The coming wave of competitive devaluations in Asia

We are today seeing a significantly altered re-run of the 1997 crisis in large parts of Asia. Once again, there is a “sudden stop” and reversal of capital flows. The big difference is the the large reserves that Asian countries accumulated during the crisis.

Korea was the first to realize a few weeks ago that unless they threw the reserves away in a futile defence of the currency, the reserves were large enough to cover the sovereign debts as well as the debts of the banking system. A crashing currency could bankrupt reckless companies, but the country would be safe. They have therefore let the currency collapse and have been free to use the reserves to lend to their over extended banks. In 1997, Asians did not have this option. They thought that the only way to prevent a run on the country was to defend the currency and signal to the rest of the world that they were sound.

I believe that the Korean currency depreciation of recent weeks is going to be the new pattern in Asia. Under normal conditions, most Asian governments are suborned by their corporate sectors, but under conditions like this, these same governments would let reckless companies stew in their own brew. An added incentive this time is that with a slowing global economy, the Asians are going to be fighting for a share of a shrinking export pie. We will therefore see more of the beggar thy neighbour game that the Europeans and Americans played during the great depression. This time around, the western world does not seem inclined to play this game leaving the field wide open to the Asians.

We in India know how ten years ago the Koreans used their depreciated currency to capture the white goods market in India. Now that the won is again at 1400 (closer to 1450 as I write) to the dollar, I see an even bigger onslaught by the Koreans because the best run conglomerates are in far better shape than they were in 1998. It will not just be white goods but every industry where there is global excess capacity (which probably means just about everything).

The won will also put pressure on Japan to embark on large scale intervention (possibly half a trillion dollars over the next year or so) to keep the yen down. The Japanese are possibly more concerned about the euro-yen cross today and their intervention could indirectly help the Europeans. But the Chinese would feel the heat of a declining won and yen.

For a couple of months now, the smart money has been shorting the renminbi (what a change a few months makes!). As Chinese exports slow down, a depreciation of the renminbi would be just what the doctor ordered. Since probably as much as half a trillion dollars of hot money flowed into China in the last couple of years, the Chinese government would just have to sit back and watch this money flow out and pull the renminbi down as it leaves. I would not be surprised if a year from today, Japan once again has the world’s largest foreign currency reserves.

Competitive devaluation by Korea, Japan and China would leave India with no choice but to let the rupee fall to levels which would be frightening (if not bankruptcy threatening) to those who have been stupid enough to borrow in dollars. Beggar thy neighbour is a very ugly game when countries start playing it in right earnest.

Posted at 11:35 am IST on Fri, 24 Oct 2008         permanent link

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