The waters are calm at present, but inflation could thrust a flock of black swans into fragile Asian financial markets. Photo: AFP / Hristo Rusev / NurPhoto

TOKYO – Asia, it seems, learned one of the biggest lessons from the region’s 1997 crisis: an economy can almost never stockpile too many foreign exchange reserves.

Thailand, Indonesia, Malaysia, South Korea and others realized that the hard way. As speculators pounced, and the financial tide surged out, central banks were caught swimming without swimsuits.

Following the 1997-8 trauma, they busily spent the next decade re-clothing their economies by way of big currency-reserve holdings. They came in handy in 2008, when Wall Street crashed. In 2013, they helped the region ride out the worst of the US Federal Reserve’s “taper tantrum.”

But now, as the post-Covid-19 reflation scare upends investment portfolios everywhere, Asia risks once again being caught in the nude as oceans of liquidity suddenly dry up.

Granted, on the surface, the water looks calm.

Asia’s developing nations are sitting on their highest FX reserves since August 2014, giving the region a much-needed guardrail should economies veer toward turmoil. The globe’s fastest-growing economies have about US$5.82 trillion worth of financial guard-railing in place.

And even if you exclude China, we’re still talking an all-time record of $2.6 trillion.

Yet there are potential shocks to come that economies including India, Indonesia and Turkey may well be ill-equipped to navigate. The biggest variable is how the US Federal Reserve responds to a sudden and unpredictable surge in inflation.

Having a well-stocked vault is key to surviving difficult times. Photo: AFP / Xie zhengyi / Imaginechina

The return of the ‘Fragile Five’

Judging from recent comments by Fed Chairman Jerome Powell, Asia might be looking at more than just tapering in the months ahead. Powell’s team just raised its 2021 headline inflation expectation by a full percentage point to 3.4%. That reflects the biggest jump in consumer prices in about 13 years.

Though the Fed argues the 5% year-on-year rise in May is “transitory,” signs of upward cost pressures virtually everywhere have punters hoping for the best – but fearing the worst. Commodity price surges have been particularly unsettling.

Three significant things have changed since the 2013-2014 tantrum. One, the fallout from a once-in-a-century pandemic. Two, central banks have never kept borrowing costs this low, this long. Three, excessive debt levels that bear the fingerprints of crises past and Covid-19 today.

Not surprisingly, attention is turning once again to the so-called “fragile five.”

The reference here is to the dreaded Morgan Stanley list no government wanted to be on – one that has included India, Indonesia, Brazil, South Africa and Turkey. Many of these economies would be highly vulnerable once again, should markets crater.

India’s vulnerabilities

Take India, which even before Covid-19 was grappling with bad-loan troubles in the pivotal state bank sector. At least statistically, Reserve Bank of India Governor Shaktikanta Das is right to tout the size of the nation’s FX reserves, which may have just exceeded a record $600 billion.

As Das puts it: “The success of these efforts is reflected in the stability and orderliness in market conditions and in the exchange rate in spite of large global spillovers. In the process, strength is imparted to the country’s balance sheet by the accumulation of reserves.”

All things considered, says strategist Vikas Bajaj at Kotak Securities, “it does give a stability to the rupee against any global risk-off. FX watchers do track if reserves are sufficient to stem any major capital outflows, as we saw during 2013 – the taper tantrum – and last year during Covid in March and April.”

Yet the magnitude of India’s coronavirus challenge adds further strain to some serious pre-existing conditions.

They include the inconvenient fact that the state sector faces its own sour-debt epidemic. Exhibit A: at State Bank of India, the nation’s biggest lender, legacy bad loans account for 65% of its non-performing debt portfolio. And its bad-loan portfolio rose 5 percentage points in the last year.

India, too, often faces a twin deficit – both in the national budget and current account – problem. This is a problem that landed it on Morgan Stanley’s list. All told, there’s a question about whether India’s reserves will be sufficient to paper over its financial cracks.

Indian Rupees. Photo: AFP / Nasir Kachroo / NurPhoto

Turkey’s tumbling lire

Turkey’s troubles are of a different magnitude.

