The fall in foreign exchange reserves heralds the Asian financial crisis 2.0

TOKYO — Few stories scare Asia more than rumors of trouble in Thailand — even more so when foreign exchange reserves are involved.

It was the devaluation of Bangkok in July 1997 that triggered the Asian financial crisis. As foreign exchange reserves dried up, the government and the Bank of Thailand had no choice but to remove the peg to the US dollar and drive the baht down sharply.

Twenty-five years later, Southeast Asia’s second-largest economy isn’t quite cascading toward a repeat of that collapse. Yet Bangkok is again ground zero for something that is gaining increasing attention in global markets: the rate at which central banks in developing Asia are depleting their foreign exchange reserves.

Thailand now shows the region’s largest decline in reserves relative to gross domestic product (GDP). Malaysia comes next, followed by India.

Broadly speaking, says economist Divya Devesh of Standard Chartered in Singapore, emerging Asian countries, excluding China, are sitting on their smallest reserve piles since the Lehman Brothers crisis in 2008.

The bank focuses on how many months of imports each economy can finance with today’s currency holdings.

As of August 2020, the region averaged about 16 months. By early 2022, it had fallen to 10 months. Today it’s around seven months – not where most investors or government officials thought Asia might be.

Raising the stakes, the dollar is rising at the fastest pace against the Japanese yen in 24 years, up almost 26% this year. It is up nearly 9.6% against the Chinese yuan.

As the dollar soars, largely thanks to rate hikes by the Federal Reserve in Washington, Asian currencies are under heavy downward pressure. Fewer reserves means less firepower to defend exchange rates.

Asian central banks are selling their stocks of dollars to defend their currencies. Photo: AFP

That’s not to say China isn’t part of this conversation.

As the yuan approaches the psychologically important level of 7 against the dollar, the People’s Bank of China “will be more concerned with slowing the pace of depreciation and keeping expectations stable than defending a specific level for the exchange rate. “says economist Lauren Gloudeman to Eurasia Group. “But if depreciation expectations coincide with large capital outflows or the depletion of reserves, its defense could strengthen.”

Gloudeman points to data released last week showing that “China’s foreign exchange reserves continued to fall to their lowest level in nearly four years.” And, according to the Institute of International Finance, portfolio outflows persisted for a seventh consecutive month in August.

Economist Carlos Casanova of Union Bancaire Privée observes that the PBOC recently unveiled a cut in reserve requirement ratios for currencies to 6% from 8%. This was the second RRR cut on currencies in 2022, following a 100 basis point cut in April. During this period, the yuan depreciated to 6.5 from 6.3 per dollar.

The idea is to boost liquidity in dollars and encourage banks to convert part of foreign exchange reserves into yuan, which will boost the Chinese currency.

But, Casanova concludes, “the move alone will not fully offset depreciation pressures. This is a signal that the PBOC is not comfortable with one-way depreciation expectations, although it is comfortable with some yuan weakness.

The decline of the yen, however, is shaking Asia in unpredictable ways. The concern is that China, South Korea or other major economies could also feel the need to weaken exchange rates, in a race to the bottom of competitive devaluations to save exports.

At the same time, according to economist Brad Setser of the Council on Foreign Relations, indications that China or Japan are selling large blocks of currencies “could put additional pressure on other Asian currencies.”

Still, now is not the time to panic, says economist Louis Kuijs of S&P Global Ratings. “Foreign reserve levels remain generally adequate. But global uncertainty and the prospect of even higher global interest rates call for careful examination of the underlying dynamics.

Despite everything, the politics of the moment are raising the temperature in Tokyo, Beijing and elsewhere. In China, according to economist Ting Lu of Nomura Holdings, the weak yuan looms over the Communist Party leadership reshuffle process that only happens once every decade – and at a time of US tensions -raised Chinese.

“Chinese leaders,” says Lu, “are particularly concerned about the bilateral exchange rate of the RMB with the dollar, as they believe that the RMB/USD somehow reflects relative economic and political strength. Second, a sharp depreciation of the RMB/USD could shake domestic sentiment and accelerate capital flight. »

Global funds are moving out of the yuan and into the US dollar. Photo: AFP / Nicolas Asfouri

Goldman Sachs analyst Maggie Wei said: “We think the PBOC could tolerate further depreciation of the yuan against the dollar, especially as the broader dollar continues to strengthen, although it may want to avoid a continuous and too rapid depreciation in one direction if possible”.

