Rising reserves of Asian economies may be contributing to excess liquidity

Another Asian Contagion May Be Only a Bad Currency Trade Away
By Matthew Benjamin and Shamim Adam

June 18 (Bloomberg) -- The next Asian contagion may be only a bad currency trade away.

Ten years after the collapse of Asian governments' overvalued currencies in 1997, the remedies they embraced to prevent a recurrence may have only traded one set of risks for another. Their ``never again'' determination has led them to new extremes: artificially low currencies, a record $3.4 trillion in reserves and export-dependent economies.

``The currency and financial policies in Asia today risk planting the seeds of a new and different financial crisis,'' says Nouriel Roubini, 49, chairman of Roubini Global Economics and a professor at New York University's Stern School of Business. ``It's a dangerous system both for these countries and for the global economy.''

In emerging markets, central banks and governments are grappling with risks including inflation, asset bubbles and vulnerability to a U.S. slowdown. For investors, meanwhile, ``risk has been underpriced,'' Roubini says, with the result that ``this can have negative effects on bonds, currencies and equity markets.''

Thailand sparked the Asian crisis in July 1997 when it devalued the baht in an effort to shore up its faltering economy, abandoning a costly policy of pegging the currency to the U.S. dollar.

Stampede
That set off a chain reaction that turned Asia's investment and real-estate boom into a bust, leading to a stampede by foreign investors rushing to pull money out. The crisis worsened as foreign-exchange reserves proved insufficient to prevent the region's currencies from plummeting.

Emerging markets have made some progress toward avoiding a similar catastrophe. Central banks are more independent, government debt has declined, financial systems are stronger and current-account balances are generally in surplus.

Economies from Russia to Brazil are booming while Indonesia, Thailand and Malaysia have earned higher credit ratings. South Korea, on the brink of default 10 years ago, recorded its 16th consecutive quarter of growth in the first three months of this year.

``A lot of lessons have been learned,'' says financier George Soros, whom Malaysia's then-Prime Minister Mahathir Mohamad blamed for worsening the 1997 crisis through currency speculation. Soros, 76, told reporters June 5 in Sao Paulo that many economies ``are incomparably better than they were 10 years ago.'' Still, he said, some governments have learned ``the wrong lesson,'' citing price controls in Argentina and ``very substantial reserves'' in Brazil.

`State of Denial'
Anwar Ibrahim, Malaysia's finance minister during the crisis, says ``fundamental flaws have not been corrected.'' Currencies are still inflexible, showing that ``we are still in a state of denial,'' he says.

As investors fled Asia after Thailand's 1997 devaluation, they set off a plunge in other currencies that had previously been propped up through fixed exchange-rate regimes. Indonesia's rupiah fell 57 percent against the U.S. dollar, causing companies to buckle under $80 billion in foreign debt and leading to riots in Jakarta.

Thailand's baht dropped 45 percent, and its stock market fell 75 percent. South Korea's won lost half its value, and its economy collapsed. Malaysia's ringgit fell 35 percent.

Hong Kong, China, Singapore, Taiwan and the Philippines also suffered. The crisis eventually spread to South America and to Russia, which defaulted on $40 billion of debt.

The IMF's Advice
Malaysia's Anwar says many governments still haven't followed the International Monetary Fund's advice to adopt flexible exchange rates that can help dissipate financial pressures.

``Fixed currencies are still a problem in the region, and they're always politically motivated,'' says Anwar, 59, who was fired in 1998 when Mahathir imposed capital controls.

China, Hong Kong, Taiwan, Malaysia, Singapore, Thailand, India, Russia and Argentina still manage their currencies, generally maintaining artificially low levels. South Korea and Indonesia allow more flexibility.

``They're all managed floats,'' says Stephen Jen, global head of currency research for Morgan Stanley in London. ``For the most part, they're more managed than float.''

Cheap currencies have led to excessive monetary and credit growth worldwide, creating asset bubbles in South Korea and China and inflating consumer prices in India, Russia and Argentina.

Credit Restrictions
Policy makers in Asia are adding restrictions on lending and increasing taxes on share trades to combat bubbles that have made Hong Kong rents the world's costliest and Chinese stocks twice as expensive as others in the region.

In December the Bank of Thailand imposed penalties on investments from overseas held less than a year in an effort to keep speculators from driving up the baht. This triggered the biggest one-day drop in 16 years for Thailand's SET stock index, which plunged 15 percent on Dec. 19.

Undervalued currencies have also helped make Asia's emerging economies almost twice as reliant on exports as the rest of the world. ``A sharp slowdown in global demand would have major ripple effects,'' says Robert Subbaraman, Lehman Brothers' Hong Kong-based chief economist for Asia excluding Japan.

Meanwhile, the build-up of foreign-exchange reserves, part of the IMF's prescription for avoiding a repeat of the 1997 crisis, has exceeded all expectations.

`Overlearned'
``Some lessons were overlearned,'' says Ted Truman, 66, a senior fellow at the Peterson Institute for International Economics in Washington.

South Korea's reserves, depleted in its unsuccessful defense of the won during the crisis, are now the world's fifth- largest, burgeoning to $250 billion from $7 billion in November 1997. China added $1 million a minute to its reserves in the first quarter of this year and now holds $1.2 trillion. India, Japan, Taiwan and Russia hold more than $200 billion each.

Truman and other economists say the massive reserves contribute to excess liquidity.

``It may no longer be appropriate to view rising reserves as a source of increasing strength against future volatility,'' New York Federal Reserve Bank President Timothy Geithner said in Singapore last week. Geithner, 45, was the U.S. Treasury Department's assistant secretary for international affairs during the crisis.

Opportunity Costs
There are opportunity costs to holding excess reserves that might otherwise be invested in infrastructure improvements, health care or higher-yielding assets, economists say.

``They're paying an enormous price in terms of standards of living,'' says Harvard University's Kenneth Rogoff, who was chief IMF economist from 2001 to 2003. ``It's as if you bought a $1 million home sitting on the San Andreas Fault and a $3 million insurance policy for it.''

What's more, by focusing on exchange rates, governments in emerging economies may overlook other risks, says Stephen Roach, chief global economist at Morgan Stanley, who becomes the firm's Asia chairman this month.

``The next crisis is never the same as the last,'' he says. ``By fixating on the problems that foreshadowed the last crisis, the risk is Asia gets blindsided by another problem.''