Mike Kerley, Co-Manager of the Asian Dividend Income Strategy along with Sat Duhra, discusses how Asia has remodelled itself following the twentieth anniversary of the Asian Financial Crisis (AFC). Debt-driven rapid expansion and growth have been replaced by conservatism and a focus on cash flow and profitability, which has reshaped investors’ outlook for the region.
In the four years between 1993 and 1996 the tiger economies of Asia led the world in terms of gross domestic product (GDP) growth and stock market returns as foreign and local investors alike embraced the investment opportunity. But trouble was brewing and Thailand was the canary in the coal mine. The strong levels of growth were funded by ever-increasing levels of debt; with offshore interest rates far more attractive than those available at home, US dollars became the funding currency of choice.
While currencies remained pegged to the US dollar the risks appeared minimal. However, a growing trade and current account deficit and rising inflation led to increasing overvaluation of the Thai baht, currency speculation grew and hot money started to move out of the Thai currency. In July 1997, after a futile attempt to stem the outflow, the Thai central bank removed the peg triggering a fall of around 15-20% in the currency − by the end of the year the baht had lost half of its value. The impact on the economy was devastating.
Contagion and a severe lack of confidence dented the whole region, including comparatively developed economies such as Hong Kong and South Korea. The Philippines and Malaysia were also strongly impacted but the most significant downturn occurred in Indonesia. Although Indonesia’s current account deficit was only half the size of Thailand’s, its currency depreciated from around 2,000 rupiah to the US dollar in August 1997 to around 15,000 in late 1998, interbank rates peaked at over 80% and two thirds of bank loans were non-performing.
The Asian Financial Crisis recovery, which on average took more than five years, was supervised by stringent International Monetary Fund (IMF) requirements and has put Asian economies on a much firmer footing. With a few exceptions, Asian currencies are free floating and as a result have much more flexibility to reflect domestic economic and liquidity cycles ensuring that systemic pressures do not build. Current and trade accounts, with the exception of India and Indonesia, are now in surplus with the practice of unhedged foreign borrowing all but ended (Chart 1).
Chart 1: Most Asian countries are now running current account surpluses
Current account as percentage (%) of GDP
Source: CEIC Data, Credit Suisse estimates: Asia Pacific Equity Research, Banks at 31 July 2017.
Meanwhile, Asian corporates’ debt-to-equity ratios have fallen (Chart 2) given more prudent capital allocation resulting in more cash generative businesses.
Chart 2: Leaner balance sheets post AFC
MSCI Asia ex-Japan net debt-to-equity
Source: Factset, CLSA, at 30 June 2017.
ASEAN (the Association of Southeast Asian Nations) used to have short-term foreign debt equivalent to 160% of foreign currency reserves in 1996. This figure is now down to less than 30% and the vast majority of this is from corporates that have corresponding overseas revenue to help offset any potential currency mismatch. The 2008 Global Financial Crisis (GFC) was born out of exuberance in the West and not the East; while Asian economies were impacted by the slowdown in global growth, Asian economic credibility was never called into question.
Structural risks in China
However, one caveat to Asia‘s investment potential is China. A credit boom following the GFC has seen debt-to-GDP balloon to 260% in 2016 from 160% in 2008. The nature of this debt, however, is different from that accrued by Southeast Asian countries in the late 1990s. Firstly most of the debt lies with state-owned enterprises and is therefore backed by more than $3tn of foreign exchange reserves and most of it is denominated in renminbi. Secondly, although China operates a fixed/managed exchange rate regime against a basket of trading currencies, the capital account is closed, which restricts the amount of speculative flows. Finally, most of the debt is owned by domestic institutions and is long term in nature, reducing the likelihood of enforced withdrawal leading to a liquidity crisis.
The impact of the Asian crisis lives long in the memory of Asian corporates. The days of rapid expansion and growth for the sake of growth have passed and been replaced by conservatism and a focus on cash flow and profitability. Corporate debt levels are at all-time lows while cash flow compares favourably to other regions in the world. For these reasons we think that Asia is well positioned relative to more developed economies, which are now showing the stresses that Asia encountered and recovered from 20 years ago.
In our view, Asian markets are currently trading on attractive valuations, corporate earnings are improving and the region’s growth prospects are strong. That said, markets will remain dictated by political factors and economic data especially from the US and China. The Asian Dividend Income Strategy remains focused on domestically-orientated sectors such as financials, information technology, telecoms, real estate and consumer discretionary, with a preference for dividend growth opportunities over defensive high yield based on valuation differentials.