South-east Asian Economic Recovery Sparks ‘Exuberance Risk’
Guest Post by Oxford Analytica
The growth outlook has improved substantively for the Association of South-east Asian Nations-5 (ASEAN-5) economies (Indonesia, Malaysia, the Philippines, Singapore and Thailand). Growth of 4.7% in 2008 slowed to 1.3% in 2009 and is expected to exceed 4.7% in 2010, according to the IMF’s January forecast.
Capital flows. Until recently, ASEAN growth prospects have not translated into a surge of capital inflows. In part, regional financial liquidity has been high enough adequately to meet the funding needs of the private sector. Fiscal accounts have been restrained and the current account has enjoyed a large surplus on the back of weak import demand. However, recent signals from the currency markets suggest capital inflows could return as a policy challenge in the coming quarters:
- Since February, bilateral exchange rates against the dollar have risen 2.25% or more in the Philippines, Malaysia, Thailand and Indonesia.
- With the exception of Indonesia, nominal-effective appreciations in the ASEAN-5 had been no more than 1% in the twelve months to February 2010.
More appreciation. The recent jump in bilateral US dollar exchange rates signals the likely path of pressure on these currencies in coming months. So far, monetary authorities have been content to allow the exchange rate itself to take some of the pressure from these inflows. This is likely to remain the case in coming months:
Still competitive. ASEAN-5 currencies have seen comparatively little real-effective appreciation in the current phase of the ‘V-shaped’ recovery. In the twelve months to February 2010, real appreciation was limited to less than 2% for all these economies, bar Indonesia. By contrast, other V-shaped recoveries have seen real appreciations ranging from 20% (South Korea) to 25% (Brazil).
Open economies. South-east Asia’s economies are highly open. In 1998, gross financial flows were equivalent to 152% of GDP on average for eleven Asian economies (India, China, Hong Kong, Taiwan, Singapore, Malaysia, Thailand, Indonesia, the Philippines, Vietnam and South Korea). That figure had risen to 224% by 2008.
Capital controls. ASEAN-5 currencies can be expected to appreciate against the dollar further in 2010. However, policymakers will not be indifferent to combinations of appreciation and inflows that become self-fulfilling. Limited scope for reserve accumulation means that further resort to controls on capital inflows is on the cards:
- Controls on short-term inflows are designed to extend the duration of investment funds. These can include mandatory non-interest-bearing deposits as a fixed percentage of a portfolio acquisition, or taxes on portfolio acquisitions.
- A key consideration is determining whether the inflows are transitory or permanent. If the latter, policymakers are better off allowing the economy to adapt to a dearer real exchange rate.
In the medium term, South-east Asia faces a potential return to exuberance of the kind not seen since the mid-1990s announcement of an ‘East Asian Miracle’. Misallocation of capital is always more susceptible to such environments, and a combination of bad luck and sluggish policy can make such misallocations catastrophic.
Yet a replay of the 1997-98 crisis is unlikely in the ASEAN-5. This owes in part to higher foreign-exchange reserves, but it is also because the backdrop, and the policy regime, are so different:
- China’s currency is unlikely to go anywhere but up, compared to a substantial depreciation in 1994. The latter, combined with the dollar’s overall surge in the mid-1990s, meant that dollar-pegged ASEAN currencies underwent substantial real appreciation. This shifted resources to the non-traded sector, fomented bubbles in that sector, and made capital flight all but inevitable.
- The exchange-rate regime has matured considerably. Tight pegs to the dollar are mostly gone or on their way out. As ASEAN-5 currencies become more flexible, foreign investment in local assets faces less assured currency-adjusted returns. The presence of ‘two-way’ risk on the exchange rate is a key deterrent to unmitigated inflows.
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