Ankara is burning through its limited reserves are an alarming rate to support a plunging lira. Turkey’s currency is down 18% this year. As of mid-April, the Central Bank of the Republic of Turkey had about $25 billion of reserves, down from $40 billion in January.

In late April, sources told Reuters Turkey had only $2 billion left. Factoring in “Turkey’s high inflation rate,” says economist Robin Brooks at Institute of International Finance, the lira is the “weakest emerging market currency in real effective terms.”.

Over the last 20 years, trouble in Turkey has time and time again increased contagion risks in world markets.

Southeast Asian wobbles

Further East, both Indonesia and Malaysia face reserve coverage rates that may be too low for comfort.

In Indonesia, Southeast Asia’s biggest economy, reserves fell to about $136 billion in May as Jakarta made external debt payments. Holdings at a five-month low just as Fed tapering talk intensifies is not where President Joko Widodo wants to be in June 2021.

On the other hand, there are scattered signs of FX reserve stability across the region, including in Bangkok, where the great fire of the 1997 crisis was first ignited.

“Well-run emerging markets improve over time,” says Lyn Alden, founder of Lyn Alden Investment Strategy. “Thailand for example was at the heart of Asian financial crisis, now has massive reserves.”

And it helps that China’s foreign-exchange reserve position is solid.

China’s FX mountain

In 1997, fears arose that Beijing might have joined Bangkok, Jakarta and Seoul and devalued the yuan. Such a step by China would have taken the crisis to an entirely different level. To exhales from financiers everywhere, China resisted the urge.

Today, some think Beijing may be sitting on too many reserves. Yet it comforts developing economies to know that President Xi Jinping has the firepower to combat financial problems as they arrive.

A case in point is the drama surrounding Evergrande Group, China’s most indebted property developer.

Several large Chinese banks, Bloomberg News reports, are restricting credit to Evergrande amid mounting concerns about the company’s financial health. Three lenders with a combined $7 billion-plus of credit exposure as of June 2020 opted not to renew Evergrande loans when they mature this year.

Even Evergrande’s efforts to reduce debt and vulnerabilities “is subject to meaningful execution risk and may also negatively affect the company’s business profile in the medium term,” says analyst Edwin Fan at Fitch Ratings.

This is on top of the default-risk saga over at China Huarong Asset Management, the one making global news for all the wrong reasons.

The good news, though, is that Beijing’s more than $3 trillion of foreign currency reserves amount to quite a rainy-day fund.

China’s vast holdings are the People’s Bank of China’s way of letting punters know that the “exchange rate is not a one-way bet,” says economist Zhang Zhiwei at Pinpoint Asset Management.

If the yuan rises too fast, it has the scope to cap the move. The same goes for speculators who might push the yuan lower.

Federal Reserve chairman Jerome Powell. Photo: AFP/The Yomiuri Shimbun
The Federal Reserve’s Jerome Powell. Photo: AFP / The Yomiuri Shimbun

Powell’s big black swan

That is sure to come in handy should the Fed, or other major central banks, serve up some big policy surprises at a moment when China – and the rest of developing Asia – is trying to recalibrate growth engines, says economist Robert Carnell at ING Bank.

Recent years, he argues, may have lulled markets into a state of complacency surrounding major tightening moves.

“Since the global financial crisis,” Carnell says, “I would say that markets have been far too willing to just wait and react to what they are told to believe by central banks, and have done far less thinking and forward-looking for themselves. Strong growth, bottlenecks in labor supply, high inflation – this stuff all screamed ‘higher rates and sooner.’”

The Fed is now telling markets it’s time to worry.

“I guess this is the by-product of reliance on forward guidance,” Carnell says. “But it’s worth remembering that central banks do not have perfect foresight, and they have a vested interest in trying to massage markets in a favorable direction, which, when it proves wide of the mark, results in an inevitable spike in volatility as markets catch up with reality. We appear to be experiencing a small dose of that today.”

The good news is that developing Asia is sitting on a rather large dose of currency-reserve insurance should things go terribly awry.

Yet not big enough, perhaps, in some cases. The disconnect could make for some chaotic trading in the second half of 2021.