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If US hikes its rate, will there be another Asian currency crisis?

While the Federal Reserve Board did not hike its benchmark interest rate in September, the U.S. central bank is still likely to start raising the rate by the end of the year. Fears are rising among market players that emerging market currencies may weaken significantly against the dollar if the greenback, which has been flowing into emerging markets, flows back to the U.S. as a result of a U.S. policy rate hike due to investors seeking higher interest rates. The Japan Center for Economic Research has recently conducted analysis of the vulnerability of the currencies of 15 emerging market and Asian countries, using five economic indicators. As a result, the research institution found that the Malaysian currency suffers relatively high vulnerability in comparison to the currencies of other Southeast Asian countries.

     Given that factors influencing currency fluctuation are complex, it cannot be simply predicted how currency markets will react. However, for the purpose of the analysis, we have chosen five economic indicators. Those are current-account balance, fiscal balance, external debt, foreign exchange and inflation rate. We then compared those factors derived from Asian and emerging countries. In addition to China, Indonesia, Thailand, Malaysia and the Philippines, which are regularly covered by the JCER's short-term Asian economy forecast, South Korea, Taiwan, Hong Kong, Singapore, Vietnam and India were added for the purpose of this analysis. Furthermore, Brazil, Turkey and South Africa, which are three of the "fragile five" countries, and Russia, which is one of the BRICs, were also added as subjects for comparison. Consequently, a total of 15 countries or regions were chosen as subjects for this analysis.

Big debts, small reserves

The chart below has the current-account balance as a proportion of nominal gross domestic product on the vertical axis and fiscal balance of general government (total of central and local government) as a proportion of GDP on the horizontal axis, with each country's figures plotted on the chart. The most recent current-account balance and fiscal balance are plotted, as well as those of the three years up to 2014, so that the chronological variations of the two criteria can be observed. 

     It is believed that currencies of countries with "twin deficits" are more vulnerable. Such countries' current-account balances and fiscal balance are both in the negative territory. Countries classified as being within the "fragile five" are such countries. Among them, we can see that India and Indonesia are improving as their current-account balances are approaching the zero line. Countries and regions, excluding Singapore, Hong Kong, South Korea and the Philippines, are in fiscal deficit territory. Thailand's current-account balance was in deficit in 2012, but is subsequently in surplus. We can also see that Malaysia and Vietnam's current-account surpluses are getting smaller.

     The chart below has the ratio of foreign debts to GDP on the horizontal axis and the ratio of foreign exchange reserves to the amount of short-term foreign debt on the vertical axis. The most recent figures are for March in 2015. Figures over the three years through 2014 are also plotted, so that variation over time can be seen. The horizontal axis shows that the smaller the figures get, the smaller the amount of foreign debts. The vertical axis shows that the bigger the figures get, the greater the foreign exchange reserves that countries have, which means that the currencies' vulnerability is low.

     Looking at the two axes, we can see that Malaysia's currency appears the most vulnerable. Turkey, Russia and South Africa -- three countries classified as one of the "fragile five" -- have large external debts. However, Malaysia's are bigger. The Southeast Asian country's foreign currency reserves are only 10% larger than its short-term external debts. Thailand, South Korea, Taiwan, Indonesia and Vietnam are found at similar locations in the chart. Their foreign debt ratios are 30-40%, while their foreign currency reserves are more than double their short-term external debts. The Philippines' external debts are not as big as those of other Southeast Asian countries. The country also has abundant foreign exchange reserves, which are increasing. 

     Looking at inflation rates, Indonesia's is around 7%, which is considered high. The second highest inflation rate in Southeast Asian countries is Malaysia's. Although the country's rate is on the rise, it remained at the 3% as of August. Inflation rates of Thailand and the Philippines are declining, with the Thai economy already in deflation and the Philippines' rate below 1%. 

     Assessing those five indicators as a whole, it turns out that, out of Southeast Asian currencies, Malaysia's currency vulnerability is becoming higher. The JCER's separate analysis also shows that Malaysia is most influenced by the world's two biggest economic changes, which are falling crude oil prices and China's economic slowdown. On top of that, Malaysia is also likely to be impacted by any hike in the U.S. interest rates.

     Having said that, however, Malaysia's current-account balance remains in surplus, and it is expected to still be in surplus in 2016.  Consequently, it is unlikely that the country will be short of foreign currencies and face another currency crisis, as occurred back in 1997. Nevertheless, concerns are emerging about things other than economic indicators, such as China's devaluation of the yuan in August and political uncertainty caused by Prime Minister Najib Razak's alleged corruption scandal.

     Malaysia is not the only Southeast Asian country that suffers from political uncertainty. Thailand, for instance, has been ruled by a military government for a prolonged period. Indonesia is now questioning President Joko Widodo's leadership ability. The Philippines will see a transfer of power in May 2016. Given that, it is necessary to pay even greater attention to political trends in Southeast Asia in order to predict changes in the currency market.

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