.

Most importantly, the share of short-term, unhedged foreign currency debt is lower than 25 years ago. This was Asia’s Achilles’ heel in 1997, as massive currency devaluations suddenly inflated external debt. Indonesia’s external debt obligations, for example, skyrocketed to 153 per cent of GDP in 1998 from 56 per cent in 1996. In contrast, a larger share of external debt today is denominated in local currency.

The region, however, still faces challenges, with no easy policy options. Asian inflation might not be as high as elsewhere, but it is still high and policy interest rates have been slow to adjust, evidenced by much lower, and in most countries, still deeply negative real interest rates. Noticeably higher domestic private debt in most economies also makes them more sensitive to higher interest rates than before.

Asian market turmoil today is not a repeat of 1997 financial crisis

Asian central banks are not single-mindedly focused on inflation, realising that raising rates too rapidly to contain inflation could trigger a domestic financial fallout. But policymakers also seem more mindful of economics’ impossible trinity, which allows for the combination of only two of the following by any country at any time: fixed exchange rates, free capital flows, and independent monetary policy.

Having learned from the 1997 crisis that excessive foreign exchange intervention to defend currencies is not always worth it – because, if foreign exchange reserves fall too far, currencies become vulnerable to speculative attack – Asian policymakers have shown a greater respect for the impossible trinity, and a greater willingness to let their currencies depreciate. Weaker Asian currencies can act as a shock absorber, helping insulate economies from what is set to be a sharp downturn in Asian exports.

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As the Fed, European Central Bank and Bank of England continue to tighten their monetary policies, putting recession pressure on their economies, and exacerbating the stress on Asia’s balance of payments, the region is likely to implement a more eclectic policy approach that involves greater flexibility in drawing on multiple instruments.

Such an approach would include measures such as raising interest rates to tolerate some further currency depreciation, while opportunistically intervening in foreign exchange markets to reduce expectations of a one-way depreciation, coordinating between central banks and governments to avoid fiscal dominance – where high government debt holds back central bank functions – and activating a second line of defence that involves piecemeal capital-flow management measures to slow down depreciation.

In the event of more extreme pressures on the balance of payment, the likelihood of a move to draconian capital controls appears low. Rather, Asia’s central banks could deploy a third line of defence, yet to be used, which involves bilateral foreign exchange swap lines or collective financial support.

While the region does face some stress points, if Asian policymakers stay the course on prudent policies and an eclectic response to the impossible trinity, the region will be well positioned to lead the next global economic recovery.

Rob Subbaraman is head of global macro research and co-head of global markets research at Nomura. Si Ying Toh is an economist for Asia ex-Japan at Nomura