Similarly, economist Julian Evans-Pritchard of Capital Economics thinks Beijing will be very careful not to let the yuan weaken beyond the 7.2 level that “we saw during the trade war”.

Still, the dollar’s gains and the likelihood that the US Federal Reserve will continue to tighten pose a daunting challenge for Chinese officials in the face of slowing economic growth. Last week, PBOC Deputy Governor Liu Guoqiang said that in the short term, yuan exchange rates are expected to fluctuate back and forth and people “shouldn’t bet on one thing.”

Liu, however, is clearly focused on the bigger picture, emphasizing that “in the future, recognition of the yuan in the world will continue to increase.”

Diana Choyleva of Enodo Economics says this tension between the next 20 weeks and the next 20 years is becoming increasingly difficult to overcome. “China,” she says, “has greatly benefited from the dollar-led global financial system. But Beijing now sees its dependence on the dollar as a strategic vulnerability.

On the one hand, Choyleva says, Xi’s team “wants to guard against the United States deploying the dollar as a weapon against them.”

On the other hand, she adds, China “wants to use the yuan as a tool to consolidate a sphere of economic influence, thereby enhancing China’s economic security.” And it wants the yuan to be a symbol of its great power status, to help bolster its claim to represent a viable alternative to the US-led international order.

For now, however, dollar zigs and zags dominate Asia in 2022 and there is a good chance that it will also be the case in the year to come. Hence the focus on Asian foreign exchange reserve levels as Fed Chairman Jerome Powell’s team in Washington picks up the pace of tightening.

Hopes that US inflation had peaked in July were dashed by news of a 0.1% increase in consumer prices in August. This means that, compared to a year earlier, prices increased by 8.3%.

Jerome Powell has indicated that more US rate hikes are on the horizon Photo: AFP/Graeme Jennings

Last week, Powell said the Fed would act “directly” to limit the risks of overheating. Some senior Fed officials are hinting at another 75 basis point rate hike next week.

The latest data means “they’re definitely going to 75 again,” says economist Jay Bryson of Wells Fargo & Co. Tiffany Wilding, an economist at Pacific Investment Management Co, says the “torrid” nature of recent data on Price suggests the problem is “stickier and broader” than conventional wisdom and means “the Fed has more work to do”.

The same is true for Asian central banks as local currencies come under increased downward pressure. With average reserves falling “sharply”, says analyst Thomas Rookmaaker of Fitch Ratings, many economies “still have substantial reserves, but for a small number the fall is an indication of rising strains on external financing. “.

Fitch calculates that reserves in the Asia-Pacific region have shrunk by about $590 billion between the end of 2021 and July 31, 2022 over the past two years, in part due to pandemic-related factors, including compression of demand.

The largest declines in value were seen in China, Singapore and Japan. But the exhaustion momentum among developing nations is the real concern as the dollar’s rally gathers pace.

“If the regional decline in reserves were to continue, it would eventually put downward pressure on the ratings of some APAC sovereigns,” Rookmaaker said.

This risk, he adds, “could be material where reserves have been a rating strength that offset other credit weaknesses, such as in the Philippines or where external financials have traditionally been weaker than their peers, like in Indonesia.

In his own research, Devesh of Standard Chartered notes that in using reserve cuts as proxies for monetary intervention, New Delhi and Bangkok have been among the most assertive. Reserves have declined by $81 billion and $32 billion, respectively, so far in 2022.

Thailand’s central bank is still spending heavily to support the baht. Image: Twitter

Meanwhile, inventories fell by about $27 billion in Seoul, $13 billion in Jakarta and $9 billion in Kuala Lumpur. By these metrics, Thailand, the Philippines, India, Indonesia and Malaysia are of most concern from a stability perspective if the dollar continues to soar.

In Thailand’s case, writes economist Chartchai Parasuk in the Bangkok Post, “Fast-draining reserves are raising concerns about the country’s economic stability.” The trend, he warns, “is unnatural and runs counter to economic theory.”

And for investors worried about an Asian Financial Crisis 2.0 trajectory for the region, it’s a sign of potential trouble ahead.

Follow William Pesek on Twitter at @WilliamPesek

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