II. Financial Developments in Emerging Asia
- International Monetary Fund. Asia and Pacific Dept
- Published Date:
- May 2006
Capital flows to emerging Asia have declined, mainly because the spread of Asian interest rates over U.S. rates has narrowed and expectations of renmimbi appreciation have waned. Accordingly, apart from brief bouts of pressure, exchange rate appreciations and reserve accumulation have slowed, outside of China. Looking ahead, FDI flows are expected to continue, but portfolio flows could become volatile should the international financial environment deteriorate.
Since the middle of 2005, capital flows to emerging Asia have largely subsided.1 Overall net capital flows actually turned negative in the second half of 2005, after reaching $40 billion in the first half, reducing exchange market pressure considerably. Equity inflows have remained sizeable, but portfolio and other non-FDI inflows have declined sharply as expectations of a renminbi revaluation waned following the adjustment on July 21, and the spread between regional and U.S. interest rates narrowed.
As capital inflows have declined, the accumulation of official reserves has moderated—except in China. In the latter half of 2005, reserve accumulation in emerging Asia excluding China amounted to a mere $8 billion, compared with $32 billion in the first half of last year. In China, the growth of foreign reserves remained essentially unchanged at around $100 billion per half-year, but there was a remarkable shift in the source of the increase, with the proportion coming from capital inflows diminishing and the share coming from the current account growing, as exports boomed while imports stagnated. By the turn of the year, the current balance accounted for nearly all of China’s increase in reserves.
Emerging Asia: Exchange Market Pressure Index
Source: IMF staff calculations.
Foreign Exchange Reserve Accumulation
Sources: CEIC Data Company Ltd; and IMF staff estimates.
At the same time, currency appreciations against the dollar in the region slowed. But with the yen weakening, regional currencies appreciated in nominal effective exchange terms.
There have, however, been brief surges in portfolio inflows, notably around the turn of the year and in March-April 2006. In December, international investors increased their exposure to emerging markets overall, triggering a $10 billion surge in net equity inflows into emerging Asia, the fastest pace since the first quarter of 2004.2 Net inflows continued in the beginning of the year reaching a total of $10 billion for January and February 2006. In response, country authorities initially allowed regional currencies to appreciate, but then stepped up intervention. As a result, reserve accumulation for the region, outside of China, picked up to $25 billion in January. After a lull in February and March, equity inflows picked up again in April, driving a renewed appreciation of regional exchange rates.
Emerging Asia: Equity Inflows, 2004 to 2006Q1
Source: Bloomberg LP.
A key reason why inflows into the region have moderated is that expectations of a large revaluation of the Chinese and other regional currencies have diminished after the Chinese authorities revalued the renminbi. On July 21, the renminbi was revalued by 2.1 percent, far less than many had been expecting. The authorities subsequently have made it clear that there would be no further ad hoc step adjustments in the exchange. In consequence, as the likelihood of a large appreciation has diminished, capital inflows into China have waned, as have “renminbi plays” on other currencies, such as the Korean won.
Another reason why capital inflows have diminished is that interest rate spreads between U.S. and regional rates have generally narrowed. At the beginning of the monetary tightening cycle in the United States in May 2004, the average spread between Asian policy rates and U.S. Fed Fund rates was around 240 basis points.3 But as the Federal Reserve gradually tightened monetary policy while policy rates in the region remained relatively stable from mid-2004 to mid-2005, this spread narrowed to just 70 basis points. Since mid-2005, in response to a pick up in inflationary pressures, monetary policy in the region has been tightened, especially in Indonesia, and the spread has stabilized, amounting to 50 basis points in mid-April. Even so, apart from Indonesia, the spread has vanished and policy rates in most economies in the region have now fallen below that of the United States.
Policy Interest Rates
Sources: CEIC Data Company Ltd; and IMF staff calculations.
Looking ahead, FDI flows into the region are expected to remain buoyant in 2006. Overall net FDI flows increased in 2005 to $66 billion from $55 billion in 2004. This increase was largely due to a recovery in FDI to the ASEAN-4 countries; these flows are now back to levels not seem since 1999. It is not yet clear why this is occurring: in part, ASEAN seems to be benefiting from a desire on the part of multinationals to diversify production locations in the region; in part, China’s boom seems to be stimulating investment in upstream activities, such as mining. In any case, this recovery is projected to continue in 2006.
Emerging Asia: Net FDI Flows
Source: IMF, World Economic Outlook.
Meanwhile, FDI into the two largest countries in emerging Asia should remain strong. In China, large inward FDI flows should continue, although they will be partially offset by growing outward FDI. Flows to India are also expected to rise as the country is seen increasingly as an attractive FDI destination, especially if progress is maintained in improving infrastructure and deepening structural reforms.
As for portfolio flows, these will depend importantly on three factors, starting with the outlook for the renminbi. Since September, revaluation expectations have revived somewhat, with the Non Deliverable Forward (NDF) market pointing to a four percent appreciation in twelve months. But in marked contrast to last year, the range of expected outcomes has narrowed, as the market seem to be pricing in the recent policy statements from the Chinese authorities. At the March 14 session of the National People’s Congress, Premier Wen indicated that there would be no more surprises on the currency front (i.e., ad hoc revaluations) and focus would be placed instead on improving exchange rate flexibility, supported by recent measures taken to liberalize the foreign exchange market.
China: Renminbi Dollar Exchange Rate
Source: CEIC Data Company Ltd.
