Asia: capital flows

[Eubulides <paraconsistent@xxxxxxxxxxx>]

http://www.atimes.com/
Asia's capital flows - this time it's different
By John Mulcahy

Asia's economies have made the transition from victim to villain without
passing through the hero phase. Five years ago the Asian currency crisis
produced a seismic shift in capital as investors ran for cover, slashing
80 percent off the Indonesian rupiah's value, for instance, in less than
six months. Now the money is flowing back into Asia, forcing massive
intervention by the Bank of Japan (BOJ) to curb the yen's strength, while
China dismisses pressure to revalue or float the yuan.

So what is different this time? ABN AMRO's chief Asian strategist, Eddie
Wong, argues that the appreciation of Asian currencies "will be a long and
gradual process, as will the trend of capital flow to Asia". ABN AMRO's
view is that the evidence of private-sector funds flowing back into Asia
suggests that economic growth is shifting "back from the West to the
East".

Capital has no conscience, of course, and the funds flowing into Asia are
far more concerned with expectations of above-average returns than with US
Treasury Secretary John Snow's aggressive lobbying for a realignment of
Asian currencies. It is no secret that Asia's domination of global
foreign-currency reserves rankles in certain quarters, prompting Snow's
strident posture on the issue. Japan and China together account for more
than 50 percent of global foreign-currency reserves, and by some lights
the yen and the yuan should be allowed to find their own level.

The perceived undervaluation of the yuan has other effects as well, not
least the claim that China is competing unfairly with US manufacturers of
clothing and toys. While the claim of unfair competition may or may not be
true, it is by no means certain that a floating yuan would actually rise.
The instability of China's banking system and pent-up "hot money" outflows
could well swamp the beneficial effects for the currency of China's
massive trade surplus. In any case, this is a moot point, as there is
little prospect of Beijing succumbing to pressure from the United States
or anywhere else to revalue or float its currency.

In a recent report, HSBC economist Geoffrey Barker notes that "the Chinese
authorities have critical domestic challenges that are likely to take
priority over altering their exchange rate. They need to dampen the surge
of investment spending that threatens to lead to a fresh round of NPLs
[non-performing loans] for the banking system."

Japan's dilemma is that it is still in the throes of deflation, and it
desires a weak currency to tackle that problem. Ideally, the yen should
fall to 150-200 to the US dollar. However, in the wake of the Group of
Seven (G7) joint statement on September 20 calling for more flexible
exchange rates, the yen strengthened to 110 against the dollar as capital
surged into Japanese assets. The BOJ poured money into the dollar as its
intervention reached a monthly record of US$40.6 billion, taking the
Japanese central bank's intervention to $121 billion for the year to date.

Asia has a quality problem for the first time in years. It is attracting
huge interest again, marked by an estimated 1,000 institutional investors
attending stockbroker CLSA's investor forum in Hong Kong and China last
month, and by a pronounced increase in market liquidity across the region.
"People who didn't want to know about Asia three months ago are desperate
to participate in placements," says David Williamson of Daiwa Securities
in Hong Kong.

And, according to HSBC economist Barker, "the flow of funds is shifting
away from financing overseas (especially US) growth and consumption, in
favor of financing growth in the region". He says the appreciation of
Asia's floating currencies, led by the yen, is partly in response to
political pressure and partly a function of a cyclical improvement in the
Japanese economy.

It is this latter point that will produce sustained capital flows. It is
true that short-term capital flows resulting from currency speculation
precipitated the Asian currency crisis in 1997, but it was economic growth
in the 1990s that required substantial capital, and a faltering of this
growth that led to the flight of investment capital from 1997 onward.
South Korea's foreign debt rose from about $44 billion in 1993 to $157
billion in 1997, while over the same period Thailand's foreign debt
doubled to $96 billion, and Malaysia's foreign debt also doubled between
1992 and 1997, to $43 billion.

