Another Kind of Asian Contagion

How come all of Asia’s markets, with the bizarre exception of China, have fallen so much farther and faster than the US markets where the credit rot began?

It’s a situation which flies in the face of the assumption that strong external positions, high but not extravagant valuations and mostly low domestic and foreign debt would provide a shield. Even if local growth slowed sharply, there should be no reason for the kind of near panic evident in the US, where exorbitant foreign and household debt and opaque asset-backed investment instruments have been all the rage. Cash-rich Asia should have been protected, but it wasn’t.

Here are the key reasons.

Asian markets have been driven down primarily by foreign selling. For example, net foreign sales in Taiwan totaled NT$61 billion on August 15 and 16, bringing total net foreign sales in that market to NT$156 billion since the beginning of the month. Those sales followed an almost equally strong surge into Taiwan – net foreign purchases in June were NT$185 billion. July showed a near buy/sell balance but that was because foreigners were buyers in the first half of the month, then became sellers. Much the same pattern can be seen for Korea and Thailand. Korea had hit a record high and Taiwan a multi-year high in late July so it is hardly surprising that when the momentum went into reverse that would plummet – both are down around 16 percent in that time.

The issue is how far fundamentals have been changed by events, or whether local liquidity can gradually fill the space left by the foreigners. All this selling has had to be absorbed by local investors who themselves have been thrown off balance by events. Interestingly in Taiwan and Thailand the big net buyers have not been local institutions, which have mostly remained on the sidelines, but individual local investors who are probably buying back many of the same stocks they had sold earlier to the foreigners at a higher price.

In both there may be scope for local institutions as well as individuals to buy. Korea’s national pension fund is committed to increasing its equity holdings and government-controlled Taiwan funds are likely to be in action before the elections at year-end. However these may not be enough should foreigners continue to exit – which many can still do at a handsome profit.

Selling by foreigners has been particularly aggressive partly because some of the Asian equity markets are relatively liquid at a time when western credit markets have dried up, leaving hedge and other funds facing redemptions desperate to find liquidity wherever they can.

A second reason for foreign selling has been the “one size fits all” attitude many take toward so-called emerging markets. Those who bracket Korea with the Philippines and Argentina are destined to find themselves facing redemptions on the assumption that in times of market distress, emerging markets will suffer more than developed ones. Of course previously some developing country markets, such as the Philippines and Indonesia, were driven to unsupportable levels by foreign buying and have since suffered the reverse. But what applies to them does not apply to economies such as Taiwan, Korea and Hong Kong, which are more developed than much of Europe.

A third reason for the Asian plunge has been the worry that local companies, banks in particular, may have been badly caught in the ABS (Asset Backed Securities) and CDO (Collateralized Debt Obligations) chaos. One Singapore bank has owned up to some losses but there are probably lots more where those came from, particularly by banks and insurance companies in Japan, Taiwan, and Korea which had been looking for places to put their cash hoards to work for high interest than available on plain vanilla deposits or T-bills.

European banks have suffered billions of dollars in losses because they were lulled by greed and ignorance into buying Wall Street’s deception B grade paper which through Moody’s approved financial alchemy was converted into Triple A rated assets. Big banks in Taiwan and Korea, which have not been entirely free of suspicions that they may be carrying more non-performing loans than they like to admit, have tumbled more than the indices.

The fourth problem applies only to Japan – the dramatic rise in its currency. The yen is 9 percent against the US dollar since early August and 6 percent between August 15 and 17. Against the New Zealand dollar it has gained 22 percent and not much less against the Australian. Both currencies had been favorites of the carry trade so expect more gigantic losses and bankruptcies from carry traders.

Whatever else happens in the world, a sharp rise in the yen will cut sharply into the profits of Japanese exporters, the main sufferers from the rout of the Topix. Korea and Thailand may have quietly welcomed the foreign money exodus, which reversed earlier sharp currency rises which were denting export profits.

Finally we come to the issue that will be the most important of all: what will be the impact of this global event on US import demand? For the medium to longer term the dangers to east Asia have probably been underestimated – though in the shorter term the above issues are probably far more important.

The fact is that the US trade deficit is unsustainable and the reckoning is probably nigh as the collapse of household credit finally brings about a recession in US consumption and hence a probable drop not just slower growth in Asian exports. Even though Japan and Europe have strong external positions, their growth is likely to slow under the impact both of the US and global credit concerns.

As for China it is remarkable mostly because its markets behave as though nothing has happened, despite mounting evidence of sharply rising inflation, various property bubbles and the prospect that a sharp slowdown in (excessive) investment will coincide with the US recession, even if the US does not take specific measures against China over its currency policy or as a scapegoat for other US problems.

So far Taiwan has suffered particularly from assumptions about US and China slowdowns. This is probably mistaken. Most of Taiwan’s exports to China are for assembly and then export to global markets, of which the US is important but not overwhelmingly so. As with Korea, those in the forefront of their industries should not suffer too much. More problematic could be commodity suppliers who could find new supplies arriving just as China’s excesses come to an end.

If energy prices join the decline, expect to see that contribute to a further slowdown in the rate of growth in global money supply, which has been fuelled by the dollar surpluses of energy exporters. Expect commodity issues to translate into a sharp fall in the Aussie dollar, which may well come on top of a credit crisis in the Australian housing market. Malaysia’s trade surplus will likely wither and Indonesia could face difficult times if there is a broadly-based commodity decline.

However, most of that is for the medium term. For now it is quite possible that the levels of bank and corporate liquidity in most of Asia will spur a significant pickup in local markets once foreigners desperate for liquidity are gone.

Most of Asia may be too dependent on the US and China markets for its own good. But most countries here are in a better position to stimulate domestic demand than older ones in the Eurozone and Japan. Meanwhile valuations are now mostly below those of the mature economies, which may be less volatile but also have very weak growth prospects and large external deficits and over-extended mortgage credit.

In sum it may be desirable to stay out of Asian markets for the time being, but most of the currencies look to be relatively safe places to hide.