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Opinion

Beware parallels with 1987 financial crash

With markets volatile, Asian states must reinforce their defenses

Despite some worrying parallels between 1987 and today, Asian investors and policymakers seem remarkably complacent.   © The LIFE Images Collection/Getty Image

Like their advanced economy counterparts, Asian investors and policymakers are remarkably complacent about the risk of an economic slowdown and financial market dislocation. Argentina's request for International Monetary Fund assistance after issuing 100-year bonds as recently as last year highlights the speed with which circumstances can change. While their economies are in stronger position, Asia too remains vulnerable.

Since the start of 2018, volatility in financial markets has increased. U.S. stock markets have fallen on some days in absolute point terms by amounts comparable to the crash of October 1987, although smaller in percentage terms, with a maximum drop of under 5%. The 22% fall in 1987 was by far the greatest single-day fall in U.S. history, double the percentage slide suffered on the worst day of the October 1929 crash.

The parallels between 1987 and today go further. In both cases, the economy was growing. There was near full employment increasing fears about rising inflation. There were similar concerns about the U.S. twin deficits, that is, large budget and trade deficits. By coincidence the trade deficit in both episodes approached around 10% of U.S. gross domestic product.

In 1987 like today, equity markets had risen sharply and valuations, by many measures, were high. U.S. interest rates were increasing. The U.S. dollar was weak.

Then as now, trade conflicts were increasing. Then it was focused on Japan and West Germany, both of which had been forced under the Plaza Accord to revalue their currencies. Today, the focus is China and Germany.

In 1987, financial innovations, such as portfolio insurance, helped spread volatility. Today, exchange traded funds, volatility trading, computerized trading and new investment styles such as risk parity funds may act as accelerants of any market correction.

Perhaps, the most eerie coincidence is that in 1987 there were rising tensions between the U.S. and Iran.

There are also important differences. Today, there are additional complications as central banks attempt to normalize monetary policy, ending a period of extraordinarily accommodative conditions which has created roughly half of all global GDP increases over the last decade and driven the rise in global equity and real estate values.

The 1987 crisis was largely confined to financial markets, which recovered quickly. In part, this was because of the first major trial of the central bank put option, whereby U.S. Federal Reserve Chairman Alan Greenspan cut rates and provided large scale liquidity support to financial markets, effectively creating the rule book for all subsequent financial crises.

Today, there is less room for maneuver. First, debt levels are much larger. Second, the problems are now global with both developed and emerging markets affected. Third, the downturn may be exacerbated by the limited capacity of policymakers to respond. Fiscal measures are limited by poor public finances. A return to non-conventional monetary policy, such as central bank asset purchases and zero or negative interest rates, is likely to be less effective. Fourth, the problems will be accentuated by political stresses. Finally, the geopolitical situation globally has also deteriorated sharply.

Over the last two decades, especially after the crisis of 1997/98, Asia took steps to limit exposure to problems in advanced economies. There have been efforts to address critical vulnerabilities -- shift away from fixed exchange rates, boost foreign exchange reserves, and reduce foreign currency debt. These sensible changes may slow the onset of a new crisis. But real economy and financial risks remain.

While local currency debt has increased, levels of unhedged foreign currency debt are substantial. Where the debt is denominated in local currency, foreign ownership is significant, especially in the Philippines, Malaysia and Indonesia. Currency weakness will cause foreign investors to exit increasing borrowing costs and decreasing funding availability.

A weaker local currency resulting from any crisis may not help buffer domestic economies. It will affect prices of staples, food, cooking oil and gasoline, where these are imported. Subsidies to lower prices will weaken public finances. Support of the financial system and the broader economy will pressure government balance sheets.

Other likely responses may compound the problem. Central bank currency purchases, money market intervention or capital controls will reduce reserves or accelerate capital outflow. Higher interest rates to support the currency and counter imported inflation will reduce growth, exacerbating the problems of high corporate and household debt, especially in countries such as China, Korea, Malaysia and Thailand with high levels of domestic borrowing.

There are also new vulnerabilities. The advent of global supply chains means that, compared with when previous crises occurred, Asian economies are far more integrated into advanced economies, especially the U.S. and Europe. Any slowdown will flow rapidly into Asian economic activity.

Asian investors and companies have rapidly increased their financial exposure to advanced economies, including investments in government and corporate debt, equities, real estate and operating businesses. There are many reasons: limited domestic opportunities especially in high growth and high technology sectors, need for diversification including protection against political uncertainty, and obtaining access to intellectual property and new markets. In the event of a crisis, these assets, especially riskier ones, will lose value reducing the wealth and flexibility of investors. This is ironic given that additional investments by central bank and sovereign wealth funds into overseas market were designed to increase financial resilience.

Asia has been slow to address long standing structural weaknesses. Nations remains highly linked to developed economies, especially dependent on foreign demand and, in some cases, foreign capital. This reflects their inability to create an integrated common market in Asia to rival the U.S. or EU. They have been unable to develop domestic consumption, reduce income inequality, avoid poor investments often into uneconomic trophy projects, expand domestic or regional capital markets, improve the business environment and corporate governance, eliminate excessive concentration of economic power in subsidized state corporations, get rid of corruption and reduce political rigidities.

While tolerable in good times, these inherent weaknesses will be mercilessly exposed in any future crisis. While time is short, it would be wise for Asian states to reduce dependence on external demand as well as their financial exposure to advanced economies to improve their ability to withstand potential volatility.

Satyajit Das is a former banker. His latest book is "A Banquet of Consequences" (published in North America as "The Age of Stagnation"). He is also the author of "Extreme Money" and "Traders, Guns & Money."

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