When the Asian financial crisis occurred 20 years ago, many nations in East and Southeast Asia succumbed because they were following inconsistent domestic and international economic and financial policies. But one trigger was the 50% fall in the Japanese yen against the dollar between the end of 1995 and the summer of 1998 amid the American stock market's bull run that lasted until 2002.
Fast forward to today, and the dollar is on a roll again, thanks to a strong economy and tensions between its fiscal and monetary policies. Higher U.S. interest rates and a stronger dollar are already raising debt interest costs for Asian borrowers, but this time the falling Chinese yuan looms as a proximate cause of trouble.
Asia's vulnerability to developments in U.S. financial markets has been widely noted. It is true that unlike the Asian financial crisis of 1997-1998, most countries in the region have stronger foreign exchange reserves. They are better positioned when measured against important indicators such as months of import cover, short-term debt and foreign debt ratios.
Most Asian countries have current account surpluses, and even those with deficits, such as India, Indonesia, Myanmar and the Philippines do not look overly challenged. But while the sensitivity to shocks is lower than it was 20 years ago, there is no cause for complacency. And there is still a potential spoiler, the yuan, which is now under downward pressure, but which was an agent of calm in the last Asian crisis.
The yuan has weakened by more than 8% against the dollar to 6.83 yuan from a high of 6.28 yuan in March. This is far off the low of 6.96 yuan at the end of 2016 before China tightened capital controls significantly. To some extent, this reflects the markets' reaction to the evolving U.S.-China trade war, as well as some guidance by the People's Bank of China.
But it also has to be seen in the context of the cumulative consequences of tighter Chinese financial policies over the last 18 months, which has resulted in the loss of economic momentum. In response, there has been a recent loosening of monetary and financial policies, in which bank reserve requirements have been trimmed three times this year, short-term interest rates have eased, and longer-term rates have dropped more markedly.
In this context, a Sino-American trade war is not only most unwelcome but also untimely. In July, the U.S. implemented a new 25% tariff on $50 billion of imports from China. U.S. President Donald Trump threatened to increase the tariff rate from 10% to 25% on a further $200 billion of imports from China if the latter retaliated (which it did), and even subject all $500 billion or so of annual imports to tariffs. Beijing's riposte was to threaten variable tariffs on an additional $60 billion of imports from the U.S.
Since China only imports about $150 billion of goods from the U.S., the scope for its own tit-for-tat tariffs is almost exhausted. If it wants to continue hitting back at the U.S., it will have to resort to some combination of currency depreciation and the use of its extensive system of regulations to target U.S. products and companies doing business in China. As far as depreciating the yuan is concerned, the Chinese authorities are moving into dangerous territory.
So far, the 8% weakening in the currency against the US dollar has more or less compensated for the U.S. tariffs imposed. But because China's tit-for-tat tariff capacity is limited, any further broadening of U.S. tariffs, as Trump has proposed, would require the currency to decline further in value to around 7.25-7.30 yuan against the dollar or even more.
This would take the currency back to levels not seen since the major currency reform and alignment of multiple exchange rates in 2008.
From a technical perspective, chart investors worry that the fall of the yuan to below 7 to the dollar could open the way for a marked depreciation. This might happen in any case in due course, because of a weaker domestic economy and associated policy easing. But now would not be good time.
Washington would see any further significant fall in the yuan as a serious escalation of the trade war, and the chances of halting or lessening it would be gone. It would probably unhinge other Asian currencies as well as global markets.
Since the Asian financial crisis, supply chains have grown bigger and more intricate and trade dependencies have become greater. This means that global sensitivity to significant change in the yuan -- increasingly the anchor currency in Asia -- is more significant. Whether they are dependent on transnational supply chains, exports to China or income from Chinese tourists, Asian nations in both Southeast and Northeast Asia are likely to be concerned about a major fall in the yuan.
For China to sanction a sharp depreciation might be "a bridge too far" for all these reasons. It would certainly represent a major risk to domestic financial stability in China when there are reports emanating from Beijing that not everyone is happy with President Xi Jinping's handling of the trade dispute with the U.S. or, more generally, with his authoritarian leadership and its consequences for the country.
A yuan depreciation could also trigger a resumption of capital flight, even though the post-2016 system of controls has proved to be much less porous than the previous regime. The People's Bank of China is now acting to penalize traders who are looking to go short on the yuan. It has the tools, including the use of currency reserves to intervene, to stand its ground if the politics so dictate.
Asia should play close attention to China's central bank in coming weeks, and equally, to the bigger picture in which further yuan depreciation may happen, regardless of how China chooses to manage it. All of this means that policymakers -- regional and otherwise -- should be prepared to allow a mixture of responses, from local currency depreciation to monetary and fiscal measures, to address the consequences.
George Magnus is an associate at Oxford University's China Centre and former chief economist at UBS. His latest book is "Red Flags -- Why Xi's China is in Jeopardy," to be published in September by Yale University Press.