While investors in Asia have been reading the runes to establish the
timing of a reflationary cycle that would underpin the domestic asset
markets, the prospect of rising prices is far more ominous for the United
States. Concerns about inflation tipped the bond market over the edge in
July, although it has since stabilized. However, any evidence pointing to
a pickup in China's inflation would be seen as a precursor to another
round of US inflation.

Any real evidence of renewed inflation would be accompanied by a shift in
monetary policy by central banks, which have almost universally adopted an
easing stance in recent times. At the moment the movements in capital have
been modest, and there is no immediate threat of inflation accelerating in
Japan or China, but it is likely to be a concern by 2004 and beyond.

In its world economic outlook, published ahead of the annual meetings in
Dubai last month, the International Monetary Fund (IMF) said Asian
currency intervention was helping to push the world economic recovery off
balance. The IMF's chief economist, Kenneth Rogoff, said the world
recovery was "dangerously dependent on domestic demand in the US, driving
the US current-account deficit up to unsustainable levels".

Rogoff added that the growing US deficit would induce a sharp decline in
the dollar at some point. "If the euro has to bear the lion's share of the
adjustment in the dollar, that is going to create a lot more difficulties
than if all the Asian currencies also allow themselves to appreciate
significantly against the dollar."

And so the debate rages, but the capital continues to ignore the sophistry
as it seeks returns. CLSA strategist Christopher Wood notes in his Greed &
Fear report that the MSCI Asia ex-Japan index has risen 39 percent from
its bottom in May, while the Standard & Poor's 500 is up 24 percent from
its March low.

"The stellar performance of both Japan and the rest of the Asian region
during the past six months is without doubt generating renewed interest in
the Asian equity investment story among global investors and asset
allocators," Wood argues.

The question is whether the flows will be orderly or whether the momentum
will again drive values so far and so fast that investors will soon be
paying too much for assets, sowing the seeds of the next Asian crisis. The
availability of unlimited cheap capital during the 1990s fueled the
classic boom and bust during that decade. In 2003, though, the wounds are
still fresh, and while portfolio investors may be paying too much for
capital, there is no compelling evidence to suggest that managers of
businesses are misallocating capital in the way they did during the 1990s.

It is true that the concentration of foreign equity investment into Asia
tends to distort capital allocation. Individuals in Paris, Texas, or in
Graz, Austria, are unlikely to invest directly in Thailand, Indonesia or
the Philippines. Instead, they will channel their investments through
banks or mutual funds, which in turn bundle the funds and transfer them to
specialist fund managers. History suggests that many of these
institutional fund managers think and act alike, producing a herd
mentality that is currently producing huge flows into Asian markets, but
which can similarly reverse as the "herd leaders" change their views.

Asian equity placements, few and far between from 1998 until very recently
(except for the dot-com period), are now a daily occurrence. The owners of
businesses are happily selling equity at current prices to investors from
Europe and, especially, the United States. Do these businesses actually
need the capital, or are they simply taking advantage of liquidity and
raising capital because it is there? A bit of both is the most probable
answer, as investment banks and stockbrokers, starved of business for
several years, rush to mop up as much of the incoming capital as possible
before the liquidity dries up again.

"The first few placements will do very well, but eventually the appetite
will be satisfied, and investors will realize that they will need to see
some performance before putting more money into these markets," says
Daiwa's Williamson in Hong Kong.

There is no doubt that Asia has rebooted itself since the cataclysmic
crisis of the late 1990s. According to the World Bank, Asia ex-Japan's
average savings rate for the period 1997-2001 was 37 percent of gross
domestic product (GDP), compared with 20 percent for Europe and 15 percent
for the United States. The creation of its own capital base has been East
Asia's persistent attraction for international equity investors, and this
time really is no different. The question, though, is whether the returns
on this capital will be any better than during the last period of capital
shift from the West to the East.

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To this day, no one has come up with a set of rules for
originality. There aren't any. [Les Paul]