Second, the outlook for portfolio flows will be affected by the evolution of spreads between Asian and U.S. interest rates. Much will depend on the extent of further tightening by the Fed and the extent to which regional economies follow in raising policy rates. If the tightening cycle in the United States ends quickly, it could alleviate possible pressures for Asian central banks to raise interest rates further. Such a situation would also help shift investors’ focus away from interest rate differentials onto the large U.S. current account deficit and the still-significant Asian surpluses, thereby sparking a weakening of the U.S. dollar and renewed upward pressure on regional currencies. In these circumstances, capital inflows into emerging Asia could surge. Alternatively, if U.S. rates continue to rise well into the year, Asia’s interest spreads could narrow further, weakening the regional balance of payments and perhaps even putting Asian currencies under downward pressure.
Interest Rates: Federal Funds Rates
Source: Bloomberg LP.
The recent narrowing of the policy rate spread has already led to some sizable portfolio outflows. During late 2004-early 2005, when international investors expected regional currencies to appreciate in line with a possible large revaluation of the Chinese renminbi, economies in the region, especially Korea and Malaysia, recorded more than $10 billion of inflows into domestic fixed income instruments. But as expectations of a sizable appreciation of regional currencies waned and U.S. interest rates rose above 4 percent, foreign investors unwound most of their long Asian fixed income positions, causing inflows to turn negative in the third quarter of 2005 and even more negative in the fourth quarter.
Selected Asia: Foreign Inflows into Fixed Income
Sources: CEIC Data Company Ltd; and IMF staff calculations.
In contrast, the end to quantitative easing in Japan is not expected to have much impact on capital flows to emerging Asia (Box 7). The yen carry trade,4 which was fueled by near-zero short-term interest rates in Japan, has certainly financed some investments into higher yielding assets and currencies in emerging Asia. The end of the quantitative easing policy, however, is unlikely to change the underlying conditions for the yen carry trade greatly as any decline in liquidity will affect only excess reserves held at the Bank of Japan (BoJ), while the BoJ has committed to maintain short-term interest rates near zero for some time. Any rise in long-term rates may also be contained, as the BoJ intends to continue its purchases of long-term government bonds. Moreover, thanks to consistent signaling from the BoJ, this policy move has been largely discounted by markets. However, changes in global risk premia or a change in dollar/yen exchange rate expectations that could arise in case of an earlier end to monetary tightening in the United States could still potentially bring about some unwinding of yen carry trades, with significant impact on capital flows.
Third, the outlook for capital flows to emerging Asia would be affected if emerging market spreads surge abruptly and global risk premia rise. So far, capital flows to the region have benefited from a benign international financial environment of low long-term interest rates in the United States and low risk aversion which has fueled declines in emerging market spreads globally as well as in the region. This narrowing of spreads has triggered a boom in external bond issuance, which reached $54 billion in 2005, its highest level since the late 1990s (Box 8). Declining risk aversion has also fueled inflows into stock markets, which have risen by 30 percent on average since mid-2005, setting off in turn a surge in issues of new equity.
In fact, emerging market spreads in the region have tightened further recently, especially in ASEAN-4 economies. Apart from the benign international financial conditions, this also reflected improved market sentiment in the Philippines and Indonesia following the recent adoption of policy packages to deal with fiscal vulnerabilities. In the Philippines, the spread on dollar bonds has fallen below 300 basis points for the first time in recent history, while in Indonesia, investor sentiment has improved markedly after the authorities cut subsidies on petroleum products while at the same time raising interest rates sharply.
Emerging Asia: External Bond Spreads
Source: JP Morgan and Bloomberg LP.
The benign international financial environment could, however, worsen. In this regard, recent financial developments in the United States are giving grounds for caution. Yields on long-term Treasury bonds have increased in 2006—with the yield on the 10-year Treasury bonds reaching 5 percent, its highest level since the beginning of the monetary tightening cycle, two years ago. So far, these developments have not had much impact on emerging market spreads and currencies, but if they were to persist, the recent fall in risk premia that has occurred in the region would likely stop and eventually revert.
United States: 10-Year Treasury Bond Yield
Source: CEIC Data Company Ltd.
Should external spreads rise, the impact on sovereign regional borrowers should be manageable. Among emerging Asian economies, only Indonesia and the Philippines would be affected by a rise in risk premia, given their relatively higher spreads and reliance on foreign financing. But even in these two cases macroeconomic fundamentals have improved significantly over the past few years. Private external debt is now at moderate levels, while fiscal positions have improved—and not only because growth has picked up, but also thanks to a series of fiscal measures.
The impact on regional asset markets should be manageable as well. In sharp contrast to the mid-1990s, asset prices are not overvalued. Housing prices remain well below their pre-crisis peaks in real terms, while equity markets valuations do not appear excessive. Following the recent rally in equity markets in the region, the average price-earnings (PE) ratio has risen from around 12 at mid-year 2005 to 14½ at end-March. But, by historical standards and with the exception of India, these PE ratios are not high—they are still below the average since 2000 of 16—because the rise in stock prices has almost been matched by an increase in corporate profits. Moreover, the region’s equity markets appear still cheaper than emerging markets in other parts of the world.
Price-Earnings Ratio on Equities
More generally, economies have become more resilient to capital account shocks. External vulnerabilities in most countries have been brought down significantly, as external debt levels have declined, foreign reserves have soared, and exchange rates have become more flexible. At the same time, corporates have improved their profitability and reduced their leverage ratios, while banking systems have become much stronger. Companies—and countries—also depend less on the more risky forms of capital inflows, with the share of FDI now much larger than in the mid-1990s and the share of short-term external borrowing much smaller. Similarly, the absolute level of portfolio flows to the region is now much smaller than during the mid-1990s—or even the level of 2003-04.
Still, there are grounds for caution. If a deterioration in the international financial environment is accompanied by a sharp slowdown in the global economy, emerging Asia—given its extensive trade and financial links with the rest of the world—would not remain unscathed.